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Developed By
Mr. Yogesh Ashar
&
Prof. Rajesh Haldipur Under
Prof. Kanu Doshi, Dean Finance, Welingkar
1
Introduction to Financial
Accounting
Objectives :
After completing this chapter, you will be able to understand:
Principles of Accounting.
Financial Statements.
GAAP
Structure
1.1 Introduction
1.2 Limitations of Accounting
1.3 Scope and Importance
1.4 Concepts and Conventions
1.5 GAAP
1.6 Forms of Organisation
1.7 Summary
1.8 Self Assessment Questions
1.1! INTRODUCTION
Why Financial Accounting?
What is common to all these Individuals?
i) Ms. Sudha Narayan Murthy (Infosys) - The Wealthiest Woman in India
ii)Mr. K P Singh (DLF Group) - The Wealthiest Man in India
iii)Ms. Perween Warsi (S&A Foods Samosa Queen) - The Wealthiest Indian
Woman Outside India
iv)Mr. Laxmi N. Mittal (Mittal Steel) - The Wealthiest Indian Outside India
v) Mr. Bill Gates (Microsoft) - The Wealthiest Man in USA
vi)Mr. Warren Buffett (Berkshire Hathaway) - The Second Wealthiest Man in USA
They are all very Rich & Famous. But above all, they hold Equity Shares in
companies indicated against their names and which are listed on recognized
stock exchanges.
How do we determine that they are Wealthy?
We can determine their wealth by counting, by accounting, by recording, by
valuing all their worldly wealth, their assets, their estates, their properties,
possessions and financial liabilities, if any.
Accounting all incomes, expenses, assets & liabilities in Monetary Terms (in
Rupees) is the sole determinant of all economic activities of all businesses,
industry, trade, commerce, also of fashion designers; software giants, media
moghuls and even NGOs (CRY, Lijjat Papad).
Accounting helps recording all financial transactions enabling preparation
of:
I. Trial Balance
II. Profit and Loss Account
III. Balance Sheet
IV. Cash flow Statement
Financial statements have their use to several segments of the society who
are called Stakeholders:
1. Shareholders
2. Investment Advisors, Analysts
3. Creditors, Vendors, Suppliers
4. Labour (Workers & Employees)
5. Government (Local, State, Central)
6. Researchers (Faculty)
7. Students of Finance
In any business, there are Purchases, Production, Sales, Loans, Stocks, Debtors,
Creditors, Bank Balance, Profits & Losses. Unless you produce goods or
services, you cant sell and unless you sell, you cant have profit. But not all sales
can be made at a profit all the time. There can be sales at a loss also. So what is
important for a business? Sales or Profit? Ideally Profitable Sales!
Basic Principles of Accounting:
Accounting is a Science (Recording) as well as an Art (Interpreting). It records
only financial transactions and records only Historical Costs (Not Market value).
These are recorded and prepared as an ongoing concern basis (not winding up)
(Capital & Revenue) (Matching concept). It expects on a year to year basis
Consistency (depreciation, stock valuation). Accounting is governed by principles
of Conservative basis (provide for unrealized losses; but ignore unrealized
profits). Accounts are prepared in a manner that the Business is separate from
the owner (hence owners capital is liability) (Business entity).
1 ENTITY CONCEPT.
2 GOING CONCERN CONCEPT.
3 MONEY MEASUREMENT CONCEPT.
4 HISTORICAL COST CONCEPT.
5 ACCRUAL CONCEPT.
6 ACCOUNTING PERIOD CONCEPT.
7 MATCHING COST AND REVENUE CONCEPT.
8 DUAL ASPECT CONCEPT.
9 COST ATTACH CONCEPT
10 VERIFIABLE OBJECTIVE EVIDENCE CONCEPT.
1 ENTITY CONCEPT:
According to this concept, the business is different from the person doing the
business. The business has a separate identity or personality which is different
from the persons or entities in the business such as proprietors, partners,
managers or the employees. Therefore, we find that all accounting records take
note of the transactions between the owner and the business. The owners are
treated as outsiders for the purpose of recording transactions. The entity concept
is applicable to all forms of business such as sole trader, partnership, Joint Stock
Company, Co-operative societies.
The transactions relating to the business only are recorded. The personal
transactions of the proprietor are not recorded in business. Similarly, the
transaction between the organisation and the proprietor is also recorded.
The Capital is shown as a liability in accounts according to the concept. It means
the capital is the money the business has to refund to the proprietor.
This concept is applicable to all forms of business organisations. In the eyes of
law, the sole trader and his business are one and the same. But for accounting
purposes they regarded as separate entities. The same is applicable in case of
Partnership firm as well.
It does not mean that the asset will always be shown at cost. It only means that
cost becomes the basis for all subsequent accounting for the asset. So the asset
may be depreciated at the end of each year and the value may be reduced.
The cost concept brings objectivity in the preparation and presentation of financial
statements.
For example: if a plot of land is purchased for Rs.200,000, it will be recorded in
the books as Rs.200,000 only even though the present market value of the land
may be Rs.500,000.
5 ACCRUAL CONCEPT:
This concept is the recognition of income and cost as they are earned or incurred.
It is not as money is received or expenses are paid. In simple words, according to
this concept we have to record the expenses for the given period say one year
even if the said expense is paid or not.
For example: we record outstanding expenses at the end of the year. It means we
have not paid the expense. But it has accrued. In the same way we also provide
for income accrued, even though it is not received.
Thus under this concept, revenues and expenses relating to a particular period is
considered. Therefore, expenses paid in advance is excluded, but expenses
outstanding is included. Similarly, income received in advance is excluded, and
income receivable is included in the books of accounts.
6 ACCOUNTING PERIOD CONCEPT:
This concept is also known as Periodicity Concept. According to this concept, the
calculation of profit or loss made cannot be postponed indefinitely or till the
business is closed. Therefore the accounting period is to be seperated. This
accounting period is generally one year. It is within this period we have to
determine the profits earned by the business or the loss suffered by the firm. It is
within this period we have to see the increase in assets or the decrease in the
assets or increase or decrease in liability.
The preparation of profit and loss account for the year ended is the best example
of accounting period concept. This concept helps to test the profitability of a
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3 CONVENTION OF CONSISTENCY:
This convention indicates that the procedure selected by the company must be
followed consistently every year. The financial statements will be comparable only
if the procedure is followed consistently.
There are several methods of charging depreciation, such as Straight Line
Method or Written Down Value Method etc. Once the company decides to follow
one particular method, then it must follow the same method year after year. In the
same way, there are different methods of valuation of stock such as FIFO or LIFO
or Average price etc. The company may adopt any of the methods of valuation of
stock, but it must be followed consistently.
However, this convention does not mean the company must be very rigid.
Whenever it is desirable, the company may change the accounting procedure.
This should be done only when there is an improvement in procedure or to
introduce a new procedure. When a change is introduced, the company must
make a disclosure of the changes made. Similarly, the procedure should not be
changed very often.
4 CONVENTION OF CONSERVATISM:
This is one of the oldest conventions of accountancy.In olden days, the Balance
Sheet was considered as one of the most important documents. It established the
valuation of assets.
Conservatism in short means the policy of playing safe. According to this
convention while preparing accounts we must not take into account any profits
unless they are realised. However, we must provide for all anticipated losses.
Sometimes, this convention is criticised on the grounds that it provides scope for
creation of secret reserves and it is against the convention of disclosure. As a
result of this convention, the profit and loss account shows lesser profit and the
Balance Sheet overstates the liability.
1.5! GAAP
13
The primary agency responsible for GAAP in India is the Accounting Standards
Board of The Institute of Chartered Accountants of India (www.icai.org). In the
US, the equivalent is the Financial Accounting Standards Board (FASB). The
Securities Exchange Board of India (SEBI) oversees companies whose shares
are publicly traded, while the Company Law Board (CLB) oversees disclosure
norms in general for all companies in India. In the US, there is a single agency
called the Securities Exchange Commission (SEC). In short, the GAAP are the
rules; the ICAI makes the rules and SEBI and CLB enforce the rules.
A basic tool used by accountants to explain business transactions is the
accounting equation. It can be expressed variously as:
Resources = Equities
Assets = Liabilities and Owner's Equity
Assets = Liabilities and Shareholders' Equity
Assets = Rs. 10 Lakhs
Liabilities = Rs. 7 Lakhs
Capital = Assets - Liabilities
(In the above example, assets are Rs. 10 lakhs and liabilities are Rs. 7 lakhs.
Hence, capital is Rs. 3 lakhs)
Shareholders' Equity consists of two parts: Capital (investment by owners) and
Retained Earnings (net income accumulated over the life of the corporation less
any dividends paid). Brief definitions of other terms in the accounting equation are
as follows:
Assets are economic resources owned by the organization. They are Unexpired,
Prepaid or Stored Costs, except Cash and Debtors. They are future probable
economic benefits as a result of past transactions or events.
Liabilities are debts owned to third parties. They are Economic Obligations or
probable sacrifice of future economic benefits arising from present obligations.
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Owner's Equity is the owner's interest in the net assets of the enterprise.
Obligations to the Owners are called Equities and include Capital and
Reserves.
Shareholders' Equity is the collective interest of all Shareholders in the net
assets. Equity in this sense is the residual interest in the entitys assets
remaining after liabilities are met.
Net assets means (Assets Liabilities)
All business transactions can be expressed in terms of the accounting equation,
and it is important to gain some mastery over describing business transactions in
terms of the accounting equation. We will discuss this further in Chapter 2.
An account is a summary device used by accountants to describe changes in
assets, liabilities, and shareholders' equity. There are various kinds of asset
accounts such as cash, land, accounts receivable, etc. Equally, there are various
kinds of liability accounts such as accounts payable, taxes payable, etc. For our
current purposes, there are just two categories of shareholders' equity accounts:
Paid-up Capital and Retained Earnings. Note that revenues increase retained
earnings and expenses decrease retained earnings. Finally, dividends decrease
retained earnings.
The end product of the accounting process is the production of financial
statements, which describe in some detail how the business organization is
performing. The basic financial statements required by Indian GAAP are:
Income Statement (also commonly called as the Profit and Loss Account)
Balance Sheet
Statement of Cash Flows
The basic financial statements required by US GAAP are:
Income Statement
Statement of Retained Earnings
15
Balance Sheet
Statement of Cash Flows
16
which do not have the two restrictions as above, and they need to have at least 3
directors and at least 7 shareholders at all times. All these conditions are as laid
down by the Companies Act and/or in the Memorandum of Association of a
company, which is like the Charter under which the company is established.
Companies are treated as legal entities separate from its shareholders, who are
co-owners of the undivided fruits of the companys assets and operations. This
means that it enjoys a continuance of existence beyond that of its shareholders.
Since it is a separate entity, it is also taxed separately. Public companies are also
classified as widely held and closely held. Widely held companies are those
whose shares are listed on a recognised stock exchange. Listed means that
shares can be publicly traded on stock exchanges openly and without restriction.
All public companies other than these are considered closely held.
4 BANKING COMPANIES:
Banking Companies are similar to Joint Stock Companies. But the maintenance
of Books of Accounts and preparation of Balance Sheet etc. are governed by
Banking Regulation Act.
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5 INSURANCE COMPANIES:
In case of Insurance Companies, the main source of revenue is the premium
collected by the Insurance Company. But the entire premium collected cannot be
treated as income because there is a contingency of claim. There are provisions
in the Insurance Act regarding how much portion of the premium can be taken to
revenue and how much must be kept in reserve.
1.7 SUMMARY
Accounting covers recording of all financial transactions to prepare meaningful
summary statements in the form of trial balance, profit and loss statement,
balance sheet and cash flow statements. These are very useful to shareholders,
investment advisors / analysts, creditors / suppliers, employees, Government,
researchers and student community.
It is based on principles of use of historical costs, recording on a going concern
basis, consistency, conservatism in accounting unrealized losses but ignoring
unrealized profits and treating owner as a different entity than the business. The
important principles are included in universal guidelines known as Generally
Accepted Accounting Principles (GAAP). The primary agency responsible for
GAAP in India is the Institute of Chartered Accountants of India. These are
enforced by Company Law Board and SEBI.
For collecting and presenting financial data, a summary device called an account
is used.
To establish credibility in financial statements companies arrange to have them
verified by independent qualified experts called Auditors.
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video1
Video2
Video3
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2
Accounting Mechanics: Processing
Accounting Information
Objectives:
After completing this chapter, you will be able to understand:
Three Golden Rules
Accounting Cycle
Trial Balance
Financial Statements
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Structure :
2.1 Introduction
2.2 Personal Accounts
2.3 Impersonal Accounts
2.4 Three Golden Rules
2.5 Manual Accounting
2.6 The Accounting Process
2.7 Deferral Adjustments
2.8 Depreciation Adjustments
2.9 Accrual Adjustments
2.10 Internet Resources and Exercises
2.11 Summary
2.12 Self Assessment Questions
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2.1 INTRODUCTION
In actual practice, accountants (and computers) use a summary device called an
account to record transactions in the companys books and records. An account
can be defined as a label used by accountants to record changes in assets,
liabilities, and Shareholders (Owners) equity. A listing of common types of
accounts and account types appears in Annexure 1.
Before we proceed much further, we should briefly differentiate between cash
basis accounting and accrual basis accounting.
In cash accounting, revenue is recorded
(recognised) only when cash is received;
and expenses are recorded only when cash
is paid. In accrual accounting, revenue is
recorded when it is earned and expenses
are recorded when they are incurred. This
system of accrual accounting, while
recognizing the income and expenses,
ignores whether the money is received or
paid for the transaction. It also includes recognition of transactions relating to
assets and liabilities as they occur irrespective of the actual receipts or payments
in respect of these.
Throughout this course we will use accrual accounting as it usually does a much
better job in evaluating business performance, and is the only method approved
by the GAAP. Indeed, following accrual accounting is a Fundamental
Accounting Assumption which means that GAAP requires any business,
which does not follow accrual accounting to state in what respect and why it has
not followed accrual accounting, and what would the impact on its results be if
accrual accounting had been followed.
Its possible to analyze transactions (business events) in terms of their effect on
the accounting equation. In actual practice, accountants do not enter transactions
using the accounting equation, as it is impractical when thousands of transactions
must be analyzed and recorded. In actual practice, accountants use a double
entry system in which each transaction affects at least two accounts. In displaying
and explaining transactions, accountants often use a T Account, which takes its
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name from the letter T. The T Account has a heading, a left side, and a right side.
The left side is known as the debit side and the right side is known as the credit
side. There is no reason why it should not be the other way around, except that
debit on the left and credit on the right has become a very common practice.
Usually computerised ledgers follow a vertical format where there are two
columns, one for debits and the other for credits, and the tallying of the totals of
each column proves the basic accounting accuracy of each account. The balance
in an account is the difference between the totals of debit and credit columns.
Account may be classified from another perspective. Thus accounts are classified
as:
Personal Accounts
Real Accounts
Nominal Accounts
2.2 PERSONAL ACCOUNTS
Personal accounts are related to persons, debtors or creditors etc. A Company
has a number of Customers (Debtors) and Suppliers (Creditors). Each one of
these is a Personal Account.
2.3 IMPERSONAL ACCOUNTS
Accounts which are not personal accounts such as Plant and Machinery account,
the Bank or cash accounts, Interest account etc. are Impersonal Accounts. These
impersonal Accounts are further sub-divided as under:
(a) Real Accounts: Accounts, which relate to assets of the firm but not its debt.
Instances of real account are:
Land
Building
Investment
Fixed deposits
Cash balance
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Bank balance
(b) Nominal Accounts: These relate to expenses, losses, gains, revenue, etc.
Instances of these are:
Salary account
Interest paid account
Commission received account
The net result of all the nominal accounts is reflected as profit or loss for the
accounting year and is transferred to the capital Account or to appropriation
account. Thus at the end of the year, the Nominal accounts have nil balance. As
we stated above, the accountant uses a double entry system in analyzing and
processing transactions. Each transaction requires at least one debit and one
credit entry. In making these entries, the accountant uses the rules of debit and
credit (which are abbreviated to Dr. and Cr. respectively). These rules can be
summarized as follows:
Account Category ! !
Increase !
Assets ! !
Liabilities !
Retained Earnings ! !
Shareholders Equity
Share Capital ! !
(Reserves)
Dividends ! !
Revenue (Sales) !
Expenses ! !
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No 1 (For Real
Accounts)
No 2 (For Personal
Accounts)
No 3 (For Nominal
Accounts)
Debit
What Comes In
The Receiver
Credit
The Giver
Debit
What Comes In
Credit
And Credit Cash A/c (Golden Rule 1: Credit what goes out)
2. You buy inventory on account (i.e., on credit) worth Rs.5,000
Asset called Inventory increases by Rs.5,000; and
Liability called Accounts Payable also increases by Rs.5,000
We debit Inventory A/c (Golden Rule 1: Debit what comes in)
And Credit Accounts Payable A/c (Golden Rule 2: Credit the giver)
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3. You introduce capital into the business (or a company issues new shares at
par) for Rs.200,000
Asset account called Cash increases by Rs.15,000
Liability called Shareholders Equity or Capital also increases by Rs.200,000
We debit Cash A/c (Golden Rule 1: Debit what comes in)
And Credit Capital A/c (Golden Rule 2: Credit Income and Liabilities)
4. You withdraw from bank Rs. 10,000 for office use;
Asset account called Cash increases by Rs.10,000
Asset account called Bank decreases by Rs.10,000
We debit Cash A/c (Golden Rule 1: Debit what comes in)
And credit Bank A/c (Golden Rule 1: Credit what goes out)
5. You bought from Rohan goods worth (at MRP) Rs. 10,000 at 20% Trade
Discount on credit;
Expense account called Purchases increases by Rs.8,000
Asset account called Rohan increases by Rs.8,000
We debit Purchases A/c (Golden Rule 1: Debit Expenses and Assets)
And credit Rohan A/c (Golden Rule 2: Credit the giver)
6. You received confirmation that a large company has selected you for a major
consulting assignment. The work will start on January 1 of next year.
No transaction, as there is no monetary impact. Hence, nothing needs to be
recorded.
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Shri Ganesh
started business
with capital of Rs.
50.000
Accounts
affected
Type of
accounts
Cash &
Capital
Real Account
Personal
Account
Debit
Cash
Capital
30
Accounts
affected
Type of
accounts
Debit
Reason for
debit of credit
Trade discount is the normal reduction from the Maximum Retail Price or Market
Price given to a trader. Note that the market price is not relevant, and is hence
ignored. Cash Discount on the other hand, is an extra discount given as a reward
for early cash settlement of the account, and hence is recorded in the books and
reflected as a cost.
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Account Number!
Account Category
1! !
Assets
2! !
Liabilities
3! !
Shareholders Equity
4! !
Revenues
5! !
Expenses
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All the above steps are performed throughout the accounting period as
transactions occur, or in batches processes. The steps that follow are performed
at the end of the accounting period. These steps are required in both, a
computerised and manual system of accounting. However, in a computerised
accounting system, generally debits will equal credits at all times; hence some of
the types of errors listed may not be encountered. Further, in computerised
accounting environments, preparing financial statements are simply a question of
generating updated reports.
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Particulars
L/F
Debit (Rs.)
Credit (Rs.)
30/5/09
Machinery Account
To Bank
Dr.
50,000
50,000
Debit
Rs.
30/5/09
To Bank
50,000
Date
Credit
Rs.
34
Bank Account
Date
Debit
Rs.
Date
Credit
Rs.
30/5/09
By Machinery
50,000
6. Prepare the trial balance to make sure that debits equal credits. The trial
balance is a simple listing of all of the ledger accounts, with debits in the left
column and credits in the right column.
The Trial Balance is simply a list of all the accounts and their balances at a given
time. At this point no adjusting entries have been made. The actual sum of each
column is not meaningful; what is important is that the sums be equal.
Note that while out-of-balance columns indicate a recording error, balanced
columns do not guarantee that there are no errors. For example, not recording an
aspect of a transaction or recording it in the wrong account would not cause an
imbalance.
7. Correct any discrepancies or errors in the trial balance. If the columns are not
in balance, look for math errors, posting errors, and recording errors. If the
columns are balanced, look for unusual balances which may point to erroneous
classification of transactions, or posting to the inappropriate accounts. Posting
errors include:
posting the wrong amount,
omitting a posting,
posting to the wrong accounts,
posting in the wrong column, or
posting more than once.
Each voucher must include at least the following: date, amount, and description of the
transaction. When practical, source documents should contain name and address of
the other party of the transaction.
When a voucher does not exist, for example, when a cash receipt is not provided by a
vendor or is misplaced, an internal voucher should be generated as soon as possible
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after the transaction, using other documents such as bank statements to support the
information on the generated source document.
Once a transaction has been journalised, the voucher is usually filed in such a way
that it is easily retrievable to verify the transaction, should the need arise at a later
date.
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To Expense
The word To is not necessary, but has very often been used by accountants to
designate the account to which an entry is credited.
Another type of deferral, Unearned Revenues, will be discussed in a following
section.
Deferrals: It goes for deferrals over a time period. When a Company has paid for
certain rights which need to be expensed out but, in all fairness, these right can
be availed over more than one year like, say, right to avail the use patent over the
current year and next three years. The amount spent in this respect has to be
expensed over four years. The write off has to be deferred over four years.
Depreciation Expense
To Accumulated Depreciation
Note that the credit is to Accumulated Depreciation not to the asset. The
Accumulated Depreciation account accumulates all depreciation charged off to
date and its normal balance is a credit. Accumulated Depreciation is a contra
asset account meaning it has a matching pair, Equipment for example, and it has
the opposite balance of its matching pair.
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Note that book or carrying value is defined as cost less accumulated depreciation.
Balance sheets reflect the book value of plant assets.
Expense
To Payable
Accrued revenue is revenue earned, but not yet recorded in the books and
records. The adjusting entry takes the following form:
!
Accounts Receivable
To Revenue
Unearned revenue arises when a business receives cash before earning the
revenue. For accounting purposes, it is categorized as a liability since the firm is
liable for future performance and cash has been paid in advance. The adjusting
entry takes the following form:
!
Revenue
To Unearned Revenue
Note that every adjusting entry involves both an income statement account and a
balance sheet account.
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!
!
!
!
!
!
!
!
!
!
!
All temporary accounts must be closed out at year-end and set back to a zero
balance for the start of the new period. Permanent accounts (balance sheet !
accounts) are not closed out. In other words, if the company has a balance of
Rs.50,000 in the Cash Account at midnight on December 31, it has the same
balance on January 1 and this account should not be closed out. However, !
temporary accounts must be closed out so that the accountant can begin !
accumulating revenues and expenses for the new period.
The closing entries transfer the revenue, expense, and dividends balances to
Retained Earnings (or Reserves and Surplus or Profit and Loss Account). The
three steps involved are as follows:
1. Debit each revenue account for the amount of its credit balance. Credit
Retained Earnings for the sum of the revenues.
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2. Credit each expense account for the amount of its debit balance. Debit
Retained Earnings for the sum of the expenses.
3. Credit the Dividends account for the amount of its debit balance. Debit
Retained Earnings.
After posting the closing entries the revenue, expense, and dividend accounts are
set back to zero, so that the accounting period can begin anew. Now only
permanent accounts have balances.
11. Prepare the financial statements.
Income statement: prepared from the revenue, expenses, gains, and losses.
Balance sheet: prepared from the assets, liabilities, and equity accounts.
Statement of retained earnings: prepared from net income and dividend
information.
Cash flow statement: derived from the other financial statements using either
the direct or indirect method (we shall learn about these methods in detail later).
12. Prepare closing journal entries that close temporary accounts such as
revenues, expenses, gains, and losses. These accounts are closed to a
temporary income summary account, from which the balance is transferred to the
retained earnings account (capital). Any dividend or withdrawal accounts also are
closed to capital account (in companies, it is closed to the Reserves or Profit &
Loss Account).
13 Post closing entries to the ledger accounts.
14. Prepare the after-closing trial balance to make sure that debits equal credits.
At this point, only the permanent accounts appear since the temporary ones have
been closed. Correct any errors.
15. Prepare reversing journal entries (optional). Reversing journal entries often
are used when there has been an accrual or deferral that was recorded as an
adjusting entry on the last day of the accounting period. By reversing the
adjusting entry, one avoids double counting the amount when the transaction
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occurs in the next period. A reversing journal entry is recorded on the first day of
the new period.
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Please Note: Most websites that we point you to are constantly being updated.
Please check to see that the information requested in this exercise is available.
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Answers
1. Cash is an asset and assets have a normal balance of debit.
2. All asset accounts have a normal balance of debit. That means that cash must
have a debit balance. A liability is something that you owe such as an invoice you
received from a vendor. If you answered Liability, you need to spend more time
working on definitions of assets, liabilities and owner's equity as well as the rules of
Debits and Credits.
3. Credit is correct. If a business makes money, capital increases. Net income is
defined as revenues less expenses. Revenues are credit accounts and expenses
are debit accounts. Therefore, the normal balance in the capital account would be a
credit. The normal balance in the capital account is not a debit. Think about it this
way. The goal of a business is to end up with a profit. That means
revenues greater than expenses. If revenues are greater than expenses and the
normal balance in a revenue account is credit, the hoped-for balance in the capital
account must also be a credit.
4. Debit. Since accounts receivable is an asset, a debit is required to increase the
balance.
5. Debit is correct. Owner withdrawals reduce the balance in the capital account.
Since the capital account has a normal balance of credit, withdrawals must have a
normal balance of debit.
6. If you answered Revenue, you just committed one of the most common mistakes
that fresh accounting students make. Revenues are recognized on the date of sale
and not on the date the cash is received. If you credit revenues on the date cash is
received, the revenue is entered twice. The correct answer is that Accounts
Receivable is credited or reduced when the cash is received.
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7. When a purchase is made on account, the liability, accounts payable will increase.
Cash is not affected until you actually pay the bill at a later date. Hence the correct
answer is Accounts Payable.
8. Remember that anything with the word payable in the account title is a liability.
The normal balance in liability accounts is credit.
9. Debit is correct, because revenues are credits while expenses are debits.
10. Prepaid Expense is an asset. The normal balance in an asset account is debit.
Hence the correct answer is Debit.
11. If you answered Revenue, remember that revenues are not debited when a sale
is made on account. Revenues are credited. Cash has not been received, hence
Cash Account also does not enter the picture. The correct answer is Accounts
Receivable.
12. Office Equipment is an asset account. The normal balance must be a debit. If
you answered credit, you still need a bit more practice.
44
Solved Example 1
Journalise the following transactions in the books of Abhay and Company, sole
proprietary concern of Mr. Abhay.
1. Purchased a running business for Rs. 3,00,000/- with the following Assets and
Liabilities:
!
Stock of goods ! !
5,000.00
12,000.00
Bank balance ! !
75,000.00
Furniture !
30,000.00
Rs.! !
Rs.
45
11.Expenses for the year paid in cash : Conveyance Rs. 700, Stationery Rs. 450,
Salary Rs. 3,000, Wages Rs. 800. Interest of Rs. 500 was paid by cheque.
Solution
Journal Entries in The Books of Abhay and Co.
Date
Particulars
L/F
Debit Rs.
Purchase Account
Plant & Machinery Account
Bank Account
Furniture Account
!
To Rohan Account
!
To Loan (Taken) Account
!
To Capital Account
(Being running business taken over)
Dr.
Dr.
Dr.
Dr.
12,000
2,00,000
75,000
30,000
Cash Account
!
To Bank Account
(Being Cash withdrawn for office use)
Dr.
10,000
Purchase Account
!
To Rohan Account
(Being goods purchased at 20% Trade
Discount)
Dr.
Drawings Account
Insurance Premium Account
!
To Bank Account
(Being Personal life insurance premium
and for machinery paid)
Dr.
Dr.
Mohan Account
!
To Sales Account
!
To Cash Account
(Being goods sold and carriage paid on
behalf on Mohan)
Credit Rs.
5,000
12,000
3,00,000
10,000
8,000
8,000
4,000
2,000
6,000
Dr.
10,200
10,000
200
46
Date
Particulars
L/F
Rohan Account
!
To Bank Account
!
To Discount received Account
(Being cheque issued and discount received)
Dr.
Purchase Account
!
To Bank Account
!
To Cash Account
!
To Memons Account
(Being goods purchased)
Dr.
Meena's Account
!
To Sales Account
(Being goods invoiced)
Dr.
Cash Account
Discount allowed Account
!
To Sales Account
Dr.
Wages Account
!
To Cash Account
(Being above expenses paid)
Dr.
Interest Account
!
To Bank Account
(Being interest paid)
Dr.
Debit Rs.
Credit Rs.
6,500
6,000
500
24,000
8,000
8,000
8,000
12,000
12,000
19,600
400
20,000
800
4,950
500
500
47
Particulars
Cash A/c
Capital A/c
Purchase A/c
Plant & Machinery A/c
Bank A/c
Furniture A/c
Rohans A/c
Loan (Taken) A/c
Drawing A/c
Insurance Premium A/c
Memons A/c
Meenas A/c
Discount Allowed A/c
Discount received A/c
Conveyance A/c
Stationery A/c
Salary A/c
Wages A/c
Interest A/c
Interest (paid) A/c
Sales A/c
L/F
Debit Rs.
Credit Rs.
26,500
44,000
2,00,000
44,500
30,000
4,000
2,000
12,000
550
700
450
3,000
800
500
-
3,00,000
6,500
12,000
8,000
500
42,000
3,69,000
3,69,000
48
2.11 SUMMARY
Financial accounting is based on an accrual basis and not on cash basis, hence
expenses are accounted as they are incurred ( not paid ) and income when it is
earned ( and not received ).
The accounts maintained in Accounts are personal or impersonal. The latter class
of impersonal accounts is further classified into real and nominal.
Whole accounting is based on three golden rules; for real accounts what comes
in is debited and what goes out is credited. Incase of personal accounts, receiver
is debited and the giver credited. For nominal accounts, expenses and assets are
debited and income and liabilities credited.
All accounting entries are first recorded in a journal. All entries in the journal are
then posted or transferred to the general ledger. The number of accounts that a
company wishes to maintain are described in what is known as chart of
accounts.
The accounting process starts with identification of the transaction, record it in a
document called voucher, and then analyze and classify the transaction. This
step involves putting rupee value to it, identifying which accounts are affected
from the chart of accounts and which of them are to be debited and credited and
by how much. The next step is recording the voucher in appropriate journal.
Normally sales, purchase, disbursement or general journals are maintained.
Entries in these journals are then posted into respective individual accounts
maintained in the ledger. All these steps make an accounting cycle as they are to
be repeated for each transaction.
All balances of ledger are tabulated in trial balance at the end of period for which
accounts are to be prepared. This trial balance needs to be adjusted for deferral
an adjustment for which the firm paid or received cash in advance, depreciation an allocation of cost for use of an asset like machinery, accrual an expense or
income occurring before cash is paid or received by the firm.
After adjusted trial balance is ready, financial statements are prepared.
49
Cash
Dr.
5,000
Sundry Debtors
40,000
Inventory of Merchandise
85,000
Prepaid Expenses
Delivery Van
Cr.
2,000
1,15,000
Sundry Creditors
45,000
Owners' Capital
1,30,000
Retained Income
72,000
2,47,000
2,47,000
50
51
52
Particulars
L/F
Debit
Cash a/c
Dr.
To Shri Ganesh Capital a/c
(Being business started with Capital of Rs.50,000)
50,000
Bank a/c
To Cash a/c
(Being an account opened and cash deposited)
Dr.
25,000
Purchases account
To Cash a/c
(Being Goods Purchased for cash)
Dr.
Purchases account
To L & T
(Being Goods Purchased from L&T)
Dr.
Purchases account
To Cash a/c
(Being goods purchased from L&T for cash)
Dr.
Cash a/c
To Sales
(Being goods sold for Cash)
Dr.
Cash a/c
To Sales
(Being goods sold for Cash)
Dr.
ONGC a/c
To Sales
(Being goods sold to ONGC)
Dr.
Credit
50,000
25,000
10,000
10,000
50,000
50,000
5,000
5,000
15,000
15,000
5,000
5,000
40,000
40,000
Cash a/c
Dr.
To Sales
(Being goods sold to ONGC and Received Cash)
Machinery Account
To HMT
(Being Machinery Purchased from HMT)
Dr.
Furniture Account
To Parmar
(Being Furniture Purchased from Parmar)
Dr.
3,000
3,000
40,000
40,000
10,000
10,000
53
Date
Particulars
L/F
Bank a/c
To Cash a/c
(Being Cash Deposited in Bank)
Dr.
Bank a/c
To ONGC
(Being half the amount due from ONGC recd)
Dr.
L & T account
To Cash a/c
(Being part of the amount due to L&T paid)
Dr.
Salary account
To Bank
(Being salary paid to Shoba by Chq.)
Dr.
Dr.
Debit
Credit
10,000
10,000
20,000
20,000
10,000
10,000
20,000
20,000
1,000
1,000
Particulars
To Bal c/d
J/F
Amount
50,000
50,000
Date
Particulars
By Cash
!
J/F
Cr.
Amount
50,000
50,000
54
Dr.! !
Date
Particulars
J/F
Cash Account
!
!
!
!
Amount
Date
Particulars
!
J/F
Amount
To G.Capital
50,000
By Bank
25,000
To Sales
15,000
By Purch
10,000
To Sales
3,000
By Purch
5,000
To Bank
2,000
By Bank
10,000
By Off. Exp
1,000
By Bal
19,000
70,000
Dr.! !
Date
Particulars
J/F
70,000
Bank Account
!
!
!
!
Amount
Date
Particulars
!
J/F
To Cash
25,000
By L&T
10,000
To Cash
10,000
By Salary
20,000
To ONGC
20,000
By Cash
2,000
By Drawings
1,000
22,000
55,000
Date
Cr.
Amount
By Bal
Dr.! !
Cr.
Particulars
!
J/F
55,000
L & T Account
!
!
!
!
Amount
To Bank
10,000
To Bal c/d
40,000
50,000
Date
Particulars
By Purchase
!
J/F
Cr.
Amount
50,000
50,000
55
Dr.! !
Date
Particulars
J/F
Purchases Account
!
!
!
!
!
Amount
To Cash
10,000
To L & T
50,000
Date
Particulars
!
J/F
Amount
By Bal
60,000
60,000
Dr.! !
Date
Particulars
J/F
To Bal
60,000
Sales Account
!
!
!
!
Amount
Date
58,000
Particulars
!
J/F
Date
Particulars
J/F
By Cash
15,000
By ONGC
40,000
By Cash
3,000
To Sales
58,000
ONGC Account
!
!
!
!
Amount
Date
40,000
Particulars
!
J/F
Date
Particulars
J/F
By Bank
20,000
By Bal c/d
20,000
To Bal c/d
40,000
HMT Account
!
!
!
!
Amount
Date
40,000
Particulars
!
J/F
Date
Particulars
To HMT
!
J/F
By Machinery
40,000
40,000
Machinery Account
!
!
!
!
!
Amount
40,000
40,000
Cr.
Amount
40,000
Dr.! !
Cr.
Amount
40,000
Dr.! !
Cr.
Amount
58,000
Dr.! !
Cr.
Date
Particulars
By Bal c/d
!
J/F
Cr.
Amount
40,000
40,000
56
Dr.! !
Date
Particulars
J/F
Furniture Account
!
!
!
!
!
Amount
To Parmar
Date
10,000
Particulars
!
J/F
Amount
By Bal c/d
10,000
10,000
Dr.! !
Date
Particulars
J/F
To Bal c/d
10,000
Parmar Account
!
!
!
!
Amount
Particulars
Date
10,000
!
J/F
Date
Particulars
J/F
By Furniture
10,000
To Bank
10,000
Salary Account
!
!
!
!
Amount
Date
20,000
Particulars
!
J/F
Date
Particulars
J/F
By Bal c/d
20,000
To Cash
20,000
Office Expenses
!
!
!
!
!
Amount
Date
1,000
Particulars
!
J/F
Date
Particulars
To Bank
!
J/F
By Bal
1,000
1,000
Drawings Account
!
!
!
!
!
Amount
1,000
1,000
Cr.
Amount
1,000
Dr.! !
Cr.
Amount
20,000
Dr.! !
Cr.
Amount
10,000
Dr.! !
Cr.
Date
Particulars
By Bal
!
J/F
Cr.
Amount
1,000
1,000
57
Annexure 1
Income Tax
Service Tax
Loans
Debentures
Unsecured Loans from Friends and Relatives
Equity
Retained Earnings (Accumulated Profits)
Current Years Profits
Adjustments
Income
Interest Income
Bank Account Interest
Fixed Deposit Interest
Interest on Debentures/ Bonds
Dividends
On Shares
On Mutual Fund Units
Consulting
ABC Design
LMN Software
Salary
My Job
Commissions
Royalties
Sales
Products
Services
Expenses
Rent and Utilities
59
Rent
Electricity
Gas
Phone
Internet
Cable TV
Office Expenses
Accounting
Legal
Software
Postage
Bank Charges
Credit Card Charges
Printing
Toner, Paper, Paper Clips
Vehicle Expenses
Petrol/ Diesel
Insurance
Repair
Rentals/ Taxi fare
Interest on Car Loan
Taxes
Income Tax
Interest and penalties
Wages and Salaries
Consulting
Wages
Travel
Air fare
60
Hotel
Meals
Taxi fare, etc
Marketing
Advertising
Trade Shows
Promotional Gifts
61
Annexure II
Account Types
Different Account types are explained in simple, layman terms, as they apply to
the accounts of an individual who does not carry on a business. However,
businesses and companies have account types in much the same way, except
that there may be some other account types (a result of their global reach and a
concession to greater levels of complexity).
Cash
The cash account type is used to denote the cash that you store, whether in your
wallet, office safe, piggybank, or mattress.
Bank
The Bank account type denotes savings or current accounts held at a bank or
other financial institution. Some of these accounts may bear interest. This is also
the appropriate account type for debit cards, which directly withdraw payments
from a current or savings account. In India, a debit card often doubles up as an
ATM Card, which allows you to withdraw cash from your bank account from a
conveniently located automated money dispensing machine, which is
electronically linked to the banks central server.
While initially, an ATM Card could only be used at the ATMs set up by the issuing
bank, now, several banks are collaborating to allow each others customers to
withdraw money from their accounts using the other banks ATMs. Debit Cards
allow you to pay for purchase just like you would with your credit card, except that
there is no free credit period, and no rollover. The money is simultaneously taken
away from your account, which is the closest equivalent of paying cash.
Credit Card
The Credit Card account type is used to denote credit card accounts, both for
cards that allow floating lines of credit (e.g. VISA, MasterCard, or Diners Club)
and with cards that do not permit continuing balances (e.g. American Express).
The last type is not very popular in India yet, and are called Charge Cards.
62
Asset, Liability
Asset and Liability accounts are used for tracking things that are of value, but that
are not directly translatable into cash. For instance, as an individual, you might
collect the costs of purchasing a house into an asset account entitled My House,
or the cost of a car into My Car, or collect together the value of your Computer
Equipment. The home loan or car loan would be represented by liability accounts
called Home Loan and Car Loan, to be drawn down as you make payments on
these loans.
If you hold assets for business purposes, their decline in value over time might be
treated as a deduction for tax purposes, that deduction being called Depreciation.
On the other hand, if you own assets that usually, or often, appreciate in value
over time, such as real estate, paintings, and investments like shares in
companies, you may see them appreciate in value, and have to recognize, for tax
purposes, what are called Capital Gains when they are sold.
Shares, Mutual Fund Units
Securities that you invest in are a form of asset that are normally acquired with
the express purpose of receiving income either in the form of dividends, interest,
or Capital Gains. There are securities markets around the world, and widely
traded securities with transparent values may be analyzed on a dayto- day (or
even minute-to-minute) basis.
Shares and Mutual Fund accounts are typically tracked in registers having three
main columns:
Price
Number of shares
Cost
In order to get useful information out of the register, it is necessary to have
multiple views on the data so that you may assess such things as:
Total Values by security
Gains/Losses by security
Return on Investment rates by security
63
64
REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video1
Video2
Video3
Video4
65
3
Accrual Accounting and the
Balance Sheet
Objectives:
After completing this chapter, you will be able to understand:
Cash to Cash Cycle.
Principles in Financial Reporting.
Fixed and Current Assets.
Net Worth.
Contingent Liabilities.
66
Structure:
3.1 Introduction
3.2 Operating Cycle of Business
3.3 Balance Sheet
3.4 Assets
3.5 Investments
3.6 Other Assets
3.7 Liabilities
3.8 Equity
3.9 Summary
3.10 Self Assessment Questions
67
3.1 INTRODUCTION
At this point it is a good idea to differentiate between accrual and cash
accounting.
Accrual Accounting
Record Revenue as earned (regardless of when cash is paid)
Record Expense as incurred (regardless of when expense is paid)
Cash Accounting
Record Revenue as cash is received (regardless when the sale is made)
Record Expense when paid (regardless when the cost is incurred)
Throughout this course we will be using accrual accounting as it usually does a
better job of measuring performance. However, many small companies properly
use the cash method of accounting or a hybrid method, accounting for revenue
using the cash method and recording expenses using accrual accounting.
3.2 OPERATING CYCLE OF BUSINESS
Figure 3.1 below depicts the Operating (business) cycle of a business. This is the
cycle in which the business purchases inventory for cash, sells it to customers on
account, and eventually collects the cash so that additional inventory can be
purchased.
The operating cycle, which is also known as the cash-to-cash cycle, is the
process of using cash to purchase current assets that are to be sold at a profit
and collected as cash. As an example, a company uses funds to purchase raw
material inventory that is produced into finished goods inventory, sold at a profit to
create a receivable and collected to become cash once again, then used to pay
the supplier, with the profits left in the business.
68
69
Revenue Principle: Record revenue when it is earned usually this is when the
business has delivered a good or service to a customer.
Matching principle: Match the expense of a period against the revenue earned
during that same period.
Accrual accounting does a good job of complying with the matching principle but
using accrual accounting necessitates making adjusting entries to properly match
expenses with revenue.
Before we proceed, let us take a brief look at what the Balance Sheet and Profit &
Loss Account (also called an Income Statement) of a business looks like.
Generally, the first, preliminary step in preparation of Balance Sheet and Profit
and Loss Account is drawing up the Trial Balance. As we saw earlier in Chapter 2,
the Trial Balance is intended to check the arithmetical accuracy of all entries in
the ledger. If all entries are accurate, then the sum total of all debit and credit
balances in all accounts put together should be equal. This is technically called
an Unadjusted Trial Balance, because entries for adjustments necessary to
recognise the principle of accrual, like taking account of prepayments and dues
as on the balance sheet date happens after this stage.
70
The liabilities and net worth on the balance sheet represent the company's
sources of funds. Liabilities and net worth are composed of creditors and
investors who have provided cash or its equivalent to the company in the past. As
a source of funds, they enable the company to continue in business or expand
operations. If creditors and investors are unhappy and distrustful, the company's
chances of survival are limited.
Assets, on the other hand, represent the company's use of funds. The company
uses cash or other funds provided by the creditor/ investor to acquire assets.
Assets include all the things of value that are owned or due to the business.
Liabilities represents a company's obligations to creditors, while net worth
represents the owner's investment in the company. In reality, both creditors and
owners are "investors" in the company with the only difference being the degree
of nervousness and the timeframe in which they expect repayment.
Presently, we will learn about the elements of the Balance Sheet and how they
either use or provide funds. For example, when a supplier sends you inventory
on credit, he or she in essence is providing "funds" that you may use to operate
your business. Recall that you record both an asset (inventory) and a liability
(accounts payable) when you purchase goods on credit. Of course, you must be
able to pay your supplier in cash in a timely manner. Otherwise, your ability to
continue to do business with that creditor, at least, will stand compromised.
An example of a companys Balance Sheet is given below. Note that there are
two Balance Sheets as on two different dates. Note also that the figures are in
Rs. Millions. This makes it possible to appreciate the figures much more easily.
71
Non-Current Assets are defined as those that will not mature into cash within the
next 12 months. They can consist of the following asset categories:
Net Fixed Assets
Investment in Subsidiaries and Joint Ventures
Intangibles
Other Assets
Fixed Assets are those assets that are long term investments which enables the
business to carry on its operations. Fixed assets represent the use of cash to
purchase physical assets whose life exceeds one year. They include assets such
as:
o Land
o Building
o Machinery and Equipment
o Furniture and Fixtures
o Leasehold Land
o Vehicles etc.
Calculating Net Fixed Assets When a fixed asset is purchased for use in
operations of the business it is recorded at cost. As the asset wears out, an
amount is charged to expense and accumulated annually in a contra-account
known as accumulated depreciation. Accumulated depreciation is the cumulative
sum of all the years' worth of wearing out that has occurred in the asset. The
gross fixed asset (purchase price) less the accumulated depreciation equals the
Net Fixed Asset Value (also known as book value).
Gross Fixed Assets (Purchase Price) Accumulated Depreciation = Net
Fixed Assets (Book Value)
72
It may so happen that a particular fixed asset was purchased from a foreign
country. As a result of a change in the exchange rate after such purchase, there is
an increase or reduction in the liability of the company in terms of rupees, for
making payment towards cost of the asset. The amount by which the liability has
so increased or reduced must be added to or deducted from the cost of the asset.
The resultant figure will be treated as the cost of the asset.
73
Depreciation!!
To! !
Dr.
Fixed Asset
3.5 INVESTMENTS
A Company may invest its surplus funds in different ways. The surplus may be
temporary or a long term basis. Often the exigencies of business may require the
Company to invest funds in a particular venture or investment.
The common forms of investment by the Companies are:
1. Investments in Govt. or Trust Securities
2. Investments in shares, debentures or bonds
3. Immovable properties
4. Investments in the capital of partnership firms
5. Balance of unutilised monies raised by Issue etc.
74
When the investment is acquired, the Investment account (real a/c) gets some
thing and is debited. The cash or cheque is paid for the acquisition. It is credited.
The suitable book entry can be:
!
Investment ! Dr.
Cash/ Bank
Investment account ! !
Dr.
To Gain on Revaluation
Loss on Revaluation !!
Dr.
To Investment account
For better presentation of information, the Investments are also classified into
trade investments and other investments. Trade investment would mean an
investment by a company in the shares or debentures of another company, not
being its subsidiary, for promoting its own trade or business.
75
Current Assets are those, which mature in less than one year. They are the sum
of the following categories:
Cash
Accounts Receivable (A/R)
Inventory (Inv)
Notes Receivable (N/R)
Prepaid Expenses
Other Current Assets
Cash is the only game in town. In Hindi, they call it, Sabse bada Rupaiah! (Cash
is the biggest of them all!) Cash pays bills and obligations. Inventory, receivables,
land, building, machinery and equipment do not pay obligations even though they
can be sold for cash, which can then be used to pay bills. If cash is inadequate or
improperly managed, the company may become insolvent and be forced into
bankruptcy. Include all bank accounts, money market and short-term savings
accounts under Cash. Cash management is discussed more in detail in Chapter
4.
Receivables are money due from customers. They arise as a result of the
process of selling inventory or services on credit, i.e., on terms that allow delivery
before collection of cash. Inventory is sold and shipped, an invoice is sent to the
customer, and later cash is collected. The receivable exists for the time period
between the selling of the inventory and the receipt of cash.
Receivables are the third most liquid asset after cash and short-term investments.
Receivables are commonly divided into three categories:
Debtors (or Accounts Receivable) Amounts owed by customers arising from
credit sales
Bills of Exchange (or Notes Receivable) Written promises to pay a definite
sum at a future date
Other receivables Amounts lent to employees, subsidiaries, etc.
76
Accounts Receivable
To Sales Revenue
The Aging of Receivables Method considers the age and amount of the Closing
Accounts Receivable balance. This method assumes that longer an account goes
uncollected, the more likely it is to go bad. The prior balance in the Allowance
Account must be considered when recording the amount of expense under this
method.
Firms often use the Percentage of Sales Method on interim statements and use
the more precise Aging of Receivables Method on year-end statements.
Under the Allowance Method when an account is deemed to be uncollectible or
irrecoverable, it is written off. The journal entry takes the following form:
Allowance for Bad Debts
!
Accounts Receivable
To Sales Revenue
This method usually does not comply very well with the matching principle as the
sale typically takes place in one period and the write-off in another period.
Receivables are proportional to sales. As sales rise, the investment you must
make in receivables also rises.
Example: Receivables vary with sales. ABC Company gives net 30 Day terms to
its customers. Any sale made today will be collected one month from today. ABC's
customers are prompt payers and all receivables are collected on the 30th day.
78
On an average, ABC will have one month's worth of sales always invested in
receivables.
In 20X5, sales are Rs.1,200,000. Receivables, which are equal to one month's
sales, total Rs.100,000. In 20X6, sales rise to Rs.2,400,000. Receivables, which
remain at one month's worth of sales, rise to Rs.200,000.
Due to the growth in sales, the company is forced to increase its investments in
accounts receivable by Rs.100,000. This investment in receivables is automatic
and unavoidable. It does not indicate the company's terms have been lengthened
or that management of collections has decayed or become looser.
Analyzing Receivables: Receivables increase for two reasons; 1) Growth in
sales, and 2) Change in average collection period. Growth in sales is a healthy
reason to increase receivables. Changing the collection period, however may not
be so favorable, particularly if the reason is due to a collection problem with a
customer. Here's an example of how analyzing your financial statements can help
you spot unfavorable trends before they become a problem. To analyze the
change in the collection period, some measure of the receivable's quality must be
used. We do this by comparing the actual collection period to the stated payment
terms. The actual collection period is known as Days In Receivables.
To determine receivable quality, the company's terms of payment are compared
to the actual collection period. The collection period and the terms should be
about equal. If the calculated collection period is greater than the offered terms,
then its time to dig deeper and see if some of the companys customers are
lagging in paying their accounts. We prepare an A/R Aging Report2 as a start.
A report where all receivable accounts are classified into how many days have
elapsed since delivery of goods has been made. Typically, aging of A/R is divided
for analysis into under 30 days, 31-60 days, 61-90 days, and 91 days and above,
if the normal credit terms are 60 days.
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Allowance for doubtful debts: At some point in time you may have customers
that are unable to pay for the goods or services they received from you. When
you determine that you will be unable to collect these amounts, you will (albeit
reluctantly) write off the receivable and record a "write-off" loss. As your business
matures, you will be able to estimate the amount of such losses. Many
businesses calculate this expense on a monthly basis based on sales or a
percentage of past due accounts. The allowance for doubtful accounts is
subtracted from gross receivables on the Balance Sheet to show the net
receivable balance.
Inventory consists of the goods and materials a company purchases to resell at
a profit. In the process, sales and receivables are generated. The company
purchases raw material inventory that is processed (aka work-inprocess
inventory) to be sold as finished goods inventory.
For a company that sells a product, inventory is often the first use of cash.
Purchasing inventory to be sold at a profit is the first step in the profit-making
cycle (operating cycle) as illustrated previously. Selling inventory does not bring
cash back into the company it creates a receivable. Only after a time lag equal
to the receivable's collection period will cash return to the company. Thus, it is
very important that the level of inventory be well managed so that the business
does not keep too much cash tied up in inventory, as this will reduce profits. At
the same time, a company must keep sufficient inventory on hand to prevent
stockouts (having nothing to sell) because this too will erode profits and may
result in the loss of customers.
The correct level of inventory is a function of the length of the company's
inventory cycle and the company's sales level. A company's inventory cycle is
divided into three phases:
the ordering phase,
the production phase, and
the finished goods/delivery phase.
The ordering phase is the time it takes a company to order and receive raw
materials. The production phase is the time it takes to produce finished goods
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from raw materials. The finished goods/delivery phase is the amount of time
finished goods remains in stock and the delivery time to a customer.
The inventory cycle in days is determined as follows:
Inventory Cycle In Days ! = Ordering Phase in Days
!
to cover any delays in receipt of the clay and production of the vases. Therefore,
the company's total inventory cycle is 27 days. To keep the cycle running
smoothly, the company must keep its investment in inventory equal to 27 days
worth of sales.
The company must keep an investment in inventory equal to its inventory cycle. If
ABC keeps only 15 days' worth of investment in inventory, it eventually will run
out of stock because clay ordered today cannot be delivered as a vase for 22
days.
This investment requires the use of cash. Thus, in the above example, ABC must
have sufficient cash to acquire at least 22 days of inventory, and that
management operates more comfortably with 27 days' sales in inventory.
Knowing this, we can estimate the rupee amount of inventory as follows:
Minimum Investment in Inventory (in Rs) = Inventory Cycle In Days
!
The investment in inventory will vary according to both the sales per day and the
length of the inventory cycle in days. As sales rise, the amount of inventory sold
daily rises and the investment in a day's worth of inventory must increase or
stockouts will eventually occur. As the inventory cycle lengthens more inventory
must be kept in hand to produce the same level of sales and the investment in
inventory increases.
Just as we measured the "quality" of accounts receivable, another ratio can be
used as an indicator of the "quality" of inventory. We do this by comparing the
actual inventory level to the inventory cycle. Insufficient inventory indicates
potential stockouts, Excessive inventory may indicate, stale inventory, poor
inventory controls, or fudging (miscounting).
To measure quality, the actual number of days of inventory in hand is measured
as follows:
Days In Inventory !
!
!
!
!
!
=!
!
Ideally, inventory will be at a level slightly greater than the inventory cycle.
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banks and other lending institutions frown greatly upon it. The Income Tax Act in
India mandates this treatment, by treating such a withdrawal as a dividend
declared, and taxing it in the recipients hands.
Days Sales in Receivables indicates how long it takes to the collect the average
level of receivables. Companies strive to reduce this ratio and lower the number
of days it takes to collect receivables. The ultimate champion in this field
undoubtedly is Dell Computers, which has built a huge business of selling
computers and associated items directly to customers without a chain of middlemen. If you wish to buy a computer from Dell, it will recover the money in
someway or the other (usually via EFT or credit card). The ratio can be calculated
using a two-step approach.
1. ! One days sales = Net Sales/360 Days
2. ! Days Sales in Receivables! !
!
!
!
!
!
!
= Average Net Accounts Receivable/One Days Sales
Other Current Assets consist of prepaid expenses and other miscellaneous and
current assets. Prepaid expenses are uses of cash to purchase in full a good or
service, the benefit of which will be received within the next 12 months. Insurance
is the most common form of prepaid expense. The premium is paid prior to the
receipt of the benefit. Paying a bill before the benefit from the purchase has been
received has depleted cash. Miscellaneous and other current assets generally
consist of small deposits or receivables.
balance sheets, report format balance sheets, and account format balance
sheets. Giving a listing of balance sheet accounts, you should be able to prepare
a classified balance sheet.
3.7 LIABILITIES
Liabilities and Net Worth are sources of cash listed in descending order from
the most nervous creditors and soonest to mature obligations (current liabilities),
to the least nervous and never due obligations (net worth). There are two sources
of funds: lender-investor and owner-investor. Lender- investor consists of trade
suppliers, employees, tax authorities and financial institutions. Owner-investor
consists of stockholders and principals who loan cash to the business. Both
lender-investor and owner-investors have invested cash or its equivalent into the
company. The only difference between the investors is the maturity date of their
obligations and the degree of their nervousness.
Current Liabilities: are those obligations that will mature and must be paid within
12 months. These are liabilities that can create a company's insolvency if cash is
inadequate. A happy and satisfied set of current creditors is a healthy and
important source of credit for short term uses of cash (inventory and receivables).
An unhappy and dissatisfied set of current creditors can threaten the survival of
the company. The best way to keep these creditors happy is to keep their
obligations current.
Current liabilities consist of the following obligation accounts:
Accounts Payable -- Trade (A/P)
Accrued Expenses
Notes Payable -- Bank (N/P Bank)
Notes Payable -- Other (N/P Other)
Current Portion of Long term Debt (generally shown separately in statements
meant for bankers).
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Proper matching of sources and uses of funds require that short term (current)
liabilities must be used only to purchase short-term assets (inventory and
receivables).
Notes Payable (N/P): are obligations in the form of promissory notes with shortterm maturity dates of less than 12 months. Often, they are demand notes
(payable upon demand). Other times they have specific maturity dates (30, 60,
90, 180, 270, 360 days maturities are typical). The notes payable always include
only the principal amount of the debt. Any interest owed is listed under accruals.
The proceeds of notes payable should be used to finance current assets
(inventory and receivables). The use of funds must be short term, so that the
asset matures into cash prior to the obligation's maturity. Proper matching would
indicate borrowing for seasonal swings in sales, which cause swings in inventory
and receivables, or to repay accounts payable when attractive discount terms are
offered for early payment.
Accounts Payable are obligations due to trade suppliers who have provided
inventory or goods and services used in operating the business. Suppliers
generally offer terms (just like you do for your customers), since the supplier's
competition offers payment terms. Whenever possible you should take advantage
of payment terms as this will help keep your costs down.
To analyze the company's payables position and relationship with suppliers we
use a ratio/quality indicator similar to the one used for accounts receivable and
inventory, known as Days In Payables.
If the company is paying its suppliers in a timely fashion, days payable will not
exceed the terms of payment.
Accrued Expenses are obligations owed but not billed such as wages and payroll
taxes, or obligations accruing, but not yet due, such as interest on a loan.
Accruals consist chiefly of wages, payroll taxes, interest payable and employee
benefits accruals such as pension funds. As a labor related category, it should
vary in accordance with payroll policy (i.e., if wages are paid weekly, the accrual
category should seldom exceed one week's payroll and payroll taxes).
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Current Portion of Long Term Debt (CLTD): is the portion of term loans due
within the next 12 months. A term loan is a loan that carries a maturity that
exceeds one year. It is divided into two segments; the portion due within 12
months (CLTD) and the portion due beyond one year (LTD). This bifurcation of
Long-term Debt is not mandated by the Companies Act for Indian companies, but
is generally insisted upon by bankers and other financers to the company,
because this figure gives a partial indication as to how much loan-servicing
burden the company carries in the year immediately following the date of the
Balance Sheet.
The non-current portion is listed separately from the current liability section. Any
interest due is listed as an accrual, and is added to the amount of the loan due.
Term loans are fundamentally different from notes payable. As sources of funds
that are repaid over a period longer than 12 months, they can be used to acquire
longer-term assets (assets that mature to cash beyond 12 months).
Some of the common uses of funds from term loans include:
Permanent Working Capital (increases in working capital due to growth)
Fixed Assets
Non-current Liabilities: are those obligations that will not become due and
payable in the coming year. There are three types of non-current liabilities, only
two of which are listed in the balance sheet:
Non-current Portion of Long Term Debt (LTD)
Contingent Liabilities
Non-current portion of long-term debt is the principal portion of a term loan not
payable in the coming year.
Contingent liabilities listed in the footnotes are potential liabilities, which
hopefully never become due.
Non-Current Portion of Long Term Debt (LTD) is the portion of a term loan that
is not due within the next 12 months. It is listed below the current liability section
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to demonstrate that the loan does not have to be fully liquidated in the coming
year. Long-term debt (LTD) provides cash to be used for a long-term asset
purchase, either as permanent working capital or as fixed assets.
Contingent Liabilities are potential liabilities that are not listed in the balance
sheet. They are listed in the footnotes because they may never become due and
payable. Contingent liabilities include:
Lawsuits
Warranties
Cross Guarantees
If the company has been sued, but the litigation has not been initiated, there is no
way of knowing whether or not the suit will result in a liability to the company. It
will be listed in the footnotes because while not a real liability, it does represent a
potential liability, which may impair the ability of the company to meet future
obligations. Alternatively, if the company guarantees a loan made by a third party
to an affiliate, the liability is contingent because it will never become due as long
as the affiliate remains healthy and meets its obligations.
Total Liabilities represents the sum of all monetary obligations of a business and
all claims creditors have on its assets.
3.8 EQUITY
Equity or Net Worth is the most patient and last to mature source of funds. It
represents the owners' share in the financing of all the assets. It consists of two
types of equity; Purchased Equity, and Earned Equity. Purchased equity consists
of:
Paid-up Equity Shares
Preference Shares (Generally, preference shareholders receive dividends
before equity shareholders, and if the company is ever liquidated, they will
receive a share in liquidation proceeds prior to common stockholders.)
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Earned equity consists of retained earnings (also called Reserves and Surplus
or Earned Surplus).
Purchased Equity represents the cash the owners have invested in the company
in the form of shares. Stock comes in several forms:
Preference Shares are shares that have some preferences to equity shares.
Generally, Preference Shareholders receive a dividend before equity
shareholders, and if the company is ever liquidated, they will receive a share in
liquidation proceeds prior to equity shareholders.
Equity Share is the general ownership tool. It is the least nervous, last to be paid
source of funds.
Paid up Capital arises if the share is quoted at an arbitrary par value (called face
value). In India there is a concept of face value, but in many countries, the
concept of face (or par) value simply does not exist.
Earned Equity (R/E) (retained earnings or earned surplus) represents profits
earned by the company and retained in the business. It is a measure of past
profitability and represents earnings the owners could have withdrawn to use
personally (by declaring and paying dividends), but chose to reinvest in the
business.
Total Liabilities and Net Worth represent the sources of funds that finance the
assets and are an indicator of the company's ability to survive in the future. A
happy, satisfied set of creditors is a harbinger of future prosperity and continued
success.
3.9 SUMMARY
The operating cycle of business is also known as cash to cash cycle. It starts
with funds collected by the owners. These are used to arrange purchases and
build materials inventory. This inventory used to produce finished products for
sale. When they are sold to customers they become Sundry Debtors. Then
collections are arranged to get cash again.
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Even though this cycle goes on and on, it is necessary to report operating results
at regular intervals; normally a year. Listed companies are required to prepare
reports every quarter.
In reporting, revenue principle is to be followed to record revenue when it is
earned, usually when goods or services are delivered to customers. Next
matching principle is to be followed to match the expense of the period against
the revenue earned during the same period. To achieve this end, accrual
accounting is necessary.
Companys financial standing on a particular date is reflected in the Balance
Sheet. It shows what it owns (assets) and what it owes (Liabilities and net worth).
From review of the balance sheet, one can monitor the ability of the business to
collect revenues, how well inventory is managed, and even assessment of the
businesss ability to satisfy its creditors and shareholders.
Assets shown in the balance sheet are classified based on their liquidity.
Noncurrent assets are those which will not mature into cash within a year. They
include net fixed assets, investments in subsidiaries, intangibles etc. Fixed assets
are long term investments which enable the business to carry operations and
include Land, Buildings, Machinery and Equipment, Furniture and Fixtures and
Vehicles etc. When the amount of accumulated depreciation is reduced from the
original value of the fixed assets we arrive at net fixed assets.
Current assets are those, which mature into cash in less than a year. Cash,
accounts receivables, inventory, pre-paid expenses are all current assets.
Accounts receivables and Inventory are controlled by monitoring how fast they
are turned over in a year.
Liabilities and net worth are sources of cash and are listed in the balance sheet in
that order. Current liabilities are that which will mature and must be paid within 12
months. Portion of a long term loan that is payable in the current year is due in
less than 12 months and has to be shown separately for Bankers. Contingent
liabilities are potential liabilities and are shown as foot notes to the balance sheet.
Equity or net worth represents owners share in financing all the assets.
Purchased equity consists of paid up share capital, while earned equity consists
of retained earnings called as reserves.
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1. Accrual Accounting records Revenue as earned ignoring whether the cash is paid
for the same. It records expense as incurred ignoring whether and when the expense
is paid in cash. Cash Accounting records revenue as cash is received and records
expense when it is paid ignoring when the cost is incurred.
2. Operating cycle of a business involves the process of converting the raw material
to cash i.e. the cash-to-cash cycle. It includes components such as purchase of raw
material inventory, converting it into finished goods inventory, sale thereof at profit to
create a receivable and collection to convert into cash once again which is used to
pay the supplier and the profits left in the business.
3. Matching principle matches the expense of a period against the revenue earned
during that same period. Accrual accounting aims to match the expenses with
income of the relevant accounting period. But it calls for making adjusting entries to
properly match expenses with revenue.
4. Non-Current Assets are those assets that will not mature into cash within the next
12 months. They include Net Fixed Assets, Investment in Subsidiaries and Joint
Ventures, Intangibles and Other Assets. The Current Assets are those assets of
business, which mature in less than one year. They include the broad groups of
Cash, Accounts Receivable, Inventory, Notes Receivable, Prepaid Expenses and
Other Current Assets.
5. Contingent liabilities are potential liabilities and not actual ones as of the date.
They have as yet not become due. These are listed by way of footnotes to the
Balance Sheet and not as part of the Balance Sheet as they have not accrued.
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video1
Video2
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4
The Profit and Loss Account or The
Income Statement
Objectives:
After completing this chapter, you will be able to understand:
Capital and Revenue Expense.
Gross Profit and Net Profit.
Earnings per Share.
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Structure:
4.1 Introduction
4.2 Distinction between Capital and Revenue
4.3 Revenue
4.4 Expenses
4.5 Gross Profit
4.6 Operating Income (EBIT)
4.7 Net Earnings
4.8 Internet Exercises
4.9 Summary
4.10 Self Assessment Questions
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4.1 INTRODUCTION
The Profit and Loss Account is the summary of all transactions, which the
company has entered into a revenue account during the accounting period.
An accounting time period that is one year long is called a fiscal year. In India,
normally, fiscal years begin on 1st April and end on 31st March. However,
companies are free to adopt any other 12-month period as their fiscal year,
provided they also draw up for tax purposes a set of accounts as on 31st March
every year as well. In the US, the Profit and Loss Account is called the Income
Statement. For understanding what revenue account is, we need to
understand the distinction between Revenue and Capital.
4.2 DISTINCTION BETWEEN CAPITAL AND REVENUE
Capital (when applied to expenses) is that which is laid out for investment/
purchases not intended to be sold at a profit in the normal course of business.
Anything, which is intended to be sold in the normal course of business, is
revenue expenditure. Capital and revenue receipts are also distinguished
similarly. Of course, the distinction is oversimplified, and can cause innumerable
problems in actual practice. Be that as it may, since this is not the place to
discuss this distinction deeply, the above explanation might suce.
There is a principle called the Revenue Recognition principle that dictates that
revenue be recognized in the accounting period in which it is earned.
Revenue accordingly is considered as earned :
when the service has been provided or
when the goods are delivered.
All revenue receipts and expenses are part of the Profit and Loss Account, the
net balance of which is transferred to Owners Equities (Reserves) in the Balance
Sheet. The Profit and Loss Account is also called an Income Statement, and is
usually presented in a format that is now globally accepted, known as the
Vertical format. We give on page 82 a sample Profit and Loss Account in this
format.
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A company deducts these costs (cost of sales, cost of goods sold) from its
revenue, showing the resultant gross profit (or loss).
4.6 OPERATING INCOME (EBIT)
In addition to the expenses directly related to producing goods and services,
companies incur operating expenses. These include advertising, salaries, rent,
research and development, oce supplies, and any other administrative
amounts spent. A company deducts these operating expenses from gross profit,
resulting in operating income (or loss). Operating income is also often called
EBIT (Earnings Before Interest and Tax). A variant of this is EBITDA (Earnings
Before Interest, Tax, Depreciation and Amortization). This is EBIT before
deduction of depreciation and amortisation of assets. Operating income
represents the enterprises revenue minus expenses required to earn that
revenue. From this amount are deducted costs relating to debt financing and tax
expenses. The remainder is called net earnings.
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31-Mar-03
31-Mar-02
INCOME
Revenues
1,90,475
1,78,153
8,024
6,832
1,98,499
1,84,985
1,10,312
1,03,991
Other Income
Total
EXPENDITURE
Raw Materials, Packing Materials
Conversion Charges
Excise Duty
Employee Costs
Sales, General and Admin Expenses
8,213
8,036
10,869
11,640
15,291
13,784
5,555
1,836
R & D Expenses
Depreciation
Provisions
Deferred Revenue Exp w/off
Interest and Finance Charges
Total
9,916
8,677
1,60,156
1,47,964
38,343
37,021
803
Extraordinary Items
PBT
501
37,540
36,519
99
1,464
2,125
-
36,075
34,394
1,496
4,058
37,571
38,452
29,415
29,877
Appropriations
Interim Dividend
Tax on Interim Dividend
Proposed Dividend
4,000
3,080
7,079
395
681
1,496
37,571
38,452
100
its shareholders. For example, if the net earnings are Rs.1 crore and 500,000
shares have been issued, the earnings per share are Rs.20 (Rs.10,00,000
500,000 = Rs.20).
Although all net earnings really belong to the shareholders, companies rarely
distribute the full amount as dividends. This is because they need the money to
grow and to expand their business, by reinvesting this money in its own
business. The total amount of a company's net earnings since its inception,
minus any payments made to shareholders by way of dividends, are called
Retained Earnings.
Although the term Retained Earnings conjures up visions of large piles of
currency notes, this is not true. Retained earnings are actually part of
shareholders' equity and represent that part of the company's assets that is
financed from profit from past operations, rather than from issuing shares to
investors or borrowing from banks or other external lenders.
Another way that shareholders benefit from retained earnings is through
dividends. A company's Board of Directors, with the advice of the management,
decides on the amount of dividends per share to pay. Highly profitable
companies often pay dividends quarterly; however, many companies do not pay
dividends at all, and a few pay dividends less often.
4.8 INTERNET EXERCISE 1: FINANCIAL ANALYSIS ACTIVITY
Compare the income statements of two large Indian pharmaceutical companies
Sun Pharmaceuticals and Dr Reddys Laboratories. To find Suns income
statement on the Internet go to www.sunpharma.com, and click on the link for
the latest Annual Report. Download the Financial Report section available in PDF
format (You need the Free Acrobat Reader to be able to view this). Dr Reddys
income statement is found at www.drreddys.com. Click on Investors, then on
Annual Reports, and go the same year as the latest available Financials of Sun
Pharmaceuticals, and select Indian GAAP standalone and download.
1. What is the first thing you see in the Financial Reports? Do the Reports you
are seeing pertain to the same accounting year?
101
2. Who are the auditors? Where has the Audit Report been signed?
3. What were the sales revenue for each company?
4. What does currently each company unit in express the figures of their financial
statements?
5. Would you consider Net of Excise Sales, or Sales including Excise for
comparability? Where does Excise duty figure in Sun Pharmaceuticals Profit
and Loss Account?
6. What was the cost of goods sold for each company? How would you deduce
the same from the Profit and Loss Account?
7. How much did each company have in operating expenses?
8. How much was the profit after tax for each company?
9. Did either company have discontinued operations, extraordinary items, or
cumulative adjustments? What were the amounts of each of these items?
10.What were the earnings per share for each company?
11.What was the amount of the current assets for each company? What are
some of the items included in current assets?
12.What was the amount of total assets for each company? What are some of
the items are included in fixed assets?
13.What was the amount of the current liabilities for each company? What are
some of the items included in current liabilities?
14.What was the amount of total liabilities for each company? What are some of
the items included in long-term liabilities?
15.Compute the following ratios for both these companies:
a. Working Capital
b. Current Ratio
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c. Quick Ratio
16.Based on the liquidity ratios, which company, Sun or Dr Reddys is better able
to meet its current obligations?
Note: This website, and most other websites that we point you to, are constantly
being updated. Please check to see that the information requested in this
exercise is available. It might be useful for you to print out the pages of the
financial statements alone (if not all pages) and keep the hard copies handy while
doing this exercise.
Internet Exercise 2: Financial Analysis Activity
Dell Computer Corporation's activities run the full range from design and
development to manufacturing, marketing, and servicing many types of
computer systems. In addition to laptops and desktops, the company also
manufactures enterprise systems. In order to accomplish all of these business
functions, the company needs to have a fairly significant investment in operating
assets. In this exercise, you will look at what types of long-term assets the
company has and how they are reported in the financial statements. The
company's most recent filing can be found on the Dell Web site, by clicking on
About Dell, Investors, Annual Reports.
1. What period does the financial year of Dell cover?
2. What types of long-term assets appear on the company's balance sheet?
What are the balances in these accounts?
3. The first footnote to the financial statements indicates that the property, plant
and equipment are carried at depreciated cost. What does that mean? Is that
allowed under GAAP? What accounting concepts apply to this method?
4. What depreciation methods does the company use?
5. How much did the company spend for capital expenditures in the latest year?
Where do you find this information? Do you think this amount of expenditure is
good or bad? Why?
103
6. What is their inventory? How many days of sale does it represent? How does
this compare with other companies in the same or other industries?
Note: The Dell Annual Report is a largish download of nearly 5 MB. So it might
be a good idea for one of you to download it on to a CD and circulate the CD to
your co-students.
Internet Exercise 3: Financial Analysis Activity
With nearly 25,000 restaurants in over 100 countries, McDonald's is the largest
and best-known global food service retailer. Go to www.mcdonalds.com under
Corporate, Investor Info, and select Financial Reports.
1. What are the sources of McDonald's revenues?
2. What are McDonald's major expenses?
Based on the "Letter to Shareholders," how did management portray the annual
performance of the corporation?
4.9 SUMMARY
The profit and loss account is the summary of all transactions, which the
company has entered into a revenue account during the accounting period.
Capital expense is that which is laid out for investment / purchase not intended
to be sold at a profit in the normal course of business. Anything which is
intended for to be sold in the normal course of business is revenue expenditure.
Capital and revenue receipts are also distinguished similarly.
When expenses for producing goods sold are deducted from revenue generated
by their sale you arrive at gross profit (or loss). From this, company deducts
operating expenses like advertising, salaries, rent, research and development,
oce supplies and other administrative expenses to arrive at Earnings Before
Interest and Tax (EBIT).
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Cost of debt financing i.e. interest is deducted from EBIT to arrive at net earnings
or profit. If all these earnings were to be distributed to shareholders one gets
earnings per share. A part of net earnings is actually distributed as dividends and
remaining part is called retained earnings. Retained earnings denote
shareholders equity and that part of the assets that is not financed through issue
of shares or long term loans.
4.10 SELF ASSESSMENT QUESTIONS
Choose the Correct answer:
1. The Balance Sheet gives us information about the ______________ of a
Company.
a. Profits & Losses
b. Income & Expenses
c. Assets & Liabilities
d. Assets & Equity
2. The Profit & Loss account gives us information about
a. Income & Expenses as on a date
b. Income & expenses for a period
c. Assets & Losses for a period
d. Assets & Liabilities as on a date
3. An Asset, which is not a fixed asset
a. Computers
b. Patents
c. Finished goods
d. Buildings
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a. Patents
b. Goodwill
c. Dematerialized shares
d. Brand names
9. Which of the following is not a source of funds
a. profit after tax
b. share capital issued
c. sale of investments
d. share buyback
10. Which of the following is not a use of funds
a. purchase of fixed assets
b. decrease in working capital
c. repayment of loan
d. share buybacks
4. Fill in the blanks:
1) All significant accounting policies are to be disclosed as part of _____
_________ ____ __ ___ __________ .
2) Fundamental Accounting Assumptions are ________ _________,
__________________ and _____________ .
3) Depreciable amount of a depreciable asset is its ___________ ________ as
reduced by its ____________ _________ _________.
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SOLVED EXAMPLE
1. Continuing with the solved example No.1 at the end of Chapter 2, post the
entries of Abhay & Co to the respective ledger accounts and prepare a Trial
Balance (assuming manual, T-form of accounts and Financial Statements are
adopted.
After preparing the Trial Balance, prepare the final accounts (i.e. Profit & Loss
Account and Balance Sheet) of Abhay and Company taking into consideration
the following further adjustments.
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Particulars
J.F
Amount Rs.
Date
Particulars
J.F
Amount Rs.
To Bank A/c
10,000
By Mohans A/c
200
To Sales A/c
19,600
By Purchase A/c
To Mohans A/c
10,050
By Conveyance A/c
700
By Stationery A/c
450
8,000
By Salary A/c
3,000
By Wages A/c
800
By Balance C/d
26,500
39,650
39,650
Capital Account
Date
Particulars
To Balance C/d
J.F
Amount Rs.
3,00,000
3,00,000
Date
Particulars
By Sundries
J.F
Amount Rs.
3,00,000
3,00,000
109
Purchase Account
Date
Particulars
J.F
Amount Rs.
To Sundries A/c
12,000
To Rohans A/c
8,000
To Bank A/c
8,000
To Cash A/c
8,000
To Memons A/c
8,000
Date
Particulars
J.F
Amount Rs.
44,000
44,000
44,000
Particulars
J.F
To Sundries
Amount Rs.
Date
2,00,000
Particulars
J.F
By Balance C/d
Amount Rs.
2,00,000
2,00,000
2,00,000
Furniture Account
Date
Particulars
J.F
To Sundries
Amount Rs.
Date
30,000
Particulars
By Balance C/d
30,000
J.F
Amount Rs.
30,000
30,000
Bank Account
Date
Particulars
To Sundries
J.F
Amount Rs.
75,000
Date
Particulars
By Cash A/c
10,000
By Drawing A/c
4,000
2,000
To Rohans A/c
6,000
To Purchase A/c
8,000
To Interest A/c
To Balance C/d
75,000
500
44,500
75,000
110
Rohans Account
Date
Particulars
J.F
To Bank A/c
Amount Rs.
Date
6,000
500
To Balance c/d
Particulars
J.F
Amount Rs.
By Sundries
5,000
By Purchase A/c
8,000
6,500
13,000
13,000
Particulars
J.F
To Balance c/d
Amount Rs.
Date
12,000
Particulars
J.F
By Sundries
Amount Rs.
12,000
12,000
12,000
Drawing Account
Date
Particulars
J.F
To Bank
Amount Rs.
Date
4,000
Particulars
J.F
By Bal c/f
Amount Rs.
4,000
4,000
4,000
Particulars
J.F
To Bank
Amount Rs.
Date
2,000
Particulars
J.F
Amount Rs.
2,000
2,000
2,000
Mohans Account
Date
Particulars
J.F
Amount Rs.
To Sales A/c
10,000
To Cash A/c
200
10,200
Date
Particulars
By Cash A/c
By Discount allowed A/c
J.F
Amount Rs.
10,050
150
10,200
111
Memons Account
Date
Particulars
J.F
To Balance c/d
Amount Rs.
Date
8,000
Particulars
J.F
By Purchase A/c
Amount Rs.
8,000
8,000
8,000
Meenas Account
Date
Particulars
J.F
To Sales A/c
Amount Rs.
Date
12,000
Particulars
J.F
By Balance c/d
Amount Rs.
12,000
12,000
12,000
Particulars
J.F
Amount Rs.
To Sales A/c
400
To Mohans A/c
150
Date
Particulars
J.F
Amount Rs.
550
550
550
Particulars
J.F
Amount Rs.
Date
500
Particulars
J.F
By Rohans A/c
Amount Rs.
500
500
500
Conveyance Account
Date
Particulars
J.F
To Cash
Amount Rs.
Date
700
Particulars
J.F
Amount Rs.
700
700
700
Stationery Account
Date
Particulars
To Cash
J.F
Amount Rs.
450
450
Date
Particulars
By Profit & Loss A/c
J.F
Amount Rs.
450
450
112
Salary Account
Date
Particulars
J.F
To Cash
Amount Rs.
Date
3,000
Particulars
J.F
Amount Rs.
3,000
3,000
3,000
Wages Account
Date
Particulars
J.F
To Cash
Amount Rs.
Date
800
Particulars
J.F
Amount Rs.
800
800
800
Interest Account
Date
Particulars
J.F
To Bank A/c
Amount Rs.
Date
500
Particulars
By Profit & Loss A/c
500
J.F
Amount Rs.
500
500
Sales Account
Date
Particulars
To Profit & Loss A/c
J.F
Amount Rs.
42,000
Date
Particulars
By Mohans A/c
10,000
By Meenas A/c
12,000
By Cash A/c
19,600
400
42,000
113
Particulars
Cash A/c
Capital A/c
Purchase A/c
Plant & Machinery A/c
Bank A/c
Furniture A/c
Rohans A/c
Loan (Taken) A/c
Drawing A/c
Insurance Premium A/c
Memons A/c
Meenas A/c
Discount Allowed A/c
Discount received A/c
Conveyance A/c
Stationery A/c
Salary A/c
Wages A/c
Interest A/c
Interest (paid) A/c
Sales A/c
L/F
Debit Rs.
Credit Rs.
26,500
44,000
2,00,000
44,500
30,000
4,000
2,000
12,000
550
700
450
3,000
800
42,000
3,00,000
6,500
12,000
8,000
500
500
83,000
4,10,500
4,10,500
114
Profit & Loss Account of Abhay and Company for year ending on ____________
Particulars
To Purchase
Less Goods lost in theft
Less Closing Stock
Rs.
44,000
By Sales
Rs.
83,000
15,000
500
27,000
800
2,000
500
Less Prepaid
1,500
To Discount Allowed
550
To Conveyance
700
To Stationery
450
Add Outstanding
Rs.
500
To Wages
To Salary
Particulars
2,000
To Insurance Premium
Rs.
3,000
1,000
To Interest
4,000
42,000
To Loss by Theft
2,000
To Depreciation (total)
Total
1,03,500
19,500
Total
1,03,500
115
Rs.
Capital Account
3,00,000
Less: Drawings
4,000
Rs.
Assets
Plant & Machinery
Less: Depreciation @ 10%
Rs.
Rs.
2,00,000
20,000 1,80,000
2,96,000
(19,500)
2,76,500 Furniture
Less: Depreciation @ 15%
30,000
4,500
25,500
12,000
Creditors
Closing Stock
Memon
8,000
Rohan
6,500
15,000
Debtors
14,500
Meena
12,000
Prepaid Insurance
Outstanding Salary
Total
500
44,500
Cash on Hand
26,500
3,04,000
Total
3,04,000
116
Problems to Solve
1. The following are the Account Balances of Highly Prosperous Limited as on
March 31, 200X.
!
55,500
60,000
Accounts Receivable !
217,500
Advertising ! !
12,000
Land 1! !
1,250
9,000
Factory Building !!
93,000
Machinery ! !
93,750
Accumulated Depreciation
!
- Factory Building !
15,750
- Machinery !!
54,000
5,100
3,750
Cash in Bank !
5,250
3,150
Marketable Securities !
7,500
7,500
5,250
15,000
Insurance ! !
3,750
150
300
!
!
30,000
117
3,000
6,000
Office Expenses !
4,500
Office Rent ! !
3,750
Office Salaries ! !
49,500
97,500
187,500
37,500
- Raw Materials !!
127,500
- Work-in-Process ! !
24,000
9,750
Repairs to Machinery !
12,750
Sales ! !
832,500
23,250
Wages ! !
226,800
Accounts payable !
15,150!!
2,594,400!!
52,500
- Raw Materials !!
247,500
- Work-in-Process ! !
15,000
119
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120
5
The Statement of Cash Flows
Objectives:
After completing this chapter, you will be able to understand:
Methods of Preparing Cash Flows.
121
Structure:
5.1 Introduction
5.2 What Purpose does the Cash Flows Serve?
5.3 Methods of Preparing Cash Flows
5.4 Summary
5.5 Self Assessment Questions
122
5.1 INTRODUCTION
The statement of cash flows is one of the principal financial statements required
by GAAP. Lets consider these financial statements in terms of what information
they provide, what accounts they include, what time period they cover, etc.
Balance Sheet
Income Statement or Profit and Loss Account
Statement of Cash Flows
Which is the most important financial statement? Remember that positive net
income on the income statement is meaningless unless the corporation can
translate earnings into cash inflows. Since most companies use accrual
accounting, the only place one can discover what has happened to cash is the
statement of cash flows. And as we have said elsewhere, cash is the only game
in town.
123
124
The steps to prepare the operating activities section (indirect method) and convert
the accrual net income figure to a cash figure are as follows:
!
Once the operating activities section has been completed, the investing and
financing activities sections can be prepared.
Non-cash investing and financing activities are reported in a separate schedule in
the statement of cash flows. They are transactions arising when firms make
investments that do not require cash and/or obtain financing other than cash, i.e.,
firm issues shares to acquire a building.
The statement of cash flows prepared using the direct method converts each item
in the income statement to a cash flow, i.e., sales are converted to cash receipts
from sales, etc. Of course, the net cash inflow from operating activities is the
same whether the statement is prepared by the indirect or direct method.
The following is an example of how a Cash Flow Statement is prepared from a
Profit and Loss Account and Balance Sheets. Please study this example carefully,
125
as this serves as an example of the Vertical Form Balance Sheet, Profit and Loss
Account Statement and Cash Flow Statement.
It is important to observe that the cash flow compares Balance Sheets as on two
dates and determines the cash inflow or outflow or none at all. It is, therefore,
more convenient to plot the Balance Sheets on two dates in a vertical form.
The information from the statement of profit and loss and balance sheet is
provided to show how the statements of cash flows under the direct method and
the indirect method have been derived. Note that neither the statement of profit
and loss nor the balance sheet is presented in conformity with disclosure and
presentation requirements of applicable laws and accounting standards. It is
important to understand the manner in which the various figures appearing in the
cash flow statement are derived. The working notes given do not form part of the
cash flow statement.
!
1 Add
2 Since
the entire cash effect of gains or losses on fixed assets will be reported in
the Investing Section of the statement of cash flows, the effect of these sales
must be removed from the Operating Activities section.
3 Changes
in current asset (other than cash) and current liability accounts result
from operating activities. For example, changes in Accounts Receivable result
from Sales on Account. Thus we have to account for these changes in the
operating activities section. An increase in accounts receivable is deducted from
net income because more sales revenue has been included in the income
statement than has been collected from customers. Similarly, decrease in
Accrued Liabilities is subtracted from net income because payment of a current
liability causes both cash and the liability to decrease.! !
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
126
There are certain transactions which will have the effect of reducing the profit but
will not affect the cash flow. Such charges are known as non-cash charges. For
eg. When we charge depreciation on the assets there is no outflow of cash but
the profit gets reduced.
Based on the above example indicate whether the following transactions will
result in an inflow of cash or an outflow of cash, or it will not affect the cash flow.
127
5.4 SUMMARY
The statement of cash flows is one of the principal financial statements required
by GAAP. It gives an opportunity to see how good is the company in realizing
adequate cash flows from its main operating business.
The statement shows cash flows from operating, investing and financing
activities.
The statement is prepared using a direct or indirect method. Under indirect
method, it is prepared by comparing two balance sheets prepared on the first and
last date of the period for which it is prepared. The process starts from the net
income and additions and subtractions are made for depreciation, loss/gain on
assets disposed, changes in current assets and liabilities.
After operating activities are completed the investing and financing sections are
prepared.
In the direct method each item on he income statement is converted into cash
flow.
128
31.03.2006
31.03.2007
Rs.
Rs.
Share Capital
275000
325000
P. & L. A/c
10000
23000
Account Payable
70000
45000
355000
393000
Machinery
100000
116000
Debtors
120000
115000
Raw Material
80000
90000
Cash
55000
72000
355000
393000
Assets
HINT:
a. Compare the Balance Sheet as at 31.3.2006 and 31.3.2007. Note the changes
that have taken place.
b. Determine the Increase / Decrease in Working Capital. And determine thee
Cash Used For Operations.
c. Proceed to determine cash flow from investing activities.
d. Proceed to determine the cash flow from financing activities.
e. Work out the cash at beginning of year and at the beginning of year.
Amalgamate (c) and (d).
129
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130
6
Accounting for Inventory
Objectives:
After completing this chapter, you will be able to understand:
Inventory Systems.
Inventory Costing.
Principles of Inventory Valuation.
131
Structure:
6.1 Introduction
6.2 Inventory Systems
6.3 Inventory Costing
6.4 Closing Stock Valuation
6.5 Summary
6.6 Self Assessment Questions
132
6.1 INTRODUCTION
The general model of an income statement of a trader takes the following form:
Sales Revenue
Less Cost of Goods Sold
Equals Gross Profit
Less Operating Expenses
Equals Net Income
In discussing accounting, we need to consider Inventory. Traders purchased
inventory and resell it. Manufacturers, on the other hand, purchase raw materials
and packing materials, process them and create finished goods, which are then
sold. For both these types of businesses, accounting for inventory is critical.
Inventory aects both the balance sheet and the income statement. Inventory
that is sold is expensed on the income statement as Cost of Goods Sold
whereas inventory unsold at year-end is shown as a current asset on the balance
sheet. Companies cost inventory by multiplying the number of units by the cost
per unit. The model of cost of goods sold takes the following form:
Beginning Inventory
+ Purchases
= Goods Available
Ending Inventory
The inventory of finished goods on 1-4-2007 of A Ltd. was 25 Units valued at Rs.
1,00,000. It acquired 22 Units during the month at the total cost of Rs. 93,500.
The inventory as of 30.4.2007 is 19 Units valued at Rs.80,750. From this, one
can work out the Cost of Goods Sold.
133
Qty.
Value
Nos.
Rs.
Inventory as on 1.4.2007
25
100000
Add: Purchases
22
93500
47
193500
19
80750
28
112750
Inventory
Note that two journal entries are required to record a sale as follows:
To Sales Revenue
AND
134
To Inventory
Since Inventory is debited when goods for resale are purchased and credited
when goods are sold, the Inventory account keeps a running balance of
Inventory on hand.
In actual practice, the accounting for Inventory may be a little more complicated
than the general model above, as we need to properly account for Freight
Inwards, Purchase Returns, Purchases Allowances, and Purchase Discounts, not
to speak of other complexities like costs incurred after receipt of goods, quality
control rejections, goods sent out to third parties for processing, spoilage,
process-waste and by-product accounting, and so on.
The computation for net sales is as follows:
Gross Sales
Sales Returns and Allowances
Sales Discounts
= Net Sales
Rs.
Gross Sales
Less: Sales Returns and Allowances
Sub-Total
Less: Sales Discounts
Net Sales
125000
9300
115700
5000
110700
135
136
Rate
Cost
Rs.
1100
10.00
11,000
500
10.25
5,125
600
10.00
6,000
750
10.50
7,875
400
10.40
4,160
3350
34160
34160/3350
i.e. Rs.
10.20
There are other methods also, like LIFO (Last In, First Out). Other than the above
three methods, no other method is approved by Indian GAAP.
Under FIFO, the first units acquired are assumed to be the first units sold.
Advantages of this method in a period of rising prices include:
Always reports current cost for Ending Inventory.
Reports higher net income.
Disadvantages of the FIFO method include:
Violates the matching principle (FIFO matches some of the previous year's
inventory cost against current revenue.)
Results in higher taxes and lower cash flows.
Does not adjust Cost of Goods Sold for the eect of inflation.
The following would illustrate the operation of FIFO.
137
The materials were purchased in lots on various dates in dierent rates. These
are issued to consumption in dierent quantities. The rates charged on quantities
issued to consumption are dierent from what they were when purchased.
Issues to consumption are made on the assumption that these came from the
oldest lot in balance. Cost of such oldest lot is charged to consumption.
Assuming Opening Stock of 300 Units valued at Rs. 3.25 per Unit, observe the
following:
Lot No.
Date
Quantity
Rate
Amount
Op St.
300
2.95
885
1-Jan
1950
3.25
6,338
5-Jan
2600
3.90
10,140
7-Jan
2250
2.93
6,581
11-Jan
1300
3.58
4,648
15-Jan
3900
2.60
10,140
Total
12300
38731
138
Date
Quantity Issued
03-Jan
1700
06-Jan
2100
09-Jan
500
700
16-Jan
1400
150
1250
50
450
22-Jan
2150
Total
10450
139
L2
L3
L4
L5
1400
550
1550
500
550
150
1400
150
550
700
50
450
100
2050
Total Issues
1950
2600
2250
1300
2050
Purchases
1950
2600
2250
1300
3900
1850
Bal.
140
The FIFO method would value the materials issued for consumption as follows:
Date
3-Jan
6-Jan
9-Jan
16-Jan
22-Jan
Total
Quantity Issued
1700
Qty.
Rate
Rs.
Op St.
300
2.95
885
Lot1
1400
3.25
4550
Lot1
550
3.25
1788
Lot 2
1550
3.90
6045
500
Lot 2
500
3.90
1950
700
Lot 2
550
3.90
2145
Lot 3
150
2.93
439
1400
Lot 3
1400
2.93
4095
150
Lot 3
150
2.93
439
1250
Lot 3
550
2.93
1609
Lot 4
700
3.58
2503
50
Lot 4
50
3.58
179
450
Lot 4
450
3.58
1609
2150
Lot 4
100
3.58
358
Lot 5
2050
2.60
5330
2100
10450
10450
33921
141
With this, the Value of Closing Stock under FIFO would go as under:
Units
Op. Stock
Add: Purchases
Units
300
12000
12300
10450
Closing Stock
1850
Rs.
2.60
Value
Rs.
4,810
The balance stock at the end of 22 January will be 1850 units and under FIFO
method if will be assumed to be out of Lot no. 5. Its value will be Rs. 4810 i.e.
Rs. 2.60 per unit.
Under the LIFO method, the last units acquired are assumed to be the first units
sold. Advantages of LIFO include:
Always matches expense and revenues
Results in lower taxes and higher cash flow
Disadvantages under LIFO include the following:
Reports lower net income
Reports understated Ending Inventory
Can be used to manipulate income. Hence, frowned upon by GAAP.
142
143
144
For instance, when the opening inventory is Rs. 50,000 and the inventory
purchased is worth Rs.1,20,000 and the estimated cost of goods sold being Rs.
1,40,000, it can be estimated that the Estimated closing Inventory shall be Rs.
30000.
6.5 SUMMARY
There are two principal types of inventory systems, periodic and perpetual.
Periodic system is used for inexpensive goods or where there is no need to track
inventory accurately throughout the year. Most companies use the Perpetual
system so that they can track inventory throughout the year.
Cost of goods sold is the largest expense in the income statement and it is
determined by the method used for inventory costing. GAAP approve specific
identification, average cost or First in, First out (FIFO) methods of inventory
costing.
While valuing inventory, interest, selling and distribution, or any abnormal costs
are not included. Also principles of consistency, disclosure, materiality and
conservatism are to be applied.
145
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146
7
Accounting for Fixed Assets
Objectives:
After completing this chapter, you will be able to understand:
Capital and Revenue Expenditure.
Accounting for Fixed Assets.
Methods of Depreciation.
147
Structure:
7.1 Why Segregate Between Capital and Revenue?
7.2 Criterion for Distinction
7.3 Capital Expenditure
7.4 Revenue Expenditure
7.5 Deferred Revenue Expenditure
7.6 Capital and Revenue Receipts
7.7 Other Examples
7.8 What Costs Form Part of Fixed Assets
7.9 Machinery Spares
7.10 Fixed Asset Accounting
7.11 Assets Purchased in the Course of the Year
7.12 Units of Production Method
7.13 Written Down Value Method
7.14 Sale of Assets
7.15 Natural Resources
7.16 Impairment of Assets
7.17 Summary
7.18 Self Assessment Questions
148
149
150
manufacturer has his factory is part of his fixed assets, and its sale would be a
capital receipt. However, the land for a dealer in real estate is his stock-intrade,
and its sale would be a revenue receipt.
152
expenses can be capitalised as part of the fixed asset schedule, the resale
value of the asset is not going to be impacted by including that amount.
ii.Companies do not give the break-up of costs capitalised and added to the value
of the asset. These are not shown separately from the actual purchase price of
the assets. A conservative view is that it may be prudent to treat such intangible
expenses as miscellaneous expenses not written off or preliminary and preoperative expenses, instead of being added to the value of fixed assets.
iii.Administrative expenses and other general overhead expenses incurred during
the construction stage which do not relate to any specific fixed asset are
usually excluded from the cost of fixed assets. However, in some
circumstances, such expenses as are specifically attributable to the
construction of a project or to the acquisition of a fixed asset or to bring 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.
borrowing cost of funds that finance the asset, such as interest and foreign
exchange losses
However, to the extent that borrowing such costs (financing costs (including
interest) on fixed assets purchased on a deferred credit basis or on monies
borrowed for construction or acquisition of fixed assets) relate to periods after
such assets are ready to be put to use are not capitalised.
An interesting situation can arise where a company finances the entire cost of an
asset through its share capital or internal cash accruals. Here, there would be no
addition under the head interest capitalised. Similarly, if full down, payment were
made in foreign currency without resorting to a foreign currency loan, addition to
the asset value towards future foreign exchange losses would not be available.
From this, one may bear in mind that the value of an asset may be dependent on
sources of its finance.
Commissioning and trial expenses capitalised until the commencement of
commercial production etc.
Any trade discounts and rebates are deducted in arriving at the purchase price of
the fixed assets. Similarly, any Government Grants related to specific fixed assets
153
154
when it has no utility value. In such a case, the profit/Loss on disposal, shall be
recognised on disposal to the Profit & Loss account.
the balance sheet and the related expenses of depreciation and amortization
amount to a substantial expense on the income statement.
The general model for accounting for fixed assets is as follows:
Asset Account (on Balance Sheet)
Land
None
Depreciation
Depletion
Intangibles
Amortization
Accumulated Depreciation
156
157
10%
Machinery Account
Date
Debit
1.9.2006 Bank
1.9.2006 Bank
Rs.
Date
Credit
(Installation Charges)
2,500
Total
Rs.
50000
Total
47,500
50000
5,000
Total
47,500
Total
42,500
47,500
5,000
Total
42,500
Bal. c/d
37,500
Total
42,500
158
Debit
Rs.
Date
Credit
Rs.
2,500
5,000
5,000
For example, if a die which cost Rs.105 million is expected to yield 20 million
units of output units over its lifetime, and the residual value is expected to be Rs.5
million, the UOP rate would be
(Cost Residual Value)/Life in Units = (105 5)/20 = Rs.5 per unit produced
If 200,000 units were manufactured in a year, the depreciation would be Rs.
1,000,000.
7.13 WRITTEN-DOWN VALUE METHOD
Under the written-down value method of depreciation, the depreciation is
expressed in percentage terms. The following years depreciation will be
calculated by applying the depreciation percentage to the book value (after
depreciation) at the beginning of the period.
For example, if an asset, which cost Rs.1,00,000, were to be depreciated at 20%
per annum under the WDV method, the first years depreciation would be Rs.
20,000. Thus the WDV of the asset at the year-end would be Rs.80,000. The
second years depreciation would be 20% of Rs.80,000, viz.Rs.16,000 (WDV at
159
the end of year II Rs.64,000); the third years depreciation would be Rs.12,800
(20% of Rs.64,000) and so on.
Taking the example we considered for Straight line method, when the rate of
Depreciation is 10%, the Machinery a/c and the Depreciation a/c for three years
would look as under:
Depreciation on WDV basis
Rate of Depreciation
10%
Machinery Account
Date
Debit
1.9.2006 Bank
1.9.2006 Bank
Rs.
Credit
(Installation Charges)
Total
Date
2,500
50000
Rs.
Total
47,500
50000
4,750
Total
47,500
Total
42,750
47,500
4,275
Total
42,750
Bal. c/d
38,475
Total
42,750
160
Debit
Rs.
Date
Credit
Rs.
2,500
4,750
4,275
The WDV method is approved under the Income-tax law, while the Companies
Act in India gives a choice for companies to apply either the SL or WDV method.
The WDV method provides for large write-offs in early years of an assets life and
smaller write-offs in later years. Asset book value is cost minus accumulated
depreciation. Note that with the WDV method, residual value is ignored in the first
years depreciation computation. It is considered in the last year, however, as
residual value should not be depreciated.
If you were trying to minimize income tax expense, which of the three methods
would you select?
7.14 SALE OF ASSETS
Since the assets life is an estimate made at the time of purchase, it may be
necessary to change this estimate of life in later years based on experience or
new information. At some point fixed assets are no longer useful and are either
discarded, sold, or traded in (exchanged) for another asset. When this happens,
regardless of the disposition of the asset, the old asset account must be credited
and the old accumulated depreciation account must be debited as the old asset
must be removed from the books and records.
If the asset is fully depreciated, accumulated depreciated is debited and the asset
account is credited thus removing it from the books and records. The necessary
accounting entry for this would be:
161
When the Depreciation is credited to Fixed Asset itself, it would not be necessary
to pass the above entry. The Fixed Asset concerned would get depleted over time
and would get nullified in course of time.
Similarly, if the asset is sold mid-year, the depreciation account must be updated.
If the sales price is greater than book value, a gain is realized; and if the sales
price is less than book value, a loss is realized.
The following would illustrate this:
In the illustration for WDV method of Depreciation, the WDV of the asset as on
31.3.2004 is Rs.38,475/-. if the asset is sold mid-year, the updating of
depreciation account is required. When the sales price is greater than its
depreciated book value, the gain is realized and is recorded as:
!
The surplus / gain in Fixed Asset a/c is transferred to Profit on Sale of Asset a/c.
!
Date
Debit
Total
Rs.
Date
Credit
40,000
Rs.
40,000
Total
40,000
In case of the asset realizing (sales price) less than its book value, a loss is
realized. This is represented by debit balance in Fixed Asset a/c, which is sold
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out. The loss on sale/ disposal of Fixed Asset is transferred to Loss on Sale of
Asset a/c.
Machinery Account
Date
Debit
Rs.
Date
Credit
Rs.
35,000
Total
38,475
Total
3,475
38,475
When an asset is sold mid-year, the Depreciation from the beginning of the year
to the date of its sale is also expensed out. However, Indian tax laws do not
favour such a treatment.
In the above example, the entire machinery has been sold. Often it may so
happen that only one of the machines is sold off and others are used for
business. In such a situation, the WDV of the unit sold/disposed off need to be
worked out from the date of its purchase/ acquisition till its disposal and that WDV
is to be removed from the asset a/c.
Continuing the above example, we note that the WDV of the Machinery a/c as on
31.3.2009 is Rs.38,475/-. We assume that the Machinery a/c consists of a
number of Machines. One of the Machines is sold for Rs.1,500 on 1.6.2009 while
the other Machines continue to remain reflected in the Machinery a/c. The
Machine, which is sold on 1.6.2009, was acquired for Rs.12,000 on 1.4.2007. The
rate of Depreciation is 10% and WDV method is followed.
It is necessary to independently work out the WDV of the machine, which is sold
since its acquisition, and work out the loss n sale of the machine.
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Bal. as on 31.3.2008
12000
1200
10800
1080
Bal. as on 31.3.2009
9720
162
Bal. as on 31.5.2009
9558
1500
8058
164
Machinery Account
Date
Debit
Rs.
38,475
Date
Credit
1.6.2009 Depreciation
Rs.
162
9,558
2,892
( on WDV of 38475-9558)
(@ 10%)
31.3.2010 Bal c/d
Total
38,475
Total
25,863
38,475
9.558
1.6.2009
1,500
1.6.2009
Total
Cash / Bank
9,558
8,058
Total
9,558
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Depletion Expense
Accumulated Depletion
Amortization Expense
Intangible Asset
Note: This entry results in directly crediting the intangible asset thus reducing its
basis.
Goodwill is recorded only when it is purchased. Goodwill is calculated as the
excess of purchase price over the market values of the individual net assets
(assets minus liabilities). Goodwill is recorded as an asset and is not amortized.
Under US GAAP, FASBs SFAS 142 requires that goodwill be evaluated annually
to see if it has increased or decreased in value. If it has decreased (usually the
case) it must be written down by debiting a loss account and crediting Goodwill.
Impact of fixed assets on the cash flow statement
In the Operating Activities Section, depreciation and amortization expense must
be added back to net income, as they are non-cash expenses. Cash expenditures
received or paid for the sale or purchase of fixed assets are included in the
Investing Section of the cash flow statement.
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7.17 SUMMARY
Fixed Asset is an asset held with the intention of being used for the purpose of
producing and providing goods or services and is not held for sale.
Distinction between capital and revenue of each transaction is necessary to
conduct exercise of matching costs with revenues. If expenditure is considered
revenue, it fully decreases profit for the period. But if it is capital, only current
years depreciation of it is charged to the current years profit.
There is no single rule of thumb, which can decide the distinction between capital
and revenue. An expenditure, which is an advantage or benefit of an enduring
nature for business ( like land, plant and machinery or patents, trademarks etc.),
is treated as capital expenditure. A payment in connection with a fixed capital, like
architects fees for building, is also a capital expenditure.
Any expenditure for day to day running of the business, purchase of the raw
materials, factory rent or for maintenance of a capital asset is revenue
expenditure.
One must remember that a fixed asset (plant and machinery) for one person can
be a trading asset for another (machinery manufacturer).
When any expenditure provides benefit to the business for about 3 to 5 years, but
does not bring any asset into existence, it is termed deferred revenue
expenditure. Typical example is advertising campaign for launch of a new
product.
Total cost of a fixed asset includes its purchase price, all taxes and duties paid,
finance charges paid, commissioning expenses. Expenses incurred prior to
commencement of business are not added to costs of fixed assets, but clubbed
together as pre-operative expenses and charged to profits of subsequent years.
Machinery spares are normally treated as a part of inventory and expensed when
put to use.
Excepting Land, which is a never expensed asset, other assets like plant,
machinery; vehicles are expensed through depreciation, natural assets by
depletion and intangibles by amortization.
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169
The company follows financial year as its accounting year. You are required
to prepare the machinery account, depreciation account, Accumulated
Depreciation account and Machinery Sale account from 2004-05 to-2007-08.
8. M/s Atlas Car Hire Company Ltd. follows financial year as its accounting year.
They charge depreciation on its cars given for hire @ 25% p.a. and follow WDV
method. The following transactions need your consideration.
On 1st April 2004 one car is purchased for Rs. 4,50,000 and 40,000 is spent
on its accessories, which are also capitalised.
On 14th April 2005 one car is purchased for RS. 7,50,000. On September 30,
2006 the first car is sold for Rs. 2,25,000 and on September 30, 2006 a new
car is purchased for As. 4,35,000. On March 15, 2007, the second car is also
sold off for Rs. 3,25,000 and another car is purchased for Rs. 6,50,000.
You are required to prepare the car account, depreciation account,
Accumulated Depreciation account and Carry Sale account from April 2004 to
2008.
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8
Current and Long Term Liabilities
Objectives:
After completing this chapter, you will be able to understand:
Short and long Term Liabilities.
Contingent Liabilities.
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Structure:
8.1 Introduction
8.2 Categories of Liabilities
8.3 Contingent Liabilities
8.4 Bonds
8.5 Methods to Raise Finance
8.6 Summary
8.7 Self Assessment Questions
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8.1 INTRODUCTION
A liability can be defined as an obligation to transfer assets or to provide services
in the future. The accounting for liabilities can be extremely important as liabilities
are often a significant amount when compared to total assets or compared to total
stockholders equity.
Liabilities arise from past transactions, i.e.
!
Salary Expense
Salary Payable
By means of this entry, salaries owed but not paid in Year X1 will be expensed in
Year X1. Salary Payable will be reflected as a current liability on the 12/31/ X1
balance sheet.
The entry to pay the liability in Year X2 will be:
!
Salary Payable
Cash
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8.4 BONDS
As indicated above, long-term liabilities are those obligations not due within the
forthcoming year. Bonds are an important type of long-term liability. Bonds (or
Debentures) are essentially notes payable representing money borrowed by a
corporation or governmental entity from the investing public. Bondholders/
debentureholders loan their money for a price interest often paid on a semiannual or annual basis. Investors buy and sell bonds on a daily basis through the
bond markets. However, the market for corporate bonds in India has not yet
developed as much as its equity markets have, and are nowhere near the breadth
and depth of corporate bond markets in the US. Much of the bonds traded in
Indian debt markets are Government Bonds, issued to finance the Governments
deficit.
Since bond investors pay money now to purchase bonds in anticipation of interest
and principal payments to be received in the future, we must now consider the
time value of money.
Two interest rates, (1) the contract interest rate and (2) the market interest rate,
interact to set the price of a bond as follows:
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Bonds sell at par when the market interest rate = the contract interest rate
Bonds sell at a discount when the market interest rate > contract interest rate
Bonds sell at a premium when the market interest rate < contact interest rate
Bonds are issued in the marketplace at par, at a discount, or at a premium. Bond
prices are quoted as a percentage of their maturity value, i.e. a Rs.1000 bond
selling at Rs.980 is quoted at 98. As a bond nears maturity, its market price
moves toward par value. On maturity (redemption) date, the market price of
bonds will equal its par value.
Bond discount really represents additional interest expense and bond premium
really represents a reduction in interest expense. There are two methods to
account for bond discount or bond premium, but we will not be discussing these
here as it is not part of your syllabus for this course.
Discount on Bonds Payable is a contra account for Bonds Payable. The carrying
value of a bond payable equals the face amount of the bond less the balance in
the contra account. The carrying value of a bond issued at a premium equals the
face amount of the bond plus the balance in the Premium Account.
Both, the bond carrying value and the periodic interest expense increase over the
life of bonds issued at a discount. At the maturity date, the bond carrying value
equals face value of the bond.
Both, the bond carrying value and the periodic interest expense decrease over
the life of the bonds issued at a premium. At the maturity date, the bond carrying
value equals the face value of the bond.
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8.6 SUMMARY
There are two broad categories of liabilities: current and long term. Current
liabilities are obligations due within a year. All other liabilities are long term.
Current portion of long term debt is also current liability. Potential obligations are
termed contingent liability. If it can be measured, it should be shown in the
financial statement as a footnote.
Bonds are an important type of long term liability. Investors loan their money to
purchase a bond for a price interest often paid on semi-annual or annual
basis. Bonds are bought and sold on a regular basis. In India, markets for bonds
are not as developed as those for equity.
Bonds are traded at a premium or discount, depending upon whether market
rates of interest are above or below contract rate of interest.
A corporation can raise long term funds by issue of equity, debt instruments or
reinvesting profits earned. Of these, second option can be called long term
liability.
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9
Inflation Accounting
Objectives:
After completing this chapter, you will be able to understand:
Necessity for Inflation Accounting.
Methods of Accounting for Inflation.
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Inflation Accounting
Structure:
9.1 What is Inflation?
9.2 Why Inflation Accounting?
9.3 Methods of Accounting for Inflation
9.4 Current Purchasing Power.(CPP)
9.5 Illustration
9.6 Economic Value Method
9.7 Summary
9.8 Self Assessment Questions
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Inflation Accounting
182
Inflation Accounting
183
Inflation Accounting
184
Inflation Accounting
Inflation Accounting
for net loss or gain in purchasing power resulting from the effect of inflation on
the companys net monetary assets or liabilities.
9.5 ILLUSTRATION:
A Ltd. has prepared its historical cost accounts for the year ended 31 March
2006, and 31 March 2007. These are reproduced below:
Balance Sheet
As on 31.3.2006
(Rs. in 000)
As on 31.3.2007
(Rs. in 000)
Non-Monetary Assets:
Fixed Assets
(At cost less depreciation)
650
725
220
250
250
350
1120
1325
Profit and Loss Account for the year ended 31st March, 2007
(Rs. in 000)
(Rs. in 000)
Sales (1760*140/135)
1760
Stock Appreciation
30
Sub-Total
Less: Purchases and other expenses
Depreciation
Net Profit
1790
1510
75
1585
205
186
Inflation Accounting
115
As on 31.3.2006 !
130
As on 31.3.2007 !
140
135
Solution:
Step (a):
Balance Sheet as on 31.3.2006
(Converted into purchasing power of rupee as on 31.3.2006)
(Rs. in 000)
Fixed Assets (650 * 130/115)
735
220
250
Equity
1205
187
Inflation Accounting
Step (b)
Balance Sheet as on 31.3.2006
(Converted into purchasing power of rupee as on 31.3.2007)
Fixed Assets (735 * 140/130)
792
237
269
1298
Step (c)
Balance sheet as on 31.3.2007
(Converted into purchasing power of rupee as on 31.3.2007)
Fixed Assets (585 * 140/115) + (140 * 140/135)
857
250
350
Equity
1457
Step (d)
Therefore, the profit for the year expressed in terms of purchasing power of rupee
as on 31.3.2007 (i.e. current purchasing power) is given by difference of equity as
per step (c) and (d) above. So, profit = Rs. (000) (1457-1298) = Rs. (000) 159
Step (e)
Profit and Loss account
For the year ended 31st March 2007
(Converted into purchasing power of rupee as on 31st March 2007)
188
Inflation Accounting
(Rs. in 000)
(Rs. in 000)
825
Closing Stock
250
2075
237
1566
90
1893
182
23
159
Note 1:
Since FIFO method is followed for determining cost of closing stock, we have
assumed that closing stock represents latest purchases. Consequently, closing
stock figures are already expressed in current purchasing power and they are not
to be converted.
Note 2:
Loss on Net monetary items:
Holding loss on opening net monetary items
Rs. (000) (269-250) !!
19
23
189
Inflation Accounting
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Inflation Accounting
Economic value method can only be applied to the business as a whole. Profit
could be determined by comparing economic values of net assets at successive
balance sheet dates and adjusting for capital introduced. The main charge
against this method is that it is based only on estimation. Estimated future cash
flows are rarely realizable and are subjective.
9.7 SUMMARY
Various systems of accounting for inflation discussed above are not free from
flaws. The CPP method was heavily criticized and modified version for accounting
for inflation in the form of CCA was introduced. But CCA has its own limitations. In
India, the Institute of Chartered Accountants of India has issued a Guidance note
on this issue, which also advocated the use of CCA. In India, leading public
sector undertakings like SAIL, BHEL, OIL, etc. are preparing inflation adjusted
financial statement under CCA as supplementary information. But the inflationadjusted accounts are not legally required in India. Discussion on this subject
gained momentum with the rise in the price levels and the tempo died down with
the fall in inflation.
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Inflation Accounting
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10
Questionable Accounting Practices
Objectives:
After completing this chapter, you will be able to understand:
Suppression of Facts through Wrong Accounting Practices.
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Structure:
10.1 Introduction
10.2 Examples of Questionable Accounting Practices
10.3 Self Assessment Questions
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10.1 INTRODUCTION
Temptation is ubiquitous in the corporate world. Especially when top
management salaries and benefits are linked to better results, and they
themselves have significant control over the policies, which can modify the
declared results materially.
In the last 5 years, an unprecedented number of large corporate collapses have
thrown up several cases of corporate greed. Many of these cases showed up
multiple irregularities, but we look below at a few selected modus operandi of
corporate greed and chicanery, with no attempt to be comprehensive.
10.2 EXAMPLES OF QUESTIONABLE ACCOUNTING PRACTICES
To earn personal profits for their directors, Indian Public Limited companies,
especially with controls in the hands of families, are also often observed to
indulge in inappropriate accounting practices. In most such cases, unfortunately,
Statutory Auditors are also managed by the Directors of the companies. Here are
a few cases collected from reports over the last two three decades of
representative questionable accounting practices followed in the Indian Industry.
[*Names of the companies are fictitious]
Shivam Computers* Company Ltd., located in Hyderabad, Andhra Pradesh, was
engaged in software development, applications and solutions suited to major
conglomerates in Indian and overseas markets. Over the years, it accumulated
large cash reserves. Instead of ploughing them back into business for expansion
or diversification, directors of this reputed IT company, successfully siphoned
cash reserves o to its associate companies owned by family members.
To support the cash reserves in Shivam Computers, its Chief Finance Ocer had
a system of presenting Fixed Deposit Receipts for several lakhs of Rupees
deposited on long term basis with its bankers. After liquidating deposits and
transferring funds, new FD Receipts were forged and presented during periodic
audits conducted by the statutory auditors.
The sound accounting and auditing procedures were circumvented. Auditors
never carried test checks and asked for the data on Fixed Deposits from the
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companys Banks which were shown to have issued FD receipts! It was later
established that statutory auditors of Shivam Computers earned audit fees that
were much more than the industry average for companies of Shivams size.
Make Sure* Company Ltd. was manufacturing aluminium caps and foils for major
bottlers and pharma companies in India. Its plant was located in Kurla, a suburb
of Mumbai. Its marketing manager booked a large single order almost equal to
20% of its annual turnover with a prominent customer having automated bottling
plant in NOIDA , Delhi.
Unfortunately, this customer had miscalculated its sales forecast and, hence,
was unable to accept delivery against this order. As the financial year end was
approaching, the management of Make Sure was not willing to expose its
marketing failure nor to show the large stockpile of closing inventory in hand in
the year end balance sheet.
Its management resorted to another unacceptable accounting practice and
recorded sale of the stocks by transferring it to its sole distributor! After two
weeks after the year end, the distributor returned the entire stocks citing a minor
technical flaw and squared the transaction. Here too, statutory auditors ignored
accepted accounting principles and failed to review major accounting
transactions for a few weeks from the end of the accounting year under audit to
the date of certifying accounts.
Nicer Pharmaceuticals* Ltd., a 100% EOU [Export Oriented Unit] owned a world
class formulations and tablet making facility in GIDC Kandla, Gujrat. Its order
books were always full. But even after operating for over 10 years, the company
was not in a position to declared dividends to its share holders spread over
India. Nicer did not have its own marketing and distribution arrangements. For
this purpose, it relied on its privately owned associates in South Africa and UAE.
The shareholders were not receiving returns on their otherwise prudent
investments because the Nicer company was invoicing its associates at prices
that were one half of the ruling prices for its drugs in the international markets.
Profit that should have accrued in the books of accounts of Nicer Ltd., was thus
reflected in the books of overseas associates and shared among the brothers
holding controlling interest in Nicer Ltd.
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This case would not have come to limelight, but for the disputes among brothers
that led to judicial investigations by the then Foreign Exchange Regulation
Authorities in Mumbai on receipt of a complaint from an aggrieved brother.
Mane Elevators* Ltd. was located in Chennai and manufactured as well as
imported escalators, passenger and freight / goods elevators. It had aggressive
management and salary package of Chief Operating Executive as well Chief
Financial Executive and Marketing President contained large bonus part that
varied with companys performance [read profits].
For the first two years profits were not significant due to fierce competition in
elevators market especially from small and local companies. Performance
bonuses for these executives were negligible. To change this situation, the CEO
of Mane Elevators, compelled marketing department to introduce Price Variation
Clause into all its existing and new contracts with its builder customers. The PV
clause was introduced to vary selling prices with every change in prices of
materials and labour inputs that occurred after the contract was entered into with
the customer.
The formula was neither spelt in details by the Chief Finance Ocer nor
explained to customers by the sales force. Naturally no customer would have
agreed to the clause or for payments for the PV. But after introduction of the
clause, customers were invoiced prices that were much higher than the ones
specified in the accepted contracts. The increase in prices was based on rise in
material cost and wages as interpreted by the CFO. In the third year, when these
higher prices were accounted, the company showed a handsome profit in its
published accounts.
From the third year of operation, enterprising CEO and CFO/ Marketing
President earned [?] handsome high performance bonus for a few years, before
they quit to join competition.
Raj Electricals* Ltd., was a giant player in the power industry, manufacturing and
installing transformers, switch gears, transmission towers etc. It was located in
Kolkatta since 1973. The Directors owned about 27% of the equity and shares
were traded at P/E ratio of about 18.
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In the last year in which there was a slump in infrastructure sector of the Indian
economy, directors observed that the net profits of their company for the year
were way below the guidance provided by them in the last press conference.
They feared at least 10% drop in share prices after the results would be known
to the markets.
The company followed percentage completion method for booking revenue on
its larger projects of Rs. Fifty lakhs and above. That means sales were recorded
in phases as these projects were progressed towards completion. For small
projects below Rs. Fifty lakhs each, revenue was recorded in the books of
accounts using the completion method. Thus, on these smaller projects no sale
was shown and nor revenue recognized until the project was complete.
Directors passed a resolution that year in their board meeting before the financial
year end, directing Chief Finance Ocer to apply the percentage completion
method of recognizing revenue in all its ongoing projects without reference to the
size and value of the projects.
The result was a smart jump in the sales revenue of the company for that year, as
sales were recorded for the first time on all projects of up to Rs. Fifty lakhs that
were in the pipeline at the close of the year. This provided satisfaction to the
directors that they lived to the profit guidance earlier issued by them and
confidence to meet the reporters again.
Himalaya Entertainments* Company Ltd., is a leader in media industry with its
production units in Mumbai, Delhi, Chennai and Kolkatta. It is engaged in
producing regional language movies and TV serials. Since beginning it had a
huge budget for advertising and publicity through print, radio and electronic
media all over India.
The company was planning to raise equity capital in the market in 1997 for
expansion of its activities in Bangladesh, Nepal and the Gulf countries where
Indian viewers had settled. When the date for filing documents for the equity
issue approached, investment bankers advised Himalayas Board, that the sales
and earnings for the year were not attractive enough to ensure full subscription.
Directors held lengthy discussions among themselves and with the auditors.
Ultimately the Board advised the Accountant that his method of charging
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advertising and publicity expenses of a year to that years profits was incorrect.
He was briefed that benefits from such expense accrue to the company over a
long period. The CFO of the company, therefore, capitalized its advertising and
publicity expenses in that year and decided to charge the same to profits over a
period of next five years.
This single questionable practice resulted in increase of Himalayas profits for
that year by 80% of its advertising and publicity spends. Just for the record,
Himalaya Entertainments public issue, as predicted by investment bankers to
the issue, was three times over subscribed!
Then there is another case of Learner and Turner Engineering Works Ltd.,
employing over 3000 workers in Chakan, near Pune in Maharashtra. The
engineering firm, providing auto components to original equipment
manufacturers, had a three year old wage settlement with the workers
recognized trade union which was due for renewal in 2002. Management was
expecting a demand for huge wage increase from the Union aliated to the left
political party.
Companys Board held several meetings with their Chief Finance Ocer on ways
and means to curtail expected wage hike. This firm followed weighted average
method to price its material issues since inception. This year, looking at double
digit inflation that was prevailing over the year, the CFO proposed to the Board
that this method of pricing issues is outdated and be replaced by Last in First
Out method used successfully by many American companies.
The proposal was accepted by the management as it was going to strengthen
their hands at the negotiating table with the Union when bargaining rounds were
to start for renewal of the lapsed wage agreement.
Material issues charged to revenue were valued in that year at the latest high
prices under the Last in First Out system, and inventory in hand at the close of
the year was valued at the last years low prices. This increased cost of goods
sold and decreased the value of closing inventory.
When the published audited accounts were released, the Union leaders were
astonished to observe that companys profits for the year had declined.
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11
Financial Accounting in
Computerized Environment
Objectives:
After completing this chapter, you will be able to understand:
Computerized Accounting
Benefits and Utilities
Packages
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Structure:
11.1 Introduction
11.2 Benefits
11.3 Utilities
11.4 Packages
11.5 Summary
11.6 Self Assessment Questions
203
11.1 INTRODUCTION
In the preceding chapters, we went through the entire gamut of accounting
process. The process would lead one from the basic voucher to the books of
prime entries, posting the entries from prime and secondary books to ledgers,
compiling the trial balance, treating the adjusting entries and finally preparing the
Income Statement for a particular period and preparation of Balance Sheet as at
a particular date. The cash flow of the enterprise also can be worked out from
the Balance Sheet of two periods and changes in cash position can be attributed
to any material financial activity or event. This gives a dierent perspective to
understanding of the financial statements.
As the electronic data processing gained ground in late sixties and seventies, the
financial accounting had been among the major systems that were
computerized. In fact, financial accounting has been the natural beneficiary of
the early spread of the EDP revolution. The computerized environment has
ideally tackled the volume and repetitive transactions of the accounting system.
It is not our aim here to go in to the nitty-gritty of the computer languages that
write the accounting programmes. There are many accounting softwares
available in the market. We shall try to appreciate the prominent common
features that can be found among dierent accounting packages.
11.2 BENEFITS
Dierent accounting software can have features that may be distinct or unique in
being more user-friendly, they all draw from the basic principles and processes
of financial accounting that we studied in the preceding chapters. In manual
accounting process, the arithmetical accuracy is of paramount concern. Any
debit that has no corresponding credit and vice versa can throw the trial balance
for a toss. Colossal man-hours must have been lost in tallying the untallied trial
balance. The errors of commission and omission in manual accounting process
are thankfully non-existent in computerized accounting.
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Some of the most common mistakes that are found in manual accounting
system are:
Posting a debit without corresponding credit
Posting a credit without corresponding debit
Posting a debit for a corresponding debit
Posting a credit for a corresponding credit
Transposition of figures in posting like posting Rs.1,520/- as against Rs.1,250/ Mistake in totaling the books of accounts
Posting the entries to wrong account etc.
Mistakes in compiling the trial balance like debits represented as credit,
mistakes in totaling etc.
One need not bother about these errors in a computerized environment. The
arithmetical accuracy of computerized accounting is one of its important
benefits. The software is programmed to accept an accounting entry for equal
and opposite debits and credits. The errors in casting or totaling are given
decent burial. Another advantage of computerized accounting is its ability to
handle bulky data processing in real time across dierent geographical locations.
The integration of cross-functional inputs generates meaningful and cohesive
information that facilitates the decision-making in real time.
There are dierent accounting packages available in the market that promise a
variety of results. The volume of transactions, their frequency and repetitive
nature would determine the suitability of the programme. To gain proficiency at
using a programme and to judge its ecacy to serve business needs, one has to
be comfortable with the basic accounting principles and processes that govern
the accounting. Sound knowledge of the needs of the business to have relevant
information also helps in evaluating any accounting programme.
At the basic level, an accounting software would give Information such as
preparing the books of prime entries, preparing ledger accounts, drawing up
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the trial balance, preparing the income statement and the balance sheet, the
cash flow statement etc. Beyond this, most of the well-known software available
seek to integrate the inventory with financial accounting. While integrating the
two, the principles of inventory valuation that we saw earlier are incorporated.
The software seek to apply FIFO, LIFO, weighted average cost or other
appropriate method of stock valuation to inventory and throw the cost of
manufacture/ consumption or sale as the case may be.
11.3 UTILITIES
Most accounting software would also facilitate the utilities like:
Ability to generate vouchers
Cheque writing facilities
Interest calculations
Aging analysis of debtors and creditors
Cost center analysis
Segment profit/loss
TDS module
Reports for taxation purposes
Reports for other control purposes
Leaving audit trail for fraud detection and control
Many enterprises also opt for their custom made software to answer to their
unique business processes that may have specific requirements for information.
Accounting software would present information by concentrating on logical
groups and sub-groups from the components of Balance Sheet and Profit &
Loss account. They would also normally provide for navigating from the primary
voucher to Balance Sheet and Profit & Loss account and vice versa i.e. from the
Balance Sheet and/or Profit & Loss account to a particular voucher. This
navigation facility may be considered as true test of the eciency of the
package. It would, of course, be subject to the necessary supervisory controls
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for security reasons. The ability of the software to facilitate multi-nodal data
feeding and updation in real time across distant locations would also test its
ecacy. This can be very crucial. Of course, all these features will have cost
aspect and the management will have to take a call on this.
11.4 PACKAGES
Many accounting software are available in the market: more popular among
them being Tally, Ex-NGn, Trio, ModAct and many others. In addition, there are
other industry specific or activity specific software like for Banking, Travel
Industry, Financial Portals, for Shares and Stock Brokers, for investors and so
on. When one is comfortable with the basics of financial accounting, proficiency
in these can be had with little eorts.
Beyond these basic accounts processing, the Management Information System
(MIS) aims to target specific information analysis that is of strategic importance
to the business. This task of information analysis and processing can be unique
to each business. The trend is to integrate the financial accounting processes
with other business systems and generate information that gives meaningful
solutions.
Most information systems available seek to span across the entire value chain of
the business. We shall call them the Enterprise Resource Planning (ERP)
systems. The objective of implementing ERP is to increase revenues and to
improve business eciencies. They aim to integrate the order processing, the
accounting, inventory and the issue-consumption-production-dispatch systems.
They further go to integrate the vendors and customers into the companys
intranet network, so as to facilitate the B2B operations of the Company.
They generate diverse reports, which can be useful at dierent levels of
hierarchy. The access to information generated by the software is also a crucial
issue. The information generated through the software is programmed to give
access to dierent levels of hierarchy on a need-to-know basis. Some of these
systems are from:
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SAPs package
Avalon
JD Edwards
MFG-Pro
Baan
Oracle Application
Ramco Marshal etc.
Organizations would undertake study of their ERP needs and gauge their
requirement for information across critical functions. It would help them
determine which ERP Package would suit them best. The cost of implementing
the package can be substantial, and it would cover the cost of the software
besides the expenses for setting up the intranet and other hardware.
Many Companies have tried to solve their Information processing needs through
implementing dierent packages and have tried to solve issues critical to their
businesses. For instance, Marico Industries aimed to streamline their supply
chain management through ERP Solution. They aimed to have excellence in
distribution performance. ERP was used to facilitate this.
The Larsen and Toubros Electrical Business Group (L&TEBG) used the ERP
Solution to obviate the diculties faced in managing mainframe-based
applications. For them, the ERP also addressed the issue of lack of integration
between manufacturing, marketing and accounts systems, which resulted in
delays in reconciliation eorts, and lack of response from dierent units. Their
eorts gave them the capability to allow their stockists to access the system of
L&T to view stock of finished goods and to place orders for standard products.
This B2B capability has given it an edge over competition. In addition, the multilocational plants posed their own problems, which were also addressed.
TVS Motors went on to gain eciency in all their physical activities and review
performance on a weekly basis through the ERP system, instead of reviewing it
once a month. It later switched on to daily monitoring of performance, which was
christened as Supporting lean manufacturing eorts. Thus, the financial
accounting integrated with other business processes goes to influence business
strategy and ecacy.
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11.5 SUMMARY
As the electronic data processing gained ground along with many other business
processes, Financial Accounting was also computerized in the late sixties.
Computerization eliminated colossal loss of time caused by errors of
commission and omission committed in manual accounting. It also brought
about timeliness in availability of the latest financial statements.
The utilities oered by computerized accounting start from the ability to generate
vouchers to the preparation of final financial statements and in providing reliable
audit trails.
Several software packages are available in the market on a stand alone basis or
as a part of comprehensive Enterprise Resource Planning (ERP). Certain industry
specific packages are also being released in the market.
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video
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SUGGESTED READINGS
by T.P.Ghosh
Financial Accounting
by Leslie Chadwick
Financial Accounting
by Prof. Harsulkar
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