Subject: Business Finance - 1

Chapter 1: Financial Accounting & Accounts Function

Chapter No. 1 – Financial Accounting & Accounts Function

Contents
Objectives of Financial Accounting and Accounts Function
Financial Accounting Process – steps involved till final accounts – differences
among proprietorship firm, partnership firm and a limited company in terms of
Financial Accounting
Different financial statements and their purposes in business
Figures – what they mean to a business – understanding financial statements
for decision-making in business
Financial Accounting as different from Management Accounting and Cost
Accounting
Formats of Financial statements for business – Profit & Loss statement,
Balance Sheet, Cash flow statement and Funds flow statement

At the end of the chapter the student will be able to:

Understand the Financial Accounting process and prepare simple statements
of P&L & Balance Sheet
Map the differences between Accounts and Finance functions in an enterprise
Understand numbers contained in financial statements in the context of
business & use them in decision making in business
Prepare other two financial statements, Cash flow and Funds flow
Map the differences among Financial Accounting, Management Accounting and
Cost Accounting

Introduction
Financial Accounting is done on the basis of certain Accounting Principles that are universal in
nature

It is based on a specific accounting system and has to follow certain basic rules that are again
universal in nature

It also involves specific standards called Accounting standards and practices called Generally
Accepted Accounting Practices (GAAP), which are different from country to country. Indian
Accounting standards are known as “AS” and Generally Accepted Accounting Practices are known
as GAAP, India

At present, readily available application software has simplified maintenance of financial accounts
and generation of required financial statements

Why Financial Accounting

Running a business, as we may recall, involves financially, certain amount of money coming in and
certain amount of money going out. The money coming in could be from the owners of the
business enterprise, loans from banks and others or due to the operations of the business
enterprise. Similarly, the money going out could be for purchasing of assets required by the
business or for meeting expenses of the business enterprise or for paying off loans earlier taken.

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Chapter 1: Financial Accounting & Accounts Function

Whatever be the purpose of money coming in and money going out, these financial transactions
are required to be recorded on a day-to-day basis so that at any given time, the owners will be in a
position to know:
How much money has come into the business and what the source of this money is
How much money has gone out of business and the purposes for which the money has
been spent
This is called “Financial Accounting”. In short, Financial Accounting faithfully records all the
transactions in a business enterprise that involve money and these transactions are referred to as
“Financial” or “Accounting” transactions. Let us examine the following examples to understand the
purpose of Financial Accounting.
Example no. 1
I have purchased goods for sale worth Rs.20,000/- against cash – I need to record the details to
know the value of goods purchased by me and against what – like cash or credit and in case it is a
credit transaction, from whom as I will be required to pay the supplier later, what is the quantum of
goods purchased so that I can know any given time how much unsold items I have on hand (called
“stocks”)
Similarly I have taken a loan of Rs. 1,00,000/- from a bank to run my business. I need to record the
details to know who has given me money so that I can return the same to the lender as and when
required and as and when agreed at the time of taking the loan.
Another example – I am selling goods worth Rs.50,000/- on credit. The buyer is going to pay me
after some time. I need to record the details to know who my customer to whom I have sold goods
on credit is, so that I can follow-up for getting the payment.
If we carefully go through the above examples, we will notice that Financial Accounting
transactions could involve:
Cash or credit (the manner of payment, now or later respectively)
Income or Expense (revenue coming in due to sale of goods or services and revenue going
out due to purchase of goods or services respectively)
Asset (what the business enterprise owns, purchased out of capital, owners’ contribution
and/or loans from others) and Liability (what the business enterprise owes to an outsider
who has given it financial resources for purchase of assets)
Thus the objective of Financial Accounting is:
To know the financial position of the business enterprise in terms of:
How much revenue has come in (Income) and how much revenue has gone out
(Expense)
At the end of a given period, say one year, whether the business is in profit
(Income > Expenses and difference between Income & Expenses) or Loss (Expense
> Income and difference between Expense & Income)
What the sources of money coming into the business enterprise (Liabilities) are and
where they have been used (Assets)
How much money did the owners bring into the business enterprise at the
beginning and what its current value is (owners’ funds – original investment as
enhanced by profits retained in the business)
Related terms in connection with the above objective are:
Accounting principles – these are common for the entire globe. For example, the
owner of the business enterprise and the business enterprise are different from
each other from Accounting angle. Proof of this principle – the owner’s contribution
called capital to the business enterprise is reflected as “Liability” in the Accounts of
the enterprise, while the owner accounts for it as an “Asset” as it is an investment.
Accounting Rules & Regulations – these are again common for the entire globe.
These rules and regulations essentially tell us which account is to be credited or
which account is to be debited. For example – I sell goods against cash – Goods
account is credited and cash account is debited.

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Chapter 1: Financial Accounting & Accounts Function

Accounting system – Cash system that can be followed by a proprietorship firm or

partnership firm – this follows cash coming in or going out for accounting for an
item of income (that could result cash coming in) or expense (that could result
cash going out). This system does not consider “credit” transactions. Hence
accounting is not done of outstanding transactions. There is no “receivable” or
“payable” in this case
Accounting standards (AS) – given by the Institute of Chartered Accountants of
India (ICAI) along with Generally Accepted Accounting Practices (GAAP), India.
Operating income (coming from the main operations of the enterprise like trading,
manufacturing or services) and non-operating income (coming from investments
made outside the business in some other business – could be share capital or debt
instruments like debenture, bond etc.)
Accounting period – this would depend upon the country in which the business
enterprise operates. For instance in India, the accounting period is from 1st April to
31st March – this is also called Uniform Accounting Period (as all kinds of business
organizations like Proprietorship firm or Partnership firm or Limited company have
to follow this uniformly in India) or Financial Year
Profit and Loss statement – statement prepared at the end of the Accounting
period as above showing the summary of all income items and expense items
besides the result of performance, namely Profit or Loss for the period.
Balance Sheet – statement of Assets and Liabilities as at the end of the Accounting
period as above, i.e., the sources of funds (term indicating money) – Liabilities and
uses of funds – Assets
Other Accounting Terms have been explained in the Chapter “Glossary of Terms”
“Fund”– this represents financial resource taken or given by the business
enterprise depending upon whether money comes in or goes out. This is a
“macro” term and includes both cash and credit. For example, a supplier giving
goods on credit does not give cash but gives goods that are worth certain specified
value.
The above information will be useful to the following users of financial statements:
Owners of the Business Enterprise
Lenders who have given money to the Business Enterprise
Other stakeholders of the Business Enterprise like employees, suppliers etc.
Government agencies like Income Tax authorities and others who are interested in
investing in the business enterprise in Share capital or loan, like debenture or bond

Functions of Accounts Department that does Financial Accounting

1. Maintenance of Accounts strictly in accordance with the Accounting Principles, following
Accounting Rules as per prescribed Accounting system and observing Accounting
standards as well GAAP depending upon the country of operations.
2. Control over amounts receivable, amounts payable, bank accounts, cash on hand etc.
3. Preparation of budgets, both revenue and capital, with the objectives of allocation of
resources, control and monitoring of expenses
4. Compliance with payment of Advance Tax as per the Rules and Regulations in this behalf
5. Thorough understanding of Income Tax Rules and Regulations with a view to minimize tax
payable by the enterprise
6. Maintenance of Financial Management Information System (popularly known as MIS) that is
a review of performance of key financial parameters vis-à-vis the estimates – this is an
important tool in taking corrective action in time and hence forms an integral part of
decision-making process
7. Being responsible for the process of “Audits” of various kinds – Internal Audit, Statutory
Audit, Tax Audit etc.

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Chapter 1: Financial Accounting & Accounts Function

Accounting Process

Decide on which Account Transactions are

Financial transaction takes
place in the Enterprise – it
could be cash or on credit –
if it is Cash, it could result
in cash inflow or outflow
To be debited or credited
In accordance with
Accounting principles, the
Relevant Rules &
Regulations & prescribed
Accounting system
maintained in ledgers –
Creditors’, debtors’ etc.
and Registers – Sales,
Purchases etc. on
individual transaction
basis

Verification step – whether the sum of all credits is equal Transactions are consolidated in a
to sum of all debits as it should be in case the business control book of accounts named
enterprise is following double-entry book-keeping system “General Ledger” – this contains a
also known as Accrual Accounting System single consolidated account for each
This is done by extracting all the balances of General item of income, expense, asset and
Ledger in a statement known as “Trial Balances”. In this liability – example, one account for
statement, the income and liabilities will appear under operating income, one debtors
“Credit” side while assets and expenses will appear under account, one creditors account etc.
“Debit” side. This statement will however disclose errors
of some types like wrong head of accounting, error of
omission or commission on both the sides to the same
extent. Example customer debited for credit sale by
Rs.10,000/- more and sales also credited by Rs.10,000/-
more.

Process of rectification of errors pointed out by the Trial Closing entries are then made –
Balance statement. Further where the errors are not shown depreciation on fixed assets, provision
by the Trial Balance, the process of reconciliation is for bad and doubtful debts, provision for
initiated especially in the case of creditors, debtors and outstanding expenses, outstanding
bank accounts. This is done by asking for statements of income, adjustment for pre-paid
our accounts with them so that we can go through entry expenses and income received in
by entry and verify whether the entries are correct or not. advance etc. are made before
If there is a mistake correction is carried out preparation of final financial statements
for the accounting year, namely Profit &
Loss statement & Balance Sheet

Step no. 1 – Accounting transaction analysis and deciding which

Account to be debited and which account to be credited
Profit & Loss statement and Balance
Step no. 2 – Entering the various transactions in the basic books of sheet are prepared – in the case of
proprietorship firms and partnership
Accounts – Registers and ledgers excluding General Ledger
firms, the two statements can be
Step no. 3 – Posting the consolidated figures each account-wise in the prepared in any format whereas in the
case of limited companies, the business
Control book called General Ledger enterprise has to prepare in accordance
Step no. 4 – Verification of the double-entry bookkeeping process with the formats provided for in
Schedule VI of The Companies’ Act
Through Trial Balance
Step no. 5 – Rectification of errors pointed out by Trial Balance
Step no. 6 – Closing and adjustment entries at the end of the Accounting period
Step no. 7 – Preparation of Profit & Loss Statement and Balance Sheet as per prescribed formats in
the case of limited companies as per Schedule VI of the Companies’ Act

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Differences among proprietorship and partnership firms on one hand and

limited companies on the other hand in respect of Financial Accounting
process/system

Parameter Sole proprietorship Partnership firms Limited companies

firms

Accounting system – No compulsion. The No compulsion under Under the provisions of

Accrual or Cash firm can choose either The Partnership Act. The Companies’ Act, it
of them but once The firm can choose is compulsory to adopt
decided, will have to either of them but the Accrual basis of
stick with it once decided, will Accounting. No choice
have to stick with it

Cash transactions and If cash system is If cash system is The enterprise has to
credit transactions adopted, credit adopted, credit account for both cash
transactions will be transactions will be and credit transactions
ignored ignored

Final audited No specific formats No specific formats Specific formats as per

statements – Schedule VI of the
presentation in Companies’ Act
specific formats

Components of P&L Trading and Profit & Trading and Profit & Profit & Loss and Profit
Statement Loss components Loss components & Loss Appropriation
components

Retained profit in Transferred to the Transferred to the Transferred to

business capital of the owner capital accounts of the Reserves & surplus as
thereby increasing the owners thereby share capital of the
(Profit After Tax as investment of the increasing their owners cannot be
reduced by profit owner in the firm. investment in the firm altered by retained
withdrawn from profits in business
business or distributed
in the form of
dividend)

Distribution of 100% Done Done Cannot be done.

profit to the owners’ Dividend is only after
capital transferring certain
minimum amount to
the General Reserve
that depends upon the
percentage of
Dividend on Capital
Share capital

Statutory audit of Not compulsory. Tax Not compulsory. Tax Compulsory under the
Accounts audit compulsory in audit compulsory in provisions of the
case turnover is case turnover is Companies’ Act,
beyond beyond besides Tax audit

Depreciation on fixed Not compulsory in the Not compulsory in the Compulsory in terms of
assets other than land books of accounts – books of accounts – the Companies’ Act –
claimed in the Income claimed in the Income Schedule XIV and the
Tax returns Tax returns rates are different
from The Income Tax
provisions

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Chapter 1: Financial Accounting & Accounts Function

Difference between finance function and accounts function

Financial Accounting Functions Corresponding Finance Functions

Maintenance of Accounts – strict compliance Financial planning and Resources mobilization.

with statutory provisions as per ICAI guidelines, Adequate resources in time and in a cost-
Accounting Standards, GAAP (India) provisions, effective way. More of market orientation than
Income Tax Act provisions etc. statute-orientation

Responsible for budgets – both revenue and Cash management – stand-by arrangements,
capital both in case of excess and deficit

Tax compliance and tax planning besides audit Responsible for treasury management – largely,
liquidity management, risk management and
investment management

Management Information System & Reports for Strategic Financial Management initiatives like
Finance expansion, diversification etc.

Finance and accounts functions may be integrated in an organisation. This means that one
department handles both. In most of the small and medium size units in India, the functions will be
integrated. A business enterprise will require a full-fledged finance department only when the
functions listed above are predominant functions impacting business in a big way. If the finance
functions are not predominant functions, Accounts department looks after Finance also. Constant
requirement of funds, surplus for investment etc, could be some of the factors influencing the need
for a full-fledged Finance department.

Different financial statements in a business enterprise and their purposes –

understanding the meaning of the figures contained in the financial
statements

Statement no. 1 – Profit & Loss statement - Denotes profit or loss for the enterprise for
the year. Usually prepared for a year that is referred to as “Financial year”. This is also called
“Uniform Accounting Period”. Can be prepared on a monthly basis too. The result will not be
accurate as some of the figures like depreciation will be more accurate only on an annual basis.
The same thing goes for provision for outstanding income or expenses too. Profit and Loss
statement indicates the financial performance of the year just gone by.

Pointers in Profit & Loss statement:

1. Whether the business earns operating profit? That is = operating income (-) operating
expenses (operations being trading, manufacturing or services) and this excludes
income from investment made in some other enterprise or other activity not connected
with the main operations of the enterprise – example sale of fixed asset, rent income,
sale of scrap generated during the process of manufacturing.

2. Is it that the business is in profit only due to “non-operating income” as described

above? If it is so, it means that the main operations of the enterprise are in loss and
the firm is able to keep its head above waters only due to profit coming from other
than main operations.

3. How do operating expenses behave? Are they increasing in proportion to the increase
in revenue or disproportionately to the increase in revenue? If they increase
disproportionately, it means that stricter control over expenses is indicated.

4. In case operating expenses have gone up, which group/s of operating expenses have
gone up? – Is it manufacturing/operations or administrative or selling/marketing or
finance expense that is going up disproportionately?

5. What is the level of closing stock in the Profit and Loss statement? Has the level gone
up disproportionately to the increase in revenue? This is important, as increase in

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levels of inventory is going to involve carrying cost like “return on investment” made in
it and this will surely reduce the profits of the enterprise.

The above list is only suggestive and not exhaustive

Statement no. 2 – Balance Sheet – Denotes position of Assets and Liabilities as on a
particular date. It is useful for a business enterprise for knowing the sources of funds for the
business enterprise and their uses. Further, any user of this statement will come to know how the
original investment in share capital by the owners has grown due to profits retained in business,
also known as “Reserves & Surplus”.
In short, capital shareholders’ funds = Total assets (-) External funds invested in business, both
short-term (not exceeding 12 months duration) and term liabilities (exceeding 12 months
duration). This usually indicates the financial performance of the past including the year just gone
by.

Example no. 2:
Suppose the sum total of all assets = Rs. 120 lacs and the external funds invested in business =
Rs. 80 lacs. The shareholders’ funds are = Rs. 120 lacs (-) Rs. 80 lacs = Rs. 40 lacs. Suppose the
starting point for this business enterprise is Rs. 20 lacs from the owners towards capital, this
means that at present the original investment of Rs. 20 lacs has grown to Rs. 40 lacs over a period
of time.

Pointers in the balance sheet:

1. What is the level of funds employed in business? Is it increasing disproportionately to
the level of revenue?
2. What is the relationship between owners’ contribution and borrowed funds? Is it in line
with what the lenders usually accept – 1.5:1 to 2:1 (excluding short-term liabilities)
3. Will the enterprise be able to meet the short-term liabilities from its short-term assets?
4. Whether the Return on Investment (ROI) for the business is coming down or going up?
– This is a combination of P&L and Balance sheet. Funds employed in business are
known from the balance sheet while the earnings are known from the Profit and Loss
statement.
5. Whether the capacity of the business enterprise to pay interest and repay loan
installments is satisfactory? – This is again a combination of Profit & Loss statement for
earnings and Balance sheet for the repayment liability

Statement no. 3 – Cash flow statement – Denotes the position of cash inflow and cash
outflow for a particular period. The period is usually one month, but can be more frequently done.
This is useful to a business enterprise from the point of view of control and monitoring the amount
of cash available in business, also known as “liquidity”. This information is required both for
planning, i.e., arranging for back up in case the available cash is less than required and control, in
case the available cash is more than required. The business enterprise cannot afford to keep more
cash than required, as idle cash does not earn any return and it is better to save tax by putting the
excess cash back into overdraft etc. The loss incurred by keeping more cash than required is often
referred to as “opportunity cost”.

Example no. 3:
My enterprise requires Rs.10lacs on an average by way of cash. Suppose my projected receipts for
December 2004 are Rs.250lacs and projected outflows are Rs.260lacs with opening balance of
Rs.10lacs. This will result in my closing balance of cash of Rs.20lacs.

This is far in excess of my requirement of Rs.10lacs. What do I do with this excess cash? I put it
back into my bank account so that I can earn some interest especially if my bank account is
overdraft like account in which case, I pay interest on the amount used by me. Once I prepare the
cash flow statement, I compare it with the actual position at the end of the month so that I can
verify as to how far I have been good in projecting my cash position for the month under review.

Pointers in the Cash flow statement

1. Has the month just gone by generated any surplus of cash or has it resulted in deficit?
2. If there is a surplus, how to utilize the same and if there is a deficit, what is the
alternative source that can give cash to fill the gap?
3. Whether the cash flow statement is useful to the business enterprise as a tool in
financial planning? – This can happen only if the estimate is realistic and the actual at
the end of the month does not differ from the estimate by a wide margin

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Statement no. 4 – Funds flow statement - Denotes movement of funds (please refer to
fund under “terms” at the beginning) during a period under review. Generation of funds and its use
can be explained in terms of assets and liabilities in simple terms as under:

In liabilities or in assets = Source of funds

In liabilities or in assets = Use of funds

From the above, the reader can understand the linkage between “Funds flow” statement and the
balance sheet of the enterprise.

Usually this period is one year. Funds flow statement can be prepared on an “Estimation” or
“Actuals” basis – this entirely depends upon the purpose for which funds flow statement is being
prepared. If it is for “Financial Planning and Resources Mobilization”, it is done on “Estimation”
basis say for the next one to two years; on the other hand, if it is prepared for review purposes, it is
done on “Actuals” basis. Having seen that this statement is closely linked to balance sheet, let us
see the difference between the two statements. While funds flow statement tells you about the
movement of funds (proposed or actual), balance sheet gives the impact on Assets and Liabilities
due to movement of funds during a given period.

Funds are divided into Resources (funds coming into business) and Uses (funds going out of
business). Resources are presented in three broad heads while uses are presented in two broad
heads as under:

Resources:
Long-term accruals from business = Funds generated from operations
Long-term funds (external) = Fresh capital coming into business like share capital or loans
+ sale of fixed assets + sale of investment etc.
Short-term funds (external) = Fresh short-term borrowing from banks for working capital +
any increase in other short-term funds like creditors for goods, creditors for expenses etc.+
any decrease in short-term (working capital) assets like inventory or cash/bank or
receivables

Uses:
Long-term uses = Fresh purchase of fixed assets + fresh investment made by the business
+ repayment of loans or redemption of bonds/debentures etc.
Short-term uses = Fresh purchase of inventory + any increase in level of receivables or
any other short-term (working capital) asset + any reduction in short-term liabilities like
bank overdraft or level of creditors etc.

Example no. 4: Long-term sources (Internal) – Rs.20lacs

Long-term sources (External) – Rs.30lacs
Short-term sources – Rs.20lacs
Total funds available – Rs.70lacs

Long-term use – Rs.40lacs

Short-term use – Rs.30lacs
Total uses – Rs.70lacs

In the above example, we observe that short-term funds are deficient in comparison with short-
term use, whereas long-term funds are in excess of long-term use. This should be the feature of
any Funds flow statement, as long-term sources that include profit retained in business will be
available both for long-term and short-term use. As against this, short-term funds (otherwise
known as “working capital funds”) are not available for long-term purposes. The reason is obvious –
short-term funds are available for day-to-day operations and hence if they are diverted to long-
term use, the efficiency of the business enterprise will be drastically affected. It will affect the
income as well as increase the cost by way of interest in case we take additional borrowing to fill
the gap caused by reduction in working capital funds.

Pointers in Funds flow statement:

1. Whether long-term sources are in excess of long-term use or is it the other way
around?
2. It is desirable to have long-term sources in excess of long-term use and this excess is
available to short-term purposes

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Chapter 1: Financial Accounting & Accounts Function
Differences among Financial Accounting, Management Accounting and Cost
Accounting
Financial Accounting
Function is to record all the
financial transactions in
accordance with certain
principles, standards etc.
Provides historical data and is
a measure of performance of
the business enterprise as a
whole
Compulsory for all the business
enterprises to follow
Useful more for outsiders as a
pointer to the financial
performance of the business
enterprise
Not much flexibility – more or
less standardised
TEFI – Entrepreneurship Development Distance Learning Program –Basic Module
Cost Accounting
Function is to analyse costs
associated with an activity or a
product or a division and
ascertain whether the activity
or a division or a product is
profitable or not
Is concerned more with costs
associated with a specific
product etc. to ascertain the
profitability of the product or
division – provides a tool in the
hands of the management to
take decision on product or
activity. Works with the data
provided by Financial
accounting
Not compulsory at least in
some industries. Maintained
purely for pricing decisions,
control of costs and planning
for profits
Useful for managerial decision-
making including management.
May not be useful for owners in
a professional set-up
Involves detailed study of costs
and hence depends upon the
nature of enterprise
Management Accounting
Function is to make required
modifications in the financial
accounting, analyse and
present it to the management
for control and managerial
decision-making
Financial accounting data
modified by regrouping the
items as required for decision-
making. Non-financial data like
quantitative data also used in
management accounting.
Further even future data
considered as required by
management
Not at all compulsory in any
industry. It is purely at the
instance of the management
for their purpose and not for
any external use
Useful for owners of the
business enterprise in any set-
up.
Thoroughly flexible in approach
depending upon the
requirement of control from the
management’s point of view.
Involves generation of
Management Information
System Reports
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Profit & Loss & Balance Sheet

Example no. 5 - A sample of “Profit and Loss” Account (Rupees in Lacs)

Income from operations 100

Operating expenses:
Salaries 30
Repairs and maintenance 3
Depreciation 10
Office and general expenses 10
Marketing expenses including
Commission, if any 7
Interest and other
Charges 10
Total expenses 70
Profit before tax 30
Tax at 35% 10.5
Profit after tax 19.5
Dividend 7.5
Profit retained in
Business [Retained Earnings] 12

Learning points:
♦ Interest is charged to income before determining the profit of the organisation. Once the profit
of the organisation is determined, tax is paid at the stipulated rate and the dividend is paid
only after this. Thus, dividend is profit allocation.
♦ This difference between “interest” and “dividend” gives opportunity to business enterprises, to
have a mix of capital of the owners and loans taken from outside, so that they can save on tax,
through the interest charged as expense on the income. The amount of tax so saved is called
“tax shield” on the interest.
♦ In the case of profit distributed among the partners as well in the case of dividend distributed
among the shareholders, these are not taxed again in the hands of the owners.

Linkage between balance sheet and profit and loss accounts

The above statement is known as the “Profit and Loss Account”. This records the income and
expenditure for a given period and is closed as soon as the period is over. The residual profit, as it
belongs to the owners, gets transferred to the capital account in another statement, called
“Balance Sheet”.

The balance sheet tells us about the following:

How much money has the business enterprise raised?
Which are the sources for the money?
What is the use for this money?

Example no. 6
The balance sheet is also known as “Assets and Liability” statement. A sample balance sheet is
shown below:

(Rupees in lacs)
Liabilities Assets
Share capital: 100 Fixed Assets 60
Reserves: 150 Less: Depreciation 30
(Retained profits Net Fixed Assets: 30
over a period of Investments: 80
time) Current Assets:
Net worth 250 Bills Receivable 100
Bank overdraft 30 Cash and Bank 35
Creditors for expenses 10 Other current assets 60

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Other current liabilities 15 Total current assets 195

Total current liabilities 55
Total Liabilities 305 Total Assets 305

Suppose profit for the year is Rs.30 lacs after paying tax and dividend. This would be transferred
to the balance sheet and the reserves at the end of the current year would be Rs.150 lacs + Rs.30
lacs = Rs.180 lacs. Similarly the depreciation claimed on the fixed assets and shown as an
operating expense would also get transferred to the balance sheet to reduce the value of the fixed
assets.

Let us assume that there is no increase in the fixed assets during the year that there are no other
changes and the depreciation for the year is Rs.10 lacs. We can construct the balance sheet for
the next year without much change, excepting to accommodate these figures of depreciation and
increase in reserves.

The balance sheet as at the end of the next year would look as under:
(Rupees in Lacs)
Liabilities Assets
Share capital 100 Fixed assets 60
Reserves and surplus 180 Less: depreciation 40
Net worth 280 Net fixed assets 20
Bank overdraft 30 Investments 100
Creditors for expenses 10 Bill Receivable 120
Other current liabilities 15 Cash and Bank 35
Total current Other current assets 60
liabilities 55 Total current assets 195
Total liabilities 335 Total Assets 335

We see that between the two balance sheets, there are two changes –
Investment has gone up by Rs.20 lacs and
Bill receivable has gone up by Rs.20 lacs.
The total is Rs.40 lacs. Where have these funds come from? This amount is the total of profit
transferred to balance sheet from the profit and loss account and depreciation added back, as it
does not involve any cash outlay. The figure is Rs.30 lacs + Rs.10 lacs = Rs.40 lacs. This figure is
referred to as “internal accruals”.
This need not be the case all the times. Where we use these funds entirely depends upon the
business priority and what we have shown is only a sample.

Learning points:
♦ The business enterprise generates funds from operations, known as “internal accruals”
comprising depreciation (which is added back, being only a book-entry) and profit after tax and
dividend;
♦ Where these funds are used is entirely dependent upon business exigencies;
♦ Depreciation claimed in the books as an expense goes to reduce the value of the fixed assets
in the books, while profit after tax and dividend is shown as “Reserves” and increases the net
worth of the company.

Example no. 7 – Cash flow statement

Opening Balance for Period

+ (Plus) Receipts during the period
- (Minus) Expenses during the period
= Closing Balance for the period (is the same as Opening Balance for the “next period”)

(Rupees in Lacs)

Cash Receipts
Revenue Receipts
Sales Receipts 100
Dividend income on shares 5
Rent income 10
Total 115

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Subject: Business Finance - 1
Chapter 1: Financial Accounting & Accounts Function

Capital Receipts
Fresh debenture 50
Fresh term loan 100
Sale of fixed asset 10
Total 160
Non-Revenue Receipt
Sale of shares 20
Total 20
Total Receipts 295

Cash Payments

Revenue expenditure
Payment to creditors 75
Payment of interest 15
Payment of expenses 25
Total 115

Capital expenditure
Purchase of fixed assets 150
Repayment of term loan 25
Total 175

Non-Revenue expenditure
Purchase of UTI Units 2
Total 2
Total Payments 292

Opening balance of cash 3

Add: Total Receipts 295
Less: Total Payments 292
Closing balance of cash 6
(Opening balance for the next period)

Example no. 8 – Funds flow statement

Financial statements - Funds flow

statement - Format

Funds inflow – sources

2003-2004
Long-term funds 2004-2005

Profit after Tax 240 265

Less:

Dividend paid 80 80

Net profit 151 176

Add:
Depreciation for the year 36 40
Amount amortised
15 15
(A) - Long-term funds (internal) 202 231
Increase in share capital 0 0
Increase in term loans 150 0
Increase in debentures/bonds 0 250
Increase in fixed deposits/acceptances and 75 50

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Subject: Business Finance - 1
Chapter 1: Financial Accounting & Accounts Function

other medium and long-term liabilities

Decrease in investments 25 15
Sale proceeds of fixed assets 15 22
(B) - Long-term funds (external) 265 337
Total Long-term funds (A+B) 467 568
Increase in short-term bank borrowing –
overdraft/cash credit
133 132
Increase in trade creditors 0 67
Increase in short-term loans 65 22
Increase in provisions and other 33 45
Short-term liabilities 0 0
Decrease in cash and bank
Decrease in inventory 0 0
Decrease in receivables 52 0
Decrease in other current assets 0 0
(C) - Short-term funds 283 286
Total funds generated during the year 750 854

Funds outflow - uses

2001- 2004-
Long-term use 2004 2005
Increase in fixed assets 175 268
Increase in investment 75 50
Decrease in term loans, redemption of
bonds and debentures and decrease in
other medium and long-term liabilities 230 200
(D) – Long-term uses 480 518
Short-term use

Increase in inventory 122 160

Increase in receivables 0 147
Increase in cash and bank 32 14
Increase in other current assets 31 15
Decrease in overdraft/cash credit 0 0
Decrease in trade creditors 85 0
Decrease in provisions and other
Short-term liabilities 0 0
Decrease in short-term loans 0 0
(E) - Short-term uses 270 336
Total uses = D + E
750 854
Summary of Funds flow statement
Long - term funds 467 568
Long- term use 480 518
Surplus or (deficit) (13) 50
Short - term funds 283 286
Short - term use 270 336
Surplus or (deficit) 13 (50)

Questions and numerical exercises for practice and reinforcement of learning

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Subject: Business Finance - 1
Chapter 1: Financial Accounting & Accounts Function

1. What kind of business organization is suitable to begin with for an entrepreneur

and why?
2. What is the objective of “financial accounting” from the point of view of the owner
of an enterprise?
3. Suppose you want to know the financial performance of your business for the
current year. Which statement gives you the relevant figures? Which statement
gives you the financial position of the enterprise?
4. Trace the advantages of a cash flow statement to a business enterprise. Can you
use this statement for planning for resources? If no, which statement is available
to you?
5. For you as the owner of a business enterprise, is it necessary to know in depth the
process of financial accounting? In case your answer is “no” how can you run the
enterprise with a full control over the amount invested in business?
6. What is the significance of “operating income” from business point of view?
Suppose you have operating loss of Rs. 5 lacs and overall profit of Rs. 2 lacs, what
does it mean? What is the source of the overall profit of Rs. 2 lacs?

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