I – Introduction to Accounting & finance

Learning Outcomes
• What is Accounting & finance
• The role of accounting in business
• Various legal forms of business
• Describe how accounting can be viewed as an information system
• Explain the role of accounting information in an organisation
• Understand the information requirements of the users of accounting
• Explain how information is made more reliable
• Explain the fundamental principles of accounting

What us ACCOUNTING and finance

Accounting

Accounting may be defined as the process of Recording, Classifying, summarizing,

Analyzing and Interpreting the financial transactions and communicating the results
thereof to the persons interested in such information.

1 Recording: This is the basic function of Accounting. It is essentially concerned with

not only ensuring that all business transaction of financial character are in fact recorded
but also that they are recorded in an orderly manner. Recording is done in the book called
“journal”.

2 Classifying: Classification is concerned with the systematic analysis of the recorded

data, with view to group transactions or entries of one nature at one place .The work of
classification is done in the book called “Ledger”.

3 Summarizing: This involves presenting the classified data in a manner, which is

understandable and useful to the internal as well as external end –users of accounting
statements. This process leads to the preparation of the following statement :-

1. Trial Balance
2. Trading Account
3. Profit &Loss Account
4. Balance Sheet

4 Analyses and Interprets: This is the final function of accounting. The recorded
financial data is analyzed and interpreted in a manner that the end-users can make a

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meaningful judgment about the financial condition and profitability of the business
operations.

5 Deals with financial transactions: - Accounting records only those transactions and
events of money, which are of a financial character.

What is Finance Anyway

Companies do not work in a vacuum, isolated from everything else. It interacts and
transacts with the other entities present in the economic environment. These entities
include Government, Suppliers, Lenders, Banks, Customers, Shareholders, etc. who deal
with the organisation in several ways. Most of these dealings result in either money
flowing in or flowing out from the company. This flow of money (or funds) has to be
managed so as to result in maximum gains to the company.

Managing this flow of funds efficiently is the purview of finance. So we can define
finance as the study of the methods which help us plan, raise and use funds in an efficient
manner to achieve corporate objectives. Finance grew out of economics as a special
discipline to deal with a special set of common problems.

The corporate financial objectives could be to:

1. Provide the link between the business and the other entities in the environment and
2. Investment and financial decision making

Let us first look at what we mean by investment and financial decision making.

1. Investment Decision

The investment decision, also referred to as the capital budgeting decision, simply means
the decisions to acquire assets or to invest in a project. Assets are defined as economic
resources that are expected to generate future benefits.

2. Financing Decision

The second financial decision is the financing decision, which basically addresses two
questions:
a. How much capital should be raised to fund the firm’s operations (both
existing & proposed)
b. What is the best mix of financing these assets?

Financing could be through two ways: debt (loans from various sources like banks,
financial institutions, public, etc.) and equity (capital put in by the investors who are also
known as owners/ shareholders). Shareholders are owners because the shares represent
the ownership in the company.

Funds are raised from financial markets. Financial markets is a generic term used to
denote markets where financial securities are teat. These markets include money markets,
debt market and capital markets. We will understand them in detail later in the 3rd
chapter.

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Financing and investing decisions are closely related because the company is going to
raise money to invest in a project or assets. Those who are going to give money to the
company (whether lenders or investors) need to understand where the company is
investing their money and what it hopes to earn from the investments so that they can
assure themselves of the safety of their money.

The questions that you may thinking about right now are “Why do we need to learn
finance? Shall we not leave it to the people who are going to specialise in finance?
Finance won’t help me in the area that I am going to work in, so why learn?” This is to
say that the knowledge of finance does not add any value to you. Is it so? Think about it.
When you get your pocket money from your parents, you do not go out and blow the
whole lot in one day because if you do, your parents are not going to give you more
money to last through that month. You quickly learn that you need to plan your
expenditure so that the money lasts throughout the month and you may actually plan to
save some of it. Those who do not get enough to meet their requirements, think about
some clever means to raise more money (like falling sick!). Alternatively if they need
more money for the month because of certain special events (like Valentine’s day) they
can plan to borrow money for a month and repay in the next month.

So you plan, raise and efficiently utilise funds that are your disposal (or at least try to).
That a business organisation also needs to do the same can hardly be overemphasised.
The scale of operations is much bigger and to efficiently manage funds at this scale,
decisions cannot be taken without sound methodology. Finance teaches you this
terminology.

For managing these funds the first thing you would need is information. External
information has to be collected from the environment and accounting provides internal
information about the firm’s operations. Accounting can be defined as an information and
measurement system that identifies, records, and communicates relevant information
about a company’s economic activities to people to help them make better decisions.

So the purpose of this book is to help you understand the accounting information and
how this information is utilised by the users to make better decisions. Two sections of the
book are devoted to that. The last two sections are devoted to various methodologies of
financial decision making that an organisation needs to follow to meet its financial goals.

Do We Need to Learn Finance?

You would now agree that a company needs to manage its own funds efficiently but your
question still remains “Why am I concerned with it?” Further arguing, you say that, “I am
going to specialise in Marketing/ Information Technology/ Human Resource
Management/ Operations Management and there is no need for me to learn finance. Also
Finance is a separate function in my organisation (or the organisation that I am going to
work for) and I am hardly going to use finance to work in my respective department.”

Think again. Everything that you do has an impact on the profitability of the company
(including drinking ten cups of coffee in a day!). So if you want to grow up to be the
CEO of the company in a few years from now (which I undoubtedly think that you would
love to) you should take the advice of the top CEOs.

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Corporate World Connection

79 per cent of the top CEOs rate Finance skills, as the most required for the CEO of the
future.
KPMG survey.

Better take the CEOs advice. But don’t get the feeling that only the CEOs require the
Finance Skills, all other functions of management also cannot do without finance and the
financial information.

Relationship of Finance with Other Functions of Management

If you are in marketing, the first thing that you wonder about is how the price of the
product is calculated. It is not always based upon what your competitors are charging or
what the market can absorb but also upon the costs that you are incurring in producing
that product. This information comes from the finance department (generic term used to
denote finance and accounting section in the organisation) but the analysis of this
information is only upto you. Finance department will also provide you with information
on your customers, do an credit analysis for you, give you information on outstandings
from your customer, provide information on what segments (customerwise, regionwise,
etc.) are doing well (or doing badly) as compared to last year, etc. Finance also helps you
decide which products are profitable and which are not.

If you plan to specialise in Information Technology, you would be glad (or sad) to know
that the first process the company automates is the accounting process. There is no way
you can understand what the hell is going on out there without understanding finance and
accounting. In fact, any other process when it is being automated in the company would
normally deal with quantitative (number based) information. All these quantitative
processes involve money and fund flows and to understand these processes the
knowledge of finance and accounting is very important. For example, if you are planning
to implement an Enterprise Resource Planning (ERP) package in your organisation, most
of the information that will go in to ERP is financial (i.e. quantitative) whether it is
marketing related, production related or HR related. Therefore, it would pay if you learn
finance well so that you do not have problems later on when you automate the business
processes.

If you planning to specialise in HR, the first thing that concerns you is how much to pay
to your employees and how to structure the pay packet so as to minimise the incidence of
tax on the employees as well as the company. You also need to learn how innovative
financial mechanisms can be used to reward your employees like Employee Stock Option
Plans (ESOPs). If you are planning to invest in training and development of your
employees, you need to justify the value added to your business by the training of your
employees. Accounting and finance supplies all this information to you.

If you were planning to specialise in Operations Management, finance would help you in
many ways. It would help you schedule your production, reduce your inventory costs,
provide information on bad suppliers, help you know which products are selling so as to
help you produce them, help you do cost analysis on the material purchased and monitor
the productivity of the processes. There is no way that you can imagine efficiently
managing your production processes without the help of finance and accounting.

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If you are planning to specialise in International Business, you are basically going to
learn the international aspects of all the functions of the business. So, you need to learn
the international aspects of finance also and how do you learn the international aspects if
you do not even know the fundamentals!

So as you can see, finance and accounting integrates with and supplements all the
functions of the organisation and no successful manager can think about growing in an
organisation if he does not understand the financial aspects of the decisions that he is
going to take.

Is Accounting Useful for Business?

You now agree that finance is useful but what about accounting? Accounting plays a vital
role in the decision-making process. An accounting system provides information in a
form that can be used to make knowledgeable financial decisions. The information
supplied by accounting is in the form of quantitative data, primarily financial and relates
to specific economic entities. Accounting provides the means for tracking activities and
measuring results. Without accounting information, many important financial decisions
would be made blindly. For example, investors would not be able to distinguish between
a healthy company and a company which is on the verge of failure; bankers would not be
able to know whether to lend to that company or not because they would not be able to
judge the creditworthiness of that company; managers would not be able to rightly price
their products or control the operations of the company, etc. The list of problems is
endless. As we said earlier, without accounting information business is impossible.

Imagine your telephone company with no system to record who calls whom and how
long they talk. Or your institute not noting down which papers have you passed and
whether you have paid your fees or not. These settings illustrate a problem with
bookkeeping, the least glamorous aspect of accounting. Bookkeeping can be defined as
the preservation of a systematic, quantitative record of an activity. Without bookkeeping,
business is impossible, as you would not know what is going on in your business.
The bookkeeping data has been used to keep a track of things and activities that the
business is performing. In the last 500 years, bookkeeping data has also been used to
evaluate the performance and health of the business. This use of bookkeeping data is an
evaluation tool may look too obvious but is most of the time not done or done
improperly. Bookkeeping is only a small part of the whole accounting system.

Accounting system can be defined as a information system which helps analyse the
transactions that the business is entering into, handle routine bookkeeping tasks and
structure information so that it can be used to evaluate the performance and health of the
business.

We defined accounting as a system for providing quantitative information, primarily

financial in nature, about economic entities that is intended to be useful in making
economic decisions. The four key components of this definition are substantiated below:

1. Quantitative: Accounting relates to numbers. This means that only the events that
can be captured in numbers are the ones registered by the accounting system. This
is the strength because numbers can be easily tabulated and summarised. It can
also be a weakness because one or two numbers cannot capture many important

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 business events. For example, the factory burning down or the death of a key
visionary of the company cannot be measured in quantitative figures.

2. Financial: The performance and the health of the business is affected by and
reflected in many dimensions. Financial, personal, social impact, public image
etc. Accounting focuses on only the financial dimension.

3. Useful: Accounting rules have a theoretical conceptual framework, which has been
developed over a long period of time. The conceptual clarity makes accounting a
very useful business tool as it is widely understood and used.

4. Decisions: Accounting is the structured reporting of what has already happened in the
past, and provides the basis for taking decisions about the future.

Often called the “Language of Business” accounting provides the means of recording and
communicating the successes and failures of business organisations. Still you should
always remember that accounting can only record and report the financial effects of
business activities and not other qualitative information.

Accounting Information Flow in Business

All business enterprises have some common activities. As shown in figure 1.1, one
common activity is the raising of financial resources. These resources, often referred to as
“capital,” can be raised from three sources: 1) Investors (Owners/ shareholders), 2)
Lenders (Creditors) and 3) The business itself by retaining the earnings that it generates.

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 Figure 1.1: Common Activities of Business Organisations

Once resources are raised, they are used to buy land, buildings, plant and machinery; to
purchase raw material and supplies; to pay employees; and to meet other operating
expenses involved in the production and marketing of goods or services. When the
product or service is sold to the customer, additional monetary resources (revenue or
sales) are generated. These resources are used to pay loans & interest, to pay taxes, to buy
new material, equipment and other items needed to continue the operations of the
business. In addition, some of the resources may be distributed to owners as a return on
their investment.

Accountants measure and report (communicate) the results of these activities. To measure
these results as accurately as possible, accountants follow a fairly standard set of
procedures, usually referred to as the accounting cycle. The accounting cycle includes
various steps, involving analysing, recording, classifying, summarising and reporting the
transactions of a business. These steps are explained in detail in the next chapter.

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Legal forms of Business Organisations

Three forms of business organisations are the most prevalent ones in India (and in the
world). The first is sole proprietorship, the second is partnership and the third is
company. There are other forms of organisations also like Trusts, Government, etc. but
these are not normally used for conducting businesses so we will not discuss them. Each
of the three forms mentioned above has advantages & disadvantages associated with
them so let us try to understand which organisational form suits the businesses most.

Sole Proprietorship
Sole proprietorship is the most predominant form of business organisation the world
over. In this form, the owner maintains the title to the assets and is personally liable for
all the liabilities of the business. Liabilities can be defined as creditors’ claims on an
organisation’s assets. Therefore, the proprietor is entitled to all the profits from the
business and is also required to absorb the losses that the business generates.

Partnership
Partnership and the sole proprietorship differ in only one aspect that the partnership has
more than one owner. So the various owners (called partners) form an agreement which
states the relationship between them as far as the business is concerned. It allows them to
state the level of investments each one of them is making as also the share of profits/
losses each one of them will get. There could also be sleeping partners (partners who
make investments in the partnership but do not take active participation in running the
business). As in sole proprietorship, the organisational requirements and legal
requirements are minimal and so are the government regulations. Sharing of resources
means that bigger investments can be made in the project then possible under
proprietorships. But the major disadvantage is the same as the proprietorship that all the
partners have unlimited liability and the partnership is dissolved when any one of the
partners dies or withdraws from the partnership.
Company
Company can be defined as an impersonal legal entity having the power to purchase, sell
and own assets and to incur liabilities while existing separately from its owners. The
ownership to the company is by holding the shares in the company and the ownership is
to the extent of proportion of shares held in the company. Company is the entity, which
functions legally separate from its owners. It can be sued and sue, sale, purchase and own
property and its employees are subject to criminal punishment for the crimes conducted
by the company. Despite the legal separation, the owners control and direct the company
and its policies. The owner shareholders select the Board of Directors who in turn select
individuals to serve as managers and monitor their activities.

As the shares representing the ownership are transferable in nature, the ownership can
change hands by simply transferring the shares from one shareholder to someone who
wants to become one. Due to this, the liability of the owner shareholder is limited to the

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investment he has made in the company thereby preventing the lenders to take over the
personal assets of the owners in case of unresolved settlement of claims.

So, seeing the advantages of a company, you would feel that the company is the best
form of doing a business. This is particularly true if you are running a big business and
want to raise money from others. But there are certain disadvantages associated with the
company also. The legal requirements are much higher than in the case of either sole
proprietorship or the partnership. Also the Government controls and monitors companies
much more than it monitors the other two organisational forms. The impracticalities of
having a large number of partners and unlimited liabilities (both in proprietorship and
partnerships) makes it unsuitable to have any other form than company form for
businesses that are big and growing. Therefore, when we will use any of the decision
models, we will focus more on the company form. Still any of these decision models
would apply also to other organisation forms, as the basic principles would remain the
same.

Fundamental Principles of Finance

There are ten fundamental principles of finance (as there are Ten Commandments) which
everyone needs to be aware of.

1. Risk Return Tradeoff

You won’t take additional risk unless you expect to be compensated with additional
return.

Risk can be defined as the level of uncertainty about the return to be earned. Almost all-
financial decisions involve some sort of risk-return trade off. When you put your money
in a bank you expect a low return because you know that your money is safe and you can
withdraw it whenever you need it. When you are investing in a lottery you know that
your chances of getting a return are very low so you expect a bigger return as compared
to your investment. The return that you desire from your investment depends on three
parameters:

1) You are foregoing consumption today to be better off in the future so you would
like to be compensated for foregoing your consumption option,
2) As the value of the money goes down with inflation, you would like to be
compensated for inflation also, and
3) You would like to be compensated for the risk that accompanies that investment
that you are going to make.

If you were getting the same return on your investment from a private company and the
government, you would like to invest your money with the government because you
consider it to be safer than the private company. Therefore the private company has to
give you higher return to induce you to invest money with it. In other words, the private
company has to compensate you for the additional risk that you would be taking up when
you are investing money with it by offering you higher return. As the level of risk goes
up, so also the expected return as depicted in the figure 1.3.

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 Figure 1.3: The Risk-Return Relationship

This simple relationship makes a great deal of sense and helps us value the different
investment options that are available to us in the right perspective.

2. Time Value of Money

A rupee received today is worth more than a rupee received in the future.

Simply because we can earn some return on the rupee received today, it is better to
receive money earlier rather than later. In your economics textbooks this return is referred
to as opportunity cost of passing the earning potential of a rupee today. This concept
helps us in bringing the cash flows that we are receiving from our investments in the
future to the present. This makes it easier for us to compare the costs and benefits
because both values are in today’s terms. If the present value of benefits are greater than
the costs, the project is creating wealth otherwise it is destroying it. This concept also
makes it easier for us to compare different projects and choose the one that offers the best
return.

To make rupees of different time periods comparable, we need to assume a specific

opportunity cost of money. This opportunity cost is governed by the first principle (Risk-
Return Trade off). We will learn in Chapter 13 how to do it.

3. Cash is King
In measuring value we will use cash flows rather than accounting profits because it is
only cash flows that the firm receives and is able to reinvest.

When a company invest its money in a project, it gets certain returns as cash flows from
the project. These cash flows are different from the accounting profits that are shown in
the books of accounts and in financial statements. But the cash flows are the real funds
that can be used and not the accounting profits. Therefore, only the cash flows that the
business is generating are relevant and not the accounting profits for us to accurately
measure the returns from the project.

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4. Incremental Cash Flows

It’s only cash flow changes that counts. In making business decisions we will only
concern ourselves with what happens as a result of that decision.

We have just said in fundamental principal three that we should use cash flows to
measure the benefits from a new project. But we still need to ask ourselves what the cash
flows will be if the project is taken on versus what they will be if it is not. That is to say,
we will only consider incremental cash flows and not the cash flows, which would have
occurred regardless of the project that we were planning to undertake. Incremental here
means, over and above the cash flows that were possible without it.

5. Curse of Competitive Markets

It’s hard to find exceptionally profitable projects. In competitive markets, extremely large
profits cannot exist for very long because of competition moving in to exploit those large
profits. As a result, profitable projects can only be found if the market is made less
competitive, either through product differentiation or by achieving a cost advantage.

Extra ordinary returns are only possible if the industry is very new, has only few
specialised players, or there are niches that are exploited. In other words, you either need
to have product differentiation or cost advantage to be able to derive more profits from
the projects then is the industry norm. Patents, service and quality are three of the most
used methods for differentiating products. Pharmaceutical is the prime example for
patents and their use to generate above average profits. In service industry, McDonalds
stands out for its fast services, cleanliness and consistency of products, which makes the
customers keep coming back. Bose Music Systems uses superior quality as a
differentiating factor to charge higher price. Similarly, cost advantages due to economies
of scale, better management, or technological factors helps the companies generate above
average profits in a competitive industry. You should remember that if your normal
project is projected to generate above average profits in a competitive industry it can not
last for long and you should always double check the assumptions that you made when
you were making those projections.

6. Efficient Capital Markets

The markets are quick and the shares are rightly priced.

We had talked about wealth maximisation as the goal of the company (or of any business
organisation). The decisions that maximise shareholder wealth are those that help
increase the market price of the company shares because the value of these shares is the
wealth of the shareholders. In order to understand how does the shares are valued or
priced in the capital markets, we need to understand the concept of efficient markets.

When we talk about efficient markets, we talk about the speed with which the
information is reflected in the share prices. An efficient market is one where all the
available information is reflected in the share prices with such a speed that there is no
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opportunity for any investor to benefit from publicly available information. As the
information arrives in the market, the large number of investors present in the market
react to the new information and buy & sell the shares of that company till they feel that
the market price correctly reflects the new information. If this adjustment process is not
biased, the market is said to be efficient.

There are two implications of efficient markets.

1. The share price in the market accurately reflects the value of the company and
2. Artificial manipulation of earnings through accounting changes will not result in
price changes.

7. Agency Problem
Managers won’t work for the owners unless it’s in their best interest. The agency
problem is a result of the separation between the decision-makers and the owners of the
firm. As a result managers may make decisions that are not in line with the goal of
maximisation of shareholder wealth.

Agency problem is the result of separation of the owner shareholder and the managers of
the company. Most of the time professional managers, who have little or no ownership in
the company, run them. This is especially true for large companies. As the managers
would like to maximise their own wealth, they would like to benefit themselves in terms
of salaries and other benefits & perks which may not be justified for the work they are
doing and is at the expense of the owners of the company. You would say that the owners
could fire the managers if they are not performing a good job and act in their best interest.
It’s not that easy and if it was possible that way the agency problem would not exist at
all. Precisely for this reason, shareholders spend lot of time in monitoring managers
through the boards of directors so as to protect their own interest. Also because of the
same reason Employee Stock Option Plans (ESOPs) were introduced so that the
managers also become the part owners of the company and have an interest in
maximising the wealth of the company.

8. Taxes Bias Business Decisions

Different tax treatments for different types of assets and liabilities make it mandatory for
the company measure the impact of all the decisions on an after-tax basis.

Taxes play a major role in investment decisions and determining the capital structure of
the company. For example, a company sets up a project in the backward area because it
gets tax incentives, which helps it reduce the cost and increase the returns. Also, the
interest that the company pays on the debt is deductible from profits before the income
tax is paid to the government. It is crucial to determine the benefit that the shareholders
will get and allows them to save money by structuring the capital structure in such a way
that the profits to them are maximised without increasing the cost. Whenever we talk
about incremental cash flows, we will only concern ourselves with after tax incremental
cash flows to the company as a whole.

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9. All Risks are not Equal
All risks are not equal since some risks can be diversified away and some cannot. The
process of diversification can reduce risk, and as a result, measuring a project or an
asset’s risk is very difficult.

When you are investing in a project and you already have an existing company, the effect
this project has is to reduce risk associated with a company as a whole. This is only
possible when both the projects do not offer good returns and bad returns at the same
time. The more unrelated the returns are from the two projects the more their
diversification would help you in reducing the risk associated with a company as a whole.
Still, some of the risks associated with a company cannot be diversified away and have to
be borne by the company. When the company has invested in two or more unrelated
projects it becomes very difficult to measure the precise risk associated with that project
making it difficult for you to value the company. Care must be taken to not to take the
average risk associated with the company as a whole as a measure of the risk associated
with individual projects or assets belonging to that company.

10. Ethical Behavior

Ethical behaviour is doing the right thing, and ethical dilemmas are everywhere in
finance. Ethical behaviour is important in financial management, just as it is important in
everything we do. Unfortunately, precisely how we define what is and what is not ethical
behaviour is sometimes difficult. Nevertheless, we should not give up the quest.

Ethical behaviour means doing the right thing. How would you define the right thing?
The basic problem is that all of us have our own individual set of values which forms the
basis for our personal judgements about what we think is the right thing to do. You
understand that we live in a society and society has a set of rules or laws that describe
what it believes to be the right thing. The manager is an employee of the shareholders and
it is his duty to do as the shareholder wishes him to do. Now the question that comes in if
the shareholder wants him to do something wrong, does manager has a right to stop the
shareholder from getting the wrong thing done. He may not be in a position to do so.

Then, there is a question of social responsibility, which means that a company has
responsibilities to society beyond the goal of maximisation of shareholder’s wealth.
There are several opinions for either side of the argument that the company has social
responsibilities or not. The only critical factor is that the shareholders need to decide
whether their company should take care of social obligations or not. Still the role of the
manager in achieving these objectives cannot be undermined.

Role of Computers in Accounting and Finance

Computers have changed everything in the way the business is conducted. How can
accounting and finance be left behind? The accounting process was amongst the first
ones to be computerised. Computers allow storage of vast amounts of information about
individual transactions. For example, information about which salesperson sold the
product, the price at which it was sold, to whom it was sold and the method of payment
can all be easily captured by the use of the technology that is prevalent today. The cost of
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gathering this information without the use of today’s technology is prohibitive both in
terms of time and money.

This vast amount of information can be compiled quickly and accurately, thereby
providing meaningful information whenever required while simultaneously reducing the
likelihood of errors so prevalent in the manual calculations. As you will soon discover,
vast amount of accountants time was spent in moving numbers from various accounting
records as well as adding and subtracting a lot of figures. Computers have made this
process virtually invisible.

While in the precomputer world, it was essential that the lenders and investors receive
condensed summaries of a company’s financial activities. Now when they can process
gigabytes of information, why should the financial report of any company be restricted to
just three financial statements? Why can’t these companies provide access to much more
detailed information online? Computer technology and Internet have made it possible to
acquire and analyse information online. Ten years ago, the only way you could have had
an access to financial statements of any company was to get the printed copy of its annual
report. Now for many companies you can download the summary financial statements
from their web sites. How will you get information ten years from now? Nobody knows
but the rapid advances in technology ensure that it will be different from anything that we
are familiar with right now.

On a fundamental level technology hasn’t changed the way in which the mechanics of
accounting are carried out, which are still the same as they were 500 years back. People
are still required to analyse complex transactions and input the results of that analysis into
the computer. Computers provide you the numbers, in whichever way you want them but
still there are two restrictions: 1) Numbers you get out depends on the numbers that go in
(remember the famous quote: GIGO which stands for Garbage In, Garbage Out) and 2)
Computers cannot analyse the transactions. Technology has not replaced judgement.

So if you are asking that question-“Why do I need to understand accounting-can’t

computers do it?” – you know the answer. You need to know what the computer is doing
if you want to be able to understand and interpret the information resulting from the
accounting process. Since judgement was required when the various pieces of
information were put into the accounting systems, judgement will be required to
appropriately use that information.

Accounting as an Information System

An accounting system consists of personnel, procedures, devices and records used by an

organisation which help in development and structure of accounting information and
communicating this information to decision makers. Design and capabilities of these
systems vary greatly from organisation to organisation. In very small businesses, the
accounting systems may consist of little more than a cashbook and a chequebook and
maybe an annual interaction with the chartered accountant for filing tax returns. In very
large businesses, accounting systems would include computers, expensive ERP software
like SAP, highly trained employees and periodic accounting reports that provides the
backbone for controlling the daily operations of every department. Still the basic purpose
of the accounting system remains the same; To meet the organisation’s need for
accounting information as efficiently as possible.

14
SBI Revamps Its Accounting System

In the present system of accounting that the SBI has, each branch is supposed to
draw out its own account, which is then sent to the head office where it is
consolidated. In the new system, the bank plans to have an urban branch, which
will consolidate the accounts for about eight to ten surrounding rural branches.
These accounts will then be sent to the 55 zonal offices of the bank for zonal
consolidation. These will then be sent to the 13 local head offices (LHO) for
further consolidation. And finally only the LHO-consolidated accounts will be
sent to the corporate office where the final consolidation will take place.

Of its 9,000 branches, the State Bank has already computerised about 2000. By
the year 2000 it plans to computerise about 3000 branches, which will account for
almost 75 per cent of the assets generated and 80 per cent of the income earned.

The bank expects to come out with a monthly balance sheet and profit and loss
account once the system is in place. SBI sources say this would require
reorientation of the existing employees to help them move on to the new system.

Accounting should be viewed as an Information System for the simple reason that it
would help focus attention on the information provided by it. Accounting helps users in
taking better decisions by providing relevant, timely and cost-effective information on the
financial and operational parameters. How accounting systems helps is shown in the
figure 2.1 given below:

Figure 2.1: Accounting as an Information System

15
In figure 2.1, the information system produces the information which is presented in the
middle of the figure. This information meets the needs of users (both external and
internal) and supports several kinds of financial decisions like performance evaluation,
capital allocation, investment decisions, etc.

Types of Accounting Information

Accounting information can be classified into two basic categories:

1. Financial Accounting
2. Management Accounting

Financial Accounting is the area of accounting that is concerned with reporting financial
information to interested external parties and can be defined as information describing the
financial resources, obligations, and activities of an economic entity (either an
organisation or an individual).

Financial accounting information is designed primarily to assist investors and creditors in

deciding where to place their money. Such decisions are important to economy because
they determine which companies and industries will receive the financial resources
necessary for growth and which will not, thereby helping in efficient allocation of
resources.

Management accounting involves development and interpretation of accounting

information specifically as an aid to management in running the business. This means
that management accounting focuses on the information needed for planning,
implementing plans and controlling costs. Therefore, the information generated by both
financial and cost accounting is used in management accounting. Cost Accounting helps
in determining the per-unit cost of manufactured products and help in interpreting this
cost data. Knowing the cost of each business operation and manufactured product is
crucial to the efficient management of a business.

Uses and Users of Accounting Information

The accounting system generates accounting information in the form of financial reports.
There are two major categories of these reports: External and Internal.

Individuals and organisations who have an economic interest in the business but are not a
part of the management use external financial reports, included in the company’s annual
report. Information is provided to these external users in the form of general-purpose
financial statements. Special reports are sometimes required by the government agencies,
which the company has to provide. Internal users, which include managers and
executives working for the company, have access to specialised management accounting
information that is not available to outsiders.

16
17
External users of accounting information

External users have limited access to an organisation’s valuable information. Success of

their decisions depend upon use of external reports that are reliable, relevant and
comparable. Typically, governmental and regulatory agencies have the power to get
reports in specific forms. Rest of the external users rely on general-purpose financial
statements like Balance sheet, Income Statement and Cash Flow Statement. The term
general purpose refers to the broad range of purposes for which external users rely on
these statements.

Each external user has special information needs depending on the kind of decisions he
has to take. These decisions involve getting answers to key questions, that are often
available in accounting reports. Let us now discuss several external users and the
questions that confront them.

Investors
Ravi owns a music cassettes store in Dehradun. He got an excellent job with a music
company in Delhi so he moved here. He hired Raman to manage his store, who sends
Ravi a check every month representing the profits from the business. How can Ravi know
whether Raman is doing a good job of managing his store? Are the amount of profits is
all that he can reasonably expect? Should he consider selling his business and invest his
money elsewhere to earn more profit?

As investors, the current owners of a firm are obviously interested in knowing how the
business is doing. If Ravi considers selling his business, he needs to know how much the
business is worth. The buyer will also be interested in a fair valuation of the firm’s assets.

Investors in a company are the shareholders (owners) of the company and in many cases
they are not a part of management. They are exposed to the greatest return and risk from
the company. Risk is high because there is no promise of either repayment of their
investment or a return on their investment. Therefore, they want information which help
them estimate how much returns they can expect in the future if they invest in a business
now. Financial statements coupled with knowledge of business plans, market forecast and
the character of management helps investors in assessing these future cash flows.

Lenders
Lenders loan money (or other resources) to the organisation. They are interested in only
one thing – being repaid with interest. Lenders include banks, financial institutions,
finance companies and public. Lenders look for information to help them assess whether
an organisation is likely to repay or not. External reports help them answer questions
about the organisation such as:

 How promptly has the company paid its past loans?

 What are the risks that it currently faces?
 Can it repay its current obligations and current liabilities?
 How relevant are its cash flow projections with which it will repay its obligations?

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Regulators
The basic requirements of the regulators is to ensure that the company is working in
accordance with the law and is not cheating the general public which is dependent on the
company for various reasons. Regulators often have legal authority or significant
influence over the activities of organisations. As government control of regulators, they
can ask for special formats of reports that the company has to provide. The income tax
authorities require organisations to use various reports for computing taxes. Registrar of
Companies (RoC) requires list of top shareholders along with the annual report.
Securities & Exchange Board of India (SEBI) and the Stock Exchanges (like National
Stock Exchange and the Bombay Stock Exchange) require that the listed companies
(companies which have wide public holding and whose shares are traded on the stock
exchange) make adequate financial disclosures in order to make sure that investor gets
sufficient information to make informed investment decisions.

Suppliers and Customers

In many cases suppliers and customers are interested in the long-term staying power of
the company. If you were going to put up a project that supplies its product to only one
customer, you would be interested in knowing whether that customer can last for a long
time. Similarly if you were the customer you would be interested in the long-term
viability of the supplier. Financial statements help you in understanding the other party’s
financial position.

Employees
Employees have a special interest in the company. They are interested in judging whether
the salaries/ wages paid to them are fair and also in assessing their future job prospects.
They are also interested to know that if the company is doing well so that they can
bargain for better wages or working conditions. External reports of other companies can
also be used to look at the salaries paid by other competing organisations to look for
better job prospects!

Internal users of the Accounting Information

Internal users are the individuals who are directly involved in managing and operating the
organisation. Therefore the internal role of accounting is to provide information to help
improve the efficiency and effectiveness of their organisation in delivering products or
services. Management accounting provides internal reports to help internal users improve
an organisation’s activities. Internal reports are not subject to the same rules as external
reports because internal users are not constrained in the use of accounting information.

They have access to a lot of private and valuable information that is kept secret from the
external users because of competitive concerns. Internal reports help answer questions
like:
 What are the manufacturing costs of a product?

19
 What is the most profitable mix of products or services?
 At what level the product should be priced at for different levels of sales?
 What level of sales is necessary to break even?
 What are the costs that the organisation has to bear whether the company produces or
not produces?
 Is it better to manufacture or do the activity in-house or the activity should be
outsourced?

Figure 2.3 Seven Common Functions in Most Organisations

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 Inform
Information
Information
Users
resources
Users
Both internal and external users rely on internal controls to monitor the company’s
operations. Internal controls procedures, set-up to protect assets and show reliable
accounting reports, promote efficiency and encourage adherence to company’s policies.

Investors
Is Accounting Information Reliable?

Investors
changes
External users like investors and creditors would like to rely on financial accounting
information without the fear that the management of the reporting organisation has
altered the information to make the company’s performance look better than what it

 Creditors
21
actually was. Internal users, i.e. the Management, would also like to be sure that
internally generated information is free from bias that might favour one outcome over
another and does not hide the true picture. Accounting information must have integrity
(the term integrity is used to represent completeness, unbroken, unimpaired sound, honest
and sincere information) because the information is very significant to the individuals
who rely on it for making important decisions. The integrity of accounting information is
enhanced in three primary ways:
1. Institutional features add significantly to the integrity of accounting information.
These features include standards for the preparation of accounting information, an
internal control structure and audits of financial statements. An audit is an
investigation of a company’s financial statements designed to determine the fairness
of the reports. External audit in India can only be done by Chartered Accountants. In
auditing financial statements, generally accepted accounting principles are the
standard by which the statements are judged. Companies Act, 1956 provides several
guidelines for companies to follow when it comes to recording and reporting
information. These guidelines are referred to wherever required and are usually given
in the annexure to the chapter where it is first referred.
2. Several professional accounting organisations play unique roles in adding to the
integrity of accounting information. These include Institute of Chartered Accountants
of India and Institute of Cost and Management Accountants of India. Institute of
Chartered Accountants of India has set up an Accounting Standards Board, which
frames the accounting standards. Apart from these there are guidance notes
3. Personal competence, judgement and ethical behaviour of professional accountants.

Perhaps the most important point is the third point because whatever be the guidelines
human beings can still find the loopholes they can take advantage of. All these points
together ensure that the users of accounting information can rely on the information to be
a fair representation of what it is suppose to represent. To help the companies take care of
special situations a lot of freedom is provided in the accounting standards. A lot of
companies exploit this freedom to disguise the actual performance of the company.
Although a auditor’s report is there to point out any significant deviations from the norms
and is a part of the annual report, how much justice they are able to do to their task is not
beyond doubt.

To enhance reliability, accountants rely on tested principles, which are discussed below:

Fundamental Accounting Concepts and Assumptions

Externally communicated accounting information must be prepared in accordance with
accounting standards that are understood by both the senders and the users of that
information. These standards are known as Generally Accepted Accounting Principles
(GAAP) and provide the general framework for determining what information is included
in financial statements and how this information is to be presented. Since accounting is a
service activity, these principles reflect the society needs and not those of accountants or
any other single constituency. These are the guidlines for measurement & presentation of
accounting information and are used by professional accountants in preparing accounting
information and reports.

Accounting principles were historically developed through common acceptance and

usage. A principle was acceptable, if most professionals permitted it. These general
principles became the basic assumptions, concepts and guidelines for preparing financial
statements. Specific principles, based on these general principles, were then developed as

22
detailed rules for reporting business transactions and events. General principles,
therefore, stem from long-used accounting practices and specific principles arise more
often from the ruling of authoritative groups. Therefore, these specific rules differ may
from country to country.

Significant differences in the specific rules create a lot of problems for multinational
businesses when they are trying to consolidate accounting information. Therefore, a need
was felt to have an international organisation that specifies the accounting standards that
can be used throughout the world. International Accounting Standards Committee (IASC)
was born as a result of this need. It issues International Accounting Standards (IAS) that
identify preferred accounting practices worldwide and encourages their worldwide
acceptance. More and more countries are modifying their practices to confirm to these
standards. As expected, India is far behind.

We need an understanding of both general and specific principles to effectively use

accounting information. Because general principles are especially crucial in using
accounting information, we will discuss them right now. Specific rules are described
wherever required and connected with the broad principles so as to help understand their
applications in the practical situations.

There are 12 general accounting principles that you should be aware of:

1. Money Measurement 2. Entity

3. Going Concern 4. Cost
5. Dual aspect 6. Accounting period
7. Conservatism 8. Realisation
9. Matching 10. Consistency
11. Materiality 12. Objectivity

1. The Money Measurement Concept

Record should be made only of that information that can be expressed in monetary terms.

Although the business may own seven buildings, five boilers, fifty cars, thirty trucks, you
can not add them together simply like that and get to know what the business is worth.

Expressing these items in monetary terms by saying that you have buildings worth Rs 15
crore, boilers worth Rs 50 lacs, cars worth Rs 1 crore and trucks worth Rs 2 crores would
make it easier for you to add up these items by adding their monetary values. You cannot
add apples and oranges directly but they can be added easily by expressing them in
monetary terms.

So money provides a common denominator by which the resources and other factors
about the business entity can be expressed and valued. Expressing in monetary terms also
helps in understanding the changes their impact on value of the resources.

As you can see, this concept imposes a severe limitation on the scope of accounting. It is
impossible for the accounting to record or report the health of the key people of the
organisation or that a plant is not working or that labour is going on strike or that the key

23
people are leaving the organisation and other important factors that may have a direct
bearing on the future of the organisation.

2. Entity Concept
Accounts can only be kept for entities, which are different from the persons who are
associated with these entities.

The business entity principle means that business is accounted for separately from its
owner(s). It also means that we account separately for each business that is controlled by
the same owner. The reason behind this principle is that separate information about each
business is needed by different users for decision making.

In sole proprietorships and partnerships, it is difficult to separate the entity from the
owners, as there is no distinction as per the law between the financial affairs of the
partnership and the partners or the proprietorship concern and the proprietor. The
difficulties in separating the expenses of the partners or the proprietor from the concern
makes it easier for them to pass on their personal expenses to the concern. This is
precisely the reason why a lot of proprietorships and partnership concerns hardly pay any
income tax.

For a company, this distinction is easier to make because company maintains separate
legal identity and its accounts correspond exactly to the scope of its activities.

3. The Going Concern Concept

Accounting records, events and transactions on the assumption that the entity will
continue to operate for an indefinitely long period of time.

Unless there is strong evidence to the contrary, accounting assumes that an entity is a
going concern. The significance of this assumption can be seen by contrasting it with
another possible alternative that the concern would be liquidated. Under the latter
assumption, accounting should attempt to measure what the entity’s resources are
currently worth to potential buyers. The going concern concept assumes that the
resources currently available to the entity will be used in its future operations.
This helps in distributing the effects of big expenses over several periods because their
benefits also accrue over several periods.

4. The Cost Concept

Assets are always shown at their cost and not at their current market value.

One of the most fundamental concepts of accounting, the cost concept says that the asset
is ordinarily entered into the accounting records at the actual cost incurred to acquire it.
Cost is measured on a cash or equal-to-cash basis. This means if cash is given for an asset
or service, its cost is measured as the amount of cash paid. If something besides cash is
exchanged (such as a car traded for a truck), cost is measured as the cash equivalent of
what is given up or received. We know that the real worth of asset may change over a
period of time so the value in the accounting records may not reflect the real value of the

24
assets owned by the concern. Land purchased in 1975 for Rs 5 lacs and a car purchased
for Rs 5 lacs in 1999 would both be recorded at these respective values in the books of
accounts. Irrespective of the fact that the land could be worth Rs 5 crores today and the
car would be worth Rs 3 lacs now. Accountants are fully aware of this fact but do not
attempt to reflect such changes in the accounts as there could be significant differences in
values estimated by different entities.

The cost concept does not mean that all assets will remain in the accounting records at
their original purchase price. The cost of the asset that has a long, but limited, life is
systematically reduced over that life by the process of depreciation. The purpose of the
depreciation process is to systematically remove the cost of the asset from the account
and show it as the cost of operations. Still Depreciation has no necessary relationship to
changes in market value or to the real worth of the asset.

To emphasise the distinction between the accounting concept and value, as we

understand it, the term book value is used for the historical cost amounts as shown in the
accounting records and the term market value for the actual value of the asset in the
market.
The cost concept provides an excellent illustration of the objectives of the accounting
principles; relevance, objectivity and feasibility. These three criteria can often conflict
with each other. For example, if a company develops a new product, it can have a
significant effect on the real value of the company. This information of the new product
is very relevant to the creditors and the investors as also the internal users but the value of
this product would normally be estimated by the management and is highly subjective.
Therefore, accounting does not attempt to record such values thereby sacrificing
relevance in the interest of objectivity. Therefore the cost concept fulfils the criteria of
objectivity and feasibility but does not fulfil the criteria of relevance. It is not purely
objective also but is relatively more objective than estimating market values and
reporting them.

5. The Dual Aspect Concept

The value of the assets owned by the concern is equal to the claims on these assets.

The fundamental accounting equation is the formal expression of the dual aspect concept.
All accounting procedures that we will discuss later are derived from this equation. The
equation is written as :

Assets = Liabilities + Owner’s Equity

Economic events, which are recorded in the accounting system, are called transactions.
Every transaction that an organisation undertakes has a dual impact on the accounting
records i.e. it will have an impact on two (or more) accounts simultaneously. This is why
accounting is also called a double-entry system.

To illustrate suppose that Ms. Sharda starts a dry-cleaning business and her first act is to
buy an industrial washing machine for Rs 1 lac with her own money. The dual aspect of
this transaction would be that a proprietorship business now has an asset, an industrial
washing machine, of Rs 1 lac and Ms. Sharda, the owner, has a claim of Rs 1 lac against
this asset. Putting this in the above equation, we get :

25
Assets (Industrial Washing Machine), Rs 1 lac = Liabilities + Owner’s Equity, Rs 1 lac

6. The Accounting Period Concept

Accounting measures activity for a specified interval of time, usually a year.

Net Income is easy to measure if you are only dealing once but the company deals
constantly and we expect the company to continue forever (remember going concern
principle). Therefore, it becomes difficult to find out whether the business is earning
anything or not. Both the managers and external users are unwilling to wait for the
closure of the business to know how the business has fared. They need to know how
things are going in the business at frequent intervals. This leads to the accounting period
concept. The first author of a known accounting text, Pacioli, wrote in 1494; “Books
should be closed each year, especially in a partnership, because frequent accounting
makes for long friendship.” So the books of the organisation are closed at regular
intervals (usually a year) and the financial statements prepared for reporting purposes.
The Companies Act also requires that a report should be prepared annually for reporting
purposes and income tax reporting is also on an annual basis.

In India, the majority of the businesses follow ‘April 1 – March 31’ (April of this year
and March of next year) as the accounting year (also known as fiscal year) but many
businesses also use calendar year as the accounting year, especially the multinational
companies. This is because its makes it easier for them to club the result of their activities
with the parent companies overseas which normally use calendar year as the accounting
year. Still, they have to prepare and report to income tax authorities following the ‘April
1 – March 31’ accounting year. The accounting period for shareholder reporting purposes
could be more or less than one year but for taxation purposes it remains the same.

For internal reporting, there is no time period specified anywhere. Companies can use
any period that they want to as computerisation have made it easier for them to take out
accounting reports as and when required. Still, many of the companies, which are not
dependent on the computers, commonly use a month as the reporting period. SEBI
requires that the companies that are listed on the stock exchanges should issue quarterly
income statements for the benefit of the external users.

7. The Conservatism Concept

Anticipate no profits but provide for all possible losses. Like most humans, managers
have a tendency to give a favourable report of the working of the entity that is under
them. Accounting safeguards are designed to offset this natural tendency of optimism.
The idea behind this principle is that the recognition of increase in entity’s earnings
requires better evidence then does the expenses. For example, if customer signs an MoU
for buying Rs 10 lacs worth of products you would not recognise this revenue in your
accounting system because the products have not changed hands and no transaction has
taken place. You will only recognise the revenue once the sale is made and the product is
delivered to the customer so that you have a legal right to claim payment. Now you can
say that only the product has been delivered but the money has not come in so you should
not recognise the sale till the time the money is paid. A cash system of accounting does
exactly that. But the point this product has been given to him, he is under a legal
obligation to pay you the amount that is due to you. Therefore, under the accrual system
26
of accounting, you would recognise that this sale as revenue and the customer owns you
money till the time he pays up. Now this debt could also become a bad debt (money
owned to you but never paid) and therefore, you would provide for some losses that can
happen due to bad debt even before they happen depending upon the past experiences
with your debtors.

The conservatism principle therefore, has two aspects:

1. recognise revenues only when they are reasonably certain
2. recognise expenses as soon as they are reasonably possible

These guiding principles are used while deciding the period in which the expenses and
the revenues fall in. Obviously, it leaves certain gaps in deciding what is meant by
reasonably certain and reasonably possible in various situations. Accounting standards do
provide certain guidelines for many specific problem areas but their abuse is quite
common in India.

Therefore, you have to provide for losses that you reasonably expect but not the revenues
that you may expect in the future to make the accounting figures reflects a conservative
approach.

8. The Realisation Concept

The sale is considered to have taken place only when either the cash is received or some
third party becomes legally liable to pay the amount.

We have just learned from the conservatism principle when the revenue should be
recognised. Realisation concept indicates the amount and revenue that should be
recognised from a given sale. The concepts states that the amount recognised is the
amount that is reasonably certain to be realised. Note the words ‘reasonably certain’.
Differences of opinion are there when interpreting what is ‘reasonably certain’.

The concept allows for the amount of the revenues recognised to be less than selling price
of the goods or services sold. If the products are sold at a discount, then the revenue is
recorded at the lower amount and not at the normal price (also called the list price). When
the goods are sold on credit, you can never be sure of the amount that would be realised,
so, you provide for bad debts also.

9. The Matching Concept

When an event affects both the revenues and expenses, the affect on each should be
recognised in the same accounting period.

As you already know, the sale of the products has two aspects:
1. Revenue aspect
2. Expense aspect

Revenues earned because the sale is going to fetch you some money and expenses
incurred for producing that product or providing that service. Correct measurement of the
net effect of the sale and expenses in any accounting period can only be made when you
match the relevant expenses to its related sales. Otherwise, it will allow a lot of freedom
27
for not showing the true profitability of the business. If you want to increase the profits,
you can show the sales but not the expenses and vice versa if you want to reduce the
profits for any given period. Therefore, the matching principle is applied by first
determining the items that constitute revenues for the period and their amount in
accordance with the conservatism concepts and then matching items of cost to these
revenues. The only problem is to determine which costs match with these revenues and
hence, are expenses for the period.

10. The Consistency Concept

The accounting policies and methods followed by the company should be the same every
year.

The consistency concept states that once an entity has decided on one method, it should
use the same method for all subsequent events of the same character unless it has a sound
reason to change the method. This is done because frequent changes in the manner of
handling same type of events, would make it very difficult for the external users to
compare financial statements over different periods. The term consistency as used here
refers to consistency over a period of time and not the logical consistency. The external
auditors have to specify in their reports if the company is changing any of its policies or
methods and the effect of these changes on the reported figures.

11. The Materiality Concept

Insignificant events would not be recorded if the benefit of recording them does not
justify the cost.

In law, there is something called ‘de minimis non curat lex’, which means that the court
will not consider trivial matters. Similarly the accounting does not attempt to record
events so insignificant that the work of recording them is not justified by the usefulness
of the results. For example, when the pencils are issued to the employees they are written
off as expenses even still when they may be used over a period of time and are assets of
the organisation. This is done because keeping a track of the use of the pencil would
require more expenses and does not serve any real purpose, as the value of the item is too
small. In other words, insignificant events will be clubbed together and recorded because
the organisation has to account for every single paisa.

The line separating material events from immaterial events is so thin that the decision
depends only on judgement and common sense. The guiding force is to look at the
expense in the light of the total expense and see whether any real benefit could be served
by going into the details of that item. The concept is very useful when estimating the
costs associated in any particular accounting period and revenues. Because many of them
would not be very close estimates and it may not be worthwhile to attempt to refine these
estimates and make these more exact.

But you should remember that there is no definitive rule that separates material
information from immaterial information. So, the materiality concept may be taken to
mean that although insignificant events may be disregarded but there must be full
disclosure of all-important information.

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12. Objectivity Principle
An evidence of the happening of the transaction should support every transaction.

The objectivity principle means that financial information is supported by independent

and unbiased evidence. It involves more than one person’s opinion. Information is not
reliable if it is based only on preparer perception. A preparer can be too optimistic or
pessimistic. An unethical preparer might even try to mislead users by intentionally
misrepresenting the truth. The objectivity principle is intended to make financial
statements useful by ensuring that they report reliable and verifiable information.

II – Financial Statements

Learning Outcomes
• Understand how the accounting process works
• Understand the basic financial statements

The Accounting Process

Although most of the managers are not concerned with how the record keeping
procedures are used in the accounting system basic knowledge of this would be useful in
understanding how the information flows to reach the final reports that they get. We will
discuss a manual system and contrast it with a computerised system so as to highlight the
benefits and the shortcomings of both the systems. The process followed by both the
systems, the manual systems & the computerised system, is the same and the steps are
easier to visualise in a manual system.

The basic accounting process is shown in the figure 2.4 below:

29
Figure 2.4: The Acconting Process

The first thing that the accounting system takes on is the financial transactions. A
transaction is defined as an external event or internal event which gives rise to a change
affecting the operations or finances of an organisation. Now there should be evidence that
a transaction has taken place. This evidence comes from the documents that are used to
support a transaction, like invoices, receipts, cheques, bank statements, etc. For recording
a transaction, it must be analysed to determine its effects on the two (or more) accounts
and the reason why it affects those accounts. As the original document cannot be used to
write these details, a standard document known as a voucher is used to accompany the
original document. Voucher is therefore the basic unit of an accounting transaction.
Every voucher mentions the two (or more) accounts that are being affected, the amount
with which each account is affected and the reason for the transaction (known as
narration). Each voucher is numbered and dated, making referencing easier.

Once the vouchers are made for the day, they are entered into an intermediate book
known as Journal. Vouchers are normally recorded in the order in which they occur.
Journal entries contain all relevant information pertaining to a transaction.

30
This data from the journal has to be rearranged to assist in analysis. For this the data is
transferred to Accounts in the General Ledger (the process is known as posting). In
accounting the term account is used to denote any item for which the transactions affect
the amount of that item. A general ledger is a group of accounts, both permanent and
temporary. In a manual system a loosely bound book with the title general ledger could
be used where at least one side of a page is maintained for every account. More pages are
added as required if the number of transactions in that particular account is high. In
computers, the records are kept in the databases and there is no limitation either on the
number of accounts or on the number of entries (except the limitation of storage space on
the computer). Hence is it much easier for the bigger companies to keep a computerised
track of their accounts than keeping a manual system.

There are five basic types of accounts: assets, liabilities, owner’s equity, revenue and
expenses. Sample account heads that fall under them are shown in Appendix II at the end
of this book.

Accounts can be represented as T-accounts, a sample of which is shown in figure 2.5

below:

Figure 2.5: A T-Account Example

This T-account shows a brand new entity, cash, whose opening balance is zero. All
increases are listed on one side and all decreases are listed on the other. Fundamentally,
there is no difference between this account and the register at the end of your chequebook
where increases are recorded in one column and decreases recorded in other column.
However, the cheque book register may show you the third column to show the running
balance in the account. A T-account is balanced only periodically (note that the rupee
sign is not shown in the T-account, as it is the normal book keeping procedure). This
method of adding the increases on one side and decreases on other side and balancing
periodically helps reduce the time and effort spent in showing the new balances every
time there is an increase or a decrease in the value of the entity. The T-account is only
used to help understand the accounting process and is not used in the business to record
transactions.

In the T-account in figure 2.5 above, the left-hand side is called the debit side and the
right hand side is called the credit side. Therefore, to debit means to make an entry on the
left-hand side of the account and to credit means to make an entry in the right-hand side

31
of an account. This was an arbitrary decision and does not have any relation to the
favourable or unfavourable meanings associated with these terms. The dual aspect means
that if you make a transaction, the sum of the debit amounts is equal to the sum of the
credit amounts because of that transaction. This is why you may also call it a double
entry book keeping effect. This means that for all the accounts taken together the sum of
the debit balances should be equal to the sum of the credit balances. If they are not equal,
something is wrong and this provides a useful mechanism to check the accuracy with
which the transactions have been recorded.

The account maintained for various items on the balance sheet, are called permanent (or
real) accounts. The balance of each account is determined at the end of each accounting
period (the account is balanced). These balances are then reported on the balance sheet as
of at the end of the period and are carried forward to the next accounting period as the
next period’s opening balance.

You know that the revenues and expenses are charged in the form of increases and
decreases in earnings because of the entity’s activities. Separate accounts are maintained
for all revenues and expense items because of the help that they provide in knowing and
controlling the costs. The accounts which are made specifically for revenue and expense
items are called temporary accounts and appear on the profit and loss account. This
means that there are temporary accounts for sales revenues, cost of sales, operating
expenses and so on. These temporary accounts are maintained for the accounting period
and are closed at the end of the accounting period. For next accounting period, fresh
temporary accounts are opened which may retain the same names but nothing else.

Remember the accounting equation, where we said that assets are equal to the sum of
liabilities and the owner’s equity. If the asset accounts should increase on the left-hand
side (i.e. the debit side) they must decrease on the right hand side (i.e. the credit side).
Given this rule for the asset side, it follows that the right hand side of the equation
consisting of liabilities and owner’s equity should behave in an opposite manner to this
for the debit and credit transactions to balance each other out. That is both the liabilities
and the owner’s equity should decrease on the left-hand side (debit) and increase on the
right hand side (credit). Schematically, these rules are presented in figure 2.6 shown
below:

Figure 2.6: Accounting Equation as a T-Account

The rules for recording revenues and expenses (i.e. the temporary accounts) can be
derived from the rules for owner’s equity. As you know that the revenue increases
owner’s equity (because earnings are a part of owner’s money) and expenditure decreases
it, it necessarily follows that the revenues are credits. A decrease in revenues should
therefore be debits. An opposite treatment would be then be given to the expenses, which
would increase on the debit side and decrease on the credit side. This can be seen in
figure 2.7 below:

32
 Figure 2.7: Accounting Equation with Revenues & Expenses

Mastering these rules require practice rather than memorisation and this is not the
purpose of this book. The purpose here is only to help you understand the process flow ,
i.e., how the accounting system works.

Financial Statements: Summary of Accounting Information

The general-purpose information provided by financial accounting is summarised in three

primary financial statements: balance sheet, income statement and cash flow
statement.

Obje
Obje
33
Introdu
Introd

Introdu
Introd
Balance S

Incom
34
 Introdu
Introd

Balance Sheet
Introdu
Introd Balance S
The balance sheet, also called statement of financial position, supplies information on
resources the organisation currently controls, where they came from, and who has claims
against them. Among other things, the balance sheet provides information that helps you
answer the following questions:

Incom
1. How large is the firm in terms of the amount of total resources?
2. How much have the owners invested in the organisation? What proportion of the
owner’s funds have been brought in fresh and what proportion represents past
35
 profits held and accumulated in the
organisation as additional owner’s
investment?
3. How much money is borrowed by
the organisation? Can it borrow
more in case of needs? When are
the borrowings due for repayment
and is the organisation in a healthy
position to pay them on time?
4. What kinds of resources does the organisation have? Are most of its resources are
committed to its present activities, or can it move rapidly into new business
opportunities?
5. How much cash does the organisation have? How much cash can it obtain
quickly? How much money is owed to it, and how much money it owes to others?

The balance sheet is the position statement which shows where the company stands in
financial terms at a specific date. Underline the words position statement and specific
date. As discussed earlier, the balance sheet is a snapshot view of the assets and liabilities
of the organisation at a point in time.

The balance sheet reports the resources of the company (the assets), the company’s
obligations (the liabilities), and the owners’ equity, which represents the difference
between what is owned (assets) and what is owned (liabilities). The basic format is
shown below in figure 2.8.

Figure 2.8: Balance Sheet as on March 31, 1999

Profit & Loss Account

The Profits & Loss A/C, also known as income statement, provides information on the
efficiency of utilisation of resources in obtaining current revenues-the current
profitability of the organisation. Among other things, it helps you answer the following
questions:

1. How large is the firm in terms of its total volume of sales?

2. What are the profitability levels of the organisation? When compared with similar
organisations in the same business, is the organisation making more or less profit?
3. What is the trend of the profitability? Are profits remaining proportionate to
changes in the volume of business activities, or are they proportionately
increasing or decreasing?
4. Compared with other similar organisations, are the costs of doing business
proportionately the same in relation to sales, or higher/ lower?
5. Since profitability is one indicator of debt-paying ability, is the organisation in a
good position to repay its bills promptly? Are profits more than adequate to cover
current interest costs?

The profit & loss a/c is an activity statement that shows details and results of the
company’s profit related activities for a period of time (For example a month, three

36
months, six months or year). It reports the amount of net income earned by a company
during a period, with annual and quarterly income statements being the most common.
Net income is the excess of a company’s revenues over its expenses. If the expenses are
more than the revenues, then the company has suffered a loss for the period.

The profits & loss a/c represents the accountant’s best effort at measuring the economic
performance of a company. The basic format is shown below in figure 2.9.

Figure 2.9: Profits & Loss a/c for the Year Ended March 31, 1999

Cash Flow Statement

The cash flow statement provides information on how the organisation is allocating the
resources that were generated by the organisation during the preceding year. It provides
answers to the following types of questions:

1. How much new resources were generated or obtained during the previous year?
2. Where did these resources come from? Were additional resources obtained from
creditors or the owners or from the profits retained in the business?
3. What has been done with these new resources generated? Are they being used to
replace or expand the organisation’s buildings, equipment, and similar items?
What proportion is being used to retire debt or distributed to owners?

The cash flow statement is an activity statement that shows the details of a company’s
activities involving cash during a period of time. The statement of cash flows reports the
amount of cash collected and paid out by a company in the following three types of
activities: operating, investing and financing.

The statement of cash flows is the most objective of the financial statements since, as you
will see in subsequent chapters, it involves a minimum of accounting estimates and
judgements. The basic format is shown below in figure 2.10.

37
Figure 2.10: Cash Flow Statement for the Year Ended March 31, 999

38
Relation between the Three Statements

The relation between the three major financial statements is denoted in the
figure 2.11.

Figure 2.11: Relationship between Three Financial Statements

A balance sheet reports an organisation’s financial position at a point in time. The income
and cash flow statements report on activities over a period of time. The two statements in
the middle column of figure 2.11 link balance sheet from the beginning to the end of a
reporting period. They explain how the financial position of an organisation changes
from one point to another.

As balance sheet is the starting point, we will discuss it in detail in the fifth chapter and
follow it with Profits & Loss A/C and Cash Flow Statement. Then we will discuss how to
analyse these statements and other components of an annual report prepared by a
company.

The Accounting Process: A Case Study

Sunil Bakshi is a business school graduate. He has always been interested in computers
and wants to start his own hardware business. As he passed out of the business school, his
grandfather funded him Rs 2,00,000 to start his own business. He decided to start a
computer parts business and named his firm “Sunil Computer Mart.”

His memory of elementary accounting taken during the first term was somewhat shaky,
but he knew that he would need accounting information to manage his business. He
remembered the accounting equation (Assets = Liabilities + Owner’s Equity) and that it
always should balance. Sunil obtained a large sheet of paper and drew lines on it to
represent the sections of the accounting equation:

Basic Accounting Equation Format

Owner’s Equity + Liabilities = Assets
Shareholder’s Equity

39
 Liabilities

Sunil then proceeded to keep records of everything that happened to his business in a
daily diary. Every Saturday night he would record the effect of the previous week’s
transactions on his accounting equation format.

• First Week:
During the first week, his diary contained the following items:
Event (1) Opened a bank account in business name and transferred Rs 1,00,000 into
1st January it.
Event (2) Took a shop on rent in Nehru Place from a person known to his father
02/ 01
Event (3) Gave Rs 10,000 to the shop owner, representing first month’s rent (Rs
02/ 01 5000) and one month’s security deposit.
Event (4) Spent Rs 500 on cleaning and fixing up the interior of the store.
05/ 01
Event (5) Met a long lost friend, who incidentally was in the same business and
06/ 01 offered to partner in the business. Sunil said he would decide about it later

At the end of the week he recorded the effects of these events on the accounting equation
as follows:
Sunil Computer Mart
Financial Position Statement as on the end of first week
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s + 1,00,000 (1)
Equity
- 500 (4)
Liabilities Cash + 1,00,000 (1)
- 10,000 (3)
- 500 (4)

Prepaid Rent + 5,000 (3)

Security Deposit + 5,000 (3)

Figures in brackets indicate the event number that the entry refers to.

Note that the events (2) and (5) have had no effect on Sunil’s statement. They did not
change the financial position of his business. Taking a shop on rent will have no effect till
the time the shop is given to Sunil in usable condition. Sunil was not obliged to take his
friend as a partner, his friend will become partner only when Sunil decides to share his
resources with him and the partner brings additional resources to work with Sunil.

Also note how Sunil recorded the effect of events (1), (2) and (3) and the reasoning
behind such recordings:

Effect of (1) Cash in the business has increased by Rs 1,00,000 because Sunil has
invested this money into the business. Therefore, it is also reflected in
owner’s equity, which represents Sunil’s share of the business.
40
Effect of (3) Gave Rs 10,000 to the shop owner, representing first month’s rent (Rs
5000) and one month’s rent as security deposit (Rs 5,000). This means
that the cash goes down by Rs 10,000. One asset (cash) has merely been
exchanged for other two (prepaid rent & security deposit). Prepaid rent
means the rent paid in advance whose benefit is yet to be taken. Total
assets did not change and therefore, total liabilities did not change either.
Effect of (4) Spent Rs 500 on cleaning and fixing up the interior of the store. Clearly
cash must have been given to pay for it. Although future benefits or
future cost savings could result from this, the benefits are too uncertain
from this intangible asset. With no visible asset increasing and cash
reduced by Rs 500, the effect has to be either on liabilities or owner’s
equity. Liabilities are not increasing; therefore the owner’s equity has to
decrease by this amount to maintain the balance. Remember we talked
about expenses reducing owner’s equity. This is a perfect example.

• Second Week:
Starting with the second week, Sunil started recording only those events that materially
affected his firm’s financial position. The events recorded during the second week are:

Event (6) Various parts of the computers costing Rs 30,000 were purchased from a
07/ 01 wholesale supplier.
Event (7) Other supplies like stationary, packing material, covers, etc. for use in the
08/ 01 business was also purchased. Rs 2,000 cash was paid for it.
Event (8) One used display counter and one used computer & printer was purchased
09/ 01 for Rs 25,000. Rs 5,000 cash was paid and the rest was payable after three
months with 18 per cent annual interest.

Try and record the above events in the financial position format given above on a
separate piece of paper. Then match your statement with the one given below:

Sunil Computer Mart

Financial Position changes in the second week
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s
Equity
Equipment + 25,000 (8)
Liabilities
Accounts Payable + 30,000 (6) Cash - 2,000 (7)
- 5,000 (8)
Loan Payable + 20,000 (8)
Inventory + 30,000 (6)

Supplies + 2,000 (7)

Note that the effect of each event is recorded separately. Also, we have not included the
figures of the first week’s events shown above so as to clearly bring out the effect of the
transactions and we are not accumulating the various effects. Another point that should
be noted is that certain increases and decreases in the owner’s equity are separately
identified and recorded for income measurement purposes but at this moment let us only

41
record the changes in owner’s equity. We will see later how to use this information to
draw up an income statement.

Effect of (6) Assets (inventory) increase by Rs 30,000. Inventory is the term given to
goods and material in hand, which is either ready for sale or will be
manufactured for sale to customers. The corresponding effect is felt on the
liabilities (accounts payable), which also increase by Rs 30,000. Accounts
payable is term given to liabilities that represent obligations to the
creditors for goods and services purchased.
Effect of (7) A simple exchange of assets where supplies increase by Rs 2,000 and cash
decreases by Rs 2,000.
Effect of (8) Assets (equipment) increase by Rs 25,000. There are two corresponding
entries; one that affects cash and other one affects loan payable. Cash
decreases by Rs 5,000 and loan payable increases by Rs 20,000.

• Third Week:
Sunil was now ready to do business and he opened his shop at the start of the third week.
On advice of other businesspersons, he adopted the following policies:

a) All sales of the computer parts would be on cash and carry basis.
b) When he will provide extra services like assembling a computer, etc. he would charge
extra for his time and send a bill (invoice) to the customer.
c) As the sales of the parts would be for cash only, he would not attempt to record the
outflow of parts (inventory) sold to the customers. He would only record the cash
coming in as sales and accounts receivables based on the invoices written. Accounts
receivables could be defined as an asset representing claims against customers for
goods or services sold on account.

The events recorded during the third week are:

Event (9) Total sales for the week was Rs 9,600.

15/ 01
Event (10) Total invoices for assembling and servicing (credit sales) for the week
15/ 01 – were Rs 2,200.
22/ 01
Event (11) Quantities of small screws, wires, switches and connectors costing Rs
18/ 01 5,000 were purchased on account as customers were asking for them along
with the computer parts.

Try and record the above events in the format given above on a separate piece of paper.
Then match your statement with the statement given below:

Sunil Computer Mart

Financial position changes in the third week
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s
Equity
+ 9,600 (9) Cash + 9,600 (9)
+ 2,200 (10)
Liabilities Inventory + 5,000 (11)
42
 Accounts Payable + 5,000 (11) Accounts + 2,200 (10)
Receivables

Effect of (9) Cash (Assets) increased by Rs 9,600. There was no other effect on the
assets (as it was decided to record the outflow of parts later). Liabilities
were not affected. Therefore, the owner’s equity increased by the amount
of revenues generated, i.e. Rs 9,600.
Effect of (10) Accounts receivables (Assets) increased by Rs 2,200. Liabilities were
unchanged. Therefore, the same effect as in event (9) would be there.
Effect of (11) Inventory (Assets) increased by Rs 5,000. Accounts payable (liabilities)
increased by Rs 5,000.

• Fourth Week:
The diary showed the following entries:

Event (12) Cash sales for the week were Rs 10,400.

23/ 01 –
30/ 01
Event (13) Credit sales for the week were Rs 2,800.
23/ 01 –
30/ 01
Event (14) Purchase of parts on account, cost Rs 4,000.
25/ 01
Event (15) Some of the customers previously invoiced paid Rs 1,500 on their
23/ 01 – accounts.
30/ 01
Event (16) Sunil paid the wholesaler Rs 25,000 on his account.
28/ 01

Try and record the above events in the financial position format given above on a
separate piece of paper. You would find that the effect of the events, (12), (13) and (14),
is the same (although with different rupee amounts) as the events (9), (10) and (11)
respectively.

Sunil Computer Mart

Financial Position changes in the fourth week
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s
Equity
+ 10,400 (12) Cash + 10,400 (12)
+ 2,800 (13) + 1,500 (15)
- 25,000 (16)

Liabilities Inventory + 4,000 (14)

Accounts Payable + 4,000 (14) Accounts Receivables + 2,800 (13)

- 25,000 (16) - 1,500 (15)

43
Effect of (15) Collection of receivables means that cash has come in and the balance
shown against the accounts receivables reduces. This means that only the
asset side is affected.
Effect of The effect is just the opposite of the above transaction. Cash is used to
(16) pay the accounts payable. Both the accounts payable and cash reduces by
the same amount.

We showed the financial position effect of each week’s events separately in order to
focus on the effect of each distinct event. The effect of all these events is cumulative. The
financial position statement below shows the effect of all events recorded in the dairy
during the month that changed the firm’s financial position.

Sunil Computer Mart

Effect of First Month’s Events on the financial Position at the end of the month
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s
Equity
+ 1,00,000 (1) Cash +1,00,000 (1)
- 500 (4) - 10,000 (3)
+ 9,600 (9) - 500 (4)
+ 2,200 (10) - 2,000 (7)
+ 10,400 (12) - 5,000 (8)
+ 2,800 (13) + 9,600 (9)
+ 10,400 (12)
+ 1,500 (15)
- 25,000 (16)

Liabilities Equipment + 25,000 (8)

Loan Payable + 20,000 (8) Prepaid Rent + 5,000 (3)

Accounts Payable + 30,000 (6) Inventory + 30,000 (6)

+ 5,000 (11) + 5,000 (11)
+ 4,000 (14) + 4,000 (14)
- 25,000 (16)
Accounts Receivables + 2,200 (10)
+ 2,800 (13)
- 1,500 (15)

Supplies + 2,000 (7)

Security Deposit + 5,000 (3)

Assume that you are in the position of Sunil Bakshi. As owner you would be interested to
know where the business stands today and whether you have made any profits from the
business transactions in the first month. From the transactions above compile a month-
end financial position (hint: add all the items under a particular category to get the
closing balance). Check your results against the financial position given below.

Sunil Computer Mart

Financial position at the end of the month
Owner’s Equity + Rs. Assets Rs.
Liabilities

44
 Shareholder’s 1,24,500
Equity
Equipment 25,000

Liabilities Cash 79,000

Loan Payable 20,000 Inventory 39,000

Accounts Payable 14,000 Accounts Receivables 3,500

Supplies 2,000
Total Liabilities 34,000
Prepaid Rent 5,000

Security Deposit 5,000

Total Liabilities + 1,58,500 Total Assets 1,58,500

Owner’s Equity

Do you think that this statement accurately represents the firm’s financial position? Do
you need any more facts before you could complete the preparation of a proper month-
end financial position? Refer back to the accounting process. We have just taken all the
balances in the individual accounts and have not done any adjustments till now. For
example, as we have not taken any inventory and have recorded sales against it, a
physical verification would be required to know how much value of inventory has been
sold out. This will also reduce the owner’s equity by a proportionate amount. Therefore,
this unadjusted financial position statement can at best serve as a starting point to reach
the exact position at the end of the period. There are basically four improperly recorded
asset measurements in the above statement. Can you identify them?

Required Month-end Adjustments to Reach Final Financial Position Statement

The four improperly reported asset measurements concern inventory, supplies, prepaid
rent and equipment. We saw above why decrease in inventory is not properly recorded.
To rectify this error, Sunil will have to count the items and their cost to find the actual
value. In manual accounting systems the inventory is physically verified at least once a
year. For computerised accounting systems, the inventory is automatically updated as the
transactions take place, making it easier to keep a track of the positions.

For the sake of ease, let us make some assumptions. The first assumption is of inventory.
Let us assume that physical verification resulted in Rs 28,500 worth of inventory and Rs
750 worth of unused supplies at the end of the first month. Another assumption that we
make is that the equipment has a useful remaining life of four years and it can be sold for
Rs 1000 at the end of fourth year. What about the telephone & power costs incurred
during the month? Neither bill has arrived and therefore nothing was recorded in the
dairy. Let us assume that Rs 1400 could be earmarked for both the bills together. Sunil
also owns the interest for the loan taken which would be paid at the end of three months
along with the loan amount. It works out to Rs 300 for one month.

You now have all the necessary information to adjust the unadjusted financial position
figures. Try and do it before you proceed.

Adjustment (17) We assumed that Sunil found the total inventory to be worth Rs
31/ 01 28,500 after verification. As the total amount of parts bought were
45
 worth Rs 39,000 and there was no beginning inventory, a consumption
of inventory worth Rs 10,500 (i.e. Rs 39,000 – 28,500) has taken
place. Note that the consumption could be in any form: sales, stolen,
broken or perished. Inventory is therefore reduced by Rs 10,500 and as
no other asset or liability is involved, owner’s equity is also reduced
by the same amount.

Adjustment (18) Similarly, supplies and owner’s equity are both reduced by Rs 1,250
31/ 01 each to record supplies used.

Adjustment (19) As the shop has already been used for one month, Rs 5,000 rent paid
31/ 01 in advance for the month ceases to be an asset and becomes an
expense. Therefore prepaid rent is reduced by this amount (which
now becomes zero) as also the owner’s equity to keep the balance as
no other asset or liability is affected.

Adjustment (20) As the usefulness of the asset is spread over four years and some
31/ 01 future usefulness of the asset is used in the first month; some part of
the asset’s value should be shown as an expense. As the equipment
was bought for Rs 25,000 and the scrap value is Rs 1,000 at the end of
four years; the question arises how to treat the loss in value. Whether
the loss in value should be treated as an expense in the first month
itself, over the life of the asset or at the end of the four years?
Logically the loss in value should be written off over the life of the
asset as the asset is used gradually over its useful life. This means that
the cost of Rs 24,000 is best spread over four years. What should be
the per month cost to be written off? (Rs.500 per month which comes
from Rs 24,000/4 = Rs 6,000 per year). This is known as depreciating
the asset over its useful life. The accumulated depreciation is written
below the asset value and then the net asset value is shown. Recording
a depreciation of Rs 500 means that the asset value is reduced by that
amount and to balance the owner’s equity is also reduced by the same
amount.

The point to be noted here is that inspite of being mentioned on the

asset side, the accumulated depreciation in effect reduces the asset
value when it increases in value. This type of account is called a
contra account.

Adjustment (21) The firm has an additional liability of Rs 1,400 for services performed
31/ 01 by power & telephone companies and this must be added to accounts
payable as the company is liable to pay whenever the bills come.
There is no new asset as the services have already been consumed and
therefore the owner’s equity must reduce by this amount.

Adjustment (22) Interest payable is a short-term liability as it is going to be paid after

31/ 01 three months when the money is returned but the amount has been
used for a month so the monthly cost (interest) has to be accounted for
a business expense. Owner’s equity decreases to balance, as there is
no change in any other asset or a liability.

46
Note that all the six transactions reduced the amount of owner’s equity, which should
now reflect the true picture of the increases due to the business operations.

Sunil Computer Mart

Financial Statement changes due to month-end adjustments
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s
Equity
- 10,500 (17) Accumulated - 500 (20)
- 1,250 (18) Depreciation on
- 5,000 (19) Equipment
- 500 (20)
- 1,400 (21)
- 300 (22)

Liabilities Prepaid Rent - 5,000 (19)

Accounts Payable + 1,400 (21) Supplies - 1,250 (18)

Interest Payable + 300 (22) Inventory - 10,500 (17)

The financial position statement below gives the final position of Sunil Computer Mart as
at end of the month.

Sunil Computer Mart

Final financial position at the end of the month
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s 1,05,550
Equity
Equipment 25,000
Less Accumulated
Depreciation (500)
Net Equipment 24,500

Liabilities Cash 79,000

Accounts Payable 15,400 Inventory 28,500

Interest Payable 300

Accounts Receivables 3,500
Loan Payable 20,000
Supplies 750
Total Liabilities 35,700
Security Deposit 5,000

Owner’s Equity + 1,41,250 Total Assets 1,41,250

Liabilities

47
So at the end of first month Sunil’s Rs 1,000,000 became Rs 1,05,550 i.e. an increase of
Rs 5,550. Not bad considering that Sunil is new to the market and has only been
operating for two weeks.

There are three significant points to be noted here:

1. The Accounting Equation always stays in balance.
2. Each transaction affects at least two accounts, sometimes more.
3. Some transactions affect only one side of the equation; some affect both sides.

Before we go ahead make sure that the above process is clear to you. If it is not, go
through it again.

How Accountants Do It

So far we have tracking changes in the accounting equation only and this is great as far as
understanding the basic process goes, but the process that the accountants use (and
discussed before) is slightly different. Let us now glance back and see how the
accountant would record these transactions.

Let us take three of the above mentioned events [(1), (4) and (6)] for illustration
purposes.

• Event (1)
Event (1) Opened a bank account in business name and transferred Rs 1,00,000 into
it.
Effect of (1) Cash in the business has increased by Rs 1,00,000 because Sunil has
invested this money into the business.
The dual-entry effect it is reflected in owner’s equity, which represents
Sunil’s share of the business.
Debit-Credit Increases in assets (cash) are recorded by debits (remember!).
Rules Increases in owner’s equity are recorded by credits. (Refer back to the
debit-credit rules if you have forgotten them)
Journal Dr. Cr.
Entry 01/ 01 Cash Rs 1,00,000
Owner’s Equity Rs 1,00,000

Entries in Ledger Accounts

Cash
31/ 12 Bal. Rs 0
01/ 01 Rs 1,00,000

Owner’s Equity
31/ 12 Bal. Rs 0
01/ 01 Rs 1,00,000

The first figure represents the closing balance of the last period. As there was no closing
balance (can you tell why?) the starting balance is zero.

48
 • Event (4)
Event (4) Spent Rs 500 on cleaning and fixing up the interior of the store.
05/ 01
Effect of (4) This is a business expense and therefore, should be recorded as such.
Clearly cash must have been given to pay for it.

Debit-Credit Decreases in assets (cash) are recorded by credits.

Rules Expenses decrease owner’s equity and are recorded by debits.

Journal Dr. Cr.

Entry 05/ 01 Maintenance Expense Rs 500
Cash Rs 500

Entries in Ledger Accounts

Cash
31/ 12 Bal. Rs 0 02/ 01 Rs 10,000
01/ 01 Rs 1,00,000 05/ 01 Rs 500

Maintenance Expense
05/ 01 Rs 500

Can you explain the figure of Rs 10,000 in the cash account above? It comes from
prepaid rent, event (3). Notice that in maintenance expense account no starting balance
mentioned as the expense accounts are started afresh every time a new accounting period
starts.

If you remember when we recorded the effect of event (4) in the accounting equation
above, we simply decreased the owner’s equity. Accountants do not do that. For different
types of revenue and expense activities, they open separate accounts so that it is easier for
them to compile these account figures into the financial statements.

• Event (6)
Event (6) Various parts of the computers costing Rs 30,000 were purchased from a
07/ 01 wholesale supplier
Effect of (6) Assets (inventory) increase by Rs 30,000.
The corresponding effect is felt on the liabilities (accounts payable)
which also increase by Rs 30,000.
Debit-Credit Increases in assets (inventory) are recorded by debits.
Rules Increases in liabilities (accounts payable) are recorded by credits.
Journal Dr. Cr.
Entry Date Inventory Rs 30,000
Accounts Payable Rs 30,000

Entries in Ledger Accounts

Inventory
31/ 12 Bal. Rs 0
07/ 01 Rs 30,000

49
 Accounts Payable
07/ 01 Rs 30,000

Other events can also be recorded in the same manner. All this would result in accounts,
which would show the balances as given in the trial balance given below:

Sunil Computer Mart

Unadjusted trial balance at the end of the month
Dr. Cr.
Shareholder’s Equity 1,00,000

Loan Payable 20,000

Event (8)
Accounts Payable 14,000
Event (6), (11), (14) & (16)
Equipment 25,000
Event (8)
Cash 79,000
Event (1), (3), (4), (7), (8), (9),
(12), (15) & (16)
Inventory 39,000
Event (6), (11) & (14)
Accounts Receivables 3,500
Event (10), (13) & (16)
Supplies 2,000
Event (7)
Prepaid Rent 5,000
Event (3)
Security Deposit 5,000
Event (3)
Cash Sales 20,000
Event (9) & (12)
Credit Sales 5,000
Event (10) & (13)
Maintenance Expense 500
Event (4)

Total 1,59,000 1,59,000

Events mentioned below the account name are put in there to help you relate these figures
to the financial position and transactions. Accountants do not write them, they only write
the account name.

There are two points that you must note out here. The shareholder’s equity here does not
show the effect of revenues and expenses events, which are shown separately. For
example, look at the cash sales and credit sales. If you club the both the sales figures into
the shareholder’s equity and subtract maintenance expenses you would get the same
figure (Rs 1,24,500) as was reported in the unadjusted financial position figure before.
Many other items also have the same balance, but note the different way of presentation.
Accountants take the ending balances of accounts and write it on the respective sides of
debit and credit.

This makes it easier for them to compile the figures later into the financial statements.
Before we go on and compile these figures into financial statements don’t you think that
we also need to do the adjustments that we did before? Yes, we have to. Let us see how
50
the above mentioned adjustments are recorded in the trial balance. The adjustments are
reproduced below for easier reference. Why don’t you try to do these adjustments in the
trial balance yourself before taking a look at the final trial balance?

Adjustment (17) We assumed that Sunil found the total inventory to be worth Rs
31/ 01 28,500 after verification. As the total amount of parts bought were
worth Rs 39,000 and there was no beginning inventory, a consumption
of inventory worth Rs 10,500 (i.e. Rs 39,000 – 28,500) has taken
place.
Inventory is therefore reduced by Rs 10,500, and Rs 10,500 is also
shown as inventory consumption.

Adjustment (18) Similarly, supplies are reduced by Rs 1,250 and Rs 1,250 is also
31/ 01 shown as supplies consumption.

Adjustment (19) As the shop has already been used for one month, Rs 5,000 rent paid
31/ 01 in advance for the month ceases to be an asset and becomes an
expense.
Therefore prepaid rent is reduced by Rs 5,000 (which makes it zero),
which is also shown as the rent expense for the month.

Adjustment (20) As the usefulness of the asset is spread over four years and some
31/ 01 future usefulness of the asset is used in the first month; some part of
the asset’s value should be shown as an expense.

This depreciation expense for the first month works out to Rs 500.
This would affect two accounts: accumulated depreciation account,
which would increase by Rs 500 and depreciation expense account,
which would show an expense of Rs 500.

Adjustment (21) The firm has an additional liability of Rs 1,400 for services performed
31/ 01 by power & telephone companies and this must be added to accounts
payable as the company is liable to pay whenever the bills come.
There is no new asset as the services have already been consumed and
therefore the owner’s equity must reduce by this amount.

Adjustment (22) Interest payable is a short-term liability as it is going to be paid after

31/ 01 three months when the money is returned but the amount has been
used for a month so the monthly cost (interest) has to be accounted for
a business expense. Interest payable account is created to represent
unpaid interest.

Note that when we were making the adjustments in the financial position, all the six
transactions reduced the amount of owner’s equity. Here the effect is not on the owner’s
equity as none of the adjustments has resulted in the increase or decrease in it. All the
changes due to these adjustments have been italicised for easy understanding.

51
Sunil Computer Mart
Adjusted trial balance at the end of the month
Dr. Cr.
Shareholder’s Equity 1,00,000

Loan Payable 20,000

Event (8)
Accounts Payable 15,400
Event (6), (11), (14), (16) &
Adjustment (21)
Interest Payable 300
Adjustment (22)
Equipment 25,000
Event (8)
Accumulated Depreciation: 500
Equipment
Adjustment (20)
Cash 79,000
Event (1), (3), (4), (7), (8), (9),
(12), (15) & (16)
Inventory 28,500
Event (6), (11) & (14) &
Adjustment (17)
Accounts Receivables 3,500
Event (10), (13) & (16)
Supplies 750
Event (7) &
Adjustment (18)
Prepaid Rent 0
Event (3) &
Adjustment (19)
Security Deposit 5,000
Event (3)
Cash Sales 20,000
Event (9) & (12)
Credit Sales 5,000
Event (10) & (13)
Maintenance Expense 500
Event (4)
Inventory Consumed Expense 10,500
Adjustment (17)
Supplies Consumed Expense 1,250
Adjustment (18)
Rent Expense 5,000
Adjustment (19)
Depreciation Expense 500
Adjustment (20)
Power & Telephone Expense 1,400
Adjustment (21)
Interest Expense 300
Adjustment (22)

Total 1,61,200 1,61,200

Transforming Trial Balance Information into Financial Statements

Now we are ready to utilise the trial balance information for developing the financial
statements. Can you guess which of the accounts below will go into balance sheet and
52
which ones will go into the income statement? (Hint: The trial balance below shows some
figures in bold and some in Italics for ease of identification).

Sunil Computer Mart

Adjusted trial balance at the end of the month
Dr. Cr.
Shareholder’s Equity 1,00,000

Loan Payable 20,000

Accounts Payable 15,400

Interest Payable 300

Equipment 25,000

Accumulated Depreciation: 500

Equipment

Cash 79,000

Inventory 28,500

Accounts Receivables 3,500

Supplies 750

Security Deposit 5,000

Cash Sales 20,000

Credit Sales 5,000

Maintenance Expense 500

Inventory Consumed Expense 10,500

Supplies Consumed Expense 1,250

Rent Expense 5,000

Depreciation Expense 500

Power & Telephone Expense 1,400

Interest Expense 300

Total 1,61,200 1,61,200

As you would have guessed by now (I sincerely hope that you have) the accounts in bold
would go into the balance sheet and the accounts in italics would go into the income
statement. Let us first look at the income statement.

• The Income Statement

We already know that Profit = Sales – Expenses, now let us see which are the expense
items for Sunil Computer Mart.
53
Rs. 500 Spent on cleaning and fixing up the interior of the shop
10,500 Worth of inventory sold to the customers
1,250 Worth of supplies used
5,000 Worth of prepaid rent expired due to the end of the month
500 Depreciation charged on equipment
1,400 Commitment to pay for power and telephone already used
300 Interest liability for the amount used for the month
Rs. 19,450 Total Expenses

Since total revenues (or sales) during the month was to the tune of Rs 25,000, the profit
for the month can be calculated by subtracting the above-mentioned amount of the
expenses. It comes to Rs 5,550. The income statement that an accountant would draw up
is shown below:

Sunil Computer Mart

Income Statement for the month of January

Revenue Rs.
Cash Sales 20,000
Credit Sales 5,000
Total Revenue 25,000

Less: Expenses
Raw Material & Supplies 11,750
Maintenance Expense 500
Rent 5,000
Power & Telephone 1,400
Total Expenses 18,650
Gross Profit 6,350
Depreciation 500
Interest 300
Net Profit 5,550

Note that by taking the expenses, which are due but not yet paid, we are following the
conservatism principle. Also by taking sales on credit for which the payment has not
come in this month, we are following the accrual system of accounting.

The Profit & Loss a/c shown above has certain limitations. Remember that the
depreciation expenses are based on estimates of the useful lives of the firm’s equipment.
Also, the income statement includes only those events that
are evidenced by business transactions. Perhaps, during the month Sunil’s shop has
caught the attention of many potential customers. A good ‘customer base’ is certainly
beneficial to Sunil in the long run; however, it cannot be recorded, as it cannot be
measured objectively until the actual transactions take place.

Despite these limitations, income statement is of vital importance and indicates that the
firm has been profitable in the first month of operations. Alter-native titles for the income
statement include earnings statement, profit & loss statement, etc. In India the term profit
& loss account is used. As internationally income statement is the most popular term we
will continue to use this term throughout the text.

54
The Balance Sheet

As you already know the balance sheet lists the amounts of owner’s equity, liabilities and
assets at the end of the accounting period. The balances of the owner’s equity, asset and
liability accounts are taken directly from the adjusted trial balance figures given above.

Sunil Computer Mart

Balance Sheet as on 31st January
Owner’s Equity + Rs. Assets Rs.
Liabilities
Shareholder’s 1,00,000 Fixed Assets
Equity

Reserves & Surplus 5,550 Gross Block 25,000

Less Accumulated
Depreciation (500)

Net Block 24,500

Liabilities Current Assets

Accounts Payable 15,400 Cash 79,000

Interest Payable 300 Inventory 28,500

Accounts Receivables 3,500

Loan Payable 20,000
Supplies 750
Total Liabilities 35,700
Security Deposit 5,000

Total Owner’s Equity + 1,41,250 Total Assets 1,41,250

Liabilities

The balance sheet has a striking resemblance to the final financial position that we made
using the accounting equation. This had to be as the accounting equation represents the
balance sheet. There are two things that need explanation here: 1) Reserves & Surplus
and 2) Bifurcation of Assets into fixed and current. Reserves & Surplus represent the
earnings that accumulate in the owner’s account. One of the several entries in it comes
from the income statement. Can you tell me which figure from the income statement
comes here? Simply looking at the figures you can guess that it is the net profit figure
that gets added up in the Reserves & Surplus Account. As the opening balance was zero
and there were no other entries, it is the only figure that is shown here.

Assets are bifurcated into fixed and current. Current assets represent those assets that will
be quickly converted to cash or used up in operations. Current assets include cash,
marketable securities, accounts receivables, inventory, etc. Fixed assets are those assets,
which are not meant to be sold or converted into finished products themselves, but are
used for business operations.

The Cash Flow Statement

The cash flow statement classifies various cash flows into three broad categories –
operating, investing and financing – and relates these categories to the beginning and
final cash balances.
55
Cash flows from operating activities are primarily the cash effects of day-to-day revenue
and expense transactions that are included in the income statement. Cash flow from
investing activities are the cash effects of purchasing and selling long term assets such as
plant and equipment. Cash flows from financing activities are the cash effects of owners
having invested in the company, lenders having loaned money to the company, any
repayments made to the creditors, or any cash withdrawals from the company by the
owners.

The cash flow statement for Sunil Computer Mart is shown below:

Sunil Computer Mart

Cash Flow Statement for the month of January
Rs. Rs.
A. Cash Flows from Operating Activities:
Net Profit as per income statement 5,550
Add back: Depreciation 500
Add back: Interest 300
Operating Profit before working capital changes 6,350
Adjusted for:
Account Receivables (3,500)
Inventory & Supplies (29,250)
Accounts Payables 15,400
Cash generated from operations (11,000)
Net Cash from Operating Activities (11,000)

B. Cash Flows from Investing Activities:

Purchase of Equipment (25,000)
Prepaid Rent (Security) (5,000)
Net Cash Used in Investing Activities (30,000)

C. Cash Flows from Financing Activities:

Cash invested by Sunil Bakshi, Owner 1,00,000
Proceeds from Loans Payable 20,000
Net Cash from Financing Activities 1,20,000

Net increase in cash & Cash Equivalents (A + B + C) 79,000

Opening Balance of Cash & Cash Equivalents 0

Closing Balance of Cash & Cash Equivalents 79,000

Let us spent some time in understanding this cash flow statement. The first thing that you
need to note is that the figure in brackets means that the cash is decreased.

Cash flow from operating activities starts with net profit from operations, which is clearly
taken from the income statement. Depreciation and interest expenses are added back to
generate cash from operations figure. Interest would have been deducted later if it were
paid to reflect net cash from operations. Now as working capital increases and decreases
are a part of the operating activities the net changes in them are going to be reflected
56
here. As accounts receivables and inventory use cash and account payables generate cash
they are treated as such. Note that as the opening balances of these accounts would be
zero (simply because it is a new organisation), we can simply take the ending balances
from the balance sheet and put them here. Otherwise, we would have subtracted the
opening balances from these figures to reflect the change. This results in a negative cash
flow from operations, which is expected as the business has just started.

The firm made only two investments, it bought equipment and it deposited security for
the shop, both of which are reflected in cash flows from investing activities.

Cash flow from financing activities show any new generations of funds by the firm to
finance its operations. Here the owner’s equity that has come in is shown as also the loan
that is repayable after three months.

Then the effect of all three heads of activities are clubbed together to generate the net
cash increase, which works out to Rs 79,000. As the starting balance of cash was zero,
this should be the ending balance. Which it is as seen in the balance sheet.

Relationship among the Financial Statements

If you have been following the preparation of the financial statements well, the
interaction between the three financial statements would be clear to you by now.

Let us summarise the relationships between the income statement and the balance sheet.
First, the cost of the depreciable asset is charged as depreciation expense as the useful life
of the asset expires. Second, as the inventory & supplies are used up they become an
expense in the income statement. Third, a part of the net profit from the income statement
ends up in the reserves & surplus section of the owner’s equity.

Let us now summarise the relationships between the income statement, balance sheet and
the cash flow statement. First, in the cash from operating activities, the profits,
depreciation and interest expenses come from income statement. Second, Working capital
changes, investing activities & financing activities changes come from the comparison of
the balance sheets of the starting and ending periods.

In other words, all the three statements are related to each other.

In the three chapters 5, 6 & 7 we will see how the three statements are reported and learn
the detailed terminology associated with them.

57
III- Analysis and Interpretation of Financial Statements

Learning Outcomes
• Financial analysis and how it is used to identify any weaknesses or strengths that
a firm might have.
• Financial ratios and how they are used to answer questions regarding a firms
financial well being.
• The basic financial statements (the balance sheet, the Profit & Loss A/c and the
statement of cash flows) and the role these statements play in financial analysis.
• The limitations with using financial ratios for financial analysis.
• How ratios are compared with other standards to recognise trends and deviations.

By now you would be thinking that financials statements are easy to understand and
interpret. Don’t be so sure. There are so many loopholes in the information available in
the financial statements that analysing financial statements has grown into a discipline of
its own. Before we go on and equip you with some of the tools necessary for analysing
the financial statements of the companies, let us expose you to some of the choices that
the company has in reporting its earnings.

Effect of Accounting Alternatives on Financial Statements

The financial statements for any company tell a great deal about the company. We have
information about the firm's resources, obligations, net worth (shareholders' equity),
profitability, and cash flows. Yet financial statements are extremely limited in their
ability to convey information.

Let us take up a hypothetical company, Simran Company Ltd., the three key financial
statements of which are given below in the figures 8.1 to 8.3.

FIGURE 8.1
Simran Company Ltd.
Balance Sheet as of June 30, 2001 and June 30, 2002
2002 2001
LIABILITIES AND SHAREHOLDERS’
EQUITY
Shareholders’ Equity
Equity shares, Rs 10 Par, 100 shares 1,000 1,000
Reserves & Surplus 57,000 43,000
Share Premium Reserves 24,000 24,000
Retained Earnings 33,000 19,000
Preference Shares, 10%, Rs 10 Par, 1,000 10,000 10,000
shares
Total Shareholders’ Equity 68,000 54,000

Long-Term Liabilities

58
 Long-Term Loans 45,000 50,000
Bonds 100,000 100,000
Deferred Taxes 39,000 35,000
Total Long-Term Liabilities 184,000 185,000

Current Liabilities
Wages Payable 3,000 2,000
Accounts Payable 29,000 25,000
Taxes Payable 15,000 12,000
Total Current Liabilities 47,000 39,000

TOTAL LIABILITIES & 299,000 278,000

SHAREHOLDERS’ EQUITY

ASSETS
Fixed Assets
Buildings and Equipment 150,000 120,000
Less Accumulated Depreciation 40,000 30,000
Net Buildings and Equipment 110,000 90,000
Land 50,000 50,000
Total Fixed Assets 160,000 140,000

Goodwill 45,000 50,000

Current Assets
Cash 8,000 7,000
Marketable Securities 12,000 9,000
Accounts Receivable, Net of Uncollectible 22,000 30,000
Accounts
Inventory 49,000 40,000
Prepaid Expenses 3,000 2,000
Total Current Assets 94,000 88,000

TOTAL ASSETS 299,000 278,000

FIGURE 8.2
Simran Company Ltd.
Profit & Loss A/c
For the Years Ending June 30, 2001 and June 30, 2002
2002 2001

Sales 297,000 246,000

Less Cost of Goods Sold 162,000 143,000
Gross Profit 135,000 103,000

Operating Expenses
Selling Expenses 30,000 25,000
General Expenses 12,000 10,000
Administrative Expenses 49,000 40,000
59
 Total Operating Expenses 91,000 75,000
Operating profit 44,000 28,000
Interest Expense 12,000 10,000

Income Before Taxes 32,000 18,000

Income Tax 13,000 7,000
Net profit 19,000 11,000

Less Dividends 5,000 3,000

Addition to Retained Earnings 14,000 8,000

Retained Earnings July 1, 2002 and 2001 19,000 11,000
Retained Earnings June 30, 2002 and 2001 33,000 19,000

Earning Per Share 18.00 10.00

FIGURE 8.3
Simran Company Ltd.
Cash Flow Statement
For the Years Ending June 30, 2002 and June 30, 2001
2002 2001

1. Cash Flows from Operating Activities

Net profit 19,000 11,000
Add Expenses Not Requiring Cash:
Depreciation 10,000 8,000
Amortisation of Goodwill 5,000 5,000
Increase in Taxes Payable and Deferred Taxes 7,000 3,000
Other Adjustments:
Add Reduction in Accounts Receivable 8,000 1,000
Add Increase in Wages Payable 1,000 0
Add Increase in Accounts Payable 4,000 0
Subtract Decrease in Accounts Payable 0 (3,000)
Subtract Increase in Inventory (9,000) (2,000)
Subtract Increase in Prepaid Expenses (1,000) 0
Net Cash from Operating Activities 44,000 23,000

2. Cash Flows from Investing Activities

Increase in Marketable Securities (3,000)
Sale of Fixed Assets 0 2,000
Purchase of New Equipment (30,000) (20,000)
Net Cash Used for Investing Activities (33,000) (18,000)

3. Cash Flows from Financing Activities

Payment of Mortgage Principal (5,000) (5,000)
Payment of Dividends (5,000) (3,000)
Net Cash from Financing Activities (10,000) (8,000)

NET INCREASE/(DECREASE) IN CASH 1,000 (3,000)

CASH BALANCE, BEGINNING OF YEAR 7,000 10,000
CASH BALANCE, END OF YEAR 8,000 7,000
60
Let us first turn our attention to inventories which, like marketable securities, are stated
using least cost methods because of the GAAP of conservatism. But how does SCL
measure the cost of their inventory? Notes to financial statements would tell us that SCL
is using the LIFO method to determine inventory cost.

LIFO/FIFO is a choice the firm is allowed under GAAP. Our inventory equation was
stated in terms of units. In rupees it is

Starting Inventory + Purchases - Cost of Goods Sold = Closing Inventory

At the end of 2001, the SCL inventory was Rs 40,000 (from Figure 8.1). Therefore, that
must be the value of the beginning inventory for 2002. The inventory at the end of 2002
was Rs 49,000 (from Figure 8.1). The cost of goods sold was Rs 162,000 for 2002 (from
Figure 8.2). In order for the inventory equation to balance, purchases must have been Rs
171,000. The equation would appear as follows:

Starting Inventory + Purchases - Cost of Goods Sold = Closing Inventory

Rs 40,000 + Rs 171,000 - Rs 162,000 = Rs 49,000

But what if SCL had decided to use FIFO to calculate inventory cost? If SCL had been on
a FIFO system, suppose that their beginning inventory for 2002 would have been Rs
45,000 and their ending inventory for 2002 would have been Rs 58,000. The balance
sheets would look different for the firm on FIFO because of the differences in beginning
and ending inventories as compared to those balances under LIFO. What would happen
to the Profit & Loss A/c? We need to know the effect of these differences on the cost of
goods sold to answer that question.

We can use the inventory equation to calculate the cost of goods sold under a FIFO
approach. The amount of purchases for 2002 would be the same Rs 171,000 under FIFO
as it was under LIFO. The LIFO/ FIFO choice focuses on which units were sold, not on
how much was spent on purchases. Using the inventory equation, we know that
beginning inventory of Rs 45,000 plus purchases of Rs 171,000 less cost of goods sold
equals the ending inventory of Rs 58,000. Then, the cost of goods sold must be equal to
Rs 158,000.

What would happen if SCL had chosen to use the weighted-average method to calculate
inventory cost? Suppose that using weighted average, the beginning inventory would
have been Rs 42,000 and the ending inventory would have been Rs 53,000. Using the
same approach we find that the cost of goods sold was Rs 160,000. Recall that under the
LIFO method that SCL actually chose, the cost of goods sold was Rs 162,000 (Figure
8.2).

Figure 8.4 presents the SCL Profit & Loss A/c for 2002 under the three alternative
inventory methods. Clearly, we can see that we must know the inventory method being
used to understand net profit. Here the net profit reported differs by as much as Rs 2,000
depending on which system was used (assuming a marginal income tax rate of 50%). If
we were evaluating identical LIFO and FIFO firms, the FIFO firm would look better if
we didn't know that the two firms were using different inventory methods.

FIGURE 8.4
61
Comparative Profit & Loss A/c’s Based on Alternative Inventory Methods of Simran
Company Ltd.
Profit & Loss A/c
For the Year Ending June 30, 2002
(A) (B) (C)
Inventory Method LIFO Weighted FIFO
Average

Sales 297,00 297,000 297,00

0 0
Less Cost of Goods 162,00 160,000 158,00
Sold 0 0

Gross Profit 135,00 137,000 139,00

0 0
Operating Expenses 91,000 91,000 91,000
Operating profit 44,000 46,000 48,000
Interest Expense 12,000 12,000 12,000

Income Before Taxes 32,000 34,000 36,000

Income Taxes 13,000 14,000 15,000
NET PROFIT 19,000 20,000 21,000

Let us now turn our attention to depreciation. For tax purposes, law largely mandates our
depreciation choices. For financial reporting, however, we have a fair degree of latitude.
We could use a double declining balance or units-of-production approach as an
alternative to straight-line depreciation. For SCL in 2002, operating costs included Rs
10,000 of depreciation calculated on a straight-line (ST.L.) basis. Suppose that the
double-declining balance (DDB) depreciation would have been Rs 18,000, and that the
units-of-production (UOP) depreciation would have been Rs 14,000. What would be the
impact on the Profit & Loss A/c had we used one of these alternative depreciation
methods? Figure 8.5 shows net profit for SCL for 2002 under the various alternative
inventory and depreciation choices. A 50% marginal tax rate is again assumed.

FIGURE 8.5
Comparative Profit & Loss A/c’s Based on Alternative Inventory and Depreciation
Methods of Simran Company Ltd.
For the Year Ending June 30, 2002
A B C D E F G H I
LIFO WA FIFO LIFO WA FIFO LIFO WA FIFO
ST.L ST.L ST.L UOP UOP UOP DDB DDB DDB

Sales 297 297 297 297 297 297 297 297 297
Less Cost of Goods Sold 162 160 158 162 160 158 162 160 158

Gross Profit 135 137 139 135 137 139 135 137 139
Operating Expenses 91 91 91 95 95 95 99 99 99
Operating profit 44 46 48 40 42 44 36 38 40
Interest Exp. 12 12 12 12 12 12 12 12 12
Income Before Taxes 32 34 36 28 30 32 24 26 28
Income Taxes 13 14 15 11 12 13 9 10 11
NET PROFIT 19 20 21 17 18 19 15 16 17
KEY: LIFO—Last-in, first-out
62
 WA—Weighted average
FIFO—First-in, first-out
ST.L—Straight-line
UOP—Units-of-production
DDB—Double-declining balance

There are nine possible net profits. Each of the three inventory methods can be matched
with each of the three depreciation methods. If we didn't explain our choice of inventory
and depreciation methods, there would be no way for the reader to determine if the firm's
reported net profit was based on relatively liberal or conservative approaches. In this
case, we could have two firms with virtually identical operations and each report a
different net profit-net profits as diverse as Rs 15,000 for a LIFO/DDB firm and Rs
21,000 for a FIFO/ST.L firm-a difference of 40 percent! A whole range of reportable
incomes between these extremes is also possible as you can see from Figure 8.5.

Remember we have just taken alternatives available to the company in just two areas.
This is enough to give you jitters. Now you know that the firm's reported net profit can be
greatly affected by the choice of accounting methods. Highly disciplined study is
required before you can actually be sure that you are not sure about any figure in any of
the financial statements.

Making Sense of Financial Statements

Let us now turn our attention to basic techniques of financial analysis. For your
convenience the three financial statements of COSCO (India) Ltd are reproduced below
as figures 8.6 to 8.8 to facilitate easy analysis. These are the figures that we would be
using for the analysis purposes of this chapter.

Figure 8.6
COSCO (India) Ltd
Balance Sheet as on March 31, 1999

(Rs) AS AT AS AT
SCH. 31ST 31ST MARCH,
MARCH, 1998
1999
I. SOURCES OF FUNDS
Share Capital A 41,610,000 41,610,000
Reserves & Surplus B 112,429,057 104,507,333
Loans:
Secured C 27,620,272 24,866,303
Unsecured D 36,142,507 63,762,779 46,572,086 71,438,389
217,801,836 217,555,722
II APPLICATION OF
. FUNDS
Fixed Assets: E
Gross Block 112,820,50 88,589,202
6
Less: Depreciation 49,768,462 39,166,629
63
 Net Block 63,052,044 49,422,573
Capital Work in 11,839,497 74,891,541 7,059,071 56,481,644
Progress
Investments F 460,356 456,784
Current Assets,
Loans & Advances:
Inventories G 115,524,83 103,267,290
7
Sundry Debtors H 33,613,920 33,137,628
Cash & Bank Balance I 4,929,270 7,920,283
Loans & Advances J 16,160,487 37,619,914
170,228,51 181,945,115
4
LESS:
Current Liabilities & Provisions:
Liabilities K 25,537,434 19,045,527
Provisions L 6,588,911 6,681,739
32,126,345 25,727,266
Net Current Assets 138,102,169 156,217,849
Miscellaneous M 4,347,770 4,399,445
Expenditure
(to the extent not written off or
adjusted)
217,801,836 217,555,722

Figure 8.7
COSCO (India) Ltd
Profit & Loss A/c for the year ending March 31, 1999

FOR THE YEAR FOR YEAR

SCHEDUL ENDED 31.03.99 ENDED 31.03.98
ES
I. INCOME
Sales 281,611,692 263,890,087
Other Income N 12,473,846 15,244,151
294,085,538 279,134,238
II. EXPENDITURE:
Purchase of Finished Goods 30,537,640 24,467,439
Materials O 107,660,077 107,310,877
Salary, Wages & Benefits P 40,406,877 33,676,728
Manufacturing,
Administration
and Selling Q 83,267,856 77,105,148
Interest & Bank Charges R 12,296,996 10,536,494
Depreciation 10,988,050 8,275,475
Misc. Expenditure w/off M 1,440,805 782,240
286,598,301 262,154,401
(Increase) in finished goods S -12,832,633 -14,426,991

64
 and work in progress
273,765,668 247,727,410
III. PROFIT BEFORE 20,319,870 31,406,828
TAXATION
IV. PROVISION FOR 5,500,000 8,300,000
TAXATION
14,819,870 23,106,828
V. DIVIDED TAX 624,150 832,200
VI. PROFIT AFTER 14,195,720 22,274,628
TAXATION
VII. PRIOR PERIOD ADJUSTMENTS ADD/(DEDUCT)
I) Taxation provision 21,554 -700,000
ii) Expenses -54,050 1,728,279
14,163,224 23,302,907

APPROPRIATIONS
TRANSFERRED TO:
A) PROPOSED DIVIDEND 6,241,500 8,322,000
B) GENERAL RESERVE 7,921,724 11,480,907
C) BALANCE CARRIED TO BALANCE SHEET 3,500,000
14,163,224 23,302,907

Figure 8.8
COSCO (India) Ltd
Cash Flow Statement for the year ending March 31, 1999
31st March 31st March
1999 1998
Rs. Rs.
A. Cash Flow From Operating Activities
Net Profit before tax and extra ordinary items 26,426,181 31,396,811
Adjustments for:
Depreciation 10,988,050 8,275,475
Miscellaneous Expenses written off 1,440,805 782,240
Operating Profit Before Working Capital 38,855,036 40,454,526
Changes
Adjustments for:
(Increase)/Decrease in Trade and Other Receivables -476,292 -9,135,891
(Increase)/Decrease in Inventories -12,257,547 -26,142,437
(Increase)/Decrease in Loans and Advances -2,453,495 15,657,043
(Decrease)/Increase in Trade Payables 2,139,019 3,361,817
(Decrease)/Increase in Other Current Liabilities 9,059,030 -13,771,335
Cash Generated From Operations 34,865,751 10,423,723
Interest Paid 10,079,056 9,248,356
Direct Taxes Paid 5,500,000 8,300,000
Cash Flow Before Extra Ordinary Items 19,286,695 -7,124,633
Extra Ordinary Items 1,443,181 708,279
Net Cash From Operating Activities 17,843,514 -6,416,354

65
B. CASH FLOW FROM INVESTING
ACTIVITIES
Purchase of Fixed Assets -29,991,043 -30,913,976
Sale of Fixed Assets 618,025 333,442
Purchase of Investments -3,572 -298,947
Sale of Investments - 2,013,000
Interest Received 3,341,248 7,315,899
Dividend Received 3,972 1,755
Net Cash Flow from/Used in Investing Activities -26,031,370 -21,548,827

C. CASH FLOW FROM FINANCING

ACTIVITIES
Proceeds from Long-term Borrowings/Loans 44,511,929 64,014,670
Repayment of Long-term Borrowings/Loans -33,120,732 -20,417,643
Dividends Payments -6,241,500 -8,322,000
Net Cash Flow from Financing Activities 5,149,697 35,275,027

Net Increase/(Decrease) in Cash and Cash -3,038,159 7,309,846

Equivalents
Opening Balance of Cash and Cash Equivalents 12,242,541 4,932,695
Closing Balance of Cash and Cash Equivalents 9,204,382 12,242,541

We can know what were the changes from year to year in absolute terms by just looking
at the figures for two years as they are placed side by side. This is the reason that these
statements are called comparative financial statements. Of course it would be easier if we
calculated the percentage changes from year to year to get a better picture. The financial
statements of COSCO (India) Ltd with percentage changes calculated are shown below in
the figures 8.9 to 8.11.

Figure 8.9
COSCO (India) Ltd
Trend Percentages on Balance Sheet as on March 31, 1999

(Rs) AS AT %age AS AT
31ST change 31ST
MARCH, from last MARCH,
1999 year 1998
SOURCES OF FUNDS
Share Capital 41,610,000 0.00% 41,610,000
Reserves & Surplus 112,429,05 7.58% 104,507,33
7 3
Loans:
Secured 27,620,272 11.08% 24,866,303
Unsecured 36,142,507 63,762,779 -10.74% 46,572,086 71,438,389
217,801,83 0.11% 217,555,72
6 2
APPLICATION OF
FUNDS
66
Fixed Assets:
Gross Block 112,820,50 27.35% 88,589,202
6
Less: Depreciation 49,768,462 27.07% 39,166,629
Net Block 63,052,044 27.58% 49,422,573
Capital Work in Progress 11,839,497 74,891,541 32.59% 7,059,071 56,481,644
Investments 460,356 0.78% 456,784
Current Assets,
Loans & Advances:
Inventories 115,524,83 11.87% 103,267,290
7
Sundry Debtors 33,613,920 1.44% 33,137,628
Cash & Bank Balance 4,929,270 -37.76% 7,920,283
Loans & Advances 16,160,487 -57.04% 37,619,914
170,228,51 -6.44% 181,945,11
4 5
LESS:
Current Liabilities & Provisions:
Liabilities 25,537,434 34.09% 19,045,527
Provisions 6,588,911 -1.39% 6,681,739
32,126,345 24.87% 25,727,266
Net Current Assets 138,102,16 -11.60% 156,217,84
9 9
Miscellaneous Expenditure 4,347,770 -1.17% 4,399,445
(to the extent not written off or adjusted)
217,801,83 0.11% 217,555,72
6 2

Figure 8.10
COSCO (India) Ltd
Trend Percentages on Profit & Loss A/c for the year ending March 31, 1999

FOR THE %age FOR YEAR

YEAR change
ENDED from last ENDED
31.03.99 year 31.03.98
INCOME
Sales 281,611,692 6.72% 263,890,087
Other Income 12,473,846 -18.17% 15,244,151
294,085,538 5.36% 279,134,238
EXPENDITURE:
Purchase of Finished Goods 30,537,640 24.81% 24,467,439
Materials 107,660,077 0.33% 107,310,877
Salary, Wages & Benefits 40,406,877 19.98% 33,676,728
Manufacturing, Administration
and Selling 83,267,856 7.99% 77,105,148
Interest & Bank Charges 12,296,996 16.71% 10,536,494
Depreciation 10,988,050 32.78% 8,275,475
Misc. Expenditure w/off 1,440,805 84.19% 782,240

67
 286,598,301 9.32% 262,154,401
(Increase) in finished goods -12,832,633 -11.05% -14,426,991
and work in progress
273,765,668 10.51% 247,727,410
PROFIT BEFORE TAXATION 20,319,870 -35.30% 31,406,828
PROVISION FOR TAXATION 5,500,000 -33.73% 8,300,000
14,819,870 -35.86% 23,106,828
DIVIDED TAX 624,150 -25.00% 832,200
PROFIT AFTER TAXATION 14,195,720 -36.27% 22,274,628
PRIOR PERIOD ADJUSTMENTS ADD/
(DEDUCT)
I) Taxation provision 21,554 -103.08% -700,000
ii) Expenses -54,050 -103.13% 1,728,279
14,163,224 -39.22% 23,302,907

APPROPRIATIONS
TRANSFERRED TO:
A) PROPOSED DIVIDEND 6,241,500 -25.00% 8,322,000
B) GENERAL RESERVE 7,921,724 -31.00% 11,480,907
C) BALANCE CARRIED TO BALANCE -100.00% 3,500,000
SHEET
14,163,224 -39.22% 23,302,907

Figure 8.11
COSCO (India) Ltd
Cash Flow Statement for the year ending March 31, 1999
Rs. 31st March %age 31st March
1999 change 1998
A. Cash Flow From Operating Activities
Net Profit before tax and extra ordinary items 26,426,181 -15.83% 31,396,811
Adjustments for:
Depreciation 10,988,050 32.78% 8,275,475
Miscellaneous Expenses written off 1,440,805 84.19% 782,240
Operating Profit Before Working Capital 38,855,036 -3.95% 40,454,526
Changes
Adjustments for:
(Increase)/Decrease in Trade and Other -476,292 -94.79% -9,135,891
Receivables
(Increase)/Decrease in Inventories -12,257,547 -53.11% -26,142,437
(Increase)/Decrease in Loans and Advances -2,453,495 -115.67% 15,657,043
(Decrease)/Increase in Trade Payables 2,139,019 -36.37% 3,361,817
(Decrease)/Increase in Other Current Liabilities 9,059,030 -165.78% -13,771,335
Cash Generated From Operations 34,865,751 234.48% 10,423,723
Interest Paid 10,079,056 8.98% 9,248,356
Direct Taxes Paid 5,500,000 -33.73% 8,300,000
Cash Flow Before Extra Ordinary Items 19,286,695 -370.70% -7,124,633
Extra Ordinary Items 1,443,181 103.76% 708,279
Net Cash From Operating Activities 17,843,514 -378.09% -6,416,354
68
B. CASH FLOW FROM INVESTING
ACTIVITIES
Purchase of Fixed Assets -29,991,043 -2.99% -30,913,976
Sale of Fixed Assets 618,025 85.35% 333,442
Purchase of Investments -3,572 -98.81% -298,947
Sale of Investments - 2,013,000
Interest Received 3,341,248 -54.33% 7,315,899
Dividend Received 3,972 126.32% 1,755
Net Cash Flow from/Used in Investing Activities -26,031,370 20.80% -21,548,827

C. CASH FLOW FROM FINANCING

ACTIVITIES
Proceeds from Long-term Borrowings/Loans 44,511,929 -30.47% 64,014,670
Repayment of Long-term Borrowings/Loans -33,120,732 62.22% -20,417,643
Dividends Payments -6,241,500 -25.00% -8,322,000
Net Cash Flow from Financing Activities 5,149,697 -85.40% 35,275,027

Net Increase/(Decrease) in Cash and Cash -3,038,159 -141.56% 7,309,846

Equivalents
Opening Balance of Cash and Cash Equivalents 12,242,541 148.19% 4,932,695
Closing Balance of Cash and Cash Equivalents 9,204,382 -24.82% 12,242,541

As you can see, understanding the changes in financial statements from year-to-year is
easier when you have percentage changes available. Let us spend some time in
understanding these changes.

In the balance sheet total loans have come down by 10.74 per cent while the total assets
have stayed at more or less the same levels. This is a good sign as the company is
replacing loans with the shareholder's money. This should have an effect on the interest
liabilities, which should come down. If we look at the interest liabilities in figure 8.10 we
see that they have in fact increased by 16.71 per cent, instead of coming down. What
happened? Can you find out? (Hint: look at schedule R in the complete annual report of
COSCO (India) Ltd. at the end of this book).

Moving on to the application of funds in figure 8.9 we find that fixed assets have gone up
by a whopping 32.59 per cent (including capital work-in-progress). This means that the
company is expanding its asset base and the effect of this increase in assets may be
visible in the next year's sales and profitability figures.
The current assets are down by 6.44 per cent while the current liabilities have jumped up
by 24.87 per cent signifying that company is improving its management of working
capital. The working capital has gone down by 11.60 per cent.

Moving on to the profit & loss a/c in figure 8.10 we find that the company's sales has
gone up by 6.72 per cent while the other income has gone down by 18.17 per cent. This
means that total income has gone up by a marginal 5.36 per cent. At the same time the
total expenditure has gone up by 10.51 per cent resulting in a sharp drop in profit before
taxation by 35.30 per cent. This drop necessatitated the reduction in dividends by 25 per

69
cent from its last year's levels and addition to reserves have also gone down by 31 per
cent over its last year's levels.

The cash flow statement shows some interesting changes. Operating profit before
working capital changes have more or less stagnated. Increase in inventories and loans &
advances have been more than offset by increase in current liabilities to increase the cash
generated from operations. Because of this the net cash from operating activities has
turned positive (i.e. the company has generated cash) from negative of last year. This is a
good sign.

Investing activities show that the fixed assets have been purchased last year also and this
year also. This needs to be investigated as to whether the company is expanding
operations or is spending the money in acquiring unproductive assets.
Because the cash was generated from operations, COSCO does not require to generate
the additional capital from financing from external sources. Hence the amount raised
from the loans is lower by 30 per cent and the repayments are higher by 62 per cent.

Summation of results from all three activities results in the reduction of cash and cash
equivalents, again showing that the company is trying to tighten its belt.

This technique of analysing year-to-year changes by calculating the percentage changes

over the chosen period is known as horizontal analysis. It is very useful when we select a
base year and want to know how we have performed over the years on the basis of that
base year. This trend analysis is important for predicting the future performance of the
company.

Still it would be very difficult (if not impossible) to use these figures when we are
comparing two companies, except when we are comparing the sizes of the companies.
For example, when we are comparing which company is bigger in terms of sales, the
absolute figures help us, but when we want to know which company spends more on the
raw material, these figures are insufficient because we want to know the raw material
usage as a percentage of sales and not as an absolute figure. This is where common-size
financial statements come in.

Common-Size Financial Statements

The common-size financial statements for COSCO (India) Ltd are shown in the figures
8.12 and 8.13. Note that the common size cash flow statement is not shown, the reasons
for which are explained a little later when we discuss how to analyse the cash flow
statement

Figure 8.12
COSCO (India) Ltd
Common-Size Balance Sheet as on March 31, 1999

(Rs) AS AT AS AT
31ST 31ST
MARCH, MARCH,
1999 1998
SOURCES OF FUNDS

70
Share Capital 19.10% 19.13%
Reserves & Surplus 51.62% 48.04%
Loans:
Secured 12.68% 11.43%
Unsecured 16.59% 29.28% 21.41% 32.84%
100.00% 100.00%
APPLICATION OF FUNDS
Fixed Assets:
Gross Block 51.80% 40.72%
Less: Depreciation 22.85% 18.00%
Net Block 28.95% 22.72%
Capital Work in Progress 5.44% 34.39% 3.24% 25.96%
Investments 0.21% 0.21%
Current Assets,
Loans & Advances:
Inventories 53.04% 47.47%
Sundry Debtors 15.43% 15.23%
Cash & Bank Balance 2.26% 3.64%
Loans & Advances 7.42% 17.29%
78.16% 83.63%
LESS:
Current Liabilities & Provisions:
Liabilities 11.73% 8.75%
Provisions 3.03% 3.07%
14.75% 11.83%
Net Current Assets 63.41% 71.81%
Miscellaneous Expenditure 2.00% 2.02%
(to the extent not written off or
adjusted)
100.00% 100.00%

Figure 8.13
COSCO (India) Ltd
Common-Size Profit & Loss A/c for the year ending March 31, 1999

FOR THE FOR YEAR

YEAR
ENDED ENDED
31.03.99 31.03.98
I. INCOME
Sales 95.76% 94.54%
Other Income 4.24% 5.46%
100.00% 100.00%
II. EXPENDITURE:
Purchase of Finished Goods 10.38% 8.77%
Materials 36.61% 38.44%
Salary, Wages & Benefits 13.74% 12.06%
Manufacturing, Administration
71
 and Selling 28.31% 27.62%
Interest & Bank Charges 4.18% 3.77%
Depreciation 3.74% 2.96%
Misc. Expenditure w/off 0.49% 0.28%
97.45% 93.92%
(Increase) in finished goods -4.36% -5.17%
and work in progress
93.09% 88.75%
III. PROFIT BEFORE TAXATION 6.91% 11.25%
IV. PROVISION FOR TAXATION 1.87% 2.97%
5.04% 8.28%
V. DIVIDED TAX 0.21% 0.30%
VI. PROFIT AFTER TAXATION 4.83% 7.98%
VII. PRIOR PERIOD ADJUSTMENTS ADD/
(DEDUCT)
I) Taxation provision 0.01% -0.25%
ii) Expenses -0.02% 0.62%
4.82% 8.35%

APPROPRIATIONS
TRANSFERRED TO:
A) PROPOSED DIVIDEND 2.12% 2.98%
B) GENERAL RESERVE 2.69% 4.11%
C) BALANCE CARRIED TO BALANCE 1.25%
SHEET
4.82% 8.35%

This technique of taking the highest figure as the base figure and converting every other
figure in that statement to a percentage of the same is known as vertical analysis. This
helps us in finding out what has been the relative change as a percentage of the base
figure so that we can look at any performance lacunas and understand the reasons for the
same as also compare with other companies.

Using Information from the Statement of Cash Flows

Analysis using cash flow information is often restricted to an analysis of the relationships
among the categories in the statement of cash flows. We do not perform vertical or
horizontal analysis because, unlike the balance sheet and Profit & Loss A/c, there is no
guarantee that a specific number from the statement of cash flows will consistently serve
as the denominator for scaling purposes. For example, all balance sheet accounts are
compared to total assets when preparing a vertical analysis of the balance sheet. Why?
Because total asset is always going to be the biggest number on the balance sheet. The
same is true for the Profit & Loss A/c. Total Income is used because it is, in almost every
case, the biggest number on the Profit & Loss A/c. In the case of the statement of cash
flows, some years the cash flow from operations may be the largest number on the
statement. In subsequent years, that number may be negative. Thus, horizontal and
vertical analyses are rarely performed using the statement of cash flows because of
scaling problems.

Although the statement of cash flows, like the other financial statements, reports
information about the past, careful analysis of this information can help investors,
72
creditors, and other assess the amounts, timing, and uncertainty of future cash flows.
Specifically, the statement helps users answer questions such as how a company is able to
pay dividends when it had a net loss, or why a company is short of cash despite increased
earnings. A statement of cash flows may show, for example, that external borrowing or
the issuance of equity shares provided the cash from which dividends were paid even
though a net loss was reported for that year. Similarly, a company may be short on cash,
even with increased earnings, because of increased inventory purchases, plant expansion,
or debt retirement.

Trends are often more important than absolute numbers for any one period. Accordingly,
cash flow statements usually are presented on a comparative basis. This enables users to
analyse a company’s cash flows over a period of time.

Ratio Analysis

Financial ratios provide the analyst with a means for making meaningful comparison of a
firm's financial data over time and with other firms. Thus, financial ratios represent an
attempt to standardise financial information in order to facilitate meaningful
comparisons. Financial ratios help us identify some of the financial strengths and
weaknesses of a company and help us compare the firm's performance to similar firms in
the same industry.

We can use ratios to answer some important questions about a firm's operations.

Question 1: How liquid is the firm?

Question 2: Is management generating adequate operating profits on the firm's
assets?
Question 3: How is the firm financing its assets?
Question 4: Are the owners (shareholders) receiving an adequate return on their
investment?

All these questions and more can be answered by using ratio analysis, which makes it one
of the most powerful tools in your hand.

Financial ratios can be divided into five basic categories. These categories consist of
liquidity ratios, efficiency ratios, leverage ratios, profitability ratios and market value
ratios.

1. Liquidity Ratios
Liquidity ratios are used to measure the ability of a firm to meet its short-term financial
obligations.

Two ratios are widely used as indicators of the company's ability to pay its short term
obligations: a) Current Ratio and b) Acid-Test Ratio.

Current Ratio
Current ratio is the most used short-term liquidity measure of the company. The current
ratio is defined as:

73
 Current Assets
Current Ratio =
Current Liabilitie s

Typical Analysis: Higher the current ratio, higher the liquidity for the firm. Traditional
norm 2:1, varies according to the industry.

Is the norm of 2:1 (or in short just 2) right? At what figure should the current ratio stand?
There is no answer to this, but it should be consistent within the same company, and it
may be measured against an industry average since there should be a norm for any
particular type of business.

COSCO (India) Ltd. 1998-99 1997-98

Current ratio 5.30 7.07

The current ratio for Cosco came down in the last one year, but it is still way above the
traditional norm of 2. Why is this so? The answer lies partly in the fact that the
inventories are at quite high levels (remember the balance sheet analysis). Why are the
inventories at such high levels is a question that can be answered only by understanding
the nature of the business and discussions with the company officials. The reasons for the
same could be anything from 'Company Policy' to 'Dead Inventory' that the company
cannot sell.

Is the current ratio then a good indicator of liquidity? Taking one year as the 'current'
period, the current ratio is an adequate reflection of liquidity as demonstrated at that point
in time, unless, for example:

• The operating cycle is so long that part of the stock or work-in-progress will not
be converted into sales invoicing until after the end of the year (as might be the
case with a public works contractor)
• Because spasmodic customer demand is linked with a high level of service from
stock, it is necessary to hold some stocks which will not be turned over within the
year (e.g. A capital equipment spares supply business);
• The figure of debtors includes contract retention money or items under dispute
which will not be collected within the year.

If such features exist, then this should be known from the nature of the business, and one
would expect to see a higher current ratio than in businesses with fast-moving stocks and
restricted credit terms.

Acid-Test Ratio
The acid-test ratio (also known as quick ratio) is a measure of short-term liquidity of the
firm. It is calculated as
C u r r eAn st s e- It sn v e n tso r i e
A c iTd e sRt a t i=o
C u r r eLni ta b i ls i t i e
Typical Analysis: Higher the quick ratio, higher the liquidity for the firm. Traditional
norm 1:1, varies according to the industry.

Inventories are deleted from the current assets to get the acid test ratio because
inventories are generally the least liquid of a firm's current assets.

74
The liquidity (or 'quick') ratio is based on the assumption that stocks will not be
converted into cash quickly enough to meet the time scale for the payment of the
creditors, and the business must therefore look to its debtors and cash balance to cover
the current liabilities. The comments made about bank overdraft facilities apply equally
to this ratio, except that in practice the bank may well be prepared to look to the
realisation of stocks to cover its repayment, in this case the unused overdraft facility is a
quick asset but the total overdraft facility is not a quick creditor.

COSCO (India) Ltd. 1998-99 1997-98

Quick ratio 1.70 3.06

Although the quick ratio also went down in line with the current ratio for Cosco, it is still
quite satisfactory. Notice how much difference is there between the current ratio and the
quick ratio just because the inventory was omitted from the current assets.

Ratios give rise to questions, but they do not provide final answers. The only test of
liquidity is the detailed time matching of transactions, something that we will learn later
in cash forecasting.

2. Efficiency Ratios

Efficiency ratios provide the basis for assessing how effectively the firm is using its
resources to generate sales. Some of the common efficiency ratios are given below:

Receivables Turnover

Receivables Turnover ratio indicates in days how quickly receivables are collected from
the customers. It is calculated as:

Receivables Turnover = Annual Credit Sales / Sundry Debtors

Typical Analysis: Higher the turnover, higher the efficiency of the firm.

COSCO (India) Ltd. 1998-99 1997-98

Receivables Turnover 8.38 7.96

As the figures for credit sales is not available from the balance sheet, total sales is usually
used to calculate the figures. For Cosco, the receivables turnover improved in the last one
year. This means that the company is realising its money from its debtors sooner or it can
also mean that the company is generating more cash sales. There is no means of finding
out the real position from the information available from the annual report.

Average Collection Period

This ratio indicates how rapidly a firm's accounts are being collected from its customers.
The average collection period is defined as

75
 360
Average Collection Period =
Receivable s Turnover

Typical Analysis: Higher the turnover, higher the efficiency of the firm.

We use 360 instead of 365 days for two reasons: 1) easier calculations and 2) most
organisations have at least 5 holidays in a year.

COSCO (India) Ltd. 1998-99 1997-98

Average Collection Period 42.97 45.21

As the ratio is just inverse of receivables turnover, it also improved in line with it for
Cosco. The caveats that we applied in that ratio also hold true for this ratio too.

Inventory-Turnover Ratio
The inventory-turnover ratio reflects the number of times that inventories are turned over
(replaced) during the year. This ratio is defined as:

Inventory- Turnover = Cost of Goods Sold / Average Inventories

Typical Analysis: Higher the turnover, higher the efficiency of the firm.

COSCO (India) Ltd. 1998-99 1997-98

Inventory turnover rate 1.63 1.60
Days to sell the average inventory 220.50 224.69

As in the case of receivables turnover and average collection period, inventory turnover
rate and days to sell the average inventory are also closely linked.

The inventory turnover rate also increased for Cosco, but it is still at a low rate for a fast
moving consumer goods company. This is pointing to the fact that there could be a
problem with the inventory confirming our current ratio analysis.

Fixed-Assets Turnover Ratio

The fixed-asset turnover ratio is used to measure the efficiency with which the firm
utilises its investment in fixed assets. This ratio is calculated as:

Fixed Assets Turnover = Sales / Net Fixed Assets

Typical Analysis: Higher the turnover, higher the efficiency of the firm.

COSCO (India) Ltd. 1998-99 1997-98

Fixed Asset Turnover 4.47 5.34

For Cosco, the fixed asset turnover rate dropped during the year. This could be due to the
fact that the company added to its fixed assets during the year. Whether these assets are
going to add to the sales or not we will only know in the current year.
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Total Asset Turnover Ratio
The total asset turnover ratio indicates how many rupees in sales the firm generates for
each dollar it has invested in assets. This ratio is calculated as:

Total Assets Turnover = Sales / Total Assets

COSCO (India) Ltd. 1998-99 1997-98

Total Asset Turnover 1.29 1.21

Although the fixed assets turnover dropped, the total assets turnover ratio went up. This
means that company is managing its other assets (including current assets) quite well.

3. Leverage Ratios
Leverage ratios are used to measure the extent to which non-owner supplied funds have
been used to finance a firm's assets. Leverage ratios can be categorised as being either
balance sheet ratios or coverage ratios.

Balance sheet leverage ratios measure the proportion of the firm's assets financed with
non-owner funds.

Debt Ratio
The long-term debt to total capitalisation ratio measures the relative importance of long-
term debt in the firm's capitalisation. The debt ratio is equal to
Total Liabilities
Debt Ratio =
Total Assets

COSCO (India) Ltd. 1998-99 1997-98

Debt ratio 0.29 0.33

The ratio has gone down for Cosco, signifying the fact that the company has reduced its
debt financing in the overall financing mix. This could be either because the debt has
come down or increase in assets has been financed from equity.

Debt - Equity Ratio

The ratio of debt in relation to total equity indicates relative size of the debt as compared
to total equity of the firm. It is calculated as:

Total Liabilitie s
Debt − Equity Ratio =
Equity + Reserves

COSCO (India) Ltd. 1998-99 1997-98

Debt-Equity ratio 0.41 0.49
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The same trend as witnessed in the debt ratio would be witnessed here because of the fact
that debt and equity are the only two components that a company uses to finance its
activities.

This ratio is one of the most widely used ratios to look at the leverage position of the
company.

Coverage ratios are used to measure a firm's ability to cover the finance charges
associated with its use of financial leverage.

Times Interest Earned Ratio

The times interest earned ratio is one of the popular coverage ratio and tells us whether
the operating profit is sufficient to cover the interest liabilities for that year. It is
calculated as:

Operating Income PBDIT

Interest Coverage Ratio = =
Annual Interest Expense Annual Interest Expense

Here PBDIT stands for Profit before Depreciation, Interest and Tax.

COSCO (India) Ltd. 1998-99 1997-98

Interest coverage ratio 3.66 4.84

For Cosco the ratio dropped significantly in the last one year, as you would expect
because of falling profits. The interests are covered quite sufficiently right now. If the
profits do not fall further and debt does not go up, the coverage is sufficient.

Debt Service Coverage Ratio (DSCR)

DSCR measures the company's ability to meet its interest and debt repayment capacity
from its operating profits. The debt service coverage ratio is calculated as:

Operating Income
Debt Service Coverage Ratio =
Annual Interest Expense + annual debt repayment

COSCO (India) Ltd. 1998-99 1997-98

Debt Service Coverage ratio 0.99 1.65

An improvement over the times interest covered ratio, DSCR shows quite a different
picture. It shows that the operating profit does not cover the debt service repayments even
one time as compared to 1.65 times last year. This is a cause for concern.

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4. Profitability Ratios
Profitability ratios serve as overall measures of the effectiveness of the firm's
management. These ratios can be divided into those that measure profitability in relation
to sales and those that measure profitability in relation to investment.
Profitability in relation to sales ratios reflects the ability of the firm's management to
control the various expenses involved in generating sales.

Operating and Net Profit Margins

The operating profit margin serves as an overall measure of operating effectiveness of the
company and is calculated as:

Operating Income
Operating Profit Margin =
Sales

The net profit margin is calculated as

Net Profit
Net Profit Margin =
Sales

Net profit in this ratio is after taxes.

COSCO (India) Ltd. 1998-99 1997-98

Operating Profit Margin 14.83% 17.99%
Net Profit Margin 4.83% 7.98%

For Cosco, both the profit margins have gone down, but the fall in the net profit margin is
steeper because of the effect of the fixed costs (like depreciation and interest). To make
more sense of these figures we will have to calculate the trend in the margin for last
several years as also we will have to discuss with the management about the possible
causes as seen by them.

Profitability in relation to investment ratios measure the firm's profitability in relation to

invested funds used to generate those profits.

Return On Investment Ratio (ROI)

Return on investment tells us about the overall profitability of the company in relation to
the total investment in the company. It is calculated as:

Operating Income
Return on Investment =
Total Assets

This ratio represents the before-tax and interest expense return on invested capital and is
particularly useful since it reflects the total earnings produced by the total assets of the
firm. In fact, when we decompose this ratio into the product of the operating profit

79
margin and total asset turnover ratio it forms the basis for earning power analysis, that is,
this ratio also equals:

Operating Income Sales

ROI = x
Sales Total Assets

Using this form of the return on investment ratio the analyst can analyse, individually, the
determinants of firm profitability.

COSCO (India) Ltd. 1998-99 1997-98

Return on assets 0.20 0.23

In line with the fall in the operating profit margins of the company, the return on assets
ratio also shows a fall. Still it is at a respectable level of 20 per cent.

Earnings Per Share Ratio (EPS)

The earnings per share ratio indicates the returns per share issued by the company. It is
calculated as:

Net Pr ofit
Earnings Per Share =
No. of Shares

COSCO (India) Ltd. 1998-99 1997-98

Earnings per share 3.41 5.35

In line with the falling profitability the earnings per share also shows the same fall.

Return On Equity Ratio (ROE)

The return on equity ratio measures the net return on investment of the common
shareholders. It is calculated as

Net Pr ofit Available to Equity Shareholde rs

Return On Equity =
Equity + Reserves

COSCO (India) Ltd. 1998-99 1997-98

Return on equity 0.09 0.15

In line with the falling profitability the ROE also shows the same fall. Note that the fall
here is more steeper than the fall in the ROA.

5. Market-Value Ratios
The market value ratios help us relate the company's financials to the market price of the
company's securities. As only the equity shares of the company are listed in the market,
only ratios concerning the equity shares of the company are calculated and shown below.

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COSCO (India) Ltd. 1998-99 1997-98
Market value of one equity share 25.00 20.00
Book value per share 37.02 35.12
Price-earnings ratio 7.33 3.74
Dividend yield 3.75% 4.00%

The market price of one equity share of face value Rs 10 is Rs 25 (June 2000). This
means that the market is valuing the share at Rs 25 as on that date & time. The value
would change from time to time as buyers and sellers continuously bid for the shares.

However, the book value of the shares is Rs 37.02 per share. This means that the share is
trading for value that is below its book value. This could possibly indicate that the share
is undervalued or there is some problem with the company that is not visible from the
company's financials or the market perception of the share is not good. The book value is
calculated as:

Equity + Reserves
Book Value =
No. of Shares

The Price to Earnings Ratio (P/E Ratio) is calculated by dividing the market price by the
EPS.

Market Price per Share

P/E Ratio =
Earning per Share

This ratio tells us about how much the market discounts the earnings. Obviously, the
higher the ratio the better the company is perceived to be in the eyes of the stock market.
You can see that the P/E ratio has improved considerably for the company, could be due
to the fact that the market perceives the earnings of the next year to be better than what it
was last year. We have calculated P/E ratio here in a retrospective manner, i.e. by looking
at the past. It is quite common to calculate the P/E ratio based on the expected this year's
earnings and next year's earnings so as to look at the undervalued and overvalued
companies realistically.

The dividend yield is the simply the return of dividend as a percentage to the current
market price and tells us about the return that is coming in cash to the shareholder every
year as a percentage of market price. It is calculated as:

Cash Dividend per share

Dividend Per Share =
Market Price per Share

This ratio is used to find out companies that return a good cash return per year for the
shareholders.

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Limitations of Financial Ratios
To fully understand a firm's strengths and weaknesses, you should use one of the two
standards against which ratios can be compared.

1. Similar ratios can be computed for the same firm from its previous financial
statements. This is commonly referred to as trend analysis and requires that the
analyst look at each ratio over several statement periods.

2. A second type of standard for comparison comes from ratios generated from firms
that have characteristics similar to the subject firm. These are referred to as
industry average ratios.

Even after comparison with the peers in the same industry, its competitors and its past
trends, you would find that the ratios do not provide the full picture of the company's
performance over any period of time. Always remember the ratios are just the indicators
of the company's performance and their analysis is not perfect in giving you the final
verdict.

Summary
The financial statements for any company tell a great deal about the company. Trend
analysis, vertical analysis and horizontal analysis are used to understand the financial
statements better.
Financial ratios help us analyse the relationship between the various items in the financial
statements. Financial ratios can be divided into five basic categories. These categories
consist of liquidity ratios, efficiency ratios, leverage ratios, profitability ratios and market
value ratios.
The financial ratios and other measurements introduced throughout this textbook,
including this chapter – and their significance – are summarised below and on the
following page as also the corresponding figures of Cosco for your reference.

Liquidity Ratios
Ratio or Other Method of Computation Significance
Measurement
Current ratio Current Assets A measure of short-term debt-
Current Liabilities paying ability
Quick ratio Quick Assets A measure of short-term debt-
Current Liabilities paying ability
Net cash provided by Appears in the statement of cash Indicates the cash generated
operating activities flows by operations after allowing
for cash payment of expenses
and operating liabilities
Free cash flow Net Cash from Operating Activities – Excess of operating cash flow
Cash used for Investing Activities over basic needs
and Dividends

Liquidity Ratios
COSCO (India) Ltd. 1998-99 1997-98
Current ratio 5.30 7.07
Quick ratio 1.70 3.06
Net cash provided by operating activities 17,843,514 -6,416,354
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Free cash flow -14,429,356 -36,287,181

Efficiency Ratios
Ratio or Other Method of Computation
Measurement
Receivables Turnover Annual Credit Sales
Sundry Debtors
Average Collection 360
Period
Receivable s Turnover
Inventory turnover rate Cost of Goods Sold
Average Inventory
Days to sell the average 360 days
inventory Daily Inventory Turnover
Fixed Asset Turnover Sales
Net Fixed Assets
Total Asset Turnover Sales
Total Assets
Working capital Current Assets – Current
Liabilities
Operating cycle Days to Sell inventory +
Days to Collect Receivables
Significance
Indicates in days how quickly receivables
are collected
Indicates how quickly receivables are
collected
Indicates how quickly inventory sells
Indicates in days how quickly inventory
sells
A measure of short-term debt-paying
ability
Indicates in days how quickly inventory
converts into cash

Efficiency Ratios
COSCO (India) Ltd. 1998-99 1997-98
Receivables Turnover 8.38 7.96
Average Collection Period 42.97 45.21
Inventory turnover rate 1.63 1.60
Days to sell the average inventory 220.50 224.69
Fixed Asset Turnover 4.47 5.34
Total Asset Turnover 1.29 1.21
Working capital 138,102,169 156,217,849
Operating cycle 263.47 269.90

Leverage Ratios
Ratio or Other Method of Computation Significance
Measurement
Debt ratio Total Liabilities Percentage of assets financed by
Total Assets creditors : indicates relative size of the
equity position
Debt-Equity ratio Total Liabilities Ratio of debt in relation to equity:
Total Equity indicates relative size of the debt
Trend in net cash Appears in comparative Indicator of a company’s ability to
provided by operating statements of cash flows generate the cash necessary to meet its
activities obligations
Interest coverage ratio Operating profit Indicator of a company’s ability to meet
Annual Interest Expense its interest payment obligations
Debt Service Coverage Operating profit Indicator of a company’s ability to meet
ratio Annual Interest + Debt its obligations to creditors
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 Repayment

Leverage Ratios
COSCO (India) Ltd. 1998-99 1997-98
Debt ratio 0.29 0.33
Debt-Equity ratio 0.41 0.49
Trend in net cash provided by operating activities 17,843,514 -6,416,354
Interest coverage ratio 3.66 4.84
Debt Service Coverage ratio 0.99 1.65

Profitability Ratios
Ratio or Other Method of Computation Significance
Measurement
Percentage changes Rupee Amount of Change The rate in which a key
in net sales Financial Statement Amount in the measure is increasing or
Earlier Year decreasing; the “growth rate”
Percentage changes Rupee Amount of Change The rate in which a key
in net profit Financial Statement Amount in the measure is increasing or
Earlier Year decreasing; the “growth rate”
Operating Profit Gross Profit – Operating Expenses The profitability of a
Margin Net Sales company’s “basic” business
activities
Net Profit Margin Net Profit An indicator of management’s
Sales ability to control costs
Return on assets Operating Profit A measure of the productivity
Average Total Assets of assets, regardless of how the
assets are financed
Earnings per share Net Profit Net profit applicable to each
Average Number of Equity Shares share of equity
Return on equity Net Profit The rate of return earned on
Average Total Equity the shareholders’ equity in the
business

Profitability Ratios
COSCO (India) Ltd. 1998-99 1997-98
Percentage change in net sales 6.72%
Percentage change in net profit -36.27%
Operating Profit Margin 14.83% 17.99%
Net Profit Margin 4.83% 7.98%
Return on assets 0.20 0.23
Earnings per share 3.41 5.35
Return on equity 0.09 0.15

Market Value Ratios

Ratio or Other Method of Computation Significance
Measurement
Market value of Quoted in financial press or disclosed Reflects both investors’

84
financial instruments in financial statements expectations and current
market conditions
Book value per share Equity Shareholders’ Equity The recorded value of net
No. of Equity Shares Outstanding assets underlying each equity
share
Price-earnings ratio Current Share Price A measure of investors’
Earnings per Share expectations about the
company’s future prospects
Dividend yield Annual Dividend Dividends expressed as a rate
Current Share Price of return on the market price
of the stock

Market Value Ratios

COSCO (India) Ltd. 1998-99 1997-98
Market value of one equity share 25.00 20.00
Book value per share 37.02 35.12
Price-earnings ratio 7.33 3.74
Dividend yield 3.75% 4.00%

Do You Know This?

Self Study Questions

1. Match the ratio to the building block of financial statement analysis to which it relates.

A. Liquidity and efficiency C. Profitability

B. Solvency D. Market

1. Dividend yield 6. Times interest earned

2. Return on total assets 7. Pledged assets to secured liabilities
3. Gross margin 8. Book value per share
4. Acid-test ratio 9. Days’ sales in inventory
5. Debt-Equity ratio 10. Accounts receivable turnover

2. For each ratio below, identify whether the change in the ratio from 1999 to 2000 is
generally regarded as favorable or unfavorable:

Ratio 2000 1999 Ratio 2000 1999

1. Net Profit margin 8% 6% 5. Accounts receivables 5.4 6.6
turnover
2. Debt ratio 45% 40% 6. Earnings per share Rs.1.24 Rs.1.20
3. Gross margin 33% 45% 7. Sales turnover 3.5 3.3
4. Acid-test ratio 0.99 1.10 8. Dividend yield 1% .8%

3. Which of the following usually is least important as a measure of short-term

liquidity?
a. Quick ratio
b. Current ratio

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 c. Debt ratio
d. Cash flows from operating activities.

4. In each of the past five years, the net sales of Soft Co. have increased at least half the
rate of inflation, but net income has increased at approximately twice the rate of
inflation. During this period, the company’s total assets, liabilities, and equity have
remained almost unchanged; dividends are approximately equal to net income. These
relationships suggest (indicate all correct answers):
a. Management is successfully controlling costs and expenses.
b. The company is selling more merchandise every year.
c. The annual return on assets has been increasing.
d. Financing activities are likely to result in a net use of cash.

5. From the viewpoint of a shareholder, which of the following relationships do you

consider of least significance?
a. The return on assets consistently is higher than the industry average.
b. The return on equity has increased in each of the past five years.
c. Net income is greater than the amount of working capital.
d. The return on assets is greater than the rate of interest being paid to
creditors.

6. The following data are available from the annual report of Newport Jeans:

Current assets Rs.480,000 Current liabilities Rs.300,000

Average total assets 2,000,000 Operating income 240,000
Average total equity 800,000 Net income 80,000

Which of the following statements are correct? (More than one statement may be
correct.)
a. The return on equity exceeds the return on assets.
b. The current ratio is .625 to 1.
c. Working capital is Rs.1,200,000.
d. None of the above answers is correct.

7. Super Company’s net income was Rs.400,000 in 1999 and Rs.160,000 in 2000. What
percentage increase in net income must Hunter achieve in 2001 to offset the decline
in profits in 2000?
a. 60% b. 150% c. 600% d. 67%

8. If a company’s current ratio declined in a year during which its quick ratio improved,
which of the following is the most likely explanation?
a. Inventory is increasing.
b. Inventory is declining.
c. Receivables are being collected more rapidly than in the past.
d. Receivables are being collected more slowly than in the past.

9. In financial statement analysis, the most difficult of the following items to predict is
whether:
a. The company’s market share is increasing or declining.
b. The company will be solvent in six months.
c. Profits will increase in the coming year.

86
 d. The market price of equity shares will rise or fall over the next two
months.

10. The following are 12 technical accounting terms introduced or emphasized in this
chapter:

P/e ratio Market share Current ratio

Debt ratio Earnings per share Operating income
Quick ratio Operating activities Return on equity
Subsidiary Comparative financial statements Parent company

Each of the following statements may (or may not) described one of these technical
terms. For each statement, indicate the term described, or answer “None” if the statement
does not correctly describe any of the terms.

a. A ratio that relates the total net income of a corporation to the holdings of
individual stockholders.
b. The classification in a statement of cash flows from which it is most important to
generate positive cash flows.
c. A measure of the long-term safety of creditors’ positions.
d. A measure of investors’ expectations of the future profitability of a business.
e. An ROI measure of the effectiveness with which management utilizes a
company’s resources, regardless of how those resources are financed.
f. A company that does business through other companies that it owns.
g. A measure of the profitability of a company’s primary business activities.
h. The most widely used measure of short-term debt-paying ability.
i. A form of business organization in which the owners are personally liable for the
debts of the business organization.
j. Financial statements in which similar items are grouped in a manner that develops
useful subtotals.

Questions

1. What is the difference between comparative financial statements and common-

size comparative statements?
2. What are three factors that would influence your decision as to whether a
company’s current ratio is good or bad?
3. What does a relatively high accounts receivable turnover indicate about a
company’s short-term liquidity?
4. What is the significance of the number of days’ sales uncollected?
5. Why is the capital structure of a company, as measure by debt and equity ratios,
of importance to financial statement analysts?
6. Why would a company’s return on total assets be different from its return on
common stockholders’ equity?
7. In financial statement analysis, what is the basic objective of observing trends in
data and ratios? Suggest some other standards of comparison.
8. Differentiate between horizontal and vertical analysis.
9. Explain how the following accounting practices will tend to raise or lower the
quality of a company’s earnings. (Assume the continuance of inflation.)

87
 a. Adoption of an accelerated depreciation method rather than straight-line
depreciation.
b. Adoption of FIFO rather than LIFO for the valuation of inventories.
c. Adoption of a 7-year life rather than a 10-year life for the depreciation of
equipment.
10. What is the quick ratio? Under what circumstances are short-term creditors most
likely to regard a company’s quick ratio as more meaningful than its current ratio?
11. Identify four ratios or other analytical tools used to evaluate profitability. Explain
briefly how each is computed.
12. Under what circumstances might a company have a high p/e ratio even when
investors are not optimistic about the company’s future prospects?
13. Alps Food Products experiences a considerable seasonal variation in its business.
The high point in the year’s activity comes in November, the low point in July.
During which month would you expect the company’s current ratio to be higher?
If the company were choosing a fiscal year for accounting purposes, what advice
would you give?

Exercises
1. Common Size Income Statements
Prepare common size income statements for Ram Company, a sole proprietorship, for the
two years shown below by converting the rupee amounts into percentages. For each year,
sales will appear as 100% and other items will be expressed as a percentage of sales.
Comment on whether the changes from 2000 to 2001 are favourable or unfavourable.

2000 2001
Sales Rs.400,000 Rs.500,000
Cost of goods sold 268,000 330,000
Gross profit Rs.132,000 Rs.170,000
Operating expenses 116,000 140,000
Net income Rs.16,000 Rs.30,000

2. Computing Ratios
A condensed balance sheet for Sleepwell Company prepared at the end of the year
appears as follows:

Assets Liabilities & Shareholders’ Equity

Cash Rs.55,000 Loans payable (due in 6 Rs.40,000
months)
Accounts receivable 155,000 Accounts payable 110,000
Inventory 270,000 Long-term liabilities 330,000
Prepaid expenses 60,000 Equity Shares, Rs.5 par 300,000
Plant & Equipment (net) 570,000 Reserves & Surplus 420,000
Other assets 90,000
Total Rs.1,200,000 Total Rs.1,200,000

During the year the company earned a gross profit of Rs.1,116,000 on sales of
Rs.2,790,000. Accounts receivable, inventory, and plant assets remained almost constant
in amount throughout the year.

Computer the following:

88
a. Current ratio
b. Quick ratio
c. Working capital
d. Debt ratio
e. Accounts receivable turnover (all sales were on credit)
f. Inventory turnover
g. Book value per share of capital stock

3. Financial Statement Analysis

Shown below are selected data from the financial statements of Bhatia Furnitures, a retail
furniture store.

From the balance sheet:

Cash Rs.30,000
Accounts receivable 150,000
Inventory 200,000
Fixed Assets (net of accumulated depreciation) 500,000
Current liabilities 150,000
Total shareholders’ equity 300,000
Total assets 1,000,000

From the Income statement:

Net sales Rs.1,500,000
Cost of goods sold 1,080,000
Operating expenses 315,000
Interest expense 84,000
Income taxes expense 6,000
Net income 15,000

From the cash flow statement

Net cash provided by operating activities Rs.40,000
(including interest paid of Rs.79,000)
Net cash used in investing activities (46,000)
Financing Activities:
Amounts borrowed Rs.50,000
Repayment of amounts borrowed (14,000)
Dividends paid (20,000)
Net cash provided by financing activities 16,000
Net increase in cash during the year Rs.10,000

a. Explain how the interest expense shown in the income statement could be
Rs.84,000, when the interest payment appearing in the statement of cash flows is
only Rs.79,000.
b. Compute the following (round to one decimal place):
1. Current ratio
2. Quick ratio
3. Working capital
4. Debt ratio
c. Comment on these measurements and evaluate Bhatia Furniture’s short-term
debt-paying ability.
d. Compute the following ratios (assume that the year-end amounts of total assets
and total shareholders’ equity also represent the average amounts throughout the
year):
1. Return on assets

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 2. Return on equity
e. Comment on the company’s performance under these measurements. Explain
why the return on assets and the return on equity are so different.
f. Discuss (1) the apparent safety of long-term creditors’ claims and (2) the
prospects for Bhatia Furniture continuing its dividend payments at the present
level.

Cases

1. Diwan Company’s financial year ended on March 31. The firm’s current and
quick ratios had been averaging 1.5 and 0.8, respectively. Its debt ratio had been
approximately 0.6. Relevant industry “norms” were 1.8, 0.9, and 0.5 for these
ratios.

During March, the firm made a concerted effort to collect receivables, with the
result that they were unusually low. The firm practically stopped all purchases of
new merchandise during the month and, by month end, inventory was abnormally
low. Sales to customers for the first week in April were included with March
data. The firm explained that these sales would have been made in March if it
hadn’t been for bad weather. On April 4th some equipment costing Rs 400,000
(Rs 50,000 down payment and the balance covered by a five-year repayment
agreement) was picked up at the suppliers. This equipment had been badly
needed since the first of the year. It had been available for pickup since March
10.
a) What was the company trying to accomplish?
b) Why was it taking these actions?
c) As an investor, would you like the firm’s auditor to report any of these
occurrences as exceptions in the opinion? Which events and why?

2. Paul and Ravi were studying two balance sheets from two different companies :
Company M and Company N (see summary data below). Ravi says, “Company
M looks as if it may have trouble staying in business. Most of the assets have
been borrowed from creditors and will have to be repaid. In fact, the equivalent
of 85 percent of the existing assets will have to be repaid to creditors within a
year, and only 25 percent of the existing assets are readily convertible to cash
within a year.”
Paul replies, “I don’t see it that way at all. To me, it looks as though Company M
is much safer than Company N. After all, it has more than twice as many assets.
Company M has 100,000 of assets which will more than cover the 85,000 of
current liabilities. Also, to protect itself, I am sure Company M had arrangements
long before the balance sheet date to refinance most of its current debt on a long-
term basis just in case.”

Balance Sheet Summary Data Company M Company N

Total Current Assets 25,000 30,000
Total Noncurrent Assets 75,000 10,000
Total Assets 100,000 40,000
Total Current Liabilities 85,000 15,000

90
 Total Noncurrent Liabilities 5,000 15,000
Total Liabilities 90,000 30,000
Total Owner’s Equity 10,000 10,000

Which of these opposing views is more nearly correct? Can you identify and
clarify the misconceptions held by the person who was incorrect? Discuss.

3. At a recent conference of financial executives, one speaker stated: Most people

really don’t appreciate the value of good financial management. A good financial
manager can take only average results from the operating management and
transform them to very good results for the equity shareholder. An absence of
financial management can lead adequately operating management into
insolvency.
Is this merely a meaningless self-serving declaration, or does it essentially
represent the truth? Discuss.

4. Two financial analysts are having a disagreement. One says, “I don’t know why
you don’t use net income to average total assets as the measure of efficient asset
usage. After all, net income is the final result. It represents what really happened.
How can you ignore interest, taxes, and extraordinary items? They are real and
they happen.”
The second analyst replies, ”That isn’t the point. Net income represents the
combined result of several different types of management, government action, and
even acts of God. By using EBIT, I can somewhat pinpoint responsibility to
operating management.”

5. Two financial analysts are in disagreement. Ravi maintains that the income
statement of a firm or, especially a series of annual statements, provide the best
measure of a firm’s performance. Paul takes exception to this. He believes net
income to be a relatively meaningless figure, and prefers to rely on funds from
operation as reported on the cash flow statement. Paul points out that net income
includes very arbitrary estimates of such things as depreciation and amortization,
and therefore is not a reliable performance indicator.
Who do you think is right? Discuss.

6. Is it possible that the various turnovers in a firm – asset, receivables, and

inventory – could be too high? Specifically, could there be any reason why a
retailer might be content with – and even prefer – a relatively low receivables
turnover? Are major retailers really retailers, or could they be considered
financial institutions? Discuss.

IV - Budgeting
Learning Outcomes
• Define a Budget and show how budgets, corporate objectives and long term
plans are related.
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 • Preparation of Budget

Planning is important to a company for several reasons. It provides a framework for

making decisions by establishing goals, objectives, and strategies. It is oriented toward
the future and involves an awareness of how today's decisions will affect tomorrow's
opportunities.

Planning starts with setting goals and objectives. As you know, goals are desired
qualitative and quantitative results. They are broad in nature and few in number, and
provide a basic direction for the company's management. They should be documented in
a clear, concise fashion so that they provide specific direction for all levels of
management. For example, the goal to achieve zero defects is easily remembered and
easily understood.

Goals also provide standards for measuring managerial performance. A quantitative one,
such as achieving a return on sales of 8%, can be measured very precisely. Conversely, a
qualitative goal, such as making quality a priority in daily operations, is less precise; and
it is more difficult to measure progress toward achieving it.

Goals typically are directed at one or more of the following areas:

• Profitability
• Market position
• Quality
• Size
• Cost leadership
• Product differentiation

Large companies typically develop a hierarchy of goals. Top management usually sets
corporate ones. Then subgoals are set at successively lower levels in the company. These
subgoals help lower-level managers direct their efforts toward accomplishing corporate
goals. Although in many companies managers at lower levels participate in the process of
setting corporate goals. This hierarchy of goals is illustrated in figure 17.1

Corporate Level
The Managing Director is directly responsible for:
 Achieving earnings per share growth in the 15 to 20 percent range.
 Achieving a return on investment of at least 20 percent.
 Formulating and implementing a corporate strategy that will enhance competitive
advantage in all business units.
 Managing technological change across all strategic business units.

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Strategic Business Unit Level
The Group A Strategic Business Unit Manager is directly responsible for:
 Increasing market share by 5 percent.
 Achieving earnings growth in the 20 to 25 percent range.
 Enhancing the sources of differentiation in the value change.
 Maintaining competitive position with regard to new technologies.

Functional Level
The Consumer Product Line Manager is directly responsible for:
 Increasing market share by 8 percent.
 Continuous improvement in customer satisfaction.
 Enhancing the sources of product differentiation.
 Changing advertising media and content.
• Figure 17-1: Hierarchy of Goals

Objectives provide more specific direction for managers in their day-to-day operations.
For example, a goal may be to attain a specific %age of market share. Objectives provide
the necessary steps toward achieving this goal. These steps might include sales goals by
territory and by product divisions. Many companies have developed detailed formal
systems to force managers to plan since managers have an aversion to doing it. The
budget is, of course, a component of this system.

The budget can be defined as a financial plan showing how the company will acquire
resources and use them in operations during a specified time period, usually one year. A
budget takes the form of a pro forma set of financial statements and supporting schedules.
Pro forma means that figures are expected amounts as opposed to actual historical
amounts. The budget is typically compiled on a monthly basis. Budgets are explained by
detailed descriptions of what managers expect to do in the short run.

Controlling involves monitoring the implementation of plans through performance

reviews. They are used to compare actual results with objectives. The frequency depends
upon the time-specific nature of the objectives. For example, some objectives involve
daily operations, and obviously daily performance reporting is appropriate. To illustrate,
an objective might be to reduce spoilage to less than 1 % per day for an ice cream
manufacturer. Daily, or even hourly, reporting may be used for feedback in this case. The
nature of the factors under management's control will also influence the frequency.

Weekly, monthly, and quarterly performance reports measure how successful the
company has been in achieving its financial goals and objectives. Variances from budget
are typically presented in a performance report so that unexpected results can be quickly
identified. Performance reports have to be timely so that the manager responsible for an
activity becomes aware of variances as soon as possible. They also have to be attention-
directing in nature, highlighting the most significant variances. The manager responsible
for a particular variance should be empowered to take corrective action with regard to a
variable under the firm's control

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Why do Budgeting at all
Having a budgeting system does not guarantee that the company's planning efforts will be
improved. In some companies, the budget is used as a planning process, but there is little
emphasis on using it to control operations. Budgeting is a cost-benefit proposition; the
system has to be designed to be used for controlling.

The advantages of budgeting must be emphasised periodically so that managers at

various levels take the process seriously and maximum benefit is attained. As mentioned
earlier, there sometimes is an aversion to planning. By emphasising the advantage of
planning and budgeting on a continuous basis, this aversion should be overcome.

1. Helps Enforce Planning

The most important advantage of budgeting is, of course, that it forces managers
to plan ahead. As a result of the corporate restructuring in the 1990s and early
2000s, many managers have had to make, and are still making, many changes in
their day-to-day operations. Simply stated, managers are very busy. Today's world
is changing so fast that managers are not simply dealing with routine situations on
a day-to-day basis. Instead, they must deal with complex problems without easy
or known solutions. Working within the framework of a plan facilitates tough
decision-making responsibilities.

A formalised budgeting system forces managers at all levels to plan. The critical
review of their proposed budget a higher managerial levels raises questions about
the way things are being done at lower levels. Managers must step back from
daily operations and take a wider view of what's really happening in their areas of
responsibility.
2. Better Coordinate Activities
As you know, companies are composed of many segments covering many
functions and programs. During the budgeting process the plans and related
financial budgets of the various segments are brought together in one place.
Typically, a budget committee will review these plans and try to integrate them
into a total plan to achieve the company's goals. This process results in opening
up of communication in the company from subordinates to superiors. There is
also communication between managers across section and department lines. For
example, if marketing plans to sell one million units, production must have plans
and a budget to produce these units. In turn, purchasing must have plans to
acquire the necessary raw materials to meet production schedules. It is inevitable
that the plans of the various departments will change during this process. This
revision process forces coordinated and continuous planning at the various levels
in the company.

3. Helps in Evaluating Performance

Performance evaluation is not an easy task. Obviously, managers desire a fair
evaluation of their performance. They want to know what is expected of them in
advance.
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 When investors evaluate a company's performance, a common technique is to
compare the current with historical results. While this is a useful technique for an
investor, for evaluating a managers' performance the firm has a better option. This
is to use the budget as a benchmark. Of course a manager's performance can be
fairly evaluated only by identifying the controllable and uncontrollable factors
that cause a significant variance between planned and actual results. If a variance
is caused by an uncontrollable factor, we can ask whether it was predictable.
Perhaps it wasn't and nothing could have been done. Alternatively, the manager
could have been prepared to take other actions. While the results cannot be
changed, competencies of managers can be assessed and lessons are learned.

For example, a division manager may have earned a profit of Rs 6,00,000 last
year. A historical benchmark approach for this division manager would be to
expect profits to increase by the same proportion in the coming year. Perhaps
management might simply say we expect profits to increase by 10 % to Rs
6,60,000. The problem with using this approach is that no attempt is being made
to adjust for changes due to uncontrollable and controllable factors. Perhaps an
investment was made in new technology toward the end of last year that should
result in substantial efficiencies. This factor would cause us to expect a more
substantial increase in profits. Using a budgeted Profit & Loss A/c as a
benchmark forces the divisional manager to factor in all the variables that are
expected to change. A stringent headquarters' review of the division manager's
plans and analysis can result in the agreement on a realistic target for the next
year. As a result, planning is integrated with performance evaluation.

4. Helps in Controlling
Successful companies create a control environment. They have an effective set of
internal controls to assure compliance with management's policies and
procedures. Controls must assure compliance by employees at all levels.
Managers must understand and follow the limits on their authority to expend the
company's resources.

Monthly budgetary control reports on spending document the manager's actions in

using the authority granted. Of course, the budgetary control system should allow
for changes during the budget period. These authorised changes should be
documented as part of the management control system.

5. Helps in Allocating Resources

During the budget planning phase many resource allocation decisions are made. A
good example is capital expenditures. The various segments of a company will
request a budgeted rupee amount for these expenditures. Invariably, the total
amount requested exceeds the company's ability to finance that total.
Consequently, a capital rationing process is used. Typically, the company will use
either the internal rate of return or net present value method of evaluating the
competing proposals for capital expenditures. Both of these methods were
described in Chapter 14. These methods enable management to look at how the

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 competing requests will further the company's capability to achieve its strategic
plan.

6. Helps in Motivating
Budgets can be used by management to motivate managers and employees. If
managers participate in the planning process and budget preparation, they are
likely to develop more of a commitment to achieving the budget's objectives. In
the process they also realise more fully that their piece of the budgets is important
in coordinating the overall plan. If a company can develop a fair budget review
process (and a fair performance evaluation process), managers will be motivated
to achieve desired results. Conversely, if these processes are not perceived as fair,
the budgetary system will have a negative effect on motivation.
In many companies promotions, raises, and bonuses are affected by managers'
performance in achieving budgetary targets. In many larger firms, for example,
division managers can earn a bonus by achieving the budgeted profit for the
division. Unfortunately, there are many pitfalls in using budgets as a motivator.
For example, a division manager may resort to techniques such as speeding up
sales order processing at the end of the budget period to increase sales and earn a
bonus.

The Process of Budgeting

A variety of approaches can be used to administer the budget. They vary with the way top
management controls the budget process. Most large companies use some type of budget
committee format. Another important ingredient is a budget manual, which describes
policies and procedures and the all-important timetable for completion.

Budget Committee
Most large companies appoint a budget committee. The advantage of having a budget
committee is that members can be selected from the various functional areas of the
company. Since a basic purpose of the committee is to coordinate activities throughout
the company, members of the committee must have expertise in the various functional
areas. These areas should include marketing, production, personnel, finance, and
accounting.

The budget director, who has ultimate responsibility for formulating the budget, chairs
the committee. The budget director's position in the company and the responsibilities
assigned will affect the perceived importance of the budget by company members. In
some companies the budget director has significant strategic authority.

Degree of Participation
There is an old saying, "People support what they help create." We have seen this idea
applied to the budgeting process. A high degree of participation is often called the
"bottom-up approach." The budgeting process is initiated at the bottom of the company,
and budgets are transferred up the company from one level to another for review and
modification. At each level, the manager discuses the plans with subordinates to
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understand their thinking. Thus, operating managers with detailed knowledge of the
environment, competitive forces, and the marketplace are used to develop plans at lower
levels. This approach empowers employees at lower levels to set targets and be
innovative.

The bottom-up approach is compatible with the total quality management movement of
the 1980s and 1990s. Managers at lower levels are empowered to assess performance and
identify opportunities for continuous improvement. Lower-level managers better
understand business processes, subprocesses,
and activities. They are also more likely to be attuned to the needs of customers. This
approach also allows for quick response to changes in competitive
forces.

Top-Down Bottom-up
 Management Style Authoritarian Participative
 Resources Centralised control Decentralised control
 Process Simple Complex
 Ownership of the budget Top management All levels of
management
 Time frame Shorter longer
• Figure 17-2: Top-Down versus Bottom-up Budgeting

Figure 17.2 portrays the two basic approaches to budgeting. At the authoritarian extreme
we have the "top-down" approach. It allows the managers at the top of the company to
use their comprehensive understanding of the environment and the company as a basis
for preparing the budget. Top management sets targets for the various functional areas
based upon its knowledge of the company's strategies, goals, and resources. Strict
application of this approach involves no negotiation with managers at lower levels.

A variation that lies somewhere between the two extremes is the case where the top-down
approach is modified to allow for negotiation with managers at middle levels in the
company.

Which approach is the best? The bottom-up approach allows the budget to be influenced
by managers who are closer to the customers. Thus, customer needs can be recognised
and prioritised more effectively. The main disadvantage of this approach is that it is very
time consuming and thus a more costly budgeting practice. And in some types of
businesses lower-level managers do not have the desire or capability to contribute to the
budgeting process.

The top-down approach has the major advantage of simplicity and consistency. It often
works best in smaller companies where the owner-manager really knows the business. It
is also often used when a firm is in a financial crisis and cannot afford the cost of bottom-
up budgeting. However, there is a risk of incompleteness due to the lack of information
about operational details. Also, managers may be dissatisfied with the budget and may
not support achieving it.

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Budgeting Phases
Firms typically go through several budgeting phases so that the coordination objectives of
budgeting are realised. Many firms use a blend of the top-down and bottom-up
approaches. Such a blend allows for an effective combination of the experience of
operating managers with top management's overall understanding of business. Such a
blend can be described as follows:

1. Top management sets forth in broad terms, and sends to the operating unit
managers, an overview of the environment, the corporate goals for the year, and
the resource constraints.

2. Each operating unit manager formulates in broad terms the unit's operating plans,
performance targets, and resource requirements.

3. Top management collects, combines, and evaluates information from all the
operating units.

4. Top management assesses and revises targets and resource availabilities, and
assigns preliminary estimates to each operating unit.

5. Operating unit managers plan their activities in detail, determine their resource
needs, and prepare their final budgets, which are sent to top management.

6. Top management combines these unit budgets, tunes them where necessary,
approves them, and sends them back to the operating unit managers for
implementation.

In such a blending process, the budget committee usually implements the top
management role. The budget director is very influential in making the process work.
During this process the company will review operating and financial programs, and there
will be communication up and down the company.

Program Planning
The planning of operating programmes is the basis for the budgeted net income from
operations. In a manufacturing company these programs include producing the product,
marketing the product, and administering the firm. In a non-profit company there is a
programme or programmes that are designed to carry out the company's mission, and
there are fund-raising and service programs to support these activities.

A value-chain analysis was developed by Michael Porter to understand the business's

strategy. Porter's model depicts the company as a collection of activities aimed at
designing, producing, marketing, delivering, and supporting its products. By looking at
the firm in terms of strategic activities instead of in terms of the usual corporate structure,
the manager can gain insight into cost behaviour and opportunities for differentiation of
the firm's products.

Porter's model features five basic links in the value chain:

1. Inbound logistics
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2. Operations
3. Outbound logistics
4. Marketing and sales
5. Service

Firm's infrastructure, human resource management, technology development, and

procurement support these activities.

Operational program planning for businesses will in some way focus on the components
of the Porter model. In planning programs, consideration must be given to the integration
of departmental activities. That is, many programs involve activities performed by
various departments. For example, when a special purpose equipment manufacturer
processes orders from customers, it will involve its marketing, production, and
accounting departments. When negotiating with a customer to obtain an order for a
custom-designed piece of equipment, it will involve its engineering and marketing
departments.

The collection of activities across departmental lines to produce a product or service is a

business process. In program planning, business processes should be analysed according
to their activities and subprocesses. For example, the business process of acquiring new
business for the firm can be broken down into sales promotion, advertising, proposal
preparation, sales training, order acceptance, and service. The processes and subprocesses
will vary by business. A potential advantage of budgeting is that it can be used to
promote planning and coordination of the activities comprising a business process.

Activity-based Budgeting
In budgeting for operating programmes the various business processes involved should
be clearly identified and understood. Activity-based budgeting is a budgeting technique
that gives specific recognition to the activities involved in a business process or
subprocess. Examples of it will be covered later. This technique is introduced at this point
to emphasise the importance of understanding the basic activities that are involved in
various business processes in the value chain.

Financial Programmes
Financial programmes have to be designed to support operations. Cash management
plans and related short-term financing are important in supporting the budget operations
for the year. Cash management includes developing banking relationships and
establishing a line of credit. The cash management programmes determines how fast
collections from customers become available and the schedule for payment of
obligations.

Financial programmes are also long run in orientation. These may include programmes to
issue new common stock or bonds for planned capital expenditures. The financial
programme may also include plans for leasing or other financing of such capital
expenditures.

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Budget Process Duration
How long should it take from the start of the budgeting process to the end? There are
advantages to keeping the duration period as short as possible. For one thing, the world
changes fast, and we want the budget process based upon planning assumptions that
won't change while the budget is being prepared. Also, the longer the process lasts, the
more likely people will lose interest in the process. It may also be more time consuming
since people may have forgotten what they did several months ago.

Having a participative budget process will necessitate more time. Therefore, a top-down
approach is more cost-effective in the sense that it takes less time and involvement by the
company's management. Many larger companies take six months to complete the budget
process. Smaller companies taking the top-down approach may take only one month or
even less than that.

Budgetary Slack
Mangers are tempted to build slack into their budgets. This phenomenon is sometimes
called "padding the budget." It refers to intentionally asking for more funds that are really
needed to support planned activities, or it can involve being ultraconservative about
expected sales. In a company that uses the budget as a basis for performance evaluation,
obviously there is a strong incentive for managers to budget very attainable targets. If
sales managers can negotiate a conservative sales budget for their territories, they will
most likely be exceeded. Their perception would be that it is better to exceed a
conservative budget rather than fail to meet an ambitious target.

Budgetary slack may also be a means for dealing with an uncertain situation. For
example, a manager in charge may view a new production process as being difficult to
predict with regard to spoilage and machine breakdowns in the early months of operation.
He may then overestimate costs as a hedge against the associated uncertainties.

Another reason for budgetary slack is the budget review process itself. Lower-level
managers may know from experience that their budget requests will be cut during the
review process. A smart manager may anticipate a 5 to 10 % cut in budget requests for
travel and entertainment. To combat this, the manager makes a request that is higher than
what he needs. Over time, the manager may build up considerable slack in the travel and
entertainment budget so that there are no constraints on travelling in style. In good times,
budgetary slack is often tolerated. It is sometimes viewed as a means of sharing the
wealth.

When fortunes are reversed, the company embarks upon procedures to eliminate the
slack. This often involves special studies by headquarters. Sometimes there are across-
the-broad cuts, which unfortunately are arbitrary and do not focus on achieving the
company's goals and mission.

One way to combat budgetary slack is for top management to keep score on how accurate
managers are in making budget projections. Managers can be asked to justify their
projections by reviewing the underlying analysis. Managers who consistently have a basis
of analysis which reflects an understanding of the business and the business processes
and subprocesses can be rewarded.

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Case studies have shown that many managers voluntarily reduce slack in bad times. Cost-
cutting campaigns to reduce budgetary slack can also be effective. However, a common
pitfall is to put too much pressure on managers, which can result in conflict among
managers in different function areas. Such conflicts may damage the budgetary process
for many years to come.

The degree of control to be achieved by the budget system depends to some extent on
options chosen in the system's design. The budget plays a relatively weak role in the
control of operations of some firms. For example, the budget in a consulting firm is
prepared by the partners to assess the financial implications of goals. However, monthly
performance reports that compare actual and budgeted cost are not reviewed with great
care. Instead, partners exercise control of operations by following the firm's quality
control policies and procedures.

Responsibility Accounting
A company can be divided into subunits called "responsibility centres." They are subunits
within the company whose manager is accountable for financial aspects of the subunit's
activities. A responsibility accounting system will account for the financial results
according to the subunits identified. There are four basic types of subunits:

1. Cost centres
2. Marketing centres
3. Profit centres
4. Investment centres

A cost centre is a department whose manager is accountable only for costs incurred. A
maintenance department is a good example. A marketing centre (sometimes-called
revenue centre) manager is responsible for revenue primarily. The manger is also
responsible for the costs required to obtain revenues, but performance is evaluated based
primarily on revenue.

In the budgeting process, responsibility centres are clearly identified. Budget targets are
set for each responsibility centre manager. Cost centres and marketing centers are at
lower levels of the company in most instances. Their managers report to a manager of a
profit centre. This sub-unit is held responsible for revenues and expenses, and its
manager is held responsible for the performance of cost center and marketing center
managers. A manager's ability to generate profits is enhanced by having more assets to
use in this process.

A manager responsible for both profit and investment heads an investment center. This
center in a large corporation is typically an entire division.

In applying the concept of responsibility centres, controllability is a key concept. We can

ask, does a manager have control over a particular cost or expense? Controllability is
obviously a matter of degree. There are two basic views of it. The more stringent is that a
manager should have veto power over controllable costs and revenues. Therefore, a
manager would not be held responsible for a cost that is authorised by someone at a
higher level in a company. Likewise a manager would not be viewed as responsible for
revenue from a client, unless accepting the client was authorised by that manager. The
second basic view is that managers are responsible for a cost or revenue over which they

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have substantial influence. This second view of controllability recognises the fact that
lower-level managers don't have absolute power. This view is the prevalent one in
practice.

Another question related to responsibility centres is: Should corporate overhead cots be
allocated to subunits? A strict view of responsibility accounting is that corporate charges
should not be allocated because the division or department manager has no control over
these costs. The more common view is that the division or department is benefiting from
services provided by corporate headquarters and should be charged for them. Another
reason supporting this view is that the mangers charged can influence corporate costs.
They can question corporate expense allocations and put pressure on to reduce them.

Continuous Budgets
Most companies prepare an annual budget for the year ahead. Whether the firm is on a
fiscal year or a calendar year, the budget process is usually completed in the last month of
the preceding year. The process will be repeated the following year. Therefore, toward
the end of each year the current formal budget covers only a short period of time ahead.

Continuous budgeting solves this problem. The budget is continuously extended another
month or quarter so that the firm is always looking ahead in its budgeting. It is common
to do a continuous budget on a quarterly basis. Therefore, at a minimum, such firms
always plan nine months ahead at the end of a quarter.

Continuous budgets have the advantage of forcing planning on a continuous basis.

Managers get involved with the process every quarter and become better at planning than
they would otherwise. They also can change the planning assumptions somewhat during
the year, as opposed to keeping them the same for the entire year. This brings up the
question of revising budgets. A continuous budgeting environment is more likely to
prompt revisions in plans and budgets in response to changed conditions. This is a real
benefit in a rapidly changing world. One criticism of annual budgets is that the firm is
stuck with a plan for a whole year and cannot adapt to its environment readily when it
changes.

Tight and Loose Budgets

Some companies have a tight budgeting system. Their managers know that going
significantly over an expense budget reflects a very poor performance. Sometimes,
however, exceeding budget is allowed if it is compensated for by reductions in costs in
other areas. For example, the office expense category might be composed of ten different
types of expenses. The telephone budget can be exceeded if other expense items such as
copying can be reduced so that the overall office expense is within budget. Tightness can
also be judged by how difficult it is to reach the budget target. Attainability relates to the
amount of "stretch" in a budget. By stretching we mean that managers will have to push
their capabilities to the maximum to achieve the target.

Some companies have loose budgeting systems. Here the budget is viewed as primarily a
planning tool. The nature of the firm's business can make it difficult for a tight budget to
be implemented. For example, companies in fast changing growth industries find it very
difficult to implement a tight profit budget. There have to be changes in plans as new

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developments arise in their industries. In contrast, firms with business units in mature
industries can implement tight profit budgets.

The Master Budget

The profit budget is the end result of the budgeting process and is the most important
component of the master budget of for-profit businesses. The master budget is a set of
budgeted financial statements and supporting schedules and plans for the coming year. It
reflects the budget targets for the firm at all levels of the company. The firm's
management has made a commitment to achieve the underlying budget targets. The
master budget is based on a set of planning assumptions that are viewed as being the most
likely.

The budgets and schedules making up the master budget are closely interrelated. Some of
these relationships are illustrated in the figure 17.3 below:

Operating

expenses

budget

Cash Sales Budgeted

Budget forecast P&L A/c

Production
schedule
(in units)

Manufacturing
Cost budget

Capital Budgeted
Expenditures balance
Budget sheet

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Figure 17.3: Elements of the Master Budget

Steps in Preparing a Master Budget

Some parts of the master budget should not be prepared until other parts have been
completed. For example, the budgeted financial statements are not prepared until the
sales, manufacturing, and operating expense budgets are available. A logical sequence of
steps for preparing the annual elements of the master budget is described below:

1. Prepare a sales forecast.

The sales forecast is the starting point in the preparation of a master budget. This forecast
is based on past experience, estimates of general business and economic conditions, and
expected levels of competition. A forecast of the expected level of sales is a prerequisite
to scheduling production and to budgeting revenue and variable costs. The arrows in our
budget diagram indicate that information "flows" from this forecast into several other
budgets.

2. Prepare budgets for production, manufacturing costs, and operating expenses.

Once the level of sales has been forecast, production may be scheduled and estimates
made of the expected manufacturing costs and operating expenses for the year. These
elements of the master budget depend on both the levels of sales and cost-volume
relationships.

3. Prepare a budgeted Profit & Loss A/c.

The budgeted Profit & Loss A/c is based on the sales forecast, the manufacturing costs
comprising the cost of goods sold, and the budgeted operating expenses.

4. Prepare a cash budget.

The cash budget is a forecast of the cash receipts and cash payments for the budget
period. The cash budget is affected by many of the other budget estimates.

The budgeted level of cash receipts depends on the sales forecast, credit terms offered by
the company, and the company's experience in collecting accounts receivable from
customers. Budgeted cash payments depend on the forecasts of manufacturing costs,
operating expenses, and capital expenditures, as well as the credit terms offered by
suppliers. Anticipated borrowing, debt repayment, cash dividends, and issuance of capital
stock also are reflected in the cash budget.

5. Prepare a budgeted balance sheet.

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A projected balance sheet cannot be prepared until the effects of cash transactions on
various assets, liability, and owners' equity accounts have been determined. In addition,
the balance sheet is affected by budgeted capital expenditures and budgeted net income.

The capital expenditures budget covers a span of many years. This budget is continuously
reviewed and updated, but usually it is not prepared anew on an annual basis.

A summary illustration of the master budget for a manufacturing firm is presented in

figure 17.4. It shows several important features of the master budget. The budgeted Profit
& Loss A/c (profit budget) is presented in Schedule A on a monthly basis. We see that
Schedule A evidences budget cycling, the planned variations in the level of activity over
the span of a year. Many businesses have predictable seasonal patterns. For example, soft
drink bottling plants are busier when the weather is warmer. Another factor that would
affect budget cycling is expected changes in the industry and the economy; which reflect
cyclical patterns.

The budgeted Profit & Loss A/c shows that cost of sales fluctuates with sales. There are
also fluctuations in the selling and administrative expenses, but they are not as
pronounced as the cost of sales. These changes reflect underlying cost behaviour patterns,
which are discussed below.

The budgeted Profit & Loss A/c for 2001 (Schedule C) shows planned net income of Rs
7,50,000 as compared to Rs 6,13,000 for 2000. Budgeted changes can be analysed by
looking at the % columns for 2001 versus 2000. These show amounts as a % of sales
because the %ages are directly comparable. For 2001, net income as a % of sales is 13.3
% versus 12.1 % for 2000. This planned increase will be achieved by lowering cost of
sales and selling and administrative expenses as a % of sales.

The budgeted balance sheet in Schedule B also reflects budget cycling. As sales activity
increases, the asset investment increases. These changes are driven by the need for more
inventory, and higher accounts receivable result from higher sales. Notice the planned
inventory build up (May through August) in anticipation of sales increases from May
through September. However, in September planned ending inventory decreases because
planned sales for October are substantially lower.

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