Chapter 2 Financial Statements PDF

THE ACCOUNTING EQUATION The accounting equation shows the relationship between the economic resources of a business and the claims against those resources. At all times, the following relationship holds: Economic resources = Claims Economic resource...

THE ACCOUNTING EQUATION The accounting equation shows the relationship between the economic resources of a business and the claims against those resources. At all times, the following relationship holds: Economic resources = Claims Economic resources are assets. The claims consist of creditors’ claims, or liabilities, and owners’ claims, or equity. (Recall that a business is separate from its owner for accounting purposes. So the owner too has a claim on the business.) The accounting equation may now be modified as follows: Assets = Liabilities + Equity We can analyze any business transaction, regardless of its size and complexity, in terms of its effect on the accounting equation. The balance sheet shows the position of assets, liabilities and equity. Assets An asset is a resource that gives benefits to its owner. An enterprise should consider a resource its asset if (a) it controls the resource, and (b) the resource is expected to give benefits. Swati enjoys the sight of trees, plants and flowers in a public park (benefits). But she can’t prevent others from going to the park (no control). So the park is not her asset. Jayesh is the unquestioned master of his broken car (control). But he can’t use it (no benefits). So the car is not his asset. An asset has the capacity to provide benefits to its owner in the form of sales, savings, comfort, safety or speed. It is expected to generate cash, directly or indirectly. Clearly, cash is an asset. Items that will turn into cash or facilitate production or sales are also assets. Home mortgage loans are a bank’s assets. Inventories and store buildings are a retailer’s assets. An automobile company’s plant and machinery are its assets. Some assets, such as plant and machinery and inventories, have physical form. These are tangible assets. Assets such as patents and trademarks confer exclusive legal rights but have no physical form. So they are intangible assets. Others such as home mortgage loans and investments in bonds are legally enforceable claims on others. These are financial assets. To sum up, an asset is what an enterprise ‘owns’. Think of assets as amounts receivable sooner or later. QUICK QUESTION Assets What are the chief assets of Apple, Coal India, Cipla, Kotak Bank, and TCS?. ONE-MINUTE QUIZ 2.1 Assets Which of the following is an asset of Mahindra & Mahindra Limited? There may be more than one correct answer. (a) Equipment with remaining life of three years. (b) Investment in Mahindra Defence Systems Limited. (c) Salaries. (d) Tax payable. Liabilities A liability is an obligation that requires to settled by giving up assets. A liability is the mirror image of an asset. Usually, it requires payment of cash. Some liabilities, such as bonds payable and trade payables, are in precise amounts. Other liabilities, such as income tax payable and pensions payable, should be estimated. Most liabilities result from contracts, e.g. amount payable for using electricity, or statutory requirements, e.g. amount payable for employer’s contribution to provident fund. A liability may also arise from a constructive obligation that an enterprise regards as payable even without a legally enforceable claim. For instance, a store may allow full refund for goods returned even after the contractual period; this may give rise to a liability. In sum, a liability is what an enterprise ‘owes’. Think of liabilities as payable. QUICK QUESTION Liabilities What are the chief liabilities of Barclays Bank, Bharat Electronics, Larsen & Toubro, Oil and Natural Gas Corporation, and Volkswagen?. ONE-MINUTE QUIZ 2.2 Liabilities Which of the following is a liability of Wipro Limited? There may be more than one correct answer. (a) Warranty payable. (b) Technical know-how. (c) Salaries payable. (d) Incomplete projects requiring further spending. Equity Equity is net assets, i.e. the difference between an enterprise’s assets and its liabilities. The equity of a business enterprise increases through investments by owners and profits from operations and decreases through distributions to owners and losses from operations. Think of equity as the residual. The equity of a company is called shareholders’ equity. Its components include share capital, securities premium, and retained earnings. Share capital is the amount contributed by the shareholders towards a company’s capital. Securities premium (or share premium) is the excess of shareholders’ contribution over share capital. The activities of a business result in revenues and expenses. Revenues are amounts charged to customers for goods and services provided. For instance, airlines earn revenue by transporting passengers and cargo. Expenses are the costs of earning revenues. The expenses of running an airline include aircraft lease rent, fuel, staff salaries, interest costs, and income tax. Net profit is the excess of revenues over expenses; net loss is the excess of expenses over revenues. Dividends are distributions to shareholders. Profits increase equity; losses, dividends and share buybacks decrease equity. Retained earnings represent the profit kept in the business. You will learn more about the components of equity as you progress. QUICK QUESTION Equity What are the chief revenues and expenses of Balaji Telefilms, Facebook, ITC, L’Oréal, and Manchester United?. ONE-MINUTE QUIZ 2.3 Equity  Which of the following is an equity item of Tata Steel Limited? There may be more than one correct answer. (a) Cash. (b) Dividend payable. (c) Amounts receivable from customers. (d) Income tax expense. We see assets all the time, e.g. cash, buildings, computers, and phones. We can’t see liabilities, still we can imagine them as requiring us to part with cash, e.g. bank loan payable, salaries payable, and tax payable. We can neither see nor imagine equity. When a business sells goods worth `1,000 for cash, it earns a revenue of `1,000. Revenue is a component of equity. So equity increases and cash increases. The increase in cash is straightforward. What does the increase in equity mean? Revenue belongs to the owner. When a business earns revenue, the owner’s claim increases. In our example, the business owes its owner `1,000 more. As an exercise, explain the effect of the following transaction: A business pays salaries of `300. What happens when an enterprise buys equipment with cash? An answer sometimes heard in class is that equity decreases. This results from a misunderstanding of equity. The effect of this transaction is that equipment increases and cash decreases. The transaction has no other effect on the accounting equation. Equity would change when a firm (a) earns revenue, (b) incurs expense, (c) pays dividend, or (d) receives capital from, or returns capital to, owner. None of these happens when an enterprise buys equipment with cash. HANDHOLD 2.1 Accounting Equation (a) Hot Chocolate has assets of `87,000 and liabilities of `53,000. How much is its equity? Equity = Assets – Liabilities = `87,000 – `53,000 = `34,000 (b) Abraham Company’s September 30 balance sheet contained the following items: Cash, `5,000; Trade receivables, `17,000; Supplies, `9,000; Equipment, `19,000; Building, `21,800; Land, `21,000; Loan payable, `12,000; Expenses payable, `x; Abraham’s equity, `77,300. What is the amount of expenses payable? To find out expenses payable, substitute the known items in the equation, Assets = Liabilities + Equity: Cash, 5,000 + Trade receivables, 17,000 + Supplies, 9,000 + Equipment, 19,000 + Building, 21,800 + Land, 21,000 = Loan payable, 12,000 + Expenses payable, x + Abraham’s equity, 77,300. Therefore, Expenses payable = `3,500. (c) On March 31, 20XX, Coffee Corner’s equity is twice its liabilities. Its assets are `81,000. Prepare its balance sheet. Assets = 81,000 = Liabilities + Equity = Liabilities + (2 × Liabilities) = 3 × Liabilities. Therefore, liabilities = `27,000. Coffee Corner’s balance sheet is as follows: Coffee Corner’s Balance Sheet, March 31, 20XX Assets ` 81,000 Liabilities 27,000 Equity 54,000 Total liabilities and equity 81,000.. TEST YOUR UNDERSTANDING 2.1 Effect on Accounting Equation Give an example of a transaction that has the following effect on the accounting equation:  Financial statements provide information about an enterprise’s financial position and financial performance. Financial statements present the financial effects of transactions and other events by grouping them into broad classes, or elements. Assets, liabilities and equity are the elements related to the measurement of financial position. Revenues and expenses are the elements related to the measurement of performance. There are four major financial statements: 1. The balance sheet shows the financial position at a point in time. 2. The statement of profit and loss reports the financial performance in a period. 3. The statement of changes in equity explains how equity changed as a result of net profit, dividends, return of capital and other transactions in a period. 4. The statement of cash flows summarizes the cash inflows and outflows resulting from operating, investing and financing activities in a period. Balance sheet reports stock, i.e. the position at a point in time. The other statements report flow, i.e. change in a period. Exhibit 2.2, Panel A to Panel D, presents Softomation’s financial statements. Note that there is no specific form for the financial statements of proprietorship and partnership businesses. EXHIBIT 2.2 Softomation’s Financial Statements Financial statements present the financial position and financial performance of a business.. Panel A. SOFTOMATION Balance Sheet, March 31, 20XX Assets Cash `15,200 Trade receivables 8,000 Supplies 1,700 Equipment 58,000 Total assets 82,900 Liabilities Trade payables ` 4,000 Loan payable 20,000 Total liabilities 24,000 Equity Capital, Suresh 50,000 Retained earnings 8,900  Ending balance 15,200 Understanding Softomation’s Financial Statements Balance sheet The balance sheet presents an enterprise’s assets, liabilities and equity at a point in time. It’s similar to a snapshot. As shown in Exhibit 2.2: Panel A, at the end of March 20XX Softomation has assets totalling `82,900, equal to the total of liabilities of `24,000 and equity of `58,900. Statement of profit and loss The statement of profit and loss, also known as profit and loss account or income statement, summarizes the revenues and expenses for a period. It’s like a video. The statement tells us about a firm’s financial performance. From Exhibit 2.2: Panel B, we note that in March 20XX Softomation earned a revenue of `20,000 from services, spent `6,600 to earn that revenue and made a net profit of `13,400 for the period. You might have noticed that the revenues and expenses appeared in the Equity column in Exhibit 2.1. We note that Softomation’s revenues are from its business activities. Statement of changes in equity The statement of changes in equity describes the changes in the equity items, e.g. share capital and retained earnings in a period. Changes in share capital result from introduction or withdrawal of capital by the owners. Changes in retained earnings result from net profit and distributions to the owners. Exhibit 2.2: Panel C tells us that in Softomation the changes came from both owner and non-owner transactions; the latter were routed through the statement of profit and loss. We note that Suresh withdrew `4,500 in cash and supplies out of Softomation’s March earnings of `13,400 and retained `8,900. Since this is the first month, there is no beginning balance. Note that distribution of profit is not an expense; so it appears in the statement of changes in equity, and not in the statement of profit and loss. Statement of cash flows The statement of cash flows reports the cash effects of an enterprise’s (a) operations, (i.e. providing goods and services), (b) investments (i.e. buying and selling assets) and (c) financing (i.e. raising and repaying funds) in a period. The statement of cash flows in Exhibit 2.2: Panel D describes how Softomation starting with no cash at the beginning managed to end the month with `15,200 in cash. Current operations brought in `6,700. Investment in equipment used up `58,000. Suresh provided `46,500, net of withdrawal, and Manish provided `20,000. HANDHOLD 2.2 Effect of Transactions Most transactions affect more than one financial statement. For instance, providing services for cash would affect the balance sheet (cash and equity), statement of profit and loss (revenue) and statement of cash flows (operating cash flow). Collecting past invoices would affect the balance sheet (cash and receivables) and the statement of cash flows (operating cash flow). Taking a bank loan would affect the balance sheet (cash and borrowings) and the statement of cash flows (financing cash flow).. ONE-MINUTE QUIZ 2.5 Effect of Transactions on Financial Statements  Which of the financial statements would be affected by the transaction, ‘Paid dividends’? (a) Statement of changes in equity; statement of cash flows. (b) Statement of profit and loss; statement of changes in equity; statement of cash flows. (c) Balance sheet; statement of changes in equity; statement of cash flows. (d) Balance sheet; statement of profit and loss; statement of changes in equity; statement of cash flows.. DISCUSSION Give examples of transactions and explain how they would QUESTION 2.2 affect the financial statements........................................................................................................................................................................................................................................ TEST YOUR UNDERSTANDING 2.2 Computing Profit from the Balance Sheet On December 31, 20X1, Kiran Bakery had assets of `85,000 and liabilities of `67,000. On December 31, 20X2, the business had assets of `99,000 and liabilities of `71,000. During 20X2, Kiran invested `35,000 and withdrew `24,500. Compute Kiran Bakery’s net profit for 20X2. FINANCIAL STATEMENT ANALYSIS: THE BASICS Suresh wants to know how his new business did in the first month. Here are some key questions: Is Softomation making good money from sales? Is Softomation earning a reasonable return on investment? Is Softomation using its assets efficiently? Are Softomation’s customers taking too long to pay? Will Softomation be able to pay its suppliers on time? Is Suresh earning a reasonable return on his investment? Does Suresh have sufficient ‘skin in the game’? Is Softomation’s profit ‘real’? What are Softomation’s risks? Let us do a bit of analysis to answer these questions.17 Is Softomation making good money from sales? Softomation made a profit of `13,400 on a revenue of `20,000. The profit margin, the ratio of profit to sales, is 67 per cent (13,400/20,000). Put differently, the business made a profit of `67 on `100 of revenue. This is impressive, because normally new businesses struggle for months, even years, before turning in a profit. Is Softomation earning a reasonable return on investment? Softomation’s investment is `82,900. Its return on assets, the ratio of profit to assets, is 16 per cent (13,400/82,900). It means Softomation earned `16 of profit for every `100 in investment. With no knowledge of the business, all we can say is that this is much better than the interest rate on bank deposits. Is Softomation using its assets efficiently? Softomation’s business revenue was `20,000 on an investment of `82,900 in equipment and other assets. Its asset turnover, the ratio of sales to assets, is 0.24 times. It means Softomation did business of `24 for every `100 invested. Software firms need much less assets than firms making steel or building aircraft. So Softomation’s turnover would seem quite low. But these are early days and it is perhaps premature to expect full utilization. Asset turnover should improve as Softomation gets more business in future. Are Softomation’s customers taking too long to pay? Softomation’s receivables are 40 per cent of sales (8,000/20,000). Note that the receivables relate to the sale on March 29 and it is possibly due next month or even later. It would be useful to know whether Softomation offers more generous credit than its industry peers in its anxiety to win business. Will Softomation be able to pay its suppliers on time? Softomation owes its suppliers `4,000. It can pay the amount comfortably from the cash of `15,200. Is Suresh earning a reasonable return on his investment? The owner’s performance need not be the same as his firm’s. On Suresh’s investment `58,900 the business earned a profit of `13,400. The return on equity, the ratio of profit to equity, is 23 per cent (13,400/58,900). This would appear to be remarkable. Note that the return on equity would come down if the loan carried interest. Does Suresh have sufficient ‘skin in the game’? We would like to know if Suresh is in this business for the long haul. Suresh’s ‘skin in the game’ is the equity of `58,900. His borrowings are `20,000. The debt-to-equity ratio, the ratio of borrowed funds to own funds, is a measure of the dependence of the business on borrowings and the owner’s commitment to the business. Softomation’s debt-to-equity ratio is 0.34:1 (20,000/58,900). So the business is not too much dependent on debt. Suresh will bear the brunt of any setback to the business and therefore he has every reason to be responsible in running the business. This should be reassuring to Softomation’s lenders, suppliers, customers, creditors and employees. Another way to think about the owner’s commitment is to find out what portion of the profit he takes out of the business. Suresh withdrew `4,500 of Softomation’s profit of `13,400. The payout ratio, the ratio of dividend to profit, is 34 per cent. While this can’t be regarded as excessive, payouts are rare at the early stages of a business. A high payout would raise questions about the owner’s faith in the prospects of the business. For this reason, venture capital firms do not look at payouts too kindly. Is Softomation’s profit ‘real’? There is no suggestion that Suresh might have fudged Softomation’s books. We trust his numbers. Rather, we would like to know whether the profit is in cash. The operations produced a net cash of `6,700 vs. profit of `13,400. The ratio of cash flow from operations to profit can tell us whether the profits are real. Softomation’s ratio is just 50 per cent (6,700/13,400). High receivables is the major explanation for the large gap between the two numbers. It simply means that revenue and profit are mostly stuck in receivables. We should wait to see if the gap closes as customers start paying and the business reaches steady state. What are Softomation’s risks? We can see three risks. First, the equipment is nearly 70 per cent of the investment. No doubt, the equipment will produce sales but it will take time. If the business slows down, Softomation will be stuck with equipment that may not have a ready market. Or it may have to sell the equipment at a distress price. Second, we don’t know the terms of the loan, such as when it is repayable and whether it carries interest. If repayment is spread over several years, there is no immediate cause for concern. However, if the loan is repayable in the next few months or on demand, the cash would be insufficient. Finally, the cash available may look good. But what if there had been no loan? Softomation would have faced a cash deficit. To see why, do a quick “what if” analysis by knocking off the cash receipt from the loan in the statement of cash flows. FORM AND CONTENT OF COMPANY FINANCIAL STATEMENTS Schedule III to the Companies Act 2013 specifies the form of financial statements for companies. Companies reporting under Accounting Standards must follow the form specified in Division I to Schedule III. Listed companies and some unlisted companies reporting under Ind AS must follow the form specified in Division II. We will now see the form and content of Ind AS consolidated statements. Balance Sheet The balance sheet has three sections: (1) assets, (2) liabilities, and (3) equity. It follows the accounting equation, Assets = Liabilities + Equity, except that equity comes before liabilities. The items within assets, liabilities and equity follow the order of permanency. Thus, items that are expected to be with the business for relatively longer periods come first and those that are expected to be converted into cash relatively quickly appear later. Assets consist of non-current assets and current assets. Non-current assets are kept for use in the company’s business and not for conversion into cash as part of the operations. These include long-term assets, such as tangible assets, intangible assets, financial assets and deferred tax assets. Tangible assets: Property, plant and equipment consists of land, buildings, plant and machinery, office equipment, computers, furniture and vehicles. Capital work-in-progress is facilities that are under construction. Intangible assets include goodwill, software, sub-contracting rights, and intellectual property rights (e.g. copyrights and patents). Financial assets are contractual rights to receive definite amounts. Examples are long-term investments, trade receivables and loans. Deferred tax assets result from differences between accounting profit  and taxable profit that are expected to be realized in future periods. Current assets are regularly converted into cash as part of the operations or within 12 months from the balance sheet date. These include inventories and financial assets. Inventories include raw materials, semi-finished products and finished goods. Financial assets include cash, short-term investments and trade receivables. Equity includes of equity share capital and other equity. Equity share capital represents the original and subsequent shares issued to the shareholders. Other equity includes retained earnings, i.e. profit not distributed to shareholders. Non-controlling interest refers to the interests of minority shareholders in the company’s subsidiaries. Liabilities consist of non-current liabilities and current liabilities. Non-current liabilities are payable after one year from the balance sheet date. These include financial liabilities, provisions and deferred tax liabilities. Financial liabilities are contractual obligations to pay definite amounts, e.g. borrowings. Provisions include estimated employee benefits payable such as gratuity, pensions and paid leave. Deferred tax liabilities result from differences between accounting profit and taxable profit that are expected to be paid in future periods. Current liabilities are payable as part of the operations or within one year from the balance sheet date. These include financial liabilities, provisions and income tax liabilities. Financial liabilities include trade payables, bills payable and security deposits payable. Provisions include estimated employee benefits payable such as gratuity, pensions and paid leave. Current tax liabilities is income tax payable for the current period. Statement of Profit and Loss The statement of profit and loss has three sections: (1) income (top line), (2) expenses (middle line), and (2) profit (bottom line). Income consists of revenue from operations and other income. Revenue from operations, or turnover, is revenue from sale of goods and services. Other income includes interest, dividend and other non-operating income. Expenses include cost of materials consumed, employee benefits expense, finance costs, depreciation and amortization expense, and other expenses. Cost of materials consumed is the cost of raw materials used up in the  operations. Purchases of stock in trade refers to the purchase of finished goods for resale. Changes in inventories of finished goods, stock-in-trade and work-in- progress refers to the increase or decrease in these over the reporting period. Employee benefits expense includes employees’ salaries and other benefits. Finance costs include interest and other borrowing costs. Depreciation and amortization expense is the charge for the use of non- current assets. Other expenses consist of expenses not mentioned above. Examples are repairs and maintenance, power and fuel, advertising and sales promotion, and insurance. Tax expense refers to income tax. Profit for the period = Income – Expenses. Other comprehensive income items are gains and losses not included in income and expenses. Comprehensive income is the sum of profit and other comprehensive income. Statement of Changes in Equity The statement of changes in equity describes changes in equity including share capital and retained earnings. Equity share capital is increased by issue of additional shares and decreased by share buyback. Retained earnings is increased by profit for the period and decreased by loss for the period and dividends. Other comprehensive income changes as a result of gains and losses. Statement of Cash Flows The statement of cash flows has three sections: operating, investing, and financing. Operating activities are for production of goods and services. Investing activities relate to acquisition and disposal of long-term assets and investments. Financing activities result in changes in equity and borrowings. Financial statements tell the story of a business in numbers. At this stage, your aim should be to get an overview of the financial statements. You will study the principles and procedures followed in the preparation, analysis and interpretation of the financial statements in later chapters. You will find it greatly useful to keep referring to company annual reports as you progress through this book. Appendix B has the financial statements of Dr. Reddy’s Laboratories Limited. QUICK QUESTION Profit and cash flow Why do profit and cash flow from operating activities differ?. QUICK QUESTION Statement of cash flows Where would you expect to find purchase of property, plant and equipment in the statement of cash flows? DISCUSSION Do the financial statements omit some important assets of a business? QUESTION 2.3....................................................................................................................................................................................................................................... Until the early 1990s, the company annual report was a simple document with the financial statements, the directors’ report, the chairman’s statement and the auditors’ report. Back then, annual reports hardly exceeded 30 pages. Over the years, reports have become much longer. Consider the size of the annual reports of some well-known companies for the year 2016. Company Number of Pages Larsen & Toubro Limited 412 Reliance Industries Limited 404 Oil and Natural Gas Corporation Limited 396 Bharti Airtel Limited 360 Tata Steel Limited 300 State Bank of India 290 Tata Motors Limited 288 Bharat Heavy Electricals Limited 276 ICICI Bank Limited 252 HDFC Bank Limited 220 Hindustan Unilever Limited 208 Still, Indian investors have reason to be grateful, because some foreign companies have much longer reports. For instance, the Deutsche Bank’s 2015 annual report runs to more than 600 pages. It is highly doubtful whether any investor, professional or lay, ever reads the full report. The reports have lots of photographs and charts. The text is full of jargon and acronyms, much of which would be unintelligible to many shareholders. There is hardly any meaningful analysis of performance. Increasingly, annual reports have become public relations documents and are, indeed, written by PR companies. Soon, shareholders may be required to attend a speed reading course and preferably acquire a degree in jargon. The annual report should communicate. These days it is used more to impress and obfuscate. It is never a bad idea to be on your guard, particularly when you are looking at numbers churned out by individuals who may have an axe to grind, endorsed by worthies who may not understand them and certified by those who may be heavily conflicted (managers, directors and auditors, since you ask). Financial statements don’t come with the caveat “Fraudulent accounting not ruled out here”. The Russian saying “Trust, but verify” is sound advice for all those who use financial statements. You should actively look for “red flags”, unusual trends and patterns that may indicate deeper problems warranting further investigation. Red flags don’t necessarily imply fraud, but ignoring them would be risky. Here are a few red flags that should make you pause, think and question: Qualified audit report: Audit reports are usually written as boilerplate. That is all the more reason why you should be sceptical when the auditors cite concerns, reservations or disagreements. Auditor resignation or removal: Auditors don’t give up or turn down clients unless there is a serious dispute. They may quit when they are pressured to go along with aggressive accounting, or they think the control systems are weak and their risk is unacceptably high, or they are not given relevant information. Management may remove auditors who are unwilling to bend the rules. Audit committee chair or independent director resignation: The audit committee chair or an independent director usually resigns only when they fundamentally disagree with the management on a vital matter. CFO resignation: CFOs may leave for justifiable reasons, such as better career, health problems, spouse’s job, children’s education, less polluted city and so on. Sometimes they resign because of a difference of opinion with the management over business decisions and financial reporting matters. Contravention of the law: Good citizens follow the law scrupulously. Run-ins with the police may indicate a fatal flaw in one’s character. Persistent problems with the law enforcement agencies, such as tax authorities, anti- corruption or anti-money laundering agencies, or regulators may be the proverbial tip of the iceberg. It is highly improbable that companies that have suppressed tax or paid bribes are holy when it comes to accounting. Promise of excessively high profitability: Companies in highly competitive industries must struggle to earn a decent profit. Monopolies are severely constrained by rules on profitability. So a business offering excessively high returns to investors should explain credibly where its profits come from.  Payment problems: Persistent default in paying suppliers and employees may be a sign of sales or profitability problems. Downgrading of credit rating is an important indicator of cash flow mismatch or excessive debt. High performance pressure and huge financial incentives: Performance- based pay cuts both ways. In good times it encourages people to do their best. In bad times it brings out the worst in them. Companies that award highly differentiated bonuses run the risk of fraudulent reporting. Lead indicators such as payment problems and aggressive organizational culture are particularly useful in avoiding or substantially reducing the loss caused by fraud. The accounting equation states that at a given time, the sum of assets must equal the sum of liabilities and equity: Assets = Liabilities + Equity. The equation helps us to understand the effect of transactions. There are four major financial statements: The balance sheet presents an enterprise’s assets, liabilities and equity. The statement of profit and loss lists an enterprise’s revenues and expenses. The statement of changes in equity describes the changes in the components of equity. The statement of cash flows lists the major items of cash receipts and cash payments. There is no specific form for the financial statements of proprietorship and partnership businesses. Companies must prepare their financial statements following the requirements of Schedule III to the Companies Act. Key items in the financial statements are as follows: Balance sheet: Assets: Non-current assets; Current assets Balance sheet: Equity: Equity share capital; Other equity. Non-controlling interests Balance sheet: Liabilities: Non-current liabilities; Current liabilities Statement of profit and loss: Income: Revenue from operations; Other income Statement of profit and loss: Expenses: Raw materials consumed; Employee benefits; Interest; Depreciation and amortization; Tax Statement of profit and loss: Profit for the period; Other comprehensive income; Comprehensive income Statement of changes in equity: Equity share capital; Retained earnings; Other comprehensive income Statement of cash flows: Operating activities; Investing activities; Financing activities REVIEW PROBLEM On January 1, 20XX, Manohar started QualPhoto Company. The following transactions took place during the first month: Jan. 1 Manohar invested `30,000 cash in the company’s share capital (shares of `10 each). 2 Bought supplies of photographic materials on credit, `9,000.  (i) Paid salaries, `5,000. Required Analyze the effect of the transactions on the related asset, liability and equity items. On August 1, 20XX, Satish Pande set up Trust Labs Company. The following transactions took place during the first month: (a) Pande invested `20,000 cash in the company’s share capital. (b) Took a bank loan, `10,000. (c) Bought equipment for cash, `12,000. (d) Bought supplies for cash, `3,000. (e) Billed customers for services, `9,000. (f) Provided services for cash, `10,000. (g) Paid sales commission, `1,000. (h) Paid profession tax, `500. (i) Collected payments for past invoices, `7,000. (j) Repaid a part of the bank loan, `6,000. (k) Paid interest on bank loan, `150. Required 1. Analyze the effect of the transactions on the related asset, liability and equity items. 2. Calculate the profit for August 20XX. On January 1, 20XX, Ajay Joshi set up Fly-by-Night Delivery Company. The following transactions took place during the first month: (a) Joshi invested `10,000 cash in the company’s share capital. (b) Bought a car for cash, `8,000. (c) Filled petrol for `1,000 on payment of `800; balance to be paid in two weeks. (d) Received advance payment from a customer, `1,000. (e) Bought office supplies on credit, `3,000. (f) Received cash for services provided, `8,000. (g) Billed customers for services, `6,200. (h) Paid office rent, `4,000. (i) Paid the amount due in (c). (j) Collected payment from customers billed in (g), `4,900. (k) Provided services to the customer in (d). Required 1. Analyze the effect of the transactions on the related asset, liability and equity items. 2. Calculate the profit for January 20XX. In June 20XX, Prasanna set up a debt rating service as a sole proprietorship. At the end of the month, the business had the following balances: Cash, `3,000; Trade Receivables, `2,000; Office Supplies, `1,000; Office Equipment, `5,000; Trade Payables, `1,000; Prasanna’s Capital, `10,000. The following transactions took place in July: (a) Paid June salaries, `400. (b) Billed clients for services, `2,000. (c) Bought office equipment for cash, `1,000. (d) Bought office supplies on credit, `100. (e) Withdrew cash for personal use, `1,000. (f) Provided services for cash, `18,000. (g) Prasanna invested in the business, `15,000. (h) Collected payments for past invoices, `1,500. (i) Paid electricity expense, `300. (j) Paid for past purchases of office supplies, `500. (k) Paid July salaries, `400. Required 1. Enter the beginning balances. 2. Analyze the effect of the transactions on the related asset, liability and equity items. 3. Calculate the profit for June 20XX. In November 20XX, Asif Mandiwala set up a weather forecasting service. At the end of the month, he had the following balances: Cash, `4,100; Trade Receivables, `3,400; Office Supplies, `1,100; Office Equipment, `10,000; Bank Loan Payable, `1,900; Mandiwala’s Capital, `16,700. The following transactions took place in December: (a) Provided services on credit, `6,100 (b) Took a bank loan, `6,000. (c) Paid himself office rent, `1,000. (d) Collected payments from clients billed in November, `2,800. (e) Used office supplies for business purposes, `300. (f) Provided services for cash, `2,800. (g) Paid interest on bank loan, `100. (h) Bought office supplies for cash, `800. (i) Billed customers for services, `1,700. (j) Cancelled a bill in (i) because of customer complaint, `100. (k) Paid staff salaries for November, `1,600. Required 1. Enter the beginning balances. 2. Analyze the effect of the transactions on the related asset, liability and equity items. 3. Calculate the profit for December 20XX. On February 1, 20XX, Arati Naik started Fête Company, a wedding planning service. The company had the following transactions in February: (a) Naik invested `14,000 cash in the company’s share capital. (b) Bought two pieces of office equipment for cash, `6,000. (c) Provided services for cash, `9,000. (d) Bought office supplies on credit, `1,500. (e) Billed customers for services, `7,500. (f) Used office supplies, `800. (g) Collected payment from customers billed in (e), `6,800. (h) Paid for office supplies bought in (d) on account, `1,200. (i) Billed customers for services, `2,100. (j) Paid Naik’s salary, `6,000. (k) Paid office rent for February, `600. The following transactions took place in March 20XX: (a) Paid office rent for March, `600. (b) Collected payments for February bills, `1,900. (c) Bought office supplies on credit, `3,000. (d) Billed clients for services, `18,300. (e) Used office supplies, `2,300. (f) Issued shares to a friend for cash, `12,000. (g) Bought office equipment for cash, `12,000. (h) Paid for office supplies bought on credit, `3,100. (i) Paid assistants’ salaries, `6,200. (j) Paid Naik’s salary, `6,000. (k) Paid a dividend, `1,900. Required 1. Analyze the effect of the transactions in February 20XX on the related asset, liability and equity items. 2. Prepare the company’s February 20XX balance sheet, statement of profit and loss, statement of changes in equity and statement of cash flows. 3. Enter the beginning balances for March 20XX. 4. Analyze the effect of the transactions in March 20XX on the related asset, liability and equity items. 5. Prepare the company’s March 20XX balance sheet, statement of profit and loss, statement of changes in equity and statement of cash flows. Sampath failed the school final exam and ran away from home. He started working as a building assistant earning between `10,000 and `15,000 a month. The job was uninteresting and strenuous. Soon he learnt driving and joined a leading car fleet on revenue-sharing terms. His monthly earnings averaged `20,000. On April 1, 20XX, he started Point Cabs, his own taxi business. He took a bank loan of `500,000 and invested his savings of `100,000 to buy a car costing `600,000. In addition, he invested `18,000 for meeting day-to-day cash needs. All cash receipts and payments were through his bank account. Sampath scribbled his activities in a rough notebook. The following are the entries for April: April 1 Started business with savings of `118,000. 1 Took a bank loan of `500,000 to be repaid in monthly instalments of `10,000 with interest at 18 per cent per annum. 1 Bought a car for cash, `600,000. 1 Bought an airport parking licence for April, `10,000. 1 Paid for fuel, `3,600. 2 Collected from customers, `1,700. 3 Collected from customers, `1,100. 4 Collected from customers, `1,300. 5 Collected from customers, `3,100. 6  Collected from customers, `1,200. 7 Collected from customers, `1,600. 8 Paid for fuel, `6,100. 8 Collected from customers, `2,400. 9 Collected from customers, `2,200. A customer did not pay a bill of `900 and will pay next month. 10 Collected from customers, `1,300. 11 Collected from customers, `1,700. 11 Bought a mobile phone for cash for business use, `12,000. 12 Collected from customers, `1,100. 13 Collected from customers, `1,800. 14 Collected from customers, `1,100. 15 Collected from customers, `600. 15 Paid for fuel, `5,300. 16 Collected from customers, `1,800. 17 Collected from customers, `1,900. 17 Paid a fine for speeding, `500. 18 Collected from customers, `1,100. 19 Collected from customers, `1,100. 20 Collected from customers, `4,500. 21 Paid for fuel, `3,400. 21 Collected from customers, `4,400. 22 Collected from customers, `2,100. 23 Collected from customers, `2,600. 24 Collected from customers, `2,900. 25 Collected from customers, `3,700. Change of `120 not returned will be adjusted next time. 26 Collected from customers, `3,100. 27 Filled fuel for `3,920 and paid `3,240. The balance will be paid next time. 27 Collected from customers, `3,200. 28 Collected from customers, `2,900. 29 Repaired a side-view mirror damaged in an accident, `750. 29 Collected from customers, `4,700. 29 Paid taxi drivers’ union subscription for the month, `500. 30 Collected from customers, `4,100. 30 Withdrew for personal purposes, `11,200. 30 Paid substitute driver’s salary, `8,000. 30 Earned interest of `130 on bank balance. 30 Paid the bank, `17,500. Required 1. Analyze the effects of the transactions on the accounting equation. 2. Prepare the financial statements for April 20XX. 3. Evaluate the performance of the business. On August 1, 20XX, Ajay and Jeevan quit as senior executives in a mutual fund to set up MoneyCare Company, an investment advisory service. Each of them deposited `50,000 in MoneyCare’s bank account in exchange for 5,000 shares. Also, they raised an interest-free loan of `20,000 for the company from their friend. They rented an office for the company in the city, costing `5,000 per month payable on the last day of the month. At the landlord’s insistence, they paid a deposit of `70,000, refundable on MoneyCare vacating the place. They leased two computers for one year on a monthly rental of `6,000 per computer and subscribed to a financial database for a fee of `11,000 per month. Computer rental and database fee were payable at the beginning of the month. They appointed a secretary on a monthly salary of `9,000 and an assistant on a monthly salary of `5,000. Depending on their credit rating, MoneyCare’s customers paid in one of the following ways: 1. Before receiving service. 2. Immediately on receiving service. 3. Within one month after receiving service. During August, MoneyCare provided services for `70,800 and raised invoices with the following payment terms: Fifteen customers with invoices totalling `62,100 could pay until end of September. Two customers with invoices totalling `8,700 had to pay immediately. MoneyCare’s other transactions in August were as follows: Paid computer rental, database fee, office rent and salaries as agreed. Received from customers amounts totalling `24,100 including `15,400 from customers who chose to pay early. Paid for office supplies costing `1,800 but did not use them. Received `9,000 from a customer for service to be provided in September. Earned interest income of `460 on the bank account. Required 1. Prepare MoneyCare’s financial statements for August. 2. What do you think of the company’s financial performance? Jet Airways (India) Ltd. is a major airline in India. The following items appeared in the company’s recent financial statements: 1. Aircraft fuel consumed 2. Employee benefits 3. Deferred tax liability 4. Travel agents’ commission 5. Purchase of investments 6. Provision for gratuity 7. Proceeds from sale of fixed assets 8. Net cash from operating activities 9. Share capital 10. Repayment of term loans and subordinated debt 11. Interest and finance charges 12. Frequent flyer points not availed of 13. Inventories 14. Aircraft lease rental 15. Wealth tax paid 16. Capital expenditure – aircraft and others 17. Dividend paid 18. Short-term borrowings 19. Unpaid dividend 20. Deposit with service tax department Required 1. Identify the financial statement – balance sheet, statement of profit and loss, statement of changes in equity, or statement of cash flows – in which you would expect to see each of the items and indicate whether it is a revenue, expense, asset, liability, equity, operating cash flow, investing cash flow, or financing cash flow. 2. Give any five items that do not appear in the above list but you would expect to see in the financial statements. 3. Verify your answers with the help of the information in the financial statements. Look through the financial statements of five companies, all from different industries. Required 1. Identify items in the financial statements that are special to each company. 2. Read the notes to the financial statements to see if they explain the items adequately. Read the auditors’ reports of 25 companies. Your sample should have Indian (private sector and public sector) and foreign (US, UK, Australian) companies. Required 1. Identify the key points from these reports and compare them across companies and countries. 2. Write in your own words what you understand from the reports. 3. In your opinion, what additional information would be useful to investors? 4. Interview auditors to find out whether they agree with your understanding of the reports and why their reports do not give the additional information. Answers to One-minute Quiz 2.1 a, b. 2.2 a, c. 2.3 b, d. (Note: Dividend payable is an equity item because it is payable to owners, not creditors.) 2.4 b. 2.5 c. Answers to Test Your Understanding 2.1 (a) Bought a building on credit; (b) Collected trade receivables; (c) Owner invested capital in cash; (d) Paid trade payables; (e) Owner withdrew cash from business for personal purposes. 2.2 Net profit = EquityDec. 31, 20X2 – EquityDec. 31, 20X1 – Investments20X2 + Drawings20X2 = (`99,000 – `71,000) – (`85,000 – `67,000) – `35,000 + `24,500 = Net loss, `500.