SYBCOM Management Acc. PDF

31 S.Y.B.COM. Elective Courses (EC) Discipline Specific Elective (DSE) Courses FinancialAccounting andAuditing (Introduction to Management Accounting andAuditing)  © UNIVERSITY OF MUMBAI Dr. Suhas Pednekar...

31 S.Y.B.COM. Elective Courses (EC) Discipline Specific Elective (DSE) Courses FinancialAccounting andAuditing (Introduction to Management Accounting andAuditing)  © UNIVERSITY OF MUMBAI Dr. Suhas Pednekar Vice-Chancellor University of Mumbai, Mumbai Dr. Kavita Laghate Anil R Bankar Professor Cum Director, Associate Prof. of History & Asst. Director & Institute of Distance & Open Learning, Incharge Study Material Section, University of Mumbai, Mumbai IDOL, University of Mumbai, Mumbai Course and Programme : Dr. Madhura Kulkarni Co-ordinator Asst. Professor in Accountancy, IDOL, University of Mumbai, Mumbai-400 098 Re-Editor : Dr. Paras Jain M.D.College of Arts, Science & Commerce, Parel, Mumbai Course Writer : Dr. Madhura Kulkarni Asst. Professor in Accountancy, IDOL, University of Mumbai, Mumbai-400 098 : Prof. V.H. Koppa Gharkul, Mumbai - Goa Road, Shivaji Nagar, Chiplun - 415605 : Dr. Sandeep Poddar S.N.D.T. College of Arts, Commerce & Science J.B. Nagar, Andheri (E), Mumbai - 400059 : Dr. Natika Poddar St. Francis Institute of Management & Research S.V. Road, Borivli (W), Mumbai : Dr. S.D. Ovhal Siddharth College of Commerce and Economics Fort, Mumbai - 400023 January 2020, S.Y.B.COM., Elective Courses (EC), Discipline Specific Elective (DSE) Courses, Financial Accounting & Auditing, (Introduction to Management Accounting & Auditing) Published by : Director Incharge, Institute of Distance and Open Learning , University of Mumbai, Vidyanagari, Mumbai - 400 098. DTP Composed : AshwiniArts Gurukripa Chawl, M.C. Chagla Marg, Bamanwada, Vile Parle (E), Mumbai Printed by :  CONTENTS Unit No. Title Page No. SECTION I MODULE - 1 1. Introduction to Management Accounting 01 2. Analysis and Interpretation of Financial Statements 10 3. Tools of Analysis of Financial Statements 38 MODULE - 2 4. Ratio Analysis and Interpretation - I 56 5. Ratio Analysis and Interpretation - II 78 MODULE - 3 6. Working Capital Management - I 95 7. Working Capital Management - II 105 MODULE - 4 8. Capital Budgeting 120 SECTION II MODULE - 5 9. Introduction to Auditing 139 10. Types of Audit 161 MODULE - 6 11. Audit Planning and Procedures and Documentation 175 MODULE - 7 12. Auditing Techniques 195 MODULE - 8 13. Auditing Technique Vouching 223 14. Auditing Technique Verification 242   I Institute of Distance and Open Learning Revised Syllabus S. Y. B.Com. With Effect from the Academic Year 2019-20 Elective Courses (EC) Discipline Specific Elective (DSE) Courses Financial Accounting and Auditing – (Introduction to Management Accounting and Auditing) SECTION I Modules at a Glance Sr. No. Modules 1 Introduction to Management Accounting 2 Ratio Analysis and Interpretation 3 Working Capital Management 4 Capital Budgeting Sr. Modules No. 1 Introduction to Management Accounting A. Introduction to Management Accounting – Meaning, Nature, Scope, Functions, Decision Making Process, Financial Accounting V/s Management Accounting B. Analysis and Interpretation of Financial Statements i) Study of Balance sheet and Income statement / Revenue statements in vertical form suitable for analysis ii) Relationship between items in Balance Sheet and Revenue statement iii) Tools of analysis of Financial Statements (i) Trend analysis (ii) Comparative Statement (iii) Common Size Statement Note : (i) Problems based on trend analysis (ii) Short Problems on Comparative and Common sized statements 2 Ratio Analysis and Interpretation (Based on Vertical Form of Financial statements) – Meaning, classification, Du Point Chart, advantages and Limitations) A. Balance Sheet Ratios : i) Current Ratio ii) Liquid Ratio  II iii) Stock Working Capital Ratio iv) Proprietary Ratio v) Debt Equity Ratio vi) Capital Gearing Ratio B. Revenue Statement Ratio: i) Gross Profit Ratio ii) Expenses Ratio iii) Operating Ratio iv) Net Profit Ratio v) Net Operating Profit Ratio vi) Stock Turnover Ratio C. Combined Ratio : i) Return on capital employed (Including Long Term Borrowings) ii) Return on proprietor's Fund (Shareholders Fund and Preference Capital) iii) Return on Equity Capital iv) Dividend Payout Ratio v) Debt Service Ratio vi) Debtors Turnover vii) Creditors Turnover (Practical Question on Ratio Analysis) 3 Working Capital Management (Practical Questions) A. Concept, Nature of Working Capital , Planning of Working Capital B. Estimation / Projection of Working Capital Requirement in case of Trading and Manufacturing Organization C. Operating Cycle 4 Capital Budgeting A. Introduction: B. The classification of capital budgeting projects C. Capital budgeting process D. Capital budgeting techniques - Payback Period, Accounting Rate of Return, Net Present Value, The Profitability Index, Discounted Payback. (Excluding calculation of cash flow)  III SECTION II Sr. No. Modules 5 Introduction to Auditing 6 Audit Planning, Procedures and Documentation 7 Auditing Techniques and Internal Audit Introduction 8 Auditing Techniques : Vouching & Verification Sr. Modules No. 5 Introduction to Auditing A. Basics – Financial Statements, Users of Information, Definition of Auditing, Objectives of Auditing, Inherent limitations of Audit, Difference between Accounting and Auditing, Investigation and Auditing. B. Errors & Frauds – Definitions, Reasons and Circumstances, Types of Error, Types frauds, Risk of fraud and Error in Audit, Auditors Duties and Responsibilities in case of fraud. C. Principles of Audit, Materiality, True and Fair view D. Types of Audit – Meaning, Advantages, Disadvantages of Balance sheet Audit, Interim Audit, Continuous Audit, Concurrent Audit and Annual Audit, Statutory Audit 6 Audit Planning, Procedures and Documentation A. Audit Planning – Meaning, Objectives, Factors to be considered, Sources of obtaining information, Discussion with Client, Overall Audit Approach B. Audit Program – Meaning, Factors, Advantages and Disadvantages, Overcoming Disadvantages, Methods of Work, Instruction before commencing Work, Overall Audit Approach. C. Audit Working Papers – Meaning, importance, Factors determining Form and Contents, Main Functions / Importance, Features, Contents of Permanent Audit File, Temporary Audit File, Ownership, Custody, Access of Other Parties to Audit Working Papers, Auditors Lien on Working Papers, Auditors Lien on Client’s Books. 7 Auditing Techniques and Internal Audit Introduction A. Test Check – Test Checking Vs Routing Checking, test Check meaning, features, factors to be considered,  IV when Test Checks can be used, advantages, disadvantages, precautions. B. Audit Sampling – Audit Sampling, meaning, purpose, factors in determining sample size – Sampling Risk, Tolerable Error and expected error, methods of selecting Sample Items Evaluation of Sample Results auditors Liability in conducting audit based on Sample C. Internal Control – Meaning and purpose, review of internal control, advantages, auditors duties, review of internal control, Inherent Limitations of Internal control, internal control samples for sales and debtors, purchases and creditors, wages and salaries. Internal Checks Vs Internal Control, Internal Checks Vs Test Checks. D. Internal Audit : Meaning, basic principles of establishing Internal audit, objectives, evaluation of internal Audit by statutory auditor, usefulness of Internal Audit, Internal Audit Vs External Audit, Internal Checks Vs Internal Audit 8 Auditing Techniques : Vouching & Verification A. Audit of Income : Cash Sales, Sales on Approval, Consignment Sales, Sales Returns Recovery of Bad Debts written off, Rental Receipts, Interest and Dividends Received Royalties Received B. Audit of Expenditure : Purchases, Purchase Returns, Salaries and Wages, Rent, Insurance Premium, Telephone expense Postage and Courier, Petty Cash Expenses, Travelling Commission Advertisement, Interest Expense C. Audit of Assets Book Debts / Debtors, Stocks – Auditors General Duties; Patterns, Dies and Loose Tools, Spare Parts, Empties and Containers Quoted Investments and Unquoted Investment Trade Marks / Copyrights Patents Know-How Plant and Machinery Land and Buildings Furniture and Fixtures D. Audit of Liabilities : Outstanding Expenses, Bills Payable Secured loans Unsecured Loans, Contingent Liabilities Reference Text: 1. Cost and Management Accounting - Colinn Dury 7th Edition 2. Cost and Management Accounting- Dbarshi Bhattacharyya pearson Publications 2013 edition 3. Management Accounting - M.Y.Khan 4. Management Accounting - I.M.pandey   V Question Paper Pattern Question Particular Marks No Q-1 Objective Questions 20 A) Sub Questions to be asked 12 and to be Marks answered any 10 B) Sub Questions to be asked 12 and to be answered any 10 (*Multiple choice / True or False / Match the columns/Fill in the blanks) Q-2 Full Length Question 15 Marks OR Q-2 Full Length Question 15 Marks Q-3 Full Length Question 15 Marks OR Q-3 Full Length Question 15 Marks Q-4 Full Length Question 15 Marks OR Q-4 Full Length Question 15 Marks Q-5 Full Length Question 15 Marks OR Q-5 Full Length Question 15 Marks Q-6 A) Theory questions 10 Marks B) Theory questions 10 Marks OR Q-6 Explain the terms 20 Marks To be asked Twelve To be answered Ten   1 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Unit Structure : 1.0 Objectives 1.1 Introduction 1.2 Meaning and Nature of Management Accounting 1.2.1 Meaning and Definition 1.2.2 Nature of Management Accounting 1.3 Function of Management Accounting 1.4 Scope of Management Accounting 1.5 Difference between Management Accounting and Financial Accounting 1.6 Exercise 1.0 OBJECTIVES After studying the unit the students will be able to:  Define the term Management accounting.  Explain the nature and functions of Management Accounting  Discuss the role of management accountant.  Explain the difference between Management accounting and financial accounting.  Understand the limitations of MA. 1.1 INTRODUCTION Management accounting can be viewed as Management-oriented Accounting. Basically it is the study of managerial aspect of financial accounting, "accounting in relation to management function”. It shows how the accounting function can be re-oriented so as to fit it within the framework of management activity. The primary task of management accounting is, therefore, to redesign the entire accounting system so that it may serve the operational needs of the firm. If furnishes definite accounting information, past, present or future, which may be used as a basis for management action. The financial data are so devised and systematically development that they become a unique tool for management decision.  2 1.2 MEANING AND NATURE OF MANAGEMENT ACCOUNTING 1.2.1 Meaning and Definition The term "Management Accounting”, observes Broad and Carmichael covers all those services by which the accounting department can assist the top management and other departments in the formation of policy, control of execution and appreciation of effectiveness. The Report of the Anglo-American Council of Productivity (1950) has also given a definition of management accounting, which has been widely accepted. According to it, "Management accounting is the presentation of accounting information in such a way as to assist the management in creation of policy and the day to day operation of an undertaking". The reasoning added to this statement was, "the technique of accounting is of extreme importance because it works in the most nearly universal medium available for the expression of facts, so that facts of great diversity can be represented in the same picture. It is not the production of these pictures that is a function of management but the use of them." An analysis of the above definition shows that management needs information for better decision-making and effectiveness. The collection and presentation of such information come within the area of management accounting. Thus, accounting information should be recorded and presented in the form of reports at such frequent intervals, as the management may want. These reports present a systematic review of past events as well as an analytical survey of current economic trends. Such reports are mainly suggestive in approach and the data contained in them are quite up to date. The accounting data so supplied thus provide the informational basis of action. The quality of information so supplied depends upon its usefulness to management in decision-making. 1.2.2 Nature of Management Accounting Following points explains the nature of Management Accounting: 1. The term management accounting is composed of 'management' and 'accounting'. The word 'management' here does not signify only the top management but the entire personnel charged with the authority and responsibility of operating an enterprise. 2. The task of management accounting involves furnishing accounting information to the management, which may base its decisions on it. 3. It is through management accounting that the management gets the tools for an analysis of its administrative action and can lay suitable stress on the possible alternatives in terms of costs,  3 prices and profits, etc. but it should be understood that the accounting information supplied to management is not the sole basis for managerial decisions. 4. Along with the accounting information, management takes into consideration or weighs other factors concerning actual execution. For reaching a final decision, management has to apply its common sense, foresight, knowledge and experience of operating an enterprise, in addition to the information that is already has. 5. The word 'accounting' used in this phrase should not lead us to believe that it is restricted to a mere record of business transactions i.e., book keeping only. 6. Management accounting has no set principles such as the double entry system of bookkeeping. In place of generally accepted accounting principles, the philosophy of cost benefit analysis is the core guide of this discipline. It says that no accounting system is good or bad but is can be considered desirable so long as it brings incremental benefits in excess of its incremental costs. 1.3 FUNCTIONS OF MANAGEMENT ACCOUNTING The basic function of management accounting is to assist the management in performing its functions effectively. The functions of the management are planning, organizing, directing and controlling. Management accounting helps in the performance of each of these functions in the following ways: 1. Provides data: Management accounting serves as a vital source of data for management planning. The accounts and documents are a repository of a vast quantity of data about the past progress of the enterprise, which are a must for making forecasts for the future. 2. Modifies data: The accounting data required for managerial decisions is properly compiled and classified. For example, purchase figures for different months may be classified to know total purchases made during each period product-wise, supplier-wise and territory-wise. 3. Analyses and interprets data: The accounting data is analyzed meaningfully for effective planning and decision-making. For this purpose the data is presented in a comparative form. Ratios are calculated and likely trends are projected. 4. Serves as a means of communicating: Management accounting provides a means of communicating management plans upward, downward and outward through the organization. Initially, it means identifying the feasibility and consistency of the various segments of the plan. At later stages it keeps all parties  4 informed about the plans that have been agreed upon and their roles in these plans. 5. Facilitates control: Management accounting helps in translating given objectives and strategy into specified goals for attainment by a specified time and secures effective accomplishment of these goals in an efficient manner. All this is made possible through budgetary control and standard costing which is an integral part of management accounting. 6. Uses also qualitative information: Management accounting does not restrict itself to financial data for helping the management in decision making but also uses such information which may not be capable of being measured in monetary terms. Such information may be collected form special surveys, statistical compilations, engineering records, etc. 1.4 SCOPE OF MANAGEMENT ACCOUNTING Management accounting is concerned with presentation of accounting information in the most useful way for the management. Its scope is, therefore, quite vast and includes within its fold almost all aspects of business operations. However, the following areas can rightly be identified as falling within the ambit of management accounting: 1. Financial Accounting: Management accounting is mainly concerned with the rearrangement of the information provided by financial accounting. Hence, management cannot obtain full control and coordination of operations without a properly designed financial accounting system. 2. Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential costing and other cost techniques play a useful role in operation and control of the business undertaking. 3. Revaluation Accounting: This is concerned with ensuring that capital is maintained intact in real terms and profit is calculated with this fact in mind. 4. Budgetary Control: This includes framing of budgets, comparison of actual performance with the budgeted performance, computation of variances, finding of their causes, etc. 5. Inventory Control: It includes control over inventory from the time it is acquired till its final disposal. 6. Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other statistical methods make the information more impressive and intelligible.  5 7. Interim Reporting: This includes preparation of monthly, quarterly, half-yearly income statements and the related reports, cash flow and funds flow statements, scrap reports, etc. 8. Taxation: This includes computation of income in accordance with the tax laws, filing of returns and making tax payments. 9. Office Services: This includes maintenance of proper data processing and other office management services, reporting on best use of mechanical and electronic devices. 10. Internal Audit: Development of a suitable internal audit system for internal control. CHECK YOUR PROGRESS 1. “The basic function of management accounting is to assist the management in performing its functions effectively”. Discuss. 2. Enlist the points explaining the scope of Management Accounting. 1.5 DIFFERENCE BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING Financial accounting and management accounting are closely interrelated since management accounting is to a large extent rearrangement of the data provided by financial accounting. Moreover, all accounting is financial in the sense that all accounting systems are in monetary terms and management is responsible for the contents of the financial accounting statements. In spite of such a close relationship between the two, there are certain fundamental differences. These differences can be laid down as follows:  6 Financial Accounting Management Accounting 1. Objectives Financial accounting is designed Management Accounting is to supply information in the form designed principally for providing of profit and loss account and accounting information for internal balance sheet to external parties use of the management. Thus, like shareholders, creditors, financial accounting is primarily an banks, investors and external reporting process while Government. Information is management accounting is primarily supplied periodically and is an internal reporting process. usually of such type in which management is not much interested. 2. Analyzing performance Financial accounting portrays the Management accounting directs its position of business as a whole. attention to the various divisions, The financial statements like departments of the business and income statement and balance reports about the profitability, sheet report on overall performance, etc., of each of them. performance or statues of the business. Financial accounting deals with Management accounting provides the aggregates and, therefore, detailed analytical data for these cannot reveal what part of the purposes. management action is going wrong and why. 3. Data used Financial accounting is Management accounting is concerned with the monetary accounting for future and, therefore, record of past events. It is a it supplies data both for present and post-mortem analysis of past future duly analyzed in detail in the activity and, therefore, out the 'management language' so that it date for management action. becomes a base for management action. 4. Monetary measurement In financial accounting only such Management is equally interested in economic events find place, non-monetary economic events, which can be described in viz., technical innovations, money. personnel in the organization, changes in the value of money, etc. These events affect management's decision and, therefore, management accounting cannot afford to ignore them.  7 5. Periodicity of reporting The period of reporting is much In management accounting there is longer in financial accounting as more emphasis on furnishing compared to management information quickly and at accounting. The Income comparatively short intervals as per Statement and the Balance the requirements of the Sheet are usually prepared management. yearly or in some cases half-yearly. Management requires information at frequent intervals and, therefore, financial accounting fails to cater to the needs of the management. 6. Nature Financial accounting is more Management accounting is more objective. subjective because management accounting is fundamentally based on judgment rather than on measurement. 7. Legal compulsion Financial accounting has more or A business is free to install or not to less become compulsory for install system of management every business on account of the accounting. legal provisions of one or the other Act. 1.6 EXERCISE 1. What are the functions of a management accounting? Elaborate each one of them. 2. Distinguish management accounting from financial accounting. 3. Objective Type Questions: a. Match Group A With Group B Group A Group B a) Financial Accounting 1. Function of management accounting b) Reports of Management 2. Mandatory c) Management Accounting 3. Technique of management d) Collection of data 4. Future oriented  8 e) Reports of Financial 5. Optional Accounting f) Budgetary Control 6. Historical Data Ans. a – 6 ,b –5 , c- 4 , d-1 , e – 2 , f -3 b. Fill in the Blanks with proper words / phase. 1. Inventory control is ________ in management accounting. 2. Financial accounting deals with ___________ data. 3. Management accounting is ________ oriented. 4. There is no legal format for management accounting____________. 5. In management accounting publication of reports is ______________. 6. Management account is __________in nature. (Answer: 1. Included, 2. Historical, 3. Future, 4. Reports, 5. Optional, 6. Analytical) c. State whether following statement are True or False. 1. Management accounting is analytical in nature. 2. Management accounting is dynamic. 3. Management accounting provides decisions to the management. 4. Management accounting is future oriented. 5. Management accounting includes Standard Costing. 6. Financial Accounting is future oriented. (Answer: 1. True 2.True 3. False 4. True 5. True 6. False) d. Multiple Choice Questions. 1. Financial accounting records only a) Actual Figures b) Budgeted figures c) Standard Figures d) All of the above 2. The use of management accounting is a) Mandatory b) Optional c) Compulsory d) All of the above 3. Management Accounting includes a) Financial Accounting b) Cost Accounting c) Budgetary control d) All of the above  9 4. Management Accounting is a) Analytical b) Future oriented c) Dynamic d) All of the above 5. Financial Accounting deals with a) Determination of cost b) Determination of profit c) Determination of prices d) None of the above 6. Management accounting relates to a) Recording of accounting data b) Recording of costing data c) Presentation of accounting data d) None of the above (Answer: 1. a, 2. b, 3.d, 4.d, 5. b, 6.c)   10 2 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS Unit Structure : 2.0 Objectives 2.1 Introduction 2.2 Meaning and Nature of Financial Statements 2.2.1 Meaning 2.2.2 Nature of Financial Statements 2.2.3 Objective of Financial Statements 2.2.4 Limitations of Financial Statements 2.3 Analysis and Interpretations of Financial Statements 2.3.1 Need of interpretation 2.3.2 Meaning of Analysis and Interpretations 2.4 Preparation of Financial Statements 2.0 OBJECTIVES After studying the unit the students will be able to:  Understand the objectives and nature of Financial Statements.  Know the characteristics of Financial Statements.  Discuss about the qualities of Ideal Financial Statements.  Interpret the financial statements. 2.1 INTRODUCTION The joint stock companies are legally required to prepare set of financial statement to periodically assess the profit earned and to know the financial position of the company as on a specified date. Thus, as in the case of other business enterprises, a limited company prepare the income statement and the balance sheet. However, in the case of companies registered under Companies Act, the Act specifies the books of accounts to be maintained and also prescribes the format and content of financial statement. In addition, the accounts must be statutorily audited by the external person called the auditor and it is duty of the auditor to submit a report in the prescribed format to the shareholder.  11 Since the owner or shareholder elect a board of director to manage the company and rely on the ability and skills of these directors to conduct the business in the most profitable manner, the Companies Act tries to protect the shareholders’ interest by prescribing a set of covenants according to which the financial statements are to be prepared and presented to the shareholders. The objective of the Company Act in laying down the various provisions with respect to accounts and audit is to ensure that adequate information is provided to be shareholders in order for them to judge the performance of the directors during an accounting period. The legal requirement laid down by the Companies Act therefore, assume a great importance in the preparation of the financial statements. 2.2 MEANING AND NATURE OF FINANCIAL STATEMENTS 2.2.1 Meaning : Every business concern wants to know the various financial aspects for effective decision making. The preparation of financial statement is required in order to achieve the objectives of the firm as a whole. The term financial statement refers to an organized collection of data on the basis of accounting principles and conventions to disclose its financial information. Financial statements are broadly grouped in to two statements: I. Income Statements (Trading, Profit and Loss Account) II. Balance Sheets In addition to above financial statements supported by the following statements are prepared to meet the needs of the business concern: (a) Statement of Retained Earnings (b) Statement of Changes in Financial Position The meaning and importance of the financial statements are as follows : Income Statements: The term 'Income Statements' is also known as Trading, Profit and Loss Account. This is the first stage of preparation of final accounts in accounting cycle. The purpose of preparing Trading, Profit and Loss Accounts to ascertain the Net Profit or Net Loss of a business concern during the accounting period. Balance Sheet: Balance Sheet may be defined as "a statement of financial position of any economic unit disclosing as at a given  12 moment of time its assets, at cost, depreciated cost, or other indicated value, its liabilities and its ownership equities." In other words, it is a statement which indicates the financial position or soundness of a business concern at a specific period of time. Balance Sheet may also be described as a statement of source and application of funds because it represents the source where the funds for the business were obtained and how the funds were utilized in the business. Statement of Retained Earnings: This statement is considered to be as the connecting link between the Profit and Loss Account and Balance Sheet. The accumulated excess of earning over losses and dividend is treated as Retained Earnings. The balance of retained earnings shown on the Profit and Loss Accounts and it is transferred to liability side of the balance sheet. Statement of Changes in Financial Position: Income Statements and Balance sheet do not disclose the operational efficiency of the concern. In order to measure the operational efficiency of the concern it is essential to identify the movement of working capital or cash inflow or cash outflow of the business concern during the particular period. To highlight the changes of financial position of a particular firm, the statement is prepared may emphasize of the following aspects : 1. Fund How Statement is prepared to know the changes in the firm's working capital. 2. Cash Flow Statement is prepared to understand the changes in the firm's cash position. 3. Statement of Changes in Financial Position is used for the changes in the firm's total financial position. 2.2.2 NATURE OF FINANCIAL STATEMENTS Financial Statements are prepared on the basis of business transactions recorded in the books of Original Entry or Subsidiary Books, Ledger, and Trial Balance. Recording the transactions in the books of primary entry supported by document proofs such as Vouchers, Invoice Note etc. According to the American Institute of Certified Public Accountants, "Financial Statement reflects a combination of recorded facts, accounting conventions and personal judgments and conventions applied which affect them materially." It is therefore, nature and accuracy of the data included in the financial statements which are influenced by the following factors : (1) Recorded Facts. (2) Generally Accepted Accounting Principles. (3) Personal Judgments. (4) Accounting Conventions  13 2.2.3 OBJECTIVES OF FINANCIAL STATEMENTS The following are the important objectives of financial statements: 1. To provide adequate information about the source of finance and obligations of the finance firm. 2. To provide reliable information about the financial performance and financial soundness of the concern. 3. To provide sufficient information about results of operations of business over a period of time. 4. To provide useful information about the financial conditions of the business and movement of resources in and out of business. 5. To provide necessary information to enable the users to evaluate the earning performance of resources or managerial performance in forecasting the earning potentials of business. 2.2.4 LIMITATIONS OF FINANCIAL STATEMENTS 1. Financial Statements are normally prepared on the basis of accounting principles, conventions and past experiences. Therefore, they do not communicate much about the profitability, solvency, stability, liquidity etc. of the undertakers to the users of the statements. 2. Financial Statements emphasize to disclose only monetary facts, i.e., quantitative information and ignore qualitative information. 3. Financial Statements disclose only the historical information. It does not consider changes in money value, fluctuations of price level etc. Thus, correct forecasting for future is not possible. 4. Influences of personal judgments leads to opportunities for manipulation while preparing of financial statements. 5. Information disclosed by financial statements based on accounting concepts and conventions. It is unrealistic due to difference in terms and conditions and changes in economic situations. 2.3 ANALYSIS AND INTERPRETATIONS OF FINANCIAL STATEMENTS 2.3.1 Need of interpretation Presentation of financial statements is the important part of accounting process. Following are some points: 1. To provide more meaningful information 2. To enable the owners, investors, creditors or users of financial statements  14 3. To evaluate the operational efficiency of the concern during the particular period. 4. More useful information is required from the financial statements to make the purposeful decisions about the profitability and financial soundness of the concern. 5. In order to fulfill the needs of the above, it is essential to consider analysis and interpretation of financial statements. 2.3.2 Meaning of Analysis and Interpretations The term "Analysis" refers to rearrangement of the data given in the financial statements. In other words, simplification of data by methodical classification of the data given in the financial statements. The term "interpretation" refers to "explaining the meaning and significance of the data so simplified." Both analysis and interpretations are closely connected and inter related. They are complementary to each other. Therefore presentation of information becomes more purposeful and meaningful—both analysis and interpretations are to be considered. Metcalf and Tigard have defined financial statement analysis and interpretations as, “a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm's position and performance”. The facts and figures in the financial statements can be transformed into meaningful and useful figures through a process called "Analysis and Interpretations. In other words, financial statement analysis and interpretation refer to the process of establishing the meaningful relationship between the items of the two financial statements with the objective of identifying the financial and operational strengths and weaknesses. 2.4 PREPARATION OF FINANCIAL STATEMENTS Financial statements should be rearranged for proper analysis and interpretations of these statements. It enables to measure the performance of operational efficiency and profitability of a concern during particular period. The items of operating revenues, non-operating revenues, operating expenses and non- operating expenses are rearranged into different heads and sub- heads are given below:  15 Vertical Profit and Loss: Profit and loss account is a statement showing the net result of business operations during the period, usually a year. Vertical Profit and loss for the year ended__________ Particulars Rs. Rs. Rs Gross Sales Cash Sales Xx Credit Sales Xx Less : Returns and allowance (xx) Net Sales XX Less: Cost of Goods Sold Opening Stock of Raw Material Xx Purchases of Raw Material Xx Less : Closing Stock of Raw Material (xx) Raw Material Consumed Xx Less: Direct expenses ( Factory Expenses) Carriage inwards Xx Factory power Xx Wages Xx Other factory expenses Xx Depreciation on Machinery Xx Depreciation on Factory Building Xx Depreciation on Patterns and Patents Xx Total xx Add: Opening stock of Finished goods Xx Add: Purchases of Finished Goods Xx Less: Closing Stock of Finished Goods (xx) Cost of Goods Sold (xx) Gross Profit / Gross Margin xx Less: a) Administration Expenses Office Expenses Xx  16 Office Rent , Rates and Taxes Xx Insurance, Office Electricity Xx Printing and stationery, Audit Fees Xx Repairs, other office expenses, Directors Fees Xx Depreciation on office Assets Xx Postage and telegrams Xx Total Administrative Expenses xx b) Selling and Distribution Expenses Salaries to salesman Xx Rent of shop, show room Xx Exhibitions, Trade fair, Sales Discount/ Xx Commission Normal Bad Debts Xx Depreciation on Delivery Van Xx Advertisement and publicity Xx Travelling / Van Expenses Xx Total Selling and Distribution Expenses Xx c) Finance Charges / Expenses Cash Discount Xx Bank Chagres Xx Abnormal bad Debts Xx Total Finance Charges / Expenses Xx Total Operating Expenses (Except Interest) (xx) Operating Profit Before Interest Xx Less: Interest Paid Interest on Debentures Or Bonds Xx Interest on Loans Xx Interest on public deposits Xx Interest on short term loans Xx Interest Paid (xx) Operating Profit After Interest Xx  17 Add: Non-operating Income Dividend on shares Xx Interest on debentures, loans etc. Xx Profit on sale of Fixed assets / investment Xx Damages received Xx Royalty / shares transfer fees Xx Total Non-operating Income Xx Less: Non-operating Expenses Loss on sale of Fixed assets / Investment Xx Damages paid / due Xx Preliminary expenses written off Xx Fine and penalty Xx Total Non-Operating Expenses (xx) Net Profit Before Tax Xx Less : Income Tax (xx) Net Profit After tax Xx Add: Profit and Loss A/c (Op. Balance) Xx Less: Appropriations Transfer to Sinking Fund Xx Dividend Paid Xx Interim Dividend Xx Transfer to Reserve Xx Appropriation (xx) Retained Earnings / Balance Transfer to Xx Balance Sheet From the above rearrangement of operating statements, the following accounting equations may be given: 1. Net Sales = Cost of sales + operating expenses + Non- operating expenses 2. Gross Profit = Net sales – Cost of goods sold 3. Net operating profit = Gross profit – operating expenses.  18 4. Gross Sales: Gross sales also called ‘Turnover’ is the amount of total sales of goods and services. This includes both cash and credit sales. Gross sales = Credit sales + cash sales 5. Cost of Goods Sold: This is the cost of purchases or cost of manufacturing the goods, which are sold during the year. Cost of Goods Sold = Opening stock + Purchases + Direct Expenses + Depreciation – less closing stock 6. Gross Profit: This is the major source of operating income of an organization. This is the amount of profit earned on purchases, manufactures and sales of goods and services. Gross Profit = Net Sales – Cost of goods sold 7. Operating Expenses: These are the expenses incurred in the course of normal conduct of business, which are related to the business activities. Broadly, operating expenses are classified into the following categories. a. Administrative Expenses: These are the expenses pertaining to general office administrative of an organization. b. Selling and Distribution Expenses: These are the expenses incurred for the purpose of increasing and maintaining the sales, distributing and delivering the goods. c. Finance Chagres: This includes: Cash discount, Bad debts (Abnormal), Bank charges, bank Commission. Operating Expenses = Administrative Expenses + Selling & Distribution Expenses + Finance Expenses 8. Operating Profit: Excess of operating income over operating expenses is called net operating profit. This is the amount of profit earned during the normal course of business. Operating profit may be a. Operating Profit before Interest: Gross Profit - Operating expenses (Before Interest) b. Operating Profit After Interest : Operating profit (before Interest) - Interest 9. Non-operating Income: Income not related to the ordinary course of business i.e. Interest on investment is not an operating income to a company, which is engaged in buying and selling of goods and services of goods. But for an investment company, interest will be considered as an operating income. 10. Non-Operating Expenses: These are the expenses, which do not relate to day to day conduct of business operations. These expenses arise due to certain unusual events and unexpected occurrences.  19 11. Net Profit : This is the excess of total operating and non- operating income over the total operating and non-operating expenses. It is therefore, ultimate profit earned by the organization. a. Net Profit before Tax = Net operating profit + Net non- operating Income b. Net profit After Tax =Net profit before tax - Income tax 12. Retained Earnings: Net profit after tax - dividend Vertical Balance Sheet: Balance sheet is a statement of assets and liabilities. Vertical Balance sheet as on __________________ Particulars Rs. Rs. Rs. A. Sources of Funds 1) Owners funds a) Share capital Equity share capital Xx Preference share capital Xx Less: Unpaid calls/ (xx) Add: Forfeiture shares Xx Xx b) Reserve and Surplus Capital Reserve / Capital Redemption Reserve Xx Share premium /General Reserve Xx Other reserve / Sinking Fund xx xx c) Losses & Fictitious Assets Profit and loss A/c Debit Balance Xx Miscellaneous Expenditure Not Written off Xx Preliminary Expenses Xx Shares Issue Expenses Xx Discount on Issue of shares or Debenture Xx (xx) Own Funds or Net Worth (a+b-c) xx 2) Loan Funds a) Long term Loans Debentures or bonds Xx Loans from banks Xx  20 Loans from financial Institutions Xx Public deposit Xx Xx b) Short Term Loans Other Loans Xx Owed Fund (a+b) Xx Total Funds Available / Capital Employed xx B. Application of Funds 1) Net Fixed Assets a) Tangible Assets Land and building (Cost) Xx Leaseholds, Plant and Machinery ( Cost) Xx Furniture and fitting, Vehicles (Cost) Xx Less: PFD (xx) Xx b) Intangible Assets Goodwill Xx Patents, Trademarks, And Designs Xx Xx Total Fixed Assets (a+b) Xx 2) Long Term Investment Investment in Govt. Securities Xx Investment immovable properties Xx Investment in capital of partnership firm Xx Long term loans given Xx Xx 3) Working Capital a) Quick Assets Cash and Bank Xx Debtors xx Less: RDD (xx) Xx Bills Receivable / Trade receivable Xx Current Investment Xx Accrued Income Xx Loans and Advance Xx  21 Inventory Xx Prepaid Expenses Xx Advance Tax Xx Advance for goods Xx Xx Less: b) Current Liabilities Creditors Xx Bills Payable / Trade Payable Xx Advance Received Xx Expenses Payable Xx Accrued Interest Xx Provision for taxation Xx Provision for dividend Xx Unclaimed Dividend Xx Provision for dividend Distribution Tax Xx Bank Overdraft Xx Income received in advance Xx (Xx) Net current assets (a-b) Xx Total Application of Fund Xx Application of Funds 1. Fixed Assets: Fixed Assets are called long-term assets. They do not flow through the cash cycle of business within one year or the normal operating cycle. They are used over several periods. Classification of Fixed Assets: a. Tangible movable assets; b. Tangible immovable assets; and c. Intangible assets. a) Tangible movable assets are the assets which can be seen, touched and moved from one place to another place. Plant and Machinery, furniture and fixtures, transportation equipment etc. Are tangible movable assets. b) Tangible immovable assets are the assets which can be seen and touched but cannot be moved from one place to another place. Such assets include land, buildings, mines, oil wells, etc. c) Intangible assets are the assets which cannot be seen and  22 touched. However, their existence can only be imagined such as patents, trademarks, copyrights, goodwill etc. Their existence is very important for the business. Fixed Assets = Tangible Assets + Intangible Assets 2. Investments: Long term investments are “Fixed Assets”. Marketable Investments are those investments which are acquired by the company by employing its surplus funds or cash temporarily. Short term investments are grouped under “Current Assets”. 3. Current Assets and Quick Assets : a) Current Assets: Current assets represent employment of money by the company on a short-term basis. Current Assets = Stock + Debtors + Cash & Bank +Loans &Advances + Marketable Securities +Other Current Assets b) Quick Assets: These assets are known as ‘ near cash’ assets. In other words, quick assets are those which can be converted into cash quickly. Therefore, they are also known as liquid assets. Quick Assets = Current Assets–Inventory –Prepayments Sources of Fund 1. Proprietor’s Funds These are the funds provided by the proprietors or the shareholders. Proprietors fund is also called as Proprietors Equity, Owners Funds, Owners Equity, or Share holders Funds. This is also known as the Net Worth of the business. Owners’ Equity refers to the claim of the owners and it is made up of contributions of proprietors by way of: Share Capital (May be Equity Share Capital only or Equity and Preference Share Capital) Plus: Reserves Plus: Profit and Loss Account (Credit) Balance (Surplus) Less: Accumulated Losses Less: Fictitious Assets (If any) a) Share Capital: Share capital is the amount that is raised by a company from the public at large, through the issue of shares. There are different concepts of share capital from the legal and accounting points of view.  23 i. Authorised Capital: Authorised Capital is the maximum capital a company can raise as mentioned in the Memorandum of Association under its Capital Clause. It is also called as the Registered Capital or Nominal Capital of the Company. ii. Issued and Unissued Capital: A company usually does not need the entire registered capital. The capital may be raised as and when necessary. Only a part of the authorised capital may be issued at a time. Issued capital is that part of the authorised capital which is actually offered to the prospective investors for subscription. iii. Subscribed Capital: The issued capital may not be fully subscribed by the public. Subscribed capital is that part of the issued capital which has been subscribed or taken up by the public. iv. Called up and Uncalled Capital: The company may not need the entire capital subscribed by the public. The company, therefore, may collect the capital in several instalments. The called-up capital is that portion of the subscribed capital which has been called or demanded by the company to be paid. The capital that is not demanded from the shareholders is called uncalled capital. v. Paid up Capital: Paid up capital is that part of the called up capital which has been actually paid by the members. The paid- up capital is the called-up amount less calls not paid.(calls unpaid or calls-in- arrears). b) Reserves and Surplus: According to Companies Act, Reserve shall not include any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability. Generally reserves are divided into two categories viz. Specific Reserves and General Reserves. Reserve created for a specific purpose is called as a “specific reserve” and a reserve created for a general purpose is called a “general reserve. General reserves are free and can be utilized for: a. Payment of Dividends. b. Development and expansion, c. Any other purpose the company thinks proper. General Reserve is also called as revenue reserve or a free reserve. A free reserve is a reserve which is available for any purpose, including payments of dividend. It is not marked for any specific purpose.  24 2. Capital Reserves: Capital reserve is created out of capital profits which do not arise in the normal course of business. The following reserves are capital reserves: a. Profits prior to incorporation b. Profit on redemption of preference shares, c. Profit on redemption of debentures, d. Securities premium, e. Profit on forfeiture of shares, f. Profit on sales of fixed assets, g. Profit on revaluation of fixed assets, h. Capital redemption of fixed assets, 3. Long-term Liabilities External borrowings of a company which constitute its owed funds are important sources of long-term finance. These borrowings are termed as fixed liabilities or t e r m liabilities or long term-loans. a) Secured loans: It refers to loans which are secured by a fixed or floating charge on the assets of the business. It includes : i. Debenture ii. Loan and advance from banks, iii. Loan and advance from subsidiaries and iv. Other loan and advances. b) Unsecured loans: It refers to the loans which are not secured by assets of the business. It is not covered by any security. It includes: i. Fixed deposits, ii. Loans and advance from subsidiaries, iii. Short-term loan and advances: a) from banks ,b)from others, iv. Other loans and advance: loan from directors, secretaries, treasurers and managers should be shown separately. Loan Fund= Secured loans +unsecured loans 4. Current Liabilities and Provisions a) Current Liabilities Current liabilities are those short-term obligations of an enterprise which mature within one year or within the operating cycle. They are as follows: i. Sundry Creditors–when goods are purchased ii. Bills Payable– by acceptance of bills drawn by creditor – (Accounts payable) iii. Interest accrued but not due iv. Wages and salaries payable–out standing expenses. v. Unclaimed dividends. vi. Bank Overdraft.  25 b) Provisions: Provision means any amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy. They are at best estimates. The examples of provisions are asunder: i. Provision for depreciation on assets. ii. Provision for doubtful debts. iii. Provision for proposed dividends. iv. Provision for taxation. Provisions relating to specific assets are shown as deduction from the specific assets. c) Quick Liabilities: These are the current liabilities which mature within a very short period of time. Quick Liabilities= Current Liabilities –Bank Overdraft Check Your Progress : 1. Give the formulas of the following: a) Proprietors Fund b) Quick Liabilities c) Quick Assets d) Net profit before tax e) Retained earnings f) Cost of goods sold g) Operating expenses 2. Give the examples of the following: a) Current Liabilities b) Provisions c) Secured loan d) Capital Reverses e) Current Assets f) Fictitious Assets g) Non-operating Income h) Administration expenses  26 2.5 SOLVED PROBLEMS Illustration 1 Following is the trial balance of Good Luck Ltd. as on 31.3.2014 Trial Balance Particulars Amt. Particulars Amt. Preliminary Expenses 20,000 Equity Shares 7,00,000 (Not yet written off) Capital (Rs.100) Administrative Expenses 4,00,000 Gross Sales 20,40,000 Land And Building 8,00,000 General Reserve 3,20,000 Plant & Machinery 6,00,000 Profit and loss A/c 2,00,000 (Cr.) Selling Expenses 1,00,000 12.5% Debentures 4,00,000 Furniture 3,00,000 Provision for Depreciation Cost of production 9,60,000 On Land & Building 2,00,000 Return Inward 40,000 On Plant & Finished Goods 2,40,000 Machinery 1,00,000 On Furniture 80,000 Government Bonds 2,80,000 Trade Expenses 4,00,000 Advance Tax 2,00,000 Trade Receivable 5,00,000 44,40,000 44,40,000 Other Information: 1. Closing stock of Finished goods as on 31.3.2014 was Rs.1,60,000. 2. Provide Dividend on Equity Shares at 10%. 3. Make provision for Income Tax of Rs.2,00,000. From the following information you are required to prepare Income Statement for the year ended 31.3.2014 and balance sheet as on that date in vertical form suitable for analysis.  27 Solution Income Statement for the year ended 31.3.2014 Particulars Amt. Amt. Gross Sales 20,40,000 Less: Return Inward 40,000 Net Sales 20,00,000 Cost of Production 9,60,000 Add Opening stock 2,40,000 Less Closing Stock (1,60,000) Cost of Goods Sold 10,40,000 Gross Profit 9,60,000 Less: Operating Expenses 1. Administrative Expenses 4,00,000 2. Selling Expenses 1,00,000 Total Operating Expenses 5,00,000 Operating Profit before Interest 4,60,000 Less: Debenture Interest 50,000 Profit After Interest before Tax 4,10,000 Less: Tax 2,00,000 Profit after tax 2,10,000 Add: Profit and loss balance 2,00,000 Total Profit 4,10,000 Less: Appropriation Equity Dividend 70,000 Retained Earning 3,40,000 Balance Sheet as on 31.3.2014 Particulars Amt. Amt. Sources of Fund 1. Share Holders Fund Equity Share Capital 7,00,000 Reserve and Surplus General Reserve 3,20,000 Profit and loss A/c 3,40,000 Total 6,60,000  28 Less: Preliminary Expenses (20,000) 6,40,000 Share Holders Fund 13,40,000 2. Loan Fund 12.5% Debentures 4,00,000 Total Sources of Fund 17,40,000 Application of Fund 1. Fixed Assets Land & Building (8,00,000 – 2,00,000) 6,00,000 Plant & Machinery (6,00,000 – 1,00,000) 5,00,000 Furniture (3,00,000 – 80,000) 2,20,000 13,20,000 2. Investment Government Bonds 2,80,000 3. Working Capital a. Current Assets Trade Receivable 5,00,000 Stock of Finish Goods 1,60,000 Advance Tax 2,00,000 Total current assets 8,60,000 b. Current Liabilities Trade Payable 4,00,000 Provision for tax 2,00,000 Equity Dividend 70,000 Debenture Interest outstanding 50,000 Total Current Liabilities 7,20,000 Net Working Capital (a-b) 1,40,000 Total Application of Fund 17,40,000 Illustration 2 Following is the Trial balance of M/s. Anand Ltd. As on 31.3.2015. Particulars Amt. Amt. Sales 20,00,000 Fixed Assets 10,00,000 Bills Receivable & Bills Payable 2,00,000 1,50,000 Cash and Bank Balance 50,000 Opening Stock 1,00,000  29 Bank Overdraft 1,00,000 Purchases 12,50,000 Administrative Expenses 30,000 Legal Expenses 20,000 Salaries 50,000 Advertisement 40,000 Warehouse Rent 20,000 Depreciation On Machinery 50,000 Interest on Bank Overdraft 10,000 Equity Shares Capital 6,00,000 General Reserve 1,00,000 Lap Top Repairs 20,000 Direct Expenses 20,000 Investment 40,000 Debtors And Creditors 1,00,000 50,000 Total 30,00,000 30,00,000 Additional Information: 1. Closing Stock on 31.3.2.15 was valued at Rs.50,000 2. Cash sales were 1/3 of credit sales. You are required to prepare vertical Income statement for the year ended 31.3.2015 and vertical Balance sheet as on that date for financial analysis. Solution Income Statement for the year ended 31.3.2015 Particulars Amt. Amt. Sales : Cash 5,00,000 Credit 15,00,000 20,00,000 Less: Cost of Goods Sold Opening Stock 1,00,000 Add: Purchases 12,50,000 Add: Direct expenses 20,000 Less: Closing Stock 50,000 Depreciation On Machinery 50,000 13,70,000  30 Gross Profit 6,30,000 Less: a. Operating Expenses Administrative Expenses 30,000 Legal Expenses 20,000 Salaries 50,000 Lap Top Repairs 20,000 Total Operating Expenses 1,20,000 b. Selling & Distribution Expenses Advertising 40,000 Warehouse rent 20,000 Total Selling expenses 60,000 Total (a+b) 1,80,000 Net profit Before Interest 4,50,000 Less: Interest on Bank overdraft 10,000 Net profit before Tax 4,40,000 Balance Sheet as on 31.3.2015 Particulars Amt. Amt. Sources of Fund 1. Share Holders Fund Share capital 6,00,000 Reserve and Surplus General Reserve 1,00,000 Profit and loss A/c 4,40,000 Share Holders Fund 11,40,000 2. Loan Fund Bank Overdraft 1,00,000 Total Sources of Fund 12,40,000 Application Of Fund 1. Fixed Assets Tangible Assets 10,00,000 2. Investment 40,000 3. Working Capital  31 a. Current Assets Inventories 50,000 Trade receivable 1,00,000 Debtors 2,00,000 Cash 50,000 Total Current Assets 4,00,000 b. Current Liabilities Creditors 50,000 Bills Payable 1,50,000 Total Current Liabilities 2,00,000 Net Working Capital (a-b) 2,00,000 Total Application of Fund 12,40,000 Illustration 3 M/s. Avinash Ltd. has provided you the following information for the year ended 31.3.2015. Particulars Amt. Particulars Amt. Sales 20,00,00 Return Inward 50,000 0 Opening Stock of Raw 1,10,000 Purchases of Raw Material 5,00,000 Material Staff Salaries 1,50,000 Commission allowed 5,000 Salesmen Salaries 25,000 Proposed Dividend 1,50,000 Bank Charges 10,000 Exhibition Expenses 35,000 Freight Inwards 40,000 Repairs of Computer 5,000 Office Rent and 45,000 Closing stock of WIP 40,000 Insurance Debenture Interest 50,000 Wages 70,000 Loss on sale of 10,000 Purchases of Finish Goods 80,000 Machinery Printing & Stationery 5,000 Interest Received on 40,000 Investment Direct expenses 50,000 Provision for Income Tax 2,00,000 Profit &Loss A/c (Credit) 2,40,000 Closing Stock of Raw 80,000 Material Depreciation on patterns 10,000 Sale of scrap 20,000 Depreciation on 20,000 Machinery  32 You are required to rearrange the above information and prepare vertical income statement, suitable for analysis. Solution Income Statement for the year ended 31.3.2015 Particulars Amt. Amt. Sales 20,00,000 Less: Return Inwards 50,000 19,50,000 Less: Cost of Material Opening Stock 1,10,000 Add: Purchases 5,00,000 Add: Freight Inwards 40,000 Less: Closing Stock 80,000 Cost of Material 5,70,000 Wages 70,000 Direct Expenses 50,000 Depreciation Machinery 20,000 Depreciation Pattern 10,000 Total Direct Expenses 7,20,000 Less: Closing stock of WIP 40,000 6,80,000 Less: Sale of Scrap 20,000 Cost of production 6,60,000 Add: Purchases of Finish Goods 80,000 7,40,000 Gross Margin 12,10,000 Less: Operating Expenses a) Administrative Expenses Staff Salaries 1,50,000 Office rent & Insurance 45,000 Printing and Stationery 5,000 Repairs and computers 5,000 Total Administrative Exp 2,05,000 b) Selling & Distribution Expenses Salesman Salaries 25,000  33 Commission allowed 5,000 Exhibition expenses 5,000 Total Selling Exp. 65,000 c) Finance Expenses Bank charges 10,000 Total Exp. (a+b+c) 2,80,000 Net profit before Interest 9,30,000 Less: Interest on Debenture 50,000 Net profit after Interest 8,80,000 Add: Non-operating Income Interest on Investment 40,000 9,20,000 Less: Non-operating Expenses Loss on sale of Machinery 10,000 Net profit before tax 9,10,000 Less: Provision for Tax 2,00,000 Net profit after tax 7,10,000 Add: P/L A/c balance 2,40,000 9,50,000 Less: Proposed Dividend 1,50,000 Net profit carried to Balance sheet 8,00,000 Illustration 4 The following balances appear in the books of M/s Ram Ltd. as on 31.3.2015. You are required to prepare a balance sheet in the vertical form. Particulars Amt. Particulars Amt. Sundry Debtors 2,00,000 Creditors 1,50,000 Trade Investment 2,50,000 Capital Reserve 1,50,000 Bank Overdraft 1,00,000 Short term 50,000 Investment Public deposit 3,00,000 Plant and 12,00,000 Machinery Bills Payable 7,90,000 Outstanding 1,20,000 Expenses  34 General Reserve 1,00,000 Cash at Bank 7,00,000 Bills Payable 2,00,000 Profit and loss 4,00,000 A/c (Credit ) Vehicles 9,00,000 Stocks 5,00,000 10% Pref. Sh. Capital 8,00,000 Land and 12,00,000 Building Commission on issue of 40,000 Preliminary 10,000 shares( not w/off) Expenses (not w/off) Provision for tax 1,00,000 Equity shares 16,00,000 capital Bank Loan 3,00,000 Debentures 5,00,000 Advance tax 3,00,000 Proposed 3,00,000 Dividend Prepaid Expenses 1,00,000 Advance to 60,000 suppliers Solution Balance Sheet as on 31.3.2015 Particulars Amt. Amt. Sources of Fund 1. Share Holders Fund a) Share Capital Equity sh. Capital 16,00,000 10% Pref.sh Capital 8,00,000 Total (a) 24,00,000 b) Reserve And Surplus General Reserve 1,00,000 P & L A/c 4,00,000 Capital Reserve 1,50,000 Total (b) 6,50,000 Total (a+b) 30,50,000 Less: Preliminary Expenses 10,000 Commission on shares 40,000 30,00,000 2. Loan Fund Debentures 5,00,000 Public Deposit 3,00,000  35 Bank Loan 3,00,000 11,00,000 Total 41,00,000 Application of Funds 1. Fixed Assets Tangible Assets Land and Building 12,00,000 Plant and Machinery 12,00,000 Vehicles 9,00,000 33,00,000 2. Investments Trade Investment 2,50,000 3. Working Capital a) Current Assets Stock 5,00,000 Sundry Debtors 2,00,000 Bills Receivable 2,00,000 Short Term Investment 50,000 Cash & bank 7,00,000 Adv. To suppliers 60,000 Adv. Tax 3,00,000 Prepaid Expenses 1,00,000 Total Current Assets 21,10,000 b) Current Liabilities Creditors 1,50,000 Outstanding Expenses 1,20,000 Bank Overdraft 1,00,000 Bills Payable 7,90,000 Provision for Tax 1,00,000 Proposed Dividend 3,00,000 Total Current Labilities 15,60,000 Working Capital (a-b) 5,50,000 Total 41,00,000  36 2.6 EXERCISE 1. Discuss the nature of Financial Statement. 2. Define financial statement analysis. Explain the need and importance of it. 3. Define Assets. Explain various types of Assets. 4. Objective type Questions A. Match Group A With Group B Group A Group B a) Source of Fund 1. Current Assets b) Liquid Assets Fund 2. Net Worth + Loan Fund c) Call in Arrears 3. Current Asset - Stock d) Retained Earnings 4. Deduct from subscribed capital e) Over subscription 5. Profit & Loss A/c balance f) Loose tools 6. Subscribed capital is more than issued capital (Answer: a – 2 ,b – 3, c- 4 , d- 5, e – 6 , f – 1) B. Fill in the Blanks with proper words / phase. 1. Trade Mark is an ______________ assets. 2. Advance tax is shown under _________________. 3. Current Liabilities = _________________ - Current Assets. 4. Fictitious Assets are _________________. 5. Securities Premium forms part of ______________. 6. Capital Employed = Fixed Assets +___________ capital. (Answer : 1. Intangible , 2. Loans and Advances, 3. Working Capital, 4. Intangible, 5. Reserve & Surplus 6. Working.) C. State whether following statement are True or False. 1. Balance sheet shows result of activities. 2. Goodwill will be shown under fictitious assets. 3. Arrears of preference dividend are contingent liabilities. 4. All quick liabilities are current liabilities. 5. Operating expenses are incurred to conduct the operations smoothly. 6. Public deposit is a secured loan. (Answer: 1. False 2. False 3.True 4.True 5.True 6. False) D. Multiple Choice Questions. 1. Patents and Copyrights is an a) Intangible Assets b) Movable assets c) Intangible fixed assets d) Fictitious Assets  37 2. Balance sheet is a a) Statement of assets and liabilities b) Statement of operating results c) Statement of working capital d) None of the above 3. Income Statement is a a) Statement of working results b) Statement of Sources of Fund c) Statement of Cash Flow d) Fund from Operation 4. Fixed assets are Rs.5, 00,000; Current Assets are Rs.3, 00,000; Current Liabilities are Rs. 1, 00,000. There is no investment, Find out capital employed. a) 8,00,000 b) 7,00,000 c) 9,00,000 d) 6,00,000 5. Sales are Rs.5, 00,000; operating cost is Rs.2, 00,000; profit on sale of machinery is Rs.10, 000, find out operating profit. a) 3,00,000 b) 3,10,000 c) 3,10,000 d) 3,50,000 6. Short term investments are shown under which head in the vertical balance sheet. a) Investment b) Current Assets c) Current Liabilities d) Fictitious Assets (Answer: 1. c, 2. a, 3. d, 4. b, 5.a, 6.b)   38 3 TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS Unit Structure: 3.1 Objectives 3.2 Introduction 3.3 Trend Ration and Trend Analysis 3.3.1 Meaning 3.3.2 Utility of Trend Analysis 3.3.3 Steps involved in calculation of trend percentage 3.3.4 Following is the example of Trend analysis 3.3.5 Comparative Balance Sheet 3.3.6 Illustration 3.4 Comparative Statement 3.4.1 Meaning and Definition 3.4.2 Importance of Comparative Statement 3.4.3 Preparation of Comparative Statements 3.4.4 Preparation of a Comparative Income Statement 3.5 Common size statement 3.5.1 Meaning 3.6 Exercise 3.1 OBJECTIVES After studying the unit the students will be able to:  Explain the meaning of financial statement analysis.  Know the meaning and utility of Trend analysis.  Understand the meaning of Comparative and Common Size Statements  Prepare the Comparative and Common Size Statements from the given information. 3.2 INTRODUCTION Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. As the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. To overcome  39 from the limitations it becomes necessary to analyse the financial statements. The analytical tools generally available to an analyst for this purpose are: 1. Comparative financial and operating Statements 2. Common-size statement 3. Trend ration and trend analysis 4. Average Analysis 5. change in working capital 6. Fund-flow and cost-flow analysis 7. Ratio analysis 3.3 TREND RATION AND TREND ANALYSIS 3.3.1 Meaning Trend analysis is an important and useful technique of analysis and interpretation of financial statement. Under this technique the ration of different items for various periods are calculate for the company over a definite period of time say three to five years and then we can analysis trend highlighted by this ratio. Trend analysis can be done in following way: i) Trend percentage, ii) Trend ratio, iii)Graphic and diagrammatic representation. 3.3.2 Utility of Trend Analysis: a) It is a simple technique. it does not involve tedious calculation and not requires trained experts b) It is brief method to indicate the future trend c) It reduces the chances of errors as it provides the opportunity to compare the percentage with absolute figures d) It computes the percentage change for different variables over a long period and then makes a comparative study of them. e) The trend percentage helps the analytics to study the changes that have occurred during the period. Such an analysis indicates the progress of business by showing ups and downs in it activity. 3.3.3 Steps involved in calculation of trend percentage The calculation of trend percentage involves the following steps. a) Selection of base year. b) Assigning a weight of 100 to be value of the variable of the base year and c) Expressing the percentage change in value of variable from base year as shown below.  40 3.3.4 Following is the example of Trend analysis Percentage Years Sales ( + ) Increase or ( - ) Decrease 1980 20,000 100 (Base year ) 1981 35,000 175 1982 28,000 140 1983 30,000 150 1984 35,000 175 1985 14,000 70 1986 22,000 110 A trend for single financial item is seldom very informative. A comparison of trend for relative items often help to analysis in perfect understanding of the business fact as is clear from the below mentioned comparative balance sheet. 3.3.5 Comparative Balance Sheet Trend Percentage 1986 1987 1988 ( base year – 1988 ) Assets Rs. Rs. Rs. 1986 1987 1988 A) Current Assets Inventory 20,000 30,000 25,000 100 150 125 Debtor 30,000 50,000 60,000 100 167 200 Cash balance 20,000 55,000 30,000 100 175 150 Total (A) B) Fixed Assets 70,000 1,15,000 1,15,000 100 164 164 Building Plant Investment 250,000 300,000 3,00,000 100 120 120 Total (B) 1,25,000 150,000 1,60,000 100 120 128 Total Assets (A + B) 80,000 1,00,000 1,20,000 100 125 150 4,55,000 5,50,000 5,80,000 100 121 127 5,25,000 6,65,000 6,95,000 100 127 132 3.3.6 Illustration: Calculate trend percentage from the following figures of X L td, taking 1979 as the base and interpret. Year Sales Stock Profit before tax 1979 1,881 709 321 1980 2,340 781 435 1981 2,655 816 458 1982 3,021 944 527 1983 3,768 1,154 672  41 Solution : Trend percentage Profit Sales Stock Years before Tax Profit (Rs. in (Rs. in Sales Stock before (Rs. in Tax Lakhs) Lakhs) Lakhs) 1979 1,881 709 321 100 100 100 1980 2,340 781 435 124 110 136 1981 2,655 816 458 141 115 143 1982 3,021 944 527 161 133 164 1983 3,768 1,154 672 200 162 209 Interpretation: The study of the above given statement of Trend percentage reveals that – i) The sales of the firm have continuously increased over a period of a five year commencing from 1979. However there has been a substantial increase in the amount of sales in the 1983 when it increased by 39%. ii) The trend of Stock is also upward although the increase in this item has been constant yet in 1983 the increased has been exceptionally. iii) The Profit of the firm has increased at much higher rat in comparison to increase in Sale and Stock during the period under study. The overall analysis of the financial items indicated that the firm is doing well, and therefore, its financial position it bound to be good. 3.4 COMPARATIVE STATEMENT 3.4.1 Meaning and Definition: The comparative statements are an important tool of horizontal financial analysis. Financial data become more meaningful when compared with similar data for previous period or a number of previous periods. Such analysis helps as in forming an opinion regarding the progress of the enterprise. Comparative statements are defined as: Foulke has defined these statement as “statement of financial position of business so designed as to provide time perspective to the consideration of various elements of financial position embodied in such statement.’’ In any comparative statement columns for more than one year’s position or working can be drawn and figures may be provided. The annual date can be compared with similar monthly or quarterly data or can be compared with similar data for the same monthly or quarterly data of the previous years.  42 In such statement the figure can be shown at the following value. a. Absolute date (money values or rupee amount). b. Increase or decrease in absolute values c. By the way of percentages d. By the way of common—size statement Two comparable units can be compared regarding profitability and financial position. The two organization may not have the identical heads of account In order to get over the difficulty, the data must first be property set before comparison In the preparation of comparative financial statement, uniformity is essential. 3.4.2 Importance of Comparative Statement: Following points explain the importance of these statements: 1. These statements are very useful in measuring the effect of the conduct of a business enterprise over the period under consideration. Regardless of its financial strength at a given point of time, the enterprises must operate successfully if it hopes to continue as a going concern. 2. The income statement measures the effects of operation. But the progress of these operations may be viewed over number of periods by preparing the income statement in a comparative form. 3. Similarly the effect of operation of financial position and the progress of a business in term of financial position can be presented by means of a comparative balance sheet. 4. The accounting authorities in U. S. A. have strongly recommended and encouraged the preparation of financial statement in the comparative from Recognising the importance of comparative financial date for two years. 5. The Indian companies Act 1956 has made this fact compulsory that in the balance sheet of a company the figure for the previous year should also be given to facilitate comparison. Though the balance sheet is a useful statement, the comparative balance sheet is even more useful for the contains not only the data of a single balance sheet but also for the past years which may be useful in studying the trends. 3.4.3 Preparation of Comparative Statements: The form of comparative balance sheet consists of two or more columns according to the number of year we prepare the balance sheet, for the date of original balance sheet and columns for the increases or decreases in various items. Proforma of comparative balance sheet for two years  43 ABC Co. Ltd. Specimen of Comparative Balance Sheet As on 31st December 1980 and 1981 (Amount in Lakhs of rupees) st st 31 31 Increase (+) Dec. Dec. /Decrease (-) % Rate 1980 1981 Amount Assets : Current Assets : Cash 240 80 - 160 - 66 1.24 Debtors less reserve for 120 96 - 24 - 40 1.60 doubtful debts Merchandise Inventory 260 320 + 66 + 46 2.46 Prepaid Expenses 100 80 - 20 - 40 1.60 Total Current Assets 720 656 - 64 - 18 1.82 Fixed Assets : Land and Building less 480 720 + 240 +100 2.0 Depreciation Furniture &Fixture less 60 80 + 20 + 66 2.66 Depreciation Plant and Machinery less 240 480 + 240 + 200 4.00 Depreciation Total fixed Assets 780 1,280 + 500 + 128 2.20 Total Assets 1,500 1,936 + 436 + 58 2.58 Liabilities and Capital: Current Liability : Trend creditors 234 510 + 276 + 108 3.08 Accrued Expenses 400 360 - 40 - 20 1.08 Total Current liabilities 634 870 + 236 + 74 2.74 Equity Capital 400 500 + 100 + 50 2.50 Retained Earnings 466 566 + 100 + 42 2.42 Total Capital 866 1,066 + 200 + 46 2.46 Total Liabilities and 1,500 1,936 + 436 + 58 2.58 Capital 3.4.4 Preparation of a Comparative Income Statement: An Income Statement shows the Net Profit or Net Loss from business operation of a definite accounting period. Like a balance sheet, a comparative income statement show the operating results for a number of accounting periods so that the changes in absolute date from one period to another may be explained and analysis.  44 The Comparative income statement contains the some columns as the comparative balance sheet and provides the same in the figures. Specimen of a Comparative Income Statement ABC Co. Ltd. Comparative Income Statement For the year ended 31st Dec. 1980 and 1981 (Amount in Lakhs of Rupees) st st 31 31 Increase (+) / % Dec. Dec. Decrease (-) Amount 1980 1981 Net Sales 1370 1442 + 72 +0.6 Less : Cost of Goods Sold 838 926 + 88 + 21 Gross Profit 532 516 - 16 - 6.4 Operating Expenses : Selling Expenses 188 182 -6 - 6.4 Gen. and Admn. Expenses 94 92 -2 - 4.2 Total Operating Expenses 282 274 -8 - 5.6 Operating Profit 250 242 -8 - 6.4 Add : Other Income Dividend 44 50 +6 + 2.8 294 292 -2 - 1.4 Less : Other Deduction Interest Paid 44 44 Nil Nil 250 248 -2 - 1.6 Less : Income Tax 124