BALANCE SHEET

What is a Balance Sheet?

Balance Sheet is a statement of assets, liabilities and equity of a company

expressed in monetary terms as on a particular date. This gives the financial
position of the company at a given point of time.

Assets are items of monetary value owned by a company. Liabilities are the
monetary claims that the company owes to the outsiders. Equity refers to the
owners’ interest in the business. The equity owners of a business are residual
claimants, having a right to what remains only after the creditors have been
paid.

Assets= Outside Liability + Owner’s Equity

Why does a company prepare Balance Sheet?

A Balance Sheet is prepared and published by companies, not on their own

volition, but because of statutory obligation, imposed by the Companies Act,
under which every public limited company is required to prepare and publish
its Balance Sheet, and other related documents, within six months from the
close of the accounting period. The Act further insists that the financial
statements should be audited by a Chartered Accountant who has to report to
the shareholders whether or not the accounts are “true and fair”. The balance
sheet could be prepared either in “T” form or in Vertical Form as given in
Annexure I and II of the scheduled VI of the Companies Act.

Why is share capital a liability?

It is essential to remember that a balance sheet is prepared not from the

owner’s point of view, but from the company’s point of view. A company is a
legal entity and has its own existence. Therefore, the balance sheet is prepared
in the name of the company itself. That is the reason why the share capital
and the reserves are shown as a liability. This concept is known as business
entity concept. Because of this the profit earned by a company after payment
of dividend to the shareholders is added to the reserves and surplus on the
liability side.

Why assets are always equal to the liabilities?

Before we go further, it may be desirable to resolve how the assets are always
equal to the liabilities. For example, if an asset is purchased on credit, an asset
is created on the right hand side of the balance sheet and immediately a
liability is also created on the left side. If the asset is purchased on cash basis,
cash is depleted to the same extent on the asset side, as the addition to
another asset. Similarly, when a liability, say a bank overdraft, is repaid, the
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liability is decreased, and correspondingly cash on the assets side also
decreases.

All business transactions have two effects, which are equal in amount, but
opposite in effect. A balance sheet is nothing but a summary of all
transactions. Therefore, it tallies always. So assets are always equal to the
liabilities. This concept is called accounting equivalence concept or double
entry book keeping concept.

Liabilities: Source of Funds

A company requires money for the purpose of acquiring fixed assets, and also
to finance its day to day operations. This money is available from various
sources. The owners themselves contribute to the company’s funds in the
form of share capital. If the company operates a successful business, profits
are generated from year to year, and they also constitute a very important
source of funds for the company, to the extent that they are sometimes
ploughed back into the business, and are not taken away by the shareholders
in the form of dividends. The owners may not be able to supply all the funds
needed by the company. Therefore, the company has to depend on outside
sources, such as banks, financial institutions, public etc., for the balance of the
required funds. Whether the funds come from the owners or from the outside
sources, they are considered as liabilities from the point of view of the
company. Therefore, the liabilities on a balance sheet indicate the various
sources from which a company receives funds.

Share Capital

It represents the contribution made by the shareholders. There are two

different types of shares:

1) Equity Shares
2) Preference shares (which enjoy preference over the equity shares in
two respects: payment of annual dividend and repayment of capital in
the event of company’s liquidation)

Preference shares usually carry a fixed rate of dividend whereas no such

commitment is associated with the equity shares. Since the equity
shareholders do not have a right to receive any fixed dividend it is said that
they are the true owners of a company; they are really exposed to all sorts of
risks. If the company is prosperous and earns fabulous profits, there is no
limit to their dividends. On the other hand, if the company incurs losses, they
get nothing. They own all and they risk all.

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There are many types of preference shares:

a) Cumulative and Non Cumulative

If the right to receive dividend is cumulative, they are known as

cumulative preference shares. If the company does not earn sufficient
profits in a year, the preference dividend may be skipped for that year;
but their right to receive that skipped dividend does not cease; it
accumulates and becomes payable as and when the company earns
sufficient profits.

b) Participating and Non Participating

Preference shares which can participate in the profits along with equity
shares are called participating preference shares; otherwise non
participating preference shares. When participating preference shares
are issued, certain limits to the extent of participation are clearly spelt
out in the terms of issue.

Before we conclude our discussion on share capital, it is desirable for us to

understand a few more terms associated with it:

Authorized Capital

Every company has to specify in its Memorandum of Association (MoA) how

much share capital it wants to raise, and in what form. This amount is called
authorized capital or the nominal capital. While deciding the quantum of the
authorized capital, the management should take into account not only the
immediate needs of the company but also its long term needs.

Issued Capital

It is not necessary that a company should issue the entire amount of the
authorized capital at any point of time. Therefore, the issued capital may be,
and is usually, less than the authorized capital. The issued capital represents
the amount of share capital, which is issued to the promoters, or to the public,
or to such other persons, as may be decided by the management.

Subscribed Capital

When shares are issued to the public, the public may or may not subscribe for
all the shares issued to them. Subscribed capital represents only that portion
of the issued capital which the public has subscribed. Therefore, it may be less
than the issued capital.

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Paid up Capital

The public need not pay the entire amount of share capital at the time of the
application itself. The money may be collected by the company from the
shareholders in installments. Therefore, the paid up capital represents that
portion of the subscribed capital which was actually paid by the shareholders.

Reserves and Surplus

This is the second item on the liabilities side. Reserves and surplus are profits
which have been retained in the firm. There are two types of reserves:
revenue reserves and capital reserves. Revenue reserves represent
accumulated retained earnings from the profits of normal business operations
(i.e. profits that arise in the ordinary course of business). These are held in
various forms: general reserve, investment allowance reserve, capital
redemption reserve (CRR), dividend equalization reserve, etc. Capital
reserves arise out of gains which are not directly related to the main line of
business. When shares are issued at a premium, the premium is a profit to the
company, but this has not arisen out of any trading transactions; so it is a
capital reserve. Similarly, when a holding company acquires a subsidiary
company and pays a price which is lower than the net assets (total assets
minus outside liabilities), the holding company makes a profit, which is again
not in its usual course of business. Another example is the gain on revaluation
of assets. This type of unusual and non-recurring profit becomes capital
reserve.

It is not possible to distribute the capital reserves in the form of dividends to

the shareholders. After complying with certain statutory regulations, it is
possible to issue bonus shares out of capital reserves. But on the other hand,
the revenue reserves can be used for distributing dividends to the
shareholders.

Surplus is the balance in the profit and loss account, which has not been
appropriated to any particular reserve account. The surplus is indicated by
the name Profit and Loss Account (Cr) as the last item under Reserves and
Surplus.

It may be noted that reserves and surplus along with equity capital represent
owner’s equity.

Owner’s equity= Equity Capital + Reserves + Surplus

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Shares issued at premium or discount:

Successful companies which are already in existence might have built up

quite a large amount of reserves. The shareholders whether old or new, are
equally entitled to participate in these reserves which, in fact, represent the
sacrifice made by the old shareholders. It would be unfair to allow the old
and the new shareholders to participate pari passu without getting a fair
amount of premium from the new shareholders. The share premium paid by
the shareholders will not be a part of the share capital but a part of the
reserves.

On the other hand, companies are also permitted to issue share at a discount,
subject to certain conditions imposed by the company law. There may be a
company which might have incurred heavy losses in the past: so the present
financial position of the company may be very bad and disappointing,
without any reserves to fall back upon. But there may be bright prospects
ahead for the company, only if it could generate sufficient funds to come out
of the mess. In such a case, a company may find it necessary to issue shares at
a discount. For example, a share having a face value of Rs. 10 may be offered
to the public at Rs. 9. However, in practice, we do not normally come across
such public issues offered at a discount.

Secured Loans

It is not possible for a company – even if it is possible, it is uneconomical- to

run the business wholly with the shareholder funds. A careful balance
between own funds and borrowed funds is essential to minimize the overall
cost of financing.

Secured loans represent the loans, raised by the company in the form of
debentures, commercial bank loans, loans from financial institutions, and
other parties. The secured loans provide a security to the lender to fall back
upon in the event of non payment of interest or principal amount or both by
the borrower. The security could be in the form of pledge, mortgage or
hypothecation.

A debenture is a loan bond which carries a fixed rate of interest payable at

stated intervals. Debentures may be issued to the public either at face value or
at a premium or at a discount. Debentures are usually redeemable at the end
of a specified period again, either at face value or at a premium (but not
usually at a discount). Debenture holders (the counter part of shareholders)
generally form a trust and appoint a trustee to look after their interests.
Debentures are basically of two types- non- convertible and convertible. These
loans carry either a fixed or floating rate of interest.

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Commercial banks give loans, generally, to meet the working capital
requirements. These loans are in the form of overdrafts, cash credits, and key
loans. They are backed by hypothecation of stocks and sometimes of book
debts also. Nowadays, commercial banks started extending long-term loans
also.

Financial institutions such as Industrial Development Bank of India (IDBI),

State Finance Corporations and Industrial Finance Corporation of India etc
give long term loans even for periods of 20 years repayable in easy annual
installments. These long term loans are secured, usually by a first or a second
charge on the fixed assets of the company. Deferred payment credit from a
supplier of machinery is another source of secured loan.

Unsecured Loans

As against the secured loans, the unsecured loans are those which are not
backed by any security. Under this category, are the loans raised by the
company from the public in the form of fixed deposits, loans and advances
from promoters, inter-corporate borrowings and unsecured loans from banks.
Now, the Companies Act has imposed a restriction that a non-financial non-
banking company cannot raise public deposits exceeding 25% of the paid-up
capital and free reserves. Another form of unsecured loan could be
commercial papers (CP). Commercial Papers are short term financing
instruments for a period 90 days to 365 days. These are normally sold at a
discount to the face value. Only reputed companies with net worth of over 8
cores can issue CP. These companies are required to get these instruments
credit rated by a rating agency.

Current Liabilities and Provisions

Current Liabilities are obligations which are expected to mature in the next
twelve months. Items of current liabilities are usually:

a) Acceptances
b) Sundry Creditors/Accounts Payable
c) Unclaimed Dividends
d) Interest accrued but not due on loan
e) Accrued expenses

A provision is an intention of the company (to pay somebody a certain sum of

money), which is reflected in the accounts. It indicates the existence of a
specific liability, against which the company wants to guard itself. Provision
for taxation, provision for expenses, provision for interest accrued but not
due, provision for dividends, gratuity, pensions, etc., are a few examples. In
order to ascertain the correct amount of profits, it is very essential to make

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provision for expenses, which are incurred but not paid for in cash. These
provisions are debited to the profit and loss account and therefore profits are
reduced to the extent of the provisions made during the period.

Assets: Application of Funds

While the liabilities on the balance sheet indicate the various sources from
which money is raised, the assets tells us the other part of the story – namely,
how this money is spent; how much money is spent towards fixed assets; and
how much towards working capital; whether there is any surplus which is
invested outside the business. Assets are valuable resources that a firm owns
or controls. Therefore, let us now examine the assets in detail.

Fixed Assets:

These assets are the ones which are used directly or indirectly for carrying on
the operations of the firm. These are ordinarily not meant for resale in the
normal course of business and are for use over relatively long periods.

Examples of fixed assets are many – land, buildings, plant, machinery, motor
vehicles, office equipment, furniture and fixtures, patents, copyrights, etc.
These are recorded at historical cost and presented as a net figure (i.e. original
cost minus depreciation/amortization) on the balance sheet.

Any fixed asset, which is still under construction, is termed as capital work-
in-progress. As soon as they are completed, they are withdrawn from capital
work-in-progress and added to the respective asset account. Similarly, when
any in-transit asset is received, it is added to its respective asset account.

Investments

These are financial securities owned by the company. Some investments

represent long term commitment of funds (usually these are the equity shares
of other companies held for income and control purposes). Other investments
are short term in nature and maybe rightly classified under current assets for
managerial purposes. Under requirements of the Companies Act, however,
short term holding of financial securities also has to be shown under
investments and not under currents assets. Company law also requires that
the quoted (i.e. those investments dealt with in a stock exchange) and the
unquoted investments should be separately indicated. They are usually
shown at cost value but the market values are also indicated, as an additional
piece of information.

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Current Assets, Loans and Advances

This category consists of cash and other assets which get converted into cash,
or which result in cash savings, during the operating cycle of the firm.
Current assets are held for a short period of time as against fixed assets which
are held for relatively longer periods. The major components of current assets,
loans and advances are: inventories, sundry debtors, cash and bank balances,
pre-paid expenses, loans and advances, marketable securities, etc.

Inventories (also called stocks) comprise of raw materials, work-in process,

finished goods, packing materials, and stores and spares. Inventories are
generally valued at cost or net realizable value, whichever is lower. The cost
of inventories comprises of purchase cost, conversion cost, and other cost
incurred to bring them to their respective present location and condition. The
cost of raw materials, stores and spares, packing materials, trading and other
products is generally determined on weighted average basis. The cost of
work-in –process and finished goods is generally determined on absorption
costing basis- this means that the cost figure includes allocation of
manufacturing overheads.

Sundry Debtors (also called accounts receivable) represent the amount owned
to the firm by its customers (who have bought goods and services on credit)
and others. Sundry debtors are classified into two categories viz., debts
outstanding for a period exceeding six months and other debts. Further,
sundry debtors are classified as debts considered good and debts considered
doubtful. Generally, firms make a provision for doubtful debts which is equal
to debts considered doubtful. The net figure of sundry debtors is arrived at
after deducting the provision for doubtful debts.

Cash and bank balances comprise of funds readily disbursable by the

company i.e. cash on hand and balance with scheduled banks and non-
scheduled banks.

Other current assets comprise of items such as interest accrued on

investments, dividends receivable, and fixed assets held for sale (the last item
is valued at net book value or estimated net realizable value, whichever is
lower).

Loans and advances comprise of items such as advances and loans to

subsidiaries, advances recoverable in cash or in kind for value to be received,
pre-paid expenses (expenditures incurred for services to be rendered in the
future and reported at the cost of unexpired service), and deposits with
government authorities. The net figure of loans and advances is arrived at
after deducting a provision for doubtful advances, if any.

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Miscellaneous Expenditures

This category consists of two items (i) miscellaneous expenditure and (ii) loss
or debit balance of profit and loss account

Miscellaneous expenditure comprises of items such as preliminary expenses,

pre-operative expenses, discount allowed on the securities, interest paid out
of capital during construction, and development expenditure to the extent not
written off or adjusted.

Losses are a decrease in owner’s equity. However, as per company law

requirements, the share capital cannot be reduced when a loss occurs. Hence
if there is a debit balance of profit and loss account carried forward after
deduction of the uncommitted reserves, if any, it is shown on the assets side.

ABC Ltd

Balance Sheet as at 30 June 2008

Liabilities Assets
Rs. Rs. Rs.
1. Share Capital xxxxx 1. Fixed Assets xxxxx
Less: Depreciation xxxx xxxxx
2. Reserves and surplus xxxxx 2.Investments xxxxx
3. Secured Loans xxxxx 3.Current assets, loans & advances xxxxx
4. Unsecured loans xxxxx 4.Fictitious assets xxxxx
(Deferred Revenue Expenditure)
5. Current Liabilities and
Provisions xxxxx
Total xxxxx Total xxxxx

The above balance sheet is “T” balance sheet as it looks like the English
alphabet “T”. The latest trend, however, is to present the same figures in a
more understandable form, which has come to be known as vertical balance
sheet, which is shown on the next page.

You can observe from these balance sheets that except for a change in the
method of presentation, both statements use the same figures, and convey the
same meaning. It has, however, been generally found that a layman feels
more at home with the vertical Balance sheet, and understands it much better
than the “T” Balance Sheet. The formats of both T Balance Sheet and Vertical
Balance Sheet are given on page 21, 22 and 23.

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Vertical Balance Sheet

1. Funds employed: Rs.

(a) Fixed Assets less depreciation xxxxxxx
(b) Investments xxxxx
(c) Net current assets (All current assets minus
current liabilities and provisions)
(xxxxx – xxxxx) xxxxx
xxxxxxx
2. Financed by: Rs.
I Shareholders’ funds:
(a) Share Capital xxxxxx
(b) Reserves and surplus
Less: fictitious assets
(xxxxx - xxxxxx) xxxxxx xxxxxx
II Borrowed funds:
(c) Secured loans xxxxxx
(d) Unsecured loans xxxxxx xxxxxx
xxxxxxx

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