Financial Accounting

Financial Accounting and
Analysis
S. No Reference No Particulars Slide
From-to
1 Chapter 1 Introduction To 5-22
Financial Accounting
2 Chapter 2 Accounting Process 23-42
3 Chapter 3 Trial Balance To Final Accounts 43-66
4 Chapter 4 Accounting Standards I 67-90
5 Chapter 5 Accounting Standards II 91-114
6 Chapter 6 Generally Accepted 115-131

Accounting Principles
7 Chapter 7 Corporate Accounts 132-165
8 Chapter 8 Cash Flow Statement 166-189

9 Chapter 9 Financial Statement Analysis I 190-204
From-to
10 Chapter 10 Financial Statement Analysis II 205-228
11 Chapter 11 Financial Statement Analysis III 229-252

Course Introduction
• Financial accounting is called the language of the business. It deals with the preparation of the
financial statements viz. income statement, balance sheet, statement of cash flows and a
statement of retained earnings.
• For the preparation of financial statements accounting standards need to be followed.
Following accounting standards brings standardization. Generally Accepted Accounting
Principles (GAAP) or the Indian GAAP are the accounting standards that are followed all over
India for the preparation of financial statements.
• To make good financial decisions, professionals carry out financial statement analysis. They
use financial analysis tools to assess the viability, stability and profitability of a business.
Ratio analysis is the most widely used tool for financial statement analysis.
Chapter 1: Introduction To
Chapter Index

From-To
7
1 Learning Objectives
Nature and Scope of Financial 8-10

2 Topic 1
Accounting
Financial Accounting, Management 11-13
3 Topic 2
Accounting and Cost Accounting
Basic Accounting Concepts 14-17

4 Topic 3
Advantages and Limitations of 18-19

5 Topic 4
20
6 Let’s Sum Up
• Describe the nature and scope of financial accounting
• Differentiate between financial accounting and management accounting
• Explain the basic accounting concepts
• Discuss the advantages and limitations of financial accounting
1. Nature and Scope of Financial Accounting
• According to the American Accounting Association (AAA), “Accounting is the process of

identifying, measuring, and communicating economic information to permit informed
judgments and decisions by users of the information.”
• Financial accounting is the field of accounting involving the preparation of financial
statements for decision makers, such as stockholders, suppliers, banks, employees,
government agencies, owners and other stakeholders.
Financial Accounting as a Service Activity
Financial Accounting as a Profession
Financial Accounting as Language of Business
Financial Accounting as Science and Art
Financial Accounting as Information System

• Financial Accounting as a Service Activity: One of the functions of financial accounting is

to provide quantitative information about the economic aspects which are useful in making
economic decisions and choosing among the alternative courses of action.
• Financial Accounting as a Profession: Financial accounting provides an array of
opportunities for professionals.
• Financial Accounting as Language of Business: It is a means of reporting and
communicating information about a business. The expression, exhibition and presentation of
accounting data known as accounting principles or rules (such as numerals and words and
debits and credit) are accepted as symbols which are unique to the discipline of accounting.
• Financial Accounting as an Information System: Accounting information is used for

forecasting, comparing and evaluating the earning capability and the financial position of a
business entity. Therefore, distribution of information is a vital function of accounting.
Business Output
Input (Data) Processing To the Users
Activities (Information)
1. Financial Accounting, Management Accounting and Cost
Accounting
• The Chartered Institute of Management Accountants (CIMA), London, defines Management

Accounting as “The process of identification, measurement, accumulation, analysis,
preparation, interpretation, and communication of information used by management to plan,
evaluate and control within an entity and to assure appropriate use of and accountability for its
resources. Management accounting also comprises the preparation of financial reports for non-
management groups such as shareholders, creditors, regulatory agencies and tax authorities".
• Management accounting uses the financial data provided by financial accounting by the
management of an organisation to improve the efficiency.
Accounting
Points Financial Accounting Management Accounting

Accounting principles It follows the Generally Accepted Accounting Principles (GAAP) It is not bound to follow the Generally Accepted
or International Financial Reporting Standards (IFRS) to create a Accounting Principles (GAAP). It can use any
sense of confidence as the data is used by external users. accounting standard or technique to generate
useful information.
Audit Independent certified public accountants audit the annual financial There are no independent audits verifying the
statements of publicly traded companies. information.
They also express an opinion on the fairness of the financial (Organisation's internal audit function may exam
information. procedures used in preparing reports).
Unit of measurement The financial information is usually expressed in monetary terms. Besides, monetary units, management accounting
This is to help in making comparisons between different data. uses measures such as machine hours, labour
hours, product units, etc. for the purpose of
analysis and decision making.
Reporting purpose Report is about the company as a whole. (Consolidated financial Management determines the contents of a report
statements) (products, customers, geographical regions,
The standards to use for financial reporting are determined: IFRS departments, divisions) and its format. Reports
or GAAP. are prepared only when management believes the
benefit of using the report exceeds the cost of
preparing the report.
Accounting
Points Financial Accounting Cost Accounting
Primary users of information It involves the preparation of a standard set of It involves the preparation of a broad range of
reports for an outside audience, which may include reports that management needs to run a business.
investors, creditors, credit rating agencies and
regulatory agencies.
Objective It provides information about the financial It provides information about the determination of
performance and financial position of an cost in order to control cost and take relevant
organisation. decisions.
Format Reports prepared under financial accounting are In this, reports are prepared using the format
highly specific in their format and content, as specified by management with the intention of
mandated by either GAAP or IFRS. including only that information pertinent to a
specific decision or situation.
Focus Financial accounting primarily focuses on reporting Cost accounting usually results in reports at a much
the results and financial position of an entire higher level of detail within the company, such as
business entity. for individual products, product lines, geographical
areas, customers, or subsidiaries.
Content of report It contains an aggregation of the financial It contains both financial and operational
information recorded through the accounting information. Operational information is collected
system. from a variety of sources that are not under the
direct control of the accounting department.
Analysis of costs and profits It presents the profit/loss incurred by an It provides detail of cost incurred and profit earned
organisation as a whole. from each job, product, process, contracts, etc.
separately.
Recording of data It records historical data. Cost accounting collects and presents the budgeted
data. It includes both historical and estimated cost
data.
1. Basic Accounting Concepts
• Major accounting concepts:
Entity Concept
Cash and Accrual Concept
Matching Concept
Double Entry Accounting System
Money Measurement Concept
Going Concern Concept
Historical Cost Concept
Accounting Period Concept
Conservatism
Realisation
Consistency
Materiality
• Entity Concept: According to this concept, a business is treated as a separate unit or entity
from the owners, creditors, managers and stakeholders.
• Cash and Accrual Concept: In cash basis of accounting, revenue is recognised when cash is
received, whereas the expense is recognised when cash is paid. In the accrual concept of
accounting, revenues or expenses are recorded when they are earned or incurred, and not when
cash is paid or received by an organisation.
• Matching Concept: According to the matching concept, the expenses incurred on earning the
revenues should be recognised during the accounting period in that time period and not in the
next or previous time period in order to reach accurate net income figure.
• Double Entry Accounting System: According to this concept, there are the two aspects of
every business transaction, namely Debit (Dr) and Credit (Cr) entries.
• Money Measurement: Only those transactions and events would be recorded in the books of
accounting that are financial or monetary in nature.
• Going Concern: Going concern concept is based upon the assumption that an organisation
would not be ceased or liquidated in the immediate future, and continues to operate for an
indefinite period.
• Historical Cost: According to the historical cost concept, the assets are measured as per the
price paid (cost incurred) to acquire them.
• Accounting Period: Accounting period refers to the period for which an organisation
evaluates its financial position. It covers the profit earned or loss incurred by the organisation
for a particular duration that is represented in the income statement.
• Conservatism: Financial transactions are recorded in the books of accounting by taking into
consideration all prospective losses and ignoring all prospective profits. This concept is based
on the conservative approach.
• Realisation: This concept states that an organisation should determine the time when
revenues are earned and expenses are incurred. The accountant should record the business
transactions only when it is realised.
• Consistency: According to this concept, the practices and methods of accounting remain
constant in different accounting periods. Therefore, the financial information of one period
can be compared to another.
• Materiality: According to this concept, the main basis of accounting should be material facts.
It emphasises the inclusion of only the important details of the material and ignoring the
insignificant details.
1. Advantages and Limitations of Financial Accounting
Advantages of accounting:
Maintaining Business Records
Preparing Financial Statement
Comparing results
Providing information to interested groups
Providing legal evidences
Helping in decision making

2. Advantages and Limitations of Financial Accounting
Limitations of accounting:
• It focuses only on financial transactions or events while ignoring the non-monetary items.
• It leads to wrong conclusions if the assumptions of accounting data are inaccurate.
• It obtains biased information from the accountant if he/she willingly makes inappropriate
estimations.
• It shows fixed asset at a particular cost, which would depreciate over time. Hence, there is a
significant difference between the original cost at which assets were purchased and the current
replacement cost.
• It provides accounting information on a yearly basis only, while the information can also be
required for a shorter duration.
Let’s Sum Up
• Accounting is a very important and old concept in business management. Accounting has
become synonymous with the “language of business”.
• With the expansion of the market and the size of the business organisations, the shareholders,
creditors, suppliers, potential buyers and various government agencies seek to get the financial
disclosure of the organisation.
• In today’s business world, accounting plays the crucial role of providing important financial
information to the interested parties.
• Financial accounting refers to the process of systematic recording of financial transactions
aimed at preparing profit and loss account and balance sheet.
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Chapter 2: Accounting
Process
Chapter Index

From-To
25
Accounting Process 26-31
2 Topic 1
Journal 32-33
3 Topic 2
Ledger 34-35
4 Topic 3
Meaning of Subsidiary Books 36-38

5 Topic 4
Bills of Exchange 39
6 Topic 5
40
7 Let’s Sum Up
• Describe the accounting process
• Explain the stages of the accounting process
• Describe the meaning and format of journal
• Describe the meaning and format of ledger
• Discuss subsidiary books
• Explain Bills of Exchange
1. Accounting Process
• The accounting process starts when a financial transaction is made.

• The main objective of this process is recording financial transactions systematically and
accurately in the journal and process them to prepare the financial statements.
• The process of financial accounting involves a number of steps:
Sources of Accounting Information
Recording the business transactions in the accounting system according to the dual aspect
concept and classifying the accounting information
Arithmetic checking of double entry book keeping
Statement measuring the profit or loss for an accounting period, statement of assets, liabilities,
and capital at the end of the accounting period
Stages in Accounting Process

Identification of Financial Transactions
Preparation of Vouchers
Recording Entries in the Books of Original Entry
Posting to the Ledger
Preparation of Trial Balance and Financial

Statements
Traditional Approach for Recording Transactions

The traditional approach is also known as the British approach. In this approach, various accounts
are classified as personal account, real account and nominal account.
• Personal Account: Debit the receiver and credit the giver
• Real Account: Debit what comes in and credit what goes out.
• Nominal Account: Debit all expenses and losses and credit all incomes and gains.
Accounting Equation
• An accounting equation refers to a statement that states that a firm has equal assets and
liabilities. Dual entry concept is the basis of the accounting equation.
• For an accounting equation, it is required to first analyse the transaction in terms of variables,
such as assets, liabilities, capital, revenue and income. After that, decide the effect of the
transaction in terms of increase and decrease on variables, and then record the effect on the
transaction in the relevant side of the equation.
Assets = Equities ( Total Claims)

Assets = Liabilities + Capital
Liabilities = Assets  Capital
Capital = Assets  Liabilities
Balance Sheet Approach of Recording Transactions

• This approach records the transactions on the basis of the accounting equation i.e. Assets =
Liabilities + Capital.
• All the accounts are classified into the following five types: assets, liabilities,
income/revenues, expenses, or capital gain/losses.
• Rules of debit and credit
– Assets Accounts: Debit increases in assets and credit decreases in assets.
– Capital Account: Credit increases in capital and debit decreases in capital.
– Liabilities Account: Credit increases in liabilities and debit decreases in liabilities.
Debit and Credit Rules

• In case of personal accounts: Debit the receiver and credit the giver.
• In case of real accounts: Debit what comes in and credit what goes out.
• In case of nominal accounts: Debit all expenses and losses and credit all incomes and gains.
1. Journal
Meaning and Format of Journal

• A journal refers to a primary book of accounts in which all transactions of a business are
recorded. The process of recording a transaction in a journal is known as journalising.
• Format of a Journal
Date Particulars L.F. Debit Amount Credit Amount

(Rs.) (Rs.)
Name of the debited account Dr.
To Name of the credited account
(Narration)

2. Journal
Process of Journalising
1. Ascertaining that the accounts are affected by the transaction and the nature of the
account which is affected
2. Ascertaining the account to be debited and the account to be credited
3. Ascertaining the amount by which the accounts are to be debited and credited
4. Recording the date and month of the transaction
5. Recording in the particular column the name of the account to be debited.
6. Recording in the “Particular” column the name of the account to be credited.
7. Recording a brief description of the transaction starting from the next line in the
“Particulars” column.
8. Drawing a line across the “Particulars” column to separate one journal entry from the
other.
1. Ledger
Meaning and Format of Ledger

• A ledger refers to a book or register in which financial transactions are permanently recorded
after being summarised and classified.
• Ledgers help in preparing a trial balance, after which the final statement is prepared.
Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)

2. Ledger
Ledger Balancing
1. Calculate the amount of both the debit and credit sides of the account separately.
2. Calculate the difference of both sides. If there is no difference, it means that the balance is nil.
If the total of the debit side is greater than the total of the credit side, the difference is written
on the credit side; and vice versa
3. Type the balance as To Balance c/d, if the difference is on the debit side. Type the balance as
To Balance b/d, if the difference is on the credit side.
4. Note that the closing balance of the previous period of an account appears as the opening
balance for the next period of the account. The closing balance of the previous period is
written in the opposite side of the next period as To Balance b/d or By balance b/d.
1. Meaning of Subsidiary Books
• Cash Book: Includes the records of all the receipts and payments made by cash and cheques.
The Cash Book, which is used to record cash as well as bank transactions, is known as Bank
Book. The Cash Book has two sides, namely the left side, which records all the cash receipts
and the right side, records all the cash payments. The special feature of the Cash Book is that
it functions as a Journal and a Ledger with regard to the cash and bank transactions
respectively.
• Petty Cash Book: Format of petty cash book is as follows
Date Purchase/Receipt Amount (Rs) Balance (Rs)

4/01/2011 Opening Balance 25,000 25,000
4/05/2011 Kitchen Supplies 3,000 22,000
4/08/2011 Furniture 9,000 13,000
• Purchase Book: Involves the records of the credit purchases of goods. However, the cash
purchases of goods or the credit purchases of assets are not recorded in this book.
• Sales Book: Involves the records of all the credit sales of goods. However, it does not record
the cash sales of goods or credit sales of assets. It is also known as Sales Journal.
• Purchase Returns Book: Includes the records of the return of goods and materials sent back
to the suppliers. It is also called to Return Outward Book.
• Sales Returns Book: Includes the records of the returns of the credit sales received back from
the customers. It is also known as the Return Inwards Book.
Bills of Exchange
A good can be bought or sold for cash or on credit. In case of a credit purchase or sale, the
payment is deferred to a future date. A bill of exchange is an instrument of credit that is used to
assure the seller that the payment would be made according to the agreed conditions. The bill of
exchange is an unconditional order to pay a certain amount on a specified date. In India, bills of
exchange are governed by the Negotiable Instruments Act 1881. Features of BOE:
1. A bill of exchange is an order to make a payment.
2. There must be a sign of the maker of the bills of exchange.
3. The amount of payment and the date of payment must be certain.
4. A bill of exchange must be payable to a certain person.
5. The bill of exchanges must be stamped as per law.
Let’s Sum Up
• Accounting process is one of the most fundamental concepts of accounting. The accounting
process helps in maintaining systematic records of all financial transactions to avoid any
possible errors.
• A journal refers to a primary book of accounts in which all transactions of a business are
recorded. A journal can also be defined as a chronological record of the business transactions.
• A ledger refers to a book or register in which financial transactions are permanently recorded
after being summarised and classified.
• After we have posted and recorded the transactions, it is necessary to balance each account
prepared in a ledger.
Post Your Query
Chapter 3: Trial Balance To
Final Accounts
Chapter Index

From-To
45
Preparing a Trial Balance 46-48

2 Topic 1
Rectifying Errors 49-55

3 Topic 2
Final Accounts 56-63

4 Topic 3
Let’s Sum Up 64
5
• Describe how to prepare a trial balance
• Discuss the rectification of errors in trial balance
• Describe different types of final accounts
1. Preparing a Trial Balance
• Trial Balance refers to a list of closing balances of ledger accounts on a particular date and
constitutes the first step towards the preparation of financial statements of an organisation.
• A trial balance is generally prepared at the end of the accounting period for preparing the
financial statements.
• Objectives of preparing a trial balance from a ledger account:
1. For achieving arithmetical accuracy of the accounts (debits must equal credits)
2. For using as a worksheet
3. For serving as a source report for preparation of financial statements
Format of a Trial Balance

Two Methods for Preparing a Trial Balance

• Traditional method: In this method, Ledger Accounts are not balanced for each debit and
credit entry. They are simply summed up and the total of debit side and credit side should be
equal to each other.
• Modern method: This method is more widely used. The modern method has been derived
from the traditional method. In this method, instead of writing down the sub total of debit and
credit entries on the trial balance, these are set off and only the net balance is indicated at the
end of the trial balance. In this method, ledger accounts are balanced.
1. Rectifying Errors
• In case of agreement in a trial balance, it can be assumed that the recording, posting and
balancing are performed correctly. However, in case the trial balance does not agree, we need
to locate the errors committed which may occur at the time of recording, classifying, or
summarising a financial transaction.
• Even when the trial balance is correct, some errors may remain in the accounting records.
• Two types of errors are committed: errors that affect the trial balance and the errors that do not
affect the trial balance. We need to identify and rectify both types of errors. The process of
rectifying the errors and correcting the accounting records is termed as rectification of errors.
Types of Accounting Errors
Errors of
Omission
Errors of
Errors of
Compensatio
Principle
n
Accounting
Errors
Errors of Principle
• It is imperative to follow the Generally Accepted Accounting Principles (GAAP) to record
accounting transactions.
• When financial transactions are recorded in violation of the accounting principles, the error is
referred to as the error of principle.
• It should be noted that the errors of principles do not affect the trial balance. This is because in
case of such errors, the entry of the transaction is made on the correct side of the account, but
the value of entry or the amount of the transaction is incorrect.
• The rectification of such errors is very important as they directly affect financial statements.
Errors of Principle
Errors of Principle may occur due to the following reasons:
• In case, there is lack of understanding, classification and hence the distinction between the
revenue and capital items. The revenue receipt may be taken as capital receipt or vice versa.
• In case, there is lack of distinction between the business expenses and personal expenses.
• In case, there is lack of distinction between the productive and non-productive expenses.
Errors of Omission
• This type of error occurs when any transaction is not completely or partially recorded in the
books of accounts. There is a difference between the errors of partial recording of transactions
and errors of completely omitting transactions.
• Errors of partial recording results in improper trial balance but the errors of completely
omitting transactions recording do not.
• If a transaction is omitted from the purchase book, it would be omitted from being posted in
the ledger as well. Consequently, the transaction is not found in the trial balance. Thus, the
accuracy of accounts is diminished.
Errors of Omission
• It is not easy to locate Errors of Omission.
• Errors of commission can be rectified by correcting the normal journal entry that was
supposed to be made for the transaction, which is omitted.
• It would correct the error in ledger accounts when the correct journal entry is posted to the
concerned ledger account.
Errors of Compensation
• In case of errors of compensation, an error is nullified with errors of equal proportion.
• It means one type of error is balanced by another error. This is why these are called errors of
compensation. It may happen that when an error occurs in an account, the same type of error
may take place in another account.
• It is not easy to detect such errors.
• Errors of compensation do not affect the trial balance.
1. Final Accounts
• The primary aim of investing money in a business is to earn profits. An organisation needs to
periodically evaluate the profits earned and losses incurred and the financial standing of the
organisation on a given date.
• In an accounting cycle, the final step is preparing the financial statements. Final accounts act
as an important source of information as they provide a structured and easy to understand
information regarding the business activities of an organisation to its users.
• According to John N. Myer, “The final accounts provide a summary of the accounts of a
business enterprise, the balance sheet reflecting assets and liabilities and the income statement
showing the results of operations during a certain period.”
2. Final Accounts
• The main aim of final accounts is to inform the owner about the progress of his/her business
and the financial position at the right time and in the right manner.
• Three types of final accounts are as follows:
Final Accounts
Trading Account Profit and Loss Account Balance Sheet

3. Final Accounts
Trading Account
• Trading Account summarises the final outcome of all buying and selling transactions in a
given period. It reveals the gross profit earned by a business firm.
• Gross profit refers to the difference between sales revenue and the direct cost of the goods
sold.
• Cost of goods sold (COGS) refers to the cost of purchasing the goods from suppliers (for
retailers) or the cost of producing the goods that are sold (for manufacturers).
• Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
4. Final Accounts
Trading Account
• Debit side of a Trading Account:
– Opening Stock - Purchases
– Purchases Returns or Returns outwards - Direct Expenses on Purchases
• Credit side of a Trading Account:
– Sales
– Sales Returns or Return inwards
– Closing stock
5. Final Accounts
Profit and Loss Account

• The profit and loss account is prepared to ascertain the net profit earned and net loss suffered
by a business over a given accounting period.
• The profit and loss account is a statement that shows the expenditures, revenues and net
income of an organisation.
• According to Carter, “A profit and loss account is an account into which all the gains and the
losses are collected in order to ascertain the excess of the gains over the losses or vice-versa.”
• Trading account shows the Gross Profit or Gross Loss of a business firm. The Gross Profit is
then transferred to the credit side of a Profit and Loss Account, while Gross Loss is transferred
to the debit side of the Profit Loss Account.
6. Final Accounts
Profit and Loss Account

• Profit and Loss Account commences with the Gross Profit or Gross Loss and is arrived at the
Net Profit or Net loss at a given time in an accounting year.
• Debit side of a Profit and Loss Account:
– Direct expenses - Indirect expenses
• Credit side of a Profit and Loss Account:
– Gross Profit
– Other gains and incomes of the business such as Interest received, Rent received,
Discounts earned and Commission earned.
7. Final Accounts
Balance Sheet
• A balance sheet shows the assets and liabilities of an organisation.
• The main aim of preparing a balance sheet is to determine the exact financial position of a
company.
• The American Institute of Certified Public Accountants defines balance sheet as, “A tabular
statement of summary of balances (debits and credits) carried forward after an actual
constructive closing of books of account and kept according to the principles of accounting.”
• A balance sheet is the detailed summary of the basic accounting equation:
Assets = Liabilities + Owner’s Equity
8. Final Accounts
Balance Sheet
A number of steps are involved in preparing a balance sheet:
1. Transferring all nominal accounts in the trial balance to the trading and profit and loss
account.
2. The personal accounts of customers are grouped under the heading of sundry debtors,
3. Group all balances of the suppliers under sundry creditors.
4. Real and personal accounts are grouped as assets and liabilities and are arranged in a proper
way. The resultant statement obtained is called the balance sheet.
Let’s Sum Up
• After we have posted transactions in a ledger account and balanced the ledger, a statement is
prepared to show the debit and credit balances separately. This statement is called trial
balance. A trial balance tests the arithmetical accuracy of the posting of transactions into the
ledger.
• The profit and loss account is prepared to ascertain the net profit earned and net loss suffered
by a business over a given accounting period.
• A balance sheet refers to a statement that summarises and presents the financial position of an
organisation on any given date.
Post Your Query
Chapter 4: Accounting
Standards - I
Chapter Index

From-To
69
Accounting Standards 70-80
2 Topic 1
Constitution of the Accounting 81-82
3 Topic 2
Standards Board of India
Procedure of Issuing Accounting 83-85

4 Topic 3
Standards
Compliance with Accounting 86-87

5 Topic 4
Standards
88
6 Let’s Sum Up
• Describe the meaning, objectives and scope of accounting standards
• Discuss the constitution of Accounting Standards Board in India
• Describe the procedure of issuing accounting standards
• Explain the need for compliance with accounting standards
1. Accounting Standards
• Accounting standards are written statements regularly issued by accounting institutes. The
standards are used to consolidate the various accounting principles that are generally accepted.
• This helps in bringing consistency in the reporting of accounting information. Under the
Companies Act, 1956, the Central Government prescribed accounting standards along with the
National Advisory Committee on Accounting Standards (NACAS).
• NACAS is a body of experts which include representatives of several regulatory groups and
government agencies. It is engaged in the practice of examining the Accounting Standards
prepared by the Institute of Chartered Accountants of India (ICAI) to be used by Indian
corporates.
• The ICAI established Accounting Standards Board (ASB) in 1977 in order to develop
accounting standards. They have notified 31 Accounting Standards (AS 1 to 7 and AS 9 to
32). The main purpose of ASB is to develop standards in the areas in which uniformity is
required.
• A large group of individual accounting standards, accounting principles, fundamental
accounting assumptions, common concepts, guidance notes, the Companies Act and ICAI’s
pronouncements are collectively known as “The Generally Accepted Accounting Principles”
(popularly termed as “G.A.A.P.”)
• The common set of accounting standards and procedures that Indian corporates follow to
compile their financial statements is termed as ‘Indian GAAP’. Indian GAAP is an
arrangement of authoritative standards and commonly accepted ways of recording and
reporting accounting information by Indian corporates.
Meaning of Accounting Standards

• The main aim of the accounting standards is improving the quality of the financial statements
and standardising the method of maintaining financial data in financial statements for all
enterprises. In other words, accounting standards help in standardisation of accounting
practices to bring credibility, transparency, uniformity and comparability in the preparation of
the financial statements.
• Purpose of accounting standards:
– It acts as a framework to produce reliable and standardised financial statements.
– It promotes proper and timely dissemination of financial information to the management,
investors and other interested parties and creates a sense of confidence among them.
Meaning of Accounting Standards

– It ensures transparency, consistency and comparability of accounting information by
providing uniformity in accounting practices as the accountants and the auditors follow
the same rules and procedures.
– It considers the business and legal environment of a country.
– It ensures uniformity in accounts in all types of businesses irrespective of their industry
and size.
– It provides flexibility by facilitating an organisation to freely adopt any of the practices
with a suitable disclosure.
Types of Accounting Standards

• The ICAI has issued 31 accounting standards till now.
• These accounting standards are mandatory for the preparation and maintenance of accounts.
• These are obligatory for the members of all the institutes.
AS Title AS Title
Numb Number
er
AS-1 Disclosure of Accounting Policies AS-6 Depreciation Accounting (revised)
AS-2 Valuation of Inventories (revised )
AS-7 Accounting for Construction Contracts
AS-3 Cash Flow Statements (revised)
AS-4 Contingencies and Events Occurring After the AS-9 Revenue Recognition
Balance Sheet Date (revised) AS-10 Accounting for Fixed Assets
AS-5 Net Profit or Loss for the period, Prior Period Items
and extraordinary items and changes in accounting AS-11 Accounting for the Effect of Changes in Foreign Exchange
policies Rates (revised)
Types of Accounting Standards AS-23 Accounting for Investments in Associates in

AS Title Consolidated Financial Statements
Numb
er AS-24 Discounting Operations
AS-13 Accounting for Investments
AS-25 Interim Financial Reporting
AS-14 Accounting for Amalgamations
AS-15 Accounting for Retirement Benefits in the AS-26 Intangible Assets

Financial Statements of Employers
AS-16 Borrowing Costs
AS-27 Financial Reporting of Interests in Joint Ventures
AS-17 Segment Reporting
AS-28 Impairment of Assets
AS-18 Related Party Disclosure
AS-19 Leases AS-29 Provisions, Contingent Liabilities and Contingent

Assets
AS-20 Earnings Per Share AS-30 Financial Instruments: Recognition and
Measurement
AS-21 Consolidated Financial Statements
AS-31 Financial Instruments: Presentation
AS-22 Accounting for Taxes on Income
AS-32 Financial Instruments: Disclosures
Applicability of Accounting Standards

• For the purpose of relaxation to the Small and Medium sized Enterprises (SMEs), the ICAI
have notified in October, 2003 certain relaxation in the applicability of accounting standards
after due consideration of the representations from various professionals and advisors.
• For the purpose of applicability of accounting standards, enterprises are classified into three
categories:
Level -I Enterprise
Level -II Enterprise
Level -III Enterprise

Applicability of Accounting Standards

• Level-I Enterprise: Includes listed enterprises , banks including co-operative banks, financial
institutions, insurance businesses, etc.
• Level-II Enterprise: Includes all commercial, industrial and business reporting enterprises,
whose turnover for the immediately preceding accounting period on exceeds Rs. 40 lakhs but
does not exceed Rs. 50 crores etc.
• Level-III Enterprise: Enterprises, which are not covered under Level-I and Level- II, are
considered as Level-III enterprises.
Enterprise Level Exemption from Accounting Standards
Level I No exemption
Level II Full exemption from AS-3, AS-17
Partial exemption from AS-15, AS- 19, AS-20, AS-28, AS-29
Level III Full exemption from AS-3, AS-17, AS-18, AS-24
Partial exemption from AS-15, AS- 19, AS-20, AS-28, AS-29
Objectives and Scope of Accounting Standards

• Objectives of the accounting standards:
– Improve the credibility and reliability of the financial statements
– Determines managerial accountability
– Assists accountants and auditors

– Enables ease of understanding

• Scope of the accounting standards:
– Efforts will be made to issue Accounting Standards which are in conformity with the
provisions of the applicable laws, customs, usages and business environment in India.
– The Accounting Standards are intended to apply only to items which are material. Any
limitations with regard to the applicability of a specific Accounting Standard will be
made clear by the ICAI from time- to- time. The date on which a particular standard will
come into effect, as well as the class of enterprises to which it will apply, will also be
specified by the ICAI. However, no standard will have retroactive application, unless
otherwise stated.

• Scope of the accounting standards:
– In formulation of Accounting Standards, the emphasis would be on laying down
accounting principles and not detailed rules for application and implementation thereof.
– The standards formulated by the ASB include paragraphs in bold italic type and plain
type, which have equal authority. Paragraphs in bold italic type indicate the main
principles. An individual standard should be read in the context of the objective stated in
that standard and this preface.
1. Constitution of the Accounting Standards Board of India
• In India, the Accounting Standards are issued by the Council of the ICAI. ICAI set up the
Accounting Standards Board in the year 1977.
• ASB has also been assigned with the responsibility to propagate the Accounting Standards and
persuade the corporations to adopt them in the preparation and presentation of their financial
statements.
• The main objective of the ASB is to consolidate the diverse accounting practices followed in
the country. This takes into consideration various applicable laws, customs, usages and the
business environment.
• The ICAI is a member of the International Federation of Accountants (IFAC) and is expected
to promote the International Accounting Standards Board’s (IASB) announcements.
2. Constitution of the Accounting Standards Board of India
• Main functions of the ASB:

– To conceive of and suggest areas in which Accounting Standards need to be developed.
– To formulate Accounting Standards with a view to assisting the Council of the ICAI in
evolving and establishing Accounting Standards in India.
– To examine how far the relevant International Accounting Standard/International
Financial Reporting Standard can be adapted while formulating the Accounting Standard
and to adapt the same.
– To review, at regular intervals, the Accounting Standards from the point of view of
acceptance or changed conditions, and, if necessary, revise the same.
– To provide, from time- to- time, interpretations and guidance on Accounting Standards.
1. Procedure of Issuing Accounting Standards
• The participation of various interested professionals is very crucial for the formulation of
accounting standards.
• Steps involved in the formulation of accounting standards of ASB:
– Determining the board for issuing accounting standards and listing them according to
priority.
– Seeking helps from various professional groups for setting the standards. These groups
draft the preliminary standards as assigned to them. The draft is then reviewed by the
ASB, which in turn sends it to various associates and bodies. The representatives of these
bodies are also invited at a meeting of the ASB for discussion.
– Issuing the exposure draft in order to invite comments from the members of institutes and
public at large. The basic points of the exposure draft:
• Comprises a statement of concepts and fundamental accounting principles related to
the standards
• Include the definition of the terms used in the standards
– Involves the manner in which the accounting principles have been applied for
formulating the standards
– Reviewing the comments of the exposure draft and prepare a final draft to the council of
institutes.
– The council of the institute would consider the final draft of the standards. The
modification of the draft (if required) is done in consultation with the ASB. After that, the
council issues the standards in their final form, under its authority.
1. Compliance with Accounting Standards
• Sub Section (3A) to section 211 of the Companies Act, 1956 requires that every Profit/Loss
Account and Balance Sheet shall comply with the Accounting Standards recommended by the
ICAI.
• In case the standards are not followed, different stakeholders would interpret the accounting
statements in different ways. In addition, the financial statements of different companies
cannot be compared if the statements are not in compliance with the accounting standards.
• The Council of ICAI lays down the following points in its Preface to the Statements of
Accounting Standards:
– Financial Statements cannot be described as complying with the Accounting Standards
unless they comply with all the requirements of each applicable standard.
2. Compliance with Accounting Standards
– The Accounting Standards would be mandatory from the respective dates stated in the
Accounting Standards. The mandatory status of an Accounting Standard indicates that
while settling their attest functions, it would be the duty of the members of the ICAI to
inspect whether the Accounting Standard conforms to the presentation of financial
statements enclosed in their audit. In the event of any deviation from the Accounting
Standard, it would be their duty to prepare adequate disclosures in their audit reports so
that the users of financial statements may be aware of such deviation.
– Ensuring compliance with the Accounting Standards while making the financial
statements is the responsibility of the management of the corporate. Statutes governing
certain enterprises require that the financial statements are prepared in compliance with
the Accounting Standards.
Let’s Sum Up
• Accounting standards are the written statements issued by accounting institutes. The standards
are used to consolidate the generally accepted accounting principles.
• The main aim of the accounting standards is improving the quality of the financial statements
and removing various alternative methods and policies of accounting.
• ICAI has issued 31 accounting standards. These accounting standards are mandatory for the
preparation and maintenance of accounts. The common set of accounting standards and
procedures that Indian corporates follow to compile their financial statements is termed as
‘Indian GAAP’.
Post Your Query
Chapter 5: Accounting Standards
II
Chapter Index

From-To
93
Implementation of Accounting 94-98

2 Topic 1
Standards
Financial Statements Reporting 99-111

3 Topic 2
112
4 Let’s Sum Up
• Discuss the implementation of the Accounting Standards
• Describe various Accounting Standards
1. Implementation of Accounting Standards
• Proper implementation of accounting standards by Indian enterprises implies that the financial
statements and disclosures of the enterprises are prepared by complying with the accounting
standards issued by the Council of ICAI.
• Implementation of accounting standards is the responsibility of the Board of Directors in an
enterprise.
• According to the clause 2AA which was added to Sec 217 of the Companies Act
(Amendment) in the year 2000, the board of directors should also include a Director’s
Responsibility Statement.
• This clause states that the entire responsibility for the implementation of accounting standards
rests with the directors of an enterprise. The auditor’s responsibility is restricted to form his
opinion and to report on the financial statements of the enterprise.
• Auditors need to ensure that the accounting standards have been implemented while preparing
the financial statements. It is the auditor’s responsibility to disclose the deviations.
• Strict adherence to the Accounting Standards would improve the presentation of financial
statements and the understanding of information on the financial statements.
• The importance of implementation of accounting standards has been stated in the “Preface to
the Statements of Accounting Standard (Revised 2004) “issued by the Council of ICAI. It
highlights the guidelines on “General Purpose Financial Statements” which are as follows:
“For discharging its functions, the ASB will keep in view the purposes
and limitations of financial statements and the attest function of the auditors.”
• Functions of ASB:
– The ASB will enumerate and describe the basic concept to which accounting principles
should be oriented and state the accounting principles to which the practices and
procedures should conform.
– The ASB will clarify the terms commonly used in financial statements and suggest
improvements in the terminology wherever necessary. The ASB will examine the various
current alternative practices in vogue and endeavour to eliminate or reduce alternatives
within the bounds of rationality.
– Accounting Standards are designed to apply to the general purpose financial statements
and other financial reporting, which are subject to the attest function of the members of
the ICAI.
• Functions of ASB:
– The term ‘General Purpose Financial Statements’ includes balance sheet, statement of
profit and loss, a cash flow statement (wherever applicable) and statements and
explanatory notes which form part thereof, issued for the use of various stakeholders,
Governments and their agencies and the public. References to financial statements in this
Preface and in the standards issued from time to time will be construed to refer to General
Purpose Financial Statements.
– Responsibility for the preparation of financial statements and for adequate disclosure is
that of the management of the enterprise. The auditor’s responsibility is to form his
opinion and report on such financial statements.
• One of the major developments in the implementation of accounting standards in India is its
convergence with International Financial Reporting Standards (IFRS).
• In order to accomplish the implementation objectives, an implementation committee has been
constituted. This committee would provide assistance to the members and other stakeholders
in the proper implementation of IFRS converged Indian Accounting Standards (Ind AS).
• The issues faced by the committee in the implementation of the accounting standards are
forwarded to the Council of ICAI for their consideration.
1. Financial Statements Reporting
• Reporting of financial statements is a major concern in accounting.

• Different countries follow different standards of reporting financial statements. The norms of
financial statements reporting are mandatorily followed by different companies in a country.
• Major accounting standards include:
– Accounting Standards: 1 and 2
– Accounting Standards: 4 and 5
– Accounting Standards: 6, 9, 10, 16 and 26
– Accounting Standards: 13, 17 and 20
Accounting Standards: 1 and 2

Accounting Standard (AS 1): Disclosure of Accounting Policies
• AS 1 is mandatory to be followed by all enterprises. It mainly deals with disclosure of
significant accounting policies which are followed while preparing and presenting financial
statements. Main aspects of AS1:
– An enterprise should disclose all significant accounting policies that are adopted while
preparing and presenting the financial statements
– Changes in accounting policies
– An enterprise should disclose in case the fundamental accounting assumptions are not
followed

Accounting Standard (AS 2): Valuation of Inventories (revised 1999)
• AS 2 is a mandatory standard. Main aspects of AS 2:
– The objective of AS 2 is to recommend the accounting treatment for inventories. A
primary issue in accounting for inventories is the amount of cost to be recognised as an
asset and carried forward until the related revenues are recognised.
– AS 2 deals with the determination of cost and its subsequent recognition as an expense,
including any write-down to net realisable value. According to AS 2, inventories should
be measured and valued at the lower of cost and net realisable value. As per AS 2 “ The
cost of inventories should comprise all costs of purchase, costs of conversion and other
costs.“

Accounting Standard (AS 4): Contingencies and Events Occurring After the Balance Sheet
Date
• Accounting Standard 4 (AS 4) deals with the treatment in financial statements of
i. Contingencies and
ii. Events occurring after the balance sheet date.
AS 5: Net Profit/Loss for the Period, Prior Period Items and Changes in Accounting Policies
• Accounting Standard 5 (AS 5) deals with “Net Profit/Loss for the Period, Prior Period Items and
Changes in Accounting Policies”. The objective of AS 5 is to recommend the classification and
disclosure of certain items in the profit and loss statement so that all organisations prepare and
present the statement uniformly. The main aspects of this standard are as follows:
– AS 5 should be applied by an organisation in presenting profit or loss from ordinary activities,
extraordinary items and prior period items in the statement of profit and loss, in accounting for
changes in accounting estimates and in disclosure of changes in accounting policies.

Accounting Standards: 6, 9, 10, 16 and 26

Accounting Standard (AS 6): Depreciation Accounting
• Accounting Standard 6 applies to all depreciable assets, except forests, plantations and similar
regenerative natural resources, wasting assets including expenditure on the exploration for
and, extraction of minerals, oils, natural gas and similar non-regenerative resources,
expenditure on research and development, goodwill and other intangible assets and live stock.
• Different accounting policies for depreciation have been adopted by various organisations.
Disclosure of accounting policies for depreciation followed by an organisation is necessary to
appreciate the view presented in the financial statements of the organisation.

Accounting Standard (AS 9): Revenue Recognition
• Accounting Standard 9 deals with the bases for ‘Revenue Recognition’ in the statement of
profit and loss of an organisation. The standard recommends the recognition of revenue
arising in the course of the ordinary activities of the organisation from sale of goods, rendering
of services, and use by others of enterprise resources yielding interest, royalties and dividends.
• It does not deal with the following modes of revenue recognition:
– revenue arising from construction contracts
– revenue arising from hire-purchase, lease agreements


Accounting Standard (AS 10): Accounting for Fixed Assets
• Accounting Standard (AS) 10 recommends accounting standards for ‘Accounting for Fixed
Assets’. The standard deals with accounting for fixed assets grouped into various categories
like land, buildings, plant and machinery, vehicles, furniture, goodwill, patents, trademarks,
etc.
• AS 10 does not deal with accounting for forests, plantations and similar regenerative natural
resources, wasting assets including mineral rights, expenditure on the exploration for and
extraction of minerals, oil, natural gas and similar non-regenerative resources, expenditure on
real estate development, livestock.

Accounting Standard (AS 16): Borrowing Costs
• Accounting Standard (AS) 16 is applied in accounting for borrowing costs and does not deal
with the actual or imputed cost of owners’ equity, including preference share capital not
classified as a liability.
• Definitions covered under AS 16 are as follows:
– Borrowing costs: It refers to interest and other costs incurred by an organisation related
to the borrowing of funds.
– A qualifying asset: It refers to an asset that necessarily takes a considerable amount of
time to get ready for its intended use or sale

Accounting Standard (AS 26): Intangible Assets
• Accounting Standard (AS) 26 recommends the accounting treatment for intangible assets not
covered in another accounting standard.
• AS 26 require an organisation to recognise an intangible asset only if a few criteria are met.
AS 26 also specify how to measure the carrying amount of intangible assets and requires
certain disclosures about intangible assets.
• If some accounting standard deals with a specific type of intangible asset, an organisation
adopts that accounting standard instead of AS 26. For example, AS 26 does not apply to
intangible assets held by an organisation for sale in the ordinary course of business.
Accounting Standards: 13, 17 and 20

Accounting Standard (AS 13): Accounting for Investments
• Accounting Standard 13 deals with accounting for investments in the financial statements
of organisations and related disclosure requirements. The standard does not deal with:
a. The bases for recognition of interest, dividends and rentals earned on investments which are
covered by Accounting Standard 9 on Revenue Recognition;
b. Investments of retirement benefit plans and life insurance enterprises; and
c. Mutual funds and venture capital funds and/or the related asset management companies,
etc.

Accounting Standard (AS 17): Segment Reporting
• Accounting Standards 17 establish accounting principles for reporting financial information
related to different types of products and services that an organisation produces and the
different geographical areas in which it operates.
• Such information helps users of financial statements in the following manner:
– understanding the performance of the enterprise
– assessing the risks and returns of the enterprise
– making more informed judgements about the enterprise as a whole

Accounting Standard (AS 20): Earnings per share
• Accounting Standard 20 prescribes accounting principles for the determination and
presentation of ‘Earnings Per Share’, which would improve comparison of performance
among different organisations for the same period and among different accounting periods for
the same organisation.
• The focus, of AS 20 is on the denominator of the earnings per share calculation. Even though
earnings per share data have limitations because of different accounting policies used for
determining ‘earnings’, a consistently determined denominator enhances the quality of
financial reports.
Let’s Sum Up
• Proper implementation of accounting standards by Indian enterprises implies that the financial
statements and disclosures of the enterprises are prepared by complying with the accounting
standards issued by the Council of ICAI.
• Auditors need to ensure that the accounting standards have been implemented while preparing
the financial statements.
• One of the major developments in the implementation of accounting standards in India is its
convergence with International Financial Reporting Standards (IFRS).
• AS 1 deals in ‘Disclosure of Accounting Policies’ and is mandatory to be followed by all
enterprise.
• Accounting Standards 2 deals in the ‘Valuation of Inventories’. This is a mandatory standard.
• .
Post Your Query
Chapter 6: Generally
Accepted
Accounting Principles
Chapter Index

From-To
117
Generally Accepted Accounting 118-120
2 Topic 1
Principles (GAAP)
International Financial Reporting 121

3 Topic 2
Standards (IFRS)
Indian Accounting Standards (AS) 122-123

4 Topic 3
Difference between IGAAP and IFRS 124-128

5 Topic 4
129
6 Let’s Sum Up
• Discuss Generally Accepted Accounting Principles
• Describe the International Financial Reporting Standards
• Explain various Indian Accounting Standards
• Discuss the difference between Indian GAAP and IFRS
1. Generally Accepted Accounting Principles (GAAP)
• There is a set of ground rules in financial accounting to present the financial information.
These rules are recognised as GAAP. Financial accounting information can be useful only
when it follows these standards and guidelines.
• GAAP is subject to amendments. Various accounting principles originate from changes in law,
tax regulations, new business organisational arrangements, or new financing or ownership
techniques.
Objectives of GAAP
• It provides an accounting framework to the various companies that follow these principles.
• It brings uniformity to the various financial statements made by different companies. It
clarifies issues and confusions regarding various accounting issues.
Meaning of GAAP
• According to the American Institute of Certified Public Accountants (AICPA), “Generally
Accepted Accounting Principles incorporate the consensus at any time as to which economic
resources and obligations should be recorded as assets and liabilities, which changes in them
should be recorded, how the recorded assets and liabilities and changes in them should be
measured, what information should be disclosed and which financial statements should be
prepared”.
• Generally Accepted Accounting Principles (GAAP) are accounting rules for standardising the
preparation and reporting of financial statements including balance sheets, income statements
and cash flow statements by organisations in a country.
Difference between GAAP & Accounting Standard

• International Accounting Standards (IAS) is a set of standard guidelines set by the
International Accounting Standard Committee (IASC), located in London. The International
Accounting Standard Board (IASB) is the standard-setting body of the IASC.
• GAAP are accounting standards followed in any country. GAAP dictates the rules or
standards, as well as the conventions to be followed when organisations in a country, records,
summarises, transact and prepare their financial statements.
• GAAP are influenced by IAS e.g. the set of rules principles, conventions and the Accounting
Standards followed in India would be known as “Indian GAAP” .
1. International Financial Reporting Standards (IFRS)
• Different countries follow different accounting standards. For promoting the standardisation of
the accounting standards, the International Accounting Standards Board (IASB) emerged. The
International Financial Reporting Standards (IFRS) are principle-based standards,
interpretations and the framework (1989) adopted by the IASB.
• The adoption of IFRS globally would prove beneficial to investors, management and other
users of financial statements.
• ICAI has announced that IFRS would be mandatory in India for preparing and presenting
financial statements from the financial year beginning on April 1, 2015. It would apply to the
companies whose worth is above Rs. 1000 crores
1. Indian Accounting Standards (AS)
• ICAI is the apex accounting body in India.

• Currently, ASB consists of members from the council and representatives of industry, banks,
Company Law Board (CLB), Central Board of Direct Taxes (CBDT), Central Board of Excise
and Customs (CBEC), Controller General of Accounts (CGA), the Comptroller and Auditor
General (CAG) of India, Securities and Exchange Board of India (SEBI), University Grants
Commission (UGC), and educational and professional institutions.
• The section 210-A of the Companies (Amendment) Act, 1999 states that the Central
Government is empowered to constitute an advisory committee named as the National
Advisory Committee for various accounting standards.
2. Indian Accounting Standards (AS)
• National Advisory Committee helps the government in formulating and implementing

accounting policies and standards. The advisory committee has a broader base than that of the
accounting standards committee. The advisory committee shall provide its recommendations
to the Central Government on accounting policies, standards and auditing.
• The ICAI issues accounting standards that are recommended in the initial years. During this
recommended period, it is expected that the accounting practices of an organisation should be
brought in line with the standards. The process of transition should be easy and smooth so that
the organisation would have no difficulty in complying with the accounting standards once
they are made mandatory.
1. Difference between IGAAP and IFRS
• IFRS is considered to be a ‘principles based’ accounting standard, whereas IGAAP

is considered to be a ‘rules based’.
• IFRS represents and includes the economics of a transaction better than IGAAP.
• Basis of difference:
– Presentation of Financial Statements
– Inventories Valuation and Revenue recognition
– Fixed assets (Tangible and Intangible)
– Disclosure of Accounting Policies

Presentation of Financial Statements

Particulars IFRS IGAAP
Balance Sheet Balance sheet captions are presented in the The balance sheet prepared as per IGAAP specifications
inverse order of liquidity i.e. illiquid items conforms to the statute. The items in the balance sheet are
appear earlier in the balance sheet. The written in the following order:
balance sheet should include the disclosure Liabilities
of either changes in equity or changes in
equity other than those arising from capital  Equity and Reserves
transactions with owners.  Debt
 Current Liabilities

Current and non-current portions of assets Assets
and liabilities are disclosed only as part of  Fixed assets
the footnotes.  Investments
 Net current assets
 Deferred expenditure and
 Accumulated losses
Income Statement Does not prescribe a standard format Does not prescribe a standard format but a few income and
although expenditure is presented in one expenditure items are disclosed in accordance with accounting
of the two formats; function or nature. standards and The Companies Act.
Cash flow statements Mandatory for all entities. Mandatory only for listed companies and companies meeting
Cash includes cash, equivalents but the specified turnover conditions.
overdrafts are excluded. Cash includes cash, equivalents (with maturities of three months
or less) and overdraft.
Inventories Valuation and Revenue recognition

Particulars IFRS IGAAP
Inventory Valuation Under IFRS (IAS 2.26), an entity must use the same cost Under IGAAP (IAS 2), the formula for determining the cost
formula for all inventories having a similar nature and use of an item of inventory needs to be selected with a view to
to the entity. For example, a multinational company must providing the fairest possible approximation to the cost
use a consistent inventory policy function for each class of incurred in bringing the item to its present location and
inventory in all of its worldwide subsidiaries. condition. Unlike IFRS, there is no stipulation for use of the
same cost formula for IGAAP.

Additional Purchase of inventory on deferred settlement terms – IGAAP does not include specific guidance with respect to
requirements in excess over the norm treatment of exchange differences in inventory valuation.
Inventory Valuation al price is to be accounted as interest over the period of It does not apply to valuation of work in progress arising in
financing. the ordinary course of business of service providers.
Measurement criteria are not applicable to commodity
broker-traders. Exchange differences are not includible in
inventory valuation.
Detail guidance is given for inventory valuation of service
providers
Fixed assets [Tangible (table 1) and Intangible (table 2)]

IFRS IGAAP IFRS IGAAP
In IFRS, an organisation shall assess In IGAAP, there is a rebuttable presumption
IFRS use component accounting. IGAAP recommends but does whether the useful life of an that the useful life of intangible assets will
not force component intangible asset is finite or not exceed 10 years.
accounting. indefinite.
Depreciation on assets is Depreciation on assets is

Intangible assets having “indefinite There is no concept of indefinite useful life
calculated on the basis of useful calculated based on higher of
useful life” cannot be amortised. in IGAAP.
life. useful life or Schedule XIV
Such assets should be tested for
A variety of depreciation methods rates.
impairment at each balance sheet
can be used to allocate the Permitted method of date and separately disclosed.
depreciable amount of an asset depreciation is the Straight
Line Method (SLM) and
Written Down Value (WDV). An intangible asset with an Test of impairment should be applied for an
indefinite useful life and which is intangible asset not yet available for use and
not yet available for use should be intangible asset amortised over the period
tested for impairment annually. exceeding 10 years
Repairs and overhaul expenditures Repair and overhaul
are capitalised as replacement. expenditure is written off.
If an intangible asset is ‘held for No such stipulation in IGAAP.

Depreciation on revaluation Depreciation on revaluation sale’ then amortisation should be
portion cannot be recouped out of portion can be recouped out stopped.
revaluation reserve and will have of revaluation reserve.
to be charged to the P&L account.
Disclosure of Accounting Policies

IFRS IGAAP
Prescribes minimum structure of financial statements and There is no separate standard for disclosure.
contains guidance on disclosures.
Requires disclosure of critical judgments made by No such requirement is specified under IGAAP.
management
Requires disclosure of information that enables users to No such requirement is specified under IGAAP.
evaluate the entity.
Requires a “Statement of Changes in Equity” which Under IGAAP, transactions are spread over several captions such as share
includes all transactions with equity holders. capital, reserves and the surplus, (profit and loss (P&L), debit balance,
etc.
Prohibits any items to be disclosed as extra-ordinary items. Specifically requires the disclosure of certain items as ‘extra-ordinary
items’.
Let’s Sum Up
• Accounting statements are prepared to communicate the financial information of a business

entity to various interested parties.
• GAAP includes principles as well as the procedures to apply these principles.
• ICAI has announced that IFRS would be mandatory in India for preparing and presenting
financial statements from the financial year beginning on April 1, 2015.
• The key differences between the two accounting frameworks based on the presentation of
financial statements, inventories valuation and revenue recognition, fixed assets (tangible and
intangible) and disclosure of accounting policies.
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Chapter 7: Corporate
Accounts
Chapter Index

From-To
134
Revised Schedule VI of the 135-162

2 Topic 1
Companies Act, 1956 (w.e.f. 1-4-
2011)
163
3 Let’s Sum Up
• Discuss the Revised Schedule VI of the Companies Act, 1956 (w.e.f. 1-4-2011)
• Describe the format of the Balance Sheet as per the Revised Schedule VI
• Explain the general instructions for preparing a Balance Sheet
• Describe the format of the Profit and Loss Statement as per the
Revised Schedule VI
• Explain the general instructions for preparing a Profit and Loss Statement
1. Revised Schedule VI of the Companies Act, 1956 (w.e.f. 1-4-
2011)
• The Ministry of Corporate Affairs (MCA) vide Notification No. S.O. 447(E) dated 28th
February, 2011 has revised Schedule VI of the Companies Act, 1956 (The Act) which provides
the instructions for the preparation of the Balance Sheet and Statement of Profit & Loss of
Corporations.
• The schedule is applicable to all corporations for the financial year commencing on or after
April 1, 2011 (except insurance companies, banking companies, supply or generation of
electricity).
• The revision of Schedule VI can be considered as a step towards the convergence of Indian
Accounting Standards to International Financial Reporting Standards (IFRS) with regards to
the presentation of financial statements.
2011)
• Another important influence of IFRS relevant to the immediate revision of Schedule VI is that
Accounting Standards have been given supremacy over Schedule VI.
• In the event of any conflict between Revised Schedule VI and Accounting Standards, the
Accounting Standard (AS) will prevail which has been stated specifically in the Revised
Schedule VI itself.
• The purpose of revising the previous schedule is to:
– Acquaint corporates with IGAAP/IFRS
– Ensure effective presentation, disclosure of financial data to facilitate organised data for
users of financial statement.
2011)
• The Revised Schedule VI (Refer Section 211 also) of the Companies Act lays down general
instructions for the preparation of the Balance Sheet and the statement of the Profit and Loss
of a company in addition to the notes incorporated adjacent to the heading of the Balance
sheet.
• The instructions are as follows:
– Where compliance with the requirements of the Act including accounting standards as
applicable to the corporations, require any change in treatment or disclosure including
addition, amendment, substitution or deletion in the head/sub-head or any changes
interest, in the financial statements or statements forming part thereof, the same shall be
made and the requirements of the Schedule VI shall stand modified accordingly.
2011)
– The disclosure requirements specified in Part I and Part II of this Schedule are in
addition to and not in substitution of the disclosures specified in the accounting standards
prescribed under the Companies Act, 1956. Additional disclosures specified in the
accounting standards shall be made in the notes to accounts or by way of additional
statement unless required to be disclosed on the face of the financial statements.
Similarly, all other disclosures as required by the Companies Act shall be made in the
notes to accounts in addition to the requirements set forth in the Schedule.
– For the purpose of the Revised Schedule VI, the terms used herein shall be as per the
applicable accounting standards.
2011)
– Except in the case of the first financial statements laid before the corporation (after its
incorporation) the corresponding amounts (comparatives) for the immediately preceding
reporting period for all items shown in the financial statements including notes shall also
be given.
– Notes to accounts shall contain information in addition to that presented in the financial
statements and shall provide where required:
• Narrative descriptions or disaggregation of items recognised in those statements.
• Information about items that do not qualify for recognition in those statements.
2011)
– Each item on the face of the Balance Sheet and Statement of Profit and Loss shall be cross
referenced to any related information in the notes to accounts. In preparing the financial
statements including the notes to accounts, a balance shall be maintained between providing
excessive detail that may not assist users of financial statements and not providing important
information as a result of too much aggregation.
– The figures appearing in the financial statements may be rounded off as follows:
• Amount below one hundred Crore rupees- rounded off to the nearest hundreds, thousands,
rupees Lakhs or Millions, or decimals thereof
• Amount equal to or above one hundred Crore rupees- rounded off to the nearest, Lakhs,
Millions or Crores, more or decimals thereof
2011)
The Companies Act, 2013

• The Companies Act, 2013 was passed on 29th August, 2013. The Act combines and amends
the Companies Act, 1956.
• The core changes of the new Act as compared to Companies Act, 1956 are:
– Companies Act, 1956 defines the term “financial year” as “the period in respect of
which any profit and loss account of the body corporate laid before it in AGM is made
up, whether that period is a year or not.” However, according to Companies Act, 2013,
every company shall follow uniform accounting year starting April 1- March 31.
2011)
The Companies Act, 2013

– According to Companies Act, 2013, every Listed Company /Public Company with
paid up capital of Rs. 100 Crores or more / Public Company with turnover of Rs. 300
Crores or more shall have at least one Woman Director.
– The Companies Act, 1956 does not define the term “financial statements.” The
Companies Act, 2013 defines the term “financial statements” to include:
• Balance Sheet as at the end of the financial year
• Profit and Loss account for the financial year
• Cash flow Statement for the financial year
• Statement of change in equity, if applicable
• Any explanatory note forming part of the above statements
2011)
• Apart from the addition of general instructions for preparation of cash flow statement, the
format of financial statements given in the Companies Act, 2013 is the same as the Revised
Schedule VI notified under the existing Companies Act, 1956.
• The Companies Act, 1956 states that the Banking Companies Act, 1956 will govern signing
requirements for financial statements of banking companies. However, the Companies Act,
2013 requires both separate and consolidated financial statements of all companies (including
banking companies) to be signed at least by the Chairperson of the company or by two
directors.
10. Revised Schedule VI of the Companies Act, 1956 (w.e.f. 1-
4-2011)
• The Companies Act, 2013 requires companies with one or more subsidiaries to place audited
financial statements of each subsidiary on its website, if any.
• The Companies Act, 2013 requires that every company with net worth of Rs. 500 crore or
above or turnover of Rs. 1,000 crore or above or a net profit of Rs. 5 crore or above in a
financial year shall constitute a Corporate Social Responsibility (CSR) committee.
4-2011)
Format of Balance Sheet

• The Revised Schedule VI of the Companies Act, 1956 is applicable for all Balance Sheets
made after 31st March, 2011. The vertical format has now been permitted.
Part I — Form of Balance Sheet
Name
Particulars of the Company…………………….
Note No. Figures as at Figures as at
the end of the end of
Balance Sheet as at ……………………… the current the previous
reporting reporting
period period
2 3 4
I. Equity and Liabilities
(1) Shareholders’ Funds
(a) Share capital
(b) Reserves and surplus
(c) Money received against
share warrants
4-2011)

Particulars Note No. Figures as at Figures as at
the current the previous
reporting reporting
period period
(2)Share Application money pending allotment

(3) Non-current liabilities
(a) long-term borrowings
(b) Deferred tax liabilities
(Net)
(c) Other Long term
liabilities
(d) Long-term provisions
(4)Current liabilities
(a) Short term borrowings
(b) Trade payables
(c) Other current liabilities
(d) Short-term provisions
Total
4-2011)

Particulars Note No. Figures as at Figures as at
the current the previous
reporting reporting
period period
Assets
(1)Non-current assets
(a) Fixed Assets
(i) Tangible assets
(ii) Intangible Assets
(iii) Capital work-in-progress
(iv) Intangible assets under
development
Advances
(e) Other Non-current
assets
(2)Current Assets
(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash
equivalents
(e) Short-term loans and
advances
(f) Other current assets
Total
4-2011)
General Instructions for the preparation of a Balance Sheet

• According to the Revised Schedule VI of the Companies Act, 1956, organisations need to
follow certain guidelines for preparation of their balance sheet for each financial year.
• These guidelines (general instructions) are:
– An asset shall be classified as current when it satisfies any of the following criteria:
• it is expected to be realised in, or is intended for sale or consumption in, the
company’s normal operating cycle;
• it is held primarily for the purpose of being traded;
4-2011)

• it is expected to be realised within twelve months after the reporting date; or
• it is the cash or cash equivalent unless it is restricted from being exchanged or used
to settle a liability for at least twelve months after the reporting date.
– All other assets shall be classified as non-current.
– A receivable shall be classified as a ‘trade receivable’ if it is in respect of the amount due
on account of goods sold or services rendered in the normal course of business.
4-2011)

• An operating cycle refers to the time between the acquisition of an asset for processing and its
realisation in cash or cash equivalents.
• A liability shall be classified as current when it satisfies any of the following criteria:
– it is held primarily for the purpose of being traded;
– it is due to be settled within twelve months after the reporting date; or
– the company does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting date. Terms of a liability that could, at the option
of the counterparty, result in its settlement by the issue of equity instruments do not affect
its classification.
4-2011)

– the company does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting date. Terms of a liability that could, at the option
of the counterparty, result in its settlement by the issue of equity instruments do not affect
its classification.
• All other liabilities shall be classified as non-current. A payable shall be classified as a ‘trade
payable’ if it is in respect of the amount due on account of goods purchased or services
received in the normal course of business.
4-2011)

• A corporation shall disclose the following items:
Share Capital
Reserves and Surplus
Non-current Liabilities
Long term loans and Short Term Loans
Current Liabilities
Non-Current Assets
Capital Work-in-Progress
Long term Investments & Current Investments
Current Assets
Other Current Assets
Contingent Liabilities and Commitments
4-2011)

• Share Capital: For each class of share capital, disclosures regarding the number and amount
of shares authorised; the number of shares issued, subscribed and fully paid, and subscribed
but not fully paid; par value per share; a reconciliation of the number of shares outstanding at
the beginning and at the end of the reporting period; the rights, forfeited shares ( amount
originally paid up)
• Reserves and Surplus: Reserves and Surplus shall be categorised as capital reserves, capital
redemption reserves, securities premium reserve, debenture redemption reserve, revaluation
reserve, surplus i.e. balance in the statement of profit & loss disclosing allocations and
appropriations such as dividend paid, bonus shares and transfer to/from reserves, etc.
4-2011)

• Long Term Borrowings and Short Term Borrowings: Long term loans shall be categorised
as: bonds/debentures , term loans from banks and from other parties deferred payment
liabilities, deposits, loans and advances from related parties, long-term maturities of finance
lease obligations , and other loans and advances.
• Non-current Assets: Non-current assets shall be categorised as: fixed assets ( tangible assets,
intangible assets, capital work-in-progress, intangible assets under development), non-current
investments ( deferred tax assets, long-term loans and advances, other non-current assets).
4-2011)

• Capital Work-in-progress: As per the Revised Schedule VI of the Companies Act, capital
work-in-progress is treated as a non-current asset. Provisions for non-current assets shall apply
in the same way on capital work-in-progress.
• Long Term Investments And Current Investments: Long term investments shall be
classified as trade investments and other investments and further classified as investment in
property, investments in equity instruments, investments in preference shares, investments in
government or trust securities, investments in units, debentures or bonds, investments in
mutual funds, investments in partnership firm, etc. other investments
4-2011)

• Current Assets: Current assets, loans and advances shall be categorised as current
investments, inventories, trade receivables, cash and cash equivalents, short- term loans and
advances, other current assets etc.
• Current Liabilities and Provisions : Current liabilities and provisions shall be categorised as
short term borrowings, trade payables, other current liabilities, short-term provisions. Short-
term borrowings shall be sub-classified as secured and unsecured. Nature of security shall be
indicated separately in each case.
4-2011)

• Contingent Liabilities and Commitments: Contingent liabilities shall be categorised as
claims against the company not acknowledged as debt, guarantees, and other money for which
the company is contingently liable. Commitments shall be categorised as estimated amount of
contracts remaining to be executed on capital account and not provided for, uncalled liability
on shares and other investments partly paid.
4-2011)

• Other Significant Disclosures: The amount of dividends proposed being distributed to equity
holders for the period and the related amount per share shall be disclosed separately. Arrears
of fixed cumulative dividends shall also be disclosed separately. Where in respect of an issue
of securities made for a specific purpose, the whole or part of the amount has not been used
for the specific purpose at the balance sheet date, there shall be indications by way of notes
about how such unused amounts have been used or invested.
4-2011)
General Instructions for preparation of the Statement of Profit and Loss

• As per the Revised Schedule VI:
• Provisions of this Part shall apply to the Income and Expenditure account in like manner as
they apply to a statement of profit and loss.
• (a) In respect of a company other than finance company revenue from operations shall
disclose separately in the notes revenue from sale of products, sale of services, other operating
revenues, less excise duty. (b) In respect of a finance company, revenue from operations shall
include revenue from interest and Other financial services.
• Finance costs shall be disclosed as interest expense , other borrowing costs, applicable net
gain/loss on foreign currency transaction and translation
4-2011)

• Other Income shall be categorised as Interest Income, Dividend Income, Net gain/loss on sale
of investments, Other non-operating income.
• Additional Information: A corporate body shall disclose by way of notes additional
information regarding aggregate expenditure and income on items such as employee benefits
expense, depreciation and amortisation expense, any item of income or expenditure which
exceeds one per cent of revenue from operations or Rs. 1, 00,000, whichever is higher, interest
income, interest expense, dividend income, net gain/loss on sale of investments, adjustments
to the carrying amount of investments.
4-2011)

• The P&L account shall also disclose by way of notes, the information regarding value of imports
during the financial year in respect of the raw material, components and spare parts, capital
goods, expenditure in foreign currency during the financial year on account of royalty, know-how,
professional and consultation fees, interest and other matters, total value if all imported raw
materials, spare parts and components consumed during the financial year and the total value of
all indigenous raw materials, spare parts and components similarly consumed and the percentage
of each to the total consumptions. Earnings in foreign exchange classified as exports of goods,
royalty, know-how, professional and consultation fees, interest and dividends, other income
4-2011)

• The corporate bodies shall disclose the expenditure incurred separately for the categories such
as Consumption of stores and spare parts, Power and fuel, Rent, Repairs to building, Repairs
to machinery, Insurance, Rates and taxes, excluding, taxes on income.
• The Revised Schedule VI of the Companies Act, 1956 lays down a new format for the
presentation of Profit and Loss (P&L) account of corporate bodies. It permits the use of the
vertical format of presentation only.
Let’s Sum Up
• The Ministry of Corporate Affairs (MCA) vide Notification No. S.O. 447(E) dated 28th
February, 2011 has revised Schedule VI of the Companies Act, 1956 (The Act) which provides
the instructions for the preparation of the Balance Sheet and Statement of Profit & Loss of
Corporations.
• The major heads under which the assets are presented in the Balance Sheet of the company as
per Schedule VI Part I of the Companies Act 1956 are (i) Non-current Assets and (ii) Current
Assets.
• The P&L account shall also disclose by way of notes, the value of imports, earnings in foreign
exchange, expenditure in foreign currency, total value of all imported raw materials, spare
parts and components consumed during the financial year, etc.
Post Your Query
Chapter 8: Cash Flow
Statement
Chapter Index

From-To
168
Concept of Cash Flow Statement 169-174

2 Topic 1
Cash Flow Statements (AS-3) 175-186

3 Topic 2
187
4 Let’s Sum Up
• Discuss the concept of Cash Flow Statement
• Explain the limitations of Cash Flow Statement
• Describe the proforma of Cash Flow Statement using direct and indirect methods
• Explain the calculation of net cash flows from operating activities, investing activities and
financing activities
• Describe the treatment of certain items in Cash Flow Statement as per AS-3
1. Concept of Cash Flow Statement
• The Cash Flow Statement is a mandatory record of an organisation’s financial reports.

• It records the amount of cash and cash equivalents entering and leaving an organisation in a
given time period.
• It is a statement which shows the change in cash balances during a specified period.
• The Cash Flow Statement enables investors to comprehend how an organisation is performing
in terms of its operations, the source of its money resources and how the available cash is
utilised.
• A Cash Flow Statement combined with the other financial statements provides information
allowing investors to evaluate the changes in net assets of an organisation, its financial
structure, its liquidity and solvency conditions and the organisation’s ability to affect the
amounts and timing of cash flows.
• Cash flow details help in assessing the ability of the organisation to generate cash and cash
equivalents to enable users in comparing the present value of the future cash flows of different
organisations.
Meaning and Objectives of Cash Flow Statement

• A Cash Flow Statement is a summary of an organisation’s inflow and outflows of cash or cash
equivalents for a given reporting period.
• It provides with the information about the historical changes in cash and cash equivalents of
an organisation by classifying the cash flows in a period owing to different activities.
• A Cash Flow Statement reports the cash flows during the period classified by operating,
investing and financing activities.
Cash Flow
Statement
Cash Flows due to Cash Flows due to Cash Flows due to

Operating Activities Investing Activities Financing Activities

• Terminologies associated with a Cash Flow Statement:
1. Cash equivalents: Short-term highly liquid investments that can be easily converted into cash.
2. Operating activities: Cash flows from operating activities include the changes in cash due to
major revenue producing activities such as sale of goods as well as major operating expenses
for purchase of goods and services, operating expenses.
3. Investing activities: Cash flows from investing activities include the changes in cash due to
purchase or sale of long-term assets.
4. Financing activities: Cash flows from financing activities include the changes in the size and
composition of the share/owner’s capital and debt of the organisation.

Objectives of a Cash Flow Statement
• Provides the knowledge of the cash position.
• Useful for providing a business with a general idea of how it will make ends meet in the short
term and thereby maintain the short term and long term solvency.
• Useful to the management for preparing dividend and profit retention policies.
• Guide the management to evaluate the changes in cash position.
• Provide the management with details about the performance of operational, financial and
investment activities for effective decision making.
• Provide a base for the preparation of cash budgets.
Limitations of Cash Flow Statement

• Cash Flow Statements are based on cash flows and record the movement of cash. Only cash
transactions are recorded. Thus, it ignores the accrual concept of accounting.
• Cash Flow Statements are not a complete substitute for the Income Statement or the Profit &
Loss Account. The net cash flow calculated in the Cash Flow Statement cannot be equal to the
net profit calculated under a profit and loss account.
• It ignores the non-cash transactions.
• The Cash Flow statement cannot substitute a Balance Sheet.
• The Cash Flow statement cannot substitute a Fund Flow Statement.
1. Cash Flow Statements (AS-3)
• The Institute of Chartered Accountants of India (ICAI) has issued the Accounting Standards
(AS-3) for the preparation of Cash Flow Statement for accounting periods starting on or after
April 1, 2001.
• Difference between AS-3 and traditional methods of Cash Flow Statement
Cash Flow Statement as per AS-3 Cash Flow Statement as per
traditional method
Cash includes not only cash in hand and bank deposits but also short-term Cash includes cash in hand and
investments or marketable securities. Such short term investments are bank deposits only.
classified as cash equivalents.
Cash flows statement includes cash flows from operating, investing and There is no such separation of
financing activities. cash flows.
Two separate approaches, direct and indirect method are followed for the A single approach is followed
preparation of a Cash Flow Statement. to prepare the Cash Flow
Statement.
Procedure to Prepare Cash Flow Statement as Per AS-3 (Revised)

• Firstly, all the information relating to the cash flow statement is collected from the Profit &
Loss Account and the Balance Sheet. The steps are:
o Opening and closing balances of cash and cash equivalents are determined. These balances are
calculated by adding Cash in hand, Cash at bank, Marketable Securities, Short term
investments( Invested for 3 or less than 3 months).
o Net Cash provided (or used) by the Operating Activities, Investing Activities, and Financing
Activities
o Net increase or decrease in Cash and Cash equivalents is determined by the aggregation of net
cash provided (or used) by the operating, investing and financing activities

o In the last step, the net increase or decrease in cash and cash equivalents is reconciled with the
opening and closing balance of cash and cash equivalents. The difference of opening and
closing balance of cash and cash equivalents should be equal to the net increase opening and
closing balance of cash and cash equivalents.
• The direct and indirect methods for presentation of Cash Flow Statement are:
o Direct Method: The net cash flows from operating activities is calculated directly by
deducting the cash outflows from Operating Activities from cash inflows from Operating
Activities.

o Indirect Method: The net cash flows from operating activities is calculated indirectly by
adding all non-operational and non-cash items debited to Profit and Loss Account and later
deducting it from non-operational and non-cash items credited to Profit and Loss Account for
a financial year.
Proforma of Cash Flow Statement using direct method:

Particulars Rs. Rs. Rs.
A. Cash flows from Operating Activities
Cash receipts from customers by sale of Goods and Services, Debtors, Royalties, Fees and Commission
Less: Cash paid to suppliers and employees
Cash generated from operations
Less: Income tax paid
Cash flows from Operation before extraordinary items
Add: Proceeds from any disaster settlement
Net cash flows from Operating Activities
B. Cash flows from Investing Activities
Proceeds from sale of fixed assets including investments
Less: Purchase of fixed assets including investments
Add: Interest received
Dividend received
Net cash flows from Investing Activities
C. Cash flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Less: Repayment of long-term borrowings including redemption of preference shares
Less: Interest paid
Dividend paid
Net cash flows from Financing Activities
Net increase in cash and cash equivalents
Add: Cash and cash equivalents at the beginning of the period
Less :Cash and cash equivalents at the end of the period
Proforma of Cash Flow Statement using indirect method:

A. Cash flows from Operating Activities
Net Profit for the period before Taxation and Extraordinary items
Add: Adjustment for Non-cash and Non-operating items charged to P&L
Depreciation
Interest paid
Foreign Exchange loss
Loss on sale of fixed assets and investments
Less: Adjustment for Non-current and Non-operating items credited to P&L account
Interest earned
Dividend earned
Profit on sale of fixed assets and investments
Operating Profit before Working Capital changes
Add: Increase in operating current liabilities
Decrease in operating current assets
Less: Increase in operating current assets
Decrease in operating current liabilities
Cash generated from operations
Less: Income tax paid
Add: Proceeds from any disaster settlement
Net cash flows from Operating Activities
Proforma of Cash Flow Statement using indirect method:

B. Cash flows from Investing Activities
Proceeds from sale of fixed assets including investments
Less: Purchase of fixed assets including investments
Add: Interest received
Dividend received
Net cash flows from Investing Activities
C. Cash flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Less: Repayment of long-term borrowings including redemption of preference shares
Less: Interest paid
Dividend paid
Net cash flows from Financing Activities
Net increase in cash and cash equivalents
Add: Cash and cash equivalents at the beginning of the period
Less: Cash and cash equivalents at the end of the period
Cash Flows from Operating Activities

• Operating activities provide details about how much cash an organisation has generated from
its core business, as opposed to peripheral activities such as investing or financing. These cash
flows are directly associated with production and sale of a firm’s products or services.
• Cash flows from operating activities:
• Direct method: In this method, gross cash receipts and gross cash payments for the major
items are disclosed such as cash receipts from customers and cash payments to suppliers and
employees. Information can be obtained from either accounting records of the organisation or
by adjusting the sales, cost of sales and other items in the P&L statement of the organisation.
Cash Flows from Operating Activities

• Indirect method: In this method, P&L account is adjusted for the effects of transactions of
non-cash nature such as depreciation, amortisation, deferred taxes, loss on sale of fixed assets
and unrealised foreign exchange gains and losses, all other items for which cash effects are
shown either in investing or financing activities. Cash inflows from operating activities
include cash receipts from sale of products or services, royalties, fees, commissions and other
revenues, insurance enterprise for premiums and claims, annuities and other benefits. Cash
outflows from operating activities include cash payments to suppliers for products and
services, cash payments to employees, cash payments from an insurance enterprise for
premiums and claims, annuities and other benefits.
Cash Flows from Investing Activities

• Cash flows from investing activities provides details of cash flows related to acquisition and
disposal of an organisation’s long-term investments such as property, plant and equipment,
(also termed as “Fixed Assets”) investment in subsidiaries and associates, etc. Cash inflows
from investing activities include proceeds from sale of property, plant and equipment, sale of
debt or equity investments of other entities, principal on loans to other entities.
• Cash outflows from investing activities include payments for purchase of property, plant and
equipment, debt or equity securities of other entities, loans given to other entities.
Cash Flows from Investing Activities

• Cash flows from investing activities are disclosed separately as these cash flows helps users to
assess whether the organisation is investing in such resources that may result in increased
profits in future or whether it is disposing out cash on resources already owned.
Cash Flows from Financing Activities

• Financing activities of an organisation result in changes in the size and composition of the
owner’s capital. Financing activities of an organisation include total capital employed (equity
shares, preference shares and long-term loans). Any inflow or outflows of cash from these
activities are treated as cash flows from financing activities.
• For example, cash inflow from financing activities includes proceeds from the issue of equity
and preference shares, debentures, etc. Cash outflow from financing activities include
redemption of preference shares, debentures, repayment of long-term loans, etc.
Let’s Sum Up
• The Cash Flow Statement records the amount of cash and cash equivalents entering and
leaving an organisation in a given time period.
• As per AS-3, two separate approaches, direct and indirect method are followed for the
preparation of a Cash Flow Statement; direct method and indirect method.
• Cash flows from extraordinary items are classified as arising out of operating, financing or
investing activities as applicable and disclosed separately.
• Cash flows from taxes on income are disclosed separately and classified as arising out of
operating activities unless otherwise specified.
• Foreign currency cash flows are converted at the prevailing exchange rate. The gain or loss on
cash and cash equivalents is reported as part of reconciliation.
Post Your Query
Chapter 9: Financial
Statement Analysis I
Chapter Index

From-To
1 Learning Objectives 192
2 Topic 1 Financial Statements 193-196
3 Topic 2 Profit and Loss Account 197-199
4 Topic 3 Balance Sheet 200-201
5 Let’s Sum Up 202

• Define financial statements
• Describe Profit and Loss Account
• Describe Balance Sheet
• Discuss the relationship between the Balance Sheet and the Profit and Loss Account
1. Financial Statements
• In a business, the sole purpose of investing money is earning profits.

• The financial position of an organisation is determined by evaluating the profit earned or loss
suffered by an organisation.
• In addition, different users of accounting information need other accounting information.
• Financial statements are created to fulfil these requirements.
• Financial statements provide information regarding total profit earned or loss suffered the net
income and the distribution of income.
• Preparation of the financial statement is the final step in the accounting cycle.
Meaning of Financial Statement

• According to John N. Myer, “The financial statements provide a summary of the accounts of a
business enterprise, the balance sheet reflecting assets and liabilities and the income statement
showing the results of operations during a certain period.”
• Instead of providing specific information to a particular group, financial statements are
prepared to satisfy the general information requirements of all users. Financial Statements
provide information such as performance details, financial position, and the changes in the
financial position of the organisation and summarise assets, liabilities, equity, income and
expenses during a particular accounting period.
Characteristics of Financial Statement
Understandability
Relevance
Reliability
Comparability
Scope of Financial Statements

• Providing information about the financial position: It refers to the reporting of assets
and liabilities of the organisation. It depicts the financial position of the organisation at a
particular point in time. This is like a snapshot of the company.
• Providing information about the financial performance: It refers to the reporting of
the expenses incurred and profits earned by the organisation during an accounting period.
• Providing information about changes in the financial position: It is presented in the
form of statement of cash flows and statement of changes in equity.
• Providing notes and supplementary schedules: It refers to information about the risks
and uncertainties affecting the organisation.
1. Profit and Loss Account
• The gross profit or gross loss calculated in a trading account is taken to the second part of the
account called the profit and loss account.
• The profit and loss account is prepared to ascertain the net profit earned or the net loss
suffered by the business over an accounting period.
• In this account, all indirect revenue expenses are shown on the debit side whereas all the
indirect revenue incomes are shown on the credit side.
• A profit and loss account can be prepared by considering the following accounting rules:
– Debiting all the expenses
– Crediting all the incomes
– Considering the balance amount, if any, as profit or loss
• The general pro forma of the profit and loss account

Component Analysis of Profit and Loss Account

• The main components of a profit and loss account are expenses and incomes.
• Two types of expenses are:
• Administrative Expenses: Expenses incurred by an organisation but not directly tied to any
specific function, such as productions or sales. e.g. office salaries.
• Selling and Distribution Expenses: The expenses that are associated with the process of
selling and delivering goods and services to customers.
• Incomes and Gains are shown on the credit side of the profit & loss account. incomes include
the gross profit and other income such as discount received, bad debts recovered.
1. Balance Sheet
The pro forma of the balance sheet

Liabilities Amount Assets Amount
(Rs.) (Rs.)
Sundry creditors Cash in hand including petty
cash
Bills payable Cash at bank

Bank overdraft Bills receivables
Employees provident fund Sundry debtors
Loans (Cr.) Loan (Dr.)

Mortgage Closing stock
Reserves or reserve funds Loose tools
Capital Investment
Add: Interest on capital Furniture and fitting
Add: Net profit Plant and machinery
Less: Drawing Land and building

Less: Income tax Leasehold land
Less: Interest on drawing Business premises
Less: Net loss Patent and trade mark
Goodwill
Total Total
2. Balance Sheet
Relationship between Profit and Loss Account and Balance Sheet

• Trading transactions of a company, such as income, sales and expenditure and the resulting
profit or loss for a given period is summarised in the profit and loss account.
• In comparison, the balance sheet provides a financial snapshot of a company at a given
moment. The balance sheet does not show the day-to-day transactions or the current
profitability of a business.
• Any profit that is not paid as dividend is shown in the retained profit column of the Balance
Sheet. The amount that will be shown as cash or at the bank under current assets on the
balance sheets will be determined in part by the incomes and expenses recorded in the P&L.
Let’s Sum Up
• Financial statements act as an important source of information as they provide a structured and
easy to understand information regarding the business activities of an organisation.
• The profit and loss account plays an important role in the accounting process as it helps in
determining the net results of the business activities. The main components of a profit and loss
account are expenses and incomes. The expenses are shown on the debit side and the incomes
are shown on the credit side of the P&L account.
• A balance sheet is the statement that summarises, and presents the financial position of an
organisation as on a particular date, by showing the assets and liabilities of the organisation.
Post Your Query
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Chapter 10:
Financial Statement Analysis
II
Chapter Index

From-To
2 Topic 1 Ratio Analysis 208-211
3 Topic 2 Types of Ratios 212-222
4 Topic 3 The DuPont Equation 223-225

 Discuss the concept of ratio analysis
 Describe the different types of ratios and their significance
 Explain the DuPont Chart

1. Ratio Analysis
• Ratio analysis is a method of analysing an organisation’s financial statements. Financial ratio

analysis can be broadly categorised into two segments:
o Time Series Comparison or Trend Analysis: The performance of the firm is compared with
the past performance to analyse how to improve the productivity and achieve sustainable
growth. While doing such an analysis, we compare the figures and ratios for a firm for many
years.
o Cross-sectional Comparison or Industry Benchmarking: The firm’s performance is
compared with the other firms in the industry. The performance has to be benchmarked with
the best in the industry both in the domestic as well as the global arena.
2. Ratio Analysis
Significance of Ratio and Ratio Analysis

• A ratio is a relationship between two or more values.
• A financial ratio depicts the relationship between two or more accounting data from financial
statements expressed in mathematical terms.
• Ratio may be expressed as ratio like 2:1, or as number or as percentage.
• Accounting ratios are indicators of the financial strength, soundness, position or weakness of
an organisation.
• Ratio analysis is an accounting tool to present accounting variables in a simple, concise and
meaningful form.
• Ratio analysis helps the management to know the profitability, financial position, liquidity,
solvency and operating efficiency of the organisation.
3. Ratio Analysis
Advantages and Limitations of Ratio Analysis

Advantages of Ratio Analysis:
• Ratio analysis is used for the analysis of financial statements
• Ratio analysis helps in simplifying accounting figures
• Ratio analysis is used to evaluate the operating efficiency of a business
• Ratio analysis helps in business forecasting
• Ratio analysis helps in identifying the weaknesses of an organisation
• Ratio analysis is used for making inter-firm or intra-firm comparisons
4. Ratio Analysis
Advantages and Limitations of Ratio Analysis

Limitations of Ratio Analysis
• Incorrect or unauthenticated data may lead to wrong interpretations
• Dependence on historical data may not help in proper forecasts
• A single ratio does not provide sufficient information
• Different firms follow different accounting principles
• Price level changes may affect the forecasting
• Qualitative factors may get ignored
• Window dressing may affect interpretations based on ratio analysis
• Personal biases may affect the way the ratios are interpreted
1. Types of Ratios
• Financial ratios are categorised based on the financial aspect of a business that they are used to
measure.
• Financial ratios help as analytical tools for comparing different organisations, industries or
different departments of a single organisation and financial data of an organisation at time
periods, etc.
• While analysing the financial statements of an organisation, it is advisable to have a complete
understanding of the different types of ratios, their calculation, and interpretation. Financial
ratios can be classified as :
Types of Ratios
Liquidity Ratios
Leverage Ratios
Profitability Ratios
Activity Ratios
2. Types of Ratios
Liquidity Ratios
• Liquidity refers to an organisation’s ability to convert its assets into cash quickly without
reducing its price significantly.
• Liquidity ratios help in assessing an organisation’s ability to meet its current liabilities using
its current assets.
• The current liabilities are the short-term obligations to be met within one financial year.
Current assets refer to the short-term assets that can be converted to cash within a year.
• Three important liquidity ratios: current ratio, quick ratio and cash ratio.
3. Types of Ratios
Liquidity Ratios
• Current Ratio: The current ratio (CR) is equal to total current assets divided by total current
liabilities. It indicates the extent to which current assets can be used to pay off current
liabilities. Current Ratio = (Current Assets)/(Current Liabilities)
• Quick Ratio: Current ratio assumes that all current assets of an organisation can be easily
converted to cash in order to meet its current liabilities. This assumption may not always be
true. There are current assets such as inventory and pre-paid expenses which cannot be readily
converted into cash. To overcome this limitation, there is another ratio called the quick ratio.
4. Types of Ratios
•Liquidity
Ratios
The quick ratio is also referred to as the acid test ratio. Quick ratio is equal to liquid current
assets divided by current liabilities.
Quick Ratio = (Cash in hand + Cash at Bank + Receivables + Marketable Securities)/(Current

Liabilities) OR
Quick Ratio = (Current Assets - Inventory - Advances - Prepayments)/(Current Liabilities)
• Cash Ratio: It is the ratio of cash and cash equivalents of an organisation to its current
liabilities. It assesses the capability of an organisation to repay its current liabilities by using its
cash and cash equivalents only.
• Cash Ratio =
5. Types of Ratios
Solvency Ratios
• Solvency ratios are used to measure the ability of an organisation to pay its long term debt and
the interest on that debt.
• Solvency ratios are a measure of the long-term sustainability of an organisation while liquidity
ratios are a measure of the current liabilities of the organisation.
• Solvency ratios are tools to assess if organisations can pay off their debt and interest on debt
on maturity. A solvency ratio higher than 20% is considered to be satisfactory. A lower
solvency ratio reveals a greater probability of the organisation’s insufficiency to pay off its
debt obligations.
6. Types of Ratios
Solvency Ratios
• Four important solvency ratios:
• Debt-equity Ratio: The debt-equity ratio is a financial ratio that is used to compare an
organisation’s total debt against its total equity. This ratio measures how much of an
organisation's asset base is financed using debt. Solvency ratios help the business owner to
track down a possible bankruptcy. The debt to equity ratio Debt-Equity ratio measures the
ratio of long-term or total debt to shareholders’ equity. Mathematically, it can be expressed as:
Debt-Equity Ratio = (Long-term debt)/(Shareholders' equity) OR
Debt-Equity Ratio = (Total debt)/(Shareholders' equity)
7. Types of Ratios
Solvency Ratios
• Debt to Total Assets Ratio = (𝐋𝐨𝐧𝐠 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭 )/(𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬)
• Proprietary Ratio = (Shareholders’ Funds/ Total Assets ) × 100
• Interest Coverage Ratio = Net profit before Interest & Taxes / Fixed Interest Charges
• Dividend Coverage Ratio = EAT (Earnings After Taxes)/ Preference Dividend
• Solvency ratio = (Profit After Tax + Depreciation) / Total liabilities
• Fixed Assets Ratio = (Net Sales)/(Net Property, Plant and Equipment)
• Capital Gearing Ratio = (Equity Share Capital)/(Fixed Interest Bearing Funds)
8. Types of Ratios
• Gross Profit Ratio = (Gross Profit )/(Net Sales) or
• Gross Profit Ratio =(Sales – (Direct materials + Direct Labour + Overhead))/Sales
• When expressed in percentage form, gross profit ratio is known as gross profit margin or gross
profit percentage.
• Gross Profit Margin = (Gross Profit )/(Net Sales) × 100
• Net Profit Ratio = (Net Profit after Tax )/(Net Sales)
• When expressed in percentage form, net profit ratio is known as net profit margin or net profit
percentage.
• Net Profit Margin = (Net Profit after Tax )/(Net Sales) × 100
9. Types of Ratios
• Operating Profit Ratio = (Operating Income)/(Sales Revenue)
• When expressed as a percentage, operating profit ratio is known as operating margin.
• Operating Margin = (Operating Income)/(Sales Revenue) x 100
• ROI = (Return from Investment-Cost of Investment)/(Cost of Investment)
• ROE = Net Income/Shareholder's Equity
• ROA = (Net Income)/(Total Assets)
10. Types of Ratios
Activity Ratios
• Average collection period = 365/(Average Receivables Turnover Ratio)
• Inventory Turnover Ratio = (Cost of Goods Sold)/(Average Inventory)
• Debtors Turnover Ratio = (Net Credit Sales)/(Average Accounts Receivables)
• Creditors Turnover Ratio = (Net Credit Purchases)/(Average Accounts Payable)
• Net Credit Purchases = Gross credit purchases – Returns to suppliers and Average Accounts
Payable = Average of bills payable at the beginning and end of the year
• Working Capital Turnover Ratio = (Net Sales)/(Average Working Capital)
11. Types of Ratios
Types of Market Ratios Calculation Uses

Earnings Per Share Net Income/ No of Ordinary Shares Outstanding Measures earnings capability of an
ordinary share
Price Earnings Ratio Market Price PerShare/ Earnings Per Share Measures the amount the investors are
(P/E Ratio) willing to pay for each dollar of
earnings.
Earnings Yield Earnings Per Share/ Market Price Per Share Measures the earnings capability of
an ordinary share relative its
market value.
Dividend Per Share Cash Dividend/No of Ordinary Shares Measures the dividend return earned
Outstanding by a share
Dividend Yield Dividend Per Share/Market Price Per Share Measures the dividend earned by a
share relative its market value.
Dividend Pay-out Dividend Per Share/Earnings Per Share Indicates the percentage of earnings
Ratio paid out as dividend.
Book Value Per Share Total Shareholders’ Equity/Total No. of Measures equity on per share basis.
Ordinary Shares
Price to Book Value Market Price Per Share/Book Value Per Share Measures market price of share
Ratio relative to book value.
1. The DuPont Equation
• DuPont equation is named after the U.S. chemical company, The DuPont Corporation in the
1920s.
• The equation is a financial ratio used to analyse an organisation’s ability to increase its return
on equity.
• Return on equity (ROE) measures the ratio between an organisation’s net income and its
stockholders' equity during a given time period.
• The DuPont equation breaks down the return on equity ratio to explain how organisations can
increase their return for investors. Return on equity is a relevant measure of how well an
organisation's management creates value for its shareholders.
• The
• DuPont equation is also referred to as the DuPont model, DuPont analysis or DuPont
method.
• The DuPont model breaks down the return on equity ratio into three components; the net
profit margin, asset turnover and the equity multiplier.
• Evaluating each of these components helps in assessing the sources of an organisation’s return
on equity and compare with its competitors.
• The DuPont model concludes that an organisation can raise its ROE by maintaining a high
profit margin, increasing asset turnover or leveraging assets more effectively.
• The formula for Return on Equity as per DuPont model:
ROE = Profit margin × Total asset turnover × Financial leverage OR
• ROE = x x
• Example:
• ROE using DuPont model.
Particulars Rs. ’000

Total Assets 250
Shareholders’ equity 50
Particulars Rs. ‘000
Revenue 100
Net income 20
•ROE = x x = 40%
Let’s Sum Up
• Ratio analysis is a tool for determining and interpreting the relationships between different
items of financial statements for providing understanding of the performance and financial
position of an organisation.
• Financial ratios can be divided into liquidity ratios, solvency ratios, profitability ratios and
activity ratios.
• In a DuPont analysis, the formula for Return on Equity ROE = (Net Income)/Revenues x
Revenues/(Total Assets) x (Total Assets)/(Shareholders′ Equity)
Post Your Query
Chapter 11:
Financial Statement Analysis
III
Chapter Index

From-To
2 Topic 1 Common Size Analysis 232-240
3 Topic 2 Trend Analysis 241-242
4 Topic 3 Percentage Change Analysis 243-246
5 Topic 4 Management’s Discussion and 247-249

Analysis: Thinking beyond Numbers

 Describe common size analysis
 Discuss trend analysis
 Explain percentage change analysis
 Discuss the importance and benefits of Management discussion and analysis

1. Common Size Analysis
• Traditional financial statements of an organisation are used for reporting the financial position
of the company for public use.
• If an investor intends to compare the financial statements of two organisations, there is a need
for a common scale in order to match the two distinct businesses for investment purposes.
• As organisations are different in size, growth, etc. comparing the traditional financial
statements might lead to misleading interpretations affecting the investors.
• Common size analysis is a popular method of financial statement analysis, which makes use
of common size financial statements. These financial statements display all items as
percentages of a common base figure.
• In common size financial statements, each item in the financial statement is reported in the
form of a percentage. This percentage is arrived at by using a base figure. For example, every
item on the income statement of an organisation is reported as a percentage of sales.
• Why use common-size analysis:
– Comparing financial information of an organisation from one period to the next.
– Comparing financial information of an organisation relative to its competitors.
– Comparing financial information of various companies in different parts of the world
when the reporting currency is different.
• A Company may have operations in several countries and the financials are in different
currencies like Great British Pound (GBP), United States Dollars (USD), and Indian Rupee
(INR) etc.
• The use of Common size analysis which translates absolute amounts in different currencies
into percentages makes comparisons and financial analysis more meaningful and simpler.
• Common size analysis methods are as follows:
i. Horizontal Common Size Analysis
ii. Vertical Common Size Analysis
Horizontal Common Size Analysis

• Horizontal common-size analysis uses one type of financial statement at a time. It makes use
of the same type of financial statement over several consecutive years.
• Usually, three years of information is used for horizontal analyses, although it is common to
extend the evaluation for measuring long-term trends in the organisation’s performance.
• The figures in each succeeding period are expressed as a percentage of the amount in the
baseline year, with the baseline amount being listed as 100%.

Income statement information of Dell Inc. as ended March, 2013 is as follows:

Assuming 2011 is the base year, 2012 and 2013 revenues will be calculated as :
Vertical Common Size Analysis

• Vertical analysis refers to the proportional analysis of a financial statement, where each item
on a financial statement is recorded as a percentage of another item.
• This implies that each item on the income statement of an organisation is recorded as a
percentage of the gross sales. On the other hand, each item on the balance sheet of an
organisation is recorded as a percentage of the total assets. Vertical analysis is helpful for
timeline analysis.

Example: Vertical analysis of a income statement
Particulars Amount (`Rs.) Percentage
Sales 10,00,000 100%
Cost of goods sold 4,00,000 40%
Gross margin 6,00,000 60%
Salaries and wages 2,50,000 25%
Office rent 50,000 5%
Supplies 10,000 1%
Utilities 20,000 2%
Other expenses 90,000 9%
Total expenses 4,20,000 42%
Net profit 1,80,000 18%


Vertical analysis of a balance sheet
Particulars Amount (`) Percentage
Cash 1,00,000 10%
Accounts receivable 2,50,000 25%
Inventory 1,50,000 15%
Total current assets 2,00,000 20%
Fixed assets 3,00,000 30%
Total assets 10,00,000 100%
Accounts payable 1,00,000 10%
Accrued liabilities 70,000 7%
Total current liabilities 2,00,000 20%
Notes payable 30,000 3%
Total liabilities 2,00,000 20%
Capital stock 1,00,000 10%
Retained earnings 1,50,000 15%
Total equity 1,50,000 15%
Total liabilities and equity 10,00,000 100%
1. Trend Analysis
• Trend
•
analysis is another tool for the analysis of an organisation’s financial statements by
investors. Investors use trend analysis to ascertain the financial position of an organisation for
decision making.
• In this method, the financial statements of an organisation are compared with each other over
a period of years after converting them into a percentage.
• The objective is to calculate and evaluate the change in the amount and per cent from one
period to the next.
2. Trend Analysis
• For instance, an investor wants to observe the trend of an organisation’s sales in 2006-2012. In
this case, year 2006 would act as the base year and the sales figure in 2006 would be restated
as 100.
• Next, the sales amounts for the years 2007 - 2012 would be presented as percentages of the
2006 figure. (each year's amounts will be divided by the 2006 amounts and the resulting
percentage will be presented.)
2006 2007 2008 2009 2010 2011 2012
31,691,000 40,930,000 50,704,00 63,891,000 79,341,000 101,154,000 120,200,000
100 129 160 202 250 319 379

1. Percentage Change Analysis
• A percentage change analysis illustrates how two items in a financial statement changed as a
percentage from one period to another period.
• Percentage change analysis helps managers and investors to assess how an organisation is
performing over a time period (from year- to- year, or quarter- to- quarter.)
• Example: evaluate the balance sheet of an organisation using percentage change analysis.
Balance sheet information of A Ltd. is as follows:
Items 2012 2013

Cash Rs. 4, 00,000 Rs. 7, 00,000
Fixed Assets Rs. 20, 00,000 Rs. 22, 00,000
Accounts Rs. 2, 00,000 Rs. 2, 50,000
receivable
• Steps to evaluate the balance sheet:

• Step 1: Identify the balance sheet items that the investor needs to analyse. Note the figures of
the selected items for the beginning and ending periods.
• Step 2: Subtract the current account from the previous account to determine the change in the
account.
• Step 3: Divide the change in the account by the old account balance to determine the
percentage change.
• Step 4: Repeat these steps for other balance sheet items for percentage change analysis.
• Steps to evaluate the income statement:

Income Statement of ABC Pvt. Ltd.
Items 2013 2012 Difference (Rs.) % Change
Revenue Rs. 18,00,000 Rs.15,00,0 3,00,000 20
00
Cost of Goods Sold Rs.10,00,000 Rs.8,50,00 1,50,000 17.6

0
Depreciation and amortization Rs.1,50,000 Rs.1,50,00 0 0

0
Selling and administrative Rs.2,25,000 Rs.1,50,00 75,000 50.0

expenses 0
Interest expense Rs.50,000 Rs.25,000 25,000 100.0
Taxes Rs.1,00,000 Rs.75,000 25,000 33.3

• Percentage analysis of the income statement of ABC Pvt. Ltd. shows that cost of sales have
increased by 17.6% in 2013 compared to 2012.
• When analysed further, it can be assessed that the increase in COGS is in the favourable
direction as revenue (sales) percentage has also increased by 20% in the year 2013.
• Percentage change analysis helps investors in comparing and evaluating the relative size of
items or the relative change in items of an organisation’s financial statements.
• Also, conversion of monetary figures into percentages also facilitates the comparison between
different organisations.
1. Management’s Discussion and Analysis: Thinking beyond
Numbers
• Financial statements are not sufficient to provide information on the overall performance of an
organisation.
• Senior managements, boards of directors also make an attempt to explain and evaluate the
overall performance and prospects of an organisation.
• In addition to financial statements, the annual reports of an organisation consist of a section
called Management’s Discussion and Analysis (MD&A).
• MD&A is a discussion and analysis of the financial activities of an organisation by its
Management’. The MD&A usually precedes the financial statements in the annual report of an
organisation and contains, among other things, comments on the organisation’s operational
outcome, its ability to satisfy its existing obligations and expansion plans, if any.
Numbers
• MD&A provides an overview of the previous year’s operations and how the organisation
progressed. Management usually also throws some light on the upcoming year, outlining its
forthcoming goals and new projects.
Principles of MD&A
Principle Implication
1. Through the Eyes of the An entity should disclose information in the MD&A
Management. that enables readers to view it through the eyes of
the Management.
2. Integration with Financial MD&A should complement as well as supplement
Statements financial statements.
3. Completeness and Materiality MD&A should be complete, fair and balanced, and
provide information that is material to the decision-
making needs of users.
4. Forward-looking Orientation A forward-looking orientation is fundamental to useful
MD&A reporting.
5. Strategic Perspective MD&A should focus on Management’s strategy for
generating value for investors over time.
6. Usefulness MD&A should be understandable, relevant, and
comparable
Numbers
• Advantages of MD&A:
– Management is better placed than others to provide information about an

organisation.
– MD&A offers the opportunity for an organisation to communicate the effectiveness

of its resources and progress towards its defined strategic objectives.
– Helpful in integrating and accumulating material information about the organisation

that investors are interested in.
– Apart from imparting information to investors, many organisations use the MD&A
to help new directors in orienting themselves to an organisation’s performance and
prospects
Let’s Sum Up
• Common size analysis is a popular method of financial statement analysis, which makes use
of common size financial statements.
• Horizontal common-size analysis uses one type of financial statement at a time over several
consecutive years. Vertical analysis refers to the proportional analysis of a financial statement,
where each item on a financial statement is recorded as a percentage of another item.
• Trend analysis evaluates an organisation’s financial information over a period of time. These
periods could be several months, quarters, or years, depending on the requirements.
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What are the main components of a financial statement?

What are the main components of a financial statement?

What is the purpose of Management's Discussion and Analysis (MD&A)?

What is the purpose of Management's Discussion and Analysis (MD&A)?

Financial Accounting and

5 Chapter 5 Accounting Standards II 91-114

6 Chapter 6 Generally Accepted 115-131

8 Chapter 8 Cash Flow Statement 166-189

10 Chapter 10 Financial Statement Analysis II 205-228

11 Chapter 11 Financial Statement Analysis III 229-252

S. No Reference No Particulars Slide

Nature and Scope of Financial 8-10

Basic Accounting Concepts 14-17

Advantages and Limitations of 18-19

• According to the American Accounting Association (AAA), “Accounting is the process of