Financial Statements: Introduction


Learning Objectives
After studying this chapter, you should be able to understand
   ...
Introduction:
The end product of the financial accounting is a set of financial statements. Some of these
statements are s...
machinery, equipment, buildings, inventories, etc., or, things that have immediate purchasing
power, like, cash and short-...
representing the amount outstanding for more than six months but considered doubtful.
        Sometimes under the head of ...
•   Money owed to suppliers of goods and services (sundry creditors/accounts payable)
•   Taxes owed to government authori...
Long-Term Liabilities
                                                                        Concept of Time
 In general,...
iv. Rent received in advance: if an enterprise owns a building and rents it to a tenant and the
    tenant has paid the re...
Now let us see the balance sheet of Wipro limited and understand the terms.

                                             ...
Let us now further demystify the balance sheet by further reducing the number of items and them
understand the interrelati...
Preparing Balance sheet: Common Sense Approach

Even without understanding the technicalities of accounting, one can prepa...
3. Took 12% loan from IDBI: Rs.1500. Deposited the same with UTI bank. In this case the
   sources increase and since they...
Furniture                 100
                    Total              4500                          Total                45...
9. Suppose the company sold 3 computers @ Rs. 18000 to a local school. In this case it has
   incurred a loss of Rs. 6000....
10. The company sold another 20 computers @ of Rs. 25000 to a local organisation (ABC ltd.).
    10% of the sales collecte...
Now let us present the above balance sheet in the format shown in exhibit 2.2

                                          C...
Income Statement


Learning Objectives

After studying this chapter, you should be able to understand
     Income Stateme...
Profit and Loss Account/Income Statement


The income statement of an organisation shows the net operating result of the a...
Expenditure Side

The expenditure side of a P & L account gives the details of all the revenue expenses whether
accrued or...
It is important to note that the profit changes by 31% not because of the change in the operating
efficiency, but just bec...
Presentation of Income Statement:
At this juncture we will see the general format of presenting the incomes and expenses. ...
sale value i.e. Rs. 500,000 was shown as the income. Similarly, when an item bought on credit, it
is recognized as an expe...
Important financial items and financial statements


    •   Sources (liabilities)
    •   Uses (assets)                  ...
Financial Statements: Cash Flow Statement


Learning Objectives

After studying this chapter, you should be able to unders...
Cash Flow Reporting

The basic objective of a cash flow statement is to provide relevant information as regards cash
recei...
•     Cash receipts from the sale of goods and the rendering of services;
        •     Cash receipts from royalties, fees...
Financing activities are activities that result in changes in the size and composition of the
   equity capital and borrow...
Cash Flow Statement

Opening cash in hand                              Cash Flow Statement
                               ...
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Comprehensive note on IS/CFS/BS

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Comprehensive note on IS/CFS/BS

  1. 1. Financial Statements: Introduction Learning Objectives After studying this chapter, you should be able to understand  Balance sheet  Income Statement  Cash Flow Statement 1
  2. 2. Introduction: The end product of the financial accounting is a set of financial statements. Some of these statements are statutory and some are not. These financial statements relate to a specific date or covers a specific period viz. month, quarter, annual. In the Indian context, he balance sheet, the profit& loss account, and cash flow statement are considered to be the statutory statements, though many companies have started including other statements in their annual reports. In this chapter we will concentrate on the two basis statutory statements viz. balance sheet and the profit & loss account. To examine the content of these financial statements and how to read them, let’s look at the financial statements of Wipro Limited for the year ending 31st march 2000 and 2001. At this point, we will focus our attention on the larger picture and not get into the nitty-gritty of the financial statements. Our goal is an overall understanding of the basic financial statements. At this stage we will ignore the details on each statement. However, as we progress through the text, we will examine these details to enable you to undertake an in-depth analysis of the financial statements. Balance sheet Let us begin with the balance sheet of Wipro Limited. The exhibit 2.1 displays the condensed balance sheet for two years. The balance sheet represents the financial picture of an organisation as it stood on a particular date. It can be prepared every day, on the last day of the week, last day of the month, last day of the year, or any other day. The balance sheet for the previous year is also presented along with the current one to facilitate comparison. Balance sheet is prepared on the basis of certain basic concepts and conventions of accounting (which will be discussed in the next chapter) and presented in the format prescribed by the Companies Act 1956. Balance Sheet, also known as the statement of financial position, reports a company's financial status at a set date noted on the statement. The statement is like a snapshot because it shows what the company is worth as on a particular date . The statement shows: • what the company owns (Assets)? • what the company owes (Liabilities)? • what belongs to the owners (Shareholders’ fund)? In the standard accounting model, the balance sheet can be represented by using the accounting equation i.e. Assets = Shareholders’ Funds + Liabilities (More about the accounting equation in the subsequent chapters). As such, both sides of the balance sheet should be same. They are in balance because, each rupee of asset acquired will have a corresponding source i.e. either collected from the share holders or the creditors Assets A thing that is valuable to the business is an asset. The value may be defined in terms of its capacity to be instrumental in production of goods or services. For example, plant and 2
  3. 3. machinery, equipment, buildings, inventories, etc., or, things that have immediate purchasing power, like, cash and short-term marketable securities; or claims that can be converted into cash such as accounts receivable; inventory of finished goods etc., are of value to the enterprise. If an item is valuable to the enterprise, the acid test of whether a particular item is an asset of an enterprise or not is the ownership of the item. If an enterprise does not hold title of a particular item though it may have physical possession (e.g., rental building), it is not represented among the list of assets. The various categories of assets are discussed as follows: Fixed Assets Fixed assets are tangible valuable things owned by the enterprise with the intention of carrying on business operations over a long time horizon. Thus, fixed assets are of a tangible nature and are durable. The usefulness of an asset to an enterprise is always either on grounds of technology or economic benefits. When the term “fixed asset” is used without qualification, the reference is generally to tangible assets and specifically to plant and machinery, buildings and land. Generally, all the fixed assets are grouped together at the original cost value to represent the gross block, from this accumulated depreciation on all the assets till the date is subtracted to arrive at the net block. Usually, this information is substantiated by a schedule containing details on original cost, accumulated depreciation till the date of previous balance sheet, and depreciation for the current accounting period for each fixed assets component. Current Assets, Loans and Advances Current assets include cash and all “cash-like” items which can be converted into cash in the near future (i.e., in a year) or during a normal operating cycle. The operating cycle, here, is defined as the time span between the cash injected into operating processes through purchase of raw materials and the cash received from the sale of goods. So, current assets are cash and bank balance, stock of raw materials, work-in-process, finished goods and account receivables. The current assets are as could be observed from the above explanati9on, asset items of current nature. Here the word current means that the assets change from (say raw materials into work-in-process, or work-in-process into finished goods, or finished goods into accounts receivables or receivable into cash) frequently during the operating period. On the other hand, fixed assets are more permanent in nature. The various components of current assets are discussed as follows: i. Cash and bank balance: Cash consists of funds that are immediately available for disbursement. Usually, most of the organisations do not keep a lot of cash on hand as most dealings are done through banks. ii. Stocks: Stocks, also known as inventories, consist of raw materials goods, half-the-way through the process (work-in-process) and finished goods awaiting sales. The conservatism concept of accounting is followed in valuing the inventory and is done either at cost or market value, whichever is lower. iii. Debtors: Debtors represent the amount owed to an enterprise by the customers. This shows the claims of the company for the goods and services rendered with an agreement to receive payment for it at a later date. The amount shown under this head is the net amount which means that out of the total debtors, the amount not likely to be collected (called, doubtful debts or bad debts), is deducted to get a clear picture of the amount receivable. Debtors are also termed as accounts receivables. Most of enterprises, in their schedule of debtors in the balance sheet, segregate the item into two categories: one 3
  4. 4. representing the amount outstanding for more than six months but considered doubtful. Sometimes under the head of debtors, certain amounts arising out of non-regular operational transactions e.g., amount yet to be received from sale of an asset, are also included. iv. Marketable securities: These are the firm’s investment in shares and debentures of corporations, and other securities for a relatively short period of time. The word marketable indicates that these securities can be sold and bought on a stock exchange. v. Prepaid expenses: These are expenses that have been paid in advance for example advance income tax or insurance premium paid in advance. If insurance premium is paid on 25th December for the next accounting year, then it will be indicated as prepaid insurance, because it has been paid for future coverage. Similarly rent paid in advance for future use of equipment or buildings will be indicated as prepaid rent. vi. Interest receivable: If interest has been earned but not received in cash as on the date of balance sheet, it is represented as interest receivable. For example if an enterprise has deposits in a bank and the bank pays interest half-yearly, then on 31st December it has earned interest but has not received it. We will represent this information on the balance sheet as interest receivable. Investments An enterprise may decide to invest in long-term securities of other institutions. For example a firm may periodically set aside certain cash and invest this cash in long-term securities, so as to ensure availability of cash for any repayment at a future date. An enterprise may also buy shares of another firm with a view to diversify its operations. Intangible Assets These are the assets that do not have physical existence, therefore, we cannot see or touch them, for example goodwill is an intangible asset. Such assets may have a fixed term of existence by law, regulation or agreement, for example patents, copyrights and leases. Difficulties may arise in ascertaining the existence and quantum of future benefits from such assets. Therefore, it is usually recommended that expenditures made by the enterprise in developing these assets should not be recognized as asset. Only if an intangible asset is acquired through purchase from other entities, should it be recognized as an asset. LIABILITIES Liabilities On the statement of financial position, debts are called liabilities. Liabilities represent what a business as a distinct entity owes to various parties either against some specific securities or otherwise either for relatively a longer period of time or for a short duration.. Examples of liabilities include: • Money owed to banks and other lenders 4
  5. 5. • Money owed to suppliers of goods and services (sundry creditors/accounts payable) • Taxes owed to government authorities • Rent owed to owners of land and buildings • Money owed to the shareholders Liabilities represent what a business as a distinct entity owes to various parties namely to shareholders, for share capital and retained earnings, and to other parties, for loans to the business entity either against some specific securities or otherwise either for relatively a longer period of time or for a short duration. Although liabilities are a necessary part of doing business, companies must manage their liabilities carefully. If a company cannot make interest payments on time and repay the principal when due, the company can be forced to declare bankruptcy and either reorganize or disband. So it is necessary to understand the liabilities in details. Generally liabilities can be differentiated on the basis of the following:  Insider and outsider  Term (period)  Secured or unsecured  Mode of repayment  Rate of interest Broadly the total liabilities can be studied under three heads viz. owners’ equity, long-term liabilities, and current liabilities, which are discussed as follows: Shareholders’(Owners’) Equity Stockholders' equity is the amount owners invested in new stock plus the earnings the company retained since it started. (Retained earnings is the amount of profit kept after dividends are paid). On the statement of financial position the amount of stockholders' equity always equals the value of all the assets minus all the liabilities. This section is subdivided into the following subsections. i. Share capital: This category of owners’ equity shows the stated value of share certificates issued (Issued share capital) and the value contributed by the shareholders to the share pool of the company (paid-up share capital). ii. Reserve funds and other funds: This section of owners’ equity represents the earnings foregone by the shareholders in the previous year(s) and retained with the business or ploughed back into the business. The net profit is apportioned to various reserves. Some of these are: investment allowance reserve rehabilitation reserve and dividend equalization reserve. Sometimes, provision for certain reserves have to be made in compliance with various regulatory requirements. The “other funds” represent funds received from other agencies such as World Food Programmes, and International Development Agency etc. this item can be seen in the balance sheet of development- oriented institutions. 5
  6. 6. Long-Term Liabilities Concept of Time In general, long-term liabilities are the enterprise’s obligations for money obtained for a relatively long period, generally more than year. These liabilities are incurred to finance the operations of the business. This, therefore, represents claim against assets. These liabilities are more often  In accounting, time is divided on against the securities by hypothecation the basis of the accounting year i.e. or pledge of the assets. twelve months. So we have the long and short-term liabilities.  Where as in economics, time is divided on the basis of the time taken for supply to change. Current Liabilities (Short-Term) Current liabilities represent the obligations maturing within a relatively short period not exceeding one year or the normal operating cycle of the business. Current liabilities include sundry creditors, tax liability, unpaid dividend, outstanding expenses and advances from customers. These dues are honored using current assets. The explanation for these terms is given below: i. Sundry creditors: Sundry creditors show the amount due to suppliers, by the enterprise. These claims are generally not secured against any asset. ii. Liability for taxation: The amount of taxes as shown in the balance sheet represent the provisions made on the basis of estimates. Since the actual tax liability is assessed based on the taxable income of the year, payment is adjusted against the provisions made. iii. Outstanding expenses: The expenses that relate to the current accounting period and, therefore, have accrued but have not been paid at the end of the accounting period, are referred to as accrued expenses. For example, wages for the month of March will remain unpaid on 31st March and, therefore, it will be represented as wages payable on the balance sheet as on 31st March. Distinguish between ‘Expenses Accrued’ and ‘Expenses Due’ 6
  7. 7. iv. Rent received in advance: if an enterprise owns a building and rents it to a tenant and the tenant has paid the rental charges in advance, then this amount will be indicated as rent received in advance, on the liability side of the balance sheet. 7
  8. 8. Now let us see the balance sheet of Wipro limited and understand the terms. Exhibit 4.1 WIPRO LIMITED BALANCE SHEET AS AT MARCH 31 2001 (All figures in rupees million) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2000 2001 2000 Share capital 466 708Gross block 9020 6757 Less Depreciation -3793 -2928 Reserves and surplus 19184 6994Net Block 5227 3829 Shareholders' Funds 19650 7702Capital Work in progress 797 708 Fixed Assets 6024 4537 Secured Loans 400 492 Unsecured Loans 47 86 Investments 1636 462 Loan Funds 447 578 Inventories 1152 1340 Sundry creditors 4813 4057Sundry Debtors 6176 4469 Provisions 532 428Cash and Bank balances 4463 747 Current Liabilities 5345 4485Loans and advances 5992 1210 Current Assets 17783 7766 Total 25442 12765 Total 25443 12765 Some observations:  The balance sheet is true as on the 31st March 2001 and 2000.  The shareholders’ fund has increased by two and half times.  A large component of the shareholders’ fund is reserves and surplus.  The share capital has decreased.  Loans have decreased during this period  Current liabilities have increased marginally.  Fixed assets have increased by one and half times  The company has huge cash and bank balance and has given huge money in the form of loans and advances to various parties. + To do: Take the balance sheet of any company of your choice and compare it with the above and write a note on your observations. Simplified Version of Balance Sheet 8
  9. 9. Let us now further demystify the balance sheet by further reducing the number of items and them understand the interrelationship. In the process you will get introduced to some more accounting terms which will be taken up for further discussion in the subsequent chapters. Exhibit 4.2 WIPRO LIMITED BALANCE SHEET AS AT MARCH 31 2001 (All figures in rupees million) Liabilities As on March 31 Assets As on March 31 2001 2001 Shareholders' Funds 19650 Fixed Assets 7660 Long Term Loan 447 Current Assets 17783 Current Liabilities 5345 Total 25442 Total 25443 So five important items of the balance sheet are as follows:  Shareholders Funds (SF or OF)  Long Term Loans (LTF)  Current Liabilities (CL)  Fixed Assets (FA)  Current Assets (CA) Some interesting relationships  SF+ LTF = Capital Employed  CA-CL = Working Capital (WC)  SF = (FA +CA)-(LTF+CL)  Capital Employed = FA+WC  Total Assets = Capital Employed + CL  Total Liabilities = FA+CA 9
  10. 10. Preparing Balance sheet: Common Sense Approach Even without understanding the technicalities of accounting, one can prepare a balance sheet. The assumption on which the balance sheet is prepared is quite basic and commonsensical: Every application (i.e. purchase of asset, or increase in asset) should have a corresponding source. So based on this assumption the total applications at any point of time will be equal to the source. Let us try to understand this with the following transactions of an hypothetical company. 1. A ltd. is company formed on 1st April 2001 to buy and sell computers. The promoters collected Rs. 1000 as share capital from their friends and relatives. The balance sheet will be as follows: Compusales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS APPLICATION OF FUNDS Capital 1000 Cash 1000 Total 1000 Total 1000 2. Purchased furniture Rs. 100 for cash. This transaction will reduce cash and increase another form of asset i.e. furniture. The balance sheet will be as follows: Compusales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 1000 Cash 900 Furniture 100 Total 1000 Total 1000 n.b. No change in capital and on the sources side. 10
  11. 11. 3. Took 12% loan from IDBI: Rs.1500. Deposited the same with UTI bank. In this case the sources increase and since they have not used that money for acquiring any asset it will be shown as cash at bank. Compusales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 1000 Cash 900 IDBI Loan 1500 Bank 1500 Furniture 100 Total 2500 Total 2500 4. Purchased air conditioner and paid by cheque: Rs.25000. This transaction will reduce the bank balance and increase another form of asset i.e. AC. No change in the sources. Comp sales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 1000 Cash 900 IDBI Loan 1500 Bank 1475 Furniture 100 AC 25 Total 2500 Total 2500 5. Entered into agreement to buy 1000 computers from a local manufacturers XY Ltd. This transaction will not affect the balance sheet. 6. Received 100 computers at the rate of Rs. 20,000. Money to be payable on a later date. So this a credit transaction. Comp sales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 1000 Cash 900 IDBI Loan 1500 Bank 1500 XY Ltd. (Creditors) 2000 Stock of Computers 2000 11
  12. 12. Furniture 100 Total 4500 Total 4500 You can see from the balance sheet that the increase in the assets is being funded by the increase in sources i.e. a new liability has been created. 7. Issued one lakh shares of Rs. 10 to the public and collected money through bank and also raised further loan of Rs. 50000 from SBI to meet the short term expenses. Comp sales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 2000 Cash 1400 IDBI Loan 1500 Bank 2500 SBI Loan 500 XY Ltd. (Creditors) 2000 Stock of Computers 2000 Furniture 100 Total 7000 Total 6000 8. 2 computers were sold @ Rs. 25000 for cash over the counter. You may aware that the computers were purchased for Rs.20000. Let us see the impact on the balance sheet.  Cash increases by Rs. 50,000  Computers decrease by Rs. 40,000  The balance is treated as Profit: Rs. 10,000 Comp sales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 2000 Cash 1450 IDBI Loan 1500 Bank 2500 SBI Loan 500 XY Ltd. (Creditors) 2000 Stock of Computers 1960 Profit 10 Furniture 100 Total 6010 Total 6010 12
  13. 13. 9. Suppose the company sold 3 computers @ Rs. 18000 to a local school. In this case it has incurred a loss of Rs. 6000.  Cash increases by Rs. 54,000  Stock decreases by Rs. 60,000  Balance is treated as loss: Rs. 6,000 Comp sales Ltd. BALANCE SHEET AS on 2001 (All figures in rupees 000) SOURCES OF FUNDS As on March 31 APPLICATION OF FUNDS As on March 31 2001 2001 Capital 2000 Cash 1504 IDBI Loan 1500 Bank 2500 SBI Loan 500 XY Ltd. (Creditors) 2000 Stock of Computers 1900 Profit 10 Furniture 100 Loss 6 Total 6010 Total 6010 Now let us summarise the Learnings from the above transactions: Some interesting relationships a) Increase in asset will have the following effects  Increase in liabilities, or  Decrease in cash/other asset b) Increase in liability will have the following effect  Increase in cash, or  Increase in other asset  Decrease in any other liability c) If Source side is greater than application, the difference is treated as ‘Profit’. d) If Source side is lesser than the application side, the difference is treated as ‘Loss’ 13
  14. 14. 10. The company sold another 20 computers @ of Rs. 25000 to a local organisation (ABC ltd.). 10% of the sales collected immediately and the balance to be collected in twelve equal installments.  Cash increases by Rs. 50,000  Debtors (Receivables) increases by 450,000  Stock decreases by Rs. 400,000  Difference is treated as profit: Rs. 100,000 Comp sales Ltd. BALANCE SHEET AS on (All figures in rupees 000) SOURCES OF FUNDS As on APPLICATION OF FUNDS As on 2001 2001 Capital 2000 Cash 1554 IDBI Loan 1500 Bank 2500 SBI Loan 500 Debtors 450 XY Ltd. (Creditors) 2000 Stock of Computers 1500 Profit 10 Furniture 100 Profit 100 Loss 6 Total 6010 Total 6110 Instead of showing the profits and losses separately, they can be netted off as follows: Comp sales Ltd. BALANCE SHEET AS on (All figures in rupees 000) SOURCES OF FUNDS As on APPLICATION OF FUNDS As on 2001 2001 Capital 2000 Cash 1554 IDBI Loan 1500 Bank 2500 SBI Loan 500 Debtors 450 XY Ltd. (Creditors) 2000 Stock of Computers 1500 Profit 104 Furniture 100 Total 6104 Total 6104  Profit = 100 + 10 – 6 = 104 14
  15. 15. Now let us present the above balance sheet in the format shown in exhibit 2.2 Comp sales Ltd. BALANCE SHEET AS on (All figures in rupees 000) Liabilities As on March 31 Assets As on March 31 2001 2001 Shareholders' Funds 2104 Fixed Assets 100 Long Term Loan 1500 Current Assets 6004 Current Liabilities 2500 Total 6104 Total 6104  Shareholders’ Fund = Capital + Profit – Loss  Current Liabilities = Creditors + SBI Loan  Current Assets = Cash + Debtors + Stock So profit or loss of an organisation can be determined by preparing the balance. However, if the expenses and incomes are many and the net result has to be determined at the end of a particular period of time then it is better to prepare the Income Statement or Profit & Loss Account. + To do: Compare the balance sheet of a manufacturing company with that of a service company and a banking company. 15
  16. 16. Income Statement Learning Objectives After studying this chapter, you should be able to understand  Income Statement  Relationship between Income Statement and Balance Sheet 16
  17. 17. Profit and Loss Account/Income Statement The income statement of an organisation shows the net operating result of the activities undertaken during a particular period of time. The income statement is also known as the Profit and Loss Account (P/L Account). It tells us the financial results of business activity –how successful the operation of the business is. If income exceeds expenses during the period, it is profit and if the expenses exceeds the income it will be treated as loss. It is important to note that the transactions recorded in the profit and loss account flow through to the balance sheet. For example in the previous section we have sent that the balance sheet shows the profit or loss. This profit or loss can also be determined by preparing the profit and loss account. We discuss the interrelationship in some details in the later part of the chapter. Some of the important items that find place in the income statement are as follows: Income Side Sales The sale of products and services is the main source of income for companies. These are usually recorded at gross value, including excise duty if any. The excise duty is then separately recorded on the expenditure side. However, for the purpose of financial analysis, it is better to arrive at the net sales figure (net of excise duty) because the rates of excise duty may change from year to year depending upon the policy of the government. The sales figure is also net of discounts and returns. In other words, if an item’s price is Rs. 50, but is sold at a discount of 10%, the sales shown in the income statement will be Rs. 45. The net sales values provide a more dependable basis for calculating the profitability ratios. Other Incomes The income received by a company from sources other than sales of its main products and services is mentioned separately. In many companies the other income constitutes a significant portion of the profit before tax. Why is it necessary to show sales and other incomes as separate items? 17
  18. 18. Expenditure Side The expenditure side of a P & L account gives the details of all the revenue expenses whether accrued or paid for during a year. Cost of goods Consumed The cost of goods consumed is arrived at after making suitable adjustments for opening and closing stocks as shown below: (Rs in Lakhs). Opening Stock 250 Add: Purchases 1200 1450 Less: Closing Stock 400 Goods Consumed 1050 It is important to note that the cost of goods consumed depends of the principles of valuation of inventory. Inventory valuation in detail will be discussed in chapter: However, we will see a very simple example to show the impact of the inventory valuation. There are different methods of valuing inventory. However, we see the impact of only two of them LIFO and FIFO. LIFO: Last-in-first-out. Under this method the goods purchased last will be used first. So the unsold stock is generally from the past purchases. FIFO: First-in-first-out. Under this method, the oldest purchase is used first. So the unsold stock is from the latest purchases. Some interesting relationships Opening Stock/Purchase Rate (Rs.) 1.5.2001 3000 4.5 2.5.2001 1000 5 4.5.2001 2000 6 10.5.2001 2500 units are sold at 10 per unit COGS Sales G.Profit FIFO Cost of Goods Sold 11250 25000 13750 (2500*4.5) LIFO Cost of Goods Sold 2000*6 14500 25000 10500 Profit changes 500*5 because of the Change in profit 31% change in the method of valuation 18
  19. 19. It is important to note that the profit changes by 31% not because of the change in the operating efficiency, but just because of the change in the valuation method. FIFO results in higher profits because of lower cost of goods sold and a higher, whereas LIFO results in lower profits because of higher cost of goods sold. Manufacturing Expenses These include all expenses related to plant and manufacturing operations like power and fuel, repairs and maintenance, stores consumed, water treatment, pollution treatment, etc. Excise Duty This is the amount paid to the government as a tax, before the goods are dispatched from the factory. Salaries and Wages Salaries and wages and all other employee benefits and amenities are included in this expenditure. They include provident fund, ESI (Employees State Insurance) contributions, medical benefits, leave travel benefits, bonus, gratuity, pension, other super-annuation benefits etc. Administrative Expenses Administrative expenses include head office expenditure, secretarial costs, postage and telephones, directors’ remuneration and other administrative expenses. Selling Expenses Selling expenses include freight, advertising and sales promotion, commissions and discounts and other selling and distribution costs. Interest The interest cost consists of interest on long-term loans, debentures, bank loans for working capital, interest on public deposits and other loans. Depreciation Depreciation is the charge for using the assets. It can be described as the cost of the assets used during the year. This amount need not be paid to any outside party. Refer to chapter: XX for details Other Expenses The other expenses include auditors’ remuneration, petty expenses, small donations, if any etc. 19
  20. 20. Presentation of Income Statement: At this juncture we will see the general format of presenting the incomes and expenses. Generally the income statement is known as ‘Trading and Profit and Loss Account’ and consists of three sections as illustrated in the following exhibit Trading Account Sales Less Cost of Goods Sold GROSS PROFIT Profit and Loss AccountGROSS PROFIT Add Other Incomes Less All other Expenses Repairs Depreciation Interest Others NET PROFIT Appropriation Account NET PROFIT Less Income Tax Transfer to Dividend Transfer to Specific Reserves RETAINED PROFIT Gross Profit: shows the ability of the business to generate profit Net Profit: Money available for distribution among the various stakeholders Retained Profit: Profit available for re-investing in the business.  Profit Before Interest and Tax (PBIT), and  Profit After Tax (PAT) Distinguish between Though, the income statement is an important statement, it has the limitation of no being able to show the cash position. This limitation can be attributed to one of the important concepts of accounting i.e. Accrual Concept. The Income statement does not tell us how much cash has been received and how cash has been paid during the period. All it does is to summarise the incomes and expenses. While preparing the balance sheet we have seen that when the company has sold 20 computers @ Rs.25000, of which only 10% was received immediately. For the purpose of determining the profit or loss, the entire 20
  21. 21. sale value i.e. Rs. 500,000 was shown as the income. Similarly, when an item bought on credit, it is recognized as an expense immediately, though the cash is yet to flow out of the business. Now let us see the profit and loss account of Wipro Ltd. WIPRO LIMITED Profit and Loss Account for the year ending Mar 31 (All figures in rupees million) 2001 2000 Income Sales and Services 30539 22735 Other Income 692 257 31231 22992 Expenditure Cost of goods sold 18103 15203 Selling, general and administrative expenses interest 5404 3995 Interest 68 286 23575 19484 Profit before taxation and non Recurring / extraordinary items 7656 3508 Provision for taxation 992 501 Profit after tax before non-recurring/ 6664 3007 Extraordinary items Non recurring / extraordinary items 16 -523 Profit for the period 6648 2484 Appropriations Interim Dividend on Preference Shares 18 26 Interim Dividend on Equity Shares 69 Proposed Dividend on Equity Shares 116 Corporate tax on dividend 13 10 Transfer to Capital Redemption Reserve 250 Transfer to general reserve 6251 2379 + To do: Study the change in the income statements over the two years and explain how profit for the period has increased by 168% . 21
  22. 22. Important financial items and financial statements • Sources (liabilities) • Uses (assets) Balance Sheet • Expenses Income Statement • Incomes Balance sheet Owner's Fund Fixed Assets Long Term Funds Investments Short Term Funds Current Assets Income Statement Sales Less Cost of goods consumed Expenses Depreciation Profit before Interest (PBIT) Interest Profit after Interest Tax Profit after Tax (PAT) 22
  23. 23. Financial Statements: Cash Flow Statement Learning Objectives After studying this chapter, you should be able to understand  Cash Flow Statement  Inter-relationship between BS, IS, and CFS 23
  24. 24. Cash Flow Reporting The basic objective of a cash flow statement is to provide relevant information as regards cash receipts and cash payments of an enterprise during the accounting period. CFS shows the movement of cash of an enterprise. It records all cash flows occurred during a particular period. It is believed that cash flow information together with other traditional accrual basis financial statements help investors creditors and others to – • Assess the enterprise’s ability to generate positive cash flow from operations in future; • Assess the enterprise’s ability to meet its obligations, its need for external financing and ability to pay dividend; • Assess the reasons for difference between net profit and net cash flow from operations; • Assess the effects on an enterprise’s financial position of both its cash and non-cash investing and financing transactions during the period. • Shows the balance in hand or at bank, • Helps in understanding the composition of cash flows, and • It facilitates financing, investment and dividend decisions. Cash and Cash Equivalents: However, the term cash and cash flow are not uniquely defined. Thus cash equivalents are risk-free short term investments, either in reporting currency or in foreign currency, having a maturity period of not exceeding three months, net of short term advances. Other definitions may mislead the users by understating the investment cash flows. What it records? It captures all the cash transactions undertaken during a particular period. In other words it records the following: • It records both revenue and capital items: Profit and loss account shows only the revenue incomes and revenue expenses, balance sheet shows the capital receipts and expenditures, whereas the cash flow statement shows all types of cash flows. The distinction between capital and revenue is not relevant while preparing CFS. For example: Salary paid (revenue expense), Purchased Plant (capital expense), Advertisement for launching a new product (deferred revenue expense) • It records all cash flows even if it previous years, or future years. For example: Advance premium paid (relating to the next year), Arrear salary paid (relating to the previous year) Components of CFS Cash flow statement explains the reasons for changes in cash and cash equivalents detailing out cash flow on various heads. Important among these heads are: • Cash flow from operating activities; • Cash flow from investing activities; • Cash flow from financing activities. Operating activities are principal revenue producing activities of the enterprise and other activities that are not investing or financing activities. Some example of cash flow from operating activities: 24
  25. 25. • Cash receipts from the sale of goods and the rendering of services; • Cash receipts from royalties, fees, commissions and other revenue; • Cash receipts and payments from contracts held for dealing or trading purposes; • Cash payments to suppliers for goods and services; • Cash payment to and on behalf of employees; • Cash payments for income tax and refunds of income tax unless specifically identified with financing or investment activities. Direct approach – Under direct approach operating cash flow information is obtained from the cash book- cash receipts and payments can be classified and aggregated under the usual heads of accounts. Indirect Approach – Under indirect cash approach cash flow form operating activities can be derived as follows: Net profit or loss Add : Non-cash charge such as depreciation, provisions, deferred taxes, unrealized foreign exchange losses; Add: Charges which are classified as part of investment or financing activities; Less : Non-cash income such as depreciation and other write backs; Less : Income which are classified as part of investment or financing activities. Add/Less : Changes in inventories, operating receivables and payables. Direct method is most appropriate for deriving operating cash flow because major heads of cash receipts and payments are disclosed. However, the SEBI has recently notified to follow indirect method only. Investing activities relate to the acquisition and disposal of long term assets and other investments not included in cash equivalents. As per Para 21 of IAS 7 and Para 21 of AS-3 separate disclosure of cash flows from investing activities is necessary. Cash inflows from investing activities include – • Receipts from collections of loans made by the enterprise and sale of debt instruments of other entities (other than cash equivalents) that were purchased by the enterprise; • Receipts from sale of equity instruments of other enter prises and from return of investment of those enterprises; • Receipts from sale of property, plant equipment and other productive assets; • Receipts from derivative transactions Cash outflows from investing activities include – • Disbursement of loan made by the enterprise and payments to acquire debt instruments of other entities (other than cash equivalents); • Payments to acquire equity instruments of other enterprises; • Payments for acquisition of property, plant and equipment. • Payments for derivative transactions. 25
  26. 26. Financing activities are activities that result in changes in the size and composition of the equity capital and borrowing of the enterprise. Cash inflows from financing activities include – • Proceeds from issuing equity instruments; • Proceeds from issuing bonds, mortgages, notes and from other short or long term borrowing. Cash outflows from financing activities include – • Repayment of amount borrowed; • Capital element of finance lease payments; • Buyback of shares; • Payment of expenses or commissions on any issue of shares, debentures, loans, notes, bonds and other financing. Situation Situation Situation Situation Situation 1 2 3 4 5 Cash from Operation Negative Positive Negative Positive Negative Cash from Financing Positive Negative Positive Positive Negative Cash from Investing Positive Positive Positive Positive Negative Which is the best combination and why? Cash Flows of some Indian companies: India Cements ACC Madras Cements Cash from Operation 85.74 84.22 66.77 Cash from Financing 419.17 -83.04 -64.54 Cash from Investing -584.13 -15.61 -44.09 Give your comments. 26
  27. 27. Cash Flow Statement Opening cash in hand Cash Flow Statement Opening Cash in hand Add: Cash Receipts Cash Sales Add Cash from Operations Collection from customers Issue of share Add Cash from Investments Issue of Debentures Loan Raised Add Cash from Financing Sale of Assets Sale of Investments Closing Cash in hand Dividend Received Intererets Received Less: Cash Payments Cash Purchases Payment to the suppliers loan repaid buy back of shares purchase of fixed assets Interest paid Divident distributed Closing Cash in hand 27

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