2. The three financial statements
• Income Statement
• Contains revenues and costs of a firm
• Revenue and costs are recognized as soon as goods and services are physically bought or sold
• You need not have to receive the cash to record revenue and you need not need to pay cash to
record expenses
• It is a “flow” statement. It is always a sum of all items during a specific period of time (say
between 1 Jan 2010 – 31 March 2010)
• Balance Sheet
• Contains Assets, Liabilities, and Equity of the firm
• Assets = Liabilities plus equity
• It is a “stock’’ statement. It represents a screenshot of firm’s position at a given point of time. (Say
As of 31 March 2010)
• Cash Flow Statement
• Represents all cash flows received or spent by the firm
• It is a “flow” statement. It is always a sum of all items during a specific period of time (say
between 1 Jan 2010 – 31 March 2010)
4. Format of Income Statement
• Revenues or Sales or Total Income
• - Cost of Goods Sold (COGS)
• = Gross Profits
• - Other Operating Expenses
• = EBITDA or PBITDTA (Earnings before interest, taxes, depreciation and amortization)
• - Depreciation
• =EBIT or PBIT (Earnings before interest and taxes)
• - Interest
• = EBT or PBT (Earnings before taxes)
• - Taxes
= EAT or PAT or net income or earnings (Earnings after tax)
5. Components of Income Statement
• Revenues = 0perating Revenue + Non-Operating Revenue
• Operating Revenue comes from core operations of company while Non-operating Revenue comes
from allied activities
• For auto manufacturing company, revenue from sale of cars is operating income while revenue
from sale of car insurance is non-operating income
• Cost of Goods Sold (COGS) = Raw Material + Direct Labor + Factory Overheads + Stores
and Spares
• These include all costs incurred in the factory and excludes all costs incurred out of factory
• Factory overheads include items like rent of factory premise, electricity, maintenance etc.
• Other Operational Expenses or Selling and General Administrative Expenses (SGA)
• All expenses incurred outside factory
• Marketing, salaries of non-factory employees, rent of offices and warehouses, insurance,
electricity usage outside factory, stationary, legal charges, consultancy charges, R&D etc,
• Direct Labor costs in COGS usually called wages while those for non factory workers are called
salaries. (Non a sacrosanct definition)
6. Components of Income Statement
• Depreciation and Amortization
• When we buy an asset which lasts for more than one accounting period, we do not recognize this
as an expense in the income statement
• Instead we recognize it as an asset
• We then deduct the portion of that asset used in current accounting period as deprecation in the
income statement
• Say you buy a headphone worth 3000 on Jan 1 2022. It will last for three years and at the end of three years
they will be worthless
• Then we will recognize headphones as assets in the balance sheet for 3000 Rs on 1 Jan 2022. We will then
deduct 1000 rs in years 2022, 2023 and 2024 income statement as depreciation
• This assumes that you use 1000 Rs worth of headphones in each of the three years.
• The value of the asset (headphone) will be 2000, 1000 and 0 at the end of 2022,2023 and 2024 respectively
• Thus, depreciation is a way of allocating multi-period expenses into different years
• The above example is simplistic. We will study actual method of calculating depreciation in later
part of the course.
• Depreciation is charged for tangible assets while amortization is charged for intangible assets.
8. Format of Cash Flow Statement
Cashflow from Operating Activities
+ Cashflow from Investment Activities
+ Cashflow from Financial Activities
= Net Cash Flow
9. Format of Cash Flow Statement
• Cashflow from Operating Activities
• Cashflows resulting from all operating revenues and expenses mentioned in income statement.
• Cashflow from Investment Activities
• Outflows
• Capital Expenditure (investment in physical assets
• Investment in common shares of other companies
• For trading purposes or investing purposes
• For strategic reasons – subsidiaries, joint ventures, sister-concerns, acquisitions
• Investments in preferred shares of other companies
• Investment in Mutual funds
• Investment in bonds of other companies
• Giving loans and advances to other companies
• Inflows
• CF from sale of physical assets
• CF from sale of shares, bonds and mutual funds
• Dividend income from common shares, preferred shares, bonds and mutual funds (Of other companies)
• Interest income from loans given to other companies and coupons received from bonds held of other companies
• Repayment receipt of loans given or bonds held
10. Format of Cash Flow Statement
• Cashflow from Financial Activities
• Inflows:
• CF from issuance of company’s own shares (common and preferred)
• CF from availing new loan
• CF from issuing company’s own bonds
• Outflows
• Dividend paid on company’s own shares (both common and preferred)
• Buyback of own shares
• Paying principal and interest on availed loans
• Paying coupon on own bonds and retiring own bonds (retiring = paying principal of bond)
12. Format of Balance Sheet
• Assets
• Non-Current or Long Term
• Property Plant and Equipment
• Land
• Intangible Assets
• Investments (financial)
• Advances
• Deferred Tax Assets
• Other Non-Current Assets
• Current or Short Term Assets
• Receivables
• Inventory
• Advances (Prepaid Expenses)
• Short term investments
• Cash and Cash Equivalents
• Other Current Assets
• Liabilities
• Non-Current or Long Term Liabilities
• Loans, advances or bonds
• Leases
• Deferred Tax Liabilities
• Other Non-Current liabilities
• Current or short term liabilities
• Payables
• Advances (Unearned Revenue)
• Short term (working capital) loans
• Current Portion of Long Term Debt (CPLTD)
• Other Current Liabilities
Equity
• Share Capital (Common plus Preferred)
• Retained Earnings
• Other Reserves
13. Components of Balance Sheet
• Assets results in benefits (either in form of money or goods and services) in future while liabilities result in an
obligation to pay (either in form of money or provision of goods and services) in future
• A machine (an asset) will benefit you in future as it will help to produce goods
• A loan (a liability) will result in an obligation to pay principal plus interest in future
• Assets result in cash to acquire them in present while liabilities result in cash inflow in present when they are
incurred
• You need to spend money to buy a machine (an asset) today
• You will receive money when you avail a loan (a liability) today
• Liabilities are other people’s money while Equity is owner’s money
• Assets are an application or use of funds while liabilities and equity are sources of fund
• Current (short term) vs Non current (Long term) = Lasting for one accounting period vs lasting for more than
one accounting period
• Unlike Income Statement and Cash Flow Statement items, items in current balance sheet depend upon the
previous period’s balance sheets
• This year’s beginning balance = Last year’s closing balance
• This year’s ending balance = This year’s beginning balance + Addition - reduction
14. Components of Balance Sheet
• Property, Plant and Equipment
• PPE can be decomposed into three parts:
• Net Fixed Assets = Gross Fixed Assets – Accumulated Depreciation
• The value of Net Fixed Assets appears on the balance sheet while other two
components (GFA and AD) are usually found in Notes to Balance Sheet
• Accumulated depreciation is the sum of all the depreciations charged to
income statement since the date of creation of the Asset
• Gross Fixed Assets represent the original historical cost of assets without
adjustment for depreciation
• Net Fixed Assets represent the current value of asset after deducting all the
depreciation charged till date
15. Components of Balance Sheet
• Property, Plant and Equipment (Cont.)
• Let’s see the example of headphones discussed previously. If we buy the
headphones on Jan 1, 2022 and if they last for three years then
Gross Fixed Assets
Beginning Balance 0 3000 3000
Addition 3000 0 0
Ending Balance 3000 3000 3000
Accumulated Depreciation
Beginning Balance 0 1000 2000
Addition 1000 1000 1000
Ending Balance 1000 2000 3000
Net Fixed Assets = Gross Fixed Assets – Acc. Dep (for all beginning balance, addition and ending balance)
Beginning Balance 0 2000 1000
Addition 2000 -1000 -1000
Ending Balance 2000 1000 0
16. Components of Balance Sheet
• Land – Does not depreciate.
• Intangible Assets
• E.g.: Patents, copyrights, goodwill, brand etc.
• All assets that do not exist in physical form, but benefit the company in long
term
• Net Intangible Assets = Gross Intangible Assets – Accumulated Amortization
• Net Intangible Assets are mentioned in balance sheet. Gross Assets and
Accumulated Amortization occur in Notes to balance sheet
• A schedule similar to fixed assets (in previous slide) can be made for
intangible assets
17. Components of Balance Sheet
• Investments (Financial)
• Investments come in both long term assets and current assets based on how
long the company plans to hold on to them
• Consist of stocks, bonds, mutual funds (of other companies) held by the
company.
• Long Term investment
• Held to Maturity (HTM) securities
• Shares of subsidiaries, sister-concerns and joint ventures
• Short term investments
• Available for Sale (AFS) securities
• Investments in some very liquid money market securities can be considered
as cash-equivalent
18. Components of Balance Sheet
• Accounts Receivable (Current Asset)
• These are recognized when the company has provided goods or service, but is
yet to receive cash from customers
• It creates a right to receive money in near future
• Can be of multiple types : Trade receivable, rent receivable, interest
receivable, dividend receivable etc.
• Accounts Payable (Current Liabilities)
• These are recognized when company has received a good or availed a service,
but has not paid for it.
• It creates an obligation to pay money in near future
• Can be of multiple types : Trade payable, rent payable, interest payable,
dividend payable etc.
19. Components of Balance Sheet
• Prepaid Expenses / Advances (in Current Assets)
• Occurs when company has paid in advance for goods and services, but has not availed them yet
• Creates a right to receive goods and services in near future
• Unearned Revenue / Advances (in current Liabilities)
• Occurs when company receives advance payment from customers, but has not provides the goods and
services
• Creates an obligation in near future to provide goods and services
• Advances in Long Term Assets can either be
• Loans given to other companies which will be paid back in more than one accounting period in future (Right
to receive money back in future)
• Advance payment paid to suppliers for a service lasting for more than one accounting period (right to receive
goods and services in future)
• Advances in Long Term Liabilities
• Refer to loans taken by the company from banks or other companies (Obligation to repay in future)
• It may also refer to Advance payment received from customers for a service lasting for more than one
accounting period (right to receive goods and services in future)
• A
20. Components of Balance Sheet
• Treatment of Loans in Balance sheet
• Loans taken by company which are payable over multiple accounting periods
are recorded in Non-Current Liabilities while those payable in current period
are recorded in current liabilities.
• Long Term Loans vs Short Term Loans
• Even in long term loans, some portion of portion would be payable in current
period. It is recorded under CPLTD
• Egg, Company takes 10L rs loan today. It will pay 1 L principal for 10 years. First
installment is due this year. Then company would recognize 9 L in long term liabilities
and 1 L in CPLTD
21. Components of Balance Sheet
• Deferred Tax Assets (DTA) and Deferred Tax Liabilities (DTL)
• Income statement reported to investors is prepared as per Companies Act while the
tax is calculated based on income statement prepared as per Income Tax act.
• Tax as per Companies act = PBT * Tax Rate
• Tax as per IT Act = Taxable income * Tax Rate
• PBT and Taxable income differ because of difference in provisions (rules) of
Companies Act and Income Tax Act
• You have to pay tax calculated as per IT act. While the tax calculated in normal
income statement as per Companies Act is a fictious amount
• If Tax (IT Act) > Tax (Companies Act) the DTA is created
• If Tax (IT Act) < Tax (Companies Act) the DTL is created
• Value of DTA/DTL = Tax (IT Act) – Tax (Companies Act)
• If value is positive, DTA is created.
• If value is negative, DTL is created
22. Components of Balance Sheet
• Shareholder’s Equity:
• Share Capital
• It is the amount raised by company by issuing shares
• = Share price * number of shares issued
• Share price is broken down into two parts – Face (Par) Value + Share Premium
• Face value is usually INR 1, 10, 100, 1000 etc. This is a fictious value that helps in accounting
of shares
• Say company issue 2 mn shares at a price of INR 48. Face value = INR 10
• Face (Par) Value of Share Capital = 10 * 2 mn = INR 20 mn
• Share Premium = (48-10) * 2 mn = INR 76 mn
• Total Share Capital = 20 mn + 76 mn = INR 96 mn
• = INR 48 * 2 mn
• Reserves and Surplus
• These are the accumulated profits of the company since its foundation
• Reserves and Surplus Ending Balance = Beginning Balance +- Profit for the current year
• Income statement feeds into balance sheet through reserves and surplus
24. Basic Accounting Equation
• Assets = Liabilities + Equity.
• This must always hold true
• So, when a particular transaction takes place, there should ALWAYS
be two entries so that both sides of Equation stay equal
25. Relationship between IS, BS and CFS
• CFS and BS
• End result of CFS is Net Cash Flow
• There is an item of Cash Balances on Balance Sheet
• This Years Cash Balance = Last Year’s Cash Balance + This Years Cash Flow
• IS and BS
• End result of income statement is PAT
• There is an item of Retained Earnings (Reserves and Surplus) on Balance
Sheet
• This Years Retained Earning = Last Year’s Retained Earning + This Years PAT –
Dividends.
26. Relationship between IS, BS and CFS
• Why are CFS and IS different
• Difference in timing
• In income statement, we recognize revenue and cost when the goods and services are
bought and sold, even if we haven’t received or paid cash
• In cash flow statement, we record a transaction only when actual cash changes hands
• The difference in the timing leads to creation of some assets and liabilities in balance
sheet
• Some items do not appear on IS. They appear only on BS and CS.
• If you buy a long term assets, the transaction will result in cash outflow and creation of
asset on balance sheet. No effect on IS
• If you take a loan, the transaction will result in a liability and a cash inflow. It won’t affect
IS
• If you repay a loan, it will result in cash outflow and reduction in a liability. It won’t affect
IS.
28. Recording Transactions
• Each transaction is recorded through Journal Entries
• Each transaction has at least two journal entries to balance the
accounting equations
• System of Debit and Credit
• ExAID : Expense and Assets Increase, then they are debited
• : Expenses and Assets decrease, then they are credited
• RELIC : Revenue, Equity and Liabilities increase, then they are credited
• : Revenue, Equity and Liabilities decrease, then they are debited
29. Examples of Recording Transactions to
illustrate relationship between IS, BS and CFS
• Explain the changes occurring in BS, CS or IS items after following transactions.
Explain the changes now and the changes after one month
• 1. Company sells Auto parts worth 1L Rs and receives cash immediately
• 2. Company pays salaries of 20L at the end of the month.
• 3. Company sells car worth 10 Lakh, customer will pay after one month.
• 4. Company receives raw material worth 20 lakhs. Will pay for after one month
• 5. Company receives advance of 1 lakh for building a software. Company will deliver software
after on 1 month.
• 6. Company pays 2 lakh in advance for rent of upcoming month
• 7. Company buys xerox machine worth 1 lakh which will last for five years (60 months)
• 8. Company takes loan of 12 lakhs. It will pay “equal principal” each month for next 5 years.
Interest Rate is 12% per annum. First payment is due at the end of the month
• 9.Company manufactures 3 cars. Sells 2 of them. Receives full payment on one car from the
customer. The other customer will pay in a month. Cost of producing car is 8 lakhs and selling
price is 10 lakhs.
