Financial Accounting

Financial Accounting

Developed By Mr. Yogesh Ashar & Prof. Rajesh Haldipur Under Prof. Kanu Doshi, Dean – Finance, Welingkar

Advisory Board Chairman Prof. Dr. V.S. Prasad Former Director (NAAC) Former Vice-Chancellor (Dr. B.R. Ambedkar Open University)

Board Members 1. Prof. Dr. Uday Salunkhe
 Group Director
 Welingkar Institute of Management

2. Dr. B.P. Sabale
 Chancellor, D.Y. Patil University, Navi Mumbai
 Ex Vice-Chancellor (YCMOU)

3. Prof. Dr. Vijay Khole
 Former Vice-Chancellor
 (Mumbai University)

4. Prof. Anuradha Deshmukh
 Former Director
 (YCMOU)

Program Design and Advisory Team Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Mr. Manish Pitke Faculty – Travel and Tourism Management Consultant

Prof. Kanu Doshi Dean – Finance Welingkar Institute of Management, Mumbai

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Prof. Dr. V.H. Iyer Dean – Management Development Programs Welingkar Institute of Management, Mumbai

Mr. Smitesh Bhosale Faculty – Media and Advertising Founder of EVALUENZ

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Prof. Vineel Bhurke Faculty – Rural Management Welingkar Institute of Management, Mumbai

Prof. Venkat lyer Director – Intraspect Development

Dr. Pravin Kumar Agrawal Faculty – Healthcare Management Manager Medical – Air India Ltd.

Prof. Dr. Pradeep Pendse Dean – IT/Business Design Welingkar Institute of Management, Mumbai

Mrs. Margaret Vas Faculty – Hospitality Former Manager-Catering Services – Air India Ltd.

Prof. Sandeep Kelkar Faculty – IT Welingkar Institute of Management, Mumbai

Mr. Anuj Pandey Publisher Management Books Publishing, Mumbai

Prof. Dr. Swapna Pradhan Faculty – Retail Welingkar Institute of Management, Mumbai

Course Editor

Prof. Bijoy B. Bhattacharyya Dean – Banking Welingkar Institute of Management, Mumbai

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Mr. P.M. Bendre Faculty – Operations Former Quality Chief – Bosch Ltd.

Course Coordinators

Mr. Ajay Prabhu Faculty – International Business Corporate Consultant

Ms. Kirti Sampat Assistant Manager – PGDM (HB) Welingkar Institute of Management, Mumbai

Mr. A.S. Pillai Faculty – Services Excellence Ex Senior V.P. (Sify)

Mr. Kishor Tamhankar Manager (Diploma Division) Welingkar Institute of Management, Mumbai

Prof. Dr. P.S. Rao Dean – Quality Systems Welingkar Institute of Management, Mumbai

Prof. Dr. Rajesh Aparnath Head – PGDM (HB) Welingkar Institute of Management, Mumbai

COPYRIGHT © by Prin. L.N. Welingkar Institute of Management Development & Research search. Printed and Published on behalf of Prin. L.N. Welingkar Institute of Management Developme velopment & Research, L.N. Road, Matunga (CR), Mumbai - 400 019. 


ALL RIGHTS RESERVED. No part of this work covered by the copyright here on mayy be re reproduced or used in any form or by any means – graphic, electronic or mechanical, including photocopying, recording, taping, web distribution or information storage and retrie retrieval systems – without the written permission of the publisher.

NOT FOR SALE. FOR PRIVATE PRIVA CIRCULATION ONLY. 4th Edition tion ( Jan-2010)

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1 Introduction to Financial Accounting Objectives : After completing this chapter, you will be able to understand: • Principles of Accounting. • Financial Statements. • GAAP

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Introduction to Financial Accounting

Structure 1.1 Introduction 1.2 Limitations of Accounting 1.3 Scope and Importance 1.4 Concepts and Conventions 1.5 GAAP 1.6 Forms of Organisation 1.7 Summary 1.8 Self Assessment Questions

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Introduction to Financial Accounting

1.1! INTRODUCTION Why Financial Accounting? What is common to all these Individuals? i) Ms. Sudha Narayan Murthy (Infosys) - The Wealthiest Woman in India ii)Mr. K P Singh (DLF Group) - The Wealthiest Man in India iii)Ms. Perween Warsi (S&A Foods – Samosa Queen) - The Wealthiest Indian Woman Outside India iv)Mr. Laxmi N. Mittal (Mittal Steel) - The Wealthiest Indian Outside India v) Mr. Bill Gates (Microsoft) - The Wealthiest Man in USA vi)Mr. Warren Buffett (Berkshire Hathaway) - The Second Wealthiest Man in USA They are all very Rich & Famous. But above all, they hold Equity Shares in companies indicated against their names and which are listed on recognized stock exchanges. How do we determine that they are Wealthy? We can determine their wealth by counting, by accounting, by recording, by valuing all their worldly wealth, their assets, their estates, their properties, possessions and financial liabilities, if any. Accounting all incomes, expenses, assets & liabilities in Monetary Terms (in Rupees) is the sole determinant of all economic activities of all businesses, industry, trade, commerce, also of fashion designers; software giants, media moghuls and even NGOs (CRY, Lijjat Papad). Accounting helps recording all financial transactions enabling preparation of: I. Trial Balance II. Profit and Loss Account III. Balance Sheet IV. Cash flow Statement

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Introduction to Financial Accounting

Financial statements have their use to several segments of the society who are called Stakeholders: 1. Shareholders 2. Investment Advisors, Analysts 3. Creditors, Vendors, Suppliers 4. Labour (Workers & Employees) 5. Government (Local, State, Central) 6. Researchers (Faculty) 7. Students of Finance In any business, there are Purchases, Production, Sales, Loans, Stocks, Debtors, Creditors, Bank Balance, Profits & Losses. Unless you produce goods or services, you can’t sell and unless you sell, you can’t have profit. But not all sales can be made at a profit all the time. There can be sales at a loss also. So what is important for a business? Sales or Profit? Ideally Profitable Sales! Basic Principles of Accounting: Accounting is a Science (Recording) as well as an Art (Interpreting). It records only financial transactions and records only Historical Costs (Not Market value). These are recorded and prepared as an ongoing concern basis (not winding up) (Capital & Revenue) (Matching concept). It expects on a year to year basis Consistency (depreciation, stock valuation). Accounting is governed by principles of Conservative basis (provide for unrealized losses; but ignore unrealized profits). Accounts are prepared in a manner that the Business is separate from the owner (hence owner’s capital is liability) (Business entity).

1.2! LIMITATIONS OF ACCOUNTING Accounting reflects and records only monetary value of all transactions and hence only takes quantitative measurements, thus the qualitative aspects are ignored and not taken into account at all. On account of Inflation, value of rupee fluctuates and decreases – but no adjustment is made in the accounts.

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Introduction to Financial Accounting

1.3! SCOPE & IMPORTANCE Accounting can be defined as an information system which measures, processes, and communicates financial information to decision makers. Decision makers can be divided into two broad categories: external and internal. In financial accounting we are concerned with external decision makers such as business owners, potential owners, creditors, etc. A financial accounting system provides summarised and categorised information about the company’s performance and state of affairs mainly for external decision makers. A management accounting system provides much richer, detailed information meant to aid a firm’s internal decision makers. In practice, these are not separate systems but are part of an integrated financial and management accounting system. Internal decisionmakers are the managers who plan, organize and run the business. They ask questions like:

• Is the available cash sufficient to pay bills? (A company can survive a long time without profits, but not too long without cash.) • What is the cost of manufacturing each unit of product? • Can we afford to give employee payraises this year? • What product line is most profitable? External decision-makers include Investors, Creditors and Others like Taxing authorities, Regulatory agencies, Customers, Labour unions and Economic planners. They ask questions like: • Is the company earning satisfactory income? • How does the company compare in size and profitability with competitors? • Will the company be able to pay its debts when they become due? There are various branches of accounting such as financial, managerial (accounting for internal decision makers), tax, auditing, cost, and so forth. The importance of accounting is that it is the universal language of business, and a basic understanding of it is necessary for almost any job in the business world. 6

Introduction to Financial Accounting

There are various kinds of enterprises such as for-profit, non-profit, government, etc. In our study of accounting we will concentrate on for-profit businesses, which operate as companies. We will touch on other forms of business structure including sole proprietorships and partnerships, but our emphasis will be on accounting for companies. For-profit businesses have two primary goals as follows: 1. Profitability – will the company earn sufficient net income to pay all its expenses and provide profits to the owners. 2. Liquidity – will the company generate sufficient cash to pay its bills as they become due.

A third objective pursued by many of the better companies is Growth – in sales, and profitability. Financial accounting is governed by rules or guidelines collectively called Generally Accepted Accounting Principles (GAAP). Many of these are mandatory by law of the country. However, some have considerable persuasive force, though they are not mandatory. As we begin to study accounting we will be gradually introduced to these principles and concepts. Some of the basic principles and concepts are:

1.4! CONCEPTS AND CONVENTIONS What are Accounting Concepts ? Accounting concepts means the rules or the principles that govern accounting. They are fundamental acounting rules that must be followed by all concerns. They provide the basis for other principles such as accounting conventions and policies. Accounting concepts means the necessary assumptions on which accounting is based. We can say concepts are like the grammer for any language.

What are the different types of accounting concepts? The different accounting concepts are as under:

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Introduction to Financial Accounting

1 ENTITY CONCEPT. 2 GOING CONCERN CONCEPT. 3 MONEY MEASUREMENT CONCEPT. 4 HISTORICAL COST CONCEPT. 5 ACCRUAL CONCEPT. 6 ACCOUNTING PERIOD CONCEPT. 7 MATCHING COST AND REVENUE CONCEPT. 8 DUAL ASPECT CONCEPT. 9 COST ATTACH CONCEPT 10 VERIFIABLE OBJECTIVE EVIDENCE CONCEPT.

1 ENTITY CONCEPT: According to this concept, the business is different from the person doing the business. The business has a separate identity or personality which is different from the persons or entities in the business such as proprietors, partners, managers or the employees. Therefore, we find that all accounting records take note of the transactions between the owner and the business. The owners are treated as outsiders for the purpose of recording transactions. The entity concept is applicable to all forms of business such as sole trader, partnership, Joint Stock Company, Co-operative societies. The transactions relating to the business only are recorded. The personal transactions of the proprietor are not recorded in business. Similarly, the transaction between the organisation and the proprietor is also recorded. The Capital is shown as a liability in accounts according to the concept. It means the capital is the money the business has to refund to the proprietor. This concept is applicable to all forms of business organisations. In the eyes of law, the sole trader and his business are one and the same. But for accounting purposes they regarded as separate entities. The same is applicable in case of Partnership firm as well.

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2 GOING CONCERN CONCEPT: Normally the business is viewed as an ongoing concern. It means the assumption is that the business will exist for a long period of time to come. It will not be wound up immediately. It is assumed that the businessman has no intention to close the business. There is no need to close the business as well. According to this concept, the business has permanent life, it will continue for a very long period of time . It will not be closed at the end of the year. It is because of this concept, assets are not valued at their market value or sale price. They are always shown at cost less depreciation. The various assets purchased will be used for a very long period of time. They are not purchased for selling them at the end of the year.

3 MONEY MEASUREMENT CONCEPT: According to this concept, only such transactions are recorded which can be expressed in terms of money. Therefore, those transactions and events that cannot be put in terms of money will not be recorded in the books of accounts. Such events may be very important, but still it will not be recorded in the books of accounts. The advantage of this concept is that money provides a common base. So the different facts of business can be expressed in terms of numbers that can be added or substracted. Thus, only monetary matters are recorded. Non-monetary matters such as the death of a manager, strikes of workers, resignation of an employee etc. will not be recorded. This is because these cannot be expressed in terms of money. This concept is also known as Monetary Unit Concept or Monetary Expression Concept. 4 HISTORICAL COST CONCEPT: It means that the assets should be recorded and valued only at cost and not at realisable value or market value, in the normal course of business.

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It does not mean that the asset will always be shown at cost. It only means that cost becomes the basis for all subsequent accounting for the asset. So the asset may be depreciated at the end of each year and the value may be reduced. The cost concept brings objectivity in the preparation and presentation of financial statements. For example: if a plot of land is purchased for Rs.200,000, it will be recorded in the books as Rs.200,000 only even though the present market value of the land may be Rs.500,000. 5 ACCRUAL CONCEPT: This concept is the recognition of income and cost as they are earned or incurred. It is not as money is received or expenses are paid. In simple words, according to this concept we have to record the expenses for the given period say one year even if the said expense is paid or not. For example: we record outstanding expenses at the end of the year. It means we have not paid the expense. But it has accrued. In the same way we also provide for income accrued, even though it is not received. Thus under this concept, revenues and expenses relating to a particular period is considered. Therefore, expenses paid in advance is excluded, but expenses outstanding is included. Similarly, income received in advance is excluded, and income receivable is included in the books of accounts.

6 ACCOUNTING PERIOD CONCEPT: This concept is also known as Periodicity Concept. According to this concept, the calculation of profit or loss made cannot be postponed indefinitely or till the business is closed. Therefore the accounting period is to be seperated. This accounting period is generally one year. It is within this period we have to determine the profits earned by the business or the loss suffered by the firm. It is within this period we have to see the increase in assets or the decrease in the assets or increase or decrease in liability. The preparation of profit and loss account for the year ended is the best example of accounting period concept. This concept helps to test the profitability of a 10

Introduction to Financial Accounting

business. This concept assumes that the profitability of a business can be measured reliably by periodic profit or loss accounts and that the revenue and cost can be properly matched. The accounting period selected should be sufficiently long enough to serve as a representative and short enough to provide current information.

7 MATCHING COST AND REVENUE CONCEPT: It means the expenses and revenue have to be matched to determine income for a particular period. This is one of the most important concept of accountancy. Once the revenue is recognised, then the problem is to identify the expenses and cost which have been incurred to earn the revenue. In order to determine the net income or profit for a accounting period, these costs and expenses have to be deducted from the revenue earned. This concept is related to Accounting Period Concept. Once the accounting period is determined, then within that period the revenue and its related cost are matched. According to this concept, the accountant is concerned with the determination of revenue for a particular period and then assigning to such revenue, the expenses or charges which are incurred to earn such revenue. Thus, the expenses incurred in a said accounting period are matched against the revenue earned.

8 DUAL ASPECT CONCEPT: According to this concept, every transaction has two aspects. This is followed in double entry book-keeping system. Every entry must have minimum two effects. According to Dual Aspect concept, every transaction has two aspects as given below: a It increases one asset and decreases another asset. b It increases one asset and increases one liability. c It decreases one asset and increases another asset. d It decreases one asset and decreases one liability. 11

Introduction to Financial Accounting

In the same way : e It increases one liability and increases another liability. f It increases one liability and decreases one asset. g It decreases one liability and increases another liability. h It decreases one liability and decreases one asset.

9 COST ATTACH CONCEPT: This concept is also known as Cost Merge Concept. In order to produce any goods or article it is necessary to purchase raw-materials, and thereafter process it to get the finished goods. In this process, the services of various factors are required. These factors are also called the Factors of Production. So we have labour cost, power, overhead expenses. These costs have a capacity to merge or attach when they are brought together. So we add material cost, labour cost and other overhead costs to get the final product cost. Only when the material is converted into a final product it gets value and utility.

10 VERIFIABLE OBJECTIVE EVIDENCE CONCEPT: According to this concept, all accounting transactions should have documentary proof. These documents may be purchase orders, delivery challan, invoice or bill, vouchers, pass book, cheque books, correspondence, agreements etc. These supporting documents form the basis for accounting entries. These are the evidence which help the auditors to verify the books of accounts. ACCOUNTING CONVENTIONS Conventions are the customs or traditions which help the preparation of accounting statements.They make the accounting statements clear and meaningful.They represent the usage or methods generally accepted and customarily used.These are the rules employed or followed by common consent. The conventions exist when there are alternatives which are equally logical. Some of these are generally accepted having regard to cost, time, habit, convenience etc. They relate to the areas like methods of depreciation, 12

Introduction to Financial Accounting

stock valuation, methods of accounting etc.

1 CONVENTION OF DISCLOSURE: This means that accounts must be prepared honestly. They must give all material information.The accounting statements must give full and fair information to the proprietors, creditors, investors and others. This convention is more important in case of a big business like the Joint Stock Companies. This is because the owners and the managers are different. The shares of the companies are also traded in the stock exchanges. So the investors must get full information. The Companies' Act, 1956 requires that the accounts of the company must give a true and fair view of the state of affairs of the company and it must be certified by the auditors. The Act also prescribes the form in which the profit and loss account and the Balance Sheet must be presented.

2 CONVENTION OF MATERIALITY: The accountant must give importance to material details and ignore unimportant details. If this is not done, the accountants will be over burdened with minute details.An item is material if the knowledge of it will influence decision making or to help decide on matters of investment. Therefore, while preparing accounts only important matters are kept and the unimportant matters are left out or they are merged with other items. For example : an amount of Rs.1,000 is material in a total amount of Rs.10,000. But the same amount of Rs.1,000 is not material in a total amount of Rs 10,00,000.

This convention puts a check on unnecessary disclosure in the financial accounts.The financial statements should not be unnecessarily bulky with all unwanted details. The Companies' Act, 1956 requires a separate disclosure of items of income and expenses, if it exceeds 1% of the total revenue of the company. We very often find these days that the companies give the figures in lakhs or crores.

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3 CONVENTION OF CONSISTENCY: This convention indicates that the procedure selected by the company must be followed consistently every year. The financial statements will be comparable only if the procedure is followed consistently. There are several methods of charging depreciation, such as Straight Line Method or Written Down Value Method etc. Once the company decides to follow one particular method, then it must follow the same method year after year. In the same way, there are different methods of valuation of stock such as FIFO or LIFO or Average price etc. The company may adopt any of the methods of valuation of stock, but it must be followed consistently. However, this convention does not mean the company must be very rigid. Whenever it is desirable, the company may change the accounting procedure. This should be done only when there is an improvement in procedure or to introduce a new procedure. When a change is introduced, the company must make a disclosure of the changes made. Similarly, the procedure should not be changed very often.

4 CONVENTION OF CONSERVATISM: This is one of the oldest conventions of accountancy.In olden days, the Balance Sheet was considered as one of the most important documents. It established the valuation of assets. Conservatism in short means the policy of playing safe. According to this convention while preparing accounts we must not take into account any profits unless they are realised. However, we must provide for all anticipated losses. Sometimes, this convention is criticised on the grounds that it provides scope for creation of secret reserves and it is against the convention of disclosure. As a result of this convention, the profit and loss account shows lesser profit and the Balance Sheet overstates the liability.

1.5! GAAP

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Introduction to Financial Accounting

The primary agency responsible for GAAP in India is the Accounting Standards Board of The Institute of Chartered Accountants of India (www.icai.org). In the US, the equivalent is the Financial Accounting Standards Board (FASB). The Securities Exchange Board of India (SEBI) oversees companies whose shares are publicly traded, while the Company Law Board (CLB) oversees disclosure norms in general for all companies in India. In the US, there is a single agency called the Securities Exchange Commission (SEC). In short, the GAAP are the rules; the ICAI makes the rules and SEBI and CLB enforce the rules.

A basic tool used by accountants to explain business transactions is the accounting equation. It can be expressed variously as: Resources = Equities Assets = Liabilities and Owner's Equity Assets = Liabilities and Shareholders' Equity Assets = Rs. 10 Lakhs Liabilities = Rs. 7 Lakhs

Capital = Assets - Liabilities (In the above example, assets are Rs. 10 lakhs and liabilities are Rs. 7 lakhs. Hence, capital is Rs. 3 lakhs)

Shareholders' Equity consists of two parts: Capital (investment by owners) and Retained Earnings (net income accumulated over the life of the corporation less any dividends paid). Brief definitions of other terms in the accounting equation are as follows: • Assets are economic resources owned by the organization. They are Unexpired, Prepaid or Stored Costs, except Cash and Debtors. They are future probable economic benefits as a result of past transactions or events. • Liabilities are debts owned to third parties. They are Economic Obligations or probable sacrifice of future economic benefits arising from present obligations.

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Introduction to Financial Accounting

• Owner's Equity is the owner's interest in the net assets of the enterprise. Obligations to the Owners are called ‘Equities’ and include Capital and Reserves. • Shareholders' Equity is the collective interest of all Shareholders in the net assets. Equity in this sense is the residual interest in the entity’s assets remaining after liabilities are met. • Net assets means (Assets – Liabilities) All business transactions can be expressed in terms of the accounting equation, and it is important to gain some mastery over describing business transactions in terms of the accounting equation. We will discuss this further in Chapter 2.

An account is a summary device used by accountants to describe changes in assets, liabilities, and shareholders' equity. There are various kinds of asset accounts such as cash, land, accounts receivable, etc. Equally, there are various kinds of liability accounts such as accounts payable, taxes payable, etc. For our current purposes, there are just two categories of shareholders' equity accounts: Paid-up Capital and Retained Earnings. Note that revenues increase retained earnings and expenses decrease retained earnings. Finally, dividends decrease retained earnings.

The end product of the accounting process is the production of financial statements, which describe in some detail how the business organization is performing. The basic financial statements required by Indian GAAP are: • Income Statement (also commonly called as the “Profit and Loss Account”) • Balance Sheet • Statement of Cash Flows The basic financial statements required by US GAAP are: • Income Statement • Statement of Retained Earnings

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Introduction to Financial Accounting

• Balance Sheet • Statement of Cash Flows

In India, the Statement of Retained Earnings is usually appended at the bottom of the Income Statement, and is more usually called as the “Profit and Loss Appropriation Account”.

An "expert" in financial accounting is called a Chartered Accountant (CA). (Certified Public Accountant, or CPA in the US). Since many people rely on accounting information it is important that accountants maintain the highest ethical standards. The professional bodies enforce a fairly strict code of conduct, and act on complaints even from members of the public against any of its members. Many of these experts are CEOs, CFOs, General Managers and Financial Controllers of major companies. As we discuss various topics in financial accounting we will also briefly consider the ethical aspect of the actions accountants need to take.

To provide greater credibility (or believability) to its financial statements for both internal and outside users, companies utilize objective third parties to examine its transactions and the financial statements themselves. These third parties are called Auditors. CAs and CPAs not only (as employees) help in drawing up of the financial statements of various enterprises they work for, but (as independent professionals providing audit services) monopolise the work of “auditing” them – which means checking on behalf of the shareholders (called statutory audit as it is mandated by the Companies Act), or as external (or sometimes in-house) advisors to the management team (called Internal Audit, which is generally discretionary but is encouraged by the Companies Act), to ascertain whether the financial statements truly and fairly represent the underlying accounting records, and also comply with the relevant GAAP.

1.6 FORMS OF ORGANISATION

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Introduction to Financial Accounting

While most of our discussion will assume that an enterprise is a company, it is by no means the only way businesses are organised. In India, as elsewhere, the simplest form of organisation is a sole proprietorship, which means a business owned by an individual. Everyone else who works for the organisation is either an employee or an independent professional. There is no distinction in law between a sole proprietorship and its owner. This means that if the sole proprietary business fails, then its liabilities will be made good from sale and realisations from the personal assets of the owner of the business.

1 PROPRIETORSHIP FIRM: A slightly more advanced form of organisation is called a Partnership Firm. In India, a partnership firm is governed by the provisions of the Indian Partnership Act, 1932. The rules thereunder and also some special rules that may be made to govern them in the state in which they are based. The basic features of a partnership firm are coming together of more than one “person” to do business together and to share its fruits (be it profits or losses). However, one major characteristic – the key ingredient of a partnership firm – is mutual agency – any partner can and does bind all other partners in any deal or transaction struck or carried out in the name of the firm, whether or not it was with the consent and agreement of the other partners. For this reason, a partnership is a relationship much like a marriage. Partners have unlimited liability, much like sole proprietorships. In a very limited way, limited liability partnerships in large professional firms have been introduced in India. In India, partnership firms are taxed separately, though under the general commercial law, a partnership firm does not enjoy recognition separate from that of its partners. In law, a partnership is just a compendious name for all or any of the partners. The form of organisation, which interests us the most, however, is the company. A company in India is one, which is registered under the Companies Act, 1956, or any earlier Act. Companies may be either public or private. Private companies restrict the number of shareholders to 50 and restrict free transferability of its shares, by usually incorporating a clause in its Articles of Association (which are the mandatory rules which it agrees to adhere to in the running of its affairs) to the effect that the shares cannot be transferred to any non-shareholder without the consent of all the other shareholders. It can be incorporated with a minimum of 2 directors who need not be its shareholders. Public companies are companies 18

Introduction to Financial Accounting

which do not have the two restrictions as above, and they need to have at least 3 directors and at least 7 shareholders at all times. All these conditions are as laid down by the Companies Act and/or in the Memorandum of Association of a company, which is like the Charter under which the company is established. Companies are treated as legal entities separate from its shareholders, who are co-owners of the undivided fruits of the company’s assets and operations. This means that it enjoys a continuance of existence beyond that of its shareholders. Since it is a separate entity, it is also taxed separately. Public companies are also classified as widely held and closely held. Widely held companies are those whose shares are listed on a recognised stock exchange. Listed means that shares can be publicly traded on stock exchanges openly and without restriction. All public companies other than these are considered closely held.

2 NON - TRADING ORGANIZATION: Non-trading organisation are formed with the objective of promoting art, culture, sports etc. Such organizations are not formed with the objective of making profit. Hence, they do not prepare a Profit & Loss Account but instead they prepare an Income & Expenditure Account and Balance Sheet.

3 JOINT STOCK COMPANIES (LIMITED COMPANY): In case of Joint Stock Companies, the share capital is contributed by a large number of investors who are spread out throughout the country or even the globe. Their liability is limited to the extent of the face value of shares subscribed by them. The preparation of accounts like Profit & Loss Account, Balance Sheet etc. are governed by the provisions in the Companies Act.

4 BANKING COMPANIES: Banking Companies are similar to Joint Stock Companies. But the maintenance of Books of Accounts and preparation of Balance Sheet etc. are governed by Banking Regulation Act.

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5 INSURANCE COMPANIES: In case of Insurance Companies, the main source of revenue is the premium collected by the Insurance Company. But the entire premium collected cannot be treated as income because there is a contingency of claim. There are provisions in the Insurance Act regarding how much portion of the premium can be taken to revenue and how much must be kept in reserve.

1.7 SUMMARY Accounting covers recording of all financial transactions to prepare meaningful summary statements in the form of trial balance, profit and loss statement, balance sheet and cash flow statements. These are very useful to shareholders, investment advisors / analysts, creditors / suppliers, employees, Government, researchers and student community. It is based on principles of use of historical costs, recording on a going concern basis, consistency, conservatism in accounting unrealized losses but ignoring unrealized profits and treating owner as a different entity than the business. The important principles are included in universal guidelines known as Generally Accepted Accounting Principles (GAAP). The primary agency responsible for GAAP in India is the Institute of Chartered Accountants of India. These are enforced by Company Law Board and SEBI. For collecting and presenting financial data, a summary device called an ‘account’ is used. To establish credibility in financial statements companies arrange to have them verified by independent qualified experts called Auditors.

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1.8 SELF ASSESSMENT QUESTIONS 1. What are the primary goals of for-profit enterprises? 2. What are the five basic concepts and principles governing accounting explained in this Chapter? Give a brief explanation of each. 3. What is an Account? Explain the different types of accounts. 4. What are the different important forms of organisational structure? 5. Which agencies lay down the rules relating to GAAP and enforce them in India and in the US?

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video1 Video2 Video3

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2 Accounting Mechanics: Processing Accounting Information Objectives: After completing this chapter, you will be able to understand: • Three Golden Rules • Accounting Cycle • Trial Balance • Financial Statements

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Accounting Mechanics: Processing Accounting Information

Structure : 2.1 Introduction 2.2 Personal Accounts 2.3 Impersonal Accounts 2.4 Three Golden Rules 2.5 Manual Accounting 2.6 The Accounting Process 2.7 Deferral Adjustments 2.8 Depreciation Adjustments 2.9 Accrual Adjustments 2.10 Internet Resources and Exercises 2.11 Summary 2.12 Self Assessment Questions

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2.1 INTRODUCTION In actual practice, accountants (and computers) use a summary device called an account to record transactions in the company’s books and records. An account can be defined as a label used by accountants to record changes in assets, liabilities, and Shareholders’ (Owners’) equity. A listing of common types of accounts and account types appears in Annexure 1. Before we proceed much further, we should briefly differentiate between cash basis accounting and accrual basis accounting. In cash accounting, revenue is recorded (“recognised”) only when cash is received; and expenses are recorded only when cash is paid. In accrual accounting, revenue is recorded when it is earned and expenses are recorded when they are incurred. This system of accrual accounting, while recognizing the income and expenses, ignores whether the money is received or paid for the transaction. It also includes recognition of transactions relating to assets and liabilities as they occur irrespective of the actual receipts or payments in respect of these. Throughout this course we will use accrual accounting as it usually does a much better job in evaluating business performance, and is the only method approved by the GAAP. Indeed, following accrual accounting is a Fundamental Accounting Assumption – which means that GAAP requires any business, which does not follow accrual accounting to state in what respect and why it has not followed accrual accounting, and what would the impact on its results be if accrual accounting had been followed. It’s possible to analyze transactions (business events) in terms of their effect on the accounting equation. In actual practice, accountants do not enter transactions using the accounting equation, as it is impractical when thousands of transactions must be analyzed and recorded. In actual practice, accountants use a double entry system in which each transaction affects at least two accounts. In displaying and explaining transactions, accountants often use a T Account, which takes its

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Accounting Mechanics: Processing Accounting Information

name from the letter T. The T Account has a heading, a left side, and a right side. The left side is known as the debit side and the right side is known as the credit side. There is no reason why it should not be the other way around, except that debit on the left and credit on the right has become a very common practice. Usually computerised ledgers follow a “vertical” format where there are two columns, one for debits and the other for credits, and the tallying of the totals of each column proves the basic accounting accuracy of each account. The balance in an account is the difference between the totals of debit and credit columns. Account may be classified from another perspective. Thus accounts are classified as: • Personal Accounts • Real Accounts • Nominal Accounts 2.2 PERSONAL ACCOUNTS Personal accounts are related to persons, debtors or creditors etc. A Company has a number of Customers (Debtors) and Suppliers (Creditors). Each one of these is a Personal Account. 2.3 IMPERSONAL ACCOUNTS Accounts which are not personal accounts such as Plant and Machinery account, the Bank or cash accounts, Interest account etc. are Impersonal Accounts. These impersonal Accounts are further sub-divided as under: (a) Real Accounts: Accounts, which relate to assets of the firm but not its debt. Instances of real account are: • Land • Building • Investment • Fixed deposits • Cash balance

26

Accounting Mechanics: Processing Accounting Information

• Bank balance (b) Nominal Accounts: These relate to expenses, losses, gains, revenue, etc. Instances of these are: • Salary account • Interest paid account • Commission received account The net result of all the nominal accounts is reflected as profit or loss for the accounting year and is transferred to the capital Account or to appropriation account. Thus at the end of the year, the Nominal accounts have nil balance. As we stated above, the accountant uses a double entry system in analyzing and processing transactions. Each transaction requires at least one debit and one credit entry. In making these entries, the accountant uses the rules of debit and credit (which are abbreviated to Dr. and Cr. respectively). These rules can be summarized as follows: Account Category ! !

!

Increase !

Decrease ! Normal !Balance

Assets ! !

!

!

!

!

Debit (Dr.) ! Credit (Cr.) ! Debit (Dr.)

Liabilities !

!

!

!

!

Credit (Cr.) ! Debit (Dr.) ! Credit (Cr.)

!

!

Credit (Cr.) ! Debit (Dr.) ! Credit (Cr.)

Retained Earnings ! !

!

Credit (Cr.) ! Debit (Dr.) ! Credit (Cr.)

Shareholders’ Equity Share Capital ! !

(Reserves) Dividends ! !

!

!

!

Debit (Dr.) ! Credit (Cr.) ! Debit (Dr.)

Revenue (Sales) !

!

!

Credit (Cr.) ! Debit (Dr.) ! Credit (Cr.)

Expenses ! !

!

!

Debit (Dr.) ! Credit (Cr.) ! Debit (Dr.)

!

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Accounting Mechanics: Processing Accounting Information

2.4 THREE GOLDEN RULES All business transactions fall into one of the above account categories. It is important that we have the rules of debit and credit committed to memory, as we will use them time and again as we proceed through the course. These are called the Three Golden Rules of double entry accounting. These three Golden Rules are briefly encapsulated in the following table:

Rule

No 1 (For “Real” Accounts)

No 2 (For “Personal” Accounts)

No 3 (For “Nominal” Accounts)

Debit

What Comes In

The Receiver

Expenses and Assets

The Giver

Incomes and Liabilities

Credit What Goes Out

As we begin to record transactions, it may be helpful to use a three-step approach. The three steps can be summarized as follows: 1. Analyze the transaction to determine its effect on asset, liability, or shareholder equity accounts. This means analyzing the impact of the transaction on the basic Balance Sheet Equation, viz. Assets = Liabilities + Shareholders’ Equity. 2. In this, determine whether the accounts affected by the given transaction are ‘Real’ account, ‘Personal’ account or ‘Nominal’ account. 3. Depending upon the nature of the account, apply the “golden rules” of debit and credit. 4. Record the entry using double entry bookkeeping. 2.5 MANUAL ACCOUNTING In a manual accounting system (i.e. one where the transactions are not recorded in any accounting software), entries are first recorded (journalized) in the book of

28

Accounting Mechanics: Processing Accounting Information

original entry called the Journal, in a chronological order. The Journal is therefore called as the Book of Prime Entry. Later, they are transferred (posted) to the General Ledger where details of each account are maintained. However, in a computerised environment, these two stages get rolled into one. There could be different journals maintained for administrative convenience, depending on the type of transactions. For example, there could be journals to record only Cash receipts, or Cash disbursements, Sales, Purchases, or another omnibus journal called General Journal help because they are invaluable in: • Disclosing in one place the complete effect of a transaction • Providing a chronological record of transactions • Helping prevent or locate errors because debit and credit amounts can be easily compared A few simple examples of transactions recorded in accordance with the above steps are given below: 1. You buy a machine for Rs.15,000, paying cash. • Asset account called “Machine” increases by Rs.15,000 • Asset account called “Cash” decreases by Rs.15,000 • We “debit” Machine A/c (Golden Rule 1: Debit what comes in) Rule

No 1 (For “Real” Accounts)

Debit

What Comes In

Credit

What Goes Out

• And “Credit” Cash A/c (Golden Rule 1: Credit what goes out) 2. You buy inventory on account (i.e., on credit) worth Rs.5,000 • Asset called “Inventory” increases by Rs.5,000; and • Liability called “Accounts Payable” also increases by Rs.5,000 29

Accounting Mechanics: Processing Accounting Information

• We “debit” Inventory A/c (Golden Rule 1: Debit what comes in) • And “Credit” Accounts Payable A/c (Golden Rule 2: Credit the giver) 3. You introduce capital into the business (or a company issues new shares at par) for Rs.200,000 • Asset account called “Cash” increases by Rs.15,000 • Liability called “Shareholders’ Equity” or “Capital” also increases by Rs.200,000 • We “debit” Cash A/c (Golden Rule 1: Debit what comes in) • And “Credit” Capital A/c (Golden Rule 2: Credit Income and Liabilities) 4. You withdraw from bank Rs. 10,000 for office use; • Asset account called “Cash” increases by Rs.10,000 • Asset account called “Bank” decreases by Rs.10,000 • We “debit” Cash A/c (Golden Rule 1: Debit what comes in) • And “credit” Bank A/c (Golden Rule 1: Credit what goes out) 5. You bought from Rohan goods worth (at MRP) Rs. 10,000 at 20% Trade Discount on credit; • Expense account called “Purchases” increases by Rs.8,000 • Asset account called “Rohan” increases by Rs.8,000 • We “debit” Purchases A/c (Golden Rule 1: Debit Expenses and Assets) • And “credit” Rohan A/c (Golden Rule 2: Credit the giver) 6. You received confirmation that a large company has selected you for a major consulting assignment. The work will start on January 1 of next year.

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Accounting Mechanics: Processing Accounting Information

• No transaction, as there is no monetary impact. Hence, nothing needs to be recorded.

31

Accounting Mechanics: Processing Accounting Information

Record the following transactions in the books of Shri Ganesh: Example: Accou nts affecte d

Type of accounts

Debit

Shri Ganesh started Cash & business Capital with capital of Rs. 50.000

Real Account Personal Account

Debit what Cash comes in (Rule 1) Capita Credit the giver l (Rule 2)

Transaction

Reason for Debit of Credit

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Accounting Mechanics: Processing Accounting Information

Solve the following transactions:

Transaction

Account Type of s accoun affected ts

Debit

Reason for debit of credit

Opened bank account and deposited Rs. 30,000 Withdrew cash from bank Rs. 10,000 office use Rohan supplied goods to Ganesh for Rs. 20,000 Sold goods to Vijay Rs. 30,000 Sold goods for cash Rs. 5,000 Purchased machinery from HMT Ltd. For Rs. 50,000 Paid salary to staff Rs. 10,000 by cheque Paid office expenses in cash Rs. 3,000

33

Accounting Mechanics: Processing Accounting Information

Trade discount is the normal reduction from the Maximum Retail Price or Market Price given to a trader. Note that the market price is not relevant, and is hence ignored. Cash Discount on the other hand, is an extra discount given as a reward for early cash settlement of the account, and hence is recorded in the books and reflected as a cost.

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Accounting Mechanics: Processing Accounting Information

The chart of accounts, unique to each company, is a comprehensive listing of accounts by number and title of account. The normal order of grouping is as follows: !

!

Account Number!

!

!

!

Account Category

!

!

!

1! !

!

!

!

!

!

Assets

!

!

!

2! !

!

!

!

!

!

Liabilities

!

!

!

3! !

!

!

!

!

!

Shareholders’ Equity

!

!

!

4! !

!

!

!

!

!

Revenues

!

!

!

5! !

!

!

!

!

!

Expenses

A sample Chart of Accounts appears in Annexure 1. The Chart of Accounts helps in properly classifying all transactions with sufficient granularity (i.e. detail) to meet almost all management information needs. Usually, a well-designed Chart of Accounts serves to integrate the Cost and Management Accounting records with the Financial Accounting records. 2.6 THE ACCOUNTING PROCESS The accounting process is a series of activities that begins with a transaction and ends with the closing of the books of account for an accounting/reporting period. Since this process is repeated in each accounting/reporting period, it is usually described as the accounting cycle and includes the following major steps: 1. Identify the transaction or other recognizable, recordable event having monetary impact. 2. Prepare the transaction’s Source Document, commonly called a voucher1 , such as a purchase order or invoice. A document is the means by which an accounting system takes cognisance of a transaction. 3. Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (rupees and paise), identifying the accounts that are affected and whether those accounts are to be debited or credited, and by how much.

35

Accounting Mechanics: Processing Accounting Information

4. Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order. (Remember that journals, ledgers and posting are of only academic significance in a computerised accounting software environment – where the journals and ledgers are the byproduct of the process of recording the entries). 5. Post general journal entries to the ledger accounts. This is the manual equivalent of indexing the journal entries in order of account name and then date, rather than in order of date (i.e., chronological order). In a computerised environment, the computer does this work at great speed and with perfect accuracy, and simultaneously with the authorisation of the transaction. In a manual system, it is an exact duplication of the work of making entries in the journal. It requires no fresh decision-making. However, this duplication serves an important purpose: it enables one to view the activity and balance in any single account at a glance. In manual systems, the journal and the ledger are completely cross-referenced: every journal page is numbered, and the page number on which it appears is written against the entry in the ledger, in a column titled JF (for Journal Folio, where Folio means page number). Similarly, the page number on which a particular account appears in the Ledger is entered against each Debit and Credit entry in the Journal, in a special column titled LF (for Ledger Folio). The cross-referencing is an invaluable tool in error diagnosis and rectification in manual accounting systems.

All the above steps are performed throughout the accounting period as transactions occur, or in batches processes. The steps that follow are performed at the end of the accounting period. These steps are required in both, a computerised and manual system of accounting. However, in a computerised accounting system, generally debits will equal credits at all times; hence some of the types of errors listed may not be encountered. Further, in computerised accounting environments, preparing financial statements are simply a question of generating updated reports.

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Accounting Mechanics: Processing Accounting Information

Format of Ledger Account and how it is posted: Eg. 1. Purchased machinery Rs. 50,000 and paid by cheque on May 30, 2009
 The journal entry will be: Date

Particulars

L/F

30/5/09

Machinery Account To Bank

Dr.

Debit (Rs.) Credit (Rs.) 50,000

50,000

The above journal entry will be posted in the Ledger as under : Machinery Account Date

Debit

Rs.

30/5/09

To Bank

50,000

Date

Credit

Rs.

1

A voucher is the original record of a transaction. During an audit, source documents are used as evidence that a particular business transaction occurred. Examples of vouchers include:

• Cash receipts • Credit card receipts • Cash register tapes • Cancelled checks • Customer invoices • Supplier invoices • Purchase orders • Time cards • Deposit slips • Notes for loans • Payment stubs for interest

37

Accounting Mechanics: Processing Accounting Information

38

Accounting Mechanics: Processing Accounting Information

Bank Account Date

Debit

Rs.

Date

Credit

Rs.

30/5/09

By Machinery

50,000

6. Prepare the trial balance to make sure that debits equal credits. The trial balance is a simple listing of all of the ledger accounts, with debits in the left column and credits in the right column. The Trial Balance is simply a list of all the accounts and their balances at a given time. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording an aspect of a transaction or recording it in the wrong account would not cause an imbalance. 7. Correct any discrepancies or errors in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. If the columns are balanced, look for unusual balances – which may point to erroneous classification of transactions, or posting to the inappropriate accounts. Posting errors include: • posting the wrong amount, • omitting a posting, • posting to the wrong accounts, • posting in the wrong column, or • posting more than once.

Each voucher must include at least the following: date, amount, and description of the transaction. When practical, source documents should contain name and address of the other party of the transaction.

39

Accounting Mechanics: Processing Accounting Information

When a voucher does not exist, for example, when a cash receipt is not provided by a vendor or is misplaced, an internal voucher should be generated as soon as possible after the transaction, using other documents such as bank statements to support the information on the generated source document. Once a transaction has been journalised, the voucher is usually filed in such a way that it is easily retrievable to verify the transaction, should the need arise at a later date.

8. Prepare adjusting entries to record accrued, deferred, and estimated amounts. In effect, these adjusting entries account for prepayments, deferrals, depreciation and provisions. The Unadjusted Trial Balance needs to be changed (adjusted). Adjusting entries are divided into three broad categories: Deferral: An adjustment for which the business paid or received cash in advance. Depreciation: An allocation of the cost of a plant asset to expense over the asset’s useful life. Accrual: An expense or a revenue occurring before the business pays or receives cash. This signifies that at the end of each accounting year, the accounts which are maintained need to be finalized and in doing so, various relevant information need to be factored in. 2.7 DEFERRAL ADJUSTMENTS A prepaid expense is an expense paid in advance and is therefore an example of a deferral. Prepaid expenses are assets, which typically expire or get used up in the near future. These need to be removed from the expense account and reflected as pre-paid expense account in the balance sheet at the appropriate place. Examples of prepaid assets are Supplies, Prepaid Rent, Prepaid Insurance, etc. The adjusting entry takes the following form:

40

Accounting Mechanics: Processing Accounting Information

!

!

!

41

Accounting Mechanics: Processing Accounting Information

!

!

!

!

Prepaid Expense (Asset)

!

!

!

!

!

!

To Expense

The word To is not necessary, but has very often been used by accountants to designate the account to which an entry is credited. Another type of deferral, Unearned Revenues, will be discussed in a following section. Deferrals: It goes for deferrals over a time period. When a Company has paid for certain rights which need to be expensed out but, in all fairness, these right can be availed over more than one year like, say, right to avail the use patent over the current year and next three years. The amount spent in this respect has to be expensed over four years. The write off has to be deferred over four years.

2.8 DEPRECIATION ADJUSTMENTS Plant assets such as buildings, equipment, etc. have multi-period lives and in compliance with the matching principle their cost must be spread over their useful lives. This allocation to expense is called Depreciation Expense. For example, the ceiling projector in a classroom may cost Rs.5,000. Let’s assume that it has a life of 5 years and at the end of five years it has no salvage value due to obsolescence. Annual depreciation expense would be Rs.5,000/5 or Rs.1,000 per year. The adjusting entry takes the following form: !

!

!

!

Depreciation Expense

!

!

!

!

!

!

To Accumulated Depreciation


Note that the credit is to Accumulated Depreciation not to the asset. The Accumulated Depreciation account accumulates all depreciation charged off to date and its normal balance is a credit. Accumulated Depreciation is a contra asset account meaning it has a matching pair, Equipment for example, and it has the opposite balance of its matching pair.

42

Accounting Mechanics: Processing Accounting Information

Note that book or carrying value is defined as cost less accumulated depreciation. Balance sheets reflect the book value of plant assets.

2.9 ACCRUAL ADJUSTMENTS Accrued expenses are expenses that a business has incurred, but not yet paid. Examples are Salary Expense at the end of the period, Interest Expense at the end of the period, etc. The adjusting entry takes the following form: !

!

!

!

!

Expense

!

!

!

!

!

!

!

To Payable


Accrued revenue is revenue earned, but not yet recorded in the books and records. The adjusting entry takes the following form: !

!

!

!

!

Accounts Receivable

!

!

!

!

!

!

!

To Revenue


Unearned revenue arises when a business receives cash before earning the revenue. For accounting purposes, it is categorized as a liability since the firm is liable for future performance and cash has been paid in advance. The adjusting entry takes the following form: !

!

!

!

!

Revenue

!

!

!

!

!

!

!

To Unearned Revenue


Provisions: Provisions are made by way of adjustment to trial balance. Provision is an amount written off or retained by way of providing for any known liability the amount of which cannot be determined with substantial accuracy. The adjusting entry takes the following form: !

!

!

!

!

Contribution to Gratuity Fund

!

!

!

!

!

!

!

To Provision for Contribution to Gratuity Fund


Note that every adjusting entry involves both an income statement account and a balance sheet account.

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Accounting Mechanics: Processing Accounting Information

9. Post adjusting entries to the ledger accounts. 10. Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found. After the adjusting entries have been journalized and posted, an adjusted trial balance is prepared by listing the ending balances of all the accounts. Some of the balances in the Adjusted Trial Balance may change from their balances in the Unadjusted Trial Balance and some may remain the same, i.e. Cash. In fact, Cash is never adjusted. From the adjusted trial balance, it is a simple matter to prepare correct financial statements. At the end of the period, the accountant must close certain accounts so that their balances are zero as the company begins a new accounting period. There are two broad types of accounts as follows: !

Temporary (nominal) Revenues, Expenses, and Dividends

! ! ! !

Permanent (real) Assets, Liabilities, and certain Shareholder Equity Accounts. These include what are often called as personal accounts, which are ! ! accounts, which stand in personal names of people and entities transacting ! with the organisation, like debtors, creditors, employees and directors.

! ! ! ! ! ! !

All temporary accounts must be closed out at year-end and set back to a zero balance for the start of the new period. Permanent accounts (balance sheet ! accounts) are not closed out. In other words, if the company has a balance of Rs.50,000 in the Cash Account at midnight on December 31, it has the same balance on January 1 and this account should not be closed out. However, ! temporary accounts must be closed out so that the accountant can begin ! accumulating revenues and expenses for the new period.

The closing entries transfer the revenue, expense, and dividends balances to Retained Earnings (or Reserves and Surplus or Profit and Loss Account). The three steps involved are as follows: 1. Debit each revenue account for the amount of its credit balance. Credit Retained Earnings for the sum of the revenues.

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Accounting Mechanics: Processing Accounting Information

2. Credit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of the expenses. 3. Credit the Dividends account for the amount of its debit balance. Debit Retained Earnings. After posting the closing entries the revenue, expense, and dividend accounts are set back to zero, so that the accounting period can begin anew. Now only permanent accounts have balances. 11. Prepare the financial statements. • Income statement: prepared from the revenue, expenses, gains, and losses. • Balance sheet: prepared from the assets, liabilities, and equity accounts. • Statement of retained earnings: prepared from net income and dividend information. • Cash flow statement: derived from the other financial statements using either the direct or indirect method (we shall learn about these methods in detail later). 12. Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital account (in companies, it is closed to the Reserves or Profit & Loss Account). 13 Post closing entries to the ledger accounts. 14. Prepare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors. 15. Prepare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction 45

Accounting Mechanics: Processing Accounting Information

occurs in the next period. A reversing journal entry is recorded on the first day of the new period.

Chapter 2 is an extremely important chapter. Much of what we will do later in the course will depend on how well we understand the basic concepts introduced in Chapter 2.

2.10 INTERNET RESOURCES AND EXERCISES1 1. IBM’s Guide to Financials: http://www.ibm.com/investor/financialguide/ This site provides an introduction on how to read and interpret the financial statements in a company’s annual report. Of course, it deals with US reporting requirements, but the general principles are very lucidly laid out and are worth a read. 2. SEBI’s Electronic Data Information Filing And Retrieval System (EDIFAR): https://sebiedifar.nic.in/ Some Quick Questions to Test Understanding of Rules of Debits and Credits 1. What is the normal balance in the cash account? Debit or Credit? 2. What type of account is cash? Asset, Liability or Owner’s Equity? 3. What is the normal balance in the capital or owner’s equity account? Debit or Credit? 4. What type of entry is required to increase the balance in the accounts receivable account? Debit or Credit? 5. What is the normal balance in the owner’s withdrawal account? Debit or Credit? 6. When cash is received on account (i.e., to be adjusted partly against past sales) which account is credited? Revenues or Accounts Receivable?

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Accounting Mechanics: Processing Accounting Information

7. If office supplies are purchased on account (i.e., on credit) which of the following accounts is credited? Cash or Accounts Payable? 8. The normal balance in notes payable is Debit or Credit? 9. What is the normal balance in an expense account? Debit or Credit? 10. What is the normal balance in prepaid expenses? Debit or Credit? 11. When a company makes a sale on account what account is debited? Revenues, Accounts Receivable or Cash? 12. What is the normal balance in the office equipment account? Debit or Credit?

1

Please Note: Most websites that we point you to are constantly being updated. Please check to see that the information requested in this exercise is available.

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Accounting Mechanics: Processing Accounting Information

Answers 1. Cash is an asset and assets have a normal balance of debit. 2. All asset accounts have a normal balance of debit. That means that cash must have a debit balance. A liability is something that you owe such as an invoice you received from a vendor. If you answered Liability, you need to spend more time working on definitions of assets, liabilities and owner's equity as well as the rules of Debits and Credits. 3. Credit is correct. If a business makes money, capital increases. Net income is defined as revenues less expenses. Revenues are credit accounts and expenses are debit accounts. Therefore, the normal balance in the capital account would be a credit. The normal balance in the capital account is not a debit. Think about it this way. The goal of a business is to end up with a profit. That means revenues greater than expenses. If revenues are greater than expenses and the normal balance in a revenue account is credit, the hoped-for balance in the capital account must also be a credit. 4. Debit. Since accounts receivable is an asset, a debit is required to increase the balance. 5. Debit is correct. Owner withdrawals reduce the balance in the capital account. Since the capital account has a normal balance of credit, withdrawals must have a normal balance of debit. 6. If you answered Revenue, you just committed one of the most common mistakes that fresh accounting students make. Revenues are recognized on the date of sale and not on the date the cash is received. If you credit revenues on the date cash is received, the revenue is entered twice. The correct answer is that Accounts Receivable is credited or reduced when the cash is received.

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Accounting Mechanics: Processing Accounting Information

7. When a purchase is made on account, the liability, accounts payable will increase. Cash is not affected until you actually pay the bill at a later date. Hence the correct answer is Accounts Payable. 8. Remember that anything with the word payable in the account title is a liability. The normal balance in liability accounts is credit. 9. Debit is correct, because revenues are credits while expenses are debits. 10. Prepaid Expense is an asset. The normal balance in an asset account is debit. Hence the correct answer is Debit. 11. If you answered Revenue, remember that revenues are not debited when a sale is made on account. Revenues are credited. Cash has not been received, hence Cash Account also does not enter the picture. The correct answer is Accounts Receivable. 12. Office Equipment is an asset account. The normal balance must be a debit. If you answered credit, you still need a bit more practice.

Open Ledger Accounts and post the below mentioned transactions: Transaction Opened bank account and deposited Rs. 30,000 Withdrew cash from bank Rs. 10,000 office use Rohan supplied goods to Ganesh for Rs. 20,000 Sold goods to Vijay Rs. 30,000 Sold goods fro cash Rs. 5,000 Purchased machinery from HMT Ltd. For Rs. 50,000 Paid office expenses in cash Rs. 3,000 Deposited cash in bank Rs. 10,000 Shri Ganesh withdrew for personal use from Bank Rs. 2,000

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Accounting Mechanics: Processing Accounting Information

Solved Example 1 Journalise the following transactions in the books of Abhay and Company, sole proprietary concern of Mr. Abhay. 1. Purchased a running business for Rs. 3,00,000/- with the following Assets and Liabilities: !

!

!

!

Rs.! !

!

!

!

!

!

Stock of goods ! !

!

12,000.00 Rohan (Cr.) ! !

!

5,000.00

Plant and Machinery !

2,00,000.00 Loan taken ! !

!

12,000.00

Bank balance ! !

!

75,000.00

Furniture !

!

30,000.00

!

!

!

!

!

Rs.

!

2. Withdrew cash from bank Rs. 10,000 for office use; 3. Rohan supplied goods to Abhay market price Rs. 10,000 at 20% Trade Discount; 4. Paid life insurance premium for Abhay Rs. 4,000/- and insurance for machinery Rs.2, 000 both by cheque. 5. Goods Purchased form Rohan sold to Mohan at market price and paid freight on his behalf Rs. 200 cash; 6. Issued a cheque of Rs. 6,000 to Rohan and earned a discount of Rs. 500; 7. Purchased goods from Mr. Memon Rs. 24,000, 1/3 against a cheque, 1/3 for cash and balance on credit; 8. Invoiced goods to Ms. Meena Rs. 12,000; 9. Cash Sales to Mr. Sanjeev Rs. 20,000 at 2% Cash Discount; 10.Mohan settled his account at a discount of Rs. 150;

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Accounting Mechanics: Processing Accounting Information

11.Expenses for the year paid in cash : Conveyance Rs. 700, Stationery Rs. 450, Salary Rs. 3,000, Wages Rs. 800. Interest of Rs. 500 was paid by cheque. Solution Journal Entries in The Books of Abhay and Co. Dat e

Particulars

L/F

Debit Rs.

Purchase Account Plant & Machinery Account Bank Account Furniture Account ! To Rohan Account ! To Loan (Taken) Account ! To Capital Account (Being running business taken over)

Dr. Dr. Dr. Dr.

12,000 2,00,000 75,000 30,000

Cash Account ! To Bank Account (Being Cash withdrawn for office use)

Dr.

10,000

Purchase Account ! To Rohan Account (Being goods purchased at 20% Trade Discount)

Dr.

Drawings Account Insurance Premium Account ! To Bank Account (Being Personal life insurance premium and for machinery paid)

Dr. Dr.

Credit Rs.

5,000 12,000 3,00,000

10,000

8,000 8,000

4,000 2,000 6,000

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Accounting Mechanics: Processing Accounting Information

Dat e

Particulars

L/F Debit Rs.

Rohan Account ! To Bank Account ! To Discount received Account (Being cheque issued and discount received)

Dr.

Purchase Account ! To Bank Account ! To Cash Account ! To Memon’s Account (Being goods purchased)

Dr.

Meena's Account ! To Sales Account (Being goods invoiced)

Dr.

Cash Account Discount allowed Account ! To Sales Account

Dr.

Wages Account ! To Cash Account (Being above expenses paid)

Dr.

Interest Account ! To Bank Account (Being interest paid)

Dr.

Credit Rs.

6,500 6,000 500

24,000 8,000 8,000 8,000 12,000 12,000 19,600 400 20,000 800 4,950 500 500

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Accounting Mechanics: Processing Accounting Information

Trial Balance of Abhay and Company as on …………. Dat e

Particulars Cash A/c Capital A/c Purchase A/c Plant & Machinery A/c Bank A/c Furniture A/c Rohan’s A/c Loan (Taken) A/c Drawing A/c Insurance Premium A/c Memon’s A/c Meena’s A/c Discount Allowed A/c Discount received A/c Conveyance A/c Stationery A/c Salary A/c Wages A/c Interest A/c Interest (paid) A/c Sales A/c

L/F Debit Rs.

Credit Rs.

26,500 - 3,00,00 44,000 0 2,00,000 44,500 30,000 6,500 4,000 12,000 2,000 12,000 8,000 550 700 500 450 3,000 800 500 42,000 3,69,000

4E+05

53

Accounting Mechanics: Processing Accounting Information

2.11 SUMMARY Financial accounting is based on an accrual basis and not on cash basis, hence expenses are accounted as they are incurred ( not paid ) and income when it is earned ( and not received ). The accounts maintained in Accounts are personal or impersonal. The latter class of impersonal accounts is further classified into real and nominal. Whole accounting is based on three golden rules; for real accounts what comes in is debited and what goes out is credited. Incase of personal accounts, receiver is debited and the giver credited. For nominal accounts, expenses and assets are debited and income and liabilities credited. All accounting entries are first recorded in a journal. All entries in the journal are then posted or transferred to the general ledger. The number of accounts that a company wishes to maintain are described in what is known as ‘chart of accounts’. The accounting process starts with identification of the transaction, record it in a document called ‘voucher’, and then analyze and classify the transaction. This step involves putting rupee value to it, identifying which accounts are affected from the chart of accounts and which of them are to be debited and credited and by how much. The next step is recording the voucher in appropriate journal. Normally sales, purchase, disbursement or general journals are maintained. Entries in these journals are then posted into respective individual accounts maintained in the ledger. All these steps make an accounting cycle as they are to be repeated for each transaction. All balances of ledger are tabulated in trial balance at the end of period for which accounts are to be prepared. This trial balance needs to be adjusted for deferral – an adjustment for which the firm paid or received cash in advance, depreciation an allocation of cost for use of an asset like machinery, accrual – an expense or income occurring before cash is paid or received by the firm. After adjusted trial balance is ready, financial statements are prepared.

54

Accounting Mechanics: Processing Accounting Information

2.12 SELF ASSESSMENT QUESTIONS Self study Exercise 1: Retail Paradise operates a retail chain store. The Trial Balance as on January 1 200X I.e. the beginning of the month is as under: Account Head

Cash

Dr.

5,000

Sundry Debtors

40,000

Inventory of Merchandise

85,000

Prepaid Expenses Delivery Van

Cr.

2,000 1,15,000

Sundry Creditors

45,000

Owners' Capital

1E+05

Retained Income

72,000

2,47,000

2E+05

The abridged version of the transactions for January 200X is as under: 1. Purchase of merchandise inventory on credit: Rs. 49,000. 2. Cash Sales: Rs.45,500. 3. Recovery effected from Sundry Debtors: Rs.37500. 4. Credit Sales: Rs.51,000. 5. Salaries paid in cash: Rs.14,000. 6. Cost of goods sold: Rs.50,000.

55

Accounting Mechanics: Processing Accounting Information

7. Payments to Sundry Creditors: Rs.42,000. 8. Expenses for Printing and Stationery paid in cash: Rs.9,000. 9. Cost of Hoarding Display - cash paid: Rs.5,000. 10. Entry for rent expense (Rent was paid quarterly in advance, Rs.6,000 per quarter. Payments were due on February 1, May 1, August 1, and November 1.) 11. Depreciation of Delivery Van: Rs.15,000.

56

Accounting Mechanics: Processing Accounting Information

You are required to: a. Enter the January 1 balances in a general ledger as opening balance. b. Prepare journal entries for each transaction. c. Post the journal entries to the ledger. Key your postings. d. Prepare a trial balance, March 31, 200X Transaction Shri Ganesh started business with Rs.50,000 Opened a Bank A/c & Deposited Rs.25,000 Purchased Goods for Cash Rs.10,000 Purchased goos from L & T Rs.50,000 Sold Goods for Cash Rs.15,000 Sold Goods to ONGC Rs.40,000 Sold Goods to ONGC Rs.3,000 & paid cash Purchased Machinery from HMT Rs.40,000 Deposited Rs.10,000 in Bank Received half the amount due from, ONGC by Cheque and deposited in bank Paid Rs.10,000 to L&T by Cheque Paid Salary to Shoba by Chq. Rs.20,000 Paid office expenses in cash Rs.1,000 Withdrew from Bank Rs.2000 for office use and Rs.1,000 for personal use

57

Accounting Mechanics: Processing Accounting Information

Journal entries in the books of Shri. Ganesh Date

Particulars

L/F

Debit

Cash a/c Dr. To Shri Ganesh Capital a/c (Being business started with Capital of Rs. 50,000)

50,000

Bank a/c Dr. To Cash a/c (Being an account opened and cash deposited)

25,000

Purchases account Dr. To Cash a/c (Being Goods Purchased for cash)

10,000

Purchases account Dr. To L & T (Being Goods Purchased from L&T)

50,000

Purchases account Dr. To Cash a/c (Being goods purchased from L&T for cash)

Credit

50,000

25,000

10,000

50,000

5,000 5,000

Cash a/c Dr. To Sales (Being goods sold for Cash)

15,000

Cash a/c Dr. To Sales (Being goods sold for Cash)

5,000

ONGC a/c Dr. To Sales (Being goods sold to ONGC)

40,000

15,000

5,000

40,000

58

Accounting Mechanics: Processing Accounting Information

Date

Particulars

L/F

Debit

Bank a/c Dr. To Cash a/c (Being Cash Deposited in Bank)

10,000

Bank a/c Dr. To ONGC (Being half the amount due from ONGC recd)

20,000

L & T account Dr. To Cash a/c (Being part of the amount due to L&T paid)

10,000

Salary account Dr. To Bank (Being salary paid to Shoba by Chq.)

20,000

Office Expenses account Dr. To Cash a/c (Being office Expenses paid by Cash)

1,000

Credit

10,000

20,000

10,000

20,000

1,000

Ledger accounts in the books of Shri Ganesh Dr.! ! Dat e

!

!

Particulars To Bal c/d

!

! J/F

!

Shri Ganesh Capital Account ! ! ! ! ! ! !

Amount 50,000 50,000

Dat e

Particulars By Cash

J/F

!

!

!

!

Cr.

Amount 50,000 50,000

59

Accounting Mechanics: Processing Accounting Information

Dr.! !

!

!

!

Dat e

!

!

Particulars

Cash Account ! ! ! !

! J/F

Amount

Dat e

!

!

Particulars

!

!

J/F

Amount

To G.Capital

50,000

By Bank

25,000

To Sales

15,000

By Purch

10,000

To Sales

3,000

By Purch

5,000

To Bank

2,000

By Bank

10,000

By Off. Exp

!

!

Dat e

!

!

Particulars

J/F

Amount

Dat e

!

!

Particulars

!

!

J/F

Amount

25,000

By L&T

10,000

To Cash

10,000

By Salary

20,000

To ONGC

20,000

By Cash

2,000

By Drawings

1,000

Dat e

!

Particulars

!

! J/F

!

!

Amount

To Bank

10,000

To Bal c/d

40,000 50,000

L & T Account ! ! ! ! Dat e

Cr.

!

Cr.

22,000

55,000

!

!

To Cash

By Bal

Dr.! !

!

70,000

Bank Account ! ! ! !

!

Cr.

19,000

70,000

!

!

1,000

By Bal

Dr.! !

!

Particulars By Purchase

55,000

! J/F

!

!

!

!

Amount 50,000

50,000

60

Accounting Mechanics: Processing Accounting Information

Dr.! ! Dat e

!

!

!

Particulars

! J/F

!

!

Purchases Account ! ! ! ! ! Dat e

Amount

To Cash

10,000

To L & T

50,000

Particulars

J/F

By Bal

!

!

!

Dat e

!

!

Particulars

!

!

!

Cr.

!

!

!

!

Cr.

J/F

Amount

!

Cr.

!

Amount

60,000

60,000

Dr.! !

!

60,000

Sales Account ! ! ! !

! J/F

Amount

To Bal

Dat e

58,000

!

!

Particulars By Cash

15,000

By ONGC

40,000

By Cash

3,000

58,000

Dr.! !

!

!

!

Dat e

!

!

Particulars

58,000

ONGC Account ! ! ! !

! J/F

Amount

To Sales

Dat e

40,000

!

!

Particulars

!

!

J/F

Amount

By Bank

20,000

By Bal c/d

20,000

40,000

Dr.! ! Dat e

!

!

!

Particulars

! J/F

To Bal c/d

!

!

HMT Account ! ! ! ! Dat e

Amount 40,000

Particulars

40,000

! J/F

By Machinery

40,000

Dr.! !

!

!

!

!

!

!

!

!

!

!

!

!

Cr.

!

!

!

Cr.

Amount 40,000 40,000

Machinery Account ! ! ! ! !

!

!

61

Accounting Mechanics: Processing Accounting Information

Dat e

Particulars To HMT

J/F

Amount 40,000 40,000

Dat e

Particulars By Bal c/d

J/F

Amount 40,000 40,000

62

Accounting Mechanics: Processing Accounting Information

Dr.! ! Dat e

!

!

!

Particulars

! J/F

To Parmar

!

!

Furniture Account ! ! ! ! ! Dat e

Amount 10,000

Particulars

J/F

By Bal c/d

Dat e

!

!

!

Particulars

! J/F

To Bal c/d

!

!

Parmar Account ! ! ! !

10,000

Particulars

! J/F

By Furniture

Dat e

!

!

!

Particulars

! J/F

To Bank

!

!

Salary Account ! ! ! !

20,000

Particulars

! J/F

By Bal c/d

Dat e

!

!

!

Particulars

! J/F

To Cash

!

!

!

Dat e

!

Office Expenses ! ! ! ! !

1,000

!

Particulars To Bank

!

! J/F

!

!

Amount 1,000 1,000

!

!

!

Cr.

!

!

!

Cr.

!

!

!

Cr.

!

!

!

Cr.

Amount

!

!

Amount

Particulars

J/F

!

!

Amount

By Bal

1,000

1,000

Dr.! !

!

Amount

20,000

Dat e

Amount

Cr.

20,000

20,000

Dr.! !

!

10,000

Dat e

Amount

!

10,000

10,000

Dr.! !

!

10,000

Dat e

Amount

!

10,000

10,000

Dr.! !

!

1,000

Drawings Account ! ! ! ! ! Dat e

Particulars By Bal

J/F

!

!

Amount 1,000 1,000

63

Accounting Mechanics: Processing Accounting Information

Annexure 1

Some Common Types of Accounts A “typical” chart of accounts is shown below. Each account is of a given account type. Common account types are discussed below at the end of this list of accounts. This list is a combination of some typical business and personal accounts. • Assets • Cash on Hand • Savings and/or Current Account • Fixed Deposits/ Certificates of Deposit • Fixed Assets • Office Premises • Furniture • Computers • Vehicles • Tools, Machinery • Investments • Shares • Debentures/ Bonds • Mutual Fund Units • Real Estate • Liabilities • Accounts Payable • Sundry Creditors (Payments due to Suppliers for Purchases on Credit) • Bills of Exchange • MasterCard/ Visa/ American Express/ Diner’s Club Dues • Taxes 64

Accounting Mechanics: Processing Accounting Information

• Income Tax • Service Tax • Loans • Debentures • Unsecured Loans from Friends and Relatives • Equity • Retained Earnings (Accumulated Profits) • Current Year’s Profits • Adjustments • Income • Interest Income • Bank Account Interest • Fixed Deposit Interest • Interest on Debentures/ Bonds • Dividends • On Shares • On Mutual Fund Units • Consulting • ABC Design • LMN Software • Salary • My Job • Commissions • Royalties • Sales • Products • Services • Expenses • Rent and Utilities 65

Accounting Mechanics: Processing Accounting Information

• Rent • Electricity • Gas • Phone • Internet • Cable TV • Office Expenses • Accounting • Legal • Software • Postage • Bank Charges • Credit Card Charges • Printing • Toner, Paper, Paper Clips • Vehicle Expenses • Petrol/ Diesel • Insurance • Repair • Rentals/ Taxi fare • Interest on Car Loan • Taxes • Income Tax • Interest and penalties • Wages and Salaries • Consulting • Wages • Travel • Air fare 66

3 Accrual Accounting and the Balance Sheet

Objectives: After completing this chapter, you will be able to understand: • Cash to Cash Cycle. • Principles in Financial Reporting. • Fixed and Current Assets. • Net Worth. • Contingent Liabilities.

67

Accrual Accounting and the Balance Sheet

Structure: 3.1 Introduction 3.2 Operating Cycle of Business 3.3 Balance Sheet 3.4 Assets 3.5 Investments 3.6 Other Assets 3.7 Liabilities 3.8 Equity 3.9 Summary 3.10 Self Assessment Questions

68

Accrual Accounting and the Balance Sheet

3.1 INTRODUCTION At this point it is a good idea to differentiate between accrual and cash accounting. Accrual Accounting • Record Revenue as earned (regardless of when cash is paid) • Record Expense as incurred (regardless of when expense is paid) Cash Accounting • Record Revenue as cash is received (regardless when the sale is made) • Record Expense when paid (regardless when the cost is incurred) Throughout this course we will be using accrual accounting as it usually does a better job of measuring performance. However, many small companies properly use the cash method of accounting or a hybrid method, accounting for revenue using the cash method and recording expenses using accrual accounting. 3.2 OPERATING CYCLE OF BUSINESS Figure 3.1 below depicts the Operating (business) cycle of a business. This is the cycle in which the business purchases inventory for cash, sells it to customers on account, and eventually collects the cash so that additional inventory can be purchased. The operating cycle, which is also known as the cash-to-cash cycle, is the process of using cash to purchase current assets that are to be sold at a profit and collected as cash. As an example, a company uses funds to purchase raw material inventory that is produced into finished goods inventory, sold at a profit to create a receivable and collected to become cash once again, then used to pay the supplier, with the profits left in the business.

69

Accrual Accounting and the Balance Sheet

Figure 3.1: Operating Cycle of a Business

Sound financial management of a company involves matching the sources and uses of cash so that obligations become due as assets mature into cash. Take a moment to study the operating/cash cycle diagram. Throughout this lesson we'll refer back to the use of funds and cash in the business operation. After all... remember that the Balance Sheet is just a report card showing where the funds are, and who has helped you acquire them (and these folks expect repayment!). So far in the course we have defined GAAP, and discussed the entity concept, the reliability principle, the cost principle, the going-concern concept, and the stable monetary unit concept. Now we’ll consider additional GAAP concepts including: Time Period concept: Even though the business will continue indefinitely, operating results need to be reported at regular intervals. All business activity is divided into time periods for purpose of reporting. The commonest time period is a year, though companies whose shares are traded on stock exchanges report more often – once every quarter.

70

Accrual Accounting and the Balance Sheet

Revenue Principle: Record revenue when it is earned – usually this is when the business has delivered a good or service to a customer. Matching principle: Match the expense of a period against the revenue earned during that same period. Accrual accounting does a good job of complying with the matching principle but using accrual accounting necessitates making adjusting entries to properly match expenses with revenue. Before we proceed, let us take a brief look at what the Balance Sheet and Profit & Loss Account (also called an Income Statement) of a business looks like. Generally, the first, preliminary step in preparation of Balance Sheet and Profit and Loss Account is drawing up the Trial Balance. As we saw earlier in Chapter 2, the Trial Balance is intended to check the arithmetical accuracy of all entries in the ledger. If all entries are accurate, then the sum total of all debit and credit balances in all accounts put together should be equal. This is technically called an Unadjusted Trial Balance, because entries for “adjustments” necessary to recognise the principle of accrual, like taking account of prepayments and dues as on the balance sheet date happens after this stage.

3.3 BALANCE SHEET The Balance Sheet is a snapshot of the company's financial standing at an instant in time. The balance sheet shows the company's financial position, what it owns (assets) and what it owes (liabilities and net worth). The totals of assets and liabilities of a balance sheet must always balance (i.e. assets = liabilities + net worth). The individual elements of a balance sheet change from day-to-day and reflect the activities of the company. Analyzing how the balance sheet changes over time will reveal important information about the company’s business trends. We'll attempt to learn how, with the Balance Sheet, you can monitor the ability of the business to collect revenues, how well inventory is managed, and even assessment of the business’s ability to satisfy its creditors and shareholders.

71

Accrual Accounting and the Balance Sheet

The liabilities and net worth on the balance sheet represent the company's sources of funds. Liabilities and net worth are composed of creditors and investors who have provided cash or its equivalent to the company in the past. As a source of funds, they enable the company to continue in business or expand operations. If creditors and investors are unhappy and distrustful, the company's chances of survival are limited. Assets, on the other hand, represent the company's use of funds. The company uses cash or other funds provided by the creditor/ investor to acquire assets. Assets include all the things of value that are owned or due to the business. Liabilities represents a company's obligations to creditors, while net worth represents the owner's investment in the company. In reality, both creditors and owners are "investors" in the company with the only difference being the degree of nervousness and the timeframe in which they expect repayment. Presently, we will learn about the elements of the Balance Sheet and how they either use or provide “funds”. For example, when a supplier sends you inventory on credit, he or she in essence is providing "funds" that you may use to operate your business. Recall that you record both an asset (inventory) and a liability (accounts payable) when you purchase goods on credit. Of course, you must be able to pay your supplier in cash in a timely manner. Otherwise, your ability to continue to do business with that creditor, at least, will stand compromised. An example of a company’s Balance Sheet is given below. Note that there are two Balance Sheets as on two different dates. Note also that the figures are in Rs. Millions. This makes it possible to appreciate the figures much more easily.

Some Terms Used in Balance Sheets 3.4 ASSETS As noted previously, anything of value that is owned or due to the business is included under the Asset section of the Balance Sheet. Assets are shown at net book value or net realizable value (more on this later), but appreciated values are not generally considered.

72

Accrual Accounting and the Balance Sheet

Non-Current Assets are defined as those that will not mature into cash within the next 12 months. They can consist of the following asset categories: • Net Fixed Assets • Investment in Subsidiaries and Joint Ventures • Intangibles • Other Assets

Fixed Assets are those assets that are long term investments which enables the business to carry on its operations. Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. They include assets such as: o Land o Building o Machinery and Equipment o Furniture and Fixtures o Leasehold Land o Vehicles etc. Calculating Net Fixed Assets When a fixed asset is purchased for use in operations of the business it is recorded at cost. As the asset wears out, an amount is charged to expense and accumulated annually in a contra-account known as accumulated depreciation. Accumulated depreciation is the cumulative sum of all the years' worth of wearing out that has occurred in the asset. The gross fixed asset (purchase price) less the accumulated depreciation equals the Net Fixed Asset Value (also known as book value). Gross Fixed Assets (Purchase Price) – Accumulated Depreciation = Net Fixed Assets (Book Value)

73

Accrual Accounting and the Balance Sheet

Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash. For most analysis purposes, intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine. Intangibles consist of assets such as: o Research and Development o Patents o Market Research o Goodwill o Organizational Expenses In several respects, intangibles are similar to prepaid expenses; the use of cash to purchase a benefit which will be expensed at a future date. Intangibles are recouped, like fixed assets, through incremental annual charges (amortization) against income. Standard accounting procedures require most intangibles to be expensed as purchased and never capitalized (i.e. put on the balance sheet). An exception to this is purchased patents that may be amortized over the life of the patent. Under each head of fixed asset, the following details is separately given: a. Original cost of the asset. b. Additions thereto during the year. c. Deductions therefrom during the year. d. Total depreciation written off or provided up to the end of the year.

It may so happen that a particular fixed asset was purchased from a foreign country. As a result of a change in the exchange rate after such purchase, there is an increase or reduction in the liability of the company in terms of rupees, for making payment towards cost of the asset. The amount by which the liability has so increased or reduced must be added to or deducted from the cost of the asset. The resultant figure will be treated as the cost of the asset.

74

Accrual Accounting and the Balance Sheet

As a result of business reorganization, it is possible that any sum may be written off like say while undergoing a reduction of capital or revaluation of assets. Every balance sheet subsequent to such reduction or revaluation must show the reduced figures. Similarly, to reflect the current enhanced value of fixed assets, some entities tend to add up certain sums by writing up / revaluing the asset. Each subsequent balance sheet should show the increased figures with the fact of revaluation prominently displayed on the face of the balance sheet. It is necessary to allocate depreciable amount of a depreciable asset in a systematic basis to each accounting year over useful life of the asset. While more about Depreciation is explained in the following chapter, it may be observed at this stage that depreciation written off or provided should be allocated under the different heads of assets and deducted in arriving at the value of the fixed assets. Depreciation in value of fixed assets is a charge against profit for the year. On one hand it is reduced from the income, as well as it is also reduced from the value of the fixed asset. The accounting entry for the same would be as under: !

Depreciation!!

!

!

To! !

Dr.

Fixed Asset

3.5 INVESTMENTS A Company may invest its surplus funds in different ways. The surplus may be temporary or a long term basis. Often the exigencies of business may require the Company to invest funds in a particular venture or investment. The common forms of investment by the Companies are: 1. Investments in Govt. or Trust Securities 2. Investments in shares, debentures or bonds 3. Immovable properties 4. Investments in the capital of partnership firms 5. Balance of unutilised monies raised by Issue etc.

75

Accrual Accounting and the Balance Sheet

When the investment is acquired, the Investment account (real a/c) gets some thing and is debited. The cash or cheque is paid for the acquisition. It is credited. The suitable book entry can be: !

Investment ! Dr.

!

Cash/ Bank

The mode of valuation of investment as reflected in the balance sheet is crucial. It may be at cost or market value of the investment. When it is valued at the market value, the difference between the cost and its present value need to be written off. If the current market value is more than its cost, it is a kind of gain. If the current market value is less than its cost, it is a loss. In both the cases, the gain or loss needs to be transferred to Income Statement as a nonoperative income/loss. The suitable book entry can be: In case of market value being more than its cost: !

Investment account ! !

!

!

!

Dr.

To Gain on Revaluation

In case of market value being less than its cost: !

Loss on Revaluation !!

!

!

Dr.

To Investment account

For better presentation of information, the Investments are also classified into trade investments and other investments. Trade investment would mean an investment by a company in the shares or debentures of another company, not being its subsidiary, for promoting its own trade or business.

76

Accrual Accounting and the Balance Sheet

Current Assets are those, which mature in less than one year. They are the sum of the following categories: • Cash • Accounts Receivable (A/R) • Inventory (Inv) • Notes Receivable (N/R) • Prepaid Expenses • Other Current Assets

Cash is the only game in town. In Hindi, they call it, Sabse bada Rupaiah! (Cash is the biggest of them all!) Cash pays bills and obligations. Inventory, receivables, land, building, machinery and equipment do not pay obligations even though they can be sold for cash, which can then be used to pay bills. If cash is inadequate or improperly managed, the company may become insolvent and be forced into bankruptcy. Include all bank accounts, money market and short-term savings accounts under Cash. Cash management is discussed more in detail in Chapter 4. Receivables are money due from customers. They arise as a result of the process of selling inventory or services on credit, i.e., on terms that allow delivery before collection of cash. Inventory is sold and shipped, an invoice is sent to the customer, and later cash is collected. The receivable exists for the time period between the selling of the inventory and the receipt of cash. Receivables are the third most liquid asset after cash and short-term investments. Receivables are commonly divided into three categories: Debtors (or Accounts Receivable) – Amounts owed by customers arising from credit sales Bills of Exchange (or Notes Receivable) – Written promises to pay a definite sum at a future date Other receivables – Amounts lent to employees, subsidiaries, etc.

77

Accrual Accounting and the Balance Sheet

Credit sales are extremely important to the economy of any country. To an individual company, there are many advantages of selling on credit (increasing revenue is the principal benefit) and a few disadvantages such as the cost of maintaining a credit department and the fact that not all customers will pay what they owe. From an accounting and a business standpoint, it is important to determine the expense, which arises when customers buy on credit and do not pay their bills. We call this expense as Bad Debts. Of course, it is even more important to try and judge your customers well, and not sell on credit to customers who are of suspicious creditworthiness.1 There are two methods to record Bad Debts: o Allowance Method o Direct Write Off Method

Entries under the Allowance Method include: At time of sale !

Accounts Receivable

!

!

To Sales Revenue

At end of period (adjusting entry) !

Bad Debts (an estimate)

!

!

To Allowance for Bad Debts

There are two methods used to estimate Bad Debts. • Percentage of Sales Method – Income Statement approach • Aging of Accounts Receivable – Balance Sheet approach Using the Percentage of Sales Method, Bad Debt Expense is based on a percentage of credit sales. When using the Percentage of Sales Method, ignore the balance in the Allowance Account when recording the expense. 78

Accrual Accounting and the Balance Sheet

The Aging of Receivables Method considers the age and amount of the Closing Accounts Receivable balance. This method assumes that longer an account goes uncollected, the more likely it is to go bad. The prior balance in the Allowance Account must be considered when recording the amount of expense under this method. Firms often use the Percentage of Sales Method on interim statements and use the more precise Aging of Receivables Method on year-end statements. Under the Allowance Method when an account is deemed to be uncollectible or irrecoverable, it is written off. The journal entry takes the following form: Allowance for Bad Debts !

To Accounts Receivable, Customer ABC

Entries under the Direct Write-Off Method include the following: At time of sale !

Accounts Receivable

!

!

To Sales Revenue

When specific account goes bad !

Bad Debt Expense

!

!

To Accounts Receivable, Customer ABC

This method usually does not comply very well with the matching principle as the sale typically takes place in one period and the write-off in another period. Receivables are proportional to sales. As sales rise, the investment you must make in receivables also rises. Example: Receivables vary with sales. ABC Company gives net 30 Day terms to its customers. Any sale made today will be collected one month from today. ABC's customers are prompt payers and all receivables are collected on the 30th day.

79

Accrual Accounting and the Balance Sheet

On an average, ABC will have one month's worth of sales always invested in receivables. In 20X5, sales are Rs.1,200,000. Receivables, which are equal to one month's sales, total Rs.100,000. In 20X6, sales rise to Rs.2,400,000. Receivables, which remain at one month's worth of sales, rise to Rs.200,000. Due to the growth in sales, the company is forced to increase its investments in accounts receivable by Rs.100,000. This investment in receivables is automatic and unavoidable. It does not indicate the company's terms have been lengthened or that management of collections has decayed or become looser. Analyzing Receivables: Receivables increase for two reasons; 1) Growth in sales, and 2) Change in average collection period. Growth in sales is a healthy reason to increase receivables. Changing the collection period, however may not be so favorable, particularly if the reason is due to a collection problem with a customer. Here's an example of how analyzing your financial statements can help you spot unfavorable trends before they become a problem. To analyze the change in the collection period, some measure of the receivable's quality must be used. We do this by comparing the actual collection period to the stated payment terms. The actual collection period is known as Days In Receivables. To determine receivable quality, the company's terms of payment are compared to the actual collection period. The collection period and the terms should be about equal. If the calculated collection period is greater than the offered terms, then its time to dig deeper and see if some of the company’s customers are lagging in paying their accounts. We prepare an A/R Aging Report2 as a start.

2

A report where all receivable accounts are classified into how many days have elapsed since delivery of goods has been made. Typically, aging of A/R is divided for analysis into under 30 days, 31-60 days, 61-90 days, and 91 days and above, if the normal credit terms are 60 days.

80

Accrual Accounting and the Balance Sheet

Allowance for doubtful debts: At some point in time you may have customers that are unable to pay for the goods or services they received from you. When you determine that you will be unable to collect these amounts, you will (albeit reluctantly) write off the receivable and record a "write-off" loss. As your business matures, you will be able to estimate the amount of such losses. Many businesses calculate this expense on a monthly basis based on sales or a percentage of past due accounts. The allowance for doubtful accounts is subtracted from gross receivables on the Balance Sheet to show the net receivable balance. Inventory consists of the goods and materials a company purchases to resell at a profit. In the process, sales and receivables are generated. The company purchases raw material inventory that is processed (aka work-inprocess inventory) to be sold as finished goods inventory. For a company that sells a product, inventory is often the first use of cash. Purchasing inventory to be sold at a profit is the first step in the profit-making cycle (operating cycle) as illustrated previously. Selling inventory does not bring cash back into the company – it creates a receivable. Only after a time lag equal to the receivable's collection period will cash return to the company. Thus, it is very important that the level of inventory be well managed so that the business does not keep too much cash tied up in inventory, as this will reduce profits. At the same time, a company must keep sufficient inventory on hand to prevent stockouts (having nothing to sell) because this too will erode profits and may result in the loss of customers. The correct level of inventory is a function of the length of the company's inventory cycle and the company's sales level. A company's inventory cycle is divided into three phases: • the ordering phase, • the production phase, and • the finished goods/delivery phase. The ordering phase is the time it takes a company to order and receive raw materials. The production phase is the time it takes to produce finished goods

81

Accrual Accounting and the Balance Sheet

from raw materials. The finished goods/delivery phase is the amount of time finished goods remains in stock and the delivery time to a customer. The inventory cycle in days is determined as follows: Inventory Cycle In Days ! = Ordering Phase in Days !

!

!

!

!

!

+ Production Phase in Days

!

!

!

!

!

!

+ Finished Goods and Delivery Phase in Days

Example: Inventory Cycle Now let's look at an example of how a small business might use this information to plan its purchases and manage inventories. ABC Company produces special clay pots and vases. The company buys clay from Sticky Clay and Co and receipt of the clay generally takes 14 days. If the company orders clay today, it will receive the clay in 14 days. To prevent stockouts (i.e., situations where there is no stock of clay, resulting in stoppage of production), the company reorders whenever clay inventories drop to 14 days. Once in the shop, the clay base is mixed with water and rests 1 day to set up to the proper texture. It takes 1 day to spin the vase, 3 days to dry, 1 day to paint and 1 more day to dry. The production cycle from wetting clay to drying the paint is thus 7 days. Because it takes 7 days to produce 7 days worth of sales, the company never lets its stock of pots and vases shrink to less than 7 days worth of sales. The delivery phase is very short because most of the product will be delivered in the immediate area. Management estimates that delivery takes one day at the most. The company's minimum inventory cycle is 22 days: Inventory Cycle In Days = Step 1 = 14 days for ordering, Step 2 = 7 days for production Step 3 = +1 day for delivery Total Cycle is 22 days. If clay is ordered today, a vase made of that clay can be delivered to a customer no sooner than 22 days from now. Now let us also assume that ABC Company’s management likes to keep an additional 5 days of inventory on hand as a cushion 82

Accrual Accounting and the Balance Sheet

to cover any delays in receipt of the clay and production of the vases. Therefore, the company's total inventory cycle is 27 days. To keep the cycle running smoothly, the company must keep its investment in inventory equal to 27 days worth of sales. The company must keep an investment in inventory equal to its inventory cycle. If ABC keeps only 15 days' worth of investment in inventory, it eventually will run out of stock because clay ordered today cannot be delivered as a vase for 22 days. This investment requires the use of cash. Thus, in the above example, ABC must have sufficient cash to acquire at least 22 days of inventory, and that management operates more comfortably with 27 days' sales in inventory. Knowing this, we can estimate the rupee amount of inventory as follows: Minimum Investment in Inventory (in Rs) = Inventory Cycle In Days !

!

!

!

!

!

!

!

!

!

X Cost of a Day's Sales (in Rs)

The investment in inventory will vary according to both the sales per day and the length of the inventory cycle in days. As sales rise, the amount of inventory sold daily rises and the investment in a day's worth of inventory must increase or stockouts will eventually occur. As the inventory cycle lengthens more inventory must be kept in hand to produce the same level of sales and the investment in inventory increases. Just as we measured the "quality" of accounts receivable, another ratio can be used as an indicator of the "quality" of inventory. We do this by comparing the actual inventory level to the inventory cycle. Insufficient inventory indicates potential stockouts, Excessive inventory may indicate, stale inventory, poor inventory controls, or fudging (miscounting). To measure quality, the actual number of days of inventory in hand is measured as follows: Days In Inventory ! ! ! ! ! !

=! !

Actual Inventory x 360! ! ! Cost of Good Sold per year

!

!

!

!

!

Ideally, inventory will be at a level slightly greater than the inventory cycle. 83

Accrual Accounting and the Balance Sheet

Days In Inventory > Inventory Cycle In Days Notes or Bills Receivable (N/R or B/R) is a receivable due to the company, in the form of a promissory note or a bill of exchange, arising because the company made a loan or a sale on credit. Making loans is the business of banks, not of operating businesses, and particularly not the business of companies with limited financial resources. A Note Receivable is a written promise to pay. A variant on this is a Bill of Exchange. The Interest payable for this promise is either actually calculated and mentioned or mentioned in a manner that the applicable interest can always be calculated as below: Interest expense = Principal x Rate x Time Notes receivable are notes due usually from one of the following sources: Customers, Employees, or Officers of the company. Bills of Exchange are invariably from customers. Customer notes receivable is when the customer who borrowed from the company probably borrowed because he could not meet the accounts receivable terms. When the customer failed to pay the invoice according to the agreed upon payment terms. The customer's obligation may have been converted to a promissory note. This happens fairly rarely in India, not because payment defaults don’t happen often, but because persons defaulting on payments are often so blasé about the default, that they don’t usually bother to document it in the form of a promissory note. Employee notes receivable may be for legitimate reasons, such as a down payment on a home, but the company is neither a charity nor a bank. More and more companies, in recognition of this fact, if they want to help the employee, cosign on the loan advanced by a bank, or advise them to borrow from a bank or other financial institution and subsidise the interest cost if that is the intent. This way, the company does not take a credit risk on lending to an employee who may in future not remain an employee. An officer or owner borrowing from the company is the worst form of note receivable. If an officer takes money from the company, it should be treated as a dividend or withdrawal and reflected as a reduction in net worth. Treating it in any other way leads to possible manipulation of the company's stated net worth, and 84

Accrual Accounting and the Balance Sheet

banks and other lending institutions frown greatly upon it. The Income Tax Act in India mandates this treatment, by treating such a withdrawal as a dividend declared, and taxing it in the recipient’s hands. Days’ Sales in Receivables indicates how long it takes to the collect the average level of receivables. Companies strive to reduce this ratio and lower the number of days it takes to collect receivables. The ultimate ”champion” in this field undoubtedly is Dell Computers, which has built a huge business of selling computers and associated items directly to customers without a chain of middlemen. If you wish to buy a computer from Dell, it will recover the money in someway or the other (usually via EFT or credit card). The ratio can be calculated using a two-step approach. 1. ! One day’s sales = Net Sales/360 Days 2. ! Days’ Sales in Receivables! ! ! ! ! ! ! ! = Average Net Accounts Receivable/One Day’s Sales

!

!

!

!

!

Other Current Assets consist of prepaid expenses and other miscellaneous and current assets. Prepaid expenses are uses of cash to purchase in full a good or service, the benefit of which will be received within the next 12 months. Insurance is the most common form of prepaid expense. The premium is paid prior to the receipt of the benefit. Paying a bill before the benefit from the purchase has been received has depleted cash. Miscellaneous and other current assets generally consist of small deposits or receivables.

3.6 OTHER ASSETS Other assets consist of miscellaneous accounts such as deposits and longterm notes receivable from third parties. They are turned into cash when the asset is sold or when the note is repaid. Total Assets is the sum of all the assets owned by or due to the business. Classified balance sheets show various categories of assets, liabilities, and shareholders’ equity accounts. Important topics to be studied include current assets, long-term assets, current liabilities, long-term liabilities, consolidated 85

Accrual Accounting and the Balance Sheet

balance sheets, report format balance sheets, and account format balance sheets. Giving a listing of balance sheet accounts, you should be able to prepare a classified balance sheet.

3.7 LIABILITIES Liabilities and Net Worth are sources of cash listed in descending order from the most nervous creditors and soonest to mature obligations (current liabilities), to the least nervous and never due obligations (net worth). There are two sources of funds: lender-investor and owner-investor. Lender- investor consists of trade suppliers, employees, tax authorities and financial institutions. Owner-investor consists of stockholders and principals who loan cash to the business. Both lender-investor and owner-investors have invested cash or it’s equivalent into the company. The only difference between the investors is the maturity date of their obligations and the degree of their nervousness. Current Liabilities: are those obligations that will mature and must be paid within 12 months. These are liabilities that can create a company's insolvency if cash is inadequate. A happy and satisfied set of current creditors is a healthy and important source of credit for short term uses of cash (inventory and receivables). An unhappy and dissatisfied set of current creditors can threaten the survival of the company. The best way to keep these creditors happy is to keep their obligations current. Current liabilities consist of the following obligation accounts: • Accounts Payable -- Trade (A/P) • Accrued Expenses • Notes Payable -- Bank (N/P Bank) • Notes Payable -- Other (N/P Other) • Current Portion of Long term Debt (generally shown separately in statements meant for bankers).

86

Accrual Accounting and the Balance Sheet

Proper matching of sources and uses of funds require that short term (current) liabilities must be used only to purchase short-term assets (inventory and receivables). Notes Payable (N/P): are obligations in the form of promissory notes with shortterm maturity dates of less than 12 months. Often, they are demand notes (payable upon demand). Other times they have specific maturity dates (30, 60, 90, 180, 270, 360 days maturities are typical). The notes payable always include only the principal amount of the debt. Any interest owed is listed under accruals. The proceeds of notes payable should be used to finance current assets (inventory and receivables). The use of funds must be short term, so that the asset matures into cash prior to the obligation's maturity. Proper matching would indicate borrowing for seasonal swings in sales, which cause swings in inventory and receivables, or to repay accounts payable when attractive discount terms are offered for early payment. Accounts Payable are obligations due to trade suppliers who have provided inventory or goods and services used in operating the business. Suppliers generally offer terms (just like you do for your customers), since the supplier's competition offers payment terms. Whenever possible you should take advantage of payment terms as this will help keep your costs down. To analyze the company's payables position and relationship with suppliers we use a ratio/quality indicator similar to the one used for accounts receivable and inventory, known as Days In Payables. If the company is paying its suppliers in a timely fashion, days payable will not exceed the terms of payment. Accrued Expenses are obligations owed but not billed such as wages and payroll taxes, or obligations accruing, but not yet due, such as interest on a loan. Accruals consist chiefly of wages, payroll taxes, interest payable and employee benefits accruals such as pension funds. As a labor related category, it should vary in accordance with payroll policy (i.e., if wages are paid weekly, the accrual category should seldom exceed one week's payroll and payroll taxes).

87

Accrual Accounting and the Balance Sheet

Current Portion of Long Term Debt (CLTD): is the portion of term loans due within the next 12 months. A term loan is a loan that carries a maturity that exceeds one year. It is divided into two segments; the portion due within 12 months (CLTD) and the portion due beyond one year (LTD). This bifurcation of Long-term Debt is not mandated by the Companies Act for Indian companies, but is generally insisted upon by bankers and other financers to the company, because this figure gives a partial indication as to how much loan-servicing burden the company carries in the year immediately following the date of the Balance Sheet. The non-current portion is listed separately from the current liability section. Any interest due is listed as an accrual, and is added to the amount of the loan due. Term loans are fundamentally different from notes payable. As sources of funds that are repaid over a period longer than 12 months, they can be used to acquire longer-term assets (assets that mature to cash beyond 12 months). Some of the common uses of funds from term loans include: • Permanent Working Capital (increases in working capital due to growth) • Fixed Assets Non-current Liabilities: are those obligations that will not become due and payable in the coming year. There are three types of non-current liabilities, only two of which are listed in the balance sheet: • Non-current Portion of Long Term Debt (LTD) • Contingent Liabilities Non-current portion of long-term debt is the principal portion of a term loan not payable in the coming year. Contingent liabilities listed in the footnotes are potential liabilities, which hopefully never become due. Non-Current Portion of Long Term Debt (LTD) is the portion of a term loan that is not due within the next 12 months. It is listed below the current liability section 88

Accrual Accounting and the Balance Sheet

to demonstrate that the loan does not have to be fully liquidated in the coming year. Long-term debt (LTD) provides cash to be used for a long-term asset purchase, either as permanent working capital or as fixed assets. Contingent Liabilities are potential liabilities that are not listed in the balance sheet. They are listed in the footnotes because they may never become due and payable. Contingent liabilities include: • Lawsuits • Warranties • Cross Guarantees If the company has been sued, but the litigation has not been initiated, there is no way of knowing whether or not the suit will result in a liability to the company. It will be listed in the footnotes because while not a real liability, it does represent a potential liability, which may impair the ability of the company to meet future obligations. Alternatively, if the company guarantees a loan made by a third party to an affiliate, the liability is contingent because it will never become due as long as the affiliate remains healthy and meets its obligations. Total Liabilities represents the sum of all monetary obligations of a business and all claims creditors have on its assets.

3.8 EQUITY Equity or Net Worth is the most patient and last to mature source of funds. It represents the owners' share in the financing of all the assets. It consists of two types of equity; Purchased Equity, and Earned Equity. Purchased equity consists of: • Paid-up Equity Shares • Preference Shares (Generally, preference shareholders receive dividends before equity shareholders, and if the company is ever liquidated, they will receive a share in liquidation proceeds prior to common stockholders.)

89

Accrual Accounting and the Balance Sheet

• Earned equity consists of retained earnings (also called Reserves and Surplus or Earned Surplus). Purchased Equity represents the cash the owners have invested in the company in the form of shares. Stock comes in several forms: Preference Shares are shares that have some preferences to equity shares. Generally, Preference Shareholders receive a dividend before equity shareholders, and if the company is ever liquidated, they will receive a share in liquidation proceeds prior to equity shareholders. Equity Share is the general ownership tool. It is the least nervous, last to be paid source of funds. Paid up Capital arises if the share is quoted at an arbitrary par value (called face value). In India there is a concept of face value, but in many countries, the concept of face (or par) value simply does not exist. Earned Equity (R/E) (retained earnings or earned surplus) represents profits earned by the company and retained in the business. It is a measure of past profitability and represents earnings the owners could have withdrawn to use personally (by declaring and paying dividends), but chose to reinvest in the business. Total Liabilities and Net Worth represent the sources of funds that finance the assets and are an indicator of the company's ability to survive in the future. A happy, satisfied set of creditors is a harbinger of future prosperity and continued success.

3.9 SUMMARY The operating cycle of business is also known as ‘cash to cash’ cycle. It starts with funds collected by the owners. These are used to arrange purchases and build materials inventory. This inventory used to produce finished products for sale. When they are sold to customers they become Sundry Debtors. Then collections are arranged to get cash again.

90

Accrual Accounting and the Balance Sheet

Even though this cycle goes on and on, it is necessary to report operating results at regular intervals; normally a year. Listed companies are required to prepare reports every quarter. In reporting, revenue principle is to be followed to record revenue when it is earned, usually when goods or services are delivered to customers. Next matching principle is to be followed to match the expense of the period against the revenue earned during the same period. To achieve this end, accrual accounting is necessary. Company’s financial standing on a particular date is reflected in the Balance Sheet. It shows what it owns (assets) and what it owes (Liabilities and net worth). From review of the balance sheet, one can monitor the ability of the business to collect revenues, how well inventory is managed, and even assessment of the business’s ability to satisfy its creditors and shareholders. Assets shown in the balance sheet are classified based on their liquidity. Noncurrent assets are those which will not mature into cash within a year. They include net fixed assets, investments in subsidiaries, intangibles etc. Fixed assets are long term investments which enable the business to carry operations and include Land, Buildings, Machinery and Equipment, Furniture and Fixtures and Vehicles etc. When the amount of accumulated depreciation is reduced from the original value of the fixed assets we arrive at net fixed assets. Current assets are those, which mature into cash in less than a year. Cash, accounts receivables, inventory, pre-paid expenses are all current assets. Accounts receivables and Inventory are controlled by monitoring how fast they are turned over in a year. Liabilities and net worth are sources of cash and are listed in the balance sheet in that order. Current liabilities are that which will mature and must be paid within 12 months. Portion of a long term loan that is payable in the current year is due in less than 12 months and has to be shown separately for Bankers. Contingent liabilities are potential liabilities and are shown as foot notes to the balance sheet. Equity or net worth represents owners’ share in financing all the assets. Purchased equity consists of paid up share capital, while earned equity consists of retained earnings called as reserves. 91

Accrual Accounting and the Balance Sheet

3.10 SELF ASSESSMENT QUESTIONS

1. Briefly distinguish between cash accounting and accrual accounting. 2. Operating cycle of a business can be observed from the Balance Sheet of the business. Do you agree to this? Explain. 3. Explain Matching principle in accounting. 4. What are Non-Current Assets and Current Assets? 5. What are Contingent liabilities? How are they reflected in Balance Sheet?

92

Accrual Accounting and the Balance Sheet

1. Accrual Accounting records Revenue as earned ignoring whether the cash is paid for the same. It records expense as incurred ignoring whether and when the expense is paid in cash. Cash Accounting records revenue as cash is received and records expense when it is paid ignoring when the cost is incurred. 2. Operating cycle of a business involves the process of converting the raw material to cash i.e. the cash-to-cash cycle. It includes components such as purchase of raw material inventory, converting it into finished goods inventory, sale thereof at profit to create a receivable and collection to convert into cash once again which is used to pay the supplier and the profits left in the business. 3. Matching principle matches the expense of a period against the revenue earned during that same period. Accrual accounting aims to match the expenses with income of the relevant accounting period. But it calls for making adjusting entries to properly match expenses with revenue. 4. Non-Current Assets are those assets that will not mature into cash within the next 12 months. They include Net Fixed Assets, Investment in Subsidiaries and Joint Ventures, Intangibles and Other Assets. The Current Assets are those assets of business, which mature in less than one year. They include the broad groups of Cash, Accounts Receivable, Inventory, Notes Receivable, Prepaid Expenses and Other Current Assets. 5. Contingent liabilities are potential liabilities and not actual ones as of the date. They have as yet not become due. These are listed by way of footnotes to the Balance Sheet and not as part of the Balance Sheet as they have not accrued.

The practical problems are given at the end of Chapter 4.

93

Accrual Accounting and the Balance Sheet

REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video1 Video2

94

4 The Profit and Loss Account or The Income Statement Objectives: After completing this chapter, you will be able to understand: • Capital and Revenue Expense. • Gross Profit and Net Profit. • Earnings per Share.

95

The Profit and Loss Account or The Income Statement

Structure: 4.1 Introduction 4.2 Distinction between Capital and Revenue 4.3 Revenue 4.4 Expenses 4.5 Gross Profit 4.6 Operating Income (EBIT) 4.7 Net Earnings 4.8 Internet Exercises 4.9 Summary 4.10 Self Assessment Questions

96

The Profit and Loss Account or The Income Statement

4.1 INTRODUCTION The Profit and Loss Account is the summary of all transactions, which the company has entered into a revenue account during the accounting period. An accounting time period that is one year long is called a fiscal year. In India, normally, fiscal years begin on 1st April and end on 31st March. However, companies are free to adopt any other 12-month period as their fiscal year, provided they also draw up for tax purposes a set of accounts as on 31st March every year as well. In the US, the Profit and Loss Account is called the Income Statement. For understanding what “revenue account” is, we need to understand the distinction between Revenue and Capital. 4.2 DISTINCTION BETWEEN CAPITAL AND REVENUE Capital (when applied to expenses) is that which is laid out for investment/ purchases not intended to be sold at a profit in the normal course of business. Anything, which is intended to be sold in the normal course of business, is revenue expenditure. Capital and revenue receipts are also distinguished similarly. Of course, the distinction is oversimplified, and can cause innumerable problems in actual practice. Be that as it may, since this is not the place to discuss this distinction deeply, the above explanation might suffice. There is a principle called the Revenue Recognition principle that dictates that revenue be recognized in the accounting period in which it is earned. Revenue accordingly is considered as earned : • when the service has been provided or • when the goods are delivered. All revenue receipts and expenses are part of the Profit and Loss Account, the net balance of which is transferred to Owners’ Equities (Reserves) in the Balance Sheet. The Profit and Loss Account is also called an Income Statement, and is usually presented in a format that is now globally accepted, known as the Vertical format. We give on page 82 a sample Profit and Loss Account in this format.

97

The Profit and Loss Account or The Income Statement

Some Terms used in Income Statements 4.3 REVENUE Companies earn revenue in one or more of the following ways: • By selling its products or services, or both • By leasing or renting equipment or property • By receiving interest from loans made to other companies or individuals Some companies have only one source of revenue; some others have several sources. For example, Hindustan Lever Limited, a large marketer of Fast- Moving Consumer Goods (FMCG) reports revenue from its products, such as food and personal care products. Infosys Technologies Ltd, a large software company, on the other hand reports revenue from software services. Some other companies, like Wipro Ltd, report revenues from software and IT-enabled services, as well as from sale of products such as lighting fixtures and vegetable oils. Financial analysts often refer to Revenues as the “top line” because, often, this is the first line in the Income Statement. 4.4 EXPENSES The Matching Principle requires that expenses be recorded in the same period in which the revenues they helped produce are recorded. In the Cash basis of accounting, expenses are recorded only when they are paid for, whereas in the accrual basis of accounting, expenses are recorded when they are incurred. Cash basis is not in accordance with GAAP. 4.5 GROSS PROFIT One simple rule of business is, "you need money to make money". Typically, producing goods for sale is the greatest cost of generating revenue. For example, a chocolate manufacturing company must buy cocoa beans, milk and other raw materials to make chocolates; it needs to pay salaries to its workers, employees and managers; and to spend money on overheads — like power, steam, security and maintenance.

98

The Profit and Loss Account or The Income Statement

A company deducts these costs (cost of sales, cost of goods sold) from its revenue, showing the resultant gross profit (or loss). 4.6 OPERATING INCOME (EBIT) In addition to the expenses directly related to producing goods and services, companies incur operating expenses. These include advertising, salaries, rent, research and development, office supplies, and any other administrative amounts spent. A company deducts these operating expenses from gross profit, resulting in operating income (or loss). Operating income is also often called EBIT (Earnings Before Interest and Tax). A variant of this is EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization). This is EBIT before deduction of depreciation and amortisation of assets. Operating income represents the enterprise’s revenue minus expenses required to earn that revenue. From this amount are deducted costs relating to debt financing and tax expenses. The remainder is called net earnings.

99

The Profit and Loss Account or The Income Statement

Profit and Loss Account of NTPC Ltd for Year ending on

31Mar-03

31Mar-02

INCOME Revenues Other Income Total

1,90,475

2E+05

8,024

6,832

1,98,499

2E+05

1,10,312

1E+05

EXPENDITURE Raw Materials, Packing Materials Conversion Charges

-

-

Excise Duty

-

-

Employee Costs

8,213

8,036

10,869

11,640

15,291

13,784

Provisions

5,555

1,836

Deferred Revenue Exp w/off

-

Interest and Finance Charges

9,916

8,677

1,60,156

1E+05

38,343

37,021

803

1

Sales, General and Admin Expenses R & D Expenses Depreciation

Total

PBT, Prior Period and Extraordinary Items Prior Period Items

-

Extraordinary Items PBT

501 37,540

36,519

100

The Profit and Loss Account or The Income Statement

Prov for Current Tax

1,464

Prov for Deferred Tax PAT

1

2,125 -

36,075

34,394

Balance Brought Forward

1,496

4,058

Add: Trf from Debenture Redemption Reserve

-

Balance available for appropriation

-

37,571

38,452

29,415

29,877

Appropriations Trf to Gen Reserve Trf to Capital Redemption Reserve

-

-

Interim Dividend

4,000

-

Tax on Interim Dividend

-

-

Proposed Dividend

3,080

7,079

Tax on Proposed Dividend

395

-

Balance carried to Balance Sheet

681

1,496

37,571

38,452

4.7 NET EARNINGS Net earnings are the "bottom line" (often literally the last line on the statement). After a company deducts all costs and expenses from revenue, the statement of earnings shows the net earnings (or loss). This figure is also called PAT (Profit After Tax). When revenues exceed costs and expenses, the bottom line shows a profit. When costs and expenses exceed revenue, the bottom line shows a loss. Growth in net earnings over the earlier period usually signals that a company is doing well. Earnings per share

101

The Profit and Loss Account or The Income Statement

Earnings per share (EPS) show how much money the shareholders would receive for each share of the company, if the company distributed all its net earnings to its shareholders. For example, if the net earnings are Rs.1 crore and 500,000 shares have been issued, the earnings per share are Rs.20 (Rs.10,00,000 ÷ 500,000 = Rs.20). Although all net earnings really belong to the shareholders, companies rarely distribute the full amount as dividends. This is because they need the money to grow and to expand their business, by reinvesting this money in its own business. The total amount of a company's net earnings since its inception, minus any payments made to shareholders by way of dividends, are called Retained Earnings. Although the term Retained Earnings conjures up visions of large piles of currency notes, this is not true. Retained earnings are actually part of shareholders' equity and represent that part of the company's assets that is financed from profit from past operations, rather than from issuing shares to investors or borrowing from banks or other external lenders. Another way that shareholders benefit from retained earnings is through dividends. A company's Board of Directors, with the advice of the management, decides on the amount of dividends per share to pay. Highly profitable companies often pay dividends quarterly; however, many companies do not pay dividends at all, and a few pay dividends less often. 4.8 INTERNET EXERCISE 1: FINANCIAL ANALYSIS ACTIVITY Compare the income statements of two large Indian pharmaceutical companies Sun Pharmaceuticals and Dr Reddy’s Laboratories. To find Sun’s income statement on the Internet go to www.sunpharma.com, and click on the link for the latest Annual Report. Download the Financial Report section available in PDF format (You need the Free Acrobat Reader to be able to view this). Dr Reddy’s income statement is found at www.drreddys.com. Click on Investors, then on Annual Reports, and go the same year as the latest available Financials of Sun Pharmaceuticals, and select Indian GAAP standalone and download.

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The Profit and Loss Account or The Income Statement

1. What is the first thing you see in the Financial Reports? Do the Reports you are seeing pertain to the same accounting year? 2. Who are the auditors? Where has the Audit Report been signed? 3. What were the sales revenue for each company? 4. What does currently each company unit in express the figures of their financial statements? 5. Would you consider Net of Excise Sales, or Sales including Excise for comparability? Where does Excise duty figure in Sun Pharmaceuticals’ Profit and Loss Account? 6. What was the cost of goods sold for each company? How would you deduce the same from the Profit and Loss Account? 7. How much did each company have in operating expenses? 8. How much was the profit after tax for each company? 9. Did either company have discontinued operations, extraordinary items, or cumulative adjustments? What were the amounts of each of these items? 10.What were the earnings per share for each company? 11.What was the amount of the current assets for each company? What are some of the items included in current assets? 12.What was the amount of total assets for each company? What are some of the items are included in fixed assets? 13.What was the amount of the current liabilities for each company? What are some of the items included in current liabilities? 14.What was the amount of total liabilities for each company? What are some of the items included in long-term liabilities? 15.Compute the following ratios for both these companies:

103

The Profit and Loss Account or The Income Statement



a. Working Capital



b. Current Ratio

c. Quick Ratio 16.Based on the liquidity ratios, which company, Sun or Dr Reddy’s is better able to meet its current obligations? Note: This website, and most other websites that we point you to, are constantly being updated. Please check to see that the information requested in this exercise is available. It might be useful for you to print out the pages of the financial statements alone (if not all pages) and keep the hard copies handy while doing this exercise. Internet Exercise 2: Financial Analysis Activity Dell Computer Corporation's activities run the full range from design and development to manufacturing, marketing, and servicing many types of computer systems. In addition to laptops and desktops, the company also manufactures enterprise systems. In order to accomplish all of these business functions, the company needs to have a fairly significant investment in operating assets. In this exercise, you will look at what types of long-term assets the company has and how they are reported in the financial statements. The company's most recent filing can be found on the Dell Web site, by clicking on About Dell, Investors, Annual Reports. 1. What period does the financial year of Dell cover? 2. What types of long-term assets appear on the company's balance sheet? What are the balances in these accounts? 3. The first footnote to the financial statements indicates that the property, plant and equipment are carried at depreciated cost. What does that mean? Is that allowed under GAAP? What accounting concepts apply to this method? 4. What depreciation methods does the company use?

104

The Profit and Loss Account or The Income Statement

5. How much did the company spend for capital expenditures in the latest year? Where do you find this information? Do you think this amount of expenditure is good or bad? Why? 6. What is their inventory? How many days of sale does it represent? How does this compare with other companies in the same or other industries? Note: The Dell Annual Report is a largish download of nearly 5 MB. So it might be a good idea for one of you to download it on to a CD and circulate the CD to your co-students. Internet Exercise 3: Financial Analysis Activity With nearly 25,000 restaurants in over 100 countries, McDonald's is the largest and best-known global food service retailer. Go to www.mcdonalds.com under Corporate, Investor Info, and select Financial Reports. 1. What are the sources of McDonald's revenues? 2. What are McDonald's major expenses? Based on the "Letter to Shareholders," how did management portray the annual performance of the corporation?

4.9 SUMMARY The profit and loss account is the summary of all transactions, which the company has entered into a revenue account during the accounting period. Capital expense is that which is laid out for investment / purchase not intended to be sold at a profit in the normal course of business. Anything which is intended for to be sold in the normal course of business is revenue expenditure. Capital and revenue receipts are also distinguished similarly. When expenses for producing goods sold are deducted from revenue generated by their sale you arrive at gross profit (or loss). From this, company deducts operating expenses like advertising, salaries, rent, research and development,

105

The Profit and Loss Account or The Income Statement

office supplies and other administrative expenses to arrive at Earnings Before Interest and Tax (EBIT). Cost of debt financing i.e. interest is deducted from EBIT to arrive at net earnings or profit. If all these earnings were to be distributed to shareholders one gets earnings per share. A part of net earnings is actually distributed as dividends and remaining part is called retained earnings. Retained earnings denote shareholders equity and that part of the assets that is not financed through issue of shares or long term loans. 4.10 SELF ASSESSMENT QUESTIONS Choose the Correct answer: 1. The Balance Sheet gives us information about the ______________ of a Company. a. Profits & Losses b. Income & Expenses c. Assets & Liabilities d. Assets & Equity 2. The Profit & Loss account gives us information about a. Income & Expenses as on a date b. Income & expenses for a period c. Assets & Losses for a period d. Assets & Liabilities as on a date 3. An Asset, which is not a fixed asset a. Computers b. Patents

106

The Profit and Loss Account or The Income Statement

c. Finished goods d. Buildings 4. Fixed assets are valued at a. Cost b. Cost less depreciation c. Cost or Market Value d. Net realizable value 5. The Least Liquid asset is a. Land b. Goodwill c. Inventories d. Patents 6. The most "Current" Liability is a. Equity share capital b. Short term loans c. Unpaid taxes d. Debentures 7. Which of the following would not appear is an annual report a. Balance Sheet b. Discounted cash flow statement c. Directors Report 107

The Profit and Loss Account or The Income Statement

d. Income Statement 8. Which of the following is not an intangible asset a. Patents b. Goodwill c. Dematerialized shares d. Brand names 9. Which of the following is not a source of funds a. profit after tax b. share capital issued c. sale of investments d. share buyback 10. Which of the following is not a use of funds a. purchase of fixed assets b. decrease in working capital c. repayment of loan d. share buybacks 4. Fill in the blanks: 1) All significant accounting policies are to be disclosed as part of _____ _________ ____ __ ___ __________ . 2) Fundamental Accounting Assumptions are ________ _________, __________________ and _____________ .

108

The Profit and Loss Account or The Income Statement

3) Depreciable amount of a depreciable asset is its ___________ ________ as reduced by its ____________ _________ _________. 4) AS 3 on Cash Flow Statements requires cash flow to be segregated and explained under the following three heads: Cash Flow from __________ activities; from __________ activities and from __________ activities. 5) Contingent _______ must be recognised, while contingent __________ must not be recognised.

SOLVED EXAMPLE 1. Continuing with the solved example No.1 at the end of Chapter 2, post the entries of Abhay & Co to the respective ledger accounts and prepare a Trial Balance (assuming manual, T-form of accounts and Financial Statements are adopted. After preparing the Trial Balance, prepare the final accounts (i.e. Profit & Loss Account and Balance Sheet) of Abhay and Company taking into consideration the following further adjustments.

109

The Profit and Loss Account or The Income Statement

i) Closing stock is to be valued at cost Rs. 15,000; ii)Depreciation on Plant and Machinery @ 10% per annum and Furniture @15% per annum. iii)Outstanding salary at Rs. 1,000 is to be provided; iv) Prepaid Insurance Rs. 500 to be adjusted. v) Uninsured goods costing Rs. 2,000 were lost by theft. Ledger Posting Cash Account Dat e

Particulars

J.F

Amount Rs.

Dat e

Particulars

J.F

Amount Rs.

To Bank A/c

10,000

By Mohan’s A/c

200

To Sales A/c

19,600

By Purchase A/c

To Mohan’s A/c

10,050

By Conveyance A/c

700

By Stationery A/ c

450

8,000

By Salary A/c

3,000

By Wages A/c

800

By Balance C/d

26,500

39,650

39,650

Capital Account Dat e

Particulars To Balance C/d

J.F

Amount Rs. 3,00,000 3,00,000

Dat e

Particulars By Sundries

J.F

Amount Rs. 3,00,000 3,00,000

110

The Profit and Loss Account or The Income Statement

Purchase Account Dat e

Particulars

J.F

Amount Rs.

To Sundries A/c

12,000

To Rohan’s A/c

8,000

To Bank A/c

8,000

To Cash A/c

8,000

To Memon’s A/c

8,000

Dat e

Particulars

J.F

By Profit & Loss A/c

Amount Rs. 44,000

44,000

44,000

Plant and Machinery Account Dat e

Particulars

J.F

To Sundries

Amount Rs.

Dat e

2,00,000

Particulars

J.F

By Balance C/d

Amount Rs. 2,00,000

2,00,000

2,00,000

Furniture Account Dat e

Particulars

J.F

To Sundries

Amount Rs.

Dat e

30,000

Particulars

J.F

By Balance C/d

Amount Rs. 30,000

30,000

30,000

Bank Account Dat e

Particulars To Sundries

J. F

Amount Dat Rs. e 75,000

Particulars By Cash A/c

J. F

Amount Rs. 10,000

By Drawing A/c

4,000

By Insurance Premium A/c

2,000

To Rohan’s A/c

6,000

To Purchase A/c

8,000

111

The Profit and Loss Account or The Income Statement

Rohan’s Account Da te

Particulars

J. F

To Bank A/c

Amount Rs.

Dat e

6,000

To Discount Received A/c

500

To Balance c/d

Particulars

J.F

Amount Rs.

By Sundries

5,000

By Purchase A/c

8,000

6,500 13,000

13,000

Loan (Taken) Account Dat e

Particulars

J.F

To Balance c/d

Amount Rs.

Dat e

12,000

Particulars

J.F

By Sundries

Amount Rs. 12,000

12,000

12,000

Drawing Account Dat e

Particulars

J.F

To Bank

Amount Rs.

Dat e

4,000

Particulars

J.F

By Bal c/f

Amount Rs. 4,000

4,000

4,000

Insurance Premium Account Dat e

Particulars

J.F

To Bank

Amount Rs.

Dat e

Particulars

J.F

By Profit & Loss A/c

2,000

Amount Rs. 2,000

2,000

2,000

Mohan’s Account Da te

Particulars To Sales A/c

J. F

Amount Rs. 10,000

Dat e

Particulars By Cash A/c

J. F

Amount Rs. 10,050

112

The Profit and Loss Account or The Income Statement

Memon’s Account Dat e

Particulars

J.F

To Balance c/d

Amount Rs.

Dat e

8,000

Particulars

J.F

By Purchase A/c

Amount Rs. 8,000

8,000

8,000

Meena’s Account Dat e

Particulars

J.F

To Sales A/c

Amount Rs.

Dat e

12,000

Particulars

J.F

By Balance c/d

Amount Rs. 12,000

12,000

12,000

Discount Allowed Account Da te

Particulars

J. F

Amount Rs.

To Sales A/c

400

To Mohan’s A/c

150

Dat e

Particulars

J. F

By Profit & Loss A/c

Amount Rs. 550

550

550

Discount Received Account Dat e

Particulars

J.F

To Profit & Loss A/c

Amount Rs.

Dat e

500

Particulars

J.F

By Rohan’s A/c

Amount Rs. 500

500

500

Conveyance Account Dat e

Particulars

To Cash

J.F

Amount Rs. 700

Dat e

Particulars By Profit & Loss A/c

J.F

Amount Rs. 700

113

The Profit and Loss Account or The Income Statement

Stationery Account Dat e

Particulars

To Cash

J.F

Amount Rs. 450 450

Dat e

Particulars By Profit & Loss A/c

J.F

Amount Rs. 450 450

114

The Profit and Loss Account or The Income Statement

Salary Account Dat e

Particulars

J.F

To Cash

Amount Rs.

Dat e

Particulars

J.F

By Profit & Loss A/c

3,000

Amount Rs. 3,000

3,000

3,000

Wages Account Dat e

Particulars

J.F

To Cash

Amount Rs.

Dat e

Particulars

J.F

By Profit & Loss A/c

800

Amount Rs. 800

800

800

Interest Account Dat e

Particulars

J.F

To Bank A/c

Amount Rs.

Dat e

Particulars

J.F

By Profit & Loss A/c

500

Amount Rs. 500

500

500

Sales Account Dat e

Particulars To Profit & Loss A/c

J.F

Amount Rs. 42,000

42,000

Dat e

Particulars

J. F

Amount Rs.

By Mohan’s A/c

10,000

By Meena’s A/c

12,000

By Cash A/c

19,600

By Discount Allowed A/c

400 42,000

115

The Profit and Loss Account or The Income Statement

Trial Balance of Abhay and Company as on …………. Dat e

Particulars Cash A/c Capital A/c Purchase A/c Plant & Machinery A/c Bank A/c Furniture A/c Rohan’s A/c Loan (Taken) A/c Drawing A/c Insurance Premium A/c Memon’s A/c Meena’s A/c Discount Allowed A/c Discount received A/c Conveyance A/c Stationery A/c Salary A/c Wages A/c Interest A/c Interest (paid) A/c Sales A/c

L/F Debit Rs.

Credit Rs.

26,500 - 3,00,00 44,000 0 2,00,000 44,500 30,000 6,500 4,000 12,000 2,000 12,000 8,000 550 700 500 450 3,000 800 42,000 500 83,000 4,10,500

4E+05

116

The Profit and Loss Account or The Income Statement

Profit & Loss Account of Abhay and Company for year ending on ____________ Particulars To Purchase

Rs.

Rs.

44,000

Particulars

Rs.

By Sales

Rs. 83,000

Less Goods lost in theft

2,000

500

Less Closing Stock

15,000

500

Cost of Goods Consumed

27,000

To Wages To Insurance Premium Less Prepaid

800 2,000 500

1,500

To Discount Allowed

550

To Conveyance

700

To Stationery

450

To Salary Add Outstanding

3,000 1,000

To Interest

4,000 42,000

To Loss by Theft

2,000

To Depreciation (total)

24,500

Total

1E+05

By Net Loss tr to Capital A/c

19,500

Total

1E+05

117

The Profit and Loss Account or The Income Statement

Balance Sheet of Abhay and Company as on Liabilities

Rs.

Rs.

Assets

Rs.

Rs.

Capital Account

3E+05

Plant & Machinery

2E+05

Less: Drawings

4,000

Less: Depreciation @ 10%

20,000 2E+05

3E+05 (19,50 0)

2,76,5 Furniture 00 Less: Depreciation @ 15%

Loan (taken) Account

30,000 4,500 25,500

12,000

Creditors

Closing Stock

15,000

Debtors

Memon

8,000

Rohan

6,500 14,500

Meena

12,000

Prepaid Insurance Outstanding Salary

Total

500

1,000 Bank Balance

44,500

Cash on Hand

26,500

3E+05

Total

3E+05

118

The Profit and Loss Account or The Income Statement

Problems to Solve 1. The following are the Account Balances of Highly Prosperous Limited as on March 31, 200X. !

!

!

!

!

!

!

!

!

Balance ! Debit Rs.! Credit Rs.

!

Equity Capital - Face Value Rs. 10 per share ! 225,000 Profit and Loss Account Balance ! !

!

!

55,500

Long term Loan !!

!

!

!

!

!

!

60,000

Accounts Receivable !

!

!

!

!

!

217,500

Advertising ! !

!

!

!

!

!

!

!

12,000

Land 1! !

!

!

!

!

!

!

!

1,250

Office Furniture & Fixtures !

!

!

!

!

9,000

Factory Building !!

!

!

!

!

!

!

93,000

Machinery ! !

!

!

!

!

!

!

93,750

!

!

Accumulated Depreciation !

- Factory Building !

!

!

!

!

!

15,750

!

- Machinery !!

!

!

!

!

!

54,000

!

- Office Furniture & Fixtures ! !

!

!

5,100

!

Provision for Bad Debts ! !

!

!

!

!

3,750

Cash in Bank !

!

!

!

!

!

5,250

Cash discount on sales ! !

!

!

!

!

3,150

Marketable Securities !

!

!

!

!

!

7,500

Long Term Investments ! !

!

!

!

!

7,500

Factory supplies used !

!

!

!

!

5,250

Duty on purchase of raw materials !

!

!

15,000

Insurance ! !

!

!

!

3,750

Interest on Marketable Securities !!

!

!

!

150

Interest on long term Investments !

!

!

!

300

Loan - short term !

!

!

!

!

!

!

!

! !

!

!

!

!

30,000 119

The Profit and Loss Account or The Income Statement

!

!

!

!

!

!

!

Balance ! Debit Rs.! Credit Rs.

!

!

!

Interest on Short term Loan ! !

!

!

!

3,000

Interest on Long term Loan ! !

!

!

!

6,000

Office Expenses !

!

!

!

!

!

!

4,500

Office Rent ! !

!

!

!

!

!

!

!

3,750

Office Salaries ! !

!

!

!

!

!

!

49,500

Purchases - Finished goods ! !

!

!

!

97,500

Purchases - Raw Materials ! !

!

!

!

187,500

Inventories - Finished goods ! !

!

!

!

37,500

!

- Raw Materials !!

!

!

!

!

!

127,500

!

- Work-in-Process ! !

!

!

!

!

24,000

Electricity for Heat & Power ! !

!

!

!

9,750

Repairs to Machinery !

!

!

!

!

!

12,750

Sales ! !

!

!

!

!

!

832,500

Salesmen’s’ salaries and expenses ! !

!

23,250

Wages ! !

226,800

!

!

!

!

!

!

Accounts payable !

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

! !

!

!

!

!

15,150!!

!

!

!

!

!

2,594,400!!

!

!

!

!

!

First recognise whether each of the above is an Asset, Liability, Income or Expense. The following additional information is provided 1. Advertising expenses have to be deferred to the extent of Rs. 3,750 2. Depreciation is to be provided at the following rates - Factory Building 2.5% of cost - Machinery 10% of cost - Office Furniture & Fixtures 10% of cost

120

The Profit and Loss Account or The Income Statement

3. Provision for Bad Debts is increased by Rs. 1500 4. Insurance is prepaid to the tune of Rs. 1050 5. Interest on Long term Investments due but not received Rs. 300 6. Interest on Short term Loan due but not paid Rs. 600 7. Office Expenses outstanding are to the tune of Rs. 450 8. Office Salaries outstanding are to the tune of Rs. 4500 9. Inventories on March 31, 200X (year end date) are valued as follows - Finished goods !

!

!

!

!

!

!

52,500

- Raw Materials !!

!

!

!

!

!

!

247,500

- Work-in-Process ! !

!

!

!

!

!

15,000

10. Provide for Income Tax @ 35% Prepare an Income statement for the year ending March 31st, 200X and a Balance Sheet as on March 31, 200X.

121

5 The Statement of Cash Flows

Objectives: After completing this chapter, you will be able to understand: • Methods of Preparing Cash Flows.

122

The Statement of Cash Flows

Structure: 5.1 Introduction 5.2 What Purpose does the Cash Flows Serve? 5.3 Methods of Preparing Cash Flows 5.4 Summary 5.5 Self Assessment Questions

123

The Statement of Cash Flows

5.1 INTRODUCTION The statement of cash flows is one of the principal financial statements required by GAAP. Let’s consider these financial statements in terms of what information they provide, what accounts they include, what time period they cover, etc. Balance Sheet Income Statement or Profit and Loss Account Statement of Cash Flows Which is the most important financial statement? Remember that positive net income on the income statement is meaningless unless the corporation can translate earnings into cash inflows. Since most companies use accrual accounting, the only place one can discover what has happened to cash is the statement of cash flows. And as we have said elsewhere, cash is the only game in town.

5.2 WHAT PURPOSE DOES THE CASH FLOWS SERVE? Cash flows serve useful purpose when viewed with its Balance Sheet and its Income Statement for the relevant period. The Income Statement may show robust topline and bottomline. Yet the company may be languishing in realizing dues from its customers and the reported income may eventually turn into bad debt in course of time. The cash flow statement may give an opportunity to see how good is the company in realizing adequate cash inflows from its main operating business. If this is not the case, then it shall have to look for other sources of finance for its day-to-day operations. Some of these sources could be: i. Income from non-operating sources, such as sale of investments, interest and dividend income which are certainly no substitute for good flow from operative income ii. Inflow of funds by way of additional short term or long term borrowings requiring cash out flow in future by way of interest payment and for the repayment of the principal, or

124

The Statement of Cash Flows

iii. Inflow of funds by way of raising additional capital etc. The statement of cash flows reports cash flows (cash receipts and cash payments) in the following categories: (1) Operating activities: Transactions which affect net income (2) Investing activities: Transactions, which affect investments in fixed assets, like property, plant, etc. (3) Financing activities: Transactions which affect the equity and debt of the Business Investors and creditors use the statement of cash flows to: 1. Evaluate management's abilities to manage cash now and in the future 2. Assess the company's ability to pay dividends and to pay creditors 3. Convert accrual net income reported on income statement to a cash basis figure In preparing a statement of cash flows, the definition of cash includes both cash (currency and bank account balances) and cash equivalents. Cash equivalents are short-term highly liquid instruments maturing in 90 days or less, i.e. T-bills (short for Treasury Bills), short term CDs (Certificates of Deposit), CPs (Commercial Paper) and other short-term financial instruments.

5.3 METHODS OF PREPARING CASH FLOWS There are two methods of preparing the statement of cash flows: (1) the Direct Method, and (2) the Indirect Method. The vast majority of publicly traded firms use the Indirect Method. The only difference between the two methods is how cash flows from operating activities are calculated. Cash flows from investing and financing activities are calculated identically in both methods. We’ll discuss the indirect method first.

125

The Statement of Cash Flows

The steps to prepare the operating activities section (indirect method) and convert the accrual net income figure to a cash figure are as follows: !

!

Begin with Net Income (NI) as reported on the income statement!

!

Add back Depreciation, Depletion, and Amortization 1 Subtract Gain on Disposal of Fixed Assets 2 Add back Loss on Disposal of Fixed Assets 2 Adjust for changes in current asset and current liability accounts as follows: 3 – Increase in Current Assets (An increase in Current Assets is deducted from NI) + Decrease in Current Assets (A decrease is Current Assets is added to NI) + Increase in Current Liabilities (An increase in Current Liabilities is added to NI) – Decrease in Current Liabilities (A decrease in Current Liabilities is deducted from NI) !

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

= Net Cash Inflow (or Outflow) from Operating Activities!!

!

!

!

!

!

Once the operating activities section has been completed, the investing and financing activities sections can be prepared. Non-cash investing and financing activities are reported in a separate schedule in the statement of cash flows. They are transactions arising when firms make investments that do not require cash and/or obtain financing other than cash, i.e., firm issues shares to acquire a building. The statement of cash flows prepared using the direct method converts each item in the income statement to a cash flow, i.e., sales are converted to cash receipts from sales, etc. Of course, the net cash inflow from operating activities is the same whether the statement is prepared by the indirect or direct method. The following is an example of how a Cash Flow Statement is prepared from a Profit and Loss Account and Balance Sheets. Please study this example carefully,

126

The Statement of Cash Flows

as this serves as an example of the Vertical Form Balance Sheet, Profit and Loss Account Statement and Cash Flow Statement. It is important to observe that the cash flow compares Balance Sheets as on two dates and determines the cash inflow or outflow or none at all. It is, therefore, more convenient to plot the Balance Sheets on two dates in a vertical form. The information from the statement of profit and loss and balance sheet is provided to show how the statements of cash flows under the direct method and the indirect method have been derived. Note that neither the statement of profit and loss nor the balance sheet is presented in conformity with disclosure and presentation requirements of applicable laws and accounting standards. It is important to understand the manner in which the various figures appearing in the cash flow statement are derived. The working notes given do not form part of the cash flow statement. !

!

1 Add

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

!

non-cash expenses such as depreciation back to net income

2 Since

the entire cash effect of gains or losses on fixed assets will be reported in the Investing Section of the statement of cash flows, the effect of these sales must be removed from the Operating Activities section. 3 Changes

in current asset (other than cash) and current liability accounts result from operating activities. For example, changes in Accounts Receivable result from Sales on Account. Thus we have to account for these changes in the operating activities section. An increase in accounts receivable is deducted from net income because more sales revenue has been included in the income statement than has been collected from customers. Similarly, decrease in Accrued Liabilities is subtracted from net income because payment of a current liability causes both cash and the liability to decrease.! ! ! ! ! ! ! 
 ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

127

The Statement of Cash Flows

Examples for Cash Flow: • When the current asset increases, there is an increase in working capital. Similarly when there is a decrease in current asset, there is a decrease in working capital. • Similarly, when there is an increase in current liability it results in decrease in working capital and vice versa. • An increase in working capital indicates an outflow of cash. And a decrease in working capital indicates inflow of cash. Based on the above example indicate whether the following transactions will result in the inflow of cash or an outflow of cash, or it will not affect the cash flow. a. Purchased goods on credit b. Sold goods on credit c. Purchased goods for cash d. Sold goods for cash e. Collected cash from debtors f. Paid to creditors g. Purchased machinery h. Repaid long term loan i. Issued shared for cash j. Issued bonus shares

There are certain transactions which will have the effect of reducing the profit but will not affect the cash flow. Such charges are known as ‘non-cash charges’. For eg. When we charge depreciation on the assets there is no outflow of cash but the profit gets reduced. Based on the above example indicate whether the following transactions will result in an inflow of cash or an outflow of cash, or it will not affect the cash flow.

128

The Statement of Cash Flows

a. Sold old machinery b. Goodwill written off c. Transferred to General Reserve d. Refund of Excess Income Tax Paid e. Bad debts written off f. Sold investments at a loss g. Loss by fire h. Loss by theft i. Preliminary expenses written off

5.4 SUMMARY The statement of cash flows is one of the principal financial statements required by GAAP. It gives an opportunity to see how good is the company in realizing adequate cash flows from its main operating business. The statement shows cash flows from operating, investing and financing activities. The statement is prepared using a direct or indirect method. Under indirect method, it is prepared by comparing two balance sheets prepared on the first and last date of the period for which it is prepared. The process starts from the net income and additions and subtractions are made for depreciation, loss/gain on assets disposed, changes in current assets and liabilities. After operating activities are completed the investing and financing sections are prepared. In the direct method each item on he income statement is converted into cash flow.

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The Statement of Cash Flows

5.5 SELF ASSESSMENT QUESTIONS From the following Balance Sheet you are required to prepare a Cash Flow Statement: Liabilities

31.03.2006

31.03.2007

Rs.

Rs.

Share Capital

275000

325000

P. & L. A/c

10000

23000

Account Payable

70000

45000

355000

393000

Machinery

100000

116000

Debtors

120000

115000

Raw Material

80000

90000

Cash

55000

72000

355000

393000

Assets

HINT: a. Compare the Balance Sheet as at 31.3.2006 and 31.3.2007. Note the changes that have taken place. b. Determine the Increase / Decrease in Working Capital. And determine thee Cash Used For Operations. c. Proceed to determine cash flow from investing activities. d. Proceed to determine the cash flow from financing activities. e. Work out the cash at beginning of year and at the beginning of year. Amalgamate (c) and (d).

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The Statement of Cash Flows

REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video

131

6 Accounting for Inventory

Objectives: After completing this chapter, you will be able to understand: • Inventory Systems. • Inventory Costing. • Principles of Inventory Valuation.

132

Accounting for Inventory

Structure: 6.1 Introduction 6.2 Inventory Systems 6.3 Inventory Costing 6.4 Closing Stock Valuation 6.5 Summary 6.6 Self Assessment Questions

133

Accounting for Inventory

6.1 INTRODUCTION The general model of an income statement of a trader takes the following form: Sales Revenue Less Cost of Goods Sold Equals Gross Profit Less Operating Expenses Equals Net Income In discussing accounting, we need to consider Inventory. Traders purchased inventory and resell it. Manufacturers, on the other hand, purchase raw materials and packing materials, process them and create finished goods, which are then sold. For both these types of businesses, accounting for inventory is critical. Inventory affects both the balance sheet and the income statement. Inventory that is sold is expensed on the income statement as Cost of Goods Sold whereas inventory unsold at year-end is shown as a current asset on the balance sheet. Companies cost inventory by multiplying the number of units by the cost per unit. The model of cost of goods sold takes the following form:

Beginning Inventory



+ Purchases



= Goods Available



– Ending Inventory



= Cost of Goods Sold

The inventory of finished goods on 1-4-2007 of A Ltd. was 25 Units valued at Rs. 1,00,000. It acquired 22 Units during the month at the total cost of Rs. 93,500. The inventory as of 30.4.2007 is 19 Units valued at Rs.80,750. From this, one can work out the Cost of Goods Sold.

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Accounting for Inventory

Qty.

Value

Nos.

Rs.

Inventory as on 1.4.2007

25

100000

Add: Purchases

22

93500

47

193500

Less: Inventory as on 30.4.2007

19

80750

Cost of goods sold as on 30.04.2007

28

112750

6.2 INVENTORY SYSTEMS There are two principal types of inventory systems, the periodic system and the perpetual system. The periodic system is used by companies, which sell relatively inexpensive goods and do not need to accurately track inventory throughout the year. Most companies use the perpetual system because it provides a detailed record of inventory throughout the year. The accounting differs depending on what system of inventory a firm is using. We will concentrate on the perpetual inventory system. The journal entry to record purchases of inventory is:

Inventory





To Accounts Payable (or Cash)

Note that two journal entries are required to record a sale as follows:

Accounts Receivable (or Cash)





To Sales Revenue

AND 135

Accounting for Inventory



Cost of Goods Sold





To Inventory


 Since Inventory is debited when goods for resale are purchased and credited when goods are sold, the Inventory account keeps a running balance of Inventory on hand. In actual practice, the accounting for Inventory may be a little more complicated than the general model above, as we need to properly account for Freight Inwards, Purchase Returns, Purchases Allowances, and Purchase Discounts, not to speak of other complexities like costs incurred after receipt of goods, quality control rejections, goods sent out to third parties for processing, spoilage, process-waste and by-product accounting, and so on. The computation for net sales is as follows: Gross Sales – Sales Returns and Allowances – Sales Discounts = Net Sales Rs. Gross Sales Less: Sales Returns and Allowances Sub-Total Less: Sales Discounts Net Sales

125000 9300 115700 5000 110700

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Accounting for Inventory

6.3 INVENTORY COSTING Proper inventory costing is important because the Cost of Goods Sold is typically the largest expense on the trader’s and manufacturer’s income statement and inventory is often the largest current asset on the balance sheet. Inventory costing is complicated by the fact that the unit cost of inventory commonly changes throughout the accounting period. Generally Accepted Accounting Principles (GAAP) provide for a number of acceptable inventory costing methods including: Specific Identification (where possible and feasible) Average Cost FIFO (First In, First Out) Specific Identification: The inventory is valued at actual cost of each unit of inventory identified. It may be possible in high value inventories where Identification is possible. Average Cost: Here, the value of inventory is taken on average cost. All the costs incurred to bring the inventories to their present location and conditions are incurred. All costs incurred in respect of the stock of the inventory are added up and are then divided by the number of units in stock. The simple average cost of inventory of 4 units acquired each at Rs. 8.00, Rs. 8.30, Rs. 8.50 and Rs. 8.80 would go as under: [ 8.00+ 8.30 + 8.50 + 8.80 ] = Rs. 33.60 / 4 = Rs.8.40 When the stock of inventory is 1200 units, the value thereof @ Rs. 8.40 would be Rs. 10,080/-. In practice, it is preferred to use the weighted average cost for valuation purposes.

137

Accounting for Inventory

Weighted average cost: Quantity

Rate

Cost Rs.

1100

10.00

11,000

500

10.25

5,125

600

10.00

6,000

750

10.50

7,875

400

10.40

4,160

3350

34160

Weighted average cost

34160/3350 i.e. Rs.

10.20

There are other methods also, like LIFO (Last In, First Out). Other than the above three methods, no other method is approved by Indian GAAP. Under FIFO, the first units acquired are assumed to be the first units sold. Advantages of this method in a period of rising prices include: • Always reports current cost for Ending Inventory. • Reports higher net income. Disadvantages of the FIFO method include: • Violates the matching principle (FIFO matches some of the previous year's inventory cost against current revenue.) • Results in higher taxes and lower cash flows. • Does not adjust Cost of Goods Sold for the effect of inflation. The following would illustrate the operation of FIFO.

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Accounting for Inventory

The materials were purchased in lots on various dates in different rates. These are issued to consumption in different quantities. The rates charged on quantities issued to consumption are different from what they were when purchased. Issues to consumption are made on the assumption that these came from the oldest lot in balance. Cost of such oldest lot is charged to consumption. Assuming Opening Stock of 300 Units valued at Rs. 3.25 per Unit, observe the following: Lot No.

Date

Quantity

Rate

Amount

Op St.

300

2.95

885

1

1-Jan

1950

3.25

6,338

2

5-Jan

2600

3.90

10,140

3

7-Jan

2250

2.93

6,581

4

11-Jan

1300

3.58

4,648

5

15-Jan

3900

2.60

10,140

Total

12300

38731

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Accounting for Inventory

From the above, the material issued for consumption is as follows:







Date





Quantity Issued









03-Jan





1700









06-Jan





2100









09-Jan





500

















700









16-Jan





1400



















150



















1250



















50



















450









22-Jan





2150









Total







10450

140

Accounting for Inventory

The following would show how Each Lot is consumed: L1 Incl. Op. Stock

L2

L3

L4

L5

1400 550 1550 500 550 150 1400 150 550 700 50 450 100 2050

Total Issues

1950

2600

2250

1300

2050

Purchases

1950

2600

2250

1300

3900

0

0

0

0

1850

Bal.

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Accounting for Inventory

The FIFO method would value the materials issued for consumption as follows: Date 3-Jan

6-Jan

9-Jan

16-Jan

22-Jan

Total

Quantity Issued 1700

Out of Lot No.

Qty.

Rate

Rs.

Op St.

300

2.95

885

Lot1

1400

3.25

4550

Lot1

550

3.25

1788

Lot 2

1550

3.90

6045

500

Lot 2

500

3.90

1950

700

Lot 2

550

3.90

2145

Lot 3

150

2.93

439

1400

Lot 3

1400

2.93

4095

150

Lot 3

150

2.93

439

1250

Lot 3

550

2.93

1609

Lot 4

700

3.58

2503

50

Lot 4

50

3.58

179

450

Lot 4

450

3.58

1609

2150

Lot 4

100

3.58

358

Lot 5

2050

2.60

5330

2100

10450

10450

33921

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Accounting for Inventory

With this, the Value of Closing Stock under FIFO would go as under: Units Op. Stock Add: Purchases

Units

300 12000

Less: Issued to Consumption

12300

10450

Closing Stock

1850

Rate (of Lot No. 5)

Rs.

2.60

Value

Rs.

4,810

The balance stock at the end of 22 January will be 1850 units and under FIFO method if will be assumed to be out of Lot no. 5. Its value will be Rs. 4810 i.e. Rs. 2.60 per unit. Under the LIFO method, the last units acquired are assumed to be the first units sold. Advantages of LIFO include: • Always matches expense and revenues • Results in lower taxes and higher cash flow Disadvantages under LIFO include the following: • Reports lower net income • Reports understated Ending Inventory • Can be used to manipulate income. Hence, frowned upon by GAAP.

143

Accounting for Inventory

6.4 CLOSING STOCK VALUATION For valuation of inventories, the broad guidelines for valuing stocks of manufacturing companies are: 1. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in, the cost of inventories. 2. In determining the cost of inventories, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred. Examples of such costs are: (a) Abnormal amounts of wasted materials, labour, or other production costs; (b) Storage costs, unless those costs are necessary in the production process prior to further production stage; (c) Administrative overheads that do not contribute to bringing the inventories to their present location and condition; and (d) Selling and distribution costs. • Closing stocks of finished goods are generally valued at “cost or market value, whichever is lower”, except when a company is in the business of mining. The mining companies value their stocks at net realisable value. There are several other accounting principles, which are appropriate to be understood at this stage. Consistency Principle: The same accounting methods and procedures must be used period-to-period. Once the entity opts for FIFO method for one year, it is not open to it to go for average method in the subsequent year. Change, if required, must be for valid and compelling reasons and must be effected only with due disclosure and indicating the effect of such change on the net results for the year. Generally, stakeholders and analysts do not regard such changes with favor.

144

Accounting for Inventory

Disclosure Principle: The business should disclose all-important information that would enable financial statement users to make informed decisions about the company. When the information given amounts to suppressing disclosure of important and relevant issues or is of such nature that it can be called ‘under information’ or misleading information then it is not due disclosure. Materiality Concept: A company must perform strictly proper accounting only for items and transactions that are significant to its financial statements. The extent of significance would be highly factual and situational. Prudence, pragmatic view of business and common sense can hold guiding light in this. Significance should not only be reckoned from the view point of current year’s operations, but as what may also be significant in the foreseeable years to come. Conservatism Principle: A company should use the least favorable figure when preparing its financial statements. The Lower of Cost or Market Rule is an application of the conservatism principle. This rules requires that inventory must be written down to market cost when market cost is less than historical cost. An error of overstating (or understating) inventory in year one generates the opposite error in year two. Thus, over a two-year period, total net income for the two-year period is correct. Inventory errors are important and correct net income should be reported in every year. Inventory estimation is often used for interim reports or for insurance appraisal of loss purposes. Closing inventory can be estimated as follows: Opening Inventory + Purchases = Total Inventory Available – Estimated Cost of Goods Sold = Estimated Ending Inventory

145

Accounting for Inventory

For instance, when the opening inventory is Rs. 50,000 and the inventory purchased is worth Rs.1,20,000 and the estimated cost of goods sold being Rs. 1,40,000, it can be estimated that the Estimated closing Inventory shall be Rs. 30000. 6.5 SUMMARY There are two principal types of inventory systems, periodic and perpetual. Periodic system is used for inexpensive goods or where there is no need to track inventory accurately throughout the year. Most companies use the Perpetual system so that they can track inventory throughout the year. Cost of goods sold is the largest expense in the income statement and it is determined by the method used for inventory costing. GAAP approve specific identification, average cost or First in, First out (FIFO) methods of inventory costing. While valuing inventory, interest, selling and distribution, or any abnormal costs are not included. Also principles of consistency, disclosure, materiality and conservatism are to be applied.

6.6 SELF ASSESSMENT QUESTIONS 1. What is the journal entry to record purchases of inventory? 2. How would you arrive at Inventory at the end of the year on the basis of the opening Inventory, the purchases made during the year and the cost of goods Sold during the year. 3. Briefly explain the periodic system and the perpetual system of inventory. 4. What are the inventory costing methods recognised by Generally Accepted Accounting Principles? Explain briefly each method. 5. How does the Consistency Principle affect stock valuation? 6. Briefly discuss the Materiality Concept in the context of stock valuation.

146

Accounting for Inventory

REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video1 Video2

147

7 Accounting for Fixed Assets

Objectives: After completing this chapter, you will be able to understand: • Capital and Revenue Expenditure. • Accounting for Fixed Assets. • Methods of Depreciation.

148

Accounting for Fixed Assets

Structure: 7.1 Why Segregate Between Capital and Revenue? 7.2 Criterion for Distinction 7.3 Capital Expenditure 7.4 Revenue Expenditure 7.5 Deferred Revenue Expenditure 7.6 Capital and Revenue Receipts 7.7 Other Examples 7.8 What Costs Form Part of Fixed Assets 7.9 Machinery Spares 7.10 Fixed Asset Accounting 7.11 Assets Purchased in the Course of the Year 7.12 Units of Production Method 7.13 Written Down Value Method 7.14 Sale of Assets 7.15 Natural Resources 7.16 Impairment of Assets 7.17 Summary 7.18 Self Assessment Questions

149

Accounting for Fixed Assets

7.1 WHY SEGREGATE BETWEEN CAPITAL AND REVENUE? At the outset, we must understand the distinction between a fixed asset and a non-fixed asset. For this, we must first appreciate the difference between Capital and Revenue. Why segregate between Capital and Revenue? The accounting concept of matching costs with revenues has made it relevant for any business to distinguish each of the items of payments as well as receipts as to whether it is of a capital nature or in the nature of revenue. Drawing up accounts for a specific period (accounting period) also necessitates the distinction between capital and revenue in respect of receipts as well as outlays. The importance of this distinction lies in the impact the decision has on the bottomline – the net profit reported by the business. If an expenditure is classified as revenue, the entire amount is treated as an expense of the period in which the expense was incurred, whereas if it was treated as a capital expenditure, then in the current year, only the current year’s depreciation on the capitalised value of the asset is charged as an expense; the rest of the cost is deferred over the life of the asset. Hence, a company wishing to show higher profitability would strain the limits of the concept of capital expenditure, to capitalise as much of its expenditure as possible. Conversely, the tax laws encourage exactly the opposite tendency, because capitalising expenditure would mean that taxable income would be higher than if the same expenditure was treated as an allowable expense. It is logical that the expenses incurred for a given period are matched with revenues earned for the same period through the Profit and Loss Account. Similarly, the payments or disbursements, which are not the expenses pertaining to that period, and receipts, which do not represent the income of that period, should not form part of the Profit and Loss Account and are therefore carried to the Balance Sheet for the adjustment in the next period. Thus, to arrive at true profit earned or loss incurred by the Business during an accounting period and to know its correct financial position, expenditure incurred

150

Accounting for Fixed Assets

and income received, receipt and payments must be distinguished as pertaining to the capital account and the revenue account. A fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.

7.2 CRITERION FOR DISTINCTION There is no single rule of thumb, which can decide the distinction between capital and revenue expenditure and capital and revenue receipt. However, general guideline of principles for distinction can be applied; with regards to the facts of each case. In other words, treatment can vary from case to case.

7.3 CAPITAL EXPENDITURE An expenditure incurred with a view to bringing an asset into existence or an advantage or benefit of an enduring nature for the business is treated as Capital Expenditure and not revenue. For example : i) Expenditure (outgoing) incurred for purchase of a plot of land ii) Expenditure incurred for purchase of plant and machinery iii) Expenditure incurred for development of patents, trademarks, know-how, etc. A payment may be regarded as capital expenditure when it is in connection with fixed capital or for acquiring capital assets. Architect’s fees for the building, payment of stamp duty or lawyer’s fees for purchase of land are examples of capital expenditure.

151

Accounting for Fixed Assets

7.4 REVENUE EXPENDITURE Any expenditure incurred for day-to-day running of the business is treated as Revenue Expenditure; it may be for production, administration, selling or financing. For example, outgoing on purchase of raw materials, rent for factory premises or electricity bills, expenses on printing and stationery, advertisement expenses, interest, bank charges, salaries, etc. are instances of revenue expenditure. Any expenditure incurred for maintenance of a capital asset is revenue expenditure. For example, repainting of factory building, charges for annual maintenance of air conditioners, repairs and replacement of parts of fixed assets like machinery, etc. are few instances of revenue expenditure. A payment is revenue expenditure when it is in relation to the stock -in- trade of the business. For example, transport cost for bringing raw materials to the shop or to the factory or expenditure on conveyance, travel, bus fare, taxi, etc. for the day-to-day running of the business.

7.5 DEFERRED REVENUE EXPENDITURE It is an expression, which has emerged out of the concepts of Accounting Year and matching costs with revenue. Any expenditure which is not in the nature of capital expenditure or does not bring any asset into existence, but yet the benefit of which to the business would be enjoyed over, say, 3-5 subsequent years, such expenditure is termed as Deferred Revenue Expenditure. Basically, such expenditure is of revenue nature, but its benefits accrue beyond the year of incurrence and hence branded as such. Examples are expenditure on advertising campaign for launching a new product.

7.6 CAPITAL AND REVENUE RECEIPTS A capital asset in the hands of one person may still be a trading asset in the hands of another, and similarly a receipt may also vary according to the nature of trade in connection with which it arises. For example, the land on which a 152

Accounting for Fixed Assets

manufacturer has his factory is part of his fixed assets, and its sale would be a capital receipt. However, the land for a dealer in real estate is his stock-intrade, and its sale would be a revenue receipt.

7.7 OTHER EXAMPLES Receipt towards sale of plant and machinery is a capital receipt and receipt towards sale of stock-in-trade is a revenue receipt. Insurance claim received towards theft of a car is a capital receipt; whereas insurance claim received in respect of stock-in-trade destroyed by fire is a revenue receipt. Thus, the treatment of a receipt or an expenditure, whether it is on capital account or on revenue account depends on its context to a business.

7.8 WHAT COSTS FORM PART OF FIXED ASSETS The cost of an item of fixed asset would include: • its purchase price • import duties and other non-refundable taxes or levies paid on such purchase price • any directly attributable cost of bringing the asset to its working condition for its intended use e.g. installation costs i. Expenses directly attributable cost of bringing the asset to its working condition for its intended use: The implementation of a project and upto the trial runs often continue over a long period of time. Expenses incurred in the course of incurring these expenses obviously add to the value of fixed assets in a company’s balance sheet. However, pragmatically speaking, these expenses may not add to the intrinsic value of the asset, in other words, while such

153

Accounting for Fixed Assets

expenses can be capitalised as part of the fixed asset schedule, the resale value of the asset is not going to be impacted by including that amount. ii.Companies do not give the break-up of costs capitalised and added to the value of the asset. These are not shown separately from the actual purchase price of the assets. A conservative view is that it may be prudent to treat such intangible expenses as “miscellaneous expenses not written off’ or “preliminary and preoperative expenses”, instead of being added to the value of fixed assets. iii.Administrative expenses and other general overhead expenses incurred during the construction stage which do not relate to any specific fixed asset are usually excluded from the cost of fixed assets. However, in some circumstances, such expenses as are specifically attributable to the construction of a project or to the acquisition of a fixed asset or to bring it to its working condition, may be included as part of the cost of the construction project or as a part of the cost of the fixed asset. • borrowing cost of funds that finance the asset, such as interest and foreign exchange losses However, to the extent that borrowing such costs (financing costs (including interest) on fixed assets purchased on a deferred credit basis or on monies borrowed for construction or acquisition of fixed assets) relate to periods after such assets are ready to be put to use are not capitalised. An interesting situation can arise where a company finances the entire cost of an asset through its share capital or internal cash accruals. Here, there would be no addition under the head “interest capitalised”. Similarly, if full down, payment were made in foreign currency without resorting to a foreign currency loan, addition to the asset value towards future foreign exchange losses would not be available. From this, one may bear in mind that the value of an asset may be dependent on sources of its finance. • Commissioning and trial expenses capitalised until the commencement of commercial production etc. Any trade discounts and rebates are deducted in arriving at the purchase price of the fixed assets. Similarly, any Government Grants related to specific fixed assets

154

Accounting for Fixed Assets

should be presented in the balance sheet by showing the grant as a deduction from the gross value of the assets concerned in arriving at their book value according to Accounting Standard 12. Where the grant related to a specific fixed asset is equal to the whole, or virtually the whole of the cost of the asset, the asset should be shown in the balance sheet at a nominal value. Alternatively, Government grants related to depreciable fixed assets may be treated as deferred income which should be recognised in the profit and loss account in a systematic and rational basis over the useful life of the asset, i.e., such grants should be allocated to income over the periods and in the proportions in which depreciation on those assets is charged. Generally, the gross capital value of an asset is reduced by the value of the capital subsidy. The self-constructed assets like building which is constructed by the entity on its own or a plant which is installed or constructed by the entity shall be capitalised at costs that are specifically related to the asset and those which are allocable to the specific asset. Where the Fixed asset is acquired in exchange or part exchange should be recorded at fair market value or net book value of an asset given up adjusted for balancing payment, cash receipt etc. Fair market value is determined with reference to asset given up or asset acquired. Often there is temptation or compulsion on the part of many entities to revalue some or all of its fixed assets. Revaluation, if resorted, should be of the class of assets as a whole and not of an individual asset. The basis of revaluation, if resorted, should always be disclosed. The increase in value on revaluation should be credited to Revaluation Reserve account while the decrease should be charged to Profit & Loss Account. Goodwill should be accounted in books of account only when actually paid for by the entity. The Gross book values and the net book values at the beginning and end of the year showing additions, deletions and other movements, expenditure incurred in course of construction and revalued amount if any be disclosed by the entity. The assets should be eliminated from the books of account on disposal or sale or

155

Accounting for Fixed Assets

when it has no utility value. In such a case, the profit/Loss on disposal, shall be recognised on disposal to the Profit & Loss account.

7.9 MACHINERY SPARES Accounting for machinery spares would call for special treatment. Machinery spares which are not specific to a particular item of fixed asset, but can be used generally for various items of fixed assets should be treated as part of any other inventory. Such general purpose machinery spares should be charged to the statement of profit and loss as and when issued for consumption in the ordinary course of operations. However, the machinery spares of the following types should be capitalised being of the nature of capital spares/insurance spares i. Machinery spares which are specific to a particular item of fixed asset, i.e., they can be used only in connection with a particular item of the fixed asset, and ii.Their use is expected to be irregular. Machinery spares of the nature of capital spares/insurance spares should be capitalised separately at the time of their purchase, whether procured at the time of purchase of the fixed asset concerned or subsequently. The total cost of such capital spares/insurance spares should be allocated in a systematic basis over a period not exceeding the useful life of the principal item, i.e., the fixed asset to which they relate. When the related fixed asset is either discarded or sold, the written down value less disposal value, if any, of the capital spares/insurance spares should be written off. The stand-by equipment shall be treated as a separate fixed asset in its own right and should be depreciated like any other fixed asset.

7.10 FIXED ASSET ACCOUNTING For most companies fixed assets (also called Plant Assets or Long Lived Assets) are extremely important as they constitute a large percentage of total assets in 156

Accounting for Fixed Assets

the balance sheet and the related expenses of depreciation and amortization amount to a substantial expense on the income statement. The general model for accounting for fixed assets is as follows: Asset Account (on Balance Sheet)

Related Expense (on Income Statement)

Land

None

Property, Plant, and Equipment

Depreciation

Natural Resources (like oilfields, mines)

Depletion

Intangibles

Amortization

Land is not depreciable because land is considered indestructible, and cannot be created either. The acquisition cost of fixed assets, includes all expenditures reasonable and necessary to get the asset in place and ready for use. Note that land and building are often purchased for a single lump sum. Since land has an unlimited life and therefore is not depreciated, the accountant must allocate the purchase price between land and building. Revenue expenditures are those incurred for normal wear and tear expenses and are debited to expense accounts. Capital expenditures, on the other hand, are those costs, which improve an asset or extend its life and are debited to the asset account. Depreciation expense can be defined as the allocation of the cost of an asset over its useful life. In order to ensure that the entity properly measure depreciation expense, the accountant needs to know the cost of the asset, and estimate it’s working life(commercial life) and its residual (salvage) value. The adjusting entry to record depreciation takes the following form: !

Depreciation Expense a/c Dr.

!

!

Accumulated Depreciation

157

Accounting for Fixed Assets

Accumulated depreciation is a contra account (its matching pair is the asset account). As the authors note, the use of a contra account allows the original cost to remain unchanged in the balance sheet. Here, the Fixed Asset would keep appearing in the Balance Sheet at its original cost, and the Accumulated Depreciation would go on contracting it to the extent of Depreciation. In actual practice, in place of Accumulated Depreciation, the Fixed Asset a/c itself may be credited by the amount of Depreciation. Generally Accepted Accounting Principles (GAAP) provide for several acceptable methods of depreciation. In this course, we will study three methods: Straight Line, Units of Production, and Written Down Value. Straight line depreciation = (Cost – Residual Value)/Life SL Depreciation allocates an equal amount of expense each year. It can be expressed in rupee or percentage terms. For example, an asset which cost Rs.110,000 and has an expected residual value of Rs.10,000 after 10 years will be depreciated at Rs.10,000 every year for 10 years, calculated as below: (Cost – Residual Value) /Life = (110,000– 10,000)/10.

7.11 ASSETS PURCHASED IN THE COURSE OF THE YEAR Since assets are typically not purchased on the first day of the year, it is necessary to calculate partial year depreciation as follows: 1. Calculate depreciation expense for a full year 2. Multiply full year depreciation by the fraction of the year the asset was in use. To take another example, A Limited has acquired a piece of machinery for Rs. 45,000 on September 1, 2006. It also incurred an aggregate sum of Rs.5,000/towards installation fees and fees of consultants on that date. The depreciation to

158

Accounting for Fixed Assets

be provided on Straight-line basis is at 10%. The Machinery a/c and the Depreciation account for three years would look as under: Depreciation on Straig Straight Line e Basis Basi Rate of Depreciation

10%

Machinery Ma ery A Accountt Date

Debit

1.9.2006 Bank 1.9.2006 Bank

Rs.

Date

Credit

45000 31.3.2007 Depreciation A/c 5000

(Installation Charges)

1.4.2007 Bal. b/d

2,500

(@10% for 6 months on Rs.50,000) 31.3.2007 Bal. c/d

Total

Rs.

50000

Total

47,500 31.3.2008 Depreciation A/c

47,500

50000

5,000

(@10% for 12 months on Rs.50,000) 31.3.2008 Bal. c/d

Total

1.4.2008 Bal. b/d

47,500

Total

42,500 31.3.2009 Depreciation A/c

42,500

47,500

5,000

31.3.2009 (@10% for 12 months on Rs.50,000)

Total

42,500

Bal. c/d

37,500

Total

42,500

159

Accounting for Fixed Assets

The Depreciation a/c for each of the years would be as under: Depreciation Dep tion Account nt Date

Debit

Rs.

Date

Credit

Rs.

31.3.2007 Machinery a/c

2,500 31.3.2007 Profit& Loss a/c

2,500

31.3.2008 Machinery a/c

5,000 31.3.2008 Profit& Loss a/c

5,000

31.3.2009 Machinery a/c

5,000 31.3.2009 Profit& Loss a/c

5,000

7.12 UNITS OF PRODUCTION METHOD The units of production method of depreciation involves two step process: !

1. Calculate the UOP Rate which = (Cost – Residual Value)/Life in Units

!

2. Multiply the rate by actual units used during the period.

For example, if a die which cost Rs.105 million is expected to yield 20 million units of output units over its lifetime, and the residual value is expected to be Rs.5 million, the UOP rate would be (Cost – Residual Value)/Life in Units = (105 – 5)/20 = Rs.5 per unit produced If 200,000 units were manufactured in a year, the depreciation would be Rs. 1,000,000. 7.13 WRITTEN-DOWN VALUE METHOD Under the written-down value method of depreciation, the depreciation is expressed in percentage terms. The following year’s depreciation will be calculated by applying the depreciation percentage to the book value (after depreciation) at the beginning of the period. For example, if an asset, which cost Rs.1,00,000, were to be depreciated at 20% per annum under the WDV method, the first year’s depreciation would be Rs. 20,000. Thus the WDV of the asset at the year-end would be Rs.80,000. The second year’s depreciation would be 20% of Rs.80,000, viz.Rs.16,000 (WDV at 160

Accounting for Fixed Assets

the end of year II – Rs.64,000); the third year’s depreciation would be Rs.12,800 (20% of Rs.64,000) and so on. Taking the example we considered for Straight line method, when the rate of Depreciation is 10%, the Machinery a/c and the Depreciation a/c for three years would look as under: Depreciation on W WDV basis asis Rate of Depreciation

10%

Machinery Ma ery A Accountt Date

Debit

1.9.2006 Bank 1.9.2006 Bank

Rs.

1.4.2007 Bal. b/d

Credit

45000 31.3.2007 Depreciation A/c 5000

(Installation Charges)

Total

Date

2,500

(@10% for 6 months) 31.3.2007 Bal. c/d

50000

Rs.

Total

47,500 31.3.2008 Depreciation A/c

47,500

50000

4,750

(@10% for 12 months) 31.3.2008 Bal. c/d

Total

1.4.2008 Bal. b/d

47,500

Total

42,750 31.3.2009 Depreciation A/c

42,750

47,500

4,275

31.3.2009 (@10% for 12 months)

Total

42,750

Bal. c/d

38,475

Total

42,750

161

Accounting for Fixed Assets

The Depreciation a/c would be: Depreciation Dep tion Account nt Date

Debit

Rs.

Date

Credit

Rs.

31.3.2007 Machinery a/c

2,500 31.3.2007 Profit& Loss a/c

2,500

31.3.2008 Machinery a/c

4,750 31.3.2008 Profit& Loss a/c

4,750

31.3.2009 Machinery a/c

4,275 31.3.2009 Profit& Loss a/c

4,275

The WDV method is approved under the Income-tax law, while the Companies Act in India gives a choice for companies to apply either the SL or WDV method. The WDV method provides for large write-offs in early years of an asset’s life and smaller write-offs in later years. Asset book value is cost minus accumulated depreciation. Note that with the WDV method, residual value is ignored in the first year’s depreciation computation. It is considered in the last year, however, as residual value should not be depreciated. If you were trying to minimize income tax expense, which of the three methods would you select? 7.14 SALE OF ASSETS Since the asset’s life is an estimate made at the time of purchase, it may be necessary to change this estimate of life in later years based on experience or new information. At some point fixed assets are no longer useful and are either discarded, sold, or traded in (exchanged) for another asset. When this happens, regardless of the disposition of the asset, the old asset account must be credited and the old accumulated depreciation account must be debited as the old asset must be removed from the books and records. If the asset is fully depreciated, accumulated depreciated is debited and the asset account is credited thus removing it from the books and records. The necessary accounting entry for this would be:

162

Accounting for Fixed Assets

!

Accumulated Depreciated a/c Dr.

!

!

To Fixes Asset account


 When the Depreciation is credited to Fixed Asset itself, it would not be necessary to pass the above entry. The Fixed Asset concerned would get depleted over time and would get nullified in course of time. Similarly, if the asset is sold mid-year, the depreciation account must be updated. If the sales price is greater than book value, a gain is realized; and if the sales price is less than book value, a loss is realized. The following would illustrate this: In the illustration for WDV method of Depreciation, the WDV of the asset as on 31.3.2004 is Rs.38,475/-. if the asset is sold mid-year, the updating of depreciation account is required. When the sales price is greater than its depreciated book value, the gain is realized and is recorded as: !

Cash / Bank a/c Dr.

!

!

To Fixed Asset a/c


The surplus / gain in Fixed Asset a/c is transferred to Profit on Sale of Asset a/c. !

Fixed Asset a/c Dr.

!

!

To Profit on Sale of Asset a/c
 Machinery Mach ry Account Ac t

Date

Debit

1.4.2009 Bal b/d 2.5.2009 Profit from Sale of Asset a/c

Total

Rs.

Date

Credit

38,475 2.5.2009 Cash / Bank 1,525

40,000

Rs. 40,000

(Sale Proceeds of asset)

Total

40,000

In case of the asset realizing (sales price) less than its book value, a loss is realized. This is represented by debit balance in Fixed Asset a/c, which is sold

163

Accounting for Fixed Assets

out. The loss on sale/ disposal of Fixed Asset is transferred to Loss on Sale of Asset a/c. Machinery Mach ry Account Ac t Date

Debit

1.4.2009 Bal b/d

Rs.

Date

Credit

38,475 2.5.2009 Cash / Bank

Rs. 35,000

(Sale Proceeds of asset) 2.5.2009 Loss on Sale of Asset a/c

Total

38,475

Total

3,475

38,475

When an asset is sold mid-year, the Depreciation from the beginning of the year to the date of its sale is also expensed out. However, Indian tax laws do not favour such a treatment. In the above example, the entire machinery has been sold. Often it may so happen that only one of the machines is sold off and others are used for business. In such a situation, the WDV of the unit sold/disposed off need to be worked out from the date of its purchase/ acquisition till its disposal and that WDV is to be removed from the asset a/c. Continuing the above example, we note that the WDV of the Machinery a/c as on 31.3.2009 is Rs.38,475/-. We assume that the Machinery a/c consists of a number of Machines. One of the Machines is sold for Rs.1,500 on 1.6.2009 while the other Machines continue to remain reflected in the Machinery a/c. The Machine, which is sold on 1.6.2009, was acquired for Rs.12,000 on 1.4.2007. The rate of Depreciation is 10% and WDV method is followed. It is necessary to independently work out the WDV of the machine, which is sold since its acquisition, and work out the loss n sale of the machine.

164

Accounting for Fixed Assets

Balance in Machine a/c which is sold on 1.6.2009 Cost of Acquisition on 1.4.2007 Less: Depreciation FTYE 31.3.2008

Bal. as on 31.3.2008

12000 1200

10800

Less: Depreciation FTYE 31.3.2009

1080

Bal. as on 31.3.2009

9720

Less: Depreciation from1.4.2009 to 31.5.2009 (for 2 months)

162

Bal. as on 31.5.2009

9558

Sale Proceeds on 1.6.2009

1500

Loss on Sale of Machine

8058

165

Accounting for Fixed Assets

Under the circumstances, the Machinery a/c as on 1.6.2009 would appear as under:


Machinery Ma nery Account A nt Date

Debit

1.4.2009 Bal b/d

Rs. 38,475

Date

Credit

1.6.2009 Depreciation

Rs. 162

(on asset sold) 1.6.2009 Sale of Asset

9,558

(WDV of asset sold) 31.3.2010 Depreciation

2,892

( on WDV of 38475-9558) (@ 10%) 31.3.2010 Bal c/d

Total

Total

38,475

25,863

38,475

Sale of Asset As a/c

1.6.2009 Sale of Asset

9.558

1.6.2009

(WDV of asset sold)

1,500

(Sale Proceeds of asset)

1.6.2009

Total

Cash / Bank

9,558

Loss on Sale of Asset a/c

8,058

Total

9,558

166

Accounting for Fixed Assets

7.15 NATURAL RESOURCES The related expense account for natural resources like oil wells and mines is called depletion and the depletion expense is calculated in a manner similar to computing units of production depreciation. The journal entry takes the following form: !

Depletion Expense

!

!

Accumulated Depletion


Accumulated Depletion is a contra asset account whose matching pair is the natural resource asset account. The related expense for intangible assets is called Amortization and it is ordinarily computed by the straight-line method. The journal entry takes the following form: !

Amortization Expense

!

!

Intangible Asset


Note: This entry results in directly crediting the intangible asset thus reducing its basis. Goodwill is recorded only when it is purchased. Goodwill is calculated as the excess of purchase price over the market values of the individual net assets (assets minus liabilities). Goodwill is recorded as an asset and is not amortized. Under US GAAP, FASB’s SFAS 142 requires that goodwill be evaluated annually to see if it has increased or decreased in value. If it has decreased (usually the case) it must be written down by debiting a loss account and crediting Goodwill. Impact of fixed assets on the cash flow statement In the Operating Activities Section, depreciation and amortization expense must be added back to net income, as they are non-cash expenses. Cash expenditures received or paid for the sale or purchase of fixed assets are included in the Investing Section of the cash flow statement.

167

Accounting for Fixed Assets

7.16 IMPAIRMENT OF ASSETS An asset is impaired when the carrying amount of the asset exceeds its recoverable amount. “Impaired assets” are assets with a fair value or productive value that is lower than the book value. Accounting for Impairment of assets is basically same as revaluation, where assets are carried at net realizable value, with the only difference that in revaluation, the realizable value is higher than cost price whereas in impairment, the realisable value is lower than cost or book value. ‘Impairment of assets” is in essence the opposite of revaluation. While revaluation is not recognized or encouraged, nor accepted as a respectable composition of the net worth of an enterprise. However, the impairment of assets need to be recognized as an expense to be routed through the profit and loss account, and thus reflected in the net worth of a company. An enterprise should assess whether there is any indication that an asset may be impaired. If any such indication exists, the enterprise should determine impairment loss if any. The impairment loss, so determined, should be adjusted against opening balance of revenue reserves being the accumulated impairment loss relating to periods prior to the years in which impairment is determined as having taken place. In case of revalued assets, an impairment loss should be recognized directly against any revaluation surplus for the asset to the extent that the impairment loss does not exceed the amount held in the revaluation surplus for that same asset. If the impairment loss exceeds the amount held in the revaluation surplus for that same asset, the excess should be adjusted against the opening balance of revenue reserves. Any impairment loss arising shall be recognized in the statement of profit and loss, unless an asset is carried at revalued amount. An impairment loss on a revalued asset should he treated as a revaluation decrease.

168

Accounting for Fixed Assets

7.17 SUMMARY Fixed Asset is an asset held with the intention of being used for the purpose of producing and providing goods or services and is not held for sale. Distinction between capital and revenue of each transaction is necessary to conduct exercise of matching costs with revenues. If expenditure is considered revenue, it fully decreases profit for the period. But if it is capital, only current year’s depreciation of it is charged to the current year’s profit. There is no single rule of thumb, which can decide the distinction between capital and revenue. An expenditure, which is an advantage or benefit of an enduring nature for business ( like land, plant and machinery or patents, trademarks etc.), is treated as capital expenditure. A payment in connection with a fixed capital, like architect’s fees for building, is also a capital expenditure. Any expenditure for day to day running of the business, purchase of the raw materials, factory rent or for maintenance of a capital asset is revenue expenditure. One must remember that a fixed asset (plant and machinery) for one person can be a trading asset for another (machinery manufacturer). When any expenditure provides benefit to the business for about 3 to 5 years, but does not bring any asset into existence, it is termed deferred revenue expenditure. Typical example is advertising campaign for launch of a new product. Total cost of a fixed asset includes its purchase price, all taxes and duties paid, finance charges paid, commissioning expenses. Expenses incurred prior to commencement of business are not added to costs of fixed assets, but clubbed together as pre-operative expenses and charged to profits of subsequent years. Machinery spares are normally treated as a part of inventory and expensed when put to use. Excepting Land, which is a never expensed asset, other assets like plant, machinery; vehicles are expensed through depreciation, natural assets by depletion and intangibles by amortization. 169

Accounting for Fixed Assets

Depreciation is normally calculated by unit of production method or written down value method. When the asset is fully depreciated, it is removed from books by passing necessary entries.

7.18 SELF ASSESSMENT QUESTIONS 1. Distinguish between Capital and Revenue expenditure. 2. What do you understand between matching costs with revenues? 3. How the bottomline is affected when an item of expenditure is treated as revenue expenditure as against when it is treated as capital expenditure? 4. Briefly explain the concept of Deferred Revenue Expenditure. 5. What difference would it make if a company decides to not provide for depreciation in its accounts for one year? 6. Do you agree that the Depreciation and Amortization mean the same? Why? 7. H. B. Industries Ltd. acquired the following machines: • On 2nd June 2004 one machine for As. 1,30,000 • On 1st October 2004 one machine for Rs. 3,25,000 on which Rs.15,000 were spent on installation. • A machine on 1st April 2005 for Rs. 2,20,000 The Company charges depreciation on its machines @ 15% p.a. following WDV method. On March 30, 2006, the first machine is sold for Rs. 80,000. On November 11, 2006, the second machine meets with an accident and the Company is able to recover Rs. 45,000 from Insurance Company.

170

Accounting for Fixed Assets

The company follows financial year as its accounting year. You are required to prepare the machinery account, depreciation account, Accumulated Depreciation account and Machinery Sale account from 2004-05 to-2007-08. 8. M/s Atlas Car Hire Company Ltd. follows financial year as its accounting year. They charge depreciation on its cars given for hire @ 25% p.a. and follow WDV method. The following transactions need your consideration. On 1st April 2004 one car is purchased for Rs. 4,50,000 and 40,000 is spent on its accessories, which are also capitalised. On 14th April 2005 one car is purchased for RS. 7,50,000. On September 30, 2006 the first car is sold for Rs. 2,25,000 and on September 30, 2006 a new car is purchased for As. 4,35,000. On March 15, 2007, the second car is also sold off for Rs. 3,25,000 and another car is purchased for Rs. 6,50,000. You are required to prepare the car account, depreciation account, Accumulated Depreciation account and Carry Sale account from April 2004 to 2008.

171

Accounting for Fixed Assets

REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video1 Video2

172

8 Current and Long Term Liabilities

Objectives: After completing this chapter, you will be able to understand: • Short and long Term Liabilities. • Contingent Liabilities.

173

Current and Long Term Liabilities

Structure: 8.1 Introduction 8.2 Categories of Liabilities 8.3 Contingent Liabilities 8.4 Bonds 8.5 Methods to Raise Finance 8.6 Summary 8.7 Self Assessment Questions

174

Current and Long Term Liabilities

8.1 INTRODUCTION A liability can be defined as an obligation to transfer assets or to provide services in the future. The accounting for liabilities can be extremely important as liabilities are often a significant amount when compared to total assets or compared to total stockholders’ equity. Liabilities arise from past transactions, i.e. !

Sample adjusting entry for Year X1:

!

!

Salary Expense

!

!

!

Salary Payable


By means of this entry, salaries owed but not paid in Year X1 will be expensed in Year X1. Salary Payable will be reflected as a current liability on the 12/31/ X1 balance sheet. The entry to pay the liability in Year X2 will be: !

!

Salary Payable

!

!

!

Cash

8.2 CATEGORIES OF LIABILITIES There are two broad categories of liabilities: current and long term. Current liabilities are obligations due within one year. All other liabilities are classified as long term. There are two types of current liabilities—known amounts and estimated amounts. Typical current liabilities of known amounts include the following: • Accounts Payable • Short Term Notes Payable • Sales Tax Payable • Current Portion of Long Term Debt

175

Current and Long Term Liabilities

• Accrued Expenses (accrued liabilities) • Payroll Liabilities • Unearned Revenues Examples of current liabilities, which must be estimated, include: • Estimated Warranty Payable 


8.3 CONTINGENT LIABILITIES Contingent liabilities are potential obligations. If the contingent liability is probable and can be reasonably estimated, it should be shown in the financial statements. Important contingent liabilities, which do not meet this standard but are reasonably possible, should be reported in a footnote.

8.4 BONDS As indicated above, long-term liabilities are those obligations not due within the forthcoming year. Bonds are an important type of long-term liability. Bonds (or Debentures) are essentially notes payable representing money borrowed by a corporation or governmental entity from the investing public. Bondholders/ debentureholders loan their money for a price – interest – often paid on a semiannual or annual basis. Investors buy and sell bonds on a daily basis through the bond markets. However, the market for corporate bonds in India has not yet developed as much as its equity markets have, and are nowhere near the breadth and depth of corporate bond markets in the US. Much of the bonds traded in Indian debt markets are Government Bonds, issued to finance the Government’s deficit. Since bond investors pay money now to purchase bonds in anticipation of interest and principal payments to be received in the future, we must now consider the time value of money. Two interest rates, (1) the contract interest rate and (2) the market interest rate, interact to set the price of a bond as follows:

176

Current and Long Term Liabilities

• Bonds sell at par when the market interest rate = the contract interest rate • Bonds sell at a discount when the market interest rate > contract interest rate • Bonds sell at a premium when the market interest rate < contact interest rate Bonds are issued in the marketplace at par, at a discount, or at a premium. Bond prices are quoted as a percentage of their maturity value, i.e. a Rs.1000 bond selling at Rs.980 is quoted at 98. As a bond nears maturity, its market price moves toward par value. On maturity (redemption) date, the market price of bonds will equal its par value. Bond discount really represents additional interest expense and bond premium really represents a reduction in interest expense. There are two methods to account for bond discount or bond premium, but we will not be discussing these here as it is not part of your syllabus for this course. Discount on Bonds Payable is a contra account for Bonds Payable. The carrying value of a bond payable equals the face amount of the bond less the balance in the contra account. The carrying value of a bond issued at a premium equals the face amount of the bond plus the balance in the Premium Account. Both, the bond carrying value and the periodic interest expense increase over the life of bonds issued at a discount. At the maturity date, the bond carrying value equals face value of the bond. Both, the bond carrying value and the periodic interest expense decrease over the life of the bonds issued at a premium. At the maturity date, the bond carrying value equals the face value of the bond.

8.5 METHODS TO RAISE FINANCE A corporation can raise funds to finance expansion by 3 methods: 1) Sell stock - sell shares of ownership - Equity Capital 2) Incur debt - Debt Capital

177

Current and Long Term Liabilities

Notes Payable: promissory notes issued by firm to borrow money from a single lender, like a bank. Bonds Payable: groups of notes payables issued to multiple lenders called bondholders. 3) Reinvest earnings and profits Of these, only the second method would qualify for being called long-term liabilities of the business. The first and the third one are referred to as owners’ equity or owners’ net worth.

8.6 SUMMARY There are two broad categories of liabilities: current and long term. Current liabilities are obligations due within a year. All other liabilities are long term. Current portion of long term debt is also current liability. Potential obligations are termed ‘contingent liability’. If it can be measured, it should be shown in the financial statement as a footnote. Bonds are an important type of long term liability. Investors loan their money to purchase a bond for a price – interest – often paid on semi-annual or annual basis. Bonds are bought and sold on a regular basis. In India, markets for bonds are not as developed as those for equity. Bonds are traded at a premium or discount, depending upon whether market rates of interest are above or below contract rate of interest. A corporation can raise long term funds by issue of equity, debt instruments or reinvesting profits earned. Of these, second option can be called long term liability.

8.7 SELF ASSESSMENT QUESTIONS 1) Briefly explain the current liabilities.

178

Current and Long Term Liabilities

2) What are the major components of current liabilities? 3) How would you distinguish the current liabilities from Contingent liabilities? How are the two disclosed in the Balance Sheet? 4) How would you deal with the long-term liabilities, which are due to mature within one year? 5) What is the relation between the contract interest rate and the market interest rate? 6) How time value of money impacts the Bonds issued by corporates?

179

Current and Long Term Liabilities

REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video

180

9 Inflation Accounting Objectives: After completing this chapter, you will be able to understand: • Necessity for Inflation Accounting. • Methods of Accounting for Inflation.

181

Inflation Accounting

Structure: 9.1 What is Inflation? 9.2 Why Inflation Accounting? 9.3 Methods of Accounting for Inflation 9.4 Current Purchasing Power.(CPP) 9.5 Illustration 9.6 Economic Value Method 9.7 Summary 9.8 Self Assessment Questions

182

Inflation Accounting

9.1 WHAT IS INFLATION? Inflation means an upward change in the prices of goods and services of general consumption. Prices reflect the value of goods and services in the economy. Price changes occur when the price of goods and services vary from what they were previously in the same market. Price changes can be classified as: a) General, b) Specific and c) Relative price changes.
 General price changes reflect increases or decreases in the value of the monetary unit. The change takes place due to the total supply of goods and services in the economy, by an imbalance in the total supply and demand of goods and services in general, or by changes in general prices of basic commodities.

9.2 WHY INFLATION ACCOUNTING? Inflation Accounting seeks to address the inherent limitations of historical cost accounting. Under historical cost accounting, the profit figure is derived by matching costs against current revenues. Such costs are actually historical costs and not current costs. For example, purchases, depreciation, etc. are shown at historical costs. This results in understatement of cost and overstatement of profit in an inflationary situation. The need for inflation accounting was therefore felt to formulate a superior accounting system to reflect the effect of changing price levels. Specifically, the need for accounting for inflation arose due to the following reasons: i) Inflation adjusted profit: The profit and loss account, under historical cost accounting, does not bear proper charges, particularly for depreciation and cost of materials consumed. This results in a high ‘paper profit’. If this inflated ‘paper profit’ is distributed

183

Inflation Accounting

by the companies to shareholders as dividends, this may lead to capital erosion. In order to arrive at the ‘real’ profit, current costs should be matched against current revenue. ii) Replacement of Assets Under historical cost accounting, depreciation charged on fixed assets is inadequate to finance the replacement of those assets. By replacement, it is not generally meant the replacement of one asset by an identical new one, but the replacement of the operating capability represented by the old asset. Also, historical cost depreciation does not fully represent the value of the asset consumed during the accounting year. For example, if an asset were purchased on 1st January 2003 for Rs. 10,00,000 having a life of 10 years with no residual value, the annual depreciation charge under historical cost accounting would be Rs. 1,00,000 (assuming SLM depreciation). At the end of the year 2003, the written down value of the asset would be shown in the Balance Sheet at Rs. 9, 00,000. But the replacement cost of the asset at the end of 2003 might be Rs. 11,00,000. Therefore, actual depreciation under current cost should have been Rs. 1,10,000 (10% of 11,00,000) and not Rs. 1,00,000. Also, at the end of the life of the asset accumulated depreciation based on historical cost of Rs. 10,00,000 would be insufficient to replace that asset. iii) Maintenance of real value of capital: Maintenance of capital means maintenance of: a) Financial Capital and b) Physical Capital. Financial Capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. In historical cost accounts, although capital is maintained in nominal money terms, it may not be maintained in real terms. Maintenance of capital in real terms means maintenance of either financial capital in constant purchasing power or physical capital. Under the concept of financial capital maintenance

184

Inflation Accounting

where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. But in an inflationary situation, mere maintenance of money capital has no meaning. The profit arrived at after maintaining money capital is not real profit, and any decision taken on the basis of the ‘paper profit’ will be misleading. iv) True and Fair view: The primary objective of financial statements is to give a true and fair view of the profit or loss for the accounting period, and true and fair value of assets and liabilities as at the end of the accounting period. These objectives are not fully achieved from financial statements prepared under historical cost basis. For example, fixed assets are shown in the Balance Sheet at their historical costs (less depreciation), which are far lower than the current replacement cost of those assets. v) Effective composition: The profits earned by the company over a period of time are not comparable under historical cost accounting. If a company’ s profit was Rs. 2,00,000 in 1990 and Rs. 15,00,000 in 2000, a shareholder’s initial reaction might be that the company has performed well. If, subsequently, the shareholder discovers that with Rs. 2,00,000 in 1990 he could buy exactly the same goods as with Rs. 20,00,000 in 2000, the apparent growth is not impressive. For effective comparison we require inflation-adjusted data.

9.3 METHODS OF ACCOUNTING FOR INFLATION There are basically two major methods of accounting for price level changes as below: a) Current Purchasing Power (CPP) and b) Current Value Systems.

185

Inflation Accounting

9.4 CURRENT PURCHASING POWER (CPP): The CPP accounting was the main system of inflation accounting favoured by the accounting profession in the early 1970’s. The fundamental aim of CPP accounting is to show the effect of inflation in the purchasing power of the equity interest. Profit is only recognised after this purchasing power has been maintained in real terms as measured by a general price index. CPP accounts are derived directly from historical cost accounts and are, therefore, largely based on generally accepted accounting principles. Following are the steps for producing CPP accounts: a) Figures for items in the balance sheet (under historical cost) at the beginning of the year are converted into rupees of purchasing power at the beginning of the year as below: 1) Non-monetary items are adjusted for changes in the purchasing power of rupee since they were acquired or revalued; 2) Monetary items (Current Assets, Current Liabilities etc.) are, by definition, already expressed in terms of purchasing power at the beginning of the year, and therefore, require no conversion. b) The items in the balance sheet at the beginning of the year [after considering step (a) above] are then updated from rupees of purchasing power at the beginning of the year to that at the end of the year. c) Figures for items in the balance sheet at the end of the year are converted into rupees of purchasing power, at the end of the year in the same manner as followed in step (a) above. d) The difference between the total equity interest in the converted balance sheets at the beginning and end of the year (after allowing for dividends and introduction of new capital) is the profit or loss for the year measured in current purchasing power. e) The profit and loss account can be prepared to get inflation-adjusted profit or loss by expressing the relevant figures in rupees of purchasing power at the end of the year. The converted profit and loss account should contain a figure 186

Inflation Accounting

for net loss or gain in purchasing power resulting from the effect of inflation on the company’s net monetary assets or liabilities.

9.5 ILLUSTRATION: A Ltd. has prepared its historical cost accounts for the year ended 31 March 2006, and 31 March 2007. These are reproduced below: Balance Sheet As on 31.3.2006 (Rs. in 000)

As on 31.3.2007 (Rs. in 000)

Non-Monetary Assets: Fixed Assets (At cost less depreciation)

650

725

Stocks at cost (based on FIFO)

220

250

Net Monetary Assets:

250

350

1120

1325

Equity (i.e. Share Capital and Reserves & Surplus)

Profit and Loss Account for the year ended 31st March, 2007 (Rs. in 000)

(Rs. in 000)

Sales (1760*140/135)

1760

Stock Appreciation

30

Sub-Total Less: Purchases and other expenses Depreciation Net Profit

1790 1510 75

1585 205

187

Inflation Accounting

The index of retail prices has moved as follows: As on 31.3.2005 !

!

115

As on 31.3.2006 !

!

130

As on 31.3.2007 !

!

140

Average for 2006-07 !

135

(All indices are imaginary) Fixed assets as on 31.3.2006 were purchased on 31.3.2005 Fixed assets purchased during the year were Rs. (‘000) 140 when the general price index was 135. Rate of depreciation on fixed assets is 10% p.a. You have to prepare CPP accounts for A Ltd. for the year 2006-2007.

Solution: Step (a): Balance Sheet as on 31.3.2006 
 (Converted into purchasing power of rupee as on 31.3.2006) (Rs. in ‘000) Fixed Assets (650 * 130/115)

735

Stock (see note 1)

220

Net Monetary Assets

250

Equity

1205

188

Inflation Accounting

Step (b) Balance Sheet as on 31.3.2006
 (Converted into purchasing power of rupee as on 31.3.2007) Fixed Assets (735 * 140/130)

792

Stock (220 * 140/130)

237

Net Monetary Assets (250 * 140/130)

269

Equity (1205 * 140/130)

1298

Step (c) Balance sheet as on 31.3.2007
 (Converted into purchasing power of rupee as on 31.3.2007) Fixed Assets (585 * 140/115) + (140 * 140/135)

857

Stock (See Note 1)

250

Net Monetary Assets

350

Equity

1457

Step (d) Therefore, the profit for the year expressed in terms of purchasing power of rupee as on 31.3.2007 (i.e. current purchasing power) is given by difference of equity as per step (c) and (d) above. So, profit = Rs. (‘000) (1457-1298) = Rs. (‘000) 159 Step (e) Profit and Loss account
 For the year ended 31st March 2007
 (Converted into purchasing power of rupee as on 31st March 2007)

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(Rs. in 000)

(Rs. in 000)

Sales (1760 * 140/135)

825

Closing Stock

250 2075

Less: Opening Stock (220 * 140/130)

237

Purchases and other expenses (1510 * 140/135)

1566

Depreciation (65 * 140/115) + (10 * 140/135)

90

1893 182

Less: Loss on Monetary items (See Note 2)

23

Net Profit at Current Purchasing Power

159

Note 1: Since FIFO method is followed for determining cost of closing stock, we have assumed that closing stock represents latest purchases. Consequently, closing stock figures are already expressed in current purchasing power and they are not to be converted. Note 2: Loss on Net monetary items: Holding loss on opening net monetary items Rs. (‘000) (269-250) !!

!

!

!

19

Holding loss on net monetary items during the year !

!

!

4

!

!

23

!

!

!

!

!

!

Rs. (‘000) (350-250) * (140/135 – {350-250}) Loss on Net monetary items: !!

!

!

!

!

!

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Inflation Accounting

Current Replacement Cost (Entry Values): In this system, current replacement cost is used as the measurement base, replacement costs are of two types: i) the Current Replacement Cost (CRC) and ii) the Net Current Replacement Cost (NCRC). The CRC refers to the cost at which an asset can be replaced in the normal course of business at the balance sheet date or at the date of sale, whichever is relevant. NCRC is used for conversion of fixed assets only. NCRC Conversion of fixed assets is calculated by determining gross replacement cost at the balance sheet date, less a proportionate deduction for accumulated depreciation. Limitations of Replacement Cost Accounting: The replacement cost accounting suffers from the limitations of: 1) Estimation of current replacement costs at particular dates involves subjective judgments and 2) By itself, replacement cost accounting is not a comprehensive system of accounting for price changes, since it fails to take into account the effect of price changes on monetary items.

9.6 ECONOMIC VALUE METHOD Under this method, the current value of an individual asset is based on the present value of the future cash flows that are expected to result from the ownership of the asset. Such present value of estimated future cash flows can be calculated from the following information: (a) the estimated cash amount of the future benefits; (b) the timing of these benefits; and (c) an appropriate discount factor (e.g. cost of capital to the company)


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Economic value method can only be applied to the business as a whole. Profit could be determined by comparing economic values of net assets at successive balance sheet dates and adjusting for capital introduced. The main charge against this method is that it is based only on estimation. Estimated future cash flows are rarely realizable and are subjective.

9.7 SUMMARY Various systems of accounting for inflation discussed above are not free from flaws. The CPP method was heavily criticized and modified version for accounting for inflation in the form of CCA was introduced. But CCA has its own limitations. In India, the Institute of Chartered Accountants of India has issued a Guidance note on this issue, which also advocated the use of CCA. In India, leading public sector undertakings like SAIL, BHEL, OIL, etc. are preparing inflation adjusted financial statement under CCA as supplementary information. But the inflationadjusted accounts are not legally required in India. Discussion on this subject gained momentum with the rise in the price levels and the tempo died down with the fall in inflation.

9.8 SELF ASSESSMENT QUESTIONS 1) How is the Inflation Accounting different from historical cost accounting? 2) Explain Replacement of Assets concept. 3) Briefly explain the process of conversion of accounts prepared under historical cost basis to inflation-adjusted accounts. 4) Explain salient features of Economic value method of accounting. 5) Visit the websites of companies like SAIL, BHEL, and OIL and study their inflation adjusted financial statement.

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video

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10 Questionable Accounting Practices

Objectives: After completing this chapter, you will be able to understand: • Suppression of Facts through Wrong Accounting Practices.

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Structure: 10.1 Introduction 10.2 Examples of Questionable Accounting Practices 10.3 Self Assessment Questions

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10.1 INTRODUCTION Temptation is ubiquitous in the corporate world. Especially when top management salaries and benefits are linked to better results, and they themselves have significant control over the policies, which can modify the declared results materially. In the last 5 years, an unprecedented number of large corporate collapses have thrown up several cases of corporate greed. Many of these cases showed up multiple irregularities, but we look below at a few selected modus operandi of corporate greed and chicanery, with no attempt to be comprehensive. 10.2 EXAMPLES OF QUESTIONABLE ACCOUNTING PRACTICES To earn personal profits for their directors, Indian Public Limited companies, especially with controls in the hands of families, are also often observed to indulge in inappropriate accounting practices. In most such cases, unfortunately, Statutory Auditors are also managed by the Directors of the companies. Here are a few cases collected from reports over the last two three decades of representative questionable accounting practices followed in the Indian Industry. [*Names of the companies are fictitious] Shivam Computers* Company Ltd., located in Hyderabad, Andhra Pradesh, was engaged in software development, applications and solutions suited to major conglomerates in Indian and overseas markets. Over the years, it accumulated large cash reserves. Instead of ploughing them back into business for expansion or diversification, directors of this reputed IT company, successfully siphoned cash reserves off to its associate companies owned by family members. To support the cash reserves in Shivam Computers, its Chief Finance Officer had a system of presenting Fixed Deposit Receipts for several lakhs of Rupees deposited on long term basis with its bankers. After liquidating deposits and transferring funds, new FD Receipts were forged and presented during periodic audits conducted by the statutory auditors. The sound accounting and auditing procedures were circumvented. Auditors never carried test checks and asked for the data on Fixed Deposits from the

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Questionable Accounting Practices

company’s Banks which were shown to have issued FD receipts! It was later established that statutory auditors of Shivam Computers earned audit fees that were much more than the industry average for companies of Shivam’s size. Make Sure* Company Ltd. was manufacturing aluminium caps and foils for major bottlers and pharma companies in India. Its plant was located in Kurla, a suburb of Mumbai. Its marketing manager booked a large single order almost equal to 20% of its annual turnover with a prominent customer having automated bottling plant in NOIDA , Delhi. Unfortunately, this customer had miscalculated its sales forecast and, hence, was unable to accept delivery against this order. As the financial year end was approaching, the management of Make Sure was not willing to expose its marketing failure nor to show the large stockpile of closing inventory in hand in the year end balance sheet. Its management resorted to another unacceptable accounting practice and recorded sale of the stocks by transferring it to its sole distributor! After two weeks after the year end, the distributor returned the entire stocks citing a minor technical flaw and squared the transaction. Here too, statutory auditors ignored accepted accounting principles and failed to review major accounting transactions for a few weeks from the end of the accounting year under audit to the date of certifying accounts. Nicer Pharmaceuticals* Ltd., a 100% EOU [Export Oriented Unit] owned a world class formulations and tablet making facility in GIDC Kandla, Gujrat. Its order books were always full. But even after operating for over 10 years, the company was not in a position to declared dividends to its share holders spread over India. Nicer did not have its own marketing and distribution arrangements. For this purpose, it relied on its privately owned associates in South Africa and UAE. The shareholders were not receiving returns on their otherwise prudent investments because the Nicer company was invoicing its associates at prices that were one half of the ruling prices for its drugs in the international markets. Profit that should have accrued in the books of accounts of Nicer Ltd., was thus reflected in the books of overseas associates and shared among the brothers holding controlling interest in Nicer Ltd.

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Questionable Accounting Practices

This case would not have come to limelight, but for the disputes among brothers that led to judicial investigations by the then Foreign Exchange Regulation Authorities in Mumbai on receipt of a complaint from an aggrieved brother. Mane Elevators* Ltd. was located in Chennai and manufactured as well as imported escalators, passenger and freight / goods elevators. It had aggressive management and salary package of Chief Operating Executive as well Chief Financial Executive and Marketing President contained large bonus part that varied with company’s performance [read profits]. For the first two years profits were not significant due to fierce competition in elevators market especially from small and local companies. Performance bonuses for these executives were negligible. To change this situation, the CEO of Mane Elevators, compelled marketing department to introduce Price Variation Clause into all its existing and new contracts with its builder customers. The PV clause was introduced to vary selling prices with every change in prices of materials and labour inputs that occurred after the contract was entered into with the customer. The formula was neither spelt in details by the Chief Finance Officer nor explained to customers by the sales force. Naturally no customer would have agreed to the clause or for payments for the PV. But after introduction of the clause, customers were invoiced prices that were much higher than the ones specified in the accepted contracts. The increase in prices was based on rise in material cost and wages as interpreted by the CFO. In the third year, when these higher prices were accounted, the company showed a handsome profit in its published accounts. From the third year of operation, enterprising CEO and CFO/ Marketing President earned [?] handsome high performance bonus for a few years, before they quit to join competition. Raj Electricals* Ltd., was a giant player in the power industry, manufacturing and installing transformers, switch gears, transmission towers etc. It was located in Kolkatta since 1973. The Directors owned about 27% of the equity and shares were traded at P/E ratio of about 18.

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Questionable Accounting Practices

In the last year in which there was a slump in infrastructure sector of the Indian economy, directors observed that the net profits of their company for the year were way below the guidance provided by them in the last press conference. They feared at least 10% drop in share prices after the results would be known to the markets. The company followed percentage completion method for booking revenue on its larger projects of Rs. Fifty lakhs and above. That means sales were recorded in phases as these projects were progressed towards completion. For small projects below Rs. Fifty lakhs each, revenue was recorded in the books of accounts using the completion method. Thus, on these smaller projects no sale was shown and nor revenue recognized until the project was complete. Directors passed a resolution that year in their board meeting before the financial year end, directing Chief Finance Officer to apply the percentage completion method of recognizing revenue in all its ongoing projects without reference to the size and value of the projects. The result was a smart jump in the sales revenue of the company for that year, as sales were recorded for the first time on all projects of up to Rs. Fifty lakhs that were in the pipeline at the close of the year. This provided satisfaction to the directors that they lived to the profit guidance earlier issued by them and confidence to meet the reporters again. Himalaya Entertainments* Company Ltd., is a leader in media industry with its production units in Mumbai, Delhi, Chennai and Kolkatta. It is engaged in producing regional language movies and TV serials. Since beginning it had a huge budget for advertising and publicity through print, radio and electronic media all over India. The company was planning to raise equity capital in the market in 1997 for expansion of its activities in Bangladesh, Nepal and the Gulf countries where Indian viewers had settled. When the date for filing documents for the equity issue approached, investment bankers advised Himalaya’s Board, that the sales and earnings for the year were not attractive enough to ensure full subscription. Director’s held lengthy discussions among themselves and with the auditors. Ultimately the Board advised the Accountant that his method of charging 199

Questionable Accounting Practices

advertising and publicity expenses of a year to that year’s profits was incorrect. He was briefed that benefits from such expense accrue to the company over a long period. The CFO of the company, therefore, capitalized its advertising and publicity expenses in that year and decided to charge the same to profits over a period of next five years. This single questionable practice resulted in increase of Himalaya’s profits for that year by 80% of its advertising and publicity spends. Just for the record, Himalaya Entertainment’s public issue, as predicted by investment bankers to the issue, was three times over subscribed! Then there is another case of Learner and Turner Engineering Works Ltd., employing over 3000 workers in Chakan, near Pune in Maharashtra. The engineering firm, providing auto components to original equipment manufacturers, had a three year old wage settlement with the workers’ recognized trade union which was due for renewal in 2002. Management was expecting a demand for huge wage increase from the Union affiliated to the left political party. Company’s Board held several meetings with their Chief Finance Officer on ways and means to curtail expected wage hike. This firm followed weighted average method to price its material issues since inception. This year, looking at double digit inflation that was prevailing over the year, the CFO proposed to the Board that this method of pricing issues is outdated and be replaced by Last in First Out method used successfully by many American companies. The proposal was accepted by the management as it was going to strengthen their hands at the negotiating table with the Union when bargaining rounds were to start for renewal of the lapsed wage agreement. Material issues charged to revenue were valued in that year at the latest high prices under the Last in First Out system, and inventory in hand at the close of the year was valued at the last year’s low prices. This increased cost of goods sold and decreased the value of closing inventory. When the published audited accounts were released, the Union leaders were astonished to observe that company’s profits for the year had declined.

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Questionable Accounting Practices

Management attributed the fall in profits to pressures on margins in the face of rising competition from local and Chinese engineering units. It was reported that the fresh demands from the Union for the wage increases were toned down by 25%!

10.3 SELF ASSESSMENT QUESTIONS 1) From the above discussion, what do you understand about questionable accounting practice? 2) From the Questionable Accounting Practices followed by various companies mentioned above, what common thread do you find that binds all of them? 3) Do you know of instances of any Indian Company having practiced a questionable accounting practice?

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video

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11 Financial Accounting in Computerized Environment Objectives: After completing this chapter, you will be able to understand: • Computerized Accounting ★ Benefits and Utilities ★ Packages

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Financial Accounting in Computerized Environment

Structure: 11.1 Introduction 11.2 Benefits 11.3 Utilities 11.4 Packages 11.5 Summary 11.6 Self Assessment Questions

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11.1 INTRODUCTION In the preceding chapters, we went through the entire gamut of accounting process. The process would lead one from the basic voucher to the books of prime entries, posting the entries from prime and secondary books to ledgers, compiling the trial balance, treating the adjusting entries and finally preparing the Income Statement for a particular period and preparation of Balance Sheet as at a particular date. The cash flow of the enterprise also can be worked out from the Balance Sheet of two periods and changes in cash position can be attributed to any material financial activity or event. This gives a different perspective to understanding of the financial statements. As the electronic data processing gained ground in late sixties and seventies, the financial accounting had been among the major systems that were computerized. In fact, financial accounting has been the natural beneficiary of the early spread of the EDP revolution. The computerized environment has ideally tackled the volume and repetitive transactions of the accounting system. It is not our aim here to go in to the nitty-gritty of the computer languages that write the accounting programmes. There are many accounting softwares available in the market. We shall try to appreciate the prominent common features that can be found among different accounting packages. 11.2 BENEFITS Different accounting software can have features that may be distinct or unique in being more user-friendly, they all draw from the basic principles and processes of financial accounting that we studied in the preceding chapters. In manual accounting process, the arithmetical accuracy is of paramount concern. Any debit that has no corresponding credit and vice versa can throw the trial balance for a toss. Colossal man-hours must have been lost in tallying the untallied trial balance. The errors of commission and omission in manual accounting process are thankfully non-existent in computerized accounting.

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Some of the most common mistakes that are found in manual accounting system are: • Posting a debit without corresponding credit • Posting a credit without corresponding debit • Posting a debit for a corresponding debit • Posting a credit for a corresponding credit • Transposition of figures in posting like posting Rs.1,520/- as against Rs.1,250/• Mistake in totaling the books of accounts • Posting the entries to wrong account etc. • Mistakes in compiling the trial balance like debits represented as credit, mistakes in totaling etc. One need not bother about these errors in a computerized environment. The arithmetical accuracy of computerized accounting is one of its important benefits. The software is programmed to accept an accounting entry for equal and opposite debits and credits. The errors in casting or totaling are given decent burial. Another advantage of computerized accounting is its ability to handle bulky data processing in real time across different geographical locations. The integration of cross-functional inputs generates meaningful and cohesive information that facilitates the decision-making in real time. There are different accounting packages available in the market that promise a variety of results. The volume of transactions, their frequency and repetitive nature would determine the suitability of the programme. To gain proficiency at using a programme and to judge its efficacy to serve business needs, one has to be comfortable with the basic accounting principles and processes that govern the accounting. Sound knowledge of the needs of the business to have relevant information also helps in evaluating any accounting programme. At the basic level, an accounting software would give Information such as preparing the books of prime entries, preparing ledger accounts, drawing up 206

Financial Accounting in Computerized Environment

the trial balance, preparing the income statement and the balance sheet, the cash flow statement etc. Beyond this, most of the well-known software available seek to integrate the inventory with financial accounting. While integrating the two, the principles of inventory valuation that we saw earlier are incorporated. The software seek to apply FIFO, LIFO, weighted average cost or other appropriate method of stock valuation to inventory and throw the cost of manufacture/ consumption or sale as the case may be.

11.3 UTILITIES Most accounting software would also facilitate the utilities like: • Ability to generate vouchers • Cheque writing facilities • Interest calculations • Aging analysis of debtors and creditors • Cost center analysis • Segment profit/loss • TDS module • Reports for taxation purposes • Reports for other control purposes • Leaving audit trail for fraud detection and control Many enterprises also opt for their custom made software to answer to their unique business processes that may have specific requirements for information. Accounting software would present information by concentrating on logical groups and sub-groups from the components of Balance Sheet and Profit & Loss account. They would also normally provide for navigating from the primary voucher to Balance Sheet and Profit & Loss account and vice versa i.e. from the Balance Sheet and/or Profit & Loss account to a particular voucher. This navigation facility may be considered as true test of the efficiency of the package. It would, of course, be subject to the necessary supervisory controls 207

Financial Accounting in Computerized Environment

for security reasons. The ability of the software to facilitate multi-nodal data feeding and updation in real time across distant locations would also test its efficacy. This can be very crucial. Of course, all these features will have cost aspect and the management will have to take a call on this.

11.4 PACKAGES Many accounting software are available in the market: more popular among them being Tally, Ex-NGn, Trio, ModAct and many others. In addition, there are other industry specific or activity specific software like for Banking, Travel Industry, Financial Portals, for Shares and Stock Brokers, for investors and so on. When one is comfortable with the basics of financial accounting, proficiency in these can be had with little efforts. Beyond these basic accounts processing, the Management Information System (MIS) aims to target specific information analysis that is of strategic importance to the business. This task of information analysis and processing can be unique to each business. The trend is to integrate the financial accounting processes with other business systems and generate information that gives meaningful solutions. Most information systems available seek to span across the entire value chain of the business. We shall call them the Enterprise Resource Planning (ERP) systems. The objective of implementing ERP is to increase revenues and to improve business efficiencies. They aim to integrate the order processing, the accounting, inventory and the issue-consumption-production-dispatch systems. They further go to integrate the vendors and customers into the company’s intranet network, so as to facilitate the B2B operations of the Company. They generate diverse reports, which can be useful at different levels of hierarchy. The access to information generated by the software is also a crucial issue. The information generated through the software is programmed to give access to different levels of hierarchy on a need-to-know basis. Some of these systems are from:

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• SAP’s package • Avalon • JD Edwards • MFG-Pro • Baan • Oracle Application • Ramco Marshal etc. Organizations would undertake study of their ERP needs and gauge their requirement for information across critical functions. It would help them determine which ERP Package would suit them best. The cost of implementing the package can be substantial, and it would cover the cost of the software besides the expenses for setting up the intranet and other hardware. Many Companies have tried to solve their Information processing needs through implementing different packages and have tried to solve issues critical to their businesses. For instance, Marico Industries aimed to streamline their supply chain management through ERP Solution. They aimed to have excellence in distribution performance. ERP was used to facilitate this. The Larsen and Toubro’s Electrical Business Group (L&TEBG) used the ERP Solution to obviate the difficulties faced in managing mainframe-based applications. For them, the ERP also addressed the issue of lack of integration between manufacturing, marketing and accounts systems, which resulted in delays in reconciliation efforts, and lack of response from different units. Their efforts gave them the capability to allow their stockists to access the system of L&T to view stock of finished goods and to place orders for standard products. This B2B capability has given it an edge over competition. In addition, the multilocational plants posed their own problems, which were also addressed. TVS Motors went on to gain efficiency in all their physical activities and review performance on a weekly basis through the ERP system, instead of reviewing it once a month. It later switched on to daily monitoring of performance, which was christened as ‘Supporting lean manufacturing efforts’. Thus, the financial accounting integrated with other business processes goes to influence business strategy and efficacy.

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11.5 SUMMARY As the electronic data processing gained ground along with many other business processes, Financial Accounting was also computerized in the late sixties. Computerization eliminated colossal loss of time caused by errors of commission and omission committed in manual accounting. It also brought about timeliness in availability of the latest financial statements. The utilities offered by computerized accounting start from the ability to generate vouchers to the preparation of final financial statements and in providing reliable audit trails. Several software packages are available in the market on a stand alone basis or as a part of comprehensive Enterprise Resource Planning (ERP). Certain industry specific packages are also being released in the market.

11.6 SELF ASSESSMENT QUESTIONS 1) What are the main functions of accounting software? 2) When the trial balance tallies, the accounts are free from all errors. Do you agree to this? Give reasons for your answer. 3) What factors can help in determining the efficacy of accounting software? 4) Familiarise yourself with one or more of the accounting software known to you. 5) Test your ability to operate some of these software. 6) Visit websites of well-known ERP Solution companies like SAP, Avalon, JD Edwards, MFG-Pro, Baan, Oracle Application etc. and observe the features unique to each.

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter.

Summary PPT MCQ Video

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SUGGESTED READINGS

Financial Accounting for Managers







by T.P.Ghosh

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The Essence of Financial Accounting







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Financial Accounting







by Prof. Harsulkar















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