Accounting primer and IFRS

 

Accounting and International Financial Reporting Standards

 

INTRODUCTION TO ACCOUNTING

  • Accounting involves recording, classifying and summarizing of financial transactions and then interpreting and communicating the results thereof.
  • Though some crude form of accounting existed for thousands of years, modern accounting has largely evolved during the past few hundred years.
  • Sole proprietorship, partnership and the company are the main forms of organizing business. Each of these has their pros and cons but the company form is more suitable for large businesses due to its ‘limited liability’ feature.
  • Various users of accounting information are classified as internal and external users. In addition to the owners, other users of accounting information include managers, lenders, creditors, analysts, prospective investors, the Government and the general public.
  • The three main financial statements are: the ‘profit and loss account’ [or income statement], ‘balance sheet’ [or statement of financial position], and the ‘cash-flow statement’.
  • The two main branches of accounting are financial accounting and management accounting. While financial accounting is primarily meant to provide useful information for external users, management accounting is an integral part of the internal management of a business.
  • Auditing involves a critical examination of the books of account records and financial statements of a business with the main objective of prevention and detection of accounting errors, mistakes and frauds. Audit may be classified into external audit and internal audit.
  • Main limitations of financial statements are: historical nature of information, exclusion of non-financial information, non-disclosure of current values of items and cost-benefit constraint.

 

 

ACCOUNTING CONCEPTS, CONVENTIONS AND POLICIES

 

  • GAAPs are defined as permissible accounting rules and practices for preparing general purpose financial statements.
  • Accounting concepts are classified as: Separate legal entity, money measurement, going concern, historical cost concept, realization concept, accrual and matching principle, accounting period and dual aspect concept.
  • Accounting Conventions are classified as: consistency principle, conservatism principle, full disclosure and materiality principle.
  • Accounts can be recorded using Cash Based Accounting System or Accrual Based Accounting System. The general purpose financial statements are based on the accrual concept.
  • Accounting equation: Assets = Capital + Liabilities.
  • Qualitative characteristics of financial statements include relevance, reliable, comparable and timeliness.
  • GAAPs in India are influenced by the Ministry of Corporate Affairs, ICAI, SEBI, RBI, CAG and provisions of Indian Companies Act and Income Tax Act etc.

Functions of Accounting:

  • Systematic Record of Business transactions:

Accounting is to maintain systematic and chronological record of financial transactions and to post them subsequently to the various Ledger Accounts and finally to prepare the Final Accounts to find out the profit or loss of the business at the end of the Accounting Period.

 

  • Protecting the property of the business:

Accounting is to calculate the correct amount of Depreciation on Assets by choosing the appropriate Method applicable to any particular assets.  Any unauthorized dissipation of any asset will bring the business to the threshold of insolvency. Accounting is to design a desirable system to protect the properties and assets of the business from unauthorized and unwarranted use

 

  • Communicating of the results:

Accounting is always to communicate the results of the recorded and transactions to the different parties who are interested in the particular business, i.e., properties, investors, creditors, employees, Govt. official and researchers etc.

 

  • Compliance with legal requirements:

Accounting is to devise and develop such a system of keeping record and reporting the results as will always meet and legal requirements to enable the proprietor or the authority to file various statements like Income-Tax Returns, Sales-Tax Returns etc.

 

RECORDING TRANSACTIONS IN THE JOURNAL AND THE LEDGER

  • The accounting equation is Assets = Owner’s Capital + Liabilities. It states that the assets of a business would always be equal to the claims of the owners and the outsiders.
  • The dual aspect concept states every financial transaction would affect a minimum of two items in such a way that the assets side would always be equal to the total of capital plus liabilities.
  • The accounting cycle involves the following steps: analyze transactions, journalize, post into the ledger accounts, prepare trial balance, adjustment entries and the financial statements.
  • Double entry rules for assets: debit the asset account to record increases, credit the asset account when the asset balance declines. Rules for liabilities and capital accounts are just the opposite of the rules for assets: credit the liability and capital accounts to record increases, and debit the liability and capital accounts to record a decrease.
  • Revenue for a period amounts to the monetary value of goods and services delivered to customers during the period. Expenses are the monetary value of goods and services used up in earning the revenues of the period.
  • Double entry rules for expenses: an increase in expenses is recorded on the debit side of the respective expense accounts, and a decrease in expenses is recorded on the credit side of the expense accounts. Since revenues by nature are just opposite to expenses, increases in revenues and incomes would be shown on the credit side and a decrease in revenues and incomes would be shown on the debit side.
  • Double entry rules for drawings: the double-entry record for withdrawal of cash from the business by the owner for personal use would be: debit drawings account, credit cash account.

Advantages of Accounting:

  • Complete and Systematic record:  Accounting is based on generally accepted principles and a scientific way of presentation of business transactions in books of accounts. As such, accounting is a complete and systematic recording of all business transactions. The limitations of humans, that they cannot keep all transactions in mind, is overcome by accounting because each and every business transaction can be recorded and analyzed through same.
  • Evidence  in  court: Systematic record of transactions is often treated by the courts as  good  evidence.
  • Determination of selling Price:  The main function of the management is decision making. Accounting helps and guides the management to take decisions in respect of determining selling price, deduction of cost, increase in sales etc.
  • Assistance to various parties: Accounting provides information to the management to enable it to do its work properly. Such information helps in the Planning, Decision making and Controlling.
  • Inter-Firm or Intra- Firm Comparison: Trading and Profit & Loss Account shows net profit earned or net loss sustained by the business. If the accounts are maintained properly, records relating to various expenses, sales, gross profit and net profit etc. can be compared.

Limitations of Accounting:

  • Records only monetary transactions:  Accounting is limited to monetary transactions only. It excludes qualitative elements like management reputation, employee morale, labour strike etc.

 

  • Effect of price level changes not considered:  Money value is bound to change often from time to time. This is a strong limitation of accounting.
  • Personal bias of Accountant affects the accounting statement: Accounting policies are framed by the Accountant. The figures of balance sheet are largely resulted by personal judgment of accountant hence it is the subjective factor that prevails in accounting and objective factor is ignored.

BASIS OF ACCOUNTING:

  • Cash Basis
  • Accrual/ Mercantile Basis
  1. i) Cash Basis: Under this basis, actual cash receipts and actual cash payments are recorded. Credit transactions are not recorded until the cash is actually received or paid.

Limitation:  Does not show actual profits and financial position of the firm.

  1. ii) Accrual/ Mercantile Basis:

In the accrual basis of accounting, the income, whether received or not, but has been earned or accrued during the period forms of the total income of that period.

ACCOUNTING CONCEPTS:

  1. Entity: The affairs of the business are distinct from the personal affairs of its owner. The business is an independent ENTITY.
  2. Money Measurement: Records are kept in monetary terms, and only matters capable of being expressed in monetary terms are reflected in the books.
  3. Going Concern: The business is assumed to have a continuing and indefinite life. The business IS NOT on the verge of extinction.
  4. Cost: Accountants compute the value of an asset by reference to its acquisition Cost, AND NOT by reference to its expected future benefits.
  5. Realization: Any change in the value of an asset may only be recognized at the moment the firm REALIZES it, or disposes of that asset.
  6. Accruals: Accrual accounting attempts to records the financial effects on an enterprise of transactions and other events and circumstances that have cash consequences for the enterprise in the periods in which these transactions, etc., occur rather than only in the periods when cash is received or paid.

 

 

  1. Matching: Revenues and expenses resulting from the same transactions (or events, circumstances, etc.) should be recognized simultaneously.
  2. Periodicity: Accounting reports must be prepared for fixed and relatively short, periods of time.
  3. Consistency: Like transactions should be treated the same way in consecutive periods.
  4. Conservatism:

(i)       The accountant should not anticipate profit, and should provide for all possible losses.

(ii)      Faced with several methods of valuing an asset, the accountant should choose that which leads to the lesser value.

ACCOUNTING EQUATION:

The equation is based on the principle that accounting deals with the property and rights to property and the sum of  the properties owned is equal to the sum of the rights to the properties. The Properties owned by a business are called assets and the rights to properties are known as liabilities or equities  of the business.

ASSETS = LIABILITIES + CAPITAL

 

 

DOUBLE-ENTRY SYSTEM: 

       The double-entry book-keeping system is based on the principle that for every business transaction that takes place two entries must be made in the accounts: a debit entry showing goods or value coming into the business, and a corresponding credit entry, showing goods or value going out of the business.

RULES OF THE DOUBLE ENTRY SYSTEM:

  1. PERSONAL ACCOUNT:
  • These accounts record a business dealing with persons or firm.
  • The person receiving something is given debit and the person giving something is given credit.

 

  1. REAL ACCOUNT:

        

These are the accounts of assets. Assets entering the business is given debit and the assets leaving the business is given credit.

 

  1. NOMINAL ACCOUNT:

       

These account deal with expense and incomes, Profit and losses. Accounts of expenses and losses are debited and accounts of incomes and gains are credited.

 

 

Debit à    the receiver

Personal Account

Credità  the giver

 

 

 

Debit à    What comes in

Real Account

Credità   What goes out

 

 

 

Debit à    Expenses and losses

Nominal Account

Credità   Incomes and gains

 

 

ADVANTAGES OF DOUBLE ENTRY SYSTEM:

 

  1. Complete record of financial transactions is maintained.
  2. It gives accurate information of amount due to and due by the business unit at any time.
  3. It is helpful in preventing frauds & errors.
  4. Arithmetical accuracy of the account books can be tested.
  5. It is helpful in preparing profit and loss account and balance sheet of a firm.

 

ACCOUNTING CYCLE:

 

 

JOURNAL:

  Journal means a daily record of the business transactions. Journal is a book of original entry because transaction is first written in the Journal from which it is posted to the ledger.

LEDGER:

A ledger account may be defined as a summary statement of all the transactions relating to a person, asset, Expense or Income which have taken place during a given period of time

LEDGER FORMAT

Dr                                                                                                                                         Cr

Date

 

Particulars JF Amount Date Particulars JF Amount
 

 

 

To ,Name of Credit A/c Rs  XXXX By ,Name of the Debit A/c Rs  XXXX

The Process of transferring journal to ledger is called Posting

 

 

 

TRIAL BALANCE

 

A trial balance is a list of all the general ledger accounts (both revenue and capital) contained in the ledger of a business. The debit balance values will be listed in the debit column of the trial balance and the credit value balance will be listed in the credit column. The purpose of a trial balance is to prove that the value of all the debit value balances equal the total of all the credit value balances.

TRIAL BALANCE FORMAT

S.No Particulars LF Debit Balance

Rs

Credit Balance

Rs

 

 

 

       

 

PROFIT AND LOSS ACCOUNT   – Concept and Meaning

Profit and loss account is prepared after the preparation of trading account. The main objective of preparing profit and loss account is to achieve the operating results of a company at the end of accounting period. Profit and loss account helps to ascertain net profit or net loss from business operation.

Contents of Profit and Loss Account:-

A Profit and Loss Account shows the following details:-

  • Gross profit or gross loss brought forward from the Trading account.
  • All indirect incomes and gains
  • All indirect expenditures and losses
  • Net profit.

Profit and Loss Account is a nominal account which is divided in two parts i.e. Income part and Expenditure Part, ie. Debit side and credit side.

In this account all indirect expenses and indirect incomes are shown, ie, incomes and expenses which are not directly related to purchase or sales.

All the indirect expenses and losses are recorded in the debit side of the profit and loss account and all the incomes except sales and closing stocks and gains are recorded in the credit side of the profit and loss account. In profit and loss account if debit side is more than the credit side, ie, expense is in excess of income, the difference is called net loss. If the credit side of profit and loss account is excess than the debit side, the difference is called net profit. Net profit amount of profit and loss account is transferred to the credit of profit and loss appropriation account and net loss of profit and account is transferred to the debit side of profit and loss appropriation account.

Profit and loss appropriation account is prepared after the preparation of profit and loss account and before the preparation of balance sheet. Profit and loss account provides the information about adjustment relating to last year. Profit and loss appropriation account also provides the information about the appropriation of dividend out of available profit. Profit and loss appropriation account shows the distribution of net profit among the shareholders in the form of dividend and transfer of profit to various reserves and issue of bonus share.

Followings are the items which are included in the debit side of profit and loss account.

  1. Gross Loss

Gross loss is the debit balance of trading account which transferred to the profit and loss account.

  1. Administrative Expenses

Administrative expenses are those expenses which are incurred for day to day running of office management. Office Salaries, Postage & Telephone, Traveling & Conveyance, Legal Charges, Office Rent, Audit Fees, Insurance etc are some of the examples of administrative expenses.
3. Financial Expenses

Financial Expenses are incurred for arranging fund to run the business. Cash discount allowed, interest on capital, interest on loan, discount on bill etc. are the examples of financial expenses.

  1. Maintenance Expenses

Expenses incurred for maintaining the fixed assets are called fixed expenses. Repair and renewable depreciation of assets are some examples of maintenance expenses.

  1. Selling and distribution expenses

Expenses incurred for the promotion of sales and distribution of sold goods is selling and distribution expenses. Packing charge, carriage , freight outward, sales tax, forwarding charge , export duty , travelling expenses etc are the examples of selling and distribution expenses.

  1. Abnormal Losses

Abnormal losses are those losses which are incurred due to the carelessness of the management. Loss on sale of asset, stock lost by fire etc are the examples of abnormal losses.

 

Following items are included in the credit side of profit and loss account

  1. Gross Profit

Gross profit is transferred from trading account and it is the beginning item of profit and loss account.

  1. Non-trading Income

Interest received from bank, incomes received from outside investments like share and debenture are known as non-trading incomes.

  1. Other incomes

Those incomes other than income from sale of goods are called other income. Discounts or commission received are the examples of other income.

BALANCE SHEET

Concept and Meaning

A balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. The balance sheet is also referred to as the Statement of Financial Position.

The balance sheet adheres to the following formula:

Assets = Liabilities + Shareholders’ Equity

Assets

Within the assets segment, accounts are listed from top to bottom in order of their liquidity, that is, the ease with which they can be converted into cash. They are divided into current assets, those which can be converted to cash in one year or less; and non-current or long-term assets, which cannot.

Liabilities

Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year.

Shareholders’ equity

Shareholders’ equity is the money attributable to a business’ owners, meaning its shareholders. It is also known as “net assets,” since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders.

There are two sides of a balance sheet Assets and Liabilities. The various items appeared in a Balance Sheet in assets column are as follows:

1) Fixed Assets:

Fixed Assets are called a long-term assets. They do not flow through the cash cycle of business within one year or normal operating cycle. They are major sources of revenue to the business. They do not vary day in and day out due to routine business transactions.

Classification of Fixed Assets

Fixed Assets are further classified into three categories:

  1. a) Tangible movable assets
  2. b) Tangible immovable assets
  3. c) Intangible assets
  4. a) Tangible movable assets

These are the assets which can be seen, touched and moved from one place to another place. Plant and Machinery, furniture and fixtures, transportation equipments etc. are tangible movable assets.

  1. b) Tangible immovable assets

These are the assets which can be seen and touched but cannot be moved from one place to another place. Eg. land buildings, mines, oil wells etc.

  1. c) Intangible assets

These are the assets which cannot be seen and touched. However their existence can only be imagined such as patents, trademarks, copyrights, goodwill etc.

2) Investments:

Investments may be shot-term and long- term. Short- term investments are marketable securities and they represent temporary investments of idle funds. These investments can be disposed off by the company at its own will at any time.

Long- term investments are held for long time. They are required to be held by the very nature of business. Here the intention of the investor is to retain the securities for a longer period of time. Eg Bonds of the other companies.

3) Current Assets and Quick Assets:

Current assets include cash, assets that are likely to become or converted into cash, or assets that are otherwise consumed in the normal process or within one year from the balance sheet date and the cash thus generated is available to pay current liabilities. Eg.  Cash Balance, Back Balance, Short term investments, Debtors, Expenses paid in advance etc.

Quick assets are known as near cash assets. Quick assets are those which can be converted into cash quickly. Therefore, they are also known as liquid assets. Debtors and cash advances can be converted into cash at a short notice.

The various items appear on the Liabilities column are as follows:

1) Proprietor’s Funds or Owner’s Equity:

These are the funds provided by the owner or the Shareholders. In case of sole trading concern, the sole trader is the single proprietor of the business. In case of partnership firms, partners are the owners and in case of companies, the shareholders are the proprietors. Proprietors Fund represents the interest of the proprietors in the business. This is the amount belonging to the proprietors. Proprietors fund is also called as “proprietors equity”, “Owners Fund”, Owners equity” or Shareholder’s Fund.

2) Reserves and Surplus:

There might be some obligations to the company which may be compulsory or voluntary, foreseen or unforeseen, recurring or non-recurring. To pay such obligations, companies generally create reserves out of profits. Such a reserve is also termed as “Retained Earning” or “Plough Back” profits.

3) Long-term Liabilities:

Company raises finance either from owners or through external borrowings. External borrowings of a company which constitutes its “owed funds” are important sources of log-term finance. These borrowings are termed as Long-term Liabilities They may be fully secured or partly secured or unsecured.

  1. a) Secured Loans:

It refers to loans which are secured by a fixed or floating charge on the assets of the business. It includes:

  1. i) Debentures
  2. ii) Loans and advances from banks

iii) Loans and advances from subsidiaries and

  1. iv) Other loans and advances

The nature of security should be specified in each case. Loans from directors, secretaries, treasures and managers should be shown under this head.

  1. b) Unsecured Loans:

It refers to the loans which are not secured by assets of the business. It is not covered by any security. It includes:

  1. i) Fixed Deposits
  2. ii) Loans and advances from subsidiaries

iii) Shot-term loans and advances from banks and from others

  1. iv) Other loans and advances: loans from directors, secretaries, treasures and managers should be shown separately.

4) Current Liabilities and Quick Liabilities:

Current liabilities are those short-term obligations of an enterprise which mature within one year or within the operating cycle. They constitute short-term sources of finance.

They are as follows:

  1. i) Sundry creditors
  2. i) Bills Payable

iii) Interest accrued but not due

  1. iv) taxes Payable
  2. v) wages and Salaries Outstanding
  3. vi) Unclaimed Dividends

vii) Bank Overdraft

Quick Liabilities are the current liabilities which mature within a very short period of time.

RATIO ANALYSIS :

Financial Statement includes the Profit & Loss Account and Balance Sheet. Every year, every business comes up with its own Financial Statements. The FS is so much overloaded with information that, it is very hard for a common man to take a decision based on it.

The FS is interpreted by different people for different purposes. For Example,

  • The Management is interested in knowing the profitability.
  • The Lenders use it to ascertain the credibility.
  • The Shareholders use it to know how their investment in doing.

One thing which helps these different Stakeholders to get the required information out of the FS is RATIO ANALYSIS. A ratio is nothing but relationship between 2 items of information.

 

TREND ANALYSIS

It helps in studying changes that have taken place over a period of more than 2 years.

We can know if the sale is in Increasing trend or not.

INTER FIRM COMPARISON

It is comparison of performance of an entity with its competitors.

By this we can know whether we have outperformed our competitors.

There are 3 main purposes for which Ratio Analysis is used

INTER PERIOD COMPARISON

It is comparison of performance of the same entity between 2 periods.

It helps to understand, whether we have performed better than last year.

 

 

 

 

 

 

 

 

There are 6 major groups of ratios

 

 

Liquidity Ratios               Working Capital Ratios                Profitability Ratios             Capital Structure Ratios

 

Turnover Ratios                                                                                  ROI Ratios

 

I LIQUIDITY RATIOS

  • It refers to an entity’s ability to comfortably meet its short term obligations. It is basically the relationship between Current Assets & current Liabilities.
  • CURRENT RATIO :
    • This ratio shows how much liquid funds we have to pay off our Current Liabilities.
    • Current Ratio = Current Assets / Current Liabilities
  • QUICK RATIO :
    • The only difference between these two is the speed with which the Current Assets can be converted into cash.
    • Quick Ratio = (Current Assets – Stock)/ Current Liabilities
  • These ratios are more useful from lenders perspective. Most banks sanction loans if the Current Ratio is 1.25 & Quick Ratio is 1.00.

 

II WORKING CAPITAL RATIOS

  • DEBTORS COLLECTION PERIOD :
  • This measures the number of days taken To collect Payments from debtors.
  • Closing debtors * 365 / Annual credit sales
  • INVENTORY HOLDING PERIOD :
  • This measures the efficiency of inventory management. For how Long an item of inventory remains in stock.
  • Average stock * 365 / Cost Of Goods Sold
  • SUPPLIERS CREDIT PERIOD :
  • This measures The credit period given to us by our suppliers.
  • Closing creditors * 365 / Annual credit purchases.

 

III PROFITABILTY RATIOS

 

  • GROSS PROFIT RATIO :
  • Gross profit is the direct income that we get from the business.{Sales – (Opening stock + Purchases – Closing stock)}.
  • The GP Ratios remains almost same for all entities in an industry.
  • Gross profit / Sales * 100
  • NET PROFIT RATIO :
  • Net profit is the incomes that we earn after deducting all expenses.
  • The NP Ratio varies from entity to entity depending on the management of the entity.
  • Net profit / Sales * 100

 

 

IV CAPITAL STRUCTURE RATIOS

 

  • LONG TERM DEBT TO EQUITY RATIO :
  • This shows the proportion of long term capital that has been financed out of debt. Current liabilities are not not included.
  • Long term Debts / Shareholders Fund
  • TOTAL DEBT TO EQUITY RATIO :
  • This shows how much asset is financed out of equity & debts. Current liabilities are included.
  • Long term Debts + Current liabilities / Shareholders Fund
  • These Ratios are used in FINANCING POLICIES.

 

V TURNOVER RATIOS

 

  • TOTAL ASSETS TURNOVER RATIO :
  • This shows how well the company has utilised its Total Assets to generate sales.
  • Sales / Total Assets
  • FIXED ASSETS TURNOVER RATIO :
  • This shows how well the company has utilised its Fixed Assets to generate sales.
  • Sales / Fixed Assets

 

VI RETURN ON INVESTMENT RATIOS

 

  • RETURN ON CAPITAL EMPLOYED :
  • It shows how much return we are generating from the Total capital employed.
  • Total capital employed includes Equity, Preference & Loans.
  • Profit before interest & Tax / Capital Employed * 100
  • RETURN ON NET WORTH :
  • It shows how much return we are generating from the Owner’s funds.
  • It is known as the “MOTHER OF ALL RATIOS”.
  • (Profit after tax – Preference dividend) / Net Worth * 100
  • DUPONT RETURN :
  • This return explains that the RONW is the combined result of 3 separate ratios or components.
  • Net profit ratio
  • Total assets turnover ratio
  • Ratio of total assets to net worth
  • RONW = (Net profit/Sales)*(Sales/Total assets)*(Total assets/Net worth)

 

 

ALTMAN’S Z-SCORE

 

  • This formula is used to predict the probability that a firm will go in to bankruptcy within 2 years.
  • The Z-Score uses multiple corporate income and balance sheet values measure the financial health of a company.

 

CASH FLOW STATEMENT

Cash flow is the net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against future financial challenges. Negative cash flow indicates that a company’s liquid assets are decreasing.

The cash flow statement reports the cash generated and used during the time interval specified. The period of time that the statement covers is chosen by the company.

The cash flow statement organizes and reports the cash generated and used in the following categories:

  1. Operating Activities – Covers the items reported on the income statement from the accrual basis of accounting to cash
  2. Investing Activities – reports the purchase and sale of long term investments and property, plant and equipment.
  3. Financing Activities – reports the issuance and repurchase of the company’s own bonds and stock and payment of dividends.
  4. Cash Provided From or Used By Operating Activities

This section of the cash flow statement reports the company’s net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as:

Accounts Receivable

Inventory

Supplies

Prepaid Insurance

Other Current Assets

Accounts Payable

Wages Payable

Payroll Taxes Payable

Interest Payable

Income Taxes Payable

Unearned Revenues

Other Current Liabilities

  1. Cash Provided From or Used By Investing Activities

This section of the cash flow statement reports changes in the balances of long-term asset accounts, such as:

Long-term Investments

Land

Buildings

Equipment

Furniture & Fixtures

Vehicles

In short, investing activities involve the purchase and/or sale of long-term investments and property, plant, and equipment.

  1. Cash Provided From or Used By Financing Activities

This section of the cash flow statement reports changes in balances of the long-term liability and stockholders’ equity accounts, such as:

Issue of Share Capital

Issue or Repayment of Bonds

Retained Earnings

In short, financing activities involve the issuance and/or the repurchase of a company’s own bonds or stock as well as short-term and long-term borrowings and repayments

 

  • Direct and Indirect methods of preparing the cash flow statement: The two methods differ only in the computation and presentation of operating cash flows, while the cash flows from investing and financing activities are similarly presented under both methods.
    1. The Direct method shows major classes of operating cash receipts and cash payments. In this method, the cash flow statement begins with cash received from customers and other operating activities, from which the cash payments to suppliers, employees and taxed paid would be subtracted to calculate net cash flow. Non-cash expenses such as depreciation are excluded because they don’t represent money spent in the current year.

 

  1. In the Indirect method in order to calculate operating cash flows, we begin with profits as reported in the profit & loss account, and make adjustments to convert profit figure into cash flow. The main adjustments required to convert profits into operating cash flows are as follows.
    1. Non-cash expenses such as depreciation; depreciation being a non-cash expense should not appear in the statement of cash flows.
    2. Cash expenses that relate to investing or financing activities, but were included in the profit & loss account.
  • Changes in working capital items : Changes in current assets and current liabilities (other than those included in cash & equivalents) affect cash flows. The general rules for adjustments to convert profit into cash flows are as follows: deduct increases in current assets, add decreases in current assets, and increases in current liabilities and deduct decreases in current liabilities.
The Income Statement and Balance sheet of Seagull Company are given below.
Seagull Company Income statement and Appropriation of Profit for the Year ended 31 December 20X2
Sales 2,80,000
Less: Cost of goods sold 51,000
Opening Stock 31 Dec 20X1  1,59,000
Purchases 2,10,000
Less: Closing Stock 31 Dec 20X2 72,000 1,38,000
Gross Profit 1,42,000
Less: Other Expenses
Operating Expenses 53,000
Depreciation 35,000 88,000
Profit before taxes 54,000
Income Taxes 18,000
Net Income 36,000
Dividends Paid 27,000
Transferred to reserves and surplus 9,000
Reserves and Surplus 20X1 90,000
Reserves and Surplus 20X2 99,000
Seagull Company Balance Sheet as on 31 December, 20X2
               Rs. Rs.
20X2 20X1 Change
Liabilities
Share Capital 110,000 100,000 10,000
Retained earnings 99,000 90,000 9,000
Debentures earnings 40,000  – 40,000
Accrued tax Payable 4,000 2,000 2,000
Accounts Payable 75,000 70,000 5,000
328,000 262,000 66,000
Assets :
Plant assets (net) 190,000 160,000 30,000
Prepaid Operating expenses 5,000 4,000 1,000
Inventory 72,000 51,000 21,000
Accounts receivable 55,000 29,000 26,000
Cash 6,000 18,000 -12,000
328,000 262,000 66,000

 

  • During 20X2, the company paid Rs.35,000 in cash to acquire a new plant to expand its productive capacity. The Plant acquisition was partly financed by an issue of debentures Of Rs. 40,000 to the plant vendor. A plant with book value of Rs. 10,000 was sold for cash of Rs. 10,000 .The Company’s general manager was disappointed by the low cash balance which had gone down in spite of good net profits.

 

  • Prepare a cash flow statement using the direct method for computing cash flows from operating activities. Explain to the general manager why cash has reduced in spite of good net profits.

 

Solution :
a. Cash Collected from customers: Rs.
Sales 2,80,000
+ Beginning sundry debtors 29,000
Total potential collections from customers 3,09,000
Closing sundry debtors 55,000
Cash collected from customers 2,54,000
b. Payments to suppliers:
Opening trade accounts payable 70,000
+ Purchases 1,59,000
Total payable to suppliers 2,29,000
Closing accounts payable 75,000
Cash paid to suppliers 1,54,000
c. Payments for operating expenses
Current Operating expenses 53,000
Less: Prepaid opening balance -4,000
Net Payable 49,000
Prepaid closing balance 5,000
Cash actually paid for operating expenses 54,000
Investing, financial and other cash flows:
a Plant Asset reconciliation:
Opening balance of plant(net) 1,60,000
Less: Sale of asset -10,000
Less: Current year depreciation -35,000
Net balance 1,15,000
Closing Balance 1,90,000
Purchase of plant during the year (balancing figure) 75,000
Out of the total new purchase of asset:
Purchased for cash:

Rs.35,000 [Investing activity cash outflow]

Purchase against debentures:

Rs.40,000 [non-cash investing activity]

b Cash from sale of asset: Rs. 10,000 be classified as investing activity cash inflow.
c Dividend paid : Rs.27,000 to be classified as financing activity outflow
d Taxes paid   = Current tax liability + opening balance – Closing balance
  =    18000 + 2000 -4000   =     16000
PRESENTATION OF CASH FLOW STATEMENT – DIRECT METHOD
Seagull company Statement of cash flows for the year ended 20X2 – Direct Method
A. Cash Flows from Operating Activities
Cash collected from customers 2,54,000
Cash payments:
         To Suppliers for purchases 1,54,000
          For operating expenses 54,000
          For income taxes 16,000
Total cash paid for operating act ivies 2,24,000
Net cash flow from operating activities 30,000
B. Cash Flow from Investing Activities
Purchase of fixed assets -35,000
Cash from sale of asset 10,000 -25,000
C Cash Flow from Financing Activities
Share Capital 10,000
Dividends -27,000 -17,000
Total Net increase (decrease) in cash flow -12,000
Cash as on 31 December, 20X1 18,000
Cash as on 31 December, 20X2 6,000

 

  • Schedule of Noncash Investing and Financing Activities: In addition to the purchase of plant assets listed in the cash flow statement, plant assets worth Rs.40,000 were purchased in exchange for debentures of the same amount.
  • Explanatory note to the general manager of seagull company: The net profit amounted to Rs.36,000 but the cash collected from operating activities was less than that primarily because of slow collections
  • from customers, further investment in inventory and pre-completely offset the increase in debtors  and inventory.  Two major cash outflows were related to the purchase of fixed assets and payment of dividends which together required a cash outflow of Rs.62,000 while the operating activities could bring
  • in cash flows of Rs.30,000 only. The resulting deficit of Rs. 32,000 was partly met by issue of share capital of Rs. 10,000 and sale of fixed asset for cash of Rs.10,000, leaving a net decrease in cash of Rs.12,000 over the year.

 

Annual Report:    

it is a report on a company’s activities throughout a financial year.

  • Annual report gives stakeholders information about the company’s activities and performance in financial terms.

 

Contents of Annual Report:

Annual report of a company mainly includes the following

 

  • Director’s Report: It is the document prepared and produced by the board of directors of a company which details the state of the company and its compliance with a set of financial, accounting and corporate responsibility standards, the company’s performance and business scope.
  • Statement of Profit & Loss : Indicates the net profits earned by the company during the current financial year. It also indicates the profits available for distribution and appropriation after meeting all expenses and tax liabilities.
  • Balance Sheet : Balance sheet provides a birds eye view on a company’s financial position, and indicates what the company has, ie., its assets, and what the company owes, ie., its liabilities. The excess of assets over liabilities is known as Owners’ Funds.
  • Notes to Accounts: Notes forming part of the financial statements gives detailed information regarding items concerned.
  • Auditor’s Report : Auditors address the report to the shareholders of the company giving an opinion on the company’s accounts.
  • Cash Flow statement: it states the company’s cash flows during the financial year.
  • Consolidated Accounts : If the company has subsidiaries, consolidated accounts are shown in the annual report.
  • Minutes from annual general meeting .
  • Disclosure of accounting Policies: The accounting policies followed in the preparation of financial statements are disclosed and stated separately.
  • Corporate Governance:

 

Auditors Report:

 

  • Auditors Report provides an opinion of the auditor on the validity and reliability of a company’s financial statements.
  • Auditor addresses his report to the shareholders or users of the financial statements of a company. The user may rely upon the report as evidence that a knowledgeable third party has investigated and rendered an opinion on the financial statements of the company.
  • A typical audit report contains three paragraphs covering the following:
  1. The responsibilities of the auditor and the management of the entity.
  2. The scope of audit.
  3. The auditor’s opinion of the entity’s financial statements.
  • The goal of an auditor’s report is to document reasonable assurance that a company’s financial statements are free from errors.

 

Types of Audit report:

  • Clean / Unqualified opinion – this report indicates the auditor’s opinion that all documents provided for evaluation indicate a true and fair view of the company’s financial activities. This is the best type of report a company can receive.
  • Qualified opinion – this report is generally positive because it indicates that the auditor has found no errors in the financial documentation. However, a qualified opinion means that the company audited has not adhered to any of the accounting standards or, if there was a scope limitation that were imposed upon the auditor’s work.
  • Adverse opinion – it is the worst type of report to receive following an audit. This type of opinion means that the company has not adhered to the accounting standards and that auditor has discovered discrepancies in the company’ financial statements. It can also be an indication of fraud within the company.
  • Disclaimer of opinion – this is the most uncommon type of report. It means that the auditor was not able to complete the audit due to a particular reason.

The best way for a company to ensure an unqualified opinion is to keep track of its finances.

 

Director’s Report :

  • A directors’ report is intended to explain to shareholders, the company’s affairs, including its subsidiaries and the nature and scope of the company’s business.
  • The report is a summation of activities of the company in the relevant financial year and an idea about possible future developments.
  • It is mandatory for every company to forward to its members along with the annual financial statements the directors report.
  • Director’s report should be attached to the balance sheet laid before the annual general meeting.
  • The report shall be prepared based on stand alone financial statement of the company.

 

Contents:

As per Section 134 of Companies Act, 2013, director’s report includes the following:

  • Extract of annual return of the company in form MGT-9.
  • Number of board meetings held during the relevant financial year.
  • Comment on Auditor’s report – explanations or comments by the board on every qualification , reservation or adverse remark or disclaimer, if any, made by the auditors in auditor’s report.
  • Particulars of loan, investment and guarantees given during the financial year.
  • Disclosure of all related party transactions entered by the company during the financial year.
  • Dividend recommendation , if any dividend was declared by the company during the financial year.
  • Post balance sheet events – material changes and commitments, if any, affecting the financial position of the company which have occurred between the end of the financial year to which the financial statements relate and the date of report. Generally, there is a gap of 4 to 5 months between end of financial year and the preparation of director’s report.
  • Risk management policy
  • Corporate Social Responsibility- policies developed and implemented by the company on CSR initiatives taken during the year.
  • Report on performance of subsidiaries, associate companies and joint ventures – it shall be contained in a separate section in the report.
  • Details of directors and KMPs appointed / resigned during the year.
  • Statement of affairs of the company.
  • Director perception of future of the company.
  • Other details

 

SEGMENT REPORTING  

Segment Reporting is the reporting of the operating segments of a company in the disclosures accompanying its financial statements. Segment reporting is intended to give information to investors and creditors regarding the financial results and position of the most important operating units of a company which they can use as the basis for decisions related to the company.

Objective 

The objective is to help users of financial statements:

  • better understand the performance of the enterprise;
  • better assess the risks and returns of the enterprise; and
  • make more informed judgements about the enterprise as a whole

 

Scope

  1. Segment Reporting should be applied in presenting general purpose financial statements.
  2. The requirements of this Standard are also applicable in case of consolidated financial statements.
  3. If a single financial report contains both consolidated financial statements and the separate financial statements of the parent, segment information need be presented only on the basis of the consolidated financial statements.

Definitions

Business segment is a

– Distinguishable component of an enterprise that is engaged in providing product or service and that is  subject to risks and returns that are different from those of other business segments.

Business Segments can be Identified on the basis of

  • The nature of the products or services;
  • The nature of the production processes;
  • The type or class of customers for the products or services;
  • the methods used to distribute the products or provide the services; and
  • if applicable, the nature of the regulatory environment, for example, banking, insurance, or public utilities.

Geographical segment

– Distinguishable component of an enterprise that is engaged in providing products or services within a particular economic environment and

-That is subject to risks and returns that are different from those of components operating in other economic environments.

Geographical Segments can be identified on the basis of

  • Similarity of economic and political conditions;
  • relationships between operations in different geographical areas;
  • proximity of operations;
  • special risks associated with operations in a particular area;
  • exchange control regulations; and
  • the underlying currency risks.

 

Reportable segment is a

Business segment or a geographical segment identified on the basis of foregoing definitions for which segment information is required to be disclosed by this Standard.

– If total external revenue attributable to reportable segments constitutes less than 75% of the total enterprise revenue, additional segments should be identified as reportable segments, even if they do not meet 10% thresholds as above, until at least 75% percent of the total enterprise revenue is included in reportable segments.

 

– A segment identified as a reportable segment in the immediately preceding period because it satisfied the relevant 10% thresholds should continue to be a reportable segment for the current period notwithstanding that its revenue, result, and assets no longer meet the 10% thresholds.

 

Enterprise revenue is revenue from sales to external customers as reported in the statement of profit and loss.

 

Segment revenue is the aggregate of

 

  • the portion of enterprise revenue that is directly attributable to a segment,
  • the relevant portion of enterprise revenue that can be allocated on a reasonable basis to a segment, and
  • revenue from transactions with other segments of the enterprise.

 

Segment expense is the aggregate of

 

  • the expense resulting from the operating activities of a segment that is directly attributable to the segment, and
  • the relevant portion of enterprise expense that can be allocated on a reasonable basis to the segment, including expense relating to transactions with other segments of the enterprise.

 

SEGMENT REVENUE/EXPENSE does not include

 

(a)Extraordinary items as defined in AS-5

(b) Interest or dividend (including earned/incurred on loans to other segment) unless the operations of the segment are primarily of a financial nature

(c) Gains on sales of investments or on extinguishments of debt (Capital gain/loss) unless the operations of the segment are primarily of a financial nature.

(d) General administration expenses, head office expenses and other expenses that arise at the enterprise level and relate to the enterprise as a whole.

(e) Income tax expenses

Segment Assets are those operating assets that are employed by a segment in its operating activities and that either are directly attributable the segment or can be allocated to the segment on a reasonable basis.

Segment assets do not include income tax assets. Segment assets are determined after deducting related allowances/ provisions that are reported as direct offsets in the balance sheet of the enterprise.

 

Segment liabilities are those operating liabilities that result from operating activities and that either are directly attributable the segment or can be allocated to the segment on a reasonable basis.

 

-Segment liabilities do not include income tax liabilities

-If the segment result of a segment includes interest expense, its segment liabilities include the related interest-bearing liabilities.

 

 

 Identifying Reporting segments

Primary segment and Secondary segment

-The dominant source and nature of risks and returns of an enterprise should govern whether its primary segment reporting format will be business segments or geographical segments.

-If the risks and returns of an enterprise are affected predominantly by differences in the products and services it produces, its primary format for reporting segment information should be business segments, with secondary information reported geographically.

-Similarly, if the risks and returns of the enterprise are affected predominantly by the fact that it operates in different countries or other geographical areas, its primary format for reporting segment information should be geographical segments, with secondary information reported for groups of related products and services.

– If risks and returns of an enterprise are strongly affected both by differences in the products and services it produces and by differences in the geographical areas in which it operates, as evidenced by a ‘matrix approach’ to managing the company and to reporting internally to the board of directors and the chief executive officer, then the enterprise should use business segments as its primary segment reporting format and geographical segments as its secondary reporting format

Matrix Approach

A ‘matrix presentation’  both business segments and geographical segments as primary segment reporting formats with full segment disclosures on each basis  will often provide useful information if risks and returns of an enterprise are strongly affected both by differences in the products and services it produces and by differences in the geographical areas in which it operates. The Standard does not require, but does not prohibit, a ‘matrix presentation’.

Reportable segments

A business segment or geographical segment should be identified as a reportable segment if:

(a) its revenue from sales to external customers and from transactions with other segments is 10 per cent or more of the total revenue, external and internal, of all segments; or

(b) its segment result, whether profit or loss, is 10 per cent or more of –

(i) the combined result of all segments in profit, or

(ii) the combined result of all segments in loss,whichever is greater in absolute amount; or

  • its segment assets are 10 per cent or more of the total assets of all segments.

 

-A business segment or a geographical segment which is not a reportable segment  may be designated as a reportable segment despite its size at the discretion of the management of the enterprise.

-If that segment is not designated as a reportable segment, it should be included as an unallocated reconciling item. If total external revenue attributable to reportable segments constitutes less than 75 per cent of the total enterprise revenue, additional segments should be identified as reportable segments, even if they do not meet the 10 per cent thresholds until at least 75 per cent of total enterprise revenue is included in reportable segments.

-A segment identified as a reportable segment in the immediately preceding period because it satisfied the relevant 10 per cent thresholds should continue to be a reportable segment for the current period notwithstanding that its revenue, result, and assets all no longer meet the 10 per cent thresholds

– If a segment is identified as a reportable segment in the current period because it satisfies the relevant 10 per cent thresholds, preceding-period segment data that is presented for comparative purposes should, unless it is impracticable to do so, be restated to reflect the newly reportable segment as a separate segment, even if that segment did not satisfy the 10 per cent thresholds in the preceding period.

Segment Accounting Policies

-Segment information should be prepared in conformity with the accounting policies adopted for preparing and presenting the financial statements of the enterprise as a whole

-The Standard does not prohibit the disclosure of additional segment information that is prepared on a basis other than the accounting policies adopted for the enterprise financial statements provided that (a) the information is reported internally to the board of directors and the chief executive officer for purposes of making decisions about allocating resources to the segment and assessing its performance and

(b) the basis of measurement for this additional information is clearly described.

– Assets and liabilities that relate jointly to two or more segments should be allocated to segments if, and only if, their related revenues and expenses also are allocated to those segments.

 

Primary Reporting Format

An enterprise should disclose the following for each reportable segment:

  • segment revenue, classified into segment revenue from sales to external customers and segment revenue from transactions with other segments;
  • amount of segment assets;
  • total amount segment result;
  • total carrying of segment liabilities;
  • total cost incurred during the period to acquire segment assets that are expected to be used during more than one period (tangible and intangible fixed assets);
  • total amount of expense included in the segment result for depreciation and amortisation in respect of segment assets for the period; and
  • total amount of significant non-cash expenses, other than depreciation and amortisation in respect of segment assets, that were included in segment expense and, therefore, deducted in measuring segment
  • An enterprise that reports the amount of cash flows arising from operating, investing and financing activities of a segment need not disclose depreciation and amortisation expense and non-cash expenses of such segment.
  • An enterprise should present a reconciliation between the information disclosed for reportable segments and the aggregated information in the enterprise financial statements. In presenting the reconciliation, segment revenue should be reconciled to enterprise revenue; segment result should be reconciled to enterprise net profit or loss; segment assets should be reconciled to enterprise assets; and segment liabilities should be reconciled to enterprise liabilities.

Secondary Segment Information

-If primary format of an enterprise for reporting segment information is business segments, it should also report the following information:

  1. a) segment revenue from external customers by geographical area based on the geographical location of its customers, for each geographical segment whose revenue from sales to external customers is 10 per cent or more of enterprise revenue;

(b) the total carrying amount of segment assets by geographical location of assets, for each geographical segment whose segment assets are 10 per cent or more of the total assets of all geographical segments; and

(c) the total cost incurred during the period to acquire segment assets that are expected to be used during more than one period (tangible and intangible fixed assets) by geographical location of assets, for each geographical segment whose segment assets are 10 per cent or more of the total assets of all geographical segments.

-If primary format of an enterprise for reporting segment information is geographical segments it should also report the following segment information for each business segment whose revenue from sales to external customers is 10 per cent or more of enterprise revenue or whose segment assets are 10 per cent or more of the total assets of all business segments:

(a) segment revenue from external customers;

(b) the total carrying amount of segment assets; and

(c) the total cost incurred during the period to acquire segment assets that are expected to be used during more than one period (tangible and intangible fixed assets).

 

Industrial Segments

Value reporting

Value added is an alternate performance measure to profit. Generally users of financial statements believe that profit is the only indicator of the prosperity of any organization

Objective

The objective of disclosure of value added statement in annual report is to report on the income earned by a diverse group of stakeholders – Human resources plus providers of capital.

Value added statement add a new direction to the current conventional accounting by disclosing information reflecting the quantum of wealth generated and distributed by the firm among various stakeholders

Value added is defined as “The wealth created by the reporting entity by its own and employee’s efforts and comprises salaries and wages, fringe benefits, interest, dividend, tax depreciation and net profit retained”.

Value added term focuses on the creation and distribution of value added.

(ii) Value added may be termed as gross value added or net value added.

(iii) Gross value added is the term used for the excess of gross sales and income from services over the cost of purchase in material and services.

(iv) Net value added is the term used for the annual charge of depreciation deducted from gross value added.

 

Approaches to Compute Value Added Reporting:

Basically there are two approaches to compute value added by the enterprise while performing its operations during a particular accounting period.

(i) Additive approach

(ii) Subtractive approach

(i) Additive Approach:

This approach concentrates on adding of all the values which are created by an enterprise. Thus interest, depreciation salaries, wages, rent, taxes, insurance employee welfare, overhead expenses and PBT all are added to give the sum of value added.

(ii) Subtractive Approach:

In this approach Raw material, bought in components, sub contract processing consumable stores, loose tools repairs and maintenance of plant and machinery and other purchased services are deducted from sales revenue and some items are added or subtracted as the case may be, increase or decrease in labour and relevant overhead in stocks.

 

Uses of Value Added Statements:

(i) Helpful to employees,

(ii) Enhances team spirit in organisation.

(iii) Provides basis for incentive schemes.

(iv) A better tool for measuring performance.

(v) Enhances users of financial statements.

(vi) Realistic view of retained earnings.

(vii) Value added statements facilitate interpretations of operating results.

(viii) Provides information for calculation of value added ratios,

(ix) Value Added Statements link the company financial accounts to the national income by reflecting the company’s contribution to national income.

(x) Value added statement overcomes the distortion in ranking of company caused by the use of inflated sales.

Following is an example of a value added statement submitted by an Indian company through its annual report.

Value Added Statement:

 

 

 

 

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