DIRECTORATE OF DISTANCE & CONTINUING EDUCATION

Utkal University, Bhubaneswar-7, Odisha

DIRECTORATE OF DISTANCE & CONTINUING EDUCATION

Utkal University, Bhubaneswar-7, Odisha
Email: helpline@ddceutkal.ac.in
Website: www.ddceutkal.ac.in

© Directorate of Distance & Continuing Education, Utkal University, Vani Vihar, Bhubaneswar-751007 The
study material is developed exclusively for the use of the students admitted under DDCE, Utkal University.

Name of the Study Material: BUSINESSES AND ECONOMIC ENVIRONMENT

ISBN : ************

Author's Name:

Dr. Giridhari Sahoo

Edited by: Dr.Biswo Ranjan Mishra

Dr. T K Satpathy

Year of Print: 2020

 DIRECTORATE OF DISTANCE & CONTINUING EDUCATION UTKAL
UNIVERSITY : VANI VIHAR BHUBANESWAR:-751007.

From the Director’s Desk

The Directorate of Distance & Continuing Education, originally established as the University Evening
College way back in 1962 has travelled a long way in the last 52 years. ‘EDUCATION FOR ALL’ is our motto.
Increasingly the Open and Distance Learning institutions are aspiring to provide education for anyone,
anytime and anywhere. DDCE, Utkal University has been constantly striving to rise up to the challenges of
Open Distance Learning system. Nearly ninety thousand students have passed through the portals of this
great temple of learning. We may not have numerous great tales of outstanding academic achievements but
we have great tales of success in life, of recovering lost opportunities, tremendous satisfaction in life, turning
points in career and those who feel that without us they would not be where they are today. There are also
flashes when our students figure in best ten in their honours subjects. In 2014 we have as many as fifteen
students within top ten of honours merit list of Education, Sanskrit, English and Public Administration,
Accounting and Management Honours. Our students must be free from despair and negative attitude. They
must be enthusiastic, full of energy and confident of their future. To meet the needs of quality enhancement
and to address the quality concerns of our stake holders over the years, we are switching over to self
instructional material printed courseware. Now we have entered into public private partnership to bring out
quality SIM pattern courseware. Leading publishers have come forward to share their expertise with us. A
number of reputed authors have now prepared the course ware. Self Instructional Material in printed book
format continues to be the core learning material for distance learners. We are sure that students would go
beyond the course ware provided by us. We are aware that most of you are working and have also family
responsibility. Please remember that only a busy person has time for everything and a lazy person has none.
We are sure you will be able to chalk out a well planned programme to study the courseware. By choosing to
pursue a course in distance mode, you have made a commitment for self improvement and acquiring higher
educational qualification. You should rise up to your commitment. Every student must go beyond the
standard books and self instructional course material. You should read number of books and use ICT learning
resources like the internet, television and radio programmes etc. As only limited number of classes will be
held, a student should come to the personal contact programme well prepared. The PCP should be used for
clarification of doubt and counseling. This can only happen if you read the course material before PCP. You
can always mail your feedback on the course ware to us. It is very important that you discuss the contents of
the course materials with other fellow learners.

We wish you happy reading.

DIRECTOR
 Centre for Distance and Online Education, Utkal University, Bhubaneswar.
Program Name: Master in Commerce Program Code: 030300
Course Name: Corporate Financial Accounting Course Code: MCM 2.1
Semester: II Credit: 4

EXPERTCOMMITTEE:-

Dr PK Hota Dr PK Pradhan
HOD, Commerce Dept Commerce Dept
Utkal University Utkal University

COURSEWRITERS:

Dr Giridhari Sahoo

COURSEEDITORS
Dr. Biswo Ranjan Mishra
Asst.Prof.(S-II),CDOE,Utkal University.

REFERENCES

1. Corporate Financial Accounting by Carl Warren

MATERIAL PRODUCTION
 Corporate Financial Accounting
Block
Block Unit No Unit
No
Accounting as an information system, Users
1 and their information needs, Concepts and
conventions
Elements of financial
statements: Recognition and Measurement Qualitative
Conceptual 2
Characteristics of financial
1 Framework of
Statement, Accounting Standard
Accounting
Historical Developments, Needs International
3 Accounting Standards, Accounting Standards in India:
Objectives
Process of Standard
4
setting.
Preparation of Company Final Accounts Managerial
5
remuneration
Statutory Financial Disposal of Company profits. Accounting Reports.
2 6
Statements Accountants Report in prospectus.
7 Half yearly Financial Report of listed Companies
Meaning and importance. Elements of F/F Statement,
8
Uses, and Funds flow Reporting, Cash flow Statement
Meaning and importance, Elements of
3 Funds Flow Statement 9
C/F statement, Uses, Cash Flow Reporting,
Accounting Standard for Cash Flow
10
Statement
Need, Process, Tools, Cross sectional Techniques,
11 Time sense Analysis, financial Ratio Analysis and
Interpretation,
Trends of Financial Ratios, Predictability of Insolvency
12
on the aspects of financial Ratios

Financial Ratios for Budgeting, Limitations of

13
Financial Ratios.
Financial Statement
4 Analysis, Corporate
Social Reporting 14 Social Income Statement, Social Balance Sheet

Value Added Statement, Importance, Preparation,

15
Interpretation of VA, Limitations

Corporate Disclosures, Modern Trends in Published

16
Accounts.
 UNIT I: CONCEPTUAL FRAMEWORK OF ACCOUNTING
Structure

1.0 Introduction.

1.1 Unit Objectives.

1.2 Accounting as an information system.

1.3 Parties interested in accounting information.

1.4 Specialized accounting fields.

1.5 Relationship of accounting with other disciplines.

1.6 Basic concepts of accounting.

1.7 Accounting standards and international accounting standards committee.

1.8 Accounting standards in India.

1.9 Summary.

1.10 Key Terms.

1.11 Questions & Exercises.

1.0 INTRODUCTION

Accounting is known as the language of business. This designation is applied to

accounting because it is the method of communicating business information. The basic
function of any language is to serve as a means of communication. Accounting duly
serves this function. The task of learning accounting is essentially the same as the task
of learning a new language. But the rapid change in business organization has
contributed to increase the complexities in this language. Like other languages, it is
undergoing continuous change in an attempt to discover better means of
communications. To enable the accounting language to convey the same meaning to all
stakeholders, it should be made standard. To make it a standard language certain
accounting principles, concepts and standards have been developed over a period of
time. This lesson based upon the different dimensions of accounting, accounting
concepts, accounting principles and the accounting standards.

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 1.1 UNIT OBJECTIVES

After reading this lesson, you will be able to:

 Know the Evolution of Accounting

 Understand the Definition of Accounting
 Comprehend the Scope and Function of Accounting
 Ascertain the Users of Accounting Information
 Know the Specialized Accounting Fields
 Understand the Accounting Concepts and Conventions
 Realize the Need for Accounting Standards

1.2 ACCOUNTING AS AN INFORMATION SYSTEM

Evolution of Accounting:

Accounting is as old as money itself. It has evolved, as have medicine, law and
most other fields of human activity in response to the social and economic needs of
society. People in all civilizations have maintained various types of records of business
activities. The oldest known are clay tablet records of the payment of wages in
Babylonia around 600 B.C. accounting was practiced in India twenty-four centuries ago
as is clear from kautilya’s book ‘arthshastra’ which clearly indicates the existence and
need of proper accounting and audit. For the most part, early accounting dealt only with
limited aspects of the financial operations of private or governmental enterprises.
Complete accounting system for an enterprise which came to be called as “double entry
system” was developed in Italy in the 15th century. The first known description of the
system was published there in 1494 by a Franciscan monk by the name Luca Pacioli.

Accounting is practiced by every one of us in our day to day life. An individual,

who is working with an organization, earns his salary every month. From this salary
amount, he goes on spending money, on various household items, such as clothing,
medicines, grocery, milk, tuition fees etc... Many people maintain diaries wherein all
these expenses are recorded every day. At the end of a month, such a person can
summarize these expenses and prepare a statement to ascertain the amount he is left
with. The amount so available will be his savings at the end of that particular month.

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 Everyone knows that “man must cut his coat according to his cloth “. If a man
carelessly spends money, he will be left with no money sooner or later. This is also true
of a businessman. A businessman receives money from sale of goods or for rendering
services and spends money for payment of purchases, salaries to staff, rent electricity
etc... He cannot remember what he received & what he spent at the end of month or a
particular period. Therefore, it is necessary for him to record these happenings
(incomes & expenses) in a systematic way. This will enable him to know whether he has
made any profit or incurred any loss during a particular period.

Definition & Features of accounting:

The most commonly accepted definitions of accounting are as under:-

Accounting is defined as “an art of recording, classifying & summarizing in a significant

manner and in terms of money, transactions & events which are in part at least, of a
financial character and interpreting the results thereof.”

 Accounting is an art: Art is that part of knowledge which enables us to attain

our objective & shows the way in which we may reach our objective in the best
possible manner. It is an art because it helps us in attaining our objective of
ascertaining the financial results by showing the best way of recording ,
classifying & summarizing the business transactions .
 Recording: Accounting not only records the transactions of financial nature but
also records them in an orderly manner. The method of recording is adjusted
according to the nature and size of the business. Thus, cash transactions, credit
transactions, purchase & sale of fixed assets etc… are recorded in different
ways.
 Classifying business transactions: The classification or grouping is done by
opening different accounts in a separate book called ledger. For example, all
transactions relating to purchases are shown on one page from the different
books of account, cash book, and credit purchases from purchase book.
 Summarizing: This is the art of presenting the classified data in the ledger, in an
understandable and useful manner to the management or other interested
parties. This involves preparation of
o Trial Balance
o Trading & Profit and Loss Account &
o Balance Sheet
 Records transactions in terms of money: Accounting records the transactions
by expressing them in terms of money. This makes the transactions more
meaningful. Thus, if the business has 06 machines, 10 tonnes of raw materials,
20 tables, 10 fans etc... It is not possible to add them together or know which one
is more valuable unless they are expressed in terms of money.

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  Records transactions of financial character: Accounting records only those
events and transactions which are of financial character. Poor lighting &
ventilation, relationship between workers and management, though they affect
the earning capacity of the business cannot be recorded in financial books.
These events cannot be expressed in terms of money.
 Interprets the financial data: Accounting involves recording, classifying &
summarizing the financial events & finally preparation of final accounts. The
interpretation of final accounts helps in making meaningful judgments about
financial condition, profitability etc.., which in turn help the management and
other interested parties to take important decisions.

Accounting as an Information System:

Accounting as a “Language of business” communicates the financial results of an

enterprise to various interested parties by means of financial statements which have to
exhibit a “true and fair” view of its state of affairs. Like any other language, accounting
has its own complicated set of rules. However, these rules have to be used with a
reasonable degree of flexibility in response to specific circumstances of an enterprise
and also in line with the changes in the economic environment, social needs, legal
requirements and technological developments.

BOOK KEEPING, ACCOUNTING & ACCOUNTANCY:-

According to G.A Lee, the accounting system has two stages

 The making of routine records , in prescribed form and according to set rules , of
all events which affect the financial state of the organization &
 The summarization from time to time of the information contained in the records ,
its presentation in a significant form to interested parties and its interpretation as
an aid to decision making by these parties .

The first stage is called Book- keeping & the second stage is called Accounting.
Book-keeping is mainly concerned with recording of financial data whereas the
accounting involves not only recording but also balancing of accounts , interpreting the
balances , ascertaining the business results by preparing Profit & loss account &
Balance Sheet .

The term Accountancy refers to a systematized knowledge of accounting and is

regarded as an academic subject like economics, statistics etc... It explains “why to do”
& “how to do” of various aspects of accounting. In other words, while accounting refers
to the actual process of preparing & presenting the accounts; Accountancy tells us why
and how to prepare the books of account and how to summarize the accounting
information & communicate it to the interested parties.

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Is Accounting a ‘Science’ or an ‘Art’?

Any organized knowledge based on certain basic principles is a ‘science’.

Accounting is also a science. It is an organized knowledge based on scientific principles
which have been developed as result of study and experience. Of course, accounting
cannot be termed as a “perfect science” like Physics or Chemistry where experiments
can be carried and perfect conclusions can be drawn. It is a social science depending
much on human behavior and other social and economic factors. Thus, perfect
conclusions cannot be drawn. Some people, therefore, though not very correctly, do not
take accounting as a science.

Art is the technique which helps us in achieving our desired objective. Accounting
is definitely an art. The American Institute of Certified Public Accountants also defines
accounting as “the art of recording, classifying and summarizing the financial
transactions”. Accounting helps in achieving our desired objective of maintaining proper
accounts, i.e., to know the profitability and the financial position of the business, by
maintaining proper accounts.

SYSTEMS OF BOOK KEEPING:-

Book keeping is the art of recording transactions in a proper set of books. There are
two systems of bookkeeping –

• Double Entry System

• Single Entry System

Double Entry System:-

1. Meaning- Double entry system is based on the principle that “every debit must
have a corresponding credit”. According to dual aspect concept, each business
transaction has two effects; receiving of a benefit & giving of a benefit. Thus each
transaction involves two accounts. Under this system, one account will be debited and
the other will be credited. The debit aspect is recorded or posted to the debit side of an
account while the credit aspect is posted to the credit side of another account. It shows
that each and every transaction is recorded at different places in the ledger in two
accounts.

2. Principles of Double Entry System: - The following are the main principles of
double entry system –

• For every transaction two parties must be interested.

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 • Every business transaction has two aspects, one receiving of benefit and other
giving it. In simple words, Double entry system means “every debit has a corresponding
credit”.

• Both the aspects are recorded in the books of account.

• The two fold effect of a business transaction is recorded by debiting one account
and crediting the other account at the same time.

3. Advantages of double entry system:-

• Both the aspects of transactions are recorded simultaneously. They are equal in
amount. Hence, this system ensures arithmetical accuracy of accounts.

• Under the system, all business transactions are recorded perfectly, completely
and systematically. Therefore, chances of errors and frauds are reduced.

• Under this system, it is easy to find out results of the business for any period and
also state of financial position on any day. Thus, under this system, the trader knows at
any time-

I. amount receivable from each customer

II. Amount payable to each supplier

III. Expenses and income under each head

IV. Amount spent on various assets

• The system enables the accountant, to prepare the annual accounts, profit & loss
account and balance sheet.

• This system can be implemented by any organization.

Single Entry System:-

Under double entry system of book keeping, both the aspects of each and every
transaction are recorded. This is known as dual aspect analysis. Under the single entry
system, only one aspect of the transaction, personal is recorded and the other aspect is
ignored. For example goods sold on credit to a customer. Here only customer’s account
is opened and debited but goods account is not to be opened. Under this system, only
the accounts which are absolutely necessary are maintained. Other accounts, nominal
& real accounts are not opened except cash. The accounts maintained under this
system are incomplete and unsystematic and therefore not reliable .The system is
followed by small business firms.

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 1.3 PARTIES INTERESTED IN ACCOUNTING INFORMATION

Following are the parties interested to know the accounting information:

 Owners: They have contributed capital to the business and hence are interested
in knowing the profits earned by the business & its financial position as on a
particular date.
 Managers: Managers are responsible for carrying on day to day business. The
accounting information will help them in planning, decision making & controlling
business.
 Employees: Employees are interested in knowing profits made by the business
from year to year so that they can put forward their claims for higher wages &
other benefits from the employees.
 Lenders: Banks & other financial institutions that have financed business
activities would like to know how efficiently the funds lent by them are utilized.
They would also like to know the profitability & financial soundness of the
business to satisfy them that their money will be safe & repayments will be made
in time.
 Creditors: They are the suppliers of goods & services to the business on credit.
They are interested in knowing the creditworthiness of the business to determine
the limits up to which credit can be granted.
 Government: Government departments collect income tax, sales tax, excise
duty etc... from the business houses. These departments are interested in
studying the financial statements of the business enterprises. Government is also
interested to keep a close watch especially on big business houses & large
industrial undertakings as to how they are conducting their business.
 Prospective Investor: A person who wants to become a partner in the business
or purchase shares of a limited company would like to know how sales &
profitable would be his investment.

ADVANTAGES OF ACCOUNTING:-

 Systematic Record: The financial transactions are recorded systematically in

different books of account. The books of account will serve as historical records.
 Controlling & protecting business properties: Accounting helps to ensure that
there is no unauthorized use or disposal of any asset or properties belonging to
the business, as proper records are maintained. The information about cash on
hand , bank balance, closing stock of goods , amounts due from customers and
amounts due to suppliers is available at any time This will enable the
management to make use of these assets in the best possible way .

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  Helps to Know Profit or Loss made: Accounting records help the management
to prepare profit and loss account for any particular period and balance sheet as
on that date. These statements will show profit or loss made by the business and
the financial position of it.
 Rendering information to users: Various interested parties such as owners,
lenders, creditors, government agencies and so on get the necessary information
about the business.
 Facilitates rational decision making: By comparing its own business results
with that of the earlier years or with those of its competitors, useful conclusions
can be drawn & suitable decisions can be taken to improve the performance.

LIMITATIONS OF ACCOUNTING:

The various concepts & conventions on which the principles of accounting are
based, to a large extent are responsible for the limitations of accounting. The limitations
are stated below:

 Accounting records only business transactions which can be measured in terms

of money. Thus quality of product & human resources, locational advantages,
licenses possessed etc... do not find any place in books of account.
 Assets are brought into at historical costs, cost at which they were acquired and
they do not reflect current market values. Therefore, for an outsider who wishes
to evaluate the business, Balance sheet is not much useful if it is not
supplemented by other information.
 Facts recorded in financial statements are greatly influenced by accounting
conventions and personal judgments of the accountant or management.
Valuation of inventory, provision for doubtful debts, and assumption about useful
life of an asset may differ from one business to another.

1.4 SPECIALIZED ACCOUNTING FIELDS

As in many other areas of human activity, a number of specialized fields in

accounting also have evolved besides financial accounting. Management accounting
and cost accounting are the result of rapid technological advances and accelerated
economic growth. The most important among them are explained below:

 Tax Accounting:

Tax accounting covers the preparation of tax returns and the consideration of the
tax implications of proposed business transactions or alternative courses of action.
Accountants specializing in this branch of accounting are familiar with the tax laws
affecting their employer or clients and are up to date on administrative regulations and
court decisions on tax cases.

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  International Accounting:

This accounting is concerned with the special problems associated with the
international trade of multinational business organizations. Accountants specializing in
this area must be familiar with the influences that custom, law and taxation of various
countries bring to bear on international operations and accounting principles.

 Social Responsibility Accounting:

This branch is the newest field of accounting and is the most difficult to describe
concisely. It owes its birth to increasing social awareness which has been
particularly noticeable over the last three decades or so. Social responsibility
accounting is so called because it not only measures the economic effects of
business decisions but also their social effects, which have previously been
considered to be immeasurable. Social responsibilities of business can no longer
remain as a passive chapter in the text books of commerce but are increasingly
coming under greater scrutiny. Social workers and people’s welfare organizations
are drawing the attention of all concerned towards the social effects of business
decisions. The management is being held responsible not only for the efficient
conduct of business as reflected by increased profitability but also for what it
contributes to social well-being and progress.

 Inflation Accounting:

Inflation has now become a world-wide phenomenon. The consequences of inflation

are dire in case of developing and underdeveloped countries. At this juncture when
financial statements or reports are based on historical costs, they would fail to reflect
the effect of changes in purchasing power or the financial position and profitability of the
firm. Thus, the utility of the accounting records, not taking care of price level changes is
seriously lost. This imposes a demand on the accountants for adjusting financial
accounting for inflation to know the real financial position and profitability of a concern.
Thus emerged a future branch of accounting called inflation accounting or accounting
for price level changes. It is a system of accounting which regularly records all items in
financial statements at their current values.

 Human Resources Accounting:

Human resources accounting is yet another new field of accounting which seeks to
report and emphasize the importance of human resources in a company’s earning
process and total assets. It is based on the general agreement that the only real long
lasting asset which an organization possesses is the quality and caliber of the people
working in it. This system of accounting is concerned with, “the process of identifying

10
and measuring data about human resources and communicating this information to
interested parties”.

1.5 RELATIONSHIP OF ACCOUNTING WITH OTHER DISCIPLINES

Accounting is closely related with several other disciplines and thus to acquire a
good knowledge in accounting one should be conversant with the relevant portions of
such disciplines. In many cases they overlap accounting. The Accountant should have a
working knowledge of the related disciplines so that he can understand such
overlapping areas and apply the knowledge of other disciplines in his own work
wherever possible, or he can take the expert advice.

a. Accounting and Economics: Economics is viewed as a science of rational

decision-making about the use of scarce resources. It is concerned with the
analysis of efficient use of scarce resources for satisfying human wants. This
may be viewed either from the perspective of a single firm or of the country as a
whole. Accounting is viewed as a system, which provides data to the users to
permit informed judgment and decisions. Some non-accounting data are also
relevant for decision-making. Still, accounting provides a major database.

Accounting overlaps economics in many respects. It contributed a lot in

improving the management decision-making process. But, economic theories
influenced the development of the decision-making tools used in accounting.
However; there exists a wide gulf between economists’ and accountants’
concepts of income and capital. Accountants got the ideas of value, income and
capital maintenance from economists, but brushed suitably to make them usable
in practical circumstances. Accountants developed the valuation, measurement
and decision-making techniques which may owe to the economic theorems for
origin but these are moulded in the work environment and suitably tempered with
reference to relevance, verifiability, freedom from bias, timeliness, comparability,
reliability and understandability.

b. Accounting and Statistics: The use of statistics in accounting can be

appreciated better in the context of the nature of accounting records. Accounting
information is very precise; it is exact to the last paisa. But, for decision-making
purposes such precision is not necessary and hence, the statistical
approximations are sought. In accounts, all values are important individually
because they relate to business transactions. As against this, statistics is
concerned with the typical value, behavior or trend over a period of time or the
degree of variation over a series of observations. Therefore, wherever a need
arises for only broad generalizations or the average of relationships, statistical
methods have to be applied in accounting data.

11
 Further, in accountancy, the classification of assets and liabilities as well
as the heads of income and expenditure has been done as per the needs of
financial recording to ascertain financial results of various operations. Accounting
records generally take a short-term view of events and are confined to a year
while statistical analysis is more useful if a longer view is taken for the purpose.
However, statistical methods do use past accounting records maintained on a
consistent basis. Accounting records are based on historical costs of fixed
assets, while the current assets are valued at the current values. The new
methods of inflation accounting are an attempt to correct this situation. The
correction of values is made on the basis of the current purchasing power of
money or the current value of the concerned assets revalued from the data of
purchase till the day of recording, charging depreciation on the current value, so
that the present value of the asset is in line with the current value of money. All
this would require the use of price indices or the price deflators, which are based
on statistical calculations of price changes. The functional relations showing
mathematical relations of one variable with one or more other variables are
based on statistical work. These relations are used widely in making cost or price
estimates for some estimated future values assigned to the given independent
variables. Several accounting and financial calculations are based on statistical
formulae. Statistical methods are helpful in developing accounting data and in
their interpretation.

For example, time series and cross-sectional comparison of accounting

data is based on statistical techniques. Now-a-days multiple discriminate analysis
is popularly used to identify symptoms of sickness of a business firm. Therefore,
the study and application of statistical methods would add extra edge to the
accounting data.

c. Accounting and Mathematics: Double Entry book-keeping can be converted in

algebraic form; in fact the first known book on this subject was part of a treatise
on algebra. The fundamental accounting equation will be discussed in detail
under ‘Dual Aspect Concept’ of this chapter. Knowledge of arithmetic and
algebra is a pre-requisite for accounting computations and measurements.
Calculations of interest and annuity are the examples of such fundamental uses.
While computing depreciation, finding out installments in hire-purchase and
installments payment transactions, calculating amount to be set aside for
repayment of loan and replacement of assets and calculating lease rentals,
mathematical techniques are frequently used. Accounting data are also
presented in ratio form.

With the advent of the computer, mathematics is becoming a vital part of

accounting. Understanding mathematics has become must to grasp the decision
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 models framed by statisticians, econometricians and the O.R.experts.Presently
graphs and charts are being extensively used for communicating accounting
information. In addition to statistical knowledge, knowledge in geometry and
trigonometry seems to be essential to have a better understanding about the
accounting communications system.

d. Accounting and Law: An economic entity operates within a legal environment.

All transactions with suppliers and customers are governed by the Contract Act,
the Sale of Goods Act, the Negotiable Instruments Act, etc. The entity itself is
created and controlled by laws. For example, a partnership business is controlled
by Partnership Act. A company is created by the Companies Act and also
controlled by Companies Act. Similarly, every country has a set of economic,
fiscal and labour laws. Transactions and events are always guided by laws of the
land. Very often the accounting system to be followed has been prescribed by
the law. For example, the Companies Act has prescribed the format of financial
statements. Banking, insurance and electric supply undertakings also have to
produce financial statements as prescribed by the respective legislations
controlling such entities. However, legal prescription about the accounting
system is the product of developments in accounting knowledge. That is to say,
legislation about accounting system cannot be enacted unless there is a
corresponding development in the accounting discipline. In that way accounting
influences law and is also influenced by law.
e. Accounting and Management: Management is a broad occupational field,
which comprises many functions and encompasses application of many
disciplines including those mentioned above. Accountants are well placed in the
management and play a key role in the management team. A large portion of
accounting information is prepared for management decision-making. Although
management relies on other data sources, accounting data are used as basic
source documents. In the management team, an accountant is in a better
position to understand and use such data. In other words, since an accountant
plays an active role in management; he understands the data requirements. So
the accounting system can be molded to serve the management purpose.

1.6 BASIC CONCEPTS OF ACCOUNTING

As we know that accounting is an art of recording business transactions in a

systematic way. For recording transactions certain basic rules are laid down. These are
based on experience, reason, usage and necessity. These are fundamental ideas or
basic assumptions underlying the theory and practice of financial accounting and are
the broad working rules for all accounting activities developed and accepted by the
accounting profession.

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 ACCOUNTING CONCEPTS

At the recording stage At the reporting stage

Going Concern Concept

Business Entity Concept
Accounting Period Concept
Money Measurement Concept
Matching Concept
Objective evidence Concept
Conservatism concept

Historical Record Concept Full Disclosure Concept

Cost Concept Consistency Concept

Dual Aspect Concept Materiality Concept

A. Concepts at the recording Stage:

 Business Entity Concept: A business is always separate from its owner. The
affairs of business must not be mixed up with the private affairs of the owners or
other persons associated with it. This concept is applicable to all forms of
business. Thus in sole proprietary or partnership business , amounts brought in
by the proprietor and partners or their personal withdrawals are shown separately
as capital and drawings respectively .This concept is applicable to all forms of
business .Thus , in sole proprietary or partnership business , amounts brought in
or personal withdrawals are shown separately as capital and drawings
respectively .
 Money Measurement Concept: In accounting, all transactions are expressed &
interpreted in terms of money. Money is the common unit of measurement. Fixed
assets like furniture, land, buildings, plant etc... are expressed in terms of money
and in terms of area, numbers. The only drawback of this concept is that
transactions which cannot be measured in terms of money do not find a place in

14
 business records. Thus, quality of product, management and industrial relations
cannot be expressed anywhere in the accounts. Secondly, the value of money
goes on decreasing due to inflationary trends in the economy from time to time
and therefore, accounting data may not reveal true & fair view of the business
affairs.
 Objective evidence Concept: According to this concept, all accounting
transactions should be evidenced & supported by objective documentary
evidence. Thus, purchase invoices, sales invoices, cash memos, vouchers,
cheque book, pass book, etc from this documentary evidence. The entries
passed in the books of account can be verified by owners, auditors & others by
reference to these documents.
 Historical record concept: Accounting involves recording of business
transactions which have taken place. A trader purchases a business premises for
Rs, 5, 00,000 /- . The mount due is paid to vendor & business acquires that
place. Now these transactions can be recorded in the books. The business
transactions are recorded as and when they take place; date wise. This leads to
preparation of historical records of all transactions. The future transactions can
hardly be identified & measured accurately.
 Cost Concept: Business transactions which can be measured in terms of money
can only be recorded. An amount spent for acquiring a particular asset will be its
cost. A trader buys an imported machine from Germany. He pays Rs. 5, 00,000 /-
to the suppliers. He has to incur further sum of Rs. 7, 00,000 /- for payment of
import duty and clearing charges. Now, in this case, total cost of the machine will
be Rs. 12, 00,000 /- . Thus, according to cost concept, an asset is recorded at
the price at which it is acquired.
 Dual Aspect Concept: Every business transaction has a dual effect, one
receiving of a benefit and the other giving of a benefit. For example, when a firm
acquires an asset (receiving of a benefit) it must have to pay cash (giving of a
benefit). Therefore, two accounts are to be opened in the books of account, one
for receiving the benefit and the other for giving the benefit. Thus, there will be a
double entry for every transaction. For each and every debit, there must be a
corresponding credit and vice versa. This is nothing but the principles of double
entry system of accounting which is known as dual aspect concern.

Let us look at another accounting implication of the dual aspect concept. The initial
amount required to start a business is contributed by the owner. If additional funds are
required, bank loans are taken. As per the dual aspect concept, all these receipts create
corresponding obligations for their repayment. In other words, a contribution to the
business, either in cash or kind, not only increases its resources (assets), but also its
obligations (liabilities) correspondingly. Thus, at any given point of time, the total assets

15
and the total liabilities must be equal. This equality is called Balance Sheet Equation or
Accounting Equation.

LIABILITIES = ASSET, orCAPITAL + LIABILITIES = ASSETS, or ASSETS –

LIABILITIES = CAPITAL

B. Concepts at Reporting Stage :

 Going Concern Concept: This concept is also known as a continuing concept
or concept of continuity of a business unit. It is presumed that a business unit has
an indefinite life or existence, unless there is specific information or clear and
strong evidence to the contrary. The whole process of preparing profit and loss
account and balance sheet is the result of this concept.
 Accounting Period Concept: Though the “going concern” concept stresses the
continuing nature of the business enterprise. It is customary to divide its life into
periods known as accounting period. An accounting period is the interval of time
at the end of which the income statement and financial position statement
(Balance sheet) are prepared to know the results and resources of the business.
This period is normally one year, 12 months ending on a particular date, says
30th June, 31st December or 31st march. This is also necessary to comply with
legal requirements, filling of income tax and sales tax returns every year, holding
of annual general meeting of shareholders of a limited company etc.
 Matching Concept: This concept is based on the accounting period concept.
The expenses which are actually incurred during a specific accounting period , in
order to earn the revenue for the said period must be matched against the
revenues which are realized for that period .Therefore , as per this concept
adjustments are made for all outstanding expenses , prepaid expenses , accrued
income , income received in advance etc .
 Conservatism concept: It is a policy of caution or playing safe and has its origin
as a safeguard against possible losses in a world of uncertainty. The accountant
wants to play safe particularly in the determination of incomes or profit or loss
and in the process of valuation, which he is associated with in the accounting
literature. He does not consider any gain or income until the same has been
realized or converted into money but he does consider all future expected losses
and contingencies. Following are the example of application of conservatism :
o Making provision for doubtful debts and discount on debtors
o Valuing stock in trade at cost or market price , whichever is less
o Making provision against fluctuations in the prices of investments
 Full disclosure concept: This implies that accounts must be honestly prepared
and all material information must be disclosed therein. The Indian companies act
makes ample provisions for the disclosure of essential information in accounts.
The contents of Balance sheet & profit and loss accounts are prescribed by law.

16
 These are designed to make disclosure of all material facts compulsory. The
practice of appending notes relating to various facts or items which do not find
place in accounting statements is in pursuance of the convention of full
disclosure of material facts.
 Consistency concept: The comparison of one accounting period with the other
is possible, only when the convention of consistency is followed. It means that
the accounting practices and methods remain unchanged from one accounting
period to another. For example, a company may adopt straight line method,
written down method or any other method of providing depreciation on fixed
assets. It is expected that keeping in mind the consistency concept, the company
would consistently follow the same method of depreciation which is chosen. Any
change from one method to another would result in inconsistency. Similarly, if
stock is valued at cost or market price, whichever is less, this principle should be
followed every year.
 Materiality Concept: This accounting concept means that effect of all
significance or material transactions must be disclosed or reported in conformity
with the generally accepted accounting principles. Items that are material in
amount and significance must be disclosed. As per the American Accounting
Association “an item should be regarded as material if there is a reason to
believe that knowledge of it would influence the decision of an informal investor”.
Indian companies act prescribes that a separate disclosure of items of expenses
and income should be made. If it exceeds 1 % of the total revenue or Rs. 5,000 /-
whichever is greater.

Qualitative Characteristics of Financial Statement:

 Relevance: This means selecting the information most likely to aid the users in
their economic decisions.
 Understandability: which implies not only that the selected information must be
intelligible but also that the users of financial reporting can understand it.
 Verifiability: This implies that the accounting results may be corroborated by
independent measures using the same method of measurement.
 Neutrality: This implies that the accounting information is directed towards the
common needs of users rather than the particular needs of specific user.
 Timeliness: This implies as early communication of information to avoid delays
in economic decision-making.
 Comparability: This implies that differences should not be the result of different
financial accounting treatments.
 Completeness: This implies that all the information that reasonably fulfills the
requirements of the other qualitative objective should be reported.

17
 Besides qualitative characteristics there are some quantitative characteristics of
financial reporting are also mentioned as under:

 To provide reliable information about economic resources and obligations of

business enterprise in order to (i) evaluate its strengths and weaknesses (ii)
show its financing and investment (iii) evaluate its ability to meet its commitments
and (iv) show its resource base for growth.
 To provide reliable information about changes in net resources resulting from a
business enterprise’s profit directed activities in order to (i) show to investor
expected dividend return (ii) show the operation’s ability to pay creditors and
suppliers, provide jobs for employees, lay taxes and generate funds for
expansion (iii) provide management with information for planning and control (iv)
show its long term profitability.
 To provide financial information useful for estimating the earning potentials of the
firm.
 To provide other information about changes in economic resources and
obligations.
 To disclose other information relevant to statement user’s needs.

1.7 ACCOUNTING STANDARDS AND INTERNATIONAL ACCOUNTING

STANDARDS COMMITTEE:

International Accounting Standards Committee (IASC) came into existence on

29th June, 1973 when 16 accounting bodies from nine nations called as founder-
members signed the agreement and constitution for its formation. The Committee has
its headquarters at London.

The objective of the Committee was “to formulate and publish inthe public
interest standards to be observed in the presentation of audited financial statements
and to promote their world-wide acceptance and observance”. The formulation of such
standards will bring uniformity in terminology, approach and presentation of results. This
will not only help in a correct understanding and exchange of economic and financial
information but also in facilitating a smooth flow of international investment.

Between 1973 and 2000, the IASC issued several Accounting Standards, known
as International Accounting Standards (IASs). Since 2001, the IASC was renamed as
the International Accounting Standards Board (IASB). The IASB has now taken over the
work of IASC. The IASB has issued a new series of pronouncements known as
International Financial Reporting Standards (IFRSs) on topics on whichthere was no
previous IAS. Besides this, the IASB has replaced some IASs with new IFRSs. Thus,
now the IASs issued by the IASC and IFRS issued by the IASB all come within the
preview of IASB.

18
 The list of 41 IASs issued7 by the IASC Between 2000-2003 and 8IFRSs issued
by the IASB is given below:

International Financial Reporting Standards (IFRS)

IFRS 1 First-time Adoption of International Financial

ReportingStandards
IFRS 2 Share-based Payment
IFRS 3 Business Combinations
IFRS 4 Insurance Contracts
IFRS 5 Non-current Assets held for Sale and Discontinued
Operations
IFRS 6 Exploration for and Evaluation of Mineral Assets
IFRS 7 Financial Instrument: Disclosures
IFRS 8 Operating Segments

International Accounting Standards (IAS)

IAS 1 Presentation of Financial Statements.

IAS 2 Inventories

IAS 3 Consolidated Financial Statements. (Originally issued in 1976, effective 1

Jan. 1977.Superseded in 1989by IAS 27 and IAS 28)

IAS 4 Depreciation Accounting. (Withdrawn in 1999 Replaced by IAS 16, 22 and

38, all of which were issued or revised in 1998)

IAS 5 Information to be Disclosed in Financial Statements.(Originally issued in

Oct. 1976, effective 1 January1997. Superseded by IAS 1 in 1997)

IAS 6 Accounting Responses to Changing Prices. (Superseded by IAS 15,

which was withdrawn in December 2003)

IAS 7 Cash Flow Statements.

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

IAS 9 Accounting for Research and Development Activities (Superseded by IAS

38 effective 1 July 1999)

IAS 10 Events after the Balance Sheet Date.

IAS 11 Construction Contracts.

IAS 12 Income Taxes.

19
 IAS 13 Presentation of Current Assets and Current Liabilities. (Superseded by
IAS 1)

IAS 14 Segment Reporting.

IAS 15 Information Reflecting the Effects of Changing Prices. (Withdrawn in

December 2003)

IAS 16 Properties, Plant and Equipment.

IAS 17 Leases.

IAS 18 Revenue.

IAS 19 Employee Benefits.

IAS 20 Accounting for Government Grants and Disclosure of Government

Assistance.

IAS 21 The Effects of Changes in Foreign Exchange Rates.

IAS 22 Business Combinations. (Superseded by IFRS 3 effective 31 March 2004)

IAS 23 Borrowing Costs.

IAS 24 Related Party Disclosures.

IAS 25 Accounting for Investments. (Superseded by IAS 39 and IAS 40 effective

2001)

IAS 26 Accounting and Reporting by Retirement Benefit Plans.

IAS 27 Consolidated and Separate Financial Statements.

IAS 28 Investments in Associates.

IAS 29 Financial Reporting in Hyperinflationary Economies.

IAS 30 Disclosures in the Financial Statements of Banks and Similar

Financial Institutions. (Superseded by IFRS 7effective 2007)

IAS 31 Interests in Joint Ventures.

IAS 32 Financial Instruments: Presentation. (Disclosure provisions. Superseded

by IFRS 7 effective 2007)

IAS 33 Earnings Per Share.

20
 IAS 34 Interim Financial Reporting.

IAS 35 Discontinuing Operations. (Superseded by IFRS 5effective 2005)

IAS 36 Impairment of Assets.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

IAS 38 Intangible Assets.

IAS 39 Financial Instruments: Recognition and Measurement.

IAS 40 Investment Properties.

IAS 41 Agriculture.

The International Accounting Standards Committee (IASC) announced in

January, 1975 the following standards regarding disclosure of fundamental accounting
assumptions and policies.

Fundamental Accounting Assumptions:

Fundamental Accounting Assumptions refer to those accounting standards whose

acceptance and use are assumed in the preparation of financial statements. The IASC
recognized the following as fundamental accounting assumptions.

Going concern: The enterprise is normally viewed as a going concern, i.e., as

continuing in operation for the foreseeable future. It is assumed that the enterprise has
neither the intention nor the necessity of liquidation or foreseeable future. It is assumed
that the enterprise has neither the intention nor the necessity of liquidation or of
curtailing materially the scale of its operations.

Consistency: It is assumed that accounting policies are constant from one period to
another.

Accrual: Revenue and costs are accrued, i.e., recognized as they are earned or
incurred (and not as money is received or paid), and recorded in the financial
statements of the periods to which they relate (the considerations affecting the process
of matching costs with revenues under the accrual assumptions are not dealt with in this
statement).

In case any of the above fundamental accounting assumptions isnot followed,

that fact should be disclosed in the financial statements together with reasons.

21
Accounting Policies:

Accounting policies include the principles, bases, conventions, rulesand

procedures adopted by management in preparing financial statements. There are
different policies in use even in relation to the same subject. The management should
select a policy which properly represents the financial position as well as the results of
operations of the enterprise.

The following considerations should govern the selection andapplication of the

appropriate accounting policies and preparation of financial statements by the
management.

Prudence: Uncertainties inevitably surround many transactions. This should be

recognized by exercising prudence in preparing financial statements. Prudence does
not, however, justify the creation of secret or hidden reserves.

Substance over form: Transactions and other events should beaccounted for and
presented in accordance with their substance andfinancial reality and not merely with
their legal form.

Materiality: Financial statements should disclose all items which are material enough to
affect evaluation or decisions.

1.8 ACCOUNTING STANDARDS IN INDIA

International Accounting

Standards Committee

Institute of Chartered

Accountants of India (ICAI)

Standing Non-standing
Committees Committees

22
 Expert Accounting Research Auditing

Advisory Standards Committee Practices

Committee Board Committee

Accounting Standard Board (ASB), constituted by ICAI on 21.04.1977, prepares

Accounting Standards (AS) and presents to ICAI for consideration and issuance under
the authority of the council of ICAI.

Clarification issued by ICAI regarding the authority attached to the documents AS:

AS establish standards which have to be complied with to ensure that financial

statements are prepared in accordance with generally accepted accounting standards.
AS become mandatory on the dates specified either in the respective documents or by
notification issued by the council.

What constitutes “true and fair view” has not been defined either in the
Companies Act 1956 or in any other statute. The pronouncements of the Institute like
AS seek to describe.The accounting principles and the methods of applying these
principles in the preparation and presentation of financial statements so that they give a
true and fair view.

Sl. Nature of Pronouncements of

Prepared by Subjects covered
No. Institute

Accounting Standard
1. Accounting Standards (AS) Accounts
Board (ASB)

Statements on Standard Auditing Auditing Practices

2. Auditing
Practices (SAP) Committee (APC)

3. Statements Research Committee Accounting Auditing

23
 (RC)

Accounting,
RC, ASB, APC,
Auditing, Taxes
4. Guidance Notes (GN) Technical
other Technical
Committees
Areas, ethics etc.

Accounting,Auditing,
Expert Advisory code of conduct and
5. Opinions
Committees Professional Ethics,
Taxes etc.

Notes:

i. AS& Statements are mandatory.

ii. GN and opinions are recommendatory.

iii. All documents except OPINIONS are issued under the authority of ICAI.

iv. Where certain matters are covered both by a “statement” and by an

“Accounting Standards”, “Statement” shall prevail till “Accounting Standard”
becomes mandatory. Once “Accounting Standards” becomes mandatory,
concerned “Statement” shall automatically stand withdrawn.

Functions of Accounting Standards Board:

 To harmonize diverse accounting policies and practices prevailing in India by

formulating Accounting Standards to be established by ICAI.
 To give due consideration to the applicable laws, customs, usage and
business environment of India.
 To integrate, to the extent possible, international Accounting Standards, in the
light of the auditing practices prevailing in India.

24
  To give classifications on issue in Accounting Standards by issuing guidance
notes.
 To propagate AS and to persuade concerned parties to adopt AS in the
preparation and presentation of financial statements.

Scope of Accounting Standards:

1. Accounting Standards should be prepared in conformity with the provisions of the

applicable laws, customs, usages and business environment of our country.
2. If due to subsequent amendments in the law, a particular Accounting Standard is
found to be not in conformity with such law, the provisions of the said law will
prevail and the financial statements should be prepared in conformity with such
law.
3. The Accounting Standards by their very nature cannot and do not override the
local regulations which govern the preparation and presentation of financial
statements in our country.
4. The ICAI will determine the extent of disclosure to be made in financial
statements and the related auditor’s reports. Such disclosure may be by way of
appropriate notes explaining the treatment of particular items.
5. The Accounting Standards are intended to apply only to items which are material.
Any limitations with regard to the applicability of a specific Standard will be made
clear by the Institute from time to time.
6. The date from which a particular Standard will come into effect, as well as the
class of enterprises to which it will apply, will also be specified by the Institute.
However, no standard will have retroactive application, unless otherwise stated.
7. The Institute will use its best endeavors to persuade the Government,
appropriate authorities, industrial and business community to adopt these
Standards in order to achieve uniformity in the presentation of financial
statements.
8. In carrying out the task of formulation of Accounting Standards, the intention is to
concentrate on basic matters. The Endeavour would be to confine Accounting

25
 Standards to essentials and not to make them so complex that they cannot be
applied effectively and on a nation-wide basis.
9. In the years to come, it is to be expected that Accounting Standards will undergo
revision and a greater degree of sophistication may then be appropriate.

PROCEDURES FOR ISSUING ACCOUNTING STANDARDS

DETERMINITION OF BROAD

AREAS BY ASB

FORMATION OF

STUDY GROUPS

HOLD DIALOGUES WITHGOVT, PSU’s, INDUSTRY ETC.

ISSUE OF EXPOSURE DRAFT

RECEIVE COMMENTS ON

EXPOSURE DRAFT

FINALISE AND PRESENT

FINAL DRAFT TO COUNCIL

COUNCIL ISSUES ACCOUNTING STANDARDS

NOTE: Council can modify the final draft of AS in consultations with ASB.

Procedure for Issuing Accounting Standards:

The Institute of Chartered Accountants of India, recognizing the need to harmonize

the diverse accounting policies and practices at present in use in India, constituted an
Accounting Standards Board (ASB) on 21st April, 1977 for issue of accounting
standards.The main function of ASB is to formulate accounting standards taking into
consideration the applicable laws, customs, usages and business environment, so
that such standards may be established by the Council of the Institute in India. ASB

26
issues guidance notes on the Accounting Standards and give clarifications on issues
arising there from. ASB will also review the Accounting Standards at periodical intervals.
The procedure for issue of accounting standards is:

1. ASB shall determine the broad areas in which Accounting Standards need to be
formulated and the priority in regard to the selection thereof.
2. In the preparation of Accounting Standards, ASB will be assisted by Study
Groups constituted to consider specific subjects. In the formation of Study
Groups, provision will be made for wide participation by the members of the
Institute and others.
3. ASB will also hold a dialogue with the representatives of the Government, Public
Sector Undertakings, Industry and other organizations for ascertaining their
views.
4. On the basis of the work of the Study Groups and the dialogue with the
organizations, an exposure draft of the proposed standard will be prepared and
issued for comments by members of the Institute and the public at large.
5. After taking into consideration the comments received, the draft of the proposed
Standard will be finalized by ASB and submitted to the Council of the Institute.
6. The Council of the Institute will consider the final draft of the proposed Standard,
and if found necessary, modify the same in consultation with ASB. The
Accounting Standard on the relevant subject will then be issued under the
authority of the Council.

The draft of the proposed standard will include the following basic points:

 A statement of concept and fundamental accounting principles relating to the

standard.
 Definitions of the terms used in the standard.
 The manner in which the accounting principles have been applied for formulating
the standard.
 The presentation and disclosure requirements in complying with the standard.
 Class of enterprises to which the standard will apply.

27
  Date from which the standard will effective.
 After taking into consideration the comments received, the draft of the proposed
standard will be finalized by ASB and submitted to the council of the Institute.
 The council of the Institute will consider the final draft of the proposed standard,
and if found necessary modify the same in consultation with ASB. The
Accounting Standard on the relevant subject will then be issued under the
authority of the council.

Accounting standards which seek to suggest rules and criteria of accounting

measurements have to keep the above in view. On the one hand, the rules and criteria
cannot be rigid and on the other they cannot permit irrational and totally expedient
accounting measurements. Formulation of proper accounting standards is a vital step in
developing accounting as a business language.

In India there are thirty two accounting standards. These accounting standards are
prepared by the Accounting Standard Board constituted by the ICAI and issued by the
ICAI. The term accounting Standard is defined as a written statement issued from time
to time by institutions of accounting profession or institutions in which it has sufficient
involvement and institutions which are established expressly for this purpose.
Accounting standards mainly deal with financial measurements and disclosures for a
fair presentation of financial statements. In this respect Accounting Standards can be
thought of as a system of measurement and disclosure

Benefits of Accounting Standards:

Accounting Standards improve the reliability and credibility of financial

statements. Standards reduce or eliminate the confusing variation in accounting
treatments. Facilitates comparison of financial statement between companies over a
period of time. Standards help in promoting a better understanding of financial
statements.

Types of Accounting Standards:

AS may be classified by their subject matter and by how they are enforced.

28
Disclosure Standards – Specify minimum uniform rules for external reporting.

Presentation Standards - Specify the form and type of accounting information to be

presented

Content Standards – Specify the accounting information which is to be published.

Accounting Standards in India:

AS Title of Standard Effective Dates

No.
1 Disclosure of Accounting Policies 1st April 1991
2 Valuation of Inventories 1st April 1999
3 Cash Flow Statement 1st April 2001
4 Contingencies and events occurring after 1st April 1996
Balance Sheet Date
5 Net Profit or loss for the period, Prior period 1st April 1996
items, Changes in Accounting Policies
6 Depreciation Accounting 1st April 1995
7 Construction Contracts 1st April 2003
8
9 Revenue Recognition 1st April 1991
10 Accounting for Fixed Assets 1st April 1991
11 Effect of Changes in Foreign Exchange Rates 1st April 1995
12 Accounting for Government Grants 1st April 1994
13 Accounting for Investments 1st April 1995
14 Accounting for Amalgamations 1st April 1995
15 Accounting for Retirement benefits in the 1st April 1995
financial statement of Employers
16 Borrowing Cost 1st April 2000
17 Segment Reporting 1st April 2001
18 Related Party Disclosure 1st April 2001
19 Leases 1st April 2001

29
20 Earnings per Share 1st April 2001
21 Consolidated Financial Statement 1st April 2001
22 Accounting for taxes on Income 1st April 2001
23 Accounting for Investments in Associates in 1st April 2002
Consolidated Financial Statements
24 Discounting Operations 1st April 2004
25 Interim Financial Reporting 1st April 2002
26 Intangible Assets 1st April 2003
27 Financial Reporting of Interests in Joint Ventures 1st April 2002
28 Impairment of Assets 1st April 2004
29 Provisions, Contingent Liabilities and Contingent 1st April 2004
Assets
30 Financial Instruments:Recognition and 1st April 2011
Measurement
31 Financial Instruments: Presentation 1st April 2011
32 Financial Instruments: Disclosures 1st April 2011

Compliance with the Accounting Standards:

While discharging their attest functions, it will be the duty of the members of the
Institute to ensure that the Accounting Standards are implemented in the presentation of
financial statements covered by their audit reports. In the event of any deviation from
the Standards, it will be also their duty to make adequate disclosures in their reports so
that the users of such statements may be aware of such deviations.

In the initial years, the Standards will be recommendatory in character and the
Institute will give wide publicity among the users and educate members about the utility
of Accounting Standards and once awareness about these requirements is ensured,
steps will be taken, in course of time, to enforce compliance with the accounting
standards. The adoption of Accounting Standards and disclosure of the extent to which
they have not been observed will, over the years, have an important effect, with
consequential improvement in the quality of presentation of financial statements.

30
IFRS Convergence in India:

The need for harmonization of financial reporting is being increasinglyfelt all over
the world to raise confidence among investors generally ininformation they are using to
make their decision and assess their risk.This requires each nation to design and
maintain National AccountingStandards in way that they largely comply with the
requirements ofInternational Financial Reporting Standards. In line with the global
trend,the Institute of Chartered Accountants of India, has proposed a plan
forconvergence of the Indian Accounting Standards with the InternationalFinancial
Reporting Standards.The Institute of Chartered Accountants of India (ICAI), has also
sofar formulated 35 Indian Accounting Standards (IND ASs) convergedwith IFRS which
are in line with corresponding IAS/IFRS, adoptableunder the conditions prevailing in the
country. All these IND ASs samehave also been notified by Ministry of Corporate Affairs
on 25 February, 2011 on the recommendation of National Advisory Committee
onAccounting Standards (NACAS).

A list of Indian Accounting Standards (IND ASs) corresponding to IAS/IFRS and as

developed and finalized by the Institute of Chartered Accountants of India approved by
the National Advisory Committee on Accounting Standards and notified by the Ministry
of Corporate Affairs is as under:

Ind AS 1: Presentation of financial statements

Ind AS 2: Inventories

Ind AS 7: Statement of cash flows

Ind AS 8: Accounting policies, changes in accounting estimates anderrors

Ind AS 10: Events after the reporting period

Ind AS 11: Construction contracts

Ind AS 12: Income tax

31
Ind AS 16: Property, plant and equipment

Ind AS 17: Leases

Ind AS 18: Revenue

Ind AS 19: Employee benefits

Ind AS 20: Accounting for government grants and disclosures of government

assistance

Ind AS 21: The effects of changes in foreign exchange rates

Ind AS 23: Borrowing costs

Ind AS 24: Related party disclosures

Ind AS 27: consolidated and separate financial statements

Ind AS 28: Investment in associates

Ind AS 29: Financial reporting in hyperinflationary economics

Ind AS 31: Interests in joint ventures

Ind AS 32: Financial instruments: presentation

Ind AS 33: Earning per share

Ind AS 34: Interim financial reporting

Ind AS 36: Impairment of assets

Ind AS 37: Provisions, contingent liabilities and contingent assets

Ind AS 38: Intangible assets

32
Ind AS 39: Financial instruments: recognition and measurements

Ind AS 40: Investment property

Ind AS 101: First-time adoption of Indian Accounting Standards

Ind AS 102: Share-based payment

Ind AS 103: Business combinations

Ind AS 104: Insurance contracts

Ind AS 105: Non-current assets held for sale and discontinued operations

Ind AS 106: Exploration for and evaluation of mineral resources

Ind AS 107: Financial instruments: disclosures

Ind AS 108: Operating segments

The Ministry of Corporate Affairs has already confirmed that there will be two
separate sets of Accounting Standards. One set to comprise the Indian Accounting
Standards (Ind ASs) conversed with International Financial Reporting Standards which
shall be applicable to specified class of companies as may be notified by the
Government. However, before such notification and implementation, it may be
necessary to amend the concerned Acts such as the Companies Act, Income Tax Act,
the Insurance Act and SEBI Act etc.

1.9 SUMMARY

33
  Accounting records only those transactions and events in terms of money which
are of a financial character.
 International Accounting Standards Committee (IASC) came into existence on 29th
June, 1973.
 Accounting policies include the principles, bases, conventions, rules and
procedures adopted by management in preparingfinancial statements.
 Responsibility for the preparation of financial statements and forthe adequate
disclosure is that of the management of theenterprise.
 The need for harmonization of financial reporting is beingincreasingly felt all over
the world to raise confidence amonginvestors generally in information they are
using to make theirdecision and assess their risk.

1.10 KEY TERMS

 Accounting: language of business.

 Financial Accounting: concerned with the recording of transactions for a
business enterprise and the periodic preparation of various reports from such
records
 Accounting Principle: the body of doctrines commonly associated with the theory
and procedure of accounting.
 Accounting Concept: accounting postulates i.e. Necessary assumptions or
conditions upon which accounting is based.
 Accounting Conventions: convention signifies the customs or traditions which
serve as a guide to the preparation of accounting statements.
 Accounting Standard: standards to be observed in the presentation of financial
statements.
 Fundamental accounting assumptions: Whose acceptanceand use are
assumed in the preparation of financial statements.
 Financial statement: An organized collection of data accordingto logical and
consistent accounting procedures.

34
  Income statement: Explains what has happened to a businessas a result of
operations between two balance sheet dates.
 Balance sheet: It is a statement of financial position of a business at a specified
moment of time.

1.11 QUESTIONS AND EXERCISES

1. Why is accounting called the language of business?

2. What are the functions of accounting?
3. Accounting as a social science can be viewed as an information system.
Examine.
4. Give an account of the various branches of accounting.
5. ‘Accounting is a service function’. Discuss the statement in the context of a
modern manufacturing business.
6. What are accounting concepts and conventions? Is there any difference between
them?
7. What is the significance of dual aspect concept?
8. Write a short note on accounting standards.
9. Explain the procedure of setting AS in India by ASB.
10. What is the position in India regarding the formulation and enforcement of
accounting standards?
11. Give an overview of the basic accounting concepts andconventions.
12. Write a note on Accounting Standards and InternationalAccounting Standards
Committee.

*****

35
 UNIT-2 STATUTORY FINANCIAL STATEMENTS

Structure

2.0 Introduction.

2.1 Unit objectives.

2.2 Statutory reports.

2.3 Preparation & presentation of final accounts.

2.4 Revised Schedule VI.

2.5 Managerial remuneration.

2.6 Divisible profits & dividends.

2.7 Recent trends in corporate reporting.

2.8 Accounting reports.

2.9 Summary.

2.10 Key Terms.

2.11 Questions and Exercises.

2.0 INTRODUCTION:

Annual reports of companies have emerged as common medium of financial

reporting. However other Medias are also being used e.g., prospects interim reporting
and public relation offers of companies. Any of these can serve the purpose of financial
reporting of a company. But despite the presences of all these medium annual reports
of companies are still regarded most significant source of information about affairs of
the companies. T.A. Lee and D. P. Tweedie in their research paper “Accounting
Information: an investigation of private shareholder usage” in 1975 (pp. 280-291) have
mentioned.

2.1 UNIT OBJECTIVES

After reading this lesson, you will be able to:

1
  Understand financial reports of company.
 Understand preparation of company final accounts.
 Realize the Need for mandatory disclosure by the Company.
 Enumerate the statutory register to be kept by the company.
 Calculate managerial remuneration.
 Enumerate the legal provisions relating to the nature of particulars to be shown in
the profit and loss account.
 Specify the legal requirements affecting presentation and preparation of
company balance sheet.

2.2 STATUTORY REPORTS

Requirement of Annual Reports:

Annual report is considered most important of the sources of information on account of

following reasons:

 Annual report is relatively more and easily accessible than any other source of
information.
 Annual report contains audited information, which creates confidence among the
public.
 Annual report includes besides financial statements, some more detailed
information such as historical summary, data, important business results,
company’s plans and policies which are not available in other sources of
information.
 Annual reports represents most commonly available source of information on
past performance.

INDIAN CORPORATE ANNUAL REPORT

Indian Corporations formed under Company Law, 1956 are legally required to
provide to their shareholders and debenture holders information regarding financial
results of an accounting period. This annual report which can be conveniently into
several section as follows:

a) Directors Report.

b) Profit and Loss Account.

2
c) Balance Sheets.

d) Notes and schedules related with financial statements.

e) Ten years record of operating results minimum 5 years records.

f) Details about employees.

There are some other Indian companies, which are providing more information in
addition to the above. Such additional disclosures are related with Human resource
Accounting inflation accounting and social corporate reporting. With the mandating of
AS-3 in India regarding cash flow statements now Indian companies are required to
present cash flow statement as per requirements of AS-3 revised by ASB of ICAI.

SUGGESTIONS FOR IMPROVEMENT IN FINANCIAL REPORTING:

a) Improvement in Director’s Report: It has been found in most of the director’s

significant events, their causes, results and implications particularly financial in coming
period. Director’s report should avoid promotional comments, subjectively and should
be frank in exposition. Director report should be more informative as has a great bearing
on credibility of the annual report as a whole.

b) Statement of objectives and strategies: It is suggested the preparation of a

separate statement of objectives of the company and its board strategies may be
prepared to help the various external users groups in predicting the future earning
power of the company.

c) Segment Reporting: Diversified companies should provide segment information

to help the users particularly investors in making better assessment of earning capacity
and general financial position of the business as a whole. It is also suggested to provide
information on foreign operations if any, such as sales, operating expenses, Net profit
and other items of balance sheet besides the only information of foreign sales.

d) Effects of Inflation: Effect of inflation on financial statement has become a

number one problem throughout the whole globe. Accounting researchers are still busy
in doing research on various models of inflation accounting and could not develop a
single inflation accounting model, which could get worldwide acceptance. However
financial reporting should incorporate information reflecting effects of inflation on the
financial statements. Management may opt any single model for the purpose.

e) Disclosures on Human resources: It has been observed by going through

various annual reports particularly in India only disclosures are being made on Human
resource information. It is desirable to provide information on human resource
accounting with the help of various models to improve the utility of financial reports for

3
the users. It has been found only few companies in public sector are using Lev and
Schwartz model for valuation of human resources. Human resources accounting
information has a great potential not only for the management but also important for
investor in investment valuation.

f) Information on Social Desirability: Annual reports should incorporate social

responsibility information so as to help to evaluate accountability of business
enterprises towards different sections of the society. A business corporation is not only
responsible only to the shareholders but also to the shareholders who are also the
users of financial reports. Various social accounting models have been developed by
accounting researchers. Management can select one model for providing social
information and can provide opportunity to stake holders to determine social desirability
of reporting entity.

g) Interim Reporting: Companies while doing financial reporting must keep in mind
that reporting has not remain only annual feature but investors and other users are
interested in getting financial information throughout an accounting year. Investment
decisions are made by the investors throughout the year and not necessarily at the end
of accounting period only. Quarterly or half yearly interim information should be reported
to the investors.

h) Simplification of Financial Reports: Financial reports should be more

simplified to make it more easily understandable by common investors. It can be done
by better-organized data. Presentation of the financial information can be made simple
with the help of graphs and diagrams and tables.

i) Highlighting Government Policies: Corporate financial reporting should

highlight policies of the governments and developments being taken in place in
economy. Any changes in government policy do affect the earning potentials of the
company. Information in this regard will help the investors while making investment
decisions.

j) Use of Accounting Ratios: Ratio Analysis is most popular tool of financial

analysis and has got worldwide recognition. Various accounting ratios along with
principal ratio i.e., ROI can be calculated and presented to analyze liquidity, profitability,
solvency and activity of the reporting enterprise. Incorporation of various accounting
ratios will improve the quality of financial reporting.

k) Information on Cash Flow Data: Investors and creditors prefer cash flow data
that net profit disclosed by the reporting entity because investors are not only interested
in mere declaration of dividends but in the payments of dividend. Creditors are also
interested in liquidity of the enterprise than the profitability. In India AS 3 has been made

4
mandatory to present cash flow statement in a prescribed format. Only cash flow data
helps the investors in making their investment decisions.

It is advised that while taking investment decisions investor must assess risk
also. Another important risk is regarded as market risk. Which is related fluctuations
e.g., in interest rates, foreign currency rates, or commodity prices that are beyond the
control of management. Although market risk affects all the firms, most extant studies
investigating interest rate risk focus on financial institutions for three primary reasons.
First, interest rate risk is economically significant for financial institutions because of the
close link between interest rate risk and operating risk. Second financial institutions are
major participants in the derivatives market, a focus of some risk studies. Third
disclosures required primarily by financial institution regulators provide empirical proxies
for risk that researchers can study.

Legal formalities and provisions for the preparation of final accounts:

In order to understand the preparation of final statement of companies, it is

necessary to follow some of the provisions and following few sections:

 Statutory contents of the final statement that is balance sheet, profit and loss
account and directors reports.
 Accounting treatment of the various new accounts and adjustments which are not
found in final accounts of sole trading concern or partnership firms.
 Calculation of managerial remuneration according to the basis of some legal
provisions.
 The meaning of divisible profits and accounting treatment of dividend in final
accounts of companies.
 Guidelines in the issue of bonus shares and accounting treatment of it in final
accounts.
 Solved examination problems by giving new ideas of examination
standards.

2.3 PREPARATION & PRESENTATION OF FINAL ACCOUNTS

Under section 210 of the Companies Act, 1956 it has been made compulsory to
present the balance sheet and profit and loss account at every annual general meeting
of the company. It should be placed within one year but not exceed 15 months.

According to Section 211 of the Companies Act, 1956, the profit and loss account
should exhibits a true and fair view of profit or loss of the company and the balance
sheet should exhibits a true and fair view of the state of affairs of the company for the
financial year and comply with the requirements of Part-II Schedule 4 of the Companies
Act.

5
 The disclosure of interest of the subsidiary company under section 212 of the
Companies Act, if the company is holding company. The following documents relating to
subsidiary companies shall be attached to its balance sheet –

- A copy of the Profit and Loss Account of each subsidiary company.

- A copy of the Balance Sheet of each subsidiary company.

- A copy of the director’s report of each subsidiary company.

- A copy of the auditor’s report of each subsidiary company.

- A statement of the holding Company which shows the interest of the subsidiaries.

Under Section 213 of the Companies Act audited and directors report shall be
attached to the balance sheet of the company.

Under Section 215 of the Companies Act, authorization of balance sheet and
Profit and Loss Account shall be given which is duly signed by manager, managing
directors, secretary on behalf of board of directors of the company.

Filing of Accounts – Under Section 220 of the Companies Act, every company
should submit the accounts and statements within 30 days of the annual general
meeting of the company with the registrar in three copies of balance sheet and Profit
and Loss Account and three copies of all documents which are equal to be attached
with the balance sheet.

BALANCE SHEET

Contents of Balance Sheet – The form of balance sheet as laid down in

schedule 4, Part I of the Companies Act. According to Section 210 of the Companies
Act, a company is required to prepare a balance sheet at the end of each trading period.
Section 211 requires the balance sheet to be set up in the prescribed form. This
provision is not applicable to banking, insurance, electricity and the other companies
governed by special Acts. The Central Government has also the power to exempt any
class of companies from compliance with the requirements of the prescribed form if it
deems to be in public interest. The object of prescribing the form is to elicit proper
information from the company so as to give a ‘true and fair’ view of the state of the
company’s affairs. As a matter of fact both window dressing and creating secret
reserves will be considered against the provisions of Section 211. Schedule VI, Part I
gives the prescribed form of company’s balance sheet. Notes and instructions regarding
various items have been given in brackets below each item. It may be noted that if
information required to be given under any of the items or sub-items in the prescribed
form cannot be conveniently given on account of lack of space, it may be given in a

6
separate schedule or schedules. Such schedules will be annexed to and form part of
the balance sheet. Schedule VI, Part I permits presentation of balance sheet both in
horizontal as well as vertical forms. The forms with necessary notes, explanations, etc.
are given below:

7
8
9
10
11
Notes:

i) Paise can also be given in addition to rupees, if desired.

ii) Dividends declared by subsidiary companies after the date of the balance
sheet should not be included unless they are in respect of a period which
closed on or before the date of the balance sheet.
iii) Any reference to benefits expected from contracts to the extent not
executed shall not be made in the balance sheet but shall be made in the
Board’s report.
iv) Particulars of any redeemed debentures which the company has power to
issue should be given.
v) Where any of the company’s debentures are held by a nominee or a
trustee for the company the nominal amount of the debenture and the
amount at which they are stated in the books of the company shall be
stated.
vi) A statement of investments (whether shown under “Investment” or under
“Current Assets” as Stock-in-trade) separately classifying trade
investments and other investments should be annexed to the balance
sheet, showing the names of the bodies corporate (including separately
the names of the bodies corporate under the same management) in
whose shares or debentures, investments have been made (including all
investments whether existing or not, made subsequent to the date as at
which the previous balance sheet was made out) and the nature and
extent of the investments so made in each such body corporate; provided
that in the case of an investment company, that is to say, a company
whose principal business is the acquisition of shares, stock, debentures or
other securities, it shall be sufficient if the statement shows only the
investments existing on the date as at which the balance sheet has been
made out. In regard to the investments in the capital of partnership firms,
the names of the firms (with the names of all their partners, total capital
and the shares of each partner) shall be given in the statement.
vii) If, in the opinion of the Board, any of the current assets, loans and
advance do not have value on realisation in the ordinary course of
business, at least equal to the amount at which they are stated, the fact
that the Board is of that opinion shall be stated.
viii)Except in the case of the first balance sheet laid before the company after
the commencement of the Act, the corresponding amounts of the
immediately preceding financial year for all items shown in the balance
sheet shall also be given in the balance sheet. The requirements in this
behalf shall, in case of companies preparing quarterly or half-yearly

12
 accounts, etc., relate to the balance sheet for the corresponding date in
the previous year.
ix) Current accounts with Directors and Manager, whether they are credit or
debit, shall be shown separately.
x) The information required to be given under any of the items or sub-items
in the Form, if it cannot be conveniently included in the balance sheet
itself, shall be furnished in a separate Schedule or Schedules to be
annexed to and forming part of the balance sheet. This is recommended
when items are numerous.
xi) Where the original cost (of fixed assets) and additions and deductions
thereto, relate to any fixed assets which has been acquired from a country
outside India, and in consequence of a change in the rate of exchange at
any time after the acquisition of such assets there has been an increase or
reduction in the liability of the company, as expressed in Indian currency,
for making payment towards the whole or a part of the cost of the asset or
for repayment of the whole or a part of moneys borrowed by the company
from any person, directly or indirectly, in any foreign currency specifically
for the purpose of acquiring the asset (being in either cases the liability
existing immediately before the date on which the change in the rate of
exchange takes effect), the amount by which the liability is so increased or
reduced during the year, shall be added to, or as the case may be,
deducted from the cost, and the amount arrived at after such addition or
deduction shall be taken to be the cost of the fixed assets.

VERTICAL FORM OF BALANCE SHEET

Name of the Company.......

Balance Sheet as at........

Schedule Figures as at the Figures as at the

end of the current end of the
No. financial year previous financial
year

I. Sources of Funds

(1) Shareholders’ Funds

(a) Capital -- -- --

(b) Reserves and Surplus ... ... ...

13
(2) Loan Funds

(a) Secured Loans ... … ...

(b) Unsecured Loans ... ... ...

Total ... ... ...

II. Application of Funds

(1) Fixed Assets

(a) Gross Block ... ... ...

(b) Less Depreciation ... ... ...

(c) Net Block ... ... ...

(d) Capital Work-in-Progress ... ... ...

(2) Investments ... ... ...

(3) Current Assets Loans and Advances

(a) Inventories ... ... …

(b) Sundry Debtors ... ... ...

(c) Cash and Bank Balances ... ... ...

(d) Other Current Assets ... ... ...

(e) Loans and Advances ... ... ...

Less: Current Liabilities and Provisions ... ... ...

(a) Liabilities ... ... ...

(b) Provisions ... ... ...

Net Current Assets

(4) (a) Miscellaneous expenditure to the

extent not written off or adjusted ... ...

(b) Profit and Loss Account ... ... ..

Total ... ... ...

14
Notes:

i) Details under each of the above items shall be given in separate Schedules. The
Schedules shall incorporate all the information required to be given under Part IA of
Schedule VI read with Notes containing General Instruction for preparation of
balance sheet.
ii) The Schedules, referred to above, accounting policies and explanatory notes that
may be attached shall form an integral part of the balance sheet.
iii) The figures in the Balance Sheet may be rounded off as per Government
Notification dated 01.08.2002.
iv) A footnote to the balance sheet may be added to show contingent liabilities
separately.

Schedule VI: Part III

Interpretation

I.
1. For the purpose of Parts I and II of this schedule, unless the context
otherwise requires:
a. the expression “provision” shall, subject to sub-clause (2) of this
clause, means any amount written off or retained by way of
providing for depreciation, renewals or diminution in value of
assets, or retained by way of providing for any known liability of
which the amount cannot be determined with substantial accuracy;
b. the expression “reserve” shall not subject as aforesaid, include any
amount written off or retained by way of providing for depreciation,
renewals or diminution in value of assets or retained by way of
providing for any known liability;
c. the expression “capital reserve” shall not include any amount
regarded as free for distribution through the profit and loss account:
and the expression “revenue reserve” shall mean any reserve other
than a capital reserve; and in this sub-clause the expression
“liability” shall include all liabilities in respect of expenditure
contracted for and all disputed or contingent liabilities.
2. Where
a. any amount written off or retained by way of providing for depreciation,
renewals or diminution in value of assets, not being an amount written
off in relation to fixed assets before the commencement of this act; or
b. any amount retained by way of providing for any known liability: In
excess of the amount which in the opinion of the directors is

15
 reasonably necessary for the purpose, the excess shall be treated for
the purposes of this Schedule as a reserve and not as a provision.
II. For the purposes aforesaid, the expression “quoted investment” means an
investment in respect of which there has been granted a quotation or permission
to deal on recognized stock exchange, and the expression “unquoted
investment” shall be constructed accordingly.

Illustration: The following are the balances of Johri Albhushan Bhander Co. Ltd. as on
31st March 2008:

Debit Rs. Credit Rs.

Premises 30,72,000 Share capital 40,00,000

Plant 33,00,000 12% Debentures 30,00,000

Stock 7,50,000 P&L A/c 2,62,500

Debtors 8,70,000 Bills payable 3,70,000

Goodwill 2,50,000 Creditors 4,00,000

Cash and Bank 4,06,500 Sales 41,50,000

Calls in Arrear 75,000 General reserve 2,50,000

Interim Dividend paid 3,92,500 Bad Debt. provision

on 1.4.97 35,000

Purchases 18,50,000

Preliminary Expenses 50,000

Wages 9,79,800

General Expenses 68,350

Salaries 2,02,250

Bad debts 21,100

Debentures Interest paid 1,80,000

1,24,67,500 1,24,67,500

16
Information:

(a) Depreciate Plant by 15%

(b) Write off ` 5,000 from Preliminary Expenses

(c) Half-year’s Debenture Interest due

(d) Credit 5% Provision on Debtors for Doubtful Debts

(e) Provide for Income Tax @ 50%

(f) Stock on 31st March, 2008 was ` 9,50,000

(g) A claim of ` 25,000 for workmen’s compensation is being disputed by the company.

Prepare Final Accounts of the company.

Solution

M/s Johri Albhushan Bhander Co. Ltd.

PROFIT AND LOSS ACCOUNT

for the year ending 31st March, 2008

Dr. Cr.

Particulars Rs. Particulars Rs.

To Opening Stock 7,50,000 By Sales 41,50,000

To Purchases 18,50,000 By Closing Stock 9,50,000

To Wages 9,79,800

To Gross Profit c/d 15,20,200

51,00,000 51,00,000

To Salaries 2,02,250 By Gross Profit b/d 15,20,200

To Deb. Interest paid1,80,000

Add: Outstanding 1,80,000 3,60,000

To General expenses 68,350

17
To Provision for Doubtful debts:

Bad debts 21,100

Add: New provision 43,500

64,600

Less: Old provision 35,000 29,600

To Depreciation: Plant 4,95,000

To Preliminary expenes. written off 5,000

To Provision for tax 1,80,000

To Net profit for the year 1,80,000

15,20,200 15,20,200

PROFIT & LOSS APPROPRIATION ACCOUNT

for the year ending 31st March, 2008

Particulars Rs. Particulars Rs.

To Interim dividends paid 3,92,500 By Balance b/d 2,62,500

To Balance c/d 50,000 By P&L A/c (Profit for the year) 1,80,000

4,42,500 4,42,500

M/s Johri Albhushan Bhander Co. Ltd.

BALANCE SHEET

as on 31.3.2008

Liabilities Rs. Assets Rs.

Shares Capital Fixed Assets

Authorised .......... Goodwill 2,50,000

Issued & Subscribed Premises 30,72,000

4,00,000 Shares of Plant 33,00,000

` 10 each 40,00,000 Less: Depreciation 4,95,000 28,05,000

18
Less: Calls in Arrear 75,000 39,25,000 Current Assets

Reserves & Surplus: Loans & Advances:

General Reserve 2,50,000 Stock 9,50,000

P&L A/c 50,000 Debtors 8,70,000

Secured Loans: Less: Provision for Bad

12% Debentures 30,00,000 Debt43,500

8,26,500

Interest Outstanding 1,80,000 Cash at Bank 4,06,500

Current Liabilities & Provisions: Miscellaneous

Bills Payable 3,70,000 Expenses & Losses:

Creditors 4,00,000 Preliminary Expenses 50,000

Provisions for Taxation 1,80,000 Less: Written off 5,000 45,000

83,55,000 83,55,000

2.4 REVISED SCHEDULE VI

Ministry of Corporate Affairs, Government of India has recently replaced the

existing Schedule VI by a revised Schedule VI which is effective from 01.04.2011 i.e.
Financial Year 2011-12 onwards. Accordingly the revised Schedule VI is based on
existing Accounting Standards and not on Ind AS and is, therefore, applicable on all
companies. It is expected that as and when date of implementation of Ind AS is notified
a separate set of Schedule VI would be issued in respect of companies preparing their
financial statements as per Ind AS. Of course, the applicability the Ind As, it was earlier
settled to be implemented in a phase manner starting from 01.04.2011 has been
deferred; the instant decision for Schedule VI can be treated as a step towards
conversions to IFRS to some extent with regard to presentation of Financial Statements.
The revised Schedule VI giving the format of Balance Sheet and Profit & Loss Account
is given below:

The revised Schedule VI as notified by Government of India through its gazette

dated 20 February, 2011 is effective from 01-04-2011 i.e., from FY 2011-2012 onward.
The revised Schedule VI formal is applicable to companies-covered under IGAAP and
Ind-As (Converged IFRS). The existing Schedule VI has been totally revamped. The
19
revised Schedule VI fairly to an extent is drafted in an IFRS-complaint manner. Below is
the revised Schedule VI which is effective from 1 April 2011.

General Instructions for Preparation of Balance Sheet:

1. An asset shall be classified as current when it satisfies any of the following

criteria:
a. it is expected to be realized in, or is intended for sale or consumption in,
the company’s normal operating cycle;
b. it is held primarily for the purpose of being traded;
c. it is expected to be realized within twelve months after the reporting date;
or
d. it is cash or cash equivalent unless it is restricted from being exchanged
or used to settle a liability for at least twelve months after the reporting
date.

All other assets shall be classified as non-current.

2. A liability shall be classified as current when it satisfies any of the following

criteria:
a. it is expected to be settled in the company’s normal operating cycle;
b. it is held primarily for the purpose of being traded;
c. it is due to be settled within twelve months after the reporting date; or
3. A company shall disclose the following in the notes to accounts:
A. Share Capital

for each class of share capital (different classes of preference shares to be

treated separately):

Part I Form of Balance Sheet

Name of the Company.........

Balance sheet as at.............

(Rupees in ......)

Particulars Note No. Figures as at Figures as at

(1) (2 ) (3 ) (4)

I. EQUITY AND LIABILITIES

1. Shareholders’ funds
a. Share capital

20
 b. Reserves and surplus
c. Money received against share
2. Share application money pending
3. Non-current liabilities
a. Long-term borrowings
b. Deferred tax liabilities (Net)
c. Other Long term liabilities
d. Long-term provisions
4. Current liabilities
a. Short-term borrowings
b. Trade payables
c. Other current liabilities
d. Short-term provisions

Total

II. ASSETS

Non-current assets

1. A. Fixed assets
a. Tangible assets
b. Intangible assets
c. Capital work-in-progress
d. Intangible assets under
B. Non-current investments
C. Deferred tax assets (net)
D. Long-term loans and advances
E. Other non-current assets
2. Current assets
a. Current investments
b. Inventories
c. Trade receivables
d. Cash and cash equivalents
e. Short-term loans and advances
f. Other current assets

Total

A. Share Capital
a) the number and amount of shares authorized;

21
 b) the number of shares issued, subscribed and fully paid, and subscribed but not
fully paid;
c) par value per share;
d) For the period of five years immediately preceding the date as at which the
Balance Sheet is prepared:
 Aggregate number and class of shares allotted as fully paid up pursuant to
contract(s) without payment being received in cash.
 Aggregate number and class of shares allotted as fully paid up by way of
bonus shares.
 Aggregate number and class of shares bought back.
e) Calls unpaid (showing aggregate value of calls unpaid by directors and officers)
f) Forfeited shares (amount originally paid up)
B. Reserves and Surplus
i. Reserves and Surplus shall be classified as:
a. Capital Reserves;
b. Capital Redemption Reserve;
c. Securities Premium Reserve;
d. Debenture Redemption Reserve;
e. Revaluation Reserve;
f. Share Options Outstanding Account;
g. Other Reserves - (specify the nature and purpose of each reserve and the
amount in respect thereof);
h. Surplus i.e. balance in Statement of Profit & Loss disclosing allocations
and appropriations such as dividend, bonus shares and transfer to/from
reserves etc.
ii. Debit balance of statement of profit and loss shall be shown as a negative figure
under the head ‘Surplus’. Similarly, the balance of “Reserves and Surplus’, after
adjusting negative balance of surplus, if any, shall be shown under the head
‘Reserves and Surplus’ even if the resulting figure is in the negative.
C. Long-Term Borrowings
i. Long-term borrowings shall be classified as:
a. Bonds/debentures.
b. Term loans
i. from banks.
ii. from other parties.
c. Deferred payment liabilities.
d. Deposits.
e. Loans and advances from related parties.
f. Long term maturities of finance lease obligations
g. Other loans and advances (specify nature).

22
 ii. Borrowings shall further be sub-classified as secured and unsecured. Nature of
security shall be specified separately in each case.
D. Other Long Term Liabilities

Other Long term Liabilities shall be classified as:

a. Trade payables
b. Others
E. Long-term provisions

The amounts shall be classified as:

a. Provision for employee benefits.

b. Others (specify nature).
F. Short-term borrowings
i. Short-term borrowings shall be classified as:
a. Loans repayable on demand
i. from banks.
ii. from other parties.
b. Loans and advances from related parties.
c. Deposit
d. Other loans and advances (specify nature).
G. Other current liabilities

The amounts shall be classified as:

a. Current maturities of long-term debt;

b. Current maturities of finance lease obligations;
c. Interest accrued but not due on borrowings;
d. Interest accrued and due on borrowings;
e. Income received in advance;
f. Unpaid dividends
g. Application money received for allotment of securities and due for refund and
interest accrued thereon.
h. Unpaid matured deposits and interest accrued thereon
i. Unpaid matured debentures and interest accrued thereon
j. Other payables (specify nature);
H. Short-term provisions

The amounts shall be classified as:

I. Tangible assets

Classification shall be given as:

23
 a. Land.
b. Buildings.
c. Plant and Equipment.
d. Furniture and Fixtures.
e. Vehicles.
f. Office equipment.
g. Others (specify nature).

J. Intangible assets
i. Classification shall be given as:
a. Goodwill.
b. Brands /trademarks.
c. Computer software.
d. Mastheads and publishing titles.
e. Mining rights.
f. Copyrights, and patents and other intellectual property rights, services and
operating rights.
g. Recipes, formulae, models, designs and prototypes.
h. Licenses and franchise.
i. Others (specify nature).
K. Non-current investments
i. Non-current investments shall be classified as trade investments and other
investments and further classified as:
a. Investment property;
b. Investments in Equity Instruments;
c. Investments in preference shares
d. Investments in Government or trust securities;
e. Investments in debentures or bonds;
f. reinvestments in Mutual Funds;
g. Investments in partnership firms
h. Other non-current investments (specify nature)
ii. Investments carried at other than at cost should be separately stated specifying
the basis for valuation thereof.
L. Long-term loans and advances

Long-term loans and advances shall be classified as:

a. Capital Advances;
b. Security Deposits;
c. Loans and advances to related parties (giving details thereof);
d. Other loans and advances (specify nature).

24
 M. Other non-current assets

Other non-current assets shall be classified as:

i. Long Term Trade Receivables (including trade receivables on deferred credit

terms);
ii. Others (specify nature)
iii. Long term Trade Receivables, shall be sub-classified as:
a. Secured, considered good;
b. Unsecured considered good;
c. Doubtful
d. Allowance for bad and doubtful debts shall be disclosed under the
relevant heads separately.
N. Current Investments
i. Current investments shall be classified as:
a. Investments in Equity Instruments;
b. Investment in Preference Shares
c. Investments in government or trust securities;
d. Investments in debentures or bonds;
e. Investments in Mutual Funds;
f. Investments in partnership firms
g. Other investments (specify nature).
O. Inventories
i. Inventories shall be classified as:
a. Raw materials;
b. Work-in-progress;
c. Finished goods;
d. Stock-in-trade (in respect of goods acquired for trading);
e. Stores and spares;
f. Loose tools;
g. Others (specify nature).
ii. Goods-in-transit shall be disclosed under the relevant subhead of inventories,
iii. Mode of valuation shall be stated.
P. Trade Receivables
i. Aggregate amount of Trade Receivables outstanding for a period exceeding six
months from the date they are due for payment should be separately stated,
ii. Trade receivables shall be sub-classified as:
a. Secured, considered good;
b. Unsecured considered good;
c. Doubtful.

25
 iii. Allowance for bad and doubtful debts shall be disclosed under the relevant heads
separately.
Q. Cash and cash equivalents
i. Cash and cash equivalents shall be classified as:
a. Balances with banks;
b. Cheques, drafts on hand;
c. Cash on hand;
d. Others (specify nature).
R. Short-term loans and advances
i. Short-term loans and advances shall be classified as:
a. Loans and advances to related parties (giving details thereof);
b. Others (specify nature).
ii. The above shall also be sub-classified as:
a. Secured, considered good;
b. Unsecured, considered good;
c. Doubtful.
iii. Allowance for bad and doubtful loans and advances shall be disclosed under the
relevant heads separately.
S. Contingent liabilities and commitments (to the extent not provided for)
i. Contingent liabilities shall be classified as:
a. Claims against the company not acknowledged as debt;
b. Guarantees;
c. Other money for which the company is contingently liable
ii. Commitments shall be classified as:
a. Estimated amount of contracts remaining to be executed on capital
account and not provided for;
b. Uncalled liability on shares and other investments partly paid
c. Other commitments (specify nature).

PART II - Form of STATEMENT OF PROFIT AND LOSS

Name of the Company........................

Profit and loss statement for the year ended...........

Particulars Note Figures for the Figures for the

No. current Reporting previous
period Reporting period
I. Revenue from operations xxx xxx
II. Other income xxx xxx
III. Total revenue (I+II) xxx xxx

26
IV. Expenses: xxx xxx
Cost of materials consumed xxx xxx
Purchases of Stock-in-Trade xxx xxx
Changes in inventories of
finished goods work-in-
progress
and Stock-in-Trade

Employee benefits expenses

Finance costs
Depreciation and amortization
expenses
Other expenses
Total expenses xxx xxx
V. Profit before exceptional
and extraordinary items and
tax (III-IV)
VI. Exceptional items xxx xxx

VII. Profit before extraordinary xxx xxx

items and tax (V - VI)
VIII. Extraordinary items xxx xxx
IX. Profit before tax (VII-VIII) xxx xxx
X. Tax expenses:
(1) Current tax xxx xxx
(2) Deferred tax xxx xxx
XI. Profit (Loss) for the period xxx xxx
from continuing operations
(VII-VIII)
XII. Profit/(loss) from xxx xxx
discontinuing operations
XIII. Tax expense of xxx xxx
discontinuing operations
XIV. Profit/(loss) from xxx xxx
discontinuing operations
(after tax) (XII-XIII)
XV. Profit (Loss) for the period xxx xxx
(XI + XIV)
XVI. Earning per equity share:
(1) Basic xxx xxx
(2) Diluted xxx xxx

Note: See accompanying notes to the financial statements

27
General Instructions for Preparation of Statement of Profit and Loss:

1. The provisions of this Part shall apply to the income and expenditure account
referred to in sub-section (2) of Section 210 of the Act, in like manner as they apply
to a statement of profit and loss.
2. (A) In respect of a company other than a finance company revenue from operations
shall disclose separately in the notes revenue from
a. sale of products;
b. sale of services;
c. other operating revenues; Less:
d. Excise duty.

(B) In respect of a finance company, revenue from operations shall include

revenue from

a. Interest; and
b. Other financial services

Revenue under each of the above heads shall be disclosed separately by way of
notes to accounts to the extent applicable.

3. Finance Costs

Finance costs shall be classified as:

a. Interest expense;
b. Other borrowing costs;
c. Applicable net gain/loss on foreign currency transactions and translation.
4. Other income

Other income shall be classified as:

a. Interest Income (in case of a company other than a finance company);

b. Dividend Income;
c. Net gain/loss on sale of investments
d. Other non-operating income (net of expenses directly attributable to such
income).
5. Additional Information
i. Net gain or loss on foreign currency transaction and translation (other than
considered as finance cost);
ii. Payments to the auditor as (a) auditor, (b) for taxation matters, (c) for company
law matters, (d) for management services, (e) for other services, (f) for
reimbursement of expenses;
iii. Details of items of exceptional and extraordinary nature;

28
 iv. Prior period items;
a. In the case of manufacturing companies,-(1) Raw materials under
broad heads. (2) Goods purchased under broad heads.
b. In the case of trading companies, purchases in respect of goods traded in
by the company under broad heads,
c. In the case of companies rendering or supplying services, gross income
derived from services rendered or supplied under broad heads.
v. Expenditure incurred on each of the following items, separately for each item:-
a. Consumption of stores and spare parts,
b. Power and fuel,
c. Rent,
d. Repairs to buildings,
e. Repairs to machinery,
f. Insurance,
g. Rates and taxes, excluding, taxes on income,
h. Miscellaneous expenses,

Contents of the P/L A/C – According to paragraph 3 of the Part II schedule 4 the P/L
A/c of a company must set up the various items relating to income and expenditure of
the company arranged under the most convenience head.

a) Turn Over – It is the aggregate amount for which sales are affected by the
company.

- Commission paid to selling agents.

- Brokerage on discount on sales.

b) In case of manufacturing companies the value of raw material consumed work-in-

progress.

- In case of trading companies, opening stocks, closing stock, purchases.

- In case of companies rendering supply services.

a) Work in progress, opening and closing figures

b) Provision for depreciation, renewals of fixed assets.

c) Interest on debentures and fixed loans.

d) Income tax.

e) Repayment of loans (reserves, provisions)

29
f) Expenditure incurred on consumption on stores and spare parts

- Power and fuel

- Rent

- Repairs to buildings and machineries

- Salaries, bonus, wages.

- Insurance

- Workmen’s welfare expenses

- Rate and taxes

- Miscellaneous expenses

Further information in Profit and Loss A/c – The P/L A/c shall also content detail
information showing payments made during the financial year to the directors or
manager in the following manner :-

- Managerial remuneration under Section 198 of the Act.

- Other allowances and commission including guarantee commission.

- Pension, gratuities.

- Payment from provident fund.

- Other payment in connection with retirement from office.

- Auditors fees, income tax and license fee, provision for taxation and other
provisions.

P/L A/c (Credit)

- Interest received, commission received (Brokerage, under-writing commission,

dividend received, premium received, miscellaneous receives)

Directors Report – Under Section 197 it has been required that directors shall make
out a report and attached the same with the every balance sheet. These reports
contents the following –

i) State the affairs of the company.

ii) The amount if any which the board proposes to carry any reserves in such
balance sheet.

30
iii) The amount if any which the board recommends should be paid by way of
dividend.

iv) Material changes and commitments if any, affecting the financial position of the
company which is occurred between the financial year to which the balance sheet
relates.

v) The report of the board of directors must deal with any changes which have
occurred during the year with the respect of the nature of the business of the company.

2.5 MANAGERIAL REMUNERATION

The company loss lays down some restrictions on the calculation of managerial
remuneration to be provided by a public company for or a private company or other
subsidiaries. Following are the details of the restriction regarding remuneration.

A. Remuneration of Directors – Provisions relating to remuneration of directors

including managing directors laid down under Section 309 a) Fee for attending each
meeting of the board should not exceed Rs.250/-, b) a whole time directors or a
managing directors may be paid remuneration either by way of monthly remuneration or
at a specified percentage of the net profit of the company like I) 5 % of the net profit for
on such directors, ii) 10 % of the net profit for all of them put together, if there are more
than one directors.

B. In case of part-time directors the commission is not more than 1 % of the profit
of the company.

C. Remuneration to Manager – Provisions relating to remuneration of a manager

at content into Section 387 of the companies Act. They are summarized as under:

- A manager may get his remuneration by way of monthly payment or by way of a

specific percentage of the Net Profit.

- Net profit is calculated with reference to Section 349 and 350.

- The total remuneration cannot exceed 5 % of the net profit except with the
approval of the central government.

Overall managerial remuneration According to Section 198 of the Companies Act, the
total managerial remuneration payable by a public company or a private company which
is subsidiary of a public company in respect of any financial year shall not exceed 11%
of the net profits of that company for that financial year. Net profits for this purpose are
to be calculated in the manner laid down in Section 349 and 350 of the Companies Act,
explained later in the chapter. Of course,this amount is exclusive of the fees payable to

31
the Directors for attending board’s meeting or a committee thereof. It may be noted that
such fee is payable only to part-time directors. The limit for such fee has been fixed as
under w.e.f. 24.7.2003.13

(a) Companies with a paid up share capital Not to exceed Rs. 20,000
and free reserves of Rs.10 crores and per meeting
above or turnover of ` 50 crores andabove

(b) Other companies Not to exceed Rs.10,000 per meeting

Within the above maximum limit of 11%, a company may pay monthly
remuneration to its managing or whole-time director in accordance with the provision of
Section 309 or to its manager in accordance to the provisions of Section 386 of the
Companies Act. Incase of no profits or inadequacy of profits in any year, the company
may pay remuneration as per the provisions of Schedule XIII, explained later in the
chapter.

Managerial remuneration includes the following:

(i) Any expenditure incurred by the company in providing any rent free
accommodation or any other benefit or amenity in respect of accommodation
free of charge to any of its managerial personnel referred above.
(ii) Any expenditure incurred by the company in providing another benefit or
amenity free of charge or at a concessional rate to any of the aforesaid persons.
(iii) Any expenditure incurred by the company in respect of any obligation or service
which, but for such expenditure by the company, would have been incurred by
any of the persons aforesaid.
(iv) Any expenditure incurred by the company to effect an insurance on the life of or
to provide any pension, annuity or gratuity for any of the aforesaid persons, his
spouse or child.

Remuneration payable to different categories of managerial personnel:

Remuneration payable to different categories of managerial personnel is as follows:

(i) Manager: Manager means a person who has got the control of the whole or
substantially the whole of the affairs of a company. There can be only one
manager in a company and such manager cannot be paid more than 5% of the
net profits of the company by way of managerial remuneration.
(ii) Managing director: Managing director means a director who has substantial
powers of management. A company cannot have both a managing director as
well as a manager. Of course, it can have more than one managing director. A
managing director can be paid by way of managerial remuneration a sum not
exceeding 5% of the net profits of the company. In case a company has more

32
 than one managing director, the total managerial remuneration payable to all the
managing directors will not exceed 10% of the net profits of the company.
(iii)Whole-time director: A whole-time director is a director who devotes his whole
time attention to the company. A company may have one or more whole-time
directors with or without managing director. A whole-time director cannot be paid
more than 5% of the net profit of the company by way of managerial
remuneration. In case a company has more than one whole-time director, the
total remuneration payable to the whole-time directors (including managing
directors, if any) should not exceed 10% of the net profits of the company.
(iv)Director: A director is one who directs, guides or manages the affairs of a
company. According to the Companies Act, the term director includes any
person occupying the position of director by whatever name called. Minimum
number of directors in case of a private company is two while it is three in case
of a public company.

The managerial remuneration payable to all the part-time directors is not to exceed
3% of the net profits of the company if the company does not have a manager or a
managing or a whole-time director. In case a company has a manager or a managing
director or a whole time director, the total remuneration payable to directors (part-time)
shall not exceed 1% of the net profits of the company. Of course, this does not include
the sitting fee payable to these directors.

The maximum managerial remuneration payable to different categories of managerial

personnel, as stated above, can be presented in the form of the following chart:

Category of managerial personnel Max. % of annual net profit

(i) Overall limit for total remuneration to all managerial

personnel 11%
(ii) Managing Director (for one) 5%
(iii) Managing Directors (more than one-for all together) 10%
(iv) Whole-time Director (for one) 5%
(v) Whole-time Directors (more than one-for all together) 10%
(vi) Manager (there cannot be more than one Manager) 5%
(vii) Managing Director or Managing Directors or
Manager with one or more Whole-time Director/Directors
(for all together) 10%
(viii) Directors (for all) when there is no Manager or
Managing Director or Whole-time Director 3%
(ix) Directors (for all) when there is a Manager or a Managing
Director or a Whole-time Director 1%

33
 Administrative ceiling regarding managerial remuneration: Section 637AA of
the Companies Act empowers the Central Government to adopt an administrative
ceiling regarding managerial remuneration payable to a particular person within the
overall ceiling fixed by the Companies Act. Such ceiling is to be fixed by the Central
Government taking into consideration the financial position of the company, the
professional qualifications and experience of the individual concerned, the remuneration
drawn by him from any other company, public policy relating to removal of disparities in
incomes, etc.

The Central Government has reviewed from time to time the entire question of
managerial remuneration in the context of socio-economic objective of State policy and
the need for establishing a correlation in managerial remuneration at comparable levels
of responsibility in Government, public sector undertakings and public limited
companies. As a result of these reviews, the Central Government has been fixing the
maximum limit of managerial remuneration payable to Managing, Whole-time or Part-
time Director or a Manager of public limited company or its subsidiaries. The first limits
were fixed on 11.11.1969, these were later on revised on 9.11.1978 and further on
1.4.1983.

The Companies (Amendment) Act, 1988, introduced a new Schedule XIII fixing
the ceilings of remuneration payable to a managing or whole-time director or a manager
of a public company or its subsidiary. The ceilings were revised w.e.f. 14th July, 1993
and later w.e.f. 1.2.1994. With a view to give still greater freedom to companies
regarding managerial appointment and remuneration, the Central Government once
again amended the Schedule XIII w.e.f. 2.3.2000 and recently w.e.f. 16.1.2002. The
revised ceilings are applicable to a person appointed as a Managing Director, Whole-
time Director or a Manager of a Company as defined in the Companies Act.

The provisions of the schedule are being summariased below:

1. Remuneration payable by companies having profits: Subject to the provisions of

Sections 198 and 309,a company having profits in a financial year may pay any
remuneration by way of salary, dearness allowance, perquisites, commission and
other allowances which shall not exceed 5% of its net profits for one such managerial
person and if there is more than one such managerial person, 10% for all of them
together.
2. Remuneration payable by companies having no profits or inadequate profits:
Notwithstanding anything contained in this part, where in any financial year, during
the currency of tenure of the managerial person, by way of salary, dearness
allowance, perquisites and any other allowances:
a) not exceeding the ceiling limit of Rs. 24,00,000 per annum or Rs. 2,00,000 per
month calculated on the following scale:

34
 Where the effective capital of Company is Monthly remuneration
payable shall not exceed (Rs.)

(i) less than rupees 1 crore 75,000

(ii) rupees 1 crore or more but less than rupees 5 crores 1,00,000
(iii) rupees 5 crores or more but less than rupees 25 crores 1,25,000
(iv) rupees 25 crores or more but less than rupees 50 crores 1,50,000
(v) rupees 50 crores or more but less than rupees 100 crores 1,75,000
(vi) rupees 100 crores or more 2,00,000

Provided that the ceiling limits specified under this subparagraph shall apply, if—

(i) payment of remuneration is approved by a resolution passed by the Remuneration

Committee;
(ii) the company has not made any default in repayment of any of its debts (including
public deposits) or debentures orinterest payable thereon for a continuous period of
thirty days in the preceding financial year before the date of appointment of such
managerial person.

(b) not exceeding the ceiling limit of Rs. 48,00,000 per annum or Rs. 4,00,000 per
month calculated on the following scale:

Where the effective capital of Company is Monthly remuneration payable

shall not exceed (Rs.)

(i) less than rupees 1 crore 1,50,000

(ii) rupees 1 crore or more but less than rupees 5 crores 2,00,000
(iii) rupees 5 crores or more but less than rupees 25 crores 2,50,000
(iv) rupees 25 crores or more but less than rupees 50 crores 3,00,000
(v) rupees 50 crores or more but less than rupees 100 crores 3,50,000
(vi) rupees 100 crores or more 4,00,000

i) Provided that the ceiling limits specified under this subparagraph shall apply, if:
payment of remuneration is approved by a resolution passed by the
Remuneration Committee;
ii) the company has not made any default in repayment of any of its debts
(including public deposits) or debentures or interest payable thereon for a
continuous period of thirty days in the preceding financial year before the date of
appointment of such managerial person;

35
 iii) a special resolution has been passed at the general meeting of the company for
payment of remuneration for a period not exceeding three years;
iv) a statement with the prescribed information as required under the Companies Act
along with a notice calling the general meeting referred to in clause (iii) is given
to the shareholders.

(c) Exceeding the ceiling limit of Rs. 48,00,000 per annum or Rs. 4,00,000 per month
calculated on the following scale:

Where the effective capital of Company is Monthly remuneration payable

shall not exceed (Rs.)

(i) less than rupees 1 crore 1,50,000

(ii) rupees 1 crore or more but less than rupees 5 crores 2,00,000
(iii) rupees 5 crores or more but less than rupees 25 crores 2,50,000
(iv) rupees 25 crores or more but less than rupees 50 crores 3,00,000
(v) rupees 50 crores or more but less than rupees 100 crores 3,50,000
(vi) rupees 100 crores or more 4,00,000

Provided that the ceiling limits specified under this subparagraph shall apply, if:

i) payment of remuneration is approved by a resolution passed by the Remuneration

Committee;
ii) the company has not made any default in repayment of any of its debts (including
public deposits) or debentures or interest payable thereon for a continuous period
of thirty days in the preceding financial year before the date of appointment of such
managerial person;
iii) a special resolution has been passed at the general meeting of the company for
payment of remuneration for a period not exceeding three years;
iv) a statement along with the prescribed information as required under the Companies
Act, along a notice calling the general meeting referred to in clause (iii) is given to
the shareholders.

Computation of net profits for managerial remuneration: Net profit for the
calculation of managerial remuneration is to be computed in accordance with the
provision of Sections 349 and 350.Section 349 provides for the addition of the following
items to the normal profits: Bounties and subsidies received from any Government, or
any public authority constituted or authorized in this behalf by any Government, unless
they are exempted, or as the Central Government otherwise directs. It prohibits the
giving of credit for the following items:

36
(i) profits by way of premium on shares or debentures of the company, which are
issued or sold by the company;
(ii) profits on sale of forfeited shares;
(iii) profits of a capital nature including profits from the sale of undertaking or any of the
undertakings of the company or any part thereof;
(iv) Profits from sale of any immovable property or fixed assets of a capital nature
comprised in the undertaking or any of the undertaking of the company, unless the
business of the company consists, whether wholly or partly, of buying or selling any
such property or assets.

Provided that where the amount for which any fixed asset is sold exceeds the
written down value thereof, referred to in Section 350, credit shall be given for so much
of the excess as is not higher than the difference between the original cost of that fixed
asset and its written down value. Further Section 349 provides for the deduction of the
following items from the profits of the company:

(i) all working charges;

(ii) directors’ remuneration;
(iii) bonus or commission paid or payable to any member of the company’s staff or
to any engineer, technician or person employed or engaged by the company,
whether on a whole time or on a part-time basis;
(iv) Any tax notified by the Central Government as being in the nature of a tax on
excess or abnormal profits. The super profits tax under Section 4 of the Super
Profits Tax Act, 1963and the surtax under Section 4 of the Companies
(Profits)Surtax Act, 1964, were notified to be taxes in the nature of tax on excess
or abnormal profits within the meaning of this clause;
(v) any tax on business profits imposed for special reasons or in special
circumstances and notified by the Central Government in this behalf;
(vi) interest on debentures issued by the company;
(vii) interest on mortgages executed by the company and on loans and advances
secured by a charge on its fixed or floating assets;
(viii) interest on unsecured loans and advances;
(ix) expenses on repairs, whether to immovable or to movable property, provided
the repairs are not of a capital nature;
(x) Outgoings inclusive of contributions made under Section293 (1)(e). This
includes contributions made to charitable and other funds;
(xi) depreciation to the extent provided in Section 350;
(xii) the excess of expenditures over income which has arisen in computing the net
profits in accordance with this section in any year which begins at or after the
commencement of this act, in so far as such excess has not been deducted in

37
 any subsequent year preceding the year in respect of which the net profits have
to be ascertained;
(xiii) any compensation or damages to be paid by virtue of any legal liability,
including a liability arising from breach of contract;
(xiv) any sum paid by way of insurance against the risk of meeting any liability,
such as is referred to in clause (xiii);
(xv) Debts considered bad and written off or adjusted during the accounting year.

Section 349, however, does not permit the deduction of the following items from the
profits of the company:

a) income-tax and super-tax payable by the company under the Indian Income-tax
Act, 1922 or any other tax on the income not covered under (iv) and (v) above;
b) any compensation, damages or payment made voluntarily, that is to say,
otherwise than by virtue of a liability such as is referred to in clause (xiii);
c) loss of a capital nature including loss on sale of undertaking or any of the
undertakings of the company or any part thereof not including any excess of
written down value over its sale proceeds or scrap value of any asset sold,
discarded, demolished or destroyed. Such excess has to be written off to profit
and loss account.

Provisions of Section350 The amount of depreciation to be deducted in

pursuance of clause (iv) of Section 349 above shall be the amount calculated with
reference to the written-down value of the assets as shown by the books of the
company at the end of the financial year expiring at the commencement of this act or
immediately thereafter and at the end of each subsequent financial year, at the rate
specified in Schedule XIV.

Provided that if any asset is sold, discarded, demolished or destroyed for any
reason before depreciation of such assets has been provided for in full, the excess, if
any, of the written-down value of such asset over its sale proceeds or, as the case may
be, its scrap value, shall be written off in the financial year in which the asset is sold,
discarded, demolished or destroyed.

According to Schedule XIV in case an asset is purchased during the year, the
depreciation thereon has to be calculated pro rata basis, from the date of purchase at
the rate specified in the Companies Act for the purposes of Section 350. However, for
purposes of Income-tax, the company has to charge depreciation as per the rates given
in the Income Tax Act.

Note: In calculating net profit for overall maximum managerial remuneration limit and
remuneration payable to directors (including managing and whole-time directors)directors’
remuneration is not deducted from gross profits. However, fees payable to directors for

38
attending Board’s meeting are to be deducted. But for calculating remuneration payable to a
manager, directors’ remuneration shall also be deducted from gross profits as given in Section
349.

Calculation of commission etc. in certain cases (Section 199):

In case, an officer or employee of a company (other than the managerial

personnel referred above) is entitled to get remuneration by way of percentage on the
net profits of the company, such profits shall also be calculated in the manner laid down
in Sections 349 and 350 discussed in this chapter.

Prohibition of tax-free payment (Section 200): A company is not allowed to make any
tax-tree payment of remuneration to its officers or employees. The intention underlying
this provision is to prevent creation of a class of persons who are immune from any
future increase in taxation.

Illustration

A manager is entitled to a commission at a certain percentage of net profit (such

commission to be charged in arriving at the net profit).

The commission is to be allowed on the following rates:

First Rs. 10,000 of the net profit Nil

Next Rs.20,000 ” ” ” ” @ 10%

Next Rs.30,000 ” ” ” ” @ 15%

Next Rs.60,000 ” ” ” ” @ 20%

Balance ” ” ” ” @ 30%

The net profit before charging the manager’s commission is Rs.1,45,000.

Compute the amount of manager’s commission.

Solution:

Calculation of Commission Payable to Manager

Profit Commission Total Net Profit considered

(Rs.) (Rs.)

First Rs. 10,000 net profit Nil 10,000

Next Rs. 20,000 @ 10% 2,000 22,000

39
Next Rs.30,000 @ 15% 4,500 34,500

Next Rs. 60,000 @ 20% 12,000 72,000

18,500 (i) 1,38,500

Balance Net Profit:

Total Profit 1,45,000

Less: Profit on which commission provided (as above) 1,38,500

6,500

Commission = 6500 × 30/130 1,500 (ii)

Total Commission payable (i) + (ii) 20,000

Illustration

The manager of M/s Slow and Steady Ltd. is entitled to get a salary of Rs. 2,500
per month plus 1 per cent commission on the net profits of the company after such
salary and commission. The following is the Profit and Loss account of the company for
the year ended 30 June, 2008.

Particulars (Rs.) Particulars (Rs.)

40
 To Salaries, wages and bonus 1,92,500 By Gross profit b/d 9,00,000

To General expenses 74,000 By Subsidy from Govt. 60,000

To Depreciation 82,000 By Profit on sale of assets

To Expenditure on scientific (Cost price ` 2,50,000and

research (cost of an apparatus) 14,000 written-down value ` 1,80,000)1,00,000

To Manager’s salary 30,000

To Commission to Manager

(on account) 6,000

To Prov. for bad and doubtful debts 17,500

To Provision for income-tax 2,40,000

To Proposed dividend 1,00,000

To Balance c/d 3,04,000

Depreciation as per income-tax rules amounts to Rs.81,000.Calculate the

remuneration payable to the Manager.

Solution

Calculation of Remuneration Payable to Manager

Particulars (Rs.) (Rs.)

Profit as per Profit & Loss A/c 3,04,000

Add: Inadmissible deductions:

Depreciation 82,000

Expenditure on Scientific Research (Capital expenditure) 14,000

Salary & Commission paid to Manager 36,000

Reserve for bad and doubtful debts 17,500

Provision for Income-tax 2,40,000

Proposed dividend 1,00,000 4,89,500

41
 7,93,500

Less: Depreciation as per Income-tax Rules 81,000

Capital profit on sale of assets, (1,80,000 + 1,00,000

– 2,50,000) 30,000 1,11,000

Net Profit for calculation of managerial remuneration 6,82,500

Net profit as calculated above 6,82,500

Less: Salary to Manager 30,000

6,52,500

The amount of Commission would therefore be = 6,52,500 × 1/101 = Rs.6,460.

However, the manager has already been paid commission to the extent of Rs.6,000.

Balance to be payable therefore comes to: Rs.460.

As per Section 387 of the Companies Act, 1956, the manager is entitled to a
maximum remuneration of = 6,82,000 ` 5/105 = Rs. 32,500.

Since maximum remuneration payable to the manager is Rs.32, 500under Section 387,
it has been assumed that the approval of the Central Government has been obtained for
the excess payment.

2.6 DIVISIBLE PROFITS & DIVIDENDS

The profits of the company which are available for the distribution of dividend to
the shareholders that is known as divisible profit. In normal course profits are distributed
as dividends only when they are left after the meeting of all the expenses like
depreciation on fixed assets, taxation, transfers a reasonable amount of reserve, past
losses etc.

There are some legal provisions Under Section 205 of the Companies Act on the
ascertainment of divisible profits. These provisions are summarized as follows:-

- Dividend should be declared only out of current year’s profit after providing for
depreciation and other losses.

- Dividend out of the profits of any previous financial year can be declared which
falls after the commencement of the company.

42
- Dividend can be declared out of the aggregate of profits.

- Dividend can be declared after the subsidies provided by the central government
or state government.

OTHER PROVISIONS RELATING TO DIVISIBLE PROFITS –

- Dividend must be paid in cash.

- Dividend is payable out of profits only.

- Capital profits – The profit which is earned not by the way of trading transactions
of the business but by other means which are not usually available for distribution of
dividend.

The following types of capital profits are not at all available for dividend: -

- Share premium account.

- Profits remaining after the reissue of the forfeited share.

- Capital redemption reserve account.

- Profits prior to incorporation.

- Profits on the redemptions of the debentures.

- Premium on issue of debentures.

- Profits acquisition of building.

- Profits on sale of fixed asset.

Capital profit can be used for:

- Paying fully paid bonus years.

- Writing of fictitious assets (discount on issue of shares, preliminary expenses,

goodwill and debentures).

- Dividend profits – Dividend is the write to claim of the shareholder of the

company. This write is available only when dividend is declared at the general meeting
of the company. The dividend once declared becomes a debts and a shareholder is
entitled to sue at loco for recovery of the same. From the accounting point of view of the
following points are to be noted:

- Dividend is calculated at the recommended rate on the paid up capital.

43
- No dividend is paid on calls on advance.

- No dividend is paid proportionately from the date of issue of shares.

TAX – These are debts at source 23 % on all dividend declared by the company.

- It is a dividend paid by the directors at any time between two annual general
meeting. (Interim dividend)

- Final dividend – Final dividend is that type of dividend which is declared after the
annual general meeting is held.

POWER OF SHARE HOLDER –

- Shareholder considers the annual accounts and balance sheet.

- They have the capacity to examine the director’s reports.

- Power to pass resolutions at the annual general meeting.

- They can declared dividend at the annual general meeting.

- There are powers to elect the directors and appointment of casual directors.

- There is power to appoint auditors.

- There is power to purchase shares which is not exceeding 5 % of the paid up

capital of the company.

WHEN THE PERSONS CAN NOT BE APPOINTING AS DIRECTORS AND WHO ARE
THEY?

The following persons cannot be appointing as directors:

- A person found by court to be of unsound mind.

- Undischarge insolvent.

- A person who has applied to be adjudged and insolvent and whose application is
pending.

- A person who has been convicted of an offence.

- A person has failed to pay calls for six months.

- A person who has been disqualified by the court under section 203.

44
UNDER WHICH CIRCUMSTANCES A DIRECTOR AUTOMATICALLY CEASES TO
BE A DIRECTOR?

- He fails to acquit qualification shares within two months.

- He is found by the court to be of unsound mind.

- He applies to the court to be adjudged an involvement.

- He is adjudged an insolvent.

- He is convicted of an offence and is sentenced to imprisonment for not less than

6 months.

- If he fails to pay calls within 6 months.

- He or any firm of which he is a partner or a private company of which he is

director receives a loan.

- He fails to disclose his interest in any contract with the company.

- He is debarred by the court from being a director.

- He occupies an office of profit unless excused.

POWERS OF THE BOARD OF DIRECTORS –

The following powers must be exercised only by the board of directors at its meeting.

- Power to make calls.

- Power to issue debentures.

- Power to borrow moneys otherwise than on debentures.

- Power to invest company’s funds.

- Power to make loan.

ISSUE OF SHARES – Public company may issue share on the basis of prospectus.
From the point of accounting entries the following points should be noted:

a) The prospectus mentions the number of shares issues by the company, the
public may be apply for more than the total number of shares issued. The excess
shares may be rejected or may be adjusted proportionately at the time of allotment.

b) Prospectus also mentioned the minimum subscription – Minimum subscription

may be defined as that a number of shares which will enable the company get enough

45
cash for proper working. This minimum subscription has to be estimated by the directors
under the companies act according to the requirements of cash and determine the
minimum number of shares which will be subscribed by the public in order to enable the
company to function.

While determining the minimum subscription the directors will have to be estimated for
each of the following separately.

- Purchase price of any property purchased.

- Any preliminary expenses payable by the company.

- The repayment of any money borrowed by the company for above two purposes.

- Requirements of working capital.

- Any other expenditure.

c. In case of the prospectus shows that the application is being made a stock
exchange or more than one stock exchange for the permission.

d. It is up to the directors to ask for the whole of the amount on shares along with
the application or the share money may be paid on installments like application money,
allotment, first call and final call but the application money must not be less than 5 % of
the nominal value of shares.

e. Money is received along with the application must be deposited in a schedule

bank and must be kept to be deposited until the company obtains the certificate of
commencement of business.

Shareholders Equity and Liability

SHAREHOLDERS’ EQUITIES:

In case of corporate organizations equity represents the interest of shareholders in the

company. So t consists of share capital, retained earnings and the reserves.

Share Capital:

The capital of a company is divided into a number of units called shares of the
company. So shares are the smallest denomination of the capital of a company. Since
the capital of a company consists of shares it is known as share capital. Basically there
are two types of share capital based on the types of shares which can be issued by a
company.

46
i) Preference Share capital: This capital consists of preference shares. Preference
shares are the shares which have a preferential right to a fixed dividend and to the
repayment of capital at the time of liquidation. Like long term loans and debentures the
preference shares are redeemable after a certain period of time. According to the
companies Amendment Act 1988 no preference share can be irredeemable. If article
permits the preference shareholders may have some additional based on the type of
preference share.

Cumulative Right – Cumulative preference shares are those where the shareholders are
entitled to receive their arrears of dividend when the company has sufficient profit and
directors decide to distribute them in way of dividend. No such right is availed for non-
cumulative preference shares. Unless he article otherwise provide all the preference
shares would be cumulative.

Participating Right – Participating preference shares have the right to participate in the
surplus profits remaining after the distribution of dividend on equity shares. The
preference shares which don’t have such rights are known as non-participating shares.

Conversion Right- As per Articles of the company the preference shareholders have the
right to convert their preference shares into equity shares after a certain period of time.

The preference shareholders also get the right to receive premium on redemption of
their shares and they can participate in the surplus remaining after the equity shares are
redeemed in case of winding up of a company. The preference shareholders don’t have
any voting rights except when dividend is outstanding for more than two years in case of
Cumulative Preference shares and for more than three years in case of non-cumulative
preference shares. But Preference shareholders have the right to vote on any resolution
for winding up of the company or for the reduction or repayment of share capital.

ii) Equity share Capital: Equity share capital consists of ordinary shares which have no
fixed right. They are normally risk bearing shares. Equity share holders get dividend and
capital after the claims of preference shareholders are met. These shareholders also
are not entitled to a fixed rate of dividend as in case of preference shares. In simple
words these shareholders have a residual claim in the company. Equity shareholders
are the ultimate decision makers in a company as they have right to vote on any
resolution placed before the company. The voting rights to the shareholders are granted
on the basis of their shareholdings.

There are three ways of raising share capital

(i) Public Offer

(ii) Private Placement

47
(iii) Right Issue

Issue of share Capital:

When a public company desires to raise capital from public, the invitation should be
made through prospectus.

The company cannot allot more than the number of shares offered through prospectus.

No allotment of shares can be made if the minimum subscription mentioned in the

prospectus is not received from the public and the company has to refund the money
received from public in form of application money. As per SEBI guidelines minimum
subscription has been fixed at 90% of the issued amount. Such subscription should be
received within 60 days the close of the issue.

The amount payable on application is fixed by the directors but the amount can’t be less
than 25% of the issue price as per SEBI guidelines.

The amount received with share application has to be kept in a scheduled bank till the
minimum subscription is raised and the certificate of commencement is obtained in case
of a new company.

If the shares are listed on a stock exchange approval of stock exchange is to be sought
before the shares are allotted.

If the number of shares applied is more than number of shares offered then board of
directors have to decide certain criterion for allotment but as per SEBI guidelines 35% of
shares offered should be allotted to small investors.

The director can call the remaining amount only after the shares have been allotted and
the names of the members are entered in the register of members.

Disclosure of share Capital in the financial statements:

i) Authorized Capital – It is the maximum amount of share capital that a company can
issue as specified in the memorandum of association. The company is registered with
this amount of capital. The authorized capital specified can also be changed with the
approval of shareholders.

ii) Issued Capital – It is the part of the authorized capital which has been offered or
issued by a company to the public. This includes shares issued for cash and for
consideration other than cash like shares allotted to vendors and promoters. It sets the
limit of the capital available for subscription.

48
iii) Subscribed Capital – It refers to that part of issued capital which has actually been
subscribed by the public and subsequently allotted to them.

iv) Called up Capital – It is that portion of the subscribed capital which the
shareholders are called upon to pay on the shares allotted to them. A company does
not want the entire amount of shares subscribed at once, hence calls up in parts when it
needs funds. The part of the entire amount which is not called by company is known
uncalled capital.

v) Paid up Capital – It is the part of called up capital which has been received by a
company from the shareholders. This is the actual capital of the company which is
included in the total of balance sheet. Paid up capital becomes equal with called up
capital if none of the shareholders is at default.

Normally as a practice the paid up share capital appears in the balance sheet and the
details of capital is given in a schedule.

Illustration:

ABC Ltd incorporated in the year 2012 with an authorized capital of rupees one crore
divided into 10 lakh shares of Rs 10 each. In December 2012 the company issued 5
lakh shares for which Rs 5 is payable in application, Rs 3 on allotment and Rs 2 on call.
Four out of five lakh shares issued is subscribed by public. In February 2013 the
company made the allotment and received allotment money. In December 2012 the
company made the call of Rs 2 per share and received the call money for 3.8 lakh
shares. Show the presentation of capital in the balance sheet of the company on 31st
March 2013.

Solution:

M/s ABC Limited

Balance Sheet as on 31st March 2013

Sources of Fund Amount (Rs)

Authorised Capital

10,00,000@10 each 100,00,000

Issued capital

5,00,000@ 10 each 50,00,000

Subscribed Capital

49
4,00,000@ 10 each 40,00,000

Called Up Capital

4,00,000@ 10 each 40,00,000

Paid up capital

3,80,000@10 each 38,00,000

Retained Earnings: It represent the cumulative net income after dividend of the firm
since its beginning. In other words it is the profit ploughed back in the business or the
internal equity of a firm.

Reserves: A reserve may be defined as a portion of profit transferred to a separate

account without affecting the normal course of financial activities of a business during
the year. Reserves are set aside for strengthening the overall financial position of the
business and to meet the future unforeseen contingencies. It also can be utilized for the
future development, extension and improvement (restructuring) of the business.

Classification of reserve:

Reserves can be broadly classified into two types - Revenue reserve and Capital
reserve.

i) Revenue reserve - Reserves created out of revenue profit of a business is called

revenue reserve. Generally the term ‘reserve and surplus’ represent the profit retained
by the entity and are known as revenue reserve. These reserves can be distributed
among the shareholders as dividends. Revenue reserves may be general or specific in
nature. General reserves are created to add strength to the financial position of a
company.

ii) Capital Reserve – Capital reserves are created out of capital profits exclusive of
trading profits. These reserves are created out of

a) Pre-incorporation profits

b) Profit realized from sale of fixed assets

c) Profit realized from reissue of forfeited of shares

d) Profits from acquisition of business

e) Premiums on shares and debentures

50
These reserves cannot be distributed as dividend to shareholders but may be used for

i) Issue of bonus shares

ii) Writing up of fictitious assets like good will

iii) Payment of premium on redemption of debentures and preference shares

Similarly the reserves may be classified as Disclosed and Undisclosed reserve.

Disclosed reserve may be revenue reserve or capital reserve. Undisclosed reserves are
the reserves which are kept secret to the public as their existence cannot be figured out
from the balance sheet. These reserves are created by disclosing the assets at lower
figures than actual or by disclosing the liabilities at enhanced figures than actual. Secret
reserves are maintained by financial institutions and companies involved in power and
water supply. Sometimes the secret reserves are also statutory. Generally commercial
business houses with few exceptions are not allowed for secret reserves because of the
risk of misuse.

LIABILITIES:

According to FASB, “Liabilities are probable future sacrifices of economic benefits

arising from present obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past transactions or services.”

According to ICAI, liability is “the financial obligation of an enterprise other than owners’
funds”.

Characteristics of Liability:

• Obligations on the part of enterprise – Liabilities are obligations on the part of

an enterprise arising out of contracts and other agreements or from governmental
actions that are enforceable at law.

• Occurrence of past transaction or event – The Obligation must arise out of

some past transaction or event. For example acquisition of goods and services
obligates an enterprise to pay or sacrifice some assets in future.

• Future Sacrifice of Assets – The essence of a liability is a duty or requirement

to sacrifice assets in the future. A liability requires an enterprise to transfer asset,
provide services or otherwise expand assets to satisfy a responsibility it has incurred or
that has been imposed on it.

51
Classification of Liabilities: Liabilities are classified either on the basis of time or
security as given below.

Current Liabilities: Obligations that are expected to be paid within the operating cycle
of the business or within one accounting period (one year of balance sheet date). The
current obligations are normally met from current assets. Current liabilities may be
definite or estimated liabilities. If the current obligation can be ascertained precisely like
trade creditors and bills payable then they are classified as definite current liabilities.
The obligations which fall in current year but the amount can’t be determined accurately
at present are known as estimated liabilities. Examples of estimated liabilities are
income tax, product warranties. Provisions on current assets are also treated as
estimated liabilities.

Long Term Liabilities: Liabilities that are neither due in the operating cycle nor in the
accounting period are classified as long term liabilities. Few examples are debentures,
Long term Bank Loans etc.

Secured Liabilities: Liabilities that are accompanied by security or hypothecation of

borrower’s assets are known as secured liabilities. In case of default by the borrower,
the lender can dispose of the asset to realize his amount. Secured liabilities may be fully
secured or partly secured. If the entire amount of liability is covered by security it is
known as fully secured and if a portion of liability is covered then that is classified as
partly secured liabilities.

Unsecured Liabilities: The liabilities which are not backed by any security are known
as unsecured liabilities. These liabilities are normally availed on the basis of the credit
worthiness of the borrower. These liabilities though not backed by securities are always
backed by legal claims.

Contingent Liabilities: Another type of liability which doesn’t fall in the preview of
above classification is known as contingent liability. According to accounting standard
29, a contingent Liability is a possible obligation that arises from past events and the
existence of which will be confirmed only by the occurrence or non-occurrence of some
future uncertain events not wholly within the control of the business. The standard
provides that “an enterprise should not recognize a contingent liability”. But the
contingent liability should be disclosed in the corporate report if its chance of occurrence
is not remote.

Provisions:

A provision is a liability. According to accounting standard 29, “a provision is a liability

which can be measured only by using a substantial degree of estimation”. So provision
is

52
I) A liability

II) Expenditure will be incurred to meet the liability

III) Quantum of such expenditure is not certain

The difference between liability and provision is that in case of former the amount is
known while in case of latter the amount is not certain. A provision is different from
accruals as accruals are liabilities to pay for goods or services that have been received
from suppliers and employees. Quite often it is necessary to estimate the amount and
timing of accruals. Yet the uncertainty element associated with accruals is far less than
in case of provisions.

The provision should be recognized in the books of accounts if the following three
conditions are satisfied:

i) An enterprise has a present obligation because of some past event

ii) It will lead to outflow of resources

iii) A reliable estimate can be made of the amount of obligation.

2.7 RECENT TRENDS IN CORPORATE REPORTING

1. ANNUAL REPORT:-

An annual report is a document produced annually by companies designed to portray a

true & fair view of the company’s annual performance, with audited financial statements
prepared in accordance with company law & other regulatory requirements & also
containing other non-financial information.

The companies Act 1956 require companies to publish their annual report & accounts.

It should include

• A Balance Sheet

• A Profit & loss Account

• A Cash flow Statement

• A Director’s Report

2. STAKEHOLDERS IN THE ANNUAL REPORT –

• Shareholders (the owners of the business)

53
• Potential Shareholders

• Managers & Employees

• Creditors & Potential Creditors

• Suppliers – Especially if the supply goods on credit

• Employees & their trade Unions

• The Government for tax purposes

3. FUNCTIONS OF THE ANNUAL REPORT –

 The stewardship & Accounting Function

 Reporting to Shareholders
 The decision making Function
 To provide information about performance & changes in the financial position of
an enterprise that is useful to a wide range of users in making economic
decisions
 Providing users, especially shareholders with financial information so that they
can make decisions such as buying or selling shares
 The Public relations function: The annual report is an opportunity to publicize the
corporate image

4. A TRUE & FAIR VIEW:-

 Directors are responsible for the preparation of the accounts which must give
true & fair view.
 A true & fair view is one where accounts reflect what has happened & do not
mislead the readers.
 The accounts must be prepared in accordance with relevant AS.

5. INFORMATION TO BE INCLUDED:-

 The rules governing the content of the annual report are derived from –

Statute law – the companies Act

Accounting Standards

Stock Exchange rules

Codes of best practice in Corporate Governance

6. COMPANIES ACT 1956:-

54
  Directors have stewardship of limited companies.
 Directors are required to publish accounts which show a true & fair view of the
company’s financial position
 Accounts must be sent to-

-- All Shareholders’

-- All Debenture holders’

-- The Registrar of companies

-- This must be done within 10 months of the Year –end for a private
company & within 7 months of the year end in the case of a public company.

7. CONTENTS: THE AUDITED INFORMATION:-

1. MAIN STATEMENTS:

Profit & loss Account

Balance Sheet

Cash Flow Statement

2. SUBSIDIARY STATEMENTS:

Statement of total recognized gains & losses

Note on historical cost profit & losses

Reconciliation of movement in shareholders’ funds

3. EXPLANATORY MATERIAL:

Accounting policies

Notes to the accounts

Principal subsidiaries

8. CONTENTS: NON –AUDITED INFORMATION:-

1. NARRATIVE ITEMS

Chairman’s Statement

Director’s Report

55
 Operating & Financial review

Review of Operation’s

Statement of Corporate Governance

Auditor’s Report

Statement’s of Director’s Responsibilities for the Financial Statements

Shareholder’s information

2. NON-NARRATIVE ITEMS

Highlights

Historical Summary

Shareholder Analysis

9. BALANCE SHEET:-

1. A Balance Sheet is a statement of the resources owned & controlled by a

business at a single point in time.

2. It gives a snapshot of assets & liabilities & capital at a point of time

3. It provides information about the companies’ funds & how they are used in the
business.

10. PROFIT & LOSS ACCOUNT:-

The profit & loss Account is a statement which shows total business revenues
less expenses.

The P & L account quantifies & explains the gains or losses of the company over
the period of time bounded by two balance sheets.

It provides a summary of the year’s trading activities –

-- Revenue from sales (Turnover)

-- Business costs

-- Profit or loss

-- How the profit was used

11. CASH FLOW STATEMENT:-

56
 This is a statement which shows the flow of cash into & out of the business.

It is not the same as a profit & loss account.

The cash flow statement only records movements of cash & for example; Does
not include credit sales or purchases until such time as cash actually flows.

This statement became mandatory because of some high profile business

failures of the 1980’s / 1990’s – these were profitable but were short of cash to pay their
debts.

The cash flow statement should not be confused with a cash flow forecast. The
former is historical whereas the latter is a forecast about the future.

12. STATEMENT OF TOTAL RECOGNISED GAINS & LOSSES:-

STRGL is a financial statement which attempts to highlight all shareholders gains

& losses and not just those from trading.

It is a summary of all the profits & losses made during the year.

It is necessary because not all gains & losses are shown on the P & L account.

Example: Revaluation of fixed assets is not classed as revenue from trading

operations & so it will not show up on the P & L account. It does show up as an addition
to revaluation reserves on the Balance Sheet.

13. NOTES TO THE ACCOUNTS:-

Provides a more detailed analysis of some of the entries in the accounts

including

Disclosure of accounting policies used (depreciation) & any changes to these

policies

An explanation for any deviation from accounting standards

Sources of turnover from different geographical areas

Details of fixed assets, investments, sharecapital, debentures & reserves

Director’s emoluments (how much the Director’s earned)

Earnings per share

14. ACCOUNTING POLICIES:-

57
1. Companies must describe the accounting policies, they use in preparing financial
statements.

2. Companies have a choice of accounting policies in many areas such as foreign

currencies, goodwill, pensions, sales & stocks.

3. As different accounting policies will result in different figures, it is necessary to

state the policy that was used so that readers of the accounts can make an informed
judgments about performance

4. It is also important to state the effect of changes in accounting policies-restating

prior year numbers where this is materially significant.

15. CHAIRMAN’S STATEMENT:-

1. An overview of the trading year

2. A personalize overview of the company’s performance over the past year

3. Usually covers strategy, financial performance & future prospects

16. DIRECTOR’S REPORT:-

The principal objective is to supplement the financial information with other

information consider necessary for a full appreciation of the companies activities. It
includes:-

• A description of the principal activities of the company

• A fair review of the current & future prospects of the business

• Information on the sale, purchase or valuation of assets

• Recommended dividends

• Employee’s Statistics

• Names of Director’s &their interests

• Details of political or charitable donations

17. OPERATING & FINANCIAL REVIEW:

• This is a statement in the annual report which provides a formalized, structured

explanation of financial performance

• The operating review covers items such as operating results, profit & dividend

58
• The financial review discusses items such as capital structure & treasury policy

18. OTHER FEATURES:-

1. Highlights:-

• An “At a Glance” summary of selected figures & ratios

2. Historical Summary

• Five years of selected data from the Balance Sheet and Profit & loss account

• Tables and graphs to illustrate trend and comparison of turnover,Profit, dividends

and EPS

2. Shareholder’s Analysis

• Detailed analysis of

• The shareholder’s for example by size of shareholding

19. AUDITOR’S REPORT:-

• Auditors are independent accountants who are registered to carry out this work

• They also have to certify that the accounts are drawn up in accordance with the
requirements of the companies act

• Auditors must make a brief a report to confirm that the accounts give a true & fair
view of firm’s financial position

Financial Statement of Companies;-

Introduction: In case of companies the maintenance of proper books of accounts and

preparation of final companies are compulsory as per the requirements of Section 209
and Section 210 0f the Companies Act 1956.

Preparation of Final Accounts: The preparation of final accounts final accounts of a

company is governed by Section 210 of the Companies Act. The important provisions
are:

At every AGM of the company the BOD should lay before the company:

1. the Balance Sheet at the end of the accounting period, and

2. a profit and loss account for the period.

59
 The Balance Sheet should be in the form as per Part I of Schedule VI and that of
P&L A/C should comply with the requirements of Part II of Schedule VI of the
Companies Act.

Profit And Loss Account:

1. Heading:

Not necessary to split the Profit and loss account into three sections viz; trading,
profit and loss and profit and loss appropriation account.

To be prepared under two headings:

• P&L a/c giving details regarding the Gross Profit and Net Profit earned by the
business during a particular period, and

• P&L Appropriation A/C giving details regarding the balance of profit and loss
brought from the last year, the Net Profit or Loss earned (or made) during the year and
appropriations made.

Note: Items appearing in P&L a/c are termed as “above the line” and those appearing in
P&L A/C are termed as “below the line”

2. Abnormal Items: should be disclosed separately and should not be mixed up

with any other item.

3. Adjustments Relating to Previous Years:

• be made in P&L Appropriation A/C.

• e.g.- recovery of heavy amount previously written off as bad, extra provision to
be created out of the income of the previous years.

4. Tax Adjustment:

• Tax deducted at source:

A company is required to deduct tax from any amount paid by it by way of

salaries, dividend, interest to its employees etc.

The P&L A/C is debited with the gross amount of salaries or interest. The tax
deducted at source is shown in the liability side till it is finally paid by the company to the
Govt.

Journal Entry in respect of the above payment:

Interest on Debentures/ Salaries A/C………….Dr

60
 To Bank A/C

To Tax Deducted at Source A/C.

Tax is also deducted in respect of dividends and interest which the company gets
on its investments.

The P&L A/C is credited with such amount.

Journal Entry in respect of the above receipt is:

Bank A/C………………………………..Dr

Tax Deducted At Source A/C……………Dr

To Interest/Dividends A/C.

5. Advance Payment of Tax: As per Section 208 of the Income Tax Act, 1961,
every individual is required to pay advance tax when the advance tax payable is
Rs.1500 or more in the relevant previous year. It appears as an Asset in the Company’s
Balance sheet. The amount so paid is adjusted against the income tax payable by the
company whenever company’s assessment for that year is finalized.

6. Provision for Taxation:

• Shown as above the line item.

• Appears as a liability till assessment in respect of that year is finalized.

7. Dividends:

• are the part of the profits of a company which is distributed among its
shareholders.

• Interim Dividends-declared during the course of the accounting year in respect of

the same accounting year.

• Final Dividend-declared by the shareholders at the AGM of the company based

on the recommendation of the BODs.

• On declaration of dividend a company is required to deposit the amount of

dividend payable in a separate Dividend Bank Account.

8. Managerial Remuneration: According to section 198 of the Companies Act

1956, the total managerial payable by a public company or a private company which is

61
the subsidiary of public company in respect of any financial year shall not exceed 11%
of the Net profits of that company for that financial year.

Managerial Remuneration- includes remuneration payable to manager,

Managing Director, whole time directors of the company.

Net Profit-be calculated before tax but after including any bounty or subsidy from
Govt.

Capital Profit and provision for repairs, bad debts etc. should not be considered
while calculating N.P for the above purpose and depreciation should be charged as per
the rate.

Illustration:

The Balance Sheet of A Ltd. as at 31.3.1995 is as follows:

Balance Sheet as at 31.3.1995

Liabilities Rs. Assets Rs.

Authorized Share Capital Sundry Assets 17,00,000

1, 50,000 Equity Shares

Of Rs. 10 each 15, 00,000

Issued, Subscribed and Paid-up

80,000 Equity Shares of

Rs. 7.50 each called-up and paid-up 6, 00,000

Reserves and surplus

Capital Redemption Reserve 1, 50,000

Plant Revaluation Reserve 20,000

Securities Premium Account 1, 50,000

Development Rebate Reserve 2, 30,000

Investment Allowance Reserve 2, 50,000

General Reserve 3, 00,000

17, 00,000 17,00,000

62
 The company wanted to issue bonus shares to its shareholders at the rate of one
share for every two shares held. Necessary resolutions were passed; requisite legal
requirements were complied with:

(a) You are required to give effect to the proposal by passing journal entries in the
books of A Ltd.

(b) Show the amended Balance Sheet.

Solution:

In the Books of A Ltd.

Journal Entries Rs. Rs.

(i) Share Final Call A/c Dr. 2, 00,000

To Share Capital A/c 2, 00,000

(Being the final call of Rs. 2.50 each on 80,000

equity shares made)

(ii) Bank A/c Dr. 2, 00,000

To Share Final Call A/c 2, 00,000

(Being the amount due on final call received)

(iii) General Reserves Dr. 3, 00,000

Securities Premium A.c Dr. 1, 00,000

To Bonus to Shareholders A/c

4, 00,000

(Being the appropriation made as above to facilitate issue

of fully paid up bonus shares at the rate of one share for every two shares held)

(iv) Bonus to Shareholders A/c Dr. 4, 00,000

To Equity Share Capital A/c 4, 00,000

63
(Being the issuance of 40,000 fully paid up shares of Rs. 10 each by way of bonus)

(b) Balance Sheet (after bonus issue)

Liabilities Amount(Rs.)Assets Amount(Rs.)

Authorised Share Capital Bank 2, 00,000

1,50,000 equity shares of Rs. 10 each 15,00,000 Sundry Assets 17,00,000

Issued and Subscribed

1,20,000 Equity Shares of Rs. 10 each

fully paid 12,00,000

Of the above, 40,000 equity shares are

allotted as fully paid up by way of bonus

shares

Reserves and Surplus

Capital Redemption Reserve 1, 50,000

Securities Premium 50,000

Development Rebate Reserve 2, 30,000

Investment Allowance Reserve 2, 50,000

Plant Revaluation Reserve 20,000

19, 00,000 19, 00,000

2.8 ACCOUNTING REPORTS

Accountant’s Report in the Prospectus:

According to the Companies Act 1956, a Prospectus issued by a company

should contain particulars as required by schedule II. Part II of schedule II also requires
a Report by the accountant in the respect of the following matters.

64
1. Purchase of Business: If the proceeds, or any part of the proceeds, of the issue of
the shares or debentures are or is to be applied directly or indirectly:-
a. in the purchase of any business, or
b. in the purchase of an interest in any business and by reason of that
purchase, or anything to be done in consequence thereof, or in connection
therewith; the company will become entitled to an interest as respect either
the capital or profits and losses or both, in such business exceeding fifty per
cent, thereof; A report made by accountants (who shall be named in the
prospectus) upon :-
i. the profits or losses of the business for each of the five financial years
immediately preceding the issue of the prospectus, and
ii. The assets and liabilities of the business at the last date to which the
accounts of the business were made up, being a date not more than
one hundred and twenty days before the date of the issue of the
prospectus.
2. Acquisition of Business:
i. If-
a. the proceeds, or any part of the proceeds, of the issue of the shares or
debentures are or is to be applied directly or indirectly in any manner
resulting in the acquisition by the company of shares in any other body
corporate; and
b. by reason of that acquisition or anything to be done in consequence
thereof or in connection therewith, that body corporate will become a
subsidiary of the company.

A report made by accountant (who shall be named in the prospectus) upon:-

a. the profits or losses of the other body corporate for each of the five financial
years immediately preceding the issue of the prospectus; and
b. the assets and liabilities of the other body corporate at the last day to which its
accounts were made up. .
ii. The said report shall-
a. indicate how the profits or losses of the other body corporate dealt with by
the report would, in respect of the shares to be acquired, have concerned
members of the company and what allowance would have fallen to be
made, in relation to assets and liabilities so dealt with for holders of other
shares, if the company had at all material times held the shares to be
acquired; and
b. where the other body corporate as subsidiaries deal with the profits or
losses and the assets and liabilities of the body corporate and its

65
 subsidiaries in the manner provided by sub-clause (ii) above in relation to
the company and its subsidiaries.

Half - yearly Financial Report of Listed Companies:

SEBl vide its circular 5, 2010 has amended clause 41 of the listing agreement.
The amended clause required listed companies should disclose, on stand alone or
consolidated basis, their quarterly (audited or un-audited with limited review), financial
results within 45 days of the end of every quarter. Audited annual results on stand-alone
as well as consolidated basis, should be disclosed within 60 days from the end of the
financial year for those entities which opt to submit their annual audited results in lieu of
the last quarter unaudited financial results with limited review.

2.9 SUMMARY

 A company’s statutory records should always be kept updated. The significance of

these records should not be underestimated. They serve as definite evidence that
the company legally exists and so do its members.
 The importance of preparing a company’s final accounts accurately and on time is
very critical for minimizing its tax liability and ensuring that the revenue is right.
 Managerial remuneration includes remuneration that is payable to the managing
director, manager, part-time directors and whole time directors. It does not include
the remuneration paid to technical advisors and secretaries.
 Bonus is an extra dividend to the equity shareholders in a joint stock company from
surplus profits.
 Balance sheet is a financial statement that encapsulates the assets, liabilities and
shareholders’ equity of a company, at ascertains point in time. These components of
a balance sheet give investors a view of what belongs to the company and what it
owes, as well as the amount invested by shareholders.

2.10 KEY TERMS:

 Appropriation: Distribution of profits.

 Balance Sheet: Statement of assets and liabilities depicting the financial position
as at the end of the financial year.
 Below the Line: Part of the Profits and Loss Account which shows the
appropriation of profits.
 Contingent Liability: Liability which depends upon the happening of a certain
event.

66
  Gross Block: Gross value of fixed assets before depreciation.
 Preliminary Expenses: Expenses incurred in connection with the formation and
registration of a company.
 Premium on shares: Amount realized in. excess of the face value of shares of a
company.
 Turnover: Total value sale of goods or supply of services,
 Underwriting Commission: Commission payable to underwriters of shares and
debentures in lien of their undertaking to subscribe to the issue in the event of
under-subscription by the public.
 Bonus: An extra dividend to the equity shareholders in a joint stock company
from surplus profits.
 Bonus shares: Shares allotted by capitalization of the reserves or surplus of a
corporate enterprise.

2.11 QUESTIONS AND EXERCISES

1. According to Section 209, what should every company’s booksof account

contain?
2. Who are responsible for keeping the books of account?
3. Name the different Statutory Books or Statutory Ledgers.
4. What does a register of debenture holders contain?
5. According to Section 217, what details should the Board ofDirectors report
contain?
6. What are divisible profits?
7. What does the bonus mean?
8. According to Section 210 of the Companies Act, when is a company required to
prepare a balance sheet?
9. What are the special features of the Profit and Loss Account of a Company?
10. What do you understand by Appropriation of Profits? What are the items relevant
in that connection?
11. Enumerate four items each of current assets and current liabilities, how are
current assets and current liabilities shown in the vertical form of Balance Sheet?
12. What are the particulars required to be given with regard to the fixed assets
while preparing Balance Sheet of a Company?
13. State the nature of particulars and information to be given in Company Final
Accounts with regard to :
 Sundry Debtors.
 Share Capital
 Reserves and Surplus.

67
14. What should be the contents of a statutory report, according to Section 165 of the
Companies Act?
15. List the requirements of a Profit and Loss Account.
16. What are the statutory provisions regarding divisible profits?
17. Discuss the rules regarding declaration and payment of dividends.

*******

68
 UNIT 3: FUNDS FLOW STATEMENT

Structure

3.0 Introduction.

3.1 Unit objectives.

3.2 Concept of funds.

3.3 Preparation of fund flow statement.

3.4 Cash flow statement.

3.5 Utility of cash flow analysis.

3.6 Cash flow analysis vs. Funds flow analysis.

3.7 Accounting standard for cash flow statement.

3.8 Summary.

3.9 Key terms.

3.10 Question and exercise.

3.11 Practical problem.

3.0 INTRODUCTION

At the end of each accounting period, preparation and presentation of financial

statements are undertaken with an objective of providing as much information as
possible for the public. The balance sheet presents a snapshot picture of the financial
position at a given point of time and the income statement shows a summary of
revenues and expenses during the accounting period. Though these are significant
statements especially in terms of the principal goals of the enterprise, yet there is a
need for one more statement which will indicate the changes and movement of funds
between two balance sheet dates which are not clearly mirrored in the balance sheet
and income statement. That statement is called as funds flow statement. The analysis
which studies the flow and movement of funds is called as funds flow analysis.

1
 1.1 UNIT OBJECTIVES

After reading this lesson, you will be able to:

 Understand the concept of funds and flow.

 Evaluate the changes in working capital in an organization.
 Ascertain the sources and uses of funds from a given financial statement.
 Prepare fund flow statement.
 Understand the concepts of cash and cash flow.
 Understand the cash flow analysis.
 Prepare cash flow statement.

3.2 CONCEPT OF FUNDS

How are funds defined? Perhaps the most ambiguous aspect of funds flow
statement understands what is meant by funds. Unfortunately there is no general
agreement as to precisely how funds should be defined. To a lay man the concept of
funds means `cash’. According to a few, `funds’ means `net current monetary assets’
arrived at by considering current assets (cash + marketable securities + short term
receivables) minus short term obligations. A third view, which is the most acceptable
one, is that concept of funds means `working capital’ and in this lesson the term `funds’
is used in the sense of Working capital.

Working Capital Concept of Funds:

The excess of an enterprise’s total current assets over its total current liabilities
at some point of time may be termed as its net current assets or working capital. To
illustrate this, let us assume that on the balance sheet date the total current assets of an
enterprise are rs.3, 00,000 and its total current liabilities are rs.2, 00,000. Its working
capital on that date will be rs.3, 00,000 – rs.2, 00,000 = rs.1, 00,000. It follows from the
above, that any increase in total current assets or any decrease in total current liabilities
will result in a change in working capital.

Flow of Funds:

The term `flow’ means change and therefore, the term `flow of funds’ means
`change in funds’ or `change in working capital’. According to manmohan and goyal,
“the flow of funds” refers to movement of funds described in terms of the flow in and out
of the working capital area. In short, any increase or decrease in working capital means
`flow of funds’. Many transactions which take place in a business enterprise may

2
increase its working capital, may decrease it or may not affect any change in it. Let us
consider the following examples.

 Purchased Machinery For Rs.3,00,000:

The effect of this transaction is that working capital decreases by 3,00,000 as cash
balance is reduced. This change (decrease) in working capital is called as application of
funds. Here the accounts involved are current assets (cash a/c) and fixed asset
(machinery a/c).

 Issue Of Share Capital Of Rs.10,00,000:

This transaction will increase the working capital as cash balance increases. This
change (increase) in working capital is called as source of funds. Here the two accounts
involved are current assets (cash a/c) and long-term liability (share capital a/c).

 Sold Plant For Rs.3,00,000:

This transaction will have the effect of increasing the working capital by rs.3,00,000
as the cash balance increases by rs.3,00,000. It is a source of funds. Here the accounts
involved are current assets (cash a/c) and fixed assets (plant a/c).

 Redeemed Debentures Worth Rs.1,00,000:

This transaction has the effect of reducing the working capital, as the redemption of
debentures results in reduction in cash balance. Hence this is an example of application
of funds. The two accounts affected by this transaction are current assets (cash a/c)
and long-term liability (debenture a/c).

 Purchased Inventory Worth Rs.10, 000:

This transaction results in decrease in cash by rs.10,000 and increase in stock by

rs.10,000 thereby keeping the total current assets at the same figure. Hence there will
be no change in the working capital (there is no flow of funds in this transaction). Both
the accounts affected are current assets.

 Notes Payable Drawn By Creditors Accepted For Rs.30,000:

The effect of this transaction on working capital is nil as it results in increase in notes
payable (a current liability) and decreases the creditors (another current liability). Since
there is no change in total current liabilities there is no flow of funds.

 Building Purchased For Rs.30,00,000 And Payment Is Made By Shares:

3
 This transaction will not have any impact on working capital as it does not result in
any change either in the current asset or in the current liability. Hence there is no flow of
funds. The two accounts affected are fixed assets (building a/c) and long term liabilities
(capital a/c).

From the above series of examples, we arrive at the following rules on flow of funds:

I. There Will Be Flow Of Funds Only When There Is A Cross-Transaction I.E.,

Only When The Transaction Involves:
 Current Assets And Fixed Assets .Ex-Purchase Of Machinery For Cash
(Application Of Funds) Or Sale Of Plant For Cash (Source Of Funds).
 Current Assets And Capital, Ex-Issue Of Shares (Source Of Funds).
 Current Assets And Long Term Liabilities, Ex-Redemption Of Debentures In
Cash (Application Of Funds).
 Current Liabilities And Long-Term Liabilities, Ex-Creditors Paid Off In Debentures
Or Shares (Source Of Funds).
 Current Liabilities And Fixed Assets, Ex-Building Transferred To Creditors In
Satisfaction Of Their Claims (Source Of Funds).

There Will Be No Flow of Funds When There Is No Cross Transaction i.e When
The Transaction Involves:

 Current Assets and Current Assets, Ex-Inventory Purchased For Cash.

 Current Liabilities and Current Liabilities, Ex-Notes Payable Issued To Creditors.
 Current Assets and Current Liabilities, Ex-Payments Made To Creditors.
 Fixed Assets And Long Term Liabilities, Ex-Building Purchased And Payment
Made In Shares Or Debentures.

a) Sources and Application Of Funds: the following are the main sources of
funds:
 Funds from Operations: the operations of the business generate revenue
and entail expenses. Revenues augment working capital and expenses other
than depreciation and other amortizations. The following adjustments will be
required in the figures of net profit for finding out the real funds from
operations:

Funds from Operations

4
Net profit for the year x x x

Add*: depreciation of fixed assets x x x

Preliminary expenses, goodwill, etc.

Written off x x x

Loss on sale of fixed assets x x x

Transfers to reserve x x x

Less: profit on sale or revaluation x x x

Dividends received, etc. X x x

Funds from operations x x x

*these items are added as they do not result in outflow of funds. In case of `net loss’ for
the year these items will be deducted.

 Issue of Share Capital: an issue of share capital results in an inflow of funds.

 Long-Term Borrowings: when a long-term loan is taken, there is an
increase in working capital because of cash inflow. A short term loan,
however, does not increase the working capital because a short-term loan
increases the current assets (cash) and the current liability (short term loan)
by the same amount, leaving the size of working capital unchanged.
 Sale of Non-Current Assets: when a fixed asset or a long-term investment
or any other non-current asset is sold, there will be inflow represented by
cash or short-term receivables.

b) Uses of Funds: the following are the main uses of funds:

 Payment of Dividend: the transaction results in decrease in working capital
owing to outflow of cash.
 Repayment of Long-Term Liability: The repayment of long-term loan involves
cash outflow and hence it is used for working capital. The repayment of a current
liability does not affect the amount of working capital because it entails an equal
reduction in current liabilities and current assets.
 Purchase of Non-Current Assets: when a firm purchases fixed assets or other
non-current assets, and if it pays cash or incurs a short-term debt, its working
capital decreases. Hence it is a use of funds.

Importance and Utility of Funds Flow Analysis:

5
 Funds flow analysis provides an insight into the movement of funds and helps in
understanding the change in the structure of assets, liabilities and owners’ equity. This
analysis helps financial managers to find answers to questions like:

i. How far capital investment has been supported by long term financing?
ii. How far short-term sources of financing have been used to support capital
investment?
iii. How much funds have been generated from the operations of a business?
iv. To what extent the enterprise has relied on external sources of financing?
v. What major commitments of funds have been made during the year?
vi. Where did profits go?
vii. Why were dividends not larger?
viii. How was it possible to distribute dividends in excess of current earnings or in the
presence of a net loss during the current period?
ix. Why are the current assets down although the income is up?
x. Has the liquidity position of the firm improved?
xi. What accounted for an increase in net current assets despite a net loss for the
period?
xii. How was the increase in working capital financed?

3.3 PREPARATION OF FUNDS FLOW STATEMENT

Two statements are involved in funds flow analysis:

I. Statement or Schedule of Changes in Working Capital.

II. Statement of Funds Flow.

I. Statement of Changes In Working Capital:

This statement when prepared shows whether the working capital has increased or
decreased during two balance sheet dates. But this does not give the reasons for
increase or decrease in working capital. This statement is prepared by comparing the
current assets and the current liabilities of two periods. It may be shown in the following
form

Schedule of Changes In Working Capital (Proforma)

Items As on As on Change

Current Assets Increase Decrease

6
 Cash Balances

Bank Balances

Marketable Securities

Stock In Trade

Pre-Paid Expenses

Current Liabilities

Bank Overdraft

Outstanding Expenses

Accounts Payable

Provision for Tax

Dividend

Increase / Decrease In Working Capital

Any increase in current assets will result in increase in working capital and any
decrease in current assets will result in decrease in working capital. Any increase in
current liability will result in decrease in working capital and any decrease in current
liability will result in increase in working capital.

a) Funds Flow Statement:

Funds flow statement is also called as statement of changes in financial position or

statement of sources and applications of funds or where got, where gone statement.
The purpose of the funds flow statement is to provide information about the enterprise’s
investing and financing activities. The activities that the funds flow statement describes
can be classified into two categories:

 Activities that generate funds, called sources, and

 Activities that involve spending of funds, called uses.

When the funds generated are more than funds used, we get an increase in working
capital and when funds generated are lesser than the funds used, we get decrease in
working capital. The increase or decrease in working capital disclosed by the schedule
of changes in working capital should tally with the increase or decrease disclosed by the
funds flow statement.

7
 The funds flow statement may be prepared either in the form of a statement or in `t’
shape form. When prepared in the form of statement it would appear as follows:

Funds Flow Statement

Sources of Funds

Issues of shares x x x

Issue of debentures x x x

Long term borrowings x x x

Sale of fixed assets x x x

*operating profit

(funds from operations) x x x

Total sources x x x

Application of Funds

Redemption of redeemable

Preference shares x x x

Redemption of debentures x x x

Payments for other long-term loans x x x

Purchase of fixed assets x x x

* operation loss (funds lost from x x x

Operations) -------------------------

Total uses x x x

--------------------------

Net increase / decrease in working capital

8
 (total sources – total uses)

When prepared in `t’ shape form, the funds flow statement would appear as follows:

Funds Flow Statement

Sources of Funds Application of Funds

* Funds From Operation x xx *Funds Lost in Operations xx x

Issue of Shares x xx Redemption Of

Preference Shares x xx

Issue of Debentures x xx Redemption of Debentures x xx

Long-Term Borrowings x xx Payment of Other Long-Term

Loans x xx

Sale Of Fixed Assets x xx Purchase Of Fixed Assets

x xx

* Decrease In Working Payment Of Dividend, Tax,

Capital x xx Etc. x xx

Increase In Working Capital x xx

*Only One Figure Will Be There.

It may be seen from the proforma that in the funds flow statement preparation,
current assets and current liabilities are ignored. Attention is given only to change in
fixed assets and fixed liabilities.

In this connection an important point about provision for taxation and proposed
dividend is worth mentioning. These two may either be treated as current liability or
long-term liability. When treated as current liabilities they will be taken to `schedule of
changes in working capital’ and thereafter no adjustment is required anywhere. If they

9
are treated as long-term liabilities there is no place for them in the schedule of changes
in working capital. The amount of tax provided and dividend proposed during the current
year will be added to net profits to find the funds from operations. The amount of actual
tax and dividend paid will be shown as application of funds in the funds flow statement.
In this lesson, we have taken them as current liabilities.

Illustration:

The balance sheet of mathi limited for two years was as follows: Liabilities Assets

2010 2011 2010 2011

Share Capital 40,000 60,000 Land & 27,700 56,600

Buildings

Share Premium 4,000 6,000 Plant & 17,800 25,650

Machinery

General Reserve 3,000 4,500 Furniture 1,200 750

Profit & Loss A/C 9,750 10,400 Stock 11,050

13,000

5% Debentures --- 13,000 Debtors 18,250

19,550

Creditors 16,750 18,200 Bank 2,400 2,000

Provision For

Taxation 4,900 5,450

784,001, 17,550 784,001 17,550

Additional Information:

Depreciation written off during the year was:

Plant and machinery Rs.6,400

Furniture Rs. 200

10
 Prepare: a schedule of changes in working capital and a statement of sources
and application of funds.

Schedule of Changes in Working Capital

2010 2011 Increase Decrease

Rs. Rs. Rs. Rs.

Current Assets:

Stock 11,050 13,000 1,950

Debtors18,250 19,550 1,300

Bank 2,400 2,000 400

(a) 31,700 34,550

Current Liabilities

Creditors 16,750 18,200 1,450

Provision for

Taxation 4,900 5,450 550

(b) 21,650 23,650

Working capital

(a) – (b) 10,050 10,900

Increase in 850 850

working Capital

10,900 10,900 3,250 3,250

Calculation Of Funds From Operations

11
Profit And Loss A/C As On 31-12-2011 10,400

Add: Transfer To Reserve 1,500

Depreciation – Plant & Machinery 6,400

Furniture 200

18,500

Less: P&L A/C As On 1-1-2011 9,750

Funds From Operations 8,750

Land & Building A/C

To Balance B/D 27,700 By Balance C/D 56,600

To Bank Purchase 28,900

(Balancing Figure) -------- --------

56,600 56,600

-------- --------

Plant & Machinery A/C

To Balance B/D 17,800 By Depreciation 6,400

To Bank Purchase 14,250 By Balance C/D 25,650

(Balancing Figure) -------- --------

32,050 32,050

-------- --------

Furniture A/C

To Balance B/D 1,200 By Depreciation 200

By Bank – Sale 250

(Balancing Figure)

By Balance C/D 750

12
 ------- ------

Statement of Sources and Application of Funds

Sources Rs. Applications Rs.

Funds From Operations 8,750 Purchase Of Land & 28,900

Share Capital 20,000 Buildings

Share Premium 2,000 Purchase of Plant & 14,250

Debentures 13,000 Increase in Working 850

Sale Of Furniture 250 Capital

--------- --------

44,000 44,000

-------- --------

Illustration: Form the following Balance Sheets as on 31December, 2006 and 31

December, 2007, you are required to preparea Schedule of Changes in the Working
Capital and a Funds flowStatement taking:

(a) the provision for tax and proposed dividends as non-

currentliabilities;
(b) the provision for tax and proposed dividends as current liabilities.

BALANCE SHEET

as on 31 December

Liabilities 2006 2007 Assets 2006 2007

(Rs.) (Rs.) (Rs.) (Rs.)

Share Capital 10,000 15,000 Fixed Assets 10,000 20,000

Profit and Loss A/c 4,000 6,000 Current Assets 13,000 14,500

Provision for Tax 2,000 3,000

Proposed Dividends 1,000 1,500

13
Sundry Creditors 4,000 6,000

Outstanding Expenses 2,000 3,000

23,000 34,500 23,000 34,500

Additional Information:

(Rs.)

Tax paid during 2007 2,500

Dividends paid during 2007 1,000

Solution:

i. When Provision for Tax and Proposed dividends are taken asnon-current
liabilities:

SCHEDULE OF CHANGES IN WORKING CAPITAL

Particulars Increase (+) Decrease (–)

(Rs.) (Rs.)

Sundry Creditors 2,000

Outstanding Expenses 1,000

Current Assets 1,500

Decrease in Working Capital 1,500

3,000 3,000

FUNDS FLOW STATEMENT

Source: (Rs.) (Rs.)

Increase in Share Capital 5,000

Funds from Operations:

Net Profit 2,000

14
Add: Provision for Tax made during

the year (3,000 + 2,500 – 2,000) 3,500

Add: Proposed Dividends 1,500 7,000

Total Sources 12,000

Applications:

Fixed assets purchased 10,000

Tax paid 2,500

Dividends paid 1,000

Total Applications 13,500

Net Decrease in Working Capital 1,500

ii. When Provision for Tax and Proposed Dividends are taken asCurrent Liabilities:

SCHEDULE OF CHANGES IN WORKING CAPITAL

Particulars Increase (+) Decrease(–)

(Rs.) (Rs.)

Sundry Creditors 2,000

Outstanding Expenses 1,000

Current Assets 1,500

Provision for Tax 1,000

Proposed Dividends 500

Decrease in Working Capital 3,000

4,500 4,500

FUNDS FLOW STATEMENT

15
 Particulars (Rs.)

Sources:

Increase in Share Capital 5,000

Funds from Operations 2,000

Total Sources 7,000

Applications:

Purchase of Fixed Assets 10,000

Decrease in Working Capital 3,000

Illustration:From the following balance sheets of X Ltd. on 31December, 2005 and

2006, you are required to prepare:

(a) A schedule of changes in working capital,

(b) A funds flow statement.

Liabilities 2005 2006 Assets 2005 2006

(Rs.) (Rs.) (Rs.) (Rs.)

Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000

General Reserve 14,000 18,000 Building 40,000 36,000

Profit and Loss A/c 16,000 13,000 Plant 37,000 36,000

Sundry Creditors 8,000 5,400 Investments 10,000 11,000

Bills Payable 1,200 800 Stock 30,000 23,400

Provision for Taxation 16,000 18,000 BillsReceivable 2,000 3,200

Provision for Doubtful Debtors 18,000 19,000

Debts 400 600 Cash/Bank 6,600 15,200

1, 55,600 1, 55,800 1, 55,600 1, 55,800

The following additional information has also been given:

16
(i) Depreciation charged on Plant was Rs. 4,000 and on Building Rs.4,000.

(ii) Provision for taxation of Rs.19,000 was made during the year2006.

(iii) Interim dividend of Rs. 8,000 was paid during the year 2006.

Solution:

SCHEDULE OF CHANGES IN WORKING CAPITAL

Particular 2005 2006 Increase (+) Decrease (–)

(Rs.) (Rs.) (Rs.) (Rs.)

Current Assets:

Cash at Bank 6,600 15,200 8,600

Debtors 18,000 19,000 1,000

Bills receivable 2,000 3,200 1,200

Stock 30,000 23,400 6,600

Current Liabilities:

Provision for doubtful debts 400 600 200

Bills payable 1,200 800 400

Sundry creditors 8,000 5,400 2,600

Total 13,800 6,800

Net Increase in working capital 7,000.

FUNDS FLOW STATEMENT

Particulars (Rs.)

Source:

Funds from Operations (See Note 1) 36,000

Total Sources 36,000

Applications:

Purchase of plant (See Note 2) 3,000

17
Tax paid (See Note 3) 17,000

Investments purchased (See Note 4) 1,000

Interim dividend paid 8,000

Total Applications 29,000

Net Increase in Working Capital 7,000

36,000

Working Notes:

1. Funds from operations:

Particulars (Rs.) (Rs.)

Profit and loss A/c balance on 31 December, 2006 13,000

Add: Items which do not decrease funds from operations

Transfer to general reserve 4,000

Provision for tax 19,000

Depreciation:

Plant 4,000

Building 4,000

Interim dividend paid 8,000 39,000

52,000

Less: Profit and Loss Account balance on 31 December, 2006 16,000

Funds from operations for the year 36,000

2. Purchase of Plant: This has been found out by preparing the PlantAccount.

PLANT ACCOUNT

Particulars (Rs.) Particulars (Rs.)

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 To Balance b/d 37,000 By Depreciation 4,000

To Bank (Purchase of plant 3,000 By Balance c/d 36,000

balancing figure)

40,000 40,000

3. Tax paid during the year has been found out by preparing a provisionfor tax account.

PROVISION FOR TAX ACCOUNT

Particulars (Rs.) Particulars (Rs.)

To Bank (being tax paid—bal. 17,000 By Balance 16,000

figure) b/d
18,000 19,000
To Balance c/d By P. & L. A/c
35,000 35,000

4. ‘Investments’ have been taken as a fixed asset presuming thatthey are long-term
investments.

1.4 CASH FLOW STATEMENT

Meaning of Concepts of Cash, Cash Flow Analysis:

While explaining the concept of `fund’ it was mentioned that in a narrower sense
the term `fund’ is also used to denote cash.The term `cash’ in the context of cash flow
analysis stands for cash and bank balances. Cash flow refers to the actual movement of
cash in and out of an organization. When cash flows into the organization it is called
cash inflow or positive cash flow. In the same way when cash flows out of the
organization, it is called cash outflow or negative cash flows. Cash flow analysis is an
analysis based on the movement of cash and bank balances. Under cash flow analysis,
all movements of cash would be considered.

Cash Flow Statement:

A cash flow statement is a statement depicting changes in cash position from

one period to another i.e. The result of cash flow analysis is given in the cash flow
statement. For example if the cash balance of a concern as per its balance sheet as on
31st march 2004 is rs.90,000 and the cash balance as per its balance sheet as on 31st

19
march 2005 is rs.1,20,000, there has been an inflow of cash of rs.30,000 in the year
2004-05 as compared to the year 2003-04. The cash flow statement explains the
reasons for such inflows or outflows of cash as the case may be.

Normally the following are principal sources of inflows of cash:

 Issue of shares and debentures for cash

 Sale of fixed assets and investments for cash
 Borrowings from banks and other financial institution
 Cash from operations outflows of cash generally include:
 Redemption of shares and debentures by cash
 Purchase of fixed assets and investments by cash
 Repayment of loans
 Cash lost in operations

PREPARATION OF CASH FLOW STATEMENT:

The Cash Flow Statement can be prepared on the same pattern on which a
Funds Flow Statement is prepared. The change in the cash position from one period to
another is computed by taking into account’ Sources’ and ‘Applications’ of cash.

Sources of Cash:

Sources of Cash can be both internal as well as external:

Internal sources Cash from operations is the main internal source. The Net Profit
shown by the Profit and Loss Account will have to be adjusted for non-cash items
finding out cash from operations. Some of these items are as follows:

(i) Depreciation. Depreciation does not result in outflow of cash and, therefore, net
profit will have to be increased by the amount of depreciation or development
rebate charged, in order to find out the real cash generated from operations.
(ii) Amortization of intangible assets. Goodwill, preliminary expenses, etc., when
written off against profits, reduce the net profits without affecting the cash
balance. The amounts written off should, therefore, be added back to profits to
find out the cash from operations.
(iii) Loss on sale of fixed assets. It does not result in outflow of cash and, therefore,
should be added back to profits.
(iv) Gains from sale of fixed assets. Since sale of fixed assets is taken as a separate
source of cash, it should be deducted from net profits.
(v) Creation of reserves. If profit for the year has been arrived at after charging
transfers to reserves, such transfers should be added back to profits. In case

20
 operations show a net loss, such net loss after making adjustments for non-cash
items will be shown as an application of cash.

Thus, cash from operations is computed on the pattern of computation of ‘Funds’

from operations, as explained in the earlier chapter. However, to find out of real cash
from operations, adjustments will have to be made for ‘changes’ in current assets and
current liabilities arising on account of operations, viz., trade debtors, trade creditors,
bills receivable, bills payable, etc.

Adjustments for Changes in Current Assets and Current Liabilities:

The cash from operations has been computed on the same pattern on which funds
from operations are computed. As a matter of fact, the fund from operations is
equivalent to cash from operations. This is because of the presumption that all are cash
transactions and all goods have been sold. However, there may be credit purchases,
credit sales, outstanding and prepaid expenses, etc. In such a case, adjustments will
have to be made for each of these items in order to find out cash from operations. This
has-been explained in the followings:

(i) Effects of Credit Sales: In business, there are both cash sales and credit sales.
In case, the total sales are Rs. 30,000 out of which the credit sales are Rs.
10,000, it means sales have contributed only to the extent of ` 20,000 in
providing cash from operations. Thus, while computing cash from operations, it
will be necessary that suitable adjustments for outstanding debtors are also
made.
(ii) Effect of Credit Purchases: Whatever have been stated regardingcredit sales is
also applicable to credit purchases. The only difference will be that decrease in
creditors from one period to another will result in decrease of cash from
operations because it means more cash payments have been made to the
creditors which will result in outflow of cash. On the other hand, increase in
creditors from one period to another will result in increase of cash from
operations because less payment has been made to the creditors for goods
supplied which will result in increase of cash balance at the disposal of the
business.
(iii)Effect of Opening and Closing Stocks: The amount of opening stock is
charged to the debit side of the Profit and Loss Account. It thus reduces the net
profit without reducing the cash from operations. Similarly, the amount of closing
stock is put on the credit side of the Profit and Loss Account. It thus increases
the amount of net Profit without increasing the cash from operations.
(iv)Effect of Outstanding Expenses: Incomes received in Advance,etc. The effect
of these items on cash from operations is similar to the effect of creditors. This
means any increase in these items will result in increase in cash from operations

21
 while any decrease means decrease in cash from operations. This is because
net profit from operations is computed after charging to it all expenses whether
paid or outstanding. In case certain expenses have not been paid, this will result
in decrease of net profit without a corresponding decrease in cash from
operations. Similarly, income received in advance is not taken into account while
calculating profit from operations, since it relates to the next year. It, therefore,
means cash from operations will be higher than the actual net profit as shown by
the Profit and Loss Account.
(v) Effect of Prepaid Expenses and Outstanding Income: The effect of prepaid
expenses and outstanding income of cash from operations is similar to the effect
of debtors. While computing net profit from operations, the expenses only for the
accounting year are charged to the Profit and Loss Account. Expenses paid in
advance are not charged to the Profit and Loss Account. Thus, pre-payment of
expenses does not decrease net profit for the year but it decreases cash from
operations. Similarly, income earned during a year is credited to the Profit and
Loss Account whether it has been received or not. Thus an income, which has
not been received but which has become due, increase the net profit for the year
without increasing cash from operations.

External sources:

The external sources of cash are:

(i) Issue of new shares: In case shares have been issued for cash, the net cash
received (i.e., after deducting expenses on issue of shares or discount on issue
of shares) will be taken as a source of cash.
(ii) Raising long-term loans: Long-term loans such as issue of debentures, loans
from Industrial Finance Corporation, State Financial Corporation, IDBI, etc., are
sources of cash. They should be shown separately.
(iii)Purchase of plant and machinery on deferred payments: In case plant and
machinery has been purchased on a deferred payment system, it should be
shown as a separate source of cash to the extent of deferred credit. However,
the cost of machinery purchased will be shown as an application of cash.
(iv)Short-term borrowings (cash credit from banks): Short-term borrowing, etc.,
from banks increase cash available and they have to be shown separately under
this head.
(v) Sale of fixed assets, investments, etc. It result in generation of cash and
therefore, is a source of cash.

Decrease in various current assets and increase in various current liabilities may be
taken as external sources of cash, if they are not adjusted while computing cash from
operations.

22
Applications of Cash:

Applications of cash may take any of the following forms:

(i) Purchase of fixed assets Cash may be utilized for additional fixed assets or
renewals or replacement of existing fixed assets.
(ii) Payment of long-term loans The payment of long-term loans such as loans
from financial institutions or debentures results in decrease in cash. It is,
therefore, an application of cash.
(iii)Decrease in deferred payment liabilities Payments for plant and machinery
purchased on deferred payment basis has to be made as per the agreement. It
is, therefore, an application of cash.
(iv)Loss on account of operations Loss suffered on account of business
operations will result in outflow of cash.
(v) Payment of tax: Payment of tax will result in decrease of cash and hence it is an
application of cash.
(vi)Payment of dividend: This decreases the cash available for business and
hence it is an application of cash.
(vii) Decrease in unsecured loans, deposits, etc. The decrease in these
liabilities denotes that they have been paid off to that extent. It results, therefore,
in outflow of cash.

Increase in various current assets or decrease in various current liabilities may be

shown as applications of cash, if changes, in these items have not been adjusted while
finding out cash from operations. The following is the format of a cash flow statement:

Cash Flow Statement for the Year Ending Say 31st March 2012

Balance as on 1-4-2011 Balance as on 1-4-2011

23
 Cash in hand x xx bank overdraft (if any) xx x

Cash at bank x xx

Add: cash inflows: cash outflows:

Here the items mentioned here the items mentioned

As sources of cash inflows as outflows of cash above

Above will be recorded will be recorded

Balance as on 31-3-2012 balance as on 31-3-2012

Bank overdraft (if any) x xx cash in hand xx x

Cash at bank x xx

x xx x xx

The accounting standard (AS) 3 issued by the institute of chartered accountants

of India requires the companies to prepare cash flow statement and present them as
part of their annual reports.

Calculation of Cash from Operations: The important step in the preparation of cash
flow statement is the calculation of cash from operations. It is calculated as follows:

The first step in the calculation of cash from operations is the calculation of funds
from operations (which is already explained in the lesson on funds flow analysis). To the
funds from operations the decrease in current assets and increase in current liabilities
will be added (except cash, bank and bank o.d.). From the added total, increase in
current assets and decrease in current liabilities will be deducted (except cash, bank
and bank o.d.). The resultant figure is cash from operations (refer illustration 3).

Pro-forma of Cash from Operations Statement

Funds from operations or funds lost from operations x xxx

Add: Decrease in current assets x xxx

24
Increase in current liabilities x xxx x xxx

Less: Increase in current assets

Decrease in current liabilities
x xx
x xx

x xxx
Cash from operations or cash lost from operations

x xxx

As in the case of fund flow analysis here also we assume provision for taxation
and proposed dividend as current liabilities.

3.5 UTILITY OF CASH FLOW ANALYSIS

Cash flow analysis yields the following advantages:

 It is very helpful in understanding the cash position of the firm. This would enable
the management to plan and coordinate the financial operations properly.
 Since it provides information about cash which would be available from
operations the management would be in a position to plan repayment of loans,
replacement of assets, etc.
 It throws light on the factors contributing to the reduction of cash balance inspite
of increase in income and vice versa.
 A comparison of the cash flow statement with the cash budget for the same
period helps in comparing and controlling cash inflows and cash outflows.

However cash flow analysis is not without limitations. The cash balance as
disclosed by the cash flow statement may not represent the real liquid position of the
business since it can be easily influenced by postponing purchases and other
payments. Further cash flow statement cannot replace the income statement or funds
flow statement. Each of them has a separate function to perform.

3.6 CASH FLOW ANALYSIS VS. FUNDS FLOW ANALYSIS

25
  A cash flow statement is concerned only with the changes in cash position while
funds flow analysis is concerned with changes in working capital position
between two balance sheet dates.
 Cash flow analysis is a tool of short-term financial analysis while the funds flow
analysis is comparatively a long-term one.
 Cash is part of working capital and therefore an improvement in cash position
results in improvement in the funds position but not vice versa. In other words
“inflow of cash” results in “inflow of funds” but inflow of funds may not necessarily
result in “inflow of cash”.
 In funds flow analysis, the changes in various current assets and current
liabilities are shown in a separate statement called schedule of changes in
working capital in order to ascertain the net increase or decrease in working
capital. But in cash flow analysis, such changes are adjusted to funds from
operations in order to ascertain cash from operations.

Limitations of Cash Flow Analysis:

Cash flow analysis is a useful tool of financial analysis. However, it has its own
limitations. These limitations are as under:

i. Cash flow statement cannot be equated with the Income Statement. An Income
Statement takes into account both cash as well as non-cash items and,
therefore, net cash flow does not necessarily means net income of the business.
ii. The cash balance as disclosed by the cash flow statement may not represent the
real liquid position of the business since it can be easily influenced by postponing
purchases and other payments.
iii. Cash flow statement cannot replace the Income Statement or the Funds Flow
Statement. Each of them has a separate function to perform.

In spite of these limitations it can be said that cash flow statement is a useful
supplementary instrument. It discloses the volume as well as the speed at which the
cash flows in the different segments of the business. This helps the management in
knowing the amount of capital tied up in a particular segment of the business.

Illustration:

From the following balances calculate cash from operations:

December 31st

2010(Rs.) 2011(Rs.)

26
 Profit and loss a/c balance 75,000 1,55,000

Debtors 45,000 42,000

Creditors 20,000 26,000

Bills receivable 12,000 15,000

Cash in hand 2,500 3,000

Prepaid expenses 1,600 1,400

Bills payable 18,000 16,000

Cash at bank 8,000 10,000

Outstanding expenses 1,200 1,600

Income received in advance 250 300

Outstanding income 800 900

Additional Information:

 depreciation written off during the year Rs.10,000

 Transfer to general reserve Rs.10,000.

Calculation of Funds from Operations

(Rs.)

Profit & Loss A/C As On 31St December 2011 1,55,000

Add: Depreciation 10,000

Transfer To General Reserve 10,000

1,75,000

Less: P & L A/C As On 1St January 2011 75,000

Funds From Operations 1,00,000

Calculation of Cash from Operations

27
 Funds from operations 1,00,000

Add: Decrease in Current Assets

Decrease in debtors 3,000

Decrease in prepaid expenses 200

Increase in Current Liabilities

Increase in creditors 6,000

Increase in outstanding expenses 400

Increase in income received in advance 50

1,09,650

Less: Increase In Current Assets

Increase in bills receivables 3,000

Increase in outstanding income 100

Decrease in Current Liabilities

Decrease in bills payable 2,000

Cash from operations

1,04,550

Note: decrease in current assets means current assets are converted into cash
and increase in current liabilities results in further generation of cash. Hence they are
added. Increase in current assets and decrease in current liabilities result in outflow of
cash. Hence they are deducted.

3.7 ACCOUNTING STANDARD FOR CASH FLOW STATEMENT

AS 3 (Revised): Cash Flow Statement

The following are the salient features of the Revised Accounting Standard (AS) 3,
Cash Flow Statements, issued by the Council of the Institute of Chartered Accountants
of India in March 1997. This Standard supersedes AS 3, Changes in Financial Position,
issued in June, 1981.This accounting standard (AS) has become mandatory
w.e.f.accounting periods beginning from 1.4.2001 for the following enterprises.

(a) Enterprises whose debt or equity securities are listed or going to be listed on a
recognized stock exchange.

28
 (b) All other commercial, industrial and business reporting enterprises whose
turnover for the accounting period exceeds Rs. 50 crores.

Objectives

Information about the cash flows of an enterprise is useful in providing users of

financial statements with a basis to assess the ability of the enterprise to generate cash
and cash equivalents and the needs of the enterprise to utilize those cash flows. The
economic decisions that are taken by users require an evaluation of the ability of an
enterprise to generate cash and cash equivalents and the timing and certainty of their
generation.

The Statement deals with the provisions of information about the historical
changes in cash and cash equivalents of an enterprise by means of a cash flow
statement which classifies cash flows during the period from operating, investing and
financing activities.

Scope:

1. An enterprise should prepare a cash flow statement and should present it for
each period for which financial statements are presented.
2. Users of an enterprise’s financial statements are interested in how the enterprise
generates and uses cash and cash equivalents. This is the case regardless of
the nature of the enterprise’s activities and irrespective of whether cash can be
viewed as the product of the enterprise, as may be the case with a financial
enterprise. Enterprises need cash for essentially the same reasons, however
different their principal revenue producing activities might be. They need cash to
conduct their operations, to pay their obligations, and to provide returns to their
investors.

Benefits of Cash Flow Information

1. A cash flow statement, when used in conjunction with the other financial
statements, provides information that enables users to evaluate the changes in
net assets of an enterprise, its financial structure (including its liquidity and
solvency), and its ability to affect the amounts and timing of cash flows in order to
adapt to changing circumstances and opportunities. Cash flow information is
useful in assessing the ability of the enterprise to generate cash and cash
equivalents and enables users to develop models to assess and compare the
present value of the future cash flows of different enterprises.
2. It also enhances the comparability of the reporting of operating performance by
different enterprise because it eliminates the effects of using different accounting
treatments for the same transactions and events.

29
 3. Historical cash flow information is often used as an indicator of the amount,
timing and certainty of future cash flows. It is also useful in checking the accuracy
of past assessments of future cash flows and in examining the relationship
between profitability and net cash flow and the impact of changing prices.

Definitions

The following terms are used in this Statement with the meanings specified:

1. Cash comprises cash on hand and demand deposits with banks.

2. Cash equivalents are short term, highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an insignificant
risk of changes in value.
3. Cash flows are inflows and outflows of cash and cash equivalents.
4. Operating activities are the principal revenue-producing activities of the
enterprise and other activities that are not investing or financing activities.
5. Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
6. Financing activities are activities that result in changes in the size and
composition of the owner’s capital (including preference share capital in the case
of a company) and borrowings of the enterprise.

Presentation of a Cash Flow Statement

The cash flow statement should report cash flows during the period classified by
operating, investing and financing activities.

Operating activities: Cash flows from operating activities are primarily derived from the
principal revenue-producing activities of the enterprise. Therefore, the generally result
from the transactions and other events that enter into the determination of net profit or
loss. Examples of cash flows from operating activities are:

(a) Cash receipts from the sale of goods and the rendering of services;
(b) Cash receipts from royalties, fees, commissions, and other revenue;
(c) Cash payments to suppliers for goods and services;
(d) Cash payments to and on behalf of employees;
(e) Cash receipts and cash payments of an insurance enterprise for premiums and
claims, annuities and other policy benefits;
(f) Cash payments or refunds of income taxes unless they can be specifically
identified with financing and investing activities; and
(g) Cash receipts and payments relating to futures contracts, forward contracts,
option contracts, and swap contracts when the contracts are held for dealing or
trading purposes.

30
Investing activities: Examples of cash flows arising from investing activities are:

(a) Cash payments to acquire fixed assets (including intangibles). There payments
include those relating to capitalized research and development costs and self
constructed fixed assets;
(b) cash receipts from disposal of fixed assets (including intangibles);
(c) cash payments to acquire shares, warrants, or debt instruments of other
enterprises and interests in joint ventures (other than payments for those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);
(d) cash receipts from disposal of shares, warrants, or debt instruments of other
enterprises and interests in joint ventures (other than receipts from those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);
(e) cash advances and loans made to third parties (other than advances and loans
made by a financial enterprise);
(f) cash receipts from the repayment of advances and loans made to third parties
(other than advances and loans of a financial enterprise);cash payments for
futures contracts, forward contracts, option contracts, and swap contracts except
when the contracts are held for dealing or trading purposes, or the payments are
classified as financing activities; and
(g) Cash receipts from futures contracts, forward contracts, option contracts, and
swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities.

Financing activities: Examples of cash flows arising from financing activities are:

(a) cash proceeds from issuing shares or other similar instruments;

(b) cash proceeds from issuing debentures, loans, notes, bonds, and other short- or
long-term borrowings; and
(c) Cash repayments of amounts borrowed.

Reporting Cash Flows from Operating Activities

1. An enterprise should report cash flows from operating activities using either:
a. the direct method, whereby major classes of gross cash receipts and
gross cash payments are disclosed; or
b. the indirect method, whereby net profit or loss is adjusted for the effects
of transactions of a non-cash nature, any deferrals or accruals of past or
future operating cash receipts payments, and items of income or expense
associated with investing or financing cash flows.

31
 2. The direct method provides information which may be useful in estimating future
cash flows and which is not available under the indirect method and is, therefore,
considered more appropriate than the indirect method. Under the direct method,
information about major classes of gross cash receipts and gross cash payments
may be obtained either:
a. from the accounting records of the enterprise; or
b. by adjusting sales, cost of sales (interest and similar income and interest
expense and similar charges for a financial enterprise) and other items in
the statement of profit and loss for:
i. changes during the period in inventories and operating receivables
and payables;
ii. other non-cash items; and
iii. Other items for which the cash effects are investing or financing
cash flows.
3. Under the indirect method, the net cash flow from operating activities is
determined by adjusting net profit or loss for the effects of:
a. changes during the period in inventories and operating receivables and
payables;
b. non-cash items such as depreciation, provisions, deferred taxes, and
unrealized foreign exchange gains and losses; and
c. all other items for which the cash effects are investing or financing cash
flows.
4. Alternatively, the net cash flow from operating activities may be presented under
the indirect method by showing the operating revenues and expenses, excluding
non-cash items disclosed in the statement of profit and loss and the changes
during the period in inventories and operating receivables and payables.

Reporting Cash Flows from Investing and Financing Activities

An enterprise should report separately major classes of gross cash receipts and
gross cash payments arising from investing and financing activities, except to the extent
that cash flows described in paragraphs are reported on a net basis.

Reporting Cash Flows on a Net Basis

1. Cash flows arising from the following operating, investing or financing activities
may be reported on a net basis:
a. Cash receipts and payments on behalf of customer’s when the cash flows
reflect the activities of the customer rather than those of the enterprise.

Examples of cash receipts and payments referred above are as follows:

i. the acceptance and repayment of demand deposits by a bank;

32
 ii. funds held for customers by an investment enterprise; and
iii. Rents collected on behalf of, and paid over to, the owners of properties.
b. Cash receipts and payments for items in which the turnovers quick, the
amounts are large, and the maturities are short.

Examples of cash receipts and payments referred above are advances made for,
and the repayments of:

i. principal amounts relating to credit card customers;

ii. the purchase and sale of investments; and
iii. Other short-term borrowings, for example, those which have a maturity period of
three months or less.
2. Cash flows arising from each of the following activities of a financial enterprise
may be reported on a net basis:
a. cash receipts and payments for the acceptance and repayment of
deposits with a fixed maturity date;
b. the placement of deposits with and withdrawal of deposits from other
financial enterprises; and
c. Cash advances and loans made to customers and the repayment of those
advances and loans.

Foreign Currency Cash Flows: Cash flows arising from transactions in a foreign
currency should be recorded in an enterprise’s reporting currency by applying to the
foreign currency amount the exchange rate between the reporting currency and the
foreign currency at the date of the cash flow. A rate that approximates the actual rate
may be used if the result is substantially the same as would arise if the rates at the
dates of the cash flows were used. The effect of changes in exchange rates on cash
and cash equivalents held in a foreign currency should be reported as a separate part of
the reconciliation of the changes in cash and cash equivalents during the period.

Extraordinary Items: The cash flows associated with extraordinary items should be
classified as arising from operating, investing or financing activities as appropriate and
separately disclosed.

Interest and Dividends: Cash flows from interest and dividends received and paid
should each be disclosed separately. Cash flows arising from interest paid and interest
and dividends received in the case of a financial enterprise should be classified as cash
flows arising from operating activities. In the case of other enterprises, cash flows
arising from interest paid should be classified as cash flows from financing activities
while interest and dividends received should be classified as cash flows from investing
activities. Dividends paid should be classified as cash flows from financing activities.

33
Taxes on Income: Cash flows arising from taxes on income should be separately
disclosed and should be classified as cash flows from operating activities unless they
can be specifically identified with financing and investing activities.

Investments in Subsidiaries, Associates, and Joint Ventures: When accounting for

an investment in an associate or a subsidiary or a joint venture; an investor restricts its
reporting in the cash flow statement to the cash flows between itself and the
investee/joint venture; for example, cash flows relating to dividends and advances.

Acquisitions and Disposals of Subsidiaries and Other Business Units

1. The aggregate cash flows arising from acquisitions and from disposals of
subsidiaries or other business units should be presented separately and
classified as investing activities.
2. An enterprise should disclose, in aggregate, in respect of both acquisition and
disposal of subsidiaries or other business units during the period each of the
following:
a. the total purchase or disposal consideration; and
b. the portion of the purchase or disposal consideration discharged by
means of cash and cash equivalents.

Non-cash Transactions: Investing and financing transactions that do not require the
use of cash or cash equivalents should be excluded from a cash flow statement. Such
transactions should be disclosed elsewhere in the financial statements in a way that
provides all the relevant information about these investing and financing activities.

Disclosure:

Components of cash and cash equivalents: An enterprise should disclose the

components of cash and cash equivalents and should present a reconciliation of the
amounts in its cash flow statement with the equivalent items reported in the balance
sheet.

Other disclosures: An enterprise should disclose together with a commentary

by management, the amount of significant cash and cash equivalent balances held by
the enterprise that are not available for use by it.

Illustration: From the following information prepare a Cash Flow Statement relating to
(a) Direct Method (b) Indirect Method. Working notes would form a part of your answer.

BALANCE SHEET
34
 as on 31.12.2006

(Rs. in ’000)

2006 2005

Assets

Cash on hand and balances with banks 200 25

Short-term investments 670 135

Sundry debtors 1,700 1,200

Interest receivable 100 –

Inventories 900 1,950

Long-term investments 2,500 2,500

Fixed assets at cost 2,180 1,910

Less: Accumulated depreciation (1,450) (1.060)

Fixed assets (net) 730 850

Total Assets 6,800 6,660

Liabilities

Sundry creditors 150 1,890

Interest payable 230 100

Income taxes payable 400 1,000

Long-term debt 1,110 1,040

Total liabilities 1,890 4,030

Shareholders’ funds

Share capital
1,500 1,250
Reserves
3,410 1,380
Total shareholders’ funds
4,910 2,630

35
 Total Liabilities and shareholders’ funds 6,800 6,660

(2) STATEMENT OF PROFIT AND LOSS

for the period ended 31.12.2006

(Rs. in ’000)

Sales 30,650

Cost of sales (26,000)

Gross profit 4,650

Administrative and selling expenses (910)

Interest expense (400)

Interest income 300

Dividend income 200

Foreign exchange loss (40)

Net profit before taxation and extraordinary item 3,350

Extraordinary item—

Insurance proceeds from earthquake disaster settlement 180

Net profit after extraordinary item 3,530

Income tax (300)

Net Profit 3,230

Additional Information: (Figures are in Rs. ’000).

(a) An amount of 250 was raised from the issue of share capital and a further 250
was raised from long-term borrowings.
(b) Interest expense was 400 of which 170 was paid during the period.100 relating
to interest expense of the prior period was also paid during the period.

36
 (c) Dividends paid were 1,200.
(d) Tax deducted at source on dividends received (included in the tax expense of
300 for the year) amounted to 40.
(e) During the period, the enterprise acquired fixed assets for 350.The payment was
made in cash.
(f) Plant with original cost of 80 and accumulated depreciation of 60was sold for
20.
(g) Foreign exchange loss of 40 represents the reduction in the carrying amount of
a short-term investment in foreign currency designated bonds arising out of a
change in exchange rate between the date of acquisition of the investment and
the balance sheet date.
(h) Sundry debtors and sundry creditors include amounts relating to credit sales and
credit purchases only.

Solution:

CASH FLOW STATEMENT

(Direct Method)

(Rs. in ’000)

37
 2006

Cash flows from operating activities

Cash receipts from customers 30,150

Cash paid to suppliers and employees (27,600)

Cash generated from operations 2,550

Income taxes paid (860)

Cash flow before extraordinary item 1,690

Proceeds from earthquake disaster settlement 180

Net cash from operating activities 1,870

Cash flows from investing activities

Purchase of fixed assets (350)

Proceeds from sale of equipment 20

Interest received 200

Dividend received 160

Net cash from investing activities 30

Cash flows from financing activities

Proceeds from issuance of share capital 250

Proceeds from long-term borrowings 250

Repayments of long-term borrowings (180)

Interest paid (270)

Dividend paid (1,200)

Net cash used in financing activities (1,150)

Net increase in cash and cash equivalents 750

Cash and cash equivalents at beginning of period (Note 1) 160

Cash and cash equivalents at end of period (Note 1) 910

38
Working Notes:

1. Cash and cash equivalents Cash and cash equivalents consistof cash on hand
and balances with banks, and investments inmoney-market instruments. Cash
and cash equivalents includedin the cash flow statement comprise the following
balance sheetamounts.

2006 2005

Cash on hand and balances with banks 200 25

Short-term investments 670 135

Cash and cash equivalents 870 160

Effect of exchange rate changes 40 –

Cash and cash equivalents as restated 910 160

Cash and cash equivalents at the end of the period include deposits with banks
of 100 held by a branch which are not freely permissible to the company because of
currency exchange restrictions. The company has undrawn borrowing facilities of 2,000
of which700 may be used only for future expansion.

2. Total tax paid during the year (including tax deducted at source on dividends
received) amounted to 900.

CASH FLOW STATEMENT

(Indirect Method)

(Rs. in ’000)

39
 2006

Cash flows from operating activities

Net profit before taxation, and extraordinary item 3,350

Adjustments for:

Depreciation 450

Foreign exchange loss 40

Interest income (300)

Dividend income (200)

Interest expense 400

Operating profit before working capital changes 3,740

Increase in sundry debtors (500)

Decrease in inventories 1,050

Decrease in sundry creditors (1,740)

Cash generated from operations 2,550

Income taxes paid (860)

Cash flows before extraordinary item 1,690

Proceeds from earthquake disaster settlement 180

Net cash from operating activities 1,870

Cash flows from investing activities

Purchase of fixed assets (350)

Proceeds from sale of equipment 20

Interest received 200

Dividends received 160

Net cash from investing activities 30

40
 Cash flows from financing activities

Proceeds from issuance of share capital 250

Proceeds from long-term borrowings 250

Repayment of long-term borrowings (180)

Interest paid (270)

Dividends paid (1,200)

Net cash used in financing activities (1,150)

Net increase in cash and cash equivalents

Cash and cash equivalents at beginning of period(Note 1) 750

Cash and cash equivalents at end of period(Note 1) 160

910

Alternative Presentation (Indirect Method)

As an alternative, in an indirect method cash flow statement, operatingprofit

before working capital changes is sometimes presented as follows:

Revenues excluding investment income 30,650

Operating expenses excluding depreciation (26,910)

Operating profit before working capital changes 3,740

Working Notes:

(Figures are in Rs. ’000)

1. Cash receipts from customers

Sales 30,650

Add: Sundry debtors at the beginning of the year 1,200

31,850

Less: Sundry debtors at the end of the year 1,700

30,150

41
 2. Cash paid to suppliers and employees

Cost of sales 26,000

Administrative & selling expenses 910

26,910

Add: Sundry creditors at the beginning of the year 1,890

Inventories at the end of the year 900 2,790

29,700

Less: Sundry creditors at the end of the year 150

Inventories at the beginning of the year 1,950 2100

27,600

3. Income taxes paid (including tax deducted at source from dividends received)

Income tax expense for the year

(including tax deducted at source from dividends received) 300

Add: Income tax liability at the beginning of the year 1,000

1,300

Less: Income tax liability at the end of the year 400

900

Out of 900, tax deducted at source on dividends received(amounting to 40), is

included in cash flows from investing activities and the balance of 860 is included in
cash flows from operating activities.

4. Repayment of long-term borrowings

Long-term debt at the beginning of the year 1,040

Add: Long-term borrowings made doing the year 250

1,290

Less: Long-term borrowings at the end of the year 1,110

180

42
 5. Interest paid

Interest expense for the year 400

Add: Interest payable at the beginning of the year 100

500

Less: Interest payable at the end of the year 230

270

3.8 SUMMARY

 The Funds Flow Statement is widely used by the financial analysts, credit
granting institution and financial managers in performance of their jobs. It has
become a useful tool in their analytical kit. This is because the financial
statements, i.e.,’ Income Statement’ and the ‘Balance Sheet’ have a limited role
to perform.
 The term ‘Funds’ has a variety of meanings. There are people who take it
synonymous to cash and to them there is no difference between a Funds Flow
Statement and a Cash Flow Statement. While others include marketable
securities besides cash in the definition of the term ‘Funds’.
 Funds flow statement helps the financial analyst in having a more detailed
analysis and understanding of changes in the distribution of resources between
two balance sheet dates. In case such study is required regarding the future
working capital position of the company, a projected funds flow statement can be
prepared.
 A Cash Flow Statement is a statement depicting change in cash position from
one period to another. For example, if the cash balance of a business is shown
by its Balance Sheet on 31December, 2007 at ` 20,000 while the cash balance
as per its Balance Sheet on 31 December, 2008 is 30,000, there has been an
inflow of cash of Rs. 10,000 in the year 2008 as compared to the year 2008.
 Cash from operations is the main internal source. The Net Profit shown by the
Profit and Loss Account will have to be adjusted for non-cash items finding out
cash from operations.
 A Cash Flow Analysis is concerned only with the change in cash position while a
Fund Flow Analysis is concerned with change in working capital position,
between two balance sheet dates. Cash is only one of the constituents of
working capital besides several other constituents such as inventories, accounts
receivable, prepaid expenses.

43
  A Cash Flow Statement is useful for short-term planning. A business enterprise
needs sufficient cash to meet its various obligations in the near future such as
payment for purchase of fixed assets, payment of debts maturing in the near
future, expenses of the business, etc.
 The balance sheet is merely a static statement. It is a statement of assets and
liabilities as on a particular date. It does not sharply focus those major financial
transactions which have been behind the balance sheet changes. One has to
draw inferences from the Balance Sheet about major financial transactions only
after comparing the Balance Sheets of two periods.

3.9 KEY TERMS

 Working Capital: working capital is that part of capital used for the purposes of
day-to-day operations of a business.
 Fund: fund refers to the long term capital used for financing current assets. It can
be ascertained by finding the difference between current assets and current
liabilities.
 Flow of funds: flow refers to transactions which change the size of fund in an
organization. The flow transactions are divided into uses and sources. While the
former refers to those transactions which reduce the funds, the latter increases
the size of fund.
 Cash: cash refers to cash and bank balances.
 Cash Flow: cash flow refers to the actual movement of cash in and out of an
organization.
 Current assets: Cash and other assets that are expected to be converted into
cash or consumed in the production of goods or rendering of services in the
normal course of business.
 Current liabilities: Liabilities payable within a year either out of the existing
current assets or by creation of other current liabilities.
 Cash flow statement: A statement depicting change in cash position from one
period to another

3.10 QUESTIONS AND EXERCISE

1. What do you mean by working capital concept of funds?

2. Explain the significance of funds flow analysis and cash flow analysis.
3. Distinguish between schedule of changes in working capital and funds flow
statement.
4. Distinguish between cash flow analysis and funds flow analysis.
5. What is a ‘Funds Flow Statement’? Examine its managerial uses.

44
 6. “A Funds Flow Statement is a better substitute for an Income Statement.”
Discuss.
7. Explain the various concepts of funds in the context of Funds Flow Analysis.
8. What do you understand by Funds Flow Statements? How are they prepared?
What are their uses?
9. What are the chief advantages of Funds Flow Statement? Also describe its
limitations.
10. Write short notes on:
a. Application of Funds
b. Importance of Funds Flow Statement.
c. Non-fund Items
11. Explain the meaning of a Cash Flow Statement. Discuss its utility.
12. Explain the technique of preparing a Cash Flow Statement with imaginary
figures.
13. What is a Cash Flow Statement? Discuss briefly the major classification of cash
flows as per AS 3.
14. Define cash and cash equivalent as suggested in Accounting Standard 3 to be
used for preparing a cash flow statement.

3.11 PRACTICAL PROBLEMS

1. Shyam and company has the following information for the year ending 31st
march 2012:sales Rs.5,000, depreciation Rs. 450, other operating expenses
Rs.4,100.

You are required to:

 Estimate The Amount Of Funds Generated During The Year.

 If The Amount Of Depreciation Increases To Rs.9,000 What Would Be Its Effect
On Funds Generated During The Year.
 Under What Circumstances Can The Funds From Operation Be Zero?

2. From the following balance sheets of damodar ltd. As on 31st december 2010
and 2011 you are required to prepare:
 A Schedule Of Changes In Working Capital
 A Funds Flow Statement.

45
Liabilities 2010(Rs.) 2011(Rs.) Assets 2010(Rs.) 2011(Rs.)

Share capital 1,00,000 1,00,000 Goodwill 12,000 12,000

General reserve 14,000 18,000 Building 40,000 36,000

Creditors 8,000 5,400 Plant 37,000 36,000

Bills payable 1,200 800 Investments 10,000 11,000

Provision for Stock 30,000 23,400

taxation 16,000 18,000 Bills receivable 2,000 3,200

Provision for Debtors 18,000 19,000

doubtful debts 400 600 Cash at bank 6,600 15,200

Profit & loss a/c 16,000 13,000

1,55,600 1,55,800 1,55,600 1,55,800

Additional information:

 Depreciation charged on plant was rs.4,000 and on building Rs.4,000.

 Provision for taxation Rs.19,000.
 Interim dividend of Rs.8,000 Was paid during the year 2011.
3. Alfa Ltd. supplies you the following Balance Sheets on 31 December:

Liabilities 2004 2005 Assets 2004 2005

(Rs.) (Rs.) (Rs.) (Rs.)

Share capital 70,000 74,000 Bank balance 9,000 7,800

Bonds 12,000 6,000 Receivable 14,900 17,700

Accounts payable 10,360 11,840 Inventories 49,200 42,700

Provision for Land 20,000 30,000

doubtful debts 700 800 Goodwill 10,000 5,000

Reserves and 10,040 10,560

surplus
1,03,100 1,03,200 1,03,100 1,03,200

46
 Additional information:

(i) Dividends amounting to Rs. 3,500 were paid during the year 2005.
(ii) Land was purchased for Rs. 10,000.
(iii) Rs.5,500 were written off on Goodwill during the year.
(iv) Bonds of Rs. 6,000 were paid during the course of the year. You arerequired to
prepare a Cash Flow Statement.

[Ans. Cash flows from: (a) Operating Activities Rs. 14,300; (b) Investment Activities
Rs.10, 000; (c) Financing Activities Rs. 9,000]

4. Toyota Limited furnishes you the following Balance Sheets for the yearsending
on 31 December 2004 and 2005. You are required to prepare aCash Flow
Statement for year ended 31 December, 2005.

Liabilities 2004(Rs) 2005(Rs.) Assets 2004(Rs) 2005(Rs.)

Equity share capital 10,000 10,000 Goodwill 1,200 1,200

General reserve 1,400 1,800 Land 4,000 3,600

Profit and Loss A/c 1,600 1,300 Building 3,700 3,600

Sundry creditors 800 540 Investments 1,000 1,100

Outstanding exps. 120 80 Inventories 3,000 2,340

Prov. for taxation 1,600 1,800 Receivables 2,000 2,220

Prov. for bad debts 40 60 Bank balance 660 1,520

15,560 15,580 15,560 15,580

Additional information:

(i) A piece of land has been sold for Rs. 400.

(ii) Depreciation amounting to Rs.700 has been charged on building.
(iii) Provision for taxation has been made for Rs. 1,900 during the year.

[Ans. Cash flows from: (a) Operating Activities Rs.1,160; (b) Investment Activities Rs.
300; (c) Financing Activities Rs. 660]

*********

47
 UNIT 4 FINANCIAL STATEMENT ANALYSIS
Structure

4.0 Introduction

4.1 Unit objectives

4.2 Need for analyzing financial statements

4.3 Techniques of analysis

4.4 Ratios for financial statement analysis

4.5 Advantages of financial ratios

4.6 Limitations of accounting ratios

4.7 Summary

4.8 Key terms

4.9 Questions and exercises

4.10 Practical problem

4.0 INTRODUCTION

Financial statement provides a summarized view of financial position and operations

of a firm. Much can be learnt about a firm from careful examination of its financial statement
as invaluable documents or performance reports. The focus of the financial analysis is on
key figures in the financial statement and the significant relationship that exist between
them. Thus analysis of financial statement involves in evaluating the relationship between
components parts of financial statements to obtain a better understanding of the firms’
position and performance.

4.1 UNIT OBJECTIVES

After reading this lesson, you will be able to:


explain the need for analyzing financial statements;

know different methods of analyzing the financial statements;

understand how investors and others examine the performance of the company
through ratio analysis;
 explain a few advanced financial analysis models with the help of ratio analysis; and
 Caution the users of financial statements for some of the limitations of financial
statement analysis.
4.2 NEED FOR ANALYZING FINANCIAL STATEMENTS

1
 The term financial statement analysis contains both analysis and interpretation.
Therefore, a distinction should be made between the two terms. The term analysis is used
to mean the simplification of the financial data by methodical classification of the data given
in the financial statement and the other hand, interpretation means “explaining the meaning
and significance of the data so simplified”.

Financial statement analysis, by determining the significance and meaning of the

financial statement data helps in forecasting the future earning, ability to pay interest and
debt maturities and profitability of a sound dividend policy. The first task of financial analyst
is to select information relevant to the decision under consideration from the total
information contain in the financial statement. The second step is to arrange the information
in a way to highlight significant relationship. The final step is interpretation and drawing
inference and conclusion. In a brief financial analysis is the process of selection, relation
and evaluation.

Objectives:

 Evaluation of past performance and financial position.

 Prediction of future performance.

4.3 TECHNIQUES OF ANALYSIS

The following tools are used to measure the operational efficiency, financial
soundness of the business:

A. Horizontal Analysis
B. Vertical Analysis
C. Trend analysis
D. Ratio analysis

A. Horizontal Analysis
An easiest way of financial statement analysis is the horizontal analysis. This analysis
calculates the change of items both absolutely in terms of amount change and relatively
through percentage change from the previous year to current year. To put it simply
horizontal analysis makes a comparison of company’s performance over a period of time.
Hence this is also known as comparative statement. Past Performance is a good indicator
but a firm never competes with its past rather with other firms operating in the industry.

2
 B. Vertical Analysis:
It is the proportional expression of each item on a financial statement to the statement in
total. So it facilitates in intercompany comparison in addition to horizontal analysis which
facilitates in intra company comparison. To cite an example a company from vertical
analysis can know its operating expenses as a proportion of sales, which can be compared
with its previous figures as well as with industry norms to find out its strength and
weakness. Horizontal and vertical analysis of Profit and loss account of Centurion Bank is
presented below.

Centurion Bank

Comparative Profit and Loss Account for the year ended 31st March 2001

(Horizontal Analysis)

For the yr For the yr

ended ended Change Change

31st March 31st March

2001 2000 Amount %

Schedule

Income

Interest Earned 13 54730 44280 10450 19.09373

Other Income 14 9809 8879 930 9.481089

64539 53159 11380 17.63275

3
Expenditure

Interest
Expended 15 44515 36249 8266 18.56902

Operating
Expenses 16 7963 6140 1823 22.89338

Depreciation 6280 4263 2017 32.11783

58758 46652 12106 20.60315

Operating
profit 5781 6506 -725 -12.5411

Provision &
Contingencies 5079 3073 2006 39.49596

Net Profit for current

yr 702 3433 -2731 -389.031

Profit B/F 3618 2454 1164 32.17247

Amount
Available

for
appropriation 4320 5887 -1567 -36.2731

4
 Centurion Bank

Comparative Profit and Loss Account for the year ended 31st March 2001

(Vertical Analysis)

For the yr
For the yr ended ended

31st March 31st March

2001 2000

Schedule Percentage Percentage

Income

Interest Earned 13 54730 84.80 44280 83.30

Other Income 14 9809 15.20 8879 16.70

64539 100.00 53159 100.00

Expenditure

Interest
Expended 15 44515 68.97 36249 68.19

Operating
Expenses 16 7963 12.34 6140 11.55

Depreciation 6280 9.73 4263 8.02

58758 91.04 46652 87.76

5
Operating
profit 5781 8.96 6506 12.24

Provision &
Contingencies 5079 7.87 3073 5.78

Net Profit for current

yr 702 1.09 3433 6.46

C. Trend analysis:

It is an extended version of horizontal analysis which involves calculation of percentage

changes in financial statement items for a number of successive years. In trend analysis
one past financial is taken as the base and is assigned a value 100 and the
corresponding figures of other years are expressed as a percentage of the base tear
value. The trend analysis of Centurion Bank given below will make it clear.

Centurion Bank: Trend Analysis of Selected Financial Data

31.03.2001 31.03.2000 31.03.1999 31.03.1998 31.03.1997 31.03.1996

Total
Assets 587971 522434 310434 158513 129524 35532

Gross
Income 64539 53159 43917 20404 11395 4433

12061 10769 9402 4744 2750 1223

Gross

6
Profit

Net Profit 702 3433 2144 2007 1624 964

TREND ANALYSIS

Total
Assets 1654.76 1470.32 873.67 446.11 364.53 100

Gross
Income 1455.88 1199.17 990.68 460.28 257.05 100

Gross
Profit 986.18 880.54 768.77 387.90 224.86 100

Net Profit 72.82 356.12 222.41 208.20 168.46 100

4.4 RATIOS FOR FINANCIAL STATEMENT ANALYSIS

Accounting Data in absolute terms does not provide much meaning as the analysis
of data involves comparisons and relations. So it becomes fairly simple to use ratios for
comparison with a competing firm and with the results of past years. If ratios are used with
understanding of industry factors and general economic conditions it acts as a powerful
device for identifying the company’s strength and weakness.

Standard of comparison:

 Rules of thumb
 Industry Standards
However the classification of the ratio is depend upon the objectives for which they are
calculated. It may also depend upon the availability of the data. Analysis of the financial
statement is made with a view to ascertain the effectiveness and efficiency and financial
soundness of the company, as such ratios can be classified on the basis of profitability,
Liquidity and turnover, financial capability, and market assessment.

Ratios 7
PROFITABILITY RATIOS:

The main objective of the business concern is to earn profits. Earning profit is
considered essential for the survival of the business. Lord Keynes says “profit is the engine
that drives the business enterprise”. A business thus needs a profit not only for its survival
but also for its expansion and diversification. The various interested groups connected with
the business expect returns from the organization. For instance, the investors want an
adequate return on their investments, worker wants higher wages, creditors want a higher
security for their interest and loan and so on. A business can discharge its obligations to the
various segments of the society only if it earns profits. Thus, profits are useful measure of
the overall efficiency of the business. Profitability ratios are calculated either in relation to
sales or in relations investment. The following are the various profitability ratios.

Gross Profit Ratio:The gross profit ratio measures the relationship of gross profit to net
sales and is usually expressed as a percentage. Thus, it is calculated by dividing the gross
profit by sales.
Gross Profit

Gross Profit Ratio =--------------- * 100

Net sales

The gross profit ratio indicates the extent to which selling prices of goods per unit
may decline without resulting in loss of the operation of a firm. It reflects the efficiency with
8
which a manufactures its products. As the gross profit is calculated by deducting cost of
goods sold from the net sales, the higher is the gross profit better is the result. There is no
standard norm of gross profit ratio and it may vary from business to business, but the gross
profit should be adequate to cover the operating expenses such as administrative
expenses, office expenses, selling and distribution expenses and to provide for fixed
charges, dividend and accumulation of reserves. A low gross profit ratio normally indicates
high cost of goods sold due to unfavorable purchasing policies, lesser sales, lower selling
prices, fierce competition, over investment in plant and machinery, etc.

Operating Ratio: The operating ratio establishes the relationship between cost of goods
sold and other operating expenses on one hand and the sales in other hand. In other
words, it measures the cost of operation per rupee of sales. By dividing the operating costs
with the net sales operating ratio is calculated. This is represented as a percentage.

Operating Cost

Operating Ratio =------------------- * 100

Net Sales

Here two major elements of this ratio are operating cost and net sales. Operating
Where Operating Cost = Cost of Goods sold + Operating Expenses
cost can be found by adding operating expenses to the cost of goods. Operating expenses
consist of administrative and office and selling & distribution expenses.

Operating ratio indicates the percentage of net sales that is consumed by operating
cost. Apparently higher the operating ratio, the less favorable it is because it would have a
small margin operating profit to cover interest, income tax, dividend and reserves. For this
ratio there is no hard and fast rule and it differs from firm to firm, the nature of the business
and its capital structure. However 75% to 85% may be considered to be a good ratio in
case of manufacturing undertaking. In order to have better idea of the ratio, either the trend
should be found by calculating operating ratio for a number of years or a comparison of the
firm should be made with another in a similar business or in the same industry.

Operating ratio is considered as yardstick for measuring operating efficiency but it

should be used cautiously because it may affected by the uncontrollable factors that are
beyond the control of the business. Further in some firms, non-operating expenses form
substantial part of the total expenses and in such cases operating ratio may give misleading
results.

9
Operating Profit ratio: The operating profit ratio is calculated by dividing operating profit by
sales. Operating profit calculated as follows;

Operating Profit

Thus, Operating Profit Ratio = --------------------- * 100

Sales

Where Operating profit = Net Sales – Operating cost

Expenses Ratio: The expenses ratio ascertains the relationship between various expenses
and volume of sales. The operating ratio reveals the average total variations in expenses. In
some of the cases the expenses may be increasing while in some it may be falling.
Therefore the expenses ratios are calculated by dividing each of the expenses or group of
expenses with net sales to analyze the cause of variation of the operating ratio. This ratio
can be calculated for each individual item of expenses or group of items of particular type of
expenses like cost of sales ratios, administrative expenses ratios, selling expenses ratios,
material consumption ratio, etc.

Particular Expenses

Particular Expenses Ratio =-------------------------- * 100

Net sales

The lower the ratio, the greater is the profitability and higher the ratio, lower is the
profitability. While interpreting the ratio, one should remember that for a fixed expense like
rent, the ratio will fall if the sales increase and for a variable expense, the ratio in proportion
to sales shall remain nearly the same.

Net Profit Ratio: The net profit ratio establishes the ratio between net profit (after tax) and
sales and indicates the efficiency of the management in manufacturing, selling,
administrative and other activities of the firm. This ratio gives an overall measure of the
firm’s profitability and is calculated as below;

Net Profit after tax

Net Profit Ratio =-------------------------- * 100

10
Net sales
 The two basic elements of the ratio are net profits and sales. Net profit will be
obtained after deducting income tax and generally, non-operating incomes expenses are
excluded from the net profits for calculating this ratio. Thus, incomes such as the interest on
investment outside the business, profit on sale of fixed assets, etc. are excluded. The ratio
is very useful because if the profit is not sufficient, the firm shall not be able to achieve a
satisfactory return on its investment. This ratio also indicates the firm’s capacity to face
adverse economic conditions such as price competition, low demand, etc. Obviously, higher
the ratio, the better is the profitability. But while interpreting the ratio, it should be kept in
mind that the performance of profits must also been in relation to investment or capital of
the firm and not only in relation to sales.

Return on Assets/Return on Investment: This is a measure of Profitability from a given

level of investment. It is one of the important measures of the performance of a company.

Net Profit after tax

Return on Assets =-------------------------- * 100

Total assets/ average total assets

Return on investment depends on profit margin and assets turn over as:

Net Profit after tax Net Profit after tax Sales

-------------------------- = ---------------------- x ------------------

Aaverage total assets Sales Average total assets

Since the ratio is used to measure the efficiency of management of assets, the non
operating items and interest expenses are not considered as it has little to do with
efficiency. So the profit in numerator should be “Net operating profit after tax”. So ratio is
normally calculated as

Net Operating Profit after tax

11
Return on Assets =------------------------------------ * 100

Total assets/ average total assets

Return on Equity: The ratio measures return from shareholders’ point of view. It points out
how efficiently the shareholders fund is employed. The ratio is calculated as follows:

Net Profit after tax

Return on Assets = ----------------------------------- * 100

Average shareholders’ Equity

The shareholders of a company expect ROE to be higher than the cost of capital so
that it can add some economic value to the firm. Return on equity can be increased with the
help of financial leverage, i.e., use of fixed cost fund or debt financing in the capital
structure of the firm.

Earnings per Share: This is one of the most commonly used measures of
expressing corporate earnings. It gains importance as the return on owners’ equity is not as
much of interest for an individual shareholder as the earnings on a per share basis. This
measure is computed by dividing the net income by the number of equity or ordinary shares
outstanding. Thus, the earnings per share of equity capital would be;

Net Income for Equity Shareholders

Earnings per Share =---------------------------------------------

Dividend per Share: This is another important per share calculation, which shows the cash
Number of equity shares
income available to the shareholder (of a share). As far as an individual shareholder is
concerned, his/her major interest in the company is in the amount of dividend that can be
earned on the investment in the shares and in the increase in the price of the shares.

Income Distributed as Dividend

Dividend per Share =---------------------------------------------

Number of equity shares

Now we will try to find out all the ratios from the financial statement of Hindustan Lever
Limited. Hindustan Lever Limited

Profit and Loss Account for the year ended 31st March 2002

12
 2002 2001

(Rs Lakhs) (Rs Lakhs)

Sales 9954,85.30 10667,55.09

Other Income 384,54.22 381,79.05

Total Revenue 10339,39.52 11049,34.74

Expenses 8142,27.96 9105,97.52

Profit before Tax 2197,11.56 1943,37.22

Tax 479,85.00 402,42.00

Profit after Tax 1717,26.56 1540,95.22

Exceptional Items 38,41.90 100,36.13

Net Profit 1755,68.46 1641,31.35

Hindustan Lever Limited

Balance Sheet as on 31st March 2002

2002 2001

Shareholders’ Funds and (Rs Lakhs) (Rs Lakhs)

Liabilities

Share Capital 220,12.44 220,12.44

Reserves & Surplus 3438,75.14 2823,56.74

Secured loans 19,61.50 43,04.39

Unsecured loans 38,68.26 40,69.47

Current Liabilities & provisions 3670,89.43 3501,82.28

Deferred Tax liabilities 117,38.49 103,13.12

13
 Total Funds 7505,45.26 6732,38.44

Assets

Fixed Assets (net) 1322,33.65 1320,06.02

Investments 2364,74.10 1635,93.12

Inventories 1278,73.62 1240,03.62

Sundry Debtors 367,85.04 424,78.47

Cash and bank balances 942,62.60 913,15.69

Other Current Assets 46,30.22 50,61.56

Loans and Advances 795,55.40 798,18.70

Deferred Tax Assets 387,30.63 349,61.26

Total Assets 7505,45.26 6732,38.44

Calculate the profitability ratios from the above financial information.

Solution:

14
 Formula 2002 2001

PAT/Sales 171726.56/995485.3 154095.22/1066755.69

= 17.25% =14.45%

PAT/Average Total 171726.56/711891.85* 154095.22/623345.69#

assets
= 24.12% = 24.72%

NOPAT/ Average 147985.16**/711891.85 130436.79**/623345.69

Investment
= 20.79% = 20.93%

PAT/ Average 171726.56/335128.38* 154095.22/276595.71#

Shareholders’ equity
= 51.24% = 55.71%

Operating Exp/sales 813309.56/995485.3 909823.10/1066755.69

= 81.7% = 85.29%

PAT/ No of equity 175568.46/2201243793 164131.35/2200922097

Shares
= Rs 7.98 = Rs 7.46

*Average of 2001 and 2002

# Average of the figures of 2000 and 2001. Figures for 2000 collected from previous
financial statement

** Calculation of Net Operating Profit:

2002 2001

Sales 995485.30 1066755.69

Less Operating exp 813309.56 909823.10

Operating Profit before Tax 182175.74 156932.59

Less Tax on OPBT

15
 Tax Reported 47985.00 40242.00

Less tax paid (36.75%) on 14131.93 14030.80

other Income

Add Tax on Interest 337.51 34190.58 284.60 26495.80

Expenses (36.75%)

NOPAT 147985.16 130436.79

LIQUIDITY RATIOS:

Liquidity ratios are calculated to measure the short term financial soundness of the
business. The ratio assesses the capacity of the company to repay its short term due and
liability. Following ratios are calculated to determine the liquidity or short term solvency ratio
of the company. Short term obligations are compared with short term resources for
calculating the ratio.

Current ratio/working capital ratio: This is one of the most important liquidity ratios. It
indicates the firm’s ability to pay its short term liabilities out of its current assets. It shows
the firm’s commitment to meet its short term current liabilities. It is calculated by dividing the
current assets by current liabilities. The formula is;

Current Assets

Current Ratio = ----------------------------------

Current Liabilities

This ratio is also known as working capital ratio. The ideal current ratio is 2:1 i.e.
current assets should be twice the current liability. When the current assets are twice the
current liability, then payment of current liability will not affect the business operation. A
higher current ratio is an indicator of idle fund, inefficient use of fund and excessive
dependence on long term fund, which is costlier than the current liabilities.

Acid-test or Quick ratio: This ratio is calculated by dividing the quick asset by
current liabilities. It indicates the firm’s abilities to pay its current liabilities out of its most
liquid assets. Quick or Liquid assets are those which can be converted into cash
immediately without any loss. In simple words quick assets are current assets excluding
16
inventory and pre-paid expenses. Similarly liquid liabilities consist of all current liabilities
except bank overdraft. The formula is
Liquid Assets

Liquid Ratio= --------------------------------

Current or liquid liabilities

Absolute Liquid Ratio: In this ratio, absolutely liquid assets are considered which excludes
Debtors, Bill receivable and Inventories as there is a doubt of its reliability in cash at a time.
This ratio is calculated by following formula:

Cash in hand + cash at bank + short term Securities

Absolute Ratio=--------------------------------------------------------------

Current liabilities

The standard norm is 1:2 which means that Re. 1 of absolute liquid assets are
sufficient to pay Rs.2 worth of current liabilities. This ratio is not normally used because a
huge amount of idle cash has to be kept.

ACTIVITY OR PERFORMANCE OR TURN-OVER RATIOS

In addition to over all measure of liquidity it’s important to measure the liquidity of
each current and liability to assess the ability of the company in prompt collection or prompt
payment which affects the company’s liquidity. The liquidity of current items is measured
through turnover ratios. As the name suggests, turnover ratio is related to sales. It is an
accepted fact that sales have direct relationship with the performance of the business.
Higher sales mean better performance, which really means better efficiency and
productivity of the business. Higher sales also mean more production, and active
participation of human resources. In this way, words turnover, performance and activity are
synonymous.

Stock or Inventory Turnover Ratio: This ratio established the relationship between costs
of goods sold and average stock. Every business has to keep optimum quantity of stock, so
that production work may be carried on smoothly.

Cost of goods sold

Stock turn over = ----------------------

Average Stock

17
 If the average inventory kept during the year is more than ordinary requirement, the
amount spent in its purchase will be unnecessarily blocked & there will also be the problem
of storing it. In case the average stock is lesser than the ordinary, the production will suffer.

Debtor Turnover Ratio: It is also known as receivable turnover. It establishes the

relationship between credit sales and average debtors. A business concern may sell on
cash as well as on credit. Following a liberal credit policy can increase the volume of sales.
But the effect of a liberal credit policy may result in tying up substantial funds of a firm in the
form of trade debtors. Trade debtors are expected to be converted into cash within a short
period and are included in assets. Thus, the liquidity position of a concern to pay its short
term obligations in time depends upon the quality of its trade debtors. By formula;

Credit Sales

Debtor Turnover ratio =---------------------

Average debtor

Average Collection period ratio: Debtor turnover is often expressed through this ratio.
The ratio provides indication of the quality of debtors and company’s collection efforts. It
represents the average number of days taken by the firm to collect from debtors and points
out the collection policy of the firm. A higher collection period implies that greater credit
period is enjoyed by the customers and vice versa.

Average trade debtor (Debtors + Bills Receivable)

Average Collection Period =------------------------------------------------------------

Average daily Sale

Creditors Turnover Ratio/Account Payable Ratio: This ratio explains the velocity with
which creditors are paid and establishes relationship between creditors & amount pay to
them. In course of business operations, a firm has to make credit purchases and incur
short-term liabilities. The supplier of goods, i.e. creditor is naturally interested in finding out
how much time the firm is likely to take in repaying its trade creditors

Total Credit purchase

Creditors Turnover Ratio =---------------------------

Accounts Payable

18
Average payment period ratio: It represents the average number of days taken by the
firm to repay its creditors. Generally, lower the ratio, the better is the liquidity position of the
firm and higher the ratio, less liquid is the position of the firm. But a higher payment period
also implies greater credit period enjoyed by the firm and consequently large the benefit are
reaped from credit suppliers. But much higher ratio may also imply a lesser discount
facilities availed or higher prices paid for the goods purchased on credit.

Average trade creditor (Creditors + Bills payable)

Average Payment Period =------------------------------------------------------------

Average daily purchase

Performance ratio also shows, whether the total capital, working capital, fixed assets and
stock of the business are profitably used or not.

Net sales
Total Capital Turnover Ratio = ----------------------
Capital Employed
Net sales or Cost Of sales
Working Capital Turnover Ratio = ---------------------------------
Working Capital
Net Sales or Cost of Sales
Fixed Assets Turnover Ratio = ---------------------------------
Fixed Assets
Illustration:

With the help of the financial information of Hindustan Lever Ltd find out the liquidity and
performance ratio.

Ratio Formula 2002 2001

19
Current ratio Current Assets/ 343106.88/367089.43 342678.04/350182.28
Current Liabilities
= 0.94 = 0.98

Quick Ratio Quick Assets/ 215233.26/367089.43 218674.42/350182.28

Current Liabilities
= 0.59 = 0.62

Inventory Cost of goods 813309.56/125938.62 909823.10/121107.05

Turnover Sold/ Average
= 6.45 times = 7.51 times
Inventory

Inventory Days in year / 360/6.45 360/7.51

Holding Inventory
= 55.81 days = 47.94 days
period Turnover

Debtor Sales/ Average 995485.30/39631.76 1066755.69/34464.72

Turnover Debtors
= 25.12 times = 30.95 times

Average Days in year / 360/25.12 = 14.33 360/30.95 = 11.63

Collection Debtor Turnover days days
Period

NB: Cost of goods sold is not provided in annual report. So it is calculated taking all
operating expenses into consideration.

SOLVENCY RATIOS:

In the short-term, the solvency of the firm is measured by the ability of the firm to
meet all its current maturing obligations. Similarly, the long-term solvency measures its
ability to meet its long-term obligations. There are two approaches for evaluating the long-
term solvency. One is in terms of evaluating the margin of safety available for lenders,
represented by the owners’ equity and the other is in terms of the ability of the firm to earn
sufficient surpluses to meet all the long-term commitments.

Debt-equity Ratios: A mix of debt and equity in the sources of finance magnifies the
earnings per share of a firm. Use of debt capital is good to certain point and after that it is
considered risky. The debt equity ratio measures the relationship of capital provided by
creditors and capital provided by shareholders. Debt for the purpose includes both long and
short term debts (Not current Liabilities). The formula for calculating the ratio is
20
 Short term + Long Term debt

Debt to Equity Ratio =--------------------------------------

Shareholders Equity

This ratio means that for every rupee of shareholders funds in the company, how
much is the lenders’ claim. Lower the lenders’ claim to the shareholders claim; lower are the
demands on the firms earnings for meeting fixed commitments in terms of interest. The
other aspect of this is that there is a lesser leverage in the capital structure of the company.

Liabilities-equity Ratios: A variant to debt equity ratio is the liabilities equity ratio. Since
current liabilities normally don’t bear any cost they are excluded from debt which is
considered in liabilities to equity ratio. Provisions are also considered for this ratio.

Debt + Current Liabilities

Liabilities to Equity Ratio =---------------------------------

Shareholders Equity

The ratio is important for organizations which have obligations of short term in nature and
they roll them over continuously.

Interest Coverage Ratio/Times Fixed Charges Covered: This is a measure of protection

available to creditors for payment of interest charges by the company. So the ratio of times
fixed charges covered is computed usually, if the company has other fixed commitments.
The ratio shows whether the company has sufficient income to cover its fixed charges
requirements by a wide margin. This ratio is computed as follows:

Earnings before interest and fixed charges

Times fixed charges covered =--------------------------------------------------

Interest & fixed charges

Illustration:

Calculate the different solvency ratios for Hindustan Lever Limited.

21
 Ratio Formula 2002 2001

Debt Equity St Debt+ LT Debt/ 5829.76/365887.58 8373.86/304369.18

Ratio
Shareholders’ = 0.02 = 0.03
equity

Liability Debt + Current 372919.19/365887.58 358556.14/304369.18

Equity Ratio Liabilities/ Equity
= 1.02 = 1.18

Interest PBIT/ Interest 220629.96/918.40 195111.64/774.42

Coverage Expenses
= 240 times = 252 times
Ratio

CAPITAL MARKET RATIOS:

These ratios relate market price to a company’s performance and alsp compare the
market value and book value of a firm. These ratios are quite helpful in making investment
decisions.

Price earnings ratio: This is the most popular measure used in investment analysis as it is
a key factor in selection of stocks. P/E ratio is a growth indicator of a firm as it compares
market price with the annual earnings of a share. A high P/E ratio indicates the market
confidence in the future earnings growth of a company.

Stock Price

Price-earnings Ratio =------------------------

Earnings per share

Dividend Yield: It represents the percentage return on the current stock price of
shareholders. Dividend Yield is calculated as:

Dividend per Share

22
Dividend Yield =------------------------

Market Price of Share

Price to book ratio: The ratio compares the market price of a company’s share with its
book value. If the ratio is more than one then it is understood that the company is
overvalued by the market and vice versa. The ratio is calculated as:
Market Price per Share

Price to book Ratio =----------------------------

Illustration:
Book value per Share
Calculate the capital market ratios of Hindustan lever limited.

Ratio Formula 2002 2001

Price Stock price/ EPS 177.50* / 7.98** 216.80* / 7.46**

Earning
Ratio

Dividend Dividend Per 5.50 / 177.50 5.00 / 216.80

yield share/ Stock Price
= 3.1% = 2.31%

Price to Market Price / 177.50/16.62 216.80 / 13.83

Book Ratio Book Value per
= 10.68 times = 15.68 times
Share

* Prevailing market Price of that time

** Calculated in profitability Ratios

Interpretation of Financial Ratios:

 The profitability ratios indicate that the company’s profit margin has increased from
14.45% (2001) to 17.25% in the year 2002. This is probably due to reduction in
expenses. At the same time the ROA is declined from 24.72% to 24.12% in 2002.
Since ROA is a product of profit margin and asset turnover the decline point out that
it is only due to assets turnover as profit margin is increasing. So the company has to
keep high asset turnover to achieve a certain rate of return on assets. Same reason
can be attributed to the decline in ROI. The ROE in case of Hindustan Lever limited
is declined almost by 4.5% from 2001 to 2002. But ROE is higher than ROA in both
23
 the years which implies that company is using a financial leverage to earn more per
rupee of shareholders’ fund than per rupee of asset. But the company should try to
use the leverage in an efficient manner to maintain or bring consistency in ROE.
 A look to the liquidity and efficiency ratios point out that there is no significant decline
in the current ratio and the decrease is because of a greater proportionate increase
in current liabilities over current assets. The quick ratio also follows the trend of
current ratio. A drop in inventory turnover is observed from the ratios. It means the
holding period of inventory has been increased. The debtor turnover ratio is also
decreasing indicating deterioration in the management of receivables. This is also
evident from the average collection period which has increased to 14.33 days from
11.63 days in its previous year. So to sum up the company’s operating cycle has
been increased.
2002 2001

Average Inventory Holding Period 55.81 47.94

Average debt Collection Period 14.33 11.63

Operating Cycle (Days) 70.14 59.57

So the company needs to have a better policy for its working capital management as
a longer operating cycle restricts the company from profitable use of funds.

 The debt equity ratio has decreased in 2002 from 2001 which may be a reason for
lower ROE in 2002. But it is worth noting that debt equity ratio varies across
industries depending on their nature. Since HLL falls under FMCG Industries, where
there is a high fluctuation in demand, probably it prefers to keep lower debt equity
ratio. Though relatively debt has been reduced, the absolute amount of interest
expenses has been increased. The PBIT of the company has also been increased
but the proportionate change in PBIT is less than the change in Interest expenses so
the coverage has been reduced. Still the ratio is too high in both the years for the
same company.
 The market ratios point out that the P/E ratio has fallen because of drop in the share
price. The dividend yield is improved because of drop in share price and higher
amount of dividend. If the capital depreciation is considered then there is negative
return to shareholders. Similarly the P/B ratio is dropped because of market price.
Book value shows a positive sign which imply that all the negative change in market

24
 ratios are due to fall in market price because of depressed economic situation of that
time.

4.5 ADVANTAGES OF FINANCIAL RATIOS

 Simplifies financial statements: Ratio Analysis simplifies the comprehension of

financial statements. Ratios tell the whole story of changes in the financial condition
of the business.
 Facilitates inter-firm comparison: Ratio Analysis provides data for inter-firm
comparison. Ratios highlight the factors associated with successful and unsuccessful
firms. They also reveal strong firms and weak firms, over-valued and undervalued
firms.
 Makes intra-firm comparison possible: Ratio Analysis also makes possible
comparison of the performance of the different divisions of the firm. The ratios are
helpful in deciding about their efficiency or otherwise in the past and likely
performance in the future.
 Helps in planning: Ratio analysis helps in planning and forecasting. Over a period
of time a firm or industry develops certain norms that may indicate future success or
failure. If relationship changes in firm’s data over different time periods, the ratios
may provide clues on trends and future problems.
Thus, “ratios can assist management in its basic function of forecasting, planning,
coordination, control and communication”.
4.6 LIMITATIONS OF ACCOUNTING RATIOS

 Comparative study required: Ratios are useful in judging the efficiency of the
business only when they are compared with the past results of the business or with
the results of a similar business. However, such a comparison only provides a
glimpse of the past performance and forecasts for future may not be correct since
several other factors like market conditions, management policies, etc., may affect
the future operations.
 Limitations of financial statements: Ratios are based only on the information
which has been recorded in the Financial Statements. As indicated in the preceding
chapter financial statements suffer from a number of limitations, the ratios derived
there from, therefore, are also subject to those limitations. For example, non-financial
changes though important for the business are not revealed by the financial

25
 statements. If the management of the company changes, it may have ultimately
adverse effects on the future profitability of the company but this cannot be judged by
having a glance at the financial statements of the company.
 Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as
final regarding good or bad financial position of the business. Other things have also
to be seen. For example, a high current ratio does not necessarily mean that the
concern has a good liquid position in case current assets mostly comprise outdated
stocks. It has been correctly observed, ‘Ratios must be used for what they are-
financial tools. Too often they are looked upon as ends in themselves rather than as
a means to an end. “The value of a ratio should not be regarded as good or bad inter
se. It may be an indication that a firm is weak or strong in a particular area but it must
never be taken as proof.’ Ratios may be linked to railroads. They tell the analyst,
‘stop, look and listen.
 Window dressing: The term window dressing means manipulation of accounts in a
way so as to conceal vital facts and present the financial statements in a way to
show a better position than what it actually is. On account of such a situation,
presence of a particular ratio may not be a definite indicator of good or bad
management. For example, a high stock turnover ratio is generally considered to be
an indication of operational efficiency of the business. But this might have been
achieved by unwarranted price reductions or failure to maintain proper stock of
goods.
 Problems of price level changes: Financial analysis based on accounting ratios
will give misleading results if the effects of changes in price level are not taken into
account. For example, two companies set up in different years, having plant and
machinery of different ages, cannot be compared, on the basis of traditional
accounting statements. This is because the depreciation charged on plant and
machinery in case of old company would be at a much lower figure as compared to
the company which has been set up recently. The financial statements of the
companies should, therefore, be adjusted keeping in view the price level changes if a
meaningful comparison is to be made through accounting ratios. The techniques of
current purchasing power and current cost accounting are quite helpful in this
respect.
 No fixed standards: No fixed standards can be laid down for ideal ratios. For
example, current ratio is generally considered to be ideal if current assets are twice
the current liabilities. However, in case of those concerns which have adequate
26
 arrangements with their bankers for providing funds when they require, it may be
perfectly ideal if current assets are equal to slightly more than current liabilities.
 Ratios are a composite of many figures: Ratios are a composite of many different
figures. Some cover a time period, others are at an instant of time while still others
are only averages. It has been said that “a man who has his head in the oven and his
feet in the ice-box is on the average, comfortable”. Many of the figures used in the
ratio analysis are no more meaningful than the average temperature of the room in
which this man sits. A balance sheet figure shows the balance of the account at one
moment of one day. It certainly may not be representative of typical balance during
the year.

Illustration: Following is the profit and Loss Account and Balance Sheet of Jai Hind Ltd.
redraft them for the purpose of analysis and calculate the following ratios:
(i) Gross Profit Ratio (ii) Overall Profitability Ratio (iii) Current Ratio (iv) Debt Equity Ratio
(v) Stock Turnover Ratio (vi) Liquidity Ratio.

Dr Profit and Loss Account Cr.

Particulars (Rs.) Particulars (Rs.)

Opening stock of Sales 10,00,000

finished goods 1,00,000 Closing stock of 1,50,000
Opening stock of raw materials 50,000 raw materials
Purchase of raw materials 3,00,000 Closing stock of 1,00,000
Direct wages 2,00,000 finished goods
Manufacturing expenses 1,00,000 Profit on sale of shares 50,000
Administration expenses 50,000
Selling and distribution 50,000
expenses 55,000
Loss on sale of plant 10,000
Interest on debentures 3,85,000
Net profit

13,00,000 13,00,000

27
 Balance Sheet
Liabilities (Rs.) Assets (Rs.)
Share capital: Fixed assets:
Equity share capital 1,00,000 Stock of raw materials 2,50,000
Preference share capital 1,00,000 Stock of finished goods 1,50,000
Reserves 1,00,000 Sundry debtors 1,00,000
Debentures 2,00,000 Bank balance 1,00,000
Sundry creditors 1,00,000 Bills Payable 50,000

6,50,000 6,50,000

Solution:
Income Statement (in Rs.)

Sales 10,00,000
Less Cost of sales:
Raw material consumed
2,00,000
(Op. Stock + Purchases – Closing stock)
2,00,000
Direct wages
1,00,000
Manufacturing expenses

5,00,000
Cost of production
1,00,000
Add Opening stock of finished goods

Less Closing stock of finished goods

1,00,000

Cost of goods sold 5,00.000

Gross Profit 5,00,000
Less Operating expenses:
50.000
Administration expenses
50,000 1,00,000

28
Selling and distribution expenses 4,00,000
Net Operating Profit 50,000
Add Non trading income: 4,50,000
Profit on sale of shares
Less Non-trading expenses or losses:
55,000
Loss on sale of plant
3,95,000
Income before interest and tax
10,000
Less Interest on debentures
3,85,000
Net Profit before tax

Balance Sheet (Or Position Statement) (Rs.)

Bank balance 50,000
Sundry debtors 1,00,000
Liquid assets 1,50,000
Inventories:
Stock of raw materials 1,50,000
Stock of finished goods 1,00,000
Current assets
4,00,000
Sundry creditors
1,00,000
Bills payable
50,000
Current liabilities
1,50,000
Working capital (Rs. 4,00,000 – Rs.1,50,000)
2,50,000
Add Fixed assets
2,50,000
5,00,000
Capital employed
2,00,000
Less Debentures
3,00,000
Shareholders' net worth
1,00,000
Less Preference Share Capital
2,00,000

29
 Equity Shareholders' net worth
Equity Shareholders' Net worth is represented: 1,00,000
Equity share capital 1,00,000
Reserves 2,00,000

Ratios:
(i) Gross Profit ratio:
Gross profit / Sales x100= 5, 00,000 /10, 00,000 x100 =50%
(ii) Overall Profitability Ratio:
Operating profit/ Capital employed x 100= 4, 00,000/5, 00,000x 100= 80%
(iii)Current Ratio:
Current assets/ Current liabilities= 4, 00,000/1, 50,000= 2.67
(iv)Debt Equity Ratio:
External equities / Internal equities =3, 50,000/3,00,000= 1.17
(v) Stock turnover ratio:
a. As regards of average total inventory
Cost of goods sold / Average inventory =5, 00,000/1,00,000= 5
b. As regards average inventory of finished goods:
Cost of goods sold/ Average inventory of finished goods= 5, 00,000/1,00,000= 5
c. As regards average inventory of raw materials:
Material Consumed / Average inventory of Raw Materials =2, 00,000 /1,00,000=2
(vi)Liquid Ratio:
Liquid Assets /Current Liabilities=1,50,000/1.50.000= 1

4.7 SUMMARY

Financial statement analysis is a process that investigates historical and present

financial data to evaluate the performance and estimate the prospects of risks and
potentials. Financial statement analysis is used by investors, creditor, security analysts,
bank lending officers, managers, governmental agencies, suppliers and many other groups
that depend on financial data for taking decisions that are related to the economy of a
company.
Examination of financial statements primarily concentrates on the data that is given
in external reports along with added information given by the management. The
examination must identify the main modifications or highlights in trends, amounts and

30
relationships. Financial statements are simply outlines of comprehensive financial
information. A large number of various groups have vested interests in gaining access to
internal financial statements, typically investors and creditors. At times their aims are
different, but usually related. Nevertheless, it is possible to apply the fundamental tools and
methodologies of financial statement analysis in an effective way by all those who are
interested. Financial statement analysis is helpful to investors in finding the type of
information required by them for making decisions related to their interest in a specific
organization.

4.8 KEY TERMS:

 Analysis: analysis means methodical classification of the data given in the financial
statements.
 Interpretation: interpretation means explaining the meaning and significance of the
data so classified.
 Financial Statements: income statement and balance sheet.
 Ratio: the relationship of one item to another expressed in simple mathematical form
is known as a ratio.
 Ratio Analysis: the process of computing, determining and presenting the
relationship of items and groups of items in financial statements.
 Financial Leverage: the ability of a firm to use fixed financial charges to magnify the
effects of changes in EBIT on the firm’s earnings per share.
 Net Worth: proprietors’ funds – intangible assets – fictitious assets.
 Debt: both long term and short term liabilities.
 Operating Profit: gross profit – operating expenses.
 Equity: proprietors’ fund.
 Capital Employed: net worth + long term liabilities.
Current Assets
 Current Ratio = ------------------------------
Current Liabilities
 Quick Assets = Current Assets---Inventories
 Net Working Capital = Current Assets ---- Current Liabilities
Sales
 Assets Turnover Ratio = —————————
Average Total Assets
COGS
 Inventory Turnover Ratio = —————————

31
 Average Inventories

4.9 QUESTIONS AND EXERCISES:

1) Who and why would anyone perform financial statement analysis?

2) List out the major components that you would concentrate while analyzing the
financial statements.
3) List out the different techniques of performing financial analysis.
4) What do you think is the purpose for the Common Size Financial Statement?
5) Explain the meaning of the term `financial statements’. State their nature and
limitations.
6) Explain the different types of financial analysis.
7) Explain the various tools of financial analysis.
8) Justify the need for analysis and interpretation of financial statements.
9) Collect the annual reports of any public limited company for a period of 5 years.
Calculate the trend percentages and prepare a report.
10) What is meant by ratio analysis? Explain its significance in the analysis and
interpretation of financial statements.
11) Explain the importance of ratio analysis in making comparisons between firms.
12) How the ratios are broadly classified? Explain how ratios are calculated under
each classification.
13) What are the limitations of ratio analysis?
14) Write short notes on:
a. Trading on Equity.
b. Debt Equity Ratio.
c. Misleading Ratios.
d. Working Capital Coverage Ratio.
15) What is percentage analysis? In what manner does it help in understanding a
balance sheet.
16) Discuss briefly the different techniques of analysis and interpretation of financial
statements.
17) What are the different methods used for analysis of financial statements?
18) What are the various types of financial statements?
19) Explain the following with examples:
a. Comparative financial statements
32
 b. Common size financial statements
20) “Ratios like statistics have a set of principles and finality about them which at
times may be misleading.” Discuss with illustrations.

4.10 PRACTICAL PROBLEM

1. The Balance Sheet of X Company Ltd. as on March 31, 2005 is given below. You are
required to calculate the following ratios:
• Current ratio,
• Quick ratio,
• Net Working capital ratio.
Balance Sheet of X Company Ltd., as on 31.3.2005

Liabilities Amount Assets Amount

Rs. Rs.

Share Capital 20,000 Buildings 20,000

Reserves and Surplus 16,000 Plant and Machinery 10,000
Debentures 10,000 Stock 8,000
Sundry Creditors 11,000 Sundry Debtors 7,000
Bank Overdraft 1,000 Prepaid 2,000
Bills Payable 2,000 expenses 12,000
Provision for Taxation 1, 000 Securities 2,000
Outstanding Expenses 1,000 Bank 1,000
Cash

62,000 62,000
Total

******

33
34
 UNIT 5: CORPORATE SOCIAL REPORTING

Structure

5.0 Introduction

5.1 Unit objectives

5.2 Social income statement

5.3 Social accounting

5.4 Value added statement

5.5 Relevance of value added statements in corporate financial reporting

5.6 Corporate disclosures

5.7 Corporate governance disclosures

5.8 Modern trends in published accounts

5.8.1 Brand Accounting

5.8.2 Lean Accounting

5.8.3 International Accounting

5.8.4 Forensic Accounting

5.9 Summary

5.10 Key terms

5.11 Questions and exercise

5.12 Practical problem

5.0 INTRODUCTION

Social Responsibility Accounting is the newest field of accounting and is the most
difficult to describe concisely. It owes its birth to increasing social awareness which has
been particularly noticeable over the last three decades or so. Social responsibility
accounting is so called because it not only measures the economic effects of business
decisions but also their social effects, which have previously been considered to be
1
immeasurable. Social responsibilities of business can no longer remain as a passive
chapter in the text books of commerce but are increasingly coming under greater
scrutiny. Social workers and people’s welfare organizations are drawing the attention of
all concerned towards the social effects of business decisions. The management is
being held responsible not only for the efficient conduct of business as reflected by
increased profitability but also for what it contributes to social well-being and progress.

5.1 UNIT OBJECTIVES

After reading this lesson, you will be able to:

 Understand about social reporting.

 Know about value added statement.
 Comparison between social cost and private cost.
 Explain the different approaches for reporting social cost benefit information.
 Describe the criteria for measuring social cost benefit.
 Understand corporate disclosure regarding social reporting.

5.2 SOCIAL INCOME STATEMENT

Measurement of Social Cost Benefit: The United Nations Industrial Development

Organization (UNIDO) and the Centre for Organization of Economic Co-operation and
Development (COECD) have come with useful publications dealing with the problemof
measuring social costs and social benefits. It may be noted, in thiscontext, that the
actual cost of or revenues from the goods and/or services to the organization do not
necessarily reflect the monetarymeasurement of the cost or benefit to the society. This
is becausethese figures are grossly distorted on account of restrictions and
controlsimposed by the Government. Hence, a different yardstick has to beused for
evaluating a particular payment in terms of cost and sacrificeon the part of the society.
Such payments are easily valued at opportunitycost or shadow prices to judge their real
impact in terms of cost tosociety for the purpose of social cost benefit evaluation. Of
course, it isalmost impossible to measure in precise monetary terms, the real costsand
benefits to the society as a result of a project. However, a broadjudgment can be made
about the acceptability or otherwise of a projecton social grounds by looking to the
different social aspects associatedwith the project. The following are some of the
indicators/criteria whichcan be used for measuring the social costs and benefits
associatedwith the projects.

2
 Employment potential: The impact of the proposed project onthe employment
situation is an important consideration in adeveloping country like India. A
project having higher employedpotential has to be preferred over a project
having a loweremployment potential.
 Capital output ratio: This ratio measures the expected outputin relation to the
capital employed in the project. Since capital is ascarce resource, the desirability
of a project can be judged onthe basis of the return which the project is expected
to give oncapital employed in the project. This criterion is particularlyimportant in
case of developing countries which suffer from aconstraint of capital resources.
According to this criterion, a projectgiving a higher output per unit of capital
employed is to be preferredover a project giving a lower output.
 Value-added per unit of capital: This criterion is similar tothe capital output
rating. However, in case of this criterion, theestimated value added by a project
is considered in place ofthe total value of the output. The term “Value Added”
refers tothe cost incurred by an organization, (such as salaries, wages,interest,
etc.) in converting materials into finished products. Thus,the value added by a
project can be ascertained by deductingthe total value of bought-out inputs, such
as raw material,components, etc. from the total value of production.This criterion
is superior to the “Capital Output Ratio” since itconsiders the net contribution of
the firm to the nation’s economy. For example, if a firm is engaged merely in
packing amanufactured product into small lots, it will have a high capitaloutput
ratio but its contribution in terms of “value added” will benegligible.While
evaluating different projects according to social cost benefitanalysis technique
projects having high “value added” contentare to be ranked high.
 Savings in foreign exchange: The impact of the project on theforeign
exchange reserves of the country is also good socialcriterion for accepting or
rejecting a project. In a developing countrylike India, where the foreign exchange
position generally remainstight, this is an important criterion, while making
appraisal of aproject. For evaluating the projects according to this
criterion,projects can be ranked according to the net contribution theprojects are
going to make to the foreign exchange reserves ofthe country. Projects having
greater potentiality in terms of foreignexchange benefits will have priority over
other projects.
 Cost benefit ratio: According to this criterion, the projects areevaluated on the
basis of total social benefits and costsassociated with the projects. Social
benefits for this purposeinclude all economic and non-economic, internal and
externalbenefits which the society is likely to receive on account of theproject.
Similarly, the term social cost includes all costs whichthe society will have to pay
whether in monetary terms or otherwisefor the project. While evaluating projects
according to this criterion, the projects are ranked according to their cost benefit

3
 ratios. Aproject having the most favorable cost benefit ratio is given thehighest
preference.

5.3 SOCIAL ACCOUNTING

Introduction:

Social accounting is concerned with the measurement and disclosureof costs

and benefits to the society as a result of operating activities of a business enterprise.
Thus, social accounting measures social costs and social benefits as a result of
business activities for communication to various groups both within and outside the
business. It may be noted that social accounting is not the application of a new set of
accounting principles or practices. It is the application of the same basic accounting
principles for measuring and disclosing the extent, to which a business enterprise has
met its social responsibility. Seidler has, therefore, defined social accountings as
“modification and application of conventional accounting to the analysis and solutions of
problems of a social nature.”

The objective of social accounting can be summarized as follows:

 Measurement of net social contribution: Social accountingaims at identifying

and measuring the periodic net socialcontribution of a firm. This includes the
aggregate of netbenefits to the company’s employees, to the community (i.e.
local population) and to the general public.
 Balance between firm’s strategies and social priorities: Social accounting
helps in determining whether the firm’sstrategies and policies are consistent with
the legitimate individual aspirations and also with the overall priorities of
thecommunity and the society.
 Communication of information: Social accounting aimsto make available
information of a firm’s goals, policies,programmes, contribution to social goals
etc. to all segmentsof the society.

Reporting of Social Cost Benefit Information:

As stated above, social accounting measures and reports the socialcosts and
benefits on account of operating activities of a business enterprise. The different criteria
used for measurement of social cost benefits have already been explained in the
preceding pages. We are now explaining the different approaches for reporting social
costs benefit information to the different segments of the society.

 Social statement approach: According to this approach, two statements are

prepared (i) Social Income Statement and (ii) SocialBalance Sheet. The Social
Income Statement provides informationaccording to social benefits and costs to

4
 employees, local communityand the general public. Social balance sheet
portrays social investmentof capital nature (i.e. social assets) Viz. Township,
roads, buildings,hospitals, schools, clubs, etc. on the assets side and the
organization’sequity and social equity on the liabilities side. This approach has
the advantage of giving adequate quantitative information for being used for
inter-firm and intra-firm comparisons.

However, this approach is criticized on the ground that in the absence of

well-accepted measurement techniques, valuation of social costs and social
benefits as per this approach cannot be considered reliable. Most of the Indian
companies are following this approach with some modifications. They include
Minerals and Metals Trading Corporation of India Ltd. (MMTC), Oil India Ltd.
(OIL), Steel Authority of India Ltd. (SAIL), Madras Refineries Ltd. (MRL) and Oil
and Natural Gas Commission (ONGC) etc.

 Operating statement approach: According to this approach, afirm presents only

the positive and negative aspects of social activities as a result of business
operations. The positive aspects are broadly termed as “social benefits” while
negative aspects are termed as “social costs.” The difference between social
benefits and social costs represent the net social contribution by the firm.

Illustration: From the following information of Steel India Ltd. For the year ended 31st
March, 2008, prepare their Social Balance Sheet as on that date:

(i) A specialist has valued their human assets at ` 828 lakhs.

(ii) Their investments were classified as:

(Rs. in lakhs)

Residential Hospital School Welfare

Buildings 17.00 1.00 1.40 0.80

Equipment 2.80 1.00 1.00 Nil

(i) Water, electricity and gas supply systems totalledRs.1 lakh.

(ii) Their Net owned funds were Rs. 26 lakhs.

Solution:

Steel India Ltd.

5
 BALANCE SHEET as on 31.03.2008

(Rs.in lakhs)

Liabilities Rs. Asset Rs.

Organization Equity 26.00 Social Capital Investment:

(a) Buildings
Social Equity 828.00 (i) Residential 17.00
(Contribution by staff) (ii) Hospital 1.00
(iii) School 1.40
(iv) Welfare 0.80 20.20

(b) Equipment
(i) Residential 2.80
(ii) Hospital 1.00
(iii) School 1.00 4.80

(c) Water Electricity and

Gas supply systems 1.00
854.00 Human assets (as valued 828.00
by the specialist) 854.00
Illustration: From the following information taken from the books of F Ltd. relating to
staff and community benefits, prepare a statement classifying the various items under
the appropriate heads, required under Corporate Social Reporting.

(Rs.)

Environment Improvements 21,10,000

Medical facilities 45,00.000

Training Programmes 10,25,000

Generation of Job Opportunities 60,75,000

Municipal Taxes 10,70,000

Increase in cost of living in the vicinity due to a thermal

power station 16,55,000

Concessional transport, water supply 11,25,000

Extra work put in by staff and officers for drought relief 18,50,000

Leave encashment and leave travel benefits 52,00,000

6
Educational facilities for children of staff members 21,60,000

Subsidised canteen facilities 14,40,000

Generation of business 25,00,000

Solution:

F Ltd.

STATEMENT RELATING TO STAFF AND COMMUNITY BENEFITS

Rs.

I. Social Benefits and Cost to Staff

A. Social Benefits to Staff

1. Medical facilities 45,00,000

2. Training programmes 10,25,000

3. Concessional transport, water supply 11,25,000

4. Leave encashment and leave travel benefits 52,00,000

5. Educational facilities for children of staff members 21,60,000

6. Subsidised canteen facilities 14,40,000

Total 1,54,50,000

B. Social Costs to Staff

Extra work put in by staff and officers for drought relief 18,50,000

Net Social Benefits to Staff (A) – (B) 1,36,00,000

II. Social Benefits and Cost to Community

A. Social Benefits to Community

1. Environmental improvements 20,10,000

2. Generation of job opportunities 60,75,000

3. Municipal taxes 10,70,000

4. Generation of business 25,00,000

7
Total 1,16,55,000

B. Social Costs to Community

Increase in cost of living in the vicinity due to a thermal

power station 16,55,000

Net Social Benefits to Community (A) – (B) 1,00,00,000

 Narrative approach: This is simplest and easiest method for reporting social
costs and social benefits information. In case of this approach, disclosure
regarding social costs and social benefits is made in a narrative and not in a
quantitative form. According to this approach, the firm generally highlights the
positive aspects of its social activities. This approach is not informative since it
does not provide quantitative information. Moreover, inter-firm and intra-firm
comparisons are also not possible.
 Goal-oriented approach: This approach is based on the listed objectives of a
firm. According to this approach, the firm prepares a list of its social and
economic goals or objectives. At the end of the accounting year, the firm
prepares its annual report giving the description of the goals both economic and
social and the firm’s performance in respect of these goals. Wherever possible,
the goals, and the achievements are presented in the form of charts and graphs.

The presentation of information about social costs and benefits in the

above manner helps in ascertaining the direction in which the firm is moving
in achieving its social goals. The actual social goals can be compared with
the predetermined social goals and the performance of the firm can be
evaluated.

 Pictorial approach: According to this approach, social activities undertaken by

an enterprise are presented in the form of pictures. The annual reports contain
photographs of school, hospital, club, Public Park established and/or maintained
by the firm. This is the simplest method of presenting social information and
hence followed by many companies in our country.

Social Cost Benefit Analysis in India

There is no legal obligation on companies in India to provide details of social

costs and social benefits while preparing their financial statements. However, some
companies in private and public sectors are giving by means of supplementary

8
information the details of social costs and benefits as a result of their operations. Some
of these companies are as follows:

1. Tata Iron and Steel Co.

2. Projects and Equipment Corporation of India Ltd.

3. Bharat Heavy Electricals Ltd.

4. Indian Petrochemicals Corporation Ltd.

5. Cement Corporation of India.

6. Bharat Petroleum Corporation India Ltd.

7. Neyveli Lignite Corporation Ltd.

8. Oil India Ltd.

9. Cochin Refineries Ltd.

10. The Minerals & Metals Trading Corporation of India Ltd.

11. Indian Rare Earths Ltd.

12. Madras Refineries Ltd.

13. Oil & Natural Gas Corporation.

5.4 VALUE ADDED STATEMENT

Value Added:

Value Added is the wealth created by a Firm, through the combined effort of (1)
Capital (2) Management and (3) Employees. This wealth concept arises due to the
input- output exchange between a Firm and components of its external environment.

Value Added = Sale Value of Outputs Less: Cost of Bought in goods and services.

Gross Value Added (GVA)

Retained Profits= Sales Revenue - Materials Cost - Wages Cost - Expenses Cost -

9
Managerial Remuneration - Depreciation Expenses - Interest paid - Taxes paid -
Dividends paid.

Transposing the same, we have the following equation –

Sales Revenue - Materials Cost - Expenses Cost = Retained Profits + Wages paid +
Managerial

Remuneration + Interest, paid + Taxes paid + Dividends paid + Depreciation Expense.

Net Value Added (NAV)

Net Value Added = Gross Value Added — Depreciation

Utility of GVA reporting than NVA reporting:

 Realistic meaning of Retained profits: There is no cash outflow from a firm to the
extent of depreciation charged. Hence, GVA reporting, which includes
depreciation as part of retained profits, properly reflects the amount retained for
business purposes.
 Objectivity: Depreciation charged in the accounts depends on the firm’s policy
and also on the estimates of the asset’s useful life, scrap value, etc. Since the
cost of bought in materials and services are deducted to compute GVA, it is
derived in an objective manner than NVA.
 Macro level analysis: At the macro level, Gross Domestic Product (GDP) is
commonly used as indicator of economic trends. GVA reporting will make
aggregation of data easier for macro level analysis.

Advantages of NVA over GVA:

 Matching: NVA reporting properly deducts depreciation, which represents a write

off of the capital cost of the asset due to wear and tear. This results in proper
matching of the period’s revenues with costs.
 Asset Life Disparity: Under GVA, cost of tools, jigs, etc. having a life of one year
would be deducted whereas depreciation on assets having a longer useful life
will not be deducted. NVA recognizes both types of assets and properly records
depreciation on the assets utilized. Calculation of Wealth: Wealth or Surplus
created by an entity will be overstated if no allowance is made towards wear and
tear or loss of value of fixed assets used by the entity.
 Impact on Productivity Bonus: When a Productivity Bonus is paid to employees
based on Value Added, NVA is more appropriate since it recognizes the effect of
mechanization, etc. by charging depreciation.

(a) Proprietary Theory; (b) Entity Theory; and (c) Enterprise Theory.

10
 a) Proprietary Theory: This theory is based on the principle that the proprietor is
the center of interest. This theory propounds that all assets belong to the
Proprietor and all liabilities are the Proprietor’s obligations. This theory holds
good only for a Sole Proprietorship or a Partnership.
b) Entity Theory: This theory is suitable for corporate form of business enterprises.
The theory suggests that the Net Income of the Reporting Entity is generally
expressed in terms of the Net Change in the Stockholders’ Equity. It represents
the residual change in equity position after deducting all outsiders’ claims. The
Reporting Entity is considered as a separate economic unit operating only for the
benefit of its Equity Shareholders.
c) Enterprise Theory: In this theory, the Reporting Entity is a Social Institution,
operating for the benefit of many interested groups like Shareholders,
Bondholders, Management, Employees, etc. The Value Added isan important
concept in this theory. When the income is defined as the reward of a larger
group of people than just shareholders, the concept and its understanding is
better.

5.5 RELEVANCE OF VALUE ADDED STATEMENTS IN CORPORATE FINANCIAL

REPORTING

 Company Ranking: The Value Added is a very good index to measure the size
and importance of company. It also overcomes the distortion in ranking caused
by the use of inflated sales.
 Systems Concept: The Value Added Statement reflects the Company’s
objectives and responsibilities in abetter fashion. It establishes the fact that the
business entity is part of a larger system interacting with other components in
the environment.
 Employee Incentives: The Value Added Statement paves way for introduction
of productivity linked bonus schemes for the employees. Calculation also
becomes easier.
 Macro level analysis: The Value Added Statement links the Company’s
financial accounts to the national income by indicating the Company’s
Contribution to National Income.
 Ratio Analysis: The Value Added Statement helps in ratio analysis. The Value
Added to Payroll, Taxes to Value Added and Value Added to Sales ratios are
used as predictive tools for analysis of different firms. It also provides for
adjustments in respect of inflation, to facilitate comparison between periods.
 Concepts: The Value Added Statement is based on fundamental concepts that
are accepted in financial statements like the going concern concept, matching
concept, consistency and substance over form, etc.

11
  Performance Measure: Value Added is a better measure of performance of
business entity than the profit. It explains the input-output relationship. Once the
value added is ascertained, it is possible to establish linkage with value to be
used —
o For the work force – for Wages, Salaries
o For the Government – for Corporation Tax and related expenses
o For the Financiers – for Interest on loans and
o For the Business – for retention for Dividends on Share Capital
 Budgeting: Value Application is a pre-condition for value generation. So
insufficiency of value added can be understood beforehand. This may be good
test for Business Budgeting than Financial Reporting.

What information can we gather from Value Added Statements?

 Wealth Creation: The Value Added Statement specifies the wealth accumulated
by the Company. It states in monetary terms the wealth accumulated by the
Company.
 Beneficiaries/participants of wealth: The Value Added Statement states the
application of Value Added to shareholders, bondholders, employees, etc. This
identifies the participants/beneficiaries of the wealth generated by the Company
and their interest in the Company in terms of value and percentage.
 Value Added based ratios: The following ratios can be computed – Value Added
to Sales, Value Added to payroll, Taxes to Value Added, etc. This facilitates
comparison of ratios between periods as well as comparison between
Companies.
 Value Added Interpretation: Value Added facilitates interpretation of operating
results or contribution of various Companies. The real wealth of Companies can
be understood only from the Value Added Statement, as the comparison of Sales
Turnover may not give a real picture. Many Companies can have the same
turnover also.

Disadvantages of Value Added Reporting:

 Risk: Employees, Government and Fund Providers are interested only in getting
their share of Value Added. The entire business risk is borne only by the
Shareholders. The residual profits after meeting the obligations of the outside
groups should be shown as the Value Added accruing to the shareholders.
 Non-uniformity: Value Added Statements are non-standardized in areas like
inclusion or exclusion of Depreciation, Taxation on Profits, etc. This can however
be overcome by defining an Accounting Standard on Value Added.

12
 5.6 CORPORATE DISCLOSURES

Environmental Disclosures:

In recent years, the public concern about adverse impact on environment due to
business activities is growing. As a result, companies have started disclosing qualitative
and quantitative information about showing their role is improvement and maintenance
of environment. However, the mode of recording and presentation of such information
for different corporations in different countries has not been uniform. The International
Accounting Standards Committee is now, therefore, working to form the global
environmental accounting standard to bring uniformly in the environmental accounting
protection throughout the world.

The following are some of the environmental issues which are pertinent to
business enterprise:

a. Environmental protection policy and programme adopted by the enterprise.

b. Improvements effected since the introduction of environmental policy in different
key areas over the period at least 5 years, whichever is shorter.
c. Environmental emission targets set by the enterprise for data and progress
achieved so far.
d. The extent to which environmental protection measures have been taken due to
government legislation.
e. Legal proceedings taken against the company for material violation of
environmental laws.
f. Financial implications of short-term and long-term environmental protection
measures.

Corporate Environmental Reporting in India

In view of the public concern about environment and the ambiguity in the
accounting treatment of environmental costs and liabilities, the corporate undertakings
world over, in their own way, have started disclosing both qualitative and financial
information about the role played by them in the improvement and maintenance of
environment. In India, the corporate sector is making environmental disclosure both on
account of statutory requirements and also on their own as discussed below:

a. Statutory disclosure: The legal provisions as to environmental disclosure in

Annual Accounts are minimal. Section 217(I)(e) of the Companies Act, 1956,
provides that the Directors’ Report shall include the particulars as to
“Conservation of energy, technology absorption, foreign exchange earnings and
outgo in such manner as may be prescribed,” Consequently, the Government of
India has prescribed the following information to be given by 21industrial

13
 groups:“Every company shall, in the report of its Board of Directors, disclose
particulars with respect to the following matters, namely:
 Conservation of energy:
(a) Energy conservation measures taken;
(b) Additional investments and proposals, if any, being implemented for
reduction of consumption of energy;
(c) Impact of the measures of (a) and (b) above for reduction of energy
consumption and consequent impact on the cost of production of goods; and
(d) Total energy consumption and energy consumption per unit of production as
per Form A in respect of industries specified in the Schedule thereto…”

b. Voluntary disclosure. Many corporate enterprises in India, on their own are

giving information in their Annual Reports on the role played by them in
environmental protection. Such information shows their concern about their
social responsibility and their inclination to protect the interest of both the
present and future generation. Some of the companies which are making such
disclosures are: Asian Paints Limited, Chloride Industries
Limited,GoodlessNerolac Paints Limited, MarutiUdyog Limited, SteelAuthority of
India Limited, Hindustan Lever Limited, etc.

Commitment to Environment

Energy Management

Conserving energy through innovative thinking and efficient process. Our efforts
focused on energy conservation as well as use of renewable energy have resulted in a
reduction of our energy consumption by 61% since 1996. It has also led to a 58%
reduction of emission of greenhouse gases. We have taken several initiatives including
process redesign, fuelsubstitution, rationalizing equipment and productivity
improvement. We have deployed new technologies to optimize electrical energy inputs
and heat recover while plugging atmospheric energy losses. This has reduced the
global warming potential as well as saved energy.

Our Energy Management and conservation efforts are based on the 5R principle-
Reduce, Reuse, and Recycle, Recover and Renew. Our focus on energy reduction is
beneficial both from an environmental viewpoint and also from the point of view of cost
saving for the company.

Sustainable Agricultural Initiatives:

Ensuring long-term access to raw materials and reducing effects of modern

farming. We aim to meet the needs of the present without compromising on the ability of
the future generations to meet their own needs. Our Sustainable Agriculture projects in

14
our tea plantations in Assam and South India work with the objective of ensuring
continued supply of tea with higher productivity, better quality and with environmental
and social benefits for all involved.

As part of the project, 2000 MT of vermi-compost made fromagricultural waste is

produced in our plantations. Experiments are under way to study the scope of use of
bio-fertilizers with an aim to reduce inorganic fertilizers by 50%. We have also published
booklets on Good Agricultural Practices for the benefit of the Tea Industry and the
environment at large. Sustainable Agriculture that ensures economic growth,
environmental protection and social progress is a key element of our plantation
operations.

5.7 CORPORATE GOVERNANCE DISCLOSURES

Corporate Governance:

Concept of Corporate Governance:

The good governance is the expectation of a stakeholder in every walkof life.

This expectation has lately come to be recognized as a right inthe corporate world also.
Corporate Governance is, therefore, the newbuzzword in corporate jargon. Its concept
has emerged over the lasttwo decades. It requires, by corporations, timely and
accuratedisclosures on all material matters relating to them, viz., financialposition,
performance, ownership and governance of the corporationetc.The objective of
corporate governance is compliance with corporatelaws and rules on the legislative side
and proper accountability to thestakeholder, legally and morally. Corporate governance
is a compulsionof long-term corporate existence. Its importance and significance
hasgreatly increased in the present era of liberalization, privatization andglobalization.
The concept of corporate governance has been well speltout by Sir Adrian Cadbury, in
the following words: “Corporate Governanceis considered with holding the balance
between economic and socialgoals and between individual and community goals. The
governanceframework is there to encourage the efficient use of resources andequally to
require accountability for the stewardship of those resources.The aim is to align as
nearly as possible the interests of individuals,corporations and society”.Thus, corporate
governance aims at enhancement of the longtermshareholder value while at the same
time, protecting the interestsof other stakeholders’ viz., the suppliers, customers,
creditors, bankers,employees, government and the society at large. Good
corporategovernance is essential not only for gaining credibility and trust but alsoas a
strategy for survival, consolidation and growth. The mainconstituents of corporate
governance are the Shareholders, the Boardof Directors, and the Management.The
need and importance of corporate governance can best beconveyed from the following
statement of Benjamin Franklin:

15
 “A little neglect may breed great mischief – for the want of a nail, the show was
lost; for the want of a shoe, the horse was lost; for the want of a horse, the rider was
lost; and for the want of a rider, the battle was lost”.

Emergence of Corporate Governance

The concept of corporate governance gained prominence in academicand

professional literature towards the end of 20th century, particularlyin the year 1980 and
onwards. In UK, many corporations collapsed inthe late 1980s and the early 1990s.
Notable cases were BCCI, PollyPeck and pension funds of the Maxwell Communication
Group. Theimpact of the failures of these corporations was quite severe on thesociety
as a whole resulting in boost of the debate on corporategovernance. The resultant focus
on the issue of corporate governanceculminated in the Cadbury Report on the financial
aspects of thecorporate governance in 1992, the Green Bury Report on
Directors’Remuneration in 1995, the Preliminary and Final Hampel Report onCorporate
Governance in 1997 and 1998. The stock exchange listingrules were also amended in
UK w.e.f. July 1993 in compliance with theCadbury Committees’ Report.

In the U.S., the intensive debate on the corporate governancesystem was

initiated in the 1980s during a period of widespreadcorporate restructuring and
takeovers. Tread Way Commission Reportwas published in the U.S. in October 1987.
The report was essentiallyin respect of fraudulent financial reporting. The Securities and
ExchangeCommission of the U.S. updated the listing requirements for thecorporation in
1988 following the above reporting. Later on, the collapseof Enron, large scale
misreporting of World Dotcom, Quest and actionagainst a leading auditing company
KPMG, and the resultant publicannoyance, all made the U.S. Government to take
appropriate legislativemeasures. Consequently, the Sarbanes-Oxley Act was passed by
theU.S. Congress in June 2002. This is, by far, the most sweeping reformof corporate
governance in USA since the great depression of thirties.The most outstanding aspect
of Act is the better regulation of auditorsand restrictions on what they can and cannot
do.In India, the history of corporate governance dates back to the year1998 with the
setting of corporate governance code developed by theConfederation of Indian
Industries (CII). The initiative got momentum byconstitution of the Corporate
Governance Committee by SEBI underthe chairmanship of Shri Kumar Mangalam Birla.
The recommendationsof the Committee were accepted by the SEBI vide press release
dated21.02.2000, as a result of which Clause 49 on corporate governancewas
incorporated in the Listing Agreements of the stock exchanges.Simultaneously, the
Central Government came forward with theCompanies (Amendment) Act, 2000, which
introduced many provisionsrelating to corporate governance, viz., additional grounds
ofdisqualification of directors in certain cases, setting up of auditcommittees, directors’
responsibility statement as a part of Directors’Report etc.

16
 The Enron debacle of 2001, the scam involving the fall of corporategiants in the
U.S. like World Com, Quest, Global Crossing and theenactment of stringent Sarbanes-
Oxley Act in the U.S., referred earlier,were some important factors which led the Indian
Government to wakeup and appoint in the year 2002, the Naresh Chandra Committee.
TheCommittee was asked to examine and recommend drasticamendments to the law
involving Auditor-Client relationships and therole of the individual auditors. The
committee, in its report, made severalrecommendations regarding auditor-company
relationship,independence of auditors, disqualification for audit assignments,prohibition
of non-audit services by the auditors, rotation of audit firms,disclosures by auditors,
appointment and remuneration of auditors etc.In 2002, SEBI itself constituted a
Committee under the chairmanship ofNarayan Murthy, Chairman of Infosys
Technologies Limited, to reviewthe performance of corporate governance in India and
make appropriaterecommendations. The Committee submitted its report to the SEBI
on8th February, 2003. In the meantime, the government accepted manyof the
recommendations of Naresh Chandra Committee andconsequently introduced
Companies (Amendment) Bill, 2003 inParliament in May 2003.

The Clause 49 of the listing agreement providing for CorporateGovernance in

February 2000 has been amended several times. It was amended twice in 2000, thrice
in the year 2001 and now further w.e.f.26August 2003 on the basis of the
recommendations of the Committee appointed by SEBI under the chairmanship of Shri
N.R. Narayana murthy.The provisions of the revised clause 49 are as under:

I. Board of Directors
A. Composition of board
(i) The board of directors of the company shall have an optimumcombination of
executive and non-executive directors with notless than fifty per cent of the
board of directors comprising ofnon-executive directors. The number of
independent directorswould depend on whether the Chairman is executive or
nonexecutive.In case of a non-executive chairman, at least one-thirdof board
should comprise of independent directors and in caseof an executive
chairman, at least half of board should compriseof independent
directors.“Provided that where the non-executive Chairman is a promoterof
the company or is related to any promoter or person occupyingmanagement
positions at the Board level or at one level belowthe Board, at least one-half
of the Board of the company shallconsist of independent directors.”

Explanation (i) For the purpose of this clause, the expression‘independent director’
shall mean non-executive director of thecompany who

17
(a) Apart from receiving director’s remuneration, does not haveany material
pecuniary relationships or transactions with thecompany, its promoters, its senior
management or its holdingcompany, its subsidiaries and associated companies;

(b) Is not related to promoters or management at the board levelor at one level
below the board;

(c) Has not been an executive of the company in the immediatelypreceding three
financial years;

(d) Is not a partner or an executive of the statutory audit firm orthe internal audit firm
that is associated with the company,and has not been a partner or an executive of any
such firmfor the last three years. This will also apply to legal firm(s)and consulting
firm(s) that have a material association withthe entity.

(e) Is not a supplier, service provider or customer of thecompany. This should

include lessor-lessee typerelationships also; and

(f) Is not a substantial shareholder of the company, i.e. owningtwo per cent or more
of the block of voting shares.

(g) Is not less than 21 years of age.

Explanation (ii) Institutional directors on the boards ofcompanies shall be considered

as independent directors whetherthe institution is an investing institution or a lending
institution.

B. Non-executive directors’ compensation and disclosures

(i) All compensation paid to non-executive directors shall be fixedby the board of
directors and shall be approved by shareholdersin general meeting. Limits shall be set
for the maximum numberof stock options that can be granted to non-executive directors
inany financial year and in aggregate. The stock options granted tothe non-executive
directors shall vest after a period of the leastone year from the date such non-executive
directors have retiredfrom the Board of the Company.

(ii) The considerations as regards compensation paid to anindependent director

shall be the same as those applied to a nonexecutivedirector.

(iii) The company shall publish its compensation philosophy andstatement of entitled
compensation in respect of non-executivedirectors in its annual report. Alternatively, this
may be put up onthe company’s website and reference drawn thereto in the

18
annualreport. Company shall disclose on an annual basis, details ofshares held by non-
executive directors, including on an “ifconverted”basis.

(iv) Nonexecutive directors shall be required to disclose their stockholding (both own
or held by/for other persons on a beneficialbasis) in the listed company in which they
are proposed to beappointed as directors, prior to their appointment. These
detailsshould accompany their notice of appointment.

C. Independent director

(i) Independent Director shall however periodically review legalcompliance reports

prepared by the company as well as stepstaken by the company to cure any taint. In the
event of anyproceedings against an independent director in connection withthe affairs of
the company, defense shall not be permitted on theground that the independent director
was unaware of thisresponsibility.

(ii) The considerations as regards remuneration paid to anindependent director shall

be the same as those applied to a nonexecutivedirector.

D. Board procedure

(i) The board meeting shall be held at least four times a year, with amaximum time
gap of four months between any two meetings.The minimum information to be made
available to the board isgiven in Annexure-1A.

(ii) A director shall not be a member in more than ten committees oract as Chairman
of more than five committees across allcompanies in which he is a director. Furthermore
it should be amandatory annual requirement for every director to inform thecompany
about the committee positions he occupies in othercompanies and notify changes as
and when they take place.

Explanation: For the purpose of considering the limit of thecommittees on which a

director can serve, all public limitedcompanies, whether listed or not, shall be included
and all othercompanies (i.e. private limited companies, foreign companies
andcompanies under Section 25 of the Companies Act, etc) shall beexcluded.

(iii) Further only the three committees viz. The Audit Committee, theShareholders’
Grievance Committee and the RemunerationCommittee shall be considered for this
purpose.

E. Code of conduct

(i) It shall be obligatory for the Board of a company to lay down thecode of conduct
for all Board members and senior managementof a company. This code of conduct
shall be posted on the websiteof the company.
19
(ii) All Board members and senior management personnel shall affirmcompliance
with the code on an annual basis. The annual reportof the company shall contain a
declaration to this effect signedby the Chief Executive Officer (CEO) and Chief
Operating Officer(COO).

Explanation: For this purpose, the term “senior management”shall mean personnel of
the company who are members of itsmanagement/operating council (i.e. core
management teamexcluding Board of Directors). Normally, this would comprise
allmembers of management one level below the executive directors.

F. Term of office of non-executive directors

Person shall be eligible for the office of nonexecutive director solong as the term
of office did not exceed nine years in three termsof three years each, running
continuously.

II. Audit Committee

A. Qualified and independent audit committee

A qualified and independent audit committee shall be set up and shallcomply with
the following:

(i) The audit committee shall have minimum three members. All themembers of
audit committee shall be nonexecutive directors, withthe majority of them being
independent.

(ii) All members of audit committee shall be financially literate and atleast one
member shall have accounting or related financialmanagement expertise.

Explanation (i) The term “financially literate” means the abilityto read and
understand basic financial statements i.e. balancesheet, profit and loss account, and
statement of cash flows.

Explanation (ii) A member will be considered to haveaccounting or related financial

management expertise if he orshe possesses experience in finance or accounting, or
requisiteprofessional certification in accounting, or any other comparableexperience
background which results in the individual’s financialsophistication, including being or
having been a chief executiveofficer, chief financial officer, or other senior officer with
financialoversight responsibilities.

(iii) The Chairman of the Committee shall be an independent director;

(iv) The Chairman shall be present at annual general meeting toanswer shareholder
queries;

20
(v) The audit committee should invite such of the executives, as itconsiders
appropriate (and particularly the head of the financefunction) to be present at the
meetings of the committee, but onoccasions it may also meet without the presence of
anyexecutives of the company. The finance director, head of internalaudit and when
required, a representative of the external auditorshall be present as invitees for the
meetings of the auditcommittee;

(vi) The Company Secretary shall act as the secretary to thecommittee.

B. Meeting of audit committee

The audit committee shall meet at least thrice a year. One meetingshall be held
before finalization of annual accounts and one every sixmonths. The quorum shall be
either two members or one third of themembers of the audit committee, whichever is
higher, and minimum oftwo independent directors.

C. Powers of audit committee

The audit committee shall have powers which should include thefollowing:

1. To investigate any activity within its terms of reference.

2. To seek information from any employee.
3. To obtain outside legal or other professional advice.
4. To secure attendance of outsiders with relevant expertise, if itconsiders
necessary.

D. Role of audit committee

The role of the audit committee shall include the following:

1. Oversight of the company’s financial reporting process and thedisclosure of its

financial information to ensure that the financialstatement is correct, sufficient
and credible.
2. Recommending the appointment and removal of external auditor,fixation of audit
fee and also approval for payment for any otherservices.
3. Reviewing with management, the annual financial statementsbefore submission
to the board, focusing primarily on;
(a) Any changes in accounting policies and practices.
(b) Major accounting entries based on exercise of judgment bymanagement.
(c) Qualifications in draft audit report.
(d) Significant adjustments arising out of audit.
(e) The going concern assumption.
(f) Compliance with accounting standards.

21
 (g) Compliance with stock exchange and legal requirementsconcerning financial
statements
(h) Any related party transactions
4. Reviewing with the management, external and internal auditors,and the
adequacy of internal control systems.
5. Reviewing the adequacy of internal audit function, including thestructure of the
internal audit department, staffing and seniorityof the official heading the
department, reporting structure coverageand frequency of internal audit.
6. Discussion with internal auditors any significant findings and followup there on.
7. Reviewing the findings of any internal investigations by the internalauditors into
matters where there is suspected fraud or irregularityor a failure of internal
control systems of a material nature andreporting the matter to the board.
8. Discussion with external auditors, before the audit commences,about nature and
scope of audit as well as post-audit discussionto ascertain any area of concern.
9. Reviewing the company’s financial and risk management policies.
10. To look into the reasons for substantial defaults in the payment tothe depositors,
debenture holders, shareholders (in case of nonpaymentof declared dividends)
and creditors.

Explanation (i) The term “related party transactions” shall havethe same meaning
as contained in the Accounting Standard 18,Related Party Transactions, issued by The
Institute of CharteredAccountants of India.

Explanation (ii) If the company has set up an audit committeepursuant to provision

of the Companies Act, the company agreesthat the said audit committee shall have
such additional functions/features as is contained in the Listing Agreement.

E. Review of information by audit committee

The Audit Committee shall mandatorily review the following information:

1. Financial statements and draft audit report, including quarterly/half-yearly

financial information;
2. Management discussion and analysis of financial condition andresults of
operations;
3. Reports relating to compliance with laws and to risk management;
4. Management letters/letters of internal control weaknesses issuedby
statutory/internal auditors; and
5. Records of related party transactions;
6. The appointment, removal and terms of remuneration of the chiefinternal auditor
shall be subject to review by the Audit Committee.
III. Audit Reports and Audit Qualifications

22
Disclosure of accounting treatment:

In case it has followed a treatment different from that prescribed in anAccounting

Standards, management shall justify why they believe suchalternative treatment is more
representative of the underlined businesstransactions. Management shall also clearly
explain the alternativeaccounting treatment in the footnote of financial statements.

IV. Whistle Blower Policy

Internal policy on access to audit committees

(i) Personnel who observe an unethical or improper practice (notnecessarily a

violation of law) shall be able to approach the auditcommittee without necessarily
informing their supervisors.

(ii) Companies shall take measures to ensure that this right of accessis
communicated to all employees through means of internalcirculars, etc. The
employment and other personnel policies ofthe company shall contain provisions
protecting “whistle blowers”from unfair termination and other unfair prejudicial
employmentpractices.

(iii) Company shall annually affirm that it has not denied any personnelaccess to the
audit committee of the company (in respect ofmatters involving alleged misconduct) and
that it has providedprotection to “whistle blowers” from unfair termination and otherunfair
or prejudicial employment practices.

(iv) Such affirmation shall form a part of the Board report onCorporate Government
that is required to be prepared andsubmitted together with the annual report.

(v) The appointment, removal and terms of remuneration of the chiefinternal auditor
shall be subject to review by the Audit Committee.

V. Subsidiary companies

(i) The company agrees that provisions relating to the compositionof the Board of
Directors of the holding company shall be madeapplicable to the composition of the
Board of Directors ofsubsidiary companies.

(ii) At least one independent director on the Board of Directors of theholding

company shall be a director on the Board of Directors ofthe subsidiary company.

(iii) The Audit Committee of the holding company shall also reviewthe financial
statements, in particular the investments made bythe subsidiary company.

23
(iv) The minutes of the Board meetings of the subsidiary companyshall be placed for
review at the Board meeting of the holdingcompany.

(v) The Board report of the holding company should state that theyhave reviewed
the affairs of the subsidiary company also.

VI. Disclosure of contingent liabilities

The company agrees that management shall provide a clear descriptionin plain
English of each material contingent liability and its risks, whichshall be accompanied by
the auditor’s clearly worded comments onthe management’s view. This section shall be
highlighted in thesignificant accounting policies and notes on accounts, as well as, inthe
auditor’’ report, wherever necessary.

VII. Disclosures
A. Basis of related party transactions
(i) A statement of all transactions with related parties including their basis shall
be placed before the Audit Committee for formal approval/ratification. If any
transaction is not on an arm’s length basis, management shall provide an
explanation to the Audit Committee justifying the same.
B. Board disclosures – risk management
(i) It shall put in place procedures to inform Board members aboutthe risk
assessment and minimization procedures. Theseprocedures shall be
periodically reviewed to ensure that executivemanagement controls risk
through means of a properly definedframework.
(ii) Management shall place a report certified by the complianceofficer of the
company, before the entire Board of Directors everyquarter documenting the
business risks faced by the company,measures to address and minimize
such risks, and any limitationsto the risk taking capacity of the corporation.
This document shallbe formally approved by the Board.
C. Proceeds from initial public offerings (IPOs)
(i) When money is raised through an Initial Public Offering (IPO) itshall disclose
to the Audit Committee, the uses/applications offunds by major category
(capital expenditure, sales and marketing,working capital, etc), on a quarterly
basis as a part of their quarterlydeclaration of financial results. Further, on an
annual basis, thecompany shall prepare a statement of funds utilized for
purposesother than those stated in the offer document/prospectus.
Thisstatement shall be certified by the independent auditors of thecompany.
The audit committee shall make appropriaterecommendations to the Board to
take up steps in this matter.
D. Remuneration of directors

24
 (i) All pecuniary relationship or transactions of the nonexecutivedirector’s vis-à-
vis the company shall be disclosed in the AnnualReport.
(ii) Further the following disclosures on the remuneration of directorsshall be
made in the section on the corporate governance of theannual report.
a. All elements of remuneration package of all the directorsi.e. salary,
benefits, bonuses, stock options, pensionetc.
b. Details of fixed component and performance linkedincentives, along with
the performance criteria.
c. Service contracts, notice period, severance fees.
d. Stock option details, if any—and whether issued at adiscount as well as
the period over which accrued andover which exercisable.
E. Management
(i) As part of the directors’ report or as an addition there to, aManagement
Discussion and Analysis Report should form partof the annual report to the
shareholders. This ManagementDiscussion and Analysis should include
discussion on thefollowing matters within the limits set by the
company’scompetitive position:
a. Industry structure and developments.
b. Opportunities and threats.
c. Segment-wise or product-wise performance.
d. Outlook
e. Risks and concerns.
f. Internal control systems and their adequacy.
g. Discussion on financial performance with respect tooperational
performance.
h. Material developments in human resources/industrialrelations front,
including number of people employed.

Management shall make disclosures to the board relating to all materialfinancial

and commercial transactions, where they have personalinterest, that may have a
potential conflict with the interest of the companyat large (for e.g. dealing in company
shares, commercial dealings withbodies, which have shareholding of management and
their relativesetc.).

F. Shareholders
(i) In case of the appointment of a new director or re-appointment ofa director
the shareholders must be provided with the followinginformation:
a. A brief resume of the director;
b. Nature of his expertise in specific functional areas; and
c. Names of companies in which the person also holds the directorship and
the membership of Committees of theboard.

25
(ii) Information like quarterly results, presentation made by companiesto analysts
shall be put on company’s website, or shall be sent insuch a form so as to
enable the stock exchange on which thecompany is listed to put it on its own
website.
(iii) A board committee under the chairmanship of a nonexecutivedirector shall
be formed to specifically look into the re-dressal ofshareholder and investors
complaints like, transfer of shares, non-receiptof balance sheet, non-receipt of
declared dividends etc.This Committee shall be designated as
‘Shareholders/InvestorsGrievance Committee’.
(iv) To expedite the process of share transfers, the board of thecompany shall
delegate the power of share transfer to an officeror a committee or to the
registrar and share transfer agents. Thedelegated authority shall attend to
share transfer formalities atleast once in a fortnight.

VIII.CEO/CFO Certification

(i) CEO (either the Executive Chairman or the Managing Director)and the CFO
(whole-time Finance Director or other persondischarging this function) of the
company shall certify that, to thebest of their knowledge and belief:
a. They have reviewed the balance sheet and profit and lossaccount and all
its schedules and notes on accounts, aswell as the cash flow statements
and the Directors’ Report;
b. These statements do not contain any materially untruestatement or omit
any material fact nor do they containstatements that might be misleading;
c. These statements together present a true and fair view ofthe company,
and are in compliance with the existingaccounting standards and/or
applicable laws/regulations;
d. They are responsible for establishing and maintaining internalcontrols and
have evaluated the effectiveness of internalcontrol systems of the
company; and they have alsodisclosed to the auditors and the Audit
Committee,deficiencies in the design or operation of internal controls,
ifany, and what they have done or propose to do to rectifythese;
e. They have also disclosed to the auditors as well as the AuditCommittee,
instances of significant fraud, if any, that involvesmanagement or
employees having a significant role in thecompany’s internal systems; and
f. They have indicated to the auditors, the Audit Committeeand in the notes
on accounts, whether or not there weresignificant changes in internal
control and/or of accountingpolicies during the year.

IX. Report on Corporate Governance

26
 (i) There shall be a separate section on Corporate Governance inthe annual
reports of company, with a detailed compliance reporton Corporate
Governance. Non-compliance of any mandatoryrequirement i.e. which is
part of the listing agreement with reasonsthereof and the extent to which
the non-mandatory requirementshave been adopted should be specifically
highlighted. Thesuggested list of items to be included in this report is given
inAnnexure-1B and list of non-mandatory requirements is given
inAnnexure-1C.
(ii) The companies shall submit a quarterly compliance report to thestock
exchanges within 15 days from the close of quarter as perthe format given
below. The report shall be submitted either bythe Compliance Officer or
the Chief Executive Officer of thecompany after obtaining due approvals.

X. Compliance

The company shall obtain a certificate from either the auditors orpracticing
company secretaries regarding compliance of conditions ofcorporate governance as
stipulated in this clause and annex thecertificate with the directors’ report, which is sent
annually to all theshareholders of the company. The same certificate shall also be
sentto the Stock Exchanges along with the annual returns filed by thecompany.

Schedule of implementation

1. The provisions of the revised clause 49 shall be implemented asper the schedule
of implementation given below:
a. By all entities seeking listing for the first time, at the time oflisting.
b. By all companies which were required to comply with therequirement of
the erstwhile clause 49 i.e. all listed entitieshaving a paid up share capital
of Rs.3 crores and above ornet worth of Rs.25 crores or more at any time
in the historyof the entity. These entities shall be required to comply
withthe requirement of this clause on or before March 31, 2004.
2. The non-mandatory requirement given in Annexure-1C shall beimplemented as
per the discretion of the company. However, thedisclosures of the adoption/non-
adoption of the non-mandatoryrequirements shall be made in the section on
corporategovernance of the Annual Report.

Annexure 1A

Information to be placed before Board of Directors

1. Annual operating plans and budgets and any updates.

2. Capital budgets and any updates.

27
 3. Quarterly results for the company and its operating divisions orbusiness
segments.
4. Minutes of meetings of audit committee and other committees ofthe board.
5. The information on recruitment and remuneration of senior officersjust below the
board level, including appointment or removal ofChief Financial Officer and the
Company Secretary.
6. Show cause, demand, prosecution notices and penalty noticeswhich are
materially important.
7. Fatal or serious accidents, dangerous occurrences, any materialeffluent or
pollution problems.
8. Any material default in financial obligations to and by the company,or substantial
non-payment for goods sold by the company.
9. Any issue, which involves possible public or product liability claimsof substantial
nature, including any judgment or order which,may have passed strictures on the
conduct of the company ortaken an adverse view regarding another enterprise
that can havenegative implications on the company.
10. Details of any joint venture or collaboration agreement.
11. Transactions that involve substantial payment towards goodwill,brand equity, or
intellectual property.
12. Significant labour problems and their proposed solutions. Anysignificant
development in Human Resources/Industrial Relationsfront like signing of wage
agreement, implementation of VoluntaryRetirement Scheme etc.
13. Sale of material nature, of investments, subsidiaries, assets,which is not in
normal course of business.
14. Quarterly details of foreign exchange exposures and the stepstaken by
management to limit the risks of adverse exchange ratemovement, if material.
15. Non-compliance of any regulatory, statutory nature or listingrequirements and
shareholders service such as non-payment ofdividend, delay in share transfer
etc.

Annexure 1B

Suggested list of items to be included in the report on corporateGovernment in the

Annual Report of Companies

1. A brief statement of company’s philosophy on code ofgovernance.

2. Board of Directors:
a. Composition and category of directors, for example,promoter, executive,
nonexecutive, independentnonexecutive, nominee director, which
institutionrepresented as lender or as equity investor.
b. Attendance of each director at the BoD meetings and thelast AGM.

28
 c. Number of other BoDs or Board Committees in which he/she is a member
or Chairperson
d. Number of BoD meetings held, dates on which held.
3. Audit Committee:
a. Brief description of terms of reference
b. Composition, name of members and Chairperson
c. Meetings and attendance during the year
4. Remuneration Committee:
a. Brief description of terms of reference
b. Composition, name of members and Chairperson
c. Attendance during the year
d. Remuneration policy
e. Details of remuneration to all the directors, as per format inmain report.
5. Shareholders Committee:
a. Name of nonexecutive director heading the committee
b. Name and designation of compliance officer
c. Number of shareholder’s complaints received so far
d. Number not solved to the satisfaction of shareholders
e. Number of pending complaints

6. General Body Meetings:

a. Location and time, where last three AGMs held.
b. Whether any special resolutions passed in the previous 3AGMs
c. Whether any special resolution passed last year throughpostal ballot –
details of voting pattern
d. Person who conducted the postal ballot exercise
e. Whether any special resolution is proposed to be conductedthrough postal
ballot
f. Procedure for postal ballot
7. Disclosures:
a. Disclosures on materially significant related partytransactions that may
have potential conflict with theinterests of company at large.
b. Disclosure of accounting treatment, if different, from thatprescribed in
accounting standards with explanation.
c. Details of non-compliance by the company, penalties,and structures
imposed on the company by Stock Exchange orSEBI or any statutory
authority, on any matter related tocapital markets, during the last three
years.
d. Whistle Blower policy and affirmation that no personnel havebeen denied
access to the audit committee.

29
 8. Means of Communication:
a. Half-yearly report sent to each household of shareholders.
b. Quarterly results
c. Newspapers wherein results normally published
d. Any website, where displayed
e. Whether it also displays official news releases; and
f. The presentations made to institutional investors or to theanalysts.
g. Whether Management Discussion & Analysis (MD&A) is apart of annual
report or not.
9. General Shareholder Information:
a. AGM: Date, time and venue
b. Financial Calendar
c. Date of Book closure
d. Divided Payment Date
e. Listing on Stock Exchanges
f. Stock Code
g. Market Price Data: High, Low during each month in lastfinancial year
h. Performance in comparison to board-based indices suchas BSE Sensex,
CRISIL index etc.
i. Register and Transfer Agents
j. Share Transfer System
k. Distribution of shareholding
l. Dematerialization of shares and liquidity
m. Outstanding GDRs/ADRs/Warrants or any Convertibleinstruments,
conversion date and likely impact on equity
n. Plant Locations
o. Address for correspondence

Annexure 1C

Non-Mandatory Requirements

1. Chairman of the Board:

A nonexecutive Chairman should be entitled to maintain aChairman’s office at
the company’s expense and also allowedreimbursement of expenses incurred in
performance of his duties.
2. Remuneration Committee:
a. The board should set up a remuneration committee todetermine on their
behalf and on behalf of the shareholderswith agreed terms of reference,
the company’s policy onspecific remuneration packages for executive
directorsincluding pension rights and any compensation payment.

30
 b. To avoid conflicts of interest, the remuneration committee,which would
determine the remuneration packages of theexecutive directors should
comprise of at least threedirectors, all of whom should be nonexecutive
directors, thechairman of committee being an independent director.
c. All the members of the remuneration committee should bepresent at the
meeting.
d. The Chairman of the remuneration committee should bepresent at the
Annual General Meeting, to answer theshareholder queries. However, it
would be up to theChairman to decide who should answer the queries.
3. Shareholder Rights

The half-yearly declaration of financial performance includingsummary of the

significant events in last six-months, should besent to each household of shareholders.

4. Postal Ballot

Currently, though there is requirement for holding the generalmeeting of

shareholders, in actual practice only a small fractionof the shareholders of that company
do or can really participatetherein. This virtually makes the concept of corporate
democracyillusory. It is imperative that this situation which has lasted toolong needs an
early correction. In this context, for shareholderswho are unable to attend the meetings,
there should be arequirement which will enable them to vote by postal ballot forkey
decisions. Some of the critical matters which should bedecided by postal ballot are
given below:

a. Matters relating to alteration in the memorandum ofassociation of the company

like changes in name, objects,address of registered office etc;
b. Sale of whole or substantially the whole of the undertaking;
(i) Sale of investments in the companies, where theshareholding or the
voting rights of the companyexceeds 25%;
(ii) Making a further issue of shares through preferentialallotment or private
placement basis;
(iii) Corporate restructuring;
(iv) Entering a new business area not germane to theexisting business of the
company;
(v) Variation in rights attached to class of securities;
(vi) Matters relating to change in management.
5. Audit Qualifications

Company may move towards a regime of unqualified financialstatements.

6. Training of Board Members

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 Company shall train its Board members in the business modelof the company as
well as the risk profile of the businessparameters of the company, their responsibilities
as directors,and the best ways to discharge them.

7. Mechanism for Evaluating nonexecutive Board Members

The performance evaluation of nonexecutive directors should bedone by a peer

group comprising the entire Board of Directorsexcluding the director being evaluated;
and Peer Group evaluationshould be the mechanism to determine whether to
extend/continuethe terms of appointment of nonexecutive directors.

5.8 MODERN TRENDS IN PUBLISHED ACCOUNTS

5.8.1 BRAND ACCOUNTING

The profitability of a business enterprise depends to a great extent onthe

marketability of its products or services. Brands or trade namesunder which the
products or services of the company are marketedplay a major role in maintaining and
improving the marketability of suchproducts or services. It is, therefore, argued by some
accountants thatthe published financial statements should disclose the value of
suchbrands or trade names and also their impact on the sales and profitachieved during
the accounting period.

Development of Brand Accounting Concept

Brand accounting is basically concerned with this aspect. In other words,it

provides a basis for the valuation of brands and their reflection in thefinancial
statements of an enterprise. The concept of ‘Brand Accounting’is quite new and the
accounting profession has yet to evolve a scientificand realistic basis for the valuation of
brands and their disclosure in thefinancial statements.

The pioneers in the field of Brand Accounting are two largecompanies of United
Kingdom: (i) Grand Metropolitan PLC, and (ii) RankHovis McDougall PLC. The Grand
Metropolitan PLC capitalised the valueof the acquired brands and disclosed them at this
figure in balancesheet. The company Chairman’s statement in the annual report for
1988stated as follows:

“During the year, your Board decided to give recognition in thebalance sheet to
the cost of significant brands acquired since January1, 1985. This move has the full
support of the company’s auditors. It willreflect to some extent the worth of our
intangible assets, althoughhomegrown brands acquired before 1985 and licences and
agreements are still excluded.”

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 The Rank Hovis McDougall PLC treated both acquired brands anddeveloped
brands alike. They capitalized them at their ‘Current use value’to the company and
showed the figures in their balance sheet. Thecompany Chairman’s statement in the
annual report for 1988 stated asfollows:

“In order to recognize the great importance of our brands, we havetaken the
opportunity this year to include them in the Balance Sheet.The figure of £ 678 million
has been shows as an intangible asset. Iwould emphasize that this (treatment) only
recognizes the value ofbrands as they are currently used by the Groups and does not
takeaccount of their future prospects or, indeed, their worth in the openmarket.”

Accounting Treatment

There is no specific international accounting standard available regardingthe

accounting treatment to be given to brands. However, brands likegoodwill are intangible
assets and do not have a physical identity. Hence,it will be advisable to follow the
provisions of AS 26.

Accounting for Goodwill: The application of this standard ismandatory for all
companies operating in United Kingdom. The standardrestricts capitalization only to
acquired brands and not capitalization ofbrands created by the companies themselves.
The capitalized value ofthe brands can be shown as ‘Intangible Assets’ and the
correspondingvalue as revaluation reserve in the company’s Balance Sheet. It maybe
noted here that the Grand Metropolitan PLC by capitalizing only theacquired brands fell
in line with SSAP-22, but Rank Hovis McDougallPLC by capitalizing both acquired as
well as created brands violatedthe provisions of SSAP-22.

According to AS 26: “Intangible Assets”, issued by ICAI, an intangibleasset

should be recognized if and only if:

(i) (a) It is probable that the future economic benefits that areattributable to the
asset will flow to the enterprise, and

(b) The cost of the asset can be measured reliably.

(ii) An intangible asset should be recognized at cost only.

(iii) Internally generated goodwill should not be recognized asan asset.
(iv) Internally generated brands, mastheads, published titles,customer lists and
similar in substance should not berecognized as intangible assets.

Thus, according to AS 26 brands or goodwill purchased can berecognized

subject to conditions (i) and (ii) above. However brands orgoodwill internally generated
should not be recognized as assets in thefirm’s books.

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 5.8.2 LEAN ACCOUNTING

Introduction:

Lean Accounting is the most recent concept in the accounting literature.In

September 2005, a Lean Accounting Summit in Detroit co-sponsoredby Association for
Manufacturing Excellence (AME) was held. Thesummit had on its agenda to codify the
principles, practices and toolsof lean accounting developed over the last 10 years. It
may be notedthat lean accounting involves lean thinking, i.e., eliminating all forms
ofwaste in the accounting process to provide quality goods or service tothe customer at
the lowest price. Thus:

a. Lean accounting focuses measuring and understanding the valuecreated for the
customer and uses this information to enhancecustomer relationships, product
design, product pricing and leanimprovements.
b. To be lean accountant one must relentlessly seek to view hisorganization
through the eyes of his customers.

However, it has been found that everybody working seriously toimplement lean
thinking in his organization ultimately bumps up againstthe accounting system prevalent
in the organization. This is because ithas been found that in most “customer focused”
companies, theiremployees in their narrow interest optimize functional performance.
Asa result there is wide waste in the enterprise and large number ofunhappy customers.

Limitations of Traditional Accounting:

The traditional accounting systems are largely and actively anti-leanbecause of

their following limitations:

(i) Non-value work:They are large, complex, wasteful processesrequiring huge

amounts of non-value work.
(ii) High-inventory Levels: They provide measurements and reportslike labor
efficiency and overhead absorption that motivate largebatch production and high
inventory levels.
(iii)Misleading reports: They have no good way to identify thefinancial impact of
the lean improvements taking place throughoutthe company. On the contrary,
the financial reports will often showthat bad things are happening when very
good lean change isbeing made.
(iv)Lack of understanding: Very few people in the companyunderstand the reports
that emanate from the accountingsystems. However, they are used to make
important and farreachingdecisions.

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 (v) Misleading costs: They use standard product costs which aremisleading when
making decisions related to quoting, profitability,sourcing, make/buy, product
rationalization, and so forth.

Meaning of Lean Accounting

Lean accounting may be defined as applying lean methods to theaccounting

processes. It may be noted that some accounting processesmay involve waste which
cannot be avoided while others may involvewaste that can be eliminated. The waste of
a later type is to be eliminatedin the same way as is done in case of other production
processes.Thus, lean accounting is the accounting technique that aims atcontinuously
eliminating waste from the transaction processes, reportsand accounting methods
throughout the organization. This all helps insimplifying accounting, quick decision
making and reducing cost.

Objectives of Lean Accounting

The objectives of lean accounting can be summarized as under:

(i) Providing appropriate information:Lean accounting aims atproviding accurate,

timely and understandable information to allsegments of an organization. It
results in motivating leantransformation throughout the organization helping in
quickdecision-making, leading to increased customer value, growth,profitability
and cash flows.
(ii) Elimination of waste: Lean accounting uses lean tools toeliminate waste from
the accounting processes besides increasedcomprehensive financial control.
(iii)Compliance with “GAAP”: Lean accounting fully complies withthe Generally
Accepted Accounting Principles (GAAP), externalreporting regulations and
internal reporting requirements.
(iv)Encourages lean culture: Lean accounting supports the leanculture by
motivating investment in people, providing informationthat is relevant and
empowering continuous improvement at everylevel of the organization.

Steps of Lean Accounting:

The following steps may be taken for introduction of lean accounting inan
organization:

(i) Defining value: This means identifying the expectation of thecustomer from a
specific product or a service. In other words, itis important to decide from
customer’s point of view what isimportant for him or what are his priorities while
paying for aparticular product or service.

35
 (ii) Identifying value streams: This refers to identification of thevalue added
activities which go into delivering specific productsand services to customers.
Non-value added activities have tobe eliminated.
(iii)Making the value stream flow: This requires the various piecesof equipment
placed in a manner in sequence of themanufacturing processes thereby enabling
a continuous singlepiece flow of production. The employees should be crossed-
trainedto perform all the steps within the cell they are working.Thus, lean
accounting uses cellular work arrangements that pulltogether people and
equipment from physically separated andfunctionally specialized departments.
(iv)Implementation of a pull system: This involves introduction ofa system where
visual controls are used to trigger upstream linksin the value stream to initiate
additional production. For instance,when a storage bin of components becomes
empty up to arequired level for replenishing a fresh supply it automatically
signalsthe upstream link in the value stream to replenish the componentswithout
the need of any paper work, viz., material or purchaserequisition slip etc.
(v) Strive for perfection: There is continuous effort for makingimprovements. A
management seeks also frontline employees’opinion for improvement in the flow
of value to the customers.Thus, the management views all employees as
intellectual assets.

Conclusion

Lean accounting is still in a work-in-process stage. And hence, theprinciples,

practices and tools of lean accounting are being graduallyformed, transformed,
improved and updated. A wide range of companiesare adopting lean accounting
methods making the required adjustmentsin the principles, methods, techniques to meet
the companies specificneeds besides maintaining adherence to generally accepted
accountingprinciples and external reporting requirements and regulations. It isexpected
that in the years to come lean accounting will become a way of life for corporate for
providing better cost effective information forthe decision making and create display and
remit simple and timelyaccounting reports for all stake holders in the organization.

5.8.3 INTERNATIONAL ACCOUNTING

Introduction:

The present LPG era, i.e., the era of liberalization, privatization andglobalization
has brought a revolutionary change in the accounting world.National corporate bodies
have overnight become multinationalcorporate having their businesses in different
locations in the world.Such corporations have their stake holders, i.e., shareholders,
creditors,customers, employees from all over the globe. It has, therefore,
becomenecessary for such corporate to have universally acceptableaccounting

36
principles, procedures and practices for making meaningfulcomparative analysis and
drawing appropriate conclusions andinterpretation of the financial statements by
interested stakeholders.The international accounting or global accounting is a
directconsequence of this necessity.

Meaning of International Accounting

It may broadly be defined as accounting that incorporates the functionalareas of

financial accounting, managerial accounting, taxation andaccounting information
systems to generate the requisite accountinginformation for stakeholders all over the
globe.

The meaning and scope of international accounting may varydepending upon the
extent to which the corporate have internationaloperations.

(i) Super national International Accounting: This accountingincludes in its fold

standards, guidelines and rules ofaccounting, auditing, taxation issued by super
nationalorganizations, viz., United Nations, the Organization ofEconomic
Cooperation and Development, the InternationalFederation of Accountants, etc.
(ii) Company Level International Accounting:Thisaccounting encompasses the
standards, guidelines andpractices that a company follows for its
internationalbusiness activities and foreign investment. These standardsor
practices may relate to accounting for transactions in aforeign currency, the
techniques for evaluating theperformance of a company’s foreign operations etc.
(iii)Country Level International Accounting: This is thebroadest definition of
international accounting. It includes thestudy of standards guidelines and rules of
accounting,auditing and taxation that exist within each country and
theircomparative study. It may be noted that generally acceptedaccounting
principles and practices may vary marginallyfrom country to country due to
requirements of eachcountry’s national accounting or statutory bodies.
Thetaxation provisions may also differ from country to country.Thus, the country
level international accounting will includein its scope a study of accounting
principles and practicesprevalent in different countries and their
comparativeanalysis. International accounting according to this
concept,therefore, covers in its scope enormous amount of territoryboth
geographically and topically.

5.8.4 FORENSIC ACCOUNTING

Introduction:

Forensic accounting is a fast emerging field in the world of accountingand

gaining constant increased prominence due to rapid increase infinancial frauds and

37
white collar crimes resulting in collapse of manycorporate giants, viz., Maxwell
Communication Group in UK, Enron &Lehman Brothers in USA and Satyam in India.
The corporate auditorslargely at present are only expected to check the compliance
ofcompanies’ books of account to the generally accepted accountingprinciples, auditing,
standards and companies policies. However, manywhite collar crimes and financial
frauds could not be detected by theauditors because they were not trained to look the
business reality ofthe situation. This created the need for development of an
accountingsystem integrating accounting, auditing and investigative skills. Thisresulted
in the emergence of a new concept of accounting popularlyknown as ‘Forensic
Accounting’.

Meaning of Forensic Accounting

The meaning of forensic accounting is changing in response to thegrowing needs

of business and industry. In simple words, forensicaccounting is accounting that is
suitable for legal review offering thehighest level of assurance about the accuracy of the
financial statementsbased on scientific and objective verification.Some of the definitions
of forensic accounting are as under:

 “Forensic Accounting is the science of gathering and presenting financial

information in a form that will be accepted by a court of jurisprudence against
perpetrators of economic crimes.” – George A. Mannie
 “Forensic Accounting is the application of financial skills and an investigative
mentality to unresolved issues conducted within the context of rules of evidence.
As an emerging discipline it encompasses financial expertise, fraud, knowledge
and understanding of business reality and the working of the legal system.” -
Bologana& Lind Quist
 “Forensic Accounting is the application of accounting principles, theories and
discipline to facts or hypotheses at issues in a legal dispute and encompasses
every branch of accounting knowledge.”– American Institute of Certified
Public Accountants (AICPA)

From the above definitions it can be concluded that forensicaccounting includes the
use of accounting, auditing and investigatingskills to assist in legal matters. Thus,
forensic accounting is the bridgewhich connects accounting system to legal system. It
consists of twomajor components:

(i) Litigation services that recognize the role of an accountantas an expert

consultant; and
(ii) Investigative services for looking deep into the financial books,records and data
to uncover for hidden assets, siphonedfunds, etc.

Role of Forensic Accountant

38
 An accountant engaged in the forensic accounting is known as
forensicaccountant. He utilizes his understanding of business information,financial
reporting systems, accounting and auditing standards,investigative techniques and legal
knowledge in performance of his jobwhich may include the following:

(i) Investigating and analysing financial evidence.

(ii) Developing appropriate computerized applications which couldhelp in the
analysis and presentation of financial evidence.
(iii) Communicating his findings in the form of documents, reports,exhibits, etc.
(iv) Assisting in legal proceedings including testifying in a law courtas a key and
expert witness.

It may be noted that a forensic accountant does not win or lose acase but seeks only
the truth by conducting evaluations, examinationsand enquiries. The services of a
forensic accountant are in greatdemand in the following areas:

(i) Assessment and settlement of insurance claims:Theclaims may relate to loss

of property, loss of profits or lossdue to any other risk insured.
(ii) Detection of fraud committed by employees: Such fraudsmay relate to loss of
property or embezzlement of funds bydishonest employees.
(iii)Assistance in criminal investigation proceedings: Acriminal offence may
also have financial implications. Theservices of a forensic accountant are quiet
useful in preparingand presenting the desired evidence.
(iv)Arbitration services: The parties to a dispute may like toget the financial liability
settled through arbitration. In somecases, settlement of dispute through
arbitration may bemandatory as per the terms of the agreement. The servicesof a
forensic accountant may be used in such cases.
(v) Miscellaneous disputes: These disputes may relate to thefollowing matters:
a. Settlement of dues of an outgoing partner.
b. Liability for professional negligence.
c. Matrimonial matters.
d. Infringement of patents and trademarks etc.

5.9 SUMMARY

 Some of the indicators/criteria which can be used to measurethe social costs and
benefits associated with projects are givenin this unit.
 Financial statement which shows how much value (wealth) hasbeen created by
an enterprise through utilization of its capacity,capital, manpower and other
resources, and how it is allocatedamong different stakeholders (employees,
lenders, shareholders,government, etc.) in an accounting period is known as a
ValueAdded Statement.

39
  Financial reporting and disclosure are potential and importantmeans for the
management to communicate a firm’s performanceand value to outside
investors. Higher means of disclosure willbe helpful to reduce information gap
between a company and itsstakeholders.
 The recent trends in published accounts are:
o Brand Accounting
o Lean Accounting
o Forensic Accounting
o International Accounting

5.10 KEY TERMS

 Social accounting: Accounting concerned with measuring anddisclosing costs

and benefits to the society as a result of operatingactivities of a business
enterprise.
 Social benefit: Any benefit to the society or any of its elementswhether
economic or non-economic, internal or external.
 Social cost: Any cost or sacrifice or determent to the society orany of its
elements whether economic or non-economic, internalor external.
 Brand accounting: Accounting concerned with valuation ofbrands and their
reflection in the financial statements of onenterprise.
 Economic value added: The operating profits after tax less thecharge for the
capital both equity as well as debt used in thebusiness.
 Environmental accounting: Management of environmental costseffectively,
presenting and disclosing environmental informationin a suitable form
 Lean accounting: Applying lean methods to the accountingprocesses.
 Forensic accounting: It is accounting that is suitable for legalreview
 International accounting: Accounting that incorporates thefunctional areas of
financial accounting, managerial accounting,taxation and accounting information
systems to generate therequisite accounting information for stakeholders all over
the globe.
 Value added: The increase in the value of a product or serviceresulting from an
alteration in the form, location or availabilityexcluding the cost of bought out
material or services

5.11 QUESTIONS AND EXERCISE

1. Explain the concept of Social Cost Benefit Analysis.

2. Discuss the different methods for measurement of Social Costand Benefits.
3. “A new dimension of financial reporting is the growing demandfor reports and
activities which reflect the contribution of anenterprise to the society at

40
 large.”Discuss the above concept and illustrate how the performanceof an
enterprise to the society at large is evaluated.
4. When should capitalization of borrowing costs cease in relationto assets and to
investments. Discuss.
5. Write a short note on corporate Social Reporting.
6. What is ‘Social Reporting’? Explain briefly the major areas coveredin social
reporting.
7. Explain the concept of Value Added. State the advantages andlimitations of a
Value Added Statement.
8. Define the term Economic Value Added State its utility. Explain itscomputation by
giving an imaginary example.

5.12 PRACTICAL PROBLEMS

1. From the following information taken from the books of F Ltd. relating tostaff and
community benefits, prepare a statement classifying the variousitems under the
appropriate heads required under Corporate SocialReporting:

Rs.

Environmental Improvements 20,10,000

Medical Facilities 45,00,000

Training Programmes 10,25,000

Generation of Job Opportunities 60,75,000

Municipal Taxes 10,70,000

Increase in Cost of Living in the vicinity due to a

thermal power station 16,55,000

Concessional Transport, Water Supply 11,25,000

Extra Work put in by staff and officers for drought relief 18,50,000

Leave Encashment and Leave Travel Benefits 52,00,000

Educational Facilities for children of staff members 21,60,000

Subsidized Canteen Facilities 14,40,000

Generation of Business 25,00,000

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[Ans. Net Social Benefits to Staff Rs.1,36,00,000;Net Social Benefits to Community
Rs.1,00,00,000]

2. From the following Profit and Loss Account of X Limited, prepare (i) GrossValue
Added Statement, and (ii) show the Reconciliation between GrossValue Added
and Profit before taxation:

PROFIT AND LOSS ACCOUNT

for the year ended 31st March, 2002

Income Rs. In Lakhs Rs. In Lakhs

Income 800
Sales 50
Other Income 850
Expenditure 600
Production and Operational Expenses 30
Administrative Expenses 30
Interest and Other Charges 20 680
Depreciation 170
Profit before taxes 30
Provision for taxes 140
Balance as per last Balance Sheet 10
150
Transferred to:
General Reserve 80
Proposed Dividend 20
Surplus carried to Balance Sheet 50
Break-up of some of the Expenditure is 150
as follows:

Production and Operational Expenses: 320

Consumption of Raw Materials and Stores 60
Salaries, Wages and Bonus 20
Cess and Local Taxes 200
Other Manufacturing Expenses 600

42
Administrative Expenses: 6
Audit Fee 8
Salaries and Commission to Directors 6
Provision for Doubtful Debts 10
Other Expenses 30

Interest and other Charges: 10

On Working Capital Loans from Bank 15
On Fixed Loans from ICICI 5
On Debentures 30

[Ans. Gross Value Added (` in lakhs) Rs.298 (including other Income), Application of
Value Added: To Employees Rs. 60, To Directors Rs.8, To Government Rs.50, To
Providers of Capital Rs.40, For Maintenance and Expansion Rs. 140]

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