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MB-107: FINANCIAL ACCOUNTING

(Faculty: Anupam De)

1. Introduction to Financial Accounting:Conventions, Concepts and Principles

Definition of Accounting : Accounting is said to be the artofRecording, art ofClassifying and art ofSummarizing ofthe business transactions in a significant manner.

Difference between Events and Transactions: AllTransactions are events but all Events are nottransactions. To become transactions, an event have topass first and any one of the rest of the following tests:

i) Financial elements which can be measured interms of money are involved.ii) There is a flow of financial elements from one

party to another.iii) There is a change in financial position.

Accounting and Economics : Economics is the science whichstudies human behaviour as a relationship between scarcemeans and resources which have alternative uses. Whenthe individual buyer and sellers have to take economic

decision for purchase and sale, they are to depend mainlyupon accounting information. A person dealing withaccounts is concerned with economic problems of anenterprise only, whereas an Economist is concerned withthe problems of an industry and the economy. Much of thestatistical data used by the Economists are available fromthe accounting records and interpretations. Thus Economicsand Accounting are closely related subjects.

Accounting is the language of a business because

accounting provides the principal means by whichinformation about a business is communicated to the othersi.e. the users of accounts.

Doctrine of Consistency : Accounting principles once usedshould be used consistently during the year and also fromone year to another. Example if accrual basis is followed in

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a certain year, cash basis should not be followed in the nextyear.

Doctrine of Disclosure : The doctrine of disclosure requiresthat all the material facts should be disclosed in the

accounting statements and reports. For example, notesregarding contingent liability (a liability which may or maynot become liability depending upon the occurrence andnon-occurrence of future event or events), market price ofinvestments etc are often given which is the result offollowing the Doctrine of Disclosure.

Doctrine of Conservatism : The doctrine of conservatismsuggests that no profit should be anticipated unless itactually takes place but provision should be made for all

possible losses and expenses. For example valuation ofinventory is done at cost or market price whichever is lower.If inventories are valued at market price, profit isanticipated beforehand i.e. even before the actual sale ofthose inventories. Again provision for bad debts are made inanticipation of debts which may become bad in future ( e.g.debtor being an individual died before paying money due ordebtor as a company gone into liquidation before repayingthe debt) though actual amount of bad debts may alwaysdiffer from the provision made for it.

Doctrine of Materiality : The doctrine of materiality suggestsall the material facts and information should be disclosedproperly. Matters which are significant require accounting ingreater details than the matters which are much lesssignificant or insignificant. For example while preparingaccounts of a big company paise is not material andhence all the figures may be shown in the nearest rupees.

Business Entity Concept : A business entity and its owners

are regarded as separate entity in accounting. Thisdistinction between a firm and its owners makes it possibleto i) record the transactions between the firm and theowner (e.g. investment made by the owner is calledcapital and withdrawal from the business is calleddrawing) ii) reveal the true picture of the affairs of thefirm, because without this distinction the transaction of the

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firm and private transactions of the owners would be mixedand the clear and fair picture of the affairs of the firm wouldnot be known.

Cost Concept : A business transaction is recorded in terms of

the amount actually passing through the transaction i.e. thehistorical cost. For example, a building is constructed andtotal expenditure incurred for it is Rs. 10.00 lacs, howevermarket price of this building is Rs. 12.00 lacs. As per thecost concept the building will be recorded in the books ofaccounts at Rs. 10.00 lacs i.e. the historical cost of thebuilding.

Money Measurement Concept : Accounting is only concernedwith those events which can be measured in terms of

money. For example a court case is pending against aconcern for some business disputes and it may face a hugeloss if the verdict of the case goes against it. However thisprobable loss can not be considered in the accounts untiland unless it can be measured in terms of money.

Going Concern Concept : A business, unless otherwiseknown, will be assumed to operate for an indefinitely longperiod of time. According this concept assets are shown inthe accounts at their historical cost not at the Net

Realisable Value (market price less relevant expenses forselling) or at the Current Replacement Cost (cost which maybe incurred to replace the assets in its present condition bya new asset). However when a business is supposed tooperate for a short period i.e. for a venture business, theassets is shown in the accounts in its Net Realisable Value(NRV).

Dual Aspect Concept : This concept recognizes two aspectsof accounting- one representing the assets and the other

representing the claims against the assets. These twoaspects are always equal to each other. The accountingequation for it:

i) Assets = Capitalii) Assets = Capital + Liabilities

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Dual aspect concept, therefore, explains the sources offunds for the business on the one hand and application offunds on the other hand.

Realisation Concept : According to this concept revenue

should be recognized in the accounts when there is nouncertainty regarding the ultimate collection (i.e. when thegoods or services are passed to the buyer and the lateraccepts the liability). However the expenses and lossesshould be realized in the accounts when those are incurredor it is probable to incur them. For example a sales orderreceived by a company is not recognized as sale until andunless the goods are supplied against this order and thecustomer has accepted it. However any expenses incurredor probable to be incurred for the production of the goods

for that sales order, is recognized immediately.

Matching Concept : According to this concept only relevantcost should be deducted from the revenue of a period forperiodical income measurement. For example suppose 100units are purchased, and out of this 100 units only 80 unitsare sold, then for matching expenses against the revenuefrom the sale of 80 units, only expenses incurred forpurchasing the 80 units will be considered.

Accrual Concept : Sometimes goods and services may bepurchased without any actual inflow or outflow of money(i.e. on credit). According to this concept income is assumedto accrue even if there have been no actual cash inflowsand cost is supposed to be incurred even if there have beenno actual cash outflows. For example if sales has takenplace though portion of the sales proceed has beenreceived and portion of it is due, the total amount of salesirrespective of the actual amount received will consideredas sales for an accounting period.

Periodic Concept : Although an enterprise is supposed tocontinue forever, for the purpose of accounting its life isdivided into small time spans of equal duration, and each ofthese time span is called the accounting period. Forexample 01-04-2005 to 31-03-2006 is an accounting period.

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Importance & Scope of Accounting

Objectives of Accounting :

Importance of Accounting : Importance of accounting is

different to internal and external users of it.

Importance to Internal Users: Internal users ofaccounts are mainly Owners, Management and

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AccountingObjectives

To provide useful

financial information

Doctrines

Materiality, Consistency,

Compatibility, Objectivity,Disclosure etc.

Assumptions

On Entity,Going

Concern,

HistoricalCost,

Financial

Period etc.

Financial Reports

Profit and LossAccount, Balance

Sheet, Fund Flow

Statements,SupplementaryStatements

Realisation of ObjectivesBy providing useful financialinformation

GAAP

(Generally

AcceptedAccounting

Principles

Accounting

Procedures Procedures

applied to

Real world.


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Employees. Owners and Managements needaccounting information foro calculating profit or loss (through Profit & Loss

Accounting or Income & Expenditure Accounting)o ascertaining financial health (through Balance

Sheet)o comparing the results with the past records or with

the different branches and departments of a sameconcern or with the competitors to improveperformance and for overall betterment of theconcern

o controlling expenses and increasing productivityo preventing fraud and misuse of fundso satisfying the external userso sustaining growth and future prospect

Employees are mainly interested in the growth andprospect of the concern to satisfy their career goal.

Importance to External Users:o Governments Authorities (like Income tax

Department, Sales Tax Departments, Excise andCustom Department etc.) are interested inaccounting for proper ascertainment of taxes,duties and cess to increase governmental revenue

o Suppliers and Lenders (like Sundry Creditors andBankers) is interested to know the repaymentcapacity of the concern and their credit rating

o Customers or prospective buyers (like SundryDebtors) is interested to know the survival capacityof the concern for future services and after-saleservices

o Prospective Investors in the concern will beinterested to know the future income growth andfuture dividend paying capacity of the concern

o Researchers and Analysts are interested to getfinancial information for their research and analysispurpose

Scope of Accounting : Accounting is the language of abusiness. Accounting departments, is an extremelyimportant department of an organization and it holds

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most important, vital and sensitive records anddocuments of a concern and it supplies most essentialinformation to run and sustain an organizationefficiently and effectively. It is vital for survival of anyorganization. Not only the internal users (i.e.

management, owners) are very much dependant on it,the external users (like bankers, lenders, govt.authorities.) also are very much dependant on theaccounting records, reports, statements to satisfytheir various information needs. Accounting systemacts a bridge between them.

Revenue Recognition

Principles of revenue recognition deal with the timing andextent (i.e. amount) of revenue to be recognized in anaccounting year. Indian Accounting Standard-9 is relevantfor this purpose. The following principles are followed forrevenue recognition:i) The amount of income must be capable of being

measured objectivelyii) The revenue must have been earned i.e. substantial

amount of goods have been delivered or services havebeen rendered and the buyer of goods or service hasaccepted the liability towards it.

iii) There is no significant uncertainty towards theultimate collection

Revenue can be recognized either on cash basis oraccrual basis. If revenue is recognized only uponcollection of the amount of sales, it is called cash basis ofaccounting. If revenue is recognized at the point of sale(i.e. goods and services have been delivered or renderedand buyer has accepted the liability) rather than at the timeof collection of cash, it is called accrual basis ofaccounting.

Double Entry System of Accounting

Under this system every transaction has always dualaspect, one is called Debit (Dr.) and other is called Credit(Cr.) And both will be equal always. For example owner

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invest cash of Rs. 1,00,000 into the business. As per doubleentry concept it can be written as:Assets (here Cash) = Equity (i.e Capital) = Rs. 1,00,000

If a machinery of Rs. 50,000 is purchased out of that cash,

the same equation can be written as:Assets (here Fixed Assets +Cash) = Equity (i.e Capital) =

Rs. 1,00,000

If a stock of goods of Rs. 20,000 is purchased on credit froma supplier, the same equation can be written as:Assets (here Fixed Assets +Stock of Goods +Cash) =

1,20,000and

Equity (i.e. Capital) + Liability (here Sundry Creditors) = Rs.

1,20,000

i.e. Assets (A) = Equity(E) + Liability (L) = 1,20,000

2. Recording System:

Transaction:

Accounting system records the transactions only. An eventbecomes a transaction if i) financial element is involved ii)there is a flow of financial elements from one party toanother and or iii) there is a change in financial positionof any one party.

For example: Machinery purchased worth Rs. 10.00 lacson credit from International Suppliers is a transaction.

Journal

Transactions are recorded in the books (i.e primary books ofentry e.g. Cash Book, Journal Proper) systematically byfollowing the Golden Rules.

Golden Rule of Accountancy (Rules of Debit andCredit)

a) Real Account: Debit what comes in and Creditwhat goes out

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b) Nominal Account: Debit all the expenses & lossesand Credit all the incomes and gains

c) Personal Account: Debit the receiver and Credit the giver

Simplification of Golden Rule: DebitAssets & Expenses, Credit

Incomes & Liabilities

Examples of Real Account: Cash, Building, Machinery,Stocks etc.Examples ofNominal Account: Expenses like Rent, Salary,

Traveling & Conveyance, Advertisement & Publicity etc. andIncomes e.g. Sales, Miscellaneous Income, DiscountedReceived etc.Examples of Personal Account: Sundry Debtors, SundryCreditors, Bank, Capital etc.

The Transaction Machinery purchased worth Rs. 10.00 lacson credit from International Suppliers may be recorded inthe Journal Proper in this way:

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Books of ..

Dr. Cr.

Dat

e

Particulars LF V. No. Amount

(Rs.)

Amount

(Rs.)?? Machinery A/cDr.

To International Suppliers

A/c

(Being machinery

purchased on credit)

?? 10,00,000

.00 10,00,000.

00


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LF: Ledger Folio, V No.: Voucher No.

Cash & Bank transactions are recorded in Cash Book, credit

Sales & Purchases are recorded in Sales Day Book & Purchase

Day Book respectively, sale & purchase returns are recorded in

Sales Return Book & Purchases Return Book respectively, in this

way transactions are recorded in all the primary books of entry

and residual transactions are recorded in Journal Proper (which

is also a primary book of entry).

Ledger:After the transactions are recorded in a systematic manner,

they are classified on the basis of different Account Heads. All

these Accounting heads are called Ledger and this act is called

posting. For example, the above journal entry may posted into

following ledger heads

Books of ..

Dr. Machinery AccountCr.Dat

e

Particulars JF Amount

(Rs.)

Dat

e


(Rs.)?? To,

International

Suppliers A/c

?? 10,00,000

.00

?? By, Balance

c/d

10,00,000.

00

10,00,00

0.00

10,00,00

0.00?? To, Balance

b/d

10,00,000

.00

Dr. International Suppliers A/c

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Cr.Dat

e


(Rs.)

Dat

e


(Rs.)?? To, Balance

c/d

?? 10,00,000

.00

?? By,

MachineryA/c

10,00,000.

00

10,00,00

0.00

10,00,00

0.00?? By, Balance

b/d

10,00,000.

00

JF: Journal Folio

Trial Balance

All the debit and credit balances of the different Ledgerheads are periodically tabulated in a separate statement orsheet to ascertain whether total of all debits are equal tototal of all credits. This statement or sheet is called TrialBalance. If Trail Balance is tallied both sides (i.e. debit sideand credit side) we can say that there is no apparentmathematical error. However it can not be said that as the

Trial Balance is tallied the accounts is correct in all respect.Because certain errors can not be detected by Trial Balancewhich are namely compensating errors (one error iscompensated by others), error of omission (one totaltransaction omitted to be posted), error of mis-posting(posted under wrong account heads without violating debitand credit), error of principles (wrong entry of journal dueto lack of knowledge in accounting principles) etc.

When the Trial Balance is not tallied both sides, temporarily

a suspense account is created and subsequently errorsare rectified by passing appropriate journal entry. Thismethod is followed in manual accounting system only.

A small Trail Balance will look like this:

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Books of ..Trail Balance As on ..

Sl. No. Name of Accounts LF Dr.Amount

(Rs.)

Cr.Amount(Rs.)

1. Cash in Hand XXXXX

2. Bank Overdraft XXXXX3. Capital XXXXX4. Building XXXXX5. Purchases XXXXX6. Sales XXXXX7. Sundry Debtors XXXXX8. Sundry Creditors XXXXX9. Salary XXXXX10. Drawings XXXXX

11. Printing Stationery XXXXX12. Advertising & Publicity XXXXX13. Opening Stock XXXXX14. Carriage Inwards XXXXX15. Drawings XXXXX16. Discount Allowed XXXXX17 Depreciation XXXXX18. Miscellaneous Income XXXXX

Total XXXXXX XXXXXX

Trading Account and Profit & Loss Account

Accounting means RCS i.e Recording, Classification andSummarising. Recording and classification is done through

journal and ledger. After this stage, Summarising stagestarts which is the most challenging and analytical stage,and a business manager is supposed to handle this stagevery efficiently and effectively. Summarising stage starts at

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the preparation of Trial Balance. After preparation of TrialBalance all the nominal accounts (refer second GoldenRules of Accountancy) are transferred to Trading A/c andProfit & Loss A/c. If no separate manufacturing account iscreated, all the manufacturing expenses and all other direct

expenses (i.e. expenses which are required to be incurredfor making the purchased or manufactured goods ready forsale) are transferred to Trading A/c and remaining nominalaccounts heads are transferred to profit & Loss A/c. If thereis surplus of income over all expenditures it is called profitand if there is deficit it is called loss. Both are adjustedwith capital. A small Trading and Profit & Loss A/c will looklike this.

Books of ..Dr. Trading Account for the period from to

Cr.Particulars Amount

(Rs.)

ParticularsAmount

(Rs.)To, Opening Stock A/c

To, Purchase

To,. Carriage Inwards

To, Gross Profit c/d

XXXXX

XXXXX

XXXXX

XXXXX

By, Sales

By, Closing Stock

XXXXX

XXXXX

XXXXXX XXXXXX

Dr. Profit & Loss Account for the period from to

Cr.To, Printing Stationery

To, Salary

To, Discount Allowed

To, Advertising &

Publicity

To, Depreciation

To. Net profit

(transferred to

XXXXX

XXXXX

XXXXX

XXXXX

XXXXX

XXXXX

By, Gross Profit b/d

By, Misc. Income

XXXXX

XXXXX

XXXXXX XXXXXX

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capital)

This presentation of Profit and Loss A/c is called horizontal

presentation. There are may be vertical presentation also.

Balance Sheet:

Balance Sheet is prepared by transferring all the realaccount (refer fist rule of Golden Rules) and personalaccount (refer third rule of Golden Rules) to a separatesheet. One side of this statement accumulates all theLiabilities and other side accumulates all the assets.

Actually assets side contains debit accounting heads andliabilities sides contains the credit accounting heads.Liabilities side is also called sources of fund and assetsside is called application of fund.

A small Balance Sheet will look like this.

Books of ..Balance Sheet As At .

Liabilities Amount(Rs.)

Assets Amount (Rs.)

CapitalOpeningAdd: Profit (or less:

Loss)

Less: Drawings

Sundry CreditorsBank Overdraft

XXXXXXXXXXXXXXXXXXXXXXXXX

XXXXX

XXXXX

Building (lessdeprecation)

Sundry Debtors(less bad debtprovision)

Closing Stock

Cash in Hand

XXXXX

XXXXX

XXXXX

XXXXX

XXXXXX XXXXXX

This presentation of Balance Sheet is called horizontalpresentation. There may be vertical presentation also.

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A standard format ofBalance Sheet will look like this:

Balance Sheet as at Rs. Rs.

SOURCES OF FUNDS Owners Fund

Capital XXXX Reserve and Surplus (P/L A/c, SharePremium,

Capital Reserveetc.)

XXXX XXXX

Loan Fund

Secured Loan (Debenture, TermLoan from

Bank etc.)

XXXX

Unsecured Loan (Unsecured loanform Directors,Relatives)

XXXX XXXX

XXXXXX APPICATION OF FUNDS Fixed Assets

Gross Block XXXXLess: Depreciation XXXX

Net Block XXXX

Investments (investment in shares,debenture & bond,investment in otherbusiness, etc.)

XXXX

Current Assets, Loans & Advances Current Assets

Inventories XXXXSundry Debtors XXXXCash & Bank Balances XXXX

XXXX

Loans & AdvancesBills Receivables XXXXOther Advances XXXX

XXXX Less: Current Liabilities &Provision

Sundry Creditors XXXX

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Tax Provision XXXXXXXX

Net Current Assets XXXX

Miscellaneous Expenditures

(Preliminary Expenses, Pre-operative Expenses, etc.)

XXXX

XXXXXX

3. Financial Statements

Income Statement:

The statement which represents the different categories ofincome earned and the expenditures and losses incurred to

earn it (Matching Concept, discussed earlier, has to be keptinto mind) is called Income Statement. Profit & Loss Account(prepared for organization running for profit makingpurposes) and Income & Expenditure Account (prepared fororganization running for non-profit making purposes) areexamples of Income Statement.

A standard format ofProfit & Loss Account will look like this:

Profit & Loss Account for the period from.Rs. Rs.

Sales XXXXLess: Cost of Goods Sold XXXXGross Profit XXXX

Less: Operating Expenses:Office & Administrative

ExpensesXXXX

Selling & DistributionExpenses

XXXX

Depreciation XXXX Operating Profit XXXXLess: Interest XXXX

Add: Other Non-operating Income XXXXLess: Non-operating Expenses XXXX

XXXX Profit Before Tax XXXXLess: Provision for Tax XXXX

Profit After Tax XXXX Appropriation of Profit

Provision for Dividend XXXX

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Reserves and Surplus XXXX

Fund Flow Statement: and Cash Flow Statement

Fund Flow Statement is to reveal how much of fund isearned from the normal business activities and how muchof fund earned from other business activities like sale offixed assets (i.e assets hold for long-term purpose not forresale), issues of shares or from accepting loans etc. It isalso supposed to reveal what portion of collected fund isutilised for acquisition of fixed assets, loan payment, taxand dividend payment etc. One side of this called sourcesof fund, other side is called application of fund.

Cash Flow Statement is a statement which presentsdetail information on annual cash inflows and cash outflowsof an entity separately under the heading of sources andtheir uses. Sources of cash flow may be analysed intomainly two broad categories: one is cash from operations(i.e money earned from normal business activities which areproduction and trading of goods and rendering of services)and the other is cash from other sources (examples aresale of fixed assts, issue of shares, accepting business loan

etc.). Use of cash may be due to acquisition of fixed assets,payment of loan, payment of taxes and dividend etc.

As per Indian Accounting Standard-3, various componentsof Cash Flow Statement is presented as operatingactivities (i.e. normal business operation), investingactivities (example: sale and purchase of fixed assets) andfinancing activities (example: issue of share capital,acceptance of loan etc.).

Interpretation and Importance

Growth of a business depends on its money earningcapacity and effective and effective use of this money orfunds for future growth, survival. Information regarding theinflows of cash or funds and outflows of cash or funds isderived by preparing Cash Flow Statement and FundFlow Statement.

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4. Ratio AnalysisComputation of different Accounting RatioQuotients used to express the comparative relationbetween the two accounting figures are called accounting

ratios. For example if Return on Capital Invested (ROI) of aconcern is 25%, it means if Rs 1oo is invested in thatconcern, Rs. 25 will be its return.

Important Accounting Ratioso Short Term Solvency or Short Term Liquidity

Ratio

CurrentRatio

=

Current Assets (i.e. stock, debtor, loans,

cash etc.)CurrentLiabilities

(i.e. creditors, bankoverdraft, provisions)

LiquidRatio(QuickAssetsRatio)

=

Liquid Assets (i.e C.A. less Stock)

Liquid Liabilities (i.e. C.L. minus bankoverdraft

o Long Term Solvency or Long Term Liquidity Ratio

DebtEquityRatio

=

Long Term Debt (i.e. Debenture, TermLoan from Bank etc.)

ProprietorsFund/Equity

(i.e. Share Capital+Reserve Surplus-Fictitious Assets )

(Fictitious assets means assets having noproductivity)

Proprietary Ratio =

Proprietors Fund

Total Assets (i.e. Total Assets-Fictitious Assets)

o Capital Gearing or Leverage Ratio

CapitalGearing

= Preference Shareholders Equity +Debentures

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RatioEquity Shareholders Equity (i.e. Equity

Share Capital +Reserve & Surplus)

Debenture Capital

Ratio

=

Debentures

Net Worth +Debentures

(Net Worth means

Shareholders Fund)

o Profitability or Earning Ratio

GrossProfit/Margin/

TurnoverRatio

=

Gross Profit (i.e. Net Sales Cost ofSales.)

Net Sales (i.e. Sales Sales Return)

Net Profit

Ratio=

Net Profit Net Sales All Expenses

Net Sales

Return onInvestment/ROI =

Net Profit i.e.PAT

PAT means profit aftertax

CapitalEmployed

(i.e. Proprietors Fund +Long Term Debt)

Return onEquity

=

Net Profit Net Sales All Expenses

ProprietorsFund/ Net

Worth

o Turnover Ratio

StockTurnover/Velocity

=

Cost ofSales

(i.e. Net Sales Margin.)

AverageStock

(i.e. [Op. stock +Cl. Stock]/2 )

DebtorTurnover

/Velocity

=

Net CreditSales or

Accounts Receivables X365 days

AccountsReceivables

Net Credit Sales

CreditorTurnover/Velocity

=

Net CreditPurchases or

Accounts Payable X 365days

AccountsPayable

Net Credit Purchases

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o Operating Ratio

OperatingRatio

=Cost of Sales & Other OperatingExpenses

Net Sales

ExpensesRatio

=

Cost ofSales

,

AdministrativeExp.

,

Selling &Dist.Exp. e

Net Sales Net Sales NetSales

o Debt Service & Ratio Dividend Ratio

Interest

CoverageRatio

=

EBIT (EBIT means Earnings

before Interest and Tax)Interest Expenses

Debt ServiceRatio (DSCR)

=

PAT +Depreciation +

Interest

PAT means Profit afterTax

Interest +Principle

Repayment ofLoan

DividendCoverageRatio

=

Net Profit - Income Tax Dividend onPreference Shares

Dividend on Equity Shares paid orproposed

o Market Price Ratio

DividendYield

=

Dividend per Equity Shares

Market Value per EquityShare

Earning PriceRatio/

Earning Yield=

EPS EPS meanEarning Per Share

Market Value per EquityShare

Interpretation & Importance of Ratio:

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Different Ratio has got different interpretation. A ratioshould be interpreted by the items used for calculating it.For example, industry standard of Current Ratio & LiquidRatio is 2:1 and 1:1 respectively. It means if a concern hasC.R. and L.R. less than that, it can be said that the concern

may be not be able to meet its short term liabilities (likebank overdraft, trade creditors) on timely basis.

Ratios are very important indicators of performance, shortrun and long run liquidity, debt servicing capacity andfinancial health of a concern. These are the best tools tocompare a particular concern with its competitors.

Limitations :

Ratios are generally calculated by the historical data whichsometimes lead to wrong and misleading decision making.Ratios are basically problem indicators not the problemsolvers. Sometimes based on one single ratio may againleads to wrong decision making. Proper diagnosis is possiblewhen implications of all ratios are examined together.

5. Inventories

Pricing : & Valuation:Stock pricing and valuation is very much important for profit calculation. Indian

Accounting Standard-2 deals with it. Normally we value stock cost and market price

whichever is lower. Calculation of the value of stock lying on hand is a critical a job

because purchase price may vary with each lot of purchase and it is virtually impossible

to identify which lots of the stock is lying in hand. To remove this practical difficulty

various stock valuation methods are used. Those are FIFO (means First In First Out, here

it is assumed that materials received first is used first), LIFO (means Last In First Out,

here it is assumed that materials received last is used first), Weighted Average Cost

(weighted average cost of materials used where both quantity and price of materials are

taken into consideration), Simple Average Cost, Base Stock Methods, Specific

Identification Methods etc. However FIFO, LIFO and Weighted Average Cost are the

most commonly used methods. Indian Accounting Standard-2 recommends FIFO and

Weighted Average Cost only for stock valuation.

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Accounting & Recording

While accounting the stock all the cost is incurred to bringthe materials into present location is included. Stock ledgers

are maintained item wise to record stock receipts, issue andbalances. For valuation of closing stock certain items areincluded e.g. goods-in-transit (Goods dispatched by thesuppliers but still in transit), goods sold on consignmentbasis etc. and certain items are excluded e.g. goods alreadysold awaiting delivery.

6. DepreciationDepreciation means wear and tear of a depreciable asset

due to use and efflux of time, fall in the value and qualitydue to obsolescence, accidents and change in marketcondition. Depreciation is popularly know as a non cashexpenditure, because though it is considered as expenses inthe profit & loss account, there is no cash outflow for it asan expense. India Accounting Standard-6 deals withdepreciation.

Methods:Various methods may be used for calculating depreciation.

Which are Straight Line Method (annual depreciationremains same year to year;, amount of annual depreciation= (Cost of the Asset Estimated Residual Value at the endof useful life)/Expected years of use), DiminishingBalance Method (Annual depreciation diminishes as theuseful life diminishes; rate of annual depreciation = 1 -Residual Value/Cost of Asset), Sums of Years DigitMethod (annual depreciation is calculated consideringdiminishing effectiveness of the remaining life of the asset),Machine Hour Rate method (annual depreciation, e.g.

machinery = (Cost of the Asset Estimated ResidualValue)/expected no of machine hours produced),Replacement Cost Methods, Annuity Methods etc.

Accounting:Depreciation may be accounted by charging depreciationagainst the asset itself or by application of fund. In the first

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case, the value of asset shown in accounts goes ondecreasing year after year. In the second case method theasset value is kept intact and a different fund nameddepreciation fund is created. The effect of depreciationaccounting is the amount of depreciation is charged i.e.

debited to P/L A/c as expenses and by the same amountasset value is decreased or for the same amount fund iscreated.

Importance :

A business is supposed to run forever (if it is not a venturebusiness which is operated for specific purpose only).Survival of the business depends mainly how its capitalbase is kept intact and how fund is created for replacing

assets and meeting contingencies. Depreciation is chargedto account so that an amount is kept aside from profit everyyear and after the end of useful life similar asset can bepurchased from that fund. If depreciation is not chargedcost of production will not be the actual, it will be lower andconsequently the profit will be overstated.

7. Provisions:Provision s: & Reserves:

A provision is a charge against profit (i.e. profit isdeducted) for either i) for a known reduction in the value ofan asset or ii) for a known liability. Provision is created,out profit available before distribution, for known futurecontingencies so that amount is available in the businessitself for meeting that contingencies whenever it arise.

A reserve is profits retained in the business (not distributedto the owners) for unknown liability and contingencieswhich may crop up in the future. It is actually an allocation

of profit made to strengthen the financial position andgeneral health of a business entity.

Doubtful Debt:Doubtful debts are debts which are doubtful to berecovered. In every types of business it is a commonphenomenon. To ensure future survival of business,

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provision are created (i.e. it is charged against profit) forfuture estimated (normally as a percentage on total debtsand this percentage may vary business to business)doubtful debts.

Bad Debt :When a claim against a debtor becomes irrecoverable (e.g.death or insolvency of an individual debtor or winding up ofa debtor being a company etc.) owing to various reasons itis called bad debts. It is quite natural to happen to anybusiness.

Importance :In order to measure net profit or net loss for an accountingperiod, it is proper that expenses and losses of the period

must be matched against the revenues of that period (referMatching Concept), which (revenues) the expenses hashelped to generate. Normally bad debts do not happen inthe year of sale, it normally happens after the sale. Henceas per the Matching Concept the provision (though it is anestimated bad debts) must be created against the profit ofthe year only in which the sales (debtors of which havebeen proved bad later on) have taken place.

Accounting Treatments:

Provision for bad and doubtful debts are created as acharge against profit i.e. it is debited to P/L A/c and creditedto Provision for Bad and Doubtful Debt A/c. Every year it isestimated normally as a percentage of the total amount ofdebts lying at the end of an accounting period and adjustedevery year if it is required so. If there is actual bad debts inany year, it is first charged against the provision createdfor it, if any, and the remaining portion or the total amount(if provision is not created) of the bad debt is charged to

profit and loss account as a loss.

8. Corporate Accounting

Preparation of Corporate Final Accounts as perCompanies act 1956:

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Indian Companies Act has certain provision for chargingdepreciation before dividend distribution, calculatingmanagerial remuneration, presentation of Profit & LossAccount and Balance Sheet, following of Indian AccountingStandards etc. Final accounts of a company are prepared as

per these provisions of Companies Act.

Issues and buyback of Equity Share- Issue andRedemption of Preference Share and Debentures

Shares of a company is floated in the market, in case ofpublic limited company, by issuing prospectus (adocuments of all relevant details of a company) to public or

in case of private limited company, through privatechannels. All the transactions of process of application &allotment of share and calls (calling the amount due onshares from shareholders), treatment of issue on discountor at premium (i.e higher price than the face value) andsubsequent forfeiture of shares due to non payment ofallotment and call money are recorded in books of accounts.Shares may be bought back by the company itself(companies act has a provision of buy back of own sharesby a company) after floating in the market. Objective of

share buy back may be reconstitution of share capital or itmay be sheer investment.

Preference share is a particular category of share,shareholders of which generally does not have any votingrights except in some special situations. Howeverpreference share holders are supposed to get fixedpercentage of dividend (which may be cumulative dividendor non-cumulative dividend) and they will have apreferential claim of their dividend (i.e. they should get

preference in getting dividend) before the equityshareholders. There is no tax benefit on preference dividendas it is not an expense. Procedure of issue and itsaccounting of preference share are almost similar to that ofequity shares. Preference shares are normally redeemed(i.e. repaid) within a certain period. Redemption may be at

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par (i.e. face value repaid) or at premium (higher than theface value is repaid).

Debentures are fixed interest bearing securities. Interest ondebentures is a legal obligation to a company and has to be

paid out even in case of loss also. Interest of debentures isallowable expenses in Income Tax. Debentures also areredeemed within a certain period as mention the debenturedocument.

-:End:-

Acconts Notes

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