Foundation Course - Course Material

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PICT.SITM PGDBM Year 1 Trimester 1Foundation Course Financial Accounting

SECTION I - TERMS RELATING TO ACCOUNTS

Asset The property of the business entity such as land, building, stocks etc. Usually split

into current assets, i.e., working capital assets and long-term assets,

i.e., fixed assets.

Balance Sheet A summary picture of what the business owns, i.e., assets and what it

owes, i.e., liabilities as on a particular date. Usually balance sheet is

prepared at the end of one year. However it can be prepared as at

the end of every month also.

Break-even point The level of activity of the business enterprise at which all costs are

equal to sales and no profit is made. Profit is generated only if the

sales are above this point and below this point loss is made.

Brought down The term brought down or B/d is written in a ledger account at the

time of its opening to indicate that the opening balance in that

account has been brought down from the previous period.

Brought forward The term brought forward B/F is used at the head of a page to

indicate that the total amount at the head of that page has been

brought forward from the foot of the previous page.

Carried down The term carried down C/d is written in a ledger account at the timeof its closing to indicate that the balance in that account has been

carried down to the next period.

Carried forward The term carried forward or its abbreviation C/f is used at the foot

(that is the bottom) of a page to indicate that the total amount at

the foot of that page has been carried forward to the head (that is,

the top) of the next page.

CapitalNormally means permanent or long-term funds of the business introduced by the

owners of the enterprise and/or borrowed in the form of long-termloans from banks and financial institutions. In the case of a limited

company, the owners capital is called share capital. The borrowings

are called debt capital.

Cash flow This usually means a statement showing all cash inflow, i.e., cash

receipts and cash outflow, i.e., cash expenditure. The statement is

prepared at least for a period of one month with the objective of

monitoring cash flows in the business and managing liquidity.

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Contribution The difference between sales revenue and variable costs incurred to

achieve the sales revenue.

Credit To credit an account means increasing the debt owed by us to somebody who has

given us loan or supplied goods or services on credit, to record

income or to reduce money owed to us by those to whom we have

supplied goods or services on credit as and when we receive payment.

Creditors Persons to whom the business enterprise owes money due to goods or

services supplied by them or for expenses.

Current asset Working capital assets which enable a business enterprise to achieve

what is known as sales revenue by the process of turn-over of the

current assets. Current assets constantly change form from cash

back to cash through the activity of the firm, i.e., trading ormanufacturing or service.

Current liability Debt of the business enterprise which is to be settled within a

period of 12 months. They are also called short-term liabilities or

working capital liabilities, like creditors, accrued expenses etc.

Debt Money owed to external agencies, like loans, creditors etc. This is classified into

short-term, medium-term/long-term etc. depending upon the period

of repayment as well as the purpose for which it has been incurred.

If it is for fixed asset, it is medium to long-term and if it is forworking capital, it is short-term.

Debit To debit an account means increasing the debt owed by somebody to us for goods

or services supplied by us on credit till we receive payment for the

same or record expenditure or for reducing the debt owed by us to

somebody who has given us a loan or supplied goods or services to us

on credit.

Debtors The money that is owned by the business and owed to it by the

customers to whom it has sold goods or supplied services on credit

basis.

Depreciation A charge against business income to enable a business enterprise to

keep a certain % of the value of a fixed asset every year with a view

to replace it at the required time. It is a book or non-cash expense

but is recognized as a business expense by the revenue authorities.

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Direct costs Same as variable costs. These costs directly contribute to a specific

activity of the enterprise, be it manufacturing, trading etc. They

vary with the level of activity.

Dividend Return to a shareholder in a limited company on its equity investment

paid by the company out of its taxed profits every year and is often

referred to as profit distributed to share holders.

Drawings Usually a term used to indicate the amount withdrawn from the

capital account or accounts of owner/owners from the firm either in

the form of cash or kind. Drawings are debited to the capital

accounts of the owners.

Equity Money brought in by the owners in the case of a limited company. It is permanent

investment in the company and is paid back to the owners only uponliquidation of the company.

Fixed assets Long-term business assets, like land, building, machinery, vehicles

etc. which act as catalysts in the activity of the enterprise but do

not form a part of the finished goods of the manufacturing company

or stocks in trade in the case of a trading enterprise. They are

subject to wear and tear and hence require replacement after some

time. Hence, the business enterprise claims depreciation on these

assets and charges the amount to its revenue income.

Fixed costs The costs that do not vary with the level of activity of the

enterprise, namely, production or sales in the case of a

manufacturing unit. In other words, irrespective of the level of

activity, the fixed costs are required to be incurred by the business

enterprise. Further only in the short-run, say one or two years,

ignoring the effect of inflation, due to which all costs keep

increasing, these costs are assumed to be fixed.

Folio Folio means the page of any book of account.

Gearing Same as leverage. A measure of external debt in relation to the

capital of the owners of the enterprise. The higher the gearing, the

greater the risk and vice-versa.

Gross profit Difference between sales revenue and the cost of making the goods

sold ignoring the incidental expenses, like administrative expenses,

selling expenses and financial expenses.

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Income statement Same as profit and loss statement. Income statement is common for

all types of activities, be they commercial or non-commercial.

However, profit and loss statement is only in the case of commercial

enterprises.

Indirect costs Same as overheads or fixed costs. These costs contribute over all to

the activity of the enterprise and not to any specific activity. Hence

these costs are allocated to the various activities to which they

contribute unlike direct costs that are absorbed by the specific

activity to which it contributes.

Inventory Comprises materials, like raw materials, consumables/ machinery

spares and packing material, work-in-progress and finished goods.

Together with bills receivables, form bulk of current or working

capital assets.

Insolvent A business enterprise is considered insolvent when it is not able to

pay its liabilities in full from the proceeds of its assets.

Journal entry An entry which forms the core of double-entry book keeping, by

debiting an account head and crediting another account head for a

financial transaction. It is also used for rectifying entries wrongly

made earlier, adjustment, transfer from trial balance to profit and

loss account and subsequently from profit and loss account to

appropriation account and balance sheet.

On account The term may mean one of the following:

(a) Purchase or sale of goods or assets on credit;

(b) Receipt of payment of money in part settlement of an existing

amount due to be received or paid;

Liability Amount owed by the business enterprise to outside agencies, which

have provided resources either in the form of money, as in the case

of bank over draft or goods as in case of creditors or services as in

the case of accrued expenses.

Loss Excess of expenditure over income in a particular accounting period.

Margin of safety The difference between sales and the break-even point sales. It

should be as high as possible.

Net current Difference between current assets and current liabilities. This

Asset is called as Net working capital.

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Net fixed assets Gross fixed assets (purchase price) as diminished by depreciation

(cumulative).

Overdraft A credit facility by which a customer of the bank can draw up to a

pre determined limit against some tangible security like inventory or

receivables or mortgage.

Over heads Indirect expenses that cannot be attributed to a specific activity

and hence are allocated over a bunch of activities.

Payables Also known as bills payables or money owed by the enterprise to

various creditors.

Posting Posting is the process of entering in the final book called Ledger theinformation already recorded in any other subsidiary book, like, sales

register, purchases register, cash book, bank book etc. It can also

be defined as transfer of entries from subsidiary book to general

ledger. This is done periodically, say weekly at the maximum

frequency level, or monthly at the minimum frequency level.

Profit Excess of sales revenue over expenditure.

Profit and loss A detailed and consolidated statement of all income and expenditure

Statement prepared at the end of a specific period, like month, quarter, half- year and year. However, the revenue authorities are insistent on

yearly statements and the other statements are meant for

management purposes.

Purchases Represent goods purchased for business purposes and are treated as

expenditure in the income and expense statement.

Receivables Also known as sundry debtors or bills receivables or book debts.

Represent money owed to the enterprise by debtors.

Reserves or Accumulated profits retained in business over a period of time.

Retained This is net of profit distributed in the form of dividend.

Earnings

Returns Either purchase returns or sales returns representing goods

returned on purchases or sales due to defects which stand adjusted

either in the amounts due from us or due to us or by replenishment

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of stocks with quality goods. Purchase return is also called return

outward and sales return is also called return inward.

Shareholders Share capital plus all kinds of reserves representing profit

Funds retained in business over a period of time.

Solvent Means that the business enterprise is able to meet its liabilities with

all its assets.

Variable costs Costs that vary with changes in the level of activity be it trading or

manufacturing or sales. Mostly direct costs vary.

Voucher Voucher refers to any written document in support of a financial

transaction.

Working capital Gross working capital = Total current assets

Net working capital = Total current assets (-) total current liabilities.

*** End of section 1 ***

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You have an outstanding debtor to the extent of Rs. 1 lac. The outstanding

bill gets paid and you deposit the cheque in your current account.

Effect - The outstanding debtors reduce to nil (asset) and the current account

Balance gets increased by Rs.1lac (another asset)

You make payment of a car repairs bill in cash.

Effect - Expenditure for the year increases - Expense account is affected

Cash account is affected as cash has been given out.

Rent income is received in cash.

Effect - Income level goes up for the accounting period & since cash has been

received, the cash balance also goes up.

Thus in all the examples that we have seen, two account heads invariably get

affected. That is why it is called double entry bookkeeping.

Accrual system of accountingAccounting period is of importance for recognising an expense or income. Whether cash

has been spent or come in is of no consequence. As a result of this, we have four

important account heads in the balance sheet of the company at the end of the accounting

period

Expense already met, but a part of it or whole of it pertains to the next accounting

period - pre-paid expense

Income already received, but a part of it or whole of it pertains to the next accounting

period - income received in advance

An expense pertaining to the current accounting period but not yet met - it has to be

booked as an expense during this period. Called by different names, provision, accrued

expenses etc.

An income pertaining to the current accounting period but not yet received - it has to

be booked as an income during this period. Called accrued income.

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One Practical illustration of Financial Accounting from day to day

life

The following illustration will serve as a window to accounting. We believe that one can

learn almost all about accountancy from this simple illustration from our day-to-day life.

It is a case of a small tea stall. Say, our friend Soma starts a tea stall. Soma brings Rs1000

on his own and borrows Rs1000 on the condition that he will have to pay an interest of

Rs300 at the end of every month. That's all he can borrow at present. Thus Soma has a

total of Rs2000, i.e. total funds available with Soma for employment in business,

(accountants call it total capital employed) represented by Rs1000 of his own money

(owners' funds same as shareholders funds) and Rs1000 of borrowed money (debt or

borrowings).

He buys a hot plate, vessels and crockery. These are the assets he will need to make tea

everyday (accountants call them fixed assets) for Rs1000. Fixed assets are assets which a

businessman uses to manufacture or run his business and does not intend to sell them in

the normal course of business. Then he buys material required to make tea viz., milk, sugar,

tea powder (stocks or inventory, part of working capital) for Rs500. Cash left with him is

Rs500.

On Day 1, he sells 100 cups of tea at Rs5 each. The tradition in the area is that you

are paid on the next day. At the end of the day, Soma has not got a single penny

from sales but he knows that he will get Rs500 tomorrow (i.e. his receivables ordebtors are Rs500). At the end of the day, he is also left with Rs200 worth ofstock (sugar, tea leaves etc) that is usable on the next day. Inventory at the end of

the day is Rs200. He has hired a helper who would cost him Rs50 per day. Thehelper's salary will be paid on weekly basis. Besides, he has to pay Rs10 as interest

on the loan. The amount payable to helper and interest are payables or more

specifically creditor for expenses. You can imagine that in a business, you will have

substantial creditors for goods also.

Basic Accounting PrinciplesSoma has not received a single penny at the end of day 1, but we know that he generated

sales of Rs500 and material cost was only Rs300 (i.e. material purchase of Rs500, net of

stock at the end of the day of Rs200). In other words, his gross profit was Rs200. We are

taking into account sales and profits despite no money being actually received. This is

called the Accrual Principle.

Consider material cost on day 1. Logically, we take material cost at Rs300, i.e. raw material

net of stock left at the end of the day. In other words, we are trying to match the revenue

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of a particular period with cost of that period only. This is called the Matching Principle.

Imagine what will happen, if at the end of day 1, Soma has to close his business and sell all

his assets. Fixed assets for which he paid Rs1000, may barely realize Rs200 in a distress

sale. But in all probability, he will run his business for a long time and even if he sells he willsell as a going concern and not as vessels and crockery. So, should we take this possible loss

of Rs800. Obviously not. The reason is that we know and we presume that Soma's business

will go on, This is called Going concern Principle. In other words, we presume that the

business concern will continue to go on and Soma will not be compelled in distress to sell his

fixed assets.

If at the end of the day, somebody promises you that he will buy your 200 cups of tea at

Rs6 tomorrow. Will you consider that you have already made a profit? A prudent

businessman will not. But on the other hand, if you discover that some of your raw material

is damaged or not usable on the next day, a prudent businessman would consider that as aloss. This is called the Principle of Conservatism.

These are all the core principles based on which accounting is done and a balance sheet is

prepared for even the largest company in the world. We will also analyze some balance

sheets (of course, it has to be an Indian company!).

Balance Sheet Has To Tally

Balance sheet is a statement containing the details of where the money has come from and

where it has gone. By its very definition, it has to tally. It is like saying that you left home

with a 100-rupee note in your pocket, spent some money at various places and came backhome. If you have lost some money, you will have to show it as a loss. All expenditures and

the balance left in your pocket have to be Rs100 plus any receipts you might have received

on the way. We will come back to balance sheet with our Soma's example.

Types Of Capital

To run any business the money you raise can be your own or somebody else's. Your own

money can be money received on inheritance, dowry, earned by your own hard work or as

received as gift. The test that you own money is money that you do not have to account

for, nor do you have to return it to anybody ever. All that is not your own money would fall

under the head - borrowed money. This is the money that belongs to somebody else and will

have to be returned and in most cases with some additional charge for use of that money.

That charge is called interest cost.

Types Of Assets

Fixed assets form the productive capacity for any business and are not traded in the

course of the business. In our example, hot plate, vessels, crockery form fixed assets

whereas milk, tea, sugar, receivables, payables etc form working capital. In working capital,

the ones that will get converted into cash are called currentassets. The ones that have to

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be paid in cash (or kind) are called current liabilities. Working capital is current assets

minuscurrent liabilities. This is also referred to as Net Working Capital. The readers

are well advised to get used to different terms relating to the same concept. At times, the

term working capital could refer to total current assets instead of only the difference

between current assets and current liabilities. Hence we prefer to use the following termsto refer to these two gross and net phenomena.

Gross Working Capital = Total current assets

Net Working Capital = Total current assets (-) Current Liabilities

To define again, current assets are assets that are expected to be converted into cash in

normal business cycle (typically less than a year) and current liabilities are liabilities

expected to be paid in cash in normal business cycle (typically less than a year). Fixed

assets under normal circumstances are used for a much longer period.

Depreciation

Obviously, fixed assets also deplete in value and have a life longer than one year but not

eternal. So any prudent businessman would understand that he has to recover the value of

fixed assets over a period of time. In case of Soma's tea business, let us say life of

vessels and crockery is 100 days. Rs1000 worth of fixed assets will need replacement on an

average after 100 days. It is as good as incurring a cost of Rs10 per day. Although you pay

once in lump sum, it is equivalent of paying a rental of Rs10 per day. When you have bought

the assets the rental cost is not to be paid to anybody but it is still to be reduced on a

notional basis. This notional cost is called Depreciation.

Trial Balance

Soma had started his business with Rs1000 and borrowed Rs1000. His activities on the

first day have been discussed.

The preliminary balance sheet or statement of Soma's business (called trial balance) on day

1 will look as follows. Trial balance is a statement showing balances of sources/ recipients

of money. It is a combination of profit and loss account and balance sheet.

Item Dr CrOwner's funds 1000

Borrowed funds 1000

Sales revenue 500

Receivables 500

Raw material stock 200

Raw material expense 300

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Fixed assets 1000

Cash balance 500

Salary 50

Interest 10Payable for expenses 60

Total 2560 2560

Profit & Loss Account

Soma's profit and loss account will be the same as your estimate of his profits or loss

going by common sense. Let us have a look at it.

Sales revenues 500

Raw materials -300

Salary -50

Depreciation -10

Interest -10

Net profit 130

Balance Sheet

The money with which we start business, will increase by the quantum of profit and

decrease by the quantum of loss.Therefore in our balance sheet, the sources of total fund available at the end of any period

are:

Your own money (equity)

Plus profits (if any) or

Minus losses (if any)

Plus other people's money (borrowings)

These funds are represented by

Fixed assets

Plus working capital.

Equity capital 1000

Net profit 130

Borrowings 1000

Total capital available 2130

Fixed assets 1000

Less depreciation 10

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Net fixed assets 990

Tea/sugar stock 200

Receivables 500

Payables -60Cash balance 500

Total capital used 2130

Cash Flow And Fund Flow

For all practical purposes fund flow and cash flow are similar. In case of Soma's tea stall,

the business saw a cash inflow of Rs1000 on account of equity, Rs1000 on account of debt,

outflow Rs1000 on account of fixed assets, Rs500 on account of working capital and at the

end of the day he was left with a balance of Rs500.Cash flow statement is as simple as below:

Cash Flow Statement (Rs)

Source of cash

Owners' funds 1000

Borrowed funds 1000

Total cash raised 2000

Use of cash

Material purchased -500

Fixed assets -1000

Cash balance 500

Note that in cash flow statement, we do not take sales revenue, depreciation, salary etc

because there has been neither cash inflow nor cash outflow in the period under

consideration.

We may make cash flow in a slightly different manner on the basis of activities. Working

capital can be treated as a use of funds and profits as a source. This facilitated financial

planning.

Cash Flow Statement

Operating activities

Net profit 130

Depreciation 10

Cash profits 140

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In every business transaction there are two aspects, you get or promise to get something

and in return you give or promise to give something.

There is no third aspect to any transaction. The former is your Debit and the latter is

Credit. Look at every transaction from the perspective of the business.

Let us go back to our example

For Soma's tea stall, look at all the transactions and debit credit accounting.

Soma brings his own Rs1000 in to the business.

What business gets is Cash - Debit

What business promise to give is Owners' funds or Equity - Credit

There is an underlying assumption or promise that owners will get back their money.

Soma borrows Rs1000

What business gets is Cash - Debit What business promises to give is Lenders (debt) - Credit

You promise to repay debt. You have to provide for interest cost also

Soma buys raw material worth Rs500

What business gets Raw material - Debit

What business gives is Cash - Credit

Soma buys fixed assets worth Rs1000

What business gets Fixed assets - Debit

What business gives is Cash Credit

Soma sells 100 cups of tea for Rs500 on credit

What promise business gets Receivables (Debit) - Debit

What business gives is Goods (Sales) - Credit

Soma hires a helper at Rs50 per day

What business gets Salaries (services) - Debit

What business promises to give is Creditors - Credit

You promise to pay salary at later date

Raw material consumed Rs300

What business gets Cost of sales (material used for earning revenue) - Debit

What business promises to give is Raw material - Credit

Interest on borrowing Rs10

What business gets is Interest - Debit (refers to use value of money)

What business promises to give is Lenders (debt) - Credit

You promise to pay interest

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For depreciation on fixed assets

What business gets is Depreciation - Debit (refers to gain from use of fixed assets)

What business promises to give is Lenders (debt) - Credit

Ledger accounts refer to balances of debits and credits in each account. The debit

balances get reduced by credit ones and vice versa. The net balances are tabulated in a

statement, which is called Trial Balance (discussed above).

Adjustment Entries

At the end of the year, some transactions may have been missed till the time of preparing

trial balance. One can pass journal entries (i.e. debit, credit that we saw above), re-

calculate the ledger balances. Generally, transactions that do not take place in cash may

not get left out. For instance, in case of Soma's tea stall, he had a helper costing Rs50 perday. He may forget to account for the same as he has not paid the salary at the end of the

first day. But salary cost has been incurred and it has accrued for the business. After

preparation of trial balance, you can adjust your account to give effect to the fact that

profits are lower by Rs50 and liabilities are higher by Rs50. Such entries are called

adjustment entries.

*** End of Section II ***

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SECTION III - FINANCE AND ACCOUNTS CONCEPTS

1. Cash system of accounting A system in which an expenditure or income is accounted

for only when cash is paid out or received into the system respectively. Income =

Receipt of cash and Expenditure = Outgo of cash. There is no concept of period of

income or expenditure in this system. In India, small enterprises adopt this method inthe initial stages of enterprise.

Larger enterprises are forced to settle even substantial Octroi payments through

cash only and hence one and all adopt cash system in India for Octroi payment. Not a

reliable system of accounting once the enterprise crosses certain stage of growth.

2. Accrual system of accounting A system in which an expenditure or income is

accounted for as soon as it is incurred or accrued respectively. There is a concept of

uniform accounting period, which in India is April March. Most of the enterprises

adopt April March year as the financial year also, as otherwise, as per existing

Income Tax Rules, the books of accounts would be required to be closed twice in a

year, once in April-March for Income Tax purposes and the second time for their

specific financial year ending.

The accounting period to which income or expenditure pertains is of paramount

importance in this method. The accounting period in which the cash out flow occurs in

the case of expenditure or cash inflow occurs in the case of income does not matter at

all. Best examples of this system Accrued income, Accrued expenses, Prepaid

expenses and Income received in advance. In India and internationally, most of thebusiness enterprises adopt Accrual System of Accounting once they are established in

their respective business.

A very reliable system of accounting with the possible shortcoming of paying tax on

unreleased profits also. Suppose a sale had been made during 1997-98 for Rs.500 lacs,

which was outstanding as at 31/03/98. The realization of the amount has not taken

place. However, on the profit accruing to the enterprise on this sale, income tax would

have been computed and tax paid accordingly.

3. Difference between cash and fund Cash means money and does notinclude credit or kind. Fund includes every thing like credit or kind. For example,

a supplier supplies materials on credit for which payment is not made immediately.

Till the payment is made by us, the supplier has given us moneys worth of goods.

Similarly services would also be provided. Thus fund could mean, either physical

cash or credit for supply of goods or services. Hence, at times, the term fund

also refers to money or moneys worth (OR) cash or kind.

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Another example is in case capital is brought into an enterprise in a form, other than

cash; say in the form of land or building or machinery or vehicle. This is also fund but

would not fall under the category of cash.

4. Components of cash flow statement Cash management is usually done on the basis of

cash inflow and cash outflow. The cash receipts and cash expenditure are reflected in

a statement called cash flow statement. This statement can be prepared at a

predetermined frequency, say every day, every week, every fortnight or every month.

Usually it is not prepared at a frequency, which is less than a month. It has revenue

receipts, revenue expenditure, capital receipts and capital expenditure unlike profit

and loss account, which has only revenue items of income and expenditure. The details

of revenue receipts/revenue expenditure and cash receipts/cash expenditure are

given in the following points.

5. Medium and long - term liability Any liability, which is not due within a period of 12months but due within a period of 5-7 years like debenture or term loan is called a

medium-term liability. In case the liability is due beyond 7/10 years like deep

discounted bond, then it is called longterm liability.

6. Revenue Receipt Receipt from operations unlike capital receipt like sale of a capital

equipment etc. Usually a period of 12 months is taken as the period in which revenue

receipt should occur.

7. Revenue Expenditure Expenditure for operations unlike capital expenditure like

purchase of machinery etc. Usually a period of 12 months is taken as the period inwhich revenue expenditure should occur.

8. Capital Receipt Receipt from owner in the form of capital or loans from lenders

which need not be repaid within 12 months. Generally all sources, which go in for

purchase of capital assets, are called capital receipts.

9. Capital Expenditure Expenditure towards purchase of capital assets or repayment of

an earlier capital receipt.

10. Opportunity cost and opportunity gain A phenomenon arising out of comparison

between returns on alternative investment opportunities available to an investor. For

example an investor gets return of 13% p.a. in bank deposits, while he can get 18% in

shares, the opportunity cost of investing in bank deposits vis--vis the investment in

shares is 18% - 13% = 5%. As against this, the investment in shares fetches an

opportunity gain of 5% p.a. Thus opportunity cost and gain are relative terms and

absolutely dynamic, as the returns even in the case of same investment vary from time

to time.

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Opportunity cost or gain is a dynamic concept and not static one. Further it is a

product of time and holds good only for a short period. It is always determined for a

pair of alternative investment opportunities.

11. Pre-tax expenditure and post-tax allocation All operating expenses like interest,

wages salaries etc. are pre-tax expenditure as they are met out of income of an

organization and not out of profits. As opposed to this, profits distributed to owners

of the company are out of taxed profits and hence they are referred to as post tax

allocation. For example, dividend is a post tax allocation. This can be appreciated by

keeping in mind three stages of income profit and profit allocation in a business.

Stage 1 income from operations and other income like dividend etc.

Stage 2 determination of profit for a given period after setting off all the

operating expenditure pre-tax expenditure, against income for the same period andpayment of tax on the same.

Stage 3 Distribution of profit after tax (some portion) among the owners of the

company in the form of dividend post-tax allocation, while keeping the balance

portion in the business itself in the form of reserves.

12. Difference between liquidity and profitability While liquidity means availability of

cash to meet all the liabilities, it need not indicate profitability of operations. An

enterprise can be liquid because its position of cash is comfortable, i.e., the cash

inflow is greater than cash out flow because of owners capital as well as otherborrowed funds, whereas, its operations need not be profitable, i.e., expenses could be

more than income. On the contrary, an enterprise can be profitable but because of

delay in realization of sale bills, it could be in cash crisis.

Thus liquidity and profitability are two independent phenomena and mostly move in

opposite direction. Example - Current Assets. The level of current assets does

indicate the level of liquidity available with an enterprise and in case it is too high the

profitability does dip in due to the cost of carrying a high level of current assets and

vice-versa.

13. Concept of reserves in the case of limited companies Reserves in the case of limited

companies represent profit retained in business since the inception of business. Profit

after tax has two components the distributed component in the form of dividend and

the retained component in the form of reserves. While in the case of a partnership

firm, the entire profit after tax can be distributed to the partners, in the case of

limited companies, a portion of the profit after tax (minimum) has to be set-aside in

the form of General Reserves, before declaring dividend.

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Reserves are of different kinds, but the major bifurcation of reserves is into free

Reserves and committed reserves. Committed reserves represent funds earmarked

for specific purposes like redemption of preference share capital, debentures etc.

while free reserves can be utilized for any purpose like declaration of dividend in

future or issue of bonus shares to existing equity shareholders.

Again in the case of partnership firms, the profit retained in business is transferred

to capital of the owners at the end of the period, while in the case of limited

companies, it is required to be shown separately as reserves. Most of us do tend to

think that reserves mean funds set aside for specific purposes, whereas they only

represent funds earmarked for specific purposes and not kept outside the business.

The funds are kept in business only, just as funds brought in by the owners in the form

of capital.

14. Importance of depreciation Depreciation as seen under Accounting Concepts is tomake a provision out of the income of the enterprise every year to take care of

requirement of funds for replacing an old asset as and when it is worn out.

Depreciation is an important tool in tax planning, as to the extent of depreciation

claimed in business, the profits are less and so is tax. Thus depreciation is necessary

for tax planning.

Depreciation also provides funds to the enterprise, as there is no cash outlay in this

case, unlike other operating expenditure involving cash outlay. Again depreciation fund

is not kept in any bank account, but invested in business assets only. Depreciation

funds can be used along with internal accruals for repayment of loan installment.

15. Amortization There are certain expenses incurred in a business enterprise, like

patent registration fees, copyright fees, franchise fees, preliminary expenses

representing company incorporation expenses, public issue of debt or equity expenses

like debenture and share capital etc. These are called deferred revenue expenditure

as they are incurred at one point of time and get written off over a period of time

against future income, unlike revenue expenditure that gets written off during the

year in which it is incurred.

Further, these expenses give benefit for a long time to the enterprise but do not

generate tangible assets. Hence they are also referred to as intangible assets.

Such deferred revenue expenditure gets written off through amortization unlike

depreciation in the case of fixed assets, which are tangible. The only exception of an

intangible asset, which is entitled to depreciation, is Technical Collaboration Fees

paid to a collaborator, who has provided production technology to us.

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16. Broad break-up of operating expenditure in a manufacturing unit

Expenses relating to production

a) Expenses on material raw material, packing material, consumable stores and

machinery spares;

b) Wages paid to workers including employers contribution to Provident Fund, bonus, ex-

gratia, uniform and other incidental expenses etc.

c) Expenses for manufacturing like depreciation on fixed assets used in factory, repairs

and maintenance on fixed assets used in factory, salaries paid to factory personnel,

utilities like power, water and fuel etc.

Expenses relating to administration General and administrative expenses like

salaries paid to administrative personnel, other administrative expenses, a host of

them like printing and stationary etc.

Expenses relating to sales Selling expenses, both direct and indirect.

Finance expenses Interest, commission, brokerage, discount and others.

Note: In the case of a trading unit, there will be no manufacturing expenses and

hence manufacturing expenses would be absent. However, material would be replaced

by trading stocks and further, if the trading unit repacks the material before selling

in the market, packing expenses would also be incurred and this has to be included.

Similarly, in the case of a unit extending services, be it in finance or any other field,

the unit will not incur any expenditure on account of materials at all. Hence, in the

case of a service unit, the expenses would only be general and administrative expenses,

besides selling expenses, if any, and of course, financial expenses towards loans taken

etc.

17. Different forms of Business organizations Sole Proprietorship firm, which is owned

by only one person. Very easy to form and no statutory regulation applicable, unlike in

the case of partnership firm and limited companies. Depending upon the activity

undertaken by the sole proprietor or proprietress, registration or license formality

would have to be complied with.

For example, commercial enterprise would be required to have license under The

Shops and Establishment Act from the local governing body. In case it is a

manufacturing unit, it requires registration under The Factories Act from the

concerned State Government. Further, in case the goods manufactured by the unit

are excisable, it requires license under The Excise Act. Sales Tax Registration

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would also be required to undertake any sale. The registering authority is the

concerned State Government and any inter-state sale would require Central Sales Tax

Act registration number.

The proprietorship firm does not have any legal entity and is always identified with the

sole proprietor. The income of the firm gets added to the income from other sources

of the sole proprietor before determining the tax liability of the owner. The income

of the firm is separately not taxed.

Partnership firm Two or more persons coming together for the purpose of business

can form a partnership firm. The maximum number of partners is 20 in the case of a

firm, which does not do banking business and 10 in the case of banking business. The

governing statute is The Partnership Act. The governing document is The

Partnership Deed, which is drawn as per the provisions of The Partnership Act.

A partnership firm has a better legal status than a sole proprietorship firm. However,

due to any change in the partnership firm like death of a partner, admission of another

partner or retirement of a partner, the firm has to be reconstituted and hence its life

is limited, unlike a limited company, which has perpetual succession. The firm requires

registration from The Registrar of Firms, which is a state government body. Unless a

partnership firm is registered, it cannot file any suit against any other person, body

for settlement of disputes. However, any other aggrieved party can haul up an

unregistered firm in a court of law.

Usually an aggrieved party filing a suit against a partnership firm files a joint caseagainst the partners and the firm. All the partners are liable for the loss of the firm

in their individual capacity also besides being partners. This means that their property

can be attached by a court of law in settlement of dues of the firm to a creditor and

when the assets of the firm are not adequate to meet the liability in full. Thus

liability of a partner is unlimited and he shares a joint and several liabilities with all

the other partners.

Advantages Has better ability to raise resources than a sole proprietorship firm.

Not many statutory regulations are applicable in the case of partnership firms unlike in

the case of limited companies.

Available expertise for running business is much more and risk associated with

business is shared among the partners.

Disadvantages Does not have full-fledged legal status. It is a very flexible form of

organization and hence disputes are more common among partners. In this connection,

please see the point below, on the provisions of partnership deed.

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Although credibility is better than a sole proprietorship firm, it can grow only up to a

certain level, beyond which, without converting it into a private limited company, we

cannot raise resources, especially debt.

Provisions of partnership deed Should be drawn in accordance with the provisions of

The Partnership Act.

Ratios for sharing the following, among partners

a) Capital,

b) Profits,

c) Assets of the firm on liquidation of the firm,

d) Losses etc.

Ratios b, c and d above need not be the same as the ratio a. In case these ratios

are not specifically mentioned, then b, c and d follow a.

Payment of salary to one or more partners who are working as per the Income TaxRules in this behalf;

Payment of interest on partners capital;

Receipt of interest on drawings of the partners;

Taking loans from the partners with interest payment;

Giving loans to partners with interest;

Provision relating to the maximum amount of drawings that each partner can make

from his capital in a year;

Admission of a minor partner to the benefits of the partnership firm;

Retirement of a partner and admission of a new partner with settlement of capital to

the exiting partner in accordance with the goodwill formula as provided in the deed.

18. Funds Flow statement A statement showing the movement of funds during a given

period, mostly a year. Herein, fund from operations forms the base, which means that

internal accruals (Profit after tax less dividend declared + depreciation and other non-

cash expenditure) are the starting point for the funds flow statement. Usually funds

flow statement is not concerned with revenue receipts and revenue expenditure but is

only concerned with changes in position of assets and liabilities during a given period.

Note the difference between funds flow statement and cash flow statement. Cash

flow statement deals with all cash generated from operations as well as other sources

and cash expended for operations as well as other purposes.

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BALANCE SHEET AND PROFIT AND LOSS ACCOUNT

STATEMENTS LINKAGE BETWEEN THEM

A sample of Profit and Loss Account (Rupees in Lacs)

Income from operations 100

Operating expenses:

Salaries 30

Repairs and maintenance 3

Depreciation 10

Office and general expenses 10

Marketing expenses

Including Commission 7

Interest and other

Charges 10Total expenses 70

Profit before tax 30

Tax at 35% 10.5

Profit after tax 19.5

Dividend 7.5

Profit retained in

Business 12.0

(Retained earnings)

Learning Points:

Interest is charged to income before determining the profit of the organisation.

Once the profit of the organisation is determined, tax is paid at the stipulated rate

and the dividend is paid only after this. Thus, dividend is profit allocation.

This difference between interest and dividend gives opportunity to business

enterprises, to have a mix of capital of the owners and loans taken from outside, so

that they can save on tax, through the interest charged as expense on the income. The

amount of tax so saved is called tax shield on the interest.

In the case of profit distributed among the partners as well in the case of dividenddistributed among the shareholders, these are not taxed again in the hands of the

owners.

Linkage between balance sheet and profit and loss accounts:

The above statement is known as the Profit and Loss Account. This records the income

and expenditure for a given period and is closed as soon as the period is over. The

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residual profit, as it belongs to the owners, gets transferred to the capital account in

another statement, called Balance Sheet.

The balance sheet tells us about the following:

How much money has the business enterprise raised?

Which are the sources for the money?

What is the use for this money?

The balance sheet is also known as Assets and Liability statement.

A sample balance sheet is shown below - (Rupees in lacs)

Liabilities Assets

Share capital: 100 Fixed Assets: 60Reserves: 150 Less: Depreciation 30

(Retained profits Net Fixed Assets 30

over a period of Investments: 80

time)

Net worth 250 Bills Receivable 100

Bank overdraft 30 Cash and Bank 35

Creditors for expenses 10 Other current assets 60

Other current liabilities 15 Total current assets 195

Total current liabilities 55

Total Liabilities 305 Total Assets 305

Suppose profit for the year is Rs.30 lacs after paying tax and dividend. This would be

transferred to the balance sheet and the reserves at the end of the current year would

be Rs.150 lacs + Rs.30 lacs = Rs.180 lacs. Similarly the depreciation claimed on the fixed

assets and shown as an operating expense would also get transferred to the balance sheet

to reduce the value of the fixed assets.

Let us assume that there is no increase in the fixed assets during the year that there are

no other changes and the depreciation for the year is Rs.10 lacs. We can construct the

balance sheet for the next year without much change, excepting to accommodate these

figures of depreciation and increase in reserves.

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The balance sheet as at the end of the next year would look as under: (Rupees in Lacs)

Liabilities Assets

Share capital 100 Fixed assets 60

Reserves and 180 Less: depreciation 40

surplus

Net worth 280 Net fixed assets 20

Bank overdraft 30 Investments 100

Creditors for expenses 10 Bill Receivable 120

Other current liabilities 15 Cash and Bank 35

Total current liabilities 55 Other current assets 60

Total current assets 195

Total liabilities 335 Total Assets 335

We see that between the two balance sheets, there are two changes

Investment has gone up by Rs.20 lacs and Bill receivable has gone up by Rs.20 lacs. The

total is Rs.40 lacs. Where have these funds come from? This amount is the total of

profit transferred to balance sheet from the profit and loss account and depreciation

added back, as it does not involve any cash outlay. The figure is Rs.30 lacs + Rs.10 lacs =

Rs.40 lacs. This figure is referred to as internal accruals. This need not be the case all

the times. Where we use these funds entirely depends upon the business priority and

what we have shown is only a sample.

Learning Points:

The business enterprise generates funds from operations, known as internal accruals

comprising depreciation (which is added back, being only a book-entry) and profit after

tax and dividend;

Where these funds are used is entirely dependent upon business exigencies;

Depreciation claimed in the books as an expense goes to reduce the value of the fixed

assets in the books, while profit after tax and dividend is shown as Reserves and

increases the net worth of the company.

The above form of balance sheet is the summarised form of balance sheet and not a

detailed one

*** End of Section III ***

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