1

Interpretation of Financial
Statements
2
BUSINESS ACTIVITIES
FORMS OF BUSINESS
Sole Proprietorship
Partnership
Company
Private Limited Company
Public Limited Company
NGOs
3
DEFINITION OF ACCOUNTING
Accounting is the process of
identifying,
measuring and
Communicating
economic information to permit
informed judgements and
decisions by users of the
information.
4
Definition of A/c (contd)
Accounting is a service
activity. Its function is to
provide quantitative
information, primarily financial
in nature, and about economic
activities, that is intended to be
useful in making economic
decisions.
5
FINANCIAL STATEMENTS
BALANCE SHEET
PROFIT & LOSS ACCOUNT
CASHFLOW STATEMENT
6
USERS OF FIN. ST.
PRESENT & POTENTIAL SHAREHOLDERS /
TRUSTEES / MEMBERS
EMPLOYEES
LENDERS
SUPPLIERS & OTHER CREDITORS
CUSTOMERS
GOVERNMENT & ITS AGENCIES
PUBLIC
7
OBJECTIVE OF FS
USERS INFORMATION NEEDS
1) Liquidity
2) Profitability
3) Solvency
8
TYPES OF ACCOUNTING
Financial accounting
Income-tax accounting
Cost accounting
Management Accounting (Management
Control Systems)
Management Reporting
9
ACCOUNTING
MECHANICS
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ACCOUNTING EQUIVALENCE
Assets = Owners Equity +
Outside Liabilities
A = OE + OL
11
DOUBLE ENTRY SYSTEM
A
A
= OE + OL
= OE + OL
In the double-entry accounting system,
every transaction is recorded by equal
amounts of debits and credits.
In the double-entry accounting system,
every transaction is recorded by equal
amounts of debits and credits.
Debit
Debit
=
=
Credit
Credit
12
ACCOUNTANTS LIFE
A
A =
OE
OE + OL
ASSETS ASSETS
Debit
for
Increase
Credit
for
Decrease
EQUITIES EQUITIES
Debit
for
Decrease
Credit
for
Increase
LIABILITIES LIABILITIES
Debit
for
Decrease
Credit
for
Increase
Debit Credit
ASSETS
+ -
LIABILITIES
- +
Debit Credit
EQUITIES
- +
Debit Credit
13
ACCOUNTING CYCLE
1. Business Transaction
2. Transaction is recorded in document
(Voucher / Receipt)
3. Analyze the transaction location ?
4. Journal Entry
5. Ledger Accounts (or T account)
6. Trial Balance
7. Balance Sheet, P&L A/c, Cash Flow
Statement
14
Balance Sheet
P & L A/c
Cash Flow
Prepare a trial
balance
Post to the
ledger
Journal Entry
Source
documents Transaction
Analyze
ACCOUNTANTS ROUTINE
15
Post to the
ledger
Source
documents
Journal Entry Prepare a trial
balance
Balance Sheet
P & L A/c
Cash Flow
Transaction
Analyze
ACCOUNTANTS ROUTINE
16
TRANSACTION-1
Chirag started business with cash Rs.30,000.
The accounts involved are:
The accounts involved are:
(1) Cash (
(1) Cash (
asset
asset
)
)
(2) Owner
(2) Owner

s Equity (
s Equity (
equity
equity
)
)
Assets = OE + OL
Cash Supplies Equipment
Accounts
Payable
Notes
Payabl
Owners'
Capital
(1) 30000 30000
30000 0 0 0 0 30000
30000 = 30000
17
TRANSACTION-1
Chirag started business with cash Rs.
30,000.
The accounts involved are: The accounts involved are:
(1) Cash ( (1) Cash (asset asset) )
(2) Owner (2) Owner s Equity ( s Equity (equity equity) )
JOURNAL ENTRY Page 1
Date Particulars LF Debit Credit
2001
Dec. 1 Cash 30,000
To Capital 30,000
Investment by owner
Debit Credit
EQUITIES
- +
Debit Credit
ASSETS
+ -
18
TRANSACTION-1 - LEDGER
JOURNAL ENTRY Page 1
Date Particulars LF Debit Credit
2001
Dec. 1 Cash 30,000
To Capital 30,000
Investment by owner
Capital
(1) 30,000
Capital
(1) 30,000
Cash
(1) 30,000
Cash
(1) 30,000
19
Matching of
Revenues & Expenses
20
INTRODUCTION
Companies need a way to measure
performance over discreet time periods.
The most popular period for measuring
income is fiscal year.
The fiscal year ends on 31
ST
March.
21
BASIS OF A/C
Accrual basis - recognizes the impact
of transactions for the time periods
when revenues and expenses occur
even if no cash changes hands
Cash basis - recognizes the impact of
transactions only when cash is
received or disbursed
22
MATCHING CONCEPT
Fundamental Accounting Concept
Matching Concept is:
Expenses incurred in earning revenue
must be matched with the
revenue earned during the current accounting
period for determining results of operations
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MANUFACTURING CO.
Trading v/s Manufacturing
Kind of Inventory
Nature of Costs
Inventory in Manufacturing Co.
Raw Materials
Work in Process (WIP)
Finished Goods
Stores & Spares
Costs in Manufacturing
Direct Costs
Indirect Costs
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COSTS
Direct Costs
are costs which can be traced to the
cost object in economically feasible way.
Indirect Costs
are costs which cannot be traced to the
cost object in economically feasible way.
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COGM
Cost of Good Manufactured (COGM)
= Direct Cost + Indirect Costs
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COGM
Cost of Good Manufactured (COGM)
= Direct Cost + Indirect Costs
Cost of Good Manufactured (COGM)
= Cost of RM Consumed
+ Other Direct Cost of Manufacturing
+ Indirect Cost of Manufacturing
+ Opening Stock of WIP
- Closing Stock of WIP
Skip Next
27
COST OF RM CONSUMED
Cost of RM Consumed =
Opening Stock of RM
+ RM Purchased
+ Directly Attributable Cost for RM
Purchase
- Purchase Returns of RM
- Closing Stock of RM
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COGS
Cost of Good Sold (COGS)
= Cost of Good Manufactured (COGM)
+ Opening Stock of Finished Goods
- Closing Stock of Finished Goods
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COSTS
Product costs - those linked with
revenue earned in the same period
Cost of goods sold or sales commissions
Without sales there is no cost of goods sold
or sales commissions.
Period costs - those linked with the
time period itself
Rent or other administrative expenses
Rent is paid even if no sales are made.
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MATCHING OF EO EXPD.
MATCHING OF EXTRA ORDINARY
EXPENDITURE
Depreciation
Large Advertisement Expenditure
Personnel Training & Development
Research & Development
Unusual Expenses, Natural Calamities
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INVENTORY
AS 2:
Inventories are defined as assets
i. held for sale in ordinary course of
business, or
ii. in the process of production for such
sale, or
iii. in the form of materials of supplies to be
consumed in the production process or
in the rendering of services
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INVENTORY VALUATION
FIRST-IN-FIRST-OUT (FIFO)
LAST-IN-FIRST-OUT (LIFO)
SIMPLE AVERAGE
WEIGHTED AVERAGE
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P & L A/C
The income statement is really just a
way of explaining changes that occur
between one balance sheet date and
another.
The balance sheet equation can be
manipulated to show that revenues
and expenses are subparts of owners
equity.
The income statement collects the
changes and combines them in one
place.
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P & L A/C
The income statement must always
indicate the exact period covered (month
ended, quarter ended, year ended).
Decision makers inside and outside the
company use the income statement to
assess the companys performance over
a span of time.
By tracking net income from period to
period, decision makers can evaluate
the success of the periods operations.
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FIXED ASSETS
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FIXED ASSETS
Fixed Assets (FA)are very important
component of the business.
FA is an asset held with the intention
of being used for the purpose of
producing or
providing goods or services and
is not held for sale in normal
course of business.
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TEST OF FA
How to test whether it is a FA or not?
Test is made at the time when the
expenditure is incurred by considering
whether the asset or benefit acquired
by the expenditure will be converted
into cash in the near future, OR
whether it will primarily be used for
conducting the operations of
business
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TYPES OF FA
FA may be
TANGIBLE FA
physical items that can be seen and touched,
such as land, natural resources, buildings,
and equipment - also known as fixed assets
or plant assets
INTANGIBLE FA
rights or economic benefits, such as
franchises, patents, trademarks, copyrights,
and goodwill that are not physical in nature
39
Allocation of Costs
Terms for allocation of costs over time:
Depreciation - allocation of the cost of
tangible assets
Depletion - allocation of the cost of natural
resources
Amortization - allocation of the cost of
intangible assets
Land is never depreciated because it
does not wear out or become obsolete.
40
Cost of Acquisition
The acquisition cost of long-lived
assets is the purchase price,
including incidental costs required
to complete the purchase, to
transport the asset, and to
prepare it for use.
41
Depreciation
Depreciation is a form of allocating the
cost of an asset to periods when the
asset is used.
Depreciation is one key factor that
distinguishes accrual accounting from
cash basis accounting.
Under the accrual basis, the cost of the
asset is allocated to the periods benefited.
Under the cash basis, the cost of the
asset would be expensed immediately.
42
Expected Life
Useful life - the time period over
which an asset is depreciated
The useful life is the shorter of the
physical life of the asset before it
wears out or the economic life of the
asset before it becomes obsolete.
The useful life can be measured in
terms other than time. For example,
the life of a truck can be measured in
miles driven.
43
Depreciation (contd.)
Depreciation does not generate cash.
Depreciation allocates the original cost
of an asset to the periods when the
asset is used.
Accumulated depreciation is merely the
total amount that an asset has been
depreciated throughout its life.
44
Depreciation (contd.)
Depreciation is a non-cash expense.
Therefore, depreciation basically has no
effect on ending cash balances
Before taxes, changes in the depreciation
method affect only the accumulated
depreciation and retained earnings
account.
45
The Decision to Capitalize
No rules about when to expense or
capitalize an expenditure are written in
stone.
An accountant might want to expense
something that a tax auditor might want to
capitalize.
The tendency in practice is to charge
an expense for repairs, parts, and
similar items.
Most of these expenditures are minor, so
the cost-benefit and materiality concepts
justify this choice.
46
METHODS OF DEPRECIATION
Straight Line Method
Declining Balance Method (WDV)
Sum-of-the-years Digits Method
Units of Production Method
47
PROFIT & LOSS
ACCOUNT
48
Introduction
Annual Report Financial Statement
Balance Sheet
Profit & Loss Account
Balance Sheet is a position statement.
P&L A/c is a flow statement.
Companies Act:
A Balance Sheet as on the last day of the
financial year
A Profit & Loss Account for the financial
year.
49
P & L A/c
P&L A/c is also called Income
Statement.
Income is calculated as the difference
between revenues and expenses.
Revenues: from operations
Expenses: specific product/service/period
Accountants have agreed to use the
accrual basis of accounting rather than
the cash basis.
50
Revenues and Expenses
Revenues - gross increases in
owners equity arising from
business operations/delivery of
goods-services to customers
Expenses - decreases in owners equity
that arise because goods or services are
delivered to customers
51
TRANSACTION
INCOME EXPENDITURE
Revenue
Income
Capital
Income
Revenue
Expendi
ture
Capital
Expend
iture
52
TRANSACTION
INCOME EXPENDITURE
Revenue
Income
Capital
Income
Revenue
Expendi
ture
Capital
Expend
iture
P & L A/c
Income (Revenue Income)
Less
Expenditure (Revenue Expenditure)
NET PROFIT/LOSS
53
TRANSACTION
INCOME EXPENDITURE
Revenue
Income
Capital
Income
Revenue
Expendi
ture
Capital
Expend
iture
BALANCE SHEET
SOURCES OF FUNDS (Liabilities)
(Capital Income)
APPLICATION OF FUNDS (Assets)
(Capital Expenditure)
54
TRANSACTION
INCOME EXPENDITURE
Revenue
Income
Capital
Income
Revenue
Expendi
ture
Capital
Expend
iture
BALANCE
SHEET
P & L A/C
55
P & L A/c CONCEPTS
ACCOUNTING PERIOD
Expenditure during A/c period which are
also expenses of that period.
Expenditure during the A/c period which
will become expense only in future periods
Expenditure during the previous A/c period
which will become expenses during the
current A/c period
Expense of the current A/c period which
have not yet been paid
56
The Accounting Time Period
Companies also prepare statements
for interim periods, generally on a
quarterly or monthly basis.
57
P & L A/c CONCEPTS (contd.)
REALIZATION CONCEPT
point of time or revenues earned
recognition of revenues
ACCRUAL CONCEPT
profits are measured by change in Owners equity
revenues increases OE, expenses decreases OE
MATCHING EXPENSES WITH REVENUE
relevant period
58
Revenues and Expenses
Income (profit) - the excess of revenues
over expenses
Revenues - Expenses = Profit
Retained earnings - additional owners
equity generated by income or profits
Revenues increase owners equity.
Expenses decrease owners equity.
59
Recognition of Revenues
Recognition - a test to determine whether
revenues should be recorded in the
financial statements
60
THE DUET: BS & P&L
BS provides a snapshot of an entitys
financial position at an instant in time.
The P&L A/c provides a moving picture of
events over a span of time and explains
the changes that have taken place
between BS dates.
61
62
BALANCE SHEET
BS is a position statement.
BS describes
the financial position of assets & liabilities
of the firm
as on a particular date
63
DEFINITION: BS
Balance Sheet is defined as
a statement of the financial position
of an enterprise
as at a given date, which exhibits
assets, liabilities, capital, etc.
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DEFINITION: BS
Balance Sheet is defined as
a statement of the financial position
of an enterprise
as at a given date, which exhibits
assets, liabilities, capital, etc.
According to Harry G Guthmann:
The BS might be
described as financial
cross-sections taken on
a particular date
65
WHY BS ?
The legal rules (Companies Act)
A Balance Sheet as on the last day of the
financial year
A Profit & Loss Account for the financial year.
BS should reflect true and fair view.
66
Owners
Equity
Owners
Equity
Owners Investment
Revenues
Owners Withdrawal
Expenses
Balance Sheet
67
LOOKS/FORM OF BS
1. HORIZONTAL
2. VERTICAL
Except in the first BS, it is required to give
the corresponding amounts for the
preceding financial year (Comparatives)
for all the items shown in the BS.
68
HORIZONTAL FORM OF BS
XYZ XYZ
XX Inventories (Stock) XX Accounts Payable (Creditors)
XX Bills Receivable) XX Bank Overdraft
XX
Accounts Receivable
(Debtors)
XX Outstanding Expenses
XX Cash / Bank B/s Current Liabilities
Current Assets XX Loan taken
XX Fixed Assets-Land, Bldg, XX Capital
Amount ASSETS Amount LIABILITIES
69
VERTICAL FORM OF BS
XYZ ABC
XX AA Miscellaneous Expenditure
XX AA Loans & Advances
XX AA Current Assets Current Liabilities
XX AA Investment
Amount cy Amount py APPLICATION OF FUNDS
XX AA
Fixed Assets Gross Block
- Depreciation
XYZ ABC
XX AA Unsecured Loans
XX AA Secured Loans
AA Reserves & Surplus
XX AA Share Capital
Amount cy Amount py SOURCES OF FUNDS
70
CONCEPTS RELATED TO BS
1. BUSINESS ENTITY
2. GOING CONCERN
3. MONETARY UNIT
4. COST
5. CONSERVATISM
6. ACCOUTING EQUIVALENCE
71
Assets = Owners Equity +
Outside Liabilities
A = OE + OL
72
A = OE + OL
Assets are properties or economic
resources owned by a business. They are
expected to provide future benefits to the
business.
Assets are properties or economic
resources owned by a business. They are
expected to provide future benefits to the
business.
Liabilities are
obligations of the
business. They
are claims
against the
assets of the
business.
Liabilities are
obligations of the
business. They
are claims
against the
assets of the
business.
Equity is the
owners claim on
the assets of the
business. It is the
residual interest in
the assets after
deducting
liabilities.
Equity is the
owners claim on
the assets of the
business. It is the
residual interest in
the assets after
deducting
liabilities.
73
A = OE + OL
XY
Z
XYZ
XX Inventories (Stock) XX
Accounts Payable
(Creditors)
XX Bills Receivable) XX Bank Overdraft
XX
Accounts Receivable
(Debtors)
XX Outstanding Expenses
XX Cash / Bank B/s Current Liabilities
Current Assets XX Loan taken
XX Fixed Assets-Land, Bldg, XX Capital
Amoun
t
ASSETS
Amount
LIABILITIES
74
A = OE + OL
XY
Z
XYZ
XX Inventories (Stock) XX
Accounts Payable
(Creditors)
XX Bills Receivable) XX Bank Overdraft
XX
Accounts Receivable
(Debtors)
XX Outstanding Expenses
XX Cash / Bank B/s Current Liabilities
Current Assets XX Loan taken
XX Fixed Assets-Land, Bldg, XX Capital
Amoun
t
ASSETS
Amount
LIABILITIES
75
A = OE + OL
Miscellaneous Expenditure
Loans & Advances
Current Assets Current Liabilities
Investment
Amoun
t
cy
Amount
py
APPLICATION OF FUNDS
Fixed Assets Gross Block
- Depreciation
XX
XX Unsecured Loans
XX Secured Loans
AA Reserves & Surplus
XX AA Share Capital
Amoun
t
cy
Amount
py
SOURCES OF FUNDS
76
Financial Statements
Prepare the Financial Statements reflecting
the transactions we have recorded.
77
Scoxs net
income is the
difference
between
Revenues and
Expenses.
The net income of
Rs.2,200
increases Scoxs
equity by
Rs.2,200.
Revenues:
Consulting revenue 3000
Expenses:
Salaries expense 800
Net income 2200
Scox Company
Income Statement
For Month Ended March 31, 2001
Income Statement
Owners' equity, 1st April 2000 0
Plus: Investment by owners 20000
Net income 2200
Owners' equity, 31st March 2002 22200
Scox Company
Statement of Changes in Owners' Equity
For Month Ended March 31, 2001
78
Accounts payable 1200 Cash 10200
Notes payable 4000 Supplies 1200
Total liabilities 5200 Equipment 16000
Owners' equity 22200
Total liabilities
and owners'
equity
27400 Total assets 27400
Assets Liabilities & Owners' Equity
Scox Company
Balance Sheet
March 31, 2001
Balance Sheet
Owners' equity 0
Investment by owners 20000
Net income 2200
Owners' equity, March 31 2001 22200
Scox Company
Statement of Changes in Owners' Equity
For Month Ended March 31, 2001
The balance sheet
reflects Scoxs
financial position at
March 31 2001
The balance sheet
reflects Scoxs
financial position at
March 31 2001
79 1
CASH FLOW
CASH FLOW
STATEMENT
STATEMENT
80 2
CASH FLOW STATEMENT
CF Statement is a flow statement.
CFS indicates changes that took place
between tow successive Balance
Sheets.
The statement of cash flows provides
a thorough explanation of the changes
that occurred in a firms cash balance
during the entire accounting period.
81 3
CFS
The statement of cash flows reports
cash receipts and payments of a
company during a given period for
operating, financing, and investing
activities.
Cash includes cash and cash
equivalents.
82 4
Why CFS?
Balance Sheet P&L A/c insufficient.
It shows the relationship of net income to changes in
cash balances.
It reports past cash flows as an aid to:
Predicting future cash flows
Evaluating the way management generates and uses cash
Determining a companys ability to pay interest and
dividends and to pay debts when they are due
It identifies changes in the mix of productive assets.
83 5
Why CFS? . . .
The statement of cash flows, along
with the income statement,
explains why balance sheet items
have changed during the period.
Legal rules.
84 6
Why CFS?
The relationship among the balance sheet,
income statement, and statement of cash
flows:
Balance Sheet
31
st
March 2009
Balance Sheet
31
st
March 2009
Balance Sheet
31
st
March 2008
Income Statement
Statement of Cash Flows
85 7
Activities Affecting Cash
Operating activities - transactions that
affect the income statement
Investing activities - activities that
involve (1) providing and collecting
cash as a lender or as an owner of
securities and (2) acquiring and
disposing of plant, property,
equipment, and other long-term
productive assets
86 8
Activities Affecting Cash . . .
Financing activities - activities that
include obtaining resources as a
borrower or issuer of securities and
repaying creditors and owners
87 9
Operating Activities
Cash inflows
Cash Receipts from
sale of goods/rendering
of services
Cash Received from
royalties, fees,
commission, etc.
Other operating
receipts
Cash outflows
Cash payments to
suppliers for
Goods/services
Cash payments to
employees
Interest and taxes paid
Other operating cash
payments
88 10
Investing Activities
Cash inflows
Sale of property, plant,
and equipment
Sale of securities that
are not cash
equivalents
Receipt of loan
repayments
Cash outflows
Purchase of property, plant,
equipment
Purchase of securities that
are not cash equivalents
Making loans
89 11
Financing Activities
Cash inflows
Borrowing cash from
creditors
Issuing equity shares
Issuing debt securities
Cash outflows
Repayment of amounts
borrowed
Repurchase of equity
shares
Payment of dividends***