Chapter 1

Assets, Liabilities, and the Balance Sheet

Anything that the business owns is an ‘Asset’, whereas everything it owes is a

‘Liability’. The business is funded by its ‘Shareholders’, who are people with an
ownership stake in it, and by those who have lent money to it, who are known as
‘Creditors’. The shareholders and the creditors are collectively known as ‘Investors’.
Thus, everything the business owns, belongs to these two categories of investors. If
the assets are liquidated, and the creditors are paid off, the residue belongs to the
shareholders. Consequently, the sum total of assets must be equal to the sum total
of liabilities. Hence a statement listing the assets and liabilities must balance, and
therefore, the term ‘Balance Sheet’.

The balance sheet indicates the health of a business at a point in time in terms of its
assets and liabilities. It is the snapshot of the business, at a point of time. A day later
if it were to be reconstructed, the odds are that at least some of the items would
have changed. The balance sheet is usually prepared at the end of the financial
year. However, it can be prepared at any point in time. Therefore, if a business were
to desire, the accountants can prepare a daily or a weekly balance sheet. The
balance sheet of a company, prepared at the end of the financial year, and audited
by its statutory auditors, is a publicly available document. It is the object of scrutiny
by investors, analysts, tax authorities, critics, and others with an interest in it.

A balance sheet has three segments:

 Assets
 Liabilities
 Equity

Assets, as we have said, are items that the business owns, whereas liabilities are
what it owes. Liabilities can be sub-categorized as ‘Equity’ and ‘Other Liabilities’.
Equity is what the business owes to its shareholders or owners, whereas other
liabilities are what it owes to entities other than the shareholders. The balance sheet
equation may therefore be stated as:

Assets = Liabilities + Equity

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Legally the business and its shareholders are distinct entities. Interested readers can
read up on the verdict in a famous case referred to as Solomon versus Solomon.
Hence, whatever is owed to the shareholders is also a liability for the company.

Types of Assets

Assets are divided into various sub-categories.

 Property, Plant and Equipment (PPE) also known as Tangible Fixed Assets
 Short-term Current Assets
 Non-current assets including long-term investments
 Intangible Assets

‘Fixed assets’ are those which typically stay in the business for a long period of time.
These include land, buildings, factory machines and equipment, computers, printers
and copiers, and motor vehicles. These items provide value to the business over a
period of time, and are not fully consumed in the year of acquisition. Expenditure on
such assets is called ‘Capital Expenditure’. There is no hard and fast rule as to what
constitutes capital expenditure and it could depend on the size of the company. A
small firm may define any expense incurred on an asset in excess of Rs. 10,000 as
capital expenditure, whereas a larger firm may state that any expense on account of
asset acquisition is excess of Rs. 100,000 is capital expenditure. If an asset is
treated as capital expenditure, a portion of the cost will be allocated as an expense
during every year that it is used. This allocation method is referred to as
‘Depreciation’ in the case of tangible fixed assets, and ‘Amortization’ in the case of
intangible assets. Minor assets are treated as an expense in the year of acquisition
itself.

The rationale for depreciation is that if an asset is going to provide benefits over
multiple years, then each year should bear a certain proportion of the cost. If the
entire expense of such an asset is allocated to the year of acquisition, that year’s
profit will be considerably understated, whereas the profits for subsequent years will
be considerably overstated. Hence, the principle of fairness warrants that the cost of
acquisition of such assets should be allocated over multiple years. There is a
common misperception that the term depreciation refers to the wear and tear
associated with fixed assets.

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There are grey areas. For instance, assume a business buys a laptop worth Rs.
150,000, and spends an additional amount to acquire various application software
licences such as MS Office 365. The question is should the entire expense be
treated as a capital expenditure, or should the amount incurred on account of the
software be expensed in the year of acquisition. The answer is, it depends. Some
firms will take the view that the computer is a long term asset whereas the software
is not. Hence, they will treat the cost of the laptop as capital expenditure, and write
off the cost of the software as an expense in the year of acquisition. Others will take
the view that the laptop in isolation is useless without the accompanying software.
Hence the entire cost will be treated as capital expenditure. Accounting is not a pure
science. Hence, we cannot term either of these approaches as right or wrong.

The term ‘Current Assets’, also known as ‘Working Capital’, refers to assets that are
expected to be sold, or converted into cash, or consumed in the course of operations
during the operating cycle. The term ‘operating cycle’ represents the period taken by
the business to go from spending cash to receiving cash. Typically a business will
buy raw materials on credit; use the material to produce goods; sell some or all of
these goods on credit; subsequently recover payments in cash from entities to whom
it has sold on credit; and use the proceeds to pay off parties from whom it has
bought goods on credit. The time period of this process is known as the operating
cycle. For most businesses, the operating cycle will be less than one year. However,
there are exceptions. Take an aircraft manufacturer such as Boeing or Airbus, or a
ship building company. The time taken to build the finished product and sell it is
usually longer than a year. Hence a semi-finished aircraft on Boeing’s assembly line,
which will be completed and sold subsequently, is a current asset and not a fixed
asset. Such assets that are lying or moving in the assembly process are referred to
as ‘Work-in-Progress’ or ‘Work-in-Process’.

The current assets on the balance sheet of a firm include:

 Cash and Bank Balances

 Receivables also called Debtors
 Inventories
o Raw Materials
o Work in progress

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 o Finished goods
 Loans and advances
o Pre-paid expenses
o Vendor advances
o Rent deposits
o Staff advances

Raw materials, work in progress, and finished goods constitute the inventory of a
manufacturing organization. An organization which is only into trading, will have only
one category of inventories. A pure service organization will have no such
inventories.

Most businesses sell on credit. It is not possible to be competitive unless credit sales
are made to customers. Often the nature of the trade is such that this facility has to
be extended. At times competitive pressures, due to the practices of other
businesses in the trade, may warrant the need to offer such a benefit to customers.
In practice, most B2B businesses buy on credit and sell on credit.

Pre-payments are an asset for parties making a payment. These could arise in
various ways. A supplier may demand an advance payment. This can happen at
times, although there are suppliers who will sell on credit. Why is this amount an
asset for the business? If the order is cancelled subsequently, the money is
refundable. Hence till the goods are delivered, the supplier owes this money to the
business. And anything that is owed to the business by an external entity is an asset.

Take the case of an Indian business that pays an insurance premium for the months
of January-December on 1st January of a year. On 31st March when the balance
sheet is being prepared, nine months premium, for the period April-December, will
be shown as an asset. This is because this amount represents a pre-paid expense.
The corresponding principle is known as the ‘matching principle’. That is, the
revenue for a financial year must be matched with expenses for the same year.

Investments

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A business may hold certain assets as an investment. For instance, a company may
buy shares of another company. A business may also have acquired assets like
bonds in the capital market as investments.

Intangible Assets

Assets such as trademarks and patents are intangible. These will provide benefits to
the business over a period of time and hence are assets. However, you cannot touch
and feel them and hence they are intangible.

One such intangible asset is ‘Goodwill’. When a company buys another company at
a price that is more than the net value of the tangible and intangible assets after
deducting the liabilities acquired in the transaction, such excess payment is called
‘Goodwill’. This excess payment usually arises due to brand value, reputation,
credibility and superior competitive advantage that the selling company has built over
time. Goodwill is strictly not an ‘intangible asset’ though it is classified under
‘intangible assets’ in accounting.

Deferred Revenue Expenditure

Like expenditure on fixed assets, certain types of expenses have long-run

consequences. For instance, a company may launch an advertising or rebranding
campaign. This will have a long-term impact. Hence, instead of treating the entire
amount spent as an expense in the year of spending, a portion will be capitalized
and reflected on the balance sheet as an asset. Like in the case of fixed assets, this
expense will be spread across years. We still remember the brand name DLF-IPL,
don’t we? DLF paid Rs. 200 crores for sponsorship of IPL in 2008 for five years up to
2012. This amount of Rs. 200 crores would be written off at Rs. 40 crore each year
from 2008 to 2012 instead of Rs. 200 crores in 2008. Similarly, if a company were to
issue shares or bonds by way of a public issue, the expenses incurred in connection
with the security issue may be capitalized. All expenses incurred in this exercise will
be treated as deferred revenue expenditure, and will be written off as expenses over
a reasonable period of time.

Depreciation

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The cost of acquisition of a fixed asset is known as the ‘gross book value’. The gross
book value less the cumulative depreciation till date, is known as the ‘net book
value’. On the balance sheet this can be shown in two ways. The gross book value
can be shown as an asset, and the accumulated depreciation can be shown as a
liability. Else the net book value can be shown as an asset. There are different
methods of depreciation, which we will study later.

Contra Assets and Liabilities

Accumulated depreciation is an example of what is termed as a ‘contra asset’. You

will learn shortly that asset accounts will have a debit balance, whereas liabilities
account will have a credit balance. However, a contra asset account will have a
credit balance, whereas a contra liability account will have a debit balance.

When it comes to fixed assets, we can show the current book value as an asset.
However, from an information standpoint, a company may prefer to show the gross
book value as an asset, and the accumulated depreciation as a contra asset. This
way someone who is perusing the balance sheet can discern easily, the original cost
of the asset, and the amount that has been written off by way of depreciation.

Another example of a contra asset is a provision for doubtful debts. For most
businesses, a certain percentage of collections due from customers will turn bad or,
in other words, prove to be uncollectable. Thus, it is a common practice to make a
provision for it. This will reduce the amount due from debtors or receivables. Since
receivables are an asset for the business, it will have a debit balance. A provision for
doubtful debts will have a credit balance because it reduces the receivables and,
therefore, is called a ‘contra asset’.

Long-Term Liabilities

Long-term liabilities are also referred to as non-current liabilities. Bonds and

debentures issued by a business are long-term liabilities. Similarly, long term loans
availed from banks and financial institutions for financing the purchase of fixed
assets of a company, are also long term liabilities.

In India the words bonds and debentures are often used interchangeably to refer to
debt securities issued by a company. In the US they have specific meanings, that is,
debentures are unsecured debt securities, whereas bonds are secured debt

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securities. The term secured means that specific assets have been earmarked as
collateral for such securities. Thus, if a business is unable to repay the investors as
promised, the investors can take possession of the assets to recover what is owed to
them. In the case of debentures there are no specific assets which have been
designated as collateral. The investors can only hope that the issuer will have
sufficient resources to pay them when the payments fall due. In terms of the
payment sequence, secured debtholders get priority over unsecured debtholders. If
the cash flow from the sale of assets that have been earmarked as collateral is
insufficient to pay the bondholders, they can stake a claim to other assets, if such
assets were to be available. Long-term bank loans are also a long-term liability.
Similarly, long-term retirement obligations such as employee pensions, are a long-
term liability.

Current Liabilities

Those liabilities falling due within the operating cycle are termed as ‘current
liabilities’. Short-term bank loans or overdrafts are categorized as current liabilities.
Long-term liabilities falling due during the next financial year are also classified as
current liabilities. For instance, take the case of a company which had issued long-
term bonds a decade ago, and which are scheduled to be repaid during the next
financial year. These bonds which have been classified as a long-term liability until
now, will be reclassified as a current liability at the end of this financial year.

Also if a term loan from a bank has been obtained, that has to be repaid in three
yearly instalments starting from next year, two thirds of the principal portion of the
loan will be shown under ‘non-current liabilities’, and one third as a ‘current liability’
at the end of the year in which such a term loan is availed.

Payables or Trade Creditors

‘Creditors’ are those who supply goods and services to a business on credit. While
most businesses have no option but to extend credit to their customers, many of
them can avail of credit offered by their suppliers. In some cases, the sales are on
cash whereas purchases are on credit. For instance, a supermarket chain will sell
exclusively on cash basis, but will avail of a substantial amount of credit from entities
from whom it acquires its inventory.

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Non-trade creditors are represented by items such as outstanding wages and
salaries, and outstanding taxes. If salary and wages remains unpaid for the financial
year at the time of preparation of the balance sheet, it will be shown as a current
liability. Similarly, if any tax payments are pending when the balance sheet is being
prepared, they will be shown as current liabilities and provisions.

The term ‘working capital’ is used for current assets. The term ‘Net Working Capital’
is used for the difference between current assets and current liabilities.

Current Assets – Current Liabilities = Net Working Capital

The assets side of a balance sheet consists of current assets and long-term assets.
The liabilities side consists of current liabilities plus long-term liabilities and equity.
We know that the two sides must balance. Hence if the net working capital is positive
it means that long-term funds are being used to partly fund current assets. This per
se is not an issue since long-term liabilities are not due in the short run. However, a
negative working capital may pose problems for the business. It indicates that short-
term liabilities are being used to partly fund long-term assets. Such assets cannot be
easily liquidated if a creditor were to demand a payment.

‘Capital Employed’ or ‘Net Assets’ is a term used for the sum of fixed assets and net
working capital. Capital employed can be derived from the liabilities side of the
balance sheet by adding Shareholders’ Funds and Bondholders’ Funds. Net Assets
can be derived from the Assets side of the balance sheet by adding Net Fixed
Assets and Net Working Capital.

Equity

Share capital is referred to as equity capital. In most countries shares have a face
value or par value. In India, the par values for shares of companies which are listed
on the stock markets, are usually one, two, five, and ten rupees. In countries like the
US we can have par values ranging from a few cents. Certain companies in the US
issue shares with a NIL par value.

If the shareholders are asked to pay more than the par value at the time of issue, the
excess is referred to as the share premium. For instance, if a company issues a
million shares with a face value of Rs. 10 at a price of Rs. 15, the share capital will
be shown as Rs. 10 million, and the share premium as Rs. 5 million.

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A business is allowed to issue shares up to a limit. The total face value of the shares
that it is allowed to issue is termed as the ‘authorized capital’. The face value of the
shares that are actually issued is termed as the issued capital. Thus, the issued
capital will be less than or equal to the authorized capital. Sometimes the face value
may be paid in instalments. The amount that is initially paid is referred to as the
‘paid-up capital’. Thus, the paid-up capital will be less than or equal to the issued
capital. The face value of shares that are held by shareholders is referred to as the
outstanding capital. In most cases the outstanding capital will be the same as the
issued capital.

Authorized, Issued, Subscribed and Paid-up Capital are illustrated in the table below:

Source: Annual Report of TVS Motors Limited for the financial year ended March 31.
2019

If an American company which has issued shares in the past were to subsequently
buy back the shares from the existing shareholders, the outstanding capital can be
less than the issued capital. However, in India this is not possible as the shares
bought back have to be expunged, that is, cancelled.

As we said earlier, US companies can issue shares with a zero par value. Hence the
entire issue proceeds in such cases represents the share premium. There are two
reasons for this. In some states in the US, the cost of incorporating the company is
directly related to the face value. Hence by issuing shares without a face value, the
issuer can bring down the cost of incorporation. Also, during a financial crisis, if the
paid-up capital is less than the issued capital, the creditors can demand that the
shareholders bring into the company the balance capital, that is, the difference
between the issued capital and the paid-up capital. However, if the face value is
zero, the creditors cannot require that the shareholders make additional contributions
subsequently.

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If a business makes a profit, it will usually retain a portion in the business to finance
growth and expansion of the business. The balance will be paid to the shareholders
in the form of dividends. The money that is retained by the business is referred to as
‘Retained Earnings’. The retained earnings show up under the head of ‘Reserves
and Surplus’ on the balance sheet.

The sum of share capital and reserves and surplus is called the ‘Net Worth’. The net
worth may be positive or negative. A positive net worth signifies that the book value
of the assets is greater than what the creditors and bondholders are required to be
paid. A negative net worth on the other hand, implies that the book value of the
assets is less than what is owed to the creditors and debtholders.

Preferred Share Capital

Preferred shares also represent ownership in a company, and may be termed as

quasi-equity. However, preferred shareholders may or may not having voting rights.
At times, such shares receive voting rights only if dividends have not been paid for a
stipulated length of time. The term `preferred' connotes the fact that such shares
have certain associated privileges. Current dividends that are due must be paid to
the preferred shareholders before any dividends can be paid to equity shareholders.
Thus, equity dividends cannot be paid if dividends on preferred shares are not paid.

Second, if a company is liquidated, the preferred shareholders have to be paid their

share, in part or in full, out of the liquidated assets, before the balance, if any, can be
paid to the equity shareholders. Thus, they are called preferred shares because they
are given preference over equity shareholders, and not because investors prefer
them.

Preferred stocks usually carry a fixed rate of dividend, although there are adjustable-
rate preferred (ARPs), which are similar to floating rate bonds. The rate may be
expressed either in currency terms or as a percentage. For instance, the term $ 3.50
preferred stock denotes shares carrying a dividend of $ 3.50 per share. Or the
shares may be described as 3.5% preferred stock with a par value of $ 100. This
once again connotes a dividend of $ 3.50 per share.

Thus, from the standpoint of income, preferred shares are similar to bonds and are
unlike equity shares which are subject to varying dividends. However, unlike bonds,

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preferred stock represent ownership of the firm, and the dividend is not a legal
liability. Just like in the case of equity dividends, the directors of a firm must meet
and declare each dividend that is paid.

Companies issue preferred shares because such instruments enable them to lock in
a fixed yet flexible expense. That is, although a fixed dividend is payable on such
stocks, the dividends can be deferred if required to be. Thus, in the event of financial
difficulties, such shares offer critical flexibility to the firm.

Preferred shares are not popular in most countries. In the US companies invest in
preferred shares because a percentage of preferred dividends received by a
company is tax-free. The reason is the following. Preferred dividends like equity
dividends are paid out of post-tax profits. In the US shareholders have to pay taxes
on equity dividends. Thus, if the preferred dividend received by a corporate
shareholder were to be taxed, considering that it will eventually end up at the hands
of its equity shareholders, it would have effectively been taxed three times. Preferred
dividends received by individual shareholders in the US are fully taxable.

Users of Financial Statements

 Shareholders: Investors in a business need to assess the risk and

return from the standpoint of their investment. They need to evaluate
whether their money is safe and sound, and what kind of returns they
can expect over time. They use such statements to judge how the
management is running the business on their behalf.

 Market analysts/advisors/ journalists: An analyst working for a mutual

fund like Franklin Templeton, or a lender like State Bank of India, or a
credit rating agency like CRISIL, would peruse financial statements
periodically to evaluate the financial health of a company. Financial
newspapers like the Economic Times or Business Line, will also
evaluate the information content of financial statements to draw
conclusions and make recommendations.

 Creditors and Potential Creditors: Suppliers need to assess if the

company will continue to make purchases in the future, and whether
the amounts due for credit sales made in the past are likely to be paid.

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 They will be looking at the working capital parameters to take business
decisions.
 Customers: They need to predict if the business will continue to be a
reliable source of goods and services. Take for instance Blackberry
and Jet Airways. Both had dedicated and loyal customers, but could
not withstand the competition in the market. Some customers may also
want to assess how much profit has been earned from their custom.
 Board of Directors: For large businesses, shareholders cannot manage
day to day operations, and this task is delegated to professional
managers. Managers use internal financial statements to take
appropriate managerial decisions.
To effectively run a company a manager needs answers to the
following questions.
 What were the company’s earnings during the previous financial
year or quarter, and did shareholders get an adequate rate of
return?
 Does the company have sufficient cash to sustain its
operations? In the short run cash is more important than profits.
If cash were to dry up a, a business may come to a grinding halt.
 For a multi-product company, managers need to know which
products are the most profitable. Based on the analysis a
product may have to be discontinued or modified.
 What was the cost of manufacturing a product or service?
Managers would like to minimize costs wherever possible to
maximize profits.

 Employees: People working in a company need to know whether their

jobs are secured and whether they are likely to be paid wages and
salaries on time. Employee Trade Unions are one of the biggest
consumers of financial statements of the company they work for.

 Tax Authorities: Authorities in charge of direct and indirect taxes would

keenly scrutinize the financial statements of a business. They need to
know how much profit has been generated, and what is the
corresponding tax liability? In India, authorities in charge of Goods and

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 Services Tax (GST) as well as the Income Tax department will
scrutinize financial statements.
 Governments: The governments at all levels, central, state, and local,
will be interested in the performance of a business. The central or
federal government will be concerned with the impact of the operations
of a company on the overall economy. Questions, like how much does
a company contribute to a country’s Gross Domestic Product or GDP,
need to be answered. The GDP of a country is the value of goods and
services produced by the residents of a country within its borders. The
governments also need to know the quantum of employment created
by a company. Based on that they need to take decisions regarding
issues such as subsidies and taxes.

Caselet-1

Preparing Balance Sheets – The Case of Finflex Consultants

Ravi Krishnan the founder of Finflex Consultancy has just hired Vivek Roy an English
Literature major as his assistant. Finflex specializes in providing services to small and
medium enterprises in and around Chennai. Ravi wanted to recruit a person with a
Finance background. However, he found that MBAs and CAs were too expensive for
him. After interviewing various candidates, Ravi felt that Vivek was the best person
that he could identify. He was intelligent and hardworking and communicated well.
Ravi was of the opinion that he could acquire the required Accounting and Finance
skills if given adequate opportunities.

At the outset Ravi asked Vivek to become familiar with the structure of a balance sheet.
He told Vivek that while balance sheets were traditionally prepared by people with an
Accounting background, he felt that Vivek need not feel handicapped by the fact that
he was a non-commerce person.

Ravi entrusted the task to Vivek with the following words of wisdom.

 A balance sheet is a record of what an entity owes and what it owns at a

particular point in time.

 Anything the entity owes is a liability.

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  Anything it owns is an asset.

 The sum total of assets must equal the sum total of liabilities. That is why it is
referred to as a balance sheet.

 The owners and the business are two distinct entities.

 Hence what the business owes to the owners is a liability for the business.

 Any debts falling due within a short period, typically one year, are referred to as
current liabilities.

 Any assets likely to be liquidated within a short period, typically one year, are
referred to as current assets.

 Assets = Liabilities + Owners’ Equity

 This is the balance sheet equation

To get started Ravi suggested that Vivek prepare a balance sheet for an individual like
himself. He felt that after completing the task, he could go on to prepare the balance
sheet for a business.

Assets and liabilities for Vivek as on 31-12-20XX.

 Cash = Rs. 50,000

 House = Rs. 4,000,000
 Housing Loan = Rs. 2,800,000
 Loan given to friend (Vikram) = Rs. 135,000
 Deposit in HDFC Bank = Rs. 250,000
 Outstanding on Credit Card = Rs. 45,000
 Jewellery = Rs. 500,000
 Art = Rs. 250,000
 Car Loan = Rs. 800,000
 Car = Rs. 600,000

Assets and liabilities for Royal Technology Corporation as on 31-12-20XX

 Issued share capital = Rs. 1,500,000

 Preferred share capital = Rs. 500,000

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 Patents and trademarks = Rs. 4,350,000

 Plant and Machinery

 Gross Value = Rs. 125,000,000

 Accumulated Depreciation = Rs. 40,000,000

 Financial Investments = Rs. 8,500,000

 Retained Earnings = Rs. 81,850,000

 Prepaid Expenses = Rs. 4,000,000

 Raw materials inventories = Rs. 10,000,000

 Sundry creditors = Rs. 70,000,000

 Taxes Outstanding = Rs. 10,000,000

 Finished goods inventories = Rs. 10,000,000

 Receivables = Rs. 70,000,000

 Long-Term Debt = Rs. 32,500,000

 Cash = Rs. 10,000,000

 Short-term Debt = Rs. 5,500,000

Ravi asked Vivek to come up with solutions to the following issues

 The balance sheet for himself as on 31 December 20XX.

 How much is Vivek’s net worth as on that day. That is, if the business is liquidated
and the debts are paid off, what can Vivek walk away with?
 The balance sheet for Royal Technology Corporation
 The current assets and current liabilities for the company
 The shareholders’ equity

Vivek was able to analyze and derive his balance sheet fairly easily. But he found the
following issues to be troublesome while analyzing Royal Technology’s Corporation’s
balance sheet

 The current assets were not equal to the current liabilities

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  He could not figure out whether prepaid expenses were an asset or a liability

 He did not understand the meaning of depreciation

 He was unsure as to what retained earnings represented and whether they

were an asset or a liability

In order to resolve his doubts Vivek turned to a book `Fundamentals of Accounting’ by

Kumar and Srinivasan. After reviewing the first few chapters he grew confident that he
could come up with the answers for the questions posed by Ravi.

Tasks for Vivek

1) Prepare a balance sheet for himself

2) What is his net worth?

3) Prepare a balance sheet for Royal Technology Corporation

4) How much are the current assets for the firm?

5) How much are the current liabilities for the firm?

6) Should current assets always equal current liabilities? Why or why not?

7) What is the equity of the shareholders’ of Royal Technology Corporation?

8) What is depreciation?

9) Are prepaid expenses an asset or a liability? Why?

10) What do retained earnings represent? Are they an asset or a liability?

Solution

Q1) Prepare a balance sheet for Vivek.

Here is Vivek’s Balance Sheet

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 Balance Sheet for Vivek as on 31-12-20XX (All amounts in Rupees)

In the American way of presentation, Assets are on the right side and Liabilities are
on the left side. The Indian style of presentation is just the opposite.

Q2) What is his net worth?

The net worth is the balancing item on the liabilities side which in this case is Rs.
2,140,000. It is what Vivek can walk away with if he sells all the assets he has for
their values as per the balance sheet and repays all his debts.

Q3) Prepare a balance sheet for Royal Technology Corporation.

Here is Royal Technology Corporation’s balance sheet.

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 Balance Sheet for Royal Technology Corporation as on 31-03-20XX (All
amounts in Rupees)

Assets Amount Amount Liabilities

Patents 4,350,000 32,500,000 Long-term Debt
Investments 8,500,000
Plant& Machinery
Gross Book Value 125,000,000
Less Depreciation -40,000,000
Net Book Value 85,000,000
Total LT Assets 97,850,000 32,500,000 Total LT Liabilities
Pre-paid Expenses 4,000,000 5,500,000 Short-Term Debt
Raw Materials 10,000,000 70,000,000 Payables
Finished Goods 10,000,000 10,000,000 Outstanding Taxes
Receivables 70,000,000
Cash 10,000,000
Total Current
Total Current Assets 104,000,000 85,500,000
Liabilities
1,500,000 Equity Share Capital
Preference Share
500,000
Capital
81,850,000 Reserves and Surplus
Total shareholders'
83,850,000
funds
Total Assets 201,850,000 201,850,000 Total Liabilities

Q4) The total current assets for the firm are Rs. 104,000,000.

Q5) The total current liabilities for the firm are Rs. 85,500,000.

Q6) Current assets need not equal current liabilities. Total assets must equal total
liabilities. That is, the sum of short-term and long-term assets must equal the sum of
short-term as well as long-term liabilities. This does not however imply that the total
of short-term assets must always be equal to the total of short-term liabilities.

Q7) The sum of assets is equal to Rs. 201,850,000. This comprises of the sum of
total long-term assets and total current assets. The sum of total long-term liabilities
plus current liabilities is 32,500,000 + 85,500,000 = Rs. 118,000,000. The
shareholder’s equity is therefore 201,850,000 – 118,000,000 = Rs. 83,850,000. Of
this Rs. 500,000 is preferred share capital. Hence, the equity shareholders’ equity is

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Rs. 83,350,000. This consists of Rs. 1,500,000 in share capital, and Rs. 81,850,000
by way of reserves and surplus.

Q8) What is depreciation?

Many assets have an economic value that is longer than one year. If the entire cost
of the asset is written off as an expense in the year of acquisition it would not be a
fair reflection. That year’s profits will be grossly understated, while the profits for
subsequent years will consequently be overstated. Thus, to portray a fair picture, a
percentage of the cost of the asset will be deducted as an expense every year. This
is termed as depreciation. Remember, that depreciation is not the financial value of
the wear and tear of an asset.

The gross book value is the cost at which the asset was acquired. The gross book
value less the accumulated depreciation gives the net book value.

Q9) Are prepaid expenses an asset or a liability?

Prepaid expenses are an asset. They represent advance payments for services to
be received by the company in the future. If the company decides not to procure the
services, the money will have to be returned to it. Thus, this is something that an
external party owes to the business or company. Thus, it is an asset for the
company.

Q10) Retained earnings represent the profits over the years that have been retained
in the business. Every year the profit after tax, which belongs to the equity
shareholders, or owners, will be bifurcated. A part will be paid out to the
shareholders in the form of cash dividends. The balance will be retained within the
business to fund future growth and expansion. It represents a component of what the
business owes to its shareholders. Therefore, it is a liability.

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