CHAPTER 3:

FINANCIAL STATEMENTS OF PROFIT MAKING ENTITIES

Learning Outcomes: The Study of this chapter should
enable you to understand:
Introduction to Financial Statements
Capital Expenditure, Revenue Expenditure & Deferred
Revenue Expenditure.
Capital Receipts and Revenue Receipts
Trading Account
Profit and Loss account
Balance Sheet
Cash Flow Statement
 Introduction to Financial Statements
Money is invested in a business with the
primary aim of earning profits. For knowing
this, it is necessary that the accountant must
measure and accumulate accounting data in
such a manner that the amount of profit
earned or loss suffered by the business may
be determined and reported. The profit
figure is needed for income tax requirements
and for chalking out expansion plans.
 Trading and profit and loss account (or income
statement)
For the purpose of determining the profit or loss figure, a
statement known as trading and profit and loss account (or
income statement), is prepared at the end of the year which
includes all items of expenses and losses, and all revenues and
gains occurring during the accounting period. This account or
income statement is divided into two parts
First part is called trading account. This part is prepared to find
out gross profit or gross loss. Gross profit is the difference
between the net sales and cost of goods sold. In other words,
gross profit/gross loss is the result of buying and selling of goods
during trading period.
The second part is called profit and loss account and shows the
final figure of net profit or net loss.
 Balance sheet

Another statement, balance sheet (or position statement),

is also prepared with an aim to know the exact financial
position of the business on the last date of the accounting
period.
The balance sheet shows the financial position of the
business in the form of its assets and liabilities. It is divided
into two parts when prepared in a T form.
On the left hand side liabilities are shown and
On the right hand side assets are shown.
These two statements, Trading and profit and loss account
and balance sheet, are known as Financial Statements.
They are also called Final Account because they are end of
the period statements, or the end product of the financial
accounting process. Both these statements are prepared
from the balances appearing in the trial balance.
 Preparation of End of the Period Statements
End of the period statements, i.e. trading and
profit and loss account and balance sheet, are
prepared from the balances appearing in the trial
balance at the end of an accounting period. It
means that trial balance becomes the basis for
the preparation of these statements. In order to
decide the place where the particular balance
should be taken, from the trial balance to end of
the period statements, the following rules may be
allowed.
 Items from the debit column of the trial balance :
Balances appearing in the debit column of the trial
balance may be items of expenses, or losses, or assets.
If the debit balance of an item represents an asset
like land, building, plant and machinery, debtors, bills
receivables, investments, cash at bank, cash in hand etc,
then it is shown on the asset side of the balance sheet.
If the debit balance of an account represents an
expense then it will be shown on the debit side of the
trading account, or on the debit side of the profit and loss
account as the case may be. The expenses are
purchases, wages, carriage, cartage, commission,
discount, salary, stationery, postage, advertisement etc.
 Items from the credit column of the trial balance :
The balances that are shown in the credit column of the
trial balance are the items of liabilities, or incomes and
gains.
If these are liabilities there they are shown on the
liability side of the balance sheet. e.g., capital, loans,
creditors, bills payable, outstanding expenses, bank
overdraft etc.
If these are incomes or gains; such balances are
shown in the trading and profit and loss account. Items
of incomes and gains are sales, discount received,
commission received, rent received etc
 Types of Expenditure
Capital Expenditure.
Revenue Expenditure.
Deferred Revenue Expenditure.
Capital Expenditure: Capital expenditure consists of
expenditure, the benefit of which is not fully enjoyed in
one accounting period but spread over several
accounting periods. It includes assets acquired for the
purpose of earning income or increasing the earning
capacity of the business or effecting economy in the
operation of an asset. These are not meant for sale.
Expenditure incurred for improving assets and
extending an existing asset is also capital expenditure.
 The sum of invoice price, freight and insurance charges,
installation and erection cost and custom duty etc. will be
capitalized in the books of a firm. These capital items appear on
the assets side of Balance Sheet.
Examples:
Interest on capital paid during the period of construction of
Company.
Expenditure in connection with or incidental to the purchase or
installation of an asset.
Acquisition of new assets.
Expenditure incurred for putting the old asset purchased, into
working condition.
Additions and extensions to existing assets.
Interest and financing charges paid brokerage and commission
paid.
 Betterment of fixed assets or improvement of an asset
to produce more, to improve its earning capacity or to
reduce its operating expenses or to increase the life of
asset.
The cost of assets will be written off by way of
depreciation over a period of its life. The amount of
depreciation is revenue expenditure and is debited to
profit and loss account. The reason for charging
depreciation to revenue i.e. profit and loss account is
that the asset is used for earning revenue. Hence the
depreciation is charged to profit and loss account. Thus,
the benefit of capital expenditure does not exhaust in
one year but extends over a number of years of its use
or life of the asset.
 Revenue Expenditure: Revenue expenditure
consists of expenditure incurred in one period of
the accounting, the full benefit of which is enjoyed
in that period only. This does not increase the
earning capacity of the business but it is incurred
in order to maintain the existing earning capacity
of the business. It includes all expenses which
arise in normal course of business. The benefit of
such expenditure is for a short period, say, one
year only and it is not to be carried forward to the
next year. The expenditure is of a recurring nature
i.e. incurred every year
 Examples:
Purchase of raw materials for conversion into finished goods.
Selling and distribution expenses incurred for sale of finished
goods e.g. sales office expenses, delivery expenses,
advertisement charges, et(%
Establishment expenses like salaries, wages, rent, rates, taxes,
insurance, and depreciation on office equipment.
Depreciation of plant, machinery and equipment.
Expenses incurred in order to maintain the existing fixed assets in
an efficient and workable state such' as repairs to building, repairs
to plant, white-washing and painting of building.
All these items appear on the debit side of trading and profit and
loss account, in case of trading concerns or income and
expenditure account, in case of non-trading concerns.
 Deferred Revenue Expenditure: Deferred Revenue Expenditure
is a revenue expenditure which has been incurred during one
accounting year but its benefit spread over years. These are of
revenue nature but are deferred or postponed. It is of quasi- capital
nature. In simpler words, we can say that Deferred Revenue
Expenses are those expenses, the benefit of which may be
extended to a number of years, say, 3 to 5 years. These are to be
charged to profit and loss account, over a period of 3 to 5 years
depending upon the benefit accrued.
Sometimes losses may be suffered of an exceptional nature e.g. loss
of an asset (uninsured) due to accident or fire; confiscation of
property in a foreign country etc. It is worth noting that the amount
which has not been debited to the profit and loss account of the
current year is shown in the balance sheet on the assets side and it
is known as fictitious asset.
 Types of Revenue

Capital Receipts
Revenue Receipts
Capital Receipts: The receipts which do not arise out of normal
course of business are known as Capital Receipts. Some examples
of Capital Receipts :
Receipts from sale of fixed assets.
Additional capital introduced by the proprietor.
Loan raised.
Revenue Receipts: The receipts which arise out of normal course
of a business are known as Revenue Receipts. Some examples of
Revenu Receipts are:
Income from sale of goods
Rent received from letting out the business property
Dividend received from shares. Interest received from
investments.
 Trading account
Trading Account is the first stage in the process of preparing final
accounts. Trading account shows the gross profit or gross loss during
an accounting year. Its main components are sales, services rendered
in the credit side and cost of such sales or services rendered in the
debit side.
Advantages of Preparing a Trading Account
Following are the advantages of preparing a trading account.
It helps in ascertaining the gross profit earned or gross loss suffered
by the business as a result of its buying and selling activities.
Comparison of the figures of purchases, sales, direct expenses,
opening stock, closing stock of the current year with that of the
previous year helps in identifying the causes of such changes with a
view to locate weak and strong areas of the trading activities of the
business.
 By calculating the ratio of gross profit to net sales, called
the gross profit ratio, the extent to which the anticipated
or planned results with respect to gross profit have been
achieved can be ascertained.
It helps in exercising effective control over direct expenses
and stock by comparing the figures of the current year
with the figures of the previous year. If there are wide
fluctuations in the figures of opening and closing stock
then the same may be investigated and action taken.
A close monitoring of the items of stock may also help in
detecting the theft of goods in the enterprise.
The different items used for the calculation of gross profit
can also be put in a 'T' shaped account and this account
will be called trading account.
 Balancing of Trading Account
Trading account is prepared to find out the gross
profit earned or gross loss incurred by the business
enterprise during the accounting period.
Gross profit is the difference between sales
and cost of goods sold
It can be shown in the form of an equation as
follows:
Gross Profit = Net sales - Cost of goods sold
When the amount of cost of goods sold is more than
the figure of net sales the balance will be gross loss.
 The figures of sales made by the business
during the accounting period are available in the
sales account in the ledger.
Cost of goods sold represents the cost price of
that merchandise which was sold during the
accounting period out of the total merchandise
which was available for sale. It can be
understood easily with the help of the following
formula.
Cost of goods sold = Opening stock + Net
purchase + Direct expenses - Closing stock.
 Opening stock is the cost price of the goods which
were accounted for from the previous year.
Net purchases are total purchases (cash
purchases + credit purchases) less purchase
returned which can be made available from the
purchases account and purchases return account in
the ledger.
Direct expenses are all such expenses which may
have to be incurred by the business for bringing the
goods or services in a saleable position. Examples of
direct expenses are carriage inwards, cartage,
freight, wages, customs duties, dock charges,
Colleague, fuel, power etc.
 Illustration 1: From the following
information, calculate gross profit.
Gross Sales Rs 80,000
Sales Return Rs 10,000
Purchase Rs 25,000
Wages Rs 5,000
Fuel & Power Rs 3,000
Opening Stock Rs 7,000
Closing Stock Rs 2,500
 Solution :
(i) Cost of goods sold = Opening stock + Net purchases
+ Direct expenses - Closing stock
= Rs 7,000 + Rs 25,000 + (Rs. 5,000 +3,000) - Rs 2,500
= Rs 37,500
(ii) Net sales = Gross sales - Sales return
Or = Cash Sales + Credit sales - Sales return
= Rs 80,000 - Rs. 10,000
= Rs 70,000
(iii) Gross profit = Net sales - Cost of goods sold
= Rs 70,000 - Rs 37,500
= Rs 32,500
 Illustration 2: From the following balance obtained from the
trial balance of Ajay for the year ended 31.12.2011, calculate
the amount of gross profit earned by him during the year
ended 31.12.2011.
Rs.
Opening stock 80,000
Cash purchases 10,00,000
Credit purchases 12,00,000
Purchases returns 10,000
Cartage 5,000
Closing stock 1,15,000
Cash sales 17,00,000
Credit sales 10,00,000
Sales returns 8,000
 Solution:
Calculation of Gross Profit
Rs. Rs. Rs.
Cash sales 17,00,000
Add credit sales 10,00,000
Total sales 27,00,000
Less sales returns 8,000
Net sales (A) 26,92,000
Opening stock 80,000
Cash purchases 10,00,000
Credit purchases 12,00,000
Total purchases 22,00,000
Less purchase returns 10,000
Net purchases 21,90,000
Cartage 5,000
Cost of goods available for sales
21,95,000
Less closing stock 1,15,000
Cost of goods sold (B)
21,60,000
Gross profit (A - B)
5,32,000
175
Alternatively,
Gross profit = Net sales - Cost of goods sold
Net sales = Total sales - Sales returns
Total sales = Cash sales + Credit sales
= Rs. 17,00,000 + Rs. 10,00,000 = Rs.
27,00,000
Net Sales = Rs. 27,00,000 - Rs. 8,000= Rs. 26,92,000
Cost of goods sold = Opening stock + Net purchases + Direct
expenses - Closing stock
Net Purchases = Total purchases - Purchases returns
Total Purchases = Cash purchases + Credit purchases
= 10,00,000 + 12,00,000
= Rs. 22,00,000
Net Purchases = 22,00,000 - 10,000
= Rs.
21,90,000
Cost of goods sold = 80,000 +
21,90,000 + 5,000 - 1,15,000
= Rs.
21,60,000
Gross profit = 26,92,000 - 21,60,000
= Rs. 5,32,000
 Illustration 3. Calculate the gross profit and its
percentage on sales from the following details.
Opening stock Rs 8,000 factory expenses Rs 2,000
Purchases Rs 2,000 Sales Rs 84,000
Purchase return Rs 4,000 Closing stock Rs 5,000
Wages Rs 7,000 Sales return Rs 9,000

Solution
i) Net sales = Sales - Sales return
= Rs 84,000 - Rs 9,000
= Rs 75,000

ii) Cost of goods sold = Opening Stock + Net purchases +

Direct exp. - Closing stock
= Rs 8,000 + (Rs 32,000 - Rs 4,000) + (Rs 7,000 + Rs
12,000) - Rs 5,000.
= Rs 8,000 + Rs 28,000 + Rs 19,000 - Rs 5,000
= Rs 50,000
iii) Gross profit = Net sales - Cost of goods sold
= Rs 75,000 - Rs. 50,000
= Rs 25,000
iv) Gross Profit on sales = Gross profit x 100
Net sale
= Rs 25,000 x 100 = 100 = 33.3333%
Rs 75,000 3
 Illustration 4. Gross profit on sales is 20%. Net
Sales is Rs. 80,000. Find gross profit & cost of goods
sold.
Solution :
i) Given, gross profit on Sales = 20%
Net Sales = Rs 80,000
Gross profit = Net sales x % Profit
100
=80,000 x 20/100 = Rs. 16,000
ii) Cost of goods sold = Net sales - Gross profit
= Rs 80,000 - Rs.16,000
= Rs 64,000
 Illustration 5. Calculate Gross Profit and Sales
from the following data :
Cost of goods sold Rs 60,000. Gross profit on Sales
= 25%.
Solution :
Given, cost of goods sold = Rs. 60,000, G.P. on
sales = 25%.
Let Sales = Rs. 100
Gross profit on sales = 25%
Cost of goods sold = Rs 100 - Rs 25 = Rs 75
If cost is Rs 75, the sales = Rs 100
If cost is Re 1, the sales = 100
If cost is Rs 60,000, the sales = 100
x 60,000/75
= Rs
80,000
Gross profit = Net sales -
Cost of goods sold
= Rs 80,000 - Rs 60,000
= Rs. 20,000
 PROFIT AND LOSS ACCOUNT
Profit and loss account is prepared to ascertain net profit
earned or net loss incurred by the business during the
accounting period. It is prepared in the same way in which
trading account is prepared. After the gross profit / gross
loss from the trading account, the remaining expenses
and losses (other than the direct expenses) whose
balances are shown in the trial balance are debited to the
profit and loss account. Similarly the items of incomes and
gains (other than sales) whose balances are shown in the
trial balance are credited to the profit and loss account.
The difference between the totals of the credit side and
debit side is done to ascertain net profit or net loss.
 If the credit side is more than the debit side than
the difference is net profit. On the other hand if the
debit side is more than the credit side than the
difference is net loss. The net profit or net loss is
the result of all the activities of the business during
the accounting period and is transferred to the
capital account. Since it is the owners, share in the
business, with net profit, the capital of the sole
trader increases and with net loss the capital of
the owner decreases.
The Performa of the profit and loss account is as
follow.
 Closing Entries
While preparing trading and profit and loss account we discussed that
all the nominal accounts are transferred to the trading and profit and
loss account in order to calculate gross profit and net profit
respectively. The recorded entries with the help of which the nominal
accounts are closed for transferring their balances to the trading and
profit and loss account are called closing entries. Thus, closing entries
are entries recorded for the purpose of closing the nominal account's
i.e. accounts of expenses and loss and incomes and gains for
ascertaining gross profit and net profit. Simple rule for recording a
closing entry is that the accounts of expenses and losses which have
debit balances are closed by transferring their balance to the debit of
Trading and Profit and Loss Accounts if incomes and given which have
credit balances are closed by transferring their balances to the credit
of Trading and Profit and Loss Account. Such entries have been given
below.
 For closing accounts of expenses
and losses which always show
debit balance
Trading & Profit & Loss A/c
Dr.
To Individual Direct Expenses
A/c
For closing accounts of incomes
and gains which have credit
balances
Individual Income & Gains
 The opening stock, purchase account,
wages accounts, carriage accounts and
Sales Return A/c etc. will be closed by
passing the following closing entry.
Trading Account .. Dr
To Opening Stock
To Purchase A/c
To wages A/c
To Carriage A/c
To Sales Returns A/c
 Similarly the closing entries for Sales and
Purchases Returns and closing stock will be as
follows:-
Sales A/c ....... Dr
Purchases Returns A/c ........ Dr
Closing Stock A/c .. Dr
To Trading A/c

Also, the closing entries for the items of expenses
and losses to be debited to Profit and Loss
Account will be as follows
Profit and Loss A/c .. Dr.
To Individual Indirect Expenses A/c
 Closing entries for the item of
incomes and gains related to
Profit and Loss A/c will be as
follows
Income and Gains A/c (individually)
.. Dr
To Profit & Loss A/c

 BALANCE SHEET
It is a statement showing the position of the assets and liabilities of the
business on the last day of the accounting year or on the date on which
it is prepared. A balance sheet depicts the financial position of the
business. You have already learned about the preparation of Trading
and Profit and Loss Account. It is once again recalled that from the trial
balance the business of all the nominal accounts, i.e. accounts
representing expenses and losses and incomes and gains, are
transferred to the trading and profit and loss account to ascertain gross
profit and net profit respectively. The remaining accounts in the trial
balance are the accounts of assets and liabilities. The accounts having
debit balances are the accounts of assets and the accounts having
credit balances are the accounts of liabilities. These balances of assets
and liabilities are shown in the balance sheet. These are balances of
real and personal accounts and are grouped as assets and liabilities.
 They are arranged in a proper way in the form of a statement
which is called a balance sheet or a position statement. When
balance sheet is represented in a 'T' from, assets are shown on
the right hand side and liabilities are shown on the left hand side.
Uses of Balance Sheet
A balance sheet helps a small business owner quickly get a
handle on the financial strength and capabilities of the business.
Is the business in a position to expand?
Can the business easily handle the normal financial
ebbs and flows of revenues and expenses? Or
Should the business take immediate steps to
encourage cash reserves?
Balance sheets can identify and analyze trends, particularly in the
area of receivables and payables.
 Is the receivables cycle lengthening?
Can receivables be collected more aggressively?
Is some debt uncollectible?
Has the business been slowing down payables to
forestall an inevitable cash shortage?
Balance sheets, along with income statements, are the most
basic elements in providing financial reporting to potential
lenders such as banks, investors, and vendors who are
considering how much credit to grant the firm.
Grouping and Marshaling (Arrangement) of Balance Sheet
The arrangement of the different items of assets and liabilities in
a balance sheet is called marshaling of balance sheet. This can
be done in two ways
 In order of liquidity
In order of permanence
In Order of Liquidity
Under this method, the assets in the balance sheet are
arranged in order of liquidity which they can be, converted
into cash. In other words, first current assets in order of
liquidity are arranged followed by fixed assets, i.e. assets
which are most liquid are shown first followed by less
liquid assets.
Similarly, liabilities are also arranged in order of liquidity,
i.e. current liabilities are first followed by less liquid
current liabilities followed by fixed liabilities. Following is
the profoma of a Sole traders balance sheet in order of
liquidity.
 Order of permanence
When the assets and liabilities in the balance
sheet are arranged in order of permanence in
the fixed items, then the marshalling of the
balance sheet is said to have been done in
order of permanence. It means when the order
is reversed as is followed for the presentation of
assets and liabilities in order of liquidity then it
will become marshalling of the items of balance
sheet in order of permanence. Given below is
the Performa for the presentation of items in a
balance sheet in order of permanence.
 Classification of Assets
An asset is anything the business
owns that has monetary value.
Assets are subdivided into current
and long-term assets to reflect the
ease of liquidating each asset. Cash
is considered the most liquid of all
assets. Long-term assets, such as
real estate or machinery, are less
likely to sell overnight or have the
capability of being quickly converted
 Fixed assets
Fixed assets are those assets that are acquired for
continued use and are not meant for resale, through
later it may be decided to sell particular assets.
Fixed assets may be:
Tangible Assets which can be seen and
touched, e.g., Land & Building, Plant &
Machinery, Furniture & Fixture etc.
Intangible Assets they can neither be seen
nor touched, e.g., goodwill of a firm, patents,
trademarks etc.
Total fixed assets
This is the total value of all fixed assets in the business,
 Total assets
Total assets represent the total value of
both the short-term and long-term
assets of the business.
Classification of Liabilities
This includes all debts and obligations
owed by the business to outside
creditors, vendors, or banks, plus the
owners equity. Often, this side of the
balance sheet is simply referred to as
Liabilities.
 Owners equity
Sometimes this is referred to as
stockholders equity or Capital. Owners
equity is made up of the initial
investment in the business as well as any
retained earnings that are reinvested in
the business.
Retained earnings
These are earnings reinvested in the
business after the deduction of any
distributions to shareholders, such as
 Adjustment Entries
The Trading and Profit and Loss Account is
prepared on the basis of the matching
principle, i.e. incomes of the year must be
mentioned with the expenses of the year.
It means in the trading and profit and loss
account all expenses only of the current
year are debited and all incomes only of
the current year are credited to arrive at
the figures of gross profit and net profit.
This means that if any item of expenses
or income is not included in the amount
 Thus, for making these changes in
this figure given in the trial balance,
some journal entries are passed
which are called adjustment entries.
In the absence of adjustment entries
the profit
or loss shown by the trading & profit
and loss account will be misleading
because in some cases expenses and
incomes will be overstated and in
other cases those will be
 Following are the common
adjustments that are made while
preparing end of period accounts.
Closing Stock
Expenses outstanding
Expenses paid in advance
Incomes accrued
Income received in advance
Depreciations
Bad Debts
 Each of these has been discussed
below.
Closing Stock : Closing stock is
shown below the trial balance as an
adjustment. The following
adjustment journal entry is made for
closing stock.
Closing Stock A/c . Dr
To Trading A/c
Closing stock is shown in the Balance
sheet and is carried forward to the
 Expenses outstanding : Some
expenses may remain unpaid on the
date of preparing the end of period
accounts. Such expenses are called
outstanding expenses and they
include salaries, rent, interest etc.
Such items are both expenses and
liabilities. The adjustment regarding
the outstanding expenses is made by
passing the following journal entry.
Expenses A/c (individually)
 Expenses paid in advance : It is customary to make
payment of some of the expenses like Insurance
premium, rent of the shop etc. in advance. If the
payments for services are not fully used on the date of
preparation of the end of the period. Accounts these
unused parts of the service in terms of money are
recorded by passing the following journal entry.
When expense is paid in advance.
Prepaid Expenses (individually) A/c Dr.
To Cash A/c
When the services of the prepaid expenses is
used.
Expense A/c ................... .Dr.
To Pre-paid Expense A/c
 Incomes Accrued : At times it
happens that certain incomes like
interest on securities, dividend on
shares commission etc. are earned
but not received. Such incomes are
called as accrued. Incomes i.e.
incomes earned interest not
received. The following adjustment
entry is passed for such items
Accrued Income A/c ..
Dr
 Income Received in Advance
Sometimes, it happens that certain
sum of money is received in advance
but not earned in that period in
which it is received such income is
called income received in advance or
unaccured income which is a liability
for the business. The following
adjustment entry is passed for such
items:
Income Account ......................
 Depreciation : Depreciation
decreases the value of an asset
because of wear and tear, passage of
time, or technology becoming
obsolete. It is an expense and is
adjusted by passing the following
adjustment entry:
Depreciation A/c Dr
To Asset A/c
The amount of depreciation is
deducted from the value of assets
 Bad Debts : Debts which are
irrecoverable are called bad debts. The
amounts of bad debts which are not
shown in the balance of bad debts in
the trial balance are adjusted by
passing the following forward entry.
Bad Debts A/c .. Dr
To Debtors A/c
Provision for bad debts : The
purpose of making a provision for bad
debts is to bring down the balance of
 Adjustments:
Closing Stock was valued at Rs. 61700.
Depreciation Furniture and Machinery @
10% p.a. and Sales Van at 20% p.a.
Outstanding Rent amounted to Rs. 900.
Bad Debts Rs. 200.
Make a Provision for Doubtful Debts @
5% on Debtors.
Cheque one-fourth of Salaries and
Wages to the Trading Account.
A new machinery was purchased on
credit and installed on 31st December
 Cash Flow Statement
Introduction
As per Clause 32 of listing agreement, the company shall
provide a cash flow statement along with balance sheet
and profit and loss account. The cash flow will be
prepared in accordance with the accounting Standard on
Cash Flow Statement ( AS-3) issued by the Institute of
Chartered Accountant of India, and the cash Flow
Statement shall be presented only under the Indirect
Method as given in AS-3.
An enterprise should prepare a cash flow statement that
shows the cash inflows, cash outflows, and net change in
cash during the accounting period from its operating,
investing, and financing activities.
 Uses of Cash Flow Statement
The statement of cash flows helps users to assess-
The companys ability to generate positive future cash
flows.
The companys ability to meet its obligations and pay
dividends.
The companys need for external financing.
The reasons for differences between the companys net
income and associated cash receipts and payments.
Both the cash and noncash aspects of the companys
investing and financing transactions.
Structure of the Statement of Cash Flows
Following are the three categories of cash flows:
Cash flows from operating activities.
Cash flows from investing activities.
 Cash Flows from Operating Activities
Operating activities include all transactions and
other events that are not investing and financing
activities. Operating activities include transactions
involving acquiring, selling, and delivering goods
for sale, as well as providing services.
Cash receipts from the sale of goods or services
and collections of accounts receivable are typical
cash inflows from operating activities.
Cash payments to suppliers for inventory and on
account, for wages, and for taxes are examples of
cash outflows from operating activities.
 Cash Flows from Investing Activities
The Cash Flows from Investing Activities section includes
all the cash inflows and outflows involved in investing activities
transactions of the company. Common cash flows from
investing activities are-
Receipts from selling investments in stocks and debt securities.
Receipts from selling property, plant, and equipment.
Payments for investments in stocks and debt securities.
Payments for purchases of property, plant, and equipment.
Cash Flows from Financing Activities
The Cash Flows from Financing Activities section includes
all the cash inflows and outflows involved in the financing
activities transactions of the company. Common financing
activities are:
 Receipts from the issuance of debt securities.
Receipts from the issuance of stocks.
Payment of dividends.
Payments to retire debt securities.
Payments to reacquire stock.
Supplemental disclosures
Non-cash investing and financing activities that
affect an entitys financial position but not the
entitys cash flow during a period should be
disclosed in supplemental part to cash flow
statement.
 Methods of Preparing Cash Flow Statement
Indian Accounting Standard allows two methods for
calculating and reporting a company's net cash flow from
operating activities:
Direct method
Indirect method
Direct Method
This method reports directly the major classes of operating
cash receipts and payments of an entity during a period.
Accrual-basis revenues and expenses must be converted to
equivalent cash receipts and payments.
The amount of cash actually collected or paid is
determined.
 Direct Method Example:
1. Cash Receipts
Sales and Cash Collected from
Customers:
Rs.
Beginning accounts receivable 50
Add: Credit Sales 160
Cash available for collection 210
Less: Ending accounts receivable (70)
Cash collected from customers 140
 2. Cash Paid
Cost of Goods Sold and Cash Paid for
Inventory:
Rs.
Closing inventory 90
Add: Cost of goods sold 120
Required inventory 215
Less: Opening inventory (100)
Cash paid for inventory this year 115
 Indirect Method
This is a method of reporting net cash flow from
operations that involves reconciling net income to a cash
basis. It shows how non-cash flows affect net income.
This method makes the following adjustments:
Adjustments for receivables and other current
operating assets.
Adjustments for payables and other current
liabilities.
Adjustments for depreciation and other non-
cash items.
Adjustments for gains and losses.
 Adjustments for Non Cash items
Depreciation and similar non-cash items do not affect
cash and are not reported on the statement of cash
flows.
Any non-cash item that reduces net income should
be added back to net income in the indirect method.
Any non-cash item that increases net income should
be subtracted from net income in the indirect
method.
Adjustment for Gains and Losses
Gains or losses do not represent the cash effect of
the transaction.
 Preparing a complete Statement of Cash Flows
Following in the process for preparing a statement of cash flows:
Prepare the heading for the statement of cash flows and list the
three major sections.
Calculate the net change in cash that occurred during the
accounting period.
Determine the net income and list this amount as the first item in
the net cash flow from operating activities section.
Calculate the increase or decrease that occurred during the
accounting period in each balance sheet account (except cash).
Determine whether the increase or decrease in each balance
sheet account (except cash) caused an inflow or outflow of cash
and, if so, whether the cash flow was related to an operating,
investing, or financing activity.
 If no cash flow occurred in Step 5, determine
whether the increase or decrease in each balance
sheet account (except cash) was the result of a
non-cash income statement item or a
simultaneous investing and/or financing
transaction.
Complete the various sections of the statement of
cash flows and check that the subtotals of the
sections sum to the net change in cash and that
the sum of the net change in cash and the
beginning cash balance is equal to the ending cash
balance reported on the balance sheet.