Framework for Preparation of Financial Statements

Introduction
Whether you watch analysts on CNBC or read articles in the Economic Times, you'll hear experts insisting on
the importance of "doing your homework" before investing in a company. In other words, investors should dig
deep into the company's financial statements and analyze everything from the auditor's report to the footnotes.
But what does this advice really mean, and how does an investor follow it?

A firm's financial statements are the primary source of information used by investors and creditors for making
investment decisions. Firm management is obligated to provide accurate information and motivated to provide
financial results that meet the expectations of BSE participants. Much of the time both results can be obtained
simultaneously. However, there are times where the accurate information will not support the expectations of
the investing community. What is management to do?

The requirement for management is to accurately report the firm's financial position. However, in the late 1990s
and early 2000s there were instances where the desire to meet investors expectations dominated the obligation
to provide accurate information. Therefore, it is necessary to understand financial statements and it’s
component.

What is Financial Statements?

They are summarized statements of accounting data prepared at the end of accounting year. These
statements are prepared to give users outside of the company, like investors and creditors, or users within
company like Board of Directors & employees more information about the company’s financial positions. A
general-purpose set of financial statements usually includes a balance sheet, income statements, statement of
owner’s equity, and statement of cash flows.

The Balance Sheet

BALANCE SHEET A financial statement reflecting the recorded values of all assets, liabilities, and owners’
equity at a point in time. The balance sheet is a summary of the assets, liabilities, and equity of a business at a
particular point in time—usually the end of the firm’s fiscal year. The balance sheet is also known as the
statement of financial condition or the statement of financial position. The values shown for the different
accounts on the balance sheet are not purported to reflect current market values; rather, they reflect historical
costs.

In essence, the balance sheet presents the details of the so-called accounting equation:
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
This equation recognizes that a company has assets and there are claims on the assets by creditors (measured in
terms of the company’s liabilities) and company owners (measured in terms of stockholders’ equity).

ASSET A physical or intangible item of value to a company or an individual. Assets are the resources of the
business enterprise, such as plant and equipment, that are used to generate future benefits. If a company owns
plant and equipment that will be used to produce goods for sale in the future, the company can expect these
assets (the plant and equipment) to generate cash inflows in the future.
There are three major categories of assets: current assets , non current assets and investments. Noncurrent assets
include plant assets, intangibles.

FIXED ASSETS - include machinery and equipment, buildings, and land. Some businesses are more capital-
intensive than others; for example, a manufacturer would typically be more capital-intensive than a wholesale
operation and, therefore, have and more fixed assets.

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ACCUMULATED DEPRECIATION The total of past periodic depreciation charges applicable to
depreciable assets carried on a company’s balance sheet, shown as a deduction from gross fixed assets.

GROSS BLOCK - Gross fixed assets mean the original cost of the fixed assets. Cumulative depreciation in
the books is as per the provisions of The Companies Act, 1956. It is last cumulative depreciation till last year +
depreciation claimed during the current year. Net block = Gross Block – Provision for Depreciation.

INTANGIBLE ASSETS are the current value of nonphysical assets that represent long-term investments of
the company. Such intangible assets include patents, copyrights, and goodwill. The cost of some intangible
assets is amortized (“spread out”) over the life of the asset.

AMORTIZATION is akin to depreciation: The asset’s cost is allocated over the life of the asset; the reported
value is the original cost of the asset, less whatever has been amortized. The number of years over which an
intangible asset is amortized depends on the particular asset and its perceived useful

CAPITAL WORK-IN-PROGRESS – This represents advances, if any, given to building contractors, value of
building yet to be completed, advances, if any, given to equipment suppliers etc. Once the equipment is
received and the building is complete, the fixed assets are capitalised in the books, for claiming depreciation
from that year onwards.Till then, it is reflected in the form of capital work in progress.

INVESTMENTS These are assets that are purchased with the intention of holding them for a long term, but
which do not generate revenue or are not used to manufacture a product. Examples of investments include
equity securities of another company and shares/bonds/units of Unit Trust of India etc for speculative purposes.
This type of investment should be ideally from the profits of the organisation and not from any other funds,
which are required either for working capital or capital expenditure. They are bifurcated in the schedule, into
“quoted and traded” and “unquoted and not traded” depending upon the nature of the investment, as to whether
they can be liquidiated in the secondary market or not.

CURRENT ASSETS (also referred to as circulating capital or working assets or gross working capital)
Current assets are assets that could reasonably be converted into cash within one operating cycle or one year,
whichever takes longer. An operating cycle begins when the firm invests cash in the raw materials used to
produce its goods or services and ends with the collection of cash for the sale of those same goods or services.
For example, if Fictitious manufactures and sells candy products, its operating cycle begins when it purchases
the raw materials for the products (e.g., sugar) and ends when it receives cash for selling the candy to retailers.
Because the operating cycle of most businesses is less than one year, we tend to think of current assets as those
assets that can be converted into cash in one year. E.g. cash, marketable securities, accounts receivable,
inventories, and prepaid expenses.

CASH comprises both currency—bills and coins—and assets that are immediately transformable into cash,
such as
deposits in bank accounts.
Every firm must have cash for current business operations. A reservoir of cash is needed because of the unequal
flow of funds into (cash receipts) and out of (cash expenditures) the business. The amount of the cash balance is
determined not only by the volume of sales, but also by the predictability of cash receipts and cash payments.

MARKETABLE SECURITIES are securities that can be readily sold when cash is needed. Every company
needs to have a certain amount of cash to fulfill immediate needs, and any cash in excess of immediate needs is
usually invested temporarily in marketable securities.
Investments in marketable securities are simply viewed as a short term place to store funds; marketable
securities do not include those investments in other companies’ stock that are intended to be long term. Some
financial reports combine cash and marketable securities into one account referred to as cash and cash
equivalents or cash and marketable securities.

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ACCOUNTS RECEIVABLE are amounts due from customers who have purchased the firm’s goods or
services but haven’t yet paid for them. To encourage sales, many firms allow their customers to “buy now and
pay later,” perhaps at the end of the month or within 30 days of the sale.
Accounts receivable therefore represents money that the firm expects to collect soon. Because not all accounts
are ultimately collected, the gross amount of accounts receivable is adjusted by an estimate of the uncollectible
accounts, the allowance for doubtful accounts, resulting in a net accounts receivable figure.

INVENTORIES represent the total value of the firm’s raw materials, work-in-process, and finished (but as yet
unsold) goods. A manufacturer of toy trucks would likely have plastic and steel on hand as raw materials, work-
in-process consisting of truck parts and partly completed trucks, and finished goods consisting of trucks
packaged and ready for shipping.

PREPAID EXPENSES The portion of any expenses paid during a stated period but applicable to future
periods. A company often needs to prepay some of its expenses. For example, insurance premiums may be due
before coverage begins, or rent may have to be paid in advance. Thus, prepaid expenses are those cash
payments recorded on the balance sheet as current assets and then shown as an expense in the income statement
as they are used.

Format of the Balance Sheet in vertical form

Balance Sheet of ..... as on .....

Particulars

I. Source of Funds:
1. Shareholder’s Funds:
(a) Share capital
Equity
Preference
Less: Calls Unpaid:
Add: Forfeited Shares

(b) Reserves and Surplus

Capital Reserve
Capital Redemption Reserve
Securities Premium
Other Reserves
Profit and Loss Account
Less: Deferred Revenue expenditure to the
extent not written-off.
Preliminary Expenses
Discount on Issue of Shares
Profit and Loss account
(debit balance, if any)
2. Loan Funds:
(a) Secured loans
Debentures
Loans and Advance from Banks
Loans from subsidiary Companies

(b) Unsecured loans

Public Deposits
Total (Capital Employed)

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 II. Application of Funds
1. Non Current Assets:
Tangible Assets
Land
Building
Leasehold Premises
Railway Sidings
Plant and Machinery
Furniture
Vehicles
Less: Provision for Depreciation

Intangible Assets
Goodwill
Patents and Trademarks
Less: Amortisation

2. Investments:
Government or Trust Securities, Shares,
Debentures, Bonds

3. Current Assets, Loans and Advances:

Quick
Sundry Debtors
Cash and Bank balances
Bills Receivable
Interest Accrued on investments
Other Current Assets
Short term Loans and Advances
Non Quick
Loose Tools / Stock in Trade, Inventories
Prepaid Expenses

Less: Current Liabilities and Provisions:

Quick liabilities & Provisions
Acceptances
Sundry Creditors
Outstanding Expenses
Provisions for Taxation
Proposed Dividends
Non Quick
Bank Overdraft / Cash Credit
Pre received Income
TOTAL
Note: A footnote to the Balance Sheet may be added to show the contingent liabilities.

LIABILITY is defined as a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.

RESERVES AND SURPLUS represent the profit retained in business since inception of business. “Surplus”
indicates the figure carried forward from the profit and loss appropriation account to the balance sheet, without
allocating the same to any specific reserve. Hence, it is mostly called “unallocated surplus”. The company

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wants to keep a portion of profit in the free form so that it is available during the next year for appropriation
without any problem.

SINKING FUND A separate pool of cash, often held in trust, into which periodic payments are made for the
future redemption of an obligation.

SECURED LOANS represent loans taken from banks, financial institutions, debentures (either from public or
through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and
building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit
permission of the working capital banks)

Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans from banks for
working capital, i.e., current assets are secured by current assets. These loans enjoy priority over unsecured
loans for settlement of claims against the company.

UNSECURED LOANS represent fixed deposits taken from public (if any) as per the provisions of Section 58
(A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975
and loans, if any, from promoters, friends, relatives etc. for which no security has been offered.
Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the
company. There are other unsecured creditors also, forming part of current liabilities, like, creditors for
purchase of materials, provisions etc.

EQUITY, also called shareholders’ equity or net worth or owners fund, reflects ownership. The equity of a
firm represents the part of its value that is not owed to creditors and therefore is left over for the owners. In the
most basic accounting terms, equity is the difference between what the firm owns—its assets—and what it
owes its creditors—its liabilities. Net worth means total of share capital and reserves and surplus.

CURRENT LIABILITIES are obligations that must be paid within one operating cycle or one year,
whichever is longer. It include:
■ Accounts payable, which are obligations to pay suppliers. They arise from goods and services that have been
purchased but not yet paid.
■ Accrued expenses, which are obligations such as wages and salaries payable to the employees of the
business, rent, and insurance.
■ Short-term loans from a bank or notes payable within a year.

INCOME STATEMENT

An income statement is a summary of the revenues and expenses of a business over a period of time, usually
either one month, three months, or one year. This statement is also referred to as the profit and lossstatement. It
shows the results of the firm’s operating and financing decisions during that time.

Income is defined as increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to
contributions from equity participants.

Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrence’s of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

Cost of goods sold - Whenever a product is manufactured or sold, certain direct costs are incurred. These costs
are designated on the income statement as cost of goods sold, or COGS. For a retail company, direct costs are
simply the cost of materials purchased for resale. For a manufacturing company, direct costs can also include

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labor costs, manufacturing overhead, and depreciation expenses associated with production. Since service
companies incur few direct costs, their income statements usually do not include cost of goods sold.

Operating expenses - Operating expenses are expenses other than cost of goods sold that a company incurs in
the normal course of business. These include items such as management salaries, advertising expenditures,
repairs and maintenance costs, research and development expenditures, lease payments, and general and
administrative expenses.

Interest expense - Interest expense is the cost to the firm of borrowing money. It depends on the overall level
of firm indebtedness and the interest rate associated with this debt. Interest expense is generally a small fraction
of total firm expenses, however, this expense as a percent of revenue can fluctuate dramatically with changes in
the firm’s borrowing requirements or with the general level of interest rates in the economy.

The operating decisions of the company—those that apply to production and marketing—generate sales or
revenues and incur the cost of goods sold (also referred to as the cost of sales or the cost of products sold). The
difference between sales and cost of goods sold is gross profit. Operating decisions also result in administrative
and general
expenses, such as advertising fees and office salaries. Deducting these expenses from gross profit leaves
operating profit, which is also referred to as operating income, or operating earnings.

Non Operating includes income from dividend on share investment made in other companies, interest on fixed
deposits/debentures, sale proceeds of special import licenses, profit on sale of fixed assets and any other sundry
receipts.

Operating and Non Operating decisions take the firm from sales to earnings before interest and taxes (EBIT)
on the income statement. The results of financing decisions are reflected in the remainder of the income
statement. When interest expenses and taxes, which are both influenced by financing decisions, are subtracted
from EBIT, the result is net income. Net income is, in a sense, the amount available to owners of the firm. If the
firm has preferred stock, the preferred stock dividends are deducted from net income to arrive at earnings
available to equity shareholders. If the firm does not have preferred stock, net income is equivalent to earnings
available for equity shareholders.

VERTICAL FORMAT
Financial statements should be rearranged for proper analysis and interpretations of these statements. It enables
to measure the performance of operational efficiency and profitability of a concern during particular period.
The items of operating revenues, non-operating revenues, operating expenses and nonoperating expenses are
rearranged into different heads and sub-heads are given below:

FORMAT OF INCOME STATEMENT

PARTICULARS Amt. (Rs.) Amt. (Rs.) Amt. (Rs.)
Gross Sales X
Less : Returns & Allowances / Sales Tax / Excise Duty X XX
Less: Cost of Goods Sold
Opening stock of goods X
Add: Purchases X
Less: Purchases Returns X X
Add: Freight and Carriage X
Less:Closing Stock of Raw Materials X
Direct wages (Factory) X
Other Factory Exp
Factory Rent and Rates X
Power and Coal X
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 Depreciation of Plant and Machinery X
Depreciation of Factory Building X
Work Manager's Salary X
Other Factory Expenses X XX XXX
Gross Profit XXX
Less: Operating Expense
(a) General & Administrative Expense X
(b) Selling Expense X
(c) Finance Expenses X X
Interest on Overdraft / CC
Operating Profit XX
Add: Non Operating Income
Discount Received X
Dividend Received X
Income from Investment X XX
Less: Non Operating Expenses
Loss on Sale of Fixed Assets X
Loss by fire / Earthquake X XX
Net Profit before Interest and Tax XXX
Less: Interest on Long term loan X
Net Profit before Tax X
Less: Provision for Income taxes X
a) Current Tax
b) Deferred tax asset / liability
Net Profit after Tax X
Less: Appropriations X
Closing balance ( to be transferred to balance sheet ) XXX

Income Statement Equations

From the above rearrangement of operating statements, the following accounting equations may be given:
(1) Net sales = Gross sales - (Returns and Allowances)

(2) Gross Profit = Net Sales - Cost of Goods Sold

(3) Operating Expenses = Office and Administrative Expenses + Selling and Distribution Expenses + Finance
Expenses

(4) Net Profit Before Interest and Tax = Operating Profit + Non-Operating Income - Non-Operating Expenses

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