Common mistakes students make in accountancy:

1. Confuse Reserves with Cash: Reserves appears on the liability side and Cash on the asset side.
Reserves is not extra cash. As a simple example, assume a company has all its assets in the form
of machinery and inventory and it has no debt. What will its balance sheet look like?
Assets = Equity + Debt
Machinery + Inventory = Paid up capital + Reserves.
What does this mean? It means that the firm has no liquid cash and that the shareholders have
complete claim on its two assets. If the firm decides to pay a dividend, it can technically use its
reserves. But dividends need to be paid in cash! So it will have to either sell inventory or some
fixed assets to generate cash or maybe borrow cash. Say, it sells inventory to raise cash. What
will happen to the balance sheet? First, inventory down, cash up. Second, cash down, reserves
down. What if it borrows cash for the purpose? First, cash up, loan up. Second, cash down,
reserves down. So this is how companies ‘dip into reserves’ to pay dividend. If the firm did not
have sufficient Reserves it could not have done so even if it had liquid cash. Why? Because
Reserves belong to shareholders and that can be used to pay them a dividend. But cash may not
necessarily ‘belong to them’. For e.g. if the accounting equation is
Cash (500) + Other assets (700) = Equity (100) +Reserves (400) + Other liabilities (700).
If the company wants to pay dividend of 450, though it has cash, only 400 of the cash at max
belongs to the shareholders. They do not have claim on the rest.
2. Taking only Paid-up share capital for Shareholder equity : In computing ratios, please remember
that Shareholder equity = Paid up share capital plus Reserves. For well performing companies,
Reserves is typically much larger than the paid up share capital. So if you ignore them, your ratio
will be way off. As a hint, your ratios like ROE will show up as greater than 100% since the net
profit can be greater than the paid up share capital but not greater than shareholder equity. So
if you get a ROE>100%, very likely you are making this mistake.
3. Confusing between receipts and earnings; payments and expenses : Receipts and payments go in
the cash flow statement, earnings and expenses go in the income statement. The former is to do
with cash movement, irrespective of the time period to which it belongs. The latter is to do with
the period in which the revenues are earned and the expenses accrue, irrespective of when they
are received and paid.
4. Confusing between capital items and revenue items : Capital items do not go into the Income
statement, they go to the balance sheet. E.g. purchase of assets, raising a loan, repaying a loan.
Revenue items are concerned with operations and are normally of a recurring nature. They go
into the Income statement. E.g. sale of goods; expenses on production, administration, selling,
interest, operations, etc.
5. What items have to be averaged and what not, in computing ratios : If both numerator and
denominator are ‘flow items’ or both are ‘stock items’ i.e. belong to the income statement or
cash flow statement, or both belong to the balance sheet, no averaging is required since the
ratio is consistent with regard to time. If one of the items is a flow item and the other a stock
item, e.g. ATR, ROE, then the stock item has to be averaged to cover the period to which the
flow item belongs. E.g. ROE = PAT/Equity. If the PAT is for the year 2019-20, the denominator
should be equity that is representative of the year rather than only at a point in time 31 March
2020. So we average the opening and closing equity balances (or if quarterly balances are
available, all of them for the year) for the year to arrive at average equity.