204a –Financial Accounting and Audit

Master of Commerce
M. Com.
SECOND YEAR
204A –FINANCIAL ACCOUNTING AND AUDIT
SCHOOL OF DISTANCE EDUCATION

ANDHRA UNIVERSITY
VISAKHAPATNAM - 530 003
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DIRECTOR
ANDHRA UNIVERSITY, VISAKHAPATNAM - 3

ANDHRA UNIVERSITY
VISAKHAPATNAM
COURSE MATERIAL PREPARATION TEAM
LESSON WRITERS GUIDELINES
Prof. K. Sambasiva Rao

Dept. of Commerce and Management Studies 7,13,14,15,16,
Andhra University 17,18,19.
Visakhapatnam.
Prof. P. Viswanadham
Dept. of Commerce and Management Studies
Andhra University 6, 8
Visakhapatnam.
Prof. A. Narasimha Rao

Andhra University 26, 27,28,29,30
Visakhapatnam.
Prof. M.Akbar Ali Khan

Department of Commerce
Osmania University 9, 10, 11, 12
Hyderabad.
Prof. A. Sudhakar
Department of Commerce
Dr.B.R.Ambedkar Open University 1, 2, 3, 4, 5
Hyderabad.
Prof. N. Chandrasekhara Rao

Department of Business Management
Velagapudi Ramakrishna Siddhardha
20, 21, 22, 23, 24, 25
Engineering College
Kanuru, Vijayawada.
EDITOR
Prof. K.Sambasiva Rao

Andhra University
Visakhapatnam.
iii
GUIDELINE 1 : FINANCIAL ACCOUNTING : AN OVER VIEW
OBJECTIVES
After studying this guideline, you should be able to:
• explain the meaning of accounting;
• discuss the need for and scope of accounting;
• describe the functions of accounting;
• explain the importance of accounting information in decision making; and
• present the basis and branches of accounting.
STRUCTURE
1.1 Introduction
1.2 Meaning of Accounting
1.3 Need for Accounting
1.4 Scope of Accounting
1.5 Book-Keeping and Accounting
1.6 Accountancy, Accounting and Accounts
1.7 Objectives of Accounting
1.8 Functions of Accounting
1.9 Advantages of Accounting
1.10 Limitations of Accounting
1.11 Accounting Information and its Users
1.12 Branches of Accounting
1.13 Basis of Accounting
1.14 Systems of Book-Keeping
1.15 Summary
1.16 Self Assessment Questions
1.17 Further Readings
1.18 Key Words
1.1 INTRODUCTION
Accounting is as old as money, yet it is still in the process of evolution. All disciplines are
developed in historical continuity, same is the case with accounting. One thought leads to another
thought. Where we are today depends to a great extent on where we were yesterday. The role
of accounting has been changing with the economic and social developments. The traditional view
of accounting as a historical description of financial activities is no longer acceptable. Over a
period of time new dimensions have been added to the discipline of accounting. Accounting has
developed to meet challenges and requirements of growing society. Present-day accounting is a
social system. It has developed by adapting to environment. Accounting is often called the language
of business. As the function of any language is to serve as a means of communication the function
of accounting is to serve as a means of communication of business information. However, the
modern system of accounting owes its origin to Luca Pacioli of Italy, who wrote the first treatise
in Double-entry system in 1494. Though the system of accounting was developed first in Italy it
was England and Ireland that it grew to its full stature. Further large scale production, cut-throat
competition. Widening of the market and changes in the technology have brought remarkable
changes in the field of accounting.
Prior to 19 th Century, book keeping system was popular and adequate to meet the
requirements of a business. During 19th century, there has been enormous expansion in the
business activity-business organisations have grown in size, concept of corporate sector has
emerged. Investments started coming from various places-inside and outside the country. There
has been diversity between owners and the management. To meet all these challenges book-
keeping has been transformed into double entry book-keeping which not only performed the
recording function but also dealt with measurement and reporting the results of business
organisations.
During 20thCentury, the quality of life of the people had improved a lot and the informational
need of the people have also changed significantly. This has necessitated the measurement and
communication of adequate, understandable and dependable financial information to the interested
parties-internal and external. To meet this requirement several branches of accounting namely
Management Accounting, Cost Accounting, Government Accounting, Social Accounting, Inflation
Accounting, Human Resource Accounting and Environmental Accounting etc., have emerged.
1.2 MEANING OF ACCOUNTING
What is accounting?
This basic question has never been answered precisely and many definitions on this subject
would emerge as follows:
In 1941, The Committee on Terminology of the American Institute of Certified
Public Accountants (AICP) defined accounting as “the art of recording, classifying and
summarising in a significant manner, and in terms of money transactions and events which are, in
part atleast, of a financial character, and interpreting the results there of'.
In 1966, The American Accounting Association (AAA) defined accounting as “the
process of Identifying, measuring and communicating economic information to permit informed
Judgements and decisions by users of the information”.
In 1970, The AICPAdefined accounting as “a service activity. Its function is to provide
quantitative information, primarily financial in nature, and about economic activities, that is intended
to be useful in making economic decisions”.
Smith and Ashburn defined accounting as “the science of recording and classifying business
transactions and events, primarily of a financial character and the art of making significant summaries,
analysis and interpretation of those transactions and events and communicating the results to
persons who must make decisions or form Judgements”.
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Eric.L. Kohlen defined accounting as “the procedure of analysing, classifying and recording
transactions in accordance with a pre-conceived plan for the benefit of (a) providing a means by
which an enterprise can be conducted in orderly fashion and (b) establishing a basis for reporting
the financial condition of enterprise and the results of its operations”.
Form the above definitions, the following characteristics of accounting emerge:
1. Events and transactions of Business
2. Accounting is the art of recording business transactions
3. The business events and transactions are essentially in monetary terms
4. Accounting is the art of classifying business transactions
5. Accounting is the art of summarising financial transactions
6. Account is an art of analysis and interpretation of business transactions
7. The results of such analysis must be communicated to the persons who are to make
decisions or form Judgements
1.3 NEED FOR ACCOUNTING
Accounting has rightly been termed as the language of the business. The basic function of a
language is to serve as a means of communication. Accounting serves this function. It communicates
the result of business operations to various parties who have some stake in the business viz the
proprietor, Creditors, Investors, government and other agencies. Accounting is primarily concerned
with business entities although non-business entities such as schools, colleges, hospitals and other
agencies also make enough use of accounting for keeping records of their money or financial
transactions. A businessman who has invested his capital in a business enterprise would like to
know whether enterprise is making profit or incurring losses: What is the position of assets and the
liabilities as on a given data, he would also like to know whether his capital in the business has
increased or decreased and so on. A Business enterprise of even small and medium size deals
with many transactions, many customers many employees and many suppliers.
With the result that it has to record thousands of transactions every year. It is impossible to
remember all the transactions in mind. Hence there is a need for a systematic and timely recording
of numerous business transactions in order to get the necessary information in respect of profits,
losses, assets, liabilities and capital of the business enterprise. Accounting plays an important role
in achieving this purpose because it records the business transactions in an orderly manner; and to
group and arrange them in the form of easily understandable financial statements-profit and Loss
Account, Balance Sheet and cash Flow statement.
Further, the need for accounting arises due to the following reasons:
1. Internal Control: As the size of the business grows, it becomes necessary to employ
outsiders to assist in the business. Since outsiders are involved, it is necessary to have
proper accounting records for the purpose of control.
2. Accountability for Moneys Invested: The proprietor in addition to his capital, may
need additional funds from outsiders. These funds have to be properly accounted for. Thus
the need arises in accounting to give information about the sources from which the funds are
obtained and how these funds are used.
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3. Impersonal Nature of Business Enterprises: In case of impersonal organisations like
companies and other corporate bodies, management is different from ownership. The
owners-share holders who have actually invested their money in the company will not take
part in the management. On their behalf the elected representatives Board of Directors
manage the company. Hence, the need for recording all financial transactions.
4. Various Types of Information: The business requires various types of information for
both external and internal use. For example, business information is required for filing
Income tax, Sales tax and other tax returns. A systematic accounting record is a must for
getting this information.
5. Prevention of Manipulations or Frauds: If proper records are maintained in the business
Enterprise, there is minimum scope for manipulations and frauds.
1.4 SCOPE OF ACCOUNTING
Any business is a bundle of transactions. These transactions are to be identified, measured,
classified, recorded, summarised, analysed, interpreted and communicated to an important wing
of management information system. It helps the Management in planning, controlling and evaluating
its activities. The accounting information acts as basis for decision making. The scope of accounting
is presented in a diagramatic form.
Scope of Accounting
Data creation and collection
Historic Predictive
↓
↓ ↓ ↓
Processing Data Data evaluation
Methods Recording ACCOUNTING Budgetary Control
Manual Accounting THEORY Performance Analysis
Mechanical Method Funds Flow Analysis
Electronic Internal Auditing
↓
→ Data Reporting
External Internal
Source: Adopted from R.J.Bull, Accounting in Business, Butter Worths, London, 1969 P.2.
Data Creation and Collection
The business transactions provide the raw material for accounting, the data collected is
historic, in the sense that it refers to events which have already taken place. Thus accounting is
concerned with what had happened. It does not make an attempt to predict and prepare for the
future.
Data Recording
After the collection of historic data, they are recorded in appropriate books of accounts in
accordance with generally accepted accounting theory. A large number of business transactions
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have to be entered in the books of original entry (Journals) and Ledgers in accordance with the
classification scheme already decided upon.
Data Processing
After the transactions have been recorded in the books of accounts, the data is to be
processed. For this purpose, manual, mechanical and electronic methods may be adopted.
Data Evaluation
Evaluation of data includes controlling the activities of business with the help of budgets and
standard costs (Budgetary Control). Evaluating the performance of business, analysing the flow
of funds and analysing the accounting information for decision making purposes by choosing among
alternative courses of action. The analytical and interpretive work of accounting maybe internal or
external and may range from simple answers to elaborate reports produced by extensive research.
Capital project analysis, Financial Forecasts, budgetary projections and analysis for reorganisation,
takeovers, mergers often lead to research based reports.
Data Reporting
Data reporting is done in two ways External and Internal.
External reporting refers to the communication of financial information about the business to
outside parties-Share holders, government agencies and regulatory bodies.
Internal reporting is concerned with the communication of results of financial analysis and
evaluation to management for decision making purpose.
1.5 BOOK-KEEPING AND ACCOUNTING
Now an attempt is made to distinguish between book-keeping and Accounting. Actually
these two are very closely related and there is no universally accepted line of demarcation between
them. The following are the points of difference between Book-Keeping and Accounting.
Book keeping is the art of keeping accounts in a regular and systematic manner. It involves
the chronological recording of financial transactions.
According to G.A. Lee the accounting system has two branches: (a) the making of routine
records from day-to-day in prescribed form and according to set rules, of all events which affect
the financial state of the organisation called as book keeping, the person who maintains them is
known as Book-keeper and (b) the summarisation from time to time of the information contained
in the records, its presentation in significant form to interested parties and its interpretation as an
aid to decision making-called as accounting, the person who is in-charge for these activities is
known accountant.
Book keeping is done in accordance with basic concepts and conventions for all types of
organisations. But the methods and procedures adopted in accounting viz analysis, interpretation,
reporting etc., may not be same for all the firms.
Book-keeping information is not of any use for managerial decisions while management
requires accounting records for important managerial decisions such as planning for future projects,
liquidity position etc.
The work of Book-Keeper is routine and clerical in nature and increasingly being done by
computers. But the work of accountant is technical in nature and requires higher level of knowledge,
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conceptual understanding and analytical skill.
Book keeping has no branches, But accounting has branches like Financial Accounting,
Cost Accounting, Management Accounting, Social Accounting, Tax Accounting, Human Resource
Accounting, Inflation Accounting and Environmental Accounting.
1.6 ACCOUNTANCY, ACCOUNTING AND ACCOUNTS
Accountancy deals with the concepts theories, principles, rules, methods, procedures etc.,
of Accounting. It tells about the maintenance preparation and presentation of accounts.
Accounting is the actual process of drawing up of accounts with a view to knowing the
financial result and position of the organisation. The result of accounting is the accounts i.e. classified
statements of transactions of the organisation.
Thus, accountancy is a systematic body of knowledge, while accounting is the practice of
that knowledge. When these two are combined, the result is accounts. In common language,
these terms are used as synonyms. However, the term accounting is more popular.
1.7 OBJECTIVES OF ACCOUNTING
Accounting is an information system basically designed to cater to the informational needs
of both external and internal parties. Information to external parties is provided through external
reporting known as annual reporting. Internal reporting is meant for providing information to the
managers working with in the organisation at various levels for taking business decisions.
From the above discussion, the objectives of accounting can be stated as follows:
1. Maintenance of Systematic Records: Accounting is done to keep a systematic record
of Financial transactions. This is done in accordance with the universally accepted accounting
concepts and conventions. Such a classified data certainly helps the users of accounting
information in arriving at reliable decisions.
2. Assessing the Operational Performance: We know that the primary objective of business
is to make profit and a businessman is very much interested in knowing the profitability
position. A proper record of incomes and expenses facilitate the preparation of income
statement. It reveals the operational efficiency of the business concern in terms of profit
earned or loss suffered during the period under consideration.
3. To Ascertain the Financial Position: The businessman is not only interested in knowing
the operational performance, but also interested in knowing the financial position of his
business. i.e., where it stands. In other words, he wants to know what the business owes
to others and what it owns, and what happened to his capital whether the capital has increased,
decreased or remained constant. A systematic record of various assets and liabilities facilitates
the preparation of a statement known as Balance Sheet. Which answers all the above
questions.
4. To Provide Accounting Information for Rational Decision Making: Various parties
are interested in knowing about the business firm, such as the owner(s), the management,
the bank, the creditors, the tax authorities, employees, consumers. For this purpose the
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accounting system has to provide the required information. This kind of information enables
the users to assess the financial strengths and weaknesses of the business, and taking rational
decisions concerning the appraisal of various proposals.
5. Protecting Business Properties: Every transaction is recorded systematically. The
information in respect of assets and properties owned by the enterprise is also recorded
and maintained properly. As such it checks the unauthorised use of business properties for
personal use.
Accounting provides protection to business properties from unjustified and unwarranted
use.
1.8 FUNCTIONS OF ACCOUNTING
The purpose of accounting is to provide financial information about an economic entity. The
financial information provided by an accounting system is needed by decision makers so as to help
them in planning, monitoring and evaluating the activities of the economic entity. Therefore, the
main functions of accounting are (1) Managerial Function and (2) Historical Function.
1. Managerial Function
Providing information to the management for planning, monitoring and evaluating the operations
and to make decisions.
2. Historical Function
Recording of data, classification of data, summarising the data, of financial nature, analysis
and interpretation of financial statements, validating the data, communication and reporting the
financial history of an organisation to the interested parties.
A brief description of the above functions are described below.
1. Recording: This is the basic function of accounting. In a business organisation everyday a
number of transactions take place. Owing to the complexities of business events it is necessary
to record them in Journal and other subsidiary books in a classified manner. Thus the
accounting system supplements human memory and facilitates the interested parties to make
use of the accounting information in an effective manner.
2. Classifying: Classification is concerned with the systematic analysis of the recorded data,
with a view to group transactions or entries of one nature at one place. The work of
classification is done in the book termed as “Ledger” A Ledger contains different types of
accounts namely personal accounts, Real accounts and Nominal accounts.
3. Summarising: From the recorded and classified data, summary reports like income
statement, Balance sheet, cash flow statements are prepared. They are easy to understand
and useful to the internal as well as external end-users.
4. Deals with Financial Transactions: Accounting records only those transactions and
events in terms of money which are of a financial character. Transactions which are not of
a financial character are not recorded in the books of account. Therefore, anything which
can not be expressed in monetary terms, does not form part of financial accounting even
though it has a significant bearing on the working of the business.
5. Analysis and Interpretation of Financial Statements: This is the final function of
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accounting. The data contained in the financial statements is to be analysed and interpreted
in a suitable manner that the end users can make a meaningful Judgements about the financial
condition and profitability of the business. Analysis involves the segregation of data into
various components and establishing relationship among them. On the other hand
interpretation means explaining the meaning & significance finally drawing inferences regarding
the phenomenon under consideration. Analysis and interpretation of data is important for
decision making. However, it is said both ‘Analysis’ and Interpretation are complementary
to each other. Interpretation requires Analysis, while Analysis is useless without interpretation.
6. Communicating the Results: Mere recording, classifying , and summarising the business
transactions is not enough but the analysed and interpreted data are to be communicated to
the users. This is done through preparation and distribution of accounting reports which
include besides the usual income statement and the balance sheet, additional information in
the form of accounting ratios, graphics, diagrams, Funds flow statements etc., Communication
should be done at regular intervals. Communication of the results helps the people understand
the profitability and financial position of the firm.
7. Validating the Data: The accountant has an obligation to supply, reliable, adequate,
relevant timely and useful data to the interested parties.
1.9 ADVANTAGES OF ACCOUNTING
A number of advantages can be derived if a proper system of accounting is followed.
These advantages are:
1. Assistance to Management: The accounting information helps the management to plan
its future activities by preparing budgets in respect of Sales, Production, expenses, cash
etc. Accounting helps in co-ordination of various activities in different departments by
providing financial details of each department.
2. Records rather than Memory: It is not possible at all to do any business by Just
remembering the business transactions which have grown in size and complexity.
Transactions therefore, must be recorded early in the books of accounts so that necessary
information about them is available in time and free from bias.
3. Operational Efficiency: It can be easily known how much profit the concern has earned
or how much loss it has incurred in a particular year. In addition to the operational efficiency,
the financial position of an organisation can also be known.
4. Historical Records: As all the financial transaction and events are recorded in the books
at actual costs. Hence, they serve as historical records.
5. Intra-period Comparisons: Accounting information when recorded properly can be
used to compare the results of one year with those of previous years.
6. Aid in Legal Matters: Systematically recorded accounting information can be produced
as an evidence in a court of law.
7. Help in Taxation Matters: Income Tax and Sales Tax authorities could be convinced
about the taxable income, Sales as the case maybe, with the help of accounting statements.
8. Sale of Business: In case, a sole trader,8or a partnership firm or even a company wants
to sell, its business, the accounting information can be utilised to determine proper purchase
price.
1.10 LIMITATIONS OF FINANCIAL ACCOUNTING
The nature of information shown by the financial Accounts and the way in which they are
reported may give the impression that the financial accounts are precise, exact and final. But they
suffer from serious limitations. They are:
i) Accounting Information is Expressed in Terms of Money: Non-Monetary
transactions, however, important they may be, are completely omitted. As such the
information supplied by financial accounting is not complete and does not portray true and
fair view of the business.
ii) Historical Data: Financial statements contain past data and the use of such data amounts
to postmortem analysis. Financial account gives information about what has happened and
not about what will happen. As such the decisions based on this information pertaining to
future cannot be realistic.
iii) Aggregate Data: In financial accounting the information is recorded for the whole concern.
It does not provide information in respect of individual items. For effectivce decision
making information about individual products, processes, departments, activities etc., is
needed
iv) Subjectivity: Recording of transactions is based on certain generally accepted accounting
principles but there exists more than one principle for the treatment of certain items. In
respect of depreciation, inventory valuation etc., Further the personal bias of the accountant
affects the accounting statements and thus permits the alternative treatments. Thus the
possibility of alternative treatments makes the results different and incomparable.
v) In accurate Estimations: Accounting information sometimes based on estimates is often
inaccurate. For example, it is not possible to predict with any degree of accuracy the
actual useful life of a fixed asset for the purpose of depreciation of a fixed asset for the
purpose of depreciation.
vi) Price Fixation: The price of a product is determined on the basis of total cost of the
product. But the total cost of the product can be ascertained only after all the expenses are
incurred.
In financial accounting there is no provision in forecasting the expenses in advance. Therefore
financial accounting is not helpful for preparing price quotations. Further price fixation
requires information regarding variable and fixed costs. However, in financial accounting
records are not maintained to furnish any such defaults.
vii) Cost Control: In financial accounting aggregation of costs of possible only at the end of
accounting period. As such the data provided by financial accounting will not help controlling
the costs. Any such effort will result in postmortern analysis as the costs are already incurred.
It does not help fixing up responsibility for incurring higher costs. Cost control requires a
constant review of actual costs from time to time which is not possible in financial accounting.
viii) Price Level Changes: Fixed assets are recorded in the financial accounting records at
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the original cost. But the prices of fixed assets vary from time to time on account of
changes in price levels. The direct result of this practice is that Balance Sheet does not
portray the true financial position of the business.
ix) Appraisal of Polices: It does not facilitate the comparison of actual performance with the
desired performance. Hence accurate appraisal of projects is not possible.
x) Strategic Decisions: Business management has to take certain strategic decisions in
respect of replacement of labour by machinery, introduction of a new product,
discontinuation of an existing line of production, expansion of capacity etc.
For taking these decisions cost benefit analysis will have to be carried out considering their
future implications. Financial Accounting does not provide any such information.
xi) Technical Subject: Financial Accounting is a technical subject. Financial accounting is
governed by the Generally Accepted Accounting principles. As such the persons who are
not conversant with accounting subject cannot effectively use the data for decision making
purpose.
In view of the limitations mentioned above one must be very careful while using the accounting
information. One should not just depend on the statements of a single year. But statements of a
number of years are to be studies systematically.
1.11 ACCOUNTING AS AN INFORMATION SYSTEM AND ITS USERS
Accounting is often referred to as language of business. The primary aim of a language is to
serve as a means of communication. Accounting is used to communicate financial and other
information to people, organisations etc., about various aspects of business and non-business
entities. Accounting is viewed as a system comprising of a series of interrelated activities. As an
information system, the accounting process serves persons both inside and outside the organisation.
It is, therefore, a discipline which collects, reports, and interprets financial information about the
activities of different organisations. Accounting as a system converts inputs into output. In other
words A system is a set of elements which operate together in order to attain a goal. Observe the
following system for better understanding.
System Elements Basic goals
College, Hospital, Police Teachers, Students, Education Help Patients
Doctors, Medicines Men, Crime Control
Equipment, Communication
Network
The inputs of accounting system are business transactions and events which are processed
with the help of accounting principles-concepts and conventions-into outputs in the form of financial
statements-profit and Loss account, Balance Sheet, Cash-flow statement for the use of managers,
investors, creditors and so on
Accounting as an information system is presented as under:
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Inputs Process Output
Business Transactions Accounting concepts and Profit & Loss Account
and events conventions Balance Sheet cash flow
statement
The basic goal of accounting system is to provide information to various interested parties.
The accounting information system should be designed to provide the special and complex needs
of internal management of the business enterprise on continuation basis. The informational needs
of to internal management include planning and control. Information should be viewed as an
economic good that assets in the allocation of resources of the society.
Users of Accounting Information
Accounting provides useful information about the activities of an entitity to various individuals
or groups for their use in making informed Judgements and decisions. The users of accounting
information an be broadly divided into three categories.
1. Management
2. Users with direct financial interest
Accounting
↓ ↓ ↓
Management Users with direct financial interest Users with indirect financial
interest
Internal External
External
1. Directors 1. Present and potential share-
2. Officers of the Company holders 1. Customers
3. Department Heads 2. Present and potential creditors 2. Taxation authorities
4. Supervisors 3. Employees, suppliers 3. Government and other
agencies
↓ ↓ 4. Financial↓analysis and ad-
visors
Decisons Decisions
5. Brokers, underwriters,
1. Assessing profitability 1. Investment decisions planners, labour unions,
2. Assessing financial posi- 2. Credit decisions consumer groups, general
tion and actual perfor- 3. Assessing firms status and public, press, etc.
mance on terms of plans projects
and goals, making plans ↓
and policies. Decisions
1. Assessing taxes
2. Protecting investors
3. Protecting public interest
4. Advice on investment de-
cisions
5. Setting economic policies
6. Measuring social and en-
vironmental protecting
programmes
7. Negotiating labour agree-
ments.
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3. Users with indirect Financial interest
Following chart shows different users of accounting information and different decisions made
by them.
Different users of Accounting Information
1. Management
Management includes top-level management, middle level Management and lower level
management. Top level management is concerned with strategic planning. It needs overall summary
reports of the enterprise. Middle level management is concerned with controlling business activities
by maintaining liaison between top-management and lower level management. As such they need
comparative information in respect for ensuring the desired results. Lower level management is
concerned with the execution of plans. They need elaborate data for understanding and executing
the plans in an optimum manner. Therefore, accounting information system should be designed in
such a way that is caters to the informational needs of managers at all levels in the organisation.
2. Users with Direct Financial Interest
Users who have direct financial interest include share holders/Investors and creditors. These
users do not participate in the actual management of the company but have interest in how business
has performed because they have invested or are thinking of investing in a company.Existing
and potential Investors are obviously interested in the past performance of a company and
its earning potential and growth prospects in the future. For this, the company’s financial statements
and other information should be analysed the decide and select profitable investment opportunities.
Similarly,the existing and potential creditors require accounting information to make
sound credit decisions viz. Whether to lend money to a company, the creditors are interested on
knowing whether the company will have enough cash to pay interest charge and repay the debt on
the due date. For this the company’s liquidity and cash flow position should be analysed. Banks,
financing companies. Insurance companies, individual creditors who lend money need accounting
information to analyse a companies profitability, liquidity and financial position before making a
loan to the company.
Besides the Investors and Creditors, there are other users such as suppliers and employees
who have direct financial interest in a company and accounting information as well.
Suppliers are interested in company’s ability to generate adequate cash flows towards the
payment of goods and services supplied.
Employees use the financial reports to assess risk and growth potential of a company,
therefore, job security and future promotional possibilities.
3. Users with Indirect Financial Interest
There are some other users who have indirect interest in a company’s business. Such users
are customers, Taxation authorities, governmental and regulatory agencies, labour unions, Financial
analysts and advisors, stock exchange brokers, underwriters, economists, Planners, consumer
groups, general public and the press.
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Customers use financial information to forecast the likelihood and/or timing of a firm going
bankrupt or being unable to meet Hs commitments.
Consumers expect goods and services of reasonably good quality at reasonable prices.
This is possible only when the firm conducts Hs activities in a satisfactory manner. Hence, the
business organisations have the responsibility of providing them with necessary information
Taxation authorities require financial statements to ascertain tax liability of a company.
Governmental and regulatory agencies are concerned with the financial activities of business
organisation for purposes of regulation to protect the public interest.
Society needs accounting information to fulfil the social responsibilities. Because, business
is an economic activity, the prosperity of business enterprise is an indicator of economic well being
of the nation. Business organisations have to discharge certain social responsibilities like creation
of employment opportunities, infrastructure facilities, and keeping the environment free from pollution
etc.
Stock brokers, financial analysts, investment advisers have an indirect interest in the
Financial performance and prospects of a company as they advise investors and creditors in their
investment decisions.
Economic planners use accounting information to set economic policies to forecast economic
activities and to evaluate economic programmes under taken by the country. The other users such
as press, general public are more concerned about business enterprises and their effect on
environment, social problems inflation and the quality of life.
Thus the users of accounting information are many and diverse. Hence the accounting
information is intended to serve the various needs of all the interested groups. However, information
should have relevant, timely and adequate information as per as possible.
1.12 BRANCHES OF ACCOUNTING
In order to satisfy needs of different people interested in the accounting information, different
branches of accounting have developed. They can broadly be classified into three categories.
1. Financial Accounting
It is concerned with recording and processing of business transactions affecting the financial
position of the firm. H is mainly confined to the preparation of financial statements for the
use of outsiders like shareholders, Creditors, banks and financial institutions. The financial
statements i.e. the profit and Loss Account and the Balance sheet show them the manner in
which operations of the business have been conducted during a specified period.
2. Cost Accounting
Cost Accounting is concerned with the ascertainment of cost of each product or Job produced
or undertaken by the firm.
3. Management Accounting
It is accounting for management i.e., accounting which provides necessary information to
the management for discharging its functions. Management Accounting is the application of
13
professional information in such a way as to assets the management in the formation of
policies of an undertaking. Management accounting covers various areas such as cost
accounting, budgetary control, inventory control, statistical methods, internal Auditing etc.
Owing to ever growing informational needs of various interested parties, new innovations
are taking place in Accounting. As a result of which, social responsibility Accounting, human
resource accounting inflation accounting environmental accounting have emerged as major branches
of accounting.
1.13 BASIS OF ACCOUNTING
Basically, there are three bases of accounting viz Cash Basis of Accounting, Accrual
(Mercantile) basis and Mixed basis.
i) Cash Basis: Under this basis actual cash receipts and actual cash payments are recorded
credit transactions are not recorded at all until the cash is actually received or paid. The
Receipt and payments Account prepared in case of non-trading concerns such as charitable
institution, a club, a school, a college etc., and professional men like a lawyer, a doctor a
chartered Accountant etc., cash basis of accounting is simple, appears to be so realistic is
verifiable and satisfies the conservative instruct. Although the basis is very simple yet it is full
of deficiencies because it ignores outstanding and prepaid expenses and accrued income
and income received in Advance and as a result does not give a true and fair view of profit
and loss and Financial position of the enterprise.
ii) Accrual (or Mercantile) Basis: Keeping in view the deficiencies of the cash basis of
accounting, the accrual basis of accounting has been developed by accountants. It considers
not only cash receipts and payments but also accruals. All the revenues earned in a year
may or may not be received in cash in that very year. Similarly all expenses incurred in a
year may or may not be paid in that year. Accrual accounting attempts to relate the revenues
and expenses to the year in which they are earned or incurred, irrespective of the cash
receipts of payments. Accrual accounting is also called Mercantile system of Accounting.
Final accounting system, it should be noted is generally on accrual basis.
The Main difference between accrual accounting and accounting based on cash is the timing
of recognition of revenues, gains, expenses and losses.
Mixed Basis
Under this basis, both cash basis and mercantile basis are followed. Incomes are recorded
on cash basis whereas expenses are taken on accrual basis and net income is ascertained by
matching incomes and expenses. Hence it is known mixed or historical method.
1.14 SYSTEMS OF BOOK-KEEPING
Broadly there are two systems of Book-Keeping viz., the double entry system and single
entry system.
Double Entry System
Every transaction has two aspects i.e. giving and receiving. For example, when a pay
money, there is somebody to receive it. Thus, for every transaction two accounts are affected at
14
the same time and with the same account, one account about giving the benefit and the other about
receiving the benefit.
Double entry is a system which recognise that every debit should have a corresponding
credit. This system has many advantages:
1. Accuracy of the accounts can be verified.
2. Final accounts can be prepared.
3. There is a check and counter check in the form of double entry, Arithmetical Accuracy
is followed.
4. All the three types of Accounts-personal, Real and Nominal are present in this system.
5. Frauds and misappropriating can be avoided.
Single Entry System
Single entry system is unscientific and unsystematic method of recording transactions and
events. Single entry system is not really a system because in some cases record may be one-sided
and in some other cases no record is maintained at all. It is more appropriate to call it an incomplete
system of recording transactions. Double effect of every transaction is ignored and only the
accounts relating to suppliers and customers and cash account are found. Thus, the system is
incomplete inaccurate and unscientific system of recording business transactions.
1.15 SUMMARY
Accounting is as old as money, yet it is still in the process of evolution. The role of Accounting
has been changing with the economic and social developments. The present day accounting is a
social system. Accounting is often called the language of business. As the function of any
language is to serve as a means of communication, the function of accounting is to serve as a
means of Communication of business information. Modern system of Accounting owes its origin
to Luca Pacioli of Italy. Accounting is the science of recording and classifying business transactions
and events, primarily of a financial character and the art of making significant summaries, analysis
and interpretation and communicating the results to persons who must take decisions or firm
judgements.
Accounting provides information to both internal and external parties and facilitates decision
making. Accounting considers only monetary transactions which are of historical nature. It suffers
from subjectivity. It does not consider the impact of price level changes on the assets and liabilities
of the firm. Further several branches of accounting namely management accounting, cost accounting,
social accounting, inflation accounting, human resource accounting and environmental accounting
have emerged.
1.16 SELF ASSESSMENT QUESTIONS
A. Short Answer Questions
1. What is accounting?
2. What is book-keeping?
3. What is the need and scope of Accounting?
15
4. What are the branches of accounting?
5. What are the different accounting systems?
6. What are the different basis of accounting?
7. Who are the various users of accounting information?
8. What are the functions of accounting?
9. What are the advantages of accounting?
10. What are the limitations of accounting?
11. What are the objectives of accounting?
12. What are the informational needs of management?
13. Distinguish between double entry and single entry
14. Distinguish between
a) Book-Keeping and accounting
b) Accountancy and accounting
c) Accrual and cash basis of accounting
B. Long Answer Questions
1. Define accounting and explain the need for accounting in business.
2. Explain the objectives of Accounting.
3. Explain how accounting helps decision-making.
4. Explain the Advantages and limitations of Accounting.
5. Who are the parties interested in accounting information? Why do they need the
information?
1.17 FURTHER READINGS
1. Anthony, Robert.N and : Account Principles, All India Traveller Book Seller:
James Reece New Delhi, 1987.
2. S.N. Maheswari : Management Accounting, Sultan Chand and Sons,
New Delhi.
3. Hendrikrew, E.S. : Accounting Theory, Khosla Publishing House,
Delhi,1984.
4. Meigs, Watter, B. and : Accounting : The Basis for Business Decisions,
Robert F.Meigs McGraw Hill, New York, 1987.
5. Bhattacharya.S.K. and : Accounting for Management, Text and Cases,
John Dearden New Delhi, 1984.
6. R.K.Sharma and : Management Accounting, Kalyani Publishers, New
Shashi K. Gupta Delhi.
16
1.18 KEY WORDS
Accounting : It is the process of identifying, measuring and
communicating economic information to permit informed
Judgements and decisions by users of the information.
Book-Keeping : It is the art of keeping accounts in a regular and systematic
manner and involves the chronological record of financial
transactions.
Double Entry System : Every transaction has two aspects i.e., giving and receiving
aspect. It is a system which recognises that every debit
should have a corresponding credit.
Single Entry System : Incomplete, inaccurate and unscientific system of recording
business transactions.
Cash basis of Accounting : Actual cash receipts and actual cash payments are
recorded suitable for non-trading organisations.
Accrual basis (or Mercantile) of : It considers not only cash receipts and cash payments
Accounting but also accruals. Accrual accounting is also called
Mercantile system of Accounting. suitable for business
organisations.
Analysis : It involves the segregation of data into various components
and establishing relationship among them
Interpretation : It involves drawing inferences regarding the phenomenon
under consideration
Financial Accounting : It is concerned with recording and processing of business
transactions affecting the financial position of the firm.
Cost Accounting : It is concerned with the ascertainment of cost of each
product of job produced or undertaken by the firm. It
facilitates cost estimation and Cost Control.
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GUIDELINE 2 : ANALYSIS OF FINANCIAL STATEMENTS
OBJECTIVES
The aim of this guideline is to discuss the nature, objectives, types of financial statements
and their analysis.
• explain the nature, objectives, meaning of financial statements and their analysis;
• describe the form and content of financial statements;
• explain the significance and limitations of financial statements analysis;
• describe the techniques of financial analysis; and
• prepare comparative, common size and trend percentage analysis of financial statement
and interpret them.
STRUCTURE
2.1 Introduction
2.2 Meaning and Nature of Financial Statements
2.3 Features of Financial Statements
2.4 Objectives of Financial Statements
2.5 Types of Financial Statements
2.6 Form and Contents of Balance Sheet
2.7 Form and Contents of Profit and Loss Account or Income Statement
2.8 Use and Importance of Financial Statements
2.9 Limitations of Financial Statements
2.10 Financial Statement Analysis
2.11 Meaning and Concept of Financial Analysis
2.12 Meaning of Interpretation
2.13 Types of Financial Analysis
2.14 Procedure for Analysis and Interpretation
2.15 Objects of Analysis and Interpretation
2.16 Techniques of Financial Statement Analysis
2.17 Summary
2.20 Key Words
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2.1 INTRODUCTION
Financial statements are end products of business transactions. They are prepared following
the consistent accounting concepts, principles, procedures and also the legal environment in which
the business organisation operates. These statements are the outcome of the summerising process
of accounting and are therefore the sources of information on the basis of which conclusions are
drawn about the profitability and the financial position of a business enterprise. Hence financial
statements are to be arranged in proper form with suitable content so that the users can understand
and make use of them in their economic decisions in a meaningful way.
As we all know the primary objective of any business is to earn profit. The finances of a
firm obtained from its owners are invested in assets. The assets are used to generate sales and
thus to earn profits. The quantum of profits ultimately depends upon the efficiency with which the
assets of the firm are managed. Therefore, the management is interested in analysing the factors
contributing for the state of affairs either good or bad. Having understood the factors, we should
learn the meaning, nature, objectives of financial statements, types, their forms and contents, use
and limitations. This unit further helps the students to equip themselves with the basic requirements
for understanding financial statements and subsequently analysing the financial statements and
preparing necessary reports for the specific decision making purposes of the various levels of
management.
2.2 MEANING AND NATURE OF FINANCIAL STATEMENTS
A financial statement is an organised collection of data according to the logical and consistent
accounting procedures. Its purpose is to convey an understanding of some financial aspects of a
business firm. It may show a position at a moment of time as in the case of Balance Sheet, or may
reveal a series of activities over a given period of time as in the case of Profit and Loss Account.
Thus, the term Financial statements generally refers to two basic statements: i) the Profit and
Loss Account or the Income Statement and ii) the Balance Sheet or the position statement. Of
course, a business may also prepare a) Statement of Retained Earnings and b) Statement of
Changes in Financial Position in addition to the above two statements.
These statements are the basic and formal means through which the corporate management
communicates financial information to various users.They are primarily directed towards the
needs of owners and incidentally to the needs of external parties, which include investors,
tax authorities, government, employees etc.
The following definitions bring out the meaning of Financial Statements.
1. American Institute of Certified Public Accountants (AICPA)
“Financial statements are prepared for the purpose of presenting a periodical review or
report on progress made by management and deal with the status of investment in the business and
the results achieved during the period under review”.
2. John N Myer
“The financial statements provide a summary of accounts of business enterprise, the balance
sheet reflecting the assets, liabilities and capital on a certain date and the income statement showing
the results of operations during a certain period.
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3. Smith and Osborne
“The end product of financial accounting in a set of financial statements prepared by the
accountants of a business enterprise that purport of reveal the financial position of the enterprise,
the result of its recent activities and an analysis of what has been done with earnings."
4. Anthony
“Financial statements, are essentially, are interim reports presented annually and reflects a division
of the life of an enterprise into more or less arbitrary accounting period-more frequently a year”.
2.3 FEATURES OF FINANCIAL STATEMENTS
Various definitions given above reveal the following features:
i) Intended Users: The financial statements are prepared intending towards those users
who have interest in the business enterprise. These statements are prepared with an
assumption that the user is familiar with the business practices and the meaning and implications
of the terms used in the business.
ii) Report History: Financial statements are prepared on the basis of past financial transactions
of a concern during specified period and generally report what has happened in the past.
However, these statements provide basis for the future for the prospective Investors and
Creditors in the form of estimates of future activities and its effect on income and on the
equity of the investors.
iii) Legal and Economic Consequences: Since financial statements reflect the elements of
economics and law, they are conceptually oriented towards economy but many of the
concepts have the origin in law. For example, convention of disclosure and convention of
materiality.
iv) Use Specific Terminology: Financial statements are end product of accounting process.
In this process, specific terminology assigned with distinct meanings is used, which indicate
the user to be conversant with it so as to understand the interpretation.
v) Financial Statements are Interrelated: The basic financial statements viz., the balance
sheet and profit & loss account are interrelated. The profit & loss account shows the
financial results of the business operations, which ultimately reflect in various balances in the
Balance Sheet.
vi) Presents Summarised and Classified Data: The volumes of business transactions convey
no meaning unless they are classified and summarised. Financial statements help in
classification and summerisation of the business data.
vii) Expressed in Money Units: All the business transaction and events are quantified,
measured and expressed in monetary units such as rupees, dollars etc., non-monetary items
find no place in financial statements.
viii) Uses different Methods of Valuation: Different methods are used for valuation of assets.
For example, inventories are valued at cost or market value, whichever is lower. Fixed
Assets are valued at cost less depreciation. Cash-in-hand and bank balances are valued at
current exchange value.
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ix) Follow Accrual Basis of Accounting: Most of the financial statements are prepared on
accrual basis rather than on cash basis. It takes into consideration all incomes due but not
received and all expenses due but not paid.
x) Amenable for Verification
The facts of the data presented through financial statements are amenable to objective
verification and hence these statements are verifiable which improves its reliability.
2.4 OBJECTIVES OF FINANCIAL STATEMENTS
Financial statements are the sources of information to the users-internal and external for
understanding the profitability and financial position of any concern. The primary objective of
financial statements is to assist the users in their economic decision making. The Accounting
Principles Board of America (APBA) states the following objectives of financial statements.
i) To provide reliable financial information about economic resources and obligations of
a business firm.
ii) To provide other needed information about changes in such economic resources and
obligations.
iii) To provide reliable information about changes in net resources arising out of business
activities
iv) To provide useful financial information, which can gainfully be utilised to predict,
compare, evaluate the business firms earning capacity.
v) To disclose, to the extent possible, other information related to the financial statements
that is relevant to the needs of users of these statements.
2.5 TYPES OF FINANCIAL STATEMENTS
Financial Statements comprise two basic statements, i) the Balance Sheet or the Position
Statements: and ii) the Profit and Loss Account or Income Statement. However, Generally Accepted
Accounting Principles (GAAP) specify that a complete set of financial statements must include:
i) Balance Sheet or Position Statement
ii) Profit and Loss Account or Income Statement
iii) Statement of Changes in Owner’s Account
iv) Statement of Changes in Financial Position
From the above description, we can conclude that the two basic financial statements known
as balance sheet and profit and loss account are required for external reporting and also for
internal needs of the management like planning, decision making and control. These two statements
are supported by number of schedules, annexures, supplementing the contents in the balance
sheet and the profit and loss account. Apart from these two basic statements, there is a need to
know about two more statements, namely, the statement of retained earnings and statement of
changes in financial position.
Before we discuss the form and contents of these statements, let us briefly explain the
meaning and significance of each of these statements.
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Balance Sheet or Position Statement
The Balance Sheet is a statement of financial position of a business at a specified movement
of time. It is a statement of assets and liabilities of a firm or what it owes and what it owns as on
a given date. In a balance sheet the assets and liabilities balance, and are equal to each other as
this statement is based on the double-entry system of book keeping
Profit and Loss Account or Income Statement
The Income statement (also termed as Profit and Loss Account) is prepared to determine
the operational position of the business. It explains what has happened to a business as a result of
operations between two balance sheet dates. For this purpose it matches revenues (incomes) and
costs (expenses) in the process of earning revenues and shows the net profit earned or loss suffered
during a particular period. The profit and loss account is prepared for a particular period generally
a year. The income statement may be prepared in the form of Manufacturing Account to find out
the cost of production, In the form of Trading Account to determine gross profit, in the form of
profit and loss account to determine net profit. A statement of Retained Earnings may also be
prepared to show the distribution of profits.
The important distinction between the two statements is that the profit and Loss Account is
for a specific period while Balance Sheet is on a particular date. Profit and Loss Account is
therefore, a flow report as contrasted with the Balance Sheet which is a static report.
However, both are complementary to each other.
iii) Statement of Changes in Owner’s Equity or Retained Earnings
Owners' equity refers to the claims of owners in the assets of the firm and includes a) paid
up share capital b) reserves and surpluses representing the undistributed profits. It is also known
as profit and loss appropriation account or income disposal statement. This statement shows the
balance of profit brought down plus profits of current year, and appropriations made out of such
profits in the form of dividends, transfer to reserves. The Balance in this account will show the
amount of profit retained and carried forward to Balance Sheet. It is, thus a connecting link
between the Balance Sheet and the Profit and Loss Account
iv) Statement of Changes in Financial Position
The Balance Sheet shows the financial condition of the business at a particular moment of
time while the income statement discloses the results of operation of business over a period of
time. However, for a better understanding of the affairs of the business it is essential to identify the
movement of working capital or cash in and out of the business. This information is available in the
statement of changes in financial position of the business. The statement may emphesises any of
the following aspects relating to change in financial position of the business.
a) Changes in working capital position: In such a case the statement is termed as
Statement of Changes of Financial Position (SCFP) working capital basis popularly
known as Funds Flow Statement.
b) Changes in cash position: In such a case the statements is termed as SCFP-Cash
basis, popularly known as Cash Flow Statement.
These two statements depicts the causes for changes in working capital and changes in cash
in the form of sources and uses between two balance sheet dates.
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2.6 FORM AND CONTENTS OF BALANCE SHEET
There is no specific form for the preparation of Balance Sheet in the case of proprietary
concern and partnership firm. The Companies Act, 1956 has prescribed a form for the preparation
of Balance Sheet. This form is set out in Part I of schedule VI or as near there to as circumstances
admit. Section 2 II (i) states that every balance sheet of a company shall give a true and fair view
of the state of affairs of the company as at the end of the financial year and follow general instructions.
The balance sheet of a Joint Stock company may be either in a) Horizontal Form or b)
Vertical form.
The assets are shown on the right hand side and capital and liabilities are shown on the left
hand side. The order of liabilities and assets is either on i) liquidity basis or ii) on permanency
basis. When Balance sheet is prepared on liquidity basis-more liquid assets like cash in hand,
cash at bank, investments are shown first and the least liquid assets will be shown at last. Liabilities
side-the liabilities to be paid in the short period are shown first, long term liabilities next and capital
on the last. The liquidity form is suitable for the banking and other financial institutions.
When Balance sheet is prepared on permanency basis-assets side, fixed assets are shown
first, liquid assets are shown at last. Liabilities side the capital is shown first, long-term liabilities
next, short-term and current liabilities in the last. The Companies Act in India has adopted
permanency form for preparing balance Sheet.
23
Proforma of Balance Sheet-Horizontal Form Schedule VI, Part I
Balance Sheet of (name of the company) as at - (date of the Balance Sheet)
Figures Liabilities Figures Figures Assets Figures

for the for the for the for the
previous current previous current
year year year year
Rs. Rs. Rs. Rs.
I. Share Capital I. Fixed Assets
Equity Good will
Preference Land & Buildings
II. Reserves & Surpluses Plant & Machinery
General Reserve Furniture
24
Share premium Trade marks
Other reserves Live stock
Profit & Loss A/c. Vehicle etc.
III. Secured Loans II. Investments
Debentures
Other secured loans III. Current Assets and Advances
IV. Unsecured Loans a) Current assets
Fixed deposits Cash
Other unsecured Loans Bank
V. Current liabilities & Short term securities
Provisions Debtors
A. Current Liabilities Bills Receivable
Creditors Closing stock
Bills Payable Prepaid expenses
Over draft b) Loans and advances
O/S expenses Advances & Loans
B. Provisions to subsidiary and other
For Taxation advance payments like
For dividends advance income tax
25
IV. Miscellaneous Expenditure
Preliminary expenses
discount on issue of
shares and debentures
V. Profit & Loss Account (Debit
Balance)
Proforma of Balance Sheet-Vertical Form
Balance Sheet of ______________ as at _________________
Particulars Schedule Figures as at Figures as at
the end of the end of
current previous
financial year financial year
Rs. Rs.
I. Sources of Funds
1. Shareholders Funds
a) Capital xxx
b) Reserves and Surpluses xxx
2. Loan Funds
a) Secured Loans xxx
b) Unsecured Loans xxx
Total xxx
II. Application of Funds
1. Fixed Assets xxx
a) Gross Block
b) Less: Depreciation
c) Net Block
2. Investments xxx
3. Current Assets and Advances
a) Cash and Bank xx
b) Short-term Securities xx
c) Debtors xx
d) Bills Receivable xx
e) Stock xx
f) Other current assets xx
xxx
Less current liabilities and
Provisions
a) Creditors xx
b) Bills payable xx
c) Overdraft xx
d) O/S Liabilities xx
e) Provisions xx xxx
Net Current Assets xxx
4. Miscellaneous expenditure xxx
5. Profit & Loss Account
Debit Balance xxx
Total xxx
26
Schedules The schedules, accounting polices and other explanatory notes form part of balance
sheet. Schedules contain all the information required under part-I of schedule VI which include,
share capital, Reserves & Surplus, Secured Loans, Unsecured Loans, Current liabilities and
provisions, Fixed assets, Investments, Current assets, Loans and advances, Miscellaneous
expenditure and profit and Loss account debit balance.
2.6 FORM AND CONTENTS OF PROFIT AND LOSS ACCOUNT OR INCOME

STATEMENT
In case of sole proprietary and partnership concerns there are no prescribed forms for
Profit and Loss Account. In case o Joint Stock company, Section 211 of the Act prescribes the
specific form for Profit and Loss account. Section 211 (2) says that Profit and Loss Account of a
Joint stock company shall give a true and fair view of the profit or Loss for the financial period and
shall comply with the requirements of part II of schedule VI. However, a specific form is given for
Banking Company and Insurance Company by the Banking Regulation Act 1949 (revised) and
Insurance Companies Act 1938 (revised) respectively.
A trading concern will prepare trading and profit and loss account for finding out gross
profit and net profit respectively. A manufacturing concern will first prepare manufacturing account
for finding out the cost of production and then it shall prepare Trading and Profit and Loss account.
In the case of Joint stock companies only one account known as profit and Loss account is
opened which in turn divided into required number of sections namely manufacturing account,
trading account, profit and loss account and profit and Loss appropriation account. The simplified
statements are given below.
Form and contents of Manufacturing Account of __________Company Ltd.
for the period ending ________
Expenses Total Incomes Total
Rs. Rs.
To Opening Stock xxx By Cost of finished goods
a) Raw material xx transferred to trading A/c. xxx
b) work-in-Progress xx xxx By Closing Stock
To Purchase of raw materials xxx Raw materials xx
To Carriage Inwards xxx Work-in-progress xx xxx
To Manufacturing wages xxx
To Factory Rent xxx
To Depreciation
Factory building xx
Machinery xx xxx
To Repairs to plant xxx
To Coal, Power, Fuel xxx
To Salary of works Manager xxx
xxxx xxxx
27
Form and contents of Trading, Profit and Loss Account of _________ Company Ltd.
for the paid ending ____________
Expenses Total Incomes Total
Rs. Rs.
To Opening Stock of Finished Goods xxx By Net Sales xxx
To Cost of Finished Goods By Closing Stock of Finished
Transferred xxx Goods xxx
To Gross Profit c/d. xxx
xxxx xxxx
To Salaries By Gross Profit b/d. xxx
To Office Rent
To Carriage outwards
To Advertising xxx
To Discount xxx
To Provision for bad and
doubtful debts xxx
To Depreciation
Office Building xx
Furniture xx xxx
To Provision for Tax xxx
To Net Profit xxx
xxxx xxxx
Form and Contents of Profit and Loss Appropriation Account of ____________

Company Ltd. for the Period ending __________
Rs. Rs.
To Transfer to General Resource xxx By Balance b/d. (Previous year xxx
To Interim Dividend xxx balance of profit)
To Final Dividend xxx By Net Profit for the Current Year xxx
To Proposed Dividend xxx
To Transfer to Sinking Fund xxx
To Transfer to other Reserves xxx
To Surplus Transferred to
Balance Sheet xxx
xxxx xxxx
Profit and Loss account or Income statement may also presented in vertical form with
detailed data. Vertical statements are suitable for further analysis and providing suitable data for
decision making. The form and content of vertical Income statement is given below.
28
Vertical Firm
Form and Contents of Income Statement of ______________ Company Ltd.
for the year ending _____________
Rs. Rs.
Sales (cash and credit less returns) xxx
Less: Cost of Goods Sold:
Opening Stock xxx
Add: Purchases xxx
Add: Wages xxx
Add: Mfg. Expenses xxx
xxx
Less: Closing Stock xxx xxx
Gross Profit xxx
Less: Operating Expenses
Office Expenses xxx
Administrative Expenses xxx
Selling Expenses xxx
Distribution Expenses xxx
Depreciation xxx xxx
Operating Profit xxx
Add: Non-Operating income xxx
xxx
Less: Non-Operating expenses xxx
Profit Before Interest & Taxes (PBIT) xxx
Less: Interest Charges
Interest on Loans xxx
Interest on Debentures xxx xxx
Profit Before Tax (PBT) xxx
Less: Provision for Tax xxx
Profit After Tax (PAT)/Net profit xxxx
2.8 USE AND IMPORTANCE OF FINANCIAL STATEMENTS

The financial statements mirror the financial position and operating strengths or weaknesses
of the concern. Financial statements which are prepared to depict true, relevant, easily
understandable, comparable, analytically represented and promptly presented financial position
29
help the users in their economic decisions. The Accounting information presented in financial
statements is needed by a variety of users. Some users have a direct interest in the firm, while
others have an indirect interest. Those who are directly interested in the financial information are
owners, managers, shareholders, creditors, investors, employees, customers and tax authorities.
The indirect users of the financial information include, financial analysts, trade associations, trade
unions etc.,
Owners have the primary interest in the financial information. They have entrusted their
financial resources to the firm and therefore would like to know periodically the performance of
the firm. Managers are the custodians of their investment and, therefore, they must submit periodical
financial reports to owners.
Managers are responsible for the overall performance of the firm. They make several
decisions and, therefore, need information. Accounting provides relevant information to them.
Thus, they have a direct interest in accounting information. Debentureholders and creditors supply
financial resources to the firm. They are interested in the continuing profitable performance of the
firms, so that they may regularly receive interest and repayment of the principal sum., They need
accounting information to analyse the firms' performance.
Potential Investors, Creditors, or owners get an idea about the firms financial strength
and performance from its financial reports. They are generally interested in the earnings, dividend
and growth trends of the firm.
Employees and trade unions also make use of the financial information. On the basis of
information revealed in the financial statements they can bargain on matters relating to salary,
bonus, fringe benefits, working conditions etc. Thus financial information is useful to employees
and unions as they get insights into matters affecting their economic and social interests.
Customers may be interested in financial statements of a firm, because a careful study of
the financial statements provide information about the prices being charged, quality of the goods
etc., by the firm.
Government also have an interest in the Financial statements for regulatory purposes. Tax
authorities have an interest in determining the taxable income of the firm.
The financial statements having a mirror of the financial position of a firm, are of immense
value to the research scholar who wants to make a study into financial operations of a particular
firm.
2.9 LIMITATIONS OF FINANCIAL STATEMENTS
Financial statements are the end result of the accounting process. The financial statements
are based on certain accounting concepts and conventions which can not be said to be fool proof.
The following are the important limitations of financial statements.
1. Interim and Not Final Reports
Financial statements do not depict the exact position and are essentially interim reports.
The exact position can be only known if the business is closed.
2. Lack of Precision and Definiteness
Financial statements may not be realistic because these are prepared by following certain
basic concepts and inventions. For example going concern gives us an idea that business will
30
continue and assets are to be recorded at cost but the book value at which the asset is shown may
not be actually realistic. Similarly, by following the principle of conservatism the financial statements
will not reflect the true position of the business.
3. Lack of Objective Judgement
Financial statements are influenced by the personal Judgement of the accountant. He may
select method for depreciation, valuation of stock amortisation of fixed assets and treatment of
deferred revenue expenditure. Such judgement if based on integrity and competency of the
accountant will definitely affect the preparation of the financial statements.
4. Impact of Non-monetary Factors Ignored
There are certain factors which have bearing on the financial position and operating results
of the business, but they do not become a part of these statements because they cannot be
measured in monetary terms. Such factors may include the reputation of the management, credit
worthiness of concern
5. Historical Nature
These statements are drawn after the actual happening of the events. They attempt to
present a view of the past performance and have nothing to do with the accounting for future.
Modern management is forward looking but these statements based on historical accounting do
not directly help in making future estimates and taking decisions for the future.
6. Artificial View
These statements do not give a real and correct report about the worth of the assets as
these are shown on historical cost basis. These statements provide artificial view as market or
replacement value and to effect of changes in the price level are completely ignored.
7. Scope for Manipulation
These statements are sometimes prepared according to the needs of the situation or the
whims of the management. A highly efficient concern may conceal its real profitability by disclosing
loss or minimum profit whereas, an inefficient concern may declare dividend by wrongly showing
more profits in the profit and loss account. For this under or over valuation of inventory, over or
under charging of depreciation and other such manipulations may be resorted to. Window dressing
may also be resorted to in order to show better financial position of a concern than its real
position.
The above limitations of financial statements must be taken into consideration before making
an analysis of financial statements.
2.10 FINANCIAL STATEMENT ANALYSIS
In the preceding paragraphs you are exposed to Financial statements in greater detail
regarding their meaning, objectives, importance and limitations. It was mentioned that, Financial
statements provide, for the reader, an understanding of some financial aspects of a firm and also
reveal the operating results over a given period of time. The above said functions delivered by
financial statements are of primary in nature. By analysing further, the same information, from
financial statements one can unravel much more important aspects like financial strengths and
31
weakness of a firm. In the following pages the meaning, types, uses and techniques of Financial
Analysis are discussed.
2.11 MEANING AND CONCEPT OF FINANCIAL ANALYSIS
Financial statements, as discussed earlier are prepared primarily for decision making. They
play a dominant role in setting the framework of managerial decisions. But the information provided
in the financial statements is not an end on itself as no meaningful conclusions can be drawn from
thus statements alone. However, the information provided in the financial statements is of immense
use in making decisions through analysis and interpretation of Financial statements. Financial
Analysis is the process of identifying the financial strength and weakness of the firm by properly
establishing relationship between the items of the balance sheet and the profit and loss Account.
There are various methods or techniques used in analysing financial statements such as comparative
statements, trend analysis. Common-size statements, schedule of charges in working capital,
Funds Flow and cash flow analysis, cost-volume profit analysis and Ratio analysis.
Analysing Financial statements according to Metcalf and Titard “is a process of evaluating
relationship between component parts of Financial statements to obtain a better understanding of
firms position and performance”. In the words of Myer, Financial statements Analysis is largely a
study of relationship among the various financial factors in a business as disclosed by a single set of
statements and a study of the trend of these factors as shown in a series of statements.
The analysis of financial statements thus, refers to the treatment of the information contained
in the financial statements in a way so as to afford a full diagnosis of the profitability and Financial
position of the firm concerned. For this purpose Financial statements are classified methodically,
analysed and compared with the figures of previous years of other similar firms.
2.12 MEANING OF INTERPRETATION
Analysis and interpretation are closely related. Interpretation is not possible with out analysis
and without interpretation analysis has no value. “To interpret means to put the meaning of statement
in simple terms for the benefit of a person”. Thus defines F. Wood in his work ‘Business Accounting’
vol. II. In any case, Interpretation is a wider term and includes criticism examination and analysis.
Thus interpretation maybe defined as critical examination of some financial transactions effected
during a definite period of time. In the words of Kennedy and Muller: “Analysis and Interpretation
of financial statements are an attempt to determine to significance and meaning of the Financial
statements data, so that forecast maybe made of the prospects for future earnings, ability to pay
intent and debt maturity, and profitability of sound dividend policy.
It is only by interpreting the Balance Sheet and the Profit an Loss account, we make the
figures appearing there at to tell the story of actual progress and Financial position of a business
concern in a clear and simple language easily understood even by the layman. Interpretation of
financial statements is really an art it involves many processess like arrangement, analysis, establishing
relationship between available facts and drawing conclusions on that basis. It has become a very
interesting and significant function of Management Accounting. It broadly includes the following.
i) Criticism, ii) Analysis, iii) Comparison, iv) Study of Trend, v) Drawing Conclusion.
The Term Financial statement analysis includes both analysis and interpretation. The term
analysis means simplification of Financial data, by methodical classification given in the financial
32
statements. Interpretation means explaining the meaning and significance of the data so simplified.
However, both analysis and interpretation are interlinked and complementary to each other, as
mentioned earlier. Analysis is useless without interpretation and interpretation without analysis is
difficult or even impossible. Most of the authors have used the term Analysis only to cover the
meanings of both analysis and interpretation since analysis involves interpretation.
2.13 TYPES OF FINANCIAL ANALYSIS
We have already learnt that various users of financial statements study them from different
angles, for different purposes. However, we can classify various types of financial analysis into
different categories depending upon the a) material used b) the object of the analysis and c) the
modus operandi of the analysis. These are explained one by one.
On the Basis of Material Used
According to this, financial analysis can be of two types. i) external analysis ii) internal
analysis
i) External Analysis: This is done by outsiders who do not have access to the detailed
internal accounting records of the business firm. These outsiders include, Investors,
Creditors, government agencies and the general public.
ii) Internal Analysis: The Internal analysis is made by those persons who have access
to the books of accounts. They are the members of the organisation-executives,
employees, officers appointed for this purpose by the government or the court. The
internal analyst can give more reliable result than the external analyst because every
type of information is at his disposal.
On the Basis Objectives
On this basis the analysis can be i) long-term and ii) short-term analysis.
i) Long-term Analysis: This analysis is made in order to study long-term financial
stability, solvency and liquidity as well as profitability and earning capacity of a business
concern-this type of analysis helps the long-term financial planning which is essential
for the continued success of a business.
ii) Short-term Analysis: This is made to determine the short-term solvency, stability
and liquidity as well as earning capacity of the business. The purpose of this analysis is
to know whether in the short term a business concern will have adequate Funds readily
available to meet its short term requirements and sufficient borrowing capacity to meet
contingencies in the near future.
On the Basis of Modus Operandi of the Analysis
On this basis, the analysis may be i) Horizontal Analysis and ii) Vertical Analysis
Horizontal Analysis: It is also known as ‘dynamic analysis’ or trend analysis. When the analysis
of Financial statements of the firm is made for two or more years it is called horizontal analysis.
Since the data for more than one year is used. It is possible to compare the performance of the
company during a year with that of the previous year. This helps to identify the trend in various
indicators of performance, such as profitability, solvency liquidity etc., over the years.
Vertical Analysis: It is also known as ‘static analysis’ or ‘Structural analysis’. When the analysis
33
of financial statements of an organisation is made for only one accounting period, it is called as
vertical analysis. For instance analysing and interpreting the performance of a company for the
year 2006 with the help of profit and Loss Account of that company for the year ending 31st
December, 2006 and Balance Sheet of that company as on that date. Under this analysis,
quantitative relationship is established between the different items shown in a particular statement
(P/L a/c and B/S). Common size statements are the form of vertical analysis.
2.14 PROCEDURE FOR ANALYSIS AND INTERPRETATION
Broadly speaking there are three steps involved in the analysis of financial statements. These
are a) selection b) classification and c) Interpretation. The first step involved selection of information
(data) relevant to the purpose of analysis of financial statements. The second step involved is the
methodical classification of the data and the third step includes drawing of inferences and conclusions.
The following preliminaries are required to be completed for making an analysis and
interpretation of financial statements.
i) The objective and extent of analysis and interpretation should be determined. The
analyst should acquaint himself with the principles and postulates of accounting. He
should know the plans and policies of the management so that he may be able to find
out whether these plans are properly executed or not.
If the aim is to find out the earning capacity of the enterprise then analysis of income
statement will be undertaken. On the other hand, if financial position is to be studied
then balance sheet analysis will be necessary
ii) The financial data given in the statements should be re-organised and re-arranged. It
will involve the grouping of similar data under same heads, breaking down of individual
components of statement according to nature.
iii) A relationship is established among financial statement, with the help of tools and
techniques of analysis such as ratios, trends, common-size, Funds flow etc.
iv) The information is interpreted in a simple and understandable way. The significance
and utility of financial data is explained for helping decision taking.
v) The conclusions drawn from interpretation are presented to the management in the
form of reports.
2.15 OBJECTIVES OF ANALYSIS AND INTERPRETATION
Every user of financial statements has a distinct objective for which he attempts to analyse
and interpret. Inspite of the variations in the objectives of interpretation by various classes of
people, there are some common objectives of interpretation which are as follows:
1. To examine the earning capacity and efficiency of various business activities with the
help of income statements.
2. To estimate about the performance efficiency and managerial ability by the management
of a business concern.
3. To determine short-term and Long-term solvency of the business concern with the
help of Balance Sheet.
34
4. To enquire about the financial position and ability to pay of the concerns seeking loans
and credits.
5. To determine the profitability and future prospects of the concern.
6. To investigate the future potential of the concern.
7. To make comparative study of operational efficiency of similar concern engaged in the
identical industry.
2.16 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
The following techniques are adopted in analysis of financial statements of a business
organisation.
i) Comparative Statements
ii) Common Size Statements
iii) Trend Analysis
iv) Ratio Analysis
v) Funds Flow Analysis
vi) Cash Flow Analysis
The first three topics are covered in this unit and the rest are explained in the subsequent
units indetail.
COMPARATIVE STATEMENTS
The Comparative financial statements are statements of the financial position at different
periods of time. The elements of financial position are shown, in a comparative form so as to give
an idea of financial position at two or more periods. Generally two financial statements-Balance
Sheet and Income Statement are prepared in comparative form for financial analysis purpose.
Not only the comparision of the figures of two periods but also be relationship between balance
sheet and Income statement enables an indepth study of Financial position and operative results.
Comparative statement reveal the following.
i) Absolute figures
ii) Changes in absolute figures i.e. increase or decrease in absolute figures
iii) Absolute data in terms of percentages
iv) Increase or decrease in terms of percentages
v) Comparision
Comparative Income Statement or Profit and Loss Account
A comparative income statement shows the absolute figures for two or more periods and
absolute changes from one period to another period. Since the figures are shown side by side,
user can quickly understand the operational performance of the firm in different periods and draw
conclusions.
35
Guidelines for Interpretation of Income Statements
The analysis and interpretation of Income statement will involve the following steps:
1. The Increase or decrease in sales should be compared with the increase or decrease in
cost of goods sold. An increase in sales will not always mean in increase in profit. The
profit ability will improve if increase in sales is more than the increase in cost of goods
sold. This results, the study of gross profit at the first instance.
2. The second step is the study of operational profit. An increase in operating profit will
result from the increase in sales position and control of operating expenses. Operating
expenses should be deducted from Gross profit to find out operating profit. A decrease
in operating profit may be due to an increase in operating expenses or decrease in
sales.
3. The increase or decrease in Net Profit will give an idea about the overall profitability of
the firm. Non-operating expenses such as interest paid, Loss from sale of assets,
payment of tax etc., decrease the figure of Net Profit. Non-operating incomes will
increase Net Profit.
4. An opinion should be formed about profitability of the firm and it should be given at the
end. It should be mentioned whether the overall profitability is good or not.
Comparative Balance Sheet
Balance Sheets as on two or more different dates are used for comparing the assets, liabilities
and the net worth of the firm. Financial statements of two or more firms can also be compared for
drawing inferences. This is called inter firm comparision.
Guidelines for Interpretation of Comparative Balance Sheet
While interpreting comparative Balance Sheet, the analyst is expected to study the following
aspects.
i) Current financial position and liquidity Position
ii) Long-term financial position
iii) Profitability of the concern.
1. Study of Current Financial Position and Liquidity Position
To study current financial position or short term financial position, the analyst should pay
attention on the working capital in both the years. The excess of current assets over current
liabilities is known as net working capital. The increase in working capital will mean inprovement
in the current financial position of the firm. An increase in current assets accompanied by the
increase in current liabilities of the same amount will not show any improvement in the short term
financial position.
The second aspect which should be studied in current financial position is the liquidity position
of the firm. If liquid assets like cash in hand, cash at bank, Bills Receivables, debtors etc., show an
increase in the second year over the first year. This will improve the liquidity position of the firm.
36
But the increase in inventory can be on account of accumulation of stocks for want of customers,
decrease in demand or inadequate sales promotion efforts. It is not good for the business.
2. Study of Long-term financial position
It can be analysed by studying the changes in fixed assets, long term liabilities and capital.
The proper financial policy of a firm will be to finance fixed assets by the issue of either long-term
securities such as debentures, bonds, loans from financial institutions or issue of fresh share capital.
An increase in fixed assets should be compared to the increase in long-term securities and capital,
then part of fixed assets have been financial from the working capital. On the other hand if the
increase in long-term securities and capital is more than the increase in fixed assets, then fixed
assets have not only been financed but part of the working capital also been financed from long-
term securities. Wise policy is to finance fixed assets by raising long-term funds. The nature of
assets which have increased or decreased should also be studied to form an opinion about the
earning capacity. The increase in plant and machinery will increase production capacity of the
firm. On the liabilities side, the increase in loaned funds will mean an increase in interest liability.
An opinion about the long-term financial position should be formed after taking into consideration
above mentioned aspects.
3. Study of Profitability Position
The study of increase or decrease in retained earnings reserves and surpluses will enable the
analyst to see whether the profitability has improved or not. An increase in the profits, will mean
an increase in profitability of the firm. The decrease in profits may mean, dividend payments, issue
of bonus shares or deteriorating in profitability of the firm.
Advantages
1. Comparative statements indicate trends in Sales, Cost of Production, Profits etc., and
help the analyst to evaluate the performance of the firm.
2. Comparative statements can also be used to compare the performance of the firm with
average performance of the industry or inter-firm comparision. This helps in identification
of the weaknesses of the firm and remedial measures can be taken accordingly.
Limitations
1. Inter-firm comparision can be misleading. If the firms are not identical in size and age
and when they follow different accounting procedures with regard to depreciation,
inventory valuation etc.,
2. Inter-period comparision may also be misleading, if the period has witnesse changes in
accounting policies, inflation, recession etc.,
Illustration - 1
From the following profit and Loss Account and the Balance Sheet of Reddy Laboratories
Ltd. for the year ended 31st December, 2005 and 2006. You are required to prepare comparative
Income statement and comparative Balance Sheet and Comment upon the significant changes.
37
Profit and Loss Account
Particulars 2005 2006 Particulars 2005 2006
To Cost of good Sold 2,00,000 2,50,000 By Sales 3,60,000 4,50,000
To Office expenses 20,000 30,000 By Invest and dividends 3,000 2,000
To Selling expenses 40,000 50,000 By Discount on
purchases 2,000 1,500
To Loss on Sale of By Profit on Sale
Fixed Assets 1,000 500 of Land 3,000 --
To Interest 2,000 1,000
To Income Tax 52,500 61,000
To Net Profit 52,500 61,000
3,68,000 4,53,500 3,68,000 4,53,500
38
Balance Sheet as on 31st December
2005 2006
Liabilities
Equity Share Capital 3,00,000 4,00,000
Preference Share Capital 1,00,000 1,50,000
Reserves 28,500 38,000
Profit and Loss A/c 52,500 61,000
Bank Overdraft 50,000 50,000
Creditors 20,500 25,000
Provision for Taxation 52,500 61,000
Proposed Dividend 30,000 35,000
6,34,000 8,20,000
Assets
Fixed Assets 4,90,000 6,49,000
Stock 50,000 41,000
Debtors 40,000 60,000
Bills Receivable 10,000 20,000
Prepaid Expenses 1,000 --
Cash in hand 15,000 20,000
Cash at bank 28,000 30,000
6,34,000 8,20,000
Solution
Reddy Laboratories Ltd., comparative Income Statement
for the year ending 2005 and 2006
Absolute Percentage
Increase or Increase or
2005 2006 decrease decrease
during 2006 during 2006
Rs. Rs. Rs. Rs.
Sales 3,60,000 4,50,000 90,000 25.00

Less: Cost of goods sold 2,00,000 2,50,000 50,000 25.00
Gross Profit 1,60,000 2,00,000 40,000 25.00
Operating Exps:
Office exps. 20,000 30,000 10,000 50.00
Selling exps. 40,000 50,000 10,000 25.00
Total Operating exps. 60,000 80,000 20,000 33.33
39
Operating Income 2,000 1,500 - 500 (-)25.00
Operating Profit 1,02,000 1,21,500 19,500 19.12
Add: Non Operating Incomes 6,000 2,000 -4,000 (-)66.67
Less: Non Operating Exps. 3,000 1,500 -1,500 (-)50.00
Profit before Tax 1,05,000 1,22,000 17,000 16.19
Less: Income Tax 52,500 61,000 8,500 16.19
Profit after Tax 52,500 61,000 8,500 16.19
Comments/Interpretation
The comparative Income statement reveals that while net sales has been increased by
25%. The cost of goods sold also increased by the same percentage. With the result Gross
Profit shows 25% increase. The total operating expenses has been increased by 33.33%.
Operating expenses percentage increase is more than the Gross Profit percentage increase.
Firm has no control over operating expenses. Operating profit and Profit before Tax shows
19.12% and 16.19% respectively. Net profit after Tax is Rs.8,500 (16.19%) increased. The
overall profitability of the firm is satisfactory.
Reddy Laboratories Ltd. comparative Balance Sheets
31st December Increase/Decrease
2005 2006 Absolute Percentage
Change Change
Assets
Current Assets:
Cash in hand 15,000 20,000 5,000 33.33
Cash at Bank 28,000 30,000 2,000 07.14
Debtors 40,000 60,000 20,000 50.00
Bills Receivable 10,000 20,000 10,000 100.00
Stock 50,000 41,000 (-)9,000 (-)18.00
Prepaid expenses 1,000 (-)1,000 (-)100.00
Total Current Assets 1,44,000 1,71,000 27,000 18.75
Fixed Assets 4,90,000 6,49,000 1,59,000 32.45
Total Assets 6,34,000 8,20,000 1,86,000 29.34
Liabilities
Current Liabilities:
Bank Overdraft 50,000 50,000 -- --
Creditors 20,500 25,000 4,500 21.95
Provision for Tax 52,500 61,000 8,500 16.19
40
Proposed dividend 30,000 35,000 5,000 16.67
Total Current Liabilities 1,53,000 1,71,000 18,000 11.76
Capital & Reserves
Equity Share Capital 3,00,000 4,00,000 1,00,000 33.33
Preference Share Capital 1,00,000 1,50,000 50,000 50.00
Reserves 28,500 38,000 9,500 33.33
Profit and Loss A/c. 52,500 61,000 8,500 16.19
Total Capital & Reserves 4,81,000 6,49,000 1,68,000 34.93
Total Liabilities 6,34,000 8,20,000 1,86,000 29.34
Comments/Interpretation
1. The above Comparative Balance sheet reveals the current Assets has been in-
creased to 18.75%. While current liabilities increase to 11.76%. There is an im-
provement in liquidity position.
2. The Fixed assets purchased was for Rs.1,59,000. As there are no long-term funds.
Fixed assets have been financed partly from Share Capital and partly from Re-
serves-This shows prudent financial policy of the firm.
3. Reserves and Profit and Loss Account increased by 33.33% and 16.19% respec-
tively. The company can go for bonus issue in the near future
4. Current financial position of the company is satisfactory. Company can go for long-
term financing because debt is cheaper than equity.
Illustration - 2
From the following particulars of Ranbaxy Ltd. You are required to prepare a compara-
tive Income Statement and Interpret the results.
Particulars 2005 2006

Sales 2,30,000 2,60,000
Cost of goods sold 1,90,000 2,00,000
Administrative Expenses 4,000 5,000
Selling expenses 8,000 9,000
Non-operating expenses 500 600
Non-operating incomes 400 2,400
Sales Returns 8,000 5,000
Tax Rate 50% 50%
41
Solution
Comparative Income Statement of Ranbaxy Ltd.

for the year ended 2005 and 2006.
Particulars 2005 2006 Absolute Percentage

Change Change
Rs.
Sales 2,30,000 2,60,000 30,000 13.04

Less: Sales Returns 8,000 5,000 (-)3,000 (-)37.50
Net Sales 2,22,000 2,55,000 33,000 14.86
Less: Cost of Goods Sold 1,90,000 2,00,000 10,000 5.26
Gross Profit 32,000 55,000 23,000 71.87
Administrative 4,000 5,000 1,000 25.00
Selling 8,000 9,000 1,000 12.50
Total Operating Expenses 12,000 14,000 2,000 16.67
Operating Profit 20,000 41,000 21,000 105.00
Add: Non-Operating Income 400 2,400 2,000 500.00
Less: Non-Operating Expenses 500 600 100 20.00
Profit Before Tax (PBT) 19,900 42,800 22,900 115.00
Less Tax 9,950 21,400 11,450 115.00
Profit After Tax (PAT) 9,950 21,400 11,450 115.00
Interpretation
1. The comparative Income Statement reveals that there has been an in increase in net
sales of 14.86. While Gross sales have increased (13.04%) sales returns have
come down by 37.50%, which is a healthy sign. It shows increased acceptability of
the company’s products and customer satisfaction.
2. The rate of growth in sales is considerably higher than the rate of growth of Cost of
goods sold. This has resulted in a handsome rise in gross profit of the company
(71.87%)
3. There is a margined increase in operating expenses (16.67%), which resulted a

wooping operating profit of 105%. Company is able exercise control over operating
expenses.
4. The Net Profit before and after tax have Increased at the same rate, Since the tax
rate applicable to both years is the same.
5. The over all profitability of the company is more than satisfactory.

42
Illustration - 3
Given below are the summarised Balance Sheets ofVolvo Ltd. As at 31st March 2006,
and 31st March 2007.
Liabilities 2006 2007 Assets 2006 2007
Capital 3,00,000 3,00,000 Cash & Bank Balance 10,000 5,000

Reserve & Surplus 1,00,000 1,50,000 Debtors 1,30,000 1,80,000
8% Debentures 1,20,000 1,00,000 Plant 1,80,000 2,00,000
Long-Term Debt 6,000 8,000 Investments 20,000 --
Bank Over draft 80,000 80,000 Goodwill 40,000 --
Creditors 88,000 80,000 Stock 3,00,000 3,10,000
Prepaid expenses 4,000 3,000
6,94,000 7,18,000 6,94,000 7,18,000
Solution
Comparative Balance Sheet of Volvo Ltd.
Particulars 31-3-2006 31-3-2007 Absolute Percentage
Change Change
Rs. Rs.
Assets
A. Current Assets
Cash and Bank Balances 10,000 5,000 (-)5,000 (-)50.00
Debtors 1,30,000 1,80,000 50,000 38.46
Bills Receivable 10,000 20,000 10,000 100.00
Investments 20,000 - (-)20,000 (-)100.00
Stock 3,00,000 3,10,000 10,000 3.33
Prepaid expenses 4,000 3,000 (-)1,000 25.00
4,74,000 5,18,000 44,000 9.28
B. Fixed Assets
Plant 1,80,000 2,00,000 (+)20,000 11.11
Goodwill 40,000 - (-) 40,000 (-)100.00
2,20,000 2,00,000 (-)20,000 (-)9.09
Total Assets A+B 6,94,000 7,18,000 24,000 3.46
43
Liabilities
C. Current Liabilities
Bank overdraft 80,000 80,000 -- --
Creditors 88,000 80,000 (-)8,000 (-)9.09
1,68,000 1,60,000 (-)8,000 (-)4.76
D. Long-Term Liabilities
8% Debentures 1,20,000 1,00,000 (-)20,000 (-)16.67
Long-Term Debt 6,000 8,000 2,000 33.33
1,26,000 1,08,000 (-)18,000 (-)14.29
E. Capital
Equity Share Capital 3,00,000 3,00,000 - -
Reserves & Surplus 1,00,000 1,50,000 50,000 50.00
4,00,000 4,50,000 50,000 12.50
Total Liabilities (C + D + E) 6,94,000 7,18,000 24,000 3.46
Interpretation
1. A close look at the balance sheet shows that there is a marginal rise in current assets
of the company. This is mainly because of fall in cash and bank balance and sale of
short term investments. This marginal rise may be attributed to debtors, Bills receiv-
able and stock increase. Current liabilities have decreased by Rs.8,000. The company
might have changed its credit policy, and its future liquidity position will be dependent
on credit management.
2. The company has written off Goodwill from the books. Fixed Assets purchased dur-
ing the year are only Rs.20,000. There is an ample scope for the company to invest in
Fixed assets. Working capital is idle, long-term funds have been paid off. It seems
company wishes to be a risk free company. Lower the risk, lower the profitability
hence company is advised to raise more long term funds and fresh capital.
3. The Profitability of the company appears to be impressive as judged by 50% increase
in Reserves and Surplus. However, the Income statement of the company must be
examined in greater detail.
The over all financial position of the company appears to be satisfactory.

COMMON SIZE STATEMENTS
Common-Size statement is a financial tool for studying the key changes and trends in the
financial position (Balance Sheet) and operating results (Profit and Loss Account) of a company.
Common-Size financial statements are also known as cent per cent or component percentage
statements. Under this technique the individual items of profit and Loss Account and Balance
Sheet are expressed as percentages in relation to some common base like ‘Sales’; ‘total Assets’;
‘total liabilities’. In the case of profit and Loss Account usually sales are taken as 100 and all other
items are expressed as a percentage of Sales. Similarly in the Balance Sheet the totalassets or
44
liabilities is treated as equivalent to 100 and each asset and liability is expressed as a percentage of
this total.
The common size analysis is an example of vertical analysis as it relates to the relationship
between various items at a point of time. Inter-firm comparision or comparision of the company’s
position with the related industry as a whole is possible with the help of vertical common-size
statement analysis.
Limitation of Common-Size Statements
1. Common-Size financial statements when read horizontally do not give information about
the trend of individual items but gives vertical trend of their relationship to total.
2. Observation of these trends is not very useful because there are definite and standard
norms for the proportions of each item to total.
Illustration - 4
Following are the Income Statement of a company for the years ending Dec 31, 2005 and
2006. Prepare Common-Size Income Statement and comment on the operating results.
2005 2006
(Rs. in ‘000) (Rs. in ‘000)
Sales 600 800
Miscellaneous Income 50 60
650 860
Expenses:
Cost of Sales 300 500
Office expenses 50 60
Selling expenses 100 150
Interest 60 90
510 800
Net Profit 140 60
650 860
45
Solution
Common-Size Income Statement for the years ending Dec 2005 and 2006
2005 2006
Particulars Absolute % Absolute %

Amount Amount
Sales 600 100.00 800 100.00

Less: Cost of Sales 300 50.00 500 62.50
Gross Profit 300 50.00 300 37.50
Operating expenses:
Office expenses 50 8.33 60 7.50
Selling expenses 100 16.67 150 18.75
Total Operating expenses 150 25.00 210 26.25
Operating Profit 150 25.00 90 11.25
Miscellaneous Income 50 8.33 60 7.50
Total Income 200 33.33 150 18.75
Less: Non operating expenses -
Interest 60 10.00 90 11.25
Net Profit 140 23.33 60 7.50
Interpretation
1. The sales and Gross profit has increased in absolute figures in 2006 as compared to
2005 but the percentage of Gross Profit to sales has come down in 2006.
2. The increase in cost of sales has brought the Gross Profit down from 50% to 37.50%
3. Operating expenses have almost remained same as a percentage to Sales i.e. 25%
and 26.25%. The slight increase in operating expenses have resulted further de-
crease in operating profits.
4. Net Profits have decreased both in absolute figures and as a percentage in 2006 as
compared to 2005
5. The overall profitability has decreased in 2006 and the reason is a rise in cost of
sales. The company is advised to take immediate steps to control its cost of sales,
otherwise the company will be in trouble.
Illustration - 5
Following are the income statements of Wipro Ltd and Satyam Ltd for the year ending
31st March, 2006.
46
Particulars Wipro Ltd. Satyam Ltd.
(Rs.’000) (Rs.’000)
Income
Sales 4,000 2,000
Miscellaneous Income 200 400
Total Income 4,200 2,400
Expenses
Cost of goods sold 2,000 1,000
Administrative expenses 200 100
Selling expenses 500 300
Non-Operating expenses 300 200
Total expenses 3,000 1,600
Tax 300 200
You are required to prepare a common-size Income Statement and analyse the same
Solution : Common-Size Income Statement of Wipro Ltd and Satyam Ltd. for the year ending
31st March, 2006.
Wipro Ltd. Satyam Ltd.
Particulars Absolute % Absolute %
Amount Amount
Sales 4,000 100.00 2,000 100.00
Less: Cost of goods sold 2,000 50.00 1,000 50.00
Gross Profit 2,000 50.00 1,000 50.00
Operating expenses:
Administrative expenses 200 5.00 100 5.00
Selling expenses 500 12.50 300 15.00
Total Operating expenses 700 17.50 400 20.00
Operating Profit 1,300 32.50 600 30.00
Add: Misc. Income 200 +5.00 400 +20.00
Less: Non-Operating Expenses 300 -7.50 200 10.00
Profit Before Tax 1,200 30.00 800 40.00
Less: Tax 300 -7.50 200 10.00
Profit after Tax 900 22.50 600 30.00
47
Interpretation :Common-Size statement analysis of Wipro Ltd and Satyam Ltd. reveals the
following facts.
1. Both companies have earned same grossprofit. i.e., 50%, but size of the companies
are different with the result Wipro Company Ltd has more sales than Satyam Ltd.
2. Operating profit is more in case of Wipro Ltd i.e. 32.50%. This indicates that Wipro
Ltd has better control over the operating expenses than Satyam Ltd.
3. Profit after tax is more in case of Satyam Ltd. than Wipro Ltd. The reason for this
can be attributed that Satyam Ltd might be providing many other services there by
increasing more miscellaneous income with the result profit after tax is more.
4. Both the companies were doing well, earning profits, profitability position is satisfactory.
But when compared both the companies, Wipro Ltd shows less profit than Satyam
Ltd. many factors such as, size, age, product diversification, capital Investment etc.,
should be taken into Account in analysing the company’s profitability.
Illustration - 6
Following are the Balance sheets of Nagarjuna Fertilizers Ltd for the year ended 31st Dec
2005 and 2006. Prepare a common size Balance Sheet and Interpret the results.
Equity Share Capital 1,00,000 1,65,000 Fixed Assets 1,20,000 1,75,000
Pref. Share Capital 50,000 75,000 Stock 20,000 25,000
Reserves 10,000 15,000 Debtors 50,000 62,500
P/L A/c 7,500 10,000 Bills Receivable 10,000 30,000
Bank OD 25,000 25,000 Prepaid expenses 5,000 6,000
Creditors 20,000 25,000 Cash at Bank 20,000 26,500
Provision for taxation 10,000 12,500 Cash in hand 5,000 15,000
Proposed dividends 7,500 12,500
2,30,000 3,40,000 2,30,000 3,40,000
Solution
Common-Size Balance Sheet of Nagarjuna Fertilizers Ltd.
2005 2006
Amount % Amount %
Assets
A. Current Assets
Stock 20,000 8.70 25,000 7.35
Debtors 50,000 21.74 62,500 18.38
Bills Receivable 10,000 4.34 30,000 8.82
Prepaid expenses 5,000 2.17 6,000 1.78
48
Cash at Bank 20,000 8.70 26,500 7.79
Cash in hand 5,000 2.18 15,000 4.41
1,10,000 47.83 1,65,000 48.53
B. Fixed Assets 1,20,000 52.17 1,75,000 51.47
1,20,000 52.17 1,75,000 51.47
Total Assets (A+B) 2,30,000 100 3,40,000 100
Liabilities
C. Current Liabilities
Bank overdraft 25,000 10.87 25,000 7.35
Creditors 20,000 8.70 25,000 7.35
Provision for taxation 10,000 4.35 12,500 3.68
Proposed dividends 7,500 3.26 12,500 3.68
C Total 62,500 27.18 75,000 22.06
D. Capital & Reserves
Equity Capital 1,00,000 43.48 1,65,000 48.53
Pref. Capital 50,000 21.74 75,000 22.05
Reserves 10,000 4.34 15,000 4.41
P/L a/c 7,500 3.26 10,000 2.95
D Total 1,67,500 72.82 2,65,000 77.94
Total Liabilities C+D 2,30,000 100.00 34,000 100.00
Interpretation
1. In 2006 Current Assets were increased from 47.83% to 48.53%. Total increase
in current Assets in absolute figures are Rs.15,000.
2. Current liabilities were decreased from 27.18% to 22.06. Company is in very
good position to pay off the current liabilities from current Assets. The liquidity
position is quite good.
3. Capital structure of the company is very much satisfactory. Fixed Assets were
financed from the capital.
4. Overall financial position is satisfactory.
49
Activity - 6
From the following P/L a/c of X Company prepare a Common-Size statement.

To Cost of goods sold 12,000 15,000 By Net Sales 16,000 20,000
To Administrative
expenses 400 400
To Selling expenses 600 800
To Net Profit 3,000 3,800
16,000 20,000 16,000 20,000
Activity - 7
The following are the Balance Sheets of GVK Ltd as on 31st December 2005 and 2006.
Equity Capital 50,000 82,500 Fixed Assets 80,000 1,47,500
Pref.Capital 25,000 37,500 Stock 10,000 12,500
Reserves 5,000 7,500 Debtors 25,000 31,250
Profit & Loss Account 3,750 5,000 Bills Receivable 5,000 15,000
8% Debentures 20,000 60,000 Prepaid expenses 2,500 3,000
Bank overdraft 12,500 12,500 Cash at Bank 10,000 13,250
Creditors 10,000 12,500 Cash in hand 2,500 7,500
Provision for taxation 5,000 6,250
Proposed dividend 3,750 6,250
1,35,000 2,30,000 1,35,000 2,30,000
Prepare a common-size Balance Sheet and Comment on the same.

TREND PERCENTAGE ANALYSIS
This analysis is an important tool of horizontal analysis. This method is immensely

helpful in making a comparative study of the financial statements of several years. Under this
method trend percentages are calculated for each item taking the figure of base year as 100.
The starting year is usually taken as the base year and on that basis the percentage for each of
the items of each of the years are calculated. These percentages can also be taken as index
Numbers showing relative changes in the financial data resulting with the passage of time.
This will exhibit the direction-upward or downward trend, to which the concern is proceed-
ing. These Trend Ratios may be compared with industry in order to know the strong or weak
points of a firm.
50
While calculating trend percentages, the following precautions may be taken
a) The accounting principles and practices must be followed constantly over the period
for which the analysis is made. This is necessary to maintain consistancy and com-
parability.
b) The base year selected should be normal and representative year
c) Trend percentages should be calculated only for those items which have logical rela-
tionship with one another.
d) Trend percentages should also be carefully studied after considering the absolute fig-
ures on which these are based. Otherwise they give misleading conclusions.
e) To make the comparision meaningful, trend percentages of the current year should be
adjusted in the light of price level changes as compared to the base year.
f) Non financial factors should be considered while interpreting the trend.
Steps in Computing the Trend Values
1. Select one of the periods as the base period. Usually first period will be taken as base
period.
2. every item in the base period is taken as 100.
3. Trend values of each item for any other period can be calculated as under.
Absolute value of the item for the period

× 100
Absolute Value of the item in the base period
Illustration - 7
Calculate the Trend percentages from the following figures of Z company taking 2002 as the
base and interpret them.
Year Sales Stock Profit Before Tax

2002 7,524 2,836 1,284
2003 9,360 3,124 1,740
2004 10,620 3,264 1,832
2005 12,084 3,776 2,108
2006 15,072 4,616 2,688
51
Solution
Trend Percentages
Base Year 2002 = 100
Sales Stock Profit before Tax

Year Amount Trend Amount Trend Amount Trend
Rs. Percentage Rs. Percentage Rs. Percentage
2002 7,524 100 2,836 100 1,284 100
2003 9,360 124 3,124 110 1,740 136
2004 10,620 141 3,264 115 1,832 143
2005 12,084 161 3,776 133 2,108 164

2006 15,072 200 4,616 163 2,688 209
Interpretation
1. The Sales have continuously increased in all the years upto 2006. The percentage
in 2006 is 200 as compared to 100 in 2002. The Increase in sales is doubled. It
is quite satisfactory.
2. The figures of stocks also have shown an increasing trend from 100 to 163.
3. The profit before Tax has substantially increased. In five years period it has more
than doubled.
4. The overall performance of the Z Ltd is more than satisfactory there is a proper
control over costs.
Activity - 8
The following data is available from the P/L a/c of X Ltd.
Particulars 2003 2004 2005 2006
Sales 1,55,000 1,63,750 1,60,000 1,66,250
Wages 53,750 53,750 57,500 60,000
Selling expenses 13,625 14,500 14,375 13,875
Gross Profit 45,000 47,500 38,750 40,000
You are required to show a) trend ratios of different items b) Trend percentages of
relationships of wages, selling expenses, gross profit to sales.
52
Illustration - 8
From the following data relating to the assets side of Balance Sheet of X Ltd for the
period ended 31st December 2003 to 31st Dec 2006. Calculate trend percentages.
(Rs. in lakhs)
Particulars 2003 2004 2005 2006

Cash 500 600 400 700
Debtors 1,000 1,250 1,625 2,000
Stock 1,500 2,000 1,750 2,500
Other Current Assets 250 375 625 750
Land 2,000 2,500 2,500 2,500
Buildings 4,000 5,000 6,000 7,500
Plant 5,000 5,000 6,000 7,500
Solution
Trend Percentages
Rs. in Lakhs
Absolute Figures Trend Percentages
Assets 2003 2004 2005 2006 2003 2004 2005 2006
Current Assets
Cash 500 600 400 700 100 120 80 140
Debtors 1,000 1,250 1,625 2,000 100 125 162.5 200
Stock 1,500 2,000 1,750 2,500 100 133.33 116.67 166.67
Other Current Assets 250 375 625 750 100 150 250.00 300.00
Total A 3,250 4,225 4,400 5,950 100 130.00 135.38 183.08
Fixed Assets
Land 2,000 2,500 2,500 2,500 100 125 125 125
Buildings 4,000 5,000 6,000 7,500 100 125 150 187.5
Plant 5,000 5,000 6,000 7,500 100 100 120 150.00
Total B 11,000 12,500 14,500 17,500 100 113.64 131.82 159.09
Grand Total A+B 14,250 16,725 18,900 23,450 100 117.36 132.63 164.56
53
Illustration - 9
From the following data relating to the liabilities of Balance Sheet of X Ltd. for the period
31st December, 2003 to 31st December, 2006 Calculate the trend percentages
Liabilities 2003 2004 2005 2006

Equity Share Capital 5,000 5,000 6,000 7,500
General Reserves 4,000 5,000 6,000 7,500
12% Debentures 2,000 2,500 2,500 2,500
Bank Overdraft 1,500 2,000 2,750 2,500
Bills Payable 500 600 400 700
Sundry Creditors 1,500 2,000 2,500 3,000
O/S Liabilities 250 375 625 750
Solution
Trend Percentages
Absolute Figures Trend Percentages
Assets 2003 2004 2005 2006 2003 2004 2005 2006
Share holders Funds
Equity Share Capital 5,000 5,000 6,000 7,500 100 100 120 150.00
General Reserve 4,000 5,000 6,000 7,500 100 125 150 187.50
Total A 9,000 10,000 12,000 15,000 100 111.11 133.33 166.67
Long term Debts
Debentures 2,000 2,500 2,500 2,500 100 125 125 125.00
Total B 2,000 2,500 2,500 2,500 100 125 125 125.00
Current Liabilities
Current Overdraft 1,500 2,000 2,750 2,500 100 133.33 183.33 166.67
Bills Payable 500 600 400 700 100 120.00 80.00 140.00
Sundry Creditors 1,500 2,000 2,500 3,000 100 133.33 166.67 200.00
O/S liability 250 375 625 750 100 150.00 250.00 300.00
Total C 3,750 4,975 6,275 6,950 100 132.67 167.33 185.33
Total A+B+C 14,750 17,475 20,775 24,450 100 118.47 140.85 165.76
Activity - 8
From the following Income Statement and Balance Sheet of Raymonds Ltd. for the
year ending 2005 and 2006 prepare comparative statements and comment on the same.
54
Income Statement

Sales 6,300 7,350
Cost of goods sold 4,550 5,950
Administrative Expenses 280 280
Selling Expenses 140 140
Net Profit 1,330 980
Balance Sheet

Equity Share Capital 4,200 4,200 Land 2,100 2,100
6% Preference Share
Capital 3,500 3,500 Buildings 3,500 3,290
Reserves 2,800 3,115 Plant 2,800 3,290
Debentures 2,100 2,450 Furniture 2,100 2,350
Bills payable 1,750 1,925 Stock 2,800 3,500
Creditors 1,050 1,400 Cash 3,150 3,430
Tax Payable 1,050 1,400
16,450 17,990 16,450 17,990
Activity - 9
Following are the two Balance sheets of Jaya Ltd and Bharat Ltd on 31-3-2006. Prepare
Common size statement and make comments.
Jaya Ltd. Bharat Ltd
Rs. Rs.
Assets
Cash 54 144
Debtors 440 452
Stock 200 348
Prepaid exps. 22 42
Other Current Assets 20 42
Fixed Assets 1,270 1,026
2,006 2,054
Liabilities
Creditors 84 308
Other Current Liabilities 156 124
Long term Debt 450 636
Capital 1,316 986
2006 2,054
55
2.16 MODEL ANSWERS TO ACTIVITIES
1. Financial statements are prepared for he purpose of presenting a periodical review of
report on progress made by the management and deal with the status of Investment in the
business and the results achieved during the period under review.
2. The prime users of financial statements are share holders, or owners, lenders, potential
investors, employees, trade unions and government etc.
3. Investors need information about profits, liquidity, short and long term financial solvancy of
the concerns to take decisions about their investments, Financial statements help in provid-
ing all this information.
4. Horizontal analysis refers to the comparision of Financial data of a company for several
years. The figures of the various years are compared with that of the base year. This is also
known as Dynamic analysis.
Vertical analysis refers to the study of relationship of various items in the financial state-
ments of an accounting period. It is also known as Static Analysis.
5. Common-Size Income Statement of X Company.
2005 2006
Particulars Rs % Rs %
Net Sales 16,000 100.00 20,000 100.00
Less: Cost of goods sold 12,000 75.00 15,000 75.00
Gross Profit 4,000 25 5,000 25.00
Administration 400 2.50 400 2.00
Selling 600 3.75 800 4.00
Total Operating Expenses 1,000 6.25 1,200 6.00
Net Profit 3,000 18.75 3,800 19.00
56
6. Common Size Balance Sheet of GVK Ltd. as on 31st Dec 2005 & 2006.
2005 2006
Particulars Amount % Amount %

Capital and Reserves
Equity Capital 50,000 37.03 82,500 35.87
Preference Capital 25,000 18.52 37,500 16.30
Reserves 5,000 3.70 7,500 3.26
P/L 3,750 2.78 5,000 2.18
Total 83,750 62.03 1,32,500 57.61
Long-term Debt
Debentures 20,000 14.81 60,000 26.09
Total 20,000 14.81 60,000 26.09
Current Liabilities
Bank Overdraft 12,500 9.26 12,500 5.43
Creditors 10,000 7.41 12,500 5.43
Provision for Taxation 5,000 3.70 6,250 2.72
Proposed dividend 3,750 2.78 6,250 2.72
Total 31,250 23.16 37,500 16.30
Grand Total 1,35,000 100.00 2,30,000 100.00
Fixed Assets 80,000 59.25 1,47,500 64.13
Total 80,000 59.25 1,47,500 64.13
Current Assets
Stock 10,000 7.41 12,500 5.43
Debtors 25,000 18.52 31,250 13.58
Bills Receivable 5,000 3.70 15,000 6.54
Prepaid exps. 2,500 1.85 3,000 1.30
Cash at Bank 10,000 7.41 13,250 5.76
Cash in hand 2,500 1.86 7,500 3.26
Total 55,000 40.75 82,500 35.87
Grand Total 1,35,000 100.00 2,30,000 100.00
Interpretation:Common Size Balance Sheet of GVK Ltd. reveals the following facts
1. In the year 2006 Current Assets were decreased from 40.75% to 35.87% though
there is an increase in absolute figures in current assets by Rs.27,500.
57
2. Current liabilities decreased from 23.16% to 16.30% implying that the company has
paid current liabilities from current Assets. The liquidity position is reasonably good
even though there is slight decrease in current Assets.
3. Fixed Assets increased from Rs.80,000 to Rs.1,47,500. as a result of purchase of

fixed Assets by additional issue of share capital and debentures.
4. The overall financial position of the company is satisfactory.
7. a) Trend Ratios of different item (Base year 2003)
Particulars 2003 2004 2005 2006

Sales 100 106 103 107
Wages 100 100 107 112
Selling Expenses 100 108 107 100
Gross Profit 100 106 86 89
b) Trend percentages of relationships of Wages, Selling expenses, Gross Profit to Sales.

Particulars 2003 2004 2005 2006
Wages 35 33 36 36
Selling Expenses 9 9 10 8
Interpretation
1. The sales for the year 2004 and 2006 have increased but the sales for the year 2005
has decreased. It is not a goods sign for the business.
2. The Wages, Selling expenses are continuously increasing.
3. Gross Profit has increased from 100 to 106 in the year 2004, but it is showing a
decreasing trend in 2005 and 2006.
4. The firm should have controlling capacity to reduce the costs. The overall perfor-
mance is not satisfactory.
8. Comparative Income Statement of Raymonds Ltd. for the year ended 2005 and 2006.
2005 2006 Increase Change in
Decrease %
Sales 6,300 7,350 1,050 16.67
Less: Cost of Goods Sold 4,550 5,950 1,400 30.77
Gross Profit A 1,750 1,400 (-)350 (-)20.00
Operating Expenses
Administrative Expenses 280 280 0 0.00
Selling Expenses 140 140 0 0.00
Total Operating Expenses B 420 420 0 0.00
58
Operating Profit (A-B) 1,330 980 (-)350 (-)26.32
Other Expenses -- -- -- --
Net Profit 1,330 980 (-)350 (-)26.32
Comparative Balance Sheet of Raymond Ltd. at the end of the year 2005 and 2006.
2005 2006 Increase Change in

decrease %
Assets
Current Assets
Stock 2,800 3,500 700 25.00
Cash 3,150 3,430 280 8.89
Total 5,950 6,930 980 16.47
Fixed Assets
Land 2,100 2,100 0 0.00
Buildings 3,500 3,290 (-)210 (-)6.00
Plant 2,800 3,290 70 17.50
Furniture 2,100 2,380 280 13.33
Total 10,500 11,060 560 5.33
Total Assets 16,450 17,990 1,540 9.36
Liabilities
Current Liabilities
Bills Payable 1,750 1,925 175 10.00
Creditors 1,050 1,400 350 33.33
Tax Payable 1,050 1,400 350 33.33
Total 3,850 4,725 875 22.73
Long-term Debt
Debentures 2,100 2,450 350 16.67
Total 2,100 2,450 350 16.67
Shareholder Funds
Equity Share Capital 4,200 4,200 0 00.00
6% Preference Share Capital 3,500 3,500 0 00.00
Reserve 2,800 3,115 315 11.25
Total 10,500 10,815 315 3.00
Total Liabilities 16,450 17,990 1,540 9.36
59
Interpretation
1. The comparative Income statement reveals that there has been an increase in sales
by 16.67% while the cost of goods sold has increased by 30.77% thereby resulting
in decrease in Gross Profit by 20% although the operating Expenses have remained
constant, there has been decrease in Net Profit by 26.32% mainly because of de-
cline in Gross Profit.
2. The company current Assets has increased by 16.47% where as the current liabili-
ties has increased by 22.73% liquidity position is poor.
3. Share holders funds increased by 3%.
4. Overall financial position to some extent satisfactory because reserves shows an

increase of 11.25%.
9. Common Size Balance Sheets

Jaya Ltd. Bharat Ltd.
Amount Percentage Amount Percentage
of Total of Total
Assets
Current Assets
Cash 54 2.69 144 7.01
Debtors 440 21.93 452 22.01
Stock 200 9.97 348 16.95
Prepaid exps. 22 1.10 42 2.04
Other Current Assets 20 0.99 42 2.04
Total Current Assets 736 36.68 1,028 50.05
Fixed Assets
Fixed Assets Net 1,270 63.32 1,026 49.95
Total Assets 2,006 100.00 2,054 100.00
Current Liabilities
Creditors 84 4.19 308 14.99
Other Current Liabilities 156 7.78 124 6.04
Total Current Liabilities 240 11.97 432 21.03
Long-term Debt
Long-term Debt 450 22.43 636 30.97
Total Long-term Debt 450 22.43 636 30.97
Capital 1,316 65.60 986 48.00
Total Liabilities 2,006 100.00 2,054 100.00
60
Interpretation
Jaya Ltd is more traditionally financed as compared to Bharat Ltd.

i) Jaya Ltd. capital consists of 65.6%, while the percentage is 48 in Bharat Ltd. Finan-
cial structure of Jaya Ltd is more safe as compared to Bharat Ltd.
ii) Both companies have followed the policy of financing fixed assets from long term
Funds. In Jaya Ltd. investments in fixed assets 63.32% while long term funds are
88.03%. Similarly in Bharat Ltd 49.95% and 78.97%.
iii) The working capital Position of both the companies is good. Jaya Ltd. has 36.68% of
current assets while current Liabilities are 11.97% conversely in Bharat Ltd current
Assets are 50.05%. While current Liabilities are 21.03%.
iv) A close look at the liquidity position indicating that the position of Bharat Ltd. appears
better but infact working capital of Jaya Ltd. (Current ration 3.06) is much better than
that of Bharat Ltd. (Current Ratio 2.4).
v) Both companies have satisfactory financial position. But incomparision Jaya Ltd has
better financial position than that of Bharat Ltd.
2.17 SUMMARY
Financial statements are the end products of accounting process, which reveal the financial
results for the period ended and financial position as on a particular data. They are the basic
statements prepared and published by every corporate undertaking for the benefit of the end
users. These statements include
a) Profit & Loss Account or Income Statement
b) Balance Sheet or Position statement
c) Retained earning statements.
The basic objective of these statements is to provide information required for decision
making by the management as well as other outsiders who are interested in the affairs of the
undertaking.
The users of financial statements include shareholders, Investors, Creditors, Lenders, Cus-
tomers, Management, Government etc., Financial statements are not free from limitations. They
provide only aggregate information to satisfy the general purpose (needs) of the users but not for
the specific needs. These are technical statements understood by only persons having some ac-
counting knowledge. They reflect historical information but not current and projected situation,
which is essential in any decision making. In addition to this, one can get idea about the organisations
performance in terms of quantitative changes but not in qualitative terms like labour relations,
quality of work, employee satisfaction etc. Financial statements are neither complete nor accurate
hence they need proper analysis before their use in decision making.
Financial statement analysis is a study of the relationship among various financial
facts and figures as given in a set of financial statements. Analysis and interpretation of
financial statements are an attempt to determine the significance and meaning of financial statement
data. Interpretation is a wider term and includes criticism, examination and analysis. Analysis and
interpretation are closely interlinked. They are complementary to each other. Analysis without
interpretation is useless and interpretation without analysis is impossible. But generally the term
61
analysis is used to include interpretation as well, since analysis is always aimed at interpretation of
the relationships that are established in the course of analysis.
Financial statement analysis canbe done based on Modus operendi and material used. Fi-
nancial analysis focuses on highlighting to facts and relationships related to managerial perfor-
mance, corporate effeciency, financial strengths and weaknesses and credit worthiness of the firm.
Most widely known techniques of Financial statement analysis are Comparative State-
ments, Trend Analysis, Common-size Statements, Ratio Analysis, Funds Flow Analysis, Cash
Flow Analysis.

1. What do you mean by financial statement?
2. What is Income Statement?
3. State the objectives of financial statement.
4. State different types of Financial Statements.
5. Explain the tools of financial analysis.
6. State the Advantages of financial statement analysis.
7. Distingush between Vertical Analysis and Horizontal Analysis.
8. What are the limitations of financial analysis.
9. Bring out the importance of Financial analysis.
10. Distingush between external analysis and internal analysis.
11. Explain the procedure for preparing comparative financial statement.
12. What do you mean by common size statement? How do you prepare them?
13. How are the trend ratios computed?
14. What is the procedure of analysis and interpretation of financial statements?
B. Long Answer Questions
1. What do you understand by financial statements? Discuss the nature of financial state-
ments.
2. Describe the characterstics of ideal financial statements.
3. Explain the significance and limitations of financial statements.
4. Explain how financial statements are useful to the various parties who are interested in
the affairs of an undertaking?
5. Discuss various types of financial statements that are usually prepared by the business-
men.
6. Briefly discuss various financial statements.
7. “Financial statements reflect a combination of recorded facts accounting conventions
and personal judgements” Discuss.
62
8. What are the different techniques used for analysis of financial statements?
9. What are the merits and demerits of different types of financial analysis?
10. What do you understand by the analysis and interpretation of financial statements?
Discuss their utility and significance to the management and others who are inter-
ested in the business.
11. What are the different methods used for the analysis and interpretation of financial
statements?
12. “Analysis without interpretation is meaningless and interpretation without analysis
is impossible". Discuss.
13. State the different types of financial analysis and discuss the limitations of analysis
and interpretation of financial statements.
14. What is the importance of comparative statements? Illustrate you answer with
particular reference to comparative Income Statements and state briefly, how these
are prepared?
15. Explain the usefulness of trend percentage in interpretation of financial perfor-
mance of a company?
16. What are common-size statements? Explain how they are prepared?
EXERCISES
1. The following are the profit and Loss Accounts of Aurabindo Pharma Ltd.,
Vishakapatnam for the years 2005 and 2006. Prepare a comparative Income State-
ment and comment on the profitability of the company.
To Opening Stock 85,000 2,00,000 By Sales 10,00,000 12,00,000
To Purchases 5,00,000 5,50,000 By Closing Stock 2,00,000 2,25,000
To Wages 60,000 80,000 By Income from
To Salaries 42,000 64,000 Investments 12,000 15,000
To Rent 35,000 40,000 By Dividends Received 5,000 7,500
To Depreciation 40,000 60,000
To Selling exps. 12,000 12,000
To Discount 5,000 7,000
To Loss on sale of Plant - 8,000
To Interest 12,000 14,000
To Net profit 4,26,000 4,12,500
12,17,000 14,47,500 12,17,000 14,47,500
63
2. The Balance Sheets of a company are given as under. Explain the significance of changes
in assets and liabilities with the help of comparative Balance Sheet.

Equity Share Capital 4,50,000 10,00,000 Fixed Assets 4,00,000 10,00,000
Preference Share Capital 1,00,000 2,00,000 Investments 2,50,000 1,00,000
General Reserve 1,00,000 2,50,000 Receivables 2,00,000 4,00,000
Profit and Loss Account 1,00,000 2,00,000 Inventories 1,00,000 4,00,000
Accounts Payable 50,000 50,000 Cash 50,000 1,00,000
Outstanding Expenses 2,00,000 3,00,000
10,00,000 20,00,000 10,00,000 20,00,000
3. From the following profit and Loss Account and the Balance Sheet of Vishaka Ltd. for
the year ended 31st December, 2005 and 2006. You are required to prepare a compara-
tive Income Statement and comparative balance sheet and comment on the performance.
Profit and Loss Account (In Lakhs of Rs.)
To Cost of goods sold 600 750 By Net Sales 800 1,000
To Operating expenses:
Administrative 20 20
Selling 30 40
To Net profit 150 190
800 1,000 800 1,000
Balance Sheet as on 31st December (In Lakhs of Rs.)

Equity Capital 400 400 Land 100 100
6% preference Capital 300 300 Building 300 270
Reserves 200 245 Plant 300 270
6% Debentures 100 150 Furniture 100 140
Creditors 150 200 Cash 100 140
Bills payable 50 75 Debtors 200 300
Tax payable 100 150 Stock 200 300
1,300 1,520 1,300 1,520
64
4. The following figures relate to the activities of Shanta Synthetics Ltd, Vijayawada. for
the year ending 31st March, 2006.
Rs.
Sales 7,50,000
Purchases 3,75,000
Opening Stock 70,000
Closing Stock 80,000
Administrative Expenses
Salaries 37,000
Rent 12,000
Postage and Stationery 5,000
Provision for Taxation 50,000
Interest 5,000
Loss on sale of assets 11,500
Profit on sale Investments 9,500
Selling & Distribution Expenses
Salaries 18,000
Advertising 6,000
Commission on Sales 7,500
Discount 2,000
You are required to study the company with the help of common-size statement.
5. Convert the following Balance Sheets into Common-size Balance Sheet and interpret the
results.
Balance Sheets as on 31st December 2005 and 2006

Equity Share Capital 1,000 1,200 Debtors 450 390
Capital Reserve 90 180 Cash 200 10
General Reserve 500 450 Stock 320 250
Sinking Fund 90 100 Investments 300 250
Debentures 450 650 Buildings 800 1,400
Sundry Creditors 200 150 Land 190 350
Others 10 20 Furniture 80 100
2,340 2,750 2,340 2,750
65
6. From the following information, interpret the results of operations of a manufacturing
concern, using Trend ratios.
Particulars 2003 2004 2005 2006
Sales 100 90 120 150

Less: Cost of Gods Sold 60 60 70 80
Less: Operating Exps. 10 10 15 20
Operating Profit 30 20 35 50
Less: Taxes 15 10 17.5 25
Profit after Tax 15 10 17.5 25
7. From the following particulars extracted, you are required to calculate a) Trend Ratios of
different items b) Trend Percentages of relationship of wages, profit after tax to sales
Year Sales (Rs.) Wages (Rs.) Profit after Tax (Rs.)
2003 7,00,000 1,00,000 32,000
2004 8,30,000 1,20,000 29,000
2005 8,50,000 1,50,000 90,000
2006 9,20,000 1,70,000 1,20,000
8. From the following data relating to the assets side of the balance Sheet of ABC Ltd,
Calculate the trend percentage taking 2003 as the base year.
Assets 2003 2004 2005 2006
Cash 100 120 80 140
Debtors 200 250 325 400
Stock 300 400 350 500
BR 50 75 125 150
Land 400 500 500 500
Building 800 1,000 1,200 1,500
Plant 1,000 1,000 1,200 1,500
Total 2,850 3,345 3,780 4,690
66
9. From the following data relating to the liabilities side of the balance sheet of Mecatronix Ltd.
you are required to calculate the trend percentage taking 2003 as the base year and com-
ment.
Liabilities 2003 2004 2005 2006
Share Capital 200 250 260 300
Reserve 100 120 130 150
12% Debentures 400 500 600 800
Bank Overdraft 20 40 50 50
Profit and Loss Account 40 44 56 52
Creditors 80 140 120 140
O/S expenses 4 6 10 8

1. Gupta, S.P. : Management Accounting, Sahitya Bhavan Publica-
tions, Agra.
2. Sharma R.K. & Shashi Gupta K : Management Accounting, Kalyani Publishers,
Ludhiana.
3. Khan & Jain : Management Accounting, Tata McGraw Hill, Pub-
lishing Co., New Delhi.
4. Jawaharlal : Management Accounting, Himalaya Publishing
Co.,New Delhi.
5. Manmohan & Goyal : Principles of Management Accounting
, Sahitya
Bhavan Publications, Agra.
6. Vinayakan.N. & Sinha : Management Accounting-Tools and Techniques
,
Himalaya Publishing House, Mumbai.
7. S.N. Maheswari : Management Accounting, Sultan Chand & Sons,

New Delhi.
2.20 KEY WORDS

Financial Statements : Statements that contain the summarised information
of the firms financial affairs, organised systematically.
They are the means to present the firms financial po-
sition to the users. These statements refers to bal-
ance sheet and Profit and Loss Account.
Permanancy Order : Arranging the assets and Liabilities in the order of
their period of their stay in the organisation, begining
with fixed assets and capital as first items in order
and current assets and current liabilities as last items.
67
Liquidity Order : Assets and Liabilities are shown in the balance sheet
in order of liquidity. Current/liquid assets and current
liabilities. Which mature in one year are shown in
the begining and the assets and Liabilities which stay
in the business for the longer period will be shown at
the end.
Financial Statements : The process of critical examination of the financial
information contained in the financial statements in
order to understand and make decisions regarding
the operations of the firm.
Vertical Analysis : The analysis of financial statements of an organisation
made for only one accounting period.
Horizontal Analysis : The analysis of financial statements of an organisation
made for two or more years.
External Analysis : The financial statements are prepared and presented
to outsiders including shareholders and others.
Internal Analysis : When the financial statements are analysed and
interpreted by the people internal to the organisation
and who have an easy access to the detailed
accounting recordes for the purpose of assisting the
managerial personal to take corrective measures and
appropriate decisions is called internal analysis.
Comparative Statements : Comparative statements refers to comparison of
financial statements pertaining to two different periods
by putting them side by side and finding out the
changes in absolute and relative changes.
Trend Analysis : A technique of studying several financial statements
over a series of years.
Common-Size Statement : The statement indicating the relationship of different
items of a financial statement with some common item
by expressing each item as a percentage of the
common item.
68
GUIDELINE 3 : RATIO ANALYSIS
OBJECTIVES
• explain the meaning of ratios and ratio analysis;
• recognise the need and importance of ratio analysis;
• assess the profitability and efficiency of the company;
• measures the short-term and long-term solvency of the company; and
• describe the role of the ratios as predictors of corporate health in spite of their limitations.
STRUCTURE
3.1 Introduction
3.2 Meaning of Ratio
3.3 Meaning of Ratio Analysis
3.4 Objectives of Ratio Analysis
3.5 Significance of Ratio Analysis
3.6 Use, Importance and Advantages of Ratio Analysis
3.7 Limitations of Ratio Analysis
3.8 Classification of Ratios
3.9 Liquidity Ratios
3.10 Turnover/Activity/Performance Ratios
3.11 Leverage Ratios
3.12 Profitability Ratios
3.12.1 General Profitability Ratios
3.12.2 Overall Profitability Ratios
3.13 Coverage Ratios
3.14 Ratios as Predictors of Corporate Health
3.15 Illustrations
3.16 Summary
3.19 Key Words
3.1 INTRODUCTION
Planning is key to the financial manager’s success. xdFinancial plans may take many forms.
But any good plan must be related to the firm's existing strengths and weaknesses. The strengths
and weaknesses of a firm can be studied with the help of Ratios. Ratios are yardsticks, indicators,
and predictors with the help of which, firm's performance can be measured. Performance in terms
69
of profitability, liquidity and solvency can be assessed with the help of Ratios. Analysis of Financial
statements with the help of ratio is termed as Ratio-analysis. The object of Ratio analysis is to help
management in analysing and interpreting the financial statements, to get adequate information use-
ful for the performance of various functions like planning, co-ordination, Control, Communication
and forecasting.
3.2 MEANING OF RATIO
A Ratio is a simple arithmetical expression of the relationship of one number to another. A
Ratio maybe defined as the indicated quotient of two mathematical expressions. Hence A ratio is a
mathematical relationship between two related items expressed in quantitative form. When this
definition of ratio is explained with reference to the items shown in financial statements, then, it is
called accounting ratio.
According to Wixon, Kell and Bedford, A ratio is an expression of the quantitative relationship
between two numbers. According to Kohler-”a ratio is the relation, of the amount, 'a' to another 'b'
expressed as the ratio of 'a' to 'b'; a : b; or as a simple fraction, integer, decimal, fraction or percent-
age”. In simple language ratio is one number expressed in terms of another and can be worked out
by dividing one number into the other. For example, if the current assets of a firm on a given data are
Rs.15,00,000 and the current liabilities are Rs.7,50,000, then the ratio of current assets to Current
liabilities will work out to be 15,00,000 / 7,50,000 = 2:1.
In Financial Analysis, a ratio is used as an index or yardstick for evaluating the financial
position and performance of a firm. An accounting figure conveys meaning when it is related to
some other relevant and inter-connected information. Obviously, no purpose will be served by
comparing two sets of figures which are not at all connected with each other. Moreover, absolute
figures are also unfit for comparison.
3.3 MEANING OF RATIO ANALYSIS
As already stated the analysis of financial statements with the help of ratios is termed as Ratio
Analysis. It implies the process of computing, determining and presenting the relationship of items or
group of items of financial statements. It also involves the comparison and interpretation of these
ratios and the use of them for future predictions.
Ratio analysis is an extremely useful, most widely and powerful tool of financial analysis.
They are helpful in providing valuable insight into a company’s financial picture and pinpoint the
business strengths and weaknesses in two ways.
• Ratios provide an easy way to compare today’s performance with the past.
• Ratios depict the areas in which a particular business is comparatively advantaged or

disadvantaged through comparing ratios to those of other businesses of the same size
within the same industry.
3.4 OBJECTIVES OF RATIO ANALYSIS
The main objectives of ratio analysis are to:
i) analyse the liquidity position of the firm.
ii) analyse the capital structure of the firm
iii) evaluate the firm's profitability over a period of time and predict its future profitability
70
iv) analyse the financial health of the firm for the purpose of internal control
v) assess the return on investment in various assets of the company
vi) assess the efficiency of the firm in assets management.
3.5 SIGNIFICANCE OF RATIO ANALYSIS

Ratio analysis is an extremely useful, most widely used and powerful tool of analysis. It is
used to analyse and interpret the financial position of an enterprise. A doctor examines his patient by
recording his body temperature, blood pressure etc., before making his conclusion regarding illness
and before giving his treatment. Similarly, a financial analyst analyses the financial statements with
various tools of analysis before commenting upon the financial health or weakness of an enterprise.
Ratio Analysis helps in making intra and inter-firm comparison. Ratios act as the index of the effi-
ciency of the firm. A study of the trend of strategic ratios helps the management in planning, fore-
casting and decision making. Ratio analysis helps the management in carrying out its functions of
coordination control and communication. It helps in identifying specific weak areas, finds the rea-
sons and suggests the remedial actions. A purposeful ratio analysis helps in identifying the following
questions and finding out suitable courses of action.
1. Whether the financial condition of the firm is basically sound;
2. Whether the capital structure of the firm is appropriate;
3. Whether the profitability of the firm is satisfactory
4. Whether the credit policy of the firm is sound; and;
5. Whether the firm is credit worthy,
Various parties like trade creditors, banks, financial institutions, investors, shareholders and
management are interested in the ratio analysis for knowing and evaluating the financial position of
a firm for different purposes like for granting credit, providing loans, or making investment decisions
in the firm.
Ratio analysis helps in budgetory control and standard costing. As they expose the strengths
and weakness of the firm.
In short, through the technique of ratio analysis the firms’s solvency long term as well as short
term, efficiency of its operations and profitability can be assessed.
3.6 USE, IMPORTANCE AND ADVANTAGES OF RATIO

ANALYSIS
Ratio analysis stands for the process of determining and presenting the relationship of items
and groups of items in the financial statements. It is a way by which financial stability and health of
a firm can be judged. The following are the main points of importance of Ratio analysis.
1. Useful in assessing the financial position
Accounting ratios reveal the financial position of the firm. This helps the banks, insurance
companies and other financial institutions in lending and making Investments decisions.
2. Useful in simplifying accounting figures

Accounting Ratios, simplify, summarise and systematise the accounting figures in order to
71
make them more understandable and in lucid form. They highlight the inter-relationship which
exists between various segments of the business as expressed by accounting statements.
Often the figures standing alone cannot help them convey any meaning and ratios help them
to relate with other figures.
3. Useful in assessing the operational efficiency
The efficiency of the firm becomes evident when analysis is based on accounting ratios.
They diagnose the financial health by evaluating liquidity, solvency and profitability.
4. Useful in forecasting
If accounting ratios are calculated for a number of years, then a trend is established. This
trend helps in setting up future plans and forecasting.
5. Useful in locating the weak spots of the business
Accounting ratios are of great assistance in locating the weak spots in the firm even though
the overall performance maybe efficient. Weakness in financial structure due to incorrect
policies in the past or present are revealed through accounting ratios.
6. Useful in comparison of performance
Through accounting ratios comparison can be made between one department with another of
a firm in order to evaluate the performance.
3.7 LIMITATIONS OF RATIO ANALYSIS
Undoubtedly, ratios are precious tools in the hands of the analyst but its significance emanates
from proper use of these ratios. Misuse or mishandling of these ratios and using them without proper
context may lead the analyst to a wrong direction. Thus, the analyst should not only be well versed
in calculating these ratios but he should have an expertise knowledge about making proper use of
these ratios. Like all tools, ratios also suffer from limitations.
1. False results if based on incorrect accounting data
Accounting Ratios can be correct only if the data is correct, sometimes, the information given
in the financial statements is affected by window dressing i.e., showing position better than
what actually is. For example, if inventory values are inflated or depreciation is not charged
on fixed assets.
2. No idea of probable happening in future
Ratios are an attempt to make an analysis of the financial statements; so they are historical
documents. Historical statement fails in predicting the future happenings.
3. Variations in accounting methods
The two firms results are comparable with the help Accounting Ratios only if they follow the
same accounting methods. Comparison will become difficult if the two concerns follow dif-
ferent methods of providing depreciation or valuing stock. Similarly, if the two firms are fol-
lowing two different standards or methods, an analysis by reference to the ratios would be
misleading.
4. Price level changes
Changes in price levels make comparison for various years difficult. For example, the ratio of
72
sales to total assets in 2006, would be much higher than in 1996, due to rising prices, but fixed
assets being shown at cost and not at market price.
5. Only one method of analysis
Ratio analysis only gives just a fraction of information needed for decision-making. So to
have a comprehensive analysis of financial statements. Ratios should be used with other
methods of analysis.
6. No common standards
It is very difficult to lay down a common standard for comparison because circumstances
differ from firm to firm and the nature of each industry is different. For example, a business
with current Ratio of more than 2:1 might not be in a position to pay current liabilities in time
because of unfavorable distribution of current assets in relation of liquidity. On the other hand,
another business with a current ratio of even less than 2:1 might not be experiencing any
difficulty in making the payment of current liabilities in time because of its favorable distribu-
tion of current assets in relation to liquidity.
7. Different meanings assigned to the same term
Different firms, in order to calculate ratios, may assign different meanings. For example,
profits for the purpose of calculating a ratio maybe taken as profit before charging interest
and tax or profit before tax but after interest or profit after tax and interest. This may affect
the calculation of ratios in different firms and such ratios when used for comparison may lead
to wrong conclusions.
8. Ignores qualitative factors
Accounting ratios are tools for quantitative analysis only. But some times qualitative factors
may surmount the quantitative aspects. The calculations derived from the ratio analysis under
such circumstances may get distorted. For example, though credit may be granted to a
customer on the basis of financial position, yet the grant of credit ultimately depends on debt-
ors character, honesty, past record and his managerial ability.
9. No use if ratios are worked out for insignificant and unrelated figures
If ratio are used for insignificant and unrelated figures, the results would be misleading, for
example, Ratio of sales and investment in government securities, such ratio may be mislead-
ing. Ratios should be calculated on the basis of cause and effect relationship. One should be
clear as to what is the cause and what is the effect before using the ratio.
10. An analyst should know the reliability and soundness of the figures from which the ratios are
computed, other wise, ratios could be misleading.
11. As a single ratio does not convey much sense, often a number of ratios are calculated to make
a better interpretation of the Financial data.
12. Ratio could give misleading results, when even there is a change in the accounting procedure.
13. A simple ratio maybe interpreted in different ways, at different times by different people,
Ratios are only means of financial analysis and not an end in itself.
73
Financial ratios are aids to analysis. They cannot be substitutes for their kind out judgement.
Financial analysis is a mental process requiring knowledge, experience, insight and personal judge-
ment, a process for which there can be no mechanical substitute. These limitations to a considerable
extent can be eliminated or corrected and the benefits of ratio analysis can be derived;
i) If the analysis is related to one firm over a period of time,
ii) If the analysis confined to a few well known ratios, which can answer specific ques-
tions.
iii) If the ratios of the firm are compared with suitable standards
iv) If the ratios are used primarily for the identification of areas for further managerial
analysis and
v) If the ratios are interpreted in the light of social, political, economic, technological and
business conditions under which the firm operates.
3.8 CLASSIFICATION OF RATIOS
Many ratios can be calculated from a typical set of financial statements. But all of them are
not necessary for studying any particular aspect. On the basis of the nature of the business concern,
the circumstances in which it is operating, and the particular questions to be answered from the ratio
analysis, certain ratios only need be selected. Every attempt should be made to keep the number of
ratios as far as possible to the minimum. This avoids possible confusion in the interpretation of ratio.
Various accounting ratios can be classified as follows.
Ratios
Traditional Classification Functional Significance

or Classification Classification
Statement Ratios
Primary Secondary
Ratios Ratios
Short-term Long-term Activity or Profitability

Solvency or Solvency or Turnover Ratios
Liquidity Ratios Leverage Ratios Ratios
Balance Sheet Profit & Loss A/c. Composite or
3.9 LIQUIDITY RATIOS

These are the ratios which measure the short-term solvancy or financial position of a firm.
These ratios are calculated to assess the short-term paying capacity of a concern or the firms ability
to meet its current obligations. The various liquidity Ratios are
i) Current Ratio
ii) Liquid Ratio or Quick Ratio or Acid Test Ratio
iii) Absolute Quick Ratio
74
i) CURRENT RATIO / WORKING CAPITAL RATIO
This ratio establishes the relationship between current Assets and current liabilities. It is an
indicator of the firms commitment to meet its current obligations and studies the short term financial
position of the firm. It is expressed as follows.
Current Assets
Current Ratio = Current Liabilities
Current Assets are the assets, which can be converted into cash with in one year.
The following is the composition of Current Assets:
i) Cash in hand, ii) Cash at bank, iii) Debtors, iv) Bills receivable, v) Marketable or short
term investments, vi) Inventory or stock, vii) Outstanding incomes, viii) prepaid expenses etc.
Current liabilities are those liabilities, which are to be paid with in a year. The following are
the current liabilities
i) Creditors, ii) Bills payable, iii) Bank overdraft, iv) Short-term loans, v) Outstanding
expenses, vi) Prepaid incomes, vii) Tax payable, viii) Dividends payable, ix) Unclaimed dividends
etc.
Rule of thumb for current ratio is 2:1 i.e., current Assets should be two times than the current
liabilities. Then the business operations will not be adversely affected, current obligations canbe met
easily, still adequate funds are available to carry out day to day operations. if the ratio is less than 2,
the business does not enjoy adequate liquidity, thus leading to trouble in settling current obligations. If
the ratio is higher than 2, though it is comfortable for the creditors, but it is an indication of idle Funds
and has not invested them.
LIQUID/QUICK/ACID TEST RATIO
This ratio is as certained by comparing the liquid assets (i.e. assets which are immediately
convertible into cash without much loss) to current liabilities. Stock and prepaid expenses are not
taken as liquid assets. The Ratio may be expressed as
Liquid Assets
Current Liabilities
A quick ratio of 1:1 is considered as idle. Ratio below 1 is an indicator of inadequate liquidity.
Even a high quick ratio is also not advisable as funds can become idle, they are to be employed more
profitably.
ABSOLUTE/SUPER QUICK RATIO

This is a variation of Quick Ratio. It is the absolute Quick assets to Quick liabilities. How-
ever, for calculation purposes it is taken as ratio of absolute Quick assets to current liabilities.
Absolute Quick Assets

Absolute Quick Ratio =
Current Liabilities
Absolute Quick Assets
Absolute Quick Ratio =
Absolute Quick Liabilities
75
Absolute Quick Assets = Cash in Hand + Cash at Bank + Short-term Investments
Absolute Quick Liabilities = Current Liabilities - Bank Overdraft
The idle ratio is 1:2. This ratio is the most vigorous measure of the firm’s liquidity position.
DEFENSIVE INTERNAL RATIO
This ratio examines the firm’s liquidity position in terms of its ability to meet projected daily
expenditure from operations. It is calculated as follows
Quick Assets
Defensive Internal Ratio =
Projected Daily Cash Requirements
Projected daily cash requirements are computed as follows:
Projected Cash Operating Expenses
Number of Days in a Year
Projected cash operating expenses are computed on the basis of past experience and future
plans. They include cost of goods sold (excluding depreciation) and operating expenses payable in
cash. The defensive interval measures the time period for which a firm can operate on the basis of
present liquid assets without resorting to the next year’s revenue. The higher the ratio, better H is,
since it reflects the ability of a firm to meet the cash requirements for a longer time period.
Illustration - 3
From the following Balance Sheet, Calculate i) Current Ratio ii) Quick Ratio and absolute
Quick Ratio and comment on Liquidity position.
Liabilities Rs. Assets Rs.
Equity Share Capital 1,20,000 Goodwill 20,000
7 % Debentures 70,000 Fixed Assets 1,06,000
Long-Term Debt 40,000 Long-term Investments 60,000
Bank Overdraft 15,000 Cash and Bank 22,000
Creditors 12,000 Accounts Receivable 38,000
Bills Payable 6,000 Stock 20,000
Tax Provision 4,000 Prepaid Rent 1,000
2,67,000 2,67,000
Solution
Current Assets 81,000
Current Ratio = = = 2.189 : 1
Current Liabilities 37,000
Quick Assets 60,000

Liquid / Quick Ratio = = 37,000 = 1.62 : 1
Current Liabilities
Quick Assets = Cash & Bank + Accounts Receivable = 22,000 + 38,000 = 60,000
76
Absolute Quick Assets 22,000
Absolute Quick Ratio = = = 1:1
Absolute Quick Liabilities 22,000
Absolute Quick Assets = Cash and Bank = 22,000
Absolute Quick Liabilities = Creditors + Bills Payable + Tax Provision
= 12,000 + 6,000 + 4,000 = 22,000
Comment: The short term financial position, liquidity position of the company is satisfactory.
3.10 TURNOVER / ACTIVITY / PERFORMANCE EFFICIENCY

RATIOS
The Turnover Ratios are also known as activity or efficiency Ratios. They will Judge how
efficienctly and effectively the firm uses its resources. They are usually calculated on the basis of
sales or cost of sales are expressed in integers rather than as a percent. The higher the turnover
ratio, the better the profitability.
The following are the important turnover Ratios.
1. FIXED ASSET TURNOVER RATIO
This ratio indicates the extent to which the investments in fixed assets contribute towards
sales. It indicates whether the investments in Fixed assets has been Judicions or not. The ratio is
calcualted as follows:
Net Sales
Fixed Assets
2. WORKING CAPITAL TURNOVER RATIO
This ratio indicates whether or not working capital has been effectively utilised in making
sales. In case a company can acheive higher volume of sales with relatively small amount of
working capital, it is an indication of the operating effeciency of the company. The ratio is calcualted
as follows:
Net Sales
Net Working Capital
If Sales are not known, cost of goods sold can be taken as numerator.
Net Working Capital = Current Assets - Current Liabilities
3. CURRENT ASSETS TURNOVER RATIO

This ratio establishes the relationship between current assets and net sales.
Current Asset Turnover Ratio = Net Sales

Current Assets
A higher ratio indicates the efficiency of the company in using its current Assets, while a low
ratio indicates the inefficency of the company.
4. CAPITAL TURNOVER RATIO
It shows the efficiency of capital employed in the business by computing how many times
capital employed is turned over in a stated period.
77
Capital Turnover Ratio = Net Sales
Capital Employed
Capital Employed = Equity Share Capital + Preference Share Capital + Reserves +
Debentures and Long-term Debit - Fictitious Assets
A higher Ratio indicates greater profits for the company while a lower ratio means that
sufficient sales are not being made and profits are lower.
5. TOTAL ASSETS TURNOVER RATIO

Net Sales
It is calculated by dividing net sales by the total assets =
Total Assets
Total Assets = Fixed Assets + Current Assets + Investments
6. STOCK TURNOVER OR INVENTORY TURNOVER RATIO

It establishes the relationship between cost of goods sold and average inventory. It indicate
the number of times the stock is turned into sales during an accounting period.
Cost of Goods Sold

Stock Turnover Ratio =
Average Stock
Opening Stock + Closing Stock
Average Stock =
2
Incase, information regarding cost of goods sold is not given, sales maybe taken as the nu-
merator. Similarly, if average stock cannot be calculated, closing stock can be taken as the denomi-
nator. Higher the ratio, the better it is for the company. A stock turnover ratio of “8” is regarded as
an ideal one. A Low ratio reveals the accumulation of Absolete stock or carrying of too much stock.
7. STOCK VELOCITY / STOCK CONVERSION PERIOD
It is expressed in terms of number of days, which indicates the time taken by the stock to get
converted into sales. It can also be expressed in months and weeks.
Average Stock × 365 Days

Stock Velocity in Days =
Cost of Goods Sold
Instead of 365 days, we can as well use 12 or 52, to obtain stock velocity in months or weeks.
When information regarding opening stock is not given or when it is not possible to calculate average
stock, then closing stock can be taken in place of average stock. A higher velocity is always better.
DEBTORS/RECEIVABLE TURNOVER RATIO

It establishes the relationship between debtors and sales. This ratio is a measure of efficiency
in collecting the debtors and tells how efficiently a company is enforcing its credit policy. The
volume sales canbe increased by following a liberal credit policy. But the effect of liberal credit
policy may result in tying up substantial funds of a firm in the form of debtors or receivable i.e
Debtors plus Bills Receivables. Debtors Turnover ratio indicates the velocity of debt collection of
firm. Two ratios are used by financial analysts to judge the liquidity of a firm. They are i) Debtors
Turnover Ratio and ii) Debt Collection Period Ratio.
78
The debtors turnover ratio is calculated as under:
Credit Sales
Average Debtors
If any information regarding credit sales is not given, then total sales can be considered as
credit sales. Debtors must be taken at gross value without adjusting for provision for bad and
doubtful debts. Also if information regarding average debtors is not given, closing balance of debtors
should be taken into account. A higher debtors turnover ratio is an indicator of sound credit manage-
ment policy. A debtors turnover ratio of 10-12 is considered as ideal.
DEBT COLLECTION PERIOD RATIO/OR DEBTORS VELOCITY
It is expressed in terms of number of days required for the debtors to get converted into cash,
it is calcualted as:
No. of Days in a Year Accounts Receivable
Debtors Turnover Ratio OR Monthly or Daily Credit Salary
A low debt collection period is good for the company and the idle debt collection period is 30-
36 days.
CREDITORS TURNOVER RATIO
It expresses the relationship between creditors and purchases. This ratio gives the average
credit period enjoyed from the creditors and is calculated as under.
Net Credit Purchases
Average Creditors
A high ratio indicates that creditors are not paid in time, while a low ratio gives an idea that
business is not taking full advantage of credit policy allowed by the creditors.
In case of insufficiency of information regarding credit purchases, the total purchases maybe
taken.
Average creditors include bills payable also and information regarding average creditors can
not found, closing balance of creditors should be taken.
CREDIT PAYMENT PERIOD
This ratio gives the average credit period enjoyed from the creditors and is calculated by
anyone of the following method:
a) No. of Days in a Year

Creditors Turnover Ratio
b) Average Creditors × Months (or Days) in a Year
Credit Purchases in the Year
Average Creditors
c)
Average Monthly (or Daily) Credit Purchases
79
Illustration - 4
The following are the ratios relating to Broadways Ltd.
Stock Velocity = 6 months, Gross Profit 25%
Creditors Velocity = 2 months, Gross Profit Amount Rs.4,00,000
Debtors Velocity = 3 months, Closing Stock is 10,000 above Opening Stock
Bills Receivable Rs.25,000, Bills Payable Rs.10,000
Calcualte a) Sales, b) Average Stock, Opening Stock and Closing Stock c) Purchases d)
Creditors e) Debtors.
Solution
a) Calculation of Sales and Cost of Goods Sold.
Given Gross Profit Rate = 25%, Gross Profit Amount Rs. 4,00,000
Gross Profit Amount 4,00,000

Sales = = 25% = 16,00,000
Gross Profit Rate
Cost of Goods Sold = Sales - Gross Profit
= 1,60,000 - 4,00,000 = 12,00,000
b) Calculation of Average Stock, Opening Stock and Closing Stock
Given Stock Velocity = 6 months
Stock Turnover = Months in a Year = 12 = 2 times.

Stock Velocity 6
Cost of Goods Sold
Stock Turnover =
Average Stock
12,00,000
2 =
Average Stock
12,00,000
Average Stock = = 6,00,000
2
Average Stock =
2
Opening Stock + Closing Stock = 12,00,000
Let Opening Stock be x
and Closing Stock be x + 10,000
x + x + 10,000 = 12,00,000
2x = 11,90,000
11,90,000
x= = 5,95,000
2 80
x = Opening Stock = 5,95,000
x + 10,000 = Closing Stock = 5,95,000 + 10,000 = 6,05,000
Hence Averge Stock = 6,00,000
Opening Stock = 5,95,000
Closing Stock = 6,05,000
c) Calculation of Credit Purchases
Cost of Goods Sold = Opening Stock + Purchases - Closing Stock
12,00,000 = 5,95,000 + Purchases - 6,05,000
Purchases = 12,00,000 + 10,000 = 12,10,000
d) Calculation of Creditors
Creditors Velocity given 2 months
12
Creditors Turnover = No. of Months = = 6 times
Velocity 6
Credit Purchases 12,10,000
Creditors Turnover = = 6 =
Average Creditors Average Creditors
Average Creditors = 12,10,000 = 2,01,667.

6
e) Calculation of Debtors
Given Debtors Velocity 3 months
12
Debtors Turnover = No. of Months in a Year = = 4 months
Velocity 3
Credit Sales
Debtors Turnover =
Average Debtors
16,00,000
4 =
Average Debtors
Average Debtors = 16,00,000 = Rs. 4,00,000.

4
Debtors = Closing Debtors - Bills Receivable
= 4,00,000 - 25,000 = Rs.3,75,000
81
Illustration - 5
Following is the summarised Profit & Loss Account for the year ending 31st March, 2006 and
the Balance Sheet as at that date.
Profit & Loss Account
Rs.
Rs.
To Opening Stock 50,000 By Sales 5,00,000
To Purchases 2,75,000 By Closing Stock 75,000
To Gross Profit 2,50,000
5,75,000 5,75,000
To Admn Expenses 75,000 By Gross Profit 2,50,000
To Selling Expenses 60,000
To Interest 15,000
To Net Profit 1,00,000
2,50,000 2,50,000
Balance Sheet
Liability Assets
Capital 5,00,000 Land & Buildings 2,50,000
Profit & Loss Account 1,00,000 Plant & Machinery 1,50,000
Creditors 1,25,000 Furniture 1,00,000
Bills Payable 75,000 Cash in Hand 87,500
Debtors 75,000
Bills Receivable 62,500
Stock 75,000
8,00,000 8,00,000
Additional Information
Average Debtors Rs.62,500

Average Creditors Rs.75,000
Credit Purchases Rs.2,00,000
You are required to calculate

i) Stock Turnover Ratio and Velocity
ii) Debtors Turnover Ratio and Velocity
iii) Creditors Turnover Ratio and Velocity
82
iv) Working Capital Turnover Ratio
v) Fixed Assets Turnover Ratio
vi) Current Assets Turnover Ratio
vii) Total Assets Turnover Ratio
viii) Capital Turnover Ratio
Solution
i) Stock Turnover Ratio and Velocity
Cost of Goods Sold 2,50,000

Stock Turnover Ratio = = = 4 times
Average Stock 62,500
Average Stock × 365 days 62,500 × 365
Stock Velocity = = = 91.25 days
ii) Debtors Turnover Ratio and Velocity
Net Credit Sales 5,00,000

Debtors Turnover Ratio = = = 8 times
Average Trade Debtors 62,500
Average Trade Debtors × 365 days 62,500 × 365
Debtors Velocity = = = 45.625 days
iii) Creditors Turnover Ratio and Velocity
Net Credit Purchases 2,00,000

Creditors Turnover Ratio = = = 2.67 times
Average Trade Creditors 75,000
Average Trade Creditors × 365 days
Creditors Velocity =
75,000 × 365
= = 136.875 days
2,00,000
Net Sales 5,00,000
iv) Working Capital Turnover Ratio = = = 5 times
Working Capital 1,00,000
Working Capital = Current Assets - Current Liabilities
Current Assets = Cash + Debtors + Bills Receivable + Closing Stock

= 87,500 + 75,000 + 62,500 + 75,000 = 3,00,000
Current Liabilities = Creditors + Bills Payable
= 1,25,000 + 75,000 = 2,00,000
Working Capital = 3,00,000 - 2,00,000 = 1,00,000

Net Sales 5,00,000
v) Fixed Assets Turnover Ratio = = = 1 time
Fixed Assets 5,00,000
Net Sales 5,00,000
vi) Current Assets Turnover Ratio = = = 1.67 times
Current Assets 3,00,000
83
Net Sales 5,00,000
vii) Total Assets Turnover Ratio = = = 0.625 times
Total Assets 8,00,000
Net Sales 5,00,000
viii) Capital Turnover Ratio = Capital Employed = 6,00,000 = 0.83 times
Capital Employed = Equity Share Capital + Preference Share Capital + Reserves +

Debentures - Fictitious Assets
= 5,00,000 + NIL + 1,00,000 + NIL - NIL
= Rs. 6,00,000
3.11 LEVERAGE RATIOS

ANALYSIS OF LONG-TERM FINANCIAL POSITION (OR) TEST OF SOLVANCY (OR)
LEVERAGE (OR) CAPITAL STRUCTURE (OR) STABILITY RATIOS
The term solvancy refers to the ability of a firm to meet its long term obligations. The long-
term indebtedness of a firm includes debenture holders, financial institutions providing medium and
long-term loans. The long term creditors of a firm are primarily interested in knowing the firms
ability to pay regularly interest on long-term borrowings, repayment of the principal amount at the
maturity and the security of their loans. To study this aspect Leverage or capital structure ratios are
used.
The short term creditors would use ratios for ascertaining their safety in meeting their obligations on
time. The long term creditors would use these leverage ratios to examine long term solvancy of the
business. There are two aspects of the longterm solvancy of a firm as reflected in its policy to repay
the principal amount on maturity and pay interest at periodic intervals. These two aspects are
interrelated and give rise to two type of leverage ratios. These ratios are also called “Capital
structure” Ratios.
The first type of leverage ratios are known as capital structure ratios which are based on the
relationship between borrowed funds and owners capital and include the following Ratios.
1. Debt-Equity Ratios
2. Proprietory Ratio
3. Fixed Assets Ratio
4. Capital Gearing Ratio
The second type of leverage ratios which are also referred to coverage ratios and include the
following
1. Interest-Coverage Ratio
2. Dividend Coverage Ratio
Liverage may also be classified as:
i) Financial leverage or Trading on equity
ii) Operating leverage
iii) Combined leverage
84
DEBT EQUITY RATIO
The debt-equity ratio is calculated to ascertain the soundness of the long-term policies of the
company. This ratio is popularly known as “External-Internal ratio” and relates the owners stake in
thebusiness vis-a-vis that of outsiders. This Ratio also reflects the relative claims of creditors and
shareholders against the assets of the business. Debt-Equity Ratio maybe calculated as follows:
Debt External Equity Long-term Debt

Debt Equity Ratio = = =
Equity Internal Equity Equity
External equities or outsiders fund include all debts, whether long-term or short term debts.
Internal equities or shareholders fund include preference share capital. Equity share capital,
Retained earnings. Debt equity Ratio of 1:1 is considered ideal. Excessive liabilities tend to cause
insolvancy. The ratio indicates extent to which the firm depends upon outsiders for its existence.
The ratio provides a margin of saftay to the creditors.
PROPRIETORY RATIO
It establishes relationship between the proprietors funds and the total tangible assets. Propri-
etor ratio is an indicator of strong financial position of business. The higher the ratio the better it is.
This ratio focusses attention on the general financial strength of the business enterprise. It may be
expressed as:
Proprietory Funds or Networth
Total Tangble Assets
Proprietory Funds = Equity Share Capital + Preference Share Capital + Reserves -

Fictitious assets
Total Tangible Assets = Fixed Assets + Investments + Current Assets
(Excluding Fictious Assets)
FIXED ASSETS RATIO
This ratio explains whether the firm has used adequate long-term funds to meet its fixed
Assets requirements. It is expressed as follows
Fixed Assets
Long-term Funds
The ratio should not be more than 1. The Ideal ratio is 0.67
Fixed Assets include “Net Fixed Assets” and trade Investments including shares in
subsidiaries.
Long-Term Funds include Share Capital + Pref. Share Capital + Reserves and Long-term Loans.
CAPITAL GEARING RATIO

The term ‘Capital Gearing’ is used to describe the relationship between fixed interest and/or
fixed dividend bearing securities and the equity share holders funds. The fixed interest or fixed
dividend bearing funds include the funds provided by the debenture holders and preference share-
holders. It can be calculated as shown as below:
85
Funds bearning fixed interest or fixed dividends or debentures + preference capital
Equity shareholders funds
In case, the amount of debentures and preference capital is more than the equity shareholders
funds, the capital structure is said to be “high geared” if the amount equity shareholders funds is
more than fixed interest or fixed dividend-bearing funds the capital structure is said to be “lower
geared” A company which is highly geared, will have to raise funds by issuing fresh equity shares
whereas, a lowly geared company will have to raise funds by way of term loans and debentures.
3.12 PROFITABILITY RATIOS

The primary objective of a business is to earn profits. Profit earning is considered essential
for the survival of the business. In the world of Lord Keynes “Profit is the engine that drives the
business enterprise”. Profitability is an indication of the efficiency with which the operations of the
business are carried on. Poor operational performance may indicate poor sales and hence poor
profits. A lower profitability may arise due to the lack of control over the expenses. Bankers and
Financial Institutions and other creditors look at the profitability ratios as an indicator whether or not
the firm earns substantially more than it pays interest for the use of borrowed funds. Owners are
interested to know the profitability as it indicates the return which they can get on their investments.
The following are the important profitability Ratios.
3.12.1 GENERAL PROFITABILITY RATIOS
The following ratios are known as general profitability Ratios
i) Gross Profit Ratio
ii) Operating Ratio
iii) Net Profit Ratio
iv) Operating profit Ratio
v) Expenses Ratio
i) GROSS PROFIT RATIO
This ratio expresses relationship between gross profit and net sales, usually represented as a
percentage. Its formula is:
Gross Profit
× 100
Net Sales
Gross Profit = Net Sales - Cost of Goods Sold
Net Sales = Sales - Sales Returns
Cost of Goods Sold = Opening Stock + Purchases + Direct Exps. - Closing Stock
Significance
Higher the ratio, the better is the firm. A low ratio indicates unfavorable condition like a
decrease in selling price not accompanied by a proportinate decrease in cost of goods sold or an
increase in cost of production.
86
ii) OPERATING RATIO
Operating Ratio establishes the relationship between cost of goods sold and operating ex-
penses on the one hand and the sales on the other hand. It represents as a percentage.
Cost of Goods Sold + Operating Expenses

Formula = × 100
Net Sales
Operating expenses includes Administrative and office expenses like rent, salaries, insurance,
directors fee depreciation etc., and selling and distribution expenses like Advertisement, transporta-
tion etc., but excludes non operating expenses like interest, dividends, Loss or Profit on sale of assets
and taxes.
Significance
Operating Ratio indicates the percentage of net sales that is consumed by operating cost.
Obviously, higher the operating Ratio, the less favourable it is, because it would have of small margin
i.e. operating profit (PBIT) to cover Interest, Income Tax and dividend and Reserves. Operating
Ratio is considered to be a yardstic of operating efficency but it should be used cautiously because
it may be affected by a number of uncontrollable factors beyond the control of the management.
iii) NET PROFIT RATIO
Net profit ratio establishes relationship between net profit (after taxes) and sales. It indicates
the result of overall operations of the firm. It is of a great significance to the proprietors and
prospective Investors as it reveals the overall profitability of a business concern. The higher the
ratio, the better is the profitability.
Net Profit After Tax

Net Profit Ratio =
Net Sales × 100
Illustration - 1
Calculate general profitability ratios from the following income statement.
Net Sales 1,00,000
Less: Cost of Goods Sold 30,000
Gross Profit 70,000
Less: Administrative Expenses 20,000
Selling Expenses 10,000
Distribution Expenses 20,000 50,000
Operating Profit 20,000
Less: Tax 10,000
Net Profit 10,000
87
Solution
Gross Profit 70,000
i) Gross Profit Ratio = × 100 = 1,00,000 × 100 = 70%
Sales
ii) Operating Ratio = × 100
Net Sales
30,000 + 50,000 80,000

= × 100 = × 100 = 80%
1,00,000 1,00,000
iii) Operating Profit Ratio = × 100 = × 100 = 20%
Net Sales 1,00,000
Cost of Goods Sold

iv) a) Cost of Goods Sold Ratio = × 100
Net Sales
30,000
= × 100 = 30%
1,00,000
b) Administrative Expenses Ratio = Administration Expenses × 100

Net Sales
20,000
= × 100= 20%
1,00,000

c) Selling Expenses Ratio = × 100 = × 100 = 10%
Net Sales 1,00,000
Distribution Expenses
d) Distribution Expenses Ratio = × 100
Net Sales
20,000
= × 100 = 20%
1,00,000
Net Profit 10,000

v) Net Profit Ratio = × 100 = × 100 = 10%
Net Sales 1,00,000
88
iv) OPERATING PROFIT RATIO
This ratio is calculated by dividing operating profit by net sales
Operating Profit
Formula = × 100
Net Sales
Operating Profit = Gross Profit - Operating expenses
Operating Profit Ratio = 100 - Operating Ratio
The higher the ratio, the better it is. The ratio indicates the position left out of every rupee
worth of sales after all operating costs have been met.
v) EXPENSES RATIOS
Expenses ratios indicate the relationship of various expenses to net sales. The ratio can be
calculated for each individual item of expense or a group of items of a particular type of expense like
cost of sales ratio, Administrative expenses ratio, selling expenses ratio, material consumed ratio.
The lower the ratio, the greater is the profitability and higher the ratio, lower is the profitability.
Cost of Goods Sold × 100

a) Cost of Goods Sold Ratio =
Net Sales
Administrative Expenses × 100

b) Administrative Expenses Ratio =
Net Sales
Selling & Distribution

Expenses Ratio
c) Selling and Distribution Expenses Ratio = × 100
Sales
3.12.2 OVERALL PROFITABILITY RATIOS
Profits are the measure of overall efficiency of a business. The higher the profits, the more
efficient is the business considered. For example company X earns a net profit Rs.1,00,000, while
company Y earns only Rs.80,000. Company X shall be considered better, but it is not indicate true
state of efficiency of the business or profitability unless profits are related with the size of invest-
ment. Say in the above example, if the total investment of company X are Rs.10,00,000, while that
of company Y are only Rs.4,00,000 company Y gives a much higher profit (80,000:4,00,000) as
compared X company (Rs.1,00,000:10,00,000). Thus overall profitability or efficiency of a business
can be measured in terms of profits related to investments made in the business. The following are
the overall profitability Ratios.
i) Return on Capital Employed Ratio
ii) Return on Net Worth Ratio
iii) Return on Equity Shareholders Funds
iv) Return on Assets Ratio
v) Return on Fixed Assets Ratio
vi) Return on Current Assets Ratio
vii) Earnings per Share
viii) Dividend per Share
89
ix) Dividend yield Ratio
x) Earnings Yield Ratio
xi) Price-Earning Ratio
xii) Book Value of Equity Share
i) Return on Capital Employed

Return on capital employed establishes the relationship between profits and capital
employed. It is most widely used ratio to measure the overall profitability and efficency of the
business.
Net Profit before Interest & Taxes
Return on Capital Employed = × 100
Capital Employed
Capital Employed = Equity Capital + Preference Share Capital + Undistributed
Profits + Reserves and Surplus + Long-term Loans & Debentures -
Fictitious Assets
Fictitious assets include preliminary expenses, discount on issue of shares and debentures, under-
writing commission, brokerage, Profit and Loss account debit balance.
Alternatively, it is calculated as Tangible and intangible fixed assets+Current Assets-Current
Liabilities
ii) Return on Net Worth Ratio
Return on shareholders investment popularly known as ROI or Return on shareholder/
Proprietory funds is the relationship between Net Profits (after Interest and Taxes) and the propri-
etors Funds
Thus, Return on Shareholder’s Net Profit (Before Interest & Tax)
= × 100
Investment or Return on Net Worth Shareholders' Funds or Networth
The two basic components of this ratio are net profits and shareholders funds.
Share holders funds or net worth include, Equity Share Capital, Preference Share Capital,
Reserves and Surplus less accumulated losses if any.
The higher the ratio, the better it is, for the shareholders.
In real sense, Equity shareholders are the real owners of the company, and interested in the
profitabilityand performance of the company. Hence the performance of a company should be
judged on the basis of return-on equity capital of the company. Return on equity capital establishes
the relationship between profits of the company and its equity capital, canbe calculated as:
Return on Equity Shareholders Funds = Net Profit - Preference Dividend

× 100
Equity Shareholders Funds
Equity Shareholders Funds = Equity Share Capital + Reserves and Surplus -
Fictitions Assets.
A higher ratio is better for the equity shareholders.
90
iv) Return on Assets Ratio
It is calculated to measure profit after tax against the investment in total assets to ascertain
whether assets are properly utilised or not
Profit After Tax
It is calculated as = × 100
Total Assets
Total Assets = Fixed Assets + Current Assets + Investments
They do not include fictitious assets. A higher ratio is better for the company.
v) Return on Fixed Assets Ratio

It is calculated to measure the Profit After Tax (PAT) earned against the investments in fixed
assets, to find out whether the assets are properly used or not in the business operations.
Profit After Tax

Fixed Assets
The higher ratio is better for the company.
vi) Return on Current Assets Ratio
This ratio is calculated to measure the profit After Tax earned against the investments on
current Assets
Profit After Tax

Current Assets
Market Strength Analysis or Investor Analysis
The market strength analysis or investor analysis are especially important for investors while
analysing information about a company. This analysis helps the investors to decide about a company
as an investment opportunity at a point of time. These ratios are also known as stock market ratios,
investment ratios or market test ratios and part of the overall profit Ratios. For Investor analysis the
following ratios are to be studied.
vii) Earnings Per Share (EPS)
It indicates the earnings available to each equity shareholder, which is calculated as
follows.
Net Profit After Tax - Preference Devidend
No. of Equity Shares
The performance and prospects of a company is much affected by its Earnings per share.
The higher the EPS, the better is the performance of the company. It is the most important
factor in investment analysis and financial analysis. EPS helps in determining the market price of the
equity share and also helps in estimating the company’s capacity to pay dividend to its equity share-
holders.
91
viii) Dividend Per Share (DPS)
It is the amount of dividend payable to the equity share holder.
Amount of Profit Available for the distribution of dividends

From the investors point of view, a higher DPS is a good sign.
ix) Dividend Yield Ratio

Dividend yield ratio is important for those investors who are interested in dividend income. It
is the ratio of Dividend Per Share (DPS) to Market Price of Share (MPS).
Dividend Per Share

Formula = Earnings Per Share × 100
x) Earnings Yield Ratio

This ratio shows a relationship between Earnings Per Share (EPS) and Market Price of
Share
Earnings Per Share

Formula = Market Price of Share × 100
xi) Pay-out Ratio or Dividend Pay-out Ratio

This is the ratio of Dividend Per Share (DPS) to Earnings Per Share (EPS).
Dividend Per Share

Formula =
Earnings Per Share
This ratio is useful for those investors who are more interested in capital appreciation. It
indicates as to what proposition of Earning is being declared as dividend and what portion is retained
by the company for re-investment.
xii) Price-Earning Ratio or P/E Ratio

Price earning ratio is the ratio between market price per equity share and earnings per share.
This ratio is calculated to make an estimate of appreciation in the value of a share. This ratio helps
the share holders to decide whether shares should be purchased or sold.
The ratio is calculated as:

Market Price of Ratio
Price Earnings Ratio = Earnings Per Share
92
xiii) Book Value of Equity Share
It is the relationship between networth and number of equity share holders. A higher book
value of the share means a stronger position of the business. The book value should not be below
the paid up value of one share.
Equity Shareholders Funds

It is determined as = No. of Equity Shares
DU-PONT CONTROL CHART
A system of management control designed by an American Company named Du-Pont

companyis popularly called as Du-Pont chart. The Factors affecting profit margin and Return on
Investment are summarised and presented in this chart. The standard ratios of a company are
compared to present ratios and changes in performance are judged.
The earning power of any company canbe measured on the basis of two factors. They are a)
The total Turnover of the business and b) The amount of profit earned on the total turnover.
The total Turnover is dependent on the total assets utilised by a business unit and the
profitability is relatively dependent on various factors like selling price, cost structure
and the total expenses. The profit contribution of every rupee of Turnover is called as profit
margin which is the popular index of business performance.The overall profitability of a
firm can be measured by using the ratio of Return on investment, which can be calculated as shown
below:
The Earning Power or Profitability = Profit Marging × Assets Turnover
Profit After Tax Sales Profit After Tax

= × =
Sales Total Assets Total Assets / Investment
93
DU-PONT CHART
Return on Investment
Net Profit Margin Total Assets Turnover
Profit After Tax ÷ Sales Sales ÷ Total Assets
Sales - Cogs + Operating Exps + Interest + Tax Fixed Assets + Working Capital
Current Assets - Current Liabilities

Illustration - 2
The Trading & Profit & Loss Account and Balance Sheet of Veera Ltd are as follows
Rs.
Sales 25,00,000
Less Cost of Goods Sold 15,00,000
Gross Profit 10,00,000
Less: Operating Expenses 4,50,000
Less: Depreciation 1,00,000
PBIT 4,50,000
Less: Interest 35,000
4,15,000
Less: Income Tax 1,66,000
PAT 2,49,000
Less: Preference Dividend 45,000
Surplus 2,04,000
Balance Sheet
Rs. Rs.
Equity Capital 10,00,000 Fixed Assets 15,00,000
9% Preference Share Capital 5,00,000 Current Assets 9,00,000
7% Debentures 5,00,000 Miscellaneous Expenses 1,00,000
General Reserve 4,00,000
Current Liabilities 1,00,000
25,00,000 25,00,000
94
Additional information per share Rs.37.50 Equity dividend at 10%
Calcualte:
i) Return on Capital Employed ii) Return on Net Worth
iii) Return on Equity Shareholders Funds iv) Return on on Assets
v) Return on Current Assets vi) Return on Working Capital
vii) Gross Profit Ratio viii) Net Profit Ratio
ix) Operating Ratio x) Operating Profit Ratio
xi) Cost of Goods Sold Ratio xii) Earning per Share
xiii) Earnings Yield Ratio xiv) Price Earnings Ratio
xv) Dividend per Share xvi) Dividend Yield Ratio
xvii) Payout Ratio xviii) Retention Ratio
Solution
PBIT 4,50,000
i) Return On Capital Employed (ROCE) = × 100 = × 100= 19.565%
ROCE 23,00,000
Capital Employed = Equity Share Capital + Pref. Share Capital + Reserves +
Debentures - Fictitious assets
= 10,00,000 + 5,00,000 + 5,00,000 + 4,00,000 - 1,00,000 = 23,00,000
Profit after Depreciation & Internet

ii) Return on Net Worth = × 100
Net Worth
= 4,15,000 × 100 = 23.05%

18,00,000
or
PAT 2,49,000
= × 100 = × 100 = 13.83%
Net Worth 18,00,000
Networth = Shareholders Funds = Proprietry Funds =
Equity Share Capital + Preference Share Capital + Reserves - Fictitious Assets
10,00,000 + 5,00,000 + 4,00,000 - 1,00,000 = 18,00,000
Net Profit - Preference Dividend 2,49,000 - 45,000
= × 100 = × 100 = 15.69%
Equity Shareholders Funds 13,00,000
Equity Shareholders Funds = Equity Share Capital + Reserves - Fictitious Assets
10,00,000 + 4,00,000 - 1,00,000 = 13,00,000
PAT 2,49,000
iv) Return on Assets = × 100 = × 100 = 10.375%
PAT 2,49,000
v) Return on Current Assets = × 100 = × 100 = 27.67%
95
PAT 2,49,000
vi) Return on Working Capital = × 100 = × 100 = 31.125%
Working Capital 8,00,000

vii) Gross Profit Ratio = × 100 = × 100 = 40%
Sales 25,00,000
Net Profit 2,49,000
viii) Net Profit Ratio = × 100 = × 100 = 9.96%
Sales 25,00,000

ix) Operating Ratio = × 100
Sales
15,00,000 + 4,50,000 19,50,000

= × 100 = 25,00,000 × 100 = 78%
25,00,000
Operating Profit 5,50,000
x) Operating Profit Ratio = × 100 = × 100 = 22%
Sales 25,00,000

xi) Cost of Goods Sold Ratio = × 100 = × 100 = 60%
Sales 25,00,000
Earnings available to Equity Shareholders 2,04,000

xii) Earning per Share = = 20,000 = 10.2
EPS 10.2
xiii) Earnings Yield Ratio = MPS = 37.5 = 0.272
MPS 37.5
xiv) Price Earnings Ratio = = = 3.68
EPS 10.2
Dividends available to Equity Shareholders 1,00,000
xv) Dividend per Share = = = Rs. 5
No. of Equity Shares 20,000
DPS 5
xvi) Dividend Yield Ratio = = = 0.133
MPS 37.5
DPS 5
xvii) Pay Out Ratio = × 100 = × 100 = 49%
EPS 10.2
xviii) Retention Ratio = 100 - Payout Ratio = 100 - 49% = 51%.
3.13 COVERAGE RATIOS

The second type of leverage ratios are known as coverage ratios, while the capital structured
ratios are calculated from the Balance Sheet data, the later is computed from the profit and loss A/
c. data. It is clear that fixed interest and fixed dividend obligations of the firm are met out of the
profits of the firm. The financial soundness of the firm lies primarily in its ability to service their
claims.
96
Interest Coverage Ratio
The interest coverage ratio is also known Debt Service Ratio. This ratio indicates whether a
business is earning sufficient profits to pay the interest charges, this measures debt service capacity
of a firm and more particularly where payment of fixed interest on long-term loan is concerned. It
is calculated as follows:
Profit Before Interest and Taxes (PBIT)

Interest - Coverage Ratio =
Fixed Interest Charges
A Debt-service ratio of around 6 is normally considered as ideal. The higher theratio thebetter
it is, as of indreates a greater margin of safety to the lenders of long-term debts.
Dividend Coverage Ratio
This ratio measures the ability of firm to pay dividend on preference shares which carry a
fixed rate of dividend. It is determined by dividing the net profits after tax or earnings After Tax
(PAT) by the amount of preference dividend. Thus
Profit After Tax

Dividend Coverage Ratio =
Preference Dividend
The higher the ratio, the better it is perceived to by the financial analyst. This ratio indicates
the safety margin available to the preference share holders. As a rule, the higher the coverage the
better it is, from the share holders point of view.
Leverage may be Classified as:
i) Financial Leverage
ii) Operating Leverage
iii) Combined Leverage
i) FINANCIAL LEVERAGE OR TRADING ON EQUITY
The use of long-term fixed interest bearing debt (Debentures) and preference share capital
along with the equity share capital is called financial leverage or capital gearing or trading on equity.
It is owners equity which is used as a basis to raise loans from outside and that is why it is called
Trading on equity.
The long-term fixed interest bearing debt is employed more profitability in the firm to earn
more profits than the earlier decision to maximise the wealth of the owners. because debt is always
cheaper than the equity. Say for example, a company has an equity capital of 1,000 shares of
Rs.100 each fully paid and earns an average profit of Rs.30,000. Now the company wants to make
expansion and needs another Rs.1,00,000. The option with the company are-either to issue new
shares or raise loan at 10% p.a. assuming that the company would earn the same rate of profits, it
is advisable to raise loans, by doing so earnings per share will magnify. The company shall pay only
Rs.10,000 as interest and the profit expected shall Rs.60,000 (Profit before Interest). After the
payment of interest, the profits left for equity shareholders shall be Rs.50,000. i.e 50% benefit on
their equity against 30%. However leverage can operate adverse also if the rate of interest on long-
term debt is more than the expected rate of earnings of the firm, therefore, it needs caution to plan
the capital structure of a firm.
97
Financial leverage can be calculated as:
EBIT
EBIT - Interest and Preference Dividend
ii) OPERATING LEVERAGE

It is obtained by dividing contribution (i.e sales minus variable cost) by the Earnings
Before Interest and Taxes (EBIT). Thus:
Contribution
Operating Leverage =
EBIT
iii) COMBINED LEVERAGE
Financial Leverage × Operating Leverage
Illustration - 6
From the following Balance Sheet of Rainbow Ltd as on 31st March, 2006. Calculate
Leverage Ratios.
Liability Rs. Assets Rs.
Equity Capital 10,00,000 Fixed Assets 87,50,000
9% Preference Capital 5,00,000 Current Assets 10,00,000
Reserves 40,00,000 Misc.expenses 3,75,000
12% Debentures 40,00,000
1,01,25,000 1,01,25,000
During the year ended 31st March, 2006. Rainbow Ltd. reported a profit before tax of
Rs.10,00,000 after providing interest. Tax Rate 50%
Solution
Long-term Debt 40,00,000
i) Debt-Equity Ratio = = = 0.78
Equity 51,25,000
Long-term Debt = Debentures = Rs. 40,00,000
Equity = Shareholders Fund =
= Equity Capital + Pref.Capital + Reserves - Fictitious Assets

= Rs.1,00,000 + 5,00,000 + 40,00,000 - 3,75,000
= Rs.51,25,000
Proprietory Funds 51,25,000

ii) Proprietory Ratio = = 97,50,000 = 0.56
Net Tangible Assets
Debentures + Pref. Capital 40,00,000 + 5,00,000
iii) Capital Gearing Ratio = = = 0.97
Equity Shareholders Funds 46,25,000
98
PBIT 14,80,000
iv) Interest Coverage Ratio = = = 3.08
Interest 4,80,000
PBIT = PBT + Interest = 10,00,00 + 4,80,000
v) Dividend Coverage Ratio = PAT = 5,00,000 = 11.11

Pref. Dividend 45,000
Illustration - 7
Calculate i) Operating Leverage, ii) Financial Leverage, and iii) Combined Leverage from the
following.
Rs.
Sales (20,000 units at Rs.10) 2,00,000
Variable Cost (Rs 6 per unit) 1,20,000
Contribution 80,000
Fixed Cost 60,000
EBIT 20,000
Less Interest 5,000
EBT 15,000
Tax 50% 7,500
PAT 7,500
Contribution 80,000
i) Operating Leverage = = = 4
EBIT 20,000
EBIT 20,000
ii) Financial Leverage = EBIT - Interest = 20,000 - 5,000 = 1.33
iii) Combined Leverage = Operating Leverage× Financial Leverage
= 4 × 1.33 = 5.32
3.14 RATIOS AS PREDICTORS OF CORPORATE HEALTH

The role of the ratios as predictors of corporate health depends upon the analyisists
perception about their predictive power. The best ratios for predicting the strenths and
weaknesses of the firm are the debt equity ratio, net operating margin, interest coverage
return on investment size and earnings stability. In this direction Beaver was the first man to use
statistical techniques to predict corporate failure. According to his study, the financial ratios
for failed companies indicated deteriation as failure approached. Alt man, other financial analyst
employed multiple discriminant analysis to predict the bankruptcy of the firms using various financial
Ratios.
99
Summary of Ratios
Objective of Analysis Ratios to be computed Formula

Current Assets
Short-term financial 1. Current Ratio
Current Liabilities
position
or 2. Quick Or Acid test or liquid Quick Assets
Test of Liquidity ratio for immediate solvency Quick Liabilities
3. Absolute liquid ratio or Absolute Liquid Assets

super quick Ratio Current Liabilities
Activity Ratios 1. Stock turnover Ratio Cost of Goods Sold

or or Average Stock
Efficiency Ratios Inventory Turnover Ratio
or
Net Credit Sales
Current Assets Increment 2. Debtors Turnover Ratio
Average Debtors
or
or
Turnover Ratios
Months in a year
Debtors Trunover Ratio
Debtors
3. Average Collection period
Credit Sales per Day

4. Creditors Turnover Ratio
Average Creditors
Creditors
5. Average payment period
Purchases per Day
Cost of Sales
6. Working Capital Turnover Ratio
Net Working Capital
7. Total Assets Turnover Cost of Sales

Total Assets
Cost of Sales
8. Fixed Assets Turnover
Fixed Assets
Cost of Sales
9. Current Assets Turnover
Current Assets
Analysis of Long-Term
Total Debt
Financial Position 1. Debt-Equity Ratio
Equity
or
Shareholders Funds
Test of Solvency 2. Proprietary Ratio
Total Assets
or
Coverage Ratios
Outsiders Liability
3. Solvency Ratio or Debt to
Total Assets
Total Assets
Fixed Assets
4. Fixed Assets to Net worth Ratio
Shareholders Fund (Net Worth)
100
5. Fixed Assets to Long Fixed Assets
Term Funds Long-term Funds
Current Assets
6. Current Assets to
Shareholders Funds
Proprietors Funds
Net Profit (Before Interest &
7. Debt Service or Interest Taxes)
Coverage Ratio Interest
Net Profit (After Interest &

8. Preference Dividend
Taxes)
Coverage Ratio Preference Dividend
Annual Cash Flow (Before

9. Cash to Debt-Service Ratio Interest & Taxes)
Sinking Fund
Interest +
1 - Tax Rate
Pref. Capital + Debentures

10. Capital Gearing Ratio
Equity
Profitability
Gross Profit
i) General Profitability 1. Gross Profit Ratio × 100
Sales
Net Profit after Tax

2. Net Profit Ratio × 100
Sales
Cost of Goods Sold +

3. Operating Ratio Operating Expenses
× 100
Sales
Operating Profit (PBIT)

4. Operating Profit Ratio × 100
Sales
Particular Expense
5. Expense Ratio × 100
Sales
Net Profit after Tax

ii) Overall Profitability 1. Return on Networth × 100
Shareholders Funds or
Net Worth
Net Profit after Tax -

Preference Dividend
2. Return on equity Capital × 100
Paid up Equity Capital
Net Profit after Tax -

Preference Dividend
× 100
3. Earning per Share (EPS) No. of Equity Shares
Net Profit
4. Return on Capital Employed × 100
Capital Employed
101
Sales or Cost of Sales
5. Capital Turnover Ratio
Capital Employed
6. Dividend Yield Ratio Dividend per Share

Market Value per Share
7. Dividend per Share Net Profit available for Dividend

DPS
8. Dividend Payout Ratio
EPS
MPS
9. Price Earning Ratio P/E Ratio EPS
Ordinary Shareholders Equity

10. Book Value per Share
11. Overall Profitability/ EAT Sales

Earning Power ×
Sales Total Assets
Capital Structure Equity Share Capital +

or 1. Capital Gearing Ratio Reserves
Leverage Ratios Pref. Capital + Debentures
Shareholders Funds + Long

2. Total Investment to Long-Term Term Liabilities
Liabilities Long-term Liabilities
Debt
3. Debt-Equity Ratio Equity
Fixed Assets
4. Fixed Assets to funded Debt
Funded Debt
EBIT
5. Financial Leverage
EBIT - Interest of Ref. Dividend
Contribution
6. Operating Leverage
EBIT
7. Combined Leverage Operating Leverage x Financial

Leveragre
102
3.15 ILLUSTRATIONS
1 The following is the Trading Profit & Loss Account of X Company Ltd. for the year
ending December 31, 2006.
Rs. Rs.
To Opening Stock 76,250 By Sales 5,00,000

To Purchases 3,15,250 By Closing Stock 98,500
To Factory Exps. 7,000
5,98,500 5,98,500
To Administrative exps. 1,01,000 By Gross Profit 2,00,000

To Selling and Distribution Exps. 12,000 By Non-Operating Income 6,000
To Non-operating Exps. 9,000
To Net Profit 84,000
2,06,000 2,06,000

a) Gross Profit Ratio
b) Operating Ratio
c) Operating Profit Ratio
d) Net Profit Ratio

e) Administrative Expenses Ratio
f) Selling and Distribution Expenses Ratio.
Solution
a) Gross Profit Ratio = × 100 = × 100 = 40%
Sales 5,00,000
b) Operating Ratio =
Sales
3,00,000 + 1,13,000 4,13,000
= × 100 = × 100 = 82.6%
5,00,000 5,00,000
c) Operating Profit = × 100 = × 100 = 17.4%
Sales 5,00,000
Net Profit 84,000
d) Net Profit Ratio = × 100 = × 100 = 16.80%
Sales 5,00,000
103
e) Administrative Expenses Ratio = Administration Expenses × 100
Sales
= 1,01,000 × 100 = 20.2%

5,00,000
Selling & Distribution Expenses
f) Selling and Distribution Expenses Ratio =
Sales
= 12,000 × 100 = 2.4%

5,00,000
2. Compute the dividend payout Ratio from the following data.
Net Profit Rs. 10,000
Provision for Tax Rs. 5,000

Preference Dividend Rs. 2,000
No.of Equity Share 3,000
Dividend per Equity Share Re. 0-40
Solution
Dividend Payout Ratio = DPS × 100

EPS
Dividend per Share (given) = Rs. 0.40
Divisible Profit
Earning per Share =
Divisible Profit = NP - Tax - Pref. Dividend
= 10,000 - 5,000 - 2,000 = 3,000
EPS = 3,000 = Rs. 1

3,000
DPS 0.40
Dividend Payout Ratio = = × 100 = 40%.
EPS 1
3. Find out i) Debtors Turnover and ii) Collection period from the following information.
Rs.
Total Sales 4,00,000
Cash Sales 80,000
Sales Returns 28,000
Debtors at the End 36,000
Bills Receivable at the End 8,000
Provision for Doubtful Debts 3,000
Total Creditors at the End 25,000
104
Solution
Credit Sales 2,92,000

Debtors Turnover = = = 6.6363 times
Average Debtors 44,000
Months in a Year
Collection Period = = 1.81 months = 1.81 × 30 = 55 days
Debtors Turnover
or
Debtors 44,000
Collection Period = = = 55 days
Sales per Day 800

Sales per Day = = = 800
No. of Working Days in a Year 365
or
Debtors × No. of Working Days
Collection Period = Net Credit Sales
44,000 × 365
= 2,92,000 = 55 days.
4. Calculate creditors payment period and Creditors Turnover from the following.
Rs.
Total Purchases 3,00,000
Cash Purchases 30,000
Purchase Returns 51,000
Creditors at the End 1,05,000
Bills payable at the End 60,000
Reserve for Discount on Creditors 8,000
Solution

Creditors Turnover = = = 1.32 times
Average Creditors 1,65,000
Months in a Year
Creditors Payment Period =
Creditors Turnover
12
= 1.32 = 9 months 5 days = 275 days
or
Total Creditors 1,65,000

Average Payment Period = = = 275 days
Average Daily Purchasers 600

Average Daily Purchasers = = = 600
No. of Working Days in a Year 365
or 105
Creditors × No. of Days in a Year
Average Payment Period =
Credit Purchases
1,65,000 × 365
= = 275 days
2,19,000
5. Calculate inventory turnover from the following information.
Cash Sales Rs.8,000
Credit Sales Rs.2,00,000
Return inwards Rs.10,000
Opening Stock Rs. 25,000
Closing Stock Rs.30,000

Gross Profit 25%
Solution
Cost of Goods Sold

Inventory turnover =
Average Stock
= 2,70,000 - 25%
= 2,70,000 - 67,500
= 2,02,500

Average Stock =
2
25,000 + 30,000 55,000

= = = 27,500
2 2

Inventory Turnover = = = 7.36 times
Average Stock 27,500
6. Given Current Ratio 2.5
Liquid Ratio 1.5

Working Capital Rs.60,000
Calculate:
a) Current Liabilities
b) Current Assets
c) Liquid Assets
d) Stock
106
Solution
Working Capital = Current Assets - Current Liabilities

Let Current Liability be x
Current Assets will be 2.5x
60,000 = 2.5x - x
1.5x = 60,000
60,000
x= 1.5 = 40,000
Current Liability (x) = 40,000
Current Asset (2.5x) = 1,00,000
Quick Assets
Liquid Ratio =
Current Liabilities
1.5 = Quick Assets

40,000
Liquid/Quick Assets = 40,000× 1.5 = 60,000
Stock = Current Asset - Quick Assets
= 1,00,000 - 60,000 = 40,000.
7. Calculate Debtors Turnover Ratio and collection period

Rs.
Total sales 1,00,000
Cash sales 20,000
Debtors at the beginning 10,000
Debtors at the end 1,50,000
Bills receivable at the beginning 7,500
Bills receivable at the end 12,500
Solution
Debtors Turnover Ratio = Credit Purchases = 80,000 = 3.56 times

Average Creditors 22,500
Months in a Year 12
Debts Collection Period = = = 3.375 months or 101 days
Creditors Turnover 3.56
8. From the following figures calculate the creditors Turnover and the Creditors payment period.
Rs.

Creditors at the beginning 20,000
107
Creditors at the end 10,000
Bills Payable at the beginning 4,000
Bills Payable at the end 6,000
Solution
Credit Purchasers 1,00,000

Creditors Turnover = = = 5 times
Average Creditors 20,000
Months in a Year 12
Creditors Payment Period = = = 2.4 months or 72 days
Creditors Turnover 5
9. The operating profit of X Ltd. after charging interest and taxes is Rs.10,000. The amount of
interest is Rs.2,000 and the provision for tax is Rs.4,000
Calculate the Interest Coverage Ratio.

Solution
Profit before Interest and Tax

Interest Coverage Ratio = Interest
= 10,000 + 2,000 + 4,000 = 8 times.

2,000
10. Net Profit before interest and Tax Rs.50,000; 10% Debentures Rs.1,00,000 (Payable in 10
installment of Rs.10,000 each) Tax Rate = 50%.
Calculate Debt Service Coverage Ratio.
Solution
Profit before Interest and Tax
Debt Service Coverage Ratio =
Principal Payment of Instalment
Interest +
1 - Tax Rate
50,000
= = 1.67 times
10,000
10,000 +
1 - .50
11. The projected cash operating expenses of a firm are estimated at Rs.7,50,000. The firm
has quick assets amounting to Rs.80,000. You are required to calculate defensive
interval ratio.
Solution
Quick Assets
Defensive Interval Ratio =
Projected Daily Cash Requirement
= 80,000 = 40 days
2,000
108
Note: Projected daily cash requirement.
= Projected Cash Operating Expenses

Number of Days in a Year
= 7,30,000 = 2,000.
365
12. a) If Ceramic Ltd.’s Current Ratio is 5.5:1, Quick Ratio is 4 to 1, Inventory is Rs.30,000,
what are its current liabilities
b) If Hindustan organic Ltd.’s inventory is Rs.60,000, Total current liabilities are Rs.1,20,000,
Quick Ratio is 2 to 1, Calculate Current Ratio
c) If Binani Zinc Ltd.'s Current Liabilities are Rs.25,000, Quick Ratio is 1.5:1, inventory is
Rs.12,500 Calculate Current Assets.
Solution
a) Let Current Liabilities be x
Current Ratio = Current Assets = 5.5 = 5.5x : x

Current Liabilities 1
Quick Ratio = Quick Assets = 4 = 4x : x

Current Liabilities 1
Inventory = Current Assets - Quick Assets
30,000 = 5.5x - 4x
30,000 = 1.5x
30,000
x =
1.5
x = 20,000
So, Current Liabilities are Rs. 20,000.
b) Inventory Rs. 60,000
Current Liabilities Rs. 1,20,000
Quick Ratio 2:1
Quick Ratio = Quick Assets to Current Liabilities
As Quick Ratio is 2 to 1, So
Quick Assets are 2 times the Current Liabilities
So Quick Assets = 2 × 1,20,000 = Rs. 2,40,000
Current Assets = Quick Assets + Inventory
= 2,40,000 + 60,000
= Rs. 3,00,000
109
Current Assets
Current Ratio = = 3,00,000 = 2.5
= 2.5 : 1
c) Current Liabilities Rs. 25,000
Inventory Rs. 12,500
Current Assets ?
Quick Ratio = Quick Assets : Current Liabilities
As Quick Ratio is 1.5:1, Quick Assets should be 1.5 time the Current Liabilities
Quick Assets = 1.5 × 25,000 = Rs. 37,500
Current Assets = Quick Assets + Inventory

= 37,500 + 12,500 = Rs.50,000
13. XLR Ltd., has the following profit and loss account for the year ended 31st March, 2006
and the Balance Sheet as on that date.
for the year ended 31st March, 2006
(Rs. in lakhs)
Particulars Rs. Particulars Rs
Opening Stock 1.75 Sales: Credit 12.00
Add: Manufacturing Cost 10.75 Cash 3.00 15.00
12.50
Less: Closing Stock 1.50
Cost of Goods Sold 11.00
Gross Profit 4.00
15.00 15.00
Administrative Expenses 0.35 Gross Profit 4.00
Selling Expenses 0.25 Other Income 0.09
Depreciation 0.50
Interest 0.47
Income Tax 1.26
Net Profit 1.26
4.09 4.09
110
Balance Sheet
as on 31st March, 2006
Equity Share of Rs.10 each 3.50 Plant & Machinery 10.00

10% Pref. Shares 2.00 Less: Depreciation 2.50 7.50
Reserves & Surpluses 2.00 Goodwill 1.40
Long-term Loan 12% 1.00 Stock 1.50
Debentures (14%) 2.50 Debtors 1.00
Creditors 0.60 Prepaid Expenses 0.25
Bills Payable 0.20 Marketable Securities 0.75
Accrued Expenses 0.20 Cash 0.25
Provision for Tax 0.65
12.65 12.65
The Market Price of the Share is Rs. 45

Reserves & Surplus Statement
(Rs. in lakhs)
Rs.
Reserves in the beginning 1.465
Net profit during the year 1.260
2.725
Less: Pref. dividend 0.200
Equity dividend 0.525 0.725
Reserves at the close of year 2.000
Calculate the following Ratios:

i) Current Ratio ix) Gross Profit Margin
ii) Quick Ratio x) Net Profit Margin
iii) Debt-Equity Ratio xi) Operating Ratio
iv) Interest Coverage xii) Return on Capital Employed
v) Fixed Charge Coverage xiii) Return on Shareholders Equity
vi) Stock Turnover xiv) EPS
vii) Debtors Turnover xv) Price Earnings Ratio
viii) Average Collection Period xvi) Earnings Yield Ratio
Solution
i) Current Ratio = Current Liabilities = = 2.27 : 1
1,65,000
111
Quick Assets 2,00,000
ii) Quick Ratio = = = 1.21 : 1
Long-term Debt 3,50,000
iii) Debt-Equity Ratio = Equity (Shareholders Fund) = = 0.467 : 1
7,50,000
PBIT 2,99,000
iv) Interest Coverage Ratio = Interest = 47,000 = 6.36 times
PBIT 2,99,000
v) Fixed Charge Coverage = = = 4.46 times
Interest + Pref. Dividend 67,000

vi) Stock Turnover = = = 6.77 times
Average Stock 1,62,500
Credit Sales 12,00,000

vii) Debtors Turnover = = = 12 times
Account Receivable 1,00,000
Days in a Year 360
viii) Average Collection Period = Debtors Turnover = 12 = 30 days
× 100 = 4,00,000 × 100 = 26.7%

Gross Profit
ix) Gross Profit Margin =
Sales 15,00,000
Net Profit 1,26,000 × 100

x) Net Profit Margin = × 100 = = 8.4%
Sales 15,00,000

xi) Opening Ratio = × 100
Sales
1,26,000 × 100
= = 80.67%
7,50,000
PAT × 100
xii) Return on Capital Employed (ROCE) =
Capital Employed
1,26,000
= × 100 = 11.45%
11,00,000
or
PBIT × 100
=
Capital Employed
2,99,000
= × 100 = 27.18%
11,00,000
PAT
xiii) Return on Shareholders Equity = × 100
Shareholders Funds
1,26,000
= × 100 = 16.8%
7,50,000
Profits available for Equity Shareholders
xiv) Earnings per Share (EPS) = Number of Equity Shares
112
= 1,06,000= 3.03
35,000
xv) Price Earnings Ratio = Market Price per Share = 45 = 14.85 times
EPS 3.03
xvi) Earnings Yield = EPS = 3.03 = .06733 or 6.73%

MPS 45
14. Using the following information construct the Balance Sheet.
Total Debt to Net Worth 0.5 to 1

Turnover of Total Assets 2
Gross Profit 30%
Average Collection Period 40 days (based on 360 days)
Inventory Turnover 3 Times
Acid Test Ratio 0.75 to 1
Common Stock 2,00,000
Retained Earnings 3,00,000
Solution
Balance Sheet
Rs. Rs.
Capital 2,00,000 Cash 20,833
Retained Earnings 3,00,000 Debtors 1,66,667
Current Liabilities 2,50,000 Inventory 3,50,000 5,37,500
7,50,000 7,50,000
Working Notes
Total Debt
i) Debt to Net Worth = Net Worth (Common Stock + Retained Earnings)
0.5 Total Debt
= 1 = 5,00,000 = 2,50,000
Total Debt = 2,50,000

Total Liabilities = Total Assets
Total Liabilities = Common Stock + Retained Earnings + Total Debt
2,00,000 + 3,00,000 + 2,50,000 = 7,50,000
Hence Total Assets = 7,50,000.
113
Sales
ii) Total Assets Turnover = = 2
Total Assets
Total Assets = 7,50,000
Sales = 7,50,000 × 2 = 15,00,000.
iii) Gross Profit Ratio = 30% of Sales
Gross Profit = 15,00,000 × 30% = 4,50,000
= 15,00,000 - 4,50,000 = 10,50,000.

360 days
iv) Debtors Turnover Ratio = Average Collection Period
360 days
= 40 days = 9
Sales
Debtors Turnover Ratio = Average Debtors
15,00,000
9 = Average Debtors
15,00,000
Average Debtors = 9 = 1,66,667.
Cost of Goods Sold

v) Inventory Turnover Ratio = Average Inventory
10,50,000
3 = Average Inventory
10,50,000
Average Inventory = = 3,50,000
3
Quick Assets
vi) Acid Test Ratio = Current Liabilities = 0.75
Quick Assets
0.75 = 2,50,000
Quick Assets = 1,87,500

Quick Assets = Cash + Debtors
1,87,500 = 20,833 + 1,66,667.
Result
Total Debt or Current Liabilities = 2,50,000
Total Assets = 7,50,000
Sales = 15,00,000
Cost of Goods Sold = 10,50,000
114
Gross Profit = 4,50,000
Debtors = 1,66,667
Stock = 3,50,000
Cash = 20,833 (Balancing Figure)
Quick Assets = 1,87,500
Fixed Assets = 2,12,500 (Balancing Figure)
15. From the following details, prepare the Balance Sheet.
Stock Velocity 6
Capital Turnover Ratio 2
Fixed Assets Turnover Ratio 4

Gross Profit 20%
Debt Collection Period 2 months

Credit Payment Period 73 days
Gross Profit 60,000
Closing stock was Rs.5,000 in excess of the opening stock.
Solution
Balance Sheet
Rs. Rs.
Capital 1,20,000 Fixed Assets 60,000
Creditors 49,000 Current Assets
Cash 16,500
Debtors 50,000
Stock 42,500 1,09,000
1,69,000 1,69,000
Working Notes
i) Gross Profit Ratio = Gross Profit × 100 = 20 = 60,000

× 100
Sales Sales
20 Sales = 60,00,000
Sales = 60,00,000 = 3,00,000.

20
= Cost of Goods Sold = Sales - Gross Profit
= 3,00,000 - 60,000 = 2,40,000.
115
Cost of Goods Sold
ii) Stock Velocity = Debtors Turnover =
Average Stock
2,40,000
= 6 = Average Stock
2,40,000
= Average Stock = = 40,000
6
= Average Stock =
2
= 40,000 =
2
= 80,000 = Opening Stock + Closing Stock
= Closing stock was Rs. 5,000 more than the opening stock
= Opening Stock = (a)

= Closing Stock = (a + 5,000)
(a) + (a + 5,000)
= 40,000 =
2
= 80,000 = a + a + 5,000
= 80,000 - 5,000 = 2a
= 75,000 = 2a
75,000
= a= = 37,500
2
= a = Opening Stock = 37,500
= Closing Stock = a + 5,000
= 42,500.
iii) Capital Turnover Ratio = 2
= Cost of Goods Sold = 2

Capital
2,40,000
= =2
Capital
2,40,000
= Capital = 2 = 1,20,000.
iv) Fixed Assets Turnover Ratio = 4

Cost of Sales
Fixed Assetss = 4
2,40,000 = 4
Fixed Assetss
116
2,40,000
Fixed Assets = = Rs. 60,0000.
4
v) Debtor Collection Period = 2 months
Months in a Year
Debtors Turnover =
Collection Period
12
= = 6
2
Credit Sales
Debtors Turnover =
Average Debtors
3,00,000
6 =
Average Debtors
3,00,000
Average Debtors = = 50,000
6
vi) Credit Payment Period = 73 days
No. of days in a Year

Creditors Turnover =
Credit Payment Period
365
= = 5
73
Creditors Turnover = Credit Purchases

Average Creditors
Credit Purchases = ?
Cost of Goods Sold = Opening Stock + Purchases - Closing Stock
2,40,000 = 37,500 + Purchases - 42,500

Purchases = 2,45,000
Credit Purchases
Creditors Turnover =
Average Creditors
2,45,000
5 =
Average Creditors
2,45,000
Creditors = = 49,000.
5
Result
Rs.
Opening Stock 37,500
Closing Stock 42,500
Capital 1,20,000
Fixed Assets 60,000
117
Debtors 50,000
Purchases 2,45,000
Creditors 49,000
Cash Balancing Figure 16,500
16. Zindal Steel Ltd. has made plans for the next year. It is estimated that the company
will employ total assets of Rs.16,00,000, 50% of the assets being financed by
borrowed capital at an interest rate of 16% per year. The direct cost for the year are esti-
mated at Rs.5,00,000 and all other operating expenses are estimated at Rs.1,00,000. The
goods will be sold to customers at 200% of the direct costs. Income-Tax rate is assumed to
be 50%.

i) Net Profit Margin
ii) Return on Assets
iii) Assets Turnover
iv) Return on Owners Equity
Solution
PAT × 100 1,36,000

i) Net Profit Margin = = × 100 = 13.6%
Sales 10,00,000
Earnings before Interest but after Tax
ii) Return on Assets = × 100
Total Assets
4,00,000 - 1,36,000
= × 100 = 16.5%
16,00,000
Sales 10,00,000
iii) Assets Turnover = Total Assets = 16,00,000 = 0.625 times
PAT 1,36,000
iv) Return on Owners Equity = × 100 = × 100 = 17%
Equity 8,00,000
Working Notes
i) Income Statement
Sales (200% of direct costs) 10,00,000
Less: Direct Cost 5,00,000
Less: Operating Expenses 1,00,000
EBIT (Earning before Interest and Taxes) 4,00,000
Less: Interest on Borrowed Capital 1,28,000
EBT 2,72,000
Less Tax 50% 1,36,000
PAT 1,36,000
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ii) Equity = Total Assets - Borrowed Capital
16,00,000 - 8,00,000 = 8,00,000.
3.16 SUMMARY
Planning is the key to the financial managers success. Financial plans may take may forms.
But any good plan must be related to the firms existing strengths and weaknesses. The strengths
and weaknesses of a firm an be studied with the help of ratios. Analysis of financial statements
with the help of ratios is termed as ratio analysis. A ratio is a simple mathematical expression
establishing the relationship between two accounting figures. The role of the ratios as predictiors
of corporate health depends upon the analyst's perception about their predictive power.
The profitability ratios measure, the profitability of a concern. While turnover ratios measure,
how efficiently the assets of the company are employed on the other hand. Liquidity ratios show
ability the firm to meet its maturing current obligations. Leverage ratios help in assessing the risk
arising from the use of fixed obligation sources. Coverage ratios show the relationship between
debt-servicing commitments and the sources of meeting these commitments.
Ratio analysis is useful in spite of its limitations. Analyst should be careful and make necessary
precautions before using them. Ratio analysis conducted in a mechanical and haphazard manner
is dangerous, but, used intelligently, ratios can provide useful insights into a firms operations.
1. Define ratio and ratio analysis.
2. Explain the use of ratio analysis.
3. Describe the significance of ratios.
4. What ratios are calculated based on profit and loss account?
5. What are limitations of ratio analysis?
6. What is Dupont analysis.
7. What are turnover ratios? What is their importance?
8. What is ratio and explain different ratios?
9. Explain the uses of ratio analysis.
10. Explain the following ratios.
a) Stock Turnover Ratio
b) Quick Ratio
c) Liquidity Ratio
d) Current Ratio
e) Coverage Ratios
f) Capital Employed
g) Gross Profit Ratio
h) Operating Ratio
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i) Capital Gearing Ratio
j) Earning Power
11. Discuss the importance of ROI.
12. What are the limitations of ratio analysis?
13. Discuss briefly the various leverage ratios.
14. Briefly explain profitability ratios.
15. Explain how ratios can be used to assess the corporate health?
B. Essay Type Questions
1. Define ratio analysis. Explain its advantages and limitations.
2. Examine the relationship between solvency, liquidity and profitability.
3. “Return on Investment is a single comprehensive measure that contains every thing
happening with in the organisation”. Explain.
4. “Accounting Ratios are mere guides and complete reliance on them in decision mak-
ing is suicidal,” Elucidate.
5. How would you analyse the financial position of a company from the point of view of
a) an Investor b) a Creditor; and c) a Financial Executive of the company
6. “Ratios like Statistics have a set of principles and finality about them which at times
maybe misleading”. Discuss
7. Write a note on the importance and significance of ratio analysis to different category
of users.
8. Explain the role of Ratio Analysis in the interpretation of financial statements. Examine
the limitation of ratio analysis.
9. What do you mean by ratio analysis? Discuss its objectives and limitations.
10. “Ratio Analysis is a tool to examine the health of business with a view to make finan-
cial results more intelligible” Explain.
11. “Ratios are indicators-some times pointers but not in themselves powerful tools of
management” Explain.
12. “Ratio analysis is only a technique for making Judgements and not a substitute for
Judgements” Explain.
13. What are important profitability Ratios? How are they worked out? Explain and illus-
trate.
14. Describe the various ratios that are likely to help the management in forming an opin-
ion on the solvency position of business.
15. What is Du-pont analysis? Explain with the help of a chart.
16. Explain the significance and limitations of ratio analysis.
120
17. Ratios are generally calculated from historical data. What is their use in assessing
the firms future financial condition?
18. Is it possible for a firm to have a current ratio and still find difficulties in paying its
current debts? Explain.
19. Calculate GP Ratio, Operating Ratio, Operating Profit Ratio
Rs.
Total Sales 5,20,000
Sales Return 20,000
Administrative Expenses 30,000
(Ans: 20%, 90%, 10%)
20. Your company had the following earnings last year.
Profit before tax Rs.24.46 lakhs
Tax Rate = 60%
Proposed dividend = 20%
Capital
9% preference shares Rs.10,00,000
Equity Shares 30,000 shares of Rs.100 each Rs.30,00,000
Reserve at the beginning of the year Rs.22,00,000.
Compute
i) Earning per Share (EPS)
ii) Book Value per Share
iii) Earnings Yield Ratio
iv) Price Earnings Ratio
v) Dividend Payment Ratio
vi) Market Price of the Equity Share is Rs.200
(Ans: Earning Per Share Rs.29.61; Book Value per share Rs.182.95;
Earnings yield 16.19%; Price Earnings Ratio 14.8%;
Dividend Payout Ratio 67.54%)
21. The Current Ratio of a company is 2:1 which of the following suggestions would im-
prove the ratio, which would reduce it and which would not change it.
a) To pay a current liability.
b) To sell a fixed asset at a slight loss.
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c) To borrow money for a short time on an interest bearing promissory note.
d) To purchase stock for cash.
e) To give interest bearing promissory note to a creditor to whom money was to be
paid.
(Ans: ‘a’ & ’b’ improve; ‘c’ reduce; ‘d’ & ’e’ no change)
22. State whether the following transactions, increase or decrease or do not effect the
working capital and give reasons.
a) A company issues Rs.1,00,000 worth shares for cash
b) Redumption of debentures worth Rs.2,00,000
c) Amount received from debtors Rs.1,00,000
d) Amount paid to creditors Rs.2,00,000
e) Plant sold for Rs.1,00,000
f) Raw material purchased worth Rs.1,00,000 from X Co. on credit basis.
(Ans: a) Increase; b) Decrease; c) No change;
d) No change; e) Increase; f) No change)
23. The following are the summarised profit and Loss Account of Tata Steels Ltd. for the
year ending 31st March, 2006 and the Balance Sheet as on that date.
Profit and Loss A/c.
Rs. Rs.
To Opening Stock 4,97,500 By Sales (Credit) 42,50,000
To Purchases (Credit) 27,26,250 By Closing Stock 7,45,000
To Manufacture Expenses 71,250
49,95,000 49,95,000
To Opening Expenses 9,75,000 By Gross Profit 17,00,000

To Non-Operating Expenses 20,000 By Non-Operating Income 45,000
To Net Profit 7,50,000
17,45,000 17,45,000
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Balance Sheet
Issued Capital Land & Building 7,50,000

10,000 equity shares of
Rs.100each 10,00,000 Plant & Machinery 4,00,000
Reserves 4,50,000 Stock in Trade 7,45,000
Profit & Loss Account 3,00,000 Sundry Debtors 2,05,000
Other Current Liabilities 4,50,000 Cash & Bank Balance 1,50,000
Bills Payable 2,00,000 Bills Receivable 1,50,000
24,00,000 24,00,000
From the above statements you are required to calculate the following ratios.
i) GP Ratio
ii) NP Ratio
iii) Operating Ratio
iv) Operating Profit Ratio
v) Return on Capital Employed
vi) Net Profit to Fixed Assets Ratio
vii) Stock Turnover Ratio
viii) Debtors Turnover Ratio
ix) Creditors Turnover Ratio
x) Sales to Working Capital
xi) Sales to Fixed Assets
xii) Sales to Capital employed
(Ans: i) 40%; ii) 17.64%; iii) 82.94%; iv) 17.06%;
v) 42.86%; vi) 65.22%; vii) 4.1 Times;
viii) 10 Times; ix) 6.8 Times; x) 7.08:1;
xi) 3.7:1; xii)2.43:1)
24. From the following balance sheet of Reliance Capital Ltd. as on 31st March 2006 Calcu-
late i) Current Ratio ii) Quick Ratio iii) Absolute liquidity Ratio iv) Ratio of inventory to
working capital v) Ratio current assets to Fixed Assets vi) Debt-Equity Ratio vii) Propri-
etary Ratio viii) Capital Gearing Ratio ix) Fixed Assets Ratio
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Balance Sheet
Liabilities Amount Assets Amount

Equity Share Capital 50,00,000 Goodwill 25,00,000
6% Preference Share Capital 25,00,000 Plant & Machinery 30,00,000
General Reserve 5,00,000 Land & Buildings 35,00,000
Profit & Loss A/c. 20,00,000 Furniture 5,00,000
12% Debentures 25,00,000 Stock 30,00,000
Creditors 4,00,000 Bills Receivable 1,50,000
Bills Payable 6,20,000 Debtors 7,50,000
Bank Overdraft 1,00,000 Bank 10,00,000
Provision for Tax 8,80,000 Marketable Securities 1,00,000
1,45,00,000 1,45,00,000
(Ans: i) 2.5:1; ii)1.0:1; iii) 0.55:1; iv)1.0:1; v)10.19;

vi) 0.20:1; vii) 0.25:1; viii) 1.00:1; ix) 0.76:1)
25. You are given the items from the Balance Sheet.
10,000 Equity Shares of Rs. 10 each 1,00,000
9% Preference shares 2,00,000
Reserves and Surpluses 60,000
Discount on issue of shares and debentures 20,000
Net Profit after Depreciation 2,20,000
Tax Rate 60%
Market Price per Share 7-50
Equity dividend 10%
Total Assets (Excluding Fictitious assets) 2,50,000
Current Assets 80,000
Calculate (a) Return on Capital Employed, (b) Return on Net Worth, (c) Return on Equity,
(d) Return on Assets, (e) Return on Current Assets, (f) Return on Fixed Assets, (g) Return
on Working Capital, (h) Earnings per Share, (i) Earnings Yield Ratio, (J) Price-Earnings
Ratio, (k) Dividend per Share, (l) Dividend Yield Ratio, (m) Pay-out Ratio, (n) Retention
Ratio.
(Ans: a) 50%; b) 61.17%; c) 46.57%; d) 33.28%;
e)104%; f) 48.94%; g) 138.66%; h) 6.52; i) 0.86;
j) 115.03; k) 1; l) 0.133; m) 0.153; n) 99.84%)
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26. You are required to prepare Balance Sheet from the following particulars.
i) Current Ratio 2
ii) Liquid Ratio 1.5
Fixed Assets
iii) Proprietary Ratio = Proprioety Fund = 0.6
iv) Working Capital Rs. 50,000

v) Reserves and Surplus Rs. 30,000
vi) Bank Overdraft
(Ans: Balance Sheet Total Rs.1,75,000)
27. With the help of the following information, complete the Balance Sheet of Vishaka Steels
Ltd.
Equity Rs.1,00,000
Current Debt to Total Debt 0.40
Total Debt to Owners Equity 0.60
Fixed Assets to Owners Equity 0.60
Total Assets Turnover 2 Times
Inventory Turnover 8 Times
(Ans: Balance Sheet Total Rs.1,60,000)
28. Given the following information for Zenith Ltd. Construct Income Statement & Balance
Sheet.
Net Sales Rs.1,00,000
Debtors Turnover Ratio based on Net Sales 2
Inventory Turnover Ratio 1.25
Fixed Assets Turnover Ratio 0.8
Debt-Assets Ratio 0.6
Net Profit Margin 5%
Gross Profit Margin 25%
Return on Investment 2%
Tax Rate 50%
Short Term Debt 50,000
(Ans: Income Statement = Net Profit Rs.5,000
Tax Rs.5,000
Balance Sheet Total Rs. 2,50,000)
29. ABC Ltd. has made plans for the next year. It is estimated that the company will employ
total assets of Rs.8,00,000, 50% of the assets being financial by borrowed capital at an
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interest rate of 16% per year. The direct cost for the year are estimated at Rs.4,80,000 and
all other operating expenses are estimated at Rs.80,000. The goods will be sold to custom-
ers at 15% of the direct costs. Income-Tax rate is assumed to be 50%
i) Net Profit Margin
ii) Return on Assets
iii) Assets Turnover
iv) Return on Owner’s Equity
(Ans: Net Profit Margin = 6.67%; Return on Assets = 14%;
Assets Turnover 0=9 Times (Sales/Assets);
Return on Owners Equity = 12% (PAT/Equity))
1. Sharma RK & Shashi Gupta K : Management Accounting, Kalyani Publishers,
Ludhiana.
2. Man Mohan & Goyal : Principles of Management Accounting
, Sahitya
Bhavan Publications, Agra.
3. Gupta S.P. : Management Accounting, Sahitya Bhavan Publica-
tions, Agra.
4. Khan & Jain : Management Accounting, Tata McGraw Hill Publish-
ing Co., New Delhi.
5. Jawharlal : Management Accounting, Himalaya Publishing Co.,
New Delhi.
6. Dr. Maheswar S.N. : Principles of Management Accounting, Sultan
Chand & Sons, New Delhi.
7. Ravi M Kishore : Management Accounting, Taxman Allied Services
Pvt. Ltd., New Delhi.
8. Vinayakan N. & Sinha I.B. : Management Accounting - Tools and Techniques,
Himalaya Publishing House, Mumbai.
3.19 KEY WORDS
Ratio : Quotient of two mathematical expressions.
Ratio Analysis : The process of establishing and interpreting various ra-
tios.
Gross Profit : The excess of net sales over cost of goods sold.
Operating Cost : The sum total of cost of goods sold, office, administra-
tion, selling and distribution expenses.
Networth : Share holders funds minus fictitious assets.
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Equity : Represents shareholders funds minus fictitious assets.
Capital Employed : a) Liability side approach: The sum total of
shareholders funds and longterm debt.
b) Assets side approach: The excess of Fixed
assets, current assets over the current liabilities.
Price Earning Ratio : Relationship between market price per share of a com-
pany and earning per share of that company.
Dividend Yield Ratio : The ratio of dividend per share to market price per
share.
Payout Ratio : Indicates as to what proportion of earning per share is
being declared as dividend.
Fixed Assets Turnover : It indicates the relationship between fixed assets and
sales. i.e. the number of times fixed Assets are being
turned over in a given period.
Capital Turnover Ratio : It shows the efficiency of capital employed in the busi-
ness by computing how many times capital employed
is turned over in a stated period.
Liquidity Ratios : Measures the short term solvency of the firm.
Current Ratio : It is the ratio of current Assets and Current Liabilities
Quick Assets : Assets which can be very quickly converted into cash
without much loss.
Debt Equity : It is the ratio of Debt and equity measures the long
term solvency of a Firm.
Capital Gearing : It describes the relationship between fixed interest and
fixed dividend bearing funds and the Equity Share hold-
ers Funds.
Proprietary Ratio : It expreses the relationship between net worth to total
assets.
Du-Pont Chart : The factors affecting profit margin and return on in-
vestment are summarised and presented in this chart.
Turnover Ratio : It Judges how efficiently and effectively the firm uses its
resources or assets converting into sales.
Stock Turnover Ratio : It establishes the relationship between cost of goods
sold and average inventory. It indicates the number of
times the stock is turned into sales during an account-
ing period.
Stock Velocity / : It indicates the time taken by the stock to get
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Stock Conversion Period converted into sales.
Debtors/ : It establishes the relationship between debtors and
Receivable Turnover Ratio sales. This ratio is a measure of efficiency in collecting
the debtors and tells how efficiently a company is en-
forcing its credit policy.
Debtors Velocity/ : It is expressed in terms of number of days required
Debt Collection Period for the debtors to get converted into cash.
Creditors Velocity/Creditors : It indicates the number of days taken by the firm to
Conversion Period/Average pay off its debts.
Payment Period
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GUIDELINE 4 : FUNDS FLOW STATEMENT
OBJECTIVES
• describe the concept and characteristics of 'Funds Flow Statement";
• understand process of preparation of "Funds Flow Statement";
• apply these methods in practice; and
• differentiate between funds flow statement and balance sheet.
STRUCTURE
4.1 Introduction
4.2 Funds - The Concept
4.3 Meaning of 'Flow of Funds'
4.4 Funds Flow Statement
4.5 Uses of Funds Flow Statement
4.6 Limitations in Funds Flow Statment
4.7 Preparation of Funds Flow Statement
4.7.1 Statement of Changes in Working Capital
4.7.2 Funds Flow Statement
4.8 Funds From Operation
4.9 Adjustment of Typical Items
4.10 Distinction between Funds Flow Statement and Income Statement
4.11 Distinction between Funds Flow Statement and Balance Sheet
4.12 Illustrations
4.13 Summary
4.16 Key Words
4.1 INTRODUCTION
The Income Statement or Balance Sheet reveals the net effect of the various transactions on
operational and financial position of the company. The balance sheet gives a summary of the assets
and liabilities of an undertaking at a particular point of time. It reveals the financial position of the
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company. The loss reflects the results of the business operations for a period of time. It contains
expenses incurred and the revenue realised in an accounting period. Every company prepares a
Balance Sheet at the end of its accounting year. It reveals financial position of the company at a
certain point of time. It portrays the financial position of the undertaking, the asset side showing the
deployment of resources in various types of properties and the liability side indicating the manner
in which these resources were obtained. The income statement measures the changes in the owner's
equity as a result of periodic operating activities. Income statement and balance sheet have a
limited role to perform. Income statement measures flows restricted to transactions that pertain to
production commercial activities. The balance sheet is merely a static statement. Balance Sheet
does not show the movement of funds. In business concerns, funds flow from different sources
and similarly funds are invested in various sources of investment. It is a continuous process. The
study and control of the funds flow process is the main objective of financial management to assess
the soundness and solvency of a firm. The traditional statements - Balance Sheet and Profit and
Loss of a business tell little about its flow of funds, i.e., financing and investing activities over the
related period. Hence they need for another statement of account for periodical increase or decrease
of funds of an enterprise and the statement is called Fund Flow Statement.
Funds flow statement indicates how the funds are obtained from various sources i.e. from
outside, generated inside and different assets, had moved to augment the assets or reduce the
liabilities. Therefore it is also calledsources and application of funds statement. The statement
is prepared in such a way as to show clearly the movement between long-term sources and
application of funds and short term sources and application of funds. Funds generated from
operations, share capital, debentures, term loans, sale of fixed assets are considered as long term.
Current liabilities and current assets are short term category.
4.2 FUNDS : THE CONCEPT
We are aware about the going concern concept. Funds keep on moving in a going concern.
In a narrow sense, it means cash only; flow statement prepared on this basis is called as "cash flow
statement". Such a statement enumarates net effects of the various business transactions on cash
and takes into account net effect of receipts and disbursements of cash. In a broader sense, the
term 'fund' refers to money values in whatever form it may exist. Here 'funds' means all financial
resources in the form of men, materials, money, machinery etc. But in a popular sense the term
'funds', means working capital i.e. the excess of current assets over current liabilities. When the
funds move inwards or outwards they cause a flow or rotation of funds.
The word 'fund' here means net working capital.Gross working capital refers to "the
firm's investment in current assets". Current assets are the assets which can be converted into cash
within an accounting year operating cycle and include cash, short-term securities, debtors, (accounts
receivable and book-debts), bills receivable and stock.
Net working capital refers to "the difference between current assets and current liabilities".
Current liabilities are those claims of outsiders, which are expected to mature for payment within
an accounting year and include creditors, bills payable and the outstanding expenses.
According to Bonniville and Dewey, 'funds' constitute prime importance in starting and
operating any business enterprise. The most significant of all financial activities is the raising and
management of funds. Financial decisions are those which concern the generation and flow of
funds from various sources and the use of these funds. It is unfortunate that the term funds flow
should be used without precision in finance. In ordinary parlance, the term fund means cash, or
atleast cash equivanent. In corporate statements, however, the so - called funds statement usually
130
refers to net working capital. The word 'funds' has different connotations for different individuals.
For the layman, it usually refers to cash; for accountants and analysts. It most frequently refers to
working capital (current assets less current liabilities); it may refer to all the sources or to the
purchasing power. For others, it may refer to the net, quick or current assets cash, temporary
investments.
The word funds is closely related to the normal decision - making process of a business, to
accounting statments, which must be compiled by a firm, and which present information on different
aspects of business. Its importance in managerial control should not be under estimated. Kenneth
Ridgley and Ronald Burns have defined the term 'funds' as one used in the sense of 'spending
power'. It refers to the value embedded in assets. Funds are usually received into a business
initially in the form of cash, and though a part of this cash may be used in the purchase of fixed
assets, part of it will be used in the payment of wages and expenses, materials and / or trading
stock directly, depending on the nature of the business. Funds do not cease to exist merely because
cash has been transformed into assets; they get embodied in these assets. If goods are sold on
credit, then part of the funds appear in the form of debtors and as debtors pay off their debts,
funds revert to cash once again.
4.3 MEANING OF "FLOW OF FUNDS"
The term 'Flow' means change. Thus flow of funds means "change in funds" or "change in
working capital". In other words, any increase or decrease in working capital means "Flow of
funds". Flow of fund is said to have taken place when a business transaction makes a change in the
fund, which existed just before the happening of the transaction. The flow of funds refers to transfer
of economic values from one asset to another; from one equity to another; from an asset to equity
or vice-versa or a combination of any these. Funds flow statement essentially studies the movement
to and from working capital area. Thus at the end of the year we can measure:
1. inflows into working capital : for the whole year as a consequence of raising of capital,
raising of loans, sale of fixed assets, sale of investments and operational inflow due. Funds
from operation have to be adjusted. Depreciation on fixed assets, amortization of assets,
and loss on sale of fixed assets, provisions and reserves are added and gain on sale of fixed
assets in to be deducted.
2. outflows from working capital : as a consequence of purchase of fixed assets, payment of
dividend, payment of taxes, payment of preference capital and long term debts, payment
of debenture etc.
The term funds flow indicates the inflows and outflows of funds during a particular accounting
period, generally a year. The flow exhibits the movements of funds in both the directions - inside
the business and outside the business. However, the flow of funds must arise due to external and
not internal transactions of the business. For instance, the capitalisation of reserves by the issue of
bonus shares is an internal transaction. Such transaction are not reflected in the statement as there
is no real addition to the funds of the company. When the term fund is used in the sense of working
capital, funds flow will mean inflow and outflow of capital.
The flow of funds occurs when a transaction changes on one hand a non-current account
and on the other a current account and vice versa. When a change in a non-current account,for
examples, fixed assets, long term liabilities and reserves and surplus etc., is followed by a change
in another non-current account, it does not amount to flow of funds. This is because of the fact that
in such cases the working capital increases neither nor decreases. Similarly, when a change in one
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current account results in a change in another current account, it does not affect funds. Funds
move from non-current to current transactions. In other words, it can be said that only the following
transactions may cause the flow of fund :
• Transactions between current assets and fixed assets.
• Transactions between current assets and capital and long-term liabilities.
• Transactions between current liabilities and fixed assets.
• Transactions between current liabilities and capital and long-term liabilities.
4.4 FUNDS FLOW STATEMENT
The fund flow statement is a financial statement, which reveals the methods by which business
has been financed and how it has used its funds between the opening and closing balance sheet
dates. Thus, a fund flow statement is a report on movement of funds explaining where from working
capital orginates and where into the same goes during an accounting period. This statement consists
of two parts :
1. Sources of Funds; and
2. Application of Funds.
The difference between the two shows the net change in the working capital during the
period. It is to be remembered that only those transactions can find place in this statement, which
affect the networking capital of the firm. The fund flow statement is a supplement to the principal
financial statements. While supplementing the position statement, it describes the source from
which additional funds were derived and the uses to which these funds were put.
* The transactions which increase working capital are sources of funds; and
* The transactions which decrease working capital are application of funds.
The basic objective of this statement is to find out increase or decrease in the working
capital during a period by showing sources and uses of working capital.
4.5 USES OF FUNDS FLOW STATEMENT

1. Fund flow statement determines the financial consequences of business operations. It
shows how the funds were obtained and used in the past. Financial manager can take
corective actions.
2. The management can formulate its financial policies i.e., dividend, reserves etc. on the
basis of this of the statement.
3. It serves as a control device, when compared with budgeted figures. The financial
manager can take remedial steps, if there is any deviation.
4. It points out the sound and weak financial position of the enterprise.
5. It points out the causes for changes in working capital.
6. It enables the bankers, creditors or financial institutions in assessing the degree of risk
involved in granting credit to the business.
7. The management can rearrange the firm's financing more effectively on the basis of this
statement.
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8. Various uses of funds can be known and after comparing them with the uses of previous
years, improvement or downfall in the firm can be assessed.
9. The statement compared with the budget concerned will show to what extent the
resources of the firm were used according to plan and to what extent the utilisation was
unplanned.
10. It indicates whether sources of funds are increasing or decreasing or constant.
4.6 LIMITATIONS OF FUNDS FLOW STATEMENT
1. The statement lacks originality because it is only rearrangement of data appearing in
account books.
2. It indicates only the past position and not the future.
3. It indicates fund flow in a summary form and it does not show various changes, which
take place continuously.
4. When both the aspects of a transaction are current, they are not considered.
5. Even when both the aspects of a transaction are non-current, they are included in this
statement.
6. It is not an ideal tool for financial analysis.
4.7 PREPARATION OF FUNDS FLOW STATEMENT
The fund flow analysis requires the preparation of two statements. They are:
i) Statement of changes in working capital; and
ii) Funds flow statement.
4.7.1 STATEMENT OF CHANGES IN WORKING CAPITAL
The working capital does change due to various transactions. The working capital position
at the beginning of a period is changed to a different position at the end of that period. A statement
of working capital is prepared to depict the changes in working capital. Working capital represents
the excess of current assets over current libilities.
Current Assets: Current assets are those assets, which are used for the day-to-day business
operations of the firm. Those assets constitute the following :
1. Inventories : Inventories represents raw materials and components, work-in-progress
and finished goods.
2. Trade Debtors : It comprise credit sales to customers.
3. Prepaid Expenses : These are those expenses which have been paid for goods and services
whose benefits have yet to be received.
4. Loans and Advances : They represent loans and advances given by the firm to other firms
for a short period of time.
5. Investment : These assets comprise short-term surplus funds invested in government
securities, shares and short-term bonds.
6. Cash and Bank Balance : These assets represent cash in hand and cash at bank, which
are used for meeting operational requirements. This current asset is purely liquid but non-
productive.
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Current Liabilities : Current liabilities form part of working capital and represent obligations
which the firm has to clear to the outside parties in a short-period, generally within a year. These
liabilities comprise the following :
1. Sundry Creditors : These liabilities stem out of purchase of raw materials on credit usually
for a period of one to two months.
2. Bank Overdrafts : These include withdrawals in excess of credit balance standing in the
firm's current account with banks.
3. Short-term Loans : Short-term borrowings by the firm from banks and others form part
of current liabilities as short-term loans.
4. Provisions : These include provisions for taxation, proposed dividends and
contingencies.
Statement of changes in working capital is prepared with current assets and current liabilities
as appearing in Balance Sheets under consideration. The statement shows the changes in individual
items of current assets and liabilities and their effect of working capital. The total increase and total
decrease in the end are compared and the difference of total increase and total decrease shows
the net increase or net decrease in the working capital. A specimen form of the statement is given
below :
STATEMENT OR SCHEDULE OF CHANGES IN WORKING CAPITAL
Particulars Amount of the Amount of the Effect on working capital
previous year current year
(Rs.) (Rs.) Increase Decrease
(Dr.) (Rs.) (Cr.) (Rs.)
Current Assets
Cash in Hand
Cash at Bank
Bills Receivable
Sundry Debtors
Temporary Investments etc.
Total Current Assets (A)
Current Liabilities
Bills Payable
Sundry Creditors
Outstanding Expenses etc.
Total Current Liabilities (B)
Net Working Capital (A-B)
Net Increase or Decrease
in Working Capital
Total
134
Steps
1. The amount of every item of current asset of the current year is compared with its amount of
previous year. If the amount of current asset of the current year is more than its amount of
previous year, the excess is recorded in debit column.
2. If the amount of current asset of current year is less than its amount of the previous year, the
deficiency is recorded in credit column.
3. Do make sure that all the accounts relating to current assets appearing in the two Balance
Sheets are gone through and differences are properly recorded.
4. If the amount of each current liabilities of current year is more than its amount of previous
year, the excess is recorded in the credit column.
5. If the amount of current liability of current year is less than its amount of previous year, the
deficit is recorded in debit column.
6. Find out totals of all debit amounts and all credit amounts.
7. The above totals are compared in the end and the difference shows decrease or increase in
the working capital.
8. If the working capital at the end of the current year is more than the working capial at the
previous year, excess is called "Increase in working capital".
If the previous year's working capital is more than the current year's working capital, such
excess is called "Decrease in working capital".
For Example
You are given the following Balance Sheets of a Company.
31st December
1999 (Rs.) 2000 (Rs.)
Assets
Cash 3,000 4,700
Accounts recievable 12,000 11,500
Land 5,000 6,600
Stock 8,000 9,000
28,000 31,800
Liabilities
Accounts Payable 7,000 4,500
Capital 20,000 25,000
Retained Earnings 1,000 2,300
28,000 31,800
Prepare a statement of changes in working capital.
135
Solution
Statement of Changes in Working Capital
31st December Changes in

Working Capital
1999 2000 Increase Decrease
(Rs.) (Rs.) (Dr.) (Cr.)
Current Assets :
Cash 3,000 4,700 1,700 -
Accounts Receivable 12,000 11,500 - 500
Stock 8,000 9,000 1,000 -
Total (A) 23,000 25,200
Current Liabilities :
Accounts Payable 7,000 4,500 2,500 -
Total (B) 7,000 4,500
Networking Capital (A-B) 16,000 20,700
Net Increase or decrease
in working capital 4,700 4,700
Total 20,700 20,700 5,200 5,200
4.7.2 FUNDS FLOW STATEMENT

After preparing the statement of changes in working capital, the statement of sources
and application of fund is prepared. This statement is prepared with the help of remaining
items in the Balance Sheet of the two-periods, all non-current assets and non-current liabilities
and other information given in the problem. That is, it is prepared on the basis of the changes
in fixed assets, long term liabilities and share capital ascertained on the basis of values of these
items shown in the Balance Sheets. Of course, additional information, if given, must also be
considered. Thus the preparation of this statement involves the ascertainment of increase or
decrease in the various items of fixed assets, long term liabilities and share capital.
Those business transactions, which cause an increase in the working capital are
considered as source of funds and on the same footing business transactions causing a decrease
in working capital is known as uses of funds.
The probable items of sources and uses of fund are tabulated below:
Sources of Funds Uses of Funds
1. Issue of fresh shares 1. Redemption of preference shares
2. Issue of debentures 2. Redemption of debentures
3. New Loans 3. Repayment of Loans
4. Sale of fixed assets 4. Purchase of fixed assets
5. Non-trading income 5. Loss from operations
6. Profits from operation 6. Payment of dividends etc.
Generally, this statement is prepared in two formats :

136
1. 'T' form or an Account form
2. Report form
Fund flow statement for the year ended ..............
Sources of Funds (inflow) Rs. Application of funds (outflow) Rs.
Trading profit xxx Trading Loss xxx
Issue of share capital xxx Redemption of Redeemable

preference shares xxx
Issue of debentures xxx Redemption of debentures xxx
Long term Borrowings xxx Payment of other long term loans xxx
Sale of Fixed Assets xxx Purchase of fixed assets xxx

Non-trading incomes xxx Non-Trading Expenditure xxx
Decrease in working capital xxx Increase in working capital xxx
xxx xxx
Alternatively
Fund flow statement for the year ended........
Particulars Rs. Rs.
Sources of funds (inflow)
Trading Profit
Issue of share capital
Issue of debentures
Long term borrowings
Sale of fixed assets
Non-Trading incomes
Total
Application of funds (outflow)

Trading loss
Redemption of redeemable pref. shares
Redemption of debentures
Payment of other long-term loans
Purchase of fixed assets
Non-trading expenditure
Total
Increase / Decrease in working capital
137
Important items / Notes in Funds flow statement
1. The change in working capital disclosed by the "statement of changes in working caital" will
always tally with changes disclosed by the funds flow statement.
2. Increase in Non-current assets = Application of funds
3. Decrease in Non-current assets = Sources of funds
4. Increase in Non-current liabilities = Sources of funds
5. Decrease in Non-current liabilities = Application of funds
6. Sources of funds = Application of funds
7. Increase in liabilities + Decrease in assets = Decrease in liabilities + Increase in assets
Example : From the following Balance Sheets of a company, prepare a sources and uses of funds
statement for the year 2000.
1st Jan. 31st Dec.
Rs. Rs.
Assets
Cash 35,000 75,000
Accounts receivable 98,000 90,000
Long-term investments 15,000 10,000
Merchandise Inventory 87,000 1,20,000
Land 20,000 30,000
2,55,000 3,25,000
Liabilities
Accounts payable 50,000 45,000
Notes payable (short-term) 20,000 35,000
Notes payable (due Dec. 2001) - 20,000
Capital stock 1,25,000 1,50,000
2,55,000 3,25,000
138
Solution
Schedule of changes in working capital
January December Changes in
2000 Working Capital
Increase Decrease
Rs. Rs. (Rs.) (Rs.)
Current Assets
Cash 35,000 75,000 40,000 -
Accounts receivable 98,000 90,000 - 8,000
Merchandise inventory 87,000 1,20,000 33,000
2,20,000 2,85,000
Current Liabilities
Accounts payable (creditors) 50,000 45,000 5,000 -
Notes - Payable (short term) 20,000 35,000 - 15,000
Notes - Payable (Due) - 20,000 - 20,000
70,000 1,00,000
Working capital 1,50,000 1,85,000
Increase in working capital 35,000
35,000
1,85,000 1,85,000 78,000 78,000
Statement of Sources and Application of funds
Sources of Funds Rs. Application of funds Rs.
Capital stock (1,50,000-1,25,000) 25,000 Purchase of land (30,000-20,000) 10,000

Funds from operation
(75,000-60,000) 15,000 Increase in working capital 35,000
Sale of investment
(15,000-10,000) 5,000
45,000 45,000
4.8 FUNDS FROM OPERATION

The main source of fund for an enterprise in the funds from operation that represents actual
amount of profit as generated by the business. For the funds flow statement, the net profit as
disclosed by Profit and Loss A/c is adjusted in order to calculate actual amount of funds from
operation. This is done to find the effect of the items such as depreciation, and distribution of
profits (general reserve, dividend, provision for taxation), loss from sale of asset etc. on net profit
which actually do not result in the out flow of funds but were treated so in the preparation of profit
and loss account of the firm. In the same way the impact of items like dividend received on
investment, capital gains etc. which do not represent income (inflow) from business operation,
must be treated properly. The procedure for adjusting profits as disclosed by profits and loss
account, in order to ascertain funds from operation is as under :
139
Profit and Loss A/c. for the year ending
Particulars Rs. Rs.
Net Profit as per P & L A/c. xxx
Add : Items which do not result in the out flow of funds
1. Depreciation charged during the year xxx

2. Loss on sale of fixed assets / investments xxx
3. Capital expenditure [like goodwill, preliminary
expenses, patents] written off against P & L A/c. xxx
4. Provision for income tax / proposed dividend xxx
5. Any other items xxx xxx
xxx
Less : Items which do not result in the inflow of funds
1. Gains on sale of fixed assets / investments xxx
2. Dividend received on investment
[credited to P & L A/c.] xxx
3. Any other items xxx xxx
Profit from business operation (or) funds from operation xxx
Example : Calculate funds from operation from the information given below as on : 31st March
2000.
a) Net profit for the year ended 31st March 2000.
b) Gain on the sale of buildings Rs. 35,500
c) Goodwill appears in the books at Rs. 1,80,000 out of that 10% has been written off during
the year.
d) Old machinery worth Rs. 8,000 has been sold for Rs. 6,500 during the year.
e) Rs. 1,25,000 has been transferred to Reserve Fund.
f) Depreciation has been provided during the year on machinery and furniture at 20% whose
total is Rs. 6,50,000.
140
Solution
Calculation of funds from operation
Particulars Rs. Rs.
Net Profit for the year 6,50,000
(+) Non-fund & Non-operating items which

have been debited to P & L A/c.
Goodwill written off 18,000
Loss on sale of machinery 1,500
(8,000-6,500)
Transfer to reserve fund 1,25,000
Depreciation (20%) 1,30,000 2,74,500
9,24,500
(-) Non-fund & Non-operating items which
have been credited to P & L A/c.
Gain on sale of buildings 35,500 35,500
Funds from operation 8,89,000
4.9 ADJUSTMENT OF TYPICAL ITEMS

1. Provision for Taxation :There are two approaches to adjust the item of provision for
taxation viz.,
i) As a current item : Under this approach, the item of provision for taxation is treated
as current liability and accordingly it is adjusted in the schedule of changes in working
capital. However, while attempting a practical problem on funds flow analysis, the item
of tax (if any) given outside the trial balance should be omitted under this approach.
The logic behind the omission is that such an adjustment item [actual payment of tax]
will affect two current accounts i.e. cash and provision for taxation. Therefore, the
transaction will not result in the flow of funds (application).
ii) As a non-current item : Under this approach, it is considered as an appropriation of
profits and thus a non-current liability. Accordingly, the amount of current provision for
taxation is to be adjusted in the funds from operation and the actual payment of tax
appears in the funds flow statement as an application.
2. Proposed dividend : It has the same treatment as that of provision for taxation.
3. Interim dividend : It is the dividend paid in between two balance sheet dates. It is a non-
operating item and as such is adjusted in the calculation of profits from operation.
4. Depreciation : It is a non-fund item and does not result in the flow of cash. It involves
simply a book entry without actual payment of cash. This entry in the books of account,
which debits P & L A/c and credits the fixed asset account, reduces the amount of profit
and the book-value of the fixed assets. As such depreciation does not affect the amount of
fund.
Thus, the amount of depreciation is adjusted in the computation of profits from operation.
141
5. Preliminary Expenses : Like depreciation it is a non-fund item which involves simply a
book entry. Every year a portion of such expenses is written-off by debiting it to profit and
loss account. However, this treatment to preliminary expenses neither results in the flow of
fund nor is it considered as an operating charge. Thus the amount of preliminary expenses
written off during the current period is to be added back to the net profit in order to determine
funds from operation.
6. Goodwill : The amount of goodwill written off does not involve flow of the funds but
requires book entry, debited to the P & L A/c. Therefore, while computing the funds from
operation, the amount of goodwill written off during the current period is added back to the
net profits for the year.
7. Creation of the reserves : Reserves are created out of profits. Therefore such reserves
constitute an appropriation of profit and not an operating charge against profits. Further, the
creation of reserve does not affect the amount of fund. Therefore, the current amount of the
reserve is to be added back to net profit to determine funds from operation.
8. Gain or Loss from the sale of a fixed asset : Firms often transfer gain or loss from sale
of asset to P & L A/c. The treatment of this item in the funds flow analysis is that it being a
non-fund item is to be adjusted in the computation of funds from operation. Thus, the gain
from the sale of the asset is deducted from the net profit and vice-versa to determine profits
from operation.
4.10 DISTINCTION BETWEEN FUNDS FLOW STATEMENT AND INCOME
STATEMENT
1. Fund flow statement deals with the financial resources required for running the business
activities. It explains how the funds were obtained and how were they used, whereas an
income statement discloses the results of the business activities, i.e. how much has been
earned and how it has been spent.
2. A fund flow statement matches the "funds raised" and "funds applied" during a particular
period. The sources and application of funds may be of capital as well as of revenue nature.
An income statement matches the incomes of a period with the expenditures of that period,
which are both of a revenue nature. For example, where shares are issued for cash, it
becomes a source of funds while preparing funds flow statement it is not an item of income
for an income statement.
3. Sources of funds are many besides operations such as share capital, debentures, sale of
fixed assets, etc. An income statement which discloses the results of operations can not
even accurately tell about the funds from operations alone because of non-fund items [such
as depreciation, written off fictitious assets etc.] being included therein.
4. There is no prescribed format for preparing a funds flow statement. Income statement does
have a prescribed format.
5. While preparing the funds flow statement both capital and revenue items are considered. In
income statement only revenue items are considered.
6. Thus, both income statement and funds flow statement have different functions to perform.
Modern management needs both. One can not be substituted for the other, rather they are
complementary to each other.
4.11 DISTINCTION BETWEEN FUNDS FLOW STATEMENT AND
BALANCE SHEET
1. Fund flow statement is dynamic in nature. It shows the changes in financial position between
142
two dates. Balance sheet is static in nature. It is prepared at the end of accounting period
and portrays the financial position on a particular date.
2. Funds flow statement incorporates items causing changes in working capital. Balance sheet
includes the balance of real and personal accounts and shows the total resources.
3. Funds flow statement is a management tool for financial analysis and helps in decision making.
Balance Sheet reveals the financial position of a business firm and one can examine the
soundness of the firm.
4. The preparation of funds flow statement is a post balance sheet exercise. Balance sheet is
the end product of all accounting operations for a particular period of time.
4.12 ILLUSTRATIONS
Balance Sheet of xyz Ltd.
Liabilities 31-12-1999 31-12-2000 Assets 31-12-1999 31-12-2000
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 2,00,000 2,30,000 Plant & Machinery 1,90,000 2,10,000
Trade Creditors 80,000 1,00,000 Building 1,05,000 1,37,000
Bank Loan 40,000 25,000 Inventory 20,000 27,000
Mortgage - 25,000 Trade Debtors 40,000 55,000
P & L A/c 65,000 83,000 Cash 30,000 34,000
3,85,000 4,63,000 3,85,000 4,63,000
Prepare from the above comparative Balance Sheet.
a) A schedule of changes in working capital; and
b) Funds flow statement
Solution
Items 1999 2000 Effects on
(Rs.) (Rs.) Working Capital
Increase (+) Decrease (-)
A) Current Assets
Trade debtors 40,000 55,000 15,000 -
Inventory 20,000 27,000 7,000 -
Cash 30,000 34,000 4,000 -
Total Current Assets (A) 90,000 1,16,000
B) Current Liabilities
Trade Creditors 80,000 1,00,000 - 20,000
Bank Loan 40,000 25,000 15,000 -
1,20,000 1,25,000
21,000
41,000 41,000
Increase in working capital (B/F) 21,000
143
Funds Flow Statement
Share Capital Plant & Machinery

(2,30,000-2,00,000) 30,000 (2,10,000-1,90,000) 20,000
Mortgage 25,000 Building (1,37,000-1,05,000) 32,000
Funds from operation

(83,000-65,000) 18,000 Increase in working capital 21,000
73,000 73,000
2) From the following Balance Sheet of TVS Company Ltd., prepare (a) schedule of changes in
working capital and (b) funds flow statement.
Balance Sheet of TVS Company Ltd.

(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 1,20,000 1,50,000 Plant & Machinery 1,00,000 1,25,000
Sundry Creditors 37,000 25,000 Land & Building 75,000 90,000
Bills Payable 15,000 17,000 Patent Rights 7,000 9,500
P & L A/c 60,000 69,000 Cash 17,000 23,000
Sundry Debtors 33,000 13,500
2,32,000 2,61,000 2,32,000 2,61,000
Depreciation of Rs. 20,000 and Rs. 25,000 have been charged on plant, land and building
respectively in 2003.
Solution
Items 31-12-2002 31-12-2003 Effects on

A) Current Assets
Cash 17,000 23,000 6,000 -
Sundry Debtors 33,000 13,500 - 19,500
Total Current Assets (A) 50,000 36,500
144
Sundry Creditors 37,000 25,000 12,000 -
Bills Payable 15,000 17,000 - 2,000
Total Current Liabilities (B) 52,000 42,000
Decrease in working
capital (B/F) 3,500
21,500 21,500
Share Capital 30,000 Purchase of plant & 45,000

machinery [W.note 2]
Funds from operation [W.note 1] 54,000 Purchase of Land & Building 40,000
[W.note 3]
Decrease in working capital 3,500 Purchase of patents [9,500-7,000] 2,500
87,500 87,500
Working Notes
Particulars Rs. Rs.
i) Calculation of funds from operation
Profits as per P & L A/c (closing balance) 69,000
Add : Depreciation on plant & machinery 20,000
Depreciation on Building 25,000 45,000
1,14,000
Less : Opening Balance of Profit 60,000
Funds from operation 54,000
ii) Calculation of plant purchased during the year.
Dr. Plant & Machinery A/c. Cr.

Particulars Rs. Particulars Rs.
To Balance b/d. 1,00,000 By Depreciation 20,000
To Cash - purchase 45,000
[Balancing - figures] By Balance c/d 1,25,000
1,45,000 1,45,000
145
ii) Calculation of land and building purchased during the year.
Dr. Land and Building A/c. Cr.

To Balance b/d. 75,000 By Depreciation 25,000

To Cash - purchase 40,000
[Balancing - figures] By Balance c/d. 90,000
1,15,000 1,15,000
3. From the following Balance Sheets of T.M.C. Ltd., prepare:
a) Statement of changes in working capital
b) Funds flow statement

Balance Sheet of TMC, Ltd.
Liabilities I year II year Assets I year II year
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital :
Equity Shares 4,50,000 6,00,000 Goodwill 1,90,000 1,40,000
6% Redeemable
pref. shares 2,25,000 1,50,000 Plant 1,60,000 2,50,000
P&L A/c 60,000 75,000 Building 2,40,000 1,95,000
Proposed dividend 55,000 67,000 Inventories 92,000 1,25,000
Trade Creditors 72,000 90,000 Trade Debtors 1,75,000 2,35,000
Bills Payable 32,000 25,000 Bills Receivables 45,000 57,000
Provision for Cash 52,000 77,000
Taxation 60,000 72,000
9,54,000 10,79,000 9,54,000 10,79,000
1. An interim dividend of Rs. 35,000 has been paid in II year.
2. Payment of Income-tax Rs. 52,000 was paid during II year.
3. Depreciation of Rs. 35,000 and Rs. 42,000 have been charged on plant and building
respectively in II year.
146
Solution
Items I year II year Effects on

A) Current Assets
Inventories 92,000 1,25,000 33,000 -

Trade debtors 1,75,000 2,35,000 60,000 -
Bills receivable 45,000 57,000 12,000 -
Cash 52,000 77,000 25,000 -
Total Current Assets (A) 3,64,000 4,94,000
Proposed dividend 55,000 67,000 - 12,000
Trade creditors 72,000 90,000 - 18,000
Bills Payable 34,000 25,000 7,000 -
Provision for Taxation 60,000 72,000 12,000
2,19,000 2,54,000
Increase in working
capital => (B/F) 95,000
1,37,000 1,37,000

Issue of equity share 1,50,000 Redeemption of pref. shares 75,000
Sale of building (W.Note 1) 3,000 Purchase of plant (W.Note 3) 1,25,000
Funds from operation (W.Note 2) 1,77,000 Interim dividend 35,000
3,30,000 3,30,000
147
Working Notes
1. Calculation of building sold during II year:
Dr. Building A/c. Cr.

By Balance c/d. 1,95,000

By Cash - sale (B/F) 3,000
2,40,000 2,40,000
2. Calculation of funds from operation Rs. Rs.

Profits as given (II year - I year) 15,000
[75,000 - 60,000]
Add : Non-operating items:
Depreciation on
Plant 35,000
Building 42,000 77,000
Goodwill written off [1,90,000 - 1,40,000] 50,000
Interim dividend 35,000
1,62,000

3. Calculation of plant purchased during II year
Dr. Plant A/c. Cr.

To Cash - purchase (B/F) 1,25,000 By Balance c/d. 2,50,000
2,85,000 2,85,000
148
4. The following comparative Balance Sheet of 7 'O' Clock Ltd., for 2003 and 2004 are
available.
(Rs.) (Rs.) (Rs.) (Rs.)
Equity Shares Capital 9,00,000 10,50,000 Fixed assets 15,30,000 18,60,000
8% Pref.
Share Capital 6,00,000 3,00,000 Investment 90,000 2,40,000
Debentures 3,00,000 6,00,000 Current Assets 7,20,000 11,25,000
P&L A/c 3,30,000 8,10,000 Discount on debentures 30,000 15,000
Current Liabilities 2,40,000 4,80,000
23,70,000 32,40,000 23,70,000 32,40,000
1. A machine costing Rs. 1,20,000 was sold for Rs. 75,000
2. A redemption at a premium of 15% was done for preference shares on 31st December,
2004.
3. Equity shares were paid a dividend at 15% for 2003; and
4. Depreciation was charged on fixed assets during the year was Rs. 1,80,000
You are required to prepare statement showing the sources and application of funds for
the year ended 31st December, 2004.
Solution
Statement of changes in working capital
Items 2003 2004 Effects on
Current Assets 7,20,000 11,25,000 4,05,000 -
Current Liabilities 2,40,000 4,80,000 - 2,40,000
Increase in working capital (B/F) 1,65,000
4,05,000 4,05,000
149
Sources of Funds Rs. Application of Funds Rs.
Equity share capital 1,50,000 Redeemption of pref. share

capital including premium
(3,00,000 + 45,000) 3,45,000
Debentures 3,00,000 Purchase of fixed asset 6,30,000
Sale of fixed asset 75,000 Payment of preference dividend 55,000
Funds from operation (W.Note 1) 9,48,000 Payment of equity dividend 1,35,000
Investment acquired 1,50,000
Increase in working capital 1,65,000
14,73,000 14,73,000
Working Notes
1. Calculation of funds from operation
Particulars Rs. Rs.
Profit as per P & L A/c for 2003 (8,10,000 - 3,30,000) 4,80,000
Add : Non-fund & Non-operating items appearing
in P & L A/c :
Loss on sale of machine 45,000
Premium on Pref. Shares redeemed 45,000
Preference dividend 48,000
Equity dividend 1,35,000
Depreciation 1,80,000
Discount on Debentures written off 15,000 4,68,000
Funds from operation => (B/F) 9,48,000
2. Calculation of premium on preference shares :

Rate
= X Amount to be redeemed
100
15
= X 3,00,000 = Rs. 45,000
100
3. Calculation of dividend
8
Preference dividend = X 6,00,000 = Rs. 48,000
100
15
Equity dividend = X 9,00,000 = Rs. 1,35,000
100
150
It is assumed that preference dividend was also paid as equity dividend cannot be declared
without declaration of pref. dividend.
Fixed Asset A/c
Dr. Cr.
To Balance b/d 15,30,000 By Depreciation 1,80,000
To Cash-Purchase By Sale 75,000

(Balancing-Figure) 6,30,000 By P & L A/c
(Loss from sale of Asset) 45,000
By Balance c/d 18,60,000
21,60,000 21,60,000
From the following Balance Sheet of Idea Ltd., you are required to prepare : (a) Statement of
changes in working capital; and (b) funds flow statement.

(Rs.) (Rs.) (Rs.) (Rs.)
Equity Shares Capital 1,20,000 1,60,000 Building 1,18,000 1,90,000
Share Premium 20,000 22,00 Machinery 40,000 80,000
Reserves 14,000 16,400 Furniture 6,000 3,000
8% Debentures - 60,000 Indentories 20,000 30,000
Corporation taxes 20,000 28,000 Sundry debtors 80,000 84,000
Sundry Creditors 70,000 84,000 Cash 16,000 29,400
P & L A/c 36,000 46,000
2,80,000 4,16,4000 2,80,000 4,16,400
During the year machinery was written off by Rs. 30,000 and furniture by Rs. 2,000.
Solution
Particulars I year II year Effects on
A) Current Assets
Inventories 20,000 30,000 10,000 -
Sundry debtors 80,000 84,000 4,000 -
Cash 16,000 29,400 13,400 -
Total Current Assets (A) 1,16,000 1,43,400
151
Corporation taxes 20,000 28,000 - 8,000
Trade creditors 70,000 84,000 - 14,000
90,000 1,12,000
Net Increase in working
capital => (B/F) 5,400
27,400 27,400
Issue of Equity share 40,000 Building 72,000

Share Premium 2,000 Machinery 70,000
8% Debentures 60,000 Net Increase in working capital 5,400
Sale of Furniture 1,000
Profit from operation 44,400
1,47,400 1,47,400
Working Notes
Dr. Building A/c. Cr.
To Balance b/d 1,18,000 By Balanced 1,90,000
To Purchase (B/F) 72,000
1,90,000 1,90,000
Dr. Machinery A/c. Cr.

To Balance b/d 40,000 By Balanced 80,000

To Cash-Purchase (B/F) 70,000 By Depreciation 30,000
1,10,000 1,10,000
Dr. Furniture A/c. Cr.

To Balance b/d 6,000 By Balanced 3,000

By Depreciation 2,000
By Cash Sale (B/F) 1,000
6,000 6,000
152
4. Calculation of funds from operation.
Particulars Amount (Rs.)
Profit for II year as per P & L A/c (46,000-36,000) 10,000
Add : Non-fund / Non-operating items appearing in
P & L app. A/c.
Reserves 2,400
Depreciation
Machinery - 30,000
Furniture - 2,000 32,000 34,400
Profit / Funds from operation 44,400
6. Balance Sheet of M/s. Black and White as on 1st January 1978 and 31st December, 1978
were as follows :-
Balance Sheet
(Rs.) (Rs.) (Rs.) (Rs.)
Creditors 40,000 44,000 Cash 10,000 7,000
M/s. White's Loan 25,000 - Debtors 30,000 50,000
Loan from Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 2,30,000 2,47,000
During the year machine costing Rs. 10,000 [Accumulated depreciation Rs. 3,000] was
sold for Rs. 5,000. The provision for depreciation against machinery as on 1st January 1998 was
Rs. 25,000 and on 31st December 1998 Rs. 40,000. Net profit for the year 1998 amounted to
Rs. 25,000. You are required to prepare statement of sources and uses and statement of changes
in working capital.
Solution Statement of changes in working capital
Particulars 1-1-1998 31-12-1998 Effects on
Current Assets
Cash 10,000 7,000 - 3,000
Debtors 30,000 50,000 20,000 -
Stock 35,000 25,000 - 10,000
153
Current Liabilities
Creditors 40,000 44,000 - 4,000
M/s. White's Loan 25,000 - 25,000 -
Net Increase in working
capital => (B/F) 28,000
45,000 45,000
Note : Loan from bank treated as long term loan.
Additional Capital 28,000 Repayment of White's Loan 25,000

Sale of Machinery 5,000 Purchase of land 10,000
Loan from Bank 10,000 Building 25,000
Funds from operation 45,000 Increase in working capital 28,000
88,000 88,000
Calculation of funds from operation
Profit for the year 25,000

Add : Depreciation
(15,000+3,000) 18,000
Loss on sale of Machinery 2,000
Loss on machine sold
Written down value of machine

[cost - depreciation]
(10,000 - 3,000) Rs. 7,000
Sold for Rs. 5,000
Loss on sale of machine Rs. 2,000
154
7. From the Balance Sheets of ABC Ltd.; make out :
a) A statement of changes in working capital
b) A funds flow statement
Balance Sheet

(Rs.) (Rs.) (Rs.) (Rs.)
Equity share capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
8% Redeemable
Pre. share capital 1,50,000 1,00,000 Land & Building 2,00,000 1,70,000
General Reserve 40,000 70,000 Plant 80,000 2,00,000
P & L A/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed dividend 42,000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 Bills Receivable 20,000 30,000
Bills Payable 20,000 16,000 Cash in Hand 15,000 10,000
Provision for
Taxation 40,000 50,000 Cash at Bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000
Additional information
1. Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on plant & land and
buildings respectively in 2003.
2. An interim dividend of Rs. 20,000 has been paid in 2003.
3. Income tax of Rs. 35,000 has been paid in 2003.
Solution
Statement of changes in working capital

Current Assets
Debtors 1,60,000 2,00,000 40,000 -
Stock 77,000 1,09,000 32,000 -
Bills Receivable 20,000 30,000 10,000 -
Cash in hand 15,000 10,000 - 5,000
Cash at Bank 10,000 8,000 - 2,000
155
Current Liabilities
Proposed dividends 42,000 50,000 - 8,000
Creditors 55,000 83,000 - 28,000
Bills payable 20,000 16,000 4,000 -
Provision for taxation 40,000 50,000 - 10,000
Net increase in working
capital => (B/F) 33,000
86,000 86,000

Issue of capital 1,00,000 Redeemption of Reedemable
Pref. Shares 50,000
Sale of land & building 10,000 Dividends paid 20,000
[W.Note 2]
Income Tad paid 35,000
Funds from operation [W.Note 1] 1,58,000 Purchase of plant [W.Note 3] 1,30,000
Net increase in working capital 33,000
2,68,000 2,68,000
Working Notes
1. Calculation of funds from operation :
Closing Balance of P & L A/c 48,000
( - ) Opening Balance of P & L A/c 30,000
18,000
Add : Depreciation [20,000 + 10,000] 30,000
Dividends paid 20,000
Income tax paid 35,000
Transfer to general reserve 30,000
Amortisation of Goodwill 25,000
Dr. Land & Building A/c. Cr.

By Sale [B/F] 10,000

2,00,000 2,00,000
156
3.
Dr. Plant A/c. Cr.
To Balance b/d. 80,000 By Depreciation 10,000

To Purchase (B/F) 1,30,000

2,10,000 2,10,000
8. Prepare a statement of sources and application of funds of Delta Media Corporation

Ltd., from the following information :
Balance Sheet

(Rs.) (Rs.) (Rs.) (Rs.)
Creditors 1,40,000 1,30,000 Cash in hand 50,000 70,000
Bills payable 40,000 30,000 Cash at Bank 1,00,000 1,20,000
Bank overdraft 50,000 - Debtors 1,65,000 1,00,000
Tax provision 75,000 65,000 Pre paid Exp. 4,000 3,000
Reserves 80,000 80,000 Stock 1,50,000 1,00,000
P & L A/c. 84,000 28,000 Fixed Assets 5,00,000 4,80,000
Share Capital 5,00,000 6,00,000 Goodwill - 60,000
9,69,000 9,33,000 9,69,000 9,33,000
The following information is given by the corporation :

1. In 1998-99, a dividend of Rs. 84,000 was paid.
2. The assets of another corporation were purchased at Rs. 1,00,000 payable in 10,000
shares of Rs. 10/- each. The assets include stock Rs. 10,000, fixed assets Rs. 30,000
and goodwill Rs. 60,000.
3. Income tax paid in 1998-99 was Rs. 10,000.
4. Net profit in 1998-99 was Rs. 38,000 before charging tax.
Solution
157

Current Assets :
Cash in hand 50,000 70,000 20,000 -
Cash at Bank 1,00,000 1,20,0000 20,000 -
Debtors 1,65,000 1,00,000 - 65,000
Prepaid Expenses 4,000 3,000 - 1,000
Stock 1,50,000 1,00,000 - 50,000
Current Liabilities :
Creditors 1,40,000 1,30,000 10,000 -
Bills Payable 40,000 30,000 10,000 -
Bank overdraft 50,000 - 50,000 -
Tax Provision 75,000 65,000 10,000 -
Net increase in working
capital (B/F) 4,000
1,20,000 1,20,000
Note : Tax provision treated as current liability.
Source and Application of Funds (FFS)

Capital Issued 1,00,000 Assets Purchased
Funds from operation 88,000 Fixed Assets 30,000
[W.Note 1] Goodwill 60,000
Income tax paid 10,000
Dividend paid 84,000
1,88,000 1,88,000
Working Notes
1. Calculation of funds from operation :

Closing Balance of P & L A/c. - 28,000
Less: Opening Balance of P & L A/c. - 84,000
56,000
158
Add: Dividends paid - 84,000
Income tax paid - 10,000
Depreciation - 50,000 1,44,000
2. Calculation of depreciation
Opening Balance of fixed assets - 5,00,000
( +) Purchases - 30,000
5,30,000
( - ) Closing Balance of fixed assets 4,80,000
Depreciation 50,000
9. The non-current assets and equities of Southern Grid Company Ltd. are given at the
beginning and the end of the current years as below :
Particulars Year End Year Beginnig
(Rs.) (Rs.)
Plant assets [Net of Depreciation] 2,85,000 1,27,000
Investments in the subsidary co. 5,80,000 2,64,000
Debentures 1,40,000 5,00,000
Capital Stock 8,00,000 8,00,000
Retained Earnings 8,21,000 4,76,000
You are unable to obain complete Balance Sheet data or income statement for the year,
but you are obtained the following information :
1. Dividends Paid Rs. 75,000/-
2. Again on the sale of the equipment of Rs. 26,000/- has been included in the net income.
The gross plant assets increased by Rs. 1,86,000/- even though equipment costing
Rs. 58,000/- with a net book value of Rs. 38,000/- was sold.
Prepare a statement of sources and uses of working capital.
Solution
1. Funds from operation Rs.
Increase in Retained earnings 3,45,000
Add : Dividends paid 75,000
4,20,000
( - ) Gain on sale of equipment 26,000

159
2. Calculation of Gain on sale of equipment
Cost of Assets 58,000
( - ) Depreciation 20,000
Book value 38,000
Sale (38,000+26,000) 64,000

Gain on sale of equipment 26,000
3.
Dr. Plant A/c. Cr.
To Opening Balance 1,27,000 By Bank (Sale) 28,000

To Bank 1,86,000 By Closing Balance 2,85,000
3,13,000 3,13,000
Funds flow statement

Funds from operation 3,94,000 Increase in Investments 3,16,000
Sale of equipment 64,000 Repayment of Debentures 3,60,000
Sale of Plant 28,000 Dividend Paid 75,000
Decrease in working capital (B/F) 2,65,000
7,51,000 7,51,000
10. The following are the Balance Sheets of Ultra Tech Ltd.
Balance Sheet
(Rs.) (Rs.) (Rs.) (Rs.)
Creditors 1,63,000 1,46,000 Cash&Bank Balance 50,000 40,000
Outstanding Debtors 77,000 73,000
Expenses 13,000 22,000 Stock 2,02,000 1,90,000
5% Debentures 90,000 70,000 Prepaid Expenses 1,000 2,000
(Rs. 100 each) Land & Building 1,00,000 1,00,000
Depreciation Fund 40,000 44,000 Machinery 72,000 80,000
Capital Reserve 6,000 7,800
P & L A/c. 10,000 15,200
Equity Share capital 1,80,000 1,80,000
5,02,000 4,85,000 5,02,000 4,85,000
160
The following additional information is also available :
a) 10% dividend on equity share capital was paid in cash.
b) Old machinery costing Rs. 12,000 was sold for Rs. 4,000 and accumulated depreciation
on that was Rs. 6,000.
c) 5% debentures of Rs. 20,000 were redeemed by purchase from open market at Rs.
96 per debenture, profit on this redemption was transferred to capital reserve.
Prepare a funds flow statement.
Solution
Particulars 1998 1999 Effects on

Current Assets
Cash /Bank Balances 50,000 40,000 - 10,000
Debtors 77,000 73,000 - 4,000
Stock 2,02,000 1,90,000 - 12,000
Prepaid Expenses 1,000 2,000 1,000 -
Current Liabilities
Creditors 1,63,000 1,46,000 17,000 -
Outstanding Expenses 13,000 22,000 - 9,000
Decrease in working
capital (B/F) => 17,000
35,000 35,000

Sale of Machine 4,000 Addition to plant/machinery 20,000
Funds from operation 36,200 Redemption of debenture
(200x96) 19,200
Decrease in working capital 17,000 Dividends paid 18,000
57,200 57,000
161
Working Notes
1.
Dr. Capital Reserve A/c. Cr.
By Opening Balance 6,000

By Profit on Redemption (200x4) 800
To Closing Balance 7,800 By P & L A/c. (B/F) 1,000
7,800 7,800
2.
Dr. Ads. P & L A/c. Cr.
To Capital Reserve 1,000 By Opening Balance 10,000
To Loss on Sale of Machinery 2,000 By Funds from Operation (B/F) 36,200
To Dividend 18,000
To Dep. on Machinery 10,000
To Closing Balance 15,200
46,200 46,200
3.
To Opening Balance 72,000 By Dep. on sold machinery 6,000
To Addition during the year 20,000 By sale process 4,000
By Loss on sale 2,000
By closing balance 80,000
92,000 92,000
4.
Dr. Depreciation A/c. Cr.
To Machinery sold 6,000 By Opening balance 40,000

To Closing Balance 44,000 By Depreciation 10,000
50,000 50,000
162
4.13 SUMMARY
The funds flow statement indicates the flow of funds among items of assets and liabilities.
Because each item has its own characteristics relating to liquidity and profitability, the extent of the
movement or the changes influence the financial strength and profitability of the undertaking. Both
the management and the bankers are keen to study any information or statement which would
reflect these aspects properly.
1. What is funds flow statement? Explain its relationship with the Balance Sheet?
2. What are the uses of the Funds flow statement?
3. Prepare a simple funds flow statement from the balance sheet of a company on the movement
of funds in that company.
4. "A funds flow statement is a better substitute for an income statement" Discuss.
5. From the following Balance Sheets of Glamour Ltd. Prepare :
1) Statement of changes in working capital 2) Funds flow statement.
Glamour Ltd. Balance Sheet

(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital
Equity Shares 4,50,000 6,00,000 Goodwill 1,90,000 1,40,000
6% redemable 2,25,000 1,50,000 Plant 1,60,000 2,50,000
Pref. Shares
P & L A/c. 60,000 75,000 Building 2,40,000 1,95,000
Proposed dividend 55,000 67,000 Inventories 92,000 1,25,000
Trade creditors 72,000 90,000 Trade debtors 1,75,000 2,35,000
Bills Payable 32,000 25,000 Bills receivable 45,000 57,000
Provision for Cash 52,000 77,000
taxation 60,000
9,54,000 10,79,000 9,54,000 10,79,000
1. An interim dividend of Rs. 35,000 has been paid in II year.
2. Payment of income tax Rs. 52,000 was paid during II year.
3. Depreciation of Rs. 35,000 and Rs. 42,000 have been charged on plant and building
respectively in II year.
6. From the following Balance Sheet of X Ltd., you are requied to prepare:
1. Statement of changes in working capital
163 and
2. Funds flow statement during the year machinery was written off by Rs. 30,000 and
furniture was depreciated by Rs. 2,000.

(Rs.) (Rs.) (Rs.) (Rs.)
Equity Shares Capital 1,20,000 1,60,000 Building 1,18,000 1,90,000
Share Premium 20,000 22,000 Machinery 40,000 80,000
Reserves 14,000 16,000 Furniture 6,000 3,000
8% Debentures - 60,000 Inventories 20,000 30,000
Corporation Taxes 20,000 28,000 S.Debtors 80,000 84,000
Sundry Creditors 70,000 84,000 Cash 16,000 29,400
P & L A/c 36,000 46,000
2,80,000 4,16,400 2,80,000 4,16,400
7. From the following Balance Sheet of Eastern Company Ltd., as on 31st December 1983
and 1984 you are required to prepare :
1. Funds flow statement 2. schedule of changes in working capital
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 3,50,000 4,35,000 Building 3,00,000 3,40,000
Debentures 2,25,000 3,20,000 Plant 3,25,000 3,75,000
General Reserve 1,20,000 1,75,000 Investment 1,65,000 1,85,000
P & L A/c. 75,000 95,000 Preliminary Expenses 9,000 -
Depreciation Inventories 75,000 1,45,000
Reserves 90,000 1,35,000 S. Debtors 95,000 1,75,000
Sundry Creditors 75,000 95,000 Bills Receivable 40,000 65,000
Bills Payable 90,000 1,10000 Cash in hand 16,000 80,000
10,25,000 13,65,000 10,25,000 13,65,000
1. Dividend for 2003 @ 15% was paid during the year 2004.
2. A plant costing Rs. 75,000 [depreciation provided Rs. 25,000] was sold for Rs. 55,000.
3. Investments amounting to Rs. 40,000 were realised for Rs. 32,000.
8. From the following Balance Sheet of a Company you are required to prepare :
164
1) A statement showing changes in the working capital and 2) A statement fo sources and
applications of funds.
Particulars January, 2002 December, 2003
(Rs.) (Rs.)
Assets
Cash 40,000 44,400
Accounts Receivable 10,000 20,700
Inventories 15,000 15,000
Land 4,000 4,000
Buildings 20,000 16,000
Equipment 15,000 17,000
Accumulated Depreciation (5,000) (2,800)
Patents 1,000 900
1,00,000 1,15,200
Liabilities
Current Liabilities 30,000 32,000
Bonds Payable 22,000 22,000
Bonds Payable Discount (2,000) (1,800)
Capital Stock 35,000 43,500
1,00,000 1,15,200
1. Income for the period Rs. 10,000.
2. A building that cost Rs. 4,000 and which had a book value of Rs. 1,000 was sold for
Rs. 1,400.
3. The depreciation charge for the period was Rs. 800.
4. There was Rs. 5,000 issue of common stock.
5. Cash dividend Rs. 2,000 and a Rs. 3,500 stock divided were declared.
1. Brigham, E.F. : Fundamentals of Financial Managment, Dryden

Press, Chicago.
2. James C, Van Horne : Financial Management and Policy, Prentice-Hall of
India, New Delhi.
3. Gitman L.J. : Principles of Managerial Finance, Harper and Gow,
New York.
165
4. Khan., M.Y & Jain P.K. : Financial Management-Text and Problesm, Tata
McGraw Hill, New Delhi.
5. Maheshwari S.N. : Financial Management: Principles and Practice,
Sultan Chand & Sons, New Delhi.
6. Pandey I.M. : Financial Management, Vikas Publishing House, New
Delhi.
7. Prasanna Chandra : Financial Management: Theory and Practice, Tata
8. Kulkarni P.V. : Financial Management: A Conceptual Approach,
Himalaya Publishing House, Bombay.
4.16 KEY WORDS
Non-Current Assets : Assets other than current assets are non current assets.
The non-current assets are fixed assets and Long-term
investments. The non-current assets are useful in
producing goods and services.
Current Liabilities : These liabilities are the short term liabilities which are
required to be cleared within one year or operating cycle
whichever is higher. These liabilities are also called as
fluctuating or temporary liabilities. Examples : Sundry
creditors, bills payable, bank overdraft, outstanding
expenditure etc.
Net Working Capital : It is the difference between the current assets and current
liabilities.
Working Capital Pool : It means various items which are included in the working
capital. The pool normally contains cash, debtors,
receivables stock, short term investments.
Funds Flow Statement : A statement prepared in a summary form to indicate
the changes occuring in terms of financial condition
between two different balance sheet dates.
166
GUIDELINE 5 : CASH FLOW STATEMENT
OBJECTIVES
• understand the meaning of cash flows from operating, investing and financing activi-
ties.
• know the objectives and purpose of cash flow statement
• prepare the cash flow statement
• know the process of reconciliation of net profits with net cash from operating activities.
• deal with 'extraordinary items' such as interest and dividends and taxes on income
while preparing cash flow statement.
STRUCTURE
5.1 Introduction
5.2 Significance of Cash Flow Statement
5.3 Difference between Cash Flow and Funds Flow Statement
5.4 Limitations of Cash Flow Statement
5.5 Procedure for Preparing a Cash Flow Statement
5.6 Calculation of Cash from Operations
5.7 Adjustment of Typical Items
5.8 Illustrations
5.9 Summary
5.12 Key Words
5.1 INTRODUCTION
Cash plays a very important role in the entire economic life of a business. Cash flow state-
ment is a flow statement as the name suggests. The cash flow statement is intended to explain the
changes that took place in the various items between two successive balance sheets. Cash flow
means inflow and outflow of cash during an accounting period. From the beginning of the year
upto the end of the year. Cash is comes in from various sources and is spent on various heads.
Incoming and outgoing of cash is referred to as cash flow.
The cash flow statement offers information in addition to those provided by the Balance
Sheet and the Profit and Loss Account. The Profit and Loss Account provides information on the
results of operations in a financial period. The balance sheet provides a picture of the financial
167
position of the company on a date. Neither of these statements provides information on the cash
flows related to operations, financing or investment activities. Since the accrual accounting prin-
ciple is followed in recognising revenues and the matching principle is followed in recording ex-
penses, a company's income and cash flows are unrelated. It is possible to conceive of a situation
in which a company reports a large profit after tax but has no or negative cash flows. The informa-
tion on a company's cash flows supplements the information provided by balance sheet and the
profit and loss account.
The cash flow statement can be conceived as a compact version of cash book in which
details are condensed and presented in broad and meaningful categories. The cash flow statement
reconciles the difference between the opening and closing balance of cash by the net cash flow
from a company's operating, investing and financing activities during a period.
In India, under clause 32 of the listing agreement with the stock exchanges, listed compa-
nies are required to present a cash flow statement for the accounting period in their annual report.
This requirement took effect from the accounting period 1995-96.
Purpose of CFS
1. To provide information about the operating, financing and investing activities of the enter-
prise and the effect of those activities on cash resources.
2. To indicate how much cash came in during the period, how much cash went out during the
period and what the net cash flow was during the period.
Objectives of CFS
The objective of the cash flow statement (CFS) is to require reporting entities falling within
its scope to report on a standardised basis their cash generation and cash absorption for a period
between two balance sheet dates. Standard headings have been revised for assisting the users to
assess the liquidity, viability and financial adaptability of the reporting entity. This will ensure that
cash flows highlight the significant components of the cash flow and facilitate comparison of the
cash flow performance of different and varying nature of businesses.
5.2 SIGNIFICANCE OF CASH FLOW STATEMENT

A cash flow statement is a vital analytical tool in the hands of financial manager that helps
him in the proper management of cash. It is an essential tool of short-term financial analysis. The
chief advantages of cash flow statement are as follows:
1. It ensures effective planning and coordination of financial operations. The analysis of cash
flow statement provides a financial manager sufficient basis to assess the position of the
firms cash that can be generated internally as against the total amount of cash requirement to
meet future obligations of the concern. With the result proper management can be made
well in advance for the availability of adequate cash if the future cash requirements of the
business cannot be met internally.
2. A comparison of the cash flow statement with the projected cash flow statement is very
useful in evaluating the cash forecasting.
3. It may be useful tool for the proper allocation of the firm's cash among its various activities
/ divisions. The analysis of cash flow statement can also help management in formulating
appropriate financial policies regarding debts, credits, collections, dividends etc.
168
4. It helps the management in investment decisions.
5. A comparative analysis of the firm's cash flow statements enables a financial manager to
assess the liquidity position of the firm.
6. A careful study of cash flow statement provides answer to some typical questions like why
cash position of the concern is tight, in spite of high incomes or vice-versa.
5.3 DIFFERENCE BETWEEN CASH FLOW STATEMENT AND FUNDS

FLOW STATEMENT
Cash Flow Statement (CFS) Funds Flow Statement (FFS)

1. It is concerned with the changes in cash 1. It is concerned with the changes in
position only. working capital between two balance sheet
dates.
2. It is based on the cash system of 2. It is based on the mercantile system of
accounting accounting i.e. accrual basis of accounting.
3. It is useful for short-range analysis 3. It is useful for long-range financial analysis
4. It is prepared by recognising the inflows 4. It attempts to identify the inflows and outflows
and outflows of cash. of funds.
5. Under cash flow analysis changes in 5. To indicate the changes in working capital, a
both current and non-current accounts separate statement is to be prepared, which is
appear in the cash flow statement. known as a schedule of changes in working
So here, there is no need to prepare capital, because FFS fails to indicate such
such statement of changes in working changes.
capital.
6. Under CFS, improvement in cash items 6. In FFS, improvement in cash position does
definitely results in improvement of not result in improvement of working capital
working capital position of the business position.
5.4 LIMITATIONS OF CASH FLOW STATEMENTS
Despite a number of advantages, cash flow statements suffer from the following limitations:
1. The operating activities, part of the statement of cash flow can be presented in one of two
ways the direct approach or the indirect approach. Comparing the direct approach for
determining the cash flow from operating activities against the indirect approach, the direct
approach provides much more useful information in terms of determining the source and use
of cash from operations. This choice reduces the usability of the statement of cash flows.
2. The statement does not reconcile the differences between taxes as reported on the firm's
income statement with what was actually paid. The magnitude of the difference between the
taxes reported as paid on the income statement against what was actually paid is at least to
us - astounding.
3. The statement permits but does not require separate disclosure of the cash flows associated
with discontinued operations and extrordinary items.
4. Non-cash investing and financing activities [such as capital leases, debt/equity swaps, and
asset exchanges] are not included in the statement. They are simply reported in a supple-
mental statement or in narrative form.
5. Interest or dividends received by the firm, as well as interest paid, are treated as operating
activities; however, dividends paid by the firm are treated as a financing activity. This incon-
sistency in treatment is a form of misleading.
5.5 PROCEDURE FOR PREPARING A CASH FLOW STATEMENT
Generally, a cash flow statement is prepared with the help of financial statements viz., in-
come statement, Balance sheet and some additional information. It is a reconciliating statement,
where cash balance at the beginning is reconciled with cash balance at the end and like funds flow
statement, it can also be prepared either in the 'report form' or in 'account form'.
The changes in the cash position from one period to another is computed by taking into
account 'sources' and applications' of cash.
Cash Position
Sources of Cash Applications of Cash
Internal Sources External Sources

of cash of cash
à Cash from operations à Issue of new shares à Decrease in unsecured

à Depreciation à Raising long term loans loans, deposits etc.
à Amortization of à Purchase of plant & à Purchase of fixed assets
intangible assets machinery on deferred à Payment of long-term loans
à Loss on sale of fixed payments à Decrease in deferred
assets à Short-term borrowings payment liabilities
à Gains from sale of fixed à Loss on account of operations
assets à Sale of fixed assets à Payment of tax
à Creation of reserves à Payment of dividend
However in addition to the above said elements, decrease in various current assets and
increase in various current liabilities may be taken as external sources of cash, if they are not
adjusted while computing cash from operations. In addition increase in various current assets or
decrease in various current liabilities may be shown as application of cash, if changes in these items
have not been adjusted while finding out cash from operations.
170
In broad, terms the cash flow statement should report cash flows during the period classi-
fied by operating, investing and financing activities. A company presents its cash flows from oper-
ating, investing and financing activities in a manner, which is most appropriate to its business.
Classification by activity provides information that allows users to assess the impact of those
activities on the financial position of the company and the amount of its cash equivalent. This
information may also be used to evaluate the relationships among these activities. A single transac-
tion may include cash flows that are classified differently. For example, when the cash repayment
of a loan includes both interest and capital, the interest element may be classified as an operating
activity and the capital element is classified as a financing activity.
Sources of Cash inflows and outflows
Inflows Outflows
From operations: To operations:

Cash sales collection of Payment for materials
accounts receivable wages and salaries, rent,
insurance, utilities, taxes.
From investments: To investments:

Short or long term securities Working capital
Subsidiaries or international CASH (i.e. short term)
Sale of assets Capital budget
(i.e. long term)
From Financing: To Financing:

Sale of securities Interest and dividends
Loans repayment of loans and
bonds
Proforma of Report Form of Cash Flow Statement (Traditional Method)
Particulars Rs. Rs.
Cash or Bank Balance at the beginning xxx

Add : Cash Inflows
Cash from operations xxx
Proceeds from sale of fixed assets xxx
Issue of shares xxx
Share premium xxx
Issue of debentures xxx
Increase in current liabilities xxx
Raising of loans xxx
171
Decrease in current assets xxx
Non-trading receipts viz;
dividend received and xxx
refund of tax xxx
xxx
xxx
Less: Cash Outflows

Purchase of fixed assets xxx
Repayment of loans xxx
Redemption of preference shares xxx
Redemption of debentures xxx
Payment of taxes xxx
Payment of dividend xxx
Cash lost on operations xxx
Increase in current assets xxx
Decrease in current liabilities xxx
Cash balance at the end xxx
xxx
xxx
Proforma of an account form of cash flow statement (Traditional Method)

Cash inflows Rs. Cash outflows Rs.
Cash or Bank Balance at the Purchase of fixed assets xxx
beginning xxx Repayment of loans xxx
Cash from operations xxx Redemption of preference shares xxx
Proceeds from sale of fixed assets xxx Redemption of debentures xxx
Issue of shares xxx Payment of dividend xxx
Share premium xxx Payment of taxes xxx
Issue of debentures xxx Cash lost in operations xxx
Raising of loans xxx Increase in current assets xxx
Decrease in current assets xxx Decrease in current liabilities xxx
Increase in current liabilities xxx Cash or Bank balance at the end xxx
Non-trading receipts :
Dividend received xxx
Refund of tax xxx
xxx xxx
172
5.6 CALCULATION OF CASH FROM OPERATIONS
The major source of cash for a business in cash from trading operations. When the account-
ing system is based on cash system, the net profit as shown by the profit and loss represents the
cash from operations. However, in actual practice the commercial organisations maintain mercan-
tile system of accounting with the result the profit as disclosed by profit and loss account is not
considered the actual cash from operation as it includes many transactions of notional cash. Thus,
net profit as shown in profit and loss account is to be adjusted to arrive at actual cash from
operations. The non-cash transactions like outstanding incomes/expenses, prepaid expenses etc.,
should be adjusted. Further all non-fund items such as depreciation, preliminary expenses written
off etc., are also to be adjusted as is done in case of fund flow statement. A detailed proforma of
the statement showing computation of cash from operations is given below:
Statement showing computation of cash from operations
Particulars Amount
(Rs.)
Net profit [as given in P & L A/c] xxx
Add :
a) Decrease in current assets
Sundry Debtors
Bills receivable
Prepaid expenses
Accured income
b) Increase in current liabilities
Sundry creditors
Bills payable
Outstanding expenses
Income received in advance
c) Non-fund items debited to P & L A/c.
Depreciation
Goodwill written off
Loss on sale of assets
Preliminary expenses written off
Less :
a) Increase in current assets
Sundry debtors
Bills receivable
Prepaid expenses
Accured income
173
b) Decrease in current liabilities
Sundry creditors
Bills payable
Outstanding expenses
Income received in advance
c) Non-fund items credited to profit and loss account
Profit on sale of assets
Cash from operations xxx
Note: The current assets and current liabilities will not include cash balances and bank over draft
respectively in the determination of cash from operations.
5.7 ADJUSTMENT OF TYPICAL ITEMS

The treatment of the typical items like depreciation, dividend, profit on sale of assets etc. in
the cash analysis is the some as is recommended for these items in the funds flow analysis. How-
ever, the provision for taxation is treated as a non-current item. The actual amount of tax paid
during the year is shown in the cash flow statement as cash outflow. The current provision of
taxation is added back to the amount of profit in order to ascertain cash from operations.
Cash flows from interest and dividends received and paid should each be disclosed sepa-
rately. Each should be classified in a consistent manner from period to period as either operating
investing or financing activities. The total amount of interest paid during the period is disclosed to
the cash flow statement whether it has been recognised as an expense in the income statement or
capitalised.
Interest paid and interest and dividends received are usually classified operating cash flows
for a financial institution. However, there is no consensus on the classification of these cash flows
for other companies. Interest paid and interest and dividends received may be classified as oper-
ating cash flows because they enter into the determination of net profit or loss. Alternatively,
interest paid and interest and dividends received may be classified as financing cash flows and
investing cash flows respectively, because they are costs of obtaining financial resources or returns
on investments.
Dividends paid may be classified as a financing cash flow because they are cost of obtaining
financial resources. Alternatively dividends paid may be classified as a component of cash flows
from operating activities in order to assist users to determine the ability of a company to pay
dividends out of operating cash flows.
However, investing and financing transactions that do not require the use of cash or cash
equivalents should be excluded. From a cash flow statement. Such transactions should be dis-
closed elsewhere in the financial statements in a way that provides all the relevant information
about these investing and financing activities.
Many investing and financing activities do not have a direct impact on current cash flows
although why do affect the capital and asset structure of a company. The exclusion of non-cash
transactions from the cash flow statement is consistent with the objective of a cash flow statement,
as these items do not involve cash flows in the current period. Examples of non-cash transactions
are: 174
1) The acquisition of asset or assets either by assuming directly related liabilities or by
means of a financial lease.
2) The acquisition of a company by means of an equity issue; and
3) The conversion of debt to equity.
PREPARATION OF CASH FLOW STATEMENT: ACCORDING TO AS-3
The Institute of Chartered Accountants of India (ICAI) has issued an accounting standard
(AS-3) providing details of how the cash flow statement should be prepared. While the standard
was first issued in 1981, it has been revised in 1997. The revised accounting standard has been
made mandatory w.e.f.; 1st April 2001 in respect of the following enterprises:
i) Enterprises whose equity or debt securities are listed in recognized stock exchanges in
India.
ii) All other commercial, Industrial and business reporting enterprises whose turnover for
the accounting period exceeds Rs.50 cr.
Thus, organisations that meet the above criteria need to necessarily follow, AS-3 in prepa-
ration of cash flow statement. The standard is not mandatory for other organizations, but it is
recommended for all the organisations to follow the AS-3. However, such organisations can choose
to prepare the cash flow statement as per the traditional method. But, the stress is given in this unit
on AS-3 method.
Meaning of Cash Flow
The cash flow statement provides information about historical changes in cash and cash
equivalents, classifying the cash flows fromoperating, investing and financing activities. Hence
let us understand the meaning of the following terms.
i) Cash: cash comprises cash on hand and at bank
ii) Cash equivalents: Cash equivalents are short term, highly liquid investments that are readily
convertible into cash.
The conditions for an item to be classified as cash equivalent are:
a) It should be highly liquid-it can be converted into cash in a very short period of time.
b) It should be of short term-it should not have a maturity of more than 3 months
c) It should not be risky-it should be possible to ascertain its value in cash without much
uncertainty.
iii) Cash flows: Cash flows are inflows and outflows of cash and cash equivalents.Cash flow
means any change in assets or liabilities that effect a change in cash or cash equivalents of
the organisation
iv) Operating activities: AS-3 suggests two ways of reporting cash flows from operating
activities. The first method is direct method wherein major heads of gross cash receipts and
gross cash payments are disclosed.the second method, called indirect method takes the net
profit as the basis. The two methods are explained in detail.
Direct Method: Under this method, cash receipts and payments pertaining to operating activities
175
are separately and individually stated. And the difference between the two is the cash from oper-
ating activities. While this method appears to be very simple and straight forward, the required
information is not directly available. For example, we need to consider cash receipts from sale of
goods and credit sales. While cash sales, can be taken as is, we need to consider cash received
from debtors rather than credit sales. Some of the adjustments that are explained below:
i) Cash received from debtors: this is calculated as under: cash received from debtors=Credit
sales+Opening balance of Debtors-Closing balance of Debtors. This can be alternatively
calculated by preparing Debtors A/c. If Bills Receivable are also involved, a Bills Receiv-
able A/c also needs to be prepared.
ii) Cash paid to creditors: as in the case of cash received from debtors. Cash paid to credi-
tors can be calculated as credit purchases+opening balance of creditors-closing balance of
creditors. It can also be calculated by preparing total creditors A/c. If Bills payable are also
involved, then Bills payable account should also be prepared. Sometimes credit purchases
are not directly known, this can be calculated by deducting cash purchases from total pur-
chases. Total purchases can be calculated as under: Total purchases = Cost of goods sold
+ Closing stock - Opening stock.
iii) Cash paid towards expenses: the cash expense incurred as shown in the profit and loss
account may not be equal to cash paid towards the same. For e.g. outstanding expenses.
Hence the following adjustment must be made.
a) Rent as per profit and loss A/c. xxx
Add: outstanding rent at the beginning xxx
xxx
Less: outstanding rent at the end xxx
Rent paid during the year xxx
b) Insurance as per the Profit and loss A/c xxx
Add: Prepaid insurance at the year-end xxx xxx
Less: Prepaid insurance at the beginning of the year xxx
Amount paid towards insurance towards the end of the year xxx
iv. Cash received from income:all revenues earned as per profit and loss account may not be
equal to actual cash received on account of such revenue. We need to adjust income received
in advance and incomes receivable. The following example makes it clear about the income
that is received during the year.
Commission income earned as per profit and loss a/c. xxx
Add: Outstanding commission at the beginning of the year xxx
Add: Commission received in advance at the end of the year xxx
xxx
Less: Outstanding commission at the end of the year xxx
Less: Commission received at the beginning of the year xxx
Commission received at the end of the year xxx
176
v. Non cash expenses: while calculating cash from operating activities, using direct method,
non cash expenses such as depreciation, preliminary expenses written off, goodwill amortiza-
tion etc. should be ignored.
Calculation of cash flow from operating activities: Direct method.
Cash receipts from customers xxx

Less: cash paid to suppliers and employees xxx
Cash generated from operations xxx
Less: income tax paid xxx
Net cash from operating activities xxx
Indirect Method. Under the indirect method, the net cash flow from operating activities is deter-
mined by adjusting net profit or loss for the effect of:
a) Non-cash items such as depreciation, provisions, deferred taxes, and unrealized for-
eign exchange gains and losses; and
b) Changes during the period in inventories and operating receivables and payables;
c) All other items for which the cash effects are investing or financing cash flows.
The indirect method is also called reconciliation method as it involves reconciliation of net
profit or loss as given in the profit and loss account and the net cash flow from statement. In other
words, net profit or loss is adjusted for non cash and non operating items which may have been
debited or credited to profit and loss account as follows:
Cash Flow from Operating Activities (Indirect Method)
Net profit Before Tax and extraordinary items xxx

Add: Non-cash and non operating Items which have been
debited to P/l a/c
a) Depreciation xxx
b) Transfer to reserves and provisions xxx
c) Goodwill xxx
d) Preliminary expenses written off xxx
e) Other intangible assets written off xxx
f) Loss on sale of disposed fixed asset xxx
g) Loss on sale of investments xxx xxx
xxx
177
Less: Non-cash and non-operating items which have been
credited to P/L A/c.
a) Profit on sale of fixed assets xxx
b) Profit in sale of investments xxx
c) Income from interest or dividends on investments xxx
Operating profit Before Working Capital Changes xxx xxx
Adjustments for changes in Current Assets and Current Liabilites xxx
Less: Non-cash and non operating items which have already been
credited to P/L A/c.
a) Gain on sale of fixed assets xxx
b) Profit on sale of investments xxx
c) Income from interest or divident from investments xxx
d) Appreciation xxx
e) Reserves written back xxx
f) Foreign exchange gain xxx xxx
xxx
Operating profit before capital changes
Adjustments for changes in current operating assets and liabilities
Add: Decrease in accounts of current operating assets (except cash
and cash equivalents)
such as
decrease in trade debtors xxx
decrease in bills recievables xxx
decrease in prepaid expenses etc xxx
Add: Increase in accounts of current operating assets(as stated above) xxx
Increase in bills payable xxx
Increase in outstanding Expenses xxx xxx
xxx
Less: Increase in Accounts of current operating Assets xxx
xxx
Less: Decrease in Accounts of Current Operating Liabilities xxx
xxx
Cash generated from (used in) operations before tax
Less: Income tax paid xxx
Cash flow before extra-ordinary items xxx
xxx
Add/less: Extraordinary items if any xxx
Net cash flow From(used in) Operating activities xxx
178
vi) Cash flows from investing activities: investing activities are the acquisition and disposal
of long term assets and other investments not included in cash equivalents. The separate
disclosure of cash flows arising from investing activities is important because the cash flows
represent the extent to which expenditures have been made for resources intended to gen-
erate future income and cash flows.
Examples of cash flows from investing activities are:
a) Cash payments to acquire fixed assets(including intangibles). These payments include
those relating to capitalized research and development costs and self constructed fixed
assets;
b) Cash receipts from disposal of fixed assets(including intangibles);
c) Cash payments to acquire shares warrants, or debt instruments of other enterprises
and interests in joint ventures ( other than payments for those instruments considered
to be cash equivalents and those held by beating or trading purposes);
d) Cash receipts from disposal of shares, warrants, or debt instruments of other enter-
prises and interests In joint venture ( Other than receipts from those instruments con-
sidered to be cash equivalents and those held for dealing or trading purposes)
e) Cash advances and loans made to third parties( Other than advances and loans made
by a financial enterprise);
f) Cash receipts from the repayments of advances and loans made to third parties( Other
then advances and loans from a financial enterprise);
g) Cash payments for futures contracts, forward contracts, option contracts and swap
contracts Except when the contracts are held for dealing or trading purposes, or the
receipts are classified as financing activities; and
h) Cash receipts from futures contracts, forward contracts, option contracts and swap
contracts are held for dealing or trading purposes or the receipts are classified as
financing activities.
vii) Cash flows from financing activities: Financing activities are activities that result in changes
in the size and composition of the owners’ capital (including preference share capital in the
case of a company) and borrowings of the enterprise.
The separate disclosure of cash flows arising from financing activities is important because
it is useful on predicting claims on future cash flows by providers of funds (both capital and
borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:
a) Cash proceeds from issuing shares or other similar instruments;
b) Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-
term borrowings; and
c) Cash repayments of amounts borrowed such as redemption of debentures, bonds,
preference shares.
179
TREATMENT OF SOME TYPICAL ITEMS
AS-3 (revised) has also provided for the treatment of cash flows from some peculiar items
as discussed below:
1. Extraordinary Items: the cash flows associated with extraordinary items should be clas-
sified as arising from operating, investing, or financing activities as appropriate and sepa-
rately disclosed in the cash flows of the enterprise.
2. Interest and Dividends: cash flows from interest and dividends received and paid should
be disclosed separately. Further, the total amount of interest paid during the period should
be disclosed in the cash flow statement whether it has been recognized as an expense in the
statement of profit and loss or capitalized. The treatment of interest and dividends received
and paid depends upon the nature of the enterprise. For this purpose, the enterprises are
classified as (i)financial enterpriseand (ii)other enterprises
i) Financial Enterprises: Cash flows arising from interest paid and dividend received
should be classified as cash flows arising from operating activities.
ii) Other Enterprises: In the case of other enterprises, cash flows arising from interest
paid should be classified as cash flows from financing activities while interest and divi-
dends received should be classified as cash flows from investing activities.
3. Taxes on Income: Cash flows arising from taxes on income should be separately dis-
closed and should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
FORMAT OF CASH FLOW STATEMENT
AS-3 (Revised) has not provided any specific format for preparing cash flow statement.
However, an idea of the suggested format can be inferred from the illustrations appearing in the
appendices to the accounting standard. The cash flow statement should report cash flows during
the period classified by (1)operating, (2) investing and (3) financing activities.
180
Cash Flow Statement
Cash Flows from Operating Activities Either
Cash reciepts from Customers xxx

Cash paid to suppliers and employees xxx
Cash generated from operations xxx
Income tax paid xxx
Cash flow before extraordinary items xxx
Extraordinary items xxx
Net cash from (used in) Operating activities xxx
OR
Net profit before tax and extraordinary items xxx
Adjustments for non-cash and non-operating items xxx
Operating profit before working capital changes xxx
Adjustments for changes in current assets and current liabilites
(List of individual items) xxx
Cash generated from operations before tax xxx
Income tax paid xxx
Cash flow before extraordinary items xxx
Extraordinary items such as reffund of tax xxx
Net cash from operating activitties xxx
Cash Flows From Investing Activities
Purchase/sale of fixed assets, purchase or sale of investments,
interest received dividend received etc. xxx
Net cash from investing activitrs xxx xxx
Cash Flows From Financing Activities:
Issue of shares, Long-term borrowings, repayments of long term borrowing,
divident paid etc. xxx
Net cash from financing activities xxx xxx
Net Increase(Decrease) in cash and cash equivalaents xxx
cash and cash equivalents at the begeniing of the period xxx
Cash and cash equivalents at the end of the period xxx
181
Format of Cash Flow Statement Approved By SEBI is given below:
Cash Flow Statement
(for the year ended……..)
A. Cash Flow From Operating Activities: Rs.
Net Profit/Loss before tax and extraordinary items xxx
Add: Depreciation xxx
Loss on sale of fixed assets xxx
Transfer to Reserves xxx
Godwill written off xxx
Preliminary expenses written off xxx
Tax provision xxx
Proposed dividends xxx
xxx
Less: Profit on sale of fixed assets and investments xxx
Income from interest or dividends on investments xxx
Other appreciations xxx
Operating Profit Before Working Capital Changes xxx
Adjustments for changers in current Assets and Liabilites
Add:Decrease in Current assets xxx
Increase in Current Liablites xxx
xxx
Less:Increase in Current Assets xxx
Decrease in Current Liabilites xxx
Less:Income Tax paid xxx
Add/Less: Extraordinary items if any xxx
Net Cash Flows From Operating Activities xxx xxx
B. Cash Flows From Investing Activities
Purchase of Fixed Assets and Investments xxx
Sale of Fixed Assets and Investments xxx
Interest received xxx
Dividends received xxx
Net Cash Flows from investing activities xxx xxx
C. Cash Flows From Financing Activities:
Proceeds from issue of Share Capital xxx
Proceeds from issue of Debentures xxx
182
Long-term Loans obtained xxx
Redumption of pref.shares and Debentures xxx
Repayment of Long-term loans xxx
Drawings xxx
Dividends paid xxx
Net cash flow from Financing Activities xxx xxx
Net Cash Increase/Decrease in Cash and Cash equivalents xxx
Cash and Cash equivalents as at…….Opening Cash Balance xxx
Cash and Cash equivalents as at……..(Closing Cash Balance xxx
The most popular and widely used format is the one, approved by SEBI. All the problems of
this unit follow the format approved by SEBI, and traditional method for the convenience of the
students.
5.8 ILLUSTRATIONS
1. Balance Sheets of A and B on 1.1.2005 and 31.12.2006 were as follows:

(Rs.) (Rs.) (Rs.) (Rs.)
Creditors 40,000 44,000 Cash 10,000 7,000
Mr. A's loan 25,000 - Debtors 30,000 50,000
Loan from Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 2,30,000 2,47,000
During the year a machine costing Rs. 10,000 [Accumulated depreciation Rs. 3,000] was
sold for Rs. 5,000. The provision for depreciation against machinery as on 1.1.2005 was Rs.
25,000 and on 31.12.2006 Rs. 40,000. Net profit for the year 2006 amounted to Rs. 45,000.
You are required to prepare cash flow statement.
183
Solution
Cash Flow Statement (Traditional Method)
Cash inflows Rs. Cash Outflows Rs.
Opening Cash Balance 10,000 Purchase of Land 10,000

Cash from Operations 59,000 Purchase of Building 25,000
Loan from Bank 10,000 Mrs. A Loan Repaid 25,000
Scale of Machinery 5,000 Drawings 17,000
Closing Cash Balance 7,000
84,000 84,000
Cash Flow Statement

As-3 (Revised) Method
Rs. Rs.
I. Cash Flows from Operating Activities
Net Profit made during the year 45,000
Add: Provision for Depreciation 18,000
Add: Loss on Sale of Machinery 2,000
Operating Profit before Working Capital changes 65,000
Add: Decrease in Stock 10,000
Increase in Creditors 4,000
79,000
Less: Increase in Debtors 20,000
Net Cash Flows from Operating Activities 59,000 59,000
II. Cash Flows from Investing Activities
Sale of Machinery 5,000
Purchase of Land (10,000)
Purchase of Building (25,000)
Net Cash Flows from Investing Activities (30,000) (30,000)
III. Cash Flows from Financing Activities
Loan from Bank 10,000
Mrs. Loan Repaid (25,000)
Drawings (17,000)
Net Cash Flows from Financing Activities (32,000) (32,000)
Net Increase / Decrease in Cash and Cash Equivalents (3,000)
Cash and Cash Equivalents at the beginning of the Period 10,000
Cash and Cash Equivalents at the end of the Period 7,000
184
Working Notes
Cash from Operations
Rs.
Profit made during the year 45,000

Add: Depreciation Provision 18,000
Add: Loss on Sale of Machinery 2,000
Cash Operating Profit before Working Capital Changes 65,000
Add: Increase in Creditors 4,000
79,000
Cash from Operations 59,000
Capital A/c.
Rs. Rs.
To Drawings (Balancing Fig.) 17,000 By Opening Balance 12,500
To Closing Balance 1,53,000 By Profit 45,000
1,70,000 1,70,000
Machinery Account (at Cost)
Rs. Rs.
To Opening Balance 80,000 By Bank 5,000
To Opening Depreciation By Loss on Sale of
Provisions 25,000 1,05,000 Machinery 2,000
By Provisions for
Depreciation 3,000 10,000
By Closing Balance 55,000
By Closing Depreciation
Provision 40,000 95,000
1,05,000 1,05,000
185
Provision for Depreciation A/c.
Rs. Rs.
To Machinery 3,000 By Balance b/d. 25,000
To Balance c/d. 40,000 By P/L A/c. (Current year
Depreciation 18,000
43,000 43,000
2. Prepare a cash flow statement from the following:

(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 2,00,000 2,50,000 Building 2,00,000 1,90,000

General Reserve 50,000 60,000 Machinery 1,50,000 1,69,000
P & L A/c 30,500 30,600 Stock 1,00,000 74,000
Term Loan 70,000 - Debtors 80,000 64,200
Creditors 1,50,000 1,35,200 Cash 500 600
Provision for Bank - 8,000
Taxation 30,000 35,000 Goodwill - 5,000
5,30,500 5,10,800 5,30,500 5,10,800
i) In 2006 dividend of Rs. 23,000 was paid.
ii) Assets of another company were purchased for a consideration of Rs. 50,000
payable in shares. The following assets wer purchased. Stock Rs. 20,000,
Machinery Rs. 10,000.
iii) Machinery was further purchased for Rs. 8,000.
iv) Depreciation within off of machinery Rs. 12,000.
v) Income tax provided during the year Rs. 33,000.
vi) Loss on sale of machinery Rs. 200 was written off to general resume.
Solution
Dr. Provision for Taxation A/c. Cr.
To Bank (Tax Paid) 28,000 By Opening Balance 30,000
To Closing Balance 35,000 By P & L 33,000
63,000 63,000
186
To Opening Balance 1,50,000 By Dep. 12,000

To Bank (Purchase) 34,000 By P & L A/c (Loss) 200
By Bank (Sale value) 2,800
By Closing Balance 1,69,000
1,84,000 1,84,000
Cash Flow Statement

AS-3 (Revised) Method
Rs. Rs.
Profit 100
Add: Income-tax Provided 33,000
Add: General Reserve Transfer 10,200
Add: Dividend Paid 23,000
Add: Depreciation on Machinery 12,000
Add: Depreciation on Building 10,000
Operating Profit before Working Capital Changes 88,300
Add: Decrease in Debtors 15,800
1,50,100
Less: Decrease in Creditors (-) 14,800
Less: Taxes Paid (-) 28,000
Net Cash Flows from Operating Activities 1,07,300 1,07,300
Purchase of Machinery (8,000)
Purchase of Goodwill (5,000)
Mortgage Loan Repaid (70,000)
Dividends Paid (23,000)
Net Increase in Cash and Cash Equipments 8,100
Cash and Cash Equivalents at the Beginning 500
Cash and Cash Equivalents at the End 8,600
187
Working Notes
Share Capital A/c.
Rs. Rs.
To Balance c/d. 2,50,000 By Balance b/d. 2,00,000
By Stock 20,000
By Machinery 30,000
2,50,000 2,50,000
Machinery
Rs. Rs.
To Share Capital 30,000 By Loss on Sale of Machinery
Transferred to General
To Bank 8,000 Resources 200
By Bank 6,800
1,88,000 1,88,000
General Reserve
Rs. Rs.
To Machinery 200 By Balance b/d. 50,000
To Balance c/d. 60,000 By P/L A/c. Transfer
Balancing Figure 10,200
60,200 60,200
Provision for Taxation

Rs. Rs.
To Bank 28,000 By Balance b/d. 30,000
To Balance c/d. 35,000 By P/L Transfer 33,000
63,000 63,000
Stock A/c.
Rs. Rs.
To Balance b/d. 1,00,000 By P/L Transfer 46,000
To Share Capital 20,000 By Balance c/d. 74,000
1,20,000 1,20,000
188
3. Wall Mart Ltd. supplies you the following Balance Sheets on 31st December.

(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 70,000 74,000 Bank Balance 9,000 7,800

Bonds 12,000 6,000 Accounts Receivable 24,900 22,700
Accounts Payable 10,360 11,840 Inventories 49,200 42,700
Provision for Land 20,000 30,000
Double Debts 700 800
Reserves & Surplus 10,040 10,560
1,03,100 1,03,200 1,03,100 1,03,200
Following additional information has also been supplied to you:

i) Dividends amounting to Rs. 3,500 were paid during the year 2006.
ii) Land was purchased for Rs. 10,000.
iii) Bonds of Rs. 6,000 were paid during the course of the year.
You are required to prepare a cash flow statement.
Solution
Traditional Method
Calculation of cash from operations:
Rs.
Difference in profit (reserve & surplus)[10,560 - 10,040] 520
Add: Dividend Paid 8,500
Total 9,020
Cash Flow Statement
Cash inflow Rs. Cash outflow Rs.

Opening Bank Repayment of bonds 6,000
Balance 9,000 Purchase of land 10,000
Increase in capital 4,000 Dividend Paid 3,500
Cash from operation 4,020 Closing Cash Balance 7,800
Dec in Current Liability
Accounts payable 1,480
Prov. doubtful debts 100 1,580
189
Inc. in C.A.
Accounts Receivable 2,200
Inventories 6,500 8,700
27,300 27,300
Note: Goodwill purchased raised during the year written off.
Cash Flow Statement

Rs. Rs.

Reserves and Surpluses 520
Operating Profit before Working Capital Charges 4,020
Add: Decrease in Accounts Receivable 2,200
Add: Increase in Accounting Payable 1,480
Net Cash Flow from Operating Activities 14,300 14,300
Land Purchased (10,000)
Share Capital 4,000
Bonds Paid (6,000)
Dividends Paid (3,500)
Net Decrease in Cash and Cash Equivalents (1,200)
Cash and Cash Equivalents at the Beginning of the Period 9,000
Cash and Cash Equivalents at the End of the Period 7,800
Working Notes
Share Capital A/c.
Rs. Rs.
To Balance c/d. 20,000 By Balance b/d. 30,000
To Bank (Purchase) 10,000
30,000 30,000
190
4. The following schedule shows the Balance Sheets in the condensed form of Sanjeev
Ltd., at the end of the year 2006.
Particulars 1.1.2006 31.12.2006

Rs. Rs.
Assets
Cash and Bank Balances 45,000 45,000
Sundry Debtors 33,500 21,500
Temporary investment 55,000 37,000
Prepaid Expenses 500 1,000
Stock 41,000 53,000
Land / Buildings 75,000 75,000
Machinery 26,000 35,000
Total 2,76,000 2,67,500
Liabilities
Sundry Creditors 51,500 48,000
Outstanding Expenses 6,500 6,000
8% Debentures 45,000 35,000
Depreciation Fund 20,000 22,000
Reserves for contingencies 30,000 30,000
Profit & Loss A/c. 8,000 11,500
Capital 1,15,000 1,15,000
Total 2,76,000 2,67,500
The following information is also available:

i) 10% dividend was paid in cash.
ii) New machinery for Rs. 15,000 was purchased but old machinery costing Rs.
6,000 was sold for Rs. 2,000 accumulated depreciation was Rs. 3,000.
iii) Rs. 10,000/-, 8% debentures were redeemed by purchase from open market @
96 for a debenture of Rs. 100.
iv) Rs. 18,000 investment were sold at book value.
You are required to prepare cash flow statement.
191
Solution
Dr. Machinery A/c (Traditional Method) Cr.

To Opening Balance 26,000 By Dep. on sold machinery 3,000

To Addition 15,000 By Sale of machinery 2,000
By Loss on sale 1,000
By closing Balance 35,000

41,000 41,000
Dr. Depreciation A/c Cr.

To Dep. on sold machine 3,000 By Opening Balance 20,000
By Dep. during the year (BIF) 5,000
To Closing balance 22,000
25,000 25,000
Dr. Adjusted Profit & Loss A/c Cr.

To Dividend 11,500 By Opening Balance 8,000
To Loss on sale of machinery 1,000 By Discount earned on
To Depreciation 5,000 redemption of debentures 400
To Closing Balance 11,500 By Cash from operations 20,600
29,000 29,000
Cash Flow Statement

Opening Balance 45,000 Redemption of debentures 9,600
Add: Cash inflows Purchase of machinery 15,000
Sale of Machinery 2,000 Payment of dividend 11,500
Sale of investment 18,000 Increase in prepaid Exp. 500
Decrease in S. Debtors 12,000 Increase in stock 12,000
Profit from operations 20,600 Decrease in creditors 3,500
Decrease in outstanding expenses 500
Closing Balance 45,000
97,600 97,600
192
Cash Flow Statement
Rs. Rs.

Profit & Loss Account 3,500
Dividends Paid 11,500
Loss on Sale of Machinery 1,000
Depreciation on Machinery 5,000
21,000
Less: Profit on Redumption of Debentures 400
Operating Profit before Working Capital Changes 20,600
Add: Decrease in Debtors 12,000
Add: Decrease in Temparary Investments 18,000
50,600
Less: Increase in Prepaid Expenses 500
Less: Increase in Stock 12,000
Less: Decrease in Creditor 3,500
Less: Decrease in O/s Expenses 500
Purchase of Mechinary (15,000)
III. Cash Flows from Financing Actgivities
Redumption of Debentures (9,600)
Payment of Dividends (11,500)
Net Cash and Cash Equivalents Nil
193
5. From this following condensed Balance Sheets of X Company Ltd., for the years ending
31st December, 2005 and 31st December 2006, make out a cash flow statement for
2006.

(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 2,00,000 2,50,000 Goodwill 50,000 45,000

9% Pref. share Land & Building 80,000 55,000
capital 60,000 40,000 Plant & Machinery 90,000 1,60,000
Capital Reserve - 10,000 Furniture 12,000 10,000
General Reserve 15,000 20,000 Investments 10,000 45,000
P & L A/c 25,000 40,000 Sundry Debtors 32,000 25,000
S. Creditors 28,000 52,000 Stock 64,000 45,000
Bills Payable 8,000 10,000 Bills Receivable 10,000 35,000
O/S Expenses 4,000 3,000 Cash in hand 10,000 25,000
Proposed dividend 18,000 25,000 Cash at Bank 15,000 26,000
Provision for
Taxation 20,000 24,000 Preliminary Exp. 5,000 3,000
3,78,000 4,74,000 3,78,000 4,74,000
i) An interim dividend of Rs. 10,000 has been paid in 2006.
ii) Rs. 2,000 has been received as dividend on trade investment.
iii) A piece of land has been sold out in 2006 and the remaining has been revalued,
profit on sale and revaluation, being transferred to capital reserve.
iv) Depreciation on plant and machinery has been written off Rs. 15,000 in 2006,
and no depreciation has been charged on land and building.
v) A machinery was sold for Rs. 18,000 [W.D.V. being Rs. 20,000] and no furniture
has been sold during the year 2006.
Solution
Dr. Plant & Machinery A/c. Cr.
To Balance b/d. 90,000 By Cash 18,000
To Cash (Purchase) B/F 1,05,000 By Adj. P & L A/c. (Loss on sale) 2,000
By Adj. P & L A/c. (Depreciation) 15,000
1,95,000 1,95,000
194
Dr. Land & Buildings A/c. Cr.
To Balance b/d. 80,000 By Cash (sale) B/F 35,000

To Capital Reserve 10,000 By Balance c/d. 55,000
90,000 90,000
Dr. Goodwill A/c. Cr.

To Balance b/d. 50,000 By Adj. P & L A/c (B/F) 5,000

By Balance c/d. 45,000
50,000 50,000
Dr. Trade Investments A/c. Cr.

To Balance b/d. 10,000 By Balance c/d. 45,000
To Cash (purchases) (B/F) 35,000
45,000 45,000
Dr. Proposed Dividend A/c. Cr.

To Cash (Paid) 18,000 By Balance c/d. 18,000
By Adj. P & L A/c. (B/F) 25,000
To Balance c/d. 25,000
43,000 43,000
Dr. General Reserve A/c. Cr.


By Adj. P & L A/c. (B/F) 5,000
20,000 20,000
195
Dr. Preliminary Expenses A/c. Cr.
To Balance b/d. 5,000 By Adj. P & L A/c. (B/F) 2,000

5,000 5,000

To Cash (paid) 20,000 By Balance b/d. 20,000

To Balance c/d. 24,000 By Adj. P & L A/c. (B/F) 24,000
44,000 44,000
Dr. Furniture A/c. Cr.

To Balance b/d. 12,000 By Adj. P & L A/c. (B/F) 2,000
12,000 12,000
Adjusted Profit & Loss A/c. (Traditional Method)

To Interim dividend 10,000 By Balance c/d. 25,000
To Proposed dividend 25,000 By Dividend received 2,000
To Provision for tax 24,000 By Cash Operating profit (B/F) 1,06,000
To General Reserve 5,000
To Goodwill 5,000
To Dep. on furniture 2,000
To Dep. on P & M 15,000
To Preliminary Exp. 2,000
To O/S Exp. for 1999 3,000
To Loss on sale of Mach 2,000
1,33,000 1,33,000
196
(for the year ended 31-12-2006)
Particulars (Cash inflows) Rs. Particulars (Cash outflows) Rs.
Cash & Bank Balance

as on 1-1-2006 25,000 Outflows of Cash
Add: Cash Inflows Payment of interim dividend 10,000
Dividend Received 2,000 Redemption of P. Shares 20,000
Sale of Land 35,000 Purchase of P & M 1,05,000
Sale of Machinery 18,000 Purchase of Investments 35,000
Issue of Shares 50,000 Increase in B/R 25,000
Increase in S. Creditors 24,000 Payment of proposed
Increase in bills payable 2,000 dividend for 2005 18,000
Increase in sundry debtors 7,000 Provision for taxation for 2005 20,000
Decrease in stock 19,000 Outstanding Expenses (2005) 4,000
Cash operating profit 1,06,000 Cash & Bank Balance (closing) 51,000
2,88,000 2,88,000
Cash Flow Statement

Rs. Rs.
General Reserve 5,000
Interim Dividend 10,000
Proposed Dividend 25,000
Provision for Tax 24,000
Goodwill Written off 5,000
Depreciation on Furniture 2,000
Depreciation on Plant & Machinery 15,000
Preliminery Expenses Written off 2,000
Loss on Sale of Machinery 2,000
1,05,000
Less: Dividend Received 2,000
Operating Profit before Working Capital Changes 1,03,000
Increase in Bills Payable 2,000
Decrease in Debtors 7,000
197
Decrease in Stock 19,000
1,55,000
Less: Increase in Bills Receivable 25,000
Decrease in O/s Expenses 1,000
1,29,000
Less: Tax Paid 20,000
Net Cash Flow from Operating Activities 1,09,000 1,09,000
Sale of Land 35,000
Purchase of Plant & Machinery (1,05,000)
Purchase of Investments (35,000)
Issue of Shares 50,000
Dividends Received 2,000
Payment of Interim Dividend (10,000)
Redemption of Preference Shares (20,000)
Payment of Dividend (18,000)
Net Cash Flows from Financing Activities 4,000 4,000
Net Increase in Cash and Cash Equivalents 26,000
Cash and Cash Equivalents at the Begening of the Period 25,000
6. Xerox Ltd., had the following figures in 1st January, 2006.

Rs.
Less: Depreciation 1,05,000

1,95,000
Bank Balance 17,500
Other Current Assets 1,25,000
Capital [shares of Rs. 10 each] 1,50,000

The company made the following estimates for 2006:

a) The profit would be Rs. 27,500 after depreciation of Rs. 30,000
198
b) The company will acquire fixed assets costing Rs. 50,000 after selling one machine
for Rs. 10,000 costing Rs. 25,000 and on which depreciation provided amounts to
Rs. 17,500.
c) Current assets and current liabilities other than bank balance at the end of 2006 are
expected to be Rs. 147,500 and Rs. 1,15,000 respectively.
d) The company will pay free of tax dividend at 10% the rate of tax being 25%.
You are required to prepare cash flow statements and ascertain the bank balance of
Xerox Ltd. as on 31st December, 2006.
Solution
Working Notes:
i) Payment of dividend = 10% of Rs. 1,50,000

(Tax free) = Rs. 15,000
Rate of Tax = 25%
If gross dividend is Rs. 100, Tax is Rs. 25 and net dividend shall be Rs. 75. So, when Rs.
75 is paid, tax is 25 and when Rs. 15,000 is paid as dividend,
25
Tax = 15,000 x = Rs. 5,000
75
ii) Cash operating profit

Rs.
Profit [as given] 27,500
Add : Depreciation 30,000

57,000
Less: Profit on sale of Machinery 2,500
55,000
iii) Profit on sale of Machinery
Rs.
Cost Machinery sold 25,000
(-) Depreciation 17,500
Written down value 7,500
Sale Value 10,000

Profit 2,500
199
Cash Flow Statement (31.12.2006)
Bank Balance on (1/1/99) 17,500 Out Flows of Cash

(+) Cash Inflows Purchase of fixed assets 50,000
Sale of Machinery 10,000 Payment of dividend 15,000
Increase in current liabilities Payment of tax on above
(1,15,000 - 50,000) 65,000 (25% of gross) 5,000
Cash operating profit Increase in current assets 22,500
(Bank Balance) 55,000 Other than Bank (31/12/99)
(Balancing figure) 55,000
1,47,500 1,47,500
Cash Flow Statement

Rs. Rs.
Profit as given 27,500
Add: Depreciation 30,000
57,500
Less: Profit on Sale of Machinery 2,500
Operating Profit before Working Capital Charges 55,000
Add: Increase in Current Liabilities 65,000
1,20,000
Less: Increase in Current Assets 22,500
97,500
Less: Taxes Paid 5,000
Purchase of Fixed Assets (50,000)
200
7. From the following information, prepare a cash flow statement for the year ended 31st
March 1998.
Balance Sheet

(Rs.) (Rs.) (Rs.) (Rs.)
Issued and Long-term assets

Paid up capital 1575 1575 (Net) 1125.00 2047.50
P & L A/c. 157.5 225 Closing stock 337.5 900.00
Mortgage Loan -- 900 Repayment (Relating
Tax un paid (Accured) 22.50 67.50 to Admn. Exp) 45.00 90.00
Trade creditors 315.00 877.50 Sundry debtors 112.50 450.00
Cash 450.00 157.50
2070.00 3645.00 2070.00 3645.00
Statement of Profit for the year ended 31st March 2006

Particulars Rs. '000 Rs. '000
Sales 2250.00
Opening Stock (1-4-97) 337.50
Add: Purchase 2,205.00
2,542.50
( - ) Closing stock (31-3-98) 900.00 1,642.50
Gross Profit 607.50
Less:
Administrative Expenses 247.50
Depreciation 180.00
Taxes [Provision] 90.00 517.50
Net Profit 90.00
( - ) Payment of dividend 22.50
67.50
( + ) Profit & Loss A/c (31-3-2005) 157.50
Balance on 31-3-2006 225.00
On 15th January 2006, a new building was purchased for Rs. 11,02,500. For making the
payment of the building, the company paid a deposit of Rs. 2,02,500 and obtained a mortgage
loan of Rs. 9,00,000 for the balance of purchase price of building.
201
Solution
Working Notes
a) Cash from operations = Net Profit for the year + Depreciation + Tax Provision +
Prepaid Expenses for previous year.
= 90,000 + 1,80,000 + 90,000 + 45,000 = Rs. 4,05,000
b) Taxes Paid = Opening Balance + Provision during the year - Closing Balance
= 22,500 + 90,000 - 67,500 = Rs. 45,000
Cash Flow Statement

Opening Balance 4,50,000 Out Flows
Cash Inflows Purchase of building 11,02,500
Mortgage loan 9,00,000 Increase in stock 5,62,500
Increase in Trade creditors 5,62,500 Increase in sundry debtors 3,37,500
Cash from operations 4,05,000 Payment of Administrative
Expenses 90,000
Taxes Paid 45,000
Closing Balance 1,57,500
23,17,500 23,17,500
Cash Flow Statement

Rs. Rs.

Profit (225 - 157.5) 67.50
Add: Depreciation 180.00
Add: Tax Provision 90.00
Add: Dividends Paid 22.50
Operating Profit before Working Capital Charges 360.00
Add: Increase in Creditors 562.00
992.50
Less: Increase in Closing Stock 562.50
Less: Increase in Prepaid Expenses 45.00
202
Less: Increase in Debtors 337.50
(22.50)
Less: Tax Paid (45.00)
Net Cash Flows from Operating Activities (67.50) (67.50)
Purchase of Building (1,102.50)
Net Cash Flow from Investing Activities (1,102.50) (1,102.50)
Mortgage Loans 900.00
Dividends Paid (22.50)
Net Cash Flows from Financing Activities 877.50 877.50
Net Decrease in Cash and Cash Equivalents 292.50
Cash and Cash Equivalents at the beginning of the Period 450.00
Cash and Cash Equivalents at the end of the Period 157.50
8. The following are the summarised Balance Sheets of a company as on 31st December,
2005 and 31st December, 2006.
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 1,00,000 1,25,000 Land & Buildings 1,00,000 95,000
General Reserve 25,000 30,000 Machinery 75,000 85,500
P & L A/c. 15,250 15,300 Stock 50,000 37,000
Bank Loan Sundry Debtors 40,000 32,100
(Long-term) 35,000 - Cash 250 300
Sundry Creditors 75,000 67,600 Bank - 4,000
Provision for Taxation 15,000 17,500 Goodwill - 1,500
2,65,250 2,55,400 2,65,250 2,55,400
During the year ended 31st December, 2006:
i) Dividend of Rs. 11,500 was paid.
ii) Assets of another company were purchased for a consideration of Rs. 25,000 pay-
able in shares. The following assets were purchased:
Stock Rs. 10,000, Machinery Rs. 15,000
iii) Machinery was further purchased for Rs. 4,000
iv) Depreciation written off on Machinery is 6,000
203
v) Income tax provided during the year Rs. 16,500
vi) Loss on sale of machinery Rs. 100 was written off to general reserve.
You are required to prepare a cash flow statement.
Solution

To Balance b/d. 75,000 By Adjusted P & L A/c.

To Share Capital 15,000 (Depreciation) 6,000
To Cash 4,000 By Cash Sale (B/F) 2,400
By General Reserve (Loss) 100
94,000 94,000
Dr. Land & Buildings A/c. Cr.

To Balance b/d. 1,00,000 By Adj. P & L A/c (Dep. B/F) 5,000
1,00,000 1,00,000

To Cash - Taxes paid (B/F) 14,000 By Balance b/d. 15,000

To Balance c/d. 17,500 By Adj. P & L A/c. 16,500
31,500 31,500
Dr. General Reserve A/c. Cr.

To Machinery A/c. By Balance b/d. 25,000

(Loss on sale) 100 By Adj. P & L A/c (B/F) 5,100
30,100 30,100
204
Adjusted Profit & Loss A/c.
To General Reserve 5,100 By Balance b/d. 15,250

To Provision for taxation 16,500 By Cash operating profit (B/F) 44,150
To Dividend Paid 11,500
To Depreciation on Machinery 6,000
To Dep. on Land & Building 5,000
59,400 59,400

Balance of Cash & Bank Outflow of Cash
(1-1-2000) 250 Payment of Bank Loan 35,000
Add: Sources of Cash inflow Decrease in creditors
issues of share capital 25,000 (75,000 - 67,600) 7,400
Decrease in stocks Purchase of machinery
(50,000 - 37,000) 13,000 (15,000 + 4,000) 19,000
Decrease in debtors Purchase of Goodwill 1,500
(40,000 - 32,100) 7,900 Payment of dividend 11,500
Sale of machinery 2,400 Payment of Tax 14,000
Cash Operating Profit 44,150 Closing Balance of Cash
and Bank (31-12-2000) 4,300
92,700 92,700
Cash Flow Statement

Rs. Rs.
Profit and Loss Account (15,200 - 15,250) 50
Add: General Reserve 5,100
Dividends 11,500
Depreciation on Machinery 6,000
Depreciation on Building 5,000
Cash Operating Profit before Working Capital Changes 44,150
205
Derecase in Debtors 7,900
65,050
Less: Decrease in Creditors 7,400
57,650
Less: Tax Paid 14,000
Purchase of Goodwill (1,500)
Purchase of Machinery (1,900)
Issue of Share Capital 25,000
Payment of Bank Loan (35,000)
(21,500) (21,500)
Cash and Cash Equivalents at the beginning of the Period 250
9. A company finds on 1st Jan. 2007 that it is facing shortage of funds with which to imple-
ment its expansion programme. On 1st Jan, 2006 it has a bank balance of Rs. 1,80,000.
From the following information, prepare a statement for the board of directors to show
how the overdraft of Rs. 68,750 as at 31.12.2006 has arisen. Figures as per the Balance
Sheets as on 31st December.
Particulars 31.12.2005 31.12.2006
Rs. Rs.
Fixed Assets 7,50,000 11,20,000
Stock & Stores 1,90,000 3,30,000
Debtors 3,80,000 3,35,000
Bank Balance 1,80,000(Dr.) 68,750 (Cr.)
Trade Creditors 2,70,000 3,50,000
Share Capital in shares of Rs. 10 each 2,50,000 3,00,000
206
The Profit for the year ended 31st Dec. 2006 before charging depreciation taxation
amounted to Rs. 2,40,000. 5,000 shares are issued on 1st Nov. 2006 at a premium of Rs. 5/- per
shares Rs. 1,37,500 was paid in March, 2006 by way of income tax. Dividend was paid as
follows:
2005 (Final) on capital at 31/12/2005 less tax 25%.
2006 interim dividend 5% free of tax.
Solution
Working Notes
i) Cash from operation during 2006.
Profit before taxation and depreciation as given in the problem is nothing but cash from
operations made during the year. Hence, the question of ascertaining cash from opera-
tions does not arise.
ii) Final Dividend (2005)
Rs.
@ 10% on capital as on 31/12/2005 (i.e. 2,50,000) = 25,000
Less: Tax @ 25% = 6,250
∴ Final dividend paid => 18,750
iii) Interim Dividend (2006)
@ 5% on share capital of Rs. 3,00,000 (Tax free) = Rs. 15,000
Cash Flow Statement

Opening Bank Balance (Dr) 1,80,000 Outflow of Cash
Add: Cash inflows Purchase of fixed assets 3,70,000
Cash from operations 2,40,000 (11,20,000-7,50,000)
Issue of shares Income Tax paid 1,37,500
(3,00,000 - 2,50,000) 50,000 Dividend Paid
Share Premium (500 x 5) 25,000 Final (2005) 18,750
Increase in Trade creditors Interim (2006) 15,000
(3,50,000 - 2,70,000) 80,000 Increase in stock
Decrease in debtors (3,30,000 - 1,90,000) 1,40,000
(3,80,000 - 3,35,000) 45,000 Increase in B/R
Closing Balance of (95,000 - 87,500) 7,500
Bank (O.D.) c/d 68,750
6,88,750 6,88,750
207
Cash Flow Statement
Rs. Rs.

Operating Profit 2,40,000
Decrease in Debtors 45,000
Less: Increase in Stock 1,40,000
Increase in B/R 7,500
Tax Paid 1,37,500
Purchase of Fixed Assets (3,70,000)
Net Cash Flows from Investing Activities (3,70,000) (3,70,000)
Issue of Shares 50,000
Issue of Share Premium 25,000
Dividends Paid : Final (18,750)
: Interim (15,000)
Net Cash Flows from Financing Activities 41,250 41,250
Net Decrease in Cash and Cash Equivalents (2,48,750)
Cash and Cash Equivalents at the beginning of the Period 1,80,000
Cash and Cash Equivalents at the end of the Period (OD) (68,750)
10. The financial position of M/s. A & B on 1st July 2005 and on 30th June 2006 was as
follows:
Particulars 1.7.2005 30.6.2006

Rs. Rs.
Assets
Cash 4,000 3,600
Debtors 35,000 38,400
Stock 25,000 22,000
Land 20,000 30,000
Buildings 50,000 55,000
Machinery 80,000 86,000
Total 2,14,000 2,35,000
208
Mrs. A's Loan - 20,000
Loan from Bank 30,000 25,000
Capital 1,48,000 1,49,000
Total 2,14,000 2,35,000
During the year, the partners withdrew Rs. 26,000 for domestic expenditure. The provi-
sion for depreciation against machinery as on 1.7.2005 was Rs. 27,000 and on 30.6.2006 Rs.36,000.
You are required to prepare cash flow statement as well as funds flow statement.
Solution
Working Notes
i) Net Profit for the year 2005-06
Rs.
Capital (30-6-2006) 1,49,000
Add: Drawings made during the year 26,000
1,75,000
Less: Capital as on (1-7-2005) 1,48,000
∴ Net Profit for the year 27,000
ii) Cash or Funds from operations

Rs.
Net Profit for the year 2005-06 27,000
Add: Depreciation on machinery provided during the year (36,000-27,000) 9,000
∴ Cash / Funds from operation 36,000
iii) Purchase of Machinery during the year 2005-06.
To Balance b/d 80,000 By Depreciation A/c 9,000
To Cash A/c purchase (B/F) 15,000 By Balance c/d 86,000
95,000 95,000
209
Cash Flow Statement for the year ending 30th June, 2006 (Traditional Method)
Opening Cash Balance (1-7-2005) 4,000 Outflow of Cash

Add: Cash inflows Purchase of machinery 15,000
Cash from operations 36,000 Land (30,000-20,000) 10,000
Loan from Mrs. A 20,000 Buildings (55,000-50,000) 5,000
Decrease in stock Drawings 26,000
(25,000-22,000) 3,000 Bank Loan Repaid
Increase in current liabilities (30,000-25,000) 5,000
(41,000 - 36,000) 5,000 Increase in debtors
(38,400 - 35,000) 3,400
Closing Cash Balance
(30-6-2006) 3,600
68,000 68,000
Cash Flow Statement

Rs. Rs.
Net Profit 27,000
Add: Depreciation 9,000
Cash Operating Profit 36,000
Increase in Current Liabilities 5,000
44,000
Purchase of Mechinery (15,000)
Purchase of Land (10,000)
Purchase of Buildings (5,000)
210
Loan from Mrs. A 20,000
Drawings (26,000)
Bank Loan Repaid (5,000)
Net Decrease in Cash and Cash Investments (400)
Statement of Changes in Working Capital
Particulars 1-7-2005 30-6-2006

Rs. Rs.
Current Assets
Cash 4,000 3,600
Debtors 35,000 38,400
Stock 25,000 22,000
Total 64,000 64,000
36,000 41,000
Working Capital (CA - CL) 28,000 23,000
Net decrease in Working Capital - 5,000
28,000 28,000
Funds Flow Statement for the year ended 30-6-2006

Funds from operations 36,000 Purchase of machinery 15,000
Loan from Mrs. A 20,000 Land 10,000
Decrease in working capital 5,000 Buildings 5,000
Drawings 26,000
Bank Loan 5,000
61,000 61,000
5.9 SUMMARY
In a business organisation, cash flow study helps the analyst to follow the directional flow
of funds. It helps him to find answers to the questions that are not addressed by the profitability
analysis. No financial analysis is, therefore, complete without analysing the movement of funds.
211
Many Indian corporates are now presenting a cash flow statement along with other aspects. It is
only through cash flow analysis that meaningful answers to the following queries are found: What is
the internal accrual during the year? What has happened to the profit generated during the year?
Why dividend pay out is high or low considering the PAT? How are assets financial during the year?
Was there any diversion of funds during the year?
1. Explain the concept of "Cash Flow". Discuss the objectives of cash flow analysis.
2. Explain clearly the difference between funds flow and cash flow statement.
3. Discuss the procedure of preparing a cash flow statement.
4. Write the procedures of ascertaining cash from operations as required for the preparation of
a cash flow statement.
5. Explain the major sources and application of cash with examples.
6. Discuss the advantages and limitations of cash flow statement.
7. What is the purpose of preparing a cash flow statement? How is it prepared?
8. Following are the comparative Balance Sheets of TFAI Ltd.
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital 1,80,000 1,90,000 Cash 60,000 40,000
Sundry Creditors 64,000 76,000 Sundry Debtors 1,55,000 1,90,000
P & L A/c 29,000 35,600 Land & Building 50,000 62,000
Patent Rights 8,000 9,000
2,73,000 3,01,000 2,73,000 3,01,000
Prepare a cash flow statement
9. Prasad Max Co. Ltd. wants to prepare a 'Cash Flow' statement for the year ended December
31, 2006 from the details given below:
a) Income statement for the year ended 31-12-2006.

Sales - 29,000
Cost of sales - 19,900
Tax Provision - 2,500
Dividend Provided - 1,600
212
b) Balance Sheets
(Rs.) (Rs.) (Rs.) (Rs.)
Capital 8,000 8,000 Fixed Assets (Gross) 12,000 18,500

Reserves & Surplus 6,000 11,000 Depreciation (3,500) (5,500)
Bank Loan Inventory 8,000 7,000
(Long-term) 4,000 6,000 Accounts Receivable 4,000 6,800
Current Liabilities 3,000 5,200 Cash 500 5,000
Dividend Provided - 1,600
21,000 31,800 21,000 31,800
10. From the following condensed balance sheets of Sabha Ltd. and additional information
prepare Cash Flow Statement.
Comparative Balance Sheet
(Rs.) (Rs.) (Rs.) (Rs.)
Share Capital Machinery 62,000 62,000
(Rs. 10 each) 79,000 91,000 Accumulated
Retained Earnings 23,820 30,820 dep. on machinery (37,000) (26,200)
7% Mortgage Loan - 20,000 Building 1,05,000 1,28,000
Sundry creditors 6,900 6,000 Accumulated dep.
Outstanding salaries 2,000 1,400 on building (43,000) (45,000)
Provision for taxation 1,000 1,400 Stock 10,220 9,620
Debtors 9,320 8,400
Cash 6,180 9,800
1,12,720 1,50,620 1,12,720 1,50,620
i) Plant costing 12,000 (Accumulated depreciation 10,000) was sold during the year
for Rs. 1,500.
ii) Buildings were acquired during the year at a cost of Rs. 21,000 in addition to a cash
payment of Rs. 1,000 a 7% mortgage loan was raised for the Balance.
iii) Dividends Rs. 8,000 were declared during the year.

iv) A sum of Rs. 12,000 was transferred to provision for taxation account.
v) Net income before tax was Rs. 28,900.

213
11. The Balance Sheet of RKS Electronics Limited are as follows:
Balance Sheet

(Rs.) (Rs.) (Rs.) (Rs.)
Equity 800 900 Fixed Assets 600 800

General Reserve 300 400 Additions 200 100
P & L Account 200 300 800 900
Provision for Taxation 300 400 Depreciation 300 350
Overdraft 300 464 500 550
Sundry creditors 1,200 1,000 Investments 200 -
Proposed Dividends 80 90 Stock 1,400 1,230
Stock Debtors 1,080 1,774
3,180 3,554 3,180 3,554
Dr. Profit and Loss A/c. Cr.

(Rs.) (Rs.) (Rs.) (Rs.)
To Taxation 250 450 By Trading Profit 430 660
To Proposed dividend 80 90 By Profit on sale of
To Transfer to investment - 30
General Reserve 100 100 By Income tax excess
To Balance c/f 200 300 provided in the previous
year - 50
By Balance from last
year 200 200
630 940 630 940
i) For the year ending 31st December, 2006 purchases were Rs. 60 lakhs and sales
Rs. 70 lakhs.
ii) Trading Profit for the year ended 31st December, 2006 was arrived at after charg-
ing depreciation Rs. 50,000 and directors remuneration Rs. 1,20,000
Prepare a Cash Flow Statement.
214
12. Prepare a Cash Flow Statement for the year 2006 from the following information:
Income statement for the year 2006
Rs.
Sales
Less: Cost of Sales 2,00,000
(Including Rs. 2,000 depreciation) 1,50,000
Gross Profit 50,000
Less:
Selling and Administrative Expenses 10,000
Interest on Loan 1,000
Other Expenses 5,000
16,000
Net Profit 34,000
Balance Sheet
Rs. Rs.
Assets
Cash in hand and at Bank 15,000 13,000
Investments 5,000 15,000
Debtors 40,000 30,000
Stock 65,000 80,000
Plant & Machinery 2,50,000 2,98,000
3,75,000 4,36,000
Liabilities
Creditors 55,000 45,000
Outstanding Expenses (Selling & Admn.) 5,000 2,000
Accumulated depreciation 8,000 10,000
Loans 15,000 25,000
Share Capital 1,72,000 2,00,000
Reserves 1,20,000 1,54,000
3,75,000 4,36,000
1. Brigham, E.F. : Fundamentals of Financial Management,Dryden

Press, Chicago.
215
2. James C, Van Harne : Financial Management and Policy,Prentice-Hall of
India, New Delhi.
3. Khan., M.Y & Jain P.K. : Financial Management-Text and Problems,Tata

4. Kulkarni P.V. : Financial Management A Conceptual Approach

,
Himalaya Publishing, Bombay.
5. Maheshwari S.N. : Financial Management: Principles and Practice,Sul-

tan Chand & Sons, New Delhi.
6. Pandey I.M. : Financial Management,Vikas Publishing House, New

Delhi.
7. Prasanna Chandra : Financial Management :Theory and Practice,Tata

5.12 KEY WORDS
Cash Flow Statement : A statement which provides a detailed explanation for the
change in a firm's cash during a particular period by indicat-
ing the firm's sources and uses of cash during that period.
Cash Flow : Refers to the sum of net income and those non-fund charges,
all types of amortised and book transfers which do not affect
the total quantity of funds in use.
Cash From Operations : It is a major source of cash flow into the business.
CFO = Cash Sales - Cash Purchases and Cash Operating
Expenses.
Outstanding or Accured Income: It is an income due to be received, it is credited to profit and
loss account but no cash is received. Hence, it is deducted
from sources from these operations.
Pre-received Income : It is an income received in advance. If there is any pre-re-
ceived income in the current year, it is shown as inflow of
cash in CFS. However, if there is any pre-received income
(in previous year), it is deducted from sources from opera-
tions, while ascertaining cash from operations.
Operating Activities : Operating Activities are the principal revenue producing ac-
tivities of the enterprise.
Investing Activities : Investing activities are the requisition and disposal of long-
term assets and investments not included in cash equivalents.
Financing Activities : Financing activities are activities that result in changes in the
size and composition of the owners capital and borrowings
of the enterprise.
216
GUIDELINE 6 : INTERNATIONAL DIMENSIONS OF
ACCOUNTING PROFESSION
OBJECTIVES
After studying this guideline, you should be able to:After studying this guideline, you should be able
to:
• The need for International Accounting Profession
• International Dimensions of accounting profession
• Need for harmonisation of accounting profession
• The role of IASB
STRUCTURE
6.1 Introduction
6.2 Reasons for International differences
6.3 Definition and meaning of International accounting
6.4 International dimensions of accounting profession
6.5 Harmonization
6.5.1 The need for harmonisation
6.5.2 Bodies concerned with harmonization
6.6 The role of IASC & IASB
6.7 IFRS
6.8 Convergence
6.9 Summary
6.10 Keywords
6.1 INTRODUCTION
The basic objective of financial reporting is to communicate information about the financial performance
of the company to all stake holders. The information needs of various users differ from one another.
In recent years, the scope of financial reporting has undergone a remarkable change. With the dramatic
growth in global trade and the accelerated internationalisation of capital markets, financial statements
prepared in one country are used in other counties more and more frequently. Investors would
ideally like to take their investment d3cisions globally, provided they are able to understand these
financial statements. However if the accounting practices between countries are different, they may
act as a barrier to many investors to take investment or capital decisions globally.
Technology and the growing potential of E- Commerce put international business within the
reach of small locally based companies as well as larger transnational corporations. The advent of E-
217
Business opportunities, coupled with improvements in telecommunications and increasingly flexible
work arrangements, have made the accountant increasingly mobile and able to perform services
from a wide variety of places.
Increasingly, the products of accounting in one country are used in various other countries.
Consequently the reasons that make national accounting standards desirable also apply internationally.
The pressure for international harmonisation comes from those who regulate, prepare and use financial
statements. For this reason, carious inter-governmental transnational bodies, including the European
Union, are interested, among things, in protecting investors within their spheres of influences.
Also, in cases, where foreign shares are quoted on the domestic stock exchange of an
investor, that stock exchange or its regular may demand financial statements that are consistent with
domestic practices. In addition, those companies that wish to issue new shares more widely that on
their domestic markets will see the advantages of standardized practices in the promotional of their
issues.
6.2 REASONS FOR INTERNATIONAL DIFFERENCE IN FINANCIAL REPORTING
International differences in financial reporting are many and various. These differences include
external environment and culture. Culture in any country contains the most basis values that an individual
may hold. It affects the way that individuals would like their society to be structured and the way they
interact with its substructure. Accounting may be seen as one of those substructures getting affected
by the culture and external environment.
The financial system that exists in a country also fairly affected that quality of accounting
profession and reporting practice. The strength, size and competence of the accountancy profession
in a country may also influence that type of financial reporting practices existing in a country. Another
factor which affects accounting practices is the level of inflation. Factors that might be relevant further
include language, history, geography, religion, eduction and others.
Due to these differences the financial reporting practices of companies in different countries
leads to great complications for those preparing, consolidating, auditing and interpreting published
financial statements.
To combat this, several organisations through the world are involved in attempts to harmonize or
standardize accounting.
6.3 DEFINITION OF INTERNATIONAL ACCOUNTING
There is no universally agreed definition of International accounting the reason being the
existences of numerous aspects of accounting that have an international dimension. An analysis of the
literature on the subject reveals four different approaches to its definition.
Universal or World Accounting:Under this approach, international accounting would mean a
universal system of accounting that could be adopted in all countries. In the framework of this concept,
international accounting is considered to be a universal system where there are uniformity in accounting
principles and practices. Harmonization of accounting standards and principles can be achieved
through convergence process which is the need of hour; though a universal system of accounting
appears to be a distant dream.
218
International Accounting: A second major concept of international accounting involves a descriptive
and informative approach. Under this concept, international dimension of accounting profession includes
all varieties of principles, methods, and standards of accounting in all countries. This concept includes
a set of generally accepted accounting principles established for each country, thereby requiring the
accountants to be multiple principles-conscious when studying international accounting.
Accounting for foreign subsidiaries/Multinational accounting: This approach refers to the
accounting practices of a parent and a foreign subsidiary. Under this approach, the accountant is
concerned mainly with the currency translation, transfer pricing, foreign exchange risk management,
accounting for foreign inflation, performance evaluation of foreign segments and consolidation of
accounts that are arising out of multinational transactions.
Politicised International Accounting: This approach emanates from the involvement of world
political institutions such as the United Nations and the Organization for Economic Cooperation and
Development in the harmonization of International accounting practices.
To sum up, International Accounting may be defined as that branch of accounting which
analyses the different accounting principles and practices prevalent around the globe, deals with the
specific technical problems encountered by individuals and MNCs in international operations and as
its ultimate goal, attempts to develop a universal system of accounting that would receive acceptance
the world over.
6.4 INTERNATIONAL DIMENSIONS OF ACCOUNTING
International Accounting covers different dimensions of accounting profession at global
level. It covers a comparative study of financial accounting principles and practices in different
countries. It also includes management accounting principles and practices of multinational businesses.
It covers the harmonization process taking place for convergence of accounting principles and practices
by various organizations at National and International level.
The following three dimensions are discussed below:
1. International Financial Accounting
2. International Management Accounting
3. Harmonization process
219
Globalisation of Business and Services
Cross Boarder Investments and

Borrowings
Cross Currency Crisis
International Accounting
International Financial International

Accounting Management
Accounting
Harmonization of
1. Transfer pricing
1. Translation Accounting Practices
2. Foreign
2. Consolidation
Currency Exchange
3. Taxation Risk Management
International
Financial Reporting
Fig.1 showing International dimensions of accounting profession

6.5 WHAT IS HARMONISATION?
‘Harmonisation’ is a process of increasing the compatibility of accounting practices buys
setting bounds of limits to their degree of variation.‘Standardization’ on the other hand refers to the
220
imposition of a more rigid and narrow set of rules.Convergence is a continuous process of ensuring
that the Generally Accepted Accounting Principles (GAAP) are formulated, aligned and updated to
international best practices (GAAPs in other countries) with suitable modifications and fine tuning
considering the domestic conditions.
6.5.1 The need for Harmonization
The number and magnitude of the differences among accounting practices across the globe
make clear the scope for harmonization. Some of the benefits of harmonization are as under:
Ø It enables a systematic review and evaluation of performance of a multinational

company having subsidiaries and associates in various countries where in each country
has its own set of GAAP.
Ø It makes the comparison of the performance of a company against its domestic and
international peers easier and more meaningful
Ø It adds international credibility to a company
Ø It provides a level playing field where no country is advantaged or disadvantaged by

its GAAP
Ø It ensures high quality financial information and disclosures.

6.5.2 Bodies concerned with harmonization: The accountancy profession has long recognised
the need for a globally harmonised accountancy framework. More than thirty years ago the accountancy
profession tool the initiative in creating the international accounting standards committee (IASE) and
the international federation of accountants (IFAC) to produce guidance in response to the increasingly
international demands of the business community. It is currently up to and should remain up to these
two bodies to develop internationally harmonised standards for the prepartati8on and verification of
corporate information.
There are a number of bodies concerned with harmonization process. There are classified as follows:
NATURE WORLD REGIONAL
Governmental UN,OCED,IOSCO EU
Professional IASC, IFAC FEE

6.6 THE ROLE OF INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE
(IASC)
Of the many bodies working for international standardization to be looked at, IASC is perhaps
the most important and the most successful. The IASC was funded in 1973 and has a secretariat
based in London. The original board members were the accountancy bodies of nine countries i.e.
Australia, Canada, France, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, the
United States of America and West Germany. International Accounting standards (IASs) were issued
by the international Accounting Standards Committee from 1973 to 2000.
221
The key role of IASC is to develop and promulgate International Accounting Standards (IASs). It
does so using due process, exposing its ideas for early discussion and subsequently for comment
once an exposure draft has been prepared. The final standard is eventually produced after appropriate
consideration comments received. A standing interpretations Committee looks at urgent issues arising
either from the existing standards or as a result of new concerns relating to existing standards world
wide.
The International Accounting Standard Board (IASB) replaced the IASC in 2001. Since then,
the IASB has proposed to replace some IASs with new international financial reporting standards
(IFRSs), and has adopted or proposed certain IFRSs on topic for w2hich there was no previous
IAS.
The IASB, based in London, began operations in 2001. It is funded by contributions collected by its
trustees, the IASC foundation, from the major accounting firms, private financial institutions and
industrial companies through out the world, central and development banks, and other international
and professional organisations. The 14 IASB members (12 of whom are full-time) are drown from
nine countries and have a variety of professional back grounds. The IASB is committed to developing,
in the public interest, a single set of high quality, global accounting standards that require transparent
and comparable information in general purposes financial statements. In pursuits of this objective, the
IASB Co- operates with national accounting standard- setters to achieve convergence in accounting
standards around the world.
The IASB is committed to developing a single set of high quality, global accounting standards that
require comparable information in general purpose financial statements. In fulfilling its objective, the
IASB co- Operates with national accounting standard –setter convergence in accounting standards
around the world.
6.7 WHAT IS IFRS?
IFRS refers to the entire body of IASB pronouncements, including standards and interpretations
approved by the IASB and IASs and SIC interpretations approved by the predecessor international
Accounting Standards Committee (IASC)
It means IFRI includes
§ IFRS issued by IASB
§ IAS issued by IASC
§ Interpretation issued by SIC
§ Interpretations issued by IFRICs
IFRS 1, First – Time Adoption of international Financial Reporting Standards
IFRS 2, Share based payment
IFRS 3, Business Combinations
IFRS 4, Insurance Contracts
IFRS 5, Non- Current Assets Held for sale and Discontinued operations
The IASB has no authority to enquire compliance with its accounting standards. However,
many countries require the financial statements to be prepared in accordance with IFRS and to give
particulars of any material departure from those standards and the reasons for it.
222
About the IFRIC
The IRRIC is the interpretative arm of the IASB and first met in February 2002. it comprises 12
voting members (all part- time) drawn from a variety of countries and professional backgrounds, and
it meets about nine times a years under a non voting chairman. The IFRIC’s principal roles is to
consider, on a timely basis within the context of international financial reporting standards and the
IASB framework, Accounting issues that are likely to receive divergent or unacceptable treatment in
the absence of authoritative guidance, with a view to reaching consensus on the appropriate accounting
treatment. In development interpretations, the IFRIC works closely with similar national interpretations
committees.
6.8 CONVERGENCE BETWEEN FASB (USA) AND IASB
A Crucial landmark was reached in October 2002, when the Financial Accounting
Standards Board (FASB) of the USA and the IASB, the world’s most influential accounting standards
board signed The Norwalk Agreementi.e. convergence agreement to create a set of key international
standards.
• The boards have agreed on the following matters:
• To understand a short- term project aimed at removing the various differences
between US GAAP and International financial Reporting Standards (IFRS) which
includes IAS.
• To remove the other differences between the IFRS and US GAAP that will remain
at January 1, 2005 through coordination off their future work programs.
• The two Boards will now be working on drafting towards an agreed principle
based approach including key standards on acquisition, financial performance
and revenue recognition. This is a very importance development in area of
harmonisation of accounting standards and indicates a paradigm shift by the FASB
moving away from its strict” rules based approach’ of the US GAAP towards the
European “ principles based approach”
Both the boards have also decided to use their best efforts to issue an exposure draft of the proposed
changes to US GAAP or IFRS that reflect Common solutions to some and perhaps all of the differences
identified for inclusion in the short term project during the year 2003.
Some of the implications of this agreement are as under:
• Companies would be required to follow the spirit of the principle rather than the
letter of the role
• Companies would have to comply with a single set of accounting principles in the
USA and Europe.
• The former SEC Chairman, Harvey Pitt, has also indicated that if the current
requirements for foreign issues in the USA to reconcile their accounts with US
GAAP may be dropped.
6.9 SUMMARY
International Accounting may be defined as that branch of accounting which analyses the
different accounting principles and practices prevalent around the globe, deals with the specific technical
223
problems encountered by individuals and MNCs in international operations and as its ultimate goal,
attempts to develop a universal system of accounting that would receive acceptance the world over.
International Accounting covers different dimensions of accounting profession at global level. It
covers a comparative study of financial accounting principles and practices in different countries. It
also includes management accounting principles and practices of multinational businesses. It covers
the harmonization process taking place for convergence of accounting principles and practices by
various organizations at National and International level.
6.10 KEYWORDS
Universal or World Accounting:Under this approach, international accounting would mean a
universal system of accounting that could be adopted in all countries.
International accounting: It includes all varieties of principles, methods, and standards of accounting
in all countries. This concept includes a set of generally accepted accounting principles established
for each country, thereby requiring the accountants to be multiple principles-conscious when studying
international accounting.
Multinational accounting: This refers to the accounting practices of a parent and a foreign
subsidiary.
Harmonisation: ‘Harmonisation’ is a process of increasing the compatibility of accounting practices
buys setting bounds of limits to their degree of variation.
Convergence: It is a continuous process of ensuring that the Generally Accepted Accounting
Principles (GAAP) are formulated , aligned and updated to international best practices (GAAPs in
other countries) with suitable modifications and fine tuning considering the domestic conditions.
IFRS: IFRS( International Financial Reporting Standards) refers to the entire body of IASB
pronouncements, including standards and interpretations approved by the IASB and IASs and SIC
interpretations approved by the predecessor international Accounting Standards Committee (IASC)
1. Discuss the factors that have induced the Internationalization of accounting.
2. Define International Accounting. What are the various dimensions of International
accounting? Explain.
3. What is Harmonization of accounting profession? Explain the role IASB in the process of
harmonization of accounting profession.
1. Prof. Shiriene Rathore, International Accounting, New Delhi
2. Samuels, J.M and Piper, International Accounting: A Survey, Croom Helm Ltd.,. London, 1985.
224
GUIDELINE 7 : INDIAN ACCOUNTING STANDARDS
OBJECTIVES
After studying this guideline, you should be able to:After studying this guideline, you should be able to:
v Need for Accounting Standards.
v Objective of Accounting Standards
v Compliance of Accounting standards
v Advantages of Accounting Standards
v Disadvantages of Accounting Standards
v Applicability of Accounting Standards
STRUCTURE
7.1 Introduction
7.2 Objectives of Accounting Standards
7.3 Scope of Accounting Standards
7.4 Procedure for issuing Accounting Standards
7.5 Compliance with the Accounting standards
7.6 Advantages of Accounting Standards
7.7 Disadvantages of Accounting Standards
7.8 Applicability of Accounting standards
7.9 Status of Accounting standards issued by ICAI
7.10 Summary
7.11 Key words
7.12 Self Assessment questions
7.1 INTRODUCTION
Accounting standards are written policy documents issued by expert accounting body or
government or other regulatory bodies covering the aspects of recognization, measurement, treatment,
presentation and disclosure of accounting transactions in the financial statements. The professional
accounting bodies all over the world, take the responsibility of preparing accounting standards. The
main function of accounting standards is to provide a rational structure of framework so that, credible
financial statements of highest quality can be produced. In USA, Financial Accounting Standards
Board (FASB) issue accounting standards. In UK, the Institute of Chartered Accountants of England
and Wales (ICAEW) issues accounting standards. In India, the Institute of Chartered Accountants
of India (ICAI) issues accountings standards and various guidance notes to deal with the matters not
covered by existing accounting standards. In order to harmonise the diverse accounting policies and
225
practices, the ICAI has established Accounting standards Board (ASB) on 21st April, 1977. The
main function of ASB is to formulate accounting standards. In the ASB constitution adequate
representation is given to Industries, Banks, Company Law Board, the Central Board of Direct
Taxes, the Comptroller and Auditor General of India and Securities Exchange Board of India etc.
While formulating Accounting Standards the ASB takes into consideration the applicable Laws,
Customs, usage and business environment. The ASB is a member in the International Accounting
Standards Committee (IASC). While formulating accounting standards in India, it gives due
consideration to the international accounting standards issued by the IASC. The ASB tries to integrate
the Indian Accounting standards with that of International Accounting standards to the possible extent
in the light of conditions and practices prevailing in India. So far, the ASB has issued 29 Accounting
standards. It also reviews the accounting standards at periodical interval.
7.2 OBJECTIVES OF ACCOUNTING STANDARDS
The objective of Accounting Standards is to standardize the diverse accounting policies and
practices with a view to eliminate to the extent possible the non comparability of financial statements
and add reliability to the financial statements.
7.3 SCOPE OF ACCOUNTING STANDARDS
The Accounting standards (AS) are formulated in conformity with the applicable Laws,
Customs, Usages and Business Environment of our country. They provide reasonable degree of
flexibility and subjectivity in response to specific circumstances, legal requirements, social needs and
Technological developments etc. The ICAI persuade the government, appropriate authorities, industrial
houses and business community to adopt the standards inorder to achieve uniformity in the preparation
of financial statements. The whole idea of Accounting Standards is centered around harmonization
of Accounting policies and practices followed by business firms. The harmonization of Accounting
policies is needed at national and international level.
7.4 PROCEDURE FOR ISSUING ACCOUNTING STANDARDS
The following procedure is followed for issuing Accounting Standards by the ICAI.
I. The ASB shall determine the broad areas in which AS need to be formulated and the
priority in regard to selection thereof.
II. In the preparation of AS, the ASB will be assisted by study groups and members of the
institute.
III. ASB will also ascertain the opinions of the Government, PSUs, Industry and other
organizations.
IV. On the basis of the work of the study groups and dialogue with the organizations referred
above an exposure draft of the proposed standard will be prepared and issued for comments
by the members of the institute and the public at large.
V. After taking into consideration the comments received, the draft of the proposed standard
will be finalized by the ASB and submitted to the council of the institute.
VI. The council of the institute will consider the final draft of the proposed standard and if found
necessary modify the same in consolation with ASB. The AS on the relevant subject will
then be issued under the authority of the council.
226
7.5 COMPLIANCE WITH THE ACCOUNTING STANDARDS
According to the Companies Act, 1956, Section 211, Sub-Section 3(A) requires that every
profit and Loss Account and Balance Sheet shall comply with the Accounting Standards. It is the
duty of the members of the institute to ensure that the Accounting Standards are implemented in the
presentation of financial statements covered by their audit reports. In the event of any deviation from
the standards it is the duty of auditors to make adequate disclosure in their reports so that users of
such statements are aware of such deviations. It is also the duty of the auditors that the mandatory
AS issued by ICAI are implemented by the organizations.
7.6 ADVANTAGES OF ACCOUNTING STANDARDS
The following are the advantages of Accounting Standards.
v Standards reduce to a reasonable extent or eliminate altogether confusing variation in the
accounting treatments used to prepare the financial statements.
v There are certain areas where important information is not required by law to be disclosed,
standards may call for disclosure beyond that required by law.
v It facilitates comparison of financial statements of different companies situated at different
places.
7.7 DISADVANTAGES OF ACCOUNTING STANDARDS
The disadvantages of setting Accounting Standards are :-
v There may be a trend towards rigidity and away from flexibility in applying accounting
standards.
v Differences in accounting standards are bound to be because of differences in the traditions
and legal system from one country to another.
v Accounting standards cannot override the law. The standards are required to be framed
within the ambit of prevailing statute even though it is not an acceptable standard.
7.8 APPLICABILITY ACCOUNTING STANDARDS
For the purpose of applicability of Accounting Standards the enterprises are classified into
3 categories. Level – I enterprises, Level – II enterprises and Level – III enterprises.
Level – I enterprise – Enterprises which fall in any one or more of the following categories, at any
time during the accounting period, are classified as Level – I enterprises :
v Enterprises whose equity or debt securities are listed whether in India or outside India.
v Enterprises which are in the process of listing their equity or debt securities as evidenced by
the board of directors’ resolution in this regard.
v Banks including co-operative banks.
v Financial institutions.
v All commercial, industrial and business reporting enterprises, whose turnover for the
immediately preceding accounting period on the basis of audited financial statements exceeds
Rs. 50 crores. Turnover does not include ‘other income’.
227
v All commercial, industrial and business reporting enterprises having borrowings, including
public deposits, in excess of Rs. 10 crores at any time during the accounting period.
v Holding and subsidiary enterprises of any one of the above at any time during the accounting
period.
Level – II Enterprise – Enterprises which are not Level – I enterprises but fall in any one or more
of the following categories are classified as Level – II enterprises:
v All commercial, industrial and business reporting enterprises, whose turnover for the
immediately preceding accounting period on the basis of audited financial statements exceeds
Rs.40 Lakhs but does not exceed Rs.50 crores. Turnover does not include ‘other income’.
v All commercial, industrial and business reporting enterprises having borrowings, including
public deposits, in excess of Rs.1 crore but not in excess of Rs.10 crores at any time during
the accounting period.
Level – III enterprises – Enterprises which are not covered under Level – I and Level – II are
considered as Level – III enterprises.
7.9 STATUS OF ACCOUNTING STANDARDS ISSUED BY ICAI
Status of the Accounting Standards Issued by the Institute of Chartered Accountants of India.
Number of the Title of the Accounting Standard Date from Enterprises

Accounting which to which
Standard (AS) mandatory applicable
(accounting
periods
commencing
on or after)
AS 1 Disclosure of Accounting Policies 1-4-1993 All
AS 2 (Revised) Valuation of Inventories 1-4-1999 All
AS 3 (Revised) Cash Flow Statement 1-4-2001 Level – I
AS 4 (Revised) Contingencies and Events Occurring 1-4-1998 All
after the Balance Sheet Date
AS 5 (Revised) Net Profit or Loss for the Period, Prior 1-4-1996 All
Period Items and Changes
in Accounting Policies
AS 6 (Revised) Depreciation Accounting 1-4-1995 All
AS 7 (Revised) Construction Contracts 1-4-2002 All
AS 8 Withdrawn and included in AS – 26 All
AS 9 Revenue Recognition 1-4-1993 All
AS 10 Accounting for Fixed Assets 1-4-2003 All
AS 11 The Effects of Changes in Foreign 1-4-2004 All
(revised – 2003) Exchange Rates
AS 12 Accounting for Govt. grants 1-4-1994 All
AS 13 Accounting for Investments 1-4-1995 All
AS 14 Accounting for Amalgamations 1-4-1995 All
228
AS 15 Accounting for Retirement 1-4-1995 All
Benefits in the Financial
Statements of Employers
AS 16 Borrowing Costs 1-4-2000 All
AS 17 Segment Reporting 1-4-2001 Level - I
AS 18 Related Party Disclosures 1-4-2001 Level - I
AS 19 Leases 1-4-2001 All
AS 20 Earning Per Share 1-4-2001 Level – I,
Refer – ASI -
12
AS 21 Consolidated Financial Statements 1-4-2001 See Note 1
AS 22 Accounting for Taxes on Income 1-4-2001 - For Listed
Companies
1-4-2002 - Companies
other than
listed
1-4-2006 - All
AS 23 Accounting for Investment in Associates
in consolidated
Financial Statements 1-4-2002 See Note 1
AS 24 Discontinuing operations 1-4-2004 Level – I
AS 25 Interim Financial Reporting 1-4-2002 Level - I
AS 26 Intangible Assets 1-4-2003 All
AS 27 Joint Financial Reporting of Interests in 1-4-2002 See Note - 1
Ventures
AS 28 Impairment of Assets 1-4-2004 - Level –I
1-4-2006 -Level-II
1-4-2008 -Level-III
AS 29 Provisions, Contingent liabilities and 1-4-2004 All
Contingent Assets
Note : Accounting Standard – 21, Accounting Standard – 23 and Accounting Standard – 27 (relating
to consolidated financial statements) are required to be complied with by an enterprise if the enterprises
pursuant to the requirement of a statute / regulator or voluntarily, prepares and presents consolidated
Accounting Standard – 1 Disclosure of Accounting Policies :
Accounting policies refers to specific accounting principles and the method of applying those
principles adopted by the enterprise in preparation and presentation of financial statements. At the
time of preparation of financial statements there are many areas which have more than are method of
accounting treatment, for example.
v Methods of Depreciation – Depreciation can be changed by using either straight line method
written Down Value method Annuity method etc.
v Treatment of expenditure during construction - The following methods are used
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§ Written off
§ Capitalisation
§ Deferment
v Conversion or translation of foreign currency item – the average rate or TT buying rate may
be used
v Valuation of in various inventions can be valued by using FIFO, LIFO, weighted average,
standard cost Retail method etc. Similarly while assessing the valuation of investment, Treatment
of Retirement Benefits, valuation of fixed assets, Treatment of contingent liabilities and in
many other areas more than one method can be followed for accounting the above item.
What method has been followed in preparation of Balance Sheet and Profit and Loss account
are to be disclosed as accounting policies. The statements of accounting policies are parts of
If there is any change in accounting policies in preparation of financial statement from one
period to subsequent period and such change affects the state of affair of balance sheet and
profit and loss account of current period such change must be disclosed in financial statement.
The amount, by which the financial statement is affected, should be disclosed to the extent
possible.
Accounting Standard – 2 Valuation of inventories:
The objective of this standard is to formulate the method of computation of cost of inventories
or stock, determine the value of closing stock / inventory at which the inventory is to be shown in
balance sheet till it is not sold and recognized as revenue. According to Accounting Standards – 2
inventories are to be valued at lower of cost and net realizable value.
Accounting Standard – 3 Cash Flow Statement:
Cash Flow Statement provide additional information to the users of financial statements.
This statement, exhibits the flow of incoming and outgoing cash. This statement assesses the ability
of the enterprise to generate cash and to utilize the cash. This statement is one of the tools for
assessing the liquidity and solvency of the enterprise. Accounting Standard –3 is applicable to the
enterprises:
I. Which have a term over of more than Rs.50 Crores in a financial year
II. Limited companies, shares of those companies are listed in stock exchange cash flow statement
of listed companies shall be presented only under the indirect method as prescribed in Accounting
Standards – 3.
Accounting Standard – 4 Contingencies and events occurring after the Balance Sheet Date
:
The main objective of this standard is to prescribe the accounting of contingencies and events
which take place after the balance sheet date, but before approval of balance sheet by Board of
Directors. This accounting standard deals with :
I. Contingencies and
II. Events occurring after the balance sheet date.
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Accounting Standard – 5 Net profit (or) Loss for the period, Prior period items and change
in Accounting Policies :
The objective or this standard is to prescribe the criteria for certain items in the profit and
loss account, so that comparability of the financial statement can be enhanced. Profit and lost account
being a period statement covers all items of the income and expenditure of that particular period.
However, if a particular income or expenditure appearing in the profit and loss account may not
relates to that period. What should be the accounting treatment and presentation of such item in the
Profit and Loss account is prescribed by this accounting standard. This accounting standard also
deals with change in accounting policy, accounting estimates and extra ordinary items.
Accounting Standard – 6 Depreciation Accounting :
Depreciation is nothing but distribution of total cost of asset over its useful life. It is a measure
or wearing out, consumption or other loss of value of a depreciable asset arising from use, passage
of time. This accounting standard is applecable to all depreciable assets except forests, plantations,
wasting assets, minerals, Natural Gas, expenditure or R & D, Good will, Live stock, Cattle, Animal
Husbandary etc. This standard explains the procedure for calculation of depreciation on assets.
Accounting Standard – 7 Construction Contracts (Revised) :
Accounting for longterm constructions contracts involve question as to when revenue should
be recognized and how to measure the revenue in the books of contractor. As the period of
construction contract is long, work of constructions starts in one year and is completed in another
year or after 4-5 years. There fore, questions arises how the profit or loss of construction contract
by contractor should, be determined. There are two ways of determining Profit or Loss.
o On year to year basis based on percentage of completion or
o On completion of the contract.
Till the revision of this Accounting Standard both the methods were recommended. However,
the revised Accounting Standard has eliminated this existing option, by adopting only percentage of
completion method for recognizing the revenue. This method justifies the accrual system of accounting
which is fundamental assumption. This Accounting Standard is applicable to construction contracts
in contractor’s financial statements. In other words this Accounting Standards does not apply to
customer (Contractee).
Accounting Standard – 9 Revenue Recognition :
This standard explains as to when the revenue should be recognized in profit and loss account
and also states the circumstances in which revenue recognition can be postponed. Revenue means
gross in flow of cash, receivables or other consideration arising in the course of ordinary activities of
an enterprise such as the sale or goods, rendering services, use of enterprises resources by others
yielding interest, dividend and royalties.
Accounting Standard – 10 Accounting for Fixed Assets :
This accounting standard is applicable to all fixed assets which are held with an intention of
being used for the purpose of producing or providing goods or services, not held for sale in the
normal course of business and expected to be used for more than one accounting period. The
examples for fixed assets are Land, Buildings – free hold, lease hold buildings, plant and machinery,
furniture and fittings etc.
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Fixed assets shall be shown in financial statements either at historical cost or revalued price.
Accounting Standard – 11 The Effect of changes in Foreign Exchange Rates:
In India financial statements are prepared in Rupee, which is the reporting currency. All the
transaction are done in Rupee, and therefore are recorded in Rupee. However, if the enterprise has
transactions in another currency, say in US $, because the enterprise is making export sales or import
material, Plants or taking loan from abroad, in these cases the transactions shall be in foreign currency
but recording and reporting has to be done in rupee. Then the question of translation of foreign
currency to Indian rupee arises. This Accounting Standards – 11 (revised 2003) is applicable to all
accounting transactions taken Place in foreign currencies, in translating the financial statement of
foreign operation and to accounting for forward exchange contracts.
Accounting Standard – 12 Accounting for Government grants :
Government grants are assistance by the Govt. in the form of cash or kind to an enterprise.
Govt. assistance which can not be valued reasonably, is excluded from Govt. grants. Govt. grants
are in the form of subsidies, cash incentives etc. This Accounting standard explains the treatment of
monitory grants related to depreciable fixed assets and grants related to non – depreciable fixed
assets.
Accounting Standard – 13 Accounting for investments :
Investments are the assets held for earning income by way of dividend, interest and rentals
for capital appreciation or for other benefits.This Accounting Standard deals with accounting for
investments in financial statements. This Accounting Standard is applicable for current investments as
well as to shares, debentures, and other securities held as “stock in trade”. This standards deals with
classification of investments, cost of investment, valuation of inventions, disposal of investment,
Reclassification of investments and disclosure of investment in financial statements.
Accounting Standard – 14 Accounting for Amalgamation:
This Accounting Standard deals with accounting to be made in the books of Transferee
company in case of Amalgamation. This standard is applicable where acquired company is dissolved
and separate entity ceased to exist and purchasing company continuous with the business of acquired
company.
Accounting Standard–15 Accounting for Retirement Benefits in the Financial Statement
Employers:
Retirements benefit schemes are arrangements where an employer provides benefits to
employees on leaving service or retirement or after an employees death to his dependents. These
retirement benefits are acquired to employee during the service period as he becomes entitled to get
the benefits. As the accrual is fundamental accounting assumption the accounting is done on accrual
basis.
Accounting Standard – 16 Borrowing Costs:
Enterprises are borrowing funds to acquire and install fixed assets and other assets. The
enterprise incur the interest cost (Cost on borrowings) to acquire and build their assets the objectives
of this Accounting Standard is to prescribe the treatment of borrowing cost (interest + other cost) in
accounting, weather the cost of borrowing should be included in the cost of Assets or not.
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As per this Accounting Standards, borrowing cost, which is directly related to the acquisition,
construction or production of qualifying assets should be capitalized. As per this Accounting Standard
the financial statements of the enterprise should disclose, the accounting policy adopted for borrowing
cost and the amount of borrowing cost capitalized during the period.
Accounting Standard – 17 Segment Reporting:
When an enterprise deals in multiple products / services and operates in different geographical
areas they are exposed to different risks and returns. Information about multiple products / Services
and their operation in different areas are called segment information. Disclosure of such information
is called segment reporting.
Accounting Standard – 18 Related Party Disclosure:
A related party is essentially any party that controls or can significantly influence the
management or operating policies of the company. This relationship generally exists between parent
and subsidiary, company, Joint Venture partners Investor and Investee, Associates etc. Related
party relationship affects the volume and decision of business of one enterprise for the benefit of the
other enterprise. Hence, disclosure of related party transactions is essential for proper understanding
of financial performance and financial position of enterprise. According to this Accounting Standards,
the facts relating to Related Party relationship and transaction between a reporting enterprise and its
related parties.
Accounting Standard – 19 Accounting for Leases:
Lease is an arrangement by which the lessor gives the right to use on asset for given period
of time to the lessee on rent. For the accounting purpose the lease is classified into two categories viz
Finance lease and operating lease. This Accounting Standard deals with the aspects of recording
lease transactions and presentation in financial statements.
Accounting Standard – 20 Earning Per Share:
Earnings per share (EPS) is a financial ratio that gives the information regarding earnings
available to each equity share. It is a very important ratio for arising the market price of a share.
According to this Accounting Standards the EPS is to be disclosed in Part IV of the Shedule VI to
the companies Act 1956.
Accounting Standard – 21 Consolidated Financial Statements:
The objective of this statement is to present financial statements of a parent and its subsidiary
(i.es) as a single economic entity. As per this accounting standard the consolidated Balance Sheet if
prepared should be prepared in the manner prescribed by this statement. As per this Accounting
Standard while preparing the consolidated financial statements, the other Accounting Standards
shall apply in the same manner as they apply in preparing the separate financial statements.
Accounting Standard – 22 Accounting for Taxes on Income:
This Accounting Standard prescribes the accounting treatment for taxes on income. According
to this Accounting Standard, tax on income is determined on the principle of accrual concept. According
to this concept, tax should be accounted in the period in which corresponding revenue and expansion
are accounted. In other words tax shall be accounted on accrual basis, not on liability to pay basis.
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Accounting Standard – 23 Accounting for investments in Associates in consolidated Financial
Statements:
This Accounting Standard was formulated with the objective to set out the principles and
procedures for recognizing the investment in associates in the consolidated financial statements of the
investor, so that the effect of investment in associates on the financial position of group is indicated.
This Accounting Standard is applicable for investment in associates when the investor prepares
consolidated financial statements. If the investor is not required to prepare consolidated financial
statements, this Accounting Standard has no applicability.
Accounting Standard – 24 Discontinuing operations:
The objective of this Accounting Standard is to establish principles for reporting information
almost discounting operations. This standard covers discounting operations rather than “discontinued
operations”. The focus of the disclosure of the information is about the operations which the enterprise
plans to discontinue rather than disclosing on the operations which are already discontinued. However,
the disclosure about discontinued operations is also covered by this standard.
Accounting Standard – 25 Interim Financial Reporting:
Interim financial reporting is the reporting for periods of less than a year, generally for a
period of 3 months as per this Accounting Standard, interim financial report means a financial report
containing either a complete set of financial statement or set of condensed financial statement for an
interim period. Interim period is a period of reporting shorter than full financial year.
Accounting Standard – 26 Intangible Assets:
Assets are of the types i.e. Tangible Assets and Intangible Assets. Tangible Assets are those
assets having physical substance and can be seen and touched like, building, plant and machinery
etc. But intangible assets not having any physical substance and therefore can not be seen and
touched like, goodwill, patent, brands, Trademark, R & D, computer software etc., This Accounting
Standards prescribes the accounting treatment for intangible assets.
After 1-4-2004 the Accounting Standard–8 ‘Accounting for Research and Development’
has been withdrawn as the Accounting for Research and Development has been covered by this
Accounting standard i.e., Accounting Standard – 26.
Accounting Standard – 27 Financial Reporting of interest in Joint Venture:
Joint Venture is defined as a contract agreement where by two or more parties carry in an
economic activity under ‘Joint Control’. As per this Accounting Standard, the Joint Venture may be
of three forms i.e, jointly controlled operations, Jointly controlled assets and Jointly controlled entities,
as per this Accounting Standard, the venture should recognize the following in respect of Jointly
controlled operations in its separate financial statements and if consolidated financial statements are
prepared, then in consolidated financial statements, the assets it controls, the liabilities it incurres, the
expenses it incurs the expenses it incurs, its share of income that it earns from the Joint Venture.
Accounting Standard – 28 Impairment of Assets:
When the value of an asset decreases, it may be called impairment of an asset. As per
Accounting Standard – 28 asset is said to be impaired when carrying amount of an asset is more than
its recoverable amount. Carrying amount is the asset value which is shown in the balance sheet. The
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asset is shown in Balance Sheet at its Cost less accumulated depreciation, or amortization and
accumulated impairment losses. Up till now in India the impairment losses are not accounted for,
therefore, the asset is shown at its cost less of depreciation, but after this Accounting Standard is
applicable’, the impairments losses on assets are to be accounted for and therefore the asset is to be
shown in Balance Sheet at its cost less depreciation less impairment loss.
Accounting Standard – 29 Provisions, Contingent liabilities and contingent assets
The objective of this Accounting Standard is to prescribe the accounting for provisions,
contingent liabilities, contingent assets and provision for restructuring cost.
7.10 SUMMARY
The function of Accounting Standards is to provide a rational structural framework to enable
the firms to prepare qualitative financial statements.The main objective of Accounting Standards is to
bring harmonization of accounting policies and practices followed by firms to standardize the diverse
accounting practices followed for many aspects of accounting. In India the ICAI recognized the
need for harmonizing the diverse accounting policies and practices and established ASB to formulate
Accounting Standards. Sofar, the ASB has issued 29 Accounting Standards.
7.11 KEYWORDS
AS – Accounting standard means the standard of accounting recommended by the ICAI
and prescribed by the central government in consultation with National Advisory Committee on
Accounting Standards (NACAS).
ASB – The main function of ASB is to formulate Accounting Standards.
1) Explain the need and objective of Accounting Standards
2) What are the advantages of setting Accounting Standards?
3) Discuss the process of developing Accounting Standards in India
4) Discuss the applicability of Accounting Standards?
5) Write a critical note on Accounting Standard – 26, Intangible Assets.
6) Write a note on the significance of Revised Accounting Standard – 3 cash flow statement
1. Students Guide to Accounting Standards – D.S. RAWAT, Taxmam Allied Services Pvt. Ltd.
2. Accountancy – S.Kr. Paul, New Central Book Agency Pvt. Ltd.
3. Advanced Accounting – Ashok Sehgal, Deepak Sahgal, Taxmam
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GUIDEDLINE 8 : INDIAN Vs. INTERNATIONAL ACCOUNTING
STANDARDS
OBJECTIVES
After studying this guideline, you should be able to:After studying this guideline, you should be able
to:
• The need for Accounting Standards in preparing financial statements
• The Indian Accounting standards and their status
• The Comparative analysis of Indian and International Accounting Standards and their
reconciliation.
STRUCTURE
8.1 Introduction
8.2 Need for accounting Standards
8.2.1 The concept
8.2.2 GAAP
8.3 International Accounting Standards
8.4 Indian Accounting Standards
8.5 GAAP 2001 survey
8.6 Comparison of Indian GAAP with International Accounting Standards:
8.7 Conclusion
8.8 Keywords
8.1 INTRODUCTION
The changing economic trend of the world requires balance sheets and accounts to be
comparable and one that would reflect the common picture. Bringing Indian Accounting Standards
on par with International Standards is a step which will help the investor community and the entire
corporate world. Financial Statements summarise the economic consequences of business activities
of an enterprise during an accounting period. Therefore, how to present information in financial
statements is an unsettled issue at any point of time.
Conventional wisdom was to prepare the statement of financial performance in three
components: manufacturing, trading and profit and loss account. Presentation of financial statements
in these three components helps in analysing the performance of the enterprise in three distinct areas:
manufacturing, trading and management of overheads. However, in the course of journeys this
conventional wisdom is lost somewhere. Schedule VI of the Companies Act, 1956, which prescribes
the format of the balance sheet and guidelines for the presentation of profit and loss account, does
not require presentation of performance in separate components.
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8.2 THE NEED FOR ACCOUNTING STANDARDS
Accounting provides information that can be used in making economic decisions. It is a service
activity and exists only to serve decision makers. The decision makers use both qualitative and
quantitative information from various sources. Accounting provides quantitative information that is
primarily financial in nature. India should act with speed to bring out necessary changes to improve
the quality of corporate reporting. It has the knowledge, expertise and resources required for
advancement in accounting and auditing. It is the responsibility of the accounting profession to take
the initiative.
8.2.1 Concept
Accounting standards are crucial to effective participation in the global market. Academic
research has shown that foreign investors are attracted to firms that use accounting standards with
which the investor is familiar. Foreign investors evaluating Indian companies as investment choices
are thus likely to exhibit a strong preference in this direction.
It showed that high quality accounting standards result in greater investor confidence, improving
liquidity, making fair market prices possible, and reducing capital costs for all issuers, domestic and
foreign.
Accounting Standards around the world are converging. This had been occurring slowly, but
the process has speeded up dramatically over the last few years. A number of countries have
announced intentions to adopt IAS. Even the United States, which has long shown a preference for
maintaining its independent standards setting body, is evidencing interest in recognising a set of
international standards. The International Accounting Standards Board and United States Financial
Accounting Standards Board are working together to harmonise the IAS and US GAAP. Releasing
a comparative study on ‘Accounting Standards: Indian GAAP, IAS and US GAAP’, undertaken by
the Institute of Chartered Accountants of India (ICAI), With globalization and the increasing mobility
of capital across borders, US GAAP seems to be emerging as the standard accounting principle of
the world at large.
8.2.2 GAAP
GAAP is the acronym for Generally Accepted Accounting Principles, which means a country
must have some basic norms of accounting, which all companies must follow; such generally accepted
norms are called GAAP. In India, all companies must adhere to the various Indian Accounting
Standards as published by the Institute of Chartered Accountants of India (ICAI). They also need to
follow other principles such as those required by the Company Law. These collectively could be
referred to as Indian GAAP.
8.3 INTERNATIONAL ACCOUNTING STANDARDS
International analysts and investors would like to compare financial statements based on
similar accounting standards, and this led to the growing support for an internationally accepted set
of accounting standards for cross-border filings. The task of facilitating the movement towards increased
comparability and harmonisation world wide was taken up by the International Accounting Standards
Committee (IASC), an independent, private sector body that was formed in 1973 by the professional
accounting bodies in the US and eight other industrialised countries to improve and harmonise
accounting standards.
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In July, 1995, IASC and the International Organisation of Securities Commissions (IOSCO)
joined in an announcement that the IASC had developed a work programme focusing on a core set
of standards, being the necessary components of a reasonably complete set of accounting standards.
Expressing support for the IASC initiative, the SEC noted that the standards should include a core
set of accounting pronouncements that constitute a comprehensive, generally accepted basis of
accounting; that the standards be of high quality, i.e., they must result in comparability; and transparency,
and they must provide for full disclosure; and that the standards must be rigorously interpreted and
applied.
In February 2000, the SEC issued a concept release on the elements of a high quality financial
reporting framework, one of which is high quality accounting standards. The release invited comment
regarding the quality of the IASC standards and also sought to identify what important concerns
would be raised by acceptance of IASC standards; and then invited comment on whether the SEC
should modify its current requirement for all financial statements to be reconciled to US GAAP.
8.4 INDIAN ACCOUNTING STANDARDS
In India, the statements on Accounting Standards are issued by the Institute of Chartered
Accountants of India to establish standards that have to be compiled with to ensure that financial
statements are prepared in accordance with generally accepted accounting standards in the country
(Indian GAAP). These standards are largely drawn from the International Accounting Standards, as
India is a member of the IASC, but have been suitably modified to cater to the requirements of local
business. The challenges that are tackled in the harmonisation of the IASC and US GAAP standards
are therefore relevant in the Indian context. A significant criticism of IAS is that the standards are too
broad and general to ensure that similar accounting methods are applied in similar circumstances may
be applied to the Indian GAAP as well. In order to improve Comparability, the number of alternatives
that are allowed in the implementation of the standards would need to be reduced. It may be noted
that in several important areas, when the Indian Standards are implemented, the accounting treatment
in these areas could lead to differences in the restatement of accounts in accordance with US GAAP.
Some of these areas are:
• Consolidated financial statements
• Accounting for taxes on income
• Financial instruments
• Intangible Assets
8.5 GAAP 2001 SURVEY
An international accounting survey, GAAP 2001, found mixed progress toward convergence
of national requirements with International Accounting Standards. Approximately, one third of the
62 countries surveyed are responding to the challenge of convergence with an active agenda and
proposed changes to national requirements. However, half of the countries surveyed reported
significant differences between national and international standards, but have not implemented or
proposed new standards to reduce the differences. As a result of major changes to international
standards that are being considered, the differences between national and international standards will
increase unless national standard setters redouble their efforts keep pace with the changes.
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Governments, regulators, investors and the accounting profession all need to rededicate
themselves to achieving convergence of accounting standards at the earliest feasible date. Across
the world from Asia to Latin America, many national governments, regulators and accounting
professional are actively considering how their national accounting requirements differ from IAS and
how to reduce those differences. This process will, in many countries, lead to a significant improvement
in financial reporting transparency and comparability.
8.6 COMPARISON OF INDIAN GAAP WITH INTERNATIONAL ACCOUNTING
STANDARDS
I. Indian Accounting Standards already issued by the Institute of Chartered Accoun-
tants of India (ICAI) corresponding to the International Accounting Standards/
International Financial Reporting Standards
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240
241
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8.7 SUMMARY
A global harmonised accountancy profession will not prevent or cure corporate failures, but it will
ensure that investors and other interested parties have prior warning of impending dangers and that
they have an opportunity to take remedial action at the earliest possible stage. Where a company’s
financial health is not in question, reliable, transparent and international comparable information can
only help to boost confidence and there by promote future corporate prosperity. The need for
harmonisation is self- evident, but it can only become a reality as a result of commitment and concerted
effort by regulators, standard setters, financiers, business interests, and the public at large.
GAAP 2001 demonstrates the necessity for users of any financial information take great care to
understand which accounting principles – national or international – have been applied in preparing
the relevant financial statements.
Although some efforts may be initiated internationally, it is clear that the most significant actions must
be undertaken at the country level, where plans for convergence of high quality accounting standards
need to be developed and implemented. Creating written standards that are comparable country –
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by- country is a critical first step, but written requirements will not actually lead to better accounting
if standards are not properly applied and enforced. Overall improvements in financial reporting will
require a joint effort in each country by the government, stock market regulators, the business
community, users of financial statements, standard setters and the accountancy profession to develop
the educational, professional and regulatory infrastructures.
8.8 KEY WORDS
GAAP: Generally Accepted Accounting Principles
IAS: Indian Accounting Standards (31)
IASC: International Accounting Standards Committee
IASB: International Accounting Standards Board
IFRS: International financial reporting standards
1. Explain the need for accounting standards. What are various bodies associated in preparing
accounting standards in India.
2. Explain a comparative analysis of Indian Accounting Standards and International Accounting
standards.
3. What are the various areas where Indian accounting standards differ from International
accounting standards? Explain.
4. Discuss the role IASB in bringing harmonization among accounting standards of different nations.
1. Prof. Shiriene Rathore, International Accounting, New Delhi.

2. Samuels J.M and Piper, International Accounting : A Survey, Croom Helm Ltd., London.
3. Students guide to Accounting Standards D.S.Rawat, Taxmam
4. Advanced Accounting Ashok Sehgal & Deepak Sehgal, Taxmam
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GUIDELINE 9 : VALUATION OF GOODWILL
OBJECTIVES
• Appreciate the need for valuation of goodwill.
• Identify the factors effecting the value of goodwill.
• Explain various types of goodwill.
• Describe the normal rate of return.
• Discuss the concept of capital employed.
• State factors determining goodwill
STRUCTURE
9.1 Introduction
9.2 Need for valuation of goodwill
9.3 Features of goodwill
9.4 Types of goodwill
9.5 Factors affecting valuation of goodwill
9.6 Summary
9.7 Glossary
9.8 Self assessment-questions
9.1 INTRODUCTION
It is generally observed that an old and established firm is in a position to earn a higher
amount of profit as compared to a new firm inspite of all other things (such as investment, location,
quality of goods etc.) remaining the same. This is because, over the period of time a firm
establishes its reputation on account of which not only do old customers continue to patronize the
firm but they also bring in new customers. This enables the firm to earn excess profits as
compared to a new firm. Goodwill has been defined as “the present value of firms anticipated
excess earning”. This definition is normally found acceptable by the courts and is found in
accounting literature. The word “excess” gives sufficient hint as to its valuation which is equal to
earning attributable to rate of return on tangible assets and intangible assets other than goodwill
over and above the normal rate of return earned by representative firms in the same industry.
“Excess” earnings also reflect at various advantages which a firm may enjoy in contrast to its
competitors.
In the words of spicer and pegler “Goodwill may be said to be that element arising form
the reputation, connection or other advantages possessed by a business which enables it to earn
greater profits than the return normally to be expected on the capital represented by the net
tangible assets employed in the business”.
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Lord Lindley defines goodwill as “The term goodwill can hardly beside to have any precise
significance. It is generally used to denote the benefit arising from connection and reputation and its
value is what can be got for the change of being able to keep that connection and improve it. Upon
the sale of an established business its goodwill has a marketable value, whether the business is that of
a professional man or of any other person. But it is plain that goodwill has no meaning except in
connection with a continuing business, and the value of the goodwill of any business to a purchaser
depends in some cases entirely, and in all very much, on the absence of competition on the part of
those by whom the business has been previously carried on”
Another significant definition of goodwill is given by SSAP-22 U.K accounting standard on
accounting for goodwill and is as follows:
“Goodwill is the difference between the value of a business as a whole and the aggregate of the fair
values of its separable net assets”.
According to Wilson “Goodwill has been very ably divided into three types-cat, dog and rat- in
view of the peculiar habits of these three animals. The cat tends to stick to the abode, cat
goodwill is therefore that which will adhere to the business which is being transferred and
is the most valuable .The dog follows his master, and dog goodwill is difficult to transfer
and is correspondingly less valuable. The rat is a migrant, rat goodwill is practically
valueless, as it represents those customers who have no specialties either to the business
or its properties and who may be here today gone tomorrow .Summed up, cat goodwill is
adherent; dog personal and rat fugitive. Adherent goodwill is only valuable as attaching to
the business; personal goodwill is unsaleable, fugitive goodwill is only valuable in that as
one fugitive goes another may arrive”.
9.2 NEED FOR VALUATION OF GOODWILL

The need for valuation of depends on the form of business organization .In the case of a sole
trader; it is usually values at the time of selling the business, so as to determine the amount payable by
the Buyer towards goodwill. In the case of partnership there are several circumstances when goodwill
has to be valued. They are
1. When a new partner is admitted
2. When a partner retires or dies
3. When there is a change in the ratio of profit-sharing and
4. When there is dissolution either by sale to a company or amalgamation with another firm.
In the case of Limited companies
1. When two or more companies amalgamate
2. When one company takes one another.
3. When the company’s shares are not quoted on the stock exchange and their value
is to be determined for the purposes of estate duty and wealth tax, etc.
4. When a person wants to purchase a large block of the company’s shares with a
view to acquire control over the management of the company.
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5. When the business of the company is being taken over by the government.
6. When the management wants to write back goodwill which it wrote off earlier to
reduce or eliminate the debit balance in the profit and loss account.
9.3 FEATURES OF GOODWILL
Goodwill has certain peculiar features which distinguish from other assets and it is worthwhile
considering them here.
1. The value of goodwill fluctuates from time to time due to changing circumstances
which are internal and external to business.
2. There can be no objective valuation of goodwill. It is subjective and it differs from estimator
to estimator
3. It is not possible to separately value each of the intangible factors contributing to goodwill.
4. Goodwill may be positive value or negative value. It is positive when the value of business is
more then the value its net separable assets and negative when the value of the business is
less then the value of its net separable assets.
5. The value goodwill has no relation to the amount invested and costs incurred in order to build
it.
6. Goodwill may be purchased or interest in the business. When a business concern is purchased
and the purchase consideration is in excess of the fair value of the separable net assets
acquired, such excess is recorded as goodwill. However, goodwill is recorded only when an
amalgamation is in the nature of purchase and is not a merger. In the case of merger, pooling
of interests method is followed and goodwill is not recorded.
9.4 TYPES OF GOODWILL
Goodwill is generally of two types:
1. Purchased goodwill
2. Non-purchased or inherent goodwill
9.4.1 Purchased goodwill
Purchased goodwill arises when one business buys another and the purchase consideration
paid is more then the value of the net tangible assets received. It can never exist in a new business
except by purchase.
It is the accepted practice to recognize only the purchased goodwill in accounting system.
Therefore goodwill should enter into the books of account of a business only in connection with a
valuation prescribed to it in the acquisition price of a business.
Following are the important features of purchased goodwill:
1. It arises on an acquisition.
2. It is demonstrated by a purchase transaction.
3. Price paid for goodwill depends upon the purchaser’s expectation of future profits.
4. It is recognized in financial statements.
247
9.4.2 Non-purchased or Inherent Goodwill
Non-purchased or Inherent goodwill is referred to as internally generated goodwill and it
arises when a business may over the years generate its own goodwill.
Following are the features of non-purchased goodwill:
1. It is internally generated.
2. A cost cannot be placed on these types of goodwill.
3. Valuation depends on subjective judgement of the valuer.
4. It is not demonstrated by a purchase consideration.
5. It is never recognized in financial statements.
9.5 FACTORS AFFECTING VALUATION OF GOODWILL
1. Locational Factors: The place or locality where the business is located determines the
goodwill. If the business is located at a favorable and prominent location, it increases the
value of goodwill.
2. Managerial Skill: Special ability and skill of the persons engaged in the management
helps in increasing profits through efficient activities which in turn increases the value of
goodwill. However, it is essential to ensure that the services of such efficient manage the
value of goodwill is higher. Management shall be continued in the future.
3. Nature of Business: The nature of business is another important factor to be considered
in deciding the value of good will. Nature of business here, we mean that the type of
production, demand for the product, competition prevailing Government regulations etc.
When the firm enjoys favorable, situations the value of goodwill increases. The more the
stable business, the more is the goodwill as vice-versa. If more business risks are involved,
less will be the goodwill. Similarly monopolistic nature of business enhances the value of
goodwill.
4. Risks in Business: When the risk is less the business enjoys more goodwill. If the risk
is more it will create less goodwill.
5. Favorable Contracts: If the firm is having on hand profitable contracts for the supply of
goods and services enhances the value of goodwill.
6. Trends in Profit:When there is an upward trend in the profits, naturally the goodwill of
the business enhances.
7. Procession of patents and trade marks: The products branded with reputed trade
marks attracts customers and distinguishes rival products from its producers and enhances
the value of goodwill of such firms.
8. Capital: When the profits of a business are more in relation to capital, the value of good
will increases. If returns on investment is more than the normal return,
9. Government’s attitude: When a business enjoys a patronage of government, people
are willing to buy products of such company, thereby, the value of goodwill increases,
Similarly, doubtful attitude of the government about a particular business discourages
persons to pay for goodwill.
248
10. Other Factors: Apart from the above factors, some other factors such as general economic
conditions, Government policy, Money market conditions, political stability etc. influence
the value of goodwill.
ILLUSTRATION : 1
X Ltd, decided to purchase a business for 8,00,000. The profits earned by the business during
the last 4 years are as follows : 2004 - 2,00,000, 2005 - 2,50,000, 2006 - 2,40,000, 2007 -
2,30,000. The business was looked after by Mr. Mohan can earn from alternate employment if not
engaged in the business would be Rs.30,000 p.a. Find out the value of goodwill on the basis of three
years purchase of the average profit for the last four years.
SOULUTION :
Average Profits :
2004 2,00,000
2005 2,50,000
2006 2,40,000
2007 2,30,000
Total of four years profit = 9,20,000
Average Profit = 9,20,000/4 = 2,30,000
Less :
Remuneration to Mohan 30,000
Adjusted Profit 2,00,000
Value of Goodwill = Adjusted Average Profit x No. of years = 2,00,000 x 3 = 6,00,000
Illustration: 1. From the following data, calculate the average profits of company.
Years Profits
2003 4,41,000
2004 6,45,000
2005 4,80,000
The following is the additional information supplied to you.
1. The profits are after changing debenture interest and tax but before providing preference
dividend.
2. Non-recurring profits are to be eliminated 10% of the profits for 2004 referred to above are
of a non- recurring nature.
3. A provision of Rs. 16,500 was omitted to be provided in the year 2005.
4. A provision of Rs. 31,5000 on Sunday debtor made in 2005, is no longer required.
5. The company has 6% preference share capital of Rs.3, 00,000.
6. The taxation rate may be presumed as 50%.
7. Debentures of Rs.6, 00,000 carrying 5% interests will be redeemed before sale of business.
8. The above profits included interest on investment amounting to Rs.18,000 per annum.
249
Solution:
Statement showing average future maintainable profits
Profits (Rs.)
2003 year
441000
2004 year 645000
Less: 10% non-recurring profit 64500
580500
2005 Year 480000
Add: provision on debtors not required 31500
511500
Less: Omission of claim 16500
495000
Less: Tax effect 50% 247500
247500
1269300
Average Profits (Rs 1269300/3) 423100
Less: After tax income on investments 18000
405100
Add: Interest on debentures (redeemed) 15000
Future Maintainable Profit 420100
Less: Preference Dividend 18000
Profits available for equity shareholders 402100
9.5.2 Normal rate of return
The term normal rate of return means the rate of return that will satisfy an ordinary investor (neither
very eager nor very reluctant to invest) in the industry concerned .Such a return differs from industry
to industry. It comprises of three components:
9.5.2.A. Return at zero risk level. This refers to the expected rate of return when a project
involves no risk- whether business or financial.
9.5.2.B. Premium for business risk. The term business risk refers to the variability in operating
profits due to change in sales. In case the nature more then the normal or average risk, the investor
will expect a higher rate of return.
9.5.2.C. Premium for financial risk. The term financial risk refers to the risk on account of pattern
of capital structure (or debt equity mix). In general, it may be said that a firm having higher debt
content in its capital structure is more risky as compared to a firm which has comparatively low debt
content.
The normal rate of return is determined keeping in view the above factors. Stock exchange
quotations usually give a very fair idea about the return expected by investors from a particular
company .For example, if the share of a company having a paid-up value of Rs.50 is quoted on the
250
stock exchange at Rs.100 on the basis of 30% dividend, the expected by the investor from the
company is 15% (i.e. 6/40*100).
While calculating the normal yield expected in case of a given company, the yield calculated
as above may have to be suitably adjusted keeping in view the circumstances of the company
concerned. For example, if in the above case, the company whose normal yield is to be calculated is
better then the company whose shares have been quoted as above, the investor may be willing to
except a lower rate of return then 15%. In a reverse course, the investor will expect a higher rate of
return then 15%.
9.5.3 Capital Employed: The value of goodwill depends not only on the amount of “average
maintainable profits” but also on the capital employed in the business to earn such profit. The term,
capital employed for valuation of goodwill should generally be calculated from the point of view of
the equity shareholders. In the words, it represents the equity shareholder’s funds in the company.
While calculating equity shareholder’s funds, any profit or loss on revaluation of assets should also
be taken into account. In case non-trading income have not been excluded while calculating “average
maintainable profits” non-trading assets should not be excluded other wise non-trading assets excluded.
Fictitious assets and goodwill if any appearing in the balance-sheet, should be excluded.
Illustration:
The following is the balance sheet of X Ltd. As on 31st December 2005:
Liabilities Total Rs. Assets Total Rs.

Share capital : Good will 300000
12% Preference Share capital 150000 Freehold porperty 3,75,000
Rs. 10 each Plant & Machinery 300000
Equity share capital Rs. 10 900000 Short term investiments 250000
each 15,00,000
Reserves Debtors 300000
Profit & Loss a/c 400000 Cash at Bank 20000
10% Debentures 600000 Preliminary Expenses
Sundry creditors 150000
Total 2445000 2445000
Solution: calculation of capital employed

Capital employed = fixed assets + current assets -current liabilities
OR
Shareholders funds + long term liabilities 975000+1450000-150000 = 2275000
Shareholders funds = equity share capital + preference share capital + reserves + P&L A/c –
preliminary expenses.
251
9.6 SUMMARY
Goodwill means the firm to earn excess profit as compared to a new firm. Goodwill defined
as “the present value of firm’s anticipated excess earnings.” Need for valuation of goodwill depends
on the form of business organization. Sole trader at the time of selling the business, in the case of
partnership a new partner is admitted, retires or dies and dissolution either by sale to a company or
amalgamation with another firm, in case of limited companies at the time of amalgamation, takeovers
and management wants to write back goodwill. Goodwill has certain peculiar features the value of
goodwill fluctuate from time to time, no objective valuation of goodwill, not possible to value each of
the intangible fact or separately and it may be positive value or negative value. Goodwill is generally
of two types purchased and non-purchased goodwill. The main factors which affect the value of the
goodwill of a firm is profitability, normal rate of return and capital employed.
9.7 GLOSSARY
Goodwill: An intangible asset arising from business connections or trade name.
Normal rate of return: The rate of return expected by an ordinary investor on his investments.
Capital employed for equity shareholders: It represents the equity shareholders funds in a
company.
Future maintainable profits: Expected future profits of a company.
Capital employed: This can be ascertained in two ways: (1) non-current liabilities plus owners’
equity; and (2) fixed assets plus net working capital.
1. Define Goodwill? What is the need for its valuation?
2. Discuss the factors that affect the value of goodwill of a firm.
3. What are the important features of’purchased’ and Non-purchased goodwill?
4. Define the following’s
a) Capital Employed
b) Maintainable Profit
c) Average Capital Employed
d) Normal Rate of Return.

1. R.L.Gupta, M. Radhaswamy, Advanced Accountancy Volume II, Sultan chand and sons,
New Delhi.
2. A.Mukherjee and M.Hanif, Modern Accountancy Volumell, Tata Me Graw-Hill, New Delhi.
3. M.C.Shukla, T.S.Grewal, S.C.Gupta, Advanced Accounts Volumell, S.Chand, New Delhi.
4. S.N.Maheshwari, S.K.Maheswari, Corporate Accounting, Vikas, New Delhi.
5. S.KR.Paul, Accountancy Volumell, New Central book agency (p) Ltd. Kolkata.
6. R.S.N.Pillai, Bagavathi, S.Uma, Fundamentals of Advanced Accounting Volumell, S.chand,
New Delhi.
252
GUIDELINE 10 : METHODS OF VALUATION OF GOODWILL
OBJECTIVES
• Explain the different methods for valuation of goodwill
• Compute the value of goodwill
• Explain the meaning of certain key terms
STRUCTURE
10.1. Introduction
10.2. Methods of Valuation of Goodwill
10.2.1. Average Profits Method
10.2.2. Capitalisation of Profit Method
10.2.3. Annuity Method
10.2.4. Super Profit Method
10.3 Summary
10.4 Glossary
10.6. Further Readings
10.7. Answers
10.1 INTRODUCTION
Goodwill may be described as the aggregate of those intangible attributes of a business which
contribute to its superior earning capacity over a normal return on investment. The need for valuation of
goodwill depends on the form of business organization. In this chapter we will discuss the various methods
for valuing goodwill.
10.2. METHODS OF VALUATION OF GOODWILL
The following are the basic methods for valuation of goodwill:
1. Average Profits Method
2. Capitalisation of Profit Method
3. Annuity Method
4. Super-Profit Method.
10.2.1. Average Profits Method
Average profit may be computed in the following manners:
a) Simple Average; and
b) Weighted Average.
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10.2.1.a. Simple Average Method:
It is nothing but the simple average profit for the last few years:
Total Profit of all the years

Average Profit =———————————————————-
Number of years
Goodwill = Average Profit x Years purchase
Illustration 1
X.Ltd purchases business from Y.Ltd on December, 2005. Profits earned by Y.Ltd for the preceding year
ended on 31st December each year were:
2002 Rs. 20000
2003 Rs. 30000
2004 Rs. 26000
2005 Rs. 24000
Calculate goodwill for three years purchase of average profits.
Solution:
Calculation of average profit:
Total Profit of all the years
Average Profit = —————————————
Number of years
20000+30000+26000+24000
= ——————————————
4
= Rs 25000
Goodwill = 3 years purchase of average profits
= 3 x 25000 = Rs. 75000
10.2.l.b. Weighted average method:
Whenever the profits trend is increase or decrease trend then use the weighted average method. Actual
profit is being multiplied by the respective number of weights (say, 1, 2, 3 and4.) in order to get the amount
of product.
Average profit = Total product / Total weights.
Good will = weighted average profit× years purchase
Illustration 2
The profits of P.Ltd. for the last 4 years were as under 2002-Rs. 20, 000; 2003- Rs. 24,000; 2004-Rs.
16,000; 2005-Rs. 30,000. Goodwill is to be valued on the basis of 2 years purchase of average profits
after assigning weights 1, 2, 3 and 4 serially to the profits.
254
Year Profit Rs. Weights Product (profit*weight)
2002 20,000 1 20,000
2003 24,000 2 48,000
2004 16,000 3 48,000
2005 30,000 4 1,20,000
Total 10 2,36,000
Total product 2, 36,000

Weighted average profit = ———————— = ——————————— = Rs. 23,600.
Total weight 10
Goodwill = 2 years purchase of average profits =2 x 23,000 = Rs. 47,200.
10.2.2. Capitalization of profit method:

Under this method, the value of the entire business is determined on the difference between the
values of the business minus net tangible assets.
Under this method, the following steps should be taken into consideration for ascertaining the
amount of goodwill:
1. Expected average net profit should be ascertained;
2. Capitalized value of profit is to be calculated on the basis of normal rate of return;
3. Net tangible assets (i.e. total tangible assets-current liabilities) should also be calculated;
4. To be deducted 3 from2 in order ascertain the value of goodwill.
Profit (adjusted)
Capitalized value of profit = ————————————× 100
Normal rate of return
Value of goodwill = capitalized value of product- net tangible assets. Illustration 3
A is desirous of selling his business to B. The firms has earned an average profit in the past of
Rs.1,60,000 p.a. It is considered that such average profit fairly represents the profit likely to be earned in
future, except that:
1. Chemists free Rs. 10,000, changed against such profits, will not be payable by B as he himself is an
able chemist and can work as such.
2. Rent at Rs. 30,000 p.a. which had been paid by A will not be a change in future since B owns his own
premises and can supply the accommodation necessary for the staff and equipment. The value is
estimate at Rs. 1, 50,000.
The value of net tangible assets of the business at the proposed date of sale was Rs.19,00,000, and it
was considered that a reasonable return on capital invested, for the type of business in question, was 8%.
The profits of the business of A would in no way be affected by the sale of the business to B and
goodwill existed and was to be paid for on the basis that A s business was a continuing enterprise calculate
the value of goodwill.
255
Solution:
Average net profit Rs. 1,60,000
Add: chemists fee 10,000
Rent 30,000
Rs. 40,000
Maintainable profit Rs. 2, 00,000
Rs.2, 00,000
Capitalized value of future profit @ 8% = ———————— x 100 = 25,00,000
8
Capitalized value of future profit 25,00,000
Less: Net tangible assets 19,00,000
Value of goodwill 6,00,000
Illustration 4
Ascertain the value of goodwill of DHANUSH Limited carrying a business from the following: Balance
sheet as at 30th June, 2004
Liabilities Total Assets Total

Paid up capital - 25000 shares 25,00,000 Good will at cost 35.000
Of Rs. 100 each fully paid Land & Building at cost 1,70,000
Bank overdraft (OD) 4,80,000 Plant and Machinery at cost less 90,000
Sundry Creditors 8,05,000 depreciation
Provision for taxation 4,25,000 Stock in trade 15,00,000
P & L a/c 6,00,000 Book debts 9,00,000
Total 48,10,000 48,10,000

The company started operations in 1999 with a paid up capital as afore stated of Rs25,00,000.
Profits earned before providing for taxation have been as follows:
Years ended 30 June:2000: Rs. 6,00,000; 2001: Rs. 7,50,000; 2002: Rs.8,50,000;
2003 : Rs.9,50,000 and 2004 : Rs. 850,000; Income tax @ 50% has been payable on these
profits. Dividends have been distributed from the profits of the first three years @ 10% and
from those of the next two years@ 15% of the paid-up capital.
256
Solution:
Computation of Net Tangible Assets
Particulars Tangible Assets: Total Rs.

Land & Buildings 11,00,000
Plant & Machinery 10,00,000
Stock in trade 15,00,000
Book debts 9,60,000
Liabilities:
Balance over drafts 4,80,000

Sundry creditors 8,05,000
Provision for tax 4,25,000
(B) Total liabilities 17,10,000
Net Tangible Assets (A-B) 28, 50,000
Calculation of average maintainable profit
Particulars Total Rs.

30th June2000 6,00,000
30'” June2001 7,50,000
30th June2002 8,50,000
30th June2003 9,50,000
30th June2004 8,50,000
Total profits 40,00,000
Average Profit = 40,00,000 / 5 = 8,00,000

Less: Provision for tax 50% = 4,00,000
Profit after tax 4,00,000
Average dividend rate= [(10% x 3) + (15% x 2)] = 12%
Average maintainable profit
Total Value of the business = —————————————× 100
4,00,000
= ——————— × 100 = Rs.33,33,333
12
Goodwill = Total value of the businessLess Net Tangible Assets
= 33,33,333 - 28,50,000 = Rs. 4,83,333.
257
10.2.3. Annuity Method
Under this method, super-profit (excess of actual profit over normal profit) is being considered as the value
of annuity over a certain number of years and for this purpose, compound interest is calculated at a certain
respective percentage. The present value of the said annuity will be the value of goodwill.
Value of goodwill
a 1 
V= 1−
1  (1 − i)n 

Where, V= Present value of annuity

a = Annual super profit
n = Number of years
i = Rate of interest
Illustration 5.
From the following particulars, compute the value of goodwill under “Annuity Method” Super profit Rs
10,000. Number of years over which super profit is to be paid 5 rate percent annum- 5%
Solution:
a 1 
V= 1−
1  (1 − i)n 

When a = Rs.10,000; I = 5% or 0.05; n = 5
10, 000  1 
V= 1− 5
= 43, 260or 43,300
0.05  (1 + 0.05) 
10.2.4 Super Profit Method

Goodwill is the value of the firm’s anticipated ‘excess’ earnings. If here are no anticipated
excess earnings over normal earnings, there can be no goodwill. Thus goodwill is paid by a buyer of
business only if the business being purchased is earning profits in excess of normal profits. The
excess profit is referred to as Super profit. Thus Super profit is the difference between the average
profit earned and normal profit, which is calculated on the basis of normal rate of return, The following
information is required to calculate goodwill as Super profit method.
a) A normal rate of return for representative forms in the industry
b) The fair value of capital employed
c) The estimated future earning - average profits earned in the past three or four years.
d) Super profit and
e) Agreed No. of years.
The normal rate of earning is the rate of earning which investors expect on their investments. This
rate differs from case to case depending on the risks involved normally, the normal rate of return will
be given. If it is not given, we have to estimate it basing on the merits of the case. In order to estimate
the normal earnings, the value of capital employed is to be find out. It not easy to estimate the capital
employed. There are two methods to find out the capital employed.
258
1st Method ;
Assets approach :
All assets at market value xxx
(other than goodwill differed revenue
expenditures such as preliminary expenses,
discounts etc.)
Less : All Liabilities due to outside parties
at revised values such as creditors, Bills Payable,
Debentures, Provision for tax, outstanding dues etc. xxx
Capital employed xxx
Less : Half of the current year profits xxx
Average capital employed xxx
2nd Method
Liabilities approach :
(a) Capital Employed :
Capital employed can also be find out by adding share capital, reserves, all profits and gain on
revaluation of assets and liabilities and deducting them from all loss shown in the Balance Sheet such
as goodwill, less on revaluation of assets and liabilities etc.
Preference share capital xxx
Equity Share capital xxx
Reserves xxx
Profits xxx
Total xxx
Less : Goodwill & other losses xxx
Capital employed xxx
Less : Half-year current profit xxx
Average capital employed xxx
(b) Normal Profit :
The normal profit is calculated on average capital employed. For the purpose of the calculating
the Average capital employed it is assumed that the profits are earned evenly throughout the year and
employ in the business. On the basis of this assumption on an average half of the profit is employed
throughout year. The average capital employed can be calculated in three ways:
1) By taking the average of capital in the beginning and capital at the end.
2) By deducting half of the current year profit from the capital at the end.
3) By adding half of the profit to the capital in the beginning.
259
(c) Future Earnings : The estimated future earnings are calculated on the basis of average profit
earned by the buying. While calculating the average profits, the profits earned in the past must be
adjusted i. e. any extraordinary losses, and extrodinary gains as they are not likely to occur in the
future. The average profits can be calculated by simple average method or by weighted average
method. While using weighted average maximum weight is to be given to the latest year.
(d) Super profit :
Super profit is the excess of average profit than the normal profit.
Super Profit = Average Profit - Normal profit
(e) Number of years purchase : In order to calculate the value of goodwill the average profits are
multiplied by certain number of years agreed between the buyer and the seller of the business.
Therefore, Goodwill = Average profit x No. of years
Illustration : 2
The Balance Sheet of XYZ Ltd as on 31 st Dec, 2002 is as follows :
Balance Sheet
Liabilities Rs. . Assets Rs. .
15% 5,000Preference
shares of Rs. 100 each 5,00,000 Goodwill 1,00,000
1,00,000, equity
share of Rs. 10/- each 10,00,000 Fixed assets 18,00,000
Reserves
(Including provision
for tax of Rs. 1,00,000) 10,00,000 Investments
(5% Govt. Loan) 2,00,000
15% Debentures 5,00,000 Current Assets 10,00,000
Creditors 2,50,000 Preliminary expenses 1,00,000
Discount on debenture 50,000
32,50,000 32,50,000
The average profit of the company is Rs. 3,10,000, the market value of machinery including
fixed assets is Rs.50,000 more. Expected rate of return is 15%. Find out the goodwill of the company
at 5 times of the super profits.
SOLUTION :
Fixed assets 18,00,000
Add : Increase the market
value of machinery 50,000 18,50,000
Current assets 10,00,000
Less : Liabilities :
Debentures 5,00,000
Creditors 2,50,000
260
Provision for tax 1,00,000 8,50,000
Capital employed 20,00,000
Less : Half of the current year profit 1,50,000
Average capital employed 18,50,000
Here : Investments in Govt. loan is taken as a non-business investment. As such the investment
of Rs. 2,00,000 and the interest of Rs. 10,000 are excluded.
Normal Profit is : Average Capital employed x Expected value of return = 18,50,000 x 15% =
2,77,500
Adjusted average profit :
3,10,000-10,000=3,00,000
Super profit = Adjusted average profit - Normal profits = 3,00,000-2,77,000 = 22,5000
3. Capitalization of Super Profits Method :
Under this, method the goodwill is estimated on the basis of the capital required to earn super
profit at normal rate of profit. The capitalized value of super profits is treated as goodwill.
Goodwill = Super profit x 100
Normal rate to profit
Sometimes the average profits are also capitalized to ascertain goodwill.
The profit should be capitalized at the reasonable rate of return to find out the total value of
business. The value of goodwill will be in the total value of business - its net assets.
However if the net assets are more than the capitalized value there will be no goodwill.
Illustration : 3
Mr. Will man invested an amount of Rs.20,00,000. The annual profit is Rs. 4,50,000 which
includes an amount of Rs, 1,00,000 received as rent of his premises. If he could invest his money in
bank deposit he could have got interest @ 10% and also engage himself in employment then by
getting an annual salary of Rs. 72,000.
Considering 2% as fair compensation risk involved in the business. Calculate the value of
goodwill of his business on capitalization of super profits at normal rate of interest.
SOLUTION :
Annual profits earned 4,50,000
Less : Rent received for premises
(abnormal income) 1,00,000 3,50,000
Less : Salary 72,000
Maintainable average profit 2,78,000
Normal profit = Investment x Normal rate of return
= 20,000 x 12/100 = 2,40,000
Super profit = Maintainable average profit - Normal profit
= 2,78,000 - 2,40,000 = Rs. 38,000
261
Goodwill on the basis of capitalization of super profits at normal rate of 10% per annum
=38,000 X 100/10 = 38,000
4) Annuity Method :
According to the annuity method the value of goodwill is the present value of an annuity of the
annual super profit payable over an expected number of years at the current rate of interest. This is
known as annuity method of goodwill. the amount of goodwill under this method can be found out by
1) Annuity Table
2) Formula.
As per the Annuity Table Method :
Goodwill = Super profit X Reference to the annuity table
As per the Formula Method :
1-1/(1+i)n
Goodwill = ———————
i
Where i = r/100
Present value of an annuity Rs. 1 for n years at r% is
1-(1+r/100)-n
—————————
r/100
Illustration 6
The following is the balance sheet of Mr. Srinivas as on 31-12-2005
Liabilities Total Assets Total Rs.

Capital 2,00,000 Land & building 50.000
General Reserve 30,000 Plant Machinery 40,000
Creditors 70,000 Investments 30,000
Sundry debtors 1,00,000
Stock 20,000
Bank 60,000
Total 3,00,000 3,00,000
The following were the net profit for the year ended:
2003 Rs. 32,280; 2004 Rs.36,870; 2005 Rs. 43,350.
The above amounts include income from investments Rs 1800 each year.
You are requires to as certain the value of goodwill of the above business at 2 years purchase of
the average super profit for 3 years taking into account the fact that the standard rate of return as
capital employed in such type of business is 10% and assuming that each years profit is immediately
withdrawn in full by Mr. Srinivas.
262
Solution:
Calculation of capital employed;
Land & Building 50,000
Plant &Machinery 40,000
Investments 30,000
Stock 20,000
Sundry debtors 1,00,000
Bank 60,000
Total assets 3,00,000
Less; creditors 70,000
Normal profit = 2,30,000 x 10/100 = Rs. 23,000
Rs.32,280 + Rs.36,870 + Rs43,350
Average profit = —————————————————————— =Rs.37, 500.
3
= 37,500 - 1800 (income from investment i.e. Non trading income)
= Rs.35,700
Super profit =Average profit- Normal profit
= 35,000 - 23,000 = Rs. 12,700
Value of goodwill = super profit x years purchase
= 12,700 x 2=Rs. 25,400.
Illustration 7
The balance sheet of Ram &co Ltd discloses the following financial position as on 31-3-2005:

Share capital 30,000 equity 30,000 Good will at cost 35.000
Shares of Rs. 10 each fully Land & Building 1,70,000
paid Plant and Machinery 90,000
Profit and loss sale 21,000 Stock 1,15,000
Capital Reserve 70,000 Book debts 95,000
Sundry creditors 61,000 Cash at Bank 7,000
Provision for tax 60,000
Total 5,12,000 5,12,000
You are asked to value the goodwill of the company 3years purchase of super profit for which purpose the
following information is supplied:
a. The reasonable return on capital invested in the class of business done by the company is 12%.
263
b. Adequate provision has been made in accounts for income tax and depreciation.
c. The rate of tax may be taken at 50%.
d. The average rate of dividend declared by the company for the past five years was 15%.
Solution:
Calculation of average capital employed: Rs.
Total assets (including goodwill, as it was purchased and paid for) 5,12,000
Less: Sundry creditors 61,000
Provision for tax 60,000 1,21,000
3,91,000
Less: ‘A of current years profit after tax (50% tax) Rs. 60,000 x 1/2 30,000
Average capital employed 3,61,000
Normal profit = 3,61,000 x 12/100 = 43,320
Super profit = Average profit - Normal profit
= 60,000 - 43,320 = Rs.16,680.
Value of goodwill = Super profit x 3years purchase
= 16,680 x 3 = Rs.50,040.
Goodwill = Rs. 50,040.
10. 3 SUMMARY
Goodwill may be aggregate of those intangible attributes of a business which contribute to its
superior earning capacity over a normal return an investment. The basic methods for valuation of goodwill
are average profits method, capitalization of profit method, annuity method and super profit method.
Average profits method sub divided into simple average and weighted average profit method. When ever
profits trend is increasing or decreasing us adopt the average profit method.
10.4 GLOSSARY
Normal Profit: The rate of earnings expected by an entrepreneur or an economic at normal
economic/business situation.
Super Profit: Super profit represents the difference between the average profit earned by the business
and the normal profit.
Profit: In accounting sense, profit is the excess of returns over expenditure in business transactions over a
given period.
Value of entire Business: The value of the entire business is determined on the difference
between the values of the business minus net tangible assets.
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Theoretical questions
1. How do you calculate average profit?
2. What is weighted average method?
3. How do you compute the future maintainable profit of a company for the purpose
of valuing goodwill?
4. How do you as cutain the value of capital employed?
5. Discuss the capitalization method of goodwill.
6. What is super profit method of goodwill? How do you calculate it?
7. Discuss the various methods for valuing goodwill.
Exercises
1. Suresh runs a general store. His net assets on 31st December, 2005 amount to 20,00,000.
After paying a rent of Rs 20,000 a year and a salary of Rs. 10,000 to the manager, he
earns a profit of Rs.1,50,000. His landlord is interested in acquiring the business 8% is
considered to be a reasonable return as capital employed. What can Suresh expect as payment for
goodwill? Goodwill is three years purchase of super profits.
[Super profit Rs.10,000: Goodwill Rs.30,000]
2. The profit of XYZ Ltd. For the last 6 years over as follows; 2000 - Rs. 12,000; 2001- Rs.15,000;
2002 - Rs.16,000; 2003 - Rs.20,000; 2004 - Rs.14,000; 2005 - Rs.25,000. Compute the value of
goodwill of XYZ Ltd. On the basis of 5 years purchase of weighed average profit after assigning
weights 1, 2, 3, 4, 5 & 6 serially to the profits. Ans (Rs.92,857)
3. The net profit of a company after providing for taxation for the past five years is: Rs.20,000; Rs.25,000;
Rs.15,000; Rs.35,000 and Rs.40,000. The net tangible assets in the business is Rs.2,00,000 on
which the normal rate of return is expected to be 10%. It is also expected that the company will be
able to maintain its super profits for the next five years.
Calculate the value of goodwill of the business on the basis of an annuity of super profit, taking the
present value of an annuity of one rupee for five years at 10% interest is Rs3.78.
Ans (Rs.26,460).
4. The net profit of business, after providing for taxation, for the past five years are: Rs.80,000;
Rs.85,000; Rs92,000; Rs.1,05,000 and Rs.1,18,000. The capital employed in the business is
Rs.8,00,000. The normal rate of return expected in this business is 10%. It is expected that the
company will be able to maintain the super profit for the next 5 years. Calculate the value of goodwill
as the basis of:
a. 5 years purchase of super profit method.
b. Annuity method, taking the present value of annuity of Re.1 for five years at 10% as 3.78 and
c. Capitalization of super profit method.
Ans [a.Rs.80,000; b.Rs.60,480(Rs.!6,OOOx3.78) c. Rs.1,60,000]
265
5. A, B, and C are partners sharing profits and losses in the ratio of 2/5, 2/5 & 1/5
respectively. It was provided in the partnership agreement that in the event of the death or retirement
of a partner, goodwill should be calculated on the basis of three years purchase of the average net
profit for the preceding five years. B retires on 31st December,1998. Calculate the amount of
goodwill due to B. net profits for the previous five years were as follows:
1984 Rs. 32,000 1985 Rs.38,000 1986 Rs. 40,000
1987 Rs. 29,000 1988 Rs.41,000.
6. Manoj Ltd. agrees to purchase the business carried on by Ram Ltd., Goodwill for this purpose is
agreed to be valued at three years purchase of the weighted average profits of past four years.
The appropriate weights to be used are:
1st year - 1, 2nd year - 2, 3rd year - 3, 4th year - 4, 5th year – 5
Profits for the five years are:
First year Rs.30,000; Second year Rs.36,000; Third year Rs.45,000; Forth year Rs.49,000 and
Fifth year Rs.52,000.
7. Pankaj Ltd. proposes to purchase the business carried on by Murthy Ltd. Goodwill for this
purpose is agreed to be value at three years purchase of the weighted average profits of the past
four years. The appropriate weights to be used are:
1983 1 1984 2
1985 3 1986 4
The Profits for these years are : 1983 Rs. 1,00,00; 1984 Rs. 1,20,000; 1985 Rs. 1,00,000; and
1986 Rs. 1,50,000. On scrutiny of the accounts the following matters, are revealed :
a. On 1st September, 1985 a major repair was made in respect of incurring the plant in Rs.30,000
which amount was changed to revenue. The said sum is agreed to be capitalized for
goodwill calculation subject to adjustment of depreciation of 10% p.a on reducing balance method.
b. The Closing stock for the year 1984 was overvalued by Rs. 10,000.
c. To cover management cost an annual charge of Rs. 25,000 should be made for the Purpose of
valuation of goodwill. Compute the value of goodwill.
8. Abhishek runs a chemist shop. His net assets on 31st December, 1998 amount to Rs.22,00,000.
After paying a rent of Rs. 24,000 a year and salary of Rs. 30,000 to the chemist, he earns a
profit of Rs. 1,80,000. His landlord, who happens to be an expert chemist, is interested in
purchasing the shop. 10% is considered to be a reasonable return on capital employed. You may
assume that the value of premises as Rs. 2,40,000 and the reasonable remuneration for the new
proprietor as chemist Rs.40,000. Ascertain the amount, if any, to be paid for goodwill.
266
9. On the basis of the following, you are required to calculate (1) Capital Employed and (2) Average
capital Employed.
Rs. Rs.
Share Capital 3,00,000 Goodwill 25,000
Reserves 1,20,000 Buildings 1,75,000
Profit of the Machinery 1,40,000
Current year 50,000 Current Assets 3,10,000
Depreciation Fund:
Machinery 40,000
Buildings 10,000
50,000
S. Creditors 30,000
6,50,000 6,50,000

1. R.L.Gupta, M. Radhaswamy, Advanced Accountancy Volume II, Sultan Chand and Sons,
New Delhi.
2. A. Mukherjee and M.Hanif, Modern Accountancy Volume II, Tata Me Graw-Hill, New
Delhi.
3. M.C. Shukla, T.S.Grewal, S.C.Gupta, Advanced Accounts Volumell, S.Chand, New
Delhi.
4. S.N. Maheshwari, S.K.Maheswari, Corporate Accounting, Vikas, New Delhi.
5. S.K.R. Paul, Accountancy Volumell, New Central book agency (p) Ltd. Kolkata.
6. R.S.N. Pillai, Bagavathi, S.Uma, Fundamentals of Advanced Accounting Volumell,
S.Chand, New Delhi.
10.7 ANSWERS
1. Super profit Rs. 10,000: Goodwill Rs. 30,000
2. Goodwill Rs. 92,857.
3. Goodwill Rs. 26,460.
4. a, Rs.80,000 ; b,Rs.60,480 (Rs.l6,000 × 3.78); c,Rs.l,60,000
5. B’s share of goodwill Rs. 43,200.
6. Goodwill Rs. 1,38,000.
7. Goodwill Rs. 3,22,620.
8. As there are no super profits, there is no goodwill
9. Capital Employed Rs. 4,45,000; Average Capital Employed Rs. 4,20,000.
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GUIDELINE 11 : VALUATION OF SHARES
OBJECTIVES
• The need for valuation of shares.
• The factors affecting the value of shares.
• Describe the quoted shares
STRUCTURE
11.1 Introduction
11.2 Quoted shares
11.3 Need for valuation of shares
11.4 Factors affecting value of shares
11.5 Summary
11.6 Glossary
11.1 INTRODUCTION
A share represents an interest in a company. There are a number of ways in which the shares
of a company may be valued .It can be valued either as an entitlement to a share of future profits, or
as an interest in the net assets that comprise the company. Therefore, the choice of method of
valuation is often governed by the reason for the investment. The majority of shareholders of a
company are interested in dividends. On the other hand, a majority of shareholders may be interested
in the realizable value of the company’s net assets since they can liquidate a company. Company
shares are not a quoted on any stock exchange. The ability to place realistic valuation on such
investments is of great importance.
11.2 QUOTED SHARES

In the case of quoted shares, the value of such shares can be obtained from the daily list of market
prices published by stock exchanges. While in some cases such prices may reflect the proper value,
in many cases they do not serve the purpose. As in the market, there are malpractices such as rigging
by manipulators, unhealthy and uninformed speculation. During the recent scam, even shares of sick
companies were manipulated to levels of high premium. Besides these factors, stock exchanges are
also subject to bullish and bearish phases, when the value of the same share differs considerably. It is
because of this reason probably, the Council of the London stock exchange opined, “We desire to
state authoritatively that stock exchange quotation are not related directly to the value of a company’s
assets or to the amount of its profits and consequently these quotation, no matter what date may be
268
chosen for reference, can not form a fair and equitable, or rational basis for compensation. The
Stock Exchange does not determine the prices of which the official list is the record. The Stock
Exchange may be likened to a scientific recording instrument which registers, not its own actions and
opinions, but the actions and opinions of private and institutional investors all over the country and
indeed the world. These actions and opinions are the result of hope, fear, guesswork, intelligent or
otherwise, good or bad investment policy and many other considerations. The quotations that result
definitely do not represent a valuation of a company by reference to its assets and it’s earning potential.
Thus the stock exchange price does not represent the strength of a company and referred to as
fundamentals in the financial literature. A fundamental analysis takes into account a thorough evaluation
of such factors as sales, profits, products, markets and management. The analysis concentrates on
the growth prospects of a company, its earning potential as indicated by earning per share (EPS), its
share in the market, its financial position, productivity factors and also such things as the quality and
ability of workforce and management which are not reflected in the financial statements. Stock
Exchange prices are no doubt influenced by fundamentals, but they are also influenced by extraneous
considerations such as political climate factors like war, embargo, and disruption to international
trader, etc.
11.3 NEED FOR VALUATION

1. When two or more companies amalgamate or one company absorbs another company, it is
necessary to form a fair and equitable basis of valuation for transferring the shares. The
prices quoted in the stock exchange, if any; do not properly indicate the actual value of the
shares. For formulating amalgamation and absorption schemes, a fresh valuation method
should be taken up.
2. When accompany has decided to undergo a process of reconstruction, to protect the rights
of the dissenting shareholders, a fresh valuation of shares should be taken up. The dissenting
shareholder should be paid as per the valuation of shares in respect of their holders.
3. When preference shares or debentures are converted into equity shares, a fresh valuation
method should be adopted for equity shares to calculate exchange ratio. It is necessary to
ascertain the number of equity shares required to be issued (based on the new valuation) for
debentures as preference shares.
4. Shares are often pledged as security for raising loans. In such cases, fresh valuation of shares
is necessary to know the real worth of shares on the basis of which loan is be provided.
5. When on company acquires majority of the shares of anther company, it is necessary to
value shares.
6. The survivor of a deceased person, who gets some shares of a company made by the will,
may require the valuation of such shares, which are not quoted in the stock exchange for
estate duty purposes.
7. Under a scheme of nationalization, when the shares of a company are taken over by the
Government, it is necessary to value the shares for reasonable compensation to the holders.
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8. When a partnership firm is dissolved and the firm is having some investment in shares, it is
necessary to value those shares for proper distribution among the partners.
11.4 FACTORS AFFECTING THE VALUE OF SHARES
The value of a share is greatly affected by the economic, political and social factors such as:
1. The nature of the company’s business;
2. The economic conditions of the country;
3. Other political and economic factors (e.g. possibility of nationalization, excise duty on goods
produced etc.);
4. The demand and supply of shares;
5. Proportion of liabilities and capital;
6. Rate of proposed dividend and past profit of the company;
7. Yield of the other related shares of the stock exchange Etc.
11.5 SUMMARY
A share represents an interest in a company. The majority of shareholders of a company are
interested in dividends on the other hand they are interested in the realizable value of the company’s
net assets. The value of quoted shares can be obtained from the daily list of market prices published
by stock exchange. The value does not represent a valuation of a company by reference to its assets
and earning potential. Thus the stock exchange price does not represent the strength of a company.
The need for valuation is for amalgamation and absorption schemes, discharge of debts and liabilities,
purchasing shares for control, the conversion of one class of shares to another class and granting loan
on the basis of security of shares. The value of a share is generally affected by the economic, political
and social factors.
11.6 GLOSSARY
Shares: Part of the Capital of a joint stock company.
Equity shares: the shares of a company which are not preference shares.
Share Capital: The total of share issued, or authorized to be issued, by the company.
Quoted Price: Usually the price of a share etc, As stated in the Official List of a Stock Exchange.
Stock Exchange: a place where stocks, shares and debentures are bought and sold under a code
of rules and regulations.
Stock Exchange Listing: The entry of shares and debentures of a company in the Official List of a
stock exchange.
1. Discuss the factors, which affect the value of shares?
2. Discuss the purposes for valuation of shares of a company?
270
1. R.L.Gupta, M. Radhaswamy, Advanced Accountancy Volume II, Sultan chand and sons,
New Delhi.
2. A.Mukherjee and M.Hanif, Modern Accountancy Volume II, Tata Me Graw-Hill, New
Delhi.
3. M.C.Shukla, T.S.Grewal, S.C.Gupta, Advanced Accounts Volumell, S.chand, New Delhi.
New Delhi.
271
GUIDELINE 12 : METHODS OF VALUATION OF SHARES
OBJECTIVES
• Explain the different methods for valuation of shares
• Compute the value of share
• Explain the meaning of certain key terms
STRUCTURE
12.1. Introduction
12.2. Methods of Valuation of shares
12.2.1. Net Assets or Break up value or Asset Backing Method.
12.2.2. Earning Capacity or Yield Basis or Market Value Method
12.2.3. Dual or Fair Value Method.
12.2.4. Other Methods.
12.2.4. a) Exchange Rate Method.
12.2.4. b) Simultaneous Equation Method.
12.3. Summary
12.4. Glossary
12.6. Further Readings
12.7. Answers
12.1. INTRODUCTION
The valuation of shares may be done by an accountant for two reasons one where there is no
market price as in the case of a proprietary company. Second where for special reason, the market price
does not reflect the true or intrinsic value of the shares. There is one more category of person who
purchase and sell shares for speculation purpose. All categories of persons will be interested in knowing
the value of shares purchased or sold by them. The term “value” of shares may mean its “Face Value” or
“Market Value” or “Intrinsic Value” or Yield Value”. The face value of a share is the value assigned to it by
the promoters of the company. The market value is the value at which they are bought and sold in the
stock in the stock exchange. The intrinsic value is based on the net company is ascertained on the basis
of its prospective yield or income.
12.2. METHODS OF VALUATION
The different methods of valuing shares may be broadly classified as follows.
1. Net Assets Basis or Intrinsic Value or Break up Value or Assets Backing Method
2. Earning Capacity or Yield Basis or Market Value Method.
3. Dual or Fair Value Method.
4. Other Methods
a. Exchange Rate Method
b. Simultaneous Equation Method
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12.2.1 Net Assets Method :
This is also known as intrinsic value method or break-up value method, or balance sheet method
or asset backing method. Under this method the net assets of the company are divided by the
number of shares to arrive at the net asset value of each share. While valuating the share as per this
method the following points are to be borne in mind.
a) The goodwill is to be revalued.
b) Fixed assets are to be taken at their market value.
c) Floating assets are also taken at market value.
d) Fictitious assets like such as preliminary expenses, accumulated losses etc. are to be
excluded.
V ALUATION OF EQUITY SHARES :
(1) Net Assets method :
All assets at market value xxx
(Goodwill, land & buildings, plant &
machinery, furniture, stock, debtors,
bills receivable, cash, bank etc.)
Total proceeds xxxx
Lees : Payment in the event of liquidation xxx
(Debentures, creditors, other liabilities etc.)
Less Preference shares xxx
Balance available for Equity shares xxx
Value for equity share = Amount available to equity share holders
No. of equity shares
Value of equity shares can also be ascertained as follows :
Equity share capital xxx
Add Reserves & Surplus xxx
Add Profit on Revaluation of assets & Liabilities xxx
Gross Equity xxx
Less : Loss on revaluation xxx
Less : Miscellaneous expenditure and xxx
other losses
Value Per equity share = Net equity
Number of equity shares
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ILLUSTRATION 1 :
The following is the Balance sheet of ABC Company Ltd. as on 31 st March, 2003.
Balance Sheet
Share Capital Fixed Assets 4,00,000
12% Preference
Share capital of
Rs. 10 each fully Paid 2,00,000 Current Assets 2,48,000
Equity shares of 10/-
each fully paid 3,00,000 Preliminary expenses 10,000
General reserve 5,000 Unwritten off discount 5,000
Debenture redemption
fund 25,000 Profit & Loss account 27,000
Investment fluctuation
fund 10,000
15% Debentures 50,000
Depreciation Fund 10,000
Sundry creditors 90,000
6,90,000 6,90,000
Current assets include investments Rs. 50,000/- market price 0f which is Rs. 48,000/- Debtors
included in Current Assets are doubtful to the extent of Rs. 5,000/- For which no provision has been
made so far. Stock at the end did not include a return of Rs. 1000/- though transaction was property
recorded and posted.
Debenture interest is owing for one year and preference, dividends are in arrears for two years.
Assuming other assets are worth book value, you are required to value the shares if:
(a) Preference shares have priority both as to the payment of capital and arrears of dividend, in
the event of liquidation takes place.
(b) Preference shares have no priority as Capital and arrear of dividend.
(c) Preference shares have priority as to the payment of capital only.
(d) Preference shares have priority as to the payment of arrears of dividend only.
SOLUTION :
Calculation of Net assets :
Assets :
Fixed assets as per book values 4,00,000
Less : Depreciation 10,000 3,90,000
Current Assets
2.48,000
6,38,000
Fall in value of investments 2,000
Provision for doubtful debts 5,000
7,000
6,31,000
Add: Increase in the value of stock at the end 1,000
Less Liabilities :
5% Debentures 50,000
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Interest on debentures for
One year 2,500 1,42,500
Net Assets. 4,89,500
2. Calculation of Value of Shares :
(a) When preference shares have priority as to repayment of capital as well as dividend :
Net assets as per above 4,89,500
Less : Preference capital 2,00,000
Preference Dividend for two years 24,000
2,24,000
Amount available to equity share holders 2,65,500
Intrinsic value of Equity shares = 2,65,500/30,000 = 8.85
(b) When Preference shares have on Priority at all :
Net assets as per above available for equity
and preference share capitals 4,89,500
4,89,500
Value per share = ——————————— = 9.79
20,000+30,000
(c) When Preference shares have Priority as to the payment of capital only :
Amount available for Equity share capital 2,89,500
Value Per share = 2,89,500 = 9.65
30,000
(d) When Preference shares have priority as to the payment of dividend only :
Less : Preference dividends for 2 years 24,000
Balance available for equity and preference Share capital 4,65,500
4,65,500
Value per shares = ————— = 9.31
50,000
(2) YIELD METHOD :
The net asset method of valuation shows emphasizes the safety of the investment. Since, as
investor is normally interested in the safety of his investment the net assets method provides information
about safety of his investment at the same time an investor may emphasis for higher yield form his
investment. The yield here means the possible return that an investor get out of his investment in the
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form of dividend, bonus shares, rights issue etc. If the return is more the price of the share also more.
Under this method the valuation of share obtained by comparing the expected rate of return with the
normal rate of return. The resulting value is called as the market value of the share.
Calculation of share value as per yield method :
First we have to calculate the expected rate of return:
Profits available for equity dividend
Expected Rate of Return =——————————————— x 100
Paid up Equity capital
Expected rate
Value of share (Market Value) = ——————————— x Paid up value of share
Normal rate
Alternatively, the market value of share can also be calculated by the following formula :
Dividend per share
Value of share = ————————————— x 100
Normal rate
ILLUSTRATION : 2
From the following Balance sheet of Auto pal Ltd. as on 31-12-2007 calculated the fair value
of equity share.
Balance Sheet
Share Capital
10% Preference shares
of Rs. 10 each 6,00,000 Fixed Assets 40,00,000
3,00,000 Equity shares
of Rs. 10% each 30,00,000 Investments (Non-trading) 5,00,000
General Reserve 5,00,000 Current Assets 20,00,000
Profit & Loss Account 4,00,000 Preliminary expenses 1,00,000
Creditors 8,00,000
Bills payable 3,00,000
66,00,000 66,00,000
The average annual Profit including Rs. 50,000 non-trading income is Rs. 5,00,000. Goodwill
is to be valued at 3 years Purchase of Super Profit. Normal rate of return on capital employed is
10%.
Solution :
Calculation of Good will :
1) Capital employed :
Fixed assets 40,00,000
276
Creditors 8,00,000
Bills payable 3,00,000 21,00,000
10
Normal Profit = 39,00,000 X ——— = 3,90,000
100
Calculation of Average adjusted Profit :
Average annual Profit 5,00,000
Less : Non-trading income 50,000
4,50,000
Super Profit + Average adjusted Profit - Normal Profit = 4,50,000 - 3,90,000 = 60,000
Therefore, Goodwill = 60,000 x 3 = 1,80,000
Valuation of Shares :
(a) Net Asset Method:
Goodwill 1,80,000
Investments 5,00,000
Total assets ———————
66,80,000
Creditors 8,00,000
Bills Payable 3,00,000
—————— 21,00,000
Net assets 45,80,000
Less : Preference share capital 6,00,000
39,80,000
Value of Equity shares :
39,80,000
———— = 13.27
3,00,000
b) Yield Method :
Average annual profit : 5,00,000
Less : Preference dividend 60,000
Profit available for Equity 4,40,000
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Profit available for equity dividend
Expected Rate of Return = ——————————————— x 100
Paid up equity capital
= 4,40,000
———————— x 100 = 14.67
3,00,000
Value of share = 14.7/10 x 10 = 14.7
Value of share as Value of share as
Per net asset method + Per yield method
Fair value of each share = ——————————————————
2
13.27 + 14.70
= ————————— = 13.99
2
(3) EARNING CAPACITY METHOD:
When some one is interested to acquire majority of shares of company in order to have controlling
interest in it, is not so much interested in the declared rate of dividend but he is interested to know the
disposable profits of the company. The profit is calculated after deducting reserves and taxes from
the net profit of the company. The profits earned by the company are compared with the capital
employed in the business and the rate of earning is found out.
Profit earned
Rate of earnings = ———————————— x 100
Capital employed
Rate of earning
Value of share = —————————————— x Paid up value of share
The rate of earning is usually calculated by taking into the total capital employed which
includes equity capital, preference capital and long term borrowings. As the total capital is taken and
preference dividend, but after tax all taken into account. On the basis of this the rate of earning is
calculated as follows :
Profit earned
Rate of earning = ——————————— x 100
Capital employed
Because of the difficulties involved in calculated by taking into account the profits available for
Equity share holding and the equity share capital only.
ILLUSTRATION : 3
Sri Krishna holds 5,000 Equity shares in Volta’s Ltd. The nominal and paid up capital consists of
1. 20,000 Equity share of Rs. 10 each
2. 10,000 10% preference share of Rs. 10 each.
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The Preference shares do not participate further in the profits.
It is ascertained that the normal annual profit of such a company is Rs. 50,000 and the normal
return by way of return on the paid up value of equity share capital for the type of business carried
out by this company is 15%. Sri Krishna required you to value his share holdings based upon the
above figures.
Solution :
Annual Net Profit : Rs. 50,000
Less : Preference dividend : 10,000
Profit available for Equity dividend : 40,000
Profits available for Equity dividend
Rate of earnings = ——————————————— x 100
paid up Equity capital
40,000
= ————————— x 100 = 20%
2,00,000
Rate of earning
Value of share = —————————————— x Paid up value of
share = 20.0/15 x 10 = 13.33
Hence the value of 5,000 shares held by Sri Krishna is %s. 5,000 x 13.33 = 66,650/-
Alternatively the value of share holdings can be calculated as follows :
capitalized value of the profit of Rs. 10,000 at 15% is = 40,000 x 100/15 = 2,66,667/-
2,66,667
Earning capacity of each Equity share = —————— = 13.33
20,000
Therefore the value of 5,000 held by Sri Krishna = 5,000 x 13.33 = 66,650/-
EXERCISES :
Exercise : 1
The following is the summarized Balance Sheet of the Victory Machines Ltd as on September 30,
2007.
Balance Sheet
Share capital :
60,000 Equity shares
of Rs. 10 each. 6,00,000 Freehold 2,40,000
Reserve and surplus Plant 1,00,000
General Reserves 2,40,000 Stock 6,20,000
Capital Reserve 80,000 Debtors 4,06,000
Profit and Loss 2,40,000 Bank 2,30,000
279
Current Liabilities and
Provisions Cash 4,000
Creditors 1,88,000
I.T.Payable 23,000
Proposed dividend 69,000
Provision for Taxation 1,60,000
16,00,000 16,00,000
Net profit (before taxation) for the past three years ended :
30th September, 2005 Rs. 2,76,000
30th September, 2006 Rs. 3,66,000
30th September, 2007 Rs. 3,95,000
Freehold Property was valued early in 2007 at Rs. 2,80,000 Average yield in this type of business is
15 per cent on Capital employed.
You are required to find out the value of each equity share on the basis of above mention facts.
Exercise : 2
On 31st December, 2007 the Balance Sheet of Ram sons Ltd. was as follows :
Balance Sheet
Share Capital Land & Buildings 5,20,000
Authorized and issued
5000 shares Rs. 100 each 5,00,00 Plant and Machinery 95,000
fully paid
Profit and Loss Account 1,03,000 Stocks 50,000
Bank O.D 20,000 Sundry Debtors 1,55,000
Creditors 77,000
Proposed Dividend 75,000
8,20,000 8,20,000
The net profits of the Company after deducting all working changes and providing
for depreciation and Taxation were as under :
Year Rs.
2003 85,000
2004 96,000
2005 90,000
2006 1,00,000
2007 95,000
280
On 31st December, 2007 Land and Buildings were valued at Rs. 2,50,000 and plant and machinery
at Rs. 1,50,000
In view of the nature of the business, it is considered that 10% is a reasonable return on
tangible capital.
You are required to Value the Company’s shares , after taking into account the revised
values of fixed assets and your own valuation of Goodwill based on five year’s Purchase of the super
profits.
Exercise : 3
From the following Balance Sheet of Vidiani Engineering Company, you are requested to
calculate the price to be paid for each share :
Balance Sheet
20,000 Equity shares of
Rs. 10 each 2,00,000 Goodwill 2,00,000
Investments at cost
General Reserve 2,00,000 (Market value is Rs. 3,00,000
2,50,000)
Workman’s Saving Fund 2,00,000 Stock at cost 5,00,000
Employees Provident
Fund 1,00,000 Debtors 4,00,000
Creditors 6,00,000 Cash 70,000
Profit and Loss Account 1,70,000
14,70,000 14,70,000
It is provided in the articles of association that for the purpose of valuation of shares, the
goodwill shall be valued on the basis of 3 years purchase of the average annual profits for the last 5
years. The profits for the last five years were Rs. 20,000, 25,000, 30,000, 35,000, 15,000.
Exercise : 4
The following information are obtained from the books of Sunrise Company Limited, as on
30th April, 2002.
10,000 Equity shares of Rs. 10 each fully paid up 1,00,000
10,000 Equity shares of Rs. 10 each Rs. 7.50 Per
Share called and paid up 75,000
10,000 Equity shares of Rs. 10 each, Rs. 5 per
Share called and paid up 50,000
General Reserve 1,35,000
Liabilities to sundry parties 55,000
Fixed assets less depreciation 1,67,000
Commission on issue of shares 6,000
Preliminary expenses 7,000
Floating assets 2,33,000
281
It is estimated that the normal average profit less tax of the company will be maintained at Rs.
36,000 and the expected rate for capitalization purpose in 8%. Calculate the values of each type of
share by the asset backing method (excluding goodwill) and also by the earning capacity method.
Assume dividends are declared on paid up capital.
Exercise : 5
The following is the summarized Balance Sheet of the confident co.Ltd. as at 31st
December, 2002.
Balance Sheet
Share Capital : Fixed Assets 8,00,000
Rs. 100 each 3,00,000 Stock 2,00,000
1,000 8% Preference Debtors 2,00,000
shares of Rs. 100 each 7,00,000
Profit and Loss Account 1,00,000 Bank 50,000
Creditors 1,50,000
12,50,000 12,50,000
The net profits of the company for the past five years before providing for taxation were
2003 Rs. 1,80,000, 2004 Rs. 2,00,000 2005 Rs 1,80,000, 2006 Rs. 1,50,000 and 2007 Rs.
1,00,000. Another company engaged in the same type of business pays dividend of 10% and its
shares are quoted on the stock exchange at Rs.110. Assuming taxation at 50% and appropriation of
10% of the balance to reserves, ascertain the value of each equity share.
Exercise : 6
The financial position of pioneer Ltd. as on 31.12.2007 was as under :
Balance Sheet
Paid up capital Goodwill 3,00,000
12% Preference Shares Land 20,00,000
& Buildings
20,000 of Rs. 100 each 20,00,000 Plant & Machinery 50,00,000
30,000 of Rs. 100 each 30,00,000 Stock-in-Trade 60,00,000
Rs. 100 each 75/- per 30,00,000 book debts 16,00,000
share paid
Reserves 10,00,000 cash at bank 78,000
Profit for 1994 15,00,000 Preliminary 22,000
Expenses
Sundry creditors 25,00,000
1,50,00,000 1,50,00,000
282
Revaluation of assets was as follows :
Land & Building Rs. 25,00,000
Plant and Machinery Rs. 65,00,000
Stock-in-trade Rs. 45,00,000
Normal return on capital employed for valuation of goodwill is 10%. Profits for the last three
years have shown an increase of Rs. 2,50,000/- annually. The basis of valuation of goodwill is 3
years purchase of sure profits. Preference shares dividend for the year was in arrear and was included
in sundry creditors. Similar companies are paying 12% dividend on equity shares. Find out the value
of Equity and preference share. ignore Income-tax.
Exercise : 7
On December 31st, 2007 the Balance Sheet of X Limited Company disclosed the following
position.
Balance Sheet of X Ltd.
Issued Capital Rs.10
shares 8,00,000 Fixed assets 10,00,000
Reserves 90,000 Current assets 4,00,000
Profit and Loss Account 1,20,000 Goodwill 1,40,000
15,40,000 15,40,000
On December 31 2007 the fixed assets were independently valued at Rs. 8,50,000 and the
Goodwill at Rs. 1,50,000. The net profit for the three years were : 2005, Rs. 1,51,600, 2006, Rs.
1,52,000 and 2007 Rs. 1,51,650 of which 20 per cent was placed to reserve, this proportion being
considered reasonable in the industry in which the company is engaged and where a fair investment
return may be taken at 10 per cent. Compute the value of the companies shares by (a) the asset
method and (b) the yield method.
Exercise : 8
Under the Articles of a private Limited Company, the value of shares is to be fixed by the
auditor. the company’s position as at 31st December, 2007 was as follows :
Balance Sheet
Share capital : Buildings at 80,000
Cost
5,000 Equity Shares Furniture at
of Rs. 100 each 5,00,000 cost 3,000
Reserve Fund 1,50,000 Stock at 4,50,000
market value
Profit and Loss
Account as on Investment 3,80,000
at cost
283
1-1-2002 80,000
Profit for 2002 4,30,000 5,10,000 Debtors 3,00,000
Less:
Depreciation fund : Provision 20,000 2,80,000
Buildings 10,000 Cash and bank
balance 70,000
Investments 45,000 55,000
12,63,000 12,63,000
You are given the following information :
(a) the Company’s prospects for 2008 are equally good.
(b) the buildings are now worth Rs. 3,50,000
(c) Public companies doing similar business show a profit earnings capacity of 15% on
market value of their shares.
(d) profits for the past three years have shown an increase of Rs. 50,000 annually.
Determine the fair value of shares.
ILLUSTRATION : 1
From the following balance sheet of ABC Co Ltd., as at 31st December 2007, find out the
intrinsic value of equity share.
Share capital Good will 25,000
8% Preference shares
of Rs. 100 each 2,00,000 land & Buildings 1,00,000
2,500 Equity shares
of Rs. 100 each 2,50,000 Plant & Machinery 2,50,000
General Reserve 20,000 Stock 1,80,000
Profit & Loss A/c 25,000 Sundry debtors 50,000
9% Debentures 1,00,000 Investment : 5%
Provision for Govt, securities (face
taxation 35,000 value Rs. 25,000) 30,000
Sundry creditors 30,000 Cash at bank 10,000
Preliminary Expenses 15,000
6,60,000 6,60,000
Goodwill should be valued at 5 years purchase of super profits. The average profit of the
company for the last three years after charging income-tax is Rs 75,000. Fair return on capital
employed is 10% Assets to be revalued-Land & Building Rs. 1,50,000 and plant and machinery Rs.
2,00,000. 284
SOLUTION :
GOOD WILL :
Average Profit 75,000
Less : Non-Trading income from 1,250
Investments @ 5% of Rs. 25,000 73,750
Less : Debenture Interest 9,000 64,750
Less : Normal return on capital employed
(Assets - Liability)
(150000 + 200000 + 180000 + 50000 + 10000 - 30000 - 35000) = 5,25,000
Capital employed : at fair return by 52,500
Capital employed : 5,25,000 x 10/100 Super Profit : 12,250
Value of goodwill = 5x 12,250 = 61,250
Valuation of shares :
Good will 61,250
Land & Buildings 1,50,000
Plant & Machinery 2,00,000
Stock 1,80,000
Sundry debtors 50,000
Investments 30,000
Cash Balance 10,000
6,81,250
Less Liabilities :
Sundry Creditors 30,000
Provision for taxation 35,000 1,65,000
Net Assets: 6,16,250
Less Preference share capital 2,00,000
Net Assets available to
equity share holders 3,16,250
Value of each Equity share : 3,16,250
2,500= Rs.126.50
Illustration : 2
The following is the Balance sheet of Ramakrishna & Co. Ltd as on 31st Dec. 2007.
Share Capital Fixed Assets : 30,000
1,000 6% Preference share
of Rs. 10 each 10,000 Current Assets 25,000
3,000 Equity shares
of Rs 10 each 30,000 Preliminary Expenses 2,000
7% debentures 10,000
Debenture Redemption
fund 5,000 Discount on Debentures 3,000
285
7% Depreciation fund 10,000 Profit & Loss A/c 12,000
72,000 72,000
You are supplied with the following information :
A. Debenture interest in owing for one year.
B. Book debts included in current assets are doubtful to the extent of Rs. 2,000 for which no
provision has been made.
C. The market value of investment included in current assets in Rs. 30,000, while the
asset has been showing at its cost of Rs.35,000
Ascertain the value of each equity share by the asset backing method :
SOLUTION :
Fixed Assets : 30,000
Less : Depreciation fund 10,000
Current Assets 25,000 20,000
Less : Provision for doubtful debts. 2,000
23,000
Less : Fall in the value of Investment : 5,000 18,000
Total Assets : 38,000
Less : Liabilities : 7% Debentures 10,000
Debenture Interests 700
Sundry creditors 7,000 17,700
Net Assets : 20,300
Value of Net Asset : 20,300
Less : Preference share capital 10,000
Net assets available to equity 10,300
share holders :
Value of each Equity share : 10,300
3,000 = Rs. 3.43
Illustration : 3
From the under mentioned balance sheet of a limited company as on 31st December, 2007, find
the intrinsic value of each equity share :
Share Capital Good will 2,00,000
6,000 6% Preference
shares of Rs. 100 each 6,00,000 Land & Buildings 1,00,000
1,00,000 equity shares Plant & Machinery 2,50,000
of Rs. 1 each 1,00,000 Furniture 80,000
Capital Reserve 20,000 Investment in Govt
General Reserve 50,000 Securities 1,00,000
Profit & Loss A/c 50,000 Stock 1,00,000
286
5% Debentures 1,00,000 Debtors 90,000
Sundry Creditors 40,000 Cash at Bank 40,000
Provision for taxation 20,000 Referred reserve
expenditure 20,000
9,80,000 9,80,000
Preference dividends are in arrear for them year. There is a disputed liability of Rs. 10,000 not
showing in the above balance sheet and Rs. 8,000 is likely to materialize. There is also a liability of
Rs. 2,000 Which remains unrecorded. Good will is worth the same figure and 5% of debtors are
considered doubtful.
SOLUTION :
Assets :
Good will 2,00,000
Land & Building 1,00,000
Plants & Machinery 2,50,000
Furniture 80,000
Investments 1,00,000
Stock 1,00,000
Debtors (90000-4500) 85,500
Cash at bank 40,000 9,55,500
Liabilities :
Creditors 40,000
Provision for taxation 20,000
Preference dividend 1,08,000
Contingent liability 8,000
Unrecorded liability 2,000 2,78,000
Net Assets 6,77,500
Less : Preference share capital 6,00,000
Net assets available to equity share holders : 77,500
Intrinsic Value of each Equity share : 77,500

1,00,000 = Rs. 0.77
Illustration : 4
A company has, as its capital, 1,00,000 ‘A’ equity shares of Rs.1 each, fully paid, 1,00,000 “B”
Equity shares of 1 each, 0.75 paise paid up paid up, and 1,00,000 “C” equity shares of Rs. 1 each.
50 paise paid up. The normal average net profit, less tax of the company is estimated to be Rs.
36,000 and the estimated rate of capitalist in 8% calculate the value of each class of share.
287
Solution :
Average net profits : 36,000
At 8% the capitalized value in 36000X100= 4,50,000
8
Value of each fully paid share : 4,50,000= 2
2,25,000
Value of each ‘A’ equity share : Rs. 2
Value of each ‘B’ equity share : 4,50,000 X 75

= 1.50
22500 100
Value of each ‘C’ equity share : 4,50,000 50 X = 1.00
225000 100
The Value of each class of share can also be found out by adopting the above formula.
‘A’ Equity shares :
Expected Rate = Profit available X 100
Total paid-up Equity share
= 36000 X 100 = 16%
225000
Value of share = 16 X 1
Rs. 2
8
‘B’ Equity shares :
Expected Rate : 36,000 X 100
= 16%
2,25,000
Value of share : 16 X 75
= Rs. 1.50
8 X 100
‘C’ Equity shares :
Expected Rate : 16%
Value of share : 16 X 50
= Rs. 1.00
8 X 100
Illustration : 5
In 31st December 2007, the balance sheet of Umamheswar Ltd. disclosed the following
position.
288
Balance Sheet
Issued capital in 4,00,000 Fixed Assets 5,00,000
Shares of Rs. 10 each Current Assets 2,00,000
Reserves 90,000 Goodwill 40,000
Profit & Loss 20,000
7,40,000 7,40,000
On 31 st December 2007 the fixed assets were independently valued at Rs. 3,50,000 and the good
will at Rs. 5,50,000. The net profits for the three years were : 2005 Rs. 51,600, 2006 Rs. 52.000,
2007 Rs. 51,650 of which 20% was placed to Reserve Account and this proportion being considered
unreasonable and where a fair investment returns may be taken at 10%.
Compute the value of the company’s share by the yield method.
SOLUTION :
Calculation of average expected future profits :
Profit for 2005 : 51,600
Profit for 2006 : 52,000
Profit for 2007 : 51,650
Total 1,55,250
Average Profit : 1,55,250
= 51,750
3
Less : 20% Transfer to reserve 10,350
————
Average profit after reserve 41,400
Expected Profits
Calculation of expected return : ———————————— X 100
Equity capital
41,400
————— x 100 = 10.35%
4,00,000
Calculation of yield value of share :
Expected Rate x Paid up value of share
———————————————————————
Normal Rate
289
= 10.35
X 10 = Rs. 10.35
10
Illustration : 6
The following is the balance sheet of XYZ Ltd. as on 31-12-2007
Share Capital Fixed Assets 4,00,000
6% Preference shares Investments
of Rs. 10 each 60,000 (Non-Trading) 50,000
30,000 equity shares Current Assets 2,00,000
of Rs. 10 each 3,00,000 Preliminary Expenses 10,000
General Reserve 50,000
Profits & Loss A/c 40,000
5% debentures 1,00,000
Sundry Creditors 80,000
Bills Payable 30,000
6,60,000 6,60,000
Average annual profit (including Rs. 5,000 non-trading income) is Rs. 50,000 Good will is to
be valued at 3 years purchase of super profit. Normal retune on capital employed is 10% calculate
the fair value of each equity share.
SOLUTION :
Valuation of Goodwill
Average annual profit 50,000
Less : Non - Trading Income 5,000
45,000
Capital employed :
Less Liabilities :
Creditors 80,000
Bills payable 30,000 2,10,000
Normal Return capital employed
3,90,000 X 10 100
39,000
Super Profit 6,0000
290
Value of good will at 3 years purchase Rs. 6000 X 3 = 18,000
Valuation of Shares :
A : Net Assets method :
Assets :
Good will 18,000
Investments 50,000
6,68,000
Liabilities :
Creditors 80,000
Bills payable 30,000 2,10,000
Net Assets : 4,58,000
Less preference share capital 60,000
Put assets available to share holders : 3,98,000
Value of Equity share :
3,98,000 = 13.27
30,000
(B) Yield Method :
Average annual profit 50,000
Less Preference dividend 3,000
Profit available for equity dividend 46,4000
(Assessing no allocation is made to Reserve)
Profit 46,400 capitalize at 10%
46,400X100 = 4,64,000
10
Value of equity share = 4,64,000 = 15.47
30,000
Fair value of each share; 13.27 + 15.47/2 = 14.37
Illustration : 7
Mr. Rama Krishna holds 12,000 Equity shares in Bharat
limited the nominal and paid up capital of which consists of
A. 40, 000 Equity shares of Rs. 1 each
B. 10, 000 8% Preference shares of Rs. 1 each it in ascertained :
1. The normal Annual net profit of such a company in Rs. 12,000 and
2. The normal return by way of dividend on the paid up value of equity share capital for the
type of business carried out by the company is 15 percent.
291
Mr. Rama Krishna requires you to value his share holding based upon the above figures.
Note : The Preference shares do not participate further in profits
Solution :
Annual net profit as given 12,000
Less transfer to reserve (say 10%) 12,00
Balance 10,800
Less Preference dividend at 8% on Rs. 10,000 800
Profit available for equity share holders 10.000
Rate of earnings 10,000 X 10 = 25%
40,000
Normal rate of return as given : 15%
Value of each equity share :
Rate of earning
——————————————X paid up value per share
Normal rate of Return
Hence the value of Mr.Rama Krishnas holding :
2 5
12,000 x 1 —— = 12,000 x —— = 20,000
3 3
Illustration : 8
From the date given below pertaining to madhuri Manufacturing limited calcutta the value of
share of if (a) only a few shares are to be sold and if (b) majority shares are to be sold.
A. Share capital 1,00,000 shares of Rs. 10 each fully paid.
B. Profit after tax and dividend.
year 2000 2001 2002
Profit 2,00,000 3,00,000 3,10,000
Dividend 13% 15% 17%
C. Normal rate of return : 12%
SOLUTION :
(a) only a few shares are to be sold :
Average dividend rate : 13+15+17
———————— =15%
3
Rate of dividend
Yield value of each Equity share = ——————————————— x Paid up inclose of
each share
292
15
—— x 10 = 12.50
12
(b) Majority shares to be sold :
Average profits Rs.2,00,000 + 3,00,000 + 3,10,000
3
three years = 2,70,000
2,70,000
value of earning —————— x 100 = 27%
1,00,000
value of each equity share : 27/12X10=22.50
Illustration : 9
The following particulars are available in relation to company :
A. Capital : 450 6% preference shares of Rs. 100 each fully paid ;
4500 equity shares of Rs. 10 each fully paid:
B. External Liabilities Rs. 7,500
C. Reserves & surplus Rs. 3,500
D. The average normal profit (after taxation) earned every year by the company Rs.
8,505
E. The normal profit earned on the market value of equity shares, fully paid, of the same type of
companies is 9%
Calculate the fair value of share assuming that out of the total, assets worth Rs. 350 are fictitious.
Solution :
A. Intrinsic value of shares :
Gross Assets will be equal to capital, reserves and surpluses and liabilities.
Pref. Share Capital 45,000
Equity share capital 45,000
90,000
Reserves and surpluses 3,500
Liabilities 7,500
Gross Assets : 1,01,000
Less Fictitious assets 350
Liabilities 7,500 7,850
Assets available to share holders : 93,150
Less amount due to preference share holders 45,000
Net assets available to equity share holders : 48,150
293
Intrinsic value of shares : 48150
= 10.70
4500
Market value by Capitalization Method :
Average Profits (After tax) 8,505
Less Preference dividend 2,700
5,805
Less Transfer to reserve say 945
Profit available to 4,860
Equity share holders
Capitalized value of Rs. 4860 at 9%
100
= 4860 X = 54,000
9
value of one equity share
= 54,000
4500 =12
Fair value of share = 1070+12.00
= Rs. 11.35
2
Illustration : 10
Find the value of equity shares and also preference shares from the following particulars.
Preference share holders having a right of 20% surplus profits.
Balance Sheet of Madhuri & Co. Ltd.
1000 6% Preference shares Good will 10,000
of 10 fully paid 1,00,000 Sundry assets 4,85,000
1000 equity shares of Preliminary 5,000
Expenses
100 fully paid 1,00,000
100 equity shares of 100
each equity shares
of 100 50,000
Reserve Accounts 20,000
Creditors 1,80,000
5,00,000 5,00,000
Sundry assets were valued at Rs. 6,20,000 find out the share value on net asset method make
necessary assumptions.
294
SOLUTION :
Net Assets :
Good will is valued at per super profit method
Capital Employed 6,20,000
Less Liabilities 1,80,000
4,40,000
Estimated profit : 4,40,000 X 10 / 100 = 44,000
Business profit 50,000
Less Estimated profit 44,000
6,000
Good will = 6000 X 3 = 18,000
Assets 6,20,000
Good will 18,000
6,38,000
Less : Liabilities 1,80,000
4,58,000
Less Preference share holders :
1,00,000
Less Equity share holders 3,58,000
1,50,000
2,08,000
surplus to preference share holders :
2,08,000 x 20 = 41600
100
Preference share capital = 1,00,000 + 41,600 = 1,41,600
Value of each preference share 14,10,000 / 1000 = 141 . 60
Equity share value
surplus to equity share 208000 - 416000 = 1,66,400
Add uncalled capital 50,000
2,16,400
Add Equity share capital1,50,000
3,66,400
Number of shares = 2000
Each share value 366400 / 2000 = 183.20
Fully paid share value = 183. 20
Partly (50) paid share value183. 20 - 50
Rs. 133.20
295
Illustration : 11
On 31st December 2007 the balance sheet of Kranthi group of companies limited is as
follows.
Balance Sheet
Share capital : shares fixed 7,50,000
of Rs. 10 each 6,00,000 current assets 3,00,000
Reserve 1,35,000 Good will 60,000
5% debentures 1,50,000
current liabilities 1,95,000
Profit & loss account 30,000
11,10,000 11,10,000
On 31 st December 2007 the fixed assets were independent valued at 5,25,000 and the
good will 75,000, The net profit for the 3 years 2005 - Rs 77400, 2006 - Rs. 78,000, 2007 -
77,475 out of which 20% was placed to reserve. The proposition being considered reasonable in
the industry in which the company is engaged where a fair investment return is taken at 10%
Compute the value of equity share by using net assets method, yield method earning capacity
method and fair value method.
Solution :
1. Net assets method :
Good will 75,000
Less Trade Liabilities 1,95,000
7,05,000
Net assets : Available for debenture holders, preference share
holders and equity share holders :
Net assets 7,05,000
Less 5% debentures 1,50,000
5,55,000
Number of equity shares : 60,000
Each share value : 555000 / 60000 = 9.25
2. YIELD METHOD
Total profits : 77,400 + 78,000+77,475 = 2,32,875
Average Profits : 232875/3 = 77,625
Less 20% Reserve 15,525 15,525 62,100
296
Capitalized value 62,100X100/10 = 6210000
Equity shares 60,000
each equity share value = 621000/60,000 = 10.35
3. EARNING CAPACITY METHOD;
Total profits : 2,32,875
Average profits ; 232875/3 = 62100
Expected rate of return = Profit valuable for equity X 100

equity share capital
= 62100/6,00,000 X 100 = 10.35%
Each equity share value = expected rate of return X paid up value of share
normal rate of return 10.35/10X100 = 10.35
4. FAIR VALUE METHOD :
Intrinsic value of share + yield value of share
2
9.25 + 10.35 = 19.60 = 9.80
2
Illustration : 12
Mr. Vinod wants to invest Rs. 32,000 in equity shares of prasad & co., Ltd. the following
particulars are available.
Issued and paid up Capital ;
12% preference shares of Rs. 100 each Rs. 11,00,000
Equity share of Rs. 10 each Rs. 7,00,000
Rs. 18,00,000
The company is three years old and has earned an aggregate net profit of Rs. 9 lakhs. The
equity shares may yield 15% If the net assets are pre-valued, the value there of is Rs. 1,40,000 more
than the value stated in the books. what in the maximum number of shares Mr. Vinod can purchase
based on fair value of the shares?
SOLUTION :
1. Value on yield basis : Average net profit for a year = 9/3
Rs. 3,00,000
Less : Preference shares dividend 12% of
11,00,000 Rs. 1,32,000
Profit available to equity share holders = Rs. 1,68,000
Actual yield = 1,68,000/700,000 X 100 = 24%
Normal yield = 15%
Value of equity share = 24 % / 15% X 10 Rs. 16
297
2. Intrinsic value
Total Assets Rs. 18,00,000
Increase in value Rs.1,40,000
19,40,000
Funds belonging to equity share holders 8,40,000
Intrinsic value of equity share = 8,40,000 / 70,000 Esq. Shares = 12 /-
3. Fair value = 16 + 12 / 2 = Rs. 14 /-
No. of shares to be purchased on the basis of fair value = 32, 000 / 14 = 2,286 equity shares.
Illustration 1
From the following balance sheet of Sonu Ltd .You are asked to ascertain the value of each equity
share of the company:
Liabilities Total Assets Total

Equity share capital 2,00,000 Land and Building 35.000
20,00,000 shares @ Rs. 10 fully paid Plant & Machinery 1,70,000
6% preference share capital 1,00,000 Good will 90,000
1,000 Shares @ Rs. 100 fully paid Investments at cost
Reserves 60,000 Stock 15,00,000
Sundry creditors 40,000 Debtors
Provision for taxation 20,000 Cash at Bank
Other liabilities 10,000 Preliminary Expenses
Total 4,30,000 4,30,000
For the purpose of valuing the shares of the company, the assets were revalued as under:
Goodwill 50,000; Land & Building at cost plus 50%, plant and machinery Rs.1,00,000; Investments
at book value; stock Rs.80,000 and Debtors book value less 10%. Solution: Calculation of share
value under net assets method.
298
Particulars Rs. Total Rs.
Goodwill 50,000
Land and Building (Rs. 1,00,000 + 50,000) 1,50,000
Plant and machinery 1,00,000
Investments 60,000
Stock 80,000
Debtors (Rs.40,000 - 4000) 36,000
Cash at Bank 24,000
Less: Liabilities
Other liabilities 10,000 70,000
Net assets 4,30,000
Less: preference share capital 1,00,000
Net assets / Funds available to equity shareholders 3,30,000
Net assets / Funds available to E.S.H.
Value of each share = —————————————————————————
No.of equity shares.
Rs. 3,30,000
= —————————— = Rs. 16.50.
20,000 shares
12.2.2. Earning Capacity or Yield or Market Value Method:
This method of valuation of shares may do valuation by any of the following ways:
a. Valuation based on rate of return.
b. Valuation based on productivity factor
12.2.2. a. Valuation based on rate of return; The term “rate of return” here means a return which
a shareholders earns on his investment. The rate of return can further be classified as (i) rate of
dividend (ii) rate of earning and (iii) price earning ratio.
12.2.2.a.i. Valuation based on rate of dividend: This method of valuation of shares is suitable for
small blocks of shares because small shareholders are usually interested in dividends.
The value of a share according to this method is ascertained as follows:
Possible rate of dividend
Value of share = ————————————————× paid up value of shares
Normal rate of dividend
OR
299
Dividend per share
—————————————— ×100
Normal rate of dividend
Total profit available for dividend
Possible rate of dividend = —————————————————————
Total paid up equity capital
Dividend on equity shares is to be calculated by deducting taxation, transfer to reserve,
transfer to debenture redemption fund and preference dividend from the maintainable profit and
dividing the residual by the number of shares.
12.2.2.a.ii. Valuation based on rate of earning: This method of valuation of shares is particularly
suitable in case of big investors because they are more interested in company’s earnings rather than
what the company distributes in the form of dividends. The value of a share will be determined as
given below:
Possible Earning Rate
Value of Share = —————————————— × Paid up Value of Share
Normal Earning Rate
Actual profit earned
Rate of Earnings = ———————————— × 100
Capital employed
Actual profit earned means before debenture interest, preference dividend but after income tax.
12.2.2.a.iii. Valuation based on price earning ratio: This value is suitable for ascertaining the
market value of shares which are quoted in a recognized stock exchange. According to this method,
the shares are valued on the basis of earning per share multiple by price earning ratio.
Market value of share = Price earning ratio × Earning per share
Profits available for equity shareholders
Earning per share = ——————————————————————————-
Market price per share

Price earning ratio = ———————————————
Earning per share
100
Price earning ratio = ————————————
Illustration
From the following particulars, calculate the value of an equity shares (based on rate of earnings).
2,000, 9% Preference shares of Rs 100 each Rs. 2,00,000
50,000 Equity shares of Rs. 10 each, Rs. 8 per share paid up Rs. 4,00,000
300
Expected profit per year before tax Rs. 2,18,000
Rate of tax 40%
Transfer to general reserve every year 20% of profit
Normal rate of earning 15%
Solution
a) Calculation of profit available to equity shareholders Rs
Expected profit before tax 2,18,000
Less: Tax 87,200
Profit after tax 1,30,800
Less: Transfer to general reserve @20% 26,160
Profit after tax and transfer to general reserve 1,04,640
Less: Preference dividend @ 9% on Rs. 2,00,000‘ 18,000
Profit available to equity shareholders 86,640
b) Calculation of expected rate of earnings
Profits available to equity shareholders

Expected rate = ———————————————————————— × 100
Paid up equity share capital
Rs. 86,640
= ——————— × 100
Rs.4,00,000
= 21.66%
c) Calculation of equity share value

Expected rate
Value per share = —————————— × Paid up value per share
Normal rate
21.66
= —————— × Rs 8
15.0
= Rs. 11.55.
Illustration
The Profit of Appurva Ltd for the year ended 31st March, 2006 were Rs. 60,00,000. After
setting apart amounts for interest on borrowings, taxation and other provisions, the net surplus available
to shareholders is estimated at Rs. 15,00,000. The Appurva Ltd capital consisted of:
a) 1,00,000 equity shares of Rs. 100 each, Rs. 50 per share paid up; and
301
b) 25,000 12% cumulative redeemable preference shares of Rs. 100 each fully paid up. Enquires in
the stock market reveal that shares of companies engaged in similar business and declaring a dividend
of 15% on equity shares are quoted at a premium of 10%. What do you expect the market value of
the company’s shares to be, basing your working on the yield method?
Solution: Rs.
Net Surplus available to shareholders 15,00,000
Less: Preference dividend @ 12% on Rs. 25,00,000 3,00,000
Amount available for equity dividend 12,00,000
Rs. 12,00,000
Possible rate of equity dividend = ——————————
Rs. 50,00,0000
= 24%
Expected market value of each equity share at 15% dividend
= paid up value of each equity share + 10% premium
= Rs. 50 + 10% of Rs. 50 = Rs. 55
Therefore, market value of one equity share at 24% possible rate of dividend
24%
= ———— × Rs. 55 = Rs. 88
15%
Illustration
On December 31, 2005, the Balance Sheet of Sweetie Company reveals the following
position.

Share capital 40,00,000 Fixed Assets 50,00,000
Shares of Rs. 10 Good will 4,00,000
Reserves 900,000 Current Assets 21,00,000
Profit and loss a/c 2,00,000
5% Discount 10,00,000
Total 75,00,000 Total 75,00,000
On December 31, 2005, the fixed assets were independently valued at Rs. 35,00.000 and goodwill
at Rs. 5,00,000. The net profits for three years were: 2003 - Rs. 5,10,000; 2004 - Rs. 5,30,000 and
2005 - Rs. 5,20,000 of which 20% was placed under reserve; this proportion being considered
reasonable in the industry in which the company is engaged and where fair investment return may be
taken at 10%. Compute the value of the company’s shares by (a) Net Assets Method and (b)
Earning Capacity Method.
302
Solution
Net Assets Method

Rs.
Market Value of Fixed Assets 35,00,000
Goodwill as per valuation 5,00,000
Current Assets as per Balance Sheet 21,00,000
61,00,000
Less: Liabilities
Current Liabilities 14,00,000 24,00,000
Net Assets 37,00,000
Net Assets
Value per Share = ————————————————
Rs. 37,00,000
= ——————————— = Rs. 9.25
4,00,000 shares
Yield Method:
510000 + 530000 + 520000
Average Profit = —————————————————— = Rs. 5,20,000
3
Less: Transfer to reserve at 20% 1,04,000
Expected Profits 4,16,000
Expected Profit
Expected rate of return = ——————————————— × 100
Equity paid up capital
4,16,000
= ———————— × 100
40,00,000
= 10.4%
303
Expected rate of dividend
Share Value = —————————————————× paid up value per share
Normal rat of return
10.4
= ———————— × 10 = Rs. 10.4
10
12.2. b. Valuation of shares based on Productivity Factor:

Productivity factor means the earning power of the company in relation to the net worth of the
company. It is calculated as follows:
Average weighted taxed profit
Productivity Factor = ————————————-———————----- × 100
Average weighted net worth (i.e., shareholders fund)
Average weighted tax profit and average net worth are ascertained by taking a number of
years whose results are relevant to the future.
Productivity factor (as compared above) is applied to the average weighted net worth of the
company on the valuation date of shares to arrive at the projected earnings (i.e., maintainable profit)
of the company. The projected earnings after necessary adjustments (if any) such as dividend on
preference shares, effect of under-utilization of productive capacity, making appropriation for
rehabilitation and replacement purposes, are dividend by the normal rate of return to arrive at the
value of the company’s business in relation to the equity shareholders. The value of company’s
business so obtained is divided by the number of equity shares to get the value of each equity share.
Valuation of shares according to this method is made clear in the following illustration:
Illustration
The following figures relate to a company which has Rs. 10,00,000 in Equity Shares and Rs. 3,00,000
in 9% Preference Shares, all of Rs. 100 each:
Average net worth adjusted tax profit
(Excluding Investment)
Rs. Rs.
2003 18,60,000 1,90,000
2004 21,50,000 2,10,000
2005 21,90,000 2,50,000
The company has investments worth Rs. 2,80,000 (at market value) on the valuation date,
the yield in respect of which has been excluded in arriving at the adjusted tax profit figures. It is
customary for similar types of companies to set aside 25% of the taxed profit for rehabilitation and
replacement purposes. On the valuation date the net worth (excluding investment) amount to
Rs.22,50,000. The normal rate of return expected is 9%. The company has paid dividends consistently
within a range of 8% to 10% on equity shares over the previous years and it expects to maintain the
same.
304
You are required to ascertain the value of each equity share on the basis of productivity;
apply 1, 2 and 3 for weighted average.
Solution
Calculation of productivity factor
Year Average Adjusted Weights Weighted Net Weighted Adjusted

Net Worth Taxed profit Worth 2 x 4 tax profit 3x4
1 2 3 4 5 6
Rs. Rs. Rs. Rs.
2003 18,60,000 1,90,000 1 18,60,000 1,90,000
2004 21,50,000 2,10,000 2 43,00,000 4,20,000
2005 21,90,000 2,50,000 3 65,70,000 7,50,000
Total 6 1,27,30,000 13,60,000

Total weighted net worth
Average weighted net worth = ——————————————————-
Total weights
1,27,30,000
= ———————————— = Rs.21,21,667
6
13,60,0000
Average Weighted Adjusted Taxed Profit = ———————— = Rs. 2,26,667
6
Average weighted adjusted taxed profit
Productivity Factor = ———————————————————————— × 100
Average weighted net worth
2,26,667
= ————————— ×100 = 10.68%
21,21,667
Rs.
Therefore Maintainable Profit = 10.68% of Rs. 22,50,000 = 2,40,300
Less: Rehabilitation and Replacement Reserve @ 25% 60,075
1,80,225
Less: Preference Dividends (9% on Rs. 3,00,000) 27,000
1,53,225
1,53,225
Capitalized value of profit for equity shareholders = —————————×100 =
17,02,500
9
Add: Value of investments = 2,80,000
19,82,500
305
Rs. 19,82,500
Value of each equity share = ————————— = Rs. 198.25
10,000
12.2.3. Dual or Fair Value Method:Fair value of share is the simple average of intrinsic value and
yield value of such a share.
Intrinsic Value + Yield Value
Fair Value = ———————————————————-
2
Illustration.
The Balance sheet of DHANUSH Ltd., as on 31-3-2005 was as under:
20,000 Equity shares of Rs. 100 each 2,00,000 Land and Building 1,25,000
General Reserve 50,000 Machinery 75,000
Profit and Loss A/c 25,000 Investment of cost (Market
Creditors 45000 Value Rs.37,500 45,000
Provision for Taxation 20,000 Debtors 50,000
Provident Fund. 17,500 Stock 37,000
Cash at Bank 25,000
3,57,500 3,57,500
Additional Information:
(1) Land and Building and Machinery are valued at Rs.1,37,500 and Rs.55,000 respectively.
(2) Of the total debtors, Rs. 2,500 are bad.
(3) Goodwill is to be taken at Rs. 25,000.
(4) The normal rate of dividend, declared by such type of companies is 15% on the paid up
capital.
(5) The average rate of dividend, declared and paid by this company is 18% on its paid up
capital. Calculate the fair value of the Equity Share of the Company.
Solution Yield Method;

Rate of Dividend
Value of share = ————————————————× paid up value per share
Normal Rate of Dividend
18%
= ———— × Rs. 100
15%
= Rs. 120.
306
Value of Equity Share on the Basis of Intrinsic Value Rs.
Goodwill 25,000
Land and Building 1,37,000
Machinery 55,000
Investments at Market Value 37,500
Debtors Less Bad Debts Rs. 2,500 47,500
Stock 37,500
Cash at Bank 25,000
3,65,000
Less: Creditors 45,000
Provident fund 17,500 82,500
Net Assets Available for Equity Shareholders 2,82,500
Number of Equity Shares 2,000
Rs. 2,82,500
Value of Equity Shares = ——————————— = Rs.141.25
2,000
Value on the basis of Net Assets + Yield Value Fair

Value of Equity Share = ——————————————————————————
—————-
2
Rs. 120 + Rs. 141.25
= ————————————— = Rs. 130.63.
2
12.2.4 Other Methods
12.2.4.a. Exchange Rate Method: Under this method, funds available for equity shareholders of
two companies are calculated and are divided by the number of shares of each company. Comparison
of value per share of each company will provide the exchange ratio for valuation of shares. This will
be clearer from the following illustration.
Illustration
On the basis of the following Balance sheets of X Ltd And Y Ltd. and the further information given
below, determine a reasonable exchange ratio on the basis of break-up value for the absorption of Y
Ltd. by X Ltd.
307
BALANCE SHEET
Liabilities Rs Assets Rs
Share Capital: Fixed assets
Equity shares of Rs.100 each 10,00,000 Land and Building 4,00,000
Less: Call in arrear (Rs.10 for 1,00,000 Machinery 4,50,000
final call) ________ Motor Car 25,000
9,00,000 Furniture Investments (face value) 25,000
Reserve and surplus: Current Assets:
General Reserve 3,50,000 Stock 7,25,000
Profit and Loss Account 2,50,000 Sundry Debtors 2,00,000
Current Liabilities: Cash at Bank: 1,05,000
Sundry Creditors 5,00,000 Miscellaneous Expenses 20,000
20,00,000 20,00,000
(1) Land and Building, Plant and Machinery and stock are worth as follows:
X Ltd Rs. Q Ltd Rs.
Land and building 5,00,000 2,00,000
Pant and Machinery 7,00,000 5,00,000
Stock 2,80,000 90,000
(2) It is agreed that goodwill is to be valued at three years’ purchase of super profits.
(3) For the past three years the profits of X Ltd have shown an increase of Rs. 20,000 annually
and the profits of Y Ltd have shown an increase of Rs. 10,000 annually.
(4) Companies of similar nature are showing a profit earning capacity of 10% on the market value
of the shares.
308
Solution :
Calculation of Average Capital Employed
Particulars Rs. X Ltd Total Rs. YLtd Total
Rs. Rs.
Land and Building 5,00,000 2,00,000
Plant and Machinery 7,00,000 5,00,000
Furniture 75,000 50,000
Stock 2,80,000 60,000
Sundry Debtors 5,00,000 2,50,000
Bank 75,000 30,000
Less: Debentures 21,80,000 11,40,000

Sundry Creditors 4,00,000 2,00,000
3,50,000 1,50,000
7,50,000 3,50,000
Less: Half of the current years Profits 14,30,000 7,90,000
1,00,000 37,500
Normal Profit 13,30,000 7,52,500
Super Profit: 1,33,000 75,200
Average Profit 1,80,000 65,000
Less: Interest on investments 5,000 2,500
Future Maintainable Profit 1,75000 62,500
Less: Normal Profit 1,33,000 75,250
Super Profit 42,000 -7250
Value of Goodwill 12,60,000 Nil
Valuation of Share
Particulars X Ltd Rs. Y Ltd Rs.
Total Assets (as above) 21,80,000 11,40,000
Add: Investments 1,00,000 50,000
22,80,000 11,90,000
Add: Goodwill 1,26,000 Nil
24,06,000 11,90,000
Less: Debentures and Creditors 7,50,000 3,50,000
Funds for Equity Shareholders 16,56,000 8,40,000
Number of Shares 10,000 5,000
Value per Share 166 168
Exchange Ratio should be 1 : 1
309
12.2.4. b. Simultaneous Equation Method: Sometimes exchange ratio between the two companies
is calculated by simultaneous equation. This generally happens when both companies (i.e. Transferor
Company and Transferee Company) have shares in each other. Valuation of shares is too made with
reference to intrinsic value under net asset method.
Illustration
B Ltd is absorbed by A Ltd on 31st March, 2006 on the basis of the following balance sheets:
Liabilities A Ltd BLtd Assets A Ltd BLtd

Rs. Rs. Rs. Rs.
Paid up Capital 2,00,000 10,00,000 Fixed Assets:
Equity Shares of Rs.5 5,00,000 Machinery 3,00,000
each 5,000 share of Rs.100 2,50,000 ______ Furniture 50,000
each fully paid General Reserve _______ 3,00,000 Current Assets
6%Debentures(Rs.100 each) 2,50,000 3,00,000 Stock 2,20,000 5,00,000
Sundry Creditors Debtors 2,00,000 2,50,000
Bank Balence 60,000 30,000
Investments:
500 Shares in --- 2,00,000
B Ltd.
400 Shares in
A Ltd.
Others 70,000
Debentures in
B Ltd. 50,000 ____
Profit & Loss ____ 1,20,000
15,00,000 11,00,000 A/c 15,00,000 11,00,000
The following is the scheme of absorption:
(1) Prior to absorption A Ltd. was to declare a dividend of 25%.
(2) For every share in B Ltd. 14 fully paid up equity shares in A Ltd. were to be issued.
(3) For each debenture in B Ltd. 7.5% preference shares of Rs. 100 each of A Ltd. were to be
issued as fully paid.
Directors of A Ltd decided to revalue the shares in B Ltd. according to their intrinsic value just before
absorption.
Calculate exchange ratio on the basis of intrinsic value of share of each company.
Solution
Calculation of Intrinsic Value:
A Ltd 1/10 shares of B Ltd. holds 1/5 shares of A Ltd. Suppose intrinsic value of A Ltd. is a and that
of B Ltd. is b.
310
a = Rs. 9,50,000 [i.e., Rs. 15,00,000 of total assets - Rs. 50,000 Investment in B Ltd -Rs. 2,50,000
Dividend-Rs. 2,50,000 Sundry Creditors] + (1 × b) /10
b = Rs. 2,30,000 (iii) + 1 x a/5
Rs. 2,30,000 + 1/5 (9,50,000 + 1b/10)
Rs. 2,30,000 + Rs. 1,90,000 + lb/50
49b/50 = Rs. 4,20,000
b = Rs. 4,20,000 x 50/49 =Rs. 4,28 571
a = Rs. 9,50,000 + 1/10 of Rs.4,28,571 = Rs. 9,50,000 + 42,857 = Rs. 9,92,857.
Value of share
Rs.9,92,875
A Ltd. = ——————————— = Rs. 4.96 approximately.
2,00,000
Rs.4,20,000
B Ltd. = ———————————— = Rs.84.
5,000
Thus exchange ratio will be approximately 17 shares of A Ltd. will be equal 1 share of B Ltd.
12.3 SUMMARY
The term “value” of shares may mean its “Face Value” or “Market Value” or “Intrinsic Value”
or Yield Value”. The face value of a share is the value assigned to it by the promoters of the company.
The market value is the value at which they are bought and sold in the stock in the stock exchange.
The intrinsic value is based on the net company is ascertained on the basis of its prospective yield or
income. The different methods of valuing shares may be broadly classified as follows: Net Assets
Basis or Intrinsic value or Break up value or Assets backing method, Earning capacity or yield Basis
or Market value Method, Dual or Fair value Method and Other Methods includes (a) Exchange
Rate Method (b) Simultaneous Equation Method.
. Net Assets Method the shares value is simply the net assets or equity, divided by the number of
shares. The value of a share is first determined by ascertaining the value of net assets of a company
and then dividing them by the number of shares. . Earning capacity or yield or Market value method
of valuation of shares may do valuation by any of the following ways: (a) Valuation based on rate of
return’ (b) Valuation based on productivity.
Valuation based on rate of return the term “rate of return” here means a return which a
shareholder earns on his investment. The rate of return can further be classified as (i) rate of dividend
(ii) rate of earning and (iii) price earning ratio.
311
12.4 GLOSSARY
Equity shares: The shares of a company which are not preference shares.
Share Nominal Value:Value of a share which is stated in the Memorandum of Association and on
the Share Certificate.
Yield: The Return earned on an investment, taking into account the annual income and its present
capital value.
Net Worth: Total amount involved in Share Capital plus Reserves. Alternatively, the difference between
total assets and outside liabilities.
Par Value:Nominal Value of a Share
Net Profit: The profit realized after charging overheads connected with distributing or selling the
goods and administering the business against gross profit.
Market Value: The market value is the value at which they are bought and sold in the stock in the
stock exchange.
Rate of Return: Means a return which a shareholder earns on his investment.
Productivity Factor: It represents the earning power of the company in relation to the value of the
assets employed for such earning.
Fair Value of Share:It is the average of the values obtained by net assets and yield methods of
valuation of shares.
Capital employed for equity shareholders: It represents the equity shareholder’s funds in a
company.

1. What are the methods of valuing the shares of a company?
2. Distinguish between intrinsic value and market value of shares?
3. Describe two methods of valuation of shares and discuss which method, in your view, is most
appropriate in valuing a minority and a majority holding.
4. Explain the circumstances under which valuation of shares is essential and discuss the various
methods of valuation.
5. Indicate briefly the steps involved in valuing shares under each of the methods:
(a) Earning basis;
(b) Net assets basis;
(c) Dual basis.
6. Explain with suitable examples the various methods of valuation of equity shares. Which will be an
appropriate method and under what situations?
Practical Problems
1. From the following information, find out the value of each share
312
Balance sheet of Ramu Ltd
Share Capital 2,00,000 Fixed Assets:
20,000 shares of Rs. 10 each Goodwill 1,90,000
Reserves & surplus 2,50,000 Investments 3,00,000
Profit & Loss a/c 30,000 current assets 50,000
Unsecured loans 80,000 Loans & advances 30,000
Current Liabilities 20,000 Misc. Expenditure 10,000
5,80,000 5,80,000
For the purpose of Valuation pf shares goodwill shall be taken at two year’s purchase of the average
profit of the last five years. The Profits for the last five years are: Rs. 50,000: Rs. 70,000: Rs. 50,000:
Rs.50,000; and Rs. 50,000.
2. On December 31, 2005, the Balance Sheet of a limited company disclosed the following position:
Capital Rs. 10 each 4,00,000 Fixed Assets 5,00,000
Reserves 90,000 Current Assets 2,00,000
P&LA/C 20,000 Goodwill 40,000
Current liabilities 1,30,000
7,40,000 7,40,000
On December 31, 2005, the fixed assets were independently valued at Rs. 3,50,000 and goodwill at
Rs. 50,000. The net profits for the three years were: 2003 Rs. 51,600; 2004 Rs.52,000; 2005
Rs.51.650 of which 20 per cent was placed to reserve, this proportion being considered reasonable
in the industry in which the company is engaged and where a fair investment return may be taken at
10%. Compute the value of company’s share by (a) Net assets method and (b) the Yield method.
3. The following is the Balance Sheet of Shuba Limited as on 31-12-2005

10,000 Equity Shares 1,00,000 Fixed Assets 2,00,000
of Rs. 10 each fully paid up
10,000 Equity Shares of
Rs. 10 each, Rs. 8 per share 80,000 Current Assets 1,30,000
Called and paid up
10,000 Equity Shares of
Rs. 10 each, Rs. 5 per share 50,000 Preliminary Expenses 10,000
Called and paid up
Reserves 40,000
313
P&LA/C 60,000
Creditors 10,000
3,40,000 3,40,000
The normal average profits of the company (after tax) will be maintained at Rs.46,000 and the
normal rate of return is 8%.
Calculate the value of each type of Equity Shares by the Asset Backing and Yield Method.
4. Following are the particulars of XYZ limited:
Equity shares of Rs. 10 each Rs. 4,00,000
5% Debentures Rs. 1,00,000
Current Liabilities Rs. 1,30,000
Current Assets Rs. 2,00,000
Fixed Assets Rs. 5,50,000
Goodwill Rs. 50,000
The profits for the last three years were Rs. 51,600, Rs. 52,000 and Rs. 51,650 respectively. 20%
is transferred to reserve. Normal rate of return is 10%. Calculate the value of shares under Net
Assets and Yield Method.
5. R. Rangarao holds 5,000 Equity Shares in Hindustan Ltd, the paid up capital of which is 30,000
Equity Shares of Re. 1 each. It is ascertained that: (a) the normal annual net profit of such company
is Rs. 5,000; and (b) the normal return for the type of business carried out by the Company is 8%.
Sri Rangarao required you to value his shareholdings based upon the above figures.
6. From the following information, calculate the value of Equity Share:
(A) The paid up Share Capital of a Company consisted of 1,000 15% preference shares of Rs. 100
each and 20,000 Equity Shares of Rs. 10 each.
(B) The average annual profits of the Company after providing for depreciation and taxation, amounted
to Rs. 75,000. It is considered necessary to transfer Rs. 10,000 to general reserve before declaring
any dividend.
(C) The normal return expected by investors on Equity Shares from the type of business carried on
by the Company is 10%.

1. R.L.Gupta, M. Radhaswamy, Advanced Accountancy Volume II, Sultan chand and sons, New
Delhi.
2. A.Mukherjee and M.Hanif, Modern Accountancy Volume II, Tata Me Graw-Hill, New Delhi.
3. M.C.Shukla, T.S.Grewal, S.C.Gupta, Advanced Accounts Volumell, S.chand, New Delhi.
314
New Delhi.
12.7 ANSWERS
1. Share Value Rs. 19.40
2. Net Asset Method Rs. 9.25; Yield Value Rs. 10.35.
3. Asset Backing Method Rs. 13, Rs. 11, Rs. 8 respectively, Yield Basis Rs. 25, Rs. 20 Rs.
12.50 respectively.
4. Net Asset Method Rs. 14.25, Yield Method Rs. 10.35.
5. Rs. 2.08.
6. Rs. 25
315
GUIDELINE 13 : ROLE OF FUNDAMENTAL AND TECHNICAL
ANALYSIS IN VALUATION OF SHARES
OBJECTIVES
v Objectives of Fundamental Analysis
v Role of Economic Forces.
v Economic Forecasting
v Industrial Product Life Cycle
v Assumptions of Technical Analysis
v Tools and Techniques of Technical Analysis
STRUCTURE
13.1 Introduction
13.2 Meaning of Fundamental Analysis
13.3 Objectives of Fundamental Analysis
13.4 Economic Analysis
13.5 Economic Forces
13.6 Methods of Economic Forecasting
13.7 Industrial Analysis
13.8 Company Analysis
13.9 Non – Financial Indicators
13.10 Technical Analysis
13.11 Assumption of Technical Analysis
13.12 Tools and Techniques of Technical Analysis
13.13 Summary
13.14 Keywords
13.15 Self Assessment questions
13.1 INTRODUCTION
The behaviour of share prices as well as, forecasting the prices of shares help the investor to
take certain decisions in the investment market. The primary purpose of making investments in stock
is to get gains from that investment. If the investor for a short period of time, it is speculative, but
when he holds it for fairly longer period he anticipates some return on his investments. Fundamental
Analysis is a method of finding out the future price of a stock, which an investor wishes to buy. It
316
relates to the examination of the intrinsic worth of a company to find out whether the current market
price is fair or not, whether it is over priced or under priced in the background of the company’s
performance, performance of the industry and also General- Socio – Political conditions of the
country. Estimate of real worth of a stock is done by considering the earning potential of the company.
The earning potential depends on investment environment and factors relenting to specific industry
such as competitiveness, quality of management, operational efficiency, profitability, capital structure
and dividend policy.
13.2 MEANING OF FUNDAMENTAL ANALYSIS

For the purpose of valuation of current intrinsic value, the fundamental analysts assume that
the current intrinsic value must be calculated not on its potential capital gain but on the total future
return for which an investor holds the share. So, A share’s true value discounts its future earnings i.e.
it takes into account the present worth of all those anticipated earnings.
13.3 OBJECTIVES OF FUNDAMENTAL ANALYSIS

The following are the objectives of fundamental analysis.
• Fundamental Analysis is an attempt to identify the under priced and over priced securities in
the market so that investment decisions (Buying and Selling) can be made.
• The fundamental analysts view investments as long term decisions.
• The primary objective of this analysis is not to make speculative profits.
• It is to avoid the risk of loss from buying an overpriced stock and selling an underpriced
stock.
• Another objective of fundamental analysis is to beat the market.
• Buying an underpriced sock and earning abnormal returns on investments is known as beating
the market.
The fundamental analysis is based on factors like economic climate and trends in financial markets, it
generally gives more realistic estimate of the value of a stock. The fundamental analysis is helpful in
establishing basic standards, but cannot be totally relied upon because of the uncertainties associated
with the economic and market factors.
The basic assumption of Fundamental Analysis is that the intrinsic value and market price of share
different from time to time. The investors, who can perform good Fundamental Analysis and identify
the discrepancies between market price and intrinsic value is able to realize profits by taking suitable
investment decisions before the discrepancy is eliminated in the market.
The Fundamental Analysis comprises of economic analysis, industry analysis and company analysis.
Fundamental analysis, thus comprises of
317
Economic Analysis
Industry Analysis
Company Analysis
Top down Approach
The fundamental analyst uses two types of approaches viz. (1) Top down approach and (2)
Bottom up approach
1. Top down Approach:Under this approach first they analyse the overall economy and
securities markets, second, they analyse the industry within which a particular company
operates and finally, they analyse the specific company.
2. Bottom Up Approach: Under this approach the fundamental analysis start with, company
analysis and the industry and over all economy.
Bottom Up Approach
Economic Analysis
Industry Analysis
Company Analysis
13.4 ECONOMIC ANALYSIS

The economic conditions prevail in a country has a major impact on overall stock prices.
Investors are concerned with those conditions in the economy which effect the performance of
organizations in which they wish to participate through purchase of stock. An understanding of the
economic forces would give an idea about future corporate earnings and the payment of dividends
and interest to investors. Economic analysis covers the following aspects.
i) Economic Analysis involves the study of economic trends in the country
ii) Economic Analysis involves the study of economic policies of the Govt. monetary policy,
fiscal policy, industrial policy, export-import policy, price policy etc.
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iii) Economic Analysis involves the study of relationship between economic trends and
economic policies and stability of such relationships.
iv) Economic Analysis also includes a study of world economic trends and their impact on
Indian economy.
13.5 ECONOMIC FORCES: The following are some of the broad forces within which the
factors of investment operate are
1. Population:
Countries, like India which has a huge population give demand for more industries like hotels,
residences, health, consumer goods industries etc. Capital being scarce in these countries
labour intensive industries grow at a faster rate. Investors prefer to invest in industries which
have a large labour force and such industries bring better rates of returns.
2. Performance of Agriculture:
In a country like India, 70% of the population depends on agriculture, contribute around
35% to GDP. The performance of agriculture is a very important force to be considered. As
the agriculture in India depends on monsoons, if the monsoon is good agriculture income
rises and the demand for industrial products and services will increase and the economy will
prosper and Vice-Versa.
3. Technology Development:
Research and development are the areas which the investor may consider for investment
purpose. The industries, which get a large amount of share in the funds for development of
country, attract lot of investments. For example, investors prefer to invest in IT industry,
Pharma industry, automobile industry etc.
4. Natural Resources:
Natural resources play an important role in the economic development of country. Untapped
and recently tapped resources would provide very high investment opportunities. Investors
generally prefer to invest in such industries which are making use of later technological
discoveries.
5. Role of Government:
In India public sector plays an important role in the economic development. Government is
the bigger investor and invests huge funds in public sector enterprises. Hence, the role of
govt. and its policies have an impact on stock market. It is an important force in economic
analysis.
6. Business Conditions:
General business conditions, the levels of business activity, business cycles influence the
demand for industrial products and the performance of industry.
7. Political Stability:
Political Stability is yet another important factor for good performance of the economy.
Political stability is indicated by stable and long term economic policies with no uncertainity.
Political uncertainities adversely affect the industrial growth and in turn the stock market.
The political and economic factors are interlinked.
8. Balance of Trade:
The balance of trade and the price of currency in the foreign exchange market also affect the
security market. Deficit trade balance and balance of payments position depreciate the
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currency in foreign exchange markets and has a negative influence on the economy and
securities market.
13.6 METHODS OF ECONOMIC FORECASTING
Economic forecasting is a measure to find out future prosperity of a pattern of investment.
Economic forecasting is a must for every investor when he has to take a decision to invest in stocks.
The technique of economic forecasting is to measure either short term or long term economic
developments well in advance. Economic forecasts are easier to find out during short term period.
Most of the economic forecasts are through the short term forecasting techniques.
Forecasting Techniques:
There are basically five economic forecasting techniques:
(i) Surveys (ii) Economic indicators (iii) Diffusion indexes (iv) Economic model building and
(v) Opportunistic model building
i) Surveys:
The simplest method of forecasting is to make a survey of the business that one is interested
to invest. This method is not accurate but an approximate method. It is based on beliefs,
intentions and future budgeting.
The method of forecast through survey is either (a) Personal contact or (b) through the
means of detailed questionnaire. For better results, surveys should be based on statistical
sampling procedures. After processing and tabulation of the information an analysis should
be made. Surveys are important method of increasing of people plan and budget for
expenditure in advance and adhere to their intentions.
2. Economic Indicators:
This method helps in finding out the leading, lagging and coincidental indicators of economic
activity. Though, a very accurate estimate may not be possible, the barometers indicate the
level of economic activity. This indication works geographically and through different weakly
and monthly periods. This method also gives results approximately and is at best an estimation
of the future economic conditions.
3. Diffusion Indexes:
The diffusion index is a method which combines the different indicators into one total measure
and it gives the weaknesses and strength of a particular time series of data. This diffusion
index is also called a census or a composite index. This is a complex statistical method and
the combination of various factors in this technique makes it extremely difficult to draw out a
proper understanding of the forecasting methods.
4. Economic Model building:
This is a mathetical and statistical application to forecast the future trend of the economy.
Economic model techniques takes one independent variable and one dependent variable
and then specifies in a formal mathematical manner the precise relation between these variables.
This model may be applied successfully in advanced countries where computers are extensively
used.
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5. Opportunistic Model Building:
This method is the most widely used economic forecasting method. This is also called sectorial
analysis of the Gross National Product Model Building. This method uses the national
accounting date to be able to forecast for a future short term period. This method is very
much reliable and it is often used for forecasting the economic conditions of an economy.
13.7 INDUSTRIAL ANALYSIS

The second stage in fundamental analysis is industry analysis.When an investor convenced
that the economy and markets are attractive for investment in common stock he should proceed to
consider those industries that promise most favourable opportunities in the coming years. Successful
investors are those who analyse the economic significance of industries and invest in those will be
successful. The purpose of industry analysis is to seek industries that are expected to grow faster
than the real rate of GNP.
Industry broadly covers all the economic activities happening in a country to bring growth.
According to standard industrial classification industries are classified into growth industries, cyclical
industries Defensive industries and cyclical grow industries. In India the broad classification of industry
is made according to the stock exchange list which is published. In this list the industries are classified
as Engineering, Electricity Generation, Textiles, Cement, Steel Mills, Cable and Electricals, Plantation,
Chemical and Pharma, Paper, Sugar, Rubber, Automobile, Cycle and Accessories, Miscellaneous.
The key characteristics in industrial analysis are,
(i) Sales trends and earning performance.
(ii) Cost structure
(iii) Technology
(iv) Govt. attitude towards industry
(v) Labour conditions
(vi) Competitive pressure
(vii) Industry share prices
(viii) Economic Environment of the country
(ix) Installed and utilized capacity
(x) Raw material and Inputs.
(xi) Industry characteristics,
(xii) Demand for the product
(xiii) Management
(xiv) Future prospects
The industry should also be evaluated or analyzed through its life cycle. Industry life cycle
may also be studied through the industrial life cycle state. There are generally four stages of an
industry viz. Pioneering stage, rapid growth stage, materials and stabilization stage and decline stage.
321
Life cycle applies to industries or product lines with in industries. The industry life cycle
concept is depicted in the following figure.
Expansion Stabilisation
Pioneering
Sales
Time
13.8 COMPANY ANALYSIS:

Company analysis is a study of the variables that influence the future of a firm both qualitatively
and quantitatively. It is a method of assessing the competitive position of a firm. Its earning and
profitability, the efficiency with which it operates its financial position and its future prospects with
respect to earnings of its shareholders. The company analysis is done by way of analyzing the
financial statements of an organization. The basic financial statements which are required as tools to
the fundamental analyst or the income statement, the balance sheet. These statements are useful for
investors and others, on the basis of these statements the future course of action may be taken by the
investors.While evaluating a company the statement must be carefully judged on the basis of correctness,
completeness, consistency and comparability. While evaluating the income statement particular attention
is to be paid in the following items.
a) Inventory cost methods
b) Depreciation
c) Earnings from regular operations
d) Intangibles
e) Earnings per share
f) Financial position etc.
Fundamental analysts make a careful analysis of shares. According to fundamental analysts
there should be a preliminary screening of investments, the economic and industrial analysis and
analysis of the company to find out its profitability and efficiency and to study different kinds of
company management.
Over a period of time the fundamental analysts have developed some valuation models to
show the effect of business decisions on the market value of a firm. The following are the models of
fundamental analysis.
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Timbergen Model:
P = f (x,y,z)
Where
P = share price
x = long – term interest rates
y = dividend yield on normal investment and
z = rate of change in share price
This model indicates: (a) that the stock prices vary directly with dividends and inversely with
interest rates. (b) this method determines share prices in such a way that it is quite similar to the
measurement of debenture prices.
William’s Model:
William values the share prices in the following manner:
n
R
P = ∑ (1 +
t=1
t
k )t
Where P = share price
Rt = expected value of return during period
k = discount rate
Graham Dodd Model:
The Graham Dodd Model is represented by the model given below:
 E
P = MD+ + A
 3
According to Graham and Dodd, the dividends of a firm determine market value of a company’s
equity.
P = share price.
M = earnings of firm paying a normal dividend
D = dividends per share
E = earnings per share and
A = adjustment for asset values
Walter Model:
Walters’ model is also described in the chapter on Dividend Policies in this book. It may be
described in the following manner:
E (b − K )(E − D )
P= +
K K2
+ (E − D )
r
P = k
K
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P = share price
E = earnings per share
K = market discount rate
b = growth rate
D = dividends per share
Earnings Model:
The Earnings Model assumes that the market value of a security is determined by the present
value of all the anticipated earnings.
n
Et − I t
P=∑
t =1 (1 + K )t
Pt = market price during period t
Et = earnings per share during period t
It = investment per share during period t
Bodenhorn’s Model:
This model based on the discount cash flow approach assumes that a firm’s equity is equated
with the present value of all future cash flows, which are represented through dividends and stock
purchases.
n
Cf t
Pt = ∑
t =1 (1 + K )t
Pt = market share price during period t
Cft = new cash flows anticipated in time period t
Ezra Solomon’s Model:
This model is represented as the investment opportunities approach. According to this
model
P = V1 + V2
Where P = market value of firm’s share
V1 = Present value of earnings from current investments and
V2 = Present value of earnings of future investments.
Ezra Solomon, therefore, takes into account existing and future investments and represents
the market value of a share as the sum of two discounted values.
Modgiliani Miller Model (MM Model):
This is the approach which presents the cost of capital approach. It takes into account
dividends, earning and capital gains.
Do
Po =
K −b
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It assumes that the rate of growth is constant, that corporate taxes do not exist, that the
number of investments is infinite. In the above example
Po = share price
D = dividend
K = rate of return
b = growth rate
13.9 NON FINANCIAL INDICATORS
In addition to financial indicators, the investor has to analyse some non – financial indicators
also. The following are the important non – financial indicators.
a) Business of the Company
b) Management
c) Market share of the company
d) Product range
e) Diversification
f) Expansion policy
g) Distribution policy
h) Foreign collaborations
i) Availability of in puts
j) Research & Development
k) Government Policy
l) Purchase time
m) New millennium trends
13.10 TECHNICAL ANALYSIS
Fundamental Analysis and technical analysis are two important approaches to security analysis.
Technical Analysis is used as a supplementary to fundamental analysis Fundamental Analyst forecasts
share prices on the basis of economic, industry and company analysis. According to technical analysis
the price of shares depends upon demand and supply of securities in the market. Technical analysts
have developed tools and techniques to study past patterns and predict future prices. Technical
Analysis is meant for predicting the price of a security.
13.11 ASSUMPTIONS OF TECHNICAL ANALYSIS

The Technical Analysis is based on the following assumptions
I. The market value of a security is primarily determined by the interaction of demand and
supply factors operating in the market
II. The demand and supply factors may be rational or irrational.
III. The security price movements depending upon sentiments, psychology and emotions of investors
or traders.
IV. The present trends are influenced by the past trends.
V. Stock prices tend to move in trends which continue for a given length of time
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VI. Shift in demand and supply can be detected through charts specially prepared to show
market action.
13.12 TOOLS AND TECHNIQUES OF TECHNICAL ANALYSIS

Technical Analysis is done from the following point of view viz. prices, time, volume, width.
The tools and techniques of Technical Analysis are explained in the following sections.
Dow Theory :
According to Charles Dow, the stock behaviour is 90% psychological and 10% logical. According
to this method the mood of the crowd determines the way in which prices move and the move can be
gauged by analyzing the price and the volume of transactions. According to Dow theory the market
always has three movements which are simultaneous in nature. They are
i. The narrow movement which occurs from day to day.
ii. The short swing which usually moves for short time like two weeks and extends
upto a month. This movement is known as shorterm movement.
iii. The third movement is also the main movement and it covers four years.
The narrow movement is called fluctuations, the short swing is know as secondary movements
and the main movement is called as primary trends. According to Dow theory the price movements
in market can be identified by means of a line chart. In this chart the technical analyst should plot the
price of the share and also mark the market average every day.
Advance Decline Theory:
The Advnace Decline Theory (ADT) takes into account the total number of securities stated
called the width of the market. Advance Decline Theory focuses on the width of the market instead
of selected securities. This theory has been widely used as the basis for developing more complex
technical measures and theories about the market movement.
Short Selling Theory:
Short selling refers to selling shares that are not owned. Investors sell short when they
expect the market price of a security to decline. They purchase security at a later date below the
selling price and reap a profit.
The technical analysts believe that it is a sophisticated technique and it is difficult for an
average investor.
Credit Balance Theory:
When cash balance builtup with the brokers, it represents high potential for the market
advancing and vice versa. A rise in the cash balances represents large amounts of money with
potential buying power. The investors leave their credit balance with the brokers only when they
anticipate a fall in security prices and thus buying opportunity. On the other hand a drop in credit
balance indicate the prices of securities will go up in future and investor will not like to buy.
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Elliot wave Theory:
In its most basic form Elliot wave theory states that the stock market follows a repetitive
rethym of waves. This theory attempts to develop a rational for long term pattern in the stock price
movements. This theory has been accepted as one of the important tools of technical analysis, for an
investor and a trader to decide on the timing of investment and for developing important market
strategies.
13.13 SUMMARY
Technical analysts have been in existence for quite a long period of time, for doing their work
in a better manner they require improved quantitative methods with improved behavioral research.
Though Technical Analysis is very important to estimate market trends, it suffers from some inherent
limitations viz. it is based upon past and historical data, unexpected events are not taken into
consideration by it. It depends upon the technical analysts have to be cleverer and luckier another to
earn more profits. Some times the technical analysts act on false signals without confirmation, they
would make mistakes and would suffer unnecessary expenses and losses.
13.14 KEY WORDS

Return on Investment: The ROI is determined by dividing net profit / income by the capital
employed or investment.
Earnings per Share (EPS): EPS denotes the post tax profit per equity share. EPS is calculated by
dividing earnings after tax by number of shares outstanding.

1) What is Fundamental Analysis? State how it is useful to a prospective investor?
2) What is company Analysis? What factors should be considered in this analysis?
3) What is Economic Analysis? Discuss the important economic forces that operate
4) Discuss the importance of forecasting techniques? State the uses of economic forecasting.
5) What is Industry Analysis? State the key characteristics in industrial analysis.
6) Explain the phases of an Industrial product life cycle.
7) State low technical analysis differs from fundamental analysis in making investment decisions.
8) Explain in details the Dow Theory.
9) Critically evaluate the Elloit wave theory on stock market predictions.

1. Investment Management – Preeti Singh. Himalaya Publishing house
2. An Introduction to investment management – Sprecher, Miffin company
3. Investment analysis and portfolio Management – M. Ranganathan and R. Madhumati, Pearson
Education Singapore (Pvt.) Ltd.
4. Security Analysis and Port folio Management – Shashi K. Gupta, Rosy Joshi, Kalyani
Publishers
5. Financial Management – I.M. Pandey, Viikas Publishers (Pvt.) Ltd.
327
GUIDELINE 14 : ACCOUNTS OF GROUP OF COMPANIES
OBJECTIVES :
The aim of this guideline is to discuss and understand about holding company.
§ Know the concept and meaning of holding companies
§ Understand about holding and subsidiary company
§ Know the relevant provisions of the companies Act. relating to consolidation accounts
STRUCTURE
14.1 Introduction
14.2 Meaning of Holding Company
14.3 Meaning of Subsidiary Company
14.4 Financial years of Holding and Subsidiary Companies
14.5 Need for Consolidated Financial Statements
14.6 Consolidated Financial Statements in India
14.7 Summary
14.8 Glossary
14.1 INTRODUCTION
Holding company occupies an important place in the modern economic activity. As the business
expands naturally it leads to formation of a group of companies. To take advantage of the legal
provisions promoters of the parent organization promote new companies for expanding business for
various activities. The parent organization acquires control interest in other companies in different
ways. The company acquiring controlling interest in another company is called the, Holding company.
The company, which in controlled is called subsidiary company.
14.2 MEANING OF HOLDING COMPANY

A holding company is one, which controls one or more companies either by means of holding
majority shares or by having the power to appoint directly or indirectly the whole, or a majority of the
board of directors of those companies’. A company controlled by a holding company is known as
subsidiary company.
A company may become holding company in any one of the three ways;
• By having more than half of the shares (more than 50%) with voting rights
• By nominating all the board of directors or majority of the board of directors
• By having sub-subsidiary relationship
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14.3 MEANING OF SUBSIDIARY COMPANY
A company controlled by a holding company is termed as subsidiary company and a company
controlled by the subsidiary company is termed as sub-subsidiary company of the principal holding
company.
The Holding company together with its all subsidiary companies is called ‘the group’. Section
4 of the companies act defines a holding company thus for the purpose of this act a company shall be
deemed to be holding company of another but only if, that the other company is its subsidiary.
Section 4 of the act defines a subsidiary company thus a company shall, subject to the provisions of
subsection, be deemed to be subsidiary of other company if, but only if.
i) that the other company controls the composition of its Board of Directors (or)
ii) that other -
(a) Whether the first mentioned company is an existing company in respect of which the
holders of preference shares issued before the commencement of this act have the same
voting rights in all respects as the holders of the equity shares, excess or controls more than
half the total voting power of such company.
(b) Whether the first mentioned company is any other company, holds more than half in nominal
value of its equality share capital or
iii) the first mentioned company is a subsidiary of any company, which is that other company’s
subsidiary.
According to this section there are three ways in which a company.
i) by holding more than half in nominal value of the equity share capital.
ii) by controlling the composition of the board of directors.
iii) by controlling more than half of voting power for example company A is a Holding company
and company B is its subsidiary if company C is the subsidiary of company B. According to
the provisions of the company’s act C will be taken as subsidiary of company A.
It may be noted that holding company and subsidiary companies incorporated companies
and have separate legal entity. The companies which one formed as a group enjoy distinct legal
existence but inter linked through share holdings.
According to the International Accounting Standards (IAS) certain parties with interest in
the parent company of a group such as shareholders, employee’s customers, and auditors are
concerned with the fortunes of the entire group. Consequently, they need to be informed about the
results of the operations and the financial position of the group as a whole. Consolidated financial
statements serve this, which presents the financial information of the group as that of a single enterprise
without regard for the legal boundaries of the separate legal existence. Group accounts, this serves
the information about the financial position and operating performance of the group as a whole i.e.,
the presents company its subsidiaries. IAS - III defines consolidated financial statement as statements,
which present the assets, liabilities, shareholders accounts, revenue and expenditure of a parent
company and its subsidiaries as those of a single firm. Requirements of Sec. 212 of the companies
act 1956.
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The balance sheet of a holding company must be attached with the following documents
relating to its subsidiary companies.
1) A copy of the balance sheet of the subsidiary company.
2) A copy of the profit & loss a/c of the subsidiary company.
3) A copy of the report of the board of directors.
4) A copy of the report of the Auditors.
5) A statement of the holding companies interest in the subsidiary.
A Holding company need not be an entirely new company either an existing company may
become holding company or a new company may be formed for acquiring majority of the shares of
other companies in order to exercise control over them. However those companies continue to
function as subsidiary companies under the holding company. Wholly owned subsidiary company is
a company is which all the shares exclusively held by the holding company. In this case there will not
be any minority shareholders. But in majority of the share holdings the minority or outsiders interest
exists.
14.4 FINANCIAL YEARS OF HOLDING AND SUBSIDIARY COMPANIES

As per the requirements of Sec., 212 of the companies Act the holding company must such
a company of the balance sheet and profit and loss account along with its own balance sheet. For this
purpose the financial years of the holding company and the subsidiary company are important.
Quite often the accounting dates of the holding company and subsidiary company vary. If
the financial year of the subsidiary company coincides with the holding company .Then the holding
company must attach a copy of the balance sheet of the subsidiary company on that date along with
its own balance sheet.
Where the financial year of the subsidiary company does not coincide with that of the holding
company, then the holding company must attach the proceeding financial year balance sheet of the
subsidiary company to its own balance sheet as on a particular date.
As per the provisions of the companies act the time interval the date of balance sheets of the
holding company and the subsidiary company should not be more than six months. Where the interval
exceeds six months the central government may extend the accounting date of either company so
that the subsidiary’s financial year may end with that of the holding company dealing with the profits
of the subsidiary company.
14.5 NEED FOR CONSOLODITATED FINANCIAL STATEMENTS

Section 212 (1) of the companies act requires the holding company to attach with its balance
sheet a statement of holding company interest in the subsidiary along with the following statements.
1) The statement must contain the extent of holding company’s interest in the subsidiary at the
end of the financial year of subsidiary company.
2) The Statement must contain the net aggregate amount of profit/losses of the subsidiary company.
Section 212(4) specifies that profits and losses of the subsidiary, which may be property,
treated in the holding companies account as revenue profits or losses. The holding company has a
share in the profits of its subsidiary company. The holding company I entitled to get the dividend paid
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by its subsidiary company. If such dividend is credited to the profit and loss account of the holding
company then it can be treated that the holding company has dealt with its share of subsidiary
companies profits in its books. If the profit dealt with is from the Holdings share of the profits from
the subsidiary in its books, the resulting figure will be any profit not deal with in the Holdings Company’s
books.
14.6 CONSOLIDATED FINANCIAL STATEMENTS IN INDIA

Section 212 of the companies Act 1956 requires that the recent balance sheet, Profit and
loss account, board of directors report and auditors report of the subsidiary company must accompany
the published accounts of the holding company. Besides, these recent published statements of the
subsidiary, a statement showing the holding companies interest in the subsidiary company , another
statement showing change in interest, if any, of the holding company in the subsidiary company from
the date of recent balance sheet of the subsidiary company to the date of balance sheet of the holding
company is to be attached along with the accounts of the holding company.
As 21 also does not make it obligatory to prepare consolidated financial statements. It only
requires that an enterprise that present consolidated financial statements should prepare and present
these statements in accordance with this standard. As per As 21 consolidated financial statements
normally include consolidatedbalance sheet, consolidated profit and loss account and notes, other
statements and explanatory material that form an integral part there of.
14.7 SUMMARY
Holding company occupies an important place in the modern economic activity. Practically
it is a part and parcel of the combination movement in business and is operated for the purpose of
controlling companies engaged in a similar line of business. As the business expands naturally it leads
to formation of a group of companies. To take advantage of the legal provisions promoters of the
parent organization promote new companies for expanding business for various activities. The parent
organization acquires control interest in other companies in different ways. The company acquiring
controlling interest in another company is called the, Holding company. The company, which in
controlled is called subsidiary company.
14.8 KEY WORDS

Holding Company; Holding Company is company, which controls other companies Subsidiary
Company; subsidiary company is company which is controlled by other company

1. State how a company become a holding company
2. Define Subsidiary company
3. Discuss the advantages and disadvantages of holding company
4. Discuss how consolidated financial statements are prepared in India
331
1. Advanced Accountancy Vol-II, R.L.Gupta and Radhaswamy, Sultan Chand
2. Advanced Accounting ; Corporate Accounting Dr.Ashok Sehgal & Deepak Sehgal
Taxmann
3. Accountancy Vol-2 S.KR. Paul, New Central Book agency
4. Corporate Accounting S.N.Maheswari Vikas Publishing House
5. Financial Accounting A managerial Perspective R.Narayana Swamy Prentice Hall of
India
332
GUIDELINE 15 : PREPARATION OF CONSOLIDATED
BALANCE SHEET WITH ONE SUBSIDIARY
OBJECTIVE
The purpose of this guideline is to explain the method of preparing consolidated balance sheet with
one subsidiary company.

• Understand the concept of consolidated balance sheet
• Explain the procedure of preparing consolidated balance sheet
• Know about investment account
• Explain about Minority interest
• Differentiate between Capital Profits and Revenue Profits
• Calculate Cost of Control/Capital Reserve
• Know about treatment of Pre-Acquisition and Post-Acquisition Profits and Losses
• Understand Common Transactions
STRUCTURE
15.1 Introduction
15.2 Elimination of Investment account
15.3 Minority Interest
15.4 Cost of Control (Goodwill) / Capital Reserve
15.5 Determination of Capital Profits and Revenue Profits
15.6 Treatment of Pre –Acquisition Losses
15.7 Elimination of Common Transactions
15.8 Treatment of Contingent Liabilities
15.9 Treatment of Unrealized Profits
15.10 Revaluation of assets and Liabilities
15.11 Summary
15.12 Key words
15.1 INTRODUCTION
Consolidated financial statements are the financial statements of a group presented as those of
a single enterprise. Here, a group refers to a parent and all its subsidiaries. Users of the financial
statements of a parent are usually concerned with and need to be informed about the financial position
and results of operations of not only the enterprise itself but also of the group as whole. The present
and potential shareholders, employees, customers, auditors are interested in the consolidated Accounts
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of the group. To know the financial performance and financial position of the group as a whole
consolidated accounts of the group are to be prepared. The consolidated financial statements normally
include the parent company and all its subsidiaries. The parent company prepares consolidated
financial statements viz., the consolidated balance sheet, consolidated profit and loss account of the
whole group and presents to its members.
The Accounting treatment in preparing the consolidated statements comprises (1)
Entire net assets of the wholly owned subsidiaries and (11) net assets his minority interest of the
partly owned subsidiaries.While preparing consolidated financial statements the accounts of the parent
company and its subsidiaries are combined on line-by-line basis by adding together various assets,
liabilities, revenue and expenses. However the inter company transactions investment account of the
parent company, pre acquisition reserves and pre acquisition profits and losses of the subsidiary
companies are to be eliminated.
The Indian company Law does not insists on the preparation of consolidated financial
statements. As per the international and national accounting standards (1AS-29) it is obligated for
parent companies to prepare consolidated financial statements other than those exempted to present
consolidated financial statements.
The following are the important principles to be taken care of while preparing the consolidated
balance sheet.
1. Elimination of investment account
2. Minority interest.
3. Cost of control (good will) or capital reserve
4. Determination of capital profits and revenue profits
5. Treatment of Pre-acquisition losses.
6. Elimination of common transactions
7. Treatment of contingent liabilities
8. Treatment of unrealized profits.
9. Revaluation of assets and liabilities
10. Treatment op Preference shares in Subsidiary Company
11. Treatment of Bonus Shares
12. Treatment of future Income Tax Reserve
13. Treatment of Dividend
14. Changes in Parent Company Equity
15. Treatment of inter Company Dividends
15.2 ELIMINATION OF INVESTMENT ACCOUNT

While preparing a consolidated balance sheet of a holding company and its subsidiary company
the investment account that appears in the assets side of the balance sheet of holding companyis to
be eliminated. The investment made by the holding company in the equity shares of the subsidiary
company appear as investment in the holding companies balance sheet assets side will not be shown
in the consolidated balance sheet.
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15.3 MINORITY INTEREST
There are two types of subsidiaries, one is wholly owned subsidiaries and the other is partly
owned subsidiaries. In the case of wholly owned subsidiaries all the equity shares are held by the
holding company. In case of partially owned subsidiaries the holding company is only a majority
shareholder. The remaining shares are held by others (outsiders) when the holding company shows
all the assets and liabilities of subsidiary in the consolidated balance sheet the share of the outsiders
(capital, plus reserves plus profits and losses) of the company must be shown as a liability item under
the heading ‘minority Interest’. The process of consolidation with minority interest is explained below.
ILLUSTRATION : 1
Following are the balance sheets of X Ltd. and its subsidiary Y Ltd. as on 31 March 2008.
Balance Sheets as on 31-3-2008
Liabilities X Y Assets X Y
Paid up Capital 1,00,000 50,000 Fixed
Of Rs. 10 each Assets 1,50,000 90,000
Creditors 50,000 30,000 Investment :
Bills Payable 50,000 20,000 3,000 shares
in Y Ltd., 30,000
2,00,000 1,00,000 2,00,000 1,00,000
X Ltd acquired 60 % of the shares in Y Ltd on 31st March 2008. You are required to
prepare a consolidated Balance sheet as on that date. Show the calculations of Minority Interest.
SOLUTION :
The X Company holds 3/5 of the shares and minority share holding is 2/5. Hence the outside
shareholders have 2/5 share in the net assets, which must be shown by the X Company on the
liabilities side under the heading minority interest.
Calculation of Minority Interest :
2/5 share in total assets of Y company = 1,00,000 x 2/5 = 40,000
Less : 2/5 share in total liabilities = 50,000 x 2/5 = 20,000
—————
Minority Interest = 20,000
The minority interest can also be calculated as the sum of the share in the capital plus reserves
and profit and loss Account Balance.
In this example there are no accumulated profits or losses. Then the Minority Share = Share
Capital held by them.
i.e., 2,000 shares held by Minority shareholders x 10 = 20,000
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Consolidated Balance Sheet of X Ltd., and its subsidiary Y Ltd., as on 31st March,
2008
Share capital 1,00,000
Of Rs.10 each Fixed Assets
Creditors: x : 1,50,000
x : 50,000 y : 90,000
2,40,000
y : 30,000 80,000 Bill receivable
Bill payable x : 20,000
x : 50,000
y : 20,000 y : 10,000
30,000
70,000
Minority interest 20,000
2,70,000 2,70,000
15.4 COST OF CONTROL (GOODWILL) ( OR ) CAPITAL RESERVE

As a first step to the preparation of consolidated balance sheet of the holding company and
its subsidiaries companies the goodwill or capital reserve in acquisition of shares in the subsidiary
must be calculated. If the price paid for the investment in the subsidiary is over and above that share
in the equity the net assets acquired by the holding company results in goodwill or cost of control.
On the other hand if the share in equity on net assets of the subsidiary is over and above the price
paid for the investment results in capital reserve. As on the date of acquisition of shares in the
subsidiary company the subsidiary may be having accumulated losses are profits and the holding
company may be acquiring shares at a premium or at a discount. While preparing the consolidated
balance sheet the profit or loss in acquisition shares is to be ascertained. If there are any profits in the
acquisition of shares in the subsidiary company it is to be credited to capital reserve account. It there
is any loss it is to be debited to good will l or cost of control account. The profit or loss in acquisition
of shares in subsidiary is calculated by company the investment either with the net assets or the equity
acquired in the Subsidiary company.
The calculation of Cost of Control (Goodwill) Or Capital Reserve is explained with the
help of the following examples.
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ILLUSTRATION : 2
The following are the balance sheets of X Ltd., and Y Ltd., as on 31st December, 2007.
Share Capital Fixed Assets 1,00,000 1,00,000
in Rs.10 each Current Assets 35,000 90,000
fully paid 1,00,000 80,000
Reserve 50,000 40,000
Profit & Loss 40,000 30,000 Investment
Creditors 25,000 30,000 in 8,000
Bills Payable 20,000 10,000 shares
Y Ltd., 1,00,000
2,35,000 1,90,000 2,35,000 1,90,000
X Ltd., acquired all the shares in Y Ltd., on 31st December, 2007. You are required to
prepare a consolidated balance sheet as on the date.
SOLUTION
Calculation of good will or capital reserve
1st Method :
Value of net assets acquired in Y Ltd.,
Gross Assets - Liabilities 1,90,000 - 40,000 = 1,50,000
Less price paid for investment: = 1,00,000
________
Capital reserve = 50,000
=======
2nd method :
Value of equity acquired in the subsidiary
Share capital 8000 shares at Rs. 10 each 80,000
Share in reserve 40,000
Share in profit & loss account 30,000
Total 1,50,000
Less price paid for investment 1,00,000
Capital Reserve : 50,000
Consolidated Balance Sheet of X Ltd. & its subsidiary Y Ltd. as on 31-12-2007
Share Capital 1,00,000 Fixed Assets
Reserves 50,000 X : 1,00,000
Profit & Loss A/c 40,000 Y : 1,00,000 2,00,000
Creditors Current Assets
X : 25,000 X : 35,000
Y : 30,000 55,000 Y : 90,000 1,25,000
Bills Payable
X : 20,000
Y : 10,000 30,000
Capital Reserve 50,000
3,25,000 3,25,000
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ILLUSTRATION : 3
The Sun Ltd., acquired the whole of shares in the moon Ltd. on 1st Jan. 2008. Their
balance sheets on 31st December 2007 were as under. You are required to Prepare Consolidated
Balance Sheet as on that date
Balance sheets on 31st December 2007
Liabilities Sun Moon Assets Sun Moon
Ltd. Ltd. Ltd. Ltd.
Share Capital Sundry
Equity Share Assets 3,40,000 1,40,000
of Rs.10 each 4,00,000 1,00,000 Investment
General Shares in
Reserve 40,000 15,000 the Moon
Profit & Loss 15,000 15,000 Co. Ltd.
Creditors 20,000 10,000 at cost 1,35,000 -
4,75,000 1,40,000 4,75,000 1,40,000
Solution :
Assets acquired 1,40,000
Less; Creditor assumed 10,000
_________
Net assets acquired 1,30,000
Cost of shares or acquisition price 1,35,000
_________
Excess paid, goodwill 5,000
OR
Price paid for shares acquired 1,35,000
Value of equity held
paid-up capital 1,00,000
General reserve 15,000
Profit & loss a/c 15,000
1,30,000
Goodwill 5,000
Since the price paid for acquiring the shares is more than the value of equity held, it results in
Goodwill.
Consolidated balance sheet of sun Ltd. and its subsidiary moon Ltd.
As on 31-12-2007
Share Capital :
Equity share of Rs. 10 4,00,000 Good will 5,000
each general reserve 40,000 Sundry Assets :
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Profit & Loss a/c 15,000 Sun : 3,40,000
Creditors : Moon : 1,40,000 4,80,000
Sun : 20,000
Moon : 10,000 30,000
4,85,000 4,85,000
15.5 DETERMINATION OF CAPITAL PROFITS AND REVENUE PROFITS

While preparing a consolidated balance sheet at a date of acquisition of shares in the subsidiary
company the profits of the subsidiary company are to be divided into pre acquisition profits and post
acquisition profits. The post acquisition profits are shown in the consolidated balance sheet and the
pre acquisition profits have to be taken into account while calculating the cost of control or capital
reserve. All the profits earned by the subsidiary company up to the date of acquisition of shares by
the holding company are known as capital profits. For e.g. the balance in the general reserve and
profit & loss a/c . The profits earned by the subsidiary company up to the acquisition of share by the
holding company are known as revenue profits.
In order to divide the reserves and profits in to capital profits and reserve profits, the date of
acquisition of shares in the subsidiary company is the deciding factor. Any reserve or profit appear in
the balance sheet on the date of purchase of share is called capital profits. Only the profits are taken
into account for calculating good will or capital reserve.
The distinction of capital profits and revenue profits is very much important only from the
point of view of holding company. From the minority share holders point of view there is no need to
distinguish the profits of the subsidiary company as capital profits and revenue profits. For the purpose
of calculating ‘minority interest’ we can take all the profits together and we need not distinguish the
capital profits and revenue profits.
ILLUSTRATION : 4
The following are the balance sheets of X Ltd., and Y Ltd., As on 31st December 2007. On
1st January, 2007 the X Ltd., acquired all the shares in the Y Ltd., when the later had a credit balance
of Rs. 35,000 on its profit & loss a/c and Rs.1,00,000 in general reserve account. You are required
to prepare a consolidated balance sheet as on 31st December 2007.
Share Capital Fixed
Equity Share Assets 2,40,000 4,25,000
of Rs.10 each 3,00,000 2,00,000 Investment
General Shares in
Reserve 1,50,000 1,00,000 the Block
Ltd., 3,60,000 -
Profit & Loss 1,00,000 80,000
Creditors 50,000 45,000
6,00,000 4,25,000 6,00,000 4,25,000
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Solution:
Date of acquisition of Shares 1-1-2007.
The credit balance in profit and loss a/c on 31-12-2007 Rs. 80,000. This comprises Rs. 35,000
as on the date of acquisition and the balance Rs. 45,000 earned after the date of acquisition.
Accordingly, Rs. 35,000 is (pre-acquisition) capital profit and Rs. 45,000 is (post- acquisition )
revenue profit.
Pre-acquisition profit should be capitalised and set off against the cost of acquiring shares and
post acquisition profit should be added to the profits of the holding company.
Cost of acquiring shares 3,60,000
Less: value of Equity held
Paid-up capital 2,00,000
General reserve 1,00,000
Profit & Loss a/c 35,000 3,35,000
Good will 25,000
Since the cost of acquiring the shares is more than the value of equity held, it results in Goodwill.
Consolidated balance sheet of X Ltd., and its subsidiary Y Ltd.
As on 31-12-2007
Share Capital 3,00,000 Good Will 25,000
Eq. Sh. of 10 each Fixed Assets
General Reserve 1,50,000 White : 2,40,000
Profit & Loss A/c 40,000 Block : 4,25,000 6,65,000
Creditors
White : 1,00,000
Block : 45,000 1,45,000
6,90,000 6,90,000
15.6 TREATMENT OF PRE-ACQUISITION LOSSES
If there are any losses in the subsidiary company as on the date of acquisition of shares by
the holding company, these losses must be taken into account in the calculation of equity held in the
subsidiary company. This is done by deducting the losses from the par value of the shares held by the
holding company. The net result is either to increase the goodwill or decrease the capital reserve, as
the case may be.
At the time of acquisition of shares in the subsidiary company. The subsidiary company may
be having debit balance of profit & loss account. Holding company share of such loss is to be taken
as capital loss and is debited to Goodwill or Cost of control account. However, the losses incurred
by the subsidiary company after the acquisition of shares by the holding company such loss is to be
treated as a revenue loss and is deducted form the profits of the holding company. If the profits are
not available, the losses are to be shown on assets side of the consolidated balance sheet.
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ILLUSTRATION : Following are the balance sheet of R Ltd., and its subsidiary S Ltd., as
on 31st December, 2007.
You are required to prepare a consolidated balance sheet 31st December, 2007.
Balance sheet of R Ltd., S Ltd., as on 31st December, 2007.
Liabilities R. Ltd. S. Ltd. Assets R. Ltd. S. Ltd.
Share Capital Fixed Assets 90,000 75,000
Equity Shares
of Rs.10 each Investment
fully Paid 1,50,000 1,00,000 10,000 Shares
General in S Ltd., 1,10,000 -
Reserve 40,000 -
Bills Payable 20,000 25,000 Current Assets 50,000 25,000
Creditors 30,000 25,000 P & L A/c 50,000
2,50,000 1,50,000 2,50,000 1,50,000
Shares were purchase by R Ltd., on 30th June, 2007. On 1st Jan., 2007 the balance sheet
of S Ltd., showed a loss of 40,000. Profits or losses are assumed to accrue evenly through out year.
SOLUTION :
1. Calculation of pre-acquisition and post- acquisition losses
(capital loss and Revenue loss)
Profit & loss account debit balance (31-12-2007) 50,000
Less : Loss as on 1st Jan. 2007 40,000
Loss incurred during the year 10,000
Loss up to 30th June 2007 (10,000 x 1/2 ) : 5,000
Loss after acquisition of shares 5,000 5,000
Total pre acquisition / Capital loss : 45,000
(Loss as on 1-1-2007, Rs.40,000 +Loss upto30th June2007 Rs. 5,000)
Total post acquisition /Revenue loss 5,000
2. Calculation of Goodwill :
Cost of investment 1,10,000
Less : Equity held in S Ltd.,
Share capital 10,000 x 10 = 1,00,000
Less : Capital Loss 45,000
55,000
Goodwill: 55,000
Since the cost of acquiring the shares is more than the value of equity held, it results in Goodwill.
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3. Profit & loss a/c balance of R Ltd., 10,000
Less : Reserve loss of S Ltd., 5,000
Balance to be shown in the consolidated Balance sheetRs.5,000
CONSOLIDATED BALANCE SHEET OF R LTD AND ITS SUBSIDIARY S LTD.
AS ON 3112-2007
Fixed Assets
General Reserve 40,000 R : 90,000
S : 75,000 1,65,000
Creditors
R : 30,000 Current Assets :
S : 25,000 55,000 R : 50,000
Bills Payable S : 25,000 75,000
R : 20,000
S : 25,000 45,000
Profit & Loss A/c 5,000
2,95,000 2,95,000
So for we have taken only one aspect while preparing consolidated balance sheet for better
and clear under standing. In practice there may be more than one aspect to be considered while
preparing consolidated balance sheet. In the following sections a few problems are worked out
involving all the aspects.
ILLUSTRATION : 6
Following are the balance sheets of JK Ltd., and SK Ltd. As on 31-12-2007. You are
required to prepare a consolidated balance sheet.
Balance sheets of JK & SK Ltd. As on 31-12-2007
Liabilities JK. Ltd. SK. Ltd. Assets JK. Ltd. SK. Ltd.
Share Capital Land &
Equity Share Buildings 50,000 80,000
of Rs.10 each 2,00,000 1,50,000 Plant &
Geneal Machinery 50,000 35,000
Reserve 80,000 45,000 Shares in
Creditors 40,000 35,000 SK Ltd.,
Bills Payable 20,000 25,000 10,000 -
Profit & Shares 1,20,000 -
Loss A/c 1,00,000 75,000 Stock 75,000 65,000
Debtors 80,000 55,000
Cash at Bank 50,000 75,000
Cash in hand 15,000 20,000
4,40,000 3,30,000 4,40,000 3,30,000
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SOLUTION :
The date of acquisition of shares is not given. hence, it is to be assumed that the shares are
acquired by the holding company as on the date of balance sheet. in this case the date of
acquisition is 31-12-2007.
1. Capital Reserve or Goodwill
Cost of the investment 1,20,000
Value of equity held:
Share capital 10,000 shares of Rs. 10 each 1,00,000
Share in Profit& loss a/c 75,000 x 2/3 50,000
Share in General Reserve 45,000 x 2/3 30,000
1,80,000
Since the cost of acquiring the shares is less than the value of equity held, it results in
Capital Reserve.
2. Minority interest :
5000 Shares of Rs. 10 Each 50,000
Profit & Loss a/c 75,000 x 1/3 25,000
Share in General Reserve 45,000 x 1/3 15,000
90,000
Consolidated balance sheet of JK Ltd., and its subsidiary SK Ltd.,
as on 31st December, 2007.
Share Capital Land & Buildings
Rs. 10 each 2,00,000 JK 50,000
General Reserve 80,000m SK 80,000 1,30,000
Creditors Plant & Machinery
JK : 40,000 JK 50,000
SK : 35,000 75,000 SK 35,000 85,000
Bills Payable Stock
JK : 20,000 JK 75,000
SK : 25,000 45,000 SK 65,000 1,40,000
Profit & Loss A/c 1,00,000 Debtors
JK 80,000
SK 55,000 1,35,000
Capital Reserve 60,000 Cash at Bank
JK 50,000
SK 75,000 1,25,000
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Minority Interest 90,000 Cash in Hand
JK 15,000
SK 20,000 35,000
6,50,000 6,50,000
ILLUSTRATION : 7
Following are the balance sheets of ABC Ltd., and its subsidiary XYZ Ltd. As on31st
December 2007. You are required to prepare a consolidate balance sheet as on that date. The
shares were acquired by ABC Ltd on 30th June, 2007.
Balance sheet of ABC Ltd. as on 31st December, 2007
15,000 Shares 15,00,000 Plant & Machinery
2,00,000
Rs. 100 each Current Assets 6,00,000
General Reserve 2,00,000 Investment 2000
Profit & Loss A/c 3,00,000 Shares of Rs. 100 3,00,000
Creditors 2,50,000 each in XYZ
Bills Payable 2,50,000 Ltd.,
25,00,000 25,00,000
Balance sheet of XYZ Ltd. as on 31st December, 2002.
3,000 Shares Plant & Machinery 2,00,000
Rs. 100 each 3,00,000 Current Assets 1,00,000
Balance on
1st Jan., 94
Add :
Net Profit
for the year 60,000 1,10,000
Creditors 50,000
Bills Payable 40,000
5,00,000 5,00,000
SOLUTION :
The balance sheets are given as on 31st December2007.
The shares are acquired in the middle of the year i.e, 30th June, 2007.
Hence the current year profits of the subsidiary company are to be divided into pre-acquisition
profits and post acquisition profits.
Out of the total current year profit of Rs.60,000, During the first 6 months i.e. up to the Date of
acquisition of shares the profit earned is 60,000 X ½ =30,000
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The Ratio between Holding Company and Minority Share holders
2000 : 1000 Shares = 2 : 1 Ratio i.e. 2/3 Holding Company and 1/3, Minority Interest
1. Pre-Acquisition Profits (Capital Profits)
Balance as on 1st January, 1994 50,000
Add : Profits earned during first 6 months
60,000 x 1/2 30,000
Total 80,000
2. Post-Acquisition Profits (Revenue Profits)
Total profit for the year 60,000
Less : Pre-acquisition profits 30,000
Total 30,000
3. Minority Interest :
Share capital 1000 share of Rs.100 each 1,00,000
1/3 share of Capital profits 80,000 x 1/3 26,667
1/3 share of Revenue profits 30,000 x 1/3 10,000
Total 1,36,667
4. Calculation of Capital Reserve or Good Will :
Price paid for the investment 3,60,000
Value of equity held :
Share capital 2000 share of
Rs. 100 each 2,00,000
2/3 share of Capital
Profit 80,000 x 2/3 53,333 2,53,333
Goodwill 46,667
Since the cost of acquiring the shares is more than the value of equity held, it results in
Goodwill.
5. Share in Revenue Profits : = 30,000 x 2/3 = 20,000
Consolidate balance sheet of ABC ltd and its subsidiary XYZ Ltd.
as on 31st December, 2007.
Liabilities Rs. Rs. Assets Rs. Rs.
Share Capital Land &
Buildings
15,000 shares ABC 14,00,000
of Rs. 100 each 15,00,000 XYZ 2,00,000 16,00,000
General Reserve 2,00,000 Plant &
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Profit & Loss 3,00,000 Machinery
ABC 2,00,000
XYZ 2,00,000 4,00,000
Share in Current
XYZ Ltd., 20,000 3,20,000 Assets
Creditors : ABC 6,00,000
ABC 2,50,000 XYZ 1,00,000 7,00,000
XYZ 50,000 3,00,000 Goodwill 46,667
Bills Payable
ABC 2,50,000
XYZ 40,000 2,90,000
Minority Interest 1,36,667
27,46,667 27,46,667
ILLUSTRATION : 8
From the balance sheets of H Ltd and S Ltd and information given below, prepare a
consolidated Balance Sheet.
Balance sheets as on 31st December, 2007.
Liabilities H.Ltd S.Ltd Assets H.Ltd S.Ltd
Share Capital Sundry
Share of Re.1 Assets 8,000 1,200
fully paid 10,000 2,000 Stock 6,100 2,400
Profit & Loss 4,000 1,200 Debtors 1,300 1,700
Reserves 1,000 600 Bills
Creditors 2,000 1,200 Receivable 100 -
Bills Payable - 300 1500 Shares in
S Ltd., at Cost 1,500 -
17,000 5,300 17,000 5,300
1. All the profit of S Ltd., been earned since the shares were acquired by H Ltd
2. The bills accepted by S Ltd., are all in favor of H Ltd., which has discounted Rs.
100 of them.
3. Sundry assets of S Ltd., are under valued by Rs. 100
4. The stock of H Ltd,. included Rs. 100 bought from S Ltd., at a profit to the later of 25 per
cent on cost.
SOLUTION :
The share betyween holding company and minority share holders is 1500 : 500, 3: 1 or
75% and 25%
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1. Pre-Acquisition Profits (Capital Profits)
Reserves - Balance on the date of acquisition 600
Sundry Assets - Under Valuation 200
Total 800
Share of H Ltd., - 75% = 800 X 75/100=600
Share of Minority., - 25% =800 X 25/100=200
2. Post-Acquisition Profits (Revenue Profits)
Profits earned after the date of acquisition 1200
Share of H Ltd., - 75% = 1200 X 75/100=900
Share of Minority., - 25% =1200 X 25/100=300
Cost of Control or Good Will OR Capital Reserve
Cost of investment 1500
Value of equity held

Share Capital 1500 Shares X Rs.1each=1500
Share in Capital Profits 600 .
21002
Capital Reserve 600 6001
Since the cost of acquiring the shares is less than the value of equity
held,itresultsinCapitalReserve. 2111212121210022221
Minority interest :
Face Value of shares 500 X Rs.1 500
Share of capital profits 200
Revenue profits 300
1000
Unrealised profit :
Unsold stock with H Ltd., 500
Unrealised profit thereon at 25% on
cost of 1/5th on sale 100
LESS Minority interest - 255 25
Holding company’s share of
unrealised profits 75
Holding Companies profit & loss a/c
Balance as per balance sheet 4,000
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ADD : Share of profit in S Ltd., 900
4,900
LESS : Unrealised profit on stock
in trade 75
4,825
Consolidated Balance Sheet of H.Ltd., and its Subsidiary S.Ltd.
as on 31st December,2007
Capital fully paid Sundry Assets
shares 10,000 H Ltd., 8,000
Profit & Loss A/c 4,825 S Ltd., 1,400 9,400
Reserves 1,000 Stock
Capital Reserve 600 H Ltd., 6,100
Creditors : S Ltd., 2,400
H Ltd., 2,000 8,500
S Ltd., 1,200 3,200 Less :
Bills Payable 300 Unrealised
Less : As per Profits 75 8,425
Conta 100 200 Debtors :
H Ltd., 1,300
Minority Interest 1,000 S Ltd., 1,700 3,000
Bills
Receivable 100
Less : As per
Contra 100 -
20,825 20,825
ILLUSTRATION : 9
From the balance sheets given below, prepare a consolidated balance sheet of ABC Ltd and
its subsidiary XYZ Ltd. The interest of the minority share holders of XYZ Ltd., are to be shown as
to be shown as a separate items.
BALANCE SHEET AS ON 30th JUNE 2007
Liabilities ABC XYZ Assets ABC XYZ
Share Capital Plant &
in Rs.10 Machinery 40,000 15,000
Shares 1,20,000 30,000 Less :
Trade Creditors 15,000 5,000 Depreciation 10,000 5,000
General Reserve 25,000 6,000 Land &
P & L A/c 12,000 9,000 Buildings(cost) 72,000 25,000
Shares in 25,000 —
XYZ Ltd.,
( 2,000
Shares)
348
Stock 18,000 3,000
Debtors 22,000 7,000
Bank 5,000 5,000
1,72,000 50,000 1,72,000 50,000
At on the date of acquisition of 2000 shares by ABC Ltd., in XYZ Ltd., the latter company
had an undistributed profits included in General reserve amounting to Rs. 5,000. The balance
appears in the profit and loss account are the profits earned after acquisition of shares by the Holding
Company.
SOLUTION
The ratio between holding company and minority share holders is 2000:1000 i.e. 2:1
Capital Profits :
General reserve balance as on date of acquisition of shares by XYZ Ltd. 5,000
Holding companies share 5000 X 2/3 = 3,333
Minority Shareholders share 5,000 x 1/3 = 1,667
Cost Control or Goodwill :
Cost the shares acquired in XYZ Ltd 25,000
Value of equity held;
Face value of shares 2000 X 10 20,000
Holding companies shares
of capital profit 3,333 23,333
Goodwill 1,667
Calculation of revenue profits :
1. Profits earned after the date of acquisition of shares
i.e. balance in the Profit and Loss account 9000
2. Amount transferred to General Reserve
(Rs.6000 – 5000) 1000
10,000
Share of Holding Company 10,000 X 2/3 =6,667
Share of Minority Interest 10,000 X 1/3= 3,333
Minority Interest :
Value of shares 1000 X 10 = 10,000
Share in capital profits 5,000 X 1/3 = 1,667
Share in Revenue profits 10,000 X 1/3= 3,337
15,000
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Consolidated Balance Sheet of ABC and its SubsidiaryXYZ Ltd.
As on 30th June 2007
12,000 Shares Good Will 1,667
of 10/- each Land & Buildings :
fully paid 1,20,000 ABC Ltd., 72,000
General Reserve 25,000 XYZ Ltd., 25,000 97,000
Profit & Loss A/c : Plant &
ABC Ltd., 12,000 Machinery :
XYZ Ltd., 6,667 18,667 Less : Dep.,
Trade Creditors : ABC Ltd., 30,000
ABC Ltd., 15,000 XYZ Ltd., 10,000 40,000
XYZ Ltd., 5,000 20,000 Stock :
Minority Interest 15,000 ABC Ltd., 18,000
XYZ Ltd., 3,000 21,000
Debtors :
ABC Ltd., 22,000
XYZ Ltd., 7,000 29,000
Bank :
ABC Ltd., 5,000
XYZ Ltd., 5,000 10,000
1,98,667 1,98,667
ILLUSTRATION : 10
The following are the summarised balance sheet of H Ltd., S Ltd., as 31st Dec. 2007.
Liabilities H Ltd. , S Ltd. , Assets H Ltd., S Ltd.,
Share Capital Fixed Assets 3,50,000 1,50,000
Shares of Rs. 100 Stock 90,000 40,000
each 5,00,000 2,00,000 Debtors 60,000 30,000
General Reserve1,00,000 - 6%Debentures in 65,000
Profit & Loss A/c 95,000 - S Ltd., (Rs.60000)
6% Debentures - 1,00,000 Share in S Ltd.,
Trade Creditors 60,000 45,000 (1500 shares) 1,20,000 -
Cash 70,000 25,000
Profit & Loss A/c - 1,00,000
7,55,000 3,45,000 7,55,000 3,45,000
350
H Ltd. acquired the shares on 1st April 2007. The profit and loss A/c of S Ltd. showed a
debit balance of Rs.1,50,000 on 1st Jan, 2007. Trade creditors of S Ltd. include Rs.20,000 for
goods supplied by H Ltd. made a profit of Rs.20,000 for goods supplied by H Ltd. made a profit of
Rs.2,000. Half of the goods were still in stock on 31st Dec. 2007. H Ltd. paid an expense of S Ltd.
amounting to Rs.2,000 changed to the profit and loss of H Ltd. But not considered in accounts of S
Ltd.
Prepare a consolidated balance sheet :
SOLUTION :
H Ltd. interest in S Ltd. = 1500 Or 3
2000 4
Pre-acquisition loss :
Loss as on 1-1-2007 1,50,000
LESS : profit earned up to 1-4-2007
(1,50,000-1,00,000) x 9 months 12,500
12 months
1,37,500
Post acquisition profit
(1,50,000 - 1,00,000) x 9 months
12 months 37,500
LESS : Expenses paid by H Ltd., not provided for 21,000
35,500
Goodwill or cost of control :
Cost of shares acquired 1,20,000
Cost of debentures acquired 65,000
1,85,000
LESS : paid up value of shares 1,50,000
Paid up value of debentures 60,000 2,10,000
(-) 25,000
ADD : Share of pre - acquisition loss :
(1,37,5000 x 3/4 ) (+) 1,03,125
Goodwill 78,125
Minority in interest :
Nominal value of shares held 50,000
ADD : Shares of post acquisition profit (35,000 x 1/4 ) 8,875
58,875
LESS : Share of pre - acquisition loss (1,37,500 x 1/4) 34,375
24,500
Consolidated profit & loss A/c Balance of H Ltd., 95,000
ADD : Expenses of S Ltd., changed 2,000
97,000
ADD : Share post acquisition profit (35,000 x 3/4) 26,625
1,23,625
351
LESS : Share of profit in inter company stock (2000 x 1/2) 1,000
1,22,625
Assets H Ltd. S Ltd. Total
Rs. Rs. Rs.
Fixed Assets 3,50,000 1,50,000 5,00,000
Stock 90,000 40,000 1,30,000
Less un realised profit 1,000
1,29,000
Debtors : 60,000 30,000 90,000
Less inter company
Transactions 20,000
6% Debentures 65,000 — 70,000
Less transfer to cost of control 65,000
Less inter company liability 5,000
60,000
NIL
Share in S Ltd., 1,20,000 — 1,20,000
Less transfer to cost
of control 1,20,000
NIL
Cash 70,000 25,000 95,000
Debentures — 1,00,000 1,00,000
Less inter company liability 60,000
40,000
Creditors 60,000 45,000 1,05,000
Less inter company debit 20,000
85,000
Consolidated Balance Sheet
Share Capital : Goodwill 78,125
5,000 Shares of 100 each 5,00,000 Fixed Assets 5,00,000
General Reserve 1,00,000 Stock 1,29,000
Profit & Loss A/c 1,22,625
Minority Interest 24,500 Debtors 70,000
6% Debentures 40,000 Cash in hand 95,000
Trade Creditors 85,000
8,72,125
8,72,125
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15.7 ELIMINATION OF COMMON TRANSACTIONS
Some common transactions take place between the holding company and the subsidiary
company. While preparing consolidated balance sheet the common transactions are to be eliminated.
Common transactions between the holding company and subsidiary company may appear in the
following instances.
1. When loans advance by one company to another company. It appears as an asset item in the
balance sheet of the company which give loan and as liability item in the balance sheet of the
company taking the loan.
2. When bills of exchange given by one company to another. This appears as a liability (bills
payable) in the balance sheet of the company accepting the bills and as an asset item (bills
payable) in the balance sheet of drawer company.
3. When goods are sold by one company to another company on credit basis. This appears as
debtors in the balance sheet of the company selling goods and as auditors in the balance
sheet of the company purchasing goods.
ILLUSTRATION : 11
The following are the summarized balance sheet of X Ltd. and Y Ltd as on 31-12-
2007. You are asked to prepare consolidated balance sheet as on the date.
Liabilities X Ltd., Y Ltd., Assets X Ltd., Y Ltd.,
Equity Share Land &
Capital Buildings 1,00,000 40,000
(Shares of Plant &
Rs. 10 each) 5,00,000 1,00,000 Machinery 1,00,000 50,000
General Stock in
Reserve 10,000 40,000 Trade 90,000 30,000
Sundry Sundry 40,000 30,000
Creditors 20,000 30,000 Debtors
Bills Payable 5,000 Bills
Receivable 5,000 -
Cash and
Bank Balance 1,15,000 25,000
Investments :
shares of
Y Ltd. in
7,500 shares 80,000
5,30,000 1,75,000 5,30,000 1,75,000
X Ltd., acquired shares in Y Ltd., on 1-1-2007. When Y Ltd., had Rs.10,000 in General
Reserve. All bills are drawn between the companies.
353
SOLUTION
The ratio between Holding Company and Minority share holders is ; 7500 : 2500, i.e. 3:1 1.
Good will or Capital Reserve:
Capital Profits And Revenue Profits
As on the date of acquisition of the balance in General Reserve Account is Rs. 10,000. It is
Capital Profit and the remaining balance i.e. 40,000 –10,000 =30,000 is Revenue profit.
Cost of shares in Y Ltd., 80,000
Value of equity held in Y Ltd.,
Share capital 7,500shares X Rs.10 = 75,000
Share in capital profits 10,000 X 3/4 = 7,500 82,500
Since the cost of acquiring the shares is less than the value of equity held it results in
Capital Reserve.
Share capital : 2,500 X Rs10 Each 25,000
1/4 th share in Capital Profits 10,000 X 1/4 2,500
1/4 th Share in Revenue Profits 30,000 X 1/4 7,500
35,000
3. Statement of General Reserves :
Balance of General Reserve of
Y Ltd., on 31-12-2007 40,000
LESS : Balance on 1-1-2007 10,000
Current year Profits (Revenue Profit) of Y Ltd 30,000
Share of holding Company in the Revenue Profits 30,000 X 3/4 = 22,500

Since there is no Profit and Loss account Balance in the Holding Company the share of current
year profits of Y Ltd are to be added to the General Reserve account and to be shown in the
consolidated balance sheet.
General reserve to be shown in Consolidated Balance Sheet :
Balance as per the Balance sheet o X Ltd 10,000
Add: Share in Revenue profits of Y Ltd 22,500
32,500
354
CONSOLIDATED BALANCE SHEET OF X LTD. AND ITS SUBSIDIARY YLTD.
AS ON 13 ST DEC. 2007.
Share Capital : Land & Buildings :
5,000 ordinary X Ltd., 1,00,000
shares of Y Ltd., 40,000 1,40,000
100/- each 5,00,000 Plant & Machinery :
General Reserve X Ltd., 1,00,000
X Ltd., 10,000 Y Ltd., 50,000 1,50,000
Y Ltd., 22,500 32,500 Stock in Trade :
Capital Reserve : 2,500 X Ltd., 90,000
Sundry Creditors : Y Ltd., 30,000 1,20,000
X Ltd., 20,000 Sundry Debtors :
Y Ltd., 30,000 50,000 X Ltd., 40,000
Y Ltd., 30,000 70,000
Minority Interest 35,000 Bank Balane :
X Ltd., 1,10,000
Y Ltd., 20,000 1,30,000
Cash Balance :
X Ltd., 5,000
Y Ltd., 5,000 10,000
6,20,000 6,20,000
15.8 TREATMENT OF CONTINGENT LIABILITIES

The following types of contingent liabilities may appear as explanatory notes at the foot of
the balance sheet by the holding and subsidiary companies.
1. Liability for calls in arrear.
2. Liability in respect of bills disconnected.
3. Liability under guarantee.
4. Arrears of dividend on commutative preference shares.
The treatment for the contingent liability in the consolidated balance sheet depends on the
nature of contingent liability : The contingent liability is of two types Viz. i) transactions between the
company and the external party which is also known as external contingent liability and ii) Transactions
between holding and subsidiary companies which is also known as internal contingent liability.
The external contingent liability will be shown as a note along with the Consolidated Balance
Sheet. But the internal contingent liability will not be shown, because it appear as an actual liability in
the consolidated balance sheet.
355
ILLUSTRATION :12
The Vijay Ltd., Acquired the whole of shares in Vinay Ltd., on 1st Jan. 2007. The Balance
Sheets of the two companies as on 31-12-2007 are as follows :
Balance Sheets ofVijay and Vinay as on 31-12-2007
Liabilities Vijay Ltd Vinay Ltd Assets Vijay Ltd Vinay Ltd
Share Capital : Fixed Assets 1,35,000 1,50,000
Equity Share of Shares in
10/- each 1,50,000 90,000 Vinay Ltd., 1,10,000 -
General
Reserve 1,20,000 15,000
Profit and Bills
Loss A/c 30,000 10,000 Receivable 70,000 -
Creditors 15,000 5,000
Bills Payable - 30,000
(Vinay (Vijay Ltd.
Ltd. accepted Bills Receivable
Rs.30,000Bills 70,000 includes
payable out of bills receivable
which 25,000 in forms Vinay
favor of Vijay Ltd. for
ltd.) 15,000 and there
is a contingent
liability on bills
discounted
40,000)
3,15,000 1,50,000 3,15,000 1,50,000
You are required to prepare a consolidated Balance Sheet
SOLUTION :
1. Goodwill or capital reserve
value of equity held :
FaceValue of shares : 90,000
General reserve 15,000
Profit & Loss a/c 10,000 1,15,000
Since the cost of acquiring the shares is less than the value of equity held it results in
Capital Reserve.
2. It is not possible to eliminate all the bills accepted by the Vinay Ltd., (Subsidiary), as some of
the bills are discounted by the VijayLtd., (Holding company) the bills of Rs.25,000 accepted
by Vinay Ltd., Rs.10,000 are discounted by vijay Ltd., and hence only 15,000 are included
356
as bills receivable from Vinay Ltd., So, only Rs.15,000 are to be eliminated from bills payable
and bills receivable for the purpose of consolidated balance sheet.
Regarding the contingent liability of Rs.40,000 in the Vijay Ltd., to the extent of Rs.10,000 is
due to discounting of bills accepted by Vinay Ltd., and the rest are the bills. As the amount of
Rs.10,000 is internal contingent liability and which is be eliminated and Rs.30,000 is external
contingent liability, which cannot be retained.
Consolidated balance sheet of Vijay total and its subsidiary Vinay Ltd.
as on 31-12-2007.
Liabilities Vijay LtdVinay Ltd Assets Vijay Ltd Vinay Ltd
Share Capital : Fixed Assets

Equity Share of Vijay
10/- each 1,50,000 Ltd., 1,35,000
General Reserve 1,20,000 Vinay
Profit & Loss A/c 30,000 Ltd., 1,50,000 2,85,000
Creditors Bills Receivable
Vijay Ltd., 15,000 (70,000-15,000) 55,000
Vinay Ltd., 5,000 20,000
Bills Payable
Vinay Ltd 30,000
Less : Payable
to Holding Co. 15,000 15,000
3,40,000 3,40,000
Note : There is a contingent liability in respect of bills discounted Rs.30,000
15.9 TREATMENT OF UN-REALIZED PROFITS

Un-realized profits may occur when there are inter company purchases. Inter company
transactions may be eliminated from debtors and creditors in the consolidated balance sheet. However
when goods are sold by one company in the group to another at a profit, any such goods remaining
unsold as on the date of balance sheet, there will be un-realized profit. Reducing the value of stock of
buying company and the profit balance of the selling company eliminates the un-realized profit. To
eliminate un-realized profits the following procedure is to be adopted.
1. First calculate the total un-realized profit on the stock remain unsold at the financial year.
2. Divide this total un-realized profit belongs to the group and, minority share holders.
3. Deduct the un-realized profit belong to the group from the stock of the receiving company and
from the profit of the setting company.
357
ILLUSTRATION : 13
From the following balance sheets of X Ltd., and Y Ltd., as on 31st Dec. 2007 you are
required to prepare a consolidated balance sheet as on 31st Dec. 2007 showing all the details and
taking in to consideration the additional information furnished along with the balance sheet.
Liabilities X Ltd. Y Ltd. Assets X Ltd. Y. Ltd.
Paid up Capital Freehold
of Rs.10 Premises 4,50,000 1,50,000
each 10,00,000 3,00,000 Plant &
General Machinery 3,50,000 1,60,000
Reserve 4,00,000 1,50,000 Furniture 80,000 30,000
Profit & Loss 3,00,000 1,80,000 Debtors 3,00,000 1,70,000
Sundry Stock 3,20,000 1,60,000
Creditors 1,00,000 70,000 Bills
Bills payable 2,00,000 1,00,000 Receivable 2,00,000 1,00,000
Investment
in 20,000 shares
in Y Ltd., 2,60,000
at cost
Cash 40,000 30,000
20,00,000 8,00,000 20,00,000 8,00,000
Additional Information :
1. X Ltd., acquired shares in Y Ltd., on 1-1-2007 When the balance on their profit & Loss A/
c and general reserve were Rs.75,000 and Rs.90,000 respectively.
2. Stock of Rs.60,000 held by Y Ltd., consists of Rs.60,000 goods purchased from Y Ltd., who
has charged profit at 25% on cost.
SOLUTION
(i) Good will or capital reserve :
Price paid for the investment 2,60,000
Face value of shares 20,000 X 10 = 2,00,000
Share in Pre-acquisition profits :
2/3 share in profit& loss a/c balance
on1-1-2007 75,000 x 2/3 50,000
2/3 share in general reserve
balance on 1-1-2007 90,000 x 2/3 60,000 3,10,000
358
Since the cost of acquiring the shares is less than the value of equity held it results
in Capital Reserve.
(ii) Minority interest :
Share Capital : 10,000 share Rs.10 each 1,00,000
1/3 share in general reserve
1,50,000 x 1/3 50,000
1/3 share in profit & loss A/c
1,80,000 x 1/3 60,000
2,10,000
(iii) Statement of general reserve :
As per the balance sheet of X Ltd., 4,00,000
General Reserve A/c of Y Ltd on 31-12-2007 1,50,000
Less : Balance on 1-1-2007 90,000
Amount transferred to General reserve 60,000
During the current year
Add: 2/3 Share belongs Holding Company 60,000 X 2/3 = 40,000
4,40,000
(iv) Profit &Loss account Balance :
Profit & loss A/c Balance as per 3,00,000
Balance sheet of X Ltd.,
Profit & Loss A/c balance as per
balance of Y Ltd., 1,80,000
Less : pre-acquisition profit 75,000
Revenue Profit/Current year Profit 1,05,000
Add : 2/3 Share belongs to Holding Company 1,05,000 X 2/3 = 70,000
3,70,000
Less : un realised profit 8,000
3,62,000
(v) Calculations of un realised profits :
X Ltd., sells goods at a profit of 25% on cost. The unsold stock of Rs.60,000 held by Y
Ltd., has been purchased from X Ltd., Rs.60,000 in selling price. Hence the profit must be expressed
as a percentage on selling price.
Let the cost price be Rs. 100
Profit at 25% 25
Selling price 125
Profit as percentage of selling price : 25/125 x 100 = 20%
359
Total un realised profit in Rs. 60,000 x 20/100 = 12000
Group’s share of un realised profit is 2/3 of 12,000 : 12,000 x 2/3 = 8,000
Minority share holders share is 12,000 x 1/3 = 4,000.
In the consolidated balance sheet Rs.8,000 must be deducted from the profit & loss A/c of
X Ltd., and stock of Y Ltd.
CONSOLIDATED BALANCE SHEET OF X LTD. AND ITS SUBSIDIARY YLTD.
AS ON 31-12-2007
Labilities Rs. . Rs. . Assets Rs. . Rs. .
Paid up Capital Freehold Premises :
in shares at X Ltd., 4,50,000
10/- each 10,00,000 Y Ltd., 1,50,000 6,00,000
General Reserve 4,40,000 Plant & Machinery
X Ltd., 3,50,000
Profit & Loss A/c 3,62,000 Y Ltd., 1,60,000 5,10,000
Current Liabilities Furniture
X Ltd., 1,00,000 X Ltd., 80,000
Y Ltd., 70,000 1,70,000 Y Ltd., 30,000 1,10,000
Capital Reserve 50,000 Debtors
Minority Interest 2,10,000 X Ltd., 3,00,000
Y Ltd., 1,70,000 4,70,000
Stock
X Ltd., 3,20,000
Y Ltd., 1,60,000
4,80,000
Less :
Un realised
Profit 8,000 4,72,000
Cash
X Ltd., 40,000
Y Ltd., 30,000 70,000
22,32,000 22,32,000
15.10 REVALUATION OF ASSETS AND LIABILITIES
Some times, at the time of acquisition of shares in the subsidiary company the assets and
liabilities of the subsidiary company are revalued. If there is any profit or loss on valuation of assets
and liabilities it is treated as capital profit or loss. This profit is not available for payment of dividend
and must be shown as a reserve in the balance sheet of a subsidiary company under the heading
capital reserve or it can be used for writing of good will. However, the loss under valuation may be
met out of revenue profits.
While preparing consolidated balance sheet the profit and revaluation (capital profit) is divided
among the holding Co. and minority share holder. Holding Co. share will be taken into account while
360
calculating goodwill or capital reserve similarly the loss on devaluation will also be taken into account
while calculating the good will or cost of control. Minority share holders share is added to the
minority interest.
If revaluation of assets takes place the profit at the end of the year have to be calculated after
charging depreciation on the revised value of the assets.
ILLUSTRATION : 14
Following are the balance sheets of X Ltd.., and Y Ltd. as on 31st Dec. 2007.
BALANCE SHEETS OF X LTD AND Y LTD. AS ON 31ST DEC. 2007.
Labilities X Ltd. Y Ltd . Assets X Ltd . Y Ltd
Share Capital 1,00,000 80,000 Fixed Assets 1,25,000 1,25,000
of 10/- each 6,000 shares
General in Y Ltd., 75,000 -
Reserve 40,000 20,000
Profit during
the year 30,000 10,000
Bills Payable 30,000 15,000
2,00,000 1,25,000 2,00,000 1,25,000
At the time of acquisition of shares By X Ltd., in Y Ltd., on 1st Jan., 2007 Plant of 50,000
of Y Ltd., was revalued at Rs. 75,000 Furniture of Rs.35,000 ware revalued at Rs.30,000 The
balance sheet of Y Ltd., showed the above assets on the non-revalued amount.
You are required to prepare a consolidated balance sheet after giving effect to the above
revaluation from 1st Jan. 2007 . Depreciation is charged on plant at 15% and on furniture at 10%
Per annum.
SOLUTION :
1. Profit on revaluation on plant 25,000
Less : loss on revaluation on furniture 5,000
Total profit on revaluation Rs. 20,000
Share of holding Co. 20,000 x 3/4 = 15,000
Share of minority share holders 20,000 x ¼ = 5,000
2. Calculation of minority interest
Share capital 2,000 share X 10 = 20,000
Share in profit on revaluation 20,000 X 1/4 = 5,000
Share in General reserve 20,000 X 1/4 = 5,000
Share in current year profit 6,750 x 1/4 = 1,687.50
Total Rs. 31,687.50

3. Goodwill or Capital Reserve :
Cost of investment = 75,000
Value of Equity held
361
Face value of share 6,000 shares X Rs.10 each = 60,000
Share in General reserve 15,000
Share in profit on revaluation 15,000
90,000
Capital reserve 15,000
Since the cost of acquiring the shares is less than the value of equity held it
results in Capital Reserve.
4. Profit & loss A/c of Y Ltd.,
Profit earned during the year 10,000
Less : Additional depreciation on plant
@15% on 25,000 3,750
Balance 6,250
Add :
Excess depreciation return off on furniture
... 10% on 5,000 500
Total Profit for the year 6,750
Holding Co. Share 6,750 x 3/4 = 5,062.50
Minority share holder shares 6,750 x 1/4 = 1,687.50
5. Revised value of the assets
(A) revised value of the plant on 1-1-2007 = 50,000
Less : Depreciation already charged = 7,500
Balance = 42,500
Add : Increased in value of plant 25,000
Total 67,500
Less : Depreciation on increased value 3,750
63,750
(B) Revised value of the furniture
Furniture on 1-1-2007 35,000
Less : Depreciation 10% 3,500
31,500
Less : Decrease in the value of Furniture 5,000
26,500
Add : Excess Depreciation charges on furniture 500
27,000
6. Value of other assets :
Value of total assets 1,25,000
Less : Revised value of plant 63,750
61,250
Less : Revised value of furniture 27,000
34,250
362
Consolidated Balance Sheet of X Ltd. and its Subsidiary Y Ltd.
AS On 31st Dec. 2007
Labilities . Rs. . Assets . Rs. .
Share Capital 1,00,000 Plant 75,000
of Rs. 10/- Less : Dep11,250 63,750
General Reserve 40,000 Furniture 30,000
Profits 30,000 Less : Dep 3,000 27,000
Share in profit Other Assets 90,750
of Y Ltd., 5,062.50 35,062.50 51,000
Bills Payable : Assets of X Ltd. 1,25,000
X Ltd., 30,000
Y Ltd., 15,000 45,000
Minority Interest 31,687.50
2,66,750 2,66,750
15.11 SUMMARY
Consolidated financial statements provides useful information to the users. Users of the financial
statements of a parent are usually concerned with and need to be informed about the financial position
and results of operations of not only the enterprise itself but also of the group as whole. The present
and potential share holders, employees, customers, auditors are interested in the consolidated Accounts
of the group. To know the financial performance and financial position of the group as a whole
consolidated accounts of the group are to be prepared. The consolidated financial statements normally
include the parent company and all its subsidiaries. The parent company prepares consolidated
financial statements viz., the consolidated balance sheet, consolidated profit and loss account of the
whole group and presents to its members.
15.12 KEY WORDS

Investment Account; the investments made by the Holding Company in the shares of
Subsidiaries is indicated as ‘Investment Account and shown in the assets side of the Balance sheet of
Holding Company.
Capital Profits; The profits which areearned by the subsidiary company upto the date of
acquisition of shares are Known as Capital profits
Revenue Profits; The profits made by the Subsidiary company after acquisition of shares by the
Holding company are known as Revenue Profits
Un-realised Profits; In the case of inter company sale of goods, the profits charged by the
selling company on the unsold portion of the stock is known as un-realised profits.
363
EXERCISE : 1
From the balance sheets given below prepare a consolidated balance sheet of X Co. Ltd and its
subsidiary Y. Co. Ltd. The interests of the minority shareholders of Y. Co. Ltd. are to be shown in the
Balance sheet of X Co Ltd and Y Co Ltd as on 31-12-2007
Liabilities X Ltd , Y Ltd , Assets X Ltd , Y Ltd ,
Share Capital Land & Buildings 1,52,00,000
Shares of Rs. 80 each2,20,00,000 Plant and Machine 22,40,000 3,20,000
20000 Shares of Shares in Y Co. Ltd
Rs. 80 each 16,00,000 18,000 shares of
General reserve 20,00,000 Rs. 80 each 28,80,000
creditors48,00,000 3,20,000 Stock 48,80,000 8,00,000
Profit and Loss Debtors 32,00,000 11,20,000
appropriation A/c 16,00,000 24,00,000 Cash at bank 20,00,000 20,80,000
3,04,00,000 43,20,000 3,04,00,000
43,20,000
EXERCISE : 2
The following are the Summarised balance sheets of imperial co Ltd. and Colonial Co. Ltd. as
on 31 st Dec. 2007.
Liabilities Imperial Colonial Assets imperial Coloniall
Co. Ltd. Co. Ltd. Co. Ltd. Co. Ltd.
Rs. Rs. Rs. Rs.
paid up Capital
In shares of Freehold Premises 4,50,000 1,20,000
Rs. 10/- each 10,00,000 3,00,000 Plant & Machinery 3,50,000 1,60,000
General Reserve 4,00,000 1,25,000 Furniture 80,000 30,000
P & L A/c 3,00,000 1,75,000 Debtors 3,00,000 1,70,000
Sundry Creditors 1,00,000 70,000 Stock 3,20,000 1,60,000
Investment in 20,000
Shares in colonial
Co. Ltd at cost 2,60,000
Cash balance 40,000 30,000
18,00,000 6,70,000 18,00,000 6,70,000
You are required to prepare a consolidated balance sheet as. on 31-12-2007, showing in
detail necessary adjustments and taking in to consideration the following information:
a) Imperial Co. Ltd. acquired the shares of colonial co. Ltd. on 1-1-2007 when the balances
on their profit and loss A/c and general reserve were Rs. 75,000 and Rs. 80,000 respectively.
364
b) Stock of Rs. 1,60,000 held by colonial Co. Ltd. Consisted of Rs. 60,000 goods purchased
form imperial Co.Ltd. Who has charged Profit at 25% on cost.
EXERCISE : 3
Following is the balance sheet of H and S :-
Balance sheets of H and S as on 31st Dec 2007.
Liabilities H S Assets H S
Rs. Rs. Rs. Rs.
Share Capital 10,000 8,000 6,400 Shares in S.Co 7,000
General reserve 4,000 2,000 Other assets 10,000 11,000
Profits (Current) 3,000 1,000
17,000 11,000 17,000 11,000
At the time of aquisition of shares by H. Company in S. company, on 1st January, 2007 plant
of Rs. 6,000 of S Ltd was revalnel at Rs. 8,000 and furniture of S Ltd of Rs. 2,000 was revalued at
Rs. 1,500. The balance sheet of S Ltd. showed the above assets on the non-revalued basis. You are
required to prepare a consolidated balance sheet after giving effect to above revaluation form 1st
January 2007. Depreciation is charged on plant at 10% and on funiture at 5%
EXERCISE : 4
Following are the balance sheets of X Ltd and Y Ltd you are required to prepare a consolidered
balance sheet
Balance Sheet of X Co., Ltd as on 31-12-2007
13,500 shares of 10/- Land & Buildings 26,400
each fully paid 1,35,000 Plant 51,870
5% Debentures 28,000 Fixtures 5,750
Trade Creditors 14,350 Investment in
Y. Ltd., 7500 shares 86,520
General Reserve 30,000 Stock 30,960
Profit & Loss A/c 33,183 Debtors
Y Ltd 10,205
Others 17,735 27,940
Cash 11,093
2,40,533 2,40,533
Balance Sheet of Y Co., Ltd as on 31-12-2007
Sundry creditors Fixtures 570
X Ltd., 9,665 Stock 45,000
365
Others 22,335 32,000 Debtors 60,000
Profit & Loss A/c 20,000 Cash 22,546
1,52,000 1,52,000
The holding of the patent company is Y Ltd. was acquired some years earlier at a premium of
15% per share and the balance at the credit of profit and loss accounts of Y Ltd. was 10,000/- Y
company purchased goods from X co, Ltd. at a cost plus 25%. The stock of Y Ltd. Consists of
15,500 goods from X co Ltd.
EXERCISE : 5
H Ltd acquird the whole of the shares in S Ltd as on 1st January, 2007 at total cost of Rs.
11,20,000 The Balance sheets on 31 st December, 2007 when accounts of both companies were
prepared and audited, were as under.
H Limited Balance Sheet as on 31st Dec., 2007
Shares Capital Freehold Premises 10,30,000
Authorised and issued Machinery 3,00,000
15, 000 shares of Rs. 100 Stock (b) 3,40,000
each fully paid 15,00,000 Debtors 2,80,000
creditors (a) 1,50,000 Investments 11,20,000
General Reserve 9,50,000 Cash 3,30,000
Profit and Loss A/c (c) 8,00,00
34,00,000 34,00,000
a) Includes Rs. 60,000 for purchses from the S Ltd on which the latter company made a profit of
Rs. 15,000
b) Includes Rs. 30,000 stock at cost purchased form the S Ltd part of Rs. 60,000 purchases (see
Note (a))
c) Includes interim dividend at the rate of 10% per annum free of tax from S Ltd.
S Limited Balance Sheet as on 31st Dec., 2007
50,000 shares of Rs. 10
each fully paid 5,00,000 Stock 2,02,000
Creditors 1,61,000 Debtors 1,58,000
General reserve as on Cash 1,10,000
1st January 1987 20,000
Profit and loss A/c 3,60,000
10,41,000 10,41,000
366
Note : The balance on profit and loss account on 1st Jan 2007 was Rs. 2,80,000 an interim dividend
of 10% per annum free of tax has been paid during the year respect of the year ended 31st
December 2007.
Prepare a consolidated balance sheet as on 31st December2007.
EXERCISE : 6
The Balance sheets of H Ltd and S Ltd. on 31st Dec., 2007 were as under
Balance sheets of H Ltd and S Ltd. As on 31st Dec., 2007
Liabilities H Ltd. S Ltd. Assets H Ltd. S Ltd.
Rs. Rs. Rs. Rs.
Share Capital shares Buildings 60000 -
of 100/- each 2,00,000 50,000 Machinery 2,00,000 -
General Reserve 30,000 10,000 Stock 40,000 85,000
Profit and Loss A/c Debtors 10,000 30,000
balance on 1-1-1989 40,000 20,000 Cash and
Profit for the year 1989 50,000 25,000 Bank balances 10,000 10,000
Creditors 30,000 30,000
Bank over draft 20,000 - 300 shares of
Bills payable 15,000 - S Ltd at a cost of 65,000
Bill Receivable- 10,000
3,85,000 1,35,000 3,85,000 1,35,000
Shares in S. Ltd were acquired by H Ltd our 1st July 2007. Bill receivable by S Ltd. are
aceepted by H Ltd.
Prepar consolidate balance sheet as on 31-12-2007
EXERCISE : 7
The following are the Balance sheets of H Ltd and S Ltd as on 31 st March 2008. H Ltd
acquired 70 per cent shares of S Limited on 30-6-2007. On 1-4-2007 general Reserve, P&L
account and preliminary expenses of S Ltd stood ar Rs.90,000, Rs.30,000 and 9,000 respectively.
Balance Sheet s As on 31-3-2008
Liablities H Ltd S Ltd Assets HLtd SLtd
Share capital of 9,00,000 3,00,000 Fixed assets 5,55,000 2,17,5000
Rs.10 each Investment
General Reserve 2,25,000 1,05,000 in S Ltd
P&LA/c Shares at 3,90,000
Creditors 1,05,000 75,000 Cost
Unclaimerd 1,35,000 82,500 Current assets 4,20,000 3,43,500
dividends --------- 7,500 Preliminary --------- 9,000
Expenses
13,65,000 5,70,000 13,65,000 5,70,000
367
Prepare the consolidated Balance Sheet of H Ltd and S.Ltd as on 31 st March 2008.
EXERCISE : 8
From the balance Sheets and information given below, You are required to prepare Consoloidited
balance sheet.
Liablities X Ltd Y Ltd Assets X Ltd YLtd

Share capital of 5,00,000 1,00,000 Fixed assets 4,00,000 60,000
Rs.10 each Stock 3,00,000 1,20,000
P&LA/c 2,00,000 60,000 Debtors 75,000 85,000
Reserves 60,000 30,000 Bill 20,000 -------
Sundry 1,00,000 60,000 Receivable
Creditors Shares in Y
Bills payable 15,000 Ltd 7500 75,000
shares at cost
8,70,000 2,65,000
Aditional information:
1. The bills accepted by Y Ltd are all in favour of X Ltd.
2. The stock of X ltd includes Rs.25,000 brought from y Ltd at a profit to the later at 20% on
sales.
3. All the profits of Y limited have been earned after the shares were acquired by X Limited,
but there was already a reserve of Rs. 30,000 at that date.
EXERCISE : 9: Thr following are the summarized balance sheets of Senior and Junior Limited as
on 31-12-2007
Liablities Senior Ltd J uniorLtd Assets SeniorLtd JuniorLtd

Share capital 4,00,000 1,00,000 Sundry 3,60,000 2,40,000
Reserves 60,000 assets
P&L A/c Shares in 4,60,000 ------
balance as on 1,20,000 60,000 Junior Ltd
1-1-2007 Cash at bank 40,000 20,000
Profit for the 80,000 20,000
year
Creditors 2,00,000 60,000
8,60,000 2,60,000 8,60,000 2,60,000
368
Senior limited acquired 80% of shares in Junior limited on 1-7-2007 . Included in the assets of
Senior Limited, there Rs .60,000 loan to Junior Limited shown as creditors in Junior Limited.
Sundry assets of Junior Ltd. Include furniture and fittings of 80,000 to be revalued at Rs. 1,00,000
being over depreciated as at 1-7-2007. Prepare Consolidated balance sheet of Senior Ltd and
its Subsidiary Junior Ltd. As 31-12-2007.
EXERCISE : 10
From the following information , Prepare Consolidated balance sheet.
Liablities Bombay Ltd Vizag Ltd Assets Bombay Ltd Vizag Ltd
Share capital 20,000 4,000 Sundry
(Rs. 10, fully assets 16,000 2,400
paid) Stock 12,200 4,800
P&L A/c 8,000 2,400 Debtors 2,600 3,400
Reserves 2,000 1,200 Bills 200 ------
Receivable
Creditors 4,000 2,400 Shares in 3,000 -----
Bills Payable ------ 600 Vizag Ltd.
Creditors
34,000 10,600 34,000 10,600
1. All the profits of Vizag Ltd has been earned since the share were acquired by Bombay
Ltd. But there was the reserve of Rs. 600 at that date.
2. The bills accepted by Vizag Ltd are in favour on Bombay Ltd, which had discounted
Rs.200 of them.
3. Sundry assets of Vizag Ltd are under valued by Rs.200
4. The stock of Bombay Ltd includes Rs 500 bought from Vizag Ltd at a profit to the latter
of 25% on Cost.

2. Advanced Accounting; Corporate Accounting Dr.Ashok Sehgal & Deepak Sehgal
Taxmann
India
369
GUIDELINE 16 : ADVANCED ASPECTS OF CONSOLIDATED
BALANCE SHEET
OBJECTIVES
In the previous Guideline the principles of simple consolidation have been explained. In this
guideline the advanced aspects of preparing consolidated balance sheets are discussed.
• Understand about preference shares in subsidiaries
• Know about treatment to Bonus shares
• Future income Tax Reserve
• Know about treatment of Dividends
• Understand changes in parent company equity
• Treat inter company dividends
STRUCTURE
16.1 Introduction
16.2 Treatment op Preference shares in Subsidiary Company
16.3 Treatment of Bonus Shares
16.4 Treatment of future Income Tax Reserve
16.5 Treatment of Dividend
16.6 Change in Parent Company Equity
16.7 Treatment of inter Company Dividends
16.8 Summary
16.9 Glossary
16.1 INTRODUCTION
Apart from the investment in equity shares the holding companies may also invest in
preference shares. The subsidiary companies from time to issue bonus shares. Such bonus shares
change the number of shares held by holding company and minority shareholders. The dividends
declared by the subsidiary company also has an effect on Goodwill and Capital Reserve of the
Holding Company. The amounts kept aside as future income tax reserve, the changes in parent
company equity and inter company dividends are some of the advanced aspects to be taken into
consideration while preparing the consolidated financial statement. In this lesson advanced aspects
in preparation of consolidated Balance sheet have been explained
370
16.2 TREATMENT OF PREFERENCE SHARES IN SUBSIDIARY COMPANIES
In addition to issue of equity shares the subsidiary company may also issue preference shares.
The treatment of these shares in the consolidated balance sheet has been explained in the following
sections. The preference shares may be held either by the holding company or outsiders.
A. When preference shares held by Holding Company :
If the holding company holds some preference shares in the subsidiary company the paid up
value will be deducted from the cost in the same way as done in the case of equity shares. The
difference between cost and paid up value results in good will or capital reserve. This amount will be
added to that part of the good will or Capital Reserve derived from the equity shares held by the
holding company.
If the subsidiary company issued preference shares either at a discount or at a premium the
amount will not be considered (discount or a premium) for calculating good will or capital reserve.
The fixed dividend on preference shares accrued up to the date of acquisition will be transferred to
goodwill as being proportion of the pre acquisition profits of the subsidiary company applicable to
preference shares.
Accrued Dividend from the date of acquisition to the date of preparation of accounts will be
treated as revenue profits and are added to the revenue profits of the holding company
B. When preference shares held by outsiders :
When preference shares are held by outsiders the minority interest will also include the paid
up value of preference shares held by them and the amount of the dividend accrued up to the date of
preparation of consolidated balance sheet.
If the profits of the subsidiary company are insufficient to pay cumulative dividend on
preference shares then a proper provision is to be made from existing reserves and is added to the
minority interest.
If there is already a debit balance of profit & loss account and profits are not sufficient to
meet all the arrears of dividend then there is no necessity of providing the arrears dividend out of the
consolidated profits. However, this has to be shown as a note along with the balance sheet
ILLUSTRATION : 1
The balance sheets of H Ltd., and S Ltd., as on 31-3-2007are as follows
371
Balance sheet of H ltd., and S Ltd., as on 31-12-2007
LIABLITIES H L TD S L TD ASSETS HLTD S L TD

7 % Preerence ------ 1,60,000 Fixed assets(Net) 5,00,000 4,40,000
shares of Rs100 15,000 equity shares 3,30,000 -------
Equity shares of Rs 2,00,000 in S ltd at cost -------
10each 80,000 1200 preference 1,20,000 -------
General Reserve 6,00,000 88,000 shares of S Ltd at
Profit and Loss A/c 1,00,000 40,000 cost 10,000 -------
6% Debentures 1,97,000 6% debentures of S 2,91,000
Proposed Dividend ------ 2,4000 Ltd at cost
On equity shares 1,24,400 Current assets
On preference 60,000
shares ------ 7,26,800
Debenture interest
accurred ------
Creditors 2,94,000
12,51,000 12,51,000 7,26,8000

Additional information;
1. The general Reserve of S Ltd as on 31-3-2006 was Rs.80,000.
2. H Ltd acquired the shares cum dividend in S ltd on 31-3-2006
3. The balance of Profit and Loss account of S Ltd is made up as follows;
Balance as on 31-3-2006 56,000
Net profit –for the year ending 31-3-2007 64,000
1,20,000
Less : Provision for proposed dividend 31,200
88,800
4. The balance of Profit and Loss Account of S Ltd as on 31-3-2006 is after providing
preference dividend of Rs11,200 and proposed equity dividend of Rs.10,000. Both of
which were subsequently paid but credited to Profit and Loss account of H Ltd.
5. No entries have been made in the books of H Ltd for debenture interest due from OR
proposed dividend of S Ltd for the year ended 31-3-2007.
6. S Ltd has issued fully paid bonus shares of Rs.40,000 on 31-3-2007 amoung the existing
shareholders by drawing upon the general reserve. The transaction has not been given
effect to in the books of S Ltd.
You are required to prepare a Consolidated Sheet of H Ltd and its subsidiary Company
S Ltd as on 31-3-2007.
372
Solution:
1. Analysis of Profits of S Ltd Capital
Revenue
General Reserve balance on 31-3-2006 80,000
———
Profit and Loss A/c Balance on 31-3-2006 56,000
64,000
1,36,000
64,000
Less ; Bonus shares issue 40,000
96,000
64,000
Share of H Ltd 75% 72,000
48,000
Share of Outsiders 24,000
16,000
2. Minority Interest
Face value of shares 5000 equity shares 50,000
400, 7 % Preference 40,000
Face value of bonus issue 10,000
Share of capital profits 24,000
Share of Revenue profits 16,000
1,40,000
3. Cost of Control/ Capital Reerves;
Cost of Invetment
15000 Equity shares 3,30,000
1200 7% Preference shares 1,20,000
4,50,000
Less; Face value of shares
15,000 Equity shares 1,50,000
1200 7% Preference shares 1,20,000
Dividend credited to P&L 15,900
Face value of bonus issue 30,000
Share of capital profits 72,000 3,87,900
Goodwill‘ 62,100
4. Profit and Loss A/c
Balance as per balance sheet 1,97,000
Less ; dividends to be credited to investment A/c;
On equity shares 7500
On preference shares 8400 15,900
1,81,100
Add: Share in Profits of S Ltd 48,000
Interest Receivable on Debentures 600
2,29,700
373
Consolidated balance sheet of H ltd., and S ltd., as on 31-3-2007
Liablities Amount Assets Amount

Equity share capital of Rs 10each 6,00,000 Goodwill
General Reserve 1,00,000 Fixed Assets H Ltd
Profit and Loss A/c 2,29,700 5,00,000 9,40,000
6% Debentures S Ltd 40,000 S Ltd 4,40,000
Less; Held by H Ltd 10,000 30,000 Current Assets H Ltd 5,77,800
Debenture interest accrued 1,800 2,91,000
Only outsiders S Ltd
Creditors H Ltd 2,94,000 2,86,800
S Ltd 1,24,400 4,18,000
Proposed dividend H Ltd 60,000
Minority Intersest 1,40,000
15,79,900 15,79,900
ILLUSTRATION : 2
The following are the balance sheet of X Ltd., and Y Ltd., as on 31-12-2007.
Balance sheet of X Ltd., and Y Ltd., as on 31-12-2007.
Labilities X Ltd . Y Ltd . Assets X Ltd . Y Ltd .
Share Capital; Fixed Assets 2,50,000 1,30,000
Equity Shares Investment in
of Rs.10/- each4,00,000 2,00,000 15000 Equity
shares in
Y Ltd. 2,30,000
6% Preference 200 10%
shares of Rs. Preference shares
100 each 50,000 of Rs.100/- in Y Ltd 23,000
General 400 5% debentures 40,000
Reserve 80,000 27,000 in X Ltd.,
Profit & Loss1,20,000 - 85, 5% debentures
5% Debentures in Y Ltd., 8,500
of 100 each 1,00,000 60,000 Stock 80,000 30,000
Bills Payable 20,000 10,000 Debtors 70,000 60,000
Creditors 30,000 53,000 Bills
Receivable 50,000 20,000
Bank 38,500 10,000
Profit&Loss 1,10,000
7,50,000 4,00,000 7,50,000 4,00,000
374
X Ltd., acquired controlling interest in Y Ltd., on 1st April 2007. On 1st Jan 2007, the
general reserve and profit & loss account (debit balance) of Y Ltd., were Rs.50,000 and Rs.1,60,000
respectively. Y Ltd., paid an equity dividend of 10% and also preference dividend out of general
reserve on 31st July, 2007 for 2006. X Ltd. credited such dividend to its profit and loss account.
The following information is also available regarding Y Ltd.,.
1. Stock costing Rs.6,000 was destroyed by fire in March, 2007 against which in insurance Co.
paid Rs.4,000 only, the balance being written off.
2. Normal repairs to fixed assets were made for the year 2007 at a cost of Rs.8000 but the
amount though outstanding has not been provided for.
3. Bills payable include Rs.4000 accepted in favor of X Ltd., which holds only Rs.3000 in its bills
receivable.
4. There is no outstanding debenture interest of any company.
Prepare consolidated balance sheet as on 31-12-2007.
SOLUTION
1.Ratio of shares held by X Ltd. 15,000 / 20,000 = ¾and minority Shareholders =n ¼
2. Pre acquisition reserve of Y Ltd. Balance on 1-1-2007 50,000
Less : 10% Equity dividend paid 20,000
6% Pref. Dividend paid 3,000 23,000
Balance : 27,000
3. Y Ltd. Profit for the year before adjustments
(1,60,000 - 1,10,000) 50,000
Add : Abnormal loss of stores 2,000
52,000
Less : Repairs provided for adjusted profits 8,000
44,000
Profit upto 31st March 2007
44,000 X 3/12 = 11,000
Less : Loss on fire accidents
On 11th March 2007. 2,000
9,000
4. Pre-acquisition loss of Y Ltd.,
Loss on 1st Jan 2007 1,60,000
LESS : Profit upto 1st April 9,000
Pre - acquisition loss 1,51,000
5. Post acquisition profit of Y Ltd. 44,000 x 9/12 33,000
6. Goodwill or capital reserve :
Cost of equity shares 2,30,000
Cost of preference shares 23,000
2,53,000
375
Less : Dividend received out of pre acquisition
Reserve of vito Ltd., wrongly credited to
Profit & loss account
Equity dividend 15,000
Preference dividend 1,200 16,200
2,36,800
Face value of shares
Equity shares 1,50,000
Preference shares 20,000
reserve Balance (27,000 x 3/4) 20,250 1,90,250
46,550
Shares of pre acquisition loss
Less : 1,51,000 x 3/4 1,13,250
1,59,800
Capital reserve being the excess
nominal value of debentures
purchased from Y Ltd., over cost
(10,000 - 8,500) 1,500
1,58,300
7. Minority Interest :
Equity Share Capital 50,000
Preference Share Capital 30,000
Share in pre acquisition
reserve 27,000 x 1/4 6,750
Share in post acquisition
profit 33,000 x 1/4 8,250
95,000
Share of pre acquisition loss
1,51,000 x 1/4 37,750
57,250
8. Consolidated Profit & Loss Account :
Balance of X Ltd.,
Share of Post acquisition 1,20,000
Profit of Y Ltd., 33,000 x 3/4 24,750
1,44,750
Set out of pre acquisitions
reserve wrongly credited 16,200
1,28,550
376
Consolidated Balance Sheet of X Ltd., and its subsidiary Y Ltd., as on 31-12-2007.
Share Capital Good Will 1,58,300
40,000 shares of Fixed Assets :
Rs. 10/- 4,00,000 Natco 2,50,000
General Reserve 80,000 Vito 1,30,000 3,80,000
Minority Interest 57,250 Store :
Profit & Loss A/c 1,28,550 Natco 80,000
5% Debentures Vito 30,000 1,10,000
Natco 1,00,000 Debtor
Vito 60,000 Natco 70,000
1,60,000 Vito 60,000 1,30,000
Less : Inter Bills Receivable
Co. Holding 50,000 Natco 50,000
1,10,000 Vito 20,000
Sundry Creditors : 70,000
Natco 30,000 Less : Inter
Vito 53,000 83,000 Co. acceptance
not discovered 3,000 67,000
Bills Payable Bank :
Natco 20,000 Natco 38,500
Vito 10,000 Vito 10,000 48,500
30,000
Less : Inter
Co. 3,000 27,000
Repair Expenses
Outstanding 8,000
8,93,800 8,93,800
16.3 TREATMENT OF BONUS SHARES
The subsidiary company may issue bonus shares to its shareholders. The issue of bonus
shares by the subsidiary company will result in increase the number of shares in the hands of the
holding company and minority shareholders. The treatment of bonus shares depend upon the source
from where bonus shares are issued. The bonus shares can be issued out of accumulated profits or
revenue profits or a combination of these two. The treatment of bonus shares is as follows :
1. When bonus shares are issued out of pre acquisition profits. It is important to distinguish
between pre acquisition and post acquisition profits for issue of Bonus shares . When bonus
shares are issued out of pre acquisition profits there will be no effect on accounting treatment
as such the value of goodwill or capital reserve remain unchanged when bonus shares are
issued out of the Pre-acquisition profits.
377
2. When bonus shares are issued or post acquisition profits the revenue profits of the subsidiary
company are reduced to that extent and the number of the shares held by the holding company
will increase. In this case it is necessary that the holding company’s share in the revenue profits
of the subsidiary company are to be calculated only after making an adjustment for such bonus
shares issued by the subsidiary company from the post acquisition profits (Revenue Profits). It
results in reduction in the share of holding company in the post acquisition profits of the subsidiary
company. In the case the goodwill is reduced because of the increase in number of shares
ILLUSTRATION - 3
M Ltd., acquired 1,600 ordinary shares of Rs. 100 each in N Ltd., on 31st December
2007. The summarized balance sheets of M Ltd., and N Ltd., as on that date were as follows :
Balance Sheets of M Ltd and N Ltd as on 31-12-2007
Liabilities M Ltd., N Ltd., Assets M Ltd., N Ltd.,
Capital 5,000 Land &
ordinary shares Buildings 1,50,000 1,80,000
of Rs.100each 5,00,000 Plant &
2,000 ordinary Machinery 2,40,000 1,09,400
shares of Rs. Investments
100 each 2,00,000 in N Ltd.,
Capital Reserve 1,20,000 at cost 3,40,000
General Stocks 1,20,000 36,000
Reserve 2,40,000 Debtors 44,000 40,000
Profit & Loss 57,200 36,000 Bills
Bank Over Draft 80,000 including Rs.
Bills Payable 3000 from
(including Rs. N Ltd., 15,800
4000 to M Ltd.) 8,400 Cash and
Creditors 47,100 9,000 Bank 14,500 8,000
9,24,300 3,73,400 9,24,300 3,73,400
You are supplied the following information.

A. N Ltd., had made a bonus issue on 31st December 2007 of one ordinary share for every two
shares held by its share holders. Effect has yet to be given in the accounts for this issue.
B. The directors are advised that land and buildings of N Ltd., are under valued by Rs.20,000
and plant and machinery of N Ltd., is overvalued by Rs.10,000 . These assets have to be
adjusted accordingly.
C. Sundry creditors of M Ltd., include Rs.12,000 due to N Ltd., you are required to prepare the
consolidated balance sheet as on 31st December, 2007.
378
SOLUTION :
The ratio between the holding company and minirity shareholders is 1600 : 400 , 4 : 1 i.e. 4/5 & 1/5,
1. Cost of control or Goodwill :

Shares 1600 x 100 1,60,000
Bonus shares 800 x 100 80,000
Capital reserve :
(1,20,000 - 1,00,000 Bonus shares = 20,000 x 4/5) 16,000
Profit & Lose A/c 36,000 x 4/5 28,800
Profit on revaluation of assets 8,000 2,92,800
Goodwill 47,200
Since the cost of investment is more than the value of equity held it results in Goodwill/Cost of Control
Share capital :
Original shares 400 x 100 40,000
Bonus shares 200 x 100 20,000
Share in capital reserve 20,000 X 1/5 4,000
Share in Profit & loss 36,000 X 1/5 7,200
Share in Revaluation of assets 10,000 X 1/5 2,000
73,200
Consolidated Balance Sheet of M Ltd., and its Subsidiary N Ltd. As At 31st December 2007
Liabilities Rs Rs Assets Rs Rs
5000 ordinary Fixed Assets
shares of Rs. Goodwill 47,200
100 each 5,00,000 Land & Buildings :
Reserves & Surpluses M Ltd., 1,50,000
General Reserve N Ltd., 1,80,000
M Ltd., 2,40,000 Add : Increase in values 20,000 3,50,000
Profit & Loss A/c Plant &
N Ltd., 57,200 Machinery
M Ltd., 2,40,000
N Ltd., 1,09,400
Bank Overdraft 80,000 Less;Decrease in value 10,000 3,39,400
Creditors :
Current Assets :
M Ltd., 47,100 Stock in hand
379
N Ltd., 9,000 M Ltd., 1,20,000
56,100 N Ltd., 36,000 1,56,000
Less : Inter Sundry Debtors
Company M Ltd., 44,000
transactions 12,000 44,100 N Ltd., 40,000
Bills Payable / N 84,000
Ltd., 8,400 Less : Inter
Less : Inter Company
Company Transactions 12,000 72,000
Transactions 3,000 5,400 Bill Receivable
Minority Interest 73,200 M Ltd., 15,800
Less : Due
from N Ltd 3,000 12,800
Cash and Bank
M Ltd., 14,500
N Ltd., 8,000 22,500
9,99,900 9,99,900
ILLUSTRATION : 4
The summarized balance sheets of H Ltd., and its S Ltd., on 31st Dec. 2007 are as follows
: Balance sheets of H Ltd., and its S Ltd., on 31st Dec. 2007
Liabilities H Ltd., S Ltd., Assets H Ltd., S Ltd.,
Share capital 5,00,000 1,00,000 Assets 5,00,000 1,70,000
Of Rs 10 each
Reserves 80,000 30,000 8,000 Shares
Profit&LossA/c60,000 40,000 in S Ltd., 1,40,000
6,40,000 1,70,000 6,40,000 1,70,000
S Ltd., had the credit balance of Rs.30,000 in the Reserves when H Ltd., acquired shares in
S Ltd., S Ltd decided to make a bonus issue out of post acquisition profits of two shares of Rs.10
each fully paid for every five shares held.
Calculate the cost of control before the issue of bonus shares and after the issue of bonus
shares. Also prepare a consolidates balance sheet after the issue of bonus shares.
SOLUTION :
The Ratio between holding company and minority shareholders is 8000 : 2000, 4;1, 4/5
and 1/5 or 80% & 20%
Cost of control before the issue of bonus shares :
Cost of 8,000 shares in S Ltd., 1,40,000
Face value of 8,000 (8,000 x 10) 80,000
Share in capital profit
(Rs.30,000 x4/5) 24,000 1,04,000
Cost of control or Goodwill 36,000
380
Cost of control after the issue of bonus shares :
Cost of 8,000 shares in S Ltd., 1,40,000
LESS :
Face value of 8,000 shares (8,000 x 10) 80,000
Face value of 3,200 shares (3200 x 10) 32,000
(2 bonus shares for every 5 8000X2/5=3200)
Shares in Reserves
(30,000 x 4/5) 24,000 1,36,000
Cost of control of Goodwill 4,000
Calculation of minority interest :
Share capital held by outsiders 20,000
Before the issue of bonus
Shares (2000 x 10)
Add : 2000 x 2/5 = 800 Bonus
Shares of Rs.10 each (800 x 10) 8,000
Add : Shares in
Reserve 30,000 x 1/5 6,000
Consolidated balance sheet of H ltd., and its S ltd., on 31st dec. 2007
Labilities . Rs. . Assets Rs. . Rs. .
Share Capital Goodwill 4,000
5,000 Shares Assets :
Rs.10 each 5,00,000 H Ltd., 5,00,000
Reserves 80,000 S Ltd., 1,70,000 6,70,000
Minority Interest 34,000
6,74,000 6,74,000
16.4 TREATMENT OF FUTURE INCOME TAX RESERVE
The Income Tax reserve created by subsidiary companies should not be treated as either pre
acquisition profits or post acquisition profits of the subsidiary companies. While preparing consolidated
Balance Sheet the future income tax reserve created be treated as on par with other liabilities and
provisions and must be shown along with provisions made by the holding company.
16.5 TREATMENT OF DIVIDEND
The following points are to be taken care of while dealing with dividends declared by subsidiary
companies.
1. Unclaimed - dividend : If unclaimed dividend appears in the balance sheet of subsidiary
company it should be divided into two parts .
A. Dividend not claimed by a company belonging to the group(Holding Company)
B. Dividend not claimed by outsiders.
381
While preparing the consolidated balance sheet the dividend not claimed by group companies
will be cancelled by corresponding unclaimed dividend appears as an asset in the books of
the group companies. The unclaimed dividend by the minority shareholders will appear in the
consolidated balance sheet as a liability item.
2. Proposed dividend : When a subsidiary company proposed dividend it debits profit & loss
account and credits proposed dividend account. While preparing consolidated balance sheet
the proposed dividends belongs to the holding company may be added to the holding
company’s share is other profits of the subsidiary company. The proposed dividend belonging
to minority share holders will be added to minority interest.
3. Payment of dividend : When the holding company received dividend from the subsidiary
company the treatment in the holding company’s books depends and answer to the
questionwhether such dividend shall be further available as dividend to the share holders
of the holding company will depend upon the following possibilities relating to the
source from which such dividends have been paid. No clarity
A. Payment of whole dividend out of pre acquisition profits : If the whole of dividend is
paid from the pre acquisition profits it must be treated as capital profit and must be taken into
consideration while calculating the goodwill or capital reserve. The dividend so received is
not available to the share holders of the holding company for dividend payment and thus it
can not be treated as revenue profit of the holding company.
B. Payment of Whole Dividend Out of Post Acquisition Profits :
If the whole dividend is received from post acquisition profits it is available to the share
holders of the holding company and can be credited to the profit and loss account of the
holding company.
C. Payment of Dividends Out of Pre-Acquisition Profits and Post Acquisition Profits :
If dividend declared partly out of pre acquisition profits (capital profits) and party out of
capital profits. (Post acquisition) the dividend received is divided into two parts i.e. dividend
declared from capital profits and dividend declared from revenue profits. The dividend
pertaining to the capital profits will be taken into accounting while calculating goodwill or
Capital Reserve and dividend pertaining to the revenue profits is credited to profit and loss
account.
ILLUSTRATION : 5
The profit and loss account of S Ltd., showed a credit balance of Rs.50,000 on 1st Jan.
2007. A dividend of 15% was paid in October 2007 for the year 2006. This dividend was credited
to the profit and loss account by H Ltd., H.Ltd acquired the shares in S Ltd., on 1st July 2007. The
bills payable of S Ltd., were all issued in favor of H Ltd., Which company got the bills discounted.
The following are the balance sheets of H Ltd., and S Ltd., as on 31st Dec. 2007.
Liabilities H Ltd., S Ltd., Assets H Ltd., S Ltd.,
Share capital Good will 40,000 30,000
(Shares of Land&Buildings. 2,00,000 1,30,000
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Rs. 100 each)5,00,000 2,00,000 Plant &
General Machinery 1,60,000 90,000
Reserve Stock 1,00,000 90,000
(1-1-2007) 1,00,000 60,000 Debtors 20,000 75,000
Profit & Loss1,40,000 90,000 1,500 Shares
Bills Payable 40,000 in S Ltd. At Cost 2,40,000
Creditors 80,000 50,000 Cash 60,000 25,000
8,20,000 4,40,000
8,20,000 4,40,000
Included in the creditors of S Ltd., is Rs., 20,000 for goods supplied by H Ltd., Included in the
stock of S Ltd., are goods to value of Rs.8,000 which were supplied by H Ltd., at a profit of 33 1/
3% on cost . In arriving at the value of S Ltd., shares the plant and machinery which then stood in the
books at Rs. 1,00,000 was revalue at Rs.1,50,000. The new value was not incorporated in the
books. No changes in these have been made since that date.
You are required to prepare consolidated balance sheet as on 31-12-2007
SOLUTION
The Ratio between holding company and Minority Shareholders is 1500 : 500, 3;1, 3/4 and
1/4 ;
Curent year Profit of the S Ltd.;
Dividend paid (15% on 2,00,000) in October,2007 30,000
Balance of profit on 31-12-2007 90,000
Total 1,20,000
LESS : Balance of profit 1-1-2007 50,000

Profit for the year 70,000
Capital Profit :
General Revenue 1-1-2007 60,000
Profit & loss A/c 1-1-2007 50,000
Profit up to 30-6-2007
(Half of Rs.70,000) 35,000
LESS : Dividend paid 30,000 5,000
Profit on Revaluation
(1,50,000 - 1,00,000) 50,000
Total 1,65,000
Holding company’s share
1,65,000 X 3/4 1,23,750
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Minority share holding share
1,65,000 X 1/4 41,250
Revenue Profit :
Profit of S Ltd., for half year 35,000
LESS : Depreciation for 1/2 year on
increased value i.e., 50,000 at 10% 2,500
Revenue profit 32,500
Holding company’s share 32,500 x 3/4 24,375
Minority share holders 32,500 x 1/4 8,125
Minority Interest :
Face value of 500 shares 50,000
Share of capital profit 41,250
Share of Revenue profit 8,125
Cost of control / capital Reserve :
Value of equity held:
Face value of 1,500 shares 1,50,000
Dividend @15% received 22,500
Share in Capital profit 1,23,750 2,96,250
LESS : Book value of goodwill 70,000
Goodwill 13,750
Profit & Loss Account of H Ltd.
Profit & loss A/c given 1,40,000
LESS : Dividend credited to
Profit & Loss A/c transferred to Capital Reserve 22,500
1,17,500
Consolidated Balance Sheet of H Ltd and its Subsidiary S Ltd.
As on 31st December 1993
Share capital 5,00,000 Goodwill 13,750
5000 shares Land & Buildings
100 each H Ltd., 2,00,000
General Reserve 1,00,000 S Ltd., 1,30,000 3,30,000
Profit & Loss1,17,500 Plant & Machinery
Less : H Ltd., 1,60,000
Unrealised profit S Ltd., 90,000
384
on stock 2,000 Add : Appreciation 50,000
1,15,500
Add : Profit 3,00,000
from S Ltd., 24,375 1,39,875 Less :
Depreciation 2,500 2,97,500
Minority Interest 99,375 Stock
Bills Payable S Ltd., 40,000 H Ltd., 1,00,000
Sundry Creditors : S Ltd., 90,000
H Ltd., 80,000 1,90,000
S Ltd., 50,000 Less :
1,30,000 Unrealised
Less : Mutual 20,000 Profit 2,000 1,88,000
owing 1,10,000 Sundry Debtors
H Ltd., 20,000
S Ltd., 75,000
95,000
Less : Mutual
Owing 20,000 75,000
Cash :
H Ltd., 60,000
S Ltd., 25,000 85,000
9,89,250 9,89,250
ILLUSTRATION : 6
From the following balance sheets of a Holding company and its subsidiary company, prepare
a consolidated Balance Sheet.
BALANCE SHEETS AS ON 31-3-2008
Labilities X Ltd. Y Ltd . Assets X Ltd . Y Ltd .
Share capital Goodwill 30,000 10,000
Rs. 10 each 5,00,000 2,00,000 Machinery 3,00,000 1,50,000
General Reserve80,000 60,000 Stock 80,000 50,000
Profit & Loss 90,000 70,000 Debtors 1,20,000 1,60,000
Creditors 50,000 40,000 Cash and
Outstanding Bank 20,000 10,000
Expenses 20,000 10,000 Investment :
16,000 shares
in S Ltd., 1,90,000
7,40,000 3,80,000 7,40,000 3,80,000
When control was acquired Y Ltd,. has Rs.40,000 in General Reserve and Rs.30,000 in
profit and loss account. Y Ltd has declared and paid a dividend of 10% on equity share capital.
Immediately on purchase of shares X Ltd., received Rs. 16,000 Dividend from Y Ltd,. Debtors of
X Ltd., include Rs.20,000 due from Y Ltd., where as creditors of Y Ltd., include Rs. 13,000 due
to X Ltd., difference being accounted for a cheque in transit.
385
SOLUTION :
The Ratio between holding company and Minority Shareholders is 16000 : 4000, 4 : 1, 4/5, and 1/5.
Profit & loss statement of Y Ltd.,
Balance on 31st March 2008 70,000
LESS : Balance when control was acquired 30,000
Profit earned during the year 40,000
Share of the Holding Company 32,000
Share of Minority shareholders 8,000
1. Goodwill or Capital Reserve :
Cost of investments 1,90,000
Face value of shares in Y ltd., 16000 X 10 =, 1,60,000
Dividends received from Y Ltd. 16,000
Share in general reserve at the time of acquisition
40,000 x 4/5 32,000
Share in profit & loss A/c
(30,000 - 20,000(Dividends) = 10,000 x 4/5) 8,000 2,16,000
Capital reserve 26,000
2. Minority Interest
Share capital 4000 x 10 40,000
Share in general reserve 60,000 x 1/5 12,000
Profit & loss A/c 70,000 x 1/5 14,000
66,000
3. Balance of general reserve statement
in Y Ltd. Balance on 31-3-2008 60,000
LESS : Balance as on acquisition of Shares 40,000
Profit Transfer to reserve during the year 20,000
Share of minority shareholders 4,000
Share of holding company 16,000
5. Profit & Loss statement of X Ltd.,
Balance as on 31-3-2008 90,000
Share in current year profit of Y Ltd. (16,000 + 32,000) 48,000
1,38,000
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Consolidated Balance Sheet of X Ltd and its Subsidiary Y Ltd.
As on 31-3-2008
Share capital Goodwill
50,000 shares X Ltd., 30,000
of 10/- each Y Ltd., 10,000 40,000
fully paid 5,00,000 Machinery
General Reserve 80,000 X Ltd., 3,00,000
Profit & Loss A/c Y Ltd., 1,50,000 4,50,000
X Ltd., 90,000 Stock
Y Ltd., 48,000 1,38,000 X Ltd., 80,000
Sundry Creditors Y Ltd., 50,000 1,30,000
X Ltd., 50,000 Debtors
Y Ltd., 45,000 X Ltd., 1,20,000
95,000 Y Ltd., 1,60,000
Less : Inter 2,80,000
company Less : Inter
transactions 20,000 75,000 company
Outstanding transactions 20,000 2,60,000
Expenses : Cash in
X Ltd., 20,000 Transit 5,000
Y Ltd., 10,000 30,000 Cash and Bank
Minority Interest 66,000 X Ltd., 20,000
Capital reserve 26,000 Y Ltd., 10,000 30,000
9,15,000 9,15,000
16.7 TREATMENT OF INTER COMPANY DIVIDENDS
Dividends received by the holding company from the subsidiary company appear as credit
item in the profit & loss A/c of the holding company. At the same time they also appear as a debit item
in the profit & loss account of subsidiary company. While preparing consolidated accounts the inter
company dividends are to be cancelled treating them as inter company owings. However, the
dividends paid from the pre acquisition profits must be taken in to account while calculating the cost
of control or capital reserve. If the dividend paid from the pre acquisition profits of subsidiary company
are wrongly credited to profit & loss account of holding company, the same must be transferred to
goodwill or capital reserve account.
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16.8 SUMMARY
The holding companies can make their investments either in equity shares or in preference shares.
The subsidiary companies from time to issue bonus shares. Such bonus shares change the number of
shares held by holding company and minority shareholders. The dividends declared by the subsidiary
company also has an effect on Goodwill and Capital Reserve of the Holding Company. The amounts
kept aside as future income tax reserve, the changes in parent company equity and inter company
dividends are some of the important issues to be taken into consideration while preparing the
consolidated financial statement.
16.9 KEY WORDS
Bonus Shares; Bonus shares are the shares issued by a company with out collecting
money from the shareholders. Usually they are issued out of the accumulated Profits.
Dividends; Dividends are the Profits distributed to the shareholders
EXERCISE : 1
On 1st January 2007 A Ltd acquired 8000 shares of B Ltd.. The respective Balance sheets as
on 31st December 2007 are given below.
Balance sheets of A Ltd and B Ltd as on 31st December 2007.
Liabilities A Ltd , B Ltd , Assets A Ltd , B Ltd
Rs. Rs. Rs. Rs. ,
Share Capital 1,00,000 1,00,000 Fixed assets 60,000 1,10,000
( Rs. 10 each) Investments 1,00,000 ———
Reserve 40,000 26,000 Debtors 25,000 20,000
P&L. A/c 36,000 35,000 Stock 30,000 40,000
creditors74,000 49,000 Bank 35,000 40,000
2,50,000 2,10,000 2,50,000 2,10,000
1) At the time of acqiring shares B Ltd. has Rs. 20,000 in reserve A/c and Rs. 12,000 in P & L
A/c
2) One bouns share for 5 fully paid shares has been declared by B Ltd. out of pre acquisition
reserve on 31 st December, 2007. No effect has been given to that in the above accouts.
5) On 1st January 2007 Building of B Ltd. Which stood in the books at Rs. 1,50,000 was
revalued at Rs. 1,60,000 but no adjustment has been made in the books. Depreciation has
been charged @ 10% per annum on reducing balance method.
6) In 2007 A Ltd Purchased goods from B Ltd. for Rs. 10,000 of which B Ltd made profit of
20% on sales, 25% of such goods are laying unsold on 31st December 2007.
You are required to prepare a consolidated Balance Sheet.
388
EXERCISE : 2
Following are the Balance sheets of H Ltd. and S Ltd as on 31st March 2007.
Balance sheets of H Ltd. and S Ltd as on 31st March 2007

Rs. Rs. Rs. Rs.
Share Capital (Rs.10)7,00,000 1,00,000 Land & Buildings 3,00,000 1,00,000
General Reserve 50,000 30,000 Plant & Machinery 2,80,000 50,000
P&L A/c 1,00,000 30,000 7000 shares of
S Ltd. 1,00,000 -
Sundry Creditors 90,000 50,000 Stock 70,000 50,000
Bills Payable 10,000 15,000 Sundry Debtors 1,50,000 20,000
Liabilies Expenses 5,000 15,000 Bills receivalbe 10,000 -
Cash and Bank 45,000 20,000
9,55,000 2,40,000 9,55,000 2,40,000
1. All the bills receivalbe of H. Ltd. including those discounted were accepted by S Ltd.
2. when 6,000 shares were acquired by H Ltd, S Ltd has Rs. 20,000 General Reserve and Rs.
5,000 Credit Balance in P & L A/c.
3. At the time of acquisition of further 1000 shares by H Ltd , S Ltd had Rs. 25,000 in General
Reserve and Rs. 28,000 Credit balance in P & L A/c from which 20% dividend was paid by S
Ltd and was received by H Ltd., on these shares and credited to P & L A/c.
4. Stock of S Ltd. Includes Rs. 20,000 purchased form H Ltd. which has made 25% profit on
cost.
5. Both the companies have proposed dividend H Ltd. 10% and S Ltd 20% but no effect has been
given in the above balance sheets.
Prepare consoldated balance sheet as at 31 st March 2007.
EXERCISE : 3
The following are the Balance sheets of H Ltd and S Ltd as on 31 March 2007;
Balance sheets of H Ltd and S Ltd as on 31 March 2007
Labilities X Ltd. Y Ltd . Assets X Ltd . Y Ltd .
Share capital Fixed Assetsts 4,80,000 2,50,000
Rs. 100 each 10,00,000 5,00,000 Investment in
General Reserve 100,000 1,70,000 Shares of S Ltd 5,00,000
Profit & Loss 1,60,000 130,000 Current Assets 7,20,000 7,50,000
Current
Liablities 4,40,000 2,00,000
17,00,000 10,00,000 17,00,000 10,00,000
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The following additional information is provided;
1. H Ltd acquired 3,000 shares in S Ltd on 1st July 2006. The reserve andsurplus position of S
Ltd as on 1st April 2006 was as under;
General Reserve Rs.2,50,000
P&L A/c (credit)Rs.1,20,000
2. On 1st October 2006 S Ltd issued one equity share for every four shares held as Bonus
shares out of the General Reserve. No entry has ben made in the books of H Ltd for the
receipt of these bonus shares. However, entry has been made in the books of S ltd for the
issue of bonus shares.
3. On 30th September 2006 S Ltd declared a dividend out of pre acquisition profits @ 25% on
4,00,000 its capital on the date. H Ltd credited the dividend to its Profit and loss account.
4. S Ltd owed to H LtdRs.50,000 for purchase of stock from H Ltd. The entire stock is held by
S Ltd on 31 March 2007. H made a Profit of 25 % on cost.
Prepare a consolidated Balance Sheet of H Ltd and its subsidiary S Ltd as on 31-3-
2007.
EXERCISE : 4
Strong Ltd acquired 3200 shares of Weak Ltd on December 2007. The summarized
Balance sheets of the two companies as on that date are given below.
Labilities Strong Ltd Weak Ltd Assets Strong Ltd Weak Ltd
Share capital Land & Buildings 3,00,000 3,60,000
Rs. 100 each 10,00,000 4,00,000 Investment in
General Reserve 480,000 3,40,000 Weal Ltd at cost 6,80,000
Profit & Loss 1,14,400 72,000 Plant & machinery 4,80,000 3,18,800
Bank loan 1,60,000 ------ Stocks 2,40,000 72,000
Bills payable 16,800 Sundry debtors 88,000 80,000
(including Rs Bills receivable
6000 to Strong) (including Rs.6000 31,600
Sundry creditors 94,400 18,000 from weak Ltd)
Cash at Bank 29,200 16,000
18,48,800 8,46,800 18,48,800 8,46,800

You are supplied with the following information
390
1. Weak Ltd made a bonus issue on 31-12-2007 of one equity share for every four shares held
by its shareholders. This has not yet been accounted for.
2. Sundry creditors of Strong Ltd included Rs.24,000 due to Weak Ltd.,
3. The directors have decided to revalue the land and buildings and plant and machinery of
Weak Ltd at Rs.4,00,000 and 2,98,800 respectively.
Prepaare a consolidated balance Sheet as on December 31, 2007.
EXERCISE : 5 : The following are the summarized balance sheets of F Ltd, S Ltd and D
Ltd as on 31-3-2007
Balance sheets of F Ltd, S Ltd and D Ltd as on 31-3-2007
F Ltd S Ltd D Ltd

Capital; ordinary shares of Rs.100 each 50,00,000 40,00,000 15,00,000
Profit and Loss A/c before taking into 12,00,000 10,00,000 5,20,000
account proposed dividend declaration
Creditors 2,00,000 2,50,000 80,000
64,00,000 52,50,000 21,00,000
Goodwill at cost 3,00,000 ------- -------
Fixed assets
Investments acquired on 1-4-2006 at cost: 35,00,000 ------- -------
30,000 ordinary shares in S Ltd ------- 14,00,000 -------
12,000 ordinary shares in D Ltd 5,00,000 4,00,000 2,00,000
Stock in trade 1,00,000 4,50,000 1,00,000
Debtors, cash and bank balances 64,00,000 52,50,000 21,00,000
The following information is available;
1. On April 1, 2006 credit balances in the profit and Loss account , before taking into
account proposed dividends were ; F Ltd Rs.8,00,000, S Ltd Rs.4,80,000 and D Ltd
Rs.30,000
2. 10% dividend was distributed in F Ltd for the year 2005-06 on 30-6-2006
3. Proposed dividend for 2006-07 to be paid wholly from the profits for that year are ; F
Ltd 10%, S Ltd 5% and D Ltd 10%
Prepare a summarized Consolidated Balance sheet as on 31-3-2007
391
EXERCISE : 6 : Strong Ltd acqujired 3,200 equity shares of Weak Ltd on 31-12-2007. The
summarized balance sheets of the two companies as on that date are given below.
You are supplied with the following information.
1.Weak Ltd made a bonus issue on 31-12-2007, of one equity share for every four shares held
by its share holders. This has not yet been accounted for.
2. Sundry creditors of strong Ltd included Rs.24,000 due to weak Ltd.
1. The directors have decided to revalue the land and buildings and plant and machinery of weak
Ltd at Rs.4,00,000 and Rs.2,98,800 respectively.
Prepare the consoloditated balance sheet as on 31-12-2007 with workings.
Labilities Strong Ltd Weak Ltd Assets Strong Ltd Weak Ltd
Share capital Land and 3,00,000 3,60,000
(Rs.100 each fully paid) 10,00,000 4,00,000 Buildings
P&LA/c Plant and 4,80,000 3,18,800
GeneralReserves 72,000 Machinery
Bank loan 3,40,000 Investment 6,80,000 ----
Bills payable ---- in Weak Ltd
(including Rs 6000 ---- 16,800 at cost 2 2,40,000 72,000
to strong Ltd) Stock 88,000 80,000
Sundry creditors Sundry 31,600 ----
debtors
94,000 18,000 Bill
Receivable
(including
Rs.6000
from Weak
Ltd) 29,200 16,000
Cash at bank
18,48,800 8,46800 18,48,800 8,46,800

2. Advanced Accounting ; Corporate Accounting Dr.Ashok Sehgal & Deepak Sehgal Taxmann
5. Financial Accounting A managerial Perspective R.Narayana Swamy Prentice Hall of India
392
GUIDELINE 17 : PREPARATION OF CONSOLIDATED
BALANCE SHEET WITH MORE THAN
ONE SUBSIDIARY
OBJECTIVES
The aim of this lesson is to explain the process of preparing consolidated Balance sheet
when there are more than one subsidiary. After studying this guideline, you should be able to:
• Calculate investment in multiple subsidiary companies
• Know the calculation of Cost of Control/Capital Reserve
• Calculate Minority Interest for all the subsidiary companies
STRUCTURE
17.1 Introduction
17.2 Direct Holding
17.3 Chain Holding
17.4 Summary
17.5 Glossary
17.1. INTRODUCTION
A company can have more than one subsidiary in two ways Viz.Firstly, Direct holding – if a
company directly acquires majority of the shares in more than one company and various subsidiaries
do not hold shares in one another Secondly, is Chain Holding OR IndirectHolding- when a company
acquires controlling shares in another company which is already a Holding Company, it results in
Chain-holding.
17.2 DIRECT HOLDING

If a company directly acquires majority of the shares in more than one company and the
subsidiaries do not hold shares in one another, the calculation of Cost of Control, Minority Interest
etc. of each subsidiary company should be done following usual procedure. When there is more
than one subsidiary the investment account of the holding company shows more than one investment
in the balance sheet.
In order to eliminate the investments and share capital of the subsidiary companies it is necessary
to calculate the cost of control or capital reserve and minority interest separately for the all the
subsidiary companies.
ILLUSTRATION : 1.
X Ltd owns the entire issued share capital of Y Ltd and 90% of the Share Capital of Z Ltd as
on 31 March,2008. As on 31 March 2008 the balances of the three companies Viz. X, Y, Z Ltd are
as follows;
393
Liablities X Ltd. Y Ltd. Z Ltd.
Rs. Rs. Rs.
Share capital ;
Equity shares of Rs. 10 each fully paid 40,00,000 2,00,000 3,00,0000
Profit and Loss account 8,00,000 80,000 2,00,000
Current Liablities 2,00,000 1,00,000 1,50,000
Owings to X Ltd — — 1,60,000
Proposed equity dividend 4,00,000 2,00,000 50,000
———————————————
54,00,000 5,80,000 8,60,000
Assets
Fixed Assets 23,90,000 1,60,000 2,40,000
Current Assets 20,40,000 4,20,000 6,20,000
Shares in Y Ltd. 2,50,000
Shares in Z Ltd 3,20,000
Owings by Y Ltd 2,20,000
Owings by Z Ltd 1,80,000
——————————————
54,00,000 5,80,000 8,60,000
As on the date of acquisition of shares in the subsidiary companies on 1st April 2007 the
balance sheets showed the following;
Profit and Loss account credit balances Y Ltd Rs.20,000 and Z LtdRs.50,000 . Y Ltd and
Z.Ltd had not paid any dividend since becoming subsidiary of X Ltd. The difference in inter company
balances is due to;
1. Payment of Rs.20,000 on 31 st March 2008 to creditors made by X Ltd on behalf of Y Ltd
was not made by the later until 2009
2. A remittence of Rs.20,000 byZ Ltd to X Ltd 0n 31 st March 2008 was received by X Ltd
in 2009.
3. Prepare a consolidated Balance Sheet of X Ltd and its subsidiaries on 31 March 2008.
SOLUTION
Capital Revenue
Profit Profit
1. Analysis of Profit of Z Ltd.,
Balance as on the date of acquisition of shares by X Ltd 50,000 —
Profits made during the year (2,00,000 – 50,000) 1,50,000
Proposed dividend of Z Ltd 50,000
—————————————
50,000 2,00,000
394
Share of X Ltd 90%
Minority Interest 10% 5,000 20,000
2. Analysis of Profit of Y Ltd.,

Balance as on the date of acquisition of shares by X Ltd 20,000 —
Profits made during the year (80,000 – 20,000) 60,000
Proposed dividend of Y Ltd 2,00,000
—————————————
20,000 2,60,000
Share of X Ltd 100% 20,000 2,60,000
3. Goodwill OR Capital Reserve;

Cost of Investments in Y Ltd 2,50,000
Cost of Investments in Z Ltd 3,20,000
5,70,000
Less : Paid up value of investments in Y Ltd 2,00,000
Paid up value of investments in Z Ltd 2,70,000
Share in Capital Profit of Y Ltd 20,000
Share in Capital Profit of Z Ltd 45,000 5,35,000
Goodwill 35,000
4. Profit and Loss A/c of X Ltd;
Balance as per the Balance sheet 8,00,000
Share in Revenue profits ofY Ltd 2,60,000
Share in Revenue Profits of Z Ltd 1,80,000
12,40,000
5. Minority Interest in Z Ltd.
Value of shares 30,000
Capital Profit 5,000
Revenue Profit 20,000
55,000
6. X Ltd has shown Y Ltd as debtor for Rs.2,20,000. Rs. 20,000 is on account of payment to
creditors of Y Ltd and Rs.2,00,000,the balance is assumed to be cash in transit from Y Ltd
to x Ltd.
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Consolidated balance sheet of X Ltd and Subsidiaries Y Ltd and Z Ltd
as on 31 March 2008
Liabilities Rs. Asets Rs

Share capital 40,00,000 Good will 35,000
4,00,000 Equity shares Fixed Assets
of Rs.10 each X 23,90,000
Profit and Loss A/c 12,40,000 Y 1,60,000
Minority Interest (C Ltd) 55,000 Z 2,40,000 27,90,000
Current Current Assets
Liablities 4,50,000 4,30,000 X 20,40,000
Less: 20,000 4,00,000 Y 4,20,000
Proposed Dividends Z 6,20,000 30,80,000
Cash in Transit 2,20,000
61,25,000 61,25,000
17.3 CHAIN HOLDING OR (INDIRECT HOLDING)
When a company acquires controlling shares in another company which is already a holding
company, it results in chain holding as explained below;
If A Ltd acquired 60% of Shares in B Ltd and B Ltd acquired 70 % of the Shares in C Ltd
In order to prepare Consolodated balance sheet analyse the Profits of C Ltd first, Share of
outsiders in the profits of C Ltd is transferred to Minority Interest and the share of other companies
in the chain is transferred to respective companies. Now anlyse the profits of B Ltd (including the
profits received from other companies in the chain). Transfer the portion of profits belonging to
outsiders to Minority Interest. Share of A Ltd in Pre acquisition profits of various subsidiaries is
adjusted in Cost of Control and the Share in post acquisition profit is added to respective reserves
and surplus accounts of A Ltd.
ILLUSTRATION : 2
The following are the Balance Sheets of H Ltd, YLtd and Z Ltd as on 31-3-2008
Assets H Ltd. Y Ltd. Z Ltd.
Rs. Rs. Rs.
Share capital 10,00,000 5,00,000 2,00,000
Reserves 1,50,000 1,50,000 1,20,000
Creditors 3,00,000 2,00,000 1,30,000
17,00,000 11,50,000 5,70,000
Fixed assets 6,00,000 3,00,000 1,50,000
Stocks 4,00,000 3,80,000 3,00,000
Debtors 1,50,000 2,20,000 1,00,000
Balance at bank 50,000 30,000 20,000
Shares in Y Ltd 5,00,000 ---- ----
Shares in Z Ltd ---- 2,20,000 ----
17,00,000 11,50,000 5,70,000
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H Ltd purchased 90% of shares in Y Ltd when the latter company had a credit balance of Rs.80,000
in the profit and loss account and a balance of Rs.60,000 in the reserve Account.
Y Ltd purchased 80% shares in Z Ltd when Z Ltd had 20,000 in reserve and Rs.30,000 as
credit balance in Profit and Loss account. H Ltd and Y Ltd acquired shares in subsidiaries on the
same date. You are required to prepare a consolidated Balance sheet as on 31 March 2008.
Solution
Analysis of profit of Z Ltd Capital Revenue Revenue
Profit Reserve Profit
General Reserve at the time of
Acquisition 20,000 —— ———
Increase in general reserve 1,00,000
Profit and Loss A/c balance at the 30,000 ———— ———

Time of acquisition
Increase in Profit and Loss A/c 90,000
50,000 1,00,000 90,000
Share of Y Ltd 80% 40,000 80,000 72,000
Minority Interest 20% 10,000 20,000 18,000
Analysis of profit of Y Ltd ;
General Reserve at the time of
Acquisition 60,000 —— —
Increase in general reserve 90,000 ——
Profit and Loss A/c balance at the 80,000 —— ——
Time of acquisition
Increase in Profit and Loss A/c 2,20,000

Share in Z Ltd 80,000 72,000
1,40,000 1,70,000 2,92,000
Share of H Ltd 90% 1,26,000 1,53,000 2,62,000
Minority Interest 10 % 14,000 17,000 29,200
Goodwill (OR) Capital Reserve:
Cost of investment in Y Ltd 5,00,000
Cost of investment in Z Ltd 2,20,000
7,20,000
397
Value of Equity Held;
Paid up value of shares in Y Ltd 500000 X 90 % 4,50,000
Paid up value of shares in Z Ltd 200000 X 80 % 1,60,000
Capital Profit of Z Ltd 40,000
Capital Profit of Y Ltd 1,26,000 7,76,000
Minority Interest: Y Ltd Z Ltd
Share Capital 50,000 40,000
Capital Profit 14,000 10,000
Revenue Reserve 17,000 20,000
Revenue Profit 29,200 18,000
1,10,200 88,000
Consolidated balance sheet of H Ltd and Subsidiaries Y Ltd and Z Ltd

as on 31 March 2008
Liabilities Rs. Asets Rs

Share capital 10,00,000 Fixed Assets
Reserve; H 6,00,000
H Ltd 1,50,000 Y 3,00,000
Share in 1,53,000 3,03,000 Z 1,50,000 10,50,000
subsidiaries Current Assets; stock
Profit and Loss A/c H 4,00,000
H Ltd 2,50,000 Y 3,80,000
Share in Z 3,00,000 10,80,000
Subsidiaries 2,62,800 5,12,800 Debtors
Capital Reserve 56,000 H 1,50,000
Minority Interest; Y 2,20,000
Y Ltd 1,10,200 Z 1,00,000 4,70,000
Z Ltd 88,000 1,98,200 Bank
Creditors; H 50,000
H 3,00,000 Y 30,000
Y 2,00,000 Z 20,000 1,00,000
Z 1,30,000 6,30,000
27,00,000 27,00,000
ILLUSTRATION : 3
As on 30th June 2007 the draft balance sheets of three companies showed the following positions.
398
Balance Sheets of X Ltd, Y Ltd and Z Ltd as On 30th June 2007
Assets X Ltd. Y Ltd. Z Ltd.
Rs. Rs. Rs.
Issued ordinary
shares of each Rs.10 20,00,000 15,00,000 8,00,000
General reserve 5,00,000 — . 2,30,000
Creditors 14,20,600 7,31,300 10,01,900
Proposed dividends 10,00,000 6,00,000 4,00,000
59,16,000 33,25,000 28,82,500
Fixed assets 13,50,000 6,00,000 7,00,000
Investments 16,00,000 15,00,000 1,00,000
Stocks 5,52,400 3,68,400 6,17,600
Debtors 11,00,700 6,91,200 9,38,800
Balance at bank 13,12,900 1,65,400 5,26,100
59,16,000 33,25,000 28,82,500
1. X Ltd., acquired 80% shares in Y Ltd., when the balance in Profit and Loss A/c was
Rs.4,00,000.
2. Y Ltd., acquired 60% shares in Z Ltd., when the balance on General reserve was Rs.1,50,000
and Profit and Loss A/c was Rs.3,05,000.
3. Proposed dividends from subsidiary companies are included in the figure for debtors in the
accounts of the parent companies.
You are required to prepare a consolidated balance sheet as at 30-6-2007 show the workings.
SOLUTION
The group has an indirect interest of 68% in Sridhar Ltd., i.e., 85% of 80% in Sridhar Ltd.,
1. Group structure (2000)
X Y Z
85% Group - Direct 80%
Indirect 68%
Y 15%
80% Minority - Direct 20%
Sridhar Indirect 17%
During 1999 X Ltd. holdings in Y Ltd. was 53 1/3% only.
399
Cost of Control in Y Ltd.,
To Investments A/c 16,00,000 By Share capital
80% of Rs.15,00,000 12,00,000
By Pre-acquisition reserve 3,33,330
By Capital reserve 54,400
By Balance showed in
consolidated
Balance Sheet 12,270
16,00,000 16,00,000
Cost of Control - Z Ltd.,
To Cost of Investment 11,96,800 By Share capital
(80% of 14,96,000) 68% of Rs. 8,00,000 5,44,000
By Capital reserve
68% of Rs. 1,50,000 1,02,000
By Pre-acquisition reserve
68% of Rs. 3,05,000 2,07,400
By Balance shown in
consolidated
Balance Sheet 3,43,400
11,96,800 11,96,800
MINORITY INTEREST
To Cost of Investment By Share Capital Y 3,00,000
in Z 20% of Rs. By Revenue Reserves
14,96,000 2,99,200 20% of Rs. 4,93,700 98,740
To Balance shown in By Share Capital - Z
consolidated 32% of Rs. 8,00,000 2,56,000
Balance Sheet 5,73,330 By Capital Reserve
32% of Rs. 2,30,000 73,600
By Revenue Reserve
32% of Rs. 4,50,000 1,44,190
8,72,530 8,72,530
REVENUE RESERVES
To Minority Interest By Balance b/d
20% of Rs. 4,93,700 98,740
32% of Rs. 4,50,000 1,44,190 By X Ltd., 9,95,400
To Cost of Control By Y Ltd., 4,93,700
in Y Ltd., 3,33,330 By Z Ltd., 4,50,000 19,39,700
in Z Ltd., 2,07,400
400
To Balance shown in
Consolidated
BalanceSheet 11,56,040
19,39,700 19,39,700
CAPITAL RESERVES
To Cost of control By Balance b/d
68% of Rs.1,50,000 1,02,000 X Ltd., 5,00,000
To Cost of control Z Ltd., 2,30,000 7,30,000
68% of Rs.2,30,000
Rs.1,50,000 54,400
To Monority Interest
32% of Rs.2,30,000 73,600
To Balance shown in
consolidated Balance Sheet 5,00,000
7,30,000 7,30,000
Pre-Acquisition Revenue Reserve of Y Group :
1999 80 x 4,00,000 2,13,330
150
2000 80 x 4,50,000 1,20,000
150
3,33,330
Investments :
Y Ltd., 15,00,000
Less : Cost of investment in Z Ltd.,
68,000 x 22 14,96,000
Investments of Z Ltd., 4,000
1,00,000
Total shown in consolidated balance sheet 1,04,000
Sundry Debtors :
X Ltd., 11,00,700
Less Dividends from Z Ltd., 4,80,000
Y Ltd., 6,91,200 6,20,700
Less dividends from Z Ltd., 3,40,000 3,51,200
Z Ltd., 9,33,800
Total to be shown in consolidated balance sheet : 19,10,700
The entire capital reserve of Z Ltd., are in the nature of Pre-acquisition Rs.1,50,000 being
the balance at the time of acquisition by Y Ltd., in Z Ltd., and the balance being build up at the time
of acquisition of shares by X Ltd., Thus the entire amount is considered in cost of control accounts.
Therefore, only the capital reserves of Y Ltd., are shown in the balance sheet.
401
CONSOLIDATED BALANCE SHEET AS ON
31ST JUNE 2002
Liabilities Rs. , Rs. , Assets Rs. , Rs. ,
Share Capital Goodwill 3,55,670
Issued ordinary shares (on consolidation)
of Rs. 10 each 20,00,000 X 13,50,000
Capital Reserve 5,00,000 Y 6,00,000
Creditors 31,53,800 Z 7,00,000 26,50,000
Revenue Reserve 11,56,040 Investment at cost 1,04,000
Proposed Dividends Stock 15,38,400
Holding Co., 10,00,000 Balance at Stock 20,04,400
Minority 1,80,000 11,80,000
85,63,170 85,63,170
ILLUSTRATION : 4
The following are the balance sheets of A Ltd., , B Ltd., and C Ltd., as at 31st December
2002.
A Ltd. B Ltd. C Ltd.
Rs. Rs. Rs.
Share Capital :
shares of each Rs.100 10,00,000 5,00,000 2,00,000
General Reserve 2,00,000 35,000 -
Profit & Loss A/c. 1,70,000 1,20,000 -
Liabilities 1,60,000 3,75,000 1,40,000
15,30,000 10,30,000 3,40,000
Assets :
Investments :
4000 shares in B Ltd. 6,00,000
500 shares in C Ltd. 25,000
1500 shares in C Ltd. 90,000
Other Assets 9,05,000 9,40,000 2,60,000
15,30,000 10,30,000 3,40,000
402
The following information is available :
1. Included in A Ltd., liabilities Rs. 50,000 due to C Ltd.,
2. B Ltd., has advanced to C Ltd., Rs.1,00,000
3. A Ltd., acquired its investment in B Ltd., on 1st January 2002 on which date the amounts
standing to the credit of general reserve and profit and loss account in B Ltd., was Rs. 35,000
and Rs.65,000 respectively.
4. A Ltd., acquired its investment in C Ltd., on 1st Jan, 2002 when the debit balance in the profit
and loss account in C Ltd.’s books was Rs.60,000.
5. B Ltd., acquired its investment in C Ltd., on 1st Jan, 2003 when the debit balance in the profit
and loss account in C Ltd., books was Rs.20,000.
6. Neither B Ltd., nor C Ltd., has paid any dividends.
7. Included in B Ltd.,’s assets are stocks valued at Rs.60,000 which were invoiced by A Ltd., at
a price which was 20 per cent above cost.
You are required to prepare a consolidated balance sheet as on 31st December 2002 showing
your workings.
SOLUTION
PROFIT AND LOSS (APPROPRIATION) ACCOUNT
Expenses A Ltd. B Ltd. C Ltd. Income A Ltd. B Ltd. C Ltd.
in Rs. in Rs. in Rs. in Rs. in Rs. in Rs.
To Balance b/d By Balance b/d
Loss as on By A Ltd., 1,70,000
1-1-2000 20,000 By B Ltd.,
2000 & 2001 40,000 Balance as
2002 20,000 on 1-1-2002 65,000
To C Ltd., Profit
Loss 5,000 45,000 for 2002 55,000
To A Ltd., 32,000 By Cost of Control
To Monitory B in C Ltd., 15,000
Interest 15,000 A in C Ltd., 15,000
To Cost of
Control By P&L 45,000
A in B Ltd., 28,000 Account of B
To Stock By P&L
Reserve 8,000 Account of A32,000
To Balance C/d1,89,000 By B Ltd., 5,000
2,02,000 1,20,000 80,000 2,02,0001,20,000 80,000
COST OF CONTROL
Expenses A Ltd. B Ltd. C Ltd. Income A Ltd. B Ltd. C Ltd.
in Rs. in Rs. in Rs. in Rs. in Rs. in Rs.
Cost of Share
Share Capital 2,00,000 - -
Capital 6,00,000 90,000 25,000
Losses Capital
Profit in
403
B Ltd., - 1,50,000 50,000
Capital
Loss
3/4 of
20,000 15,000
1/4 of
60,000 15,000 On 1-1-2002 1,00,000
Less Share
Capital of Revenue
Reserve 45,000 10,000 Loss in 30,000
C Ltd., -
70,000
4/5 there of 56,000
(90000 x 4/5)
Goodwill 1,44,000
6,00,000 1,50,000 50,000 6,00,0001,50,000 50,000
NOTE :
1. Revenue loss of C Ltd., to be debited to B Ltd., - 3/4 of Rs.60,000 Viz. the loss incurred in
2000, 2001 and 2002.
2. Loss of C Ltd., to be debited to cost of control B in C Ltd., 3/4 of loss as on 1-1-2000,
Rs.20,000 A in C Ltd., 1/4 A loss till the end of 2001 Viz. Rs.60,000.
3. Profit in B Ltd., after debiting Rs. 45,000 (loss from C Ltd.,) is Rs.75,000 made up as :
a) As on 1-1-2002 Rs.65,000 less Rs.30,000 i.e. 3/4 of the loss of C in 2000 and 2001 are
Rs.40,000 Rs.35,000.
b) Profit 2002 Rs.55,000 less Rs.15,000 i.e. 3/4 the loss in C in 2002 of Rs.40,000
i) 4/5 of (a) i.e. Rs.28,000 in to be credited to A’s P&L A/c.
ii) 4/5 of (b) i.e. Rs.32,000 is to be credited to A’s P&L A/c.
iii)1/5 of Rs.75,000 is to be credited to minority interest.
iv) Stock reserve is 4/5 of the unrealised profit i.e. 20/120 of Rs. 60,000.
Minority interest (Only of B Ltd.,)
Share capital 1,00,000
Share of profit 15,000
Share of general reserve 7,000
1,22,000
CONSOLIDATED BALANCE SHEET AS ON 31ST DECEMBER 2002
Liabilities Rs. , , Assets Rs. , Rs. ,
General Reserve 2,00,000 Other Assets 19,55,000
Profit & Loss A/c 1,89,000 Less :
Liabilities 5,25,000 Unrealised
404
Minority & Utility 1,22,000 Profit 8,000
19,47,000
20,36,000 20,36,000
Note : Rs. 50,000 owing by A Ltd., to C Ltd., and Rs.1,00,000 owing by C Ltd., have been
deducted from these two items.
Goodwill : A in B
1,44,000
LESS : Capital reserve :
B in C 45,000
A in C--------- 10,000-------------
55,000
89,000
17.2 SUMMARY
When a company acquires controlling shares in another company which is already a Holding
Company, it results in Chain-holding. If a company directly acquires majority of the shares in more
than one company and the subsidiaries do not hold shares in one another, the calculation of Cost of
Control, Minority Interest etc. of each subsidiary company should be done following usual procedure.
When there is more than one subsidiary the investment account of the holding company shows more
than one investment in the balance sheet.
17.3 KEY WORDS

Chain holding; if a company acquires controlling shares in another company which is already a
company, it results in chain holding.
Cross holding; If a subsidiary company is holding some shares in the holding company, such
situation refers to cross holding.

EXERCISE : 1
A Ltd is the parent compaines of B Ltd. and C. Ltd. The Share capital of B Ltd and C Ltd are
Rs. 5,00,000 and Rs. 2,00,000 respectively (all in Rs. 10 fully paid shares) and particulars of the
holding are as follows :
Undistributed profit as on the date of purchase of shares.
B Ltd C Ltd.
Rs. Rs.
B Ltd. acquired 2,500 sharein C Ltd - 5000
A Ltd. acquired 15,000 shares in C Ltd - 7,000
A Ltd. acquired 40,000 shares in B Ltd 30,000 8,000
405
As on 31 st March 2002, the undistributed profits are B Ltd. Rs. 40, 000 and C Ltd. Rs.
10,000. No dividends have been paid or declared and no losses incurred in any of the relevant
years. Show how the total profits of the subsidiary companies will be dealt in preparing consolidated
Balance sheet.
From the balance sheets given below prepare consolidated balance sheet of X Co. Ltd and its
subsidiary Y. Co. Ltd. The interests of the minority shareholders of Y. Co. Ltd. are to be shown in the
Balance sheet of X Co Ltd and Y Co Ltd as on 31-12-2002
Liabilities X Ltd , Y Ltd , Assets X Ltd , Y Ltd ,
Share Capital Land & Buildings 1,52,00,000
shares of Rs. 80 each2,20,00,000 Plant and Machine 22,40,000 3,20,000
20000 shares of Shares in Y Co. Ltd
Rs. 80 each 16,00,000 18,000 shares of
General reserve 20,00,000 Rs. 80 each 28,80,000
creditors48,00,000 3,20,000 Stock 48,80,000 8,00,000
Profit and Loss Debtors 32,00,000 11,20,000
appropriation A/c 16,00,000 24,00,000 Cash at bank 20,00,000 20,80,000
3,04,00,000 43,20,000 3,04,00,000 43,20,000
EXERCISE : 2
The following are the Summarised balance sheets of imperial co Ltd. and Colonial Co. Ltd. as
on 31 st Dec. 2002.
Liabilities Imperial Colonial Assets imperial Coloniall
Co. Ltd. Co. Ltd. Co. Ltd. Co. Ltd.
Rs. Rs. Rs. Rs.
paid up Capital
In shares of Freehold Premises 4,50,000 1,20,000
Rs. 10/- each 10,00,000 3,00,000 Plant & Machinery 3,50,000 1,60,000
General Reserve 4,00,000 1,25,000 Furniture 80,000 30,000
P & L A/c 3,00,000 1,75,000 Debtors 3,00,000 1,70,000
Sundry Creditors 1,00,000 70,000 Stock 3,20,000 1,60,000
Investment in 20,000
Shares in colonial
Co. Ltd at cost 2,60,000
Cash balance 40,000 30,000
18,00,000 6,70,000 18,00,000 6,70,000
406
You are required to prepare a consolidated balance sheet as. on 31-12-2002, showing in
detail necessary adjustments and taking in to consideration the following information:
a) Imperial Co. Ltd. acquired the shares of colonial co. Ltd. on 1-1-2002 when the balances
on their profit and loss A/c and general reserve were Rs. 75,000 and Rs. 80,000 respectively.
b) Stock of Rs. 1,60,000 held by colonial Co. Ltd. Consisted of Rs. 60,000 goods purchased
form imperial Co.Ltd. Who has charged Profit at 25% on cost.
EXERCISE : 3
Following is the balance sheet of H and S :-
Balance sheet as on 31st Dec 2002.
Liabilities H S Assets H S
Rs. Rs. Rs. Rs.
Share Capital 10,000 8,000 6,400 Shares in S.Co 7,000
General reserve 4,000 2,000 Other assets 10,000 11,000
Profits (Current) 3,000 1,000
17,000 11,000 17,000 11,000
At the time of aquisition of shares by H. Company in S. company, on 1st January, 2002 plant
of Rs. 6,000 of S Ltd was revalnel at Rs. 8,000 and furniture of S Ltd of Rs. 2,000 was revalued at
Rs. 1,500. The balance sheet of S Ltd. showed the above assets on the non-revalued basis. You are
required to prepare a consolidated balance sheet after giving effect to above revaluation form 1st
January 2002. Depreciation is charged on plant at 10% and on funiture at 5%
EXERCISE : 4
Following are the balance sheets of X Ltd and Y Ltd you are required to prepare a
consolidered balance sheet
Balance Sheet of X Co., Ltd
5% Debentures 28,000 Fixtures 5,750
Trade Creditors 14,350 Investment in
Y. Ltd., 7500 shares 86,520
General Reserve 30,000 Stock 30,960
Profit & Loss A/c 33,183 Debtors
Y Ltd 10,205
Others 17,735 27,940
Cash 11,093
2,40,533 2,40,533
407
Balance Sheet of Y Co., Ltd
Sundry creditors Fixtures 570
X Ltd., 9,665 Stock 45,000
Others 22,335 32,000 Debtors 60,000
Profit & Loss A/c 20,000 Cash 22,546
1,52,000 1,52,000
The holding of the patent company is Y Ltd. was acquired some years earlier at a premium of
15% per share and the balance at the credit of profit and loss accounts of Y Ltd. was 10,000/- Y
company purchased goods from X co, Ltd. at a cost plus 25%. The stock of Y Ltd. Consists of
15,500 goods from X co Ltd.
EXERCISE : 5
On 1st January 1988 A Ltd acquired 800 shares of Rs. 10 each of B Ltd at Rs. 90,000. The
respective Balance sheets as on 31st December 1990 are given below.
Capital & Liabilities A Ltd , B Ltd , Assets A Ltd , B Ltd
Rs. Rs. Rs. Rs. ,
Share Capital Fixed assets 60,000 1,10,000
( Rs. 10 each) 1,00,000 1,00,000 Investments 1,00,000 15,000
Reserve 40,000 26,000 Debtors 25,000 20,000
P&L. A/c 36,000 35,000 Stock 30,000 40,000
creditors74,000 49,000 Bank 35,000 25,000
2,50,000 2,10,000 2,50,000 2,10,000
1) At the time of acqiring shares B Ltd. has Rs. 20,000 in reserve and Rs. 12,000 in P & L A/c.
2) B Ltd Paid 10% dividend in 2000, 12% in 2001 and 15% in 2002 for the years 1999, 2000
and 2001 respectively.
3) Proposed dividend of both the companies for 2002 is 10%
4) One bouns share for 5 fully paid shares has been declared by B Ltd. out of pre acquisition
reserve on 31 st December, 2002. No effect has been given to that in the above accouts.
5) On 1st January 2000 Building of B Ltd. Which stood in the books at Rs. 1,50,000 was
revalued at Rs. 1,60,00 but no adjustment has been made in the books. Depreciation has been
charged @ 10% per annum on reducing balance method.
408
6) In 2002 A Ltd Purchase from B Ltd. goods for Rs. 10,000 of which B Ltd made profit of 20%
on sales 25% of such goods are laying unsold on 31st December 2002.
You are required to prepare a consolidated Balance Sheet.
EXERCISE : 6
H Ltd acquird the whole of the shares in S Ltd as on 1st January, 2002 at total cost of Rs.
11,20,000 The Balance sheets on 31 st December, 2002 when accounts of both companies were
prepared and audited, were as under.
H Limited Balance Sheet as on 31st Dec., 2002
15, 000 shares of Rs. 100 Stock (b) 3,40,000
each fully paid 15,00,000 Debtors 2,80,000
creditors (a) 1,50,000 Investments 11,20,000
General Reserve 9,50,000 Cash 3,30,000
Profit and Loss A/c (c) 8,00,00
34,00,000 34,00,000
a) Includes Rs. 60,000 for purchse from the S Ltd on which the latter company made a profit of
Rs. 15,000
b) Includes Rs. 30,000 stock at cost purchased form the S Ltd part of Rs. 60,000 purchases (see
Note (a))
c) Includes interim dividend at the rate of 10% per annum free of tax from S Ltd.
S Limited Balance Sheet as on 31st Dec., 2002
50,000 shares of Rs. 10
each fully paid 5,00,000 Stock 2,02,000
Creditors 1,61,000 Debtors 1,58,000
General reserve as on Cash 1,10,000
1st January 1987 20,000
Profit and loss A/c 3,60,000
10,41,000 10,41,000
Note : The balance on profit and loss account on 1st Jan 2002 was Rs. 2,80,000 an interim dividend
of 10% per annum free of tax having been paid during the year respect of the year ended
31st December 2002.
409
Make the necessary adjustments and show a consolidated balance sheet as on 31st
December2002.
EXERCISE : 7
From the following balance sheets of shakti Ltd. and Yukti Ltd as on 31st Dec 2002. Prepare
a Consolidated Balance sheet.
(Rs. in lakhs)
Liabilities Shakti Yukti Assets Shakti Yukti
Shares Capital Good will - 40
Shares of 10/- 400 200 Sundry assets 265 276.4
General Reserve 36 40 Investment Shares
Profit & Loss a/c in Yukti 280 -
Balance 34 32
Profit for the year 15 14
Creditors 60 30.4
545 316.4 545 316.4
In the case of yukti Ltd. the profit for the year shakti Ltd acquired 90% of the shares in yukti
Ltd on 31 st Dec 2001
36,000/- of the sundry assets of shakti Ltd. and 12,400/- on yukthi Ltd. are to be written off
out of current yer’s profits.
EXERCISE : 8
A Ltd. is the parent company of B Ltd. and C Ltd. the share capital of B Ltd. are 5,00,000/
- respectively. Call in 10/- fully paid shares) and particulars of the holding are as follows:
Undistributed profit as on the date of purchase of shares.
B Ltd C Ltd.
Rs. Rs.
B Ltd. acqired 2,500 shares in C Ltd - 5000
A Ltd. acqired 15,000 shares in C Ltd - 7,000
A Ltd. acqired 40,000 shares in B Ltd 30,000 8,000
As on 31 st March 2002, the undistributed profits are B Ltd. Rs. 40, 000 and C Ltd. Rs.
10,000. No dividends have been paid or declared and no losses incurred in any of the relevant
years. Show how the total profits of the subsidiary companies will be dealt in preparing consolidated
Balance sheet.
410
EXERCISE : 9
The Balance sheets of H Ltd and S Ltd. on 31st Dec., 2002 were as under
Rs. Rs. Rs. Rs.
Share Capital shares Buildings 60000 -
of 100/- each 2,00,000 50,000 Machinery 2,00,000 -
General Reserve 30,000 10,000 Stock 40,000 85,000
Profit and Loss A/c Debtors 10,000 30,000
balance on 1-1-1989 40,000 20,000 Cash and
Profit for the year 1989 50,000 25,000 Bank balances 10,000 10,000
Creditors 30,000 30,000
Bank over draft 20,000 - 300 shares of
Bills payable 15,000 - S Ltd at a cost of 65,000
Bill Receivable- 10,000
3,85,000 1,35,000 3,85,000 1,35,000
Shares in S. Ltd were required by H Ltd our 1st July 2002. Bill receivable hold by S Ltd. are
aceepted owing by H Ltd in respect of goods supplied.
Prepare the consolidate balance sheet.
EXERCISE : 10
Following are the Balance sheets of H Ltd. and S Ltd as on 31st March 2002.
Rs. Rs. Rs. Rs.
Share Capital (Rs.10)7,00,000 1,00,000 Land & Buildings 3,00,000 1,00,000
General Reserve 50,000 30,000 Plant & Machinery 2,80,000 50,000
P&L A/c 1,00,000 30,000 7000 shares of

S Ltd. 1,00,000 -
Sundry Creditors 90,000 50,000 Stock 70,000 50,000
Bills Payable 10,000 15,000 Sundry Debtors 1,50,000 20,000
Liabilies Expenses 5,000 15,000 Bills receivalbe 10,000 -
Cash and Bank 45,000 20,000
9,55,000 2,40,000 9,55,000 2,40,000
411
1. All the bills receivalbe of H. Ltd. Including those discounted were accepted by S Ltd.
2. when 6,000 shares were acquired by S Ltd; S Ltd has Rs. 20,000 General Reserve and Rs.
5,000 Credit Balance in P & L A/c.
3. At the time of acquisition of further 1000 shares by H Ltd S Ltd had Rs. 25,000 General
Rserve and Rs. 28,000 Credit balance in P & L A/c from which 20% dividend was paid by L
Ltd and was received by H Ltd., on these share and credited to P & L A/c.
4. Stock of S Ltd. Includes Rs. 20,000 purchased form H Ltd. which has made 25% profit on
cost.
5. Both the companies have proposed dividend H Ltd. 10% and S Ltd 20% but no effect has
been given in the above balance sheets.
Prepare consoldated balance sheet as at 31 st March 2002.
Taxmann
India
412
GUIDELINE 18 : PREPARATION OF CONSOLIDATED PROFIT
AND LOSS ACCOUNT
OBJECTIVES
The aim of this guideline is to explain the method of preparing consolidated Profit and
Loss Account
• Prepare consolidated profit and loss account
• Understand the steps involved in preparation of consolidated profit and loss
account
• Understand the need for consolidated profit and loss account
• Grasp the difficulties in preparation of consolidated profit and loss account
STRUCTURE
18.1 Introduction
18.2 Adjustments to Profit and Loss
18.3 Summary
18.4 Glossary
18.1 INTRODUCTION
The consolidated balance sheet of a group of companies is prepared to show the financial
position of the group as whole. The objective of preparing consolidated profit and loss account of a
Group of companies is to provide a true and fair view of the financial performance of the group as
a whole in a financial year. The share holders of holding company and other parties interested are
also able to judge the trend of the profits of the group.
18.2. ADJUSTMENTS TO PROFIT AND LOSS

Preparation of Consolidated Profit and Loss account involves simple aggregation of the
items appearing in the Profit and loss accounts of the Holding and its subsidiaries subject to the
following adjustments.
1. Inter company sales are to be eliminated from purchases and sales appearing in the
Consolidated profit and loss account. At the time of consolidation some goods remain
unsold, profit unreasised from the point ofview of the Holding companu is eliminated
2. Revaluation of assets of the subsidiary company; additional depreciation on revaluation
is to be adjusted. Share of minority shareholders in the profits of the subsidiary company
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is calculated after adjustment of additional or excess depreciation due to increase or
decrease in the value of assets.
3. Minority Interest; Share of monority shareholders in the Profit/Loss of the subsidiary
company is transferred from consolidated profit and loss account to minority interest
account
4. Holding company’s share in pre acquisition profit/Loss is transferred from consolidated
profit and loss account to Goodwill/ Capital Reserve A/c as the case may be.
5. Income from inter company investment such as interest, dividends received as well as
receivable is eliminated from both sides of Consolidated profit and Loss account.
However, if the Holding company has not passed entries for share in the proposed
dividend of the subsidiary company, Proposed dividend of the subsidiary company will
be reduced by the share of the Holding company in such proposed dividend.
6. arrears of preference dividend on shares held by minority shareholders appears as
contingent liability in the Consolidated balance sheet. Alternatively, arrears can be debited
to the consolidated Profit and Loss account credited to Minority interest, Provided there
isa credit balance in the profit and Loss account of the subsidiary company.
ILLUSTRATION : 1
X Ltd., holds 3000 Equity shares of Rs.10 each in Y Ltd., Whole capital consist of 10,000
Equity shares of Rs.30 each and 14% 1,000 cumulation preference shares of Rs.100 each. Y Ltd.,
has also issued 14% Debentures to the extent of Rs. 2,00,000 out of which X Ltd., hold Rs.1,00,000.
The following are the profit & loss Accounts of the two companies for the year ended 31st March,
2008.
Liabilities X Ltd.. Y Ltd.. Assets X Ltd.. Y Ltd..
To Purchase 15,00,000 6,00,000 By Sales 19,00,000 15,00,000
Adjusted
To Manufacturing - 4,00,000
Expenses
To Gross Profit 4,00,000 5,00,000
19,00,000 15,00,000 19,00,000 15,00,000
To Sundry Exp. 1,50,000 1,84,000 By Gross Profit 4,00,000 5,00,000
To Debenture Interest - 28,000 By Debenture
To Profit C/D 2,98,000 2,88,000 By Interest 14,000 -
By Interim Dividend
(Gross) 42,000 -
4,56,000 5,00,000 4,56,000 5,00,000
By Net Profit b/d 2,98,000 2,88,000
To Income Tax 1,40,000 1,20,000
To Purchase Dividend - 14,000
To Interest Dividend - 56,000
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To Proposal Dividend1,00,00084,000
To Balance C/D 58,000 14,000
2,98,000 2,88,000 2,98,000 2,88,000
The following further information is given :
1. The shares were acquired by X Ltd., on 1st July 2007 but the debentures were acquired on
1st April 2007. Y Ltd., was incorporated on 1st April 2007.
2. The Tax deducted from dividends @ 20% and interest is 10% .
3. During the year Y Ltd., sold to X Ltd., goods costing Rs.1,00,000 at the selling price of
Rs.1,50,000 . One fourth of the goods remain unsold on 31st March 2008 . The goods were
valued at cost by the holding company for closing stock purpose.
Prepare consolidated profit & loss Account.
SOLUTION
The dividend received has been eliminated against in term dividend paid.
The proposed dividend includes Rs. 63,000 payable to X Ltd., by Y Ltd., This has been
eliminated.
Capital profit 2,88,000
LESS : 1,20,000
6,000 1,26,000
1,62,000
1,62,000 x 1/4 x 3/4 = 30,375
It is assumed that the dividends are paid or proposed out of current year profits.
Consolidated Profit and Loss Account of X Ltd. & Y Ltd. for the Year
Ended 31st March, 2008.
Expenses Total of Adjustment Total Income Total of Adjustment Total
X& X &
Y Ltd. Y Ltd.
To Purchses
Adjusted 2100000 -150000 1950000 By Sales 3400000 -1500003250000
To Mfg.
Expenses 400000 - 400000
To Gross
Profit c/d 900000 - 900000
3400000 -150000 3250000 3400000 -1500003250000
To Sundry
Expenses 358000 - 3,58,000 By Gross
Profit 900000 - 900000
To Debenture
Interest 28000 -14000 14000 By Debenture
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Interest 14000 -14000 -
To Profit c/d570000 -42000 528000 By Dividend 42000 -42000
956000 -56000 900000 956000 -56000 900000
To Income Tax 260000 - 260000 By Net
Profit 570000 -42000 528000
To Preference
Dividends 6000 - 6000
To Interim
Dividends 56000 -42000 14000
To Proposed
Dividends 184000 -63000 121000
To Capital
Profit +30375 30375
To Stock
Reserve +12500 12500
To Share of
outside share
holders -5500 5500
To Balance a/c 64000 +14625 78625
570000 -42000 528000 570000 -42000 528000
ILLUSTRATION : 2
H Ltd has a subsidiary company for a number of years one subsidiary company, S Lrd in which
it holds 80 % of the equity shares. On 1st July2007 H Ltd acquired 60% equity shares of Z Ltd also
has Rs.100,000 8% preference shares, all of which are held outside the group. For the year ended
31 December 2007 the Profit and Loss accounts of these three companies are as follows;
Particulars H Ltd S Ltd Z Ltd

Trading profit 98,000 84,000 38,000
Investment income 30,000 ------ ------
Total 1,28,000 84,000 38,000
Less Provisin for taxation 58,000 42,000 19,000
70,000 42,000 19,000
Less ; Proposed Dividend
Preference ------ 8,000 ------
Equity 65,000 15,000 ------
Balance Carried to Reserves 5,000 19,000 19,000
Following further information is provided;
1. The proposed equity dividend receivable frfom S Ltd is included in H Ltd’s investment income.
2. The only inter company transaction was the manufacture of a machine by S Ltd following an
order fromH Ltd,
3. This machine cost Rs.10,000 to make and was sold to H Ltd on Decemenr 2007 fro Rs.12,000.
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4. Prepare consolidated Profit and Loss Account of H Ltd and its subsidiary companies for the
year end 31 December,2007.
Solution;
1. Profit for the period
S Ltd ; Preference Dividend 8,000
Proposed Dividend 20% of 15,000 3,000
Retained Profits20% of 19,000 3,800
14,800
Z Ltd Retained Profits 40% of 19,000 7600
22,400
2. Share of H Ltd in pre acquisition profits of Z Ltd
Profit after tax for the year 19,000
Profit up to 1 st July 2007 Pre acquisition period 9,500
Share of H Ltd 60% 5,700
3. Proposed dividend of S Ltd will not appear in the consolidated profit and Loss account .
Share of Minority in the proposed dividend is transferred to minority interest and share of
Holding company in the proposed dividend of S Ltd is cancelled being income from inter
group investment.
Consolidated Profit and Loss Account of H Ltd. And its subsidiaries S Ltd & Z Ltd. for the
Year Ending 31st March, 2008.
H Ltd S Ltd Z Ltd Adjustments Total

Provision for taxation 58,000 42,000 19,000 ----- 1,19,000
Net Profit 70,000 42,000 19,000 12,000 1,19,000
1,28,000 84,000 38,000 12,000 2,38,000
Minority Interest ----- 14,800 7,600 ----- 22,400
Proposed Dividend 65,000 12,000 ----- 12,000 65,000
Provision for unrealized ----- 2,000 2,000
profit
Capital Profit ----- ----- 5,700 -----
Balance c/d 5,000 13,200 5,700 ----- 23,900
70,000 42,00 19,000 12,000 1,19,000
98,000 84,000 38,000 ----- 2,20,000

Trading Profits 30,000 ----- ----- 12,000 18,000
Investment income 1,28,000 84,000 38,000 12,000 2,38,000
Net Profit b/d 70,000 42,000 19,000 12,000 1,19,000

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18.3 SUMMARY:
The objective of preparing consolidated profit and loss account of a Group of companies is to
provide a true and fair view of the financial performance of the group as a whole in a financial year.
The share holders of holding company and other parties interested are also able to judge the trend
in the profits of the group.
18.4 KEY WORDS

Inter Company Sales; the sales took place between the Holding company and subsidiaries
Minority Interest; The shareholders other than Holding company in a subsidiary company

1. Discuss the important points to be taken into considertion while preparing the
consolidated Profit and Loss Account
2. State the advantages of Preparing the consolidated Profit and Loss Account.
3. Following are the Profit and Loss abstracts of A Ltd and its subsidiary B Ltd for
the year ending 31-12-2007. You are required to prepare a consolidated Profit
and Loss account for the year ending 31-12-2007.
A Ltd B Ltd
Profit and Loss account balance at 1-1-2007 36,000 15,000
Trading profit 71,000 40,000
Dividends(gross) from B Ltd Preference 5,4000
Ordinary 7,500
1,19,000 55,000
Depreciation 12,000 4,000
Debenture interest 10,000
Taxes 22,000 15,000
Director’s emoulaments 7,000 3,000
Dividends paid (date of payment
6% preference ; 30th June 3,000
31st December 3,000
Ordinary;
Interm 30 th June 12,000 5,000
31st December 12,000 5,000
Profit and loss A/c balance at 31st Decemebr 2007 44,900 17,000
1,19,900 55,000
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The following additional information is available;
A Ltd B Ltd
Ordinary shares of Rs.1 each fully paid 4,00,000 2,00,000
6% Preference shares of Rs1 each fully paid ——— 1,00,000
Shares in B Ltd held by A Ltd;
Ordinary shares acquired on 1st July,2007 1,50,000
Preference shares acquired on 1st January,2007 90,000
Income and expenditure are deemed to accrue evenly throughout the year. All dividends are
payable out of current year’s profits. The directors of B ltd resigned on 1st July,2007 and were
replaced on that day by directors of A Ltd who are to receive the same remunaration as the
former directors.

Taxmann
India
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GUIDELINE 19 : SHARE MOVEMENT OF EQUITY SINCE
THE DATE OF ACQUISITION
OBJECTIVES
This guideline is intended to explain the share movement of equity since the date of
acquisition.
• Know the movement of shares
• Understand the step by step concept
• Prepare consolidated Balance Sheet
STRUCTURE
19.1 Introduction
19.2 Meaning of Share Movement
19.3 Acquisition of shares on different dates
19.4 Preparation of Consolidated Balance sheet
19.5 Summary
19.6 Key Words
19. 1 INTRODUCTION
So far we understand that the movement of equity in subsidiary companies was restricted to
operating activities resulting in Profit or Loss from the date of acquisition to the date of preparation of
consolidated balance sheet. Thus the movement of equity was confined to Post acquisition profit or
loss. The share of minority interest in post acquisition profit and losses was added to minority interest
and parent’s share in post acquisition profits and losses were adjusted to the profit and loss account
of Holding Company.
19.2 MEANING OF SHARE MOVEMENT

Besides post acquisition profits movement of equity in post acquisition period is also affected
by sale and purchase of shares in subsidiary company changes the proportionate interest of the
Minority and the Holding company. In this case consolidation of balance sheet takes place on the
basis of number of shares held by the parent on the date of preparation of consolidated balance
sheet. In the case of sale of shares, profit or loss on the sale of shares is ascertained in the usual
manner and is taken to profit and loss account.
19.3 ACQUISITION OF SHARES ON DIFFERENT DATES

So far, it was assumed that controlling shares were acquired on a single date. If shares are
acquired on different dates and obtain control of the other company, the consolidated financial
420
statements are prepared only from the date on which, the holding – subsidiary relationship comes
into existence. If two or more investments are made over a period of time the equity of the subsidiary
company at the date of investment is generally determined on a step-by-step basis. On the other
hand if small investments are made over a period of time and then an investment is made that results
in control, the date of the latest investment may be taken as the date of investment.
Purchase of Shares:
When one company acquires controlling interest in another company in a succession of
purchases of shares at different dates, for the convenience of calculation the date of latest purchase
may be taken as the date of acquiring controlling interest. In such case the controlling interest in a
subsidiary company may not be established by the first purchase of shares. When share are purchased
on different dates it is important to decide the method of calculating the cost of control or capital
reserve.
Sale of Shares:
When a holding company disposes off a part of its holding in the subsidiary company and the
holding subsidiary relation continues while preparing the consolidated balance sheet the following
method may be followed.
1. The profit or loss on sale of shares should be ascertained. If there is a loss it is debited to the
cost of control account. If there is a gain it can be credited to capital revenue account or kept
under separate category investment fluctuation fund.
2. The minority interest and cost of control should be ascertained on the basis of number of
shares presently held by the holding company and the minority.
19.4 PREPARATION OF CONSOLIDATED BALANCE SHEET

Section 42(3) of the companies act 1956, deals with the cross holding. Generally a subsidiary
company is not allowed to acquire shares in the holding company. However, if the shares are
acquired by the subsidiary company before the acquisition of controlling interest by the holding
company or before the commencement of the companies Act, it can continue to hold these shares
but with out voting rights. The following chart gives a clear picture of cross holding in case of a partly
owned subsidiary.
H Ltd 60 % shares Minority
20 % shares S Ltd 40 % shares shareholders
Minority interest in S Ltd is equal to 40 % of net worth (i.e. share capital and reserves and
surpluses) of S Ltd. But the net worth of S Ltd can not be calculated unless we know the value of
20% of the holding of S Ltd in H Ltd and the value of shares in H Ltd is in turn depend upon the value
of investment in 60 % shares if S Ltd. This problem can be solved with the help of simultaneous
equations.
ILLUSTRATION: 1. The summarized Balance sheets of A Ltd and its subsidiary B Ltd are as
follows;
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Balance sheets of A Ltd and its subsidiary B Ltd as on 31-12-2007
Liabilities A Ltd B Ltd Assets A Ltd BLtd

Share capital in Fixed Assets
equity shares Current Assets
of Rs.10 each 2,00,000 50,000 Shares in B Ltd at ------
Reserves 20,000 5,000 cost 3000 shares
Profit and Loss
A/c as on 1-1-
2007 30,000 10,000
Profit for the
year 8,000 8,000
Add;
Dividends
from B Ltd
Less ; 4,000 ------
dividends paid
Creditors ------ (5,000)
30,000 20,000
2,92,000 88,000 2,92,000 88,000
A Ltd had acquired 4,000 shares in B Ltd at Rs.
Rs.20 each on 1-1-2007 and sold 1000 of them at the same price on 1st October,2007.
The sale is cum dividend. An interim dividend of 120 % was paid by B Ltd on st1
July,2007. You are required to prepare a consolidated Balance sheet on 31-12-2007.
Solution
1. Shares held by A Ltd in B Ltd on the date of Consolidation
Shares acq1uired – Shares sold = 4,000 – 1,000 = 3,000
Shares held by minority shareholders = 2,000 shares
2. Analysis table
A Ltd Minority shareholders
Share capital 30,000 20,000
Reserves (5000) 3,000 2,000
Profit and Loss on 1-1-2007 10,000 6,000 4,000
Equity of B Ltd on the date of
acquisition i.e. 1-1-2007 39,000 26,000
Post acquisition profit after
Interim dividend 8,000-5,000 1,800 1,200
Minority Interest 27,200
Goodwill/Capital Reserve
Cost of investment 60,000
Less; Value of equity held 39,000
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Goodwill 21,000
Profit and Loss account to be shown in the consolidated Balance sheet
Balance of A Ltd 0n 1-1-2007 30,000
Profit for the year of A Ltd 8,000
Add; Dividends from B Ltd 4,000
Add; share in B Ltd Post acquisition
Profits 1,800
43,800
Consolidated Balance Sheet of A Ltd and its Subsidiary B Ltd as on 31-12-2007
Liabilities Amount Assets Amount

Share capital in equity Goodwill 21,000
shares of Rs.10 each 2,00,000 Fixed Assets 2,80,000
Reserves 20,000 Current assets 40,000
Profit and Loss A/c 43,000
Creditors 50,000
3,41,000 3,41,000
ILLUSTRATION : 2
The DCM Ltd., acquires shared in OCM Ltd., in the following manner.
Date Number of shares cost
1-1-2005 2,000 30,00,000
1-1-2006 1,000 1,75,000
1-1-2007 1,000 20,00,000
On 1-1-2005 OCM had a share capital of Rs.70,00,000 in shares of Rs.1000 each. As on
that date the maintainable profits were 21,00,000. Profits for 2005, 2006, and 2007 were Rs.7,00,000
Rs.14,00,000 Rs.7,00,000 respectively. The following are the Balance sheet of DCM and OCM
Ltd. on 31st Dec.2007.
Liabilities DCM OCM Assets DCM OCM
Ltd., Ltd., Ltd., Ltd.,
Share capital Fixed Assets 82,50,000 1,20,00,000
10,000 shares of Investment in
Rs. 1,000 each1,00,00,000 OCM Ltd., 67,50,000
7,000 shares of
Rs. 1000 each 70,00,000
Reserves 25,00,000 14,00,000
Creditors 10,00,000 8,00,000
Profit & Loss A/c15,00,00028,00,000
1,50,00,000 1,20,00,000 1,50,00,000 1,20,00,000
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You are required to prepare consolidated balance sheet as on 31st Dec. 2007.
SOLUTION
Calculation of Cost of Control (or) Capital Reserve
First Second Third Total
Particulars Block Block Block
Rs. Rs. Rs. Rs.
Cost of Shares 30,00,000 17,50,000 20,00,000 67,50,000
Less :
Paid up Value of Shares20,00,000 10,00,000 10,00,000 40,00,000
10,00,000 7,50,000 10,00,000 27,50,000
Less :
Share in pre -
acquisition Profits
21,00,000 x 2/7 6,00,000
700000 + 2100000 x 1/7 4,00,000
700000 + 2100000 + 6,00,000
1400000 x 1/7 16,00,000
Cost of control
Goodwill 4,00,000 3,50,000 4,00,000 11,50,000
Ratio of shares held by DCM Ltd., and outsiders.
1. On 1-1-2005 = 2 : 5
2. On 1-1-2006 = 3 : 4
3. On 1-1-2007 = 4 : 3
Since 1-1-2007 the DCM has become holding company because it acquires majority of share.
NOTE : When 1st 2000 shares were purchased the capital profit were Rs.21,00,000 When 2 set
of 1000 shares were purchased capital profits were 28,00,000 (21,00,000 + 7,00,000)
and for the third purchase the capital profit were 42,00,000 (21,00,000 + 7,00,000 +
14,00,000).
Consolidated Balance Sheet of DCM and its Subsidiary OCM Ltd.
As on 31st December 2007
Liabilities Rs. . Rs. . Assets Rs. . Rs. .
Share capital 1,00,00,000 Fixed Assets
Reserves : DCM 82,50,000
DCM 25,00,000 OCM 1,20,00,000
OCM 8,00,000 33,00,000 Goodwill
Creditors :
DCM 10,00,000 2,02,50,000
OCM 8,00,000 18,00,000 16,00,000
Profit & Loss A/c
DCM 15,00,000
OCM 16,00,000 31,00,000
2,18,50,000 2,18,50,000
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MINORITY INTEREST :
SHARE CAPITAL : 3000 of Rs. 1000 each 30,00,000
ADD : Share in reserves 14,00,000 x 3/7 6,00,000
ADD : Share in P & L A/c 28,00,000 x 3/7 12,00,000
ILLUSTRATION : 3
From the following balance sheet and information prepare a consolidated balance sheet as
on 31st Dec. 2007.
BALANCE SHEET AS ON 31ST DECEMBER, 2007
Share capital 1,00,000 20,000 Assets 93,000 32,000
Rs. 100 each Share in S
Investment at cost 18,000
Reserve 3,000
Profit & Loss A/c
1st Jan., 94 6,000 7,200
Profit for the
year 2,000 4,800
1,11,000 32,000 1,11,000 32,000
H bought 1,600 shares in S at Rs.15 per share when the profit and less account of the latter
stood at Rs.4,400 and sold 400 of them on 30th June, 2007 at Rs.22.50 per share crediting the
profit on sale to the investment reserve account.
SOLUTION :
1. Calculation of profit on sale :
sale price of 400 shares sold at
Rs.22.50 per share 9,000
LESS : Cost price of share of Rs.15 per share 6,000
Profit on sale transferred to investment fluctuating
account (Already shown in the balance sheet). 3,000
2. Calculation of cost of control :
This is to be calculated on the basis of existing
number of shares 18,000
LESS : Paid up value of shares 12,000
6,000
LESS : Share of capital profits 1200/2000 x 440 2,640
Cost of control 3,360
3. Calculation of minority interest :
Number of shares held by outsiders
800 x 10 8,000
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ADD : Proportionate share of all existing reserves
800/2000 x (7,200 + 4,800) 4,800
CONSOLIDATED BALANCE SHEET
AS ON 31ST DECEMBER 2007
Share capital 1,00,000 Cost of Control 3,360
Investment Fixed Assets
fluctuation Reserve 3,000 H Ltd., 93,000
Minority Interest 12,800 S Ltd., 32,000 1,25,000
Profit & Loss A/c
H Company on
1st Jan., 6,000
During the year 2,000
Share from
S Ltd., 4,560 12,560
1,28,360 1,28,360
19.5 SUMMARY
The sale and purchase of shares in subsidiary company changes the proportionate interest of the
Minority and the Holding company. In this case consolidation of balance sheet takes place on the
basis of number of shares held by the parent on the date of preparation of consolidated balance
sheet. In the case of sale of shares, profit or loss on the sale of shares is ascertained in the usual
manner and is taken to profit and loss account.
19.6 KEY WORDS

Step-by-step acquisition; if an enterprise makes two or more investments in another enterprise
at different dates and eventually obtain the control of other enterprise.
Date of investment; If small investments are made over a period of time and then an investment
is made that results in control, the date of the latest investment may betaken as the date of investment.
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Exercise – 1
Following are the Balance Sheets of h Ltd and S Ltd as on 31-3-2007
Liabilities A Ltd B Ltd Assets A Ltd BLtd

Share capital in Land & buildings 3,00,000 1,00,000
equity shares Plant ,machinery 2,80,000 50,000
of Rs.10 each 7,00,000 1,00,000 7,000Shares in S 1,00,000 ----
Reserves 50,000 30,000 Stock 70,000 50,000
Profit and Loss A/c1,00,000 30,000 Debtors 1,50,000 20,000
Creditors 90,000 50,000 Bills receivable 10,000 -----
Bills payable 10,000 15,000 Cash and Bank 45,000 20,000
Liablities for 5,000 15,000
expenses 9,55,000 2,40,000 9,55,000 2,40,000
1. All the bills receivable of H Ltd including those discounted were accepted by S Ltd.
2. When 6,000 shares were acquired by H Ltd in S Ltd has Rs.20,000 in Reserve A/c and
Rs.5,000 credit balance in Profit and Loss account.
3. At the time of acquisition of further 1,000 shares by H Ltd , S Ltd had Rs.25,000 in
Reserve A/c and Rs.28,000 credit balance in Profit and Loss account from which 20%
dividend was paid by S Ltd and dividend received by H Ltd on these shares was credited
to Profit and Loss account.
4. Stock of S Ltd includes Rs.20,000 purchased from H Ltd which has made 25% profit on
cost.
5. Both the companies have proposed dividend. H Ltd 10% and S Ltd 20% but no effect
has yet been given in the above Balance Sheets.
You are required to prepare a Consolidated Balance Sheet .

Taxmann
India
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GUIDELINE 20 : FINANCIAL REPORTING
OBJECTIVES
• Meaning of Financial Statement,
• Objectives with which Financial Statements are made,
• Importance of Financial Reports, and
• Features of an ideal report.
STRUCTURE
20.1 Introduction
20.2 Objectives of Financial Statements
20.3 Financial Reporting
20.4 Essentials of a Good Report
20.5 Objectives of Financial Reporting
20.6 Summary
20.7 Glossary
20.1 INTRODUCTION
A company prepares different accounts to record day to day transactions of business. Towards
the end of the year, they prepare important financial statements like Profit and Loss account, Balance
sheet, Profit appropriation account etc. These accounts help the company to find out the level of
profit or loss earned during the accounting year.
Recently, companies are constantly monitoring the activities to enforce better control of their
results. This require up do date accurate account of information of different activities. The role of
accounting under went perceptible change from record keeping to facilitator of information. Preparation
of financial reports must be understood in this backdrop.
20.2 OBJECTIVES OF FINANCIAL STATEMENTS
Financial Statements are prepared with the following objectives;
1. They provide reliable information about economic resources and obligations of the company
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2. They contain information about change in net resources.
3. They provide financial information useful for estimating the earning capacity of the company.
4. They show the information about the obligations of the company to creditors.
5. Provide information relevant to statement user’s needs.
6. Facilitate information for decision making.
7. Give information without any delay.
8. Declare consistent, comparable figures and numbers to avoid confusion among users.
9. Prepare these statements by following certain professionally accepted standards and norms.
10. Providing complete picture about the company results.
Financial statements are prepared to present fair and true picture of the company by following
the generally accepted accounting principles(GAAP). Legal limitations have to be kept in preparation
of these statements. It will be difficult for the accountant to keep in view the informational needs of
all concerned. However, the statements contain comprehensive detailed picture of the financial position
of the firm.
20.3 FINANCIAL REPORTING
Apart from Financial Statements, accountant has to prepare number of reports to satisfy the
informational requirements of various parties inside and outside the company. He has to process the
data in such a way that it can be presented in a report form so as to readily help users in deciding
important issues of purchase, investment, borrowing etc. This function is popular in today’s accounting
profession. Since the job involves preparation of reports, it is called Reporting.
Reporting can be defined as communicating facts and data through reports and statements to
the persons for whom such facts and data are collected. Reporting starts when and where accounting
ends. The reports are made and circulated as per the established requirements of the company.
Report may take shape of a letter, draft, schedule, statement, chart, graph, diagram and any other
method of statistical presentation. When facts and data are collected and compiled from accounting
records and put in a written form they are called accounting reports.
R.L Smith defines accounting reports as instruments of communication, the nervous system
of organizational anatomy. These reports consist of financial data and are in the form of schedules
and statements.
Financial reporting includes not only financial statements but also other means of
communicating information that relates directly or indirectly to the information provided by the
accounting system i.e., information about an enterprise’s resources, obligations, earnings etc. Financial
reporting provides information that is useful to present and future investors and creditors and other
429
users in making rational investment, credit and similar decisions. The information must be
understandable to those who have a reasonable understanding of business and economic activities
and are willing to study the information.
Financial reporting provides information to help present and future investors and creditors
and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from
dividends or interests. The prospects for those cash receipts are affected by an enterprise’s ability to
generate enough cash to meet it’s obligations when due and it’s other cash operating needs to reinvest
in operations and to pay cash dividends and may also be affected by perceptions of investors and
creditors generally about the ability of the firm. It reflects in the stock prices of the firm in the market.
Thus the financial reporting should provide information to help investors, creditors and others to
assess the amount, timing and uncertainty of prospective net cash inflows.
Financial Reporting should provide information about the economic resources of an enterprise,
the claims to these resources and the effects of different transactions, events and circumstances that
change resource and claims to these resources.
Financial reporting provides information about an enterprise’s financial performance during a

period. Investors and creditors often use the information about the past to help in assessing the
prospects of an enterprise. Thus, although investment and credit decisions reflect investors and
creditor’s expectations about future enterprise performance, those expectations are commonly based
at least partly on evaluation of past enterprise performance.
The primary focus of financial reporting is information about an enterprise’s performance

provided by measures of earnings and its components. Financial reporting should provide information
about how an enterprise obtains and spends cash about its borrowing and repayment of borrowing,
about its capital transactions, including cash dividends and other distributions of enterprise resources
of owners, and about other factors that may affect an enterprise’s liquidity or solvency.
Therefore, financial reporting should provide information about how management of an
enterprise has discharged its responsibility to owners for the use of enterprise resources entrusted to
it. Financial reporting should provide information that is useful to managers and directors in making
decisions of the company.
20.4 ESSENTIALS OF A GOOD REPORT
A report must be user friendly without compromising the technical norms. While drafting a report,
certain principles must be followed. There are certain guidelines one must follow while preparing a
report. The following points must be observed while making a good report.
i) SUITABLE TITLE: A report should bear a clear, suitable title indicating the contents. Details
of its origin and destination must be mentioned clearly.
ii) SIMPLICITY: Report should not be too lengthy or too short. In the name of simplicity we
should not sacrifice crucial information. If we give too many details, user may overlook
important points.
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iii) ROUTINE DETAILS: A report must contain certain routine details like, time, date of
preparation, units of information, name and designation of person preparing it, name and
designation of person for whom it is meant etc.
iv) BREVITY: Report should be precise, concise, specific and accurate. Executive time is scarce
and hence the report must fulfil the requirement for which it is made. It should contain what
is relevant and should exclude what is not used in normal circumstances.
v) ADAPTABILITY: The form and the content of the report should as far as possible be suited
to the persons using it. It should be adaptable to incorporate timely changes and decision
requirements of the position. Complete appraisal of the executives in terms of their
temperament, knowledge, decision making style, informational requirements must be done
before designing a reporting system.
vi) TIMELINESS: Report should be prepared in time and presented in time so that manager
takes decision in time. It is to be remembered that the purpose of historic information is often
to supplement the personal qualities and facilities of the management. It would be just a
waste of time and effort to prepare and convey information which is too late to be of use and
interest. The frequent needs of the user, natural time cycle of basic data, cost of preparing the
report etc., are the basic factors which would determine the frequency of submitting the
reports.
vii) THE PRINCIPLE OF EXCEPTION: A report should be prepared by following the principle
of exception whereby report is to a greater degree limited to events highlighting trouble spots
as well illuminating priority areas calling for management attention and action. This principle
implies that a) information presented should be restricted to matters which are under the
control of the user of the report b) concentration should be allowed only on essential events/
data and c) the volume of report and data is considerably reduced to the bare minimum.
viii) ACCURACY: Accuracy of information in each report is a must. Accuracy must be decided
based on the objective of report. It believed that by eliminating unnecessary details, both the
clarity and accuracy may be improved.
ix) MEDIA OF PRESENTATION: A report may be presented through several media. It may
be in written form or oral form or graphic form. An ideal report is presented in such a way
that it uses all the formats that are available today to maximize the attractiveness and impact.
x) COORDINATION OF DATA: Data supplied from different departments should not
contradict each other and consistency is the key. Numbers, units and measures must be
explained in clear terms so that unnecessary confusion is minimized.
xi) UPTODATE: We live through revolutionary changes wherein information is available through
different sources. Companies have to follow the trend and keep themselves ahead of the
changing trends. Similarly, unnecessary information should be abandoned to reduce
unnecessary effort.
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xii) COST: A report is said to be ideal only when the cost of preparing it is reasonable and is
consistent with the benefits accruing from its use. The cost of preparing and submitting the
report should never exceed the benefit to be derived from the use of such report.
xiii) ATTRACTIVENESS: Report must be attractive enough so that the user will find it convenient
to locate use remember and follow-up for action. It should contain few thoughts for user to
improve his mood and escape boredom.
xiv) NUMBER OF REPORTS: It is actually difficult to decide on the number of reports to be

prepared in an organization. An objective criterion must be followed while asking for accounting
reports in an organization. Duplication must be avoided.
20.5 OBJECTIVES OF FINANCIAL REPORTING
i) To provide information which is useful to investors, creditors and others in making rational
decisions.
ii) To assist investors and creditors in assessing future net cash flows to the enterprise in respect
of amount, timing and uncertainty.
iii) To identify sources of finance and types of assets and claims of creditors against the assets.
iv) To help executives find the requirements for funds and suggest alternative sources.
v) To provide a fair and accurate view of the results achieved during a period as against a
previous period.
vi) To provide information about enterprise performance and earnings potential.
vii) To make available all latest information on external and internal changes having cost implications
and profitability on the firm.
viii) To follow legal provisions of reporting from time to time.
20.6 SUMMARY
A company has to prepare number of accounting statements at the end of the financial year.
These statements are also known as final accounts. Profit and Loss account, Balance Sheet, are such
accounts. These are made to find out the results of the company. Company will decide its tax obligation,
dividend etc., from these results. Final accounts serve limited purpose since these are made to fulfill
legal requirements. Number of interested parties like creditors, suppliers, customers, stock investors
require in depth information of the company activities which final accounts do not facilitate. Recent
trend towards this direction is to prepare and provide number of reports to meet the needs of
external parties as well as internal decision making. Accounting professionals must understand the
reporting requirements of an organization and prepare reports which is a systematic function called
‘Financial Reporting’.
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20.7 GLOSSARY
FINANCIAL STATEMENTS: The end product of financial accounting process is a set of reports
that are called financial statements. Profit and loss account, Balance sheet and Statement of changes
in financial position are called financial statements.
FINANCIAL REPORTS: Financial reports includes not only financial statements but also other
means of communicating information that relates to the accounting system on an enterprises resources,
obligations earnings etc., to insiders as well as outsiders when ever needed.
1. What is a Financial Statement? State the objectives with which Financial Statements are
prepared?
2. Define the concept ‘Financial Reporting’? Discuss the essentials of a good report?
3. Discuss the difference between financial statement and financial report?
Clare Roberts, Paul Weetman and Paul Gordon, International Financial Accounting, Pearson Education,
2002
Jawahar Lal, Corporate Financial Reporting-Theory and Practice, Taxman’s, 2005
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GUIDELINE 21 : TYPES OF FINANCIAL REPORTS
OBJECTIVES
• Need for classification of the financial reports,
• Different types of reports, and
• Functions of financial reports.
STRUCTURE
21.1 Introduction
21.2 Operating Reports
21.3 Financial Reports
21.4 External Reports
21.5 Internal Reports
21.6 Functions of Financial Reports
21.7 Summary
21.8 Glossary
21.1 INTRODUCTION
Information is life blood of a business. Today’s firm deriving competitive advantage based on its
ability to connect itself with the rest of the world. In other words, net work is important. Company
must systematize, digitalize and rationalize the internal information flow. Managements survive on
their digital nervous system as said by the famous Bill Gates of Micro Soft.
The efficiency of the organization is governed by the efficiency of information flow. Financial reports
provide information about the financial position of the concern. These reports are necessary for
accounting purpose. However, number of other reports will be required by different decision levels.
Various types of reports are used by the organization. These may be classified as follows.
A. On the basis of Information

1) Operating reports
2) Financial reports
B) On the basis of users
1) External reports
2) Internal reports
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REPORTS
Operating Reports Financial Reports
Control Reports Information Static Reports Dynamic

Reports Reports
Current Control Summary Control Balance Other

Reports Reports Sheet Supplementa
ry Balance
Trend Analytical Activity
Financial Account of effective Financial Changes

use of Funds over period
21.2 OPERATING REPORTS
A company has certain physical or service operations to serve the customers. Operational reports to
a larger extent contain information on the operations. These are further classified into a) Control
reports and b) Information reports.
a) Control reports: Reports which are prepared to help management in exercising control over
operations of the concern are known as control reports. These reports are designed to measure
actual performance with standard and budgeted targets. They indicate the variances and the
causes of such variances. These reports convey a detailed view of the operative activity and
focus our attention upon the off-standard or above-standard performances during a particular
period. These reports can be prepared weekly, monthly, quarterly or yearly.
Control reports are further divided into I) Current control reports, and II) Summary control reports.
I) Current control reports: These reports are intended to locate without loss of time and
immediately the deviations of actual performances from standard or budgeted performance,
so that prompt control action can be taken. However, such reports related to a small fragment
of a whole period. Such control reports are usually prepared for the areas where many
deviations are expected such as sales, income factory overhead etc.
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II) Summary control reports: These reports are intended to summarize the deviations from targets/
objectives over a period, so that necessary action can be taken at higher levels. It may be
remembered that current control reports convey deviation in a short period and call for
control action at lower levels. But summary control reports call for action at highest level. In
other words, summary control reports and at summarizing the deviations from standard over
long period and highlighting the impact of such deviations on budgeted profit.
b) Information reports: The coverage of these reports is wider than that of control reports. Information
reports are those reports which provide useful information for planning and policy formulation
for the future. While control reports are intended to serve a driving force for control action and
are confined to the efficient operation of the business, information reports aim of segregating
those facts and presenting them in a simple and clear form which would greatly affect the planning
and policies. We may classify them into I) Trend reports ii) Analytical reports and iii) Activity
reports.
i) Trend Reports: Trend reports are those which provide information in a comparative
fashion over a period of time. These reports depict the information of events over a
period of time. Thus, in the case of trend reports, the results between two or more
periods are compared and changes are incorporated therein.
ii) Analytical reports: These reports provide information in an analytical manner about
composition of certain results. A comparison of the same activity for different functional
areas or comparison of actual results with standard or predetermined objectives etc., is
incorporated in such reports. Thus, we can say that analytical reports are based on the
horizontal comparison of results, with the help of such reports, one can easily identify the
specific factors in the overall total.
iii) Activity reports: Sometimes, information reports can be prepared on the basis of each
activity/Department. Such reports may be prepared in two ways. I) Individual activity
reports and ii) Joint Activity Reports. Individual activities are confined only to those
activities which are accomplished under the direction of a particular executive responsible
for that. On the other hand, joint activity reports relate to the activities accomplished
under the direction of all executives.
21.3 FINANCIAL REPORTS
Financial reports may further be classified into I) Static and ii) Dynamic reports.
i) Static Financial Reports: A balance sheet is a Static Financial report. But some subsidiary
statements or schedules or also prepared and attached to the balance sheet. These statements
or schedules provide detailed information about the individual items shown in the balance
sheet. The balance sheet and its supplementary statements are called static because they
depict assets, debts and liabilities at a particular date.
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ii) Dynamic Financial Reports: Static reports are said to be inadequate in the sense that they
reveal only the appraisal of soundness of financial policies and liquidity of assets. Dynamic
reports are considered more useful because they reveal;
a. The comparison of financial position with budgeted or forecasted position.
b. The measurement of effectiveness of funds invested in various assets.
c. The change in financial position over a period of time
The dynamic reports may include the following:
a) Financial Control report: When a projected balance sheet is prepared as a part of regular
operating budget, the actual balance sheet and projected balance sheet may be compared
and such comparison would reveal information not only in respect of financial position
but would also help in check and control. If supplementary statements are also prepared,
then control over individual assets can be made more effective.
b) Report of Measure of effective use of funds: For an in-depth study of financial position,
it is necessary to obtain information about the volume of investments in each asset and
profit earned on it. Various measures are used to examine the profitability and effectiveness
of the funds invested in various assets. A report containing information obtained through
these measures is known as report of measures of effective use of funds.
c) Report of Financial changes: Reports indicating the changes in financial position between
two periods are known as reports of financial changes. They include Funds flow statement
cash flow statement and statement of changes in working capital.
Reports from the view point of users may be classified into two types:
1. External Reports
2. Internal Reports
21.4 EXTERNAL REPORTS
External reports are those which are prepared for the use of external parties, i.e.,
Shareholders,Government officials, Stock Exchange authorities and other institutions. These reports
may be of following types:
a) Annual Accounts: Such reports include usually income statement, balance sheet and director’s
reports. Reporting to shareholders had assumed wider dimensions in the present age. It is obligatory
to send shareholders a copy of annual accounts. Adequate efforts have been made in western
countries to improve the quality and quantity of information to be included in such reports.
437
b) Reports to the Government: In our country, it has been made obligatory to send a copy of
annual accounts to the registrar of companies. In addition, Sales tax return, Income tax returns,
excise duty returns etc., are to be prepared and submitted to several authorities.
c) Report to Stock Exchange: If the shares of a company are listed in a stock exchange, a
report on the prescribed form has to be submitted to the stock exchange authorities. In addition,
a copy of annual account has also to be sent to them.
d) Report to credit Institution: A number of reports of varying nature and size have to be submitted
to the various institutions from which credit facilities are to be availed.
21.5 INTERNAL REPORTS
Internal reports are prepared for the use of internal parties like different levels of management,
employees etc. These are not public documents and they do not have to confirm to any statutory
standards. These reports function as a vehicle for communicating to the various levels of management.
It is also significant to note that these repots are prepared keeping into account the preferences and
tastes of the recipients and purposes for which they are required. Internal reports may further be
classified into I) routine reports and ii) special reports iii) reports to various levels of management.
i) Routine Reports: Control reports are the best example of routine reports. As such, these
reports are prepared and submitted when a control system exists. These are just to activate the
control function. Reporting through these reports is described as feed back process because
the data for these reports do come from the recipient of the reports and are sent back to him in
a different shape. The nature of information, details, periodicity, etc., would greatly depend
upon the levels of management.
ii) Special reports: A budget, Plan, Budgetary control program, related operations and
information reports- all these provide significant and basic information for management decisions.
Yet, such information may be an adequate for management decisions or more details are required
for decisions certain areas of operation. Reports prepared on the basis of such special studies
and analysis is known as special reports. Thus, special reports are needed for making specific
decisions. Such reports contain extraordinary information which are considered necessary to
overcome a particular problem or situation.
Since special reports are prepared for providing information to help in decision making with regard
to a particular problem, no particular principle or form can be laid down or standardized. Much will
depend upon the nature of problem under study. Each report has to be prepared in such a form as to
meet the objective for which it is being prepared. The data required for such report may not fully
available with accounting department, data have to be generated and collected for which special staff
may be appointed.
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21.6 FUNCTIONS OF FINANCIAL REPORTS
Reports stimulate corrective actions in addition to help in planning and control. ‘The following are the
functions of financial reports.
i) To Provide Information: The main function of financial reports is to present and to communicate
required information to operating management and top management. Operating management
may include Foreman, Supervisors, Departmental Heads, Plant and Divisional Managers and
Chief Executives. All these levels of management need information of varying degree and quality
and such information are provided to them only through accounting reports.
ii) To help in Control: Another function of financial reports is to help the management in executing
proper and adequate control. The control can be made more effective through reports as
compared to personal investigation, survey and relations. Reports in fact provide the basis for
control by obtaining necessary information in respect of each operative activity, abnormal events
can be checked.
iii) To have management by exception: The most important principle is management by exception.
This principle lies in the fact that the management should intervene only those areas and only at
that time where and when a particular activity is not being carried out according to planned one.
Incase when operation is normal, the management should not interfere. As such the management
must have sufficient and necessary information about the areas, where significant deviations
from the standard or plan have taken place. All such deviations or variances are conveyed
through the reports and therefore reports help too much in observing the principle of Management
by Exception.
iv) To achieve the overall objective: Financial reports also help, through indirectly, the management
in achieving the objective of maximum profit. Reports motivate the executives and personnel to
take all necessary steps which may lead to the earning of adequate return.
21.7 SUMMARY
Financial reports provide information about the financial position of a concern. These reports are
necessary for accounting purpose. However, number of other reports will be required by different
decision levels. Various types of reports are used by the organization hierarchy. These may be classified
on the basis of Information as operating reports and financial reports. Another classification will be
on the basis of users as External reports and Internal reports. External reports are those, which are
prepared for the use of external parties, i.e., Shareholders, Government officials, Stock Exchange
authorities and other institutions. Internal reports are prepared for the use of internal parties like
different levels of management and employees of different departments. Internal reports may further
be classified into I) routine reports and ii) special reports iii) reports to various levels of management.
Special reports are prepared for providing information to help in decision-making with regard to a
particular problem. Financial reports as a whole help the management to achieve organizational
439
objectives, facilitates better management decision making, control and motivation of people at the
workplace.
21.8 GLOSSARY
INFORMATION: Processed data that could be used objectively to help management decision
making is called information. Any truth or piece of news only when it is useful can be said as information
SPECIAL REPORT : A budget, Plan, Budgetary control program, related operations and information
reports that provide significant and basic information for specific management decisions.. Report
prepared on the basis of such special studies and analysis is known as special report. Special
reports contain extraordinary information which is necessary to overcome a particular problem or
situation.
1. Why Financial Reports require classification? What purpose does it serve in a big organization?
2. Discuss the different criteria followed while classifying financial reports?
Paul H Walgenbach, Ernst I, Hanson and Norman E.Dittrich, Financial Accounting, Harcourt Brace
Jovanovich,1988
Gordon Shillinglaw and Phillip E. Meyer, Accounting: A Management Approach, Irwin, 1986
440
GUIDELINE 22 : FINANCIAL REPORTING PRACTICES IN
INDIA
OBJECTIVES
• Basic purpose of preparing financial reports,
• General and special purposes served by financial reports, and
• Concept of management information system.
STRUCTURE
22.1 Introduction
22.2 General purpose financial reporting
22.3 Specific purpose reporting
22.4 Emergence of management information system
22.5 Summary
22.6 Glossary
22.1 INTRODUCTION
The Indian Companies Act 1956 clarifies the basic purpose of financial reporting. Providing
shareholders of the company financial statements and other related information is a must. In India,
shareholders are the primary users of financial reporting. However, there are other potential users
also, who are interested in reporting information for making economic decisions.
22.2 GENERAL PURPOSE FINANCIAL REPORTING

The term financial reporting is used to mean general purpose external financial reporting. Often, it is
said that the purpose of financial reporting is the preparation of general purpose financial reports for
external users. Therefore, financial statements are presented in order to help a number of external
users like investors, employees, lenders, suppliers, trade creditors, customers, governments and
public in general. They used financial statements in order to satisfy some of their different needs for
information. These needs were explained below:
A) INVESTORS: Providers of risk capital and their advisors are concerned with the risk inherent
and the return from their investments. They look for information to help them determine whether
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they should buy hold or sell. Shareholders are also interested in information which enables them
to assess the ability of the enterprise to pay dividends.
B) EMPLOYEES: Employees and their representative groups are interested in information about
the stability and profitability of their employers. They are also interested in information which
enables them to assess the ability of the enterprise to provide remuneration, retirement benefits
and employment opportunities.
C) LENDERS: Lenders are interested in information that enables them to determine whether their
loans and the interest attaching to them will be paid when due.
D) SUPPLIERS AND TRADE CREDITORS: Suppliers and trade creditors are interested in
information that enable them to decide whether money owing to them will be paid when due.
Trade creditors are interested in an enterprise over a shorter period than lenders.
E) CUSTOMERS: Customers require information about the continuance of an enterprise when
they have a long term involvement with the enterprise.
F) GOVERNMENT AND THEIR AGENCIES: Government and their agencies are interested in
the allocation of resources and the activities of the firm. They also require information in order to
regulate the activities of enterprise, determine taxation policies and other statistical purposes.
G) PUBLIC: Companies affect public in a variety of ways. They provide employment to locals,.
Source inputs from suppliers etc. Financial statements may assist the public by providing information
about the trends and recent developments in the wealth of the firm and the range of its activities.
Information needs of all these users can not be met by financial statements. Yet, there are needs
common to all users. Management of an enterprise has the primary responsibility to furnish
information about the financial position, performance and changes in financial position of the
enterprise.
22.3 SPECIFIC PURPOSE REPORTING

Financial reporting so far has focused on general purpose financial reporting which aims to satisfy the
information needs of all potential users. Company law provisions in almost all countries have accepted
the utility of general purpose financial reporting. Due to this, specific needs of specific users have
been largely ignored on the assumption that general purpose reports can satisfy the informational
needs of all external users. However, suggestions have continuously been made to present specific
purpose reports to help them in their decision functions. For example, financial reports submitted to
obtain credit or loans may not be useful to other users.
However, proposal for specific purpose reports is criticized on following grounds:

a) The cost of developing specialized reports to satisfy special requirements of specific users
may exceed the benefits.
b) Specialized needs of specific users can not be ascertained with any degree of certainty.
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c) Issuing multiple reports about the financial results of an enterprise can create confusion among
various users.
d) Multiple reports may not be desirable and practicable from the standpoint of information
economics.
In India, companies continue to adhere to general purpose reporting system to aid investors, creditors
and other external users in their economic decisions.
22.4 EMERGENCE OF MANAGEMENT INFORMATION SYSTEM

Every big corporate entity today has been using electronic data processing system, Computerized
accounting systems in order to upkeep the business affairs. These systems are highly flexible and
useful to elicit any kind of information required on fingertips.
Management Information System in an integrated system wide implementation of structured flow of
information at various levels to facilitate speedy decision making. Accounting information can be vied
as an interface of MIS in organizations today.
With the computerization of corporate offices and the use of advanced computer software packages
like Oracle, SAP, BAAN etc., reporting has become an instant task to the day to day contingencies.
22.5 SUMMARY
According to the Indian Companies Act 1956, the basic purpose of financial reporting is providing
shareholders of the company financial statements and other related information. In India, in general,
shareholders are the primary users of financial reporting. Financial statements are also presented in
order to help a number of external users like investors, employees, lenders, suppliers, trade creditors,
customers, governments and public in general. They used financial statements in order to satisfy
some of their different needs for information.
Specific needs of specific users have been largely ignored on the assumption that general purpose
reports can satisfy the informational needs of all external users. However, suggestions have continuously
been made to present specific purpose reports to help them in their decision functions. For example,
financial reports submitted to obtain credit or loans may not be useful to other users.
Management Information System in an integrated system wide implementation of structured flow of
information at various levels to facilitate speedy decision making. Accounting information can be vied
as an interface of MIS in organizations today. With the computerization of corporate offices and the
use of advanced computer software packages like Oracle, SAP, BAAN etc., reporting has become
an instant task to the day to day contingencies. MIS will ensure real time flow of internal as well as
external information within the organization.
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22.6 GLOSSARY
Management Information System(MIS)
System of people, computer network and structured flow of reports within the organization to ensure
speedy decision making.

1.What is general purpose reporting? Whose purpose does it serve?
2.Discuss the need to prepare special purpose reporting?
3.Discuss the emergence of MIS in complementing financial reporting?

Thomas G Evans, Martin E Taylor, International Accounting And Reporting, New York Macmillan ,
1985
Clare Roberts, Paul Weetman and Paul Gordon, International Financial Accounting, Pearson Education,
2002.
444
GUIDELINE 23 : LIMITATIONS OF FINANCIAL REPORTING
23.0 OBJECTIVES
• limitations to be understood while preparing financial reports, and
• Precautions need to be taken when these reports are used.
STRUCTURE
23.1 Introduction
23.2 Limitations of financial reporting
23.3 Precautions needed while using financial reports
23.4 Summary
23.5 Glossary
23.1 INTRODUCTION
Financial reporting has been systematized in large multinational companies. They employ outside
professional agencies to provide timely reports that serve different decision purposes. Large scale
data bases are maintained by the consultants who provide analytical reports across industry. These
reports eliminate bias and offer systematic guidance with nationally and internationally accepted
bench marks of comparison.
23.2 LIMITATIONS OF FINANCIAL REPORTING

Financial reports generated in the organizations must be used keeping certain limitations in mind.
They are discussed below:
1. RELEVANCE: Relevance is closely and directly related to the concept of useful information.
Relevance implies that all those items of information should be reported that aid the users in making
decisions and predictions. Relevant information also reduces decision makers uncertainty about future
acts. Ability to predict users requirements determine the relevance or irrelevance of reports. In today’s
complex financial environment, a general purpose report aiming to fulfill all needs of users become
irrelevant.
2. RELIABILITY: Reliability is described as the quality that makes information usable. User will
form judgment about the financial position of the firm. Reliability differs from item to item. Some
items presented in the reports may be more reliable than others. For example, information regarding
the plant and machinery may be less reliable than the current assets because of the realization of
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current assets is within one year. Similarly, current assets are calculated on the basis of estimates
which involve personal judgment.
Many factors affect the reliability of information such as uncertainties inherent in subject matter and
accounting measurement. Accounting measurements may be subject to error and 100 per cent precision
is not possible. The possibility of error in measuring information and business events may create
difficulty in attaining high degree of reliability. However, it is the responsibility of management to
report reliable information in all reports.
3. UNDERSTANDABILITY: Understandability is influenced by a combination of personal
characteristics of the user and the usage of his perceptual mechanism. Since company financial reporting
aims at general purpose financial reporting, it is not usable by all categories of individual users to suit
their decision requirements. Therefore, any presentation of information should not only facilitate
understanding but also minimize misunderstanding.
4. COMPARABILITY: Economic decision requires making choice among possible courses of action.
While making decisions, the decision maker will make comparisons among alternatives, which is
facilitated by financial information.
Financial reports of different firms are not able to achieve comparability because of differences in
business operations of companies and also because of the managements viewpoints in respect of
their transactions. Different firms follow different accounting practices to describe basically similar
activities. Two corporate entities may view the same risk, uncertainty, benefit or cost in different
fashions and this may lead to different inferences of similar financial statements.
5. .CONSISTENCY: Consistency of method over a period of time makes accounting information
useful. However, companies change the use of accounting principles and practices which lead to
erroneous comparisons.The value of inter company comparisons is reduced because of variations in
accounting practices.
6. NEUTRALITY: Neutrality is also known as the quality of objectivity or freedom from bias. In
formulating and implementing standards, the primary concern should be the relevance and reliability
of the results. companies have historically followed creative accounting that could conceal or inflate
results according to the bias of the powers that rule the management.
7. .MATERIALITY: Material judgments are quantitative in nature. Accounting guidelines to test
materiality are amount of an item, trend of net income, average net income for a series of years,
assets, liabilities, trends and ratios that that establish meaningful relationship on information contained
in annual reports. Judgment is exercised while estimating inventory items, bad debts, loss occurred
out of an operation which is purely contingent upon the firm, person etc. Hence, what is material or
immaterial is purely debatable.
8. TIMELINESS: Timeliness means having information available to decision makers before it loses
its capacity to influence decisions. If information is not available when it is needed or becomes
available long after the events are reported, it has no value for the user. Some reports need to be
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prepared quickly like a take over bid by a competitor or a strike by a trade union. Financial information
is historical and suffers from element of futuristic utility.
9. VERIFIABILITY: Verifiability contributes to the usefulness of information and the assurance for
verification upon ambiguity or importance. Since the transactions are in huge volumes, verifiability of
the results may not be a practical idea. Methodological verification, measurement verification could
be provided with sample audit from independent agency.
10. CONSERVATISM: Since business activities are surrounded with uncertainties, accountants have
to be careful and critical with the goings on. Conservatism ensures all risks are considered and
uncertainties are provided. Sometimes conservatism acts as a hindrance in representing the true and
fair views
23.3 PRECAUTIONS NEEDED WHILE USING FINANCIAL REPORTS

Financial reports are prepared by professionals in the organization who use their experience in creating
them. However, user of these reports has to take maximum care while using these reports. They are
given below;
1. UNDERSTANDING THE DATA
Reports contain lot of data expressed in quantitative numbers. User must first of all understand
the units in which the data is expressed. Misreading data would result in misinterpreting the entire
report. While following foreign currencies etc., one must calculate their Indian equivalent.
2. UNDERSTANDING THE TOTAL PICTURE
Reports must be read completely a couple of times before understanding them. One must
understand the total picture presented before arriving at fast judgment. While studying the
organization, effort must be made to analyze the contribution from each subsystem and then
arrive at a total view of the problem
3. ANALYSING THE TRENDS
Trend have to be read carefully. Lot of judgmental errors occur while reading trends. Misreading
them would result in decisions that would prove costly later on.
4. MAKING COMPARISONS
Making comparisons on the basis of secondary data is highly subjective. Effort must be made to
understand background details. For example, comparison of two units without understanding
their age, track record, human competencies would mislead our judgment.
5. JUDGING THE ABSENT DETAILS
Report will contain brief information. It will be prepared with the available details. User must try
to substantiate lot of missing information on their own before judging the report.
6. READING BETWEEN THE LINES
447
Reading the message or guideline in the information is important rather than reading report
verbatim. Ability of the user lies in understanding the report by using past experience, common sense
and wisdom.
7. PROVIDING FOR BIAS

Reports however objectively they are made include some bias of the person preparing them.
Further, user will be selective in their perception while reading. People live in a make believe
world. They see what they want to see and believe what they want to believe. One can not
eliminate personal bias in the present world. While taking important decisions, one has to be
careful in judging bias in reports.
8. UNDERSTANDING CULTURE AND CONTEXT
Understanding the people, their culture and the physical setting is very much important in
understanding information. Every system has certain cultural strengths as well as weaknesses.
Every place has a history. Understanding nature and pace of change is also important. After
understanding these factors of influence, one must understand the reports.
9. PREDICTING FUTURE
Predicting future is a difficult ball game. Yet, reports contain number of estimates, predictions
etc., which could change very fast. These things must be understood carefully.
10. IMPLEMENTATION
Decisions taken or recommended would be highly attractive on paper. However, number of
problems arise during the course of implementation of these decisions. One must take the practical
and human consequences of a decision before taking one.
23.4 SUMMARY
Financial reports generated in the organizations must be used keeping certain limitations in mind.
How far a report is relevant and reliable is the first issue. Whether the user understands the report
thoroughly is the next limitation. The factors of consistency, comparability, neutrality, timeliness are
key in deciding the quality of a report. Reports must be prepared with verifiable sources of information.
Above all, one must be conservative in judging the information present in the report. While
understanding these limitations, users of financial reports must keep certain precautions in mind.
Understanding the data and analyzing the problem in given culture and organizational context is the
key. One must be efficient at reading between the lines and understanding personal bias. Care must
be taken while predicting future and understanding trends and drawing inferences on inter firm
comparisons. Above all one must be wise, practical, commonsensical as well as understand the
human element of the organizations which is normally not given in financial reports.
448
23.5 GLOSSARY
TREND
Analyzing future on the basis of historical information on the assumption that past is a basis for future,
or past repeats in future to certain extent.
1 Discuss the limitations of financial reporting?
2. Elaborate on the precautions that required to be taken while using financial reports?

William H. Beaver, Financial Reporting: An Accounting Revolution, New Jersey, Prentice Hall
Inc., Englewood cliffs,1981
Jawahar lal, Financial Reporting by Diversified Companies, Vision Books, New Delhi,1985
449
GUIDELINE 24 : RECENT TRENDS IN PUBLISHED
FINANCIAL STATEMENTS
24.0 OBJECTIVES
• The objectives of published financial statements,
• Recent trends in published financial statements, and
• Basic understanding of profit and loss account, balance sheet and funds flow statement.
STRUCTURE
24.1 Introduction
24.2 Objectives of published financial statements
24.3 Recent trends in published financial statements
24.4 Summary
24.5 Glossary
24.1 INTRODUCTION
Section 210, 216 and 217 of the Companies Act 1956 make it compulsory for the board of directors
to present before the company’s annual general meeting a copy of the profit and loss account and
balance sheet together with the directors’ and auditor’s reports. All these reports are published and
circulated to the shareholders of the firm and made available to public use. Hence these statements
are called published financial statements.
24.2 OBJECTIVES OF PUBLISHED FINANCIAL STATEMENTS

1. Providing information on the performance of the company during the financial year.
2. Facilitating the present year performance with that of immediate previous year. Public therefore
will clearly understand whether production, sales, and profit are on the rise.
3. Information about the sources and uses of different types of funds during the year.
4. Launch of new products and performance of existing products/projects.
5. Information on what the firm owns and owes at the end of a year.
6. Progress of research and development and the results achieved during the year.
7. Progress of capital projects.
450
8. Information about employees management relations during the year.
9. Company projections of the macroeconomic trends and company plans to grow accordingly.
10. Details of the company role in discharging it’s social responsibility.
11. Information about the future projects of the firm.
12. Information about the commitments and liabilities for which no provision has been made and
the reason for not making such provision.
13. Giving particulars of any material liability arising after the date of balance sheet but before the
adoption of such accounts by direction.
14. Giving information of important appointments in the management cadres with details of
compensations.
15. Providing information about utilization of capacity and reasons for underutilization.
16. Company understanding of the growth potential of the industry and the future competitive
scenario in the market and the strategy of the company to counter competition.
17. What are the important changes that are implemented in the immediate future and the
preparation of the firm towards that direction?
24.3 RECENT TRENDS IN PUBLISHED FINANCIAL STATEMENTS

Accounting is the language employed to communicating financial information of a concern to various
parties. Communication of financial information and other information by published financial statements
serves it’s purpose only when it satisfies the needs of persons. People having insufficient knowledge
can not understand the accounting language. Efforts are being made to bring the financial statements
closer to the grasp of the users in layman language.
Present trend in this direction is to add the profit and loss account and the balance sheet with
additional statements like;
a) Profit and loss account and balance account and balance sheet drawn in a summarized
manner in a columnar form.
b) Presentation of the highlights of the information contained in the published accounts.
c) Preparing funds flow statements.
d) Provision of important accounting ratios.
e) Use of flow charts, graphs and diagrams.
f) Use of schedules.
A.SUMMARISED PROFIT AND LOSS ACCOUNT AND BALANCE SHEET:

Advanced countries have changed the preparation of traditional two sided balance sheet and profit
and loss account and are following columnar forms of balance sheet and profit and loss account
which are simpler ways of preparation. Balance sheet in columnar form may be prepared in any of
the following two ways- American or British.
451
In India, columnar form of balance sheet and profit and loss account is not as popular as it is in
advanced countries. One of the reasons for slow adoption of this form is that schedule vi has prescribed
the two sided (‘T”) form for the preparation of the final accounts. Even then many of the companies
in India have adopted this form of presentation of final accounts. Efforts should be made to make this
form popular because it speaks out the correlation of every item with the other items. Thus, this form
conveys more meaning to the layman.
B.HIGHLIGHTS:
Highlights are generally given at the start of the annual report so that the user may come across the
important facts of the company immediately. When he opens the report highlights are also put under
the heading like “Year at A Glance” Highlights are given so that the reader may know the working of
the company at a glance without loss of time. Highlights usually cover information about sales,
production, profit before tax and after tax, amount spent on capital projects, working capital, gross
and net fixed assets, shareholders equity and important land marks of the year.
An illustration of a small company highlights is given below ( Rs. Crore)
HIGHLIGHTS OF 2007 2007 2006

Income 1318 1151
Profit: Before Depreciation and Tax 254 186
After Depreciation and Tax 181 116
Depreciation 71 70
Taxes 2 -
Invested Capital
Shareholder’s funds 425 311
Long term Deposits 456 501
Per Share:
Earnings 672 424
Dividend 250 100
C.FUNDS FLOW STATEMENT

Funds flow statement is becoming popular day by day because it explains why in spite of huge
profits earned by the company faced with difficulty in making the payment of creditors in time. It is an
operational statement which reveals the means by which the business has been financed and how it
has used it’s funds between the opening and closing balance sheet dates. An illustration is given
below:
452
Particulars Change in Pro Working Capital
INCREASE DECREASE
2006 2007
Current Assets
Debtors 1.40 1.70 .30 ---
Stock .77 1.90 .32 ---
Bills Receivable .20 .30 .10 ---
Cash .15 .10 --- .05
Cash at Bank .10 .08 --- .02
2.62 3.27 ---
Current Liabilities
Creditors .25 .47 --- .22
Bills payable .20 .16 .04 ---
Liability for Expenses .30 .36 --- .06
Provision for tax .40 .50 ---. 10
Provision for Dividend .42 .50 .08
1.57 1.99
Working Capital 1.05 1.28 --- .23
Increase in Working Capital .23 .23
1.28 1.28 .76 .76
b. FUNDS FLOW STATEMENT
Source Rs. Applications Rs.
Funds from operations 0.83 Redemption of Share Capital 0.50
Issue of equity Shares 1.00 Plant Purchased 1.42
Sale of Land 0.50 Investments Purchased 0.11
Sale of Machine 0.10 Interim Dividend 0.20
Dividend Received 0.03 Increase in working capital 0.23
2.46 2.46
453
24.4 SUMMARY
Section 210, 216 and 217 of the Companies Act 1956 make it compulsory for the board of directors
to present before the company’s annual general meeting a copy of the profit and loss account and
balance sheet together with the directors’ and auditor’s reports. All these reports are published and
circulated to the shareholders of the firm and made available to public use. Apart from this financial
information of a concern need to be communicated to various parties. Communication of financial
information and other information by published financial statements serves it’s purpose only when it
satisfies the needs of persons. . Efforts are being made to bring the financial statements closer to the
grasp of the users in layman language.
Present trend in this direction is to add the profit and loss account and the balance sheet with
additional statements like Profit and loss account and balance account and balance sheet drawn in a
summarized manner in a columnar form, Presentation of the highlights of the information contained in
the published accounts, Preparing funds flow statements, Provision of important accounting ratios,
use of flow charts, graphs and diagrams and use of schedules.
24.5 GLOSSARY
ACCOUNTING RATIOS
Technique of analyzing and facilitating comparison between two accounting figures and expressing
them as a proportion of one against the other.
Ex: Profit to Equity Shares( Earning per Share)
FUND
Amount available in money or its equivalent under a specific head that is available for further deployment.
Ex: Different heads of current assets, Depreciation fund etc.

1. List the objectives of published financial statements?
2. .Discuss the recent trends in published financial statements?

M Y Khan, P K Jain, Management Accounting, Tata Mc graw Hill, 1993
454
GUIDELINE 25 : INTERNATIONAL DIMENSIONS OF
FINANCIAL REPORTING
25.0 OBJECTIVES
1. Emergence of the concept of accounting standards the world over,
2. Process of setting financial accounting standards in US,
3. Financial Accounting standards in India, and
4. Impact of International accounting standards on Indian accounting standards.
STRUCTURE
25.1 Introduction
25.2 The accounting standards board of the British
25.3 Financial accounting standards board (fasb) of us
25.4 Standard setting in India
25.5 Impact of international accounting standards on Indian accounting ‘
standards
25.6 Summary
25.7 Glossary
25.1 INTRODUCTION
Financial reporting experienced many changes during the recent past. Some of the significant changes
include implementation of accounting standards. What is described as standard today used to be
known as principles a couple of years ago. The British first introduced the term standard in the year
1969 and the Americans adopted the term in 1973. The idea of adopting internationally uniform
standards for accounting as well as financial reporting took momentum from time to time.
Presently, standard setting bodies are active in number of countries such as the US, Canada, UK,
Australia, Newzeland, Japan, Netherlands including India. The purpose of each of these organizations
is to promote the dissemination of timely and useful information to investors and certain other parties
having an interest in corporate performance.
25.2 THE ACCOUNTING STANDARDS BOARD OF THE BRITISH
The Britishers first established Accounting Standards Committee in 1970 which stated its intention to
advance accounting standards along five lines as follows:
455
a) Narrowing the area of difference and variety of accounting practices.
b) Disclosure of accounting bases.
c) Disclosure of departures from established accounting standards.
d) Wider exposure for major proposals on accounting standards.
e) Continuing program for encouraging improved accounting standards in legal and regulatory
measures.
The Accounting Standards Board(ASB) of the British issued the following guidelines in the year
1991.
a) To be objective and neutral in preparing accounting information
b) To ensure that accounting standards are clearly expressed and supported by reasonable analysis
of the issues.
c) To determine what should be incorporated in accounting standards based on research, public
consultation.
d) To ensure that a process of regular communication of accounting standards is produced with due
regard to international developments.
e) To ensure consistency between accounting standards and company law.
f) To conduct cost/benefit analysis for implementation of accounting standards.
g) To take into account the opinions of financial community while proposing changes.
25.3 FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) OF US
In the year 1985, the FASB of US issued a statement declaring it’s mission,” To establish and
improve standards of financial accounting and reporting for the guidance and education of public
including issuers, auditors and users of financial information.” The board seeks to accomplish it’s
mission by the following measures:
a) Improving the usefulness of financial reporting by focussing on certain primary characteristics (
relevance, reliability, comparability, consistency)
b) Keeping standards up-to-date.
c) Considering areas of financial reporting that need improvement.
d) Improving the general understanding of financial reporting, it’s nature and it’s purpose.
In pursuing these aims, the board says that it follows the following precepts:
a) to be objective in it’s decision making and preserve neutrality in the information that results from
it’s standards.
b) To weigh the views of it’s constituents but ultimately to rely on it’s own judgment.
c) To issue standards only when the benefits are expected to exceed cost.
d) To minimize disruption when making needed changes.
e) To review past decisions and to make changes when necessary.
456
The end result of the above elaborate and costly procedure is the promulgation of a statement of
financial accounting standards. The FASB has so far issued 137 Financial Accounting Standards.
25.4 STANDARD SETTING IN INDIA

Keeping in view the international developments in the field of accounting, the Institute of Chartered
Accountants of India[ICAI] constituted Accounting
Standards SB]97 The board was entrusted with the following functions:
a) To formulate accounting standards which may be established by the council of ICAI in India.
While formulating standards, the ASB is required to take into consideration the applicable laws,
customs and usages and business environment. It is also required to give due consideration to
International Accounting Standards issued by the IASC and to integrate with them.
b) To propagate the Accounting Standards and persuade the concerned parties to adopt them in
the preparation and presentation of financial statements.
c) To issue guidance notes on the Accounting Standards and give clarification on issues arising there
from.
d) To review the accounting standards at periodical intervals.
The ASB has issued 29 Accounting Standards so far the list of which is given below.
AS1. Disclosure of Accounting Policies.
AS2. Valuation of Inventories.
AS3. Cash Flow Statements.
AS4. Contingencies and Events Occurring after the balance sheet date.
AS5. Net Profit or Loss for the period. Prior Period items and changes in Accounting Policies.
AS6. Depreciation Accounting.
AS7. Accounting for Construction Contracts.
AS8. Accounting for Research and Development.
AS9. Revenue Recognition.
AS10 Accounting for Fixed Assets
AS11. Accounting for the Effects of changes in Foreign Exchange Rates.
AS12. Accounting for Government Grants.
AS13. Accounting for Investments.
AS14. Accounting for Amalgamations.
AS15. Accounting for Retirement Benefits in the Financial Statements of Employers.
AS16.Borrowing Costs
AS17.Segment Reporting
457
AS18 Related Party Disclosures
AS19.Leases
AS20. Earnings Per Share.
AS21. Consolidated Financial Statements.
AS22.Accounting for Taxes on Income.
AS23. Accounting for Investments in Associates in Consolidated Financial Statements.
AS24. Discontinuing Operations
As25. Interim Financial Reporting
AS26. Intangible Assets
AS27. Financial Reporting of Interest in Joint Venture.
AS28. Impairment of Assets.
AS29. Provisions, Contingent Liabilities and Contingent Assets.
Compliance with accounting standards has been made mandatory. According to Section 211(3A) of
Indian Companies Act 1999, every profit and loss account and balance sheet shall comply with the
accounting standards.
25.5 IMPACT OF INTERNATIONAL ACCOUNTING STANDARDS ON INDIAN
ACCOUNTING STANDARDS
Accounting Standards Board of the ICAI is engaged in the task of formulating and issuing accounting
standards since 1977. The Accounting standards issued by the ASB of the ICAI are primarily based
on International Accounting Standards (IAS) issued by the International Accounting Standards
Committee. Necessary modifications are carried out to suit and adjust to the trade, usage, customs,
business and economic conditions and laws prevailing in India. Since several IASs are revised from
time to time particularly on account of ‘Comparability and Improvement Project’ carried out by
IASC during 1988 to 1993 Indian Accounting Standards confirmed to the revisions of IAS.
The International Accounting Standards Committee (IASC) has so far issued 41 accounting standards
of which a large number of standards have been revised recently which are designated as ‘International
Financial Reporting Standards’. Accordingly some of the Indian Companies while reporting their
annual reports are giving information about assets, liabilities, income statement in terms of US GAAP
and Indian GAAP.
India today enjoys a very small share of the international funds market . There is a growing realization
that these funds will increasingly flow to those markets which are strongly regulated and which have
an ethical base. International investors and lenders will be willing to provide funds only to those
enterprises whose financial statements are prepared on lines with which they are familiar. If
internationally accepted accounting standards are to be speedily introduced and implemented in this
country, what is needed is the voluntary acceptance of such standards by all concerned.
458
25.6 SUMMARY
Financial reporting experienced many changes during the recent past. Some of the significant changes
include implementation of accounting standards. The idea of adopting internationally uniform standards
for accounting as well as financial reporting took momentum from time to time. Presently, standard
setting bodies are active in number of countries such as the US, Canada, UK, Australia, Newzeland,
Japan, Netherlands including India. The purpose of each of these organizations is to promote the
dissemination of timely and useful information to investors and certain other parties having an interest
in corporate performance. The Britishers first established Accounting Standards Committee in 1970
which stated its intention to advance accounting standards.
In the year 1985, the FASB of US declared that it’s mission was to establish and improve standards
of financial accounting and reporting for the guidance and education of public including issuers,
auditors and users of financial information. Keeping in view the international developments in the field
of accounting, the Institute of Chartered Accountants of India [ICAI] constituted Accounting Standards
SB 97. The ASB has issued 29 Accounting Standards so far. The International Accounting Standards
Committee (IASC) has so far issued 41 accounting standards of which a large number of standards
have been revised recently which are designated as ‘International Financial Reporting Standards’.
Accordingly some of the Indian Companies while reporting their annual reports are giving information
about assets, liabilities, income statement in terms of US GAAP and Indian GAAP.
25.7 GLOSSARY
STANDARD
Any accepted process, practice method or yardstick of measurement by a system.

1. What is the need for Accounting standards? Review the international developments towards
establishing accounting standards?
2. Discuss developments towards Accounting standard setting in India?
3. Analyze the impact of international developments on Accounting Standard setting in India?

Louis Harris, A Study of the Attitudes Toward An Assessment of the FASB, Stamford, FASB, 1985
Michael Bromwich, The Economics of Accounting Standards Setting, Prentice Hall International,
1985.
459
GUIDELINE 26 : FINANCIAL AUDIT
OBJECTIVES
· The concept of Audit
· Scope of Audit
· Objectives of Auditing
· Frauds and Errors
· Detection of Errors
· Qualities of Auditor
STRUCTURE
26.1 Introduction
26.2 Accountancy and Audit
26.3 Auditing and Investigation
26.4 Auditors : External and Internal
26.5 Auditing
26.6 Objectives of Auditing
26.7 Frauds
26.8 Errors
26.9 Detection of Errors
26.10 Advantages of Auditing
26.11 Limitations of Auditing
26.12 Qualities of an Auditor
26.13 Summary
26.14 Key Words
26.1 INTRODUCTION
460
Audit does not mean “checking the totals” or “ticking”. It does not mean merely checking
the arithmetical accuracy. It does not mean even checking of cash or stock or any other asset or
liability. It is not merely detecting frauds or errors. Auditing considers something much more than
this. The term ‘audit’ is derived from the Latin term “audire” which means to hear. Initially, the
auditor used to hear” the accounts of the accountants. Businessmen wanted assurance that their
book-keepers had accurately and properly kept the books of account.
The commercial and industrial revolutions brought changes in the thinking of “audit”. Owners
of businesses needed more and more finances’ for the development of their business. Business
now knew no boundaries. Local trades developed further into international trade. Businessmen
borrowed large sums of money. Independent audit came to stay since those days. Audit became
the systematic investigation of not only the operations of the business but also its procedures. This
is mainly to determine whether books of account are in conformity with various status or accounting
concepts and conventions or with other prescribed criteria. These statutes are ever-changing.
Accounting concepts and conventions are never rigid. The prescribed criteria undergo changes
with the passage of time. Therefore, the thinking about auditing is also never rigid or static; it is
reviewed from time to time. Now the time has come when the auditor is considered accountable
to society at large.
The Indian Companies Act, 1913, prescribed, for the first time, the qualifications for an
auditor in India. A person passing the examination of the Government Diploma in Accountancy
conducted by the then Provincial Government qualified to be an auditor. Then under the Auditors’
Certificates Rules of 1932, the Indian Accountancy Board was established. The accountancy
profession then steadily grew further. Finally, autonomy was granted to the accountancy profession
by the Central Government on the passing of the Chartered Accountants Act, 1949. This Act,
which is reviewed regularly, regulates and controls the accountancy profession.
Initially, audit was merely a cash audit. The main object was to ascertain whether all the
receipts and payments were properly recorded. But the objects of the modern auditing have
undergone wide changes. The ultimate object is to verify the financial position as disclosed by the
financial statements. Eric L. Kohler in “A Dictionary of Accountants” states:
“In general, the term does not refer to specific procedures but connotes only
whatever work an accountant undertakes in the way of substantiating or examining
a transaction, the records of a series of transactions, a financial statement, or a
schedule reflecting one or more transactions or accounts. In a narrower sense,
the term refers to the particular procedures generally recognised by the accountants
as essential in acquiring sufficient information to permit the expression of an
informed opinion as ‘a financial statement or statements’. “
Changes have continuously taken place in- the conduct of audit. Initially, only internal
evidences were considered for the checking of the accuracy of records. Now the external evidences
are also necessary. The main aim now is not to verify the. mechanical accuracy of all records but
to see the functioning of the accounting system as a whole.
Audit, therefore, is an examination of books of account with vouchers and other records
of a company by an independent auditor to enable him to report whether the accounts are drawn
461
up in conformity with the law and according to the best of the information and explanations given
to him and as shown by the books the balance sheet gives a true and fair view of the stare of
affairs of the business as on a closing date and that profit and loss account gives a true and fair
view of the profit or loss for the financial period.
Thus audit is not merely an examination and verification of assets and liabilities only. The
resultant figure of profit and loss account or revenue account is also equally important. Finally, the
examination of such assets and liabilities as well as that of profit and loss account or the revenue
account should be such as to enable the auditor to report thereon.
In other words, the audit is not confined to the mere purpose of detecting errors and
frauds. This might be one of the restrictive purposes or might be case for investigation but not the
main purpose of audit. Of course, audit may reveal the existence of such errors and frauds. This
may arise in the normal course of the conduct of audit. The auditor should also keep alive himself
against the possible existence of such errors and frauds.
On the other hand, the existence of normal audit does not fully prevent the occurrence of
errors and frauds. They still exist in some degree or the other. Thus detection and prevention of
errors and frauds is not the main purpose of audit though they may be considered as subsidiary
purposes.
But the scope, definition and objectives of auditing again have shifted.
Arther W. Holmes in his “Basic Auditing Principles” states:
“Long-range objectives of an audit should be to serve as a guide to management’s
future decisions in all financial matters, such as controlling, forecasting, analysing
and reporting. These objectives have their purposes-the improvement of
performances.”
From the above statement, one can easily realise the changing or shifting scope and objectives
of auditing. Lately, it has been thought that the function and duties of an auditor do not end here. As
the approach towards auditing changes, society expects more from the auditor. Shri A.K. Chanda,
former Comptroller and Auditor-General of India. States :
ing. Its purpose is to bring
“Audit is not an inquisition and its mission is not one of fault-find
to the notice of the administration lacunae in the rules and regulations and lapses, and to suggest
possible ways and means for the execution of plans and projects with greater expedition, efficiency
and economy.”
Shri Gian Prakash, Comptroller and Auditor-General of India, goes a step further. While
addressing the annual meeting of the Institute of Chartered Accountants in 1978, he said:
“Today most of the economic activities are largely conducted through public finances. In a
rapidly developing economy this has to be so. The Companies which are not in the public sector
have also public finances invested in them to a very large extent. Whether these large public funds are
properly used is the responsibility of the statutory auditors to see. These auditors are in the nature of
watchdogs and trustees of the nation’s finances.”
462
26.2 ACCOUNTANCY AND AUDITING
Book-keeping is the art of recording all the day-to-day transactions in the books of account.
Accounting is the art of recording and classifying and then summa rising these transactions which are
of a financial character. The summary will be in the form of financial statements. On the other hand,
auditing is concerned with the verification of these accounting data with the purpose of determining
the reliability and accuracy of these accounting statements. It is a systematic examination of these
financial statements to determine how far they have adhered to the management policies and generally
accepted accounting principles.
Accounting, therefore, includes the collection of data and then its classification and
summarisation according to proper and generally accepted principles. An accountant reduces the
mass of details and information in understandable short forms. Auditing, on the other hand, is a
critical and investigative examination of such a data.
An auditor is supposed to examine the records presented before him. At times, he may
bring out the weaknesses and inefficiencies not only in the records or the systems but also in the
working of such systems. Of course, the auditor is in a better position to point out such weaknesses
and inefficiencies because of the nature of work he is engaged in. On the other hand, if he does not
draw the attention of the owners or the management towards such weaknesses and inefficiencies,
he may himself run into difficulties. He must go deep into the details of the figures so as to determine
the financial p0sition of the management and the results of its operation.
Accountancy feeds the details necessary for the preparation of the statements that are
required not only for the formulation of managerial decisions but also for the auditors to enable them
ity
to give a report thereon. Accounting is essentially a process to maintain all information in conform
with generally accepted accounting principles.
One peculiar position of the corporate structure of management is the divorce of ownership
from the. management. A large number of persons join together, pool their resources and do the
business activities involving a large magnitude. All the owners cannot take part in the management.
But accounting is that activity of the management the result of which must, be communicated to the
owners—a large number of shareholders. But the checking of the accounts is entrusted to an
independent agency known as auditors. Accounting will first process various types of information
and statements which in turn will be verified by the auditors.
The facts recorded in the books of accounts and the financial statements can be distorted
because of self-interest, carelessness, personal bias or dishonesty of the persons concerned. Errors
and frauds arise out of these. The auditor examines the reliability of these statements and thus
eliminates these causes of the distortion of facts.
Sometimes the auditor of a company is called upon by the client to prepare the financial
statements. When he prepares such statements he acts as an accountant. He himself thereafter
starts explaining these statements critically. Here he acts as an auditor. Both the functions are
separate.
463
26.3 AUDITING AND INVESTIGATION
Auditors are, sometimes, concerned with investigations but audit should not be mixed up
with investigations. It is not a part of the auditing function. But Chartered Accountants are experts or
specialists in their subjects and can take up successfully the work of investigation.
The main purpose of auditing is to see whether the balance sheet shows a true and fair view
of the state of affairs of the company and the profit and loss account shows a true and fair view of the
profit or loss for the financial period. On the other hand, investigations have certain specified objects
as their aim. They may be in connection with the proposed purchase of a business or admission of a
new partner, or may be in connection with a suspected fraud. They may be for finding out the profit-
earning capacity of future years.
Audit is concerned with the examination of books of accounts ‘and records for the period
concerned which is usually one year. On the other hand, an investigation may cover even two years
or more. An investigator will have to plan out the full-time schedule. If the investigator is also the
auditor, the work of investigation will be facilitated.
Audit is the examination of books of accounts and other records connected therewith. But
the scope of investigation many a time requires an examination of other records also.
Auditing is carried on by the persons qualified under the Companies Act, 1956, i.e., by the
practicing chartered accountants. They are thus always outside agencies and not a part of management.
On the other hand, investigations may be carried out by persons in the employment of the company
or may be by the outside agencies. Some investigations, designed to find out better methods for
increasing profitability, etc., are normally conducted by experienced persons who are in the
employment of the organisation concerned.
Auditors are appointed by the shareholders of the company. On the other hand, many a
time third parties appoint investigators to conduct a particular investigation. Where a company has
asked for credit facilities from a bank, the bank may order an investigation through an independent
person for finding out the creditworthiness of that company. If a prospective investor wants to invest
his surplus funds in a running business, he may ask for an investigation as to the profitability of the
business and the safety of his funds.
Sometimes investigations are ordered under statutes. Under certain circumstances,
investigations are also ordered under the provisions of the Companies Act, 1956.
Whatever be the objectives of investigation and by whatever agencies these investigations
are ordered, the auditor is best suited for such investigations. Because of his expert knowledge and
experience, the auditor may have no difficulty in accepting such work; he can apply his knowledge
for this purpose also and that too successfully.
26.4 AUDITORS : EXTERNAL AND INTERNAL

External auditors, also known as professional auditors, have qualified in the various
professional examinations. They are the members of the professional body (in India, the Institute of
Chartered Accountants of India). On the other hand, the internal auditors mayor may not be
professionally qualified. Of course, normally they are also qualified.
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Internal auditors are a part of an organisation. They are engaged as employees for the work
of internal audit. On the other hand, external auditors are not employees of the organisation. They are
independent persons. The Companies Act lays down the rights, duties, responsibilities and liabilities
of the external auditors. In the case of partnership firms, proprietary concerns, etc., the rights, duties,
responsibilities and liabilities depend upon the assignment and the contract, as audit is not compulsory
in cases of such concerns.
The internal auditors carry out their duties under the directions and instructions of the employers
or the management. Duties of the external or professional auditors are stated in the Companies Act.
26.5 AUDITING AND INVESTIGATION

Auditing is “concerned with the verification of accounting data, with determining the accuracy
and reliability of accounting statements and reports” (R.K. Moutz in “Fundamentals of Auditing”). It
is, therefore, concerned with the examination of all accounting data from the books of accounts,
vouchers and other documents. On the basis of such an examination, the auditor has to determine
the extent of accuracy of all the accounting statements and reports emerging from such books of
accounts and other records. On the basis of this, he determines the extent of reliability of such
accounting statements and records. He has to report whether the final statements are properly drawn
up. He has to further report whether the balance sheet gives a true and fair view of the state of affairs
of the business as on a day and whether the profit and loss account gives a true and fair view of the
profit or loss for the period under review. Of course, he has to base his report on the information and
the explanations given to him and on the books and records produced before him for his examination.
If he is not satisfied, he has to report at such.
He has, therefore to see that all the transactions are correctly entered in the books of accounts.
He will verify them along with proper evidence that may be produced before him. For the verification
of an entry of sales transaction, he will verify the sales invoice and other evidence. Thus, for determining
accuracy and reliability, he will have to go through the relevant evidence that is produced before him
in support of all the transactions. He has to verify this evidence critically and just not mechanically.
A mere comparison of entries with the evidence is not enough. It is a critical comparison. Thus
auditing is not merely testing the, arithmetical accuracy of the books of accounts, but also evaluation
of all evidence that is produced in support of each transaction. Today the scope of “auditing” is
changing and increasing with the changes in the economic conditions of the country. Today it is not
only a ‘ticking’ profession. The scope of auditing has increased and is increasing year after year.
Audit is not and should not be an investigation. It is not the primary objective of audit to discover
frauds. However, if the auditor finds a cause for suspicion in the accounts, his role changes from
that of a watchdog to a bloodhound. Only then does the auditor perform his duty well.
26.6 OBJECTIVES OF AUDITING
The objectives of auditing can be divided into two broad parts:
(1) The main objective:
Reporting is the main objective of auditing.
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(2) Other objectives:
(i) Detection and prevention of frauds and
(ii) Detection and prevention of errors.
Reporting : The main objective of auditing is to report whether the balance, sheet presents a true
and fair view of the state of affair and the profit and loss account presents R, true and fair view of
the. profit or loss for the financial period. Section 227 of the Companies Act, 1956, enunciates this
objective of auditing. For this .purpose, it is the duty of the auditor to examine the books of
accounts and other records and to verify all, evidence in support of all the transactions entered into
the books of account. This examination helps the auditor in forming .an opinion about the correctness
and the reliability of the financial statements.
The same principle applies to clients other than the limited companies. Of course, the
purpose of audit may vary according to the terms of reference in each case. But in such cases also,
the basic objective remains the same, unless there is some specific objective stated in the terms of
reference.
Other Objectives : Other objectives can broadly be divided into two categories:
(i) Detection and prevention of frauds, and
(ii) Detection and prevention of errors.
While examining the books of accounts and records for the purpose of forming an opinion
about the financial statement, the auditor has always to keep in mind the possible existence of frauds
and errors. These frauds and errors vitally affect these financial statements. However, the discovery
of frauds and errors may be incidental to the main objective.
The objectives of auditing can further be extended depending upon the specific terms of
reference. In the case of internal audit, the objective is also to examine whether the policies and
procedures laid down by the top management are properly adhered to. In the case of propriety
audit, the objective is to .check the propriety of transactions. In case of the operations audit, the
objective is to evaluate the efficiency of various operations and department.
26.7 FRAUDS
Mr. Eric L. Kohler defines a fraud as :
“The successful practice of deception or artifice with the intention of cheating or injuring
another. Ordinarily a fraud involves a willful, misrepresentation, the deliberate concealment
of a material fact for the purpose of inducing another person to do or to refrain from
doing something to his detriment, or the failure to disclose a material fact, thus a person
may be fraudulently misled into giving up claims to property, waiving legal rights or entering
into a disadvantageous contract.”
(“A Dictionary for Accountants”, Fourth Edition, page 201.)
Thus a fraud may involve misappropriation of money, goods or any property. This act of
committing a fraud is wilful. A fraud may also involve the manipulation of accounts. It might be a
wilful misrepresentation It might be a concealment of important and material facts. A fraud is, therefore,
an act or instance of deception.
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When the business is small there are fewer chances of fraud of the first type. The owner
himself manages the whole affairs. He has no reason to commit such a fraud. Even in such cases
where the owner has delegated the management of cash or goods or property to another person,
the personal touch and supervision of the owner always exist. And hence, the chances of such frauds
are rare. But where the business expands beyond a limit, the owner is separated from the management.
Business complexities and routine work increase manifold. The management of cash, goods and
other property is left with the paid assistants. Thus chance of frauds are more in such circumstances.
The owner has therefore to entrust the work of detecting and preventing such frauds to the independent
auditor. The management divides the work an10ng each member of the staff in such a manner that
the work of one is. automatically checked by the other in the normal course of business. This is
known as internal check. Before the auditor takes up his work, he will find out the extent and
effectiveness of the internal check in the organisation. He has to find out the weakest points of the
Management. The weakest points are those centres where the internal check does not exist or is
inadequate. The auditor will have to concentrate more in that section. While auditing the transaction
emanating from such section, the auditor will have to pay more attention. However, the auditor is not
an insurance against frauds. But if he is entrusted with the work specifically for detecting frauds, it is
his duty to do so. Under Honnal circumstances, detecting of fr1uds and errors is not the main
object but an incidental object.
But even for the fulfillment of the main objective, the auditor will have to keep in mind this
incidental objective. The existence of a fraud means wrong statement at one place or the other which
in turn effects the financial statements. Some part of such statements may be stated wrongly as the
result of a fraud. Many frauds affect reliability and the correctness of the financial statements. Thus,
the auditor will have to keep in mind the possibility of frauds while auditing. Once he suspects the
existence of a fraud, it will be his duty to probe unto its roots and unearth or discover the fraud. On
page 11 of the “Statement of Auditing Practices” (1968 Edition), issued by the Institute of Chartered
Accountants of India, it is stated that “while an audit under the Companies Act is not intended and
cannot be relied upon to disclose all defalcations and other irregularities, their discovery may be
incidental to such an audit.” So long as the auditor acts honestly and carefully and follows generally
accepted or recognised normal auditing procedure or standards, he will not be responsible for
frauds even if he has not discovered these frauds.
Where the system of internal check is efficient the chances of frauds are rare because the
work of each person is checked by another. Unless there is collusion of two or more persons, the
chances of frauds in such cases are remote. And the collusion itself is difficult as one day or the
other, it is bound to be leaked out. Thus two or more than two persons are kept simultaneously at
the weakest link. But the existence of internal check is not the full insurance. Frauds may still take
place. The transactions may be tested depending upon the circumstances. If the auditor finds
anything irregular during the test check, he must abandon the test check and examine the books
fully in greater detail.
Some of the instances of frauds involving misappropriation of money, goods or property
may be enumerated as under :
(i) Inclusion of fictitious payments ;
(ii) Entering payments more than actually made ;
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(iii) Omission of cash receipt ;
(iv) Recording receipts less than actually received ;
(v) Misappropriating the cash of the company without recording the payment or without omitting
receipt. Here the actual cash balance will not tally with the cash balance as shown by the
cash book.
(vi) Misappropriation of goods by entering fictitious purchase invoices of large quantities and
getting delivery of a lesser quantity, thus receiving the balance quantity privately; and
(vii) Issuing a quantity of goods more than invoiced. This is in collusion with the other party.
The other type of fraud involves 111anipulation or falsification of accounts. This is also wilfully
done for the purpose of misrepresentation. The position of the company may be shown better or
rosier than what it is dividend. This may be to show success of the management or to maintain
confidence of shareholders, investors, lenders and creditors. It might be for the personal benefit of
the managers, etc. If profits are more, the commission -that may be given to them will be more.
Hence, they are interested in showing larger profits. In such cases, the trusted men themselves are
involved in the fraud. The persons enjoying the maximum confidence of the management are responsible
for such frauds because of their own personal interest. They commit the fraud willfully and intentionally.
Where the position is shown rosier than what it really is also known as “window dressing.”
In order to show a large amount of fixed assets and to show more profit, depreciation may
not be provided or inadequate depreciation may be provided. Similarly, the closing stock may be
overvalued. On the same lines, to show more profits, purchases may be suppressed and the sales
may be inflated. Revenue expenses may be shown as capital expenditure. Similarly, to show more
profit, items of provision for outstanding expenses may be suppressed. Alternatively, such a provision
may be inadequate. Certain expenses may also be suppressed. Conversely, income which will be
received in a subsequent year may be credited in the current year in order to inflate the profit for the
year.
The above are some of the examples of frauds that can be committed by the trusted men or
the persons responsible for the management.
At times, the purpose of manipulation of accounts may be quite opposite. The examples
described above are the instances for inflating the profits. But sometimes, the various fraudulent
manipulations may be completely for the opposite purpose. The persons concerned may want to
show smaller profits than what they actually are. If profits are concealed, the real worth of the shares
is not properly known to the shareholders and the share market. This method of reducing profit is
also resorted to avoid business competitions. The idea is to give a wrong impression to the
competitors. The most important reason for showing lesser profit is to reduce the incidence of
Income-tax.
The above discussion on frauds can be summarised thus:

Frauds can take place in one or more of the following forms:
(1) Misappropriation of cash or embezzlement of cash :
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(a) by suppressing the receipts, e.g.,
(i) Suppressing cash sales,
(ii) Teeming and lading,
(iii) Not recording receipts of a casual nature,
(iv) Not recording or short-recording sale proceeds of assets which
are already fully written off, and
(v) Writing off of certain book debts or advances though received
and not recording such receipts.
(b) by inflating payments, e.g.,
(i) Recording fictitious payments,
(ii) Recording amounts more than actually spent,
(iii) Not recording discounts and allowances, and
(iv) Showing wages paid to “Ghost” or “Dummy” workers.
(2) Misappropriation of goods.
(3) Services rendered but not accounted for.
(4) Manipulation of accounts and falsification of accounts, e.g.,
(i) Recording fictitious sales by the Manager or Director to earn more
commission.
(ii) Falsification of accounts to deceive shareholders, creditors, bankers, etc.,
(iii) Showing more profits than the actual in order to declare a dividend wrongly.
(iv) Showing less profits than the actual to avoid taxes and to deceive
shareholders, etc.
Window Dressing The company sometimes may present its financial statements in such a manner
that the picture or the position is shown rosier or better than what it is. This is known as “window
dressing.” The financial position is shown more improved. It is different from a fraud which may
involve recording of fictitious transactions. Window- dressing is more in the nature of a
misrepresentation.
Window dressing may be accomplished in more than one ways, the important ones of which are as
under:
(1) The income and sales of a subsequent period are recorded in the current year. The cash
position or liquidity is shown better.
(2) Goods in transit are not recorded and are shown as sales.
(3) Loans given to Directors and other officers, etc., during the current year are received back
and again given in the beginning of the subsequent year.
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(4) Revenue expenditure is recorded as capital expenditure, or deferred revenue expenditure in
certain cases. (5) Suppressing purchases and entering them in the subsequent year. (6)
Providing short liabilities and-depreciation.
26.8 ERRORS
As discussed earlier, one of the incidental objectives of auditing is not only to detect
errors but also to prevent a recurrence of such errors. Some errors are the result of human lapses
and are not intentional. Errors are something incorrectly made through ignorance or inadvertence.
But certain errors are the result of wilful manipulations which are frauds.
Under any circumstances, the auditor has to take enough care to see that most of the
errors are detected during the course of audit, though auditing is not an insurance against errors.
This may not be the ‘position in case of proprietary firms and partnership, where detection of
errors and frauds may be the most important objective.
Errors may be classified as under:
(1) Errors of principle ;
(2) Errors of omission ;
(3) Errors of commission ;
(4) Errors of duplication ; and
(5) Compensating errors.
Errors of Principle. Errors that take place for not recording transactions according to the
fundamental principles of book-keeping or accountancy are the errors of principle. The valuation
of stock, which is not made as per the basic principles of accountancy, will not be a correct valuation.
If depreciation is not provided as per the rules, the provision is not correct. Recording revenue
expenditure as capital expenditure is wrong. Conversely, recording capital expenditure as revenue
expenditure is also wrong. These errors are errors of principle. Such errors are sometimes committed
intentionally also with the object of manipulation of accounts. The ultimate purpose may be to show
fraudulently more profit or less profit. Thus errors of principle have an ultimate effect on the profit
for the year. If more depreciation is provided, the profit is reduced. If capital expenditure is shown
as revenue expenditure, then also the profit is reduced. Where there is undervaluation of stock,
then also profit is reduced. On the other hand, where revenue expenses are recorded as capital
expenditure or where inadequate depreciation is provided or where closing stock is overvalued,
the profit is inflated. The profit is shown more than what it actually is.
Effects of errors of principle are the same even if they are not committed intentionally.
Such errors are not disclosed in the trial balance. The trial balance will agree in spite of such errors.
These errors are not located by just checking arithmetical accuracy or just by checking totals,
postings and castings. They can be detected only by going in details in each and every transaction.
One must have an inquiring or investigating mind for locating such errors. As a matter of fact, an
auditor must be very careful about such errors. Only careful checking will help him in detecting
these errors of principle. In one case expenditure for the construction of a swimming pool was
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debited to the repairs account. This was found out when the auditor examined the Directors minute
books wherein the decision to construct the swimming pool was recorded. After reading this
resolution, the auditor inquired whether such a swimming pool was at all constructed. At this time,
it was found out that expenditure on the construction of the swimming pool was debited to the
repairs account.
The following are examples of errors of principle:
1. Recording revenue expenditure as capital expenditure;
2. Recording capital expenditure as revenue expenditure;
3. Provision of excess depreciation;
4. Provision of inadequate depreciation;
5. Non-provision of depreciation;
6. Wrong provision for outstanding expenses;
7. Wrong adjustment of prepaid expenses;
8. Wrong provision of income accrued but not received;
9. Overvaluation of stock;
10. Under valuation of stock; and
11. Wrong provision for bad and doubtful debts.
From the above list, it can be seen that such errors have an effect on the profit for the
year. They simultaneously affect the state of affairs of the company also. In other words, the effect
is on the reliability of the financial statements which are reported upon by the auditors as discussed
earlier.
Errors of Omission. Sometimes a transaction is omitted fully or partially while writing
books of account. For example, while recording purchase book, one bill received from the supplier
may be completely omitted. Similarly, one or more sales invoices might be omitted completely
while writing the sales book. Such errors are known as the “errors of omission.”
Here, the transaction is omitted while writing .the books of account; when a whole
transaction is omitted, both the debit and credit aspects are omitted, for any transaction, its debit
aspect is always equal to its credit aspect. It means both the debit and credit aspects of the
transactions are omitted and they are omitted equally. It will not, therefore, affect the tallying of
the trial balance. When a purchase transaction is omitted, the debit to the purchase account is
omitted and correspondingly an equal .credit aspect of the supplier is also omitted. Thus, both the
debit and credit, aspects are equally omitted and the arithmetical accuracy of the trial balance is
not affected.
As it has no effect on the trial balance, it is difficult to locate such errors.
Some errors of omission are, on the other hand, easy to locate also Salary is paid once in
a month. Thus there must be 12 entries on the debit side of the salary account. If water bills or
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property taxes are paid once in every quarter, there must be four items in a year. Similarly, for the
payment of monthly rent, there must be 12 items in a year. If the number of entries are less than the
number as discussed above, the auditor can easily find out the omission of an item.
But sometimes it is difficult to locate errors of omission, for a purchase transaction is
difficult to locate. On the other hand, the omission of a sales transaction is not difficult. All sales
invoices are consecutively numbered in any series. Attention is always drawn if there is any break,
in the series. A break may be due to the cancellation of an invoice or may be: due to an omission
in recording. But this is not so in the case of purchases. The suppliers are many. The same supplier
sells to many other parties also. Hence, the control through invoice numbers is very difficult. Only
while scrutinising the party’s ledger, one can locate such errors. After all, the supplier will demand
his dues in time. And when the payment is made, the account of the supplier is debited. Then, in
the account of the supplier there will be only debit without any corresponding credit. Hence, the
attention of the auditor is invited to the debit balance of the supplier. This will help in locating the
transaction which has been omitted from the books of account.
If any entry is recorded and both the debit and credit aspects have remained unposted in the
ledger, then also the effect is the same as that of errors of omission, as if the transaction is not
recorded in the books of original entry. While checking posting into the ledger, the auditor must
glance through the books to see whether any item has remained unposted into the ledger.
Errors of Omission may be intentional or otherwise. They have effect on the profit or loss
for the year.
Errors of Commission. Here the transactions are recorded in the books of original entry. Maybe,
the amount in the original entry is wrongly recorded. The amount of Rs. 215 might be entered as Rs.
125 in the books of original entry. While vouching the purchases with the original invoices, such
errors can be located and rectified. If the error is committed in the books of original entry, it might not
affect the trial balance. If a purchase transaction is wrongly entered into purchase book, the purchase
account is debited with a wrong amount and the supplier’s account is also credited with the same
wrong amount. Hence, no effect on the trial balance.
But some other types of errors of commission do affect the trial balance. There might be a
totalling mistake or a casting mistake. As a result, the balance or the total of a particular account will
be wrong Sometimes posting is made of a wrong amount. The original item of Rs. 415 may be
posted wrongly as Rs. 514. Similarly, 3n item of debit may be wrongly debited on the wrong side of
the account. Instead of debiting an account by Rs. 415, the same account is credited by Rs. 514.
Here two mistakes are completed simultaneously, i.e., the wrong amount is posted and, secondly,
the posting is done on the wrong side. Such mistakes have an effect on the trial balance.
There are other illustrations of such errors. A purchase transaction may be entered wrongly
in the sales book or the purchase returns book or the sales returns book. The effects are wrong.
But the trial balance will tally. There is a- wrong recording of a transaction from the very inception.
A purchase is recorded as sales Goods account is credited and the corresponding amount is
debited to the personal account of the supplier. In fact, the supplier’s account should have been
credited and the goods account should have been debited. Similarly, the sales return might have
been recorded as the purchase returns from the very inception. Such mistakes can be located
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while vouching sales books, purchase books or returns registers. If not detected at that time, the’
errors can be located while scrutinising the party’s ledger account.
Sometimes some adjustment entries are recorded wrongly. An entry for commission
receivable might be recorded as if the same were for the commission payable. Such errors can be
located while vouching the transaction with the original supporting’ evidence.
Thus, some errors of commission have an effect on the trial balance. While some errors of
commission do not affect the trial balance.
Errors of Duplication. Where the same transaction is recorded twice by the clerk concerned, the
same is also posted twice in the ledger. Both the debit and the credit aspects are posted twice in the
ledger. Therefore, the trial balance will agree. It, therefore, cannot be easily located through the
trial balance. While vouching the original entry with the voucher, one entry will remain unvouched.
Thus, the mistake can be located.
It is always desirable to give full particulars and details against each entry. If a purchase
invoice is recorded twice, it can be located through the number of the relevant invoice. Many times,
the supplier sends the invoice in duplicate. The auditor should see that the duplicate invoice is also
not recorded.
It is also advisable to mention the invoice number while crediting the supplier’s account in
the ledger. Similarly, while making the payment to the supplier, the number of the invoice against
which the payment is made may also be entered on the debit side of his ledger account. While
scrutinising the supplier’s ledger account, such an error of duplication can be located as there will
be an additional entry. The double payment made in respect of the same bill can also be so located
through the scrutiny of the ledger account.
Therefore, more care is required to locate the errors of duplication. These are not easily
traceable through the trial balance.
Compensating Errors. Sometimes the effect of one error is counterbalanced or compensated by
the effect of another error or errors. Such errors are called “compensating errors”. They are also
known as offsetting errors because the effects are off-set. The trial balance will agree though two or
more; errors still exist.
A supplier’s account was credited by Rs. 10 instead of Rs. 100. There was a short credit of
Rs. 90. Another account, say, another personal account or nominal account, is debited by Rs. 10
instead of Rs. 100. Thus, there is a short debit of Rs. 90. Thus there is simultaneously a short credit
and a short debit of Rs. 90 each. Both the sides of the trial balance are equally affected. These are
compensating errors.
Let us take more illustrations. Mr. A’s account is, debited more by Rs. 100. On the other
hand, the amount of Rs. 100 received as rent is posted twice to the rent account. Thus the excess
debit in Mr. A’s account is compensated by an excess credit in the rent account. On the other hand,
Mr. A’s account is debited less by Rs. 100, and one entry of Rs. 100 in respect of rent received is not
posted to the credit of the rent account. A short debit of Rs 100 in A’s account is compensated by the
short credit in the rent account. The purchase book is totalled excess by Rs.200. Thus, the purchase
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account will be .debited more by Rs. 200. Simultaneously, while totalling the ledger account, the
credit side of the commission account was totalled more by Rs. 100. The travelling expenses account
was totalled short by Rs. 100. There are three different mistakes. Debit to the purchase account is
more by Rs. 200 ; debit to the travelling account is less by Rs. 100 ; and credit to the commission
account is more by Rs. 100. Errors are so committed that the trial balance will agree though there are
three errors. They are all compensating errors. Excess debits in one or more accounts are compensated
by excess credits in one or more accounts. The trial balance will continue to agree. It will be difficult
to locate such errors.
While checking the totals, postings and castings, the auditor can locate these mistakes. After
rectifying these three mistakes, the trial balance will again agree. Some compensating errors may
affect the profit or loss of (he year, while others may not.
26.9 DETECTION OF ERRORS

If the trial balance does not agree, it means that there are clerical errors. Detection of such
errors should be taken up in the following stages :
(1) First, check up the totals of the trial balance again. It is quite likely that there may be errors
in the totalling of the trial balance itself.
(2) Then find out the actual difference in the trial balance. Halve this difference. See whether any
item of debit side with that amount is wrongly entered on the credit side. It may be that any
item of the credit side with that-balance is entered wrongly on the debit side.
(3) See the nature of certain accounts. There are certain accounts which must have debit balances,
whereas certain accounts must have credit balances. In case of a limited company, the share
capital account must have a credit balance. Similarly the share premium account has always
a credit balance. Accounts of allthe reserve have credit balances, e.g., the General Reserve,
the Reserve for Doubtful Debts, the Capital Redemption Reserve, the Development Rebate
Reserve, etc. There is only one exception. The reserve for discount on creditors is a debit
balance being the reserve in respect of discount receivable from the creditors. Provisions for
all expenses are credit balances. Debtors have debit balances. Fixed assets have debit
balances. Thus, see the nature of all accounts and see that they are placed in the proper
column of the trial balance.
(4) If the errors are still not detected, check up again the balances of ledger accounts with the
trial balance.
(5) Check up the totals of the ledger accounts. See also the carry forwards to the next page.
(6) Verify that no entry of the books of original entry has remained unposted. In other words,
see the cash book, the purchases book, the sales book, the journal, etc., and verify whether
there is any item which has remained unposted.
(7) Verify the totals of all the books of account.
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(8) Verifying the opening balances of the ledger with the previous year’s final trial balance. Similarly,
the opening cash and bank balances should be verified with the same trial balance. Also see
that the trial balance of the opening balances agrees. If there is any difference in the opening
trial balance, then there will be same difference in the closing trial balance also.
(9) Check up again the posting of entries from various books into the ledger again.
(10) Where the difference in the trial balance is divisible by 9 (nine), then the difference may be
due to. the misplacement of consecutive digits of any figure, e.g., 45 may be posted us 54,
56 as 65, 78 as 87, and so on. The error of a round sum like 1, 10, 100, 1,000, etc. may be
normally due to mistakes in totalling.
(11) See that all the transfers from one account to another are done through journal entries.
Verify whether there are mistakes in the direct posting, if any.
(12) Verify the journal entries. See that the total of the debit aspect of all journal entries is equal to
the total of credit aspects. It may happen that the mistakes may be on account of such wrong
journal entries.
(13) Where the books are maintained on a self-balancing ledger or where there are control
accounts, see that the balances in the control accounts tally with the totals of balances in the
respective personal ledgers, like the customer’s ledger, the supplier’s ledger or the deposit
ledger.
26.10 ADVANTAGES OF AUDITING

1. As discussed earlier, audit helps in
(a) dectecting and preventing errors, and
(b) detecting and preventing frauds.
2. The accountants and other staff know in advance that the auditor is going to visit them and
check their books and records. This fact keeps them vigilant. The work is normally kept up-
to-date.
3. As the work is kept up-to-date, the information that is required by the management is always
available as and when demanded. This in turn helps the management to study in time the
financial position of the company and its result. This facilitates in planning the financial affairs.
4. Audited accounts help the company in more than one way. Incase of losses by fire or
burglary or similar reasons, the claims can be lodged without much difficulty.
5. Financial institutions and; bankers always prefer the audited accounts. Bankers prefer audited
accounts even in the case of partnership firms and proprietary concerns. They know that
where the accounts are audited, they are authentic and reliable.
6. Where the accounts are audited, the owners of the business and management can get
professional advice as and when required from the auditors who are well-informed of the
financial affairs.
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This advice may be in the matter of accounting or in respect of taxation and other legal
matters.
7. Where the books of accounts are audited, the final accounts and the financial statements are
uniformly prepared. Where the financial statements are uniform over years, their comparison
is facilitated.
8. Audited accounts are normally preferred by the income-tax and the sales-tax authorities
even in the case of non-corporate concerns. The filing of necessary returns becomes easy.
As the accounts are properly classified, all information can be easily located and compiled in
time.
9. In the case of a proprietary concern, audited accounts will be more useful for valuation
purposes while admitting a partner.
10. Similarly, audited accounts are more convenient in a partnership firm where a new partner is
admitted or where a partner retires. Even the calculation and the settlement of the claim of a
deceased partner is facilitated.
11. In the case of the sale of a whole concern as a going concern to another party, the audited
accounts will help in finding out the worth of the business. Assets and liabilities can be valued
properly. Even the valuation of goodwill can be made by an independent person without
any difficulty.
12. In case of manufacturing concerns, audited accounts are more reliable for the purposes of
data for casting purposes for finding out the cost of a product.
13. Because of the advantages of audit, the partnership firms or proprietary concerns also get
their books of account audited. The owners are assured of the correctness of their accounts.
The sleeping or the dormant partners are then satisfied that there are no frauds.
14. Audit safeguards the interests of the workers, owners, investors and creditors. It also
safeguards the interests of the government for various tax purposes. Audited accounts are
useful for the purpose of settling trade union disputes. Profit’ and the trend of profitability
will ‘be easily relied upon if the accounts are audited in case where there are employer-
employee disputes.
15. Audit is sometimes directed towards an investigation into the productive uses of raw materials
and scarce resources. It thus helps in detecting the wastages and hidden losses. In the absence
of internal audit and internal check, the statutory audit can be really useful in this direction. In
other words, audit reviews the weaknesses and the inefficiencies that are disclosed from the
books, records and other financial statements.
16. For the purposes of issue of various licences, the government requires the audited accounts.
26.11 LIMITATIONS OF AUDITING

Though auditing, has its advantages, it has its limitations too. An auditor has to depend on the
books of accounts and other records presented before him. If these accounts are prepared with
476
malafi4e intentions and for that n1anipulations are committed, the auditor may not fully unearth, them.
Auditing may not reveal such manipulations fully.
Sometimes, the auditor has to depend upon the opinion of the experts of other subjects.
Many a time he depends upon the legal opinion. The auditor is not expected to be an expert in all
fields. He may rely upon the certificates issued by engineers or architects.
The purpose of auditing is- well served, if there is independence of auditors. Under the law,
the shareholders appoint the auditors for the company. ‘In reality, the directors appoint their auditors.
Auditors depend upon the explanations and information given by the clients or their responsible
officers. The Companies Act, 1956, also provides that such officers must give correct information.
But it is quite likely that such explanations and information may not be correct. This affects the report
of the auditors.
While preparing the financial statements, certain principles are applied. Depreciation is
calculated as per prescribed rules but in reality, the machinery may have depreciated more or less.
According to the information, certain amounts of debtors may be considered doubtful of recovery.
In reality, the bad debts n1ay be more than the provision f<?r doubtful debts. After all, these are the
points which require judgment. But judgment will depend on so many factors. These factors do not
remain constant. This affects the financial statements and the auditors’ report thereon. Thus, the
audited accounts may not be fully correct at times. The purchasing power of the rupee changes. The
financial statements do not reveal the present value of the assets and liabilities. Inflationary’ trends are
not taken care of. The audited statements, therefore, may not disclose the reality.
26.12 QUALITIES OF AN AUDITOR
(l) Under the Companies Act, 1956, the auditor of a company must be a chartered accountant
holding a certificate of practice issued by the Institute of Chartered Accountants of India.
(2) The auditor, being a chartered accountant, is considered an expert. He is expected to
possess exhaustive knowledge of accounting and other allied subjects. His knowledge of
accounting and. its principles and techniques should be sound.
(3) He must be familiar with commercial laws like the Contract Act, the Partnership Act, in
addition to con1pany law and taxation laws: He must have the basic knowledge of industrial
laws also. Where a company is governed by a special statute, the knowledge of such a statute
is a must.
(4) He should be equipped with the necessary information, and special features peculiar to the
business of his client. He is, of course, not expected to be a technical person.
(5) He must be up-to-date in respect of case laws affecting audit and the auditors. This will
help him in understanding his rights, duties, powers, responsibilities and liabilities as an auditor.
(6) He must have an a1ert mind. He must use his experience and observation. Only a person
with common sense can achieve this.
(7) “An auditor must be honest, i.e., he must not certify what he does not believe to be true;
and he must take reasonable care and skill before he believes what he certifies is true.”
(Lord Justice Lindley in re. London and General Bank, 1895)
(8) He must be vigilant and cautious. He should be able to discharge his duties boldly, faithfully
and honestly.
477
(9) He should not disclose the secrets of his clients.
(10) He should be clear and unambiguous in his reporting.
26.13 SUMMARY
Audit does not mean “checking the totals” or “ticking”. It does not mean merely checking
the arithmetical accuracy. It does not mean even checking of cash or stock or any other asset or
liability. It is not merely detecting frauds or errors. Auditing considers something much more than this.
The term ‘audit’ is derived from the Latin term “audire” which means to hear. Initially, the auditor
used to hear” the accounts of the accountants. Book-keeping is the art of recording all the day-to-
day transactions in the books of account. Accounting is the art of recording and classifying and then
summa rising these transactions which are of a financial character. The summary will be in the form of
financial statements. Auditors are, sometimes, concerned with investigations but audit should not be
mixed up with investigations. It is not a part of the auditing function. The main objective of auditing is
to report whether the balance, sheet presents a true and fair view of the state of affair and the profit
and loss account presents are true and fair view of the. profit or loss for the financial period. The
company sometimes may present its financial statements in such a manner that the picture or the
position is shown rosier or better than what it is. This is known as “window dressing.” Though
auditing has its advantages, it has its limitations too.
26.14 KEY WORDS
Audit is derived from latin term ‘audire’ which means to hear
Book-keeping is the art of recording all the day-to-day transactions in the books of accounts.
External auditors also known as professional auditors.
Errors are something incorrectly made through ignorance or inadvertence.
Fraud might be a willful misrepresentation
1. Explain the term auditing and discuss how it differs from accountancy.
2. Define auditing and explain the objectives of auditing.
3. What do you mean by a fraud. Enumerate the various forms under which a fraud can take
place.
4. Discuss various types of errors.
5. What do you mean window dressing ?
6. Discuss various advantages and limitations of auditing.
7. Enumerate the qualities of auditor

1. Cost and Management Audit V.K. Saxena and C.D.Vashista Sultan chand & Co, New
Delhi
2. Cost and Management Audit A.R. Ramanadham Tata MC-Hill, New Delhi.
478
GUIDELINE 27 : COST AUDIT
OBJECTIVES

· the term cost audit and objectives
· various appointing authorities of cost auditor
· various advantages of cost audit
· cost audit programmes
STRUCTURE
27.1 Introduction
27.2 Objectives
27.3 Appointing Authorities
27.4 Advantages of Cost Audit
27.5 Organisation for Cost Audit
27.6 Cost Audit Programme
27.7 Areas of Cost Audit
27.8 Summary
27.9 Key words
27.1 INTRODUCTION
The term. ‘audit’ means examination of books of accounts and vouchers so as to ascertain
their accuracy. Cost audit has been defined as the verification of the correctness of cost accounts and
a. check on the adherence to the cost accounting plan.
The Institute of Cost & Works Accountants of India defines cost audit as “an audit of efficiency
of minute details of expenditure while the work is in progress and not a post-mortem
examination…………… Financial Audit is a ‘fait accompli’. Cost Audit is mainly a preventive measure,
“guide for management policy and decision, in addition to being a barometer of performance.”
27.2 OBJECTIVES
Broadly, there are two aspects of Cost Audit, viz, -
(a) the protective aspect, and
(b) the constructive aspect.
479
Protective aspect will deal with proper ascertainment and control of cost by :
(i) detecting errors, e.g.-errors of omission and errors of commission;
(ii) verifying that cost accounts are correctly maintained in conformity with accepted
cost accounting principles adopted in the industry, and
(iii) ensuring that the cost accounting routine laid down is properly carried out.
Of late, mechanical devices are being increasingly used in accounting and the auditor can
safely rely on the arithmetical accuracy or the figures. But that does not relieve the auditor from
exercising greater care in checking the original sources from which the various entries and transactions
emanate.
So far as the constructive aspect is concerned, a great deal will depend upon the attitude of
management and/or the appointing authority and the scope of audit. In short, the auditor will act here
in an advisory capacity for the well-being of the owners of the -company. His function may thus
extend to judging:
(a) whether or not the existing procedures are adequate and effective: to the management for
making decisions;
(b) whether or not the projected expenditure could give optimum results;
(c) whether the money invested in one type of investment could be more profitably invested in
another;
(d) whether the return from capital employed is adequate: if not, whether it can be bettered.
Sometimes, the constructive aspect of the cost audit is known as ‘Propriety Audit’. Propriety
and efficiency audit1 are therefore considered as the two important aspects of cost
audit. It is needless 10 point out that these can be better conducted by a professional
expert having mature wisdom and sound judgment.
27.3 APPOINTING AUTHORITIES

A cost auditor may be appointed by
(i) External ‘authorities such as
(a) Government,
(b) Trade Association,
(c) Tribunals etc., and
(ii) Internal authorities, i.e., management.
(a) Government : The Government may appoint a cost auditor where it is necessary
1. ‘so to do’ in the opinion of the Government (see Cost Audit in India),
2. to ascertain correct cost of contract given to private industries under ‘cost-plus
contracts’ ;
3. to give protection to certain industries as a matter of government policy and for the
interest of the public at large;
480
4. to fix fair prices of certain commodities so as to prevent undue profiteering.
(b) Trade Association: The appointment of auditor in this case’ will be largely influenced
by the authority vested in the trade association by the members of the association concerned. Here
the auditor may be ‘appointed to-
1. ascertain comparative profitability of its members;
2. determine minimum prices to stop undesirable neck and neck price-cutting race
among its members.
(c) Tribunals: Sometimes, audit of cost accounts may also be directed by Labour
Tribunals to settle trade disputes for more wages bonuses, share in profits, etc. or by Income-tax
Tribunals to assess. Correct profits for assessment purposes.
27.4 ADVANTAGES OF COST AUDIT

1. Cost audit win assist in detecting errors and malpractices preventing fraud and manipulation.
Of course, these are achieved by each type of audit. Cost audit will definitely help to improve
cost accounting methods and techniques and. will facilitate internal control by highlighting points
job exceptions.
2. The cost data if audited will gain a high degree of reliability and hence can be more effectively
used for inter-firm comparison.
3. Cost audit will be distinctly advantageous in increasing productivity, rationalising operations
and effecting savings. Like industrial engineers, cost experts would pay for themselves several
times over in any sizeable undertaking. Their services will help to pinpoint the concrete reasons
for the heavy losses incurred at present by many of the public sector undertakings.
4. It wil1 bring more confidence on the costing data and hence will facilitate taking important
decisions.
5. The external cost auditor with his varied knowledge, mature wisdom and s und judgment can
suggest improvements to the management and also help the cost accountant in many complicated’
matters.
6. Cost audit will help the work of statutory financial audit inasmuch as the financial
auditor may rely on many important costing data such as cost of closing stock, raw
materials, work-in progress or finished goods. In financial accounts stock is to be
valued at cost or market price whichever is lower. The actual cost of closing stock is
reliably available from costing books only. In other matters, like payment of commission
on gross profit, production bonus to staff, managerial remuneration on departmental
profits etc. the data supplied by cost accounts, may be safely relied upon by the financial
auditor. The task of the financial auditor will therefore become more easy if the cost
accounts are audited.
27.5 ORGANISATION FOR COST AUDIT
No standard pattern can be laid down for the organisation of the cost audit function. It will
be influenced by the size and nature of business, existing system and attitude of the management
concerned.
481
In large companies, there will be an internal audit department which is generally vested with
the work of cost audit. Internal auditor in such a case will conduct cost audit in addition to other
functions. Of course, in large units, there may be a separate “Organisation and Methods” department
in addition to Internal Audit Department. In that case, the Internal Audit Department will perform the
protective aspect of cost audit while the Organisation and Methods Department will be responsible
for constructive aspect. It may be noted that there is no consensus of opinion on the division of
responsibilities of these two departments. But it may be stressed that these two departments should
work together for the overall benefits of the concern.
In small concerns, it may not be possible to have a separate internal audit department. If
that is so, one or two internal auditors may be appointed. They will be responsible to the top
management and will perform cost audit in addition to other internal work.
27.6 COST AUDIT PROGRAMME

Who ever conducts cost audit, it should be done in a systematic manner. Therefore, a plan of
operations should be carefully drafted. Such a plan will ensure that the work is executed at right time
and at minimum cost. while planning the programme or procedure for cost audit, the following points
are to be taken into consideration.
(1) Whether partial or complete audit: Cost audit may be partial or complete depending upon the
objective and appointing authority. Whether this is confined to only some or all the item s and
aspect s of the system should be ascertained first.
(2) Frequency of audit: In some concerns the audit may be carried out periodically while in others
it may be a continuous and concurrent audit. Periodical audit is one which is taken” up at the
close of the financial year when accounts have been prepared. Continuous audit involves detailed
examination of books of accounts at some regular intervals. Therefore, the frequency of audit
should be determined having regard to object of audit, areas to be covered, volume of
transactions, efficiency of internal audit and so on.
(3) Audit Notes: This refers to a written record of queries made, replies received thereto and
correspondence, if any, entered into during the course of an audit. Every auditor has, therefore,
to I maintain one Audit Note Book.
(4) Questionnaire: Questionnaires are genera1Jy issued by the auditor to the appropriate authorities
so as to receive a reply to each question in the form of ‘yes’ or ‘no’. This gives the auditor a
complete idea as to the system and procedure followed. For example, questionnaires in
respect of material and labour may be stated as follows:
(A) Questionnaire on Material :
1. Are incoming materials checked as and when received?
2. Are Goods Received Notes written up for all incoming materials?
3. Are Bin Cards entered regularly from Goods Received Notes?
4. Are materials properly kept in the appropriate bins, racks etc.?
5. Are materials issued against authorised Requisition Notes?
482
6. Is each return of materials to the stores covered by Material Return Note or Stores
Debit Note?
7. Is material transfer from one shop to another made on the basis of authorised Transfer
Note?
8. What is the basis for pricing material issues to production?
9. Is the perpetual inventory system in existence?
10. Does the physical stock agree with book figure?
11. Does it take into account the following?
(a) Optimum Order size,
(b) Store and handling costs,
(c) Lead-time.
12. Are there any obsolete and slow-moving items in stock?
13. Are all losses and gains reported to management in time ?
14. Does the entire system of recording and control involved too many forms and too much
paper work?
(B) Questionnaire on labour :
1. Are the attendance records ‘completed and checked daily ?
2. Are gate passes used for workers going out of the factory during working hours or on
short leave ?
3. Is there proper time-keeping and time booking method using modern time recording
devices ?
4. Is reconciliation between gate time and job time made at regular intervals ?
5. Is overtime work, if any, properly sanctioned by appropriate authority? Are the overtime
records maintained along with attendance records ?
6. Are payments to the workers made on the due date and in presence of foreman or shop
supervisor ?
7. Is payment to absent workers made only through the absentee payment register?
8. Is there any system of internal control regarding preparation and payment of wages?
9. Is leave to workers granted by proper authority? Is the leave register properly maintained?
(5) Audit Methodology: This includes:
(a) Vouching:. i.e., inspection by the auditor of the documentary evidence which
substantiates a transaction.
(b) Checking and ticking: This includes checking of all cal culations and postings and
marking and initialing them with a coloured pencil or ink.
(c) Test checks: This is nothing but application of the principles of sampling to reduce the
volume of work so as to save time. When there is an efficient system of internal control,
483
the auditor can rely more on test checking but thereby he cannot shirk his own
responsibilities.
(6) General : The cost auditor should also cover the fol1owing points in his programme while
undertaking the cost audit in an undertaking:
1. Study the basic structure of the unit.
2. Find out the types of products, production during the period, installed capacity
utilised and the reasons for any underutilisation of capacity.
3. Study the contracts, agreements and other arrangements with the collaborators, if
any, and ancillary units.
4. Get acquainted with the manufacturing processes.
5. Study the organisation chart and the levels of authorities for various purposes.
6. Study the cost accounting procedures and see whether the same are adequate
and whether the records kept are in conformity with the Cost Accounting principles
and practice and statutory provisions, if any.
7. See whether standard costing and budgetary control systems are in operation and, if
so, whether the same are adequate.
8. Check up the existence and effectiveness of internal conttols.
9. Locate the key/limiting factors of the company and examine whether the same are
being utilised to the maximum extent.
10. Check the system of classification/codification of the materia1, cost centres,
overheads, etc.
(7) Audit Report: On completion of audit, an auditor has to submit his audit report incorporating
a certificate regarding the correctness or otherwise of accounts along with his suggestions, if any,
for improvements in the operation. The report should be concise and submitted to the appropriate
authorities in right time to be of effective use to the parties concerned. It should comply with
statutory provisions, if any
27.7 AREAS OF COST AUDIT

Cost audit is concerned mainly with. propriety and efficiency audit. It, therefore, covers all
the areas of production, sales and other management functions. Some of the areas which may be
examined by the cost auditor are mentioned below.
(I) Raw Materials:
(1) Procedure in purchasing raw materials and that on receipt and issues. The auditor win
thoroughly examine all receipts and documents relating to purchases, receipt and inspection
and issue to production shops.
(2) Efficiency in purchasing raw materials; whether materials are purchased at economic buying
quantity.
484
(3) Adequacy of the procedure relating to control of loss or pilferage of materials lying in stores
or shops or in both.
(4) Reasonableness of losses, scraps, waste, etc. arising out of manufacture.
(5) Accounting for scrap, waste, spoilage, defectives, etc. to ensure proper cost allocation.
(6) The method of pricing issues; whether the method followed is in accordance with that
prescribed and its consistency.
(7) Adequacy of the procedure for posting stores ledger and bin card on a day-to-day basis.
(8) Procedure followed in accounting and control of components manufactured internally, if
any.
(9) Method of valuation of closing stock, its relationship with the method followed in pricing
issues and its consistency from year to year.
(10) Physical verification of closing stock. Tendency to write down stock to manipulate profit
should be detected.
(11) Reasonableness of the value of closing stock vis-à-vis opening stock and production
programme.
(12) Examination of material cost variances where standard costing is employed. Correctness of
the computation of the variances and reporting of variances for necessary managerial action
should be scrutinized.
(II) Labour:
Proper utilisation of labour will lead to increase in efficiency and productivity. This is of vital
importance in the present Indian economic condition.
The auditor’s duty will, therefore, be to assess performance efficiency of labour. To this end,
actual performance will have to be measured and compared with standard performance. In measuring
actual performance, the auditor should
(i) verify the booking of workers’ attendance and see that Time Cards are maintained ;
(ii) examine Job Cards and Idle Time cards, and
(iii) check the reconciliation of attendance time with effective time and idle time.
Regarding overtime, the auditor should ensure that it is properly sanctioned by appropriate
authority. It should also be ensured that overtime records are properly maintained along with
attendance records.
For preventing fraud in wages payments, it is the duty of a cost auditor to see that duties of
wages department are so divided as to reduce the possibility of collusion to a minimum and that
wage packets are regularly checked to establish that payroll does not mc1ude fictitious names.
Secondly, payment to absent workers are made only through the absentee payment register.
485
The auditor should also see that labour has been classified into direct and indirect and that
each job bears respective share of labour cost. He should also examine whether inefficiencies are
reported to the management in time so as to ensure maximum utilisation of labour.
(III) Overheads
The auditor should examine, inter alia, the following :
(1) classification of overheads into (i) manufacturing overheads, (ii) administration overheads
and (iii) selling and distribution overheads, and collection of overhead costs;
(2) legitimacy of payments made for overhead costs;
(3) adequacy and reasonableness of overhead costs compared to volume of production;
(4) allocation and apportionment of overhead costs to cost centers or cost units;
(5) correctness of calculation of overhead absorption rates;
(6) treatment of under/over-absorbed overheads;
(7) method of valuation of closing stock to en3ure that over head costs are consistently included
or excluded.
(IV) Depreciation
(1) Checking the asset register which should show cost. Scrap value, if any, date of acquisition
and rate of depreciation.
(2) Verifying that cost. of renovation, if any, has been properly added to the asset.
(3) Adequacy or other wise of depreciation rate vis-a-vis the provisions of sub-section (2) of
section 205 of the Companies Act, 1956.
(4) Consistency of depreciation rates from year to year.
(5) Allocation of depreciation cost to various cost centres in proportion to the utilisation.
(V) Capital Expenditure :
(1) Propriety and authority for a capital expenditure.
(2) Collection of capital expenditure and comparison with budget regularly.
Accounting of capital expenditure including charges for transport, erection etc. to capital
heads. Maintenance of proper asset register. Correctness of depreciation rates and physical verification
of fixed assets.
(VI) Capital Utilisation:
(1) Reasonableness of idle capacity and reasons for idle capacity.
(2) Reasonableness of cost of maintenance, repairs, replacement, etc.
(3) General imbalance in production facilities.
(4) Optimum Utilisation of resources.
486
27.8 SUMMARY
Cost audit is a critical review undertaken for the purpose of (a) verification of the correctness
of Cost Accounts ; and (b) checking that Cost Accounting Plan is adhered to. The cost audit of
companies is not compulsory each year, but cost accounts must be maintained by companies falling
under the purview of cost audit as per the legal provisions. Cost audit is an efficiency audit, proprietory
audit and different from Financial Audit. Cost Audit is a specialised service which can be rendered
only by a qualified Cost Accountant. It examines whether proper cost accounting records in the
manner as required under the Companies Act in regard to various elements of cost as raw materials,
labour and overhead are being maintained by the company. It helps in correct valuation of work in
progress and closing stock leading to correct exhibition of profit and thus also guards against efforts
of tax evasion through incorrect valuation. It results in effective use of men, material and machines
which results in generating surplus giving scope for new investment and thus enhances employment
opportunities.
27.9 KEY WORDS

Statutory Cost Audit is a system of cost audit introduced by Government to review, examine the
Cost Accounting records of specified company.
Efficiency Audit is the audit which ensures that every rupee invested yields optimum results.
Proprietory Audit is an audit in which the various actions and decisions are examined to find out
whether they are in public interest and whether they meet the standards of conduct.

1. What is meant by the term “Cost Audit” ? What are the objectives sought to be served by
cost audit?
2. Explain various advantages of cost audit.
3. Elucidate the procedure of appointing of cost auditor
4. Briefly explain the scope of ‘Cost Audit’.
5. Explain various areas of cost audit, which may be examined by cost auditor.

1. Cost and Management Audit V.K. Saxena and C.D.Vashista Sultan Chand & Co, New
Delhi
487
GUIDELINE 28 : CLASSIFICATION OF AUDIT
OBJECTIVES
· Various types of audit
· Classification as per the Organisational Structure of Business
· Classification as to the Method or approach to work
STRUCTURE
28.1 Introduction
A) Classification as per the Organisational Structure of Business
1) Statutory Audit
2) Private Audit
(a) Audit of a Sole Trader
(b) Audit of Individuals
(c) Audit of Partnership Firms
3) Government Audit
4) Internal Audit
B) Classification as to the Method or approach to work
a) Continuous Audit
b) Interim Audit
c) Periodical Audit or Final or Annual Audit
d) Partial Audit
e) Balance Sheet Audit
f) Cash Audit
g) Procedural Audit
h) Financial Audit
i) Cost Audit
j) Special Audit
k) Operational Audit
l) Management Audit
28.2 Summary
28.3 Key Words
28.1 INTRODUCTION
The various types of audit that can be undertaken can be divided, broadly, into two categories:
(A) Classification as per the organisational structure of business; and
(B) Classification as to the method of approach to work.
488
Let us now study in detail the different types of audit under each category.
A. CLASSIFICATION AS PER THE ORGANIZATIONAL STRUCTURE OF
BUSINESS
A business house may be a corporate body or a non-corporate, body it may be run by the
Government or-by private individuals. Audit maybe lndertaken by independent auditors or may be
by persons within the rganisation. Thus different types of audit under this category can be :
(1) Statutory Audit;
(2) Private Audit ;
(3) Government Audit; and
(4) Internal Audit.
1. STATUTORY AUDIT
In the case of a limited company, the shareholders are its owners. On he other hand, its
management is in the hands of a few who are the directors. In most of the cases, these directors get
the work done through their executives. The larger the size of the organisation, the larger would be
the extent of delegation of work. There would be a larger number of departments. Thus ownership is
divorced from the management. The companies Act has, therefore, made it obligatory for all companies
to get their accounts audited by independent, qualified auditors. Here the appointment of the auditor
is in accordance with the statutory requirements laid under the Companies Act, 1956. Rights, duties,
responsibilities and powers of the auditor are laid down ‘in the Companies Act. An auditor will have)
see the resolution passed for his appointment in the minutes book.
Statutory Audit can further be divided broadly as follows :
Type of Audit Undertaken under which Act?
1. Company Audit Companies Act, 1956
2. Co-operative Society Co-operative Societies Act, enacted in various
States.
3. Public Charity Trust
Indian Trust Act and under State enactments like
the Bombay Public Trust Act in Maharashtra and
Gujarat.
4. Banking Companies Banking Regulation Act, 1949, read with the
Companies Act, 1956. Electricity Supply Act, 1948.
5. Electricity Companies Electricity Supply Act, 1948
6. Institutions Under special laws, if any.
Various Acts as discussed above lay down the provisions concerning audit and appointment
of auditors and concerning their rights, duties, lowers and responsibilities.
2. PRIVATE AUDIT
Where audit is not compulsory under any statute but it undertaken merely for the satisfaction
of the owners and to get advantages there from, it is a private audit. The various types of private audit
are :
(a) Audit of sole-traders:
(b) Audit of individuals;
(c) Audit of partnership firms: and
489
(d) Audit of institutions not covered under the statutory audit. Here, audit is not compulsory,
though it has many advantages.
(a) Audit of a Sole-Trader
In such cases the business is owned by a single individual. The owner takes the decision
whether to get the books of account audited or not. The owner will also decide the scope of the audit
as a result of agreement or understanding with the auditor. The nature of the auditor’s work and his
duties and responsibilities will depend upon this agreement of arrangement. 3ut the auditor should be
careful in getting clear instructions. Any ambiguity as to the precise duties of the auditor may land
him in difficulty. In the case of the audit of a limited company, the rights, powers, duties and
responsibilities of an auditor are governed by the Companies Act, 1956. But there is no such law for
the audit of the accounts of sole-traders or partnership firms. In this case, the agreement is the final
document. In case the auditor is charged with negligence, he can protect himself by producing this
agreement.
(b) Audit of Individuals:
Some individuals, who are not businessmen, may have a large income as well as heavy
expenses. An individual may have a number of buildings from which he collects rents. He might
appoint clerks to collect rents and maintain accounts. Similarly, some individuals may have share
transactions records of which are maintained by a clerk. It is advisable for such individuals to see that
the accounts are audited by an independent auditor. In this case also, before he certifies the balance
sheet and income and expenditure account for income-tax purposes the auditor must know his duties
precisely. These should be carefully defined in writing, so that a future dispute does not arise as to the
extent of his responsibilities. This is particularly important because if the auditor is found negligent in
his duties, his responsibility extends not only to his client but also to the third parties who may suffer
a loss due to the negligence of the auditor. If the businessman has obtained a loan from a bank on the
basis of the accounts certified by an auditor, the auditor may be held responsible to the bank for any
loss on account of non-payment of the loan if it is found that the auditor was negligent while certifying
the accounts.
(c) Audit of Partnership Firms
Even in the case of a partnership firm, as in the case of a sole-trader, the auditor is not
appointed under any statute but by the partners mutually under an agreement or arrangement with the
auditor. Though legally it is not compulsory to get the books of the partnership firm audited, but it is
advisable and sometimes even necessary. In this case also, the rights, duties, powers and responsibilities
of the auditor are governed by the arrangement or agreement and not under any law as in the case of
limited companies where there are differences among the partners or where different partners look
after different departments or where financing partners are dormant or sleeping partners. It is
advantageous for the partnership firm to get its books of account audited. Thus, the audit of a
partnership firm or a sole trader differs from the audit of a limited company.
While undertaking the audit of a partnership firm, the auditor must refer to the deed of
partnership which is the most important document. He must see the original copy, he must obtain a
copy duly certified by one of the partners. From this deed of partnership, the auditor should refer to
the following points:
(1) Name of the partnership firm;
(2) Nature of its business;
(3) Names of the partners and their capital;
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(4) Whether any minor child is admitted to the benefits of partnership;
(5) Share of each partner in profit or loss;
(6) Provision regarding interest on partners capital accounts, or their drawing accounts
and as loan to and from partners;
(7) Conditions regarding drawing by each partner;
(8) Duration of partnership;
(9) Clause regarding salary or remuneration to one or more partners;
(10) Accounting year of the firm;
(11) Rights, duties and powers of the partners;
(12) Clause regarding goodwill and its valuation;
(13) Terms regarding retirement of a partner or dissolution of the firm ;
(14) Terms regarding introduction of one or more new partners; and
(15) Arbitration clause.
Most of the above clauses are dealt with by the Partnership Act, 1932. If the deed of
partnership is silent on one or more points, the respective provisions of the Partnership Act, 1932,
will apply.
In the absence of any agreement to the contrary, the following provisions of the Partnership
Act, 1932, would apply:
(1) All partners will share profit or loss equally.
(2) All partners have implied authority to bind the firm and the other partners. In other
words, the act of a partner in the normal course of the business binds the firm. This
authority of the partner is known as the implied authority.
(3) None of the partners will be entitled to receive any salary or remuneration.
(4) Interest payable to a partner on his capital shall be payable out of profits only.
(5) A partner contributing moneys in excess of the agreed amount will get interest at the rate of
6 per cent per annum.
(6) The partners shall use the property of the firm exclusively for the purposes of the business.
(7) A new partner cannot be introduced unless there is a consent, of all partners.
(8) Every partner has the right of access to the books of accounts and to inspect and copy these
books of accounts.
(9) When the other partners carryon the business after a partner eases to be a partner due to
death or for any other reasons without settlement of accounts between them, the outgoing
partner or the heirs of the deceased partner are entitled to either such share of profit attributable
to his share in the property of the firm or interest at the rate of 6 per cent on his share in the
property of the firm.
(10) While settling the accounts of the firm on its dissolution, the goodwill of the, firm will be
considered as one of the assets of the firm. This goodwill may be sold separately or along
with’ the other properties of the firm. Anyone or more partners will have the right to bid for
the purchase of this goodwill.
(11) On the dissolution of the firm, while settling the accounts, losses (including deficiencies of
capital) shall be paid in the following order:
(i) First, out of profits,
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(ii) Secondly, out of capital, and
(iii) Lastly, by the partners individually in their profit-sharing ratio.
(12) On the dissolution of the firm, its assets; including any sums contributed by the partners to
make up deficiencies, shall be applied in the following order:
(i) First, in paying debts of the firm to third parties;
(ii) Secondly, in paying off proportionately to the .partners due to them for loans;
(iii) Thirdly, if there is any balance, in paying proportionally to the partners towards their
capital; and
(iv) Fourthly, the balance, if any, shall be divided among the partners in their profit-
sharing ratio.
Advantages of Audit of a Partnership Firm :
(1) Where anyone of the partners is in charge of the accounts, the audit is advisable as it will
avoid any financial dispute among the partners
(2) All the partners do not take an active part in the affairs of the firm. Some are working
partners, others are the financing partners. Sometimes some financing partners are dormant
or sleeping partners. Such partners can be satisfied that there are no frauds if the accounts
of the firm are fully audited.
(3) If the accounts of the firm are audited, the settlement of accounts and the valuation of the
goodwill are facilitated when a partner dies or retires or when one or more new partners are
admitted to the firm.
(4) The partners can avail themselves of the benefits of the expertise of audit for the purposes of
taxation or better management, etc.
(5) The above advantages are over and above the advantages of audit as described in Chapter
1 of the book.
Audit of a Joint-Stock Company and a Partnership Firm-Distinction
(1) Audit of the accounts of all limited companies is compulsory and obligatory under the
provisions of the Companies Act.
On the other hand, the audit of the accounts of a partnership firm is not compulsory but it is
purely voluntary. Such an audit is undertaken to avail of the various advantages discussed
earlier
(2) In the case of a joint-stock company, the auditor must be a qualified practising chartered
accountant according to Section 226 of the Companies Act, 1956.
In the case of a partnership firm, no qualifications are stipulated to an auditor. The auditor
of a firm need not be a chartered accountant unless the deed of partnership so requires.
But normally a chartered accountant in practice undertakes the audit of the firm.
In the case of a limited company certain disqualifications are also prescribed. In other
words, certain persons, though practising chartered accountants, cannot be appointed
auditors of a limited company. These restrictions are laid down statutorily in the Companies
Act. No such restrictions are applicable in the case of audit of a partnership firm.
(3) In the case of a limited company, the scope of audit is defined under the Companies Act,
whereas in the case of a partnership firm, there are no statutory or mandatory provisions.
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The scope of audit will depend on the agreement or the arrangement between the partners
on the one hand and the auditors on the other.
(4) Similarly, the rights, duties, powers and the responsibilities of the auditors of a limited
company are described statutorily under the Companies Act. On the other hand, the
rights, duties, powers and the responsibilities of the auditor of a partnership firm are
contractual and depend on the agreement or the arrangement between the partners and
the auditor.
(5) In the case of a limited company, the auditor gives his report to the members or the
shareholders of the company, while in the case of a partnership firm, the auditor gives his
report to the partners of the firm.
(6) The extent of work of an auditor of a limited company is as per the provisions of the
Companies Act, whereas in the case of a partnership firm, the extent of work of an
auditor may be enlarged or restricted or carried by the partners and this will be as per
agreement or the arrangement between, the partners and the auditor.
Audit of Institutions not covered under the Statutory Audit :
There are certain institutions which are not covered under any statute. Accounts of a public
charity trust will be covered under the Indian Trust Act and other State Trust Acts. But private trusts
for the benefit of certain persons like children, widows, etc., are not covered. Such trusts have
property the income from which has to be applied in a certain manner only as per the trust deed or
a similar document creating the trust. Such a trust may have a good income. The management of such
trusts may be in the hands of some trustees of executors. It is advisable that the accounts of such
trusts are audited to ensure such trusts are audited to ensure that all transactions are properly recorded
and the property and income from such property are. properly managed as per the documents
creating such a trust. Sometimes there are instructions in the trust deed itself directing the audit of the
books of accounts of such a trust. The settler of the trust has thought in advance about the audit of the
trust to see that the affairs of the trust are not mismanaged. Audit, therefore, helps the settlers, the
trustees and the beneficiaries all alike.
3. GOVERNMENT AUDIT
Government audit can be broadly divided into the following categories:
(i) Audit of government offices and departments;
(ii) Audit of government undertakings registered as ‘companies’ ;
(iii) Audit of government undertakings not registered as companies; and
(iv) Audit of those companies to whom the government has given sizable loans (e.g., many shipping
companies).
Those government undertakings which are registered as companies are normally audited by
the statutory auditors who are chartered accountants. But here the shareholders do not appoint the
auditors. They are appointed by the Comptroller and Auditor-General of India.
The staff of the Comptroller and Auditor-General are appointed to audit the accounts of the
other three types of undertakings. Besides, they also audit the accounts of government companies’
though statutory auditors also audit their accounts.
The audit department of the Comptroller and Auditor-General is an independent department.
Normally government audit is a continuous audit, as against the periodical audit in commercial concerns.
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4. INTERNAL AUDIT
Internal audit may be in addition to the statutory audit. When commercial firms or companies
grow beyond certain limits, it is advisable to appoint Internal auditors in addition to the statutory
auditors. Internal auditors audit the accounts and other relevant records daily and regularly.
Internal audit may be done by
(i) Independent persons or agencies appointed for the purpose, and/or
(ii) A separate department within the company or employees of the company appointed for this
purpose.
Independent persons or agencies appointed to take up the internal audit mayor may not be
chartered accountants. But normally most of the chartered accountants who act independently. Many
a time, some large companies have an internal audit department within their own organisations.
Normally this department is headed by a chartered accountant.
We will study later, in detail, the concept of internal audit and its relationship with the statutory
audit, and independent audit.
B. CLASSIFICATION AS TO THE METHOD OR APPROACH TO WORK
As seen earlier, various types of audits are classified broadly into two categories-first, as per.
the organisational structure .of the business, and secondly, as to the method or approach to the audit
work or according to the conduct of audit. This classification can be considered as by reference to
instructions also.
Various audits under these classifications may be :
(a) Continuous Audit ;
(b) Periodical Audit;
(c) Interim Audit ;
(d) Occasional Audit;
(e) Partial Audit;
(f) Balance Sheet Audit;
(g) Standard Audit ;
(h) Cost Audit;
(i) Efficiency Audit; and
(j) Operational Audit.
(a) Continuous Audit
Continuous audit implies that there is a continuous visit of the auditor. The auditor examines
the books of account regularly during the year by visiting the client throughout the year periodically.
He may visit weekly or fortnightly or monthly, and so on. When the auditor visits the client’s office,
he checks up all the transactions up-to-date, where possible.
The work, therefore, is conducted throughout the financial year. Though the audit is conducted
continuously, yet it is not the interim audit. Of course, the benefit of the continuous audit can be
taken up for interim audit. Sometimes, for continuous audit, the auditor visits the client daily throughout
the period.
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Advantages of continuous Audit:
(1) As the auditor visits the client daily or at frequent intervals, he can complete the audit at the
end of the year in time. The final audit can be completed without any loss of time. Audited
accounts can be presented in time.
(2) As the audit takes place continuously, the errors are detected in time and are rectified
immediately.
(3) The chances of frauds are reduced and they can be found out before it is too late.
(4) The regular presence of the auditor itself reduces the chance of frauds.
(5) In continuous audit, the audit work is carried out in more detail.
(6) The audit staff is effectively used during the year. When there is slackness in other work, the
staff can be sent regularly.
(7) Because the auditor remains present almost throughout the year) he can fully acquaint himself
with the business of his client and there are no chances of omitting important points and
issues.
(8) The clients also can get the audited information as and when necessary.
(9) Continuous audit helps the interim audit also. Interim figures can be published in
time.
Disadvantages of continuous audit :
(1) The client or his staff may alter the figures fraudulently after the audit.
(2) Sometimes due to regular presence of the auditor, the work of the accounts department is
interrupted. Sometimes the auditor may have to sit idle for want of books, whereas the
book-keepers may have to sit idle in order to enable the auditor to complete his work.
(3) Continuous and exhaustive note-taking is necessary in the case of continuous audit. Clerical
errors may be rectified immediately but notes required at the time of finalisation of accounts
will have to be preserved. These notes must be taken up in full detail.
(4) Continuous audit becomes a mechanical affair at times.
(5) Continuous audit is at times expensive also.
Overcoming disadvantages of continuous audit. The above disadvantages are such that they
can be overcome. The .first disadvantage can be overcome by using special ticks and keeping
vigilance. The auditor should plan out the audit programme in such a manner that no part of checking
is left out. The audit programme should be prepared exhaustively and should be regularly checked.
Regular note-taking can also help the .auditor in not omitting any part of the work.
By a judicious allocation of work, the auditor can minimise the chances of audit becoming
mechanical. A senior assistant must take overall care to see that all disadvantages are overcome.
The continuous audit may prove to be expensive in the case of small concerns. But for small concerns,
the continuous audit may not be that necessary also.
Thus, the above precautions can be taken by an auditor to guard against the disadvantages
of the continuous audit.
(b) Interim Audit
An audit that is taken up between the annual audit is an interim audit. Interim audit is conducted
to cover a certain period or to complete the audit upto a certain date within the financial year. The
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client may desire to have complete para for the quarter or half-year. The auditor may, therefore,
under specific instructions of the client, undertake such an audit the interim audit should not be
confused with continuous audit. Both are different. The scope of interim audit falls within the purview
of the final audit, or the annual audit which will be carried out later. The main purposes of interim audit
can be :
(i) To get the half-yearly or periodical data of the turnover, gross profit, etc., and
(ii) To get the profit for the period which may help the management to declare the interim dividend.
Now, it is the latest trend in advanced countries to declare the interim figures of the turnover,
etc. Many large companies have started doing this in our country as well.
The auditor, while conducting interim audit, should try to see that certain aspects that are
necessary at the time of final audit are not over looked just because they were explained at the time
of the interim audit. All such aspects must be examined again. Even while preparing the audit
programme, the auditor should see that certain aspects brought forward from the interim audit are
also covered while taking up the final audit.
Secondly, he should see that the books of account and other records are not altered after the
completion of the interim audit and before the completion of the final audit.
Advantages of Interim Audit.

(1) Interim audit helps the management to publish the audited interim figures of expenses, turnover
and profit.
(2) Interim audit helps the auditor and the management to complete early final audit. For large
companies it is more advantageous.
(3) As in the case of continuous audit, frauds and errors can be detected at the earliest.
(4) There is a moral check over the staff that audit is going to be taken up soon.
Disadvantages of Interim Audit.
(1) Figures may be altered in the books of account and other records after affect the final audit
adversely.
(2) The audit staff will have to prepare notes at the time of interim audit even for the final audit
and will have to keep them in n1ind when it is taken up.
(3) This in itself is an additional work for auditors.
The disadvantages discussed above are such that they can be guarded against, by taking
necessary precautionary steps. On the top of it, the auditor will be doing a good service to his client
by pointing out certain financial and other weaknesses to the management at the earliest opportunity.
He need not wait till the final audit. The management, in turn, can take timely action before it is too
late.
Interim Audit and Continuous Audit : As discussed earlier, the interim audit should not be confused
with the continuous audit and should not be considered synonymous with it. The important points of
distinction between the two are as under :
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Continuous Audit Interim Audit
Period The period covered is as per the The period covered is up to a definite
convenience of both the client and the date as per the instructions of the client
auditor
The object is to audit the books of The main object is to find out interim
account as and when they are figures of the turnover, expenses and
Object
completed so that the final audit can profit so as to declare an interim dividend
be completed soon or in time or to publish interim figures.
Verification Verification of assets and liabilities Verification of assets and liabilities is
of assets may be taken up at the time of final taken up at the time of interim audit and
and audit at the end of the accounting again at the time of the final audit
liabilities period
Preparation and checking of the trial
Trial balance It is not necessary to prepare and
check the trial balance periodically balance at the end of a definite period
is necessary besides the preparation
and checking of the same at the time
of the final audit.
These final accounts are prepared and

Profit and It is not necessary to prepare checked for the purpose of interim audit
loss account and check these financial and these are again prepared and
and balance statements periodically checked at the time of the final audit.
sheet
From the above discussion, it can be observed that both the interim audit and the continuous audit
have their merits and demerits. Precautions can be taken to guard against their demerits. Both
are possible and even necessary for larger companies.
(c) Periodical Audit or Final or Annual Audit
Audit which is taken up at the close of the financial year is known periodical audit or the
final audit. At the end of such a financial year, the ledger accounts and other books of accounts are
balanced, the trial balance is drawn out and final accounts are prepared. Routine checking and
other audit procedure normally will not start until the close of the financial year. Sometimes, the
audit may start before the close of the year, but the substantial part of the audit will be after the
close of the year. Audit is carried on up to its conclusion. The full auditing is done and completed
in one continuous session. This is how periodical audit or final audit differs from the continuous
audit. The auditor completes all the checking of all the books of accounts in one single session. In
the case of continuous audit, the auditor visits the client continuously or more than once. In case of
periodical of final audit, the auditor visits the client once in a year and keeps on going till the audit
is over.
Secondly, in continuous audit, the auditor can arrange the audit programme of various
clients in such a manner that at the time of the finalisation of audit much of the routine work is
completed. But where continuous audit is not taken up, the whole work of audit is to be completed
at a stretch.
In the case of periodical audit, the danger of manipulation of accounts or alterations of
figures is not as much as it is in the case of continuous audit.
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Anyway, this type of audit is considered satisfactory in the case of mall concerns. Till
recently, most of the concerns had periodical audit. But now many concerns, and large concerns
in particular, prefer continuous audit because final accounts and annual reports can be published
without much delay. Even partnership firms also prefer continuous audit in certain cases.
Periodical or final audit is many a time known as “complete audit” or “detailed audit”.
They are different in certain aspects. As a matter of act, in complete or detailed audit, all the
transactions are checked completely. But nowadays this is not possible and even not necessary in
the case of larger concerns. It will be very difficult to take up detailed or complete audit in such
larger concerns. In the case of periodical audit, the auditor may prefer to employ sample checking
in order to overcome the pressure of work. He may not check all the vouchers or may not check
complete posting, and so on.
Advantages :
(1) As the work can be completed in one session, there s no need to take notes to indicate as
to which stage work has been completed.
(2) There is no possibility of alteration of figures in the books of account after the audit is
completed.
(3) The auditor’s arrangement of the time-table of audit work is simplified.
Disadvantages :
(1) If the concern is large and the. work is of an extended nature, there may be delays in
completing the audit, thus delaying the preparation of final accounts and delaying the holding
of the annual general meeting. The accounts may not be published in time. This delays the
declaration of dividend.
(2) The auditor may find it difficult to arrange his audit staff if more clients have their financial
year’s ending on the same day.
(d) Partial Audit
Audit is considered to be partial where the auditor is instructed to carry out the audit of a
particular work only. Even there might be restrictions as to his powers of enquiry or checking. Here
the liability of the auditor is also different from his liability for complete audit. His liability will be
considered from the point of view of the terms of reference. It is advisable for the auditor to take in
writing the terms of reference and the scope of his work. He should also mention the same in his
report while he undertakes a partial audit. But a partial audit is not a practicable idea.
(e) Balance Sheet Audit
The balance sheet audit is comparatively of recent origin. In the U.S.A. this has proved very
popular. Such a type of audit is used where the size of the company becomes very large.
In this type of audit, it is necessary to commence audit on the basis of the balance sheet and
the auditor works back to the books of original entry and other evidences.
In the balance sheet audit, it is assumed that there is a reliable system of internal check and
internal audit. The auditor must consider the extent of internal control and its dependability. Much of
the work of vouching, posting, casting and other routine audit is eliminated considering the soundness
of the internal control system. Thus, it is necessary that the auditor must be highly skilled and experienced
and must have ability to interpret the accounts in depth.
The balance sheet audit consists of the complete verification of all the items contained in the
balance sheet and the other related items. This procedure is assumed on the basis that two successive
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balance sheets are compared and profit for the year can be ascertained. Of course, the auditor will
check up the general ledger also. He will, in particular, examine items of unusual nature and items
affecting the balance sheet. He will also see that all incomes relating to items of all the assets are
received or adjusted. Similarly he will also see that all outstanding expenses are provided for.
This type of audit is not a complete audit, but only a partial audit. It is, in other words a part
of the work of normal, complete audit
Procedure for the Balance Sheet Audit:
(1) Verify all the assets and liabilities as on the date of the balance sheet.
(2) Examine the variations in fixed assets. Examine the schedule of the fixed assets. Study the
movements of the fixed assets and depreciation.
(3) Examine the components of current assets. Compare them with the figures of the previous
year
(4) Study the schedules of outstanding expenses, outstanding income, prepaid expenses and
income received in advance.
(5) Examine the other items of the balance sheet. Compare them with the figures of the previous
year. Scrutinise the reasons for variations and their effect on the profit for the year.
(6) Compare the profit and loss account with that, relating to the previous year. Examine the
reasons for important variances.
(7) See the details of variable expenses and study them in relation to the turnover, production,
etc.
(8) Verify the quantitative details of purchases, production, turnover and opening and closing
stocks.
(9) Examine all the items of an unusual or non-recurring nature, e.g., insurance claim, loss or
profit on sale of assets, etc.
(10) Verify the statement of sources and applications of funds.Compare with this the statement
of the previous year.
(11) Study various ratios and study again in relation to the ratios of the earlier years. Examine the
trend of this ratio. In the absence of detailed checking, this examination will prove to be very
useful.
(12) Examine the minute books of the company. See that the policy matters of importance are
properly executed and study their effect on the finances. Examine all the items of minutes,
affecting the accounts in general and the balance sheet in particular. See in particular the
resolutions for transferring the amount to or from the reserves, See also the other similar
items of directives concerning the accounts and finances.
The above is the list of items of importance for the auditors. More items will have to be
checked at the discretion of the auditors. The extent of checking will also depend upon the soundness
of the internal control system within the organization of the clients.
(f) Cash Audit
In the case of cash audit, the auditor is concerned with the checking and examination of all
the cash transactions. Cash transactions will comprise all cash receipts and all the cash payments.
Receipts and payments may be of any nature. He will check up all those transactions with the help of
all possible evidences like vouchers, etc.
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But when the auditor undertakes cash audit, he must make mention this fact in his report.
This is very important. This type of audit is not a complete audit but is merely a partial audit.
(g) Procedural Audit
A procedural audit involves the following steps:
(1) Examining and reviewing of internal procedures and records,
(2) Ascertaining their follow-up and reliability for the compilation of final account,
(3) Ensuring that the procedures involved are the most effective but at the same time economical,
(4) Ascertaining the adequacy and effectivene&s of the internal control systems and
(5) Ascertaining that any changes made in the internal contro1 system are brought to the notice
of the auditor.
Under the present economic conditions, we find that many organisations have outgrown
their size. They have become very large. At the same time, the complexities of business and business
laws have also increased too much. Under the circumstances, it has become not only necessary but
also imperative to objectively review various systems implemented in the organi sation and also to
review the internal control procedures and their effectiveness within the organisation. This can be
done through procedural audit. Though it is a separate audit procedure itself, it can be a part of
whole audit.
Many a time, certain transactions are audited in depth, so as to find out the origin of transactions
and to examine the existence of a proper internal control system and procedures.
Audit can also be classified as under:
(1) Financial audit, and
(2) Cost audit.
(h) Financial Audit
The discussion so far has related to financial audit. In the subsequent pages a major part of
the discussion will also be on the financial audit only. It is the audit that pertains to the financial
records of the organization.
(i) Cost Audit
Financial audit implies a thorough examination of the financial records of the company. On
the other hand, cost audit implies the complete examination of the cost records of the company.
Here the auditor verifies the correctness of the cost records of the company, and also sees that the
organisation has adhered to its cost accounting plan prepared by the company. The Companies
Act, 1956, for the first time introduced cost audit by inserting Sec. 233B in the An1ending Act of
1965. Accordingly, certain companies may be directed to maintain cost records. These again may be
accounts by the external cost accountants qualified for this purpose. Normally this should assist the
management in cost control in particular. This improves the position of the company.
Cost audit is mainly directed to those companies which are engaged in production, processing,
manufacturing or mining activities. Cost audit is mainly directed in respect of cost records pertaining
to the utilisation of material or labour or to other items of cost as may be prescribed by the Central
Government to include such particulars in the books of account. So far cost audit has been directed
to many industries including nylon, electric motors, textiles, dyes, etc.
More about cost audit will be discussed in the chapters relating to the audit of companies.
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(j) Special Audit
Sec. 233A was inserted in the Companies Act, 1956, in 1960. This Section gave power to
the Central Government to direct special audit in certain cases as enumerated in that Section.
The Central Government may direct a special audit if it is of the opinion:
(a) that the affairs of any company are not being managed in accordance with sound business
principles or prudent commercial policies, or
(b) that any company is being managed in a manner likely to cause serious injury or damage to
the interests of the trade, industry, or business to which it pertains, and
(c) that the financial position of the company is such as to endanger its solvency.
The topic of special audit will be discussed in greater detail in the following pages dealing
with the audit of companies.
(k) Operational Audit
At present the term “operational audit” is being discussed very widely. Operational audit has
two main purposes :
(i) To improve profitability of an organisation, and
(ii) To help in achieving the other organisational objectives which are, for example, securing
social objectives, developing human resources, etc.
This is done independently by the internal auditors.
Where external auditor carry out operational audit, it is known as the management advisory
services or management consulting. In operational audit, the internal auditor goes beyond financial
records. It aims at improved future business operations. It is all aid to the management in a larger
way of its functioning.
(i) Management Audit
With the increase in the complexities of management of big businesses, the importance of
management audit is also increasing. The main objectives of the management audit can be considered
as under:
(i) To study the management of an organisation and to bring out its efficiencies, and ineffectiveness,
and
(ii) To help the management in its weak areas as to its functions and performance. .
William P. Leonard defines management audit as under:
“The management audit may be defined as a comprehensive and constructive examination of
an organisational structure of a company, institution or branch of government, or of any component
thereof, such as a division or department, and its plans and objectives, its means of operation, and its
use of human and physical facilities.”
(The Management Audit by WILLIAM P. LEONARD)
Thus, the auditor’s aim is to find out the ineffective or inefficient management actions. The
statutory auditor of a company can be in a better position to take up’ the management audit of that
company because he has an intimate knowledge of the affairs of the company. Recent changes in the
Companies Act, 1956, ask auditors to report to the shareholders items as referred to in the
Manufacturing and Other Companies (Auditor’s Report) Order, 1975.
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This audit (popularly known as “social audit”) is an action in the direction of management
audit. Nonetheless, the management audit is distinct from the statutory audit. The statutory auditor is
mainly concerned with the examination of the historical records and the performance of the company
in the past year. On the other hand, the management auditor, besides reviewing the past, has to look
into the future also.
28.2 SUMMARY
The various types of audit that can be undertaken can be divided, broadly, into two categories
namely (a) Classification as per the organizational structure of business ; and (b) Classification as to
the method of approach to work. Audit may be undertaken by independent auditors or may be by
persons within the organisations. Thus different types of audit are classification as per the organizational
structure of business are (1) Statutory audit (2) Private audit (3) Government Audit and (4) Internal
Audit. As to the method or approach to the audit work or according to the conduct of audit, the
classification may be (a) Continuous audit, (b) Periodical audit, (c) Interim audit, (d) Occasional
audit, (e) Partial audit, (f) Balance Sheet audit, (g) Standard audit, (h) Cost audit, (i) Efficiency audit,
(j) Operational audit.
28.3 KEY WORDS :
Private Audit is an audit which is undertaken merely for the satisfaction of the owners.
Internal Auditors audit the accounts and other relevant records daily and regularly.
Continuous Audit is a kind of audit in which audit is conducted throughout the financial year.
Balance Sheet Audit is used where the size of the company is very large and it consists of the
complete verification of all the items containing balance sheet.
Cost Audit implies the complete examination of the cost records of the company.
Management Audit is used to find out the ineffective or inefficient management actions and is also
known as ‘Social Audit’.
Special Audit is the audit done with a special approval of central government.
28.4 SELF ASSESSMENT QUESTIONS :
1. Classify various types of audit as per the organizational structure of business.
2. What is a private audit ? Explain its types.
3. Differentiate between Cost, Management and Financial Audits.
4. What are the advantages and disadvantages of continuous audit.
5. What are the advantages and disadvantages of partnership firms.
6. Distinguish between Interim Audit and Continuous Audit.
7. Explain the following :
a) Government Audit
b) Special Audit
c) Operational Audit
d) Internal Audit.
Delhi
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GUIDELINE 29 : APPOINTMENT OF AUDITORS
OBJECTIVES
· Qualifications and disqualifications of an Auditor.
· Appointment and Removal of an auditor and
· Rights and duties of auditor.
· Civil and Criminal liabilities of an auditor.
· Auditor’s liability to third parties.
STRUCTURE
29.1 Introduction
29.2 Qualification of an Auditor
29.3 Appointment of Auditors
29.4 Removal of an auditor
29.5 Rights and Duties of an Auditor
29.6 Civil and Criminal Liabilities of an Auditor
29.7 Auditor’s Liability to third parties
29.8 Summary
29.9 Key Words
29.1 INTRODUCTION
In the trading case “The Kingston Cotton Mill Co. Ltd. Case” the learned Judge Lopes, L.J.
made the remark that an auditor “is a witch dog and not a blood hound”. In this case the accounts of
the company had been falsified by the manager by over valuation of stock in trade for a number of
years. Since the over valuations undetected and dividend was paid out of inflated profits. The
auditors had included the total value of stock-in-trade on the basis of a certificate of the manager
without checking the stock physically. The auditor was changed with negligence in duty. It was held
that “it was not a part of his duty to take stock, that he was entitled to accept such certificates in the
absence of suspicious.
A blood hound always pretends wrong and bark at every body other than its master. A
watch dog on the other hand, is always watchful. An auditor is also a watch dog in the sense that he
is appointed by the shareholders to safe guard their interests. Comparing the role of an auditor with
that of a watch dog the learned Judge said that an auditor is bound to be a detective or to approach
his work with suspicion or with a foregone conclusion that there is some thing wrong.
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The auditor is expected to discharge his duties according to professional standards. He is
expected to exercise reasonable care skill and caution in making enquiries and investigations. What
is reasonable care and skill depends on the circumstances of each case. But in any case he should
not begin his work with an attitude of suspicion. He can trust the tried servants of the company. He
is entitled to assume that they are honest and to rely upon their representation provided takes a
reasonable care. If there is any suspicion he should probe it thoroughly. In the absence of any suspicion
he is only bound to be reasonably cautious and careful.
An auditor, therefore is expected to be more than a watch dog. He must be always alert and
vigilant in performing his duties. He has to safe guard the interests of the shareholders. He should
see that the Balance sheet reflects the true financial position of the company.
As the duties of auditor are such, it is remarked that the auditor is the watch dog but not a
blood hound.
The company audit has been made compulsory by the Indian companies Act 1955. It contains
provisions with regard to company audit and the auditor. It provides for the appointment, remuneration,
removal, duties and qualifications etc.
29.2 QUALIFICATIONS OF AN AUDITOR

According to section 226 of companies Act, the auditor of a company must possess either of
the following two qualifications.
1. He should be Chartered Accountant with in the meaning of the Chartered Accountant’s Act
1949. If firm is appointed as the auditor all the partners of the firm must be practicing
Chartered Accountants. This means only a Practising Chartered Accountant is eligible for
appointment of an auditor.
2. He should be a holder of a certificate under the Restricted Auditor’s Certificate (Part B
states) Rules 1956.
Disqualifications : Section 226 (3) of the companies Act provides that none of the following
persons shall be qualified for appointment as auditor of a company.
a) a body corporate
b) an officer or employee of the company
c) a person who is a partner or who is in the employment of an officer or employee of the
company.
d) a person who is indebted to the company for an amount exceeding Rs.1,000.
e) a person who has given any guarantee or provided any security in connection with the
indebtedness of any third person to the company for an amount exceeding Rs. 1,000.
If an auditor incurs any of the above disqualifications after his appointment, he will be deemed
to have vacated his office.
29.3 APPOINTMENT OF AUDITORS
Section 224 of Indian Companies Act, 1956 lays down provisions for the appointment of a
company auditor. Board of Directors, Shareholders and Government are endowered to appoint the
auditors.
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Appointment by Directors : The first auditor of a company shall be appointed by the directors
within one month from the date of registration of the company. The auditor so appoints shall hold the
office until the conclusion of the first annual general meeting. But the company may choose the same
auditor at its first annual meeting or may appoint some other auditor in his place. If the Board fails to
appoint the first auditor with in one month from the date of registration, the company may appoint
first auditor in annual general meeting.
Appointment by Shareholders: Every company shall appoint an auditor at each annual general
meeting by passing a resolution. Such auditor shall hold office from the conclusion of that meeting
until the conclusion of the next annual general meeting. The company should intimate the auditor so
appointed with 7 days of the appointment unless he is retiring auditor. The auditor after the receipt
of appointment order, must intimate the Registrar in writing of his acceptance or rejection of
appointment with in 30 days. But a retiring auditor on re-appointment however need not submit his
intimation to the Registrar.
Appointment by the Central Government : Due to any reason if the Company fails to appoint an
auditor at the annual general meeting, it must inform the same to the Central Government within 7
days from the date of annual general meeting. In such a case the Central Government may appoint
a person as the auditor of the company.
Appointment by passing a Special Resolution : Section 224 A of the companies Act provides
that in case of a company in which not less than 25% of the subscribed share capital is held whether
singly or in any combination by
i) a public financial institution or a Government company or a Central Government or a State
Government.
ii) any financial or other institution established by any provincial or State Act or in which a State
Government holds 51 per cent of the subscribed capital.
iii) a Nationalised Bank or an insurance company carrying on general insurance business.
The appointment of the auditor shall be made by passing a special Resolution. If a company
fails to pass a resolution appointing an auditor, the Central Government will appoint the auditor.
Casual Vacancies :If any casual vacancy arises before annual general meeting of shareholders, the
board of directors may fill the vacancy. If that casual vacancy caused by the resignation of an
auditor, shall be filled only by the company in the annual general meeting. The auditor appointed in
casual vacany shall hold office until the conclusion of next annual general meeting.
Compulsory Re-appointment of Auditors : A retiring auditors by what so ever authority appointed
shall be reappointed unless
1) he is a qualified for re-appointment or
2) he has given notice in writing of his unwillingness for reappointment or
3) a resolution has been passed at that meeting appointing somebody instead of him or providing
expressly that he shall not be re-appointed.
4) where a notice has been served at an intended resolution to appoint a fresh auditor in the
place of a retiring auditor and by reason of death, in capacity or disqualification of the proposed
auditor, the resolution cannot be proceeded with
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Appointment in Government Companies : In the case of Government companies, the Central
Government will appoint the auditor in consultation with the Comptroller and Auditor General of
India, (Sec. 619 (2))
Remuneration of the Auditor :
Section 224(8) provides for the remuneration of an auditor as follows :
1) The remuneration of auditor will be fixed by the Board of Directors when the auditor is
appointed by the Board and
2) The remuneration shall be fixed by the Central Government when the auditor is appointed by
the Central Government.
3) In all other cases his remuneration shall be fixed by the company in its general meeting or in
such manner as the company in general meeting may determine.
4) It is to be noted that any sums paid by the company in respect of the auditor’s expenses shall
be deemed to be included in the term “remuneration”.
5) If the auditor’s service have been requisitioned for other purposes in addition to normal
annual audit, he is entitled to a remuneration in addition to the normal fee for his audit work.
29.4 REMOVAL OF AN AUDITOR

With the previous permission of the Central Government any auditor may be removed from
office even before the expiry of his term. But it can be done only by the company in its annual general
meeting (Sec. 224 (7).
But there is an exception to the above rule relating to the removal of the first auditor. If he
was a first auditor he may be removed from office by the company in its annual general meeting even
without the prior approval of Central Government.
Procedural for removal of auditor :
According to Sec. 225 of the Companies Act, a special notice of 14 days has to be served
for moving a resolution at an annual general meeting appointing as auditor, a person other than a
retiring auditor or providing expressly that a retiring auditor shall not be reappointing. A copy of such
resolution should be made available to the retiring auditor. It means that no new auditor can be
appointed in place of existing auditor without serving a 14 days notice to the latter.
The retiring auditor, has got a right to represent his case in writing to the company. He must
be given sufficient time to represent his case. This right was given for the first time in India by the
Companies Act 1956, with a view to prevent the management from removing an auditor without the
knowledge of share holders. He has got a right to ask the company to circulate his written
representation among its members. His written explanation must be printed and served to the
shareholders before the meeting takes place. The retiring auditor has a right to attend the meeting
where his removal is being discussed. If the court orders for removal on the application of company
or agreed party no such presentation is allowed.
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29.5 RIGHTS AND DUTIES OF AN AUDITOR
An auditor must have certain rights in order to perform his statutory duties honestly and
efficiently. The companies Act recognizes this and confers upon him those rights. Rights and duties
are inter-connected. Hence they go together. In the case of sole trading concern and partnership
firms the rights and duties of the auditor are customary and moral. But in case of Joint Stock
Company the rights and duties of an auditor are statutory.
Rights (Powers) of an Auditor : An auditor of a company has got the following rights.
1. Rights to access to books, accounts and vouchers : The auditor of a company has a
right of access, at all times to the books and vouchers of the company wherever they kept.
The term ‘books’ include all statutory, statistical and financial books including cost accounting
records. The term vouchers includes all documents, correspondence, agreements etc.
2. Right to obtain information and explanation : the auditor has a right to call for, any
explanations or information from different officers of the company as he may thinks necessary
for the performance of his duties. He can also report such statements to the members (Sec.
227 (1)).
3. Right to receive notices and to attend General meeting : The auditor has a right to
receive all notices and other communications relating to any general meeting of the company
in the same way as a member of a company.
4. Right to attend general meetings : The auditor has a right to attend any general meeting
and to be heard at any general meeting. He is not expected to answer the questions in the
general meeting. He has also a right to speak at such meetings where the accounts are being
discussed.
5. Right to correct wrong statements : The auditor has a right to correct wrong statements
made by the directors relation to accounts. But he cannot avoid liability for any omission in
his report by making verbal explanation at the meeting.
6. Right to report to members : The auditor has a right to make report to the members on
the accounts examined by him. He has a right to submit qualified report.
7. Right to refuse to start the work : The auditor has a right to refuse to start the audit work
until the management balance the books and prepare the final statement of accounts.
8. Right to sign audit report : The auditor has a right to sign the auditor’s certificate after
completion of audit. Further he has a right to sign or authenticate any other document of the
company which the law requires to be signed or authenticated by the auditor.
9. Right to visit the branches : The auditor has a right to visit the branches of the company
and audit the accounts maintained by them, if no qualified auditors are appointed for branch
audit.
10. Right to have legal and technical advice : The auditor has a right to take expert advice
in respect of any legal or technical matter for the proper discharge of his duties.
11. Right to receive remuneration : The auditor has a right to receive the remuneration for
auditing the accounts of the company. The right accrues only after he has completed the
work.
507
12. Right to be indemnified : He has a right to be indemnified out of the assets of the company
against any liability incurred by him in defending himself against civil and criminal proceedings,
provided the judgement is in his favour (Sec. 633).
13. Right to lien : The auditor has a right to exercise lien on working papers. However the
auditor has no right of lien on the books of account audited by him.
The rights of an auditor cannot be limited either by the Articles of Association or by resolution
of shareholders. Any provision of this nature is void under eyes of law (Newton Vs. Brimingham).
29.6 CIVIL AND CRIMINAL LIABILITIES OF AN AUDITOR
An auditor is expected to discharge his duties, according to “generally accepted auditing
standards”. A professional auditor being an expert ; is expected to exercise accepted professional
standards”. i.e. he must exercise the same degree of prudence, skill and care as any other professional
person in similar circumstances would be expected to do. The work of an auditor is of personal
character and must be performed either by him or by his partners.
From the legal view point the liability of an auditor may be considered under two heads.
1. Liabilities in case of private business i.e. Non-statutory audit
2. Liabilities in case of company audit.
I. Liabilities in case of private business i.e. Non-statutory audit :
Audit is voluntary in case of a private business such as sole trading concern and partnership
firms etc. There are no legal provisions as to the appointment, remuneration, duties, rights etc. of
auditor. Auditor is appointed by an agreement with his client. It is desirable to have the agreement
in writing. His duties, rights and liabilities depend upon the agreement entered by him with the client.
He should honestly, deligentry and sincerely follow the instructions given to him by the client. In other
words his liability in case of private business is contractual liability. When the auditor performs his
duties according to the instructions and directions he can escape from any legal liabilities. If his client
suffers any loss due to his negligence or breath of trust or duty and the errors or frauds remain
undetected he would be liable for damages. To prove the auditor is liable, the client is required to
prove the following charges.
i) Some losses were caused to the client.
ii) These losses were caused to the firm due to the negligence of the auditor.
2. Liabilities in case of company audit :
Audit in the case of a company is compulsory by law. The auditor is appointed as per the
provisions of the companies Act. His rights, duties and liabilities are also determined by the Act. The
liabilities of a company auditor may be studied on the following pattern.
a) Civil Liabilities : i) Negligence of duty, ii) Breach of trust or misfeasance., iii) Liabilities
towards third parties.
b) Criminal Liabilities : i) Under Companies Act, ii) Under Indian Penal Code, iii) Under
other Acts.
A. Civil Liabilities : Civil Liabilities means the dispute over some losses caused to one party
due to the act of the other party. Liability of an auditor to pay damages is known as civil liability.
Civil liability may arise due to negligence or misefeasance of the auditor. The civil liabilities of a
company auditor may be studied on the following lines.
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i) Liability for Negligance : An auditor is appointed to perform certain duties. To the
extent of his duties as an auditor he acts as an agent of his client. As an agent the auditor has to
perform his duties with reasonable skill and care. If he acts negligently, on account of which the is
made to suffer loss, the auditor may held liable for damages. He has to make good the loss suffered
by the company on account of his negligence. Negligence without a loss does not call loss legal
remedy in damages. In order to hold the auditor liable for negligence the following conditions are to
be proved.
1. Auditor was negligent in dischange of his duties.
2. Due to his negligence the company has suffered a loss.
ii) Liability for misfeasance : The term ‘misfeasance, implies a breach of trust or duty imposed
by-law. The companies Act specifies certain duties of an auditor and the auditor is also required
under general law not be negligent in his work. If the auditor does not perform his duties properly as
laid down in companies Act, and as a result, his client suffers, he may be held liable for misfeasance.
iii) Liabilities toward Third parties : There are several persons who take advantage of the
accounts audited by the auditor. They rely completely upon the final accounts certified by the auditor
and enter into transactions with the company. These parties besides the client may be creditors,
bankers, tax authorities, prosparative share holders etc. Normally an auditor is not liable to third
parties. The reason is that, the auditor is an agent, responsible to his client and not to the third parties
who have not appointed him. There is no privity of contract with them.
Important Case Laws :
1. Leed Estate Building and Investment Society Ltd. Vs. Shephered (1887) : In this
case, the Articles provided that dividend and director’s remuneration were to be paid out of profits.
The auditor did not examine the articles. Dividends were declared and bonus were paid out of
capital. On an action being brought against the auditor, he pleded that he was not aware of the
existence of the articles. It was held that he was guilty of negligence and hence liable for damages.
2. Irsh Woolen Company Limted Vs. Tyson and others (1900) : In this case there was
considerable understatement of trade liabilities and supervision of some of the purchased, invoices.
There by the accounts were manipulated and falsified. As a result, the dividends were paid out of
capital. The auditor did not care to obtain the statements of accounts from the creditors and was
negligent in the discharge of his duties. It was held that the auditor was liable for all the damages
sustained by the company.
3. The London Oil Storage Company Limited Vs. Seear, Hasluck and Co. (1904) : In
this case, the company suffered a loss because of negligence on the part of the auditor to verify the
existence of the petty cash in hand which was shown as £ 796, but in fact the petty cash was only
£30. As a result the company suffered to the extent of £ 766. The auditor did not count the petty
cash in hand and simply compared the petty cash balance shown in the Balance Sheet with that
shown in the petty cash book. It was held that the auditor was guilty of breach of duty and hence
liable for damages.
4. The Westminister Road Construction and Engineering Co. Ltd. (1932):
The liquidator of the company brought action against the auditors, who also acted as
accountants, for their failure to detect omission of liabilities and over valuation of work in progress
resulting in wrong ascertainment of profit to the extent of £ 3458 from which dividend was paid. It
was held that an auditor is guilty of misfeasance for the failure to detect either the omission of liabilities
509
from the Balance Sheet or the valuation of work in progress, where each is detectable by pro
checking.
5. Union Bank of Allahabad case (1925) : In this case the manager of the bank had borrowed
large sums of money from the Bank for his personal use and for his relatives without provisioning any
proper security. The auditor signed the false balance sheet blindly, trusting the dishonest manager
and secretary of the bank. It was held that the auditor was liable for negligence as he did not act the
reasonable care and skill.
b. Criminal liabilities : Auditor has been considered an officer of the company under the
provisions of sec. 2 (3). Criminal liability of an auditor arises because of offences against the statutory
provisions specifically laid down. In such cases an auditor is liable not only to the share holders but
also to the state. In case of criminal liability, an auditor is punishable with fine or imprisonment or
both as might be provided in the relevant Acts such as companies Act, Income Tax Act such as
companies Act, Income Tax Act, Indian Penal Code etc. The criminal liabilities of a company
auditor may be studied on the following lines.
i) Criminal Liabilities under Companies Act :An auditor is criminally liable in the following
cases under the companies Act :
Section 233 : An auditor is punishable with a fine extending to Rs. 1,000 if he signs the
report or signs or authenticates a document which is not incomfirmity with the requirements of section
227 and 229.
Section 240 : The auditor of a company is required to extent full assistance to an officer
appointed by the Central Government to investigate the affairs of the company. If he does not do he
is punishable with imprisonment upto six months or with a fine upto Rs. 2,000 or both.
Section 478 : On application of the official liquidator the auditor of a company can be
publicly examined in the High Court, The notes shall be taken down and signed by the auditor. Such
signed Notes may be used in evidence against such officer.
Section 539 : If an auditor destroys, multilates, alters, falsiffes or secretes any books,
papers or securities, and makes any fraudulent entry in any register, books of account or document
of the company, he shall be punishable with imprisonment for a term which may extend to seven
years and also be liable to fine.
Section 63 : If the auditor authorises the issue of prospectus of a company containing a
false and untrue statements, he is punishable with imprisonment for a term of 2 years or a fine of Rs.
5,000 or both.
Section 628 If the auditor of a company deliberately makes a statement in any return,
report, certificate, Balance Sheet prospectus etc which is false in any material or deliberately omits
any material fact, he shall be punishable with imprisonment for a term which may extend to two year
and shall also liable to fine.
Section 68 : If the auditor induces a person fraudulently to invest money by knowingly or
recklessly making a statement or promise which is false or misleading or if he dishonestly conceals
the material facts, he shall be punishable with imprisonment for a term upto 3 years or with fine upto
Rs. 10,000 or both.
ii) Criminal Liabilities under Indian Penal Code :
Section 177 (IPC) : Six months simple imprisonment or fine of rs. 100 or both for false
declaration amounting to fraud or fraudulently furnishing false information.
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Section 19 (IPC) : prescribes imprisonment upto seven years and fine for giving false evidence
in Judicial proceedings.
iii) Criminal Liabilities under other Acts :
1. Under Section 104 of the Life Insurance Corporation Act 1956, an auditor may be
sentenced to imprisonment or fine or both if he gives a false statement knowingly in any
return, report on other forms to be issued under this Act.
2. Under section 227 of the Income Tax Act. Auditor is liable for 2 years imprisonment if he
submits any false statement in the form of accounts for the preparation of Income Tax
returns.
Important case laws – Criminal :
1. Rex Vs Lord Kolsant and another : In this case, the company has built up huge amounts
as secrete reserves in boom years and later on, used them when the company has suffered heavy
losses, without disclosing about these reserves to the share holders. The chairman, Lord Kylsant
and the auditor were criminally prosecuted on the ground that the chairman issued false statements of
accounts with an idea to deceive the shareholders and that the auditor has abetted in the issue of such
false reports. Both the accused were acquitted in the criminal case and the auditor was made liable
under civil liabilities for the breach of duty in connection with the accounts of the company. It may be
concluded that an auditor who does not disclose the fact of the creation of secret reserve and their
subsequent utilization in writing up the profits may have a civil liability but not be held criminally liable.
2. Rex Vs. Hinds Musgrave and Steven : In this case two directors and an auditor were
prosecuted on the ground that they have recklessly made a misleading statement in prospectus. The
auditor was prosecuted on the basis of his report set out in the prospectus. It was held that the
auditor was not reckless and hence was acquitted.
29.7 AUDITORS LIABILITY TO THIRD PARTIES :
When the auditor was negligent in discharging of his duties he is liable for damages only to
the Company or its liquididator. To make an auditor is liable for negligence, two things must be
proved.
a) auditor was negligent in discharging of his duties.
b) Due to his negligence the company has suffereda loss.
Where a third party has advanced any amount to a concern on the good faith of a certified
Balance Sheet in regard to the audit for which there has been negligence, the third party can’t hold
the auditor responsible for his loss. The reason is that, the auditor as an agent, responsible to his
clients and not to third parties who have not appointed him. There is no privity of contract with them.
It was held in Re Liver Pool and Wagon Supply Association Limited. In this cases auditor was held
not liable for misfeasance, as the loss sustained by creditors and not by the company appointed him.
If the auditor is guilty of fraud he becomes liable to a third party. There need not be a privity
of contract between the auditor and the third party.
The auditor’s liability to third parties was considered in the case of Derry Vs. Peek. If the
third party wants to hold the auditor liable for damages should prove the following facts.
1. That the statement of Balance Sheet signed by the auditor was materially untrue.
2. That the auditor knew that the statement or Balance Sheet was untrue.
3. That the statement was made to induce the third party act on it.
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4. That the third party did act upon the statement and suffered loss.
If third party advanced any loan to the company, on the faith of a certified Balance Sheet,
can claim damages from the auditor if he can prove all points stated above.
The Indian Courts also hold the same view that an auditor does not owe any duty to the third
parties and hence he cannot be held liable by them. In the case ofCommissioner of income Tax
Madras Vs. G.M. Dandekar it has been held that the auditor (defendant) owned no duty to
Income Tax Department since, he was not appointed by it and there was thus no negligence involved.
The present position regarding the liability of auditors to third parties is entirely different.
This is as a result of the British House of Lords decision in 1963 in the case of Hedley Byrne & Co.
Vs. Heller and Partners. It may be mentioned here that this case does not directly concern the
accountant but the principle laid down in this case is applicable to him. As result of the decision
“auditors can no longer be regarded as immune from liability in cases where they knew or ought to
have known that the report or statement prepared by them would be shown to and relied upon by
theory third party in that particular connection”.
29.8 SUMMARY
Indian companies Act, 1956 provides for the appointment, remuneration, removal, duties
and qualifications, etc. According to section 226 of companies Act, the auditor of a company must
posses either of the following qualifications. He should be a chartered accountant with in the meaning
of the Chartered Accountant’s Act 1949. He should be a holder of a certificate under the Restricted
Auditor’s certificate (part B states) Rules 1956. Section 226 (3) provides various disqualifications
of an auditor. Board of Directors, Share holders and Government are empowered to appoint the
auditors. The retiring auditor has got a right to represent his case in writing to the company. He must
be given sufficient time to represent his case. The rights of an auditor cannot be limited either by the
Articles of Association or by resolution of share holders. Liabilities of an auditor may be considered
in case of private business i.e. non-statutory audit and liabilities in case of company audit.
29.9 KEY WORDS
Casual vacancy is caused by the resignation of an auditor.
Auditor is appointed as per section 224 of Indian Companies Act.
Civil Liability is the liability of an auditor to pay damages.
1. State the provisions of Indian Companies Act, 1956 regarding qualifications of an auditor.
2. State the procedure of appointment and removal of auditors.
3. What are the rights of an auditor in a limited company.
4. Explain the civil and criminal liabilities of an auditor under the companies Act.
5. Discuss the liability of an auditor for negligence.
6. “An auditor must be a watch dog but not a blood hound” Elucidate.
Delhi
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GUIDELINE 30 : AUDIT REPORT
OBJECTIVES
· The concept of audit report
· The importance and various types of audit report
STRUCTURE
30.1 Introduction
30.2 Meaning and Definition of Audit Report
30.3 Importance of Audit Report
30.4 Types of Auditor’s Report
30.5 Clean Report
30.6 Qualified Report
30.7 Summary
30.8 Key Words
30.1 INTRODUCTION
Audit is compulsory to all companies. The main purpose of company audit is to safe guard
the interests of the share holders. After completion of audit the auditor has to submit a report of his
findings to the share holders of the company. Such a report is known as “Audit Report”. The auditor
has to clearly disclose the scope of the work done and the responsibility assumed regarding the
fairness of accounts or financial statements.
30.2 MEANING AND DEFINITION OF AUDIT REPORT
The auditor’s report is the medium through which an auditor expresses his opinion on the
financial statements. A report is nothing but a statement of facts. The facts and information collected
and incorporated in the Auditor’s report are to be conveyed to the shareholders. The audit report
should be written in clear and concise words. It should contain only facts and not any assumptions.
There should be no room for ambiguity. Hence it is said that Auditor’s Report is the end product of
every audit.
An audit report has been defined by different authors and practitioners. The important
definition given by Lancaster is given below.
Lancaster defines an audit report as “Statement of collected and considered facts, so drawn
up as to give clear and complete information to persons who are not already in possession of the full
facts of the subject matter of the report.
30.3 IMPORTANCE OF AUDIT REPORT

Audit report is of much helpful to the share holders. Through audit report share holders
understand the financial position and other aspects of the company. It reveals the opinion of the
auditor on the account maintained by the company.
513
Contents of Audit Report : An auditor must state in his report the following :
1) Whether in his opinion and to the best of his information and according to the explanations
given to him, the accounts examined by him given the information required by the Act in the
manner so required and give a true and fair view :
a) in the case of balance sheet, of the state of the Company’s affairs as at the end of its
financial year ; and
b) in the case of profit and loss account, of the profit or loss for its financial year.
2) Whether he has obtained all the information and explanations which to the best of his knowledge
and belief were necessary for the purpose of his audit.
3) Whether in his opinion, proper books of account as required by law have been kept by the
company so far as appears from his examination of those books, and proper returns adequate
for the purpose of is audit have been received from branches not visited by him.
4) Whether the report on the accounts of any branch office audited under section 228 by a
person other than company’s auditor has been forwarded to him as required and how he has
dealt with the same in preparing the auditor’s report ; and
5) Whether the company’s balance sheet and profit and loss account dealt with by the
report are in agreement with the books of account and returns.
30.4 TYPES OF AUDITOR’S REPORT
An auditors report may be a clean report or qualified report.
Clean Report is also called as unqualified report. When the auditor is completely satisfied
and finds nothing objectionable in final accounts, he will give a report to the share holders which is
known as clean report. In other words, a clean report is a report which is free from any adverse
comment.
Qualified Report : when an auditor is not satisfied with the final accounts, he should instruct
the directors make necessary alterations. If the directors fail to refuse to do so, he must mention in
his report the point on which he is not satisfied, such a report may be called as qualified report.
30.5 CLEAN REPORT
To the shareholders of XYZ Company Ltd.,
We have audited the attached balance sheet of X and Company Ltd., as at 31st March,
1991, and also attached the profit and loss Account of the Company for the year ended on that date
and report that
1) We have obtained all the information and explanations which to the best of our
knowledge and belief were necessary for the purposes of our audit.
2) In our opinion, proper books of account as required by law have been kept by the
company, so far as appears from our examination of the books and
3) The company’s balance sheet and profit and loss Account deals with by this report are in
agreement with the books of account.
4) In our opinion and to the best of our information and according to the explanations given to
us, the accounts examined by us give the information required by the Act in the manner so
required and give a true and fair view.
a) In the case of the balance sheet, of the state of the company’s affairs as at 31st March, 1991.
514
b) In the case of Profit and Loss Account, of the profit for the year ended on that date.
Date : 31-3-1991 K.L.G.R. Solanki
(Chartered Accountant)
30.6 QUALIFIED REPORT
An auditor’s report may be a clean report or qualified report. When the auditor is satisfied
with the final accounts he will submit a report to the shareholders called as clean report.
When an auditor is not satisfied with the final accounts, he should instruct the directors to
make necessary alterations. If the directors fails or refuse to do so, he must mention in his report may
be called as qualified report.
Generally a qualified report exhibits an adverse reflection on the activities of the directors.
Some times it may leads to bad consequences. Generally the directors will persuade not to give
qualified report. The auditor being person appointed to safeguard the interests of share holders
should not allow himself influenced by directly or indirectly. He should not hesitate to submit his
report when he was not satisfied. The auditor should make the report very clear and no ambiguous
words or phrases should be used.
Specimen of Qualified Report :
To the share holders of PQR Company Ltd.
I have audited the annexed Balance Sheet of PQR Ltd. As at 31.3.1991 and also the annexed
profit and loss account of the company for the year ended on that date and report that :
1) I have obtained all the information and explanations which to the best of my knowledge and
belief were necessary for the purpose of my audit.
2) in my opinion proper books of account as required bylaw have been kept by the company
so far as appears from my examination of the books.
3) The Balance Sheet and profit and loss account dealt with by this report are in agreement with
the books of account.
4) Subject to the reservations given below, in my opinion and to the best of my information and
according to the explanations given to me, the accounts give the information required by the
companies Act, 1956, in the manner so required and give a true and fair view.
a) In the case of Balance Sheet of the state of the affairs of the company as at 31st March 1991
and
b) In the case of the profit and loss account of the profit of the company for the year ended on
that date.
i) The provision for depreciation on fixed assets is inadequate.
ii) No provision has been made for the doubtful debts in face of the fact that some of the debts
are quite old time barred.
iii) The stock-in-trade has been valued at market price which is higher than the cost price.
iv) The investments have been valued at cost price which is in excess of the market price by Rs.
6500.
v) Rs. 150 spent on machinery by way of repairs is capitalised.
Date : 31-3-1991 K. Ramrao,
515
(Chartered Accountant)
30.7 SUMMARY
After completion of audit the auditor has to submit a report of his findings to the share
holders of the company. Such a report is known as “Audit Report”. The auditor has to clearly
disclose the scope of the work done and the responsibility assumed regarding the fairness of accounts
or financial statements. Through audit report share holders understand the financial position and
other aspects of the company. It reveals the opinion of the auditor on the account maintained by the
company. Clean Reportis also called as unqualified report. Qualified Report when an auditor is not
satisfied with the final accounts, he should instruct the directors make necessary alterations. If the
directors fail to refuse to do so, he must mention in his report the point on which he is not satisfied,
such a report may be called as qualified report.
30.8 KEY WORDS
Audit Report is nothing but statement of facts. It is the end product of every audit.
Clean Report is also called an unqualified report which is free from any adverse comment.
Qualified Report is the one in which the auditor points out the failure of directors.
1. What is the meaning of audit report and explain its importance ?
2. Discuss the various contents of audit report.
3. What is a clean report ? Draft a specimen clean report.
4. What is qualified report ? Draft a specimen qualified audit report of a joint stock company.
Delhi
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516

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Master of Commerce

204A –FINANCIAL ACCOUNTING AND AUDIT

SCHOOL OF DISTANCE EDUCATION

SCHOOL OF DISTANCE EDUCATION

LESSON WRITERS GUIDELINES

Prof. K. Sambasiva Rao

Prof. A. Narasimha Rao

Prof. M.Akbar Ali Khan

Prof. N. Chandrasekhara Rao

Prof. K.Sambasiva Rao

Balance Sheet of (name of the company) as at - (date of the Balance Sheet)

Figures Liabilities Figures Figures Assets Figures

2.6 FORM AND CONTENTS OF PROFIT AND LOSS ACCOUNT OR INCOME

Form and Contents of Profit and Loss Appropriation Account of ____________

2.8 USE AND IMPORTANCE OF FINANCIAL STATEMENTS

Sales 3,60,000 4,50,000 90,000 25.00

Particulars 2005 2006

Comparative Income Statement of Ranbaxy Ltd.

Particulars 2005 2006 Absolute Percentage

Sales 2,30,000 2,60,000 30,000 13.04

3. There is a margined increase in operating expenses (16.67%), which resulted a

5. The over all profitability of the company is more than satisfactory.

Liabilities 2006 2007 Assets 2006 2007

Capital 3,00,000 3,00,000 Cash & Bank Balance 10,000 5,000

The over all financial position of the company appears to be satisfactory.

Particulars Absolute % Absolute %

Sales 600 100.00 800 100.00

From the following P/L a/c of X Company prepare a Common-Size statement.

Particulars 2005 2006 Particulars 2005 2006

Prepare a common-size Balance Sheet and Comment on the same.

This analysis is an important tool of horizontal analysis. This method is immensely

Absolute value of the item for the period

Year Sales Stock Profit Before Tax

Base Year 2002 = 100

Sales Stock Profit before Tax

2002 7,524 100 2,836 100 1,284 100

2003 9,360 124 3,124 110 1,740 136

2004 10,620 141 3,264 115 1,832 143

2005 12,084 161 3,776 133 2,108 164

Particulars 2003 2004 2005 2006

Liabilities 2003 2004 2005 2006

Particulars 2005 2006

Liabilities 2005 2006 Assets 2005 2006

Particulars Amount % Amount %

3. Fixed Assets increased from Rs.80,000 to Rs.1,47,500. as a result of purchase of

4. The overall financial position of the company is satisfactory.

7. a) Trend Ratios of different item (Base year 2003)

Particulars 2003 2004 2005 2006

b) Trend percentages of relationships of Wages, Selling expenses, Gross Profit to Sales.

2005 2006 Increase Change in

Total Liabilities 16,450 17,990 1,540 9.36

3. Share holders funds increased by 3%.

4. Overall financial position to some extent satisfactory because reserves shows an

9. Common Size Balance Sheets

Jaya Ltd is more traditionally financed as compared to Bharat Ltd.

A. Short Answer Questions

Liabilities 2005 2006 Assets 2005 2006

Balance Sheet as on 31st December (In Lakhs of Rs.)

Liabilities 2005 2006 Assets 2005 2006