Understanding Financial Statements

Managers, shareholders, creditors, employees, suppliers, lenders, business partners, tax

authorities, regulators, and other interested groups seek answers to the following important
questions about a firm:

• What is the financial position of the firm at a given point of time?

• How has the firm performed financially over a given period of time?
• What have been the sources and uses of cash over a given period of time?

To answer the above questions, the accountant prepares three statements, the balance
sheet, the profit and loss account, and the cash flow statement. The balance sheet shows
the financial position (or condition) of the firm at a given point of time. It provides a
snapshot and may be regarded as a static picture. The profit and loss account reflects the
performance of the firm over a period of time. Finally, the cash flow statement shows the
sources and uses of cash during the period.

Usually a firm has to prepare two sets of statements, one for financial reporting and the
other for tax purposes. The statements meant for financial reporting are found in the
annual report and are public; the statements for tax purposes are not public. This chapter
discusses the former, not the latter.

This chapter provides a primer on financial statements. It is divided into nine sections as
follows:

• Overview of business activities

• Basic concepts underlying financial accounting.
• How the accounting model works
• Balance sheet
• Statement of profit and loss
• Statement of cash flows

1.1 OVERVIEW OF BUSINESS ACTIVITIES

Financial statements present the results of a firm's business activities. So, before we discuss
financial statements, let us look at the business activities they attempt to portray.

The key business activities of a firm are: (a) establishing goals and developing strategies,
(b) raising funds, (c) investing in resources, and (d) conducting operations.

The goals of a firm are the end results the firm seeks to achieve and the strategies of the
firm are the means for achieving its goals. A firm sets its goals and develops its strategies
taking into account the economic, institutional, and cultural environment in which it operates.

To illustrate, the goals of Modern Electronics may be to develop a stream of new electronic
products that it can manufacture and market profitably so that the value of the firm is enhanced.
To accomplish its goals, Modern Electronics may pursue the following strategies: (a) invest
substantially in research and development, (b) manufacture the critical devices internally to
ensure quality and protect against imitation by competitors, and (c) market the products through
highly qualified and trained technical personnel.
 Modern Electronics will need funds for its activities. The two broad sources of finance
available to a firm are shareholders' funds (also called equity) and loan funds (also called debt).
Shareholders' funds come mainly in the form of equity capital (referred to as ordinary capital
in India) and retained earnings and secondarily in the form of preference capital. Loan funds
can be raised through various means or instruments such as debentures, term loans, deferred
credit, fixed deposits, and working capital loans.

The finances raised by a firm are invested in a variety of fixed assets such as land, buildings,
equipment, and warehouses. These resources provide the capacity to manufacture and
distribute products and services for years to come. Apart from fixed assets, the firm also invests
in raw materials, receivables, manpower training, research and development, and other things
so that it can carry out operating activities.

Operating activities are concerned with the production and delivery of goods and services
to customers. Firms seek to charge a price for their goods and services so that they cover all
their costs and earn a satisfactory profit margin.

Exhibit 1.1
Business Activities

Establish goals
and strategies

Raise Invest in
finances resources

Conduct
operations

1.2 BASIC CONCEPTS UNDERLYING FINANCIAL ACCOUNTING

A business firm engages in a number of economic transactions. It raises capital, it invests in

different kinds of assets, it buys raw materials on credit or cash, it transforms raw materials
into finished goods by applying labour and machinery, it sells finished goods on credit, it
collects its receivables, it pays interest and taxes, it depreciates its machineries, it repays
borrowed money, so and so forth.

The financial accounting model processes the economic transactions to produce a set of
financial statements as shown in Exhibit 1.2.

Exhibit 1.2
The Accounting Model

Economic Accounting Financial

transactions model statements
 The framework of financial accounting is based on several concepts (also referred to as
postulates, conventions and principles) which have received widespread, though not universal,
acceptance by accountants. The important concepts are briefly described below:

Entity Concept For purposes of accounting, the business firm is regarded as a separate entity.
Accounts are maintained for the entity as distinct from the persons who are connected with it.
The accountant records transactions as they affect this entity and regards owners, creditors,
suppliers, employees, customers and the government as parties transacting with this entity.

Money Measurement Concept Accounting is concerned with only those facts which are
expressible in monetary terms. The use of a monetary yardstick provides a means by which
heterogeneous elements, such as land, plant and equipment, inventories, securities, and
goodwill may be expressed in a common denominator.

Going Concern Concept According to the going concern concept, accounting is normally
based on the premise that the business entity will remain a going concern for an indefinitely
long period.

Cost Concept Assets acquired by a business are generally recorded at their cost and this is
used for all subsequent accounting purposes. For example, depreciation is charged on the basis
of the original cost. It is evident that this concept is related to the stable monetary unit concept.

Dual Aspect Concept Regarded as the most distinctive and fundamental concept of
accounting, the dual aspect concept provides the basis for accounting mechanics. Before
explaining this concept, let us define the terms ‘assets’, ‘liabilities’, and 'equity'.

Assets are what the firm ‘owns’. The major assets of a firm are land, buildings, plant and
machinery, financial securities, inventories, debtors, bank balances, and advances and loans
given to others.

Liabilities are what the firm owes to various parties such as lenders, suppliers, employees,
government, and others. Term loans, working capital advances, trade credit, wages payable,
and taxes payable are examples of liabilities.

Equity represents the residual interest of the owners in the assets of the firm. Equity is simply
the difference between the assets of the firm and its liabilities.

According to the dual aspect principle the assets of the firm are always equal to its liabilities
and equity.
Assets = Liabilities + Equity

How come that the above identity always holds? To answer this question let us look at the
relationship between the firm (the accounting entity) and the owners.

If the firm makes profits which are ploughed back in the business, Retained Earnings
(which represent a part of equity) increase. It is as if the firm were telling the owners: “Since
you have created me, the profits that I have retained belong to you. So, I am increasing the
Retained Earnings and thereby acknowledging that you have a higher claim on me”.
 What happens if the firm incurs losses? If the firm incurs losses, Retained Earnings decline.
It is as if the firm were telling the owners: “Since you have created me, the losses incurred by
me shall be borne by you. So I am reducing the Retained Earnings and thereby reducing your
claim on me”.

Thus, the balance in the Retained Earnings account is adjusted to ensure that the balance
sheet always balances.

Accounting Period Concept In order to know the results of business operations and financial
position of the firm periodically, time is divided into segments referred to as accounting
periods. Income is measured for these periods and the financial position is assessed at the end
of an accounting period.
Accrual Concept Revenues are recognised when sales are made or services rendered,
irrespective of when cash is received. Expenses are matched to sales, regardless of when cash
is paid. Net profit of a period is the difference between the revenues earned and expenses
incurred in the period.

Realisation Concept According to the realisation concept, revenue is deemed to be earned

only when it is realised. When is revenue realised? It is normally deemed to be realised when
goods are shipped or delivered to the customer, and not when a sales order is received or a
contract signed or goods manufactured.

Matching Concept Once revenues for an accounting period are recognised, expenses incurred
in generating these revenues are matched against them. This ensures that sales and cost of
goods sold in the income statement refer to the same products. Note that expenses are matched
to revenues and not vice versa.

1.3 HOW THE ACCOUNTING MODEL WORKS

At this juncture, it might be instructive to show how the accounting model processes economic
transactions. We will use a simple illustration in which all the transactions will be recorded
directly on the balance sheet.

Ram sets up a proprietory business called Ram Enterprises. The transactions of the firm
for the first quarter are recorded on the balance sheet as follows:

Transaction 1: Ram contributes Rs.500,000 as equity capital which is deposited in a bank

account opened in the name of Ram Enterprises.

This means that an asset (bank deposit) increases by Rs.500,000 and an equity account
(share capital) increases by Rs.500,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Share capital : Rs.500,000 Bank deposit : Rs.500,000

Total : Rs.500,000 Total : Rs.500,000

Transaction 2: Ram Enterprises pays Rs.100,000 as deposit for hiring office premises – we
will call this as ‘premise deposit’.
 This means that an asset (premise deposit) increases by Rs.100,000 and another asset (bank
deposit) decreases by Rs.100,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Share capital : Rs.500,000 Bank deposit : Rs.400,000
Premise deposit : Rs.100,000

Total : Rs.500,000 Total : Rs.5,00,000

Transaction 3: Ram Enterprises buys furniture and fixtures for Rs.300,000 in cash.

This means that an asset (furniture and fixtures) increases by Rs.300,000 and another asset
(bank deposit) decreases by Rs.300,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.100,000
Premise deposit Rs.100,000
Furniture & fixtures Rs.300,000

Total Rs.500,000 Total Rs.500,000

Transaction 4: Ram Enterprises buys merchandise worth Rs.300,000 on credit.

This means that an asset (merchandise) increases by Rs.300,000 and an equity account
(trade creditors) increases by Rs.300,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.100,000
Trade credit Rs.300,000 Premise deposit Rs.100,000
Furniture & fixtures Rs.300,000
Merchandise Rs.300,000

Total Rs.800,000 Total Rs.800,000

Transaction 5: Ram Enterprises sells merchandise costing Rs.100,000 for Rs.120,000 on

cash.

This means that an asset (bank deposit) increases by Rs.120,000, another asset
(merchandise) decreases by Rs.100,000, and an equity account (Retained Earnings) increases
by Rs.20,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.220,000
 Retained Earnings Rs.20,000 Premise deposit Rs.100,000
Trade creditors Rs.300,000 Furniture & fixtures Rs.300,000
Merchandise Rs.200,000

Total Rs.820,000 Total Rs.820,000

Note that this transaction generated a profit of Rs.20,000 which has been retained in the
business. This is shown in the Retained Earnings account.

Transaction 6: Ram Enterprises sells merchandise costing Rs.80,000 for Rs.100,000 on

credit.

This means that an asset (debtors) increases by Rs.100,000, another asset (merchandise)
decreases by Rs.80,000, and an equity account (Retained Earnings) increases by Rs.20,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.220,000
Retained Earnings Rs.40,000 Premise deposit Rs.100,000
Trade creditors Rs.300,000 Furniture & fixtures Rs.300,000
Merchandise Rs.120,000
Debtors Rs.100,000

Total Rs.840,000 Total Rs.840,000

Transaction 7: Ram Enterprises pays establishment expenses of Rs.5,000 in cash.

This means that an asset (bank deposit) decreases by Rs.5,000 and an equity account
(Retained Earnings) decreases by Rs.5,000.

The effect of this transaction on the balance sheet of Ram Enterprises is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.215,000
Retained Earnings Rs.35,000 Premise deposit Rs.100,000
Trade credit Rs.300,000 Furniture & fixtures Rs.300,000
Merchandise Rs.120,000
Debtors Rs.100,000

Total Rs.835,000 Total Rs.835,000

Transaction 8: Ram Enterprises pays Rs.9,000 as rent in cash.

This means that an asset (bank deposit) decreases by Rs.9,000 and an equity account
(Retained Earnings) decreases by Rs.9,000.

The effect of this transaction on the financial position of the firm is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.206,000
Retained Earnings Rs.26,000 Premise deposit Rs.100,000
 Trade credit Rs.300,000 Furniture & fixtures Rs.300,000
Merchandise Rs.120,000
Debtors Rs.100,000

Total Rs.826,000 Total Rs.826,000

Transaction 9: Ram Enterprises depreciates its furnitures and fixtures by Rs.10,000.

This means that an asset (furniture and fixtures) decreases by Rs.10,000 and an equity
account (Retained Earnings) decreases by Rs.10,000.

The effect of this transaction on the financial position of the firm is as follows:

Liabilities + Equity Assets

Capital Rs.500,000 Bank deposit Rs.206,000
Retained Earnings Rs.16,000 Premise deposit Rs.100,000
Trade credit Rs.300,000 Furniture & fixtures Rs.290,000
Merchandise Rs.120,000
Debtors Rs.100,000

Total Rs.816,000 Total Rs.816,000

If you compare the above balance sheet with the opening balance sheet you find that
‘Retained Earnings’ which is nil in the opening balance sheet is Rs.16,000 in the above balance
sheet. This implies that the transactions of the first quarter have resulted in a profit of
Rs.16,000. Put differently, revenues have exceeded expenses by Rs.16,000. The statement
showing revenues, expenses, and profit (or loss), which is the profit and loss statement, is given
below.

Profit and Loss Statement

• Revenues 220,000
Cash sales : 120,000
Credit sales : 100,000

• Expenses 204,000
Merchandise cost : 180,000
Establishment expenses : 5,000
Rent : 9,000
Depreciation : 10,000

• Profit 16,000

Accounting Is as Simple as 1-2-3-4

If you carefully review the above illustration, you will find that accounting is as simple as 1-2-
3-4. The four rules of accounting are as follows:
Rule 1. Every transaction has a bearing on at least two accounts in the balance sheet. Examples:

• When Ram contributes Rs.500,000 toward share capital, the share capital account
increases by Rs.500,000 and the bank deposit increases by Rs.500,000.
• When Ram Enterprises buys furniture and fixtures for Rs.300,000 in cash, the furniture
and fixtures account increases by Rs.300,000 and the bank deposit account decreases
by Rs.300,000.
• When Ram Enterprises sells merchandise costing Rs.80,000 for Rs.100,000 on credit,
the merchandise account decreases by Rs.80,000, the debtors account increases by
Rs.100,000, and the Retained Earnings account increases by Rs.20,000.
• When Ram Enterprises pays Rs.9,000 as rent in cash, the bank deposit account
decreases by Rs.9,000 and the Retained Earnings account decreases by Rs.9,000.

Rule 2. Irrespective of what the transaction is, the balance sheet identity is always
preserved.

Assets =Equity + Liabilities

Rule 3. Transactions which do not result in a revenue or expense, have no bearing on the
‘Retained Earnings’ account. Examples:
• Ram contributes Rs.500,000 toward share capital which is deposited in a bank
account.
• Ram Enterprises buys furniture and fixtures for Rs.300,000 in cash.
• Ram Enterprises buys merchandise worth Rs.300,000 on credit.

Rule 4. Transactions which result in a revenue or expense have a bearing on the

‘Retained Earnings’ account. Revenues augment ‘Retained Earnings’
whereas expenses decrease ‘Retained Earnings’. Transactions which result
in revenues and expenses are reflected on the Profit and Loss Account.

1.3 BALANCE SHEET

As you have seen, the balance sheet shows the financial condition of a business at a given time.
Exhibit 1.3 shows the balance sheet of a hypothetical firm Horizon Limited as at March
31,20X1, prepared as per the format prescribed under the companies Act.

Please note that:

• The balance sheet is prepared for Horizon Limited which is regarded as a separate
accounting entity (entity concept).
• The figures in the balance sheet are expressed in monetary terms (monetary concept).
• The balance sheet assumes that Horizon Limited is a going concern (going concern
concept).
• The fixed assets are stated at cost less depreciation (cost concept).
• The current assets are stated at cost or market value, whichever is lower (conservatism
concept).
• Assets are equal to liabilities + equity (dual aspect concept).
 Exhibit 1.3
Balance Sheet of Horizon Limited as at March 31, 20X1
Rs million
________________________________________________________________________
EQUITY AND LIABILITIES 20X1 20X0

• Shareholders’ Equity 500 450

• Share capital 100 100
• Retained Earnings 400 350
• Non-current Liabilities 300 270
• Long-term borrowings 200 180
• Deferred tax liabilities (net) 50 45
• Other long-term liabilities - -
• Long-term provisions 50 45
• Current Liabilities 200 180
• Short-term borrowings 40 30
• Trade payables 120 110
• Other current liabilities 30 30
• Short-term provisions 10 10
1,000 900
ASSETS

• Non-current Assets 600 550

• Fixed assets 500 450
• Non-current investments 50 40
• Long-term loans and advances 50 60
• Current Assets 400 350
• Current investments 20 20
• Inventories 160 140
• Trade receivables 140 120
• Cash and cash equivalents 60 50
• Short-term loans and advances 20 20
1000 900
________________________________________________________________________

Equity and Liabilities

Equity and liabilities represent what the firm owes others. The format prescribed in the
Companies Act classifies equity and liabilities as follows:
• Equity
• Non-current liabilities
• Current liabilities

Equity Capital also called as Shareholders’ funds represent the contribution made by
shareholders in some form or the other. They include share capital, Retained Earnings, and
money received against share warrants. Equity capital includes equity (or ordinary) capital
and preference capital. Equity capital represents the contribution of equity shareholders who
are the owners of the firm. Equity capital, being risk capital, carries no fixed rate of dividend.
Preference capital represents the contribution of preference shareholders and the dividend rate
payable on it is generally fixed.

Retained Earnings (Other Equity), often the most significant item on the balance sheet,
represent retained earnings as well as non-earnings items such as share premium. Retained
Earnings comprise of capital reserves, securities premium reserve, debenture redemption
reserve, revaluation reserve, general reserve, other Retained Earnings in the statement of profit
and loss.

Non-current Liabilities Non – current liabilities are liabilities which are expected to be settled
after one year of the reporting date. They include long-term borrowings, deferred tax liabilities,
long-term provisions, and other long-term liabilities.

Long-term borrowings are borrowings which have a tenor of more than one year. They
generally comprise of term loans from financial institutions and banks in India and abroad,
rupee bonds (debentures) and foreign currency bonds, and public deposits. Term loans and
bonds are typically secured by a charge on the assets of the firm, whereas public deposits
represent unsecured borrowings.

Deferred tax liability (or asset) arises because of the temporary differences between taxable
income and accounting profit. A deferred tax liability (asset) is recognised when the charge in
the financial statements is less (more) than the amount allowed for tax purposes.

Other non –current liabilities include items like liability toward premium on redemption of
non-convertible debentures, deferred payment liabilities, and so on.

Long-term provisions include provisions for employee benefits such as provident fund,
gratuity, superannuation, and leave encashment and other provisions.

Current Liabilities Current liabilities are liabilities which are due to be settled within twelve
months after the reporting date. They include short-term borrowings, trade payables, short-term
provisions, and other current liabilities. Short-term borrowings are borrowings which have
a tenor of less than one year. They comprise mainly of working capital loans, inter-corporate
deposits, commercial paper, and public deposits maturing in less than one year.

Trade payables are amounts owed to suppliers who have sold goods and services on credit.
Short-term provisions mainly represent provisions for dividend and taxes
Other current liabilities are items like current maturities of long term borrowings, advance
payments from customers, and so on.

Assets

Assets are resources which are expected to provide a firm with future economic benefits, by
way of higher cash inflows or lower cash outflows. Resources are recognised as assets in
accounting when (a) the firm acquires rights over them as a result of a past transaction and (b)
the firm can quantify future economic benefits with a fair degree of accuracy
Assets are classified as follows under the format prescribed by the Companies Act:
• Non- current assets
• Current assets
Non-current Assets Non-current assets are relatively long-lived assets. They consist of fixed
assets, non-current investments, deferred tax assets (net), long-term loans and advances, and
other non-current assets.
Fixed assets comprise of tangible fixed assets, intangible fixed assets, capital work-in progress,
and intangible assets under development. Tangible fixed assets include items such as land,
buildings, plant, machinery, furniture, and computers. They are reported in the balance sheet
at their net book value, which is simply the gross value (the cost of acquiring the asset) less
accumulated depreciation. Intangible fixed assets include items such as patents, copyrights,
trademarks, and goodwill. Intangible fixed assets are reported at their net book value, which is
simply the gross value less accumulated amortisation.
Non-current investments generally comprise of financial securities like equity shares,
preference shares, and debentures of other companies, most of which are likely to be associate
companies and subsidiary companies. These investments are meant to be held for a long period
and are made for the purpose of income and control.Non-current investments are stated at cost
less any diminution of value which is regarded as permanent in the opinion of management.
Long-term loans and advances are usually loans and advances to subsidiaries, associate
companies, employees, and others for a period of more than one year.
Other non-current assets consist of items like prepaid debt issue cost, interest accrued on
deposits or loans, and so on.
Current Assets An asset is classified as a current asset when it satisfies any of the following
criteria: (a) it is expected to be realised in, or is intended for sale or consumption in, the
company’s normal operating cycle, (b) it is held primary for the purpose of being traded, (c) it
is expected to be realised within twelve months after the reporting date, or (d) it is cash or cash
equivalent unless it is restricted from being exchanged or used to settle a liability for at least
twelve months after the reporting date. All other assets are classified as non-current.

Current assets include current investments, inventories, trade receivables, cash and cash
equivalents, short-term loans and advances, and other currents assets. Current investments
mainly represent short-term holdings of units or shares of mutual fund schemes. These
investments are made primarily to generate income from short-term cash surpluses of the firm.
Current investments are carried at cost or market (fair) value, whichever is lower.

Inventories (also called stocks) comprise of raw materials, work-in-process, finished goods,
packing materials, and stores and spares. Inventories are generally valued at cost or net
realisable value, whichever is lower. The cost of inventories includes purchase cost,
conversion cost, and other cost incurred to bring them to their respective present location and
condition. The cost of raw materials, stores and spares, packing materials, trading and other
products is generally determined on weighted average basis. The cost of work-in-process and
finished goods is generally determined on absorption costing basis - this means that the cost
figure includes allocation of manufacturing overheads.

Trade receivables (also called accounts receivable or sundry debtors) represent the
amounts owed to the firm by its customers (who have bought goods and services on credit) and
others. Sundry debtors are classified into two categories viz., debts outstanding for a period
exceeding six months and other debts. Further, sundry debtors are classified as debts
considered good and debts considered doubtful. Generally, firms make a provision for doubtful
debts which is equal to debts considered doubtful. The net figure of trade receivables is arrived
at after deducting the provision for doubtful debts.
 Cash and cash equivalents comprise of cash on hand and credit balances with scheduled
banks and non-scheduled banks.

Short-term loans and advances comprise of loans and advances given to suppliers,
employees, and other companies that are recoverable within a year. The net figure of short-
term loans and advances is arrived at after deducting a provision for doubtful advances, if any.

Other current assets comprise of items such as interest accrued on investments, dividends
receivable, and fixed assets held for sale (the last item is valued at net book value or estimated
net realisable value, whichever is lower).

1.4 STATEMENT OF PROFIT AND LOSS

The statement of profit and loss presents a summary of the operating and financial transactions
which have contributed to the change in the owners' equity during the accounting period.
Revenues are transactions that augment owners' equity and expenses are transactions that
diminish owners' equity. Hence, the net change in owners' equity during an accounting period,
called as profit after tax, is:

Profit after tax = Revenues - Expenses

This relationship is the basis for constructing the statement of profit and loss which first
reports revenues, then expenses, and finally the profit after tax.

Among the various principles underlying the financial accounting model, two are of
particular significance for understanding the profit and loss account, viz., the realisation
principle and the matching principle. Though they have been touched upon earlier, they bear
reiteration here.

According to the realisation principle, a revenue is recognised when the transaction

generating the revenue takes place and not when the cash for the transaction is received. To
illustrate this principle, let us consider an example. Suppose a firm sells goods worth Rs.10,000
on credit to a customer. The revenue is recognised when the sale takes place even though cash
may be received later. When the firm receives cash, it will adjust its balance sheet by
decreasing the debtors and increasing the cash.

The matching principle says that the expenses associated with a product are recognised
when the product is sold not when the cash payment is made. For example, consider a retail
firm that purchases an item from a wholesaler, stocks is, and finally sells it. The expense will
be recognised when the item is sold, not when it is purchased or when it is paid for.

Together, the realisation and matching principles form the basis for what is called accrual
accounting. Thanks to accrual accounting, the profit after tax of a firm is generally different
from its net cash flow.

Exhibit 1.4 shows the statement of profit and loss for Horizon Limited for the year ending
March 31, 20X1, prepared as per the format prescribed by the Companies Act.
 Exhibit 1.4
Statement of Profit and Loss for Horizon Limited for Year Ending March
31, 20X1
Rs. in million

Current Period Previous Period

• Revenues from Operations 1290 1172
• Other Income 10 8
• Total Revenues 1300 1180
• Expenses
• Material expenses 600 560
• Employee benefit expenses 200 180
• Finance costs 30 25
• Depreciation and amortization expenses 50 45
• Other expenses 240 210
• Total Expenses 1120 1020
• Profit Before Exceptional items and tax 180 160
• Exceptional Items - -
• Profit Before Extraordinary Items and Tax 180 160
• Extraordinary Items - -
• Profit Before Tax 180 160
• Tax Expense 50 40
• Profit (Loss) for the Period 130 120

Revenues from operations represent revenues from (a) sales of products and services less
excise duties and (b) other operating income. For a finance company, revenues from operations
consist of revenues from interest and financial services.

Other income consists of the following: (a) interest income (in case of a company other
than a finance company), (b) dividend income, (c) net gain/loss on sale of investments, and (d)
other non-operating income (net of expenses directly attributable to such income).
Expenses comprise of material expenses, employee benefit expenses, finance costs,
depreciation and amortisation expenses, and other expenses. Material expenses equal the cost
of materials consumed plus purchase of stock-in-trade minus (plus) increase (decrease) in
inventories of finished goods, work-in-progress, and stock-in-trade. Employee benefit
expenses are classified as follows: (a) salaries and wages, (b) contribution to provident and
other funds, (c) expense on employee stock option plan (ESOP) and employee stock purchase
plan (ESPS), and (d) staff welfare expenses. Finance costs are classified as follows: (a)
interest expense, (b) other borrowing costs, and (c) applicable net gain / loss on foreign
currency transactions and translations. Depreciation represents the allocation of the cost of
tangible fixed assets to various accounting periods that benefit from their use; likewise,
amortisation represents the allocation of the cost of intangible fixed assets to various
accounting periods that benefit from their use.
Exceptional items are material items which are which are infrequent, but not unusual,
and they have to be disclosed separately by virtue of their size and incidence, for financial
statements to present a true and fair view. Examples of exceptional items are profits or losses
on the disposal of fixed assets, abnormal charges for bad debts and write-offs of inventories,
surplus arising from the settlement of insurance claims, write off of previously capitalised
expenditure on intangible fixed assets other than as part of a process of amortisation.

Tax expense consists of current tax and deferred tax. Current tax is computed by
multiplying the taxable income, as reported to the tax authorities, by the appropriate tax rate.
Deferred tax, also called future income tax, is an accounting concept that arises on account of
temporary difference (also called timing difference) caused by items which are included for
calculating taxable income and accounting profit but in a different manner over time. For
example, depreciation is charged as per the written down value for the taxable income but as
per the straight line method for calculating the accounting profit. As a result, there are
differences in the year-to-year depreciation charges under the two methods, but the total
depreciation charges over the life of the asset would be the same under both the methods.

1.7 OTHER ITEMS IN THE ANNUAL REPORT

The annual report of the company is perhaps the most important source of information about
the affairs of the company. In addition to the three financial statements , which form its core,
the annual report contains the following:

• Directors’ Report
• Management Discussion and Analysis
• Report on Corporate Governance
• Notes to Financial Statements

Directors’ Report Directors’ Report gives a summary of financial performance, recommends

a dividend, provides information on appointment of directors, auditors, and cost auditors, and
carries a Directors’ Responsibility Statement. In addition, it contains information on credit
rating, fixed deposits, employee stock option scheme, strategic acquisitions and alliances,
human resources development, subsidiary companies, corporate social responsibilities,
conservation of energy, technology absorption, and foreign exchange earnings and outgo.

Management Discussion and Analysis The section on Management Discussion and Analysis
provides an overview of the industry, spells out the strategy and thrust areas of the company,
dwells on the risks faced by the company and its risk mitigation initiatives, presents highlights
of the company’s financial performance, and gives an idea of its internal control system.

Report on Corporate Governance Required under Clause 49 of the Listing Agreement with
stock exchanges, the corporate governance report gives information on the company’s
philosophy on corporate governance, board of directors, audit committee,
shareholders/investors grievance committee, other board committees, remuneration of
directors, and general shareholder information.

Notes to Financial Statements Notes to financial statements provide, interalia, significant

accounting policies followed by the firm with respect to fixed assets, investments, inventories,
borrowing cost, revenue recognition, operating expenses, retirement benefits, depreciation,
foreign exchange transactions, provisions, contingent liabilities, and so on and schedules which
give details of various items in the balance sheet (such as share capital, Retained Earnings,
secured loans, unsecured loans, fixed assets, investments, inventories, sundry debtors, cash and
bank balances, loans and advances, current liabilities and provisions) and the statement of profit
and loss (such as sales/income from operations, other income, manufacturing, selling, and
administrative expenses, research and development expenditure, and interest).

End