accounts UNIT 1

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Executive Placement 2003_{School of Management Studies – Striving towards Excellence} BIM

Vels University www.velsuniv.org

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SYLLABUS

• _{UNIT I:}

•

• _{Financial Accounting: Meaning of double entry}

accounting, Meaning, nature and importance

Accounting cycle, accounting equation. Journal, Ledger and Trial Balance .Accounting concepts and

conventions, Financial statements- Profit & Loss

account & Balance sheet. Financial statement Analysis- Comparative Analysis, Common size & Trend Analysis

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• _{UNIT II}

•

• _{Financial Statement Analysis - Ratio analysis –}

Classification of ratios, Advantages & Disadvantages - Fund flow statements advantages and disadvantages- Marginal costing – Cost Volume Profit analysis – Break Even analysis – BEP, P/V ratio, MS

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• _{UNIT III:}

• _{Introduction to Financial Management – Nature of}

Financial management –Objectives of financial

management -Financial Decisions- Organization of Finance function – Agency Problem

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• _{UNIT IV}

• _{Sources of capital -Cost of Capital – Meaning and}

Significance – Components – Cost of Equity, Cost of Debt, Cost of Preferred capital, Cost of retained

earnings and weighted average cost of capital. Capital budgeting – meaning – Different methods – Payback, Net Present Value, Internal rate of return, Profitability

index and average rate of return

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• _{UNIT V}

•

• _{Financial ,Operating and Combined Leverages –Meaning}

of Capital Structure -Determinants of capital

structure .Dividend decision – Dividend policy - Dividend theories – Walter and Gordon modelof dividend –

Stability of dividend – Share split – Buyback of shares.

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REFERENCES

•

• _{1. I.M.Pandey, Financial Management, Vikas publishing}

house Ltd., 9th edition, 2007.

• _{2. Prasanna Chandra, Financial Management Theory and}

Practice, Tata McGraw Hill, 7th Edition, 2008.

• _{3. Financial and Management accounting by Reddy and}

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• _ACCOUNTING:

• _{Accounting is the process of collecting, recording,}

classifying summarizing and interpreting financial data for the needs of management.

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CLASSIFICATION (OR) BRANCHES OF

ACCOUNTING

• _{FINANCIAL ACCOUNTING}

– JOURNAL, LEDGER AND TRIAL BALANCE – _{FINAL ACCOUNTS}

• _{TRADING ACCOUNT}

• _{PROFIT & LOSS ACCOUNT}

• _{BALANCE SHEET} • _{COST ACCOUNTING} – _{COST SHEET} – _{STANDARD COSTING} • _{VARIANCE ANALYSIS} • _{MANAGEMENT ACCOUNTING}

• _-_{FINANCIAL STATEMENT ANALYSIS –}COMPARATIVE, COMMON SIZE, TREND ANALYSIS

– _{CAPITAL BUDGETING} – _{RATIO ANALYSIS}

– _{FUND FLOW STATEMENT} – _{MARGINAL COSTING}

• _{BREAK EVEN ANALYSIS} • _{P/V RATIO}

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Financial accounting

• _{The main purpose is to ascertain the profit or loss and}

to indicate the financial position of the company.

• _{The two important statements prepared in financial}

accounting are Profit & loss accounts and Balance sheet.

• _{Profit & loss accounts – to know the profitability of the}

company

• _{Balance sheet – to know the financial position of the}

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Functions/advantages/need/importance/purpose/objective s/uses of financial accounting

• _{Book keeping functions}

• _{Classification of functions}

• _{Preparation of financial statements}

• _{Segregating financial transactions}

• _{Interpretation of financial data}

• _{Reporting of information}

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Limitations/disadvantages of financial accounting

• _{Historical data}

• _{Financial statements for the enterprise as a whole}

• _{It fails to help in price fixation}

• _{Not useful in cost control}

• _{Evaluation of policies not possible}

• _{Actual costs alone are recorded}

• _{Does not provide information for strategic decision}

making

• _{Complicated and technical subject}

• _{Monetary subject}

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Cost accounting

• _{The process of accounting for cost from the point at}

which expenditure is incurred or committed to the company of its ultimate relationship with cost centres and cost units.

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Functions/Advantages/need/importance/purpose/objectiv es/uses of cost accounting

• _{Ascertaining cost}

• _{Fixation of selling price}

• _{Cost control}

• _{Cost reduction}

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Limitations/disadvantages of cost accounting

• _{It involves too many forms and statements.}

• _{It involves more clerical work}

• _{It is costly to introduce and operate}

• _{It depends on financial accounting. If any error in}

financial accounting will affect cost accounting too.

• _{It is difficult to ascertain the fully reliable cost}

• _{Each cost accountant may use different method which}

create confusion

• _{Since different companies use different methods, it is}

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Management accounting

• _{Management accounting is the presentation of}

accounting information in such a way as to assist management in the creation of policy and in the day to day operations of the company.

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Functions/Advantages/need/importance/purpose/objectiv es/uses of Management accounting

• _{To help in planning and policy formulation} • _{To help in the interpretation process}

• _{To help in decision making}

• _{To help in controlling performance} • _{To help in coordinating}

• _{To help in organizing}

• _{To help in expansion, diversification and strategic business problems} • _{Communication and management policies}

• _{To help in motivating employees} • _{Helps in reporting the information} • _{Helps in forecasting}

• _{Helps in the achievement of objectives} • _{It uses special tools and techniques}

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Limitations/disadvantages of management accounting

• _{Weakness of source records}

• _{Consistent efforts}

• _{Management accounting is not a substitute}

• _{Mixed discipline}

• _Resistance

• _{Costly installation}

• _{Developmental stage}

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Users of accounting information

• Internal users (Primary Users) of accounting information include the following:

– _{Management: for analyzing the organization's performance and} position and taking appropriate measures to improve the company results.

– Employees: for assessing company's profitability and its consequence on their future remuneration and job security.

– _{Owners: for analyzing the viability and profitability of their} investment and determining any future course of action.

• Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

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Users of accounting information…

• _{External users (Secondary Users) of accounting information include the} following: – Creditors: for determining the credit worthiness of the organization. Terms of credit are set by creditors according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks. – Tax Authorities: for determining the credibility of the tax returns filed on behalf of the company.

– Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.

– Customers: for assessing the financial position of its suppliers which is necessary for them to maintain a stable source of supply in the long term.

– Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decisions.

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ACCOUNTING CYCLE

• _JOURNAL

_-RECORDING

• _LEDGER

_-CLASSIFYING

• _{TRIAL BALANCE -SUMMARISING}

• _{FINAL ACCOUNTS - INTERPRETING}

– _{TRADING ACCOUNT}

– _{PROFIT & LOSS ACCOUNT FINANCIAL}

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ACCOUNTING CYCLE…

• _JOURNAL:

– _{Journal is a daily record of business transactions.} – _{It is also called as day book}

– _{The process of recording transactions in the journal called} Journalizing

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ACCOUNTING CYCLE…

• _{FORMAT OF JOURNAL}

• _S.No _{Date Particulars L.F Debit(Rs.) Credit} (Rs.)

• _{Name of the A/c} • _{To Name of the A/c} • _(Narration)

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ACCOUNTING CYCLE…

• _{ADVANTAGES OF JOURNAL:}

– It reduces the possibility of errors

– _{It provides an explanation of the transaction}

– It provides a chronological record of all transactions

– Journal provides records of all business transactions in one place on the time and date basis.

– All transactions are recorded on the basis of receipts or bill, so we can check authenticity of each journal entries with their bills.

– There is minimum chance to avoid any particular transaction because in journal transactions are recorded date basis.

– Accountant writes every journal entry’s narration bellow of that journal entry, so other auditor can know what the reason of that journal entry is.

– In journal, every transaction is recorded after deep analysis of two accounts on the basis of double entry system, so there is minimum chance of mistake in journal.

– _{Journal is the basis of posting in ledger accounts. With making of journal, accountant can not make ledger} accounts.

– If there is mistake in ledger, we can rectify it with the help of journal or rectify journal entry in journal.

– All opening journal entries , closing journal entries and all other transactions which is not recorded in any other subsidiary books , will be recorded in journal .

– _{Journal is also needed in every type of accounting software . These accounting software can make auto system of} posting journal entries by their automatic processing , but accountant must feed journal entries in journal and other specific vouchers of journal .

– In journal , there is one column of ledger folio . It is very important for checking reference of each account's posting with its original journal entry .

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ACCOUNTING CYCLE…

• _{DISADVANTAGES OR LIMITATIONS OF JOURNAL:}

– _{It will be too long if all the transactions are recorded} – _{Difficult to ascertain the balance of each account}

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ACCOUNTING CYCLE…

• _LEDGER:

– _{Ledger provides a summary of similar transactions at one} place.

– _{It is a summary statement of complete transactions relating to} an account.

– _{Ledger is considered as main book of accounts}

– _{It is considered to be the principal book of accounts which} helps us in attaining the main objective of accounting.

– _{It provides vital information like’} • _{Total sales value periodically} • _{Total purchases periodically}

• _{Amount due from individual customers} • _{Amount due to individual suppliers}

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ACCOUNTING CYCLE...

DIFFERENCE BETWEEN JOURNAL AND LEDGER

• _JOURNAL

– It is a book of original entry

– All transactions are recorded in a chronological order

– It has greater weightage because it is a book of source of entry

– _{Unit of classification of data is transaction}

– _{Process of recording financial transactions is} called as Journalising

– _{It is a continuous process day after day}

• _LEDGER

– It is a source of secondary entry

– All transactions pertaining to a particular account appear at one place

– It is the main source of information

– Unit of classification of data is the account

– Process of recording transactions in the ledger is called as posting

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ACCOUNTING CYCLE...

• _{DIFFERENCE BETWEEN JOURNAL AND LEDGER}

– Journal is the book of prime (first) entry, while Ledger is the book of final entry.

– _{• In other words, ledger contains analytical records, while journal contains chronological records.} – • Narration is required in a journal that is not the case in the ledger.

– • Transactions are recorded in the sequence of occurrence in the journal, whereas transactions are classified and recorded in relevant accounts in the ledger.

– • Data can be classified based on transaction in the ledger, while the basis of classification of data are accounts in the ledger.

– • A transaction is firstly recorded in the journal soon after the occurrence of it; it is only then transferred to the ledger.

– • Final accounts cannot directly be prepared from journal, but ledgers form the basis for easy preparation of final accounts.

– • Accuracy of journal cannot be tested, but accuracy of ledger can be tested to a certain extent using trial balance.

– • Journal has two columns for debit and credit, whereas a ledger has two sides of an account one for debit and the other for credit.

– • Journals are not balanced at the end of a period, but accounts in the ledger are balanced at the end of a specific period.

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ACCOUNTING CYCLE..

• _{TRIAL BALANCE:}

– _{A statement containing the balances of all ledger accounts, as} at any given date, arranged in the form of debit and credit columns placed side by side and prepared with the object of checking the arithmetical accuracy of ledger postings.

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ACCOUNTING CYCLE..

• _{IMPORTANCE OR SIGNIFICANCE OF TRIAL BALNCE:}

– _{Summary of various accounts} – Proof of double entry

– Ensuring of arithmetical accuracy

– Trial balance facilitates preparation of final accounts.

– Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that accountants use as a basis while preparing financial statements.

– Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded in the books in accordance with the double entry concept of accounting. If the totals of the trial balance do not agree, the differences may be investigated and

resolved before financial statements are prepared. Rectifying basic accounting errors can be a much lengthy task after the financial statements have been prepared because of the changes that would be required to correct the financial statements.

– Trial balance ensures that the account balances are accurately extracted from accounting ledgers. Trail balance assists in the identification and rectification of errors

– It provides a complete picture of each account in the ledger

– It supplies in one place ready reference of all the balances of the ledger accounts. – It helps to locate the errors

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ACCOUNTING CYCLE..

• _{LIMITATIONS OF TRIAL BALANCE:}

– _{Trial Balance only confirms that the total of all debit balances} match the total of all credit balances.

– _{Trial balance totals may agree in spite of errors. An example} would be an incorrect debit entry being offset by an equal credit entry.

– _{Likewise, a trial balance gives no proof that certain}

transactions have not been recorded at all because in such case, both debit and credit sides of a transaction would be omitted causing the trial balance totals to still agree.

– _{Types of accounting errors and their effect on trial balance are} more fully discussed in the section on Suspense Accounts.

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Accounting principles (or) Accounting concepts

• _{Accounting principles are the set of rules and guidelines for the} preparation of financial statements and reports

• _{The accounting concepts are} • _{Business entity concept} • _{Going concern concept}

• _{Money measurement concept} • _{Accounting period concept} • _{Dual aspect concept}

• _{Cost concept – assets in historical cost}

• _{Matching concept – revenue and expenses matched to know profit} • _{Revenue recognition concept - Inflow and outflow equal}

• _{Accrual concept – revenue or expenses incurred not received or} paid

• _{Objective evidence concept – everything based on evidence –} auditor

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Accounting conventions

• _{Convention of full disclosure}

– _{All information should be revealed}

• _{Convention of consistency}

– _{Rules, practices and concepts should be used}

• _{Convention of materiality}

– _{Only required and important items in financial items.} Unimportant should ne left out or merged.

• _{Convention of conservatism}

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Difference between Book keeping and Accounting

• _{Bookkeeping is} _the _process _of _recording, _in

chronological order, the daily transactions of a business entity. It forms part of the accounting information system.

• _{On the other hand,}_accounting_{is an information system}

– includes the process of recording, classifying, summarizing, reporting, analyzing and interpreting the financial condition and performance of a business – in order to communicate it to stakeholders for business decision making.

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Systems of book keeping

• _{Single entry system}

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Single entry system

• _{For every transaction there should be one debit and one}

credit. This has to be recorded in the journal.

• _{Eg: If Rs. 2000 worth of raw materials purchased by the}

company , then Rs. 2000 will be going out of the company and Rs. 2000 worth of raw material coming in to the company.

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Single entry system…

• _{It does not record the two fold effect of each and every} transaction.

• _{In this single entry, sometimes the business transactions} are recorded in an unsystematic manner by recording only single aspect, sometimes two fold aspect and sometimes omitting both.

• _{So, it is called as “Single entry double entry or no entry”} • _{The accounts maintained in the single entry is not reliable} • _{With this single entry system of accounting, profit & loss}

account and balance sheet can not be prepared. • _{This system is followed in small business}

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Double entry system

• _{In double entry system, in every transaction, there will}

be one debit and one credit.

• _{An Italian merchant named Luco Pacioli invented the}

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Advantages of double entry system

• _{It reveals the detailed information}

• _{Helps in determining profit & loss}

• _{Gives information about financial position}

• _{It is based on dual aspect concept ie for every debit}

one credit will be there. The information provided in the double entry system will be accurate.

• _{It helps in preventing frauds and errors.}

• _{It satisfies the tax authorities.}

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Difference between single entry and double entry system of book keeping.

• _{Single entry is an incomplete and unscientific method of}

book keeping where as double entry is a complete and scientific method of book keeping.

• _{In single entry system, debit and credit do not agree}

where as in double entry system, dual aspect concept is used.

• _{In single entry, only personal and cash accounts are}

maintained where as in double entry, Personal account, real account and nominal account are maintained.

• _{In single entry, Profit and loss and balance sheet cannot}

be prepared where as in double entry it can be prepared.

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Debit and Credit

• _{Debit: (Dr)}

– _{Benefit receiving aspect}

• _{Credit: (Cr)}

– _{Benefit giving aspect}

– _{In Ledger, Trial balance and Profit & Loss account, the left} hand side is known as debit side and right side know as credit side.

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• _{ALL THE FINANCIAL TRANSACTIONS HAVE TWO ASPECTS}

• _{DOUBLE ENTRY SYSTEM}

DEBIT – BENEFIT RECEIVING ASPECT CREDIT – BENEFIT GIVING ASPECT

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NATURE OF ACCOUNT

• _{PERSONAL ACCOUNT}

• _{EG: RAMU A/C, GANESH A/C, BANK A/C, RS & CO A/C ETC}

• _{REAL ACCOUNT}

• _{TANGIBLE ASSETS}

– _{EG: MACHINE, LAND, STOCK ETC}

• _{INTANGIBLE ASSETS}

– EG: GOODWILL, PATENTS ETC

• _{NOMINAL ACCOUNT}

• _EXPENSES

– _{EG: SALARY A/C, RENT A/C}

• _INCOME

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GOLDEN RULE OF ACCOUNTS

NATURE OF

ACCOUNT

DEBIT (DR)

CREDIT (CR)

PERSONAL

A/C

THE

RECEIVER

THE GIVER

REAL A/C

WHAT

COMES IN

WHAT GOES

OUT

NOMINAL

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FINANCIAL STATEMENTS

• _{PROFIT AND LOSS ACCOUNT}

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PROFIT AND LOSS ACCOUNT

• Profit & loss account is prepared to ascertain the net profit or net loss of the company in an accounting period

• It is an account into which all gains and losses are collected in order to ascertain the excess of gains over the losses or vice versa

• The left side of the profit and loss account is the debit side (dr) where all the operating and non operating expenses are mentioned.

• The right side of the statement is called as credit side (Cr) where all the operating and non operating income are mentioned

• If income is more than the expenses, then company gets Net profit • If income is less than the expenses, then it is Net loss.

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PROFIT AND LOSS ACCOUNT

• _{Important expenses}

– _{Carriage inwards – transport charges paid while bringing the} raw material to the company

– _{Carriage outwards – transport charges paid while selling the} products to customers

– _{Bad debts – amount which is given as credit but not received} – _Depreciation

– _{Tax, interest, dividend paid} – _{Salary, wages, rent paid} – _{Discount, commission paid}

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PROFIT AND LOSS ACCOUNT

• _{Important income:}

– _Sales

– _{Interest, dividend received} – _{Rent received}

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PROFORMA OF PROFIT AND LOSS ACCOUNT

• _EXPENSES

– _Purchases – _Wages – _{Salary, rent} – _Discount – _Tax – _Interest – _Power – _Electricity – _{Carriage inwards} – _{Carriage outwards} – _{Clearing charges} – _{Packing charges} – _{Dock dues} – _{Coal, gas}

• _INCOME

– _Sales – _{Commission received} – _{Rent received} – _{Interest received} – _{Dividend received} – _{Discount received} – _{Other income}

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PROFORMA OF PROFIT AND LOSS ACCOUNT…..

– _{Dividend paid} – _{Trade charges} – _{Manufacturing expenses} – _Stationary – _Insurance – _Repair – _{Office expenses} – _{Sundry expenses} – _{Establishment expenses} – _{Commission paid} – _{Advertise expenses}

– _{Selling and distribution expenses} – _{Audit expenses}

– _Depreciation – _{Bad debts}

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BALANCE SHEET

• _{The balance sheet comprises of list of assets and}

liabilities of the company on a given date

• _{It presents the financial position of a concern.}

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PROFORMA OF BALANCE SHEET

LIABILITIES

• _{CURRENT LIABILITIES} • Creditors • Bills payable • Outstanding expenses • _{Tax payable} • Dividend payable • Bank overdraft

• LONG TERM LIABILITIES

• EQUITY

• Equity share capital • Preference share capital

• Reserves & Surplus (Retained Earnings)

• _DEBT • Debentures • Bank loan

ASSETS

• _{CURRENT ASSETS} • Cash in hand • Cash at bank • Debtors • _{Bills receivable} • Stock • Prepaid expenses

• Short term investments

• FIXED ASSETS

• Land & building • Plant & machinery • Furniture

• _{Loose tools} • Motor car

• Long term investment • Goodwill

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CURRENT ASSETS AND FIXED ASSETS

CURRENT ASSETS

• The asset which can be converted into cash within one accounting period

• Ex

• Debtor – company gives credit to customers. Customers will pay later to the company. Till then the customers are mentioned as Debtors

• _{Bill receivable – Same as debtor. The main difference is} that bills receivable is considered as promissory note. Even if customer cheats, company can take action against them

• _{Stock or Inventory – It may be Raw material or Work in} progress and Finished goods

• _{Prepaid expenses – amount paid by the company in} advance

• Short term investment – company invest their surplus cash in short time (for period less than one year) • Cash

• _{Current assets are, therefore, very important to cash} flow management and forecasting, because they are the assets that a business uses to pay its bills, repay borrowings, pay dividends and so on,

FIXED ASSETS

• The asset which takes more than one year to convert into cash

• Ex

• _{Land & building’} • Plant & machinery • Furniture

• _{Long term investment} • Loose tools

• Motor car • _Goodwill

• Patents and copyrights

• Fixed assets are not held for resale but for the production, supply, rental or administrative purposes.

• _{Fixed assets are normally expected to be used for} more than one accounting period which is why they are part of Non Current Assets of the entity. Economic benefits from fixed assets are therefore derived in the long term.

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CURRENT LIABILITIES AND LONG TERM

LIABILITIES

CURRENT LIABILITIES

• The liability which has to be paid by the company within one accounting period

• Ex

• _{Creditors – credit received by the company from} the suppliers

• Bills payable – similar to creditors but bills payable is a promissory note. If company defaults, then the suppliers will take action against the company • Outstanding expenses – expenses not paid by the

company eg: Outstanding rent, outstanding salary • Tax payable

• Dividend payable

• _{Bank overdraft – company may withdraw more} from their current account above the available balance and to be repaid within the year

LON TERM LIABILITIES

• The liabilities which can be paid even after one year by the company is called as long term liabilities.

• _Eg

• EQUITY

• Equity share capital – amount received by the company by issuing equity share. For this company pays equity dividend to the equity shareholders. The dividend rate is not fixed

• Preference share capital – amount received by the company by issuing preference share. For this company pays fixed preference dividend to preference shareholders

• _{Reserves & Surplus (Retained Earnings) – unused} last year profit

• DEBT

• _{Debentures – amount received by the company by} issuing debentures. For this company pays fixed interest to the debenture holders

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FINANCIAL STATEMENT

• _{Financial statements refer to formal and original}

statements prepared by a business concern to disclose its financial information

• _{The two major financial statements are}

– _{Profit & loss account} – _{Balance sheet}

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USES OF FINANCIAL STATEMENTS

• Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions.

• A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend funds.

• _{Philanthropies may use financial statements of a non-profit as a component in determining where to donate funds.}

• _{Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid} by a company.

• Vendors who extend credit may use financial statements to assess the creditworthiness of the business. • Employees also may use reports in making collective bargaining agreements

• _{Managers require Financial Statements to manage the affairs of the company by assessing its financial performance and position and taking} important business decisions.

• Shareholders use Financial Statements to assess the risk and return of their investment in the company and take investment decisions based on their analysis.

• _{Customers use Financial Statements to assess whether a supplier has the resources to ensure the steady supply of goods in the future. This is} especially vital where a customer is dependant on a supplier for a specialized component.

• _{Competitors compare their performance with rival companies to learn and develop strategies to improve their competitiveness.} • General Public may be interested in the effects of a company on the economy, environment and the local community.

• Governments require Financial Statements to determine the correctness of tax declared in the tax returns. Government also keeps track of economic progress through analysis of Financial Statements of businesses from different sectors of the economy.

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ESSENTIALS OF GOOD FINANCIAL STATEMENTS

• Simplicity: Financial statements should be simple so that concerned individuals can easily understand and interpret them properly. For this, the statements must be simple and clear.

• Right time: These must be prepared at the right time. Any delay in their presentation may decrease their usefulness.

• _{Compliance with legal requirements: Financial statements must be prepared in the form and style as required by the Act. They must have} subject-matter as prescribed and must be presented as stated in the Act.

• _{Adherence of accounting principles: The financial statements must be based on the Generally Accepted Accounting Principles (GAAP) so that they} may have universal acceptance.

• _{Disclosure: The financial statements should disclose all the relevant and material facts. It should be transparent so that the users of accounting} information can draw neat conclusions.

• _{Authentic: The information contained in the financial statements should be authentic supported by evidence.}

• _{Relevant to the purpose: Financial statements must be relevant to their purposes. Irrelevant and unnecessary informations should not be included} in these statements.

• Complete and accurate informations: Financial statements should include the complete and accurate information about the progress of a business and its future prospects. Informations should be based on facts. False and incomplete information results in wrong interpretation.

• Comparability: Financial statements should be comparable. The comparison can be made between present and past as well as between one business and the other. It increases the utility of the statements. This can be done when similar accounting principles are adopted for their presentation. • Facilitating the analysis: Decisions can be taken only by proper analysis of the financial statements. Thus, financial statements should be prepared

in such a way that it may facilitate the analysis. For this, the various items should be classified and grouped in a proper manner, so that data can be obtained easily for analysis.

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LIMITATIONS OF FINANCIAL STATEMENTS

• Based on traditions and conventions: Financial statements are prepared and based upon traditions and conventions which allow the usage of personal judgments.

• Based on historical data: Financial statements are based on historical data while parties are more interested in knowing the present position and future prospects of

the business enterprise.

• Scope of manipulations: Financial statements are sometimes prepared according to the needs of the situation or whims of the management. Management can

manipulate financial statements by under-valuation or over-valuation of inventory, under or over charging of depreciation etc.

Sometimes window dressing is resorted to in order to show better financial position of a concern than its real position. So financial statements are not free from bias. • Influenced by personal judgements: Financial statements are influenced by personal judgements of the account. On many issues more than one methods are

permitted. For example, method of depreciation, valuation of stock, valuation of goodwill etc. all depend upon the personal judgements of the policy-maker of the enterprise.

• Ignore qualitative aspects: Financial statements show only those facts which can be expressed in money terms. Qualitative aspects of the business units are omitted

from the books, because they cannot be expressed in money terms. Thus, cordial employer-employee relations, efficiency of management, firm?s ability to develop new products, customer satisfaction, etc. have a vital role in the profitability of the firm, but here ignored and omitted because these are qualitative in nature. • Ignore inflationary effects: Changes in price level make data meaningless. Financial statements record transactions at historical costs. No account is taken of the

present value.

• Ignore the interest of other parties: Financial statements are prepared with a view to take care of the interest of proprietors only and ignore the interests of all

other interested parties like creditors, investors, workers, stock exchanges, taxation authorities, economists, researchers, politicians, etc.

• Financial statements are only interim reports: Financial statements are essentially interim reports. They cannot be final. The actual profit or loss of a business can

be determined only when the business is ultimately closed. The existence of contingent assets and liabilities, deferred revenue expenses make the statement less accurate and more subjective.

• Artificial view: Financial statements do not reveal a real and correct picture of the worth of assets and their loss of value. The reason is that they are shown on

historical cost. Thus, these statements provide artificial view. Market or replacement value and the effect of the changes in the price level are completely ignored. • Incapable: Financial statements are incapable of showing profitability, operational efficiency, financial soundness, etc. of the business.

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TECHNIQUES OR TOOLS FOR FINANCIAL

STATEMENT ANALYSIS

• COMPARATIVE STATEMENT ANALYSIS (OR) HORIZONTAL ANALYSIS

– _{Comparative financial statement is a analysis of financial statements of the company for two years or of} the two companies of similar types. Horizontal analysis is also regarded as Dynamic Analysis. It is an important method of analysis which is used to make comparison between two financial statements. Being a technique of horizontal analysis and applicable to both financial statements, income statement and balance sheet, it provides meaningful information when compared to the similar data of prior periods. The comparative statement of income statements enables to review the operational performance and to draw conclusions, whereas the balance sheets, presenting a change in the financial position during the period, show the effects of operations on the assets and liabilities. Thus, the absolute change from one period to another may be determined.

• _{COMPARATIVE BALANCE SHEET}

• COMPARATIVE PROFIT AND LOSS ACCOUNT • COMMONSIZE STATEMENT ANALYSIS (OR) VERTICAL ANALYSIS

– _{The figures of financial statements are converted to percentages. It is performed by taking the total} balance sheet as 100. The balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability to total liabilities. Thus, it shows the relation of each component to the whole - Hence, the name common size.

• _{COMMON SIZE BALANCE SHEET}

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TECHNIQUES OR TOOLS FOR FINANCIAL

STATEMENT ANALYSIS...

• TREND ANALYSIS

– Trend analysis is the analysis of the trend of the financial ratios of the company over the years. It is an important tool of horizontal analysis. Under this analysis, ratios of different items of the financial statements for various periods are calculated and the comparison is made accordingly. The analysis over the prior years indicates the trend or direction. Trend analysis is a useful tool to know whether the financial health of a business entity is

improving in the course of time or it is deteriorating. • RATIO ANALYSIS

– Ratio analysis is the analysis of the interrelationship between two financial figures. The most popular way to analyze the financial statements is computing ratios. It is an

important and widely used tool of analysis of financial statements. While developing a meaningful relationship between the individual items or group of items of balance sheets and income statements, it highlights the key performance indicators, such as, liquidity,

solvency and profitability of a business entity. The tool of ratio analysis performs in a way

that it makes the process of comprehension of financial statements simpler, at the same time, it reveals a lot about the changes in the financial condition of a business entity.

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TECHNIQUES OR TOOLS FOR FINANCIAL

STATEMENT ANALYSIS...

• FUND FLOW STATEMENT

– The objective of this analysis is to extract the information relating to working capital. The amount of net working capital is determined by deducting the total of current liabilities from the total of current assets. The statement of changes in working capital provides the information in relation to working capital between two financial periods.

• CASH FLOW STATEMENT