FA2

Financial Accounting 100
The composition of the board of directors varies from company to company, but generally it
includes several officers of the corporation and several outsiders. The outsiders are called
independent directors because they do not directly participate in managing the business.
Management, appointed by the board of directors to carry out corporate polices and run day-to-
day operations, consists of the operating officers—generally the president, or chief executive
officer; vice presidents; chief financial officer; and chief operating officer. Besides being
responsible for running the business, management has the duty of reporting the financial results
of its administration to the board of directors and the stockholders. Though management must, at
a minimum, make a comprehensive annual report, it generally reports more often. The annual
reports of public corporations are available to the public.
Advantages and Disadvantages of Incorporation

As noted, managers of a corporation must be familiar with the advantages and disadvantages of
this form of business.
Advantages of Incorporation Some of the advantages of the corporate form of business follow.
Separate legal entity: As a separate legal entity, a corporation can buy and sell property,
sue other parties, enter into contracts, hire and fire employees, and be taxed.
Limited liability: Because a corporation is a legal entity, separate from its owners, its
creditors can satisfy their claims only against the assets of the corporation, not against the
personal property of the corporation’s owners. Because the owners are not responsible for the
corporation’s debts, their liability is limited to the amount of
their investment. In contrast, the personal property of sole proprietors and partners generally is
available to creditors.
Ease of capital generation: It is fairly easy for a corporation to raise capital because shares
of ownership in the business are available to a great number of potential investors for a small
amount of money. As a result, a single corporation can have many owners.
Ease of transfer of ownership: A stockholder can normally buy and sell shares of stock
without affecting the corporation’s activities or needing the approval of other owners.
Lack of mutual agency: If a stockholder tries to enter into a contract for a corporation, the
corporation is not bound by the contract. In a partnership, because of what is called mutual
agency, all the partners can be bound by one partner’s actions.
Continuous existence: Because a corporation is a separate legal entity, an owner’s death,

incapacity, or withdrawal does not affect the life of the corporation. A corporation’s life is set by
its charter and regulated by state laws.
Centralized authority and responsibility: The board of directors represents the

stockholders and delegates the responsibility and authority for day-to-day operation to a single
person, usually the president. Operating power is centralized rather than divided among the
multiple owners of the business. The president may delegate authority over certain segments of
the business to others, but he or she is held accountable to the board of directors. If the board is
dissatisfied with the performance of the president, it can replace that person.
Professional management: Large corporations have many owners, most of whom are not
able to make timely decisions about business operations. Thus, management and ownership are
usually separate. This allows management to hire the best talent available to run the business.
Disadvantages of Incorporation
Some of the disadvantages of corporations follow.
Government regulation: As “creatures of the state,” corporations are subjectto greater

control and regulation than are other forms of business. They must file many reports with the
state in which they are chartered. Publicly held corporations must also file reports with the
Securities and Exchange Commission and with the stock
exchanges on which they are listed. They must also maintain internal controls and have audits
conducted in compliance with regulations set by the Public Company Accounting Oversight
Board (PCAOB). Meeting these requirements is very costly.
Double taxation: A major disadvantage of the corporate form of business is double

taxation. Because a corporation is a separate legal entity, its earnings are subject to federal and
state income taxes, which may be as much as 35 percent of corporate earnings. If any of a
corporation’s after-tax earnings are paid out as dividends, the
earnings are taxed again as income to the stockholders. In contrast, the earnings of sole
proprietorships and partnerships are taxed only once, as income to the owners.
Limited liability: Limited liability restricts the ability of a small corporation to borrow
money. Because creditors can lay claim only to the assets of a corporation, they may limit their
loans to the level secured by those assets or require stockholders to guarantee the loans
personally.
Separation of ownership and control: Just as limited liability can be a drawback of

incorporation, so can the separation of ownership and control. Management sometimes makes
decisions that are not good for the corporation. Poor communication can also make it hard for
stockholders to exercise control over the corporation or even to recognize that management’s
decisions are harmful.
Equity Financing
Equity financing is accomplished by issuing stock to investors in exchange for assets, usually
cash. Once the stock has been issued to them, the stockholders can transfer their ownership at
will. Large corporations can have millions of shares of stock, thousands of which change
ownership every day. They, therefore, often appoint independent
registrars and transfer agents (usually banks and trust companies) to help perform the transfer
duties. The outside agents are responsible for transferring the corporation’s stock, maintaining
stockholders’ records, preparing a list of stockholders forstockholders ‘meetings, and paying
dividends.
Two important terms in equity financing are par value and legal capital:
Par value is an arbitrary amount assigned to each share of stock. It must be recorded in the
capital stock accounts. Par value usually bears little, if any, relationship to the market value of
the shares. For example, although Google’s stock initially sold for$85 per share and the market
value is now much higher, its par value per share is
only $0.001.
Legal capital is the number of shares issued multiplied by the par value. It is the minimum
amount that a corporation can report as contributed capital. For example, even though the total
market value of Google’s shares now exceeds$200 billion, Google’s legal capital is only about
$325,140 (325.14 million shares × $0.001).
To help with its initial public offering (IPO), a corporation often uses an underwriter—an
intermediary between the corporation and the investing public. For a fee—usually less than 1
percent of the selling price—the underwriter guarantees the sale of the stock. The corporation
records the amount of the net proceeds of the offering in its Capital Stock and Additional Paid-in
Capital accounts. The net proceeds are what the public paid less the underwriter’sfees, legal
expenses, and any other direct costs of the offering.
The costs of forming a corporation are called start-up and organization costs.
These costs include:
State incorporation fees

Attorneys’ fees for drawing up the articles of incorporation
The cost of printing stock certificates
Accountants’ fe es for registering the firm’s initial stock
Other expenditures necessary for the formation of the corporation
Theoretically, start-up and organization costs benefit the entire life of a corporation. For that
reason, a case can be made for recording them as intangible assets and amortizing them over the
life of the corporation. However, a corporation’s life normally isnot known, so accountants
expense start-up and organization costs as they are incurred.
Advantages of Equity Financing Financing a business by issuing common stock has several
advantages.
Decreased financial risk: Issuing common stock is less risky than financing with long-term
debt because a company does not pay dividends on common stock unless the board of directors
decides to pay them. In contrast, if a company does not pay interest on long-term debt, it can be
forced into bankruptcy.
Increased cash for operations: When a company does not pay a cash dividend, it can shift
the cash generated by profitable operations back into the company’s operations. Google, for
instance, does not currently pay any dividends, and its issuance of common stock provides it
with funds for expansion.
Better debt to equity ratio: A company can use the proceeds of a common stock issue to
maintain or improve its debt to equity ratio.
Disadvantages of Equity Financing Issuing common stock also have certain disadvantages.
Increased tax liability: Whereas the interest on debt is tax-deductible, the dividends paid on
stock are not tax-deductible.
Decreased stockholder control: When a corporation issues more stock, it dilutes its
ownership. Thus, the current stockholders must yield some control to the new stockholders.
Contributed capital: The stockholders’ investments in the corporation.
Retained earnings: The earnings of the corporation since its inception, less any losses,
dividends, or transfers to contributed capital. Retained earnings are reinvested in the business.
They are not a pool of funds to be distributed to the stockholders; instead, they represent the
stockholders’ claim to assets resulting from profitable
operations.
Treasury stock: Shares of the corporation’s own stock that it has bought back on the open
market are called treasury stock. The cost of these shares is treated as a reduction in
stockholders’ equity. By buying back the shares, the corporation reduces the ownership of the
business.
A corporation can issue two types of stock:
Common stock is the basic form of stock. If a corporation issues only one type of stock, it is
common stock. Because shares of common stock carry voting rights, they generally provide
their owners with the means of controlling the corporation. Common stock is also called
residual equity, which means that if the corporation
is liquidated, the claims of all creditors and usually those of preferred stockholders rank ahead of
the claims of common stockholders.
Preferred stock is stock that a corporation may issue to attract investors whose goals differ
from those of common stockholders. Preferred stock gives its owners preference over common
stockholders, usually in terms of receiving dividends and in terms of claims to assets if the
corporation is liquidated. In addition to identifying the kind of stock and its par value, the
description of contributed capital in Exhibit 2 specifies the number of shares authorized, issued,
and outstanding.
Authorized shares are the maximum number of shares that a corporation’s state charter
allows it to issue. Most corporations are authorized to issue more shares than they need to issue
at the time they are formed. Thus, they are able to raise more capital in the future by issuing
additional shares. When a corporation issues all of its authorized shares, it cannot issue more
without a change in its state charter.
Issued shares are those that a corporation sells or otherwise transfers to stockholders. The
owners of a corporation’s issued shares own 100 percent of the business. Uniss ued shares have
no rights or privileges until they are issued.
Outstanding shares are shares that a corporation has issued and that are still in circulation.
Treasury stock is not outstanding because it consists of shares that a corporation has issued but
has bought back and thereby put out of circulation. Thus, a corporation can have more shares
issued than are currently outstanding.
Characteristics of Preferred Stock
Most preferred stock has one or more of the following characteristics: preference as to
dividends, preference as to assets if a corporation is liquidated, convertibility, and a callable
option. A corporation may offer several different classes of preferred stock, each with distinctive
characteristics to attract different investors.
Preference as to Dividends Preferred stockholders ordinarily must receive a certain amount of

dividends before common stockholders receive anything. The amount that preferred
stockholders must be paid before common stockholders can be paid is usually stated in dollars
per share or as a percentage of the par value of the preferred shares. For example, a company
might pay an annual dividend of $4 per share on preferred stock, or it might issue preferred
stock at $50 par value and pay an annual dividend of 8 percent of par value, which would also
be $4 per share.
Preferred stockholders have no guarantee of receiving dividends. A company’s board of

directors must declare dividends on preferred stock before any liability arises. The consequences
of not granting an annual dividend on preferred stock vary according to whether the stock is
noncumulative or cumulative.
If the stock is noncumulative preferred stock and the board of directors fails to declare a
dividend on it in any given year, the company is under no obligation to make up the missed
dividend in future years.
If the stock is cumulative preferred stock, the dividend amount per share accumulates from
year to year, and the company must pay the whole amount before it pays any dividends on
common stock.
Dividends not paid in the year they are due are called dividends in arrears. If a corporation has
dividends in arrears, it should report the amount either in the body of its financial statements or
in a note to its financial statements. The following note is typical of one that might appear in a
corporation’s annual report:
Dividends in Arrears
Transaction Harbach Corporation has 20,000 outstanding shares of $10 par value, 6 percent
cumulative preferred stock. Operations in 2015 produced income of only $8,000. However, the
board of directors declared a $6,000 cash dividend to the preferred stockholders.
Computation Dividends in arrears are calculated as follows. 2015 dividends due preferred
stockholders [(20,000 × $10) × 0.06] $12,000 Less 2015 dividends declared to preferred
stockholders 6,000 2015 preferred stock dividends in arrears $ 6,000
Comment Before the corporation can pay a dividend in 2016 to common stockholders, it must
pay the preferred stockholders the $6,000 in arrears from 2015, plus $12,000 for 2016 for a total
of $18,000.
Dividend Distribution
Transaction In 2016, Harbach Corporation earns income of $60,000 and wants to pay dividends
to both preferred and common stockholders. The board of directors declares a $24,000 dividend.
Computation
The dividend would be distributed as follows.
2016 declaration of dividends $24,000
Less 2015 preferred stock dividends in arrears 6,000
Amount available for 2016 dividends $18,000
Less 2016 dividends due preferred stockholders [(20,000 × $10) × 0.06] 12,000
Remainder available to common stockholders $ 6,000
Q No.1 At the close of the current year, the stockholders’ equity section of Rockhurst
Corporation’s balance sheet was as follows:
Stockholder’s equity:
$ 6 preferred stock, $100 par value, callable at $102,
200,000 shares authorized----------------------------------------------- $ 12000,000
Common stock, $5 par value, 5000,000 shares authorized: 14000,000
Additional paid-in capital:

Preferred ------------------------------------------------------------- $ 360,000
Common ------------------------------------------------------------- 30,800,000
31160,000
Retained earnings-------------------------------------------------------- 2680,000
59840,000
On the basis of this information, answer the following questions and show necessary supporting
computations.
1. How many shares of preferred stock have been issued?

2. What is the total annual dividend requirement on the outstanding preferred
stock?
3. How many shares of common stock have been issued ?
4. What was the average price per share received by the corporation for its
common stock, including shares subscribed?
5. If company decided to give $1.5 dividend per common stock outstanding,
give the total amount of dividend on common stock.
Q No.2 Presented below is the information necessary to compute the net assets and book value
per share of common stock for Ahora Advertising, Inc.:
8% cumulative preferred stock, $100 par (callable at $110) $300,000

Common stock, $5 par, authorized 100,000 shares 450,000
Additional paid-in-capital 679,200
Deficit 130,200
Dividends in arrears on preferred stock, 1 full year 24,000
Compute:
(a) amount of net assets ( stockholders equity)

(b) book value per share of common stock
Q No.3 Radio Shack stores included the following stockholders' equity on its year-end balance
sheet at December 31, 19X8, with all dollar amounts, except par value per share, in millions:
Stockholders' Equity ($ Millions)
Preferred stock, 6%, cumulative $ 100

Common stock—par value $1 per share; 250,000,000
shares authorized, 139,000,000 shares issued 139
Paid-in capital in excess of par—common 110
Retained earnings 1,693
$ 2,042
Required
Assume that preferred dividends are in arrears for 19X7 and 19X8. Record the
declaration of a $50 million cash dividend on December 30, 19X9. Use separate
Dividends Payable accounts for Preferred and Common. An explanation is not required.
Q No.4 Wolfa Company has outstanding two classes of $100 par value stock: 5000 shares of 8%
cumulative preferred and 25,000 shares of common. The company had a $50,000 retained
earning at the beginning of the current year, and preferred dividends had not been paid for two
years. During the current year, the company earned $300,000. What will be the balance in
retained earnings at the end of the current year, if the company pays a dividend of $2 per share
on the common stock?
Q No.5 Stockholders' equity information for two independent companies, Granada

Enterprises, Inc., and Traigon Corp. is as follows:
Granada Enterprises, Inc. Granada is authorized to issue 60,000 shares of $5 par

common stock. All the stock was issued at $12 per share. The company incurred a net
loss of $41,000 in 20X1. It earned net income of $60,000 in 20X2 and $90,000 in 20X3.
The company declared no dividends during the three-year period.
Traigon Corp.Traigon's charter authorizes the company to issue 10,000 shares of $2.50
preferred stock with par value of $50 and 120,000 shares of no-par common stock.
Traigon issued 1,000 shares of the preferred stock at $54 per share. It issued 40,000
shares of the common stock for a total of $220,000. The company's Retained Earnings
balance at the beginning of 20X3 was $64,000, and net income for the year was $90,000.
During 20X3, the company declared the specified dividend on preferred and a $0.50 per
share dividend on common. Preferred dividends for 20X2 were in arrears.
Required
For each company, prepare the stockholders' equity section of its balance sheet at
December 31, 20X3. Show the computation of all amounts. Entries are not required.
Q No.6 Zaponata Corporation was organized in 20X1. At December 31, 20X1, Zaponata's
balance sheet reported the following stockholders' equity:
Preferred stock, 5%, $10 par, 50,000 shares

authorized,
none issued $ —
Common stock, $2 par, 100,000 shares authorized,
10,000 shares issued 20,000
Paid in capital in excess of par—common 30,000
Retained earnings (Deficit) (5,000)
Total stockholders' equity $ 45,000
Required
Answer the following questions, making journal entries as needed.
1. What does the 5% mean for the preferred stock? After Zaponata issues preferred stock,
how much in annual cash dividends will Zaponata expect to pay on 1,000 shares?
2. At what price per share did Zaponata issue the common stock during 20X1?
3. Were first-year operations profitable? Give your reason.
4. During 20X2, the company completed the following selected transactions. Journalize
each transaction. Explanations are not required.
a. Issued for cash 5,000 shares of preferred stock at par value.
b. Issued for cash 1,000 shares of common stock at a price of $7 per share.
c. Issued 20,000 shares of common stock to acquire a building valued at $120,000.
d. Net income for the year was $50,000, and the company declared no dividends.
Make the closing entry for net income.
5. Prepare the stockholders' equity section of the Zaponata Corporation balance sheet at
December 31, 20X2.
Q No. 7 The following accounts and related balances of Witt, Inc., are arranged in no particular
order:
Interest expense $ 6,100 Accounts receivable, net $ 46,000

Property, plant, and Paid-in capital in excess of
equipment, net 261,000 par—common 19,000
Common stock, $1 par, Accrued liabilities 26,000
500,000 shares authorized, Long-term note payable 42,000
236,000 shares issued 236,000 Inventory 81,000
Dividends payable 9,000 Prepaid expenses 10,000
Retained earnings ? Common stockholders'
Accounts payable 31,000 equity, June 30, 20X1 222,000
Trademark, net 9,000 Net income 51,000
Preferred stock, $0.10, no-par, Total assets, June 30 20X1 404,000
10,000 shares authorized Cash 10,000
and issued 25,000
Required
1. Prepare the company's classified balance sheet in the account format at June 30, 20X2.
Use the accounting equation to compute Retained Earnings.
2. Compute rate of return on total assets and rate of return on common stockholders' equity
for the year ended June 30, 20X2.
Q No.8 The balance sheet of Hardwood Furniture, Inc., reported the following:
Stockholders' Investment
[same as Stockholders' Equity] ($ Thousands)
Cumulative preferred stock $ 45

Common stock, $1 par, authorized 40,000,000
shares;
issued 16,000,000 shares 16,000
Additional paid-in capital 217,000
Retained earnings (Deficit) (77,165)
Total stockholders' investment $155,880
Notes to the financial statements indicate that 9,000 shares of $1.45 preferred stock with
a stated value of $5 per share were issued and outstanding. The preferred stock has a
liquidation value of $25 per share, and preferred dividends are in arrears for two years,
including the current year. The additional paid-in capital belongs to common. On the
balance sheet date, the market value of the Hardwood Furniture common stock was
$9.50 per share.
Required
1. Is the preferred stock cumulative or noncumulative? How can you tell?
2. What is the amount of the annual preferred dividend?
3. What is the total paid-in capital of the company?
4. What was the total market value of the common stock?
5. Compute the book value per share of the preferred stock and the common stock.
Q No.9 The partners who own Craven & Thames wished to avoid the unlimited personal
liability of the partnership form of business, so they incorporated the partnership as C & T
Services, Inc. The charter from the state of Louisiana authorizes the corporation to issue 10,000
shares of 6%, $100 par preferred stock and 250,000 shares of no-par common stock. In its first
month, C & T Services completed the following transactions:
Jan. 3 Issued 6,300 shares of common stock to Craven and
3,800 shares to Thames, both for cash of $10 per share.
12 Issued 1,000 shares of preferred stock to acquire a patent
with a market value of $110,000.
22 Issued 1,500 shares of common stock to other investors
for $15 cash per share.
Required
1. Record the transactions in the general journal.
2. Prepare the stockholders' equity section of the C & T Services, Inc., balance sheet at
January 31. The ending balance of Retained Earnings is $40,300.
Q No.10 Kraft Unlimited, Inc., was organized and authorized to issue 5,000 shares of $100par
value, 9 percent preferred stock and 50,000 shares of no par, $5 stated value common stock on
July 1, 2014. Stock-related transactions for Kraft Unlimited follow.
July 1 Issued 10,000 shares of common stock at $11 per share.

1 Issued 500 shares of common stock at $11 per share for services rendered in
connection with the organization of the company.
2 Issued 1,000 shares of preferred stock at par value for cash.
10 Issued 2,500 shares of common stock for land on which the asking price was
$35,000. Market value of the stock was $12. Management wishes to record
the land at the market value of the stock.
Aug. 2 Purchased 1,500 shares of its common stock at $13 per share.
10 Declared a cash dividend for one month on the outstanding preferred stock
and $0.02 per share on common stock outstanding, payable on August 22
to stockholders of record on August 12.
12 Date of record for cash dividends.
22 Paid cash dividends.
Required
Prepare journal entries to record these transactions.
Chapter 7
Regulatory Framework &International Accounting Standards
Accounting Concepts
A number of accounting concepts have been applied ever since financial statements were first
produced for external reporting purposes. These have become second nature to accountants and
are not generally reinforced, other than through custom and practice.
The historical cost concept
It means that assets are normally shown at cost price, and that this is the basis for valuation of
the asset.
The money measurement concept
Accounting information has traditionally been concerned only with those facts covered by (a)
and (b) which follow:
(a) It can be measured in monetary units, and
(b) Most people will agree to the monetary value of the transaction.
This limitation is referred to as the money measurement concept, and it means that accounting
can never tell you everything about a business. For example, accounting does not show the
following:
(c) Whether the business has good or bad managers,
(d) Whether there are serious problems with the workforce,
(e) Whether a rival product is about to take away many of the best customers,
(f) Whether the government is about to pass a law which will cost the business a lot of extra
expense in future.
The reason that (c) to (f) or similar items are not recorded is that it would be impossible to work
out a monetary value for them which most people would agree to.
Some people think that accounting and financial statements tell you everything you want to
know about a business. The above shows that this is not the case.
The business entity concept
The business entity concept implies that the affairs of a business are to be treated as being quite
separate from the non-business activities of its owner(s). The items recorded in the books of the
business are, therefore, restricted to the transactions of the business. No matter what activities
the proprietor(s) get up to outside the business, they are completely disregarded in the books
kept by the business. The only time that the personal resources of the proprietor(s) affect the
accounting records of a business is when they introduce new capital into the business, or take
drawings out of it.
The dual aspect concept
This states that there are two aspects of accounting, one represented by the assets of the business
and the other by the claims against them. The concept states that these two aspects are always
equal to each other. In other words, this is the alternate form of the accounting equation:
ASSETS = LIABILITIES + CAPITAL10.7
As you know, double entry is the name given to the method of recording transactions under the
dual aspect concept.
The time interval concept
One of the underlying principles of accounting, the time interval concept, is that financial
statements are prepared at regular intervals of one year. For internal management purposes they
may be prepared far more frequently, possibly on a monthly basis or even more frequently.
Fundamental accounting concepts
These comprise a set of concepts considered so important that they have been enforced through
accounting standards and/or through the Companies Acts.
The five enforced through the Companies Act are the going concern concept, the consistency
concept, the prudence concept, the accruals concept, and the separate determination concept.
1 Going concern
The going concern concept implies that the business will continue to operate for the foreseeable
future. As a result, if there is no going concern problem, it is considered sensible to keep to the
use of the historical cost concept when arriving at the valuations of assets. Compared with this
unspecified time horizon, under IAS 1, the relevant time period is at least 12 months from the
balance sheet date.
Suppose, however, that a business is drawing up its financial statements at 31 December
20X8. normally, using the historical cost concept, the assets would be shown at a total value of
Rs.100,000. It is known, however, that the business will be forced to close down in February
20X9, only two months later, and the assets are expected to be sold for only Rs.15,000.
In this case it would not make sense to keep to the going concern concept, and so we
can reject the historical cost concept for asset valuation purposes. In the balance sheet at
31 December 20X8 the assets will therefore be shown at the figure of Rs.15,000. Rejection of
the going concern concept is the exception rather than the rule.
Examples where the going concern assumption should be rejected are:
If the business is going to close down in the near future;
Where shortage of cash makes it almost certain that the business will have to cease
trading;
Where a large part of the business will almost certainly have to be closed down because
of a shortage of cash.
2 Consistency
Even if we do everything already listed under the concepts, there will still be quite a few
different ways in which items could be recorded. This is because there can be different
interpretations as to the exact meaning of a concept. Each business should try to choose the
methods which give the most reliable picture of the business.
This cannot be done if one method is used in one year and another method in the next year, and
so on. Constantly changing the methods would lead to misleading profits being calculated10.2
from the accounting records. Therefore the convention of consistency is used. The consistency
concept says that when a business has once fixed a method for the accounting treatment of an
item, it will enter all similar items that follow in exactly the same way.
However, it does not mean that the business has to follow the method until the business closes
down. A business can change the method used, but such a change is not made without a lot of
consideration. When such a change occurs and the profits calculated in that year are affected by
a material amount (i.e. one that makes a noticeable difference to the figures shown in the
financial statements) then, either in the profit and loss account itself or in one of the reports that
accompany it, the effect of the change should be stated.
3 Prudence
Very often accountants have to use their judgment to decide which figure to take for an item.
Suppose a debt has owed for quite a long time, and no one knows whether it will ever be paid.
Should the accountant be an optimist in thinking that it will be paid, or be more pessimistic?
It is the accountant’s duty to see that people get the proper facts about asiness.
bu The
accountant should make certain that assets are not valued too highly. Similarly, liabilities should
not be shown at values that are too low. Otherwise, people might in advisedly lend money to a
business, which they would not do if they had been provided with the proper facts.
The accountant should always exercise caution when dealing with uncertainty while, at the same
time, ensuring that the financial statements are neutral – that gains and losses are neither
overstated nor understated – and this is known as prudence.
It is true that, in applying the prudence concept, an accountant will normally make sure that all
losses are recorded in the books, but that profits and gains will not be anticipated by recording
them before they should be recorded. Although it emphasises neutrality, many people feel that
the prudence concept means that accountants will normally take the figure relating to unrealized
profits and gains which will understate rather than overstate the profit for a period. That is, they
believe that accountants tend to choose figures that will cause the capital of the business to be
shown at a lower amount rather than at a higher amount.
The recognition of profits at an appropriate time has long been recognized as being in need of
guidelines and these have long been enshrined in what is known as the realisation concept.
The realisation concept holds to the view that profit and gains can only be taken into account
when realisation has occurred and that realisation occurs only when the ultimate cash realised is
capable of being assessed (i.e. determined) with reasonable certainty. Several criteria have to be
observed before realisation can occur:
Goods or services are provided for the buyer;
The buyer accepts liability to pay for the goods or services;
The monetary value of the goods or services has been established;
The buyer will be in a situation to be able to pay for the goods or services.
Notice that it is not the time

10.3
When the order is received; or
When the customer pays for the goods.
However, it is only when you can be reasonably certain as to how much will be received that
you can recognise profits or gains.
Of course, recognising profits and gains now that will only be 100 per cent known in future
periods is unlikely to ever mean that the correct amount has been recognised. Misjudgments can
arise when, for example, profit is recognised in one period, only to discover later that this was
incorrect because the goods involved have been returned in a later period because of some
deficiency. Also, where services are involved rather than goods, the services might turn out to be
subject to an allowance being given in a later period owing to poor performance.
What do you think the accountant should do about these possibilities when applying the
realisation concept?
The accountant needs to take every possibility into account yet, at the same time, the prudence
concept requires that the financial statements are ‘neutral’, that is, that neither gains nor
losses should be overstated or understated.
4 The accruals concept
The accruals concept says that net profit is the difference between revenues and the expenses
incurred in generating those revenues, i.e.
Revenues − Expenses = Net Profit

Determining the expenses used up to obtain the revenues is referred to as matching expenses
against revenues. The key to the application of the concept is that all income and charges
relating to the financial period to which the financial statements relate should be taken into
account without regard to the date of receipt or payment.
This concept is particularly misunderstood by people who have not studied accounting. To many
of them, actual payment of an item in a period is taken as being matched against the revenue of
the period when the net profit is calculated. The fact that expenses consist of the assets used up
in a particular period in obtaining the revenues of that period, and that cash paid in a period and
expenses of a period are usually different, as you will see later, comes as a surprise to a great
number of them.
5 Separate determinations
In determining the aggregate amount of each asset or liability, the amount of each individual
asset or liability should be determined separately from all other assets and liabilities. For
example, if you have three machines, the amount at which machinery is shown in the balance
sheet should be the sum of the values calculated individually for each of the three machines.
Only when individual values have been derived should a total be calculated.
This concept is, perhaps, best described in relation to potential gains and potential losses. If a
business is being sued by a customer for Rs.10,000 and there is a high probability that the
business will lose the case, the prudence concept requires the Rs.10,000 to be included as a
liability in the financial statements. The same business may, itself, be suing a supplier for
Rs.6,000 and may have a good probability of winning the case. It might be tempting to offset the
two claims, leaving a net liability of Rs.4,000 to appear in the financial statements. Yet, this
would be contrary to the realisation concept which would not allow the probable Rs.6,000 gain
to be realised until it was viewed with reasonable certainty that it was going to be received. The
separate determination concept prohibits the netting-off of potential liabilities and potential
gains. As a result, only the probable Rs.10,000 expense would be recognised in the financial
statements.
6 Substance over form

It can happen that the legal form of a transaction can differ from its real substance. Where this
happens, accounting should show the transaction in accordance with its real substance which is,
basically, how the transaction affects the economic situation of the business. This means that
accounting in this instance will not reflect the exact legal position concerning that transaction.
You have not yet come across the best and easiest illustration of this concept. Later in your
studies you may have to learn about accounting for fixed assets being bought on hire purchase.
We will take a car as an example.
From a legal point of view, the car does not belong to the business until all the hire
purchase instalments have been paid, and an option has been taken up whereby the
business takes over legal possession of the car.
From an economic point of view, you have used the car for business purposes, just as
any other car owned by the business which was paid for immediately has been used. In
this case, the business will show the car being bought on hire purchase in its ledger
accounts and balance sheet as though it were legally owned by the business, but also
showing separately the amount still owed for it.
In this way, therefore, the substance of the transaction has taken precedence over the legal form
of the transaction.
Materiality
The accounting concepts already discussed have become accepted in the business world, their
assimilation having taken place over many years. However, there is one overriding rule applied
to anything that appears in a financial accounting statement – that of materiality – it should be
‘material’. That is, it should be of interest to the stakeholders, those people who make use of
financial accounting statements. It need not be material to every stakeholder, but it must be
material to a stakeholder before it merits inclusion.
Accounting does not serve a useful purpose if the effort of recording a transaction in a certain
way is not worthwhile. Thus, if a box of paper-clips was bought it would be used up over a
period of time, and this cost is used up every time someone uses a paper-clip. It is possible to
record this as an expense every time a paper-clip is used but, obviously, the price of a paper-clip
is so small that it is not worth recording it in this fashion, nor is the entire box of paper-clips.
The paper-clips are not a material item and, therefore, the box would be charged as an expense
in the period it was bought, irrespective of the fact that it could last for more than one
accounting period. In other words, do not waste your time in the elaborate recording of trivial
items.
Similarly, the purchase of a cheap metal ashtray would also be charged as an expense in the
period it was bought because it is not a material item, even though it may in fact last for twenty
years.
Businesses fix all sorts of arbitrary rules to determine what material is and what is not. There is
no law that lays down what these should be – the decision as to what is material and what is not
is dependent upon judgment. A business may well decide that all items under Rs.100 should be
treated as expenses in the period in which they were bought, even though they may well be in
use in the business for the following ten years. Another business, especially a large one, may fix
the limit at Rs.1,000. Different limits may be set for different types of item.
It can be seen that the size and the type of business will affect the decisions as to which items
are material. With individuals, an amount of Rs.1,000 may well be more than you, as a student,
possess. For a multi-millionaire, what is a material item and what is not will almost certainly not
be comparable. Just as individuals vary, then, so do businesses. Some businesses have a great
deal of machinery and may well treat all items of machinery costing less than Rs.1,000 as not
being material, whereas another business which makes about the same amount of profit, but has
very little machinery, may well treat a Rs.600 machine as being a material item as they have
fixed their materiality limit at Rs.250.
List of International Accounting Standards

IAS 1: PRESENTATION OF FINANCIAL STATEMENTS
IAS 2: INVENTORIES
IAS 7: CASH FLOW STATEMENTS (Statement of Cash Flow) amended in 2007
IAS 8: NET PROFIT OR LOSS FOR THE PERIOD, FUNDAMENTAL ERRORS AND
CHANGES IN ACCOUNTING POLICIES (Accounting policies, Changes in Accounting
Estimates and Errors) amended in 2005
IAS 10: EVENTS AFTER THE BALANCE SHEET DATE (Events after the reporting period)
amended in 2007
IAS 11: CONSTRUCTION CONTRACTS
IAS 12: INCOME TAXES
IAS 14: SEGMENT REPORTING superseded by IFRS 8 (Operating segments) in 2009
IAS 15: INFORMATION REFLECTING THE EFFECTS OF CHANGING PRICES
(Withdrawn in 2005)
IAS 16: PROPERTY, PLANT AND EQUIPMENT
IAS 17: LEASES
IAS 18: REVENUE
IAS 19: EMPLOYEE BENEFITS
IAS 20: ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF
GOVERNMENT ASSISTANCE
IAS 21: THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
IAS 22: BUSINESS COMBINATIONS superseded by IFRS 3 (Business Combination) in 2004
IAS 23: BORROWING COSTS
IAS 24: RELATED PARTY DISCLOSURES
IAS 26: ACCOUNTING AND REPORTING BY RETIREMENT BENEFIT PLANS
IAS 27: CONSOLIDATED FINANCIAL STATEMENTS AND ACCOUNTING FOR
INVESTMENTS IN SUBSIDIARIES superseded by (Separate Financial Statements) in 2013
IAS 28: ACCOUNTING FOR INVESTMENTS IN ASSOCIATES superseded by (Investment
in associates and joint venture) in 2013
IAS 29: FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES
IAS 30: DISCLOSURES IN THE FINANCIAL STATEMENTS OF BANKS AND SIMILAR
FINANCIAL INSTITUTIONS superseded by IFRS 7 (Financial Instruments: Disclosure) in
2007
IAS 31: FINANCIAL REPORTING OF INTERESTS IN JOINT VENTURES superseded by
IFRS 11(Joint agreements) and IFRS 12 (Disclosure of interests in other entities) in 2013
IAS 32: FINANCIAL INSTRUMENTS: PRESENTATION AND DISCLOSURE
IAS 33: EARNINGS PER SHARE
IAS 34: INTERIM FINANCIAL REPORTING
IAS 35: DISCONTINUING OPERATIONS superseded by IFRS 5 (Non-current assets held for
sale and discontinued operations) in 2005
IAS 36: IMPAIRMENT OF ASSETS
IAS 37: PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
IAS 38: INTANGIBLE ASSETS
IAS 39: FINANCIAL INSTRUMENTS, RECOGNITION AND MEASUREMENT
IAS 40: INVESTMENT PROPERTY
IAS 41: AGRICULTURE
IFRS 1: First – time adoption of international financial reporting standard

IFRS 2: Share based payment
IFRS 3: Business Combinations
IFRS 4: Insurance Contract

IFRS 5: Non-current assets held for sale and discontinued operations
IFRS 6: Exploration for and evaluation for mineral resources
IFRS 7: Financial instrument – Disclosures
IFRS 8: Operating segments
IFRS 9: Financial instruments
IFRS 10: Consolidated financial statements
IFRS 11: Joint arrangements
IFRS 12: Disclosure of interests in other entities
IFRS 13: Fair value measurement
IFRS 14: Regulatory deferral accounts
IFRS 15: Revenue from contracts with customer (applicable from January 01, 2018)
IFRS 16: Leases (applicable from January 01, 2019)
IAS 1: Presentation of Financial Statements
This standard describes the preparation and presentation requirements of financial

statements. It defines the requirements which a financial statement has to observe to
achieve a fair presentation (i.e. to provide a picture that corresponds to the actual
economic conditions). According to IAS a complete financial statement has to contain
the following components: a balance sheet, an income statement, a statement showing
changes in equity, a cash flow statement and explanatory notes.
IAS 2: Inventories
The accounting treatment of inventories is carried out according to the historical cost
system. IAS 2 defines how to determine the costs of purchase and conversion and
states that the inventories "should be measured at the lower of cost and net realizable
value". In addition, it describes treatments which are permitted for calculating the costs
of inventories.
IAS 7: Cash Flow Statements (Statement of Cash flow) amended in

2007
The cash flow statement is a required component of an IAS financial statement. IAS 7
explains this requirement by the benefits of cash flow information which it provides. It
defines cash and cash equivalents and stipulates the rough structure of a cash flow
statement. The cash flows are to be differentiated into those obtained from operating,
investing and financing activities.
IAS 8: Net Profit or Loss for the Period, Fundamental Errors and
Changes in Accounting Policies (Accounting policies, changes in
accounting estimates and errors) amended in 2005
This standard is supposed to guarantee that all enterprises present their income
statement in a consistent form. It defines ordinary business activities and requires
disclosing extraordinary items separately. The disclosure of single items of income and
expense is dependent upon how relevant the information is for explaining the
performance of the enterprise. In addition, it regulates how to handle fundamental

balancing errors from prior accounting periods and under which circumstances changes
in the accounting policy are permitted.
IAS 10: Events After the Balance Sheet Date (Events after the
reporting period) amended in 2007
If the enterprise receives information after the balance sheet date which leads to an
adjustment in the amounts recognized in the financial statement, it has to follow the
instructions of this standard. This could, for example, be the bankruptcy of a customer
shortly after the balance sheet date, which leads to a retroactive adjustment of the
corresponding trade receivable account, or also the discovery of an error or fraud. IAS
10 provides information about which events should be adjusted and which are not.
IAS 11: Construction Contracts
Construction contracts often span several accounting periods. IAS 11 determines how
the revenue and costs of a contract should be recognized and how they should be
allocated to the accounting periods.
IAS 12: Income Taxes

This standard establishes how current taxes for the accounting period and deferred tax
liabilities have to be accounted. Deferred taxes arise due to temporary differences
between the carrying amount of an asset and its tax base.
IAS 14: Segment Reporting superseded by IFRS 8 (Operating

segments) in 2009
To be able to better judge the risks and returns of individual business areas, segment
reporting is helpful. IAS 14 distinguishes between business and geographical segments
for which separate reports should be given. In addition, the different disclosures for the
primary and secondary reporting formats are identified.
IAS 15: Information Reflecting the Effects of Changing Prices

(Withdrawn in 2005)
Since no consensus could be reached concerning the application of this standard, it
isn't obligatory. The purpose of IAS 15 is to bring clarity about the effects of changing
prices on the measurement of balance sheet items. Therefore corresponding
disclosures are required, such as the amount of depreciation or cost of sales
adjustments.
IAS 16: Property, Plant and Equipment

This standard determines which assets may be accounted as property, plant and
equipment, under which conditions their recognition is carried out, how they are to be
measured, and which depreciation method should be chosen. In addition it describes,
what the financial statement should disclose.
IAS 17: Leases

IAS 17 distinguishes between finance and operating leases. The respective assignment
has considerable consequences for the way in which the leased asset is balanced. In
addition, it establishes how to deal with any excess of sales proceeds and leaseback
transactions.
IAS 18: Revenue

The date at which revenue is recognized is important for the accurate determination of
the enterprise's success. According to IAS 18 the revenue should be recognized "when
it is probable that future economic benefits will flow to the enterprise and these benefits
can be measured reliably". There are requirements for the measurement of revenue, for
the identification of the transactions and for recognizing revenue from different business
activities.
IAS 19: Employee Benefits

Employees receive various benefits: salaries and wages, supplementary payments,
pensions, specific leaves, termination and equity compensation benefits. IAS 19
standardizes the recognition and measurement of all short-term and long-term
employee benefits as well as post-term employment benefits. The treatments of
obligations resulting from retirement benefits are of increasing importance.
IAS 20: Accounting for Government Grants and Disclosure of

Government Assistance
If an enterprise receives direct government grants, then, according to the standard,
these are to be recognized as income and assigned to the accounting periods in which
they are intended to provide compensation for corresponding expenses by the
enterprise.
IAS 21: The Effects of Changes in Foreign Exchange Rates

Business transactions in foreign currencies carry the risk of fluctuations in the exchange
rate. IAS 21 regulates the initial recognition of a foreign currency transaction and the
subsequent reportage, particularly the determination of the correct exchange rate that
applies to later balance sheet dates. Furthermore it determines how to deal with
exchange differences.
IAS 22: Business Combinations superseded by IFRS 3 (Business

combination) 2004
A business combination can occur either in the form of an acquisition of an enterprise
or a uniting of interests. IAS 22 establishes the procedure for preparing a financial
statement according to these two forms. For example, it determines that the purchase
method should be applied in accounting for an acquisition and that goodwill (the
difference between the cost of purchase and the fair value of the acquired assets)
should be amortized on a systematic basis over its useful life.
IAS 23: Borrowing Costs

Interest charges and other costs which arise in connection with the borrowing of funds
are recognized under IAS 23 as an expense. The capitalization of borrowed funds as
part of the acquisition or production costs of so-called "qualifying assets" is alternatively
permitted. "Qualifying assets" are those which take a substantial period of time for the
conversion into a serviceable or marketable condition.
IAS 24: Related Party Disclosures

Related enterprises or individuals which exert a significant influence or even control
over the reporting enterprise could have an effect on its financial position and operating
results. For example, they could carry out transactions with the enterprise which a third
party wouldn't do. IAS 24 requires detailed information about links to related enterprises
and persons, provided that there exists control. If business was carried out between
related parties, the type of transaction and the nature of the related party relationship
should be disclosed.
IAS 26: Accounting and Reporting by Retirement Benefit Plans

If the employer guarantees retirement benefits, then their balancing under IAS 26 is
dependent upon whether the retirement benefit plan is a defined contribution plan
(usually a pension fund) or a defined benefit plan. The latter is processed via funds or
provisions for pension fund liabilities. Accounting and disclosure requirements for
retirement benefit plans are specified in this standard.
IAS 27: Consolidated Financial Statements and Accounting for

Investments in Subsidiaries superseded by (Separate financial
statements) in 2013
According to IAS 27 all domestic and foreign subsidiaries are in principle to be included
in the consolidated financial statement of the parent company, unless the subsidiary is
solely held for the purpose of subsequent disposal or it is significantly impaired by
severe long-term restrictions in its ability for funds transfer to the parent. IAS 27 also
establishes the procedures regarding consolidation.
IAS 28: Accounting for Investments in Associates superseded by

(Investment in associates and joint venture) in 2013
If the reporting enterprise has significant influence in, but not control over, another
enterprise, then it is considered an associate. IAS 28 requires the equity method be
applied in balancing such enterprises. The investment in these enterprises should be
recorded at cost and, thereafter, to be adjusted for the change in the investor's share of
the profit or losses.
IAS 29: Financial Reporting in Hyperinflationary Economies

Without the necessary adjustments, the reporting in hyperinflationary economies can be
misleading due to a severe loss in purchasing power. IAS 29 characterizes the concept
of "hyperinflationary economies" and establishes that the measuring unit has to reflect
the price levels, respectively the purchasing power at the balance sheet date. So the
historical costs are to be adjusted to the current costs at the balance sheet date.
IAS 30: Disclosures in the Financial Statements of Banks and

Similar Financial Institutions superseded by IFRS 7 (Financial
instrument: Disclosure) in 2007
Due to their economic significance and the special character of their business
operation, specific requirements exist for the financial statements of banks. That's why
in this standard - amongst other issues - a detailed breakdown of the income statement
is required with regard to the interest, dividend income, fee and commission income
and expense, gains less losses arising from dealing securities, investment securities
and foreign currencies. The listing of the assets and liabilities, reflecting their relative
liquidity, is characteristic for a bank balance sheet. Also of great importance are the
instructions for stating the contingencies and risks of banking.
IAS 31: Financial Reporting of Interests in Joint Ventures

superseded by IFRS 11 (Joint agreements) and IFRS 12 (Disclosure
of interests in other entities) in 2013
Joint ventures are jointly controlled operations, enterprises or assets. IAS 31 stipulates
that jointly controlled entities should be reported by proportionate consolidation (the
equity method is, however, permitted as an alternative).
IAS 32: Financial Instruments: Disclosure and Presentation

A financial instrument is defined by IAS 32 as a contract which both gives rise to a
financial asset of one enterprise and a financial liability or an equity instrument of the
other. These can be both traditional primary financial instruments, such as bonds, and
also derivative financial instruments, such as interest rate or currency swaps. Derivative
instruments are frequently undertaken to protect the business activities against
currency or interest rate risks; however, they can also serve as speculation. IAS 32
standardizes the presentation and the disclosure of the financial instruments.
Additionally detailed information is required concerning interest rate and credit risks as
well as the risk management policies of the enterprise.
IAS 33: Earnings Per Share

An important figure for enterprises, whose shares are traded publicly, is the
measurement EPS (earnings per share), by which the performance of the enterprise
can be compared with other enterprises. Undiluted, basic earnings (the net profit or loss
after deducting preference dividends attributable to ordinary shareholders) are
distinguished from diluted earnings (the net profit or loss adjusted for the effects of all
potential ordinary shares).
IAS 34: Interim Financial Reporting

The interim financial report provides timely information within the accounting period,
particularly for the investors, creditors etc. IAS 34 doesn't mandate interim reports, but
merely requires that such reports by enterprises conform to IAS. Therefore an interim
financial report should, at a minimum, include a condensed balance sheet, income
statement, change in equity statement, cash flow statement and selected explanatory
notes. Furthermore it is stipulated that in the interim financial report the same
accounting practices and treatments should be employed as are found in the annual
financial statement.
IAS 35: Discontinuing Operations superseded by IFRS 5 (Non-

current assets held for sale and discontinued operations) in 2005
This standard describes how to balance an enterprise's operations which are intended
to be disposed of or discontinued.
IAS 36: Impairment of Assets

An asset is regarded as impaired if its carrying amount exceeds the amount which
could be recovered through use or sale of the asset. IAS 36 stipulates how the
impairment is identified and how the impairment loss is to be recognized and
measured. If an impairment loss decreases or no longer exists it is mandatory to carry
out a reversal of an impairment loss.
IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Under IAS 37 provisions are liabilities which are uncertain with regard to their timing or
amount. IAS 37 defines under which circumstances provisions have to be recognized
and to what amount they have to be balanced. Contingent liabilities and contingent
assets should not be recognized. However, details regarding these can be required,
provided that the realization of contingent liabilities or assets is probable.
IAS 38: Intangible Assets

Every enterprise is in possession of intangible assets, such as patents, licenses,
computer software, copyrights, trademarks, customer lists or supplier relationships.
Provided that an intangible asset is clearly identifiable and the enterprise has control
over it, it is required to be accounted according to IAS 38 if it is probable that a future
economic benefit will flow to the enterprise from the asset and its costs can be reliably
measured. The asset should be "allocated on a systematic basis over the best estimate
of its useful life".
IAS 39: Financial Instruments, Recognition and Measurement

IAS 39 amends IAS 32 particularly with instructions related to so-called "derivatives".
These are, e.g. swaps, option contracts, futures, forwards or complex, hybrid financial
instruments which frequently serve for speculation purposes. IAS 39 regulates the
recognition and measurement of these instruments. The distinctive feature of the
relatively new IAS 39 is the subsequent measurement of financial assets at their fair
values.
IAS 40: Investment Property

IAS 40 should be applied in the recognition, measurement and disclosure of investment
property. This can be land or a building or a part of a building held to earn rentals or for
capital appreciation rather than for the purposes of other business processes.
This standard provides the possibility to choose between to models, the fair value
model and the cost model.
IAS 41: Agriculture

This standard concerns accounting of biological assets, agricultural produce at the point
of harvest and governmental grants related to a biological asset. Basis for recognition
and measurement of biological assets is the fair value model.
IFRS 1 – 16 should be included.
Chapter 8
An introduction to the financial statements of limited liability companies
The trading and profit and loss accounts for both private and public companies are drawn up in
exactly the same way.45.11
The trading account of a limited company is no different from that of a sole trader or a
partnership. However, some differences may be found in the profit and loss account. The two
main expenses that would be found only in company accounts are directors’ remuneration and
debenture interest.
Directors’ remuneration
As directors exist only in companies, this type of expense is found only in company accounts.
Directors are legally employees of the company, appointed by the shareholders. Their
remuneration is charged to the profit and loss account.
Debenture interest
The interest payable for the use of the money is an expense of the company, and is payable
whether profits are made or not. This means that debenture interest is charged as an expense in
the profit and loss account itself. Contrast this with dividends which are dependent on profits
having been made.
There are two main types of shares:
1. Preference shares. Holders of these shares get an agreed percentage rate of dividend
before the ordinary shareholders receive anything.
2. Ordinary shares. Holders of these shares receive the remainder of the total profits
available for dividends. There is no upper limit to the amounts of dividends they can
receive.
For example, if a company had 50,000 5 per cent preference shares of $1 each and 200,000
ordinary shares of $1 each, then the dividends would be payable as in Exhibit 45.1.
Illustration 10.1
Year 1 2 3 4 5
$ $ $ $ $
Profits appropriated
For dividends 6,500 10,500 13,500 28,500 17,500
Preference dividends (5%) 2,500 2,500 2,500 2,500 2,500
Ordinary dividends (2%) 4,000 (4%) 8,000 (51/2%) 11,000 (13%) 26,000 (71/2%) 15,000
6,500 10,500 13,500 28,500 17,500
The two main types of preference shares are non-cumulative preference shares and cumulative
preference shares:
1. Non-cumulative preference shares. These can receive a dividend up to an agreed
percentage each year. If the amount paid is less than the maximum agreed amount, the
shortfall is lost by the shareholder. The shortfall cannot be carried forward and paid in a
future year.
2. Cumulative preference shares. These also have an agreed maximum percentage
dividend. However, any shortfall of dividend paid in a year can be carried forward.
These arrears of preference dividends will have to be paid before the ordinary
shareholders receive anything.
The appropriation account

Next under the profit and loss account is a section called the ‘profit and loss appropriation
account’. The appropriation account shows how the net profitsreato be appropriated, i.e. how
the profits are to be used. This is similar in nature to the appropriation account you learnt about
when you looked at partnership accounts, in that it involves distributing the profit. However, that
is as far as the similarity goes.
We may find any of the following in the appropriation account:
Credit side
1. Net profit for the year. This is the net profit brought down from the main profit and loss
account.
2. Balance brought forward from last year. As you will see, all the profits may not be
appropriated during a period. This then will be the balance on the appropriation account, as
brought forward from the previous year. It is usually called retained profits.
Debit side
3. Transfers to reserves. The directors may decide that some of the profits should not be
included in the calculation of how much should be paid out as dividends. These profits are
transferred to reserve accounts.
There may be a specific reason for the transfer such as a need to replace fixed assets. In this case
an amount would be transferred to a fixed assets replacement reserve.
Or the reason may not be specific. In this case an amount would be transferred to a general
reserve account.
4. Amounts written off as goodwill. Goodwill, in a company, may have amounts written off it
from time to time. When this is done the amount written off should be shown in the
appropriation account and not in the main profit and loss account. (See also Section 45.16.)
5. Preliminary expenses. When a company is formed, there are many kinds of expenses
concerned with its formation. These include, for example, legal expenses and various
government taxes. Since 1981 these cannot be shown as an asset in the balance sheet, and can be
charged to the appropriation account.
6. Taxation payable on profits. At this point in your studies you do not need to know very
much about taxation. However, it does affect the preparation of accounts, and so we will tell you
here as much as you need to know now. Sole traders and partnerships pay income tax based on
their profits. Such income tax, when paid, is simply charged as drawings – it is not an expense.
In the case of companies, the taxation levied upon them is called corporation tax. It is also
based on the amount of profits made. In the later stages of your examinations you will learn how
to calculate it. At this point you will be told how much it is, or be given a simple arithmetical
way of ascertaining the amount.
Corporation tax is not an expense; it is an appropriation of profits. This was established by two
legal cases many years ago. However, for the sake of presentation and to make the accounts
more understandable to the general reader, it is not shown with the other appropriations.
Instead, as in Exhibit 45.5 it is shown as a deduction from profit for the year before taxation (i.e.
this is the net profit figure) to show the net result, i.e. profit for the year after taxation.
7. Dividends. Out of the remainder of the profits the directors propose what dividends should be
paid.
8. Balance carried forward to next year. After the dividends have been proposed there will
probably be some profits that have not been appropriated. These retained profits will be carried
forward to the following year.
Illustration 10.1 shows the profit and loss appropriation account of a new business for its first
three years of trading.
Illustration 10.2
ABC Ltd has share capital of 400,000 ordinary shares of Rs.1 each and 200,000 5 per cent
preference shares of Rs.1 each.
The net profits for the first three years of business ended 31 December are: 20X4,
Rs.109,670; 20X5 Rs.148,640; and 20X6 Rs.158,220.
Transfers to reserves are made as follows: 20X4 nil; 20X5, general reserve, Rs.10,000;
and 20X6, fixed assets replacement reserve, Rs.22,500.
Dividends were proposed for each year on the preference shares at 5 per cent and on the
ordinary shares at: 20X4, 10 per cent; 20X5, 12.5 per cent; 20X6, 15 per cent.
Corporation tax, based on the net profits of each year, is 20X4 Rs.41,000; 20X5
Rs.52,500; 20X6 Rs.63,000.
ABC Ltd
Profit and Loss Appropriation Accounts (1)
For the year ended 31 December 20X4
Rs. Rs.
Profit for the year before taxation 109,670
Less Corporation tax (41,000)
Profit for the year after taxation 68,670
Less Proposed dividends:
Preference dividend of 5% 10,000
Ordinary dividend of 10% 40,000
(50,000)
Retained profits carried forward to next year 18,670
(2) For the year ended 31 December 20X5

Rs. Rs. Rs.
Add Retained profits from last year 18,670
114,810
Less Transfer to general reserve 10,000
Proposed dividends:
Ordinary dividend of 121/2% 50,000
60,000
(70,000)
(3) For the year ended 31 December 20X6

Rs. Rs. Rs.

Add Retained profits from last year 44,810
140,030
Less Transfer to fixed assets replacement reserve 22,500
Proposed dividends:
Ordinary dividend of 15% 60,000
70,000
(92,500)
45.12
Note: In the balance sheet, corporation tax owing is normally shown as a current liability.
Q.1 Select Ltd is registered with an authorised capital of 300,000 ordinary shares of $1. The
following trial balance was extracted from the books of the company on 31 March 20X1, after
the preparation of the trading account:
Dr Cr
$ $
Ordinary share capital, fully paid 200,000
Land and buildings at cost 170,000
Sundry debtors 38,300
Furniture and fittings at cost 80,000
VAT 3,800
Sundry Creditors 25,000
Inventory at 31 March 20X0 42,000
Bank 12,000
Trading account: gross profit 98,050
Office salaries and expenses 25,000
Accumulated provision for depreciation on furniture and fittings 32,000
Share premium account 20,000
Advertising and selling expenses 5,000
Bad debts 250
Provision for doubtful debts 600
Profit and loss account 12,000
Directors’ fees 11,300
387,650 387,650
Required:
Prepare the profit and loss account of the company for the year ending 31 March 20X1, and
balance sheet as at that date, after taking into account the following adjustments:
(i ) The provision for doubtful debtors is to be adjusted to $700.
(ii ) Depreciation is to be provided in respect of furniture and fittings at 10% per annum on cost.
(iii ) $25,000 is to be transferred from profit and loss to general reserve.
(iv) Provide for a proposed dividend on share capital at 10%.
Q.2 Here is the trial balance of ZEE Ltd as at 30 April 20X5:

Dr Cr
$ $
Share capital: authorised and issued 200,000
Inventory as at 30 April 20X4 102,994
Debtors 227,219
Creditors 54,818
8% debentures 40,000
Fixed assets replacement reserve 30,000
General reserve 15,000
Profit and loss account as at 30 April 20X4 12,411
Debenture interest 1,600
Equipment at cost 225,000
Motor vehicles at cost 57,200
Bank 4,973
Cash 62
Sales 880,426
Purchases 419,211
Returns inwards 18,400
Carriage inwards 1,452
Wages and salaries 123,289
Rent, business rates and insurance 16,240
Discounts allowed 3,415
Directors’ remuneration 82,400
Provision for depreciation at 30 April 20X4:
Equipment 32,600
Motor vehicles 18,200
1,283,455 1,283,455
Given the following information as at 30 April 20X5, draw up a profit and loss account and
balance sheet for the year to that date:
(i) Inventory $111,317.
(ii) The share capital consisted of 300,000 ordinary shares of 50p each and 50,000 12 per cent
preference shares of $1 each. The dividend on the preference shares was proposed to be paid as
well as a dividend of 18 per cent on the ordinary shares.
(iii) Accrued: rent $802; Directors’ remuneration $6,000.
(iv) Debenture interest 1/2 year’s interest owing.
(v) Depreciation on cost: Equipment 20 per cent; Motor vehicles 25 per cent.
(vi) Transfers to reserves: General reserve $5,000; Fixed assets replacement reserve $10,000.
Q.3 Burden PLC has an authorised capital of 500,000 ordinary shares of $0.50 each.
(a) At the end of its financial year, 31 May 20X9, the following balances appeared in the
company’s books:
$
Issued capital: 400,000 shares fully paid 200,000
Freehold land and buildings at cost 320,000
Inventory in trade 17,800
10% debentures 30,000
Trade debtors 6,840
Trade creditors 8,500
Expenses prepaid 760
Share premium 25,000
General reserve 20,000
Expenses outstanding 430
Profit and loss account balance (1 June 20X8) 36,200
Bank overdrawn 3,700
Fixtures, fittings and equipment at cost 54,000
Provision for depreciation 17,500
‘
The company’s trading and profit and loss accounts had been prepared and revealed a net profit
of $58,070. However, this figure and certain balances shown above needed adjustment in view
of the following details which had not been recorded in the company’s books.
(i) It appeared that a trade debtor who owed $300 would not be able to pay. It was decided to
write his account off as a bad debt.
(ii) An examination of the company’s Inventory on 31 May 20X9 revealed that some items
shown in the accounts at a cost of $1,800 had deteriorated and had a resale value of only $1,100.
(iii) At the end of the financial year some equipment which had cost $3,600 and which had a net
book value of $800 had been sold for $1,300. A cheque for this amount had been received on 31
May 20X9.
Required:
1. A statement which shows the changes which should be made to the net profit of $58,070 in
view of these unrecorded details.
(b) The directors proposed to pay a final dividend of 10% and to transfer $50,000 to general
reserve on 31 May 20X9.
Required:
2. For Burden PLC (taking account of all the available information) The profit and loss
appropriation account for the year ended 31 May 20X9.
3. Two extracts from the company’s balance sheet as at 31 May 20X9, showing in detail:
(i) The current assets, current liabilities and working capital
(ii) The items which make up the shareholders’ funds.
Chapter 9
Cash Flow Statements
Cash flows are the lifeblood of a business. They enable a company to pay expenses, debts,
employees’ wages, and taxes, and to invest in the assets it needs for its operations. Without
sufficient cash flows, a company cannot grow and prosper. Because of the importance of cash
flows, one must be alert to the possibility that items may be incorrectly classified in a statement
of cash flows and that the statement may not fully disclose all pertinent information.
The statement of cash flows shows how a company’s operating, investing, and financing
activities have affected cash during an accounting period. It explains the net increase (or
decrease) in cash during the period. For purposes of preparing this statement, is defined as
including both cash and cash equivalents. are investments that can be quickly converted to cash;
they have a maturity of 90 days or less when they are purchased.
They include money market accounts, commercial paper, and Treasury bills. A company invests
in cash equivalents to earn interest on cash that would otherwise be temporarily idle.
Suppose, for example, that a company has Rs.1,000,000 that it will not need for 30 days. To earn
a return on this amount, the company could place the cash in an account that earns interest (such
as a money market account), lend the cash to another corporation by purchasing that
corporation’s short-term notes (commercial paper), or purchase a short-term obligation of the
U.S. government (a Treasury bill).
Because cash includes cash equivalents, transfers between the Cash account and cash
equivalents are not treated as cash receipts or cash payments. On the statement of cash flows,
cash equivalents are combined with the Cash account. Cash equivalents should not be confused
with short-term investments, or marketable securities. These items are not combined with the
Cash account on the statement of cash flows; rather, purchases of marketable securities are
treated as cash outflows, and sales of marketable securities are treated as cash inflows.
Purposes of the Statement of Cash Flows

The primary purpose of the statement of cash flows is to provide information about a company’s
cash receipts and cash payments during an accounting period. A secondary purpose is to provide
information about a company’s operating, investing, and financing activities during the
accounting period.
Some information about those activities may be inferred from other financial statements, but the
statement of cash flows summarizes all transactions that affect cash.
Uses of the Statement of Cash Flows

The statement of cash flows is useful to management, as well as to investors and creditors.
Management uses the statement of cash flows to assess liquidity, to determine dividend
policy, and to evaluate the effects of major policy decisions involving investments and
financing. Examples include determining if short-term financing is needed to pay current
liabilities, deciding whether to raise or lower dividends, and planning for investing and
financing needs.
Investors and creditors use the statement to assess a company’s ability to manage cash
flows, to generate positive future cash flows, to pay its liabilities, to pay dividends and
interest, and to anticipate its need for additional financing.
Classification of Cash Flows

The statement of cash flows has three major classifications: operating, investing, and financing
activities. The components of these activities are illustrated in Figure 1 and summarized below.
1. Operating activities involve the cash inflows and outflows from activities that enter into the
determination of net income. Cash inflows in this category include cash receipts from the sale of
goods and services and from the sale of trading securities. Trading securities are a type of
marketable security that a company buys and sells for the purpose of making a profit in the near
term. Cash inflows also include interest and dividends received on loans and investments. Cash
outflows include cash payments for wages, inventory, expenses, interest, taxes, and the purchase
of trading securities. In effect, accrual-based income from the income statement is changed to
reflect cash flows.
2. Investing activities involve the acquisition and sale of property, plant, and equipment and
other long-term assets, including long-term investments. They also involve the acquisition and
sale of short-term marketable securities, other than trading securities, and the making and
collecting of loans. Cash inflows include the cash received from selling marketable securities
and long-term assets and from collecting on loans. Cash outflows include the cash expended on
purchasing these securities and assets and the cash lent to borrowers.
3. Financing activities involve obtaining resources from stockholders and providing them with
a return on their investments, and obtaining resources from creditors and repaying the amounts
borrowed or otherwise settling the obligations. Cash inflows include the proceeds from stock
issues and from short- and long-term borrowing. Cash outflows include the repayments of loans
(excluding interest) and payments to owners, including cash dividends. Treasury stock
transactions are also considered financing activities. Repayments of accounts payable or accrued
liabilities are not considered repayments of loans; they are classified as cash outflows under
operating activities.
Noncash Investing and Financing Transactions

Companies occasionally engage in significant noncash investing and financing transactions.
These transactions involve only long-term assets, long-term liabilities, or stockholders’ equity.
For instance, a company might exchange a long-term asset for a long-term liability, settle a debt
by issuing capital stock, or take out a long-term mortgage to purchase real estate. Noncash
transactions represent significant investing and financing activities, but they are not reflected on
the statement of cash flows because they do not affect current cash inflows or outflows. They
will, however, affect future cash flows. For this reason, they are disclosed in a separate schedule
or as part of the statement of cash flows.
The first step in preparing the statement of cash flows is to determine cash flows from operating
activities. The income statement indicates how successful a company has been in earning an
income from its operating activities, but because that statement is prepared on an accrual basis, it
does not reflect the inflow and outflow of cash related to operating activities. Revenues are
recorded even though the company may not yet have received the cash, and expenses are
recorded even though the company may not yet have expended the cash. Thus, to ascertain cash
flows from operations, the figures on the income statement must be converted from an accrual
basis to a cash basis.
There are two methods of accomplishing this:
The direct method adjusts each item on the income statement from the accrual basis to
the cash basis. The result is a statement that begins with cash receipts from sales and
interest and deducts cash payments for purchases, operating expenses, interest payments,
and income taxes to arrive at net cash flows from operating activities.
The indirect method does not require the adjustment of each item on the income
statement. It lists only the adjustments necessary to convert net income to cash flows
from operations.
The direct and indirect methods always produce the same net figure. The average person finds
the direct method easier to understand because its presentation of operating cash flows is more
straightforward than that of the indirect method. However, the indirect method is the
overwhelming choice of most companies and accountants. A survey of large companies shows
that 99 percent use this method. The indirect method focuses on adjusting items on the income
statement to reconcile net income to net cash flows from operating activities. These items
include depreciation, amortization, and depletion; gains and losses; and changes in the balances
of current asset and current liability accounts.
Schedule of Cash Flows from

Operating Activities
The treatment of income statement items that do not affect cash flows can be summarized as
follows:
Add to or Deduct from Net Income
Depreciation expense Add
Amortization expense Add
Depletion expense Add
Losses Add
Gains Deduct
The following summarizes the adjustments for increases and decreases in current assets and
current liabilities:
Add to Deduct from
Net Income Net Income
Current assets
Accounts receivable (net) Decrease Increase
Inventory Decrease Increase
Prepaid expenses Decrease Increase
Current liabilities
Accounts payable Increase Decrease
Accrued liabilities Increase Decrease
Income taxes payable Increase Decrease
investing Activities
To determine cash flows from investing activities, accounts involving cash receipts and cash
payments from investing activities are examined individually. The objective is to explain the
change in each account balance from one year to the next.
Although investing activities center on the long-term assets shown on the balance sheet, they
also include any short-term investments shown under current assets on the balance sheet and any
investment gains and losses on the income statement.
Financing Activities
Determining cash flows from financing activities is very similar to determining cash flows from
investing activities, but the accounts analyzed relate to short-term borrowings, long-term
liabilities, and stockholders’ equity.
Cash flow statement is the Reconciliation of Net Profit to the Net Cash Flows.
Cash Flow Statement
For the Period Ended December 20XX
Using Indirect Method
Cash flow from operation activities

Net profit before interest and tax and extra ordinary items xxx
Adjustment for; (non-cash items) xxx
Add:
Depreciation (for the period) xxx
Bed Debts expense xxx
Amortization of Goodwill, patent or intangible assets xxx
Amortization of discount on debenture or share xxx
Loss of sale of fixed assets xxx xxx
Less:
Gain on sale of fixed assets xxx
Dividend and interest received on investment xxx (xxx)
Operating profit xxx
Increase in current assets (except cash/bank) (xxx)
Decrease in current assets (except cash/bank) xxx
Increase in current liabilities (except tax, interest and dividend payable) xxx
Decrease in current liabilities (except tax, interest and dividend payable) (xxx) (xxx)
Cash generated from operation xxx
Interest paid (actual cash paid) (xxx)
Income tax paid (actual cash paid) (xxx)
Net Cash from operating activities xxx
Cash flow from investing activities
Purchase of fixed assets (actual cash paid) (xxx)
Sale of fixed assets (actual cash received) xxx
Interest received (actual cash received) xxx
Dividend received (actual cash received) xxx
xxx
Cash flow from financing activities

Issue of share capital (actual cash received) xxx
Issue of debenture (actual cash received) xxx
Received from long term loans (actual cash received) xxx
Payment of long term loans (actual cash paid) (xxx)
Dividend paid (actual cash paid) (xxx)

Cash generated from operations xxx
Increase (decrease) in net cash during the period xxx
Add:
Cash and cash equivalents at beginning of period xxx
Cash and cash equivalents at ending of period xxx
Cash flow statement is the Reconciliation of Net Profit to the Net Cash Flows.
Cash Flow Statement
For the Period Ended December 20XX
Using Direct Method
Cash flow from operation activities

Cash receipts from customers xxx
Cash paid to suppliers and employees (xxx)
Interest paid (xxx)
Income tax paid (xxx)
Net Cash from operating activities xxx
Cash flow from investing activities
Purchase of fixed assets (actual cash paid) (xxx)
Sale of fixed assets (actual cash received) xxx
Interest received (actual cash received) xxx
Dividend received (actual cash received) xxx
Net Cash flow from investing activities xxx
Cash flow from financing activities
Issue of share capital (actual cash received) xxx
Issue of debenture (actual cash received) xxx
Received from long term loans (actual cash received) xxx
Payment of long term loans (actual cash paid) (xxx)
Dividend paid (actual cash paid) (xxx)
Increase (decrease) in net cash during the period xxx
Add:
Cash and cash equivalents at beginning of period xxx
Cash and cash equivalents at ending of period xxx
CASH FLOW STATEMENT
Indirect Approach
Q No.1
Net income------------------------------------------------- Rs.495,000
Sales of plant assets-------------------------------------- Rs.56,500
Issue of shares for cash --------------------------------- Rs.150,000
Increase of Account Receivable------------------------- Rs.12000
Amortization of intangible assets----------------------- Rs.5000
Loss on sales of plant assets----------------------------- Rs.1500
Purchase of plant assets---------------------------------- Rs.75,000
Borrowed from MCB at 8% for five year ------------- Rs.300,000
Increase of current liability------------------------------- Rs.17000
Increase of inventory-------------------------------------- Rs.6000
Dividend paid---------------------------------------------- Rs.55000
Purchased building and accepted note for six month Rs.450,000
Income tax paid-------------------------------------------- Rs.36,500
Interest paid------------------------------------------------ Rs.25,000
Interest and dividend received -------------------------- Rs.12000
Loss on sale of plant assets------------------------------- Rs.1570
Loan made to borrowers---------------------------------- Rs.100,000
Redemption of long-term loan--------------------------- Rs.50,000
Required: Prepare cash flow statement showing operating, investing and financing activities under
indirect method.
Q No.2
Net income------------------------------------------------- Rs.795,000

Sales of plant assets-------------------------------------- Rs.66,500
Issue of shares--------------------------------------------- Rs.250,000
Increase of Account Receivable------------------------- Rs.12000
Amortization of intangible assets----------------------- Rs.5000
Gain on sales of plant assets----------------------------- Rs.1500
Purchase of plant assets---------------------------------- Rs.175,000
Borrowed from MCB at 8% for five year ------------- Rs.300,000
Increase of current liability------------------------------- Rs.17000
Decrease of inventory-------------------------------------- Rs.6000
Dividend paid---------------------------------------------- Rs.55000
Income tax paid-------------------------------------------- Rs.36,500
Interest paid------------------------------------------------ Rs.25,000
Interest and dividend received -------------------------- Rs.12000
Loan made to borrowers---------------------------------- Rs.100,000
Redemption of long-term loan--------------------------- Rs.50,000
Stock dividend -------------------------------------------- Rs. 50,000
Purchase of franchise cost -------------------------- Rs. 200,000
Settled loan of a lender by issuing shares worth Rs. 125,000
Required:
Prepare cash flow statement showing operating, investing and financing activities under indirect
method.
Cash Flow Statement

Q No.3 The following income statement and selected balance sheet account data are available for
Satelllite Transmissions, Inc,. at December 31:
SATELLITE TRANSMISSIONS, INC

Income Statement
For the Year Ended December 31,2015
Net Income 205,000

Gain on sales of marketable securities 4000
Depreciation expense 26000
Loss on sale of plant assets 12500
Gain on sale of securities 6500
Selected account balances:

End of Year Beg. of Year
A/c Receivable Rs.650,000 720,000
Accrued interest receivable 9000 6000
Inventories 800,000 765,000
Short term prepayments 20,000 15,000
Account payable 570,000 562,000
Accrued operating expense payable 65,000 94,000
Accrued interest payable 21,000 12,000
Accrued income taxes payable 22,000 35,000
Company issued 45000 shares at Rs.17. Redeemed bonds payable Rs.75,000, purchased plant assets
Rs.200,000. Loan made to associated company for 4 years at 5% Rs.150,000.
Required:
Prepare Cash Flow Statement by Indirect Method showing separately operating, investing and
financing activities.
Cash Flow Statement

Q. No.4 Accountants for Creve Coeur Manufacturing have assembled the following data for the year
ended December 31, 2006
December 31
2005 2006
Current assets:
Cash and cash equivalents Rs.30600 Rs.34800
Accounts receivable 70100 73700
Inventories 90600 96500
Prepaid expenses 3200 2100
Current liabilities:
Note payable Rs.36300 36800
Accounts Payable 72100 67500
Income tax payable 5900 6800
Accrued liabilities 28300 23200
Transactions data for 2006:
Acquisition of long term investment---------------------------------------- Rs.44800
Acquisition of building by issuing long-term note payable----------------- 162,000
Stock dividend-------------------------------------------------------------------- 12600
Collection of loan----------------------------------------------------------------- 10300
Depreciation expense-------------------------------------------------------------- 19200
Acquisition of equipment--------------------------------------------------------- 69,000
Payment of long-term debts by issuing common stock k----------------------89400
Sale of long-term investment--------------------------------------------------- 12200
Amortization expense----------------------------------------------------------- 1100
Payment of long-term debt----------------------------------------------------- 47800
Gain on sale of investment----------------------------------------------------- 3500
Payment of cash dividends------------------------------------------------------- 48300
Issuance of long-term debt to borrow cash------------------------------------- 21000
Net income------------------------------------------------------------------------- 92500
Issuance of preferred stock for cash-------------------------------------------- 36200
Required:
Prepare cash flow statement showing operating, investing and financing activities under indirect
method
Cash Flow Statement

Assignment/Practice Questions
Q No.5 Following data is selected from a company record.
Income Statement items (2005)

Sales 140,000
Cost of goods sold 59,000
Depreciation 7000
Salaries expense 28000
Income tax expense 9000
Interest expense 5000
Other expense 15,800
Gain on sale of fixed asset 4000
Net income 20,200
Balance Sheet items 2005 2004

Cash Rs.19200 Rs.20500
Accounts Receivable 22,000 22,000
Mds. Inventory 75,000 68000
Investment-long term 15,000 ------
Other Fixed assets 113,500 114,500
244,700 225,000
Accumulated Depreciation 20,000 32,000

A/C Payable 14,000 17,000
Salaries payable 1500 2500
Bonds payable 54,000 54,000
Common stock 126,000 100,000
Retained earnings 24,700 16,500
244,700 225,000
Required:
Prepare Cash Flow Statement
Q. No. 6 Accountants for Creve Coeur Manufacturing have assembled the following data for the year
ended December 31,2006
December 31
2006 2005
Current assets:
Cash and cash equivalents Rs.30600 Rs.34800
Accounts receivable 70100 73700
Inventories 90600 96500
Prepaid expenses 3200 2100
Note payable 36300 36800
Accounts Payable 72100 67500
Accrued liabilities 28300 23200
Transactions data for 2006:
Acquisition of long term investment------------------------------------------ Rs.44800
Acquisition of building by issuing long-term note payable----------------- 162,000
Stock dividend----------------------------------------------------------------------- 12600
Collection of loan------------------------------------------------------------------- 10300
Depreciation expense--------------------------------------------------------------- 19200
Acquisition of equipment---------------------------------------------------------- 69,000
Payment of long-term debts by issuing common stock k---------------------- 89400
Sale of long-term investment------------------------------------------------------ 12200
Amortization expense---------------------------------------------------------------- 1100
Payment of long-term debt--------------------------------------------------------- 47800
Gain on sale of investment--------------------------------------------------------- 3500
Payment of cash dividends--------------------------------------------------------- 48300
Issuance of long-term debt to borrow cash------------------------------------- 21000
Net income------------------------------------------------------------------------- 92500
Issuance of preferred stock for cash-------------------------------------------- 36200
Required:
Prepare cash flow statement showing operating, investing and financing activities under indirect
method
Q No.7 The balances of the accounts of Multan cement co. limited at end of 2002 and 2003 are as
follows:
Assets 2003 2002

Cash 60000 100000
A/c Receivable 150000 175000
Inventory 275500 250000
Land 75000 ------
Plant 800000 625000
Machine 90000 100000
1450,500 1250000
Accumulated depreciation 210500 200000

A/c payable 155000 75000
Long-term loan 25000 --------
Common stock 1000000 875000
Retained earning 60,000 100,000
1450,500 1250000
Plant sold during the period at Rs.16,000, its cost Rs.30,000 and accumulated depreciation Rs.10,000.
Company reported net loss for the year 2003 Rs.40000
Required:
Prepare cash flow statement
Q No.8
The comparative Balance sheet of ABC company for the two years are as under:
Assets Dec.31,02 Dec.31,01

Cash 87500 105000
Inventory 162500 175000
Prepaid Rent 40000 45000
Short term investment 168500 124500
Plant assets 440000 415000
1073500 1024500
Liabilities and shareholder’s equities

Accumulated depreciation 168500 124500
Share capital 605000 570000
A/c payable 90000 100000
Salaries payable 15000 15000
Unearned rent 15000 10000
Long-term loan 60000 100000
1073500 1024500
Additional data:
Plant assets sold at a gain of Rs.7500. Cost of the plant was 30,000 and accumulated depreciation
Rs.18000.
Net income for the year 2002 Rs.90,000. Cash dividend paid Rs.75000.
Required:
Prepare Cash flow statement
Q No.9 Prepare the 19X3 statement of cash flows for Robins Corporation, using the indirect
method to report cash flows from operating activities. in a separate schedule, report robins
noncash investing and financing activities.
December 31
------------------------------------
19X3 19X2
------------------------------------
Current assets:
Cash and cash equivalents Rs.19,000 Rs.3,000

Accounts receivable 22,000 23,000
Inventories 34,000 31,000
Prepaid expenses 1,000 3,000
Notes payable ( for inventory purchase) Rs.11,000 Rs.7,000

Accounts payable 24,000 19,000
Accrued liabilities 7,000 9,000
Income tax payable 10,000 10,000
Transection data for 19X3:
Purchase of equipment Rs.98,000

Payments of cash dividend 18,000
Net income 26,000
Issuance of common stock to retire bonds payable 13,000
Purchase of long term investment 8,000
Issuance of long term note payable to purchase patent 37,000
Depreciation expense 7,000
Issuance of long term note payable to borrow cash 7,000
Issuance of common stock for cash 19,000
Sale of building 74,000
Amortization expense 3,000
Purchase of treasury stock 5,000
Loss on sale of building 2,000
Q No.10
Indirect method
Plywood Products Corporation of America accountants have assembled the following data for
the year ended December 31, 19X7
December 31
----------------------------------------
19X7 19X6
-------- -----------
Current accounts (all result from operations)
Current assets:
Cash and cash equivalents................................................ Rs.85,700 Rs.22,700
Accounts recievable........................................................... 59,700 64,200
Inventories............................................................................ 88,600 83,000
Prepaid expenses.................................................................. 5,300 4,100
Notes payable (for inventory purchases)............................ Rs.22,600 Rs.18,300
Accounts payable................................................................... 52,900 55,800
Income tax payable................................................................ 18,600 16,700
Accrued liablities................................................................... 25,500 27,200
Transaction data for 19X7:

Acquisition of long term
Sale of equipment......................... Rs.58,000
Investment..................................... Rs. 31,600
Amortization expense................... 5,300
Acquisition of land by
Purchase of treasury stock........... 14,300
Issuing long term note :
Loss sale of equipment.................. 11,700
Payable................................................ 113,000
Payment of cash
Stock dividends..................................... 31,800
dividends............................................ 18,300
Collection of loan................................... 8,700
Issuance of long term
Depreciation expense.......................... 26,800
Note payable to borrow
Acquisition of building........................ 125,300
cash.................................................... 34,400
Retirement of bonds
Net income.......................................... 67,100
Payable by issuing
Issuance of common stock
Common stock..................................... 65,000
For cash............................................... 41,200
Required: prepare Plywood products' statement of cash flows, using the indirect method to
report operating activities. Include an accompanying schedule of noncash investing and
financing activities.
Q No.11 Accountants for manufacturing firm have assembled the following data for the year
ended December 31, 19X4:
December 31
-----------------------------------
-
19X4 19X3
-----------------------------------
-Current accounts (all result from operations):
Current assets:
Cash and cash equivalents...................................... Rs.30,600
Rs.34,800
Accounts receivable.................................................... 70,100 73,700
Inventories.................................................................... 90,600 96,500
Prepaid expenses......................................................... 3,200 2,100
Notes payable (for inventory purchases)...................... Rs.36,300
Rs.36,800
Accounts payable.......................................................... 72,100
67,500
Income tax payable..................................................... 5,900 6,800
Accrued liablities....................................................... 28,300
23,200
Transaction data for 19X4:

Acquisition of long term investment............................. Rs. 44,800
Acquisition of building by issuing long term note payable.......................................162,000
Stock dividents......................................................................................... 12,600
Collection of loan.................................................................................... 10,300
Depreciation expense........................................................................ 19,200
Acquisition of equipment................................................................... 69,000
Payment of long term debt by issuing common stock........................... 89,400
Sale of long term investment.................................................................... 12,200
Amortization expense........................................................................ 1,100
Payment of long term debt................................................................. 47,800
Gain on sale of investment.............................................................. 3,500
Payment of cash dividends................................................................... 48,300
Issuance of long term debt to borrow cash............................... 21,000
Net income............................................................................. 92,500
Issuance of preferred stock for cash............................................. 36,200
Required:
Prepare statement of cash flows, using the indirect method to report operating activities. Include
an accompanying schedule of noncash Investing and financing activities.
Chapter 10
RATIO ANALYSIS
FINANCIAL STATEMENT ANALYSIS
TYPES OF RATIO COMPARISONS
Ratio analysis is not merely the calculation of a given ratio. More important is the interpretation
of the ratio value. A meaningful basis for comparison is needed to answer such questions as “Is
it too high or too low?” and “Is it goodor bad?”
Two types of ratio comparisons can be made, cross-sectional and time-series.
Cross-Sectional Analysis
Cross-sectional analysis involves the comparison of different firms’ financial ratios at the same
point in time. Analysts are often interested in how well a firm has performed in relation to other
firms in its industry. Frequently, a firm will compare its ratio values to those of a key competitor
or group of competitors that it wishes to emulate. This type of cross-sectional analysis, called
benchmarking, has become very popular. Comparison to industry averages is also popular.
For example we are interested to analyze Fauji Cement as well as Maple Leaf Cement and for
this purpose we decided to take Lucky Cement as benchmark and also obtained information
about overall cement industry ratios to compare both companies performance.
Analysts have to be very careful when drawing conclusions from ratio comparisons. It’s
tempting to assume that if one ratio for a particular firm is above the industry norm, this is a sign
that the firm is performing well, at least along the dimension measured by that ratio. However,
ratios may be above or below the industry norm for both positive and negative reasons, and it is
necessary to determine why
a firm’s performance differs from its industry peers.Thus, ratio analysis on its own is probably
most useful in highlighting areas for further investigation.
Time-Series Analysis
Time-series analysis evaluates performance over time. Comparison of current to past

performance, using ratios, enables analysts to assess the firm’s progress. Developing trends can
be seen by using multiyear comparisons. Any significant year-to-year changes may be
symptomatic of a problem, especially if the same trend is not an industry-wide phenomenon.
CATEGORIES OF FINANCIAL RATIOS
Financial ratios can be divided for convenience into five basic categories:
a) liquidity
b) activity
c) debt
d) profitability
e) market ratios
1. Liquidity ratios, which give us an idea of the firm’s ability to pay off debts that are maturing
within a year.
2. Asset management ratios, which give us an idea of how efficiently the firm is using its assets.
3. Debt management ratios, which give us an idea of how the firm has financed its assets as well
as the firm’s ability to repay its long-term debt.
4. Profitability ratios, which give us an idea of how profitably the firm is operating and utilizing
its assets.
5. Market value ratios, which bring in the stock price and give us an idea of what investors think
about the firm and its future prospects.
Liquidity, activity, and debt ratios primarily measure risk. Profitability ratios measure return.
Market ratios capture both risk and return.
As a rule, the inputs necessary for an effective financial analysis include, the income statement
and the balance sheet.
We will use the 2014 income statements and balance sheets for Hudson Company, to
demonstrate ratio calculations. Note, however, that the ratios presented in the remainder of this
chapter can be applied to almost any company other than financial sector. Of course, many
companies in different industries use ratios that focus on aspects peculiar to their industry.
Hudson Co.
Balance Sheet
As at December 31, 2014
Assets Rs. Equities Rs.

Cash 710 Current
A/c Receivable 2106 Liabilities 1215
Inventory 4982 A/c Payable 948
7798 Accrued expenses
4190
Long Term Debt
Owner’s Equities
Common 10,000
Plant 18,584 Stock(Rs.10) 10,029
26,382 Retained 26,382
Earnings
Income Statement
For The Year Ended December 31, 2014
Rs.
Sales 28,000
Less: Cost of Goods Sold 13,740
Gross Profit 14,260

Less: Operating Expenses 6,000
Operating 8,260
Profit(EBIT) 419
Interest expenses 7,841
EBT 3,136
Less: Tax (40%) 4,705
Net Income
Sales $28,000
Less: Cost of goods sold 11,600
Depreciation 2,140
Earnings before interest and

taxes $14,260
Less: Interest paid 980
Taxable Income $13,280

Taxes (35%) 4,648
Net Income $8,632
LIQUIDITY RATIO
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they
come due. Liquidity refers to the solvency of the firm’s overall financial position—the ease with
which it can pay its liabilities. These ratios can provide early signs of cash flow problems and
impending business failure. Clearly it is desirable that a firm is able to pay its liabilities, so
having enough liquidity for day-to-day operations is important. However, liquid assets, like cash
held at banks and marketable securities, do not earn a particularly high rate of return, so
shareholders will not want a firm to overinvest in liquidity. Firms have to balance the need for
safety that liquidity provides against the low returns that liquid assets generate for investors. The
two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.
CURRENT RATIO
The current ratio, one of the most commonly cited financial ratios, measures the firm’s ability
to meet its short-term obligations. It is expressed as follows:
Current Ratio = Current assets/current liabilities
A higher current ratio indicates a greater degree of liquidity. How much liquidity a firm needs
-term financing
depends on a variety of factors, including the firm’s size, its access to short
sources like bank credit lines, and the volatility of its business. For example, a grocery store
whose revenues are relatively predictable may not need as much liquidity as a manufacturing
firm who faces sudden and unexpected shifts in demand for its products. The more predictable a
firm’s cash flows, the lower the acceptable current ratio. Generally 2:1 shows quite satisfactory
and stable liquidity position.
QUICK RATIO
The quick (acid-test) ratio is similar to the current ratio except that it excludes inventory,
which is generally the least liquid current asset. The generally low liquidity of inventory results
from two primary factors:
(1) Many types of inventory cannot be easily sold because they are partially completed items,
special-purpose items, and the like; and (2) inventory is typically sold on credit, which means
that it becomes an account receivable before being converted into cash. An additional problem
with inventory as a liquid asset is that the times when companies face the most urgent need for
liquidity, when business is bad, are precisely the times
when it is most difficult to convert inventory into cash by selling it. The quick ratio is calculated
as follows:
Quick Ratio = Current Assets-Inventory/Current Liability
As with the current ratio, the quick ratio level that a firm should strive to achieve depends
largely on the nature of the business in which it operates. The quick ratio provides a better
measure of overall liquidity only when a firm’s inventory cannot be easily converted into cash.
If inventory is liquid, the current ratio is a preferred measure of overall liquidity.
ACTIVITY RATIOS
Activity ratios measure the speed with which various accounts are converted into sales or
cash—inflows or outflows. In a sense, activity ratios measure how efficiently a firm operates
along a variety of dimensions such as inventory management, disbursements, and collections. A
number of ratios are available for measuring the activity of the most important current accounts,
which include inventory, accounts receivable, and accounts payable. The efficiency with which
total assets are used can also be assessed.
INVENTORY TURNOVER
Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory. It is

calculated as follows:
(a) Cost of Goods Sold/Average Inventory = Times
(b) Inventory in days = 365 days/……Times = days
If you are interested to find days, u can use alternative formulae for this purpose as given below:
Inventory in days = Average inventory *365/ Cost of goods sold
Average inventory is computed with the support of beginning inventory and ending inventory
provided both information is given. If information is not given then use ending inventory as
average inventory.
In case question does not provide information about ‘cost of goods sold’, then we can use
‘sales’ information as an alternative.
This ratio indicates, on average, in how many days firm is able to sell its inventory which varies
from industry to industry. The resulting turnover is meaningful only when it is compared with
that of other firms in the same industry or to the firm’s past inventory turnover. An inventory
turnover of 20 would not be unusual for a grocery store, whose goods are highly perishable and
must be sold quickly, whereas an aircraft manufacturer might turn its inventory just four times
per year.
AVERAGE COLLECTION PERIOD
The average collection period, or average age of accounts receivable, is useful in evaluating
credit and collection policies. It is arrived at by dividing the average daily sales into the accounts
receivable balance:
The average collection period is meaningful only in relation to the firm’s credit terms. If
Company has given 30-day credit terms to customers, an average collection period of 55 days
may indicate a poorly managed credit or collection department, or both. It is also possible that
the lengthened collection period resulted from an intentional relaxation of credit-term
enforcement in response to competitive pressures. If the firm had extended 60-day credit terms,
the 55-day average collection period would be quite acceptable. Clearly, additional information
ies. It can be
is needed to evaluate the effectiveness of the firm’s credit and collection polic
calculated as follows;
(a) Sales/Average A/c Receivable = Times
(b) 365 days/ Times = days
You can also use straight formulae to calculate Average A/c Receivable days:
Average A/c Receivable *365/Sales
AVERAGE PAYMENT PERIOD
The average payment period, or average age of accounts payable, is calculated in the same
manner as the average collection period:
(a) Purchases /Average A/c Payable = Times
(b) 365 days / Times = days
You can use alternative formulae to calculate days:
Average A/c Payable *365/ Purchases
These days are meaningful only in relation to the average credit terms extended to the firm. If
Company’s suppliers have extended, on average, 30 -daycredit terms, an analyst would give
company a low credit rating because it was taking too long to pay its liabilities. Prospective
lenders and suppliers of trade credit are interested in the average payment period because it
provides insight into the firm’s liabilities paying patterns.
TOTAL ASSET TURNOVER
The total asset turnover indicates the efficiency with which the firm uses its assets to generate
sales. Total asset turnover is calculated as follows:
Assets Turnover = Sales /Total Assets
Generally, the higher a firm’s total asset turnover, the moreefficiently its assets have been used.
This measure is probably of greatest interest to management because it indicates whether the
firm’s operations have been financially efficient.
Fixed Assets Turnover Ratio
The fixed assets turnover ratio, which is the ratio of sales to net fixed assets, measures how
effectively the firm uses its plant and equipment:
Fixed Assets Turnover = Sales / Fixed Assets
DEBT RATIO
Debt, the amount borrowed by firm for short term or long term is always attached with cost.
Firm obtains loan to get more benefits than its cost. The debt position of a firm indicates the
amount of other people’s money being used to generate profits. Inneral, ge the financial analyst
is most concerned with long-term debts because these commit the firm to a stream of contractual
payments over the long run. The more debt a firm has, the greater its risk of being unable to
meet its contractual debt payments. Because creditors’ claims must be satisfied before the
earnings can be distributed to shareholders, current and prospective shareholders pay close
attention to the firm’s ability to repay debts.
Lenders (who given funds) are also concerned about the firm’sindebtedness. In general, the
more debt a firm uses in relation to its total assets, the greater its financial leverage.
Financial leverage is the magnification of risk and return through the use of fixed-cost
financing, such as debt and preferred stock. The more fixed-cost debt a firm uses, the greater
will be its expected risk and return.
TIMES INTEREST EARNED RATIO
The times interest earned ratio, sometimes called the interest coverage ratio, measures the
firm’s ability to make contractual interest payments. The higher its value, the better able the firm
is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:
EBIT/Interest expense = time interest earned
The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits
shown in the income statement. Higher the time interest earned, better for firm.
Debt-to-Equity Ratio.
To assess the extent to which the firm is using borrowed money, we may use several different
debt ratios.
debt-to-equity ratio = total debt of the firm/ shareholders’ equity
For example if debt to equity ratio is 0.81, it means that creditors are providing 0.81 rupee of
financing for each Rs.1 being provided by shareholders.
Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of
the firm’s financing that is being provided by shareholders, and the larger the creditor cushion
(margin of protection) in the event of shrinking asset values or outright losses.
Debt-to-Total-Assets Ratio.
The debt-to-total-assets ratio = total debt/ total assets:
This ratio serves a similar purpose to the debt-to-equity ratio. It highlights the relative
importance of debt financing to the firm by showing the percentage of the firm’s assets that is
supported by debt financing. If this ratio is 40%, means that 40 percent of the firm’s assets are
financed with debt, and the remaining 60 percent of the financing comes from shareholders’
equity. Theoretically, if the firm were liquidated right now, assets could be sold to net as little as
40percent on the rupee before creditors would face a loss. Once again, this points out that the
greater the percentage of financing provided by shareholders’ equity, the larger the cushion of
protection afforded the firm’s creditors. In short, the higher the debt -to-total-assets ratio, the
greater the financial risk; the lower this ratio, the lower the financial risk.
Profitability Ratios
Profitability ratios are of two types – those showing profitability in relation to sales and those
showing profitability in relation to investment. Together, these ratios indicate the firm’s overall
effectiveness of operation.
Profitability in Relation to Sales.
Gross profit margin:
Gross Profit margin = Gross Profit/Sales
This ratio tells us the profit of the firm relative to sales, after we deduct the cost of producing the
goods. It is a measure of the efficiency of the firm’s operations, as well as an indication of how
products are priced. If gross profit margin is significantly above the industry, indicating that it is
relatively more effective at producing and selling products above cost.
Net profit margin:
Net Profit margin = Net Profit / Sales
The net profit margin is a measure of the firm’s profitability of sales after taking account of all
expenses and income taxes. It tells us a firm’s net income per rupee of sales.
By considering both ratios jointly, we are able to gain considerable insight into the operations of
the firm. If the gross profit margin is essentially unchanged over a period of several years but the
net profit margin has declined over the same period, we know that the cause is either higher
selling, general, and administrative expenses relative to sales, or a higher tax rate. On the other
hand, if the gross profit margin falls, we know that the cost
of producing goods relative to sales has increased. This occurrence, in turn, may be due to lower
prices or to lower operating efficiency in relation to volume.
Return on Total Assets
Net income divided by total assets gives us the return on total assets (ROA):
ROA = Operating Profit (EBIT) / Total Assets
You must look at a number of ratios, see what each suggests, and then look at the overall
situation
when you judge the performance of a company and consider what actions it should undertake to
improve.
Return on Equity (ROE).
Another summary measure of overall firm performance is return on equity. Return on equity
(ROE) compares net profit after taxes (minus preferred stock dividends, if any) with the equity
that shareholders have invested in the firm. Analysts and financial managers often evaluate the
firm’s return on investment by comparing its income to its investment usin g ratios such as the
firm’s return on equity
ROE = Net Profit / Stock holder’s equity
A high ROE may indicate the firm is able to find investment opportunities that are very
profitable. Of course, one weakness of this measure is the difficulty in interpreting the book
value of equity. ROE reflects the effects of all of the other ratios, and it is the single best
accounting measure of performance. Investors like a high ROE, and high ROEs are correlated
with high stock prices. However, other things come into play. For example, financial leverage
generally increases the ROE but also increases the firm’s risk; so if a high ROE is achieved by
using a great deal of debt, the stock price might end up lower than if the firm had been using less
debt and had a lower ROE.
Valuation Ratios/Market value ratios
We use market value ratios, which relate the stock price to earnings and book value price. If the
liquidity,
asset management, debt management, and profitability ratios all look good and if investors think
these ratios will continue to look good in the future, the market value ratios will be high, the
stock price will be as high as can be expected, and management will be judged to have been
doing a good job.
The market value ratios are used in three primary ways: (1) by investors when they are deciding
to buy or sell a stock, (2) by investment bankers when they are setting the share price for a new
stock issue (an IPO), and (3) by firms when they are deciding how much to offer for another
firm in a potential merger.
Analysts and investors use a number of ratios to gauge the market value of the firm. The most
important is the firm’s price-earnings ratio (P/E):
P/E Ratio = Share Price/Earnings per Share

That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a total
basis or on a per-share basis. The P/E ratio is a simple measure that is used to assess whether a
stock is over- or under-valued, based on the idea that the value of a stock should be proportional
to the level of earnings it can generate for its shareholders.
P/E ratios can vary widely across industries and tend to be higher for industries with high
growth rates.
Market/Book Ratio
n of how investors
The ratio of a stock’s market price to its book value gives another indicatio
regard the company. Companies that are well regarded investors, which mean low risk and high
growth—have high M/B ratios.
Book value per share= Common equity/Shares outstanding
We then divide the market price per share by the book value per share to get the market/book
(M/B) ratio:
Market to Book Value = Market price per share/Book value per share
Exercise:
Q No. 1 Prepare a multiple-step income statement for ABC Company from the following data
and also prepare Common Size Income Statement.
Cost of goods sold $450

Interest expense 30
Depreciation expense 120
Net sales 990
Interest income 80
Advertising expense 100
General and administrative expenses 150
Q No.2 Using the following information to prepare a common size income statement:
Net sales $1,000

Cost of goods sold 600
Gross profit $400
General and administrative expenses 250
Selling expenses 120
Operating profit $30
Net profit $20
Q No.3 Use the following information to analyze the BJ Company. Calculate any profit
measures deemed necessary in order to discuss the profitability of the company .
BJ Company
Income Statements
For the Years Ended Dec. 31, 2014 and 2015
2014 2015
Net sales Rs.174,000 Rs.167,000
COGS 114,000 115,000
Gross profit 60,000 52,000
General and administrative expenses 54,000 46,000
Operating profit 6,000 6,000
Interest expense (1,000) (1,000)
Earnings before taxes 5,000 5,000
Income taxes 2,000 2,000
Net income 3,000 3,000
Q No.4 Use the following selected financial data for Happy Valley Co. to answer questions.
Net sales Rs.200,000
Cost of goods sold 90,000
Operating expenses 80,000
Net income 10,000
Total assets 180,000
Total liabilities 120,000
Calculate (1) debt ratio (2) operating profit margin (3) return on equity (4) net profit
margin (5) Gross Profit ratio (6) Operating expense ratio (7) Assets turnover
Q No.5 Use the following selected financial information for Cascabel Corporation to answer
questions
Cascabel Corporation
Balance Sheet
December 31, 2015
Assets Liabilities and stockholders' equity

Current assets Current liabilities
Cash 2 Accounts payable 36
Short-term investments 10 Accrued liabilities 25
Accounts receivable 52 Total current liabilities 61
Inventory 57
Other current assets 8 Long-term debt 102
Total current assets 129 Total liabilities 163
Long-term assets Stockholders' equity

Net Plant 195 Common stock (10) 110
Retained earnings 51
Total stockholders' equity 161
Total assets 324 Total liabilities and equity 324
Cascabel Corporation
Income Statement
For the Year Ended December 31, 2015
Net sales 345

Cost of goods sold 248
Gross profit 97
Operating expenses 74
Operating profit 23
Interest expense 8
Earnings before taxes 15
Net profit 11
Additional information: Market price of stock is Rs.25. Firm declared and paid dividend 20% on
par value of stock.
Compute following ratios:
Current ratio (2) Quick ratio (3)Debt ratio (4)Equity ratio (5)Inventory turnover in days(use 360
days) (6) Receivable turnover in days(use 360 days) (7) Earnings per share (8)Book value per
share (9)Interest coverage ratio (10) Gross Profit ratio
Q No.6 Selected data from recent annual reports of the Coca-Cola Compnay and Pepsi Co,
Inc. are shown.
Coca-Cola Pepsi Co
Balance sheet statistics:
At year end:
Quick assets 2002 2774
Current assets 3604 3551
Total assets 8283 15127
Current liabilities 3658 3692
Total liabilities 4798 11236
Total stockholders’ equity 3485 3891
Additional information:
Inventory 784 494
Income Statement data:

Net Sales 8966 15242
Cost of goods sold 3892 7468
Interest expense 308 610
Net income 1724 901
Compute the following for each company:
1. Net income as a percentage of sales

2. Return on assets
3. Return on equity
4. Working capital
5. Receivable turnover
6. Inventory turnover
7. Quick ratio
8. Debt ratio
9. Interest coverage ratio
10. Current ratio
Q No.7: The accounting records of Kin Corporation showed the following balances at the end of
2003 and 2004:
2003 2004
Cash $ 35,000 $ 25,000
A/c receivable 91,000 90,000
Inventory 160,000 140,00
Short-term investment 4,000 5,000
Land 90,000 100,000
Equipment 880,000 640,000
Less: Accumulated depreciation (260,000) (200,000)
Total assets 1,000,000 800,000
A/c payable 105,000 46,000

Accrued liabilities 43,600 29,000
Bonds payable 8% 280,000 280,000
Capital stock 165,000 110,000
Total equities 1,000,000 800,000
Sales 2,200,000 1,600,000

Cost of goods sold 1,606,000 1,120,000
Gross profit 594,000 480,000
Expenses(including $22,400 interest expense) 336,600 352,000
Income tax 91,000 48,000
Net income 166,400 80,000
Cash dividend of $40,000 was paid.
All sales were made on credit at a relatively uniform rate during the year. Inventory and
receivables did not fluctuate materially. The market price of the company’s stock on December
31, 2004 was $86 per share; on December 31, 2003 it was $43.5.
Instruction:
Compute the following ration of 2003 and 2004:
(i) Quick ratio (iii) Equity ratio (iv) Debt ratio (v) Earning per share
(vi) Price earnings ratio (vii) Gross profit (ix) Inventory turnover (xi) Receivable turnover
(xii) Interest coverage ratio
Q No.8 A condensed balance sheet for Durham Corporation prepared at the end of the year
appears below.
Assets Liabilities
Cash $ 55,000 Note payable 40,000
Account Receivable 155,000 Account payable 110,000
Inventory 270,000 Long-term loan 330,000
Prepaid expenses 60,000 Capital stock ($5) 300,000
Plant assets 660,000 Retained earnings 420,000
1200,000 1200,000
During the year the company earned a gross profit of $ 1,116,000 on sales of $2790,000.
Operating expenses $500,000 and interest expenses $33,000, tax rate is 40% and company paid
20% dividend.
Compute the following:
1. Current ratio
2. Quick ratio
3. Equity ratio
4. Receivable turnover
5. Inventory turnover
6. Book value per share of capital stock
7. debt ratio
9. dividend coverage ratio
10. Earnings per share
Q No.9 Bowlin Beverages Companies As at December 31,2005
Assets Equities
Cash $ 77,500 A/c Payable $ 129,00
Receivables 336,000 Notes payable 84,000
Inventories 241,500 Other current liabilities 117,000
Total current assets 655,000 Total current liabilities 330,000
Net fixed assets 292,500 Long term debt 256,500
Common equity(Rs.10) 361,000
Total assets 947,500 Total liabilities and equities 947,500
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 1996
Sales
Cost of goods sold $1607,500
Gross profit 1392,500
Selling expense 215,000
General and administrative expense 115,000
Earning before interest and taxes 30,000
Interest expense 70,000
Earning before taxes 24,500
Income taxes 45,500
Net income 18,200
27,300
Required:
Compute following ratios:
1. Current ratio
2. Quick ratio
3. Debt ratio
4. Equity ratio
5. Inventory turnover in days
6. Receivable turnover in days
7. Earning per share
8. Book value per share
10. Gross Profit ratio
Q.10 You are to study the following financial statements for two furniture stores and then
answer the questions which follow.
Financial Statements
X Y
$ $ $ $
Profit and loss accounts
Sales 555,000 750,000
Less Cost of goods sold
Opening stock 100,000 80,000
Add Purchases 200,000 320,000
Cost of goods available 300,000 400,000
Less Closing stock (60,000) (240,000) (70,000) (330,000)
Gross profit 315,000 420,000
Less Depreciation 5,000 15,000
Wages, salaries and commission 165,000 220,000
Other expenses 45,000 (215,000) 35,000 (270,000)
Net profit 100,000 150,000
Balance sheets
Fixed assets
Equipment at cost 50,000 100,000
Less Depreciation to date (40,000) 10,000 (30,000) 70,000
Current assets
Stock 60,000 70,000
Debtors 125,000 100,000
Bank 25,000 12,500
210,000 182,500
Less Current liabilities
Creditors (104,000) 106,000 (100,500) 82,000
116,000 152,000
Financed by:
Capitals
Balance at start of year 76,000 72,000
Add Net profit 100,000 150,000
176,000 222,000
Less Drawings (60,000) (70,000)
116,000 152,000
Required:
(a) Calculate the following ratios for each business:
(i) Gross profit as percentage of sales;
(ii) Net profit as percentage of sales;
(iii) Expenses as percentage of sales;
(iv) Stock turnover;
(v) Rate of return of net profit on capital employed;
(vi) Current ratio;
(vii) Acid test ratio;
(viii) Account receivable/sales ratio;
(ix) Account payable/purchases ratio.
(b) Drawing upon all your knowledge of accounting, comment upon the differences and
similarities of the accounting ratios for X and Y. Which business seems to be the most efficient?
Give possible reasons.
FINANCIAL RATIOS & SIGNIFICANCE/COMMENTS
S# RATIO OR RATE SIGNIFICANCE OR COMMENTS

1 Working Capital(Net) It measures the Short Term Debt paying ability
and also shows that how much amount/working
capital is available in the business to operate the
business efficiently and conveniently.
2 Working Capital Ratio or It measures the short term debt paying ability out
Current Ratio of Current Assets available.
3 Acid Test or Quick or liquid Test It measures the short term debt paying ability out
Ratio of the liquid cash and cash equivalents
4 Receivables turnover ratio Indicates how quickly receivables are collected.
5 Days to collect Average Accounts It indicates that how many days are required to
R/A collect the Receivables.
6 Inventory Turnover Ratio It indicates how quickly Inventory sells.
7 Days required to sell the Average It indicates that how many days are required to
Inventory sell the inventory.
8 Operating Cycle or Average Age It indicates in days how quickly Cash is being
of Operating Cycle invested in to inventory and converts back into
Cash
9 Debt Ratio It shows the percentage of Assets financed by the

Creditors; indicates also the relative size of the
equity position.
10 Interest Coverage Ratio It is an indicator of a company’s ability to meet

its interest payment obligations.
11 Gross profit Rate It measure the profitability of the company’s

products
12 Net Profit Rate or Net Income as An indicator of management’s ability to control

a Percentage of Sales costs
13 Operating Expense Ratio An indicator which measures the management’s

ability to control the expense
14 Earnings Per share/stock Net income applicable to each share issued or

outstanding.
15 Return on Assets It measures the productivity of assets, Regardless

of how much the assets are financed.
16 Return on Equity The rate of return earned on the stockholder

equity in the business.
17 Return on Stockholders’ Equity The rate of return earned on the; common

stockholders’ equity appropriate when company
has both common and preferred stocks.
18 Operating Income The profitability of company’s basic business

income.
176

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Financial Accounting 100

Advantages and Disadvantages of Incorporation

Continuous existence: Because a corporation is a separate legal entity, an owner’s death,

Centralized authority and responsibility: The board of directors represents the

Government regulation: As “creatures of the state,” corporations are subjectto greater

Double taxation: A major disadvantage of the corporate form of business is double

Separation of ownership and control: Just as limited liability can be a drawback of

State incorporation fees

Contributed capital: The stockholders’ investments in the corporation.

A corporation can issue two types of stock:

Characteristics of Preferred Stock

Preference as to Dividends Preferred stockholders ordinarily must receive a certain amount of

Preferred stockholders have no guarantee of receiving dividends. A company’s board of

Additional paid-in capital:

1. How many shares of preferred stock have been issued?

8% cumulative preferred stock, $100 par (callable at $110) $300,000

(a) amount of net assets ( stockholders equity)

Stockholders' Equity ($ Millions)

Preferred stock, 6%, cumulative $ 100

Q No.5 Stockholders' equity information for two independent companies, Granada

Granada Enterprises, Inc. Granada is authorized to issue 60,000 shares of $5 par

Preferred stock, 5%, $10 par, 50,000 shares

Interest expense $ 6,100 Accounts receivable, net $ 46,000

Cumulative preferred stock $ 45

July 1 Issued 10,000 shares of common stock at $11 per share.

The historical cost concept

The money measurement concept

The business entity concept

The dual aspect concept

The time interval concept

Fundamental accounting concepts

Notice that it is not the time

4 The accruals concept

Revenues − Expenses = Net Profit

6 Substance over form

List of International Accounting Standards

IFRS 1: First – time adoption of international financial reporting standard

IFRS 4: Insurance Contract

IAS 1: Presentation of Financial Statements

This standard describes the preparation and presentation requirements of financial

IAS 7: Cash Flow Statements (Statement of Cash flow) amended in

performance of the enterprise. In addition, it regulates how to handle fundamental

IAS 12: Income Taxes

IAS 14: Segment Reporting superseded by IFRS 8 (Operating

IAS 15: Information Reflecting the Effects of Changing Prices

IAS 16: Property, Plant and Equipment

IAS 17: Leases

IAS 18: Revenue

IAS 19: Employee Benefits

IAS 20: Accounting for Government Grants and Disclosure of

IAS 21: The Effects of Changes in Foreign Exchange Rates

IAS 22: Business Combinations superseded by IFRS 3 (Business

IAS 23: Borrowing Costs

IAS 24: Related Party Disclosures

IAS 26: Accounting and Reporting by Retirement Benefit Plans

IAS 27: Consolidated Financial Statements and Accounting for

IAS 28: Accounting for Investments in Associates superseded by

IAS 29: Financial Reporting in Hyperinflationary Economies

IAS 30: Disclosures in the Financial Statements of Banks and

IAS 31: Financial Reporting of Interests in Joint Ventures

IAS 32: Financial Instruments: Disclosure and Presentation

IAS 33: Earnings Per Share

IAS 34: Interim Financial Reporting

IAS 35: Discontinuing Operations superseded by IFRS 5 (Non-