Basic Framework of Financial Statements

BALANCE SHEET A financial statement reflecting the recorded values of all assets, liabilities, and owners’ equity
at a point in time. The balance sheet is a summary of the assets, liabilities, and equity of a business at a particular point
in time—usually the end of the firm’s fiscal year. The balance sheet is also known as the statement of financial
condition or the statement of financial position. The values shown for the different accounts on the balance sheet are
not purported to reflect current market values; rather, they reflect historical costs.

In essence, the balance sheet presents the details of the so-called accounting equation:

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

This equation recognizes that a company has assets and there are claims on the assets by creditors (measured in terms
of the company’s liabilities) and company owners (measured in terms of stockholders’ equity).

ASSET
Assets are probable economic benefits obtained or controlled by a particular entity as a result of past transactions or
events. Future economic benefits refers to the capacity of an asset to benefit the enterprise by being exchanged for
something else of value to the enterprise, by being used to produce something of value to the enterprise, or by being
used to settle its liabilities. The future economic benefits of assets usually result in net cash inflows to the enterprise.
There are three major categories of assets: current assets, non current assets and investments.

Assets are recognized in the financial statements when

(1) the item meets the definition of an asset,
(2) it can be measured with sufficient reliability,
(3) the information about it is capable of making a difference in user decisions, and
(4) the information about the item is reliable.

FIXED ASSETS - include machinery and equipment, buildings, and land. Some businesses are more capital-intensive
than others; for example, a manufacturer would typically be more capital-intensive than a wholesale operation and,
therefore, have and more fixed assets.

ACCUMULATED DEPRECIATION The total of past periodic depreciation charges applicable to depreciable assets
carried on a company’s balance sheet, shown as a deduction from gross fixed assets.

GROSS BLOCK - Gross fixed assets mean the original cost of the fixed assets. Cumulative depreciation in the books
is as per the provisions of The Companies Act, 2002. It is last cumulative depreciation till last year + depreciation
claimed during the current year. Net block = Gross Block – Provision for Depreciation.

INTANGIBLE ASSETS are the current value of nonphysical assets that represent long-term investments of the
company. Such intangible assets include patents, copyrights, and goodwill. The cost of some intangible assets is
amortized (“spread out”) over the life of the asset.

AMORTIZATION is akin to depreciation: The asset’s cost is allocated over the life of the asset; the reported value is
the original cost of the asset, less whatever has been amortized. The number of years over which an intangible asset is
amortized depends on the particular asset and its perceived useful

CAPITAL WORK-IN-PROGRESS – This represents advances, if any, given to building contractors, value of
building yet to be completed, advances, if any, given to equipment suppliers etc. Once the equipment is received and
the building is complete, the fixed assets are capitalised in the books, for claiming depreciation from that year
onwards.Till then, it is reflected in the form of capital work in progress.

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INVESTMENTS These are assets that are purchased with the intention of holding them for a long term, but which do
not generate revenue or are not used to manufacture a product. Examples of investments include equity securities of
another company and shares/bonds/units of Unit Trust of India etc for speculative purposes.
This type of investment should be ideally from the profits of the organisation and not from any other funds, which are
required either for working capital or capital expenditure. They are bifurcated in the schedule, into “quoted and traded”
and “unquoted and not traded” depending upon the nature of the investment, as to whether they can be liquidiated in
the secondary market or not.

CURRENT ASSETS (also referred to as circulating capital or working assets or gross working capital)
Current assets are assets that could reasonably be converted into cash within one operating cycle or one year, whichever
takes longer. An operating cycle begins when the firm invests cash in the raw materials used to produce its goods or
services and ends with the collection of cash for the sale of those same goods or services. For example, if Fictitious
manufactures and sells candy products, its operating cycle begins when it purchases the raw materials for the products
(e.g., sugar) and ends when it receives cash for selling the candy to retailers. Because the operating cycle of most
businesses is less than one year, we tend to think of current assets as those assets that can be converted into cash in one
year. E.g. cash, marketable securities, accounts receivable, inventories, and prepaid expenses.

CASH comprises both currency—bills and coins—and assets that are immediately transformable into cash, such as
deposits in bank accounts. Cash and cash equivalents represents money on hand and balances of checking accounts at
banks. Cash includes coins, checks, money orders, bank drafts, and any item acceptable to a bank for deposit
Every firm must have cash for current business operations. A reservoir of cash is needed because of the unequal flow
of funds into (cash receipts) and out of (cash expenditures) the business. The amount of the cash balance is determined
not only by the volume of sales, but also by the predictability of cash receipts and cash payments.

MARKETABLE SECURITIES are securities that can be readily sold when cash is needed. Every company needs to
have a certain amount of cash to fulfill immediate needs, and any cash in excess of immediate needs is usually invested
temporarily in marketable securities.
Investments in marketable securities are simply viewed as a short term place to store funds; marketable securities do
not include those investments in other companies’ stock that are intended to be long term. Some financial reports
combine cash and marketable securities into one account referred to as cash and cash equivalents or cash and
marketable securities.

ACCOUNTS RECEIVABLE are amounts due from customers who have purchased the firm’s goods or services but
haven’t yet paid for them. To encourage sales, many firms allow their customers to “buy now and pay later,” perhaps
at the end of the month or within 30 days of the sale.
Accounts receivable therefore represents money that the firm expects to collect soon. Because not all accounts are
ultimately collected, the gross amount of accounts receivable is adjusted by an estimate of the uncollectible
accounts, the allowance for doubtful accounts, resulting in a net accounts receivable figure.

INVENTORIES represent the total value of the firm’s raw materials, work-in-process, and finished (but as yet unsold)
goods. A manufacturer of toy trucks would likely have plastic and steel on hand as raw materials, work-in-process
consisting of truck parts and partly completed trucks, and finished goods consisting of trucks packaged and ready for
shipping.

PREPAID EXPENSES The portion of any expenses paid during a stated period but applicable to future periods. A
company often needs to prepay some of its expenses. For example, insurance premiums may be due before coverage
begins, or rent may have to be paid in advance. Thus, prepaid expenses are those cash payments recorded on the balance
sheet as current assets and then shown as an expense in the income statement as they are used.

OTHER ASSETS are assets that cannot be classified elsewhere on the balance sheet, including prepayments for
services or benefits that affect the company over a future period greater than the period of time encompassed by the
current asset classification, are reported as other assets or deferred charges.

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 Format of the Balance Sheet in vertical form
Balance Sheet of ..... as on .....

Particulars

I. Source of Funds:
1. Shareholder’s Funds:
(a) Share capital
Equity
Preference
Less: Calls Unpaid:
Add: Forfeited Shares

(b) Reserves and Surplus

Capital Reserve
Capital Redemption Reserve
Securities Premium
Other Reserves
Profit and Loss Account
Less: Deferred Revenue expenditure to the extent
not written-off.
Preliminary Expenses
Discount on Issue of Shares
Profit and Loss account
(debit balance, if any)
2. Loan Funds:
(a) Secured loans
Debentures
Loans and Advance from Banks
Loans from subsidiary Companies

(b) Unsecured loans

Public Deposits
Total (Capital Employed)

II. Application of Funds

1. Non Current Assets:
Tangible Assets
Land
Building
Leasehold Premises
Railway Sidings
Plant and Machinery
Furniture
Vehicles
Less: Provision for Depreciation

Intangible Assets
Goodwill
Patents and Trademarks
Less: Amortisation

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 2. Investments:
a) Trade Investments
b) Non Trade Investments

3. Current Assets, Loans and Advances:

Quick
Sundry Debtors
Cash and Bank balances
Bills Receivable
Interest Accrued on investments
Other Current Assets
Short term Loans and Advances
Non Quick
Loose Tools / Stock in Trade, Inventories
Prepaid Expenses

Less: Current Liabilities and Provisions:

Quick liabilities & Provisions
Acceptances
Sundry Creditors
Outstanding Expenses
Provisions for Taxation
Proposed Dividends
Non Quick
Bank Overdraft / Cash Credit
Pre received Income
TOTAL
Note: A footnote to the Balance Sheet may be added to show the contingent liabilities.

LIABILITY is defined as a present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits. Liabilities are usually classified as
current or non-current liabilities.

Three essential characteristics of an accounting liability include the following:

1. A duty or obligation to pay exists.
2. The duty is virtually unavoidable by a particular entity.
3. The event obligating the enterprise has occurred.

RESERVES AND SURPLUS represent the profit retained in business since inception of business. “Surplus” indicates
the figure carried forward from the profit and loss appropriation account to the balance sheet, without allocating the
same to any specific reserve. Hence, it is mostly called “unallocated surplus”. The company wants to keep a portion
of profit in the free form so that it is available during the next year for appropriation without any problem.

SINKING FUND A separate pool of cash, often held in trust, into which periodic payments are made for the future
redemption of an obligation.

SECURED LOANS represent loans taken from banks, financial institutions, debentures (either from public or through
private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or
hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working
capital banks)

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Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans from banks for working
capital, i.e., current assets are secured by current assets. These loans enjoy priority over unsecured loans for
settlement of claims against the company.

UNSECURED LOANS represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of
The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if
any, from promoters, friends, relatives etc. for which no security has been offered.
Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company.
There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials,
provisions etc.

EQUITY, also called shareholders’ equity or net worth or owners fund, reflects ownership. The equity of a firm
represents the part of its value that is not owed to creditors and therefore is left over for the owners. In the most basic
accounting terms, equity is the difference between what the firm owns—its assets—and what it owes its creditors—its
liabilities. Net worth means total of share capital and reserves and surplus.

RETAINED EARNINGS represents the accumulated earnings of the corporation less dividends distributed to
shareholders. A negative balance in the retained earnings account is referred to as a deficit. The retained earnings
account does not represent cash or any other asset.

TREASURY STOCK represents a corporation’s own stock that has been reacquired after having been issued and fully
paid. Such reacquired shares are held in the treasury for reissue and are not retired.

CURRENT LIABILITIES are obligations that must be paid within one operating cycle or one year, whichever is
longer. It include:
■ Accounts payable, which are obligations to pay suppliers. They arise from goods and services that have been
purchased but not yet paid.
■ Accrued expenses, which are obligations such as wages and salaries payable to the employees of the business, rent,
and insurance.
■ Short-term loans from a bank or notes payable within a year.

CONTINGENT LIABILITIES arise from an existing situation or set of circumstances involving uncertainty as to
possible loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.
Examples of contingent liabilities include product warranties and pending litigation.

OFF-BALANCE SHEET items are sometimes encountered in financial statement analysis. Off-balance sheet items
generally refer to the application of procedures that provide financing without adding debt on a balance sheet, thus not
affecting financial ratios or borrowing capacity of an enterprise. Off-balance sheet items are often related to the sale of
receivables with recourse and leases.

BALANCE SHEET LIMITATIONS

The balance sheet has major limitations. First, the balance sheet does not reflect current value or fair market value
because accountants apply the historical cost principle in valuing and reporting assets and liabilities. Second, the
balance sheet omits many items that have financial value to the business. For example, the value of the company’s
human resources including managerial skills is often significant but is not reported. In addition, professional judgment
and estimates are often used in the preparation of balance sheets and can possibly impair the usefulness of the
statements.

INCOME STATEMENT

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An income statement is a summary of the revenues and expenses of a business over a period of time, usually either one
month, three months, or one year. This statement is also referred to as the profit and loss statement. It shows the results
of the firm’s operating and financing decisions during that time.

Income is defined as increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to
contributions from equity participants.

Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrence’s of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

Cost of goods sold - Whenever a product is manufactured or sold, certain direct costs are incurred. These costs are
designated on the income statement as cost of goods sold, or COGS. For a retail company, direct costs are simply the
cost of materials purchased for resale. For a manufacturing company, direct costs can also include labor costs,
manufacturing overhead, and depreciation expenses associated with production. Since service companies incur few
direct costs, their income statements usually do not include cost of goods sold.

Operating expenses - Operating expenses are expenses other than cost of goods sold that a company incurs in the
normal course of business. These include items such as management salaries, advertising expenditures, repairs and
maintenance costs, research and development expenditures, lease payments, and general and administrative expenses.

Interest expense - Interest expense is the cost to the firm of borrowing money. It depends on the overall level of firm
indebtedness and the interest rate associated with this debt. Interest expense is generally a small fraction of total firm
expenses, however, this expense as a percent of revenue can fluctuate dramatically with changes in the firm’s borrowing
requirements or with the general level of interest rates in the economy.

The operating decisions of the company—those that apply to production and marketing—generate sales or revenues
and incur the cost of goods sold (also referred to as the cost of sales or the cost of products sold). The difference
between sales and cost of goods sold is gross profit. Operating decisions also result in administrative and general
expenses, such as advertising fees and office salaries. Deducting these expenses from gross profit leaves operating
profit, which is also referred to as operating income, or operating earnings.

Non Operating includes income from dividend on share investment made in other companies, interest on fixed
deposits/debentures, sale proceeds of special import licenses, profit on sale of fixed assets and any other sundry receipts.

EXTRAORDINARY ITEMS:
Extraordinary items are material events and transactions that are both unusual in nature and infrequent of occurrence.
Extraordinary items could result if gains or losses were the direct result of any of the following events or
circumstances:
1. A major casualty, such as an earthquake,
2. An expropriation of property by a foreign government, and
3. A prohibition under a newly enacted law or regulation.
Extraordinary items are shown separately, net of tax, in order that trend analysis can be made of income before
extraordinary items.

Operating and Non Operating decisions take the firm from sales to earnings before interest and taxes (EBIT) on the
income statement. The results of financing decisions are reflected in the remainder of the income statement. When
interest expenses and taxes, which are both influenced by financing decisions, are subtracted from EBIT, the result is
net income. Net income is, in a sense, the amount available to owners of the firm. If the firm has preferred stock, the

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preferred stock dividends are deducted from net income to arrive at earnings available to equity shareholders. If the
firm does not have preferred stock, net income is equivalent to earnings available for equity shareholders.

VERTICAL FORMAT
Financial statements should be rearranged for proper analysis and interpretations of these statements. It enables to
measure the performance of operational efficiency and profitability of a concern during particular period. The items of
operating revenues, non-operating revenues, operating expenses and non-operating expenses are rearranged into
different heads and sub-heads are given below:

FORMAT OF INCOME STATEMENT

PARTICULARS Amt. (Rs.) Amt. (Rs.) Amt. (Rs.)
Gross Sales X
Less : Returns & Allowances / Sales Tax / Excise Duty X XX
Less: Cost of Goods Sold
Opening stock of goods X
Add: Purchases X
Less: Purchases Returns X X
Add: Freight and Carriage X
Less:Closing Stock of Raw Materials X
Direct wages (Factory) X
Other Factory Exp
Factory Rent and Rates X
Power and Coal X
Depreciation of Plant and Machinery X
Depreciation of Factory Building X
Work Manager's Salary X
Other Factory Expenses X XX XXX
Gross Profit XXX
Less: Operating Expense
(a) General & Administrative Expense X
(b) Selling Expense X
(c) Finance Expenses X X
Interest on Overdraft / CC
Operating Profit XX
Add: Non Operating Income
Discount Received X
Dividend Received X
Income from Investment X XX
Less: Non Operating Expenses
Loss on Sale of Fixed Assets X
Loss by fire / Earthquake X XX
Net Profit before Interest and Tax XXX
Less: Interest on Long term loan X
Net Profit before Tax X
Less: Provision for Income taxes X
a) Current Tax
b) Deferred tax asset / liability
Net Profit after Tax X
Less: Appropriations X
Closing balance ( to be transferred to balance sheet ) XXX

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Income Statement Equations
From the above rearrangement of operating statements, the following accounting equations may be given:
(1) Net sales = Gross sales - (Returns and Allowances)

(2) Gross Profit = Net Sales - Cost of Goods Sold

(3) Operating Expenses = Office and Administrative Expenses + Selling and Distribution Expenses + Finance
Expenses

(4) Net Profit Before Interest and Tax = Operating Profit + Non-Operating Income - Non-Operating Expenses

LIMITATIONS OF INCOME STATEMENT

Among other things the income statement does not include many items that contribute to the earnings of an
enterprise, especially items that cannot be quantified. In addition, the income numbers reported on income statements
are often the result of accounting methods employed by the accountant in preparing the statements. Accounting
methods can affect the quality of earnings reflected on the income statement.

NOTES TO THE FINANCIAL STATEMENTS (FOOTNOTES)

Notes to the financial statements, or footnotes for short, are the means of amplifying or explaining the items
presented in the main body of the statements. Financial statements themselves are concise and condensed, and any
explanatory information that cannot readily be abbreviated is added in greater detail in the footnotes. In such cases,
the report contains a statement similar to this: "The accompanying footnotes are an integral part of the financial
statements."

Footnotes provide detailed information on financial statement figures, accounting policies, explanatory data such as
mergers and stock options, and any additional disclosure. Footnote disclosures usually include accounting rules
methods, estimated figures such as pension fund, and profit-sharing arrangements, terms and characteristics of long-
term debt, particulars of lease agreements, contingencies, and tax matters.

The Summary of Significant Accounting Polices answers such questions as: What method of depreciation is used on
plant assets? What valuation method is employed on inventories? What amortization policy is followed in regard to
intangible assets? How are marketing costs handled for financial reporting purposes? Notes also describe financial
disclosures about items not appearing in the financial statements

The footnotes appear at the end of the financial statements and explain the figures in those statements both in
narrative form and in numbers. It is essential that the financial manager evaluate footnote information to arrive at an
informed opinion about the company's financial stature and earning potential.

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