BASIC FINANCIAL

CONCEPTS / TERMS
(Compiled by Prof. Prasad Bhat)

Compiled by Prof. Prasad Bhat Page 1

1. BUSINESS CONCEPTS
1. INTRODUCTION

 Every person carries out some kind of commercial / money activity. An employee gets
salary, bonus and he spend money to buy grocery, food, clothing, school fees etc.
 A trader purchases and sells goods to earn profits. A doctor treats his patients and earns
money, a lawyer advises his clients, a chartered accountant provides taxation guidance,
event manager plans grand parties etc.
 All such economic / monetary activities should be properly recorded to know whether
there is profit or loss, amount of savings, cash inflows and outflows etc.

2. BUSINESS TRANSACTIONS

 Business can be defined as any commercial / monetary activity carried on for the
purpose of earning profits.
 Following are the features of a business –
 commercial / economic activity,
 involving goods and / or services,
 having money value, and
 with profit motive
 Further, such business activities are performed through ‘transactions.’
 Transaction includes an exchange of goods and/or services having monetary value.
Transaction involves the following –
 purchase / sale of goods and services and money is paid / received immediately,
 purchase / sale of goods and services and money will be paid / received in the future,
 exchange of goods and services against goods and services (i.e., barter),
 providing money / funds as loans or advance,
 transfer of goods or services as a gift or donation etc.

Every business undertakes number of transactions. It depends upon the size of a business
entity. Each day numerous business transactions are carried out, in hundreds / thousands.
Whether a businessman can remember all transactions – not at all. Hence, all such business
transactions should be recorded in systematic manner. Recording of business transactions
in a systematic manner in the books of account is known as bookkeeping and accounting.

Compiled by Prof. Prasad Bhat Page 2

3. FORMS OF BUSINESS ORGANIZATIONS

 A business organisation is an establishment intended to carry commercial business by

producing goods or services and meet the customers’ needs.
 A business organization is a formal body / association created for carrying out business
activities. It is structured and operated in an authorized form of ownership.
 The focus of business organizations is the systematic management of men, material, and
machines for the purpose of earning huge profits.
 A business organization may consist of a single individual (sole proprietor), partnership
firm (two or more individuals), or a company form of organization.
 The different forms of business organizations are based on the size of the business,
funds involved and decision-making criteria. Success of every business is based on the
quality of decisions. Such decisions affect the ultimate objective – profits!

The various forms of business organizations are given below –

A) Sole Proprietor
 A business which is totally owned by an individual is known as sole proprietorship or
a sole trading concern. This is the most popular form of business organization. It is
the easiest mode of doing business. A single individual is the owner of business.
 Formation of sole proprietorship is simple. It does not require statutory registrations.
 The proprietor puts his own money in the business and controls entire operations of
a business and is liable for all financial burdens and debts.
 Sole proprietorship concerns include shops / retail business, home-based businesses,
individual consulting firms, commission agents, etc.
 No Separate Legal Entity: in case of sole proprietorship, there is no separate legal
entity. In the eyes of law, the owner and business are one and the same. If the owner
dies or becomes insolvent, the business dies.
 Unlimited Liability: the sole proprietor is the only person liable for the business. If the
financial obligations (liabilities) of the business cannot be paid out of its properties, a
sole owner shall use his personal property to repay the obligations of the business.
 Profits Sharing: there is no sharing of profits or losses, since the entire gain or loss
belongs to the sole proprietor.
 No Legal Formalities: to start sole proprietary business, no separate registration is
needed. However, very few legal formalities are needed, such as basic licenses.

Compiled by Prof. Prasad Bhat Page 3

B) Partnership Firm
 In a partnership firm, two or more individuals come together to start a business.
 Each individual partner gives his share of money, property, or experience and expects
some profits from the business. The partners are the joint owners of the business.
 Basically, partnership is defined as an agreement between persons who have agreed
to share profits of a business, carried on by all, or any of them acting for all.
 As per the Partnership Act, 1932, there should be minimum 2 partners and maximum
50 partners in a firm. All the partners share profits / losses in their pre-decided ratio.
 Partnership Agreement: a partnership firm is created on the basis of an agreement
between all the partners. The agreement (partnership deed) contains details of capital
contribution, rights and duties, profit sharing ratio etc.
 No Separate Legal Entity: a partnership firm is not a separate legal entity. In the eyes
of law, the partners and the business are one and the same. If all the partners die or
becomes insolvent, the business dies.
 Unlimited Liability: all partners are jointly and severally liable for the business debts.
If financial obligations (liabilities) of the business cannot be paid out of its properties,
all partners shall use their personal property to repay the obligations of the business.
 Profits Sharing: all the profits or losses of the business are shared by the partners in
their pre-decided ratio. If no ratio is fixed, the profits or losses are equally shared.
 Mutual Agency: every partner acts as the principal as well as agent of the firm. This is
known as doctrine of mutual agency. Partnership is based on good faith and trust.
Every partner must act in the best interests of the firm.

C) Joint Stock Company

 Post Industrial Revolution, trade, commerce and manufacture became highly complex
due to large scale of operations, huge funds requirements, manpower needs, rising
taxation etc. This gave rise to the concept of ‘Joint Stock Company’.
 A Joint Stock Company (i.e., a company) is a voluntary association, where capital is
contributed by a large number of people.
 A company is a body corporate and a legal entity having separate status and an
identity apart from its members.
 A company is created only through registration (incorporation) process carried out
under the Companies Act, 2013. A company can be described as an artificial person
created by law, having a common seal and perpetual succession.

Compiled by Prof. Prasad Bhat Page 4

  Today, a company is a professional and respected form of business organization. On
the basis of membership, it is classified under following categories –
o Public Limited Company – minimum 7 members and maximum unlimited,
o Private Limited Company – minimum 2 members and maximum 200 members,
o One Person Company (OPC) – only one individual member.

 Separate Legal Entity: due to registration, a company becomes an artificial person

having a separate personality which is distinct from the members constituting it.
Thus, a company is a separate legal entity having its own corporate name. Properties
and obligations are recorded in the name of company and not its members.
 Limited Liability: a company is separate legal entity and hence liability of its members
is limited to the amount unpaid on the shares held by them. If shares fully paid-up,
members’ liability is zero.
 Perpetual Succession: a company is a separate entity and it does not depend upon its
members. A company is created by law and it can be terminated only by law. A
company has perpetual life and continues forever, even it all members die or change.
 Transferability of Shares: the capital of a company is divided into parts called shares.
The shares are movable property and transferable from one person to another.

D) Limited Liability Partnership (LLP)

 Limited Liability Partnership (LLP) is a hybrid form of organization having features of
a partnership as well as a company
 In an LLP, there is benefits of limited liability (like a company) but allows its members
the flexibility of organizing their internal structure (like a partnership).
 Due to flexibility in its formation and operation, LLP is a suitable form of organization
for small enterprises.
 LLP is a body corporate, artificial legal person, having a legal entity separate from its
partners. It has perpetual succession and any change, death, insanity, retirement of
partners does not affect the existence of the LLP.
 LLP is a separate legal entity, liable to the full extent of its assets, with limited liability
of the partners. The liability is limited to their agreed contribution in the LLP.
 Every partner of a LLP is an agent of the LLP, but not of other partners. The liability of
the partners will be limited to their agreed contribution in the LLP.
 Every LLP is formed for carrying on a lawful business with a view to earn profit.

Compiled by Prof. Prasad Bhat Page 5

2. ACCOUNTING BASICS
1. INTRODUCTION

 Accounting is as old as money itself. People in all civilizations have maintained various
types of records of business activities. In India, accounting was practiced since centuries.
Kautilya’s book ‘Arthshastra’ clearly mentions existence of accounting and audit.
 Whether it is sole proprietor, partnership firm, company or even Government, everybody
keeps records of transactions to have adequate information about the economic activity.
 Accounting deals with measurement of monetary activities involving inflow and outflow
of funds, which helps in managerial decision-making process.
 Accounting is the language of business. It helps a business in finding out profits / losses
for a period as well as its financial position on a particular date.
 Accounting has its own established principles which are guided by certain concepts and
conventions.

2. MEANING OF ACCOUNTING

 As per the American Institute of Certified Public Accountants (AICPA), ‘ Accounting is the
art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and
interpreting the result thereof.’
 Traditionally speaking, accounting is a process of systematically recording, classifying
and summarizing business financial transactions (also known as book-keeping).
 However, modern day functions of accounting include analysing and interpreting the
financial results of a business. Further, the present scenario consists of globalization of
business, multinational companies, separation of ownership & management. The scope
of accounting has increased to include communication of results to various stakeholders.
 We can say that the function of accounting is to provide quantitative information,
financial nature, about the economic entities, that is useful in economic decisions.
 Thus, accounting may be defined as the process of recording, classifying, summarising,
analysing and interpreting the financial transactions and communicating the results
thereof to the persons interested in such information.
 The entire process can be divided into two parts, viz. bookkeeping and accounting.

Compiled by Prof. Prasad Bhat Page 6

3. OBJECTIVE / NEED / PURPOSE OF ACCOUNTING

1) Systematic Recording of Transactions – Basic objective of accounting is the systematic

recording the financial aspects of business transactions. These recorded transactions are
later classified and summarized logically for the preparation of financial statements and
for their analysis and interpretation.

2) Ascertainment of Financial Performance – Preparation of Profit & Loss (P&L) Statement

to know the financial results (profit or loss) of business operations for a particular period.

If Sales Revenue > Expenses = Profit

If Sales Revenue < Expenses = Loss

The P&L statement helps stakeholders to know the financial performance of the business

3) Ascertainment of Financial Position – Preparation of Balance Sheet to know the financial

position of a business as on a particular date. Balance Sheet is a statement of assets and
liabilities of a business at a particular point of time and helps in ascertaining the financial
health of the business Balance sheet shows the assets / property of a business as well as
the financial obligations (liabilities) of the business.

4) Rational Decision-making – Accounting communicates financial results of a business to

various stakeholders. Accounting helps stakeholders in taking rational decisions.

5) Planning & Forecasting – Accounting helps in planning and forecasting future events and
desired financial performance and financial position. Analysis of past data, identifying
trends and proper interpretation helps in better planning.

6) Taxation – Accounting records provides accurate information for computation of various

taxes and duties.

7) Cost Control & Reduction – Accounting helps to identify areas of expenses / cost control
and reduction. Such cost reduction helps in enhancing future profits.

8) Legal Compliance – Maintenance of proper accounting records and reports is needed as

per Companies Act, 2013. Hence, accounting serves to comply statutory requirements.

9) Communication of Financial Results – Various stakeholders have diverse interests in a

business concern. Hence, communication of true and fair financial results is vital for
good corporate governance practices.

10) Evidence – Accounts are admissible as documentary evidence in the Court of Law.
Hence, proper accounts can be used in case of suits relating to disputes, frauds etc.

Compiled by Prof. Prasad Bhat Page 7

4. PROCESS OF ACCOUNTING

a) Transaction – the first step of accounting is financial transaction where there is exchange
of benefits, goods, services, transfer of funds, borrowings, etc. Cash transaction refers to
a business deal where immediate payment is made or received. Credit Transaction is a
business deal where payment or receipt of money is postponed to a future date.

b) Document – every business transaction shall be supported by valid documents. Such

documents include bill, invoice, receipt, challan, delivery slip, note, voucher etc. Every
monetary business transaction is recorded on the basis of such documentary evidence.

c) Recording – this is the basic function of accounting. All business monetary transactions
are recorded in the books of account. Recording is done in a book called ‘Journal.’ A
Journal may further be divided into several subsidiary books according to the nature and
size of the business.

d) Classifying – classification is based on the systematic analysis of the recorded data, with
to group similar transactions at one place. This makes information compact and usable.
Such classification is done in a ‘Ledger’ book. In a ledger, all financial transactions of
similar nature are collected. E.g., transactions related to salary payments, rent received,
sales, purchases etc.

e) Summarising – at the end of accounting period (financial year) all the classified data is
summarized and reports are prepared. All the account balances are summarized and
listed in a report known as ‘Trial Balance’. Summarization deals with preparation and
presentation of records in a useful manner. This process leads to preparation of the
financial statements.

f) Finalization – at the end of accounting period (financial year), a summary of transactions

and account balances is prepared in the form of Trial Balance. On the basis of such Trial
Balance, the Financial Statements are prepared viz. Profit & Loss Statement and Balance
Sheet. In case of certain companies, Cash Flow Statement is also prepared.

Compiled by Prof. Prasad Bhat Page 8

g) Analysing – once financial statements (P&L Statement & Balance Sheet) are prepared,
the next step is analysis. Analysis means methodical study and understanding of given
financial statements. Financial Statements are simplified for better understanding.

h) Interpreting – once financial statements are studied & analysed, interpretation is needed.
Interpretation deals with explaining the meaning and significance of various financial
relationships. Proper analysis and interpretation will help end-users to make meaningful
judgement about the financial condition and profitability of the business operations.

i) Communicating – the entire process of accounting ends with proper communication

with the concerned parties. Financial statements should be transmitted to the end-users
for decision-making. Various accounting reports are prepared and distributed.

3. Recording
1. Transaction 2. Document
(Journal)

6. Financial
4. Classifying 5. Summarizing Statements
(Ledger) (Trial Balance)
(P&L / Bal. Sheet)

9.
7. Analysis 8. Interpretation
Communication

Compiled by Prof. Prasad Bhat Page 9

3. KEY FINANCIAL TERMS
1. FINANCIAL STATEMENTS

Financial Statements

Profit & Loss

Balance Sheet
Statement

Income Expenses Assets Liabilities Capital

2. TERMINOLOGY

1) Balance Sheet
 Balance Sheet is a statement showing assets, liabilities and capital of a business as
on a particular date.
 Balance Sheet depicts the financial position of a business as on a particular date.
 In India, financial year / accounting year starts on 1st April and ends on 31st March.
 Hence, generally, Balance Sheet is prepared as on 31st March, i.e., year-end.
 However, for companies which are listed on Stock Exchange, financial statements are
prepared and communicated every quarter-end (30 June, 30 Sept, 31 Dec, 31 March).

2) Assets
 assets denote property / ownership of a business
 used for business purposes
 have monetary value
 helps in generating sales revenue / profits

Assets

Based on Tangibility Based on Time Period

Tangible Assets Intangible Assets Non-Current Assets Current Assets

Compiled by Prof. Prasad Bhat Page 10

3) Tangible Assets are those assets which can be seen or physically touched. For example:
building, land, furniture, vehicles etc.

4) Intangible Assets are those assets which cannot be seen or physically touched, but they
are owned by a business and useful for generating revenue and profits. For example:
goodwill, patent, trademarks, copyrights and other Intellectual Property Rights (IPR) etc.

5) Non-Current Assets
 assets held for long-term purposes
 useful life of more than 12 months (i.e., greater than 1 year)
 not held for resale purpose in ordinary course of business
 non-current assets can be classified into fixed assets and long-term investments
 for example: machinery, equipment, goodwill, vehicles, patents, etc.

6) Fixed Assets
 used for long-term purposes (more than 12 months)
 held for carrying out the main operations of a business
 not held for resale purpose in ordinary course of business
 can be classified into tangible assets and intangible assets

7) Goodwill
 value of image, reputation, brand value of a business
 goodwill helps in customer acquisition and retention
 it facilitates premium pricing and adds to higher revenues and profit
 KFC, Nike, BMW, Starbucks etc.

8) Patent
 exclusive legal right to use certain invention, technology, manufacturing process etc.
 patent holder gets ultimate power to use his invention and nobody else can use it
 patent creates domination in the specific product market, thereby higher profits
 especially prominent in pharmaceutical and technology industry

9) Trademark
 exclusive legal right to use certain logo, pictures, design etc.
 customer identifies the logo with the quality / value of the product or service
 trademarks help in premium pricing and adds to higher revenues and profit

Compiled by Prof. Prasad Bhat Page 11

10) Copyright
 exclusive legal right to use creative work – literature, programs, music, films etc.
 nobody else can reproduce / imitate / copy the books, songs, music, etc.
 the copyright holder can sell or assign his creation and earn profits.

11) Royalty
 a holder of IPR (patent, trademark, copyrights etc.) may transfer his rights
 where such owner of IPR transfers his exclusive rights, he earns money for the same
 royalty is a contractual amount (money) received by the owner of IPR
 royalty is paid by a person for using the assets belonging to another person.

12) Investment
 investment is a cash outflow for buying monetary assets
 investment denotes such assets which are held not for business purposes
 purpose of investment is to earn interest, profit, dividend or other benefits.
 held for earning passive income / other income
 for example: long term investments in Bank FD, mutual funds, deposits etc.

13) Current Assets

 assets held for short-term purposes, held for day-to-day business operations
 supposed to be converted into money / cash upto 12 months (i.e., upto 1 year)
 example: cash, bank balance, inventory, debtors, bills receivables, prepaid expenses,
accrued income, short-term investments, short-term loans given etc.

14) Inventory / Stock

 material held for sale in ordinary course of business
 material used in business operations for manufacturing / trading activities
 includes raw material, work-in-progress, finished goods, spares etc.
 inventory or stock is a constituent of current assets

15) Debtors
 customers to whom goods / services are sold on credit
 customers from whom money is receivable by the business
 debtors are a constituent of current assets

Compiled by Prof. Prasad Bhat Page 12

16) Bills Receivables (B/R)
 bills receivables are similar concept to debtors, and it is a part of current assets
 persons / customers from whom money is receivable by the business
 a separate document known as ‘bill of exchange’ is created for higher safety of funds

17) Prepaid Expenses

 these are expenses which are paid in advance
 benefit of such expense will be received in future (next accounting year)
 prepaid expense is a constituent of current assets

18) Accrued Income

 these are incomes which are earned but not received yet
 for example: interest on Bank Fixed Deposit is receivable at end of financial year, but
received in the next year.
 accrued income is a constituent of current assets

19) Liability
 liability denote a financial obligation of a business
 amount payable (owed) to outsiders (money value)
 liability also known as ‘debt’ of a business owed to third parties
 classified into non-current liability and current liability

Liabilities

Based on Time Period

Non-Current Liabilities Current Liabilities

20) Non-Current Liability

 long-term liability
 payable after 12 months (i.e., later than 1 year)
 for example: Bank Loan, Borrowings from Financial Institution, Corporate Debentures,
Deposits Accepted from public / members, trade payable (beyond 1 year) etc.

Compiled by Prof. Prasad Bhat Page 13

21) Debentures
 debentures are a type of long-term borrowing from general public and other lenders,
 generally, debentures are secured by a collateral
 maximum tenure (maturity) of secured debentures is 10 years
 company pays annual interest and repayment (redemption) of funds are maturity

22) Deposits
 deposits are a type of medium-term borrowing from general public / members,
 generally, deposits are secured by a collateral
 maximum tenure (maturity) of deposits is 36 months
 company pays annual interest and repayment of funds are maturity

23) Current Liabilities

 liabilities which are payable within a short period of time,
 supposed to be paid upto 12 months (i.e., upto 1 year)
 for example: creditors, bills payable, outstanding (unpaid) expenses, bank overdraft,
short-term loans taken, provision for tax, proposed dividend etc.

24) Creditors
 suppliers from whom goods / services are purchased on credit
 suppliers to whom money is payable by the business
 creditors are a constituent of current liabilities

25) Bills Payable (B/P)

 bills payable are similar to creditors
 persons / suppliers to whom money is payable by the business
 a separate document known as ‘bill of exchange’ is created for commitment to pay
 bills payable (B/P) is a constituent of current liabilities

26) Outstanding (Unpaid) Expenses

 these are expenses which are incurred during the financial year, but not paid yet
 for example: unpaid salary, unpaid rent, unpaid electricity bill etc.
 outstanding expenses are a constituent of current liabilities

Compiled by Prof. Prasad Bhat Page 14

27) Bank Overdraft (BOD)
 short-term borrowing from a bank
 a businessman is allowed to withdraw additional funds over and above bank balance
 such additional funds are in the form of loan, which is repayable with interest
 bank overdraft is a constituent of current liabilities

28) Provisions
 expenses which are payable by a business, but the actual amount is not certain
 provision is a type of liability created for approximate amount
 example: provision for income tax, provision for employee compensation etc.

29) Proposed Dividend

 dividend means profits which are distributed by a company to its members
 once a company declares dividend, it becomes a commitment to pay within 30 days
 proposed dividend is a constituent of current liabilities

30) Contingent Liability

 a financial obligation relating to an existing event or future event which may or may
not arise, depending on occurrence or non-occurrence of uncertain future happening
 contingent liability is not recorded in a Balance Sheet
 contingent liability is recorded outside the Balance Sheet (notes to accounts), as a
part of disclosure requirements to investors
 Example: disputed cases pending in Courts, guarantees given to others etc.

31) Capital
 capital means the funds / money contributed by owner of a business
 in case of sole proprietor, capital is introduced by the single owner
 in case of partnership firm, capital is introduced by the partners
 in case of company, capital is contributed by multiple shareholders. In a company,
capital is classified into equity share capital and preference share capital.

Compiled by Prof. Prasad Bhat Page 15

32) Authorized Share Capital
 in a company, the total capital is divided into equal parts, each part known a ‘share’.
Every share has a face value, generally ₹ 10 / 5 / 2 / 1 or any number (except fraction)
 where a company is legally registered / incorporated, the Board of Directors decide
the maximum number of shares that can be issued by the company
 such maximum number of shares is known as ‘Authorized Share Capital’
 at any point of time, the total capital of a company cannot go beyond the authorized
share capital. However, a company may increase its authorized share capital through
approval from its shareholders.
 example: Auth. Capital ₹ 10,00,000 divided into 100000 shares of face value ₹ 10 each

33) Equity Share Capital

 in a company, the total capital is divided into equal parts, each part known a ‘share’.
Every share has a face value, generally ₹ 10 / 5 / 2 / 1 or any number (except fraction)
 every company has equity share capital, hence it is called common / ordinary capital
 equity shareholders are the real owners of a company, they share the risks and enjoy
the profits of the company. Dividend is optional at the decision of Board of Directors.
 for public limited company, equity shares can be listed on recognized stock exchange
via SEBI approval. Thereafter, shares are traded (buy / sell) on the stock exchange.
The price at which shares are traded is known as market price / value.

34) Preference Share Capital

 a company may have another type of share capital known as preference share capital
(although not mandatory)
 preference shareholders get priority over equity shareholders for dividend payments
as well as repayment of capital. Fixed rate dividend is paid every year, if profits.
 further, where a company has sufficient profits, dividend to preference shareholders
is always compulsory, whereas dividend to equity shareholders is always optional

35) General Reserves / Retained Earnings

 where a company earns profits, it may set-aside certain profits for future purposes
 such set-aside profits are known as ‘reserves’ or ‘retained earnings’
 reserves or retained earnings belong to equity shareholders of a company

Compiled by Prof. Prasad Bhat Page 16

36) Security Premium
 where a company issues / sells shares at a price, higher than its face value, the extra
amount received by the company is known as ‘premium’.
 such extra amount collected is recorded under the heading ‘security premium’
 example: face value ₹ 10 / share and IPO price ₹ 90, hence premium ₹ 80 per share
 security premium belongs to equity shareholders of a company

Financial Statements

Profit & Loss

Balance Sheet
Statement

Income Expenses Assets Liabilities Capital

37) Profit & Loss (P&L) Statement

 Profit & Loss (P&L) Statement shows the income and expenses of a business, for a
certain period of time
 Profit & Loss Statement depicts the financial performance of a business for a period
If Income > Expenses = Profit

If Income < Expenses = Loss

 In India, financial year / accounting year starts on 1st April and ends on 31st March.
 Hence, generally, P&L Statement is prepared for the year ended 31st March.
 However, for companies which are listed on Stock Exchange, financial statements are
prepared and communicated every quarter-end (30 June, 30 Sept, 31 Dec, 31 March).

38) Income
 income means sales, revenue, turnover or any other sources of earning money
 in the ordinary course of business, income represents an amount earned from sale of
goods, rendering of services, receipt of interest, commission, royalty, dividends etc.
 income can be classified into two parts – revenue from operations and other income

Compiled by Prof. Prasad Bhat Page 17

39) Revenue from Operations
 income earned from the primary / main activities of a business (goods & services)
 revenue from operations is the main source of income for a business
 it pertains to core business activities as well correlated to main business
 example: for stationery business, sale of books, notebooks, pens, pencils etc.

40) Other Income

 income earned from activities which are not related to the main business
 generally, other income is passive income, which are earned alongside main business
 example: for stationery business, rent received, interest on bank FD etc.

41) Expenses
 expenses include various costs relating to a business
 expenses are recorded for an accounting period, say a financial year
 total expenses are compared with total income to measure profit or loss
 as per Companies Act, 2013, total expenses are classified into various categories

42) Cost of Material Consumed

 cost of raw material used in business operations for an accounting period
 cost of raw material purchased includes its buying cost, duties, and taxes, carriage
inwards (transport cost)
 cost of raw material consumed requires adjustment with opening stock and closing
stock of material, to compute actual material used (consumed) during the year
 material consumed = opening stock (+) purchases (-) returns (-) closing stock

43) Purchases of Stock in Trade (SIT)

 trading means such goods which is bought for the sole purpose of re-selling as it is
 purchases of stock-in-trade means such goods which are purchased for resale

44) Changes in Inventory of Finished Goods, Work-in-Progress and Stock-in-Trade

 changes in inventory means difference between opening stock & closing stock
 changes in inventory (stock) = opening stock (-) closing stock
 opening stock means material in hand at the start of financial year, 1 st April
 closing stock means material in hand at the end of financial year, 31 st March

Compiled by Prof. Prasad Bhat Page 18

45) Employee Benefit Expenses
 employee benefit expenses include all costs incurred for workers and staff
 example: salary, wages, provident fund contribution, bonus, incentives, employees’
health insurance premium, pension, staff welfare costs etc.

46) Finance Cost

 basically, finance cost includes the interest paid on borrowings / loans
 finance costs include interest expense and bank charges

47) Depreciation and Amortization

 depreciation means reduction in value of tangible fixed assets due to usage, damage,
wear and tear, change in technology or passage of time
 amortization is reduction in value of intangible assets such as goodwill, patent etc.
 depreciation and amortization are non-cash expenses, i.e., there is no cash outflow

48) Other Expenses

 the last heading in expenses is other expenses, which are not covered above
 example: rent, electricity, advertisement, commission, printing, stationery, internet,
postage, insurance premium, telephone charges, repairs, maintenance, bad debts etc.

49) Bad Debts

 where a customer to whom we sold goods on credit commits default in payment, it is
known as bad-debts
 bad-debt is a loss due to non-receipt of money from customers

50) Net Profit / Net loss

 the difference between total revenue and total expenses during an accounting period.
 where difference is positive, it is known as net profit and where such difference is
negative, it is referred to as net loss. This is after deducting all expenses and tax.

51) Account (A/c)

 account is summarized record of all business transactions relating to a person, assets,
income or expense.
 all business transactions are recorded at one place relating to a particular head.
 example: Rent A/c, Salary A/c, Bank A/c, Cash A/c, Furniture A/c, Investment A/c etc.

Compiled by Prof. Prasad Bhat Page 19

52) Gross Profit
 gross profit is the difference between total income and total manufacturing expenses
during an accounting period.
 the aggregate cost of raw material consumed along with all the manufacturing costs
is known as ‘Cost of Goods Sold (COGS)’
 hence, gross profit = Total Income (-) COGS
 expenses related to administrative, marketing, selling, distribution, interest etc. is not
considered while computing gross profit.

53) Operating Profit

 operating profit is difference between total income and COGS as well as operating
expenses during an accounting period.
 operating profit = Total Income (-) COGS (-) Operating Expenses
 operating expenses include administrative, marketing, selling, distribution etc.
 operating profit is also known as Earnings / Profit before Interest and Tax (EBIT / PBIT)

3. TYPES OF EXPENDITURE

Sr. Revenue Expenditure Capital Expenditure

1 Expenditure for short-term benefits Expenditure for long-term benefits
(upto 1 year) (more than 1 year)
2 Day-to-day expenses, routine Non-recurring expenses
nature
3 Incurred for operating activities Incurred for creation of non-current
assets / fixed assets
4 Recorded in Profit & Loss Recorded in Balance Sheet
Statement
5 Generally, small amount expenses Generally, high value expenditure
6 E.g., rent paid, raw material bought, E.g., purchase of land, machinery,
salary, interest on loan, postage, long-term investment, acquiring
depreciation etc. patents etc.

Compiled by Prof. Prasad Bhat Page 20

4. FINANCIAL STATEMENTS
1. INTRODUCTION

 Financial statements are formal and structured records that show financial activities of a
business. Financial Statements show the financial performance and financial position of
a business entity.
 They provide a summary of the financial transactions, and resources of the entity over a
specific period. These statements are crucial tools for assessing the entity's financial
health, profitability, and overall performance.
 Financial Statements facilitate financial analysis of past data as well as future projections
of a business. The main types of financial statements are:
1. Profit & Loss Statement (Income Statement): The primary objective of any business
is to earn profits. The income statement shows the revenues, expenses, and profits or
losses of an entity over a specific period, generally a year or a quarter. It shows how
much money the business earned (revenues) and the costs incurred to generate those
revenues (expenses). The difference between revenues and expenses is net income
or net loss. Profit & Loss Statement is considered as the most important document
for the various stakeholders.

2. Balance Sheet (Statement of Financial Position): Balance Sheet provides a summary

of an entity's financial position at a specific point in time. It lists a company's assets,
liabilities, and shareholders' funds.

3. Cash Flow Statement: Cash Flow statement tracks the inflows and outflows of cash
and cash equivalents (bank balance) during a specific period. It categorizes cash flows
into operating activities, investing activities, and financing activities, providing
insights into how cash is generated and used by the entity. Cash Flow Statement is
prepared to highlight the liquidity position of a business. It helps to understand the
various sources of funds (inflows) and utilization of funds (outflows).

 Each financial statement serves specific purpose and together provides a comprehensive
overview of an entity's financial performance, position, and liquidity. These statements
are essential for stakeholders’ decision-making. Financial statements are prepared as per
applicable accounting standards and generally accepted principles of accounting.

Compiled by Prof. Prasad Bhat Page 21

2. OBJECTIVES / IMPORTANCE OF FINANCIAL STATEMENTS

1) Provide Financial Information: The primary purpose of financial statements is to offer

relevant and reliable financial information about a company's performance, financial
position, and cash flows. This information is crucial for decision-making by various
stakeholders, such as investors, creditors, management, employees, and regulators.
2) Assessing Financial Performance: Financial statements allow stakeholders to assess
how well a company has performed over a specific period. Key components, such as
income, and profit margins, help in evaluating company's profitability and efficiency.
3) Evaluating Financial Position: Balance Sheet provides an overview of a company's
assets, liabilities, and capital as on a date. It helps stakeholders understand the
organization's financial health, solvency, and liquidity.
4) Facilitate Investment Decisions: Investors (existing and potential) rely on financial
statements to evaluate the company's potential for growth and profitability. These
statements provide insights into the company's historical financial performance and
can be used to make informed investment decisions.
5) Facilitate Credit Decisions: Lenders (Banks, Fin. Inst.) and creditors use financial
statements to assess a company's creditworthiness and ability to repay debt. They
analyze financial ratios and cash flow patterns to evaluate the risk associated with
lending money to the company.
6) Facilitate Regulatory Compliance: Financial statements are essential for complying
with various legal and regulatory requirements, such as tax reporting, auditing, and
disclosure standards.
7) Monitoring Operational Performance: Financial statements help company's top-level
management monitor its own performance and make informed decisions about
resource allocation, cost management, and business strategy.
8) Benchmarking & Comparisons: Stakeholders use financial statements to benchmark a
company's performance against its competitors, industry standards, or prior periods.
This comparison helps identify areas of improvement or potential areas of concern.
9) Assisting in Valuation: Financial statements are vital in determining the value of a
company. Valuation analysts and potential buyers use financial information to assess
the company's worth during mergers, acquisitions, or sales.
10) Disclosure of Information to Public: Listed companies are required to publish their
financial statements for transparency & accountability to shareholders and the public.

Compiled by Prof. Prasad Bhat Page 22

3. LIMITATIONS OF FINANCIAL STATEMENTS

Even though financial statements are useful for understanding financial performance and
position of a business, they have certain limitations that stakeholders should be aware of
while using them for decision-making and analysis.

Following are key limitations –

1) Historical Nature: Financial statements are based on past transactions and events.
They reflect the financial position and performance of the entity up to a specific date
in the past. They may not fully show future financial health of the organization.
2) Non-Financial Information: Basically, financial statements measure financial data and
may not provide complete picture of non-financial factors that impact an entity's
operations, such as customer satisfaction, employee morale, innovation, etc.
3) Based on Estimates: Preparation of financial statements involves making estimates
and judgments. These estimates can be subject to biases, errors, or assumptions,
which can affect the accuracy and reliability of the financial information.
4) Omission of Intangible Assets: Basically, financial statements do not include valuable
intangible assets like intellectual property, goodwill, or human capital. These assets
significantly contribute to a company's profits but may not reflected in Balance Sheet.
5) Non-Disclosure of Sensitive Information: Certain sensitive information, such as
pending legal disputes, or upcoming strategic initiatives, may not be disclosed in the
financial statements, which may pose as critical risks or opportunities.
6) Lack of Real-time Information: Financial statements are prepared at the end of
reporting periods (quarterly or annually). Important events in-between these dates,
may result in outdated information for decision-making.
7) Ignorance of Future Events: Financial statements do not account for future events or
changes that may impact the company's financial position and performance. Factors
like changes in the economic environment, technological advancements, or industry
disruptions are not reflected in the statements.

Despite these limitations, financial statements remain valuable tools for understanding an
entity's financial performance and position. To reduce such limitations, stakeholders often
use supplementary information, such as management discussions and analysis, footnotes
to the financial statements, and other non-financial parameters, to get comprehensive view
of the entity's overall health and prospects.

Compiled by Prof. Prasad Bhat Page 23

4. PROFIT & LOSS STATEMENT

 A Profit and Loss Statement (P&L), also known as ‘Income Statement’, is one of the three
primary financial statements.
 The P&L Statement is used to assess the financial performance of a business over a
specific period of time, i.e., a year or a quarter.
 The P&L Statement provides a summary of company's revenues, expenses, and profits
or losses during that period. It is a crucial tool for investors, creditors, management, and
other stakeholders to evaluate the company's profitability and operating efficiency.
 Key Components of a Profit and Loss Statement:

1. Revenue from Operations (Sales / Turnover): This section represents the total income
generated from a company's primary business activities. It includes revenue from
sale of goods or services, as well as other operating income, related to main business

2. Other Income: This section represents the income earned from activities which are
not related to main business. Generally, other income is a passive income, which is
earned alongside main business activities. Example – for a textile business, income
from interest on Bank Fixed Deposit is other income.

3. Cost of Material Consumed: Cost of raw material used in business operations for an
accounting period. This cost includes its buying cost, duties, and taxes, carriage
inwards (transport cost). Raw Material consumed = opening stock (+) purchases (+)
expenses on purchase (-) purchase returns (-) closing stock.

4. Purchases of Stock in Trade (SIT): Trading goods means the goods which are bought
for the sole intention of re-selling it. Purchases of stock-in-trade means such material
which is purchased for resale purposes.

5. Changes in Inventory of Finished Goods (FG), Work-in-Progress (WIP) and Stock-in-

Trade (SIT): Changes in inventory means difference between opening stock & closing
stock. In simple words, changes in inventory (stock) = opening stock (-) closing stock.

6. Employee Benefit Expenses: This head includes expenses incurred for workers and
employees. Example – salary, wages, bonus, incentives, employees’ health insurance
premium, pension, staff welfare costs, provident fund contribution, etc.

Compiled by Prof. Prasad Bhat Page 24

 7. Finance Cost: Basically, finance cost means the interest paid on borrowings / loans.
Further, finance costs also include bank charges

8. Depreciation and Amortization: Depreciation means reduction in value of tangible

fixed assets. Amortization is reduction in value of intangible assets such as goodwill,
patent etc. Depreciation and amortization are non-cash expenses.

9. Other Expenses: The last section under expenses is ‘other expenses.’ Other expenses
include rent, electricity, advertisement, commission, printing, stationery, internet,
postage, insurance premium, telephone charges, repairs, maintenance, bad debts etc.

10. Profit Before Tax (PBT): Profit before Tax (taxable profit) is calculated by subtracting
all the expenses from the total income. It represents the profit earned by a company
before paying income tax.

11. Tax Expense: Tax expenses shows the income tax amount as computed as per the
provisions of the Income Tax Act, 1961.

12. Exceptional Items: Exceptional or Extraordinary items are transactions, events which
are non-recurring or non-operating. Basically, they are beyond company’s control.
Hence, these items are reported separately in P&L Statement. For Example: legal
settlements, refunds, losses from natural disasters, effects of war or terrorism etc.

13. Profit After Tax (PAT): Profit after Tax (net profit) is calculated by subtracting income
tax expense from Profit before Tax (PBT). Net profit belongs to the shareholders and
is available for payment of dividends.

14. Earnings per Share (EPS): Earnings per Share is financial parameter used to measure
a company's profitability on a per-share basis. EPS is a critical indicator for investors
and analysts as it helps them assess a company's earnings relative to the number of
outstanding shares. To calculate EPS, the formula is –

EPS = (Net Profit – Preference Dividends)

Number of Equity Shares Outstanding

Compiled by Prof. Prasad Bhat Page 25

 Significance / Importance of the Profit and Loss Statement:

1. Profitability Assessment: P&L Statement is a primary tool for evaluating a company's

profitability during a specific period. It helps stakeholders determine if the company's
operations are generating profits or incurring losses.
2. Performance Comparison: By comparing P&L Statements of different periods or with
industry benchmarks, stakeholders can assess company's financial performance.
3. Financial Decision-making: Investors and creditors use the P&L Statement to make
informed decisions about investing in or lending to the company.
4. Management Evaluation: Managers use P&L Statement to analyze cost structures,
identify areas of inefficiency, and make strategic decisions to improve profitability.
5. Financial Reporting: The P&L statement is a vital component of a company's financial
reporting, providing a clear picture of its financial performance to external parties.

5. BALANCE SHEET

 A Balance Sheet is one of the fundamental financial statements that provides a summary
of a company's financial position at a specific point in time.
 It presents a summary of the company's assets, liabilities, and shareholders' equity,
helping stakeholders assess the financial health and stability of the business.

 Key Components of a Balance Sheet:

1. Assets: Assets are the ownership / properties of a company. Assets are categorized
into two main types –
a) Non-Current Assets (Long-term Assets): Non-current assets are expected to be
held or used for more than 1 year. Non-Current assets used for business purposes
and not held for resale in the ordinary course. They include items like property,
plant, and equipment (PP&E), intangible assets, long-term investments, etc.

b) Current Assets: Current assets are short term assets which are expected to be
converted into cash or used within 1 year. Examples are cash, bank balance,
debtors, receivables, inventory, and short-term investments etc.

Compiled by Prof. Prasad Bhat Page 26

 2. Liabilities: Liabilities represent the financial obligations of a company. It is amount
which a company owes to outsiders. They are categorized into two main types –

a) Non-Current Liabilities (Long-term Liabilities): Non-current liabilities long-term

obligations, that are not due within one year. These can include long-term loans
from banks and financial institutions, debentures, deposits etc.

b) Current Liabilities: Current liabilities are short-term obligations which are to be

paid within one year. Examples include creditors, payable, short-term borrowings,
outstanding expenses, bank overdraft etc.

3. Equity (Owner's Capital): Shareholders' equity represents the shareholders’ funds

invested in a company as on a particular date. It is classified into two parts –
a) Equity Share Capital: This is the actual amount of full paid-up equity shares
contributed by the members of a company.
b) Other Equity: Other equity includes retained earnings (past accumulated profits),
general reserve, security premium and other reserves of the company.

 Significance / Importance of the Balance Sheet:

1. Financial Position: A Balance Sheet provides a comprehensive view of a company's

financial position, showing the total value of its assets, the sources of funds (liabilities
and equity) used to finance those assets, and the relationship between the two.
2. Liquidity Assessment: By comparing current assets to current liabilities, stakeholders
can measure a company's short-term ability to meet its financial obligations.
3. Solvency Evaluation: Non-current assets and long-term liabilities in a Balance Sheet
help assess company's long-term solvency & capacity to meet long-term obligations.
4. Debt and Equity Mix: Balance Sheet shows the proportion of borrowed funds and
owned funds used to finance the company's assets, which is crucial for financial risk.
5. Investor Decision-making: Investors use Balance Sheet to understand a company's
financial health and make informed investment decisions.
6. Creditworthiness: Lenders and Creditors use Balance Sheet to evaluate a company's
creditworthiness and assess the risk of lending to or transacting with the company.

Compiled by Prof. Prasad Bhat Page 27

6. CASH FLOW STATEMENT

 Cash Flow Statement is an important financial statement that provides an overview of a

company's cash inflows and outflows over a specific period.
 Cash Flow Statement is essential for assessing the company's ability to generate cash,
meet its financial obligations, and understand the sources and uses of cash.
 It measures the liquidity position of the company over a period of time, accounting year.
 The Balance Sheet and Profit & Loss Statement provide a firm’s assets-liabilities and its
performance, respectively. However, both these statements fail to explain the changes
(with reasons) in the liquidity position of the firm.
 Cash Flow Statement discloses the changes in cash / bank position between two or more
periods. Cash Flow Statement provides reasons for such changes and also clarifies the
modes in which cash is generated as well as utilized by the firm during the period.

Classification of Cash Flow Statement

As per Accounting Standard, a Cash Flow Statement is classified into three main categories
of cash inflows and cash outflows. Such classification provides information that allows its
users to assess the impact of those activities on the financial position of the company. This
facilitates better utilization of financial statements by its users, viz. shareholders, creditors,
financial institutions. Following are the three activities under Cash Flow Statement –

1) Cash Flows from Operating Activities

Operating Activities are the primary / main revenue generating activities of a company.
Operating activities include cash effects of those transactions and events that enter into
the determination of net profit or loss. Cash receipts from selling goods and providing
services. Cost of goods sold and other operative expenses result in cash disbursements.
Following are examples of Cash Flows from Operating Activities:
a) Cash receipts from the sales of goods and the rendering of services:
b) Cash receipts from royalties, fees, commissions, and other revenues.
c) Cash payments to suppliers for goods and services;
d) Cash payments to and on behalf of employees;
e) Cash payments or refunds of income taxes; and
f) Changes in working capital

Compiled by Prof. Prasad Bhat Page 28

2) Cash Flows from Investing Activities
Investing Activities represent cash flows related to a company's investments in long-
term assets and long-term investments. It includes cash used for purchasing or selling
property, plant, and equipment (fixed assets), acquiring or selling other businesses, and
buying or selling investments in securities. The following are examples of cash flows
arising from investing activities:
a) Payment to acquire fixed assets (including intangibles);
b) Receipt from sale of fixed assets (including intangibles);
c) Payments to acquire shares of other companies, joint ventures etc.;
d) Receipts from sale of long-term investment, shares;
e) Payment towards long-term advances and loans made to third parties;
f) Receipts from repayment of long-term advances and loans made to third parties.
g) Interest received on investments; and
h) Dividend received on investments.

3) Cash Flows from Financing Activities

Financing activities show the cash flows related to a company's financing activities,
including transactions with shareholders and creditors. It includes cash received from
issuing shares or debentures, as well as cash paid for dividends, share buy-back, and
debt repayments. Financing activities are activities that result in changes in the size and
composition of the owner’s capital (including preference share capital) and borrowings
of the company. Following are examples of cash flows arising from financing activities:
a) Receipts from issuing shares or other similar instruments;
b) Receipts from issuing debentures, loans notes, bonds, long-term borrowing;
c) Repayments of amounts borrowed i.e., redemption of debentures, bonds etc.
d) Payments towards redeem preference shares;
e) Payment towards buy-back of equity shares;
f) Payment of Interest on Borrowings; and
g) Payment of Dividend on Share Capital.

Compiled by Prof. Prasad Bhat Page 29

Importance / Benefits / Merits Cash Flow Statement

1. Cash Management: Cash Flow Statement helps companies monitor their cash inflows
and outflows, allowing them to manage cash effectively and ensure sufficient liquidity
for daily operations.

2. Financial Health: Investors use Cash Flow Statement to evaluate company's financial
health. A company with positive operating cash flows and adequate cash reserves is
generally considered more financially stable.

3. Assessing Cash Generation: Cash Flow Statement provides inputs about a company's
ability to generate cash from core business activities. Ideally, cash flow from operating
activities should be positive which indicates a healthy and sustainable business model. A
net-positive cash flow denotes surplus day-to-day activities, which facilitates operating
capabilities. Surplus funds can be used for paying dividends and repaying loans, short-
term investments and less dependency on borrowed funds.

4. Investment Decisions: Investors use Cash Flow Statement to assess a company's capital
expenditure and investment decisions. Net-negative cash flow from investing activities
indicates higher capex, which results in future growth by increasing production capacity.
Long term investments signify surplus fund generation.

5. Financing Decisions: Cash Flow Statement reveals how the company raises capital and
manages its financing activities. It helps stakeholders understand the company's capital
structure and debt management practices.

6. Detecting Cash Flow Issues: A negative cash flow, especially in operating activities, may
signal potential financial problems or indicate that the company is relying on external
financing to fund its operations.

7. Comparing Profit & Cash Flows: Cash Flow Statement complements the P & L Statement
by providing inputs into the actual cash movements underlying reported profits. It helps
identify differences between reported profit and actual cash flow.

Hence, Cash Flow Statement is a crucial tool for assessing liquidity position of a company
and understanding its ability to generate and manage cash, necessary for sustainable
growth and financial stability.

Compiled by Prof. Prasad Bhat Page 30

Changes in Working Capital

Event Result Reason

Increase in Current Asset Cash Outflow Blockage of Funds
Decrease in Current Assets Cash Inflow Release of Funds

Increase in Current Liability Cash Inflow Release of Funds

Decrease in Current Liability Cash Outflow Blockage of Funds

Increase in Net Working Capital Cash Outflow Blockage of Funds

Decrease in Net Working Capital Cash Inflow Release of Funds

Illustrations:

Current Assets 2022-23 2021-22 Increase / Amount Inflow /

(current year) (last year) decrease (₹) Outflow
Inventory 1,50,000 1,25,000
Debtors 40,000 60,000
Bills Receivable 25,000 15,000
Advance given 10,000 15,000

Current Liabilities 2022-23 2021-22 Increase / Amount Inflow /

(current year) (last year) decrease (₹) Outflow
Creditors 85,000 75,000
Bills Payable 15,000 20,000
Outstanding Exp. 10,000 25,000
Bank Overdraft 20,000 40,000

Compiled by Prof. Prasad Bhat Page 31