MBA604_Financial Reporting and Analysis

Financial Statements: The Balance Sheet II 145 January 1 Opening balance 500 units @ ` 25 per unit 3 Issue 70 units 4 Issue 100 units 8 Issue 80 units 13 Received from supplier 200 units @ ` 24.50 per unit 14 Returned to store 15 units @ ` 24 per unit 16 Issue 180 units 20 Received from supplier 240 units @ ` 24.75 per unit 24 Issue 304 units 25 Received from supplier 320 units @ ` 24.00 per unit 26 Issue 112 units 27 Returned to store 12 units @ ` 24.50 per unit 28 Received from supplier 100 units @ ` 25 per unit Work out on the basis of First-in, First-out. This revealed that on the 15th there was a shortage of five units and another on the 27th of eight units. Solution: Stores Ledger Account (FIFO) Receipts Issue Stock Date Qty. Rate Amt Qty. Rate Amt Qty. Rate Amt Jan. — — — — — 500 25.00 12,500 1— 3— — — 70 25 1,750 430 — 10,750 4— 8— — — 100 25 2,500 330 — 8,250 13 200 — — 80 25 2,000 250 — 6,250 Refund 24.50 4,900 — — — 250 25.00 6,250 14 15 200 24.50 4,900 15 — 24.00 36 — — — 250 25.00 6,250 16 — 200 24.50 4,900 20 240 15 24.00 360 — Shortage 5 25 125 245 25.00 6,125 200 24.00 4,900 15 24.00 360 — — 180 25 4,500 65 25.00 1,625 200 24.00 4,900 15 24.50 360 24.75 5,940 — — — 65 25.00 1,625 200 24.50 4,900 CU IDOL SELF LEARNING MATERIAL (SLM)

146 Financial Reporting and Analysis 15 24.00 360 240 24.75 5,940 24 — — — 65 25.00 1,625 200 24.50 4,900 15 24.00 360 24 24.75 594 216 24.75 5,346 25 320 24.00 7.680 — — — 216 24.75 5,346 320 24.50 7,680 26 — — — 112 24.75 2,772 104 24.75 2,574 320 24.00 7,680 27 12 24.50 294 — — — 104 24.75 2,574 320 24.00 7,680 — — — — — — 12 24.50 294 27 — — Shortage 8 24.75 198 96 24.75 12,376 320 24.00 7,680 12 24.50 294 28 100 25.00 2,500 — — — 96 24.75 2,376 320 24.00 7,680 12 24.50 294 100 25.00 2,500 Closing stock 528 units = ` 12,850 Last-in, First-out (LIFO) The LIFO method of costing and inventory valuation is based on the principle that materials entering production are the most recently purchased. The method assumes that the most recent cost, generally the replacement cost is the most significant in matching cost with revenue in the income determination. The cost of the last lot of materials received is used to price materials issued until the lot is exhausted, then the next lot pricing is used, and so on through successive lots. Advantages 1. It provides a better matching of current costs with current revenues. 2. It results in real income in times of rising prices, by maintaining net income at a lower level than other costing methods. 3. In industries subject to sharp materials price fluctuations, the method minimises unrealised inventory gains and losses and tends to stabilise reported operating profits. Income is reported only when it is available for distribution as dividends or for other purposes. 4. Probably the most important arguments in favour of LIFO is its role in tax saving. It is generally considered a cheap form of tax avoidance by business firms. By valuing inventory at beginning-of-period prices and calculating cost of sales at the current prices, the firm creates secret reserves which are not taxed. As long as prices and inventory levels do not CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 147 decline, this benefit remains and in this case the tax saving is permanent. However, if the tax rates go up in the meantime, the so-called tax saving will be eliminated by higher tax rates. 5. LIFO produces an income statement which shows correct profit or losses and financial position. it correlates current cost and sales, and income statements show the result of operation, excluding profits or losses due to changing price levels. Disadvantages The following are the limitations of the LIFO method of costing: 1. Inventory valuations do not reflect the current prices and therefore are useless in the context of current conditions. 2. The argument that LIFO should be used for matching current costs with current revenue, is not sound. The most recent purchase costs are matched against the revenues of the current period. However, unless both purchases and sales occur regularly in even quantities, the revenues will not be matched with the current costs at the time of sale. When purchases are irregular and unrelated to the timing of sales, the matching is illogical and unsystematic, particularly if prices and costs are changing rapidly. 3. The profit of a firm can be manipulated with the LIFO method in operation. By timing purchases, a company can cause higher or lower costs to flow into the income statement, thus increasing or decreasing reported net income at will. 4. Another limitation which also results from LIFO’s lowering of the earnings figure is the effect it will have on existing bonus and profit sharing plans. Employees and managers who are interested in the growth of these plans may have difficulty in understanding a drop in the benefits which were created wholly or partially by an accounting change. During a period of rising costs, LIFO produces the desirable effect of reducing taxable income and tax liability; thereby conserving cash. On the other hand, it also affects the profit reported in the financial statements. Illustrative Problem 2. Prepare a stores ledger account from the following transactions under the LIFO method. Jan. 1 Received 1,000 units @ ` 1.00 per unit 10 Received 260 units @ ` 1.05 per unit 20 Issue 700 units Feb. 4 Received 400 units @ ` 1.15 per unit 21 Received 300 units @ ` 1.25 per unit March 16 Issue 620 units CU IDOL SELF LEARNING MATERIAL (SLM)

148 Financial Reporting and Analysis April 12 Issued 240 units ` 1.10 per unit May 10 Received 500 units @ 25 Issued 380 units Solution: Receipts Stores Ledger Account (LIFO) Stock Rate Issue Date Qty. Amt Qty. Rate Amt January 1,000 Amt Qty. Rate 1 260 1.00 1,000 —— — 1,000 1.00 1,000 10 — 1.05 273 —— 1,260 1,273 20 260 1.05 560 400 —— 440 1.00 273 560 February 300 440 1,020 4 1.15 460 —— 1,395 — 1.25 375 —— — 960 21 — 1,260 March — — — 300 1.25 375 640 652 16 500 320 1.15 368 — 400 April — — 80 1.15 92 400 12 160 1.00 160 950 532 May 1.10 550 — 900 10 418 520 25 — — 380 1.10 The Closing Stock consists of 120 units at ` 1.10 = 132 400 units at Re. 1.00 = 400 ` 532 Highest-in, First-out (HIFO) This method is based on the principle that materials received at the highest price in the stock are issued first. This will have the effect of pricing materials issued at the highest price and inventory valuation being made at the lowest possible prices. If the prices fluctuate widely, the highest cost will always be entering into the cost of goods sold. For instance, suppose on a particular date the stock ledger shows stock representing 500 units at the rate of ` 20,700 units at the rate of ` 12, and 300 units at the rate of ` 25. If materials are issued, then out of the above three lots, first of all 300 units would be issued. After this lot is over, then the second lot of 500 units, which becomes the highest priced stock after despatches of 300 units, would be taken up for transmission to production departments. Like other methods, this method also requires detailed records on the stores ledger. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 149 Base Stock Price Under this method, it is assumed that the minimum stock of a commodity which must always be carried is in the nature of a fixed asset and is never realised while the business continues. This minimum stock is carried at original cost. The stock in excess of this figure would be treated in accordance with one of the other methods, that is, FIFO or LIFO. The limitation of this method is that while measuring the return on capital employed in the business, the stock value may be undervalued and therefore the resulting business results will not be reliable. Illustrative Problem 3. From the following information prepare a stores ledger account assuming 100 units as base stock following the FIFO method: Rate Received 500 units Rate per unit ( `) January 1, 2007 Received 300 units 20 January 10 Issued 700 units 24 January 15 Received 400 units — January 20 Issued 300 units 28 January 25 Received 500 units — January 27 Issued 200 units 22 January 31 — Solution: Stores Ledger Account Base stock Price with FIFO (minimum stock 100 units) Date Receipts Issue Stock Rate Qty. Rate Amt Qty. Rate Amt Qty. Amt 2016 500 20 10,000 — — — 500 20 10,000 Jan. 1 300 Jan. 10 24 7,200 500 20 10,000 — Jan. 15 300 24 7,200 400 Jan. 20 — — — 400 20 8,000 100 20 2,000 Jan. 25 500 300 24 7,200 Jan. 27 — Jan. 31 28 11,200 — — — 400 28 11,200 — — 300 28 8,400 100 20 2,000 100 28 2,800 22 1100 500 22 11,000 — — 100 28 2,800 100 20 2,000 100 22 2,200 400 22 8,800 CU IDOL SELF LEARNING MATERIAL (SLM)

150 Financial Reporting and Analysis B. Average Price Methods Simple Average This method is based on the principle that materials issued should be priced on an average price and not on exact cost price. The simple average is an average of prices without having regard to the quantities involved. It should be used when prices do not fluctuate very much and the stock value is small. The average under this method is calculated by dividing the total of rates of materials in the storeroom by the number of rates of prices. This method is easy to operate. Illustrative Problem 5. Prepare a stores ledger account by following the simple average method on the basis of information given in Illustrative Problem 3. Solution: Stores Ledger Account (Simple Average Price Method) Date Receipts Issue Stock Qty. Rate Amt Qty. Rate Amt Qty. Rate Amt 2016 500 20 10,000 — —— 500 20 10,000 Jan. 1 300 24 7,200 500 20 10,000 Jan. 10 300 24 7,200 100 Jan. 15 — — — 700 22 15,400 500 1,800 Jan. 20 400 200 13,000 Jan. 25 28 11,200 — —— 700 Jan. 27 — 500 5,200 Jan. 31 500 — — 300 26 7,800 16,200 11,200 — 22 11,000 — —— — — 200 25 5,000 Average price for different issues has been calculated as follows: Jan. 15 700 units = 20 + 24/2 = ` 22 per unit Jan. 25 300 units = 24 + 28/2 = ` 26 per unit Jan. 31 200 units = 28 + 22/2 = ` 25 per unit Weighted Average Under this method, issue of materials is priced at the average cost price of the materials in hand, a new average being computed whenever materials are received. In this method, total quantities and total costs are considered while computing the average price and not the total of rates divided by total number of rates as in simple average. The weighted average is calculated each time a purchase is made. The quantity bought is added to the stock in hand, and the revised balance is then divided into the new cash value of the stock. The effect of early price is thus eliminated. This method avoids fluctuations in price and reduces the number of calculations to be made, as each issue is charged at the same price until a fresh purchase necessitates the computation of a new average. It gives an acceptable figure for stock values. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 151 Advantages The following are the advantages of the weighted average method: 1. The method is logical and consistent as it absorbs cost while determining the average for pricing material issues. 2. The changes in the prices of materials do not much affect the materials issues and stock. 3. The method follows the concept of total stock and total valuation. 4. Both cost of materials issued and in stock tend to reflect actual costs. Disadvantages However, the weighted average method also has the following disadvantages: 1. Simplicity and convenience are lost when there is too much change in the prices of materials. 2. An average price is not based on actual price incurred, and therefore is not realistic. It follows only arithmetical convenience. Illustrative Problem 6. Prepare a store ledger account on the basis of information given in Illustrative Problem 3 by following the weighted average method. Solution: Receipts Issue Stock Date Qty. Rate Amt Qty. Rate Amt Qty. Rate Amt 2016 500 20 10,000 — —— 500 20 10,000 Jan. 1 300 24 7,200 800 21.50 17,200 Jan. 10 — — 700 21.50 15,050 100 2,150 Jan. 15 — 28 — —— 500 26.70 13,350 Jan. 20 400 — 11,200 200 5,340 Jan. 25 22 — 300 26.70 8,010 700 16,340 Jan. 27 — — — —— 500 11,672 Jan. 31 500 11,000 — 200 23.34 4,668 — Periodic Simple Average In cost accounting, where job costs may be prepared infrequently, say monthly, or bimonthly, it may be necessary to price materials issued by taking the average price ruling during that period. If it is calculated monthly, the average of the unit prices of all the receipts during the month is adopted as the rate for pricing issue during the month. Only a simple calculation has to be done at the end of the accounting period. The opening stock is not considered for computing periodic simple average because it has not been purchased during the current period and would have been included in the previous year’s calculations. However, purchases made during the current year and closing stock CU IDOL SELF LEARNING MATERIAL (SLM)

152 Financial Reporting and Analysis are taken into account while computing this average. Basically, this method follows the principle of simple average price, but a period is set for which the average is calculated. Taking the above example, the total receipts and issue of the materials would be shown as follows: Receipts Issues Qty Rate Amt Qty Rate Amt 1,700 94 39,400 1,200 23.50 28,200 94 = ` 23.50 = The periodic simple average = Total prices of the materials Total No. of prices 4 Closing stock = Units 1700 – 1200 = 500 = ` 39,400 – 28,200 = ` 11,200 The above rate, i.e., ` 23.50 per unit will be used for pricing the materials issued during the period. Periodic Weighted Average This method is quite similar to the weighted average price method with only one difference that in this method average price is not calculated at the time of every new receipt of materials but only periodically. Periodic weighted average is calculated by dividing the total value of the materials purchased during a given period, by the total quantity purchased during the same period. Opening stock—its value and quantity both—are not considered while computing this average. In the above example, the periodic weighed average will be computed as follows: Receipts Issues Qty Rate Amt Qty Rate Amt Total 1,700 23.18 39,400 1200 23.18 27,816 Closing stock quantity = 500 Amount = ` 11,584 Periodic weighted average = Total cost of materials purchased Total quantity purchased = 39,400 1,700 = 23.18 Moving Simple Average Under this method, periodic simple average prices are further averaged. In this way, moving average is obtained by dividing periodic average prices of different periods by the number of periods taken. The periods chosen cover the period in which the material is issued. The following example explains this method. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 153 Months Periodic average price (`) Moving average price (`) January 2.55 2.88 February 2.65 3.02 March 2.72 3.16 April 2.95 3.32 May 3.15 3.46 June 3.25 3.59 July 3.40 August 3.50 3.74 September 3.68 October 3.80 November 3.90 December 4.15 In the above example, moving average has been obtained for a six month period. The moving simple average method will give prices to be used for materials issued which are below the periodic average prices. This will be true when prices are showing an upward trend. In periods of falling prices, the resulting issue prices under the moving average method will be greater than the periodic average prices. This influences the value of closing stock which may be undervalued or overvalued. Moving Weighted Average This method finds the materials issues price by dividing the total of the periodic weighted average prices for a number of periods by the total number of such periods. This is similar to the moving simple average method. C. Normal Price Methods Standard Price This method charges materials issued into the factor at a predetermined budgeted, or estimated price reflecting a normal or an expected future price. A standard price is fixed for each class of materials in advance after making proper investigations. Receipts and issues of materials are recorded in quantities only on the materials ledgers, thereby simplifying the record keeping. The difference between actual price and standard price is transferred to a purchase price variance which reveals to what extent actual costs are different from standard materials cost. Materials are charged into cost of goods sold at the standard price avoiding inconsistencies in different actual cost methods. This method helps in knowing the purchase efficiency. If the total actual cost is less than the standard price, there will be favourable purchasing efficiency and vice versa. This method is simple to operate and provides stability in costing system. However, standard price does not often reflect actual or expected cost, but only a generalised target. The stock value need not show actual cost incurrence and therefore does not necessarily conform to acceptable principles of stock valuation. CU IDOL SELF LEARNING MATERIAL (SLM)

154 Financial Reporting and Analysis Inflated Price This price includes carrying costs, cost of contingencies and also the losses arising out of evaporation, shrinkage, etc. This method aims to cover/recover the full cost of materials purchased. Replacement Price or Market Price Under this method, materials issues are priced at replacement price on the date the issue is made. The replacement cost (market price) is the cost of securing the same type of material at the current moment in time. This method has the following advantages: Advantages 1. The replacement cost approach matches current revenue against current cost and is therefore useful in measuring the operating results of a business firm correctly and accurately. 2. The use of replacement cost brigs out clearly the difference between holding gains and operating gains and financial statement users will have a better understanding of the financial statement. If replacement cost is not used, the profit resulting due to holding of materials and inventory is taxed and therefore, impairs the capital of a business firm. 3. The replacement price, if used, will disclose good or bad buying made by the purchase department of the firm. 4. The replacement cost approach helps in determining a selling price for the product which is competitive and realistic. 5. In case the prices of materials have decreased, the materials should be charged to the production at the current replacement price and the resulting loss should be taken into consideration in the accounts of the firm. Disadvantages However, this method has certain disadvantages. Firstly, the objectivity is lost in accepting the replacement cost as the basis of materials pricing. The “replacement” concept is a relative one and in the absence of market for the materials, no equitable replacement price is determinable. This increases the subjectivity in selection of a current replacement price. Secondly, this is not based on actual cost, that is, cost incurred, and therefore, may add confusion and complications in cost accounting. Thirdly, this method is workable only when market prices are available and reflect current cost of replacing the materials. Illustrative Problem 7. The following are the transactions in respect of purchase and issue of components forming part of an assembly of a product manufactured by a firm which requires to update its cost of production, every often for bidding tenders and finalising cost-plus contracts. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 155 Date Quantity (in Nos.) Particulars 2016 January 5 1,000 purchased at ` 1.20 each February 11 2,000 issued 1 1,500 purchased ` 1.30 each March 18 2,400 issued 26 1,000 issued 8 1,000 purchased at ` 1.40 each 17 1,500 purchased at ` 1.30 28 2,000 issued The stock on 1st January, 2016 was 5,000 Nos. valued at ` 1.10 each. State the method you would adopt in pricing the issue of components giving reasons. What value would be placed on stocks as on 31st March which happens to be the financial year-end and how would you treat the difference in value if any, on the stock account? Solution: Stores Ledger Date Qty. Receipts Amt Qty. Issue Amt Qty. Stock Amt Jan. 1 1,000 Rate 1,200 Rate 5,000 Rate 5,500 1.20 1,000 1,200 6,000 1.10 6,700 5 1,500 1,950 1,000 1.20 1,100 11 1,30 1.10 4,000 4400 1,000 1,400 1,500 1,950 5,500 6,350 Feb. 1 1,500 1.40 1,950 900 1.30 990 18 1.30 1.10 3100 3410 1,000 1.10 1,100 2,100 2,310 26 3,100 3,710 Mar. 8 1,500 1.30 1,950 4,600 5,660 500 1.40 700 17 2,600 3,010 28 2,600 3,010 31 Note: 500 units @ ` 1.40 = ` 700 The closing stock consists of 2,100 units @ ` 1.10 = ` 2,310 2,600 ` 3,010 The stores ledger shows that the value of closing stock based on actual cost is ` 3,010. The last purchase effected on 17th March @ ` 1.30 per unit represents the current market price. On this basis, the value of stock as on 31st March works out to ` 3,380. This is higher than cost. Moreover, in cost books, stocks are shown at cost and not at market value. Hence, no adjustment is otherwise necessary. Illustrative Problem 8. From the records of an oil distributing company, the following summarised information is available for the month of March 2016. CU IDOL SELF LEARNING MATERIAL (SLM)

156 Financial Reporting and Analysis Sales of the month: ` 19,25,000 Opening Stock as on 1st March, 2016: 1.25,000 litres @ ` 6.50 per litre Purchases (including freight and insurance): 5th March 1,50,000 litres @ ` 7.10 per litre 27th March 1,00,000 litres @ ` 7.00 per litre Closing stock as on 31st March, 2016: 1,30,000 litres General administrative expenses for the month: ` 45,000 On the basis of the above information, work out the following using FIFO and LIFO methods of inventory valuation assuming that pricing of issues is being done at the end of the month after all receipts during the month: (a) Value of closing stock as on 31st March, 2016 (b) Cost of goods sold during March 2016 (c) Profit or loss for March 2016 Solution: A. FIFO Method of Pricing Issues Stores Ledger Date Receipts Value ` Qty. litres Issue Value ` Qtylitres Stock Value ` Particulars Qty. litre Rate ` Rate ` 1,25,000 Rate ` 8,12,500 per litre per litre 2,75,000 per litre 1.3.2016 Balance b/d 3,75,000 2,50,000 17,65,000 5.3.2016 Purchases 1,50,000 7.10 10,65,000 8,12,500 6.50 27.3.2016 Purchases 1,00,000 7.00 7,00,000 18,77,500 8,52,000 25,77,500 Issues 16,64,500 (3,75,000 – 1,25,000 6.50 1,30,000 = 2,45,000 1,20,000 710 1,30,000 9,13,000 units) 2,45,000 2,50,000 17,65,000 B. LIFO Method of Pricing Issues Stores Ledger Date Receipts Issue Stock Rate ` Particulars Qty. litre Rate ` Value ` Qty. litres Rate ` Value ` Qty. litres per litre Value ` per litre per litre 1.3.2016 Balance b/d 1,50,000 7.10 10,65,000 1,25,000 6.50 8,12,500 5.3.2016 Purchases 1,00,000 7.00 7,00,000 2,75,000 18,77,500 27.3.2016 Purchases 3,75,000 25,77,500 17,65,000 7.00 7,00,000 Issues 1,00,000 7.10 10,29,500 1,30,000 1,45,000 17,29,500 8,48,000 2,45,000 2,50,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 157 Closing stock, cost of goods sold, profit under FIFO (a) Value of closing stock ` 9,13,000 (b) Cost of goods sold (8,12,500 + 8,52,000) ` 16,64,500 (c) Profit Sales ` 19,25,000 Less: Cost of goods sold ` (16,64,500) General administration expenses ` (45,000) Profit ` 2,15,500 Closing stock, cost of goods sold, profit under LIFO (a) Value of closing stock ` 848,000 17,29,500 (b) Cost of goods sold (7,00,000 + 10,29,500) ` 19,25,000 (c) Profit: Sales ` 17,74,500 1,50,500 Less: Cost of goods sold 17,29,500 General administration expenses 45,00 Profit ` Illustrative Problem 9. Show how the items given ahead relating to purchases and issue of raw material item will appear in the stores ledger card, using weighted average method for issue pricing: Units Price per unit (`) 20 Jan. 1 Opening Balance 300 22 ? Jan. 5 Purchases 200 23 ? Jan. 11 Issue 150 ? Jan. 22 Purchases 200 Jan. 24 Issue 150 Jan. 28 Issue 200 Solution: Store Ledger Account Date Receipts Issue Stock Qty. Rate Qty. Rate Amt Qty. Rate Amt Amt 300 6,000 Jan. 1 — —— —— — 500 10,400 Jan. 5 200 22 4,400 —— — 350 7,280 Jan. 11 — —— 150 20.80 3,120 550 11,880 Jan. 22 200 23 4,600 —— — 400 8,640 Jan. 24 — —— 150 21.60 3,240 200 4,320 Jan. 28 — —— 200 21.60 4,320 CU IDOL SELF LEARNING MATERIAL (SLM)

158 Financial Reporting and Analysis Issue Prices: Jan 11 = 7,280 / 350 = ` 20.80 per unit Jan 24 = 8,640 / 400 = ` 21.60 per unit Jan 28 = 4,320 / 200 =` 21.60 per unit Illustrative Problem 10. The Stock Ledger Account for Material X in a manufacturing concern reveals the following data for the quarter ended 30th September, 2016. Receipts Issues Quantity Price Quantity Price Units ` Units ` July 1 Balance b/d 1,600 2.00 — — July 9 3,000 2.20 — — July 13 Aug. 5 — — 1,200 2,556 Aug. 17 — — 900 1,917 Aug. 24 3,600 2.40 — — Sept. 11 — — 1,800 4,122 Sept. 27 2,500 2.50 — — — — 2,100 4,971 Sept. 29 — — 700 1,656 Physical verification on 30th September, 2016 revealed an actual stock of 3,800 units. You are required to: (a) Indicate the method of pricing employed above. (b) Complete the above account by making entries you would consider necessary including adjustments, if any, and giving explanations for such adjustments. Solution: (a) The verification of the value of issues applied in the problem shows that Weighted Average Method of pricing  ` 2556    has been followed. For example, the issue price of 1200 units of July 13 will be ` 2.13   1200 units  which is the weighted average price of purchase made on July 9 and July 1 opening stock, calculated as follows: Weighted average price (1600 units ´ ` 2) + (3000 units ´ ` 2.20) = 1600 units + 3000 units ` 9800 = 4600 units = ` 2.13 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 159 (b) The complete Stores Ledger account giving the transactions as stated in the problem together with the necessary adjustments is given below: Stores Ledger Account (Weighted Average Method) ` Receipts Issue Stock Date Qty. Rate Amt Qty. Rate Amt Qty. Rate Amt `` `` `` July 1 1600 2.00 3,200 1,600 2.00 3,200 9 3,000 2.20 6,600 4,600 2.13 9,800 13 1200 2.13 2,556 3,400 2.13 7,244 Aug. 5 900 2.13 1,917 2,500 2.13 5,327 17 3,600 2.40 8,640 6,100 2.29 13,967 24 2.29 4,122 4,300 2.29 9,845 1800 Sept. 11 2,500 2.50 6,250 6,800 2.37 16,095 27 2.37 4,971 4,700 2.37 11,124 2100 29 700 2.37 1,656 4,000 2.37 9,468 30 200* 2.37 473 3,800 2.37 8,995 Closing Stock: 3,800 units, value of closing stock = ` 8,995 * Shortage of 200 units has been charged at the weighted average price of the goods in stock. Closing stock 3800 units × ` 2.37 = ` 9,006. Since the figures of issue prices have been taken directly as given in the question, there is a minor difference in the value of closing stock. Illustrative Problem 11. The following transactions in respect of material Y occurred during the six months ended 30th June, 2017. Month Purchase (units) Price per unit (`) Issued (units) January 200 25 Nil February 300 24 250 March 425 26 300 April 475 23 550 May 500 25 800 June 600 20 400 Required: The chief accountant argues that the value of closing stock remains the same, no matter which method of pricing of material issues is used. Do you agree? Why or why not? Detailed stores ledgers are not required Solution: In the given problem, the total number of units purchased from January to May 2017 is 1,900 and the same have also been issued during this period. Thus, there was no stock at the end of May 2017 which could become opening stock for the next month. In June 2017, only a single purchase and a single issue of material was made. The closing stock is of 200 units. In this situation, stock of CU IDOL SELF LEARNING MATERIAL (SLM)

160 Financial Reporting and Analysis 200 units at the end of June, 2017 will be valued at ` 20 per unit irrespective of the pricing method of material issues. Hence, one would agree with the argument of the Chief Accountant. However, this will not be true with the value of closing stock at the end of each month. Moreover, the value of closing stock at the end of June 2017 would have been different under different pricing methods if there were several purchases at different prices and several issues during the month. Illustrative Problem 12. ABC Limited provides you the following information. Calculate the cost of goods sold and ending inventory, applying the LIFO method of pricing raw materials under the Perpetual and Periodical Inventory Control System. Date Particulars Units Per unit cost (`) January 1 Opening Stock 200 10 10 Purchases 400 12 12 Withdrawals 500 — 16 Purchases 300 11 19 Issues 200 — 30 Receipts 100 15 Also, explain in brief the reasons for a difference in profit, if any. Solution: Computation of Cost of Goods Sold and Ending Inventory Particulars Under Perpetual Under Periodic Inventory Method Inventory Method Units ´ Rate Units ´ Rate = Amount = Amount ` ` (i) Cost of Goods sold/withdrawn or issued: On 12th Jan. 400 ´ 12 = 4,800 100 ´ 15 = 1,500 300 ´ 11 = 3,300 100 ´ 10 = 1,000 300 ´ 12 = 3,600 700, ` 8,400 500 5,800 100 ´ 12 = 1,200 On 19th Jan. 200 ´ 11 = 2,200 200 ´ 10 = 2,000 (ii) Ending Inventory Total ` 8,000 300 ` 3,200 100 ´ 10 = 1,000 100 ´ 11 = 1,100 100 ´ 15 = 1,500 300 ` 3,600 Reasons for Difference in Profits. The cost of goods sold/issued/withdrawn is more under Periodic Inventory System as compared to Perpetual Inventory System. Hence, the profit under the CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 161 former will be less as compared to the later. Alternatively, it can be so said that less the amount of ending inventory, less will be the profits. Illustrative Problem 13. The following are the particulars regarding receipts and issues of certain material: Opening stock 1,000 kg @ ` 9.00 per kg Purchased 5,000 kg @ ` 8.50 per kg Issued 600 kg Issued 3,750 kg Issued 650 kg Purchased 2,500 kg @ ` 8 per kg The credit balance of price variance account, before transfer to costing profit and loss account, was ` 500. Calculate the standard rate at which the above issues should be made, and determine the value of closing stock. Solution: The standard price at which the materials were issued in the last period was ` 9. This gave a profit of ` 500. Therefore, this time, materials should be valued at a lower standard price as compared to last period. The standard price for this period should therefore be: Value of the Closing Stocks: Opening stock 1,000 kg @ ` 9 ` 9,000 Purchases 5,000 kg @ ` 8.50 42,500 Purchases 2,500 kg @ ` 8 20,000 8,500 kg 71,500 Less: Issues 5,000 kg @ ` 8.50 42,500 Balance 3,500 units ` 29,000 The value of stock at standard price is ` 29750 (3500 ` 8.50). The stock, therefore, will be valued at ` 29.750 and ` 750 will be debited to the price variance account. D. Specific Identification Method The specific identification method involves: (a) Keeping track of the purchase price of each specific unit; (b) Knowing which specific units are sold; and (c) Pricing the ending inventory at the actual prices of the specific units not sold. CU IDOL SELF LEARNING MATERIAL (SLM)

162 Financial Reporting and Analysis The objective is to match the unit cost of the specific item sold with sales revenue. This method is based on the assumption that each unit purchased, sold or in inventory has its own identity, that it is separate and distinguishable from any other unit. Each unit sold or remaining in inventory is identified and its specific unit cost is used in calculating cost of goods sold or ending inventory cost. To take an example, assume that an art dealer purchased two seemingly identical pieces of pottery during a period. The first piece is purchased for ` 3000 and the second is purchased several months latter for ` 3,500. Assume also that only one of these items is sold by the dealer during the period. The amounts assigned to cost of goods sold and ending inventory will depend on which specific piece of pottery is sold. If the item sold is the first piece of pottery, cost of goods sold is ` 3000 and ending inventory is ` 3,500. On  the other  hand, if  the  second  piece  is the  one sold,  the numbers would be reversed; that is cost of goods sold will be ` 3,500 and ending inventory would be ` 3000. Specific identification is used for inventory items that are not ordinarily interchangeable, whereas FIFO, weighted average cost, and LIFO are typically used when there are large numbers of interchangeable items in inventory. Specific identification matches the actual historical costs of the specific inventory items to their physical flow; the costs remain in inventory until the actual identifiable inventory is sold. FIFO, weighted average cost, and LIFO are based on cost flow assumptions. Under these methods, companies must make certain assumptions about which goods are sold and which goods remain in ending inventory. As a result, the allocation of costs to the units sold and to the units in ending inventory can be different from the physical movement of the items. The specific identification method provides a highly objective procedure for matching costs with sales revenue because the costs flow pattern matches the physical flow of the goods. However, this method does not work for large volumes of identical low-cost items. This method is appropriate for companies that handle a relatively low volume of physical units, each having a high cost per unit such as original oil paintings, antiques, diamonds, automobiles, jewellery, furs, etc. The specific identification method is not appropriate where each unit is the same in appearance but is differentiated from other units through serial numbers, such as the same model of washers, refrigerators or televisions. 4.10 Summary Liabilities are currently existing obligations which a business enterprise intends to meet at some time in future. These are obligations resulting from past transactions that require the firm to pay money, provide goods, or perform services in the future. Liabilities can be classified as current liability and long-term liability. Current liabilities are debtor obligations payable within one year of the balance sheet date. Current liabilities can further be divided into account payable, bills payable, interest payable, wages and salary payable and advances from customers. Long-term liabilities become due after one year. A long-term liability supported by a mortgage is a secured debt. An unsecured debt is one for which the creditor relies primarily on the integrity and general power of the borrower. A contingent liability is not a legal or effective liability rather it is a potential future CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 163 liability. Contingent liabilities are those which will arise in the future only on the occurrence of a specified event. Contingent liabilities are not formally recorded in the accounts system, but appear as footnotes to me balance sheet. Equity is a residual claim—a claim to the assets remaining after the debts to creditors have been discharged. Inventory include tangible property held for sale in course of business or in the process of production for such sale or for consumption in the production of goods or services for sale including maintenance etc. Inventories are kept by manufacturing firms and merchandising (retailing) firms. For merchandising firms, inventories are often the largest or most valuable current asset. Characteristics of Equity: (1) Equity in a business enterprise stems from ownership rights. It involves a relation between an enterprise and its owners as owners rather than as employees, suppliers, customers, lenders or in some other non-owner role. (2) Equity represents the source of distributions by an enterprise to its owners, whether in the form of cash dividends or other distributions of assets. (3) An enterprise may have several types of equity (e.g., equity shares, preference shares, etc.) with different degrees of risk stemming from different rights. (4) Owners equity is originally created by owners’ investments in an enterprise and may from time to time be augmented by additional investments by owners. Inventory includes tangible property that: (i) is held for sale in the normal course of business or (ii) will be used in producing goods or services for sale. Inventories are current asset and reported on the balance sheet and as current assets they can be used or converted into cash within one year or within the next operating cycle of the business, whichever is longer. There are two principal ways of accounting for inventories: (a) Perpetual Inventory System it requires a continuous record of addition to or reductions in material, work-in-progress and cost of goods sold on a day to day basis; (b) Periodic Inventory System under this method, the entire book inventory is verified at a given date by an actual count of materials on hand. This physical inventory is usually taken near the end of accounting period. The following are generally accepted methods of inventory pricing, each based on a different assumption of cost flow: A. Cost Price Methods 1. First-in, First-out (FIFO) Method 2. Last-in, First-out (LIFO) Method B. Average Price Methods 1. Weighted Average Method 2. Periodic Simple Average Method 3. Periodic Weighted Average Method CU IDOL SELF LEARNING MATERIAL (SLM)

164 Financial Reporting and Analysis 4. Moving Simple Average Method 5. Moving Weighted Average Method C. Normal Price Methods 1. Standard Price Method 2. Inflated Price Method 3. Replacement or Market Price Method D. Specific Identification Method First-in, First-out (FIFO) Method: The FIFO method follows the principle that materials received first are issued first. The FIFO method is suitable where: (i) the size and cost of raw materials units are large, (ii) materials are easily identified as belonging to a particular purchased lot, and (iii) not more than two or three different receipts of the materials are on hand at one time. The LIFO method of costing and inventory valuation is based on the principle that materials entering production are the most recently purchased. Weighted Average Method: Under this method, issue of materials is priced at the average cost price of the materials in hand, a new average being computed whenever materials are received. Normal Price Methods: Standard Price: This method charges materials issued into the factor at a predetermined budgeted, or estimated price reflecting a normal or an expected future price. A standard price is fixed for each class of materials in advance after making proper investigations. Receipts and issues of materials are recorded in quantities only on the materials ledgers, thereby simplifying the record keeping. The difference between actual price and standard price is transferred to a purchase price variance which reveals to what extent actual costs are different from standard materials cost. Materials are charged into cost of goods sold at the standard price avoiding inconsistencies in different actual cost methods. This method helps in knowing the purchase efficiency. If the total actual cost is less than the standard price, there will be favourable purchasing efficiency and vice versa. This method is simple to operate and provides stability in costing system. However, standard price does not often reflect actual or expected cost, but only a generalised target. The stock value need not show actual cost incurrence and therefore does not necessarily conform to acceptable principles of stock valuation. Inflated Price: This price includes carrying costs, cost of contingencies and also the losses arising out of evaporation, shrinkage, etc. This method aims to cover/recover the full cost of materials purchased. Replacement Price or Market Price: Under this method, materials issues are priced at replacement price on the date the issue is made. The replacement cost (market price) is the cost of securing the same type of material at the current moment in time. The specific identification method involves: (a) Keeping track of the purchase price of each specific unit; (b) Knowing which specific units are sold; and (c) Pricing the ending inventory at the actual prices of the specific units not sold. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 165 4.11 Key Words/Abbreviations  LIFO: Last-in First-out.  FIFO: First-in First-out.  HIFO: Highest-in First-out. 4.12 Learning Activity 1. Through an error in counting of goods at 31st December, 2015, the ABC company overstated the amount of goods on hand by ` 10,000. Assuming that the error  was not  discovered, what was the effect upon net income for 2015? Upon owners’ equity at 31st December, 2015? Upon net income for year 2016? Upon owners’ equity at 31st December, 2016? _________________________________________________________________ _________________________________________________________________ 2. You have been asked to make an analysis of the financial statements of two companies in the same industry, ABC company and XYZ company. Prices have been increasing steadily for several years. In the course of analysis, you find that the inventory value shown on the ABC company balance sheet is quite close to the current replacement cost of the merchandise on hand. However, for XYZ company, the carrying value of the inventory is far below current replacement cost. What method of inventory valuation is probably used by ABC company? By XYZ company? If it is assumed that the two companies are identical except for the inventory valuation used, which company has probably been reporting higher net income in recent years? _________________________________________________________________ _________________________________________________________________ 3. ACB Company was established in January 2015. The company made the following three purchases of merchandise in chronological order: 1800 units at ` 225 each, 3200 units at ` 240, and 2400 units at ` 265. By early December, the company came to know that 7000 units would be sold by year-end at an average selling price of ` 420. Management decided to purchase an additional 800 units in December at a unit cost of ` 288. The company’s suppliers, anxious to increase 2015 sales, offered a substantial quantity discount if the company triples the size of its order. Under the terms of this offer, the company could buy 2400 units at a unit cost of ` 268. CU IDOL SELF LEARNING MATERIAL (SLM)

166 Financial Reporting and Analysis You are required to explain: (a) What effect, if any, would the December purchase decision have had on ABC company’s FIFO-based financial statements in 2015? (b) What effect, if any, would the December purchase decision have had on ABC company’s LIFO-based financial statements in 2015? _________________________________________________________________ _________________________________________________________________ 4.13 Unit End Questions (MCQ and Descriptive) A. Descriptive Type Questions 1. Compare and contrast FIFO and LIFO as methods of inventory valuation. 2. Discuss the advantages and disadvantages of FIFO method of inventory valuation. 3. Discuss the advantages and disadvantages of LIFO method of inventory valuation. 4. Explain ‘Lower of Cost or Market’ rule for inventory valuation. 5. Explain the factors influencing choice of inventory methods. 6. Explain the following methods of inventory valuation: (a) Standard cost method (b) Replacement cost method. 7. What are the salient features of Ind AS-2 on inventory valuation? 8. Discuss perpetual and periodic inventory system. What are their advantages and disadvantages? 9. Explain the factors influencing choice of inventory methods. 10. What are the implications associated with the selection of inventory methods? 11. Define liabilities. Mention important characteristics of liabilities. 12. “Liabilities are probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or services.” Comment on this statement. 13. Which method(s) would you adopt for the valuation of liabilities? Give reasons. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 167 14. Explain the meaning of the term ‘current liabilities.’ Describe some items accepted as ‘current liabilities’ in financial accounting. 15. “In accounting, current and noncurrent distinction is followed, but yet they are not adequate.” In the light of this statement, explain implications associated with present practice of defining current assets and current liabilities. 16. Distinguish between equity and liabilities. Problems 1. From the following details of stores receipts and issues of material “EXA” in a manufacturing unit, prepare the Stock Ledger using “Weighted Average” method of valuing the issues: Nov. 1 Opening stock 2,000 units @ ` 5 each Nov. 3 Issued 1,500 units to Production Nov. 4 Received 4,500 units @ ` 6.00 each Nov. 8 Issued 1,600 units to production Nov. 9 Returned to stores 100 units by Production Department (from the issues of November, 3) Nov. 16 Received 2,400 units @ ` 6.50 each Nov. 19 Returned to the supplier 200 units out of the quantity received on November 4 Nov. 20 Received 1,000 units @ ` 7.00 each Nov. 24 Issued to production 2,100 units Nov. 27 Received 1,200 units @ ` 7.50 each Nov. 29 Issued to Production 2,800 units (use rates upto two decimal places). [Ans. Cost of issued materials ` 18,256 Closing stock ` 19,558] 2. You are presented with the following information by Sphix Engineering Co. relating to the first week of September, 2017. Materials—The transactions in connection with the materials are as follows: Days Units Rate per unit (`) Issues 1st 40 15.00 Units 2nd 20 16.50 3rd 30 4th 50 14.30 5th 20 6th 40 CU IDOL SELF LEARNING MATERIAL (SLM)

168 Financial Reporting and Analysis Calcualte the cost of materials issued under FIFO method and Weighted Average Method of issue of materials. [Ans. Cost of materials issued Stock Units Amt Units Amt. `` FIFO 90 1359 20 286 Weighted Average 90 1350 20 295] 3. Show the stores ledger entries as they would appear when using: (a) the weighted average method (b) the LIFO method of pricing issues, in connection with the following transactions: April Unit Value 1 Balance in hand 300 600 2 Purchased 200 440 4 Issued 150 460 6 Purchased 200 11 Issued 150 480 19 Issued 200 20 Purchased 200 27 Issued 250 4. On January 1, Mr. G started a small business buying and selling a special yarn. He invested his savings of ` 4,00,000 in the business and during the next six months, the following transactions occurred: Yarn Purchase Yarn Sales Quantity Date of receipt Quantity Total cost Date of Total value despatch boxes (` ) boxes (` ) February 500 April 600 25,000 January 13 200 7,200 June 10 400 27,000 February 8 20 15,200 March 11 400 15200 25 April 12 June 15 600 24,000 400 14,000 500 14,000 The yarn is stored in premises Mr. G. has rented and the closing stock of yarn counted on 30th June was 500 boxes. Other expenses incurred and paid in cash during the six months period amounted of ` 2,300. Required: (a) Calculate the value of the material issued during the six month period and the value of closing stock at the end of June, using the following methods of pricing: CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statements: The Balance Sheet II 169 (i) FIFO (ii) LIFO, and (iii) Weighted average (b) Calculate and discuss the effect each of the three methods of material pricing will have on the reported profit of the business, and examine the performance of the business during the first six month period. [Ans. Closing stock Cost of sales Profit FIFO ` 14,000 ` 19,600 4,500 FIFO ` 19,600 ` 54,800 10,100 Weighted Average ` 16,486 ` 57,914 6,986] 4.14 References 1. Accounting Principles Board, Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, New York: AICPA, 1970, p. 50. 2. Financial Accounting Standards Board, Concept No. 6, Elements of Financial Statements, Stamford: FASB, December 1985, para 35. 3. The Institute of Chartered Accounts of India, Guidance Note on Terms Used in Financial Statements, New Delhi: ICAI, Sept. 1983, p. 19. 4. Financial Accounting Standards Board, Concept No. 6, Elements of Financial Statements, Stamford: FASB, December 1985, paras 60-63. 5. Ahmed Belkaoui, Accounting Theory, Thomson Learning, 2000, p. 168. 6. Eldon S. Hendriksen, Accounting Theory, Irwin, 1984, p. 459. 7. Everett E. Adam, Jr. and Ronald J. Ebert, Production and Operations Management, Englewood Chiffs: Prentice Hall, 1982, p. 464. 8. American Institute of Certified Public Accountants, Accounting Research Bulletin No. 43, AICPA, 1968. 9. International Accounting Standards Committee, Valuation and Presentation of Inventories in the Context of Historical Cost System, IAS-2, March 1976. 10. Financial Accounting Standards Board, Concept No.3, Elements of Financial Statements of Business Enterprises, Stamford: FASB, December 1980, p. 12. CU IDOL SELF LEARNING MATERIAL (SLM)

170 Financial Reporting and Analysis UNIT 5 THE INCOME STATEMENT Structure: 5.0 Learning Objectives 5.1 Introduction 5.2 Revenue-producing Activities 5.3 Revenue Recognition Criteria 5.4 Amount (Measurement of Revenue Recognised) 5.5 Summary 5.6 Key Words/Abbreviations 5.7 LearningActivity 5.8 Unit End Questions (MCQ and Descriptive) 5.9 References 5.0 Learning Objectives After studying this unit, you will be able to:  Describe the concept of revenue  Understand revenue recognition criteria CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 171 5.1 Introduction REVENUE Meaning of Revenues Revenues are earned from the sale of goods or services done by a business entity to the others. The business entity receives or will receive (in future) cash or something else of value. Generally, cash is received immediately from the sale of goods or rendering services. If goods or services are sold on credit, then cash will not be received immediately but at a future date. In this situation, it is assumed that the business enterprise has received/created accounts receivable/debtors. In both the cases, i.e., whether goods and services are sold on cash or credit, revenues are considered to be earned by the business entity. Further, the gross increase in assets’ and capital eventually pertains to cash. Revenues earned results into inflows and gross increase in the value of assets and capital of a business entity and outflows of goods or services from the firm to its customers. Generally, revenues are defined differently taking broader or narrower views about the components of revenue. The Institute of Chartered Accountants of India (ICA-1) defines revenue in its Accounting Standard (AS) No. 9 as following. “Revenue is the gross inflow of cash, receivables or other consideration arising in the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.” Thus, revenues will be increase in asset values in the firm due to the primary operations of the business and on account of production or sales of product or services. The following items are not included within the definition of revenue. (a) Realised gains resulting from the disposal of, and unrealised gains resulting from the holding of non-current assets, e.g., fixed assets; (b) Unrealised holding gains resulting from the change in value of current assets, and the natural increase in the herds and agricultural and forest products; (c) Realised or unrealised gains resulting from changes in foreign exchange rates and adjustments arising on the translation of foreign currency financial statements; CU IDOL SELF LEARNING MATERIAL (SLM)

172 Financial Reporting and Analysis (d) Realised gains resulting from the discharge of an obligation at less than its carrying amount; (e) Unrealised gains resulting from the restatement of the carrying amount of an obligation. Thus, revenue does not include all recognised increases in assets or decreases in liabilities. Receipts of the proceeds of a cash sale is revenue under generally accepted accounting principles because the net result of the sale is a change in owners’ equity. On the other hand, receipts of proceeds of a loan, investment by owners or receipt of an asset purchased for cash, income on investments, gains on the sale of fixed assets are not revenues, as per the accounting standard issued by the ICAI. 5.2 Revenue-producing Activities As stated earlier, revenues arise only from those activities that are designated business operations. These activities are known as earning process or operating cycle of a business enterprise, especially in a manufacturing concern. These activities undertaken by the firm together make a profit and include a fairly long chain of events. In the earning process or operating cycle of a manufacturing concern, the following six critical events (activities) are generally found: 1. Acquisition of resources. 2. Receipt of customer orders. 3. Production. 4. Delivery of goods or performance of services. 5. Collection of cash. It may be mentioned that each of the above critical events is a productive activity, that adds value in some measure to the goods or merchandise purchased. On these grounds, a portion of the ultimate sale price ought to be recognised as revenue as each activity is performed. The difficulty is that the ultimate sale price is the joint product of all activities, and it is impossible to say with certainty how much is attributable to any one of them. For this reason, in accounting, revenue is recognised at a single point in this earning process or operating cycle. The main reasons for choosing a single point or event or activity and not measuring the separate profit contribution of each activity is to have greater objectivity in revenue and income measurement. Obviously, profit cannot be objectively measured at each step of the operating cycle. Revenues, in most cases, are the joint result of many profit-directed activities (events) of an enterprise and revenue is often described as being earned gradually and continuously by the whole of enterprise activities. Earnings in this sense is a technical term that refers to the activities that gave rise to the revenue — purchasing, manufacturing, selling, rendering service, delivering goods, the occurrence of an event specified in a contract and so forth. All of the profit-directed activities of CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 173 an enterprise that comprise the process by which revenue is earned is, therefore, rightly called the earning process. Figure 5.1 illustrates the above activities, constituting the operating cycle or earning process of a typical manufacturing concern. Acquisition of resources Collection of cash Receipts of customer orders Delivery of goods or performance of services Production Fig. 5.1: Operating Cycle or Earning Process of a Manufacturing Concern 5.3 Revenue Recognition Criteria It is generally accepted that revenue is earned throughout all stages of the operating cycle. However, accountants always debate and have problems as to when during the operating cycle can revenue be recorded as earned. For this, some criteria have been developed which are called ‘Revenue Recognition Criteria.’ Recognition criteria are based on the desire for both relevant and reliable accounting information. AS-9 ‘Revenue Recognition’ contains the following criteria for revenue recognition. 1. Revenue Recognised at the Point of Sale: With limited exceptions, revenue is recognised at the point of sale. Generally Accepted Accounting Principles, require the recognition of revenue in the accounting period in which the sale occurs. Throughout the operating cycle, the business enterprise works forward the eventual sale of the goods and collection of the sales price. The enterprise’s earning process should be substantially complete before revenue is recorded. Also, the revenue should be realised before it is recorded in the accounts. Realised means the goods or services are exchanged for cash or claims to cash. It is at the point of sale, then the two important conditions for revenue recognition are met — at that time the revenue is both earned and realised. CU IDOL SELF LEARNING MATERIAL (SLM)

174 Financial Reporting and Analysis 2. Revenue Recognition in Sale of Services: In transaction involving sale or rendering of services, revenues are usually recognised as the services are performed. For services, providing the service is the act of performance. For example, a real estate broker should record sale commission or brokerages as revenues when the real estate transaction is consummated. Revenues from renting hotel rooms are recognised each day the room is rented. Revenues from maintenance contracts are recognised in each month covered by the contract. Revenues from repairing an automobile will be recognised when the repairs have been fully completed. In the repair of automobile, revenues are not recognised in case of partial repairs, because the service is to provide a completed repair job. 3. Revenue Recognition in Construction Work: Some transactions may involve long term constructions and projects that may extend over several years. Examples are construction of roads, dams, large office buildings, bridges, ships, aircrafts, etc. In all such projects, the customer usually provides the product or project specifications. The long-term construction contract has provisions for predetermined amounts the customer must pay at different point and stages of work or suggest a formula that will determine customer payments within the actual project costs plus a reasonable profit. In construction projects, revenues are recognised by the (i) Percentage-completion method or (ii) Completed Contract method. (i) Percentage-completion Method: The percentage-completion method simply allocates the estimated total gross profit on contract among the several accounting periods involved in proportion to the estimated percentage of the contract completed each period. To use this method, we must have a reasonably accurate and reliable procedure for estimating periodic progress on the contract. Most often, estimates of the percentage of contract completion are tied to the proportion of total costs incurred. If the income earned by the work done in the period can be reliably estimated, then revenue is appropriately recognised in each such period. This leads to earlier recognition of revenue. Investors and external users may be informed more promptly of changes in volume of business activity or in the profit rate. Second, this method is likely to report smoother income stream in long cycle operations. Income smoothing is said to occur when a business enterprise selects from among acceptable alternative accounting methods to achieve income results that are relatively stable (i.e., smooth) over time. (ii) Completed Contract Method: Performance consists of the execution of a single act. Alternatively services are performed in more than a single act, and the services yet to be performed are so significant in relation to the transaction taken as a whole that performance cannot be deemed to have been completed until the execution of those acts. The completed contract method is relevant to those patterns of performance and accordingly revenue is recognised when the sole or final act takes place and the service becomes chargeable. As an alternative to percentage-completion method, the completed contract method may be used to account for long-term construction projects. This method recognises revenues upon final approval of the project by the customer, i.e., in effect at delivery. CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 175 Under the completed contract method, cost incurred on a project are treated as assets and held in an asset account (Work-in-progress Account) till the period in which revenue is recognised. An example in taken here to illustrate the percentage-completion method and completed contract method. Assume the following data about a contract to be completed within three years. Year Project Payments Works Percentage Completion Method Complete Contract Method cost received completed 2016 Revenues Expenses Income Revenues Expenses Income 2017 incurred from till date 2018 customer (%) ` 80,000 ` 20 ` ` ` ` `` 2,00,000 60,000 70 90,000 80,000 10,000 – –– 1,20,000 2,05,000 100 2,25,000 2,00,000 25,000 – – -– 1,85,000 1,35,000 1,20,000 15,000 4,50,000 4,00,000 50,000 4,00,000 4,50,000 – 4,50,000 4,00,000 50,000 4,50,000 4,00,000 50,000 In the above example 20%, 50% and 30% of the project work was completed in the years 2016, 2017 and 2018 respectively. It can be noticed that though both the methods report same total income over the entire three year period, entire revenue recognition and matching of expenses has been done in the third year for contract completion method. On the other hand, in percentage completion method, the total income is spread over three years based on percentage of completion. The payments received from the customer are not relevant in determining revenue recognition. 4. Revenue Recognition in Instalment Credit Sales: Many business and merchandising firms sell goods on instalment basis wherein the customer pays a certain amount as instalment on the dates of instalment. In instalment sales revenue is not recognised at the point of sale. The reason is that the amount of income cannot reliably be measured at the point of sale if customers do not pay the future instalments. Therefore, in this case, revenue is recognised when the instalment payments are received. Under the instalment method, the instalment payment received is considered as revenue and a proportionate part of the cost of sales becomes costs in the same period. The cost of the product is allocated by the ratio, cash collected during the period divided by total sales price (total cash expected). The instalment method indicates a conservative picture on revenue recognition; because the sale of the product does not constitute sufficient evidence that revenue has been earned. Only the actual receipt of cash from the customer will provide the evidence required for revenue recognition. Thus, in the instalment method, revenue realisation precedes revenue (profit) recognition, i.e., first instalment money is to be received before it is to be recognised as revenue. 5. Revenue Recognition using Production Method: In some cases, the amount of income that can be earned can be reliably measured as soon as the production is over. For instance, in case of certain grains and other crops, the government announces the price at which the farmers can sell their products. In such cases, although no sales have taken place, revenue can be reliably estimated CU IDOL SELF LEARNING MATERIAL (SLM)

176 Financial Reporting and Analysis at the point when the crops have been harvested. Therefore, revenue can also be recognised at the time of harvest. The ICAI (India) in its Accounting Standard No. 9, states: “At certain stages in specific industries, such as when agricultural crops have been harvested or mineral ores have been extracted, performance may be substantially complete prior to the execution of the transaction generating revenue. In such cases, when sale is assured under forward contract or a government guarantee or where market exists and there is a negligible risk of failure to sell, the goods involved are often valued at net realisable value. Such amounts, not revenue, are sometimes recognised in the statement of profit and loss and appropriately described. 6. Revenue Recognition When a Firm Receives Interest, Royalties and Dividends: A firm may allow others to use its resources and thereby can receive: (i) Interest (ii) Royalties and (iii) Dividends (a) Interests are charges for the use of cash resources or amounts due to the enterprises; (b) Royalties are charges for the use of such assets as know-how, patents, trademarks and copyrights; (c) Dividends are rewards from the holding of investments in shares. Interest accrues, in most circumstances, on the time basis determined by the amount outstanding and the rate applicable. Usually, discount or premium on debt securities held is treated as though it were accruing over the period to maturity. Royalties accrue in accordance with the terms of the relevant agreement and are usually recognised on that basis unless, having regard to the substance of the transactions, it is more appropriate to recognise revenue on some other systematic and rational basis. Dividends from investments in shares are not recognised in the statement of profit and loss until a right to receive payment is established. When interest, royalties and dividends from foreign countries require exchange permission and uncertainty in remittance is anticipated, revenue recognition may need to be postponed. 7. Money Received or Amounts paid in Advance: Sometimes money is received or amounts are billed in advance of the delivery of goods or rendering of services, i.e., before revenue is to be recognised, e.g., rents or amount of magazine subscriptions received in advance. Such items are rightly not treated as revenue of the period in which they are received but as revenue of the future period or periods in which they are earned. These amounts are carried as ‘unearned revenue’, i.e., liabilities, until the earning process is complete. In the future periods when these amounts are recognised as revenues, it results in recording a decrease in a liability rather than an increase in an asset. CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 177 5.4 Amount (Measurement of Revenue Recognised) Revenue is measured in terms of the value of the products or services exchanged and is the amount that customers are reasonably certain to pay. In order to determine the amount likely to be paid by customers and to be recognised as revenue, some adjustments shall be made in the gross sales value of the goods and services sold. These adjustments are as follows: 1. Discounts: Discounts may be generally of two types — trade discount and cash discount. Trade discounts are used in determining the invoice prices, i.e., actual selling price from published catalogs or list price, say list price less 30%. Trade discounts and list prices do not appear in the accounting records of either the purchaser or seller and are disregarded. The amount of trade discount is deducted from the sales figure directly, without showing it as a separate item on the profit and loss account. Thus, the sales revenue will be recorded at not more than the sale value of actual transaction. Trade discounts enable a supplier to vary prices for small and large purchasers and by changing the discount schedules, to alter price periodically without the inconvenience and expense of revising catalogs and price lists. Cash discounts, also known as sales discounts, are the amounts offered to the customers for making prompt payments. To encourage early payment of bills, many firms designate a discount period that is shorter than the credit period. Purchasers who remit payment during this period are entitled to deduct a cash discount from the total payment. The cash discount can be recorded in any of the two ways: (i) If customers are making payment at the time of sales, cash discount can be deducted from gross sales and thus sales revenue will be recorded at the net amount of sales. (ii) If customers are not making payments at the time of sales, but subsequently during the discount period, cash discount can be recorded as an expense of the period and sales revenue, then, will be recorded at the amount of gross sales without deducting the amount of cash discount. 2. Sales Returns and Allowances: Sometimes, the purchasers return a part of goods purchased to the seller if they are dissatisfied with the goods. In these cases, the amount of cash finally to be received can be expected to be less than the stated selling prices. The amounts of sales returns and allowances are therefore deducted from the gross sales and the remaining amount is recognised as the revenue. The amount of sales returns and allowances are shown separately in the profit and loss account and deducted from the gross sales amount. It should be noted that sales returns and allowances deducted from the gross sales of a period may not relate totally to the actual sales of that period. This practice is a deviation from the matching concept but is followed because the amounts of sales returns are difficult to estimate in advance, even at the time of preparing profit and loss account. CU IDOL SELF LEARNING MATERIAL (SLM)

178 Financial Reporting and Analysis 3. Bad Debts: At times, some customers do not make payments and the firm incurs a bad debt expense. Bad debt expense is classified as a selling expense on the profit and loss account, although some business enterprises include it with administrative expenses. The amount of bad debt expense is estimated in advance that will result from a period’s sales in order to show the bad debt expense in the same period. This procedure not only matches bad debt losses with related sales revenue but also results in an estimated realisable amount for debtors and accounts receivables in the balance sheet at the end of the period. The amount of revenue to be recognised for a period should be adjusted for estimated bad debts expenses. This adjustment of revenue is done in the period when revenue is recognised and not in a later period when some customer’s accounts are found to have bad debts to be uncollectible. If the adjustments of bad debts are postponed to future periods, reported income of subsequent periods would be affected by earlier decisions to extend credit to customers or to record bad debts when they occur. Thus, the performance of a business enterprise for the period of sale and the period when a customer’s account is judged uncollectible would be measured inaccurately. 4. Revenue Measurement in Non-cash Transactions: If a sale involves a non-cash transaction or non-cash assets, such as the trading of an old car for a new car, the amount of revenue to be recorded will be the cash equivalent of the goods received or given up, whichever is more clearly determinable. AS-9 ON DISCLOSURE RELATING TO REVENUE RECOGNITION The ICAI’s AS-9 ‘Revenue Recognition’ has the following suggestions with regard to its disclosure. 1. Revenue from sales or service transactions should be recognised when the requirements as to performance set out in points (2) and (3) below are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed. 2. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled: (i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and (ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods. CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 179 3. In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service. 4. Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognised when no significant uncertainty as to measurability or collectability exists. These revenues arc recognised on the following bases: (i) Interest on a time proportion basis taking into account the amount outstanding and the rate applicable. (ii) Royalties on an accrual basis in accordance with the terms of the relevant agreement (iii) Dividends from investment in shares when the owner is to receive payment is established. 5. In addition to the disclosures required by Accounting Standard-1 on Disclosure of Accounting Policies’ (AS-1), an enterprise should also disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties. Notes on Accounts  Notes to Accounts shall present information about the basis of preparation of the financial statements and shall provide where required: (a) narrative description or disaggregation of items recognised in those statements; and (b) information about items that do not qualify for recognition in those statements.  Notes to Accounts shall present information about the specific accounting policies used.  Disclose any information required by IFRSs that is not presented elsewhere in the financial statement.  Each item on the face of the Balance Sheet and Statement of Profit and Loss shall be crossed-referenced to any related information in the Notes to Accounts.  Notes are presented in a systematic manner and cross-referenced from the face of the financial statements to the relevant note.  Other disclosures including contingent liabilities and unrecognised contractual commitments.  Non-financial disclosures such as the entity’s financial risk and management objectives and policies. CU IDOL SELF LEARNING MATERIAL (SLM)

180 Financial Reporting and Analysis 5.5 Summary Revenue are earned from the sale of goods and services done by a business entity to the others though revenue does not include all recognised increases in assets or decreases in liabilities. Items not included within the definition of revenue: (a) Realised gains resulting from the disposal of, and unrealised gains resulting from the holding of non-current assets, e.g., fixed assets; (b) Unrealised holding gains resulting from the change in value of current assets, and the natural increase in the herds and agricultural and forest products; (c) Realised or unrealised gains resulting from changes in foreign exchange rates and adjustments arising on the translation of foreign currency financial statements; (d) Realised gains resulting from the discharge of an obligation at less than its carrying amount; (e) Unrealised gains resulting from the restatement of the carrying amount of an obligation. In the earning process or operating cycle of a manufacturing concern, the following six activities are found: (1) Acquisition of resources, (2) Receipt of customer orders, (3) Production, (4) Delivery of goods or performance of services and (5) Collection of cash. AS-9 contains the following criteria for revenue recognition: revenue recognised: (i) at the Point of Sale, (ii) in Sale of Service, (iii) in Construction work (revenue in construction work is recognised by: (a) Percentage-completion method (Percentage-completion method simply allocates the estimated total gross profit on contract among the several accounting periods involved in proportion to the estimated percentage of the contract completed each period) and (b) Completed Contract method (Completed Contract Method is relevant to those patterns of performance and accordingly revenue is recognised when the sole or final act takes place and the service becomes chargeable. This method recognises revenues upon final approval of the project by the customer, i.e., in effect at delivery), (iv) in Instalment Credit sales, (v) using production method, (vi) when a firm receives interest, royalties and dividends, and (vii) money received or amount paid in advance. Discounts may be generally of two types — trade discount and cash discount. Trade discounts are used in determining the invoice prices, i.e., actual selling price from published catalogs or list price, say list price less 30%. Cash discounts, also known as sales discounts, are the amounts offered to the customers for making prompt payments. AS-9 ‘Revenue Recognition’ suggestions with regard to its disclosure: (1) Revenue from sales or service transactions should be recognised when the requirements as to performance set out in points (2) and (3) below are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed. (2) In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled: (i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 181 retains no effective control of the goods transferred to a degree usually associated with ownership; and (ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods. (3) In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service. (4) Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognised when no significant uncertainty as to measurability or collectability exists. These revenues arc recognised on the following bases: (i) Interest on a time proportion basis taking into accountthe amount outstanding and the rate applicable, (ii) Royalties on an accrual basis in accordance with the terms of the relevant agreement and (iii) Dividends from investment in shares when the owner is to receive payment is established. (5) In addition to the disclosures required by Accounting Standard - 1 on Disclosure of Accounting Policies’ (AS-1), an enterprise should also disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties. (1) Notes to Accounts shall present information about the basis of preparation of the financial statements and shall provide where required (a) narrative description or disaggregation of items recognised in those statements; and (b) information about items that do not qualify for recognition in those statements. (2) Notes to Accounts shallpresent information about the specific accounting policies used Disclose any information required by IFRSs that is not presented elsewhere in the financial statement. (3) Each item on the face of the Balance Sheet and Statement of Profit and Loss shall be crossed-referenced to any related information in the notes to accounts. (4) Notes are presented in a systematic manner and cross-referenced from the face of the financial statements to the relevant note. (5) Other disclosures including contingent liabilities and unrecognised contractual commitments. (6) Non-financial disclosures such as the entity’s financial risk and management objectives and policies. 5.6 Key Words/Abbreviations  AS: Accounting Standard.  ICAI: The Institute of Chartered Accountants of India. CU IDOL SELF LEARNING MATERIAL (SLM)

182 Financial Reporting and Analysis 5.7 Learning Activity 1. The stages of production and sale of a product are as follows (all in Rupees): Stage Activity Costs to Date Net Realisable Value A Raw Materials 10,000 8,000 B WIP 1 12,000 13,000 C WIP 2 15,000 19,000 D Finished Product 17,000 30,000 E Ready for Sale 17,000 30,000 F Sale Agreed 17,000 30,000 G Delivered 18,000 30,000 State and explain the stage at which you think revenue will be recognized and how much would be gross profit and net profit on a unit of this product? _________________________________________________________________ _________________________________________________________________ 2. Nihit Ltd. has an authorised capital of ` 50,00,000 divided into equity shares of ` 10 each. The company invited applications for 3,00,000 shares. Applications for 2,75,000 shares were received. All calls were made and were duly received except the final call of ` 3 per share on 5,000 shares. 4,000 of the shares on which the final call was not received were forfeited. Sow how share capital will appear in the balance sheet of the company. Also prepare notes to accounts. _________________________________________________________________ _________________________________________________________________ 3. Rajeev Ltd. has the following balances on 1st April, 2018: Securities Premium Reserve ` 6,00,000 Statement of Profit and Loss ` 4,00,000 During the year ended 31st March, 2019 it incurred a loss of ` 2,60,000. How would you show these items in the Balance Sheet and Notes to Accounts? _________________________________________________________________ _________________________________________________________________ CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 183 5.8 Unit End Questions (MCQ and Descriptive) A. Descriptive Type Questions 1. What is revenue? What are the rules regarding revenue recognition? 2. Discuss the activities associated with generation of revenue in a manufacturing concern. 3. “The term ‘revenue realisation’ is used in a technical sense by accountants to establish specific rules for the timing of revenue reporting under circumstances where no single solution is necessarily superior to others in the above context of revenue. The realisation concepts has, therefore, become a pragmatic test for the timing of revenue.” In the light of above statement: (a) Explain and justify why revenue is often recognised as earned at the time of sale. (b) Explain in what situations it would be appropriate to recognise revenue as the productivity activity takes place. (c) At what times, other than those included in (a) and (b) above, may it be appropriate to recognise revenue? Explain. 4. What points are considered while measuring revenue? 5. Distinguish between a revenue and a cash receipt. Under what conditions will they be the same? 6. Explain the procedures and justification for using the following methods of revenue recognition: (a) Instalment method and (b) Percentage-completion method. 7. Explain the guidelines and disclosure requirements as given in AS-9 “Revenue Recognition”. B. Multiple Choice/Objective Type Questions 1. Revenue is generally recognised when the earning process is virtually complete and an exchange has taken place. What principle is described herein? (a) Consistency (b) Matching (c) Realisation (d) Conservatism 2. Rent revenue collected one month in advance should be accounted for as: (a) Revenue in the month collected (b) A current liability CU IDOL SELF LEARNING MATERIAL (SLM)

184 Financial Reporting and Analysis (c) A separate item in stockholders’ equity (d) An accrued liability 3. The term ‘revenue recognition’ conventionally refers to: (a) The process of identifying transaction to be recorded as revenue in an accounting period. (b) The process of measuring and relating revenues and expenses of an enterprise for an accounting period. (c) The earning process which gives rise to revenue realisation. (d) The process of identifying those transactions that result in an inflow of assets from customers. 4. Under what conditions, is it proper to recognise revenues prior to the sale of merchandise? (a) When the concept of internal consistency (of amounts of revenue) must be complied with. (b) When the revenue is to be reported as an instalment sale. (c) When the ultimate sale of the goods is at an assured sale price. (d) When management has a long established policy to do so. 5. The percentage-completion method of accounting for long term construction type contracts is preferable when. (a) Estimates of costs to complete and extent of progress towards completion are reasonably dependable. (b) The collectibility of progress billings from the customer is reasonably assured. (c) A contractor is involved in numerous projects. (d) The contracts are of a relatively short duration. 6. The principal disadvantage of using the percentage of completion method of recognising revenue from long-term contract is that it: (a) Is unacceptable for income tax purposes. (b) May require that inter-period tax allocation procedures be used. (c) Give results based upon estimates which may be subject to considerable uncertainty (d) Is likely to assign a small amount of revenue to a period during which much revenue was actually earned. CU IDOL SELF LEARNING MATERIAL (SLM)

The Income Statement 185 7. Revenue recognition: (a) takes place at the point of sale (b) takes place when goods are received (c) may take place only after a purchase order is signed (d) is an objectively, determinable point in time requiring little or no judgement Answers 1. (a), 2. (d), 3. (c), 4. (c), 5. (b), 6. (d), 7. (a) 5.9 References 1. The Institute of Chartered Accountants of India, AS No. 9, Ibid. 2. Financial Accounting Standards Board, Concept No. 3, Elements of Financial Statements Business Enterprises, 1980. 3. FASB, Concept No. 3, Ibid. 4. American Institute of Certified Public Accountants, Accounting Terminology Bulletin No. 2, Proceeds, Revenue Income, Profit and Earnings, AICPA, 1955, p. 2. 5. The Institute of Chartered Accountants of India, AS No. 9, Revenue Recognition, ICAI, 1986, para 4. 6. Financial Accounting Standards Board, Concept Statement No. 6, Elements of Financial Statements, 1985, para 78. 7. FASB, Concept No. 6, Ibid., para 84–86. CU IDOL SELF LEARNING MATERIAL (SLM)

186 Financial Reporting and Analysis UNIT 6 FINANCIAL STATEMENT ANALYSIS I Structure: 6.0 Learning Objectives 6.1 Introduction 6.2 Objectives of Financial Statement Analysis 6.3 Techniques of Financial Statement Analysis 6.4 Common Size Statements 6.5 Summary 6.6 Key Words/Abbreviations 6.7 Learning Activity 6.8 Unit End Questions (MCQ and Descriptive) 6.9 References 6.0 Learning Objectives After studying this unit, you will be able to:  describe and draft a report on intra-firm and inter-firm comparison  perform financial statement analysis for management control purposes  prepare and interpret common size statements of income and financial position 6.1 Introduction Financial Statement Analysis is an analysis which highlights important relationships in the financial statements. Financial statement analysis embraces the methods used in assessing and interpreting the results of past performance and current financial position as they relate to particular factors of CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 187 interest in investment decisions. It is an important means of assessing past performance and in forecasting and planning future performance. According to Lev1, “Financial Statement Analysis is an information processing system designed to provide data for decision making models, such as the portfolio selection model, bank lending decision models, and corporate financial management models.” 6.2 Objectives of Financial Statement Analysis The major objective of financial statement analysis is to provide decision makers information about a business enterprise for use in decision making. Users of financial statement information are the decision makers concerned with evaluating the economic situation of the firm and predicting its future course. Financial statement analysis can be used by the different users and decision makers to achieve the following objectives: 1. Assessment of Past Performance and Current Position: Past performance is often a good indicator of future performance. Therefore, an investor or creditor is interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance. Similarly, the analysis of current position indicates where the business stands today. For instance, the current position analysis will show the types of assets owned by a business enterprise and the different liabilities due against the enterprise. It will tell what the cash position is, how much debt the company has in relation to equity and how reasonable the inventories and receivables are. 2. Prediction of Net Income and Growth Prospects: The financial statement analysis helps in predicting the earning prospects and growth rates in the earnings which are used by investors while comparing investment alternatives and other users interested in judging earning potential of business enterprises. Investors also consider the risk or uncertainty associated with the expected return. The decision makers are futuristic and are always concerned with the future. Financial statements which contain information on past performances are analysed and interpreted as a basis for forecasting future rates of return and for assessing risk. 3. Prediction of Bankruptcy and Failure: Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. After being aware about probable failure, both managers and investors can take preventive measures to avoid/minimise losses. Corporate managements can effect changes in operating policy, reorganise financial structure or even go for voluntary liquidation to shorten the length of time losses. In accounting and finance area, empirical studies conducted have suggested a set of financial ratios which can give early signal of corporate failure. Such a prediction model based on financial statement analysis is useful to managers, investors and creditors. Managers may use the ratios CU IDOL SELF LEARNING MATERIAL (SLM)

188 Financial Reporting and Analysis prediction model to assess the solvency position of their firms and thus can take appropriate corrective actions. Investors and shareholders can use the model to make the optimum portfolio selection and to bring changes in the investment strategy in accordance with their investment goals. Similarly, creditors can apply the prediction model while evaluating the creditworthiness of business enterprises. 4. Loan Decision by Financial Institutions and Banks: Financial statement analysis is used by financial institutions, loaning agencies, banks and others to make sound loan or credit decision. In this way, they can make proper allocation of credit among the different borrowers. Financial statement analysis helps in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date, etc. 6.3 Techniques of Financial Statement Analysis Various techniques are used in the analysis of financial data to emphasise the comparative and relative importance of data presented and to evaluate the position of the firm. Among the more widely used of these techniques are the following: (i) Comparative statements (ii) Common size statements (iii) Trend analysis (iv) Ratio analysis Comparative Statements Comparative analysis of financial statements refers to “over the period comparison” of various figures to understand the change and rate of change. It involves simultaneous presentation and analysis of income statements or balance sheets of the same firm for two or more accounting periods (intra-firm) or for different firm over an accounting period (inter-firm). Horizontal analysis is used for the same. The percentage analysis of increases and decreases in corresponding items in comparative financial statements is called horizontal analysis. Horizontal analysis involves the computation of amount changes and percentage changes from the previous to the current year. The amount of each item on the most recent statement is compared with the corresponding item on one more earlier statements. The increase or decrease in the amount of the item is then listed, together with the per cent of increase or decrease. When the comparison is made between two statements, the earlier statement is used as the base. If the horizontal analysis includes three or more statements, there are two alternatives in the selection of the base. First, the earliest date or period may be used as the basis for comparing all later dates or periods: or second, each statement may be compared with the immediately preceding statement. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 189 Figures 6.1 and 6.2 present the comparative balance sheet and profit and loss account respectively of a company with the amount of increase or decrease and percentage changes shown. The percentage change is computed as follows: Amount of change Percentage change = Previous year amount × 100 ABC LTD. BALANCE SHEET 31st March, 2016 and 31st March 2017 Particulars (in `000) (Increase (Decrease) 2016 2017 Amount Percentage I. Equity and Liabilities 40,000 45,000 5,000 12.50 1. Shareholders’ Funds 19,024 20,800 1,776 9.34 (a) Share Capital (b) Reserves and Surplus 10,000 11,000 1,000 10.00 2. Non-current Liabilities 6,000 2,000 –4,000 –66.67 (a) Long-term borrowings 4,000 3,000 –1,000 –25.00 (b) Other long-term liabilities (c) Long-term provisions 300 325 25 8.33 3. Current Liabilities 3,200 4,275 1075 33.59 (a) Short-term borrowings –100 20.00 (b) Trade payables 500 400 10.77 (c) Other current liabilities 8,576 9,300 924 5.13 (d) Short-term provisions 4700 Total 91,600 96,300 II. Assets 44,440 45,600 1160 2.61 1. Non-current Assets 700 800 100 14.29 (a) Fixed assets 500 800 160.00 (i) Tangible assets 1300 (ii) Intangible assets 25,600 4,200 16.41 (b) Non-current investments 13,000 29,800 –1,000 –7.69 2. Current Assets 12,000 –1,700 –32.69 (a) Inventories 5,200 39.09 (b) Trade receivables 1,760 3500 1,040 25.00 (c) Cash and cash equivalents 2,800 100 (d) Short-term loans and advances 400 5,200 5.13 (e) Other current assets 4,700 Total 91,600 96,300 Fig. 6.1: Balance Sheet CU IDOL SELF LEARNING MATERIAL (SLM)

190 Financial Reporting and Analysis ABC LTD. STATEMENT OF PROFIT AND LOSS 31st March, 2016 and 31st March, 2017 Particulars (in `000) (Increase/Decrease) Amount Percentage I. Revenue from operations 2016 2017 II. Other Incomes III. Total Revenue (I + II) 37,02,000 39,11,000 2,09,000 5.65 IV. Expenses: 44,000 55,000 11,000 25.00 Cost of materials consumed 37,46,000 39,66,000 2,20,000 5.87 Purchase of Stock-in-trade Changes in inventories of 12,39,500 16,00,000 3,60,500 29.08 finished goods, work-in-progress and stock-in-trade –1,00,000 –1,10,000 –10,000 10.00 Employee benefit expense 11,04,000 12,50,000 1,46,000 13.22 Financial costs –20.00 Depreciation and amortisation expense 25,000 20,000 –5,000 2.00 Other expenses 50,000 51,000 1,000 –3.23 Total Expenses 4,96,000 4,80,000 16.93 V. Profit before tax (III – IV) 28,14,500 32,91,000 –16,000 –27.54 VI. Tax expense: 9,31,500 6,75,000 4,76,500 1. Current tax –2,56,500 –27.54 2. Deferred tax 4,65,750 3,37,500 VII. Profit/Loss for the period 0 0 –1,28,250 –27.54 VII. Earning per equity share: Basic –27.54 4,65,750 3,37,500 –1,28,250 46.58 33.75 –12.83 Fig. 6.2: Profit and Loss Statement Importance of Comparative Statements:  It makes the data more simpler and understandable  It indicates the trend of change by putting the figures of different items for a number of years side by side.  It indicates the strong and the weak points of the concern  It compares the firm’s performance with the average performance of the industry.  It helps in forecasting the profitability and financial soundness of the business. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 191 6.4 Common Size Statements Common size statements involve expressing comparisons in percentages. Common size statements may be prepared in order to compare percentages of a current period with past periods, to compare individual business, or to compare one business with industry percentages published by trade associations and financial information services. Common size financial statements contain the percentages of a key figure alone, without the long corresponding amount figures. The use of percentages is usually preferable to the use of absolute figures. An illustration will make this clear. If company A earns `10,000 and Company B earns ` 1,000, which is more profitable? The answer is likely to be company A. However, the total shareholders equity of company A is ` 10,00,000 and company B is ` 10,000, the return on equity will be as follows: Earnings Return on Equity = Equity Company A ` 10,000 Company B = ` 10,00,000 = 1% ` 1,000 = ` 10,000 = 10% Comparing the return on equity, it can be clearly said that company B is more profitable than company A. The use of common size statements can make comparisons of business enterprises of different sizes much more meaningful since the numbers are brought to common base, i.e., per cent. Such statement allows an analyst to compare the operating and financing characteristics of may two companies of different sizes in the same industry. Care must be exercised in the use of common size statements when the absolute figures are small, because a small absolute change can result in a very substantial percentage change. For example, if net profits last year amounted to `1,000 and increased this year to `5,000, this would be an increase of only `4,000 in net profits, but represents a substantial increase in percentage terms. Common size statements can be prepared in vertical analysis and horizontal analysis from formats. In vertical analysis format, a figure from a year is compared with a base selected from the same year. For example, if advertising expenses were `10,000 in 2016 and sales ` 10,00,000, then the advertising expenses will be 1% of sales. In horizontal analysis format, the amount of an item (an account) is expressed in terms of that same account figure for a selected base year. For example, if sales were `8,00,000 in 2016 and `12,00,000 in 2017, then sales increased to 150% of the 2016 level in 2017, an increase of 50%. CU IDOL SELF LEARNING MATERIAL (SLM)

192 Financial Reporting and Analysis Vertical Analysis uses percentages to show the relationship of the different parts to the total in a single statement. Vertical analysis sets a total figure in the statement equal to 100% and computes the percentage of each component of that figure. The figure to be used as 100% will be total assets or total liabilities and equity capital in the case of balance sheet and revenue or sales in the case of the profit and loss account. The same has been presented with the help of following examples (see Figures 6.3 and 6.4) ABC LTD. STATEMENT OF PROFIT AND LOSS 31st March, 2016 and 31st March, 2017 Particulars (in `000) (Increase/Decrease) 2016 % 2017 % I. Equity and Liabilities 40,000 43.67 45,000 46.73 1. Shareholder’s Funds 19,024 20.77 20,800 21.60 (a) Share capital (b) Reserves and surplus 10,000 10.92 11,000 11.42 2. Non-current Liabilities 6,000 6.55 2,000 2.08 (a) Long-term borrowings 4,000 4.37 3,000 3.12 (b) Other long-term liabilities (c) Long-term provisions 300 0.33 325 0.34 3. Current Liabilities 3,200 3.49 4,275 4.44 (a) Short-term borrowings 0.55 0.42 (b) Trade payables 500 9.36 400 9.87 (c) Other current liabilities 8,576 9,500 (d) Short-term provisions Total 91,600 100.00 96,300 100 II. Assets 44,440 48.52 45,600 47.35 700 0.76 800 0.83 1. Non-current assets 500 0.55 1.35 (a) Fixed assets 1,300 (i) Tangible assets 25,600 27.95 (ii) Intangible assets 13,000 14.19 29,800 12.46 (b) Non-current investments 5,200 5.68 12,000 3.63 1,760 1.92 3,500 2.91 2. Current Assets 0.44 2,800 0.52 (a) Inventories 400 (b) Trade receivables 500 (c) Cash and cash equivalents (d) Short-term loans and advances (e) Other current assets Total 91,600 100 96,300 100 Fig. 6.3: Statement of Profit and Loss CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 193 ABC LTD. STATEMENT OF PROFIT AND LOSS 31st March, 2016 and 31st March, 2017 Particulars (in `000) (Increase (Decrease) 2016 % 2017 % I. Revenue from operations 37,02,000 100.00 39,11,000 100.00 II. Other Income 44,000 1.19 55,000 1.41 III. Total Revenue (I +11) 37,46,000 101.19 39,66,000 101.41 IV. Expenses: Cost of materials consumed: Purchase of stock-in-trade 12,39,500 33.48 16,00,000 40.91 Changes in inventories of finished goods, –1,10,000 –2.81 12,50,000 31.96 work-in-progress and stock-in-trade –1,00,000 –2.70 0.51 20,000 1.30 Employee benefit expense 11,04,000 29.82 51,000 12.27 4,80,000 84.15 Financial costs 25,000 0.68 32,91,000 17.26 6,75,000 Depreciation and amortization expense 50,000 1.35 8.63 3,37,500 0 Other expenses 4,96,000 13 40 3,37,500 8.63 Total Expenses 28,14,500 76.03 33.75 V. Profit before tax (III – IV) 9,31,500 25.16 VI. Tax expense: 1. Current tax 4,65,750 12.58 2. Deferred tax 0 VII. Profit/(Loss) for the period 4,65,750 12.58 VIII. Earning per equity share: Basic 46.58 Fig. 6.4: Statement of Profit and Loss Importance of Common Size Statements Analysis of financial statement with the help of common size statement is more useful. Because the financial statement of different firms can be converted into uniform common size format irrespective of the size of individual item. Common size income statements establishes relationship between sales and other items of income statement and this relationship is helpful in evaluating operational activities of a business firm. Whereas, a Common Size Balance Sheet is very useful for comparing the profitability and financial position of two more business firms. Significance of Financial Analysis In the words of Gerstenberg, “The management can measure the effectiveness of its own policies and decisions, determine the advisability of adopting new policies and procedures and documents to owners, the results of their managerial efforts.” CU IDOL SELF LEARNING MATERIAL (SLM)

194 Financial Reporting and Analysis (i) Significance for Management: Management of a firm is always interested in the solvency, profitability and the capital structure of the firm. They want to make sure that the business must be in a solvent position to pay the debts as and when they fail due. They are also interested not only in the current years profit but also in the capacity of the business to earn more profits in future. By comparing the financial statements of their business with the financial statements of other rims in the same area it can draw significant conclusions about the sales, profits, expenses, etc. (ii) Significance for Creditors: Short-term creditors want to know the liquidity of the business whether the company will have sufficient current assets and cash to pay their debts or not. Current ratio and quick ratio calculated on the basis of financial statements help them in assessing this. On the other hand, long-term creditors want to know that whether the company will be able to pay the interest consistently, and whether the company will be able to pay their debts when they fall due. With the help of interest coverage ratio, they can find out whether the company will be able to pay the interest regularly or not on the basis of debt-equity ratio they can find out whether the company will be able to pay their debts on maturity. (iii) Significance for Investors: Investors and shareholders of the business are interested in the longevity of the firm. Therefore, they want to know the earning capacity of the business and its prospects for future growth and prosperity. Analysing the financial statements helps in assessing the capacity of the business to pay dividend at a higher rate and also the safety of their investments. (iv) Significance for Government: Government can judge on the basis of analysis of financial statements, which industry is progressing on the desired way and which industry is in actual need of financial help. Government can take decision to reduce the GST in those industries where the profit margins are low in comparison to the cost of production. On the other hand, if the profit margins are too high in comparison to the cost of production, Government can increase the GST or can enforce the price regulation. (v) Significance for Employees: Employees on the basis of profitability can ascertain as to how much bonus and increase in their wages is possible from the profits of the company. Analysis of the financial statements also help the trade unions in negotiating wage agreements. (vi) Significance for Stock Exchange Authorities: By analysing the financial statements they determine the price earning ratio and earning per share with the help of which the market price of a company’s share is determined. (vii) Significance for Financial Institutions: All the financial institutions which provide finance to the industries such as banks, insurance companies, etc. want to know the profit earning capacity of the businesses and its long-term solvency. They want to assess not only the present position of the business enterprise but also its likely position in the future. (viii) Significance for Taxation Authorities: They analyse the financial statement of a company CU IDOL SELF LEARNING MATERIAL (SLM)