BASICS OF ACCOUNTING

CHAPTER 1: WHAT IS ACCOUNTING?

1.1 The Story of Accounting

Imagine you run a small shop. Every day you buy goods, sell them, pay rent, and receive money. After a few
weeks, you might wonder: Am I actually making a profit? Where did all the money go? How much do I owe
people, and how much do others owe me?

This is exactly the problem that Accounting solves. Accounting is the system that records, organises, and
reports all financial activities of a business so that the owner and others can understand what is really
happening.

Official Definitions

Definition 1 — AICPA (1961)

"Accounting is the art of recording, classifying and summarising in a significant manner and in terms
of money, transactions and events which are, in part at least, of a financial character, and interpreting
the results thereof."

Definition 2 — American Accounting Association (1966)

"The process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by the users of accounting."

In Simple Words

Accounting is the language of business. Just like we use words to communicate with people, businesses use
accounting figures to communicate their financial story. It tells you:

•​ Whether the business is making a profit or a loss

•​ What assets (things owned) and liabilities (amounts owed) the business has
•​ How much cash is coming in and going out
•​ Whether the business is financially healthy

1.2 Objectives of Accounting

Why do we keep accounts? Here are the five main reasons:

Accounting and Financial Statement Analysis | Study Notes

 # Objective What it means
1 Decision Making Records help owners, banks, and investors make smart financial
decisions.
2 Systematic Every transaction is written down in an organised way so nothing is
Recording missed or forgotten.
3 Ascertain Results At the end of each year, a Profit & Loss Account is prepared to know
the net result.
4 Financial Position A Balance Sheet shows what the business owns and owes on a specific
date.
5 Solvency Position It shows whether the business can pay its debts and meet its
obligations.

1.3 Types of Accounting

Type Purpose
Financial Accounting Records and reports what happened — profit/loss and financial
position. Prepared for outsiders like banks and investors.
Cost Accounting Tracks costs of producing goods/services. Helps control expenses and
improve efficiency.
Management Accounting Provides information to managers for planning, decisions, and internal
control.

Accounting and Financial Statement Analysis | Study Notes

 CHAPTER 2: KEY ACCOUNTING TERMS

Before you can understand accounting, you need to learn its vocabulary. Think of these as the alphabet of
accounting.

Any event involving the exchange of money or money's worth between two
Transaction
parties. Example: Buying goods for Rs. 5,000 is a transaction.

Anything of value owned by the business that will help generate future profit.
Asset
Example: Cash, machinery, land, computers, vehicles.

Money the business owes to others. Example: Loan from bank, amount owed
Liability
to a supplier.

Money invested into the business by the owner. It is shown as a liability

Capital
because the business owes it back to the owner.

Money or goods taken out of the business by the owner for personal use. It
Drawings
reduces capital.

Income earned from the regular business activities. Example: Sales income,
Revenue
service fees received.

Expense Money spent to run the business. Example: Rent, salaries, electricity bills.

Profit When total income is more than total expenses. Profit = Income - Expenses.

When total expenses are more than total income. It reduces the owner's
Loss
capital.

A person who owes money to the business. Example: A customer who bought
Debtor
goods on credit.

A person to whom the business owes money. Example: A supplier who gave
Creditor
goods on credit.

Stock / Inventory Goods available for sale in the business. It is an asset.

A document that proves a transaction happened. Example: A bill, receipt, or

Voucher
invoice.

Trade Discount A reduction given at the time of sale. It is NOT recorded in the books.

Accounting and Financial Statement Analysis | Study Notes

 Cash Discount A reduction given to encourage early payment. It IS recorded in the books.

Remember!
Current Assets are assets that can be converted to cash within one year (e.g. debtors, stock, cash).
Fixed Assets are held for long-term use (e.g. land, machinery, furniture). Current Liabilities are
payable within one year (e.g. outstanding salaries, short-term loans). Long-term Liabilities are
payable after one year (e.g. bank loans, debentures).

Accounting and Financial Statement Analysis | Study Notes

 CHAPTER 3: ACCOUNTING CONCEPTS & CONVENTIONS

Accounting is not random. It follows a set of rules and principles to make sure all businesses record and
report their finances in a consistent and honest way. These rules are called Accounting Concepts and
Conventions.

Think of these like the traffic rules of accounting. Everyone follows the same rules so there is order and
everyone understands the reports.

3.1 Basic Assumptions

A. Business Entity Concept

The business is treated as completely separate from its owner. Even if Raj owns a shop, the shop's money
and Raj's personal money are always kept separate.

Example
If Raj takes Rs. 2,000 from the shop's cash for his personal groceries, it is recorded as 'Drawings' in
the business books — not as a normal business expense.

B. Going Concern Concept

We assume the business will continue operating for a long time into the future and will not shut down. This
is why assets are recorded at their historical cost and not at the price they would fetch if the business closed
down tomorrow.

Example
A machine bought for Rs. 1,00,000 is shown at cost (less depreciation) in the books, not at its scrap
value of Rs. 5,000 — because we assume the business will keep using it.

C. Money Measurement Concept

Only those events that can be expressed in money (rupees) are recorded in accounting books. Non-financial
events — even if important — are not recorded.

Example
If a company has a very hardworking and talented manager, this fact cannot be recorded in accounts
because it has no monetary value assigned to it.

Accounting and Financial Statement Analysis | Study Notes

D. Accounting Period Concept

Business activities are divided into fixed time periods (usually one year) for reporting purposes. This helps
compare performance year after year. In India, the accounting period is typically April 1 to March 31.

Example
Even though a business runs continuously, we prepare a Profit & Loss Account for each year
separately. So profits are calculated for January to December or April to March.

E. Accrual Concept

Revenue and expenses are recorded when they are earned or incurred, NOT when the cash is actually
received or paid. This gives a more accurate picture of the business.

Accrual Basis (Correct) Cash Basis (Incomplete)

Rent of December is recorded in December even Rent is only recorded when the cash is paid in
if paid in January. January.
Sales made in March on credit are shown as Sales are only recorded when cash is collected
March income. next month.

3.2 Basic Principles

F. Realization Concept
Income is recognised only when it is actually earned — either cash is received OR a legal right to receive it
is established (like raising an invoice or transferring goods).

Example
If you receive an advance payment for goods to be delivered next month, it is NOT income yet. It
becomes income only when the goods are delivered.

G. Matching Concept
Expenses should be matched with the revenue they helped to generate, in the same accounting period. This
ensures the profit figure is accurate.

Example
If salaries for March are paid in April, they are still shown as March's expense because those
employees worked in March to generate March's revenue.

H. Historical Cost Concept

Accounting and Financial Statement Analysis | Study Notes

 Assets are always recorded at their original purchase price (historical cost), not at their current market value.
The purchase price is an objective fact; market value keeps changing.

Example
Land bought for Rs. 10 lakh 10 years ago may be worth Rs. 50 lakh today. In the books, it is still
shown at Rs. 10 lakh (less any depreciation or adjustments).

I. Full Disclosure Concept

All significant and relevant information must be disclosed in the financial statements so that users can make
informed decisions. Nothing material should be hidden.

J. Dual Aspect / Duality Concept

Every transaction has two aspects — something is received and something is given. This is the foundation of
the Double Entry System. Every debit must have an equal and opposite credit.

Example
When you buy goods for Rs. 5,000 cash: Goods (asset) INCREASES by Rs. 5,000 and Cash (asset)
DECREASES by Rs. 5,000. Both sides are always equal.

3.3 Modifying Principles (Conventions)

K. Conservatism / Prudence
When in doubt, always choose the option that shows LESS profit or LOWER asset value. Record all known
losses immediately, but do not record profits until they are certain.

Example
If there is a chance some debtors will not pay, create a 'Provision for Bad Debts' immediately (to
reduce profit). But if you expect profits to increase next year, do NOT record those expected profits
now.

L. Consistency Concept
Once a method is chosen (e.g. valuing stock using FIFO or LIFO; using straight-line depreciation), keep
using the SAME method year after year. This makes results comparable across periods.

Example
If you valued stock using FIFO in Year 1, use FIFO in Year 2 as well. Changing methods just to show
better profits is not acceptable without disclosure.

Accounting and Financial Statement Analysis | Study Notes

M. Materiality Concept
Only significant (material) information needs to be separately disclosed. Very small, insignificant amounts
can be grouped together or treated simply without elaborate procedures.

Example
A stapler worth Rs. 50 need not be capitalised as a fixed asset even though it lasts 3 years. It can
simply be expensed out as stationery because the amount is immaterial.

Accounting and Financial Statement Analysis | Study Notes

CHAPTER 4: TYPES OF ACCOUNTS & GOLDEN RULES

In accounting, every item involved in a transaction belongs to a specific type of account. Once you know the
type, you apply the corresponding Golden Rule to decide whether to Debit or Credit it.

4.1 The Three Types of Accounts

Type What it includes Examples

Personal A/c Natural persons (individuals), Ram's A/c, SBI Bank A/c, Salary Payable A/c,
artificial persons (companies, Capital A/c
banks), representative accounts
(outstanding salaries)
Real A/c Tangible assets (can be Cash A/c, Machinery A/c, Stock A/c (tangible);
seen/touched) and Intangible Goodwill A/c, Patent A/c (intangible)
assets (cannot be touched but
have value)
Nominal A/c All expenses, losses, incomes, Salary A/c, Rent A/c, Commission Received
and gains. These accounts are A/c, Loss by Fire A/c
closed at year-end and
transferred to P&L Account.

4.2 The Golden Rules of Debit and Credit

These three Golden Rules tell you WHAT to debit and WHAT to credit for each type of account. Memorise
these — they are the heart of accounting.

Account Type DEBIT CREDIT

Personal A/c Debit the Receiver (who receives Credit the Giver (who gives benefit /
benefit / owes money to business) from whom business receives)

Real A/c Debit what comes IN to the business Credit what goes OUT of the business
(asset increasing) (asset decreasing)

Nominal A/c Debit all Expenses and Losses (money Credit all Incomes and Gains (money
going out for nothing) coming in for services given)

4.3 Applying the Golden Rules — Worked Examples

Transaction DEBIT CREDIT Reason

Started business with Rs. Cash A/c Capital A/c Cash (Real) comes IN. Owner
50,000 cash (Personal) gives the money.

Accounting and Financial Statement Analysis | Study Notes

 Bought goods for Rs. 10,000 Purchases Cash A/c Purchases (Nominal) = expense.
cash A/c Cash (Real) goes OUT.
Sold goods for Rs. 15,000 cash Cash A/c Sales A/c Cash (Real) comes IN. Sales
(Nominal) = income.
Paid rent Rs. 3,000 Rent A/c Cash A/c Rent (Nominal) = expense. Cash
(Real) goes OUT.
Bought goods on credit from Purchases Suresh A/c Purchases = expense (Nominal).
Suresh A/c Suresh (Personal) is the giver.
Received commission Rs. Cash A/c Commissio Cash (Real) comes IN. Commission
2,000 n A/c (Nominal) = income.
Paid salary Rs. 5,000 Salary A/c Cash A/c Salary (Nominal) = expense. Cash
(Real) goes OUT.

Accounting and Financial Statement Analysis | Study Notes

CHAPTER 5: THE ACCOUNTING EQUATION

The Accounting Equation is the foundation of the entire Balance Sheet. Every single transaction in
accounting is based on this one simple equation:

ASSETS = LIABILITIES + CAPITAL (Owner's Equity)

This equation always balances. It can also be rearranged:

•​ Capital = Assets − Liabilities (Owner's claim = what is left after paying all debts)
•​ Liabilities = Assets − Capital (Creditor's claim = total assets minus owner's share)

Why does it always balance?

Because of the Dual Aspect Concept — every transaction affects two accounts equally. If assets go
up, either liabilities go up OR capital goes up by the same amount. The equation never breaks.

5.1 The Equation in Action — Step by Step

Let us trace a few transactions and see how the equation stays balanced every time:

Transaction Assets Liabilities Capital

1. Started business with Rs. Cash +20,000 — +20,000 (Capital)
20,000 cash
2. Bought goods worth Rs. 5,000 Stock +5,000 +5,000 —
on credit (Creditor)
3. Sold goods costing Rs. 2,000 Cash +3,000 | Stock -2,000 — +1,000 (Profit =
for Rs. 3,000 cash Capital)
4. Paid rent Rs. 500 cash Cash -500 — -500 (Expense =
Capital)
5. Paid creditor Rs. 2,000 cash Cash -2,000 -2,000 —
(Creditor)

RATIO ANALYSIS

Accounting and Financial Statement Analysis | Study Notes

 📖 What is Ratio Analysis?
Ratio analysis is a method of evaluating a company's financial performance by calculating mathematical
relationships between numbers found in financial statements — mainly the Balance Sheet, Income Statement,
and Cash Flow Statement.

Think of ratios like a doctor's checkup for a company. Instead of checking blood pressure or heart rate, we
check profitability, liquidity, and efficiency. A single number in isolation (like 'profit = ₹5 crore') doesn't tell
us much. But a ratio gives us context — is that profit good relative to sales? Relative to assets used? That's
what ratios reveal.

Where do the numbers come from?

▸ Balance Sheet → Assets, Liabilities, Equity (a snapshot at one point in time)
▸ Income Statement → Revenue, Expenses, Profit (over a period of time)
▸ Cash Flow Statement → Cash inflows and outflows

Why do we use Ratio Analysis?

▸ To compare a company's performance over different years (Trend Analysis)
▸ To compare one company against competitors or industry benchmarks
▸ To identify strengths, weaknesses, and financial risks early
▸ Used by investors, lenders, managers, and regulators

💡 Remember: There is no single 'perfect' ratio. Always look at a combination of ratios and compare
them to industry norms or historical data for meaningful conclusions.

Accounting and Financial Statement Analysis | Study Notes

 📊 Five Categories of Ratios — Quick Overview
Category Core Question It Answers Key Ratios Included

1. Can the company pay its Current Ratio, Quick Ratio, Cash Ratio
Liquidity short-term bills?

2. Can the company survive Debt-to-Equity, Interest Coverage, Debt Ratio

Solvency / long-term debt?
Leverage

3. Is the company generating enough Gross Margin, Net Margin, ROA, ROE
Profitabilit profit?
y

4. Is the company using its assets Asset Turnover, Inventory Days, Receivable
Efficiency effectively? Days
/ Activity

5. Market / What do investors think the P/E Ratio, EPS, Book Value per Share
Valuation company is worth?

💧 Section 1: Liquidity Ratios

Liquidity ratios measure a company's ability to meet its short-term financial obligations (debts due within one
year). A company may be profitable on paper but still go bankrupt if it can't pay its bills on time. Think of
liquidity as the company's 'cash readiness'.

Key Terms You Need to Know First

▸ Current Assets: Cash, inventory, receivables — anything convertible to cash within 1 year
▸ Current Liabilities: Bills, loans, payables — amounts due within 1 year
▸ Quick Assets: Current assets MINUS inventory and prepaid expenses (only the most liquid items)
Ratio Name Formula Formula What It Means & Why Used
Components

Current Ratio Current Assets÷ Numerator: Total Checks if assets due in 1 year can cover
Current Liabilities current assets (cash liabilities due in 1 year. A ratio of 2:1 is
+ stock + generally ideal — for every ₹1 owed, the
debtors)Denominat company has ₹2 in hand. Too low = risk
or: Total current of default. Too high = idle assets.
liabilities (creditors
+ short-term loans)

Quick (Current Assets − Numerator: Only A stricter test than current ratio.
Ratio(Acid Test) Inventory − fast-converting Inventory may not sell quickly, so we
Prepaid)÷ Current assets (cash, remove it. Ideal ratio is 1:1. If it drops
Liabilities receivables)Denomi below 1, the company cannot pay
nator: Current short-term debts without selling stock —
liabilitiesExcludes: a warning sign.
Inventory (takes
time to sell)

Accounting and Financial Statement Analysis | Study Notes

 Ratio Name Formula Formula What It Means & Why Used
Components

Cash Ratio (Cash + Cash Numerator: Only The most conservative liquidity ratio —
Equivalents)÷ actual cash and counts only money the company already
Current Liabilities bank has. Used by lenders to assess immediate
balancesDenominat payment ability. A ratio of 0.5 is often
or: Current considered acceptable; above 1 means
liabilitiesMost very strong cash position.
conservative
measure

Net (Current Assets − Numerator: Net Shows what portion of total assets is
WorkingCapital Current working capital (a available as working capital. Positive =
Ratio Liabilities)÷ Total difference, not a company has buffer; Negative = potential
Assets ratio)Denominator: financial distress. Expresses working
Total assets of the capital as a proportion of company size.
company

💡 Remember: Rule of Thumb: Current Ratio > 2 is comfortable. Quick Ratio > 1 is healthy. Always
compare within the same industry — a supermarket naturally runs lower liquidity than a software firm.

🏦 Section 2: Solvency / Leverage Ratios

Solvency ratios assess a company's ability to meet its long-term obligations — debts due over more than one
year. While liquidity is about surviving the next few months, solvency is about surviving the next several
years. These ratios tell us how much the company relies on borrowed money versus its own funds.

Key Terms You Need to Know First

▸ Total Debt: All borrowed money (both short-term and long-term)
▸ Equity (Shareholders' Funds): Money invested by owners + retained profits
▸ EBIT: Earnings Before Interest and Tax — operating profit before financing costs
▸ Interest Expense: The cost the company pays for borrowing money

Ratio Name Formula Formula What It Means & Why Used

Components

Debt-to-Equ Interest-Bearing Numerator: Only Compares borrowed money

ityRatio Debt÷ Shareholders' borrowings that (interest-bearing only) to owners'
(D/E) Equity carry interest — money. Trade payables are
bank loans, excluded because they carry no
debentures, bonds interest and are part of normal
(short + long term). operations. A D/E of 1 means equal
Excludes trade debt and equity. Higher D/E = more
payables, accrued financial risk. Common
expenses & other benchmark: below 2 for most
operating industries. High D/E is normal in
[Link] capital-intensive sectors like
tor: Total equity utilities.
(paid-up capital +
reserves & surplus)

Accounting and Financial Statement Analysis | Study Notes

 Ratio Name Formula Formula What It Means & Why Used
Components

Debt Ratio Interest-Bearing Numerator: Tells what proportion of assets are

Debt÷ Total Assets Interest-bearing financed by interest-bearing debt.
borrowings only A ratio of 0.4 means 40% of assets
(bank loans, bonds, are funded by borrowings. The
debentures). Note: stricter version (borrowings only)
Some textbooks use isolates true financial risk. The
Total Liabilities broader version (total liabilities)
instead — both includes trade payables and
versions exist. The captures overall leverage. Always
borrowings-only clarify which version is being used.
version is more Above 0.6 (borrowings-only) is
analytically generally considered high risk.
[Link]
r: Total assets of the
company

Equity Total Equity÷ Total Numerator: The flip side of the debt ratio.
Ratio Assets Shareholders' Shows what proportion of assets
equityDenominator: are funded by the owners. A higher
Total assetsNote: equity ratio = more financial
Debt Ratio + Equity stability and less reliance on
Ratio = 1 external lenders.

InterestCov EBIT÷ Interest Numerator: EBIT Measures how many times the
erage Ratio Expense (Revenue − COGS company can pay its interest from
− Operating operating profits. A ratio of 3
Expenses)Denomin means it earns 3x the interest it
ator: Annual owes — safe. Below 1.5 is
interest expense on considered dangerous. Lenders
loans closely watch this ratio.

Debt Net Operating Numerator: Used by banks before granting

ServiceCove Income÷ Total Debt Operating income loans. A DSCR above 1.25 means
rage Service after the company comfortably services
(DSCR) taxDenominator: its debt. Below 1 means income is
Total principal + insufficient to cover repayments —
interest payments high default risk.
due

💡 Remember: High leverage (debt) amplifies both profits AND losses. It's called the 'double-edged
sword' of finance. A company with D/E of 3 can generate great returns in boom times, but collapse during
downturns.

💰 Section 3: Profitability Ratios

Profitability ratios measure how efficiently a company generates profit from its revenues, assets, and equity.
They answer the fundamental question: 'Is the business worth running?' These ratios are the most closely
watched by investors and shareholders.

Key Terms You Need to Know First

Accounting and Financial Statement Analysis | Study Notes

▸ Gross Profit: Revenue minus Cost of Goods Sold (COGS). Profit before operating expenses.
▸ Operating Profit (EBIT): Gross Profit minus operating expenses (salaries, rent, depreciation)
▸ Net Profit (PAT): Final profit after ALL expenses, interest, and taxes
▸ EBITDA: Earnings Before Interest, Tax, Depreciation and Amortization — a popular cash-flow proxy

Ratio Name Formula Formula What It Means & Why Used

Components

Gross Gross Profit÷ Numerator: Shows how much profit remains after
ProfitMargin Revenue × 100 Revenue − Cost of covering the direct cost of making/buying
Goods products. A 40% margin means for every ₹100
SoldDenominator: in sales, ₹40 is gross profit. Used to assess
Total Revenue / Net pricing strategy and production efficiency.
SalesResult
expressed as %

OperatingProfi Operating Profit Numerator: Gross Measures profit from core business
t Margin (EBIT)÷ Revenue Profit − Operating operations, excluding financing effects. Two
× 100 Expenses companies with same gross margin but
Denominator: Total different operating margins indicate one has
RevenueExcludes: higher overheads. Ideal for comparing
Interest and tax operational efficiency across firms.

Net Net Profit (PAT)÷ Numerator: Profit The ultimate profitability measure — what
ProfitMargin Revenue × 100 after all expenses, percentage of every rupee of sales becomes
interest & actual profit. A 10% net margin means ₹10
taxDenominator: kept per ₹100 sold. Must be compared with
Total RevenueThe industry benchmarks; margins vary widely
'bottom line' (e.g., FMCG vs. IT vs. Trading).
percentage

Return Net Profit÷ Total Numerator: Net Shows how efficiently the company uses ALL
onAssets Assets × 100 profit after its assets to generate profit. ROA of 8% means
(ROA) taxDenominator: ₹8 profit per ₹100 of assets. Capital-intensive
Average total assets industries (steel, airlines) naturally have lower
(beginning + ending ROAs than tech firms.
÷ 2)Measures asset
productivity

Return Net Profit÷ Numerator: Net Measures return generated on owners'

onEquity Shareholders' profit after investment. ROE of 20% = every ₹100
(ROE) Equity × 100 taxDenominator: invested by shareholders earned ₹20. Widely
Average used by equity investors. The DuPont analysis
shareholders' breaks ROE into margin × turnover × leverage
equityKey metric for deeper insight.
for investors

EBITDAMargi EBITDA÷ Revenue Numerator: Popular in valuation and M&A. Since it

n × 100 Earnings before excludes non-cash items (depreciation) and
Interest, Tax, financing costs, it gives a cleaner view of
Depreciation & operating cash generation. Widely used in
AmortizationDeno comparing companies with different capital
minator: Total structures or tax regimes.
RevenueProxies
cash generation

Accounting and Financial Statement Analysis | Study Notes

 Ratio Name Formula Formula What It Means & Why Used
Components

Return EBIT÷ Capital Numerator: EBIT Measures how effectively the company uses
onCapital Employed × 100 (Operating all capital (debt + equity) to generate returns.
Employed(RO Profit)Denominator: Unlike ROE, it is not distorted by high
CE) Total Assets − leverage. ROCE > cost of capital = value is
Current being created. Frequently used in
Liabilities(= infrastructure and manufacturing sectors.
Long-term capital
used)

💡 Remember: DuPont Formula: ROE = Net Profit Margin × Asset Turnover × Equity Multiplier.
This breakdown helps identify whether ROE is driven by profitability, efficiency, or financial leverage.

Accounting and Financial Statement Analysis | Study Notes

 ⚙️ Section 4: Efficiency / Activity Ratios
Efficiency ratios (also called Activity or Turnover ratios) measure how effectively a company manages its
assets to generate revenue. They track the speed at which assets are being used and converted into sales or
cash. Think of these as measuring the 'engine speed' of the business.

Key Terms You Need to Know First

▸ Cost of Goods Sold (COGS): Direct costs of producing goods sold during the period
▸ Average Inventory: (Opening Stock + Closing Stock) ÷ 2
▸ Accounts Receivable: Money owed to the company by its customers (debtors)
▸ Accounts Payable: Money the company owes to its suppliers (creditors)

Ratio Name Formula Formula What It Means & Why Used

Components

InventoryTu COGS÷ Average Numerator: Cost of Measures how many times

rnover Inventory Goods inventory is sold and replaced in a
Ratio SoldDenominator: year. A ratio of 6 means stock turns
(Opening + Closing over every 2 months. Low ratio =
Inventory) ÷ overstocking or slow sales. High
2Higher = faster ratio = efficient but risk of
stock movement stockouts. Varies greatly: grocery
stores have high turnover, jewelry
stores have low.

Inventory 365÷ Inventory Numerator: 365 Tells how many days on average it
Days(Days TurnoverOR(Avg daysDenominator: takes to sell the entire inventory. 60
Sales Inventory ÷ COGS) × Inventory Turnover days = stock sits for 2 months
ofInventory 365 RatioResult: before being sold. Lower is usually
— DSI) Number of days better — fewer days means faster
cash conversion. Compare within
industry only.

Receivables Net Credit Sales÷ Numerator: Total Measures how efficiently the
Turnover Average Accounts credit sales for the company collects cash from credit
Ratio Receivable yearDenominator: customers. A ratio of 12 means it
(Opening + Closing collects its entire receivables 12
Debtors) ÷ 2 times a year (~once a month).
Lower ratio = slow collections =
possible bad debts building up.

Days 365÷ Receivables Numerator: 365 Shows average number of days to

SalesOutsta TurnoverOR(Avg daysDenominator: collect payment from customers. 45
nding Receivables ÷ Net Receivables days DSO means customers
(DSO)/ Sales) × 365 TurnoverResult: typically pay in 45 days. The lower
Debtor Days Average collection the better. Compare with credit
period in days terms offered (e.g., if you give 30
days credit but DSO is 60,
collections are poor).

Payable (Avg Accounts Numerator: Average Measures how long the company
Days(Days Payable÷ COGS) × accounts payable × takes to pay its own suppliers.
PayableOuts 365 365Denominator: Higher DPO = company is using

Accounting and Financial Statement Analysis | Study Notes

 Ratio Name Formula Formula What It Means & Why Used
Components

tanding — COGS or total supplier credit effectively (free

DPO) credit financing). But too high = strained
purchasesResult: supplier relationships. Balancing
Days taken to pay DSO and DPO is key to managing
suppliers working capital.

Asset Net Revenue÷ Numerator: Total Measures how much revenue is

TurnoverRa Average Total Assets revenue / net generated per rupee of total assets.
tio salesDenominator: A ratio of 1.5 means ₹1.50 in sales
(Opening + Closing for every ₹1 of assets. Asset-heavy
Total Assets) ÷ 2 industries (manufacturing) have
lower ratios; asset-light ones
(consulting) have higher. Useful for
cross-firm comparisons within a
sector.

Fixed Net Revenue÷ Net Numerator: Net Focuses specifically on how well
AssetTurnov Fixed Assets revenueDenominato long-term assets (plant, machinery,
er r: Net fixed assets property) generate revenue.
(after Important in capital-heavy
depreciation)Measu industries. A declining ratio may
res use of long-term indicate overcapacity or aging
assets equipment.

Cash DSI + DSO − DPO DSI: Days to sell The single most comprehensive
Conversion inventoryDSO: efficiency metric. It shows the total
Cycle Days to collect days from paying for inventory to
(CCC) from receiving cash from customers.
customersDPO: Shorter CCC = better liquidity and
Days to pay efficiency. Negative CCC (like
suppliers Amazon) means collecting cash
before paying suppliers — a
powerful competitive advantage!

💡 Remember: Cash Conversion Cycle Example: If DSI = 40 days, DSO = 35 days, DPO = 30 days
→ CCC = 40 + 35 − 30 = 45 days. The company needs 45 days of cash tied up in the operating cycle.

📈 Section 5: Market / Valuation Ratios

Market ratios link a company's financial performance to its stock market value. They are primarily used by
investors and analysts to decide whether a stock is overvalued, undervalued, or fairly priced. These ratios
require both accounting data AND the current market price of the stock.

Key Terms You Need to Know First

▸ Market Price per Share: Current price at which the stock trades on the exchange
▸ Earnings per Share (EPS): Net profit divided by number of outstanding shares
▸ Book Value per Share: Shareholders' equity divided by number of shares — the accounting value
▸ Dividend: The portion of profit distributed to shareholders

Accounting and Financial Statement Analysis | Study Notes

 Ratio Name Formula Formula What It Means & Why Used
Components

Earnings Net Profit − Numerator: Net Shows how much profit is attributable to
PerShare Preference profit after tax each share. EPS of ₹25 means each share
(EPS) Dividends÷ Weighted minus preference earned ₹25 of profit. A rising EPS over
Avg Shares dividendsDenomina time is a positive signal. Used as an input
Outstanding tor: Number of into P/E ratio. Important: higher EPS
equity sharesResult: doesn't always mean better — compare
Profit per share with share price.

Price-to-Ear Market Price per Numerator: Current The most widely used valuation ratio.
ningsRatio Share÷ Earnings per stock P/E of 20 means investors are paying ₹20
(P/E) Share (EPS) priceDenominator: for every ₹1 of earnings — they're
EPS (annual)Result: paying a 20x premium. High P/E = high
Times multiple growth expectations (often seen in tech).
Low P/E = value stock or declining
company. Compare P/E to sector
average.

💡 Remember: Caution: A low P/E doesn't always mean 'cheap'. It could mean the company is in
decline. Always combine P/E with EPS growth rate. The PEG Ratio = P/E ÷ EPS Growth Rate helps
account for growth expectations.

Accounting and Financial Statement Analysis | Study Notes

 📋 Section 6: Master Summary — All Ratios at a Glance
Use this table as a quick revision reference for all ratios covered in this guide.

Category Ratio Formula (Simplified) Benchma What It Measures

rk

LIQUIDITY Current Ratio Current Assets ÷ Current >2:1 Short-term paying ability
Liabilities
LIQUIDITY Quick Ratio (CA − Inventory − >1:1 Immediate liquidity without
Prepaid) ÷ CL stock
LIQUIDITY Cash Ratio (Cash + Equivalents) ÷ >0.5 Strictest liquidity test
CL
SOLVENCY Debt-to-Equity Interest-Bearing Debt ÷ <2 Financial risk / leverage
Equity (borrowings only)
SOLVENCY Debt Ratio Interest-Bearing Debt ÷ <0.6 Asset financing by
Total Assets borrowings
SOLVENCY Interest EBIT ÷ Interest Expense >2 Ability to pay interest
Coverage
SOLVENCY DSCR Net Op. Income ÷ Debt >1.25 Loan repayment capacity
Service
PROFITABIL Gross Margin Gross Profit ÷ Revenue Industry Production efficiency
ITY % norm
PROFITABIL Net Profit Net Profit ÷ Revenue % Industry Overall profitability
ITY Margin norm
PROFITABIL ROA Net Profit ÷ Total Assets Industry Asset productivity
ITY % norm
PROFITABIL ROE Net Profit ÷ Equity % >15% Shareholder return
ITY
PROFITABIL ROCE EBIT ÷ Capital >WACC Capital efficiency
ITY Employed %
EFFICIENCY Inventory COGS ÷ Avg Inventory Higher Stock management speed
Turnover better
EFFICIENCY Debtor Days 365 ÷ Receivables Lower Collection efficiency
(DSO) Turnover better
EFFICIENCY Payable Days (Avg Payables ÷ COGS) Balance Supplier payment speed
(DPO) × 365 needed
EFFICIENCY Asset Turnover Revenue ÷ Avg Total Higher Revenue per asset rupee
Assets better
EFFICIENCY Cash Conv. DSI + DSO − DPO Lower / Overall working capital
Cycle Negative efficiency
MARKET EPS Net Profit ÷ Shares Rising Profit per share
Outstanding trend

Accounting and Financial Statement Analysis | Study Notes

 Category Ratio Formula (Simplified) Benchma What It Measures
rk

MARKET P/E Ratio Market Price ÷ EPS vs. sector Market valuation multiple
avg

🔢 Section 7: Worked Example — Applying All Ratios

Let's apply the ratios to a fictional company — Stellar Manufacturing Ltd. — using figures from their
financial statements.

Financial Data for Stellar Manufacturing Ltd. (FY 2024)

Item Value Item Value

Revenue (Net Sales) ₹50,00,000 Cost of Goods Sold ₹30,00,000

(COGS)

Gross Profit ₹20,00,000 Operating Expenses ₹8,00,000

EBIT ₹12,00,000 Interest Expense ₹2,00,000

Net Profit (PAT) ₹7,00,000 Total Assets ₹40,00,000

Current Assets ₹15,00,000 Current Liabilities ₹6,00,000

Inventory ₹4,00,000 Accounts Receivable ₹5,00,000

Cash & Equivalents ₹2,00,000 Total Debt ₹14,00,000

(Long-term)

Shareholders' Equity ₹18,00,000 Market Price per ₹140

Share

Shares Outstanding 1,00,000 Annual ₹7

Dividend/Share

Calculated Ratios for Stellar Manufacturing Ltd.

Ratio Calculation Result Interpretation

Current
Ratio
15,00,000 ÷ 6,00,000 2.5 ✅ Healthy — can cover short-term debts
comfortably

Quick Ratio (15L − 4L) ÷ 6L = 11L

÷ 6L
1.83 ✅ Very liquid even without selling
inventory

Cash Ratio 2,00,000 ÷ 6,00,000 0.33 ⚠️ Slightly low — relies on receivables

for full coverage

Debt-to-Equi
ty
14,00,000 ÷ 18,00,000 0.78 ✅ Conservative leverage — only
interest-bearing debt vs. equity

Accounting and Financial Statement Analysis | Study Notes

 Ratio Calculation Result Interpretation

Interest
Coverage
12,00,000 ÷ 2,00,000 6.0x ✅
owes
Excellent — earns 6x the interest it

Gross Profit
Margin
(20L ÷ 50L) × 100 40% ✅ Good margin, strong pricing power
Net Profit
Margin
(7L ÷ 50L) × 100 14% ✅ Healthy bottom line for manufacturing
ROA (7L ÷ 40L) × 100 17.5% ✅ Strong — generates ₹17.5 for every
₹100 of assets

ROE (7L ÷ 18L) × 100 38.9% ✅ Excellent return for equity

shareholders

Asset
Turnover
50L ÷ 40L 1.25x ✅ Good — ₹1.25 revenue per ₹1 of
assets

EPS 7,00,000 ÷ 1,00,000 ₹7.00 ₹7 profit per share

P/E Ratio ₹140 ÷ ₹7 20x Market values company at 20x earnings

Dividend
Yield
(₹7 ÷ ₹140) × 100 5% ✅ Attractive yield for income investors

💡 Remember: Overall Verdict: Stellar Manufacturing Ltd. looks financially healthy — strong
profitability, conservative leverage, and good liquidity. The slightly low cash ratio is worth monitoring but
is not alarming given the strong current ratio.

⚠️ Section 8: Limitations of Ratio Analysis

While ratio analysis is powerful, it has important limitations that every student and analyst must understand:

▸ Historical Data Only: Ratios are based on past financial data — they do not predict future performance.
▸ Accounting Policies Differ: Two companies may use different depreciation methods, inventory valuation
(FIFO vs LIFO), or revenue recognition policies — making direct comparison misleading.
▸ No Industry Context: A ratio is only meaningful when compared to an industry benchmark. A 5% net
margin is poor for FMCG but excellent for an airline.
▸ Window Dressing: Management may temporarily improve ratios at year-end (e.g., delaying purchases to
boost current ratio), misleading analysts.
▸ Inflation Effects: During high inflation, historical cost-based assets are understated, distorting ROA and
asset turnover.
▸ Non-Financial Factors Ignored: Employee morale, brand value, innovation, management quality, and
competitive dynamics are NOT captured in ratios.
▸ Seasonality: Businesses with seasonal cycles (retail, tourism) will show very different ratios at different
times of the year.

💡 Remember: Always use ratio analysis as a starting point for investigation — not as a final verdict.
Combine it with industry research, management commentary, and qualitative judgment.

Accounting and Financial Statement Analysis | Study Notes

Cash Flow Statement — Adjustments Reference Table
Indirect Method | AS-3 (Revised) / IAS-7 | Items with 2-Step treatment are highlighted
2-Step Rule: Proposed Dividend, Interim Dividend, and Income Tax each require TWO entries — (1) Add
back the P&L charge under Operating Activities, and (2) Deduct the actual cash payment under
Financing/Operating Activities.

Cash Flow
Adjustment / Item Step Treatment in Cash Flow Statement
Section

A. OPERATING ACTIVITIES — Non-Cash Adjustments to Net Profit (Add-backs)

Depreciation on Fixed Assets Add back to Net Profit — non-cash expense

(Building, Plant & Machinery, Step 1 of 1 Operating already charged to P&L
Vehicles, Fixtures)

Goodwill Written Off / Add back to Net Profit — non-cash expense

Step 1 of 1 Operating
Amortisation

Loss on Sale of Fixed Assets / Add back to Net Profit — non-cash loss
Step 1 of 1 Operating
Machinery (actual sale proceeds go to Investing)

Provision for Doubtful Debts Add back to Net Profit — non-cash charge
Step 1 of 1 Operating
(increase)

Provision for Taxation — created Add back to Net Profit — non-cash charge
Step 1 of 1 Operating
during the year (actual tax paid deducted separately)

Premium on Redemption of Add back to Net Profit — non-cash write-off

Step 1 of 1 Operating
Debentures written off to P&L

Profit on Sale of Fixed Assets / Deduct from Net Profit — non-cash gain
Step 1 of 1 Operating
Investments (full sale proceeds reclassified to Investing)

B. PROPOSED DIVIDEND — 2 Adjustments Required

PROPOSED DIVIDEND ADD BACK to Net Profit under Operating

(Current Year — declared in P&L Step 1 of 2 Activities
but not yet paid in cash) ↓ Add Operating → Reason: Already debited to P&L as an
Back appropriation, but no cash has left yet.
Must be reversed here.

PROPOSED DIVIDEND DEDUCT under Financing Activities

Step 2 of 2
(Previous Year — actually paid in Financing → Reason: Cash actually paid out this
↓ Cash Out
cash during current year) year for last year's declared dividend.

C. INTERIM DIVIDEND — 2 Adjustments Required

INTERIM DIVIDEND ADD BACK to Net Profit under Operating

(Declared and charged to P&L Step 1 of 2 Activities
during the current year) ↓ Add Operating → Reason: Already debited to P&L, so
Back net profit is understated. Add it back to
reverse the P&L effect.

INTERIM DIVIDEND DEDUCT under Financing Activities

Step 2 of 2
(Actual cash paid during the Financing → Reason: Represents actual cash paid to
↓ Cash Out
current year) shareholders during the year.

D. INCOME TAX — 2 Adjustments Required

Accounting and Financial Statement Analysis | Study Notes

 Cash Flow
Adjustment / Item Step Treatment in Cash Flow Statement
Section

INCOME TAX ADD BACK to Net Profit under Operating

(Provision created / charged to Step 1 of 2 Activities
P&L during the year) ↓ Add Operating → Reason: Non-cash provision charged to
Back P&L; actual cash payment is treated
separately.

INCOME TAX DEDUCT under Operating Activities

Step 2 of 2
(Actual tax paid in cash during the Operating → Reason: Actual cash outflow for tax
↓ Cash Out
year) (may relate to prior year provision).

E. OPERATING ACTIVITIES — Working Capital Adjustments

Increase in Debtors / Bills Deduct — cash blocked in current assets

— Operating
Receivable / Prepaid Expenses

Decrease in Debtors / Bills Add — cash released from current assets

— Operating
Receivable / Prepaid Expenses

Increase in Creditors / Bills Add — cash saved (liability increased)

— Operating
Payable / Outstanding Expenses

Decrease in Creditors / Bills Deduct — cash paid out to settle liabilities

— Operating
Payable / Outstanding Expenses

Increase in Stock / Inventory — Operating Deduct — cash used to build inventory

Decrease in Stock / Inventory — Operating Add — cash released from inventory

F. INVESTING ACTIVITIES

Sale of Fixed Assets (Building, Add — full sale proceeds are a cash inflow
Plant, Machinery, Vehicles, Inflow Investing from Investing
Fixtures)

Purchase of Fixed Assets (Land, Deduct — cash paid for acquisition of fixed
Outflow Investing
Building, Plant, Machinery) assets

Sale of Long-term Investments Add — cash inflow from Investing

Inflow Investing
Activities

Purchase of Long-term Investments Deduct — cash outflow for Investing

Outflow Investing
Activities

Interest Received / Dividend Add — cash inflow from Investing

Inflow Investing
Received Activities (AS-3)

G. FINANCING ACTIVITIES — Inflows

Issue of Equity / Preference Share Add — cash inflow from Financing

Inflow Financing
Capital (cash) Activities

Issue of Debentures / Bonds Add — cash inflow from Financing

Inflow Financing
Activities

Proceeds from Long-term Loans / Add — cash inflow from Financing

Inflow Financing
Mortgage Loans Activities

Accounting and Financial Statement Analysis | Study Notes

 Cash Flow
Adjustment / Item Step Treatment in Cash Flow Statement
Section

Securities Premium on Issue of Add — part of share issue proceeds;

Inflow Financing
Shares Financing inflow

H. FINANCING ACTIVITIES — Outflows

Redemption of Debentures / Deduct — cash outflow from Financing

Outflow Financing
Repayment of Loans Activities

Premium Paid on Redemption of Deduct — cash outflow from Financing

Outflow Financing
Debentures (actual cash) Activities

Redemption of Preference Share Deduct — cash outflow from Financing

Outflow Financing
Capital Activities

Accounting and Financial Statement Analysis | Study Notes

 COMPANY FINAL ACCOUNTS

A Complete Student Guide to Adjustments, Treatment & Formats

Income Statement (Statement of Profit & Loss) | Balance Sheet | All Adjustments Explained

1. INTRODUCTION — WHY DO ADJUSTMENTS EXIST?

When a Trial Balance is prepared, it only reflects transactions that have been recorded in the books
during the year. However, the Accrual Concept and Matching Principle require that:

✔ All expenses incurred during the year are charged — whether paid or not.
✔ All income earned during the year is credited — whether received or not.
✔ Items paid in advance (prepaid) are excluded from this year's expenses.
✔ Assets are stated at their true value (after depreciation, bad debts, stock write-downs).

Adjustments are journal entries made OUTSIDE the Trial Balance to ensure the financial statements present a
TRUE AND FAIR VIEW of the company's performance and position.

KEY PRINCIPLE TO REMEMBER: Every adjustment affects TWO places — either (i) the Income
Statement AND the Balance Sheet, or (ii) two items within the Balance Sheet. This is the double-entry
principle.

2. ADJUSTMENTS: TREATMENTS AND EXPLANATIONS

For each adjustment below, the table shows: (Column 1) Treatment in the Income Statement (Statement of
Profit & Loss), (Column 2) Treatment in the Balance Sheet, and (Column 3) The conceptual reason for the
treatment.

A. CLOSING STOCK

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Deducted from
Shown as Current
Cost of Goods sold
Asset under Closing stock has not yet been consumed in
in the Income
'Inventories'. It earning revenue. Matching Principle: only the cost
Statement. This
Closing Stock represents the of goods actually sold should be matched against
reduces total
unsold goods still sales revenue. Unsold goods remain an asset and
expenses and
owned by the must not be charged as an expense this year.
increases Net
business.
Profit.

B. DEPRECIATION

Accounting and Financial Statement Analysis | Study Notes

 Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Deducted from the
Depreciation Shown under
gross value of the
on Fixed 'Depreciation and
respective fixed Fixed assets lose value over time due to use,
Assets Amortisation
asset on the Assets wear, or obsolescence. Accrual Principle: the cost
(Machinery, Expense' in the
side. Shown as: of using an asset must be spread over its useful
Buildings, Income Statement.
Asset Cost − life. Each year a portion of the cost is used up and
Patents, Increases total
Accumulated must be recognised as an expense.
Furniture, expenses and
Depreciation = Net
etc.) reduces Net Profit.
Book Value.

Common Depreciation Methods: Straight Line Method (SLM) — Equal amount each year = Cost / Useful
Life. Written Down Value (WDV) — Fixed % on reducing balance each year.

C. OUTSTANDING (ACCRUED) EXPENSES

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Added to the
respective
Outstanding Shown as a
expense in Accrual Concept: expenses belong to the period
Expenses e.g. Current Liability
Income in which they are incurred, not when cash is
Unpaid Salaries, under 'Outstanding
Statement (e.g., paid. Even though unpaid at year-end, the
Unpaid Wages, Expenses'. The
Salaries + expense has been 'used' in this year's
Outstanding business owes this
Outstanding = operations.
Interest amount.
Total Salaries
charged).

D. PREPAID (UNEXPIRED) EXPENSES

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Deducted from the
Prepaid respective expense Shown as a Current
(Unexpired) in Income Asset under Matching Principle: only the portion of the
Expenses e.g. Statement (e.g., 'Prepaid Expenses'. expense that relates to this accounting period
Prepaid Insurance - Prepaid It represents a should be charged this year. The prepaid portion
Insurance, portion = Actual future benefit belongs to next year and is therefore an asset.
Prepaid Rent expense for the already paid for.
year).

Accounting and Financial Statement Analysis | Study Notes

 E. ACCRUED INCOME

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Added to the
Accrued
respective income Shown as a Current
Income (e.g. Accrual Concept: income is recognised when it is
in Income Asset under
Interest earned, not when cash is received. If income has
Statement (e.g., 'Accrued Income'
Receivable, been earned but not yet received, it must still be
Interest Income + or 'Income
Rent recognised in this period.
Accrued = Total Receivable'.
Receivable)
Interest credited).

F. INCOME RECEIVED IN ADVANCE

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Deducted from the
Shown as a Current
respective income
Liability under
Income in Income Matching/Accrual Principle: income belongs to
'Income Received
Received in Statement (e.g., the period it is earned. The advance relates to a
in Advance'. The
Advance (e.g. Rent Received - future period; it has not yet been earned, so it
business has an
Rent Received Advance portion). cannot be treated as current year income. It is a
obligation to
in Advance) Only the earned liability (deferred income).
provide services or
portion is shown as
return money.
income.

G. BAD DEBTS WRITTEN OFF

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Deducted from
Included Income Trade Receivables Prudence / Conservatism Concept: if it is clear
Statement. (Debtors). The that a debtor will not pay, keeping that amount as
Bad Debts
Increases total debtor balance is an asset overstates the business's financial
Written Off
expenses and reduced since position. The loss must be recognised
reduces Net Profit. recovery is not immediately.
expected.

H. PROVISION FOR DOUBTFUL DEBTS

Accounting and Financial Statement Analysis | Study Notes

 Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Net increase in Deducted from Prudence Concept: some debtors may not pay in
Provision for
provision is Trade Receivables / the future. We anticipate likely losses and create a
Doubtful
included in the Debtors to show provision. The debtors figure in the Balance Sheet
Debts (New or
Income Statement. the net realisable then reflects only the amount we expect to
Increased)
Reduces Net Profit. value. actually collect.

How to calculate: (i) Write off confirmed bad debts first. (ii) Apply provision % on remaining debtors. (iii)
If existing provision < required → charge difference to P&L.

I. MANAGER'S / MD's COMMISSION

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Included in the
Income Statement.
Accrual Concept: the commission is earned by the
Reduces Net Profit. Shown as Current
Manager's / manager during this year based on this year's
If 'after charging Liability under
MD's profits, so it must be expensed this year regardless
commission': 'Other Current
Commission of when it is paid. For 'after charging
Commission = Net Liabilities' if
on Net Profit commission', the circular calculation must be
Profit before unpaid at year-end.
resolved using the formula.
commission × Rate
/ (100 + Rate).

Formula when commission is 'after charging such commission': Commission = Net Profit before
commission × Rate ÷ (100 + Rate). Example: 5% commission on profit of ₹1,05,000 = 1,05,000 × 5/105 =
₹5,000.

J. GOODS SENT ON APPROVAL (SALE OR RETURN)

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Reverse the
Add back the goods
incorrect Sales
(at cost) to Closing Revenue Recognition Principle: a sale is only
Goods Sent on entry: deduct the
Stock / Inventories recognised when risk and reward transfer to the
Approval / approval-basis
as they remain the buyer. Goods sent on approval have NOT been
Sale or amount from
property of the accepted yet, so they cannot be treated as sold.
Return Basis Revenue from
seller until The goods still legally belong to the seller.
Operations and
approved.
Debtors.

K. LOSS BY FIRE / THEFT AND INSURANCE CLAIMS

Accounting and Financial Statement Analysis | Study Notes

 Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Loss of goods →
deducted from Insurance claim
Loss by Fire / COGS in the receivable (if Prudence + Accrual: the loss is real and must be
Theft (with or Income Statement. admitted but not recognised immediately. If insurance compensates
without Net unrecovered yet received) → partly or fully, that is income for the year. The net
Insurance loss → included shown as Current uninsured loss is a genuine expense of the
Claim) under Other Asset under Other business.
Expenses, reducing Current Assets.
Net Profit.

L. PRELIMINARY / PRE-INCORPORATION EXPENSES

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
The remaining
The portion written
unamortised Preliminary expenses are deferred revenue
off (e.g. 1/3rd or
Preliminary / balance is shown expenditure. They are amortised (spread) over
20%) is included
Pre-incorpora under 'Other several years since the benefit is received over
under 'Other
tion Expenses Non-Current multiple periods. Writing off a portion each year
Expenses' in the
(Written Off) Assets'. Reduce by matches cost with the benefit period. Full
Income Statement.
the written-off write-off in one year would distort profits.
Reduces Net Profit.
amount each year.

M. SUSPENSE ACCOUNT

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Transfer the
Suspense balance
A suspense account is a temporary holding
Suspense to the relevant
No effect on account used when the nature of a transaction is
Account (e.g. Fixed Asset
Income Statement initially unclear. Once clarified, it must be
relates to account (e.g. Office
if it relates to an transferred to the correct account. Since it relates
purchase of Equipment
asset purchase. to a capital (fixed asset) purchase, it becomes part
Fixed Asset) increases).
of the asset's cost, not an expense.
Removes suspense,
increases asset.

N. INTEREST ON DEBENTURES / LOANS (OUTSTANDING)

Accounting and Financial Statement Analysis | Study Notes

 Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Full year's interest
is shown' in the
Outstanding
Interest on Income Statement.
(unpaid) interest Accrual Concept: interest is a cost of borrowing
Debentures / If already partially
shown as Current that accrues with the passage of time. All interest
Loans paid, only the
Liability under for the full year, whether paid or not, must be
(Accrued / outstanding
'Other Current recognised as an expense of the accounting period.
Outstanding) (accrued) portion is
Liabilities'.
the additional
charge.

O. INTEREST ON CASH CREDIT / BANK OVERDRAFT

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Added to the Cash
Shown' in the
Credit / Bank Accrual Principle: the bank charges interest for
Interest on Income Statement.
Overdraft balance using the overdraft facility throughout the year.
Cash Credit / Calculated on the
under Current Even if not yet debited by the bank at year-end,
Bank outstanding balance
Liabilities, as it is the business has incurred the cost and must
Overdraft × rate. Reduces Net
an outstanding recognise it.
Profit.
liability.

P. RENT RECOVERABLE FROM SUB-TENANT

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Rent
Shown as Current
Recoverable Accrual Concept: income is recognised when
Added to Other Asset under 'Other
from earned, not when received. Since the sub-tenant
Income in the Current Assets'
Sub-tenant has used the premises, the rent is earned this
Income Statement. (Accrued Income /
(Accrued period even if not yet collected.
Rent Receivable).
Income)

Q. OBSOLETE / DAMAGED STOCK (NET REALISABLE VALUE)

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Obsolete / Closing stock is Closing stock is Prudence Concept + AS-2 (Inventories): stock
Damaged valued at Net shown at NRV (not must be valued at the lower of cost or NRV. If

Accounting and Financial Statement Analysis | Study Notes

 Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Closing Stock Realisable Value cost) under goods cannot be sold at cost, the loss in value
(Lower of (NRV) if NRV < Inventories. The must be recognised immediately. Overstating
Cost or NRV) cost. The write-down reduces inventory overstates profit and assets.
write-down the inventory
increases expenses figure.
(or reduces the
closing stock
credit), thereby
reducing Net Profit.

R. CORRECTION OF ERRORS (e.g. Rent to Wrong Account)

Treatment inIncome Treatment

Adjustment Why We Do This
Statement inBalance Sheet
Remove from
Ensure rent expense Error Correction: the debit to 'Landlord's
Rent Debited Debtors (the
appears correctly under Account' (a debtor) wrongly created an
to Wrong Landlord's Account
'Other Expenses' in the asset. Since it is a payment for rent (an
Account (e.g., balance is cleared).
Income Statement with the expense), it must be removed from
Landlord's Rent is correctly an
correct amount. No double debtors and recognised as an expense in
Account) expense, not a
charge should occur. the Income Statement.
receivable.

S. INCOME TAX (Company)

Treatment
Treatment
Adjustment inIncome Why We Do This
inBalance Sheet
Statement
Tax payable (if not
yet paid) is shown
Tax expense is For a company, income tax is a statutory
as 'Short-term
shown separately in obligation of the company itself (unlike a sole
Provisions' under
Income Tax the Income trader where it is personal). It is therefore charged
Current Liabilities.
(Company) Statement. Net in the Income Statement below Profit before tax.
Advance tax paid
Profit after tax is The Companies Act requires separate disclosure
(if any) is shown
the final figure. of current and deferred tax.
under Other
Current Assets.

3. FORMAT — INCOME STATEMENT (Companies Act)

Companies prepare a Statement of Profit and Loss in vertical format as per the Companies Act. It flows
top-down: Revenue at the top, Expenses below, and Net Profit at the bottom. The Net Profit is then
transferred to Reserves & Surplus in the Balance Sheet.

Accounting and Financial Statement Analysis | Study Notes

 STATEMENT OF PROFIT AND LOSS (for the year ended 31st March 20XX)

Particulars Note Amount (₹)

I. REVENUE
(a) Revenue from operations (Net Sales / Turnover) 1 ×××
(b) Other income (Interest received, rent received, profit on asset sale) 2 ×××
Total Revenue (A) ×××
II. EXPENSES
(a) Cost of materials consumed / Purchases 3 ×××
Add: Opening stock | Less: Closing stock (adj.)
(b) Employee benefit expenses (Salaries, wages + outstanding, PF) 4 ×××
(c) Finance costs (Interest on debentures / loans — full year) 5 ×××
(d) Depreciation and amortisation expense 6 ×××
(e) Other expenses (Rent, insurance, bad debts, provision, advertisement, 7 ×××
office expenses, preliminary exp. w/o, loss by fire)
Total Expenses (B) ×××
Profit before tax (A − B) ×××
Less: Tax expense (Current tax + Deferred tax) ( ×× )
Net Profit for the year (transferred to Reserves & Surplus) ×××

KEY NOTES: (1) Revenue from operations = Net Sales after deducting returns. (2) Finance costs = interest
on debentures/loans for the FULL year (add outstanding if partially paid). (3) Depreciation appears under
expenses here — NOT deducted from assets in this statement. (4) Net Profit flows to Reserves & Surplus in
the Balance Sheet.

4. FORMAT — BALANCE SHEET (Companies Act)

The Balance Sheet under the Companies Act is prepared in vertical format. It has two sections: (I) Equity &
Liabilities — sources of funds, and (II) Assets — how funds are deployed. Total Assets must always equal
Total Equity & Liabilities.

BALANCE SHEET AS AT 31ST MARCH 20XX

Particulars Note Amount (₹)

I. EQUITY AND LIABILITIES
1. Shareholders' funds
(a) Share capital (Equity + Preference share capital) 1 ×××

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 Particulars Note Amount (₹)
(b) Reserves and surplus (General reserve + Net profit from P&L + 2 ×××
Securities premium)
2. Non-current liabilities
(a) Long-term borrowings (Debentures, long-term bank loans) 3 ×××
(b) Long-term provisions (Provision for gratuity, long-term warranty) 4 ×××
3. Current liabilities
(a) Trade payables (Creditors, bills payable) 5 ×××
(b) Other current liabilities (Outstanding expenses, income received in 6 ×××
advance, MD commission payable)
(c) Short-term provisions (Provision for tax, proposed dividend) 7 ×××
TOTAL EQUITY AND LIABILITIES ×××

II. ASSETS
1. Non-current assets
(a) Fixed assets — Tangible (Land & building, Plant & machinery, 8 ×××
Furniture — less accumulated depreciation)
(b) Fixed assets — Intangible (Goodwill, patents, trademarks — less 8 ×××
amortisation)
(c) Non-current investments 9 ×××
(d) Other non-current assets (Preliminary expenses — unamortised 10 ×××
balance)
2. Current assets
(a) Inventories (Closing stock — at cost or NRV, whichever is lower) 11 ×××
(b) Trade receivables (Debtors + bills receivable — less bad debts — 12 ×××
less provision for doubtful debts)
(c) Cash and cash equivalents (Cash in hand + Cash at bank) 13 ×××
(d) Other current assets (Prepaid expenses, accrued income, insurance 14 ×××
claim receivable)
TOTAL ASSETS ×××

KEY NOTES: (1) TOTAL ASSETS must always equal TOTAL EQUITY AND LIABILITIES. (2) Net
Profit from the Income Statement is added to Reserves & Surplus here. (3) Fixed assets are shown NET
(cost less accumulated depreciation). (4) Trade receivables are shown NET (after deducting bad debts
written off and provision for doubtful debts). (5) Preliminary expenses appear at the unamortised
(remaining) balance.

5. QUICK REFERENCE — WHERE DOES EACH ITEM GO?

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 Income Statement (Statement of Profit & Loss) Balance Sheet

Revenue from Operations Non-Current Assets

Sales / Turnover (net of returns) Fixed assets — tangible (net of depreciation)
Less: Goods sent on approval (reverse) Fixed assets — intangible (net of amortisation)
Add: Accrued income (Other Income) Non-current investments
Less: Income received in advance Preliminary expenses (unamortised balance)
Add: Insurance claim (Other Income) Current Assets
Expenses (reduce Net Profit) Inventories / Closing stock (at cost or NRV)
Purchases / Cost of materials consumed Trade receivables (net of bad debts + provision)
Changes in Inventories (opening − closing stock) Cash and cash equivalents
Employee benefit expenses (salaries + Prepaid expenses
outstanding) Accrued income / interest receivable
Finance costs (interest on loans / debentures) Insurance claim receivable
Depreciation and amortisation Equity & Liabilities
Rent, insurance, advertising (net of prepaid) Share capital
Bad debts + Provision for doubtful debts Reserves & surplus (incl. Net Profit added)
Manager / MD commission Long-term borrowings (debentures, loans)
Preliminary expenses written off Trade payables (creditors, bills payable)
Net unrecovered loss by fire / theft Other current liabilities (outstanding exp., advance income)
Tax expense (current + deferred) Short-term provisions (tax payable, commission payable)

6. KEY ACCOUNTING CONCEPTS BEHIND ADJUSTMENTS

Concept What it means for adjustments

Record income when EARNED and expenses when INCURRED — not when cash
Accrual Concept
moves. This is why we add outstanding expenses and accrued income.
Match expenses to the revenue they help generate in the same period. This is why we
Matching Principle
prepaid expenses are carried forward and depreciation is charged.
Prudence / Anticipate all losses but not gains. This drives bad debt provisions, stock write-downs
Conservatism to NRV, and immediate recognition of fire losses.
Assume the business will continue operating. This justifies depreciating assets over
Going Concern
their useful life rather than writing them off immediately.
Recognise revenue only when earned and certain. This is why goods sent on approval
Revenue Recognition
are NOT recorded as sales until acceptance.

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 Every adjustment must have TWO effects: one on the Income Statement and one on
Double Entry the Balance Sheet (or two on the Balance Sheet). Total Assets always = Capital +
Liabilities.

Disclaimer: This is an AI Generated guide. It has been checked for errors. In case you spot any error please
inform immediately.

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