NATURE AND SCOPE OF PUBLIC FINANCE

Monday, May 16, 2016 5:10 AM Posted by Indira

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NATURE AND SCOPE Of PUBLIC FINANCE

         Meaning of Public Finance


The term public Finance is a combination of two words: public and finance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 Therefore, to understand the meaning of public finance, it is necessary to have some knowledge of these two words.  The word ‘public’ is a collective term for individuals living within an administrative territory.  It is used to signify the government or the state, which represents the public. The word ‘finance’ implies income and expenditure of the government.  Hence, public finance can be defined as the science of income and expenditure of all levels of government, whether it is central government, state government or local government. It studies through what sources the government gets revenue, how it spends for promoting public welfare and how it controls and administers income and expenditure. Thus public finance is a branch of economics which deals with revenues and expenditures of the government and with administration of revenues and expenditures.
The classical economists with their faith in laissez-faire and market mechanism advocated  minimum  interference of the state in economic activity. They believed that the market forces of demand and supply, which would act as an invisible hand, guided all economic decisions. The invisible hand of the market mechanism brings about automatic adjustment in the allocation of resources in a competitive economy. They also believed that supply creates its own demand and general overproduction and involuntary unemployment is well neigh impossible and full employment and price stability is supposed to reach automatically due to the operation of the market forces. Hence the role of the state was not to interfere with operation of the market forces. The activities of the state were tolerated only as a necessary evil and were to be kept to the minimum possible scale. They believed that government is the best government, which spends the least and imposes the least amount of taxes. Hence a small budget was considered as the best budget. Thus under laissez faire capitalism the government has to be just a witness of the economic game of individuals by standing at the boundary of the pavilion. With this philosophy in the background the scope of public finance was obviously very limited.

The subject of public finance lacked a systematic discussion in the hands of  the classical economists. Adam Smith’s well known book ‘An Inquiry into the Nature and Causes of Wealth of Nations’ deals with the ‘expenses of the sovereign or the commonwealth’, “the sources of general or public revenue of the society” and ‘ public debts’ David Ricardo in his book ‘Principles of Political Economy and Taxation’ published in 1817, devoted to the discussions of problems of taxation. He also discussed the problems of public debt in his Essays on Funding System. J.S Mill in his well known work ‘Principles of Political Economy’ published in 1848,discussed at length the general principles of taxation, classification of taxes into direct and indirect taxes,  and problems of national debt. In short, the classical economists recognized the importance of public finance and divided the subject matter of public finance into government revenue, expenditure and debt aspects, thereby limiting its scope and treating it as a positive science. The Neo-classical economists also gave little significance to the discussions of Public Finance. A systematic exposition of the whole subject of Public Finance disappeared from the major works of Alfred Marshall and Edgeworth, the two great economists of the 19th century.

However, it was Charles.F.  Bastable who first made an attempt to make a systematic study of public finance. His book’ Public Finance’ published in 1892, was exclusively devoted to the study of public finance . According to Bastable  ‘Public Finance deals with the income and expenditure of public authorities of the state and their mutual relation as also with financial administration and control’. This definition correctly emphasized the growing importance of financial administration and control. Dalton in his book ‘Principles of Public Finance’ published in 1922, defined “Public Finance as one of those subjects that lie on the borderline between Economics and Politics. It is concerned with the income and expenditure of public authorities and with the adjustment of one to the other”. The term ‘ public authorities’ refers to government or the state at all levels, central, state and local. Dalton realized that public finance lie very close to practical politics.


Philip E. Taylor said that ‘Public Finance deals only with the finances of the g public in an organized group under the institution government. The finances of the government include raising and disbursement of government funds. Public finance is concerned with the operations of the fisc or public treasury. To the degree that it is a science, it is a fiscal science, its policies are fiscal policies and its problems are fiscal problems”. Mrs. Ursula Hicks states that the main content of Public Finance consists of the examination and appraisal of the methods by which governing bodies provide for collective satisfaction of wants and secure the necessary funds to carry out the purpose. This definition makes it clear that satisfaction of collective wants is the starting point leading to secure necessary funds.
The above definitions of public finance point out that public finance is concerned with revenue expenditure process of the government and how the revenue expenditure process is administered. It is only concerned with how the public authorities have collected revenue and spent them for collective satisfaction of wants. It is not concerned with how the revenue expenditure process is affecting the social and economic aspects of the economy.. Thus the scope of public finance was narrow and Public Finance was regarded only as a positive science
However, with the appearance of the Great Depression in the thirties and the publication of J.M. Keynes’s ‘General Theory of Employment Interest and Money’ in 1936, the influence of the government fiscal operations on the overall level of economic activity and the level of employment became an essential part of the study of Public Finance. Modern Economists like Musgrave, Brownlee and Allen Rolph and Break and Bernard.P.Herber and those following them therefore emphasized the inclusion of the “ principles of public economy” in the scope of public finance. Richard A. Musgrave observed that “ the complex problems that centre around the revenue expenditure process of the government is referred to traditionally as public finance.” while operations of public household involve money flows of receipts and expenditures, the basic problems are not issues of finance; rather they are problems of resource allocation, distribution of income, full employment and price stability”.  Brownlee and Allen says that  “ It is with the public economy…  with the effects of governmental  money spending and money raising activities upon the allocation of resources, distribution of income and general level of economic activity within the economy that the bulk of our analysis is concerned.
The study of effects of  fiscal operations  is included in the scope of public finance. Prof. Herber says “The government means of allocation is accomplished through the budgetary practices of taxing and spending... in addition to allocation function public finance is also concerned with three other major areas of economic activity.- distribution, stabilization and economic growth.” Rolph and Break. defined public finance as the discovery and appraisal of the effects of government financial policies. Naturally the appraisal of the results achieved involves value judgments. It means that effects of fiscal operations are studied and analysed and it is seen whether they are good or bad. Thus, the above definitions points out that scope of Public Finance has been widened by modern economists and it can be said that Public Finance is also a normative Science.

The scope and subject matter of Public Finance           


  In the light of above discussion the subject matter and scope of public finance may be summarized as under:

                                       

Public Revenue:

The income of the state from all sources is referred to as public revenue. This part of public finance deals with the several sources from which the state derives its revenue. It discusses and analyses the comparative advantages of various methods of raising revenue and the principles which should govern the choice between them. Since taxation is the most important source of revenue for any government, we study the different types of taxes, the canons of taxation, the theories of taxation, the impact and incidence of taxation, the effects of taxation, the problems of tax evasion and avoidance and its remedial measures.                                                                                                                                     

      Public Expenditure:

Modern state has to perform various functions in order to maximize the welfare of the people. These activities involve heavy public expenditure. This part of public finance, studies  the fundamental principles governing the flow of government funds into different spending streams, the method of incurring state funds on various items of expenditure, classification and justification of public expenditure, canons of public expenditure, problems relating to expenditure of public funds, the reasons for growth of public expenditure, the theories explaining the growth of public expenditure, the effects of public expenditure on the economic life of the country,  the expenditure policies of the government and the measures adopted for keeping a check on public expenditure.                                                       
3.Public debt:

Public debt arises when the governments borrow when their expenditure exceeds revenue. This branch of Public Finance studies causes of borrowing, sources of public debt, classification of public debt, effects of public debt, methods of debt redemption, and public debt management.
4.Financial administration:

Financial administration is concerned with the study of different aspects of public budget. Budget is the master financial plan of the government. The whole procedure of preparation of the budget, presentation of the budget, passing and execution of the budget, evaluation of the budget, all these aspects fall into the subject matter of financial administration. In short, financial administration studies the organizing and disbursing of the finances of the state.                                     

5.Economic stabilization and growth:

This part of public finance deal with the use of public revenue and public expenditure to secure stability in prices by checking inflationary and deflationary tendencies., full ,employment, optimum use of resources and equitable distribution of income and wealth. The use of fiscal tools to achieve economic stability has assumed much importance after the publication of Keynes’s ‘General Theory’.

     In the case of less developed countries, fiscal policy is used as a tool to stimulate economic growth. Hence, the main consideration of financial administration is to frame and implement various policies required for growth. The use of fiscal policy to stimulate economic growth in less developed countries became significant after Second World War.

     Federal Finance:


The existence of multi-layer system of government necessitates a corresponding division of functions and resources between different layers of government. The principles of allocation of resources between different government, problems relating to intergovernmental financial flows, financial adjustments made by the central government to state governments etc. are studied in this part of public finance.
According to Prof. Richard A.   Musgrave, The scope of public finance embraces three functions of government budget policy. These three functions are :
Allocation function,
Distribution function
Stabilization function.
Allocation function refers to the allocation of resources by means of revenue and expenditure policies for the satisfaction of public wants. Distribution function is concerned with measures taken to bring about an equitable distribution of income and wealth in the economy. Government redistributes income by taxing the rich and spending on welfare programmers for the poor. Stabilisation function is concerned with measures taken to maintain price stability and full employment.. It means that the effects of fiscal operations on allocation of resources, distribution of income , full employment and price stability and growth  are studied in the scope of public finance.
The scope of public finance is not just to study of public revenue and public expenditure. It covers a full discussion of the influence of government fiscal operations on the level of overall activity, employment, prices and growth process of the economic system as a whole

Reasons for widening scope of public finance:

The scope of public finance is not static, but dynamic in the sense that it is continuously widening with the passage of time. Several factors have contributed to the widening scope of public finance. They are:

1.Change in the concept of the state:

The classical economists with their faith in laissez-faire advocated minimum functions of the government. Under the policy of laissez-faire, the state was regarded as a police state, which was primarily interested in the protection of the citizens from external aggression and maintaining law and order in the country. The concept of the state and its functions gradually changed especially after the global depression of the thirties. The publication of Keynes’s ‘General theory’ sounded the death knell of classical version of laissez-faire. Keynes emphasized increased state participation in economic life. The concept of police state has given place to welfare state. It is now universally agreed that the object of the state is to maximize the welfare of the community as a whole.

2.Increase in the activities of the state:

The change in the concept of the state from police state to welfare state has extended its functions. It has to make provision for medical facilities, housing, education, poor relief sanitation and various other services of public utility so as to enhance the welfare of the community. The modern state helps the people to raise their productive power by constructing infrastructural facilities such as railways, roads, power projects, post and telegraph etc. It takes steps in reducing inequalities in the distribution of income and wealth, it controls the price of essential commodities, it takes steps to counteract inflation and deflation. In times of war it has to mobilize and control the entire resources of the nation in order to face it successfully.

Governments of advanced countries are responsible for maintaining the stability and expanding the level of employment and bringing about the goal of full employment as far as possible. In the case of developing countries the government is committed to the programme of accelerated economic development. Thus it is obvious that the functions of developed and developing countries are expanding with the increase in responsibilities of the government. In order to discharge these increased functions the state has to increase its expenditure. To meet the increased expenditure it has to mobilize funds with the help of the methods laid down by the science of public finance. Hence, the scope and importance of public finance has expanded considerably in modern times with  the  increase in the functions of the state.

3.Influence of Keynes:


The publication of Keynes’s ‘General Theory of Employment Interest and Money’ was a big blow to the old classical economics, which was based on laissez faire. Keynes shattered the basic foundations of the classical doctrine. He asserted that supply does not create its own demand and full employment and price stability is not supposed to reach automatically. According to Keynes in an advanced economy the propensity to consume diminishes as income increases. In other words, the propensity to save increases as income increases. Hence larger proportion of additional income is saved and not spent. This tendency of less consumption and larger savings results in lowering of demand for goods and services. Hence to maintain income and employment at the current level, it is necessary to offset the effects of declining private expenditure by a corresponding increase in public expenditure directly by undertaking public works programs on a larger scale. Thus Keynes showed clearly that the operations of public finance can be used successfully to regulate aggregate demand and create conditions of full employment and economic stability. Thus, due to the influence of Keynes the scope of public finance has widened.

4.Changing problems of Economics:

In the thirties and forties the problem was one of stabilization of the economy i.e. to get out from a situation of unemployment and reaching a stage of full employment. Since fifties attention has been shifted to the rate of growth of potential output and inflation. After a high level of employment has been reached in,  the problem became one of restraining inflation without losing full employment at the same time. . Besides the appearance of stagflation has raised doubts regarding the effectiveness of traditional fiscal measures and called for a new approach.

5.Problems of economic development in under developed countries:

In under developed countries the main objective is rapid economic development. Public finance can accelerate economic development in many ways such as increasing the rate of savings and investment, promoting economic stability, equal distribution of income and wealth.
Nature of Public finance

Public finance is a science. Science is a systematic study of any subject which studies the casual relationship between facts. Public finance ia systematic study relating to revenue and expenditure of the government. It also studies the casual relationship between facts relating to revenue and expenditure of the government.
Public finance is an art

Art is the application of knowledge for achieving definite objective. Fiscal policy which is an important instrument of public finance makes use of the knowledge of revenue and expenditure. To achieve the objective of economic equality, taxes are levied at a progressive rate. The magnitude of development expenditure is enhanced  to achieve economic development. Since every tax is likely to be opposed, it becomes essential to plan their timing and volume. The process of leving tax is certainly an art. Budget making is an art  in itself. Study of public finance helps to solve many practical problems. Therefore Public finance is an art .It is concerned with real problems.

Public finance is a positive as well as  normative science

In its positive aspect, the study of public finance is concerned with the revenue expenditure process of the government. It was considered as a description  of how public authorities collect revenue, how they make expenditure and how the revenue expenditure process is administered.. It deals with the facts as they are. It is not concerned with the good and bad effects or with the welfare aspect of certain tax or expenditure or the adverse effects of certain taxes  or budgetary policies. The classical economists regarded that public finance is a positive science. They neglected the normative aspect of fiscal operations. It was argued that “ fiscal problem pure and simple should not be confused with alien considerations of social and economic policy”.
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 In its normative aspect it anlyses the effects of fiscal operations on the overall level of economic activity. It is also assessed to what extent they are good or bad.  In its normative aspect norms or standards of fiscal operations are laid down, investigated and appraised. The basic norm of modern public finance is social welfare. In fact, it is the welfare aspect of the subject which makes public finance a normative science.  The
normative character of public finance received emphasis from Keynes in  his General Theory. He pointed out that fiscal operations can be used to influence the general level of economic activity. Governments all over the world  have been  making use of fiscal devices to control cyclical fluctuations, reduce inequality in the distribution of income and wealth to achieve full employment and economic growth, prove the normative aspect of the science of public finance

It is clear that public finance is not only a study of the revenue  expenditure process, but also its effects on the economy as a whole. Modern governments are not merely concerned with revenue raising and spending exercise ,but also with the good and bad effects of every  move  involved in that process. It means that the governments do exercise some value judgements while taking up any step in matters related to taxation, public expenditure,, borrowing and deficit financing as well as in the satisfaction of social wants. Hence public finance is a positive as well as a normative science. On normative consideration, public finance becomes a skillful art, whereas in its positive aspect, it remains a fiscal science.

Comparison between public finance and private finance:

Public finance deals with income and expenditure between of public authorities. It includes the policies and methods employed to secure money to carry out its expenditure. whereas private finance deals with the income and expenditure of an individual, private company or business ventures. It includes the study of their own view regarding expenditure and borrowing. A comparison between public finance and private finance  is not only necessary, but also useful to understand and appreciate the nature of problems of these two branches more correctly.  There are similarities as well as dissimilarities between private finance and public finance.

Similarities:


1.    Same objective:

Both the individual and the state have the same objective i.e the satisfaction of human wants. Public finance is concerned with the satisfaction of social or collective wants, whereas private finance is concerned with the satisfaction of personal or individual wants.

1.Maximum advantage
Both public and private finance try to secure maximum advantage or satisfaction. A private individual tries to secure maximum gains from his expenditure. Likewise the government also wishes to secure maximum social advantage from its financial operations.

2.Borrowings
Borrowing becomes essential both in public and private finance when current income fall short of current expenditure. An individual borrows from different sources such as relatives, friends and financial institutions .The state also borrows from individuals and financial institutions. Besides both public and private finance are required to repay the loans sooner or later.

3.Adjustment of income and expenditure:
Since the resources at the disposal of the individuals and government are limited compared to their needs, both public finance and private finance face the problem of adjustment of income to expenditure.

4.Problem of choice:
Both public and private finance face the problem of choice as both are concerned with unlimited ends with scarce resources.

5.Contribution to national product:
The financial activities both the private sector and public sector helps to increase savings, investment and production and thereby contributes to national product

6.Efficient management
 Private as well as public finance needs efficient management and administration. In the event of collapse of an efficient management, both are compelled to face dire consequences

Dissimilarities/Distinction between public finance and private finance: 


Public finance differs from private finance in many respects. The major sources of difference are:
1.Adjustment of income and expenditure:

An individual adjusts his expenditure to his income, while public authorities adjust their income to expenditure. An individual first calculates his income and then determines his expenditure. Public authorities on the other hand first determines the volume their expenditure and then devise ways and means to raise necessary revenue to meet the expenditure. The individual cuts the coat according to his cloth. But government decides the size of the coat and tries to get the required cloth.The difference in adjustment of income and expenditure arises because the individual ordinarily knows the size of his income, while the government does not know its income.

2.Application of the principle of  equi - marginal utility: 

An individual is more capable of applying the principle of equi- marginal utility to plan his expenditure than a government because he is more free to follow his own scale of preferences. A public authority is supposed to have no freedom in respect of expenditures such as defense, law and order, education, poor relief etc.

3.Nature of resources:
The resources of an individual are more or less limited while that of a public authority is enormous. Besides tax revenue the public authorities can borrow from external sources and can resort to the method of deficit financing to increase their income, but an individual can never do so. Public authorities can also pass laws to take over profitable private business and trade in their hands for the purpose of raising income.

4.Coercive methods:
The government can use compulsory methods to collect revenue. No individual can refuse to pay taxes if he is liable to pay . But private individuals and businessman cannot use force to get their income. Hence income of public authorities is more assured than that of private individuals.

5.Motive of Expenditure:
Motive behind private expenditure is profit, whereas government is motivated by social welfare.

6.Nature of budget:
An individual generally believes in surplus budget and a deficit budget is considered always undesirable. On the contrary government may find it useful to have deficit budget for several years especially in times of war and economic development.

7.Long term considerations:
Private individuals   investments in those fields of business where returns are quick. They keep in view short-term considerations. But government is influenced by long term considerations as it is guardian of  both the present and future generation. Hence the government undertakes such projects like construction of multipurpose river valley projects, soil conservation Schemes, education, public health, aforestation etc.

8.Publicity and audit:
Private individuals like to keep their financial transactions secret, while government gives greatest publicity to its financial activities. e.g. maximum publicity is given to the budget proposals and allocations of resources  to different heads in the five year plan. Besides the accounts of the public authorities are subject to compulsory audit and inspection, while it is always not mandatory for individuals

9.Deliberation in expenditure:
The pattern of expenditure of an individual is governed by customs, habits, status and personal needs. On the other hand pattern of public expenditure is governed by deliberate economic policy of the government.

10.Compulsory character of expenditure:
        Certain expenditure of the public authorities are compulsory in character. They cannot avoid or postpone.
        certain expenditure like     defense, maintenance of law and order, relief in times of natural calamities etc.    
        Findlay Shirras says that compulsory character is an important feature of public finance


11.Impact of expenditure

An individual’s spending policy has very little impact on the society as a whole. But the state can change the nature of the economy through   its  fiscal policy. By following a deficit budget it can control depression. Likewise it can  fight  inflation through a surplus budget

12.Budget period:

There is no particular time period for individual plans. They plan according to the time duration over which he earns his income. It may for weekly wages, monthly income or annual profits. But the government prepares its budget for one year.



References

1.       Hugh Dalton: Principles of Public Finance

2        Ursula Hicks : Astudy in Public Finance
3        Richard  A.Musgrave : TheTheory of Public Finance
4        Philip.E.Taylor : Economics of Public Finance
5        Bernard.P.Herber: Modern Public Finance
6        P.C.Jain : Economics of Public Finance
7        S.N.Chand: Public Finance
8        H.L.Bhatia : Public Finance
9        .B.P.Tyagi.Public Finance




FINANCIAL STATEMENTS

Sunday, May 15, 2016 3:50 AM Posted by Indira

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 FINANCIAL STATEMENTS

Financial statements contain summarized information of the firm’s financial affairs organized systematically. These are the mirrors  which reflect the financial  position and operating strength of the firm.These statements are prepared from the accounting records maintained by the firm. Accounting principles and procedures are followed to prepare the statements. A firm communicates financial information to its users through  financial statements. The users of financial information are owners, managers, creditors, potential investors, employees, government, customers.
       Owners have primary interest in financial information  because  they have invested their financial resources. Therefore they would like to know periodical financial position of the firm. Managers are responsible for the overall performance of the firm. They make several decisions and therefore need information about the financial affairs of the firm. Creditors supply the financial resources to the firm. They are interested in the continuing profitable performance of the firm so that they may regularly receive interest and repayment of principal. Potential investors get an idea about the firm’s  financial strength and performance from financial statements. They are generally interested in the earnings, dividends and growth trends of the firm. Employees and trade unions make use of financial statements. They can bargain  on the matters related to salary determination, bonus, fringe benefits  or working conditions on the basis of financial information. Government has an in interest  in financial statements for regulatory purposes. The tax department of the government has an interest in in determining the taxable income of the firm. Customers are interested in financial information because a careful study of the financial statements may provide information about prices being charged by the firm.
Objectives of Financial Statements
The basic objective of financial statements is to assist in decision making.The other objectives are:
- To provide reliable information about economic resources( assets) and obligations( liabilities) of the firm
 - To provide financial information in estimating the earning potential of the enterprise. 
- To disclose to the extent possible other information related to financial statement that is relevant to the statement users. 
- To analyse the short term liquidity  position of the firm . 
-  To assess the strength and weakness of the firm in various areas. 
-.T assess the corporate excellence, 
- To judge credit worthiness of the firm. 
- To forecast bond rating.(i). To evaluate the intrinsic value of equity shares, 
-.To predict bankruptcy. 
-  To assess market risk.
Types of financial statements
 Two basic financial statements are prepared by a firm. They are: 
1. Balance sheet or statement of changes in financial position. 
2.Profit and Loss account or Income Statement.
 These statements are contained in the company’s annual report. In addition, two ancillary statements, Cash Flow Statement and Fund Flow Statement  are prepared by companies.
Balance sheet
A balance sheet indicates the financial condition or state of affairs of a business firm at a particular point of time. It provides information about assets, liabilities and owners equity of a business firm on a specific date. For eg. Balance sheet of a firm prepared on 31st  December 1991 reveals a firm’s financial position on that date. So  it is a stock or status statement. Like any other statements a balance sheet should contain a heading. Heading includes the name of the firm, type of statement and date to which the statement applies. A balance sheet is often described as the snapshot of company’s financial position.
Forms of balance sheet
A balance sheet can be presented in the account form or report firm. Balance sheet in the account form has been divided into two sides. The right hand side lists the assets of the company and left hand side shows the liabilities of the company and owner’s equity. The left hand side gives details of the sources of borrowed funds and owners original investments plus reserves and surpluses. It is a horizontal presentation of the balance sheet. It is the traditional orm of balance sheet.
In the report form of balance sheet, a step wise balance sheet is prepared. It lists assets at the top and liabilities and owners equity below that. In the report form of balance sheet assets liabilities and owners’s equity are  listed downward or vertical form. It is a vertical presentation of the balance sheet.
As the name indicates the total of the two sides of the balance sheet must always balance because the total assets invested in business at a point of time are matched precisely by the sources of these assets. This necessarily follows from the accounting equation              
                   TA  = TL + OE ( TL = Total assets, TL = Total liabilities, OE =Owner’s equity ) and does not indicate anything about the firm’s financial strength.
The Indian Company’s Act,1956 ,requires companies register under it to submit their balance sheet in horizontal or vertical form.
                         Format of Account Form of Balance Sheet  
Company ABC
Balance Sheet as on  as on 31st December 2014
Liabilities
( .in lakhs)
Assets
( .in lakhs)
Long term liabilities

Fixed assets

Secured loans
100
Land, buildings, plant and machinery
1300
Unsecured loans
50
Investments
400
Current liabilities

Current assets

Bank borrowing
30
Cash and bank balances
150
Accounts payable
10
Sundry debtors
80
Bills payable
7
Inventories
120
Income received in advance
3
Bills receivable
100
Owners Equity
1600
Advances
50
Reserves and surplus
 400


Total iabilities and equity
*        2200
  Total Assets
*        2200
             
                                  Format of  Report form of   Balance sheet                                                                                                                  
                                              Company ABC

                     Balance sheetfor the year ended 31st December  2014

                Assets

               Fixed Assets

              Land and building                     1300
              Investments                                400 
              
              Current Assets
      
               Cash and bank balance             150
               Sundry debtors                           80       
               Inventories                                 120
               Bills receivables                         100
               Advances                                     50
               
                Total assets                             2200


                Liabilities
                             
                Long term loans

                Secured loans                           100
                Unsecured loans                         50    
              


                Current Liabilities
                 
                Bank borrowing                          30
                Accounts payable                       10 
                Bills payable                                  7
                Income received in advance             3       

               Owner's equity                           1600
               Reserves and surpluses               400
             
              Total liabilities                            2200

 Marshalling of assets and liabilities

 The process of arranging the balance sheet items (assets and liabilities) in a specific order is called Marshalling of assets and liabilities. In marshalling of assets two orders are followed  
       
    1.Order of liquidity   2.     2. Order of permanence

Order of liquidity: Following the generally accepted principles of accounting, assets are listed in the order of liquidity. The most liquid asset cash is placed first and the least liquid asset goodwill is placed last. In the case of liabilities the liquidity that can be paid out at the earliest (bank overdraft) is placed first and the liability that has got the highest life time is placed last.

Order of permanence: This order is the reverse of liquidity. The asset with highest permanence ( least liquid asset) goodwill is placed first and the asset with least permanence, cash ( highest liquid asset ) is placed last. In the case of liabilities the liability that has the highest permanence, equity capital is placed first and that have to be paid at the earliest ( bank overdraft) is placed last.

Items in the balance sheet

Assets
 Assets are the valuable possessions owned by a firm. Assets are resources which are expected to provide a firm with future economic benefits. They have been acquired by a firm at specific monetary  costs for conducting its operations. Assets are classified as follows

1.Fixed assets  2. Investments  3. Current assets , loans and advances

 Fixed assets     :   Fixed assets are also known as long term assets or non current assets. Fixed assets are expected to provide benefits for more than one year. These are held for periods longer than the accounting period. They are held for carrying on the operations of the firm and are not meant for sale. These assets may be tangible or intangible.

Tangible fixed assets: Tangible fixed assets  include land ,building machinery, equipment ,furniture etc. The costs of these fixed assets are reduced every year by the amount of depreciation. Depreciation of the asset is the process of allocating cost and does not involve any cost

Intangible fixed assets: Intangible fixed assets include firm’s rights including patents, copyrights, trade marks, trade names, and goodwill. Patents are the exclusive rights granted by  governments enabling the holder to control the use of an invention. Copy rights are the exclusive rights to reproduce and sell literary, musical and artistic works. Trade marks and trade names are exclusive rights granted by the government to use certain names, labels, symbols, designs etc

Goodwill : Goodwill is an accounting concept..Goodwill in financial statements arise when a company is purchased by another  company for more than its face value of its identifiable assets. It represents the amount of money a company has paid or would pay over the face value of net assets to acquire another company. e.g a software company have net assets valued at Rs.1 million. But company’s overall value including its intellectual capital is valued at Rs.10 million. Then 9  million is the face value of goodwill. This goodwill represents the exclusive earning power of a firm due to special advantage it possess.

Long term investments : Long term investments represents financial securities owned by the firm. It shows investments in shares, debentures and bonds of other firms or government bodies for profit and control. These investments are held are for a period greater than the accounting period. Usually long term investments are shown at  their cost, but current market price may be indicated.

Other non current assets : Other non current assets  are those which cannot be included in the above categories. Usually they represent deferred charges. Prepayments for services or benefits for a period longer than the accounting period are referred to as deferred charges. They include advertising, preliminary expenses etc.

Current Assets: Current assets also called liquid assets are those resources of a firm which are either in the form of cash or other assets which can be converted into cash within the accounting period or the operating cycle of business. The accounting period is one year. The operating cycle is the time taken to convert raw materials into finished goods, sell finished goods and convert receivables( goods sold for credit) into cash. Most operating cycle is less than or equal to the accounting period.

Current assets include: 1.Cash  2.Marketable securities 3.Accounts receivables, 4.Sundry debtors 5. Bills receivables  5. Inventories or stocks,  6.Prepaid  expenses and accrued income 7. Loans and advances.

Cash :  Cash is the most liquid asset. It is the current purchasing power in the hands of the firm and can be used for the purpose of acquiring  resources  or paying obligations. Cash includes actual money in hand and cash deposits in the bank account.

Marketable securities:  Marketable securities are temporary short term investments in shares, bonds, debentures and other securities. These securities are readily marketable and can be converted into cash within the accounting period..A firm usually invests in marketable securities when it has surplus cash..A number of Indian companies invest  their surplus cash in the units of UTI or other securities such as commercial paper and other short term investments. It is a common practice to show marketable securities at their original cost or current market price which is lower.

Accounts receivable:  Accounts receivables also called sundry debtors is the amount due from the customers when goods and services have been sold on credit. The amounts are receivable in cash during the accounting period.

Bills receivables: Bills receivables represent written promises by debtors to pay a definite sum after some specified period of time. A firm may discount bills receivables with a bank and realise cash immediately .The amount of discount is the bank’s commission

Inventories or stocks :  Inventories or stocks include raw materials, work in process and finished goods in the case of manufacturing firms. Raw materials and work in process( semi finished goods) are needed for production. Stock of finished goods are kept for  meeting the needs of customers on a continuing basis..Inventories are shown in the balance sheet at the original cost or at market price  whichever is less. Inventories are the least liquid  current asset. First  they have to be sold and receivables have to be collected.

Pre paid expenses:  Pre paid expenses  are the expenses of the future period paid in advance. Examples of prepaid expenses are the pre paid insurance premium, pre paid rent and tax paid in advance

Accrued Income : Accrued income are the benefits which the firm has earned,  but they have not been received  in cash yet. They include such items as accrued dividends, accrued commission or accrued interest.
Loans and advances: are the amounts loaned to  the employees, advances given to suppliers  advances against the acquisition of capital asset.

Liabilities

Liabilities are the debt payable in future. Generally liabilities are created by borrowing money or purchasing goods and services Liabilities are of two types:

1. Current liabilities  2.Long term liabilities

Current liabilities include accounts payable or sundry creditors,  bills payable, expenses payable, income received in advance, and installments of  long term loan.

 Accounts payable or sundry creditors : Accounts payable or sundry creditors represents the amount due to suppliers of goods and services  bought on credit. This liability is shown in the balance sheet till payment has been made to the creditors

Bills payable  : Bills payable  are the promises made in writing by a firm to make payments of a specified sum to its creditors at some specified future date.    Bills are written by creditors over the firm and becomes bills payable once they are accepted by the firm..Bills payable have a life less than one year. Therefore they are shown as current liabilities

Bank borrowings : Commercial banks advance short term credit to firms to finance their current assets

Provisions :  They include provision for taxes and dividends. Every business firm has to pay tax on its income .Usually it takes time to finalize the amount of tax with tax authorities. Therefore  the amount of tax is estimated and shown as provision for taxes or tax liability in the balance sheet. Similarly provision for payment of dividends to the shareholders may be created  and shown as current liability

Expenses payable: The firm may owe payments to its employees and others  at the end of the accounting period for the services rendered in the  in the current year These payments are payable within a short period. Examples of outstanding expenses are wages payable, rent payable or commission payable.  

Income received in advance: Some times a firm may receive income for the goods and services to be supplied in future. As goods and services have to be provided in the accounting period, such receipts are shown as current liabilities in the balance sheet. 

Instalments of short term loan which is payable in the current year will form a part of the current liability.  

Long term liabilities
Long term liabilities are obligations payable in a period of time greater than the accounting period. Long term liabilities represent borrowing for a long period of time. They include debentures, bonds secured long term loans, and unsecured long term loans, share capital and reserves and surpluses                             

Debentures and bonds are issued by a firm  to the public to raise debt. The firm has the obligation to pay interest and return the principal sum
Secured long term loan:  These are borrowings of the firm against which specific security have been provided. The important component of the secured loans are the loans from commercial bank and other financial institutions.

3.Unsecured loans:  These are borrowings against which no specific security has been provided. The major component f the unsecured loan are loans and advances from the promoters,  inter corporate  borrowing and unsecured loans from the banks.
Share capital:  Share capital is divided into two types. Equity capital and preference capital..Equity capital represents the contribution of equity holders who are the owners of the firm. Equity capital being risky capital  carries no fixed rate of dividends. Preference capital represents the contribution of preference share holders and dividend rate payable on it is fixed.
Reserves and surpluses are profits which are retained in the firm. So they are known as retained earnings or undistributed profits. There are two types of reserves: 1.Revenue  Reserves and  2.Capital reserve. Revenue reserve represent accumulated retained earning from the profit of normal business operations. These are held in various forms: general reserve, investment allowance reserve ,dividend equalization  and so on. Capital reserve arise out of gains which are not related to normal business operations. Examples of such gains are the premium on the issue of shares or gain on the revaluation of assets.
Net Worth: It is the sum of share capital plus reserves and surpluses. It is also known as owner’s equity.

Profit and Loss Account  or Income Statement

Profit and loss account provides information  on the operation of the firm. It shows whether the firm has made profit or loss in the accounting year. It   is  the  ‘ scoreboard ‘ of firm’s performance during a period of time. Since profit and loss account reflects the result of firm’s operations for a period of time it is a flow statement. It provides a summary of revenues , expenses  and net income (ie profit or loss) of the firm. It serves as a measure of firm’s profitability .

Revenues are the amounts which the customers pay to the firms for providing goods and services to them. The cost of the economic resources used to earn revenue during a period of time is called expenses of the firm. To determine the profit and loss expenses incurred during an accounting period are matched against revenues earned during that period. Net profit or net income which is an indicator of  firm’s profitable operation is the amount by which revenues earned during that period exceed expenses incurred during that period. If the total expenses exceed total revenues the firm’s operation seems to be unprofitable. It is a situation of loss to the firm.
The profit and loss account has a heading. The name of the firm or company appears first in the heading followed by income statement. The third line shows the period of time of the firm

Forms of profit and loss account
The profit and loss account can be presented  in two  forms 1.Report form. 2. Account form. Typically company’s employ report form.

Report form
Report form statement  may be single step statement or multi step statement. Single step statement is  the commonly used format for income statement.. In a single step statement all revenue items are recorded first.It is known as top line figures. Then expense items are shown and finally net profit is given.Net profit figures are called bottom line figures.It is the last line in the profit and loss account.  A single step statement aggregates all revenues and expenses and uses only one subtraction to arrive at net profit or loss

In contrast to single step statement which aggregates all revenues and expenses , a multistep statement provides disaggregated information. Instead of showing only final profit measure, ie profit after tax, a multi step statement shows profit measures at intermediate stages as well. It uses multiple subtractions in arriving at net income. It is a disaggregated profit measure. Following examples show formats  of single step statement and multi step  statements
                    
                    Format of single step  income statement 
Company ABC
Profit & Loss Account
For the year ended  December 31, 2014
Sales Revenues
*        1810
Other non operating revenues
               190
Total revenue
             2000
Expenses

Cost of goods sold
             1220
General and administrative expenses
               120
Selling expenses
               100
Interest
                 40
Depreciation
                200
Non operating expenses
                  40
Provision for tax
                140
Total expenses          
              1860
Net profit
               140
Appropriation of profit

Provision for dividend
                40
Transfers to reserves & surpluses
              100
 Total
              140







                         















                 






           Format of   Multi step income statement
Company ABC
Profit & Loss Account
For the year ended  December 31, 2014
Sales revenue
   1810
Cost of goods sold
    1220
Gross profit
    590                      
Operating expenses

General  & Administrative expenses
              120
Selling expense
              100
Depreciation
              200
Total operating expenses
             420             
Operating profit
        170                  
Other income
              190            
Total income
              360
Non operating expense
                40
Profit before interest & tax
          320                
Interest
                40
Profit before tax
              280
Provision for tax
              140
Appropriation of profit
Provision for dividend
                40
Revenues and surpluses
              100
Total
             140

                              
                                                                
    


                                                                                                               

  Account form

Profit &loss account can be prepared in account form The account form divides  the  profit & loss account in to two sides. The left hand side is used to record expense items  and right hand side lists revenue items

                                   Format of  Account form of income statement

Company ABC
Profit & Loss Account
For the year ended  December 31, 2014
Expenses
. In  lakhs
                 Revenues
.lakhs
Cost of goods sold
   1220         
Sales revenue
1810
General  & Administrative expenses
     120
Other income
   190
Selling expense
     100
Total revenue
2000
Interest
       40 


Depreciation
    200


Non operating expense
       40


Provision for tax
     140


Total expenses
   1860


 Net profit
     140  


Appropriation of profit



Provision for dividend
       40


 Reserves and surpluses
       100


Total
       140



Items or lines in the profit and loss account

Sales revenue:

Sales revenue is the total value of sales. It is referred to as the top line.

Cost of goods sold

Cost of goods sold also called cost of sales represents the direct material cost, labour cost, cost oof power,fuel and other costs incurred for producing the goods during the accounting period. Cost of goods sold can be defined as:

                 Cost of opening stock + Cot of purchases – Cost of closing stock.

Assume that a wholesaler has 100 units of unsold stock valued at .10 each unit.The firm produces 500 units at .10 for each unit during the year. The firm can sell  600 units.( Opening stock of 100 units + Purchase of 500 units) during the year. But its unsold stock is 80 units during the year.  Then it could sell only 520 units during the year.( Opening stock of 100 units + production of 500 units- 80 units of unsold stock). At the rate of .10 each the cost of goods sold is  . 5200. Thus the cost of goods sold  is  different from production cost which represents only the cost of goods produced during the accounting year.
Gross Profit

The difference between sales revenue and cost of goods sold  is called gross profit. This is the first and broadest  measure of profit.

Operating expenses

Operating expenses are the expenses incurred by the firm for running its operation. During the accounting period. General and administrative expenses, selling and distribution expenses, research and development expense and depreciation are the major items of operating expense.

Operating profit

The difference between gross profit and operating expense  is called operating profit.

Non operating income or other income

Revenues which are incidental or indirect to the main operations of the firm are called non operating income. e g .gross proceeds from the sale of  an old equipment  is non operating income. Similarly dividends and interest income from short term investments also examples of  non operating income.

Non operating expense

Expenses which are incidental or indirect to the main operations of the firm are called non operating expense. Expenses incurred in generating non operating revenues are classified in this category.

Profit before interest and tax

It is also referred to as earnings before interest and taxes. It  is equal to operating profit of the firm plus non operating revenue minus non operating expense. It is a measure before considering before considering interest expense and taxes.

Interest

Interest is the periodic expense incurred for borrowings like term loans, ,working capital, loans, commercial paper, unsecured loan provided by promoters etc.

Profit before tax

It is the difference between profit before interest and tax and interest payments. It is a measure of profit before taking into account taxes.

Provision for income tax

Provision  for income tax payable on the basis of taxable income as computed under the Income Tax Act.
Profit after tax

Profit after tax is obtained by subtracting the income tax provision from profit before tax.It is also called net profit or net income or the bottom line. When profit after tax is positive, the firm is said to be in black. When it is negative, the firm is said to be in red. Profit after tax is a measure of change in owner’s equity arising from the revenues and expenses of the accounting period.

Appropriations

From the amount available for appropriations  ie. Profit after tax , provision is made for proposed dividend and transfers made to the reserve.

Purposes or uses of profit and loss account

 -  Allows the shareholders to see the business has performed, whether it has earned an acceptable return
  - Helps to identify whether profit earned  by a business firm is sustainable.
  -   Enables a comparison with other business competitors.
 - Allows the directors of a company to satisfy their legal requirements to report on the financial    record of the    business.
 - The net profit or net loss from profit and loss account will be useful for taking the decision of payment of dividend.
 -    Employees may demand reward on the basis good performance in profit and loss account.
-  Bank can take decision for providing more loan to company, if bank sees good net profit in profit and loss account
- Company can calculate different profitability ratio on the basis of items of profit and loss account
- Current year profit and loss account is the base of comparing its figure with past year
- After making profit and loss account, company can create its relationship with company's   balance sheet for deep insight. Company can calculate return on investment, return on total  assets and inventory turnover ratio.

Difference between balance sheet and profit and loss account

The Profit and loss account shows revenues and expenses  and the resulting  profit or loss    during a set period of time. The balance sheet summarizes the financial position of a company for one specific point in time 
The profit and loss is a statement of financial performance and the balance sheet is a      
Statement of financial position
Profit and loss account shows the company’s  revenue , expenses and the resulting profit or  
 loss over a period of   time. Balance sheet shows company’s assets , liabilities and owner’s
 equity at a specific date
Profit and loss account is a flow statement as it reflects the result of its financial
 operations for a period of time. Balance sheet is stock statement as  it shows assets, liabilities
and equity at a point of time
It is essential that both profit and loss account and balance sheet are examined together in order to get a clear picture of the firm’s financial standing

Statement of changes in financial position

The two  basic financial statements are balance sheet and profit and loss statement. The balance sheet gives a static view of sources ( liabilities) and uses (assets) of funds. But it does not indicate the causes of changes in    assets and liabilities and owner’s equity between two points of time. Changes in owner’s equity is partially reflected in profit and loss account, but besides profits, owner’s equity may change due to factors such as additional investment, or withdrawal of profits. Therefore an additional statement is needed to show the changes in assets and liabilities and owner’s equity between dates of two balance sheet. Such statement is referred to as  statement of changes in financial position. This statement is intended to summaries changes in assets and liabilities resulting from financial transactions and investments during the period  as well as those changes  which resulted due to changes in owner’s equity and the way in which firms used its financial resources during the period
Changes in financial position may be related to different concepts of funds. The two most common concepts are  
1. Cash 
2..working capital. 
Accordingly there are two statements.
1.      Statement of changes in cash popularly known as cash flow statement
2.      Statement of changes in working capital popularly known as fund flow statement.
Cash flow statement or statement of changes in cash
A statement of changes in financial position over a period of time on the basis of cash is commonly known as cash flow statement. It indicates sources and uses of cash.  Activities of the firm that generates cash are called sources of cash and the activities that absorb cash are called uses of cash. A firm generates cash when it issues shares, debentures and bonds, raise bonds sell its products and dispose assets. A firm uses cash to meet its expenses to acquire assets, to pay wages and salaries, interest dividends etc.  If the business transactions that results in increase in cash or cash equivalents are called cash inflow or sources of cash.  If the business transactions that results in decrease in cash or cash equivalents are known as cash outflow or uses of cash. Cash equivalents are short term highly liquid investments that are readily convertible into cash without significant loss of value. Cash equivalents are held for meeting short term cash commitments. Cash comprises cash in hand and demand deposits. Cash plays a very important role in the entire economic life of business. In fact what blood is to human body, cash is to business. It is very essential for business to maintain adequate balance of cash.      

   A cash flow statement summarizes cash inflow and cash outflow .ie  where cash came and       where cash went. It shows flow of cash in and out of business. . A firm generates cash when it increases its liabilities as well as owner’s equity and dispose of its assets.  On the other hand  a firm uses cash when it reduces its liabilities as well as owner’s equity  and acquires assets .

Sources of cash

The following are the main sources of cash.
Profitable operations
Decrease in assets 
 Increase in liabilities including  bonds and debentures
 Sale proceeds from  ordinary and preference shares
Uses of cash

Uses of cash are:
 The loss from operations
 Increase in assets 
Decrease in liabilities including  bonds and debentures 
Redemption of  redeemable preference shares
Payment of cash dividends

Classified cash flow statement

To understand  better how cash flows have  been influenced by various decisions, it is helpful to classify cash flow into three classes.

1..Operating activities
2. Investing activities                                             
3.   Financing activities

Operating activities

Operating activities are the principal revenue producing activity. Operating activities involve production and sale of goods and services. Cash inflow from operating activities include  money received from the customers for the sale of goods and services. Cash outflow from operating activities include payments to the suppliers for materials, to the employers for their services , to the government for taxes and interest payments.

Investing activities

Investing activities involve acquiring and disposing of fixed assets, buying and selling of financial securities, disbursing and collection of loans. Cash inflow from investing activities the receipts from the sale of both physical and  financial assets, recovery of loans and collection of dividends and interest. Cash outflow  from  investing activities include payments for the purchase of  financial as well as physical assets and disbursement of loans.

Financing activities

  Financing activities include raising of money from lenders and shareholders, paying interest, dividend and redeeming loans and share capital. Cash inflow from financing activities include receipts from issue of securities  and from loans and deposits. Cash outflow from financing activities include payment of interest on various forms of borrowing, payment of dividend, redemption of loan preference shares.
 The earliest and direct method of preparing cash flow statement is to record cash inflow and cash outflow and find the net changes during the given period. ie the dates of two balance sheets. How a firm has obtained cash and how it has spend cash during a given period, we have to look at changes in each items of the balance sheet over that  period. As an analytical tool ,the statement of cash flow is useful in determining short term viability of the firm, particularly its ability to pay bills. It reflects the firm’s liquidity. An analysis of cash flow is useful for short term planning. A historical analysis of cash flows provides insight to prepare reliable cash flow projections for the immediate future.

Fund flow statement or statement of changes in working capital

Working capital is defined as the difference between current assets and current liabilities. Working capital determines the liquidity position of the firm. A statement of changes in working capital reveals to the management the way in which working capital was obtained and used. It s a summary of firm’s working capital position.

Sources of working capital

1. Funds from profitable operation
2. Sale of current assets

  a).Sale of long term investments ( shares, bonds and debentures)
  b).Sale of fixed assets like land and building ,plant and equipments
  c). Sale of intangible fixed assets like, goodwill patents and copyright

3.Long term financing
Long term borrowings ( institutional loans,bonds and debentures)
Issue of equity and preference shares
Short term financing such as bank borrowing

Uses of working capital

1.Loss from operations

2.Purchase of non current assets
  a). Purchase of long term investments ( shares, bonds and debentures)
  b). Purchase of fixed assets like land and building ,plant and equipments
  c). Purchase of intangible fixed assets like, goodwill patents and copyright

3.Repayment of long term debt
4.Redemption of redeemable preference shares
5.Payment of cash dividend

The difference between sources and uses of working capital measures changes in working capital.If the sources of funds are greater than uses of funds, there is an increase in working capital. An increase in current assets and decrease increase in current liabilities cause an increase in working capital. Likewise A decrease in current assets and an increase in current liabilities cause an decrease in working capital.

Standardised Financial  Statements

Companies differ considerably in size. Hence it is difficult to compare their financial statements directly. Even for the same company, if its size changes overtime, it is difficult to compare financial statements of different times. Hence for meaningful comparisons  financial statements are standardized. There are two forms of stanardised statements

1.Common size statements  
2. Common base year financial statements
 Common size statements

A useful and convenient way of standardizing financial statements is to express  each item  in the profit and loss account as a percentage of sales  in the balance sheet as a percentage of assets. The resulting financial statements are called common size statements. When each item in the profit and loss account as a percentage of sales  in the balance sheet as a percentage of assets, we arrive at common size statements
.
Common base year statements 

 Common base year statements are prepared to find out the trends in revenues, profits, net worth, debts and so on over a period of time. A useful way of doing this is to select a base year and express each item relative to the amount in the base year. The resulting statements are called common base year statements. Each item in the profit and loss account and balance sheet are expressed relative to the amount in the base year

 Applications of financial statements

Financial statements  can be  very useful tools for understanding a firm’s performance and condition. The major applications of financial statements are:
1.      To assess corporate excellence
2.      To assess the credit worthiness
3.      To  forecast bankruptcy
4.      To value equity shares
5.      To predict bond rating
6.      To estimate market risk. 


Problems of financial statements

Certain problems or issues are encountered in financial statement analysis. They are:

Lack of underlying theory: In the absence of underlying theory the financial statement analysis appears to be adhoc, informal, and subjective.

Conglomerate firms: Many firms, particularly large firms have operations covering a wide range of activities. Given the diversity of their productive lines, it is difficult to find suitable benchmark for evaluating their financial performance and condition

Window dressing: Firms resort to window dressing to project a financial picture.eg. a firm may prepare a balance sheet at a point when its inventory level is very low. As a result it may appear that a firm has very comfortable liquidity position.

Price level changes: As price level changes are not taken into account, balance sheet  figures are distorted and profits misinterpreted

Variations in accounting  policies: Due to diversity of accounting policies and practice comparative financial statements analysis may be vitiated

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