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Income Statement - DOC

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									          Chapter: 7
The Income Statement




               1
Learning Objectives
After studying this chapter, you should be able to understand following
    Income Statement
    Income
    Expenses
    All receipts are not income
    All payments are not expense
    Difference between expenses and asset
    Earning per shares
    Basic EPS and Diluted EPS




                                                                          2
INTRODUCTION

The objective of financial statements is to provide information about the financial
position, performance and cash flows of an enterprise that is useful to a wide range of
users in making economic decisions. The balance sheet shows the financial position of a
company, the income statement shows the financial performance, and the cash flow
statement shows the inflow and outflow of cash. The focus of this chapter is the financial
performance of a company as reflected by the income statement. Income statement is also
known as the statement of profit and loss.

The income statement of a company shows the net result of the activities undertaken
during a particular period of time. The income statement is also known as the Profit and
Loss Account (P/L Account) or the statement of profit and loss. It tells us the financial
results of business activity –how successful the operation of the business is. If income
exceeds expenses during the period, it is profit and if the expenses exceeds the income it
will be treated as loss.
.

WHYA SEPARATE INCOME STATEMENT?
The chapter on the accounting equation and the balance sheet has demonstrated that
every transaction can be captured through the accounting equation and balance sheet. The
financial position of a company can be analysed by comparing the accounting equation or
balance sheet on two different dates. So where is the need for another statement called
income statement. To answer the above question, let us take and example and understand
the limitations of accounting equation and balance sheet.

Example 7.1
ABC ltd started business with Rs. 100,000 and during the first quarter had the following
transactions:
      Took 12% loan = 100,000
      Purchased stock of goods for cash = 50000
      Purchased furniture (life =5 years) = 20,000
      Sold 50% stock for cash = 80,000
      Expenses paid for the quarter = 20000




                                                                                        3
Accounting equation for after each transaction is given in the table 7.1:
                             Table 7.1
                        Accounting Equation
 Profit +   12% Loan+     Capital =    Cash +     Goods+   Furniture
                           100000     100000
             100000        100000     200000
             100000        100000     150000      50000
             100000        100000     130000      50000       20000
 55000       100000        100000     210000      25000       20000
 35000       100000        100000     190000      25000       20000
 32000       100000        100000     187000      25000       20000
 31000       100000        100000     187000      25000       19000

And table 7.2 shows the balance sheet at the end of the quarter as reflected by the last
accounting equation

                        Table 7.2
            Balance Sheet of ABC ltd ( in 000)
             Sources                       Assets
 Capital                100000        Cash           187000
 12% IDBI Loan          100000        Goods           25000
 Profit                  31000        Furniture       19000
                        231000               Total   231000

Though Table 7.1 and Table 7.2 show the profit, but how did the company arrive at that
profit is not very clearly visible. Accounting equation and balance sheet treats the change
in equity as profit.
     Equity (Capital + Profit) at the beginning of the quarter = 100,000
     Equity (Capital + Profit) at the end of the quarter = 131,000
     Change in equity = 31,000 is treated as capita

However, the management would like to know the reasons for the change in the equity.
Equity changes due to profit or infusion of capital or buy back of capital. Profit, which
changes equity, is the focus of this chapter. Profit can also be explained as the excess of
revenue over the expenses. See the income statement of ABC ltd. shown as table 7.3.




                                                                                         4
                        Table 7.3
                   Income Statement
 Sales                                           80000
 COGS                                            25000
 Gross Profit                                    55000
 Less
 Expense                                         20000
 Profit Before Depreciation Interest and Tax
 (PBIT)                                          35000
 Depreciation                                     1000
 Profit Before Interest and Tax (PBIT)           34000
 Interest                                         3000
 Profit Before Tax (PBT)                         31000

So the income statement very clearly shows various expenses and different profits.
Income statement helps in evaluating the performance of a company or a division or a
company or a manager of company or division. It helps in understanding the composition
of expenses and get an idea about profit at different levels.

UNDERLYING ASSUMPTIONS
According to the framework for preparation and presentation of the financial statements
issued by the Institute of Chartered Accountants of India , following are the underlying
assumptions for preparing the income statement:
information.

Accrual Basis
Financial statements are prepared on the accrual basis of accounting. Under this basis, the
effects of transactions and other events are recognised when they occur (and not as cash
or a cash equivalent is received or paid) and they are recorded in the accounting records
and reported in the financial statements of the periods to which they relate. Financial
statements prepared on the accrual basis to inform users not only of past events
involving the payment and receipt of cash but also of obligations to pay cash in the future
and of resources that represent cash to be received in the future. Hence, they provide the
type of information about past transactions and other events that is most useful to users in
making economic decisions.




                                                                                          5
      Example 7.2
      ABC ltd started business with cash Rs. 50,000 on 1st April. Took 12% loan of Rs. 50,000.
      Purchased goods on credit= 50,000; Sold 50% of goods on credit for 50,000 during the
      first month. Table 7.4 show the accounting equation and the financial statements for the
      first month.



                                                       Table 7.4
                                                                        Income
            Balance Sheet of ABC ltd ( in 000)                         Statement          Cash Flow Statement
             Sources                          Assets
Capital                     50000     Cash        100000           Sales      50000      Receipts
12% IDBI Loan               50000     Goods        25000           COGS       25000      Capital         50000
Creditors                   50000     Debtors      50000                      25000      Loan            50000
Profit                      24500                                  Less                                 100000
Outstanding Interest         500                                   Interest        500   Payments               0
                            175000        Total    175000          Profit     24500      Cash in hand   100000


      One can see from the table 7.4 that because of the accrual concept the following credit
      transactions are recorded:
           Credit purchases shown as creditors
           Credit Sales shown as debtors
           Interest due but not paid shown as outstanding interest

      Going Concern
      The financial statements are normally prepared on the assumption that an enterprise is a
      going concern and will continue in operation for the foreseeable future. Hence, it is
      assumed that the enterprise has neither the intention nor the need to liquidate or curtail
      materially the scale of its operations; if such an intention or need exists, the financial
      statements may have to be prepared on a different basis and, if so, the basis used is
      disclosed.


      Consistency
      In order to achieve comparability of the financial statements of an enterprise through
      time, the accounting policies are followed consistently from one period to another; a
      change in an accounting policy is made only in certain exceptional circumstances.




                                                                                                            6
INCOME
According to the framework income is increase in economic benefits during the
accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.

Example 7.3
Following is the accounting equation of ABC ltd as on 1st April 2005
                                                                   st
                                  Accounting Equation as on 1 April
 Shareholders Fund +       Long Term Loans+   Current Liabilities = Fixed Assets +       Current Assets
         2079                     1500                2000                600                 4979

Let us examine the implications of the following transactions:
     Sold fixed asset costing Rs.200 for Rs. 200: In this case one asset is converted
        into another asset. Fixed asset decreases by 200 and current asset increases by
        200. No change in the shareholders fund. No in income as per the above
        definition.
     Repaid 40% of loan: Decrease in the long term liability and decrease in the cash.
        No change in the shareholders fund. No in income as per the above definition
     Sold stock of goods costing 1000 for 1500 for cash. Stock ( part of the CA)
        reduces by 1000 and cash (part of CA) increases by 1500. The shareholders fund
        increases by the balancing figure i.e. Rs. 500. Such a change in the shareholders’
        fund is called income as per the above definition.

The definition of income encompasses both revenue and gains. Revenue arises in the
course of the ordinary activities of an enterprise and is referred to by a variety of different
names including sales, fees, interest, dividends, royalties and rent. Gains represent other
items that meet the definition of income and may,or may not, arise in the course of the
ordinary activities of an enterprise.

Various kinds of assets may be received or enhanced by income; examples include cash,
receivables and goods and services received in exchange for goods and services supplied.
Income may also result in the settlement of liabilities. For example, an enterprise may
provide goods and services to a lender in settlement of an obligation to repay an
outstanding loan. Table 7.5 shows the possible effects of income

                                       Table 7.5
                                 Effect of Income
 Transaction                                     Effect
 Sale of goods for cash                          Receipts of cash
 Sale of goods on credit                         Creation of debtor
 Sale of goods to write of a liability           Reduction of a debt
 Sale of goods to pay off a creditor             Reduction of creditor




                                                                                              7
In this text, revenue, sales, turnover are treated as income. Income is classified into two
categories: operating income and other income.
     Tata Steel: Sale of steel is the operating income. Sale of shares of other
        companies is non-operating income.
     Bajaj Auto Limited: Sale of scooters is the operating income. Sale of old furniture
        or sale of shares or bonds or debentures of another company is non-operating
        incomes
Table 7.6 shows income from other sources (other income) as percentage of total income
of some of the well-known companies of India.

                  Table 7.6
  Other Income as % of Total Income (2006)
 Tata Steel Ltd.                       1%
 Wipro Ltd.                            1%
 Reliance Energy Ltd.                  12%
 Videsh Sanchar Nigam Ltd.             3%
 Siemens Ltd.                          5%

CMIE Data base


Income and Receipt
Is every receipt an income? Of course, it is not. Receipt is the inflow of cash and every
inflow of cash is not an income. A company receives money for several reasons:
     Capital
     Loan
     Donations
     Sale of assets
     Advance

Similarly due to the accrual principles, incomes which are not received in cash
immediately are also recorded in the books. So there are some receipts which are not
incomes and there are some incomes which may not be receipt in a particular accounting
period as shown by the Table 7.7.

                                          Table 7.7
                                    Income and Receipt
 Raised capital through fresh issue of shares       Capital receipt and not an income
 Raised 12% loan for a bank                         Creation of a liability not an income
 Sold sold on credit                                Income but not a receipt
 Interest on investments received                   Income and a receipt
 Sold goods for cash                                Receipt is an income

Recognition of Income
Income is recognised in the statement of profit and loss when an increase in future economic
benefits related to an increase in an asset or a decrease of a liability has arisen that can be
measured reliably. Income should be recognised, if the following conditions are met:


                                                                                                  8
      Completion of earning process: The firm must have provided all the goods or
       services for which it is to be paid.
      Assurance of payment: The firm should be in position to quantify the cash or
       other assets expected to be received for the goods or services provided.

EXPENSE
Expense is decrease in economic benefits during the accounting period in the form of
outflow or reduction of assets or decreases of liabilities that result in decreases in equity,
other than those relating to distribution to equity participants.

Example 7.4
Following is the accounting equation of ABC ltd as on 1st April 2005
                                                                st
                                 Accounting Equation as on 1 April
 Shareholders Fund +      Long Term Loans+   Current Liabilities = Fixed Assets +        Current Assets
         2079                    1500                2000                600                  4979

Let us examine the implications of the following transactions:
     Purchase of fixed asset costing Rs.1000 : In this case one asset is converted into
        another asset. Fixed asset increases by 1000 and current asset decreases by
        1000.. No change in the shareholders fund. No expense as per the above
        definition.
     Repaid 40% of loan: Decrease in the long term liability and decrease in the cash.
        No change in the shareholders fund. There is a payment but no expense as per the
        above definition. Repayment of loan is reduction of liability and reduction of
        cash. No change in the shareholders fund. No expense as per the above definition

      Sold stock of goods costing 1000 for 1500 for cash. Stock ( part of the Current
       Assets) reduces by 1000 and cash (part of Current Assets) increases by 1500.
       The decrease in stock is an expense and such expense is called cost of goods sold.

           o   Cost of Goods Sold (expense): 1000
           o   Reduction of stock (decrease in asset): 1000
           o   Increase in cash (increase in asset): 1500
           o   Increase in shareholders’ funds (profit): 500

Expenses and Losses
The framework also treats losses as expenses. Losses represent decreases in economic
benefits and as such they are no different in nature from other expenses. Following are
some of the common losses that appear in the income statement:
                    Bad debt: Loss due to the insolvency of debtors
                    Loss due to theft
                    Loss of stock due to fire or natural calamities
                    Loss on the sale of non-current assets




                                                                                                 9
The definition of expenses also includes unrealised losses. When losses are recognised in
the statement of profit and loss, they are usually displayed separately because knowledge
of them is useful for the purpose of making economic decisions.


Expense and Payment
Is every payment an expense? Of course, it is not. Payment is outflow of cash. A
company makes payment for several reasons:
     Buy back of capital
     Redemption of loan
     Donations
     Purchase of assets
     Advances to the suppliers
     Expenses

Similarly due to the accrual principles, expenses which are not paid in cash immediately
are also recorded in the books. One can also use the matching principle to understand
the relationship between payments and expenses.
     Payments the benefit of which expires in the current accounting period are called
        expenses
     Payment the benefit of which will continue for more than one accounting period
        will be partly treated as an expense and partly shown as an asset. However, one
        has to define the period of benefit as shown in table 7.8

                            Table: 7.8
                 Expense and the Matching Principle
 Advertisement              100,000 100,000 100,000         100,000
 Period of benefit             1          2         4         10
 Expenses of the period     100,000 50,000       25,000     10,000
 Asset                         0       50,000    75,000     90,000

So there are some payments which are not expenses and there are some payments which
may not result in payments in a particular accounting period as shown by the Table 7.9.


                                        Table 7.9
                                   Payment and Expense
 Salary paid                              An expense
 Advance rent paid                        Benefit not expired so it will be an asset
 Payment for acquiring a plant            Not an expense.
 Interest on loan due but not paid        Expense but not a payment
 Depreciation                             Expense but not a payment
 Repayment or buy-back of shares          Not an expense.




                                                                                       10
Recognition of Expense
According to the Framework, expenses are recognised in the statement of profit and loss
when a decrease in future economic benefits related to a decrease in an asset or an
increase of a liability has arisen that can be measured reliably. This means, in effect, that
recognition of expenses occurs simultaneously with the recognition of an increase of
liabilities or a decrease in assets. See the following transactions:
       Paid salaries for the period: Salary is an expense and there is a corresponding decrease in
        asset cash.
       Salaries for the period due but not paid: Salary is an expense but there is no
        corresponding decrease in the asset. However, there is an increase in the liabilities in the
        form of outstanding salaries.
       Advance rent paid in the previous period: Rent is an expense. No change in the cash in
        the current period. No creation of liability. However, there is a decrease in the asset
        advance rent.

According to the Framework, sometimes expenses are also recognised in the statement
of profit and loss on the basis of a direct association between the costs incurred and the
earning of specific items of income. This process, commonly referred to as the matching
of costs with revenues, involves the simultaneous or combined recognition of revenues
and expenses that result directly and jointly from the same transactions or other events;
for example, the various components of expense making up the cost of goods sold are
recognised at the same time as the income derived from the sale of the goods.

The Framework further stresses that when economic benefits are expected to arise over
several accounting periods and the association with income can only be broadly or
indirectly determined, expenses are recognised in the statement of profit and loss on the
basis of systematic and rational allocation procedures. This is often necessary in
recognising the expenses associated with the using up of assets such as plant and
machinery, goodwill, patents and trademarks; in such cases, the expense is referred to as
depreciation or amortisation. These allocation procedures are intended to recognise
expenses in the accounting periods in which the economic benefits associated with these
items are consumed or expire.

        Purchased goods for sale: shown as an asset
       When the goods are sold: Value of sales is shown as income and the
        corresponding cost of goods sold is treated as expense
       Purchased plant: shown as an asset
       Depreciation on plant: value of the asset is reduced to the extent of depreciation
        and depreciation is treated as an expense.




                                                                                                 11
Example 7.5
ABC ltd. had capital represented by goods costing Rs. 40,000 and furniture costing
10,000.
     Capital = Goods + Furniture
     50,000 = 40,000 + 10,000

Transactions during the period are as follows:
    Sold 50% of good for 50,000 for cash
    Salary paid = 1000
    Depreciation = 2000

Table 7.10 shows the financial statement at the end of the accounting period.


                                            Table: 7.10
                                                                              Cash Flow
     Balance Sheet of ABC ltd ( in 000)            Income Statement           Statement
       Sources               Assets             Sales           50000   Receipts
Capital     50,000   Goods        20,000        Less                    Sales        50000
Profit      27000    Furniture    8,000         COGS            20000   Less
                     CIH           49,000       Depreciation     2000   Salary        1000
                                                Salary           1000
           77,000                  77,000       Profit          27000   CIH          49000

Some times an expense is recognised immediately in the statement of profit and loss
when an expenditure produces no future economic benefits. An expense is also
recognised to the extent that future economic benefits from an expenditure do not qualify,
or cease to qualify, for recognition in the balance sheet as an asset. If a company spends
money on research and development and such expense does not result in any benefit then
the entire




                                                                                          12
PROFIT
Profit is the excess of income over the expenses for a period. Profit for the period is
determined using the accrual principle and matching principle. According to the
matching principle, revenue for a period should be compared with the corresponding
expenses.


Example 7.6
Sales per month = 10,000 (60% on credit)
Cost of goods per month = 25%
Salaries per month = 2000
Depreciation for the year = 6000
Interest per month= 100
Tax rate = 25%
Table 7.11 shows profit for different accounting periods using the principles of accrual
and matching.

                               Table 7.11
                           Income Statement
Accounting Period (months)                1     3          6        12
Sales                               10,000 30,000     60,000   120,000
COGS                                 2,500  7,500     15,000    30,000
                    Gross Profit     7,500 22,500     45,000    90,000
Salaries                             2,000  6,000     12,000    24,000
                            PBDIT    5,500 16,500     33,000    66,000
Depreciation                           500  1,500      3,000     6,000
                             PBIT    5,000 15,000     30,000    60,000
Interest                               100    300        600     1,200
                              PBT    4,900 14,700     29,400    58,800
Tax                                  1,225  3,675      7,350    14,700
                              PAT    3,675 11,025     22,050    44,100

      Gross profit: Excess of sales over the cost of goods is called gross profit. This is
       also called the gross margin from the business.
      Profit before depreciation, interest , tax (PBDIT): If the operating expenses like
       salaries, rent are deducted from the gross profit we will get PBIT.
      Profit before interest and tax (PBIT): If depreciation is deducted from PBDIT, we
       will get PBIT: PBIT shows the profit generating ability of a company. It is the
       surplus available for the lenders, government, and shareholders.
      Profit after tax (PAT): If interest and tax are deducted from PBIT, we will get
       PAT. PAT is the money available for distribution among the shareholders. PAT
       shows profit generating ability of a company.

Table 7.11 A shows different profits of some of the well known companies of India.



                                                                                        13
                                                  Table 7.11 A
          Different Profit of the selected Indian Companies (Rs. In crores) for the year ending 2006

                                                                                          Cash          Retained
Company Name                                PAT     PBDIT         PBIT        PBT        profits         profits
Oil & Natural Gas Corp. Ltd.             14,431     32,284      25,463      21,745       24,405          7,114
Reliance Industries Ltd.                  9,069     15,007      11,606      10,712       12,494          7,480
State Bank Of India                       4,407     27,829      27,065      6,906        5,170           3,567
Steel Authority Of India Ltd.             4,013      7,628       6,420      5,953        5,408           3,071
Tata Steel Ltd.                           3,506      6,144       5,410      5,241        4,293           2,686




INCOME STATEMENT AND ACCOUNTING EQUATION
We can understand the process of determining the income for the period by using the
accounting equation.

Example 7.7
Following are the financial items of ABC ltd..
     Capital: Rs 10000
     12% Loan: Rs. 30000
     Fixed Assets: Rs. 20000
     Stock: Rs. 15000
     Cash: 5000
Above items can be represented in the form of an accounting equation as follows:

                  Accounting Equation
Capital +     Loan = Fixed Assets + Stock + Cash
 30000        10000       20000       15000 5000




                                                                                                   14
      Suppose the stock is sold at 20000 and expenses in cash are 2000. The equation will be
     as follows:

                               Accounting Equation
     Capital +      Profit +   Loan =    Fixed Assets +     Stock +    Cash
       10000          1800      30000         20000            0       21800


                                                                       Income Statement
     Now let us see the income statement.                          Sales            20000
                                                                   Less
We can see that it is possible to                                  COGS             15000
determine the profit by using the                                      Gross Profit  5000
accounting equation. However, to get                               Less
a clear picture of the process of                                  Other
determining profit and to see the                                  Expenses          2000
various of components of expenses                                            PBIT    3000
and income it may be useful to                                     Interest          1200
prepare a separate income statement.                                          PBT    1800
                                                                   Tax                  0
                                                                              PAT    1800




                                                                                         15
FORMAT OF INCOME STATEMENT


Income statement can be presented in vertical or horizontal format:
                               Sample income Statement
                           Expenses              Income
                      COGS                3000 Sales       15000
                      Salary and Rent     2000
                      General Expenses    1500
                      Depreciation         500
                      Interest            2000
                      Taxes               2500
                      Profit              3500
                                          5000              5000




      Sample Income Statement                          Sample Income Statement
 Revenue                   15000              Revenue                             15000
 Plus Other incomes             0             Less
 Less                                         COGS                                 3000
 COGS                        3000                                    Gross Profit 12000
 Salary and Rent             2000             Operating Expenses                   3500
 General Expenses            1500                    Profit Before Depreciation
                                                      Interest and Tax (PBDIT)     8500
 Depreciation                 500
                                              Depreciation                          500
 Interest                    2000
                                                  Profit Before Interest and Tax
 Provision for Tax           2500                                         (PBIT)   8000
                   PAT       3500             Interest                             2000
                                                       Profit Before Tax (PBT)     6000
                                              Tax Provision                        2500
                                                         Profit After Tax (PAT)    3500




                                                                                          16
COMPONENTS OF INCOME STATEMENT

Revenue or Sales
Revenue represents sale of products and services produced or traded by an enterprise.
These are usually recorded at gross value, including excise duty if any. When an
organisation provides services or sells goods it receives cash immediately or receives
commitment to be paid on some future date. Such commitments are called debtors or
receivables. The excise duty is then separately deducted from the gross sales. Revenue
can be generated by a firm in a variety of ways. According to the Schedule VI (see
Appendix 7.1 for the details of Schedule VI) of the Companies Act, the aggregate amount
for which sales are effected by the company, giving the amount of sales in respect of each
class of goods dealt with by the company, and indicating the quantities of such sales for
each class separately. In 2006, NALCO generated a revenue of 4851 crores as shown in
Exhibit: 7.1 . Other income of NALCO was less than 5% of the total income for the year
2006.



   Exhibit: 7.1: NALCO




Other Incomes
The income received by a company from sources other than sales of its main products
and services is mentioned separately. In many companies the other income constitutes a
significant portion of the profit before tax. Other incomes on average account for around
2% of the sales and less than 20% of the profit after tax as shown by the Table 7.12,




                                                                                       17
                                         Table: 7.12
                  Position of Other Incomes of the companies forming a part
                                          of Nifty
                                                  2004      2005       2006
                  As % of Sales                     2%        2%         2%
                  AS % of PAT                      18%       16%        19%
                  Source: CMIE data base

Other incomes include dividend and interest from the investments made by the company
in other companies.


Expenditure Side

The expenditure side of income statement shows the details of all the revenue expenses
whether accrued or paid for during a year.

Revenue Expenses
Revenue expense are those transactions (reduction of assets or increase in liabilities) the
benefit of which expires within an accounting period. The accounting period may be a
year, half year, quarter, or a month. According to the matching concept of accounting,
expenses of an accounting period should be charged against the income of that period to
determine profit for the period. See the Table 7.13 to get a better understanding of
revenue expenses and the accounting period:

                                             Table 7.13
                            Expense, Cash Outflow, Asset, and Liability
             Accounting Period                  3 months    6 months      12 months
             Expense Per Month                    1000        1000           1000
             Expense Paid                         6000        6000           6000
             Expense for the period               3000        6000          12000
             Liability (Outstanding Expense)        0          0             6000
             Asset (Advance Expense)              3000         0              0



In the following section we will understand the various components of expenditure.




                                                                                        18
Cost of Goods Sold/Consumed (COGS)
The cost of goods consumed is arrived at after making suitable adjustments for opening
and closing stocks. According to the matching concept, when the goods are sold, the
corresponding cost will be treated as an expense and it is called cost of goods sold
(COGS).

Example 7.8
ABC Ltd had an opening stock of 800 units @ 20. During the first quarter it purchased
3000 units @ 40 and sold 3300 units @ 50.

              Cost of Goods Sold
                          Qty  Price        Value
Opening Stock             800    20        16,000
Add Purchase             3000    40        120,000
                                           136,000

Cost of Goods Sold         3300            126,000



Cost of goods sold = Opening stock + Purchases – Closing stock


It is important to note that the cost of goods consumed depends of the value of the closing
stock. Value of closing stock depends on the methods of issuing inventory. Following are
some of the common methods of issuing inventory.

Last-in-first-out (LIFO).
Under this method the goods purchased last will be used first. So the unsold stock is
generally from the past purchases or the opening stock.

Example 7.9

ABC Ltd had an opening stock of 1000 units @ 10. During the first quarter it purchased
3000 units @ 20 and sold 2500 units @ 40.

         Cost of Goods Sold using LIFO
                      Qty       Price   Value
Opening Stock         800        20    16000
Add Purchase         3000        40    120000
                                       136000
COGS              3000 @40     120000
                  300 @ 20       6000 126,000

Closing Stock              500        20    10,000




                                                                                        19
First-in-first-out (FIFO):
Under this method, the oldest purchase is used first. So the unsold stock is from the latest
purchases.
Example 7.10

ABC Ltd had an opening stock of 1000 units @ 20. During the first quarter it purchased
3000 units @ 40 and sold 3300 units @ 60.

             Cost of Goods Sold using FIFO
                           Qty     Price          Value
 Opening Stock             800      20            16000
 Add Purchase             3000      40           120000
                                                 136000
 COGS                        800       20
                            2500       40          116,000

 Closing Stock               500       40            20,000

       Profit = Sales – COGS = 198,000 – 116,000 = 82,000


Simple Average Method
Under this method, the material issued or used during the period are valued at the simple
average price.

Example 7.11
ABC Ltd had an opening stock of 2000 units @ 20. During the first quarter it purchased
3000 units @ 40 and sold 3300 units @ 60.

Simple average price = (P1 + P2 + P3 + Pn)/n

             Cost of Goods Sold using FIFO
                            Qty     Price          Value
 Opening Stock             2000      20            16000
 Add Purchase              3000      40           120000
                                                  136000
 COGS                        3300       30        99,000

 Closing Stock               1700       30        51,000

       Profit = Sales –COGS = 198,000 – 99,000 = 99,000




                                                                                          20
Weighted Average Method:
Under this method, the material issued or used during the period is valued at the weighted
average price.

Weighted average price =( p1*q1 + p2*q2 +p3*q3)/q1+q2+q3

Example 7.12
ABC Ltd had an opening stock of 2000 units @ 20. During the first quarter it purchased
3000 units @ 40 and sold 3300 units @ 60.

Simple average price = (P1 + P2 + P3 + Pn)/n

            Cost of Goods Sold using FIFO
                           Qty     Price                  Value
Opening Stock             2000      20                    16000
Add Purchase              3000      40                   120000
                          5000                           136000
COGS                      3300     27.2
                                                            89,760

Closing Stock                   1700        27.2            46,240

      Profit = Sales –COGS = 198,000 – 89,760 =108,240




                                   Inventory Valuation in NALCO
          Finished goods are valued at lower of cost or net realisable value. Cost is determined on the basis
           of current year's average cost of production and excludes selling and distribution overheads,
           interest, exchange variation and depreciation on capitalised exchange variation.
          Raw materials, stores, spare parts and tools are valued at weighted average cost net of CENVAT
           credit wherever applicable.




                                                                                                        21
Example 7.13

Following are the details of the purchases made by ABC ltd on different dates at
different rates.
                                   Rate
Purchase Date        Stock         (Rs.)
1.5.2006             3000           4.5
2.5.2006             1000            5
4.5.2006             2000            6

Suppose the company sells 2500 units at Rs. 10 per unit. Accounting profit of the
company is equal to the sales less the cost of goods sold. However, the COGS depends on
the method of valuing inventories.

             Gross Profit and Inventory Valuation
                                Sales    COGS          G. Profit
 FIFO                          25,000    11,250         13,750
 LIFO                          25,000    14,500         10,500
 Simple Average                25,000    12,917         12,083
 Weighted Average              25,000    12,708         12,292



It is important to note that the change in profit not because of the change in the
operating efficiency, but just because of the change in the valuation method.

FIFO results in higher profits because of lower cost of goods sold and a higher closing
stock. LIFO results in lower profits because of higher cost of goods sold.

By changing the method of inventory valuation one is able to shuffle between expenses
and assets. See the following table:

                                                           Simple    Weighted
                                           LIFO    FIFO    Average   Average
                COGS (Expense)             14500   11250    12917     12708
                Stock (Asset)              16000   19250    17583     17792
                Total value of purchase    30500   30500    30500     30500




Excise Duty
This is the amount paid to the government as a tax, before the goods are dispatched from
the factory. Generally excise duty is deducted from the gross sales.

Salaries and Wages
Salaries and wages and all other employee benefits and amenities are included in this
expenditure.   They include provident fund, ESI (Employees State Insurance)


                                                                                          22
contributions, and medical benefits, leave travel benefits, bonus, gratuity, pension, other
superannuation benefits etc. Table 7.14 shows salaries and wages as percentage of total
sales of some of the well known Indian companies.

                                            Table 7.14
                              Salaries and Wages as % of Sales (2006)
                     IT                                        Pharma
       Wipro Ltd.                        42% Sun Pharmaceutical Inds. Ltd.           6%
       Tata Consultancy Services Ltd.    46% Ranbaxy Laboratories Ltd.               9%
       Satyam Computer Services Ltd.     59% Glaxosmithkline Pharmaceuticals Ltd.   10%
       Infosys Technologies Ltd.         47% Cipla Ltd.                              5%
       H C L Technologies Ltd.           35% Dr. Reddy'S Laboratories Ltd.           9%

Administrative Expenses
Administrative expenses include head office expenditure, secretarial costs, postage and
telephones, directors’ remuneration and other administrative expenses.

Cost of Production
Income statement will not show the cost of production as a separate item. However, one
can calculate the cost of production by collecting the relevant information. Cost of
production includes raw material cost, energy, salaries and wages etc. and other operating
expenses. Selling expense and the interest cost are not the part of the cost of production.
Table: 7.15 shows the cost of production advertisement as a percentage of sales of some
Indian companies.



                                            Table 7.15
                             Cost of production as % of Sales (2006)
                         Hindustan Petroleum Corpn. Ltd.           94%
                         Steel Authority Of India Ltd.             69%
                         Tata Motors Ltd.                          73%
                         Reliance Industries Ltd.                  73%
                         National Aluminium Co. Ltd.               44%
                         Hero Honda Motors Ltd.                    68%
                         I T C Ltd.                                35%
                       Source: CMIE Data base




Selling Expenses
Selling expenses include freight, advertising and sales promotion, commissions and
discounts and other selling and distribution costs. Table: 7.16 shows advertisement as a
percentage of sales of some Indian companies.




                                                                                          23
                                            Table:7.16
                              Advertisement as % of Sales (2006)
                           Tata Tea Ltd.                        9%
                           Hindustan Lever Ltd.                 8%
                           Dabur India Ltd.                    11%
                           Bharti Airtel Ltd.                   4%
                           Ranbaxy Laboratories Ltd.            6%
                          Source: CMIE Data base


Borrowing Cost
According to the Accounting Standard -16, borrowing costs are interest and other costs
incurred by an enterprise in connection with the borrowing of funds. Borrowing cost may
include the following items:

      interest and commitment charges on bank borrowings and other short-term and
       long-term borrowings;
      amortisation of discounts or premiums relating to borrowings;
      amortisation of ancillary costs incurred in connection with the arrangement of
       borrowings;
      finance charges in respect of assets acquired under finance leases or under other
       similar arrangements; and
      exchange differences arising from foreign currency borrowings to the extent that
       they are regarded as an adjustment to interest costs.

According to the AS- 16, borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset should be capitalised as part of the cost of
that asset. The amount of borrowing costs eligible for capitalisation should be determined
in accordance with this Statement. Other borrowing costs should be recognised as an
expense in the period in which they are incurred.

The interest cost consists of interest on long-term loans, debentures, bank loans for
working capital, interest on public deposits and other loans. Table 7.17 shows interest as
a percentage of sales of some Indian companies.


                                             Table 7.17
                                   Interest as % of Sales (2006)
                        Williamson Magor & Co. Ltd.                138%
                        G V K Power & Infrastructure Ltd.           74%
                        J C T Electronics Ltd.                      43%
                        Indiabulls Financial Services Ltd.          30%
                        R P G Cables Ltd.                           23%
                        Mukand Engineers Ltd.                       18%
                       Source: CMIE Data base




                                                                                          24
Depreciation
Depreciation is the charge for using the assets. It can be described as the cost of the assets
used during the year. Depreciation is the wear and tear of the asset. It is the decrease in
the value of the asset with the passage of time. Depreciation is the allocation of the cost
over the life of the asset. Depreciation will be shown as an expense in the income
statement and as reduction in the value of the asset in the balance sheet. Table 7.18
shows depreciation as percentage of sales of the well known companies of India.


                    Table 7.18
        Depreciation % of Sales (2006)
 A B B Ltd.                               1%
 A C C Ltd.                               4%
 Bajaj Auto Ltd.                          2%
 Bharat Heavy Electricals Ltd.            2%
 Bharat Petroleum Corpn. Ltd.             1%
 Bharti Airtel Ltd.                      14%
Source: CMIE Data base




Two popular methods of calculating depreciation are : Straight line method (SLM),
Reducing balance method (RBM).

Straight Line Method (SLM)
In the SLM depreciation is determined by allocating the cost over the life. The total cost
of the asset less salvage value, if any, will be distributed over the life of the asset.
     Depreciation = (Cost of the asset – Salvage Value)/Life
     Depreciation = (Cost of the asset –Salvage Value)*Rate

This method is called SLM because the amount of depreciation remains constant over the
life.

Example 7.14:

A limited started business with capital of Rs. 100,000. Purchased plant costing 50,000 on
credit from Mr.X and stock worth of 75,000 for cash. Life of the plant is 5 years. No
salvage value. Table 7.19 shows the depreciation, accumulated depreciation and the
written down value of the asset.




                                                                                           25
                     Table 7.19
                  Depreciation: SLM
                                               Written
                                Accumulated    Down
 Year    Cost    Depreciation   Depreciation   Value
  1     50,000     10,000         10,000       40,000
  2                10,000         20,000       30,000
  3                10,000         30,000       20,000
  4                10,000         40,000       10,000
  5                10,000         50,000          0

Reducing Balance Method
In the Reducing balance method (RBM), depreciation is calculated on the opening
balance of the asset or in other words, it is calculated on the written down value of the
asset. Written down value of the asset is cost of the asset less the accumulate
depreciation. In this method, the amount of depreciation goes on reducing over the life.
Unlike the SLM, the written down value of the asset will not become zero.

 Example 7.15:

A limited started business with capital of Rs. 100,000. Purchased plant costing 50,000 on
credit from Mr.X and stock worth of 75,000 for cash. Rate of depreciation =40 %. No
salvage value. Table 7.20 shows the depreciation, accumulated depreciation and the
written down value of the asset.



                     Table 7.20
                  Depreciation: RBM
                                               Written
                                Accumulated    Down
 Year    Cost    Depreciation   Depreciation   Value
  1     50,000     20,000         20,000       30,000
  2                12,000         32,000       18,000
  3                7,200          39,200       10,800
  4                4,320          43,520       6,480
  5                2,592          46,112       3,888

For details of depreciation please refer to the chapter on the fixed assets.

Depreciation and Financial Statements
Let us see the impact of depreciation on the financial statements.




                                                                                      26
Example 7.16

ABC ltd started business with Capital of 100,000; Purchased stock of goods for Rs.
50,000; Purchased plant on credit from Mr. X for Rs. 50,000; 60% of the stock of goods
sold for Rs. 50,000 for cash. Rate of depreciation = 10% Table 7.21 shows the financial
statements at the for the first year

                                 Table:7.21- Financial Statement
                                                                                Cash Flow
  Balance Sheet at the end of the first year       Income Statement             Statement
Capital                               100,000     Sales        50,000       Capital 100,000
Accumulated Profit                      15,000                              Sales      50,000
X                                       50,000    Less                               150,000
                                      165,000     COGS             30,000
Cash                                  100,000     Depreciation      5,000   Stock     50,000
Stock                                   20,000
Plant                                   50,000                     35,000
Less Accumulated Depreciation           -5,000                              CIH      100,000
                                      165,000     Profit           15,000   Total    150,000

      Depreciation = Costs * Rate = 50,000 * 10% = 5000
      Depreciation is shown as an expense in the income statement
      Depreciation is reduced from the value of the plant in the balance sheet
      Accumulated depreciation = Depreciation for the first year

 Example 7.17:
Let us continue with the information given in the example 7.16.
Second year: Transactions are as follows:
     Sold entire stock for 50,000
     Took a new show room and paid Rs. 15,000 for three years
     Table 7.22 shows the financial statements.

                                  Table:7.22- Financial Statement
               Balance Sheet                       Income Statement         Cash Flow Statement
                                                                            Opening
Capital                              100,000      Sales            50,000   CIH          100,000
Accumulated Profit                    35,000                                Sales         50,000
X                                     50,000      Less                                   150,000
                                     185,000      COGS             20,000
Cash                                 135,000      Depreciation      5,000   Rent          15,000
Stock                                      0      Rent              5,000
Advance Rent                          10,000
Plant                                 50,000                       30,000
Less Accumulated Depreciation        -10,000                                CIH          135,000
                                     185,000      Profit           20,000   Total        150,000

      Depreciation = Costs * Rate = 50,000 * 10% = 5000


                                                                                        27
       Depreciation is shown as an expense in the income statement
       Depreciation is reduced from the value of the plant in the balance sheet
       Accumulated depreciation = Depreciation for the first year + Depreciation for the
        second year
       Advance Rent = Rent Paid – Rent for the current year
       Accumulated Profit = Profit of the first year + Profit for the second year


Bad Debts:
When a company extends credit to customers, there is always the risk of not getting the
amount. Bad debt is the loss due to the non-payment by the customers. Each year the
company is required to estimate amount of bad debt and do the following:
    Show it as a loss in the income statement, or charge it against the provisions for
      bad and doubtful debt;
    Reduce the debtors to that extent

 Example 7.18:
Assets and the corresponding sources of ABC as on 1st April 2006 are as follows: Capital
of ABC ltd = 50,000; 12% Loan = 70,000; Cash = 20,000; Stock = 25,000; Debtors (Mr.
Y) = 75,000. During the year 2006, the company sold entire stock for Rs. 35,000 to Mr.
X on credit. Mr. Y became insolvent and could pay only 75% of the money due. Table
7.23 shows the necessary financial statements.

                                   Table- 7.23: Financial Statement
                                                             Cash Flow
Opening Balance Sheet         Income Statement               Statement       Closing Balance Sheet
Capital        50,000       sales           35,000      CIH         20,000   Capital         50,000
12% Loan       70,000                                   Y           56,250   12% Loan        70,000
              120,000       COGS            25,000      Total       76,250   Profit         -17,150
                                                                                           102,850
                            Bad Debts      18,750                            Cash            67,850
Cash             20,000     Interest        8,400      Interest     8,400    Stock                0
Stock            25,000                    52,150                            Y                    0
Y                75,000                                CIH         67,850    X               35,000
                120,000     Profit         -17,150     Total       76,250                  102,850

       Money due from Mr. Y = 75,000
       Money received from Mr. Y = 75% = 56,250
       Bad Debt = 75,000 – 56,250 = 18,750

Provisions for Bad and Doubtful Debts
Sometimes companies keep aside a part of the current profit to meet future bad debt.
Such amount kept aside is called provisions for bad and doubtful debts.

Example 7.19:




                                                                                      28
On 1st April 2005, ABC started business with capital of Rs. 50,000. Purchased stock of
goods for cash = 20,000 and sold 50% of goods for 35000 on credit. Rent paid for the
period = 5000 and the company created a provision of 5% of the debtors to meet
unexpected loss due to the bad debts. Table 7.24 show the financial statements at the end
of the accounting period.
                                 Table-7.24: Financial Statements
                                         Cash Flow Statement
                                                                                                 st
 Income Statement for the year             for the year ending          Balance Sheet as on 31        March
      ending March 2006                        March 2006                           2006
Sales                     35,000        Capital           50,000       Capital                        50,000
                                        Total             50,000       Profit                         18,250
COGS                         10,000                                    Total                          68,250
Rent                          5,000
Provisions for Doubtful
Debts                         1,750     Stock            20,000        Stock                          10,000
                             16,750     Rent              5,000        Debtors                        35,000
                                                                       Less Provision for
                                        CIH              25,000        Doubtful debts                 -1,750
                                                                       Cash                           25,000
Profit                       18,250     Total            50,000        Total                          68,250

Example 7.19
Refer to the financial statements shown in the table 7.24. During the year 2006-07 the
company had following transactions:
    Sold 60% of the stock for 15,000 for cash.
    One of the debtors who had to pay Rs. 2000 became insolvent. She could pay
       60% of the amount due.
    Rent paid for the two years: 10000

Table 7.25 show the financial statements at the end of the year 2007
                                Table- 7.25: Financial Statements
                                          Cash Flow
        Income Statement                  Statement                   Closing Balance Sheet
                                    Opening
Sales                    15,000     CIH           25,000      Capital                                    50,000
                                    Sales         15,000      Profit                                     22,250
COGS                      6,000     Collection      1,200     Total                                      72,250
Rent                      5,000                   41,200
Provisions for Doubtful
Debts                         0                               Stock                                       4,000
                         11,000     Rent          10,000      Debtors                                    33,000
                                                              Less Provision for Doubtful
                                    CIH           31,200      debts                                        -950
                                                              Advance Rent                                5,000
                                                              Cash                                       31,200
Profit                    4,000     Total         41,200      Total                                      72,250

        Rent paid = 10,000
        Rent for the current year (Expense) = 5000


                                                                                            29
       Advance Rent (Asset) = 5000
       Opening Provision for doubtful debt = 1750
       Bad debt for the current year = 40% of 2000 = 800
       Bad debt for the current year is not charged against the income once again since
        the company is already having the Provisions. Bad debt is charged against the
        Provisions. So the balance sheet will show the balance provisions to be carried
        forward.
    Since the company has no further credit sales, it has not creas
Other Expenses
The other expenses include auditors’ remuneration, petty expenses, small donations, if
any etc.

Appropriation of Profit
Appropriation of profit is the distribution of profit. Profit after tax (PAT) is available for
distribution among the shareholders as dividend. However, the management is under no
obligation to distribute the profit. Profit appropriation statement, which is generally
incorporated in the income statement, shows the profit retained for reinvestment, profit
distributed as dividend, tax on dividend distributed, profit transferred to some specific
reserves. Exhibit 7.3 shows the profit for the year and the appropriations of Wipro
Limited for the year ending March 2006 and the March 2005

                                                               2006                  2005
Exhibit 7.3: Wipro Limited (Rs. Million)




Source: Annual Report of Wipro Limited




Earning Per Share
According to AS -20, a company should present basic and diluted earnings per share on
the face of the statement of profit and loss for each class of equity shares that has a
different right to share in the net profit for the period. An enterprise should present basic
and diluted earnings per share with equal prominence for all periods presented.




                                                                                             30
Basic earnings per share should be calculated by dividing the net profit or loss for the
period attributable to equity shareholders by the weighted average number of equity
shares outstanding during the period.

For the purpose of calculating basic earnings per share, the net profit or loss for the
period attributable to equity shareholders should be the net profit or loss for the period
after deducting preference dividends and any attributable tax thereto for the period.

According to AS-20, the weighted average number of equity shares outstanding during
the period reflects the fact that the amount of shareholders' capital may have varied
during the period as a result of a larger or lesser number of shares outstanding at any
time. It is the number of equity shares outstanding at the beginning of the period, adjusted
by the number of equity shares bought back or issued during the period multiplied by the
time-weighting factor. The time-weighting factor is the number of days for which the
specific shares are outstanding as a proportion of the total number of days in the period; a
reasonable approximation of the weighted average is adequate in many circumstances.

For the purpose of calculating diluted earnings per share, the net profit or loss for the
period attributable to equity shareholders and the weighted average number of shares
outstanding during the period should be adjusted for the effects of all dilutive potential
equity shares. Diluted earning per share reflects the existence of stock options or other
rights that can be converted into shares in the future. Exhibit 7.4 shows the basic and
diluted EPS of Wipro Limited for the year ending March 2006 and March 2005.


                                                              2006                 2005
Exhibit 7.3: Wipro Limited




Source: Annual Report of Wipro Limited




LIMITATIONS OF INCOME STATEMENT

Though, the income statement is an important statement, it has the limitation of not being
able to show the cash position. This limitation can be attributed to one of the important
concepts of accounting i.e. Accrual Concept.


                                                                                             31
The Income statement does not tell us how much cash has been received and how cash
has been paid during the period. All it does is to summarise the incomes and expenses.
While preparing the balance sheet we have seen that when the company has sold 20
computers @ Rs.25000, of which only 10% was received immediately. For the purpose
of determining the profit or loss, the entire sale value i.e. Rs. 500,000 was shown as the
income. Similarly, when an item bought on credit, it is recognized as an expense
immediately, though the cash is yet to flow out of the business.




                                                                                             32
Key Terms




Accrual Basis:
Under this basis, the effects of transactions and other events are recognised when they
occur (and not as cash or a cash equivalent is received or paid) and they are recorded in
the accounting records and reported in the financial statements of the periods to which
they relate.

Going concern assumption
According to this assumption, the enterprise has neither the intention nor the need to
liquidate or curtail materially the scale of its operations; if such an intention or need
exists, the financial statements may have to be prepared on a different basis and, if so, the
basis used is disclosed

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

Receipt
Receipt is the inflow of cash and every inflow of cash is not an income. A company
receives money for several reasons: Capital, Loan, Donations, Sale of assets, Advance

Expense
Expense is decrease in economic benefits during the accounting period in the form of
outflow or reduction of assets or decreases of liabilities that result in decreases in equity,
other than those relating to distribution to equity participants.

Loss
Losses represent decreases in economic benefits and as such they are no different in
nature from other expenses. Following are some of the common losses that appear in the
income statement: Bad debt, Loss due to theft, Loss of stock due to fire or natural
calamities, Loss on the sale of non-current assets

Recognition of Expense
Expenses are recognised in the statement of profit and loss when a decrease in future
economic benefits related to a decrease in an asset or an increase of a liability has arisen
that can be measured reliably.

Profit
Profit is the excess of income over the expenses for a period. Profit for the period is
determined using the accrual principle and matching principle. According to the




                                                                                            33
matching principle, revenue for a period should be compared with the corresponding
expenses.
Revenue or Sales
Revenue represents sale of products and services produced or traded by an enterprise.
These are usually recorded at gross value, including excise duty if any. When an
organisation provides services or sells goods it receives cash immediately or receives
commitment to be paid on some future date.

Revenue Expenses
Revenue expense are those transactions (reduction of assets or increase in liabilities) the
benefit of which expires within an accounting period. The accounting period may be a
year, half year, quarter, or a month.

Cost of Goods Sold/Consumed (COGS)
According to the matching concept, when the goods are sold, the corresponding cost will
be treated as an expense and it is called cost of goods sold (COGS). Cost of goods
consumed is arrived at after making suitable adjustments for opening and closing stocks.

Last-in-first-out (LIFO).
Under this method the goods purchased last will be used first. So the unsold stock is
generally from the past purchases or the opening stock.


First-in-first-out (FIFO):
Under this method, the oldest purchase is used first. So the unsold stock is from the latest
purchases.

Cost of Production
Income statement will not show the cost of production as a separate item. However, one
can calculate the cost of production by collecting the relevant information. Cost of
production includes raw material cost, energy, salaries and wages etc. and other operating
expenses.

Borrowing Cost
According to the Accounting Standard -16, borrowing costs are interest and other costs
incurred by an enterprise in connection with the borrowing of funds.

Depreciation
Depreciation is the charge for using the assets. It can be described as the cost of the assets
used during the year. Depreciation is the wear and tear of the asset. It is the decrease in
the value of the asset with the passage of time. Depreciation is the allocation of the cost
over the life of the asset. Depreciation will be shown as an expense in the income
statement and as reduction in the value of the asset in the balance sheet.

Straight Line Method (SLM)




                                                                                           34
In the SLM, depreciation is determined by allocating the cost over the life. The total cost
of the asset less salvage value, if any, will be distributed over the life of the asset.

Reducing Balance Method
In the Reducing balance method (RBM), depreciation is calculated on the opening
balance of the asset or in other words, it is calculated on the written down value of the
asset. Written down value of the asset is cost of the asset less the accumulate
depreciation. In this method, the amount of depreciation goes on reducing over the life.

Bad Debts:
When a company extends credit to customers, there is always the risk of not getting the
amount. Bad debt is the loss due to the non-payment by the customers.

Provisions for Bad and Doubtful Debts
Sometimes companies keep aside a part of the current profit to meet future bad debt.
Such amount kept aside is called provisions for bad and doubtful debts.

Appropriation of Profit
Appropriation of profit is the distribution of profit. Profit after tax (PAT) is available for
distribution among the shareholders as dividend. However, the management is under no
obligation to distribute the profit. Profit appropriation statement, which is generally
incorporated in the income statement, shows the profit retained for reinvestment, profit
distributed as dividend, tax on dividend distributed, profit transferred to some specific
reserves.

Earning Per Share
Profit after tax if distributed over the number of share, it is called earning per share
(EPS).

Basic EPS
Basic earnings per share should be calculated by dividing the net profit or loss for the
period attributable to equity shareholders by the weighted average number of equity
shares outstanding during the period.

Diluted EPS
For the purpose of calculating diluted earnings per share, the net profit or loss for the
period attributable to equity shareholders is divided by weighted average number of
shares outstanding during the period.




                                                                                             35
Theoretical Questions

   1. What is income?
   2. How is income different from profit?
   3. When is income recognized in the income statement?
   4. What are expenses?
   5. What is an income statement?
   6. Explain some of the important items of an income statement.
   7. Distinguish between expense and asset?
   8. All payments are not expenses. Explain.
   9. All receipts are not incomes. Explain
   10. Examine the impact on expenses due but not paid on the financial statements.
   11. What is depreciation?
   12. Answer the following questions:
          i.  Why aren’t purchase of equipment shown in the income statement?
         ii. Why is credit sales shown in the income statement?
        iii. Why is dividend not shown in the income statement?
        iv.   What is premium on issue of shares not shown in the income statement?
         v.   Why is depreciation on furniture an expense?
        vi.   Why is interest due but not paid shown as an expense?

   13. Explain the impact of depreciation on the financial statements.
   14. What are the different methods of charging depreciation?
   15. Examine the impact of provision for bad and doubtful debts on the income
       statements.
   16. Explain the process of determining EPS.
   17. What is relevance of diluted EPS?
   18. What is weighted average number of share?
   19. What is appropriation of profit?
   20. What is the composition of borrowing cost?
   21. Examine the impact of borrowing cost on the financial statement.
   22. What is the difference between revenue and profit?
   23. Explain the relationship between income statement and accounting equation.




Numerical Questions
  1. Classification: Classify the following items into Revenues, Cost of Goods Sold,
     Selling Overheads, Non-operating incomes, Administration Expenses, Not an
     Income Statement Item:
      Credit sales, Discount received, Interest paid, insurance, Consultant’s Salary,
         Interest received, Bad Debt, Bad Debt Recovered, Capital Raised, Money
         borrowed from bank, Sales Tax, Income Tax, Furniture purchased.
         Depreciation on furniture, Loss due to the fire, Winnings from lottery tickets,



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       Purchase of land, Expense on the MD’s Son studies, Cash received from
       customers.

2. Sales, 100,000; COGS = 40% of sales; operating expenses = 20%; interest = 5%
   of sales; depreciation = 2000; Profit = 20% of sales. Balance is the provision for
   bad debts. Required: Income Statement
3. XYZ started business with capital of 50,000; Other transactions are follows:
         
          took 12% loan of Rs. 100,000; Pur
4. A ltd makes both cash and credit sales. Prepare the income statement from the
   following information:
      i.   Credit sales for November: 230000
     ii. Cash received in November;
               a. From October’s credit sales: 90000
               b. From November’s credit sales: 45000
               c. From November’s cash sales: 76000
    iii. Gross profit: 32% of Sales
    iv.    Net Profit: 16% of Sales

5. Comment on the profitability of the following companies
                                Profit Position
                                    A        B        C
                 PBIT           50,000 50,000 -25000
                 PBT             5000 45,000
                 PAT             3000 30,000
                 Dividend        2700        0      5,000

6. Following are financial items of D ltd.
     i.   Cash: 15000, Accounts Receivables: 42000, Inventory: 33000, Accounts
          Payables: 24000, Capital: 45000, Retained Earning: 21000
    ii. Following are the transactions during the year:
                 Borrowed 30000 on a long term basis
                 Interest expense for the year: 3000. However, not paid.
                 Inventory purchased: 400000 on credit
                 Sales: 500000. 40% for cash.
                 Cost of goods sold: 75%
                 Paid to suppliers: 20%
                 Paid wages: 120000




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7. Following are the transactions of transactions of XYZ ltd.

                               Transactions for the year
                        Started business with
                        capital                       100,000
                        Purchased plant on credit      50,000
                        Purchased stock for cash       50,000
                        Sold 60% stock for             50,000
                        Depreciation                     10%

       Required: Income Statement, Balance Sheet, Cash Flow Statement



8. Following are the transactions of transactions of XYZ ltd.

                               Transactions for the year
                   Started business with capital           100,000
                   Took 12% loan on 1st July               200,000
                   Purchased plant on credit                50,000
                   Purchased stock for cash                 50,000
                   Purchased stock on credit from X        100,000
                   Sold 50% stock for                      200,000
                   Salary per month                          3,000
                   Salaries paid                            24,000
                   Depreciation per annum                     10%

       Required: Income Statement, Balance Sheet, Cash Flow Statement



9. Refer to question 7. Prepare the financial statement for the first quarter (Q1) , and
   the second quarter (Q2),

10. Following are the transactions of transactions of XYZ ltd.

                        Transactions for the year ending 2005
                   Started business with capital           100,000
                   Took 12% loan on 1st July               200,000
                   Purchased plant on credit                50,000
                   Purchased stock for cash                 50,000
                   Purchased stock on credit from X        100,000
                   Sold 50% stock on credit                200,000
                   Rent per month                            2,000
                   Rent paid                                24,000
                   Depreciation                               10%
                   Create a provision for doubtful debts       5%


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                 Required: Income Statement, Balance Sheet, Cash Flow Statement for the
                 year.


      11. Refer to the question no. 9. Following are the transactions during 2006
                   Sold balance stock 175,000 on credit
                   Received 50% of the opening balance of debtors
                   Mr. X, one of the debtors, who owes Rs. 5000 becomes insolvent. He
                      could pay only 40% of the money due. Balance money was treated as
                      bad debt.
                   Company decides to maintain provision for doubtful debt = 5% on the
                      closing debtors.
             Required: Income Statement, Balance Sheet, Cash Flow Statement for the
             year.

      12. Following is the Wipro Limited for two years:
                                             WIPRO LIMITED
                              Profit and Loss Account for the year ending Mar 31
                                        (All figures in rupees million)
                                                                                          2001        2000
Income
Sales and Services                                                                         30539       22735
Other Income                                                                                 692         257
                                                                                           31231       22992
Expenditure
Cost of goods sold                                                                         18103       15203
Selling, general and administrative expenses interest                                       5404        3995
Interest                                                                                         68      286
                                                                                           23575       19484
                     Profit before taxation and non Recurring / extraordinary items         7656        3508


Provision for taxation                                                                       992         501
                                                Profit after tax before non-recurring/      6664        3007
Extraordinary items


Non recurring / extraordinary items                                                              16     -523
                                                                  Profit for the period     6648        2484
Appropriations
Interim Dividend on Preference Shares                                                            18          26
Interim Dividend on Equity Shares                                                                            69
Proposed Dividend on Equity Shares                                                           116
Corporate tax on dividend                                                                        13          10
Transfer to Capital Redemption Reserve                                                       250
Transfer to general reserve                                                                 6251        2379


Required:



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   Study the change in the income statements over the two years and explain how
    profit for the period has increased by 168% .
   Visit the web site of Wipro Limited and collect the latest two years income
    statement and compare with the above income statement.




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