Format of Income Statement | Accounting

After reading this article you will learn about the format of income statement.

Introduction to Income Statement:

An important component of financial statements of an entity is Statement of Comprehensive Income. The main purpose of this statement is performance measurement. For a business entity performance is measured in terms of profit. There are different concepts of profit depending upon the users’ need. Often an entity presents measure those profits on the face of the Statement of Compre­hensive Income.

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It may be noted that Statement of Comprehensive Income is the latest title of Indian version of Profit and Loss Account. Having discussed the concept of comprehensive income, we shall make comparative analysis of Indian profit and loss account with the international version of Statement of Comprehensive Income.

Statement of Comprehensive Income is a two-part statement – the first part being the Statement of Income and the second part Statement of Other Comprehen­sive Income.

Check below a structure of the recent version of the single statement two-part Statement of Comprehensive Income:

Statement of Comphrehensive Income

Examining this format carefully.

The main observations would be the following:

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i. Revenue and other income are segregated. Revenue arises from sale of goods and sale of services, and return for the use of entity’s resource by others in the form of royalty, dividend and interest are presented as other income.

That apart the following items also add to profit of the entity but presented separately:

(a) Profit on sale of property, plant and equipment, intangible assets or financial assets,

(b) Insurance claims,

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(c) Fair value gain arising out of revaluation property, plant and equipment, intangible assets or financial assets are not included in revenue.

Revenue is presented net of taxes, discounts and rebates. Installment interest or defer payment interest is segregated while determining the revenue.

Revenue is recognised applying percentage of completion basis for long term construction contract. Under this method depending upon the stage of completion of the work, revenue can be apportioned and profit is determined. The same concept is applied for sale of service and sale of real estate.

ii. Changes in inventories of finished goods and work in progress:

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For a manufacturing entity, the difference between closing inventories of work in progress and finished goods and opening inventories are adjusted against the revenue. This is called inventory adjustment.

Alternatively, it is possible to take the difference between opening and closing inventories of work in progress and finished goods, and adjust to the expenses.

It may be mentioned that Trial Balance considers the opening inventories. Stock taking takes place the year end. The latest value of the stock is shown in the Balance Sheet. Thus the difference between the opening and closing inventories are adjusted.

iii. Raw material consumed:

It is given by:

Opening inventory of raw material + Purchases – Closing Inventory of raw material

A trading entity presents costs of goods sold which is given by – Opening stock + Purchases – Closing stock

A trading entity does not have any work in progress and raw material inventories. It purchases and sale finished goods.

iv. Employee benefit expenses:

All expenses on account of salaries and wages including provision for retirement benefits and other employee benefits. Termination benefits are also charged to the Statement of Income.

v. Depreciation and amortisation expenses:

Property, Plant and Equipment are depreciated because of wear and tear, usage, obsolescence or simply by passage of time.

On the other hand, intangible assets are amortised. Amortisation is the equivalent of depreciation for intangible assets. Of course, certain intan­gible assets are considered to have indefinite life. Such intangible assets are not amortised.

vi. Impairment of property, plant and equipment and intangible assets:

Impairment loss is the reduction in value of assets as shown in the Balance Sheet (which is termed as carrying amount). Impairment loss is measured taking the difference between – Recoverable amount and Carrying amount.

Note that recoverable amount is higher of the fair value less costs to sell and value in use.

vii. Other expenses:

They include factory administrative, selling and distribu­tion and general expenses other than borrowing costs. Employee benefit expenses, raw material consumed (or cost of goods sold for trading entities), depreciation and amortisation and impairment loss are shown as separate line items.

Similarly, (a) loss of sale of property, plant and equipment, intangible assets or financial assets, (b) fair value loss held for trading financial assets, investment property, (c) mark to market exchange fluctuation loss on monetary assets and liabilities are not included in other expenses. They are presented as separate line items.

viii. Adjustment for expenses capitalised:

Certain expenses are incurred for self-constructed property, plant and equipment or intangible asset which is recorded under the normal account heads like raw material consumed, employee benefit expenses and other expenses. Based on separate record maintained, the entity will analyse the proportion of expenses to be charged to self-constructed property, plant and equipment or intangible asset.

ix. Finance expenses:

It comprises of borrowing costs which is defined as interest and other costs that an entity incurs in connection with the borrowing of funds. Examples of other costs are issue expenses and discount to face value.

Borrowing costs that are directly attributable to the acquisition, construc­tion or production of a qualifying asset are capitalised as part of the cost of that asset. Qualifying assets are non-financial assets which take substantial time before being ready for intended use. Substantial period may be interpreted as a period of 12 months. Example of qualified assets: property, plant and equipment, intangible assets, investment property, inventories.

Suppose, an entity borrows Rs.10,00,000 for construction of a plant @ 10% p.a. on 1.1.2007. The plant was ready for use on 1.10.2008. The entity follows calendar year as accounting period. How much of the interest shall be capitalised (means included in the cost of the plant) and how much shall be charged to the Income Statement? Interest for the period 1.1.2007 to 30.9.2008 shall be capitalised and interest for the period 1.10.2008 to 31.12.2008 shall be charged to Income Statement.

x. Share of profit of associates:

Associates are entities wherein the investor enjoys significant influence. When an entity prepares consolidated financial statements under equity method accounting of associates, its share of profit is accounted for as income.

xi. Profit/loss on sale of property, plant and equipment, intangible assets, financial assets:

When an entity sell these assets there may arise profit/loss which is adjusted in the Statement of Income.

Suppose, an entity purchased plant and machinery for Rs.10 lacs, it has charged depreciation over 3 years amounting to Rs.3 lacs. Then the asset is sold for Rs.4 lacs. So the written down value of the assets (which is original cost minus accumulated depreciation charge) was Rs.7 lacs. Loss on sale is Rs.3 lacs (sale proceeds minus written down value). This loss is charged to the Income Statement. Similarly, profit on sale of asset is also accounted for in the Income Statement.

xii. Fair value gain/loss on held for trading financial assets/liabilities:

Held for Trading Financial Assets are short term investments in financial assets like shares, debentures, government securities like GOI bond or T-bills, derivatives like options and futures. These investments are measured at fair value at the end of each reporting period. Best measure of the fair value of these investments are quoted market price.

Suppose purchase price of shares is Rs.5 lacs and market price at the year end is Rs.6 lacs – then there is a fair value gain of Rs.1 lac. Alternatively, if the purchase price is Rs.5lacs and market price at the year end is Rs.4lacs – then there is a fair value loss of Rs.1 lac. This profit/loss is charged to the income statement. This fair value gain/loss is accounted for even if the asset is not sold.

Similarly, there may be increase in liability arising out of fair loss. Refer to Example 9.4.

xiii. Fair value gain/loss on investment property:

Investment property is defined as a property (in the form of land or a building or part of a building or both) which is held by the owner or by the lessee under a finance lease to earn rentals or for capital appreciation or both. If an entity adopts revaluation accounting, the fair value loss or gain on the investment property is charged to the Income Statement. This fair value gain/loss is accounted for even if the asset is not sold.

xiv. Exchange fluctuation gain/loss:

An entity may have foreign currency denominated debtors, creditors, bank deposit, loans. These assets and liabilities are termed as monetary assets or liabilities as the amount to be received or paid is fixed in terms of a foreign currency. For the purpose of preparation of financial statements, they are translated applying exchange rate at the reporting date. Because of the fluctuation of Indian currency, which is the currency of the Indian entities, against the foreign currency in terms of which these monetary assets or liabilities are denominated, there may arise loss or gain. Such exchange fluctuation loss/gain is charged to the Income Statement.

Suppose, Entity E has sold goods to a foreign customer for US$ 100,000 on credit. This transaction is translated applying spot rate on the date of transaction.

If the spot rate is $ 1 = Rs.45 on the date of transaction, then the Journal Entry is:

Sundry Debtors Dr. Rs.45,00,000

Sales Cr. Rs.45,00,000

At the year end debtors arc standing at $ 100,000; it is a monetary asset. The entity will collect only $ 100,000 irrespective of the exchange rate on the date of collection. Now assume that at the year end debtors remain uncollected and closing exchange rate is $ 1 = Rs.52.

What should be the accounting entry?

Debtors Dr. Rs.7,00,000

Exchange Fluctuation Gain Cr. Rs.7,00,000

Because of rupee depreciation, value of debtors in terms of the reporting currency (Le. Indian rupee) has increased. This mark to market exchange fluctuation gain is charged to the income statement even if the amount is not yet collected.

xv. Income tax expense:

It comprises of income tax charge as per tax law as well as accounting adjustments for deferred tax expense or income

xvi. Items included in statement of other comprehensive income:

The follow­ing items are included:

a. Exchange differences in translating foreign operations;

b. Gain (loss) on fair value changes in available for sale financial instruments;

c. Gain (loss) fair value changes in Cash Flow Hedges;

d Gain on Revaluation of Property, Plant and Equipment;

e. Actuarial Gain (Loss) on defined benefit pension plans;

f. Share of other comprehensive income of associates;

g. Income tax relating to items of other comprehensive income.

xvii. Profit attributable to:

Owners of the entity

Non-controlling interest

xviii. Total comprehensive income attributable to:

Owners of the entity

Non-controlling interest

Same as item xv.

xix. Earnings per share:

Basic

Diluted

Cost of Goods Sold and Gross Profit:

While presenting the Statement of Income various entities present different types profit, namely, gross profit, operating profit, EBITDA, Profit before tax, Profit after tax.

Gross Profit is normally presented by trading entities.

Gross profit = Sales minus cost of goods sold.

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

Example 1:

During 2008, X Ltd. purchased 500 units of an electronic iron for Rs.2,00,000 which includes refundable VAT of Rs.2000. The company spent Rs.3,000 on account of transportation and transit insurance. These goods were sold for Rs.3,00,000 inclusive of VAT of Rs.3,500. The company spent Rs.40,000 on account of wages and expenses. Unsold goods at the year end is 20 units. The company deposited VAT due to the Government department. Find out gross profit. How much VAT did the company deposit?

Note:

Sales are recognised net of VAT which is separately accounted for. Similarly, refundable VAT is not included in the cost of goods but includes transportation and insurance. Wages and other expenses are not included in the gross profit calculation.

The company paid VAT amounting to Rs.1500 [VAT on sales minus VAT refundable on purchases]

Inventory valuation and computation of cost of goods sold:

Inventories are valued at lower of the cost and net realisable value. When inventories are sold, the carrying amount of the goods are expensed.

Cost of purchase comprises of purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase.

IAS 2 suggests to apply of either of the two cost formulas – FIFO or weighted average cost formula. The inherent assumption of FIFO formula units purchased first are issued/consumed first. So inventories and usage reflects different lots and different valuation. Whereas in weighted average cost of beginning inven­tory and new purchases are added up and weighted average cost is computed. Weighted average cost can be computed for each new purchase or periodically.

Example 2:

Using the following purchases of goods by a trading entity and issues for sales, determine of cost of 2600 units of inventories as on 31.1.2008 and cost of goods sold.

The entity follows FIFO formula.

Solution:

Cost of goods sold 16, 000 units: Rs.5,06,350

Inventories 2600 units: Rs.91,000.

Example 3:

Using the following purchases of goods by a trading entity and issues for sales, determine of cost of 2600 units of inventories as on 31.1.2008 and cost of goods sold.

The entity follows weighted average formula.

Solution:

Cost of goods sold 16, 000 units: Rs.5,08,830

Inventories 2600 units: Rs.88,521.

Which of the two formula for inventory valuation is better? FIFO reflects latest price of the inventory and thus cost of goods sold is valued cost of older lots. Therefore, gross profit is inflated in times of price rise. In this method, cost of goods sold is not valued at current cost, and therefore, often weighted average appears to be a better option.

Preparation of income statement by trading entities:

Discussed below in Example 4 the stand-alone Income Statement of a trading entity. The stand-alone Income Statement means non-consolidated income statement. In case a trading entity is having subsidiaries or joint ventures, then it has to prepare consolidated income statement as well.

Example 4:

X Ltd. has provided the following account details for the year 2008 (Rs. in thousand):

Sales 30,000 ; Purchases 12,000, Opening stock 2,000; Closing stock 1,000; Employee Benefits expense 3000; General Expenses 2,000.

Property, Plant and Equipment 30,000 ; Charge 10% depreciation p.a.

Intangible Assets 4,000; Charge 10% amortisation.

The company has assessed as on 31.12.2008 that fair value less costs to sale of the Property, Plant and Equipment is 22,000 and value in use is 27,000.

Interest on bank loan 400.

Dividend from subsidiaries 200; dividend from joint ventures 100; dividend from associates 100.

As on 31.12.2008, the market value of held for trading investments of the company is 12,000 as against the carrying amount of 12,500. Estimated income tax liability 600.

There is no item of other comprehensive income. Prepare Statement of Compre­hensive Income. Assume that average no. of outstanding shares of the company is 1000 thousand.

Solution:

1. Impairment loss: Recoverable amount = Higher of the Fair Value less Costs to sale and Value in Use i.e. 27,000

Impairment loss = Carrying amount 30,000 – Recoverable amount 27,000 = 3,000

2. Depreciation is charged on value of Property, Plant and Equipment after charging impairment loss, i.e. New value of asset 27,000 x 10% = 2700.

3. Difference between the market price and the carrying amount.

Example 5:

Y Ltd. has provided the following account details for the year 2008 (Rs.in thousand):

Sales 25,000; Purchases 12,000, Opening stock 2,000; Closing stock 1,000; Employee Benefits expense 2000; General Expenses 2,000. Estimated income tax liability 600.

Property, Plant and Equipment 30,000; Charge 10% depreciation p.a. Intangible Assets 4,000; Charge 10% amortisation.

The company has assessed as on 31.12.2008 that fair value less costs to sale of the Property, Plant and Equipment is 28,000 and value in use is 27,000.

Interest on bank loan 400.

Dividend from subsidiaries 200; dividend from joint ventures 100; dividend from associates 100.

As on 31.12.2008, the market value of available for sale investment of the company is 12,000 as against the carrying amount of 12,500.

There is no item of other comprehensive income. Prepare Statement of Compre­hensive Income. Assume that average no. of outstanding shares of the company is 1000 thousand.

Solution:

1. Impairment loss: Recoverable amount = Higher of the Fair Value less Costs to sale and Value in Use i.e. 28,000

Impairment loss = Carrying amount 30,000 – Recoverable amount 28,000 = 2,000

2. Depreciation is charged on value of Property, Plant and Equipment after charging impairment loss, Le. New value of asset 28,000 X 10% = 2800.

3. Difference between the market price and the carrying amount. Fair value loss is transferred to Fair Value Reserve for AFS Investments. In this case, it will be negative reserve.

We have already encountered the terms operating profit, profit before tax and profit after tax in Examples 9.4 and 9.5.

Depreciation Methods:

Depreciation is a systematic allocation of depreciable amount over the useful life of the asset. Depreciable amount is the cost of the asset or any other amount substituted for cost less residual value. Residual value is net amount expected to be obtained (from the disposal of an asset at the end of its useful life after deducting expenses of disposal. This is reviewed at the end of each financial year- end.

There are many different methods of charging depreciation – four important methods are:

(i) Straight line method,

(ii) Reducing balance method,

(iii) Sum of digit method and

(iv) Unit of production method.

Straight line method depreciation:

Under this method depreciable amount of the asset is charged equally over its useful life.

Example 6:

Purchase price of a plant is Rs.80 lacs, its estimated useful life is 20 years and residual value is Rs.4 lacs. Find out annual depreciation Charge. What is straight line depreciation rate?

Solution:

Example 6(a):

Assume that 5 years of useful life of the plant discussed in Example 9.6, has expired in the year 2007. Find out the accumulated depreciation as on 31.12.2007 and Carrying amount of the plant as on that date.

The company decides to revalue the plant in the year 2008 by 20% of its carrying amount. It estimates that residual value will remain the same and the remaining useful life of the asset will be 15 years. How should it account for the revaluation of the asset? Find out depreciation charge for 2008.

Solution:

31 December, 2007

Accumulated depreciation = 5 × Rs.3.8 lacs = Rs.19 lacs

Carrying amount of the plant = Rs.80 lacs – Rs.19 lacs = Rs.61 lacs.

2008

Revaluation Surplus: Rs.61 lacs × 20% = Rs.12.20 lacs

Accumulated Depreciation Dr. 19.00

Plant Cr. 19.00

(Accumulated depreciation is adjusted to the cost of the plant before revalua­tion).

Plant Dr. 12.20

Revaluation Surplus Cr. 12.20

(Revaluation surplus is presented in the Statement of Other Comprehensive Income and transferred to equity. This is not charged in the income statement.)

Now the asset will be depreciated over the remaining useful life on the basis of new depreciation charge.

Reducing balance method of depreciation:

Under this method depreciation is charged on the successive net carrying amount of the asset.

Example 6(b):

Take data from Example 9.6 and compute reducing balance depreciation rate.

Solution:

Example 6(c):

Take the reducing balance depreciation rate from Example 9.6(b) and find out depreciation charge for first 5 years, accumulated deprecia­tion and written down value of the asset.

You may verify that depreciation charge for year 1 is on Rs.80 lacs @ 10.8749% and in year 2 is on Rs. 71.30 lacs @ 10.8749%.

Now you may compare the depreciation charge of an asset under straight line method and reducing balance method. Study Example 9.6 (d).

9.6(d) Entity E purchased a piece of equipment for Rs.2,00,000 and estimated its useful life to be 10 years and residual value at the end of the useful life to be Rs.10,000. Show in tabular form the yearly depreciation charge under straight line method (SLM) and reducing balancing methods. Graphically present the depreciation charge and interpret the result.

Solution:

It may be observed that under reducing balance method depreciation charge in the early years is very high as compared to the SLM depreciation charge. However, it reverses at the later part of the asset’s life.

Therefore, if an entity analyses that the underlying product is highly competitive and susceptible to technological advancement, then it may charge reducing balance depreciation. On the other hand, for basic industries like oil refinery, steel, aluminium etc. in which the degree of technological obsolescence is not so high the plant can be depreciated applying straight line method.

Sum of digit method of depreciation:

Under this method depreciation charge is computed as follows:

Digits are sequence of the numbers up to the number representing useful life of the asset.

Example 6(e):

A plant is having useful life 10 years and depreciable amount of Rs.10,00,000. Find out depreciation charge for Year 1-10.

Solution So sum of digit is –

1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = (10 × 11)/2 =55

Sum upto n digit = n (n + 1)/2

Depreciation for the first year = 10/55 × 10,00,000

Units of production method of depreciation:

Under this method depreciation charge is determined on the basis of estimated production units. This method is suitable for minerals reserve like oil field, coal or iron mines. Depreciation is charged on the basis of actual extraction of mineral over the estimated reserve.

Example 6(f):

An oil field is having 5 billion (estimated) barrels of oil reserve. The Oil Exploration Company produced 20 million barrels during the year. The Exploration and Evaluation Assets are valued at Rs.500 million. Charge depre­ciation on the Exploration and Evaluation Assets.

Exploration and Evaluation assets are capitalised portion of the exploration and evaluation expenditure (of oil exploration company) recognised as assets in accordance with the entity’s policy.

Exploration and evaluation expenditures are those expenditures which are incurred by an entity in connection with the exploration for and evaluation of mineral resources before the technical feasibility and commercial viability of extracting a mineral resource is established. Once the technical feasibility and commercial viability of extracting a mineral resource is established, the appro­priate portion of the expenditure is capitalised as a Exploration and Evaluation Asset.

Solution:

Distinction between Revenue and Capital:

This distinction is crucial for the preparation of profit and loss account and understanding the term profit. Let us understand the issue first by way of examples.

Example 7:

On 1st January, 2008, Bhuban Zinc Ltd. raised equity share capital of Rs.100 million and invests in Land Rs.40 million, Factory Building Rs.30 million, Plant and Machinery Rs.100 million and Furniture Rs.5 million. Balance of the money required is raised through Term Loan from a Bank @ 10% interest p.a.

How do you look at these transactions? Are these transactions in the nature of capital or revenue?

Concept 1:

Any transaction that relates to raising of capital or repayment thereof is capital transaction in nature. So raising of equity share capital and term loan are capital transactions. Expenses incurred to raise capital or repayment of capital is adjusted to the amount of capital raised.

Concept 2:

Any transaction that relates to investment in assets or disposal of assets is capital in nature. But profit or loss arising out of disposal of assets is not capital in nature. An asset is defined as a resource controlled by an enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Examples of assets are land, building, plant and machin­ery, furniture, goodwill, patent right, copyright, etc.

Applying these two basic concepts, if we analyse the transactions stated in Example 9.7, we find all these items are either equity, liability or assets. Keep in mind that a liability is defined as a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Equity is the residual interest both in the assets of the enterprise after deducting all its liabilities.

Continuing with the figures given in Example 9.7, we find that total assets are follows:

The above assets are financed through a Term Loan of Rs.90 million which is liability and balance is financed through equity share capital of Rs.100 million which is broadly termed as equity. In fact this gives you an opening balance sheet of the company with which the business is commenced.

There is nothing in these transactions which could be termed as revenue item.

Thus capital items arc of three types:

Capital Items

Assets are further classified as current asset and non-current asset. Current assets are those which are expected to be converted in cash within a period of twelve months or within normal operating cycle of the business. Non-current assets are those which are not classified as current assets. Say, a company purchases raw materials for production which remains unutilized during the accounting period.

It is expected that such raw materials will be consumed in the production process during the next accounting period. So, the stock of raw materials should be treated as current assets. Take another example. A company purchases plant and machin­ery which is expected to be used in the production process for 20 years. So, plant and machinery should be treated as non-current asset. Depreciation is charged on non-current assets.

Similarly, liabilities are also classified as current and long-term. Liabilities which are to be paid within a period of twelve months or within the normal operating cycle of the business are treated as current liabilities. Other liabilities are classified as long-term.

These classification are important for the purpose of presentation of balance sheet items.

Revenue items are classified as expense and income. Income is defined as increase in economic benefit during accounting period in the form of inflows or enhancements of assets, or decreases in liabilities that result in increase in equity, other than those relating to contributions from equity participants.

Income includes both revenues and gains. Revenue arises in the course of ordinary activities of the entity. An example is sales. Gain may arise from sale of plant and machinery at price higher than its cost of purchase.

Expenses are decrease in economic benefits during the accounting period in the form of outflows or depletion of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity partici­pants. Expenses includes losses. Examples of expenses are cost of materials consumed, wages and salaries, depreciation, etc.

Revenue Items

It is also necessary to understand matching concept and accrual principle. Expenses incurred to earn revenue within an accounting period to be matched. Let us first talk about matching. Say, a company buys 100 units of an item (a Rs.100 per unit and sold 80 units @ Rs.120 per unit during the accounting period 2007-08. What is the amount of profit earned during 2007-08?

Which of the following views are correct?

Of course, you will accept the first view. Expense for 80 units of goods actually sold should be charged to find out profit. It is improper matching to book all purchases as sales as that profit is not earned. Also it is improper to charge expense of all purchases against sale of 80 units. Thus expense for balance 20 units is not treated as revenue expenditure. It is treated as an asset.

Now let us talk about accrual. It is being classified as one of the three fundamen­tal accounting assumptions. Other two are going concern and consistency which we shall discuss later on. A company worked out salaries and other benefits due to employees during the accounting period Rs.100 million of which only Rs.90 million was paid. Should Rs.90 million which were paid be treated as an expense for computing profit of the accounting period? No, that’s not the correct approach.

According to the accrual principle, revenue and costs are accrued, that is, recognized as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate. Whether money is paid or not is irrelevant. Salaries and other employee benefits to extent of Rs.100 million is to be charged while computing profit or loss. Then how should we recognize the unpaid amount of Rs.10 million? This unpaid amount is recognized as a liability – a better heading would be “Outstand­ing Wages”.

Example 8:

Having installed factory and other assets, the Bhuban Zinc Ltd. (discussed in Example 9.7) started production and sales.

The following transac­tions took place:

1. Raw material purchased Rs.200 million, of which due to suppliers Rs.20 million and balance was paid. Raw material consumed for production is Rs.190 million.

2. Wages incurred Rs.40 million, of which Rs.1 million remained unpaid.

3. Power and fuel Rs.10 million, paid Rs.11 million.

4. Salaries and other employee benefits for administrative staff Rs.8 million.

5. Other administrative expenses Rs.5 million of which Rs.6 million was paid.

6. Repairs and maintenance Rs.2 million which paid in full.

7. Interest on term loan remains unpaid.

8. Depreciation on assets:

Scrap estimation – Factory building 5%, Plant and Machinery 10%, Furni­ture nil

Useful life – Factory Building 15 years, Plant and Machinery 10 years, Furniture 5 years.

9. Selling and distribution expenses Rs.5 million.

10. Tax 35%

11. Sales Rs.3 50 million of which Rs.50 million to be collected from customers.

12. Unsold finished goods – Cost Rs.10 million, Selling Price Rs.18 million.

Analyse these transactions. Identify revenue item and capital item.

1. Since the business is started new, there is no opening stock of raw material. There is closing stock of raw materials Rs.10 million.

Raw material consumed is a revenue item (expense) to be charged to Profit and Loss Account for the purpose of computing profit whereas closing stock of raw material is an asset from which economic benefit would be derived in future (matching).

2. Wages incurred Rs.40 million for production, whether paid or remained unpaid, is revenue item (accrual). It is an item of expense. Unpaid amount Rs.1 million is treated as a liability under the head “Outstanding wages”.

3. Power and fuel Rs.10 million is an expense (matching) to be charged to the Profit and Loss Account. Rs.1 million advance payment on account of power and fuel should be treated as an asset under the head “Prepayments”.

4. Salaries and other employee benefits Rs.8 million is treated as an expense (matching) to be charged to the Profit and Loss Account.

5. Other administrative expenses Rs.5 million is an expense (matching) to be charged to the Profit and Loss Account. Rs.1 million advance payment on account of other administrative expenses should be treated as an asset under the head “Prepayments”.

6. Repairs and maintenance Rs.2 million is an expense (matching) to be charged to the Profit and Loss Account.

7. Interest payable on term loan is to be worked out even if not paid (accrual) and to be charged to the Profit and Loss Account (matching). It works out to be Rs.9 million (10% on Rs.90 million Term Loan). Unpaid interest is generally added with the loan principal and shown as a liability.

8. Depreciation is charged on the cost or carrying amount of the non- current asset. Land is not treated as a depreciable asset.

9. Selling and distribution expenses Rs.5 million is an expense (matching) to be charged to the Profit and Loss Account.

10. Tax is levied by the Central Government. Appropriate amount of tax is computed applying the rate prescribed in the Income-tax Act and Rules. However, amount of tax to be charged to the Profit and Loss Account applying matching principle needs a detailed discussion. Till such time we are taking the amount of tax as an expense. Subsequently, we shall learn how to compute deferred tax asset and deferred tax liability.

11. Sales Rs.350 million are revenue and to be shown in the Profit and Loss Account (accrual), amount not yet collected is to be shown as an asset under the head (Sundry Debtors).

12. Unsold finished goods at cost Rs.10 million is classified as an asset under the head “Inventories” sub-head “Finished goods”. Why should the invento­ries be shown at cost not at the market value?

This is because of prudence. In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realized though not necessarily in cash. Provision is made for all known liabilities and losses even though amount cannot be determined with certainty and represents only a best estimate in the light of available information.

Based on prudence, inventories are valued at the lower of cost and net realizable value. However, there are exceptions to the prudence principle. While applying fair value accounting, rule of prudence is sacrificed in many counts and assets are value at their fair value which may be market price. However, inventories are value at lower of the cost and net realizable value.

Operating Profit, Profit before Tax and Profit after Tax:

In contrast to trading entities which emphasises on gross profit in the profit determination process, Manufacturing entities would give importance to oper­ating cost:

Operating Profit = Operating Revenue minus Operating Expenses

While computing operating revenue, other income comprising of return for using entity’s resource by other entities like royalty, interest and dividend are included in the Income Statement after operating profit is computed. Similarly, non-operating profit or gain and loss like fair value gain/loss on held for trading investments and investment property, and profit/ loss on sale of property plant and equipment are not considered while computing operating profit.

Profit before Tax =

Operating Profit

+ Borrowing Costs

+ Non-operating income

– Fair value loss on Held for Trading Investments and Investment Property

+ Fair value Gain on Held for Trading Investments and Investment Property

– Loss on Sale of Property, Plant and Equipment, Intangible Assets, Investment Property, Financial Assets

+ Profit on Sale of Property, Plant and Equipment, Intangible Assets, Investment

Property, Financial Assets

± Other items gain/loss

Profit After Tax = Profit Before tax

– Current Tax Provision

– Provision for Deferred Tax Expense

+ Provision for Deferred tax Income/Tax refund

Distributable profit:

This is given by PAT plus balance of Profit and Loss Account balance of Profit and Loss Account standing from previous years. Generally, the whole amount of profit is not used during the year. As per law, a company have to transfer a part of profit to various reserves and the balance is distributed by way of dividend. This is reflected in the appropriation section (which is also called below the line of Indian format of the Profit and Loss Account).

Example 9:

Zenith Ltd. has provided the following account details for the year 2008 (Rs.in thousand):

Sales 25,000; Purchase of raw materials 12,000, Opening Inventories: raw materials 500, work in progress 200, finished goods 600; Closing Inventories: raw materials 600, work in progress 220, finished goods 750; Employee Benefits expense 2000; General Expenses 2,000. Estimated income-tax liability 600, estimated tax refund 50;

Property, Plant and Equipment 30,000. The company revalued property, plant and equipment by 5000. Charge 10% depreciation p.a.

Intangible Assets 4,000; Charge 10% amortisation

Interest on bank loan 400.

Dividend from subsidiaries 200; dividend from joint ventures 100; dividend from associates 100.

As on 31.12.2008, the market value of available for sale investment of the company is 12,000 as against the carrying amount of 12,500.

There is no item of other comprehensive income. Prepare Statement of Compre­hensive Income. Assume that average no. of outstanding shares of the company is 1000 thousand.

Solution:

Profit and Loss Account – Indian presentation:

Presented below Profit and Loss Account of Tata Steel Ltd.

Appropriations:

After computation of the profit available for distribution or disposable profit, appropriations are shown at the bottom of the vertical profit and loss account (see Example 9.9). Appropriations include (i) transfer to general reserve (ii) transfer to debenture redemption reserve and (iii) proposed dividends.

Part II of Schedule VI requires disclosure of proposed transfer to reserves and withdrawals from the reserve, if any. The Companies (Transfer of Profits to Reserves) Rules, 1975 specifies percentage of profit to be transferred to reserve in case dividend is proposed. Percentage of profit to be transferred to reserve is applied to “current profit”. The current profit is arrived at after providing for depreciation and arrears depreciation. Current profit implies profit after tax.

Percentage of profit to be transferred to reserves is as follows:

A company can voluntarily transfer higher percentage of current profits to reserve.

However, before such a higher transfer it is necessary to ensure:

1. Maintenance of dividends to shareholders at a rate equal to the three- yearly average rate of dividends declared by the company;

2. If there is issue of bonus shares, maintenance of three-yearly average, amount of dividend declared by the company.

Let us understand various concepts of profit taking an example.

Example 10:

Lovna Trading Ltd. provides the following information for the year ended on 31-12-2008. You are required to prepare Profit and Loss Account in vertical form showing PBIT, PBT, PAT, Distributable Profit and Profit Available to the Equity Shareholders. How much balance of Profit and Loss Account will remain after the desired appropriations?

Solution: 

1. Increase in stock: Closing Stock-Opening Stock =Rs.120 lacs- Rs.100lacs

2. Expenses:

3. Interest = 10% of Rs.2000 lacs = Rs.200 lacs.

4. Transfer to Reserve = 60% of Rs.675 lacs = Rs.405 lacs.

5. Dividend to Preference shareholders = 10% of Rs.200 lacs = Rs.20 lacs Distribution tax = 10% of Rs.2 lacs = Rs.2 lacs

6. Dividend to Equity Shareholders = 20% of Rs. 1000 lacs = Rs. 200 lacs Distribution tax = 10% of Rs. 200 lacs = Rs. 20 lacs

Preparation of profit and loss account from trial balance:

All items of revenue/income have credit balance and all items of expense/loss have debit balance. Assets are having debit balance. Liabilities and share­holders’ funds are having credit balance.

In fact, for the preparation of Profit and Loss Account, we need to identify items of revenue/income and expense/loss.

Example 11:

Given below is a Trial Balance of Collina Health Care Products Ltd.

Other Information:

Closing Stock Rs.180 lacs. Assume 35% corporate tax. Company proposes equity dividend @20%. Distribution tax 10%. Transfer to Reserve 20% of PAT.

Identify revenue/income, expense/loss, assets, liabilities and shareholders’ funds. Prepare vertical Profit and Loss Account for the year ended 31st March, 2009.

Solution:

Identification of Accounting Elements

Profit and Loss Account

Corporate profit and loss account – Requirements of the com­pany law:

In Part II of Schedule VI to the Companies Act, 1956 requirements relating to Profit and Loss Account of a company are prescribed.

Important requirements are stated below:

1. No format for Profit and Loss Account is prescribed. It required that various items relating to income and expenditure of the company should arranged under the most convenient head.

2. Disclosures for sales or gross turnover, purchases and stocks—

a. Turnover (aggregate amount of sales effected by each class of goods indicating the quantities); commission paid to sole selling agent; commission paid to other selling agents; brokerage and discount on sales.

b. Value of raw material consumed giving item-wise break up and indicating quantities.

c. Opening and closing stock of goods produced giving item-wise break up and indicating quantities.

d. The trading companies have to disclose goods purchased, opening stock and closing stock giving break up of each class of goods traded and indicating quantities.

e. The companies rendering services have to disclose gross income derived from services rendered or supplied.

f. Other companies have to disclose gross income derived under differ­ent heads.

g. For work-in-progress (incomplete production) extent of completion at the beginning and end of the year.

3. Disclosure about expenditure: Companies have to disclose the following items of expenditure:

a. Depreciation, renewals or diminution in value of fixed assets;

b. Interest;

c. Taxation on profit;

d. Expenditure on account of consumption of stores and spares, power and fuel, rent, repairs to building, repairs to machinery;

e. Salaries, wages and bonus; contribution to provident and other funds; workmen and staff welfare expenses; insurance; rates and taxes; miscellaneous expenditure, post employment benefits like pension, gratuity, etc., audit fees, managerial remuneration.

4. Disclosure of income/loss:

a. Profits or losses on investments

b. Income from investments

c. Dividend from subsidiaries

d. Provision for losses of subsidiary companies.

5. Disclosure about appropriations:

a. Reserve for repayment of share capital and loan

Managerial Remuneration:

Part II of Schedule VI requires disclosure of payments provide for or made to—

1. The directors including managing directors and managers of the company;

2. The directors including managing directors and managers of the subsidiar­ies of the company.

The following payments to directors including managing directors or managers require disclosure:

i. Managerial remuneration paid or payable under section 198;

ii. Any other perquisites or benefits in cash or kind stating approximate money value where practicable;

iii. Pensions, gratuities, payment from provident funds in excess of own contribution and interest thereupon;

iv. Compensation for loss of office;

v. Consideration in connection with retirement from office.

Section 198 prescribes the maximum percentage of profit that can be paid as managerial remuneration. For this purpose profit is to be calculated as specified in section 349. It is required to include a statement showing computation of profit in accordance with section 349 and calculation of amount payable to directors including managing directors and managers.

Computation of managerial remuneration is guided by the provisions of sections 198, 309, 310, 311, 352 and 387 of the Companies Act and Schedule XIII to the Companies Act. The directors, whole-time and managing directors and manag­ers are considered as managerial personnel for this purpose. Overall ceiling for managerial remuneration is based on the net profit which is to be computed as per sections 349 and 350 of the Companies Act.

Meaning of managerial remuneration:

In addition to salary and commission, the term “remuneration” includes:

1. Expenditure in relation to rent-free accommodation or any benefit or amenity free of charge in relation to accommodation;

2. Expenditure in relation to any other benefit or amenity provided by the company free of cost or at concessional rate;

3. Any expenditure incurred by the company in respect of obligation to be met by the directors and managers;

4. Any expenditure incurred by the company to effect life insurance or for annuity, pension or gratuity for the directors and managers or their spouse and children.

Overall limit:

Section 198 of the Companies Act requires that total managerial remu­neration payable by a public company or a private company which is subsidiary of a public company to its directors and its manager in respect of any financial year shall not exceed eleven per cent of the profits of the company for that financial year. This is the overall restriction on the maximum amount of the managerial remuneration. Net profit for this purpose shall be computed in the manner laid down in sections 349, 350 and 351. Remuneration of the directors shall not be deducted from the gross profit.

The aforesaid eleven per cent maximum limits do not include fees payable to directors under section 309. It may be mentioned that section 309 states that the remuneration payable to the directors of a company including managing or whole-time directors does not include—

i. Any remuneration for services rendered by any such director which are of professional nature, and in the opinion of the Central Government the director possesses requisite qualifications for the practice of the profession;

ii. Remuneration by way of fees for each meeting of the Board or a committee thereof.

Part II of Schedule XIII to the Companies Act states that subject to the provisions of sections 198 and 309, a company having profits in a financial year may pay any remuneration by way of salary, dearness allowance, perquisites, commissions and other allowances, which shall not exceed 5% of its net profit for one such managerial person and 10% for all of them together. This means for all the directors maximum ceiling of managerial remuneration is 10% of the net profit and for directors as well as managers together the maximum ceiling is 11%.

Ceiling for Managerial remuneration stated in Schedule XIII in case profit of the company is not adequate:

(A) A company not having any profit or adequate profit may pay remuneration to its managerial personnel by way of salary, dearness allowance, perquisites and any other allowances not exceeding ceiling limit of Rs.24,00,000 p.a. or Rs.2,00,000 per month calculated in a scale based on effective capital:

The ceiling stated above is applicable if (i) payment of remuneration is approved by a resolution passed by the Remuneration Committee, and (ii) the company has not made any default in repayment of its debts.

(B) A company not having any profit or adequate profit may pay remuneration to its managerial personnel by way of salary, dearness allowance, perquisites and any other allowances not exceeding ceiling limit of Rs.48,00,000 p.a. or Rs.4,00,000 per month calculated in a scale based on effective capital:

The ceiling stated above is applicable if (i) payment of remuneration is approved by a resolution passed by the Remuneration Committee, (ii) the company has not made any default in repayment of its debts, (iii) a special resolution has been passed at the general meeting of the company for the payment of such remu­neration for a period not exceeding a period of three years, and (iv) a detailed statement about the business of the company submitted to the shareholders’ along with the notice of the meeting.

A company may pay managerial remuneration exceeding the ceiling stated in (B) when its effective capital is negative after obtaining prior approval of the Central Government.

In addition, the managerial personnel are entitled to perquisites in the form of contribution to provident funds, gratuity and leave encashment, children educa­tion allowance (maximum Rs. 5,000), holiday passage for children studying outside India/family members staying outside India (once in a year by economy class or twice in a year by first class) and leave travel concession.

Effective capital means share capital (excluding share application money or advance against shares), share premium account balance, reserves and surplus (excluding revaluation reserve), long-term loans and deposits repayable after one year (excluding working capital loans, overdrafts, interest during loans which are not funded, bank guarantee, etc. and other short-term arrangement) as reduced by investments (except in case of investment company), accumulated losses and preliminary expenses.

Monthly or quarterly payment of remuneration:

Section 198(3) clarifies that within the overall limit of maximum remu­neration, a company may pay monthly remuneration to managing or whole-time directors in accordance with section 309 or to the managers as per section 387.

Section 309(3) explains that whole-time or managing director can be paid remuneration by monthly payment or by way of specified percentage of net profits or partly by one and partly by the other. However, payment to one managing or whole-time director shall not exceed 5% of the net profit and payment to more than one managing or whole-time directors shall exceed more than 10% of net profit.

Other directors (i.e. who are not managing or whole-time directors) may be paid remuneration (i) either by way of monthly, quarterly or annual payment with the approval of Central Government, or (ii) by way of commission on authorisation by the company through a special resolution.

In fact, in the Press Note 1/94 dated 2-2-1994 issued by the Department of Company Affairs it has been clarified that approval of the Central Government is not required by the companies in regard to managerial remuneration which is not in excess of the prescribed percentage. So it appears that for payment of remuneration on monthly, quarterly or annual basis within the prescribed percentage no specific approval of the Central Government is required.

Section 387 of the Companies Act states that a company can pay its managerial remuneration either by way of monthly payment or by way of specified percentage of the net profits computed in the manner laid down in sections 349, 350 and 351 of the Companies Act or partly by one and partly by the other.

Determination of net profits:

1. While computing net profit, bounties and subsidies received from the Government or any public authority should be added to revenue;

2. While computing net profit the credit should be given to the following items:

3. While computing net profit the following items shall be deducted:

4. While computing net profit the following items shall not be deducted:

a. Income-tax and super-tax;

b. Compensation and damages paid voluntarily;

c. Loss of capital nature

Section 350 requires depreciation charge at the rates specified in Schedule XIV of the Companies Act.

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