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Monday, January 01, 2001

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Balance-sheet basics

N. R. Parasuraman on the form and contents of a typical balance-sheet.

ALL COMPANIES are statutorily required to come out with a final statement of accounts every year. The final statement of accounts consist of the balance-sheet, the profit and loss (P&L) account, supporting schedules, the auditor's report, a statement of accounting policies and additional notes on account. The balance-sheet and P&L account are designed to give a bird's eye view of the state of affairs of a company.

Schedule VI of the Companies Act details the format and typical contents of the balance-sheet and P&L account. Companies are given the option to have their statements in either the `horizontal' or `vertical' format. As most companies follow the latter, the discussion will be confined to that format. Companies are also given the freedom to have the figures published in thousands, lakhs or crores of rupees depending upon the scale and magnitude of operations.

A typical vertical balance-sheet's design is as per the ``funds-flow'' analogy. A company gets its source of funds from share capital, outside loans, short-term loans and accumulated reserves. These funds are deployed in fixed assets, investments and net current assets. Companies are required to show the previous year's figures also alongside the relevant items to give a comparison.

Schedule VI also gives a detailed write-up of the details that should be shown in respect of various items in the statements. For instance, under each item of fixed asset, the original cost, the additions thereto, depletions therefrom, accumulated deprec iation so far and the net value of the assets on the final date should be clearly indicated in the schedule. Similarly, as regards the share capital, details regarding the authorised, issued, subscribed, called-up and paid-up capital should be indicated . Of course, these pieces of additional information need not be in the main statements, but can be given as schedules attached thereto.

The totals of the sources of funds and application of funds will tally. The item miscellaneous expenditure on the application side relates to deferred revenue expenditure. These are revenue items of expenditure, which have been treated as `capital' becau se of the largeness of the amounts involved and/or the fact that the impact of these expenses can be enjoyed by the future years in some measure. The last item, that is, P&L account, will make an appearance in the applications side only if the company h as accumulated losses overall -- that is, to that extent the funds belonging to the company have been eroded.

The following are a few typical questions, and explanation thereto, on the form and content of the final statements:

What is the distinction between capital reserves and general reserves?

During the course of its operations over a number of years a company may accumulate profits not distributed to the shareholders and keep it for a rainy day. In fact, this could also be deliberately done to expand the company's activities, by ploughing ba ck a part of the profits into the business. These come under the category of general reserves or `free' reserves. A portion of the profits could be set apart for ensuring uniform payment of dividends in future years, and this is called `dividend equalisa tion fund'. This also is a part of the general reserves and is free.

Capital reserve, on the other hand, arises out of a sale or revaluation of the assets of the company. Any windfall profit made by the company from selling its assets, brand or trademark will not constitute a `free' reserve, since it has not arisen out of the line of business that the company has set out to do. Such profits are transferred to a special reserve account. This is a capital reserve, and is not available for free distribution among the shareholders and can be used only for issuing bonus share s or asset re-engineering.

Amounts collected by companies as share premium also fall under this category.

Is it possible to ascertain the quality of sundry debtors (people who owe money to the company) from a balance-sheet?

Yes. Schedule VI requires every company to classify its outstanding debtors into those that have been outstanding for more than six months and those that are less than six months old. Further, the company must show a separate classification of debtors i nto: a) those that they consider to be good for which no provision is deemed necessary, and where the outstanding is fully secured; b) those considered good, but for which the company does not have any security; and c) those considered doubtful or bad.

By taking these figures into account, both in their absolute measure and in relation to the volume of operations of the company, one can easily verify the overall quality of debtors.

What are contingent liabilities and where are they shown?

Contingent liabilities are estimated payments that the company may have to make if a future event takes place. For instance, suppose the excise authorities have imposed a heavy levy on the company, which has been disputed by the company on some justifia ble grounds, but the authorities have gone on appeal against the company, it is a contingent liability. In the normal course, the company does not expect the liability to crystallise, but if the court verdict ultimately goes against the company, it will have to meet the liability. This is a contingent liability.

It should be borne in mind that if there is a reasonable chance of the expenditure having to be incurred, prudential accounting and the concept of objectivity would demand that the company make a provision for its straightaway. It follows that what we ca ll `contingent liability' are items that the company does not reasonably expect to incur, but they remain a looming possibility.

Contingent liabilities are not part of the accounts and are not considered for determining the current profits or losses. They are mentioned as a footnote to the balance-sheet giving a brief explanation as to the nature of the item and its present status .

What is the difference between a `charge' and an `appropriation' in respect of profits?

It is common knowledge that any item of expenditure incurred in the running of an organisation has to be deducted from its income to arrive at the profits, provided the expenditure is `revenue' in nature. It is also known that provisions for depreciation , bad debts and other known items of expenditure have to be made. These expenses, which must compulsorily be deducted from the income, are called `charges' to the profits. In other words, regardless of whether the company makes a profit or loss, these ex penses have to be taken into account.

An `appropriation', on the other hand, arises only when a company has made a profit. From the profit, the company sets apart portions for taxation, reserves for equalising dividends, dividends to the shareholders, and so on. These items will be taken int o account only if the company makes a profit. Should there be no profit, these deductions or `expenditure' would also not be there. Such items are called `appropriation' to profits.

Based on the old style of accounts, the charges and appropriations were known as `above-the-line' and `below-the-line' items respectively.

If any item in the financial statements of a company relate to a director, are they shown separately? If so, why?

The broad philosophy of a company style of organisation is that the management of its affairs is entrusted by the shareholders to a group of persons called the directors. While giving the directors freedom to run the company, the shareholders are entitl ed to information of transactions in which the directors are financially involved. With this in mind, Schedule VI stipulates that the items should be shown separately. For instance, when dealing with loans and advances, loans granted to directors should be separately shown. Similarly, when interest payments are made or received from directors, these should be separately shown.

Are the profits shown in accounting statements different from those furnished in income-tax returns? If so, why?

The statement of accounts are prepared in accordance with the provisions of the Companies Act. The Income-Tax (I-T) Act allows various expenditure as deduction from the income for computing the tax liability. Certain items of expenditure, which the compa ny has incurred, may not be so allowed as deductions under the I-T Act. Further, the rates of depreciation are different under the two Acts. The I-T Act also allows special deductions for certain items of capital expenditure and specific revenue expendit ure such as research and development expenses and outlays for scientific research. For these reasons, the profits as arrived at for purposes of the Companies Act are different from those under the I-T Act. This does not mean that the company has to maint ain two sets of books. The profits arrived at as per the Companies Act will have to be adjusted keeping in mind the provisions of the I-T Act.

In this context, the well-known principle that planning for reducing income-tax liability is not only legitimate but also a reflection on the company's ability to manage its resources must be noted. Avoidance of tax liability by concealing income or infl ating expenditure is illegal and falls under the category of tax evasion. Tax planning, on the other hand, takes advantage of the incentives announced under the income-tax regulations and is fully transparent.

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