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21 financialandmgtaccaccounting


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This ppt all about the basic concept of finance.

This ppt all about the basic concept of finance.

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  • 1. FINANCIAL AND MANAGEMENT ACCOUNTINGUnit - 1 Accounting – Defination – According for historical function andmanagerial function – Scope of accounting – Financial accounting andManagement accounting – Managerial uses – Differences. Financial Accounting: Accounting concepts – Convections –Principles – Accounting standards – International Accountingstandards.Unit-2 Double entry system of accounting - Accounting books –Preapartion of journal and ledger, subsidiary books - Errors andrectification – Preparation of trial balance and final accounts. Accounting from incomplete records - Statements of affairsmethods -Conversion method - Preparation of Trading, Profit & LossAccount and Balance Sheet from incomplete records.Unit - 3 Financial Statement Analysis - Financial statements - Nature offinancial statements - Limitations of financial statements - Analysis ofinterpretation -Types of analysis -- External vs Internal analysis -Horizontal vs Vertical analysis - Tools of analysis - Trend analysis -Common size statements -Comparative statements. Ratio Analysis - Types - Profitability ratios - Turnover ratios -Liquidity ratios - Proprietary ratios - Market earnings ratios - Factorsaffecting efficiency of ratios - How to make effective use of ratioanalysis - Uses and limitation of ratios - Construction of Profit andLoss Account and Balance Sheet with ratios and relevant figures -Inter-firm, Intra-firm comparisons.
  • 2. Unit -4 Fund Flow Statements - Need and meaning - Preparation ofschedule of changes in working capital and the fund flow statement -Managerial uses and limitation of fund flow statement. Cash Flow Statement - Need - Meaning - Preparation of cashflow statement - Managerial uses of cash flow statement - Limitations– Differences between fund How and cash tlow analysis.Unit-5 Budgeting and Budgetary Control: Preparation of various typesof budgets - Classification of budgets - Budgetary control system -Mechanism -Master budget.Unit-6 Capital Budgeting System - Importance - Methods of capitalexpenditure appraisal - Payback period method - ARR method - DCFmethods - NPV andIRR methods - Their rationale - Capital rationing.REFERENCES: 1. Arulanandam & K.S. Raman, Advanced Accounting. 2. Gupta & Radbasamy, Advanced Accountmg. 3. Shukla & T.S. Grewal, Advanced Accounting. 4. Jain &Narang, Advanced Cost Accounting, 5. Das Gupta, Advanced Studies in Cost Accounting. 6. Maheswari, Management Accounting & Financial Accounting. 1. Manmohan & Goyal, Principles of Management Accounting. 7. Prasad, Advanced Cost Accounting.
  • 3. FINANCIAL AND MANAGEMENT ACCOUNTINGLESSON TITLE 1. Accounting an Introduction 2. Management Accounting 3. Theory Base of Accounting - Accounting Standards 4. Practical Base of Accounting - Origin and Analysis of Business Transactions 5. Financial Statements of Profit-making Entities Manufacturing-cum-Trading Organisations 6. Financial Statements of Non-Profit-making Entities 7. Errors Management 8. Accounts from Incomplete Records - Single Entry System 9. Financial Statement Analysis 10. Ratio Analysis 11. Fund Flow Analysis 12. Cash Flow Analysis 13. Budgeting and Budgetary Control 14. Capital Budgeting 15. Case Study
  • 4. LESSON - 1 ACCOUNTING: AN INTRODUCTIONLearning outcomes; on completion of this chapter, you should be ableto:  Explain the nature of accounting.  Identify the various branches of accounting.  Explain the process of creation of financial statements and their interpolation.  Explain the various objectives of financial statements.  Identify the various uses of accounting information.INTRODUCTION Accounting discipline deals with measurement of economicactivities affecting inflow and outflow of economic resources to developuseful information for decision making. At household level informationabout outflow and inflow of cash resources helps -.0 assess financialposition and plan household activities. At Government level,information about inflow from taxes (direct as well as indirect) andexpenditure on various activities (developmental and nondevelopmental) is needed for planning and budgeting. Althoughaccounting can be discipline has universal applicability, but itsgrowth is closely associated with the developments in the businessworld. Thus to understand accounting as a field of study for universalapplication, it is best identified with recording of business transactionand thereby creating economic information about business enterprisesto facilitate decision making.NATURE OF ACCOUNTING:1.2 Accounting i. is man-made;
  • 5. ii. has evolved over a period of time; iii. is practiced in a social system; iv. is a systematic exercise; v. is judgmentat at times; vi. follows flexible, not a rigid approach; vii. is essentially a language; viii. as a language, has a very well defined syntax of its own; and ix. Communicates financial information for decision making. Accounting being a man-made system has evolved over a periodof time to provide financial information of business enterprises tousers of accounting information. A large number of groups with variedinterests in affairs of a business enterprise have emerged over a periodof time, especially after emergence of corporate forms of organizationinvolving separation of ownership management. These user groupsinclude those who;  manage the activities of the enterprise( management)  own the enterprise( owners/ shareholders)  extend credit for supply of goods to the enterprises (creditors)  buy goods from the enterprises( customers)  lend money to the enterprises( banks and financial information)  are employed in the enterprises (employees)  intend to make investment in the enterprises(mvestors)  are doing research(researchers)  are engaged in collection of taxes ( sales tax and income tax  authorities)
  • 6.  formulate fiscal and monetary policies (other Government  department)  are members of the public at large(general public) Internal users of accounting information are inside theenterprise and need information to control and plan the activities ofthe business to manage it effectively. These include Owners in case ofnon corporate enterprises and managers and directors in case ofcorporate business. Their information needs are satined throughvarious reports which are generally prepared internal use and remainunpublished. External users of accounting information are outside theenterprise. The information need of these user groups are met bymeasuring the desired information by following a systematic process.It results in creation of financial statements which are generallypublished to make the information available to external user group fordecision making. The need for communicating relevant and usefulinformation to that potential internal and external users is alwaysthere and accounting is intended to perform that role.Thus, accounting may be defined as: "the process of identifying, measuring and communicatinginformation to permit judgement and decision by the users"( American Accounting Association)BRANCHES OF ACCOUNTINGFinancial Accounting: It primarily concentrates on creation of financialinformation for external user groups such as creditors, investors,lenders and so on. It deals with business events which have alreadyoccurred and is, therefore, historical in nature. Traditionally, the aimwas to develop information about income and financial position on the
  • 7. basis of events which had taken place during a period of time. Recenttrend in corporate form of organization is to provide information aboutcash flows and earnings per sh^e also as part of published financialstatements. Management Accounting - The information provided bythe financial accounting system is significant but not sufficient forsmooth orderly and efficient conduct of business. Management needsmore information to discharge its function of stewardship, planning,control and decision-making. As information needs of managementvary from enterprise to enterprise, the grouping and reporting ofinformation takes different forms. Trie different ways of groupinginformation and preparing reports as desired by managers fordischarging their functions are referred to a management accounting.Management accounting provides information to the management notonly about cost but also revenue, profit, investment etc., for managingbusiness more efficiently and effectively. A very important componentof management accounting is cost accounting which deals with costascertainment and cost control. Few other branches of accounting which are of recentorigin are social responsibility accounting and human resourcesaccounting. The first one involves accounting for social costs incurredby the enterprise and social benefits created by it while the seconddeals with accounting for human resources. In the present book, we are concerned with financialaccounting only. The word accounting and financial accounting areused interchangeably. Financial accounting provides information to externaluser groups in the form of published financial statements. As theseusers are involved in preparation of financial statements, it is very
  • 8. essential that the published statements have credibility and regardedas reliable by external users. Therefore, accounting, as a language forcommunicating information, needs to have a strong syntax of its ownfor preparing credible financial statements. The syntax of accounting language comprises of analysisand recording of business transactions on the basis of double Entrysystem of book keeping and the basic principles on which thepractical system is based. The theory base; of accounting consists ofGenerally Accepted Accounting Principles (GAAP), Conceptualframework and Accounting Standards (AS) issued by the professionalaccounting bodies all over the world, The credibility of the financial statements is establishedthrough analysis independent examinations by a chatteredaccountant who certifies that the information provided therein givestrue and fair view of the activities of tM business in conformity withaccepted principles and practices. This process of attestation ofaccount is known as auditing of accounts.MEANING OF FINANCIAL ACCOUNTING Measurement of accounting information involves threebasic steps as per the traditional definition of accounting by theAmerican Institute of Certified Public Accounts (AICPA) which definesaccounting as "the are of recording, classifying and summarizing in asignificant manner and in terms of money, transaction- and eventswhich are negative part atleast of financial character and interpretingthe results thereof. On this basis of above information, Accounting or moreprecise financial accounting can be basically divided into two parts", A. Creation of financial information. B. Use of financial information.
  • 9. A. Creation of financial information: Creation of financial information involves three steps:
  • 10. 1. Recording: The process of creation of financial information starts with theoccurrence of a business transaction which can be Qualified. Thetransaction is evidenced by some document such as Sales bill, Passbook, Salaries slip etc., The systematic record of those transactions ischronological order (i.e. the order in which they occur ) is made in abook called JOURNAL BOOK. The four basic questions need to beaddressed while recording namely, what to record, when to record,how to record and at what value to record?What to record? Since-accounting is regarded as language of thebusiness, it should systematically record all the transaction andevents which affect the results of business and ignore the persontransaction of the proprietor. Before recording in the journal book, allbusiness transaction expressed in terms of money. Consequentlybusiness activities which cannot be expressed in terms of money suchas strikes, changes in the composition of board of directors etc., arenot recorded. Thud decision makers will get informa^on only aboutmoney aspects of the business enterprise from a accounting records.When to record? Usually business transaction is recorded only whenit has occurred. Thus accounting is basically historical in nature.How to record? Usually business transaction has two aspects andboth these are recorded by passing analysts entry in an journal book.This system of recording is called double entry book keeping system.At what value to record? To record occurrence of an event in journalbook, decision about the value of the transaction is needed. A number of different valuation bases are used inaccounting in varying degrees and include historical cost, currentcost, realizable value and present value. These valuation based
  • 11. generally assume significance in case of valuation of assets. Historicalcost refers to amount paid / payable to acquire an asset. The currentcost means the amount that would have to be paid, if the asset is tobe acquired currently. The realizable value refers to the net realizablevalue of the assets if it is to be disposed. The present value of an assetis the present discounted value of the future inflows that analysis itemis expected to generate in the normal course of business.2. Classifying: After recording monetary transactions in the journalbook, next step is to classify the recorded information into relatedgroups to put information in compact and usable forms. For e.g., alltransactions involving cash inflows (receipts) and cash outflows(payments) can be grouped to develop useful information is calledledger book. Mechanism used for classification of recordedinformation is to open accounts which are called ledger accounts.3. Summarizing: Basic aim of accounting is to create financial information in aform which will be useful to the decision makers. To achieve this end,accounts containing classified information in the ledger book arebalanced. After balancing of the ledger book, account balances arelisted statement giving names of theses accounts and their balance iscalled " TRIAL BALANCE " on the basts of trail balance, summariesare prepared to give useful information about the financial resultsduring a time period and the financial position at a point of time.Reporting of summarizes of the business transaction is done in theform of financial statements which are known as FINAL ACCOUNTS.According to international Accounting standard - 1 the term financialstatements covers balance sheet, income statements or profit and lossaccounts, notes and other statements and explanatory material which
  • 12. are identified as being part of the financial statements. The process ofcreation of financial information can be summarized as follows:
  • 13. Analysis of Recording Classificati Summariza business Journal on in ledger tion first in transaction Book book trial evidenced balance by source and then in document financial statements Thus recording, classifying and summarizing are three basicsteps involved in creation of financial statement which ascertain andcommunicate result of business entity. For this is assumed thatbusiness and its owner have separate existence. For accountingpurpose, even a division of the business or a branch of it may betreated as an accounting entity.B. Use of Financial Information / Statements: Financial statements prepared by a business enterpriseare published and are available to the decision makers. Sounddivision making requires analysis and interpretation of these financialstatements. A very commonly used tool for financial analysis is ratioanalysis. However, there are other tools which are used by thedecision makers to undertake analysis. The widely used tools forcarrying out analysis are : • Cash flow statement • Fund flow statement Ratio analysis • Comparative statement • Common size statement However to analyze and interpret these financialstatements, the user shou/d be aware of purpose and nature of thesestatements can be described as follows : "Financial statements are prepared for the purpose ofpresenting a periodical review or report on progress by management
  • 14. and deal with the status of investment in the business and the resultsachieved during the period under review. They reflect a combination ofrecorded facts, accounting, conventions and personal judgements andjudgements and conventions applied after them materially. Thesoundness of the judgement necessarily depends on the competenceand integrity of those who make them and on their adherence toGenerally Accepted Accounting Principles and Conventions. (BombayStock Exchange Official Directory).OBJECTIVES OF ACCOUNTING The main objective of accounting are as follows:  The main records of business: In accounting, systematic record of monetary aspects of business events are maintained. The first step in preparation of financial statements. This is referred to as book-keeping.  Calculation of profit or loss: To calculate profit earned or losses suffered during a period of time, a business enterprise prepares an Income Statement. It is also referred to a trading and profit and loss account.  Depiction of financial position: In addition to profit (or loss), sound decision-making requires information about the financial position of a busiriess enterprises. To depict financial position of a business, financial position statement is prepared. On the one hand, it gives details of resources owned by the business enterprise. Resource owned are termed as assets. On the other hand it contains the information about obligations of business. Obligation of the business towards outsiders and owner are referred to as liabilities and capital respectively. Financial position statement is also termed as balance sheet which provide information about sources of finance (e.g. outside liability and owners equity) and the resources (eg. assets) of the business.
  • 15.  To portiay the liquidity position: Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing about its capital transactions, cash dividends and other distribution of resources by the enterprise to owners and about other factors that may affect an enterprises liquidity and solvency.  Control over the property and asset of the firm: Accounting provides up-to-date information about the various assets that the firm possess and the liabilities the firm owes so that nobody can claim a payment which is not due to him.  To file tax returns: This is the objective which really hardly needs emphasis. The credible accounting records provide the best bases for filing returns of both, direct as well as indirect taxes.  To make financial information available to various groups and users: Accounting is called the language of business. It aims to communicate information about financial results and financial position of a business enterprise to decision makers,USERS OF ACCOUNTING INFORMATION Users of accounting information can be grouped asfollowsOwners: Owners refers to a person or group of persons who havesupplied capital for running the business. It refers to individual incase of joint stock companies. Information needs of shareholders haveassumed great significance in the corporate business world because ofseparation of ownership and management in case of joint stockcompanies owners are interested in the financial information, toknow"about safety of amount invested and return on amountinvested.
  • 16. Managers: For managing business profitably informationaboutHnancial result and financial position is needed by managementBy providing this information, accounting helps managers in efficientand smooth running of a business enterprise.Investors: Prospective investors would like to know about the pastperformance of the business enterprise before making investment inthat concern. By analyzingihistorical information provided byaccounting records, they can arrive at a decision about the expectedreturn and risk involved in investing in particular business enterprise.Creditors and Financial Institutions: Whosoever is extending creditor loan to a businessenterprise, would like to have information aboutits repaying capacity, creditworthiness etc., The required informationcan be obtained by analyzing and interpreting the financialstatements of the business enterprise.Employees: Employees are concerned about job security and futureprospectus. Both of thpse are intimately related with the performanceof the business enterprise, Thus by analyzing financial statementsthey can draw conclusions about their job security and futureprospectus.Government: Government policies relating to taxation, providingsubsidies etc., are guided by the relevance of the industry in theeconomic development of the country and the past performance of theindustry. Information about the past performance is provided by theaccounting system, collection of taxes is also based on accountingrecords.Researchers: Researchers need financial information for testinghypothesis and development of theories and models. The financialstatement provides the recorded information.
  • 17. Customers: (Customers who have developed loyalties to a businessare ceitainly interested in the continuance of the business. Theycertainly want to know about the future directions of the enterprisewith which they are associating themselves. The way to informationabout the enterprise is through their financial statements.Public: An enterprise affects the public at large in many ways such asprovider of the employment to a number of persons being a customerto many supplier a provider of amenities on the locality, a cause ofconcern to the public due to pollution etc., Hence public at large isinterested in knowing the future directions of the enterprise and theonly window to peep inside the enterprise is their financialstatements.ACCOUNTING AND THEIR DISCIPLINES: Accounting is the best understood when the other relateddisciplines are conceptually clear to the user. For e.g., a user canhardly understand financial statements with lots of tables and graphsin it. He is not comfortable with the basics of mathematics andstatistics. Accounting is very intimately connected with manydisciplines more important of which are economics, law, management,statistics and mathematics.Linkage with Economics: Accounting has strong linkages with economics. It has acquiredits most important concepts of income and capital from economics.The accountant as well as economist agree that capital should bemaintained intact while calculating income and this income can bedistributed without affecting capital. However, the interpretation ofthe two concepts by accountant and economist differ a great dealdespite similarities. The capital to an economist is like a tree and
  • 18. income is like a fruit on that tree. In technical terms, a stock of wealth(Tree) or assets existing at a point of time is called capital whereasflow of benefits from the wealth through a given periodvs calledincome. Hence capital and wealth are synonyms for the economist.The methodology adopted by economist is finding income is to find outthe excess of capital at the end of the year over the beginning of theyear. If the capital increases, it is more income. However as the capitaldecreases it is called loss. To arrive at the value of the capital orwealth, the present value of the future benefits is calculated bydiscounting expected benefits at the required rate of return. Hence tofind out the worth of an asset, the economist will have to estimate thelife of the asset and the likely benefits to be desired from it. Thebenefits will be discounted at the requires rate of return of the assethas an exceptionally long life. Hence economists valuation of capitaland income are highly subjective. Accountant tries to impart practicability to the concept ofcapital and income. Recognizing that future benefits of an asset withlong life of say 100 years are difficult to estimate, the accountant putsa value of the asset at which it was acquired. However, his attitude isquite flexible and makes use of other bases of measurement whereverthe need arises. The income of business belongs to a owner. Theaccountant finds income as a direct result of matching of revenue andexpense of the same period. It is always calculated at the end of aperiod. The matching of revenues and expense can be done ondifferent basis viz accrual, cash and hybrid bases. The bases arediscussed in detail later:Linkage with Mathematics: Accounting is all about figures and operations on thesefigures. The basic system of accounting can be very convenientlyconverted in the mathematical form in the form of an accounting
  • 19. equation. Simple mathematical operations involved in accounting areaddition, subtraction, multiplication and division. Besides manyaspects of accounting involve calculations which involve strongknowledge of mathematics. For e.g., calculation of interest, calculationof the annuity needed to depreciate an asset with a defined rate ofinterest over its estimated useful life, bifurcation of a hire purchaseinstalment in cash price component and interest component etc.,Linkages with Statistics: Accounting is not only about the preparation of accountinginformation, it also involves the presentation and interpretation ofaccounting information. The presentation aspects involved creation oftables and graphs etc., the knowledge of which essentially lies in thediscipline of statistics. One of the most debated topic of accountingnamely inflation accounting involves extensive conversation ofhistorical accounting information with the help of price indices, animportant constituent of the discipline of statistics. The interpretationof accounting information involves making absolute and relativecomparison with the help of ratio analysis. The knowledge of statisticsis needed for the purpose. An important way of calculating interest isthrough the concept of average due date, which is based on theknowledge of averages.Linkages with Law: Accounting essentially operates within a legalenvironment. Many business organizations are governed by theirrespective statues which prescribe the many aspects of theiraccounting information including the presentation of information. Fore.g., the Indian Companies Activities, 1956 prescribes the rules formanagerial remuneration. It also prescribes the format of balancesheet as well as profit and loss account, The banking, insurance and
  • 20. electricity companies have also to prepare their accounts as per therequirement of the respective statutes governing them.
  • 21. LESSON - 2 MANAGEMENT ACCOU NTINGDEFINITION OF MANAGEMENT ACCOUNTING The accounting activity can be classified into two parts.Financial Accounting and Management Accounting. Though both ofthem are interlinked, Management accounting is future oriented,dynamic and is made to be decisive and control relevant. International Federation of Accountants (IFAC) definedManagement Accounting process as "the process of identification,measurement, accumulation, analysis, preparation, interpretation andcommunication of information both financial and operating used bymanagement to plan, evaluate and controJ within an organisation andto assure use of and accountability for its resources". ICWAI published Glossary of Management Accounting termsdefining Management Accounting as "a system of collection andpresentation of relevant economic information relating to an enterprisefor planning, coordinating and decision making", Management Accounting : Official Terminology of CIMA is definedManagement Accounting as "the provision of information required bymanagement for such purposes as: 1. Formulation of policies 2. Planning and controlling the activities of the enterprise 3. Decision taking on alternative course of action 4. Disc losure to those external to the entity (shareholders and others) 5. Disclosure to employees 6. Safeguarding assetsThe assets involves participation in management to ensure that thereis effective:
  • 22. • Formulation of plans to meet objectives (long-term planning) • Formulation of short-term operation plans (budgeting/ profit making)". American Accounting Association defines ManagementAccounting as "the application of appropriate techniques and conceptsin processing historical and projected economic data of an entity toassist management in establishing plans for reasonable economicobjectives and in the making of rational decisions with a view towardsthese objectives". Richard M.S. Wilson and Wai Fong Chua define ManagerialAccounting as "Managerial Accounting encompasses techniques andprocesses that are intended to provide financial and non-financialinformation to people within an organisation to make better decisionsand thereby achieve organisational control and enhanceorganisational effectiveness" The Management Accounting is used by management to planthe activity, evaluate performance, ensure integrity of financialinformation and to irnplement the system of reporting that is linked toorganisational responsibilities and contributes to the effectiveperformance measurement. The definition of Management Accountingembraces all functions undertaken by accountants in an organisation.Management Accounting needs to be dynamic and forward looking. Italso comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatoryagencies and tax authorities. The role of Management Accountant isnot determined by an isolated concept. It is determined by therequirements of business as Expressed in its structures.
  • 23. SCOPE OF MANAGEMENT ACCOUNTING Management Accounting includes Financial Accounting andextends to the operation of a system of cost accounting and financialmanagement. While meeting the legal and conventional requirementsregarding the presentation of financial statements (profit and lossaccount, balance sheet and funds flow statements) it stresses uponthe establishment and operation of internal controls. The scope ofManagement Accounting, inter alia, includes:  Formation, installation and operation of accounting, cost accounting, tax accounting and information systems. Management Accountant has to  construct and re-construct these systems to meet the changing needs of management functions  The compilation and preservation of vital data for management planning. The account and document files are respository of vast quantities of details about the past progress of the enterprise, without which forecasts of the future is very difficult for the enterprise. The Management Accountant presents the past data in such a way as to reflect the trends of evbnts to the management.  Providing means of communicating management plans to the various levels of organisation. This, on the one hand, ensures the coordination of various segments of the enterprise plans and on the other defines the role of individual segments in the whole plan and assists the management in directing their activities.  Providing and installing an effective system of feedback reports. This would enable the management in its controlling function. By pinpointing the significant deviations between actual and expected activities, and by adhering to the principles of selectivity and relevance, such reports help in jthe installation and operation of the system of Management by Exception. The
  • 24. Management Accounting is expected to analyse the deviation by reasons and responsibility and to suggest appropriate corrective measures in deserving cases.  Analysing and interpreting accounting and other data to make it understandable and usable to the management. It is only through such analysis and clarification that the management is enabled to place the various data and figures in proper perspective in the performance of its functions. Such analysis assists management- in the location of responsibilities and to effect necessary changes in the organisational setup to achieve the objectives of the enterprise in a more efficient manner.  Assisting management in decision making by (i) providing relevant accounting and other data and (ii) analysing the effect of alternative proposals on the profits and position of the enterprise. Management Accountant helps the management in proper understanding and analysis of the problem in hand and presentation of factual information obviously in financial terms.  Providing methods and techniques for evaluating the performance of the management in the light of the objectives of the enterprise, thus assisting in the jrnpiementation of the principle Management by Objectives.  Improving, modifying and sharpening the effectiveness of the existing techniques of analysis. The Management Accountant would always think of increasing the practicability of existing techniques. He should be on the look-out of the development of new techniques as well. Thus, Management Accounting serves not only as a tool in thehands of management, but also provides for a technique evaluating
  • 25. the performance of its functions of planning/decision making andcontrol, and at the same time, enabling the owners and otherinterested parties to evaluate and appraise the management of theenterprise.FUNCTIONS OF MANAGEMENT ACCOUNTING Management Accountant is one of the best assets formanagement. His contribution has been growing with passage of time.He will continue to deliver the goods in a magnificent manner infuture with varied experiences. Scope is expanding and managementsof various sectors are benefiting. Excerpts from the "Preface toStatements on International Management Accounting" issued oy theinternational Federation of Accountants in February 1987 arereproduced below: "Management Accounting is used by management to; Plan - to gain an understanding, to expected business transactions and other economic events and their impact on the organisation, and to use this understanding as a basis for a course of action to be followed by the organisation in the future; Evaluate - to judge the implications of various past and/orfuture events; Control - to ensure the integrity of financial information concerning an organisations activities or its resources; Assure accountability - to implement the system of reporting that is closely aligned to organisational responsibilities and that contributes to the effective measurement of management performance"
  • 26. The functions of Management Accounting can be broadly classifiedinto; (a) Periodic interval accounting reports, and (b) Ad hoc analysis of data decision making. It is increasingly felt that Management Accountants shouldinvolve themselves more and more in decision making and problemsolving of organisations. The areas of decision making and problemsolving are dealt in the following paras:  Strategic Management Accounting: This function helps the organisation prepare long-term plans, formulate corporate strategy and forecast and evaluate the competitors.  Investment Appraisal: This activity includes the (i) appraisal of long-term investment (ii) funding of accepted programmes projects, and (iii) post-audit of accepted programmes.  Financial Management: It deals with raising of funds for investment, managing surplus funds, controlling working capital etc,  Short-term ad hoc decisions: This includes analysing data for taking decisions c i pricing, product introduction, acceptance of special orders etc.  Managing the organisation of information system: This includes not only organising the enterprises financial data but fulfilling the information needs of all the segments of the organisation.FUNCTIONS OF MANAGEMENT ACCOUNTANT The term Management Accountant has many Director,Financial Director, Financial Controller, Finance Comptroller etc., aresome of the terms used to designate with the work ManagementAccounting. Depending situation, size, nature arid organisationalsetup and his position in the company, the Management Accountantmay be required to perform various and varied functions. Theimportance and effectiveness of his function would also depend upon
  • 27. the confidence reposed in him by the top management and thefunctional managers. His functions generally embrace each and everyactivity of the management. The essence of Management Accountantsfunctions are as follows:  The Management Accountant will establish, coordinate and : administer plans to facilitate the forecasting of sales, expense budgets and cost standards that will permit profit planning, capital budgeting and financing.  The Management Accountant will formulate accounting policy and procedures. Operating data and special reports must be prepared so that the performance can be compared with plans and standards, and any variance between actual operations and pre-determined standards can be analysed for corrective actions by management Such comparisons between actual and expected activities should help the management in proper fixation of responsibility and also in evaluation of various functional and divisional heads.  The Management Accountant will be responsible for the protection of business assets to the extent possible by external controls and internal auditing and insurance coverage.  The Management Accountant will be responsible for tax policies and procedures and will supervise and coordinate the reports required by various authorities. ;  The Management Accountant must continually £e aware of economic and social forces as well as the effect of the Government policies and actions on business activities. An analysis of the above list (obviously not exhaustive) ofunctions, reflects the status of a Management Accountant. He is theprincipal office in-charge of the accounts of the company. He shall beresponsible to the Board of Directors for the maintenance of adequateaccounting procedures and records on the operation of business. He
  • 28. shall be responsible to the President or the Chairman of the Board orthe Board of Directors. Thus, in his broad functional activities, theManagement Accountant is responsible to the policy making group oftop management, whereas, in his administrative activities he ssresponsible to the top executive offer.MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING The financial accounting classifies and records an entitystransactions normally in money terms, in accordance with establishedconcepts, principles, accounting standards and legal requirements. Itaims to present a true and fair view jof the overall results of thosetransactions. Management Accounting has been described as acontinuous process of analysis, planning and control in the context ofproviding decision support for decision makers. ManagementAccounting is more concerned with decision making and a key role forManagement Accountant is acting as a provider of financialinformation to support these decisions, There are several differencesbetween Financial Accounting and Management Accounting as are setout in Table 1.1.Financial Accounting and Management Accounting both appear to besimilar inasmdch as both study the impact of business transactionsand events of the enterprise, reports and interpret the results thereof.Both provide information for internals as well as external use. ButManagement Accounting although having its roots in FinancialAccounting differs from the latter in following respects:  Financial Accounting studies the business transactions and events for the enterprise as a whole. It does not trace the path of events with in the enterprise. Management Accounting, in additions to the study of the events in relation to the enterprise as a whole, takes organisation in its various units and segments
  • 29. and attempts to trace the impact and effect of the business transactions and events through these various divisions and sub-divisions. Thus, while the financial statements -profit and loss account, balance sheet and flow statements reveal the overall performance and position of the enterprise. Management Accounting reports emphasis on the details of operational costs, inventories, products, processes and jobs. It traces the effect and impact of the business transactions and events on costs, inventories, processes, jobs and products. Financial Accounting is more attached with reporting the results and positions of business to persons and authorities other than management-Government, Creditors, Investors, Owners, etc. At times, Financial Accounting follows window- dressing tactics in order to project a better than actual image of the enterprise. Management Accounting is concerned more with generating information for the use of internal management and hence the information reflects the real or really expected position. Financial Accounting is necessarily historical. It records and analyses business events long after they have taken place. Management Accounting analyses the events as they take place and also anticipates such events for the future. Thus, it uses data which generally has relevance to the future. Since Financial Accounting data is historical in nature, it is more precise than the Management Accounting data, which generally reflects Ihe expected future, and hence could only be an estimation. This provides the necessary rapidly to Management Accounting information. The periodicity in reporting financial accounts is much wider than in case of Management Accounting. In Financial
  • 30. Accounting, generally, results are reported on year to year basis. In Management Accounting is free to formulate its own rules, procedures and forms because the information generates is solely for internal consumption.  Financial Accounting has to governed by the generally accepted principles. This is so because, it has to cater for the informational needs of the outsiders and legal provisions. Management Accounting is free to formulate its own rules, procedures and forms because the information it generates is solely for internal consumption.  Financial Statements prepared under Financial Accounting consists of monetary information only. Management Accounting statements, in addition to monetary information, also consists non-monetary information viz., quantities of materials consumed, number of workers, quantities produced and sold and so on.TABLE 1.1: MANAGEMENT ACCOUNTING vs. FINANCIALACCOUNTING Nature Fianacial Accounting Management Accoutning 1. Governed by Company law etc. Needs of managers 2. Basic functions Transaction Decision support recording, Publication Provision of of external financial Management 3. Users statements information External Internal
  • 31. 4. Availibility Publicly available Confidential5. Time focus Past and present Present and future6. Period Usually one year As appropriate7. Main emphasis Explanation Planning and control8. Speed of Slow but detailed and Fast but approximate prepartion accurate9. Form of whole of entity Segmented to control presentations units10. Style and Standardized Tailored to details requirement and Objective, verifiable summarized11. Criteria and consistent Relevant, useful and Money understandable12. Unit of Somewhat technical Money physical units account For use by non-13. Nature of accountants data
  • 32. LESSON - 3 THEORY BASE OF ACCOUNTING - ACCOUNTING STANDARDS Accounting is "the process of identifying, measuring andcommunicating information to permit judgement and decisions by theusers of accounts" -American Accounting Association. It is absolutelynecessary that accounting information contained in financialstatements are credible and are regarded as reliable by the differentuser groups to be consistent. Preparation of financial statements onuniform and consistent basis improves their comparability andcredibility. It has two aspects, namely, • The financial statements of an enterprise for different accounting years are based on similar accounting procedures and policies so that meaningful comparisons over a period of time can be made1 about he progress of the enterprise. This is commonly referred to as Time series analysis’. • The financial statements of many enterprises at a point of time are based on similar accounting procedures and policies so that conclusions can be drawn about their relative performance at a point of time. It is known as Cross-sectional analysis. , It is the function of Accounting Standards -to provide a rationalstructural framework so that credible financial statements of thehighest quality can be produced. According to T.P. Ghosh accountingstandards are defined as under’. “Accounting standards are the policy documents issued by the recognised expert accountancy body relating to various aspects of measurement,
  • 33. treatment and disclosure of accounting transactions and events” It is clear from the above definition that accounting standardsprovide aframework for the preparation of the financial statements. They alsodraw the boundaries within which acceptable conduct lies. In theabsence of accounting standards, many alternatives will exist and willgive the accountant the| leverage to colourhis accounting records theway he likes. Such Creative Accounting Practices’ will certainlycreate financial statements which are unreliable and lower theconfidence of user in the reported results. Hence the need for acoherent pet of accounting standards is imperative. The efficientfunctioning of the financial system depends upon the confidence thatuser groups have in the fairness and reliability of the financialstatements of the businesses ana it is the function of accountingstandards to create this genera) sense of confidence by providing; astructural framework within which credible financial statements canbe produced. The whole idea of ‘Accounting Standards’ is centredaround harmonisation in the accounting policies and practicesfollowed by businesses. The basic purpose of Accounting Standardsis to standardize the diverse accounting practices followed formany aspects of accounting. The harmonisation of accountingpolicies and practices is needed at national level as well asinternational level. To tackle the problem at national level, theInstitute of Chartered Accountants of" India issues accountingstandards (called ASs) formulated by the Accounting Standards Board(ASB). At international level, International Accounting StandardsCommittee (IASC) issues International Accounting Standards (calledlASs). The objective of the IASC in terms of standard setting is "towork generally for the improvement and harmonisation of regulations,accounting standards and procedures relating to the presentation offinancial statements. The Institute of Chartered Accountants of India
  • 34. is a member of IASC and has a tacit understanding with the IASC thatit would adopt the accounting standards issued by IASC after duerecognition of the conditions and practices prevailing in India. At theinternational level, IASC has issued 32 international accountingstandards. At the national level, ICAI has issued 15 accountingstandards on various issues of accounting and a preliminary draftof a proposed accounting standard on borrowing costs is being madeby the ASB in addition to the revision contemplated in existingstandards on valuation of inventories and accounting for constructioncontracts.ACCOUNTING STANDARDS (N INDIA The Institute of Chartered Accountants of India, fullyrecognising the need cf harmonizing the diverse accounting policiesand practices established Accounting Standards Board on 21 st April,1977 so that accounting as a language could develop along the rightlines. Accounting Standard Boards (ASB) main function is toformulate accounting standards to be issued under the authority ofthe council of the institute. Accounting standards provide rules andcriteria of accounting measurement. However the rules criteria areintended lo be used if: a sociai system and hence are never intended lobe rigid as in case of physical sciences.Constitution of ASB :The consistitution of ASB gives adequate representation to allinterested parties and, at present, it consists of members of thecouncil and representatives to industry, banks, Company Law Board,Central Board of Direct Taxes and the Comptroller and AuditorGeneral of India, Security Exchange Board of India etc,Functions of ASB :The main function of ASB is to fomralate accounting standards. Whileformulating accounting standards, ASB takes into consideration the
  • 35. applicable laws, customs, usage and business environment. TheInstitute is the member of International Accounting StandardsCommittee (IASC) and has agreed to support the objectives of IASC.While formulating standards, it gives due consideration to theInternational Accounting Standards (IAS) issued by IASC and tries tointegrate them, to the extent possible, in the light of conditions andpractices prevailing in India. It also reviews the accounting standardsat periodical intervals.FORMULATION OF ACCOUNTING STANDARDSThe following points need to be kept in mind while drafting accountingstandards, namely - • The accounting standards issued are in conformity with the provisions of the applicable laws, customs, usage and business environment of our country; • The accounting standards are in the nature of laws but not laws. Though every possible care is taken while drafting standards that they are in conformity with eh applicable laws, still the conflict between the law and an accounting standard might arise due to amendments in the law subsequent to the issuance of the accounting standard. As clarified in the Statements of Accounting Standards, accounting standards cannot and do not override the statute and in all such cases of conflicts, the provisions of the law will prevail and the financial statements should be prepared in conformity with the relevant laws Obviously, to that extent, the accounting standards shall not be applicable. However, "the institute will determine the extenl of disclosure to be made in financial statements and the related auditors reports. Such disclosure may be by way of appropriate notes explaining the treatment of particular items. Such explanatory notes will be only in the nature of clarification
  • 36. and therefore, need not be treated as adverse comments on the related financial statements" • The accounting standards are intended to apply only to items which are material and become applicable from the date as specified by the institute. They are applicable to all classes of enterprise unless otherwise stated. No standard is applicable retroactively, unless otherwise stated; • The accounting standards are to address the basic mattes, to the extent possible. The idea is to confine them to essentials only and not to make them complex. The ASB has drawn an elaborate procedure for formulatingaccounting standards. However, it needs to be emphasised that thestandards are issued under the authority of the council of theinstitute. The procedure involves the following steps: a) Firstly, the ASB determines the broad areas in which accounting standards need to be formulated; b) Secondly, the ASB takes the assistance of the various study groups to formulate standards The preliminary drafts of the standards are prepared by the Study groups which take up the specific subjects assigned to them. The draft prepared by a Study Group is considered by ASB and sent to various outside bodies like FICCI, ASSOCHAM, SCOPE, CLB, C&AG, ICWAI, ICSI, CBDT etc. and the representative of these bodies are also invited at a meeting of ASB for discussion. c) Thirdly, after taking into consideration their views, the draft of the standard is issued as exposure draft for soliciting comments from members of the institute and public at large.
  • 37. The draft is issued to a large number of institutions and is published in the journal of the institute. The exposure draft includes the following basic points: • A statement of concepts and fundamental accounting principles relating to the standard; • Definitions of the terms used in the standard; • The manner in which the accounting principles have been applied for formulating the standard; • The presentation and disclosure requirements in complying with the standard; • Class of enterprises to which the standard will apply, • Date from which the standard will be effective. d) Fourthly, the comments on the exposure draft are then considered by the ASB and a final draft is prepared and submitted to the council of the institute; e) Lastly, the council of the institute considers the final draft of the proposed standard, and if found necessary, modifies the same in consultation with ASB. The accounting standard on the relevant subject is then issued under the authority of the council.NATURE OF ACCOUNTING STANDARDS The accounting standards issued by the ICAI-arerecommendatory in nature in the initial years. During the period astandard is recommendatory, it is expected that the accountingpractices shall be brought in line with the standard. In other words,the recommendatory period is allowed to smoothen the process oftransition so that no enterprise should have difficulty in conforming to
  • 38. the accounting standards once they are made mandatory. Once anaccounting standard is made mandatory, it is applicable to allenterprises whose accounts are audited by the members. During the period an accounting standard is recommendatory,tne auditors of companies are required to recommend and persuadetheir cfients to comply with the requirements of the accountingstandard even though it is recommendatory in nature. Regarding themandatory standards, it is the duty of the auditors to ensure that theaccounting standards are followed in the preparation and presentationof the financial statements. If the mandatory accounting standardshave not beer, complied with, the auditor is required to makeadequate disclosure in his report so that the users of financialstatements are aware of the non-compliance on the part of theenterprise. If a member fails to do so, the Chartered Accountants Actexplicitly provides that “a chartered accountant in practice will bedeemed to be guilty of professional misconduct if he ails to inviteattention to any material departure from the generally acceptedprocedure of audit applicable to the circumstances” It is amply clear that standards on their own have no legalbacking and hence, are not enforceable on the public at large. Hencethe institute depends on is members for implementation of accountingstandards issued by it through their attest function. To make iteffective, following steps are needed: • Self-regulation on the part of the business organisation so that I hey adhere to these standards while finalising their accounts; • Legal backing to the accounting standards. The standards as they are issued not have no legal backing and institute depends on its memters for their implementation through their attest function;
  • 39. • Publicising the use of accounting standards and making the user: of accounting information more informed about their right of getting a more true and fair picture of the results of business based on these accounting standards; • To avoid duplication of authority. If more than one authority issues standards, it is bound to create a confusion in the mind of the user as to which standard needs to be followed. A recent development, worthy of attention, is the establishment of two accounting standards by the government under the Income Tax Act, 1961 which are to be followed in the preparation of financial statements in case the assessee prefers mercantile basis accounting, (Accounting Standard I relating to disclosure of accounting policies and Accounting Standard II relating to disclosure of prior period and extraordinary items and changes in accounting policies). To conclude, the Institute and its members are duty bound toformulate and implement accounting standards to provide objectiveand reliable accounting data that would satisfy the informationrequirements of the users To achieve this, problem of duality ofauthority should be tackled and the system of dual accountingstandards in view of its expertise in the field. To improve theireffectiveness, it is also suggested that the standards should be given alegal backing with strong punishment for the erring businessorganisations. At the same time, to make a genuine case forrecognition of accounting standards and to prevent abuse of financialstatements, more credibility should be provided to the process ofstandard setting.ACCOUNTING STANDARDS ISSUED BY THE INSTITUTEAS-1 Disclosure of Accounting Policies :
  • 40. The standard defines Accounting Policies as referring to thespecific accounting principles and the methods of applying thoseprinciples adopted by the enterprise in the preparation andpresentation of financial statements. It recommends the disclosure ofsignificant accounting policies adopted in the preparation andpresentation of financial statements in a manner that should formpart of the financial statements. It also recommends that hedisclosure should normally be at one place. Any change in theaccounting policies which has a material effect in the current periodor which is reasonably expected to have material effect in later pejodsshould be disclosed. It also emphasises that the disclosure ofcompliance with fundamental accounting assumption of GoingConcern, Consistency and Accrual is not needed. However, if they arenot followed, the fact must be disclosed.AS-2 Valuation of Inventories : The inventories should be normally valued at Lower of Cost orMarket where market value means net realizable value. The historicalcost of inventory can be ascertained by use of FIFO, Average Cost, ofLIFO formulae. When organization have different items in inventory,each item may be dealt with separately, or similar items may be dealtwith as a group. The historical cost of manufactured inventories may be arrivedon the basis of either direct costing or absorption costing. Whereabsorption costing is used, the fixed costs should be based on thenormal level of production. Overheads other than productionoverheads should be included as part of the inventory cost only 10
  • 41. the extent that they clearly relate to putting the inventories in theirpresent location and condition. The accounting policy in respect of inventories should beproperly disclosed and any change in it which has a material effect inthe current accounting period or which is reasonably expected to havematerial effect in later periods should be disclosed. The amount bywhich an item in the financial statements is affected by such changeshould also be disclosed to the extent ascertainabfe. Where suchamount is not ascertainable, wholly or in part, the fact should beindicated. The Specific Identification Method, Adjusted Selling PriceMethod, Standard Cost Method and Base Stock Method are to beused in specific circumstances. However, if base stock method isused, the difference between the value at which it is carried and thevalue by applying the method at which stock in excess of the basestock is valued should be disclosed.AS-3 Changes in Financial Position : A statement of changes in financial position should bepublished along with its published accounts. Such a statement shouldbe prepared and presented for the period covered by the profit andloss account and for the corresponding period. It may be prepare onworking capital basis or cash basis. It emphasises that the fundsprovided from operation and used in the operation be shownseparately and the form of statement should be most informative inthe circumstances. However, the standard is no longer vaJid as it hasbeen superseded by new standard AS-3 (Revised) ‘Cash FlowStatement’ issued in March, 1997.
  • 42. AS-3 (Revised) Cash Flow Statement: The cash flow statement should report cash flows coring theperiod classified by operating, investing and financing activities. Anenterprise should report cash Hows from operating activities usingeither (a) direct method; or (b) indirect method. The inflow and outflowfrom the investing and financing activities should be shownseparately. Investing and financing transactions that do not requirethe use of the cash or cash equivalents and should present areconciliation of the amounts in its cash flow statement with theequivalent items reported in the balance sheet. The enterprise shouldalso disclose the amount of significant cash and cash equivalentsbalances that are not available for use by it.AS-4 (Revised) Contingencies and Events Occurring after theBalance Sheet Date : A contingency is a condition or situation, the ultimate outcomeof which, gam or loss, will be known or determined only on theoccurrence, or non-occurrence, of one or more uncertain events. Acontingent loss should be recognised if (a) it is probable that futureevents will confirm that ari asset has been impaired or a liability hasbeen incurred on the balance sheet date^ and (b) a reasonableestimate of the amount of the resulting loss can be made. Acontingent gain should not be recognised. If either of the twoconditions mentioned above are not met, a disclosure should be madeof the existence of the contingency specifying: • the nature of the contingency; • the uncertainties which may affect the future outcome; : • an estimate of the financial effect, or a statement that such ail estimate cannot be made.
  • 43. Assets and liabilities should be adjusted for events occurringafter balance sheet date that provide additional evidence to assist theestimation of the amounts relating to conditions existing at thebalance sheet date (for: example, insolvency of a debtor subsequent tofinalisation of financial statements) or that indicate that thefundamental accounting assumption of going concern is notappropriate. Dividends, proposed (or declared) by the enterprise: afterthe balance sheet date but before approval of the financial statements,and pertaining to the period covered by financial statement, should beadjusted. Adjustments to assets and liabilities are not appropriate forevents occurring after the balance sheet date, if such events do notrelate to conditions existing at the balance sheet date (for example,decline in market value of the investment). Disclosure should be madein the report of the approving authority of those events occurring afterthe balance sheet date that represent material changes andcommitments affecting the financial position of the enterprisespecifying: • the nature of the event; I • an estimate of the financial effect, or a statement that such an estimate cannot be made.AS-5 (Revised) Net Profit or Loss for the Period, Prior hems andChanges in Accounting Policies :The objective of this standard is to prescribe the classification anddisclosure of certain items in the statement of profit and loss so thatall enterprises prepare and present their financial statements on auniform basis to improve their comparability. It explains that profit orloss of a period comprises of ordinary activities, extraordinaryactivities and prior period items and all three need to be disclosed
  • 44. separately. It also includes the impact of change in accountingestimates and change in accounting policies. Ordinary activities are any activities which are undertaken byan enterprise as part of its business and such related activities inwhich the enterprise engages in furtherance of, incidental to, orarising from, these activities. Extraordinary items are incomes orexpenses that arise from events or transactions that are clearlydistinct from the ordinary activities of the enterprise and, therefore,are not expected to recur frequently or regularly. Prior period itemsareincome or expenses which arise in the current period as a result oferrors or omissions in the preparation of the financial statements ofthe one or more prior periods. The net profit or loss for the periodcomprises the following components, each of which should bedisclosed on the face of the statement of profit and loss; • profit or loss from ordinary activities; and • extraordinary items. Prior period items are normally included in the determination ofnet profit or loss for the current period. An alternative approach is tohow such items in the statement of profit and loss after determinationof current net profit or loss. The second approach seems betterbecause that will help ascertain the result of current period unaffectedby the mistakes of the past, in either case, the objective is to indicatethe effect of such items on the current profit or loss. Change in Accounting Estimates Vs. Change in AccountingPolicies:A distinction should always be made between change in accountingestimates and changes in accounting policies. When it is difficult todistinguish between the change in accounting estimate and change inaccounting policies, it should be regarded as change in accountingestimate, with appropriate disclosure in the periods of change, which
  • 45. may be current period only or current period as well as future periods.The effect of change in an accounting estimate should be classified asordinary or extraordinary depending upon whether the originalestimate was regarded as ordinary or extraordinary item. However, therevision of estimate, by its nature, cannot be called extraordinary orprior period item. When change in accounting estimate/ change inaccounting policy takes place which has a material effect, its natureand amount should be disclosed. If the effect is not ascertainable, thefact should be disclosed in the financial statement.AS-6 (Revised) Depreciation Accounting : The depreciable amount of an asset comprising of its historicalcost, or other amount substituted for historical cost in the financialstatements, less the estimated realizable value should be allocated ona systematic basis to each accounting period during the useful life ofthe asset. The historical cost may undergo revision arising as a resultof increase or decrease in long term liability on account of exchangerate fluctuations, price adjustments, changes in duties or similarfactors. The useful life of the asset may itself be subjected to revision,in which case, the unamortised balance of the asset be depreciatedover its remaining life. Any addition or extension to an existing assetshould be depreciated along with the original asset, unless theextension has a separate identity, in which case it should bedepreciated on the basis of an estimate of its own life. Wheredepreciable asses are disposed of, discarded, demolished or destroyed,the net surplus or deficiency, if material, is disclosed separately. Thechange of method, if warranted, should be done with retrospectiveeffect from the date of asset coming to use. In case of revaluation ofasset, the revalued amount should be amortised over the remaininguseful life of the asset. The information to be included in the financialstatements should comprise of historical cost or any substitutedamount, total depreciation for the period in respect of each class of
  • 46. asset and related accumulated depreciation. The following informationshould be disclosed in the financial statements along with disclosureof other accounting policies: • depreciation methods used; and • depreciation rates or the useful lives of the asset, if they are different from the principal rates specified in the statute governing the enterprise.AS-7 Accounting for Construction Contracts : The standard deals with the problem of allocation of revenuesand related costs to the accounting periods over the duration of thecontract. The long term construction contracts could be fixed pricecontracts where contractor agrees to a fixed contract price or cost pluscontracts where the contractor is reimbursed for allowable orotherwise defined costs, and is also allowed a percentage of thesecosts or a fixed fees. Both these contracts can be accounted by eitherpercentage of completion method or completed contract method.Under percentage of completion method, the amount of revenuerecognised is determined with reference to the stage of completion ofthe contract activity at the end of each accounting period. Thecompleted contract method is based on results as determined whenthe contract is completed or substantially completed. Profit in the case of fixed price contract should be recognisedwhen the work has progressed to a reasonable extent- say 25 or 30%.While recognising profit under percentage of completion method, theappropriate allowance for future unforeseeable facts should be madeon either a specific or percentage basis. A foreseeable loss on entirecontract should always be provided for in the financial statementsirrespective of the amount of work done and the method of accountingfollowed. Disclosure of changes in accounting policy used for
  • 47. construction contracts should be made in the financial statementsgiving the effect of the change and its amount.AS-8 Accounting for Research and Development: The prescribed research and development costs outlined in para7 of Hie standard relating to a business should be charged to therevenues of the period in which they are incurred unless the criteriamentioned in para 9 of the standard are met, in which case, thecharging of these expenses can be deferred to future accountingperiods. The research and development costs, once written off, arcnever reinstated in accounts. The deferred research and developmentcost should be allocated on a systematic basis to future accountingperiods by reference to either to the sale or use of the product orprocess or to the time period over which the product or process isexpected to be sold or unused. If at any point of time, criteria fordeferral as detailed in para 9 are not met, the unamortised balance ofresearch and development expenditure should be charged to the profitand loss account. When the criteria for deferral continue to be met butthe amount of the deferred research and development costs and otherrelevant costs exceed the expected filture revenues/ benefits relatedthereto, such expenses should be charged as an expense immediately.The amount charged to profit and loss account should be explicitlydisclosed and unamortised research and development costs should beshown in the balance sheet under the head "MiscellaneousExpenditure". ,AS-9 Revenue Recognition : The standard mainly deals with the timing of revenue. Revenueis defined as "gross inflow of cash, receivable or other considerationarising in the course of ordinary activities of an enterprise from thesale of goods, from the rendering of services, and from the use by
  • 48. others of enterprise resources yielding interest, royalties anddividends. The revenue is recognised in case of sale when: • the seller of goods has transferred the property in goods tci the buyer along with significant risks and rewards of the ownership ; and seller has no effective control over goods transferred; • no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale. The revenue from rendering of services is recognised eitherunder completed service method or proportionate completion method.Completed service method is a method of accounting which recognisesrevenue in the statement of profit and loss only when the rendering ofservices under a contract is completed or substantially completed.Proportionate completion method is a method of accounting whichrecognises revenues in the statement of profit and loss proportionatelywith the degree of completion of services under a pontract.Revenue arising from interest is recognised on a time proportionbasis, royalties on an accrual basis and dividends from investments inshares when the owners right to receive payment is established.AS-10 Recounting for Fixed Assets : Fixed asset is an asset held with the intention of being used forthe purpose of producing or providing goods or services and is not he!d for :he sais in the notarial course of business. The gross book vaiueof a fixed asset shoulo be either historical cost or a revalued amount.The cost of a fixed asset should normally comprise of its purchaseprice and other attributable cost of bringing the asset to its workingcondition for its intended use. Financing costs relating to deferredcredits or to borrowed funds attributable to construction oracquisition of fixed assets for the period up to the completion of
  • 49. construction or acquisition of fixed assets should also be included inthe gross book value of the asset to which it relates. When a fixedasset is acquired in exchange or in part exchange for another asset,the cost of the asset required should be recorded either at fair marketvalue or at the net book value of the asset given up, adjusted for anybalancing; payment or receipt of cash or other consideration.Subsequent expenditures related to an item of fixed asset should beadded to its book value only if they increase the future benefits fromthe existing asset beyond its previously assessed standards ofperformance. Material items retired from active use and held fordisposal should be stated at the lower of their net book value and; net49haracteri value. Losses arising from the disposal of fixed assetcarried at cost should be 49haracteri in the profit and loss account. Normally the entire class of asset should be revalued andrevaluation should never result in the net book value of the class ofasset being greater than the recoverable amount of assets of thatclass. Gain on revaluation should normally be taken to the owner’sinterest in the form of ‘Revaluation Reserve’ Alternatively it could betaken to profit and loss account. Loss on revaluation should normallybe taken to profit and loss account except that such a decrease isrelated to; an increase which was previously recorded as a credit tothe revaluation reserve and which has not been subsequently reversedor 49haracte, it may be charged directly to that account. On disposalof a previously revalued item of fixed asset, the difference between netdisposal proceeds and the net book value should be charged orcredited to the profit and loss statement except that to the extent thatsuch a loss is related to an increase which was previously recorded asa credit to revaluation reserve and which has not been subsequentlyreversed or 49haracte, it may be charged directly to that account.Goodwill should he recorded in the books only when some considerationin money or money’s worth has been paid for it. A proper disclosure of
  • 50. the gross and net book value of the asset as well as relevant amount,if the assets are stated at revalued amounts should be made.AS-H (Revised) Accounting for tbc Effects of Changes in ForeignExchange Rates : The standard deais with (a) accounting for transactions inforeign currencies; and (b) translating the financial statements offoreign branches for inclusion in the financial statements of theenterprise. The standard details the methods to be adopted forconverting foreign transactions denominated in foreign currency inthe reporting currency defined as currency used in presenting thefinancial statements of the enterprise. The standard recommendsproper disclosure of the exchange differences arising on foreigncurrency transaction. Disclosure is also encouraged of an enterprise’sforeign currency risk management policy.AS-12 Accounting for Government Grants : Government grants are assistance by government in cash orkind to an enterprise for past or future compliance with certainconditions. Government grants can be 50haracteri in accounts on thebasis of capital approach or Income approach, based on nature ofrelevant grant. However, the government grant should not be50haracteri until there is reasonable assurance that (i) the enterprisewill comply with the conditions attached to them; and (ii) the grantwill be received. A proper disclosure should be made of the accountingpolicy adopted for government grants, including the methods ofpresentation in the financial statements including the nature andextent of government grant 50haracteri in the financial statements,including grants of non-monetary assets given at a concessional rateor free of cost.
  • 51. AS-13 Accounting for Investments : The standard deals with accounting for investment in financialstatements of enterprises and related disclosure requirements. Anenterprise should disclose current investments and long-terminvestments distinctly in the financial statements. A currentinvestment is an investment that by its nature readily realizable andis intended to be used for not more than one year from the date onwhich such investment is made. A long-tern investment is aninvestment other than a current investment. The cost of acquisitionshould include charges such as brokerage, fees and duties. If aninvestment is acquired by issue of share or other security, theacquisition cost should be fair value of the security issued. IF aninvestment is acquired in exchange for another asset, the acquisitioncost should be the determined cost with reference to the fair value ofthe asset given up. Investment properties should be treated as long-term investments. Current investments should be carried in the financialstatements at the lower of cost and fair market value determinedeither on an individual investment basis or by category ofinvestments, but not on an overall (or global) basis. Long-terminvestments should be carried at their cost, although a provision fordiminution in their value, other than temporary, should be made. Anychange in the carried value of the investment should be carried to theprofit and loss account. Profit or loss on disposal of investmentsshould be 51haracteri and shown in the profit and loss account.Significant disclosure requirements are also inserted in the standardand include among other things, the disclosure of accounting policyfor determination of carrying amount of investments, classification ofinvestments, profit and loss on disposal of investments and changesin carrying amounts of these investments, for current and long-term
  • 52. investment separately and aggregate amount of quoted and unquotedinvestments.AS-14 Accounting for Amalgamation : The standard deals with the accounting for amalgamation andthe treatment of any resultant goodwill or reserves. Amalgamation is52haracterized as either in the nature of merger or purchasedepending upon five conditions enumerated. Amalgamation in thenature of merger is accounted for by ‘Pooling of interest method’ andamalgamation in the nature of purchase is accounted by ‘Purchasemethod’. The consideration for the amalgamation means ihe aggregateof the shares and other securities issued and the payment made inthe form of cash or other assets by the transferee company to theshareholders of the transferor company. The identity of all the reserves in amalgamation in the nature ofmerger is preserved. However, in the case of amalgamation in thenature of purchase, only statutory reserves are preserved by givingdebit to a new account called ‘Amalgamation Adjustment Account’.Goodwill only arise in case of ‘Purchase method’. Goodwill arising onamalgamation is amortised over a period not exceeding five yearsunless a somewhat longer period can be justified. When anamalgamation is effected after the balance sheet date but before theissuance of the financial statements of either party to theamalgamation, disclosure should be made in accordance with AS-4but the amalgamation should not be incorporated in the financialstatements.AS-15 Accounting for Retirement Benefits in the FinancialStatements of Employers:
  • 53. The standard deals with the accounting of retirement benefitsconsisting of (a) Provident funds; (b) Superannuation/ pension; (c)Gratuity; (d) Leave encashment benefit on retirement; (e) Postretirement health and welfare schemes; and (f) Other retirementbenefits in the financial statements of employers. The contribution ofthe employer towards the provident fund and other contributionschemes should be charged to the statement of profit and loss for theperiod. The accounting treatment of gratuity and other benefitschemes will depend on the type of arrangement which the employerhas chosen to make. Any alterations in the retirement benefit costsshould be charged or credited to the statement of profit and loss asthey arise in accordance with AS-5.
  • 54. LESSON-4 PRACTICAL BASE OF ACCOUNTING – ORIGIN AND ANALYSIS OF BUSINESS TRANSACTIONS Accounting process begins with the origin of businesstransactions and is followed by analyses of these transactions. Afterorigin and analysis of transactions comes recording, classification andsummarization of business transactions culminating in preparation offinancial statements,Origin of Business Transactions Accounting deals with business transactions which havealready taken place, As financial accounting concentrates on monetarytransactions of the past it is basically historical in nature. Since itamounts to making recording and analysis of historical informationonly, it is also known as post-mortem accounting. For recordingbusiness transactions, it is necessary that these transactions areevidenced by an appropriate document such as cash memopurchase bill, sales bill, cheque book, pass book, salary slip, etc.,Documentwhich provides evide nce cf the transaction is called the SourceDocument.Analysis of Business Transactions In accounting record is made of monetary transactions whichare evidenced by a source document and double entry system isapplied for recording. According to J.R Batliboi “every businesstransaction has a two-foid effect and that it affects two accounts inopposite directions and if a complete record were to be made of suchtransaction, it would be necessary to debit one account and credit
  • 55. another account. It is this recording of the two-fold effect of everytransaction that has given rise to the term Double Entry System” To analyze the dual aspect of each transactions and to find outthe accounts to be debited and credited following two approached canbe followed. 7. Accounting Equation Approach 8. Traditional Approach. 9. Accounting Equation Approach: Equality of assets on one hand and liabilities and capital on theother hand is called basic accounting equation and is written as ASSETS = LIABILITIES + CAPITAL expected Where assets refer to resources which are owned bybusiness enterprise and are to benefit future operations, liabilities aredebts payable to parties external to business and capital means theamount payable to owners of the business enterprise (also calledowner’s equity ) The dual aspect of some business transactions is analyzed asfollows: 10. Introduction of resources by the owner: Rs. 5,00,000 cash and furniture worth Rs. 20, 000 invested bythe owner in the business. Introduction of Rs.5,00,000 cash increases business cash byRs. 5,00,000 and it creates analysis obligation to pay Rs. 5,00,000 tothe owner which is recorded as capital. In terms of accountingequation its effect is asfollows:
  • 56. ASSETS = LIABILITIES + CAPITAL Cash (Rs.5,00,000) =__ + capital (Rs.5,00,000)Further, if furniture worth Rs.20,000 is provided by theproprietor, the accounting equation appears as under:Cash + Furniture = Capital(Rs.5,00,000) (Rs.20,000) - +(5,00,000 + 20,000 ) Rs. 5,20,000 Rs.5,20,000 11. Purchase of assets for cash and / or credit : Purchased building for Rs,2,00,000 and paid Rs. 10,000 cashimmediately. It increases business assets or resources by Rs,1,90,000 as cash decreases by Rs. 10,000 and building increases byRs.2,00,000. It also creates an obligation to pay Rs. 1,90,000 infuture. The accounting equation now appears as follows; Cash + Furniture = Creditors for building + Capital(Rs.5,00,000 (Rs.20,000) (Rs.1,90,000)(Rs.5,20,000) –Rs. 10,000)+ Building(Rs. 2,00,000) -7,10,000 = Rs.7,10,000 12. Paid into bank Rs.3,00,000 It decreases cash balance and increase bank balance and thus,have no net effect on total assets as shown below: Cash + Bank = Creditors for building + Capital(Rs.4,90,000 (Rs.1,90,000) (Rs.5,20,000) 13. (Rs. 3,00,000)
  • 57. + Furniture + Building(Rs. 20,000) (Rs. 2,00,000) -7,10,000 = Rs.7,10,000 14. Payment of Rs. 1,90,000 by cheque to creditors for building : It decreases bank balance by Rs.1,90,000 and creditors forbuilding by Rs. 1,90,000 as shown below: Cash + Bank = Creditors for building +Capital(Rs.1,90,000 (Rs. 3,00,000) (Rs.1,90,000)(Rs.5,20,000) - Rs. 1,90,000) - Rs. 1,90,000)+ Furniture + Building(Rs. 20,000) (Rs. 2,00,000) Rs. 5,20,000 = Rs. 5,20,000 15. Purchase of goods for Cash/Credit: Business enterprise purchase goods worth Rs. 50,000 for cashand Rs.20,000 on credit. It increases stock of goods by Rs. 70,000, decreases cash byRs.50,000 and creates analysis obligation to pay. Rs.20,000 to thesupplier of goods. After this accounting equation appears as follows:Cash + Bank + Stock of goods = Creditors + Capital
  • 58. (Rs.1,90,000 (Rs. 1,10,000) (Rs.70,000) (Rs.20,000)(Rs.5,20,000) 16. 50,000)+ Furniture + Building(Rs. 20,000) (Rs.2,00,000) Rs. 5,40,000 = Rs.5,40,000 17. Rs. 40,000 cash and Rs.20,000 goods withdrawn for personal use:It decreases cash by Rs.40,000 and goods by Rs.20,000. At the sametime, it decreases capital by Rs.60,000 as shown below:Cash + Bank + Stock of goods = Creditors +Capital(Rs. 1,40,000 (Rs. 1,10,000) (Rs.70,000 (Rs.20,000)(Rs.5,20,000- 50,000) -Rs,20,000) -Rs.60,000) + Furniture + Building(Rs. 20,000) (Rs.2,00,000) Rs. 4,80,000 = Rs.4,80,000if accounting equation after above transactions is to be presented inthe form of balance sheet, it will appear as follows :
  • 59. Balance Sheet Liabilities Amount Assets amountCapital 4,65,000 Cash 1,25,000Creditors 20,000 Bank 1,10,000 Stock 30,000 Furniture 20,000 Building 2,00,000 4,85,000 4,85,000Classification of Accounts and rules for Recording Transactions : For recording business transaction all accounts are divided intothree categories, 1) Assets Account 2) Liability Account 3) Capital Account For recording changes in assets, liabilities and capital two basic rules are followed :Rule No. 1 for recording changes in assets : Increase in asset is debited and decrease in asset in credited.Rule No. 2 for recording changes in liabilities and capital : Increase in liabilities and capital are credited and decrease inliabilities and capital are debited.
  • 60. Transaction Assets = No. Creditors Trade for Cash + Bank + Stock+ Furniture+ Building = Creditors Capital Building + + 1. 5,00,00 - - 20,000 - = - - 5,20,000 0 2. 5,00,00 - - 20,000 - = - - 5,20,000 0 - - - +2,00,00 + - - - 10,000 0 1,90,000 3. 4,90,00 - - 20,000 2,00,000 = 1,90,000 - 5,20,000 0 +3,00,00 - - - - - - - 0 3,00,00 0 4. 1,90,00 3,00,000 - 20,000 20,000 = 1,90,000 - 5,20,000 0 -1,90,000 - - - - - - - 1,90,000 5. 1,90,00 1,10,000 - 20,000 20,000 = - - 5,20,000 0 - +70,000 - - - + 20,000 - - 50,000 6. 1,40,00 1,10,000 70,000 20,000 20,000 = - 20,000 5,20,000 0 - -20,000 - - - - - 60,000 - 40,000 7. 1,00,00 1,10,000 50,000 20,000 20,000 = - 20,000 4,60,000 0 - -20,000 - - - - + 50,000 + 25,000 8. 1,25,00 1,10,000 30,000 20,000 20,000 = - 20,000 4,65,000 0 Analysis of Changes in Capital Account Increases and decreases in capital account can take place due to introduction of capital, withdrawal of cash, goods and other assets for personal use ( called drawings ), revenue and income earned
  • 61. ( resulting in increase in capital) and expenses incurred ( resulting indecrease in capital). Recording the effect of all these transactionsdirectly in the capital account will make it unwieldy. In actualpractice, net effect of revenue and expense transaction during anaccounting period as shown by profit and loss account is transferredto capital account. Similarly cumulative effect of drawings during anaccounting period is recorded in the capital account at the end of theaccounting period. For this purpose, temporary capital accounts areopened. These are called temporary accounts because these accountsstart with zero balance in the beginning of the accounting period andat the end of the accounting period, these account are closed andtheir net effect it transferred to capital account. These include: a) Revenue Account(mcluding other incomes and gains) b) Expense Account(mcludmg losses) c) Drawing Account.As these accounts record changes which affect capital account only,no separate rule is required for recording changes in temporaryaccounts. For example: i. Revenue increases capital and decrease in capital is credited, therefore revenue earned is credited to revenue account. ii. Expense decreases capital and decrease in capital is debited, therefore, expenses are debited to expense account. iii. Drawings decrease capital and decrease in capital is debited, therefore, the value of assets withdrawn for personal use is debited to drawings account. Thus capital at the end of the period may be calculated asfollows: Closing capital = Opening capital + Additional capital
  • 62. - Drawings +Revenue and Gains - Expenses To sum up, under accounting equation approach allaccounts are divided into three, categories namely, assets, liabilitiesand capital. Capital account is further sub-divided into permanentand temporary account For recording changes in assets Rule NO. 1 isapplied and to record increases and decreases in liabilities and capitalRule N0.2 is followed.Illustration: Prepare a statement showing analysis of transactions,title and nature of affected accounts, relevant rule of recording andthe account to be debited and credited on the basis of transactions ofMr. X for the month of December,1998. Transactions for the month ofDecember, 1998, were asfollows Rs. 1. Received cash form debtors 20,000 2. Deposited cash in bank 4,000 3. Payment to creditors by 4,000 cheque 4. Machine purchased for 10,000 5. Traveling Expenses 5,000Statement Showing Analysis of TransactionsTransactions Analysis Title and Rule Entry Nature of AccountReceived cash Increase Cash – Debit Debit cashfrom debtors cash Asset increase inRs. 20,000 Decrease Debtor– assets Credit the amount Asset Credit Debtors
  • 63. due from decrease in debtors assetDeposited Increase Bank – Debit Debit bankcash in bank bank asset increase inRs. 4000 balance asset Credit cash Decreases Cash - asset Credit cash in decrease hand increase assetPayment to Decreases Debit Debitcreditors by amount Creditors – decrease in creditorscheque payable to Liability liabilityRs.4,000 creditors decreases Bank – Credit bank Asset decrease in Credit Bank balance asset Increases Machinery – Debit DebitMachinery machinery asset increase in machinerypurchased assetRs.10,000 Decreases Cash - asset Credit cash cash in Credit hand decrease in asset Expenses Traveling DebitTraveling incurred on expense- Debit travelingexpenses travel Temporary increase in Expenses
  • 64. Rs.5000 increases capital expenses cash in (Expense) hand Cash - Asset Credit Credit cash decreases decrease in assetAnalysis of Valuation of Assets and Liabilities Financial accounting is basically historical in nature andbusiness transactions are accounted at their value on the date of thetransactions. As a result asset and liabilities also appear at historicalvalue. To portray true and fair fianancial position in balance sheetsome of the assets and liabilities need revaluation to show these itemsat realistic, and not historical, level in the balance sheet. To achievethis objective without changing asset and liabilities balances inaccounting records, valuation records, valuation accounts are openedto account for increase or decrease in historical value of these items. Rules relating to analyze to assets and liabilities can beextended to accommodate analysis of valuation accounts as follows:
  • 65. 1. Valuation of Assets : Various valuation accounts generally opened to account fordecreae in the value of assets are ‘provision for discount on debtorsaccount’, ‘provision for doubtful debts account’, ‘stock reserveaccount’, ‘investment fluctuation reserve account, provision for (oraccumulated) depreciation account ‘and so on. The accounts areopened to bring and report assets at their reduced level. As decrease in assets are credited, therefore valuation accountsresulting in decrease in assets are credited. For example, assets machine of Rs. 2,00,000 is depreciated byRs. 20,000 at the end of accounting year 1998, the depreciationreduces (or decreases) the value of asset and it is calculated to theassets account with the help of the following entry. Debit Depreciation account (Being and expenses account andhence debited) Credit Machinery account.Alternatively, with the help of a valuation account called provision fordepreciation account, decrease in asset account can be recorded usingthe following entry:Debit Depreciation AccountCredit provision for depreciation account (or accumulateddepreciation) The provision for depreciation is shown as assetsdeduction from the machinery account (because it has assets creditbalance and machinery account has a debit balance) and the sameimpact is achieved.
  • 66. Conversely, if revaluation result in increase in value ofassets, the f valuation accounts are debited.Thus rule is as follows:Credit valuation account if asset account is to be decreased.Debit valuation account if asset account is to be increased2. Valuation of Liabilities: Like provision for discount on debtors, Provision fordiscount on creditors account is created. As per conservationprinciple, it should not be provided because anticipated gains are nottaken into account. But it is analysts accepted accounting practice tomake provision for discount on creditors. It results in decrease inliabilities. As decrease in liabilities are debited, valuation accountsrecording decrease in liabilities are debited. Conversely, valuationaccount recording in increase in liabilities are credited. This rule is asfollows:Debit valuation account if liability account is to be decreased.Credit valuation account if liability account is to be increased. Second aspect of valuation accounts generally appears intemporary capital accounts and ultimately affects capital account.Thus, an entry on debit side of an account means eitherIncrease in asset orDecrease in liabilities orDecrease in capital orIncrease in Drawings orIncrease in expenseand analysis entry on credit side of an account indicates either
  • 67. Increase in liabilities orIncrease in capital orDecrease in asset orIncrease in revenueTraditional Approach Both accounting equation approach and traditionalapproach record dual aspect of business transactions. But inaccounting literature, generally, traditional approach is referred to asdouble entry system. For analysis and recording of transactions,traditionally all ledger accounts are divided as follows.Personal Accounts: Accounts recording transactions with a person or group ofpersons are called personal accounts. These accounts are necessary,in particular, to record credit transactions. Personal accounts are offollowing types.
  • 68. 1. Natural person(s) Accounts are accounts of individual living beings andinclude accounts ;of individuals such as Ramesh capital account. Ramaccount, Neha account and so on.2. Artificial or legal person(s) Accounts include accounts of legal entities such asReliance Industries Limited Account, Delhi Corporation Account,Goodwill Co-operative society Account, Punjab National Bank Accountand so on.3. Group / representative personal account: group personal accounts are accounts of natural and legalpersons grouped together such as debtors account, creditors account,share capital account etc. commission outstanding account, salariesoutstanding account etc., represent the person to whom commissionor salary is payable and are called representative personal accounts. Accounts which are not personal are termed asimpersonal accounts and are divided into real and nominal accounts.Real Accounts: Real Accounts relate to properties of a business enterprisewhich can be tangible or intangible.
  • 69. 1. Tangible real accounts: Accounts of properties having physical existence likecash, building, stock of goods, furniture etc., are called tangible realaccounts.2. Intangible real accounts: Include account of things which cannot be physically feltor touched but are capable or monetary measurement such asaccounts of goodwill, patents rights, trade-marks rights, copy rightsetc.,Nominal Accounts: Accounts relating to income, revenue, gain, expenses andlosses are termed as nominal accounts. Example of nominal accountsare salaries, rent, commission, discount allowed, rent received, salesinterest received etc. For recording changes in personal, real andnominal accounts, following rules are followed.Rule No.I - for personal accounts. Debit the receiver and credit the giverRule No.II - for real accounts Debit what comes in and credit what goes out.Rule No.Ill - for nominal accounts Debit all expenses and losses and credit all revenue, gains andincomes.Dual aspect of some business transactions is analyzed by applyingtraditional rules as follows.Transactions Analysis Title and Rule Entry
  • 70. Nature of AccountIntroduction Business Cash-Real Debit what Debit cashof cash by gets cash Capital comes in.owners owner is personal Credit the Credit the giver giver Capitalcash Bank Bank-Personal Debit the Debit bankdeposited in receives receiverbank cash Business Cash – Real Credit what Credit cash gives goes out cashBuilding Building Building – Real Debit what Debitpurchased comes in comes in Buildingfrom Mr. X on X is the X – Personal Credit thecredit giver giver Credit XPurchase of Goods Goods – Real Debit what Debit Goodsgoods for are comes incash received Cash – Real Credit what Credit cash Cash in goes out paidPayment of Service of Salary – Debit all Debit salarysalary to an the Nominal expensesemployee employee utilized Credit cash Business Credit what pays Cash – Real goes out
  • 71. cash for service utilizedRent of Building Rent – Nominal Debit all Debit Rentbuilding due is used Rent expenses Credit rentbut not paid by outstanding – Credit the outstanding business personal giver rent for (representative) the period is payable Note: Rent payable or outstanding is a personal account and shows he amount payable to the owner of the building. Advantages of Double Entry System 1. Scientific System: Double entry system records, classifies and summarizes business transactions in a systematic manner and thus, produce useful information for decision-makers. It is more scientific as compared to single entry system of book-keeping.
  • 72. 2. Complete record of business transactions: It maintains complete record of a business transaction. Itrecords both debit and credit aspect with explanation for thetransactions.3. Arithmetical accuracy of records: Under double entry system arithmetical accuracy ofrecords can be checked by preparing a trial balance. However, someerrors cannot be deducted by preparing assets trial balance. ,4. Ascertainment of profit of loss: Profit or loss due to operation of business can be knownby preparing profit and loss account.5. Information about financial position of the business enterprise: It can be obtained by preparing balance sheet .at a pointof time.6. Lesser possibility of fraud: Possibility of frauds and misappropriation is minimized ascomplete information is recorded under this system.7. Helps users of accounting information: Double entry system is most scientific and extensivelyused system of book-keeping all over the world. This system providessystematic and reliable information, it meets the needs the users ofaccounting information, and assist them in sound decision making.Analysis of Purchases and Sales of Goods Following transactions relating to sale and purchase ofgoods need careful analysis. 1. Purchases and sales,
  • 73. 2. Discount received and discount allowed, 3. Sales tax 4. Cheques issued and cheques received. 5. Bad debts (applicable in case of credit transactions only).1. Analysis of Purchases and Sales: In accounting vocabulary, purchases and sales refer topurchase and sale of items in which the business is dealing in thenormal course of business. For example, purchase of car by assets cardealer for resale is purchase of goods but purchase of car by amanufacturing concern for official use is recorded as an asset.Purchases includes items acquired for resale, and not for utilizationduring business operations.Purchase of goods increases goods held for resale and sale of goodsdecreases goods. Goods in hand are called Stock or Inventory.Suppose goods costing Rs.5,000 are purchased and goods costingRs.4,000 are sold for Rs.6,500. theoretically effect of thesetransactions can be analyzed as follows: Goods purchased increases stock (Asset /Real account)by Rs.5,000 and decreases cash (Asset / Real account) Rs.5,000.Therefore, the entry is as follows: Rs. Debit stock 5,000 Credit stock 5,000 At the time of sale of goods costing Rs.4,000 for Rs.6,500cash (Asset / Real account) increases by Rs.6,500 stock (Asset / Realaccount) decreases by Rs.4,000 and profit on sale ( Gain / Temporarycapital account ) increases by Rs.2,500Therefore, the entry is as follows.
  • 74. Rs. Debit cash 6,500 Credit stock 4,000 Credit profit on sale 2,500 Theoretically, it is possible to find out the stock in handafter each purchase transaction and to calculate stock of goods andprofit ( or loss ) on sale of goods at the time of sale and record this inaccounting records. But it is impracticable or not feasible to record Sale andpurchase transactions in this manner. Purchase of goods are recorded in purchase account.Sales are recorded in sales account and no attempt is made tocalculate profit (or loss) on sale at the time of sale.At the time of cash purchase of goods Rs. Debit purchases (Asset / Real account) 5,000 Credit cash (Asset / Real account) 5,000 At the time of cash sale of goods: Debit cash (Asset J Real account) 6,500 Credit sales (Revenue / Temporary Capital account (Revenue)) 6,500At the end of the accounting period: Cost of goods remaining unsold is determined on thebasis of physical stock-taking. Goods in hand are listed and generallyprices at its historical cost. In this case physical stock taking willreveal stock in hand worth Rs. 1,000 i.e. cost of goods purchased(Rs.5,000) minus the cost of goods sold (Rs.4,000). Value of stock inhand at the end of the account in g^ period is recorded as follows. Rs. Debit closing stock (Asset / Real 1,000
  • 75. account) Credit purchases (Asset / Real account) 1,000 In case of purchases and opening stock are transferred nitrading account and to record the amount of closing stock followingprocedure isfollowed, Debit closing stock Credit Trading AccountThe gross profit along with other incomes is compared with indirectexpenses to find out net profit ( or loss) during an accounting period.Then net profit ( or loss) is transferred to capital account Assumingthere are no expenses, net profit is equal to Rs.2,500. ( i.e. sales(6500) - cost of sales (4000)). The entry for transfer of net profit tocapital account is as follows: Rs. Debit profit and loss (nominal 2,500 Account) Credit capital (capital Account) 2,5002. Analysis of Commission, Rebate and Discount:, Commission is the amount payable to analysis agent,broker, employee etc., for services rendered by him in transacting thebusiness. It is generally calculated as a percentage of the value of thebusiness transacted. Rebate is a reduction granted on the amount chargeablefor goods sold and services rendered. It is given under specifiedconditions such as rebate in airfare to senior citizens, rebate in railfares to the handicapped persons, rebate to the senior citizens underthe Income Tax Activities etc..
  • 76. Discount is a reduction from a states amount such asdiscount allowed to debtors to encourage prompt payment, issue ofsecurities ata price below their nominal value to attract subscribers,amount charged by assets bankat the time of discounting of a bill of exchange for discounting futurecash flow to its present value etc., Suppose a dealer in Vimal Fabrics purchases cloth fromReliance Industries Limited at assets list price of Rs.300 per metreless 35% discount Company allows additional discount @5% of listprice if payment is made immediately.Now the cost of purchases of M/Statements, Vimal Fabrics and salesrevenue of M/Statements Reliaance Indusries Limites for accountingpurposes is Rs.195 per metre (i.e. Rs.300 - 35 % of Rs. 300). IfM/Statements Vimal Fabrics makes cash payment, the entry is Book of M/Statements Reliance Book of M/S Vimal Fabrics Industries Ltd Rs. Rs.Debit Cash 180 (Real A/C) Debit purchases 195 (Revenue A/C)Debit 15 (Expenses Credit cash 180Discount A/C) AllowedCredit sales 195 (Revenue Credit Discount 15 A/C) Received3. Analysis of Sales Tax: From purchasers point of view sales tax forms part of thecost of purchases. But from sellers point of view, sales tax chargedshows-the-amount collected on behalf of and payable to the sales TaxDepartment of the Government. It is recorded in a separate account
  • 77. named ‘Sales Tax payable Account’, Suppose an item is sold forRs.1,100 including sales tex Rs.100. the entry is as follows Books of Seller Books of PurchaserDebit Cash 1,100 (Real A/C) Debit Purchaser 1,100 (Real A/C)Credit Sales 1,100 (Revenue A/C) Credit Cash 1,100 (Real A/C)Credit Sales tax payable 100(Represtative personal A/C)4. Analysis of cheques issued and cheques received: In case of payments made by issue of cheque, it isrecorded inbank account straightway. But in case of cheques received, it isrecorded in bank account only when the cheque is deposited in bankon the same day. If the cheque received is not deposited on the sameday, it is treated as cash on the day of receipt of cheque and when it isdeposited in bank, it is treated as cash deposited in bank.For example, if Rs.5,000 cheque received from Mr. P on 31.1.1999 isdeposited in bank on 31.1.1999 itself, the entry on 31.1.1999 is asfollows Rs. Debit bank 5,000 (Personal Account) Credit P 5,000 (Personal Account)But if cheque is deposited on, say 5.2,1999, the entries are as follows:On 31.1.1999 Debit bank (Real Account) Credit P (Account)On 5.2.1999 Debit bank (Personal Account) Credit cash (Real Account)
  • 78. Above mentioned traditional approach for cheques received isfollowed when:1. Cheques received are currently due. Post - dated cheques shouldnot be recorded in cash book.2. Cheques received are not crossed Account Payee . Crossedcheques are recorded in bank column directly. A better way of recording cheques received is to recordthese as cheques in Hand, and to transfer it to bank account at thetime cheque is deposited in bank.5. Bad debts: Bad debts refer to the amount of debt that cannot berecovered form the credit customers. At the time when businessenterprise becomes definite about the non-recovery of assets certainsum from debts, the amount receivable is reduced by creditingdebtors account. As the amount non-recoverable is a loss, it is debitedto a new account, called bad debts account and, at the end of theaccounting period, it is transferred to profit and loss account. Thus,entry for recording bad debts is as under. Debit Bad debts (Nominal / Temporary Capital A/C) Credit Debtors(Group personal / Asset A/C)
  • 79. LESSON - 5 FINANCIAL STATEMENTS OF PROFIT-MAKING ENTITIES MANUFACTURING-CUM-TRADING ORGANISATIONS The basic operation of a trading organisation involves purchaseof, finished goods and their subsequent sale to final customerswithout any,, substantial modification. At any point of time, a traderhas to manage only one, kind of inventory, namely that of theFinished Goods and it is Trading account.In contrast, a Manufacture-cum-Traders basic operationinvolves purchase of raw material and its subsequent conversion intofinished product; followed by their trading. At any point of time, hehas to manage three kinds of inventories, namely, those of RawMaterials’ Finished Goods, and Unfinished Goods (popularly calledWork-in-process). He like a trader^ ascertains his gross results ofoperation with the help of following equation:Gross Profit = Net Sales - Cost of Goods Soldwhere Cost of Goods Sold = Opening Stock of Finished Goods + Costof Finished Goods manufactured during the period - Closing Stock ofFinished. Goods + Direct Expenses related with Trading. Note the contrast in the determination of the Gross Profit of aManufacturer with that of a Trader. The new aspect is the Cost ofFinished Goods manufactured during the year as compared toPurchase (less returns) of Finished Goods during the period of atrading organisation. The cost of finished goods manufactured duringa periods is computed is a new account called ManufacturingAccount which precedes the trading and profit and loss account of
  • 80. manufacturer-cum-trader. In fact the "Income statement of amanufacturer-cum-trader is made in three stages and is calledManufacturing, Trading and Profit and Loss /recount for the periodending . . .*. To prepare the manufacturing account, a manufacturer divideshis expenditures in three parts, namely, Material cost, Labour Costand Other costs. These three categories are further subdivided in twomore categories, namely, Direct and Indirect. The Direct Costs are those which do not lose their existence inthe final product. Indirect costs are those which are not direct costs.Hence, for the manufacture of furniture, cost in incurred on wood is aDirect Material Cost whereas cost incurred on nails and fevicol usedis a indirect Material cost. The reason is that whereas wood has notlost its existence in the final furniture made,nails and fevicol have lost it. Similarly, the cost paid to person who isactually making the furniture (also called carpenter) is called Directlabour Cost whereas cost paid to a person who is supervising manycarpenters Is an example of Indirect Labour Cost. The Indirect Costs comprising of indirect material costs,indirect labour costs and indirect other costs are collectively calledOverheads. Overheads are further subdivided in three categoriesnamely, Factory; Office and Administration and Selling andDistribution. Hence, a manufacturer views his total cost in six ways,namely, (a) Direct Material Cost; (b) Direct Labour Cost; (c) Other Direct Cost; (d) Factory Overheads; (e) Office & Administration Overheads; (f) Selling & Distribution Overheads;
  • 81. The cost of manufactured goods will include the first fourcomponents of the cost of a manufacturer and the last two aspects areshown in the profit and loss account. The cost is computed instatement form" as below:Computation of cost of finished goods manufactured during theperiod.Direct Material consumed*+ Direct Labour+ Direct Other CostsPrime Cost+ factory Overhead (net of Scrap value realised**)Gross Works (Manufacturing) Cost+ Opening Stock of Work-in-Process_ Closing Stock of Work-in-ProcessCost of goods manufactured Opening stock of Raw Material + Purchase of Raw Materialduring the. period + Closing stock of Raw Material + Freight inward +Duties+ Subsidies + Duty Drawbacks - Return Outward. ** Scrap isthe incidental residue arisin; from a process of manufacture havingvery low sales value. This is shown as a deduction from the factoryoverheads. Alternatively, it can be shown as a deduction from the totalworks (manufacturing) cost. ;The information, when contained in the account form, appears asbelow:Dr. Manufacturing Account Cr.To Opening Stock – Raw xxx By Scrap xxxMaterialTo Purchaser of Raw - By Rebates xxxMaterial xxx By Purchases returns xxxTo Freight Inward xxx By Subsidies xxxTo Duties and Taxes xxx By Duty Draw Back xxxTo Fatory Overheads xxx By Closing stock-Raw xxx
  • 82. MaterialTo Opening Stock– Work xxx By Closing stock -in progress Work in process xxx By Cost manufactured xxx Goods transferred to trading account xxx xxx Note that stocks of raw material and work-in-process have beenadjusted in the manufacturing account whereas the stock of finishedgoods is adjusted in the trading account. Factory overheads includeindirect material, indirect labour and other indirect costs incurred inthe factory. Hence, expenses like depreciation of plant, repairs ofplant, factory lighting, factory telephone expenses are shown in themanufacturing account instead of profit and loss account But thedepreciation of office furniture (office& administration overheads) anddepreciation of delivery vans (selling & distribution overheads) areshown in the profit and loss account. MANUFACTURING DEPARTMENT AS PROFIT CENTRE The business organisation, instead of being viewed as a whole,can be looked up as comprising of various parts where each part isresponsible for the overall results of the business in their own smallmeasures. These small parts arc called Responsibility Centres of thebusiness and are categorised as (a) Expense Centres (b) RevenueCentres (c) Profit Centres and (d) Investment Centres. These centers,being headed by responsible managers who are subject to internalevaluation by their seniors at regular intervals, have a strong case forprojecting their division / part of business as a profit-making division. Hence often the goods are transferred by the manufacturingdepartment to the trading department at a transfer price which ismade up of its manufacturing cost + mark up or profit In other words,the manufacturing department is essentially viewed as a Profitcentre. The transfer of goods internally at a profit leads to the profit
  • 83. being recognised in the manufacturing account which is transferred tothe profit and loss account with the help of the following entry. Manufacturing A/c Dr. To Profit and Loss A/c However, this profit is not realised unless goods are sold to theultimate customer by the trading division. Hence if finished goodsremain unsold at the end of the accounting period it leads to valuationof the finished goods at a price which is more than the cost of thesegoods to the business as a whole. The excess represents theUnrealised profit contained in the value of the stock. This valuationof inventory violates the principle of Lower of cost or market value asinventory value advocated by AS-2 on valuation of inventories. It alsoviolates Conservatism principle by recognising a profit which is notrealised (anticipated gains) by transferring goods from one of businessdepartment to another department.The anomaly is removed by creating a stock reserve for the unrealizedprofit contained in the closing stock from the profit and loss accountwith the help of the following entry. Profit and Loss A/c Dr. To Stock Reserve A/c The entry reduces the profit to the extent of unrealized profit inclosing f stock. The stock reserve account is shown as a deductionfrom the value of;| closing stock in the balance sheet and hence theclosing stock is properly valued at its cost to the business as a whole.Next year, this becomes the opening stock and is transferred to thetrading account at the transfer value. The stock reserve (on openingstock of finished goods) is shown on the credit side of the profit lossaccount of the next year.
  • 84. VALUATION OF INVENTORIES IN A MANUFACTURINGDEPARTMENT The value of inventory is computed by adding cost of purchase,cost off conversion, and other cost incurred in the normal course ofbusiness in bringing; the inventories up to their present location andcondition. However, as per AS-2, the inventory is valued at lower ofcost or market price characterised by the net realizable value. Thehistorical cost of inventory is normally determined by using First inFirst out (FIFO), Weighted Average or Last in First out (LIFO) formulaeas per recommendation of AS-2. The value of raw material should bebased on cost of purchase and other cost incurred in the normalcourse of business in bringing the inventories up to their presentlocation and condition. The value of finished goods inventory shouldbe based on cost of manufacture which includes besides directmaterial, direct labour and other direct costs, the fair proportion offactory overheads. The WIP is commonly valued at factory cost.However, while valuing it, the concepts of Equivalent Unit is used.According to institute of Cost and Management accountants,London, Equivalent units are a notional- quantity of completed unitssubstituted for an actual quantity of incomplete physical units inprogress when the aggregate work content of the incomplete units isdeemed to be equivalent to that of substituted quantity ........ Henceby using the concept of equivalent units, a 50% complete work inprocess of 10,000 units is treated as 5,000 completed units and thenthe overall cost can be allocated amongst the completed units as wellas incomplete units, the complete units being taken as 100%complete.Illustration 1: From the following particulars, prepare themanufacturing account of A with units column: Unit Rs.
  • 85. Opening Stock - Raw Material 1,000 10,000Purchase of Raw Material 10,000 1,10,000Closing Stock 500 ?Freight – Inward 10,000Freight – Outward 15,000Direct Wages 85,000Indirect WagesFactory 40,000Office 50,000Other Factory Oveheads 30,000Opening Stock – Work in Purchase (40% complete) 1,500 15,000Closing Stock – Work in Process (30% complete) 3,000 ?
  • 86. Dr. Manufacturing Account Cr. Particulars Unit Amount Particulars Unit Amount 1,000 10,000 By Closing Stock - Raw Material 500 6,000To Purchases - By Closing Stock 3,000 27,000Raw Matertial 10,000 1,10,000 - WIP (3)To Freight - 10,000 By Trading A/c 9,000 2,67,000Inward [cost of finished goods transferred to trading account (3) (b.f.)]To Direct Wages 85,000To FactoryOverheads (2) 70,000To Opening Stock 1,500 15,000- WIP 12,500 3,00,000 12,500 3,00,000 Working Notes: 1. Calculation of closing stock of raw material (based on FIFO) Average pncs of Purchase made during the year = of Purchase + Freight (Inward) Cost No. of units purchase = (1,10,000 + 10,000) 10,000 = Rs. 12 Value of closing stock of raw material 500 units x Rs. 12 = = Rs. 6,000 2. Factory Overheads Indirect Factory wages = 40,000 Other Factory overheads = 30,000. 70,000
  • 87. 3. Calculation of closing stock of work in process and finished goods transferred to trading department.Units manufactured during Units % of completion Equivalent units the year during the yearOpening Stock of work inprocess 1,500 60 % 900Goods started and finishedduring the year 7,500 100 % 7,500Closing Stock of work inprocess 3,000 30 % 900 Total 9,300
  • 88. Cost incurred during the year Raw Material Consumed = 1,24,000*** Direct Labour = 85,000 Factory overheads = 70,000 Hence, average cost of equivalent = 2,79,000/9,300 units Value of closing stock of work in = Rs. 27,000 process Value of finished goods = [Opening stock of WIP + Cost of completing opening WIP + Cost of goods started and finished during the year] = Rs. 15,000 + 900 units x Rs. 30 + 7,500 units x Rs. 30 = Rs. 15,000 +Rs. 27,000 + Rs. 2,25,000 = Rs. 2,67,000* Opening stock at the beginning of the year was 40% complete andhence % completed during the year was remaining 60%.** Total finished goods transferred during the year is 9,000. Since1,500 units are from the opening stock of WIP, the remaining (7,500units) must be those which were started and finished during the yearon the basis of cost flow assumption of FIFO.*** 10,000 (Opening stock +RM) + 1,10,000 (Purchases) - 6,000(Closing Stock) +1 0,000 (Freight) = Rs. 1,24,000.
  • 89. LESSON - 6 FINANCIAL STATEMENTS OF NON-PROFIT-MAKING ENTITIES On the other hand, primary objective of a non-profitorganisation is to meet some socially desirable goal or to renderservices to its members. Non-profit organisations include hospitals, educationalinstitutions, clubs, political associations, religious institutions,charitable societies etc. These organisations survive on donations,grants, subscription from members, etc. Sometimes trading activities,such as hospital canteen, club restaurant health club, chemist shop,barshop etc. also take place in such institutions to provide certainfacilities to members or public in general. Surplus or profijt from suchincidental trading activities is used to fulfil the objectives for whichthe organisation was established. A person familiar with preparation of financial statements ofprofit-making organisations should have no difficulty in preparingfinancial statements of non-profit organisations for clear and effectivecommunication, with their users. This is so because the set of rules orprinciples followed for preparing financial statements of both profit-making and non-profit making entities are almost same. Non-profit organisations do not prepare profit and loss accountbecause their primary objective is not to earn profit but to serve itsmembers or society in general. However, these organisations compareincomes and expenses to check whether the organisation havesufficient resources to carry out its objectives. To achieve this Incomeand Expenditure Account* is prepared by: non-profit organisations
  • 90. and is accompanied by a balance sheet tc show the financial positionof the organisation. INCOME AND EXPENDITURE ACCOUNTIncome and expenditure account is like profit and loss account ofprofit-making organisations. Non-profit organisations follow the samerules or principles for preparing income and expenditure accountwhich are followed by commercial organisations for preparing profitand loss account. Following points should be noted:a) It is a nominal account. It records all expenses and losses on debit side and all incomes and gains on credit side of the account. As it records incomes and expenses, the word expenditure is used here in the sense of an expense.b) Expenses debited to income and expenditure account include expenditure of revenue nature. Similarly, the incomes credited to income and expenditure account are also of revenue nature. Items of capital nature are, not included in income and expenditure account but the portion of capital expenditure which expires during the year is charged to income and expenditure account as depreciation.c) It includes incomes and expenses of current year on accrual basis irrespective of flow of cash. Therefore, adjustment relating to outstanding expenses, prepaid expenses, accrued income, unearned income etc. are taken into account.d) Excess of credit side over debit side is termed as surplus and is known as excess of income over expenditure. However, if debit side exceeds credit side, there is a deficit and is termed as excess of expenditure over income.: Like transfer of profit or loss
  • 91. to capital account in case of profit-making entities, surplus or deficit of non-profit organisations is transferred to capital fund.Some Peculiar Items: Though the rules for preparing profit and lossaccount of commercial organisations and income and expenditureaccount of non-profit. organisations are same, but there are someitems which are peculiar to non-profit organisations. Items peculiar tonon-trading organisations are as follows:a) Capital Fund : Excess of assets over liabilities is called capital fund or general fund. It is similar to capital account of commercial organisations.b) Annual Subscription : Subscription received from members is a revenue item and credited to income and expenditure account. It is primary source of income of a non-profit organisation.c) Government Grant: Government schools, colleges, public hospitals etc. depend upon Government grant for their activities. The recurring grants in the form of maintenance grant is, by and large, spent in the year of receipt and is treated as revenue receipt (income) and credited to income and expenditure account. Other grants such as building grant, library grant etc., are treated as capital receipt and transferred to a fund account. Besides Governments contribution to library fund, building fund etc., additions may take the form of retention of surplus, amount charged from students, contribution from trustees etc.d) Life-Membership Fees: Fees received for life membership is a capita] receipt, as it is of non-recurring nature. It is directly added to capital fund or general fund.
  • 92. e) Entrance Fees : Fees paid by new members at the time of joining the organisation is called entrance fees. Since, the fees is paid only once by members, it is clearly of non-recurring nature. Hence, it should be treated as capital receipt and be shown in balance sheet as a part of the general fund.f) Donation : Donations received for specific purposes are capitalized and recorded on liabilities side of the balance sheet. These included donation for building, donation for extension of library hall, donation for library books, donation for seminar room, donation for sports activities etc. When the donation is utilised for the purpose, the amount of donation is transferred to capital fund. When the purpose for which the donation is to be utilised is not mentioned, It is called general donation and treated as income.g) Honorarium : Payment to non-employees for services received is called honorarium. It is a revenue item and debited to income and expenditure account.h) Legacy : Amount received by non-profit organisations as per Will of a deceased person is called legacy. As this item is of non- recurring nature, it is treated as capital receipt and recorded on liabilities side of the balance sheet. However, if the amount is small it can be credited to income and expenditure account.i) Endowment Fund : It refers to a fund from a bequest or gift. The fund contains assets uonated by the donor with stipulation that income earned by these assets but not the gift itself can be used for principal activities of the organisation. Sometimes, income may also be restricted. These kind of restrictions must properly be reflected in the financial statements. The fund is treated as capital receipt and recorded on the liability side.
  • 93. j) Subscription for Periodicals : Subscription for newspapers, magazines etc. is treated as income and credited to income and expenditure account.k) Sale of Old Periodicals : Sale of old newspapers, magazines etc. is treated as income and credited to income and expenditure account.l) Sale of Assets : Sale price of old asset is a capital receipt and not recorded in income and expenditure account. However, profit or loss on sale of asset is transferred to income and expenditure account. To recapitulate profit (or loss) on sale of fixed asset is calculated by comparing sale price with book value of asset sold on the date of sale.m) Income from specific fund and expenses related to specific fund : Generally, incomes and expenses are recorded in income and expenditure account. But if expenses arc incurred on certain items for which a fund exists, then expenses are not debited to income and expenditure account but deducted from specific fund account. Similarly, income from investment of specific fund is added directly to fund is added directly to fund and not credited to income and expenditure account For example, match fund balance of Rs. 10,000 income from matches Rs. 5,000 and match expenses Rs. 12,000 ure shown on liabilities side of balance sheet -as foolows; Match Fund 10,000 Add income from 5,000 matches 15,000 Less Mtch Expenses 12,000 3,000
  • 94. However, if after adjustment of income and expenses related toa specific fund, fund balance is negative, it is transferred to debit sideof income and expenditure accountn) Outstanding expenses & prepaid expenses : To recapitulate, the expenses of current year are to be taken on accrual basis while making income and expenditure account. Hence, the payment on account of expenses need to be adjusted for outstanding expenses and prepaid expenses. The entries for the two aspects may be recalled from the chapter on final accounts, namely:-for outstanding expenses.Expenses A/c Dr. To Outstanding Expenses A/cFor prepaid expensesPrepaid Expenses A/c Dr. To Expense A/cOutstanding expenses account is shown in the balance sheet onliability side and prepaid expenses account on the asset side. Bothaccounts are transferred to their respective expense accounts of thenext year to find out its amount correctly.o) Accrued income (or income outstanding) and unearned income(or income received in advance):The same treatment is accorded to the income to be shown in incomeand expenditure account The entries passed are:For income outstandingIncome Outstanding A/c Dr. To Income A/c
  • 95. For income received in advanceIncome A/c Dr. To Income Received in Advance A/cIncome outstanding account is shown in the balance sheet on theasset side and income received in advance on the liability side of thebalance sheet. Both accounts are transferred to their respectiveincome accounts of the next year to find out its amount correctly.p) Life membership fund : Sometimes, member of a non organisation pay their membership fees at die time of admission only. The fees received is clearly of non-recurring nature and is given in lieu of subscriptions to be paid every year which are of recurring nature. If nothing is specified in the question, assume that life membership fund to be capital nature and add it to be capital fund. However, if some kind of amortisation schedule is given, than a suitable part out of capital fund should be transferred to income and expenditure denoting the income of that year. Illustration I: From the trial balance and the additional information of a public school, prepare Income and Expenditure Account for the year ending December 31,1998 and the Balance Sheet as at that date. Trial Balance as at Decembr 31, 1998 Amount (Dr.) Amount (Cr.)Building 2,50,000 Admission Fees 5,000Fruniture 40,000 Tution Fees 2,00,000Library Books 60,000 Rent of Hall 4,00016% Investmetns (1-1- 2,00,000 Creditors for Books 6,00098) SuppliedSalaries 2,00,000 Miscllanoues 12,000
  • 96. ReceiptsStationery 15,000 Annual Government 1,40,000 GrantGeneral Expenses 8,000 Donations Received 25,000 for library booksAnnual Sports Expense 6,000 Capital Fund 4,00,000Cash 1,000Bank 20,000 Interest on 8,000 Investments 8,00,000 8,00,000Additional Information; 1) Tuition fees receivable for the year 1998 amounted to Rs. 10,000. 2) Salaries payable for the year 1998 amounted to Rs. 12,000 3) Furniture costing Rs. 10,000 was purchased on 1 -7-1998. depreciation on furniture @ 10% p. a. 4) Depreciate building by 5% and library books by 20%.
  • 97. Dr. Income and Expenditure Account for the year ending December 31, 1998 Cr.To Salaries 2,00,000 By Tution Fees 2,00,000Add 12,000 2,12,000 Add 10,000 2,10,000Outstanding OutstandingTo Stationery 15,000 By Annual 1,40,000 Goverenment GrantTo Annual 6,000Sports ExpensesTo General 8,000 By Admission 5,000Expenses FeesTo Depreciation By Rent of Hall 4,000on FurnitureOn 10,000 (for 500 By 12,000½ year) Miscellanoues ReceiptsOn 30,000 (for 1 3,000 3,500 By Interest on 8,000year) InvestmentTo Deprecitation 12,500on BuildingTo Depreciation 12,000 Add Accured 24,000 32,000on Library InterestBooksTo Excess of 1,34,000Income overExpenditure 4,03,00 4,03,000 0 Balance Sheet as at December 31, 1998
  • 98. Liabilities Amount Assets AmountOutstanding 12,000 Cash 1,000SalaryCreditors for 6,000 Bank 20,000BooksSuppliedDonation for 25,000 Tution Fees 10,000Library Books ReceivableCapital Fund Accounted 24,000 Interest on InvestmentOn 1-1-98 4,00,000 Investments 20,000Add Surplus 1,34,000 5,34,000 Furniture on 1- 30,000 1-98 Add purchased 10,000 on 1-7-1998 40,000 Less 3,500 36,500 Depreciation Library Books 60,000 Less 12,000 48,000 Deprcaition Building 2,50,000 Less 12,500 2,37,500 Depreciation 5,77,00 5,77,000 0 RECEIPT AND PAYMENT ACCOUNT
  • 99. Besides income and expenditure account and the balance sheet, financial statements of non-profit organisations invariably include Receipts and Payment Account. It is nothing but a summary of cash receipts and cash payments during the relevant period. From chronological record of cash transactions in the cashbook, summary of cash transactions is prepared at the end of the period under consideration. It does not give the date of the transact ion (s). Thus, both cashbook and Receipt and Payment Account provide the same information but in a different manner. a) It is real account. All receipts are recorded on its debit side and all payments are credited. b) It starts with balance of cash and bank in the beginning of the period under consideration. c) It records all items of revenue and capital nature resulting in inflow and outflow of cash. Again the period to which the transaction relates is not significant. Transactions of previous year, current year and subsequent years are recorded, provided they affect flow of cash in the current year. d) Balance of receipt and payment account shows the balance of cash and bank at the end of the period under consideration. Difference between Income and Expenditure Account and Receipt and Payment Account: Income and Expenditure A ccount Receipt and Payment AccountI) It is a nominal account. It is a real account.2) It is a summary of the working of It is a summary of cash and bankthe organisation. transactions of the organisation.3) It is based on accrual system. It is based on cash system4) It records expenses and losses on It records inflow of cash on debit
  • 100. debit side and incomes and gains on side and outflow of cash on creditcredit side. side5) It is a temporary account and has It is real account and startsno opening and closing balance. with opening balance of cash and bank.6) Itlis closed at the end of the year It is balanced at the end of theand balance figure of the account is year and the balance carriedtransferred to capital fund. forward shows the cash and bank balance at the end of the period.7) It records items of revenue nature It records items both of capitalonly irrespective of their effect on flow and revenue nature provided theyof cash. affect flow of cash.8) It records transactions of current It records transactions of previousyear only. years, current year and subsequent years provided flow of cash is affected. BALANCE SHEET Like commercial organisations, non-profit organisations prepare balance sheet to show the financial position of the Organisation. If trial balance is not given in the question, first of all balance sheet on the first day of the period under consideration (called Opening Balance Sheet) is prepared. It records assets and liabilities in the beginning of the period. Donations to capital fund are added to balance of capital fund in the beginning of the period and after adjustment of deficit or surplus as revealed by income and expenditure account, the balance capita] fund is recorded in the
  • 101. balance sheer prepared on the last day of the period underconsideration (called Closing Balance Sheet) Opening and Closing balance sheet on the basis of informationgiven in Illustration 2 appear as follows: Balance Sheet as at December 31. 1997 Liabilities Amount Assets AmountSalaries 4,000 Cash 1,000OutstandingCapital Fund 1,59,000 Bank 40,000(Balancing figure) Outstanding 2,000 Subscription Furniture 20,000 Building 1,00,000 1,63,000 1,63,000 Balance Sheet as at December 31, 1998 Liabilities Amount Assets AmountSalaries 1,000 Cash 900OutstandingCapital fund Bank 20,000On 1-1-98 1,59,000 Outstanding 3,000 SubscriptionAdd 4,500 1,63,000 Investments 30,000Surplus Add Accrued 600 30,600 Interest Furniture 20,000 on 1-1-98 Less sold 5,000 15,000 Building 1,00,000 Less 5,000 95,000 Depreciation 1,64,50 1,64,500 0
  • 102. Hence it is amply clear that the financial statements of a non-profitinstitution comprises of four basic statements, namely:- i) A balance sheet at the start of the period (i.e., opening balance sheet); ii) Receipts & Payments Account which is a summary of cash transactions because most of the transactions of non-profit organisation are in cash (and/or bank); In fact, these two statements plus some additional information (essentially j about the outstanding / prepaid expenses and accrued / unearned incomes) provide the basic material which is necessary to compute the deficit / surplus generated by the non-profit organisation and to find out their financial position at the end of the period. This is done in the next two statements, namely, iii) Income and Expenditure Account showing incomes generated and expenses incurred during the year to find out the deficit / surplus; iv) A balance sheet at the end of the period {i.e., closing balance sheet)All these statements are intimately connected. In examination,normally one or two of these statements are given along withadditional information well, it will be easier to make the statementsrequired in examination problems. For example,a) Fixed assets appearing in the opening balance sheet will go to the closing balance sheet after not sold. If they are sold, the sale price wi11 increase the receipts of cash during the year in
  • 103. receipts and payments account and the difference of sale price and their value on the date of sale will be charged to income and expenditure account as loss or gain on sale of fixed assetb) The receipts in receipts and payment account will be divided in two parts, namely capital and revenue. Revenue receipts, e.g., subscription received will denote (he subscription received during the year whether pertaining to past / present / future years. However, it will be adjusted in the light of information about accrued / unearned subscription given in the opening balance sheet and additional information and adjusted subscription,/ representing subscription of the current year whether received in past / current / future years, will be shown on the credit side of the income and expenditure account of the current year. Capital receipts such as Iife membership fees, legacy etc. will be taken to liability side of the closing balance sheet under suitable headings.c) The payments in receipts and payment account will be divided in two parts, namely, capital and revenue. Revenue payments or expenses, e.g. salary paid will denote the salary paid during the year whether pertaining to past / present / future years. However, it will be adjust in the light of information about outstanding /prepaid salary and adjusted salary, representing salary of the expenditure account Capital expenditure, denoting assets will be taken to asset side of the closing balance sheet after depreciation which will be shown in the income and expenditure account on the debit side (expenditure side).From examination point of view, preparation of financial statements ofno-profit organisations can be studies under the following categories:
  • 104. 1) When Receipts and Payments account along with additional information is given and rest of the basic statements are to be prepared;2) When results of an incidental trading (commercial) activity ofa non-profit organisation (e.g. Bar activities in a club) are to be ascertained by preparing (Bar) Trading Account along with income and expenditure account and balance sheet at the end of the period;3) When in receipts and Payments account the balance of bank is given as per pass book;4) When trial balance along with additional information is given and few basic statements are to be prepared;5) When Income and Expenditure account along with additional information is given and rest of Ihe basic statements are to be prepared;6) When both Receipts and Payments account and Income and Expenditure account along with additional information are given, and balance sheet in the beginning and at the end are required;7) When balance sheet at the beginning and at the end along with additional information is given, and Receipts and Payments account and Income and Expenditure account for the year are required;8) When raw information is given, and all the basic statements are to be prepared;
  • 105. 9) When wrong statements / incomplete statements are given and corrected accounts of non-profit organisation are to be prepared;10) Accounts of hospitals;11) accounts of educational institution including libraries.Case I: When Receipt and Payment Account along with additional information is given, and rest of the basic statements are to be prepared. Generally examination problems require preparation of income andexpenditure account and balance sheet at the end of the period fromthe information given. But to complete balance sheet the figure ofcapital fund in the beginning is required. To calculate informationabout capital fund in the beginning, balance sheet at ithe beginning ofthe period should be prepared. Thus, to solve the si examinationproblems it is suggested to prepare the following simultaneously; 1) Balance sheet at the beginning of the period. 2) Income and Expenditure Account for the period under consideration. 3) Balance sheet at the end of the period.To prepare income and expenditure account from receipt and paymentaccount, all items appearing in receipts and payment account shouldbe analysed one by one. AH items of capital nature are directlyrecorded in the balance sheet All items of, revenue nature appearingin receipts and payment account are transferred to income andexpenditure account, it is to be ensured that these represent; incomesand expenses of the current period only. To achieve this, levenue
  • 106. items appearing in receipts and payment account are adjusted, toshift from cash to accrual basis, before transferring these items toincome and expenditure account.Case II : When results of an incidental trading (commercial) activity ofnon-orofit organisation (e.g. Bar activities in a club) are to beascertained by preparing Trading Account along with income andexpenditure account and balance sheet at the end of the period.Non profit organisations basically survive on donations, grantssubscriptions from members etc. Sometimes trading activities such ashospital canteen, bar, club, beauty parlour, health club, restaurant,chemist shop run by a Govt hospital or co-operative store also takeplace in such institutions to provide certain facilities to members orpublic in general. As the surplus or profit from such incidentalcommercial (trading) activities is used to fulfil the objectives for whicnthe organisation was established, therefore, profit from such activitiesis transferred to income and expenditure account. Procedure followedis as follows:a) Prepare trading account to calculate profit (or loss) due to incidental trading activity. All costs and revenues and incomes directly related with such activity are recorded in trading account. Balance of trading account showing profit or loss is transferred to income and expenditure account.b) Income and Expenditure account records, besides trading profit (or loss) all other incomes and expenses not directly related with trading activity. Surplus (or deficit) as revealed by income and expenditure account is transferred to capital fund as usual.Case III: When in receipts and Payments account the balance of bankis given as per pass book.
  • 107. Sometimes, receipts and payments account given in the questionshows opening and closing bank balance as per pass book. It meansthe information about various receipts and payments given in thereceipts and payments account is as per pass book. To solve thequestion, first of all given receipts and payments account should beredrafted and bank balance and various receipts and payments as percash book should be recorded.Case IV: When trial balance along with additional information is givenand few basic statements are to prepared.It has already been emphasized that accounts of non-profit makingentities are not materially different from the accounts of a profit-making entity. Hence, if information is given in the form of trialbalance it does not poses a special problem (See Illustration 1), Allaccount have to be analysed to find out whether they result ingeneration of deficit/surplus or are accounts of assets / liabilities. Thestatements are prepared in the usual manner.Case V: When Income and expenditure Account along with Additionalinformation is given and rest of the basic statements are to beprepared.Sometimes examination problem requires receipt and paymentaccount and balance sheet from the information given in the question.To prepare receipt and payment account from income and expenditureaccount, all items appearing in income and expenditure accountshould be analysed one by one to find out their effect on flow of cash.To recapitulate, income and expenditure account records all incomesand expenses of the current period on accrual basis. Therefore, theinformation appearing in the income and expenditure account is to beadjusted in the light of additional information given in the question tofind out inflow and outflow of cash on account of incomes and
  • 108. expenses respectively. Then, information about capital receipts andcapital payments included in additional information is analysed andrecorded in the receipt and payment account After recording allreceipts and payments and opening balance of cash and bank, theaccount is balanced. Balancing of receipt and payment account nowreveals the closing balance of cash and bank.Sometimes, closing balance of cash and bank is given in the questionand opening balance is to be calculated. In such a case closingbalance to be carried forward, along with all receipts and payments, isrecorded and balancing figure reveals balance of cash and bank in thebeginning of the period.Case VI: When both Receipt and Payment Account and Income andExpenditure Account along with additional information are given, andbalance sheet in the beginning and at the end are required.Sometimes both receipts and payment account and .income andexpenditure account are given in the questions along with additionalinformation about assets and liabilities in the beginning of the year. Inthis case balance sheet as at the end of the year is to be prepared- Toprepare balance sheet, items given are compared and informationabout prepaid expenses, the amount of salaries shown in receipt andpayment account is less than the amount shown in the income andexpenditure account, the difference is on account of salariesoutstanding at the end of the year. Students have to be very carefulwhen amount appearing in receipts and payment account is morethan that appearing in income and expenditure account. For Example:a) Insurance premium amount in receipt and payment account is Rs. 200 and in income and expenditure account is Rs.120 Excess payment of insurance premium can be either on account of outstanding amount in the beginning of the year or advance
  • 109. payment for the next year. Generally insurance premium is paid in advance, therefore, excess amount is treated as unexpired insurance and recorded on assets side.b) Income and Expenditure account shows stationery amount Rs.500 and the amount recorded in receipts and payment account is Rs.700. In this case, difference is either treated as stock of stationery (purchases-consumed) at the end or amount outstanding in the beginning on account of creditors for stationery.c) Interest on investment in income and expenditure account is Rs.1000 and Rs.1500 is shown in receipt and payment account on account if interest on investment. In this case difference of Rs.500 can be treatedi as interest received in advance at the end of the year and recorded on liabilities side of closing balance sheet. Alternatively difference of Rs.500 can be assumed on account of interest earned but not received in the beginning of the year and recorded on asset side of opening balance sheet ;d) Salary account recorded in receipt and payment account is Rs. 10,000 and Rs.9,000 is shown in income and expenditure account In this case, Rs. 1,000 can be shown in closing balance sheet on asset side as advance salary or it can be treated as salaries outstanding in the beginning of the year and recorded on liabilities side of opening balance sheet.It is clear from above that if amount appearing in receipt andpayment! account is more than that appearing in income andexpenditure account, it ispossible to treat the difference in more thanone way. In such a case, student sfiould make a logical assumptionand write the assumption made as part of working notes,
  • 110. Case VII: When balance sheet at the beginning and at the end of theperiod along with additional information are given, and receipts andpayments account or income and expenditure account for the year arerequired:The information about assets and liabilities is given in the beginningas well "as the end along with additional information either aboutreceipts and payments or about incomes and expenditures. Theinfonnation can be adjusted to find out the incomes and expendituresor receipts and payments. For example, opening balance sheet showssalary outstanding of Rs.IOO and payments show that on account ofsalary Rs. 14,100 was paid. It will mean that payment to be shown inreceipts and payments account is Rs. 14,100 but salary of the currentyear to be shown in income and expenditure account will be Rs.14,000 betause the payment includes Rs. 100 on account of last year.Case VIII: When raw information is given and basic statements are tobe prepared: When raw information is given, it virtually involves thewriting of entire books of accounts of non-profit organisations, Duecare mast be taken In recording transactions in these books. Allreceipts and payments should be recorded in the receipts andpayments account. All expenses and incomes should be posted toincome and expenditure account keeping in mind the wholediscussion we had so far. Hence, recurring items will find their way toincome and expenditure account and non-recurring would be taken tobalance sheet., the assets and liabilities at the end of the year areenumerated in the closing balance sheet. The opening balance sheet isnormally prepared to find out the missing figure of capital fund in thebeginning of the year.Case IX: When Incomplete / Wrong statements are given andcorrected accounts of non-profit organisation are to be prepared.
  • 111. Case X: Accounts of Hospital: Hospitals, like other non profitorganisations, are required to prepare financial statements to presenttheir activities in a meaningful manner. Hospitals generally operate anumber of separate but related activities. Inspite of the variedactivities undertaken, the procedure of preparation and presentationof financial statements is similar to the one used by other non profitorganisations.Case XI: Accounts of educational institutions: like other non-profitorganisations, educational institutions need to report on theiractivities and to effectively communicate their financial needs. Theseinstitutions by and large, depend upon Government Grants for theiractivities. Unrestricted grants are grants that by their term are fullyexpended with in the year or receipt, and are treated as income andcredited to income and expenditure account.
  • 112. LESSON - 7 ERRORS MANAGEMENT Trial balance is prepared to check the arithmetical accuracy orcorrectness of recording in journal, posting to ledger and balancing ofledger accounts In case trial balance agrees, it is assumed thatrecording, posting and balancing has been done correctly oraccurately. However, if it does not tally, efforts are made to locateerrors in accounting records. Moreover, agreement of trial balance isnot a conclusive proof of accuracy of records. Even when the trialbalance agrees, some errors may remain in accounting records. Forexample, non-recording of credit sale transaction in Sales Book willnot affect (he agreement of trial balance because both (i.e., debit aswell as credit) aspects of the sale transaction are not recorded in thiscase. Errors, whether affecting trial balance or not affecting trialbalance, are to be corrected. The procedure followed to remedy theerrors committed and to set right accounting records is calledrectification of errors.Type of Errors1. Errors of Omission : It refers to omission of a transaction at the time of recording in subsidiary books or posting to ledger. When a transaction is not recorded in the books of original entry, agreement of trial balance is not affected because both (debit as well as credit) aspects of a transaction are not recorded. However, if omission takes place at the time of posting into ledger accounts, agreement of trial balance is disturbed as either debit or credit aspect of the transaction is ignored. For example, omission of credit purchase transaction at the time of recording in purchases book does not affect the agreement of trial balance, as posting to purchases book does not affect the
  • 113. agreement of trial balance, as posting to purchases amount and suppliers account is not done. However, omission at the time of posting to suppliers account affects the agreement of trial balance as posting to purchases account takes place.2. Errors of Commission : Besides omission at the time of recording or posting, business transactions are sometimes recorded and posted in a wrong manner. Such errors are referred to as errors of commission. These errors may or may not affect the agreement of trial balance. For example, 1 recording of wrong amount in subsidiary books, posting an amount to wrong account, etc. are two sided errors and do mot affect trial balance; However wrong totaling (or casting) of subsidiary books, posting on wrong side of an account, posting of wrong amount, wrong balancing of an account etc, are one sided errors and affect the agreement of trial balance.3. Compensating Errors: When two or more one sided errors take place in such a way that their effect is nullified, these are referred to as I compensating errors. For example, if Rs. 500 credit sales to Ramesh to posted to debit side of Rameshs account is omitted at the time of posting and Rs. 500 credit purchases from Naresh to be posted to credit side of Nareshs account is not posted to credit side of Nareshs account, these ? are termed as compensating errors. First error reduces debit side total by Rs. 500 and second error reduces credit side total by Rs. 500. As a result, trial balance agrees. Thus, compensating errors do not affect the agreement of trial balance. Errors of omission, commission and compensating errors are also termed as clerical errors4. Errors of Principle : Besides clerical errors, sometimes accounting principles are violated in accounting process. Errors
  • 114. involving violation of accounting principles are termed as e.rors of principle. Generally, these errors relate to distinction between capital and revenue items. Treatment of capital expenditure as revenue receipts or vice versa are errors of principle. For example, debiting purchase of furniture to office expenses account, crediting rent received from tenant to tenants account, crediting sale of furniture sales account, debiting payment of salaries to employees account etc. involve errors of principle. These error do not affect the agreement of trial balance.ERROR MANAGEMENTThe whole idea of error management can be executed in three steps,namely:-i. Prevention of errors,ii. Detection of errors, and(A) Prevention of ErrorsThe best way to manage the errors is to prevent them from occurringin the accounts prepared by the business concern. As is said,"Prevention is better than cure". It is the responsibility of themanagement to prevent errors. The management can prevent theerrors in the nature of fraud by exercising an effective internal controlsystem. It should also curb its own tendencies to window dress theaccounts in order to present their report card in a colourful manner. Itshould not allow the prejudice and bias to enter the accounts where itis avoidable.The errors other than fraud are caused by the following reasons:i) Ignorance on the part of employees of latest accountingdevelopments, generally accepted accounting principles, appropriate
  • 115. account classification of the necessary subsidiary ledgers withcontrolling accounts and of good accounting practices in general;ii) Carelessness on the part of those doing the accounting work.(B) Detection of ErrorsDespite the best of the efforts of the management, some errors maystill remain in the accounts. However, the rectification of error ispossible only when an error is detected. From the point of view ofdetection of errors, all errors can be broadly classified in twocategories: i) Errors which do not affect the agreement of the triafbalance. They are also called two sided errors or undisclosed errors. These errors take the form of complete omission, commission, principles or compensating errors. The errors are called undisclosed because one is net sure of their presence or absence. ii) Errors which effect the agreement of trial balance. They are also caiied one-sided errors or disclosed errors. These errors take the form of partial omission or commission errors. They are also called disclosed errors because one is sure of their existence due to disagreement of trial balance.Following procedure can be adopted to locate the errors which arethere is the trial balance:a) Recheck the totals of Dr. and Cr. Side of trial balance to establish undercasting and overcasrting on either side;
  • 116. b) Recheck the ledger balances as to their amount and nature (whether Dr. or Cr.) and ensure that they are posted on the right side of the trial balance;c) If still error is not located, divide the difference in trial balance by 2. If the amount of any account is same as computed number, recheck the nature of the account (whether Dr. and Cr.) and ensure it is posted on the right side of the trial balance;d) Divide the difference by 9. If it is completely divisible, the error probably may be an outcome of the transposition of the figure (e.g.. 95 written as 59). Although it may give some idea, the exercise has to be very thorough;e) If the difference is very big, the balance in various accounts should be compared with balances of me last year. If the difference is material, we have sufficient cause to examine the account in detail;f) If still the error is not locatable, recheck the totals of subsidiary books and ensure they are properly transferred;g) Recheck the schedules of debtors and creditors;h) Recomputed the account balances;i) If stil! the error is not detected, recheck all the entries in the genera! journal for any possible omission, commission, principle and self compensating errors.
  • 117. (C) Rectification of Errors Once error is detected, the need for its rectification arises. Therectification of error should always be done with the help of a journalentry and not by cutting, pasting or overwriting at the place of error.Rectification of error depends upon the type of error and the time ofits rectification. Accordingly, the topic of rectification of error can bebroadly discussed as under;Rectification of Two Sided Errors Two sided errors are rectified by passing a journal entry calledrectifying entry. Thus, rectification entries are entries passed tocorrect the errors committed and set right the accounting records.Rectification procedure is explained with the help of few examples asfollows:-1) Payment of rent of building Rs. 5,000 is debited to landlordsaccount.Entry Passed: Landlord Account Dr.5,000 To cash Account 5,000Entry Required: Rent Account Dr.5,000 To cash Account 5,000 To rectify, credit landlord account which was wrongly debitedand debit rent account which should have been debited. Thus,rectifying entry, is:
  • 118. Rent Account Dr. 5,000 To Landlord Account 5,0002) Cash purchase of goods worth Rs. 5,000 from M/s PrashantFurniture is debited to furniture accountEntry Passed: Furniture Account Dr.5,000 To cash Account 5,000Entry Required: Purchases Account Dr.5,000 To cash Account 5,000 To rectify, credit furniture account which was wrongly debitedand debit purchases account which should have been debited. Thus,rectifying entry is:Purchase Account Dr. 5,000 To Furniture Account 5,0003) Rs. 5,000 received from Ramesh is wrongly credited to NareshAccount.Entry Passed: Cash Account Dr.5,000 To Naresh Account 5,000
  • 119. Entry Required: Cash Account Dr.5,000 To Ramesh Account 5,000 To rectify, debit Nareshs account which was wrongly creditedand credit Rameshs account not creditei earlier. Thus, rectifying entryis: Naresh Account Dr. 5,000 To Ramesh Account 5,0004) Rs. 5,000 goods purchased on credit from Mr. Anil wrongly postedto the debit side of Anils account and purchases book total Rs.25,000 posted to debit side of purchases account as Rs. 15,000.As Anils account is wrongly debited by Rs. 5,000 instead of creditinghis account by Rs. 5,000 to correct Anils account Rs. 10,000 shouldbe credited to Anils account. Since purchases account is debited byRs. 35,000 instead of Rs. 25,000 therefore, purchases account isdebited by Rs. 10,000. Thux. rectifying entry is: Purchase Account Dr. 10,000 To Anil Account 10,0005) A sale of Rs. 10,000 to Subash is entered in the sales books as Rs.1,000. It means sales account is credited by Rs. 9,000 less andSubhashs account is debited by Rs. 9,000 less. Therefore, reclijyingentry is:
  • 120. Subhash Account Dr. 9,000 To Sales Account 9,000Rectification of One-Sided Errors Errors which affect the agreement of the trial balance aretermed as onesided errors. Undercasting (totaled less) of subsidiarybooks, overcastting (excess total) of subsidiary books, omission ofposting to an account, posting of wrong amount to an account,posting on wrong side of an account-etc., are some of the errors whichaffect the agreement of trial balance. If .one-sided errors are locatedbefore the preparation of trial balance, error is corrected by enteringthe amount in affected account. For example, if total credit sales areRs. 10,000 but sales book is wrongly totaled as Rs. 9,500 error isrectified as follows:Dr. Sales Account Cr. By sundries as per sales books 9,500 By undercasting of sales book 500Rectification of One-Sided Errors after the Preparation of TrialBalance In case of disagreement of trial balance, efforts are made tolocate errors, and rectify them as discussed above. However, ifreason for disagreement of trial balance can not be found, a new account called SUSPENSEACCOUNT is opened. Difference in trial balance is recorded is
  • 121. suspense account so that the trial balance agrees and the process ofpreparation of financial statement can can start. In trial balance, if debit total is more than credit total, thesuspense account is credited Similarly, if credit total is more thandebit total, suspense^account is debited,Journal entries for one-sided errors through suspense account: Difference in trial balance which is caused by one-sided errorsis put in suspense account. After opening of suspense account if someerrors are located, a .journal entry is passed to rectify them.Rectification of one-sided errors involves either debit or credit to theaccount to be rectified. To complete the double entry, second aspect isrecorded with the help of suspense account.-Difference in trialbalance transferred to suspense account is recorded as openingbalance of suspense account. After location and rectification of allerrors suspense account is automatically closed. Journal entries required to rectify the one-sided errors given inillustration 6 are as follows:1) Purchases book has been totaled Rs. 500 less (undercasting): Itmeans at he time of posting to purchases account, it has been debitedby Rs. 500 less. To correct it, purchases account should be debited byRs. 500 To complete double entry, second aspect is recorded throughsuspense account. The rectification entry appears as follows: Purchase Account Dr. 500 To Suspense Account 500
  • 122. 2) Sales book has been totaled Rs. 1,000 more (ovcrcastting) : Itmeans ut the time of posting of sales book to sales account. Rs. 1,000excess amoum has been credited. To correct the records, salesaccount should be debited by Rs. 1,000. To complete double entry,suspense account is credited. The rectification entry is as under: Sales Account Dr. 1,000 To Suspense Account 1,0003) Rs. 1,000 cash received from X has not heen posted to hisaccount : This amount should have been posted to credit side of Xaccount. To rectify the mistake of non-posting, Xs account should becredited by Rs. 1,000- To complete double entry, suspense account isdebited by the same account. The journal entry required to rectify theerror is as under; Suspense Account Dr. 1,000 To X 1,0004) Sales return from V Rs. 700 has been posted to Ys account asRs. 70 :Rs. 700 should have been credited to Ys account. As the amountactually credited is just Rs. 70, Rs. 630 more should be credited to Ysaccount. To complete double entry, suspense accouni is debited byRs. 630 as follows: Suspense Account Dr. 630 To YA/c 630
  • 123. 5) Rs. 4,000 cash paid to a creditor has been posted to the credit sideof creditors account: Rs. 4,000 cash paid to a creditor should havebeen debited To creditor account but ft is actually credited to creditorsaccount. To have correct balance in creditors account Rs. 8,000should be debited to creditors accounf. Debiting of double amount i.e.,Rs. 8,000 nullfiles the effect of wrong credit of Rs. 4,000 and ensurescorrect debit of Rs. 4,000. The journal entry | passed for this is asfollows: Creditors Account Dr. 3,000 To Suspense Account 8,000Above entries are posted to suspense account as follows;Dr Suspense Account Cr. To Difference in 7,870 By Purchase A/c 500 trial balance By Sales A/c 1,000 (balancing figure) By Creditors 8,000 To X 1,000 To Y 630 After rectification of all the errors, suspense account mustbalance. In this case after posting of rectification entries to suspenseaccount, one finds the debit side is short by Rs 7 870 This balancingfigure m suspense account as taken as the opening balance ofsuspense account, being the difference in tnal balance transferred tosuspense account.Errors and Profit : Errors will effect profit only when nominalaccounts recorded in income statement are affected. Effect of
  • 124. abovementioned errors and their effect on profit is explained asfollows: a) Wrong credit to sales account increase reported profit by Rs. 70,000. Correct profit can be calculated by rectification of this error. Rectification reduces sales account balance and thus, profit by Rs. 70,000. b) Wrong debit to wages account reduces reported profit by Rs. 1,000. To calculate correct profit rectification entry is passed. It ^uces wages account balance by Rs. 1,000 and thus, increases profit by Ri. 1,000. c) Non-posting of discount received balance reduces reported; profit by Rs 2,500 and thus, increase profit figures by Rs. 2,500 to report-correct profit figure, - d) Non-oostine of totalsales return increases net sales by Rs. 12,000. It by Rs. 12,000. Rectification ;of this error reduces net sales by Rs. 32,000 and thus profit after rectification is reduced by Rs 12,000 to report correct profit, e) It does not affect any nominal account and, thus has no effect on profit. It has not effect on profit as no nominal account is affected. :Effect on profit Errors (a), (b), (c) and (d) do not affect nominal accounts andtherefore, have no effect on profits. Error (e) affects nominal accounts. This error increases officesexpenses reduces the amount of purchases. As a result, gross profit isincreased and is nduced by the same amount. Therefore, this error
  • 125. has no effect on net profit figure. Rectification of this error reducesgross profit and increases net profit by the same amount. Error (f) reduces rent account balance by Rs. 2,000 and thusincreases net profit by Rs. 2,000 . Rectification of this error reducesnet profit figure by Rs. 2,000 to report correct net profit figure.Rectification of Errors after Finalisation of Accounts or inthe nextaccounting period The management should make every conceivable effort toprevent occurrence of the errors in the accounts. However, if still someerrors creep in the accounts, they should be detected and rectifiedbefore the flnalisation of accounts. But if despite the best of theirefforts the management is not able to trace the errors, the differenceshould be put to the Suspense A/c and accounts finalized. Thesuspense account should be shown in the balance sheet til! such timeitscauses are ascertained. In the next accounting period, the rectification should be doneas and when tfye error is detected. However, the method ofrectification will depend upon whether the account affected is anominal account or any other account. If the account affected is otherthan nominal, the rectification is done in the usual manner, Forexample, the amount received from X inadvertently recorded in Ysaccount and left untraced last year will be rectified in the current yearby debiting X and crediting Y. Had this error been traced last yearitself, the same rectification entry would have followed. However, if the error involves a nominal account having itsimpact on the profit, the rectification is done in a different manner.For example, if last year (he sales be jk was undercast by Rs. 10,000,it would have led to a suspense account with a credit balance of Rs.
  • 126. 10,000 in the trial balance. If the error was to be detected last yearbefore the fmalisation of accounts, the rectification entry would havebeen ; Suspense Account Dr. 10,000 To Sales Account 10,000 However if the error is detected in the current year after thefinalisation of accounts, the same rectification entry will ensure thatthe current year sales is unnecessarily inflated by Rs. 10,000. The lastyear profit was under reported by Rs. 10,000 and the current yearprofit will be over reported by the same amount.The errors of these kind should be correct as "Prior Period Items orthrough Profit and Loss Adjustment Account and shown in thecurrent year profit and loss account as prior period items as per therequirement of AS-5 (Revised). As per AS-5, Prior period items areincome or expenses which arise in the current period as a result oferrors omissions in the preparation of the financial statements of theone or more prior periods. It is recommended that the impact of theprior period items be shown separately in the profit and loss accountof the current accounting period.Hence, the entry for this aspect will be: Suspense Account Dr 10,000 To Profit & toss Adjustment Account 10,000 The profit and loss adjustment account is closed by transfer tothe current year profit and loss account as a prior period item. Hence,the profit of current year clearly reflects the effect of the errors of thepast period.
  • 127. A close look at the following examples will make more clear themechanism of rectification (a) if its is done in the same accountingperiod; and (b) if it is done in the next accounting period;i) Purchase book is undercast by Rs. 5,000:Rectification entry ij it is done in the accounting period of the error Purchase Account Dr. 5,000 To Suspense Account 5,000Rectification entry if it is done in the next accounting period, Profit & Loss Adjustment Account Dr. 5,000 To Suspense Account 5,000ii) Rent paid of Rs. 2,000 debited to landlord account and included inthe list ofdebtors:Rectification entry if it is done in the accounting period of the error itself Rent Account Dr. 2,000 To Debtors Account 2,000Rectification entry if it is done in the next accounting period Profit & Loss Adjustment Account Dr. 2,000 To Debtors Account 2,000
  • 128. iii) Private purchases of Rs. 1,000 passed through purchase account:Rectification entry if it is done in the accounting period of the error itself Drawings Account Dr. 1,000 To Purchase Account 1,000Rectification entry if it is done in the next accounting period. Drawings Account Dr. 1,000 Profit & Loss Adjustment Account 1,000iv) Cash received of Rs. 4,000 from X shown on the debit of Ysaccount: Rectification entry if if is done in the accounting period of theerror itself. Suspense Account Dr. 8,000 To X Account 4,000To Y Account 4,000 Rectification entry if if is done in the nextaccounting period. Suspense Account Dr. 8,000 To X Account 4,000 To V Account 4,600Note that the entry is same in both the cases. The basic reason isjthat the account affected is not a nominal account.
  • 129. Illustration 1; A book keeper while preparing his trial balance finds that thedebit exceeds by Rs. 7,250. Being required to prepare the finalaccount he places the difference to a suspense account. In the nextyear the following mistakes were discovered: a) A sale of Rs. 4,000 has been passed through the purchase day book. The entry in the customers account has been correctly recorded; b) Goods worth Rs. 2,500 taken away by the proprietor for his use has been debited to repairs account; c) A bill receivable for Rs. 1,300 received from Krishna has been dishonoured on maturity but no entry passed; : d) Salary of Rs. 650 paid to a clerk has been debited to his personal account; e) A purchase of Rs. 750 from Raghubir has been debited to his account. Purchase account has been correctly debited; f) A sum of Rs. 2,250 written off as depreciation on furniture has not been debited to depreciation account.Draft the joyrnal entries for rectifying the above mistakes and preparethe suspense account and profit and loss adjustment account, Journal a) Suspense A/c Dr. 8,000 To Profit & Loss Adjustment A/c 8,000 (Being wrong recording of sales as purchase last year rectified)
  • 130. b) Drawings A/c Dr. 2,500 To Profit & Loss Adjustment A/c 2,500 (Being Drawings made last year inadvertently shown as repairs now rectified)c) Krishna A/c Dr. 1,300 To Bills Receivable A/c 1,300 (Being bill dishonoured last year now recorded in the books)d) To Profit & Loss Adjustment A/c Dr. 650 To Clerks Personal A/c 650 (Being salary paid to clerk last year inadvertently shown in his personal account now rectified)e) Suspense A/c Dr. 1,500 To Raghubir A/c 1,500 (Being purchase from Raghubir) shown on debit side of his account inadvertently now rectified)f) Profit & Loss Adjustment A/c Dr. 1,500 To Suspense A/c 1,500 (Being depreciation not shown last year now rectified)Dr. Suspense Account
  • 131. Cr.To Profit & Loss 8,000 By balance b/d 7,250Adjustment A/cTo Raghubir A/c 1,500 By Profit & Loss 2,250 Adjustment A/c 9,500 9,500Dr. Profit & Loss Adjustment AccountCr.To Clerks Persona] 650 By Suspense A/c 8,000A/cTo suspense A/c 2,250 By Drawings A/c 2,500To Profit & Loss 7,600Adjustment A/c(Transfer) 10,500 10,500
  • 132. LESSON - 8 ACCOUNTS FROM INCOMPLETE RECORDS-SINGLE ENTRY SYSTEMSALIENT FEATURESa) Incomplete Double Entry System : Dual aspect of a transaction is not recorded under this system. Recording is done according to convenience and information needs of the business. As information needs of business entities are governed by size of business, nature of Business, prevailing circumstances etc., the procedure of recording followed by different business entities may vary. Therefc -e, there is no uniformity in maintenance of records under single entry system.b) Flexibility : Single entry system is flexible as recording procedure can be adjusted according to the information needs of a particular business enterprise. As rules of double entry system are not followed, knowledge of principles of double entry system of book-keeping is not necessary.c) Variation of Recording Process : Single entry system is incomplete double entry system, varying according to information needs of business entities. There is no hard and fast rule for maintenance of records under this system. But, generally, cash book and personal accounts are maintained under this system.d) Importance of Source Document: As complete recording is not done urder single entry system, source document like sales bills, purchase bills, vouchers etc., play very important role in
  • 133. collection of necessary information, for finding out profit (or loss) and preparing financial position statement.c) Less Expensive: As complete records are not kept, time and labou; involved in maintaining accounting records is less in comparison to double entry system.d) Suitability : Use of single entry system is not permitted in case of corporate entities. It is generally followed by non-corporate entities of small size.Limitations of Single Entry System. Single entry system hasfollowing limitations;a) Unscientific : There are no set rules for maintaining records under such system. Absence of systematic recording of both aspects of a transaction under single entry system makes it unscientific.b) No trial balance : Dual aspect of a transaction is not recorded under this system. As a result, trial balance can not be prepared from accounting records maintained. Hence, arithmetical accuracy of accounting records can not be checked.c) Determination of true profit (or loss) not possible : Nominal accounts are not maintained and, therefore, it is not possible to prepare trading account and profit and loss account to calculate gross profit and net profit respectively. Although the amount of net profit is determinable but the absence of details of revenue, other incomes, expenses and losses affect sound decision making.d) True financial position cannot be determined: Absence of real accounts makes the job of preparation of balance sheet a
  • 134. very difficult one. As information about assets is not available from records, these items are estimated. Statement listing assets and liabilities in this case is called Statement of Affairs instead of Balance sheet. Statement of affairs fails to reveal the true financial position of the business.e) More chances of errors and frauds : Trial balance cannot be prepared to check prima facie arithmetical accuracy of accounts. It encourages carelessness, misappropriations and frauds because, in the absence of comolete records, detection of errors and frauds is very difficult.f) Unsuitable for planning and control : In the absence of reliable information about nominal and real account, effective planning and control over expenses, assets etc., is not possible. :g) Legally not recognised : According to the Indian Companies Act, 1956, single entry system cannot be employed by companies. Moreover, accounts maintained on single entry are not accepted by sales tax and income tax authorities.h) Inter- firm Comparisons not possible : Because of variation in. accounting procedure and rules, comparisons of two or more businesses is not possible. Inspite of the above limitations, an accountant is requiredto ascertain profit, (or loss) and prepare financial position statementat accounting date. Methods followed for this are a follows:a) Statement of Affairs Method or Pure Single-Entry System.b) Conversion Method or Quasi Single-Entry System.
  • 135. Statement of Affairs Method Under statement of affairs method, statement of affairs isprepared in the beginning and the end of the year to calculate capitalin the beginning and the end of the year respectively. Statement ofaffairs lists assets on right hand side, liabilities on the left hand sideand the excess of assets over liabilities is assumed to be capital andrecorded on left hand side so that total assets are equal to liabilities isassumed to be capital and recorded on left hand side so thatinformation about assets and liabilities plus capital. It must beremembered that complete information about assets and liabilities isnot available from accounting records and some of these assets andliabilities are estimated. Proforma of a Statement of Affairs is asfollows; Statement of Affairs as on... Liabilities Amount Assets Amount Creditors Cash Bills payable Bank Outstanding Debtors expenses Unearned income Bills receivable Loans Stock Capital (Balancing Prepaid expenses figure) Accrued income Fixed assetsDistinction Between Statement of Affairs and Balance Sheet :Following are the points of difference between a statement of affairsand a balance shed.a) Balance shees records balances of assets, liabilities and capital drawn from the ledger books. Statement of Affairs contains information either drawn from accounting records (if records are maintained) or bases on estimates (if records are not
  • 136. maintained). Therefore, information contained in balance sheet is more reliable as compared to information contained in the statement of Affairs.b) Balance sheet contains information about capital as per accounting records In statement of affairs capital is taken as balancing figure, being the difference between lotal assets and total liabilities.c) Balance sheet lists balances of assets, liabilities and capital .drawn from accounting records based on double entry system. If an asset or liability is omitted, balance sheet does not tally. Then, error is detected and corrected. However, in case of statement of affairs, omission of an asset or liability goes unnoticed because capital is taken as balancing figure.d) Balance sheet is prepared to show financial position of the business as per accounting records. Statement of affairs, on the other hand, is prepared to calculate capital at a particular point of time.Calculation of Profit (or loss): To calculated profit or oss followingsteps arerequired:a) To find out capital in the beginning of the year (called opening capital) prepare statement of affairs at the beginning of the year.b) To calculate capital at the end of the year (called closing capital) statement of affairs at the end of the year is prepared.c) After calculating opening capital and closing capital, capita] introduced and drawings made during the year are adjusted to
  • 137. find out profit (or loss) for the year by using the following relationship.Opening Capital + Additional Capital – Drawings + Profits **ClosingCapitalOrProfit = Closing Capital - Additional Capital + Drawings - OpeningCapitalCalculation of profit or loss is shown in the form of a statement asfollows: Statement of Profit (or loss) for the period ending.... Amount Capital at the end Add: drawings Less: additional capital introduced during the year Less: capital in the beginning of the year Profit (or loss) for the yearAdjustment to be made: Sometimes certain adjustments are given inthe question. These adjustments may relate to interest on capital,interest on drawings, depreciation on fixed assets, provi^ons fordoubtful debts etc., In this case statement of affairs, prepared tocalculate capital on the date of statement, records assets andliabilities before any adjustment.Profit as shown by statement of profit in this case is not net.profitearned duringthe year.Profit as shown by statement cf profit isadjusted to calculate netprofit asfollows:
  • 138. Profit and Lots Account /or the year ending..... To Depreciation on Fixed Asset By Profit before adjustment as shown in the statement of profit To Provision for Doubtful By Interest on Drawing Debts To Interest on Capital To Net Profit transferred to Capital AccountConversion Method Accounts maintained under single entry system are notsufficient to extract trial balance at the end of the accounting period.As a result, final accounts or financial statements cannot be preparedfrom incomplete records unless steps are taken for their completion.Under conversion method, cash accountant, debtors account,creditors account etc., maintained on single entry basis are analysedand an attempt is made to complete double entry by makingnecessary posting is done. After completing records on the basis ofdouble entry system or preparation of final accounts from incompleterecords. In actual practice, conversion involves completion of ledgerbooks, preparation of a trial balance and, then financial statements. ;However, for solving examination problems, above mentionedprocedure of conversion and the absence of detailed information in thequestion. To solve examination problems significant informationrequired for completion of trading account, profit and loss accountand balance sheet is calculated from whatever information is given inthe question. After calculating significant information missing in thequestions, final accounts are prepared as usual.To calculate missing figures, the following steps are recommended:
  • 139. a) Prepare statement of affairs in the beginning of the year.b) Prepare cash book or cash account.c) Prepare total debtors account and bills receivable account.d) Prepare final accounts. : Whatever information is given in the question, record that inaccounts) involved. Knowledge about items usually appearing in theseaccounts gives an idea about information missing in the question.Then an attempt is made to calculate missing information by usingrules of double entry system, Proforma of Total Debtors Account, Total Creditors Account,Bills Receivable Account and Bills Payable Account is given below tohave an idea about the items isuaily appearing in these accounts.Dr. Total Debtors A/cCr. To balance b/d By Cash or Bank A/c (Debtor in the beginning) (Amount received from debtors) To Sales A/c To Bills receivable A/c (Credit sales) (Bills drawn on debtors) To Bills receivable A/c By Sales Return A/c (Bill dishonoured) By Discount Allowed A/c By Bad Debts A/c By balance c/d (Debtors at the end of the year)Dr. Bills Receivable A/cCr. To balance b/d By Cash A/c & Discount A/c (Balance in the beginning) (for B/R Discount) To Debtors A/c By Creditors A/c
  • 140. (Bills drawn during the year) (B/R endorsed to creditors) By Cash A/c (B/R encashed on due date) By Debtors A/c (B/R dishonoured) By balance c/d (B/R at the end)Dr. Total Creditors A/cCr. To Cash A/c or Bank A/c By balance b/d (Amount paid to creditors) (Creditors in the beginning) To Bills Receivable A/c By purchases A/c (for B/R endorsed) (Credit purchases) To Bills Payable A/c By Bills payable A/c (Bills accepted) (Bills payable dishonoued) To Purchases Return A/c To Discount Received A/c To balance c/d (Creditors at the end)Dr. Bills Payable A/cCr. To Cash A/c By balance b/d (B/P paid on due dates) (B/P in the beginning) To Creditors A/c By Creditors A/c (B/P dishonoured) (Bills accepted during the year) To balance c/d (B/P at the end)Gross Profit Ratio: Sometimes, gross profit ratio (i.e. Gross profit /Net sales x 100) is given in the question. In that, case, the amount ofgross profit figure in trading account, calculation of missinginformation about any one of the items recorded in trading accountcan take place. Items recorded in trading account are opening stock,purchases, direct expenses and closing stock.
  • 141. Illustration 1: Find out the amount of direct expenses from thefollowingdetails: Rs. Stock on 1-4-98 17,000 Stock on 31-3-999 12,000 Purchases during 1998-99 000 Sales during 1998-99 1,28,000 Gross profit ratio 25%Dr. Trading Account for the year ended March 31, 1999 Cr. To Opening Stock 17,000 By Sales 1,28,000 To Purchases 77,000 By Closing Stock 12,000 To Direct Expenses 14,000 (Balancing figure) To Gross Profit (25% of Rs. 1,28,000) 1,40,000 1,40,000Illustration 2:Data Ram maintains his records on single entry system. Whilerecords of. business takings and payments have been kept, these havenot been reconciled with cash in hand. From time to time cash hasbeen paid into a bank account and cheques thereon have been drawnboth for business use and private purposes. From the followinginformation, prepare the final accounts for the year 1998:Assets and liabilities at the beginning and at the end of the periodhave given below: 1-1-1998 31-12-1998 Stock 20,000 15,000 Bank Balance 8,000 12,000 Cash in hand 300 400
  • 142. Debtors 14,000 20,000Creditors 27,300 30,000Investments 50,000 50,000Other transactions are as follows:Cash paid in bank 1,50,000Private dividends paid into bank 59,700Private payments out of bank 26,000Business payments for goods out of bank 1,22,000Cash takings 2,50,000Payment for goods by cash and cheque 1,60,000Wages 97,700Delivery Expenses 7,000Rent and rates 2,000Lighting 1,000General Expenses 4,600 During the year, cash amounting to Rs. 20,000 was stolen fromthe till, ucods worth Rs. 24,000 were withdrawn from private use. Norecord has been kept of amounts taken from cash for personal useand a difference in cahs amounting to Rs. 7,300 is treated as privateexpenses.Dr. Cash A/c Cr. To balance b/d 300 By Defalcation 20,000 To Sales A/c 2,50,000 By Bank A/c 1,50,000 To Debtors A/c 1,42,000 By Drawings A/c 7,300 (balancing figure) By Purchases A/c 1,02,300 (1,600,000-57,700) By Wages A/c 97,700 By Delivery Expenses 7,000 A/c By Rent& Rates A/c 2,000 By Lighting A/c 1,000 By General Exp. A/c 4,600 By balance c/d 400 3,92,300 3,92,300
  • 143. Dr. Bank A/c Cr. To balance b/d 8,000 By drawings A/c 26,000 To Cash A/c 1,50,000 By Business Payment 1,22,000 A/c To Capital A/c 59,700 By Purcahse A/c 57,700 (Dividend) (balancing figure) By balance c/d 12,000 2,17,000 2,17,000Dr. Sundry Debtors A/c Cr. To balance b/d 14,000 By Cash A/c 1,42,000 To Sales A/c (balancing By balance c/d 20,000 figure) 1,62,00 1,62,000 0Dr. Sundry Creditors Cr. To balance c/d 30,000 By balance b/d 27,300 By Purchases A/c (balancing 2,700 figure) 30,000 30,000
  • 144. Balance Sheet as at 1-1-98 Liabilities Amount Assets AmountCreditors 27,300 Stock 20,000Capital (Balancing figure) 65,000 Bank 8,000 Cash 300 Debtors 14,000 Investments 50,000 92,300 92,300 Trading & Profit & Loss A/c for the year ended 31-12-98To Opening Stock 20,000 By Sales :A/cTo Wages 97,700 Cash 2,50,000To Purchaes : Credit 1,48,000Cash 1,60,000 By closing Stock 15,000 A/cCredit 2,700 1,62,000Less Drawings 24,000 1,38,700To Gross Profit 1,56,600 4,13,000 4,13,000To Business Payment 1,22,000 By Gross Profit 1,56,600A/cTo Rent & Rates A/c 2,000To Lighting A/c 1,000To General Expenses 4,600A/cTo delivery Expenses A/c 7,000To Defalcation A/c 20,000 1,56,60 1,56,600 0 Balance Sheet as at 31-12-98
  • 145. Liabilities Amount Assets Amount Opening Capital 65,000 Investment 50,000 Add: Additional Capital 59,700 Stock 15,000 1,24,700 Debtors 20,000 Less: Drawings 57,300 (7,300+26,000+24,000 67,400 Bank 12,000 ) Creditors 30,000 Cash 400 97,400 97,400Difference between Double Entry system and Single Entry System Of difference between double u"Hry system aj)d single entrysystem of book keeping.a) Dual-Aspect : Under double ciury syrricrti bolh aspects of al! business transactions are rcco:tie. Under single entry system both aspects of all business transactions are not recorded.b) Trial Balance: Under double entry system trial balance can be prepared to check the arithmetical accuracy of accounts. Under single entry sysuai trial balance cannot be prepared because duaI-aspect of ail transactions are not recorded.c) Type of Accounts: Under double entry system nominal, persona! and real accounts are maintained. Under single entry system, generally, personal accounts and cash books is maintained.d) Rules of Recording : Under double entry system, rules of double entry system are followed by all concerns. Under single entry system, as the system is adjusted according to convenience and needs of the business, rules followed for recording vary from concern to concern.
  • 146. c) Cost : As complete records ore kept under double entry system, cost of maintaining records is more in comparison to single entry system.d) Legal Recognition : Corporate entities cannot follow single entry system as it goes against the provisions of the Indian Companies Act, 1956. Even sales tax and income tax authorities do not recognise single entry system.g) Details of Net Profit (or Loss) : Under double entry system details of expenses, revenue and incomes are available because of maintenance of normal accounts. Under single entry system, though net profit (or loss) is calculated, but details of expenses revenue and incomes are not available.h) Financial position : Under double entry system, financialposition statement reveals trne financial position based on accounting, records. Under single entry system, statement of affairs based on incomplete records and estimates is prepared to reveal financial position of he business.i) Errors and Frauds : Non-preparation of trial balance due to incomplete recording under single entry system encourages carelessness, misappropriations and frauds. Fear of detection of errors and frauds under double entry system reduces chances of errors and frauds. j) Inter-firm Comparisons : Comparison of two or more business, concern is possible under double entry system because same set of rules are followed by all concerns. Inter-firm comparisons under single entry are not valid because of variation in rules of recording.
  • 147. k) Reliability : Absence of systematic recording on the basis of double entry rules makes information available under single entry system less reliable as compared to information available under double entry system.l) Suitable : Double entry system is suitable for all types of business. IS> enTry system suits only small non-corporate enuues.
  • 148. LESSON - 9 FINANCIAL STATEMENT ANALYSISMEANING OF FINANCIAL STATEMENTS According to Himpton John, "A financial statement is anorganized collection of data according to logical and consistentaccounting procedures. Its purpose is to convey an understanding ofsome financial aspects of a business firm. It may show assets positionat a moment of time as in the case of a balance sheet, or may reveal aseries of activities over a given period of limes, as in the case of anincome statement ". On the basis of the information provided in the financialstatements, management makes a review of the progress of thecompany and decides the future course of action.DIFFERENT TYPES OF FINANCIAL STATEMENTS 1. Income Statement 2. Balance Sheet 3. Statement of Retained earnings 4. Funds flow statement 5. Cash flow statement. 6. Schedules.FUNDAMENTAL CONCEPTS OF ACCOUNTING 1. Going concern concept 2. Matching concept ( Accruals concept) 3. Consistency concept 4. Prudence concept ( conservation concept)
  • 149. 5. Business entity concept 6. Stable monetary unit concept 7 Money measurement concept 7. Objectivity concept 8. Materiality concept 9. Realization concept.LIMITATIONS OF FINANCIAL STATEMENTS1. In profit and loss account net profit is ascertained on the basisof historical costs.2. Profit arrived at by the profit and loss account is of interim nature. Actual profit can be ascertained only after the firm achieves the maximum capacity.3. The net income disclosed by the profit and toss account is not absolute but only relative.4. The net income is the result of personal judgment and bias of accountants cannot be removed in the matters of depreciation, stock valuation, etc.,5. The profit and loss account does not disclose factors like quality of product, efficiency of the management etc.,6. There are certain assets and liabilities which are not disclosed by the balance sheet. For example the most tangible asset of a company is its management force and a dissatisfied labour force is its liability which are not disclosed by the balance sheet.
  • 150. 7. The book value of assets is shown as original cost less depreciation. But in practice, the value of the assets may differ depending upon the technological and economic changes.8. The assets are valued in a Balance sheet on a going concern basis. Some of the assets may not relate their value on winding up.9. The accounting year may be fixed to show a favorable picture of the business. In case of Sugar Industry the Balance sheet prepared in off season depicts a better liquidity position than in the crushing season.10. Analysis Investor likes to analyse the present and future prospectus of the business while the balance sheet shows past position. As such the use of a balance sheet is only limited.11. Due to flexibility of accounting principles, certain liabilities like provision for gratuity etc. are not shown in the balance sheet giving the outsiders a misleading picture.12. The financial statements are generally prepared from the point of view of shareholders and their use is limited in decfsion making by the management, investors and creditors.13. Even the audited financial statements does not provide complete accuracy.14. Financial statements do not disclose the changes in managernent, Loss of markets, etc. which have a vital impact on the profitability of the concern.
  • 151. 15. The financial statements are based on accounting policies which vary form company to company and as such cannot be formed as a reliable basis of judgment.FORMATS OF FINANCIAL STATEMENTS The two main financial statements, viz the Income Statementand the Balance sheet, can either be presented in the horizontal formor the vertical form where statutory provisions are applicable, thestatement has to be prepared in accordance with such provisions.Income Statement : There is no legal format for the profit and loss A/C. Therefore, itcan be presented in the traditional T form, or vertically, in statementform. An example of the two formats is given as under.(i) Horizontal, or “T” form: Manufacturing, Trading and profit and loss A/C of………........... for the year ending .........................Dr Cr Particulars Rs. Particualrs Rs.To opening stock By cost of finished Goods Xxxx c/d Raw materials xxx By closing stock Work in progress xxx Raw materials xxx Work in progress xxxTo purchases of raw xxxmaterialsTo manufacturing wages xxxTo carriage inwards xxxTo other Factory Expenses xxx xxx xxx By sales xxxTo opening stock of xxx By closing stock of xxx
  • 152. finished finishedgoods goodsTo cost of Finished goods xxx By Gross Loss c/d xxxb/dTo Gross Profit c/d xxx xxx xxxTo Gross Loss b/d xxx By Gross profit b/d xxxTo office and Admn. xxx By Miscellaneous Receipts xxxExpenseTo Interest and financial xxx By Net Loss c/d xxxexpensesTo provision for Income-tax xxxTo Net Profit c/d xxx xxx xxxTo net loss b/d xxx By Balance b/d xxxTo general reserve xxx (from previous year)To Dividend xxx By Net profit b/d xxxTo Balance c/f xxx xxx xxx(ii) Vertical Form Income statement of ………… for the year ending ……………... Particulars Rs. Rs.Sales xxxxLess: Sales Returns xxx Sales Tax/ Exise Duty xxx xxxxNet sales (1) xxxxCost of Goods SoldMaterials Consumed xxxxDirect Labour xxxxManufacturing Expenses xxxxAdd / less Adjustment for change in stock xxxx (2) xxxxGross Profit (1) – (2) xxxLess: Operating Expenses Office and Administration Expenses Selling and Distribution Expenses xxx xxx xxx Operating Profit XxxxAdd: Non-operating Income XxxLess: Non-oprating Expenses (including Interest) xxxx
  • 153. Profit before Tax xxx xxxx Less : Tax xxx Profit After Tax xxxx Appropriations Transfer to reserves Dividend declared /paid xxxx Surplus carried to Balance sheet xxx xxx xxxx Balance Sheet The Companies Activities, 1956 stipulates that the Balance sheet of a joint stock company should be prepared as per part I of schedule VI of the Activities. However, the statement form has been emphasized upon by accountants for the purpose of analysis and Interpretation. The permission of the Centra! Government is necessary for adoption of the statement* form. (i) Horizontal Form Balance sheet of .................... as on .................... Liabilities Rs. Assets Rs.Share Capital xxx Fixed Assets:(with all paticulars of 1. Goodwill xxxAuthorized, Issued, 2. Land & Building xxxSubscribed capital) Called xxx 3. Leasehold property xxxup capital 4. Plant and Machinery xxx 5. Furniture and Fittings xxxLess: Calls in Arrears xxx 6. Patents and Trademarks xxxAdd: Forfeited Shares xxx 7. Vehicles xxxReserves and Surplus : Investments1. Capital Reserve xxx Current Assets, loans and2. Capital Redemption Advancesreserve xxx (A) Current Assets3. Share premium xxx 1. Interest accured on4. Other premium xxx Investments xxxLess: debit balance of Profit xxx 2. Loose tools xxxand loss A/C (if any) 3. Stock in trade xxx5. Profit and Loss xxx 4. Sundry Debtors xxx
  • 154. Appropriation A/C Less: Provision for doubtful6. Sinking Fund xxx debts 5. cash in hand xxx 6. cash in Bank xxxSecured Loans (B) Loans and Advances Debentures xxx 7. Advances to subsidiaries xxxAdd: Outstanding Interest xxx 8. Bills Receivable xxxLoans from Banks xxx 9. Prepaid Expenses xxxUnsecured Loans Miscellaneous Expenditure (to the extent not written off or Fixed Deposits xxx adjusted) xxxShort-term loans and xxxadvancesCurrent Liabilities and 1. Preliminary expenses xxxProvisions 2. Discount on Issue of xxx shares and debenturesA. Current Liabilites 3. Underwriting Commssion xxx1. Bills Payable xxx2. Sudnry Creditors xxx Profit and Loss account (Loss),3. Income received in xxx if anyadvance4. unclaimed Dividends xxx5. Other Liabilities xxxB. Provisions6. Provisions for Taxation xxx7. Proposed Dividends xxx8. Proposed funds & xxxpensionfund contingent liabilitiesnotProvided for xxx xxx
  • 155. (ii) Vertical Form: Balance sheet of ………………………. as on …………………Particulars Schedule No. Current Previous year YearI. Source of funds1. Share holders funds a. capital xxxx xxxx b. Reserves and surplus xxxx xxxx2. Loans funds a. Secured Loans xxxx xxxx b. Unsecured Loans xxxx xxxx TotalII. Application of funds1. Fixed Assets a. Gross Block xxxx xxxx b. less Deprciation xxxx xxxx c. Net block xxxx xxxx d. Capital work in progress xxxx xxxx2. Investments xxxx xxxx3. Current Assets, Loans and Advances a. Inventions xxxx xxxx b. Sundry Debtors xxxx xxxx c. Cash and Bank balance xxxx xxxx d. other current assets xxxx xxxx e. Loans and Advances xxxx xxxxLess : current Liabilities and Provisions a. Current Laibilities xxxx xxxx b. Provisions xxxx xxxx xxxx xxxxNet Current Assets4. a. Miscellaneuos Expenditure to xxxx xxxxthe extent not written off or adjusted b. Profit and Loss Account (debit) xxxx xxxx Total xxxx xxxx
  • 156. (ii) Vertical Form for analysis Balance sheet of ……… as on …………….. Particulars Rs.ASSETSCurrent Assets Cash and Bank Balances xxxx Debtors xxxx Stock xxxx Other Current Assets xxxx (1) xxxxFixed Assets xxxxLess: Depreciation xxxxInvestments xxxx (2) xxxx Total (1) + (2) xxxxxLIABILITIESCurrent Liabilities : Bills Payable xxxx Creditors Other Current Liabilities (3) xxxxLong Term Debt Debentures xxxx Other Long-term Debts xxxx (4) xxxxCapital and Reserves Share Capital xxxx Reserves and surplus xxxx (5) xxxxTotal Long term funds Total (3)+(4)+(5) xxxxxStatement of Retained Earnings: Profit and Loss Appropriation Account Particulars Rs. Particulars Rs.To transfer to xxx By Last year’s xxxReserves balanceTo Dividend xxx By Current Year’s net xxx profit (Transferred
  • 157. from profit and loss A/C)To Dividend proposed xxxTo surplus carried to xxx By Excess provisions xxxBalance sheet (which are no longer required) By Reserves withdrawn (if any) xxx xxx xxxxIllustration: 1 From the following information, prepare a verticalIncomeStatement.Sales 2,00,000Opening stock 10,000Closing stock 15,000Purchases 40,000Operating Expenses 12,000Rate of Tax 50%Solution: Income Statement Particulars Rs. Rs. Sales 2,00,000 Less : cost of goods sold: Opening stock 10,000 Add: Pruchases 40,000 50,000 Less: closing Stock 15,000 35,000 Gross Profit 1,65,000 Less: operating expenses 12,000 Operating profit 1,53,000 Less: non-operating expenses 4,000 Profit before tax 1,49,000 Less: Income tax (50%) 74,500 Net profit after tax 74,500
  • 158. Illustration: 2 From the following particulars, pertaining to Mohan Ltd.,you are required to prepare a comparative Income Statement andinterpret the changes. Particulars Rs. Rs. Sales 58,000 65,200 Cost of goods sold 47,600 49,200 Administration expenses 1,016 1,000 Selling expenses 1,840 1,920 Non -operating expenses 140 155 Non-operating expenses 96 644 Sales returns 2000 1,200 Tax rate 43.75% 43.75%
  • 159. Solution: Comparative Income Statement of Mohan Ltd., for the years2000 and 2001. Particulars 2000 2001 Rs. Rs. Sales 58,000 65,200 Less Returns 2,000 1,200 Net sales 56,000 64,000 Less: Cost of Goods sold 47,600 49,200 Gross Profit (A) 8,400 14,800 Less: Operating expenses Administration expenses 1,016 1,000 Selling expenses 1,840 1,920 Total operating expenses (B) 2,856 2,920 Operating profit (A)-(B) 5,544 11,880 Add: non - operating incomes 96 644 Less: non- operating expenses 5,640 12,524 140 155 Net profit before tax 5,500 12,369 Less: Tax 2,406 5,411 Net profit after Tax 3094 6,958Techniques of Financial Statement Analysis: The following techniques are adopted in analysis offinancial statements of a business organization: • Comparative Statements • Common size Statements • Trend Analysis • Funds flow Analysis • Cash flow Analysis • Ration Analysis • Value Added Analysis. The first three topics are covered in this chapter and the restare discussed in the subsequent chapters in detail.
  • 160. Comparative Financial Statements Comparative financial statements are statements pf financialposition of a business designed to provide time perspective to theconsideration of various elements of financial position embodied insuch statements. Comparative Statements reveal the following: .i. Absolute data (money values or rupee amounts)ii. Increase or reduction in absolute data (in terms of moiwy values)iii. Increase or reduction in absolute data (in terms of percentages)iv. Comparison (in terms of ratios)v. Percentage of totals.a. Comparative Income Statement or Profit and Loss Account: A comparative income statement shows the absoluie figures fortwo or more periods and the absolute change from one period toanother. Since the figures are shown side by side, the user canquickly understand the operational performance of the firm indifferent periods and draw conclusions.b. Comparative Balance Sheet Balance sheet as on two or more different dates are used forcomparing the assets, liabilities and the net worth of the companyComparative balance sheet is useful for studying the trends ofanalysis undertaking. Financial Statements of two or more firms can also be comparedfor drawing inferences. This is called interfirm Comparison.Advantages:
  • 161. Comparative statements vidicate trends in sales, cost ofproduction, profits etc., and help the analyst to evaluate theperformance of the company. Comparative statements can also be used to compare theperformance of the industry or inter-firm comparison. This helps inidentification of the weaknesses of the firm and remedial measurescan be taken; accordingly.Weaknesses: Inter-firm comparison can be misleading if the firms are notidentical in size and age and when they follow different accountingprocedures with regard to depreciation, inventory valuation etc., Inter-period comparison may also be misleading if the periodhas witnessed changes in accounting policies, inflation, recession etc.Illustration 3: The following is the profit and loss account of Ashok Ltd., forthe years 2000 and 2001. Prepare comparative Income Statement andcomment on the profitability of the undertaking.
  • 162. Particulars 2000 2001 Particulars 2000 2001 Rs. Rs. Rs. Rs.To Cost of 2,31,625 2,41,950 By Sales 3,60,728 4,17,125goods soldTo Office 23,266 27,068 Less 5,794 6,952expenses ReturnsTo Interest 45,912 57,816 3,54,934 4,10,173expensesTo Loss on 627 1,750 By Othersale of fixed incomes :To Income 21,519 40,195 By Discount 2,125 1,896Tax on purchaseTo Net 35,371 44,425 By Profit on 1,500Profit sale of land 3,60,457 4,13,379 3,60,457 4,13 ,379
  • 163. Solution: ASHOK LTD.Comparative Income Statement for the years ending 2000 and 2001 Particulars 2000 Rs. 2001 Rs. Increase (+) Increase (+) Decrease (-) Decrease (-) Amount Percentages (Rs.)Sales 3,60,728 4,17,125 +56,397 +15.63Less: Sales returns 5,794 6,952 +1.158 +19.98 3,54,934 4,10,173 +55,239 +15.56Less: Cost of goods 2,31,625 2,41,950 + 10,325 +4.46soldGross Profit 1,23,309 1,68,223 +44.914 +36.42Operating Expenses: Office 23,266 27,068 +3,802 + 16.34expenses Selling 45,912 57,816 +11,904 +25.93expensesTotal operating 69,178 84,884 +15,706 +22.70expensesOperating profit 54,131 83,339 +29,208 +53.96Add: Other incomes 5,523 3,206 -2,317 -41.95 59,654 86,545 +26.891 +45.08Less: Other 2,764 1,925 -839 -30.35expensesProfit before tax 56,890 84,620 +27,730 +48.74Less: Income tax 21,519 40,195 +18,676 +86.79Net Profit after tax 35,371 44,425 +9,054 +25.60 The comparative Income statement reveals that while the netsales has been increased by 15.5%, the cost of goods sold increasedby 4.46%. So gross profit is increased by 36.4%. The total operatingexpenses has been increased by 22.7% and the gross profit issufficient to compensate increase in operating expenses. Net profit
  • 164. after tax is 9,054 (i.e., 25.6%) increased. The overall profitability of theundertaking is satisfactory.Illustration: 4 The following are the Balance Sheets of Gokul Ltd., for the yearsending 31s1 December, 2000,2001.
  • 165. Particulars 2000 2001 Rs. Rs.LiabilitiesEquity share capital 2,00,000 3,30,000Preference share capital 1,00,000 1,50,000Reserves 20,000 30,000Profit and Loss a/c 15,000 20,000Bank overdraft 50,000 50,000Creditors 40,000 50,000Provision for taxation 20,000 25,000Proposed Dividend 15,000 25,000 Total 4,60,000 6,80,000Fixed AssetsLess: Depreciation 2,40,000 3,50,000Stock 40,000 50,000Debtors 1,00,000 1,25,000Bills Receivable 20,000 60,000Prepaid expenses 10,000 12,000Cash in hand 40,000 53,000Cash at Bank 10,000 30,000 Total 4,60,000 6,80,000
  • 166. Solution: Comparative Balance Sheet Particulars 31st Dec. 31st Dec. Inerease(+) Increase(+) 2000 2001 Decrease(-) Decrease(-) Rs. Rs. Amount(Rs.) PercentagesASSETSCurrent Assets:Cash at bank and in 50,000 83,000 +33,000 +66hand Bills receivable 20,000 60,000 +40,000 +200Debtors 1,00,000 1,25,000 +25,000 +25Stock 40,000 50,000 +10,000 +25Prepaid expenses 10,000 12,000 +2,000 +20Total Current Assets 2,20,00 3,30,000 +1,10,000 +50Fixed Assets 2,40,000 3,50,000 +1,10,000 +45.83Total Assets 4,60,000 6,80,000 2,20,000 47.83LIABILITIESCurrent Liabilities:Bank overdraft 50,000 50,000Creditors 40,000 50,000 +10,000 +25Proposed dividend 15,000 25,000 +10,000 +66.67Provision for taxation 20,000 25,000 +5,000 +25Total Current 1,25,000 1,50,000 +25,000 +20LiabilitiesCapital and Reserve:Equity share capital 2,00,000 3,30,000 +1,30,000 +65Preference share 1,00,000 1,50,000 +50,000 +50capitalReserves 20,000 30,000 +10,000 +50Profit and Loss a/c 15,000 20,000 +5,000 +33.33 3,35,000 5,30,000 +1,95,000 +58.21 Total Liabilities 4,60,000 6,80,000 +2,20,000 +47.83 Interpretation:
  • 167. 1. The above comparative Balance sheet reveals the current assets has been increased to 50%, while current liabilities increase to 20% only. Cash increased to Rs.33,000 (i.e. 66%), There is an improvement in liquidity position.2. The fixed assets purchased was for Rs, 1,10,000. As there are no long-term funds, it should have been purchased partly from Share Capital.3. Reserves and Profit and Loss a/c increased by 50% and 33.33% respectively. The company may issue bonus shares in near future.4. Current financial position of the company is satisfactory. It should issue more long-term funds.COMMON SIZE STATEMENTS The figures shown in financial statements viz. Frofit and LossAccount and Balance sheet are converted to percentages so as toestablish each element to the total figure of the statement and thesestatement are called Common Size Statements. These statements areuseful in analysis of the performance of the company by analyzingeach individual element to the total figure of the statement. Thesestatements will also assist in analyzing the performance over yearsand also with the figures of the competitive firm in the industry formaking analysis of relative efficiency. The following statements showthe method of presentation of the data.Illustration: 5 Common Size Income Statement of XYZ Ltd., for the year ended31st March, 2001.
  • 168. Particulars Amount (Rs.) % to SalesSales (A) 14,00,000 100Raw materials 5,40,000 16.4Direct wages 2,30,000 16.4Faciory expenses 1,60,000 11.4 (B) 9,30,000 66.4GrossProfit (A) - 4,70,000 33.6(B)Less: Administrative 1,10,000 7.9expensesSelling and distribution 80,000 5.7expensesOperating Profit 2,80,000 20.0Add: Non-operative income 40,000 2.9 3,20,000 22.9Less: Non-operating 60,000 43expenses Profit before tax 2,60,000 18.6Less: Income tax 80,000 5.7 Profit after tax 1,80,000 12.9 Common Size Balance Sheet of XYZ Particulars Amount (Rs.) % to TotalASSETSFixed AssetsLand 50,000 5.3Buildings 1,10,000 11.7Plant and Machinery 2,50,000 26.6Current Assets :Inventory
  • 169. Raw materials 80,000 8.5 Work-in-progress 50,000 5.3 Finished goods 1,60,000 17.0 Sundry debtors 2,10,000 22.4 Cash at Bank 30,000 3.2 Total 9,40,000 100.0 Capital and Liabiltiies Euqity Share capital 2,50,000 26.6 Preference Share Capital 1,00,000 10.6 General reserve 1,60,000 17.0 Debentures 80,000 8.5 Current Liabilities Sundry Creditors 2,20,000 23.4 Creditors for expenses 40,000 4.3 Bills payable 90,000 9.6 9,40,000 100.0 Analysis of performance and position can be made from the above Common Size Statements. llustration: 6 From the following P&L A/c prepare a Common Size Income Statement- Particulars 2000 2001 Particulars 2000 2001 Rs. Rs. Rs. Rs.To Cost of goods 12,000 1 5,000 By Net Sales 16,000 20,000soldTo Administrative 400 400expensesTo Selling 600 800expenses
  • 170. To Net Profit 3,000 3,800 16,000 20,000 16,000 20,000 Common Size Income Statement Particulars 2000 2001 Rs. % Rs. % Net sales 16,000 100.00 20,000 100.00 Less: Cost of goods sold 12,000 75.00 15,000 7500 Gross 4,000 25.00 5,000 25.00 Profit Less: Operating expenses Administration 400 2.50 400 2.00 expenses Selling expenses 600 3.75 800 4.00 Total Operating 1,000 6.25 1,200 6.00 expenses Net Profit 3,000 18.75 3,800 19.00 Illustration: 7 Following are Balance sheet of Vinay Ltd. for the year ended 31 st December 2000 and 2001. Liabilities 2000 2001 Assets 2000 2001 Rs. Rs. Rs. Rs.Equity capital 1,00,000 1 ,65,000 Fixed Assets (Net) 1 ,20,000 1,75,000Pref. Capital 50,000 75,000 Stock 20,000 25,000Reserves 10,000 15,000 Debtors 50,000 62,500P&L A/c 7,500 10,000 Bills receivable 10,000 30,000Creditors 20,000 25,000 Cash at Bank 20,000 26,500
  • 171. Provision 10,000 12,500 Cash in hand 5,000 15,000for taxationProposed 7,500 12,500dividends 2,30,000 3,40,000 2,30,000 3,40,000 Prepare a common size balance sheet and interpret the same. Solution; Common Size Balance Sheet of Vinay Ltd. for the year ended 31.12.2001 & 2002 Particulars 2000 2001 Rs. % Rs. % Capital & Reserves: Equity Capital 1,00,000 43,48 1 ,65,000 48.53 Pref. Capital 50,000 21,74 75,000 22.05 Reserves 10,000 4.34 15,000 4.41 P&L A/c 7,500 3.26 10,000 2.95 (i) 1,67,500 72.82 2,65,000 77.94 Current Liabilities: Bank overdraft 25,000 10.87 25,000 7.35 Creditors 20,000 8.70 25,000 7.35 Provisions for taxation 10,000 4.35 12,500 3.68 Proposed dividends 7,500 3.26 12,500 3.68 (ii) 62,500 27.18 75,000 22.06 Total Liabilities (ij + (ii) 2,30,000 100.00 3,40,000 100.00 Fixed Assets (Net) (a) 1,20,000 52.17 1,75,000 51.47 Current Assets: Stock 20,000 8.70 25,000 7.35 Debtors 50,000 21.74 62,500 18.38 Bills receivable 10,000 4.34 30,000 8.82 Cash al bank 20,000 8.70 26,500 7.79 Cash in hand 5,000 2.18 15,000 4.41 (b) 1,10,000 47.83 1,65,000 48.53
  • 172. Total Asses (a + b) 2,30,000 100.00 3,40,000 100.00Interpretation :(1) In 2001 Current Assets were increased from 47.83% to 48.53%. Cash balance increased by Rs. 16,500.(2) Current Liabilities were decreased from 27.18% to 22.06%. So, the company can pay off the Current Liabilities from Current Assets. The liquidity position is reasonably good.(3) Fixed Assets were increased from Rs. 3,20,000 in 2000 to Rs. 1,75,000 in 2001. These were purchased from the additional share capital issued.
  • 173. (4) So, the ove.all financial position is satisfactory.TREND ANALYSIS In trend analysis ratios of different items are calculated forvarious periods for comparison purpose. Trend analysis can be doneby trend percentage, trend ratios and graphic and diagrammaticrepresentation. The trend analysis is a simple technique and doesnot involve tedious calculations.Illustration: 8 From the following data, calculate trend percentage taking 1999as base. Particulars 1999 2000 2001 Rs. Rs. Rs. Sales 50,000 75,000 1,00,000 Purchases 40,000 60,000 72,000 Expenses 5,000 8,000 15,000 Profit 5,000 7,000 13,000
  • 174. Solution: Particulars 1999 Rs. 2000 2001 Rs. Trend Percentage Base 1999 Rs. Rs. Rs. Rs. 1999 2000 2001Purchases 40,000 60,000 72,000 100 150 180Expenses 5,000 8,000 15,000 100 160 300Profit 5,000 7,000 13,000 100 140 260Sales 50,000 75,000 1,00,000 100 150 200 Illustration: 9 From the following data, calculate trend percentages (1999 as base) Particulars 1999 2000 2001 Rs. Rs. Rs. Cash 200 240 160 Debtors 400 500 650 Stock 600 800 700 Other Current Assets 450 600 750 Land 800 1,000 1,000 Buildings 1,600 2,000 2,400 Plant 2,000 2,000 2,400
  • 175. Solution: Particulars 2000 2001 (Base Year 1999) Rs. Rs. Rs. 1999 2000 2001Cash 200 240 160 100 120 80Debtors 400 500 650 100 125 163Other Current 450 600 750 100 133 167AssetsTotal Current 1,650 2,140 2,260 100 130 137AssetsFixed Assets:Land 800 1,000 1,000 100 125 125Buildings 1,600 2,000 2,400 100 125 150Plant 2,000 2,000 2,400 100 100 120Total Fixed Assets 4,400 5,000 5,800 100 114 132
  • 176. LESSON-10 RATIO ANALYSISINTRODUCTION The financial statements viz. the income statement, the Balancesheet The Income statement, the Statement of retained earnings andthe Statement of changes in financial position report what hasactually happened to earnings during a specified period. The balancesheet presents a summary of financial position of the company at agiven point of time. The statement of retained. earnings reconcilesincome earned during the year and any dividends distributed with thechange in retained, earnings between the start and end of thefinancial. year under study. The statement of changes in financialposition provides a summary of funds flow during the period offinancial statements. Ratio analysis is a very powerful analytical tool for measuringperformance of an organisation. The ratio analysis concentrates onthe interrelationship among the figures appearing in theaforementioned four financial-statements. The ratio analysis helps themanagement to analyse the past. performance of the firm and to makefurther projections. Ratio analysis allow 1-interested parties likeshareholders, investors, creditors, Government analysts to make anevaluation of certain aspects of a firms performance. Ratio analysis is a process of comparison of one figure againstanother, which make a ratio, and the appraisal of the ratios to makeproper analysis about the strengths and weaknesses of the firmsoperations. The calculation of ratios is a relatively easy and simpletask but the proper analysis and interpretation of the ratios can be
  • 177. made only by the skilled analyst. While interpreting the financialinformation, the analyst has to be careful in limitations imposed bythe accounting concepts and methods of valuation. Information ofnon-financial nature will also be taken into consideration before ameaningful analysis is made.Ratio analysis is extremely helpful in providing valuable insight into acompanys financial picture. Ratios normally pinpoint a businessstrengths and weakness in two ways: • Ratios provide an easy way to compare todays performance with past. • Ratios depict the areas in which a particular business is competitively advantaged or disadvantaged through comparing ratios to those of other businesses of the same size within the same industry.CATEGORIES OF RATIOS The ratio analysis is made under six broad categories as follows: • Long-term solvency ratios • Short-term solvency ratios • Profitability ratios • Activity ratios • Operating ratios • Market test ratiosLong-Tenn Solvency Ratios The long-term financial stability of the firm may be consideredas dependent upon its ability to meet all its liabilities, including thosenot current payable. The ratios which are important in measuring thelong-term solvency L as follows:
  • 178. • Debt-Equity Ratio • Shareholders Equity Ratio . • Debt to Networth Ratio • Capital Gearing Ratio • Fixed Assets to Long-term Funds Ratio • Proprietary Ratio • Dividend Cover • Interest Cover • Debt Service Coverage Ratio1. Debt-Equity Ratio: Capital is derived from two sources: shares and loans. It is quitehkely for only shares to be issued when the company is formed, butloans are invariably raised at some later date. There are numerousreasons for issuing loan capital. For instance, the owners might wantto increase their investment but avoid therisk which attaches to sharecapital, and they can do this by making a secured loan. Alternatively,management might require additional finance which the shareholdersare unwilling to supply and so a loan is raised instead. In either case,the effect is to introduce an element of gearing or leverage into thecapital structure :of the company. There are numerous ways ofmeasuring gearing, but the debt-equity ratio is perhaps mostcommonly used. Long - term debt Share holders funds This ratio indicates the relationship between loan funds and networth of the company, which is known as gearing. If the proportion ofdebt to equity is low, a company is said to be low-geared, and viceversa. A debt equity ratio of 2:1 is the norm accepted by financial
  • 179. institutions for financing of projects. Higher debt-equity ratio may bepermitted for highly capital intensive industries like petrochemicals,fertilizers, power etc. The higher the gearing, the more volatile thereturn to the shareholders. The use of debt capital has direct implications for the profitaccruing to the ordinary shareholders, and expansion is oftenfinanced in this manner with the objective of increasing theshareholders rate of return. This objective is achieved only if the rateearned on the additional funds raised exceeds that payable to theproviders of the loan. The shareholders of a highly geared company reapdisproportionate benefits when earnings before interest and taxincrease. This is because interest payable on a large proportion oftotal finance remains unchanged. The converse is also true, and ahighly geared company is likely to find itself in severe financialdifficulties if it suffers a succession of trading losses. It is not possibleto specify an optimal level of gearing for companies but, as a generalrule, gearing should be low in those industries where demand isvolatile and profits are subject to fluctuation. A debt-equity ratio which shows a declining trend over the yearsis usually taken as a positive sigh reflecting on increased cash accrualand debt repayment. In fact, one of the indicators of a unit turningsick is a rising debt-equity ratio. Usually in calculating the ratio, thepreference share capital is excluded from debt, but if the ratio is toshow effect of use of fixed interest sources on earnings available to theshareholders then it is to be included. On the other hand, if the ratiois to examine financial solvency, then preference shares shall formpart of the capital.
  • 180. 2. Shareholders Equity Ratio : This ratio is calculated as follows: Shareholders Equity Total assets (tan gible) It is assumed that larger the proportion of the shareholdersequity, the stronger is the financial position of the firm, This ratio willsupplement the debt-equity ratio. In this ratio the relationship isestablished between the shareholders funds and the total assets.Shareholders funds represent both equity and preference capital plusreserves and surplus less losses. A reduction in shareholders equitysignaling the over dependence on outside sources for long-termfinancial needs and this carries the risk of higher levels of gearing.This ratio indicates the degree to which unsecured creditors areprotected against iosr in the event of liquidation.3. Debt to Net worth Ratio : This ratio is calculated as follows: Long - term debt Networth The ratio compares long-term debt to the net worth of the firmi.e., the capital and free reserves less intangible assets. This ratio isfiner than the debt-equity ratio and includes capital which is investedin fictitious assets like deferred expenditure and carried forwardtosses. This ratio would be of more interest to the contributories oflong-term finance to the firm, as the ratio gives a S factual idea of theassets available to meet the long-term liabilities.4. Capital Gearing Ratio :
  • 181. It is the proportion of fixed interest bearing funds to Equityshareholders, funds: Fixed int eresi bearing funds : Equity Shareholders fundsThe fixed interest bearing funds include debentures, long-term loansand preference share capital. The equity shareholders funds includeequity share capital, reserves and surplus. Capital gearing ratioindicates the degree of vulnerability of earnings available for equityshareholders. This ratio signals the firm which is operating on tradingon equity. It also indicates the changes in benefits accruing to equityshareholders by changing the levels of fixed interest bearing funds inthe organisation.5. Fixed Assets to Long-term Funds Ratio : The fixed assets is shown as a proportion to long-term funds asfollows: Fixed Assets Long - term Funds The ratio includes the proportion of long-term funds deployed infixed assets. Fixed assets represents the gross fixed assets minusdepreciation provided on this till the date of calculation. Long-termfunds include share capital, reserves and surplus and long-termloans. The higher the ratio indicates the safer the funds available incase of liquidation. It also indicates the proportion of long-term fundsthat is invested in working capital.6. Proprietor Ratio : It express the relationship between net worth and total asset
  • 182. Net worth Total AssetsNet worth = Equity Share Capital-t-Preference ShareCapital+Fictitious Assets Total Assets = Fixed Assets + Current Assets(excluding fictitious assets) Reserves earmarked specifically for a particular purpose shouldnot be included in calculation of Net worth. A high proprietory ratioindicative of strong financial position of the business. The higher theratio, the better it is.7. Interest Cover: Profil before interest depreciationand tax Interest The interest coverage ratio sLjws how many times interestcharges are covered by funds that are available for payment ofinterest. An interest cover of 2:1 is considered reasonable by financialinstitutions. A very high ratio indicates that the firm is conservative inusing debt and a very low ratio indicates excessive use of debt.8. Dividend Cover : Net Profit after tax Dividend This ratio indicates the number of times the dividends arecovered by net profit his highlights the amount retained by a companyfor financing of future operations.9. Debt Service Coverage Ratio :
  • 183. It indicates whether the business is earning sufficient profits topay not only the interest charges, but also the instalments due to theprincipal amount. It is calculated as: PBIT Interest + Periodic Loan Instalment (1 - Rate of Income Tax) The greater the debt service coverage ratio, the better rs theservicing ability of the organisation.Short-term Solvency Ratios The short-term solvency ratios, which measure the liquidity ofthe firm and its liability of the firm and its ability to meet it- maturingshort-term obligations. Liquidity is defined as the ability to realisevalue in money, the most liquid of assets. It refers to the ability to payin cash, the obligations that -are due. The corporate liquidity has two dimensions viz., quantitativeand qualitative concepts. The quantitative concept includes thequantum, structure and utilisation of liquid assets and in thequalitative concept, it is the ability to meet all present and potentialdemands on cash" from any source in a manner that minimizes costand maximizes the value of the firm. Thus, corporate liquidity is, avital factor in business - excess liquidity, though a guarantor ofsolvency would reflect lower profitability, deterioration in managerialefficiency, increased speculation and unjustified expansion, extensionof too liberal credit and dividend policies. Too little liquidity then maylead to frustration of-i business objectives, reduced rate of return,business opportunity missed and& weakening of morale. Theimportant ratios in measuring short-term solvency are: (1) Current Ratio (2) Quick Rarip (3) Absolute Liquid Ratio
  • 184. 1. Current Ratio : Current Assets, Loans & Advances Current Liabilities & Provisions This ratio measures the solvency of the company in the short-term. Current assets are those assets which can be converted intocash within a year. Current liabilities and provisions are thoseliabilities that are payable within a year. A current ratio 2:1 indicatesa highly solvent position. A current ratio 1.33:1 is considered bybanks as the minimum acceptable level for providing working capitalfinance. The constituents of the current assets are as important as thecurrent assets themselves for evaluation of a companys solvencyposition, A very high current ratio will have adverse impact on theprofitability of the organisation. A high current ratio may be due to thepiling up of inventory, inefficiency in collection of debtors, highbalances in Cash and Bank accounts without proper investment2. Quick Ratio or Liquid Ratio: Current Assets, Loans & Advances - Inventories Current Liabilities & Provisions- Bank Overdraft Quick ratio used as measure of the companys ability to meet itscurrent obligations. Since bank overdraft is secured by theinventories, the other current assets must be sufficient to meet othercurrent liabilities. A quick ratio of 1:1 indicates highly solventposition. This ratio is also called acid test ratio. This ratio serves as asupplement to the current ratio in analysing liquidity.3. Absolute Liquid Ratio (Super Quick Ratio):
  • 185. It is the ratio of absolute liquid assets to quick liabilities.However, for calculationpurposes, it is taken as ratio of absoluteliquid assets to current liabilities. Absolute liquid assets include cashin hand, cash at bank and short term or temporary investments. Absolute Liquid Assets Current LiabilitiesAbsolute Liquid Assets =Cash in Hand + Cash at Bank + Short terminvestmentsThe ideal Absolute liquid ratio is taken as 1:2 or 0.5.Activity Ratios or Turnover Ratios Activity ratios measure how effectively the firm employs itsresources. These ratios are also called turnover ratios which involvecomparison between the level of sales and investment in variousaccounts - inventories, debtors, fixed assets etc. activity ratios areused to measure the speed with which various accounts are convertedinto sales or cash. The following activity ratios are calculated foranalysis:1. Inventory : A considerable amount of a companys capital may be tied up inthe financing of raw materials, work-in-progress and finished goods. Itis important to ensure that the level of stocks is kept a low aspossible, consistent with the need to fulfill customers orders in time.
  • 186. Inventory Turnover Ratio = Cost of goods sold Average Inventory Sales Average InventoryAverage inventory = Opening stock+Closing stock 2 The higher the stock turn over rate the lower the stock turnoverperiod the better, although the ratios will vary between companies.For example, the stock turnover rate in a food retailing company mustbe higher than the rate in a manufacturing concern. The level ofinventory in a company may be assessed by the use of the inventoryratio, which measures how much has been tied up in inventory. Inventory Ratio = Inventory X 100 Current Assets The inventory turnover ratio measures how many times acompanys inventory has been sold during the year. If the inventoryturnover ratio has decreased from past, it means that either inventoryis growing or sales are dropping. In addition to that, if a firm has aturnover that is slower than for its industry, then there may beobsolete goods on hand, or inventory stocks may be high. Lowinventory turnover has impact on the liquidity of the business.2. Debtors : The three main debtor ratios are as follows:
  • 187. (1) Debtor Turnover Ratio Debtor turnover, which measures whether the amount ofresources tied up in debtors is reasonable and whether the companyhas been efficient in converting debtors into cash. The formula is: Credit Sales Average DebtorsThe higher the ratio, the better the position.(ii) Average Collection Period Average collection period, which measures how long it take tocollect amounts from debtors. The formula is: Average debtors X 365 Credit Safes The actual collection period can be compared with the statedcredit terms of the company. If it is longer than those terms, then thisindicates some insufficiency in the procedures for collecting debts.(ii) Bad Debts Bad debts, which measures the proposition of bad debts tosales: Bad debts Sales This ratio indicates the efficiency of the credit controlprocedures of the company. Its level will depend on the type ofbusiness. Mail order-companies have to accept a fairly high level ofbad debts, white retailing organisations should maintain very lowlevels or, if they do not allow credit accounts, none at all. The actualratio is compared with the target or norm to decide whether or not it isacceptabie.
  • 188. 3. Creditors:(i) Creditors Turnover Period The measurement of the creditor turnover period shows theaverage time taken to pay for goods and services purchased by thecompany. The formula is: Average creditors X 365 Purchases In general the longer the credit period achieved the better,uecause delays in payment mean that the operation of the companyare being financed interest free by, suppliers of funds. But there willbe a point beyond which-delays in payment will damage relationshipswith suppliers which, if they are operating in a sellers market, mayharm the company. If too long a period is taken to pay creditors, thecredit rating of the company may suffer, thereby making it moredifficult to obtain suppliers in the future.(ii) Creditors Turnover Ratio Credit purchases Average creditors The term creditors include trade creditors and bills payable.4. Assets Turnover Ratios: This measures the companys ability to generate sales revenuein relation to the size of the asset investment A low asset turnovermay be remedied by increasing sales or by disposing of certain assetsor both. To assist in establishing which part of the asset structure isnot being used efficiently, the asset turnover ratio should be sub-analysed.(i) Fixed Assets Turnover Ratio
  • 189. Sales Fixed assets This ratio will be analysed further with ratios for each maincategory of asset This is a difficult set of ratios to interpret as assetvalues are based on historic cost An increase in the fixed asset figuremay result from the replacement of an asset at an increased price orthe purchase of an additional asset intended to increase productioncapacity. The later transaction might be expected to result inincreased sales whereas the former would more probably be reflectedin reduced operating costs. The ratio of the accumulated depreciation provision to the totalof fixed assets at cost might be used as an indicator of the average ageof the assets; particularly when depreciation rates are noted in theaccounts.The ratio of sales value per share foot of floor space occupied isparticularly significant, for trading concerns, such as a wholesalewarehouse or a department store.(ii) Total Assets Turnover RatioThis ratio indicates the number of times total assets are being turnedover in a year. Sales Total assets The higher the ratio indicates overtrading of total assets while alow ratio indicates idle capacity.5. Working Capital Turnover Ratio : This ratio is calculated as follows: Sales Working capital
  • 190. This ratio indicates the extent of working capital turned over inachieving sales of the firm.6. Sales to Capital Employed Ratio :This ratio is ascertained by dividing sales with capital employed. Sales —————————— Capital employed This ratio indicates, efficiency in utilisation of capital employedin generating revenue.Profitability Ratios The purpose of study and analysis of profitability ratios are tohelp assess the adequacy of profits earned by the company and also todiscover whether profitability is increasing or declining. Theprofitability of the firm is the net result of a large number of policiesand decisions. The profitability ratios are measured with reference tosales, capital employed, total assets employed; shareholders funds etc.The major profitability rates are as follows: (a) Return on capital employed (or Return on investment) [ROIor ROCE] (b) Earnings per share (EPS) (c) Cash earnings per share (Cash EPS) (d) Gross profit margin (e) Net profit margin (f) Cash profit ratio (g) Return on assets
  • 191. (h) Return on Net worth (or Return on Shareholders equity)I. Return on Capital Employed (ROCE) or Return on Investment(ROI) The strategic aim of a business enterprise is to earn a return oncapital. If in any particular case, the return in the long-run is notsatisfactory, then the deficiency should be corrected or the activity beabandoned for a more favourable one. Measuring the historicalperformance of an investment center calls for a comparison of theprofit that has been earned with capital employed. The rate of returnon investment is determined by dividing net profit or income by thecapital employed or investment made to achieve that profit. ROI = Profit X 100 Invested capital ROI consists of two components viz, I. Profit margin, and fl.Investment turnover, as shown below:ROI = Net profit = Net profit X Sales Investment Sales Investment in assets It will be seen from the above formula that ROI can be improvedby increasing one or both of its components viz., the profit margin andthe investment turnover in any of the following ways: • Increasing the profit margin • Increasing the investment turnover, or • Increasing both profit margin and investment turnoverThe obvious generalisations that can be made about the ROI formulaare that any action is beneficial provided that it: • Boosts sales • Reduces invested capital
  • 192. • Reduces costs (while holding the other two factors constant)
  • 193. Table-1: Computation of Capital Employed Share capital of the company xxx Reserves and surplus xxx Loans (secured/ unsecured) xxx xxx Less: (a) Capital-in-progress xxx (b) Investment outside the business xxx (c) Preliminary expenses (d) Debit balance of Profit and Loss xxx xxx A/c Capital employed xxx Return on in vestment analysis provides a strong incentive foroptimal utilisation of these assets of the company. This encouragesmangers to obtain, assets that will provide a satisfactory return oninvestment and to dispose of assets that are not providing anacceptable return. In selecting amongst alternative long-terminvestment proposals, ROI provides a suitable measure forassessment of profitability of each proposal.2. Earnings Per Share (EPS): The objective of financial Management is wealth or valuemaximisation of a corporate entity. The value is maximized whenmarket price of equity shares is maximised. The use of the objective ofwealth maximisation or net present value maximisation has beenadvocated as an appropriate and operationally feasible criterion tochoose among the alternative financial actions. In practice, theperformance of a corporation Is better judged in terms of its earningsper share (EPS). The EPS is one of the important measures ofeconomic performance of a corporate entity. The flow of capital to the companies under the present imperfectcapital market conditions woold be made on the evaluation of EPS.Investors lacking inside and detailed information would look upon the
  • 194. EPS as the best base to lake their investment decisions. A higher EPSmeans better capital productivity. EPS = Net Profit after tax and preference dividend No. of Equity SharesI EPS when Debt and Equity used = (EBIT – 1) (1 – T) NII. EPS when Debt, Preference and Equity used = (EBIT – I ) (1 – T) - DP N Where EBIT = Earnings before interest and tax I = Interest T = Rate of Corporate tax DP = Preference Dividend N = Number of Equity shares EPS is one of the most important ratios which measures the netprofit earned per share. EPS is one of the major factors affecting thedividend policy of the firm and the market prices of the company.Growth in EPS is more relevant for pricing of shares from absoluteEPS. A steady growth in EPS year after year indicates a good track ofprofitability.3. Cash Earnings Per Share : The cash earnings per share (Cash EPS is calculated by dividingthe net profit before depreciation with number of equity shares. Net profit + Depreciation No. of Equity Shares This is a more reliable yard stick for measurement ofperformance of companies, especially for highly capital intensive
  • 195. industries where provision for depreciation is substantial. Thismeasures the cash earnings per share and is also a relevant factor fordetermining the price for the companys shares. However, this methodis not as popular as EPS and is used as a supplementary measure ofperformance only.4. Gross Profit Margin : The gross profit margin is calculated as follows:= Sales - Cost of goods sold X 100 Gross profit X 100 Sales Sales The ratio measures the gross profit margin on the total net salesmade by the company. The grosi, profit represents the excess of salesproceeds during the 1 period under observation over theircost, before taking into account administration, selling anddistribution and financing charges. The ratio . measures theefficiency of the companys operations and this can also be ; comparedwith the previous years results to ascertain the efficiency partnerswith respect to the previous years. When everything normal, the gross profit margin should remainunchanged, irrespective of the level of production and sales, since it isbased on the assumption that all costs deducted when computinggross profit which are directly variable with sales. A stable gross profitmargin is therefore, the norm and any variation from it call for carefulinvestigations, which may be caused; due to the following reasons:(i) Price cuts: A company need to reduce its selling price to achievethe desired increase in sales.
  • 196. (ii) Cost increases: The price which a company pay its suppliersduring period of inflation, is likely to rise and this reduces thegross profit margin unless an appropriate adjustment is made tothe selling price.(iii) Change in mix: A change in the range or mix of products soldcauses the overall gross profit margin assuming individual productlines earn different gross profit percentages.(iv) Under or Over-valuation of stocks. If closing stocks are under-valued, cost of goods sold is inflatedand profit understated. An incorrect valuation may be the result of anerror during stock taking or it may be due to fraud The gross profitmargin may be compared with that of competitors in the industry toassess the operational performance relative to the other players in theindustry.5. Net Profit Margin: The ratio is calculated as follows: Net profit before interest and tax X 100 Sales The ratio is designed to focus attention on the net profit marginarising from business operations before interest and tax is deducted.The convention is to express profit after tax and interest as apercentage of sales. A drawback is that the percentage which results,varies depending on the sources employed to finance businessactivity; interest is charged above the line while dividends arededucted below the line. It is for this reason that net profit i.e.earnings before interest and tax (EBIT) is used. This ratio reflects nt: profit margin on the total sales afterdeducting all expenses but before deducting interest and taxation.This ratio measures the efficiency of operation of the company. The
  • 197. net profit is arrived at from gross profit after deductingadministration, selling and distribution expenses. The non-operatingincomes and expenses are ignored in computation of net profit beforetax, depreciation and interest This ratio could be compared with that of the previous yearsand with that of competitors to determine the trend in net profitmargins of the company and its performance in the industry. Thismeasure will depict the correct trend of performance where there areerratic fluctuations in the tax provisions from year to year. It is to beobserved that majority of the costs debited to the profit and lossaccount are fixed in nature and any increase in sales will cause thecost per unit to decline because of the spread of same fixed cost overthe increased number of units sold.6. Cash Profit Ratio Cash profit X 100 SalesWhere Cash profit = Net profits Depreciation Cash profit ratio measures the cash generation in the businessas a result of trie operations expressed in terms of sales. The cashprofit ratio is a more reliable indicator of performance where there aresharp fluctuations in the profit before tax and net profit from year toyear owing to difference in depreciation charged. Cash profit ratioeva)iates the efficiency of operations in terms of cash generation andis not affected y the method of depreciation charged. It also facilitatethe inter-firm comparison of performance since different methods ofdepreciation may be adopted by different companies.7. Return on Assets : This ratio is calculated as follows:
  • 198. Net profit after tax X 100 Total assets The profitability, of the firm is measured by establishing relationof net profit with the total assets of the organisation. This ratioindicates the efficiency of utilisation of assets in generating revenue.8. Return on Shareholders Funds or Return on Net Worth Net profit after interest and tax X 100 Net worth Where, Net worth = Equity capital + Reserves and Surplus. This ratio expresses (he nel profit in Icrms of the equityshareholders funds. This ratio is an important yardstick ofperformance of equity shareholders since it indicates the return on thefunds employed by them. However, this measure is based on thehistorical net worth and will be high for old plants and low for newplants. The factor which motivates shareholders to invest in a companyis the expectation of an adequate rate of return on their funds andperiodically, they will want to assess the rate of return earned in orderto decide whether to continue with their investment. There are variousfactors of measuring the return including the earnings yield anddividend yield which are examined at later stage. This ratio is usefulin measuring the rate of return as a percentage of the book value ofshareholders equity. The further modification of this ratio is made by considering theprofitability from equity shareholders point of view can also be worked
  • 199. out by taking the profits after preference dividend and comparingagainst capital employed after deducting both long-term loans andpreference capital.Operating Ratios The ratios of all operating expenses (i.e. materials used, labour,factory-overheads, administration and selling expenses) to sales is theoperating ratio. A comparison of the operating ratio would indicatewhether the cost content is high or low in the figure of sales. If theannual comparison shows that the sales has increased themanagement would be naturally interested and concerned to know asto which element of the cost has gone up. It is not necessary that themanagement should be concerned only when the operating ratio goesup. If the operating ratio has fallen, though the unit selling price hasremained the same, still the position needs analysis as it may be thesum total of efficiency in certain departments and inefficiency inothers, A dynamic management should be interested in making acomplete analysis. It is, therefore, necessary to break-up the operating ratio intovarious cost ratios. The major components of cost are: Material,labour and overheads. Therefore, it is worthwhile to classify the costratio as:1. Materials Cost Ratio = MaterialsConsumed X 100 Sales2. Labour Cost Ratio = Labour Cost Sales100 X Sales3. Factory Overhead Ratio X 100 = Factory Expenses Sales4. Administrative Expense Ratio = Administrative Expenses X 100
  • 200. Sales5. Selling and distribution expenses ratio = Selling and Distribution Expenses X 100 SalesGenerally all these ratios are expressed in terms of percentage. Thentotal up all the operating ratios. This is deducted from 100 will beequal to the net profit ratio. If possible, the total expenditure foreffecting sales should be divided into two categories, viz. Fixed andvariable and then ratios should be worked out. The ratio of variableexpenses to sales will be generally constant; that of fixed expensesshould fall if sales increase, it will increase if sales fall.Market Test Ratios The market test ratios relates the firms stock price to itsearnings and book value per share. These ratios give management anindication of what investors think of the companys past performanceand future prospectus. If firms profitability, solvency and turnoverratios are good, then the market test ratios will be high and its shareprice is also expected to be high. The market test ratios are as follows:- 1. Dividend payout ratio 2. Dividend yield ; 3. Book value 4. Price/Earnings ratio1. Dividend Payout Ratio: Dividend per share Earnings per share
  • 201. Dividend payout ratio is the dividend per share divided by theearnings per share. Dividend payout indicates the extent of the netprofits distributed to the shareholders as dividend. A high payoutsignifies a liberal distribution policy and a low payout reflectsconservative distribution policy.2. Dividend Yield Dividend per share X 100 Market price This ratio reflects the percentage yield that an investor receiveson this investment at the current market price of the shares. Thismeasure is useful forinvestors who are interested in yield per share rather than capitalappreciation.3. Book Value: Equity Capitalf +Reserves - Prqfit&Lass debit balance. Total number of equity shares; This ratio indicates the net worth per equity share. The bookvalue is a reflection of the past earnings and the distribution policy ofthe company. A high book value indicates that a company has hugereserves and is a potential bonus candidate. A low book value signifiesliberal distribution policy of bonus and dividends, or alternatively, apoor track record of profitability. Book value is considered lessrelevant for the m^ker price as compared to EPS, as it reflects the pastrecord whereas the market discounts the future prospects.4. Price Earnings Ratio (P/E Ratio): Current market price
  • 202. Earnings per share This ratios measures the number of times the earnings of thelatest year at which the share price of a company is quoted. Itsignifies the number of years, in which the earnings can equal tocurrent market price. This ratio reflects the markets assessment ofthe future earnings potential of the company. A high P/e ratio reflectsearnings potential and a low P/E ratio low earnings potential. The P/Eratio reflects the markets confidence in the companys equity. P/eratio is a barometer of the market sentiment Companies with excellenttrack record of profitability, professional management and liberaldistribution policy have high P/E ratios whereas companies withmoderate track record, conservative distribution policy and averageprospects quote a low P/E ratios. The market price discounts theexpected earnings of a company for the current year as opposed to thehistorical EPS.LIMITATIONS IN THE USE OF RATIO ANALYSIS Ratios by themselves mean nothing. They must always becompared with: • a norm or a target • previous ratios in order to assess trends • the ratios achieved in other com; arable companies (inter- company comparisons), and • caution has to be exercised in using ratios.The following limitations must be taken into account: Ratios are calculated from financial statements w.ach are affected by the financial bases and policies adopted on such matters as depreciation and the valuation of stocks.
  • 203.  Financial statements do not represent a complete picture of the business, but merely a collection of facts which can be expressed in monetary terms. They may not refer to other factors which affect performance. Over use of ratios as controls on managers could be dangerous, in that management might concentrate more on simply improving the ratio than on dealing with the significant issues. For example, the return on capital employed can be improved by reducing assets rather than increasing profits. A ratio is a comparison of two figures, a numerator and a denominator In comparing ratios it may be difficult to determine whether differences are due to changes in the numerator, or in the denominator or in both. Ratios are inter-connected. They should not be treated in isolation. The effective use of ratios, therefore, depends on being aware of all these limitations and ensuring that, following comparative analysis, they are used as a trigger point for investigation and corrective action rather than being treated as meaningful in themselves. The analysis of ratios clarifies trends and weaknesses in performance as a guide to action as long as proper comparisons are made and the reasons for adverse trends or deviations from the norm are investigated thoroughly.Illustration 1: From the given Balance Sheets calculate: (a) Debt-equity ratio (b) Liquid ratio (c) Fixed assets to current assets ratio
  • 204. (d) Fixed assets to Net worth ratio Balance Sheet Liability Rs. Assets Rs. Share Capital 1,00,000 Goodwill 60,000 Reserve 20,000 Fixed assets (Cost) 1,40,000 Profit and Loss a/c 30,000 Stock 30,000 Secured Loans 80,000 Debtors 30,000 Creditors 50,000 Advances 10,000 Provisions for taxation 20,000 Cash 30,000 3,00,000 3,00,000Solution:(a) Debt-equity ratio = Outsiders Funds Shareholders Funds Outsiders Funds Rs. Shareholders Rs. FundsSecured Loans 80,000 Share Capital 1,00,000Creditors 50,000 Reserves 20,000Provisions for taxation 20,000 Profit and Loss a/c 30,000 1,50,000 1,50,000 Debt-equity ratio = 1,50,000= 1:1 1,50,000(b) Liquid ratio = Liquid Assets Current LiabilitiesNote: Advances are treated as current asset. Secured Joans are treated as current liability.Liquid ratio = 70,000 = 0.47:1 1,50,000
  • 205. (c) Fixed Assets to Currents Assets Ratio = Fixed Assets Current Liabilities Fixed Assets = 1,40,000 Current Assets (Rs) Cash 30,000 Stock 30,000 Debtors 30,000 Advances 10,000 1,00,000Fixed assets to current assets ratio = 1,40,000 = 1.4:1 1,00,000(d) Fixed Assets to Net worth Ratio = Fixed Assets Net worth
  • 206. Share Capital 1,00,000 Reserves 20,000 P & L a/c 30,000 1,50,000 Less: Provision for taxation 20,000 1,30,000Fixed Assets to Net worth ratio = 1,40,000 1,30,000 = 1.08:1Illustration 2: From the following data calculate; (a) Current ratio (b) Quick ratio (c) Stock Turnover ratio (d) Operating ratio (e) Rate of return on equity capital Balance Sheet as on Dec., 31,2001 Liabilities Rs. Assets Rs.Equity Share 1,00,000 Plant and Machinery 6,40,000Capital (Rs. 10 shares)Profit and loss 3,68,000 Land and buildings 80,000accountCreditors 1,04,000 Cash 1, 60,000Bills payable 2,00,000 Debtors 3,60,000 Less: Provision for 3,20,000 bad debts 40,000Other Current 20,000 Stock 4,80,000liabilities Prepaid Insurance 12,000
  • 207. 16,92,000 16,92,000 Income Statement for the year ending 31st Dec., 2001 (Rs.)Sales 4,00,000Less: Cost of goods sold 30,80,000 9,20,000Less: Operating expenses 6,80,000Net Profit 2,40,000Less: Income tax paid 50% 1,20.000New Profit after tax 1,20,000 Balances at the beginning of the year: Debtors Rs. 3,00,000 Stock Rs. 4,00,000Solution:(a) Current ratio = Current Assets Current Liabilities
  • 208. Current Assets Rs. Current Liabilities Rs.Cash Creditors 1,04,000Debtors 3,20,000 Bills Payable 2,00,000Stock 4,80,000 Other Current 20,000 LiabilitiesPrepaid insurance 12,000 9,72,000 3,24,000Current ratio = 9,72,000 3:1 3,24,000(b) Quick ratio = Liquid Assets Current Liabilities Liquid assets (Rs.) Cash Debtors 1,60,000 Current liabilities Rs.3,24,000 3,20,000 4,80,000 Liquid ratio = 4,80,000 = 1.48:1 3,24,000(c) Stock Turnover Ratio = Cost of goods sold Average slock Cost of goods sold = 30,80,000Average Stock = Opening Stock + Closing Stock 2 = 4,00,000 + 4,80,000 = 4,40,000 2Stock Turnover Ratio = 3,80,000 = 7 times
  • 209. 4,40,000(d) Operating Ratio = Cost of goods sold + Operating expresses X 100 Net Sales = 30,80,000 + 6,80,000 + 40,00,000 100 X = 94% 40,00,000(e) Rate of return on equity capital: = Net profit afer lax Equity share capital = 1,20,000 X 100 = 12% 10,00,000Illustration 3: The following are the Trading and P&L A/c for the yearended 31st December 2001 and the Balance Sheet as on that date ofK. Ltd. Trading and P & L A/c Particulars Rs. Particulars Rs. To Opening Stock 9,950 By Sales 85,000 To Purchases 54,5.25 By Closing Stock 14,900 To Wages 1,425 To Gross Profit 34,000 99,900 99,900 To Administrative 15,000 By Gross Profit 34,000 Expenses To Selling Expenses 3,000 By Interest 300 To Financial Expenses 1,500 By Profit on sale 600 of shares
  • 210. To Loss on sale of assets 400 To Net Profit 15,000 34,900 34,900Balance Sheet Liabilities Rs. Assets Rs. Share Capital 20,000 Land and Buildings 15,000 Reserves 9,000 Plant & Machinery 8,000 Current Liabilities 13,000 Stock 14,900 P&LA/c 6,000 Debtors 7,1000 Cash at Bank 3,000 48,000 48,000You are required to Calculate; (a) Current Ratio (b) Operating Ratio (c) Stock Turnover Ratio (d) Net Profit Ratio (e) Fixed Assets Turnover RatioSolution:(a) Current ratio = Current Assets Current Liabilities Current Assets (Rs.) Cash at Bank 3,000 Current liabilities Rs. 13,000 Debtors 7,100 Stock 14,900
  • 211. 25,000Current ratio = 25,000 Rs. 1.923:1 13,000(b) Operating Ratio = Cost of goods sold + Operating expresses X 100 Net SalesCost of goods sold = 9,950 + 54,525 + 1,425 - 14,900 = 51,000Operating expenses = 19,500Operating Ratio = 51,000 + 19,500 X 100 = 82.94% 85,000(c) Stock Turnover Ratio = Cost of goods sold Average stock Average Stock = 9,950 + 14,900 = 12,425 2Stock Turnover Ratio = 51,000 = 4.1 times 12,425(d) Net Profit Ratio = Net Profit = 100 Net Sales = 15,000 = 100 = 17.65% 85,000(e) Fixed Assets Turnover Ratio = Net Sales Fixed Assets
  • 212. = 85,000 = 3.7 times 23,000Illustration 4; The following is the Trading and Profit and Loss a/cand Balance Sheet of a firm. Trading and P & L A/c Particulars Rs. Particulars Rs.To Opening Stock 10,000 By Sales 1,00,000To Purchases 55,000 By Closing Stock 15,000To Gross Profit c/d 50,000 1,15,000 1,15,000To Administrative Expenses 15,000 By Gross Profit b/d 50,000To Interest 3,000To Selling Expenses 12,000To Net Profit 20,000 50,000 50,000 Balance Sheet Liabilities Rs. Assets Rs.Capital 1,00,000 Land and Buildings 50,000Profit and Loss a/c 20,000 Plant & Machinery 30,000Creditors 25,000 Stock 15,000Bills Payable 15,000 Debtors 15,000 Bills receivable 12,500 Cash at Bank 17,500 Furniture 20,000 1,60,000 1,60,000Calculate the following ratios:
  • 213. (a) Inventory turnover ratio (b) Current Ratio (c) Gross profit ratio (d) Net profit ratio (e) Operating ratio (f) Liquidity ratio (g) Proprietary ratioSolution:(a) Inventory Turnover ratio = Cost of goods sold Average stock Cost of goods sold Opening Stock 10,000 Purchases 55,000 65,000 Less: Closing Stock 1 5,000 50,000Average Stock = Opening Stock + Closing Stock 2 = 10,000 + 15,000 = 12,500 2 Stock Turnover ratio = 50,000 = 4 times 12,500(b) Current ratio = Current Assets Current LiabilitiesCurrent Assets (Rs.) Current Assets Rs. Current liabilities Rs. Stock 15,000 Creditors 25,000 Debtors 15,000 Bills Payable 15,000 B/R 12,500 Cash at Bank 17,500
  • 214. 60,000 40,000Current ratio = 60,000 = 1.5:1 40,000(b) Gross Profit Ratio = Gross Profit X 100 = 50% Net Sales(c) Net Profit Ratio = Net Profit X 100 Net Sales = 20,000 = 20% 1,00,000(d) Operating Profit = Cost of goods sold + Operating expresses = 100 Net SalesCost of goods sold = 50,000 Operating expenses (Rs.) Administration expenses Selling expenses 15,000 12,000 27,000Operating ratio = 50,000 + 27,000 X 100 77 % 1,00,000(e) Liquidity ratio = Liquid Assets Current LiabilitiesCurrent Assets (Rs.) Liquid Assets Rs. Current liabilities Rs. Cash at Bank 17,500 Creditors 25,000 Bills Receivable 12,500 Bills Payable 15,000
  • 215. Debtors 15,000 45,000 40,000Liquidity ratio = 45,000 40,000(f) Proprietary ratio = Shareholder’s Funds X 100 Total AssetsShareholders Furuis (Rs.)Capital Profit and Loss a/c 1,00,000 Total Assets Rs. 1,60,000 20,000 1,20,000Proprietary ratio = 1,20,000 = 75% X 100 1,60.000Illustration 5: A company has a profit margin of 20% and assetturnover of 3 times. What is the companys return on investment?How will this return on investment vary if – (i) Profit margin is increased by 5% ? (ii) Asset turnover is decreased to 2 times? (iii) Profit margin is decreased by 5% and asset turnover is increased to 4 times.Calculation of impact of change in profit margin and change in assetturnover on return on investmentReturn on investment = Profit Margin x Asset Turnover = 20% x 3 times = 60%(i) If profit margin is increased by 5% : ROI = 25% x 3 = 75%
  • 216. (ii) If asset turnover is decreased to 2 times: ROI = 20% x 2 = 40%(iii) If profit margin decreased, by 5% and asset turnover is increasedto 4 times: ROI = 15% x 4 = 60%Illustration 6: There are three companies in the countrymanufacturing a particular chemical. Following data are available forthe year 2000-2001. (Rs. lakhs)Company Net Sales Operating Cost Operating AssetsA Ltd. 300 255 125B Ltd. 1,500 1,200 750C Ltd. 1,400 1,050 1,250Which is the best performer as per your assessment and why? Comparative Statement of Performance Particulars A Ltd. B Ltd. C Ltd. Sales 300 1,500 1,400 Less: Operating Cost 255 1,200 1,050 OperatingProfit (A) 45 300 350 Operating Assets (B) 125 750 1,250 Return on capital employed 36% 40% 28% (A) / (B) x 1 00Analysis: Basing on the return on capital employed, B Ltd., is thebest performer as compared to A Ltd. and C Ltd.Illustration 7: Calculate the P/E ratio from the following: (Rs.)Equity Share Capital (Rs. 20 each) 50,00,000Reserves and Surplus 5,00,000Secured Loans at 15% 25,00,000Unsecured Loans at 12.5% 10,00,000Fixed Assets 30,00,000
  • 217. Investments 5,00,000Operating Profit 25,00,000,Income-taxRate50% (Rs.)Operating Profit 25,00,000Less: Interest onSecured Loans @ 15% 3,75,000Unsecured Loans @ 12.5% 1,25,000 5,00,000Profit before tax (PBT) 20,00,000Less: Income-tax @ 50% 10,00,000Profit aaer tax (PAT) 10,00,000No. of Equity shares 2,50,000EPS = Profit after tax No. of Equity shares = Rs. 10,00,000 = Rs. 4 Rs. 2,50,000Market price per share = Rs. 50P/E Ratio = Market price per share / EPS = Rs.50/Rs.4 = 12.50Illustration 8: The capital of Growfast Co. Ltd., is as follows:
  • 218. 10% Preference shares of Rs.10 each 50,00,000 Equity shares of Rs. 100 each 70,00,000 1,20,00,000Additional information:Profit after tax at 50% Rs. 15,00,000Deprication Rs. 6,00,000Equity dividend paid 10%Market price per equity share Rs. 200Calculate the following: (i) The cover for the preference and equity dividends (ii) The earnings per share (iii) The price earnings ratio (iv) The net funds flowSolution:(i) The cover for the Preference and Equity dividends: Profit after tax = Preference dividend + Equity dividend = Rs. 15,00,000 = 1.25 times Rs. 5,00,000 + to 7,00,000(ii) The Earning Per Share: = Net profit after preference dividend No. of Equity Shares = Rs. 15,00,000 – Rs. 5,00,000 = Rs. 14.29 Rs.7,00,000(iii) The Price Earnings Ratio:
  • 219. = Market price per share Earning per share = Rs.200 = 14 times Rs. 14.29(iv) The Net Funds Flow: (Rs.) Profit after tax 15,00,000 Add: Depreciation 6,00,000 21,00,000
  • 220. LESSON-II FUNDS FLOW ANALYSISINTRODUCTION The Profit and Loss account and Balance Sheet statements arethe common important accounting statements of a businessorganisation. The Profit and Loss account provides financialinformation relating to only a limited range of financial transactionsentered into during an accounting period and which have impact onthe profits to be reported. The Balance Sheet contains informationrelating to capital or debt raised or assets purchased. But both theabove two statements do not contain sufficiently wide range ofinformation to make assessment of organization by the end user of theinformation.FUNDS FLOW ANALYSIS In view of recognised importance of capital inflows and outflows,which often involve large amounts of money should be reported to thestakeholders, the funds flow statement is devised. This statement isalso called Statement of Sources and application of funds andStatement of changes in financial position. The Funds flow statement contain all the details of the financialresources which have became available during an accounting periodand the ways in which those resources have been used up. Thisstatement discloses the amounts raised from various sources offinance during a period and. then explains how that finance has beenused in the business. This statement is valuable in interpretation ofthe accounts.
  • 221. It is a very useful tool in analysis of finrncial statements whichanalyses the changes taking place between two balance sheet dates.The statement analyses the change between the opening and closingbalance sheets for the period. A balance sheet sets out the financial position at a point of time,setting liabilities from which funds have been raised against assetsacquired, by the use of those funds. A funds flow statement analysesthe changes which have taken place in the assets and liabilitiesduring certain period as disclosed by a comparison of the opening andclosing balance sheets.Concept ofFund’ The term ‘fund’, has been defined and interpreted differently bydifferent experts. Broadly, the term fund refers to all the financialresources of the company. However, the most acceptable meaning ofthe ‘fund’ is working capital. Working Capital is the excess of CurrentAssets over Current fi Liabilities. While attempting to understand theconcept of funds Flow Analysis! & we shali also abide by the populardefinition of funds, meaning working capital.Concept of Flow The ‘flow’ of funds refer to transfer of economic values from oneasset equity to another. When funds mean working capital, flow offunds refers to movement of funds which cause a change in workingcapital of the organisation. To identify a flow of funds, we have tounderstand the difference between ‘Current’ and ‘Non-Current’ account
  • 222. CLASSIFICATION OF BALANCE SHEET ITEMS For preparation of funds flow statement, the whole iterrs of thesheet is classified into the following four categories as shown in Table Table 1: CLASSIFICATION OF BALANCE SHEET ITEMS Liabilities Rs. Assets Rs.1. Non-Current Liabilities II. Non-Current AssetsEquity Share Capital Land XXXPreference Share Capital XXX Buildings XXXReserves and Surplus XXX Plant and Machinery XXXDebentures XXX Less: DepreciationLong-term loans XXX Furniture and Fittings XXX Vehicles XXX Patents XXXNon-Current Liabilities II. Non-Current Assets Trade Marks XXX Goodwill XXX Preliminary expenses XXX Profit and Loss A/c (Debit XXX balance) Total (A) XXX Total (A) XXX Total (A) XXXIII. Current Liabilities IV. Current AssetsTrade Creditors XXX Inventories XXXBank Overdraft XXX Trade Debtors XXXBills Payable Provisions XXX Bills Receivable XXXagainst current liabilities XXX Cash and Bank Balances XXX Loans and Advances XXX Investments Temporary) XXX Total (B) XXX Total (B) XXXGrand Total (A+B) XXX Grand Total (A+B) XXX
  • 223. The excess of current assets over current liabilities is calledworking capital. The excess of funds generated over funds outgo fromnon-current assets and non-current liabilities will lead to increase ordecrease in working capital. This can further be analysed intoincrease or decrease in respective current assets and currentliabilities.IDENTIFICATION OF FLOW OF FUNDS A flow of funds takes place only if a Current Account isinvolved. To identify a flow, journalise the transaction, identify the twoaccounts involved as Current and Non-Current and apply theGeneral Rule.
  • 224. General Rule • Transactions which involve only Current Accounts do not result in a flow. • Transactions which involve only Non-Current Accounts do not result in a flow. • Transactions which involve one Current Account and one Non- Current Account results in a flow of funds.Proformas of Funds Flow Statement The relationship between sources and application of funds andits impact j on working capital is explained in the format of Statementof Sources and Application of Funds given in Tables 2 and 3.Table 2: PROFORMA OF STATEMENT OF SOURCES ANDAPPLICATION OF FUNDSStage 1: Statement of Sources and Application of Funds of XYZ Ltd.,for the year ended 31st March, 2001. Rs.Fund from Operations xxxIssue of Share Capital xxxRaising of long-term loans xxxReceipts from partly paid shares, called up xxxSales of non-current (fixed) assets xxxNon-trading receipts, such as dividends received xxxSale of Investments (long-term) xxxDecrease in Working Capital (as per schedule of xxxchanges in w.c) Total xxxApplication or Uses of Funds:Funds Lost in Operations xxxRedemption of Preference Share Capital xxx
  • 225. Redemption of Debentures xxxRepayment of long-term loans xxxPurchase of non-current investments xxxNon-trading payments xxxPayments of dividends xxxPayment of tax xxxIncrease in Working Capital (as per schedule of xxxchanges in w.c) Total xxx The funds flow statement can also be presented in a verticalform, wherein all Sources are listed down, totaled and then allApplications are listed at one place and totaled. The totals should bethe same, the difference being the Increase or Decrease in WorkingCapital. However, the Horizontal format is more commonly used. Table 3: FORM OF FUNDS FLOW STATEMENTFunds Flow Statement of XYZ Ltd., for the year ended 31" March, 2001 Sources Rs. Applications Rs.Funds from Operations xxx Funds lost in Operations xxxIssue of Share Capital xxx Redemption of Preference , Share xxx capitalIssue of Debentures xxx Redemption of Debentures: xxxRaising of long-term xxx Repayment of long-term loans xxxloansReceipts from partly paid xxx Purchase of non-current (fixed) xxxshares, called up assetsSale of non-current xxx Purchase of long-term xxx(fixed) assets : InvestmentsNon-trading receipts xxx Purchase of long-term xxxsuch as dividends investmentsSale of long-term xxx Payment of Dividends xxxInvestments
  • 226. Net Decrease in Working xxx Payment of tax* xxxCapital Net Increase in Working Capital xxx xxx xxx*Note: Payment of dividend and tax will appear as an application offunds only when these items are appropriations of profits and notcurrent liabilities. STATEMENT OF CHANGES IN WORKING CAPITAL This statement follows the Statement of Sources andApplication, of Funds. The primary purpose of the statement is toexplain the net change in Working Capital, as arrived in Funds FlowStatement. In this statement, all Current Assets and CurrentLiabilities are individually listed. Against each of account, the figurepertaining to that account at the beginning and at the end of theaccounting period is shown. The net change in its position is alsoshown. The changes taking place with respect to each account shouldadd up to equal the ; net change in working capital, as shown by theFunds Flow Statement. A proforma of the Statement of changes in-Working Capital is being presented below:  Increase in current assets and decrease in current liabilities : The acquisition of current assets and repayment of current liabilities will result in funds outflow. The funds may be applied to finance an increase in stock, debtors etc or to reduce the amount owed to trade creditors, bank overdraft, bills payable etc.  Decrease in current assets and increase in current liabilities: The reduction in current assets e.g. stock or debtors balances will result in release of funds to be applied elsewhere. Short-
  • 227. term funds raised during the period by any increase in thecurrent liabilities like trade creditors, bank overdraft and taxdues, means that these sources have lent more at the end of theyear than at the beginning.
  • 229. Table 4: PROFORMA OF STATEMENT OF ANALYSIS OF CHANGESINWORKING CAPITALThe relation between Stage I and Stage II is given below in the figure:Stage I : List the sources from which capital has been derived during the accounting period, and the ways in which working capital has been used up, i.e. list the transactions which cause working capital to increase or decreaseStage IIl : Analyse the net increase or decrease in working capital into changes in the constituent items i.e. stock, debtors, creditors and cashThe basic rules in preparation of the funds flow statement is asfollows: • An increase in an asset over the year is an application of funds. • A decrease in an asset over the year is a source of funds. • A decrease in a liability over the year is an application of funds.
  • 230. • An increase in a liability over the year is a source of funds.SOURCES OF FUNDSThe funds inflow into the organisation will come from the followingsources:Funds Generated from Operations During the course of trading activity; a company generatesrevenue" mainly in the form of sale proceeds and paid out for costs.The difference between these two items will be the amount of fundsgenerated by the trading operations. The funds generated frombusiness operations are aruved at after making the followingadjustments:
  • 231. Table 5: PROFORMA FOR COMPUTATION OF FUNDS GENERATEDFROM OPERATIONSFunds from operations can also be calculated by preparing AdjustedProfit and Loss Account as follows: ADJUSTED PROFIT AND LOSS ACCOUNT
  • 232. Table 6: PROFORMA OF ADJUSTED PROFIT AND LOSS ACCOUNTNotes : Depreciation on fixed assets or amortisation of intangible assets like preliminary expenses, patens, goodwill etc., written off is charged, against profit to reflect the use of fixed assets or written off of intangible asset. In, these transactions there is no corresponding cash outlay occurs and hence, add back the
  • 233. amount charged against profit, to arrive at the total funds generated from business operations. The Profit or Loss on sale of non-current assets (fixed asses and long-term, investments) is adjusted to arrive at the true funds from operations. The provision for tax made in the profit and loss account is to be added back to the reported profit The actual amount paid as tax is to be shown as the application of funds in the funds flow statement. The provision for tax, if it is shown in the balance sheet, need not be considered for calculation of funds! generated fro operations. Any amount appropriated in the Profit and Loss account towards transfer to reserves or proposed dividend is to be added back to arrive at the funds generated from operation. The actual amount paid as dividend is to be shown, as application of funds in the funds flow statement. The dividend proposed but awaiting payment is a current liability in tie balance sheet. If this amount increases, from one year end to the next, the extra liability appears as a source of funds.Funds raised from Shares, Debentures and Long-term Loans The long-term funds injected into the business during the yearby issue of new shares or debentures and by raising long-term loans.If any premium is collected, that is also form part of funds raised fromthe above said sources of finance.
  • 234. Sale of Fixed Assets and Long-term Investments Any amount generated from sale of fixed assets or long-terminvestments is a source of funds. While preparation of the funds flowstatement the gross sale proceeds from sale is taken as source offunds. This activity does not produce fresh funds, but it releasesfunds used to finance the assets. Any profit or loss arising from suchsale is adjusted in the funds generated from operations.APPLICATION OF FUNDS The use of funds in an organisation take place in the followingforms:1. Repayment of Preference Capital or Debentures or Long-term Debt: This represents the application of organisations funds released from business through redemption of preference shares or debentures, repayment of long-term loans previously made by the organisation. Any reduction in Equity capital is also taken as application of funds.2. Purchase of Fixed Assets or Long-term Investments: The funds used to purchase long-term assets are usually the most significant application of fund during the year. This group includes capital expenditures on land, building plant and machinery, furniture and fittings, vehicles and long-term investments outside the business.3. Distribution of Dividends and Payment of Taxes: The dividends distributed to the shareholders and tax paid during the year is the application of funds for the firm.
  • 235. 4. Loss from Operations: Losses made in the trading activities use up the funds. If costs exceed revenue, a cash outflow will be experienced. The adjustments are made as shown above in point (i) in the sources of funds,Illustration 1: Calculate funds from operations with the help of thefollowing Profit and Loss A/c.Calculation of funds from operations
  • 236. Illustration 2: From the following Manufacturing, Trading and Profit& Loss Account of a company, calculate Funds from operations. Manufacturing, Trading, Profit & Loss Appropriation A/c
  • 237. The amount Rs. 35,000 is transferred to Adjusted Profit and Loss a/cand the tax paid Rs.25,000 is shown on the applications side of theFunds Flow StatementIllustration 4: Following are the extracts from the Balance Sheetsof{a; company-on two different dates Particulars 31-3-2000 31-23-2001 Rs. Rs.P&L A/c 50,000 80,000Provision for Taxation 10,000 15,000Proposed Dividends 5,000 10,000Additional Information 1) Tax Paid during the year 2000 – 2001 Rs.2,500 2) Dividends paid for the period 2000- 2001 Rs. 1,000On the basis of the above information, calculate ‘Funds fromOperations’ taking provision for tax and proposed dividend as (a) Non-current liabilities (b) Current liabilities.a) Provision for tax and proposed Dividend are taken as non-currentliabilitiesProvision for Taxation A/c Particulars Rs. Particulars Rs.To Income Tax A/c 2,500 By balance b/d 10,000(tax paid|) (opening balance)To Balance c/d 15,000 By P&L A/c (provision 7,500(closing balance) made in the current year) [bal.fig.]
  • 238. 17,500 17,500 Particulars Rs. Particulars Rs.To Dividend A/c 1,000 By Balance b/d 5,000(being dividend paid (Opening balance)during the year)To balance c/d 10,000 By P&L A/c (Proposed 6,000(closing balance dividend for the current 11,000 11,000Adjusted P & L A/c Particulars Rs. Particulars Rs.To Provision for 7,500 By Balance b/d 50,000Taxation (opening balance)A/cTo proposed Dividend 6,000 By Funds from 43,500 Operations (bal. fig.)To Balance c/d 80,000(closing balance 93,500 93,500Illustration 5: The following information has been extracted from theBalance Sheets of a company Particulars 31st Dec. 2000 31st Dec. 2001Machinery 80,000 2,00,000Accumulated Depreciation 30,000 35,000Profit and Loss Account 25,000 40,000The following additional information is also available:(i) A machine costing Rs. 20,000 was purchased during the year by issue of equity shares.
  • 239. (ii) On January 1, 2001, a machine costing Rs. 15,000 (with an accumulated depreciation of Rs.5,000) was sold for Rs.7,000.Find out sources/ application of funds. Particulars Rs. Particulars Rs.To Machinery A/c 5,000 By Balance b/d 30,000To Balance c/d 35,000 By Adjusted P&L A/C 10,000 (balancing figure) 40,000 40,000
  • 240. Machinery A/c Particulars Rs. Particulars Rs.To Balance b/d 80,000 By cash (sales) 7,000To Share Capital 20,000 By Accumulated 5,000 depreciationTo Cash-Purchases 1,15,000 By Adjusted P & L A/c 3,000(balancing figure) (Loss on sale) By Balance c/d 2,00,000 2,15,00 2,15,000 0Accumulated Depreciation A/c Particulars Rs. Particulars Rs.To Accumulated 10,000 By Balance b/d 25,000Depreciation A/cTo Machinery A/c (Loss 3,000 By Funds from 28,000on sale) Operations (bal. fig.)To Balance c/d 40,000 53,000 53,000(i) Purchase of machinery for Rs.20,000 by issue of equity shares is neither a source nor an application of funds.(ii) Sale of machinery for Rs.7,000 is a source of funds,(iii) Purchase of machinery for Rs.1,15,000 for cash is an application of funds, (iv) Funds from operations of Rs.28,000 is a source of funds.Illustration 6: From the following information, you are required toascertain the amount of flow of funds on account of Plant.
  • 241. Rs.Opening Balance of Plant 1,32,500Closing Balance of Plant 1,97,500Provision for Depreciation on Plant at the beginning 45,000of the yearProvision for Depreciation on Plant at the end of the 61,000year During the year, a plant costing Rs. 65,000 was purchased inexchange for fully paid debentures. An old Plant costing Rs. 40,000was sold for Rs.34,000. Depreciation provided on the same amountedto Rs.18,000.Accumulated Deprecation A/c Particulars Rs. Particulars Rs.To Machinery A/c 40,000 By Balance b/d 4,24,000(Depn.of sold Machine)To Closing balance c/d 4,11,000 By Adjusted P&L A/c 27,000 (Balancing Figure( [Depn. provided during the year] 4,51,000 4,51,000Illustration 8 :Extracts from Balance Sheets Particulars As on 31st As on 31st March March, 2001
  • 242. 2000 Rs. Rs.Equity from Balance Sheets 4,00,000 5,00,0008% Preference Share Capital 2,00,000 1,50,000Additional Information : (i) Equity shares were issued during the year against purchase of machinery for Rs.50,000. (ii) 8% Preference shares worth Rs. 1,00,000 were redeemed during the year.Prepare necessary accounts to find out sources/applications of funds.
  • 243. Equity Share Capital A/c Particulars Rs. Particulars Rs.To Machinery A/c 40,000 By Balance b/d 4,24,000(Depn.of sold Machine)To Closing balance c/d 4,11,000 By Adjusted P&L A/c 27,000 (Balancing Figure( [Depn. provided during the year] 4,51,000 4,51,000Equity Share Capital A/c Particulars Rs. Particulars Rs.To Balance c/d 5,00,000 By Balance b/d 4,00,000 By Machinery A/c 50,000 By Cash-Issue (balancing 50,000 figure) 5,00,000 5,00,000 8% Preference Share Capital A/c Particulars Rs. Particulars Rs.To cash (Application) 1,00,000 By Balance b/d 2,00,000To Balance c/d 1,50,000 By Cash-Issue (balancing 50,000 figure) 2,50,000 2,50,0001. Issue of equity shares purchase of machinery is neither a source nor application of funds.
  • 244. 2. Issue of shares worth Rs.50,000 for cash is a source of funds.3. Redemption of preference shares worth Rs.1,00,000 is an application of funds.4. Issue of preference shares of Rs. 50,000 is a source of funds.Illustration 9 :Prepare a statement showing changes in working capital Particulars 2000 2001AssetsCash 60,000 94,000Debtors 2,40,000 2,30,000Stock 1,60,000 1,80,000Land 1,00,000 1,32,000 Total 5,60,000 6,36,000Capital & LiabilitiesShare Capital 4,00,000 5,00,000Creditors 1,40,000 90,000Retained earnings 20,000 46,000 Total 5,60,000 6,36,000 Statement showing changes in working capital Particulars 2000 2001 Increase Decrease (+) (-)Current AssetsCash 60,000 94,000 34,000Debtors 2,40,000 2,30,000 10,000Stock 1,60,000 1,80,000 20,000 4,60,000 5,04,000Current LiabilitiesCreditors 1,40,000 90,000 50,000Working Capital (CA- 3,20,000 4,14,000CL)Net increase in 94,000 94,000Working Capital 4,14,000 4,14,000 1,04,000 1,04,000
  • 245. Illustration 10 : Following are summerised Balance Sheets ‘X’ Ltd. ason 31st December, 2000 and 2001. You are required to prepare aFunds Statement for the year ended 31st December, 2001. Liabilities 2000 2001 Assets 2000 2001Share Capital 1,00,000 1,25,000 Goodwill - 2,500General Reserve 25,000 30,000 Buildings 1,00,000 95,000P&L A/c 15,250 15,300 Plant 75,000 84,500Bank Loan 35,000 67,600 Stock 50,000 37,000(Long-term)Creditors 75,000 - Debtors 40,000 32,100Provision for Tax 15,000 17,500 Bank - 4,000 Cash 250 300 2,65,250 2,55,400 2,65,250 2,55,400Additional Information: (i) Dividend of Rs. 11,500 was paid. (ii) Depreciation written off on plant Rs.7,000 and on buildings Rs.5,000. (iii) Provision for tax was made during the year Rs. 16,500.Statement showing Changes in Working Capital Particulars 2000 2001 Increas Decrease e (-) (+)Current AssetsCash 250 300 50Bank - 4,000 4,000Debtors 40,000 32,100 7,900Stock 50,000 37,000 13,000 90,250 73,400
  • 246. Current LiabilitiesCreditors Working 75,000 - 75,000 -Capital (CA - CL) 15,250 73,400Net increase in Working 8,150 58,150Capital 73,400 73,400 79,050 79,050 Funds Flow Statement Sources Rs. Application Rs.Funds from 45,050 Purchase of Plant 16,500operationsIssue of Shares 25,000 Income tax paid 14,000Hank Loan 32,600 Dividend paid 11,500 Goodwill paid 2,500 Net increase in 58,150 Working Capital 1,02,650 1,02,650Working Notes:Share Capital A/cParticulars Rs. Particulars RsTo Balance c/d 1,25,000 By Balance b/d 1,00,000 By Bank a/c 25,000 1,25,000 1,25,000General Reserve A/c Particulars Rs. Particulars Rs.To Balance c/d 30,000 By Balance b/d 25,000
  • 247. By P&L a/c 5,000 30,000 30,000Provision for Taxation A/cParticulars Rs. Particulars Rs.To Bank a/c 14,000 By Balance b/d 15,000To Balance c/d 17,500 By P&L a/c 16,500 31,500 31,500Bank Loan A/c Particulars Rs. Particulars Rs.To Balance c/d 67,600 By Balance b/d 35,000 By Bank a/c 2,600 67,600 67,600Land and Building A/c Particulars Rs. Particulars Rs.To Balance c/d 1,00,000 By Depreciation 5,000 a/c (P&L a/c) By Balance c/d 95,000 1,00,000 1,00,000Plant A/c Particulars Rs. Particulars Rs.To Balance c/d 75,000 By Depreciation a/c 7,000 (P&L a/c)To Bank 16,500 By Balance c/d 84,500 91,500 91,500
  • 248. Goodwill A/c Particulars Rs. Particulars Rs.To Bank 2,500 By Balance c/d 2,500 2,500 2,500Calculation of Funds from Operations: (Rs.)Balance of P&L a/c (2001)Add: Non-fund and non-operatingitems which have already debited toP&L a/c:General reserve 5,000Provision for tax 16,500Dividends paid 11,500Depreciation: On Buildings 5,000 On Plant 7,000 45,000 60,300Less: Balance of P&L a/c (2000) 15,250 Funds from Operations 45,050Illustration 11: From the following Balance Sheets of ABC Ltd. on31st Dec. 2000 and 2001, you are required to prepare (i) A Schedule ofchanges in working capital, (ii) A Funds Flow Statement. (Rs.)Liabilities 2000 2001 Assets 2000 2001Share Capital 2,00,000 2,00,000 Goodwill 24,000 24,000General Reserve 28,000 36,000 Buildings 80,000 72,000P&L A/c 32,000 26,000 Plant 74,000 72,000Creditors 16,000 10,800 Investments 20,000 22,000Bills payable 2,400 1,600 Stock 60,000 46,800,Provision for Tax 32,000 36,000 Bills 4,000 6,400 receivable
  • 249. Provision for 800 1,200 Debtors 36,000 3 8,000doubtful debts Cash & Bank 13,200 30,400 balances 3,11,200 3,11,600 3,11,200 3,11,600Additional Information: (i) Depreciation provided on plant was Rs.8,000 and on Buildings Rs.8,000 (ii) Provision for taxation made during the year Rs.38,000 (iii) Interim dividend paid during the year Rs. 16,000.Statement showing Changes in Working Capital Increase Decrease Particulars 2000 2001 in W.C. in W.C.Current AssetsCash & Bank 13,200 30,400 17200BalancesDebtors 36,000 38,000 2,000Bills Receivable 4,000 6,400 2,400Stock 60,000 46,800 13,200 1,13,200 1,21,600Current LiabilitiesProvision for 800 1,200 400doubtful debtsBills Payable 2,400 1,600 800Creditors Working 16,000 10,800 5,200Capital (CA - CL) 19,200 13,600 94,000 1,08,000Increase in Working 14,000 14,000Capital 1,08,000 1,08,000 27,600 27,600
  • 250. Funds Flow StatementSources Rs. Application Rs.Funds from 72,000 Purchase of Plant 6,000operations Tax paid 34,000 Purchase of investments 2,000 Interim dividend paid 16,000 Increase in Working Capital 14,000 72,000 72,000Working Notes: Provision for Taxation A/cParticulars Rs. Particulars Rs:To Balance c/d 36,000 By P&L a/c 32,000To Balance c/d 36,000 By P&L a/c 28,000 70,000 70,000 Plant A/cParticulars Rs. Particulars Rs:To Balance c/d 74,000 By Depreciation 8,000To Balance (Purchase) 6,000 By Balance c/d 72,000 80,000 80,000 Buildings A/cParticulars Rs. Particulars Rs:To Balance c/d 80,000 By Depreciation 8,000 By Balance c/d 72,000 80,000 80,000Investments A/c Particulars Rs. Particulars Rs.
  • 251. To Balance b/d 20,000 By Balance c/d 22,000To Bank (Purchase) 2,000 22,000 22,000Adjusted Profit & Loss A/c Particulars Rs. Particulars Rs.To Non-fund and Non- By Balance on (31-12-200) 32,000operating items already By Funds from operations 72,000debited to P&L a/c:Transfer to General Reserve 8,000Provision for Tax 38,000Depreciation on Plant 8,000Depreciation on Buildings 8,000Interim dividend 16,000To Balance on 3 1-1 2-2001 26,000 1,04,000 1,04,000 General Reserve A/c Particulars Rs. Particulars Rs.To Balance c/d 36,000 By Balance 28,000 By P&L a/c 8,000 36,000 36,000Illustration 12: From the following Balance Sheet of X Ltd., as on31st December, 2000 and 31st December 2001, you are required toprepare a funds | flow statement. (Rs.) Liabilities 2000 2001 Assets 2000 2001Share Capital 4,00,000 5,00,000 Land and 4,00,000 4,80,000 BuildingsGeneral 80,000 1,40,000 Machinery 3,60,000 2,60,000
  • 252. ReserveP&L A/c 64,000 78,000 Stock 2,00,000 2,52,000Bank Loan 3,20,000 80,000 Debtors 1,60,000 1,28,000(Long term)Creditors 3,00,000 2,60,000 Cash at Bank 1,04,000 18,000Provision for 60,000 80,000Taxation 12,24,000 11,38,000 12,24,000 11,38,000Additional Information : (i) During the year ended 31st December 200 dividend of Rs.84,000 was paid. (ii) Assets of another company were purchased for a consideration of Rs. 1,00,000 payable by the issue of shares. The assets included Land- and Buildings of Rs.50,000 and stock of Rs.50,000. (iii) Depreciation written off on machinery is Rs.24,000 and on Land and . Buildings is Rs.45,000. (iv) Income-tax paid during the year was Rs.70,000. (v) Additions to Buildings were for Rs.75,000.Statement showing Changes in Working Capital Particulars 2000 2001 Increase in Decrease W.C. in W.C.Current AssetsCash at Bank 1,04,000 18,000 86,000Debtors 1,60,000 1,28,000 32,000Stock 2,00,000 2,52,000 52,000 4,64,000 3,98,000Current Liabilities
  • 253. Creditors Working 3,00,000 2,60,000 40,000Capital 1,64,000 1,38,000 1,64,000 1,38,000Decrease in working 26,000 26,000capital 1,64,000 1,64,000 1,18,000 1,18,000 Funds Flow Statement for the year ending 31st Dec. 2001 Sources Rs. Application Rs.Issue of Shares 50,000 Purchase Of Land & 75,000 BuildingsSale of Machinery 76,000 Bank Loan paid 2,40,000Funds from 3,17,000 Dividend paid 84,000operationsDecrease in 26,000 Income-tax paid 70,000Working Capital 4,69,000 4,69,000Working Notes:Provision for Taxation A/cParticulars Rs. Particulars Rs.To Cash 70,000 By Balance b/d 60,000To Balance b/d 80,000 By Adj. P&L a/c 90,000 1,50,000 1,50,000Machinery A/cLand and Buildings A/c
  • 254. Particulars Rs. Particulars Rs.To Balance b/d 3,60,000 By Adj. P&L a/c 24,000 By Sale of Machinery 76,000 By Balance c/d 2,60,000 3,60,000 3,60,000 Land and Buildings A/cParticulars Rs. Particulars Rs.To Balance b/d 4,00,000 By Adj. P&L a/c 45,000To Share Capital 50,000 By Balance c/d 4,80,000To Cash 75,000 5,25,000 5,25,000General Reserve A/cParticulars Rs. Particulars Rs.To Balance c/d 1,40,000 By Balance b/d 80,000 By Adj. P&L a/c 60,000 1,40,000 1,40,000Adjusted Profit & Loss A/cParticulars Rs. Particulars Rs.To Machinery 24,000 By Opening Balance 64,000To Land & 45,000 By Funds from 3,17,000Buildings OperationsTo Provision for 90,000taxTo General 60,000ReserveTo Dividends paid 84,000
  • 255. To Closing 78,000balance 3,81,000 3,81,000FUNDS FLOW STATEMENT Vs. PROFIT AND LOSS ACCOUNT Following are the main differences between a Funds FlowStatement and a Profit and Loss Account: 1. Objective: The main objective of preparing a Funds Flow Statement is to ascertain the funds generated from operations. The statement reveals the sources of funds and their uses. The main objective of preparing a Profit and Loss Account is to ascertain the net profit earned/ loss incurred by the company out of the business operations at the end of a particular period. 2. Basis: The Funds Flow Statement is prepared based on the financial statements of two consequent years. A Profit and Loss Account is prepared on the basis of nominal accounts. 3. Usefulness: The Funds Flow Statement is useful for creditors and management. The Profit and Loss Account is useful not only to creditors and management but also to the shareholders and outside parties. 4. Type of Data Used: The Funds Flow Statement takes into account only the funds available from trading operations but also the funds available from other sources like issue of share capital/ debentures, sale of fixed assets etc. Whereas, the Profit and Loss Account uses only income and
  • 256. expenditure transactions relating to trading operations of a particular period. For instance, when shares are issued for cash, the same is shown infunds flow statement as a source of funds whereas in profit and loss accountit is now shown as income. 5. Legal Necessity: Preparation of Funds Flow Statement is not a statutory obligation and is left to the discretion of management. Preparation of Profit and Loss Account is a statutory obligation.FUNDS FLOW STATEMENT Vs. BALANCE SHEET Following are the main difference between a Funds FlowStatement and a Balance Sheet.1. Objective: The Funds Flow Statement is prepared to know the total sources and their uses in a year. Balance Sheet is prepared to know the financial position of a company as on a particular date.2. Basis: The Funds Flow Statement is prepared with the help of the balance sheets of two consecutive years. The Balance Sheet is prepared oh the basis of different accounts in the ledger.3. Usefulness: Funds Flow. Statement is useful for the management for internal financial management. A Balance Sheet is useful not only for the management but also to the shareholders, creditors, outsiders and Government agencies etc.4. Treatment of Current Assets and Current Liabilities: In Funds Flow Statement current assets and current liabilities are
  • 257. used to find out increase or decrease in working capital. In Balance Sheet, current assets and current liabilities are shown itemwise.5. Legal Necessity: Preparation of Funds Flow Statement is at the discretion of management. Preparation of Balance Sheet is a statutory obligation.USES OF FUNDS FLOW STATEMENT(1) To determine financial consequences of operations: Funds Flow Analysis determines the financial consequences of business operations. In the following cases, Funds Flow Analysis helps the management to understand the movement of funds and in effective funds management: • Many a time, a company inspite of earning large profits may have unsatisfactory liquidity position. The reasons for such a position and the financial consequences of business operations can be ascertained with the help of funds flow statement. • The company may be incurring losses but its liquidity position is sound or the firm will be investing in fixed Assets despite losses. • The firm may declare dividend inspite of losses or low profits. • The profit earned by the firm from different sources is not easily understood by the management.
  • 258. • There may be sufficient cash in the business. But how such high liquidity is existing is not known.To fill financial blind spots : The Funds Flow Statement is designedto fill financial blind spots of the operating statement. It translates theeconomic consequences of operations into financial information as abasis for action.(2) Working capital utilisation: The Funds Flow Statement helps the management in assessing the activity of working capital and whether the working capital has been effectively used to the maximum extent in business operations or not. The statement also depicts the surplus or deficit in working capital than required. This helps the management to use the surplus working capital profitability or to locate the sources of additional working capital in case of scarcity.(3) To aid in securing new finances: A statement of changes in financial position is useful for the creditor in considering the companys request for new term loan.(4) Helps in allocation of financial resources: Funds Flow Statement helps the management in taking decisions regarding allocation of the limited financial resources among different projects on priority basis.(5) Helps in deciding the urgency of a problem: Funds Flow Analysis helps to relate the time factor to financial planning. This enables the management to identify critical points throughout the passage of time. The management as also the outsiders concern themselves with the information system geared up; towards changes in financial position as the behaviour of funds flow figures relates to the criteria upon which management strategy is based.
  • 259. (6) Helps in evaluation of operational issues: The statement of changes functions as an analytical guide for evaluating operational issues. The statement enables the management to ascertain in which the study of trends of success or failure of operations and available resources.DRAWBACKS OF FUNDS FLOW ANALYSIS Historical nature: The funds flow statement is historical in nature like any other financial statement. It does not estimate the sources and application of funds for the near future. Structural changes are not disclosed: The funds flow statement does not disclose the structural changes in financial relationship in a firm not it discloses the major policy changes with regard to investment in current assets and short term financing. Significant additions to inventories financed by short term creditors are not furnished in the statements as they are offset by each other while computing net changes in working capital. New items are not disclosed: The funds flow statement does not disclose any new or original items which affect the financial position of the business. The funds flow statement simply rearranges the data given in conventional financial statements and schedules. Not relevant: A study of changes in cash is more relevant than a study of changes in funds for the purpose of managerial decision-making. Not foolproof: The funds flow statement is prepared from the data provided in the balance sheet and profit and loss account.
  • 260. Hence, the defects in financial statements will be carried over tofunds flow statement also.
  • 261. LESSON-12 CASH FLOW ANALYSESINTRODUCTION Cash flow statement provides information about the cashreceipts and payments of a firm for a given period. It providesimportant information that compliments the profit and loss accountand balance sheet. The information about the cash-flows of a firm isuseful in providing users or financial statements with a basis toassess the ability of the enterprise to generate cash and cashequivalents and the needs of the enterprise to utilise these cash flows.The economic decisions that are taken by users require an evaluationof the ability of an enterprise to generate cash and cash equivalentsand the timing and certainly of their generation. The statement dealswith the provision of information about the historical changes in cashequivalents of an enterprise by means of a cash flow statement whichclassifies cash flows during the period from operating) investing andfinancing activities.Meaning of certain Terms• Cash comprises cash on hand and demand deposit with banks.• Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. Examples of cash equivalents are, treasury bills, commercial paper etc.• Cash flows are inflows and outflows of cash and cash equivalents. It means the movement of cash into the organisation and movement of cash out of the organisation. The
  • 262. difference between the cash inflow and outflow is known as net cash flow which can be either net cash inflow or net cash outflow.• Classification of cash flowsThe cash flow statement during a period is classified into three maincategories of cash inflows and cash outflows:• Cash flows from Operating activities:Operating activities are the principal revenue-producing activities ofthe enterprise and other activities that are not investing and financingactivities. Operating activities include cash effects of thosetransactions and events that enter into the determination of net profitor loss. Following are examples of cash flows from operating activities:• Cash receipts from the sale of goods and the rendering of services• Cash receipts from royalties, fees, commissions, and other revenue• Cash payment to suppliers for goods and services• Cash payments to and on behalf of employees• Cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits• Cash payments or refunds of income-taxes unless they can be specifically identified with financing and investing activities.• Cash receipts and payments relating to future contracts, forward contracts, option contracts, and swap contracts when the contracts are held for dealing or trading purpose etc.,
  • 263. Cash From OperationsFunds from Operations xxx(as learnt in the previous chapter)Add: Increase in Current Liabilities xxx (excluding Bank Overdraft) Decrease in Current Assets xxx xxx (excluding cash & bank balance) xxxLess: Increase in Current Assets xxx (excluding cash & bank balance) Decrease in Current Liabilities xxx xxx (excluding bank overdraft)Cash from Operations xxx• Cash Flows from Investing Activities:Investing activities are the acquisition and disposal of long-termassets and other investments not included in cash equivalents. Inother words, investing activities include-transactions and events thatinvolve the purchase and sale of long-term productive assets, (e.g.,land, building, plant and machinery, etc) not held for re sale andother investments. The following are examples of cash flows arising*from investing activities:• Cash payments to acquire fixed assets (including intangibles). ;• These payments include those relating to capitalised research and development costs and self-constructed fixed assets.• Cash receipts from disposal of fixed assets (including intangibles)
  • 264. • Cash payments to acquire shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes)• Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes)• Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise)• Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise)• Cash receipts and payments relating to future contracts, forward contracts,, option contracts, and swap contracts except when the contracts are, held for dealing or trading purposes, or the receipts are classified as financing activities.• Cash Flows from Financing Activities:Financing activities are activities that result in changes in the size andcomposition of the owners’ capital (including preference share capitalin the case of a company) and borrowings of the enterprise. Followingare the examples of cash flows arising from financing activities:• Cash proceeds from issuing shares or other similar instruments• Cash proceeds from issuing debentures, loans notes, bonds and other short-term borrowing• Cash repayments of amounts borrowed• Payment of dividend
  • 265. Information required for Cash Flow StatementThe following basic information is needed for the preparation of acash flow statement: Comparative Balance Sheets: Balance Sheets at the beginning and at the end of the accounting period indicate the amount of changes that have taken place in assets, liabilities and capital. Profit and Loss Account : The profit and loss account of the current period enables to determine the amount of cash provided by or used in operations during the accounting period after making adjustments for non-cash, current assets and current liabilities. Additional Data: In addition to the above statements, additional data are collected to determine how cash has been provided or used e.g., Sale or purchase of assets for cash.Cash Flow Statement of XYZ Ltd. for the year ending 31" March2001 Source Rs. Application Rs.Opening Balances Opening BalancesCash XXX Bank overdraftBank XXX Cash outflowsCash Inflows Redemption of Redeemable XXX Preference SharesCash from Operations XXX Redemption of Debentures XXXIssue of Shares XXX Repayment of Loans XXXRaising of Long Term Non Operating Expenses XXXLoans/Debentures XXX Closing Balances XXX
  • 266. Sale of Fixed Assets XXX Cash XXXand InvestmentsNon Trading Receipts XXX Bank XXX XXX XXXNote : The Cash Flow Statement can also be presented in the verticalform. However, the horizontal form given above is convenient and ismore commonly used.Funds Flow Statement vs. Cash Flow StatementBoth funds flow and cash flow statements are used in analysis of pasttransactions of a business firm. The difference between these twostatements are given below: • Funds flow statements is based on the accrual accounting system. In case of preparation cash flow statements all transactions effecting the cash or cash equivalents is only taken into consideration. • Funds flow statement analysis the sources and application of funds of long-term nature and the net increase or decrease in long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or decrease in current assets and current liabilities in calculating the cash flow of funds from operations. • Funds Flow analysis is more useful for long range financial planning. Cash flow analysis is more useful for identifying and correcting die current liquidity problems of the firm. • Funds flow statement analysis is a broader concept, it takes into account both long-term and short-term funds into account
  • 267. in analysis. But cash flow statement only deal with the one of the current assets on balance sheet assets side. • Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statements Start with the opening balance of cash and reach to the closing balance of cash by proceeding through sources and uses.Illustration: 1From the following information, you are required to ascertain cashflow operationParticulars 31.12.2000 31.12.2001Net Profit 70,000Debtors 42,000 40,000Bills Receivable 8,000 13,000Creditors 47,000 50,000Bills payable 15,000 10,000Stock 58,000 65,000
  • 268. Calculation of Cash from operationsProfit made during the year 70,000Add: Decrease in debtors 2,000Increase in Creditors 3,000 5,000 75,000Less: Increase in Bill Receivable 5,000Increase in stock 7,000[ Decrease in Bills payable 5,000 17,000Cash from operations 58,000Illustration: 2From the following balances, you are required to calculate cash fromoperations:Particulars December December 31 2000 31 2001Debtors 50,000 47,000Bill Receivable 10,000 12,500Creditors 20,000 25,000Bills Payable 8,000 6,000Outstanding Expenses 1,000 1200Prepaid Expenses 800 700Accrued Income 600 750Income Received in Advance 300 250Profit made during the year - 1,30,000 Calculation of Cash from operationsProfit made during the year 1,30,000Add: Decrease in debtors 3,000Increase in Creditors 5,000Increase in Outstanding Expenses 200Decrease in Prepaid Expenses 100 1,38,000Less: Increase in Bill Receivable 2,500Increase in Accrued Income 150Decrease in Bills Payable 2,000Decrease in Income Receive in Advance 50 4,700Cash from Operations 1,33,600
  • 269. Illustration: 3From the following information, calculate cash from operations Particulars 2000 2001P&LA/c (credit) 40,000 50,000Debtors 20,000 26,000Bills Receivable 20,000 12,000Prepaid Rent 2,000 3,000Prepaid Insurance 1,000 800Goodwill 20,000 14,000Depreciation 32,000 40,000Creditors 20,000 30,000 Statement showing Cash from operationsClosing balance P&L A/c 50,000Add: Decrease in Bill Receivable 8,000Decrease in Prepaid Insurance 200Increase in Creditors 10,000Depreciation 8,000Goodwill 6,000 32,200 82,200Less: Increase in debtors 6,000Increase in prepaid rent 1,000Opening balance of P&L A/c 40,000 47,000Cash from Operations 35,200Illustration: 4From the following balance sheets of Sulekha Ltd. you are required toprepare a cash flow statement Liabilities 2000 2001 Assets 2000 2007 Rs. Rs. Rs. Rs.
  • 270. Share capital 3,00,000 3,75,000 Cash 45,000 70,500Trade editors 1,05,000 67,500 Debtors 1,80,000 1,72,500P&L A/c 15,000 34,500 Stock in Trade 1,20,000 1,35,000 Land 75,000 99,000 4,20,000 4,77,000 4,20,000 4,77,000Cash flow Statement of Sulekha Ltd. for the year 2001 Sources Rs. Application Rs.Opening Balance of cash 45,000 Purchase of Land 24,000Issue of Share Capital 75,000 Decrease in Trade 37,500 CreditorsCash Operating Profit 19,500 Closing balance 70,500(Diff. In P&L A/c)Decrease in Debtors 7,500 1,47,000 1,47,000Illustration: 5From the following balance sheets of Zindal Ltd/prepare cashflowstatement. Liabilities 2000 2007 Assets 2000 2007Share Capital 600 800 Goodwill 230 1808% redeemable Pref. 300 200 Land & Buildings 400 340SharesGeneral reserve 80 140 Plant 160 400P&L Account 60 96 Debtors 320 400Proposed dividend 84 100 Stock 154 218Creditors 110 166 Bills Receivable 40 60Bills Payable 40 32 Cash in hand 30 20Provision for tax 80 100 Cash at Bank 20 16Total 1354 1634 1354 1634
  • 271. Additional information:1) Depreciation of Rs.20,000 and Rs.40,000 have been charged on plant account and land and buildings account, respectively in 2001.2) An interim dividend of Rs.40,000 has been paid in 2001.3) Income tax Rs.70,000 was paid during the year 2001.1. Plant Account Particulars Rs. Particulars Rs.To Opening Balance 1,60,000 By Depreciation 20,000on 1-1-2001To Purchases-cash 2,60,000 By closing balance 4,00,000 on 31-12-2001 4,20,000 4,20,0002. Land and Building AccountParticulars Rs. Particulars Rs.To Opening Balance 4,00,000 By Depreciation 40,000on 1-1-2001 By cash (sales- balancing figure) By closing balance on 3,40,000 31-12-2001 4,00,000 4,00,0003. Provision for taxation Account Particulars Rs. Particulars Rs.Cash 70,000 By Opening Balance on 80,000
  • 272. 1-1-2001To closing balance 1,00,000 By P&L Account 90,000on 31-12-2001 (balancing figure) 1,70,000 1,70,000 Calculation of cash from operationsClosing balance P&L A/c on 31-12- 96,0002001:Less: Balance of P&L A/c on 1-1-2001: 60,000 36,000Add: Profit used for reserves &provisions:Proposed dividend 1,00,000Interim dividend 40,000Provisions for taxation 90,000Transfer to general reserve 60,000 2,90,000 3,26,000Add : Profit used for writing off non-cash A/c:Goodwill 50,000Depreciation:Plant 20,000Land & Building 40,000 1,10,000 4,36,000Add: increase in creditors 56,000Funds from operations 4,92,000Less: Increase in current assets:Debtors 80,000Stock 64,000Bills Receivable 20,000 1,64,000 3,28,000Less: Decrease in current liabilities:Bills Payable 8,000Cash from Operations 3,20,000Cash flow statement for the year ended December 31,2001 Cash in-flows Rs. Cash out-flows Rs.Op. Bal. As on 1-1-2001Cash 30,000 Purchase of plant 2,60,000Bank 20,000 Payment of final 84,000
  • 273. dividend for 2000 Payment of interim 40,000 dividendAdd: Cash inflows: Income-tax paid 70,000Operations 3,20,000 Redemption of Pref. 1,00 SharesSale of land & bldg. 20,000 1,00,000Issue of shares 2,00,000 5,54,000 Closing balance on 31-12-2001 Cash in hand 20,000 Cash in bank 16,000 5,90,00 5,90,000 0Illustration: 6From the following information you are required to prepare a CashFlow Statement of Shanti Stores Ltd for the year ended 31" December,2001 Balance Sheets Liabilities 2000 2001 Assets 2000 2001Share Capital 70,000 70,000 Plant 50,000 91,000 MachinerySecured Loans Inventory 15,000 40,000Repayable (2001) 40,000 Debtors 5,000 20,000Creditors 14,000 39,000 Cash 20,000 7,000Tax payable 1,000 3,000 Prepaid 2,000 4,000 General Exp.P&L A/c 7,000 10,000 92,000 1,62,000 92,000 1,62,000
  • 274. Profit & Loss A/c for the year ended 31" December, 2001 Particulars Rs. Particulars Rs.To Opening Inventory 15,000 By sales 1,00,000To Purchases 98,000 By Closing inventory 40,000To Gross Profit c/d 27,000 1,40,000 1,40,000To General Expenses 11,000 By Gross Profit b/d 27,000To Depreciation 8,000To Taxes 4,000To Net Profit c/d 4,000 27,000 27,000To Dividend 1,000 By Balance b/d 7,000To Balance c/d 10,000 By Net Profit b/d 4,000 11,000 11,000
  • 275. Working Notes: Machinery A/c Particulars Rs. Particulars Rs.To Balance b/d By Depreciation a/c 8,000(Opening balance) 50,000 By Balance c/d – (closing balance) 91,000To Bank a/c -Purchases (bal. Fig.) 49,000 99,000 99,000 Provision for Taxation Particulars Rs. Particulars Rs.To Bank a/c - tax By Balance b/d 1 ,000Paid (bal. Fig.) 2,000 By P & L a/c -To Balance c/d - (current year) 4,000closing balance 3,000 5,000 5,000
  • 276. (Rs.)Net Profit 4,000Add: Depreciation 8,000Taxes 4,000Funds from Operations 16,000Cash from Operations Rs.Funds from Operations 16,000Add: Increase in Creditors 25,000 41,000Less: Increase in Debtors 15,000Increase in Inventory 25,000Increase in Prepaid General Expenses 2,000 42,000Cash lost in Operations 1,000 Cash Flow Statement of M/s Shanti Stores Ltd. for the year ending 31" December, 2001 Sources Rs. Application Rs.To Balance c/d - Cash OutflowOpening Cash Balance 20,000 Machine Purchased 49,000Cash InflowsSecured Loans raised 40,000 Taxes Paid 2,000 Dividends paid 1,000 Cash lost in Operations 1,000 Closing cash Balance 7,000 60,000 60,000Illustration: 7The following are the balance Sheets of X Ltd. For the year ending 31 stDecember 2000 and 2001
  • 277. Particulars 2000 2001Liabilities Rs. Rs.Share Capital 2,00,000 3,00,000Profit and Loss Account 1,20,000 1,60,000Sundry creditors 60,000 50,000Provision for taxation 40,000 50,000Proposed Dividend 20,000 30,000 4,40,000 5,90,000 Particulars 2000 2001Assets: Rs. Rs.Fixed Assets 1,60,000 2,00,000Add: Additions 40,000 60,000 2,00,000 2,60,000Less: Depreciation 18,000 24,000 1,82,000 2,36,000Investments 8,000 16,000Stock 1,60,000 2,18,000Debtors 60,000 80,000Cash 30,000 40,000 4,40,000 5,90,000Additional information:1) Taxes Rs. 44,000 and dividend Rs. 24,000 were paid during the year 20012) The net profit for the year 2001 before depreciation Rs. 1,34,000 Cash Flow Statement for the year ending 31 st December, 2001 Sources Rs. Application Rs.Opening Balance of Cash OutflowsCash(1-1-2001) 30,000 Purchase of fixed assets 60,000
  • 278. Cash inflows: Taxes paid 44,000Issue of share capital 1,00,000 Dividend paid 24,000Cash from operations 1,34,000 Purchase of investments 8,000 Increase in Stock 58,000 Increase in debtors 20,000 Decrease in creditors 10,000 Closing balance of cash 40,000 2,64,000 2,64,000Working Notes: Fixed Assets a/cParticulars Rs. Particulars Rs.To Balance 2,00,000 By Balance c/d 2,60,090To Bank a/c 60,000 2,60,000 2,60,000 Investments a/cParticulars Rs. Particulars Rs.To Balance b/d 8,000 By Balance c/d 16,000To Bank 50,000(Balancing figure) 94,000 16,000Provision for taxation a/cParticulars Rs. Particulars Rs.To Bank 44,000 By Balance c/d 44,000To Balance c/d 50,000 By P & L a/c 50,000 94,000 94,000Proposed dividends a/c
  • 279. Particulars Rs. Particulars Rs.To Bank 24,000 By Balance c/d 24,000To Balance c/d 30,000 By P & L a/c 30,000 54,000 54,000 Calculation of cash from operations Rs.Profit and Loss a/c balance on (3 1-12-2001) 1,60,000Add: Non-cash and non-operating itemsalready debited to Profit and Loss a/c :Depreciation on fixed assets 6,000Proposed dividend 34,000Provision for taxation 54,000 94,000 2,54,000Less: Non-cash and non-operating itemswhich have already been credited to P&L a/cProfit and Loss a/c on 1-1-2001 1,20,000 1,20,000Cash operating profit 1,34,000Illustration: 8From the following Balance Sheets of Exe. Ltd. Make out thestatement of sources and uses of cash: Liabilities 2000 2001 Assets 2000 2001 Rs. Rs. Rs. Rs.Equity Share 3,00,000 4,00,000 Goodwill 1,15,000 90,000Capital8% Redeemable 1,50,000 1,00,000 Land and 2,00,000 1,70,000Preference Share BuildingsCapitalGeneral Reserve 40,000 70,000 Plant 80,000 2,00,000Profit & Loss 30,000 48,000 Debtors 1,60,000 2,00,000Account
  • 280. Proposed 42.000 50,000 Stock 77,000 1,09,000DividendCreditors 55,000 83,000 Bills 20,000 30,000 ReceivableBill Payable 20,000 16,000 Cash in Hand 15,000 10,000Provision for 40,000 50,000 Cash at Bank 10,000 8,000Taxation 6,77,000 8,17,000 6,77,000 8,17,000Additional information: a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant and Land and Building respectively in 2001. b) An interim dividend of Rs. 20,000 has been paid in 2000. c) Rs. 35,000 Income-tax was paid during the year 2001.Working Notes:(i) Adjusted Profit & Loss accountParticulars Rs. Particulars Rs.To Depreciation on 10,000 By Balance b/d 30,000plantTo Depreciation 20,000 By Funds from 2,18,000to buildings operations (balancing figure)To Goodwill written off 25,000To Provision of 45,000taxationTo Interim dividend 20,000To Dividend proposed 50,000
  • 281. To Transfer to 30,000General ReserveTo Balance c/d 48,000 2,48,000 2,48,000(ii) Provision for taxation accountParticulars Rs. Particulars Rs.To Bank 35,000 By Balance b/d 40,000To Balance c/d 50,000 By P.& L A/c 45,000 85,000 85,000(iii) Land and building account Particulars Rs. Particulars Rs.To Balance b/d 2,00,000 By Depreciation 20,000 By Bank (sale) 10,000 By Balance c/d 1,70,00 2,00,000 2,00,000
  • 282. (iv) Plant account Particulars Rs. Particulars Rs.To Balance b/d 80,000 By Depreciation 10,000To Bank (purchase) 1,30,000 By balance c/d 2,00,000 2,10,000 2,10,000(v) Cash from operations Rs.Funds from operations 2,18,000Add: Increase in creditors 28,000 2,46,000Less:Decrease in Bills Payable 4,000Increase in Debtors 40,000Increase in Stock 32,000Increase in Bills receivable 10,000 86,000Cash from operations 1,60,000(vi) In the absence of information, it has been presumed that there is no profit (loss) and no accumulated depreciation on that part of land and buildings which has been sold.
  • 283. Cash flow statement for the year ending 31st December 2001Cash Balance as on 1- Rs. Outflows of cash: Rs.1-2001Cash in hand 1 5,000 Redemption of 50,000 RedeemableCash at bank 10,000 Preference share 20,000Add: Inflows of cash: Payments of interim 42,000 dividendIssue of Shares 1,00,000 Payment of tax 35,000Sale of Land and 10,000 Purchase of Plant 1,30,000BuildingFunds from operations 2,18,000 Decrease in bills payable 4,000Increase in creditors 28,000 Increase in debtors 40,000 Increase in stock 32,000 Increase in B/R 10,000 Cash Balance as on 31- 12-2001 Cash in hand 10,000 Cash at bank 8,000 3,81,000 3,81,000Illustration: 9Balance Sheets of XYZ Ltd. as on 1-1-2000 and 31-12-2001 was asfollows: Liabilities 1-1-2001 31-12-2001Capital 1,25,000 1,53,000Creditors 1,40,000 1,44,000Bank loan 65,000 50,000Bills Payable 20,000 30,000 3,50,000 3,77,000Assets:Cash 20,000 17,000Debtors 30,000 80,000Stock 45,000 35,000
  • 284. Machinery 80,000 65,000Land 90,000 80,000Buildings 65,000 70,000Goodwill 20,000 30,000 3,50,000 3,77,000During the year, a machine costing Rs. 12,000 (accumulateddepreciation Rs.4,000) was sold for Rs.7,000. Balance of provisionsfor depreciation against machinery as on 1-1-2001 was Rs.35,000 andon 31-12-2001 Rs. 50000 Prepares cash Flow statement.Cash Flow Statement for the year ending 31 st December 2001 Sources Rs. Applications Rs.Opening balance of Cash 20,000 Cash outflows:Cash inflows: Building Purchased 5,000Sale of Machinery 7,000 Machinery Purchased 12,000Sale of Land 10,000 Bank Loan repaid 15,000Increase in creditors 4,000 Goodwill 10,000Increase in Bills Payable 10,000 Drawings 27,000Decrease in stock 10,000 Increase in debtors 50,000Cash from operations 75,000 Cash balance (31-12-2001) 17,000 1,36,000 1,36,000 Machinery a/c Sources Rs. Applications Rs.To Balance b/d 1,15,000 By Bank (Sale) 7,000To Bank (Purchase) 12,000 By Provisions for depreciation 4,000 a/c By P & L a/c (Loss on sale) 1,000 By Balance c/d 1,15,000 1,27,000 1,27,000 Land a/c Particulars Rs. Particulars Rs.To Balance b/d 90,000 By Bank (Purchase) 10,000
  • 285. By Balance c/d 80,00090,000 90,000
  • 286. Buildings a/c Particulars Rs. Particulars Rs.To Balance b/d 65,000 By Balance c/d 70,000To Bank (Purchases) 5,000 70,000 70,000 Goodwill a/c Particulars Rs. Particulars Rs.To Balance b/d 20,000 By Balance c/d 30,000To Bank 10,000 30,000 30,000 Bank Loan a/c Particulars Rs. Particulars Rs.To Bank 15,000 By Balance c/d 65,000To Balance c/d 50,000 65,000 65,000 Provisions for Depreciation a/c Particulars Rs. Particulars Rs.To Machinery a/c 4,000 By Balance c/d 35,000To Balance c/d 50,000 By P & L a/c 19,000 54,000 54,000 Calculation of Cash from operationsBalance of P & L a/c(Net Profit on (31/12/2001) 55,000Add : Non-cash and non-operating itemsdebited to P & L a/cDepreciation on Machinery 19,000Loss on sale of Machinery 1,000 20,000Cash from operations 75,000 Capital a/c Particulars Rs. Particulars Rs.To Drawings (Balancing 27,000 By Balance b/d 1,25,000figure)To Balance c/d 1,53,000 By Net Profit 55,000 1,80,000 1,80,000USES CASH FLOW STATEMENT
  • 287. • Helps in efficient cash management - One of the most important functions of the management is to manage companys cash resources in such a way that adequate cash is available to meet the liabilities. A projected cash flow statement enables the management to plan and co-ordinate the financial operation of the business efficiently.• Helps in internal financial management - The cash flow analysis helps the management in exploring the possibility of repayment of long term debts which depends upon the availability of cash.• Discloses the movement of cash - The cash flow statement discloses the increase or decrease in cash and the reasons therefore. It helps the finance Manager in explaining how the company is short of cash despite higher profit and vice versa.• Discloses success or failure of cash planning - Comparison of actual and budgeted cash flow statement will disclose the failure or success of the management in managing cash resources and necessary remedial measures can be taken in case of deviations. :• Helps to determine the likely flow of cash - Projected cash flow statements help the management to determine the likely inflow or outflow of cash from operations and the amount of cash required to be raised from other sources to meet the future needs of the business.• Supplemental to funds flow statement - Cash flow analysis supplements the analysis provided by funds flow statement as cash is a part of the working capital.
  • 288. • Better tool of analysis - For payment of liabilities which are likely ,to be matured in the near future, cash is more important than the working capital. As such, cash flow statement is certainly a better tool of analysis than funds flow statement for short term analysis.LIMITATIONS OF CASH FLOW ANALYSIS• Misleading inter-industry comparison - Cash flow statement does not measure the economic efficiency of one company in relation to another. Usually a company with heavy capital investment will have more cash inflow. Therefore, inter-industry comparison of cash flow statement may be misleading.• Misleading comparison over a period of time - Just because the companys cash flow has increased in the current year, a company may not be better off than the previous year. Thus, the comparison over a period of time can be misleading.• Misleading inter-firm comparison - The terms of purchases and sales will differ from firm to firm. Moreover, cash inflow does not always mean profit. Therefore, inter-firm comparison of cash flow may also be misleading.• Influenced by changes in management policies - The cash balance as disclosed by the cash flow statement may not represent the real liquid position of the business. The cash can be easily influenced by purchases and sales policies, by making certain advance payments or by postponing certain payments.• Cannot be equated with income statement - Cash flow statement cannot be equaled with the income statement. An
  • 289. income statement, takes into account both cash as well as non- cash items. Hence net cash flow does not necessarily mean net income of the business.• Not a replacement of other statements - Cash flow statement is only a supplement of funds flow statement and cannot replace the income statement or the funds flow statement as each one has its own function or, purpose of preparation.Despite the above limitations, cash flow statement is a very useful toolof financial analysis. It discloses the volume and speed at which cashflows in various segments of the business and the amount of capitaltied-up in a particular segment.
  • 290. LESSON- 13 BUDGETING AND BUDGETARY CONTROLBUDGET Budget is a financial and/or quantitative statement, preparedand approved prior to a defined period of time, of the policy to bepursued during that period for the purpose of attaining a givenobjective. - CIMA Official Terminology - It is a plan quantified in monetary terms, prepared andapproved prior to a defined period of time, usually showing plannedincome to be generated and/or expenditure to be incurred during thatperiod and the capital to be employed to attain a given objective. It is aplan of future activities for an organisation. It is expressed mainly infinancial terms, but also usually incorporates many non-officialquantitative measures as well.BUDGETING Budgeting is the whole process of designing, implementing andoperating budgets. The main emphasis in this is short-term budgetingprocess involving the prevision of resources to support plans whichare being implemented.BUDGETARY CONTROL Budgetary control is the establishment of budgets relating theresponsibilities of executives to the requirements of a policy, and thecontinuous comparison of actual with budgeted results, either tosecure by individual actionthe objective of that policy or to provide a basis for its revision.
  • 291. - CMA Official TerminologyFORECAST Vs. BUDGET A forecast is a prediction of the future state of world, inconnection with those aspects of the world, which are relevant to andlikely to affect on future activities. Forecast is calculation of probableevents. Both forecasting and planning involve recognition of therelevant factors in a given situation and understanding of what eachfactor has contributed to it and how each is likely to affect the future.Any organised business cannot avoid anticipating or calculatingfuture conditions and trends for the framing of its future policy anddecision. Forecast is concerned with probable events and thebudgeting relates to planned events Budgeting should be preceded byforecasting, but forecasts may be made for purpose other thanbudgeting.Requirements of a Sound Budgeting System The following are the essential requirements of a soundbudgeting system:  Clear lines of authority and responsibility have to be established throughout the organisation and the authority and responsibility of different levels of management and departmental executives are clearly defined.  The organisational goal should be quantified and clearly stated. These goals should be within the framework of organisation’s strategic and long range plans. The setting of budgets is not a process detached from planning of the companys overall policy.
  • 292. A well defined business policy and objective is a prerequisite for budgeting. The budget system should be established on the highest possible level of motivation. All levels of management should participate in setting budgets. Since this can produce more realistic targets, lead to better understanding of corporate objectives and the constraints within which organisation works. Participation in budgeting process will motivate the personnel to achieve budget levels of efficiency and activity. The budget control system should provide for a degree of flexibility designed to change in relation to the level of activity attained and the impact of changes in sales and production levels on revenue, expenses are known. It enables more accurate assessment of managerial and organisational performance. Proper communication systems should be established for management reporting and information service so that information relating to actual performance is presented to the manager responsible for it promptly to enable the manager to know the nature of variations so that remedial action is taken wherever necessary. Educating the budget process and creation of cost awareness atmosphere will lead to effective implementation of budgets. The top managements involvement in budget process is essential for successful implementation of the budgets. It should take interest not only in setting the budgets and targets but also to check upon the actual attainment, motivating the personnel, rewarding for achievements, investigation into
  • 293. reasons for any deviation of actuals from budgeted results, taking punitive action wherever necessary.  A sound system for generating accurate and reliable and prompt accounting information is basic for successful implementation of budget system in an organisation.Advantages of Budgeting• Budgetary control establishes a basis for internal audit by regularly evaluating departmental results.• Only reporting information which has not gone according to plan, it economises on managerial time and maximizes efficiency. This is called Management by Exception reporting.• Scarce resources should be allocated in an optimal way, thus controlling expenditure• It forces management to plan ahead so that long-term goals are achieved.• Communication is increased throughout the firm and coordination should be improved.• An effective budgetary control system will allow people to participate in the setting of budgets, and thereby have a motivational impact on the work force. Individual and corporate goals are aligned.• Areas of efficiency and inefficiency are identified. Variance analysis will prompt remedial action where necessary
  • 294. • The budget provides a yardstick against which the performance of the firm can be evaluated. It is better to compare actual with budget rather than with the past, since the latter may no longer be suitable for current and expected conditions.• People are made responsible for items of cost and revenue, i.e. areas of responsibility are clearly delineatea.Problems in Budgeting• Budgets are perceived by the work force as pressure devices imposed by top management. This can have an adverse effect on labour relations.• It can be difficult to motivate an apathetic work force.• The pressure in the budgeting system may result in inaccurate record keeping. :• Managers may over-estimate costs in order that they will not be held responsible in the future for over spending. The difference between the minimum necessary costs and the costs built into the budget is called slack.• Departmental conflict arises because of competition for resource allocation. Departments blame each other if targets are not achieved.• Uncertainties can occur in the system, e.g. uncertainty over demand, inflation, technological change, competition, weather etc. ;
  • 295. • It may be difficult to align individual and corporate goals. Individual goals often change and may be much lower than the firms goals.• It is important to match responsibility with control, otherwise, a manager will be demotivated. Costs can only be controlled by a manager if they occur within a certain time span and can be influenced by that manager. A problem arises when a cost can be influenced by more than one person.• Managers are often accused of wasting expenditure when they either (i) demand a greater budget allowance than is really needed, or (ii) unnecessary spending in order to fully utilise their allowance through fear of future cut-backs. Zero base budgeting can overcome this problem.• Sub-optimal decisions may arise when a manager tries to enhance his short-run performance in a way which is detrimental to the organisation as a whole, e.g. delaying expenditure urgently needed repairs.• They are based on assumed conditions (e.g. rates of interest) and relationship (e.g. product-wise held constant) that are not varied to reflect the actual circumstances that come about.• They make allowance for tasks to be performed only in relation to volume rather than time.
  • 296. • They compare current costs with estimates "based only on historical analysis.• Their short-term horizon limits the perspective, so short-term results may be sought at the expense of longer term stability or success.• They have a built-in bias that tends to perpetuate inefficiencies. For example, next years budget is determined by increasing last years by 15 per cent, irrespective of the efficiency factor in last year.• As with all types of budgets the game of beating the system may take more energy factor in last year.• The fragile internal logic of static budget will be destroyed if top management reacts to draft budgets by requiring changes to be made to particular items, which are then not reflected through the whole budget.BUDGETING PROCESSThe method by which the annual budget is prepared will differ fromorganisation to organisation. In some organisations budgeting may bea well organised, well documented procedures while in others thebudget may be prepared in a rather ad hoc and disorganised manner.The budget process is shown in the following figure. The steps inbudgeting process representative to all organisations is given below:1. Specification and Communication of Organisational Objectives :
  • 297. Budget is a medium through which organisations objectivesand polices are reflected. Budgeting is used as a tool for implementingthe organisational objectives. It is essential to understand,specification and documentation of organisational objectives beforethe managers start for budgeting the organisational activities.Following from a statement of objectives, a corporate long-range orstrategic plan can be built up. Distinction may be drawn betweencurrent operating activities and future strategic activities. Budgetingis a management tool used for shorter term planning and control. Thisclassification of activities into short-term and strategic long-term andcommunication to the managers will lay down a sort of guide forbudgeting the activities within the specified objectives and activities.
  • 298. 2. Determination of Key Success Factors : The performance of every organisation will be particularlyinfluenced by certain critical success factors, key factor will influencethe activities of an undertaking and it will limit the volume of outputand will have direct impact on the profitability of the organisation.Critical success factors may consist of a specified raw material, aspecific type of labour skill, a tool, a service facility, floor space, cashresources etc. The limitation or shortage of such critical factors mayresult in restricting capacity utilisation. The limiting factors may shiftfrom time to time due to external and internal circumstances,. Inorganisations which are already operating at maximum capacity, themost critical success factor is likely to be productive capacity. Inmajority of organisation the most critical factor is likely to beconsumer demand or the expected level of revenues or funds. Becauseof this, the sales or funds budget is usually the first budget to beprepared. It will determine the content of other related budgets.3. Establishment of Clear Ones of Authority and Responsibility: An organisational chart defining the lines of authority andresponsibility of the managers responsible for accomplishment of
  • 299. organisational objectives is to be prepared. The organisational chartshould define the following: • The responsibility of individual functional managers • Delegation of authority to the concerned functional managers • Inter-functional relationship of the organisation.4. Establishment of Budget Centres : Budget centre is a section of an organisation for which separatebudgets can be prepared and control exercised (CMA officialterminology). The entire organisation is divided into differentsegments, which are clearly defined for the purpose of budgetarycontrol according to responsibilities of departmental heads. Thesesegments of an organisation defined for the purpose of budgetarycontroL are technically referred to as budget centers.5. Determination of Budget Period : Budget period is a period for which the budget is prepared. Abudget can; be a long-term budget or short-term budget. A short termbudget is generally prepared for one year or lesser period. Quarterly,monthly or even weekly budget can be prepared for certain operationsof the company. The short-term budget will generally not exceed thefull accounting year. The long-term budget which extend to five oreven more years. This long-term budget will agree with long-termforecast of sales, organisational schemes for expansionmodernisation, diversification etc. The long-term budgets are used forplanning whereas short-term budget is used for implementation oflong range plans, activities, objectives and also for control purposes.Capital expenditure budget and Research and developmentexpenditure budget are the examples of long-term budgets. Annualsales budget, Income and expenditure budget are the examples ofshort-term budgets.
  • 300. 6. Establishment of Budget Committee : In small organisations, the person incharge of finance andaccounting functions will involve in preparation of budgets. Thesetting up of a budget Committee is necessary in case of large andcomplex organisations. As the budget involves the various functionalactivities, the closest association of functional managers is essentialfor satisfactory formulation and implementation of the budget Thebudget committee will be composed of major functional heads. It canbe effective medium for coordination and review of the budgetprogramme. The main functions of budget committee are as follows: • To review the functional budget estimates. • To recommend the functional budgets for revision. • To review and advise on the general policies affecting more than one function. • To review, approval and adoption of revised budgets. • To receive and analyse the-periodic performance reports from budget centers. • To examine the budget reports showing actuals compared with budget. • To locate the responsibility for discrepancies between actuals and budgets, and recommends the corrective action. • To participate in decision making in strategic issue like, expansion, modernisation, diversification and revision of organisational activities, which have direct relationship to the companys budgets.7. Appointment of Budget Controller :
  • 301. Proper budget administration is facilitated by the budgetcontroller who is made responsible for the preparation of the budgetand coordinating activities of the individual departments. Hisfunctions and responsibilities will include the following:(a) Generation and dissemination of information needed for decision-making and planning to each person in the organisation having such responsibilities. The information may include, but is not limited to, forecasts of economic and social conditions, governmental influences, organisation goals and standards for decision making, economic and financial guidelines, performance data, performance standards and the prerequisite plans of others in the enterprise.(b) Establishing and maintaining a planning system which: • Channels of information to each of persons responsible for planning, • Schedules the formulation of plans, • Structures the plans of sub-sections of the enterprise into composites at which points, tests are made for significant deviations from economic and financial guidelines and from goal achievement and repeats the process for larger segments to and including the enterprises as a whole, and • Disseminates advice of approval, disapproval or revision of plans to affected individuals in accordance with established lines of authority and organisational responsibilities.(c) Construction and using models of the enterprise both in total and by sub-sections, to test the effect of internal and external variables upon the achievement of organisation goals.
  • 302. (d) Ensuring the accumulation of performance data related to responsibility centers within the organisation, measured against the plans, whether period or project, for each centre, transmitted to each centre, and the analysis of deviations of actual from planned performance.The budget controller is responsible for the final preparation,presentation and interpretation of the financial plan of the company.He is responsible for development of budget procedures. He will act asa staff manager coordinating all budget functions.8. Preparation of Budget Manual: Budget manual is the documentation of policies and proceduresinvolved in implementation of budgetary control system. A budgetmanual will normally set out the following: • Responsibility and authority of different levels of management. • Establishment of organisational hierarchy. • Definition and clarification of various terms used in budgets. • Fixation of responsibility for preparation and implementation of budgets and budgetary system. • Specification and timing of statements and reports. • Procedures in management information system in the organisation. • Procedures in feed-back and feed-forward control systems. • Exhaustive programme of budget preparation.The budget manual contains the standardised form which becomeinformation generation for preparation of budgets. It contains acomplete programme of activities involved in budget preparation. Thebudget manual should provide detailed procedure for preparation anddevelopment and control of each budget like Sales budget, Production
  • 303. budget, Direct material budget, Direct labour budget, Overheadbudget, Capital expenditure budget, R&D expenses budget etc.PREPARATION OF SALES OR REVENUE BUDGET The sales revenue budget is the starting point of most masterbudgets. In manufacturing organisations sales budgeting begins withthe forecasting of the sales of individual products. These forecastsmay be by geographical area, by class of customer or by some othersegment. In case of manufacturing companies, the budgeting willbegin with the Revenue budget of the organisation. Forecasting salesis a difficult task as many assumptions need to be made aboutconsumer demand, environmental conditions likely customer demandat different prices, the probable prices for similar products sold bycompetitors, the number of economic activity in the regions where theproduct is sold, the number of sales personnel required to service theestimated demand, the appropriate level of advertising andpromotional expenditures, the impact of anticipated changes inexchange rates and changes in the taxes such as value added tax orcustoms and excise duties.PREPARATION OF BUDGETS Once the sales budget has been determined from a range ofsales forecasts it is possible to construct the following other budgets:1. Production Budget The production budget is an estimate of the quantity of goodsthat must be produced during the budget period. The aim of theproduction function will presumably be to supply finished goods of aspecified quality to meet marketing demands. The sum of salesrequirements plus changes in stock levels of finished goods gives the
  • 304. production requirements for the period being budgeted. In order toconstruct the production budget we need the level of sales expectedand the desired levels of stock of finished goods. The following formulais used for calculation of units to be produced. Production = Sales + Closing stock - Opening stock Production budget should be developed keeping in view theoptimal, balance between sales, inventories and production so as toresult in minimum cost. Once the production level is determined, itbecomes the starring point for the direct materials, direct labour andmanufacturing overhead budgets.2. Plant Utilisation Budget Plant utilisation budget is prepared for the estimation of plantcapacity to meet the budgeted production during the periodconsidered under the budget" For this purpose the plant capacity isexpressed in terms of convenient units of measurement likeproduction in hours, production in weight (M.T./Kg.) production inunits etc. Budgeted machine load in each department should beworked out. In case the budgeted plant utilisation is more than theplant capacity the management may think of extra shift working,purchase of new machinery, overtime working, sub-contracting etc.When the budgeted plant utilisation in lesser than the plant capacity,management should consider the ways to increase sales volume.3. Direct Materials Budget The direct materials budget specifies the budgeted quantities ofeach raw material required for the budgeted production. Therequirement to purchase of direct material can be calculated with thehelp of the following formula.
  • 305. Purchases = Closing stock + Usage - Opening stock The materials budget provides basis for fixing optimum levels ofinventory stocks, establishment of control over material usage andpurchase cost budget.4. Direct Labour Budget The direct labour budget will ensure that the plan will make therequired number of employees of relevant grades and suitable skillsavailable at the right times. It specifies the direct labour requirement,of various products as envisaged in the production budget. The directlabour budget will be developed for both direct labour hours anddirect labour cost. After the labour requirements relating to differentgrades are finalized, estimated rate per hour and labour cost per unitis arrived at:Illustration 1: The direct labour hour requirements of three of the productsmanufactured in a factory, each involving more than one labouroperation, are estimated as follows:Direct Labour Hour / per unit (in minutes) Product 1 2 3Operation 1 18 42 30 2 - 12 24 3 9 9 -
  • 306. The factory works 8 hours per day, 6 days in a week. The budgetquarter is taken as 13 weeks and during a quarter, lost hours due toleave and holidays and other causes are estimated to be 124. The budgeted hourly rates for the workers manning theoperations, 1, 2 and 3 are Rs.2.00, Rs.2.50 and Rs.300 respectively.The budgeted sales of the product during the quarter are: Product 1 9,000 units 2 15,000 units 3 12,000 unitsThere is a carry over of 5,000 units of Product 2 and 4,000 units ofProduct 3 and it is proposed to built up a stock at the end of thebudget quarter as follows: Product 1 1,000 units 3 2,000 unitsPrepare a manpower budget for the quarter showing for eachoperation:(i) Direct labour hours, (ii) Direct labour cost, and (iii) Number ofworkers.Before preparing the quarterly manpower budget for 3 productsoperation-wise, it is necessary to work out the following: (a) Production budget, (b) Direct labour hours for each productoperation-wise, (c) Number of workers required for each operation.(a) Production Budget for the quarter ending ..... Particulars Product 1 Product 2 Product 3Budgeted Sales (units) 9,000 15,000 12,000Add: Stock to (closing) 1,000 - 2,000be built up Total 10,000 15,000 14,000
  • 307. Less: Carry-over (opening) - 5,000 4,000stockBudgeted 10,000 10,000 10,000Production(b) Direct Labour Hour for each Product (operation-wise)Operation I Particulars Product 1 Product 2 . Product 3Direct labour hrs. per unit 18 42 30(minutes)Budget Production (units) 10,000 10,000 10,000Direct labour hrs. required: 10,000 x 18 10,000 x 42 10,000 x 30 60 60 60 3,000 hrs. 7,000 hrs. 5,000 hrs.Total labour hours required for Operation I = 15,000 hours.Operation II Particulars Product 1 Product 2 . Product 3Direct labour hrs. per unit - 12 24(minutes)Budget Production (units) 10,000 10,000 10,000 -Direct labour hrs. required: 10,000 x 12 10,000 x 24 60 60 - 2,000 hrs. 4,000 hrs.Total labour hours required for Operation II = 6,000 hours.Operation III
  • 308. Particulars Product 1 Product 2 . Product 3Direct labour hrs. per unit 9 6 -(minutes)Budget Production (units) 10,000 10,000 10,000 -Direct labour hrs. required: 10,000 x 9 10,000 x 6 60 60 1,500 hrs. 1,000 hrs. -Total labour hours required for Operation III = 2,500 hours.(c) Number of Workers required for each OperationWorking hrs. of factory in a quarter = 13 624 hoursweeks x 6 days week x 8 hours a dayLess: Loss of hours due to leave, holidays 124 hoursand others causesTotal available hours per man 500 hoursNow, the requirements for manpower for each operation can beworked out.Manpower Requirement:Total direct labour hrs./ Total available hours required per man a. Operation I = 15,000/500 = 30 men b. Operation II = 6,000/500 = 12 men c. Operation III = 2,500/500 = 5 menNow, manpower budget for the quarter can be prepared for the threeproducts and for each operation. The same is given below:
  • 309. Hr. No. ofOperation Product I Product II Product 3 Total rate workers D.I. Cost D.L. Cost D.L. Cost D.L. Cost Rs. Hrs. Rs. Hrs. Rs. Hrs. Rs. Hrs. Rs. 14,000 10,000 15,000 30,000 30 I 2.00 3,000 6,000 7,000 5,000 2.50 - - 2,000 5,000 4,000 10,000 6,000 15,000 12 II 3.00 1,500 4,500 1,000 3,000 - - 2,500 7,500 5 III Total 4,500 10,500 10,000 22,000 9,000 20,000 23,500 52,500 47 5. Manufacturing Expenses Budget Manufacturing overhead refers to the aggregate of factory indirect material, indirect labour and indirect expenses which can be divided into fixed and variable elements of manufacturing overhead. The fixed manufacturing overhead will not vary with the change in the level of activity and it can be estimated with a fair degree of accuracy. On the other hand, variable manufacturing overhead per unit will be estimated and the total variable manufacturing overhead will be determined with the help of the activity level. Preparation of variable overhead budget is based on scheduled production and operating conditions. Illustration 2: Gama Engineering Company Limited manufacturers two Products X and Y. An estimate of the number of units expected to be sold in the first seven months of 2001 is given below: Months Product X Product Y January 500 1,400
  • 310. February 600 1,400March 800 1,200April 1,000 1,000May 1,200 800June 1,200 800July 1,000 980It is anticipated that: (a) There will be no work-in-progress at the end of any month; (b) Finished units equal to half the anticipated sales for the next month will be in stock at the end of each month (including June 2001).The budgeted production and production costs for the year ending 31 stJune, 2001 are as follows: Particulars Product X Product YProduction (units) 11,000 12,000Direct materials per unit (Rs.) 12 19Direct wages per unit (Rs.) 5 7Other manufacturing charges (Rs.) 33,000 48,000apportionable to each type ofproductYou are required to prepare: (a) Production budget showing the number of units to be manufactured each month. (b) Summarised production cost budget for the 6 month- period January to June 2001.(a) Production Budget (for the 6 months ending 30th June, 2001) (units)
  • 311. Particulars Jan. Feb. March April May JuneProduct XClosing Stock 300 400 500 600 600 500Sales 500 600 800 1,000 1,200 1,200 800 1,000 1,300 1,600 1,800 1,700Less: Opening Stock 250 300 400 500 600 600Production (in units) 550 700 900 1,100 1,200 1,100Product YClosing stock 700 600 500 400 400 450Sales 1,400 1,400 1,200 1,000 800 800 2,100 2,000 1,700 1,400 1,200 1,250Less: Opening Stock 700 700 600 500 400 400Production (in units) 1,400 1,300 1,100 900 800 850(b) Summarised Production Cost Budget (for the 6 months ending 30 thJune, 2001) . (Rs.) Production X-5,550 units Y-6,350 units Unit Total Cost Unit Cost Total Cost CostDirect materials 12 66,600 19 1,20,650Direct wages 5 27,750 7 44,450Manufacturing 3 16,650 4 25,400charges Total 20 1,11,000 30 1,90,500Note: Manufacturing charges have been presumed to be variable costsin the absence of any other information. They could, however bepresumed to be fixed charges also for the whole year. In such a case
  • 312. they will be taken as 50% of the annual charges for the first sixmonths in each case.6. Administrative Expenses Budget Administrative expenses in an organisation will be incurred forthe following activities: (a) Formulation of policies, (b) Directing the organisation, and (c) Controlling the operations of an organisation etc. The administrative expenses will not include those expenses whichare incurred for manufacturing, selling and distribution, R&Dfunctions. The administrative overheads are of a fixed nature and thechange in the level of activity will not bring any change in theadministrative expenses incurred. Cm study o behaviour of costs, ifany administrative expenses are of variable or semi-variable nature,those expenses can be budgeted with the Level of activity.7. Selling and Distribution Expense Budget Selling expenses refers to expenses incurred relating tc theactivities: (a) Creation and stimulation of demand of companys product, and (b) Secure orders. Selling expenses include salesmens salaries, commissions,expenses and related administrative cost etc. Distribution expensesrefers fo expenses incurred relating to the following activities: (a) Maintaining and creating demand of product, and (b) Making the goods available in the hands of the customer. Distribution expenses include transportation, freight charges,stock control, warehousing etc.
  • 313. Preparation of selling and distribution expense budget is based onthe sales budget. The selling and distribution expenditure can beestimated with the help of flexible budgeting technique.8. Research and Development Budget This will cover materials, equipment and suppliers, salaries,expenses and other costs relating to design, development andtechnical research projects.9. Capital Expenditure Budget The capital expenditure budget represents the expectedexpenditure on fixed assets during the budget period. It is an outlayon assets that are required and held for the purpose of generatingincome, e.g. plant and machinery, motor vehicles, premises etc. It is aplan for capital expenditure, in monetary terms. Capital expendituremay be incurred for expansion, diversification, modernisation plans. Itrelates to projects involving huge capital outlay and long-termcommitments. A capital expenditure budget must reveal followinginformation projectwise: • Original appropriation • Cumulative expenditure up-to-date • Unutilised appropriation • Fresh appropriation, and • Limit carried to next period Programme budgeting technique is more appropriate for capitalexpenditure budgeting.
  • 314. Capital expenditure authorisation is the formal authority toincur capital expenditure which meets the criteria defined to achievethe results laid down under a system of capital appraisal. Levels ofauthority must be clearly defined and the reporting structure of actualexpenditure through prior authorisation on a formal proposal basisand monitoring as expenditure is incurred.10. Manpower Budget Manpower budget will taken an overall view of the organisationsneeds for manpower for all areas of activity - sales, manufacturing,administrative, executive and so on for a period of years.11. Marketing Expenditure Budget Marketing budget include estimated expenditure to be inquiredfor advertising promotional activities, public relations, marketingresearch, customer services etc. during the budget period.12. Capital Budget Capital budget is concerned with the question of capacity andstrategic direction. This must deal with the evaluation of alternatedispositions of capital funds as well as with the choice of the bestcapital structure.PREPARATION OF MASTER BUDGET AND ITS IMPLEMENTATION Master budget is a budget which is prepared from, andsummarises the functional budgets. It is a summary budget thatincorporates the key figures and totals of ail other budgets. Theprocess in preparation of Master budget is shown in the figureBudgetary Process (given at the beginning of this chapter).
  • 315. The Master budget may closely reflect two dimension ofthe organisations: (1) Organisational Structure: All revenues and expenditures must be attributed to the budget centre and managers responsible for them. At the control stage, later, a system of responsibility accounting reports must be built up to inform responsible managers for the progress of that result against budgets. (2) Products or Programmes: In this dimension, the budget information is organised to show the revenues, costs, contributions, profits and levels of production/ sales activity for each product or programme produced by, the organisation.Negotiation of Budgets : Budgets may be prepared in a top-down or bottom-up manner.In either process, the budget will need to be negotiated by superiors,subordinates and by different departments competing for the scarceresources. This process of negotiation allows the exercise of bothformal and informal power. Participation in budgeting appears to leadto more positive attitude towards the budget and greater acceptance ofit.Coordination and Review of Budget: Incompatibility and inconsistency may arise because thebudgeting process, usually involves a number of different departments- e.g. sales,-production, marketing and numerous senior and lowerlevel managers. It should be ensured that consistency is arrived at infinalisatcin of master budget.
  • 316. Acceptance of Communication of Budgets : After the master budget is accepted and agreed upon by all thelevels of organisational hierarchy, it will be passed on forimplementation. It is essential that each manager responsible forimplementing the budget policy be informed as to his responsibility.Budget Monitoring: It is important that the actual performance of each managershould be regularly and frequently compared against budget targets inorder to prevent it from getting out of control and in case of change ininternal and external business environment a revision of the budgetmay be necessitated.CASH FLOW BUDGET Cash flow budget is a detailed budget of income and cashexpenditure incorporating both revenue and capital items. The cashflow budget should be prepared in the same format in which theactual position is to be presented. The years budget is usually phasedinto shorter periods for control, e.g. monthly or quarterly. Cashbudget is concerned with liquidity must reflect changes betweenopening and closing debtor balances and between opening and closingcreditor balances as well as focusing attention on other inflows andoutflows of cash. The cash budget shows the cash flows arising fromthe operational budgets and the profit and assets structure. A cashbudget can be prepared in the following ways:1. Receipts and Payments Method :
  • 317. In this method all the expected receipts and payments forbudget period are considered. All the ash inflow and outflow of allfunctional budgets including capital expenditure budgets areconsidered. Accruals and adjustments in accounts will not affect thecash flow budget. All anticipated cash inflow is added to the openingbalance of cash and all ash payments are deducted from this to arriveat the closing balance of cash. This method is commonly used inbusiness organisations.2. Adjusted Income Method : In this method the annual cash flows are calculated byadjusting the sales revenues and costing figures for delays in receiptsand payments (changes in debtors and creditors) and eliminating non-cash items such as Depreciation.3. Adjusted Balance Sheet Method : In this method, the budgeted balance sheet is predicted byexpressing each type of assets and short-term liabilities as percentageof the expected sales. The profit is also calculated as a percentage ofsales, so that the increase in owners equity can be forecast. Knownadjustments, may be made to long-term liabilities and the balancesheet will then show if additional finance is needed. It is important to note that the capital budget will also beconsidered while preparation of cash flow budget because the annualbudget may disclose a need for new capital investments and also, thecosts and revenues of any new projects coming on stream will need tobe incorporated in the short-term budgets. A number of additionalfinancial statements, such as sources and application of fundsstatement or schedules or loan service payments or capital raisingschedules may be produced.
  • 318. Illustration 3: Prepare a cash budget for the three months ending 30 th June,2001 from the information given below:a. (Rs.) Month Sales Materials Wages OverheadsFebruary 14,000 9,600 3,000 1,700March 15,000 9,000 3,000 1,900April 16,000 9,200 3,200 2,000May 17,000 10;000 3,600 2,200June 18,000 10,400 4,000 2,300b. Credit Terms:Sales/ Debtor - 10% sales are on cash, 50% of the credit sales arecollected next month and the balance in the following month.Creditors Materials 2 months Wages ¼ month Overheads ½ monthc. Cash and bank balance on l" April, 2001 is expected to be Rs.6,000.d. Other relevant information is: (i) Plant and Machinery will be installed in February 2001 at a cost of Rs.96,000. The monthly instalments of Rs.2,000 is payable from April onwards. (ii) Dividend @ 5% on Preference Share Capital of Rs.2,00,000 will be paid on 1st June. (iii) Advance to be received for sale of vehicles Rs.9,000 in June.
  • 319. (iv) Dividends from investments amounting to Rs. 1,000 are expected to be received in June. (v) Income-tax (advance) to be paid in June, is Rs.2,000.Working Notes:Collection from Sales/ Debtors Month Calculation April May JuneFebruary (14,000-10% of 14,000) x 50% 6,300 - -March (15,000-10% of 15,000) x 50% 6,750 6,750 -April 10% of 16,000 1,600 - - (16,000-10% of 16,000) x 50% - 7,200 7,200May 10% of 17,000 - 1,700 - (17,000-10% of 17,000) x 50% - - 7,650June 10% of 18,000 - - 1,800 14,650 15,650 16,650Cash budget for the quarter April - June 2001 Particulars April May June Total1. Balance b/f 6,000 3,950 3,000 6,0002. ReceiptsSales (Note 1) 14,650 15,650 16,650 46,950Dividend - - 1,000 1,000Advanced against - - 9,000 9,000vehicle Total 20,650 19,600 29,650 62,9503. PaymentCreditors* 9,600 9,000 9,200 27,800Wages* 3,150 3,500 3,900 10,550Overhead* 1,950 2,100 2,250 6,300Capital Expenditure 2,000 2,000 2,000 6,000Income tax advance - - 2,000 2,000 Total 16,700 16,600 29,350 62,650
  • 320. 4. Balance c/f 3,950 3,000 300 300* Payments for creditors, wages and overhead have been computed onthe same pattern.FLEXIBLE BUDGETING Flexible budget is a budget which, by recognising the differencein behaviour between fixed and variable costs in relation tofluctuations in output, turnover, or other variable factors etc. It isdesigned to change in relation to the level of activity actually attained. A flexible budget is one that takes account of a range of possiblevolumes It is sometimes referred to as a multi-volume budget. Therange of possible outputs may be known as the relevant range.Flexing a budget takes place when the original budget is deliberatelyamended to take account of change activity levels. The flexible budget is based on the fundamental difference inbehaviour of fixed costs, variable costs and semi-variable costs. Sincefixed costs do not vary with short-run fluctuations in activity it can beseen that the flexible budget will really consist of two parts: The first isa fixed budget begin made up of fixed costs and the fixed componentof semi-variable costs. The second part is a truly flexible budget thatconsists solely of variable costs.Steps in Preparation The steps involved in preparation of flexible budget are asfollows: • Specify the time period that is used. • Classify all costs into fixed, variable and semi-variable categories.
  • 321. • Determine the types of standards that are to be used. • Analyse cost behaviour patterns in response to past levels of activity. • Build up the appropriate flexible budget for specified levels of activity.Importance Flexible budgets are important aids to decision making whichhelp the management in the following ways: • Flexible budget enable an organisation to predict its performance and income levels at a given range of sales levels and activity levels. It can be seen the impact of changes in sales and production levels on revenue, expenses and ultimately income. • Flexible budgets enables more accurate assessment of managerial and organisational performance.Disadvantages The procedure for drawing up a flexible budget is quite straightforward. The flexed budget is only accurate, if costs behave in apredicted manner. All too often assumptions are made about costbehaviour which are too simplistic and hence do not reflect whatactually happens. • Flexible budgets assume linearity of costs and therefore take no account of, for example discounts for bulk purchases of materials Labour costs are unlikely to behave in a linear fashion unless a piecework scheme is in operation.
  • 322. • Such budgets also rely on the assumption of continuity when costs may actually behave in a stepped or discontinue matter. • The method of determining the fixed and variable elements of costs is often arbitrary and hence the flexed cost bear little relation to the correct budgeted cost for the flexed level of activity. • Although flexed budgets tend to maintain fixed costs at the same level whatever the level of output/ sales, very often fixed costs are actually fixed only over a relevant output range.Illustration 4: ABC Ltd. Manufactures a single product for which marketdemand exists for additional quantity. Present sale of Rs.60,000 permonth utilised only 70% capacity of the plant. Sales Manager assuresthat with a reduction of 10% in the price he would be in a position toincrease the sale by about 25% to 30%The following data are available:a) Selling price Rs. 10 per unitb) Variable cost Rs.3 per unitc) Semi-variable cost Rs.6,000 fixed plus Re.0.50 per unitd) Fixed cost Rs.20,000 at present level estimated to be Rs.24,000 as 80% output.You are required to submit the following statements to the Boardshowing: 1. The operating profits at 60%, 70% and 80% levels at current selling price and at proposed selling price.
  • 323. 2. The percentage increase in the present output which will be required to maintain the present profit margin at the proposed selling price.Statement of Operating Profit at different capacity levels atCurrent Selling Price (Rs.) Capacity Levels Product and Sales 60% 70% 80% (units) 6,000 7,000 8,000Sales (@Rs. 10) (A) 60,000 70,000 80,000Costs: Variable cost (@ Rs.3) 18,000 21,000 24,000 Semi-variable cost Fixed component 6,000 6,000 6,000Variable component (@ Re.0.50 per unit) 3,000 3,500 4,000Fixed cost 20,000 20,000 24,000Total cost (B) 47,000 50,500 58,000Profit (A) - (B) 13,000 19,500 22,000Statement of Operating Profit at different capacity levels atproposed Selling Price (Rs.) Capacity Levels 60% 70% 80%Sales (@ Rs.9) 54,000 63,000 72,000Less: Total cost 47,000 50,500 58,000 Profit 7,000 12,500 14,000Calculation of Percentage Increase in present output for desiredprofit
  • 324. (Rs. per unit)Proposed selling price 9.00Less: Variable cost (Rs.3.00 + Re.0.50) 3.50Contribution per unit 5.50 (Rs.)Present Profit 13,000Add: Fixed cost (Rs.20,000 + Rs.6,000) 26,000Desired Contribution 39,000Required Output Desired Contribution= Contribution per unit Rs.39,000= Rs.5.50 = 7,091 unitsIncrease in Production required = 7,091 units - 6,000 units = 1,091 unitsPercentage increase over present Output 1,091= 6,000 x 100 = 18.18%
  • 325. LESSON-14 CAPITAL BUDGETINGMEANING OF CAPITAL BUDGETING Capital budgeting is the process of making investment decisionsin the capital expenditures. A progressive business firm always movesahead, its fixed assets and other resources continue to expand orthere comes a need for expanding them. Capital budgeting actuallythe process of making investment decisions in capital expenditure, orfixed assets. A capital expenditure may be as an expenditure thebenefits of which are expected to be received over a period of timeexceeding one year. Capital expenditure is one which is intended tobenefit future periods and normally includes investments in fixedassets and other development projects. It is essentially a long-termfunction. Capital budgeting is also known as Investment DecisionMaking, Capital Expenditure Decisions, Planning Capital Expenditureetc. Capital budgeting is the most important and complicatedproblem of managerial decisions. Because it is concerned withdesigning and carrying out through a systematic investmentprogramme. It involves the planning of such expenditures whichprovide yields over a number of years. Charles T Homgreen has defined capital budgeting as, "Capitalbudgeting is long term planning for making and financing proposedcapital outlays. According to Philippatos, "Capital budgeting is concerned withthe allocation of the firms scarce financial resources among theavailable market opportunities. The consideration of investment
  • 326. opportunities involves the comparison of the expected future streamsof earnings from a project, with the immediate and subsequentstreams of expenditure for it". Richard and Green have defined "Capital budgeting as acquiringinputs with long-run return". According to Lynch, "Capital budgeting consists in planningdevelopment of available capital for the purpose of maximising thelong-term profitability of the concern"Features of Investment Decisions: • Capita] budgeting decisions • Huge funds are invested in long-term asets. • The future benefits will occur to the firm over a series of years. • They involve the exchange of current funds for the benefits to be achieved in future. • They have a significant effect on the profitability of the concerns. • They are strategic investment decisions. • They are irreversible decisions. Capital budgeting has a vital role to play in the broader process ofstrategic planning and budgetary control. Capital budgeting systemsshould strive to create an atmosphere which encourages thegeneration of new investment proposals and evaluates them asaccuracy as possible. However, loss-making proposals must beidentified at the earliest possible moment.
  • 327. IMPORTANCE OF CAPITAL BUDGETING Capital budgeting means planning for capital assets. Capitalbudgeting decisions are among the most crucial and critical businessdecisions. It is the most important single area of decision-making forthe management. Unsound investment decision may prove to be fatalto the very existence of the concern. The significance of capitalbudgeting arises mainly due to the following:(1) Large Investment: Capital budgeting decisions, generally, involve large investmentof funds. The funds available with the firm are always limited and thedemand for the funds far exceeds the resources. These funds areraised by the firm from various internal and external resources atsubstantial cost of capital. A wrong decision prove disastrous for thecontinued survival of the firm. Hence it is very important for a firm toplan and control its capital expenditure.(2) Long-Term Commitment of Funds: The funds involved in capital expenditure are not only large butmore or less permanently blocked also in long-term investment. Thelonger the time, the greater the risk involved. Greater the riskinvolved, greater is the need for careful planning of capitalexpenditure, i.e. capital budgeting. The long-term commitment offunds increases the financial risk involved in the investment decision.Firms decision to invest in long-term assets has a decisive influenceon the rate and direction of its growth. An unsound investmentdecision may prove to, be fatal to the very existence of the firm. Hencea careful planning is essential:
  • 328. (3) Irreversible in Nature : Most investment decisions are irreversible. Once the decision foracquiring a permanent asset is taken, it is very difficult to reverse thatdecision. It is difficult to find a market of such capital goods once theyhave been acquired. The only alternative will be to scrap the capitalassets so purchased or sell them at a substantial loss in the event ofthe decision being proved wrong.(4) Complicacies of Investment Decisions : The long term investment decisions are more complicated innature. The capital budgeting decisions require an assessment offuture events which are uncertain. It is really a difficult task toestimate the probable future events. In most projects the investmentof funds has to be made immediately but the returns are expectedover a number of future years. Both returns as well as the length ofthe period over which they will accrue are uncertain.(5) Long-term Effect on Profitability: Capital budgeting decisions have a long-term and significant onthe profitability of a concern. Capital budgeting is of utmostimportance to avoid over-investment or under-investment HI fixedassets. An unwise decision may prove disastrous and fatal to the veryexistence of the concern. The future growth and profitability of thefirm depends upon the investment decision taken today. Capitalexpenditure projects exercise a great impact on the profitability of thefirm for a very long time.(6) National Importance:
  • 329. Investment decision taken by individual concern is of nationalimportance because it determines employment, economic activitiesand economic growth.CAPITAL BUDGETING PROCESS Capital budgeting is a complex process as it involves decisionsto the investment of current funds for the benefit to be achieved infuture and the future is always uncertain. A capital budgeting processmay involve a number of steps depending upon the size of theconcern, nature of projects, their numbers, complexities anddiversities etc. That is, capital budgeting decisions of a firm have apervasive influence on the entire spectrum of entrepreneurialactivities. Hence they require a complex combination and knowledgeof various disciplines for their effective administration, such aseconomics, finance, mathematics, economic forecasting, projectiontechniques and techniques of financial control. In order to tie all theseelements, a financial manager must keep in mind the threedimensions of capital budgeting programme - policy, plan andprogramme. These three Ps constitute a sound capital budgetingprogramme. Quinin G David has suggested that (a) project generation, (b)project evaluation, (c) Project selection and (d) project execution arethe important steps involved in a capital budgeting process. However,the following procedure may be adopted in the process of capitalbudgeting.
  • 330. (1) Identification of Investment Proposals Investment opportunities have to be identified or searched for:they do not occur automatically. The capital budgeting process beginswith the identification of investment proposals. The first step incapital budgeting process is the conception of a profit-making idea.Investment proposals of various types may originate at different levelswithin a firm, depending on their nature. They may originate from thelevel of workers to top management level. Most of the proposals, in thenature of cost reduction or replacement or process for productimprovement take place at plant level. The proposal for adding newproduct may emanate from the marketing department or from plantmanager who thinks of a better way of utilizing idle capacity.Suggestions for replacing an old machine or improving the productiontechniques may arise at the factory level. The departmental headanalyses the various proposals in the light of the corporate strategiesand submits suitable proposals to the capital expenditure planningcommittee in case of large organisation or to the officers concernedwith the process of long-term investment decisions. A continuous flow of profitable capital expenditure proposals isitself an indications of a healthy and vital business concern. Although
  • 331. business may pursue many goals, survivals and profitability are twoof the most important objectives.(2) Screening the Proposals Screening and selection procedures would differ from firm tofirm. Each proposal is then subjected to a preliminary screeningprocess in order to assess whether it is technically feasible; resourcesrequired are available and the expected returns are adequate tocompensate for the risk involved. In large organisations, a capitalexpenditure planning committee is established for screening forvarious proposals received from different departments. The committeeviews these proposals from various angles to ensure that these are inaccordance with the corporate strategies or selection criterion of thefirm and also do not lead to departmental imbalances. All care mustbe taken in selecting a criterion to judge the desirability of theprojects. The criterion selected should be a true measure of theinvestment projects profitability, and as far as possible, it must beconsistent with the firms objective of maximising its market value.This stage involves the comparison of the proposals with otherprojects according to criteria of the firm. This is done either byfinancial manager or by a capital expenditure planning committee.Such criteria should encompass the supply and cost of capital and theexpected returns from alternative investment opportunities.(3) Evaluation of Various Proposals The next step in the capital budgeting process is to evaluate theprofitability of various proposals. If a proposal satisfies the screeningprocess, it is then analysed in more detail by gathering technical,economic and other data. Projects are also classified, for example, newproducts or expansion or improvement and ranked within eachclassification with respect to profitability, risk and degree of urgency.
  • 332. There are many methods which may be used for this purpose such aspay back period method, rate of return method, net present valuemethod etc. All these methods of evaluating profitability of capitalinvestments proposals have been discussed in detail below. Thevarious proposals of investments may be classified as:(a) Mutually exclusive proposals(b) In-dependent proposals(c) Contingent proposals Mutually Exclusive Proposals serve the same purpose andcompete with each other in a way that the acceptance of oneprecludes the acceptance of other or others. Thus, two or moremutually exclusive proposals cannot both or all be accepted. Sometechnique has to be used for selecting the better or the best one. Oncethis is done, other alternative automatically gets eliminated. Acompany may, for instance, propose to use semi-automatic machineor highly automatic machine for production. Here choosing the highlyautomatic machine precludes the acceptance of the semi-automaticmachine. Independent Proposals are those which do not compete withone another and the same may be either accepted or rejected on thebasis of minimum return on investment required. For instance, whenthere are two proposals, a firm can undertake both the proposals. Contingent or Dependent Proposals are those whoseacceptance depends upon the acceptance of one or more otherproposals. For instance, a firm decides to build a factory in a remotearea, it may have to invest in houses, hospitals, roads etc. for the staffThus, building a factory also requires investment in facilities foremployees. The total investment will be treated as a-single investment.
  • 333. (4) Establishing Priorities After evaluation of various proposals, the unprofitable oruneconomic proposals are rejected, the accepted proposals i.e.profitable proposals are put in priority. It may not be possible for thefirm to invest immediately in all the acceptable proposals. Thus, it isessential to tank the various proposals and to establish priorities afterconsidering urgency, risk and profitability involved therein.(5) Final Approval Proposals finally recommended by the committee are sent to thetop management along with a detailed report, both of capitalexpenditures and of sources of capital. Financial manager will presentseveral alternative capital budgets. When capital expenditureproposals are finally selected, funds are allocated for them. Projectsare then sent to the budget committee for incorporating them in thecapital budget.(6) Implementing Proposals Preparation of a capital expenditure budgeting andincorporation of a particular proposal in the budget does not itselfauthorise to go ahead with the implementation of the project. Arequest for authority to spend the amount should further be made tothe capital expenditure committee which may like to review theprofitability of the project in the changed circumstances. Further,while implementing the project, it is better to assign responsibilitiesfor completing the project within the given time frame and cost limitso as to avoid unnecessary delays and cost over runs. Networktechniques used in the project management such as PERT and CPMcan also be applied to control and monitor the implementation of theprojects.
  • 334. (7) Performance Review Last but not the least important step in the capital budgetingprocess is an evaluation of the performance of the project, after it hasbeen fully implemented. It is the duty of the top management orexecutive committee to ensure that funds are spent in accordancewith the allocation made in the capital budget. A control over suchcapital expenditure is very much essential and for that purpose amonthly report showing the amount allocated, amount spent, amountapproved but not spent should be prepared and submitted to thecontroller. The evaluation is made through post completion audit byway of comparison of actual expenditure on the project with thebudgeted one, and also by comparing the actual return from theinvestment with the anticipated return. The unfavourable variances, ifany, should be looked into and the causes of the same be identified sothat corrective action may be taken in future.EVALUATION OF INVESTMENT PROPOSALS The funds available with the firm are always limited and it isnot possible to invest funds in all the proposals at a time. Therefore,it is very essential to select from amongst the various competingproposals, those which give the highest benefit. A firm may face asituation where more investment proposals may be poor- Themanagement has to select the most profitable project or to take up themost profitable project first. There are many considerations, economicas well as non-economic, which influence the capital budgetingdecisions. Because of the utmost importance of the capital budgetingdecision, a sound appraisal method should be adopted to measure theeconomic worth of each investment project. Capital expendituresrepresent long-term commitment in the sense that current investmentyields benefits in future. The capital expenditure decisions assume
  • 335. great importance for the future development of the concern. Theimportant factor that influences the capital budgeting decision is theprofitability of the prospective investment. The risk involved in theproposal cannot be ignored because profitability and risk are directlyrelated, that is, higher the profitability, the greater becauseprofitability and risk are directly related, that is, higher theprofitability, the greater the risk and vice-versa. The goal of financialmanagement of a firm is the worth maximisation of the firm, and inorder to achieve this goal, the management must select those projectswhich deserve first priority in terms of their profitability. Whileevaluating, two basic principles are kept in mind, namely, the biggerbenefits are always preferable to small ones and that early benefits arealways better than the deferred ones. The essential property of soundevaluation technique is that it should maximise the shareholderswealth. The following other characteristic should also be possessed bya sound investment evaluation criterion: (1) It should provide a means of distinguishing between acceptable and unacceptable projects (2) It should provide clear cut ranking of the projects in order of the profitability or desirability. (3) It should also solve the problem of choosing among alternative projects. (4) It should be a criterion which is applicable to any conceivable investment project. (5) It should emphasise upon early and bigger cash benefits in comparison to distant and smaller benefits. (6) The method should be suitable according to the nature and size of capital project to be evaluated.
  • 336. METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSALS A number of appraisal methods may be recommended forevaluating the capital expenditure proposals. The most important andcommonly used methods are:Traditional Methods: 1. Pay-back period Method or Pay-out or Pay-off Method 2. Improvements in Traditional Approach to Pay-back period Method. 3. Rate of Return Method or Accounting Method.Time Adjusted Methods or Accounting Methods: 4. Net Present Value Method 5. Internal Rate of Return Method 6. Profitability Index Method.TRADITIONAL METHODS(1) Pay-back Period Method The term pay-back (or pay-out or pay-off or break-even periodor recoupment period) refers to the period in which the project willgenerate the necessary cash to recoup the initial investment. Businessunits, while selecting investment projects, would consider the recoveryof cost as the first and foremost concern even though earningmaximum profits is their ultimate .goal. This method describes interms of period of time the relationship between annual savings (cashinflow) and total amount of capital expenditure (investment), paybackperiod is defined as the number of years required for the savings incosts or net cash inflow (after tax but before depreciation) to recoupthe original cost of the project In simple sentence, it represents thenumber of years in which the investment is expected to "pay for itself.Under this method, various investments are ranked according to the
  • 337. length of their pay-back period in such a manner that the investmentwith a shorter pay-back period is preferred to the one which haslonger pay-back period.Calculation of Pay-back Period(a) In the case of even cash inflows : If the annual cash inflows are constant, the pay-back period canbe computed by dividing cash outlay (original investment) by annualcash inflows. For instance, if a project requires Rs. 10,000 as initialinvestment and it will generate an annual cash inflow of Rs.2,500 forten years, the pay-back period will be 4 years, calculated as follows: Initial InvestmentPay - back Period = Annual Cash Inflow Rs. 10,000 = Rs. 2,500 = 4 years(b) In the case of uneven inflows : If cash inflows are not uniform, the calculation of pay-backperiod takes a cumulative form. In such a case the pay-back periodcan be found out by adding up the figure of net cash inflows until thetotal is equal to initial investment. For instance, if-a project requiresan initial investment of Rs. 10,000 and the annual inflow for 5 yearsare Rs.3,000; Rs.4,000; Rs.2,500; Rs.2,000 and Rs.2,000 respectively,the pay-back period will be calculated as follows: Year Annual Cash Cumulative Cash Inflows Inflow Rs. Rs. 1 3,000 3,000 2 4,000 7,000 3 2,500 9,500 4 2,000 11,500
  • 338. 5 2,000 13,500 The above workings show that in 3 years Rs.9,500 has beenrecovered. Rs.500 is left out of in-tial investment. In the fourth yearthe cash inflow is Rs.2,000. It means the pay-back period is between 3to 4 years, calculated as follows: Rs.500Pay - back Period = 3 years + Rs.2,000 = 3.25 yearsIllustration 1: Payoff Ltd., is producing articles mostly by manuallabour and is considering to replace it by a new machine. There aretwo alternative models M and N of the new machine. Prepare astatement of profitability showing the payback period from thefollowing information: Machine M Machine NEstimated life of machine 4 years 5 yearsCost of machine Rs.9,000 Rs. 18,000Estimated savings in scrap Rs.500 Rs.800Estimated savings in direct wages Rs. 6,000 Rs. 8,000Additional cost of maintenance Rs.800 Rs. 1,000Additional cost of supervision Rs. 1,200 Rs. 1,800
  • 339. Solution:Statement showing annual cash inflows Machine M Machine N Rs. Rs.Estimated savings in scrap 500 800Estimated savings in direct wages 6,000 8,000Total savings (A) 6,500 8,800Additional cost of maintenance 800 1,000Additional cost of supervision 1,200 1,800Total additional cost (B) 2,000 2,800New cash inflow (A) - (B) 4,500 6,000 Original InvestmentPay-back Period = Annual Average Cash Inflow Rs.9,000 Rs.18,000 = Rs.4,500 = 2 years Rs.6,000 = 3 yearsMachine M should be preferred because it has a shorter pay-backperiod.Acceptance or Reject Criterion : Many firms use the pay-back period as an accept or rejectcriterion as well as a method of ranking projects. If the pay-backperiod calculated for a project is less than the maximum pay-backperiod set by management, it would be accepted; if not, it would berejected. As a ranking method, it gives highest ranking to the projectwhich as shortest pay-back period and lowest ranking to the projectwith highest pay-back period. Thus, if die firm has to choose amongtwo mutually exclusive projects, project with shorter pay-back periodwill be selected.
  • 340. Advantages of Pay-back Method :1) It is easy to calculate and simple to understand.2) It saves in cost, as it requires lesser times and labour as compared to other methods.3) Under this method, a shorter pay-back period is preferred to the one having a longer pay-back period, and it reduces the loss through obsolescence and is more suited to the developing countries, like India, which are in the process of development and have quick obsolescence.4) This method is useful to a concern which is short of cash and is eager to get back the cash invested in a capital expenditure project.5) As the method considers the cash flows during the pay-back period of the project, the estimates would be reliable and the result may be comparatively more accurate.Disadvantages of Pay-back Method :(1) It does not take into account the cash inflows earned after the pay-back period and hence the true profitability of the project cannot be correctly assessed.(2) This method does not consider the amount of profit earned on investment after the recovery of cost of investment.(3) It does not take into consideration the cost of capital which is a very important factor in making a sound investment decisions.(4) It may be difficult to determine the minimum acceptable pay- back period, it is usually, a subjective decision.
  • 341. (5) It ignores interest factor which is considered to be a very significant factor in taking sound investment decision.(6) Too much emphasis on the "liquidity of the investment", ignoring the "profitability of investment" may not be justified in a number of situations.(7) It ignores time value of money. Cash flows received in different years are treated equally.(8) It doe not take into account the life of the project, depreciation, scrap-value, interest factor etc. Because, a rupee tomorrow is worthless than a rupee today.(2) Improvement in Traditional Approach to Pay-back Period One of the most commonly used techniques for evaluatingcapital investment proposal is the cash pay-back method. Someauthorities on accountancy, in order to make up the deficiencies ofthe pay-back period method, evolved new concepts. The improvementsare discussed below:(a) Post Pay-back Profitability : One of the limitations of the pay-back period method is that itneglects the profitability of investment beyond the pay-back period.This method is also known as Surplus Life over pay-back period.According to this method, the project .Which gives the greatest postpay-back period profits may be accepted. It has been explained in thefollowing illustration: Post pay-back profitability = Annual Cash Inflow (Estimated Life - Pay-back Period)
  • 342. Further, post pay-back profitability index can also be calculatedby multiplying the above formula with 100.Illustration 2: A concern is considering two projects X and Y.Following are the particulars in respect of them: Project X Project YCost (Rs.) 1,40,000 1,40,000Economic Life (in years) 10 10Estimated Scrap (in Rs.) 10,000 14,000Annual Savings 25,000 20,000 Ignoring income-tax, recommend the best of these projectsusing (a) payback period, (b) post pay-back profit, and (c) index of postpay-back profit.Solution: Project X Project Y 1. Cost 1,40,000 1,40,000 2. Savings 25,000 20,000 3. Pay-back period 5.6 years 7 years 4. Economic Life 10 years 10 years 5. Surplus Life 4.4 years 3 years 6. Post pay-back profit (2 x 5) 1,10,000 60000 7. Index of post pay-back profit 1,10,000 60,000 1,40,000 x 100 1,40,000 x 100 = 78.6% = 42.9%Project X is the best one by all the methods of ranking.(B) Discounted Pay-back Period :
  • 343. Another serious limitation of pay-back period method is that itignores the time value of money. This method can be improved ormodified to consider the time value of money. Under this method thepresent values of all cash outflows and inflows are computed at anappropriate discount rate. The number of periods taken in recoveringthe investment outlay on the present value basis is called thediscounted pay-back period. The present values of all inflows arecumulated in order of time. The time period at which the cumulatedpresent value of cash inflow equals the present value of cash outflowsis known as discounted payback period.Illustration 3: The following are the particulars relating to a project Rs. Cost of the project 50,000 Operating Savings: 1st year 5,000 2nd year 20,000 3rd year 30,000 4th year 30,000 5th year 10,000 Calculate (i) pay-back period ignoring interest factor and (ii)discount pay-back period taking into account interest factor at 10%.Solution:(i) Pay-back period Year Annual Cumulative Savings Rs. Savings Rs. 1 5,000 5,000 2 20,000 25,000 3 30,000 55,000Upto second year, Rs.25,000 recovered Rs.50,000- Rs.25,000Therefore, pay-back period = 2 years + Rs.30,000
  • 344. Rs.25,000 = 2 + Rs.30,000 = 2 years 10 months(ii) Discounted Pay-back period at 10% interest factor Discounted Cumulative Years Savings PV Factor Savings Discounted Savings Rs. Rs. Rs. 1 5,000 0.9091 4,546 4,546 2 20,000 0.8265 16,530 21,076 3 30,000 0.7513 22,539 43,615 4 30,000 0.6830 20,490 64,105, Rs. 50,000 - Rs.43,615Discounted pay-back period = 3 years + Rs.20,490 = 3 years 4 months(C) Pay-back Reciprocal Sometimes, pay-back reciprocal method is employed to estimatethe internal rate of return generated by a project. Annual Cash InflowPay-back Reciprocal = Total Investment However, this method of ranking investment proposals shouldbe used only when: • Annual savings are even for the entire period. • The economic life of the project is at least twice of the pay-back period.
  • 345. (3) Rate of Return Method (Accounting Method) This method is also known as Accounting Rate of Returnmethod or Return on Investment of Average Rate of Return method.According to this method, various projects are ranked in order of therate of earnings or rate or return. Projects which yield the highestearnings are selected and others are ruled out. The return oninvestment can be expressed in several ways, as follows:(a) Average Rate of Return Method Here, average profit, after tax and depreciation, is calculatedand then it is divided by the total capital outlay or total investment inthe project. This method establishes the ratio between the averageannual profits to total outlay. Average Annual ProfitAverage Rate of Return = Outlay of the Project x 100Project giving a higher rate of return will be preferred over those givinglower rate of return.(b) Return Per unit of Investment Method In this method, the total profit after tax and depreciation isdivided by the total investment. This gives us the average rate ofreturn per unit of amount invested in the project. Total ProfitReturn per unit of Investment = Net Investment x 100(c) Return on Average Investment Method
  • 346. Under this method the percentage return on average amount ofinvestment is calculated. To calculate the average investment, theoutlay of the project is divided by two. Total Profit after deprec. & TaxesReturn on Average Investment = Total Net Investment /2 x 100(d) Average Return on Average Investment Method Under this method, average profit after depreciation and taxes isdivided by the average of amount of investment. This is an appropriatemethod of rate of return on investment. Average AnnualAverage Return on Average Investment = Net Investment / 2 x 100Illustration 4: Calculate the average rate of return for projects A andB from the following: Project A Project BInvestment Rs.20,000 Rs.30,000Expected Life (no salvage value) 4 years 5 yearsProjected Net Income, after interest, depreciation and taxes: Years Project A Project B Rs. Rs. 1 2,000 3,000 2 1,500 3,000 3 1,500 2,000 4 1,000 1,000 5 - 1,000 Total 6,000 10,000If the required rate of return is 1 2% which project should beundertaken?Solution: Project A Project B
  • 347. Rs. Rs.Total profit, after interest, 6,000 10,000depreciation and taxesExpected Life 4 years 5 yearsAverage Profit 1,500 2,000Investment 20,000 30,000Average Rate of Return 1-500 2,000Average Rate of Return 1,500 2,000 20,000 x 100 = 7.5% 30,000 x 100 = 6.6%Average Return on 1,500 2,000Average Investment 20,000/2 x 100 = 15% 30,000/2 x 100 = 13.33% The average return on average investment is higher in the caseof Project A, besides it is also higher than the required rate of returnof 12%. Project A is suggested to be undertaken.Merits of Rate of Return MethodThe following are the merits: • It is simple to understand and easy to calculate. • It takes into consideration the total earnings from the project during its life time. Thus this method gives a better view of profitability as compared to pay-back period method. • It is based upon accounting concept of profit. It can be calculated from the financial data. Demerits of Rate of Return Method : This method suffers from the following demerits: • It ignores the time value of money. Profits earned in different periods are valued equally. • This method may not reveal true and fair view in the case of long-term investments. • It does not take into consideration the cash flows which is more important than the accounting profits. • It ignores the fact that profits can be reinvested.
  • 348. • There are different methods for calculating the Accounting Rate of Return. Each method gives different results. This reduces the reliability of the method.TIME ADJUSTED METHOD (DISCOUNTED CASH FLOW METHOD) Discounting is just opposite of compounding. In compound rateof interest, the future value of the present money is ascertainedwhereas in discounting, the present alue of future money iscalculated. The rate at which the future cash flows are reduced totheir present value is termed as discount rate. Discount rate,otherwise called time value of money, is some interest rate whichexpresses the time preference for a particular future cash flow. The discounted cash flow method is an improvement on thepay-back method as well as accounting rate of return. This method isbased on the fact that future value of money will not be equal to thepresent value of money. That is, discounted cash flow techniquerecognises that Re. one of today (cash outflow) is worth more than received at a future date (cash inflow). Die time adjusted ordiscounted cash flow method take into account the profitability andalso the time value of money. The discounted cash flow method forevaluating capital investment proposals are of three types:1. Net Present Value Method This method is also known as Excess Present Value or Net GainMethod or Time Adjusted methods. Under this method, cash inflowsand cash outflows associated with each project are first worked out.The present values of these cash inflows and outflows are thencalculated at the rate acceptable to the management. This rate of
  • 349. return is considered as the cut-off rate and is generally determined onthe basis of cost of capital suitably adjusted to allow for the riskelement involved in the project. The present values of total of cash inflows should be comparedwith present values of cash outflows. If the present value of cashinflows are greater than (or equal to) the present value of cashoutflows (or initial investment), the project would be accepted. If it isless, then proposal will be rejected.Illustration 5: A company is considering the purchase of the twomachines with the following details: Machine I Machine II Life Estimated 3 years 3 years Rs. Rs. Capital Cost 10,000 10,000 Net earning after tax: 1st year 8,000 2,000 2nd year 6,000 7,000 3rd year 4,000 10,000 You are required to suggest which machine should be preferred.Solution: Calculation of Net Present Value (10%) Machine I Machine II Year PV Factor Cash Present Cash Present Inflow Rs. Value Rs. Inflow Rs. Value Rs.1 0.909 8,000 7,272 2,000 1,8182 0.826 6,000 4,956 7,000 5,782
  • 350. 3 0.751 4,000 3,004 10,000 7,510 15,232 15,110 Less: Cost Net Present Value 10,000 10,000 5,232 5,110 Machine I should be preferred as net present value is Rs.5,232which is higher than Rs.5,110 in case of Machine II.Merits of Net Present Value Method The merits of this method of evaluating investment proposal areas follows:s • This method considers the entire economic life of the project. • It takes into account the objective of maximum profitability. • It recognises the time value of money. • This method can be applied where cash inflows are uneven. • It facilitates comparison between projects.Demerits of this method are as follows: • It is not easy to determine an appropriate discount rate. • It involves a great deal of calculations. It is more difficult to understand and operate. • It is very difficult to forecast the economic life of any investment exactly. • It may not give good results while comparing projects with unequal investment of funds.2. Internal Rate of Return Method This method ^ popularly known as time adjusted rate of returnmethod or discounted rate of return method. The internal rate ofreturn is defined as the interest rate that equates the present value ofthe expected future receipts to the cost of the investment outlay. Thisinternal rate of return is found by trial and error. First, we compute
  • 351. the present value of the cash-flows from an investment, using anarbitrarily selected interest rate. Then, we compare the present valueso obtained with the investment cost. If the present value is higherthan the cost figure, we try a higher rate of interest and go throughthe procedure again. Conversely, if the present value is lower than thecost, lower the interest rate and repeat the process. The interest ratethat brings about this equality is defined as the internal rate of return.This rate of return is compared to the cost of capital and the projecthaving higher difference, if they are mutually exclusive, is adoptedand other one is rejected. As this determination of internal rate ofreturn involves a number of attempts to make the present value ofearnings equal to investment, this approach is also called the Trialand Error Method.Illustration 6: Initial Investment Rs.60,000 Life of the Asset 4 yearsEstimated net annual cash-flows: 1st year Rs. 15,000 2nd year Rs.20,000 3rd year Rs.30,000 4th year Rs.20,000Calculate Internal Rate of Return.
  • 352. Solution: Calculation of Internal Rate of Return Annual PVF PVF PVF PVFYear PV PV PV PV Cashflow 10% 12% 14% 15% 1 15,000 0.909 13,635 0.892 13,380 0.877 13,155 0.869 13,035 2 20,000 0.856 16,520 0.797 15,940 0.769 15,380 -0.756 15,120 3 30,000 0.751 22,530 0.711 21,330 0.674 20,220 0.657 19,710 4 20,000 0.683 13,660 0.635 12,700 0.592 11,840 0.571 11,420 66,345 63,350 60,595 59,285Total of PV of Cash inflow Initial investment is Rs.60,000. Hence internal rate of return must be between 14% and 15% (Rs.60,595 and Rs.59,285). The difference comes to Rs. 1.310 (Rs.60,595 - Rs.59,285). For a difference of 1,310, difference in rate = 1% (Excess PV: 60595-60,000=595) 595 Therefore, exact Internal Rate of Return = 14% +1,310 x 1% = 14% + 0.45% =14.45% 3. Profitability Index Number It is also a time adjusted method of evaluating the investment proposals. Profitability index also called Benefit Cost Ratio or Desirability factor. It is the ratio of the present value of cash inflows, at the required rate of return to the initial cash outflow of the investment. The probability index is less than one. By computing
  • 353. profitability indices for various projects, the financial manager canrank them in order of their respective ratio of profitability. PV of Cash Flows Profitability Index = Initial Cost OutlayIllustration 7: The initial cash outlay of a project is Rs.50,000.Estimated cash inflows: 1st year Rs.20,000 2nd year Rs. 15,000 3rd year Rs.25,000 4th year Rs. 10,000Compute Profitability Index.Solution:Calculation of Profitability Index Cash Inflows PV Factor at Year PV Rs. Rs. 10% 1 20,000 9.909 18,180 2 15,000 0.826 12,390 3 25,000 0.751 18,775 4 10,000 0.683 6,830 Total 56,175
  • 354. Total Present Value = Rs.56,175Less: Initial Outlay = Rs.50,000Net Present Value = 6,175 PV Cash InflowProfitability Index (gross) = Initial Cash Outflow 56,175 50,000 = 1.1235Profitability index is higher than 1, the proposal can be accepted.CAPITAL RATIONING Capital rationing is a situation where a firm has moreinvestment proposals than it can finance. Many concerns have limitedfunds. Therefore, all profitable investment proposal may not beaccepted at a time. In such event the firm has to select from amongstthe various competing proposals, those which give the highestbenefits. There comes the problem of rationing them. Thus capitalrationing may be defined as a situation where the management hasmore profitable investment proposals requiring more amount offinance than the funds available to the firm. In such a situation, thefirm has not only to select profitable investment proposals but also torank the projects from the highest to lowest priorityIllustration 8: X Ltd. is considering the purchase of a machine. Twomachines are available, A and B. The cost of each machine isRs.60,000. Each machine has an expected life of 5 years. Net profitsbefore tax but after depreciation during the expected life of themachine are given below: Year Machine A Machine B Rs. Rs. 1 15,000 5,000 2 20,000 15,000
  • 355. 3 2500 20,000 4 15,000 30,000 5 10,000 20,000 Following the method of return on investment ascertain whichof the alternates will be more profitable. The average rate of tax maybe taken at 50%.Solution : Computation of profit after tax year Machine A Machine B Profit Tax at Profit Profit Tax at Profit before tax 50% after tax before tax 50% after tax Rs. Rs. Rs. _ Rs. 1 15,000 7,500 7,500 5,000 2,500 2,500 2 20,000 10,000 10,000 15,000 7,500 7,500 3 25,000 12,500 12,500 20,000 10,000 10,000 4 15,000 7,500 7,500 30,000 15,000 15,000 5 10,000 5,000 5,000 20,000 10,000 10,000 Total 85,000 42,500 42,500 90,000 45,000 45,000 Machine A Machine BAverage profit Rs. 42,000 Rs. 45,000after tax 5 = Rs. 8,500 5 = Rs. 9000Investment Rs. 60,000 Rs. 60,000Average Rs. 60,000 Rs. 60,000Investment 2 = Rs. 30,000 2 = Rs. 30,000Average Return on Rs. 8,500 Rs. 9,000Investment 60,000 x 100 = Rs. 14.17% 60,000 x 100 = Rs. 15%
  • 356. Average Return on Rs. 8,500 Rs. 9,000Average 30,000 x 100 = Rs. 28.34% 30,000 x 100 = Rs. 30%InvestmentMachine B is more profitable.Illustration 9 : A Ltd. Company is considering the purchase of a newmachine which will carry out operations preformed by labour. X andY are alternative models. From the following information, you arerequired to prepare a profitability statement and work out the pay-back period for each model.
  • 357. Model X Model Y Rs. Rs.Estimated Life 5 years 6 yearsCost of Machine 1,50,000 2,50,000Cost of indirect materials 6,000 8,000Estimated savings in scrap 10,000 15,000Additional cost of maintenance 19,000 27,000Estimated savings in directwages:Employees not required 150 200Wages per employee 600 600Taxation to be regarded 50% of profit before charging depreciation.Which model you recommend ?Solution: Profitability Statement Model X Model Y (Rs) (Rs)Estimated saving per 10,000 15,000year scrapWages (150x600) 90,000 1,35,000(200x600)Total Savings 1,00,000 1,35,000Less: Additional CostCost of indirect 8,000materials 6,000Cost of Maintenance19,000 25,000 27,000 35,000Additional Ear