Financial And Management ing Notes @ Mba Bk.doc y4o5a

FINANCIAL AND MANAGEMENT ING

Unit - 1 ing

–

Defination

–

According

for

historical

function

and

managerial function – Scope of ing – Financial ing and Management ing – Managerial uses – Differences.

Financial ing: ing concepts – Convections – Principles – ing standards – International ing standards.

Unit-2 Double entry system of ing - ing books – Preapartion of journal and ledger, subsidiary books - Errors and rectification – Preparation of trial balance and final s.

ing from incomplete records - Statements of affairs methods -Conversion method - Preparation of Trading, Profit & Loss and Balance Sheet from incomplete records.

Unit - 3 Financial Statement Analysis - Financial statements - Nature of financial statements - Limitations of financial statements - Analysis of interpretation -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 - Factors affecting efficiency of ratios - How to make effective use of ratio analysis - Uses and limitation of ratios - Construction of Profit and Loss and Balance Sheet with ratios and relevant figures - Inter-firm, Intra-firm comparisons.

Unit -4 Fund Flow Statements - Need and meaning - Preparation of schedule 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 cash flow 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 types of budgets - Classification of budgets - Budgetary control system - Mechanism -Master budget.

Unit-6 Capital Budgeting System - Importance - Methods of capital expenditure appraisal - Payback period method - ARR method - DCF methods - NPV and IRR methods - Their rationale - Capital rationing.

FINANCIAL AND MANAGEMENT ING

LESSON

TITLE

1.

ing an Introduction

2.

Management ing

3.

Theory Base of ing - ing Standards

4.

Practical Base of ing - Origin and Analysis of Business Transactions

5.

Financial Statements of Profit-making Entities Manufacturing-cumTrading Organisations

6.

Financial Statements of Non-Profit-making Entities

7.

Errors Management

8.

s 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

LESSON - 1 ING: AN INTRODUCTION Learning outcomes; on completion of this chapter, you should be able to:  Explain the nature of ing.  Identify the various branches of ing.  Explain the process of creation of financial statements and their interpolation.  Explain the various objectives of financial statements.  Identify the various uses of ing information.

INTRODUCTION ing discipline deals with measurement of economic activities affecting inflow and outflow of economic resources to develop useful information for decision making. At household level information about outflow and inflow of cash resources helps -.0 assess financial position and plan household activities. At Government level, information about inflow from taxes (direct as well as indirect) and expenditure on various activities (developmental and non developmental) is needed for planning and budgeting. Although ing can be discipline has universal applicability, but its growth is closely associated with the developments in the business world. Thus to understand ing as a field of study for universal application, it is best identified with recording of business transaction and thereby creating economic information about business enterprises to facilitate decision making.

NATURE OF ING: 1.2 ing i. is man-made; 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.

ing being a man-made system has evolved over a period of time to provide financial information of business enterprises to s of ing information. A large number of groups with varied interests in affairs of a business enterprise have emerged over a period of time, especially after emergence of corporate forms of organization involving separation of ownership management. These groups include 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(ivestors)



are doing research(researchers)



are engaged in collection of taxes ( sales tax and income tax



authorities)



formulate

fiscal

and

monetary

policies

(other

Government 

department)



are of the public at large(general public)

Internal s of ing information are inside the enterprise and need information to control and plan the activities of the business to manage it

effectively. These include Owners in case of non corporate enterprises and managers and directors in case of corporate business. Their information needs are satined through various reports which are generally prepared internal use and remain unpublished. External s of ing information are outside the enterprise. The information need of these groups are met by measuring the desired information by following a systematic process. It results in creation of financial statements which are generally published to make the information available

to

external



group

for

decision

making.

The

need

for

communicating relevant and useful information to that potential internal and external s is always there and ing is intended to perform that role. Thus, ing may be defined as:

"the process of identifying, measuring and communicating information to permit

judgement

and decision by the s" ( American ing

Association)

BRANCHES OF ING

Financial ing: It primarily concentrates on creation of financial information for external groups such as creditors, investors, lenders and so on. It deals with business events which have already occurred and is, therefore, historical in nature. Traditionally, the aim was to develop information about income and financial position on the basis of events which had taken place during a period of time. Recent trend in corporate form of organization is to provide information about cash flows and earnings per sh^e also as part of published financial statements. Management ing - The information provided by the financial ing system is significant but not sufficient for smooth orderly and efficient conduct of business. Management needs more information to discharge

its function of stewardship, planning, control and decision-making. As information needs of management vary from enterprise to enterprise, the grouping and reporting of information takes different forms. Trie different ways of grouping information and preparing reports as desired by managers for discharging their functions are referred to a management

ing.

Management ing provides information to the management not only about cost but also revenue, profit, investment etc., for managing business more efficiently and effectively. A very important component of management ing is cost ing which deals with cost ascertainment and cost control. Few other branches of ing which are of recent origin are social responsibility ing and human resources ing. The first one involves ing for social costs incurred by the enterprise and social benefits created by it while the second deals with ing for human resources.

In the present book, we are concerned with financial ing only. The word ing and financial ing are used interchangeably.

Financial ing provides information to external groups in the form of published financial statements. As these s are involved in preparation of financial statements, it is very essential that the published statements have credibility and regarded as reliable by external s. Therefore, ing, as a language for communicating information, needs to have a strong syntax of its own for preparing credible financial statements.

The syntax of ing language comprises of analysis and recording of business transactions on the basis of double Entry system of book keeping and the basic principles on which the practical system is based. The theory base; of ing consists of Generally Accepted ing Principles

(GAAP), Conceptual framework and ing Standards (AS) issued by the professional ing bodies all over the world,

The credibility of the financial statements is established through analysis independent examinations by a chattered ant who certifies that the information provided therein gives true and fair view of the activities of tM business in conformity with accepted principles and practices. This process of attestation of is known as auditing of s.

MEANING OF FINANCIAL ING Measurement of ing information involves three basic steps as per the traditional definition of ing by the American Institute of Certified Public s (AIA) which defines ing as "the are of recording, classifying and summarizing in a significant manner and in of money, transaction- and events which are negative part atleast of financial character and interpreting the results thereof. On this basis of above information, ing or more precise financial ing can be basically divided into two parts", A. Creation of financial information. B. Use of financial information.

A. Creation of financial information: Creation of financial information involves three steps:

1. Recording: The process of creation of financial information starts with the occurrence of a business transaction which can be Qualified. The transaction is evidenced by some document such as Sales bill, book, Salaries slip etc., The systematic record of those transactions is chronological order (i.e. the order in which they occur ) is made in a book called JOURNAL BOOK. The four basic questions need to be addressed while recording namely, what to record, when to record, how to record and at what value to record?

What to record? Since-ing is regarded as language of the business, it should systematically record all the transaction and events which affect the results of business and ignore the person transaction of the proprietor. Before recording in the journal book, all business transaction expressed in of money. Consequently business activities which cannot be expressed in of money such as strikes, changes in the composition of board of directors etc., are not recorded. Thud decision makers will get information only about money aspects of the business enterprise from a ing records.

When to record? Usually business transaction is recorded only when it has occurred. Thus ing is basically historical in nature.

How to record? Usually business transaction has two aspects and both these are recorded by ing 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 journal book, decision about the value of the transaction is needed. A number of different valuation bases are used in ing in varying degrees and include historical cost, current cost, realizable value and present value. These valuation based generally assume significance in case of valuation of assets. Historical cost refers to amount paid / payable to acquire an

asset. The current cost means the amount that would have to be paid, if the asset is to be acquired currently. The realizable value refers to the net realizable value of the assets if it is to be disposed. The present value of an asset is the present discounted value of the future inflows that analysis item is expected to generate in the normal course of business. 2. Classifying: After recording monetary transactions in the journal book, next step is to classify the recorded information into related groups to put information in compact and usable forms. For e.g., all transactions involving cash inflows (receipts) and cash outflows (payments) can be grouped to develop useful information is called ledger book. Mechanism used for classification of recorded information is to open s which are called ledger s.

3. Summarizing: Basic aim of ing is to create financial information in a form which will be useful to the decision makers. To achieve this end, s containing classified information in the ledger book are balanced. After balancing of the ledger book, balances are listed statement giving names of theses s and their balance is called " TRIAL BALANCE " on the basis of trail balance, summaries are prepared to give useful information about the financial results during a time period and the financial position at a point of time. Reporting of summarizes of the business transaction is done in the form of financial statements which are known as FINAL S. According to international ing standard - 1 the term financial statements covers balance sheet, income statements or profit and loss s, notes and other statements and explanatory material which are identified as being part of the financial statements. The process of creation of financial information can be summarized as follows:

Recording Journal Book

Analysis of business transaction evidenced by source document

Classificati on in ledger book

Summariza tion first in trial balance and then in financial

Thus recording, classifying and summarizing are three basic steps involved in creation of financial statement which ascertain and communicate result of business entity. For this is assumed that business and its owner have separate existence. For ing purpose, even a division of the business or a branch of it may be treated as an ing entity.

B. Use of Financial Information / Statements: Financial statements prepared by a business enterprise are published and are available to the decision makers. Sound division making requires analysis and interpretation of these financial statements. A very commonly used tool for financial analysis is ratio analysis. However, there are other tools which are used by the decision makers to undertake analysis. The widely used tools for carrying out analysis are : 

Cash flow statement



Fund flow statement Ratio analysis



Comparative statement



Common size statement

However to analyze and interpret these financial statements, the should be aware of purpose and nature of these statements can be described as follows : "Financial statements are prepared for the purpose of presenting a periodical review or report on progress by management and deal with the status of investment in the business and the results achieved during the period under

review. They reflect a combination of recorded facts, ing, conventions and personal judgements and judgements and conventions applied after them materially. The soundness of the judgement necessarily depends on the competence and integrity of those who make them and on their adherence to Generally Accepted ing Principles and Conventions. (Bombay Stock Exchange Official Directory). OBJECTIVES OF ING The main objective of ing are as follows:  The main records of business: In ing, 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 .  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.  To portray 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 enterprise's liquidity and solvency.

 Control over the property and asset of the firm: ing provides upto-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 ing 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 s: ing is called the language of business. It aims to communicate information about financial results and financial position of a business enterprise to decision makers,

S OF ING INFORMATION s of ing information can be grouped as follows Owners: Owners refers to a person or group of persons who have supplied capital for running the business. It refers to individual in case of t stock companies. Information needs of shareholders have assumed great significance in the corporate business world because of separation of ownership and management in case of t stock companies owners are interested in the financial information, to know"about safety of amount invested and return on amount invested.

Managers: For managing business profitably information aboutHnancial result and financial position is needed by management By providing this information, ing helps managers in efficient and smooth running of a business enterprise.

Investors: Prospective investors would like to know about the past performance of the business enterprise before making investment in that concern. By analyzingihistorical information provided by ing records, they can arrive at a decision about the expected return and risk involved in investing in particular business enterprise.

Creditors and Financial Institutions: Whosoever is extending credit or loan to a business'enterprise, would like to have information about its repaying capacity, creditworthiness etc., The required information can be obtained by analyzing and interpreting the financial statements of the business enterprise.

Employees: Employees are concerned about job security and future prospectus. Both of these are intimately related with the performance of the business enterprise, Thus by analyzing financial statements they can draw conclusions about their job security and future prospectus.

Government: Government policies relating to taxation, providing subsidies etc., are guided by the relevance of the industry in the economic development of the country and the past performance of the industry. Information about the past performance is provided by the ing system, collection of taxes is also based on ing records.

Researchers: Researchers need financial information for testing hypothesis and development of theories and models. The financial statement provides the recorded information.

Customers: (Customers who have developed loyalties to a business are ceitainly interested in the continuance of the business. They certainly want to know about the future directions of the enterprise with which they are associating themselves. The way to information about the enterprise is through their financial statements.

Public: An enterprise affects the public at large in many ways such as provider of the employment to a number of persons being a customer to many supplier a provider of amenities on the locality, a cause of concern to the public due to pollution etc., Hence public at large is interested in knowing the future

directions of the enterprise and the only window to peep inside the enterprise is their financial statements.

ING AND THEIR DISCIPLINES: ing is the best understood when the other related disciplines are conceptually clear to the . For e.g., a can hardly understand financial statements with lots of tables and graphs in it. He is not comfortable with the basics of mathematics and statistics. ing is very intimately connected with many disciplines more important of which are economics, law, management, statistics and mathematics.

Linkage with Economics: ing has strong linkages with economics. It has acquired its most important concepts of income and capital from economics. The ant as well as economist agree that capital should be maintained intact while calculating income and this income can be distributed without affecting capital. However, the interpretation of the two concepts by ant and economist differ a great deal despite similarities. The capital to an economist is like a tree and income is like a fruit on that tree. In technical , a stock of wealth (Tree) or assets existing at a point of time is called capital whereas flow of benefits from the wealth through a given periodvs called income. Hence capital and wealth are synonyms for the economist. The methodology adopted by economist is finding income is to find out the excess of capital at the end of the year over the beginning of the year. If the capital increases, it is more income. However as the capital decreases it is called loss. To arrive at the value of the capital or wealth, the present value of the future benefits is calculated by discounting expected benefits at the required rate of return. Hence to find out the worth of an asset, the economist will have to estimate the life of the asset and the likely benefits to be desired from it. The benefits will be discounted at the requires rate of return of the asset has an exceptionally long life. Hence economists valuation of capital and income are highly subjective.

ant tries to impart practicability to the concept of capital and income. Recognizing that future benefits of an asset with long life of say 100 years are difficult to estimate, the ant puts a value of the asset at which it was acquired. However, his attitude is quite flexible and makes use of other bases of measurement wherever the need arises. The income of business belongs to a owner. The ant finds income as a direct result of matching of revenue and expense of the same period. It is always calculated at the end of a period. The matching of revenues and expense can be done on different basis viz accrual, cash and hybrid bases. The bases are discussed in detail later:

Linkage with Mathematics: ing is all about figures and operations on these figures. The basic system of ing can be very conveniently converted in the mathematical form in the form of an ing equation. Simple mathematical operations involved in ing are addition, subtraction, multiplication and division. Besides many aspects of ing involve calculations which involve strong knowledge of mathematics. For e.g., calculation of interest, calculation of the annuity needed to depreciate an asset with a defined rate of interest over its estimated useful life, bifurcation of a hire purchase instalment in cash price component and interest component etc.,

Linkages with Statistics: ing is not only about the preparation of ing information, it also involves the presentation and interpretation of ing information. The presentation aspects involved creation of tables and graphs etc., the knowledge of which essentially lies in the discipline of statistics. One of the most debated topic of ing namely inflation ing involves extensive conversation of historical ing information with the help of price indices, 'an important constituent of the discipline of statistics. The interpretation of ing information involves making absolute and relative comparison with

the help of ratio analysis. The knowledge of statistics is needed for the purpose. An important way of calculating interest is through the concept of average due date, which is based on the knowledge of averages.

Linkages with Law: ing essentially operates within a legal environment. Many business organizations are governed by their respective statues which prescribe the many aspects of their ing information including the presentation of information. For e.g., the Indian Companies Activities, 1956 prescribes the rules for managerial remuneration. It also prescribes the format of balance sheet as well as profit and loss , The banking, insurance and electricity companies have also to prepare their s as per the requirement of the respective statutes governing them.

LESSON - 2 MANAGEMENT ACCOU NTING

DEFINITION OF MANAGEMENT ING The ing activity can be classified into two parts. Financial ing and Management ing. Though both of them are interlinked, Management ing is future oriented, dynamic and is made to be decisive and control relevant. International Federation of ants (IFAC) defined Management ing

process

as

"the

process

of

identification,

measurement,

accumulation, analysis, preparation, interpretation and communication of information both financial and operating used by management to plan, evaluate and control within an organisation and to assure use of and ability for its resources". ICWAI published Glossary of Management ing defining Management ing as "a system of collection and presentation of relevant economic information relating to an enterprise for planning, coordinating and decision making", Management ing : Official Terminology of CIMA is defined Management

ing

as

"the

provision

of

information

required

by

management 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. Disclosure to those external to the entity (shareholders and others) 5. Disclosure to employees 6. Safeguarding assets

The assets involves participation in management to ensure that there is effective: 

Formulation of plans to meet objectives (long-term planning)



Formulation

of

short-term

operation

plans

(budgeting/

profit

making)".

American ing Association defines Management ing as "the application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist management in establishing plans for reasonable economic objectives and in the making of rational decisions with a view towards these objectives". Richard M.S. Wilson and Wai Fong Chua define Managerial ing as "Managerial ing encomes techniques and processes that are intended to provide financial and non-financial information to people within an organisation to make better decisions and thereby achieve organisational control and enhance organisational effectiveness" The Management ing is used by management to plan the activity, evaluate performance, ensure integrity of financial information and to implement

the

system

of

reporting

that

is

linked

to

organisational

responsibilities and contributes to the effective performance measurement. The definition of Management ing embraces all functions undertaken by ants in an organisation. Management ing needs to be dynamic and forward looking. It also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies and tax authorities. The role of Management ant is not determined by an isolated concept. It is determined by the requirements of business as Expressed in its structures.

SCOPE OF MANAGEMENT ING Management ing includes Financial ing and extends to the operation of a system of cost ing and financial management. While meeting the legal and conventional requirements regarding the presentation of financial statements (profit and loss , balance sheet and funds flow

statements) it stresses upon the establishment and operation of internal controls. The scope of Management ing, inter alia, includes:  Formation, installation and operation of ing, cost ing, tax ing and information systems. Management ant 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 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 ant presents the past data in such a way as to reflect the trends of events 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 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 Management ing is expected to analyse the deviation by reasons and responsibility and to suggest appropriate corrective measures in deserving cases.

 Analysing and interpreting ing 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 ing and other data and (ii) analysing the effect of alternative proposals on the profits and position of the enterprise. Management ant helps the management in proper understanding and analysis of the problem in hand and presentation of factual information obviously in financial .

 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 ant 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 ing serves not only as a tool in the hands of management, but also provides for a technique evaluating the performance of its functions of planning/decision making and control, and at the same time, enabling the owners and other interested parties to evaluate and appraise the management of the enterprise.

FUNCTIONS OF MANAGEMENT ING Management ant is one of the best assets for management. His contribution has been growing with age of time. He will continue to deliver the goods in a magnificent manner in future with varied experiences. Scope is

expanding and managements of various sectors are benefiting. Excerpts from the "Preface to Statements on International Management ing" issued oy the international Federation of ants in February 1987 are reproduced below: "Management ing 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/or future events; Control - to ensure the integrity of financial information concerning an organisation's activities or its resources;

Assure ability - to implement the system of reporting that is closely aligned to organisational responsibilities and that contributes to the effective measurement of management performance"

The functions of Management ing can be broadly classified into; (a) Periodic interval ing reports, and (b) Ad hoc analysis of data decision making. It is increasingly felt that Management ants should involve themselves more and more in decision making and problem solving of organisations. The areas of decision making and problem solving are dealt in the following paras:  Strategic Management ing: 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) postaudit 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 enterprise's financial data but fulfilling the information needs of all the segments of the organisation.

FUNCTIONS OF MANAGEMENT ANT The term 'Management ant' has many Director, Financial Director, Financial Controller, Finance Comptroller etc., are some of the used to designate with the work Management ing.

Depending situation,

size, nature arid organisational setup and his position in the company, the Management ant may be required to perform various and varied functions. The importance and effectiveness of his function would also depend upon the confidence reposed in him by the top management and the functional managers. His functions generally embrace each and every activity of the management. The essence of Management ant's functions are as follows:  The Management ant will establish, coordinate and: ister plans to facilitate the forecasting of sales, expense budgets and cost standards that will permit profit planning, capital budgeting and financing.  The Management ant will formulate ing 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 ant will be responsible for the protection of business assets to the extent possible by external controls and internal auditing and insurance coverage.  The Management ant will be responsible for tax policies and procedures and will supervise and coordinate the reports required by various authorities. ;  The Management ant 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) o functions, reflects the status of a Management ant. He is the principal office incharge of the s of the company. He shall be responsible to the Board of Directors for the maintenance of adequate ing procedures and records on the operation of business. He shall be responsible to the President or the Chairman of the Board or the Board of Directors. Thus, in his broad functional activities, the Management ant is responsible to the policy making group of top management, whereas, in his istrative activities he ss responsible to the top executive offer.

MANAGEMENT ING VS FINANCIAL ING The financial ing classifies and records an entity's transactions normally in money , in accordance with established concepts, principles, ing standards and legal requirements. It aims to present a 'true and fair view' jof the overall results of those transactions. Management ing has been described as a continuous process of analysis, planning and control in the context of providing decision for decision makers. Management

ing is more concerned with decision making and a key role for Management ant is acting as a provider of financial information to these decisions, There are several differences between Financial ing and Management ing as are set out in Table 1.1.

Financial ing and Management ing both appear to be similar inasmdch as both study the impact of business transactions and events of the enterprise, reports and interpret the results thereof. Both provide information for internals as well as external use. But Management ing although having its roots in Financial ing differs from the latter in following respects:  Financial ing 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 ing, in additions to the study of the events in relation to the enterprise as a whole, takes organisation in its various units and segments 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 , balance sheet and flow statements reveal the overall performance and position of the enterprise. Management ing 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 ing is more attached with reporting the results and positions of business to persons and authorities other than managementGovernment, Creditors, Investors, Owners, etc. At times, Financial ing follows window-dressing tactics in order to project a better than actual image of the enterprise. Management ing is concerned more with generating information for the use of internal management and hence the information reflects the real or really expected position.

 Financial ing is necessarily historical. It records and analyses business events long after they have taken place. Management ing 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 ing data is historical in nature, it is more precise than the Management ing data, which generally reflects Ihe expected future, and hence could only be an estimation. This provides the necessary rapidly to Management ing information.

 The periodicity in reporting financial s is much wider than in case of Management ing. In Financial ing, generally, results are reported on year to year basis. In Management ing is free to formulate its own rules, procedures and forms because the information generates is solely for internal consumption.

 Financial ing 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 ing 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 ing consists 'of monetary information only. Management ing 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 ING Nature

vs. FINANCIAL ING

Fianacial ing

Management

1. Governed by

Company law etc.

Accoutning Needs of managers

2. Basic functions

Transaction

Decision



recording,

Provision

of

Publication 3. s

of Management

external

financial information

statements

Internal

4. Availibility

External Publicly available

Confidential

5. Time focus

Past and present

Present and future

6. Period

Usually one year

As appropriate

7. Main emphasis

Explanation

Planning and control

8. Speed prepartion

of Slow but detailed and Fast but approximate accurate

9. Form of whole of entity presentations

Segmented to control

10. Style and Standardized details

Tailored

Objective, 11.

Criteria

12. Unit

of

13. Nature of data

units to

requirement

and

verifiable summarized

and consistent

Relevant, useful and

Money

understandable

Somewhat technical

Money physical units For

use

ants

by

non-

LESSON - 3 THEORY BASE OF ING - ING STANDARDS

ing is "the process of identifying, measuring and communicating information to permit judgement and decisions by the s of s" -American ing Association. It is absolutely necessary that ing information contained in financial statements are credible and are regarded as reliable by the different groups to be consistent. Preparation of financial statements on uniform and consistent basis improves their comparability and credibility. It has two aspects, namely, The financial statements of an enterprise for different ing years



are based on similar ing procedures and policies so that meaningful comparisons over a period of time can be made 1 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

ing

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 'ing Standards' -to provide a rational structural framework so that credible financial statements of the highest quality can be produced. According to T.P. Ghosh ing standards are defined as under’.

“ing standards are the policy documents issued by the recognised expert ancy body relating to various aspects of measurement, treatment and disclosure of ing transactions and events”

It is clear from the above definition that ing standards provide a

framework for the preparation of the financial statements.

They also draw the

boundaries within which acceptable conduct lies. In the absence of ing standards, many alternatives will exist and will give the ant the| leverage to colour'his ing records the way he likes.

Such 'Creative

ing Practices’ will certainly create financial statements which are unreliable and lower the confidence of in the reported results. Hence the need for a coherent pet of ing standards is imperative. The efficient functioning of the financial system depends upon the confidence that groups have in the fairness and reliability of the financial statements of the businesses ana it is the function of ing standards to create this genera) sense of confidence by providing; a structural framework within which credible financial statements can be produced.

The whole idea of ‘ing

Standards’ is centred around harmonisation in the ing policies and practices followed by businesses. The basic purpose of 'ing Standards' is to standardize the diverse ing practices

followed

for

many

aspects

of ing. The harmonisation of ing policies and practices is needed at national level as well as international level. To tackle the problem at national level, the Institute of Chartered ants of" India issues ing standards (called AS's) formulated by the ing Standards Board (ASB). At international level, International ing Standards Committee (IASC) issues International ing Standards (called lAS's).

The objective of the

IASC in of standard setting is "to work generally for the improvement and harmonisation of regulations, ing standards and procedures relating to the

presentation

of

financial

statements'.

The

Institute

of

Chartered

ants of India is a member of IASC and has a tacit understanding with the IASC that it would adopt the ing standards issued by IASC after due recognition of the conditions and practices prevailing in India. At the international level, IASC has issued 32 international ing standards. At the national level, ICAI has issued 15 ing standards on various issues of ing and a preliminary draft of a proposed ing standard on borrowing costs is being made by the ASB in addition to the revision

contemplated in existing standards on valuation of inventories and ing for construction contracts.

ING STANDARDS (N INDIA The Institute of Chartered ants of India, fully recognising the need cf harmonizing the diverse ing policies and practices established 'ing Standards Board' on 21 st April, 1977 so that ing as a language could develop along the right lines. ing Standard Board's (ASB) main function is to formulate ing standards to be issued under the authority of the council of the institute. ing standards provide rules and criteria of ing measurement. However the rules' criteria are intended lo be used if: a sociai system and hence are never intended lo be rigid as in case of physical sciences.

Constitution of ASB : The consistitution of ASB gives adequate representation to all interested parties and, at present, it consists of of the council and representatives to industry, banks, Company Law Board, Central Board of Direct Taxes and the Comptroller and Auditor General of India, Security Exchange Board of India etc,

Functions of ASB : The main function of ASB is to fomralate ing standards. While formulating ing standards, ASB takes into consideration the applicable laws, customs, usage and business environment. The Institute is the member of International ing Standards Committee (IASC) and has agreed to the objectives of IASC. While formulating standards, it gives due consideration to the International ing Standards (IAS) issued by IASC and tries to integrate them, to the extent possible, in the light of conditions and practices prevailing in India. It also reviews the ing standards at periodical intervals.

FORMULATION OF ING STANDARDS The following points need to be kept in mind while drafting ing standards, namely 

The ing standards issued are in conformity with the provisions of the applicable laws, customs, usage and business environment of our country;



The ing 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 ing standard might arise due to amendments in the law subsequent to the issuance of the ing standard. As clarified in the 'Statements of ing Standards', ing 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 ing standards shall not be applicable. However, "the institute will determine the extenl of disclosure to be made in financial statements and the related auditor's 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 and therefore, need not be treated as adverse comments on the related financial statements"



The ing 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 ing 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 formulating ing standards. However, it needs to be emphasised that the standards are issued under the authority of the council of the institute. The procedure involves the following steps:

a) Firstly, the ASB determines the broad areas in which ing 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 assigned to them.

which take 'up the specific subjects

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 of the institute and public at large. 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 ing principles relating to the standard;



Definitions of the used in the standard;



The manner in which the ing 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 ing standard on the relevant subject is then issued under the authority of the council.

NATURE OF ING STANDARDS

The ing standards issued by the ICAI-are recommendatory in nature in the initial years. During the period a standard is recommendatory, it is expected that the ing practices shall be brought in line with the standard. In other words, the recommendatory period is allowed to smoothen the process of transition so that no enterprise should have difficulty in conforming to the ing standards once they are made mandatory. Once an ing standard is made mandatory, it is applicable to all enterprises whose s are audited by the . During the period an ing standard is recommendatory, tne auditors of companies are required to recommend and persuade their cfients to comply with the requirements of the ing standard even though it is recommendatory in nature. Regarding the mandatory standards, it is the duty of the auditors to ensure that the ing standards are followed in the preparation and presentation of the financial statements. If the mandatory ing standards have not beer, complied with, the auditor is required to make adequate disclosure in his report so that the s of financial statements are aware of the non-compliance on the part of the enterprise. If a member fails to do so, the Chartered ants Act explicitly provides that “a chartered ant in practice will be deemed to be guilty of professional misconduct if

he ails to invite attention to any material departure from the generally accepted procedure of audit applicable to the circumstances”

It is amply clear that standards on their own have no legal backing and hence, are not enforceable on the public at large. Hence the institute depends on is for implementation of ing standards issued by it through their attest function. To make it effective, following steps are needed:



Self-regulation on the part of the business organisation so that I hey adhere to these standards while finalising their s;



Legal backing to the ing 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;



Publicising the use of ing standards and making the : of ing information more informed about their right of getting a more true and fair picture of the results of business based on these ing 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 as to which standard needs to be followed.

A recent development, worthy of

attention, is the establishment of two ing 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

ing,

(ing

Standard

I

'relating

to

disclosure of ing policies and ing Standard II relating to disclosure of prior period and extraordinary items and changes in ing policies).

To conclude, the Institute and its are duty bound to formulate and implement

ing standards

to provide objective

and reliable

ing data that would satisfy the information requirements of the s To achieve this, problem of duality of authority should be tackled and the system of dual ing standards in view of its expertise in the field. To improve their effectiveness, it is also suggested that the standards should be given a legal backing with strong punishment for the erring business organisations. At the same time, to make a genuine case for recognition of ing standards and to prevent abuse of financial statements, more credibility should be provided to the process of standard setting.

ING STANDARDS ISSUED BY THE INSTITUTE AS-1 Disclosure of ing Policies :

The standard defines 'ing Policies' as referring to the specific ing principles and the methods of applying those principles adopted by the enterprise in the preparation and presentation of financial statements. It recommends the disclosure of significant ing policies adopted in the preparation and presentation of financial statements in a manner that should form part of the financial statements. It also recommends that he disclosure should normally be at one place. Any change in the ing policies which has a material effect in the current period or which is reasonably expected to have material effect in later pe\jods should be disclosed. It also emphasises that the disclosure of compliance with fundamental ing assumption of Going Concern, Consistency and Accrual is not needed. However, if they are not followed, the fact must be disclosed.

AS-2 Valuation of Inventories :

The inventories should be normally valued at 'Lower of Cost or Market' where market value means net realizable value. The historical cost of inventory can be ascertained by use of 'FIFO', 'Average Cost', of 'LIFO' formulae. When organization have different items in inventory, each item may be dealt with separately, or similar items may be dealt with as a group.

The historical cost of manufactured inventories may be arrived on the basis of either direct costing or absorption costing. Where absorption costing is used, the fixed costs should be based on the normal level of production. Overheads other than production overheads should be included as part of the inventory' cost only 10 the extent that they clearly relate to putting the inventories in their present location and condition.

The ing policy in respect of inventories should be properly disclosed and any change in it which has a material effect in the current ing period or which is reasonably expected to have material effect in later periods should be disclosed. The amount by which an item in the financial statements is affected by such change should also be disclosed to the extent ascertainabfe. Where such amount is not ascertainable, wholly or in part, the fact should be indicated.

The 'Specific Identification Method', 'Adjusted Selling Price Method', 'Standard Cost Method' and 'Base Stock Method' are to be used in specific circumstances. However, if base stock method is used, the difference between the value at which it is carried and the value by applying the method at which stock in excess of the base stock is valued should be disclosed.

AS-3 Changes in Financial Position :

A statement of changes in financial position should be published along with its published s. Such a statement should be prepared and presented for the period covered by the profit and loss and for the corresponding period. It may be prepare on working capital basis or cash basis. It emphasises that the funds provided from operation and used in the operation be shown separately and the form of statement should be most informative in the circumstances. However, the standard is no longer vaJid as it has been superseded by new standard AS-3 (Revised) ‘Cash Flow Statement’ issued in March, 1997.

AS-3 (Revised) Cash Flow Statement:

The cash flow statement should report cash flows coring the period classified by operating, investing and financing activities. An enterprise should report cash Hows from operating activities using either (a) direct method; or (b) indirect method. The inflow and outflow from the investing and financing activities should be shown separately. Investing and financing transactions that do not require the use of the cash or cash equivalents and should present a reconciliation of the amounts in its cash flow statement with the equivalent items reported in the balance sheet. The enterprise should also disclose the amount of significant cash and cash equivalents balances that are not available for use by it.

AS-4 (Revised) Contingencies and Events Occurring after the Balance Sheet Date : A contingency is a condition or situation, the ultimate outcome of which, gam or loss, will be known or determined only on the occurrence, or nonoccurrence, of one or more uncertain events. A contingent loss should be recognised if (a) it is probable that future events will confirm that ari asset has been impaired or a liability has been incurred on the balance sheet date^ and (b) a reasonable estimate of the amount of the resulting loss can be made. A contingent gain should not be recognised. If either of the two conditions

mentioned above are not met, a disclosure should be made of 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.

Assets and liabilities should be adjusted for events occurring after balance sheet date that provide additional evidence to assist the estimation of the amounts relating to conditions existing at the balance sheet date (for: example, insolvency of a debtor subsequent to finalisation of financial statements) or that indicate that the fundamental ing assumption of going concern is not appropriate. Dividends, proposed (or declared) by the enterprise: after the balance sheet date but before approval of the financial statements, and pertaining to the period covered by financial statement, should be adjusted. Adjustments to assets and liabilities are not appropriate for events occurring after the balance sheet date, if such events do not relate to conditions existing at the balance sheet date (for example, decline in market value of the investment). Disclosure should be made in the report of the approving authority of those events occurring after the balance sheet date that represent material changes and commitments affecting the financial position of the enterprise specifying:



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 and Changes in ing Policies :

The objective of this standard is to prescribe the classification and disclosure of certain items in the statement of profit and loss so that all enterprises prepare and present their financial statements on a uniform basis to improve 'their comparability. It explains that profit or loss of a period comprises of ordinary activities, extraordinary activities and prior period items and all three need to be disclosed separately. It also includes the impact of change in ing estimates and change in ing policies.

Ordinary activities are any activities which are undertaken by an enterprise as part of its business and such related activities in which the enterprise engages in furtherance of, incidental to, or arising from, these activities. Extraordinary items are incomes or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly. Prior period items are'income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of the one or more prior periods. The net profit or loss for the period comprises the following components, each of which should be disclosed 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 of net profit or loss for the current period. An alternative approach is to how such items in the statement of profit and loss after determination of current net profit or loss. The second approach seems better because that will help ascertain the result of current period unaffected by the mistakes of the past, in either case, the objective is to indicate the effect of such items on the current profit or loss.

Change in ing Estimates Vs. Change in ing Policies: A distinction should always be made between change in ing estimates and changes in ing policies. When it is difficult to distinguish between

the change in ing estimate and change in ing policies, it should be regarded as change in ing estimate, with appropriate disclosure in the periods of change, which may be current period only or current period as well as future periods. The effect of change in an ing estimate should be classified as ordinary or extraordinary depending upon whether the original estimate was regarded as ordinary or extraordinary item. However, the revision of estimate, by its nature, cannot be called extraordinary or prior period item. When change in ing estimate/ change in ing policy takes place which has a material effect, its nature and amount should be disclosed. If the effect is not ascertainable, the fact should be disclosed in the financial statement.

AS-6 (Revised) Depreciation ing :

The depreciable amount of an asset comprising of its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated realizable value should be allocated on a systematic basis to each ing period during the useful life of the asset. The historical cost may undergo revision arising as a result of increase or decrease in long term liability on of exchange rate fluctuations, price adjustments, changes in duties or similar factors. The useful life of the asset may itself be subjected to revision, in which case, the unamortised balance of the asset be depreciated over its remaining life. Any addition or extension to an existing asset should be depreciated along with the original asset, unless the extension has a separate identity, in which case it should be depreciated on the basis of an estimate of its own life. Where depreciable asses are disposed of, discarded, demolished or destroyed, the net surplus or deficiency, if material, is disclosed separately. The change of method, if warranted, should be done with retrospective effect from the date of asset coming to use. In case of revaluation of asset, the revalued amount should be amortised over the remaining useful life of the asset. The information to be included in the financial statements should comprise of historical cost or any substituted amount, total depreciation for the period in

respect of each class of asset and related accumulated depreciation. The following information should be disclosed in the financial statements along with disclosure of other ing 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 ing for Construction Contracts :

The standard deals with the problem of allocation of revenues and related costs to the ing periods over the duration of the contract. The long term construction contracts could be fixed price contracts where contractor agrees to a fixed contract price or cost plus contracts where the contractor is reimbursed for allowable or otherwise defined costs, and is also allowed a percentage of these costs or a fixed fees. Both these contracts can be ed by either percentage of completion method or completed contract method. Under percentage of completion method, the amount of revenue recognised is determined with reference to the stage of completion of the contract activity at the end of each ing period. The completed contract method is based on results as determined when the contract is completed or substantially completed.

Profit in the case of fixed price contract should be recognised when the work has progressed to a reasonable extent- say 25 or 30%. While recognising profit under percentage of completion method, the appropriate allowance for future unforeseeable facts should be made on either a specific or percentage basis. A foreseeable loss on entire contract should always be provided for in the financial statements irrespective of the amount of work done and the method of ing followed. Disclosure of changes in ing policy used for construction contracts should be made in the financial statements giving the effect of the change and its amount.

AS-8 ing for Research and Development:

The prescribed research and development costs outlined in para 7 of Hie standard relating to a business should be charged to the revenues of the period in which they are incurred unless the criteria mentioned in para 9 of the standard are met, in which case, the charging of these expenses can be deferred to future ing periods. The research and development costs, once written off, arc never reinstated in s. The deferred research and development cost should be allocated on a systematic basis to future ing periods by reference to either to the sale or use of the product or process or to the time period over which the product or process is expected to be sold or unused. If at any point of time, criteria for deferral as detailed in para 9 are not met, the unamortised balance of research and development expenditure should be charged to the profit and loss . When the criteria for deferral continue to be met but the amount of the deferred research and development costs and other relevant costs exceed the expected filture revenues/ benefits related thereto, such expenses should be charged as an expense immediately. The amount charged to profit and loss should be explicitly disclosed and unamortised research and development costs should be shown in the balance sheet under the head "Miscellaneous Expenditure". ,

AS-9 Revenue Recognition :

The standard mainly deals with the timing of revenue. Revenue is defined as "gross inflow of cash, receivable or other consideration arising in the course of ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. 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 either under completed service method or proportionate completion method. Completed service method is a method of ing which recognises revenue in the statement of profit and loss only when the rendering of services under a contract is completed or substantially completed. Proportionate completion method is a method of ing which recognises revenues in the statement of profit and loss proportionately with the degree of completion of services under a pontract. Revenue arising from interest is recognised on a time proportion basis, royalties on an accrual basis and dividends from investments in shares when the owner's right to receive payment is established.

AS-10 Recounting for Fixed Assets :

Fixed asset is an asset held with the intention of being used for the 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 vaiue of a fixed asset shoulo

be either historical cost or a revalued amount. The cost of a fixed asset should normally comprise of its purchase price and other attributable cost of bringing the asset to its working condition for its intended use. Financing costs relating to deferred credits or to borrowed funds attributable to construction or acquisition of fixed assets for the period up to the completion of construction or acquisition of fixed assets should also be included in the gross book value of the asset to which it relates. When a fixed asset is acquired in exchange or in part exchange for another asset, the cost of the asset required should be recorded

either at fair market value or at the net book value of the asset given up, adjusted for any balancing; payment or receipt of cash or other consideration. Subsequent expenditures related to an item of fixed asset should be added to its book value only if they increase the future benefits from the existing asset beyond its previously assessed standards of performance. Material items retired from active use and held for disposal should be stated at the lower of their net book value and; net 44haracteri value. Losses arising from the disposal of fixed asset carried at cost should be 44haracteri in the profit and loss .

Normally the entire class of asset should be revalued and revaluation should never result in the net book value of the class of asset being greater than the recoverable amount of assets of that class. Gain on revaluation should normally be taken to the owner’s interest in the form of ‘Revaluation Reserve’ Alternatively it could be taken to profit and loss . Loss on revaluation should normally be taken to profit and loss except that such a decrease is related to; an increase which was previously recorded as a credit to the revaluation reserve and which has not been subsequently reversed or 44haracte, it may be charged directly to that . On disposal of a previously revalued item of fixed asset, the difference between net disposal proceeds and the net book value should be charged or credited to the profit and loss statement except that to the extent that such a loss is related to an increase which was previously recorded as a credit to revaluation reserve and which has not been subsequently reversed or 44haracte, it may be charged directly to that . Goodwill should he recorded in the books only when some consideration in money or money’s worth has been paid for it. A proper disclosure of 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) ing for tbc Effects of Changes in Foreign Exchange Rates :

The standard deais with (a) ing for transactions in foreign currencies; and (b) translating the financial statements of foreign branches for inclusion in the financial statements of the enterprise. The standard details the methods to be adopted for converting foreign transactions denominated in foreign currency in the reporting currency defined as currency used in presenting the financial statements of the enterprise. The standard recommends proper disclosure of the exchange differences arising on foreign currency transaction. Disclosure is also encouraged of an enterprise’s foreign currency risk management policy.

AS-12 ing for Government Grants :

Government grants are assistance by government in cash or kind to an enterprise for past or future compliance with certain conditions. Government grants can be 45haracteri in s on the basis of capital approach or Income approach, based on nature of relevant grant. However, the government grant should not be 45haracteri until there is reasonable assurance that (i) the enterprise will comply with the conditions attached to them; and (ii) the grant will be received. A proper disclosure should be made of the ing policy adopted for government grants, including the methods of presentation in the financial statements including the nature and extent of government grant 45haracteri in the financial statements, including grants of non-monetary assets given at a concessional rate or free of cost.

AS-13 ing for Investments :

The standard deals with ing for investment in financial statements of enterprises and related disclosure requirements. An enterprise should disclose current investments and long-term investments distinctly in the financial statements. A current investment is an investment that by its nature readily realizable and is intended to be used for not more than one year from the date on which such investment is made. A long-tern investment is an

investment other than a current investment. The cost of acquisition should include charges such as brokerage, fees and duties. If an investment is acquired by issue of share or other security, the acquisition cost should be fair value of the security issued. IF an investment is acquired in exchange for another asset, the acquisition cost should be the determined cost with reference to the fair value of the asset given up. Investment properties should be treated as longterm investments.

Current investments should be carried in the financial statements at the lower of cost and fair market value determined either on an individual investment basis or by category of investments, but not on an overall (or global) basis. Long-term investments should be carried at their cost, although a provision for diminution in their value, other than temporary, should be made. Any change in the carried value of the investment should be carried to the profit and loss . Profit or loss on disposal of investments should be 46haracteri and shown in the profit and loss . Significant disclosure requirements are also inserted in the standard and include among other things, the disclosure of ing policy for determination of carrying amount of investments, classification of investments, profit and loss on disposal of investments and changes in carrying amounts of these investments, for current and long-term investment separately and aggregate amount of quoted and unquoted investments.

AS-14 ing for Amalgamation :

The standard deals with the ing for amalgamation and the treatment of any resultant goodwill or reserves. Amalgamation is 46haracterized as either in the nature of merger or purchase depending upon five conditions enumerated. Amalgamation in the nature of merger is ed for by ‘Pooling of interest method’ and amalgamation in the nature of purchase is ed by ‘Purchase method’. The consideration for the amalgamation means ihe aggregate of the shares and other securities issued and the payment made in the form of

cash or other assets by the transferee company to the shareholders of the transferor company.

The identity of all the reserves in amalgamation in the nature of merger is preserved. However, in the case of amalgamation in the nature of purchase, only statutory reserves are preserved by giving debit to a new called ‘Amalgamation Adjustment ’. Goodwill only arise in case of ‘Purchase method’. Goodwill arising on amalgamation is amortised over a period not exceeding five years unless a somewhat longer period can be justified. When an amalgamation is effected after the balance sheet date but before the issuance of the financial statements of either party to the amalgamation, disclosure should be made in accordance with AS-4 but the amalgamation should not be incorporated in the financial statements.

AS-15 ing for Retirement Benefits in the Financial Statements of Employers:

The standard deals with the ing of retirement benefits consisting of (a) Provident funds; (b) Superannuation/ pension; (c) Gratuity; (d) Leave encashment benefit on retirement; (e) Post retirement health and welfare schemes; and (f) Other retirement benefits in the financial statements of employers. The contribution of the employer towards the provident fund and other contribution schemes should be charged to the statement of profit and loss for the period. The ing treatment of gratuity and other benefit schemes will depend on the type of arrangement which the employer has chosen to make. Any alterations in the retirement benefit costs should be charged or credited to the statement of profit and loss as they arise in accordance with AS5.

LESSON-4 PRACTICAL BASE OF ING – ORIGIN AND ANALYSIS OF BUSINESS TRANSACTIONS

ing process begins with the origin of business transactions and is followed by analyses of these transactions. After origin and analysis of transactions comes recording, classification and summarization of business transactions culminating in preparation of financial statements,

Origin of Business Transactions

ing deals with business transactions which have already taken place, As financial ing concentrates on monetary transactions of the past it is basically historical in nature. Since it amounts to making recording and analysis of historical information only, it is also known as post-mortem ing. For recording business transactions, it is necessary that these transactions are evidenced by an appropriate document such as cash memo purchase bill, sales bill, cheque book, book, salary slip, etc., Document which provides evide

nce cf the transaction is called the Source Document.

Analysis of Business Transactions

In ing record is made of monetary transactions which are evidenced by a source document and double entry system is applied for recording. According to J.R Batliboi “every business transaction has a two-foid effect and that it affects two s in opposite directions and if a complete record were to be made of such transaction, it would be necessary to debit one and credit another . It is this recording of the two-fold effect of every transaction that has given rise to the term Double Entry System”

To analyze the dual aspect of each transactions and to find out the s to be debited and credited following two approached can be followed. 7. ing Equation Approach 8. Traditional Approach.

9. ing Equation Approach:

Equality of assets on one hand and liabilities and capital on the other hand is called basic ing equation and is written as

ASSETS = LIABILITIES + CAPITAL

expected Where assets refer to resources which are owned by business enterprise and are to benefit future operations, liabilities are debts payable to parties external to business and capital means the amount payable to owners of the business enterprise (also called owner’s equity )

The dual aspect of some business transactions is analyzed as follows: 10.

Introduction of resources by the owner:

Rs. 5,00,000 cash and furniture worth Rs. 20, 000 invested by the owner in the business. Introduction of Rs.5,00,000 cash increases business cash by Rs. 5,00,000 and it creates analysis obligation to pay Rs. 5,00,000 to the owner which is recorded as capital. In of ing equation its effect is as follows:

ASSETS = LIABILITIES + CAPITAL Cash (Rs.5,00,000) =__ + capital (Rs.5,00,000) Further, if furniture worth Rs.20,000

is provided by the

ing equation appears as under: Cash

+

Furniture

= Capital

proprietor, the

(Rs.5,00,000)

11.

(Rs.20,000)

-

+(5,00,000

Rs. 5,20,000

20,000 ) Rs.5,20,000

+

Purchase of assets for cash and / or credit :

Purchased

building

for

Rs,2,00,000

and

paid

Rs.

10,000

cash

immediately. It increases business assets or resources by Rs, 1,90,000 as cash decreases by Rs. 10,000 and building increases by Rs.2,00,000. It also creates an obligation to pay Rs. 1,90,000 in future. The ing equation now appears as follows; Cash + (Rs.5,00,000

Furniture

=

(Rs.20,000)

Creditors for building + Capital (Rs.1,90,000)

(Rs.5,20,000) –

Rs. 10,000) + Building (Rs. 2,00,000) -7,10,000

12.

= Rs.7,10,000

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

=

(Rs.4,90,000 13. + Furniture

Creditors for building + (Rs.1,90,000)

(Rs. 3,00,000) + Building

(Rs. 20,000) (Rs. 2,00,000)

-7,10,000

= Rs.7,10,000

Capital

(Rs.5,20,000)

14.

Payment of Rs. 1,90,000 by cheque to creditors for building :

It decreases bank balance by Rs.1,90,000 and creditors for building by Rs. 1,90,000 as shown below:

Cash + (Rs.1,90,000

Bank

=

(Rs. 3,00,000)

(Rs.1,90,000)

- Rs. 1,90,000) + Furniture

Creditors for building +

Capital

(Rs.5,20,000)

- Rs. 1,90,000)

+ Building

(Rs. 20,000) (Rs. 2,00,000)

Rs. 5,20,000

15.

= Rs. 5,20,000

Purchase of goods for Cash/Credit:

Business enterprise purchase goods worth Rs. 50,000 for cash and Rs.20,000 on credit.

It increases stock of goods by Rs. 70,000, decreases cash by Rs.50,000 and creates analysis obligation to pay. Rs.20,000 to the supplier of goods. After this ing equation appears as follows:

Cash

+ Bank

+ Stock of goods

(Rs.1,90,000 (Rs. 1,10,000) 16.

(Rs.70,000)

= Creditors + Capital (Rs.20,000)

(Rs.5,20,000)

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 same time, it decreases capital by Rs.60,000 as shown below:

Cash (Rs. 1,40,000

+ Bank (Rs. 1,10,000)

- 50,000) Furniture (Rs. 20,000)

+ Stock of goods = Creditors (Rs.70,000 -Rs,20,000)

(Rs.20,000)

+ Capital (Rs.5,20,000 - Rs.60,000) +

+ Building (Rs.2,00,000)

Rs. 4,80,000

= Rs.4,80,000

if ing equation after above transactions is to be presented in the form of balance sheet, it will appear as follows :

Balance Sheet Liabilities Capital Creditors

Amount Assets 4,65,000 Cash 20,000 Bank Stock Furniture Building 4,85,000

amount 1,25,000 1,10,000 30,000 20,000 2,00,000 4,85,000

Classification of s and rules for Recording Transactions : For recording business transaction all s are divided into three categories,

1)

Assets

2)

Liability

3)

Capital

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 in liabilities and capital are debited.

Transactio n

Assets

=

No. Creditor Furniture Cash +

Bank +

Stock+

+

s for Building

=

Building

1.

5,00,00

-

-

20,000

-

=

+ -

2.

0 5,00,00

-

-

20,000

-

=

0

-

-

-

+2,00,00

- 10,000 4,90,00

-

-

20,000

0 2,00,000

-

-

-

3.

0

+3,00,00

-

0

=

Trade Creditor

Capital

s+ -

5,20,000

-

-

5,20,000

+

-

-

1,90,000 1,90,000

-

5,20,000

-

-

-

1,90,000

-

5,20,000

3,00,00

4.

5.

0 1,90,00

3,00,000

-

20,000

20,000

0

-1,90,000

-

-

-

-

-

-

1,90,000 -

-

5,20,000

-

+ 20,000

-

-

20,000

5,20,000

-

-

- 60,000

-

20,000

4,60,000

-

-

+ 50,000

-

20,000

4,65,000

1,90,00 0

6.

- 50,000 1,40,00 0

7.

- 40,000 1,00,00 0

8.

+ 25,000 1,25,00

1,10,000 -

1,10,000 -

1,10,000 -

1,10,000

-

20,000

20,000

+70,000

-

-

70,000

20,000

20,000

-20,000

-

-

50,000

20,000

20,000

-20,000

-

-

30,000

20,000

20,000

0

Analysis of Changes in Capital

=

=

=

=

=

Increases and decreases in capital can take place due to introduction of capital, withdrawal of cash, goods and other assets for personal use ( called drawings ), revenue and income earned ( resulting in increase in capital) and expenses incurred ( resulting in decrease in capital). Recording the effect of all these transactions directly in the capital will make it unwieldy. In actual practice, net effect of revenue and expense transaction during an ing period as shown by profit and loss is transferred to capital . Similarly cumulative effect of drawings during an ing period is recorded in the capital at the end of the ing period. For this purpose, temporary capital s are opened. These are called temporary s because these s start with zero balance in the beginning of the ing period and at the end of the ing period, these are closed and their net effect it transferred to capital . These include:

a) Revenue (mcluding other incomes and gains) b) Expense (mcludmg losses) c) Drawing .

As these s record changes which affect capital only, no separate rule is required for recording changes in temporary s. For example: i.

Revenue increases capital and decrease in capital is credited, therefore revenue earned is credited to revenue .

ii.

Expense decreases capital and decrease in capital is debited, therefore, expenses are debited to expense .

iii.

Drawings decrease capital and decrease in 'capital is debited, therefore, the value of assets withdrawn for personal use is debited to drawings .

Thus capital at the end of the period may be calculated as follows:

Closing capital = Opening capital + Additional capital - Drawings +Revenue and Gains - Expenses

To sum up, under ing equation approach all s are divided into three, categories namely, assets, liabilities and capital. Capital is further sub-divided into permanent and temporary For recording changes in assets Rule NO. 1 is applied and to record increases and decreases in liabilities and capital Rule N0.2 is followed.

Illustration: Prepare a statement showing analysis of transactions, title and nature of affected s, relevant rule of recording and the to be debited and credited on the basis of transactions of Mr. X for the month of December,1998. Transactions for the month of December, 1998, were as follows 1. Received cash form debtors 2. Deposited cash in bank 3. Payment to creditors by

Rs. 20,000 4,000 4,000

cheque 4. Machine purchased for 5. Traveling Expenses

10,000 5,000

Statement Showing Analysis of Transactions Transactions

Analysis

Received cash Increase

Title and Nature of Cash –

Rule

Entry

Debit

from debtors cash

Asset

increase in

Rs. 20,000

Decrease

Debtor–

assets

Credit

the amount

Asset

Credit

Debtors

Debit cash

Deposited

due from

decrease in

debtors Increase

Bank –

asset Debit

asset

increase in

cash in bank bank Rs. 4000

balance Decreases

asset Cash - asset

decrease

hand

increase asset Debit

Debit

Creditors –

decrease in

creditors

Liability

liability

decreases

Bank –

Credit

bank

Asset

decrease in

to Decreases

creditors

by amount

cheque

payable to

Rs.4,000

creditors

balance

Credit Bank

asset

Increases

Machinery –

Debit

Debit

machinery

asset

increase in

machinery

purchased Rs.10,000

Credit cash

Credit

cash in

Payment

Machinery

Debit bank

asset Decreases

Cash - asset

Credit cash

cash in

Credit

hand

decrease in asset

Traveling

Expenses

Traveling

incurred on

expense-

Debit Debit

traveling

expenses

travel

Temporary

increase in

Rs.5000

increases

capital

expenses

cash in

(Expense)

hand

Cash - Asset Credit

decreases

Expenses

Credit cash

decrease in asset

Analysis of Valuation of Assets and Liabilities Financial ing is basically historical in nature and business transactions are ed at their value on the date of the transactions. As a result asset and liabilities also appear at historical value. To portray true and fair fianancial position in balance sheet some of the assets and liabilities need revaluation to show these items at realistic, and not historical, level in the balance sheet. To achieve this objective without changing asset and liabilities balances in ing records, valuation records, valuation s are opened to for increase or decrease in historical value of these items.

Rules relating to analyze to assets and liabilities can be extended to accommodate analysis of valuation s as follows:

1. Valuation of Assets : Various valuation s generally opened to for decreae in the value of assets are ‘provision for discount on debtors ’, ‘provision for doubtful debts ’, ‘stock reserve ’, ‘investment fluctuation reserve , provision for (or accumulated) depreciation ‘and so on. The s are opened to bring and report assets at their reduced level.

As decrease in assets are credited, therefore valuation s resulting in decrease in assets are credited.

For example, assets machine of Rs. 2,00,000 is depreciated by Rs. 20,000 at the end of ing year 1998, the depreciation reduces (or decreases) the value of asset and it is calculated to the assets with the help of the following entry.

Debit Depreciation (Being and expenses and hence debited) Credit Machinery .

Alternatively, with the help of a valuation called provision for depreciation , decrease in asset can be recorded using the following entry:

Debit Depreciation Credit provision for depreciation (or accumulated depreciation)

The provision for depreciation is shown as assets deduction from the machinery (because it has assets credit balance and machinery has a debit balance) and the same impact is achieved.

Conversely, if revaluation result in increase in value of assets, the f valuation s are debited.

Thus rule is as follows:

Credit valuation if asset is to be decreased. Debit valuation if asset is to be increased

2. Valuation of Liabilities: Like provision for discount on debtors, Provision for discount on creditors is created. As per conservation principle, it should not be provided because anticipated gains are not taken into . But it is analysts accepted ing practice to make provision for discount on creditors. It results in decrease in liabilities. As decrease in liabilities are debited, valuation s recording decrease in liabilities are debited. Conversely, valuation recording in increase in liabilities are credited. This rule is as follows:

Debit valuation if liability is to be decreased. Credit valuation if liability is to be increased.

Second aspect of valuation s generally appears in temporary capital s and ultimately affects capital .

Thus, an entry on debit side of an means either Increase in asset or Decrease in liabilities or Decrease in capital or Increase in Drawings or Increase in expense

and analysis entry on credit side of an indicates either Increase in liabilities or Increase in capital or Decrease in asset or

Increase in revenue

Traditional Approach Both ing equation approach and traditional approach record dual aspect of business transactions. But in ing literature, generally, traditional approach is referred to as double entry system. For analysis and recording of transactions, traditionally all ledger s are divided as follows.

Personal s: s recording transactions with a person or group of persons are called personal s. These s are necessary, in particular, to record credit transactions. Personal s are of following types.

1. Natural person(s)

s are s of individual living beings and include s ;of individuals such as Ramesh capital . Ram , Neha and so on.

2. Artificial or legal person(s) s include s of legal entities such as Reliance Industries Limited , Delhi Corporation , Goodwill Co-operative society , Punjab National Bank and so on.

3. Group / representative personal : group personal s are s of natural and legal persons grouped together such as debtors , creditors , share capital etc. commission outstanding , salaries outstanding etc., represent the person to whom commission or salary is payable and are called representative personal s. s which are not personal are termed as impersonal s and are divided into real and nominal s.

Real s: Real s relate to properties of a business enterprise which can be tangible or intangible.

1. Tangible real s:

s of properties having physical existence like cash, building, stock of goods, furniture etc., are called tangible real s.

2. Intangible real s: Include of things which cannot be physically felt or touched but are capable or monetary measurement such as s of goodwill, patents rights, trade-marks rights, copy rights etc.,

Nominal s: s relating to income, revenue, gain, expenses and losses are termed as nominal s. Example of nominal s are salaries, rent, commission, discount allowed, rent received, sales interest received etc. For recording changes in personal, real and 'nominal s, following rules are followed.

Rule No.I - for personal s. Debit the receiver and credit the giver Rule No.II - for real s Debit what comes in and credit what goes out. Rule No.Ill - for nominal s Debit all expenses and losses and credit all revenue, gains and incomes.

Dual aspect of some business transactions is analyzed by applying traditional rules as follows.

Transactions

Analysis

Title and

Rule

Entry

Nature of Introduction

Business

Cash-Real

Debit what Debit cash

of

cash

by gets cash Capital

owners

owner

cash

the giver Bank

deposited bank

comes in.

is personal

Bank-Personal

in receives

Credit

the Credit

giver Debit

Capital the Debit bank

receiver

cash Business

Cash – Real

Credit what Credit cash

gives

goes out

Building

cash Building

purchased

comes in

Building – Real

Debit what Debit comes in

Building

from Mr. X on X is the X – Personal

Credit

credit Purchase

giver Credit X Debit what Debit Goods

goods cash

giver of Goods for are

comes

received Cash

Payment

Goods – Real

Cash – Real

in

in

Credit what Credit cash goes out

paid of Service of Salary

salary to an the employee

the

Nominal

– Debit

all Debit salary

expenses

employee utilized

Credit cash

Business

Credit what

pays cash Cash – Real

goes out

for service

utilized of Building

Rent building

due is

but not paid

Rent – Nominal Debit

used Rent

by

outstanding

business

personal

rent

all Debit

expenses – Credit

Credit

Rent rent

the outstanding

giver

for (representative)

the period is payable Note: Rent payable or outstanding is a personal 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.

2. Complete record of business transactions: It maintains complete record of a business transaction. It records both debit and credit aspect with explanation for the transactions.

3. Arithmetical accuracy of records: Under double entry system arithmetical accuracy of records can be checked by preparing a trial balance. However, some errors cannot be deducted by preparing assets trial balance. ,

4. Ascertainment of profit of loss: Profit or loss due to operation of business can be known by preparing profit and loss .

5. Information about financial position of the business enterprise: It can be obtained by preparing balance sheet .at a point of time.

6. Lesser possibility of fraud: Possibility of frauds and misappropriation is minimized as complete information is recorded under this system.

7. Helps s of ing information: Double entry system is most scientific and extensively used system of book-keeping all over the world. This system provides systematic and reliable information, it meets the needs the s of ing information, and assist them in sound decision making.

Analysis of Purchases and Sales of Goods Following transactions relating to sale and purchase of goods need careful analysis. 1. Purchases and sales,

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 ing vocabulary, purchases and sales refer to purchase and sale of items in which the business is dealing in the normal course of business. For example, purchase of car by assets car dealer for resale is purchase of goods but purchase of car by a manufacturing concern for official use is recorded as an asset. Purchases includes items acquired for resale, and not for utilization during business operations.

Purchase of goods increases goods held for resale and sale of goods decreases goods. Goods in hand are called Stock or Inventory. Suppose goods costing Rs.5,000 are purchased and goods costing Rs.4,000 are sold for Rs.6,500. theoretically effect of these transactions can be analyzed as follows:

Goods purchased increases stock (Asset /Real ) by Rs.5,000 and decreases cash (Asset / Real ) Rs.5,000. Therefore, the entry is as follows: Debit stock Credit stock

Rs. 5,000 5,000

At the time of sale of goods costing Rs.4,000 for Rs.6,500 cash (Asset / Real ) increases by Rs.6,500 stock (Asset / Real ) decreases by Rs.4,000 and profit on sale ( Gain / Temporary capital ) increases by Rs.2,500

Therefore, the entry is as follows. Debit cash

Rs. 6,500

Credit stock Credit profit on sale

4,000 2,500

Theoretically, it is possible to find out the stock in hand after each purchase transaction and to calculate stock of goods and profit ( or loss ) on sale of goods at the time of sale and record this in ing records.

But it is impracticable or not feasible to record Sale and purchase transactions in this manner. Purchase of goods are recorded in purchase . Sales are recorded in sales and no attempt is made to calculate profit (or loss) on sale at the time of sale. At the time of cash purchase of goods Debit purchases (Asset / Real ) Credit cash (Asset / Real )

Rs. 5,000 5,000

At the time of cash sale of goods: Debit cash (Asset J Real ) Credit sales (Revenue / Temporary

6,500

Capital (Revenue))

6,500

At the end of the ing period: Cost of goods remaining unsold is determined on the basis of physical stock-taking. Goods in hand are listed and generally prices at its historical cost. In this case physical stock taking will reveal 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 in hand at the end of the in g^ period is recorded as follows. Real

Rs. 1,000

) Credit purchases (Asset / Real )

1,000

Debit

closing

stock

(Asset

/

In case of purchases and opening stock are transferred ni trading and to record the amount of closing stock following procedure is followed,

Debit closing stock Credit Trading

The gross profit along with other incomes is compared with indirect expenses to find out net profit ( or loss) during an ing period. Then net profit ( or loss) is transferred to capital Assuming there 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 to capital is as follows: Rs. Debit

profit

and

loss

(nominal 2,500

) Credit capital (capital )

2,500

2. Analysis of Commission, Rebate and Discount:,

Commission is the amount payable to analysis agent, broker, employee etc., for services rendered by him in transacting the business. It is generally calculated as a percentage of the value of the business transacted.

Rebate is a reduction granted on the amount chargeable for goods sold and services rendered. It is given under specified conditions such as rebate in airfare to senior citizens, rebate in rail fares to the handicapped persons, rebate to the senior citizens under the Income Tax Activities etc..

Discount is a reduction from a states amount such as discount allowed to debtors to encourage prompt payment, issue of securities ata price below their nominal value to attract subscribers, amount charged by assets bank

at the time of discounting of a bill of exchange for discounting future cash flow to its present value etc.,

Suppose a dealer in Vimal Fabrics purchases cloth from Reliance Industries Limited at assets list price of Rs.300 per metre less 35% discount Company allows additional discount @5% of list price if payment is made immediately. Now the cost of purchases of M/Statements, Vimal Fabrics and sales revenue of M/Statements Reliaance Indusries Limites for ing purposes is Rs.195 per metre (i.e. Rs.300 - 35 % of Rs. 300). If M/Statements Vimal Fabrics makes cash payment, the entry is Book of M/Statements Reliance Industries Ltd Rs. Debit Cash 180 (Real A/C) Debit 15 (Expenses Discount

Book of M/S Vimal Fabrics

Debit purchases Credit cash

Rs. 195 (Revenue A/C) 180

Credit Discount

15

A/C)

Allowed Credit sales

195 (Revenue A/C)

Received

3. Analysis of Sales Tax:

From purchaser's point of view sales tax forms part of the cost of purchases. But from seller's point of view, sales tax charged shows-the-amount collected on behalf of and payable to the sales Tax Department of the Government. It is recorded in a separate named ‘Sales Tax payable ’, Suppose an item is sold for Rs.1,100 including sales tex Rs.100. the entry is as follows

Books of Seller

Books of Purchaser

Debit Cash 1,100 (Real A/C) Debit Purchaser Credit Sales 1,100 (Revenue A/C) Credit Cash Credit Sales tax payable 100

1,100 (Real A/C) 1,100 (Real A/C)

(Represtative personal A/C)

4. Analysis of cheques issued and cheques received: In case of payments made by issue of cheque, it is recorded in bank straightway. But in case of cheques received, it is recorded in bank only when the cheque is deposited in bank on the same day. If the cheque received is not deposited on the same day, it is treated as cash on the day of receipt of cheque and when it is deposited 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 is deposited in bank on 31.1.1999 itself, the entry on 31.1.1999 is as follows

Debit bank Credit P

Rs. 5,000 (Personal ) 5,000 (Personal )

But if cheque is deposited on, say 5.2,1999, the entries are as follows: On 31.1.1999 Debit bank Credit P

(Real ) ()

On 5.2.1999 Debit bank Credit cash

(Personal ) (Real )

Above mentioned traditional approach for cheques received is followed when: 1. Cheques received are currently due. Post - dated cheques should not be recorded in cash book.

2. Cheques received are not crossed ' Payee '. Crossed cheques are recorded in bank column directly.

A better way of recording cheques received is to record these as ' cheques in Hand', and to transfer it to bank at the time cheque is deposited in bank.

5. Bad debts: Bad debts refer to the amount of debt that cannot be recovered form the credit customers. At the time when business enterprise becomes definite about the non-recovery of assets certain sum from debts, the amount receivable is reduced by crediting debtors . As the amount non-recoverable is a loss, it is debited to a new , called bad debts and, at the end of the ing period, it is transferred to profit and loss . Thus, entry for recording bad debts is as under. Debit Bad debts (Nominal / Temporary Capital A/C) Credit Debtors(Group personal / Asset A/C)

LESSON - 5 FINANCIAL STATEMENTS OF PROFIT-MAKING ENTITIES MANUFACTURING-CUM-TRADING ORGANISATIONS

The basic operation of a trading organisation involves purchase of, finished goods and their subsequent sale to final customers without any,, substantial modification. At any point of time, a trader has to manage only one, kind of inventory, namely that of the 'Finished Goods' and it is adjusted.in? Trading . In

contrast, a

Manufacture-cum-Trader's

basic

operation

involves

purchase of raw material and its subsequent conversion into finished product; followed by their trading. At any point of time, he has to manage three kinds of inventories, namely, Unfinished Goods'

those

of

'Raw

(popularly called

Materials’ 'Finished

Work-in-process).

Goods', and

He like a trader^'

ascertains his gross results of operation with the help of following equation:

Gross Profit = Net Sales - Cost of Goods Sold

where Cost of Goods Sold = Opening Stock of Finished Goods + Cost of Finished Goods manufactured during the period - Closing Stock of Finished. Goods + Direct Expenses related with Trading.

Note the contrast in the determination of the Gross Profit of a Manufacturer with that of a Trader. The new aspect is the 'Cost of Finished Goods manufactured during the year as compared to 'Purchase (less returns) of Finished Goods during the period' of a trading organisation. The cost of finished goods manufactured during a periods is computed is a new called 'Manufacturing ' which precedes the trading and profit and loss

of manufacturer-cum-trader. In fact the "Income statement of a manufacturercum-trader is made in three stages and is called 'Manufacturing, Trading and Profit and Loss /recount for the period ending . . .*. To prepare the manufacturing , a manufacturer divides his expenditures in three parts, namely, Material cost, Labour Cost and Other costs. These three categories are further subdivided in two more categories, namely, 'Direct and Indirect'.

The 'Direct Costs' are those which do not lose their existence in the final product. Indirect costs are those which are not direct costs. Hence, for the manufacture of furniture, cost in incurred on wood is a 'Direct Material Cost' whereas cost incurred on nails and fevicol used is a 'indirect Material cost'. The reason is that whereas wood has not lost its existence in the final furniture made, nails and fevicol have lost it. Similarly, the cost paid to person who is actually making the furniture (also called carpenter) is called 'Direct labour Cost' whereas cost paid to a person who is supervising many carpenters Is an example of Indirect Labour Cost'. '

The 'Indirect Costs' comprising of indirect material costs, indirect labour costs and indirect other costs are collectively called 'Overheads'. Overheads are further

subdivided

in

three

categories

namely,

Factory;

Office

and

istration and Selling and Distribution. 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 & istration Overheads; (f) Selling & Distribution Overheads;

The cost of manufactured goods will include the first four components of the cost of a manufacturer and the last two aspects are shown in the profit and loss . The cost is computed in statement form" as below:

Computation of cost of finished goods manufactured during the period. Direct Material consumed* + Direct Labour + Direct Other Costs Prime Cost + factory Overhead (net of Scrap value realised**) Gross Works (Manufacturing) Cost + Opening Stock of Work-in-Process _ Closing Stock of Work-in-Process Cost of goods manufactured

Opening stock of Raw Material + Purchase of Raw Material during the. period + Closing stock of Raw Material + Freight inward + Duties+ Subsidies + Duty Drawbacks - Return Outward. ** Scrap is the incidental residue arisin; from a process of manufacture having very low sales value. This is shown as a deduction from the factory overheads. Alternatively, it can be shown as a deduction from the total works (manufacturing) cost. ; The information, when contained in the form, appears as below:

Dr. Manufacturing Cr. To Opening Stock – Raw xxx By Scrap Material To Purchaser of Raw By Rebates Material xxx By Purchases returns To Freight Inward xxx By Subsidies To Duties and Taxes xxx By Duty Draw Back To Fatory Overheads xxx By Closing stock-Raw Material To Opening Stock– Work xxx By Closing stock in progress Work in process By Cost manufactured

xxx xxx xxx xxx xxx xxx

xxx xxx

Goods transferred to trading xxx

xxx

Note that stocks of raw material and work-in-process have been adjusted in the manufacturing whereas the stock of finished goods is adjusted in the trading . Factory overheads include indirect material, indirect labour and other indirect costs incurred in the factory. Hence, expenses like depreciation of plant, repairs of plant, factory lighting, factory telephone expenses are shown in the manufacturing instead of profit and loss But the depreciation of office furniture (office& istration overheads) and depreciation of delivery vans (selling & distribution overheads) are shown in the profit and loss .

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 is responsible for the overall results of the business in their own small measures. These small parts arc called 'Responsibility Centres' of the business and are categorised as (a) Expense Centres (b) Revenue Centres (c) Profit Centres and (d) Investment Centres. These centers, being headed by responsible managers who are subject to internal evaluation by their seniors at regular intervals, have a strong case for projecting their division / part of business as a profit-making division. Hence often the goods are transferred by the manufacturing department to the trading department at a transfer price which is made up of its manufacturing cost + mark up or profit In other words, the manufacturing department is essentially viewed as a 'Profit centre'. The transfer of goods internally at a profit leads to the profit being recognised in the manufacturing which is transferred to the profit and loss 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 the ultimate customer by the trading division. Hence if finished goods remain unsold at the end of the ing period it leads to valuation of the finished goods at a price which is more than the cost of these goods to the business as a whole. The excess represents the 'Unrealised profit' contained in the value of the stock. This valuation of inventory violates the principle of 'Lower of cost or market value' as inventory value advocated by AS-2 on valuation of inventories. It also violates 'Conservatism' principle by recognising a profit which is not realised (anticipated gains) by transferring goods from one of business department to another department.

The anomaly is removed by creating a stock reserve for the unrealized profit contained in the closing stock from the profit and loss with 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 in closing f stock. The stock reserve is shown as a deduction from the value of;| closing stock in the balance sheet and hence the closing stock is properly valued at its cost to the business as a whole. Next year, this becomes the opening stock and is transferred to the trading at the transfer value. The stock reserve (on opening stock of finished goods) is shown on the credit side of the profit loss of the next year.

VALUATION OF INVENTORIES IN A MANUFACTURING DEPARTMENT The value of inventory is computed by adding cost of purchase, cost off conversion, and other cost incurred in the normal course of business in bringing; the inventories up to their present location and condition. However, as

per AS-2, the inventory is valued at lower of cost or market price characterised by the net realizable value.

The historical cost of inventory is normally

determined by using First in First out (FIFO), Weighted Average or Last in First out (LIFO) formulae as per recommendation of AS-2. The value of raw material should be based on cost of purchase and other cost incurred in the normal course of business in bringing the inventories up to their present location and condition. The value of finished goods inventory should be based on cost of manufacture which includes besides direct material, direct labour and other direct costs, the fair proportion of factory overheads. The WIP is commonly valued at factory cost. Unit is used. According

However, while valuing it, the concepts of Equivalent to

institute

of Cost

and

Management

ants, London, 'Equivalent units are a notional- quantity of completed units substituted for an actual quantity of incomplete physical units in progress when the aggregate work content of the incomplete units is deemed to be equivalent to that of substituted quantity .......'.

Hence by using the concept of

equivalent units, a 50% complete work in process of 10,000 units is treated as 5,000 completed units and then the overall cost can be allocated amongst the completed units as well as incomplete units, the complete units being taken as 100% complete.

Illustration 1:

From the following particulars, prepare the manufacturing

of A with units column:

Opening Stock - Raw Material Purchase of Raw Material Closing Stock Freight – Inward Freight – Outward Direct Wages Indirect Wages Factory Office Other Factory Oveheads Opening Stock – Work in Purchase (40% complete)

Unit 1,000 10,000 500

1,500

Rs. 10,000 1,10,000 ? 10,000 15,000 85,000 40,000 50,000 30,000 15,000

Closing Stock – Work in Process (30% complete)

3,000

?

Dr. Particulars

To Purchases Raw Matertial To Freight Inward

To Direct Wages To Factory Overheads (2) To Opening Stock - WIP

Manufacturing Unit Amount Particulars 1,000 10,000 By Closing Stock Raw Material By Closing Stock 10,000 1,10,000 - WIP (3) 10,000 By Trading A/c [cost of finished goods transferred to trading (3) (b.f.)] 85,000

1,500

Unit

Cr. Amount

500 3,000

6,000 27,000

9,000

2,67,000

12,500

3,00,000

70,000 15,000

12,500 3,00,000 Working Notes:

1. Calculation of closing stock of raw material (based on FIFO)

Cost of Purchase + Freight (Inward)

Average pncs of Purchase made during the year =

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 Other Factory overheads

= 40,000 = 30,000. 70,000

3.

Calculation of closing stock of work in process and finished goods

transferred to trading department.

Units manufactured during the year Opening Stock of work in process Goods started and finished during the year Closing Stock of work in process Total

Units

% of completion

Equivalent units

during the year 1,500

60 %

900

7,500

100 %

7,500

3,000

30 %

900 9,300

Cost incurred during the year Raw Material Consumed Direct Labour Factory overheads

= = =

1,24,000*** 85,000 70,000

Hence, average cost of equivalent

=

2,79,000/9,300

Value of closing stock of work in

=

Rs. 27,000

process Value of finished goods

=

[Opening stock of WIP + Cost of

units

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 and hence % completed during the year was remaining 60%. ** Total finished goods transferred during the year is 9,000. Since 1,500 units are from the opening stock of WIP, the remaining (7,500 units) must be those which were started and finished during the year on 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.

LESSON - 6 FINANCIAL STATEMENTS OF NON-PROFIT-MAKING ENTITIES

On the other hand, primary objective of a non-profit organisation is to meet some socially desirable goal or to render services to its .

Non-profit organisations include hospitals, educational institutions, clubs, political associations, religious institutions, charitable societies etc. These organisations survive on donations, grants, subscription from , etc. Sometimes trading activities, such as hospital canteen, club restaurant health club, chemist shop, barshop etc. also take place in such institutions to provide certain facilities to or public in general. Surplus or profijt from such incidental trading activities is used to fulfil the objectives for which the organisation was established.

A person familiar with preparation of financial statements of profitmaking

organisations

should

have

no

difficulty

in

preparing

financial

statements of non-profit organisations for clear and effective communication, with their s. This is so because the set of rules or principles 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 because their primary objective is not to earn profit but to serve its or society in general. However, these organisations compare incomes and expenses to check whether the organisation have sufficient resources to carry out its objectives. To achieve this 'Income and Expenditure * is prepared by: non-profit organisations and is accompanied by a balance sheet tc show the financial position of the organisation.

INCOME AND EXPENDITURE Income and expenditure is like profit and loss of profit-making organisations. Non-profit organisations follow the same rules or principles for preparing income and expenditure which are followed by commercial organisations for preparing profit and loss . Following points should be noted:

a)

It is a nominal . It records all expenses and losses on debit side and all incomes and gains on credit side of the . 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 include expenditure' of revenue nature. Similarly, the incomes credited to income and expenditure are also of revenue nature. Items of capital nature are, not included in income and expenditure but the portion of capital \ expenditure which expires during the year is charged to income and expenditure 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 .

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 to capital 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 loss of' commercial organisations and income and expenditure of non-profit. organisations are same, but there are some items which are peculiar to nonprofit organisations. Items peculiar to non-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 of commercial organisations.

b)

Annual Subscription : Subscription received from is a revenue item and credited to income and expenditure . 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 . Other grants such as building grant, library grant etc., are treated as capital receipt and transferred to a fund . Besides Government's 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-hip Fees: Fees received for life hip is a capita] receipt, as it is of non-recurring nature. It is directly added to capital fund or general fund.

e)

Entrance Fees : Fees paid by new at the time of ing the organisation is called entrance fees. Since, the fees is paid only once by , 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 .

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 .

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.

j)

Subscription for Periodicals : Subscription for newspapers, magazines etc. is treated as income and credited to income and expenditure .

k)

Sale of Old Periodicals : Sale of old newspapers, magazines etc. is treated as income and credited to income and expenditure .

l)

Sale of Assets : Sale price of old asset is a capital receipt and not recorded in income and expenditure . However, profit or loss on sale of asset is transferred to income and expenditure . 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 . But if expenses arc incurred on certain items for which a fund exists, then expenses are not debited to income and expenditure but deducted from specific fund . Similarly,

income from

investment of specific fund is added directly to fund is added directly to fund and not credited to income and expenditure 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 Add

income

10,000 from

5,000

matches

15,000

Less Mtch Expenses

12,000 3,000

However, if after adjustment of income and expenses related to a specific fund, fund balance is negative, it is transferred to debit side of income and expenditure

n)

Outstanding expenses & prepaid expenses : To recapitulate, the expenses of current year are to be taken on accrual basis while making income and expenditure . Hence, the payment on 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 s, namely:-

for outstanding expenses. Expenses A/c

Dr.

To Outstanding Expenses A/c For prepaid expenses Prepaid Expenses A/c Dr. To Expense A/c

Outstanding expenses is shown in the balance sheet on liability side and prepaid expenses on the asset side. Both s are transferred to their respective expense s of the next 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 income and expenditure The entries ed are:

For income outstanding Income Outstanding A/c

Dr.

To Income A/c For income received in advance Income A/c

Dr.

To Income Received in Advance A/c

Income outstanding is shown in the balance sheet on the asset side and income received in advance on the liability side of the balance sheet. Both

s are transferred to their respective income s of the next year to find out its amount correctly.

p)

Life

hip

fund

:

Sometimes,

member

of a

non

organisation pay their hip fees at die time of ission 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 hip 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 for the year ending December 31,1998 and the Balance Sheet as at that date.

Trial Balance as at Decembr 31, 1998

Building Fruniture Library Books 16% Investmetns (1-198) Salaries

Stationery

Amount (Dr.) 2,50,000 40,000 60,000 2,00,000

ission Fees Tution Fees Rent of Hall Creditors for Books

Supplied 2,00,000 Miscllanoues Receipts 15,000 Annual Government

General Expenses

Grant 8,000 Donations Received

Annual Sports Expense

for library books 6,000 Capital Fund

Amount (Cr.) 5,000 2,00,000 4,000 6,000

12,000

1,40,000

25,000

4,00,000

Cash Bank

1,000 20,000 Interest on

8,000

Investments 8,00,000

8,00,000

Additional 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%.

Dr. Income and Expenditure for the year ending December 31, 1998 Cr. To Salaries 2,00,000 By Tution Fees 2,00,000 Add 12,000 2,12,000 Add 10,000 2,10,000 Outstanding To Stationery

Outstanding 15,000 By Annual

1,40,000

Goverenment Grant To

Annual

6,000

Sports Expenses To General

8,000 By

Expenses To Depreciation on Furniture On 10,000 (for

5,000

Fees By Rent of Hall

500

4,000

By

½ year)

12,000

Miscellanoues

On 30,000 (for 1

3,000

Receipts 3,500 By Interest on

year) To Deprecitation

12,500

on Building To Depreciation

12,000 Add

on

ission

Investment

Library

Books To Excess Income

of

8,000

Accured

24,000

32,000

Interest

1,34,000

over

Expenditure 4,03,000 Balance Sheet as at December 31, 1998

4,03,000

Liabilities Outstanding Salary Creditors

Amount 12,000 Cash

for

6,000 Bank

for

25,000 Tution

Assets

Amount 1,000

20,000

Books Supplied Donation

Library Books Capital Fund

Fees

Receivable ed Interest

On 1-1-98 Add Surplus

10,000

4,00,000 1,34,000

24,000 on

Investment Investments 5,34,000 Furniture on 1-

20,000 30,000

1-98 Add purchased

10,000

on 1-7-1998 Less

40,000 3,500

36,500

Depreciation Library Books Less

60,000 12,000

48,000

2,50,000 12,500

2,37,500

Deprcaition Building Less Depreciation 5,77,000

5,77,000

RECEIPT AND PAYMENT

Besides income and expenditure and the balance sheet, financial statements of non-profit organisations invariably include 'Receipts and Payment

'. 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 ' provide the same information but in a different manner. a)

It is real . 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 shows the balance of cash and bank at the end of the period under consideration.

Difference between Income and Expenditure and Receipt and Payment :

Income and Expenditure A ccount Receipt and Payment I) It is a nominal . It is a real . 2) It is a summary of the working of It is a summary of cash and bank the organisation.

transactions of the organisation.

3) It is based on accrual system. It is based on cash system 4) It records expenses and losses on It records inflow of cash on debit debit side and incomes and gains on side and outflow of cash on credit credit side.

side

5)

It is a temporary and has

no opening and closing balance.

6)

It is real and starts with opening balance of cash and

bank. Itlis closed at the end of the year It is balanced at the end of the

and balance figure of the is year transferred to capital fund.

7)

and

the

balance

carried

forward shows the cash and bank

balance at the end of the period. It records items of revenue nature It records items both of capital

only irrespective of their effect on flow and revenue nature provided they of cash. affect flow of cash. 8) It records transactions of current It records transactions of previous year 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 , the balance capita] fund is recorded in the balance sheer prepared on the last day of the period under consideration (called Closing Balance Sheet)

Opening and Closing balance sheet on the basis of information given in Illustration 2 appear as follows:

Balance Sheet as at December 31. 1997 Liabilities Salaries

Amount 4,000 Cash

Outstanding Capital Fund (Balancing figure)

Assets

Amount 1,000

1,59,000 Bank Outstanding

40,000 2,000

Subscription Furniture Building 1,63,000 Balance Sheet as at December 31, 1998 Liabilities Salaries

Amount 1,000 Cash

Outstanding Capital fund On 1-1-98 1,59,000

Assets

20,000 1,00,000 1,63,000

Amount 900

Bank Outstanding

20,000 3,000

Add

4,500

it

is

amply clear

Subscriptio n 1,63,000 Investments

Hence

that the

30,000

Surplus Add Accrued

600

Interest Furniture

20,000

on 1-1-98 Less sold Building Less

5,000 1,00,000 5,000

30,600

15,000 95,000

Depreciation 1,64,500 1,64,500 financial statements of a non-profit institution comprises of four basic statements, namely:i)

A balance sheet at the start of the period (i.e., opening balance sheet);

ii)

Receipts

&

transactions

Payments because

most

of

which the

is

a

summary

transactions

of

of

cash

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 showing incomes generated and expenses incurred during the year to find out the deficit / surplus;

A balance sheet at the end of the period {i.e., closing balance sheet)

iv)

All these statements are intimately connected. In examination, normally one or two of these statements are given along with additional information well, it will be easier to make the statements required 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 wi 11 increase the receipts of cash during the year in receipts and payments and the difference of sale price and their value on the date of sale will be charged to income and expenditure as loss or gain on sale of fixed asset

b)

The receipts in receipts and payment 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 of the current year. Capital receipts such as Iife hip fees, legacy etc. will be taken to liability side of the closing balance sheet under suitable headings.

c)

The payments in receipts and payment 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 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 on the debit side (expenditure side).

From examination point of view, preparation of financial statements of no-profit organisations can be studies under the following categories:

1)

When Receipts and Payments 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 along with income and expenditure and balance sheet at the end of the period;

3)

When in receipts and Payments the balance of bank is given as per book;

4)

When trial balance along with additional information is given and few basic statements are to be prepared;

5)

When Income and Expenditure along with additional information is given and rest of Ihe basic statements are to be prepared;

6)

When both Receipts and Payments and Income and Expenditure 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 and Income and Expenditure for the year are required;

8)

When raw information is given, and all the basic statements are to be prepared;

9)

When wrong statements / incomplete statements are given and corrected s of non-profit organisation are to be prepared;

10)

s of hospitals;

11)

s of educational institution including libraries.

Case I: When Receipt and Payment along with additional information is given, and rest of the basic statements are to be prepared. '

Generally examination problems require preparation of income and expenditure and balance sheet at the end of the period from the information given. But to complete balance sheet the figure of capital fund in the beginning is required. To calculate information about capital fund in the beginning, balance

sheet at ithe beginning of the period should be prepared. Thus, to solve the si examination problems it is suggested to prepare the following simultaneously;

1) Balance sheet at the beginning of the period. 2) Income and Expenditure for the period under consideration. 3) Balance sheet at the end of the period.

To prepare income and expenditure from receipt and payment , all items appearing in receipts and payment should be analysed one by one. AH items of capital nature are directly recorded in the balance sheet All items of, revenue nature appearing in receipts and payment are transferred to income and expenditure , it is to be ensured that these represent; incomes and expenses of the current period only. To achieve this, levenue items appearing in receipts and payment are adjusted, to shift from cash to accrual basis, before transferring these items to income and expenditure .

Case II : When results of an incidental trading (commercial) activity of nonorofit organisation (e.g. Bar activities in a club) are to be ascertained by preparing Trading along with income and expenditure and balance sh'eet at the end of the period.

Non profit organisations basically survive on donations, grants subscriptions from etc. Sometimes trading activities such as hospital canteen, bar, club, beauty parlour, health club, restaurant, chemist shop run by a Govt hospital or co-operative store also take place in such institutions to provide certain facilities to or public in general. As the surplus or profit from such incidental commercial (trading) activities is used to fulfil the objectives for whicn the organisation was established, therefore, profit from such activities is transferred to income and expenditure . Procedure followed is as follows:

a)

Prepare trading 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 . Balance of trading showing profit or loss is transferred to income and expenditure .

b)

Income and Expenditure 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 is transferred to capital fund as usual.

Case III: When in receipts and Payments the balance of bank is given as per book.

Sometimes, receipts and payments given in the question shows opening and closing bank balance as per book. It means the information about various receipts and payments given in the receipts and payments is as per book. To solve the question, first of all given receipts and payments should be redrafted and bank balance and various receipts and payments as per cash book should be recorded.

Case IV: When trial balance along with additional information is given and few basic statements are to prepared. It has already been emphasized that s of non-profit making entities are not materially different from the s of a profit-making entity. Hence, if information is given in the form of trial balance it does not poses a special problem (See Illustration 1), All have to be analysed to find out whether they result in generation of deficit/surplus or are s of assets / liabilities. The statements are prepared in the usual manner.

Case V: When Income and expenditure along with Additional information is given and rest of the basic statements are to be prepared.

Sometimes examination problem requires receipt and payment and balance sheet from the information given in the question. To prepare receipt and payment from income and expenditure , all items appearing in income and expenditure should be analysed one by one to find out their effect on flow of cash. To recapitulate, income and expenditure records all incomes and expenses of the current period on accrual basis. Therefore, the information appearing in the income and expenditure is to be adjusted in the light of additional information given in the question to find out inflow and outflow of cash on of incomes and expenses respectively. Then, information about capital receipts and capital payments included in additional information is analysed and recorded in the receipt and payment After recording all receipts and payments and opening balance of cash and bank, the is balanced. Balancing of receipt and payment now reveals the closing balance of cash and bank.

Sometimes, closing balance of cash and bank is given in the question and opening balance is to be calculated. In such a case closing balance to be carried forward, along with all receipts and payments, is recorded and balancing figure reveals balance of cash and bank in the beginning of the period.

Case VI: When both Receipt and Payment and Income and Expenditure along with additional information are given, and balance sheet in the beginning and at the end are required.

Sometimes both receipts and payment and .income and expenditure are given in the questions along with additional information about assets and liabilities in the beginning of the year. In this case balance sheet as at the end of the year is to be prepared- To prepare balance sheet, items given are compared and information about prepaid expenses, the amount of salaries shown in receipt and payment is less than the amount shown in the income and expenditure , the difference is on of salaries outstanding at the end of the year. Students have to be very careful when

amount appearing in receipts and payment is more than that appearing in income and expenditure . For Example:

a)

Insurance amount in receipt and payment is Rs. 200 and in income and expenditure is Rs.120 Excess payment of insurance can be either on of outstanding amount in the beginning of the year or advance payment for the next year. Generally insurance is paid in advance, therefore, excess amount is treated as unexpired insurance and recorded on assets side.

b)

Income and Expenditure shows stationery amount Rs.500 and the amount recorded in receipts and payment is Rs.700. In this case, difference is either treated as stock of stationery (purchasesconsumed) at the end or amount outstanding in the beginning on of creditors for stationery.

c)

Interest on investment in income and expenditure is Rs.1000 and Rs.1500 is shown in receipt and payment on 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 of interest earned but not received in the beginning of the year and recorded on asset side of opening balance sheet ;

d)

Salary recorded in receipt and payment is Rs. 10,000 and Rs.9,000 is shown in income and expenditure 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 and payment! is more than that appearing in income and expenditure , it ispossible to

treat the difference in more than one way. In such a case, student sfiould make a logical assumption and write the assumption made as part of working notes,

Case VII: When balance sheet at the beginning and at the end of the period along with additional information are given, and receipts and payments or income and expenditure for the year are required:

The information about assets and liabilities is given in the beginning as well "as the end along with additional information either about receipts and payments or about incomes and expenditures. The infonnation can be adjusted to find out the incomes and expenditures or receipts and payments. For example, opening balance sheet shows salary outstanding of Rs.IOO and payments show that on of salary Rs. 14,100 was paid. It will mean that payment to be shown in receipts and payments is Rs. 14,100 but salary of the current year to be shown in income and expenditure will be Rs. 14,000 betause the payment includes Rs. 100 on of last year.

Case VIII: When raw information is given and basic statements are to be prepared: When raw information is given, it virtually involves the writing of entire books of s of non-profit organisations, Due care mast be taken In recording transactions in these books. All receipts and payments should be recorded in the receipts and payments . All expenses and incomes should be posted to income and expenditure keeping in mind the whole discussion we had so far. Hence, recurring items will find their way to income and expenditure and non-recurring would be taken to balance sheet., the assets and liabilities at the end of the year are enumerated in the closing balance sheet. The opening balance sheet is normally prepared to find out the missing figure of capital fund in the beginning of the year.

Case IX: When Incomplete / Wrong statements are given and corrected s of non-profit organisation are to be prepared.

Case X: s of Hospital: Hospitals, like other non profit organisations, are required to prepare financial statements to present their activities in a meaningful manner. Hospitals generally operate a number of separate but related activities. Inspite' of the varied activities undertaken, the procedure of preparation and presentation of financial statements is similar to the one used by other non profit organisations.

Case

XI:

s

of

educational

institutions:

like

other

non-profit

organisations, educational institutions need to report on their activities and to effectively communicate their financial needs. These institutions by and large, depend upon 'Government Grants' for their activities. Unrestricted grants are grants that by their term are fully expended with in the year or receipt, and are treated as income and credited to income and expenditure .

LESSON - 7 ERRORS MANAGEMENT

Trial balance is prepared to check the arithmetical accuracy or correctness of recording in journal, posting to ledger and balancing of ledger s In case trial balance agrees, it is assumed that recording, posting and balancing has been done correctly or accurately. However, if it does not tally, efforts are made to locate errors in ing records. Moreover, agreement of trial balance is not a conclusive proof of accuracy of records. Even when the trial balance agrees, some errors may remain in ing records. For example, non-recording of credit sale transaction in Sales Book will not affect (he agreement of trial balance because both (i.e., debit as well as credit) aspects of the sale transaction are not recorded in this case. Errors, whether affecting trial balance or not affecting trial balance, are to be corrected. The procedure followed to remedy the errors committed and to set right ing records is called rectification of errors.

Type of Errors 1.

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 s, 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 agreement of trial balance, as posting to purchases amount and supplier's is not done. However, omission

at the time of posting to supplier's affects the agreement of trial balance as posting to purchases 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 , 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 , posting of wrong amount, wrong balancing of an 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 Ramesh's is omitted at the time of posting and Rs. 500 credit purchases from Naresh to be posted to credit side of Naresh's is not posted to credit side of Naresh's , 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 errors

4.

Errors of Principle : Besides clerical errors, sometimes ing principles are violated in ing process. Errors involving violation of ing 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

, crediting rent received from tenant to tenant's , crediting sale of furniture sales , debiting payment of salaries to employee's etc. involve errors of principle. These error do not affect the agreement of trial balance.

ERROR MANAGEMENT The whole idea of error management can be executed in three steps, namely:i.

Prevention of errors,

ii.

Detection of errors, and

(A) Prevention of Errors The best way to manage the errors is to prevent them from occurring in the s prepared by the business concern. As is said, "Prevention is better than cure". It is the responsibility of the management to prevent errors. The management can prevent the errors in the nature of fraud by exercising an effective internal control system. It should also curb its own tendencies to window dress the s in order to present their report card in a colourful manner. It should not allow the prejudice and bias to enter the s where it is avoidable.

The errors other than fraud are caused by the following reasons: i)

Ignorance on the part of employees of latest ing developments,

generally accepted ing principles, appropriate classification of the necessary subsidiary ledgers with controlling s and of good ing practices in general; ii)

Carelessness on the part of those doing the ing work.

(B) Detection of Errors

Despite the best of the efforts of the management, some errors may still remain in the s. However, the rectification of error is possible only when an error is detected. From the point of view of detection of errors, all errors can be broadly classified in two categories:

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 are there is the trial balance: a)

Recheck the totals of Dr. and Cr. Side of trial balance to establish undercasting and overcasrting on either side;

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 is same as computed number, recheck the nature of the (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 s should be compared with balances of me last year. If the difference is material, we have sufficient cause to examine the 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 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.

(C) Rectification of Errors Once error is detected, the need for its rectification arises. The rectification of error should always be done with the help of a journal entry and not by cutting, pasting or overwriting at the place of error. Rectification of error depends upon the type of error and the time of its rectification. Accordingly, the topic of rectification of error can be broadly discussed as under;

Rectification of Two Sided Errors Two sided errors are rectified by ing a journal entry called rectifying entry. Thus, rectification entries are entries ed to correct the errors committed and set right the ing records.

Rectification procedure is explained with the help of few examples as follows:1) Payment of rent of building Rs. 5,000 is debited to landlord's .

Entry ed:

Landlord To cash

Entry Required:

Rent To cash

Dr. 5,000 5,000

Dr. 5,000 5,000

To rectify, credit landlord which was wrongly debited and debit rent which should have been debited. Thus, rectifying entry, is: Rent To Landlord

Dr. 5,000 5,000

2) Cash purchase of goods worth Rs. 5,000 from M/s Prashant Furniture is debited to furniture Entry ed:

Furniture

Dr. 5,000

To cash

Entry Required:

5,000

Purchases

Dr. 5,000

To cash

5,000

To rectify, credit furniture which was wrongly debited and debit purchases which should have been debited. Thus, rectifying entry is:

Purchase

Dr. 5,000 To Furniture

5,000

3) Rs. 5,000 received from Ramesh is wrongly credited to Naresh . Entry ed:

Cash

Dr. 5,000

To Naresh

Entry Required:

Cash

5,000

Dr. 5,000

To Ramesh

5,000

To rectify, debit Naresh's which was wrongly credited and credit Ramesh's not creditei earlier. Thus, rectifying entry is:

Naresh To Ramesh

Dr. 5,000 5,000

4) Rs. 5,000 goods purchased on credit from Mr. Anil wrongly posted to the debit side of Anil's and purchases book total Rs. 25,000 posted to debit side of purchases as Rs. 15,000.

As Anil's is wrongly debited by Rs. 5,000 instead of crediting his by Rs. 5,000 to correct Anil's Rs. 10,000 should be credited to Anil's . Since purchases is debited by Rs. 35,000 instead of Rs.

25,000 therefore, purchases is debited by Rs. 10,000. Thux. rectifying entry is: Purchase To Anil

Dr. 10,000 10,000

5) A sale of Rs. 10,000 to Subash is entered in the sales books as Rs. 1,000. It means sales is credited by Rs. 9,000 less and Subhash's is debited by Rs. 9,000 less. Therefore, reclijying entry is: Subhash To Sales

Dr. 9,000 9,000

Rectification of One-Sided Errors Errors which affect the agreement of the trial balance are termed as onesided errors. Undercasting (totaled less) of subsidiary books, overcastting (excess total) of subsidiary books, omission of posting to an , posting of wrong amount to an , posting on wrong side of an -etc., are some of the errors which affect the agreement of trial balance. If .one-sided errors are located before the preparation of trial balance, error is corrected by entering the amount in affected . For example, if total credit sales are Rs. 10,000 but sales book is wrongly totaled as Rs. 9,500 error is rectified as follows:

Dr.

Sales

Cr.

By sundries as per sales books

By undercasting of sales book

9,500

500

Rectification of One-Sided Errors after the Preparation of Trial Balance

In case of disagreement of trial balance, efforts are made to locate errors, and rectify them as discussed above. However, if reason for disagreement of trial balance can not be found, a new called SUSPENSE is opened. Difference in trial balance is recorded is suspense so that the trial balance agrees and the process of preparation of financial statement can can start. In trial balance, if debit total is more than credit total, the suspense is credited Similarly, if credit total is more than debit total, suspense^ is debited,

Journal entries for one-sided errors through suspense : Difference in trial balance which is caused by one-sided errors is put in suspense . After opening of suspense if some errors are located, a .journal entry is ed to rectify them. Rectification of one-sided errors involves either debit or credit to the to be rectified. To complete the double entry, second aspect is recorded with the help of suspense .Difference in trial balance transferred to suspense is recorded as opening balance of suspense . After location and rectification of all errors suspense is automatically closed.

Journal entries required to rectify the one-sided errors given in illustration 6 are as follows:

1) Purchases book has been totaled Rs. 500 less (undercasting): It means at 'he time of posting to purchases , it has been debited by Rs. 500 less. To correct it, purchases should be debited by Rs. 500 To complete double entry, second aspect is recorded through suspense . The rectification entry appears as follows: Purchase To Suspense

Dr. 500 500

2) Sales book has been totaled Rs. 1,000 more (ovcrcastting) : It means ut the time of posting of sales book to sales . Rs. 1,000 excess amoum has been credited. To correct the records, sales should be debited by Rs. 1,000. To complete double entry, suspense is credited. The rectification entry is as under: Sales To Suspense

Dr. 1,000 1,000

3) Rs. 1,000 cash received from X has not heen posted to his : This amount should have been posted to credit side of X . To rectify the mistake of non-posting, X's should be credited by Rs. 1,000- To complete double entry, suspense is debited by the same . The journal entry required to rectify the error is as under; Suspense To X

Dr. 1,000 1,000

4) Sales return from V Rs. 700 has been posted to Y's as Rs. 70 : Rs. 700 should have been credited to Y's . As the amount actually credited is just Rs. 70, Rs. 630 more should be credited to Y's . To complete double entry, suspense accouni is debited by Rs. 630 as follows: Suspense To YA/c

Dr. 630 630

5) Rs. 4,000 cash paid to a creditor has been posted to the credit side of creditor's : Rs. 4,000 cash paid to a creditor should have been debited To creditor but ft is actually credited to creditors . To have correct balance in creditors Rs. 8,000 should 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 ensures correct debit of Rs. 4,000. The journal entry' | ed for this is as follows:

Creditors

Dr. 3,000

To Suspense

8,000

Above entries are posted to suspense as follows;

Dr

Suspense To

Difference

trial

in

7,870

balance

(balancing figure) To X

1,000

To Y

630

By Purchase A/c

Cr. 500

By Sales A/c

1,000

By Creditors

8,000

After rectification of all the errors, suspense must balance. In this case after posting of rectification entries to suspense , one finds the debit side 'is short by Rs 7 870 This balancing figure m suspense as taken as the opening balance of suspense , being the difference in tnal balance transferred to suspense .

Errors and Profit : Errors will effect profit only when nominal s recorded in income statement are affected. Effect of abovementioned errors and their effect on profit is explained as follows: a)

Wrong credit to sales increase reported profit by Rs. 70,000. Correct profit can be calculated by rectification of this error. Rectification reduces sales balance and thus, profit by Rs. 70,000.

b)

Wrong debit to wages reduces reported profit by Rs. 1,000. To calculate correct profit rectification entry is ed. It ^uces wages 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 reportcorrect 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 and, thus has no effect on profit. It has not effect on profit as no nominal is affected. :

Effect on profit Errors (a), (b), (c) and (d) do not affect nominal s and therefore, have no effect on profits. Error (e) affects nominal s. This error increases offices expenses reduces the amount of purchases. As a result, gross profit is increased and is nduced by the same amount. Therefore, this error has no effect on net profit figure. Rectification of this error reduces gross profit and increases net profit by the same amount. Error (f) reduces rent balance by Rs. 2,000 and thus increases net profit by Rs. 2,000 . Rectification of this error reduces net profit figure by Rs. 2,000 to report correct net profit figure.

Rectification

of Errors after Finalisation

of s or in the next

ing period The management should make every conceivable effort to prevent occurrence of the errors in the s. However, if still some errors creep in

the s, they should be detected and rectified before the flnalisation of s. But if despite the best of their efforts the management is not able to trace the errors, the difference should be put to the Suspense A/c and s finalized. The suspense should be shown in the balance sheet til! such time itscauses are ascertained. In the next ing period, the rectification should be done as and when tfye error is detected. However, the method of rectification will depend upon whether the affected is a nominal or any other . If the affected is other than nominal, the rectification is done in the usual manner,' For example, the amount received from X inadvertently recorded in Y's and left untraced last year will be rectified in the current year by debiting X and crediting Y. Had this error been traced last year itself, the same rectification entry would have followed.

However, if the error involves a nominal having its impact 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 with a credit balance of Rs. 10,000 in the trial balance. If the error was to be detected last year before the fmalisation of s, the rectification entry would have been ; Suspense To Sales

Dr. 10,000 10,000

However if the error is detected in the current year after the finalisation of s, the same rectification entry will ensure that the current year sales is unnecessarily inflated by Rs. 10,000. The last year profit was under reported by Rs. 10,000 and the current year profit will be over reported by the same amount. The errors of these kind should be correct as "Prior Period Items'' or through 'Profit and Loss Adjustment ' and shown in the current year profit and loss as prior period items as per the requirement of AS-5 (Revised). As per AS-5, Prior period items are income or expenses which arise in the current

period as a result of errors omissions in the preparation of the financial statements of the one or more prior periods. It is recommended that the impact of the prior period items be shown separately in the profit and loss of the current ing period.

Hence, the entry for this aspect will be: Suspense

Dr 10,000

To Profit & toss Adjustment

10,000

The profit and loss adjustment is closed by transfer to the current year profit and loss as a prior period item. Hence, the profit of current year clearly reflects the effect of the errors of the past period. A close look at the following examples will make more clear the mechanism of rectification (a) if its is done in the same ing period; and (b) if it is done in the next ing period; i) Purchase book is undercast by Rs. 5,000: Rectification entry ij it is done in the ing period of the error Purchase To Suspense

Dr. 5,000 5,000

Rectification entry if it is done in the next ing period, Profit & Loss Adjustment To Suspense

Dr. 5,000 5,000

ii) Rent paid of Rs. 2,000 debited to landlord and included in the list of debtors: Rectification entry if it is done in the ing period of the error itself Rent To Debtors Rectification entry if it is done in the next ing period

Dr. 2,000 2,000

Profit & Loss Adjustment To Debtors

Dr. 2,000 2,000

iii) Private purchases of Rs. 1,000 ed through purchase : Rectification entry if it is done in the ing period of the error itself Drawings To Purchase

Dr. 1,000 1,000

Rectification entry if it is done in the next ing period. Drawings

Dr. 1,000

Profit & Loss Adjustment

1,000

iv) Cash received of Rs. 4,000 from X shown on the debit of Y's : Rectification entry if if is done in the ing period of the error itself. Suspense To X

Dr. 8,000 4,000

To Y 4,000 Rectification entry if if is done in the next ing period. Suspense

Dr. 8,000

To X

4,000

To V

4,600

Note that the entry is same in both the cases. The basic reason is jthat the affected is not a nominal . Illustration 1; A book keeper while preparing his trial balance finds that the debit exceeds by Rs. 7,250. Being required to prepare the final he places the difference to a suspense . In the next year the following mistakes were discovered: a)

A sale of Rs. 4,000 has been ed through the purchase day book. The entry in the customer's has been correctly recorded;

b)

Goods worth Rs. 2,500 taken away by the proprietor for his use has been debited to repairs ;

c)

A

bill receivable for Rs.

1,300 received from Krishna has

been dishonoured on maturity but no entry ed; :

d)

Salary of Rs. 650 paid to a clerk has been debited to his personal ;

e)

A purchase of Rs. 750 from Raghubir has been debited to his . Purchase has been correctly debited;

f)

A sum of Rs. 2,250 written off as depreciation on furniture has not been debited to depreciation .

Draft the joyrnal entries for rectifying the above mistakes and prepare the suspense and profit and loss adjustment , Journal a)

Suspense A/c

Dr. 8,000

To Profit & Loss Adjustment A/c (Being b)

wrong

recording

of

sales

8,000 as

purchase last year rectified) Drawings A/c

Dr. 2,500

To Profit & Loss Adjustment A/c (Being

Drawings

inadvertently c)

2,500

made

last

year

as

repairs

now

shown

rectified) Krishna A/c To Bills Receivable A/c (Being bill dishonoured last year now recorded in the books)

Dr. 1,300 1,300

d)

To Profit & Loss Adjustment A/c

Dr. 650

To Clerk's Personal A/c

650

(Being salary paid to clerk last year inadvertently shown in his personal e)

now rectified) Suspense A/c

Dr. 1,500

To Raghubir A/c

1,500

(Being purchase from Raghubir) shown on f)

debit

side

of

his



inadvertently now rectified) Profit & Loss Adjustment A/c

Dr. 1,500

To Suspense A/c (Being

1,500

depreciation

not

shown

last

year now rectified)

Dr. To

Suspense Cr. Profit

&

Loss

Adjustment A/c To Raghubir A/c

8,000

By balance b/d

1,500

By

Profit

&

7,250 Loss

2,250

Adjustment A/c Dr. Cr. To Clerk's

9,500 Profit & Loss Adjustment

9,500

Persona]

650

By Suspense A/c

8,000

A/c To suspense A/c To Profit & Loss

2,250 7,600

By Drawings A/c

2,500

Adjustment

A/c

(Transfer) 10,500

10,500

LESSON - 8 S FROM INCOMPLETE RECORDS-SINGLE ENTRY SYSTEM

SALIENT FEATURES a)

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 s 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 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 ing 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

has following

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 ing records maintained. Hence, arithmetical accuracy of ing records can not be checked.

c)

Determination of true profit (or loss) not possible : Nominal s are not maintained and, therefore, it is not possible to prepare trading and profit and loss 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 s makes the job of preparation of balance sheet a 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 s. 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 , 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, s maintained on single entry are

not accepted by sales tax and

income tax authorities.

h)

Inter- firm Comparisons not possible : Because of variation in. ing procedure and rules, comparisons of two or more businesses is not possible. 'Inspite of the above limitations, an ant is required to

ascertain profit, (or loss) and prepare financial position statement at ing 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.

Statement of Affairs Method Under statement of affairs method, statement of affairs is prepared in the beginning and the end of the year to calculate capital in the beginning and the end of the year respectively. Statement of affairs lists assets on right hand side, liabilities on the left hand side and the excess of assets over liabilities is assumed to be capital and recorded on left hand side so that total assets are equal to liabilities is assumed to be capital and recorded on left hand side so that information about assets and liabilities plus capital. It must be ed that complete information about assets and liabilities is not available from ing records and some of these assets and liabilities are estimated. Proforma of a Statement of Affairs is as follows; Statement of Affairs as on...

Liabilities Creditors Bills payable Outstanding

Amount

Assets

Amount

Cash Bank Debtors

expenses Unearned income Loans Capital (Balancing

Bills receivable Stock Prepaid expenses

figure) Accrued income Fixed assets Distinction Between Statement of Affairs and Balance Sheet : Following are the points of difference between a statement of affairs and 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 ing records (if records are maintained) or bases on estimates

(if

records

are

not

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 ing 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 ing 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 ing 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 following steps are required: 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 find out profit (or loss) for the year by using the following relationship.

Opening Capital + Additional Capital – Drawings + Profits **Closing Capital

Or Profit = Closing Capital - Additional Capital + Drawings - Opening Capital Calculation of profit or loss is shown in the form of a statement as follows: 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 year Adjustment to be made: Sometimes certain adjustments are given in the' question. These adjustments may relate to interest on capital, interest on drawings, depreciation on fixed assets, provi^ons for doubtful debts etc., In this case statement of affairs, prepared to calculate capital on the date of statement, records assets and liabilities before any adjustment.

Profit as shown by statement of profit in this case is not net.profit earned during the year.

Profit as shown by statement cf profit is'adjusted to calculate net profit as follows: Profit and Lots /or the year ending..... To Depreciation on Fixed Asset

By Profit before adjustment as shown in

To Provision for Doubtful Debts To Interest on Capital To Net Profit transferred to Capital

the statement of profit By Interest on Drawing

Conversion Method s maintained under single entry system are not sufficient to extract trial balance at the end of the ing period. As a result, final s or financial statements cannot be prepared from incomplete records unless steps are taken for their completion. Under conversion method, cash ant, debtors , creditors etc., maintained on single entry basis are analysed and an attempt is made to complete double entry by making necessary posting is done. After completing records on the basis of double entry system or preparation of final s from incomplete records.

In actual practice, conversion involves completion of ledger books, preparation of a trial balance and, then financial statements. ; However, for solving examination problems, above mentioned procedure of conversion and the absence of detailed information in the question. To solve examination problems significant information required for completion of trading , profit and loss and balance sheet is calculated from whatever information is given in the question. After calculating significant information missing in the questions, final s are prepared as usual. To calculate missing figures, the following steps are recommended: a)

Prepare statement of affairs in the beginning of the year.

b)

Prepare cash book or cash .

c)

Prepare total debtors and bills receivable .

d)

Prepare final s.

:

Whatever information is given in the question, record that in s) involved. Knowledge about items usually appearing in these s gives an idea about information missing in the question. Then an attempt is made to calculate missing information by using rules of double entry system,

Proforma of Total Debtors , Total Creditors , Bills Receivable and Bills Payable is given below to have an idea about the items isuaily appearing in these s.

Dr.

Total Debtors A/c

Cr. To balance b/d (Debtor in the beginning)

By Cash or Bank A/c (Amount received from debtors) To Bills receivable A/c (Bills drawn on debtors) By Sales Return A/c By Discount Allowed A/c By Bad Debts A/c By balance c/d (Debtors at the end of the

To Sales A/c (Credit sales) To Bills receivable A/c (Bill dishonoured)

year) Dr.

Bills Receivable A/c

Cr. To balance b/d (Balance in the beginning) To Debtors A/c (Bills drawn during the year)

By Cash A/c & Discount A/c (for B/R Discount) By Creditors A/c (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/c

Cr. To Cash A/c or Bank A/c (Amount paid to creditors) To Bills Receivable A/c (for B/R endorsed)

By balance b/d (Creditors in the beginning) By purchases A/c (Credit purchases)

To Bills Payable A/c (Bills accepted) To Purchases Return A/c To Discount Received A/c To balance c/d (Creditors at the end)

Dr.

By Bills payable A/c (Bills payable dishonoued)

Bills Payable A/c

Cr. To Cash A/c (B/P paid on due dates) To Creditors A/c (B/P dishonoured)

By balance b/d (B/P in the beginning) By Creditors A/c (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 of gross profit figure in trading , calculation of missing information about any one of the items recorded in trading can take place. Items recorded in trading are opening stock, purchases, direct expenses and closing stock.

Illustration 1:

Find out the amount of direct expenses from the following

details: Stock on 1-4-98 Stock on 31-3-999 Purchases during 1998-99 Sales during 1998-99 Gross profit ratio Dr.

Rs. 17,000 12,000 000 1,28,000 25%

Trading for the year ended March 31, 1999

To Opening Stock To Purchases To Direct Expenses

17,000 By Sales 77,000 By Closing Stock 14,000

1,28,000 12,000

Cr.

(Balancing figure) To Gross Profit (25% of Rs. 1,28,000) 1,40,000

1,40,000

Illustration 2: Data Ram maintains his records on single entry system.

While records of.

business takings and payments have been kept, these have not been reconciled with cash in hand. From time to time cash has been paid into a bank and cheques thereon have been drawn both for business use and private purposes. From the following information, prepare the final s for the year 1998:

Assets and liabilities at the beginning and at the end of the period have given below:

Stock Bank Balance Cash in hand Debtors Creditors Investments

1-1-1998 20,000 8,000 300 14,000 27,300 50,000

31-12-1998 15,000 12,000 400 20,000 30,000 50,000

Other transactions are as follows: Cash paid in bank Private dividends paid into bank Private payments out of bank Business payments for goods out of bank Cash takings Payment for goods by cash and cheque Wages Delivery Expenses Rent and rates Lighting General Expenses

1,50,000 59,700 26,000 1,22,000 2,50,000 1,60,000 97,700 7,000 2,000 1,000 4,600

During the year, cash amounting to Rs. 20,000 was stolen from the till, ucods worth Rs. 24,000 were withdrawn from private use. No record has been kept of amounts taken from cash for personal use and a difference in cahs amounting to Rs. 7,300 is treated as private expenses.

Dr. To balance b/d To Sales A/c To Debtors A/c (balancing figure)

Cash A/c 300 By Defalcation 2,50,000 By Bank A/c 1,42,000 By Drawings A/c By Purchases A/c (1,600,000-57,700) By Wages A/c By Delivery Expenses A/c By Rent& Rates A/c By Lighting A/c By General Exp. A/c By balance c/d 3,92,300

Cr. 20,000 1,50,000 7,300 1,02,300 97,700 7,000

2,000 1,000 4,600 400 3,92,300

Bank A/c

Dr. To balance b/d To Cash A/c

To

Capital

8,000 By drawings A/c 1,50,000 By Business Payment A/c 59,700 By Purcahse A/c

A/c

Cr. 26,000 1,22,000

57,700

(Dividend) (balancing figure) By balance c/d 2,17,000 Dr. To balance b/d To Sales A/c

12,000 2,17,000

Sundry Debtors A/c 14,000 By Cash A/c By balance c/d

(balancing

Cr. 1,42,000 20,000

figure) 1,62,000 Dr. To balance c/d

Sundry Creditors 30,000 By balance b/d By Purchases A/c (balancing

1,62,000 Cr. 27,300 2,700

figure) 30,000

30,000

Balance Sheet as at 1-1-98 Liabilities Creditors Capital (Balancing figure)

Amount Assets 27,300 Stock 65,000 Bank Cash Debtors Investments 92,300

Amount 20,000 8,000 300 14,000 50,000 92,300

Trading & Profit & Loss A/c for the year ended 31-12-98 To Opening Stock

20,000 By Sales :

A/c To Wages To Purchaes : Cash

97,700 Cash Credit By closing Stock

1,60,000

2,50,000 1,48,000 15,000

A/c Credit Less Drawings To Gross Profit

2,700 1,62,000 24,000

To Business Payment A/c To Rent & Rates A/c To Lighting A/c To General Expenses A/c To delivery Expenses A/c To Defalcation A/c

1,38,700 1,56,600 4,13,000

4,13,000

1,22,000 By Gross Profit

1,56,600

2,000 1,000 4,600 7,000 20,000 1,56,600

1,56,600

Balance Sheet as at 31-12-98

Liabilities Opening Capital Add: Additional Capital Less: Drawings (7,300+26,000+24,000 ) Creditors

Amount 65,000 59,700 1,24,700 57,300

Assets Investment Stock Debtors

Amount 50,000 15,000 20,000

67,400 Bank

12,000

30,000 Cash 97,400

400 97,400

Difference between Double Entry system and Single Entry System

Of difference between double u"Hry system aj)d single entry system 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 s. Under single entry sysuai trial balance cannot be prepared because duaI-aspect of ail transactions are not recorded.

c)

Type of s: Under double entry system nominal, persona! and real s are maintained. Under single entry system, generally, personal s 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.

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 s. 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, financial'position statement reveals trne financial position based on ing, 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.

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.

LESSON - 9 FINANCIAL STATEMENT ANALYSIS

MEANING OF FINANCIAL STATEMENTS

According to Himpton John, "A financial statement is an organized collection of data according to logical and consistent ing procedures. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show assets position at a moment of time as in the case of a balance sheet, or may reveal a series of activities over a given period of limes, as in the case of an income statement ".

On the basis of the information provided in the financial statements, management makes a review of the progress of the company 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 ING 1. Going concern concept 2. Matching concept ( Accruals concept) 3. Consistency concept 4. Prudence concept ( conservation concept)

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 STATEMENTS 1.

In profit and loss net profit is ascertained on the basis of

historical costs.

2.

Profit arrived at by the profit and loss 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 is not absolute but only relative.

4.

The net income is the result of personal judgment and bias of ants cannot be removed in the matters of depreciation, stock valuation, etc.,

5.

The profit and loss 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.

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 ing 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 ing 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.

15.

The financial statements are based on ing 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 Statement and the Balance sheet, can either be presented in the horizontal form or the vertical form where statutory provisions are applicable, the statement has to be prepared in accordance with such provisions.

Income Statement

:

There is no legal format for the profit and loss A/C. Therefore, it can be presented in the traditional T form, or vertically, in statement form. 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 To opening stock

Raw materials Work in progress To purchases of raw materials To manufacturing wages To carriage inwards To other Factory Expenses

To opening stock of finished

Rs.

Particualrs By cost of finished Goods

c/d xxx By closing stock xxx Raw materials Work in progress xxx

xxx xxx xxx xxx By sales xxx By closing stock of finished

Rs. Xxxx

xxx xxx

xxx xxx xxx

goods To cost of Finished goods

goods xxx By Gross Loss c/d

xxx

To Gross Loss b/d To office and n.

xxx xxx xxx By Gross profit b/d xxx By Miscellaneous Receipts

xxx xxx xxx

Expense To Interest and financial

xxx By Net Loss c/d

xxx

b/d To Gross Profit c/d

expenses To provision for Income-tax To Net Profit c/d To To To To

net loss b/d general reserve Dividend Balance c/f

xxx xxx xxx xxx By Balance b/d xxx (from previous year) xxx By Net profit b/d xxx

xxx xxx xxx

xxx

xxx

(ii) Vertical Form Income statement of ………… for the year ending ……………... Particulars Sales Less: Sales Returns Sales Tax/ Exise Duty Net sales (1) Cost of Goods Sold Materials Consumed Direct Labour Manufacturing Expenses Add / less Adjustment for change in stock

Rs.

Rs. xxxx xxx xxx

xxxx xxxx xxxx xxxx xxxx xxxx

(2) Gross Profit (1) – (2) Less: Operating Expenses Office and istration Expenses Selling and Distribution Expenses Operating Profit Add: Non-operating Income

xxxx xxx

xxx xxx

xxx Xxxx Xxx

Less: Non-oprating Expenses (including Interest) Profit before Tax Less : Tax Profit After Tax Appropriations Transfer to reserves Dividend declared /paid Surplus carried to Balance sheet

xxxx xxx xxxx xxx xxxx

xxxx xxx xxx xxxx

Balance Sheet The Companies Activities, 1956 stipulates that the Balance sheet of a t stock company should be prepared as per part I of schedule VI of the Activities. However, the statement form has been emphasized upon by ants 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 Share Capital (with all paticulars Authorized,

of

Rs. Assets xxx Fixed Assets: 1. Goodwill

Issued,

Subscribed capital) Called

2. Land & Building xxx 3. Leasehold property

Rs. xxx xxx xxx

up capital

4. Plant and Machinery

xxx

Less: Calls in Arrears Add: Forfeited Shares Reserves and Surplus : 1. Capital Reserve 2. Capital Redemption reserve 3. Share 4. Other Less: debit balance of Profit

5. Furniture and Fittings 6. Patents and Trademarks 7. Vehicles Investments Current Assets, loans and Advances (A) Current Assets 1. Interest accured on Investments 2. Loose tools

xxx xxx xxx

xxx xxx xxx xxx xxx xxx xxx

xxx xxx

and loss A/C (if any) 5. Profit and Loss Appropriation A/C 6. Sinking Fund

xxx xxx

3. Stock in trade 4. Sundry Debtors Less: Provision for doubtful debts 5. cash in hand 6. cash in Bank (B) Loans and Advances 7. Advances to subsidiaries 8. Bills Receivable

xxx xxx

xxx xxx

Secured Loans Debentures Add: Outstanding Interest

xxx xxx

Loans from Banks Unsecured Loans

xxx 9. Prepaid Expenses Miscellaneous Expenditure

xxx xxx xxx

(to the extent not written off

Fixed Deposits Short-term loans

and

advances Current

and

Liabilities

or xxx adjusted) xxx

1. Preliminary expenses

Provisions

2.

Discount

xxx xxx Profit

3.

(Loss), xxx if any

received

in

advance 4. unclaimed Dividends 5. Other Liabilities

xxx xxx

B. Provisions 6. Provisions for Taxation 7. Proposed Dividends 8. Proposed funds &

xxx xxx xxx

pension fund contingent not Provided for

on

Issue

xxx of

shares and debentures 3. Underwriting Commssion

A. Current Liabilites 1. Bills Payable 2. Sudnry Creditors

Income

xxx

liabilities

and

Loss



xxx

xxx

xxx

xxx

(ii) Vertical Form: Balance sheet of ………………………. as on …………………

Particulars

Schedule No.

I. Source of funds 1. Share holders funds a. capital b. Reserves and surplus 2. Loans funds a. Secured Loans b. Unsecured Loans Total II. Application of funds 1. Fixed Assets a. Gross Block b. less Deprciation c. Net block d. Capital work in progress

Current

Previous

year

Year

xxxx xxxx

xxxx xxxx

xxxx xxxx

xxxx xxxx

xxxx xxxx xxxx xxxx

xxxx xxxx xxxx xxxx

2. Investments

xxxx

xxxx

3. Current Assets, Loans and Advances a. Inventions b. Sundry Debtors c. Cash and Bank balance d. other current assets e. Loans and Advances

xxxx xxxx xxxx xxxx xxxx

xxxx xxxx xxxx xxxx xxxx

xxxx xxxx xxxx

xxxx xxxx xxxx

xxxx

xxxx

xxxx xxxx

xxxx xxxx

Less : current Liabilities and Provisions a. Current Laibilities b. Provisions Net Current Assets 4. a. Miscellaneuos Expenditure to the extent not written off or adjusted b. Profit and Loss (debit) Total

(ii) Vertical Form for analysis Balance sheet of ……… as on ……………..

Particulars

Rs.

ASSETS Current Assets Cash and Bank Balances Debtors Stock Other Current Assets (1)

xxxx xxxx xxxx xxxx xxxx

Fixed Assets Less: Depreciation Investments (2) Total (1) + (2) LIABILITIES Current Liabilities : Bills Payable Creditors Other Current Liabilities (3) Long Term Debt Debentures Other Long-term Debts (4) Capital and Reserves Share Capital Reserves and surplus (5) Total Long term funds Total (3)+(4)+(5)

xxxx xxxx xxxx xxxx xxxxx

xxxx

xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxxx

Statement of Retained Earnings: Profit and Loss Appropriation

To

Particulars transfer

Reserves To Dividend

to

Rs. xxx By

Particulars Last year’s

balance xxx By Current Year’s net

Rs. xxx

xxx

profit

(Transferred

from profit and loss A/C) To Dividend proposed To surplus carried to Balance sheet

xxx xxx By Excess provisions (which are no longer required) By Reserves withdrawn (if any) xxx

xxx

xxx xxxx

Illustration: 1 From the following information, prepare a vertical Income Statement.

Sales Opening stock Closing stock Purchases Operating Expenses

2,00,000 10,000 15,000 40,000 12,000

Rate of Tax 50% Solution: Income Statement Particulars Sales Less : cost of goods sold: Opening stock Add: Pruchases Less: closing Stock Gross Profit Less: operating expenses Operating profit Less: non-operating expenses Profit before tax

Rs.

Rs. 2,00,000

10,000 40,000 50,000 15,000 35,000 1,65,000 12,000 1,53,000 4,000 1,49,000

Less: Income tax (50%) Net profit after tax

74,500 74,500

Illustration: 2 From the following particulars, pertaining to Mohan Ltd., you are required to prepare a comparative Income Statement and interpret the changes.

Particulars Sales Cost of goods sold istration expenses Selling expenses Non -operating expenses Non-operating expenses Sales returns Tax rate

Rs. 58,000 47,600 1,016 1,840 140 96 2000 43.75%

Rs. 65,200 49,200 1,000 1,920 155 644 1,200 43.75%

Solution: Comparative Income Statement of Mohan Ltd., for the years 2000 and 2001.

Particulars

Sales Less Returns Net sales Less: Cost of Goods sold Gross Profit (A) Less: Operating expenses istration expenses Selling expenses Total operating expenses (B) Operating profit (A)-(B) Add: non - operating incomes Less: non- operating expenses

2000

2001

Rs. 58,000 2,000 56,000 47,600 8,400

Rs. 65,200 1,200 64,000 49,200 14,800

1,016 1,840 2,856 5,544 96 5,640 140 5,500 2,406 3094

1,000 1,920 2,920 11,880 644 12,524 155 12,369 5,411 6,958

Net profit before tax Less: Tax Net profit after Tax Techniques of Financial Statement Analysis:

The following techniques are adopted in analysis of financial 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 rest are discussed in the subsequent chapters in detail.

Comparative Financial Statements Comparative financial statements are statements pf financial position of a business designed to provide time perspective to the consideration of various elements of financial position embodied in such statements. Comparative Statements reveal the following: . i.

Absolute data (money values or rupee amounts)

ii.

Increase or reduction in absolute data (in of moiwy values)

iii.

Increase or reduction in absolute data (in of percentages)

iv.

Comparison (in of ratios)

v.

Percentage of totals.

a. Comparative Income Statement or Profit and Loss : A comparative income statement shows the absoluie figures for two or more periods and the absolute change from one period to another. Since the figures are shown side by side, the can quickly understand the operational performance of the firm in different periods and draw conclusions.

b. Comparative Balance Sheet Balance sheet as on two or more different dates are used for comparing the assets, liabilities and the net worth of the company Comparative balance sheet is useful for studying the trends of analysis undertaking. Financial Statements of two or more firms can also be compared for drawing inferences. This is called interfirm Comparison. Advantages: Comparative statements vidicate trends in sales, cost of production, profits etc., and help the analyst to evaluate the performance of the company.

Comparative statements can also be used to compare the performance of the industry or inter-firm comparison. This helps in identification of the weaknesses of the firm and remedial measures can be taken; accordingly.

Weaknesses: Inter-firm comparison can be misleading if the firms are not identical in size and age and when they follow different ing procedures with regard to depreciation, inventory valuation etc., Inter-period comparison may also be misleading if the period has witnessed changes in ing policies, inflation, recession etc.

Illustration 3: The following is the profit and loss of Ashok Ltd., for the years 2000 and 2001. Prepare comparative Income Statement and comment on the profitability of the undertaking.

Particulars To Cost of goods sold To Office

2000 2001 Particulars Rs. Rs. 2,31,625 2,41,950 By Sales

23,266

27,068 Less

expenses

45,912

expenses To Loss on

627

57,816

5,794

6,952

3,54,934

4,10,173

1,896

1,750 By Other

sale of

Tax To Net

2001 Rs. 4,17,125

Returns

To Interest

fixed To Income

2000 Rs. 3,60,728

incomes :

21,519

40,195 By Discount

2,125

35,371

on purchase 44,425 By Profit on

1,500

Profit

sale of land 3,60,457 4,13,379

3,60,457

4,13 ,379

Solution: ASHOK LTD. Comparative Income Statement for the years ending 2000 and 2001

Particulars

Sales Less: Sales returns Less: Cost of goods sold Gross Profit Operating Expenses: Office

2000 Rs. 2001 Rs. Increase (+)

Increase (+)

Decrease (-)

Decrease (-)

Amount

Percentages

3,60,728 4,17,125 5,794 6,952 3,54,934 4,10,173 2,31,625 2,41,950

(Rs.) +56,397 +1.158 +55,239 + 10,325

+15.63 +19.98 +15.56 +4.46

1,23,309 1,68,223

+44.914

+36.42

23,266

27,068

+3,802

+ 16.34

expenses Selling

45,912

57,816

+11,904

+25.93

expenses Total operating

69,178

84,884

+15,706

+22.70

Less: Other

54,131 5,523 59,654 2,764

83,339 3,206 86,545 1,925

+29,208 -2,317 +26.891 -839

+53.96 -41.95 +45.08 -30.35

expenses Profit before tax Less: Income tax Net Profit after tax

56,890 21,519 35,371

84,620 40,195 44,425

+27,730 +18,676 +9,054

+48.74 +86.79 +25.60

expenses Operating profit Add: Other incomes

The comparative Income statement reveals that while the net sales has been increased by 15.5%, the cost of goods sold increased by 4.46%. So gross profit is increased by 36.4%. The total operating expenses has been increased by 22.7% and the gross profit is sufficient to compensate increase in operating

expenses. Net profit after tax is 9,054 (i.e., 25.6%) increased. The overall profitability of the undertaking is satisfactory.

Illustration: 4 The following are the Balance Sheets of Gokul Ltd., for the years ending 31s1 December, 2000,2001.

Particulars

2000

Liabilities Equity share capital Preference share capital Reserves Profit and Loss a/c Bank overdraft Creditors Provision for taxation Proposed Dividend Total

2001 Rs.

Rs.

2,00,000 1,00,000 20,000 15,000 50,000 40,000 20,000 15,000 4,60,000

3,30,000 1,50,000 30,000 20,000 50,000 50,000 25,000 25,000 6,80,000

2,40,000 40,000 1,00,000 20,000 10,000 40,000 10,000 4,60,000

3,50,000 50,000 1,25,000 60,000 12,000 53,000 30,000 6,80,000

Fixed Assets

Less: Depreciation Stock Debtors Bills Receivable Prepaid expenses Cash in hand Cash at Bank Total

Solution: Comparative Balance Sheet 31st Dec.

31st Dec.

Inerease(+)

Increase(+)

2000

2001

Decrease(-)

Decrease(-)

Rs.

Rs.

Amount(Rs.)

Percentages

50,000

83,000

+33,000

+66

20,000 1,00,000 40,000

60,000 1,25,000 50,000

+40,000 +25,000 +10,000

+200 +25 +25

10,000

12,000

+2,000

+20

Total Current Assets Fixed Assets

2,20,00 2,40,000

3,30,000 3,50,000

+1,10,000 +1,10,000

+50 +45.83

Total Assets

4,60,000

6,80,000

2,20,000

47.83

Bank overdraft Creditors Proposed dividend

50,000 40,000 15,000

50,000 50,000 25,000

+10,000 +10,000

+25 +66.67

Provision for taxation

20,000

25,000

+5,000

+25

1,25,000

1,50,000

+25,000

+20

Liabilities Capital and Reserve: Equity share capital

2,00,000

3,30,000

+1,30,000

+65

Preference

1,00,000

1,50,000

+50,000

+50

capital Reserves

20,000

30,000

+10,000

+50

Profit and Loss a/c

15,000

20,000

+5,000

+33.33

3,35,000

5,30,000

+1,95,000

+58.21

4,60,000

6,80,000

+2,20,000

+47.83

Particulars

ASSETS Current Assets: Cash at bank and in hand Bills receivable Debtors Stock Prepaid expenses

LIABILITIES Current Liabilities:

Total

Current

share

Total Liabilities

Interpretation:

1.

The above comparative Balance sheet reveaJs 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 longterm 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 Loss and Balance sheet are converted to percentages so as to establish each element to the total figure of the statement and these statement are called Common Size Statements. These statements are useful in analysis of the performance of the company by analyzing each individual element to the total figure of the statement. These statements will also assist in analyzing the performance over years and also with the figures of the competitive firm in the industry for making analysis of relative efficiency. The following statements show the method of presentation of the data.

Illustration: 5 Common Size Income Statement of XYZ Ltd., for the year ended 31 st March, 2001.

Particulars

Amount (Rs.)

% to Sales

Sales

(A)

14,00,000

100

Raw materials

5,40,000

16.4

Direct wages

2,30,000

16.4

Faciory expenses

1,60,000

11.4

9,30,000

66.4

(A) -

4,70,000

33.6

istrative

1,10,000

7.9

distribution

80,000

5.7

2,80,000

20.0

40,000

2.9

3,20,000

22.9

60,000

43

2,60,000

18.6

80,000

5.7

1,80,000

12.9

(B) GrossProfit (B) Less: expenses Selling and expenses Operating Profit Add: Non-operative income Less:

Non-operating

expenses Profit before tax Less: Income tax Profit after tax

Common Size Balance Sheet of XYZ Particulars

Amount (Rs.)

% to Total

ASSETS Fixed Assets Land

50,000

5.3

Buildings

1,10,000

11.7

Plant and Machinery

2,50,000

26.6

Raw materials

80,000

8.5

Work-in-progress

50,000

5.3

1,60,000

17.0

Current Assets : Inventory

Finished goods

Sundry debtors

2,10,000

22.4

30,000

3.2

9,40,000

100.0

Euqity Share capital

2,50,000

26.6

Preference Share Capital

1,00,000

10.6

General reserve

1,60,000

17.0

80,000

8.5

2,20,000

23.4

Creditors for expenses

40,000

4.3

Bills payable

90,000

9.6

9,40,000

100.0

Cash at Bank Total Capital and Liabiltiies

Debentures Current Liabilities Sundry Creditors

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 StatementParticulars To Cost of goods sold To istrative expenses To Selling expenses To Net Profit

2000 Rs. 12,000

2001 Particulars Rs. 1 5,000 By Net Sales

400

400

600

800

3,000 3,800 16,000 20,000

2000 Rs. 16,000

16,000

2001 Rs. 20,000

20,000

Common Size Income Statement Particulars

2000

2001

Net sales

Rs. % Rs. % 16,000 100.00 20,000 100.00

Less: Cost of goods sold

12,000

Gross Profit Less:

7500

4,000

25.00

5,000

25.00

400

2.50

400

2.00

Operating

expenses istration expenses Selling expenses Total

75.00 15,000

600

Operating 1,000

3.75

800

4.00

6.25

1,200

6.00

18.75

3,800

19.00

expenses Net Profit

3,000

Illustration: 7 Following are Balance sheet of Vinay Ltd. for the year ended 31 st December 2000 and 2001.

Liabilities Equity capital

2000

2001

Rs.

Rs.

1,00,000

Assets

1 ,65,000 Fixed Assets (Net)

2000 Rs.

2001 Rs.

1 ,20,000 1,75,000

Pref. Capital

50,000

75,000 Stock

20,000

25,000

Reserves

10,000

15,000 Debtors

50,000

62,500

P&L A/c

7,500

10,000 Bills receivable

10,000

30,000

Creditors

20,000

25,000 Cash at Bank

20,000

26,500

Provision

10,000

12,500 Cash in hand

5,000

15,000

for taxation Proposed

7,500

12,500

2,30,000

3,40,000

dividends 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 Rs. Capital & Reserves: Equity Capital

2000 %

Rs.

2001 %

1,00,000

43,48 1 ,65,000

48.53

50,000 10,000 7,500 1,67,500

21,74 4.34 3.26 72.82

75,000 15,000 10,000 2,65,000

22.05 4.41 2.95 77.94

Bank overdraft Creditors Provisions for taxation

25,000 20,000 10,000

10.87 8.70 4.35

25,000 25,000 12,500

7.35 7.35 3.68

Proposed dividends (ii) Total Liabilities (ij + (ii)

7,500 62,500 2,30,000

3.26 27.18 100.00

12,500 75,000 3,40,000

3.68 22.06 100.00

1,20,000

52.17

1,75,000

51.47

20,000 50,000 10,000

8.70 21.74 4.34

25,000 62,500 30,000

7.35 18.38 8.82

Pref. Capital Reserves P&L A/c (i) Current Liabilities:

Fixed Assets (Net) Current Assets: Stock Debtors Bills receivable

(a)

Cash al bank Cash in hand

20,000 8.70 26,500 7.79 5,000 2.18 15,000 4.41 (b) 1,10,000 47.83 1,65,000 48.53 Total Asses (a + b) 2,30,000 100.00 3,40,000 100.00

Interpretation : (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.

(4)

So, the ove.all financial position is satisfactory.

TREND ANALYSIS In trend analysis ratios of different items are calculated for various periods for comparison purpose.

Trend analysis can

be .done

by trend

percentage, trend ratios and graphic and diagrammatic representation.

The

trend analysis is a simple technique and does not involve tedious calculations.

Illustration: 8 From the following data, calculate trend percentage taking 1999 as base.

Particulars

1999 Rs.

2000 Rs.

2001 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

Solution: Particulars

1999 Rs.

2000

Rs.

Rs. Rs.

Purchases

2001 Rs. Trend Percentage Base 1999

Rs.

1999

2000

2001

40,000

60,000

72,000

100

150

180

Expenses

5,000

8,000

15,000

100

160

300

Profit

5,000

7,000

13,000

100

140

260

Sales

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 Debtors

200 400

240 500

160 650

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

Solution:

Particulars

2000 2001 (Base Year 1999) Rs.

Rs.

Rs.

1999 2000 2001

Cash

200

240

160

100

120

80

Debtors

400

500

650

100

125

163

450

600

Other

Current

750

100

133

167

Assets Total

Current 1,650 2,140 2,260

100

130

137

800 1,000 1,000

100

125

125

Buildings

1,600 2,000 2,400

100

125

150

Plant

2,000 2,000 2,400

100

100

120

Total Fixed Assets

4,400 5,000 5,800

100

114

132

Assets Fixed Assets: Land

LESSON-10 RATIO ANALYSIS

INTRODUCTION The financial statements viz. the income statement, the Balance sheet The Income statement, the Statement of retained earnings and the Statement of changes in financial position report what has actually happened to earnings during a specified period. The balance sheet presents a summary of financial position of the company at a given point of time. The statement of retained. earnings reconciles income earned during the year and any dividends distributed with the change in retained, earnings between the start and end of the financial. year under study. The statement of changes in financial position provides a summary of funds flow during the period of financial statements.

Ratio

analysis

is

a

very

powerful

analytical

tool

for

measuring

performance of an organisation. The ratio analysis concentrates on the interrelationship among the figures appearing in the aforementioned four financialstatements. The ratio analysis helps the management to analyse the past. performance of the firm and to make further projections. Ratio analysis allow 1interested parties like shareholders, investors, creditors, Government analysts to make an evaluation of certain aspects of a firm's performance.

Ratio analysis is a process of comparison of one figure against another, which make a ratio, and the appraisal of the ratios to make proper analysis about the strengths and weaknesses of the firm's operations. The calculation of ratios is a relatively easy and simple task but the proper analysis and interpretation of the ratios can be made only by the skilled analyst. While interpreting the financial information, the analyst has to be careful in limitations imposed by the ing concepts and methods of valuation.

Information of non-financial nature will also be taken into consideration before a meaningful analysis is made. Ratio analysis is extremely helpful in providing valuable insight into a company's financial picture. Ratios normally pinpoint a business strengths and weakness in two ways:



Ratios provide an easy way to compare today's 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 ratios

Long-Tenn Solvency Ratios The long-term financial stability of the firm may be considered as dependent upon its ability to meet all its liabilities, including those not current payable. The ratios which are important in measuring the 'ong-term solvency L as follows: 

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 Ratio

1. Debt-Equity Ratio: Capital is derived from two sources: shares and loans. It is quite hkely for only shares to be issued when the company is formed, but loans are invariably raised at some later date. There are numerous reasons for issuing loan capital. For instance, the owners might want to increase their investment but avoid the'risk which attaches to share capital, and they can do this by making a secured loan. Alternatively, management might require additional finance which the shareholders are 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 the capital structure :of the company. There are numerous ways of measuring gearing, but the debt-equity ratio is perhaps most commonly used.

Long - term debt Share holders funds This ratio indicates the relationship between loan funds and net worth of the company, which is known as gearing. If the proportion of debt to equity is low, a company is said to be low-geared, and vice versa. A debt equity ratio of 2:1 is the norm accepted by financial institutions for financing of projects. Higher debt-equity ratio may be permitted for highly capital intensive industries like petrochemicals, fertilizers, power etc. The higher the gearing, the more volatile the return to the shareholders.

The use of debt capital has direct implications for the profit accruing to the ordinary shareholders, and expansion is often financed in this manner with the objective of increasing the shareholders' rate of return. This objective is achieved only if the rate earned on the additional funds raised exceeds that payable to the providers of the loan.

The shareholders of a highly geared company reap disproportionate benefits when earnings before interest and tax increase. This is because interest payable on a large proportion of total finance remains unchanged. The converse is also true, and a highly geared company is likely to find itself in severe financial difficulties if it suffers a succession of trading losses. It is not possible to specify an optimal level of gearing for companies but, as a general rule, gearing should be low in those industries where demand is volatile and profits are subject to fluctuation.

A debt-equity ratio which shows a declining trend over the years is usually taken as a positive sigh reflecting on increased cash accrual and debt repayment. In fact, one of the indicators of a unit turning sick is a rising debtequity ratio. Usually in calculating the ratio, the preference share capital is excluded from debt, but if the ratio is to show effect of use of fixed interest sources on earnings available to the shareholders then it is to be included. On the other hand, if the ratio is to examine financial solvency, then preference shares shall form part of the capital.

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 shareholders' equity, the stronger is the financial position of the firm, This ratio will supplement the debt-equity ratio. In this ratio the relationship is established between the shareholders funds and the total assets. Shareholders funds represent both equity and preference capital plus reserves and surplus less losses. A reduction in shareholder's equity signaling the over dependence on outside sources for long-term financial needs and this carries the risk of higher levels of gearing. This ratio indicates the degree to which unsecured creditors are protected 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 firm i.e., the capital and free reserves less intangible assets. This ratio is finer than the debtequity ratio and includes capital which is invested in fictitious assets like deferred expenditure and carried forward tosses. This ratio would be of more interest to the contributories of long-term finance to the firm, as the ratio gives a S factual idea of the assets available to meet the long-term liabilities.

4. Capital Gearing Ratio : It is the proportion of fixed interest bearing funds to Equity shareholders, funds: Fixed int eresi bearing funds :

Equity Shareholder's funds The fixed interest bearing funds include debentures, long-term loans and preference share capital. The equity shareholders funds include equity share

capital, reserves and surplus. Capital gearing ratio indicates the degree of vulnerability of earnings available for equity shareholders. This ratio signals the firm which is operating on trading on equity. It also indicates the changes in benefits accruing to equity shareholders by changing the levels of fixed interest bearing funds in the organisation.

5. Fixed Assets to Long-term Funds Ratio : The fixed assets is shown as a proportion to long-term funds as follows:

Fixed Assets Long - term Funds

The ratio includes the proportion of long-term funds deployed in fixed assets. Fixed assets represents the gross fixed assets minus depreciation provided on this till the date of calculation. Long-term funds include share capital, reserves and surplus and long-term loans. The higher the ratio indicates the safer the funds available in case of liquidation. It also indicates the proportion of long-term funds that is invested in working capital.

6. Proprietor Ratio : It express the relationship between net worth and total asset

Net worth Total Assets

Net worth

= Equity Share Capital-t-Preference Share Capital+Fictitious Assets

Total Assets = Fixed Assets + Current Assets (excluding fictitious assets) Reserves earmarked specifically for a particular purpose should not be included in calculation of Net worth. A high proprietory ratio indicative of strong financial position of the business. The higher the ratio, the better it is.

7. Interest Cover: Profil before interest depreciationand tax Interest

The interest coverage ratio sLjws how many times interest charges are covered by funds that are available for payment of interest. An interest cover of 2:1 is considered reasonable by financial institutions. A very high ratio indicates that the firm is conservative in using 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 are covered by net profit his highlights the amount retained by a company for financing of future operations.

9. Debt Service Coverage Ratio : It indicates whether the business is earning sufficient profits to pay not only the interest charges, but also the instalments due to the 'principal' 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 the servicing ability of the organisation.

Short-term Solvency Ratios The short-term solvency ratios, which measure the liquidity of the firm and its liability of the firm and its ability to meet it- maturing short-term

obligations.

Liquidity is defined as the ability to realise value in money, the

most liquid of assets. It refers to the ability to pay in cash, the obligations that -are due.

The corporate liquidity has two dimensions viz., quantitative and qualitative concepts. The quantitative concept includes the quantum, structure and utilisation of liquid assets and in the qualitative concept, it is the ability to meet all present and potential demands on cash" from any source in a manner that minimizes cost and maximizes the value of the firm. Thus, corporate liquidity is, a vital factor in business - excess liquidity, though a guarantor of solvency would reflect lower profitability, deterioration in managerial efficiency, increased speculation and unjustified expansion, extension of too liberal credit and dividend policies. Too little liquidity then may lead to frustration' of-i business objectives, reduced rate of return, business opportunity missed and& weakening of morale.

The important ratios in measuring short-term solvency

are: (1) Current Ratio (2) Quick Rarip (3) Absolute Liquid Ratio

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 into cash within a year. Current liabilities and provisions are those liabilities that are payable within a year. A current ratio 2:1 indicates a highly solvent position. A current ratio 1.33:1 is considered by banks as the minimum acceptable level for providing

working capital finance. The constituents of the current assets are as important as the current assets themselves for evaluation of a company's solvency position, A very high current ratio will have adverse impact on the profitability of the organisation. A high current ratio may be due to the piling up of inventory, inefficiency in collection of debtors, high balances in Cash and Bank s without proper investment 2. Quick Ratio or Liquid Ratio:

Current Assets, Loans & Advances - Inventories

Current Liabilities & Provisions- Bank Overdraft

Quick ratio used as measure of the company's ability to meet its current obligations. Since bank overdraft is secured by the inventories, the other current assets must be sufficient to meet other current liabilities. A quick ratio of 1:1 indicates highly solvent position. This ratio is also called acid test ratio. This ratio serves as a supplement to the current ratio in analysing liquidity.

3. Absolute Liquid Ratio (Super Quick Ratio): It is the ratio of absolute liquid assets to quick liabilities. However, for calculation'purposes, it is taken as ratio of absolute liquid assets to current liabilities. Absolute liquid assets include cash in hand, cash at bank and short term or temporary investments.

Absolute Liquid Assets

Current Liabilities

Absolute Liquid Assets =Cash in Hand + Cash at Bank + Short term investments

The 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 its resources. These ratios are also called turnover ratios which involve comparison between the level of sales and investment in various s - inventories, debtors, fixed assets etc. activity ratios are used to measure the speed with which various s are converted into sales or cash. The following activity ratios are calculated for analysis:

1. Inventory :

A considerable amount of a company's capital may be tied up in the financing of raw materials, work-in-progress and finished goods. It is important to ensure that the level of stocks is kept a low as possible, consistent with the need to fulfill customer's orders in time.

Inventory Turnover Ratio =

Cost of goods sold Average Inventory

Sales Average Inventory

Average inventory =

Opening stock+Closing stock 2

The higher the stock turn over rate the lower the stock turnover period the better, although the ratios will vary between companies. For example, the stock turnover rate in a food retailing company must be higher than the rate in a manufacturing concern. The level of inventory in a company may be assessed by the use of the inventory ratio, 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 a company's inventory has been sold during the year. If the inventory turnover ratio has decreased from past, it means that either inventory is growing or sales are dropping. In addition to that, if a firm has a turnover that is slower than for its industry, then there may be obsolete goods on hand, or inventory stocks may be high. Low inventory turnover has impact on the liquidity of the business.

2. Debtors : The three main debtor ratios are as follows:

(1) Debtor Turnover Ratio Debtor turnover, which measures whether the amount of resources tied up in debtors is reasonable and whether the company has been efficient in converting debtors into cash. The formula is: Credit Sales Average Debtors The higher the ratio, the better the position.

(ii) Average Collection Period Average collection period, which measures how long it take to collect amounts from debtors. The formula is:

Average debtors

X 365

Credit Safes

The actual collection period can be compared with the stated credit of the company. If it is longer than those , then this indicates some insufficiency in the procedures for collecting debts.

(ii) Bad Debts Bad debts, which measures the proposition of bad debts to sales: Bad debts Sales This ratio indicates the efficiency of the credit control procedures of the company. Its level will depend on the type of business. Mail order-companies have to accept a fairly high level of bad debts, white retailing organisations should maintain very low levels or, if they do not allow credit s, none at all. The actual ratio is compared with the target or norm to decide whether or not it is acceptabie.

3. Creditors: (i) Creditors Turnover Period The measurement of the creditor turnover period shows the average time taken to pay for goods and services purchased by the company. 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 company are being financed interest free by, suppliers of funds. But there will be a point beyond which-delays in payment will damage relationships with suppliers which, if they are operating in a seller's market, may harm the company. If too long a period is taken to pay creditors, the credit rating of the company may suffer, thereby making it more difficult 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 company's ability to generate sales revenue in relation to the size of the asset investment A low asset turnover may be remedied by increasing sales or by disposing of certain assets or both. To assist in establishing which part of the asset structure is not being used efficiently, the asset turnover ratio should be sub-analysed.

(i) Fixed Assets Turnover Ratio Sales Fixed assets This ratio will be analysed further with ratios for each main category of asset This is a difficult set of ratios to interpret as asset values are based on historic cost An increase in the fixed asset figure may result from the replacement of an asset at an increased price or the purchase of an additional asset intended to increase production capacity. The later transaction might be expected to result in increased sales whereas the former would more probably be reflected in reduced operating costs.

The ratio of the accumulated depreciation provision to the total of fixed assets at cost might be used as an indicator of the average age of the assets; particularly when depreciation rates are noted in the s.

The ratio of sales value per share foot of floor space occupied is particularly significant, for trading concerns, such as a wholesale warehouse or a department store.

(ii) Total Assets Turnover Ratio This ratio indicates the number of times total assets are being turned over in a year. Sales Total assets The higher the ratio indicates overtrading of total assets while a low ratio indicates idle capacity.

5. Working Capital Turnover Ratio : This ratio is calculated as follows: Sales Working capital This ratio indicates the extent of working capital turned over in achieving 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 employed in generating revenue.

Profitability Ratios The purpose of study and analysis of profitability ratios are to help assess the adequacy of profits earned by the company and also to discover whether

profitability is increasing or declining. The profitability of the firm is the net result of a large number of policies and decisions. The profitability ratios are measured with reference to sales, capital employed, total assets employed; shareholders funds etc. The major profitability rates are as follows: (a) Return on capital employed (or Return on investment) [ROI or 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 (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 on capital. If in any particular case, the return in the long-run is not satisfactory, then the deficiency should be corrected or the activity be abandoned for a more favourable one. Measuring the historical performance of an investment center calls for a comparison of the profit that has been earned with capital employed. The rate of return on investment is determined by dividing net profit or income by the capital 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 improved by increasing one or both of its components viz., the profit margin and the investment turnover in any of the following ways: 

Increasing the profit margin



Increasing the investment turnover, or



Increasing both profit margin and investment turnover

The obvious generalisations that can be made about the ROI formula are that any action is beneficial provided that it: 

Boosts sales



Reduces invested capital



Reduces costs (while holding the other two factors constant)

Table-1: Computation of Capital Employed Share capital of the company Reserves and surplus Loans (secured/ unsecured) Less: (a) Capital-in-progress (b) Investment outside the business

xxx xxx

(c) Preliminary expenses (d) Debit balance of Profit and Loss

xxx

A/c Capital employed

xxx xxx xxx xxx

xxx

xxx

Return on in vestment analysis provides a strong incentive for optimal utilisation of these assets of the company. This encourages mangers to obtain, assets that will provide a satisfactory return on investment and to dispose of assets that are not providing an acceptable return. In selecting amongst alternative long-term investment proposals, ROI provides a suitable measure for assessment of profitability of each proposal.

2. Earnings Per Share (EPS): The objective of financial Management is wealth or value maximisation of a corporate entity. The value is maximized when market price of equity shares is maximised. The use of the objective of wealth maximisation or net present value maximisation has been advocated as an appropriate and operationally feasible criterion to choose among the alternative financial actions. In practice, the performance of a corporation Is better judged in of its earnings per share (EPS). The EPS is one of the important measures of economic performance of a corporate entity. The flow of capital to the companies under the present imperfect capital market conditions woold be made on the evaluation of EPS. Investors lacking inside and detailed information would look upon the EPS as the best base to lake their investment decisions. A higher EPS means better capital productivity.

EPS = Net Profit after tax and preference dividend No. of Equity Shares I EPS when Debt and Equity used =

(EBIT – 1) (1 – T) N

II. 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 net profit earned per share. EPS is one of the major factors affecting the dividend policy of the firm and the market prices of the company. Growth in EPS is more relevant for pricing of shares from absolute EPS. A steady growth in EPS year after year indicates a good track of profitability.

3. Cash Earnings Per Share : The cash earnings per share (Cash EPS is calculated by dividing the 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 of performance of companies, especially for highly capital intensive industries where provision for depreciation is substantial. This measures the cash earnings per share and is also a relevant factor for determining the price for the company's shares.

However, this method is not as popular as EPS and is used as a supplementary measure of performance 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 sales made by the company. The grosi, profit represents the excess of sales proceeds during the

1 period

under

observation

over

their

cost,

before

taking

istration, selling and distribution and financing charges.

into The

ratio . measures the efficiency of the company's operations and this can also be ; compared with the previous years results to ascertain the efficiency partners with respect to the previous years.

When everything normal, the gross profit margin should remain unchanged, irrespective of the level of production and sales, since it is based on the assumption that all costs deducted when computing gross profit which are directly variable with sales. A stable gross profit margin is therefore, the norm and any variation from it call for careful investigations, which may be caused; due to the following reasons:

(i)

Price cuts:

A company need to reduce its selling price to achieve the

desired increase in sales.

(ii)

Cost increases: The price which a company pay its suppliers during period of inflation, is likely to rise and this reduces the gross profit margin

unless

an appropriate adjustment is made to the selling price.

(iii)

Change in mix: A change in the range or mix of products sold causes the overall gross profit margin assuming individual product lines earn

different (iv)

gross profit percentages.

Under or Over-valuation of stocks. If closing stocks are under-valued, cost of goods sold is inflated and profit

understated. An incorrect valuation may be the result of an error during stock taking or it may be due to fraud The gross profit margin may be compared with that of competitors in the industry to assess the operational performance relative to the other players in the industry.

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 margin arising from business operations before interest and tax is deducted. The convention is to express profit after tax and interest as a percentage of sales. A drawback is that the percentage which results, varies depending on the sources employed to finance business activity; interest is charged 'above the line while dividends are deducted '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 after deducting all expenses but before deducting interest and taxation. This ratio measures the efficiency of operation of the company. The net profit is arrived at from gross profit after deducting istration, selling and distribution expenses. The non-operating incomes and expenses are ignored in computation of net profit before tax, depreciation and interest

This ratio could be compared with that of the previous year's and with that of competitors to determine the trend in net profit margins of the company and its performance in the industry. This measure will depict the correct trend of performance where there are erratic fluctuations in the tax provisions from year to year. It is to be observed that majority of the costs debited to the profit and loss are fixed in nature and any increase in sales will cause the cost per unit to decline because of the spread of same fixed cost over the increased number of units sold.

6. Cash Profit Ratio Cash profit X 100 Sales

Where Cash profit = Net profits Depreciation Cash profit ratio measures the cash generation in the business as a result of trie operations expressed in of sales. The cash profit ratio is a more reliable indicator of performance where there are sharp fluctuations in the profit before tax and net profit from year to year owing to difference in depreciation charged. Cash profit ratio eva)'iates the efficiency of operations in of cash generation and is not affected y the method of depreciation charged. It also facilitate the inter-firm comparison of performance since different methods of depreciation may be adopted by different companies.

7. Return on Assets : This ratio is calculated as follows:

Net profit after tax

X 100

Total assets The profitability, of the firm is measured by establishing relation of net profit with the total assets of the organisation. This ratio indicates the efficiency of utilisation of assets in generating revenue.

8. Return on Shareholders Funds or Return on Net Worth Net profit after interest and taxX 100 Net worth

Where, Net worth = Equity capital + Reserves and Surplus.

This ratio expresses (he nel profit in Icrms of the equity shareholders funds. This ratio is an important yardstick of performance of equity shareholders since it indicates the return on the funds employed by them. However, this measure is based on the historical net worth and will be high for old plants and low for new plants.

The factor which motivates shareholders to invest in a company is the expectation of an adequate rate of return on their funds and periodically, they will want to assess the rate of return earned in order to decide whether to continue with their investment. There are various factors of measuring the return including the earnings yield and dividend yield which are examined at later stage. This ratio is useful in measuring the rate of return as a percentage of the book value of shareholders equity.

The further modification of this ratio is made by considering the profitability from equity shareholders point of view can also be worked out by taking the profits after preference dividend and comparing against capital employed after deducting both long-term loans and preference capital.

Operating Ratios The ratios of all operating expenses (i.e. materials used, labour, factoryoverheads, istration and selling expenses) to sales is the operating ratio. A

comparison of the operating ratio would indicate whether the cost content is high or low in the figure of sales. If the annual comparison shows that the sales has increased the management would be naturally interested and concerned to know as to which element of the cost has gone up. It is not necessary that the management should be concerned only when the operating ratio goes up. If the operating ratio has fallen, though the unit selling price has remained the same, still the position needs analysis as it may be the sum total of efficiency in certain departments and inefficiency in others, A dynamic management should be interested in making a complete analysis. It is, therefore, necessary to break-up the operating ratio into various cost ratios. The major components of cost are: Material, labour and overheads. Therefore, it is worthwhile to classify the cost ratio as:

1.

Materials Cost Ratio

= MaterialsConsumed X 100 Sales

2.

Labour Cost Ratio

X 100 = Labour Cost Sales Sales

3.

Factory Overhead Ratio

X 100 = Factory Expenses Sales

4.

istrative Expense Ratio

X 100 = istrative Expenses Sales

5.

Selling and distribution expenses ratio

= Selling and Distribution Expenses X 100 Sales

Generally all these ratios are expressed in of percentage. Then total up all the operating ratios. This is deducted from 100 will be equal to the net profit

ratio. If possible, the total expenditure for effecting sales should be divided into two categories, viz. Fixed and variable and then ratios should be worked out. The ratio of variable expenses to sales will be generally constant; that of fixed expenses should fall if sales increase, it will increase if sales fall.

Market Test Ratios The market test ratios relates the firm's stock price to its earnings and book value per share. These ratios give management an indication of what investors think of the company's past performance and future prospectus. If firm's profitability, solvency and turnover ratios are good, then the market test ratios will be high and its share price 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 ratio

;

1. Dividend Payout Ratio: Dividend per share Earnings per share

Dividend payout ratio is the dividend per share divided by the earnings per share. Dividend payout indicates the extent of the net profits distributed to the shareholders as dividend. A high payout signifies a liberal distribution policy and a low payout reflects conservative distribution policy.

2. Dividend Yield Dividend per share Market price

X 100

This ratio reflects the percentage yield that an investor receives on this investment at the current market price of the shares. This measure is useful for investors who are interested in yield per share rather than capital appreciation.

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 book value is a reflection of the past earnings and the distribution policy of the company. A high book value indicates that a company has huge reserves and is a potential bonus candidate. A low book value signifies liberal distribution policy of bonus and dividends, or alternatively, a poor track record of profitability. Book value is considered less relevant for the m^ker price as compared to EPS, as it reflects the past record whereas the market discounts the future prospects.

4. Price Earnings Ratio (P/E Ratio):

Current market price Earnings per share

This ratios measures the number of times the earnings of the latest year at which the share price of a company is quoted.

It signifies the number of

years, in which the earnings can equal to current market price. This ratio reflects the market's assessment of the future earnings potential of the company. A high P/e ratio reflects earnings potential and a low P/E ratio low earnings potential. The P/E ratio reflects the market's confidence in the company's equity. P/e ratio is a barometer of the market sentiment Companies with excellent track record of profitability, professional management and liberal distribution policy have high P/E ratios whereas companies with moderate

track record, conservative distribution policy and average prospects quote a low P/E ratios.

The market price discounts the expected earnings of a

company for the current year as opposed to the historical EPS.

LIMITATIONS IN THE USE OF RATIO ANALYSIS Ratios by themselves mean nothing.

They must always be compared

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 : 

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.



Financial statements do not represent a complete picture of the business, but merely a collection of facts which can be expressed in monetary . 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

(d)

Fixed assets to Net worth ratio Balance Sheet Liability

Share Capital Reserve Profit and Loss a/c Secured Loans Creditors Provisions for taxation

Rs. 1,00,000 20,000 30,000 80,000 50,000 20,000

Assets Goodwill Fixed assets (Cost) Stock Debtors Advances Cash

3,00,000 Solution: (a) Debt-equity ratio =

Outsiders Funds

Rs. 60,000 1,40,000 30,000 30,000 10,000 30,000 3,00,000

Shareholders Funds

Outsider's Funds

Rs.

Shareholders'

Rs.

Secured Loans

Funds 80,000 Share Capital

Creditors

50,000 Reserves

20,000

Provisions for taxation

20,000 Profit and Loss a/c

30,000

1,00,000

1,50,000

1,50,000

Debt-equity ratio = 1,50,000= 1:1 1,50,000

(b) Liquid ratio = Liquid Assets Current Liabilities

Note: Advances are treated as current asset. Secured Joans are treated as current liability. Liquid ratio =

70,000 = 0.47:1 1,50,000

(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 1,00,000

Fixed 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

Share Capital Reserves P & L a/c

1,00,000 20,000 30,000 1,50,000 20,000 1,30,000

Less: Provision for taxation

1,40,000

Fixed Assets to Net worth ratio =

1,30,000

= 1.08:1

Illustration 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 Equity Capital shares) Profit

Rs. Share

(Rs.

and

10

loss

Creditors Bills payable

Assets

1,00,000 Plant

Rs. and

6,40,000

Machinery

3,68,000 Land and buildings

1,04,000 Cash 2,00,000 Debtors

80,000

1, 60,000

3,60,000 Less: Provision for bad

Other

Current

40,000 20,000 Stock

3,20,000

debts

4,80,000

liabilities Prepaid Insurance 16,92,000

12,000 16,92,000

Income Statement for the year ending 31st Dec., 2001 (Rs.) Sales Less: Cost of goods sold

4,00,000 30,80,000 9,20,000 6,80,000 2,40,000 1,20.000 1,20,000

Less: Operating expenses Net Profit Less: Income tax paid 50% New Profit after tax Balances at the beginning of the year: Debtors

Rs. 3,00,000

Stock

Rs. 4,00,000

Solution: (a) Current ratio =

Current Assets Current Liabilities

Current Assets

Rs.

Current Liabilities

Cash

Creditors

Rs. 1,04,000

Debtors

3,20,000 Bills Payable

Stock

4,80,000 Other

2,00,000 Current

20,000

Liabilities Prepaid insurance

12,000 9,72,000

Current ratio

=

(b) Quick ratio =

Liquid Assets

3,24,000

9,72,000 3:1 3,24,000

Current Liabilities

Liquid assets

(Rs.)

Cash Debtors

Current liabilities Rs.3,24,000

1,60,000 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 = 30,80,000 Average Stock

=

Opening Stock + Closing Stock 2 = 4,00,000 + 4,80,000 = 4,40,000 2

Stock Turnover Ratio = 3,80,000

= 7 times

4,40,000

(d) Operating Ratio =

Cost of goods sold + Operating expresses X 100 Net Sales = 94%

X 100 = 30,80,000 + 6,80,000 + 40,00,000 40,00,000

(e) Rate of return on equity capital: = Net profit afer lax Equity share capital

=

1,20,000

= 12%

X 100

10,00,000

Illustration 3: The following are the Trading and P&L A/c for the year ended 31st December 2001 and the Balance Sheet as on that date of K. Ltd. Trading and P & L A/c

Particulars To Opening Stock To Purchases To Wages

Particulars

9,950 By Sales 54,5.25 By Closing Stock

Rs. 85,000 14,900

1,425

To Gross Profit To

Rs.

istrative

34,000 99,900

99,900

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 To Loss on sale of assets To Net Profit

400 15,000

34,900

34,900

Balance Sheet Liabilities

Rs.

Share Capital

Assets

20,000 Land and Buildings

Reserves

9,000 Plant & Machinery

Current Liabilities

13,000 Stock

P&LA/c

Rs. 15,000 8,000 14,900

6,000 Debtors

7,1000

Cash at Bank 48,000

3,000 48,000

You are required to Calculate; (a) Current Ratio (b) Operating Ratio (c) Stock Turnover Ratio (d) Net Profit Ratio (e) Fixed Assets Turnover Ratio

Solution: (a) Current ratio

=

Current Assets Current Liabilities

Current Assets Cash at Bank Current liabilities Debtors Stock

(Rs.) 3,000 Rs. 13,000 7,100 14,900 25,000 Rs. 1.923:1

Current ratio

= 25,000 13,000

(b) Operating Ratio =

Cost of goods sold + Operating expresses X 100 Net Sales

Cost of goods sold = 9,950 + 54,525 + 1,425 - 14,900

Operating expenses Operating Ratio

= 51,000

= 19,500

= 51,000 + 19,500

= 82.94%

X 100

85,000

(c) Stock Turnover Ratio = Cost of goods sold Average stock Average Stock =

9,950 + 14,900

= 12,425

2

Stock Turnover Ratio =

51,000

= 4.1 times

12,425

(d) Net Profit Ratio =

Net Profit

= 100

Net Sales

= 15,000

= 17.65%

= 100

85,000

(e) Fixed Assets Turnover Ratio

= Net Sales Fixed Assets = 85,000

= 3.7 times

23,000

Illustration 4; The following is the Trading and Profit and Loss a/c and Balance Sheet of a firm.

Trading and P & L A/c Particulars

Rs.

Particulars

To Opening Stock

10,000 By Sales

To Purchases

55,000 By Closing Stock

To Gross Profit c/d

50,000 1,15,000

To istrative Expenses

1,00,000 15,000 1,15,000

15,000 By Gross Profit b/d

To Interest

Rs.

50,000

3,000

To Selling Expenses

12,000

To Net Profit

20,000 50,000

50,000

Balance Sheet Liabilities Capital

Rs.

Assets

Rs.

1,00,000 Land and Buildings

50,000

Profit and Loss a/c

20,000 Plant & Machinery

30,000

Creditors

25,000 Stock

15,000

Bills Payable

15,000 Debtors

15,000

1,60,000 Calculate the following ratios: (a) Inventory turnover ratio (b) Current Ratio

Bills receivable

12,500

Cash at Bank

17,500

Furniture

20,000 1,60,000

(c) Gross profit ratio (d) Net profit ratio (e) Operating ratio (f) Liquidity ratio (g) Proprietary ratio Solution: = Cost of goods sold

(a) Inventory Turnover ratio

Average stock Cost of goods sold Opening Stock Purchases

10,000 55,000 65,000 1 5,000 50,000

Less: Closing Stock

Average 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 Liabilities

Current Assets Current Assets

(Rs.) 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 60,000

40,000

Current 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%

= 20,000 1,00,000

(d) Operating Profit = Cost of goods sold + Operating expresses

= 100

Net Sales Cost of goods sold = 50,000 Operating expenses

(Rs.)

istration expenses Selling expenses

15,000 12,000 27,000

Operating ratio

= 50,000 + 27,000 X 100

77 %

1,00,000

(e) Liquidity ratio = Liquid Assets Current Liabilities Current Assets Liquid Assets Cash at Bank Bills Receivable Debtors

(Rs.) Rs.

Current liabilities

17,500 Creditors 12,500 Bills Payable 15,000 45,000

Rs. 25,000 15,000 40,000

Liquidity ratio = 45,000 40,000

(f) Proprietary ratio = Shareholder’s Funds

X 100

Total Assets Shareholder's Furuis

(Rs.)

Capital Profit and Loss a/c Total Assets

1,00,000 Rs. 1,60,000 20,000 1,20,000

Proprietary ratio = 1,20,000

= 75%

X 100

1,60.000

Illustration 5: A company has a profit margin of 20% and asset turnover of 3 times. What is the company's 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 asset turnover on return on investment

Return on investment

= Profit Margin x Asset Turnover = 20% x 3 times

(i)

If profit margin is increased by 5% : ROI = 25% x 3

= 75%

(ii) If asset turnover is decreased to 2 times:

= 60%

ROI = 20% x 2

= 40%

(iii) If profit margin decreased, by 5% and asset turnover is increased to 4 times: ROI

= 15% x 4

= 60%

Illustration 6: There are three companies in the country manufacturing a particular chemical. Following data are available for the year 2000-2001. (Rs. lakhs) Company

Net Sales

Operating Cost Operating Assets

A Ltd.

300

255

125

B Ltd.

1,500

1,200

750

C Ltd.

1,400

1,050

1,250

Which is the best performer as per your assessment and why? Comparative Statement of Performance Particulars Sales Less: Operating Cost OperatingProfit (A) Operating Assets (B) Return on capital employed

A Ltd. 300 255 45 125 36%

B Ltd. 1,500 1,200 300 750 40%

C Ltd. 1,400 1,050 350 1,250 28%

(A) / (B) x 1 00 Analysis: Basing on the return on capital employed, B 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) Reserves and Surplus Secured Loans at 15% Unsecured Loans at 12.5% Fixed Assets Investments

50,00,000 5,00,000 25,00,000 10,00,000 30,00,000 5,00,000

Operating Profit

25,00,000,

Income-taxRate50%

(Rs.)

Ltd., is the best

Operating Profit Less: Interest on Secured Loans @ 15%

25,00,000 3,75,000

Unsecured Loans @ 12.5% Profit before tax (PBT) Less: Income-tax @ 50% Profit aaer tax (PAT)

1,25,000

No. of Equity shares EPS

=

5,00,000 20,00,000 10,00,000 10,00,000 2,50,000

Profit after tax No. of Equity shares

=

Rs. 10,00,000

= Rs. 4

Rs. 2,50,000

Market price per share

= Rs. 50

P/E Ratio

= Market price per share / EPS = Rs.50/Rs.4

= 12.50

Illustration 8: The capital of Growfast Co. Ltd., is as follows:

10% Preference shares of Rs.10 each Equity shares of Rs. 100 each

50,00,000 70,00,000 1,20,00,000

Additional information: Profit after tax at 50%

Rs. 15,00,000

Deprication

Rs. 6,00,000

Equity dividend paid

10%

Market price per equity share Rs. 200

Calculate 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 flow

Solution: (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:

= 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

LESSON-II FUNDS FLOW ANALYSIS

INTRODUCTION The Profit and Loss and Balance Sheet statements are the common important ing statements of a business organisation. The Profit and Loss provides financial information relating to only a limited range of financial transactions entered into during an ing period and which have impact on the profits to be reported. The Balance Sheet contains information relating to capital or debt raised or assets purchased. But both the above two statements do not contain sufficiently wide range of information to make assessment of organization by the end of the information.

FUNDS FLOW ANALYSIS In view of recognised importance of capital inflows and outflows, which often involve large amounts of money should be reported to the stakeholders, the funds flow statement is devised. This statement is also called 'Statement of Sources and application of funds' and 'Statement of changes in financial position'.

The Funds flow statement contain all the details of the financial resources which have became available during an ing period and the ways in which those resources have been used up. This statement discloses the amounts raised from various sources of finance during a period and. then explains how that finance has been used in the business. This statement is valuable in interpretation of the s.

It is a very useful tool in analysis of finrncial statements which analyses the changes taking place between two balance sheet dates. The statement analyses the change between the opening and closing balance 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 assets acquired, by the use of those funds. A funds flow statement analyses the changes which have taken place in the assets and liabilities during certain period as disclosed by a comparison of the opening and closing balance sheets.

Concept of'Fund’

The term ‘fund’, has been defined and interpreted differently by different experts. Broadly, the term 'fund' refers to all the financial resources of the company. However, the most acceptable meaning of the ‘fund’ is 'working capital'. Working Capital is the excess of Current Assets over Current fi Liabilities. While attempting to understand the concept of funds Flow Analysis! & we shali also abide by the popular definition of funds, meaning working capital.

Concept of Flow The ‘flow’ of funds refer to transfer of economic values from one asset equity to another. When 'funds' mean working capital, flow of funds refers to movement of funds which cause a change in working capital of the organisation. To identify a 'flow' of funds, we have to understand the difference between ‘Current’ and ‘Non-Current’

CLASSIFICATION OF BALANCE SHEET ITEMS

For preparation of funds flow statement, the whole iterrs of the sheet is classified into the following four categories as shown in Table

Table 1: CLASSIFICATION OF BALANCE SHEET ITEMS

Liabilities 1. Non-Current Liabilities Equity Share Capital Preference Share Capital Reserves and Surplus Debentures Long-term loans

Rs.

XXX XXX XXX XXX

Non-Current Liabilities

Assets II. Non-Current Assets Land Buildings Plant and Machinery Less: Depreciation Furniture and Fittings

Rs. XXX XXX XXX

Vehicles Patents

XXX XXX

XXX

II. Non-Current Assets Trade Marks

XXX

Goodwill

XXX

Preliminary expenses

XXX

Profit and Loss A/c (Debit

XXX

balance) Total (A)

XXX

III. Current Liabilities

Total (A)

XXX

Total (A)

XXX

IV. Current Assets

Trade Creditors

XXX

Inventories

XXX

Bank Overdraft

XXX

Trade Debtors

XXX

Bills Payable Provisions

XXX

Bills Receivable

XXX

against current liabilities

XXX

Cash and Bank Balances

XXX

Loans and Advances

XXX

Investments Temporary)

XXX

Total (B) Grand Total (A+B)

XXX XXX

Total (B) Grand Total (A+B)

XXX XXX

The excess of current assets over current liabilities is called working capital. The excess of funds generated over funds outgo from non-current assets

and non-current liabilities will lead to increase or decrease in working capital. This can further be analysed into increase or decrease in respective current assets and current liabilities.

IDENTIFICATION OF 'FLOW OF FUNDS

A 'flow' of funds takes place only if a Current is involved. To identify a flow, journalise the transaction, identify the two s involved as 'Current' and 'Non-Current' and apply the General Rule.

General Rule 

Transactions which involve only Current s do not result in a flow.



Transactions which involve only Non-Current s do not result in a flow.



Transactions which involve one Current and one Non-Current results in a flow of funds.

Proformas of Funds Flow Statement

The relationship between sources and application of funds and its impact j on working capital is explained in the format of Statement of Sources and Application of Funds given in Tables 2 and 3.

Table 2: PROFORMA OF STATEMENT OF SOURCES AND APPLICATION OF FUNDS Stage 1: Statement of Sources and Application of Funds of XYZ Ltd., for the year ended 31st March, 2001.

Fund from Operations Issue of Share Capital Raising of long-term loans Receipts from partly paid shares, called up Sales of non-current (fixed) assets Non-trading receipts, such as dividends received Sale of Investments (long-term) Decrease in Working Capital (as per schedule of

Rs. xxx xxx xxx xxx xxx xxx xxx xxx

changes in w.c) Total

Application or Uses of Funds: Funds Lost in Operations Redemption of Preference Share Capital Redemption of Debentures Repayment of long-term loans

xxx

xxx xxx xxx xxx

Purchase of non-current investments Non-trading payments Payments of dividends Payment of tax Increase in Working Capital (as per schedule of

xxx xxx xxx xxx xxx

changes in w.c) Total

xxx

The funds flow statement can also be presented in a vertical form, wherein all Sources are listed down, totaled and then all Applications are listed at one place and totaled. The totals should be the same, the difference being the Increase or Decrease in Working Capital. However, the Horizontal format is more commonly used.

Table 3: FORM OF FUNDS FLOW STATEMENT Funds Flow Statement of XYZ Ltd., for the year ended 31" March, 2001

Sources

Rs.

Applications

Rs.

Funds from Operations

xxx Funds lost in Operations

Issue of Share Capital

xxx Redemption of Preference , Share xxx

Issue of Debentures

capital xxx Redemption of Debentures:

Raising

of

long-term xxx Repayment of long-term loans

xxx

xxx xxx

loans Receipts from partly paid xxx Purchase of non-current (fixed) xxx shares, called up assets Sale of non-current xxx Purchase

of

long-term xxx

(fixed) assets : Non-trading

of

long-term xxx

Investments receipts xxx Purchase

such as dividends investments Sale of long-term xxx Payment of Dividends

xxx

Investments Net Decrease in Working xxx Payment of tax*

xxx

Capital Net Increase in Working Capital

xxx

xxx

xxx

*Note: Payment of dividend and tax will appear as an application of funds only when these items are appropriations of profits and not current liabilities.

STATEMENT OF CHANGES IN WORKING CAPITAL This statement follows the Statement of Sources and Application, of Funds.

The primary purpose of the statement is to explain the net change in

Working Capital, as arrived in Funds Flow Statement.

In this statement, all

Current Assets and Current Liabilities are individually listed.

Against each of

, the figure pertaining to that at the beginning and at the end of the ing period is shown.

The net change in its position is also shown.

The changes taking place with respect to each should add up to equal the ; net change in working capital, as shown by the Funds 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-term funds raised during the period by any increase in the current liabilities like trade creditors, bank overdraft and tax dues, means that these sources have lent more at the end of the year than at the beginning.

STATEMENT OF CHANGES IN WORKING CAPITAL

Table 4: PROFORMA OF STATEMENT OF ANALYSIS OF CHANGES IN WORKING CAPITAL

The 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 ing period, and the ways in which working capital has been used up, i.e. list the transactions which cause working capital to increase or decrease

Stage IIl :

Analyse the net increase or decrease in working capital into changes in the constituent items i.e. stock, debtors, creditors and cash

The basic rules in preparation of the funds flow statement is as follows: 

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.



An increase in a liability over the year is a source of funds.

SOURCES OF FUNDS The funds inflow into the organisation will come from the following sources:

Funds Generated from Operations

During the course of trading activity; a company generates revenue" mainly in the form of sale proceeds and paid out for costs.

The difference

between these two items will be the amount of funds generated by the trading operations.

The funds generated from business operations are aruved at after

making the following adjustments:

Table 5: PROFORMA FOR COMPUTATION OF FUNDS GENERATED FROM OPERATIONS Funds from operations can also be calculated by preparing Adjusted Profit and Loss as follows:

ADJUSTED PROFIT AND LOSS

Table 6: PROFORMA OF ADJUSTED PROFIT AND LOSS Notes : 

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 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 longterm, investments) is adjusted to arrive at the true funds from operations.



The provision for tax made in the profit and loss 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 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 year by issue of new shares or debentures and by raising long-term loans. If any is collected, that is also form part of funds raised from the above said sources of finance.

Sale of Fixed Assets and Long-term Investments

Any amount generated from sale of fixed assets or long-term investments is a source of funds. While preparation of the funds flow statement the gross sale proceeds from sale is taken as source of funds. This activity does not produce fresh funds, but it releases funds used to finance the assets. Any profit or loss arising from such sale is adjusted in the funds generated from operations.

APPLICATION OF FUNDS

The use of funds in an organisation take place in the following forms:

1.

Repayment of Preference Capital or Debentures or Long-term Debt: This represents the application of organisation's 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 longterm investments outside the business.

3.

Distribution of Dividends distributed to

the

and Payment of Taxes: The

dividends

shareholders and tax paid during the year is the

application of funds for the firm.

4.

Loss from Operations: Losses made in the trading activities use up th e 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 the following Profit and Loss A/c.

Calculation of funds from operations

Illustration 2: From the following Manufacturing, Trading and Profit & Loss of a company, calculate Funds from operations. Manufacturing, Trading, Profit & Loss Appropriation A/c

The amount Rs. 35,000 is transferred to Adjusted Profit and Loss a/c and the tax paid Rs.25,000 is shown on the applications side of the Funds Flow Statement

Illustration 4: Following are the extracts from the Balance Sheets of {a; company-on two different dates

Particulars

31-3-2000 Rs. 50,000 10,000 5,000

P&L A/c Provision for Taxation Proposed Dividends

31-23-2001 Rs. 80,000 15,000 10,000

Additional Information 1)

Tax Paid during the year 2000 – 2001

Rs. 2,500

2)

Dividends paid for the period 2000- 2001 Rs. 1,000

On the basis of the above information, calculate ‘Funds from Operations’ 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-current liabilities Provision for Taxation A/c

Particulars To Income Tax A/c (tax paid|) To Balance c/d

Rs. Particulars 2,500 By balance b/d (opening balance) 15,000 By P&L A/c (provision

(closing balance)

Rs. 10,000

7,500

made in the current year) [bal.fig.] 17,500

17,500

Particulars To Dividend A/c

Rs. Particulars 1,000 By Balance b/d

(being dividend paid during the year) To balance c/d

Rs. 5,000

(Opening balance)

10,000 By P&L A/c (Proposed

(closing balance

6,000

dividend for the current 11,000

11,000

Adjusted P & L A/c Particulars To Provision for

Rs. Particulars 7,500 By Balance b/d

Taxation

Rs. 50,000

(opening balance)

A/c To proposed Dividend

6,000 By Funds from

43,500

Operations (bal. fig.) To Balance c/d

80,000

(closing balance 93,500

93,500

Illustration 5: The following information has been extracted from the Balance Sheets of a company Particulars Machinery Accumulated Depreciation Profit and Loss

31st Dec. 2000 80,000 30,000 25,000

31st Dec. 2001 2,00,000 35,000 40,000

The following additional information is also available: (i)

A machine costing Rs. 20,000 was purchased during the year by issue of equity shares.

(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 To Machinery A/c To Balance c/d

Rs. Particulars 5,000 By Balance b/d 35,000 By Adjusted P&L A/C

Rs. 30,000 10,000

(balancing figure) 40,000

40,000

Machinery A/c Particulars To Balance b/d To Share Capital

Rs. Particulars 80,000 By cash (sales) 20,000 By Accumulated

Rs. 7,000 5,000

depreciation 1,15,000 By Adjusted P & L A/c

To Cash-Purchases (balancing figure)

(Loss on sale) By Balance c/d

3,000

2,00,000 2,15,000

2,15,000 Accumulated Depreciation A/c Particulars To Accumulated Depreciation A/c To Machinery A/c (Loss on sale) To Balance c/d

Rs.

Particulars

Rs.

10,000 By Balance b/d

3,000 By

Funds

25,000

from

Operations (bal. fig.) 40,000 53,000

(i)

28,000

53,000

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 to ascertain the amount of flow of funds on of Plant.

Opening Balance of Plant Closing Balance of Plant Provision for Depreciation on Plant at the beginning

Rs. 1,32,500 1,97,500 45,000

of the year Provision for Depreciation on Plant at the end of the

61,000

year During the year, a plant costing Rs. 65,000 was purchased in exchange for fully paid debentures. An old Plant costing Rs. 40,000 was sold for Rs.34,000. Depreciation provided on the same amounted to Rs.18,000.

Accumulated Deprecation A/c

Particulars To Machinery A/c

Rs.

Particulars

Rs.

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

4,51,000

Illustration 8 : Extracts from Balance Sheets Particulars

As on 31st

As on 31st March

March,

2001

2000

Equity from Balance Sheets 8% Preference Share Capital

Rs. 4,00,000 2,00,000

Rs. 5,00,000 1,50,000

Additional 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 s to find out sources/applications of funds.

Equity Share Capital A/c

Particulars

Rs.

To Machinery A/c

Particulars

40,000 By Balance b/d

Rs. 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

4,51,000

Equity Share Capital A/c Particulars To Balance c/d

Rs.

Particulars

5,00,000 By Balance b/d

Rs. 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

To cash (Application)

1,00,000 By Balance b/d

To Balance c/d

1,50,000 By Cash-Issue (balancing

Rs. 2,00,000 50,000

figure) 2,50,000 1.

2,50,000

Issue of equity shares purchase of machinery is neither a source nor application of funds.

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

Assets Cash Debtors Stock Land Total Capital & Liabilities Share Capital Creditors Retained earnings Total

2001

60,000 2,40,000 1,60,000 1,00,000 5,60,000

94,000 2,30,000 1,80,000 1,32,000 6,36,000

4,00,000 1,40,000 20,000 5,60,000

5,00,000 90,000 46,000 6,36,000

Statement showing changes in working capital

Particulars

Current Assets Cash Debtors Stock

2000

60,000 2,40,000 1,60,000 4,60,000

Current Liabilities Creditors Working Capital (CACL) Net increase in

2001

Increase

Decrease

(+)

(-)

94,000 2,30,000 1,80,000 5,04,000

1,40,000 3,20,000

90,000 4,14,000

34,000 10,000 20,000

50,000

94,000

94,000

Working Capital 4,14,000

4,14,000

1,04,000

1,04,000

Illustration 10 : Following are summerised Balance Sheets ‘X’ Ltd. as on 31 st December, 2000 and 2001. You are required to prepare a Funds Statement for the year ended 31st December, 2001.

Liabilities

2000

2001

Assets

2000

2001

1,00,000

1,25,000

Goodwill

-

2,500

General Reserve

25,000

30,000

Buildings

1,00,000

95,000

P&L A/c

15,250

15,300

Plant

75,000

84,500

Bank Loan

35,000

67,600

Stock

50,000

37,000

(Long-term) Creditors

75,000

-

Debtors

40,000

32,100

Provision for Tax

15,000

17,500

Bank

-

4,000

Cash

250

300

2,65,250

2,55,400

Share Capital

2,65,250

2,55,400

Additional 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 Assets Cash Bank Debtors Stock

250 -

300 4,000

40,000 32,100 50,000 37,000

90,250 73,400

50 4,000 7,900 13,000

Current Liabilities Creditors Working

75,000

-

75,000

-

Capital (CA - CL) Net increase in Working

15,250 73,400 8,150

58,150

Capital 73,400 73,400

79,050

79,050

Funds Flow Statement Rs.

Sources

Application

Rs.

Funds from

45,050

Purchase of Plant

16,500

operations Issue of Shares

25,000

Income tax paid

14,000

Hank Loan

32,600

Dividend paid

11,500

Goodwill paid

2,500

Net increase in

58,150

Working Capital 1,02,650

1,02,650

Working Notes: Share Capital A/c Particulars To Balance c/d

Rs. 1,25,000

Particulars By Balance b/d By Bank a/c

1,25,000

Rs 1,00,000 25,000 1,25,000

General Reserve A/c Particulars To Balance c/d

Rs. 30,000

Particulars By Balance b/d By P&L a/c

Rs. 25,000 5,000

30,000

30,000

Provision for Taxation A/c Particulars

Rs.

Particulars

To Bank a/c

14,000

By Balance b/d

15,000

To Balance c/d

17,500

By P&L a/c

16,500

31,500

Rs.

31,500

Bank Loan A/c Particulars

Particulars

Rs.

To Balance c/d

67,600

By Balance b/d By Bank a/c

67,600

Rs. 35,000 2,600 67,600

Land and Building A/c Particulars To Balance c/d

Rs.

Particulars

1,00,000

By

Depreciation

Rs. 5,000

a/c (P&L a/c) By Balance c/d 1,00,000

95,000 1,00,000

Plant A/c Particulars To Balance c/d

Rs.

Particulars

Rs.

75,000

By Depreciation a/c

7,000

(P&L a/c) To Bank

16,500 91,500

By Balance c/d

84,500 91,500

Goodwill A/c Particulars To Bank

Rs. 2,500

Rs.

Particulars By Balance c/d

2,500

2,500

2,500

Calculation of Funds from Operations: (Rs.) Balance of P&L a/c (2001) Add: Non-fund and non-operating items which have already debited to P&L a/c: General reserve Provision for tax Dividends paid Depreciation: On Buildings On Plant

5,000 16,500 11,500 5,000 7,000

Less: Balance of P&L a/c (2000) Funds from Operations

45,000 60,300 15,250 45,050

Illustration 11: From the following Balance Sheets of ABC Ltd. on 31 st Dec. 2000 and 2001, you are required to prepare (i) A Schedule of changes in working capital, (ii) A Funds Flow Statement. (Rs.) Liabilities Share Capital

2000

2001

Assets

2,00,000 2,00,000 Goodwill

2000

2001

24,000

24,000

General Reserve

28,000

36,000 Buildings

80,000

P&L A/c

32,000

26,000 Plant

74,000

72,000

Creditors

16,000

10,800 Investments

20,000

22,000

60,000

46,800,

4,000

6,400

36,000

3 8,000

Bills payable Provision for Tax

Provision for doubtful debts

2,400 32,000

800

1,600 Stock 36,000 Bills receivable 1,200 Debtors

72,000

Cash & Bank

13,200

30,400

balances 3,11,200 3,11,600

3,11,200 3,11,600

Additional 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 Particulars Current Assets Cash & Bank Balances Debtors Bills Receivable Stock Current Liabilities Provision for doubtful debts Bills Payable Creditors Working

2000

Increase

Decrease

in W.C.

in W.C.

2001

13,200

30,400

17200

36,000 4,000 60,000 1,13,200

38,000 6,400 46,800 1,21,600

2,000 2,400

800

1,200

2,400

1,600

800

16,000

10,800

5,200

19,200 94,000

13,600 1,08,000

13,200

400

Capital (CA - CL)

Increase in Working

14,000

14,000

Capital 1,08,000

1,08,000

27,600

27,600

Funds Flow Statement Sources Funds from

Application

Rs. 72,000

Rs.

Purchase of Plant

6,000

operations Tax paid

34,000

Purchase of investments Interim dividend paid

2,000 16,000

Increase in Working Capital

14,000

72,000

72,000

Working Notes: Provision for Taxation A/c Particulars

Rs.

Particulars

Rs:

To Balance c/d

36,000 By P&L a/c

32,000

To Balance c/d

36,000 By P&L a/c

28,000

70,000

70,000 Plant A/c

Particulars To Balance c/d To Balance (Purchase)

Rs.

Particulars

Rs:

74,000 By Depreciation

8,000

6,000 By Balance c/d

72,000

80,000

80,000 Buildings A/c

Particulars To Balance c/d

Rs.

Particulars

Rs:

80,000 By Depreciation

8,000

By Balance c/d

72,000

80,000

80,000

Investments A/c Particulars To Balance b/d

Rs.

Particulars

20,000 By Balance c/d

Rs. 22,000

To Bank (Purchase)

2,000 22,000

22,000

Adjusted Profit & Loss A/c Particulars To

Non-fund

operating

Rs.

and

items

Nonalready

debited to P&L a/c: Transfer to General Reserve Provision for Tax

Particulars

Rs.

By Balance on (31-12-200)

32,000

By Funds from operations

72,000

8,000 38,000

Depreciation on Plant

8,000

Depreciation on Buildings

8,000

Interim dividend

16,000

To Balance on 3 1-1 2-2001

26,000 1,04,000

1,04,000

General Reserve A/c Particulars To Balance c/d

Rs.

Particulars

Rs.

36,000

By Balance

28,000

By P&L a/c

8,000

36,000

36,000

Illustration 12: From the following Balance Sheet of X Ltd., as on 31 st December, 2000 and 31st December 2001, you are required to prepare a funds | flow statement. (Rs.) Liabilities

2000

Share Capital

4,00,000

General

80,000

Reserve P&L A/c

64,000

2001

Assets

2000

2001

5,00,000 Land and

4,00,000

4,80,000

Buildings 1,40,000 Machinery

3,60,000

2,60,000

2,00,000

2,52,000

78,000 Stock

Bank Loan

3,20,000

(Long term) Creditors

3,00,000

Provision for

60,000

80,000 Debtors

1,60,000

2,60,000 Cash at Bank

1,04,000

1,28,000

18,000

80,000

Taxation 12,24,000 11,38,000

12,24,000

11,38,000

Additional 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 Assets Cash at Bank

1,04,000

18,000

86,000

Debtors

1,60,000 1,28,000

32,000

Stock

2,00,000 2,52,000

52,000

4,64,000 3,98,000 Current Liabilities Creditors Working 3,00,000 2,60,000 Capital

40,000

1,64,000 1,38,000 1,64,000 1,38,000 Decrease in working

26,000

26,000

capital 1,64,000 1,64,000

1,18,000

1,18,000

Funds Flow Statement for the year ending 31st Dec. 2001

Rs.

Sources

Application

Issue of Shares

50,000 Purchase Of Land &

Sale of Machinery

Buildings 76,000 Bank Loan paid

Funds from operations Decrease

3,17,000 Dividend paid

in

26,000 Income-tax paid

Rs. 75,000

2,40,000 84,000

70,000

Working Capital 4,69,000

4,69,000

Working Notes: Provision for Taxation A/c Particulars

Rs.

Particulars

To Cash

70,000 By Balance b/d

60,000

To Balance b/d

80,000 By Adj. P&L a/c

90,000

1,50,000

Rs.

1,50,000

Machinery A/c Land and Buildings A/c Particulars To Balance b/d

Rs.

Particulars

Rs.

3,60,000 By Adj. P&L a/c

24,000

By

Sale

of

Machinery By Balance c/d

76,000

2,60,000

3,60,000

3,60,000

Land and Buildings A/c Particulars

Rs.

To Balance b/d

Particulars

Rs.

4,00,000 By Adj. P&L a/c

45,000

To Share Capital

50,000 By Balance c/d

To Cash

75,000 5,25,000

4,80,000 5,25,000

General Reserve A/c Particulars

Rs.

To Balance c/d

Particulars

Rs.

1,40,000 By Balance b/d

80,000

By Adj. P&L a/c

60,000

1,40,000

1,40,000

Adjusted Profit & Loss A/c Particulars

Rs.

To Machinery

24,000 By Opening Balance 64,000

To

Land

Buildings To Provision

&

45,000 By

Funds

Operations for

90,000

tax To General

60,000

Reserve To Dividends paid

84,000

To Closing

78,000

balance

Particulars

Rs. from 3,17,000

3,81,000

3,81,000

FUNDS FLOW STATEMENT Vs. PROFIT AND LOSS Following are the main differences between a Funds Flow Statement and a Profit and Loss : 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 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 is prepared on the basis of nominal s.

3.

Usefulness: The Funds Flow Statement is useful for creditors and management. The Profit and Loss 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 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 uses only

income

and

expenditure

operations of a particular period.

transactions

relating

to

trading

For instance, when shares are issued for cash, the same is shown in funds flow statement as a source of funds whereas in profit and loss it 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 is a statutory obligation.

FUNDS FLOW STATEMENT Vs. BALANCE SHEET

Following are the main difference between a Funds Flow Statement 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 s 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 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.



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 designed to fill financial blind spots of the operating statement. It translates the economic consequences of operations into financial information as a basis 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 company's 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 age 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.

(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 . Hence, the defects in financial statements will be carried over to funds flow statement also.

LESSON-12 CASH FLOW ANALYSES INTRODUCTION Cash flow statement provides information about the cash receipts and payments of a firm for a given period. It provides important information that compliments the profit and loss and balance sheet. The information about the cash-flows of a firm is useful in providing s or financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise these cash flows. The economic decisions that are taken by s require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainly of their generation. The statement deals with the provision of information about the historical changes in cash equivalents of an enterprise by means of a cash flow statement which classifies cash flows during the period from operating) investing and financing activities.

Meaning of certain 

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 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 flows

The cash flow statement during a period is classified into three main categories of cash inflows and cash outflows:



Cash flows from Operating activities:

Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing and financing activities. Operating activities include cash effects of those transactions and events that enter into the determination of net profit or 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 s 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.,

Cash From Operations

Funds from Operations (as learnt in the previous chapter) Add: Increase in Current Liabilities

xxx xxx

(excluding Bank Overdraft) Decrease in Current Assets

xxx

xxx

(excluding cash & bank balance) xxx Less: 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-term assets and other investments not included in cash equivalents. In other words, investing activities include-transactions and events that involve the purchase and sale of long-term productive assets, (e.g., land, building, plant and machinery, etc) not held for re sale and other 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)



Cash payments to acquire shares, warrants, or debt instruments of other enterprises and interests in t 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 t 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 and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise. Following are 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

Information required for Cash Flow Statement

The following basic information is needed for the preparation of a cash flow statement: 

Comparative Balance Sheets: Balance Sheets at the beginning and at the end of the ing period indicate the amount of changes that have taken place in assets, liabilities and capital.



Profit and Loss : The profit and loss of the current period enables to determine the amount of cash provided by or used in operations during the ing 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" March 2001

Source Opening Balances

Rs.

Application Opening Balances

Cash

XXX Bank overdraft

Bank

XXX Cash outflows

Cash Inflows

Rs.

Redemption of Redeemable

XXX

Cash from Operations

Preference Shares XXX Redemption of Debentures

XXX

Issue of Shares

XXX Repayment of Loans

XXX

Raising of Long Term Loans/Debentures

Non Operating Expenses XXX Closing Balances

XXX XXX

Sale of Fixed Assets XXX Cash

XXX

and Investments Non Trading Receipts

XXX

XXX Bank

XXX

XXX

Note : The Cash Flow Statement can also be presented in the vertical form. However, the horizontal form given above is convenient and is more commonly used.

Funds Flow Statement vs. Cash Flow Statement Both funds flow and cash flow statements are used in analysis of past transactions of a business firm. The difference between these two statements are given below: 

Funds flow statements is based on the accrual ing 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 both long-term and short-term funds into 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: 1 From the following information, you are required to ascertain cash flow operation Particulars Net Profit Debtors Bills Receivable Creditors Bills payable Stock

31.12.2000 42,000 8,000 47,000 15,000 58,000

31.12.2001 70,000 40,000 13,000 50,000 10,000 65,000

Calculation of Cash from operations Profit made during the year

70,000

Add: Decrease in debtors

2,000

Increase in Creditors

3,000

5,000 75,000

Less: Increase in Bill Receivable Increase in stock

5,000 7,000

[ Decrease in Bills payable

5,000

17,000 58,000

Cash from operations Illustration: 2

From the following balances, you are required to calculate cash from operations:

Particulars

December December

Debtors Bill Receivable Creditors Bills Payable Outstanding Expenses Prepaid Expenses Accrued Income Income Received in Advance Profit made during the year

31 2000 50,000 10,000 20,000 8,000 1,000 800 600 300 -

31 2001 47,000 12,500 25,000 6,000 1200 700 750 250 1,30,000

Calculation of Cash from operations Profit made during the year Add: Decrease in debtors Increase in Creditors Increase in Outstanding Expenses Decrease in Prepaid Expenses Less: Increase in Bill Receivable Increase in Accrued Income Decrease in Bills Payable Decrease in Income Receive in Advance Cash from Operations

1,30,000 3,000 5,000 200 100 1,38,000 2,500 150 2,000 50

4,700 1,33,600

Illustration: 3 From the following information, calculate cash from operations Particulars P&LA/c (credit) Debtors Bills Receivable Prepaid Rent Prepaid Insurance Goodwill Depreciation Creditors

2000

2001

40,000 20,000 20,000 2,000 1,000 20,000 32,000 20,000

50,000 26,000 12,000 3,000 800 14,000 40,000 30,000

Statement showing Cash from operations Closing balance P&L A/c

50,000

Add: Decrease in Bill Receivable

8,000

Decrease in Prepaid Insurance

200

Increase in Creditors

10,000

Depreciation

8,000

Goodwill

6,000

32,200 82,200

Less: Increase in debtors

6,000

Increase in prepaid rent

1,000

Opening balance of P&L A/c

40,000

Cash from Operations

47,000 35,200

Illustration: 4 From the following balance sheets of Sulekha Ltd. you are required to prepare a cash flow statement

Liabilities

2000

Share capital

Rs. 3,00,000

Trade editors

1,05,000

2001

Assets

Rs. 3,75,000 Cash 67,500 Debtors

2000

2007

Rs. 45,000

Rs. 70,500

1,80,000

1,72,500

P&L A/c

15,000

34,500 Stock in Trade

1,20,000

1,35,000

75,000

99,000

4,20,000

4,77,000

Land 4,20,000

4,77,000

Cash flow Statement of Sulekha Ltd. for the year 2001 Sources

Rs.

Application

Rs.

Opening Balance of cash

45,000 Purchase of Land

24,000

Issue of Share Capital

75,000 Decrease

37,500

Cash

Creditors 19,500 Closing balance

Operating

Profit

(Diff. In P&L A/c) Decrease in Debtors

in

Trade

70,500

7,500 1,47,000

1,47,000

Illustration: 5 From the following balance sheets of Zindal Ltd/prepare cashflow statement. 2000 2007

Liabilities Share Capital 8% redeemable Shares General reserve

Pref.

2000 2007

600

800 Goodwill

230

180

300

200 Land & Buildings

400

340

140 Plant

160

400

320

400

154

218

166 Bills Receivable

40

60

80

P&L

60

Proposed dividend

84

Creditors

Assets

110

96 Debtors 100 Stock

Bills Payable

40

32 Cash in hand

30

20

Provision for tax

80

100 Cash at Bank

20

16

Total

1354 1634

1354 1634

Additional information: 1)

Depreciation of Rs.20,000 and Rs.40,000 have been charged on plant and land and buildings , 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

Particulars

Particulars

Rs.

To Opening Balance 1,60,000 By Depreciation

20,000

on 1-1-2001 To Purchases-cash

Rs.

2,60,000 By closing balance

4,00,000

on 31-12-2001 4,20,000 2.

4,20,000

Land and Building

Particulars

Rs.

Particulars

To Opening Balance 4,00,000 By Depreciation

Rs. 40,000

on 1-1-2001 By cash (salesbalancing figure) By closing balance on 3,40,000 31-12-2001 4,00,000

3.

4,00,000

Provision for taxation Particulars

Cash

Rs.

Particulars

70,000 By Opening Balance on

1-1-2001 To closing balance 1,00,000 By P&L on 31-12-2001

Rs. 80,000

90,000

(balancing figure) 1,70,000

1,70,000

Calculation of cash from operations Closing balance P&L A/c on 31-12-

96,000

2001: Less: Balance of P&L A/c on 1-1-2001: Add: Profit used for reserves &

60,000

provisions: Proposed dividend Interim dividend Provisions for taxation Transfer to general reserve

1,00,000 40,000 90,000 60,000

36,000

2,90,000 3,26,000

Add : Profit used for writing off noncash A/c: Goodwill Depreciation: Plant Land & Building

50,000 20,000 40,000 1,10,000 4,36,000 56,000 4,92,000

Add: increase in creditors Funds from operations Less: Increase in current assets: Debtors Stock Bills Receivable

80,000 64,000 20,000

Less: Decrease in current liabilities: Bills Payable Cash from Operations

1,64,000 3,28,000 8,000 3,20,000

Cash flow statement for the year ended December 31,2001 Cash in-flows Op. Bal. As on 1-1-2001 Cash Bank

Add: Cash inflows:

Rs.

Cash out-flows

Rs.

30,000 Purchase of plant 20,000 Payment of final

2,60,000 84,000

dividend for 2000 Payment of interim

40,000

dividend Income-tax paid

70,000

Operations

3,20,000 Redemption of Pref.

1,00

Shares Sale of land & bldg. Issue of shares

20,000 2,00,000

1,00,000 5,54,000 Closing balance on 31-12-2001 Cash in hand Cash in bank

20,000 16,000 5,90,000

5,90,000 Illustration: 6

From the following information you are required to prepare a Cash Flow Statement of Shanti Stores Ltd for the year ended 31" December, 2001

Balance Sheets Liabilities Share Capital

2000 70,000

2001

2000

2001

50,000

91,000

15,000

40,000

5,000

20,000

20,000

7,000

2,000

4,000

92,000

1,62,000

70,000 Plant Machinery Inventory

Secured Loans Repayable (2001) Creditors

Assets

40,000 Debtors 14,000

Tax payable

1,000

39,000 Cash 3,000 Prepaid General Exp.

P&L A/c

7,000

10,000

92,000 1,62,000

Profit & Loss A/c for the year ended 31" December, 2001 Particulars

Rs.

Particulars

To Opening Inventory

15,000 By sales

To Purchases To Gross Profit c/d

98,000 By Closing inventory 27,000

Rs. 1,00,000 40,000

1,40,000 To General Expenses

11,000 By Gross Profit b/d

To Depreciation To Taxes

8,000 4,000

To Net Profit c/d

4,000 27,000

1,40,000 27,000

27,000

To Dividend

1,000 By Balance b/d

7,000

To Balance c/d

10,000 By Net Profit b/d

4,000

11,000

11,000

Working Notes: Machinery A/c Particulars

Rs. Particulars

To Balance b/d (Opening balance)

By Depreciation a/c

Rs. 8,000

50,000 By Balance c/d – (closing balance)

91,000

To Bank a/c Purchases (bal. Fig.)

49,000 99,000

99,000

Provision for Taxation Particulars

Rs. Particulars

To Bank a/c - tax Paid (bal. Fig.)

By Balance b/d

1 ,000

2,000 By P & L a/c -

To Balance c/d -

closing balance

Rs.

(current year)

4,000

3,000 5,000

5,000

(Rs.) Net Profit

4,000

Add: Depreciation

8,000

Taxes

4,000

Funds from Operations

16,000

Cash from Operations

Rs. Funds from Operations

16,000

Add: Increase in Creditors

25,000 41,000

Less: Increase in Debtors

15,000

Increase in Inventory

25,000

Increase in Prepaid General Expenses

2,000

Cash lost in Operations

42,000 1,000

Cash Flow Statement of M/s Shanti Stores Ltd. for the year ending 31" December, 2001 Sources To Balance c/d Opening Cash Balance Cash Inflows Secured Loans raised

Rs.

Application Cash Outflow 20,000 Machine Purchased 40,000 Taxes Paid Dividends paid Cash lost in Operations Closing cash Balance 60,000

Rs. 49,000 2,000 1,000 1,000 7,000 60,000

Illustration: 7 The following are the balance Sheets of X Ltd. For the year ending 31 st December 2000 and 2001

Particulars Liabilities Share Capital

2000 Rs. 2,00,000

2001 Rs. 3,00,000

Profit and Loss

1,20,000

1,60,000

Sundry creditors

60,000

50,000

Provision for taxation

40,000

50,000

Proposed Dividend

20,000

30,000

4,40,000

5,90,000

2000

2001

Rs.

Rs.

1,60,000

2,00,000

40,000

60,000

2,00,000

2,60,000

18,000

24,000

1,82,000

2,36,000

8,000

16,000

1,60,000

2,18,000

Debtors

60,000

80,000

Cash

30,000

40,000

4,40,000

5,90,000

Particulars Assets: Fixed Assets Add: Additions Less: Depreciation Investments Stock

Additional information: 1)

Taxes Rs. 44,000 and dividend Rs. 24,000 were paid during the year 2001

2)

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

Opening Balance of Cash (1-1-2001) Cash inflows:

Rs.

Application

Rs.

Cash Outflows

30,000 Purchase of fixed assets Taxes paid

Issue of share capital

1,00,000 Dividend paid

Cash from operations

1,34,000 Purchase of investments

60,000 44,000 24,000 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

2,64,000

Working Notes: Fixed Assets a/c Particulars

Rs.

To Balance

Particulars

Rs.

2,00,000 By Balance c/d

2,60,090

To Bank a/c

60,000 2,60,000

2,60,000

Investments a/c

Particulars

Rs.

To Balance b/d

Particulars

Rs.

8,000 By Balance c/d

16,000

To Bank

50,000

(Balancing figure)

94,000

16,000

Provision for taxation a/c Particulars

Rs.

Particulars

Rs.

To Bank

44,000

By Balance c/d

44,000

To Balance c/d

50,000

By P & L a/c

50,000

94,000

94,000

Proposed dividends a/c Particulars

Rs.

Particulars

Rs.

To Bank

24,000 By Balance c/d

24,000

To 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) Add: Non-cash and non-operating items

1,60,000

already debited to Profit and Loss a/c : Depreciation on fixed assets Proposed dividend Provision for taxation Less:

Non-cash

and

non-operating

6,000 34,000 54,000

94,000 2,54,000

items

which have already been credited to P&L a/c Profit and Loss a/c on 1-1-2001 Cash operating profit

1,20,000

1,20,000 1,34,000

Illustration: 8 From the following Balance Sheets of Exe. Ltd. Make out the statement of sources and uses of cash: Liabilities

2000

2001

Assets

2000

2001

Equity Share

Rs. Rs. 3,00,000 4,00,000 Goodwill

Rs. 1,15,000

Rs. 90,000

Capital 8% Redeemable

1,50,000 1,00,000 Land and

2,00,000

1,70,000

80,000

2,00,000

1,60,000

2,00,000

Preference Share

Buildings

Capital General Reserve

40,000

70,000 Plant

Profit & Loss

30,000

48,000 Debtors

Proposed

42.000

50,000 Stock

77,000

1,09,000

Dividend Creditors

55,000

83,000 Bills

20,000

30,000

Bill Payable

20,000

Receivable 16,000 Cash in Hand

15,000

10,000

Provision for

40,000

50,000 Cash at Bank

10,000

8,000

Taxation 6,77,000 8,17,000

6,77,000 8,17,000

Additional 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 Particulars

Rs.

To Depreciation on plant To Depreciation

Particulars

10,000 By Balance b/d

to

20,000 By

buildings

Funds

Rs. 30,000

from

2,18,000

operations (balancing figure)

To Goodwill written off

25,000

To Provision of taxation

45,000

To Interim dividend

20,000

To Dividend proposed

50,000

To Transfer to

30,000

General Reserve To Balance c/d

48,000 2,48,000

(ii)

Provision for taxation

2,48,000

Particulars

Rs.

Particulars

Rs.

To Bank

35,000 By Balance b/d

40,000

To Balance c/d

50,000 By P.& L A/c

45,000

85,000

85,000

(iii) Land and building Particulars To Balance b/d

Rs.

Particulars

2,00,000 By Depreciation

2,00,000

Rs. 20,000

By Bank (sale)

10,000

By Balance c/d

1,70,00 2,00,000

(iv) Plant Particulars

Rs.

To Balance b/d

Particulars

80,000 By Depreciation

To Bank (purchase)

Rs. 10,000

1,30,000 By balance c/d

2,00,000

2,10,000

2,10,000

(v) Cash from operations Rs. Funds from operations Add: Increase in creditors Less: Decrease in Bills Payable Increase in Debtors Increase in Stock Increase in Bills receivable Cash from operations (vi)

2,18,000 28,000 2,46,000 4,000 40,000 32,000 10,000

86,000 1,60,000

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.

Cash flow statement for the year ending 31st December 2001 Cash Balance as on 11-2001 Cash in hand

Rs. Outflows of cash:

1 5,000 Redemption

Add: Inflows of cash:

Land

Payments

of

and

Building Funds from operations Increase in creditors

50,000

20,000 interim

dividend 1,00,000 Payment of tax

Issue of Shares of

of

Redeemable 10,000 Preference share

Cash at bank

Sale

Rs.

42,000

35,000

10,000 Purchase of Plant

1,30,000

2,18,000 Decrease in bills payable 28,000 Increase in debtors

4,000 40,000

Increase in stock

32,000

Increase in B/R

10,000

Cash Balance as on 3112-2001 Cash in hand

10,000

Cash at bank

8,000

3,81,000

3,81,000

Illustration: 9 Balance Sheets of XYZ Ltd. as on 1-1-2000 and 31-12-2001 was as follows: Liabilities Capital Creditors Bank loan Bills Payable Assets: Cash Debtors Stock Machinery

1-1-2001 1,25,000 1,40,000 65,000 20,000 3,50,000

31-12-2001 1,53,000 1,44,000 50,000 30,000 3,77,000

20,000 30,000 45,000 80,000

17,000 80,000 35,000 65,000

Land Buildings Goodwill

90,000 65,000 20,000 3,50,000

80,000 70,000 30,000 3,77,000

During the year, a machine costing Rs. 12,000 (accumulated depreciation Rs.4,000) was sold for Rs.7,000. Balance of provisions for depreciation against machinery as on 1-1-2001 was Rs.35,000 and on 31-12-2001 Rs. 50000 Prepares cash Flow statement.

Cash Flow Statement for the year ending 31st December 2001 Sources

Rs.

Opening balance of Cash

Applications

Rs.

20,000 Cash outflows:

Cash inflows:

Building Purchased

Sale of Machinery

5,000

7,000 Machinery Purchased

Sale of Land

12,000

10,000 Bank Loan repaid

Increase in creditors

15,000

4,000 Goodwill

10,000

Increase in Bills Payable

10,000 Drawings

27,000

Decrease in stock

10,000 Increase in debtors

50,000

Cash from operations

75,000 Cash balance (31-12-2001)

17,000

1,36,000

1,36,000

Machinery a/c Sources To Balance b/d To Bank (Purchase)

Rs.

Applications

1,15,000 By Bank (Sale) 12,000 By Provisions for depreciation a/c By P & L a/c (Loss on sale) By Balance c/d 1,27,000

Rs. 7,000 4,000

1,000 1,15,000 1,27,000

Land a/c Particulars To Balance b/d

Rs. Particulars 90,000 By Bank (Purchase) By Balance c/d

Rs. 10,000 80,000

90,000

90,000

Buildings a/c Particulars To Balance b/d To Bank (Purchases)

Rs. Particulars 65,000 By Balance c/d 5,000 70,000 Goodwill a/c

Particulars To Balance b/d To Bank

Rs. Particulars 20,000 By Balance c/d 10,000 30,000

Rs. 70,000 70,000 Rs. 30,000 30,000

Bank Loan a/c Particulars To Bank To Balance c/d

Rs. Particulars 15,000 By Balance c/d 50,000 65,000

Rs. 65,000 65,000

Provisions for Depreciation a/c Particulars To Machinery a/c To Balance c/d

Rs. Particulars 4,000 By Balance c/d 50,000 By P & L a/c 54,000

Rs. 35,000 19,000 54,000

Calculation of Cash from operations Balance of P & L a/c (Net Profit on (31/12/2001) Add : Non-cash and non-operating items debited to P & L a/c Depreciation on Machinery Loss on sale of Machinery Cash from operations

55,000

19,000 1,000

20,000 75,000

Capital a/c Particulars To Drawings (Balancing figure) To Balance c/d

Rs. Particulars 27,000 By Balance b/d

1,53,000 By Net Profit 1,80,000

Rs. 1,25,000

55,000 1,80,000

USES CASH FLOW STATEMENT 

Helps in efficient cash management - One of the most important functions of the management is to manage company's 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 coordinate 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.



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 company's 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 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 income statement,

takes into 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 tool of financial analysis. It discloses the volume and speed at which cash flows in various segments of the business and the amount of capital tied-up in a particular segment.

LESSON- 13 BUDGETING AND BUDGETARY CONTROL BUDGET

Budget is a financial and/or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. -

CIMA Official Terminology -

It is a plan quantified in monetary , prepared and approved prior to a defined period of time, usually showing planned income to be generated and/or expenditure to be incurred during that period and the capital to be employed to attain a given objective. It is a plan of future activities for an organisation. It is expressed mainly in financial , but also usually incorporates many non-official quantitative measures as well.

BUDGETING

Budgeting is the whole process of deg, implementing and operating budgets. The main emphasis in this is short-term budgeting process involving the prevision of resources to plans which are being implemented.

BUDGETARY CONTROL

Budgetary

control

is

the

establishment

of

budgets

relating

the

responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision.

- CMA Official Terminology

FORECAST Vs. BUDGET A forecast is a prediction of the future state of world, in connection with those aspects of the world, which are relevant to and likely to affect on future activities. Forecast is calculation of probable events. Both forecasting and planning involve recognition of the relevant factors in a given situation and understanding of what each factor has contributed to it and how each is likely to affect the future. Any organised business cannot avoid anticipating or calculating future conditions and trends for the framing of its future policy and decision. Forecast is concerned with 'probable events' and the budgeting relates to 'planned events' Budgeting should be preceded by forecasting, but forecasts may be made for purpose other than budgeting.

Requirements of a Sound Budgeting System

The following are the essential requirements of a sound budgeting 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 company's overall policy. 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 management's 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 reasons for any deviation of actuals from budgeted results, taking punitive action wherever necessary.

 A sound system for generating accurate and reliable and prompt ing 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



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. ;



It may be difficult to align individual and corporate goals. Individual goals often change and may be much lower than the firm's 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.



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 year's budget is determined by increasing last year's 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 PROCESS

The method by which the annual budget is prepared will differ from organisation to organisation. In some organisations budgeting may be a well organised, well documented procedures while in others the budget may be prepared in a rather ad hoc and disorganised manner. The budget process is shown in the following figure. The steps in budgeting process representative to all organisations is given below:

1.

Specification and Communication of Organisational Objectives :

Budget is a medium through which organisation's objectives and polices are reflected. Budgeting is used as a tool for implementing the organisational objectives. It is essential to understand, specification and documentation of organisational

objectives

before

the

managers

start

for

budgeting

the

organisational activities. Following from a statement of objectives, a corporate long-range or strategic plan can be built up. Distinction may be drawn between current operating activities and future strategic activities. Budgeting is a management tool used for shorter term planning and control. This classification of activities into short-term and strategic long-term and communication to the managers will lay down a sort of guide for budgeting the activities within the specified objectives and activities.

2.

Determination of Key Success Factors :

The performance of every organisation will be particularly influenced by certain critical success factors, key factor will influence the activities of an undertaking and it will limit the volume of output and will have direct impact on the profitability of the organisation. Critical success factors may consist of a specified raw material, a specific type of labour skill, a tool, a service facility, floor space, cash resources etc. The limitation or shortage of such critical factors may result in restricting capacity utilisation. The limiting factors may shift from time to time due to external and internal circumstances,. In organisations which are already operating at maximum capacity, the most critical success factor is likely to be productive capacity. In majority of organisation the most critical factor is likely to be consumer demand or the expected level of revenues or funds. Because of this, the sales or funds budget is usually the first budget to be prepared. 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 and responsibility of the managers responsible for accomplishment of organisational objectives is to be prepared. The organisational chart should define the following: 

The responsibility of individual functional managers

4.



Delegation of authority to the concerned functional managers



Inter-functional relationship of the organisation. Establishment of Budget Centres :

Budget centre is a section of an organisation for which separate budgets can be prepared and control exercised (CMA official terminology). The entire organisation is divided into different segments, which are clearly defined for the purpose of budgetary control according to responsibilities of departmental heads. These segments of an organisation defined for the purpose of budgetary controL are technically referred to as budget centers.

5.

Determination of Budget Period :

Budget period is a period for which the budget is prepared. A budget can; be a long-term budget or short-term budget. A short term budget is generally prepared for one year or lesser period.

Quarterly, monthly or even weekly

budget can be prepared for certain operations of the company. The short-term budget will generally not exceed the full ing year. The long-term budget which extend to five or even more years. This long-term budget will agree with long-term

forecast

of

sales,

organisational

schemes

for

expansion

modernisation, diversification etc. The long-term budgets are used for planning whereas short-term budget is used for implementation of long range plans, activities, objectives and also for control purposes. Capital expenditure budget and Research and development expenditure budget are the examples of long-term budgets.

Annual sales budget, Income and expenditure budget are the

examples of short-term budgets.

6.

Establishment of Budget Committee :

In small organisations, the person incharge of finance and ing functions will involve in preparation of budgets. The setting up of a budget

Committee is necessary in case of large and complex organisations. As the budget involves the various functional activities, the closest association of functional

managers

is

essential

for

satisfactory

formulation

and

implementation of the budget The budget committee will be composed of major functional heads. It can be effective medium for coordination and review of the budget programme. 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 company's budgets.

7.

Appointment of Budget Controller :

Proper budget istration is facilitated by the budget controller who is made responsible for the preparation of the budget and coordinating activities of the individual departments. His functions 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.

(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 as a staff manager coordinating all budget functions.

8.

Preparation of Budget Manual:

Budget manual is the documentation of policies and procedures involved in implementation of budgetary control system. A budget manual will normally set out the following: 

Responsibility and authority of different levels of management.



Establishment of organisational hierarchy.



Definition and clarification of various 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 become information generation for preparation of budgets. It contains a complete programme of activities involved in budget preparation. The budget' manual should provide detailed procedure for preparation and development and control of each budget like Sales budget, Production budget, Direct material budget, Direct labour budget, Overhead budget, Capital expenditure budget, R&D expenses budget etc.

PREPARATION OF SALES OR REVENUE BUDGET

The sales revenue budget is the starting point of most master budgets. In manufacturing organisations sales budgeting begins with the forecasting of the sales of individual products. These forecasts may be by geographical area, by class of customer or by some other segment. In case of manufacturing companies, the budgeting will begin with the Revenue budget of the organisation.

Forecasting sales is a difficult task as many assumptions need to

be made about consumer demand, environmental conditions likely customer

demand at different prices, the probable prices for similar products sold by competitors, the number of economic activity in the regions where the product is sold, the number of sales personnel required to service the estimated demand, the appropriate level of advertising and promotional expenditures, the impact of anticipated changes in exchange rates and changes in the taxes such as value added tax or customs and excise duties.

PREPARATION OF BUDGETS

Once the sales budget has been determined from a range of sales forecasts it is possible to construct the following other budgets:

1.

Production Budget

The production budget is an estimate of the quantity of goods that must be produced during the budget period. The aim of the production function will presumably be to supply finished goods of a specified quality to meet marketing demands. The sum of sales requirements plus changes in stock levels of finished goods gives the production requirements for the period being budgeted. In order to construct the production budget we need the level of sales expected and the desired levels of stock of finished goods. The following formula is used for calculation of units to be produced.

Production = Sales + Closing stock - Opening stock

Production budget should be developed keeping in view the optimal, balance between sales, inventories and production so as to result in minimum cost. Once the production level is determined, it becomes the starring point for the direct materials, direct labour and manufacturing overhead budgets.

2.

Plant Utilisation Budget

Plant utilisation budget is prepared for the estimation of plant capacity to meet the budgeted production during the period considered under the budget" For this purpose the plant capacity is expressed in of convenient units of measurement like production in hours, production in weight (M.T./Kg.) production in units etc. Budgeted machine load in each department should be worked out. In case the budgeted plant utilisation is more than the plant 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 of each raw material required for the budgeted production. The requirement to purchase of direct material can be calculated with the help of the following formula. Purchases = Closing stock + Usage - Opening stock

The materials budget provides basis for fixing optimum levels of inventory stocks, establishment of control over material usage and purchase cost budget.

4.

Direct Labour Budget

The direct labour budget will ensure that the plan will make the required number of employees of relevant grades and suitable skills available at the right times. It specifies the direct labour requirement, of various products as envisaged in the production budget. The direct labour budget will be developed for both direct labour hours and direct labour cost. After the labour requirements relating to different grades are finalized, estimated rate per hour and labour cost per unit is arrived at:

Illustration 1:

The

direct

labour

hour

requirements

of

three

of

the

products

manufactured in a factory, each involving more than one labour operation, are estimated as follows:

Direct Labour Hour / per unit (in minutes)

Product

Operation 1 2 3

1

2

3

18 9

42 12 9

30 24 -

The factory works 8 hours per day, 6 days in a week. The budget quarter is taken as 13 weeks and during a quarter, lost hours due to leave and holidays and other causes are estimated to be 124.

The budgeted hourly rates for the workers manning the operations, 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 2 3

9,000 units 15,000 units 12,000 units

There is a carry over of 5,000 units of Product 2 and 4,000 units of Product 3 and it is proposed to built up a stock at the end of the budget quarter as follows:

Product

1 3

1,000 units 2,000 units

Prepare a manpower budget for the quarter showing for each operation: (i) Direct labour hours, (ii) Direct labour cost, and (iii) Number of workers.

Before preparing the quarterly manpower budget for 3 products operation-wise, it is necessary to work out the following:

(a) Production budget, (b) Direct labour hours for each product operationwise, (c) Number of workers required for each operation. (a) Production Budget for the quarter ending ..... Particulars

Product 1

Product 2

Product 3

Budgeted Sales (units)

9,000

15,000

12,000

Add: Stock to be (closing)

1,000

-

2,000

10,000

15,000

14,000

-

5,000

4,000

10,000

10,000

10,000

built up Total Less:

Carry- (opening)

over stock Budgeted Production (b)

Direct Labour Hour for each Product (operation-wise)

Operation I Particulars

Product 1

Product 2

. Product 3

Direct labour hrs. per unit

18

42

30

10,000

10,000

10,000

10,000 x 18 60

10,000 x 42 60

10,000 x 30 60

3,000 hrs.

7,000 hrs.

5,000 hrs.

(minutes) Budget Production (units)

Direct labour hrs. required:

Total labour hours required for Operation I = 15,000 hours. Operation II Particulars

Product 1

Product 2

. Product 3

Direct labour hrs. per unit (minutes) Budget Production (units)

Direct labour hrs. required:

-

12

24

10,000

10,000

10,000

10,000 x 12 60

10,000 x 24 60

2,000 hrs.

4,000 hrs.

-

-

Total labour hours required for Operation II = 6,000 hours.

Operation III Particulars

Product 1

Product 2

. Product 3

Direct labour hrs. per unit

9

6

-

10,000

10,000

10,000

(minutes) Budget Production (units)

Direct labour hrs. required:

10,000 x 9 60

10,000 x 6 60

1,500 hrs.

1,000 hrs.

Total labour hours required for Operation III = 2,500 hours.

(c)

Number of Workers required for each Operation

Working hrs. of factory in a quarter = 13

624 hours

weeks x 6 days week x 8 hours a day

Less: Loss of hours due to leave, holidays

124 hours

and others causes

Total available hours per man

500 hours

-

-

Now, the requirements for manpower for each operation can be worked out.

Manpower Requirement: Total direct labour hrs./ Total available hours required per man a. Operation I b. Operation II c. Operation III

= 15,000/500 = 6,000/500 = 2,500/500

= 30 men = 12 men = 5 men

Now, manpower budget for the quarter can be prepared for the three products and for each operation. The same is given below:

Operation

Hr. rate Rs.

I

2.00 2.50

II III Total

5.

3.00

Product I

D.I. Hrs.

Cost Rs.

3,000 6,000 -

-

1,500 4,500

Product II

D.L. Hrs. 7,000

Cost Rs. 14,000

Product 3

D.L. Hrs. 5,000

Cost Rs.

Total

D.L. Hrs.

No. of workers

Cost Rs.

10,000 15,000 30,000

30

2,000

5,000 4,000 10,000

6,000

15,000

12

1,000

3,000

2,500

7,500

5

4,500 10,500 10,000

-

-

22,000 9,000 20,000 23,500 52,500

47

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

February

600

1,400

March

800

1,200

April

1,000

1,000

May

1,200

800

June

1,200

800

July

1,000

980

It 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 st June, 2001 are as follows:

Particulars

Product X

Product Y

(units)

11,000

12,000

Direct materials per unit

(Rs.)

12

19

Direct wages per unit

(Rs.)

5

7

Other manufacturing charges

(Rs.)

33,000

48,000

Production

apportionable to each type of

product

You 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) Particulars

Jan. Feb.

March April

May

June

600

500

Product X Closing Stock

300

400

500

Sales

500

600

800

600

800 1,000 1,300 Less: Opening Stock

250

300

400

Production (in units)

550

700

900

1,000 1,200

1,200

1,600 1,800

1,700

500

600

600

1,100 1,200

1,100

Product Y Closing stock

700

Sales

600

500

400

400

450

1,400

1,400 1,200 1,000

800

800

2,100

2,000 1,700 1,400

1,200

1,250

500

400

400

900

800

850

Less: Opening Stock

700

Production (in units)

1,400

700

600

1,300 1,100

(b) Summarised Production Cost Budget (for the 6 months ending 30 th June, 2001) . (Rs.) Production

X-5,550 units Unit Cost

Total Cost

Y-6,350 units Unit Cost

Total Cost

Direct materials

12

66,600

19

1,20,650

Direct wages

5

27,750

7

44,450

Manufacturing

3

16,650

4

25,400

20

1,11,000

30

charges Total

1,90,500

Note: Manufacturing charges have been presumed to be variable costs in the absence of any other information. They could, however be presumed to be fixed charges also for the whole year. In such a case they will be taken as 50% of the annual charges for the first six months in each case.

6.

istrative Expenses Budget istrative expenses in an organisation will be incurred for the

following activities: (a)

Formulation of policies,

(b)

Directing the organisation, and

(c)

Controlling the operations of an organisation etc.

The istrative expenses will not include those expenses which are incurred for manufacturing, selling and distribution, R&D functions. The istrative overheads are of a fixed nature and the change in the level of activity will not bring any change in the istrative expenses incurred. Cm study o behaviour of costs, if any istrative 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 the activities: (a)

Creation and stimulation of demand of company's product, and

(b)

Secure orders.

Selling expenses include salesmen's salaries, commissions, expenses and related istrative cost etc. Distribution expenses refers 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.

Preparation of selling and distribution expense budget is based on the sales budget. The selling and distribution expenditure can be estimated 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 and technical research projects.

9.

Capital Expenditure Budget

The capital expenditure budget represents the expected expenditure on fixed assets during the budget period. It is an outlay on assets that are required and held for the purpose of generating income, e.g. plant and machinery, motor vehicles, premises etc. It is a plan for capital expenditure, in monetary . Capital

expenditure

may

be

incurred

for

expansion,

diversification,

modernisation plans. It relates to projects involving huge capital outlay and long-term commitments. A capital expenditure budget must reveal following information 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

capital

expenditure budgeting.

Capital expenditure authorisation is the formal authority to incur capital expenditure which meets the criteria defined to achieve the results laid down under a system of capital appraisal. Levels of authority must be clearly defined and the reporting structure of actual expenditure through prior authorisation on a formal proposal basis and monitoring as expenditure is incurred.

10.

Manpower Budget

Manpower budget will taken an overall view of the organisations needs for manpower for all areas of activity - sales, manufacturing, istrative, executive and so on for a period of years.

11.

Marketing Expenditure Budget

Marketing budget include estimated expenditure to be inquired for advertising

promotional

activities,

public

relations,

marketing

research,

customer services etc. during the budget period.

12.

Capital Budget

Capital budget is concerned with the question of capacity and strategic direction. This must deal with the evaluation of alternate dispositions of capital funds as well as with the choice of the best capital structure.

PREPARATION OF MASTER BUDGET AND ITS IMPLEMENTATION

Master budget is a budget which is prepared from, and summarises the functional budgets. It is a summary budget that incorporates the key figures and totals of ail other budgets. The process in preparation of Master budget is shown in the figure Budgetary Process (given at the beginning of this chapter).

The

Master budget

may

closely

reflect

two

dimension

of the

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 ing reports must be built up to inform responsible managers for the progress of that result against budgets.

(2)

Products

or

information

Programmes: is

organised

In

this

to

show

dimension, the

the

revenues,

budget 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 scarce resources. This process of negotiation allows the exercise of both formal and informal power. Participation in budgeting appears to lead to more positive attitude towards the budget and greater acceptance of it.

Coordination and Review of Budget:

Incompatibility and inconsistency may arise because the budgeting process, usually involves a number of different departments - e.g. sales,-

production, marketing and numerous senior and lower level managers. It should be ensured that consistency is arrived at in finalisatcin of master budget.

Acceptance of Communication of Budgets :

After the master budget is accepted and agreed upon by all the levels of organisational hierarchy, it will be ed on for implementation. It is essential that each manager responsible for implementing the budget policy be informed as to his responsibility.

Budget Monitoring:

It is important that the actual performance of each manager should be regularly and frequently compared against budget targets in order to prevent it from getting 'out of control' and in case of change in internal and external business environment a revision of the budget may be necessitated.

CASH FLOW BUDGET

Cash flow budget is a detailed budget of income and cash expenditure incorporating both revenue and capital items. The cash flow budget should be prepared in the same format in which the actual position is to be presented. The year's budget is usually phased into shorter periods for control, e.g. monthly or quarterly. Cash budget is concerned with liquidity must reflect changes between opening and closing debtor balances and between opening and closing creditor balances as well as focusing attention on other inflows and outflows of cash. The cash budget shows the cash flows arising from the operational budgets and the profit and assets structure. A cash budget can be prepared in the following ways:

1.

Receipts and Payments Method :

In this method all the expected receipts and payments for budget period are considered. All the ash inflow and outflow of all functional budgets including capital expenditure budgets are considered. Accruals and adjustments in s will not affect the cash flow budget. All anticipated cash inflow is added to the opening balance of cash and all ash payments are deducted from this to arrive at the closing balance of cash. This method is commonly used in business organisations.

2.

Adjusted Income Method :

In this method the annual cash flows are calculated by adjusting the sales revenues and costing figures for delays in receipts and 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 by expressing each type of assets and short-term liabilities as percentage of the expected sales. The profit is also calculated as a percentage of sales, so that the increase in owners equity can be forecast. Known adjustments, may be made to longterm liabilities and the balance sheet will then show if additional finance is needed.

It is important to note that the capital budget will also be considered while preparation of cash flow budget because the annual budget may disclose a need for new capital investments and also, the costs and revenues of any new projects coming on stream will need to be incorporated in the short-term budgets. A number of additional financial statements, such as sources and application of funds

statement

or schedules or loan

capital raising schedules may be produced.

service

payments or

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

Overheads

February

14,000

9,600

3,000

1,700

March

15,000

9,000

3,000

1,900

April

16,000

9,200

3,200

2,000

May

17,000

10;000

3,600

2,200

June

18,000

10,400

4,000

2,300

b.

Credit :

Sales/ Debtor - 10% sales are on cash, 50% of the credit sales are collected next month and the balance in the following month.

Creditors

Materials

2 months

Wages

¼ month

Overheads

½ month

c.

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.

(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

June

February

(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

7,200

10% of 17,000

-

1,700

-

(17,000-10% of 17,000) x 50%

-

-

7,650

10% of 18,000

-

-

1,800

May June

14,650 15,650 16,650

Cash budget for the quarter April - June 2001 Particulars 1. Balance b/f 2. Receipts Sales (Note 1)

April

May

June

Total

6,000

3,950

3,000

6,000

16,650

46,950

14,650 15,650

Dividend

-

-

1,000

1,000

Advanced against vehicle

-

-

9,000

9,000

29,650

62,950

Total 20,650 19,600 3. Payment Creditors*

9,600

9,000

9,200

27,800

Wages*

3,150

3,500

3,900

10,550

Overhead*

1,950

2,100

2,250

6,300

Capital Expenditure

2,000

2,000

2,000

6,000

Income tax advance

-

-

2,000

2,000

29,350

62,650

300

300

Total 16,700 16,600 4. Balance c/f

3,950

3,000

* Payments for creditors, wages and overhead have been computed on the same pattern.

FLEXIBLE BUDGETING

Flexible budget is a budget which, by recognising the difference in behaviour between fixed and variable costs in relation to fluctuations in output, turnover, or other variable factors etc. It is designed to change in relation to the level of activity actually attained.

A flexible budget is one that takes of a range of possible volumes It is sometimes referred to as a multi-volume budget. The range of possible outputs may be known as the relevant range. 'Flexing' a budget takes place when the original budget is deliberately amended to take of change activity levels.

The flexible budget is based on the fundamental difference in behaviour of fixed costs, variable costs and semi-variable costs. Since fixed costs do not vary with short-run fluctuations in activity it can be seen that the flexible budget will really consist of two parts: The first is a fixed budget begin made up of fixed costs and the fixed component of semi-variable costs. The second part is a truly flexible budget that consists solely of variable costs.

Steps in Preparation The steps involved in preparation of flexible budget are as follows: 

Specify the time period that is used.



Classify all costs into fixed, variable and semi-variable categories.



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 which help 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 straight forward. The flexed budget is only accurate, if costs behave in a predicted manner. All too often assumptions are made about cost behaviour which are too simplistic and hence do not reflect what actually happens.



Flexible budgets assume linearity of costs and therefore take no 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.



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 market demand exists for additional quantity. Present sale of Rs.60,000 per month utilised only 70% capacity of the plant. Sales Manager assures that with a reduction of 10% in the price he would be in a position to increase the sale by about 25% to 30%

The following data are available:

a) Selling price b) Variable cost c) Semi-variable cost d) Fixed cost

Rs. 10 per unit Rs.3 per unit Rs.6,000 fixed plus Re.0.50 per unit 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 Board showing: 1.

The operating profits at 60%, 70% and 80% levels at current selling price and at proposed selling price.

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 at Current Selling Price (Rs.) Capacity Levels Product and Sales

60%

70%

80%

(units)

6,000 60,000

7,000 70,000

8,000 80,000

Sales (@Rs. 10)

(A)

Costs: Variable cost (@ Rs.3)

18,000

21,000

24,000

6,000

6,000

6,000

3,000

3,500

4,000

20,000 47,000

20,000 50,500

24,000 58,000

(A) - (B) 13,000

19,500

22,000

Semi-variable cost Fixed component Variable component (@ Re.0.50 per unit) Fixed cost Total cost

(B)

Profit

Statement of Operating Profit at different capacity levels at proposed Selling Price

(Rs.) Capacity Levels Sales

(@ Rs.9)

60%

70%

80%

54,000 63,000 72,000

Less: Total cost

47,000 50,500 58,000 Profit

7,000 12,500 14,000

Calculation of Percentage Increase in present output for desired profit (Rs. per unit) Proposed selling price Less: Variable cost Contribution per unit

9.00 (Rs.3.00 + Re.0.50)

3.50 5.50 (Rs.)

Present Profit Add: Fixed cost Desired Contribution

Required Output

13,000 (Rs.20,000 + Rs.6,000)

26,000 39,000

=

Desired Contribution Contribution per unit

=

Rs.39,000 Rs.5.50

= 7,091 units

Increase in Production required = 7,091 units - 6,000 units

=

Percentage increase over present Output =

1,091 6,000

x 100

= 18.18%

1,091 units

LESSON-14 CAPITAL BUDGETING MEANING OF CAPITAL BUDGETING

Capital budgeting is the process of making investment decisions in the capital expenditures. A progressive business firm always moves ahead, its fixed assets and other resources continue to expand or there comes a need for expanding them. Capital budgeting actually the process of making investment decisions in capital expenditure, or fixed assets. A capital expenditure may be as an expenditure the benefits of which are expected to be received over a period of time exceeding one year. Capital expenditure is one which is intended to benefit future periods and normally includes investments in fixed assets and other development projects.

It is essentially a long-term function.

Capital

budgeting is also known as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure etc.

Capital budgeting is the most important and complicated problem of managerial decisions. Because it is concerned with deg and carrying out through a systematic investment programme. It involves the planning of such expenditures which provide yields over a number of years.

Charles T Homgreen has defined capital budgeting as, "Capital budgeting is long term planning for making and financing proposed capital outlays.

According to Philippatos, "Capital budgeting is concerned with the allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project, with the immediate and subsequent streams of expenditure for it".

Richard and Green have defined "Capital budgeting as acquiring inputs with long-run return".

According to Lynch, "Capital budgeting consists in planning development of available capital for the purpose of maximising the long-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 of strategic planning and budgetary control. Capital budgeting systems should strive to create an atmosphere which encourages the generation of new investment proposals and evaluates them as accuracy as possible. However, loss-making proposals must be identified at the earliest possible moment.

IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting means planning for capital assets. Capital budgeting decisions are among the most crucial and critical business decisions. It is the most important single area of decision-making for the management. Unsound investment decision may prove to be fatal to the very existence of the concern. The significance of capital budgeting arises mainly due to the following:

(1)

Large Investment:

Capital budgeting decisions, generally, involve large investment of funds. The funds available with the firm are always limited and the demand for the funds far exceeds the resources. These funds are raised by the firm from various internal and external resources at substantial cost of capital. A wrong decision prove disastrous for the continued survival of the firm. Hence it is very important for a firm to plan and control its capital expenditure.

(2)

Long-Term Commitment of Funds:

The funds involved in capital expenditure are not only large but more or less permanently blocked also in long-term investment. The longer the time, the greater the risk involved. Greater the risk involved, greater is the need for careful planning of capital expenditure, i.e. capital budgeting. The long-term commitment of funds increases the financial risk involved in the investment decision. Firm's decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. An unsound investment decision may prove to, be fatal to the very existence of the firm. Hence a careful planning is essential:

(3)

Irreversible in Nature :

Most investment decisions are irreversible. Once the decision for acquiring a permanent asset is taken, it is very difficult to reverse that decision. It is

difficult to find a market of such capital goods once they have been acquired. The only alternative will be to scrap the capital assets so purchased or sell them at a substantial loss in the event of the decision being proved wrong.

(4)

Complicacies of Investment Decisions :

The long term investment decisions are more complicated in nature. The capital budgeting decisions require an assessment of future events which are uncertain. It is really a difficult task to estimate the probable future events. In most projects the investment of funds has to be made immediately but the returns are expected over a number of future years. Both returns as well as the length of the period over which they will accrue are uncertain.

(5)

Long-term Effect on Profitability: Capital budgeting decisions have a long-term and significant on the

profitability of a concern. Capital budgeting is of utmost importance to avoid over-investment or under-investment

HI

fixed assets. An unwise decision may

prove disastrous and fatal to the very existence of the concern. The future growth and profitability of the firm depends upon the investment decision taken today. Capital expenditure projects exercise a great impact on the profitability of the firm for a very long time.

(6)

National Importance: Investment decision taken by individual concern is of national importance

because it determines employment, economic activities and economic growth.

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions to the investment of current funds for the benefit to be achieved in future and the future is always uncertain. A capital budgeting process may involve a number of

steps depending upon the size of the concern, nature of projects, their numbers, complexities and diversities etc. That is, capital budgeting decisions of a firm have a pervasive influence on the entire spectrum of entrepreneurial activities. Hence they require a complex combination and knowledge of various disciplines for their effective istration, such as economics, finance, mathematics, economic forecasting, projection techniques and techniques of financial control. In order to tie all these elements, a financial manager must keep in mind the three dimensions of capital budgeting programme - policy, plan and programme. These three Ps constitute a sound capital budgeting programme.

Quinin G David has suggested that (a) project generation, (b) project evaluation, (c) Project selection and (d) project execution are the important steps involved in a capital budgeting process. However, the following procedure may be adopted in the process of capital budgeting.

(1)

Identification of Investment Proposals

Investment opportunities have to be identified or searched for: they do not occur automatically. The capital budgeting process begins with the identification of investment proposals. The first step in capital budgeting process is the conception of a profit-making idea.

Investment proposals of various types may

originate at different levels within a firm, depending on their nature. They may originate from the level of workers to top management level. Most of the proposals, in the nature of cost reduction or replacement or process for product improvement take place at plant level. The proposal for adding new product may emanate from the marketing department or from plant manager who thinks of a better way of utilizing idle capacity. Suggestions for replacing an old machine or improving the production techniques may arise at the factory level. The departmental head analyses the various proposals in the light of the corporate strategies and submits suitable proposals to the capital expenditure planning committee in case of large organisation or to the officers concerned with the process of long-term investment decisions.

A continuous flow of profitable capital expenditure proposals is itself an indications of a healthy and vital business concern. Although business may pursue many goals, survivals and profitability are two of the most important objectives.

(2) Screening the Proposals

Screening and selection procedures would differ from firm to firm. Each proposal is then subjected to a preliminary screening process in order to assess whether it is technically feasible; resources required are available and the expected returns are adequate to compensate for the risk involved. In large organisations, a capital expenditure planning committee is established for screening for various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and also do not lead to departmental imbalances. All care must be taken in selecting a criterion to judge the desirability of the projects. The criterion selected should be a true measure of the investment project's profitability, and as far as possible, it must be consistent with the firm's objective of maximising its market value. This stage involves the comparison of the proposals with other projects according to criteria of the firm. This is done either by financial manager or by a capital expenditure planning committee. Such criteria should encom the supply and cost of capital and the expected returns from alternative investment opportunities.

(3)

Evaluation of Various Proposals

The next step in the capital budgeting process is to evaluate the profitability of various proposals. If a proposal satisfies the screening process, it is then analysed in more detail by gathering technical, economic and other data. Projects are also classified, for example, new products or expansion or improvement and ranked within each classification with respect to profitability, risk and degree of urgency. There are many methods which may be used for this purpose such as pay back period method, rate of return method, net present value method etc. All these methods of evaluating profitability of capital

investments proposals have been discussed in detail below. The various 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 and compete with each other in a way that the acceptance of one precludes the acceptance of other or others. Thus, two or more mutually exclusive proposals cannot both or all be accepted. Some technique has to be used for selecting the better or the best one. Once this is done, other alternative automatically gets eliminated. A company may, for instance, propose to use semi-automatic machine or highly automatic machine for production. Here choosing the highly automatic machine precludes the acceptance of the semi-automatic machine.

Independent Proposals are those which do not compete with one another and the same may be either accepted or rejected on the basis of minimum return on investment required. For instance, when there are two proposals, a firm can undertake both the proposals.

Contingent or Dependent Proposals are those whose acceptance depends upon the acceptance of one or more other proposals. For instance, a firm decides to build a factory in a remote area, it may have to invest in houses, hospitals, roads etc. for the staff Thus, building a factory also requires investment in facilities for employees. The total investment will be treated as asingle investment.

(4)

Establishing Priorities

After evaluation of various proposals, the unprofitable or uneconomic proposals are rejected, the accepted proposals i.e. profitable proposals are put

in priority. It may not be possible for the firm to invest immediately in all the acceptable proposals. Thus, it is essential to tank the various proposals and to establish priorities after considering urgency, risk and profitability involved therein.

(5)

Final Approval

Proposals finally recommended by the committee are sent to the top management along with a detailed report, both of capital expenditures and of sources of capital. Financial manager will present several alternative capital budgets. When capital expenditure proposals are finally selected, funds are allocated for them. Projects are then sent to the budget committee for incorporating them in the capital budget.

(6)

Implementing Proposals

Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorise to go ahead with the implementation of the project. A request for authority to spend the amount should further be made to the capital expenditure committee which may like to review the profitability of the project in the changed circumstances. Further, while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PERT and M can also be applied to control and monitor the implementation of the projects.

(7)

Performance Review

Last but not the least important step in the capital budgeting process is an evaluation of the performance of the project, after it has been fully implemented. It is the duty of the top management or executive committee to

ensure that funds are spent in accordance with the allocation made in the capital budget. A control over such capital expenditure is very much essential and for that purpose a monthly report showing the amount allocated, amount spent, amount approved but not spent should be prepared and submitted to the controller. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one, and also by comparing the actual return from the investment with the anticipated return. The unfavourable variances, if any, should be looked into and the causes of the same be identified so that corrective action may be taken in future.

EVALUATION OF INVESTMENT PROPOSALS

The funds available with the firm are always limited and it is not possible to invest funds in all the proposals at a time.

Therefore, it is very essential to

select from amongst the various competing proposals, those which give the highest benefit. A firm may face a situation where more investment proposals may be poor- The management has to select the most profitable project or to take up the most profitable project first. There are many considerations, economic as well as non-economic, which influence the capital budgeting decisions. Because of the utmost importance of the capital budgeting decision, a sound appraisal method should be adopted to measure the economic worth of each investment project. Capital expenditures represent long-term commitment in the sense that current investment yields benefits in future. The capital expenditure decisions assume great importance for the future development of the concern.

The important factor that influences the capital budgeting

decision is the profitability of the prospective investment. The risk involved in the proposal cannot be ignored because profitability and risk are directly related, that is, higher the profitability, the greater because profitability and risk are directly related, that is, higher the profitability, the greater the risk and viceversa. The goal of financial management of a firm is the worth maximisation of the firm, and in order to achieve this goal, the management must select those projects which deserve first priority in of their profitability. While

evaluating, two basic principles are kept in mind, namely, the bigger benefits are always preferable to small ones and that early benefits are always better than the deferred ones.

The essential property of sound evaluation technique is that

it should maximise the shareholders' wealth. The following other characteristic should also be possessed by a 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.

METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSALS

A number of appraisal methods may be recommended for evaluating the capital expenditure proposals. The most important and commonly 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 ing Method.

Time Adjusted Methods or ing 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 period or recoupment period) refers to the period in which the project will generate the necessary cash to recoup the initial investment. Business units, while selecting investment projects, would consider the recovery of cost as the first and foremost concern even though earning maximum profits is their ultimate .goal. This method describes in of period of time the relationship between annual savings (cash inflow) and total amount of capital expenditure (investment), payback period is defined as the number of years required for the savings in costs or net cash inflow (after tax but before depreciation) to recoup the original cost of the project In simple sentence, it represents the number of years in which the investment is expected to "pay for itself. Under this method, various investments are ranked according to the length of their pay-back period in such a manner that the investment with a shorter pay-back period is preferred to the one which has longer 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 can be computed by dividing cash outlay (original investment) by annual cash inflows. For instance, if a project requires Rs. 10,000 as initial investment and it will generate an annual cash inflow of Rs.2,500 for ten years, the pay-back period will be 4 years, calculated as follows:

Pay - back Period

(b)

=

Initial Investment Annual Cash Inflow

=

Rs. 10,000 Rs. 2,500

= 4 years

In the case of uneven inflows :

If cash inflows are not uniform, the calculation of pay-back period takes a cumulative form. In such a case the pay-back period can be found out by adding up the figure of net cash inflows until the total is equal to initial investment. For instance, if-a project requires an initial investment of Rs. 10,000 and the annual inflow for 5 years are 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

1 2 3 4 5

Inflows Rs. 3,000 4,000 2,500 2,000 2,000

Inflow Rs. 3,000 7,000 9,500 11,500 13,500

The above workings show that in 3 years Rs.9,500 has been recovered. Rs.500 is left out of in-tial investment. In the fourth year the cash inflow is Rs.2,000. It means the pay-back period is between 3 to 4 years, calculated as follows: Rs.500 Pay - back Period = 3 years + Rs.2,000 = 3.25 years

Illustration 1: Payoff Ltd., is producing articles mostly by manual labour and is considering to replace it by a new machine. There are two alternative models M and N of the new machine. Prepare a statement of profitability showing the payback period from the following information:

Estimated life of machine Cost of machine Estimated savings in scrap Estimated savings in direct wages Additional cost of maintenance Additional cost of supervision

Machine M 4 years Rs.9,000 Rs.500 Rs. 6,000 Rs.800 Rs. 1,200

Machine N 5 years Rs. 18,000 Rs.800 Rs. 8,000 Rs. 1,000 Rs. 1,800

Solution: Statement showing annual cash inflows

Machine M Machine N Rs. Rs. 500

800

Estimated savings in direct wages

6,000

8,000

Total savings (A)

6,500

8,800

800

1,000

Additional cost of supervision

1,200

1,800

Total additional cost (B)

2,000

2,800

New cash inflow (A) - (B)

4,500

6,000

Estimated savings in scrap

Additional cost of maintenance

Pay-back Period

=

=

Original Investment Annual Average Cash Inflow Rs.9,000 Rs.4,500 = 2 years

Rs.18,000 Rs.6,000

= 3 years

Machine M should be preferred because it has a shorter pay-back period.

Acceptance or Reject Criterion :

Many firms use the pay-back period as an accept or reject criterion as well as a method of ranking projects. If the pay-back period calculated for a project is less than the maximum pay-back period set by management, it would be accepted; if not, it would be rejected. As a ranking method, it gives highest ranking to the project which as shortest pay-back period and lowest ranking to the project with highest pay-back period. Thus, if die firm has to choose among two mutually exclusive projects, project with shorter pay-back period will be selected.

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 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.

(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 the life of the project, depreciation, scrapvalue, 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 evaluating capital investment proposal is the cash pay-back method. Some authorities on ancy, in order to make up the deficiencies of the pay-back period method, evolved new concepts. The improvements are discussed below:

(a)

Post Pay-back Profitability :

One of the limitations of the pay-back period method is that it neglects 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 post pay-back period profits may be accepted. It has been explained in the following illustration:

Post pay-back profitability = Annual Cash Inflow (Estimated Life Pay-back Period)

Further, post pay-back profitability index can also be calculated by 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:

Cost (Rs.) Economic Life (in years) Estimated Scrap (in Rs.) Annual Savings

Project X 1,40,000 10 10,000 25,000

Project Y 1,40,000 10 14,000 20,000

Ignoring income-tax, recommend the best of these projects using (a) payback period, (b) post pay-back profit, and (c) index of post pay-back profit. Solution: Project X 1.

Cost

2.

Savings

3.

Pay-back period

4.

Economic Life

5.

Project Y

1,40,000

1,40,000

25,000

20,000

5.6 years

7 years

10 years

10 years

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 : Another serious limitation of pay-back period method is that it ignores the

time value of money. This method can be improved or modified to consider the time value of money. Under this method the present values of all cash outflows and inflows are computed at an appropriate discount rate. The number of periods taken in recovering the investment outlay on the present value basis is

called the discounted pay-back period. The present values of all inflows are cumulated in order of time. The time period at which the cumulated present value of cash inflow equals the present value of cash outflows is known as discounted payback period. Illustration 3: The following are the particulars relating to a project Rs. 50,000

Cost of the project Operating Savings: 1st year 2

nd

5,000

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 payback period taking into interest factor at 10%. Solution: (i)

Pay-back period Year

Annual

Cumulative

1

Savings Rs. 5,000

Savings Rs. 5,000

2

20,000

25,000

3

30,000

55,000

Upto second year, Rs.25,000 recovered Therefore, pay-back period = 2 years +

Rs.50,000- Rs.25,000 Rs.30,000

Rs.25,000 = 2 + Rs.30,000 = 2 years 10 months (ii)

Discounted Pay-back period at 10% interest factor

Years

Savings

PV Factor

Rs.

Discounted

Cumulative

Savings Rs.

Discounted Savings 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,

Discounted pay-back period

Rs. 50,000 - Rs.43,615 = 3 years + Rs.20,490 = 3 years 4 months

(C)

Pay-back Reciprocal

Sometimes, pay-back reciprocal method is employed to estimate the internal rate of return generated by a project.

Annual Cash Inflow Pay-back Reciprocal = Total Investment However, this method of ranking investment proposals should be used only when:

(3)



Annual savings are even for the entire period.



The economic life of the project is at least twice of the pay-back

period.

Rate of Return Method (ing Method)

This method is also known as ing Rate of Return method or Return on Investment of Average Rate of Return method. According to this method, various projects are ranked in order of the rate of earnings or rate or return. Projects which yield the highest earnings are selected and others are

ruled out. The return on investment can be expressed in several ways, as follows:

(a)

Average Rate of Return Method

Here, average profit, after tax and depreciation, is calculated and then it is divided by the total capital outlay or total investment in the project. This method establishes the ratio between the average annual profits to total outlay.

Average Rate of Return =

Average Annual Profit Outlay of the Project

x 100

Project giving a higher rate of return will be preferred over those giving lower rate of return.

(b)

Return Per unit of Investment Method

In this method, the total profit after tax and depreciation is divided by the total investment. This gives us the average rate of return per unit of amount invested in the project.

Return per unit of Investment =

(c)

Total Profit Net Investment

x 100

Return on Average Investment Method

Under this method the percentage return on average amount of investment is calculated. To calculate the average investment, the outlay of the project is divided by two.

Return on Average Investment =

Total Profit after deprec. & Taxes Total Net Investment /2 x 100

(d)

Average Return on Average Investment Method

Under this method, average profit after depreciation and taxes is divided by the average of amount of investment. This is an appropriate method of rate of return on investment. Average Annual Net Investment / 2

Average Return on Average Investment =

x 100

Illustration 4: Calculate the average rate of return for projects A and B from the following: Project A Rs.20,000 4 years

Investment Expected Life (no salvage value)

Project B Rs.30,000 5 years

Projected Net Income, after interest, depreciation and taxes: Years 1 2 3 4 5 Total

Project A Rs. 2,000 1,500 1,500 1,000 6,000

Project B Rs. 3,000 3,000 2,000 1,000 1,000 10,000

If the required rate of return is 1 2% which project should be undertaken?

Solution:

Total profit, after interest, depreciation and taxes Expected Life Average Profit Investment

Project A

Project B

Rs.

Rs.

6,000

10,000

4 years

5 years

1,500

2,000

20,000

30,000

Average Rate of Return Average Rate of Return

1-500

2,000

1,500

2,000

Average Return on

20,000 x 100 = 7.5% 1,500

30,000 x 100 = 6.6% 2,000

Average Investment

20,000/2 x 100 = 15% 30,000/2 x 100 = 13.33%

The average return on average investment is higher in the case of Project A, besides it is also higher than the required rate of return of 12%. Project A is suggested to be undertaken. Merits of Rate of Return Method The 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 ing 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 ing profits.



It ignores the fact that profits can be reinvested.



There are different methods for calculating the ing 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 rate of interest, the future value of the present money is ascertained whereas in discounting, the present alue of future money is calculated. The rate at which the future cash flows are reduced to their present value is termed as discount rate. Discount rate, otherwise called time value of money, is some interest rate which expresses the time preference for a particular future cash flow.

The discounted cash flow method is an improvement on the pay-back method as well as ing rate of return. This method is based on the fact that future value of money will not be equal to the present value of money. That is, discounted cash flow technique recognises that Re. one of today (cash outflow) is worth more than Re. one received at a future date (cash inflow). Die time adjusted or discounted cash flow method take into the profitability and also the time value of money. The discounted cash flow method for evaluating capital investment proposals are of three types:

1.

Net Present Value Method

This method is also known as Excess Present Value or Net Gain Method or Time Adjusted methods. Under this method, cash inflows and cash outflows associated with each project are first worked out. The present values of these cash inflows and outflows are then calculated at the rate acceptable to the management. This rate of return is considered as the cut-off rate and is generally determined on the basis of cost of capital suitably adjusted to allow for the risk element involved in the project.

The present values of total of cash inflows should be compared with present values of cash outflows. If the present value of cash inflows are greater than (or equal to) the present value of cash outflows (or initial investment), the project would be accepted. If it is less, then proposal will be rejected.

Illustration 5: A company is considering the purchase of the two machines with the following details:

Machine I

Machine II

3 years Rs. 10,000

3 years Rs. 10,000

8,000 6,000 4,000

2,000 7,000 10,000

Life Estimated Capital Cost Net earning after tax: 1st year 2nd year 3rd year

You are required to suggest which machine should be preferred.

Solution: Calculation of Net Present Value (10%)

Machine I Year

PV Factor

1

0.909

Cash

Machine II

Present

Cash

Present

Inflow Rs. Value Rs. Inflow Rs. Value Rs. 8,000 7,272 2,000 1,818

2

0.826

6,000

4,956

7,000

5,782

3

0.751

4,000

3,004

10,000

7,510

Less: Cost Net Present Value

15,232

15,110

10,000

10,000

5,232

5,110

Machine I should be preferred as net present value is Rs.5,232 which 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 are as follows:s



This method considers the entire economic life of the project.



It takes into 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 return method or discounted rate of return method. The internal rate of return is defined as the interest rate that equates the present value of the expected future receipts to the cost of the investment outlay. This internal rate of return is found by trial and error. First, we compute the present value of the cash-flows from an investment, using an arbitrarily selected interest rate. Then, we compare the present value so obtained with the investment cost.

If the present value is higher than the

cost figure, we try a higher rate of interest and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process.

The interest rate that 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 project having higher difference, if they are mutually exclusive, is adopted and other one is rejected. As this determination of internal rate of return involves a number of attempts to make the present value of

earnings equal to investment, this approach is also called the Trial and Error Method.

Illustration 6: Initial Investment Rs.60,000 Life of the Asset Estimated net annual cash-flows: 1st year

Rs. 15,000

2nd year

Rs.20,000

3rd year

Rs.30,000

4th year

Rs.20,000

Calculate Internal Rate of Return.

4 years

Solution: Calculation of Internal Rate of Return Annual

PVF

PVF

PVF

1

Cashflow 15,000

10% 0.909

13,635

12% 0.892

PV 14% 13,380 0.877 13,155

15% 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

Year

PVF PV

Total of PV of Cash inflow

PV

66,345

63,350

PV

60,595

59,285

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 profitability indices for various projects, the financial manager can rank them in order of their respective ratio of profitability. PV of Cash Flows Initial Cost Outlay

Profitability Index =

Illustration 7: The initial cash outlay of a project is Rs.50,000. Estimated cash inflows: 1st year 2nd year 3rd year

Rs.20,000 Rs. 15,000 Rs.25,000

4th year

Rs. 10,000

Compute Profitability Index.

Solution: Calculation of Profitability Index

Year

Cash Inflows

PV Factor at 10%

PV Rs.

1

Rs. 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

Total Present Value Less: Initial Outlay Net Present Value

= = =

Profitability Index (gross)

=

Rs.56,175 Rs.50,000 6,175 PV Cash Inflow Initial Cash Outflow 56,175 50,000

= 1.1235

Profitability index is higher than 1, the proposal can be accepted.

CAPITAL RATIONING

Capital

rationing is

a situation

where a firm

has more

investment

proposals than it can finance. Many concerns have limited funds. Therefore, all profitable investment proposal may not be accepted at a time. In such event the firm has to select from amongst the various competing proposals, those which give the highest benefits.

There comes the problem of rationing them.

Thus

capital rationing may be defined as a situation where the management has more profitable investment proposals requiring more amount of finance than the funds available to the firm.

In such a situation, the firm has not only to select

profitable investment proposals but also to rank the projects from the highest to lowest priority

Illustration 8: X Ltd. is considering the purchase of a machine. Two machines are available, A and B. The cost of each machine is Rs.60,000. Each machine has an expected life of 5 years. Net profits before tax but after depreciation during the expected life of the machine are given below: Year 1 2 3

Machine A Rs. 15,000 20,000 2500

Machine B Rs. 5,000 15,000 20,000

4 5

15,000 10,000

30,000 20,000

Following the method of return on investment ascertain which of the alternates will be more profitable. The average rate of tax may be 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

Average profit after tax

Machine A Rs. 42,000 5 = Rs. 8,500

Investment

Average Investment

Average Return on Investment

Machine B Rs. 45,000 5 = Rs. 9000

Rs. 60,000

Rs. 60,000 2 =

Rs. 60,000 Rs. 30,000

Rs. 8,500 60,000

Rs. 60,000

2 =

Rs. 30,000

Rs. 9,000 x 100 = Rs. 14.17%

60,000 x 100 = Rs. 15%

Average Return on Average

Rs. 8,500 30,000

Rs. 9,000 x 100 = Rs. 28.34%

30,000

x 100 = Rs. 30%

Investment

Machine B is more profitable.

Illustration 9 : A Ltd. Company is considering the purchase of a new machine which will carry out operations preformed by labour. X and Y are alternative models. From the following information, you are required to prepare a profitability statement and work out the pay-back period for each model.

Estimated Life Cost of Machine Cost of indirect materials Estimated savings in scrap Additional cost of maintenance Estimated savings in direct wages: Employees not required Wages per employee

Model X Rs. 5 years 1,50,000 6,000 10,000 19,000

Model Y Rs. 6 years 2,50,000 8,000 15,000 27,000

150 600

200 600

Taxation to be regarded 50% of profit before charging depreciation. Which model you recommend ?

Solution: Profitability Statement

Estimated saving per

Model X

Model Y (Rs)

(Rs) 10,000

15,000

90,000

1,35,000

1,00,000

1,35,000

year scrap

Wages (150x600) (200x600)

Total Savings Less: Additional Cost Cost of indirect

8,000

materials 6,000 Cost of Maintenance 19,000 Additional Earnings Less: Tax @ 50% Cash flow (annual) Less: Depreciation:

25,000 75,000 37,500 37,500 30,000

27,000

2,50,000 » 6

35,000 1,00,000 50,000 50,000 41,667

1,50,000 » 5 Net Increase in earnings Pay-back period:

7,500

8,333

1,50,000 37,500

2,50,000 = 4 years

50,000

= 5 years

Cost of Machine Annual Cash Flow 7,500

8,300

1,50,000 x100 =

2,50,000 x100 = 3.3%

5%

A pay-back period of Model X is less than that of Model Y, ^nd also the return on Investment is higher in respect of X, Model X is recommended.

Illustration 10: A company proposing to expand its production can go either for an automatic machine costing Rs.2,24,000 with an estimated life of 5V2 years or an ordinary machine costing Rs.60,000 having an estimated life of 8 years.

The annual sales and

Automatic

Ordinary

Machine Rs.

Machine Rs.

costs are estimated as follows: Sales 1,50,000

1,50,000

Costs: Materials

50,000

50,000

12,000 24,000

60,000 20,000

Labour Variable Overhead

Compute the comparative profitability under pay-back method.

Solution:

Annual Sales

Automatic Machine

Ordinary Machine

Rs.

Rs.

1,50,000

1,50,000

Less: Variable Cost Materials

50,000

50,000 Labour

60,000

12,000 Overheads 24,000

86,000

Marginal Profit

20,000

1,30,000

64,000 20,000

2,24,000

3 ½ years

60,000

Pay-back period: 64,000

Post pay-back profitability

20,000

1 _

1

64,000 5 2 32 = Rs. 1,28,000

= 3 years

20,000 (8-5 yrs.) = Rs. 1,00,000

Illustration 11: The Tamil Nadu Fertilizers Ltd. is considering a proposal for the investment of Rs.5,00,000 on product development which is expected to generate net cash inflows for 6 years as under:

Year 1 2 3 4 5 6

Net Cash Flows ('000) Nil 100 160 240 300 600

The following are the present value factors @ 15% p.a.

Year Factor

1

2

3

4

5

6

0.87

0.76

0.66

0.57

0.50

0.43

Solution: Calculation of Net Present Value

Year

Cash Inflows

PV Factor

Present Values

1 2 3 4 5

('000) Rs. Nil 100 160 240 300

0.87 0.76 0.66 0.57 0.50

('000) Rs. Nil 76.0 105.60 136.80 150.00

6

600

0.43

258.00

Total Less: Cash Outlay Net Present Value

726.40 500.00 226.40

As the net present value is positive, the proposal is acceptable.

Illustration 12: The financial manager of a company has to advise the Board of Directors on choosing between two compelling project proposals which require an equal investment of Rs. 1,00,000 and are expected to generate cash flows as under:

End of year

1 2 3 4 5 6

Project I Rs. 48,000 32,000 20,000 Nil 24,000 12,000

Project II Rs. 20,000 24,000 36,000 48,000 16,000 8,000

Which project proposal should be recommended and why? Assume the cost of capital to be 10% p.a. The following are the present value factors at 10% p.a.

Year Factor

1

2

3

4

5

6

0.909

0.826

0.751

0.683

0.621

0.564

Solution: Calculation of Net Present Value Year

Project I

Project II

PV

PV of

PV of

Net Cash

Net Cash

Factor

Project I

Project

Inflows Rs.

Inflows Rs.

@ 10% Rs.

11 Rs.

1

48,000

20,000

9.909

43,632

18,130

2

32,000

24,000

0.826

26,432

19,8.24

3

20,000

36,000

0.751

15,020

27,036

4

Nil

48,000

0.683

Nil

32,784

5

24,000

16,000

0.62.1

14,904

9,936

6

12,000

8,000

0.564

6,768

4,512

Total 1,06,756 Less: Cash Outlay Net Present Value

1,12,272

1,00,000

1,00,000

6,756

12,272

Project II should be accepted as the NPV is more than that of Project I.

Illustration 13: From the following information, calculate the net present value of the two projects and suggest which of the two profits should be accepted assuming a discount rate of 10%.

Profit X

Profit Y

Rs.

Rs.

Initial Investment

20,000

30,000

Estimated Life

5 years

5 years

1,000

2,000

Scrap Value

Profits before depreciation and after taxes are as follows:

Year

Profit X

Profit Y

Rs.

Rs.

1

5,000

20,000

2

10,000

10,000

3

10,000

5,000

4

3,000

3,000

5

2,000

2,000

Solution : PV of Re.1

Cash Flows

Year

1 2 3 4 5 6

Project X

Project Y

Rs.

Rs.

5,000

20,000

10,000 10,000

@10%

Present Value of Net Cash Flow Project X

Project Y

Rs.

Rs.

0.909

4,545

18,180

10,000 5,000

0.836 0.751

8,260 8,510

8,260 3,755

3,000 2,000

3,000 2,000

0.683 0.621

2,049 1,242

2,049 1,242

1,000

2,000

0.621

621 24,227 20,000 4,227

1,242 34,728 30,000 4,728

Project Y should be selected as NPV of Project Y is higher.

Illustration 14: A firm is considering the purchase of a machine. Two machines A and B are available, each costing Rs.50,000. In comparing the profitability of those machines a discount rate of 10% is to be used- Earnings after taxation are expected to be as follows: You are also given the following data:

Year

Machine A Cash

Machine B Cash

Inflow Rs.

Inflow Rs.

1

15,000

5,000

2

20,000

1 5,000

3

25,000

20,000

4

15,000

30,000

5

10,000

20,000

You are also given the following data :

year

PV Factor @ 10%

discount 1

0.909

2

0.826

3

0.751

4

0.683

5

0.621

Evaluate the projects using: (a)

the pay-back period

(b)

the ing rate of return

(c)

the net present value

(d)

the profitability index

Solution: Year

Cash Inflow

Cumulative Cash

Rs.

Inflow Rs.

1

15,000

15,000

2

20,000

35,000

3

25,000

60,000

4

15,000

75,000

5

10,000

85,000

The above calculation shows that in two years Rs.35,000 has been recovered. Rs. 15,000 is left out of initial investment. In the 3 rd year cash inflow is Rs.25,000. It means the pay-back period is between 2nd and 3 year, thus:

Pay-back Period = 2+

15,000 25,000 = 2.6 years

(b) Machine B Year

Cash Inflow

Cumulative Cash

Inflow Rs.

Rs.

1

5,000

5,000

2

15,000

20,000

3

20,000

40,000

4

30,000

70,000

5

20,000

90,000

In three years Rs.40,000 has been recovered. The balance left out of initial investment is Rs. 10,000. It means the pay-back period is between 3 rd and 4th year, thus: Pay-back Period = 3+

10,000 30,000 = 3.33 years

Machine A should be purchased. Because pay-back period is less. ing Rate of Return Machine A Total Returns

=

Rs.85,000

Average Return

=

Rs.85,000 » 5 = Rs.17,000

17,000 50,000

Average Rate of Return =

x 100 = 34%

Machine B Total Returns

=

Rs.90,000

Average Return

=

Rs.90,000 » 5 = Rs.18,000

Average Rate of Return =

Net Present Value

18,000 50,000

x 100 = 36%

Calculation of Net Present Value

s

PV Factor Cash Inflows Cash Inflows

PV

PV

@ 10% Rs.

Machine A Rs.

Machine B

Machine B Rs.

Machine A Rs.

1

0.909

15,000

5,000

13,635

4.545

2

0,826

20,000

15,000

16,520

12,390

3

0.751

25,000

20,000

18,775

15,020

4

0.683

15,000

30,000

10,245

20,490

5

0.621

10,000

20,000

6,210

12,420

65,385

64,865

50,000

50,000

15,385

14,865

Total Less: Cash Outlay Net Present Value

The Net Present Value of Machine A is more than that of Machine B. So, Machine A should be purchased.

Probability Index

Present Values Machine A = Cost of Investment

65,385 =

50,000

= 1.308

64,865 Machine B = 50,000

= 1.297

Probability Index of Machine A is more than that of Machine B and therefore, Machine A should be preferred.

LESSON - 15 : CASE STUDY CASE-1 BUSINESS DECISION

Adams Company and Baker Company are in the same line of business and both were recently organized, so it may be assumed that the recorded costs for assets are close to extent market values. The balance sheets for the two companies are as follows at July 31, 19

ADAMS COMPANY Balance Sheet July 31,19 Assets

$

Liabilities & Owner's

$

Cash

4,800

Equity Liabilities:

s

9,600

Notes payable (due in

62,400

43,200

receivable Land

36,000

60 days) s payable

Building

60,000

Total liabilities

Office equipment

12,000

Owner's Equity Ed Adams, capital

122,400

105,600 16,800 122,400

BAKER COMPANY Balance Sheet July 31,19 ___

Assets

$

Liabilities & Owner's

Cash

24,000

Equity Liabilities:

s

48,000

Notes payable (due in 60

receivable Land Building Office equipment

7,200

days) s payable

12,000

Total liabilities

1,200

Owner's Equity Ed Adams, capital

92,400

$

14,400

9,600 24,000 68,400

92,400

Questions :

(1)

Assume that you are a banker and that each company has applied to you for a 90-day loan of $ 12,000. Which would you consider to be the more favourable prospect?

(2)

Assume that you are an investor considering the purchase of one or both of the companies. Both Ed Adams and Tom Baker have indicated to you that they would consider selling their respective business. In either transaction you would assume the existing liabilities. For which business would you be willing to pay the higher price? Explain your answer fully. (It is recognised that for either decision, additional information would be useful, but you are to reach your decisions on the basis of the information available).

CASE- 2

BUSINESS DECISION

Richard Fell, a college student with several summers' experience as a guide on canoe camping trips, decided to go into business for himself. To start his own guide service, Fell estimated that at least $ 4,800 cash would be needed. On June 1, he borrowed $ 3,200 from his father and signed a threeyear note payable which stated that no interest would be charged. He deposited this borrowed money along with $ 1,600 of his own savings in a business bank to begin a business known as Birchbark Canoe Trails. The $ '3,200 note payable is a liability of the business entity. Also on June I, Birchbark Canoe Trails carried out the following transactions: (i)

Bought a number of canoes at a total cost of $ 6,400, paid $ 1,600 cash and agreed to pay the balance within 60 days.

(ii)

Bought camping equipment at a cost of $ 3,200 payable in 60 days,

(iii)

Bought supplies for cash, $ 800.

After the close of the season on September 10, Fell asked another student, Joseph Gallal, who had taken a course in ing, to help him determine the financial position of the business. ;

The only record Fell had maintained was a checkbook with memorandum notes written on the check stubs. From this source Gallal discovered that Fell had invested an additional $ 1,600 of his own savings in the business on July 1, and also that the s payable arising from the purchase of the canoes and camping equipment had been paid in full. A bank statement received from the bank on September 10 showed a balance on deposit of $ 3,240. Fell informed Gallal that he had deposited in the bank all cash received by the business. He had also paid by check all bills immediately upon receipt; consequently, as of September 10, all bills for the season had been paid.

The canoes and camping equipment were all in excellent condition at the end of the season and Fell planned lo resume operations the following summer, In fact he had already accepted reservations from many customers who wished to return.

Gallai felt that some consideration should be given to the wear and

tear on the canoes and equipment but he agreed with Fell that for the present purpose the canoes and equipment should be listed in the balance sheet at the original cost. The supplies remaining on hand had cost $ 40 and Fell felt that he could obtain a refund for this amount by returning them to the supplier.

Gallai suggested that two balance sheets be prepared, one to show the condition of the business on June 1 and the other showing the condition on September 10. He also recommended to Fell that a complete set of ing records be established.

Questions :

1.

Use the information in the first paragraph (including the three numbered transactions) as a basis for preparing a balance sheet dated June 1.

2.

Prepare a balance sheet at September 10. (Because of the incomplete information available, it is not possible to determine the amount of cash at September 10, by adding cash receipts and deducting cash payments throughout the season. The amount on deposit as reported by the bank at September 10, is to be regarded as the total cash belonging to the business at that date).

3.

By comparing the two balance sheets, compute the change in owner's equity. Explain the sources of this change in owner's equity and state whether you consider the business to be successful. Also comment on the cash position at the beginning and end of the season. Has the cash position improved significantly? Explain.

CASE-3 BUSINESS DECISION

Condensed comparative financial statements for Pacific Corporation appear below:

PACIFIC CORPORATION Comparative Balance Sheets As of May 31 (in thousands of dollars)

Assets

Year 3 Year 2

Current assets Plant

and

equipment

(net

depreciation) Total assets

Year l

$

$

$

3,960

2,610

3,600

of 21,240 19,890

14,400

25,200 22,500

18,000

Liabilities & Stockholder's Equity Current liabilities

2,214

2,052

1,800

Long-term liabilities

4,716

3,708

3,600

Capital stock ($10 par) Retained earnings Total equity

liabilities

12,600 12,600 5,670

&

4,140

stockholder's 25,200 22,500

8,100 4,500 18,000

PACIFIC CORPORATION Comparative Income Statements For Years May 31 (in thousands of dollars)

Assets

Year 3

Year 2

Year l

$

$

$

Net sales

90,000

75,000

60,000

Cost of goods sold

58,500

46,500

36,000

Gross Profit on sales

31,500

28,500

24,000

Operating expenses

28,170

25,275

21,240

Income before income taxes

3,330

3,225

2,760

Income taxes

1,530

1,500

1,260

Net income

1,800

1,725

1,500

Cash dividends paid (plus 20% in

270

465

405

stock in Year 2) Cash dividends per share

063

1.11

1.50

Questions ; 1.

Prepare a three-year comparative balance sheet in percentages rather than dollars, using Year 1 as the base year.

2.

Prepare common size comparative income statements for the three-year period, expressing all items as percentage components of net sales for each year.

3.

Comment on the significant trends and relationships revealed by the analytical computations in 1 and 2. These comments should cover current assets and current liabilities, plant and equipment, capital stock, retained earnings, and dividends.

4.

If the capital stock of this company were selling at $ 11.50 per share, would you consider it to be overpriced, underpriced, or fairly priced? Consider such factors as book value per share, earnings per share, dividend yield, trend of sales and trend of the gross profit percentage. Also consider the types of investors to whom the stock would be attractive or unattractive.

CASE-4 BUSINESS DECISION

Combelt Cereal Company is engaged in manufacturing a breakfast cereal. You are asked to advise management on sales policy for the coming year.

Two proposals are being considered by management which will" (i) increase the volume of sales, (ii) reduce the ratio of selling expense to sales, and (iii) decrease manufacturing cost per unit. These proposals are as follows:

Proposal No.1:

Increase advertising expenditures by offering

stamps

It is proposed that each package of cereal will contain stamps which will be redeemed for cash prizes. The estimated cost of this plan for a sales volume of over 500,000 boxes is estimated at $ 60 per 1,000 boxes sold. The new advertising plan will take the place of all existing advertising expenditures and the current selling price of 70 cents per unit will be maintained.

Proposal No. 2 : Reduce selling price of product

It is proposed that the selling price of the cereal be reduced by 5% and that advertising expenditures be increased over those of the current year. This plan is an alternative to Proposal No.1, and only one will be adopted by management.

Management has provided you with the following information as to the current year's operations:

Quantity sold Selling price per unit Manufacturing cost per unit

500,000 boxes $0.70 $0.40

Selling expenses, 20% of sales (one-fourth of which was for newspaper advertising)

istrative expenses, 6% of sales Estimates for the coming year for each proposal are shown below: Increase

in

unit

Proposal No. 1 sales 50%

Proposal No. 2 30%

volume Decrease in manufacturing 10%

5%

cost per unit Newspaper advertising Other selling expenses plan expense istrative expenses

10% of sales 8% of sales None 10% of sales

None 8% of sales $ 0.06 per box 5% of sales

Questions: 1.

Which of the two proposals should management select?

2.

In of your recommendation, prepare a statement comparing the income from operations for the current year with the anticipated income from operations for the coming year under Proposal No.l and under Proposal No.2. In preparing the statement use the following column headings: 

Current Year



Proposal No. 1; and



Proposal No. 2

MODEL QUESTION PAPER Paper 1.6: FINANCIAL AND MANAGEMENT ING Time : 3 hours

Maximum Marks: 100

PART-A

(5x8= 40 marks)

Answer any Five questions 1.

What are the advantages of management ing, how it differ from financial ing?

2.

What are the different types of errors, how this can be managed well?

3.

Describe the various ing standards.

4.

What are the advantages and limitations of ratio analysis?

5.

State the difference between cash flow and fund flow statement.

6.

State the requisites for an effective budgetary control system.

7.

From the trial balance and the additional information of a public school, prepare Income and Expenditure for the year ending December 31, 1998 and the Balance Sheet as at that date.

Trial Balance as at December 31, 1998 Amount

Building Furniture Library Books 16% Investments (1-1-98) Salaries Stationery

General Expenses

Amount

(Dr.) 2,50,000 ission Fees

Cr.) 5,000

40,000 Tuition Fees 60,000 Rent of Hall 2,00,000 Creditors

2,00,000 4,000 for

Books

Supplied 2,00,000 Miscellaneous Receipts 15,000 Annual

8,000

rant Donations library books

6,000

12,000

Government

1,40,000

Received for

25,000

Annual Sports Expense

6,000 Capital Fund

Cash

1,000

Bank

4,00,000

20,000 Interest on Investments

8,000

8,00,000

8,00,000

Additional 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.

Charge

depreciation on furniture @ 10% p.a. 4)

8.

Depreciate building by 5% and library books by 20%.

A book keeper while preparing his trial balance finds that the debit exceeds by Rs. 7,250. Being required to prepare the final he places the difference to a suspense . In the next year the following mistakes were discovered:

a)

A sale of Rs. 4,000 has been ed through the purchase day book. The entry in the customer's has been correctly recorded,

b)

Goods worth Rs. 2,500 taken away by the proprietor for his use has been debited to repairs ;

c)

A bill

receivable for Rs. 1,300

received

from

Krishna

has

been dishonoured on maturity but no entry ed;

d)

Salary of Rs. 550 paid to a clerk has been debited to his personal ;

e)

A purchase of Rs. 750 from Raghubir has been debited to his . Purchase has been correctly debited;

f)

A sum of Rs. 2,250 written off as depreciation on furniture has not been debited to depreciation .

Draft the journal entries for rectifying the above mistakes and prepare the suspense and profit and loss adjustment 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) 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

650

To Clerk's Personal A/c (Being salary paid to clerk last year inadvertently shown in his personal 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 inadvertently now rectified f) Profit & Loss Adjustment A/c Dr To Suspense A/c

2,250 2,250

(Being depreciation not shown last year now rectified)

PART - B

(4 x 15 = 60 marks)

Answer any Four questions. Question No. 15 is compulsory

9.

Data Ram maintains his records on single entry system. While records of business takings and payments have been kept, these have not been reconciled with cash in hand. From time to time cash has been paid into a bank and cheques thereon have been drawn both for business use and private purposes. From the following information, prepare the final s for the year 1998:

Assets and liabilities at the beginning and at the end of the period have given below:

Stock Bank Balance

1-1-1998 20,000 8,000

31-12-1998 15,000 12,000

Cash in hand

300

400

Debtors

14,000

20,000

Creditors

27,300

30,000

Investments

50,000

50,000

Other transactions are as follows: Cash paid in bank Private dividends paid into bank Private payments out of bank Business payments for goods out of bank Cash takings Payment for goods by cash and cheque Wages

1,50,000 59,700 26,000 1,22,000 2,50,000 1,60,000 97,700

Delivery Expenses Rent and rates Lighting General Expenses

7,000 2,000 1,000 4,600

During the year, cash amounting to Rs. 20,000 was stolen from the till. Goods worth Rs. 24,000 were withdrawn from private use. No record has been kept of amounts taken from cash for personal use and a difference in calls amounting to Rs. 7,300 is treated as private expenses.

10.

Following are summarised Balance Sheets of 'X' Ltd. as on 31 st December, 2000 and 2001. You are required to prepare a Funds Flow Statement for the year ended 31st December, 2001.

Liabilities

Assets

2000

2001

Share Capital 1,00,000 1,25,000

Goodwill

-

2,500

General

25,000

30,000

Buildings 1,00,000

Reserve P&L A/c

15,250

15,300

Plant

75,000

84,500

Bank Loan

35,000

67,600

Stock-

50,000

37,000

(Long-term) Creditors

75,000

-

Debtors

40,000

32,100

17,500

Bank

-

4,000

Cash

250

300

Provision

2000

for 15,000

2001

95,000

Tax 2,65,250 2,55,400

2,65,250 2,55,400

Additional Information:

(i)

Dividend of Rs.11,500 was paid.

(ii)

Depreciation written off on plar.t Rs. 7,000 and on buildings Rs. 5,000.

(iii)

Provision for tax was made during the year Rs. 16,500.

11.

From the following Balance Sheets of Exe. Ltd. Make out the statement of sources and uses of cash:

Liabilities

2000

2001

Assets

2000

2001 90,000

Equity Share

3,00,000 4,00,000 Goodwill

1,15,000

Capital 8% Redeemable

1.50.000 1,00,000 Land and

2,00,000 1,70,000

Preference Share

Buildings

Capital General Reserve

40,000

Profit & Loss

30,000

Proposed

42,000

Dividend Creditors

55,000

Bill Payable

Provision for

70,000 Plant 48,00 Debtors

80,000 2,00,000 1,60,000 2,00,000

50,000 Stock

83,000. Bills

77,000 1,09,000

20,000

30,000

20,000

Receivable 16,000 Cash in

15,000

10,000

40,000

Hand 50,000 Cash at

10,000

8,000

Taxation

Bank 6,77,000 8,17,000

6,77,000 8,17,000

Additional info (a)

Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant and Land and Building respectively in 2001.

2.

(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.

Gama Engineering Company Limited manufacturers two Products X and Y. An estimate of the number of units expected to be sold in the firs; seven months of 2001 is given below:

Months

Product X

Product Y

January February

500 600

1,400 1,400

March

800

1,200

April May

1,000 1,200

1,000 800

June July

1,200 1,000

800 980

It 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 3l rt June, 2001 are as follows:

Particulars Production Direct materials per unit Direct wages per unit Other manufacturing charges

(Units) (Rs.) (Rs.) (Rs.)

Product X 11,000 12 5 33,000

Product Y 12,000 19 7 48,000

apportionable to each type of product You 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.

13.

A firm is considering the purchase of a machine. Two machines A and B are available, each costing Rs.50,000. In comparing the profitability of those machines a discount rate of 10% is to be used. Earnings after taxation are expected to be as follows:

Year

Machine A cash

Machine B cash

1 2 3 4 5

Inflow Rs. 15,000 20,000 25,000 15,000 10,000

Inflow Rs. 5,000 15,000 20,000 30,000 20,000

You are also given the following data:

Year

PV Factor @ 10%

1 2 3 4 5 Evaluate the projects using : (a)

the pay-back period

(b)

the ing rate of return

(c)

the net present value

(d)

the profitability index

discount 0.909 0.826 0.751 0.683 0.621

14.

Following are Balance sheet of Vinay Ltd. for the year ended 31 st December 2000 and 2001.

Liabilities

2000 Rs.

Equity capital

2001

Assets

Rs.

2000 Rs.

1,00,000 1,65,000 Fixed Assets

2001 Rs.

1,20,000 1,75,000

Pref. Capital

50,000

(Net) 75,000 Stock

Reserves

10,000

15,000 Debtors

50,000

62,500

P&L A/c

7,500

10,000 Bills

10,000

30,000

20,000

receivable 25,000 Cash at

20,000

26,500

10,000

Bank 12,500 Cash in

5,000

15,000

Creditors

Provision for taxation Proposed dividends

20,000

25,000

hand 7,500

12,500

2,30,000 3,40(000 2,30,000 3,40,000 Prepare a common size balance sheet and interpret the same.

15.

Attempt the following Case:

CASE: BUSINESS DECISION Condensed comparative financial statements for appear below:

PACIFIC CORPORATION Comparative Balance Sheets As of May 31 (in thousands of dollars)

Assets Current assets Plant and equipment

(net

of

depreciation) Total assets Liabilities & Stockholder's Equity Current liabilities Long-term liabilities Capital stock ($10 par) Retained earnings Total liabilities & stockholder's equity

Year 3 $ 3,960 21,240

Year 2 $ 2,610 19,890

Year 1 $ 3,600 14,400

25,200

22,500

18,000

2,214 4,716 12,600 5,670 25,200

2,052 3,708 12,600 4,140 22,500

1,800 3,600 8,100 4,500 18,000

PACIFIC CORPORATION Comparative Income Statements For Years May 31 (in thousands of dollars)

Assets Net sales Cost of goods sold Gross Profit on sales Operating expenses Income before Income taxes Income taxes Net income Cash dividends paid (plus 20% in stock in Year 2) Cash dividends per share

Year 3 $ 90,000 58,500 31,500 28,170 3,330 1,530 1,800 270

Year 2 $ 75,000 46,500 28,500 25,275 3,225 1,500 1,725 465

Year 1 $ $ 60,000 36,000 24,000 21,240 2,760 1,260 1,500 405

0.63

1.11

1.50

Questions:

1.

Prepare a three-year comparative balance sheet in percentages rather than dollars, using Year 1 as the base year.

2.

Prepare common size comparative income statements for the three-year period, expressing all items as percentage components of net sales for each year,

3.

Comment on the -significant trends and relationships revealed by the analytical computations in 1 and 2. These comments should cover current assets and current liabilities, plant and equipment, capital stock, retained earnings, and dividends.

4.

If the capital stock of this company were selling at $ 11.50 per share, would you consider it to be overpriced, underpriced, or fairly priced? Consider such factors as book value per share, earnings per share,

dividend yield, trend of sales and trend of the gross profit percentage. Also consider the types of investors to whom the stock would be attractive or unattractive.