FINANCIAL AND MANAGEMENT ACCOUNTING

Unit - 1

Accounting – Defination – According for historical function and

managerial function – Scope of accounting – Financial accounting

and Management accounting – Managerial uses – Differences.

Financial Accounting: Accounting concepts – Convections –

Principles – Accounting standards – International Accounting

standards.

Unit-2

Double entry system of accounting - Accounting books –

Preapartion of journal and ledger, subsidiary books - Errors and

rectification – Preparation of trial balance and final accounts.

Accounting from incomplete records - Statements of affairs

methods -Conversion method - Preparation of Trading, Profit & Loss

Account 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 Account 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.

REFERENCES:

1. Arulanandam & K.S. Raman, Advanced Accounting.

2. Gupta & Radbasamy, Advanced Accountmg.

3. Shukla & T.S. Grewal, Advanced Accounting.

4. Jain &Narang, Advanced Cost Accounting,

5. Das Gupta, Advanced Studies in Cost Accounting.

6. Maheswari, Management Accounting & Financial Accounting.

1. Manmohan & Goyal, Principles of Management Accounting.

7. Prasad, Advanced Cost Accounting.

FINANCIAL AND MANAGEMENT ACCOUNTING

LESSON TITLE

1. Accounting an Introduction

2. Management Accounting

3. Theory Base of Accounting - Accounting Standards

4. Practical Base of Accounting - Origin and Analysis of

Business Transactions

5. Financial Statements of Profit-making Entities

Manufacturing-cum-Trading Organisations

6. Financial Statements of Non-Profit-making Entities

7. Errors Management

8. Accounts from Incomplete Records - Single Entry System

9. Financial Statement Analysis

10. Ratio Analysis

11. Fund Flow Analysis

12. Cash Flow Analysis

13. Budgeting and Budgetary Control

14. Capital Budgeting

15. Case Study

LESSON - 1

ACCOUNTING: AN INTRODUCTION

Learning outcomes; on completion of this chapter, you should be able to:

Explain the nature of accounting.

Identify the various branches of accounting.

Explain the process of creation of financial statements and

their interpolation.

Explain the various objectives of financial statements.

Identify the various uses of accounting information.

INTRODUCTION

Accounting discipline deals with measurement of 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 accounting can be discipline has universal

applicability, but its growth is closely associated with the

developments in the business world. Thus to understand accounting

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 ACCOUNTING:

1.2 Accounting

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.

Accounting being a man-made system has evolved over a

period of time to provide financial information of business

enterprises to users of accounting 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 user 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(mvestors)

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 members of the public at large(general

public)

Internal users of accounting 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 users of accounting information are

outside the enterprise. The information need of these user 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 user group for decision making. The need for

communicating relevant and useful information to that potential

internal and external users is always there and accounting is

intended to perform that role.

Thus, accounting may be defined as:

"the process of identifying, measuring and communicating

information to permit judgement and decision by the users"

( American Accounting Association)

BRANCHES OF ACCOUNTING

Financial Accounting:

It primarily concentrates on creation of financial

information for external user 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 Accounting - The information provided by

the financial accounting 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

accounting. Management accounting 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 accounting

is cost accounting which deals with cost ascertainment and cost

control.

Few other branches of accounting which are of recent

origin are social responsibility accounting and human resources

accounting. The first one involves accounting for social costs

incurred by the enterprise and social benefits created by it while the

second deals with accounting for human resources.

In the present book, we are concerned with financial

accounting only. The word accounting and financial accounting are

used interchangeably.

Financial accounting provides information to external

user groups in the form of published financial statements. As these

users are involved in preparation of financial statements, it is very

essential that the published statements have credibility and

regarded as reliable by external users. Therefore, accounting, as a

language for communicating information, needs to have a strong

syntax of its own for preparing credible financial statements.

The syntax of accounting 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 accounting

consists of Generally Accepted Accounting Principles (GAAP),

Conceptual framework and Accounting Standards (AS) issued by the

professional accounting bodies all over the world,

The credibility of the financial statements is established

through analysis independent examinations by a chattered

accountant 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

account is known as auditing of accounts.

MEANING OF FINANCIAL ACCOUNTING

Measurement of accounting information involves three

basic steps as per the traditional definition of accounting by the

American Institute of Certified Public Accounts (AICPA) which defines

accounting as "the are of recording, classifying and summarizing in

a significant manner and in terms of money, transaction- and events

which are negative part atleast of financial character and

interpreting the results thereof.

On this basis of above information, Accounting or more

precise financial accounting 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, Pass

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-accounting 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 terms of money. Consequently

business activities which cannot be expressed in terms of money

such as strikes, changes in the composition of board of directors

etc., are not recorded. Thud decision makers will get informa^on

only about money aspects of the business enterprise from a

accounting records.

When to record? Usually business transaction is recorded only

when it has occurred. Thus accounting is basically historical in

nature.

How to record? Usually business transaction has two aspects and

both these are recorded by passing analysts entry in an journal

book. This system of recording is called double entry book keeping

system.

At what value to record? To record occurrence of an event in

journal book, decision about the value of the transaction is needed.

A number of different valuation bases are used in

accounting 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 accounts which are called ledger accounts.

3. Summarizing:

Basic aim of accounting is to create financial information in a

form which will be useful to the decision makers. To achieve this

end, accounts containing classified information in the ledger book

are balanced. After balancing of the ledger book, account balances

are listed statement giving names of theses accounts and their

balance is called " TRIAL BALANCE " on the basts 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 ACCOUNTS. According to international Accounting standard -

1 the term financial statements covers balance sheet, income

statements or profit and loss accounts, 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:

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 accounting

purpose, even a division of the business or a branch of it may be

treated as an accounting 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 user shou/d 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

Analysis of business transaction evidenced by source document

Recording Journal Book

Classification in ledger book

Summarization first in trial balance and then in financial statements

and the results achieved during the period under review. They

reflect a combination of recorded facts, accounting, 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 Accounting Principles

and Conventions. (Bombay Stock Exchange Official Directory).

OBJECTIVES OF ACCOUNTING

The main objective of accounting are as follows:

The main records of business: In accounting, systematic

record of monetary aspects of business events are

maintained. The first step in preparation of financial

statements. This is referred to as book-keeping.

Calculation of profit or loss: To calculate profit earned or

losses suffered during a period of time, a business enterprise

prepares an Income Statement. It is also referred to a trading

and profit and loss account.

Depiction of financial position: In addition to profit (or loss),

sound decision-making requires information about the

financial position of a busiriess enterprises. To depict financial

position of a business, financial position statement is

prepared. On the one hand, it gives details of resources

owned by the business enterprise. Resource owned are

termed as assets. On the other hand it contains the

information about obligations of business. Obligation of the

business towards outsiders and owner are referred to as

liabilities and capital respectively. Financial position

statement is also termed as balance sheet which provide

information about sources of finance (e.g. outside liability and

owners equity) and the resources (eg. assets) of the business.

To portiay the liquidity position: Financial reporting should

provide information about how an enterprise obtains and

spends cash, about its borrowing and repayment of borrowing

about its capital transactions, cash dividends and other

distribution of resources by the enterprise to owners and

about other factors that may affect an enterprise's liquidity

and solvency.

Control over the property and asset of the firm: Accounting

provides up-to-date information about the various assets that

the firm possess and the liabilities the firm owes so that

nobody can claim a payment which is not due to him.

To file tax returns: This is the objective which really hardly

needs emphasis. The credible accounting records provide the

best bases for filing returns of both, direct as well as indirect

taxes.

To make financial information available to various groups and

users: Accounting is called the language of business. It aims to

communicate information about financial results and financial

position of a business enterprise to decision makers,

USERS OF ACCOUNTING INFORMATION

Users of accounting information can be grouped 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 joint 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

joint 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, accounting 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

accounting 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 thpse 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 accounting system, collection of taxes is also based on

accounting 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.

ACCOUNTING AND THEIR DISCIPLINES:

Accounting is the best understood when the other

related disciplines are conceptually clear to the user. For e.g., a user

can hardly understand financial statements with lots of tables and

graphs in it. He is not comfortable with the basics of mathematics

and statistics. Accounting is very intimately connected with many

disciplines more important of which are economics, law,

management, statistics and mathematics.

Linkage with Economics:

Accounting has strong linkages with economics. It has

acquired its most important concepts of income and capital from

economics. The accountant 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 accountant 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 terms,

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.

Accountant 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 accountant

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 accountant 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:

Accounting is all about figures and operations on these

figures. The basic system of accounting can be very conveniently

converted in the mathematical form in the form of an accounting

equation. Simple mathematical operations involved in accounting

are addition, subtraction, multiplication and division. Besides many

aspects of accounting 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:

Accounting is not only about the preparation of accounting

information, it also involves the presentation and interpretation of

accounting 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

accounting namely inflation accounting involves extensive

conversation of historical accounting information with the help of

price indices, 'an important constituent of the discipline of statistics.

The interpretation of accounting 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:

Accounting essentially operates within a legal

environment. Many business organizations are governed by their

respective statues which prescribe the many aspects of their

accounting 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 account, The banking,

insurance and electricity companies have also to prepare their

accounts as per the requirement of the respective statutes

governing them.

LESSON - 2

MANAGEMENT ACCOU NTING

DEFINITION OF MANAGEMENT ACCOUNTING

The accounting activity can be classified into two parts.

Financial Accounting and Management Accounting. Though both of

them are interlinked, Management accounting is future oriented,

dynamic and is made to be decisive and control relevant.

International Federation of Accountants (IFAC) defined

Management Accounting 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 controJ within an organisation

and to assure use of and accountability for its resources".

ICWAI published Glossary of Management Accounting terms

defining Management Accounting as "a system of collection and

presentation of relevant economic information relating to an

enterprise for planning, coordinating and decision making",

Management Accounting : Official Terminology of CIMA is

defined Management Accounting 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. Disc losure 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 Accounting Association defines Management

Accounting 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

Accounting as "Managerial Accounting encompasses 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 Accounting is used by management to plan

the activity, evaluate performance, ensure integrity of financial

information and to irnplement the system of reporting that is linked

to organisational responsibilities and contributes to the effective

performance measurement. The definition of Management

Accounting embraces all functions undertaken by accountants in an

organisation. Management Accounting 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 Accountant is not determined by an isolated concept.

It is determined by the requirements of business as Expressed in its

structures.

SCOPE OF MANAGEMENT ACCOUNTING

Management Accounting includes Financial Accounting and

extends to the operation of a system of cost accounting and

financial management. While meeting the legal and conventional

requirements regarding the presentation of financial statements

(profit and loss account, balance sheet and funds flow statements) it

stresses upon the establishment and operation of internal controls.

The scope of Management Accounting, inter alia, includes:

Formation, installation and operation of accounting, cost

accounting, tax accounting and information systems.

Management Accountant has to

construct and re-construct these systems to meet the

changing needs of management functions

The compilation and preservation of vital data for

management planning. The account and document files are

respository of vast quantities of details about the past

progress of the enterprise, without which forecasts of the

future is very difficult for the enterprise. The Management

Accountant presents the past data in such a way as to reflect

the trends of evbnts to the management.

Providing means of communicating management plans to the

various levels of organisation. This, on the one hand, ensures

the coordination of various segments of the enterprise plans

and on the other defines the role of individual segments in the

whole plan and assists the management in directing their

activities.

Providing and installing an effective system of feedback

reports. This would enable the management in its controlling

function. By pinpointing the significant deviations between

actual and expected activities, and by adhering to the

principles of selectivity and relevance, such reports help in

jthe installation and operation of the system of 'Management

by Exception'. The Management Accounting is expected to

analyse the deviation by reasons and responsibility and to

suggest appropriate corrective measures in deserving cases.

Analysing and interpreting accounting and other data to make

it understandable and usable to the management. It is only

through such analysis and clarification that the management

is enabled to place the various data and figures in proper

perspective in the performance of its functions. Such analysis

assists management- in the location of responsibilities and to

effect necessary changes in the organisational setup to

achieve the objectives of the enterprise in a more efficient

manner.

Assisting management in decision making by (i) providing

relevant accounting and other data and (ii) analysing the

effect of alternative proposals on the profits and position of

the enterprise. Management Accountant helps the

management in proper understanding and analysis of the

problem in hand and presentation of factual information

obviously in financial terms.

Providing methods and techniques for evaluating the

performance of the management in the light of the objectives

of the enterprise, thus assisting in the jrnpiementation of the

principle 'Management by Objectives'.

Improving, modifying and sharpening the effectiveness of the

existing techniques of analysis. The Management Accountant

would always think of increasing the practicability of existing

techniques. He should be on the look-out of the development

of new techniques as well.

Thus, Management Accounting serves not only as a tool in 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 ACCOUNTING

Management Accountant is one of the best assets for

management. His contribution has been growing with passage 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 Accounting"

issued oy the international Federation of Accountants in February

1987 are reproduced below:

"Management Accounting is used by management to;

Plan - to gain an understanding, to expected business

transactions and other economic events and their impact on

the organisation, and to use this understanding as a basis for

a course of action to be followed by the organisation in the

future;

Evaluate - to judge the implications of various past and/or

future events;

Control - to ensure the integrity of financial information

concerning an organisation's activities or its resources;

Assure accountability - to implement the system of reporting

that is closely aligned to organisational responsibilities and

that contributes to the effective measurement of management

performance"

The functions of Management Accounting can be broadly classified

into;

(a) Periodic interval accounting reports, and

(b) Ad hoc analysis of data decision making.

It is increasingly felt that Management Accountants 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 Accounting: This function helps the

organisation prepare long-term plans, formulate corporate

strategy and forecast and evaluate the competitors.

Investment Appraisal: This activity includes the (i) appraisal of

long-term investment (ii) funding of accepted programmes

projects, and (iii) post-audit of accepted programmes.

Financial Management: It deals with raising of funds for

investment, managing surplus funds, controlling working

capital etc,

Short-term ad hoc decisions: This includes analysing data for

taking decisions c i pricing, product introduction, acceptance

of special orders etc.

Managing the organisation of information system: This

includes not only organising the enterprise's financial data but

fulfilling the information needs of all the segments of the

organisation.

FUNCTIONS OF MANAGEMENT ACCOUNTANT

The term 'Management Accountant' has many Director,

Financial Director, Financial Controller, Finance Comptroller etc., are

some of the terms used to designate with the work Management

Accounting. Depending situation, size, nature arid organisational

setup and his position in the company, the Management Accountant

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

Accountant's functions are as follows:

The Management Accountant will establish, coordinate and:

administer plans to facilitate the forecasting of sales, expense

budgets and cost standards that will permit profit planning,

capital budgeting and financing.

The Management Accountant will formulate accounting policy

and procedures. Operating data and special reports must be

prepared so that the performance can be compared with plans

and standards, and any variance between actual operations

and pre-determined standards can be analysed for corrective

actions by management Such comparisons between actual

and expected activities should help the management in

proper fixation of responsibility and also in evaluation of

various functional and divisional heads.

The Management Accountant will be responsible for the

protection of business assets to the extent possible by

external controls and internal auditing and insurance

coverage.

The Management Accountant will be responsible for tax

policies and procedures and will supervise and coordinate the

reports required by various authorities. ;

The Management Accountant must continually £e aware of

economic and social forces as well as the effect of the

Government policies and actions on business activities.

An analysis of the above list (obviously not exhaustive) o

functions, reflects the status of a Management Accountant. He is the

principal office in-charge of the accounts of the company. He shall

be responsible to the Board of Directors for the maintenance of

adequate accounting 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 Accountant is responsible to the policy

making group of top management, whereas, in his administrative

activities he ss responsible to the top executive offer.

MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING

The financial accounting classifies and records an entity's

transactions normally in money terms, in accordance with

established concepts, principles, accounting standards and legal

requirements. It aims to present a 'true and fair view' jof the overall

results of those transactions. Management Accounting has been

described as a continuous process of analysis, planning and control

in the context of providing decision support for decision makers.

Management Accounting is more concerned with decision making

and a key role for Management Accountant is acting as a provider of

financial information to support these decisions, There are several

differences between Financial Accounting and Management

Accounting as are set out in Table 1.1.

Financial Accounting and Management Accounting 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 Accounting although having its roots

in Financial Accounting differs from the latter in following respects:

Financial Accounting studies the business transactions and

events for the enterprise as a whole. It does not trace the path

of events with in the enterprise. Management Accounting, in

additions to the study of the events in relation to the

enterprise as a whole, takes organisation in its various units

and segments and attempts to trace the impact and effect of

the business transactions and events through these various

divisions and sub-divisions. Thus, while the financial

statements -profit and loss account, balance sheet and flow

statements reveal the overall performance and position of the

enterprise. Management Accounting reports emphasis on the

details of operational costs, inventories, products, processes

and jobs. It traces the effect and impact of the business

transactions and events on costs, inventories, processes, jobs

and products.

Financial Accounting is more attached with reporting the

results and positions of business to persons and authorities

other than management-Government, Creditors, Investors,

Owners, etc. At times, Financial Accounting follows window-

dressing tactics in order to project a better than actual image

of the enterprise. Management Accounting is concerned more

with generating information for the use of internal

management and hence the information reflects the real or

really expected position.

Financial Accounting is necessarily historical. It records and

analyses business events long after they have taken place.

Management Accounting analyses the events as they take

place and also anticipates such events for the future. Thus, it

uses data which generally has relevance to the future.

Since Financial Accounting data is historical in nature, it is

more precise than the Management Accounting data, which

generally reflects Ihe expected future, and hence could only

be an estimation. This provides the necessary rapidly to

Management Accounting information.

The periodicity in reporting financial accounts is much wider

than in case of Management Accounting. In Financial

Accounting, generally, results are reported on year to year

basis. In Management Accounting is free to formulate its own

rules, procedures and forms because the information

generates is solely for internal consumption.

Financial Accounting has to governed by the 'generally

accepted principles'. This is so because, it has to cater for the

informational needs of the outsiders and legal provisions.

Management Accounting is free to formulate its own rules,

procedures and forms because the information it generates is

solely for internal consumption.

Financial Statements prepared under Financial Accounting

consists 'of monetary information only. Management

Accounting statements, in addition to monetary information,

also consists non-monetary information viz., quantities of

materials consumed, number of workers, quantities produced

and sold and so on.

TABLE 1.1: MANAGEMENT ACCOUNTING vs. FINANCIAL

ACCOUNTING

Nature Fianacial Accounting Management

Accoutning

1. Governed by

2. Basic functions

Company law etc.

Transaction

recording,

Needs of managers

Decision support

Provision of

3. Users

Publication of

external financial

statements

External

Management

information

Internal

4. Availibility

5. Time focus

6. Period

7. Main emphasis

8. Speed of prepartion

9. Form of presentations

10. Style and details

11. Criteria

12. Unit of account

13. Nature of data

Publicly available

Past and present

Usually one year

Explanation

Slow but detailed

and accurate

whole of entity

Standardized

Objective, verifiable

and consistent

Money

Somewhat technical

Confidential

Present and future

As appropriate

Planning and control

Fast but approximate

Segmented to control

units

Tailored to

requirement and

summarized

Relevant, useful and

understandable

Money physical units

For use by non-

accountants

LESSON - 3

THEORY BASE OF ACCOUNTING - ACCOUNTING STANDARDS

Accounting is "the process of identifying, measuring and

communicating information to permit judgement and decisions by

the users of accounts" -American Accounting Association. It is

absolutely necessary that accounting information contained in

financial statements are credible and are regarded as reliable by the

different user 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

accounting years are based on similar accounting

procedures and policies so that meaningful comparisons

over a period of time can be made1 about he progress of

the enterprise. This is commonly referred to as 'Time series

analysis’.

The financial statements of many enterprises at a point of

time are based on similar accounting procedures and

policies so that conclusions can be drawn about their

relative performance at a point of time. It is known as

'Cross-sectional analysis'. ,

It is the function of 'Accounting Standards' -to provide a

rational structural framework so that credible financial statements

of the highest quality can be produced. According to T.P. Ghosh

accounting standards are defined as under’.

“Accounting standards are the policy documents issued by the

recognised

expert accountancy body relating to various aspects of

measurement,

treatment and disclosure of accounting transactions and

events”

It is clear from the above definition that accounting 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 accounting standards, many alternatives will exist

and will give the accountant the| leverage to colour'his accounting

records the way he likes. Such 'Creative Accounting Practices’ will

certainly create financial statements which are unreliable and lower

the confidence of user in the reported results. Hence the need for a

coherent pet of accounting standards is imperative. The efficient

functioning of the financial system depends upon the confidence

that user groups have in the fairness and reliability of the financial

statements of the businesses ana it is the function of accounting

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 ‘Accounting Standards’ is centred

around harmonisation in the accounting policies and practices

followed by businesses. The basic purpose of 'Accounting Standards'

is to standardize the diverse accounting practices followed for

many aspects of accounting. The harmonisation of accounting

policies and practices is needed at national level as well as

international level. To tackle the problem at national level, the

Institute of Chartered Accountants of" India issues accounting

standards (called AS's) formulated by the Accounting Standards

Board (ASB). At international level, International Accounting

Standards Committee (IASC) issues International Accounting

Standards (called lAS's). The objective of the IASC in terms of

standard setting is "to work generally for the improvement and

harmonisation of regulations, accounting standards and procedures

relating to the presentation of financial statements'. The Institute of

Chartered Accountants of India is a member of IASC and has a tacit

understanding with the IASC that it would adopt the accounting

standards issued by IASC after due recognition of the conditions and

practices prevailing in India. At the international level, IASC has

issued 32 international accounting standards. At the national level,

ICAI has issued 15 accounting standards on various issues of

accounting and a preliminary draft of a proposed accounting

standard on borrowing costs is being made by the ASB in addition to

the revision contemplated in existing standards on valuation of

inventories and accounting for construction contracts.

ACCOUNTING STANDARDS (N INDIA

The Institute of Chartered Accountants of India, fully

recognising the need cf harmonizing the diverse accounting policies

and practices established 'Accounting Standards Board' on 21st April,

1977 so that accounting as a language could develop along the right

lines. Accounting Standard Board's (ASB) main function is to

formulate accounting standards to be issued under the authority of

the council of the institute. Accounting standards provide rules and

criteria of accounting 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 members 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 accounting standards.

While formulating accounting standards, ASB takes into

consideration the applicable laws, customs, usage and business

environment. The Institute is the member of International

Accounting Standards Committee (IASC) and has agreed to support

the objectives of IASC. While formulating standards, it gives due

consideration to the International Accounting 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 accounting standards at periodical intervals.

FORMULATION OF ACCOUNTING STANDARDS

The following points need to be kept in mind while drafting

accounting standards, namely -

The accounting standards issued are in conformity with the

provisions of the applicable laws, customs, usage and

business environment of our country;

The accounting standards are in the nature of laws but not

laws. Though every possible care is taken while drafting

standards that they are in conformity with eh applicable laws,

still the conflict between the law and an accounting standard

might arise due to amendments in the law subsequent to the

issuance of the accounting standard. As clarified in the

'Statements of Accounting Standards', accounting standards

cannot and do not override the statute and in all such cases of

conflicts, the provisions of the law will prevail and the financial

statements should be prepared in conformity with the relevant

laws Obviously, to that extent, the accounting standards shall

not be applicable. However, "the institute will determine the

extenl of disclosure to be made in financial statements and

the related 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 accounting standards are intended to apply only to items

which are material and become applicable from the date as

specified by the institute. They are applicable to all classes of

enterprise unless otherwise stated. No standard is applicable

retroactively, unless otherwise stated;

The accounting standards are to address the basic mattes, to

the extent possible. The idea is to confine them to essentials

only and not to make them complex.

The ASB has drawn an elaborate procedure for formulating

accounting 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

accounting standards need to be formulated;

b) Secondly, the ASB takes the assistance of the various study

groups to formulate standards The preliminary drafts of the

standards are prepared by the Study groups which take 'up

the specific subjects assigned to them. The draft prepared

by a Study Group is considered by ASB and sent to various

outside bodies like FICCI, ASSOCHAM, SCOPE, CLB, C&AG,

ICWAI, ICSI, CBDT etc. and the representative of these

bodies are also invited at a meeting of ASB for discussion.

c) Thirdly, after taking into consideration their views, the draft of

the standard is issued as exposure draft for soliciting

comments from members of the institute and public at

large. The draft is issued to a large number of institutions

and is published in the journal of the institute. The exposure

draft includes the following basic points:

A statement of concepts and fundamental accounting

principles relating to the standard;

Definitions of the terms used in the standard;

The manner in which the accounting principles have

been applied for formulating the standard;

The presentation and disclosure requirements in

complying with the standard;

Class of enterprises to which the standard will apply,

Date from which the standard will be effective.

d) Fourthly, the comments on the exposure draft are then

considered by the ASB and a final draft is prepared and

submitted to the council of the institute;

e) Lastly, the council of the institute considers the final draft of

the proposed standard, and if found necessary, modifies the

same in consultation with ASB. The accounting standard on

the relevant subject is then issued under the authority of

the council.

NATURE OF ACCOUNTING STANDARDS

The accounting standards issued by the ICAI-are

recommendatory in nature in the initial years. During the period a

standard is recommendatory, it is expected that the accounting

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 accounting standards once they are made mandatory. Once

an accounting standard is made mandatory, it is applicable to all

enterprises whose accounts are audited by the members.

During the period an accounting standard is recommendatory,

tne auditors of companies are required to recommend and persuade

their cfients to comply with the requirements of the accounting

standard even though it is recommendatory in nature. Regarding

the mandatory standards, it is the duty of the auditors to ensure

that the accounting standards are followed in the preparation and

presentation of the financial statements. If the mandatory

accounting standards have not beer, complied with, the auditor is

required to make adequate disclosure in his report so that the users

of financial statements are aware of the non-compliance on the part

of the enterprise. If a member fails to do so, the Chartered

Accountants Act explicitly provides that “a chartered accountant 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 members for implementation of

accounting 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 accounts;

Legal backing to the accounting standards. The standards as

they are issued not have no legal backing and institute

depends on its memters for their implementation through

their attest function;

Publicising the use of accounting standards and making the

user: of accounting information more informed about their

right of getting a more true and fair picture of the results of

business based on these accounting standards;

To avoid duplication of authority. If more than one authority

issues standards, it is bound to create a confusion in the mind

of the user as to which standard needs to be followed. A

recent development, worthy of attention, is the establishment

of two accounting standards by the government under the

Income Tax Act, 1961 which are to be followed in the

preparation of financial statements in case the assessee

prefers mercantile basis accounting, (Accounting Standard I

'relating to disclosure of accounting policies and Accounting

Standard II relating to disclosure of prior period and

extraordinary items and changes in accounting policies).

To conclude, the Institute and its members are duty bound to

formulate and implement accounting standards to provide objective

and reliable accounting data that would satisfy the information

requirements of the users To achieve this, problem of duality of

authority should be tackled and the system of dual accounting

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 accounting standards and to prevent abuse of

financial statements, more credibility should be provided to the

process of standard setting.

ACCOUNTING STANDARDS ISSUED BY THE INSTITUTE

AS-1 Disclosure of Accounting Policies :

The standard defines 'Accounting Policies' as referring to the

specific accounting 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 accounting 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

accounting 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 accounting 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 accounting policy in respect of inventories should be

properly disclosed and any change in it which has a material effect

in the current accounting 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 accounts. Such a statement

should be prepared and presented for the period covered by the

profit and loss account 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 non-occurrence, 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 accounting 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 Accounting 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 accounting

estimates and change in accounting 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 Accounting Estimates Vs. Change in

Accounting Policies:

A distinction should always be made between change in accounting

estimates and changes in accounting policies. When it is difficult to

distinguish between the change in accounting estimate and change

in accounting policies, it should be regarded as change in

accounting 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 accounting 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

accounting estimate/ change in accounting 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 Accounting :

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 accounting 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 account 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 accounting policies:

depreciation methods used; and

depreciation rates or the useful lives of the asset, if they are

different from the principal rates specified in the statute

governing the enterprise.

AS-7 Accounting for Construction Contracts :

The standard deals with the problem of allocation of revenues

and related costs to the accounting 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 accounted 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 accounting

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 accounting followed. Disclosure of changes in

accounting policy used for construction contracts should be made in

the financial statements giving the effect of the change and its

amount.

AS-8 Accounting 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

accounting periods. The research and development costs, once

written off, arc never reinstated in accounts. The deferred research

and development cost should be allocated on a systematic basis to

future accounting 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 account. 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 account 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 accounting

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 accounting 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 49haracteri value.

Losses arising from the disposal of fixed asset carried at cost should

be 49haracteri in the profit and loss account.

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 account. Loss on revaluation should

normally be taken to profit and loss account 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 50haracte, it may be charged directly to

that account. 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

50haracte, it may be charged directly to that account. 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) Accounting for tbc Effects of Changes in

Foreign Exchange Rates :

The standard deais with (a) accounting 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 Accounting 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 50haracteri in accounts on

the basis of capital approach or Income approach, based on nature

of relevant grant. However, the government grant should not be

51haracteri 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 accounting policy adopted for government grants, including the

methods of presentation in the financial statements including the

nature and extent of government grant 51haracteri in the financial

statements, including grants of non-monetary assets given at a

concessional rate or free of cost.

AS-13 Accounting for Investments :

The standard deals with accounting 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 long-term 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 account. Profit or loss on disposal of

investments should be 52haracteri and shown in the profit and loss

account. Significant disclosure requirements are also inserted in the

standard and include among other things, the disclosure of

accounting 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 Accounting for Amalgamation :

The standard deals with the accounting for amalgamation and

the treatment of any resultant goodwill or reserves. Amalgamation

is 52haracterized as either in the nature of merger or purchase

depending upon five conditions enumerated. Amalgamation in the

nature of merger is accounted for by ‘Pooling of interest method’

and amalgamation in the nature of purchase is accounted 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 account called ‘Amalgamation Adjustment

Account’. 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 Accounting for Retirement Benefits in the Financial

Statements of Employers:

The standard deals with the accounting 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 accounting 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 AS-5.

LESSON-4

PRACTICAL BASE OF ACCOUNTING – ORIGIN AND ANALYSIS

OF BUSINESS TRANSACTIONS

Accounting 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

Accounting deals with business transactions which have

already taken place, As financial accounting 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 accounting. 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, pass book, salary slip, etc.,

Document

which provides evide nce cf the transaction is called the Source

Document.

Analysis of Business Transactions

In accounting 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 accounts in

opposite directions and if a complete record were to be made of

such transaction, it would be necessary to debit one account and

credit another account. 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 accounts to be debited and credited following two

approached can be followed.

7. Accounting Equation Approach

8. Traditional Approach.

9. Accounting Equation Approach:

Equality of assets on one hand and liabilities and capital on

the other hand is called basic accounting 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 terms of accounting

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

proprietor, the accounting equation appears as under:

Cash + Furniture = Capital

(Rs.5,00,000) (Rs.20,000) - +(5,00,000 +

20,000 )

Rs. 5,20,000 Rs.5,20,000

11. Purchase of assets for cash and / or credit :

Purchased building for Rs,2,00,000 and paid Rs. 10,000 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 accounting equation now appears as follows;

Cash + Furniture = Creditors for building + Capital

(Rs.5,00,000 (Rs.20,000) (Rs.1,90,000)

(Rs.5,20,000) –

Rs. 10,000)

+ Building

(Rs. 2,00,000)

-7,10,000 = Rs.7,10,000

12. Paid into bank Rs.3,00,000

It decreases cash balance and increase bank balance and

thus, have no net effect on total assets as shown below:

Cash + Bank = Creditors for building + Capital

(Rs.4,90,000 (Rs.1,90,000) (Rs.5,20,000)

13. (Rs. 3,00,000)

+ Furniture + Building

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

-7,10,000 = Rs.7,10,000

14. Payment of Rs. 1,90,000 by cheque to creditors

for building :

It decreases bank balance by Rs.1,90,000 and creditors for

building by Rs. 1,90,000 as shown below:

Cash + Bank = Creditors for building +

Capital

(Rs.1,90,000 (Rs. 3,00,000) (Rs.1,90,000)

(Rs.5,20,000)

- Rs. 1,90,000) - Rs. 1,90,000)

+ Furniture + Building

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

Rs. 5,20,000 = Rs. 5,20,000

15. Purchase of goods for Cash/Credit:

Business enterprise purchase goods worth Rs. 50,000 for 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 accounting equation appears as follows:

Cash + Bank + Stock of goods = Creditors +

Capital

(Rs.1,90,000 (Rs. 1,10,000) (Rs.70,000) (Rs.20,000)

(Rs.5,20,000)

16. 50,000)

+ Furniture + Building

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

Rs. 5,40,000 =

Rs.5,40,000

17. Rs. 40,000 cash and Rs.20,000 goods withdrawn

for personal use:

It decreases cash by Rs.40,000 and goods by Rs.20,000. At the

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

Cash + Bank + Stock of goods = Creditors +

Capital

(Rs. 1,40,000 (Rs. 1,10,000) (Rs.70,000 (Rs.20,000)

(Rs.5,20,000

- 50,000) -Rs,20,000) -

Rs.60,000) + Furniture + Building

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

Rs. 4,80,000 = Rs.4,80,000

if accounting equation after above transactions is to be presented

in the form of balance sheet, it will appear as follows :

Balance Sheet

Liabilities Amount Assets amount

Capital 4,65,000 Cash 1,25,000

Creditors 20,000 Bank 1,10,000

Stock 30,000

Furniture 20,000

Building 2,00,000

4,85,000 4,85,000

Classification of Accounts and rules for Recording

Transactions :

For recording business transaction all accounts are divided

into three categories,

1) Assets Account

2) Liability Account

3) Capital Account

For recording changes in assets, liabilities and capital

two basic rules are followed :

Rule No. 1 for recording changes in assets :

Increase in asset is debited and decrease in asset in credited.

Rule No. 2 for recording changes in liabilities and capital :

Increase in liabilities and capital are credited and decrease in

liabilities and capital are debited.

Transactio

n

No.

Assets =

Cash + Bank + Stock+Furniture

+Building =

Creditor

s for

Building

+

Trade

Creditor

s +

Capital

1. 5,00,00

0

- - 20,000 - = - - 5,20,00

0

2. 5,00,00

0

- 10,000

-

-

-

-

20,000

-

-

+2,00,00

0

= -

+

1,90,000

-

-

5,20,00

0

-

3. 4,90,00

0

-

3,00,00

0

-

+3,00,00

0

-

-

20,000

-

2,00,000

-

= 1,90,000

-

-

-

5,20,00

0

-

4. 1,90,00

0

-

3,00,000

-1,90,000

-

-

20,000

-

20,000

-

= 1,90,000

-

1,90,000

-

-

5,20,00

0

-

5. 1,90,00

0

- 50,000

1,10,000

-

-

+70,00

0

20,000

-

20,000

-

= -

-

-

+ 20,000

5,20,00

0

-

6. 1,40,00

0

- 40,000

1,10,000

-

70,000

-20,000

20,000

-

20,000

-

= -

-

20,000

-

5,20,00

0

- 60,000

7. 1,00,00

0

+

25,000

1,10,000

-

50,000

-20,000

20,000

-

20,000

-

= -

-

20,000

-

4,60,00

0

+

50,000

8. 1,25,00

0

1,10,000 30,000 20,000 20,000 = - 20,000 4,65,00

0

Analysis of Changes in Capital Account

Increases and decreases in capital account can take

place due to introduction of capital, withdrawal of cash, goods and

other assets for personal use ( called drawings ), revenue and

income earned ( resulting in increase in capital) and expenses

incurred ( resulting in decrease in capital). Recording the effect of

all these transactions directly in the capital account will make it

unwieldy. In actual practice, net effect of revenue and expense

transaction during an accounting period as shown by profit and loss

account is transferred to capital account. Similarly cumulative effect

of drawings during an accounting period is recorded in the capital

account at the end of the accounting period. For this purpose,

temporary capital accounts are opened. These are called temporary

accounts because these accounts start with zero balance in the

beginning of the accounting period and at the end of the accounting

period, these account are closed and their net effect it transferred

to capital account. These include:

a) Revenue Account(mcluding other incomes and gains)

b) Expense Account(mcludmg losses)

c) Drawing Account.

As these accounts record changes which affect capital account only,

no separate rule is required for recording changes in temporary

accounts. For example:

i. Revenue increases capital and decrease in capital is

credited, therefore revenue earned is credited to revenue

account.

ii. Expense decreases capital and decrease in capital is

debited, therefore, expenses are debited to expense

account.

iii. Drawings decrease capital and decrease in 'capital is

debited, therefore, the value of assets withdrawn for

personal use is debited to drawings account.

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

follows:

Closing capital = Opening capital + Additional capital

- Drawings

+Revenue and Gains

- Expenses

To sum up, under accounting equation approach all

accounts are divided into three, categories namely, assets, liabilities

and capital. Capital account is further sub-divided into permanent

and temporary account 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 accounts, relevant rule of recording and

the account 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

Rs.

1. Received cash form debtors 20,000

2. Deposited cash in bank 4,000

3. Payment to creditors by

cheque

4,000

4. Machine purchased for 10,000

5. Traveling Expenses 5,000

Statement Showing Analysis of Transactions

Transactions

Analysis Title and Nature of Account

Rule Entry

Received

cash from

debtors Rs.

20,000

Increase

cash

Decrease

the amount

due from

debtors

Cash –

Asset

Debtor–

Asset

Debit

increase in

assets

Credit

decrease in

asset

Debit cash

Credit

Debtors

Deposited

cash in bank

Rs. 4000

Increase

bank

balance

Decreases

cash in

hand

Bank –

asset

Cash - asset

Debit

increase in

asset

Credit

decrease

increase

asset

Debit bank

Credit cash

Payment to

creditors by

cheque

Rs.4,000

Decreases

amount

payable to

creditors

decreases

bank

balance

Creditors –

Liability

Bank –

Asset

Debit

decrease in

liability

Credit

decrease in

asset

Debit

creditors

Credit Bank

Machinery

purchased

Rs.10,000

Increases

machinery

Decreases

cash in

hand

Machinery –

asset

Cash - asset

Debit

increase in

asset

Credit

decrease in

asset

Debit

machinery

Credit cash

Traveling

expenses

Rs.5000

Expenses

incurred on

travel

increases

cash in

hand

decreases

Traveling

expense-

Temporary

capital

(Expense)

Cash - Asset

Debit

increase in

expenses

Credit

decrease in

asset

Debit

traveling

Expenses

Credit cash

Analysis of Valuation of Assets and Liabilities

Financial accounting is basically historical in nature and

business transactions are accounted 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 accounting records, valuation records,

valuation accounts are opened to account 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 accounts as follows:

1. Valuation of Assets :

Various valuation accounts generally opened to account for

decreae in the value of assets are ‘provision for discount on debtors

account’, ‘provision for doubtful debts account’, ‘stock reserve

account’, ‘investment fluctuation reserve account, provision for (or

accumulated) depreciation account ‘and so on. The accounts are

opened to bring and report assets at their reduced level.

As decrease in assets are credited, therefore valuation

accounts 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 accounting year 1998, the depreciation

reduces (or decreases) the value of asset and it is calculated to the

assets account with the help of the following entry.

Debit Depreciation account (Being and expenses account and

hence debited) Credit Machinery account.

Alternatively, with the help of a valuation account called provision

for depreciation account, decrease in asset account can be recorded

using the following entry:

Debit Depreciation Account

Credit provision for depreciation account (or accumulated

depreciation)

The provision for depreciation is shown as assets

deduction from the machinery account (because it has assets credit

balance and machinery account has a debit balance) and the same

impact is achieved.

Conversely, if revaluation result in increase in value of

assets, the f valuation accounts are debited.

Thus rule is as follows:

Credit valuation account if asset account is to be decreased.

Debit valuation account if asset account is to be increased

2. Valuation of Liabilities:

Like provision for discount on debtors, Provision for

discount on creditors account is created. As per conservation

principle, it should not be provided because anticipated gains are

not taken into account. But it is analysts accepted accounting

practice to make provision for discount on creditors. It results in

decrease in liabilities. As decrease in liabilities are debited,

valuation accounts recording decrease in liabilities are debited.

Conversely, valuation account recording in increase in liabilities are

credited. This rule is as follows:

Debit valuation account if liability account is to be decreased.

Credit valuation account if liability account is to be increased.

Second aspect of valuation accounts generally appears

in temporary capital accounts and ultimately affects capital account.

Thus, an entry on debit side of an account 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 account indicates either

Increase in liabilities or

Increase in capital or

Decrease in asset or

Increase in revenue

Traditional Approach

Both accounting equation approach and traditional

approach record dual aspect of business transactions. But in

accounting literature, generally, traditional approach is referred to

as double entry system. For analysis and recording of transactions,

traditionally all ledger accounts are divided as follows.

Personal Accounts:

Accounts recording transactions with a person or group of

persons are called personal accounts. These accounts are

necessary, in particular, to record credit transactions. Personal

accounts are of following types.

1. Natural person(s)

Accounts are accounts of individual living beings and

include accounts ;of individuals such as Ramesh capital account.

Ram account, Neha account and so on.

2. Artificial or legal person(s)

Accounts include accounts of legal entities such as

Reliance Industries Limited Account, Delhi Corporation Account,

Goodwill Co-operative society Account, Punjab National Bank

Account and so on.

3. Group / representative personal account:

group personal accounts are accounts of natural and

legal persons grouped together such as debtors account, creditors

account, share capital account etc. commission outstanding

account, salaries outstanding account etc., represent the person to

whom commission or salary is payable and are called representative

personal accounts.

Accounts which are not personal are termed as

impersonal accounts and are divided into real and nominal

accounts.

Real Accounts:

Real Accounts relate to properties of a business

enterprise which can be tangible or intangible.

1. Tangible real accounts:

Accounts of properties having physical existence like

cash, building, stock of goods, furniture etc., are called tangible real

accounts.

2. Intangible real accounts:

Include account of things which cannot be physically felt

or touched but are capable or monetary measurement such as

accounts of goodwill, patents rights, trade-marks rights, copy rights

etc.,

Nominal Accounts:

Accounts relating to income, revenue, gain, expenses

and losses are termed as nominal accounts. Example of nominal

accounts are salaries, rent, commission, discount allowed, rent

received, sales interest received etc. For recording changes in

personal, real and 'nominal accounts, following rules are followed.

Rule No.I - for personal accounts.

Debit the receiver and credit the giver

Rule No.II - for real accounts

Debit what comes in and credit what goes out.

Rule No.Ill - for nominal accounts

Debit all expenses and losses and credit all revenue,

gains and

incomes.

Dual aspect of some business transactions is analyzed by applying

traditional rules as follows.

Transaction

s

Analysis Title and

Nature of

Account

Rule Entry

Introduction

of cash by

owners

Business

gets cash

owner is

the giver

Cash-Real

Capital

personal

Debit what

comes in.

Credit the

giver

Debit cash

Credit

Capital

cash

deposited in

bank

Bank

receives

cash

Business

gives

cash

Bank-Personal

Cash – Real

Debit the

receiver

Credit

what goes

out

Debit bank

Credit cash

Building

purchased

from Mr. X on

credit

Building

comes in

X is the

giver

Building – Real

X – Personal

Debit what

comes in

Credit the

giver

Debit

Building

Credit X

Purchase of

goods for

cash

Goods

are

received

Cash in

paid

Goods – Real

Cash – Real

Debit what

comes in

Credit

what goes

out

Debit Goods

Credit cash

Payment of

salary to an

employee

Service

of the

employe

Salary –

Nominal

Debit all

expenses

Debit salary

e utilized

Business

pays

cash for

service

utilized

Cash – Real

Credit

what goes

out

Credit cash

Rent of

building due

but not paid

Building

is used

by

business

rent for

the

period is

payable

Rent – Nominal

Rent

outstanding –

personal

(representative

)

Debit all

expenses

Credit the

giver

Debit Rent

Credit rent

outstanding

Note: Rent payable or outstanding is a personal account and shows

he amount payable to the owner of the building.

Advantages of Double Entry System

1. Scientific System:

Double entry system records, classifies and summarizes

business transactions in a systematic manner and thus, produce

useful information for decision-makers. It is more scientific as

compared to single entry system of book-keeping.

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 account.

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 users of accounting 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

users of accounting 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 accounting 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 account)

by Rs.5,000 and decreases cash (Asset / Real account) Rs.5,000.

Therefore, the entry is as follows:

Rs.

Debit stock 5,000

Credit stock 5,000

At the time of sale of goods costing Rs.4,000 for

Rs.6,500 cash (Asset / Real account) increases by Rs.6,500 stock

(Asset / Real account) decreases by Rs.4,000 and profit on sale

( Gain / Temporary capital account ) increases by Rs.2,500

Therefore, the entry is as follows.

Rs.

Debit cash 6,500

Credit stock 4,000

Credit profit on sale 2,500

Theoretically, it is possible to find out the stock in 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 accounting records.

But it is impracticable or not feasible to record Sale and

purchase transactions in this manner.

Purchase of goods are recorded in purchase account.

Sales are recorded in sales account 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

Rs.

Debit purchases (Asset / Real account) 5,000

Credit cash (Asset / Real account) 5,000

At the time of cash sale of goods:

Debit cash (Asset J Real account) 6,500

Credit sales (Revenue / Temporary

Capital account (Revenue)) 6,500

At the end of the accounting 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 account in g^ period is recorded

as follows.

Rs.

Debit closing stock (Asset / Real

account)

1,000

Credit purchases (Asset / Real

account)

1,000

In case of purchases and opening stock are transferred

ni trading account and to record the amount of closing stock

following procedure is

followed,

Debit closing stock

Credit Trading Account

The gross profit along with other incomes is compared with indirect

expenses to find out net profit ( or loss) during an accounting

period. Then net profit ( or loss) is transferred to capital account

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 account is as follows:

Rs.

Debit profit and loss (nominal

Account)

2,500

Credit capital (capital Account) 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 accounting

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

Book of M/S Vimal Fabrics

Rs. Rs.

Debit Cash 180 (Real A/C) Debit purchases 195 (Revenue A/C)

Debit

Discount

Allowed

15 (Expenses

A/C)

Credit cash 180

Credit sales 195 (Revenue

A/C)

Credit Discount

Received

15

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 account named ‘Sales Tax payable Account’, 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 1,100 (Real A/C)

Credit Sales 1,100 (Revenue

A/C)

Credit Cash 1,100 (Real A/C)

Credit Sales tax payable

100 (Represtative

personal A/C)

4. Analysis of cheques issued and cheques received:

In case of payments made by issue of cheque, it is

recorded in

bank account straightway. But in case of cheques received, it is

recorded in bank account 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

Rs.

Debit bank 5,000 (Personal Account)

Credit P 5,000 (Personal Account)

But if cheque is deposited on, say 5.2,1999, the entries are as

follows:

On 31.1.1999

Debit bank (Real Account)

Credit P (Account)

On 5.2.1999

Debit bank (Personal Account)

Credit cash (Real Account)

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 'Account 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 account 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 account. As the amount non-recoverable is a loss,

it is debited to a new account, called bad debts account and, at the

end of the accounting period, it is transferred to profit and loss

account. Thus, entry for recording bad debts is as under.

Debit Bad debts (Nominal / Temporary Capital A/C)

Credit Debtors(Group personal / Asset A/C)

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 account.

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, those of

'Raw Materials’ 'Finished Goods', and Unfinished Goods' (popularly

called Work-in-process). 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 account called 'Manufacturing

Account' which precedes the trading and profit and loss account of

manufacturer-cum-trader. In fact the "Income statement of a

manufacturer-cum-trader is made in three stages and is called

'Manufacturing, Trading and Profit and Loss /recount for the period

ending . . .*.

To prepare the manufacturing account, 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 Administration 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 & Administration 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 account. 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 account form, appears as

below:

Dr. Manufacturing Account Cr.

To Opening Stock – Raw xxx By Scrap xxx

Material

To Purchaser of Raw - By Rebates xxx

Material xxx By Purchases returns xxx

To Freight Inward xxx By Subsidies xxx

To Duties and Taxes xxx By Duty Draw Back xxx

To Fatory Overheads xxx By Closing stock-Raw xxx

Material

To Opening Stock– Work xxx By Closing stock -

in progress Work in process xxx

By Cost manufactured xxx

Goods transferred to

trading account

xxx xxx

Note that stocks of raw material and work-in-process have

been adjusted in the manufacturing account whereas the stock of

finished goods is adjusted in the trading account. 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 account instead of profit and loss

account But the depreciation of office furniture (office&

administration overheads) and depreciation of delivery vans (selling

& distribution overheads) are shown in the profit and loss account.

MANUFACTURING DEPARTMENT AS PROFIT CENTRE

The business organisation, instead of being viewed as a

whole, can be looked up as comprising of various parts where each

part 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 account which is

transferred to the profit and loss account with the help of the

following entry.

Manufacturing A/c Dr.

To Profit and Loss A/c

However, this profit is not realised unless goods are sold to

the ultimate customer by the trading division. Hence if finished

goods remain unsold at the end of the accounting 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 account 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 account 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 account at the transfer value. The stock reserve (on

opening stock of finished goods) is shown on the credit side of the

profit loss account 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. However, while valuing it, the concepts of

Equivalent Unit is used. According to institute of Cost and

Management accountants, London, 'Equivalent units are a

notional- quantity of completed 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 account of A with units column:

Unit Rs.

Opening Stock - Raw Material 1,000 10,000

Purchase of Raw Material 10,000 1,10,000

Closing Stock 500 ?

Freight – Inward 10,000

Freight – Outward 15,000

Direct Wages 85,000

Indirect Wages

Factory 40,000

Office 50,000

Other Factory Oveheads 30,000

Opening Stock – Work in Purchase (40%

complete)

1,500 15,000

Closing Stock – Work in Process (30% complete) 3,000 ?

Dr. Manufacturing Account Cr.

Particulars Unit Amoun

t

Particulars Unit Amount

1,000 10,000 By Closing Stock -

Raw Material 500 6,000

To Purchases - By Closing Stock 3,000 27,000

Raw Matertial 10,000 1,10,00

0

- WIP (3)

To Freight - 10,000 By Trading A/c 9,000 2,67,000

Inward [cost of finished

goods transferred

to

trading account (3)

(b.f.)]

To Direct Wages 85,000

To Factory

Overheads (2) 70,000

To Opening

Stock

1,500 15,000

- WIP

12,500 3,00,00

0

12,500 3,00,000

Working Notes:

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

FIFO)

Average pncs of Purchase made during the year =

= (1,10,000 + 10,000)

10,000

= Rs. 12

Value of closing stock of raw material =

= Rs. 6,000

2. Factory Overheads

Indirect Factory wages = 40,000

Other Factory overheads = 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

Units % of completion

during the year

Equivalent units

Opening Stock of work in

process 1,500 60 % 900

Goods started and finished

during the year 7,500 100 % 7,500

Closing Stock of work in

process 3,000 30 % 900

Total 9,300

Cost of Purchase + Freight (Inward)

No. of units purchase

500 units x Rs. 12

Cost incurred during the year

Raw Material Consumed = 1,24,000***

Direct Labour = 85,000

Factory overheads = 70,000

Hence, average cost of equivalent

units

= 2,79,000/9,300

Value of closing stock of work in

process

= Rs. 27,000

Value of finished goods = [Opening stock of WIP + Cost of

completing opening WIP + Cost

of goods started and finished

during the year]

= Rs. 15,000 + 900 units x Rs. 30

+ 7,500 units x Rs. 30

= Rs. 15,000 +Rs. 27,000 + Rs.

2,25,000

= Rs. 2,67,000

* Opening stock at the beginning of the year was 40% complete 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 members.

Non-profit organisations include hospitals, educational

institutions, clubs, political associations, religious institutions,

charitable societies etc. These organisations survive on donations,

grants, subscription from members, etc. Sometimes trading

activities, such as hospital canteen, club restaurant health club,

chemist shop, barshop etc. also take place in such institutions to

provide certain facilities to members 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

profit-making organisations should have no difficulty in preparing

financial statements of non-profit organisations for clear and

effective communication, with their users. 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

account because their primary objective is not to earn profit but to

serve its members 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 Account* is prepared by: non-

profit organisations and is accompanied by a balance sheet tc show

the financial position of the organisation.

INCOME AND EXPENDITURE ACCOUNT

Income and expenditure account is like profit and loss account of

profit-making organisations. Non-profit organisations follow the

same rules or principles for preparing income and expenditure

account which are followed by commercial organisations for

preparing profit and loss account. Following points should be noted:

a) It is a nominal account. It records all expenses and losses on

debit side and all incomes and gains on credit side of the

account. As it records incomes and expenses, the word

'expenditure' is used here in the sense of an expense.

b) Expenses debited to income and expenditure account include

expenditure' of revenue nature. Similarly, the incomes

credited to income and expenditure account are also of

revenue nature. Items of capital nature are, not included in

income and expenditure account but the portion of capital \

expenditure which expires during the year is charged to

income and expenditure account as depreciation.

c) It includes incomes and expenses of current year on accrual

basis irrespective of flow of cash. Therefore, adjustment

relating to outstanding expenses, prepaid expenses, accrued

income, unearned income etc. are taken into account.

d) Excess of credit side over debit side is termed as surplus and

is known as excess of income over expenditure. However, if

debit side exceeds credit side, there is a deficit and is termed

as excess of expenditure over income.: Like transfer of profit

or loss to capital account in case of profit-making entities,

surplus or deficit of non-profit organisations is transferred to

capital fund.

Some Peculiar Items: Though the rules for preparing profit and loss

account of' commercial organisations and income and expenditure

account of non-profit. organisations are same, but there are some

items which are peculiar to non-profit 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 account of

commercial organisations.

b) Annual Subscription : Subscription received from members

is a revenue item and credited to income and expenditure

account. It is primary source of income of a non-profit

organisation.

c) Government Grant: Government schools, colleges, public

hospitals etc. depend upon Government grant for their

activities. The recurring grants in the form of maintenance

grant is, by and large, spent in the year of receipt and is

treated as revenue receipt (income) and credited to income

and expenditure account. Other grants such as building grant,

library grant etc., are treated as capital receipt and

transferred to a fund account. Besides 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-Membership Fees: Fees received for life membership is

a capita] receipt, as it is of non-recurring nature. It is directly

added to capital fund or general fund.

e) Entrance Fees : Fees paid by new members at the time of

joining the organisation is called entrance fees. Since, the fees

is paid only once by members, it is clearly of non-recurring

nature. Hence, it should be treated as capital receipt and be

shown in balance sheet as a part of the general fund.

f) Donation : Donations received for specific purposes are

capitalized and recorded on liabilities side of the balance

sheet. These included donation for building, donation for

extension of library hall, donation for library books, donation

for seminar room, donation for sports activities etc. When the

donation is utilised for the purpose, the amount of donation is

transferred to capital fund. When the purpose for which the

donation is to be utilised is not mentioned, It is called general

donation and treated as income.

g) Honorarium : Payment to non-employees for services

received is called honorarium. It is a revenue item and debited

to income and expenditure account.

h) Legacy : Amount received by non-profit organisations as per

Will of a deceased person is called legacy. As this item is of

non-recurring nature, it is treated as capital receipt and

recorded on liabilities side of the balance sheet.

However, if the amount is small it can be credited to income

and expenditure account.

i) Endowment Fund : It refers to a fund from a bequest or gift.

The fund contains assets uonated by the donor with

stipulation that income earned by these assets but not the gift

itself can be used for principal activities of the organisation.

Sometimes, income may also be restricted. These kind of

restrictions must properly be reflected in the financial

statements. The fund is treated as capital receipt and

recorded on the liability side.

j) Subscription for Periodicals : Subscription for newspapers,

magazines etc. is treated as income and credited to income

and expenditure account.

k) Sale of Old Periodicals : Sale of old newspapers, magazines

etc. is treated as income and credited to income and

expenditure account.

l) Sale of Assets : Sale price of old asset is a capital receipt

and not recorded in income and expenditure account.

However, profit or loss on sale of asset is transferred to

income and expenditure account. To recapitulate profit (or

loss) on sale of fixed asset is calculated by comparing sale

price with book value of asset sold on the date of sale.

m) Income from specific fund and expenses related to

specific fund : Generally, incomes and expenses are

recorded in income and expenditure account. But if expenses

arc incurred on certain items for which a fund exists, then

expenses are not debited to income and expenditure account

but deducted from specific fund account. Similarly, income

from investment of specific fund is added directly to fund is

added directly to fund and not credited to income and

expenditure account For example, match fund balance of Rs.

10,000 income from matches Rs. 5,000 and match expenses

Rs. 12,000 ure shown on liabilities side of balance sheet -as

foolows;

Match Fund

Add income from

matches

Less Mtch Expenses

10,000

5,000

15,000

12,000 3,00

0

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 account

n) Outstanding expenses & prepaid expenses : To

recapitulate, the expenses of current year are to be taken on

accrual basis while making income and expenditure account.

Hence, the payment on account of expenses need to be

adjusted for outstanding expenses and prepaid expenses. The

entries for the two aspects may be recalled from the chapter

on final accounts, namely:-

for outstanding expenses.

Expenses A/c Dr.

To Outstanding Expenses A/c

For prepaid expenses

Prepaid Expenses A/c Dr.

To Expense A/c

Outstanding expenses account is shown in the balance sheet on

liability side and prepaid expenses account on the asset side. Both

accounts are transferred to their respective expense accounts 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 account The entries passed 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 account is shown in the balance sheet on the

asset side and income received in advance on the liability side of

the balance sheet. Both accounts are transferred to their respective

income accounts of the next year to find out its amount correctly.

p) Life membership fund : Sometimes, member of a non

organisation pay their membership fees at die time of

admission only. The fees received is clearly of non-recurring

nature and is given in lieu of subscriptions to be paid every

year which are of recurring nature. If nothing is specified in

the question, assume that life membership fund to be capital

nature and add it to be capital fund. However, if some kind of

amortisation schedule is given, than a suitable part out of

capital fund should be transferred to income and expenditure

denoting the income of that year.

Illustration I: From the trial balance and the additional

information of a public school, prepare Income and

Expenditure Account for the year ending December 31,1998

and the Balance Sheet as at that date.

Trial Balance as at Decembr 31, 1998

Amount

(Dr.)

Amount (Cr.)

Building 2,50,000 Admission Fees 5,000

Fruniture 40,000 Tution Fees 2,00,000

Library Books 60,000 Rent of Hall 4,000

16% Investmetns (1-1-

98)

2,00,000 Creditors for Books

Supplied

6,000

Salaries 2,00,000 Miscllanoues

Receipts

12,000

Stationery 15,000 Annual Government

Grant

1,40,000

General Expenses 8,000 Donations Received

for library books

25,000

Annual Sports Expense 6,000 Capital Fund 4,00,000

Cash 1,000

Bank 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.

depreciation on furniture @ 10% p. a.

4) Depreciate building by 5% and library books by 20%.

Dr. Income and Expenditure Account for the year ending December 31, 1998

Cr.

To Salaries 2,00,00

0

By Tution Fees 2,00,00

0

Add

Outstanding

12,000 2,12,000 Add

Outstanding

10,000 2,10,000

To Stationery 15,000 By Annual

Goverenment

Grant

1,40,000

To Annual

Sports

Expenses

6,000

To General

Expenses

8,000 By Admission

Fees

5,000

To Depreciation

on Furniture

By Rent of Hall 4,000

On 10,000 (for

½ year)

500 By

Miscellanoues

Receipts

12,000

On 30,000 (for 1

year)

3,000 3,500 By Interest on

Investment

8,000

To

Deprecitation

12,500

on Building

To Depreciation

on Library

Books

12,000 Add Accured

Interest

24,000 32,000

To Excess of

Income over

Expenditure

1,34,000

4,03,00

0

4,03,00

0

Balance Sheet as at December 31, 1998

Liabilities Amount Assets Amount

Outstanding

Salary

12,000 Cash 1,000

Creditors for

Books

Supplied

6,000 Bank 20,000

Donation for

Library Books

25,000 Tution Fees

Receivable

10,000

Capital Fund Accounted

Interest on

Investment

24,000

On 1-1-98 4,00,00

0

Investments 20,000

Add Surplus 1,34,00

0

5,34,000 Furniture on 1-

1-98

30,000

Add purchased

on 1-7-1998

10,000

40,000

Less

Depreciation

3,500 36,500

Library Books 60,000

Less

Deprcaition

12,000 48,000

Building 2,50,00

0

Less

Depreciation

12,500 2,37,500

5,77,00

0

5,77,00

0

RECEIPT AND PAYMENT ACCOUNT

Besides income and expenditure account and the balance

sheet, financial statements of non-profit organisations invariably

include 'Receipts and Payment Account'. It is nothing but a

summary of cash receipts and cash payments during the relevant

period. From chronological record of cash transactions in the

cashbook, summary of cash transactions is prepared at the end of

the period under consideration. It does not give the date of the

transact ion (s). Thus, both cashbook and 'Receipt and Payment

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

a) It is real account. All receipts are recorded on its debit side

and all payments are credited.

b) It starts with balance of cash and bank in the beginning of the

period under consideration.

c) It records all items of revenue and capital nature resulting in'

inflow and outflow of cash. Again the period to which the

transaction relates is not significant. Transactions of previous

year, current year and subsequent years are recorded,

provided they affect flow of cash in the current year.

d) Balance of receipt and payment account shows the balance of

cash and bank at the end of the period under consideration.

Difference between Income and Expenditure Account and

Receipt and Payment Account:

Income and Expenditure A

ccount

Receipt and Payment Account

I) It is a nominal account. It is a real account.

2) It is a summary of the working of

the organisation.

3) It is based on accrual system.

It is a summary of cash and bank

transactions of the organisation.

It is based on cash system

4) It records expenses and losses

on debit side and incomes and gains

on credit side.

It records inflow of cash on debit

side and outflow of cash on credit

side

5) It is a temporary account and

has no opening and closing balance.

It is real account and starts

with opening balance of cash and

bank.

6) Itlis closed at the end of the year

and balance figure of the account is

transferred to capital fund.

It is balanced at the end of the

year and the balance carried

forward shows the cash and bank

balance at the end of the period.

7) It records items of revenue

nature only irrespective of their

effect on flow of cash.

It records items both of capital

and revenue nature provided

they affect flow of cash.

8) It records transactions of current

year only.

It records transactions of

previous years, current year and

subsequent years provided flow

of cash is affected.

BALANCE SHEET

Like commercial organisations, non-profit organisations

prepare balance sheet to show the financial position of the

Organisation. If trial balance is not given in the question, first of all

balance sheet on the first day of the period under consideration

(called Opening Balance Sheet) is prepared. It records assets and

liabilities in the beginning of the period. Donations to capital fund

are added to balance of capital fund in the beginning of the period

and after adjustment of deficit or surplus as revealed by income and

expenditure account, the balance capita] fund is recorded in the

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 Amount Assets Amount

Salaries

Outstanding

4,000 Cash 1,000

Capital Fund 1,59,000 Bank 40,000

(Balancing figure) Outstanding

Subscription

2,000

Furniture 20,000

Building 1,00,000

1,63,000 1,63,000

Balance Sheet as at December 31, 1998

Liabilities Amount Assets Amount

Salaries

Outstandin

g

1,000 Cash 900

Capital fund Bank 20,000

On 1-1-98 1,59,00

0

Outstanding

Subscription

3,000

Add Surplus 4,500 1,63,000 Investments 30,000

Add

Accrued

600 30,600

Interest

Furniture on

1-1-98

20,000

Less sold 5,000 15,000

Building 1,00,00

0

Less

Depreciatio

n

5,000 95,000

1,64,50

0

1,64,50

0

Hence it is amply clear that the 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 & Payments Account which is a summary of cash

transactions because most of the transactions of non-profit

organisation are in cash (and/or bank);

In fact, these two statements plus some additional

information (essentially j about the outstanding / prepaid

expenses and accrued / unearned incomes) provide the

basic material which is necessary to compute the deficit /

surplus generated by the non-profit organisation and to

find out their financial position at the end of the period.

This is done in the next two statements, namely,

iii) Income and Expenditure Account showing incomes

generated and expenses incurred during the year to find

out the deficit / surplus;

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

balance sheet)

All these statements are intimately connected. In examination,

normally one or two of these statements are given along 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 wi11 increase the receipts of cash during the year in

receipts and payments account and the difference of sale

price and their value on the date of sale will be charged to

income and expenditure account as loss or gain on sale of

fixed asset

b) The receipts in receipts and payment account will be divided

in two parts, namely capital and revenue. Revenue receipts,

e.g., subscription received will denote (he subscription

received during the year whether pertaining to past / present /

future years. However, it will be adjusted in the light of

information about accrued / unearned subscription given in

the opening balance sheet and additional information and

adjusted subscription,/ representing subscription of the

current year whether received in past / current / future years,

will be shown on the credit side of the income and

expenditure account of the current year. Capital receipts such

as Iife membership fees, legacy etc. will be taken to liability

side of the closing balance sheet under suitable headings.

c) The payments in receipts and payment account will be divided

in two parts, namely, capital and revenue. Revenue payments

or expenses, e.g. salary paid will denote the salary paid during

the year whether pertaining to past / present / future years.

However, it will be adjust in the light of information about

outstanding /prepaid salary and adjusted salary, representing

salary of the expenditure account Capital expenditure,

denoting assets will be taken to asset side of the closing

balance sheet after depreciation which will be shown in the

income and expenditure account on the debit side

(expenditure side).

From examination point of view, preparation of financial statements

of no-profit organisations can be studies under the following

categories:

1) When Receipts and Payments account along with additional

information is given and rest of the basic statements are to be

prepared;

2) When results of an incidental trading (commercial) activity ofa

non-profit organisation (e.g. Bar activities in a club) are to be

ascertained by preparing (Bar) Trading Account along with

income and expenditure account and balance sheet at the end

of the period;

3) When in receipts and Payments account the balance of bank is

given as per pass book;

4) When trial balance along with additional information is given

and few basic statements are to be prepared;

5) When Income and Expenditure account along with additional

information is given and rest of Ihe basic statements are to be

prepared;

6) When both Receipts and Payments account and Income and

Expenditure account along with additional information are

given, and balance sheet in the beginning and at the end are

required;

7) When balance sheet at the beginning and at the end along

with additional information is given, and Receipts and

Payments account and Income and Expenditure account for

the year are required;

8) When raw information is given, and all the basic statements

are to be prepared;

9) When wrong statements / incomplete statements are given

and corrected accounts of non-profit organisation are to be

prepared;

10) Accounts of hospitals;

11) accounts of educational institution including libraries.

Case I: When Receipt and Payment Account along with additional

information is given, and rest of the basic statements are to

be prepared. '

Generally examination problems require preparation of income and

expenditure account 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 Account for the period under

consideration.

3) Balance sheet at the end of the period.

To prepare income and expenditure account from receipt and

payment account, all items appearing in receipts and payment

account 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 account are transferred

to income and expenditure account, 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

account are adjusted, to shift from cash to accrual basis, before

transferring these items to income and expenditure account.

Case II : When results of an incidental trading (commercial) activity

of non-orofit organisation (e.g. Bar activities in a club) are to be

ascertained by preparing Trading Account along with income and

expenditure account and balance sh'eet at the end of the period.

Non profit organisations basically survive on donations, grants

subscriptions from members 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 members 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

account. Procedure followed is as follows:

a) Prepare trading account to calculate profit (or loss) due to

incidental trading activity. All costs and revenues and incomes

directly related with such activity are recorded in trading

account. Balance of trading account showing profit or loss is

transferred to income and expenditure account.

b) Income and Expenditure account records, besides trading

profit (or loss) all other incomes and expenses not directly

related with trading activity. Surplus (or deficit) as revealed by

income and expenditure account is transferred to capital fund

as usual.

Case III: When in receipts and Payments account the balance of

bank is given as per pass book.

Sometimes, receipts and payments account given in the question

shows opening and closing bank balance as per pass book. It means

the information about various receipts and payments given in the

receipts and payments account is as per pass book. To solve the

question, first of all given receipts and payments account 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 accounts of non-profit making

entities are not materially different from the accounts 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

account have to be analysed to find out whether they result in

generation of deficit/surplus or are accounts of assets / liabilities.

The statements are prepared in the usual manner.

Case V: When Income and expenditure Account along with

Additional information is given and rest of the basic statements are

to be prepared.

Sometimes examination problem requires receipt and payment

account and balance sheet from the information given in the

question. To prepare receipt and payment account from income and

expenditure account, all items appearing in income and expenditure

account should be analysed one by one to find out their effect on

flow of cash. To recapitulate, income and expenditure account

records all incomes and expenses of the current period on accrual

basis. Therefore, the information appearing in the income and

expenditure account is to be adjusted in the light of additional

information given in the question to find out inflow and outflow of

cash on account 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 account After recording all receipts and payments and

opening balance of cash and bank, the account is balanced.

Balancing of receipt and payment account 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 Account and Income and

Expenditure Account along with additional information are given,

and balance sheet in the beginning and at the end are required.

Sometimes both receipts and payment account and .income and

expenditure account 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 account is less than the amount shown in

the income and expenditure account, the difference is on account of

salaries outstanding at the end of the year. Students have to be

very careful when amount appearing in receipts and payment

account is more than that appearing in income and expenditure

account. For Example:

a) Insurance premium amount in receipt and payment account is

Rs. 200 and in income and expenditure account is Rs.120

Excess payment of insurance premium can be either on

account of outstanding amount in the beginning of the year or

advance payment for the next year. Generally insurance

premium is paid in advance, therefore, excess amount is

treated as unexpired insurance and recorded on assets side.

b) Income and Expenditure account shows stationery amount

Rs.500 and the amount recorded in receipts and payment

account is Rs.700. In this case, difference is either treated as

stock of stationery (purchases-consumed) at the end or

amount outstanding in the beginning on account of creditors

for stationery.

c) Interest on investment in income and expenditure account is

Rs.1000 and Rs.1500 is shown in receipt and payment

account on account if interest on investment. In this case

difference of Rs.500 can be treatedi as interest received in

advance at the end of the year and recorded on liabilities side

of closing balance sheet. Alternatively difference of Rs.500

can be assumed on account of interest earned but not

received in the beginning of the year and recorded on asset

side of opening balance sheet ;

d) Salary account recorded in receipt and payment account is Rs.

10,000 and Rs.9,000 is shown in income and expenditure

account In this case, Rs. 1,000 can be shown in closing

balance sheet on asset side as advance salary or it can be

treated as salaries outstanding in the beginning of the year

and recorded on liabilities side of opening balance sheet.

It is clear from above that if amount appearing in receipt and

payment! account is more than that appearing in income and

expenditure account, 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 account or income and expenditure account 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 account of salary Rs. 14,100 was paid. It will mean

that payment to be shown in receipts and payments account is Rs.

14,100 but salary of the current year to be shown in income and

expenditure account will be Rs. 14,000 betause the payment

includes Rs. 100 on account of last year.

Case VIII: When raw information is given and basic statements are

to be prepared: When raw information is given, it virtually involves

the writing of entire books of accounts 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 account. All expenses and incomes should be posted to

income and expenditure account keeping in mind the whole

discussion we had so far. Hence, recurring items will find their way

to income and expenditure account 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 accounts of non-profit organisation are to be prepared.

Case X: Accounts 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: Accounts 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 account.

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 accounts 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 accounting 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 accounting 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 accounting 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 accounts, agreement of trial balance is

disturbed as either debit or credit aspect of the transaction is

ignored. For example, omission of credit purchase transaction

at the time of recording in purchases book does not affect the

agreement of trial balance, as posting to purchases book does

not affect the agreement of trial balance, as posting to

purchases amount and supplier's account is not done.

However, omission at the time of posting to supplier's account

affects the agreement of trial balance as posting to purchases

account takes place.

2. Errors of Commission : Besides omission at the time of

recording or posting, business transactions are sometimes

recorded and posted in a wrong manner. Such errors are

referred to as errors of commission. These errors may or may

not affect the agreement of trial balance. For example, 1

recording of wrong amount in subsidiary books, posting an

amount to wrong account, etc. are two sided errors and do

mot affect trial balance; However wrong totaling (or casting)

of subsidiary books, posting on wrong side of an account,

posting of wrong amount, wrong balancing of an account etc,

are one sided errors and affect the agreement of trial balance.

3. Compensating Errors: When two or more one sided errors

take place in such a way that their effect is nullified, these are

referred to as I compensating errors. For example, if Rs. 500

credit sales to Ramesh to ' posted to debit side of Ramesh's

account is omitted at the time of posting and Rs. 500 credit

purchases from Naresh to be posted to credit side of Naresh's

account is not posted to credit side of Naresh's account, these

?' are termed as compensating errors. First error reduces

debit side total by Rs. 500 and second error reduces credit

side total by Rs. 500. As a result, trial balance agrees.

Thus, compensating errors do not affect the agreement of trial

balance. Errors of omission, commission and compensating

errors are also termed as clerical errors

4. Errors of Principle : Besides clerical errors, sometimes

accounting principles are violated in accounting process.

Errors involving violation of accounting principles are termed

as e.rors of principle. Generally, these errors relate to

distinction between capital and revenue items. Treatment of

capital expenditure as revenue receipts or vice versa are

errors of principle. For example, debiting purchase of furniture

to office expenses account, crediting rent received from

tenant to tenant's account, crediting sale of furniture sales

account, debiting payment of salaries to employee's account

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 accounts 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 accounts in order to present their report card in a colourful

manner. It should not allow the prejudice and bias to enter the

accounts where it is avoidable.

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

i) Ignorance on the part of employees of latest accounting

developments, generally accepted accounting principles,

appropriate account classification of the necessary subsidiary

ledgers with controlling accounts and of good accounting practices

in general;

ii) Carelessness on the part of those doing the accounting work.

(B) Detection of Errors

Despite the best of the efforts of the management, some errors may

still remain in the accounts. 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 account is same as computed

number, recheck the nature of the account (whether Dr. and

Cr.) and ensure it is posted on the right side of the trial

balance;

d) Divide the difference by 9. If it is completely divisible, the

error probably may be an outcome of the transposition of the

figure (e.g.. 95 written as 59). Although it may give some idea,

the exercise has to be very thorough;

e) If the difference is very big, the balance in various accounts

should be compared with balances of me last year. If the

difference is material, we have sufficient cause to examine the

account in detail;

f) If still the error is not locatable, recheck the totals of

subsidiary books and ensure they are properly transferred;

g) Recheck the schedules of debtors and creditors;

h) Recomputed the account balances;

i) If stil! the error is not detected, recheck all the entries in the

genera! journal for any possible omission, ' commission,

principle and self compensating errors.

(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 passing a journal entry called

rectifying entry. Thus, rectification entries are entries passed to

correct the errors committed and set right the accounting 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

account.

Entry Passed: Landlord Account Dr.

5,000

To cash Account

5,000

Entry Required: Rent Account Dr.

5,000

To cash Account

5,000

To rectify, credit landlord account which was wrongly debited

and debit rent account which should have been debited. Thus,

rectifying entry, is:

Rent Account Dr.

5,000

To Landlord Account

5,000

2) Cash purchase of goods worth Rs. 5,000 from M/s Prashant

Furniture is debited to furniture account

Entry Passed: Furniture Account Dr.

5,000

To cash Account

5,000

Entry Required: Purchases Account Dr.

5,000

To cash Account

5,000

To rectify, credit furniture account which was wrongly debited

and debit purchases account which should have been debited. Thus,

rectifying entry is:

Purchase Account Dr. 5,000

To Furniture Account

5,000

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

Account.

Entry Passed: Cash Account Dr.

5,000

To Naresh Account

5,000

Entry Required: Cash Account Dr.

5,000

To Ramesh Account

5,000

To rectify, debit Naresh's account which was wrongly credited

and credit Ramesh's account not creditei earlier. Thus, rectifying

entry is:

Naresh Account Dr.

5,000

To Ramesh Account

5,000

4) Rs. 5,000 goods purchased on credit from Mr. Anil wrongly posted

to the debit side of Anil's account and purchases book total Rs.

25,000 posted to debit side of purchases account as Rs. 15,000.

As Anil's account is wrongly debited by Rs. 5,000 instead of

crediting his account by Rs. 5,000 to correct Anil's account Rs.

10,000 should be credited to Anil's account. Since purchases

account is debited by Rs. 35,000 instead of Rs. 25,000 therefore,

purchases account is debited by Rs. 10,000. Thux. rectifying entry

is:

Purchase Account Dr.

10,000

To Anil Account

10,000

5) A sale of Rs. 10,000 to Subash is entered in the sales books as

Rs. 1,000. It means sales account is credited by Rs. 9,000 less and

Subhash's account is debited by Rs. 9,000 less. Therefore, reclijying

entry is:

Subhash Account Dr.

9,000

To Sales Account

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 account, posting of wrong amount to an account,

posting on wrong side of an account-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 account. 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 Account Cr.

By sundries as per sales books

9,500

By undercasting of sales book

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 account called SUSPENSE

ACCOUNT is opened. Difference in trial balance is recorded is

suspense account 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 account is credited Similarly, if credit total is more than

debit total, suspense^

account is debited,

Journal entries for one-sided errors through suspense

account:

Difference in trial balance which is caused by one-sided errors

is put in suspense account. After opening of suspense account if

some errors are located, a .journal entry is passed to rectify them.

Rectification of one-sided errors involves either debit or credit to the

account to be rectified. To complete the double entry, second

aspect is recorded with the help of suspense account.-Difference in

trial balance transferred to suspense account is recorded as opening

balance of suspense account. After location and rectification of all

errors suspense account 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

account, it has been debited by Rs. 500 less. To correct it,

purchases account should be debited by Rs. 500 To complete

double entry, second aspect is recorded through suspense account.

The rectification entry appears as follows:

Purchase Account Dr.

500

To Suspense Account

500

2) Sales book has been totaled Rs. 1,000 more (ovcrcastting)

: It means ut the time of posting of sales book to sales account. Rs.

1,000 excess amoum has been credited. To correct the records,

sales account should be debited by Rs. 1,000. To complete double

entry, suspense account is credited. The rectification entry is as

under:

Sales Account Dr.

1,000

To Suspense Account

1,000

3) Rs. 1,000 cash received from X has not heen posted to his

account : This amount should have been posted to credit side of X

account. To rectify the mistake of non-posting, X's account should

be credited by Rs. 1,000- To complete double entry, suspense

account is debited by the same account. The journal entry required

to rectify the error is as under;

Suspense Account Dr.

1,000

To X

1,000

4) Sales return from V Rs. 700 has been posted to Y's

account as Rs. 70 :

Rs. 700 should have been credited to Y's account. As the amount

actually credited is just Rs. 70, Rs. 630 more should be credited to

Y's account. To complete double entry, suspense accouni is debited

by Rs. 630 as follows:

Suspense Account Dr.

630

To YA/c

630

5) Rs. 4,000 cash paid to a creditor has been posted to the credit

side of creditor's account: Rs. 4,000 cash paid to a creditor should

have been debited To creditor account but ft is actually credited to

creditors account. To have correct balance in creditors account 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' |

passed for this is as follows:

Creditors Account Dr.

3,000

To Suspense Account

8,000

Above entries are posted to suspense account as follows;

Dr Suspense Account

Cr.

To Difference in

trial balance

(balancing figure)

To X

To Y

7,870

1,000

630

By Purchase A/c

By Sales A/c

By Creditors

500

1,000

8,000

After rectification of all the errors, suspense account must

balance. In this case after posting of rectification entries to

suspense account, one finds the debit side 'is short by Rs 7 870 This

balancing figure m suspense account as taken as the opening

balance of suspense account, being the difference in tnal balance

transferred to suspense account.

Errors and Profit : Errors will effect profit only when nominal

accounts recorded in income statement are affected. Effect of

abovementioned errors and their effect on profit is explained as

follows:

a) Wrong credit to sales account increase reported profit

by Rs. 70,000. Correct profit can be calculated by

rectification of this error. Rectification reduces sales

account balance and thus, profit by Rs. 70,000.

b) Wrong debit to wages account reduces reported profit

by Rs. 1,000. To calculate correct profit rectification

entry is passed. It ^uces wages account balance by Rs.

1,000 and thus, increases profit by Ri. 1,000.

c) Non-posting of discount received balance reduces

reported; profit by Rs 2,500 and thus, increase profit

figures by Rs. 2,500 to report-correct profit figure, -

d) Non-oostine of totalsales return increases net sales by

Rs. 12,000. It by Rs. 12,000. Rectification ;of this error

reduces net sales by Rs. 32,000 and thus profit after

rectification is reduced by Rs 12,000 to report correct profit,

e) It does not affect any nominal account and, thus has no

effect on profit. It has not effect on profit as no nominal

account is affected. :

Effect on profit

Errors (a), (b), (c) and (d) do not affect nominal accounts and

therefore, have no effect on profits.

Error (e) affects nominal accounts. 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 account 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 Accounts or

in the next

accounting period

The management should make every conceivable effort to

prevent occurrence of the errors in the accounts. However, if still

some errors creep in the accounts, they should be detected and

rectified before the flnalisation of accounts. 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 accounts finalized.

The suspense account should be shown in the balance sheet til!

such time itscauses are ascertained.

In the next accounting period, the rectification should be done

as and when tfye error is detected. However, the method of

rectification will depend upon whether the account affected is a

nominal account or any other account. If the account 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 account 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 account 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 account 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 accounts, the

rectification entry would have been ;

Suspense Account Dr.

10,000

To Sales Account

10,000

However if the error is detected in the current year after the

finalisation of accounts, 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 Account' and shown in the

current year profit and loss account 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

account of the current accounting period.

Hence, the entry for this aspect will be:

Suspense Account Dr

10,000

To Profit & toss Adjustment Account

10,000

The profit and loss adjustment account is closed by transfer to

the current year profit and loss account as a prior period item.

Hence, the profit of current year clearly reflects the effect of the

errors of 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

accounting period; and (b) if it is done in the next accounting period;

i) Purchase book is undercast by Rs. 5,000:

Rectification entry ij it is done in the accounting period of the error

Purchase Account Dr.

5,000

To Suspense Account

5,000

Rectification entry if it is done in the next accounting period,

Profit & Loss Adjustment Account Dr.

5,000

To Suspense Account

5,000

ii) Rent paid of Rs. 2,000 debited to landlord account and included in

the list of

debtors:

Rectification entry if it is done in the accounting period of the error

itself

Rent Account Dr.

2,000

To Debtors Account

2,000

Rectification entry if it is done in the next accounting period

Profit & Loss Adjustment Account Dr.

2,000

To Debtors Account

2,000

iii) Private purchases of Rs. 1,000 passed through purchase account:

Rectification entry if it is done in the accounting period of the error

itself

Drawings Account Dr.

1,000

To Purchase Account

1,000

Rectification entry if it is done in the next accounting period.

Drawings Account Dr.

1,000

Profit & Loss Adjustment Account

1,000

iv) Cash received of Rs. 4,000 from X shown on the debit of Y's

account: Rectification entry if if is done in the accounting period of

the error itself.

Suspense Account Dr.

8,000

To X Account

4,000

To Y Account 4,000 Rectification entry if if is done in the next

accounting period.

Suspense Account Dr.

8,000

To X Account

4,000

To V Account

4,600

Note that the entry is same in both the cases. The basic reason is

jthat the account affected is not a nominal account.

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

account he places the difference to a suspense account. In the next

year the following mistakes were discovered:

a) A sale of Rs. 4,000 has been passed through the

purchase day book. The entry in the customer's account

has been correctly recorded;

b) Goods worth Rs. 2,500 taken away by the proprietor for

his use has been debited to repairs account;

c) A bill receivable for Rs. 1,300 received from

Krishna has been dishonoured on maturity but no entry

passed; :

d) Salary of Rs. 650 paid to a clerk has been debited to his

personal account;

e) A purchase of Rs. 750 from Raghubir has been debited

to his account. Purchase account has been correctly

debited;

f) A sum of Rs. 2,250 written off as depreciation on

furniture has not been debited to depreciation account.

Draft the joyrnal entries for rectifying the above mistakes and

prepare the suspense account and profit and loss adjustment

account,

Journal

a) Suspense A/c

To Profit & Loss Adjustment A/c

Dr. 8,000

8,000

(Being wrong recording of sales as

purchase last year rectified)

b) Drawings A/c

To Profit & Loss Adjustment A/c

(Being Drawings made last year

inadvertently shown as repairs now

rectified)

Dr. 2,500

2,500

c) 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

To Clerk's Personal A/c

(Being salary paid to clerk last year

inadvertently shown in his personal

account now rectified)

Dr. 650

650

e) Suspense A/c

To Raghubir A/c

(Being purchase from Raghubir) shown

on debit side of his account

inadvertently now rectified)

Dr. 1,500

1,500

f) Profit & Loss Adjustment A/c

To Suspense A/c

(Being depreciation not shown last

year now rectified)

Dr. 1,500

1,500

Dr. Suspense Account

Cr.

To Profit & Loss

Adjustment A/c

8,000 By balance b/d 7,250

To Raghubir A/c 1,500 By Profit & Loss

Adjustment A/c

2,250

9,500 9,500

Dr. Profit & Loss Adjustment Account

Cr.

To Clerk's Persona]

A/c

650 By Suspense A/c 8,000

To suspense A/c 2,250 By Drawings A/c 2,500

To Profit & Loss

Adjustment A/c

(Transfer)

7,600

10,500 10,500

LESSON - 8

ACCOUNTS 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 accounts are maintained

under this system.

d) Importance of Source Document: As complete recording is

not done urder single entry system, source document like

sales bills, purchase bills, vouchers etc., play very important

role in collection of necessary information, for finding out

profit (or loss) and preparing financial position statement.

c) Less Expensive: As complete records are not kept, time and

labou; involved in maintaining accounting records is less in

comparison to double entry system.

d) Suitability : Use of single entry system is not permitted in

case of corporate entities. It is generally followed by non-

corporate entities of small size.

Limitations of Single Entry System. Single entry system 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 accounting records maintained. Hence,

arithmetical accuracy of accounting records can not be

checked.

c) Determination of true profit (or loss) not possible :

Nominal accounts are not maintained and, therefore, it is not

possible to prepare trading account and profit and loss

account to calculate gross profit and net profit respectively.

Although the amount of net profit is determinable but the

absence of details of revenue, other incomes, expenses and

losses affect sound decision making.

d) True financial position cannot be determined: Absence

of real accounts makes the job of preparation of balance sheet

a very difficult one. As information about assets is not

available from records, these items are estimated. Statement

listing assets and liabilities in this case is called 'Statement of

Affairs' instead of Balance sheet. Statement of affairs fails to

reveal the true financial position of the business.

e) More chances of errors and frauds : Trial balance cannot

be prepared to check prima facie arithmetical accuracy of

accounts. It encourages carelessness, misappropriations and

frauds because, in the absence of comolete records, detection

of errors and frauds is very difficult.

f) Unsuitable for planning and control : In the absence of

reliable information about nominal and real account, effective

planning and control over expenses, assets etc., is not

possible. :

g) Legally not recognised : According to the Indian Companies

Act, 1956, single entry system cannot be employed by

companies. Moreover, accounts maintained on single entry

are not accepted by sales tax and income tax authorities.

h) Inter- firm Comparisons not possible : Because of

variation in. accounting procedure and rules, comparisons of

two or more businesses is not possible.

'Inspite of the above limitations, an accountant is

required to ascertain profit, (or loss) and prepare financial position

statement at accounting date. Methods followed for this are a

follows:

a) Statement of Affairs Method or Pure Single-Entry System.

b) Conversion Method or Quasi Single-Entry System.

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 remembered that complete information about

assets and liabilities is not available from accounting 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 Amount Assets Amount

Creditors Cash

Bills payable Bank

Outstanding

expenses

Debtors

Unearned income Bills receivable

Loans Stock

Capital (Balancing

figure)

Prepaid expenses

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 accounting 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

accounting records In statement of affairs capital is taken as

balancing figure, being the difference between lotal assets

and total liabilities.

c) Balance sheet lists balances of assets, liabilities and

capital .drawn from accounting records based on double entry

system. If an asset or liability is omitted, balance sheet does

not tally. Then, error is detected and corrected. However, in

case of statement of affairs, omission of an asset or liability

goes unnoticed because capital is taken as balancing figure.

d) Balance sheet is prepared to show financial position of the

business as per accounting records. Statement of affairs, on

the other hand, is prepared to calculate capital at a particular

point of time.

Calculation of Profit (or loss): To calculated profit or 'oss

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 Account /or the year ending.....

To Depreciation on Fixed

Asset

By Profit before

adjustment as shown in

the statement of profit

To Provision for Doubtful

Debts

By Interest on Drawing

To Interest on Capital

To Net Profit transferred to

Capital Account

Conversion Method

Accounts maintained under single entry system are not

sufficient to extract trial balance at the end of the accounting

period. As a result, final accounts or financial statements cannot be

prepared from incomplete records unless steps are taken for their

completion. Under conversion method, cash accountant, debtors

account, creditors account etc., maintained on single entry basis are

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 accounts 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 account, profit and loss account

and balance sheet is calculated from whatever information is given

in the question. After calculating significant information missing in

the questions, final accounts 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 account.

c) Prepare total debtors account and bills receivable account.

d) Prepare final accounts. :

Whatever information is given in the question, record that in

accounts) involved. Knowledge about items usually appearing in

these accounts 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 Account, Total Creditors Account,

Bills Receivable Account and Bills Payable Account is given below to

have an idea about the items isuaily appearing in these accounts.

Dr. Total Debtors A/c

Cr.

To balance b/d By Cash or Bank A/c

(Debtor in the beginning) (Amount received from

debtors)

To Sales A/c To Bills receivable A/c

(Credit sales) (Bills drawn on debtors)

To Bills receivable A/c By Sales Return A/c

(Bill dishonoured) By Discount Allowed A/c

By Bad Debts A/c

By balance c/d

(Debtors at the end of the

year)

Dr. Bills Receivable A/c

Cr.

To balance b/d By Cash A/c & Discount A/c

(Balance in the beginning) (for B/R Discount)

To Debtors A/c By Creditors A/c

(Bills drawn during the year) (B/R endorsed to creditors)

By Cash A/c

(B/R encashed on due date)

By Debtors A/c

(B/R dishonoured)

By balance c/d

(B/R at the end)

Dr. Total Creditors A/c

Cr.

To Cash A/c or Bank A/c By balance b/d

(Amount paid to creditors) (Creditors in the beginning)

To Bills Receivable A/c By purchases A/c

(for B/R endorsed) (Credit purchases)

To Bills Payable A/c By Bills payable A/c

(Bills accepted) (Bills payable dishonoued)

To Purchases Return A/c

To Discount Received A/c

To balance c/d

(Creditors at the end)

Dr. Bills Payable A/c

Cr.

To Cash A/c By balance b/d

(B/P paid on due dates) (B/P in the beginning)

To Creditors A/c By Creditors A/c

(B/P dishonoured) (Bills accepted during the

year)

To balance c/d

(B/P at the end)

Gross Profit Ratio: Sometimes, gross profit ratio (i.e. Gross

profit / Net sales x 100) is given in the question. In that, case, the

amount of gross profit figure in trading account, calculation of

missing information about any one of the items recorded in trading

account can take place. Items recorded in trading account are

opening stock, purchases, direct expenses and closing stock.

Illustration 1: Find out the amount of direct expenses from the

following

details:

Rs.

Stock on 1-4-98 17,000

Stock on 31-3-999 12,000

Purchases during 1998-99 000

Sales during 1998-99 1,28,000

Gross profit ratio 25%

Dr. Trading Account for the year ended March 31, 1999

Cr.

To Opening Stock 17,000 By Sales 1,28,000

To Purchases 77,000 By Closing Stock 12,000

To Direct Expenses 14,000

(Balancing figure)

To Gross Profit

(25% of Rs.

1,28,000)

1,40,000 1,40,000

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 account and cheques thereon have been

drawn both for business use and private purposes. From the

following information, prepare the final accounts for the year 1998:

Assets and liabilities at the beginning and at the end of the period

have given below:

1-1-1998 31-12-1998

Stock 20,000 15,000

Bank Balance 8,000 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 1,50,000

Private dividends paid into bank 59,700

Private payments out of bank 26,000

Business payments for goods out of bank 1,22,000

Cash takings 2,50,000

Payment for goods by cash and cheque 1,60,000

Wages 97,700

Delivery Expenses 7,000

Rent and rates 2,000

Lighting 1,000

General Expenses 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. Cash A/c Cr.

To balance b/d 300 By Defalcation 20,000

To Sales A/c 2,50,000 By Bank A/c 1,50,000

To Debtors A/c 1,42,000 By Drawings A/c 7,300

(balancing figure) By Purchases A/c 1,02,300

(1,600,000-57,700)

By Wages A/c 97,700

By Delivery Expenses

A/c

7,000

By Rent& Rates A/c 2,000

By Lighting A/c 1,000

By General Exp. A/c 4,600

By balance c/d 400

3,92,30

0

3,92,300

Dr. Bank A/c Cr.

To balance b/d 8,000 By drawings A/c 26,000

To Cash A/c 1,50,000 By Business Payment

A/c

1,22,000

To Capital A/c

(Dividend)

59,700 By Purcahse A/c 57,700

(balancing figure)

By balance c/d 12,000

2,17,00

0

2,17,000

Dr. Sundry Debtors A/c

Cr.

To balance b/d 14,000 By Cash A/c 1,42,000

To Sales A/c (balancing

figure)

By balance c/d 20,000

1,62,00

0

1,62,000

Dr. Sundry Creditors Cr.

To balance c/d 30,000 By balance b/d 27,300

By Purchases A/c (balancing

figure)

2,700

30,000 30,000

Balance Sheet as at 1-1-98

Liabilities Amount Assets Amoun

t

Creditors 27,300 Stock 20,000

Capital (Balancing

figure)

65,000 Bank 8,000

Cash 300

Debtors 14,000

Investments 50,000

92,300 92,300

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

To Opening Stock

A/c

20,000 By Sales :

To Wages 97,700 Cash 2,50,000

To Purchaes : Credit 1,48,000

Cash 1,60,00

0

By closing Stock

A/c

15,000

Credit 2,700

1,62,00

0

Less Drawings 24,000 1,38,700

To Gross Profit 1,56,600

4,13,00 4,13,00

0 0

To Business Payment

A/c

1,22,000 By Gross Profit 1,56,600

To Rent & Rates A/c 2,000

To Lighting A/c 1,000

To General Expenses

A/c

4,600

To delivery Expenses

A/c

7,000

To Defalcation A/c 20,000

1,56,60

0

1,56,60

0

Balance Sheet as at 31-12-98

Liabilities Amount Assets Amount

Opening Capital 65,000 Investment 50,000

Add: Additional

Capital

59,700 Stock 15,000

1,24,700 Debtors 20,000

Less: Drawings 57,300

(7,300+26,000+24,00

0)

67,400 Bank 12,000

Creditors 30,000 Cash 400

97,400 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 accounts.

Under single entry sysuai trial balance cannot be prepared

because duaI-aspect of ail transactions are not recorded.

c) Type of Accounts: Under double entry system nominal,

persona! and real accounts are maintained. Under single entry

system, generally, personal accounts and cash books is

maintained.

d) Rules of Recording : Under double entry system, rules of

double entry system are followed by all concerns. Under single

entry system, as the system is adjusted according to

convenience and needs of the business, rules followed for

recording vary from concern to concern.

c) Cost : As complete records ore kept under double entry

system, cost of maintaining records is more in comparison to

single entry system.

d) Legal Recognition : Corporate entities cannot follow single

entry system as it goes against the provisions of the Indian

Companies Act, 1956. Even sales tax and income tax

authorities do not recognise single entry system.

g) Details of Net Profit (or Loss) : Under double entry system

details of expenses, revenue and incomes are available

because of maintenance of normal accounts. Under single

entry system, though net profit (or loss) is calculated, but

details of expenses revenue and incomes are not available.

h) Financial position : Under double entry system,

financial'position statement reveals trne financial position

based on accounting, records. Under single entry system,

statement of affairs based on incomplete records and

estimates is prepared to reveal financial position of 'he

business.

i) Errors and Frauds : Non-preparation of trial balance due to

incomplete recording under single entry system encourages

carelessness, misappropriations and frauds. Fear of detection

of errors and frauds under double entry system reduces

chances of errors and frauds.

j) Inter-firm Comparisons : Comparison of two or more

business, concern is possible under double entry system

because same set of rules are followed by all concerns. Inter-

firm comparisons under single entry are not valid because of

variation in rules of recording.

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

accounting 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 ACCOUNTING

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 account net profit is ascertained on the basis

of historical

costs.

2. Profit arrived at by the profit and loss account is of interim

nature. Actual profit can be ascertained only after the firm

achieves the maximum capacity.

3. The net income disclosed by the profit and toss account is not

absolute but only relative.

4. The net income is the result of personal judgment and bias of

accountants cannot be removed in the matters of

depreciation, stock valuation, etc.,

5. The profit and loss account does not disclose factors like

quality of product, efficiency of the management etc.,

6. There are certain assets and liabilities which are not disclosed

by the balance sheet. For example the most tangible asset of

a company is its management force and a dissatisfied labour

force is its liability which are not disclosed by the balance

sheet.

7. The book value of assets is shown as original cost less

depreciation. But in practice, the value of the assets may

differ depending upon the technological and economic

changes.

8. The assets are valued in a Balance sheet on a going concern

basis. Some of the assets may not relate their value on

winding up.

9. The accounting year may be fixed to show a favorable picture

of the business. In case of Sugar Industry the Balance sheet

prepared in off season depicts a better liquidity position than

in the crushing season.

10. Analysis Investor likes to analyse the present and future

prospectus of the business while the balance sheet shows past

position. As such the use of a balance sheet is only limited.

11. Due to flexibility of accounting principles, certain liabilities like

provision for gratuity etc. are not shown in the balance sheet

giving the outsiders a misleading picture.

12. The financial statements are generally prepared from the

point of view of shareholders and their use is limited in

decfsion making by the management, investors and creditors.

13. Even the audited financial statements does not provide

complete accuracy.

14. Financial statements do not disclose the changes in

managernent, Loss of markets, etc. which have a vital impact

on the profitability of the concern.

15. The financial statements are based on accounting policies

which vary form company to company and as such cannot be

formed as a reliable basis of judgment.

FORMATS OF FINANCIAL STATEMENTS

The two main financial statements, viz the Income 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 Rs. Particualrs Rs.

To opening stock By cost of finished Goods

c/d

Xxxx

Raw materials xxx By closing stock

Work in progress xxx Raw materials xxx

Work in progress xxx

To purchases of raw

materials

xxx

To manufacturing wages xxx

To carriage inwards xxx

To other Factory Expenses xxx

xxx xxx

By sales xxx

To opening stock of

finished

xxx By closing stock of

finished

xxx

goods goods

To cost of Finished goods

b/d

xxx By Gross Loss c/d xxx

To Gross Profit c/d xxx

xxx xxx

To Gross Loss b/d xxx By Gross profit b/d xxx

To office and Admn.

Expense

xxx By Miscellaneous Receipts xxx

To Interest and financial

expenses

xxx By Net Loss c/d xxx

To provision for Income-

tax

xxx

To Net Profit c/d xxx

xxx xxx

To net loss b/d xxx By Balance b/d xxx

To general reserve xxx (from previous year)

To Dividend xxx By Net profit b/d xxx

To Balance c/f xxx

xxx xxx

(ii) Vertical Form

Income statement of ………… for the year ending ……………...

Particulars Rs. Rs.

Sales xxxx

Less: Sales Returns xxx

Sales Tax/ Exise Duty xxx xxxx

Net sales (1) xxxx

Cost of Goods Sold

Materials Consumed xxxx

Direct Labour xxxx

Manufacturing Expenses xxxx

Add / less Adjustment for change in stock

(2)

xxxx

xxxx

Gross Profit (1) – (2) xxx

Less: Operating Expenses

Office and Administration Expenses

Selling and Distribution Expenses xxx

xxx xxx

Operating Profit Xxxx

Add: Non-operating Income Xxx

Less: Non-oprating Expenses (including Interest) xxxx

Profit before Tax xxx

xxxx

Less : Tax xxx

Profit After Tax xxxx

Appropriations

Transfer to reserves

Dividend declared /paid xxxx

Surplus carried to Balance sheet xxx

xxx

xxxx

Balance Sheet

The Companies Activities, 1956 stipulates that the Balance

sheet of a joint stock company should be prepared as per part I of

schedule VI of the Activities. However, the statement form has been

emphasized upon by accountants for the purpose of analysis and

Interpretation. The permission of the Centra! Government is

necessary for adoption of the 'statement* form.

(i) Horizontal Form

Balance sheet of .................... as on ....................

Liabilities Rs. Assets Rs.

Share Capital xxx Fixed Assets:

(with all paticulars of

Authorized, Issued,

Subscribed capital) Called

1. Goodwill

2. Land & Building

xxx

xxx

up capital xxx 3. Leasehold property

4. Plant and Machinery

5. Furniture and Fittings

xxx

xxx

xxx

Less: Calls in Arrears xxx 6. Patents and Trademarks xxx

Add: Forfeited Shares xxx 7. Vehicles xxx

Reserves and Surplus : Investments

1. Capital Reserve xxx Current Assets, loans

and

2. Capital Redemption Advances

reserve xxx (A) Current Assets

3. Share premium xxx 1. Interest accured on

4. Other premium xxx Investments xxx

Less: debit balance of Profit xxx 2. Loose tools xxx

and loss A/C (if any) 3. Stock in trade xxx

5. Profit and Loss xxx 4. Sundry Debtors xxx

Appropriation A/C Less: Provision for doubtful

6. Sinking Fund xxx debts

5. cash in hand xxx

6. cash in Bank xxx

Secured Loans (B) Loans and Advances

Debentures xxx 7. Advances to subsidiaries xxx

Add: Outstanding Interest xxx 8. Bills Receivable xxx

Loans from Banks xxx 9. Prepaid Expenses xxx

Unsecured Loans Miscellaneous Expenditure

(to the extent not written off

or

Fixed Deposits xxx adjusted) xxx

Short-term loans and

advances

xxx

Current Liabilities and

Provisions

1. Preliminary expenses

2. Discount on Issue of

shares

xxx

xxx

and debentures

A. Current Liabilites 3. Underwriting Commssion xxx

1. Bills Payable xxx

2. Sudnry Creditors xxx Profit and Loss account

(Loss),

3. Income received in

advance

xxx if any

4. unclaimed Dividends xxx

5. Other Liabilities xxx

B. Provisions

6. Provisions for Taxation xxx

7. Proposed Dividends xxx

8. Proposed funds &

pension

xxx

fund contingent liabilities

not

Provided for

xxx xxx

(ii) Vertical Form:

Balance sheet of ………………………. as on …………………

Particulars Schedule No. Current

year

Previous

Year

I. Source of funds

1. Share holders funds

a. capital xxxx xxxx

b. Reserves and surplus xxxx xxxx

2. Loans funds

a. Secured Loans xxxx xxxx

b. Unsecured Loans xxxx xxxx

Total

II. Application of funds

1. Fixed Assets

a. Gross Block xxxx xxxx

b. less Deprciation xxxx xxxx

c. Net block xxxx xxxx

d. Capital work in progress xxxx xxxx

2. Investments xxxx xxxx

3. Current Assets, Loans and Advances

a. Inventions xxxx xxxx

b. Sundry Debtors xxxx xxxx

c. Cash and Bank balance xxxx xxxx

d. other current assets xxxx xxxx

e. Loans and Advances xxxx xxxx

Less : current Liabilities and Provisions

a. Current Laibilities xxxx xxxx

b. Provisions xxxx xxxx

xxxx xxxx

Net Current Assets

4. a. Miscellaneuos Expenditure to xxxx xxxx

the extent not written off or adjusted

b. Profit and Loss Account (debit) xxxx xxxx

Total xxxx xxxx

(ii) Vertical Form for analysis

Balance sheet of ……… as on ……………..

Particulars Rs.

ASSETS

Current Assets

Cash and Bank Balances xxxx

Debtors xxxx

Stock xxxx

Other Current Assets xxxx

(1) xxxx

Fixed Assets xxxx

Less: Depreciation xxxx

Investments xxxx

(2) xxxx

Total (1) + (2) xxxxx

LIABILITIES

Current Liabilities :

Bills Payable xxxx

Creditors

Other Current Liabilities

(3) xxxx

Long Term Debt

Debentures xxxx

Other Long-term Debts xxxx

(4) xxxx

Capital and Reserves

Share Capital xxxx

Reserves and surplus xxxx

(5) xxxx

Total Long term funds

Total (3)+(4)+(5) xxxxx

Statement of Retained Earnings:

Profit and Loss Appropriation Account

Particulars Rs. Particulars Rs.

To transfer to

Reserves

xxx By Last year’s

balance

xxx

To Dividend xxx By Current Year’s

net profit

(Transferred from

profit and loss A/C)

xxx

To Dividend

proposed

xxx

To surplus carried to xxx By Excess provisions xxx

Balance sheet (which are no longer

required)

By Reserves

withdrawn

(if any) xxx

xxx xxxx

Illustration: 1

From the following information, prepare a

vertical Income

Statement.

Sales 2,00,000

Opening stock 10,000

Closing stock 15,000

Purchases 40,000

Operating Expenses 12,000

Rate of Tax 50%

Solution:

Income Statement

Particulars Rs. Rs.

Sales 2,00,000

Less : cost of goods sold:

Opening stock 10,000

Add: Pruchases 40,000

50,000

Less: closing Stock 15,000

35,000

Gross Profit 1,65,000

Less: operating expenses 12,000

Operating profit 1,53,000

Less: non-operating expenses 4,000

Profit before tax 1,49,000

Less: Income tax (50%) 74,500

Net profit after tax 74,500

Illustration: 2

From the following particulars, pertaining to Mohan Ltd.,

you are required to prepare a comparative Income Statement and

interpret the changes.

Particulars Rs. Rs.

Sales 58,000 65,200

Cost of goods sold 47,600 49,200

Administration expenses 1,016 1,000

Selling expenses 1,840 1,920

Non -operating expenses 140 155

Non-operating expenses 96 644

Sales returns 2000 1,200

Tax rate 43.75% 43.75%

Solution:

Comparative Income Statement of Mohan Ltd., for the years

2000 and 2001.

Particulars 2000

Rs.

2001

Rs.

Sales 58,000 65,200

Less Returns 2,000 1,200

Net sales 56,000 64,000

Less: Cost of Goods sold 47,600 49,200

Gross Profit (A) 8,400 14,800

Less: Operating expenses

Administration expenses 1,016 1,000

Selling expenses 1,840 1,920

Total operating expenses (B) 2,856 2,920

Operating profit (A)-(B) 5,544 11,880

Add: non - operating incomes 96 644

Less: non- operating expenses 5,640 12,524

140 155

Net profit before tax 5,500 12,369

Less: Tax 2,406 5,411

Net profit after Tax 3094 6,958

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 terms of moiwy

values)

iii. Increase or reduction in absolute data (in terms of

percentages)

iv. Comparison (in terms of ratios)

v. Percentage of totals.

a. Comparative Income Statement or Profit and Loss

Account:

A comparative income statement shows the absoluie figures

for two or more periods and the absolute change from one period to

another. Since the figures are shown side by side, the user 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 accounting

procedures with regard to depreciation, inventory valuation etc.,

Inter-period comparison may also be misleading if the period

has witnessed changes in accounting policies, inflation, recession

etc.

Illustration 3:

The following is the profit and loss account of Ashok Ltd., for

the years 2000 and 2001. Prepare comparative Income Statement

and comment on the profitability of the undertaking.

Particulars 2000 2001 Particulars 2000 2001

Rs. Rs. Rs. Rs.

To Cost of

goods sold

2,31,62

5

2,41,95

0

By Sales 3,60,72

8

4,17,12

5

To Office

expenses

23,266 27,068 Less

Returns

5,794 6,952

To Interest

expenses

45,912 57,816 3,54,93

4

4,10,17

3

To Loss on

sale of

fixed

627 1,750 By Other

incomes :

To Income

Tax

21,519 40,195 By Discount

on purchase

2,125 1,896

To Net

Profit

35,371 44,425 By Profit on

sale of land

1,500

3,60,45

7

4,13,37

9

3,60,45

7

4,13

,379

Solution:

ASHOK LTD.

Comparative Income Statement for the years ending 2000 and 2001

Particulars 2000

Rs.

2001

Rs.

Increase

(+)

Decrease

(-)

Amount

(Rs.)

Increase (+)

Decrease (-)

Percentages

Sales 3,60,72

8

4,17,12

5

+56,397 +15.63

Less: Sales returns 5,794 6,952 +1.158 +19.98

3,54,93

4

4,10,17

3

+55,239 +15.56

Less: Cost of goods

sold

2,31,62

5

2,41,95

0

+ 10,325 +4.46

Gross Profit 1,23,30

9

1,68,22

3

+44.914 +36.42

Operating

Expenses:

Office

expenses

23,266 27,068 +3,802 + 16.34

Selling

expenses

45,912 57,816 +11,904 +25.93

Total operating 69,178 84,884 +15,706 +22.70

expenses

Operating profit 54,131 83,339 +29,208 +53.96

Add: Other incomes 5,523 3,206 -2,317 -41.95

59,654 86,545 +26.891 +45.08

Less: Other

expenses

2,764 1,925 -839 -30.35

Profit before tax 56,890 84,620 +27,730 +48.74

Less: Income tax 21,519 40,195 +18,676 +86.79

Net Profit after tax 35,371 44,425 +9,054 +25.60

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 2001

Rs. Rs.

Liabilities

Equity share capital 2,00,000 3,30,000

Preference share capital 1,00,000 1,50,000

Reserves 20,000 30,000

Profit and Loss a/c 15,000 20,000

Bank overdraft 50,000 50,000

Creditors 40,000 50,000

Provision for taxation 20,000 25,000

Proposed Dividend 15,000 25,000

Total 4,60,000 6,80,000

Fixed Assets

Less: Depreciation 2,40,000 3,50,000

Stock 40,000 50,000

Debtors 1,00,000 1,25,000

Bills Receivable 20,000 60,000

Prepaid expenses 10,000 12,000

Cash in hand 40,000 53,000

Cash at Bank 10,000 30,000

Total 4,60,000 6,80,000

Solution:

Comparative Balance Sheet

Particulars 31st Dec.

2000

Rs.

31st Dec.

2001

Rs.

Inerease(+)

Decrease(-)

Amount(Rs.)

Increase(+)

Decrease(-)

Percentages

ASSETS

Current Assets:

Cash at bank and in

hand Bills receivable

50,000

20,000

83,000

60,000

+33,000

+40,000

+66

+200

Debtors 1,00,000 1,25,000 +25,000 +25

Stock 40,000 50,000 +10,000 +25

Prepaid expenses

Total Current Assets

10,000

2,20,00

12,000

3,30,000

+2,000

+1,10,000

+20

+50

Fixed Assets 2,40,000 3,50,000 +1,10,000 +45.83

Total Assets 4,60,000 6,80,000 2,20,000 47.83

LIABILITIES

Current Liabilities:

Bank overdraft 50,000 50,000

Creditors 40,000 50,000 +10,000 +25

Proposed dividend 15,000 25,000 +10,000 +66.67

Provision for taxation

Total Current

Liabilities

20,000

1,25,000

25,000

1,50,000

+5,000

+25,000

+25

+20

Capital and Reserve:

Equity share capital 2,00,000 3,30,000 +1,30,000 +65

Preference share

capital

1,00,000 1,50,000 +50,000 +50

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

Total Liabilities 4,60,000 6,80,000 +2,20,000 +47.83

Interpretation:

1. The above comparative Balance sheet reveals the current

assets has been increased to 50%, while current liabilities

increase to 20% only. Cash increased to Rs.33,000 (i.e. 66%),

There is an improvement in liquidity position.

2. The fixed assets purchased was for Rs, 1,10,000. As there are

no long-term funds, it should have been purchased partly

from Share Capital.

3. Reserves and Profit and Loss a/c increased by 50% and

33.33% respectively. The company may issue bonus shares

in near future.

4. Current financial position of the company is satisfactory. It

should issue more long-term funds.

COMMON SIZE STATEMENTS

The figures shown in financial statements viz. Frofit and Loss

Account 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 31st 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

(B) 9,30,000 66.4

GrossProfit (A) -

(B)

4,70,000 33.6

Less: Administrative

expenses

1,10,000 7.9

Selling and distribution

expenses

80,000 5.7

Operating Profit 2,80,000 20.0

Add: Non-operative income 40,000 2.9

3,20,000 22.9

Less: Non-operating

expenses

60,000 43

Profit before tax 2,60,000 18.6

Less: Income tax 80,000 5.7

Profit after tax 1,80,000 12.9

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

Current Assets :

Inventory

Raw materials 80,000 8.5

Work-in-progress 50,000 5.3

Finished goods 1,60,000 17.0

Sundry debtors 2,10,000 22.4

Cash at Bank 30,000 3.2

Total 9,40,000 100.0

Capital and Liabiltiies

Euqity Share capital 2,50,000 26.6

Preference Share Capital 1,00,000 10.6

General reserve 1,60,000 17.0

Debentures 80,000 8.5

Current Liabilities

Sundry Creditors 2,20,000 23.4

Creditors for expenses 40,000 4.3

Bills payable 90,000 9.6

9,40,000 100.0

Analysis of performance and position can be made from the

above Common Size Statements.

llustration: 6

From the following P&L A/c prepare a Common Size Income

Statement-

Particulars 2000 2001 Particulars 2000 2001

Rs. Rs. Rs. Rs.

To Cost of goods

sold

12,000 1 5,000 By Net Sales 16,000 20,000

To Administrative 400 400

expenses

To Selling

expenses

600 800

To Net Profit 3,000 3,800

16,000 20,000 16,000 20,000

Common Size Income Statement

Particulars 2000 2001

Rs. % Rs. %

Net sales 16,000 100.00 20,000 100.00

Less: Cost of goods

sold

12,000 75.00 15,000 7500

Gross

Profit

4,000 25.00 5,000 25.00

Less: Operating

expenses

Administration

expenses

400 2.50 400 2.00

Selling expenses 600 3.75 800 4.00

Total Operating

expenses

1,000 6.25 1,200 6.00

Net Profit 3,000 18.75 3,800 19.00

Illustration: 7

Following are Balance sheet of Vinay Ltd. for the year ended

31st December 2000 and 2001.

Liabilities 2000 2001 Assets 2000 2001

Rs. Rs. Rs. Rs.

Equity capital 1,00,000 1 ,65,000 Fixed Assets

(Net)

1 ,20,000 1,75,000

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

for taxation

10,000 12,500 Cash in hand 5,000 15,000

Proposed

dividends

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.

Solution;

Common Size Balance Sheet of Vinay Ltd.

for the year ended 31.12.2001 & 2002

Particulars 2000 2001

Rs. % Rs. %

Capital & Reserves:

Equity Capital 1,00,000 43,48 1 ,65,000 48.53

Pref. Capital 50,000 21,74 75,000 22.05

Reserves 10,000 4.34 15,000 4.41

P&L A/c 7,500 3.26 10,000 2.95

(i) 1,67,500 72.82 2,65,000 77.94

Current Liabilities:

Bank overdraft 25,000 10.87 25,000 7.35

Creditors 20,000 8.70 25,000 7.35

Provisions for taxation 10,000 4.35 12,500 3.68

Proposed dividends 7,500 3.26 12,500 3.68

(ii) 62,500 27.18 75,000 22.06

Total Liabilities (ij + (ii) 2,30,000 100.00 3,40,000 100.00

Fixed Assets (Net)

(a)

1,20,000 52.17 1,75,000 51.47

Current Assets:

Stock 20,000 8.70 25,000 7.35

Debtors 50,000 21.74 62,500 18.38

Bills receivable 10,000 4.34 30,000 8.82

Cash al bank 20,000 8.70 26,500 7.79

Cash in hand 5,000 2.18 15,000 4.41

(b) 1,10,000 47.83 1,65,000 48.53

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 2000 2001

Rs. Rs. Rs.

Sales 50,000 75,000 1,00,00

0

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.

2001 Rs. Trend Percentage Base

1999

Rs. Rs. Rs. 1999 2000 2001

Purchases 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 200 240 160

Debtors 400 500 650

Stock 600 800 700

Other Current Assets 450 600 750

Land 800 1,000 1,000

Buildings 1,600 2,000 2,400

Plant 2,000 2,000 2,400

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

Other Current

Assets

450 600 750 100 133 167

Total Current

Assets

1,650 2,140 2,260 100 130 137

Fixed Assets:

Land 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

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 financial-statements. The ratio analysis helps

the management to analyse the past. performance of the firm and

to make further projections. Ratio analysis allow1-interested 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 accounting 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 long-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 debt-equity 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 debt-equity 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 accounts

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

accounts - inventories, debtors, fixed assets etc. activity ratios are

used to measure the speed with which various accounts 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

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.

X 100

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

Credit Safes

The actual collection period can be compared with the stated

credit terms of the company. If it is longer than those terms, 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

X 365

levels or, if they do not allow credit accounts, 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

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

X 365

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 accounts.

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

Invested capital

ROI consists of two components viz, I. Profit margin, and fl.

Investment turnover, as shown below:

ROI = Net profit = Net profit 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:

X 100

X

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 xxx

Reserves and surplus xxx

Loans (secured/ unsecured) xxx

xxx

Less: (a) Capital-in-progress xxx

(b) Investment outside the

business

xxx

(c) Preliminary expenses

(d) Debit balance of Profit and Loss

A/c

xxx xxx

Capital employed 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 terms 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 Gross profit

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 into account administration, selling

and distribution and financing charges. 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,

X 100 X 100

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 gross profit percentages.

(iv) 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

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

X 100

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

administration, 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 account 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

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 terms of sales. The cash

profit ratio is a more reliable indicator of performance where there

X 100

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 terms 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

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 tax

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.

X 100

X 100

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, factory-overheads, administration 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

Sales

2. Labour Cost Ratio = Labour Cost Sales

Sales

3. Factory Overhead Ratio = Factory Expenses

Sales

4. Administrative Expense Ratio = Administrative Expenses

Sales

5. Selling and distribution

expenses ratio = Selling and Distribution Expenses

Sales

Generally all these ratios are expressed in terms 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

X 100

X 100

X 100

X 100

X 100

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

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;

X 100

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 account:

Ratios are calculated from financial statements w'.ach

are affected by the financial bases and policies adopted on

such matters as depreciation and the valuation of stocks.

Financial statements do not represent a complete

picture of the business, but merely a collection of facts which

can be expressed in monetary terms. They may not refer to

other factors which affect performance.

Over use of ratios as controls on managers could be

dangerous, in that management might concentrate more on

simply improving the ratio than on dealing with the significant

issues. For example, the return on capital employed can be

improved by reducing assets rather than increasing profits.

A ratio is a comparison of two figures, a numerator and

a denominator In comparing ratios it may be difficult to

determine whether differences are due to changes in the

numerator, or in the denominator or in both.

Ratios are inter-connected. They should not be treated

in isolation. The effective use of ratios, therefore, depends on

being aware of all these limitations and ensuring that,

following comparative analysis, they are used as a trigger

point for investigation and corrective action rather than being

treated as meaningful in themselves.

The analysis of ratios clarifies trends and weaknesses in

performance as a guide to action as long as proper

comparisons are made and the reasons for adverse trends or

deviations from the norm are investigated thoroughly.

Illustration 1: From the given Balance Sheets calculate:

(a) Debt-equity ratio

(b) Liquid ratio

(c) Fixed assets to current assets ratio

(d) Fixed assets to Net worth ratio

Balance Sheet

Liability Rs. Assets Rs.

Share Capital 1,00,000 Goodwill 60,000

Reserve 20,000 Fixed assets (Cost) 1,40,000

Profit and Loss a/c 30,000 Stock 30,000

Secured Loans 80,000 Debtors 30,000

Creditors 50,000 Advances 10,000

Provisions for

taxation

20,000 Cash 30,000

3,00,000 3,00,000

Solution:

(a) Debt-equity ratio = Outsiders Funds

Shareholders Funds

Outsider's Funds Rs. Shareholders' Rs.

Funds

Secured Loans 80,000 Share Capital 1,00,000

Creditors 50,000 Reserves 20,000

Provisions for

taxation

20,000 Profit and Loss a/c 30,000

1,50,000 1,50,000

Debt-equity ratio = 1,50,000

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

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

= 1:1

= 0.47:1

= 1.4:1

1,00,000

(d) Fixed Assets to Net worth Ratio = Fixed Assets

Net worth

Share Capital 1,00,000

Reserves 20,000

P & L a/c 30,000

1,50,000

Less: Provision for taxation 20,000

1,30,000

Fixed Assets to Net worth ratio =

= 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 Rs. Assets Rs.

Equity Share

Capital (Rs. 10

shares)

1,00,000 Plant and

Machinery

6,40,000

Profit and loss

account

3,68,000 Land and buildings 80,000

Creditors 1,04,000 Cash 1, 60,000

Bills payable 2,00,000 Debtors

3,60,000

1,40,000

1,30,000

Less: Provision for

bad debts

40,000

3,20,000

Other Current

liabilities

20,000 Stock 4,80,000

Prepaid Insurance 12,000

16,92,000 16,92,000

Income Statement for the year ending 31st Dec., 2001

(Rs.)

Sales 4,00,000

Less: Cost of goods sold 30,80,000

9,20,000

Less: Operating expenses 6,80,000

Net Profit 2,40,000

Less: Income tax paid 50% 1,20.000

New Profit after tax 1,20,000

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 Rs.

Cash Creditors 1,04,000

Debtors 3,20,000 Bills Payable 2,00,000

Stock 4,80,000 Other Current

Liabilities

20,000

Prepaid insurance 12,000

9,72,000 3,24,000

Current ratio = 9,72,000

3,24,000

(b) Quick ratio = Liquid Assets

Current Liabilities

Liquid assets (Rs.)

Cash Debtors 1,60,000

3,20,000

4,80,000

Liquid ratio = 4,80,000

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

2

3:1

Current liabilities Rs.3,24,000

= 1.48:1

= 4,40,000

Stock Turnover Ratio = 3,80,000

4,40,000

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

Net Sales

= 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%

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 Rs. Particulars Rs.

To Opening Stock 9,950 By Sales 85,000

To Purchases 54,5.25 By Closing Stock 14,900

To Wages 1,425

To Gross Profit 34,000

99,900 99,900

= 7 times

X 100

X 100

X 100

= 94%

To Administrative

Expenses

15,000 By Gross Profit 34,000

To Selling Expenses 3,000 By Interest 300

To Financial Expenses 1,500 By Profit on sale

of shares

600

To Loss on sale of assets 400

To Net Profit 15,000

34,900 34,900

Balance Sheet

Liabilities Rs. Assets Rs.

Share Capital 20,000 Land and Buildings 15,000

Reserves 9,000 Plant & Machinery 8,000

Current Liabilities 13,000 Stock 14,900

P&LA/c 6,000 Debtors 7,1000

Cash at Bank 3,000

48,000 48,000

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 (Rs.)

Cash at Bank 3,000

Debtors 7,100

Stock 14,900

25,000

Current ratio = 25,000

13,000

(b) Operating Ratio = Cost of goods sold + Operating expresses

Net Sales

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

Operating expenses = 19,500

Operating Ratio = 51,000 + 19,500

85,000

(c) Stock Turnover Ratio = Cost of goods sold

Average stock

Average Stock = 9,950 + 14,900

2

Stock Turnover Ratio = 51,000

12,425

Current liabilities Rs. 13,000

Rs. 1.923:1

X 100

= 51,000

X 100 = 82.94%

= 12,425

= 4.1 times

(d) Net Profit Ratio = Net Profit

Net Sales

= 15,000

85,000

(e) Fixed Assets Turnover Ratio = Net Sales

Fixed Assets

= 85,000

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 Rs.

To Opening Stock 10,000 By Sales 1,00,000

To Purchases 55,000 By Closing Stock 15,000

To Gross Profit c/d 50,000

1,15,00

0

1,15,00

0

To Administrative Expenses 15,000 By Gross Profit b/d 50,000

To Interest 3,000

To Selling Expenses 12,000

= 100

= 100 = 17.65%

= 3.7 times

To Net Profit 20,000

50,000 50,000

Balance Sheet

Liabilities Rs. Assets Rs.

Capital 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

Bills receivable 12,500

Cash at Bank 17,500

Furniture 20,000

1,60,000 1,60,000

Calculate the following ratios:

(a) Inventory turnover ratio

(b) Current Ratio

(c) Gross profit ratio

(d) Net profit ratio

(e) Operating ratio

(f) Liquidity ratio

(g) Proprietary ratio

Solution:

(a) Inventory Turnover ratio = Cost of goods sold

Average stock

Cost of goods sold

Opening Stock 10,000

Purchases 55,000

65,000

Less: Closing Stock 1 5,000

50,000

Average Stock = Opening Stock + Closing Stock

2

= 10,000 + 15,000

2

Stock Turnover ratio = 50,000

12,500

(b) Current ratio = Current Assets

Current Liabilities

Current Assets (Rs.)

Current Assets Rs. Current liabilities Rs.

Stock 15,000 Creditors 25,000

Debtors 15,000 Bills Payable 15,000

B/R 12,500

Cash at Bank 17,500

60,000 40,000

Current ratio = 60,000

40,000

(b) Gross Profit Ratio = Gross Profit

Net Sales

(c) Net Profit Ratio = Net Profit

Net Sales

= 12,500

= 4 times

= 1.5:1

X 100

X 100

= 50%

= 20,000

1,00,000

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

Net Sales

Cost of goods sold = 50,000

Operating expenses (Rs.)

Administration expenses Selling

expenses

15,000

12,000

27,000

Operating ratio = 50,000 + 27,000

1,00,000

(e) Liquidity ratio = Liquid Assets

Current Liabilities

Current Assets (Rs.)

Liquid Assets Rs. Current liabilities Rs.

Cash at Bank 17,500 Creditors 25,000

Bills Receivable 12,500 Bills Payable 15,000

Debtors 15,000

45,000 40,000

Liquidity ratio = 45,000

40,000

= 20%

= 100

X 100 77 %

(f) Proprietary ratio = Shareholder’s Funds

Total Assets

Shareholder's Furuis (Rs.)

Capital Profit and Loss a/c 1,00,000

20,000

1,20,000

Proprietary ratio = 1,20,000

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 = 60%

(i) If profit margin is increased by 5% :

ROI = 25% x 3 = 75%

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

ROI = 20% x 2 = 40%

X 100

Total Assets Rs.

1,60,000

X 100 =

75%

(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 A Ltd. B Ltd. C Ltd.

Sales 300 1,500 1,400

Less: Operating Cost 255 1,200 1,050

OperatingProfit (A) 45 300 350

Operating Assets (B) 125 750 1,250

Return on capital employed

(A) / (B) x 1 00

36% 40% 28%

Analysis: Basing on the return on capital employed, B Ltd., is the

best performer as compared to A Ltd. and C Ltd.

Illustration 7: Calculate the P/E ratio from the following:

(Rs.)

Equity Share Capital (Rs. 20 each) 50,00,000

Reserves and Surplus 5,00,000

Secured Loans at 15% 25,00,000

Unsecured Loans at 12.5% 10,00,000

Fixed Assets 30,00,000

Investments 5,00,000

Operating Profit 25,00,000,

Income-taxRate50% (Rs.)

Operating Profit 25,00,000

Less: Interest on

Secured Loans @ 15% 3,75,000

Unsecured Loans @ 12.5% 1,25,000 5,00,000

Profit before tax (PBT) 20,00,000

Less: Income-tax @ 50% 10,00,000

Profit aaer tax (PAT) 10,00,000

No. of Equity shares 2,50,000

EPS = Profit after tax

No. of Equity shares

= Rs. 10,00,000

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:

= Rs. 4

10% Preference shares of Rs.10 each 50,00,000

Equity shares of Rs. 100 each 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

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.7,00,000

= 1.25 times

= Rs. 14.29

(iii) The Price Earnings Ratio:

= Market price per share

Earning per share

= Rs.200

Rs. 14.29

(iv) The Net Funds Flow:

(Rs.)

Profit after tax

Add: Depreciation

15,00,000

6,00,000

21,00,000

= 14 times

LESSON-II

FUNDS FLOW ANALYSIS

INTRODUCTION

The Profit and Loss account and Balance Sheet statements are

the common important accounting statements of a business

organisation. The Profit and Loss account provides financial

information relating to only a limited range of financial transactions

entered into during an accounting 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 user 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

accounting 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 accounts.

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’ account

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 Rs. Assets Rs.

1. Non-Current Liabilities II. Non-Current Assets

Equity Share Capital Land XXX

Preference Share Capital XXX Buildings XXX

Reserves and Surplus XXX Plant and Machinery XXX

Debentures XXX Less: Depreciation

Long-term loans XXX Furniture and Fittings XXX

Vehicles XXX

Patents XXX

Non-Current Liabilities II. Non-Current Assets

Trade Marks XXX

Goodwill XXX

Preliminary expenses XXX

Profit and Loss A/c (Debit XXX

balance)

Total (A) XXX

Total

(A)

XXX Total (A) XXX

III. Current Liabilities 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)

XXX Total (B) XXX

Grand Total (A+B) XXX Grand Total (A+B) 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 Account is

involved. To identify a flow, journalise the transaction, identify the

two accounts involved as 'Current' and 'Non-Current' and apply the

General Rule.

General Rule

Transactions which involve only Current Accounts do not

result in a flow.

Transactions which involve only Non-Current Accounts do not

result in a flow.

Transactions which involve one Current Account and one Non-

Current Account results in a flow of funds.

Proformas of Funds Flow Statement

The relationship between sources and application of funds 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.

Rs.

Fund from Operations xxx

Issue of Share Capital xxx

Raising of long-term loans xxx

Receipts from partly paid shares, called up xxx

Sales of non-current (fixed) assets xxx

Non-trading receipts, such as dividends received xxx

Sale of Investments (long-term) xxx

Decrease in Working Capital (as per schedule of xxx

changes in w.c)

Total xxx

Application or Uses of Funds:

Funds Lost in Operations xxx

Redemption of Preference Share Capital xxx

Redemption of Debentures xxx

Repayment of long-term loans xxx

Purchase of non-current investments xxx

Non-trading payments xxx

Payments of dividends xxx

Payment of tax xxx

Increase in Working Capital (as per schedule of

changes in w.c)

xxx

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 xxx

Issue of Share Capital xxx Redemption of Preference ,

Share capital

xxx

Issue of Debentures xxx Redemption of Debentures: xxx

Raising of long-term

loans

xxx Repayment of long-term loans xxx

Receipts from partly

paid shares, called up

xxx Purchase of non-current (fixed)

assets

xxx

Sale of non-current

(fixed) assets :

xxx Purchase of long-term

Investments

xxx

Non-trading receipts

such as dividends

xxx Purchase of long-term

investments

xxx

Sale of long-term

Investments

xxx Payment of Dividends xxx

Net Decrease in Working

Capital

xxx Payment of tax* xxx

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 account, the

figure pertaining to that account at the beginning and at the end of

the accounting period is shown. The net change in its position is

also shown. The changes taking place with respect to each account

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 accounting period, and the ways in which

working capital has been used up, i.e. list the

transactions which cause working capital to increase or

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 Account as follows:

ADJUSTED PROFIT AND LOSS ACCOUNT

Table 6: PROFORMA OF ADJUSTED PROFIT AND LOSS

ACCOUNT

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 long-term, investments) is adjusted to arrive at the true

funds from operations.

The provision for tax made in the profit and loss account is to

be added back to the reported profit The actual amount paid

as tax is to be shown as the' application of funds in the funds

flow statement. The provision for tax, if it' is shown in the

balance sheet, need not be considered for calculation of

funds! generated fro operations.

Any amount appropriated in the Profit and Loss account

towards transfer to reserves or proposed dividend is to be

added back to arrive at the funds generated from operation.

The actual amount paid as dividend is to be shown, as

application of funds in the funds flow statement. The dividend

proposed but awaiting payment is a current liability in tie

balance sheet. If this amount increases, from one year end to

the next, the extra liability appears as a source of funds.

Funds raised from Shares, Debentures and Long-term Loans

The long-term funds injected into the business during the year

by issue of new shares or debentures and by raising long-term

loans. If any premium is collected, that is also form part of funds

raised 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 long-term

investments outside the business.

3. Distribution of Dividends and Payment of Taxes: The

dividends distributed to the shareholders and tax paid during

the year is the application of funds for the firm.

4. Loss from Operations: Losses made in the trading activities

use up the funds. If costs exceed revenue, a cash outflow will

be experienced. The adjustments are made as shown above in

point (i) in the sources of funds,

Illustration 1: Calculate funds from operations with the help of the

following Profit and Loss A/c.

Calculation of funds from operations

Illustration 2: From the following Manufacturing, Trading and Profit

& Loss Account of a company, calculate Funds from operations.

Manufacturing, Trading, Profit & Loss Appropriation A/c

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 31-23-2001

Rs. Rs.

P&L A/c 50,000 80,000

Provision for Taxation 10,000 15,000

Proposed Dividends 5,000 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 Rs. Particulars Rs.

To Income Tax A/c

(tax paid|)

2,500 By balance b/d

(opening balance)

10,000

To Balance c/d

(closing balance)

15,000 By P&L A/c (provision

made in the current

year)

[bal.fig.]

7,500

17,500 17,500

Particulars Rs. Particulars Rs.

To Dividend A/c

(being dividend paid

during the year)

1,000 By Balance b/d

(Opening balance)

5,000

To balance c/d

(closing balance

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

dividend for the

current

6,000

11,000 11,000

Adjusted P & L A/c

Particulars Rs. Particulars Rs.

To Provision for

Taxation

A/c

7,500 By Balance b/d

(opening balance)

50,000

To proposed Dividend 6,000 By Funds from

Operations

(bal. fig.)

43,500

To Balance c/d

(closing balance

80,000

93,500 93,500

Illustration 5: The following information has been extracted from the Balance

Sheets of a company

Particulars 31st Dec. 2000 31st Dec. 2001

Machinery 80,000 2,00,000

Accumulated Depreciation 30,000 35,000

Profit and Loss Account 25,000 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 Rs. Particulars Rs.

To Machinery A/c 5,000 By Balance b/d 30,000

To Balance c/d 35,000 By Adjusted P&L A/C

(balancing figure)

10,000

40,000 40,000

Machinery A/c

Particulars Rs. Particulars Rs.

To Balance b/d 80,000 By cash (sales) 7,000

To Share Capital 20,000 By Accumulated

depreciation

5,000

To Cash-Purchases

(balancing figure)

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

(Loss on sale)

3,000

By Balance c/d 2,00,000

2,15,00

0

2,15,000

Accumulated Depreciation A/c

Particulars Rs. Particulars Rs.

To Accumulated

Depreciation A/c

10,000 By Balance b/d 25,000

To Machinery A/c (Loss

on sale)

3,000 By Funds from

Operations (bal. fig.)

28,000

To Balance c/d 40,000

53,000 53,000

(i) Purchase of machinery for Rs.20,000 by issue of equity shares

is neither a source nor an application of funds.

(ii) Sale of machinery for Rs.7,000 is a source of funds,

(iii) Purchase of machinery for Rs.1,15,000 for cash is an

application of funds, (iv) Funds from operations of Rs.28,000 is

a source of funds.

Illustration 6: From the following information, you are required to

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

Rs.

Opening Balance of Plant 1,32,500

Closing Balance of Plant 1,97,500

Provision for Depreciation on Plant at the beginning

of the year

45,000

Provision for Depreciation on Plant at the end of

the year

61,000

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 Rs. Particulars Rs.

To Machinery A/c

(Depn.

of sold Machine)

40,000 By Balance b/d 4,24,000

To Closing balance c/d 4,11,000 By Adjusted P&L A/c 27,000

(Balancing

Figure( [Depn.

provided during the

year]

4,51,00

0

4,51,000

Illustration 8 :

Extracts from Balance Sheets

Particulars As on 31st

March,

2000

As on 31st March

2001

Rs. Rs.

Equity from Balance Sheets 4,00,000 5,00,000

8% Preference Share

Capital

2,00,000 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 accounts to find out sources/applications of

funds.

Equity Share Capital A/c

Particulars Rs. Particulars Rs.

To Machinery A/c

(Depn.

of sold Machine)

40,000 By Balance b/d 4,24,000

To Closing balance c/d 4,11,000 By Adjusted P&L A/c

(Balancing

Figure( [Depn.

provided during the

year]

27,000

4,51,00

0

4,51,000

Equity Share Capital A/c

Particulars Rs. Particulars Rs.

To Balance c/d 5,00,000 By Balance b/d 4,00,000

By Machinery A/c 50,000

By Cash-Issue (balancing

figure)

50,000

5,00,00

0

5,00,000

8% Preference Share Capital A/c

Particulars Rs. Particulars Rs.

To cash (Application) 1,00,000 By Balance b/d 2,00,000

To Balance c/d 1,50,000 By Cash-Issue (balancing

figure)

50,000

2,50,00

0

2,50,000

1. 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 2001

Assets

Cash 60,000 94,000

Debtors 2,40,000 2,30,000

Stock 1,60,000 1,80,000

Land 1,00,000 1,32,000

Total 5,60,000 6,36,000

Capital & Liabilities

Share Capital 4,00,000 5,00,000

Creditors 1,40,000 90,000

Retained earnings 20,000 46,000

Total 5,60,000 6,36,000

Statement showing changes in working capital

Particulars 2000 2001 Increase

(+)

Decrease

(-)

Current Assets

Cash 60,000 94,000 34,000

Debtors 2,40,000 2,30,000

10,000

Stock 1,60,000 1,80,000 20,000

4,60,00

0

5,04,000

Current Liabilities

Creditors 1,40,000 90,000 50,000

Working Capital (CA-

CL)

3,20,000 4,14,000

Net increase in

Working Capital

94,000 94,000

4,14,000 4,14,000 1,04,000 1,04,000

Illustration 10 : Following are summerised Balance Sheets ‘X’ Ltd.

as on 31st 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

Share Capital 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

(Long-term)

35,000 67,600 Stock 50,000 37,000

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 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

e

(+)

Decrease

(-)

Current Assets

Cash 250 300 50

Bank - 4,000 4,000

Debtors 40,000 32,100 7,900

Stock 50,000 37,000 13,000

90,250 73,400

Current Liabilities

Creditors Working

Capital (CA - CL)

75,000 - 75,000 -

15,250 73,400

Net increase in Working

Capital

8,150 58,150

73,400 73,400 79,050 79,050

Funds Flow Statement

Sources Rs. Application Rs.

Funds from

operations

45,050 Purchase of Plant 16,500

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

Working Capital

58,150

1,02,65

0

1,02,650

Working Notes:

Share Capital A/c

Particulars Rs. Particulars Rs

To Balance c/d 1,25,000 By Balance b/d 1,00,000

By Bank a/c 25,000

1,25,000 1,25,000

General Reserve A/c

Particulars Rs. Particulars Rs.

To Balance c/d 30,000 By Balance b/d 25,000

By P&L a/c 5,000

30,000 30,000

Provision for Taxation A/c

Particulars Rs. Particulars Rs.

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 31,500

Bank Loan A/c

Particulars Rs. Particulars Rs.

To Balance c/d 67,600 By Balance b/d 35,000

By Bank a/c 2,600

67,600 67,600

Land and Building A/c

Particulars Rs. Particulars Rs.

To Balance c/d 1,00,000 By Depreciation

a/c (P&L a/c)

5,000

By Balance c/d 95,000

1,00,000 1,00,000

Plant A/c

Particulars Rs. Particulars Rs.

To Balance c/d 75,000 By Depreciation a/c

(P&L a/c)

7,000

To Bank 16,500 By Balance c/d 84,500

91,500 91,500

Goodwill A/c

Particulars Rs. Particulars Rs.

To Bank 2,500 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 5,000

Provision for tax 16,500

Dividends paid 11,500

Depreciation:

On Buildings 5,000

On Plant 7,000 45,000

60,300

Less: Balance of P&L a/c (2000) 15,250

Funds from Operations 45,050

Illustration 11: From the following Balance Sheets of ABC Ltd. on

31st Dec. 2000 and 2001, you are required to prepare (i) A Schedule

of changes in working capital, (ii) A Funds Flow Statement.

(Rs.)

Liabilities 2000 2001 Assets 2000 2001

Share Capital 2,00,000 2,00,000 Goodwill 24,000 24,000

General Reserve 28,000 36,000 Buildings 80,000 72,000

P&L A/c 32,000 26,000 Plant 74,000 72,000

Creditors 16,000 10,800 Investments 20,000 22,000

Bills payable 2,400 1,600 Stock 60,000 46,800,

Provision for Tax 32,000 36,000 Bills

receivable

4,000 6,400

Provision for

doubtful debts

800 1,200 Debtors 36,000 3 8,000

Cash & Bank

balances

13,200 30,400

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 2000 2001Increase

in W.C.

Decreas

e in

W.C.

Current Assets

Cash & Bank

Balances

13,200 30,400 17200

Debtors 36,000 38,000 2,000

Bills Receivable 4,000 6,400 2,400

Stock 60,000 46,800 13,200

1,13,200 1,21,600

Current Liabilities

Provision for

doubtful debts

800 1,200 400

Bills Payable 2,400 1,600 800

Creditors Working

Capital (CA - CL)

16,000 10,800 5,200

19,200 13,600

94,000 1,08,000

Increase in Working

Capital

14,000 14,000

1,08,000 1,08,000 27,600 27,600

Funds Flow Statement

Sources Rs. Application Rs.

Funds from

operations

72,000 Purchase of Plant 6,000

Tax paid 34,000

Purchase of investments 2,000

Interim dividend paid 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 Rs. Particulars Rs:

To Balance c/d 74,000 By Depreciation 8,000

To Balance (Purchase) 6,000 By Balance c/d 72,000

80,000 80,000

Buildings A/c

Particulars Rs. Particulars Rs:

To Balance c/d 80,000 By Depreciation 8,000

By Balance c/d 72,000

80,000 80,000

Investments A/c

Particulars Rs. Particulars Rs.

To Balance b/d 20,000 By Balance c/d 22,000

To Bank (Purchase) 2,000

22,000 22,000

Adjusted Profit & Loss A/c

Particulars Rs. Particulars Rs.

To Non-fund and Non-

operating items already

debited to P&L a/c:

By Balance on (31-12-200)

By Funds from operations

32,000

72,000

Transfer to General

Reserve

8,000

Provision for Tax 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

1,04,00

0

1,04,000

General Reserve A/c

Particulars Rs. Particulars Rs.

To Balance c/d 36,000 By Balance 28,000

By P&L a/c 8,000

36,000 36,000

Illustration 12: From the following Balance Sheet of X Ltd., as on

31st December, 2000 and 31st December 2001, you are required to

prepare a funds | flow statement.

(Rs.)

Liabilities 2000 2001 Assets 2000 2001

Share Capital 4,00,000 5,00,000 Land and

Buildings

4,00,000 4,80,000

General

Reserve

80,000 1,40,000 Machinery 3,60,000 2,60,000

P&L A/c 64,000 78,000 Stock 2,00,000 2,52,000

Bank Loan

(Long term)

3,20,000 80,000 Debtors 1,60,000 1,28,000

Creditors 3,00,000 2,60,000 Cash at Bank 1,04,000 18,000

Provision for

Taxation

60,000 80,000

12,24,000 11,38,00

0

12,24,00

0

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

W.C.

Decrease

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

Capital

3,00,000 2,60,000 40,000

1,64,000 1,38,000

1,64,000 1,38,000

Decrease in working

capital

26,000 26,000

1,64,000 1,64,000 1,18,000 1,18,000

Funds Flow Statement for the year ending 31st Dec. 2001

Sources Rs. Application Rs.

Issue of Shares 50,000 Purchase Of Land &

Buildings

75,000

Sale of Machinery 76,000 Bank Loan paid 2,40,000

Funds from

operations

3,17,000 Dividend paid 84,000

Decrease in

Working Capital

26,000 Income-tax paid 70,000

4,69,000 4,69,000

Working Notes:

Provision for Taxation A/c

Particulars Rs. Particulars Rs.

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 1,50,000

Machinery A/c

Land and Buildings A/c

Particulars Rs. Particulars Rs.

To Balance b/d 3,60,000 By Adj. P&L a/c 24,000

By Sale of

Machinery

76,000

By Balance c/d 2,60,000

3,60,000 3,60,000

Land and Buildings A/c

Particulars Rs. Particulars Rs.

To Balance b/d 4,00,000 By Adj. P&L a/c 45,000

To Share Capital 50,000 By Balance c/d 4,80,000

To Cash 75,000

5,25,000 5,25,000

General Reserve A/c

Particulars Rs. Particulars Rs.

To Balance c/d 1,40,000 By Balance b/d 80,000

By Adj. P&L a/c 60,000

1,40,000 1,40,000

Adjusted Profit & Loss A/c

Particulars Rs. Particulars Rs.

To Machinery 24,000 By Opening Balance 64,000

To Land &

Buildings

45,000 By Funds from

Operations

3,17,000

To Provision for 90,000

tax

To General

Reserve

60,000

To Dividends

paid

84,000

To Closing

balance

78,000

3,81,000 3,81,000

FUNDS FLOW STATEMENT Vs. PROFIT AND LOSS ACCOUNT

Following are the main differences between a Funds Flow

Statement and a Profit and Loss Account:

1. Objective: The main objective of preparing a Funds Flow

Statement is to ascertain the funds generated from

operations. The statement reveals the sources of funds

and their uses. The main objective of preparing a Profit

and Loss Account is to ascertain the net profit earned/ loss

incurred by the company out of the business operations at

the end of a particular period.

2. Basis: The Funds Flow Statement is prepared based on the

financial statements of two consequent years. A Profit and

Loss Account is prepared on the basis of nominal

accounts.

3. Usefulness: The Funds Flow Statement is useful for

creditors and management. The Profit and Loss Account is

useful not only to creditors and management but also to

the shareholders and outside parties.

4. Type of Data Used: The Funds Flow Statement takes into

account only the funds available from trading operations

but also the funds available from other sources like issue

of share capital/ debentures, sale of fixed assets etc.

Whereas, the Profit and Loss Account uses only income

and expenditure transactions relating to trading

operations of a particular period.

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 account

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 Account 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 accounts in the

ledger.

3. Usefulness: Funds Flow. Statement is useful for the

management for internal financial management. A Balance

Sheet is useful not only for the management but also to the

shareholders, creditors, outsiders and Government agencies

etc.

4. Treatment of Current Assets and Current Liabilities: In

Funds Flow Statement current assets and current liabilities are

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 passage of time. The management as also

the outsiders concern themselves with the information

system geared up; towards changes in financial position as

the behaviour of funds flow figures relates to the criteria

upon which management strategy is based.

(6) Helps in evaluation of operational issues: The

statement of changes functions as an analytical guide for

evaluating operational issues. The statement enables the

management to ascertain in which the study of trends of

success or failure of operations and available resources.

DRAWBACKS OF FUNDS FLOW ANALYSIS

Historical nature: The funds flow statement is historical in

nature like any other financial statement. It does not estimate

the sources and application of funds for the near future.

Structural changes are not disclosed: The funds flow

statement does not disclose the structural changes in financial

relationship in a firm not it discloses the major policy changes

with regard to investment in current assets and short term

financing. Significant additions to inventories financed by

short term creditors are not furnished in the statements as

they are offset by each other while computing net changes in

working capital.

New items are not disclosed: The funds flow statement

does not disclose any new or original items which affect the

financial position of the business. The funds flow statement

simply rearranges the data given in conventional financial

statements and schedules.

Not relevant: A study of changes in cash is more relevant

than a study of changes in funds for the purpose of

managerial decision-making.

Not foolproof: The funds flow statement is prepared from

the data provided in the balance sheet and profit and loss

account. 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 account

and balance sheet. The information about the cash-flows of a firm is

useful in providing users 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 users 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 Terms

Cash comprises cash on hand and demand deposit with

banks.

Cash equivalents are short-term, highly liquid investments

that are readily convertible into known amounts of cash and

which are subject to an insignificant risk of changes in value.

Examples of cash equivalents are, treasury bills, commercial

paper etc.

Cash flows are inflows and outflows of cash and cash

equivalents. It means the movement of cash into the

organisation and movement of cash out of the organisation.

The 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

premiums and claims, annuities and other policy benefits

Cash payments or refunds of income-taxes unless they can be

specifically identified with financing and investing activities.

Cash receipts and payments relating to future contracts,

forward contracts, option contracts, and swap contracts when

the contracts are held for dealing or trading purpose etc.,

Cash From Operations

Funds from Operations

(as learnt in the previous chapter)

xxx

Add: Increase in Current Liabilities

(excluding Bank Overdraft)

Decrease in Current Assets

(excluding cash & bank balance)

xxx

xxx xxx

xxx

Less: Increase in Current Assets

(excluding cash & bank balance)

Decrease in Current Liabilities

(excluding bank overdraft)

xxx

xxx xxx

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 joint

ventures (other than payments for those instruments

considered to be cash equivalents and those held for dealing

or trading purposes)

Cash receipts from disposal of shares, warrants, or debt

instruments of other enterprises and interests in joint

ventures (other than receipts from those instruments

considered to be cash equivalents and those held for dealing

or trading purposes)

Cash advances and loans made to third parties (other than

advances and loans made by a financial enterprise)

Cash receipts from the repayment of advances and loans

made to third parties (other than advances and loans of a

financial enterprise)

Cash receipts and payments relating to future contracts,

forward contracts,, option contracts, and swap contracts

except when the contracts are, held for dealing or trading

purposes, or the receipts are classified as financing activities.

Cash Flows from Financing Activities:

Financing activities are activities that result in changes in the size

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 accounting period indicate the amount

of changes that have taken place in assets, liabilities and

capital.

Profit and Loss Account : The profit and loss account of the

current period enables to determine the amount of cash

provided by or used in operations during the accounting

period after making adjustments for non-cash, current assets

and current liabilities.

Additional Data: In addition to the above statements,

additional data are collected to determine how cash has been

provided or used e.g., Sale or purchase of assets for cash.

Cash Flow Statement of XYZ Ltd. for the year ending 31"

March 2001

Source Rs. Application Rs.

Opening Balances Opening Balances

Cash XXX Bank overdraft

Bank XXX Cash outflows

Cash Inflows Redemption of Redeemable

Preference Shares

XXX

Cash from Operations XXX Redemption of Debentures XXX

Issue of Shares XXX Repayment of Loans XXX

Raising of Long Term Non Operating Expenses XXX

Loans/Debentures XXX Closing Balances XXX

Sale of Fixed Assets

and Investments

XXX Cash XXX

Non Trading Receipts XXX Bank XXX

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 accounting

system. In case of preparation cash flow statements all

transactions effecting the cash or cash equivalents is only

taken into consideration.

Funds flow statement analysis the sources and application of

funds of long-term nature and the net increase or decrease in

long-term funds will be reflected on the working capital of the

firm. The cash flow statement will only consider the increase

or decrease in current assets and current' liabilities in

calculating the cash flow of funds from operations.

Funds Flow analysis is more useful for long range financial

planning. Cash flow analysis is more useful for identifying and

correcting die current liquidity problems of the firm.

Funds flow statement analysis is a broader concept, it takes

into account both long-term and short-term funds into account

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 31.12.2000 31.12.2001

Net Profit 70,000

Debtors 42,000 40,000

Bills Receivable 8,000 13,000

Creditors 47,000 50,000

Bills payable 15,000 10,000

Stock 58,000 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 5,000

Increase in stock 7,000

[ Decrease in Bills payable 5,000 17,000

Cash from operations 58,000

Illustration: 2

From the following balances, you are required to calculate cash from

operations:

Particulars Decembe

r 31

2000

Decembe

r 31 2001

Debtors 50,000 47,000

Bill Receivable 10,000 12,500

Creditors 20,000 25,000

Bills Payable 8,000 6,000

Outstanding Expenses 1,000 1200

Prepaid Expenses 800 700

Accrued Income 600 750

Income Received in Advance 300 250

Profit made during the year - 1,30,000

Calculation of Cash from operations

Profit made during the year 1,30,000

Add: Decrease in debtors 3,000

Increase in Creditors 5,000

Increase in Outstanding Expenses 200

Decrease in Prepaid Expenses 100

1,38,000

Less: Increase in Bill Receivable 2,500

Increase in Accrued Income 150

Decrease in Bills Payable 2,000

Decrease in Income Receive in Advance 50 4,700

Cash from Operations 1,33,600

Illustration: 3

From the following information, calculate cash from operations

Particulars 2000 2001

P&LA/c (credit) 40,000 50,000

Debtors 20,000 26,000

Bills Receivable 20,000 12,000

Prepaid Rent 2,000 3,000

Prepaid Insurance 1,000 800

Goodwill 20,000 14,000

Depreciation 32,000 40,000

Creditors 20,000 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 47,000

Cash from Operations 35,200

Illustration: 4

From the following balance sheets of Sulekha Ltd. you are required

to prepare a cash flow statement

Liabilities 2000

Rs.

2001

Rs.

Assets 2000

Rs.

2007

Rs.

Share capital 3,00,000 3,75,000 Cash 45,000 70,500

Trade editors 1,05,000 67,500 Debtors 1,80,000 1,72,500

P&L A/c 15,000 34,500 Stock in Trade 1,20,000 1,35,000

Land 75,000 99,000

4,20,000 4,77,000 4,20,00

0

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 in Trade

Creditors

37,500

Cash Operating Profit

(Diff. In P&L A/c)

19,500 Closing balance 70,500

Decrease in Debtors 7,500

1,47,000 1,47,000

Illustration: 5

From the following balance sheets of Zindal Ltd/prepare cashflow

statement.

Liabilities 2000 2007 Assets 2000 2007

Share Capital 600 800 Goodwill 230 180

8% redeemable

Pref.

300 200 Land & Buildings 400 340

Shares

General reserve 80 140 Plant 160 400

P&L Account 60 96 Debtors 320 400

Proposed dividend 84 100 Stock 154 218

Creditors 110 166 Bills Receivable 40 60

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 account and land and buildings account, respectively

in 2001.

2) An interim dividend of Rs.40,000 has been paid in 2001.

3) Income tax Rs.70,000 was paid during the year 2001.

1. Plant Account

Particulars Rs. Particulars Rs.

To Opening Balance

on 1-1-2001

1,60,000 By Depreciation 20,000

To Purchases-cash 2,60,000 By closing

balance on 31-12-

2001

4,00,000

4,20,00

0

4,20,000

2. Land and Building Account

Particulars Rs. Particulars Rs.

To Opening Balance

on 1-1-2001

4,00,000 By Depreciation 40,000

By cash (sales-

balancing figure)

By closing balance on

31-12-2001

3,40,000

4,00,00

0

4,00,00

0

3. Provision for taxation Account

Particulars Rs. Particulars Rs.

Cash 70,000 By Opening Balance on

1-1-2001

80,000

To closing balance

on 31-12-2001

1,00,000 By P&L Account

(balancing figure)

90,000

1,70,000 1,70,000

Calculation of cash from operations

Closing balance P&L A/c on 31-12-

2001:

96,000

Less: Balance of P&L A/c on 1-1-2001: 60,000 36,000

Add: Profit used for reserves &

provisions:

Proposed dividend 1,00,000

Interim dividend 40,000

Provisions for taxation 90,000

Transfer to general reserve 60,000 2,90,000

3,26,000

Add : Profit used for writing off non-

cash A/c:

Goodwill 50,000

Depreciation:

Plant 20,000

Land & Building 40,000

1,10,000

4,36,000

Add: increase in creditors 56,000

Funds from operations 4,92,000

Less: Increase in current assets:

Debtors 80,000

Stock 64,000

Bills Receivable 20,000 1,64,000

3,28,000

Less: Decrease in current liabilities:

Bills Payable 8,000

Cash from Operations 3,20,000

Cash flow statement for the year ended December 31,2001

Cash in-flows Rs. Cash out-flows Rs.

Op. Bal. As on 1-1-2001

Cash 30,000 Purchase of plant 2,60,000

Bank 20,000 Payment of final 84,000

dividend for 2000

Payment of interim

dividend

40,000

Add: Cash inflows: Income-tax paid 70,000

Operations 3,20,000 Redemption of

Pref. Shares

1,00

Sale of land & bldg. 20,000 1,00,000

Issue of shares 2,00,000

5,54,000

Closing balance on

31-12-2001

Cash in hand 20,000

Cash in bank 16,000

5,90,00

0

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 2000 2001 Assets 2000 2001

Share Capital 70,000 70,000 Plant

Machinery

50,000 91,000

Secured Loans Inventory 15,000 40,000

Repayable (2001) 40,000 Debtors 5,000 20,000

Creditors 14,000 39,000 Cash 20,000 7,000

Tax payable 1,000 3,000 Prepaid

General Exp.

2,000 4,000

P&L A/c 7,000 10,000

92,00

0

1,62,00

0

92,00

0

1,62,000

Profit & Loss A/c for the year ended 31" December, 2001

Particulars Rs. Particulars Rs.

To Opening

Inventory

15,000 By sales 1,00,000

To Purchases 98,000 By Closing inventory 40,000

To Gross Profit c/d 27,000

1,40,00

0

1,40,000

To General Expenses 11,000 By Gross Profit b/d 27,000

To Depreciation 8,000

To Taxes 4,000

To Net Profit c/d 4,000

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 Rs.

To Balance b/d By Depreciation a/c 8,000

(Opening balance) 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 Rs.

To Bank a/c - tax By Balance b/d 1 ,000

Paid (bal. Fig.) 2,000 By P & L a/c -

To Balance c/d - (current year) 4,000

closing balance 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 42,000

Cash lost in Operations 1,000

Cash Flow Statement of M/s Shanti Stores Ltd.

for the year ending 31" December, 2001

Sources Rs. Application Rs.

To Balance c/d - Cash Outflow

Opening Cash Balance 20,000 Machine Purchased 49,000

Cash Inflows

Secured Loans raised 40,000 Taxes Paid 2,000

Dividends paid 1,000

Cash lost in Operations 1,000

Closing cash Balance 7,000

60,000 60,000

Illustration: 7

The following are the balance Sheets of X Ltd. For the year ending

31st December 2000 and 2001

Particulars 2000 2001

Liabilities Rs. Rs.

Share Capital 2,00,000 3,00,000

Profit and Loss Account 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

Particulars 2000 2001

Assets: Rs. Rs.

Fixed Assets 1,60,000 2,00,000

Add: Additions 40,000 60,000

2,00,000 2,60,000

Less: Depreciation 18,000 24,000

1,82,000 2,36,000

Investments 8,000 16,000

Stock 1,60,000 2,18,000

Debtors 60,000 80,000

Cash 30,000 40,000

4,40,000 5,90,000

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 31st December,

2001

Sources Rs. Application Rs.

Opening Balance of

Cash

Cash Outflows

(1-1-2001) 30,000 Purchase of fixed assets 60,000

Cash inflows: Taxes paid 44,000

Issue of share capital 1,00,000 Dividend paid 24,000

Cash from operations 1,34,000 Purchase of investments 8,000

Increase in Stock 58,000

Increase in debtors 20,000

Decrease in creditors 10,000

Closing balance of cash 40,000

2,64,000 2,64,000

Working Notes:

Fixed Assets a/c

Particulars Rs. Particulars Rs.

To Balance 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. Particulars Rs.

To Balance b/d 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) 1,60,000

Add: Non-cash and non-operating items

already debited to Profit and Loss a/c :

Depreciation on fixed assets 6,000

Proposed dividend 34,000

Provision for taxation 54,000 94,000

2,54,000

Less: Non-cash and non-operating items

which have already been credited to P&L a/c

Profit and Loss a/c on 1-1-2001 1,20,000 1,20,000

Cash operating profit 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

Rs.

2001

Rs.

Assets 2000

Rs.

2001

Rs.

Equity Share

Capital

3,00,000 4,00,000 Goodwill 1,15,000 90,000

8% Redeemable

Preference Share

Capital

1,50,000 1,00,000 Land and

Buildings

2,00,000 1,70,000

General Reserve 40,000 70,000 Plant 80,000 2,00,000

Profit & Loss

Account

30,000 48,000 Debtors 1,60,000 2,00,000

Proposed

Dividend

42.000 50,000 Stock 77,000 1,09,000

Creditors 55,000 83,000 Bills

Receivable

20,000 30,000

Bill Payable 20,000 16,000 Cash in Hand 15,000 10,000

Provision for

Taxation

40,000 50,000 Cash at Bank 10,000 8,000

6,77,000 8,17,00

0

6,77,00

0

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 account

Particulars Rs. Particulars Rs.

To Depreciation on

plant

10,000 By Balance b/d 30,000

To Depreciation 20,000 By Funds from 2,18,000

to buildings 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

General Reserve

30,000

To Balance c/d 48,000

2,48,000 2,48,000

(ii) Provision for taxation account

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 account

Particulars Rs. Particulars Rs.

To Balance b/d 2,00,000 By Depreciation 20,000

By Bank (sale) 10,000

By Balance c/d 1,70,00

2,00,000 2,00,000

(iv) Plant account

Particulars Rs. Particulars Rs.

To Balance b/d 80,000 By Depreciation 10,000

To Bank (purchase) 1,30,000 By balance c/d 2,00,000

2,10,000 2,10,000

(v) Cash from operations

Rs.

Funds from operations 2,18,000

Add: Increase in creditors 28,000

2,46,000

Less:

Decrease in Bills Payable 4,000

Increase in Debtors 40,000

Increase in Stock 32,000

Increase in Bills receivable 10,000 86,000

Cash from operations 1,60,000

(vi) In the absence of information, it has been presumed that

there is no profit (loss) and no accumulated depreciation on

that part of land and buildings which has been sold.

Cash flow statement for the year ending 31st December 2001

Cash Balance as on 1-

1-2001

Rs. Outflows of cash: Rs.

Cash in hand 1 5,000 Redemption of

Redeemable

50,000

Cash at bank 10,000 Preference share 20,000

Add: Inflows of cash: Payments of interim

dividend

42,000

Issue of Shares 1,00,000 Payment of tax 35,000

Sale of Land and

Building

10,000 Purchase of Plant 1,30,000

Funds from operations 2,18,000 Decrease in bills

payable

4,000

Increase in creditors 28,000 Increase in debtors 40,000

Increase in stock 32,000

Increase in B/R 10,000

Cash Balance as on 31-

12-2001

Cash in hand 10,000

Cash at bank 8,000

3,81,000 3,81,000

Illustration: 9

Balance Sheets of XYZ Ltd. as on 1-1-2000 and 31-12-2001

was as follows:

Liabilities 1-1-2001 31-12-2001

Capital 1,25,000 1,53,000

Creditors 1,40,000 1,44,000

Bank loan 65,000 50,000

Bills Payable 20,000 30,000

3,50,000 3,77,000

Assets:

Cash 20,000 17,000

Debtors 30,000 80,000

Stock 45,000 35,000

Machinery 80,000 65,000

Land 90,000 80,000

Buildings 65,000 70,000

Goodwill 20,000 30,000

3,50,000 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. Applications Rs.

Opening balance of

Cash

20,000 Cash outflows:

Cash inflows: Building Purchased 5,000

Sale of Machinery 7,000 Machinery Purchased 12,000

Sale of Land 10,000 Bank Loan repaid 15,000

Increase in creditors 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

1,36,00

0

1,36,00

0

Machinery a/c

Sources Rs. Applications Rs.

To Balance b/d 1,15,000 By Bank (Sale) 7,000

To Bank (Purchase) 12,000 By Provisions for depreciation

a/c

4,000

By P & L a/c (Loss on sale) 1,000

By Balance c/d 1,15,000

1,27,00

0

1,27,00

0

Land a/c

Particulars Rs. Particulars Rs.

To Balance b/d 90,000 By Bank (Purchase) 10,000

By Balance c/d 80,000

90,000 90,000

Buildings a/c

Particulars Rs. Particulars Rs.

To Balance b/d 65,000 By Balance c/d 70,000

To Bank (Purchases) 5,000

70,000 70,000

Goodwill a/c

Particulars Rs. Particulars Rs.

To Balance b/d 20,000 By Balance c/d 30,000

To Bank 10,000

30,000 30,000

Bank Loan a/c

Particulars Rs. Particulars Rs.

To Bank 15,000 By Balance c/d 65,000

To Balance c/d 50,000

65,000 65,000

Provisions for Depreciation a/c

Particulars Rs. Particulars Rs.

To Machinery a/c 4,000 By Balance c/d 35,000

To Balance c/d 50,000 By P & L a/c 19,000

54,000 54,000

Calculation of Cash from operations

Balance of P & L a/c

(Net Profit on (31/12/2001) 55,000

Add : Non-cash and non-operating items

debited to P & L a/c

Depreciation on Machinery 19,000

Loss on sale of Machinery 1,000 20,000

Cash from operations 75,000

Capital a/c

Particulars Rs. Particulars Rs.

To Drawings (Balancing

figure)

27,000 By Balance b/d 1,25,000

To Balance c/d 1,53,000 By Net Profit 55,000

1,80,000 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 co-ordinate

the financial operation of the business efficiently.

Helps in internal financial management - The cash flow

analysis helps the management in exploring the possibility of

repayment of long term debts which depends upon the

availability of cash.

Discloses the movement of cash - The cash flow

statement discloses the increase or decrease in cash and the

reasons therefore. It helps the finance Manager in explaining

how the company is short of cash despite higher profit and

vice versa.

Discloses success or failure of cash planning -

Comparison of actual and budgeted cash flow statement will

disclose the failure or success of the management in

managing cash resources and necessary remedial measures

can be taken in case of deviations. :

Helps to determine the likely flow of cash - Projected

cash flow statements help the management to determine the

likely inflow or outflow of cash from operations and the

amount of cash required to be raised from other sources to

meet the future needs of the business.

Supplemental to funds flow statement - Cash flow

analysis supplements the analysis provided by funds flow

statement as cash is a part of the working capital.

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 terms of

purchases and sales will differ from firm to firm. Moreover,

cash inflow does not always mean profit. Therefore, inter-firm

comparison of cash flow may also be misleading.

Influenced by changes in management policies - The

cash balance as disclosed by the cash flow statement may not

represent the real liquid position of the business. The cash can

be easily influenced by purchases and sales policies, by

making certain advance payments or by postponing certain

payments.

Cannot be equated with income statement - Cash flow

statement cannot be equaled with the income statement. An

income statement, takes into account both cash as well as

non-cash items. Hence net cash flow does not necessarily

mean net income of the business.

Not a replacement of other statements - Cash flow

statement is only a supplement of funds flow statement and

cannot replace the income statement or the funds flow

statement as each one has its own function or, purpose of

preparation.

Despite the above limitations, cash flow statement is a very useful

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 terms, 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 terms, but also usually incorporates

many non-official quantitative measures as well.

BUDGETING

Budgeting is the whole process of designing, implementing

and operating budgets. The main emphasis in this is short-term

budgeting process involving the prevision of resources to support

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 accounting information is basic for successful

implementation of budget system in an organisation.

Advantages of Budgeting

Budgetary control establishes a basis for internal audit by

regularly evaluating departmental results.

Only reporting information which has not gone according to

plan, it economises on managerial time and maximizes

efficiency. This is called 'Management by Exception reporting.

Scarce resources should be allocated in an optimal way, thus

controlling expenditure

It forces management to plan ahead so that long-term goals

are achieved.

Communication is increased throughout the firm and

coordination should be improved.

An effective budgetary control system will allow people to

participate in the setting of budgets, and thereby have a

motivational impact on the work force. Individual and

corporate goals are aligned.

Areas of efficiency and inefficiency are identified. Variance

analysis will prompt remedial action where necessary

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

Delegation of authority to the concerned functional managers

Inter-functional relationship of the organisation.

4. Establishment of Budget Centres :

Budget centre is a section of an organisation for which

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 accounting 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

accounting 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 administration 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 terms used in budgets.

Fixation of responsibility for preparation and implementation

of budgets and budgetary system.

Specification and timing of statements and reports.

Procedures in management information system in the

organisation.

Procedures in feed-back and feed-forward control systems.

Exhaustive programme of budget preparation.

The budget manual contains the standardised form which 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 terms 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 18 42 30

2 - 12 24

3 9 9 -

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 9,000 units

2 15,000 units

3 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 1,000 units

3 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

operation-wise, (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 built up

(closing) 1,000 - 2,000

Total 10,000 15,000 14,000

Less: Carry-

over stock

(opening) - 5,000 4,000

Budgeted

Production

10,000 10,000 10,000

(b) Direct Labour Hour for each Product (operation-wise)

Operation I

Particulars Product 1 Product 2 . Product 3

Direct labour hrs. per unit

(minutes)

18 42 30

Budget Production (units) 10,000 10,000 10,000

Direct labour hrs. required: 10,000 x 1860

10,000 x 4260

10,000 x 3060

3,000 hrs. 7,000 hrs. 5,000 hrs.

Total labour hours required for Operation I = 15,000 hours.

Operation II

Particulars Product 1 Product 2 . Product 3

Direct labour hrs. per unit

(minutes)

- 12 24

Budget Production (units) 10,000 10,000 10,000

Direct labour hrs. required:-

10,000 x 1260

10,000 x 2460

- 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

(minutes)

9 6 -

Budget Production (units) 10,000 10,000 10,000

Direct labour hrs. required: 10,000 x 960

10,000 x 660

-

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

weeks x 6 days week x 8 hours a day

624 hours

Less: Loss of hours due to leave, holidays

and others causes

124 hours

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 = 15,000/500 = 30 men

b. Operation II = 6,000/500 = 12 men

c. Operation III = 2,500/500 = 5 men

Now, manpower budget for the quarter can be prepared for the

three products and for each operation. The same is given below:

OperationHr.rate Product I Product II Product 3 Total

No. of worker

s

Rs. D.I. Hrs.

Cost Rs.

D.L. Hrs.

Cost Rs.

D.L. Hrs.

Cost Rs.

D.L. Hrs.

Cost Rs.

I 2.00 3,000 6,000 7,00014,000

5,00010,000 15,000 30,000 30

II2.50 - - 2,000 5,000 4,000 10,000 6,000 15,000 12

III3.00 1,500 4,500 1,000 3,000 - - 2,500 7,500 5

Total 4,50010,50

010,000

22,000 9,000 20,000 23,500 52,500 47

5. Manufacturing Expenses Budget

Manufacturing overhead refers to the aggregate' of factory

indirect material, indirect labour and indirect expenses which can be

divided into fixed and variable elements of manufacturing overhead.

The fixed manufacturing overhead will not vary with the change in

the level of activity and it can be estimated with a fair degree of

accuracy. On the other hand, variable manufacturing overhead per

unit will be estimated and the total variable manufacturing

overhead will be determined with the help of the activity level.

Preparation of variable overhead budget is based on scheduled

production and operating conditions.

Illustration 2:

Gama Engineering Company Limited manufacturers two

Products X and Y. An estimate of the number of units expected to be

sold in the first seven months of 2001 is given below:

Months Product X Product Y

January 500 1,400

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

31st June, 2001 are as follows:

Particulars Product X Product Y

Production (units) 11,000 12,000

Direct materials per unit (Rs.) 12 19

Direct wages per unit (Rs.) 5 7

Other manufacturing charges

apportionable to each type of

product

(Rs.) 33,000 48,000

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

Product X

Closing Stock 300 400 500 600 600 500

Sales 500 600 800 1,000 1,200 1,200

800 1,000 1,300 1,600 1,800 1,700

Less: Opening Stock 250 300 400 500 600 600

Production (in units) 550 700 900 1,100 1,200 1,100

Product Y

Closing stock 700 600 500 400 400 450

Sales 1,400 1,400 1,200 1,000 800 800

2,100 2,000 1,700 1,400 1,200 1,250

Less: Opening Stock 700 700 600 500 400 400

Production (in units) 1,400 1,300 1,100 900 800 850

(b) Summarised Production Cost Budget (for the 6 months ending

30th June, 2001) .

(Rs.)

Production X-5,550 units Y-6,350 units

Unit

Cost

Total Cost Unit Cost Total Cost

Direct materials 12 66,600 19 1,20,650

Direct wages 5 27,750 7 44,450

Manufacturing

charges

3 16,650 4 25,400

Total 20 1,11,000 30 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. Administrative Expenses Budget

Administrative 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 administrative expenses will not include those expenses

which are incurred for manufacturing, selling and distribution, R&D

functions. The administrative overheads are of a fixed nature and

the change in the level of activity will not bring any change in the

administrative expenses incurred. Cm study o behaviour of costs, if

any administrative expenses are of variable or semi-variable nature,

those expenses can be budgeted with the Level of activity.

7. Selling and Distribution Expense Budget

Selling expenses refers to expenses incurred relating tc 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 administrative 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 terms. 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, administrative, 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 accounting

reports must be built up to inform responsible

managers for the progress of that result against

budgets.

(2) Products or Programmes: In this dimension, the budget

information is organised to show the revenues, costs,

contributions, profits and levels of production/ sales

activity for each product or programme produced by,

the organisation.

Negotiation of Budgets :

Budgets may be prepared in a top-down or bottom-up

manner. In either process, the budget will need to be negotiated by

superiors, subordinates and by different departments competing for

the 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 passed 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 accounts 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 long-term 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 service payments or capital

raising schedules may be produced.

Illustration 3:

Prepare a cash budget for the three months ending 30th 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 Terms:

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

May 10% of 17,000 - 1,700 -

(17,000-10% of 17,000) x 50% - - 7,650

June 10% of 18,000 - - 1,800

14,650 15,65

0

16,650

Cash budget for the quarter April - June 2001

Particulars April May June Total

1. Balance b/f 6,000 3,950 3,000 6,000

2. Receipts

Sales (Note 1) 14,650 15,650 16,650 46,950

Dividend - - 1,000 1,000

Advanced against - - 9,000 9,000

vehicle

Total 20,650 19,600 29,650 62,950

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

Total 16,700 16,600 29,350 62,650

4. Balance c/f 3,950 3,000 300 300

* 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 account 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 account 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 account of, for example discounts for bulk purchases of

materials Labour costs are unlikely to behave in a linear

fashion unless a piecework scheme is in operation.

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 Rs. 10 per unit

b) Variable cost Rs.3 per unit

c) Semi-variable cost Rs.6,000 fixed plus Re.0.50 per unit

d) Fixed cost Rs.20,000 at present level estimated to be

Rs.24,000 as 80% output.

You are required to submit the following statements to the 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

(units)

60%

6,000

70%

7,000

80%

8,000

Sales (@Rs. 10)

(A)

60,000 70,000 80,000

Costs:

Variable cost (@ Rs.3) 18,000 21,000 24,000

Semi-variable cost

Fixed component 6,000 6,000 6,000

Variable component (@ Re.0.50 per 3,000 3,500 4,000

unit)

Fixed cost 20,000 20,000 24,000

Total cost (B) 47,000 50,500 58,000

Profit (A) -

(B)

13,000 19,500 22,000

Statement of Operating Profit at different capacity levels at

proposed Selling Price

(Rs.)

Capacity Levels 60% 70% 80%

Sales (@ Rs.9) 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 9.00

Less: Variable cost (Rs.3.00 + Re.0.50) 3.50

Contribution per unit 5.50

(Rs.)

Present Profit 13,000

Add: Fixed cost (Rs.20,000 + Rs.6,000) 26,000

Desired Contribution 39,000

Required Output

Desired Contribution= Contribution per unit

Rs.39,000= Rs.5.50 = 7,091 units

Increase in Production required

= 7,091 units - 6,000 units = 1,091 units

Percentage increase over present Output

1,091= 6,000 x 100 = 18.18%

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

designing 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 administration,

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 encompass 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 a-single

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 CPM

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 vice-versa. 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 terms 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 Accounting Method.

Time Adjusted Methods or Accounting Methods:

4. Net Present Value Method

5. Internal Rate of Return Method

6. Profitability Index Method.

TRADITIONAL METHODS

(1) Pay-back Period Method

The term pay-back (or pay-out or pay-off or break-even 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 terms 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:

Initial Investment Pay - back Period = Annual Cash Inflow

Rs. 10,000= Rs. 2,500 = 4 years

(b) In the case of uneven inflows :

If cash inflows are not uniform, the calculation of pay-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

Inflows

Cumulative Cash

Inflow

Rs. Rs.

1 3,000 3,000

2 4,000 7,000

3 2,500 9,500

4 2,000 11,500

5 2,000 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:

Machine M Machine

N

Estimated life of machine 4 years 5 years

Cost of machine Rs.9,000 Rs. 18,000

Estimated savings in scrap Rs.500 Rs.800

Estimated savings in direct wages Rs. 6,000 Rs. 8,000

Additional cost of maintenance Rs.800 Rs. 1,000

Additional cost of supervision Rs. 1,200 Rs. 1,800

Solution:

Statement showing annual cash inflows

Machine M

Rs.

Machine N

Rs.

Estimated savings in scrap 500 800

Estimated savings in direct wages 6,000 8,000

Total savings (A) 6,500 8,800

Additional cost of maintenance 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

Original Investment Pay-back Period = Annual Average Cash Inflow

Rs.9,000 Rs.18,000= Rs.4,500 = 2 years 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 account the cash inflows earned after the

pay-back period and hence the true profitability of the project

cannot be correctly assessed.

(2) This method does not consider the amount of profit earned on

investment after the recovery of cost of investment.

(3) It does not take into consideration the cost of capital which is

a very important factor in making a sound investment

decisions.

(4) It may be difficult to determine the minimum acceptable pay-

back period, it is usually, a subjective decision.

(5) It ignores interest factor which is considered to be a very

significant factor in taking sound investment decision.

(6) Too much emphasis on the "liquidity of the investment",

ignoring the "profitability of investment" may not be justified

in a number of situations.

(7) It ignores time value of money. Cash flows received in

different years are treated equally.

(8) It doe not take into account the life of the project,

depreciation, scrap-value, interest factor etc. Because, a

rupee tomorrow is worthless than a rupee today.

(2) Improvement in Traditional Approach to Pay-back

Period

One of the most commonly used techniques for evaluating

capital investment proposal is the cash pay-back method. Some

authorities on accountancy, 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:

Project X Project Y

Cost (Rs.) 1,40,000 1,40,000

Economic Life (in years) 10 10

Estimated Scrap (in Rs.) 10,000 14,000

Annual Savings 25,000 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 Project Y

1. Cost 1,40,000 1,40,000

2. Savings 25,000 20,000

3. Pay-back period 5.6 years 7 years

4. Economic Life 10 years 10 years

5. Surplus Life 4.4 years 3 years

6. Post pay-back profit (2 x 5) 1,10,000 60000

7. Index of post pay-back profit 1,10,000

1,40,000 x 100

60,000

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.

Cost of the project 50,000

Operating Savings:

1st year 5,000

2nd year 20,000

3rd year 30,000

4th year 30,000

5th year 10,000

Calculate (i) pay-back period ignoring interest factor and (ii)

discount pay-back period taking into account interest factor at 10%.

Solution:

(i) Pay-back period

Year Annual

Savings Rs.

Cumulative

Savings Rs.

1 5,000 5,000

2 20,000 25,000

3 30,000 55,000

Upto second year, Rs.25,000 recovered

Rs.50,000- Rs.25,000Therefore, pay-back period = 2 years + 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 FactorDiscounted

Savings

Cumulative

Discounted

Savings

Rs. Rs. Rs.

1 5,000 0.9091 4,546 4,546

2 20,000 0.8265 16,530 21,076

3 30,000 0.7513 22,539 43,615

4 30,000 0.6830 20,490 64,105,

Rs. 50,000 - Rs.43,615 Discounted pay-back period = 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 InflowPay-back Reciprocal = Total Investment

However, this method of ranking investment proposals should

be used only when:

Annual savings are even for the entire period.

The economic life of the project is at least twice of the pay-

back period.

(3) Rate of Return Method (Accounting Method)

This method is also known as Accounting 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 Annual ProfitAverage Rate of Return = 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.

Total Profit Return per unit of Investment = Net Investment x 100

(c) 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.

Total Profit after deprec. & TaxesReturn on Average Investment = Total Net Investment /2 x

100

(d) Average Return on Average Investment Method

Under this method, average profit after depreciation and

taxes is divided by the average of amount of investment. This is an

appropriate method of rate of return on investment.

Average Annual

Average Return on Average Investment = Net Investment / 2 x 100

Illustration 4: Calculate the average rate of return for projects A

and B from the following:

Project A Project B

Investment Rs.20,000 Rs.30,000

Expected Life (no salvage value) 4 years 5 years

Projected Net Income, after interest, depreciation and taxes:

Years Project A Project B

Rs. Rs.

1 2,000 3,000

2 1,500 3,000

3 1,500 2,000

4 1,000 1,000

5 - 1,000

Total 6,000 10,000

If the required rate of return is 1 2% which project should be

undertaken?

Solution:

Project A Project B

Rs. Rs.

Total profit, after interest,

depreciation and taxes

6,000 10,000

Expected Life 4 years 5 years

Average Profit 1,500 2,000

Investment 20,000 30,000

Average Rate of Return 1-500 2,000

Average Rate of Return 1,500

20,000 x 100 = 7.5%

2,000

30,000 x 100 = 6.6%

Average Return on

Average Investment

1,500

20,000/2 x 100 = 15%

2,000

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 accounting concept of profit. It can be

calculated from the financial data.

Demerits of Rate of Return Method :

This method suffers from the following demerits:

It ignores the time value of money. Profits earned in different

periods are valued equally.

This method may not reveal true and fair view in the case of

long-term investments.

It does not take into consideration the cash flows which is

more important than the accounting profits.

It ignores the fact that profits can be reinvested.

There are different methods for calculating the Accounting

Rate of Return. Each method gives different results. This

reduces the reliability of the method.

TIME ADJUSTED METHOD (DISCOUNTED CASH FLOW

METHOD)

Discounting is just opposite of compounding. In compound

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 accounting 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 account 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

Life Estimated 3 years 3 years

Rs. Rs.

Capital Cost 10,000 10,000

Net earning after tax:

1st year 8,000 2,000

2nd year 6,000 7,000

3rd year 4,000 10,000

You are required to suggest which machine should be

preferred.

Solution:

Calculation of Net Present Value (10%)

Machine I Machine II

Year PV Factor Cash

Inflow

Rs.

Present

Value Rs.

Cash

Inflow

Rs.

Present

Value Rs.

1 0.909 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

15,232 15,110

Less: Cost Net Present Value 10,000 10,000

5,232 5,110

Machine I should be preferred as net present value is Rs.5,232

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 account the objective of maximum profitability.

It recognises the time value of money.

This method can be applied where cash inflows are uneven.

It facilitates comparison between projects.

Demerits of this method are as follows:

It is not easy to determine an appropriate discount rate.

It involves a great deal of calculations. It is more difficult to

understand and operate.

It is very difficult to forecast the economic life of any

investment exactly.

It may not give good results while comparing projects with

unequal investment of funds.

2. Internal Rate of Return Method

This method ^ popularly known as time adjusted rate of

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 4 years

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.

Solution:

Calculation of Internal Rate of Return

YearAnnual

Cashflow

PVF

10%PV

PVF

12%PV

PVF

14%PV

PVF

15%PV

1 15,000 0.909 13,635 0.892 13,380 0.877 13,155 0.869 13,035

2 20,000 0.856 16,520 0.797 15,940 0.769 15,380 -0.756 15,120

3 30,000 0.751 22,530 0.711 21,330 0.674 20,220 0.657 19,710

4 20,000 0.683 13,660 0.635 12,700 0.592 11,840 0.571 11,420

Total of PV of Cash inflow 66,345 63,350 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 Profitability Index = Initial Cost Outlay

Illustration 7: The initial cash outlay of a project is Rs.50,000.

Estimated cash inflows:

1st year Rs.20,000

2nd year Rs. 15,000

3rd year Rs.25,000

4th year Rs. 10,000

Compute Profitability Index.

Solution:

Calculation of Profitability Index

YearCash Inflows

Rs.

PV Factor at

10%PV Rs.

1 20,000 9.909 18,180

2 15,000 0.826 12,390

3 25,000 0.751 18,775

4 10,000 0.683 6,830

Total 56,175

Total Present Value = Rs.56,175

Less: Initial Outlay = Rs.50,000

Net Present Value = 6,175

Profitability Index (gross) =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 Machine A Machine B

Rs. Rs.

1 15,000 5,000

2 20,000 15,000

3 2500 20,000

4 15,000 30,000

5 10,000 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

Machine A Machine B

Average profit

after tax

Rs. 42,000

5 = Rs. 8,500

Rs. 45,000

5 = Rs. 9000

Investment Rs. 60,000 Rs. 60,000

Average

Investment

Rs. 60,000

2 = Rs. 30,000

Rs. 60,000

2 = Rs. 30,000

Average Return

on

Investment

Rs. 8,500

60,000 x 100 = Rs.

14.17%

Rs. 9,000

60,000 x 100 = Rs. 15%

Average Return

on

Average

Investment

Rs. 8,500

30,000 x 100 = Rs.

28.34%

Rs. 9,000

30,000 x 100 = Rs. 30%

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.

Model X Model Y

Rs. Rs.

Estimated Life 5 years 6 years

Cost of Machine 1,50,000 2,50,000

Cost of indirect materials 6,000 8,000

Estimated savings in scrap 10,000 15,000

Additional cost of maintenance 19,000 27,000

Estimated savings in direct

wages:

Employees not required 150 200

Wages per employee 600 600

Taxation to be regarded 50% of profit before charging depreciation.

Which model you recommend ?

Solution:

Profitability Statement

Model X

(Rs)

Model Y (Rs)

Estimated saving per

year scrap

10,000 15,000

Wages (150x600)

(200x600)

90,000 1,35,000

Total Savings 1,00,000 1,35,000

Less: Additional Cost

Cost of indirect

materials 6,000

8,000

Cost of Maintenance

19,000 25,000 27,000 35,000

Additional Earnings 75,000 1,00,000

Less: Tax @ 50% 37,500 50,000

Cash flow (annual) 37,500 50,000

Less: Depreciation:

1,50,000 » 5

30,000 2,50,000 » 6 41,667

Net Increase in

earnings

7,500 8,333

Pay-back period: 1,50,000

37,500 = 4

years

2,50,000

50,000 = 5 years

Cost of Machine

Annual Cash Flow

7,500

1,50,000 x100 =

5%

8,300

2,50,000 x100 =

3.3%

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.

Automatic

Machine

Ordinary

Machine

The annual sales and

costs

Rs. Rs.

are estimated as

follows:

Sales 1,50,000 1,50,000

Costs:

Materials 50,000 50,000

Labour 12,000 60,000

Variable Overhead 24,000 20,000

Compute the comparative profitability under pay-back

method.

Solution:

Automatic

Machine Rs.

Ordinary Machine

Rs.

Annual Sales 1,50,000 1,50,000

Less: Variable Cost

Materials

50,000

50,000

Labour

12,000

60,000

Overheads 24,000 86,000 20,000 1,30,000

Marginal Profit 64,000

20,000

2,24,000

Pay-back period: 64,000

3 ½ years 60,000

20,000 = 3 years

Post pay-back profitability 1 _ 1

64,000 5 2 3 2

20,000 (8-5

yrs.)

= Rs. 1,28,000 = 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 Net Cash Flows

('000)

1 Nil

2 100

3 160

4 240

5 300

6 600

The following are the present value factors @ 15% p.a.

Year 1 2 3 4 5 6

Factor 0.87 0.76 0.66 0.57 0.50 0.43

Solution:

Calculation of Net Present Value

Year Cash Inflows

('000) Rs.

PV Factor Present Values

('000) Rs.

1 Nil 0.87 Nil

2 100 0.76 76.0

3 160 0.66 105.60

4 240 0.57 136.80

5 300 0.50 150.00

6 600 0.43 258.00

Total 726.40

Less: Cash Outlay 500.00

Net Present Value 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:

Project I Project II

Rs. Rs.

End of

year

1 48,000 20,000

2 32,000 24,000

3 20,000 36,000

4 Nil 48,000

5 24,000 16,000

6 12,000 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

0.909

2

0.826

3

0.751

4

0.683

5

0.621

6

0.564

Solution:

Calculation of Net Present Value

Year Project I

Net Cash

Inflows

Project II

Net Cash

Inflows

PV

Factor

@ 10%

PV of

Project I

PV of

Project

11

Rs. Rs. Rs. 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 1,12,272

Less: Cash Outlay 1,00,000 1,00,000

Net Present Value 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

Scrap Value 1,000 2,000

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 :

YearCash Flows

PV of

Re.1

@10%

Present Value of Net

Cash Flow

Project X Project Y Project X Project Y

Rs. Rs. Rs. Rs.

1 5,000 20,000 0.909 4,545 18,180

2 10,000 10,000 0.836 8,260 8,260

3 10,000 5,000 0.751 8,510 3,755

4 3,000 3,000 0.683 2,049 2,049

5 2,000 2,000 0.621 1,242 1,242

6 1,000 2,000 0.621 621 1,242

24,227 34,728

20,000 30,000

4,227 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

Inflow

Machine B Cash

Inflow

Rs. 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 accounting rate of return

(c) the net present value

(d) the profitability index

Solution:

Year Cash Inflow Cumulative Cash

Inflow

Rs. 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 3rd

year cash inflow is Rs.25,000. It means the pay-back period is

between 2nd and 3 year, thus:

15,000Pay-back Period = 2+ 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 3rd and 4th year, thus:

10,000Pay-back Period = 3+ 30,000 = 3.33 years

Machine A should be purchased. Because pay-back period is

less.

Accounting Rate of Return

Machine A

Total Returns = Rs.85,000

Average Return = Rs.85,000 » 5 = Rs.17,000

17,000Average Rate of Return = 50,000 x 100 = 34%

Machine B

Total Returns = Rs.90,000

Average Return = Rs.90,000 » 5 = Rs.18,000

18,000Average Rate of Return = 50,000 x 100 = 36%

Net Present Value

Calculation of Net Present Value

sPV Factor

@ 10%

Cash

Inflows

Machine A

Cash

Inflows

Machine B

PV

Machine B

PV

Machine A

Rs. Rs. Rs. 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

Total 65,385 64,865

Less: Cash Outlay 50,000 50,000

Net Present Value 15,385 14,865

The Net Present Value of Machine A is more than that of

Machine B. So, Machine A should be purchased.

Probability Index

Present Values 65,385

Machine A = Cost of Investment = 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

Equity

$

Cash 4,800 Liabilities:

Accounts

receivable

9,600 Notes payable (due in

60 days)

62,400

Land 36,000 Accounts payable 43,200

Building 60,000 Total liabilities 105,600

Office

equipment

12,000 Owner's Equity

Ed Adams, capital 16,800

122,400 122,400

BAKER COMPANY

Balance Sheet

July 31,19 ___

Assets $Liabilities & Owner's

Equity$

Cash 24,000 Liabilities:

Accounts

receivable

48,000 Notes payable (due in 60

days)

14,400

Land 7,200 Accounts payable 9,600

Building 12,000 Total liabilities 24,000

Office

equipment

1,200 Owner's Equity

Ed Adams, capital 68,400

92,400 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 three-year 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 account 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

accounting, 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 accounts

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 accounting 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 Year l

$ $ $

Current assets 3,960 2,610 3,600

Plant and equipment (net of

depreciation)

21,240 19,890 14,400

Total assets 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) 12,600 12,600 8,100

Retained earnings 5,670 4,140 4,500

Total liabilities & stockholder's

equity

25,200 22,500 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

stock in Year 2)

270 465 405

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

premium stamps

It is proposed that each package of cereal will contain

premium stamps which will be redeemed for cash prizes. The

estimated cost of this premium 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 500,000 boxes

Selling price per unit $0.70

Manufacturing cost per unit $0.40

Selling expenses, 20% of sales (one-fourth of which was for

newspaper advertising)

Administrative expenses, 6% of sales

Estimates for the coming year for each proposal are shown below:

Proposal No.

1

Proposal No. 2

Increase in unit sales

volume

50% 30%

Decrease in manufacturing

cost per unit

10% 5%

Newspaper advertising None 10% of sales

Other selling expenses 8% of sales 8% of sales

Premium plan expense $ 0.06 per box None

Administrative expenses 5% of sales 10% of sales

Questions:

1. Which of the two proposals should management select?

2. In support 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 ACCOUNTING

Time : 3 hours Maximum Marks: 100

PART-A (5x8= 40 marks)

Answer any Five questions

1. What are the advantages of management accounting, how it

differ from financial accounting?

2. What are the different types of errors, how this can be

managed well?

3. Describe the various accounting 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 Account for

the year ending December 31, 1998 and the Balance Sheet as

at that date.

Trial Balance as at December 31, 1998

Amount

(Dr.)

Amount

Cr.)

Building 2,50,000 Admission Fees 5,000

Furniture 40,000 Tuition Fees 2,00,000

Library Books 60,000 Rent of Hall 4,000

16% Investments

(1-1-98)

2,00,000 Creditors for Books

Supplied

6,000

Salaries 2,00,000 Miscellaneous Receipts 12,000

Stationery 15,000 Annual Government

rant

1,40,000

General Expenses 8,000 Donations Received

for library books

25,000

Annual Sports Expense 6,000 Capital Fund 4,00,000

Cash 1,000

Bank 20,000 Interest on Investments 8,000

8,00,00

0

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) Depreciate building by 5% and library books by 20%.

8. A book keeper while preparing his trial balance finds that the

debit exceeds by Rs. 7,250. Being required to prepare the

final account he places the difference to a suspense account.

In the next year the following mistakes were discovered:

a) A sale of Rs. 4,000 has been passed through the

purchase day book. The entry in the customer's

account has been correctly recorded,

b) Goods worth Rs. 2,500 taken away by the proprietor

for his use has been debited to repairs account;

c) A bill receivable for Rs. 1,300 received from

Krishna has been dishonoured on maturity but no

entry passed;

d) Salary of Rs. 550 paid to a clerk has been debited to

his personal account;

e) A purchase of Rs. 750 from Raghubir has been debited

to his account. Purchase account has been correctly

debited;

f) A sum of Rs. 2,250 written off as depreciation on

furniture has not been debited to depreciation

account.

Draft the journal entries for rectifying the above mistakes and

prepare the suspense account and profit and loss adjustment

account

Journal

a) Suspense A/c Dr.

To Profit & Loss Adjustment A/c

(Being wrong recording of sales as purchase last

year rectified)

8,000

8,000

b) Drawings A/c Dr.

To Profit & Loss Adjustment A/c

(Being Drawings made last year inadvertently

shown as repairs now rectified)

2,500

2,500

c) Krishna A/c Dr.

To Bills Receivable A/c

1,300

1,300

(Being bill dishonoured last year now recorded in

the books)

d) To Profit & Loss Adjustment A/c Dr.

To Clerk's Personal A/c

(Being salary paid to clerk last year inadvertently

shown in his personal account now rectified)

650 650

e) Suspense A/c Dr.

To Raghubir A/c

(Being purchase from Raghubir )shown on debit

side of his account inadvertently now rectified

1,500

1,500

f) Profit & Loss Adjustment A/c Dr

To Suspense A/c

(Being depreciation not shown last year

now rectified)

2,250

2,250

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 account and cheques

thereon have been drawn both for business use and private

purposes. From the following information, prepare the final

accounts for the year 1998:

Assets and liabilities at the beginning and at the end of the

period have given below:

1-1-1998 31-12-1998

Stock 20,000 15,000

Bank Balance 8,000 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 1,50,000

Private dividends paid into bank 59,700

Private payments out of bank 26,000

Business payments for goods out of bank 1,22,000

Cash takings 2,50,000

Payment for goods by cash and cheque 1,60,000

Wages 97,700

Delivery Expenses 7,000

Rent and rates 2,000

Lighting 1,000

General Expenses 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 31st

December, 2000 and 2001. You are required to prepare a

Funds Flow Statement for the year ended 31st December, 2001.

Liabilities 2000 2001 Assets 2000 2001

Share Capital 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

(Long-term)

35,000 67,600 Stock- 50,000 37,000

Creditors 75,000 - Debtors 40,000 32,100

Provision for

Tax

15,000 17,500 Bank - 4,000

Cash 250 300

2,65,25

0

2,55,40

0

2,65,250 2,55,40

0

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

Equity Share

Capital

3,00,000 4,00,000 Goodwill 1,15,000 90,000

8% Redeemable

Preference Share

Capital

1.50.000 1,00,000 Land and

Buildings

2,00,000 1,70,000

General Reserve 40,000 70,000 Plant 80,000 2,00,000

Profit & Loss

Account

30,000 48,00 Debtors 1,60,000 2,00,000

Proposed

Dividend

42,000 50,000 Stock 77,000 1,09,000

Creditors 55,000 83,000. Bills

Receivable

20,000 30,000

Bill Payable 20,000 16,000 Cash in

Hand

15,000 10,000

Provision for

Taxation

40,000 50,000 Cash at

Bank

10,000 8,000

6,77,00

0

8,17,00

0

6,77,000 8,17,00

0

Additional info

(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.

2. 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 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

3lrt June, 2001 are as follows:

Particulars Product X Product Y

Production (Units) 11,000 12,000

Direct materials per unit (Rs.) 12 19

Direct wages per unit (Rs.) 5 7

Other manufacturing charges

apportionable to each type of

product

(Rs.) 33,000 48,000

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

Inflow

Machine B cash

Inflow

Rs. Rs.

1 15,000 5,000

2 20,000 15,000

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 accounting rate of return

(c) the net present value

(d) the profitability index

14. Following are Balance sheet of Vinay Ltd. for the year ended

31st December 2000 and 2001.

Liabilities 2000 2001 Assets 2000 2001

Rs. Rs. Rs. Rs.

Equity capital 1,00,000 1,65,000 Fixed

Assets

(Net)

1,20,000 1,75,000

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 for

taxation

10,000 12,500 Cash in

hand

5,000 15,000

Proposed

dividends

7,500 12,500

2,30,00

0

3,40(000 2,30,000 3,40,00

0

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 Year 3 Year 2 Year 1

$ $ $

Current assets 3,960 2,610 3,600

Plant and equipment (net of

depreciation)

21,240 19,890 14,400

Total assets 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) 12,600 12,600 8,100

Retained earnings 5,670 4,140 4,500

Total liabilities & stockholder's

equity

25,200 22,500 18,000

PACIFIC CORPORATION

Comparative Income Statements

For Years May 31

(in thousands of dollars)

Assets Year 3 Year 2 Year 1

$ $ $

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

stock in Year 2)

270 465 405

Cash dividends per share 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.