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CHAPTER II

LITERATURE REVIEW

2.1 Financial Distress

Predicted the financial strength of a company is generally carried out by an

external company such as investors, creditors, auditors, government, and business

owners. external parties companies typically respond to distress signals such as

delivery delays, product quality problems, loss of trust from customers, bills from

banks or creditors, and others to indicate the presence of financial distress, the

situation is very difficult even to say that when approaching bankruptcy not be

resolved will have a major impact on those companies with the loss of confidence of

the stakeholders, which are experienced by the company. (Brahmana, 2006)

In a study conducted by Luciana Spica Almilia, Platt and Platt (2002) defines

financial distress as the decline stage of a company's financial condition prior to the

bankruptcy or liquidation. Platt and Platt (2002) suggests the usefulness of the

information if a company is experiencing financial distress are:

1. Can speed management measures to prevent the problem before the

bankruptcy.

2. The management can take action merger or takeover that companies are better

able to pay the debt and manage the company better.

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3. Provide early warning / early presence of bankruptcy in the future.

By Luciana Spica Almilia (2003), studies relating to the company's financial distress

typically use financial ratios of the company.

2.2 Financial Restructuring

Financial restructuring is a process geared to avoiding the liquidation of the

company. Usually it involves agreement by the third to satisfy creditors claims under

certain terms and conditions. Financial restructuring may also be carried out by

concluding an agreement with all creditors of the company under which creditors will

be paid on somewhat different terms than those initially accepted by the company

when credit and loans were extended. This form of financial restructuring enables the

company to continue its operations and minimize creditor’s losses.

In this project, we will talking debt restructuring as part of financial

restructuring. The restructured corporate agents also has another reason doing debt

restructuring as follows (Manurung, 2011):

1. Low interest rate

Companies get cheaper loans from other lenders due to better performance

and building good relationship with lenders.

2. Credit unification

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Loans held by companies in a variety of different sources, for example bank

loans, to be made into one place to make it more efficient.

3. Improve the company’s capital structure

At a considerable debt and equity capital structure is very small then it look

awful because the ratio of debt to equity is quite high, but interest payment

also high. When a portion of the debt is converted to equity, it will make the

debt to equity ratio decreases and thus make better company’s capital

structure.

4. Agreements between lenders and owner of the company

Lenders agreed with owner of the company to improve the performance for

more rapid progress.

2.2.1 Financial Restructuring Method

There are three methods in financial restructuring (Manurung, 2011):

1. Extended period

First method taken by the company to restructure the debts of the company is

to make the loan period longer than previous period and deferred interest payment.

This action is taken to improve cash flow so that company can pay out other

consideration in company operations. And also this action is also filed with the

perception that the company could still be sustained in the future (going concern

concept).

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2. Conversion of debt to shares

Second method taken by the company to restructure the debts of the company

is to convert debt to shares or equity. This action is taken to make better performance

of company.

3. File for bankruptcy

If the two methods as mentioned above cannot be achieved, then we will do a

third method. That is file for bankruptcy. Purpose of bankruptcy is filed lenders

company, that receiving loans from the lenders, to district court. This action is taken

because the lenders cannot receive loan payment from lenders of the company.

2.3 Long-Term Financing

2.3.1 Equity Financing for Private Company

The initial capital is required to start a business is usually provided by the

entrepreneur herself and her immediate family. When a private company decides to

raise outside equity capital, it can seek funding from several potential sources: angel

investors, venture capital firms, institutional investors, and corporate investors (Berk,

DeMarzo, Harford, 2012)

a. Angel Investors

Individual investors who buy equity in small private firms are called angel

investors. For many start-ups, the first round of outside private equity financing is

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often obtained from angels. In most cases, firms need more capital than what a few

angels can provide. Finding angels is difficult-often it is a function of how well

connected the entrepreneur is in the local community. Most entrepreneurs, especially

those launching their first start-up company, many firms that require equity capital for

growth must turn to the venture capital industry.

b. Venture Capital Firms

A venture capital firms is a limited partnership that specializes in raising

money to invest in the private equity of young firms. Typically, institutional

investors, such as pension funds, are the limited partners in the venture capital firm.

The general partners are known as venture capitalists and they work for and run the

venture capital firm. Venture capital firms offer limited partners a number of

advantages over investing directly in start-ups themselves as angel investors. Because

these firms invest in many start-ups, limited partners are more diversified than if they

invested on their own. They also benefit from the expertise of the general partners.

However, these advantages come at a cost. General partners are usually charge

substantial fees, taken mainly as a percentage of the positive returns they generate.

c. Institutional Investors

Institutional investors such as pensions fund, insurance companies,

endowments, and foundation mange large quantities of money. They are major

investors in many different types of assets. So, not surprisingly, they are also active

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investors in private companies. Institutional investors may invest directly in private

firms, or they may invest indirectly by becoming partners in venture capital firms.

d. Corporate Investors

Many established corporations purchase equity in younger, private companies.

A corporation that invest in private companies is referred to by many different names,

including corporate investor, corporate partner, strategic partner, and strategic

investor. Most of the other types of investors in private firms that we have considered

so far are primarily interested in the financial return that they will earn on their

investment. Corporate investors, by contrast, might invest for corporate strategic

objective in addition to the desire for investment return.

2.3.2 Private Debt for Private Company

Private Debt is a debt that is not publicly traded. The first debt financing many

young firms undertake is a bank loan. However, even very large, established firms

use bank loans as part of their debt financing. Bank loans are an example of private

debt, debt that is not publicly traded. The private debt market is larger than the

publicly debt market. Private debt has the advantage that it avoids the cost and delay

of registration with SEC if the company wants to IPO. The disadvantage is that

because it is not publicly traded, it is illiquid, Meaning that it is hard for a holder of

the firm’s private debt to sell it in a timely manner. (Berk, DeMarzo, Harford, 2012)

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There are several segments of the private debt market, bank loans (terms loans

and lines of credit) and private placements as follows (Berk, DeMarzo, Harford,

2012):

a. Bank Loans.

A syndicate bank loan is a single loan that is funded by a group of banks

rather than just a single bank. A term loan is a bank loan that lasts for a specific term.

Usually, one member of the syndicate (the led bank) negotiates the terms of the bank

loan. Many companies establish a revolving line of credit, a credit commitment for a

specific time period up to some limit, typically two to three years, which a company

can use as needed. A company may be able to get a larger line of credit or a lower

interest rate if it secures the line of credit by pledging an asset as collateral. Such a

line of credit is referred to as an asset-backed line of credit.

Writers also use regulations issued by Bank of Indonesia, No. 7/2/PBI/2005

about PBI Bank Asset Quality Rating. Application of uniform classification within

PBI No. 7/2/PBI/2005 regarding Asset Quality Rating Bank is one of the concrete

implementation of the risk management best practices. This system is a system that is

intended for all banks in order to maintain and strengthen the overall banking industry

from the threat of instability due to problems of borrowers who have a financial

exposure in the banking system.

Further application of this approach is described by one debtor mechanism

concept and one project concept. Collectibility judgment with one debtor concept is a

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way of assessment of the collectibility of the uniform / uniform by all banks with

exposure to finance, either syndicated or separately, to the same debtor. In this case,

Article 5 of Regulation No. 7/2/PBI/2005 embrace this way the whole individual or

business entity is an entity that generates cash flows as a source of repayment of

Earning Assets.

As one project concept is a way a uniform assessment of the collectibility by

all banks with exposure to finance, either syndicated or separately, to the same

project. The mechanism underlying this assessment is the basis of Article 6 of

Regulation No. 7/2/PBI/2005 where uniformity collectability of debtors (project) was

rated by all the banks on the basis of a connection chain and cash flows significantly

in the production process by the debtor.

b. Private Placements

A private placement is a bond issue that does not trade on public market but

rather is sold to a small group of investors. Because a private placement does not

need to be registered, it is less costly to issue and often a simple promissory note is

sufficient. Privately placed debt also need not conform to the same standards as

public debt; as a consequence, it can be tailored to the particular situation.

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2.4 Short-Term Financing

The first step in short term financial planning is to forecast the company’s

future cash flows. This exercise has two distinct objectives (Berk, DeMarzo, Harford,

2012). First, a company forecasts its cash flows to determine whether it will have

surplus cash or a cash deficit for each period. Second, management needs to decide

whether that surplus or deficit is temporary or permanent. If it is permanent, it may

affect the firm’s long term financial decision. For example, if a company anticipates

an ongoing surplus of cash, it may choose to increase its dividend payouts. Deficit

resulting from investments in long term projects are often financed using long term

long term sources of capital, such as equity or long-term bonds.

2.4.1 Negative Cash Flow Shocks

Occasionally, a company will encounter circumstances in which cash flows

are temporarily negative for an unexpected reason. These situations, which we refer

to as negative cash flow shock, can create short term financing needs (Berk,

DeMarzo, Harford, 2012).

2.4.2 Seasonality

For many firms, sales are seasonal, when sales are concentrated during few

months, sources and uses of cash are also likely to be seasonal. Firms in this position

may find themselves with a surplus of cash during some months that is sufficient to

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compensate for a shortfall during other months. However, because of timing

differences, such firms often have short-term needs (Berk, DeMarzo, Harford, 2012).

2.4.3 Cash Budget

Cash budget is a forecast of cash inflows and outflows o quarterly or

sometimes monthly basis used to identify potential cash shortfalls. By cash budget,

we can immediately see that there will be a substantial cash shortfall in some or any

period of forecast (Berk, DeMarzo, Harford, 2012).

2.4.4 Short-Term Financing with Bank Loans

One of the primary sources of short-term financing, especially for small

business, is the commercial bank. Bank loans are typically initiated with a promissory

note (a write statement that indicates the amount of a loan, the date payment is due,

and the interest rate). There is 3 (three) types of bank loans: a single, end-of-period

payment loan, a line of credit, and a bridge loan (Berk, DeMarzo, Harford, 2012). In

addition, we compare the interest rates of bank loans and present the common

stipulations and fees associated with them.

a. Single, End-of-Period Payment Loans

The most straightforward type of bank loan is a single, end-of-period payment

loan, such a loan agreement requires that the firm pay interest on the loan and pay

back the principal in one lump sum at the end of the loan. The interest rate may be

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fixed or variable. With a fixed interest rate, the specific rate that the commercial bank

will charge is stipulated at the time the loan is made. With a variable interest rate, the

terms of the loan may indicate that the rate will vary with some spread relative to a

benchmark rate, such as the yield on one-year treasury securities or the prime rate.

The prime rate is the rate banks charge their most creditworthy customers. However,

large corporations can often negotiate bank loans at an interest rate that is below the

prime rate.

b. Line of Credit

Another common type of bank loan arrangement is line of credit, in which a

bank agrees to lend a firm any amount up to a stated maximum. This flexible

agreement allows the firm to draw upon the line of credit whenever it chooses.

Firms frequently use lines of credit to finance seasonal needs. An

uncommitted line of credit is an informal agreement that does not legally bind the

bank to provide the funds. As long as the borrower’s financial condition remains

good, the bank is happy to advance additional funds. A committed line credit consists

of a legally binding written agreement that obligates the bunk to provide fund to a

firm regardless of the financial condition of the firm (unless the firm is bankrupt)as

long as the firm satisfies any restrictions in the agreement.

c. Bridge Loan

A bridge loan is another type of short term bank loan that is often used to

―bridge the gap‖ until a firm can arrange for long term financing. Bridge loans are

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often quoted as discount loans with fixed interest rates. With a discount loan, the

borrower is required to pay the interest at the beginning of the loan period. The lender

deducts interest from the loan proceeds when the loan is made.

2.5 The Cost of Bankruptcy

If increasing debt increases the value of firm, why not shift to nearly 100%

debt? One part of the answer comes from bankruptcy cost. With more debt, there is a

greater chance that the firm will be unable to make its required interest payments and

will default on its debt obligations. A firm that has trouble meeting its debt

obligations is in financial distress. Bankruptcy is a long and complicated process that

imposes both direct and indirect cost on the firm and its investors that the assumption

of perfect capital market ignores. (Berk, DeMarzo, Harford, 2012)

2.5.1 Direct Cost of Bankruptcy

Each country has a bankruptcy code that details the process for dealing with a

firm in default of its debt obligation. The bankruptcy code is designed to provide an

orderly process for settling a firm’s debts. (Berk, DeMarzo, Harford, 2012)

However, the process is still complex, time-consuming, and costly. When a

corporation becomes financially distressed, outside professionals, such as legal and

accounting experts, consultants, appraisers, auctioneers, and others with experience

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selling distressed assets, are generally hired. Investment bankers may also assist with

a potential financial restructuring.

In addition to the money spent by the firm, the creditors may incur costs

during the bankruptcy process. In the case of reorganization, creditors must often wait

several years for a reorganization plan to be approved and to receive payment. To

ensure that their right and interest are respected, and to assist in valuing their claims

in proposed reorganization, creditors may seek separate legal representation and

professional advice.

2.5.2 Indirect Cost of Bankruptcy

Aside from the direct legal and administrative costs of bankruptcy, many

other indirect costs are associated with financial distress. Whereas these costs are

difficult to measure accurately, they are often much larger than the direct cost of

bankruptcy.

Indirect cost of bankruptcy often occurs because the firm may renege on both

implicit and explicit commitments and contracts when in financial distress.

Importantly, many of these indirect cost may be incurred even if the firm is not yet

financial distress, but simply faces a significantly possibility of bankruptcy in the

future. Consider the following examples (Berk, DeMarzo, Harford, 2012):

a. Loss of Customers. Because bankruptcy may enable firms to walk away from

future commitments to their customers, those customers may be unwilling to

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purchase products whose value depends on future support or service from the

firm.

b. Loss of Suppliers. Suppliers may be unwilling to provide a firm with inventory if

they fear they will not be paid.

c. Cost to Employees. One important cost that often receives a great deal of press

coverage is the cost of financial distress to employees. Most firms offer their

employees explicit long-term employment contracts, or an implicit promise

regarding job security. However, during bankruptcy these contracts and

commitments are often ignored and significant numbers of employees may be

laid off. In anticipation of this, employees will be less willing to work for firms

with significant bankruptcy risk and so will demand a higher compensation to do

so. Thus, hiring and retaining key employees may be costly for a firm with high

leverage.

d. Fire Sales of Assets. A company in distress may be forced to sell assets quickly

to raise cash, possibly accepting a lower price than the assets are actually worth

to the firm. Which cost are likely to be large when creditors are more pessimistic

than management regarding the value of the asset, and so creditors will try to

force liquidation even at low prices.

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2.6 Project Financing

Project financing may be defined as the raising of funds on a limited-recourse

or nonrecourse basis to finance an economically separable capital investment project

in which the providers of the funds look primarily to the cash flow from the project as

the source of funds to service their loans and provide the return of and a return on

their equtiy invested in the project. (Finnerty, 2007)

Project finance usually typically include the following basic features:

1. An agreement by financially responsible parties to complete the project and,

toward that end, to make available to the project all funds necessary to achieve

completion.

2. An agreement by financially responsible parties (typically taking the form of a

contract for the purchase of project output) that, when project completion occurs

and operations commence, the project will have available sufficient cash to

enable it to meet all its operation expenses and debt service requirement, even if

the project fails to perform on account of force majeure or for any other reason.

3. Assurance by financially responsible parties that, in the event a disruption in

operation occurs and funds are required to restore the project to operating

condition, the necessary funds will be made available through insurance

recovery, advance against future deliveries, or some other means.

The steps in project financing are as follows:

1. Project identification

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2. Risk identification & minimizing

3. Technical and financial feasibility

4. Equity Partners arrangement

5. Negotiation and Loan syndication

6. Commitments and documentation

7. Disbursement of fund

8. Monitoring and review

9. Financial Closure / Project Closure

10. Repayments & Subsequent monitoring

From ten steps we can conclude it into 3 basic stages are as follows:

1. Pre-financing stage: Project identification, Risk identification and minimizing,

technical and financial feasibility.

2. Financing stage: Equity partners arrangement, negotiation and loan syndication,

commitment and documentation, disbursement of fund.

3. Post financing stage: Monitoring and reviewing, financial closure / project

closure, repayments and subsequent monitoring.

2.7 Technical Feasibility

Prior to the start of construction, the project sponsor must undertake extensive

engineering work to verify the technological processes and design of the proposed

facility. If the project requires new or unproven technology, test facilities or a pilot

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plant will normally have to be constructed to test the feasibility of the processes

involved and to optimize the design of the full scale facilities. Even if the technology

is proven, the scale envisioned for the project may be significantly larger than

existing facilities that utilize the same technology. The related capital cost and the

impact of the project expansion on operating efficiency are then reflected in the

original design specification and financial projection (Finnerty, 2007)

This technical feasibility finally will drive financial manager to predict and

calculate the project construction cost from begin to end until commissioning and

operating period. The detailed engineering and design work provide the basis for

estimating the construction cost for the project. It should include the cost all facilities

necessary for the project’s operation as a free-standing entity, especially if the project

is to be located in remote area. Beside all of that, construction cost estimates should

also include a contingency factor adequate to cover possible design errors or

unforeseen costs. The size of this factor depends on uncertainties that may affect

construction cost but, in most major projects, a 10 percent contingency factors (for

example: 10% of a direct cost) is normally viewed as sufficient if the design of the

project facilities has been finalized. Larger contingency will be necessary if the

project is still in the design phase, the more preliminary the design, the larger the

contingency factor that will be appropriate. (Finnerty, 2007)

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2.8 Economic Viability

Economic viability will depend primarily on the marketability of the project

input and output (price and volume). The cost of production will affect the pricing of

the project output. Projections of operating costs are prepared after project design

work has been completed. Each cost element, such as raw materials, labor, overhead,

taxes, royalties, and maintenance expense, must be identified and quantified.

Typically, this estimation is accomplished by dividing the cost element into fixed and

variable cost components and estimating each category separately. Each operating

cost element should be escalated over the term of the projection at a rate that reflects

the anticipated rate of inflation (Finnerty, 2007)

2.9 Analyzing Project Risk

As a rule, lenders will not agree to provide funds to a project unless they are

convinced that it will be a viable going concern. A project cannot have an established

credit record prior to completion—in fact, it cannot have such a record prior to having

operated successfully for a long enough period to establish its viability beyond any

reasonable doubt. Consequently, lenders to a project will require that they be

protected against certain basic risks. (Finnerty, 2007)

In light of the business and financial risks associated with a project, lenders

will required security arrangements designed to transfer these risks to financially

capable parties and to protect prospective lenders. The various risks are characterized

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here as: completion, technological, raw material, supply, economic, financial,

currency, political, environmental, and force majeure risks. (Finnerty, 2007)

2.9.1 Completion Risk

Completion risk is the risk that a project may not be completed and/or

produce revenue, either because the financing was cut off before completion or

because the project’s construction was done poorly (Finnerty, 2007).

The reason of the financing was cut off because:

1. A higher-than-anticipated rate of inflation, shortages of critical supplies,

unexpected delays that slow down construction schedules, or merely an

underestimation of construction costs

2. A lower-than-expected price for the project’s output or a higher-than-expected

cost for a critical input might reduce the expected rate of return to such an extent

that the sponsors no longer find the project profitable.

2.9.2 Raw Material Supply Risk

Raw material is a material or substance used in the primary production or

manufacturing of a good. Raw materials are often natural resources such as oil, iron

and wood. Before being used in the manufacturing process raw materials often are

altered to be used in different processes.

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Particulary in connection with natural resource projects, there is a risk that the

natural resources, raw materials, or other factors of production necessary for

successful operation may become depleted or unavailable during the life of the

project. (Finnerty, 2007)

2.9.3 Financial Risk

.If a significant portion of the debt financing for a project consists of floating-

rate debt, there is a risk that rising interest rate could jeopardize the project’s ability

to service its debt. (Finnerty, Ph.D, 2007)

2.9.4 Currency Risk

Currency risk arises when the project’s revenue stream or its cost stream is

denominated in more than one currency, or when the two streams are denominated in

different currencies. (Finnerty, 2007)

2.9.5 Partnership

The partnership form of organization is frequently used in structuring joint

venture projects. Each project sponsor , either directly or through a subsidiary,

becomes a partner in a partnership that is formed to own and operate the project.

Under the terms of a partnership agreement, the partnership hires its own operating

personnel and provides for a management structure and a decision-making process.

(Finnerty, 2007)

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2.10 Financial Feasibility

To make the financial feasibility, for at least, we must consider the following

item as a follows:

1. Business plan/model

It is any plan that works for a business to look ahead, allocate resources, focus on

key points, and prepare for problems and opportunities.

2. Project financial statement with assumption

It is a forecast for some period of time (term) with considering some assumption

start from before the construction process until it finish.

3. Financial Structure, which is usually come from project sponsor (Equity form)

and bank loan (Loan form).

4. DCF, IRR, NPV, and WACC.

Discounted Cash Flow (DCF) techniques are available to facilitate the

evaluation process. The objective is to find projects that are worth more to the

sponsors than they cost—project that have a positive net present value (NPV)

(Finnerty, 2007). The steps to evaluation of a proposed project are:

a. Estimate the expected future cash flows from the project.

b. Assess the risk and determine a required rate of return (cost of capital) for

discounting the expected future cash flow.

c. Compute the present value of the expected future cash flow.

d. Determine the cost of the project and compare it to what the project is worth.

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The internal rate of return (IRR) is a rate of return used in capital budgeting

to measure and compare the profitability of capital investments. An investment is

considered acceptable if its internal rate of return is greater than an established

minimum acceptable rate of return or cost of capital. (Finnerty, 2007)

The net present value (NPV) is a measure of discounted cash inflow to

present the cash outflow to determine whether a prospective investment will be

profitable. NPV is a central tool in discounted cash flow (DCF) analysis, and is a

standard method for using the time value of money to appraise long-term projects.

(Finnerty, 2007)

The weighted average cost of capital (WACC) serves as the hurdle rate for

a project. It can always be represented as the weighted average cost of the

components of any financing package that will allow the project to be undertaken.

For example, such a financing package could be 20% debt plus 80% equity; 55% debt

plus 45 % equity; and so on (Finnerty, 2007)

In general, the WACC can be calculated with the following formula:

WACC = Ke x (E/(D+E) + Kd x (D/(D+E)

Ke = Cost of Equity

Kd = Cost of debt, Cost of debt should be after tax

E = Equity

D = Debt

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Formula for calculating Ke

Ke = Rf + β ( Rm – Rf)

Rf = Risk Free, we can use ORI (Obligasi retail republic Indonesia)

Rm = Market risk

Β = Beta

In this project, we use WACC to be our discount factor to present value the free cash

flow and/or to calculate the IRR and NPV of the project.

2.11Financial Statement

According accountingtools.com, Financial statements are a collection of

reports about an organization's financial results and condition. They are useful for the

following reasons:

To determine the ability of a business to generate cash, and the sources and uses

of that cash.

To determine whether a business has the capability to pay back its debts.

To track financial results on a trend line to spot any looming profitability issues.

To derive financial ratios from the statements that can indicate the condition of

the business.

To investigate the details of certain business transactions, as outlined in the

disclosures that accompany the statements.

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Every public company is required to produce four financial statements (Berk,

DeMarzo, Harford, 2012):

1. Balance sheet

A list of a company’s assets and liabilities that provides snapshot of the

company’s financial position at a given point in time.

2. Income statement or profit and loss statement

A list of a company’s revenues and expenses over a period of time.

3. Statement of cash flows

An accounting statement that shows how a company has used the cash it earned

during a set of period.

4. Statements of shareholder’s equity

An accounting measure of a company’s net worth that represent the difference

between the company’s assets and its liabilities.

2.12 Liquidity Analysis

Although the book value of a company’s equity is not good estimate of its true

value as an ongoing company, it is sometimes used as an estimate of the liquidation

value of the company, the value of a company after its assets are sold and liabilities

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paid. We can also learn a great deal of useful information from a company’s balance

sheet that goes beyond the book value of the company’s equity.

Creditors often compare a company’s current assets and current liabilities to

assess whether the company has sufficient working capital to meet its short-term

needs. This comparison is sometimes summarized in the company’s current ratio or

quick ratio (Berk, DeMarzo, Harford, 2012).

Current ratio is the ratio of current assets to current liabilities

Current ratio = Current Assets/Current Liabilities

Quick ratio is the ratio of current assets other than inventory to current liabilities

Quick ratio = (Current Assets-Inventory)/Current Liabilities

Cash ratio is the ratio of Cash and cash equivalent to current liabilities

Cash ratio = (Cash + cash equivalents)/Current Liabilities

2.13 Statement of Financial Accounting Standard (PSAK)

In these thesis, we also use PSAK (Statement of Financial Accounting

Standard) released by IAI (Ikatan Akuntan Indonesia) no 16. This statement aims to

regulate the accounting treatment of fixed assets, so that users of financial statements

can discern information about an entity’s investment in fixed assets and the changes

in this investment. PSAK no 16 page 20 stated that recognition of costs carrying

amount of fixed assets is stopped when the asset is at the desired location and

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condition of assets ready to be used in accordance with the intent of management.

Therefore, the cost of the use and development of assets not included in the carrying

amount of the assets. For example, the following costs are not included in the

carrying amount of fixed assets:

Cost incurred when fixed assets has been able to operate in accordance with the

intent of management but have not used or are still operating below capacity

Initial loss surgery, such as the demand for output is still low

Cost of relocating or reorganizing part or all of the operating entities.

2.14 Budget

Budget is a process design to achieve corporate objectives in a profit or a

formal and systematic approach rather than the implementation of management

responsibilities in the planning, coordination, and oversight (Sunyoto, 2012).

According research.ucla.edu, Budget generally include both direct and

indirect costs. Indirect costs are now referred to as Facilities & Administrative costs

(F&A). Both are real costs. Direct plus F&A costs equal total costs. Direct costs can

be easily identified with a particular project, e.g. salaries & wages, employee benefits,

consultants, equipment, supplies, travel.

Reasons why we need budgeting are (Sunyoto, 2012):

1. To be used as a formal juridicial basis in selecting the sources and uses of funds.

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2. To hold restrictions on the amount of funds requested and used

3. To specify the type of funding and source of fund to accommodate control

process.

4. Achieve maximum result inline with source and used of fund.

5. Monitoring and evaluation of all activities.

Budget period is known as the period covered by a budget. The length of the

budget period depends upon the nature of the plan being made. It is the feeling of the

people that the longer period covered, the less reliable will be the figures obtained.

(Prasad and Sinha, 1990)

Budget period have been divided under the following three heads (Prasad and

Sinha, 1990):

1. Short period budget—that is budget which is prepared for a short time say three

months, six months, or maximum a year.

2. Long period budget—that is budget which is prepared for a longer time say over

five to ten years or even more period. The length of time mostly depends upon

external economic conditions and internal circumstances.

3. Medium term budget—that is budget which is covered a period of three to four

years.

According ehow.com, factors that affecting the validity of budgeting are:

1. Cost of sales.

2. Planned expansion.

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3. Financing cost.

4. Other variable cost.

Budget formulation process (Sunyoto, 2012):

1. Budget Schedule.

2. Budget report.

3. Performance report.

4. Special report.

5. Budget controlling.

2.15 Forecasting

Forecasting is a common statistical task in business, where it helps inform

decisions about scheduling of production, transportation and personnel, and provides

a guide to long-term strategic planning. Forecasting is also about predicting the future

as accurately as possible, given all the information available including historical data

and knowledge of any future events that might impact the forecast. Therefore, it is

necessary for a company to make forecast for its business to monitor its development

through years. (Basya, Indah Sari, 2011).

Goal of forecasting is to be as accurate as possible. Thus, by having a more

accurate forecast, the company will be able to plan the use of resources in a more

efficient and more effective ways to minimize waste by adapting to its expectations of

the future. In other words, all forecasts are the company’s option of future and

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decisions made today are based on the forecasts, which may or may not come to pass.

Even though forecasting is about predicting of what will occur in the future and it is

also an uncertain process, the accuracy of the forecast is an important as the outcome

predicted by the forecast. (Basya, Indah Sari, 2011)

There are seven key principles for forecasting that, if applied correctly, could

increase a company’s efficiency and accuracy in forecasting. These seven key

principles are the following (Moon, Mentzer, Smith, Garver, 1998):

1. Understand what forecasting is and is not

2. Forecast demand, plan supply

3. Communicate, cooperate, and collaborate (CCC)

4. Eliminate island of analysis

5. Use tools wisely

6. Make it important

7. Measure, measure, measure.

In conclusion, forecasting is very important to be implemented in business

industry to measure and predict what could happen in the future by using historical

data. The data will give picture of what had already happen during the business in the

past years and will give valuable lessons from it. During the business process, it is

most likely for changes to occur. Therefore, the forecast need to be made frequently

so that the business can adapt itself to the changes. (Basya, Indah Sari, 2011)