FINANCIAL AND MANAGEMENT ACCOUNTING Unit - 1 Accounting Defination According for historical function and managerial function Scope

ope of accounting Financial accounting and Management accounting Managerial uses Differences. Financial Accounting: Accounting concepts Convections Principles Accounting standards International Accounting standards. Unit-2 Double entr s stem of accounting ! Accounting boo"s Preapartion of #ournal and ledger$ subsidiar boo"s ! %rrors and rectification Preparation of trial balance and final accounts. Accounting from incomplete records ! Statements of affairs methods !Conversion method ! Preparation of &rading$ Profit ' (oss Account and )alance Sheet from incomplete records. Unit - 3 Financial Statement Anal sis ! Financial statements ! *ature of financial statements ! (imitations of financial statements ! Anal sis of interpretation !& pes of anal sis !! %+ternal vs Internal anal sis ! ,ori-ontal vs .ertical anal sis - &ools of anal sis ! &rend anal sis ! Common si-e statements !Comparative statements. /atio Anal sis ! & pes ! Profitabilit ratios ! &urnover ratios ! (i0uidit ratios ! Proprietar ratios ! Mar"et earnings ratios ! Factors affecting efficienc of ratios ! ,o1 to ma"e effective use of ratio anal sis ! 2ses and limitation of ratios ! Construction of Profit and (oss Account and )alance Sheet 1ith ratios and relevant figures ! Inter!firm$ Intra!firm comparisons. Unit -4 Fund Flo1 Statements ! *eed and meaning ! Preparation of schedule of changes in 1or"ing capital and the fund flo1 statement ! Managerial uses and limitation of fund flo1 statement.

Cash Flo1 Statement ! *eed ! Meaning ! Preparation of cash flo1 statement ! Managerial uses of cash flo1 statement ! (imitations Differences bet1een fund ,o1 and cash tlo1 anal sis. Unit-5 )udgeting and )udgetar Control: Preparation of various t pes of budgets ! Classification of budgets ! )udgetar control s stem ! Mechanism !Master budget. Unit-6 Capital )udgeting S stem ! Importance ! Methods of capital e+penditure appraisal ! Pa bac" period method ! A// method ! DCF methods ! *P. and I// methods ! &heir rationale ! Capital rationing. REFERENCES: 3. Arulanandam ' 4.S. /aman$ Advanced Accounting. 5. 6upta ' /adbasam $ Advanced Accountmg. 7. Shu"la ' &.S. 6re1al$ Advanced Accounting. 8. 9ain '*arang$ Advanced Cost Accounting, :. Das 6upta$ Advanced Studies in Cost Accounting. ;. Mahes1ari$ Management Accounting & Financial Accounting. 1. Manmohan ' 6o al$ Principles of Management Accounting. <. Prasad$ Advanced Cost Accounting.

FINANCIAL AND MANAGEMENT ACCOUNTING LESSON 3. 5. 7. 8. :. ;. <. >. ?. 3@. 33. 35. 37. 38. 3:. Accounting an Introduction Management Accounting &heor )ase of Accounting ! Accounting Standards Practical )ase of Accounting ! =rigin and Anal sis of )usiness &ransactions Financial Statements of Profit!ma"ing %ntities Manufacturing!cum! &rading =rganisations Financial Statements of *on!Profit!ma"ing %ntities %rrors Management Accounts from Incomplete /ecords ! Single %ntr S stem Financial Statement Anal sis /atio Anal sis Fund Flo1 Anal sis Cash Flo1 Anal sis )udgeting and )udgetar Control Capital )udgeting Case Stud TITLE

LESSON - 1
ACCOUNTING: AN INTRODUCTION (earning outcomesA on completion of this chapter$ ou should be able to: %+plain the nature of accounting. Identif the various branches of accounting. %+plain the process of creation of financial statements and their interpolation. %+plain the various ob#ectives of financial statements. Identif the various uses of accounting information. INTRODUCTION Accounting discipline deals 1ith measurement of economic activities affecting inflo1 and outflo1 of economic resources to develop useful information for decision ma"ing. At household level information about outflo1 and inflo1 of cash resources helps !.@ assess financial position and plan household activities. At 6overnment level$ information about inflo1 from ta+es Bdirect as 1ell as indirectC and e+penditure on various activities Bdevelopmental and non developmentalC is needed for planning and budgeting. Although accounting can be discipline has universal applicabilit $ but its gro1th is closel associated 1ith the developments in the business 1orld. &hus to understand accounting as a field of stud for universal application$ it is best identified 1ith recording of business transaction and thereb creating economic information about business enterprises to facilitate decision ma"ing. NATURE OF ACCOUNTING: 1.2 Accountin i. ii. iii. iv. v. vi. vii. is man!madeA has evolved over a period of timeA is practiced in a social s stemA is a s stematic e+erciseA is #udgmentat at timesA follo1s fle+ible$ not a rigid approachA is essentiall a languageA

viii. i+.

as a language$ has a ver 1ell defined s nta+ of its o1nA and Communicates financial information for decision ma"ing.

Accounting being a man!made s stem has evolved over a period of time to provide financial information of business enterprises to users of accounting information. A large number of groups 1ith varied interests in affairs of a business enterprise have emerged over a period of time$ especiall &hese user groups include those 1hoA manage the activities of the enterpriseB managementC o1n the enterpriseB o1nersD shareholdersC e+tend credit for suppl BcreditorsC bu goods from the enterprisesB customersC lend mone informationC are emplo ed in the enterprises Bemplo eesC intend to ma"e investment in the enterprisesBmvestorsC are doing researchBresearchersC are engaged in collection of ta+es B sales ta+ and income ta+ authoritiesC formulate 6overnment departmentC are members of the public at largeBgeneral publicC fiscal and monetar policies Bother to the enterprisesB ban"s and financial of goods to the enterprises after emergence of corporate forms of organi-ation involving separation of o1nership management.

Internal users of accounting information are inside the enterprise and need information to control and plan the activities of the business to manage it effectivel . &hese include =1ners in case of non corporate enterprises and managers and directors in case of corporate business. &heir information needs are satined through various reports 1hich are generall prepared internal use and remain unpublished. %+ternal users of accounting information are outside the enterprise. &he information need of these user groups are met b measuring the desired information b follo1ing a s stematic process. It results in creation of financial statements 1hich are generall

published to ma"e the information available to e+ternal user group for decision ma"ing. &he need for communicating relevant and useful information to that potential internal and e+ternal users is al1a s there and accounting is intended to perform that role. &hus$ accounting ma be defined as: Ethe process of identif ing$ measuring and communicating information to permit #udgement and decision b the usersE B American Accounting AssociationC !RANC"ES OF ACCOUNTING Fin#nci#$ Accountin : It primaril concentrates on creation of financial information for

e+ternal user groups such as creditors$ investors$ lenders and so on. It deals 1ith business events 1hich have alread occurred and is$ therefore$ historical in nature. &raditionall $ the aim 1as to develop information about income and financial position on the basis of events 1hich had ta"en place during a period of time. /ecent trend in corporate form of organi-ation is to provide information about cash flo1s and earnings per shFe also as part of published financial statements. Management Accounting ! &he information provided b the financial accounting s stem is significant but not sufficient for smooth orderl and efficient conduct of business. Management needs more information to discharge its function of ste1ardship$ planning$ control and decision!ma"ing. As information needs of management var from enterprise to enterprise$ the grouping and reporting of information ta"es different forms. &rie different 1a s of grouping information and preparing reports as desired b managers for discharging their functions are referred to a management accounting. Management accounting provides information to the management not onl about cost but also revenue$ profit$ investment etc.$ for managing business more efficientl and effectivel . A ver important component of management accounting is cost accounting 1hich deals 1ith cost ascertainment and cost control.

Fe1 other branches of accounting 1hich are of recent origin are social responsibilit accounting and human resources accounting. &he first one involves accounting for social costs incurred b the enterprise and social benefits created b it 1hile the second deals 1ith accounting for human resources. In the present boo"$ 1e are concerned 1ith financial accounting onl . &he 1ord accounting and financial accounting are used interchangeabl . Financial accounting provides information to e+ternal user groups in the form of published financial statements. As these users are involved in preparation of financial statements$ it is ver essential that the published statements have credibilit and regarded as reliable b e+ternal users. &herefore$ accounting$ as a language for communicating information$ needs to have a strong s nta+ of its o1n for preparing credible financial statements. &he s nta+ of accounting language comprises of anal sis and recording of business transactions on the basis of double %ntr s stem of boo" "eeping and the basic principles on 1hich the practical s stem is based. &he theor baseA of accounting consists of 6enerall Accepted Accounting Principles B6AAPC$ Conceptual frame1or" and Accounting Standards BASC issued b the professional accounting bodies all over the 1orld$ &he credibilit of the financial statements is established through

anal sis independent e+aminations b a chattered accountant 1ho certifies that the information provided therein gives true and fair vie1 of the activities of tM business in conformit 1ith accepted principles and practices. &his process of attestation of account is "no1n as auditing of accounts. MEANING OF FINANCIAL ACCOUNTING Measurement of accounting information involves three basic steps as per the traditional definition of accounting b the American Institute of Certified Public Accounts BAICPAC 1hich defines accounting as Ethe are of recording$ classif ing and summari-ing in a significant manner and in terms of mone $

transaction! and events 1hich are negative part atleast of financial character and interpreting the results thereof. =n this basis of above information$ Accounting or more precise financial accounting can be basicall divided into t1o partsE$ A. Creation of financial information. ). 2se of financial information. A. C%&#tion o' 'in#nci#$ in'o%(#tion: Creation of financial information involves three steps:

1. R&co%)in : &he process of creation of financial information starts 1ith the occurrence of a business transaction 1hich can be Gualified. &he transaction is evidenced b some document such as Sales bill$ Pass boo"$ Salaries slip etc.$ &he s stematic record of those transactions is chronological order Bi.e. the order in 1hich the occur C is made in a boo" called 9=2/*A( )==4. &he four basic 0uestions need to be addressed 1hile recording namel $ 1hat to record$ 1hen to record$ ho1 to record and at 1hat value to recordH *+#t to %&co%), Since!accounting is regarded as language of the business$ it should s stematicall record all the transaction and events 1hich affect the results of business and ignore the person transaction of the proprietor. )efore recording in the #ournal boo"$ all business transaction e+pressed in terms of mone . Conse0uentl business activities 1hich cannot be e+pressed in terms of mone such as stri"es$ changes in the composition of board of directors etc.$ are not recorded. &hud decision ma"ers 1ill get informaFon onl about mone aspects of the business enterprise from a accounting records. *+&n to %&co%), 2suall business transaction is recorded onl 1hen it has occurred. &hus accounting is basicall historical in nature. "o- to %&co%), 2suall business transaction has t1o aspects and both these are recorded b passing anal sts entr in an #ournal boo". &his s stem of recording is called double entr boo" "eeping s stem. At -+#t .#$u& to %&co%), &o record occurrence of an event in #ournal boo"$ decision about the value of the transaction is needed. A number of different valuation bases are used in accounting in var ing degrees and include historical cost$ current cost$ reali-able value and present value. &hese valuation based generall assume significance in case of valuation of assets. ,istorical cost refers to amount paid D pa able to ac0uire an asset. &he current cost means the amount that 1ould have to be paid$ if the asset is to be ac0uired currentl . &he reali-able value refers to the net reali-able value of the assets if it is to

be disposed. &he present value of an asset is the present discounted value of the future inflo1s that anal sis item is e+pected to generate in the normal course of business. 2. C$#//i'0in : After recording monetar transactions in the #ournal boo"$ ne+t step is to classif the recorded information into related groups to put information in compact and usable forms. For e.g.$ all transactions involving cash inflo1s BreceiptsC and cash outflo1s Bpa mentsC can be grouped to develop useful information is called ledger boo". Mechanism used for classification of recorded information is to open accounts 1hich are called ledger accounts. 3. Su((#%i1in : )asic aim of accounting is to create financial information in a form 1hich 1ill be useful to the decision ma"ers. &o achieve this end$ accounts containing classified information in the ledger boo" are balanced. After balancing of the ledger boo"$ account balances are listed statement giving names of theses accounts and their balance is called E &/IA( )A(A*C% E 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. /eporting of summari-es of the business transaction is done in the form of financial statements 1hich are "no1n as FI*A( ACC=2*&S. According to international Accounting standard ! 3 the term financial statements covers balance sheet$ income statements or profit and loss accounts$ notes and other statements and e+planator material 1hich are identified as being part of the financial statements. &he process of creation of financial information can be summari-ed as follo1s:

Anal sis of business transaction evidenced b source document

/ecording 9ournal )oo"

Classification in ledger boo"

Summari-atio n first in trial balance and then in financial statements

&hus recording$ classif ing and summari-ing are three basic steps involved in creation of financial statement 1hich ascertain and communicate result of business entit . For this is assumed that business and its o1ner have separate e+istence. For accounting purpose$ even a division of the business or a branch of it ma be treated as an accounting entit . !. U/& o' Fin#nci#$ In'o%(#tion 2 St#t&(&nt/: Financial statements prepared b a business enterprise are published and are available to the decision ma"ers. Sound division ma"ing re0uires anal sis and interpretation of these financial statements. A ver commonl used tool for financial anal sis is ratio anal sis. ,o1ever$ there are other tools 1hich are used b the decision ma"ers to underta"e anal sis. &he 1idel used tools for carr ing out anal sis are : Cash flo1 statement Fund flo1 statement /atio anal sis Comparative statement Common si-e statement

,o1ever to anal -e and interpret these financial statements$ the user shouDd be a1are of purpose and nature of these statements can be described as follo1s : EFinancial statements are prepared for the purpose of presenting a periodical revie1 or report on progress b management and deal 1ith the status of investment in the business and the results achieved during the period under revie1. &he reflect a combination of recorded facts$ accounting$ conventions and personal #udgements and #udgements and conventions applied after them materiall . &he

soundness of the #udgement necessaril depends on the competence and integrit of those 1ho ma"e them and on their adherence to 6enerall Accepted Accounting Principles and Conventions. B)omba Stoc" %+change =fficial Director C. O!3ECTI4ES OF ACCOUNTING &he main ob#ective of accounting are as follo1s: &he main records of business: In accounting$ s stematic record of monetar aspects of business events are maintained. &he first step in preparation of financial statements. &his is referred to as boo"!"eeping. Calculation of profit or loss: &o 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 Bor lossC$ sound decision! ma"ing re0uires information about the financial position of a busiriess enterprises. &o depict financial position of a business$ financial position statement is prepared. =n the one hand$ it gives details of resources o1ned b the business enterprise. /esource o1ned are termed as assets. =n the other hand it contains the information about obligations of business. =bligation of the business to1ards outsiders and o1ner are referred to as liabilities and capital respectivel . Financial position statement is also termed as balance sheet 1hich provide information about sources of finance Be.g. outside liabilit and o1ners e0uit C and the resources Beg. assetsC of the business. &o portia the li0uidit position: Financial reporting should provide information about ho1 an enterprise obtains and spends cash$ about its borro1ing and repa ment of borro1ing about its capital transactions$ cash dividends and other distribution of resources b the enterprise to o1ners and about other factors that ma affect an enterpriseIs li0uidit and solvenc . Control over the propert and asset of the firm: Accounting provides up!to! date information about the various assets that the firm possess and the liabilities the firm o1es so that nobod can claim a pa ment 1hich is not due to him.

 &o file ta+ returns: &his is the ob#ective 1hich reall hardl needs emphasis. &he credible accounting records provide the best bases for filing returns of both$ direct as 1ell as indirect ta+es. &o ma"e 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 ma"ers$ USERS OF ACCOUNTING INFORMATION 2sers of accounting information can be grouped as follo1s O-n&%/: =1ners refers to a person or group of persons 1ho have supplied capital for running the business. It refers to individual in case of #oint stoc" companies. Information needs of shareholders have assumed great significance in the corporate business 1orld because of separation of o1nership and management in case of #oint stoc" companies o1ners are interested in the financial information$ to "no1Eabout safet of amount invested and return on amount invested. M#n# &%/: For managing business profitabl information about,nancial result and financial position is needed b management ) providing this information$ accounting helps managers in efficient and smooth running of a business enterprise. In.&/to%/: Prospective investors 1ould li"e to "no1 about the past performance of the business enterprise before ma"ing investment in that concern. ) anal -ingihistorical information provided b accounting records$ the can arrive at a decision about the e+pected return and ris" involved in investing in particular business enterprise. C%&)ito%/ #n) Fin#nci#$ In/titution/: Jhosoever is e+tending credit or loan to a businessIenterprise$ 1ould li"e to have information about its repa ing capacit $ credit1orthiness etc.$ &he re0uired information can be obtained b anal -ing and interpreting the financial statements of the business enterprise.

E(5$o0&&/: %mplo ees are concerned about #ob securit and future prospectus. )oth of thpse are intimatel related 1ith the performance of the business enterprise$ &hus b anal -ing financial statements the can dra1 conclusions about their #ob securit and future prospectus. Go.&%n(&nt: 6overnment policies relating to ta+ation$ providing subsidies etc.$ are guided b the relevance of the industr in the economic development of the countr and the past performance of the industr . Information about the past performance is provided b the accounting s stem$ collection of ta+es is also based on accounting records. R&/&#%c+&%/: /esearchers need financial information for testing h pothesis and development of theories and models. &he financial statement provides the recorded information. Cu/to(&%/: BCustomers 1ho have developed lo alties to a business are ceitainl interested in the continuance of the business. &he certainl 1ant to "no1 about the future directions of the enterprise 1ith 1hich the are associating themselves. &he 1a to information about the enterprise is through their financial statements. 6u7$ic: An enterprise affects the public at large in man 1a s such as provider of the emplo ment to a number of persons being a customer to man supplier a provider of amenities on the localit $ a cause of concern to the public due to pollution etc.$ ,ence public at large is interested in "no1ing the future directions of the enterprise and the onl 1indo1 to peep inside the enterprise is their financial statements. ACCOUNTING AND T"EIR DISCI6LINES: Accounting is the best understood 1hen the other related disciplines are conceptuall clear to the user. For e.g.$ a user can hardl understand financial statements 1ith lots of tables and graphs in it. ,e is not comfortable 1ith the basics of mathematics and statistics. Accounting is ver mathematics. intimatel connected 1ith man disciplines more important of 1hich are economics$ la1$ management$ statistics and

Lin8# & -it+ Econo(ic/: Accounting has strong lin"ages 1ith economics. It has ac0uired its most important concepts of income and capital from economics. &he accountant as 1ell as economist agree that capital should be maintained intact 1hile calculating income and this income can be distributed 1ithout affecting capital. ,o1ever$ the interpretation of the t1o concepts b accountant and economist differ a great deal despite similarities. &he capital to an economist is li"e a tree and income is li"e a fruit on that tree. In technical terms$ a stoc" of 1ealth B&reeC or assets e+isting at a point of time is called capital 1hereas flo1 of benefits from the 1ealth through a given periodvs called income. ,ence capital and 1ealth are s non ms for the economist. &he methodolog adopted b economist is finding income is to find out the e+cess of capital at the end of the ear over the beginning of the ear. If the capital increases$ it is more income. ,o1ever as the capital decreases it is called loss. &o arrive at the value of the capital or 1ealth$ the present value of the future benefits is calculated b discounting e+pected benefits at the re0uired rate of return. ,ence to find out the 1orth of an asset$ the economist 1ill have to estimate the life of the asset and the li"el benefits to be desired from it. &he benefits 1ill be discounted at the re0uires rate of return of the asset has an e+ceptionall long life. ,ence economists valuation of capital and income are highl sub#ective. Accountant tries to impart practicabilit to the concept of capital and income. /ecogni-ing that future benefits of an asset 1ith long life of sa 3@@ ears are difficult to estimate$ the accountant puts a value of the asset at 1hich it 1as ac0uired. ,o1ever$ his attitude is 0uite fle+ible and ma"es use of other bases of measurement 1herever the need arises. &he income of business belongs to a o1ner. &he accountant finds income as a direct result of matching of revenue and e+pense of the same period. It is al1a s calculated at the end of a period. &he matching of revenues and e+pense can be done on different basis vi- accrual$ cash and h brid bases. &he bases are discussed in detail later: Lin8# & -it+ M#t+&(#tic/: Accounting is all about figures and operations on these figures. &he basic s stem of accounting can be ver convenientl converted in the mathematical

form in the form of an accounting e0uation. Simple mathematical operations involved in accounting are addition$ subtraction$ multiplication and division. )esides man aspects of accounting involve calculations 1hich involve strong "no1ledge of mathematics. For e.g.$ calculation of interest$ calculation of the annuit needed to depreciate an asset 1ith a defined rate of interest over its estimated useful life$ bifurcation of a hire purchase instalment in cash price component and interest component etc.$ Lin8# &/ -it+ St#ti/tic/: Accounting is not onl about the preparation of accounting information$ it also involves the presentation and interpretation of accounting information. &he presentation aspects involved creation of tables and graphs etc.$ the "no1ledge of 1hich essentiall lies in the discipline of statistics. =ne of the most debated topic of accounting namel inflation accounting involves e+tensive conversation of historical accounting information 1ith the help of price indices$ Ian important constituent of the discipline of statistics. &he interpretation of accounting information involves ma"ing absolute and relative comparison 1ith the help of ratio anal sis. &he "no1ledge of statistics is needed for the purpose. An important 1a averages. Lin8# &/ -it+ L#-: Accounting essentiall man operates 1ithin a legal environment. Man of calculating interest is through the concept of average due date$ 1hich is based on the "no1ledge of

business organi-ations are governed b their respective statues 1hich prescribe the aspects of their accounting information including the presentation of information. For e.g.$ the Indian Companies Activities$ 3?:; prescribes the rules for managerial remuneration. It also prescribes the format of balance sheet as 1ell as profit and loss account$ &he ban"ing$ insurance and electricit companies have also to prepare their accounts as per the re0uirement of the respective statutes governing them.

LESSON - 2 MANAGEMENT ACCOU NTING

DEFINITION OF MANAGEMENT ACCOUNTING &he accounting activit can be classified into t1o parts. Financial Accounting and Management Accounting. &hough both of them are interlin"ed$ Management accounting is future oriented$ d namic and is made to be decisive and control relevant. International Federation of Accountants BIFACC defined Management Accounting process as Ethe process of identification$ measurement$ accumulation$ anal sis$ preparation$ interpretation and communication of information both financial and operating used b management to plan$ evaluate and contro9 1ithin an of Management Accounting terms defining organisation and to assure use of and accountabilit for its resourcesE. ICJAI published 6lossar Management Accounting as Ea s stem of collection and presentation of relevant economic information relating to an enterprise for planning$ coordinating and decision ma"ingE$ Management Accounting : =fficial &erminolog for such purposes as: 3. Formulation of policies 5. Planning and controlling the activities of the enterprise 7. Decision ta"ing on alternative course of action 8. Disc losure to those e+ternal to the entit Bshareholders and othersC :. Disclosure to emplo ees ;. Safeguarding assets &he assets involves participation in management to ensure that there is effective: Formulation of plans to meet ob#ectives Blong!term planningC Formulation ma"ingCE. of short!term operation plans BbudgetingD profit of CIMA is defined Management Accounting as Ethe provision of information re0uired b management

American Accounting Association defines Management Accounting as Ethe application of appropriate techni0ues and concepts in processing historical and pro#ected economic data of an entit to assist management in establishing plans for reasonable economic ob#ectives and in the ma"ing of rational decisions 1ith a vie1 to1ards these ob#ectivesE. /ichard M.S. Jilson and Jai Fong Chua define Managerial Accounting as EManagerial Accounting encompasses techni0ues and processes that are intended to provide financial and non!financial information to people 1ithin an organisation to ma"e better decisions and thereb organisational effectivenessE &he Management Accounting is used b management to plan the activit $ evaluate performance$ ensure integrit of financial information and to irnplement the s stem of reporting that is lin"ed to organisational responsibilities and contributes to the effective performance measurement. &he definition of Management Accounting embraces all functions underta"en b accountants in an organisation. Management Accounting needs to be d namic and for1ard loo"ing. It also comprises the preparation of financial reports for non!management groups such as shareholders$ creditors$ regulator agencies and ta+ authorities. &he role of Management an isolated concept. It is determined b the Accountant is not determined b achieve organisational control and enhance

re0uirements of business as %+pressed in its structures. SCO6E OF MANAGEMENT ACCOUNTING Management Accounting includes Financial Accounting and e+tends to the operation of a s stem of cost accounting and financial management. Jhile meeting the legal and conventional re0uirements regarding the presentation of financial statements Bprofit and loss account$ balance sheet and funds flo1 statementsC it stresses upon the establishment and operation of internal controls. &he scope of Management Accounting$ inter alia, includes: Formation$ installation and operation of accounting$ cost accounting$ ta+ accounting and information s stems. Management Accountant has to construct and re!construct these s stems to meet the changing needs of management functions

 &he compilation and preservation of vital data for management planning. &he account and document files are respositor of vast 0uantities of details about the past progress of the enterprise$ 1ithout 1hich forecasts of the future is ver difficult for the enterprise. &he Management Accountant presents the past data in such a 1a as to reflect the trends of evbnts to the management. Providing means of communicating management plans to the various levels of organisation. &his$ 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 1hole plan and assists the management in directing their activities. Providing and installing an effective s stem of feedbac" reports. &his 1ould enable the management in its controlling function. ) to the principles of selectivit pinpointing the significant deviations bet1een actual and e+pected activities$ and b adhering and relevance$ such reports help in #the installation and operation of the s stem of IManagement b %+ceptionI. &he Management Accounting is e+pected to anal se the deviation b reasons and responsibilit cases. Anal sing and interpreting accounting and other data to ma"e it understandable and usable to the management. It is onl through such anal sis and clarification that the management is enabled to place the various data and figures in proper perspective in the performance of its functions. Such anal sis assists management! in the location of responsibilities and to effect necessar changes in the organisational setup to achieve the ob#ectives of the enterprise in a more efficient manner. Assisting management in decision ma"ing b BiC providing relevant and to suggest appropriate corrective measures in deserving

accounting and other data and BiiC anal sing the effect of alternative proposals on the profits and position of the enterprise. Management Accountant helps the management in proper understanding and anal sis of the problem in hand and presentation of factual information obviousl in financial terms.

 Providing methods and techni0ues for evaluating the performance of the management in the light of the ob#ectives of the enterprise$ thus assisting in the #rnpiementation of the principle IManagement b =b#ectivesI. Improving$ modif ing and sharpening the effectiveness of the e+isting techni0ues of anal sis. &he Management Accountant 1ould al1a s thin" of increasing the practicabilit of e+isting techni0ues. ,e should be on the loo"! out of the development of ne1 techni0ues as 1ell. &hus$ Management Accounting serves not onl as a tool in the hands of management$ but also provides for a techni0ue evaluating the performance of its functions of planningDdecision ma"ing and control$ and at the same time$ enabling the o1ners 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. ,is contribution has been gro1ing 1ith passage of time. ,e 1ill continue to deliver the goods in a magnificent manner in future 1ith varied e+periences. Scope is e+panding and managements of various sectors are benefiting. %+cerpts from the EPreface to Statements on International Management AccountingE issued o the international Federation of Accountants in Februar 3?>< are reproduced belo1: EManagement Accounting is used b management toA Plan - to gain an understanding$ to e+pected 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 follo1ed b organisation in the futureA Evaluate - to #udge the implications of various past andDor future eventsA Control ! to ensure the integrit of financial information concerning an the

organisationIs activities or its resourcesA

Assure accounta ilit! - to implement the s stem of reporting that is closel aligned to organisational responsibilities and that contributes to the effective measurement of management performanceE &he functions of Management Accounting can be broadl classified intoA BaC Periodic interval accounting reports$ and BbC Ad hoc anal sis of data decision ma"ing. It is increasingl felt that Management Accountants should involve themselves more and more in decision ma"ing and problem solving of organisations. &he areas of decision ma"ing and problem solving are dealt in the follo1ing paras: Strategic Management Accounting: &his function helps the organisation prepare long!term plans$ formulate corporate strateg evaluate the competitors. Investment Appraisal: &his activit includes the BiC appraisal of long!term investment BiiC funding of accepted programmes pro#ects$ and BiiiC post!audit of accepted programmes. Financial Management: It deals 1ith raising of funds for investment$ managing surplus funds$ controlling 1or"ing capital etc$ Short!term ad hoc decisions: &his includes anal sing data for ta"ing decisions c i pricing$ product introduction$ acceptance of special orders etc. Managing the organisation of information s stem: &his includes not onl organising the enterpriseIs financial data but fulfilling the information needs of all the segments of the organisation. FUNCTIONS OF MANAGEMENT ACCOUNTANT &he term IManagement AccountantI has man Director$ Financial Director$ Financial Controller$ Finance Comptroller etc.$ are some of the terms used to designate 1ith the 1or" Management Accounting. Depending situation$ si-e$ nature arid organisational setup and his position in the compan $ the Management Accountant ma be re0uired to perform various and varied functions. &he importance and effectiveness of his function 1ould also depend upon the confidence reposed in him b the top management and the functional managers. ,is functions generall and forecast and

embrace each and ever activit of the management. &he essence of Management AccountantIs functions are as follo1s: &he Management Accountant 1ill establish$ coordinate and: administer plans to facilitate the forecasting of sales$ e+pense budgets and cost standards that 1ill permit profit planning$ capital budgeting and financing. &he Management Accountant 1ill formulate accounting polic and procedures. =perating data and special reports must be prepared so that the performance can be compared 1ith plans and standards$ and an variance bet1een actual operations and pre!determined standards can be anal sed for corrective actions b responsibilit heads. &he Management Accountant 1ill be responsible for the protection of business assets to the e+tent possible b e+ternal controls and internal auditing and insurance coverage. &he Management Accountant 1ill be responsible for ta+ policies and procedures and 1ill supervise and coordinate the reports re0uired b various authorities. A &he Management Accountant must continuall Ke a1are of economic and social forces as 1ell as the effect of the 6overnment policies and actions on business activities. An anal sis of the above list Bobviousl not e+haustiveC o functions$ reflects the status of a Management Accountant. ,e is the principal office in!charge of the accounts of the compan . ,e shall be responsible to the )oard of Directors for the maintenance of ade0uate accounting procedures and records on the operation of business. ,e shall be responsible to the President or the Chairman of the )oard or the )oard of Directors. &hus$ in his broad functional activities$ the Management Accountant is responsible to the polic ma"ing group of top management$ 1hereas$ in his administrative activities he ss responsible to the top e+ecutive offer. management Such comparisons bet1een actual and e+pected activities should help the management in proper fi+ation of and also in evaluation of various functional and divisional

MANAGEMENT ACCOUNTING 4S FINANCIAL ACCOUNTING &he financial accounting classifies and records an entit Is transactions normall in mone terms$ in accordance 1ith established concepts$ principles$ accounting standards and legal re0uirements. It aims to present a Itrue and fair vie1I #of the overall results of those transactions. Management Accounting has been described as a continuous process of anal sis$ planning and control in the conte+t of providing decision support for decision ma"ers. Management Accounting is more concerned 1ith decision ma"ing and a "e role for Management Accountant is acting as a provider of financial information to support these decisions$ &here are several differences bet1een Financial Accounting and Management Accounting as are set out in &able 3.3. Financial Accounting and Management Accounting both appear to be similar inasmdch as both stud the impact of business transactions and events of the enterprise$ reports and interpret the results thereof. )oth provide information for internals as 1ell as e+ternal use. )ut Management Accounting although having its roots in Financial Accounting differs from the latter in follo1ing respects: Financial Accounting studies the business transactions and events for the enterprise as a 1hole. It does not trace the path of events 1ith in the enterprise. Management Accounting$ in additions to the stud of the events in relation to the enterprise as a 1hole$ ta"es 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. &hus$ 1hile the financial statements !profit and loss account$ balance sheet and flo1 statements reveal the overall performance and position of the enterprise. Management Accounting reports emphasis on the details of operational costs$ inventories$ products$ processes and #obs. It traces the effect and impact of the business transactions and events on costs$ inventories$ processes$ #obs and products. Financial Accounting is more attached 1ith reporting the results and positions of business to persons and authorities other than management!6overnment$ Creditors$ Investors$ =1ners$ etc. At times$ Financial Accounting follo1s

1indo1!dressing tactics in order to pro#ect a better than actual image of the enterprise. Management Accounting is concerned more 1ith generating information for the use of internal management and hence the information reflects the real or reall e+pected position. Financial Accounting is necessaril historical. It records and anal ses business events long after the have ta"en place. Management Accounting anal ses the events as the ta"e place and also anticipates such events for the future. &hus$ it uses data 1hich generall has relevance to the future. Since Financial Accounting data is historical in nature$ it is more precise than the Management Accounting data$ 1hich generall rapidl to Management Accounting information. &he periodicit in reporting financial accounts is much 1ider than in case of Management Accounting. In Financial Accounting$ generall $ results are reported on ear to ear basis. In Management Accounting is free to formulate its o1n rules$ procedures and forms because the information generates is solel for internal consumption. Financial Accounting has to governed b the Igenerall accepted principlesI. &his is so because$ it has to cater for the informational needs of the outsiders and legal provisions. Management Accounting is free to formulate its o1n rules$ procedures and forms because the information it generates is solel for internal consumption. Financial Statements prepared under Financial Accounting consists Iof monetar information onl . Management Accounting statements$ in addition to monetar sold and so on. information$ also consists non!monetar information vi-.$ 0uantities of materials consumed$ number of 1or"ers$ 0uantities produced and reflects Ihe e+pected future$ and hence could onl be an estimation. &his provides the necessar

TA!LE

1.1:

MANAGEMENT

ACCOUNTING

./.

FINANCIAL

ACCOUNTING *ature 3. 6overned b 5. )asic functions Fianacial Accounting Compan la1 etc. &ransaction Publication 7. 2sers 8. Availibilit :. &ime focus ;. Period <. Main emphasis >. Speed of prepartion ?. Form presentations 3@. St le and details Standardi-ed 33. Criteria 35. 2nit of account 37. *ature of data consistent Mone Some1hat technical of of Management Accoutning *eeds of managers

recording$ Decision support Provision e+ternal of information Internal Confidential Present and future As appropriate Planning and control Management

financial statements %+ternal Publicl available Past and present 2suall one ear %+planation accurate 1hole of entit

Slo1 but detailed and Fast but appro+imate Segmented to control units &ailored /elevant$ to re0uirement useful and and summari-ed

=b#ective$ verifiable and understandable Mone ph sical units For use b non! accountants

LESSON - 3 T"EOR9 !ASE OF ACCOUNTING - ACCOUNTING STANDARDS

Accounting is Ethe process of identif ing$ measuring and communicating information to permit #udgement and decisions b the users of accountsE !American Accounting Association. It is absolutel necessar that accounting information contained in financial statements are credible and are regarded as reliable b the different user groups to be consistent. Preparation of financial statements on uniform and consistent basis improves their comparabilit and credibilit . It has t1o aspects$ namel $ &he financial statements of an enterprise for different accounting ears are based on similar accounting procedures and policies so that meaningful comparisons over a period of time can be made 3 about he progress of the enterprise. &his is commonl referred to as I&ime series anal sisL. &he financial statements of man enterprises at a point of time are based on similar accounting procedures and policies so that conclusions can be dra1n about their relative performance at a point of time. It is "no1n as ICross!sectional anal sisI. $ It is the function of IAccounting StandardsI !to provide a rational structural frame1or" so that credible financial statements of the highest 0ualit can be produced. According to &.P. 6hosh accounting standards are defined as underL. MAccounting standards are the polic documents issued b the recognised e+pert accountanc bod relating to various aspects of measurement$ treatment and disclosure of accounting transactions and eventsN It is clear from the above definition that accounting standards provide a frame1or" for the preparation of the financial statements. &he also dra1 the boundaries 1ithin 1hich acceptable conduct lies. In the absence of accounting standards$ man alternatives 1ill e+ist and 1ill give the accountant theO leverage to

colourIhis accounting records the 1a he li"es. Such ICreative Accounting PracticesL 1ill certainl create financial statements 1hich are unreliable and lo1er the confidence of user in the reported results. ,ence the need for a coherent pet of accounting standards is imperative. &he efficient functioning of the financial s stem depends upon the confidence that user groups have in the fairness and reliabilit of the financial statements of the businesses ana it is the function of accounting standards to create this generaC sense of confidence b providingA a structural &he 1hole frame1or" 1ithin 1hich credible financial statements can be produced.

idea of PAccounting StandardsL is centred around harmonisation in the accounting policies and practices follo1ed b businesses. &he basic purpose of IAccounting StandardsI is to standardi-e the diverse accounting practices aspects follo1ed for man of accounting. &he harmonisation of accounting policies and practices is

needed at national level as 1ell as international level. &o tac"le the problem at national level$ the Institute of Chartered Accountants ofE India issues accounting standards Bcalled ASIsC formulated b the Accounting Standards )oard BAS)C. At international level$ International Accounting Standards Committee BIASCC issues International Accounting Standards Bcalled lASIsC. terms of standard setting is Eto 1or" generall &he ob#ective of the IASC in for the improvement and

harmonisation of regulations$ accounting standards and procedures relating to the presentation of financial statementsI. &he Institute of Chartered Accountants of India is a member of IASC and has a tacit understanding 1ith the IASC that it 1ould adopt the accounting standards issued b IASC after due recognition of the conditions and practices prevailing in India. At the international level$ IASC has issued 75 international accounting standards. At the national level$ ICAI has issued 3: accounting standards on various issues of accounting and a preliminar draft of a proposed accounting standard on borro1ing costs is being made b the AS) in addition to the revision contemplated in e+isting standards on valuation of inventories and accounting for construction contracts. ACCOUNTING STANDARDS :N INDIA &he Institute of Chartered Accountants of India$ full recognising the need cf harmoni-ing the diverse accounting policies and practices established IAccounting Standards )oardI on 53st April$ 3?<< so that accounting as a language could develop along the right lines. Accounting Standard )oardIs BAS)C main function is to

formulate accounting standards to be issued under the authorit of the council of the institute. Accounting standards provide rules and criteria of accounting measurement. ,o1ever the rulesI criteria are intended lo be used if: a sociai s stem and hence are never intended lo be rigid as in case of ph sical sciences. Con/titution o' AS! : &he consistitution of AS) gives ade0uate representation to all interested parties and$ at present$ it consists of members of the council and representatives to industr $ ban"s$ Compan (a1 )oard$ Central )oard of Direct &a+es and the Comptroller and Auditor 6eneral of India$ Securit %+change )oard of India etc$ Function/ o' AS! : &he main function of AS) is to fomralate accounting standards. Jhile formulating accounting standards$ AS) ta"es into consideration the applicable la1s$ customs$ usage and business environment. &he Institute is the member of International Accounting Standards Committee BIASCC and has agreed to support the ob#ectives of IASC. Jhile formulating standards$ it gives due consideration to the International Accounting Standards BIASC issued b IASC and tries to integrate them$ to the e+tent possible$ in the light of conditions and practices prevailing in India. It also revie1s the accounting standards at periodical intervals. FORMULATION OF ACCOUNTING STANDARDS &he follo1ing points need to be "ept in mind 1hile drafting accounting standards$ namel ! &he accounting standards issued are in conformit 1ith the provisions of the applicable la1s$ customs$ usage and business environment of our countr A &he accounting standards are in the nature of la1s but not la1s. &hough ever possible care is ta"en 1hile drafting standards that the are in conformit 1ith eh applicable la1s$ still the conflict bet1een the la1 and an accounting standard might arise due to amendments in the la1 subse0uent to the issuance of the accounting standard. As clarified in the IStatements of Accounting StandardsI$ accounting standards cannot and do not override the statute and in

all such cases of conflicts$ the provisions of the la1 1ill prevail and the financial statements should be prepared in conformit 1ith the relevant la1s =bviousl $ to that e+tent$ the accounting standards shall not be applicable. ,o1ever$ Ethe institute 1ill determine the e+tenl of disclosure to be made in financial statements and the related auditorIs reports. Such disclosure ma be b 1a of appropriate notes e+plaining the treatment of particular items. Such e+planator notes 1ill be onl in the nature of clarification and therefore$ need not be treated as adverse comments on the related financial statementsE &he accounting standards are intended to appl onl to items 1hich are

material and become applicable from the date as specified b the institute. &he are applicable to all classes of enterprise unless other1ise stated. *o standard is applicable retroactivel $ unless other1ise statedA &he accounting standards are to address the basic mattes$ to the e+tent possible. &he idea is to confine them to essentials onl and not to ma"e them comple+. &he AS) has dra1n an elaborate procedure for formulating accounting standards. ,o1ever$ it needs to be emphasised that the standards are issued under the authorit of the council of the institute. &he procedure involves the follo1ing steps: aC Firstl $ the AS) determines the broad areas in 1hich accounting need to be formulatedA bC Secondl $ the AS) ta"es the assistance of the various stud groups to standards

formulate standards &he preliminar drafts of the standards are prepared b the Stud groups 1hich ta"e Iup the specific sub#ects assigned to them. &he draft prepared b a Stud 6roup is considered b AS) and sent to various outside bodies li"e FICCI$ ASS=C,AM$ SC=P%$ C()$ C'A6$ ICJAI$ ICSI$ C)D& etc. and the representative of these bodies are also invited at a meeting of AS) for discussion.

cC &hirdl $ after ta"ing into consideration their vie1s$ the draft of the standard is issued as e+posure draft for soliciting comments from members of the institute and public at large. &he draft is issued to a large number of institutions and is published in the #ournal of the institute. &he e+posure draft includes the follo1ing basic points: A statement of concepts and fundamental accounting principles relating to the standardA Definitions of the terms used in the standardA &he manner in 1hich the accounting principles have been applied for formulating the standardA &he presentation and disclosure re0uirements in compl ing 1ith the standardA Class of enterprises to 1hich the standard 1ill appl $ Date from 1hich the standard 1ill be effective.

dC Fourthl $ the comments on the e+posure draft are then considered b the AS) and a final draft is prepared and submitted to the council of the instituteA eC (astl $ the council of the institute considers the final draft of the proposed standard$ and if found necessar $ modifies the same in consultation 1ith AS). &he accounting standard on the relevant sub#ect is then issued under the authorit of the council. NATURE OF ACCOUNTING STANDARDS &he accounting standards issued b the ICAI!are recommendator in nature in the initial ears. During the period a standard is recommendator $ it is e+pected that the accounting practices shall be brought in line 1ith the standard. In other 1ords$ the recommendator period is allo1ed to smoothen the process of transition so that no enterprise should have difficult in conforming to the accounting standards once the are made mandator . =nce an accounting standard is made mandator $ it is applicable to all enterprises 1hose accounts are audited b the members.

During the period an accounting standard is recommendator $ tne auditors of companies are re0uired to recommend and persuade their cfients to compl 1ith the re0uirements of the accounting standard even though it is recommendator in nature. /egarding the mandator standards$ it is the dut of the auditors to ensure that the accounting standards are follo1ed in the preparation and presentation of the financial statements. If t"e mandator accounting standards have not beer$ complied 1ith$ the auditor is re0uired to ma"e ade0uate disclosure in his report so that the users of financial statements are a1are of the non!compliance on the part of the enterprise. If a member fails to do so$ the Chartered Accountants Act e+plicitl provides that Ma chartered accountant in practice 1ill be deemed to be guilt accepted procedure of audit applicable to the circumstancesN It is ampl clear that standards on their o1n have no legal bac"ing and hence$ are not enforceable on the public at large. ,ence the institute depends on is members for implementation of accounting standards issued b it through their attest function. &o ma"e it effective$ follo1ing steps are needed: Self!regulation on the part of the business organisation so that I he adhere to these standards 1hile finalising their accountsA (egal bac"ing to the accounting standards. &he standards as the are issued not have no legal bac"ing and institute depends on its memters for their implementation through their attest functionA Publicising the use of accounting standards and ma"ing 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 standardsA &o avoid duplication of authorit . If more than one authorit issues standards$ it is bound to create a confusion in the mind of the user as to 1hich standard needs to be follo1ed. A recent development$ 1orth of attention$ is the establishment of t1o accounting standards b the government under the of professional misconduct if he ails to invite attention to an material departure from the generall

Income &a+ Act$ 3?;3 1hich are to be follo1ed in the preparation of financial statements in case the assessee prefers mercantile basis accounting$ BAccounting Standard I Irelating to disclosure of accounting policies and Accounting Standard II relating to disclosure of prior period and e+traordinar items and changes in accounting policiesC.

&o conclude$ the Institute and its members are dut bound to formulate and implement accounting standards to provide ob#ective and reliable accounting data that 1ould satisf the information re0uirements of the users &o achieve this$ problem of dualit of authorit should be tac"led and the s stem of dual accounting standards in vie1 of its e+pertise in the field. &o improve their effectiveness$ it is also suggested that the standards should be given a legal bac"ing 1ith strong punishment for the erring business organisations. At the same time$ to ma"e a genuine case for recognition of accounting standards and to prevent abuse of financial statements$ more credibilit should be provided to the process of standard setting. ACCOUNTING STANDARDS ISSUED !9 T"E INSTITUTE AS-1 Di/c$o/u%& o' Accountin 6o$ici&/ : &he standard defines IAccounting PoliciesI as referring to the specific accounting principles and the methods of appl ing those principles adopted b 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 normall be at one place. An change in the accounting policies 1hich has a material effect in the current period or 1hich is reasonabl e+pected to have material effect in later peQ#ods should be disclosed. It also emphasises that the disclosure of compliance 1ith fundamental accounting assumption of 6oing Concern$ Consistenc and Accrual is not needed. ,o1ever$ if the are not follo1ed$ the fact must be disclosed.

AS-2 4#$u#tion o' In.&nto%i&/ : &he inventories should be normall valued at I(o1er of Cost or Mar"etI 1here mar"et value means net reali-able value. &he historical cost of inventor can be ascertained b use of IFIF=I$ IAverage CostI$ of I(IF=I formulae. Jhen organi-ation have different items in inventor $ each item ma be dealt 1ith separatel $ or similar items ma be dealt 1ith as a group. &he historical cost of manufactured inventories ma be arrived on the basis of either direct costing or absorption costing. Jhere absorption costing is used$ the fi+ed costs should be based on the normal level of production. =verheads other than production overheads should be included as part of the inventor I cost onl 3@ the e+tent that the clearl relate to putting the inventories in their present location and condition. &he accounting polic in respect of inventories should be properl disclosed and an change in it 1hich has a material effect in the current accounting period or 1hich is reasonabl e+pected to have material effect in later periods should be disclosed. &he amount b 1hich an item in the financial statements is affected b such change should also be disclosed to the e+tent ascertainabfe. Jhere such amount is not ascertainable$ 1holl or in part$ the fact should be indicated. &he ISpecific Identification MethodI$ IAd#usted Selling Price MethodI$ IStandard Cost MethodI and I)ase Stoc" MethodI are to be used in specific circumstances. ,o1ever$ if base stoc" method is used$ the difference bet1een the value at 1hich it is carried and the value b appl ing the method at 1hich stoc" in e+cess of the base stoc" is valued should be disclosed.

AS-3 C+#n &/ in Fin#nci#$ 6o/ition :

A statement of changes in financial position should be published along 1ith its published accounts. Such a statement should be prepared and presented for the period covered b the profit and loss account and for the corresponding period. It ma be prepare on 1or"ing capital basis or cash basis. It emphasises that the funds provided from operation and used in the operation be sho1n separatel and the form of statement should be most informative in the circumstances. ,o1ever$ the standard is no longer va9id as it has been superseded b ne1 standard AS!7 B/evisedC PCash Flo1 StatementL issued in March$ 3??<. AS-3 :R&.i/&); C#/+ F$o- St#t&(&nt: &he cash flo1 statement should report cash flo1s coring the period classified b operating$ investing and financing activities. An enterprise should report cash ,o1s from operating activities using either BaC direct methodA or BbC indirect method. &he inflo1 and outflo1 from the investing and financing activities should be sho1n separatel . Investing and financing transactions that do not re0uire the use of the cash or cash e0uivalents and should present a reconciliation of the amounts in its cash flo1 statement 1ith the e0uivalent items reported in the balance sheet. &he enterprise should also disclose the amount of significant cash and cash e0uivalents balances that are not available for use b it. AS-4 :R&.i/&); Contin &nci&/ #n) E.&nt/ Occu%%in #'t&% t+& !#$#nc& S+&&t D#t& : A contingenc is a condition or situation$ the ultimate outcome of 1hich$ gam or loss$ 1ill be "no1n or determined onl on the occurrence$ or non!occurrence$ of one or more uncertain events. A contingent loss should be recognised if BaC it is probable that future events 1ill confirm that ari asset has been impaired or a liabilit has been incurred on the balance sheet dateF and BbC a reasonable estimate of the amount of the resulting loss can be made. A contingent gain should not be recognised. If either of the t1o conditions mentioned above are not met$ a disclosure should be made of the e+istence of the contingenc specif ing: the nature of the contingenc A the uncertainties 1hich ma affect the future outcomeA :

an estimate of the financial effect$ or a statement that such ail estimate cannot be made. Assets and liabilities should be ad#usted for events occurring after balance

sheet date that provide additional evidence to assist the estimation of the amounts relating to conditions e+isting at the balance sheet date Bfor: e+ample$ insolvenc of a debtor subse0uent to finalisation of financial statementsC or that indicate that the fundamental accounting assumption of going concern is not appropriate. Dividends$ proposed Bor declaredC b the enterprise: after the balance sheet date but before approval of the financial statements$ and pertaining to the period covered b financial statement$ should be ad#usted. Ad#ustments to assets and liabilities are not appropriate for events occurring after the balance sheet date$ if such events do not relate to conditions e+isting at the balance sheet date Bfor e+ample$ decline in mar"et value of the investmentC. Disclosure should be made in the report of the approving authorit of those events occurring after the balance sheet date that represent material changes and commitments affecting the financial position of the enterprise specif ing: the nature of the eventA I an estimate of the financial effect$ or a statement that such an estimate cannot be made.

AS-5 :R&.i/&); N&t 6%o'it o% Lo// 'o% t+& 6&%io)< 6%io% +&(/ #n) C+#n &/ in Accountin 6o$ici&/ : &he ob#ective of this standard is to prescribe the classification and disclosure of certain items in the statement of profit and loss so that all enterprises prepare and present their financial statements on a uniform basis to improve Itheir comparabilit . It e+plains that profit or loss of a period comprises of ordinar activities$ e+traordinar activities and prior period items and all three need to be disclosed separatel . It also includes the impact of change in accounting estimates and change in accounting policies.

=rdinar activities are an activities 1hich are underta"en b an enterprise as part of its business and such related activities in 1hich the enterprise engages in furtherance of$ incidental to$ or arising from$ these activities. %+traordinar items are incomes or e+penses that arise from events or transactions that are clearl distinct from the ordinar activities of the enterprise and$ therefore$ are not e+pected to recur fre0uentl or regularl . Prior period items areIincome or e+penses 1hich 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. &he net profit or loss for the period comprises the follo1ing components$ each of 1hich should be disclosed on the face of the statement of profit and lossA profit or loss from ordinar activitiesA and e+traordinar items. Prior period items are normall included in the determination of net profit or loss for the current period. An alternative approach is to ho1 such items in the statement of profit and loss after determination of current net profit or loss. &he second approach seems better because that 1ill help ascertain the result of current period unaffected b the mista"es of the past$ in either case$ the ob#ective 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 al1a s be made bet1een change in accounting estimates and changes in accounting policies. Jhen it is difficult to distinguish bet1een the change in accounting estimate and change in accounting policies$ it should be regarded as change in accounting estimate$ 1ith appropriate disclosure in the periods of change$ 1hich ma be current period onl or current period as 1ell as future periods. &he effect of change in an accounting estimate should be classified as ordinar or e+traordinar depending upon 1hether the original estimate 1as regarded as ordinar or e+traordinar item. ,o1ever$ the revision of estimate$ b its nature$ cannot be called e+traordinar or prior period item. Jhen change in accounting estimateD change in accounting polic ta"es place 1hich 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 :R&.i/&); D&5%&ci#tion Accountin : &he depreciable amount of an asset comprising of its historical cost$ or other amount substituted for historical cost in the financial statements$ less the estimated reali-able value should be allocated on a s stematic basis to each accounting period during the useful life of the asset. &he historical cost ma undergo revision arising as a result of increase or decrease in long term liabilit on account of e+change rate fluctuations$ price ad#ustments$ changes in duties or similar factors. &he useful life of the asset ma itself be sub#ected to revision$ in 1hich case$ the unamortised balance of the asset be depreciated over its remaining life. An addition or e+tension to an e+isting asset should be depreciated along 1ith the original asset$ unless the e+tension has a separate identit $ in 1hich case it should be depreciated on the basis of an estimate of its o1n life. Jhere depreciable asses are disposed of$ discarded$ demolished or destro ed$ the net surplus or deficienc $ if material$ is disclosed separatel . &he change of method$ if 1arranted$ should be done 1ith 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. &he information to be included in the financial statements should comprise of historical cost or an substituted amount$ total depreciation for the period in respect of each class of asset and related accumulated depreciation. &he follo1ing information should be disclosed in the financial statements along 1ith disclosure of other accounting policies: depreciation methods usedA and depreciation rates or the useful lives of the asset$ if the are different from the principal rates specified in the statute governing the enterprise. AS-= Accountin 'o% Con/t%uction Cont%#ct/ :

&he standard deals 1ith the problem of allocation of revenues and related costs to the accounting periods over the duration of the contract. &he long term construction contracts could be fi+ed price contracts 1here contractor agrees to a fi+ed contract price or cost plus contracts 1here the contractor is reimbursed for allo1able or other1ise defined costs$ and is also allo1ed a percentage of these costs or a fi+ed fees. )oth these contracts can be accounted b either percentage of completion method or completed contract method. 2nder percentage of completion method$ the amount of revenue recognised is determined 1ith reference to the stage of completion of the contract activit completed or substantiall completed. Profit in the case of fi+ed price contract should be recognised 1hen the 1or" has progressed to a reasonable e+tent! sa 5: or 7@R. Jhile recognising profit under percentage of completion method$ the appropriate allo1ance for future unforeseeable facts should be made on either a specific or percentage basis. A foreseeable loss on entire contract should al1a s be provided for in the financial statements irrespective of the amount of 1or" done and the method of accounting follo1ed. Disclosure of changes in accounting polic used for construction contracts should be made in the financial statements giving the effect of the change and its amount. AS-> Accountin 'o% R&/&#%c+ #n) D&.&$o5(&nt: &he prescribed research and development costs outlined in para < of ,ie standard relating to a business should be charged to the revenues of the period in 1hich the are incurred unless the criteria mentioned in para ? of the standard are met$ in 1hich case$ the charging of these e+penses can be deferred to future accounting periods. &he research and development costs$ once 1ritten off$ arc never reinstated in accounts. &he deferred research and development cost should be allocated on a s stematic basis to future accounting periods b reference to either to the sale or use of the product or process or to the time period over 1hich the product or process is e+pected to be sold or unused. If at an point of time$ criteria for deferral as detailed in para ? are not met$ the unamortised balance of research and development e+penditure should be charged to the profit and loss account. Jhen the at the end of each accounting period. &he completed contract method is based on results as determined 1hen the contract is

criteria for deferral continue to be met but the amount of the deferred research and development costs and other relevant costs e+ceed the e+pected filture revenuesD benefits related thereto$ such e+penses should be charged as an e+pense immediatel . &he amount charged to profit and loss account should be e+plicitl disclosed and unamortised research and development costs should be sho1n in the balance sheet under the head EMiscellaneous %+penditureE. $ AS-? R&.&nu& R&co nition : &he standard mainl deals 1ith the timing of revenue. /evenue is defined as Egross inflo1 of cash$ receivable or other consideration arising in the course of ordinar activities of an enterprise from the sale of goods$ from the rendering of services$ and from the use b others of enterprise resources ielding interest$ ro alties and dividends. &he revenue is recognised in case of sale 1hen: the seller of goods has transferred the propert in goods tci the bu er along 1ith significant ris"s and re1ards of the o1nership and seller has no effective control over goods transferredA A no significant uncertaint e+ists regarding the amount of the consideration that 1ill be derived from the sale. &he revenue from rendering of services is recognised either under completed service method or proportionate completion method. Completed service method is a method of accounting 1hich recognises revenue in the statement of profit and loss onl 1hen the rendering of services under a contract is completed or substantiall completed. Proportionate completion method is a method of accounting 1hich recognises revenues in the statement of profit and loss proportionatel 1ith the degree of completion of services under a pontract. /evenue arising from interest is recognised on a time proportion basis$ ro alties on an accrual basis and dividends from investments in shares 1hen the o1nerIs right to receive pa ment is established.

AS-1@ R&countin 'o% FiA&) A//&t/ : Fi+ed asset is an asset held 1ith the intention of being used for the purpose of producing or providing goods or services and is not heSd for :he sais in the notarial course of business. &he gross boo" vaiue of a fi+ed asset shoulo be either historical cost or a revalued amount. &he cost of a fi+ed asset should normall comprise of its purchase price and other attributable cost of bringing the asset to its 1or"ing condition for its intended use. Financing costs relating to deferred credits or to borro1ed funds attributable to construction or ac0uisition of fi+ed assets for the period up to the completion of construction or ac0uisition of fi+ed assets should also be included in the gross boo" value of the asset to 1hich it relates. Jhen a fi+ed asset is ac0uired in e+change or in part e+change for another asset$ the cost of the asset re0uired should be recorded either at fair mar"et value or at the net boo" value of the asset given up$ ad#usted for an balancingA pa ment or receipt of cash or other consideration. Subse0uent e+penditures related to an item of fi+ed asset should be added to its boo" value onl if the increase the future benefits from the e+isting asset be ond its previousl assessed standards of performance. Material items retired from active use and held for disposal should be stated at the lo1er of their net boo" value andA net 8@haracteri value. (osses arising from the disposal of fi+ed asset carried at cost should be 8@haracteri in the profit and loss account. *ormall the entire class of asset should be revalued and revaluation should never result in the net boo" value of the class of asset being greater than the recoverable amount of assets of that class. 6ain on revaluation should normall be ta"en to the o1nerLs interest in the form of P/evaluation /eserveL Alternativel it could be ta"en to profit and loss account. (oss on revaluation should normall be ta"en to profit and loss account e+cept that such a decrease is related to A an increase 1hich 1as previousl recorded as a credit to the revaluation reserve and 1hich has not been subse0uentl reversed or 8@haracte$ it ma be charged directl to that account. =n disposal of a previousl revalued item of fi+ed asset$ the difference bet1een net disposal proceeds and the net boo" value should be charged or credited to the profit and loss statement e+cept that to the e+tent that such a loss is related to an increase 1hich 1as previousl recorded as a credit to revaluation reserve and 1hich has not been subse0uentl reversed or 8@haracte$ it ma be charged directl to that

account. #ood$ill s"ould "e recorded in t"e oo%s onl! $"en some consideration in mone! or mone!&s $ort" "as een paid for it. A proper disclosure of the gross and net boo" value of the asset as 1ell as relevant amount$ if the assets are stated at revalued amounts should be made. AS-" :R&.i/&); Accountin 'o% t7c E''&ct/ o' C+#n &/ in Fo%&i n EAc+#n & R#t&/ : &he standard deais 1ith BaC accounting for transactions in foreign currenciesA and BbC translating the financial statements of foreign branches for inclusion in the financial statements of the enterprise. &he standard details the methods to be adopted for converting foreign transactions denominated in foreign currenc in the reporting currenc defined as currenc used in presenting the financial statements of the transaction. Disclosure is also encouraged of an enterprise. &he standard recommends proper disclosure of the e+change differences arising on foreign currenc enterpriseLs foreign currenc ris" management polic . AS-12 Accountin 'o% Go.&%n(&nt G%#nt/ : 6overnment grants are assistance b government in cash or "ind to an

enterprise for past or future compliance 1ith certain conditions. 6overnment grants can be 83haracteri in accounts on the basis of capital approach or Income approach$ based on nature of relevant grant. ,o1ever$ the government grant should not be 83haracteri until there is reasonable assurance that BiC the enterprise 1ill compl 1ith the conditions attached to themA and BiiC the grant 1ill be received. A proper disclosure should be made of the accounting polic adopted for government grants$ including the methods of presentation in the financial statements including the nature and e+tent of government grant 83haracteri in the financial statements$ including grants of non!monetar assets given at a concessional rate or free of cost. AS-13 Accountin 'o% In.&/t(&nt/ : &he standard deals 1ith accounting for investment in financial statements of enterprises and related disclosure re0uirements. An enterprise should disclose current

investments and long!term investments distinctl current investment is an investment that b intended to be used for not more than one

in the financial statements. A reali-able and is

its nature readil

ear from the date on 1hich such

investment is made. A long!tern investment is an investment other than a current investment. &he cost of ac0uisition should include charges such as bro"erage$ fees and duties. If an investment is ac0uired b issue of share or other securit $ the ac0uisition cost should be fair value of the securit issued. IF an investment is ac0uired in e+change for another asset$ the ac0uisition cost should be the determined cost 1ith 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 lo1er of cost and fair mar"et value determined either on an individual investment basis or b categor of investments$ ut not on an overall 'or glo al( asis. (ong!term investments should be carried at their cost$ although a provision for diminution in their value$ other than temporar $ should be made. An 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 85haracteri and sho1n in the profit and loss account. Significant disclosure re0uirements are also inserted in the standard and include among other things$ the disclosure of accounting polic for determination of carr ing amount of investments$ classification of investments$ profit and loss on disposal of investments and changes in carr ing amounts of these investments$ for current and long!term investment separatel and aggregate amount of 0uoted and un0uoted investments. AS-14 Accountin 'o% A(#$ #(#tion : &he standard deals 1ith the accounting for amalgamation and the treatment of an resultant good1ill or reserves. Amalgamation is 85haracteri-ed as either in the nature of merger or purchase depending upon five conditions enumerated. Amalgamation in the nature of merger is accounted for b PPooling of interest PPurchase methodL and amalgamation in the nature of purchase is accounted b

methodL. &he consideration for the amalgamation means ihe aggregate of the shares

and other securities issued and the pa ment made in the form of cash or other assets b the transferee compan to the shareholders of the transferor compan . &he identit of all the reserves in amalgamation in the nature of merger is preserved. ,o1ever$ in the case of amalgamation in the nature of purchase$ onl statutor reserves are preserved b giving debit to a ne1 account called arise in case of PPurchase PAmalgamation Ad#ustment AccountL. 6ood1ill onl

methodL. 6ood1ill arising on amalgamation is amortised over a period not e+ceeding five ears unless a some1hat longer period can be #ustified. Jhen an amalgamation is effected after the balance sheet date but before the issuance of the financial statements of either part to the amalgamation$ disclosure should be made in accordance 1ith AS!8 but the amalgamation should not be incorporated in the financial statements. AS-15 Accountin E(5$o0&%/: &he standard deals 1ith the accounting of retirement benefits consisting of BaC Provident fundsA BbC SuperannuationD pensionA BcC 6ratuit A BdC (eave encashment benefit on retirementA BeC Post retirement health and 1elfare schemesA and BfC =ther retirement benefits in the financial statements of emplo ers. &he contribution of the emplo er to1ards the provident fund and other contribution schemes should be charged to the statement of profit and loss for the period. &he accounting treatment of gratuit and other benefit schemes 1ill depend on the t pe of arrangement 1hich the emplo er has chosen to ma"e. An alterations in the retirement benefit costs should be charged or credited to the statement of profit and loss as the arise in accordance 1ith AS!:. 'o% R&ti%&(&nt !&n&'it/ in t+& Fin#nci#$ St#t&(&nt/ o'

LESSON-4 6RACTICAL !ASE OF ACCOUNTING B ORIGIN AND ANAL9SIS OF !USINESS TRANSACTIONS

Accounting process begins 1ith the origin of business transactions and is follo1ed b anal ses of these transactions. After origin and anal sis of transactions comes recording$ classification and summari-ation of business transactions culminating in preparation of financial statements$ O%i in o' !u/in&// T%#n/#ction/ Accounting deals 1ith business transactions 1hich have alread ta"en place$ As financial accounting concentrates on monetar transactions of the past it is basicall historical in nature. Since it amounts to ma"ing recording and anal sis of historical information onl $ it is also "no1n as post!mortem accounting. For recording business transactions$ it is necessar that these transactions are evidenced b an appropriate document such as cash memo purchase bill$ sales bill$ che0ue boo"$ pass boo"$ salar slip$ etc.$ Document 1hich provides evide nce cf the transaction is called the Source Document.

An#$0/i/ o' !u/in&// T%#n/#ction/ In accounting record is made of monetar transactions 1hich are evidenced b a source document and double entr s stem is applied for recording. According to 9./ )atliboi Mever business transaction has a t1o!foid effect and that it affects t1o accounts in opposite directions and if a complete record 1ere to be made of such transaction$ it 1ould be necessar to debit one account and credit another account. It is this recording of the t1o!fold effect of ever transaction that has given rise to the term Double %ntr S stemN &o anal -e the dual aspect of each transactions and to find out the accounts to be debited and credited follo1ing t1o approached can be follo1ed. <. Accounting %0uation Approach

>. &raditional Approach. ?. Accountin ECu#tion A55%o#c+: %0ualit of assets on one hand and liabilities and capital on the other hand is called basic accounting e0uation and is 1ritten as ASS%&S T (IA)I(I&I%S ) CAPI&A( e+pected Jhere assets refer to resources 1hich are o1ned b business

enterprise and are to benefit future operations$ liabilities are debts pa able to parties e+ternal to business and capital means the amount pa able to o1ners of the business enterprise Balso called o1nerLs e0uit C &he dual aspect of some business transactions is anal -ed as follo1s: 3@. Introduction of resources b the o1ner: /s. :$@@$@@@ cash and furniture 1orth /s. 5@$ @@@ invested b the o1ner in the business. Introduction of /s.:$@@$@@@ cash increases business cash b /s. :$@@$@@@ and it creates anal sis obligation to pa /s. :$@@$@@@ to the o1ner 1hich is recorded as capital. In terms of accounting e0uation its effect is as follo1s: ASS%&S T (IA)I(I&I%S U CAPI&A( Cash B/s.:$@@$@@@C TVV U capital B/s.:$@@$@@@C Further$ if furniture 1orth /s.5@$@@@ accounting e0uation appears as under: Cash B/s.:$@@$@@@C U Furniture B/s.5@$@@@C /s. :$5@$@@@ T Capital ! UB:$@@$@@@ U 5@$@@@ C /s.:$5@$@@@ is provided b the proprietor$ the

11. 6u%c+#/& o' #//&t/ 'o% c#/+ #n) 2 o% c%&)it :

Purchased building for /s$5$@@$@@@ and paid /s. 3@$@@@ cash immediatel . It increases business assets or resources b /s$ 3$?@$@@@ as cash decreases b /s. 3@$@@@ and building increases b Cash U B/s.:$@@$@@@ /s. 3@$@@@C U )uilding B/s. 5$@@$@@@C !<$3@$@@@ 12. 6#i) into 7#n8 R/.3<@@<@@@ It decreases cash balance and increase ban" balance and thus$ have no net effect on total assets as sho1n belo1: Cash U B/s.8$?@$@@@ 37. B/s. 7$@@$@@@C U Furniture U )uilding B/s. 5@$@@@C B/s. 5$@@$@@@C !<$3@$@@@ T /s.<$3@$@@@ )an" T Creditors for building U B/s.3$?@$@@@C Capital B/s.:$5@$@@@C T /s.<$3@$@@@ Furniture B/s.5@$@@@C /s.5$@@$@@@. It also creates an obligation to pa T Creditors for building U Capital B/s.3$?@$@@@C B/s.:$5@$@@@C /s. 3$?@$@@@ in future. &he accounting e0uation no1 appears as follo1sA

14. 6#0(&nt o' R/. 1<?@<@@@ 70 c+&Cu& to c%&)ito%/ 'o% 7ui$)in : It decreases ban" balance b /s.3$?@$@@@ and creditors for building b 3$?@$@@@ as sho1n belo1: Cash U B/s.3$?@$@@@ U Furniture )an" B/s. 7$@@$@@@C ! /s. 3$?@$@@@C U )uilding B/s. 5@$@@@C B/s. 5$@@$@@@C T Creditors for building U B/s.3$?@$@@@C ! /s. 3$?@$@@@C Capital /s.

B/s.:$5@$@@@C

/s. :$5@$@@@

T /s. :$5@$@@@

15. 6u%c+#/& o' oo)/ 'o% C#/+2C%&)it: )usiness enterprise purchase goods 1orth /s. :@$@@@ for cash and /s.5@$@@@ on credit. It increases stoc" of goods b /s. <@$@@@$ decreases cash b /s.:@$@@@ and creates anal sis obligation to pa . /s.5@$@@@ to the supplier of goods. After this accounting e0uation appears as follo1s: Cash U )an" U Stoc" of goods B/s.<@$@@@C T Creditors U Capital B/s.5@$@@@C B/s.:$5@$@@@C

B/s.3$?@$@@@ B/s. 3$3@$@@@C 3;. :@$@@@C U Furniture B/s. 5@$@@@C U )uilding B/s.5$@@$@@@C

/s. :$8@$@@@

T /s.:$8@$@@@

1=. R/. 4@<@@@ c#/+ #n) R/.2@<@@@ oo)/ -it+)%#-n 'o% 5&%/on#$ u/&: It decreases cash b /s.8@$@@@ and goods b /s.5@$@@@. At the same time$ it decreases capital b /s.;@$@@@ as sho1n belo1: Cash B/s. 3$8@$@@@ ! :@$@@@C Furniture B/s. 5@$@@@C U )uilding B/s.5$@@$@@@C /s. 8$>@$@@@ T /s.8$>@$@@@ U )an" B/s. 3$3@$@@@C U Stoc" of goods T Creditors B/s.<@$@@@ !/s$5@$@@@C B/s.5@$@@@C U Capital B/s.:$5@$@@@ ! /s.;@$@@@C U

if accounting e0uation after above transactions is to be presented in the form of balance sheet$ it 1ill appear as follo1s :

!#$#nc& S+&&t Li#7i$iti&/ Capital Creditors A(ount A//&t/ 8$;:$@@@ Cash 5@$@@@ )an" Stoc" Furniture )uilding 8$>:$@@@ #(ount 3$5:$@@@ 3$3@$@@@ 7@$@@@ 5@$@@@ 5$@@$@@@ 8$>:$@@@

C$#//i'ic#tion o' Account/ #n) %u$&/ 'o% R&co%)in T%#n/#ction/ : For recording business transaction all accounts are divided into three categories$ 3C 5C 7C Assets Account (iabilit Account Capital Account For recording changes in assets$ liabilities and capital t1o basic rules are follo1ed : Ru$& No. 1 'o% %&co%)in c+#n &/ in #//&t/ : Increase in asset is debited and decrease in asset in credited. Ru$& No. 2 'o% %&co%)in c+#n &/ in $i#7i$iti&/ #n) c#5it#$ : Increase in liabilities and capital are credited and decrease in liabilities and capital are debited.

T%#n/#ction A//&t/ No. C%&)ito%/ C#/+ E 3. 5. 7. 8. :. ;. <. >. :$@@$@@@ :$@@$@@@ ! 3@$@@@ 8$?@$@@@ !7$@@$@@@ 3$?@$@@@ ! 3$?@$@@@ ! :@$@@@ 3$8@$@@@ ! 8@$@@@ 3$@@$@@@ U 5:$@@@ 3$5:$@@@ !#n8 E ! ! ! ! U7$@@$@@@ 7$@@$@@@ !3$?@$@@@ 3$3@$@@@ ! 3$3@$@@@ ! 3$3@$@@@ ! 3$3@$@@@ Stoc8E ! ! ! ! ! ! ! ! U<@$@@@ <@$@@@ !5@$@@@ :@$@@@ !5@$@@@ 7@$@@@ Fu%nitu%&E 5@$@@@ 5@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ !ui$)in ! ! U5$@@$@@@ 5$@@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ ! 5@$@@@ D D D D D D D D D 'o% !ui$)in E ! ! U 3$?@$@@@ 3$?@$@@@ ! 3$?@$@@@ ! 3$?@$@@@ ! ! ! ! ! ! ! T%#)& C%&)ito%/ E ! ! ! ! ! ! ! ! U 5@$@@@ 5@$@@@ ! 5@$@@@ ! 5@$@@@ C#5it#$ :$5@$@@@ :$5@$@@@ ! :$5@$@@@ ! :$5@$@@@ ! :$5@$@@@ ! :$5@$@@@ ! ;@$@@@ 8$;@$@@@ U :@$@@@ 8$;:$@@@ D

An#$0/i/ o' C+#n &/ in C#5it#$ Account Increases and decreases in capital account can ta"e place due to introduction of capital$ 1ithdra1al of cash$ goods and other assets for personal use B called dra1ings C$ revenue and income earned B resulting in increase in capitalC and e+penses incurred B resulting in decrease in capitalC. /ecording the effect of all these transactions directl in the capital account 1ill ma"e it un1ield . In actual practice$ net effect of revenue and e+pense transaction during an accounting period as sho1n b profit and loss account is transferred to capital account. Similarl cumulative effect of dra1ings during an accounting period is recorded in the capital account at the end of the accounting period. For this purpose$ temporar capital accounts are opened. &hese are called temporar accounts because these accounts start 1ith -ero 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. &hese include: aC /evenue AccountBmcluding other incomes and gainsC

bC %+pense AccountBmcludmg lossesC cC Dra1ing Account. As these accounts record changes 1hich affect capital account onl $ no separate rule is re0uired for recording changes in temporar accounts. For e+ample: i. /evenue increases capital and decrease in capital is credited$ therefore revenue earned is credited to revenue account. ii. %+pense decreases capital and decrease in capital is debited$ therefore$ e+penses are debited to e+pense account. iii. Dra1ings decrease capital and decrease in Icapital is debited$ therefore$ the value of assets 1ithdra1n for personal use is debited to dra1ings account. &hus capital at the end of the period ma be calculated as follo1s: Closing capital T =pening capital U Additional capital ! Dra1ings U/evenue and 6ains ! %+penses &o sum up$ under accounting e0uation approach all accounts are divided into three$ categories namel $ assets$ liabilities and capital. Capital account is further sub!divided into permanent and temporar account For recording changes in assets /ule *=. 3 is applied and to record increases and decreases in liabilities and capital /ule *@.5 is follo1ed. I$$u/t%#tion: Prepare a statement sho1ing anal sis 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. W for the month of December$3??>. &ransactions for the month of December$ 3??>$ 1ere as follo1s 3. /eceived cash form debtors /s. 5@$@@@

5. Deposited cash in ban" 7. Pa ment to creditors b che0ue 8. Machine purchased for :. &raveling %+penses St#t&(&nt S+o-in An#$0/i/ o' T%#n/#ction/ T%#n/#ction/ /eceived An#$0/i/ Tit$& #n) N#tu%& o' Account Cash Asset Debtor Asset

8$@@@ 8$@@@ 3@$@@@ :$@@@

Ru$& Debit increase in assets Credit decrease in

Ent%0 Debit cash

cash Increase cash

from debtors /s. Decrease the 5@$@@@ amount due from debtors Deposited cash Increase ban" balance Decreases cash in hand Pa ment creditors to Decreases b amount pa able to creditors decreases ban" balance Increases Machiner purchased /s.3@$@@@ Decreases cash in hand machiner

Credit Debtors

)an" asset

asset Debit increase in asset

Debit ban"

in ban" /s. 8@@@

Cash ! asset

Credit decrease increase asset Debit decrease

Credit cash

Debit creditors

Creditors (iabilit

in liabilit

che0ue /s.8$@@@

Credit )an" Asset decrease in asset Machiner asset Debit increase in asset Debit machiner Credit )an"

Cash ! asset

Credit decrease in

Credit cash

asset %+penses &raveling e+penses /s.:@@@ incurred on travel increases cash in hand decreases &raveling e+pense! &emporar capital B%+penseC Cash ! Asset Credit decrease in asset An#$0/i/ o' 4#$u#tion o' A//&t/ #n) Li#7i$iti&/ Financial accounting is basicall historical in nature and business transactions are accounted at their value on the date of the transactions. As a result asset and liabilities also appear at historical value. &o portra true and fair fianancial position in balance sheet some of the assets and liabilities need revaluation to sho1 these items at realistic$ and not historical$ level in the balance sheet. &o achieve this ob#ective 1ithout 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. /ules relating to anal -e to assets and liabilities can be e+tended to accommodate anal sis of valuation accounts as follo1s: Credit cash Debit increase in e+penses Debit traveling %+penses

3. .aluation of Assets : .arious valuation accounts generall opened to account for decreae in the value of assets are Pprovision for discount on debtors accountL$ Pprovision for doubtful debts accountL$ Pstoc" reserve accountL$ Pinvestment fluctuation reserve account$ provision for Bor accumulatedC depreciation account Pand so on. &he 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 e+ample$ assets machine of /s. 5$@@$@@@ is depreciated b /s. 5@$@@@ at the end of accounting ear 3??>$ the depreciation reduces Bor decreasesC the value of asset and it is calculated to the assets account 1ith the help of the follo1ing entr . Debit Depreciation account B)eing and e+penses account and hence debitedC Credit Machiner account. Alternativel $ 1ith the help of a valuation account called provision for depreciation account$ decrease in asset account can be recorded using the follo1ing entr : Debit Depreciation Account Credit provision for depreciation account Bor accumulated depreciationC &he provision for depreciation is sho1n as assets deduction from the machiner account Bbecause it has assets credit balance and machiner account has a debit balanceC and the same impact is achieved. Conversel $ if revaluation result in increase in value of assets$ the f valuation accounts are debited. &hus rule is as follo1s: Credit valuation account if asset account is to be decreased.

Debit valuation account if asset account is to be increased 2. 4#$u#tion o' Li#7i$iti&/: (i"e 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 ta"en into account. )ut it is anal sts accepted accounting practice to ma"e 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. Conversel $ valuation account recording in increase in liabilities are credited. &his rule is as follo1s: Debit valuation account if liabilit account is to be decreased. Credit valuation account if liabilit account is to be increased. Second aspect of valuation accounts generall appears in temporar capital accounts and ultimatel affects capital account. &hus$ an entr on debit side of an account means either Increase in asset or Decrease in liabilities or Decrease in capital or Increase in Dra1ings or Increase in e+pense and anal sis entr on credit side of an account indicates either Increase in liabilities or Increase in capital or Decrease in asset or Increase in revenue T%#)ition#$ A55%o#c+ )oth accounting e0uation approach and traditional approach record dual aspect of business transactions. )ut in accounting literature$ generall $ traditional

approach is referred to as double entr

s stem. For anal sis and recording of

transactions$ traditionall all ledger accounts are divided as follo1s.

6&%/on#$ Account/: Accounts recording transactions 1ith a person or group of persons are called personal accounts. &hese accounts are necessar $ in particular$ to record credit transactions. Personal accounts are of follo1ing t pes. 1. N#tu%#$ 5&%/on:/; Accounts are accounts of individual living beings and include accounts
A

of individuals such as /amesh capital account. /am account$ *eha account and so

on.

2. A%ti'ici#$ o% $& #$ 5&%/on:/; Accounts include accounts of legal entities such as /eliance Industries (imited Account$ Delhi Corporation Account$ 6ood1ill Co!operative societ Account$ Pun#ab *ational )an" Account and so on.

3. G%ou5 2 %&5%&/&nt#ti.& 5&%/on#$ #ccount: 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 1hom commission or salar personal accounts. Accounts 1hich are not personal are termed as impersonal accounts and are divided into real and nominal accounts. R&#$ Account/: /eal Accounts relate to properties of a business enterprise 1hich can be tangible or intangible. is pa able and are called representative

1. T#n i7$& %&#$ #ccount/: Accounts of properties having ph sical e+istence li"e cash$ building$ stoc" of goods$ furniture etc.$ are called tangible real accounts. 2. Int#n i7$& %&#$ #ccount/: Include account of things 1hich cannot be ph sicall felt or touched but are capable or monetar measurement such as accounts of good1ill$ patents rights$ trade!mar"s rights$ cop rights etc.$ No(in#$ Account/:

Accounts relating to income$ revenue$ gain$ e+penses and losses are termed as nominal accounts. %+ample of nominal accounts are salaries$ rent$ commission$ discount allo1ed$ rent received$ sales interest received etc. For recording changes in personal$ real and Inominal accounts$ follo1ing rules are follo1ed. /ule *o.I ! for personal accounts. Debit the receiver and credit the giver /ule *o.II ! for real accounts Debit 1hat comes in and credit 1hat goes out. /ule *o.Ill ! for nominal accounts Debit all e+penses and losses and credit all revenue$ gains and incomes. Dual aspect of some business transactions is anal -ed b appl ing traditional rules as follo1s. T%#n/#ction/ Introduction cash b o1ners An#$0/i/ Tit$& #n) N#tu%& Ru$& Ent%0

of )usiness gets o1ner

o' Account Cash!/eal Capital Debit

1hat Debit cash

cash personal is )an"!Personal

comes in. Credit giver Debit receiver the Credit Capital the Debit ban"

the giver cash deposited in )an" ban" receives cash )usiness )uilding purchased gives cash )uilding from comes in W is

Cash /eal )uilding /eal

Credit

1hat Credit cash

goes out Debit 1hat Debit )uilding comes in

Mr. W on credit

the W Personal

Credit giver

the Credit W

giver

Purchase goods for cash

of 6oods received Cash

are 6oods /eal

Debit comes

1hat Debit 6oods in 1hat Credit cash all Debit salar

in Cash /eal of Salar *ominal

Credit goes out Debit e+penses

Pa ment salar to

paid of Service an the emplo ee utili-ed )usiness pa s

emplo ee

Credit cash Cash /eal Credit goes out 1hat

cash

for service utili-ed /ent of building )uilding is /ent *ominal Debit due but not paid used business b /ent outstanding e+penses personal Credit giver all Debit Credit the outstanding /ent rent

rent for the BrepresentativeC period pa able is

*ote: /ent pa able or outstanding is a personal account and sho1s he amount pa able to the o1ner of the building. A).#nt# &/ o' Dou7$& Ent%0 S0/t&( 1. Sci&nti'ic S0/t&(: Double entr s stem records$ classifies and summari-es business transactions in a s stematic manner and thus$ produce useful information for decision! ma"ers. It is more scientific as compared to single entr s stem of boo"!"eeping.

2. Co(5$&t& %&co%) o' 7u/in&// t%#n/#ction/: It maintains complete record of a business transaction. It records both debit and credit aspect 1ith e+planation for the transactions. 3. A%it+(&tic#$ #ccu%#c0 o' %&co%)/: 2nder double entr s stem arithmetical accurac of records can be chec"ed b preparing a trial balance. ,o1ever$ some errors cannot be deducted b preparing assets trial balance. $ 4. A/c&%t#in(&nt o' 5%o'it o' $o//: Profit or loss due to operation of business can be "no1n b preparing profit and loss account. 5. In'o%(#tion #7out 'in#nci#$ 5o/ition o' t+& 7u/in&// &nt&%5%i/&: It can be obtained b preparing balance sheet .at a point of time. 6. L&//&% 5o//i7i$it0 o' '%#u): Possibilit of frauds and misappropriation is minimi-ed as complete information is recorded under this s stem. =. "&$5/ u/&%/ o' #ccountin in'o%(#tion: Double entr s stem is most scientific and e+tensivel used s stem of boo"!"eeping all over the 1orld. &his s stem provides s stematic and reliable information$ it meets the needs the users of accounting information$ and assist them in sound decision ma"ing. An#$0/i/ o' 6u%c+#/&/ #n) S#$&/ o' Goo)/ Follo1ing transactions relating to sale and purchase of goods need careful anal sis. 3. Purchases and sales$ 5. Discount received and discount allo1ed$ 7. Sales ta+ 8. Che0ues issued and che0ues received.

:. )ad debts Bapplicable in case of credit transactions onl C. 1. An#$0/i/ o' 6u%c+#/&/ #n) S#$&/: In accounting vocabular $ purchases and sales refer to purchase and sale of items in 1hich the business is dealing in the normal course of business. For e+ample$ purchase of car b assets car dealer for resale is purchase of goods but purchase of car b a manufacturing concern for official use is recorded as an asset. Purchases includes items ac0uired for resale$ and not for utili-ation during business operations. Purchase of goods increases goods held for resale and sale of goods decreases goods. 6oods in hand are called Stoc" or Inventor . Suppose goods costing /s.:$@@@ are purchased and goods costing /s.8$@@@ are sold for /s.;$:@@. theoreticall effect of these transactions can be anal -ed as follo1s: 6oods purchased increases stoc" BAsset D/eal accountC b /s.:$@@@ and decreases cash BAsset D /eal accountC /s.:$@@@. &herefore$ the entr is as follo1s: Debit stoc" Credit stoc" /s. :$@@@ :$@@@

At the time of sale of goods costing /s.8$@@@ for /s.;$:@@ cash BAsset D /eal accountC increases b /s.;$:@@ stoc" BAsset D /eal accountC decreases b /s.8$@@@ and profit on sale B 6ain D &emporar capital account C increases b /s.5$:@@ &herefore$ the entr is as follo1s. Debit cash Credit stoc" Credit profit on sale /s. ;$:@@ 8$@@@ 5$:@@

&heoreticall $ it is possible to find out the stoc" in hand after each purchase transaction and to calculate stoc" of goods and profit B or loss C on sale of goods at the time of sale and record this in accounting records.

)ut 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 Bor lossC on sale at the time of sale. At the time of cash purchase of goods Debit purchases BAsset D /eal accountC Credit cash BAsset D /eal accountC At the time of cash sale of goods: Debit cash BAsset * /eal accountC Credit sales B/evenue D &emporar Capital account B/evenueCC At the end of the accounting period: Cost of goods remaining unsold is determined on the basis of ph sical stoc"!ta"ing. 6oods in hand are listed and generall prices at its historical cost. In this case ph sical stoc" ta"ing 1ill reveal stoc" in hand 1orth /s. 3$@@@ i.e. cost of goods purchased B/s.:$@@@C minus the cost of goods sold B/s.8$@@@C. .alue of stoc" in hand at the end of the account in gF period is recorded as follo1s. Debit closing stoc" BAsset D /eal accountC Credit purchases BAsset D /eal accountC /s. 3$@@@ 3$@@@ ;$:@@ ;$:@@ /s. :$@@@ :$@@@

In case of purchases and opening stoc" are transferred ni trading account and to record the amount of closing stoc" follo1ing procedure is follo1ed$ Debit closing stoc" Credit &rading Account &he gross profit along 1ith other incomes is compared 1ith indirect e+penses to find out net profit B or lossC during an accounting period. &hen net profit B or lossC is transferred to capital account Assuming there are no e+penses$ net profit is e0ual to

/s.5$:@@. B i.e. sales B;:@@C ! cost of sales B8@@@CC. &he entr for transfer of net profit to capital account is as follo1s: /s. Debit profit and loss Bnominal AccountC Credit capital Bcapital AccountC 5$:@@ 5$:@@

2. An#$0/i/ o' Co((i//ion< R&7#t& #n) Di/count:< Commission is the amount pa able to anal sis agent$ bro"er$ emplo ee etc.$ for services rendered b him in transacting the business. It is generall calculated as a percentage of the value of the business transacted. /ebate 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 citi-ens$ rebate in rail fares to the handicapped persons$ rebate to the senior citi-ens under the Income &a+ Activities etc.. Discount is a reduction from a states amount such as discount allo1ed to debtors to encourage prompt pa ment$ issue of securities ata price belo1 their nominal value to attract subscribers$ amount charged b assets ban" at the time of discounting of a bill of e+change for discounting future cash flo1 to its present value etc.$ Suppose a dealer in .imal Fabrics purchases cloth from /eliance Industries (imited at assets list price of /s.7@@ per metre less 7:R discount Compan allo1s additional discount X:R of list price if pa ment is made immediatel . *o1 the cost of purchases of MDStatements$ .imal Fabrics and sales revenue of MDStatements /eliaance Indusries (imites for accounting purposes is /s.3?: per metre Bi.e. /s.7@@ ! 7: R of /s. 7@@C. If MDStatements .imal Fabrics ma"es cash pa ment$ the entr is )oo" of MDStatements /eliance Industries (td /s. Debit Cash 3>@ B/eal ADCC Debit Discount 3: B%+penses )oo" of MDS .imal Fabrics /s. 3?: B/evenue ADCC 3>@

Debit purchases Credit cash

Allo1ed Credit sales

ADCC 3?: B/evenue ADCC

Credit Discount /eceived

3:

3. An#$0/i/ o' S#$&/ T#A: From purchaserIs point of vie1 sales ta+ forms part of the cost of purchases. )ut from sellerIs point of vie1$ sales ta+ charged sho1s!the!amount collected on behalf of and pa able to the sales &a+ Department of the 6overnment. It is recorded in a separate account named PSales &a+ pa able AccountL$ Suppose an item is sold for /s.3$3@@ including sales te+ /s.3@@. the entr is as follo1s !oo8/ o' S&$$&% Debit Cash 3$3@@ B/eal ADCC Credit Sales 3$3@@ B/evenue ADCC Credit Sales ta+ pa able 3@@ B/eprestative personal ADCC 4. An#$0/i/ o' c+&Cu&/ i//u&) #n) c+&Cu&/ %&c&i.&): In case of pa ments made b issue of che0ue$ it is recorded in ban" account straight1a . )ut in case of che0ues received$ it is recorded in ban" account onl 1hen the che0ue is deposited in ban" on the same da . If the che0ue received is not deposited on the same da $ it is treated as cash on the da of receipt of che0ue and 1hen it is deposited in ban"$ it is treated as cash deposited in ban". For e+ample$ if /s.:$@@@ che0ue received from Mr. P on 73.3.3??? is deposited in ban" on 73.3.3??? itself$ the entr on 73.3.3??? is as follo1s /s. :$@@@ BPersonal AccountC :$@@@ BPersonal AccountC !oo8/ o' 6u%c+#/&% Debit Purchaser 3$3@@ B/eal ADCC Credit Cash 3$3@@ B/eal ADCC

Debit ban" Credit P

)ut if che0ue is deposited on$ sa :.5$3???$ the entries are as follo1s: =n 73.3.3???

Debit ban" Credit P =n :.5.3??? Debit ban" Credit cash

B/eal AccountC BAccountC

BPersonal AccountC B/eal AccountC

Above mentioned traditional approach for che0ues received is follo1ed 1hen: 3. Che0ues received are currentl due. Post ! dated che0ues should not be recorded in cash boo". 5. Che0ues received are not crossed IAccount Pa ee I. Crossed che0ues are recorded in ban" column directl . A better 1a of recording che0ues received is to record these as I che0ues in ,andI$ and to transfer it to ban" account at the time che0ue is deposited in ban". 5. !#) )&7t/: )ad debts refer to the amount of debt that cannot be recovered form the credit customers. At the time 1hen business enterprise becomes definite about the non!recover of assets certain sum from debts$ the amount receivable is reduced b crediting debtors account. As the amount non!recoverable is a loss$ it is debited to a ne1 account$ called bad debts account and$ at the end of the accounting period$ it is transferred to profit and loss account. &hus$ entr for recording bad debts is as under. Debit )ad debts B*ominal D &emporar Capital ADCC Credit DebtorsB6roup personal D Asset ADCC

LESSON - 5 FINANCIAL STATEMENTS OF 6ROFIT-MAFING ENTITIES MANUFACTURING-CUM-TRADING ORGANISATIONS

&he basic operation of a trading organisation involves purchase of$ finished goods and their subse0uent sale to final customers 1ithout an $$ substantial modification. At an point of time$ a trader has to manage onl one$ "ind of inventor $ namel that of the IFinished 6oodsI and it is ad#usted.inH &rading account. In contrast$ a Manufacture!cum!&raderIs basic operation involves purchase of ra1 material and its subse0uent conversion into finished productA follo1ed b their trading. At an point of time$ he has to manage three "inds of inventories$ namel $ those of I/a1 MaterialsL IFinished 6oodsI$ and 2nfinished 6oodsI Bpopularl called Jor"!in!processC. ,e li"e a traderFI ascertains his gross results of operation 1ith the help of follo1ing e0uation: 6ross Profit T *et Sales ! Cost of 6oods Sold 1here Cost of 6oods Sold T =pening Stoc" of Finished 6oods U Cost of Finished 6oods manufactured during the period ! Closing Stoc" of Finished. 6oods U Direct %+penses related 1ith &rading. *ote the contrast in the determination of the 6ross Profit of a Manufacturer 1ith that of a &rader. &he ne1 aspect is the ICost of Finished 6oods manufactured during the ear as compared to IPurchase Bless returnsC of Finished 6oods during the periodI of a trading organisation. &he cost of finished goods manufactured during a periods is computed is a ne1 account called IManufacturing AccountI 1hich precedes the trading and profit and loss account of manufacturer!cum!trader. In fact the EIncome statement of a manufacturer!cum!trader is made in three stages and is called IManufacturing$ &rading and Profit and (oss Drecount for the period ending . . .Y.

&o prepare the manufacturing account$ a manufacturer divides his e+penditures in three parts$ namel $ Material cost$ (abour Cost and =ther costs. &hese three categories are further subdivided in t1o more categories$ namel $ IDirect and IndirectI. &he IDirect CostsI are those 1hich do not lose their e+istence in the final product. Indirect costs are those 1hich are not direct costs. ,ence$ for the manufacture of furniture$ cost in incurred on 1ood is a IDirect Material CostI 1hereas cost incurred on nails and fevicol used is a Iindirect Material costI. &he reason is that 1hereas 1ood has not lost its e+istence in the final furniture made$ nails and fevicol have lost it. Similarl $ the cost paid to person 1ho is actuall ma"ing the furniture Balso called carpenterC is called IDirect labour CostI 1hereas cost paid to a person 1ho is supervising man carpenters +s an e+ample of Indirect (abour CostI. I &he IIndirect CostsI comprising of indirect material costs$ indirect labour costs and indirect other costs are collectivel called I=verheadsI. =verheads are further subdivided in three categories namel $ Factor A =ffice and Administration and Selling and Distribution. ,ence$ a manufacturer vie1s his total cost in si+ 1a s$ namel $ BaC Direct Material CostA BbC Direct (abour CostA BcC =ther Direct CostA BdC Factor =verheadsA BeC =ffice ' Administration =verheadsA BfC Selling ' Distribution =verheadsA &he cost of manufactured goods 1ill include the first four components of the cost of a manufacturer and the last t1o aspects are sho1n in the profit and loss account. &he cost is computed in statement formE as belo1: Co(5ut#tion o' co/t o' 'ini/+&) oo)/ (#nu'#ctu%&) )u%in t+& 5&%io). Direct Material consumedY U Direct (abour U Direct =ther Costs Prime Cost U factor =verhead Bnet of Scrap value realisedYYC

6ross Jor"s BManufacturingC Cost U =pening Stoc" of Jor"!in!Process V Closing Stoc" of Jor"!in!Process Cost of goods manufactured =pening stoc" of /a1 Material U Purchase of /a1 Material during the. period ) Closing stoc" of /a1 Material U Freight in1ard U DutiesU Subsidies U Dut Dra1bac"s ! /eturn =ut1ard. YY Scrap is the incidental residue arisinA from a process of manufacture having ver lo1 sales value. &his is sho1n as a deduction from the factor overheads. Alternativel $ it can be sho1n as a deduction from the total 1or"s BmanufacturingC cost. A &he information$ 1hen contained in the account form$ appears as belo1: Dr. &o =pening Stoc" /a1 Material &o Purchaser of /a1 ! Material &o Freight In1ard &o Duties and &a+es &o Fator =verheads &o =pening Stoc" Jor" in progress Manufacturing Account +++ ) Scrap +++ +++ +++ +++ +++ ) /ebates ) Purchases returns ) Subsidies ) Dut Dra1 )ac" ) Closing stoc"!/a1 Material ) Closing stoc" ! Jor" in process ) Cost manufactured 6oods transferred to trading account Cr. +++ +++ +++ +++ +++ +++ +++ +++ +++

+++

*ote that stoc"s of ra1 material and 1or"!in!process have been ad#usted in the manufacturing account 1hereas the stoc" of finished goods is ad#usted in the trading account. Factor overheads include indirect material$ indirect labour and other lighting$ factor telephone e+penses are sho1n in the indirect costs incurred in the factor . ,ence$ e+penses li"e depreciation of plant$ repairs of plant$ factor manufacturing account instead of profit and loss account )ut the depreciation of office furniture Boffice' administration overheadsC and depreciation of deliver vans Bselling ' distribution overheadsC are sho1n in the profit and loss account.

MANUFACTURING DE6ARTMENT AS 6ROFIT CENTRE &he business organisation$ instead of being vie1ed as a 1hole$ can be loo"ed up as comprising of various parts 1here each part is responsible for the overall results of the business in their o1n small measures. &hese small parts arc called I/esponsibilit CentresI of the business and are categorised as BaC %+pense Centres BbC /evenue Centres BcC Profit Centres and BdC Investment Centres. &hese centers$ being headed b responsible managers 1ho are sub#ect to internal evaluation b their seniors at regular intervals$ have a strong case for pro#ecting their division D part of business as a profit!ma"ing division. ,ence often the goods are transferred b the manufacturing department to the trading department at a transfer price 1hich is made up of its manufacturing cost U mar" up or profit In other 1ords$ the manufacturing department is essentiall vie1ed as a IProfit centreI. &he transfer of goods internall at a profit leads to the profit being recognised in the manufacturing account 1hich is transferred to the profit and loss account 1ith the help of the follo1ing entr . Manufacturing ADc &o Profit and (oss ADc ,o1ever$ this profit is not realised unless goods are sold to the ultimate customer b the trading division. ,ence if finished goods remain unsold at the end of the accounting period it leads to valuation of the finished goods at a price 1hich is more than the cost of these goods to the business as a 1hole. &he e+cess represents the I2nrealised profitI contained in the value of the stoc". &his valuation of inventor violates the principle of I(o1er of cost or mar"et valueI as inventor value advocated b AS!5 on valuation of inventories. It also violates IConservatismI principle b recognising a profit 1hich is not realised Banticipated gainsC b transferring goods from one of business department to another department. &he anomal is removed b creating a stoc" reserve for the unreali-ed profit Dr.

contained in the closing stoc" from the profit and loss account 1ith the help of the follo1ing entr .

Profit and (oss ADc &o Stoc" /eserve ADc

Dr.

&he entr reduces the profit to the e+tent of unreali-ed profit in closing f stoc". &he stoc" reserve account is sho1n as a deduction from the value ofAO closing stoc" in the balance sheet and hence the closing stoc" is properl valued at its cost to the business as a 1hole. *e+t ear$ this becomes the opening stoc" and is transferred to the trading account at the transfer value. &he stoc" reserve Bon opening stoc" of finished goodsC is sho1n on the credit side of the profit loss account of the ne+t ear. 4ALUATION OF IN4ENTORIES IN A MANUFACTURING DE6ARTMENT &he value of inventor is computed b adding cost of purchase$ cost off conversion$ and other cost incurred in the normal course of business in bringingA the inventories up to their present location and condition. ,o1ever$ as per AS!5$ the inventor is valued at lo1er of cost or mar"et price characterised b the net reali-able value. &he historical cost of inventor is normall determined b using First in First out BFIF=C$ Jeighted Average or (ast in First out B(IF=C formulae as per recommendation of AS!5. &he value of ra1 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. &he value of finished goods inventor should be based on cost of manufacture 1hich includes besides direct material$ direct labour and other direct costs$ the fair proportion of factor overheads. &he JIP is commonl valued at factor cost. ,o1ever$ 1hile valuing it$ the concepts of %0uivalent 2nit is used. According to institute of Cost and Management accountants$ (ondon$ I%0uivalent units are a notional! 0uantit of completed units substituted for an actual 0uantit of incomplete ph sical units in progress 1hen the aggregate 1or" content of the incomplete units is deemed to be e0uivalent to that of substituted 0uantit .......I. ,ence b using the concept of e0uivalent units$ a :@R complete 1or" in process of 3@$@@@ units is treated as :$@@@ completed units and then the overall cost can be allocated amongst the completed units as 1ell as incomplete units$ the complete units being ta"en as 3@@R complete. Illustration 1: From the follo1ing particulars$ prepare the manufacturing account of A 1ith units column:

=pening Stoc" ! /a1 Material Purchase of /a1 Material Closing Stoc" Freight In1ard Freight =ut1ard Direct Jages Indirect Jages Factor =ffice =ther Factor =veheads =pening Stoc" Jor" in Purchase B8@R completeC Closing Stoc" Jor" in Process B7@R completeC

2nit 3$@@@ 3@$@@@ :@@

/s. 3@$@@@ 3$3@$@@@ H 3@$@@@ 3:$@@@ >:$@@@ 8@$@@@ :@$@@@ 7@$@@@ 3:$@@@ H

3$:@@ 7$@@@

Dr. 6#%ticu$#%/ &o Purchases ! /a1 Matertial &o Freight ! In1ard Unit 3$@@@ 3@$@@@

&o Direct Jages &o Factor =verheads B5C &o =pening Stoc" ! JIP

Manufacturing Account A(ount 6#%ticu$#%/ 3@$@@@ ) Closing Stoc" ! /a1 Material ) Closing Stoc" 3$3@$@@@ ! JIP B7C 3@$@@@ ) &rading ADc Zcost of finished goods transferred to trading account B7C Bb.f.C[ >:$@@@ <@$@@@ 3:$@@@ 7$@@$@@@

Unit :@@ 7$@@@ ?$@@@

Cr. A(ount ;$@@@ 5<$@@@ 5$;<$@@@

3$:@@ 35$:@@

35$:@@

7$@@$@@@

*o%8in Not&/: 1. Calculation of closing stock of raw material !ased on "I"#$ Average pncs of Purchase made during the ear T
Cost of Purchase U Freight BIn1ardC *o. of units purchase

T B3$3@$@@@ U 3@$@@@C 3@$@@@ T /s. 35 .alue of closing stoc" of ra1 material T 500 units x Rs. 12

T /s. ;$@@@ %. "actor& #'erheads Indirect Factor 1ages =ther Factor overheads T 8@$@@@ T 7@$@@@. <@$@@@ (. Calculation of closing stock of work in process and finished goods transferred to trading department.

2nits manufactured during the ear =pening Stoc" of 1or" in process 6oods started and finished during the ear Closing Stoc" of 1or" in process &otal

2nits

R of completion during the ear

%0uivalent units

3$:@@ <$:@@ 7$@@@

;@ R 3@@ R 7@ R

?@@ <$:@@ ?@@ ?$7@@

Cost incurred during the ear /a1 Material Consumed Direct (abour Factor overheads ,ence$ average cost of e0uivalent units .alue of closing stoc" of 1or" in process .alue of finished goods

T T T T T T

3$58$@@@YYY >:$@@@ <@$@@@ 5$<?$@@@D?$7@@ /s. 5<$@@@ Z=pening stoc" of JIP U Cost of completing opening JIP U Cost of goods started and finished during the

T T T

ear[ /s. 3:$@@@ U ?@@ units + /s. 7@ U <$:@@ units + /s. 7@ /s. 3:$@@@ U/s. 5<$@@@ U /s. 5$5:$@@@ /s. 5$;<$@@@

Y =pening stoc" at the beginning of the ear 1as 8@R complete and hence R completed during the ear 1as remaining ;@R. YY &otal finished goods transferred during the ear is ?$@@@. Since 3$:@@ units are from the opening stoc" of JIP$ the remaining B<$:@@ unitsC must be those 1hich 1ere started and finished during the ear on the basis of cost flo1 assumption of FIF=. YYY 3@$@@@ B=pening stoc" U/MC U 3$3@$@@@ BPurchasesC ! ;$@@@ BClosing Stoc"C U3 @$@@@ BFreightC T /s. 3$58$@@@.

LESSON - 6 FINANCIAL STATEMENTS OF NON-6ROFIT-MAFING ENTITIES

=n the other hand$ primar ob#ective of a non!profit organisation is to meet some sociall desirable goal or to render services to its members. *on!profit organisations include hospitals$ educational institutions$ clubs$ political associations$ religious institutions$ charitable societies etc. &hese 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 ta"e place in such institutions to provide certain facilities to members or public in general. Surplus or profi#t from such incidental trading activities is used to fulfil the ob#ectives for 1hich the organisation 1as established. A person familiar 1ith preparation of financial statements of profit!ma"ing organisations should have no difficult in preparing financial statements of non!profit organisations for clear and effective communication$ 1ith their users. &his is so because the set of rules or principles follo1ed for preparing financial statements of both profit!ma"ing and non!profit ma"ing entities are almost same. *on!profit organisations do not prepare profit and loss account because their primar ob#ective is not to earn profit but to serve its members or societ in general. ,o1ever$ these organisations compare incomes and e+penses to chec" 1hether the organisation have sufficient resources to carr out its ob#ectives. &o achieve this IIncome and %+penditure AccountY is prepared b : non!profit organisations and is accompanied b a balance sheet tc sho1 the financial position of the organisation. INCOME AND EG6ENDITURE ACCOUNT Income and e+penditure account is li"e profit and loss account of profit!ma"ing organisations. *on!profit organisations follo1 the same rules or principles for

preparing income and e+penditure account 1hich are follo1ed b

commercial

organisations for preparing profit and loss account. Follo1ing points should be noted: aC It is a nominal account. It records all e+penses and losses on debit side and all incomes and gains on credit side of the account. As it records incomes and e+penses$ the 1ord Ie+penditureI is used here in the sense of an e+pense. bC %+penses debited to income and e+penditure account include e+penditureI of revenue nature. Similarl $ the incomes credited to income and e+penditure account are also of revenue nature. Items of capital nature are$ not included in income and e+penditure account but the portion of capital , e+penditure 1hich e+pires during the ear is charged to income and e+penditure account as depreciation. cC It includes incomes and e+penses of current ear on accrual basis irrespective of flo1 of cash. &herefore$ ad#ustment relating to outstanding e+penses$ prepaid e+penses$ accrued income$ unearned income etc. are ta"en into account. dC %+cess of credit side over debit side is termed as surplus and is "no1n as e+cess of income over e+penditure. ,o1ever$ if debit side e+ceeds credit side$ there is a deficit and is termed as e+cess of e+penditure over income.: (i"e transfer of profit or loss to capital account in case of profit!ma"ing entities$ surplus or deficit of non!profit organisations is transferred to capital fund. Some Peculiar Items: &hough the rules for preparing profit and loss account ofI commercial organisations and income and e+penditure account of non!profit. organisations are same$ but there are some items 1hich are peculiar to non!profit organisations. Items peculiar to non!trading organisations are as follo1s: aC C#5it#$ Fun) : %+cess of assets over liabilities is called capital fund or general fund. It is similar to capital account of commercial organisations.

bC

Annu#$ Su7/c%i5tion : Subscription received from members is a revenue item and credited to income and e+penditure account. It is primar income of a non!profit organisation. source of

cC

Go.&%n(&nt G%#nt: 6overnment schools$ colleges$ public hospitals etc. depend upon 6overnment grant for their activities. &he recurring grants in the form of maintenance grant is$ b and large$ spent in the ear of receipt and is treated as revenue receipt BincomeC and credited to income and e+penditure account. =ther grants such as building grant$ librar grant etc.$ are treated as capital receipt and transferred to a fund account. )esides 6overnmentIs contribution to librar fund$ building fund etc.$ additions ma ta"e the form of retention of surplus$ amount charged from students$ contribution from trustees etc.

dC

Li'&-M&(7&%/+i5 F&&/: Fees received for life membership is a capita[ receipt$ as it is of non!recurring nature. It is directl added to capital fund or general fund.

eC

Ent%#nc& F&&/ : Fees paid b

ne1 members at the time of #oining the once b

organisation is called entrance fees. Since$ the fees is paid onl

members$ it is clearl of non!recurring nature. ,ence$ it should be treated as capital receipt and be sho1n in balance sheet as a part of the general fund. fC Don#tion : Donations received for specific purposes are capitali-ed and recorded on liabilities side of the balance sheet. &hese included donation for building$ donation for e+tension of librar hall$ donation for librar boo"s$ donation for seminar room$ donation for sports activities etc. Jhen the donation is utilised for the purpose$ the amount of donation is transferred to capital fund. Jhen the purpose for 1hich the donation is to be utilised is not mentioned$ It is called general donation and treated as income. gC "ono%#%iu( : Pa ment to non!emplo ees for services received is called honorarium. It is a revenue item and debited to income and e+penditure account.

hC

L& #c0 : Amount received b

non!profit organisations as per Jill of a

deceased person is called legac . As this item is of non!recurring nature$ it is treated as capital receipt and recorded on liabilities side of the balance sheet. ,o1ever$ if the amount is small it can be credited to income and e+penditure account. iC En)o-(&nt Fun) : It refers to a fund from a be0uest or gift. &he fund contains assets uonated b the donor 1ith stipulation that income earned b these assets but not the gift itself can be used for principal activities of the organisation. Sometimes$ income ma also be restricted. &hese "ind of restrictions must properl be reflected in the financial statements. &he fund is treated as capital receipt and recorded on the liabilit side. #C Su7/c%i5tion 'o% 6&%io)ic#$/ : Subscription for ne1spapers$ maga-ines etc. is treated as income and credited to income and e+penditure account. "C S#$& o' O$) 6&%io)ic#$/ : Sale of old ne1spapers$ maga-ines etc. is treated as income and credited to income and e+penditure account. lC S#$& o' A//&t/ : Sale price of old asset is a capital receipt and not recorded in income and e+penditure account. ,o1ever$ profit or loss on sale of asset is transferred to income and e+penditure account. &o recapitulate profit Bor lossC on sale of fi+ed asset is calculated b comparing sale price 1ith boo" value of asset sold on the date of sale. mC Inco(& '%o( /5&ci'ic 'un) #n) &A5&n/&/ %&$#t&) to /5&ci'ic 'un) : 6enerall $ incomes and e+penses are recorded in income and e+penditure account. )ut if e+penses arc incurred on certain items for 1hich a fund e+ists$ then e+penses are not debited to income and e+penditure account but deducted from specific fund account. Similarl $ income from investment of specific fund is added directl to fund is added directl to fund and not credited to income and e+penditure account For e+ample$ match fund balance of /s. 3@$@@@ income from matches /s. :$@@@ and match e+penses -s. 35$@@@ ure sho1n on liabilities side of balance sheet !as foolo1sA

Match Fund Add income from matches (ess Mtch %+penses

3@$@@@ :$@@@ 3:$@@@ 35$@@@ 7$@@@

,o1ever$ if after ad#ustment of income and e+penses related to a specific fund$ fund balance is negative$ it is transferred to debit side of income and e+penditure account nC Out/t#n)in &A5&n/&/ H 5%&5#i) &A5&n/&/ : &o recapitulate$ the e+penses of current ear are to be ta"en on accrual basis 1hile ma"ing income and e+penditure account. ,ence$ the pa ment on account of e+penses need to be ad#usted for outstanding e+penses and prepaid e+penses. &he entries for the t1o aspects ma be recalled from the chapter on final accounts$ namel :! for outstanding e+penses. %+penses ADc Dr. &o =utstanding %+penses ADc For prepaid e+penses Prepaid %+penses ADc Dr. &o %+pense ADc =utstanding e+penses account is sho1n in the balance sheet on liabilit side and prepaid e+penses account on the asset side. )oth accounts are transferred to their respective e+pense accounts of the ne+t ear to find out its amount correctl . o; Acc%u&) inco(& :o% inco(& out/t#n)in ; #n) un&#%n&) inco(& :o% inco(& %&c&i.&) in #).#nc&;: &he same treatment is accorded to the income to be sho1n in income and e+penditure account &he entries passed are: For income outstanding

Income =utstanding ADc &o Income ADc

Dr.

For income received in advance Income ADc Dr. &o Income /eceived in Advance ADc Income outstanding account is sho1n in the balance sheet on the asset side and income received in advance on the liabilit side of the balance sheet. )oth accounts are transferred to their respective income accounts of the ne+t ear to find out its amount correctl . pC (ife membership fund : Sometimes$ member of a non organisation pa their membership fees at die time of admission onl . &he fees received is clearl of non!recurring nature and is given in lieu of subscriptions to be paid ever ear 1hich are of recurring nature. If nothing is specified in the 0uestion$ assume that life membership fund to be capital nature and add it to be capital fund. ,o1ever$ if some "ind of amortisation schedule is given$ than a suitable part out of capital fund should be transferred to income and e+penditure denoting the income of that ear. Illustration I: From the trial balance and the additional information of a public school$ prepare Income and %+penditure Account for the December 73$3??> and the )alance Sheet as at that date. )rial *alance as at Decem!r (1+ 1,,ear ending

)uilding Fruniture (ibrar )oo"s 3;R Investmetns B3!3!?>C Salaries Stationer

A(ount :D%.; 5$:@$@@@ 8@$@@@ ;@$@@@ 5$@@$@@@

Admission Fees &ution Fees /ent of ,all Creditors for )oo"s

A(ount :C%.; :$@@@ 5$@@$@@@ 8$@@@ ;$@@@ 35$@@@ 3$8@$@@@

Supplied 5$@@$@@@ Miscllanoues /eceipts 3:$@@@ Annual 6overnment

6eneral %+penses Annual Sports %+pense Cash )an"

6rant >$@@@ Donations /eceived for librar boo"s ;$@@@ Capital Fund 3$@@@ 5@$@@@ Interest on Investments ><@@<@@@

5:$@@@ 8$@@$@@@ >$@@@ ><@@<@@@

A))ition#$ In'o%(#tionI 3C &uition fees receivable for the ear 3??> amounted to /s. 3@$@@@. 5C Salaries pa able for the ear 3??> amounted to /s. 35$@@@ 7C Furniture costing /s. 3@$@@@ 1as purchased on 3 !<!3??>. depreciation on furniture . 3@R p. a. 8C Depreciate building b :R and librar boo"s b 5@R.

Dr. +ncome and E/penditure Account for t"e !ear ending 0ecem er 11, 1223 Cr. &o Salaries 5$@@$@@@ ) &ution Fees 5$@@$@@@ Add =utstanding 35$@@@ 5$35$@@@ Add =utstanding 3@$@@@ &o Stationer 3:$@@@ ) Annual 6overenment 6rant &o Annual Sports %+penses &o 6eneral ;$@@@ >$@@@ ) Admission Fees ) /ent of ,all :@@ 7$@@@ ) Miscellanoues on >$@@@

5$3@$@@@ 3$8@$@@@

:$@@@ 8$@@@ 35$@@@

%+penses &o Depreciation on Furniture =n 3@$@@@ Bfor \ earC =n 7@$@@@ Bfor 3 earC &o Deprecitation on )uilding &o Depreciation on (ibrar )oo"s &o %+cess Income %+penditure 4<@3<@@@ of over

/eceipts 7$:@@ ) Interest Investment 35$:@@ 35$@@@ Add Interest 3$78$@@@

Accured

58$@@@

75$@@@

4<@3<@@@

4alance S"eet as at 0ecem er 11, 1223 Li#7i$iti&/ =utstanding Salar Creditors for A(ount 35$@@@ Cash ;$@@@ )an" 5:$@@@ &ution Fees A//&t/ A(ount 3$@@@ 5@$@@@ 3@$@@@

)oo"s Supplied Donation for

(ibrar )oo"s Capital Fund =n 3!3!?> Add Surplus 8$@@$@@@ 3$78$@@@

/eceivable Accounted Interest on Investment Investments :$78$@@@ Furniture on 3!3!?> Add purchased on 3!<!3??> (ess Depreciation (ibrar )oo"s (ess Deprcaition )uilding (ess Depreciation 5<==<@@@ 8@$@@@ 7$:@@ ;@$@@@ 35$@@@ 5$:@$@@@ 35$:@@

58$@@@ 5@$@@@ 7@$@@@ 3@$@@@

7;$:@@ 8>$@@@ 5$7<$:@@ 5<==<@@@

RECEI6T AND 6A9MENT ACCOUNT )esides income and e+penditure account and the balance sheet$ financial statements of non!profit organisations invariabl include I/eceipts and Pa ment AccountI. It is nothing but a summar of cash receipts and cash pa ments during the relevant period. From chronological record of cash transactions in the cashboo"$ summar of cash transactions is prepared at the end of the period under consideration. It does not give the date of the transact ion BsC. &hus$ both cashboo" and I/eceipt and Pa ment AccountI provide the same information but in a different manner. aC It is real account. All receipts are recorded on its debit side and all pa ments are credited. bC It starts 1ith balance of cash and ban" in the beginning of the period under consideration. cC It records all items of revenue and capital nature resulting inI inflo1 and outflo1 of cash. Again the period to 1hich the transaction relates is not significant. &ransactions of previous ear$ current ear and subse0uent ears are recorded$ provided the affect flo1 of cash in the current ear.

dC

)alance of receipt and pa ment account sho1s the balance of cash and ban" at the end of the period under consideration.

Di''&%&nc& 7&t-&&n Inco(& #n) EA5&n)itu%& Account #n) R&c&i5t #n) 6#0(&nt Account: Income and E.penditure A ccount /eceipt and Pa&ment Account IC It is a nominal account. It is a real account. 5C It is a summar of the 1or"ing of the It is a summar of cash and ban" organisation. transactions of the organisation.

7C It is based on accrual s stem. It is based on cash s stem 8C It records e+penses and losses on debit It records inflo1 of cash on debit side and side and incomes and gains on credit side. :C It is a temporar account and has no outflo1 of cash on credit side It is real account and starts 1ith

opening and closing balance. opening balance of cash and ban". ;C Itlis closed at the end of the ear and It is balanced at the end of the ear and balance figure of the account is transferred to the balance carried for1ard sho1s the capital fund. <C It records items of revenue nature onl cash and ban" balance at the end of the period. It records items both of capital and revenue nature provided the affect flo1 of cash. ear It records transactions of previous ears$ current ear and subse0uent ears

irrespective of their effect on flo1 of cash. >C onl . It records transactions of current

provided flo1 of cash is affected. !ALANCE S"EET (i"e commercial organisations$ non!profit organisations prepare balance sheet to sho1 the financial position of the =rganisation. If trial balance is not given in the 0uestion$ first of all balance sheet on the first da of the period under consideration

Bcalled =pening )alance SheetC 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 ad#ustment of deficit or surplus as revealed b income and e+penditure account$ the balance capita[ fund is recorded in the balance sheer prepared on the last da of the period under consideration Bcalled Closing )alance SheetC =pening and Closing balance sheet on the basis of information given in Illustration 5 appear as follo1s: 4alance S"eet as at 0ecem er 11. 1225 6ia ilities Salaries =utstanding Capital Fund B)alancing figureC Amount Assets 8$@@@ Cash 3$:?$@@@ )an" =utstanding Subscription Furniture )uilding 1<63<@@@ 4alance S"eet as at 0ecem er 11, 1223 6ia ilities Salaries =utstanding Capital fund =n 3!3!?> Add Surplus Amount 3$@@@ Cash Assets Amount ?@@ 5@$@@@ 7$@@@ 7@$@@@ ;@@ 5@$@@@ :$@@@ 3$@@$@@@ :$@@@ 3:$@@@ ?:$@@@ 1<64<5@@ Amount 3$@@@ 8@$@@@ 5$@@@ 5@$@@@ 3$@@$@@@ 1<63<@@@

3$:?$@@@ 8$:@@

)an" =utstanding Subscription 3$;7$@@@ Investments Add Accrued Interest Furniture on 3! 3!?> (ess sold )uilding (ess Depreciation 1<64<5@@

7@$;@@

,ence it is ampl iC iiC

clear that the financial statements of a non!profit institution

comprises of four basic statements$ namel :! A balance sheet at the start of the period 'i.e., opening balance sheetCA /eceipts ' Pa ments Account 1hich is a summar of cash transactions because most of the transactions of non!profit organisation are in cash BandDor ban"CA In fact$ these t1o statements plus some additional information Bessentiall # about the outstanding D prepaid e+penses and accrued D unearned incomesC provide the basic material 1hich is necessar to compute the deficit D surplus generated b the non!profit organisation and to find out their financial position at the end of the period. &his is done in the ne+t t1o statements$ namel $ iiiC Income and %+penditure Account sho1ing incomes generated and e+penses incurred during the ear to find out the deficit D surplusA ivC A balance sheet at the end of the period 7i.e., closing balance sheetC

All these statements are intimatel connected. In e+amination$ normall one or t1o of these statements are given along 1ith additional information 1ell$ it 1ill be easier to ma"e the statements re0uired in e+amination problems. For e+ample$ aC Fi+ed assets appearing in the opening balance sheet 1ill go to the closing balance sheet after not sold. If the are sold$ the sale price 1i 33 increase the receipts of cash during the ear in receipts and pa ments account and the difference of sale price and their value on the date of sale 1ill be charged to income and e+penditure account as loss or gain on sale of fi+ed asset bC &he receipts in receipts and pa ment account 1ill be divided in t1o parts$ namel capital and revenue. /evenue receipts$ e.g.$ subscription received 1ill denote Bhe subscription received during the ear 1hether pertaining to past D present D future ears. ,o1ever$ it 1ill be ad#usted in the light of information about accrued D unearned subscription given in the opening balance sheet and

additional information and ad#usted subscription$D representing subscription of the current ear 1hether received in past D current D future ears$ 1ill be sho1n on the credit side of the income and e+penditure account of the current ear. Capital receipts such as Iife membership fees$ legac etc. 1ill be ta"en to liabilit side of the closing balance sheet under suitable headings. cC &he pa ments in receipts and pa ment account 1ill be divided in t1o parts$ namel $ capital and revenue. /evenue pa ments or e+penses$ e.g. salar paid 1ill denote the salar paid during the ear 1hether pertaining to past D present D future ears. ,o1ever$ it 1ill be ad#ust in the light of information about outstanding Dprepaid salar and ad#usted salar $ representing salar of the e+penditure account Capital e+penditure$ denoting assets 1ill be ta"en to asset side of the closing balance sheet after depreciation 1hich 1ill be sho1n in the income and e+penditure account on the debit side Be+penditure sideC. From e+amination point of vie1$ preparation of financial statements of no!profit organisations can be studies under the follo1ing categories: 3C Jhen /eceipts and Pa ments account along 1ith additional information is given and rest of the basic statements are to be preparedA 5C Jhen results of an incidental trading BcommercialC activit ofa non!profit organisation Be.g. )ar activities in a clubC are to be ascertained b preparing B)arC &rading Account along 1ith income and e+penditure account and balance sheet at the end of the periodA 7C Jhen in receipts and Pa ments account the balance of ban" is given as per pass boo"A 8C Jhen trial balance along 1ith additional information is given and fe1 basic statements are to be preparedA :C Jhen Income and %+penditure account along 1ith additional information is given and rest of Ihe basic statements are to be preparedA

;C

Jhen both /eceipts and Pa ments account and Income and %+penditure account along 1ith additional information are given$ and balance sheet in the beginning and at the end are re0uiredA

<C

Jhen balance sheet at the beginning and at the end along 1ith additional information is given$ and /eceipts and Pa ments account and Income and %+penditure account for the ear are re0uiredA

>C

Jhen ra1 information is given$ and all the basic statements are to be preparedA

?C

Jhen 1rong statements D incomplete statements are given and corrected accounts of non!profit organisation are to be preparedA

3@C 33C

Accounts of hospitalsA accounts of educational institution including libraries.

C#/& I: Jhen /eceipt and Pa ment Account along 1ith additional information is given$ and rest of the basic statements are to be prepared. I 6enerall e+amination problems re0uire preparation of income and e+penditure

account and balance sheet at the end of the period from the information given. )ut to complete balance sheet the figure of capital fund in the beginning is re0uired. &o calculate information about capital fund in the beginning$ balance sheet at ithe beginning of the period should be prepared. &hus$ to solve the si e+amination problems it is suggested to prepare the follo1ing simultaneousl A 3C )alance sheet at the beginning of the period. 5C Income and %+penditure Account for the period under consideration. 7C )alance sheet at the end of the period.

&o prepare income and e+penditure account from receipt and pa ment account$ all items appearing in receipts and pa ment account should be anal sed one b one. A, items of capital nature are directl recorded in the balance sheet All items of$ revenue nature appearing in receipts and pa ment account are transferred to income and e+penditure account$ it is to be ensured that these representA incomes and e+penses of the current period onl . &o achieve this$ levenue items appearing in receipts and pa ment account are ad#usted$ to shift from cash to accrual basis$ before transferring these items to income and e+penditure account. C#/& II : Jhen results of an incidental trading BcommercialC activit of non!orofit organisation Be.g. )ar activities in a clubC are to be ascertained b preparing &rading Account along 1ith income and e+penditure account and balance shIeet at the end of the period. *on profit organisations basicall survive on donations$ grants subscriptions from members etc. Sometimes trading activities such as hospital canteen$ bar$ club$ beaut parlour$ health club$ restaurant$ chemist shop run b a 6ovt hospital or co!operative store also ta"e place in such institutions to provide certain facilities to members or public in general. As the surplus or profit from such incidental commercial BtradingC activities is used to fulfil the ob#ectives for 1hicn the organisation 1as established$ therefore$ profit from such activities is transferred to income and e+penditure account. Procedure follo1ed is as follo1s: aC Prepare trading account to calculate profit Bor lossC due to incidental trading activit . All costs and revenues and incomes directl related 1ith such activit are recorded in trading account. )alance of trading account sho1ing profit or loss is transferred to income and e+penditure account. bC Income and %+penditure account records$ besides trading profit Bor lossC all other incomes and e+penses not directl related 1ith trading activit . Surplus Bor deficitC as revealed b income and e+penditure account is transferred to capital fund as usual.

C#/& III: Jhen in receipts and Pa ments account the balance of ban" is given as per pass boo". Sometimes$ receipts and pa ments account given in the 0uestion sho1s opening and closing ban" balance as per pass boo". It means the information about various receipts and pa ments given in the receipts and pa ments account is as per pass boo". &o solve the 0uestion$ first of all given receipts and pa ments account should be redrafted and ban" balance and various receipts and pa ments as per cash boo" should be recorded. C#/& I4: Jhen trial balance along 1ith additional information is given and fe1 basic statements are to prepared. It has alread been emphasi-ed that accounts of non!profit ma"ing entities are not materiall different from the accounts of a profit!ma"ing entit . ,ence$ if information is given in the form of trial balance it does not poses a special problem BSee Illustration 3C$ All account have to be anal sed to find out 1hether the result in generation of deficitDsurplus or are accounts of assets D liabilities. &he statements are prepared in the usual manner. C#/& 4: Jhen Income and e+penditure Account along 1ith Additional information is given and rest of the basic statements are to be prepared. Sometimes e+amination problem re0uires receipt and pa ment account and balance sheet from the information given in the 0uestion. &o prepare receipt and pa ment account from income and e+penditure account$ all items appearing in income and e+penditure account should be anal sed one b one to find out their effect on flo1 of cash. &o recapitulate$ income and e+penditure account records all incomes and e+penses of the current period on accrual basis. &herefore$ the information appearing in the income and e+penditure account is to be ad#usted in the light of additional information given in the 0uestion to find out inflo1 and outflo1 of cash on account of incomes and e+penses respectivel . &hen$ information about capital receipts and capital pa ments included in additional information is anal sed and recorded in the receipt and pa ment account After recording all receipts and pa ments and opening

balance of cash and ban"$ the account is balanced. )alancing of receipt and pa ment account no1 reveals the closing balance of cash and ban". Sometimes$ closing balance of cash and ban" is given in the 0uestion and opening balance is to be calculated. In such a case closing balance to be carried for1ard$ along 1ith all receipts and pa ments$ is recorded and balancing figure reveals balance of cash and ban" in the beginning of the period. C#/& 4I: Jhen both /eceipt and Pa ment Account and Income and %+penditure Account along 1ith additional information are given$ and balance sheet in the beginning and at the end are re0uired. Sometimes both receipts and pa ment account and .income and e+penditure account are given in the 0uestions along 1ith additional information about assets and liabilities in the beginning of the ear. In this case balance sheet as at the end of the ear is to be prepared! &o prepare balance sheet$ items given are compared and information about prepaid e+penses$ the amount of salaries sho1n in receipt and pa ment account is less than the amount sho1n in the income and e+penditure account$ the difference is on account of salaries outstanding at the end of the ear. Students have to be ver careful 1hen amount appearing in receipts and pa ment account is more than that appearing in income and e+penditure account. For %+ample: aC Insurance premium amount in receipt and pa ment account is /s. 5@@ and in income and e+penditure account is /s.35@ %+cess pa ment of insurance premium can be either on account of outstanding amount in the beginning of the ear or advance pa ment for the ne+t ear. 6enerall insurance premium is paid in advance$ therefore$ e+cess amount is treated as une+pired insurance and recorded on assets side. bC Income and %+penditure account sho1s stationer amount /s.:@@ and the amount recorded in receipts and pa ment account is /s.<@@. In this case$ difference is either treated as stoc" of stationer Bpurchases!consumedC at the end or amount outstanding in the beginning on account of creditors for stationer .

cC

Interest on investment in income and e+penditure account is /s.3@@@ and /s.3:@@ is sho1n in receipt and pa ment account on account if interest on investment. In this case difference of /s.:@@ can be treatedi as interest received in advance at the end of the ear and recorded on liabilities side of closing balance sheet. Alternativel difference of /s.:@@ can be assumed on account of interest earned but not received in the beginning of the ear and recorded on asset side of opening balance sheet A

dC

Salar account recorded in receipt and pa ment account is /s. 3@$@@@ and /s.?$@@@ is sho1n in income and e+penditure account In this case$ /s. 3$@@@ can be sho1n in closing balance sheet on asset side as advance salar or it can be treated as salaries outstanding in the beginning of the ear and recorded on liabilities side of opening balance sheet.

It is clear from above that if amount appearing in receipt and pa mentS account is more than that appearing in income and e+penditure account$ it ispossible to treat the difference in more than one 1a . In such a case$ student sfiould ma"e a logical assumption and 1rite the assumption made as part of 1or"ing notes$ C#/& 4II: Jhen balance sheet at the beginning and at the end of the period along 1ith additional information are given$ and receipts and pa ments account or income and e+penditure account for the ear are re0uired: &he information about assets and liabilities is given in the beginning as 1ell Eas the end along 1ith additional information either about receipts and pa ments or about incomes and e+penditures. &he infonnation can be ad#usted to find out the incomes and e+penditures or receipts and pa ments. For e+ample$ opening balance sheet sho1s salar outstanding of /s.I== and pa ments sho1 that on account of salar /s. 38$3@@ 1as paid. It 1ill mean that pa ment to be sho1n in receipts and pa ments account is /s. 38$3@@ but salar of the current ear to be sho1n in income and e+penditure account 1ill be /s. 38$@@@ betause the pa ment includes /s. 3@@ on account of last ear.

C#/& 4III: Jhen ra1 information is given and basic statements are to be prepared: Jhen ra1 information is given$ it virtuall involves the 1riting of entire boo"s of accounts of non!profit organisations$ Due care mast be ta"en In recording transactions in these boo"s. All receipts and pa ments should be recorded in the receipts and pa ments account. All e+penses and incomes should be posted to income and e+penditure account "eeping in mind the 1hole discussion 1e had so far. ,ence$ recurring items 1ill find their 1a to income and e+penditure account and non! recurring 1ould be ta"en to balance sheet.$ the assets and liabilities at the end of the ear are enumerated in the closing balance sheet. &he opening balance sheet is normall prepared to find out the missing figure of capital fund in the beginning of the ear. C#/& IG: Jhen Incomplete D Jrong statements are given and corrected accounts of non!profit organisation are to be prepared. C#/& G: Accounts of ,ospital: ,ospitals$ li"e other non profit organisations$ are re0uired to prepare financial statements to present their activities in a meaningful manner. ,ospitals generall operate a number of separate but related activities. InspiteI of the varied activities underta"en$ the procedure of preparation and presentation of financial statements is similar to the one used b other non profit organisations. C#/& GI: Accounts of educational institutions: li"e other non!profit organisations$ educational institutions need to report on their activities and to effectivel communicate their financial needs. &hese institutions b and large$ depend upon I6overnment 6rantsI for their activities. 2nrestricted grants are grants that b their term are full e+pended 1ith in the ear or receipt$ and are treated as income and credited to income and e+penditure account.

LESSON - =
ERRORS MANAGEMENT

&rial balance is prepared to chec" the arithmetical accurac or correctness of recording in #ournal$ posting to ledger and balancing of ledger accounts In case trial balance agrees$ it is assumed that recording$ posting and balancing has been done correctl or accuratel . ,o1ever$ if it does not tall $ efforts are made to locate errors in accounting records. Moreover$ agreement of trial balance is not a conclusive proof of accurac of records. %ven 1hen the trial balance agrees$ some errors ma remain in accounting records. For e+ample$ non!recording of credit sale transaction in Sales )oo" 1ill not affect Bhe agreement of trial balance because both 'i.e., debit as 1ell as creditC aspects of the sale transaction are not recorded in this case. %rrors$ 1hether affecting trial balance or not affecting trial balance$ are to be corrected. &he procedure follo1ed to remed the errors committed and to set right accounting records is called rectification of errors. T05& o' E%%o%/ 1. E%%o%/ o' O(i//ion : It refers to omission of a transaction at the time of recording in subsidiar boo"s or posting to ledger. Jhen a transaction is not recorded in the boo"s of original entr $ agreement of trial balance is not affected because 7ot+ Bdebit as 1ell as creditC aspects of a transaction are not recorded. ,o1ever$ if omission ta"es 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 e+ample$ omission of credit purchase transaction at the time of recording in purchases boo" does not affect the agreement of trial balance$ as posting to purchases boo" does not affect the agreement of trial balance$ as posting to purchases amount and supplierIs account is not done. ,o1ever$ omission at the time of posting to supplierIs account affects the agreement of trial balance as posting to purchases account ta"es place.

5.

E%%o%/ o' Co((i//ion : )esides omission at the time of recording or posting$ business transactions are sometimes recorded and posted in a 1rong manner. Such errors are referred to as errors of commission. &hese errors ma or ma not affect the agreement of trial balance. For e+ample$ 3 recording of 1rong amount in subsidiar boo"s$ posting an amount to 1rong account$ etc. are t1o sided errors and do mot affect trial balanceA ,o1ever 1rong totaling Bor castingC of subsidiar boo"s$ posting on 1rong side of an account$ posting of 1rong amount$ 1rong balancing of an account etc$ are one sided errors and affect the agreement of trial balance.

7.

Co(5&n/#tin E%%o%/: Jhen t1o or more one sided errors ta"e place in such a 1a that their effect is nullified$ these are referred to as I compensating errors. For e+ample$ if /s. :@@ credit sales to /amesh to I posted to debit side of /ameshIs account is omitted at the time of posting and /s. :@@ credit purchases from *aresh to be posted to credit side of *areshIs account is not posted to credit side of *areshIs account$ these HI are termed as compensating errors. First error reduces debit side total b /s. :@@ and second error reduces credit side total b /s. :@@. As a result$ trial balance agrees. &hus$ compensating errors do not affect the agreement of trial balance. %rrors of omission$ commission and compensating errors are also termed as clerical errors

8.

E%%o%/ o' 6%inci5$& : )esides clerical errors$ sometimes accounting principles are violated in accounting process. %rrors involving violation of accounting principles are termed as e.rors of principle. 6enerall $ these errors relate to distinction bet1een capital and revenue items. &reatment of capital e+penditure as revenue receipts or vice versa are errors of principle. For e+ample$ debiting purchase of furniture to office e+penses account$ crediting rent received from tenant to tenantIs account$ crediting sale of furniture sales account$ debiting pa ment of salaries to emplo eeIs account etc. involve errors of principle. &hese error do not affect the agreement of trial balance.

ERROR MANAGEMENT &he 1hole idea of error management can be e+ecuted in three steps$ namel :!

i. ii.

Prevention of errors$ Detection of errors$ and

:A; 6%&.&ntion o' E%%o%/ &he best 1a to manage the errors is to prevent them from occurring in the accounts prepared b the business concern. As is said$ EPrevention is better than cureE. It is the responsibilit of the management to prevent errors. &he management can prevent the errors in the nature of fraud b e+ercising an effective internal control s stem. It should also curb its o1n tendencies to 1indo1 dress the accounts in order to present their report card in a colourful manner. It should not allo1 the pre#udice and bias to enter the accounts 1here it is avoidable. &he errors other than fraud are caused b the follo1ing reasons: iC Ignorance on the part of emplo ees of latest accounting developments$ generall

accepted accounting principles$ appropriate account classification of the necessar subsidiar ledgers 1ith controlling accounts and of good accounting practices in generalA iiC Carelessness on the part of those doing the accounting 1or".

:!; D&t&ction o' E%%o%/ Despite the best of the efforts of the management$ some errors ma still remain in the accounts. ,o1ever$ the rectification of error is possible onl classified in t1o categories: iC %rrors 1hich do not affect the agreement of the triafbalance. &he are also called t1o sided errors or undisclosed errors. &hese errors ta"e the form of complete omission$ commission$ principles or compensating errors. &he errors are called undisclosed because one is net sure of their presence or absence. 1hen an error is detected. From the point of vie1 of detection of errors$ all errors can be broadl

iiC

%rrors 1hich effect the agreement of trial balance. &he are also caiied IIone!sided errors or disclosed errors. &hese errors ta"e the form of partial omission or commission errors. &he are also called disclosed errors because one is sure of their e+istence due to disagreement of trial balance.

Follo1ing procedure can be adopted to locate the errors 1hich are there is the trial balance: aC /echec" the totals of Dr. and Cr. Side of trial balance to establish undercasting and overcasrting on either sideA bC /echec" the ledger balances as to their amount and nature B1hether Dr. or Cr.C and ensure that the are posted on the right side of the trial balanceA cC If still error is not located$ divide the difference in trial balance b 5. If the amount of an account is same as computed number$ rechec" the nature of the account B1hether Dr. and Cr.C and ensure it is posted on the right side of the trial balanceA dC Divide the difference b ?. If it is completel divisible$ the error probabl ma be an outcome of the transposition of the figure 'e.g.. 28 1ritten as :?C. Although it ma give some idea$ the e+ercise has to be ver thoroughA eC If the difference is ver big$ the balance in various accounts should be

compared 1ith balances of me last ear. If the difference is material$ 1e have sufficient cause to e+amine the account in detailA fC If still the error is not locatable$ rechec" the totals of subsidiar boo"s and ensure the are properl transferredA gC hC /echec" the schedules of debtors and creditorsA /ecomputed the account balancesA

iC

If stilS the error is not detected$ rechec" all the entries in the generaS #ournal for an errors. possible omission$ I commission$ principle and self compensating

:C; R&cti'ic#tion o' E%%o%/ =nce error is detected$ the need for its rectification arises. &he rectification of error should al1a s be done 1ith the help of a #ournal entr and not b cutting$ pasting or over1riting at the place of error. /ectification of error depends upon the t pe of error and the time of its rectification. Accordingl $ the topic of rectification of error can be broadl discussed as underA R&cti'ic#tion o' T-o Si)&) E%%o%/ &1o sided errors are rectified b passing a #ournal entr called rectif ing entr . &hus$ rectification entries are entries passed to correct the errors committed and set right the accounting records. /ectification procedure is e+plained 1ith the help of fe1 e+amples as follo1s:! 3C Pa ment of rent of building /s. :$@@@ is debited to landlordIs account. Entr! Passed: (andlord Account &o cash Account :$@@@ Entr! -e9uired: /ent Account &o cash Account :$@@@ &o rectif $ credit landlord account 1hich 1as 1rongl debited and debit rent account 1hich should have been debited. &hus$ rectif ing entr $ is: /ent Account &o (andlord Account Dr. :$@@@ :$@@@ Dr. :$@@@ Dr. :$@@@

5C Cash purchase of goods 1orth /s. :$@@@ from MDs Prashant Furniture is debited to furniture account Entr! Passed: Furniture Account Dr. :$@@@

&o cash Account :$@@@ Entr! -e9uired: Purchases Account &o cash Account :$@@@ &o rectif $ credit furniture account 1hich 1as 1rongl debited and debit Dr. :$@@@

purchases account 1hich should have been debited. &hus$ rectif ing entr is: Purchase Account Dr. :$@@@ &o Furniture Account :$@@@

7C /s. :$@@@ received from /amesh is 1rongl credited to *aresh Account. Entr! Passed: Cash Account &o *aresh Account :$@@@ Entr! -e9uired: Cash Account &o /amesh Account Dr. :$@@@ :$@@@ Dr. :$@@@

&o rectif $ debit *areshIs account 1hich 1as 1rongl credited and credit /ameshIs account not creditei earlier. :"us, rectif!ing entr! is: *aresh Account &o /amesh Account Dr. :$@@@ :$@@@

8C /s. :$@@@ goods purchased on credit from Mr. Anil 1rongl posted to the debit side of AnilIs account and purchases boo" total /s. 5:$@@@ posted to debit side of purchases account as /s. 3:$@@@. As AnilIs account is 1rongl debited b /s. :$@@@ instead of crediting his account b /s. :$@@@ to correct AnilIs account /s. 3@$@@@ should be credited to AnilIs account.

Since purchases account is debited b /s. 7:$@@@ instead of /s. 5:$@@@ therefore$ purchases account is debited b /s. 3@$@@@. :"u/. rectif!ing entr! is: Purchase Account &o Anil Account 3@$@@@ :C A sale of /s. 3@$@@@ to Subash is entered in the sales boo"s as /s. 3$@@@. It means sales account is credited b /s. ?$@@@ less and SubhashIs account is debited b /s. ?$@@@ less. &herefore$ recli;!ing entr! is: Subhash Account &o Sales Account R&cti'ic#tion o' On&-Si)&) E%%o%/ %rrors 1hich affect the agreement of the trial balance are termed as onesided errors. 2ndercasting Btotaled lessC of subsidiar boo"s$ overcastting Be+cess totalC of subsidiar boo"s$ omission of posting to an account$ posting of 1rong amount to an account$ posting on 1rong side of an account!etc.$ are some of the errors 1hich affect the agreement of trial balance. If .one!sided errors are located before the 5%&5#%#tion o' t%i#$ 7#$#nc&< error is corrected b entering the amount in affected account. For e+ample$ if total credit sales are /s. 3@$@@@ but sales boo" is 1rongl totaled as /s. ?$:@@ error is rectified as follo1s: Dr. Sales Account ) sundries as per sales boo"s ?$:@@ ) undercasting of sales boo" :@@ R&cti'ic#tion o' On&-Si)&) E%%o%/ #'t&% t+& 6%&5#%#tion o' T%i#$ !#$#nc& In case of disagreement of trial balance$ efforts are made to locate errors$ and rectif them as discussed above. ,o1ever$ if reason for disagreement of Cr. Dr. ?$@@@ ?$@@@ Dr. 3@$@@@

trial balance can not be found$ a ne1 account called S2SP%*S% ACC=2*& 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 Similarl $ if credit total is more than debit total$ suspenseF account is debited$ 3ou%n#$ &nt%i&/ 'o% on&-/i)&) &%%o%/ t+%ou + /u/5&n/& #ccount: Difference in trial balance 1hich is caused b one!sided errors is put in

suspense account. After opening of suspense account if some errors are located$ a .#ournal entr is passed to rectif them. /ectification of one!sided errors involves either debit or credit to the account to be rectified. &o complete the double entr $ second aspect is recorded 1ith 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 automaticall closed. 9ournal entries re0uired to rectif the one!sided errors given in illustration ; are as follo1s: 1; 6u%c+#/&/ 7oo8 +#/ 7&&n tot#$&) R/. 5@@ $&// :un)&%c#/tin ;: It means at Ihe time of posting to purchases account$ it has been debited b /s. :@@ less. &o correct it$ purchases account should be debited b /s. :@@ &o complete double entr $ second aspect is recorded through suspense account. &he rectification entr follo1s: Purchase Account &o Suspense Account Dr. :@@ :@@ appears as

2; S#$&/ 7oo8 +#/ 7&&n tot#$&) R/. 1<@@@ (o%& :o.c%c#/ttin ; : It means ut the time of posting of sales boo" to sales account. /s. 3$@@@ e+cess amoum has been credited. &o correct the records$ sales account should be debited b /s. 3$@@@. &o complete double entr $ suspense account is credited. &he rectification entr is as under: Sales Account Dr. 3$@@@

&o Suspense Account 3$@@@ 3; R/. 1<@@@ c#/+ %&c&i.&) '%o( G +#/ not +&&n 5o/t&) to +i/ #ccount : &his amount should have been posted to credit side of W account. &o rectif the mista"e of non!posting$ WIs account should be credited b /s. 3$@@@! &o complete double entr $ suspense account is debited b the same account. &he #ournal entr re0uired to rectif the error is as underA Suspense Account &o W 3$@@@ 4; S#$&/ %&tu%n '%o( 4 R/. =@@ +#/ 7&&n 5o/t&) to 9J/ #ccount #/ R/. =@ : /s. <@@ should have been credited to ]Is account. As the amount actuall credited is #ust /s. <@$ /s. ;7@ more should be credited to ]Is account. &o complete double entr $ suspense accouni is debited b /s. ;7@ as follo1s: Suspense Account &o ]ADc Dr. ;7@ ;7@ Dr. 3$@@@

:C /s. 8$@@@ cash paid to a creditor has been posted to the credit side of creditorIs account: /s. 8$@@@ cash paid to a creditor should have been debited &o creditor account but ft is actuall credited to creditors account. &o have correct balance in creditors account /s. >$@@@ should be debited to creditors accounf. Debiting of double amount i.e., /s. >$@@@ nullfiles the effect of 1rong credit of /s. 8$@@@ and ensures correct debit of /s. 8$@@@. &he #ournal entr I O passed for this is as follo1s: Creditors Account &o Suspense Account Above entries are posted to suspense account as follo1sA Dr Suspense Account Cr. Dr. 7$@@@ >$@@@

&o Difference in trial balance figureC &o W &o ] Bbalancing

<$><@

) Purchase ADc ) Sales ADc ) Creditors

:@@ 3$@@@ >$@@@

3$@@@ ;7@

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 Iis short b /s < ><@ &his balancing figure m suspense account as ta"en as the opening balance of suspense account$ being the difference in tnal balance transferred to suspense account. E%%o%/ #n) 6%o'it : %rrors 1ill effect profit onl 1hen nominal accounts recorded in income statement are affected. %ffect of abovementioned errors and their effect on profit is e+plained as follo1s: aC Jrong credit to sales account increase reported profit b /s. <@$@@@. Correct profit can be calculated b <@$@@@. bC Jrong debit to 1ages account reduces reported profit b /s. 3$@@@. &o calculate correct profit rectification entr is passed. It Fuces 1ages account balance b /s. 3$@@@ and thus$ increases profit b /i. 3$@@@. cC *on!posting of discount received balance reduces reportedA profit b /s 5$:@@ and thus$ increase profit figures b /s. 5$:@@ to report!correct profit figure$ ! dC *on!oostine of totalsales return increases net sales b /s. 35$@@@. It report correct rectification of this error. /ectification reduces sales account balance and thus$ profit b /s.

b /s. 35$@@@. /ectification Aof this error reduces net sales b /s. 75$@@@ and thus profit after rectification is reduced b /s 35$@@@ to profit$

eC

It does not affect an nominal account and$ thus has no effect on profit. It has not effect on profit as no nominal account is affected. :

E''&ct on 5%o'it %rrors 'a(, ' (, 'c( and 'd( do not affect nominal accounts and therefore$ have no effect on profits. %rror BeC affects nominal accounts. &his error increases offices e+penses reduces the amount of purchases. As a result$ gross profit is increased and is nduced b the same amount. &herefore$ this error has no effect on net profit figure. /ectification of this error reduces gross profit and increases net profit b the same amount. %rror BfC reduces rent account balance b /s. 5$@@@ and thus increases net profit b /s. 5$@@@ . /ectification of this error reduces net profit figure b /s. 5$@@@ to report correct net profit figure. R&cti'ic#tion o' E%%o%/ #'t&% Fin#$i/#tion o' Account/ o% in t+& n&At #ccountin 5&%io) &he management should ma"e ever conceivable effort to prevent occurrence of the errors in the accounts. ,o1ever$ if still some errors creep in the accounts$ the should be detected and rectified before the flnalisation of accounts. )ut if despite the best of their efforts the management is not able to trace the errors$ the difference should be put to the Suspense ADc and accounts finali-ed. &he suspense account should be sho1n in the balance sheet tilS such time itscauses are ascertained. In the ne+t accounting period$ the rectification should be done as and 1hen tf e error is detected. ,o1ever$ the method of rectification 1ill depend upon 1hether the account affected is a nominal account or an other account. If the account affected is other than nominal$ the rectification is done in the usual manner$I For e+ample$ the amount received from W inadvertentl recorded in ]Is account and left untraced last ear 1ill be rectified in the current ear b debiting W and crediting ]. ,ad this error been traced last ear itself$ the same rectification entr 1ould have follo1ed.

,o1ever$ if the error involves a nominal account having its impact on the profit$ the rectification is done in a different manner. For e+ample$ if last ear Bhe sales be #" 1as undercast b /s. 3@$@@@$ it 1ould have led to a suspense account 1ith a credit balance of /s. 3@$@@@ in the trial balance. If the error 1as to be detected last ear before the fmalisation of accounts$ the rectification entr 1ould have been A Suspense Account &o Sales Account 3@$@@@ ,o1ever if the error is detected in the current ear after the finalisation of accounts$ the same rectification entr 1ill ensure that the current ear sales is unnecessaril inflated b /s. 3@$@@@. &he last ear profit 1as under reported b /s. 3@$@@@ and the current ear profit 1ill be over reported b the same amount. &he errors of these "ind should be correct as EPrior Period +tems<< or through IProfit and (oss Ad#ustment AccountI and sho1n in the current ear profit and loss account as prior period items as per the re0uirement of AS!: B/evisedC. As per AS!:$ Prior period items are income or e+penses 1hich 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 sho1n separatel in the profit and loss account of the current accounting period. ,ence$ the entr for this aspect 1ill be: Suspense Account &o Profit ' toss Ad#ustment Account Dr 3@$@@@ 3@$@@@ Dr. 3@$@@@

&he profit and loss ad#ustment account is closed b transfer to the current ear profit and loss account as a prior period item. ,ence$ the profit of current ear clearl reflects the effect of the errors of the past period. A close loo" at the follo1ing e+amples 1ill ma"e more clear the mechanism of rectification BaC if its is done in the same accounting periodA and BbC if it is done in the ne+t accounting periodA iC Purchase boo" is undercast b /s. :$@@@:

-ectification entr! i; it is done in t"e accounting period of t"e error Purchase Account &o Suspense Account -ectification entr! if it is done in t"e ne/t accounting period, Profit ' (oss Ad#ustment Account &o Suspense Account Dr. :$@@@ :$@@@ Dr. :$@@@ :$@@@

iiC /ent paid of /s. 5$@@@ debited to landlord account and included in the list of debtors: -ectification entr! if it is done in t"e accounting period of t"e error itself /ent Account &o Debtors Account -ectification entr! if it is done in t"e ne/t accounting period Profit ' (oss Ad#ustment Account &o Debtors Account Dr. 5$@@@ 5$@@@ Dr. 5$@@@ 5$@@@

iiiC Private purchases of /s. 3$@@@ passed through purchase account: -ectification entr! if it is done in t"e accounting period of t"e error itself Dra1ings Account &o Purchase Account -ectification entr! if it is done in t"e ne/t accounting period. Dra1ings Account Profit ' (oss Ad#ustment Account Dr. 3$@@@ 3$@@@ Dr. 3$@@@ 3$@@@

ivC Cash received of /s. 8$@@@ from W sho1n on the debit of ]Is account: -ectification entr! if if is done in t"e accounting period of t"e error itself. Suspense Account &o W Account Dr. >$@@@ 8$@@@

&o ] Account 8$@@@ -ectification entr! if if is done in t"e ne/t accounting period. Suspense Account &o W Account &o . Account Dr. >$@@@ 8$@@@ 8$;@@

*ote that the entr is same in both the cases. &he basic reason is #that the account affected is not a nominal account. Illustration 10 A boo" "eeper 1hile preparing his trial balance finds that the debit e+ceeds b /s. <$5:@. )eing re0uired to prepare the final account he places the difference to a suspense account. In the ne+t ear the follo1ing mista"es 1ere discovered: aC A sale of /s. 8$@@@ has been passed through the purchase da boo". &he entr in the customerIs account has been correctl recordedA bC 6oods 1orth /s. 5$:@@ ta"en a1a b the proprietor for his use has been debited to repairs accountA cC A bill receivable for /s. 3$7@@ received from 4rishna has been dishonoured on maturit but no entr passedA :

dC

Salar of /s. ;:@ paid to a cler" has been debited to his personal accountA

eC

A purchase of /s. <:@ from /aghubir has been debited to his account. Purchase account has been correctl debitedA

fC

A sum of /s. 5$5:@ 1ritten off as depreciation on furniture has not been debited to depreciation account.

Draft the #o rnal entries for rectif ing the above mista"es and prepare the suspense account and profit and loss ad#ustment account$ *ournal aC Suspense ADc &o Profit ' (oss Ad#ustment ADc B)eing 1rong recording of sales as purchase last ear rectifiedC bC Dra1ings ADc &o Profit ' (oss Ad#ustment ADc B)eing Dra1ings made last sho1n as repairs no1 rectifiedC cC 4rishna ADc &o )ills /eceivable ADc B)eing bill dishonoured last ear no1 recorded in the boo"sC Dr. 3$7@@ 3$7@@ ear inadvertentl Dr. 5$:@@ 5$:@@ Dr. >$@@@ >$@@@

dC

&o Profit ' (oss Ad#ustment ADc &o Cler"Is Personal ADc B)eing salar paid to cler" last ear inadvertentl sho1n in his personal account no1 rectifiedC

Dr. ;:@ ;:@

eC

Suspense ADc &o /aghubir ADc B)eing purchase from /aghubirC sho1n on debit side of his account inadvertentl no1 rectifiedC

Dr. 3$:@@ 3$:@@

fC

Profit ' (oss Ad#ustment ADc &o Suspense ADc B)eing depreciation not sho1n last ear no1 rectifiedC

Dr. 3$:@@ 3$:@@

Dr. Cr. &o Profit ' (oss

Suspense Account >$@@@ 3$:@@ ) balance bDd ) Profit ' (oss <$5:@ 5$5:@ ?<5@@ Cr. >$@@@ 5$:@@

Ad#ustment ADc &o /aghubir ADc

Ad#ustment ADc ?<5@@ Dr. Profit ' (oss Ad#ustment Account &o Cler"Is Persona[ ADc ;:@ ) Suspense ADc &o suspense ADc 5$5:@ ) Dra1ings ADc &o Profit ' (oss <$;@@ Ad#ustment ADc B&ransferC 1@<5@@ 1@<5@@

LESSON - > ACCOUNTS FROM INCOM6LETE RECORDS-SINGLE ENTR9 S9STEM

SALIENT FEATURES aC Inco(5$&t& Dou7$& Ent%0 S0/t&( : Dual aspect of a transaction is not recorded under this s stem. /ecording is done according to convenience and information needs of the business. As information needs of business entities are governed b si-e of business$ nature of )usiness$ prevailing circumstances etc.$ the procedure of recording follo1ed b different business entities ma var . &herefc !e$ there is no uniformit in maintenance of records under single entr s stem. bC F$&Ai7i$it0 : Single entr s stem is fle+ible as recording procedure can be ad#usted according to the information needs of a particular business enterprise. As rules of double entr s stem are not follo1ed$ "no1ledge of principles of double entr s stem of boo"!"eeping is not necessar . cC 4#%i#tion o' R&co%)in 6%oc&// : Single entr s stem is incomplete double entr s stem$ var ing according to information needs of business entities. &here is no hard and fast rule for maintenance of records under this s stem. )ut$ generall $ cash boo" and personal accounts are maintained under this s stem. dC I(5o%t#nc& o' Sou%c& Docu(&nt: As complete recording is not done urder single entr s stem$ source document li"e sales bills$ purchase bills$ vouchers etc.$ pla cC ver important role in collection of necessar information$ for finding out profit Bor lossC and preparing financial position statement. L&// EA5&n/i.&: As complete records are not "ept$ time and labouA involved in maintaining accounting records is less in comparison to double entr s stem.

dC

Suit#7i$it0 : 2se of single entr s stem is not permitted in case of corporate entities. It is generall follo1ed b non!corporate entities of small si-e.

(imitations limitationsA aC

of Single

%ntr

S stem.

Single

entr

s stem

has

follo1ing

Un/ci&nti'ic : &here are no set rules for maintaining records under such s stem. Absence of s stematic recording of both aspects of a transaction under single entr s stem ma"es it unscientific.

bC

No t%i#$ 7#$#nc& : Dual aspect of a transaction is not recorded under this s stem. As a result$ trial balance can not be prepared from accounting records maintained. ,ence$ arithmetical accurac of accounting records can not be chec"ed.

cC

D&t&%(in#tion o' t%u& 5%o'it :o% $o//; not 5o//i7$& : *ominal 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 respectivel . Although the amount of net profit is determinable but the absence of details of revenue$ other incomes$ e+penses and losses affect sound decision ma"ing.

dC

T%u& 'in#nci#$ 5o/ition c#nnot 7& )&t&%(in&): Absence of real accounts ma"es the #ob of preparation of balance sheet a ver 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 IStatement of AffairsI instead of )alance sheet. Statement of affairs fails to reveal the true financial position of the business.

eC

Mo%& c+#nc&/ o' &%%o%/ #n) '%#u)/ : &rial balance cannot be prepared to chec" prima facie arithmetical accurac of accounts. It encourages carelessness$ misappropriations and frauds because$ in the absence of comolete records$ detection of errors and frauds is ver difficult.

fC

Un/uit#7$& 'o% 5$#nnin #n) cont%o$ : In the absence of reliable information about nominal and real account$ effective planning and control over e+penses$ assets etc.$ is not possible. :

gC

L& #$$0 not %&co ni/&) : According to the Indian Companies Act$ 3?:;$ single entr s stem cannot be emplo ed b companies. Moreover$ accounts maintained on single entr are authorities. not accepted b sales ta+ and income ta+

hC

Int&%- 'i%( Co(5#%i/on/ not 5o//i7$& : )ecause of variation in. accounting procedure and rules$ comparisons of t1o or more businesses is not possible. IInspite of the above limitations$ an accountant is re0uired to ascertain

profit$ Bor lossC and prepare financial position statement at accounting date. Methods follo1ed for this are a follo1s: aC Statement of Affairs Method or Pure Single!%ntr S stem. bC Conversion Method or Guasi Single!%ntr S stem.

St#t&(&nt o' A''#i%/ M&t+o) 2nder statement of affairs method$ statement of affairs is prepared in the beginning and the end of the ear to calculate capital in the beginning and the end of the ear respectivel . Statement of affairs lists assets on right hand side$ liabilities on the left hand side and the e+cess of assets over liabilities is assumed to be capital and recorded on left hand side so that total assets are e0ual 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 follo1sA Statement of Affairs as on... 1ia!ilities Creditors )ills pa able =utstanding e+penses 2nearned income (oans Capital B)alancing figureC Accrued income Fi+ed assets Di/tinction !&t-&&n St#t&(&nt o' A''#i%/ #n) !#$#nc& S+&&t : Follo1ing are the points of difference bet1een a statement of affairs and a balance shed. aC )alance shees records balances of assets$ liabilities and capital dra1n from the ledger boo"s. Statement of Affairs contains information either dra1n from accounting records Bif records are maintainedC or bases on estimates Bif records are not maintainedC. &herefore$ information contained in balance sheet is more reliable as compared to information contained in the statement of Affairs. bC )alance sheet contains information about capital as per accounting records In statement of affairs capital is ta"en as balancing figure$ being the difference bet1een lotal assets and total liabilities. Amount Assets Cash )an" Debtors )ills receivable Stoc" Prepaid e+penses Amount

cC

)alance sheet lists balances of assets$ liabilities and capital .dra1n from accounting records based on double entr s stem. If an asset or liabilit is omitted$ balance sheet does not tall . &hen$ error is detected and corrected. ,o1ever$ in case of statement of affairs$ omission of an asset or liabilit goes unnoticed because capital is ta"en as balancing figure.

dC

)alance sheet is prepared to sho1 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.

C#$cu$#tion o' 6%o'it :o% $o//;: &o calculated profit or Ioss follo1ing steps are re0uired: aC &o find out capital in the beginning of the ear Bcalled opening capitalC prepare statement of affairs at the beginning of the ear. bC &o calculate capital at the end of the ear Bcalled closing capitalC statement of affairs at the end of the ear is prepared. cC After calculating opening capital and closing capital$ capita[ introduced and dra1ings made during the ear are ad#usted to find out profit Bor lossC for the ear b using the follo1ing relationship.

=pening Capital U Additional Capital Dra1ings U Profits YYClosing Capital =r Profit T Closing Capital ! Additional Capital U Dra1ings ! =pening Capital Calculation of profit or loss is sho1n in the form of a statement as follo1s: Statement of Profit 'or loss( for t"e period ending.... Amount Capital at the end Add: dra1ings (ess: additional capital introduced during the ear

(ess: capital in the beginning of the ear Profit Bor lossC for the ear A)Ku/t(&nt to 7& (#)&: Sometimes certain ad#ustments are given in theI 0uestion. &hese ad#ustments ma relate to interest on capital$ interest on dra1ings$ depreciation on fi+ed assets$ proviFons for doubtful debts etc.$ In this case statement of affairs$ prepared to calculate capital on the date of statement$ records assets and liabilities before an ad#ustment. Profit as sho1n b statement of profit in this case is not net.profit earned during the ear. Profit as sho1n b statement cf profit isIad#usted to calculate net profit as follo1s: Profit and 6ots Account =or t"e !ear ending..... &o Depreciation on Fi+ed Asset ) Profit before ad#ustment as sho1n in the statement of &o Provision for Doubtful Debts &o Interest on Capital &o *et Profit transferred to Capital Account Con.&%/ion M&t+o) Accounts maintained under single entr s stem are not sufficient to e+tract 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 ta"en for their completion. 2nder conversion method$ cash accountant$ debtors account$ creditors account etc.$ maintained on single entr basis are anal sed and an attempt is made to complete double entr b ma"ing necessar posting is done. After completing records on the basis of double entr accounts from incomplete records. s stem or preparation of final profit ) Interest on Dra1ing

In actual practice$ conversion involves completion of ledger boo"s$ preparation of a trial balance and$ then financial statements. A ,o1ever$ for solving e+amination problems$ above mentioned procedure of conversion and the absence of detailed information in the 0uestion. &o solve e+amination problems significant information re0uired for completion of trading account$ profit and loss account and balance sheet is calculated from 1hatever information is given in the 0uestion. After calculating significant information missing in the 0uestions$ final accounts are prepared as usual. To c#$cu$#t& (i//in 'i u%&/< the follo1ing steps are recommended: aC bC cC dC Prepare statement of affairs in the beginning of the ear. Prepare cash boo" or cash account. Prepare total debtors account and bills receivable account. Prepare final accounts. :

Jhatever information is given in the 0uestion$ record that in accountsC involved. 4no1ledge about items usuall appearing in these accounts gives an idea about information missing in the 0uestion. &hen an attempt is made to calculate missing information b using rules of double entr s stem$ Proforma of &otal Debtors Account$ &otal Creditors Account$ )ills /eceivable Account and )ills Pa able Account is given belo1 to have an idea about the items isuail appearing in these accounts. Dr. Cr. &o balance bDd BDebtor in the beginningC &o Sales ADc BCredit salesC &o )ills receivable ADc B)ill dishonouredC ) Cash or )an" ADc BAmount received from debtorsC &o )ills receivable ADc B)ills dra1n on debtorsC ) Sales /eturn ADc ) Discount Allo1ed ADc ) )ad Debts ADc ) balance cDd BDebtors at the end of the earC )otal De!tors A2c

Dr. Cr.

*ills /ecei'a!le A2c ) Cash ADc ' Discount ADc Bfor )D/ DiscountC ) Creditors ADc B)D/ endorsed to creditorsC ) Cash ADc B)D/ encashed on due dateC ) Debtors ADc B)D/ dishonouredC ) balance cDd B)D/ at the endC

&o balance bDd B)alance in the beginningC &o Debtors ADc B)ills dra1n during the earC

D%. Cr. &o Cash ADc or )an" ADc BAmount paid to creditorsC &o )ills /eceivable ADc Bfor )D/ endorsedC &o )ills Pa able ADc B)ills acceptedC &o Purchases /eturn ADc &o Discount /eceived ADc &o balance cDd BCreditors at the endC

)otal Creditors A2c ) balance bDd BCreditors in the beginningC ) purchases ADc BCredit purchasesC ) )ills pa able ADc B)ills pa able dishonouedC

D%. C%. &o Cash ADc B)DP paid on due datesC &o Creditors ADc B)DP dishonouredC &o balance cDd B)DP at the endC

*ills Pa&a!le A2c ) balance bDd B)DP in the beginningC ) Creditors ADc B)ills accepted during the earC

G%o// 6%o'it R#tio: Sometimes$ gross profit ratio Bi.e. 6ross profit D *et sales + 3@@C is given in the 0uestion. In that$ case$ the amount of gross profit figure in trading account$ calculation of missing information about an one of the items recorded in

trading account can ta"e place. Items recorded in trading account are opening stoc"$ purchases$ direct e+penses and closing stoc". Illustration 1: details: Stoc" on 3!8!?> Stoc" on 73!7!??? Purchases during 3??>!?? Sales during 3??>!?? 6ross profit ratio Dr. /s. 3<$@@@ 35$@@@ @@@ 3$5>$@@@ 5:R Cr. 3$5>$@@@ 35$@@@ Find out the amount of direct e+penses from the follo1ing

:rading Account for t"e !ear ended Marc" 11, 1222 3<$@@@ ) Sales <<$@@@ ) Closing Stoc" 38$@@@

&o =pening Stoc" &o Purchases &o Direct %+penses B)alancing figureC &o 6ross Profit B5:R of /s. 3$5>$@@@C

3$8@$@@@ Illustration %: Data /am maintains his records on single entr s stem.

3$8@$@@@

Jhile records of. business

ta"ings and pa ments have been "ept$ these have not been reconciled 1ith cash in hand. From time to time cash has been paid into a ban" account and che0ues thereon have been dra1n both for business use and private purposes. From the follo1ing information$ prepare the final accounts for the ear 3??>: Assets and liabilities at the beginning and at the end of the period have given belo1: 3!3!3??> 5@$@@@ >$@@@ 7@@ 38$@@@ 5<$7@@ :@$@@@ 73!35!3??> 3:$@@@ 35$@@@ 8@@ 5@$@@@ 7@$@@@ :@$@@@

Stoc" )an" )alance Cash in hand Debtors Creditors Investments

=ther transactions are as follo1s: Cash paid in ban" Private dividends paid into ban" Private pa ments out of ban" )usiness pa ments for goods out of ban" Cash ta"ings Pa ment for goods b cash and che0ue Jages Deliver %+penses /ent and rates (ighting 6eneral %+penses 3$:@$@@@ :?$<@@ 5;$@@@ 3$55$@@@ 5$:@$@@@ 3$;@$@@@ ?<$<@@ <$@@@ 5$@@@ 3$@@@ 8$;@@

During the ear$ cash amounting to /s. 5@$@@@ 1as stolen from the till$ ucods 1orth /s. 58$@@@ 1ere 1ithdra1n from private use. *o record has been "ept of amounts ta"en from cash for personal use and a difference in cahs amounting to /s. <$7@@ is treated as private e+penses. Dr. &o balance bDd &o Sales ADc &o Debtors ADc Bbalancing figureC Cash ADc 7@@ ) Defalcation 5$:@$@@@ ) )an" ADc 3$85$@@@ ) Dra1ings ADc ) Purchases ADc B3$;@@$@@@!:<$<@@C ) Jages ADc ) Deliver %+penses ADc ) /ent' /ates ADc ) (ighting ADc ) 6eneral %+p. ADc ) balance cDd 3<?2<3@@ Cr. 5@$@@@ 3$:@$@@@ <$7@@ 3$@5$7@@ ?<$<@@ <$@@@ 5$@@@ 3$@@@ 8$;@@ 8@@ 3<?2<3@@

Dr. &o balance bDd &o Cash ADc &o Capital ADc BDividendC

4an% A=c >$@@@ ) dra1ings ADc 3$:@$@@@ ) )usiness Pa ment ADc :?$<@@ ) Purcahse ADc Bbalancing figureC ) balance cDd 2<1=<@@@ Sundr Debtors ADc 38$@@@ ) Cash ADc ) balance cDd 1<62<@@@ Sundr Creditors 7@$@@@ ) balance bDd ) Purchases ADc Bbalancing figureC 3@<@@@

Cr. 5;$@@@ 3$55$@@@ :<$<@@ 35$@@@ 2<1=<@@@ Cr. 3$85$@@@ 5@$@@@ 1<62<@@@ Cr. 5<$7@@ 5$<@@ 3@<@@@

Dr.

&o balance bDd &o Sales ADc Bbalancing figureC

Dr. &o balance cDd

!#$#nc& S+&&t #/ #t 1-1-?> Li#7i$iti&/ Creditors Capital B)alancing figureC A(ount A//&t/ 5<$7@@ Stoc" ;:$@@@ )an" Cash Debtors Investments ?2<3@@ A(ount 5@$@@@ >$@@@ 7@@ 38$@@@ :@$@@@ ?2<3@@

:rading & Profit & 6oss A=c for t"e !ear ended 11-1>-23 &o =pening Stoc" ADc &o Jages &o Purchaes : Cash Credit (ess Dra1ings &o 6ross Profit 5@$@@@ ) Sales : ?<$<@@ Cash Credit ) closing Stoc" ADc 3$7>$<@@ 3$:;$;@@ 4<13<@@@ 5$:@$@@@ 3$8>$@@@ 3:$@@@

3$;@$@@@ 5$<@@ 3$;5$@@@ 58$@@@

4<13<@@@

&o )usiness Pa ment ADc &o /ent ' /ates ADc &o (ighting ADc &o 6eneral %+penses ADc &o deliver %+penses ADc &o Defalcation ADc

3$55$@@@ ) 6ross Profit 5$@@@ 3$@@@ 8$;@@ <$@@@ 5@$@@@ 1<56<6@@

3$:;$;@@

1<56<6@@

4alance S"eet as at 11-1>-23 Li#7i$iti&/ =pening Capital Add: Additional Capital (ess: Dra1ings B<$7@@U5;$@@@U58$@@@C Creditors A(ount ;:$@@@ :?$<@@ 3$58$<@@ :<$7@@ A//&t/ Investment Stoc" Debtors A(ount :@$@@@ 3:$@@@ 5@$@@@ 35$@@@ 8@@ ?=<4@@

;<$8@@ )an" 7@$@@@ Cash ?=<4@@

Di''&%&nc& 7&t-&&n Dou7$& Ent%0 /0/t&( #n) Sin $& Ent%0 S0/t&( =f difference bet1een double uE,r s stem a#Cd single entr s stem of boo" "eeping. aC Du#$-A/5&ct : 2nder double ciur transactions are not recorded. bC T%i#$ !#$#nc&: 2nder double entr s stem trial balance can be prepared to chec" the arithmetical accurac of accounts. 2nder single entr s suai trial balance cannot be prepared because duaI!aspect of ail transactions are not recorded. cC T05& o' Account/: 2nder double entr s stem nominal$ personaS and real accounts are maintained. 2nder single entr accounts and cash boo"s is maintained. dC Ru$&/ o' R&co%)in : 2nder double entr s stem$ rules of double entr s stem$ generall $ personal s rricrti bolh aspects of alS business transactions are rcco:tie. 2nder single entr s stem both aspects of all business

s stem are follo1ed b all concerns. 2nder single entr s stem$ as the s stem is ad#usted according to convenience and needs of the business$ rules follo1ed for recording var from concern to concern. cC Co/t : As complete records ore "ept under double entr s stem$ cost of

maintaining records is more in comparison to single entr s stem. dC L& #$ /ecognition : Corporate entities cannot follo1 single entr s stem as it goes against the provisions of the Indian Companies Act$ 3?:;. %ven sales ta+ and income ta+ authorities do not recognise single entr s stem. gC D&t#i$/ o' N&t 6%o'it :o% Lo//; : 2nder double entr s stem details of

e+penses$ revenue and incomes are available because of maintenance of normal accounts. 2nder single entr s stem$ though net profit Bor lossC is calculated$ but details of e+penses revenue and incomes are not available.

hC

Fin#nci#$ 5o/ition : 2nder double entr s stem$ financialIposition statement reveals trne financial position based on accounting$ records. 2nder single entr s stem$ statement of affairs based on incomplete records and estimates is prepared to reveal financial position of Ihe business.

iC

E%%o%/ #n) F%#u)/ : *on!preparation of trial balance due to incomplete recording under single entr s stem encourages carelessness$ misappropriations and frauds. Fear of detection of errors and frauds under double entr s stem reduces chances of errors and frauds. #C Int&%-'i%( Co(5#%i/on/ : Comparison of t1o or more business$ concern is possible under double entr s stem because same set of rules are follo1ed b all concerns. Inter!firm comparisons under single entr are not valid because of variation in rules of recording. "C R&$i#7i$it0 : Absence of s stematic recording on the basis of double entr rules ma"es information available under single entr s stem less reliable as compared to information available under double entr s stem. lC Suit#7$& : Double entr s stem is suitable for all t pes of business. IS^ en&r s stem suits onl small non!corporate enuues.

LESSON - ? FINANCIAL STATEMENT ANAL9SIS

MEANING OF FINANCIAL STATEMENTS According to ,impton 9ohn$ EA financial statement is an organi-ed collection of data according to logical and consistent accounting procedures. Its purpose is to conve an understanding of some financial aspects of a business firm. It ma sho1 assets position at a moment of time as in the case of a balance sheet$ or ma reveal a series of activities over a given period of limes$ as in the case of an income statement E. =n the basis of the information provided in the financial statements$ management ma"es a revie1 of the progress of the compan and decides the future course of action. DIFFERENT T96ES OF FINANCIAL STATEMENTS 3. Income Statement 5. )alance Sheet 7. Statement of /etained earnings 8. Funds flo1 statement :. Cash flo1 statement. ;. Schedules. FUNDAMENTAL CONCE6TS OF ACCOUNTING 3. 6oing concern concept 5. Matching concept B Accruals conceptC 7. Consistenc concept 8. Prudence concept B conservation conceptC :. )usiness entit concept ;. Stable monetar unit concept

<

Mone measurement concept

<. =b#ectivit concept >. Materialit concept ?. /eali-ation concept. LIMITATIONS OF FINANCIAL STATEMENTS 3. In profit and loss account net profit is ascertained on the basis of historical costs. 5. Profit arrived at b the profit and loss account is of interim nature. Actual profit can be ascertained onl after the firm achieves the ma+imum capacit . 7. &he net income disclosed b the profit and toss account is not absolute but onl relative. 8. &he net income is the result of personal #udgment and bias of accountants cannot be removed in the matters of depreciation$ stoc" valuation$ etc.$ :. &he profit and loss account does not disclose factors li"e 0ualit of product$ efficienc of the management etc.$ ;. &here are certain assets and liabilities 1hich are not disclosed b the balance sheet. For e+ample the most tangible asset of a compan is its management force and a dissatisfied labour force is its liabilit 1hich are not disclosed b the balance sheet. <. &he boo" value of assets is sho1n as original cost less depreciation. )ut in practice$ the value of the assets ma differ depending upon the technological and economic changes. >. &he assets are valued in a )alance sheet on a going concern basis. Some of the assets ma not relate their value on 1inding up.

?.

&he accounting ear ma be fi+ed to sho1 a favorable picture of the business. In case of Sugar Industr the )alance sheet prepared in off season depicts a better li0uidit position than in the crushing season.

3@.

Anal sis Investor li"es to anal se the present and future prospectus of the business 1hile the balance sheet sho1s past position. As such the use of a balance sheet is onl limited.

33.

Due to fle+ibilit of accounting principles$ certain liabilities li"e provision for gratuit etc. are not sho1n in the balance sheet giving the outsiders a misleading picture.

35.

&he financial statements are generall prepared from the point of vie1 of shareholders and their use is limited in decfsion ma"ing b the management$ investors and creditors.

37. 38.

%ven the audited financial statements does not provide complete accurac . Financial statements do not disclose the changes in managernent$ (oss of mar"ets$ etc. 1hich have a vital impact on the profitabilit of the concern.

3:.

&he financial statements are based on accounting policies 1hich var form compan to compan and as such cannot be formed as a reliable basis of #udgment.

FORMATS OF FINANCIAL STATEMENTS &he t1o main financial statements$ vi- the Income Statement and the )alance sheet$ can either be presented in the hori-ontal form or the vertical form 1here statutor provisions are applicable$ the statement has to be prepared in accordance 1ith such provisions. Inco(& St#t&(&nt :

&here is no legal format for the profit and loss ADC. &herefore$ it can be presented in the traditional & form$ or verticall $ in statement form. An e+ample of the t1o formats is given as under. :i; "o%i1ont#$< o% LTM 'o%(: Manufacturing$ &rading and profit and loss ADC ear ending ......................... Dr Particulars &o opening stoc" /a1 materials Jor" in progress &o purchases of ra1 materials &o manufacturing 1ages &o carriage in1ards &o other Factor %+penses &o opening stoc" of finished goods &o cost of Finished goods bDd &o 6ross Profit cDd &o 6ross (oss bDd &o office and Admn. %+pense &o Interest and financial e+penses &o provision for Income!ta+ &o *et Profit cDd &o net loss bDd &o general reserve &o Dividend &o )alance cDf /s. Particualrs ) cost of finished 6oods cDd +++ ) closing stoc" +++ /a1 materials Jor" in progress +++ +++ +++ +++ AAA ) sales +++ ) closing stoc" of finished goods +++ ) 6ross (oss cDd +++ AAA +++ ) 6ross profit bDd +++ ) Miscellaneous /eceipts +++ ) *et (oss cDd +++ +++ AAA +++ ) )alance bDd +++ Bfrom previous earC +++ ) *et profit bDd +++ AAA Cr /s. W+++ +++ +++ of ___........... for the

AAA +++ +++ +++ AAA +++ +++ +++ AAA +++ +++ AAA

:ii; 4&%tic#$ Fo%( Income statement of ____ for the ear ending _____... 6#%ticu$#%/ Sales (ess: Sales /eturns R/. +++ R/. ++++

Sales &a+D %+ise Dut N&t /#$&/ Cost of 6oods Sold Materials Consumed Direct (abour Manufacturing %+penses Add D less Ad#ustment for change in stoc"

+++ B3C

++++ ++++ ++++ ++++ ++++ ++++ ++++ +++

B5C

G%o// 6%o'it B3C B5C (ess: =perating %+penses =ffice and Administration %+penses Selling and Distribution %+penses #perating Profit Add: *on!operating Income (ess: *on!oprating %+penses Bincluding InterestC Profit before &a+ (ess : &a+ Profit After )a. Appropriations &ransfer to reserves Dividend declared Dpaid Surplus carried to )alance sheet

+++ +++

+++ W+++ W++ ++++ +++ ++++ +++ AAAA ++++ +++ +++ AAAA

!#$#nc& S+&&t &he Companies Activities$ 3?:; stipulates that the )alance sheet of a #oint stoc" compan should be prepared as per part I of schedule .I of the Activities. ,o1ever$ the statement form has been emphasi-ed upon b necessar for adoption of the IstatementY form. :i; "o%i1ont#$ Fo%( )alance sheet of .................... as on .................... Li#7i$iti&/ S+#%& C#5it#$ B1ith all paticulars of Authori-ed$ Issued$ Subscribed capitalC Called up capital R/. A//&t/ +++ FiA&) A//&t/: 3. 6ood1ill 5. (and ' )uilding +++ 7. (easehold propert R/. +++ +++ +++ accountants for the purpose of anal sis and Interpretation. &he permission of the CentraS 6overnment is

8. Plant and Machiner (ess: Calls in Arrears Add: Forfeited Shares R&/&%.&/ #n) Su%5$u/ : 3. Capital /eserve 5. Capital /edemption reserve 7. Share premium 8. =ther premium (ess: debit balance of Profit and loss ADC Bif an C :. Profit and (oss Appropriation ADC ;. Sin"ing Fund S&cu%&) Lo#n/ Debentures Add: =utstanding Interest (oans from )an"s Un/&cu%&) Lo#n/ Fi+ed Deposits Short!term loans and advances Current (iabilities and Provisions +++ +++ +++ +++ +++ +++ +++ +++ +++ :. Furniture and Fittings ;. Patents and &rademar"s <. .ehicles In.&/t(&nt/ Cu%%&nt A//&t/< $o#n/ #n) A).#nc&/ :A; Cu%%&nt A//&t/ 3. Interest accured on Investments 5. (oose tools 7. Stoc" in trade 8. Sundr Debtors (ess: Provision for doubtful debts :. cash in hand ;. cash in )an" :!; Lo#n/ #n) A).#nc&/ <. Advances to subsidiaries >. )ills /eceivable

+++ +++ +++ +++

+++ +++ +++ +++ +++ +++ +++ +++ +++

+++ +++

+++ ?. Prepaid %+penses Mi/c&$$#n&ou/ %+penditure Bto the e+tent not 1ritten off or +++ ad#ustedC +++ 3. Preliminar e+penses 5. Discount on Issue of shares and debentures 7. 2nder1riting Commssion +++ +++ Profit and (oss account B(ossC$ +++ if an +++ +++ +++ +++ +++ AAA

+++ +++ +++ +++

A. Current (iabilites 3. )ills Pa able 5. Sudnr Creditors 7. Income received in advance 8. unclaimed Dividends :. =ther (iabilities ). Provisions ;. Provisions for &a+ation <. Proposed Dividends >. Proposed funds ' pension fund contingent liabilities not Provided for

AAA

:ii; 4&%tic#$ Fo%(: )alance sheet of _________. as on _______ Particulars I. Source of funds 3. Share holders funds a. capital b. /eserves and surplus 5. (oans funds a. Secured (oans b. 2nsecured (oans &otal II. A55$ic#tion o' 'un)/ 3. Fi+ed Assets a. 6ross )loc" b. less Deprciation c. *et bloc" d. Capital 1or" in progress 5. Investments 7. Current Assets$ (oans and Advances a. Inventions b. Sundr Debtors c. Cash and )an" balance d. other current assets e. (oans and Advances (ess : current (iabilities and Provisions a. Current (aibilities b. Provisions *et Current Assets 8. a. Miscellaneuos %+penditure to the e+tent not 1ritten off or ad#usted b. Profit and (oss Account BdebitC &otal Schedule *o. Current ear Previous ]ear ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++

++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++

++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++

:ii; 4&%tic#$ Fo%( 'o% #n#$0/i/ )alance sheet of ___ as on _____.. Particulars ASS%&S Current Assets Cash and )an" )alances Debtors Stoc" =ther Current Assets B3C Fi+ed Assets (ess: Depreciation Investments B5C &otal B3C U B5C LIA!ILITIES Current (iabilities : )ills Pa able Creditors =ther Current (iabilities B7C (ong &erm Debt Debentures =ther (ong!term Debts B8C Capital and /eserves Share Capital /eserves and surplus B:C &otal (ong term funds &otal B7CUB8CUB:C St#t&(&nt o' R&t#in&) E#%nin /: Profit and (oss Appropriation Account 6#%ticu$#%/ &o transfer to /eserves &o Dividend R/. 6#%ticu$#%/ +++ ) (ast earLs balance +++ ) Current ]earLs net profit B&ransferred from profit and loss ADCC &o Dividend proposed +++ R/. +++ +++ +++++ /s. ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ +++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++ ++++

&o surplus carried to )alance sheet

+++ ) %+cess provisions B1hich are no longer re0uiredC ) /eserves 1ithdra1n Bif an C +++

+++

+++ ++++

Illustration: 1 From the follo1ing information$ prepare a vertical Income Statement. Sales =pening stoc" Closing stoc" Purchases =perating %+penses /ate of &a+ :@R Solution: Income Statement Particulars Sales (ess : cost of goods sold: =pening stoc" Add: Pruchases (ess: closing Stoc" 6ross Profit (ess: operating e+penses =perating profit (ess: non!operating e+penses Profit before ta+ (ess: Income ta+ B:@RC *et profit after ta+ Illustration: % From the follo1ing particulars$ pertaining to Mohan (td.$ ou are re0uired to prepare a comparative Income Statement and interpret the changes. Particulars /s. /s. /s. 3@$@@@ 8@$@@@ :@$@@@ 3:$@@@ 7:$@@@ 3$;:$@@@ 35$@@@ 3$:7$@@@ 8$@@@ 3$8?$@@@ <8$:@@ <8$:@@ /s. 5$@@$@@@ 5$@@$@@@ 3@$@@@ 3:$@@@ 8@$@@@ 35$@@@

Sales Cost of goods sold Administration e+penses Selling e+penses *on !operating e+penses *on!operating e+penses Sales returns &a+ rate

:>$@@@ 8<$;@@ 3$@3; 3$>8@ 38@ ?; 5@@@ 87.<:R

;:$5@@ 8?$5@@ 3$@@@ 3$?5@ 3:: ;88 3$5@@ 87.<:R

Solution: Comparative Income Statement of Mohan (td.$ for the ears 5@@@ and 5@@3. Particulars Sales (ess /eturns *et sales (ess: Cost of 6oods sold 6ross Profit BAC (ess: =perating e+penses Administration e+penses Selling e+penses &otal operating e+penses B)C =perating profit BAC!B)C Add: non ! operating incomes (ess: non! operating e+penses *et profit before ta+ (ess: &a+ *et profit after &a+ T&c+niCu&/ o' Fin#nci#$ St#t&(&nt An#$0/i/: &he follo1ing techni0ues are adopted in anal sis of financial statements of a business organi-ation: Comparative Statements Common si-e Statements &rend Anal sis Funds flo1 Anal sis Cash flo1 Anal sis /ation Anal sis .alue Added Anal sis. &he first three topics are covered in this chapter and the rest are discussed in the subse0uent chapters in detail. Co(5#%#ti.& Fin#nci#$ St#t&(&nt/ 5@@@ /s. :>$@@@ 5$@@@ :;$@@@ 8<$;@@ >$8@@ 3$@3; 3$>8@ 5$>:; :$:88 ?; :$;8@ 38@ :$:@@ 5$8@; 7@?8 5@@3 /s. ;:$5@@ 3$5@@ ;8$@@@ 8?$5@@ 38$>@@ 3$@@@ 3$?5@ 5$?5@ 33$>>@ ;88 35$:58 3:: 35$7;? :$833 ;$?:>

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 follo1ing: . i. ii. iii. iv. v. Absolute data Bmone values or rupee amountsC Increase or reduction in absolute data Bin terms of moi1 valuesC Increase or reduction in absolute data Bin terms of percentagesC Comparison Bin terms of ratiosC Percentage of totals.

#. Co(5#%#ti.& Inco(& St#t&(&nt o% 6%o'it #n) Lo// Account: A comparative income statement sho1s the absoluie figures for t1o or more periods and the absolute change from one period to another. Since the figures are sho1n side b side$ the user can 0uic"l understand the operational performance of the firm in different periods and dra1 conclusions. 7. Co(5#%#ti.& !#$#nc& S+&&t )alance sheet as on t1o or more different dates are used for comparing the assets$ liabilities and the net 1orth of the compan Comparative balance sheet is useful for stud ing the trends of anal sis underta"ing. Financial Statements of t1o or more firms can also be compared for dra1ing inferences. &his is called interfirm Comparison. A).#nt# &/: Comparative statements vidicate trends in sales$ cost of production$ profits etc.$ and help the anal st to evaluate the performance of the compan . Comparative statements can also be used to compare the performance of the industr or inter!firm comparison. &his helps in identification of the 1ea"nesses of the firm and remedial measures can be ta"enA accordingl . *&#8n&//&/:

Inter!firm comparison can be misleading if the firms are not identical in si-e and age and 1hen the follo1 different accounting procedures 1ith regard to depreciation$ inventor valuation etc.$ Inter!period comparison ma also be misleading if the period has 1itnessed changes in accounting policies$ inflation$ recession etc. Illustration (: &he follo1ing is the profit and loss account of Asho" (td.$ for the ears 5@@@ and 5@@3. Prepare comparative Income Statement and comment on the profitabilit of the underta"ing.

Particulars &o Cost of goods sold &o =ffice e+penses &o Interest e+penses &o (oss on sale of fi+ed &o Income &a+ &o *et Profit

5@@@ /s. 5$73$;5: 57$5;;

5@@3 Particulars /s. 5$83$?:@ ) Sales 5<$@;> (ess /eturns

5@@@ /s. 7$;@$<5> :$<?8

5@@3 /s. 8$3<$35: ;$?:5

8:$?35 ;5< 53$:3? 7:$7<3 7$;@$8:<

:<$>3; 3$<:@ ) =ther incomes : 8@$3?: ) Discount on purchase 88$85: ) Profit on sale of land 8$37$7<?

7$:8$?78

8$3@$3<7

5$35: 3$:@@ 7$;@$8:<

3$>?;

8$37 $7<?

Solution: AS,=4 (&D. Comparative Income Statement for the ears ending 5@@@ and 5@@3 Particulars 5@@@ /s. 5@@3 /s. Increase BUC Decrease B!C Sales (ess: Sales returns (ess: Cost of goods sold 6ross Profit =perating %+penses: =ffice e+penses Selling e+penses &otal operating e+penses =perating profit Add: =ther incomes (ess: =ther e+penses Profit before ta+ (ess: Income ta+ *et Profit after ta+ 7$;@$<5> :$<?8 7$:8$?78 5$73$;5: 3$57$7@? 57$5;; 8:$?35 ;?$3<> :8$373 :$:57 :?$;:8 5$<;8 :;$>?@ 53$:3? 7:$7<3 8$3<$35: ;$?:5 8$3@$3<7 5$83$?:@ 3$;>$557 5<$@;> :<$>3; >8$>>8 >7$77? 7$5@; >;$:8: 3$?5: >8$;5@ 8@$3?: 88$85: Increase BUC Decrease B!C

Amount B/s.C Percentages U:;$7?< U3:.;7 U3.3:> U3?.?> U::$57? U3:.:; U 3@$75: U8.8; U88.?38 U7;.85 U7$>@5 U33$?@8 U3:$<@; U5?$5@> !5$73< U5;.>?3 !>7? U5<$<7@ U3>$;<; U?$@:8 U 3;.78 U5:.?7 U55.<@ U:7.?; !83.?: U8:.@> !7@.7: U8>.<8 U>;.<? U5:.;@

&he comparative Income statement reveals that 1hile the net sales has been increased b 3:.:R$ the cost of goods sold increased b 8.8;R. So gross profit is increased b 7;.8R. &he total operating e+penses has been increased b 55.<R and the gross profit is sufficient to compensate increase in operating e+penses. *et profit after ta+ is ?$@:8 Bi.e.$ 5:.;RC increased. &he overall profitabilit of the underta"ing is satisfactor . Illustration: 3 &he follo1ing are the )alance Sheets of 6o"ul (td.$ for the ears ending 73 s3 December$ 5@@@$5@@3.

Particulars Li#7i$iti&/ %0uit share capital Preference share capital /eserves Profit and (oss aDc )an" overdraft Creditors Provision for ta+ation Proposed Dividend Tot#$ FiA&) A//&t/ (ess: Depreciation Stoc" Debtors )ills /eceivable Prepaid e+penses Cash in hand Cash at )an" Tot#$

5@@@ /s. 5$@@$@@@ 3$@@$@@@ 5@$@@@ 3:$@@@ :@$@@@ 8@$@@@ 5@$@@@ 3:$@@@ 8$;@$@@@

5@@3 /s. 7$7@$@@@ 3$:@$@@@ 7@$@@@ 5@$@@@ :@$@@@ :@$@@@ 5:$@@@ 5:$@@@ ;$>@$@@@

5$8@$@@@ 8@$@@@ 3$@@$@@@ 5@$@@@ 3@$@@@ 8@$@@@ 3@$@@@ 8$;@$@@@

7$:@$@@@ :@$@@@ 3$5:$@@@ ;@$@@@ 35$@@@ :7$@@@ 7@$@@@ ;$>@$@@@

Solution: Comparative )alance Sheet Particulars 73st Dec. 5@@@ /s. ASS%&S Current Assets: Cash at ban" and in hand )ills receivable Debtors Stoc" Prepaid e+penses &otal Current Assets Fi+ed Assets &otal Assets (IA)I(I&I%S Current (iabilities: )an" overdraft Creditors Proposed dividend Provision for ta+ation &otal Current (iabilities Capital and /eserve: %0uit share capital Preference share capital /eserves Profit and (oss aDc :@$@@@ 8@$@@@ 3:$@@@ 5@$@@@ 3$5:$@@@ 5$@@$@@@ 3$@@$@@@ 5@$@@@ 3:$@@@ 7$7:$@@@ &otal (iabilities Interpretation: 3. &he above comparative )alance sheet revea9s the current assets has been increased to :@R$ 1hile current liabilities increase to 5@R onl . Cash 8$;@$@@@ :@$@@@ :@$@@@ 5:$@@@ 5:$@@@ 3$:@$@@@ 7$7@$@@@ 3$:@$@@@ 7@$@@@ 5@$@@@ :$7@$@@@ ;$>@$@@@ U3@$@@@ U3@$@@@ U:$@@@ U5:$@@@ U3$7@$@@@ U:@$@@@ U3@$@@@ U:$@@@ U3$?:$@@@ U5$5@$@@@ U5: U;;.;< U5: U5@ U;: U:@ U:@ U77.77 U:>.53 U8<.>7 :@$@@@ 5@$@@@ 3$@@$@@@ 8@$@@@ 3@$@@@ 5$5@$@@ 5$8@$@@@ 8$;@$@@@ >7$@@@ ;@$@@@ 3$5:$@@@ :@$@@@ 35$@@@ 7$7@$@@@ 7$:@$@@@ ;$>@$@@@ U77$@@@ U8@$@@@ U5:$@@@ U3@$@@@ U5$@@@ U3$3@$@@@ U3$3@$@@@ 5$5@$@@@ U;; U5@@ U5: U5: U5@ U:@ U8:.>7 8<.>7 73st Dec. 5@@3 /s. InereaseBUC DecreaseB!C AmountB/s.C IncreaseBUC DecreaseB!C Percentages

increased to /s.77$@@@ Bi.e. ;;RC$ &here is an improvement in li0uidit position. 5. &he fi+ed assets purchased 1as for /s$ 3$3@$@@@. As there are no long!term funds$ it should have been purchased partl from Share Capital. 7. /eserves and Profit and (oss aDc increased b :@R and 77.77R respectivel . &he compan ma issue bonus shares in near future. 8. Current financial position of the compan is satisfactor . It should issue more long!term funds. COMMON SINE STATEMENTS &he figures sho1n in financial statements vi-. Frofit and (oss Account and )alance sheet are converted to percentages so as to establish each element to the total figure of the statement and these statement are called Common Si-e Statements. &hese statements are useful in anal sis of the performance of the compan b anal -ing each individual element to the total figure of the statement. &hese statements 1ill also assist in anal -ing the performance over ears and also 1ith the figures of the competitive firm in the industr for ma"ing anal sis of relative efficienc . &he follo1ing statements sho1 the method of presentation of the data. Illustration: 4 Common Si-e Income Statement of W]` (td.$ for the ear ended 73st March$ 5@@3. 6#%ticu$#%/ Sales /a1 materials Direct 1ages Facior e+penses B)C BAC A(ount :R/.; 38$@@$@@@ :$8@$@@@ 5$7@$@@@ 3$;@$@@@ ?$7@$@@@ O to S#$&/ 3@@ 3;.8 3;.8 33.8 ;;.8

6rossProfit

BAC ! B)C

8$<@$@@@ 3$3@$@@@ >@$@@@ 5$>@$@@@ 8@$@@@ 7$5@$@@@

77.; <.? :.< 5@.@ 5.? 55.? 87 3>.; :.< 35.?

(ess: Administrative e+penses Selling and distribution e+penses =perating Profit Add: *on!operative income

(ess: *on!operating e+penses Profit before ta+ (ess: Income ta+ Profit after ta+

;@$@@@ 5$;@$@@@ >@$@@@ 3$>@$@@@

Common Si-e )alance Sheet of W]` Particulars ASS%&S Fi+ed Assets (and )uildings Plant and Machiner Current Assets : Inventor /a1 materials Jor"!in!progress Finished goods Sundr debtors Cash at )an" &otal Capital and (iabiltiies %u0it Share capital Preference Share Capital 5$:@$@@@ 3$@@$@@@ 5;.; 3@.; >@$@@@ :@$@@@ 3$;@$@@@ 5$3@$@@@ 7@$@@@ ?$8@$@@@ >.: :.7 3<.@ 55.8 7.5 3@@.@ :@$@@@ 3$3@$@@@ 5$:@$@@@ :.7 33.< 5;.; Amount B/s.C R to &otal

6eneral reserve Debentures Current (iabilities Sundr Creditors Creditors for e+penses )ills pa able

3$;@$@@@ >@$@@@

3<.@ >.:

5$5@$@@@ 8@$@@@ ?@$@@@ ?$8@$@@@

57.8 8.7 ?.; 3@@.@

Anal sis of performance and position can be made from the above Common Si-e Statements. llustration: 5 From the follo1ing P'( ADc prepare a Common Si-e Income Statement! 6#%ticu$#%/ &o Cost of goods sold &o Administrative e+penses &o Selling e+penses &o *et Profit 2@@@ R/. 35$@@@ 8@@ 2@@1 6#%ticu$#%/ R/. 3 :$@@@ ) *et Sales 8@@ 2@@@ R/. 3;$@@@ 2@@1 R/. 5@$@@@

;@@ >@@ 7$@@@ 7$>@@ 3;$@@@ 5@$@@@

3;$@@@

5@$@@@

Common Si-e Income Statement 6#%ticu$#%/ *et sales (ess: Cost of goods sold G%o// 6%o'it (ess: =perating e+penses Administration e+penses 8@@ 5.:@ 8@@ 5.@@ 2@@@ R/. 3;$@@@ 35$@@@ 4<@@@ O 3@@.@@ <:.@@ 25.@@ 2@@1 R/. 5@$@@@ 3:$@@@ 5<@@@ O 3@@.@@ <:@@ 25.@@

Selling e+penses &otal =perating e+penses N&t 6%o'it Illustration: 6

;@@ 3$@@@ 3<@@@

7.<: ;.5: 1>.=5

>@@ 3$5@@ 3<>@@

8.@@ ;.@@ 1?.@@

Follo1ing are )alance sheet of .ina (td. for the ear ended 73 st December 5@@@ and 5@@3. Li#7i$iti&/ 2@@@ R/. %0uit capital Pref. Capital /eserves P'( ADc Creditors Provision for ta+ation Proposed dividends 3$@@$@@@ :@$@@@ 3@$@@@ <$:@@ 5@$@@@ 3@$@@@ <$:@@ 5$7@$@@@ 2@@1 R/. 3 $;:$@@@ Fi+ed Assets B*etC <:$@@@ Stoc" 3:$@@@ Debtors 3@$@@@ )ills receivable 5:$@@@ Cash at )an" 35$:@@ Cash in hand 35$:@@ 7$8@$@@@ 5$7@$@@@ 7$8@$@@@ A//&t/ 2@@@ R/. 3 $5@$@@@ 5@$@@@ :@$@@@ 3@$@@@ 5@$@@@ :$@@@ 2@@1 R/. 3$<:$@@@ 5:$@@@ ;5$:@@ 7@$@@@ 5;$:@@ 3:$@@@

Prepare a common si-e balance sheet and interpret the same. Solution0 Common Si-e )alance Sheet of .ina (td. for the ear ended 73.35.5@@3 ' 5@@5

6#%ticu$#%/ /s. Capital ' /eserves: %0uit Capital Pref. Capital /eserves

2@@@ R 3$@@$@@@ :@$@@@ 3@$@@@ 87$8> 53$<8 8.78 /s.

2@@1 R 8>.:7 55.@: 8.83

3 $;:$@@@ <:$@@@ 3:$@@@

P'( ADc BiC Current (iabilities: )an" overdraft Creditors Provisions for ta+ation Proposed dividends BiiC &otal (iabilities Bi# U BiiC Fi+ed Assets B*etC Current Assets: Stoc" Debtors )ills receivable Cash al ban" Cash in hand BaC

<$:@@ 3$;<$:@@ 5:$@@@ 5@$@@@ 3@$@@@ <$:@@ ;5$:@@ 5$7@$@@@ 3$5@$@@@ 5@$@@@ :@$@@@ 3@$@@@

7.5; <5.>5 3@.>< >.<@ 8.7: 7.5; 5<.3> 3@@.@@ :5.3< >.<@ 53.<8 8.78

3@$@@@ 5$;:$@@@ 5:$@@@ 5:$@@@ 35$:@@ 35$:@@ <:$@@@ 7$8@$@@@ 3$<:$@@@ 5:$@@@ ;5$:@@ 7@$@@@

5.?: <<.?8 <.7: <.7: 7.;> 7.;> 55.@; 3@@.@@ :3.8< <.7: 3>.7> >.>5

5@$@@@ >.<@ 5;$:@@ <.<? :$@@@ 5.3> 3:$@@@ 8.83 BbC 3$3@$@@@ 8<.>7 3$;:$@@@ 8>.:7 &otal Asses Ba U bC 5$7@$@@@ 3@@.@@ 7$8@$@@@ 3@@.@@

Interpretation : B3C In 5@@3 Current Assets 1ere increased from 8<.>7R to 8>.:7R. Cash balance increased b /s. 3;$:@@. B5C Current (iabilities 1ere decreased from 5<.3>R to 55.@;R. So$ the compan can pa off the Current (iabilities from Current Assets. &he li0uidit position is reasonabl good. B7C Fi+ed Assets 1ere increased from /s. 7$5@$@@@ in 5@@@ to /s. 3$<:$@@@ in 5@@3. &hese 1ere purchased from the additional share capital issued.

B8C

So$ the ove.all financial position is satisfactor .

TREND ANAL9SIS In trend anal sis ratios of different items are calculated for various periods for comparison purpose. &rend anal sis can be .done b trend percentage$ trend ratios &he trend anal sis is a simple and graphic and diagrammatic representation. techni0ue and does not involve tedious calculations. Illustration: From the follo1ing data$ calculate trend percentage ta"ing 3??? as base. 6#%ticu$#%/ Sales Purchases %+penses Profit 1??? R/. :@$@@@ 8@$@@@ :$@@@ :$@@@ 2@@@ R/. <:$@@@ ;@$@@@ >$@@@ <$@@@ 2@@1 R/. 3$@@$@@@ <5$@@@ 3:$@@@ 37$@@@

Solution: Particulars Purchases %+penses Profit Sales Illustration: , From the follo1ing data$ calculate trend percentages B3??? as baseC 6#%ticu$#%/ 1??? /s. Cash Debtors Stoc" =ther Current Assets (and )uildings Plant 5@@ 8@@ ;@@ 8:@ >@@ 3$;@@ 5$@@@ 2@@@ /s. 58@ :@@ >@@ ;@@ 3$@@@ 5$@@@ 5$@@@ 2@@1 /s. 3;@ ;:@ <@@ <:@ 3$@@@ 5$8@@ 5$8@@ 3??? /s. /s. 8@$@@@ :$@@@ :$@@@ :@$@@@ 5@@@ /s. /s. ;@$@@@ >$@@@ <$@@@ <:$@@@ 5@@3 /s. /s. <5$@@@ 3:$@@@ 37$@@@ 3$@@$@@@ &rend Percentage )ase 3??? 3??? 3@@ 3@@ 3@@ 3@@ 5@@@ 3:@ 3;@ 38@ 3:@ 5@@3 3>@ 7@@ 5;@ 5@@

Solution: 6#%ticu$#%/ /s. Cash Debtors =ther Current Assets &otal Current Assets Fi+ed Assets: (and )uildings Plant &otal Fi+ed Assets >@@ 3$;@@ 5$@@@ 8$8@@ 3$@@@ 5$@@@ 5$@@@ :$@@@ 3$@@@ 5$8@@ 5$8@@ :$>@@ 3@@ 3@@ 3@@ 3@@ 35: 35: 3@@ 338 35: 3:@ 35@ 375 5@@ 8@@ 8:@ 3$;:@ 2@@@ /s. 58@ :@@ ;@@ 5$38@ 2@@1 /s. 3;@ ;:@ <:@ 5$5;@ :!#/& 9&#% 1???; 3??? 3@@ 3@@ 3@@ 3@@ 5@@@ 35@ 35: 377 37@ 5@@3 >@ 3;7 3;< 37<

LESSON-1@ RATIO ANAL9SIS

INTRODUCTION &he financial statements vi-. the income statement$ the )alance sheet &he Income statement$ the Statement of retained earnings and the Statement of changes in financial position report 1hat has actuall happened to earnings during a specified period. &he balance sheet presents a summar of financial position of the compan at a given point of time. &he statement of retained. earnings reconciles income earned during the ear and an dividends distributed 1ith the change in retained$ earnings bet1een the start and end of the financial. ear under stud . &he statement of changes in financial position provides a summar of funds flo1 during the period of financial statements. /atio anal sis is a ver po1erful anal tical tool for measuring performance of an organisation. &he ratio anal sis concentrates on the interrelationship among the figures appearing in the aforementioned four financial!statements. &he ratio anal sis helps the management to anal se the past. performance of the firm and to ma"e further pro#ections. /atio anal sis allo13!interested parties li"e shareholders$ investors$ creditors$ 6overnment anal sts to ma"e an evaluation of certain aspects of a firmIs performance. /atio anal sis is a process of comparison of one figure against another$ 1hich ma"e a ratio$ and the appraisal of the ratios to ma"e proper anal sis about the strengths and 1ea"nesses of the firmIs operations. &he calculation of ratios is a relativel eas and simple tas" but the proper anal sis and interpretation of the ratios can be made onl b the s"illed anal st. Jhile interpreting the financial information$ the anal st has to be careful in limitations imposed b the accounting concepts and methods of valuation. Information of non!financial nature 1ill also be ta"en into consideration before a meaningful anal sis is made.

/atio anal sis is e+tremel helpful in providing valuable insight into a compan Is financial picture. /atios normall pinpoint a business strengths and 1ea"ness in t1o 1a s: /atios provide an eas 1a to compare toda Is performance 1ith past. /atios depict the areas in 1hich a particular business is competitivel advantaged or disadvantaged through comparing ratios to those of other businesses of the same si-e 1ithin the same industr . CATEGORIES OF RATIOS &he ratio anal sis is made under si+ broad categories as follo1s: (ong!term solvenc ratios Short!term solvenc ratios Profitabilit ratios Activit ratios =perating ratios Mar"et test ratios

Lon -T&nn So$.&nc0 R#tio/ &he long!term financial stabilit of the firm ma be considered as dependent upon its abilit to meet all its liabilities$ including those not current pa able. &he ratios 1hich are important in measuring the Iong!term solvenc ( as follo1s: Debt!%0uit /atio Shareholders %0uit /atio . Debt to *et1orth /atio Capital 6earing /atio Fi+ed Assets to (ong!term Funds /atio Proprietar /atio Dividend Cover

Interest Cover Debt Service Coverage /atio

1. D&7t-ECuit0 R#tio: Capital is derived from t1o sources: shares and loans. It is 0uite h"el for onl shares to be issued 1hen the compan is formed$ but loans are invariabl raised at some later date. &here are numerous reasons for issuing loan capital. For instance$ the o1ners might 1ant to increase their investment but avoid theIris" 1hich attaches to share capital$ and the can do this b ma"ing a secured loan. Alternativel $ management might re0uire additional finance 1hich the shareholders are un1illing to suppl 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 compan . &here are numerous 1a s of measuring gearing$ but the debt!e0uit commonl used. (ong ! term debt Share holders funds &his ratio indicates the relationship bet1een loan funds and net 1orth of the compan $ 1hich is "no1n as gearing. If the proportion of debt to e0uit is lo1$ a compan is said to be lo1!geared$ and vice versa. A debt e0uit ratio of 5:3 is the norm accepted b financial institutions for financing of pro#ects. ,igher debt!e0uit ratio ma be permitted for highl capital intensive industries li"e petrochemicals$ fertili-ers$ po1er etc. &he higher the gearing$ the more volatile the return to the shareholders. ratio is perhaps most

&he use of debt capital has direct implications for the profit accruing to the ordinar shareholders$ and e+pansion is often financed in this manner 1ith the achieved ob#ective of increasing the shareholdersI rate of return. &his ob#ective is providers of the loan.

onl if the rate earned on the additional funds raised e+ceeds that pa able to the

&he shareholders of a highl geared compan reap disproportionate benefits 1hen earnings before interest and ta+ increase. &his is because interest pa able on a large proportion of total finance remains unchanged. &he converse is also true$ and a highl geared compan is li"el to find itself in severe financial difficulties if it suffers a succession of trading losses. It is not possible to specif an optimal level of gearing for companies but$ as a general rule$ gearing should be lo1 in those industries 1here demand is volatile and profits are sub#ect to fluctuation. A debt!e0uit ratio 1hich sho1s a declining trend over the ears is usuall ta"en as a positive sigh reflecting on increased cash accrual and debt repa ment. In fact$ one of the indicators of a unit turning sic" is a rising debt!e0uit ratio. 2suall in calculating the ratio$ the preference share capital is e+cluded from debt$ but if the ratio is to sho1 effect of use of fi+ed interest sources on earnings available to the shareholders then it is to be included. =n the other hand$ if the ratio is to e+amine financial solvenc $ then preference shares shall form part of the capital. 2. S+#%&+o$)&%/ ECuit0 R#tio : &his ratio is calculated as follo1s: S"are"olders E9uit! :otal assets Btan gi le( It is assumed that larger the proportion of the shareholdersI e0uit $ the stronger is the financial position of the firm$ &his ratio 1ill supplement the debt!e0uit ratio. In this ratio the relationship is established bet1een the shareholders funds and the total assets. Shareholders funds represent both e0uit and preference capital plus reserves and surplus less losses. A reduction in shareholderIs e0uit signaling the over dependence on outside sources for long!term financial needs and this carries the ris" of higher levels of gearing. &his ratio indicates the degree to 1hich unsecured creditors are protected against iosr in the event of li0uidation. 3. D&7t to N&t -o%t+ R#tio : &his ratio is calculated as follo1s:

6ong ! term de t ?et$ort" &he ratio compares long!term debt to the net 1orth of the firm i.e.$ the capital and free reserves less intangible assets. &his ratio is finer than the debt!e0uit ratio and includes capital 1hich is invested in fictitious assets li"e deferred e+penditure and carried for1ard tosses. &his ratio 1ould 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. C#5it#$ G&#%in R#tio : It is the proportion of fi+ed interest bearing funds to %0uit shareholders$ funds: Fi/ed int eresi earing funds : E9uit! S"are"older<s funds &he fi+ed interest bearing funds include debentures$ long!term loans and preference share capital. &he e0uit shareholders funds include e0uit share capital$ reserves and surplus. Capital gearing ratio indicates the degree of vulnerabilit of earnings available for e0uit shareholders. &his ratio signals the firm 1hich is operating on trading on e0uit . It also indicates the changes in benefits accruing to e0uit shareholders b changing the levels of fi+ed interest bearing funds in the organisation. 5. FiA&) A//&t/ to Lon -t&%( Fun)/ R#tio : &he fi+ed assets is sho1n as a proportion to long!term funds as follo1s: Fi/ed Assets 6ong - term Funds &he ratio includes the proportion of long!term funds deplo ed in fi+ed assets. Fi+ed assets represents the gross fi+ed assets minus depreciation provided on this till the date of calculation. (ong!term funds include share capital$ reserves and surplus

and long!term loans. &he higher the ratio indicates the safer the funds available in case of li0uidation. It also indicates the proportion of long!term funds that is invested in 1or"ing capital. 6. 6%o5%i&to% R#tio : It e+press the relationship bet1een net 1orth and total asset ?et $ort" :otal Assets *et 1orth T %0uit Share Capital!t!Preference Share CapitalUFictitious Assets for a particular purpose should not be

&otal Assets T Fi+ed Assets U Current Assets Be+cluding fictitious assetsC /eserves earmar"ed specificall included in calculation of *et 1orth. A high proprietor ratio indicative of strong financial position of the business. &he higher the ratio$ the better it is. =. Int&%&/t Co.&%: Profil efore interest depreciationand ta/ +nterest &he interest coverage ratio s(#1s ho1 man times interest charges are covered b funds that are available for pa ment of interest. An interest cover of 5:3 is considered reasonable b financial institutions. A ver high ratio indicates that the firm is conservative in using debt and a ver lo1 ratio indicates e+cessive use of debt. >. Di.i)&n) Co.&% : ?et Profit after ta/ 0ividend &his ratio indicates the number of times the dividends are covered b net profit his highlights the amount retained b operations. a compan for financing of future

?. D&7t S&%.ic& Co.&%# & R#tio : It indicates 1hether the business is earning sufficient profits to pa not onl the interest charges$ but also the instalments due to the IprincipalI amount. It is calculated as: P4+: +nterest U Periodic 6oan +nstalment B3 ! -ate of +ncome :a/( &he greater the debt service coverage ratio$ the better rs the servicing abilit of the organisation. S+o%t-t&%( So$.&nc0 R#tio/ &he short!term solvenc ratios$ 1hich measure the li0uidit of the firm and its liabilit of the firm and its abilit to meet it! maturing short!term obligations. (i0uidit is defined as the abilit to realise value in mone $ the most li0uid of assets. It refers to the abilit to pa in cash$ the obligations that !are due. &he corporate li0uidit has t1o dimensions vi-.$ 0uantitative and 0ualitative concepts. &he 0uantitative concept includes the 0uantum$ structure and utilisation of li0uid assets and in the 0ualitative concept$ it is the abilit to meet all present and potential demands on cashE from an source in a manner that minimi-es cost and ma+imi-es the value of the firm. &hus$ corporate li0uidit is$ a vital factor in business ! e+cess li0uidit $ though a guarantor of solvenc 1ould reflect lo1er profitabilit $ deterioration in managerial efficienc $ increased speculation and un#ustified e+pansion$ e+tension of too liberal credit and dividend policies. &oo little li0uidit then ma lead to frustrationI of!i business ob#ectives$ reduced rate of return$ business opportunit missed and' 1ea"ening of morale. short!term solvenc are: B3C Current /atio B5C Guic" /arip B7C Absolute (i0uid /atio 1. Cu%%&nt R#tio : &he important ratios in measuring

Current Assets, 6oans & Advances Current 6ia ilities & Provisions &his ratio measures the solvenc of the compan in the short!term. Current assets are those assets 1hich can be converted into cash 1ithin a ear. Current liabilities and provisions are those liabilities that are pa able 1ithin a ear. A current ratio 5:3 indicates a highl solvent position. A current ratio 3.77:3 is considered b ban"s as the minimum acceptable level for providing 1or"ing capital finance. &he constituents of the current assets are as important as the current assets themselves for evaluation of a compan Is solvenc position$ A ver high current ratio 1ill have adverse impact on the profitabilit of the organisation. A high current ratio ma be due to the piling up of inventor $ inefficienc in collection of debtors$ high balances in Cash and )an" accounts 1ithout proper investment 2. Puic8 R#tio o% LiCui) R#tio: Current Assets, 6oans & Advances ! +nventories Current 6ia ilities & Provisions- 4an% @verdraft Guic" ratio used as measure of the compan Is abilit to meet its current

obligations. Since ban" overdraft is secured b the inventories$ the other current assets must be sufficient to meet other current liabilities. A 0uic" ratio of 3:3 indicates highl solvent position. &his ratio is also called acid test ratio. &his ratio serves as a supplement to the current ratio in anal sing li0uidit . 3. A7/o$ut& LiCui) R#tio :Su5&% Puic8 R#tio;: It is the ratio of absolute li0uid assets to 0uic" liabilities. ,o1ever$ for calculationIpurposes$ it is ta"en as ratio of absolute li0uid assets to current liabilities. Absolute li0uid assets include cash in hand$ cash at ban" and short term or temporar investments.

A solute 6i9uid Assets Current 6ia ilities Absolute (i0uid Assets TCash in ,and U Cash at )an" U Short term investments &he ideal Absolute li0uid ratio is ta"en as 3:5 or @.:. Acti.it0 R#tio/ o% Tu%no.&% R#tio/ Activit ratios measure ho1 effectivel the firm emplo s its resources. &hese ratios are also called turnover ratios 1hich involve comparison bet1een the level of sales and investment in various accounts ! inventories$ debtors$ fi+ed assets etc. activit ratios are used to measure the speed 1ith 1hich various accounts are converted into sales or cash. &he follo1ing activit ratios are calculated for anal sis: 1. In.&nto%0 : A considerable amount of a compan Is capital ma be tied up in the financing of ra1 materials$ 1or"!in!progress and finished goods. It is important to ensure that the level of stoc"s is "ept a lo1 as possible$ consistent 1ith the need to fulfill customerIs orders in time. Inventor &urnover /atio T Cost of goods sold Average Inventor

Sales Average Inventor

Average inventor

=pening stoc"UClosing stoc" 5

&he higher the stoc" turn over rate the lo1er the stoc" turnover period the better$ although the ratios 1ill var bet1een companies. For e+ample$ the stoc" must be higher than the rate in a turnover rate in a food retailing compan

manufacturing concern. &he level of inventor in a compan ma be assessed b the use of the inventor ratio$ 1hich measures ho1 much has been tied up in inventor . +nventor! -atio A +nventor! Current Assets &he inventor turnover ratio measures ho1 man times a compan Is inventor has been sold during the ear. If the inventor turnover ratio has decreased from past$ it means that either inventor is gro1ing or sales are dropping. In addition to that$ if a firm has a turnover that is slo1er than for its industr $ then there ma be obsolete goods on hand$ or inventor stoc"s ma be high. (o1 inventor turnover has impact on the li0uidit of the business. 2. D&7to%/ : &he three main debtor ratios are as follo1s: 1$ De!tor )urno'er /atio Debtor turnover$ 1hich measures 1hether the amount of resources tied up in debtors is reasonable and 1hether the compan debtors into cash. &he formula is: Credit Sales Average 0e tors &he higher the ratio$ the better the position. ii$ A'erage Collection Period Average collection period$ 1hich measures ho1 long it ta"e to collect amounts from debtors. &he formula is: Average de tors Credit Safes X 365 has been efficient in converting X 100

&he actual collection period can be compared 1ith the stated credit terms of the compan . If it is longer than those terms$ then this indicates some insufficienc in the procedures for collecting debts. ii$ *ad De!ts )ad debts$ 1hich measures the proposition of bad debts to sales: 4ad de ts Sales &his ratio indicates the efficienc of the credit control procedures of the compan . Its level 1ill depend on the t pe of business. Mail order!companies have to accept a fairl high level of bad debts$ 1hite retailing organisations should maintain ver lo1 levels or$ if the do not allo1 credit accounts$ none at all. &he actual ratio is compared 1ith the target or norm to decide 1hether or not it is acceptabie. 3. C%&)ito%/: i$ Creditors )urno'er Period &he measurement of the creditor turnover period sho1s the average time ta"en to pa for goods and services purchased b the compan . &he formula is: Average creditors Purc"ases X 365

In general the longer the credit period achieved the better$ uecause dela s in pa ment mean that the operation of the compan are being financed interest free b $ suppliers of funds. )ut there 1ill be a point be ond 1hich!dela s in pa ment 1ill damage relationships 1ith suppliers 1hich$ if the are operating in a sellerIs mar"et$ ma harm the compan . If too long a period is ta"en to pa creditors$ the credit rating of the compan ma suffer$ thereb ma"ing it more difficult to obtain suppliers in the future. ii$ Creditors )urno'er /atio Credit purc"ases Average creditors

&he term creditors include trade creditors and bills pa able. 4. A//&t/ Tu%no.&% R#tio/: &his measures the compan Is abilit to generate sales revenue in relation to the si-e of the asset investment A lo1 asset turnover ma be remedied b increasing sales or b disposing of certain assets or both. &o assist in establishing 1hich part of the asset structure is not being used efficientl $ the asset turnover ratio should be sub! anal sed. i$ "i.ed Assets )urno'er /atio Sales Fi/ed assets &his ratio 1ill be anal sed further 1ith ratios for each main categor of asset &his is a difficult set of ratios to interpret as asset values are based on historic cost An increase in the fi+ed asset figure ma result from the replacement of an asset at an increased price or the purchase of an additional asset intended to increase production capacit . &he later transaction might be e+pected to result in increased sales 1hereas the former 1ould more probabl be reflected in reduced operating costs. &he ratio of the accumulated depreciation provision to the total of fi+ed assets at cost might be used as an indicator of the average age of the assetsA particularl 1hen depreciation rates are noted in the accounts. &he ratio of sales value per share foot of floor space occupied is particularl significant$ for trading concerns$ such as a 1holesale 1arehouse or a department store. ii$ )otal Assets )urno'er /atio &his ratio indicates the number of times total assets are being turned over in a ear. Sales :otal assets &he higher the ratio indicates overtrading of total assets 1hile a lo1 ratio indicates idle capacit .

5. *o%8in C#5it#$ Tu%no.&% R#tio : &his ratio is calculated as follo1s: Sales Bor%ing capital &his ratio indicates the e+tent of 1or"ing capital turned over in achieving sales of the firm. 6. S#$&/ to C#5it#$ E(5$o0&) R#tio : &his ratio is ascertained b dividing sales 1ith capital emplo ed. Sales aaaaaaaaaa Capital emplo!ed &his ratio indicates$ efficienc in utilisation of capital emplo ed in generating revenue. 6%o'it#7i$it0 R#tio/ &he purpose of stud and anal sis of profitabilit ratios are to help assess the ade0uac of profits earned b the compan and also to discover 1hether profitabilit is increasing or declining. &he profitabilit of the firm is the net result of a large number of policies and decisions. &he profitabilit ratios are measured 1ith reference to sales$ capital emplo ed$ total assets emplo edA shareholders funds etc. &he ma#or profitabilit rates are as follo1s: BaC /eturn on capital emplo ed Bor /eturn on investmentC Z/=I or /=C%[ BbC %arnings per share B%PSC BcC Cash earnings per share BCash %PSC BdC 6ross profit margin BeC *et profit margin BfC Cash profit ratio

BgC /eturn on assets BhC /eturn on *et 1orth Bor /eturn on Shareholders e0uit C I. R&tu%n on C#5it#$ E(5$o0&) :ROCE; o% R&tu%n on In.&/t(&nt :ROI; &he strategic aim of a business enterprise is to earn a return on capital. If in an particular case$ the return in the long!run is not satisfactor $ then the deficienc should be corrected or the activit 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 1ith capital emplo ed. &he rate of return on investment is determined b dividing net profit or income b the capital emplo ed or investment made to achieve that profit. -@+ T Profit +nvested capital /=I consists of t1o components vi-$ I. Profit margin$ and fl. Investment turnover$ as sho1n belo1: -@+ A ?et profit +nvestment A ?et profit Sales W Sales +nvestment in assets X 100

It 1ill be seen from the above formula that /=I can be improved b increasing one or both of its components vi-.$ the profit margin and the investment turnover in an of the follo1ing 1a s: Increasing the profit margin Increasing the investment turnover$ or Increasing both profit margin and investment turnover

&he obvious generalisations that can be made about the /=I formula are that an action is beneficial provided that it: )oosts sales /educes invested capital

/educes costs B1hile holding the other t1o factors constantC

&able!3: Computation of Capital %mplo ed Share capital of the compan /eserves and surplus (oans BsecuredD unsecuredC (ess: BaC Capital!in!progress BbC Investment outside the business BcC Preliminar e+penses BdC Debit balance of Profit and (oss ADc Capital emplo ed +++ +++ +++ +++ +++ +++

+++

+++ +++

/eturn on in vestment anal sis provides a strong incentive for optimal utilisation of these assets of the compan . &his encourages mangers to obtain$ assets that 1ill provide a satisfactor return on investment and to dispose of assets that are not providing an acceptable return. In selecting amongst alternative long!term investment proposals$ /=I provides a suitable measure for assessment of profitabilit of each proposal. 2. E#%nin / 6&% S+#%& :E6S;: &he ob#ective of financial Management is 1ealth or value ma+imisation of a corporate entit . &he value is ma+imi-ed 1hen mar"et price of e0uit ma+imisation has been advocated as an appropriate and operationall shares is feasible ma+imised. &he use of the ob#ective of 1ealth ma+imisation or net present value criterion to choose among the alternative financial actions. In practice$ the performance of a corporation Is better #udged in terms of its earnings per share B%PSC. &he %PS is one of the important measures of economic performance of a corporate entit . &he flo1 of capital to the companies under the present imperfect capital mar"et conditions 1oold be made on the evaluation of %PS. Investors lac"ing inside and detailed information 1ould loo" upon the %PS as the best base to la"e their investment decisions. A higher %PS means better capital productivit . EPS A ?et Profit after ta/ and preference dividend ?o. of E9uit! S"ares I E6S -+&n D&7t #n) ECuit0 u/&)

'E4+: C 1( '1 C :( *

II. E6S -+&n D&7t< 6%&'&%&nc& #n) ECuit0 u/&) A Jhere 'E4+: C + ( '1 C :( - 0P ? %)I& T %arnings before interest and ta+ I T Interest & T /ate of Corporate ta+ DP T Preference Dividend * T *umber of %0uit shares %PS is one of the most important ratios 1hich measures the net profit earned per share. %PS is one of the ma#or factors affecting the dividend polic of the firm and the mar"et prices of the compan . 6ro1th in %PS is more relevant for pricing of shares from absolute %PS. A stead gro1th in %PS ear after ear indicates a good trac" of profitabilit . 3. C#/+ E#%nin / 6&% S+#%& : &he cash earnings per share BCash %PS is calculated b dividing the net profit before depreciation 1ith number of e0uit shares. ?et profit ) 0epreciation ?o. of E9uit! S"ares &his is a more reliable companies$ especiall for highl ard stic" for measurement of performance of capital intensive industries 1here provision for

depreciation is substantial. &his measures the cash earnings per share and is also a relevant factor for determining the price for the compan Is shares. ,o1ever$ this method is not as popular as %PS and is used as a supplementar performance onl . measure of

4. G%o// 6%o'it M#% in : &he gross profit margin is calculated as follo1s: A Sales - Cost of goods sold Sales X 100 #ross profit Sales X 100

&he ratio measures the gross profit margin on the total net sales made b the compan . &he grosi$ profit represents the e+cess of sales proceeds during the period under observation over their cost$ before ta"ing into administration$ selling and distribution and financing charges. 3 account

&he ratio . measures

the efficienc of the compan Is operations and this can also be A compared 1ith the previous ears results to ascertain the efficienc partners 1ith respect to the previous ears. Jhen ever thing normal$ the gross profit margin should remain unchanged$ irrespective of the level of production and sales$ since it is based on the assumption that all costs deducted 1hen computing gross profit 1hich are directl variable 1ith sales. A stable gross profit margin is therefore$ the norm and an variation from it call for careful investigations$ 1hich ma be causedA due to the follo1ing reasons: BiC Price cuts: A compan need to reduce its selling price to achieve the

desired increase in sales. BiiC Cost increases: &he price 1hich a compan pa its suppliers during period of an

inflation$ is li"el to rise and this reduces the gross profit margin unless appropriate ad#ustment is made to the selling price. BiiiC

C"ange in mi/: A change in the range or mi+ of products sold causes the overall gross profit margin assuming individual product lines earn different gross profit percentages.

BivC

Dnder or @ver-valuation of stoc%s. If closing stoc"s are under!valued$ cost of goods sold is inflated and profit

understated. An incorrect valuation ma be the result of an error during stoc" ta"ing

or it ma be due to fraud &he gross profit margin ma be compared 1ith that of competitors in the industr to assess the operational performance relative to the other pla ers in the industr . 5. N&t 6%o'it M#% in: &he ratio is calculated as follo1s: ?et profit efore interest and ta/ Sales &he ratio is designed to focus attention on the net profit margin arising from business operations before interest and ta+ is deducted. &he convention is to e+press profit after ta+ and interest as a percentage of sales. A dra1bac" is that the percentage 1hich results$ varies depending on the sources emplo ed to finance business activit A interest is charged Iabove the line 1hile dividends are deducted Ibelo1 the lineI. It is for this reason that net profit i.e. earnings before interest and ta+ B%)I&C is used. &his ratio reflects nt: profit margin on the total sales after deducting all e+penses but before deducting interest and ta+ation. &his ratio measures the efficienc of operation of the compan . &he net profit is arrived at from gross profit after deducting administration$ selling and distribution e+penses. &he non!operating incomes and e+penses are ignored in computation of net profit before ta+$ depreciation and interest &his ratio could be compared 1ith that of the previous earIs and 1ith that of competitors to determine the trend in net profit margins of the compan and its performance in the industr . &his measure 1ill depict the correct trend of performance 1here there are erratic fluctuations in the ta+ provisions from ear to ear. It is to be observed that ma#orit of the costs debited to the profit and loss account are fi+ed in nature and an increase in sales 1ill cause the cost per unit to decline because of the spread of same fi+ed cost over the increased number of units sold. 6. C#/+ 6%o'it R#tio Cas" profit Sales X 100 X 100

Jhere Cash profit T *et profits Depreciation Cash profit ratio measures the cash generation in the business as a result of trie operations e+pressed in terms of sales. &he cash profit ratio is a more reliable indicator of performance 1here there are sharp fluctuations in the profit before ta+ and net profit from ear to ear o1ing to difference in depreciation charged. Cash profit ratio evaCIiates the efficienc of operations in terms of cash generation and is not affected the method of depreciation charged. It also facilitate the inter!firm comparison of performance since different methods of depreciation ma be adopted b different companies. =. R&tu%n on A//&t/ : &his ratio is calculated as follo1s: ?et profit after ta/ :otal assets &he profitabilit $ of the firm is measured b establishing relation of net profit 1ith the total assets of the organisation. &his ratio indicates the efficienc utilisation of assets in generating revenue. of X 100

>. R&tu%n on S+#%&+o$)&%/ Fun)/ o% R&tu%n on N&t *o%t+ ?et profit after interest and ta/ ?et $ort" Jhere$ *et 1orth T %0uit capital U /eserves and Surplus. &his ratio e+presses Bhe nel profit in Icrms of the e0uit shareholders funds. &his ratio is an important ardstic" of performance of e0uit shareholders since it indicates the return on the funds emplo ed b them. ,o1ever$ this measure is based on the historical net 1orth and 1ill be high for old plants and lo1 for ne1 plants. X 100

&he factor 1hich motivates shareholders to invest in a compan

is the

e+pectation of an ade0uate rate of return on their funds and periodicall $ the 1ill 1ant to assess the rate of return earned in order to decide 1hether to continue 1ith their investment. &here are various factors of measuring the return including the earnings ield and dividend ield 1hich are e+amined at later stage. &his ratio is useful in measuring the rate of return as a percentage of the boo" value of shareholders e0uit . &he further modification of this ratio is made b considering the profitabilit from e0uit shareholders point of vie1 can also be 1or"ed out b ta"ing the profits after preference dividend and comparing against capital emplo ed after deducting both long!term loans and preference capital. O5&%#tin R#tio/ &he ratios of all operating e+penses Bi.e. materials used$ labour$ factor ! overheads$ administration and selling e+pensesC to sales is the operating ratio. A comparison of the operating ratio 1ould indicate 1hether the cost content is high or lo1 in the figure of sales. If the annual comparison sho1s that the sales has increased the management 1ould be naturall interested and concerned to "no1 as to 1hich element of the cost has gone up. It is not necessar that the management should be concerned onl 1hen the operating ratio goes up. If the operating ratio has fallen$ though the unit selling price has remained the same$ still the position needs anal sis as it ma be the sum total of efficienc in certain departments and inefficienc in others$ A d namic management should be interested in ma"ing a complete anal sis. It is$ therefore$ necessar to brea"!up the operating ratio into various cost ratios. &he ma#or components of cost are: Material$ labour and overheads. &herefore$ it is 1orth1hile to classif the cost ratio as: 1. M#t&%i#$/ Co/t R#tio T MaterialsConsumed Sales 2. L#7ou% Co/t R#tio T 6a our Cost Sales Sales X 100

X 100

X 100

3.

F#cto%0 O.&%+&#) R#tio

T Factor! E/penses Sales

4.

A)(ini/t%#ti.& EA5&n/& R#tio

T Administrative E/penses Sales

X 100

4.

S&$$in #n) )i/t%i7ution &A5&n/&/ %#tio T Selling and 0istri ution E/penses Sales X 100

6enerall all these ratios are e+pressed in terms of percentage. &hen total up all the operating ratios. &his is deducted from 3@@ 1ill be e0ual to the net profit ratio. If possible$ the total e+penditure for effecting sales should be divided into t1o categories$ vi-. Fi+ed and variable and then ratios should be 1or"ed out. &he ratio of variable e+penses to sales 1ill be generall constantA that of fi+ed e+penses should fall if sales increase$ it 1ill increase if sales fall. M#%8&t T&/t R#tio/ &he mar"et test ratios relates the firmIs stoc" price to its earnings and boo" value per share. &hese ratios give management an indication of 1hat investors thin" of the compan Is past performance and future prospectus. If firmIs profitabilit $ solvenc and turnover ratios are good$ then the mar"et test ratios 1ill be high and its share price is also e+pected to be high. &he mar"et test ratios are as follo1s: ! 3. Dividend pa out ratio 5. Dividend ield 7. )oo" value 8. PriceD%arnings ratio 1. Di.i)&n) 6#0out R#tio: 0ividend per s"are Earnings per s"are
A

Dividend pa out ratio is the dividend per share divided b the earnings per share. Dividend pa out indicates the e+tent of the net profits distributed to the shareholders as dividend. A high pa out signifies a liberal distribution polic and a lo1 pa out reflects conservative distribution polic . 2. Di.i)&n) 9i&$) 0ividend per s"are Mar%et price &his ratio reflects the percentage X 100

ield that an investor receives on this

investment at the current mar"et price of the shares. &his measure is useful for investors 1ho are interested in ield per share rather than capital appreciation. 3. !oo8 4#$u&: E9uit! Capitalf )-eserves - Pr9fit&6ass de it alance. :otal num er of e9uit! s"aresA &his ratio indicates the net 1orth per e0uit share. &he boo" value is a

reflection of the past earnings and the distribution polic of the compan . A high boo" value indicates that a compan has huge reserves and is a potential bonus candidate. A lo1 boo" value signifies liberal distribution polic of bonus and dividends$ or alternativel $ a poor trac" record of profitabilit . )oo" value is considered less relevant for the mF"er price as compared to %PS$ as it reflects the past record 1hereas the mar"et discounts the future prospects. 4. 6%ic& E#%nin / R#tio :62E R#tio;: Current mar%et price Earnings per s"are &his ratios measures the number of times the earnings of the latest ear at 1hich the share price of a compan is 0uoted. It signifies the number of ears$ in 1hich the earnings can e0ual to current mar"et price. &his ratio reflects the mar"etIs

assessment of the future earnings potential of the compan . A high PDe ratio reflects earnings potential and a lo1 PD% ratio lo1 earnings potential. &he PD% ratio reflects the mar"etIs confidence in the compan Is e0uit . PDe ratio is a barometer of the mar"et sentiment Companies 1ith e+cellent trac" record of profitabilit $ professional management and liberal distribution polic have high PD% ratios 1hereas companies 1ith moderate trac" record$ conservative distribution polic and average prospects 0uote a lo1 PD% ratios. &he mar"et price discounts the e+pected earnings of a compan for the current ear as opposed to the historical %PS. LIMITATIONS IN T"E USE OF RATIO ANAL9SIS /atios b themselves mean nothing. &he must al1a s be compared 1ith: a norm or a target previous ratios in order to assess trends the ratios achieved in other comA arable companies Binter!compan comparisonsC$ and caution has to be e+ercised in using ratios.

&he follo1ing limitations must be ta"en into account: /atios are calculated from financial statements 1I.ach are affected b the financial bases and policies adopted on such matters as depreciation and the valuation of stoc"s. Financial statements do not represent a complete picture of the business$ but merel a collection of facts 1hich can be e+pressed in monetar terms. &he ma not refer to other factors 1hich affect performance. =ver use of ratios as controls on managers could be dangerous$ in that management might concentrate more on simpl improving the ratio than on dealing 1ith the significant issues. For e+ample$ the return on capital emplo ed can be improved b reducing assets rather than increasing profits.

A ratio is a comparison of t1o figures$ a numerator and a denominator In comparing ratios it ma be difficult to determine 1hether differences are due to changes in the numerator$ or in the denominator or in both. /atios are inter!connected. &he should not be treated in isolation. &he effective use of ratios$ therefore$ depends on being a1are of all these limitations and ensuring that$ follo1ing comparative anal sis$ the are used as a trigger point for investigation and corrective action rather than being treated as meaningful in themselves. &he anal sis of ratios clarifies trends and 1ea"nesses 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 thoroughl .

Illustration 1: From the given )alance Sheets calculate: BaC BbC BcC BdC Debt!e0uit ratio (i0uid ratio Fi+ed assets to current assets ratio Fi+ed assets to *et 1orth ratio )alance Sheet Li#7i$it0 Share Capital /eserve Profit and (oss aDc Secured (oans Creditors Provisions for ta+ation R/. 3$@@$@@@ 5@$@@@ 7@$@@@ >@$@@@ :@$@@@ 5@$@@@ 7$@@$@@@ Solution: BaC Debt!e0uit ratio T @utsiders Funds S"are"olders Funds A//&t/ 6ood1ill Fi+ed assets BCostC Stoc" Debtors Advances Cash R/. ;@$@@@ 3$8@$@@@ 7@$@@@ 7@$@@@ 3@$@@@ 7@$@@@ 7$@@$@@@

Out/i)&%J/ Fun)/ Secured (oans Creditors Provisions for ta+ation

R/.

S+#%&+o$)&%/J Fun)/

R/. 3$@@$@@@ 5@$@@@ 7@$@@@ 3$:@$@@@

>@$@@@ Share Capital :@$@@@ /eserves 5@$@@@ Profit and (oss aDc 3$:@$@@@

Debt!e0uit ratio T 3$:@$@@@ 3$:@$@@@ BbC (i0uid ratio T 6i9uid Assets Current 6ia ilities

= 1:1

*ote: Advances are treated as current asset. Secured 9oans are treated as current liabilit . (i0uid ratio T <@$@@@ 3$:@$@@@ = 0.47:1

BcC Fi+ed Assets to Currents Assets /atio T Fi/ed Assets Current 6ia ilities Fi/ed Assets T 3$8@$@@@ Cash Stoc" Debtors Advances Fi+ed assets to current assets ratio T 3$8@$@@@ 3$@@$@@@ BdC Fi+ed Assets to *et 1orth /atio T Fi+ed Assets *et 1orth Current Assets B/sC 7@$@@@ 7@$@@@ 7@$@@@ 3@$@@@ 3$@@$@@@ = 1.4:1

Share Capital /eserves P ' ( aDc (ess: Provision for ta+ation

3$@@$@@@ 5@$@@@ 7@$@@@ 3$:@$@@@ 5@$@@@ 3$7@$@@@ 1,40,000 1,30,000 T 3.@>:3

Fi+ed Assets to *et 1orth ratio T

Illustration %: From the follo1ing data calculateA BaC BbC BcC BdC BeC Current ratio Guic" ratio Stoc" &urnover ratio =perating ratio /ate of return on e0uit capital )alance Sheet as on Dec.$ 73$5@@3 Li#7i$iti&/ %0uit Share Capital R/. A//&t/ R/. ;$8@$@@@ >@$@@@ 3$ ;@$@@@

3$@@$@@@ Plant and Machiner 7$;>$@@@ (and and buildings 3$@8$@@@ Cash 5$@@$@@@ Debtors 7$;@$@@@ (ess: Provision for bad

B/s. 3@ sharesC Profit and loss account Creditors )ills pa able

=ther Current liabilities

debts 8@$@@@ 5@$@@@ Stoc" Prepaid Insurance 3;$?5$@@@

7$5@$@@@ 8$>@$@@@ 35$@@@ 3;$?5$@@@

Inco(& St#t&(&nt 'o% t+& 0&#% &n)in 31/t D&c.< 2@@1 B/s.C Sales (ess: Cost of goods sold (ess: =perating e+penses 8$@@$@@@ 7@$>@$@@@ ?$5@$@@@ ;$>@$@@@

*et Profit (ess: Income ta+ paid :@R *e1 Profit after ta+ )alances at the beginning of the ear: Debtors Stoc" Solution: BaC Current ratio T Current Assets Current 6ia ilities /s. 7$@@$@@@ /s. 8$@@$@@@

5$8@$@@@ 3$5@.@@@ 3$5@$@@@

Cu%%&nt A//&t/ Cash Debtors Stoc" Prepaid insurance

R/.

Cu%%&nt Li#7i$iti&/ Creditors

R/. 3$@8$@@@ 5$@@$@@@ 5@$@@@

7$5@$@@@ )ills Pa able 8$>@$@@@ =ther Current (iabilities 35$@@@ ?$<5$@@@

7$58$@@@

Current ratio T

?$<5$@@@ 7$58$@@@

3:1

BbC Guic" ratio T

6i9uid Assets Current 6ia ilities

(i0uid assets Cash Debtors

B/s.C 3$;@$@@@ 7$5@$@@@ 8$>@$@@@ Current liabilities Rs.3,24,000

(i0uid ratio T 8$>@$@@@ 7$58$@@@ BcC Stoc" &urnover /atio T Cost of goods sold Average sloc% Cost of goods sold T 7@$>@$@@@ Average Stoc"
A

= 1.48:1

@pening Stoc% ) Closing Stoc% 5 T 8$@@$@@@ U 8$>@$@@@ 5 = 4,40,000

Stoc" &urnover /atio T

7$>@$@@@ 8$8@$@@@

= 7 times

'd( @perating -atio A

Cost of goods sold ) @perating e/presses ?et Sales T 7@$>@$@@@ U ;$>@$@@@ U 8@$@@$@@@ 8@$@@$@@@

X 100

X 100

= 94%

BeC /ate of return on e0uit capital: T ?et profit afer la/ E9uit! s"are capital T 3$5@$@@@ 3@$@@$@@@ Illustration (: &he follo1ing are the &rading and P'( ADc for the ear ended 73 st December 5@@3 and the )alance Sheet as on that date of 4. (td. &rading and P ' ( ADc 6#%ticu$#%/ &o =pening Stoc" &o Purchases &o Jages &o 6ross Profit R/. 6#%ticu$#%/ ?$?:@ ) Sales :8$:.5: ) Closing Stoc" 3$85: 78$@@@ ??$?@@ &o Administrative %+penses &o Selling %+penses &o Financial %+penses &o (oss on sale of assets &o *et Profit 3:$@@@ ) 6ross Profit 7$@@@ ) Interest 3$:@@ ) 8@@ 3:$@@@ 34<?@@ 34<?@@ Profit on sale of ??$?@@ 78$@@@ 7@@ ;@@ R/. >:$@@@ 38$?@@ X 100 T 35R

shares

!#$#nc& S+&&t

Li#7i$iti&/ Share Capital /eserves Current (iabilities P'(ADc

R/.

A//&t/

R/. 3:$@@@ >$@@@ 38$?@@ <$3@@@ 7$@@@ 4><@@@

5@$@@@ (and and )uildings ?$@@@ Plant ' Machiner 37$@@@ Stoc" ;$@@@ Debtors Cash at )an" 4><@@@

]ou are re0uired to CalculateA BaC Current /atio BbC =perating /atio BcC Stoc" &urnover /atio BdC *et Profit /atio BeC Fi+ed Assets &urnover /atio Solution: BaC Current ratio T Current Assets Current 6ia ilities

Current Assets Cash at )an" Debtors Stoc" 7$@@@ <$3@@ 38$?@@ 5:$@@@

B/s.C Current liabilities Rs. 13,000

Current ratio

T 5:$@@@ 37$@@@

Rs. 1.923:1

BbC =perating /atio A

Cost of goods sold ) @perating e/presses ?et Sales

X 100

Cost of goods sold T ?$?:@ U :8$:5: U 3$85: ! 38$?@@ =perating e+penses =perating /atio T 3?$:@@ T :3$@@@ U 3?$:@@ >:$@@@ BcC Stoc" &urnover /atio T Cost of goods sold Average stoc% Average Stoc" T ?$?:@ U 38$?@@ 5 Stoc" &urnover /atio T :3$@@@ 35$85: BdC *et Profit /atio T *et Profit ?et Sales T 3:$@@@ >:$@@@ = 100 X 100

= 51,000

= 82.94%

= 12,425

= 4.1 times

= 100

= 17.65%

BeC Fi+ed Assets &urnover /atio

T ?et Sales Fi/ed Assets T >:$@@@ 57$@@@ = 3.7 times

Illustration 30 &he follo1ing is the &rading and Profit and (oss aDc and )alance Sheet of a firm.

&rading and P ' ( ADc 6#%ticu$#%/ &o =pening Stoc" &o Purchases &o 6ross Profit cDd &o Administrative %+penses &o Interest &o Selling %+penses &o *et Profit R/. 6#%ticu$#%/ R/. 3$@@$@@@ 3:$@@@ 1<15<@@@ :@$@@@

3@$@@@ ) Sales ::$@@@ ) Closing Stoc" :@$@@@ 1<15<@@@ 3:$@@@ ) 6ross Profit bDd 7$@@@ 35$@@@ 5@$@@@ 5@<@@@

5@<@@@

)alance Sheet Li#7i$iti&/ Capital Profit and (oss aDc Creditors )ills Pa able R/. A//&t/ R/. :@$@@@ 7@$@@@ 3:$@@@ 3:$@@@ 35$:@@ 3<$:@@ 5@$@@@ 1<6@<@@@ 3$@@$@@@ (and and )uildings 5@$@@@ Plant ' Machiner 5:$@@@ Stoc" 3:$@@@ Debtors )ills receivable Cash at )an" Furniture 1<6@<@@@ Calculate the follo1ing ratios: BaC Inventor turnover ratio BbC Current /atio BcC 6ross profit ratio BdC *et profit ratio BeC =perating ratio BfC (i0uidit ratio BgC Proprietar ratio Solution:

BaC Inventor &urnover ratio T Cost of goods sold Average stoc% Cost of goods sold =pening Stoc" Purchases (ess: Closing Stoc" 3@$@@@ ::$@@@ ;:$@@@ 3 :$@@@ :@$@@@

Average Stoc" T @pening Stoc% ) Closing Stoc% 5 T 3@$@@@ U 3:$@@@ 5 Stoc" &urnover ratio T :@$@@@ 35$:@@ BbC Current ratio T Current Assets Current 6ia ilities Current Assets Cu%%&nt A//&t/ Stoc" Debtors )D/ Cash at )an" R/. B/s.C Cu%%&nt $i#7i$iti&/ R/. 5:$@@@ 3:$@@@ T 35$:@@

T 8 times

3:$@@@ Creditors 3:$@@@ )ills Pa able 35$:@@ 3<$:@@ ;@$@@@

8@$@@@

Current ratio T ;@$@@@ 8@$@@@ BbC 6ross Profit /atio T #ross Profit ?et Sales BcC *et Profit /atio T *et Profit *et Sales

T 3.::3 W 3@@ T :@R

W 3@@

T 5@$@@@ 3$@@$@@@

T 5@R

BdC =perating Profit T Cost of goods sold ) @perating e/presses ?et Sales Cost of goods sold T :@$@@@ =perating e+penses B/s.C 3:$@@@ 35$@@@ 5<$@@@ =perating ratio T :@$@@@ U 5<$@@@ 3$@@$@@@

T 3@@

Administration e+penses Selling e+penses

W 3@@

<< R

BeC (i0uidit ratio Current Assets LiCui) A//&t/ Cash at )an" )ills /eceivable Debtors

T 6i9uid Assets Current 6ia ilities B/s.C R/. Cu%%&nt $i#7i$iti&/ R/. 5:$@@@ 3:$@@@ 8@$@@@ 3<$:@@ Creditors 35$:@@ )ills Pa able 3:$@@@ 8:$@@@

(i0uidit ratio T 8:$@@@ 8@$@@@ BfC Proprietar ratio T S"are"older&s Funds :otal Assets Shareholder7s "uruis Capital Profit and (oss aDc B/s.C 3$@@$@@@ &otal Assets /s. 3$;@$@@@

W 3@@

5@$@@@ 3$5@$@@@

Proprietar ratio T 3$5@$@@@ 3$;@.@@@

W 3@@

T <:R

Illustration 4: A compan has a profit margin of 5@R and asset turnover of 7 times. Jhat is the compan Is return on investmentH ,o1 1ill this return on investment var if BiC BiiC BiiiC Profit margin is increased b :R H Asset turnover is decreased to 5 timesH Profit margin is decreased b :R and asset turnover is increased to 8 times. Calculation of impact of change in profit margin and change in asset turnover on return on investment /eturn on investment T Profit Margin + Asset &urnover T 5@R + 7 times BiC If profit margin is increased b :R : /=I T 5:R + 7 T <:R T ;@R

BiiC If asset turnover is decreased to 5 times: /=I T 5@R + 5 /=I T 3:R + 8 T ;@R T 8@R BiiiC If profit margin decreased$ b :R and asset turnover is increased to 8 times:

Illustration 5: &here are three companies in the countr manufacturing a particular chemical. Follo1ing data are available for the ear 5@@@!5@@3. B/s. la"hsC Compan *et Sales =perating Cost =perating Assets

A (td. ) (td. C (td.

7@@ 3$:@@ 3$8@@

5:: 3$5@@ 3$@:@

35: <:@ 3$5:@

Jhich is the best performer as per our assessment and 1h H Co(5#%#ti.& St#t&(&nt o' 6&%'o%(#nc& 6#%ticu$#%/ Sales (ess: =perating Cost =peratingProfit BAC =perating Assets B)C /eturn on capital emplo ed A Lt). 7@@ 5:: 8: 35: 7;R ! Lt). 3$:@@ 3$5@@ 7@@ <:@ 8@R C Lt). 3$8@@ 3$@:@ 7:@ 3$5:@ 5>R

BAC D B)C + 3 @@ Anal sis: )asing on the return on capital emplo ed$ ) (td.$ is the best performer as compared to A (td. and C (td. +llustration 5: Calculate the PD% ratio from the follo1ing: B/s.C %0uit Share Capital B/s. 5@ eachC /eserves and Surplus Secured (oans at 3:R 2nsecured (oans at 35.:R Fi+ed Assets Investments =perating Profit Income!ta+/ate:@R =perating Profit (ess: Interest on Secured (oans X 3:R 2nsecured (oans X 35.:R Profit before ta+ BP)&C (ess: Income!ta+ . :@R Profit aaer ta+ BPA&C No. o' ECuit0 /+#%&/ B/s.C 5:$@@$@@@ 7$<:$@@@ 3$5:$@@@ :$@@$@@@ 5@$@@$@@@ 3@$@@$@@@ 3@$@@$@@@ :@$@@$@@@ :$@@$@@@ 5:$@@$@@@ 3@$@@$@@@ 7@$@@$@@@ :$@@$@@@ 5:$@@$@@@$

5$:@$@@@

%PS

T A

Profit after ta/ ?o. of E9uit! shares -s. 3@$@@$@@@ -s. 5$:@$@@@ A -s. E

Mar"et price per share PD% /atio

T /s. :@ T Mar"et price per share D %PS T /s.:@D/s.8 T 35.:@

Illustration -: &he capital of 6ro1fast Co. (td.$ is as follo1s:

3@R Preference shares of /s.3@ each %0uit shares of /s. 3@@ each

:@$@@$@@@ <@$@@$@@@ 3$5@$@@$@@@

Additional information: Profit after ta+ at :@R Deprication %0uit dividend paid Mar"et price per e0uit share Calculate the follo1ing: BiC BiiC BiiiC BivC Solution: BiC &he cover for the Preference and %0uit dividends: Profit after ta/ A Preference dividend ) E9uit! dividend A -s. 3:$@@$@@@ /s. :$@@$@@@ U to <$@@$@@@ BiiC &he %arning Per Share: A ?et profit after preference dividend ?o. of E9uit! S"ares T /s. 3:$@@$@@@ /s. :$@@$@@@ /s.<$@@$@@@ BiiiC &he Price %arnings /atio: A Mar%et price per s"are T /s. 38.5? &he cover for the preference and e0uit dividends &he earnings per share &he price earnings ratio &he net funds flo1 /s. 3:$@@$@@@ /s. ;$@@$@@@ 3@R /s. 5@@

T 3.5: times

Earning per s"are A -s.>FF /s. 38.5? BivC &he *et Funds Flo1: B/s.C Profit after ta+ Add: Depreciation 3:$@@$@@@ ;$@@$@@@ 53$@@$@@@

T 38 times

LESSON-II
FUNDS FLO* ANAL9SIS

INTRODUCTION &he Profit and (oss account and )alance Sheet statements are the common important accounting statements of a business organisation. &he Profit and (oss account provides financial information relating to onl a limited range of financial transactions entered into during an accounting period and 1hich have impact on the profits to be reported. &he )alance Sheet contains information relating to capital or debt raised or assets purchased. )ut both the above t1o statements do not contain sufficientl 1ide range of information to ma"e assessment of organi-ation b the end user of the information. FUNDS FLO* ANAL9SIS In vie1 of recognised importance of capital inflo1s and outflo1s$ 1hich often involve large amounts of mone should be reported to the sta"eholders$ the funds flo1 statement is devised. &his statement is also called <Statement of Sources and application of funds< and <Statement of c"anges in financial position<. &he Funds flo1 statement contain all the details of the financial resources 1hich have became available during an accounting period and the 1a s in 1hich those resources have been used up. &his statement discloses the amounts raised from various sources of finance during a period and. then e+plains ho1 that finance has been used in the business. &his statement is valuable in interpretation of the accounts.

It is a ver useful tool in anal sis of finrncial statements 1hich anal ses the changes ta"ing place bet1een t1o balance sheet dates. &he statement anal ses the change bet1een 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 1hich funds have been raised against assets ac0uired$ b the use of those funds. A funds flo1 statement anal ses the changes 1hich have ta"en place in the assets and liabilities during certain period as disclosed b a comparison of the opening and closing balance sheets. Conc&5t o'JFun)Q &he term PfundL$ has been defined and interpreted differentl b different e+perts. )roadl $ the term IfundI refers to all the financial resources of the compan . ,o1ever$ the most acceptable meaning of the PfundL is <$or%ing capital<. Jor"ing Capital is the e+cess of Current Assets over Current fi (iabilities. Jhile attempting to understand the concept of funds Flo1 Anal sisS & 1e shali also abide b the popular definition of funds$ meaning 1or"ing capital. Conc&5t o' F$o&he Pflo1L of funds refer to transfer of economic values from one asset e0uit to another. Jhen <funds< mean 1or"ing capital$ flo1 of funds refers to movement of funds 1hich cause a change in 1or"ing capital of the organisation. &o identif a <flo$< of funds$ 1e have to understand the difference bet1een P Current& and P?on-Current& account

CLASSIFICATION OF !ALANCE S"EET ITEMS For preparation of funds flo1 statement$ the 1hole iterrs of the sheet is classified into the follo1ing four categories as sho1n in &able T#7$& 1: CLASSIFICATION OF !ALANCE S"EET ITEMS Li#7i$iti&/ 3. ?on-Current 6ia ilities %0uit Share Capital Preference Share Capital /eserves and Surplus Debentures (ong!term loans R/. A//&t/ ++. ?on-Current Assets (and )uildings Plant and Machiner (ess: Depreciation Furniture and Fittings .ehicles Patents ?on-Current 6ia ilities ++. ?on-Current Assets &rade Mar"s 6ood1ill Preliminar e+penses Profit and (oss ADc BDebit balanceC &otal BAC &otal BAC III. Current 6ia ilities &rade Creditors )an" =verdraft )ills Pa able Provisions against current liabilities WWW WWW WWW WWW WWW &otal BAC +G. Current Assets Inventories &rade Debtors )ills /eceivable Cash and )an" )alances (oans and Advances Investments &emporar C &otal B)C 6rand &otal BAU)C WWW WWW 6rand &otal BAU)C &otal B)C WWW WWW WWW WWW WWW WWW WWW WWW WWW WWW WWW WWW WWW WWW R/. WWW WWW WWW WWW WWW WWW

WWW WWW WWW WWW

&he e+cess of current assets over current liabilities is called $or%ing capital. &he e+cess of funds generated over funds outgo from non!current assets and non! current liabilities 1ill lead to increase or decrease in 1or"ing capital. &his can further be anal sed into increase or decrease in respective current assets and current liabilities. IDENTIFICATION OF JFLO* OF FUNDS A Iflo1I of funds ta"es place onl if a Current Account is involved. &o identif a flo1$ #ournalise the transaction$ identif the t1o accounts involved as ICurrentI and I*on!CurrentI and appl the 6eneral /ule.

6eneral /ule &ransactions 1hich involve onl Current Accounts do not result in a flo1. &ransactions 1hich involve onl *on!Current Accounts do not result in a flo1. &ransactions 1hich involve one Current Account and one *on!Current Account results in a flo1 of funds. 6%o'o%(#/ o' Fun)/ F$o- St#t&(&nt &he relationship bet1een sources and application of funds and its impact # on 1or"ing capital is e+plained in the format of Statement of Sources and Application of Funds given in &ables 5 and 7. T#7$& 2: 6ROFORMA OF STATEMENT OF SOURCES AND A66LICATION OF FUNDS Stage 3: Statement of Sources and Application of Funds of W]` (td.$ for the ear ended 73st March$ 5@@3. /s. +++ +++ +++ +++ +++ +++ +++ +++ +++

Fund from =perations Issue of Share Capital /aising of long!term loans /eceipts from partl paid shares$ called up Sales of non!current Bfi+edC assets *on!trading receipts$ such as dividends received Sale of Investments Blong!termC Decrease in Jor"ing Capital Bas per schedule of changes in 1.cC Tot#$

A55$ic#tion o% U/&/ o' Fun)/: Funds (ost in =perations /edemption of Preference Share Capital /edemption of Debentures /epa ment of long!term loans Purchase of non!current investments *on!trading pa ments Pa ments of dividends Pa ment of ta+

+++ +++ +++ +++ +++ +++ +++ +++

Increase in Jor"ing Capital Bas per schedule of changes in 1.cC Tot#$

+++ AAA

&he funds flo1 statement can also be presented in a vertical form$ 1herein all Sources are listed do1n$ totaled and then all Applications are listed at one place and totaled. &he totals should be the same$ the difference being the Increase or Decrease in Jor"ing Capital. ,o1ever$ the ,ori-ontal format is more commonl used. T#7$& 3: FORM OF FUNDS FLO* STATEMENT Fun)/ F$o- St#t&(&nt o' G9N Lt).< 'o% t+& 0&#% &n)&) 31R M#%c+< 2@@1 Sou%c&/ Funds from =perations Issue of Share Capital Issue of Debentures /aising of long!term loans /eceipts from partl paid R/. A55$ic#tion/ R/. +++ +++ +++ +++ +++ +++ +++ +++ +++ +++ AAA

+++ Funds lost in =perations +++ /edemption of Preference $ Share capital +++ /edemption of Debentures: +++ /epa ment of long!term loans +++ Purchase of non!current Bfi+edC assets +++ Purchase of long!term Investments +++ Purchase of long!term investments +++ Pa ment of Dividends +++ Pa ment of ta+Y *et Increase in Jor"ing Capital AAA

shares$ called up Sale of non!current Bfi+edC assets : *on!trading receipts such as dividends Sale of long!term Investments *et Decrease in Jor"ing

Capital

H?ote: Pa ment of dividend and ta+ 1ill appear as an application of funds onl 1hen these items are appropriations of profits and not current liabilities. STATEMENT OF C"ANGES IN *ORFING CA6ITAL

&his statement follo1s the Statement of Sources and Application$ of Funds. &he primar purpose of the statement is to e+plain the net change in Jor"ing Capital$ as arrived in Funds Flo1 Statement. In this statement$ all Current Assets and Current (iabilities are individuall listed. Against each of account$ the figure pertaining to that account at the beginning and at the end of the accounting period is sho1n. &he net change in its position is also sho1n. &he changes ta"ing place 1ith respect to each account should add up to e0ual the A net change in 1or"ing capital$ as sho1n b the Funds Flo1 Statement. A proforma of the Statement of changes in !Jor"ing Capital is being presented I belo1: Increase in current assets and decrease in current liabilities : &he

ac0uisition of current assets and repa ment of current liabilities 1ill result in funds outflo1. bills pa able etc. Decrease in current assets and increase in current liabilities: &he reduction in current assets e.g. stoc" or debtors balances 1ill result in release of funds to be applied else1here. Short!term funds raised during the period b an increase in the current liabilities li"e trade creditors$ ban" overdraft and ta+ dues$ means that these sources have lent more at the end of the ear than at the beginning. &he funds ma be applied to finance an increase in stoc"$ debtors etc or to reduce the amount o1ed to trade creditors$ ban" overdraft$

STATEMENT OF C"ANGES IN *ORFING CA6ITAL

T#7$& 4: 6ROFORMA OF STATEMENT OF ANAL9SIS OF C"ANGES IN *ORFING CA6ITAL &he relation bet1een Stage I and Stage II is given belo1 in the figure:

Stage + :

(ist the sources from 1hich capital has been derived during the accounting period$ and the 1a s in 1hich 1or"ing capital has been used up$ i.e. list the transactions 1hich cause 1or"ing capital to increase or decrease

Stage ++l :

Anal se the net increase or decrease in 1or"ing capital into changes in the constituent items i.e. stoc"$ debtors$ creditors and cash

&he basic rules in preparation of the funds flo1 statement is as follo1s: An increase in an asset over the ear is an application of funds. A decrease in an asset over the ear is a source of funds. A decrease in a liabilit over the ear is an application of funds. An increase in a liabilit over the ear is a source of funds.

SOURCES OF FUNDS &he funds inflo1 into the organisation 1ill come from the follo1ing sources:

Fun)/ G&n&%#t&) '%o( O5&%#tion/ During the course of trading activit A a compan generates revenueE mainl in the form of sale proceeds and paid out for costs. &he difference bet1een these t1o items 1ill be the amount of funds generated b the trading operations. ad#ustments: &he funds generated from business operations are aruved at after ma"ing the follo1ing

T#7$& 5: 6ROFORMA FOR COM6UTATION OF FUNDS GENERATED FROM O6ERATIONS Funds from operations can also be calculated b preparing Ad#usted Profit and (oss Account as follo1s: AD3USTED 6ROFIT AND LOSS ACCOUNT

T#7$& 6: 6ROFORMA OF AD3USTED 6ROFIT AND LOSS ACCOUNT 8otes : Depreciation on fi+ed assets or amortisation of intangible assets li"e preliminar e+penses$ patens$ good1ill etc.$ 1ritten off is charged$ against profit to reflect the use of fi+ed assets or 1ritten off of intangible asset. In$ these transactions there is no corresponding cash outla occurs and hence$ add bac" the amount charged against profit$ to arrive at the total funds generated from business operations.

&he Profit or (oss on sale of non!current assets Bfi+ed asses and long!term$ investmentsC is ad#usted to arrive at the true funds from operations. &he provision for ta+ made in the profit and loss account is to be added bac" to the reported profit &he actual amount paid as ta+ is to be sho1n as theI application of funds in the funds flo1 statement. &he provision for ta+$ if itI is sho1n in the balance sheet$ need not be considered for calculation of fundsS generated fro operations. An amount appropriated in the Profit and (oss account to1ards transfer to reserves or proposed dividend is to be added bac" to arrive at the funds generated from operation. &he actual amount paid as dividend is to be sho1n$ as application of funds in the funds flo1 statement. &he dividend proposed but a1aiting pa ment is a current liabilit in tie balance sheet. If this amount increases$ from one ear end to the ne+t$ the e+tra liabilit appears as a source of funds.

Fun)/ %#i/&) '%o( S+#%&/< D&7&ntu%&/ #n) Lon -t&%( Lo#n/ &he long!term funds in#ected into the business during the ear b issue of ne1 shares or debentures and b raising long!term loans. If an premium is collected$ that is also form part of funds raised from the above said sources of finance.

S#$& o' FiA&) A//&t/ #n) Lon -t&%( In.&/t(&nt/ An amount generated from sale of fi+ed assets or long!term investments is a source of funds. Jhile preparation of the funds flo1 statement the gross sale proceeds from sale is ta"en as source of funds. &his activit does not produce fresh funds$ but it releases funds used to finance the assets. An profit or loss arising from such sale is ad#usted in the funds generated from operations.

A66LICATION OF FUNDS &he use of funds in an organisation ta"e place in the follo1ing forms: 3. /epa&ment of Preference Capital or De!entures or 6ong-term 0e t: &his represents the application of organisationIs funds released from business through redemption of preference shares or debentures$ repa ment of long! term loans previousl made b the organisation. An reduction in %0uit capital is also ta"en as application of funds. 5. Purchase of "i.ed Assets or 1ong9term In'estments: &he funds used to purchase long!term assets are usuall the most significant application of fund during the ear. &his group includes capital e+penditures on land$ building plant and machiner $ furniture and fittings$ vehicles and long!term investments outside the business. 7. Distri!ution of Di'idends and Pa&ment of )a.es: &he dividends distributed to the shareholders and ta+ paid during the ear is the application of funds for the firm. 8. 1oss from #perations: (osses made in the trading activities use up th e funds. If costs e+ceed revenue$ a cash outflo1 1ill be e+perienced. &he ad#ustments are made as sho1n above in point BiC in the sources of funds$ Illustration 1: Calculate funds from operations 1ith the help of the follo1ing Profit and (oss ADc.

C#$cu$#tion o' 'un)/ '%o( o5&%#tion/

Illustration >: From the follo1ing Manufacturing$ &rading and Profit ' (oss Account of a compan $ calculate Funds from operations. M#nu'#ctu%in < T%#)in < 6%o'it : Lo// A55%o5%i#tion A2c

&he amount /s. 7:$@@@ is transferred to Ad#usted Profit and (oss aDc and the ta+ paid /s.5:$@@@ is sho1n on the applications side of the Funds Flo1 Statement Illustration 3: Follo1ing are the e+tracts from the )alance Sheets ofbaA compan !on t1o different dates 6#%ticu$#%/ P'( ADc Provision for &a+ation Proposed Dividends Additional Information 3C 5C &a+ Paid during the ear 5@@@ 5@@3 Dividends paid for the period 5@@@! 5@@3 /s. 5$:@@ /s. 3$@@@ 31-3-2@@@ /s. :@$@@@ 3@$@@@ :$@@@ 31-23-2@@1 /s. >@$@@@ 3:$@@@ 3@$@@@

=n the basis of the above information$ calculate PFunds from =perationsL ta"ing provision for ta+ and proposed dividend as BaC *on!current liabilities BbC Current liabilities. aC Provision for ta+ and proposed Dividend are ta"en as non!current liabilities Pro'ision for )a.ation A2c 6#%ticu$#%/ &o Income &a+ ADc Bta+ paidOC &o )alance cDd Bclosing balanceC 3<$:@@ R/. 6#%ticu$#%/ 5$:@@ ) balance bDd Bopening balanceC 3:$@@@ ) P'( ADc Bprovision made in the current earC Zbal.fig.[ 3<$:@@ R/. 3@$@@@ <$:@@

6#%ticu$#%/ &o Dividend ADc Bbeing

R/. 6#%ticu$#%/ 3$@@@ ) )alance bDd B=pening

R/. :$@@@

dividend paid during the earC &o balance cDd Bclosing balance 33$@@@ Ad;usted P : 1 A2c 6#%ticu$#%/ &o Provision for &a+ation ADc &o proposed Dividend &o )alance cDd Bclosing balance ?7$:@@

balanceC 3@$@@@ ) P'( ADc BProposed dividend for the current 33$@@@ ;$@@@

R/. 6#%ticu$#%/ <$:@@ ) )alance bDd Bopening balanceC ;$@@@ ) Funds from =perations Bbal. fig.C >@$@@@

R/. :@$@@@ 87$:@@

?7$:@@

Illustration 4: &he follo1ing information has been e+tracted from the )alance Sheets of a compan 6#%ticu$#%/ Machiner Accumulated Depreciation Profit and (oss Account 31/t D&c. 2@@@ >@$@@@ 7@$@@@ 5:$@@@ 31/t D&c. 2@@1 5$@@$@@@ 7:$@@@ 8@$@@@

&he follo1ing additional information is also available: BiC BiiC A machine costing /s. 5@$@@@ 1as purchased during the ear b issue of e0uit shares. =n 9anuar 3$ 5@@3$ a machine costing /s. 3:$@@@ B1ith an accumulated depreciation of /s.:$@@@C 1as sold for /s.<$@@@. Find out sourcesD application of funds. 6#%ticu$#%/ &o Machiner ADc &o )alance cDd R/. 6#%ticu$#%/ :$@@@ ) )alance bDd 7:$@@@ ) Ad#usted P'( ADC Bbalancing figureC 8@$@@@ 8@$@@@ R/. 7@$@@@ 3@$@@@

M#c+in&%0 A2c 6#%ticu$#%/ &o )alance bDd &o Share Capital &o Cash!Purchases Bbalancing figureC 2<15<@@@ Accu(u$#t&) D&5%&ci#tion A2c Particulars &o Accumulated Depreciation ADc &o Machiner ADc B(oss on saleC &o )alance cDd /s. Particulars /s. 5:$@@@ 5>$@@@ 3@$@@@ ) )alance bDd 7$@@@ ) 8@$@@@ 53<@@@ BiC 53<@@@ Funds from =perations R/. 6#%ticu$#%/ >@$@@@ ) cash BsalesC 5@$@@@ ) Accumulated depreciation 3$3:$@@@ ) Ad#usted P ' ( ADc B(oss on saleC ) )alance cDd R/. <$@@@ :$@@@ 7$@@@ 5$@@$@@@ 2<15<@@@

Bbal. fig.C

Purchase of machiner for /s.5@$@@@ b issue of e0uit shares is neither a source nor an application of funds.

BiiC BiiiC

Sale of machiner for /s.<$@@@ is a source of funds$ Purchase of machiner for /s.3$3:$@@@ for cash is an application of funds$ BivC Funds from operations of /s.5>$@@@ is a source of funds.

Illustration 5: From the follo1ing information$ ou are re0uired to ascertain the amount of flo1 of funds on account of Plant. /s. 3$75$:@@ 3$?<$:@@

=pening )alance of Plant Closing )alance of Plant

Provision for Depreciation on Plant at the beginning of the ear Provision for Depreciation on Plant at the end of the ear

8:$@@@ ;3$@@@

During the ear$ a plant costing /s. ;:$@@@ 1as purchased in e+change for full paid debentures. An old Plant costing /s. 8@$@@@ 1as sold for /s.78$@@@. Depreciation provided on the same amounted to /s.3>$@@@.

Accu(u$#t&) D&5%&c#tion A2c Particulars &o Machiner ADc BDepn. of sold MachineC &o Closing balance cDd /s. Particulars /s. 8$58$@@@ 5<$@@@

8@$@@@ ) )alance bDd 8$33$@@@ ) Ad#usted P'( ADc B)alancing FigureB ZDepn. provided during the ear[ 4<51<@@@

4<51<@@@

Illustration - : %+tracts from )alance Sheets 6#%ticu$#%/ A/ on 31/t M#%c+< 2@@@ /s. 8$@@$@@@ 5$@@$@@@ A/ on 31/t M#%c+ 2@@1 /s. :$@@$@@@ 3$:@$@@@

%0uit from )alance Sheets >R Preference Share Capital Additional Information : BiC BiiC

%0uit shares 1ere issued during the ear against purchase of machiner for /s.:@$@@@. >R Preference shares 1orth /s. 3$@@$@@@ 1ere redeemed during the ear.

Prepare necessar accounts to find out sourcesDapplications of funds.

ECuit0 S+#%& C#5it#$ A2c Particulars &o Machiner ADc BDepn. of sold MachineC &o Closing balance cDd /s. Particulars /s. 8$58$@@@ 5<$@@@

8@$@@@ ) )alance bDd 8$33$@@@ ) Ad#usted P'( ADc B)alancing FigureB ZDepn. provided during the ear[ 4<51<@@@

4<51<@@@

ECuit0 S+#%& C#5it#$ A2c Particulars &o )alance cDd /s. Particulars /s. 8$@@$@@@ :@$@@@ Bbalancing :@$@@@ 5<@@<@@@ :$@@$@@@ ) )alance bDd ) Machiner ADc ) 5<@@<@@@ 3I Preference S"are Capital A=c Particulars &o cash BApplicationC &o )alance cDd /s. Particulars /s. 5$@@$@@@ Bbalancing :@$@@@ 3$@@$@@@ ) )alance bDd 3$:@$@@@ ) Cash!Issue Cash!Issue

figureC

figureC 2<5@<@@@ 3. 5. 7. Issue of e0uit shares purchase of machiner 2<5@<@@@ is neither a source nor

application of funds. Issue of shares 1orth /s.:@$@@@ for cash is a source of funds. /edemption of preference shares 1orth /s.3$@@$@@@ is an application of funds.

8.

Issue of preference shares of /s. :@$@@@ is a source of funds.

Illustration , : Prepare a statement sho1ing changes in 1or"ing capital 6#%ticu$#%/ Assets Cash Debtors Stoc" (and Tot#$ Capital ' (iabilities Share Capital Creditors /etained earnings Tot#$ 2@@@ ;@$@@@ 5$8@$@@@ 3$;@$@@@ 3$@@$@@@ 5<6@<@@@ 8$@@$@@@ 3$8@$@@@ 5@$@@@ 5<6@<@@@ 2@@1 ?8$@@@ 5$7@$@@@ 3$>@$@@@ 3$75$@@@ 6<36<@@@ :$@@$@@@ ?@$@@@ 8;$@@@ 6<36<@@@

St#t&(&nt /+o-in c+#n &/ in -o%8in c#5it#$ 6#%ticu$#%/ Cu%%&nt A//&t/ Cash Debtors Stoc" 2@@@ 2@@1 Inc%&#/& :E; ;@$@@@ 5$8@$@@@ 3$;@$@@@ 4<6@<@@@ ?8$@@@ 5$7@$@@@ 3$>@$@@@ 5<@4<@@@ 78$@@@ 3@$@@@ 5@$@@@ D&c%&#/& :-;

Cu%%&nt Li#7i$iti&/ Creditors Jor"ing Capital BCA!C(C *et increase in Jor"ing Capital

3$8@$@@@ 7$5@$@@@ ?8$@@@ 8$38$@@@

?@$@@@ 8$38$@@@

:@$@@@ ?8$@@@

8$38$@@@

3$@8$@@@

3$@8$@@@

Illustration 1< : Follo1ing are summerised )alance Sheets PWL (td. as on 73 st December$ 5@@@ and 5@@3. ]ou are re0uired to prepare a Funds Statement for the ear ended 73st December$ 5@@3.
1ia!ilities Share Capital %<<< 3$@@$@@@ %<<1 3$5:$@@@ Assets 6ood1ill %<<< %<<1 5$:@@

6eneral /eserve P'( ADc )an" (oan B(ong!termC Creditors Provision for &a+

5:$@@@ 3:$5:@ 7:$@@@ <:$@@@ 3:$@@@ 2<65<25@

7@$@@@ 3:$7@@ ;<$;@@ ! 3<$:@@ 2<55<4@@

)uildings Plant Stoc" Debtors )an" Cash

3$@@$@@@ <:$@@@ :@$@@@ 8@$@@@ ! 5:@ 2<65<25@

?:$@@@ >8$:@@ 7<$@@@ 75$3@@ 8$@@@ 7@@ 2<55<4@@

A))ition#$ In'o%(#tion: BiC BiiC BiiiC Dividend of /s. 33$:@@ 1as paid. Depreciation 1ritten off on plant /s.<$@@@ and on buildings /s.:$@@@. Provision for ta+ 1as made during the ear /s. 3;$:@@.

St#t&(&nt /+o-in C+#n &/ in *o%8in C#5it#$ Particulars Current Assets Cash )an" Debtors Stoc" %<<< %<<1 Increase =$ 5:@ ! 8@$@@@ :@$@@@ ?@$5:@ Cu%%&nt Li#7i$iti&/ Creditors Jor"ing Capital BCA ! C(C *et increase in Jor"ing 3:$5:@ >$3:@ <7$8@@ <7$8@@ :>$3:@ <7$8@@ <?$@:@ <?$@:@ <:$@@@ 7@@ 8$@@@ 75$3@@ 7<$@@@ <7$8@@ ! <:$@@@ ! :@ 8$@@@ <$?@@ 37$@@@ Decrease 9$

Capital

Funds Flo$ Statement Sou%c&/ /s. A55$ic#tion R/.

Funds from operations Issue of Shares ,an" (oan

8:$@:@ 5:$@@@ 75$;@@

Purchase of Plant Income ta+ paid Dividend paid 6ood1ill paid *et increase in Jor"ing Capital

3;$:@@ 38$@@@ 33$:@@ 5$:@@ :>$3:@ 1<@2<65@

1<@2<65@

Bor%ing ?otes: S+#%& C#5it#$ A2c Particulars &o )alance cDd /s. 3$5:$@@@ Particulars ) )alance bDd ) )an" aDc 1<25<@@@ /s 3$@@$@@@ 5:$@@@ 1<25<@@@

G&n&%#$ R&/&%.& A2c Particulars &o )alance cDd /s. 7@$@@@ Particulars ) )alance bDd ) P'( aDc 3@<@@@ /s. 5:$@@@ :$@@@ 3@<@@@

6%o.i/ion 'o% T#A#tion A2c Particulars &o )an" aDc &o )alance cDd /s. 38$@@@ 3<$:@@ 31<5@@ Particulars ) )alance bDd ) P'( aDc /s. 3:$@@@ 3;$:@@ 31<5@@

!#n8 Lo#n A2c Particulars &o )alance cDd R/. ;<$;@@ 6=<6@@ Particulars ) )alance bDd ) )an" aDc R/. 7:$@@@ 5$;@@ 6=<6@@

L#n) #n) !ui$)in A2c Particulars &o )alance cDd R/. 3$@@$@@@ ) Particulars Depreciation aDc R/. :$@@@

BP'( aDcC ) )alance cDd 1<@@<@@@ 6$#nt A2c Particulars &o )alance cDd R/. <:$@@@ ) Particulars Depreciation aDc R/. <$@@@ ?:$@@@ 1<@@<@@@

BP'( aDcC &o )an" 3;$:@@ ?1<5@@ ) )alance cDd >8$:@@ ?1<5@@

Goo)-i$$ A2c Particulars &o )an" R/. 5$:@@ 2<5@@ Particulars ) )alance cDd R/. 5$:@@ 2<5@@

C#$cu$#tion o' Fun)/ '%o( O5&%#tion/: :R/.; )alance of P'( aDc B5@@3C Add: *on!fund and non!operating items

1hich have alread debited to P'( aDc: 6eneral reserve Provision for ta+ Dividends paid Depreciation: =n )uildings =n Plant 6ess: )alance of P'( aDc B5@@@C Fun)/ '%o( O5&%#tion/

:$@@@ 3;$:@@ 33$:@@ :$@@@ <$@@@ 8:$@@@ ;@$7@@ 3:$5:@ 8:$@:@

Illustration 11: From the follo1ing )alance Sheets of A)C (td. on 73 st Dec. 5@@@ and 5@@3$ ou are re0uired to prepare BiC A Schedule of changes in 1or"ing capital$ BiiC A Funds Flo1 Statement. B/s.C
1ia!ilities Share Capital 6eneral /eserve P'( ADc Creditors )ills pa able Provision for &a+ Provision for doubtful debts Cash ' )an" balances 3<11<2@@ 3<11<6@@ 3<11<2@@ 3<11<6@@ 37$5@@ 7@$8@@ %<<< 5$@@$@@@ 5>$@@@ 75$@@@ 3;$@@@ 5$8@@ 75$@@@ >@@ %<<1 Assets %<<< 58$@@@ >@$@@@ <8$@@@ 5@$@@@ ;@$@@@ 8$@@@ 7;$@@@ %<<1 58$@@@ <5$@@@ <5$@@@ 55$@@@ 8;$>@@$ ;$8@@ 7 >$@@@

5$@@$@@@ 6ood1ill 7;$@@@ )uildings 5;$@@@ Plant 3@$>@@ Investments 3$;@@ Stoc" 7;$@@@ )ills receivable 3$5@@ Debtors

Additional Information: BiC BiiC BiiiC Depreciation provided on plant 1as /s.>$@@@ and on )uildings /s.>$@@@ Provision for ta+ation made during the ear /s.7>$@@@ Interim dividend paid during the ear /s. 3;$@@@. Particulars %<<< 2@@1 Increase in Decrease

St#t&(&nt /+o-in C+#n &/ in *o%8in C#5it#$

>.C. Current Assets Cash ' )an" )alances Debtors )ills /eceivable Stoc" Cu%%&nt Li#7i$iti&/ Provision for doubtful debts )ills Pa able Creditors Jor"ing Capital BCA ! C(C 3?$5@@ ?8$@@@ Increase Capital 1<@><@@@ 1<@><@@@ 2=<6@@ in Jor"ing 38$@@@ 37$;@@ 3$@>$@@@ 37$5@@ 7;$@@@ 8$@@@ ;@$@@@ 3$37$5@@ >@@ 5$8@@ 3;$@@@ 7@$8@@ 7>$@@@ ;$8@@ 8;$>@@ 3$53$;@@ 3$5@@ 3$;@@ 3@$>@@ >@@ :$5@@ 15>FF 5$@@@ 5$8@@

in >.C.

37$5@@

8@@

38$@@@ 2=<6@@

Fun)/ F$o- St#t&(&nt

Sou%c&/ Funds from operations /s. <5$@@@ A55$ic#tion Purchase of Plant &a+ paid Purchase of investments Interim dividend paid Increase in Jor"ing Capital =2<@@@ /s. ;$@@@ 78$@@@ 5$@@@ 3;$@@@ 38$@@@ =2<@@@

Bor%ing ?otes: Provision for :a/ation A=c Particulars &o )alance cDd &o )alance cDd /s. 7;$@@@ 7;$@@@ =@<@@@ Plant A=c Particulars &o )alance cDd &o )alance BPurchaseC /s. Particulars /s: >$@@@ <5$@@@ >@<@@@ Particulars ) P'( aDc ) P'( aDc /s: 75$@@@ 5>$@@@ =@<@@@

<8$@@@ ) Depreciation ;$@@@ ) )alance cDd >@<@@@ 4uildings A=c

Particulars &o )alance cDd

/s.

Particulars

/s: >$@@@ <5$@@@ >@<@@@

>@$@@@ ) Depreciation ) )alance cDd >@<@@@

In.&/t(&nt/ A2c Particulars &o )alance bDd /s. Particulars /s. 55$@@@

5@$@@@ ) )alance cDd

&o )an" BPurchaseC

5$@@@ 22<@@@ 22<@@@

A)Ku/t&) 6%o'it H Lo// A2c Particulars &o *on!fund and *on!operating items alread debited to P'( aDc: &ransfer to 6eneral /eserve Provision for &a+ Depreciation on Plant Depreciation on )uildings Interim dividend &o )alance on 7 3!3 5!5@@3 >$@@@ 7>$@@@ >$@@@ >$@@@ 3;$@@@ 5;$@@@ 1<@4<@@@ #eneral -eserve A=c Particulars &o )alance cDd /s. 7;$@@@ Particulars ) )alance ) P'( aDc 36<@@@ /s. 5>$@@@ >$@@@ 36<@@@ 1<@4<@@@ /s. ) Particulars )alance on B73!35!5@@C ) /s. 75$@@@ <5$@@@

Funds from operations

Illustration 1%: From the follo1ing )alance Sheet of W (td.$ as on 73 st December$ 5@@@ and 73st December 5@@3$ ou are re0uired to prepare a funds O flo1 statement. B/s.C
1ia!ilities Share Capital 6eneral /eserve P'( ADc )an" (oan B(ong termC %<<< 8$@@$@@@ >@$@@@ ;8$@@@ 7$5@$@@@ %<<1 Assets %<<< 8$@@$@@@ 7$;@$@@@ 5$@@$@@@ 3$;@$@@@ %<<1 8$>@$@@@ 5$;@$@@@ 5$:5$@@@ 3$5>$@@@

:$@@$@@@ (and and )uildings 3$8@$@@@ Machiner <>$@@@ Stoc" >@$@@@ Debtors

Creditors Provision for &a+ation

7$@@$@@@ ;@$@@@ 35$58$@@@

5$;@$@@@ Cash at )an" >@$@@@ 33$7>$@@@

3$@8$@@@

3>$@@@

35$58$@@@

33$7>$@@@

Additional Information : BiC BiiC During the ear ended 73st December 5@@ dividend of /s.>8$@@@ 1as paid. Assets of another compan 1ere purchased for a consideration of /s. 3$@@$@@@ pa able b the issue of shares. &he assets included (and! I and )uildings of /s.:@$@@@ and stoc" of /s.:@$@@@. BiiiC Depreciation 1ritten off on machiner is /s.58$@@@ and on (and and <. )uildings is /s.8:$@@@. BivC BvC Income!ta+ paid during the ear 1as /s.<@$@@@. Additions to )uildings 1ere for /s.<:$@@@.

St#t&(&nt /+o-in C+#n &/ in *o%8in C#5it#$ Particulars Current Assets Cash at )an" Debtors Stoc" Current (iabilities Creditors Jor"ing Capital 3$;8$@@@ 3$;8$@@@ Decrease capital in 1or"ing 5;$@@@ 3$7>$@@@ 3$7>$@@@ 5;$@@@ 3$@8$@@@ 3$;@$@@@ 5$@@$@@@ 8$;8$@@@ 7$@@$@@@ 3>$@@@ 3$5>$@@@ 5$:5$@@@ 7$?>$@@@ 5$;@$@@@ 8@$@@@ :5$@@@ >;$@@@ 75$@@@ %<<< %<<1 Increase in >.C. Decrease in >.C.

3$;8$@@@

3$;8$@@@

3$3>$@@@

3$3>$@@@

Funds Flo$ Statement for t"e !ear ending 11st 0ec. >FF1 Sou%c&/ Issue of Shares Sale of Machiner Funds from operations Decrease in Jor"ing Capital 4<6?<@@@ 4<6?<@@@ /s. A55$ic#tion /s. <:$@@@ 5$8@$@@@ >8$@@@ <@$@@@

:@$@@@ Purchase =f (and ' )uildings <;$@@@ )an" (oan paid 7$3<$@@@ Dividend paid 5;$@@@ Income!ta+ paid

>orking 8otes: 6%o.i/ion 'o% T#A#tion A2c Particulars &o Cash &o )alance bDd /s. Particulars /s. ;@$@@@ ?@$@@@ 1<5@<@@@

<@$@@@ ) )alance bDd >@$@@@ ) Ad#. P'( aDc 1<5@<@@@

M#c+in&%0 A2c 6and and 4uildings A=c Particulars &o )alance bDd /s. Particulars /s. 58$@@@ <;$@@@ 5$;@$@@@ 3<6@<@@@

7$;@$@@@ ) Ad#. P'( aDc ) Sale of Machiner ) )alance cDd 3<6@<@@@ 6and and 4uildings A=c

Particulars &o )alance bDd &o Share Capital &o Cash

/s.

Particulars

/s. 8:$@@@ 8$>@$@@@ 5<25<@@@

8$@@$@@@ ) Ad#. P'( aDc :@$@@@ ) )alance cDd <:$@@@ 5<25<@@@

G&n&%#$ R&/&%.& A2c Particulars &o )alance cDd /s. Particulars /s. >@$@@@ ;@$@@@ 1<4@<@@@

3$8@$@@@ ) )alance bDd ) Ad#. P'( aDc 1<4@<@@@

A)Ku/t&) 6%o'it H Lo// A2c Particulars &o Machiner &o (and ' )uildings &o Provision for ta+ &o 6eneral /eserve &o Dividends paid &o Closing balance /s. Particulars ;8$@@@ from 7$3<$@@@ /s.

58$@@@ ) =pening )alance 8:$@@@ ) ?@$@@@ ;@$@@@ >8$@@@ <>$@@@ 3<>1<@@@ Funds

=perations

3<>1<@@@

FUNDS FLO* STATEMENT 4/. 6ROFIT AND LOSS ACCOUNT Follo1ing are the main differences bet1een a Funds Flo1 Statement and a Profit and (oss Account: 1. #!;ecti'e: &he main ob#ective of preparing a Funds Flo1 Statement is to ascertain the funds generated from operations. &he statement reveals the sources of funds and their uses. &he main ob#ective of preparing a Profit and (oss Account is to ascertain the net profit earnedD loss incurred b the compan out of the business operations at the end of a particular period. 2. 4asis: &he Funds Flo1 Statement is prepared based on the financial statements of t1o conse0uent ears. A Profit and (oss Account is prepared on the basis of nominal accounts. 3. Dsefulness: &he Funds Flo1 Statement is useful for creditors and management. &he Profit and (oss Account is useful not onl to creditors and management but also to the shareholders and outside parties. 4. :!pe of 0ata Dsed: &he Funds Flo1 Statement ta"es into account onl the funds available from trading operations but also the funds available from other sources li"e issue of share capitalD debentures$ sale of fi+ed assets etc. Jhereas$ the Profit and (oss Account uses onl income and e+penditure transactions relating to trading operations of a particular period. !r instan"e, #$en s$ares are issue% &!r "as$, t$e same is s$!#n in &un%s &l!# statement as a s!ur"e !& &un%s #$ereas in 'r!&it an% l!ss a""!unt it is n!# s$!#n as in"!me. 5. 6egal ?ecessit!: Preparation of Funds Flo1 Statement is not a statutor obligation and is left to the discretion of management. Preparation of ProfitI and (oss Account is a statutor obligation. FUNDS FLO* STATEMENT 4/. !ALANCE S"EET

Follo1ing are the main difference bet1een a Funds Flo1 Statement and a )alance Sheet. 3. #!;ecti'e: &he Funds Flo1 Statement is prepared to "no1 the total sources and their uses in a ear. )alance Sheet is prepared to "no1 the financial position of a compan as on a particular date. 5. *asis: &he Funds Flo1 Statement is prepared 1ith the help of the balance sheets of t1o consecutive ears. &he )alance Sheet is prepared oh the basis of different accounts in the ledger. 7. ?sefulness: Funds Flo1. Statement is useful for the management for internal financial management. A )alance Sheet is useful not onl for the management but also to the shareholders$ creditors$ outsiders and 6overnment agencies etc. 8. )reatment of Current Assets and Current 1ia!ilities: In Funds Flo1

Statement current assets and current liabilities are used to find out increase or decrease in 1or"ing capital. In )alance Sheet$ current assets and current liabilities are sho1n item1ise. :. 1egal 8ecessit&: Preparation of Funds Flo1 Statement is at the discretion of management. Preparation of )alance Sheet is a statutor obligation. USES OF FUNDS FLO* STATEMENT B3C To )&t&%(in& 'in#nci#$ con/&Cu&nc&/ o' o5&%#tion/: Funds Flo1 Anal sis determines the financial conse0uences of business operations. In the follo1ing cases$ Funds Flo1 Anal sis helps the management to understand the movement of funds and in effective funds management: Man a time$ a compan inspite of earning large profits ma have unsatisfactor li0uidit position. &he reasons for such a position and the financial conse0uences of business operations can be ascertained 1ith the help of funds flo1 statement.

&he compan ma be incurring losses but its li0uidit position is sound or the firm 1ill be investing in fi+ed Assets despite losses.

&he firm ma declare dividend inspite of losses or lo1 profits.

&he profit earned b the firm from different sources is not easil understood b the management.

&here ma

be sufficient cash in the business. )ut ho1 such high

li0uidit is e+isting is not "no1n. To 'i$$ 'in#nci#$ 7$in) /5ot/ : &he Funds Flo1 Statement is designed to fill financial blind spots of the operating statement. It translates the economic conse0uences of operations into financial information as a basis for action. B5C *o%8in c#5it#$ uti$i/#tion: &he Funds Flo1 Statement helps the used to the ma+imum e+tent in

management in assessing the activit of 1or"ing capital and 1hether the 1or"ing capital has been effectivel business operations or not. &he statement also depicts the surplus or deficit in 1or"ing capital than re0uired. &his helps the management to use the surplus 1or"ing capital profitabilit or to locate the sources of additional 1or"ing capital in case of scarcit . B7C To #i) in /&cu%in n&- 'in#nc&/: A statement of changes in financial position is useful for the creditor in considering the compan Is re0uest for ne1 term loan. B8C ,elps in allocation of financial resources: Funds Flo1 Statement helps the management in ta"ing decisions regarding allocation of the limited financial resources among different pro#ects on priorit basis. B:C "&$5/ in )&ci)in t+& u% &nc0 o' # 5%o7$&(: Funds Flo1 Anal sis helps to relate the time factor to financial planning. &his enables the management to

identif critical points throughout the passage of time. &he management as also the outsiders concern themselves 1ith the information s stem geared upA to1ards changes in financial position as the behaviour of funds flo1 figures relates to the criteria upon 1hich management strateg is based. B;C "&$5/ in &.#$u#tion o' o5&%#tion#$ i//u&/: &he statement of changes functions as an anal tical guide for evaluating operational issues. &he statement enables the management to ascertain in 1hich the stud of trends of success or failure of operations and available resources. DRA*!ACFS OF FUNDS FLO* ANAL9SIS @istorical nature: &he funds flo1 statement is historical in nature li"e an other financial statement. It does not estimate the sources and application of funds for the near future. Structural changes are not disclosed: &he funds flo1 statement does not disclose the structural changes in financial relationship in a firm not it discloses the ma#or polic changes 1ith regard to investment in current assets and short term financing. Significant additions to inventories financed b short term creditors are not furnished in the statements as the are offset b each other 1hile computing net changes in 1or"ing capital. 8ew items are not disclosed: &he funds flo1 statement does not disclose an ne1 or original items 1hich affect the financial position of the business. &he funds flo1 statement simpl rearranges the data given in conventional financial statements and schedules. 8ot rele'ant: A stud of changes in cash is more relevant than a stud of changes in funds for the purpose of managerial decision!ma"ing. 8ot foolproof: &he funds flo1 statement is prepared from the data provided in the balance sheet and profit and loss account. ,ence$ the defects in financial statements 1ill be carried over to funds flo1 statement also.

LESSON-12
CAS" FLO* ANAL9SES
INTRODUCTION Cash flo1 statement provides information about the cash receipts and pa ments of a firm for a given period. It provides important information that compliments the profit and loss account and balance sheet. &he information about the cash!flo1s of a firm is useful in providing users or financial statements 1ith a basis to assess the abilit of the enterprise to generate cash and cash e0uivalents and the needs of the enterprise to utilise these cash flo1s. &he economic decisions that are ta"en b users re0uire an evaluation of the abilit of an enterprise to generate cash and cash e0uivalents and the timing and certainl of their generation. &he statement deals 1ith the provision of information about the historical changes in cash e0uivalents of an enterprise b means of a cash flo1 statement 1hich classifies cash flo1s during the period from operatingC investing and financing activities. M&#nin o' c&%t#in T&%(/ Cash comprises cash on hand and demand deposit 1ith ban"s.

Cash e0uivalents are short!term$ highl li0uid investments that are readil convertible into "no1n amounts of cash and 1hich are sub#ect to an insignificant ris" of changes in value. %+amples of cash e0uivalents are$ treasur bills$ commercial paper etc.

Cash flo1s are inflo1s and outflo1s of cash and cash e0uivalents. It means the movement of cash into the organisation and movement of cash out of the organisation. &he difference bet1een the cash inflo1 and outflo1 is "no1n as net cash flo1 1hich can be either net cash inflo1 or net cash outflo1.

C$#//i'ic#tion o' c#/+ '$o-/

&he cash flo1 statement during a period is classified into three main categories of cash inflo1s and cash outflo1s:

C#/+ '$o-/ '%o( O5&%#tin #cti.iti&/:

=perating activities are the principal revenue!producing activities of the enterprise and other activities that are not investing and financing activities. =perating activities include cash effects of those transactions and events that enter into the determination of net profit or loss. Follo1ing are e+amples of cash flo1s from operating activities: Cash receipts from the sale of goods and the rendering of services Cash receipts from ro alties$ fees$ commissions$ and other revenue Cash pa ment to suppliers for goods and services Cash pa ments to and on behalf of emplo ees Cash receipts and pa ments of an insurance enterprise for premiums and claims$ annuities and other polic benefits Cash pa ments or refunds of income!ta+es unless the can be specificall identified 1ith financing and investing activities. Cash receipts and pa ments relating to future contracts$ for1ard contracts$ option contracts$ and s1ap contracts 1hen the contracts are held for dealing or trading purpose etc.$

C#/+ F%o( O5&%#tion/ Funds from =perations Bas learnt in the previous chapterC Add: Increase in Current (iabilities Be+cluding )an" =verdraftC Decrease in Current Assets Be+cluding cash ' ban" balanceC +++ (ess: Increase in Current Assets Be+cluding cash ' ban" balanceC Decrease in Current (iabilities Be+cluding ban" overdraftC Cash from =perations Cash Flo1s from Investing Activities: +++ +++ +++ +++ +++ +++ +++ +++

Investing activities are the ac0uisition and disposal of long!term assets and other investments not included in cash e0uivalents. In other 1ords$ investing activities include!transactions and events that involve the purchase and sale of long!term productive assets$ Be.g.$ land$ building$ plant and machiner $ etcC not held for re sale and other investments. &he follo1ing are e+amples of cash flo1s arisingY from investing activities: Cash pa ments to ac0uire fi+ed assets Bincluding intangiblesC. A

&hese pa ments include those relating to capitalised research and development costs and self!constructed fi+ed assets.

Cash receipts from disposal of fi+ed assets Bincluding intangiblesC

Cash pa ments to ac0uire shares$ 1arrants$ or debt instruments of other enterprises and interests in #oint ventures Bother than pa ments for those

instruments considered to be cash e0uivalents and those held for dealing or trading purposesC Cash receipts from disposal of shares$ 1arrants$ or debt instruments of other enterprises and interests in #oint ventures Bother than receipts from those instruments considered to be cash e0uivalents and those held for dealing or trading purposesC Cash advances and loans made to third parties Bother than advances and loans made b a financial enterpriseC Cash receipts from the repa ment of advances and loans made to third parties Bother than advances and loans of a financial enterpriseC Cash receipts and pa ments relating to future contracts$ for1ard contracts$$ option contracts$ and s1ap contracts e+cept 1hen the contracts are$ held for dealing or trading purposes$ or the receipts are classified as financing activities. C#/+ F$o-/ '%o( Fin#ncin Acti.iti&/:

Financing activities are activities that result in changes in the si-e and composition of the o1nersL capital Bincluding preference share capital in the case of a compan C and borro1ings of the enterprise. Follo1ing are the e+amples of cash flo1s 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 borro1ing Cash repa ments of amounts borro1ed Pa ment of dividend

Information re0uired for Cash Flo1 Statement

T+& 'o$$o-in 7#/ic in'o%(#tion i/ n&&)&) 'o% t+& 5%&5#%#tion o' # c#/+ '$o/t#t&(&nt:

Comparative )alance Sheets: )alance Sheets at the beginning and at the end of the accounting period indicate the amount of changes that have ta"en place in assets$ liabilities and capital. Profit and (oss Account : &he profit and loss account of the current period enables to determine the amount of cash provided b or used in operations during the accounting period after ma"ing ad#ustments for non!cash$ current assets and current liabilities. Additional Data: In addition to the above statements$ additional data are collected to determine ho1 cash has been provided or used e.g.$ Sale or purchase of assets for cash.

C#/+ F$o- St#t&(&nt o' G9N Lt). 'o% t+& 0&#% &n)in 31R M#%c+ 2@@1 Source =pening )alances Cash )an" Cash Inflo1s Cash from =perations Issue of Shares /aising of (ong &erm (oansDDebentures /s. Application =pening )alances WWW )an" overdraft WWW Cash outflo1s /edemption of /edeemable WWW WWW WWW WWW WWW WWW WWW GGG R/.

Preference Shares WWW /edemption of Debentures WWW /epa ment of (oans *on =perating %+penses WWW Closing )alances

Sale of Fi+ed Assets and WWW Cash Investments *on &rading /eceipts WWW )an" GGG

Not& : &he Cash Flo1 Statement can also be presented in the vertical form. ,o1ever$ the hori-ontal form given above is convenient and is more commonl used. Fun)/ F$o- St#t&(&nt ./. C#/+ F$o- St#t&(&nt )oth funds flo1 and cash flo1 statements are used in anal sis of past transactions of a business firm. &he difference bet1een these t1o statements are given belo1: Funds flo1 statements is based on the accrual accounting s stem. In case of preparation cash flo1 statements all transactions effecting the cash or cash e0uivalents is onl ta"en into consideration. Funds flo1 statement anal sis the sources and application of funds of long! term nature and the net increase or decrease in long!term funds 1ill be reflected on the 1or"ing capital of the firm. &he cash flo1 statement 1ill onl consider the increase or decrease in current assets and currentI liabilities in calculating the cash flo1 of funds from operations. Funds Flo1 anal sis is more useful for long range financial planning. Cash flo1 anal sis is more useful for identif ing and correcting die current li0uidit problems of the firm.

Funds flo1 statement anal sis is a broader concept$ it ta"es into account both long!term and short!term funds into account in anal sis. )ut cash flo1 statement onl deal 1ith the one of the current assets on balance sheet assets side.

Funds flo1 statement tallies the funds generated from various sources 1ith various uses to 1hich the are put. Cash flo1 statements Start 1ith the opening balance of cash and reach to the closing balance of cash b proceeding through sources and uses.

I$$u/t%#tion: 1 From the follo1ing information$ ou are re0uired to ascertain cash flo1 operation

Particulars *et Profit Debtors )ills /eceivable Creditors )ills pa able Stoc"

(1.1%.%<<< 85$@@@ >$@@@ 8<$@@@ 3:$@@@ 5><@@@

(1.1%.%<<1 <@$@@@ 8@$@@@ 37$@@@ :@$@@@ 3@$@@@ 65<@@@

C#$cu$#tion o' C#/+ '%o( o5&%#tion/ Profit made during the ear Add: Decrease in debtors Increase in Creditors (ess: Increase in )ill /eceivable Increase in stoc" Z Decrease in )ills pa able Cash from operations I$$u/t%#tion: 2 From the follo1ing balances$ ou are re0uired to calculate cash from operations: Particulars Debtors )ill /eceivable Creditors )ills Pa able =utstanding %+penses Prepaid %+penses Accrued Income Income /eceived in Advance Profit made during the ear Decem!er Decem!er (1 (1 %<<< :@$@@@ 3@$@@@ 5@$@@@ >$@@@ 3$@@@ >@@ ;@@ 7@@ ! %<<1 8<$@@@ 35$:@@ 5:$@@@ ;$@@@ 35@@ <@@ <:@ 5:@ 3$7@$@@@ 5$@@@ 7$@@@ :$@@@ <$@@@ :$@@@ 3<$@@@ 5><@@@ :$@@@ =5<@@@ <@$@@@

C#$cu$#tion o' C#/+ '%o( o5&%#tion/ Profit made during the ear Add: Decrease in debtors Increase in Creditors Increase in =utstanding %+penses Decrease in Prepaid %+penses (ess: Increase in )ill /eceivable Increase in Accrued Income Decrease in )ills Pa able Decrease in Income /eceive in Advance C#/+ '%o( O5&%#tion/ 5$:@@ 3:@ 5$@@@ :@ 3$7@$@@@ 7$@@@ :$@@@ 5@@ 3@@ 1<3><@@@

8$<@@ 1<33<6@@

I$$u/t%#tion: 3 From the follo1ing information$ calculate cash from operations Particulars P'(ADc BcreditC Debtors )ills /eceivable Prepaid /ent Prepaid Insurance 6ood1ill Depreciation Creditors %<<< 8@$@@@ 5@$@@@ 5@$@@@ 5$@@@ 3$@@@ 5@$@@@ 75$@@@ 5@$@@@ St#t&(&nt /+o-in C#/+ '%o( o5&%#tion/ Closing balance P'( ADc Add: Decrease in )ill /eceivable Decrease in Prepaid Insurance Increase in Creditors Depreciation 6ood1ill (ess: Increase in debtors Increase in prepaid rent =pening balance of P'( ADc C#/+ '%o( O5&%#tion/ I$$u/t%#tion: 4 From the follo1ing balance sheets of Sule"ha (td. ou are re0uired to prepare a cash flo1 statement
1ia!ilities Share capital &rade editors 2@@@ /s. 7$@@$@@@ 3$@:$@@@ %<<1 Assets %<<< /s. 8:$@@@ 3$>@$@@@ 2@@= /s. <@$:@@ 3$<5$:@@

%<<1 :@$@@@ 5;$@@@ 35$@@@ 7$@@@ >@@ 38$@@@ 8@$@@@ 7@$@@@

:@$@@@ >$@@@ 5@@ 3@$@@@ >$@@@ ;$@@@ ;$@@@ 3$@@@ 8@$@@@ 8<$@@@ 35<2@@ 75$5@@ >2<2@@

/s. 7$<:$@@@ Cash ;<$:@@ Debtors

P'( ADc

3:$@@@

78$:@@ Stoc" in &rade (and

3$5@$@@@ <:$@@@ 4<2@<@@@

3$7:$@@@ ??$@@@ 4<==<@@@

4<2@<@@@

4<==<@@@

C#/+ '$o- St#t&(&nt o' Su$&8+# Lt). 'o% t+& 0&#% 2@@1 Sources =pening )alance of cash Issue of Share Capital Cash =perating Profit BDiff. In P'( ADcC Decrease in Debtors /s. Application /s. 58$@@@ &rade 7<$:@@ <@$:@@

8:$@@@ Purchase of (and <:$@@@ Decrease in

Creditors 3?$:@@ Closing balance <$:@@ 1<4=<@@@

1<4=<@@@

I$$u/t%#tion: 5 From the follo1ing balance sheets of `indal (tdDprepare cashflo1 statement. 1ia!ilities Share Capital >R redeemable Pref. Shares 6eneral reserve P'( Account Proposed dividend Creditors )ills Pa able Provision for ta+ Tot#$ 2@@@ ;@@ 7@@ >@ ;@ >8 33@ 8@ >@ 1354 2@@= Assets 2@@@ 57@ 8@@ 3;@ 75@ 3:8 8@ 7@ 5@ 1354 2@@= 3>@ 78@ 8@@ 8@@ 53> ;@ 5@ 3; 1634

>@@ 6ood1ill 5@@ (and ' )uildings 38@ Plant ?; Debtors 3@@ Stoc" 3;; )ills /eceivable 75 Cash in hand 3@@ Cash at )an" 1634

A))ition#$ in'o%(#tion: 3C Depreciation of /s.5@$@@@ and /s.8@$@@@ have been charged on plant account and land and buildings account$ respectivel in 5@@3.

5C 7C 1. 6$#nt Account Particulars

An interim dividend of /s.8@$@@@ has been paid in 5@@3. Income ta+ /s.<@$@@@ 1as paid during the ear 5@@3.

/s.

Particulars

/s. 5@$@@@ 8$@@$@@@ 4<2@<@@@

&o =pening )alance on 3!3!5@@3 &o Purchases!cash

3$;@$@@@ ) Depreciation 5$;@$@@@ ) closing balance on 73!35!5@@3 4<2@<@@@

2.

L#n) #n) !ui$)in Account /s. Particulars /s. 8@$@@@

Particulars &o =pening )alance on 3!3!5@@3

8$@@$@@@ ) Depreciation ) cash Bsales!balancing

figureC ) closing balance on 73! 35!5@@3 4<@@<@@@

7$8@$@@@ 4<@@<@@@

3.

6%o.i/ion 'o% t#A#tion Account Particulars /s. Particulars /s. >@$@@@ ?@$@@@

Cash &o closing balance on 73!35!5@@3

<@$@@@ ) =pening )alance on 3!3! 5@@3 3$@@$@@@ ) P'( Account Bbalancing figureC 1<=@<@@@

1<=@<@@@

C#$cu$#tion o' c#/+ '%o( o5&%#tion/ Closing balance P'( ADc on 73!35!5@@3: (ess: )alance of P'( ADc on 3!3!5@@3: Add: Profit used for reserves ' provisions: Proposed dividend Interim dividend Provisions for ta+ation &ransfer to general reserve Add : Profit used for 1riting off non!cash ADc: 6ood1ill Depreciation: Plant (and ' )uilding Add: increase in creditors Funds from operations (ess: Increase in current assets: Debtors Stoc" )ills /eceivable (ess: Decrease in current liabilities: )ills Pa able C#/+ '%o( O5&%#tion/ C#/+ '$o- /t#t&(&nt 'o% t+& 0&#% &n)&) D&c&(7&% 31<2@@1 Cash in9flows =p. )al. As on 3!3!5@@3 Cash )an" R/. Cash out9flows R/. 5$;@$@@@ >8$@@@ 8@$@@@ <@$@@@ 3$@@ 3$@@$@@@ :$:8$@@@ Closing balance on 73! 35!5@@3 ?;$@@@ ;@$@@@ 3$@@$@@@ 8@$@@@ ?@$@@@ ;@$@@@ :@$@@@ 5@$@@@ 8@$@@@ 3$3@$@@@ 4<36<@@@ 56<@@@ 8$?5$@@@ >@$@@@ ;8$@@@ 5@$@@@ 7;$@@@

5$?@$@@@ 3<26<@@@

3$;8$@@@ 3<2><@@@ >$@@@ 3<2@<@@@

7@$@@@ Purchase of plant 5@$@@@ Pa ment of final dividend for 5@@@ Pa ment of interim

Add: Cash inflo1s: =perations Sale of land ' bldg. Issue of shares

dividend Income!ta+ paid 7$5@$@@@ /edemption of Shares 5@$@@@ 5$@@$@@@

Pref.

Cash in hand Cash in ban" 5<?@<@@@ I$$u/t%#tion: 6

5@$@@@ 3;$@@@ 5<?@<@@@

From the follo1ing information ou are re0uired to prepare a Cash Flo1 Statement of Shanti Stores (td for the ear ended 73E December$ 5@@3

!#$#nc& S+&&t/ 1ia!ilities Share Capital Secured (oans /epa able B5@@3C Creditors &a+ pa able P'( ADc 38$@@@ 3$@@@ <$@@@ ?2<@@@ %<<< <@$@@@ %<<1 Assets %<<< :@$@@@ 3:$@@@ :$@@@ 5@$@@@ 6eneral 5$@@@ %<<1 ?3$@@@ 8@$@@@ 5@$@@@ <$@@@ 8$@@@

<@$@@@ Plant Machiner Inventor 8@$@@@ Debtors 7?$@@@ Cash 7$@@@ Prepaid %+p. 3@$@@@ 1<62<@@@

?2<@@@

1<62<@@@

6%o'it H Lo// A2c 'o% t+& 0&#% &n)&) 31R D&c&(7&%< 2@@1 Particulars &o =pening Inventor &o Purchases &o 6ross Profit cDd &o 6eneral %+penses &o Depreciation &o &a+es &o *et Profit cDd &o Dividend &o )alance cDd /s. 3:$@@@ ) sales ?>$@@@ ) Closing inventor 5<$@@@ 1<4@<@@@ 33$@@@ ) 6ross Profit bDd >$@@@ 8$@@@ 8$@@@ 2=<@@@ 3$@@@ ) )alance bDd 3@$@@@ ) *et Profit bDd 2=<@@@ <$@@@ 8$@@@ Particulars /s. 3$@@$@@@ 8@$@@@ 1<4@<@@@ 5<$@@@

11<@@@

11<@@@

*o%8in Not&/: M#c+in&%0 A2c Particulars &o )alance bDd B=pening balanceC &o )an" aDc ! Purchases Bbal. Fig.C 8?$@@@ ??<@@@ ??<@@@ /s. Particulars ) Depreciation aDc :@$@@@ ) )alance cDd Bclosing balanceC ?3$@@@ /s. >$@@@

6%o.i/ion 'o% T#A#tion Particulars &o )an" aDc ! ta+ Paid Bbal. Fig.C &o )alance cDd ! closing balance 7$@@@ 5<@@@ /s. Particulars ) )alance bDd 5$@@@ ) P ' ( aDc ! Bcurrent earC 8$@@@ /s. 3 $@@@

5<@@@

B/s.C *et Profit Add: Depreciation &a+es Fun)/ '%o( O5&%#tion/ 8$@@@ >$@@@ 8$@@@ 16<@@@

C#/+ '%o( O5&%#tion/ /s. Funds from =perations Add: Increase in Creditors (ess: Increase in Debtors Increase in Inventor Increase in Prepaid 6eneral %+penses C#/+ $o/t in O5&%#tion/ 3:$@@@ 5:$@@@ 5$@@@ 85$@@@ 3$@@@ 3;$@@@ 5:$@@@ 41<@@@

C#/+ F$o- St#t&(&nt o' M2/ S+#nti Sto%&/ Lt). 'o% t+& 0&#% &n)in 31R D&c&(7&%< 2@@1 Sou%c&/ &o )alance cDd ! =pening Cash )alance Cash Inflo1s Secured (oans raised A55$ic#tion C#/+ Out'$o5@$@@@ Machine Purchased 8@$@@@ &a+es Paid Dividends paid Cash lost in =perations C$o/in c#/+ !#$#nc& 6@<@@@ R/. R/. 8?$@@@ 5$@@@ 3$@@@ 3$@@@ <$@@@ 6@<@@@

I$$u/t%#tion: = &he follo1ing are the balance Sheets of W (td. For the ear ending 73 st December 5@@@ and 5@@3

Particulars (iabilities Share Capital Profit and (oss Account Sundr creditors Provision for ta+ation Proposed Dividend

%<<< /s. 5$@@$@@@ 3$5@$@@@ ;@$@@@ 8@$@@@ 5@$@@@ 4<4@<@@@

%<<1 -s. 7$@@$@@@ 3$;@$@@@ :@$@@@ :@$@@@ 7@$@@@ 5<?@<@@@

Particulars Assets: Fi+ed Assets Add: Additions (ess: Depreciation Investments Stoc" Debtors Cash

%<<< /s. 3$;@$@@@ 8@$@@@ 5$@@$@@@ 3>$@@@ 3$>5$@@@ >$@@@ 3$;@$@@@ ;@$@@@ 7@$@@@ 4<4@<@@@

%<<1 /s. 5$@@$@@@ ;@$@@@ 5$;@$@@@ 58$@@@ 5$7;$@@@ 3;$@@@ 5$3>$@@@ >@$@@@ 8@$@@@ 5<?@<@@@

A))ition#$ in'o%(#tion: 3C 5C &a+es /s. 88$@@@ and dividend /s. 58$@@@ 1ere paid during the ear 5@@3 &he net profit for the ear 5@@3 before depreciation /s. 3$78$@@@ C#/+ F$o- St#t&(&nt 'o% t+& 0&#% &n)in 31/t D&c&(7&%< 2@@1
Sources =pening )alance of Cash B3!3!5@@3C Cash inflo1s: Issue of share capital Cash from operations /s. Application Cash =utflo1s 7@$@@@ Purchase of fi+ed assets &a+es paid 3$@@$@@@ Dividend paid 3$78$@@@ Purchase of investments Increase in Stoc" ;@$@@@ 88$@@@ 58$@@@ >$@@@ :>$@@@ /s.

Increase in debtors Decrease in creditors Closing balance of cash 2<64<@@@

5@$@@@ 3@$@@@ 8@$@@@ 2<64<@@@

*o%8in Not&/: FiA&) A//&t/ #2c Particulars &o )alance &o )an" aDc /s. Particulars /s. 5$;@$@?@ 2<6@<@@@

5$@@$@@@ ) )alance cDd ;@$@@@ 2<6@<@@@

In.&/t(&nt/ #2c Particulars &o )alance bDd &o )an" B)alancing figureC 6%o.i/ion 'o% t#A#tion #2c Particulars &o )an" &o )alance cDd 88$@@@ :@$@@@ ?8$@@@ /s. Particulars ) )alance cDd ) P ' ( aDc 88$@@@ :@$@@@ ?8$@@@ /s. /s. Particulars /s. 3;$@@@

>$@@@ ) )alance cDd :@$@@@ ?4<@@@

16<@@@

6%o5o/&) )i.i)&n)/ #2c Particulars &o )an" &o )alance cDd /s. Particulars /s. 58$@@@ 7@$@@@ 54<@@@

58$@@@ ) )alance cDd 7@$@@@ ) P ' ( aDc 54<@@@

C#$cu$#tion o' c#/+ '%o( o5&%#tion/ /s. Profit and (oss aDc balance on B7 3!35!5@@3C Add: *on!cash and non!operating items alread debited to Profit and (oss aDc : Depreciation on fi+ed assets Proposed dividend Provision for ta+ation (ess: *on!cash and non!operating items 1hich have alread been credited to P'( aDc Profit and (oss aDc on 3!3!5@@3 C#/+ o5&%#tin 5%o'it I$$u/t%#tion: > From the follo1ing )alance Sheets of %+e. (td. Ma"e out the statement of sources and uses of cash:
1ia!ilities %0uit Share Capital >R /edeemable Preference Share Capital 6eneral /eserve Profit ' (oss Account Proposed Dividend Creditors )ill Pa able Provision for &a+ation 8@$@@@ 7@$@@@ 85.@@@ ::$@@@ 5@$@@@ 8@$@@@ %<<< /s. 7$@@$@@@ 3$:@$@@@ %<<1 Assets %<<< /s. 3$3:$@@@ 5$@@$@@@ %<<1 /s. ?@$@@@ 3$<@$@@@

3$;@$@@@

;$@@@ 78$@@@ :8$@@@

?8$@@@ 5$:8$@@@

3$5@$@@@

3$5@$@@@ 1<34<@@@

/s. 8$@@$@@@ 6ood1ill 3$@@$@@@ (and and )uildings <@$@@@ Plant 8>$@@@ Debtors :@$@@@ Stoc" >7$@@@ )ills /eceivable 3;$@@@ Cash in ,and :@$@@@ Cash at )an"

>@$@@@ 3$;@$@@@ <<$@@@ 5@$@@@ 3:$@@@ 3@$@@@

5$@@$@@@ 5$@@$@@@ 3$@?$@@@ 7@$@@@ 3@$@@@ >$@@@

6<==<@@@

><1=<@@@

6<==<@@@

><1=<@@@

A))ition#$ in'o%(#tion: aC Depreciation of /s. 3@$@@@ and /s. 5@$@@@ have been charged on Plant and (and and )uilding respectivel in 5@@3. bC An interim dividend of /s. 5@$@@@ has been paid in 5@@@. cC /s. 7:$@@@ Income!ta+ 1as paid during the ear 5@@3. *o%8in Not&/: :i; A)Ku/t&) 6%o'it H Lo// #ccount Particulars &o Depreciation on plant &o Depreciation buildings &o 6ood1ill 1ritten off &o Provision of ta+ation &o Interim dividend &o Dividend proposed &o &ransfer to 6eneral /eserve &o )alance cDd 5:$@@@ 8:$@@@ 5@$@@@ :@$@@@ 7@$@@@ 8>$@@@ 2<4><@@@ 2<4><@@@ to /s. Particulars R/. 7@$@@@ from Bbalancing 5$3>$@@@

3@$@@@ ) )alance bDd 5@$@@@ ) Funds

operations figureC

:ii;

6%o.i/ion 'o% t#A#tion #ccount /s. Particulars R/. 8@$@@@ 8:$@@@

Particulars &o )an" &o )alance cDd

7:$@@@ ) )alance bDd :@$@@@ ) P.' ( ADc

>5<@@@

>5<@@@

:iii; L#n) #n) 7ui$)in #ccount Particulars &o )alance bDd /s. Particulars R/. 5@$@@@ 3@$@@@ 3$<@$@@ 2<@@<@@@

5$@@$@@@ ) Depreciation ) )an" BsaleC ) )alance cDd 2<@@<@@@

:i.; 6$#nt #ccount Particulars &o )alance bDd &o )an" BpurchaseC /s. Particulars R/. 3@$@@@ 5$@@$@@@ 2<1@<@@@

>@$@@@ ) Depreciation 3$7@$@@@ ) balance cDd 2<1@<@@@

:.; C#/+ '%o( o5&%#tion/ /s. Fun)/ '%o( o5&%#tion/ Add: Increase in creditors (ess: Decrease in )ills Pa able Increase in Debtors Increase in Stoc" Increase in )ills receivable C#/+ '%o( o5&%#tion/ BviC 8$@@@ 8@$@@@ 75$@@@ 3@$@@@ 5$3>$@@@ 5>$@@@ 2<46<@@@

>;$@@@ 1<6@<@@@

In the absence of information$ it has been presumed that there is no profit BlossC and no accumulated depreciation on that part of land and buildings 1hich has been sold.

C#/+ '$o- /t#t&(&nt 'o% t+& 0&#% &n)in 31/t D&c&(7&% 2@@1 Cash )alance as on 3!3! 5@@3 Cash in hand Cash at ban" Add: Inflo1s of cash: Issue of Shares Sale of (and and )uilding Funds from operations Increase in creditors /s. =utflo1s of cash: 3 :$@@@ /edemption of /edeemable 3@$@@@ Preference share Pa ments of interim dividend 3$@@$@@@ Pa ment of ta+ 3@$@@@ Purchase of Plant 5$3>$@@@ Decrease in bills pa able 5>$@@@ Increase in debtors Increase in stoc" Increase in )D/ Cash )alance as on 73!35! 5@@3 Cash in hand Cash at ban" 3<>1<@@@ 3@$@@@ >$@@@ 3<>1<@@@ /s. :@$@@@ 5@$@@@ 85$@@@ 7:$@@@ 3$7@$@@@ 8$@@@ 8@$@@@ 75$@@@ 3@$@@@

I$$u/t%#tion: ? !#$#nc& S+&&t/ o' G9N Lt). #/ on 1-1-2@@@ #n) 31-12-2@@1 -#/ #/ 'o$$o-/: 1ia!ilities Capital Creditors )an" loan )ills Pa able A//&t/: Cash Debtors Stoc" Machiner (and )uildings 6ood1ill 1919%<<1 3$5:$@@@ 3$8@$@@@ ;:$@@@ 5@$@@@ 3<5@<@@@ 5@$@@@ 7@$@@@ 8:$@@@ >@$@@@ ?@$@@@ ;:$@@@ 5@$@@@ 3<5@<@@@ (191%9%<<1 3$:7$@@@ 3$88$@@@ :@$@@@ 7@$@@@ 3<==<@@@ 3<$@@@ >@$@@@ 7:$@@@ ;:$@@@ >@$@@@ <@$@@@ 7@$@@@ 3<==<@@@

During the ear$ a machine costing /s. 35$@@@ Baccumulated depreciation /s.8$@@@C 1as sold for /s.<$@@@. )alance of provisions for depreciation against machiner as on 3!3!5@@3 1as /s.7:$@@@ and on 73!35!5@@3 /s. :@@@@ Prepares cash Flo1 statement. C#/+ F$o- St#t&(&nt 'o% t+& 0&#% &n)in 31/t D&c&(7&% 2@@1 Sources =pening balance of Cash Cash inflo1s: Sale of Machiner Sale of (and Increase in creditors Increase in )ills Pa able Decrease in stoc" Cash from operations /s. Applications /s.

5@$@@@ Cash outflo1s: )uilding Purchased <$@@@ Machiner Purchased 3@$@@@ )an" (oan repaid 8$@@@ 6ood1ill 3@$@@@ Dra1ings 3@$@@@ Increase in debtors <:$@@@ Cash balance B73!35!5@@3C 1<36<@@@ :$@@@ 35$@@@ 3:$@@@ 3@$@@@ 5<$@@@ :@$@@@ 3<$@@@ 1<36<@@@

M#c+in&%0 #2c Sources &o )alance bDd &o )an" BPurchaseC /s. Applications /s. <$@@@ 8$@@@ 3$@@@ 3$3:$@@@ 1<2=<@@@

3$3:$@@@ ) )an" BSaleC 35$@@@ ) Provisions for depreciation aDc ) P ' ( aDc B(oss on saleC ) )alance cDd 1<2=<@@@ L#n) #2c

6#%ticu$#%/ &o )alance bDd

R/. 6#%ticu$#%/ ?@$@@@ ) )an" BPurchaseC ) )alance cDd ?@<@@@

R/. 3@$@@@ >@$@@@ ?@<@@@

!ui$)in / #2c 6#%ticu$#%/ &o )alance bDd &o )an" BPurchasesC R/. 6#%ticu$#%/ ;:$@@@ ) )alance cDd :$@@@ =@<@@@ Goo)-i$$ #2c R/. 6#%ticu$#%/ 5@$@@@ ) )alance cDd 3@$@@@ 3@<@@@ !#n8 Lo#n #2c 6#%ticu$#%/ &o )an" &o )alance cDd R/. 6#%ticu$#%/ 3:$@@@ ) )alance cDd :@$@@@ 65<@@@ 6%o.i/ion/ 'o% D&5%&ci#tion #2c 6#%ticu$#%/ &o Machiner aDc &o )alance cDd R/. 6#%ticu$#%/ 8$@@@ ) )alance cDd :@$@@@ ) P ' ( aDc 54<@@@ C#$cu$#tion o' C#/+ '%o( o5&%#tion/ )alance of P ' ( aDc B*et Profit on B73D35D5@@3C Add : *on!cash and non!operating items debited to P ' ( aDc Depreciation on Machiner (oss on sale of Machiner C#/+ '%o( o5&%#tion/ C#5it#$ #2c &o 6#%ticu$#%/ Dra1ings B)alancing R/. 6#%ticu$#%/ 5<$@@@ ) )alance bDd 3$:7$@@@ ) *et Profit 1<>@<@@@ USES CAS" FLO* STATEMENT R/. 3$5:$@@@ ::$@@@ 1<>@<@@@ 3?$@@@ 3$@@@ ::$@@@ R/. 7:$@@@ 3?$@@@ 54<@@@ R/. ;:$@@@ 65<@@@ R/. <@$@@@ =@<@@@ R/. 7@$@@@ 3@<@@@

6#%ticu$#%/ &o )alance bDd &o )an"

5@$@@@ <:$@@@

figureC &o )alance cDd

"&$5/ in &''ici&nt c#/+ (#n# &(&nt - =ne of the most important functions of the management is to manage compan Is cash resources in such a 1a that ade0uate cash is available to meet the liabilities. A pro#ected cash flo1 statement enables the management to plan and co!ordinate the financial operation of the business efficientl .

"&$5/ in int&%n#$ 'in#nci#$ (#n# &(&nt - &he cash flo1 anal sis helps the management in e+ploring the possibilit of repa ment of long term debts 1hich depends upon the availabilit of cash.

Di/c$o/&/ t+& (o.&(&nt o' c#/+ - &he cash flo1 statement discloses the increase or decrease in cash and the reasons therefore. It helps the finance Manager in e+plaining ho1 the compan is short of cash despite higher profit and vice versa.

Di/c$o/&/ /ucc&// o% '#i$u%& o' c#/+ 5$#nnin - Comparison of actual and budgeted cash flo1 statement 1ill disclose the failure or success of the management in managing cash resources and necessar remedial measures can be ta"en in case of deviations. :

"&$5/ to )&t&%(in& t+& $i8&$0 '$o- o' c#/+ - Pro#ected cash flo1 statements help the management to determine the li"el inflo1 or outflo1 of cash from operations and the amount of cash re0uired to be raised from other sources to meet the future needs of the business.

Su55$&(&nt#$ to 'un)/ '$o- /t#t&(&nt - Cash flo1 anal sis supplements the anal sis provided b funds flo1 statement as cash is a part of the 1or"ing capital.

!&tt&% too$ o' #n#$0/i/ - For pa ment of liabilities 1hich are li"el $to be matured in the near future$ cash is more important than the 1or"ing capital. As such$ cash flo1 statement is certainl a better tool of anal sis than funds flo1 statement for short term anal sis.

LIMITATIONS OF CAS" FLO* ANAL9SIS Mi/$&#)in int&%-in)u/t%0 co(5#%i/on - Cash flo1 statement does not of one compan in relation to another. be

measure the economic efficienc &herefore$ inter!industr misleading.

2suall a compan 1ith heav capital investment 1ill have more cash inflo1. comparison of cash flo1 statement ma

Mi/$&#)in co(5#%i/on o.&% # 5&%io) o' ti(& - 9ust because the compan Is cash flo1 has increased in the current ear$ a compan ma not be better off than the previous ear. &hus$ the comparison over a period of time can be misleading.

Mi/$&#)in int&%-'i%( co(5#%i/on - &he terms of purchases and sales 1ill differ from firm to firm. Moreover$ cash inflo1 does not al1a s mean profit. &herefore$ inter!firm comparison of cash flo1 ma also be misleading.

In'$u&nc&) 70 c+#n &/ in (#n# &(&nt 5o$ici&/ - &he cash balance as disclosed b the cash flo1 statement ma not represent the real li0uid position of the business. &he cash can be easil influenced b purchases and sales policies$ b pa ments. ma"ing certain advance pa ments or b postponing certain

C#nnot 7& &Cu#t&) -it+ inco(& /t#t&(&nt - Cash flo1 statement cannot be e0ualed 1ith the income statement. An income statement$ ta"es into account both cash as 1ell as non!cash items. ,ence net cash flo1 does not necessaril mean net income of the business.

Not # %&5$#c&(&nt o' ot+&% /t#t&(&nt/ - Cash flo1 statement is onl a supplement of funds flo1 statement and cannot replace the income statement or the funds flo1 statement as each one has its o1n function or$ purpose of preparation.

Despite the above limitations$ cash flo1 statement is a ver useful tool of financial anal sis. It discloses the volume and speed at 1hich cash flo1s in various segments of the business and the amount of capital tied!up in a particular segment.

LESSON- 13 !UDGETING AND !UDGETAR9 CONTROL

!UDGET )udget is a financial andDor 0uantitative statement$ prepared and approved prior to a defined period of time$ of the polic to be pursued during that period for the purpose of attaining a given ob#ective. ! CIMA =fficial &erminolog ! It is a plan 0uantified in monetar terms$ prepared and approved prior to a defined period of time$ usuall sho1ing planned income to be generated andDor e+penditure to be incurred during that period and the capital to be emplo ed to attain a given ob#ective. It is a plan of future activities for an organisation. It is e+pressed mainl in financial terms$ but also usuall incorporates man non!official 0uantitative measures as 1ell. !UDGETING )udgeting is the 1hole process of designing$ implementing and operating budgets. &he main emphasis in this is short!term budgeting process involving the prevision of resources to support plans 1hich are being implemented. !UDGETAR9 CONTROL )udgetar control is the establishment of budgets relating the responsibilities of e+ecutives to the re0uirements of a polic $ and the continuous comparison of actual 1ith budgeted results$ either to secure b individual action the ob#ective of that polic or to provide a basis for its revision. ! CMA =fficial &erminolog

FORECAST 4/. !UDGET A forecast is a prediction of the future state of 1orld$ in connection 1ith those aspects of the 1orld$ 1hich are relevant to and li"el to affect on future activities. Forecast is calculation of probable events. )oth forecasting and planning involve recognition of the relevant factors in a given situation and understanding of 1hat each factor has contributed to it and ho1 each is li"el to affect the future. An organised business cannot avoid anticipating or calculating future conditions and trends for the framing of its future polic and decision. Forecast is concerned 1ith Iprobable eventsI and the budgeting relates to Iplanned eventsI )udgeting should be preceded b forecasting$ but forecasts ma be made for purpose other than budgeting. R&Cui%&(&nt/ o' # Soun) !u) &tin S0/t&( &he follo1ing are the essential re0uirements of a sound budgeting s stem: Clear lines of authorit and responsibilit have to be established throughout the organisation and the authorit and responsibilit of different levels of management and departmental e+ecutives are clearl defined. &he organisational goal should be 0uantified and clearl stated. &hese goals should be 1ithin the frame1or" of organisationLs strategic and long range plans. &he setting of budgets is not a process detached from planning of the compan Is overall polic . A 1ell defined business polic and ob#ective is a prere0uisite for budgeting. &he budget s stem 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 ob#ectives and the constraints 1ithin 1hich organisation 1or"s. Participation in budgeting process 1ill motivate the personnel to achieve budget levels of efficienc and activit .

 &he budget control s stem should provide for a degree of fle+ibilit designed to change in relation to the level of activit attained and the impact of changes in sales and production levels on revenue$ e+penses are "no1n. It enables more accurate assessment of managerial and organisational performance. Proper communication s stems should be established for management reporting and information service so that information relating to actual performance is presented to the manager responsible for it promptl to enable the manager to "no1 the nature of variations so that remedial action is ta"en 1herever necessar . %ducating the budget process and creation of cost a1areness atmosphere 1ill lead to effective implementation of budgets. &he top managementIs involvement in budget process is essential for successful implementation of the budgets. It should ta"e interest not onl in setting the budgets and targets but also to chec" upon the actual attainment$ motivating the personnel$ re1arding for achievements$ investigation into reasons for an deviation of actuals from budgeted results$ ta"ing punitive action 1herever necessar . A sound s stem for generating accurate and reliable and prompt accounting information is basic for successful implementation of budget s stem in an organisation. A).#nt# &/ o' !u) &tin )udgetar control establishes a basis for internal audit b regularl evaluating departmental results. =nl reporting information 1hich has not gone according to plan$ it

economises on managerial time and ma+imi-es efficienc . &his is called IManagement b %+ception reporting.

Scarce resources should be allocated in an optimal 1a $ thus controlling e+penditure

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 budgetar control s stem 1ill allo1 people to participate in the setting of budgets$ and thereb have a motivational impact on the 1or" force. Individual and corporate goals are aligned.

Areas of efficienc

and inefficienc

are identified. .ariance anal sis 1ill

prompt remedial action 1here necessar &he budget provides a ardstic" against 1hich the performance of the firm can be evaluated. It is better to compare actual 1ith budget rather than 1ith the past$ since the latter ma conditions. People are made responsible for items of cost and revenue$ i.e. areas of responsibilit are clearl delineatea. 6%o7$&(/ in !u) &tin )udgets are perceived b the 1or" force as pressure devices imposed b top management. &his can have an adverse effect on labour relations. It can be difficult to motivate an apathetic 1or" force. no longer be suitable for current and e+pected

&he pressure in the budgeting s stem ma "eeping. :

result in inaccurate record

Managers ma

over!estimate costs in order that the

1ill not be held

responsible in the future for over spending. &he difference bet1een the minimum necessar costs and the costs built into the budget is called slac". Departmental conflict arises because of competition for resource allocation. Departments blame each other if targets are not achieved. 2ncertainties can occur in the s stem$I e.g. uncertaint over demand$ inflation$ technological change$ competition$ 1eather etc. A It ma be difficult to align individual and corporate goals. Individual goals often change and ma be much lo1er than the firmIs goals. It is important to match responsibilit 1ith control$ other1ise$ a manager 1ill be demotivated. Costs can onl be controlled b a manager if the occur 1ithin a certain time span and can be influenced b that manager. A problem arises 1hen a cost can be influenced b more than one person. Managers are often accused of 1asting e+penditure 1hen the either BiC BiiC demand a greater budget allo1ance than is reall needed$ or unnecessar spending in order to full utilise their allo1ance through fear of future cut!bac"s. `ero base budgeting can overcome this problem. Sub!optimal decisions ma arise 1hen a manager tries to enhance his short! run performance in a 1a 1hich is detrimental to the organisation as a 1hole$ e.g. dela ing e+penditure urgentl needed repairs. &he are based on assumed conditions Be.g. rates of interestC and relationship Be.g. product!1ise held constantC that are not varied to reflect the actual circumstances that come about.

&he ma"e allo1ance for tas"s to be performed onl in relation to volume rather than time.

&he compare current costs 1ith estimates Ebased onl on historical anal sis.

&heir short!term hori-on limits the perspective$ so short!term results ma be sought at the e+pense of longer term stabilit or success.

&he have a built!in bias that tends to perpetuate inefficiencies. For e+ample$ ne+t earIs budget is determined b increasing last earIs b 3: per cent$ irrespective of the efficienc factor in last ear.

As 1ith all t pes of budgets the game of Ibeating the s stemI ma ta"e more energ factor in last ear.

&he fragile internal logic of static budget 1ill be destro ed if top management reacts to draft budgets b re0uiring changes to be made to particular items$ 1hich are then not reflected through the 1hole budget.

!UDGETING 6ROCESS &he method b 1hich the annual budget is prepared 1ill differ from organisation to organisation. In some organisations budgeting ma be a 1ell organised$ 1ell documented procedures 1hile in others the budget ma be prepared in a rather ad hoc and disorganised manner. &he budget process is sho1n in the follo1ing figure. &he steps in budgeting process representative to all organisations is given belo1: 1. S5&ci'ic#tion #n) Co((unic#tion o' O% #ni/#tion#$ O7K&cti.&/ : )udget is a medium through 1hich organisationIs ob#ectives and polices are reflected. )udgeting is used as a tool for implementing the organisational ob#ectives. It is essential to understand$ specification and documentation of organisational ob#ectives before the managers start for budgeting the organisational activities.

Follo1ing from a statement of ob#ectives$ a corporate long!range or strategic plan can be built up. Distinction ma be dra1n bet1een current operating activities and future strategic activities. )udgeting is a management tool used for shorter term planning and control. &his classification of activities into short!term and strategic long!term and communication to the managers 1ill la do1n a sort of guide for budgeting the activities 1ithin the specified ob#ectives and activities.

2.

D&t&%(in#tion o' F&0 Succ&// F#cto%/ : &he performance of ever organisation 1ill be particularl influenced b

certain critical success factors$ "e

factor 1ill influence the activities of an

underta"ing and it 1ill limit the volume of output and 1ill have direct impact on the profitabilit of the organisation. Critical success factors ma consist of a specified ra1 material$ a specific t pe of labour s"ill$ a tool$ a service facilit $ floor space$ cash resources etc. &he limitation or shortage of such critical factors ma result in restricting capacit utilisation. &he limiting factors ma shift from time to time due to e+ternal and internal circumstances$. In organisations 1hich are alread operating at ma+imum capacit $ the most critical success factor is li"el to be productive capacit . In ma#orit of organisation the most critical factor is li"el to be consumer demand or the e+pected level of revenues or funds. )ecause of this$ the sales or funds budget is usuall the first budget to be prepared. It 1ill determine the content of other related budgets. 3. E/t#7$i/+(&nt o' C$&#% On&/ o' Aut+o%it0 #n) R&/5on/i7i$it0: An organisational chart defining the lines of authorit and responsibilit of the managers responsible for accomplishment of organisational ob#ectives is to be prepared. &he organisational chart should define the follo1ing: &he responsibilit of individual functional managers Delegation of authorit to the concerned functional managers Inter!functional relationship of the organisation.

4.

E/t#7$i/+(&nt o' !u) &t C&nt%&/ : )udget centre is a section of an organisation for 1hich separate budgets can be

prepared and control e+ercised BCMA official terminolog C. &he entire organisation is divided into different segments$ 1hich are clearl defined for the purpose of contro( are technicall budgetar control according to responsibilities of departmental heads. &hese segments of an organisation defined for the purpose of budgetar referred to as budget centers. 5. D&t&%(in#tion o' !u) &t 6&%io) : )udget period is a period for 1hich the budget is prepared. A budget canA be a long!term budget or short!term budget. A short term budget is generall prepared for one ear or lesser period. Guarterl $ monthl or even 1ee"l budget can be prepared for certain operations of the compan . &he short!term budget 1ill generall more ears. &his long!term budget 1ill agree 1ith long!term organisational schemes for forecast not e+ceed the full accounting ear. &he long!term budget 1hich e+tend to five or even of sales$ e+pansion modernisation$ diversification etc. &he

long!term budgets are used for planning 1hereas short!term budget is used for implementation of long range plans$ activities$ ob#ectives and also for control purposes. Capital e+penditure budget and /esearch and development e+penditure budget are the e+amples of long!term budgets. Annual sales budget$ Income and e+penditure budget are the e+amples of short!term budgets. 6. E/t#7$i/+(&nt o' !u) &t Co((itt&& : In small organisations$ the person incharge of finance and accounting functions 1ill involve in preparation of budgets. &he setting up of a budget Committee is necessar in case of large and comple+ organisations. As the budget involves the various functional activities$ the closest association of functional managers is essential for satisfactor formulation and implementation of the budget &he budget committee 1ill be composed of ma#or functional heads. It can be effective

medium for coordination and revie1 of the budget programme. &he main functions of budget committee are as follo1s: &o revie1 the functional budget estimates. &o recommend the functional budgets for revision. &o revie1 and advise on the general policies affecting more than one function. &o revie1$ approval and adoption of revised budgets. &o receive and anal se the!periodic performance reports from budget centers. &o e+amine the budget reports sho1ing actuals compared 1ith budget. &o locate the responsibilit for discrepancies bet1een actuals and budgets$ and recommends the corrective action. &o participate in decision ma"ing in strategic issue li"e$ e+pansion$ modernisation$ diversification and revision of organisational activities$ 1hich have direct relationship to the compan Is budgets. =. A55oint(&nt o' !u) &t Cont%o$$&% : Proper budget administration is facilitated b the budget controller 1ho is made responsible for the preparation of the budget and coordinating activities of the individual departments. ,is functions and responsibilities 1ill include the follo1ing: BaC 6eneration and dissemination of information needed for decision!ma"ing and planning to each person in the organisation having such responsibilities. &he information ma include$ but is not limited to$ forecasts of economic and social conditions$ governmental influences$ organisation goals and standards for decision ma"ing$ economic and financial guidelines$ performance data$ performance standards and the prere0uisite plans of others in the enterprise. BbC %stablishing and maintaining a planning s stem 1hich: 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 1hich 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 1hole$ and

Disseminates advice of approval$ disapproval or revision of plans to affected individuals in accordance 1ith established lines of authorit and organisational responsibilities.

BcC

Construction and using models of the enterprise both in total and b sub! sections$ to test the effect of internal and e+ternal variables upon the achievement of organisation goals.

BdC

%nsuring the accumulation of performance data related to responsibilit centers 1ithin the organisation$ measured against the plans$ 1hether period or pro#ect$ for each centre$ transmitted to each centre$ and the anal sis of deviations of actual from planned performance.

&he budget controller is responsible for the final preparation$ presentation and interpretation of the financial plan of the compan . ,e is responsible for development of budget procedures. ,e 1ill act as a staff manager coordinating all budget functions. >. 6%&5#%#tion o' !u) &t M#nu#$: )udget manual is the documentation of policies and procedures involved in implementation of budgetar control s stem. A budget manual 1ill normall set out the follo1ing: /esponsibilit and authorit of different levels of management. %stablishment of organisational hierarch . Definition and clarification of various terms used in budgets. Fi+ation of responsibilit for preparation and implementation of budgets and budgetar s stem.

Specification and timing of statements and reports. Procedures in management information s stem in the organisation. Procedures in feed!bac" and feed!for1ard control s stems. %+haustive programme of budget preparation.

&he budget manual contains the standardised form 1hich become information generation for preparation of budgets. It contains a complete programme of activities involved in budget preparation. &he budgetI manual should provide detailed procedure for preparation and development and control of each budget li"e Sales budget$ Production budget$ Direct material budget$ Direct labour budget$ =verhead budget$ Capital e+penditure budget$ /'D e+penses budget etc. 6RE6ARATION OF SALES OR RE4ENUE !UDGET &he sales revenue budget is the starting point of most master budgets. In manufacturing organisations sales budgeting begins 1ith the forecasting of the sales of individual products. &hese forecasts ma be b geographical area$ b class of customer or b some other segment. In case of manufacturing companies$ the budgeting 1ill begin 1ith the /evenue budget of the organisation. Forecasting sales is a difficult tas" as man assumptions need to be made about consumer demand$ environmental conditions li"el customer demand at different prices$ the probable prices for similar products sold b competitors$ the number of economic activit in the regions 1here the product is sold$ the number of sales personnel re0uired to service the estimated demand$ the appropriate level of advertising and promotional e+penditures$ the impact of anticipated changes in e+change rates and changes in the ta+es such as value added ta+ or customs and e+cise duties. 6RE6ARATION OF !UDGETS =nce the sales budget has been determined from a range of sales forecasts it is possible to construct the follo1ing other budgets: 1. 6%o)uction !u) &t

&he production budget is an estimate of the 0uantit of goods that must be produced during the budget period. &he aim of the production function 1ill presumabl be to suppl finished goods of a specified 0ualit to meet mar"eting demands. &he sum of sales re0uirements plus changes in stoc" levels of finished goods gives the production re0uirements for the period being budgeted. In order to construct the production budget 1e need the level of sales e+pected and the desired levels of stoc" of finished goods. &he follo1ing formula is used for calculation of units to be produced. Production T Sales U Closing stoc" ! =pening stoc" Production budget should be developed "eeping in vie1 the optimal$ balance bet1een sales$ inventories and production so as to result in minimum cost. =nce the production level is determined$ it becomes the starring point for the direct materials$ direct labour and manufacturing overhead budgets. 2. 6$#nt Uti$i/#tion !u) &t Plant utilisation budget is prepared for the estimation of plant capacit to meet the budgeted production during the period considered under the budgetE For this purpose the plant capacit is e+pressed in terms of convenient units of measurement li"e production in hours$ production in 1eight BM.&.D4g.C production in units etc. )udgeted machine load in each department should be 1or"ed out. In case the budgeted plant utilisation is more than the plant capacit the management ma thin" of e+tra shift 1or"ing$ purchase of ne1 machiner $ overtime 1or"ing$ sub!contracting etc. Jhen the budgeted plant utilisation in lesser than the plant capacit $ management should consider the 1a s to increase sales volume. 3. Di%&ct M#t&%i#$/ !u) &t &he direct materials budget specifies the budgeted 0uantities of each ra1 material re0uired for the budgeted production. &he re0uirement to purchase of direct material can be calculated 1ith the help of the follo1ing formula.

Purchases T Closing stoc" U 2sage ! =pening stoc" &he materials budget provides basis for fi+ing optimum levels of inventor stoc"s$ establishment of control over material usage and purchase cost budget. 4. Di%&ct L#7ou% !u) &t &he direct labour budget 1ill ensure that the plan 1ill ma"e the re0uired number of emplo ees of relevant grades and suitable s"ills available at the right times. It specifies the direct labour re0uirement$ of various products as envisaged in the production budget. &he direct labour budget 1ill be developed for both direct labour hours and direct labour cost. After the labour re0uirements relating to different grades are finali-ed$ estimated rate per hour and labour cost per unit is arrived at: Illustration 1: &he direct labour hour re0uirements of three of the products manufactured in a factor $ each involving more than one labour operation$ are estimated as follo1s: Di%&ct L#7ou% "ou% 2 5&% unit :in (inut&/; Product =peration 3 5 7 3> ! ? 85 35 ? 7@ 58 ! 3 5 7

&he factor 1or"s > hours per da $ ; da s in a 1ee". &he budget 0uarter is ta"en as 37 1ee"s and during a 0uarter$ lost hours due to leave and holida s and other causes are estimated to be 358. &he budgeted hourl rates for the 1or"ers manning the operations$ 3$ 5 and 7 are /s.5.@@$ /s.5.:@ and /s.7@@ respectivel . &he budgeted sales of the product during the 0uarter are:

Product

3 5 7

?$@@@ units 3:$@@@ units 35$@@@ units

&here is a carr over of :$@@@ units of Product 5 and 8$@@@ units of Product 7 and it is proposed to built up a stoc" at the end of the budget 0uarter as follo1s: Product 3 7 3$@@@ units 5$@@@ units

Prepare a manpo1er budget for the 0uarter sho1ing for each operation: BiC Direct labour hours$ BiiC Direct labour cost$ and BiiiC *umber of 1or"ers. )efore preparing the 0uarterl manpo1er budget for 7 products operation!1ise$ it is necessar to 1or" out the follo1ing: BaC Production budget$ BbC Direct labour hours for each product operation! 1ise$ BcC *umber of 1or"ers re0uired for each operation. :#; 6%o)uction !u) &t 'o% t+& Cu#%t&% &n)in ..... Particulars )udgeted Sales BunitsC Add: Stoc" to be BclosingC built up Tot#$ (ess: Carr !over BopeningC 1@<@@@ ! 3@$@@@ 15<@@@ :$@@@ 3@$@@@ 14<@@@ 8$@@@ 3@$@@@ Product 1 ?$@@@ 3$@@@ Product % 3:$@@@ ! Product ( 35$@@@ 5$@@@

stoc" )udgeted Production :7;

Di%&ct L#7ou% "ou% 'o% &#c+ 6%o)uct :o5&%#tion--i/&; Particulars Product 1 per unit 3> Product % 85 . Product ( 7@

O5&%#tion I

Direct

labour

hrs.

BminutesC

)udget Production BunitsC

3@$@@@

3@$@@@

3@$@@@

Direct labour hrs. re0uired:

3@$@@@ + 3> ;@ 7$@@@ hrs.

3@$@@@ + 85 ;@ <$@@@ hrs.

3@$@@@ + 7@ ;@ :$@@@ hrs.

&otal labour hours re0uired for =peration I T 3:$@@@ hours. O5&%#tion II Particulars Direct labour hrs. per unit Product 1 ! 3@$@@@ ! Direct labour hrs. re0uired: ! 3@$@@@ + 35 ;@ 5$@@@ hrs. 3@$@@@ + 58 ;@ 8$@@@ hrs. Product % 35 3@$@@@ . Product ( 58 3@$@@@

BminutesC )udget Production BunitsC

&otal labour hours re0uired for =peration II T ;$@@@ hours.

O5&%#tion III Particulars Direct labour hrs. per unit Product 1 ? 3@$@@@ Product % ; 3@$@@@ . Product ( ! 3@$@@@ ! Direct labour hrs. re0uired: 3@$@@@ + ? ;@ 3$:@@ hrs. 3@$@@@ + ; ;@ 3$@@@ hrs. !

BminutesC )udget Production BunitsC

&otal labour hours re0uired for =peration III T 5$:@@ hours.

:c;

Nu(7&% o' *o%8&%/ %&Cui%&) 'o% &#c+ O5&%#tion ;58 hours

Jor"ing hrs. of factor in a 0uarter T 37 1ee"s + ; da s 1ee" + > hours a da (ess: (oss of hours due to leave$ holida s and others causes &otal available hours per man

358 hours

:@@ hours

*o1$ the re0uirements for manpo1er for each operation can be 1or"ed out. M#n5o-&% R&Cui%&(&nt: &otal direct labour hrs.D &otal available hours re0uired per man a. =peration I b. =peration II c. =peration III T 3:$@@@D:@@ A ;$@@@D:@@ T 5$:@@D:@@ T 7@ men T 35 men T : men

*o1$ manpo1er budget for the 0uarter can be prepared for the three products and for each operation. &he same is given belo1:
"%. %#t& /s. I II III &otal 5.@@ 5.:@ 7.@@ No. o' -o%8&%/

O5&%#tion

6%o)uct I D.I. ,rs. 7$@@@ ! 3$:@@ 8$:@@

6%o)uct II D.(. ,rs. <$@@@ 5$@@@ 3$@@@ 3@$@@@

6%o)uct 3 D.(. ,rs. :$@@@ 8$@@@ ! D.(. ,rs.

Tot#$

Cost /s. ;$@@@ ! 8$:@@ 3@$:@@

Cost /s. 38$@@@ :$@@@ 7$@@@

Cost /s. 3@$@@@ 3@$@@@ !

Cost /s. 7@$@@@ 3:$@@@ <$:@@ 7@ 35 :

3:$@@@ ;$@@@ 5$:@@

55$@@@

?$@@@

5@$@@@

57$:@@

:5$:@@

8<

5.

M#nu'#ctu%in EA5&n/&/ !u) &t

Manufacturing overhead refers to the aggregateI of factor indirect material$ indirect labour and indirect e+penses 1hich can be divided into fi+ed and variable elements of manufacturing overhead. &he fi+ed manufacturing overhead 1ill not var 1ith the change in the level of activit and it can be estimated 1ith a fair degree of accurac . =n the other hand$ variable manufacturing overhead per unit 1ill be estimated and the total variable manufacturing overhead 1ill be determined 1ith the help of the activit level. Preparation of variable overhead budget is based on scheduled production and operating conditions. Illustration %: 6ama %ngineering Compan (imited manufacturers t1o Products W and ]. An estimate of the number of units e+pected to be sold in the first seven months of 5@@3 is given belo1:

Mont+/ 9anuar Februar March April Ma 9une 9ul It is anticipated that: BaC BbC

6%o)uct G :@@ ;@@ >@@ 3$@@@ 3$5@@ 3$5@@ 3$@@@

6%o)uct 9 3$8@@ 3$8@@ 3$5@@ 3$@@@ >@@ >@@ ?>@

&here 1ill be no 1or"!in!progress at the end of an monthA Finished units e0ual to half the anticipated sales for the ne+t month 1ill be in stoc" at the end of each month Bincluding 9une 5@@3C.

&he budgeted production and production costs for the ear ending 73 st 9une$ 5@@3 are as follo1s: Particulars Product A Product B

Production Direct materials per unit Direct 1ages per unit =ther manufacturing charges

BunitsC B/s.C B/s.C B/s.C

33$@@@ 35 : 77$@@@

35$@@@ 3? < 8>$@@@

apportionable to each t pe of product ]ou are re0uired to prepare: BaC BbC Production budget sho1ing the number of units to be manufactured each month. Summarised production cost budget for the ; month!period 9anuar to 9une 5@@3. :#; 6%o)uction !u) &t :'o% t+& 6 (ont+/ &n)in 3@t+ 3un&< 2@@1; BunitsC Particulars Product W Closing Stoc" Sales 7@@ :@@ >@@ (ess: =pening Stoc" Production Bin unitsC Product ] Closing stoc" Sales <@@ 3$8@@ 5$3@@ (ess: =pening Stoc" Production Bin unitsC <@@ 3$8@@ ;@@ 3$8@@ 5$@@@ <@@ 3$7@@ :@@ 3$5@@ 3$<@@ ;@@ 3$3@@ 8@@ 3$@@@ 3$8@@ :@@ ?@@ 8@@ >@@ 3$5@@ 8@@ >@@ 8:@ >@@ 3$5:@ 8@@ >:@ 5:@ ::@ 8@@ ;@@ 3$@@@ 7@@ <@@ :@@ >@@ 3$7@@ 8@@ ?@@ ;@@ 3$@@@ 3$;@@ :@@ 3$3@@ ;@@ 3$5@@ 3$>@@ ;@@ 3$5@@ :@@ 3$5@@ 3$<@@ ;@@ 3$3@@ Can. "e!. Darch April Da& Cune

BbC Summarised Production Cost )udget Bfor the ; months ending 7@th 9une$ 5@@3C . B/s.C

Production

A94+44< units ?nit Cost )otal Cost ;;$;@@ 5<$<:@ 3;$;:@ 3$33$@@@

B95+(4< units ?nit Cost 3? < 8 7@ )otal Cost 3$5@$;:@ 88$8:@ 5:$8@@ 3$?@$:@@

Direct materials Direct 1ages Manufacturing charges Tot#$

1> 8 1 5@

8ote: Manufacturing charges have been presumed to be variable costs in the absence of an other information. &he could$ ho1ever be presumed to be fi+ed charges also for the 1hole ear. In such a case the 1ill be ta"en as :@R of the annual charges for the first si+ months in each case. 6. A)(ini/t%#ti.& EA5&n/&/ !u) &t Administrative e+penses in an organisation 1ill be incurred for the follo1ing activities: BaC BbC BcC Formulation of policies$ Directing the organisation$ and Controlling the operations of an organisation etc.

&he administrative e+penses 1ill not include those e+penses 1hich are incurred for manufacturing$ selling and distribution$ /'D functions. &he administrative overheads are of a fi+ed nature and the change in the level of activit 1ill not bring an change in the administrative e+penses incurred. Cm stud o behaviour of costs$ if an administrative e+penses are of variable or semi!variable nature$ those e+penses can be budgeted 1ith the (evel of activit . =. BaC BbC S&$$in #n) Di/t%i7ution EA5&n/& !u) &t Selling e+penses refers to e+penses incurred relating tc the activities: Creation and stimulation of demand of compan Is product$ and Secure orders.

Selling e+penses include salesmenIs salaries$ commissions$ e+penses and related administrative cost etc. Distribution e+penses refers fo e+penses incurred relating to the follo1ing activities: BaC BbC Maintaining and creating demand of product$ and Ma"ing the goods available in the hands of the customer.

Distribution e+penses include transportation$ freight charges$ stoc" control$ 1arehousing etc. Preparation of selling and distribution e+pense budget is based on the sales budget. &he selling and distribution e+penditure can be estimated 1ith the help of fle+ible budgeting techni0ue. >. R&/&#%c+ #n) D&.&$o5(&nt !u) &t &his 1ill cover materials$ e0uipment and suppliers$ salaries$ e+penses and other costs relating to design$ development and technical research pro#ects. ?. C#5it#$ EA5&n)itu%& !u) &t &he capital e+penditure budget represents the e+pected e+penditure on fi+ed assets during the budget period. It is an outla on assets that are re0uired and held for the purpose of generating income$ e.g. plant and machiner $ motor vehicles$ premises etc. It is a plan for capital e+penditure$ in monetar terms. Capital e+penditure ma be incurred for e+pansion$ diversification$ modernisation plans. It relates to pro#ects involving huge capital outla and long!term commitments. A capital e+penditure budget must reveal follo1ing information pro#ect1ise: =riginal appropriation Cumulative e+penditure up!to!date 2nutilised appropriation Fresh appropriation$ and (imit carried to ne+t period

Programme budgeting techni0ue is more appropriate for capital e+penditure budgeting. Capital e+penditure authorisation is the formal authorit s stem of capital appraisal. (evels of authorit must be clearl to incur capital defined and the

e+penditure 1hich meets the criteria defined to achieve the results laid do1n under a reporting structure of actual e+penditure through prior authorisation on a formal proposal basis and monitoring as e+penditure is incurred. 1@. M#n5o-&% !u) &t Manpo1er budget 1ill ta"en an overall vie1 of the organisations needs for manpo1er for all areas of activit ! sales$ manufacturing$ administrative$ e+ecutive and so on for a period of ears. 11. M#%8&tin EA5&n)itu%& !u) &t Mar"eting budget include estimated e+penditure to be in0uired for advertising promotional activities$ public relations$ mar"eting research$ customer services etc. during the budget period. 12. C#5it#$ !u) &t Capital budget is concerned 1ith the 0uestion of capacit as 1ell as 1ith the choice of the best capital structure. 6RE6ARATION OF MASTER !UDGET AND ITS IM6LEMENTATION Master budget is a budget 1hich is prepared from$ and summarises the functional budgets. It is a summar budget that incorporates the "e figures and totals of ail other budgets. &he process in preparation of Master budget is sho1n in the figure )udgetar Process Bgiven at the beginning of this chapterC. and strategic

direction. &his must deal 1ith the evaluation of alternate dispositions of capital funds

&he organisations: B3C

Master budget

ma

closel

reflect

t1o

dimension

of the

=rganisational Structure: All revenues and e+penditures must be attributed to the budget centre and managers responsible for them. At the control stage$ later$ a s stem of responsibilit accounting reports must be built up to inform responsible managers for the progress of that result against budgets.

B5C

Products or Programmes: In this dimension$ the budget information is organised to sho1 the revenues$ costs$ contributions$ profits and levels of productionD sales activit for each product or programme produced b $ the organisation.

N& oti#tion o' !u) &t/ : )udgets ma be prepared in a top!do1n or bottom!up manner. In either

process$ the budget 1ill need to be negotiated b superiors$ subordinates and b different departments competing for the scarce resources. &his process of negotiation allo1s the e+ercise of both formal and informal po1er. Participation in budgeting appears to lead to more positive attitude to1ards the budget and greater acceptance of it. Coo%)in#tion #n) R&.i&- o' !u) &t: Incompatibilit and inconsistenc ma arise because the budgeting process$ usuall involves a number of different departments ! e.g. sales$!production$ mar"eting and numerous senior and lo1er level managers. It should be ensured that consistenc is arrived at in finalisatcin of master budget. Acc&5t#nc& o' Co((unic#tion o' !u) &t/ : After the master budget is accepted and agreed upon b all the levels of organisational hierarch $ it 1ill be passed on for implementation. It is essential that

each manager responsible for implementing the budget polic be informed as to his responsibilit . !u) &t Monito%in : It is important that the actual performance of each manager should be regularl and fre0uentl compared against budget targets in order to prevent it from getting Iout of controlI and in case of change in internal and e+ternal business environment a revision of the budget ma be necessitated. CAS" FLO* !UDGET Cash flo1 budget is a detailed budget of income and cash e+penditure incorporating both revenue and capital items. &he cash flo1 budget should be prepared in the same format in 1hich the actual position is to be presented. &he earIs budget is usuall phased into shorter periods for control$ e.g. monthl or 0uarterl . Cash budget is concerned 1ith li0uidit must reflect changes bet1een opening and closing debtor balances and bet1een opening and closing creditor balances as 1ell as focusing attention on other inflo1s and outflo1s of cash. &he cash budget sho1s the cash flo1s arising from the operational budgets and the profit and assets structure. A cash budget can be prepared in the follo1ing 1a s: 1. R&c&i5t/ #n) 6#0(&nt/ M&t+o) : In this method all the e+pected receipts and pa ments for budget period are considered. All the ash inflo1 and outflo1 of all functional budgets including capital e+penditure budgets are considered. Accruals and ad#ustments in accounts 1ill not affect the cash flo1 budget. All anticipated cash inflo1 is added to the opening balance of cash and all ash pa ments are deducted from this to arrive at the closing balance of cash. &his method is commonl used in business organisations. 2. A)Ku/t&) Inco(& M&t+o) :

In this method the annual cash flo1s are calculated b ad#usting the sales revenues and costing figures for dela s in receipts and pa ments Bchanges in debtors and creditorsC and eliminating non!cash items such as Depreciation. 3. A)Ku/t&) !#$#nc& S+&&t M&t+o) : In this method$ the budgeted balance sheet is predicted b e+pressing each t pe of assets and short!term liabilities as percentage of the e+pected sales. &he profit is also calculated as a percentage of sales$ so that the increase in o1ners e0uit can be forecast. 4no1n ad#ustments$ ma be made to long!term liabilities and the balance sheet 1ill then sho1 if additional finance is needed. It is important to note that the capital budget 1ill also be considered 1hile preparation of cash flo1 budget because the annual budget ma disclose a need for ne1 capital investments and also$ the costs and revenues of an ne1 pro#ects coming on stream 1ill 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 pa ments or capital raising schedules ma be produced. Illustration (: Prepare a cash budget for the three months ending 7@ th 9une$ 5@@3 from the information given belo1: a. Donth Februar March April Ma 9une Sales 38$@@@ 3:$@@@ 3;$@@@ 3<$@@@ 3>$@@@ Daterials ?$;@@ ?$@@@ ?$5@@ 3@A@@@ 3@$8@@ >ages 7$@@@ 7$@@@ 7$5@@ 7$;@@ 8$@@@ #'erheads 3$<@@ 3$?@@ 5$@@@ 5$5@@ 5$7@@ B/s.C

7.

C%&)it T&%(/:

SalesD Debtor ! 3@R sales are on cash$ :@R of the credit sales are collected ne+t month and the balance in the follo1ing month. Creditors Materials Jages =verheads c. d. BiC 5 months c month \ month

Cash and ban" balance on lE April$ 5@@3 is e+pected to be /s.;$@@@. =ther relevant information is: Plant and Machiner on1ards. BiiC BiiiC BivC BvC Dividend X :R on Preference Share Capital of /s.5$@@$@@@ 1ill be paid on 3st 9une. Advance to be received for sale of vehicles /s.?$@@@ in 9une. Dividends from investments amounting to /s. 3$@@@ are e+pected to be received in 9une. Income!ta+ BadvanceC to be paid in 9une$ is /s.5$@@@. 1ill be installed in Februar 5@@3 at a cost of /s.?;$@@@. &he monthl instalments of /s.5$@@@ is pa able from April

*o%8in Not&/: Co$$&ction '%o( S#$&/2 D&7to%/ Donth Februar March April Ma Calculation B38$@@@!3@R of 38$@@@C + :@R B3:$@@@!3@R of 3:$@@@C + :@R 3@R of 3;$@@@ B3;$@@@!3@R of 3;$@@@C + :@R 3@R of 3<$@@@ B3<$@@@!3@R of 3<$@@@C + :@R 9une 3@R of 3>$@@@ April ;$7@@ ;$<:@ 3$;@@ ! ! ! ! 14<65@ Da& ! ;$<:@ ! <$5@@ 3$<@@ ! ! 15<65@ Cune <$5@@ ! <$;:@ 3$>@@ 16<65@

C#/+ 7u) &t 'o% t+& Cu#%t&% A5%i$ - 3un& 2@@1 Particulars 3. )alance bDf 5. /eceipts Sales B*ote 3C Dividend Advanced against vehicle 7. Pa ment CreditorsY JagesY =verheadY Capital %+penditure Income ta+ advance 8. )alance cDf ?$;@@ 7$3:@ 3$?:@ 5$@@@ ! Tot#$ 3;$<@@ 7$?:@ ?$@@@ 7$:@@ 5$3@@ 5$@@@ ! 3;$;@@ 7$@@@ ?$5@@ 7$?@@ 5$5:@ 5$@@@ 5$@@@ 5?$7:@ 7@@ 5<$>@@ 3@$::@ ;$7@@ ;$@@@ 5$@@@ ;5$;:@ 7@@ April ;$@@@ 38$;:@ ! ! Tot#$ 5@$;:@ Da& 7$?:@ 3:$;:@ ! ! 3?$;@@ Cune 7$@@@ 3;$;:@ 3$@@@ ?$@@@ 5?$;:@ )otal ;$@@@ 8;$?:@ 3$@@@ ?$@@@ ;5$?:@

Y Pa ments for creditors$ 1ages and overhead have been computed on the same pattern. FLEGI!LE !UDGETING Fle+ible budget is a budget 1hich$ b recognising the difference in behaviour bet1een fi+ed 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 activit actuall attained. A fle+ible budget is one that ta"es account of a range of possible volumes It is sometimes referred to as a multi!volume budget. &he range of possible outputs ma be "no1n as the relevant range. IFle+ingI a budget ta"es place 1hen the original budget is deliberatel amended to ta"e account of change activit levels.

&he fle+ible budget is based on the fundamental difference in behaviour of fi+ed costs$ variable costs and semi!variable costs. Since fi+ed costs do not var 1ith short!run fluctuations in activit it can be seen that the fle+ible budget 1ill reall consist of t1o parts: &he first is a fi+ed budget begin made up of fi+ed costs and the fi+ed component of semi!variable costs. &he second part is a trul fle+ible budget that consists solel of variable costs. St&5/ in 6%&5#%#tion &he steps involved in preparation of fle+ible budget are as follo1s: Specif the time period that is used. Classif all costs into fi+ed$ variable and semi!variable categories. Determine the t pes of standards that are to be used. Anal se cost behaviour patterns in response to past levels of activit . )uild up the appropriate fle+ible budget for specified levels of activit .

I(5o%t#nc& Fle+ible budgets are important aids to decision ma"ing 1hich help the management in the follo1ing 1a s: Fle+ible budget enable an organisation to predict its performance and income levels at a given range of sales levels and activit levels. It can be seen the impact of changes in sales and production levels on revenue$ e+penses and ultimatel income. Fle+ible budgets enables more accurate assessment of managerial and organisational performance. Di/#).#nt# &/ &he procedure for dra1ing up a fle+ible budget is 0uite straight for1ard. &he fle+ed budget is onl accurate$ if costs behave in a predicted manner. All too often assumptions are made about cost behaviour 1hich are too simplistic and hence do not reflect 1hat actuall happens.

Fle+ible budgets assume linearit of costs and therefore ta"e no account of$ for e+ample discounts for bul" purchases of materials (abour costs are unli"el to behave in a linear fashion unless a piece1or" scheme is in operation.

Such budgets also rel

on the assumption of continuit

1hen costs ma

actuall behave in a stepped or discontinue matter. &he method of determining the fi+ed and variable elements of costs is often arbitrar and hence the fle+ed cost bear little relation to the correct budgeted cost for the fle+ed level of activit . Although fle+ed budgets tend to maintain fi+ed costs at the same level 1hatever the level of outputD sales$ ver often fi+ed costs are actuall fi+ed onl over a relevant output range. Illustration 3: A)C (td. Manufactures a single product for 1hich mar"et demand e+ists for additional 0uantit . Present sale of /s.;@$@@@ per month utilised onl <@R capacit of the plant. Sales Manager assures that 1ith a reduction of 3@R in the price he 1ould be in a position to increase the sale b about 5:R to 7@R &he follo1ing data are available: aC Selling price bC .ariable cost cC Semi!variable cost dC Fi+ed cost /s. 3@ per unit /s.7 per unit /s.;$@@@ fi+ed plus /e.@.:@ per unit /s.5@$@@@ at present level estimated to be /s.58$@@@ as >@R output. ]ou are re0uired to submit the follo1ing statements to the )oard sho1ing: 3. &he operating profits at ;@R$ <@R and >@R levels at current selling price and at proposed selling price.

5.

&he percentage increase in the present output 1hich 1ill be re0uired to maintain the present profit margin at the proposed selling price.

St#t&(&nt o' O5&%#tin 6%o'it #t )i''&%&nt c#5#cit0 $&.&$/ #t Cu%%&nt S&$$in 6%ic& B/s.C Capacit& 1e'els Product and Sales units$ Sales BX/s. 3@C Costs: .ariable cost BX /s.7C Semi!variable cost Fi+ed component .ariable component BX /e.@.:@ per unitC Fi+ed cost &otal cost Profit 3>$@@@ ;$@@@ 7$@@@ 5@$@@@ 8<$@@@ 37$@@@ 53$@@@ ;$@@@ 7$:@@ 5@$@@@ :@$:@@ 3?$:@@ 58$@@@ ;$@@@ 8$@@@ 58$@@@ :>$@@@ 55$@@@ BAC 5<E 5+<<< ;@$@@@ =@O =<@@@ <@$@@@ -<E -+<<< >@$@@@

B)C BAC ! B)C

St#t&(&nt o' O5&%#tin 6%o'it #t )i''&%&nt c#5#cit0 $&.&$/ #t 5%o5o/&) S&$$in 6%ic& B/s.C Capacit& 1e'els Sales BX /s.?C 5<E :8$@@@ 8<$@@@ Profit <$@@@ 6<E ;7$@@@ :@$:@@ 35$:@@ -<E <5$@@@ :>$@@@ 38$@@@

(ess: &otal cost

C#$cu$#tion o' 6&%c&nt# & Inc%&#/& in 5%&/&nt out5ut 'o% )&/i%&) 5%o'it B/s. per unitC Proposed selling price ?.@@

(ess: .ariable cost Contribution per unit

B/s.7.@@ U /e.@.:@C

7.:@ :.:@ B/s.C

Present Profit Add: Fi+ed cost Desired Contribution B/s.5@$@@@ U /s.;$@@@C

37$@@@ 5;$@@@ 7?$@@@

R&Cui%&) Out5ut 0esired Contri ution Contri ution per unit /s.7?$@@@ -s.8.8F

A <$@?3 units

Inc%&#/& in 6%o)uction %&Cui%&) T <$@?3 units ! ;$@@@ units T 3$@?3 units

6&%c&nt# & inc%&#/& o.&% 5%&/&nt Out5ut T 3$@?3 ;$@@@ + 3@@ T 3>.3>R

LESSON-14 CA6ITAL !UDGETING

MEANING OF CA6ITAL !UDGETING Capital budgeting is the process of ma"ing investment decisions in the capital e+penditures. A progressive business firm al1a s moves ahead$ its fi+ed assets and other resources continue to e+pand or there comes a need for e+panding them. Capital budgeting actuall the process of ma"ing investment decisions in capital e+penditure$ or fi+ed assets. A capital e+penditure ma be as an e+penditure the benefits of 1hich are e+pected to be received over a period of time e+ceeding one ear. Capital e+penditure is one 1hich is intended to benefit future periods and normall includes investments in fi+ed assets and other development pro#ects. It is essentiall a long! term function. Capital budgeting is also "no1n as Investment Decision Ma"ing$ Capital %+penditure Decisions$ Planning Capital %+penditure etc. Capital budgeting is the most important and complicated problem of managerial decisions. )ecause it is concerned 1ith designing and carr ing out through a s stematic investment programme. It involves the planning of such e+penditures 1hich provide ields over a number of ears. Charles & ,omgreen has defined capital budgeting as$ ECapital budgeting is long term planning for ma"ing and financing proposed capital outla s. According to Philippatos$ ECapital budgeting is concerned 1ith the allocation of the firmIs scarce financial resources among the available mar"et opportunities. &he consideration of investment opportunities involves the comparison of the e+pected future streams of earnings from a pro#ect$ 1ith the immediate and subse0uent streams of e+penditure for itE. /ichard and 6reen have defined ECapital budgeting as ac0uiring inputs 1ith long!run returnE.

According to ( nch$ ECapital budgeting consists in planning development of available capital for the purpose of ma+imising the long!term profitabilit of the concernE

F&#tu%&/ o' In.&/t(&nt D&ci/ion/: Capita[ budgeting decisions ,uge funds are invested in long!term asets. &he future benefits 1ill occur to the firm over a series of ears. &he involve the e+change of current funds for the benefits to be achieved in future. &he have a significant effect on the profitabilit of the concerns. &he are IstrategicI investment decisions. &he are irreversible decisions.

Capital budgeting has a vital role to pla in the broader process of strategic planning and budgetar control. Capital budgeting s stems should strive to create an atmosphere 1hich encourages the generation of ne1 investment proposals and evaluates them as accurac as possible. ,o1ever$ loss!ma"ing proposals must be identified at the earliest possible moment.

IM6ORTANCE OF CA6ITAL !UDGETING 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!ma"ing for the management. 2nsound investment decision ma prove to be fatal to the ver e+istence of the concern. &he significance of capital budgeting arises mainl due to the follo1ing:

:1;

L#% & In.&/t(&nt: Capital budgeting decisions$ generall $ involve large investment of funds. &he

funds available 1ith the firm are al1a s limited and the demand for the funds far e+ceeds the resources. &hese funds are raised b the firm from various internal and e+ternal resources at substantial cost of capital. A 1rong decision prove disastrous for the continued survival of the firm. ,ence it is ver important for a firm to plan and control its capital e+penditure. :2; Lon -T&%( Co((it(&nt o' Fun)/: &he funds involved in capital e+penditure are not onl large but more or less permanentl bloc"ed also in long!term investment. &he longer the time$ the greater the ris" involved. 6reater the ris" involved$ greater is the need for careful planning of capital e+penditure$ i.e. capital budgeting. &he long!term commitment of funds increases the financial ris" involved in the investment decision. FirmIs decision to invest in long!term assets has a decisive influence on the rate and direction of its gro1th. An unsound investment decision ma prove to$ be fatal to the ver e+istence of the firm. ,ence a careful planning is essential: :3; I%%&.&%/i7$& in N#tu%& : Most investment decisions are irreversible. =nce the decision for ac0uiring a permanent asset is ta"en$ it is ver difficult to reverse that decision. It is difficult to find a mar"et of such capital goods once the loss in the event of the decision being proved 1rong. :4; Co(5$ic#ci&/ o' In.&/t(&nt D&ci/ion/ : &he long term investment decisions are more complicated in nature. &he capital budgeting decisions re0uire an assessment of future events 1hich are uncertain. It is reall a difficult tas" to estimate the probable future events. In most pro#ects the investment of funds has to be made immediatel but the returns are have been ac0uired. &he onl alternative 1ill be to scrap the capital assets so purchased or sell them at a substantial

e+pected over a number of future ears. )oth returns as 1ell as the length of the period over 1hich the 1ill accrue are uncertain. :5; Lon -t&%( E''&ct on 6%o'it#7i$it0: Capital budgeting decisions have a long!term and significant on the profitabilit of a concern. Capital budgeting is of utmost importance to avoid over! investment or under!investment
,I

fi+ed assets. An un1ise decision ma

prove

disastrous and fatal to the ver e+istence of the concern. &he future gro1th and profitabilit of the firm depends upon the investment decision ta"en toda . Capital e+penditure pro#ects e+ercise a great impact on the profitabilit of the firm for a ver long time. :6; N#tion#$ I(5o%t#nc&: Investment decision ta"en b individual concern is of national importance because it determines emplo ment$ economic activities and economic gro1th. CA6ITAL !UDGETING 6ROCESS Capital budgeting is a comple+ process as it involves decisions to the investment of current funds for the benefit to be achieved in future and the future is al1a s uncertain. A capital budgeting process ma involve a number of steps depending upon the si-e of the concern$ nature of pro#ects$ their numbers$ comple+ities and diversities etc. &hat is$ capital budgeting decisions of a firm have a pervasive influence on the entire spectrum of entrepreneurial activities. ,ence the re0uire a comple+ combination and "no1ledge of various disciplines for their effective administration$ such as economics$ finance$ mathematics$ economic forecasting$ pro#ection techni0ues and techni0ues of financial control. In order to tie all these elements$ a financial manager must "eep in mind the three dimensions of capital budgeting programme ! polic $ plan and programme. &hese three Ps constitute a sound capital budgeting programme. Guinin 6 David has suggested that BaC pro#ect generation$ BbC pro#ect evaluation$ BcC Pro#ect selection and BdC pro#ect e+ecution are the important steps

involved in a capital budgeting process. ,o1ever$ the follo1ing procedure ma be adopted in the process of capital budgeting.

:1;

I)&nti'ic#tion o' In.&/t(&nt 6%o5o/#$/ Investment opportunities have to be identified or searched for: the do not

occur automaticall . &he capital budgeting process begins 1ith the identification of investment proposals. &he first step in capital budgeting process is the conception of a profit!ma"ing idea. Investment proposals of various t pes ma originate at different levels 1ithin a firm$ depending on their nature. &he ma originate from the level of 1or"ers to top management level. Most of the proposals$ in the nature of cost reduction or replacement or process for product improvement ta"e place at plant level. &he proposal for adding ne1 product ma emanate from the mar"eting department or from plant manager 1ho thin"s of a better 1a of utili-ing idle capacit . Suggestions for replacing an old machine or improving the production techni0ues ma arise at the factor level. &he departmental head anal ses the various proposals in the light of the corporate strategies and submits suitable proposals to the capital e+penditure planning committee in case of large organisation or to the officers concerned 1ith the process of long!term investment decisions. A continuous flo1 of profitable capital e+penditure proposals is itself an indications of a health and vital business concern. Although business ma pursue man goals$ survivals and profitabilit are t1o of the most important ob#ectives. :2; Sc%&&nin t+& 6%o5o/#$/

Screening and selection procedures 1ould differ from firm to firm. %ach proposal is then sub#ected to a preliminar screening process in order to assess 1hether it is technicall feasibleA resources re0uired are available and the e+pected returns are ade0uate to compensate for the ris" involved. In large organisations$ a capital e+penditure planning committee is established for screening for various proposals received from different departments. &he committee vie1s these proposals from various angles to ensure that these are in accordance 1ith the corporate strategies or selection criterion of the firm and also do not lead to departmental imbalances. All care must be ta"en in selecting a criterion to #udge the desirabilit of the pro#ects. &he criterion selected should be a true measure of the investment pro#ectIs profitabilit $ and as far as possible$ it must be consistent 1ith the firmIs ob#ective of ma+imising its mar"et value. &his stage involves the comparison of the proposals 1ith other pro#ects according to criteria of the firm. &his is done either b financial manager or b a capital e+penditure planning committee. Such criteria and cost of capital and the e+pected returns from should encompass the suppl

alternative investment opportunities. :3; E.#$u#tion o' 4#%iou/ 6%o5o/#$/ &he ne+t step in the capital budgeting process is to evaluate the profitabilit of various proposals. If a proposal satisfies the screening process$ it is then anal sed in more detail b gathering technical$ economic and other data. Pro#ects are also classified$ for e+ample$ ne1 products or e+pansion or improvement and ran"ed 1ithin each classification 1ith respect to profitabilit $ ris" and degree of urgenc . &here are man methods 1hich ma be used for this purpose such as pa bac" period method$ rate of return method$ net present value method etc. All these methods of evaluating profitabilit of capital investments proposals have been discussed in detail belo1. &he various proposals of investments ma be classified as: BaC BbC BcC Mutuall e+clusive proposals In!dependent proposals Contingent proposals Dutuall& E.clusi'e Proposals serve the same purpose and compete 1ith each other in a 1a that the acceptance of one precludes the acceptance of other or others.

&hus$ t1o or more mutuall e+clusive proposals cannot both or all be accepted. Some techni0ue has to be used for selecting the better or the best one. =nce this is done$ other alternative automaticall gets eliminated. A compan ma $ for instance$ propose to use semi!automatic machine or highl automatic machine for production. ,ere choosing the highl automatic machine. Independent Proposals are those 1hich do not compete 1ith one another and the same ma be either accepted or re#ected on the basis of minimum return on investment re0uired. For instance$ 1hen there are t1o proposals$ a firm can underta"e both the proposals. Contingent or Dependent Proposals are those 1hose acceptance depends upon the acceptance of one or more other proposals. For instance$ a firm decides to build a factor in a remote area$ it ma have to invest in houses$ hospitals$ roads etc. for the staff &hus$ building a factor also re0uires investment in facilities for emplo ees. &he total investment 1ill be treated as a!single investment. automatic machine precludes the acceptance of the semi!

:4;

E/t#7$i/+in 6%io%iti&/ After evaluation of various proposals$ the unprofitable or uneconomic

proposals are re#ected$ the accepted proposals i.e. profitable proposals are put in priorit . It ma not be possible for the firm to invest immediatel in all the acceptable proposals. &hus$ it is essential to tan" the various proposals and to establish priorities after considering urgenc $ ris" and profitabilit involved therein. :5; Fin#$ A55%o.#$ Proposals finall recommended b the committee are sent to the top

management along 1ith a detailed report$ both of capital e+penditures and of sources of capital. Financial manager 1ill present several alternative capital budgets. Jhen capital e+penditure proposals are finall selected$ funds are allocated for them.

Pro#ects are then sent to the budget committee for incorporating them in the capital budget. :6; I(5$&(&ntin 6%o5o/#$/ Preparation of a capital e+penditure budgeting and incorporation of a particular proposal in the budget does not itself authorise to go ahead 1ith the implementation of the pro#ect. A re0uest for authorit to spend the amount should further be made to the capital e+penditure committee 1hich ma li"e to revie1 the profitabilit of the pro#ect in the changed circumstances. Further$ 1hile implementing the pro#ect$ it is better to assign responsibilities for completing the pro#ect 1ithin the given time frame and cost limit so as to avoid unnecessar dela s and cost over runs. *et1or" techni0ues used in the pro#ect management such as P%/& and CPM can also be applied to control and monitor the implementation of the pro#ects. :=; 6&%'o%(#nc& R&.i&(ast but not the least important step in the capital budgeting process is an evaluation of the performance of the pro#ect$ after it has been full implemented. It is the dut of the top management or e+ecutive committee to ensure that funds are spent in accordance 1ith the allocation made in the capital budget. A control over such capital e+penditure is ver much essential and for that purpose a monthl report sho1ing the amount allocated$ amount spent$ amount approved but not spent should be prepared and submitted to the controller. &he evaluation is made through post completion audit b 1a of comparison of actual e+penditure on the pro#ect 1ith the budgeted one$ and also b comparing the actual return from the investment 1ith the anticipated return. &he unfavourable variances$ if an $ should be loo"ed into and the causes of the same be identified so that corrective action ma be ta"en in future. E4ALUATION OF IN4ESTMENT 6RO6OSALS &he funds available 1ith the firm are al1a s limited and it is not possible to invest funds in all the proposals at a time. &herefore$ it is ver essential to select from amongst the various competing proposals$ those 1hich give the highest benefit.

A firm ma face a situation 1here more investment proposals ma be poor! &he management has to select the most profitable pro#ect or to ta"e up the most profitable pro#ect first. &here are man considerations$ economic as 1ell as non!economic$ 1hich influence the capital budgeting decisions. )ecause of the utmost importance of the capital budgeting decision$ a sound appraisal method should be adopted to measure the economic 1orth of each investment pro#ect. Capital e+penditures represent long!term commitment in the sense that current investment ields benefits in future. &he capital e+penditure decisions assume great importance for the future development of the concern. &he important factor that influences the capital budgeting decision is the profitabilit of the prospective investment. &he ris" involved in the proposal cannot be ignored because profitabilit and ris" are directl related$ that is$ higher the profitabilit $ the greater because profitabilit and ris" are directl related$ that is$ higher the profitabilit $ the greater the ris" and vice!versa. &he goal of financial management of a firm is the 1orth ma+imisation of the firm$ and in order to achieve this goal$ the management must select those pro#ects 1hich deserve first priorit in terms of their profitabilit . Jhile evaluating$ t1o basic principles are "ept in mind$ namel $ the bigger benefits are al1a s preferable to small ones and that earl benefits are al1a s better than the deferred ones. &he essential propert of sound a sound investment evaluation techni0ue is that it should ma+imise the shareholdersI 1ealth. &he follo1ing other characteristic should also be possessed b evaluation criterion: B3C B5C B7C B8C B:C B;C It should provide a means of distinguishing bet1een acceptable and unacceptable pro#ects It should provide clear cut ran"ing of the pro#ects in order of the profitabilit or desirabilit . It should also solve the problem of choosing among alternative pro#ects. It should be a criterion 1hich is applicable to an conceivable investment pro#ect. It should emphasise upon earl and bigger cash benefits in comparison to distant and smaller benefits. &he method should be suitable according to the nature and si-e of capital pro#ect to be evaluated.

MET"ODS OF E4ALUATING CA6ITAL IN4ESTMENT 6RO6OSALS A number of appraisal methods ma )raditional Dethods: 3. Pa !bac" period Method or Pa !out or Pa !off Method 5. Improvements in &raditional Approach to Pa !bac" period Method. 7. /ate of /eturn Method or Accounting Method. )ime Ad;usted Dethods or Accounting Dethods: 8. *et Present .alue Method :. Internal /ate of /eturn Method ;. Profitabilit Inde+ Method. TRADITIONAL MET"ODS :1; 6#0-7#c8 6&%io) M&t+o) &he term pa !bac" Bor pa !out or pa !off or brea"!even period or recoupment periodC refers to the period in 1hich the pro#ect 1ill generate the necessar cash to recoup the initial investment. )usiness units$ 1hile selecting investment pro#ects$ 1ould consider the recover of cost as the first and foremost concern even though earning ma+imum profits is their ultimate .goal. &his method describes in terms of period of time the relationship bet1een annual savings Bcash inflo1C and total amount of capital e+penditure BinvestmentC$ pa bac" period is defined as the number of ears re0uired for the savings in costs or net cash inflo1 Bafter ta+ but before depreciationC to recoup the original cost of the pro#ect In simple sentence$ it represents the number of ears in 1hich the investment is e+pected to Epa for itself. 2nder this method$ various investments are ran"ed according to the length of their pa !bac" period in such a manner that the investment 1ith a shorter pa !bac" period is preferred to the one 1hich has longer pa !bac" period. be recommended for evaluating the

capital e+penditure proposals. &he most important and commonl used methods are:

Calculation of Pa !bac" Period :#; In t+& c#/& o' &.&n c#/+ in'$o-/ : If the annual cas" inflo1s are constant$ the pa !bac" period can be computed b dividing cash outla Boriginal investmentC b annual cash inflo1s. For instance$ if a pro#ect re0uires /s. 3@$@@@ as initial investment and it 1ill generate an annual cash inflo1 of /s.5$:@@ for ten ears$ the pa !bac" period 1ill be 8 ears$ calculated as follo1s: Initial Investment Annual Cash Inflo1 /s. 3@$@@@ /s. 5$:@@ T 8 ears

Pa ! bac" Period

T T

:7;

In t+& c#/& o' un&.&n in'$o-/ : If cash inflo1s are not uniform$ the calculation of pa !bac" period ta"es a

cumulative form. In such a case the pa !bac" period can be found out b adding up the figure of net cash inflo1s until the total is e0ual to initial investment. For instance$ if!a pro#ect re0uires an initial investment of /s. 3@$@@@ and the annual inflo1 for : ears are /s.7$@@@A /s.8$@@@A /s.5$:@@A /s.5$@@@ and /s.5$@@@ respectivel $ the pa ! bac" period 1ill be calculated as follo1s: 9&#% Annu#$ C#/+ In'$o-/ /s. 7$@@@ 8$@@@ 5$:@@ 5$@@@ 5$@@@ Cu(u$#ti.& C#/+ In'$o/s. 7$@@@ <$@@@ ?$:@@ 33$:@@ 37$:@@

3 5 7 8 :

&he above 1or"ings sho1 that in 7 ears /s.?$:@@ has been recovered. /s.:@@ is left out of in!tial investment. In the fourth ear the cash inflo1 is /s.5$@@@. It means the pa !bac" period is bet1een 7 to 8 ears$ calculated as follo1s:

/s.:@@ Pa ! bac" Period T 7 ears U /s.5$@@@ T 7.5: ears

Illustration 1: Pa off (td.$ is producing articles mostl b manual labour and is considering to replace it b a ne1 machine. &here are t1o alternative models M and * of the ne1 machine. Prepare a statement of profitabilit sho1ing the pa bac" period from the follo1ing information: Dachine D 8 ears /s.?$@@@ /s.:@@ /s. ;$@@@ /s.>@@ /s. 3$5@@ Dachine 8 : ears /s. 3>$@@@ /s.>@@ /s. >$@@@ /s. 3$@@@ /s. 3$>@@

%stimated life of machine Cost of machine %stimated savings in scrap %stimated savings in direct 1ages Additional cost of maintenance Additional cost of supervision

Solution: Statement sho1ing annual cash inflo1s M#c+in& M R/. %stimated savings in scrap %stimated savings in direct 1ages &otal savings BAC Additional cost of maintenance Additional cost of supervision &otal additional cost B)C *e1 cash inflo1 BAC ! B)C =riginal Investment T Annual Average Cash Inflo1 /s.?$@@@ /s.8$:@@ T /s.3>$@@@ /s.;$@@@ :@@ ;$@@@ ;$:@@ >@@ 3$5@@ 5$@@@ 8$:@@ M#c+in& N R/. >@@ >$@@@ >$>@@ 3$@@@ 3$>@@ 5$>@@ ;$@@@

Pa !bac" Period

5 ears

T 7 ears

Machine M should be preferred because it has a shorter pa !bac" period. Acc&5t#nc& o% R&K&ct C%it&%ion : Man firms use the pa !bac" period as an accept or re#ect criterion as 1ell as a method of ran"ing pro#ects. If the pa !bac" period calculated for a pro#ect is less than the ma+imum pa !bac" period set b management$ it 1ould be acceptedA if not$ it 1ould be re#ected. As a ran"ing method$ it gives highest ran"ing to the pro#ect 1hich as shortest pa !bac" period and lo1est ran"ing to the pro#ect 1ith highest pa !bac" period. &hus$ if die firm has to choose among t1o mutuall e+clusive pro#ects$ pro#ect 1ith shorter pa !bac" period 1ill be selected. A).#nt# &/ o' 6#0-7#c8 M&t+o) : 3C It is eas to calculate and simple to understand.

5C 7C

It saves in cost$ as it re0uires lesser times and labour as compared to other methods. 2nder this method$ a shorter pa !bac" period is preferred to the one having a longer pa !bac" period$ and it reduces the loss through obsolescence and is more suited to the developing countries$ li"e India$ 1hich are in the process of development and have 0uic" obsolescence.

8C :C

&his method is useful to a concern 1hich is short of cash and is eager to get bac" the cash invested in a capital e+penditure pro#ect. As the method considers the cash flo1s during the pa !bac" period of the pro#ect$ the estimates 1ould be reliable and the result ma be comparativel more accurate.

Di/#).#nt# &/ o' 6#0-7#c8 M&t+o) : B3C It does not ta"e into account the cash inflo1s earned after the pa !bac" period and hence the true profitabilit of the pro#ect cannot be correctl assessed. B5C &his method does not consider the amount of profit earned on investment after the recover of cost of investment. B7C It does not ta"e into consideration the cost of capital 1hich is a ver important factor in ma"ing a sound investment decisions. B8C It ma be difficult to determine the minimum acceptable pa !bac" period$ it is usuall $ a sub#ective decision. B:C It ignores interest factor 1hich is considered to be a ver significant factor in ta"ing sound investment decision. B;C &oo much emphasis on the Eli0uidit of the investmentE$ ignoring the

Eprofitabilit of investmentE ma not be #ustified in a number of situations. B<C It ignores time value of mone . Cash flo1s received in different ears are treated e0uall .

B>C

It doe not ta"e into account the life of the pro#ect$ depreciation$ scrap!value$ interest factor etc. )ecause$ a rupee tomorro1 is 1orthless than a rupee toda .

:2;

I(5%o.&(&nt in T%#)ition#$ A55%o#c+ to 6#0-7#c8 6&%io) =ne of the most commonl used techni0ues for evaluating capital investment

proposal is the cash pa !bac" method. Some authorities on accountanc $ in order to ma"e up the deficiencies of the pa !bac" period method$ evolved ne1 concepts. &he improvements are discussed belo1: :#; 6o/t 6#0-7#c8 6%o'it#7i$it0 : =ne of the limitations of the pa !bac" period method is that it neglects the profitabilit of investment be ond the pa !bac" period. &his method is also "no1n as Surplus (ife over pa !bac" period. According to this method$ the pro#ect .Jhich gives the greatest post pa !bac" period profits ma be accepted. It has been e+plained in the follo1ing illustration: Post pa !bac" profitabilit T Annual Cash Inflo1 B%stimated (ife ! Pa !bac" PeriodC Further$ post pa !bac" profitabilit multipl ing the above formula 1ith 3@@. Illustration %: A concern is considering t1o pro#ects W and ]. particulars in respect of them: Pro;ect A 3$8@$@@@ 3@ 3@$@@@ 5:$@@@ Pro;ect B 3$8@$@@@ 3@ 38$@@@ 5@$@@@ Follo1ing are the inde+ can also be calculated b

Cost B/s.C %conomic (ife Bin earsC %stimated Scrap Bin /s.C Annual Savings

Ignoring income!ta+$ recommend the best of these pro#ects using BaC pa bac" period$ BbC post pa !bac" profit$ and BcC inde+ of post pa !bac" profit. Solution: Pro;ect A 3. 5. 7. 8. :. ;. <. Cost Savings Pa !bac" period %conomic (ife Surplus (ife Post pa !bac" profit B5 + 8( Inde+ of post pa !bac" profit 3$3@$@@@ 3$8@$@@@ + 3@@ D =>.6O 3$8@$@@@ 5:$@@@ :.; ears 3@ ears 8.8 ears 3$3@$@@@ ;@$@@@ 3$8@$@@@ + 3@@ D 42.?O Pro;ect B 3$8@$@@@ 5@$@@@ < ears 3@ ears 7 ears ;@@@@

Pro#ect W is the best one b all the methods of ran"ing.

:!;

Di/count&) 6#0-7#c8 6&%io) : Another serious limitation of pa !bac" period method is that it ignores the

time value of mone . &his method can be improved or modified to consider the time value of mone . 2nder this method the present values of all cash outflo1s and inflo1s are computed at an appropriate discount rate. &he number of periods ta"en in recovering the investment outla on the present value basis is called the discounted pa !bac" period. &he present values of all inflo1s are cumulated in order of time. &he time period at 1hich the cumulated present value of cash inflo1 e0uals the present value of cash outflo1s is "no1n as discounted pa bac" period. Illustration (: &he follo1ing are the particulars relating to a pro#ect /s. :@$@@@

Cost of the pro#ect =perating Savings:

3st ear 5nd ear 7rd ear 8th ear :th ear

:$@@@ 5@$@@@ 7@$@@@ 7@$@@@ 3@$@@@

Calculate BiC pa !bac" period ignoring interest factor and BiiC discount pa ! bac" period ta"ing into account interest factor at 3@R. Solution: :i; 6#0-7#c8 5&%io) Bear 3 5 7 Annual Sa'ings Cumulati'e Sa'ings /s. :$@@@ 5@$@@@ 7@$@@@ /s. :$@@@ 5:$@@@ ::$@@@

2pto second ear$ /s.5:$@@@ recovered &herefore$ pa !bac" period T > !ears U /s.:@$@@@! /s.5:$@@@ /s.7@$@@@ /s.5:$@@@ T 5 U /s.7@$@@@ T 5 ears 3@ months BiiC Discounted Pa !bac" period at 3@R interest factor Discounted Bears Sa'ings /s. 3 5 7 8 :$@@@ 5@$@@@ 7@$@@@ 7@$@@@ @.?@?3 @.>5;: @.<:37 @.;>7@ PV "actor Sa'ings /s. 8$:8; 3;$:7@ 55$:7? 5@$8?@ Sa'ings /s. 8$:8; 53$@<; 87$;3: ;8$3@:$ Cumulati'e Discounted

/s. :@$@@@ ! /s.87$;3:

Discounted pa !bac" period T 1 !ears )

/s.5@$8?@

T 7 !ears 8 mont"s :C; 6#0-7#c8 R&ci5%oc#$ Sometimes$ pa !bac" reciprocal method is emplo ed to estimate the internal rate of return generated b a pro#ect. Annual Cash Inflo1 Pa !bac" /eciprocal T &otal Investment ,o1ever$ this method of ran"ing investment proposals should be used onl 1hen: :3; Annual savings are even for the entire period. &he economic life of the pro#ect is at least t1ice of the pa !bac" R#t& o' R&tu%n M&t+o) :Accountin M&t+o); &his method is also "no1n as Accounting /ate of /eturn method or /eturn on Investment of Average /ate of /eturn method. According to this method$ various pro#ects are ran"ed in order of the rate of earnings or rate or return. Pro#ects 1hich ield the highest earnings are selected and others are ruled out. &he return on investment can be e+pressed in several 1a s$ as follo1s: :#; A.&%# & R#t& o' R&tu%n M&t+o) ,ere$ average profit$ after ta+ and depreciation$ is calculated and then it is divided b the total capital outla or total investment in the pro#ect. &his method establishes the ratio bet1een the average annual profits to total outla . Average Annual Profit =utla of the Pro#ect + 3@@ period.

Average /ate of /eturn T

Pro#ect giving a higher rate of return 1ill be preferred over those giving lo1er rate of return. :7; R&tu%n 6&% unit o' In.&/t(&nt M&t+o) In this method$ the total profit after ta+ and depreciation is divided b the total investment. &his gives us the average rate of return per unit of amount invested in the pro#ect. &otal Profit *et Investment + 3@@

/eturn per unit of Investment T

:c;

R&tu%n on A.&%# & In.&/t(&nt M&t+o) 2nder this method the percentage return on average amount of investment is

calculated. &o calculate the average investment$ the outla of the pro#ect is divided b t1o.
&otal Profit after deprec. ' &a+es &otal *et Investment D5 + 3@@

/eturn on Average Investment T

:);

A.&%# & R&tu%n on A.&%# & In.&/t(&nt M&t+o) 2nder this method$ average profit after depreciation and ta+es is divided b

the average of amount of investment. &his is an appropriate method of rate of return on investment.
Average /eturn on Average Investment T Average Annual *et Investment D 5 + 3@@

I$$u/t%#tion 4: Calculate the average rate of return for pro#ects A and ) from the follo1ing: Investment %+pected (ife Bno salvage valueC Pro;ect A /s.5@$@@@ 8 ears Pro;ect 4 /s.7@$@@@ : ears

Pro#ected *et Income$ after interest$ depreciation and ta+es: Jears 3 5 7 8 : &otal Pro;ect A /s. 5$@@@ 3$:@@ 3$:@@ 3$@@@ ! ;$@@@ Pro;ect 4 /s. 7$@@@ 7$@@@ 5$@@@ 3$@@@ 3$@@@ 3@$@@@

If the re0uired rate of return is 3 >I 1hich pro#ect should be underta"enH Solution: Pro;ect A /s. &otal profit$ after interest$ depreciation and ta+es %+pected (ife Average Profit Investment Average /ate of /eturn Average /ate of /eturn Average /eturn on Average Investment 3$:@@ 5@$@@@ + 3@@ T <.:R 3$:@@ 5@$@@@D5 + 3@@ T 3:R ;$@@@ 8 ears 3$:@@ 5@$@@@ 3!:@@ 5$@@@ 7@$@@@ + 3@@ T ;.;R 5$@@@ 7@$@@@D5 + 3@@ T 37.77R Pro;ect * /s. 3@$@@@ : ears 5$@@@ 7@$@@@ 5$@@@

&he average return on average investment is higher in the case of Pro#ect A$ besides it is also higher than the re0uired rate of return of 35R. Pro#ect A is suggested to be underta"en. Merits of /ate of /eturn Method &he follo1ing are the merits: It is simple to understand and eas to calculate. It ta"es into consideration the total earnings from the pro#ect during its life time. &hus this method gives a better vie1 of profitabilit as compared to pa ! bac" period method.

It is based upon accounting concept of profit. It can be calculated from the financial data.

Demerits of /ate of /eturn Method : &his method suffers from the follo1ing demerits: It ignores the time value of mone . Profits earned in different periods are valued e0uall . &his method ma investments. It does not ta"e into consideration the cash flo1s 1hich is more important than the accounting profits. It ignores the fact that profits can be reinvested. &here are different methods for calculating the Accounting /ate of /eturn. %ach method gives different results. &his reduces the reliabilit of the method. TIME AD3USTED MET"OD :DISCOUNTED CAS" FLO* MET"OD; Discounting is #ust opposite of compounding. In compound rate of interest$ the future value of the present mone is ascertained 1hereas in discounting$ the present alue of future mone is calculated. &he rate at 1hich the future cash flo1s are reduced to their present value is termed as discount rate. Discount rate$ other1ise called time value of mone $ is some interest rate 1hich e+presses the time preference for a particular future cash flo1. &he discounted cash flo1 method is an improvement on the pa !bac" method as 1ell as accounting rate of return. &his method is based on the fact that future value of mone 1ill not be e0ual to the present value of mone . &hat is$ discounted cash flo1 techni0ue recognises that /e. one of toda Bcash outflo1C is 1orth more than /e. one received at a future date Bcash inflo1C. Die time ad#usted or discounted cash flo1 method ta"e into account the profitabilit and also the time value of mone . &he discounted cash flo1 method for evaluating capital investment proposals are of three t pes: not reveal true and fair vie1 in the case of long!term

1.

N&t 6%&/&nt 4#$u& M&t+o) &his method is also "no1n as %+cess Present .alue or *et 6ain Method or

&ime Ad#usted methods. 2nder this method$ cash inflo1s and cash outflo1s associated 1ith each pro#ect are first 1or"ed out. &he present values of these cash inflo1s and outflo1s are then calculated at the rate acceptable to the management. &his rate of return is considered as the cut!off rate and is generall determined on the basis of cost of capital suitabl ad#usted to allo1 for the ris" element involved in the pro#ect. &he present values of total of cash inflo1s should be compared 1ith present values of cash outflo1s. If the present value of cash inflo1s are greater than Bor e0ual toC the present value of cash outflo1s Bor initial investmentC$ the pro#ect 1ould be accepted. If it is less$ then proposal 1ill be re#ected. Illustration 4: A compan is considering the purchase of the t1o machines 1ith the follo1ing details: Machine I (ife %stimated Capital Cost *et earning after ta+: 3st ear 5nd ear 7rd ear 7 ears /s. 3@$@@@ >$@@@ ;$@@@ 8$@@@ Machine II 7 ears /s. 3@$@@@ 5$@@@ <$@@@ 3@$@@@

]ou are re0uired to suggest 1hich machine should be preferred.

Solution: Calculation of *et Present .alue B3@RC

M#c+in& I 9&#% 3 5 7 64 F#cto% @.?@? @.>5; @.<:3

M#c+in& II 6%&/&nt 4#$u& R/. 3$>3> :$<>5 <$:3@ 3:$33@ 3@$@@@ :$33@

C#/+ In'$o- 6%&/&nt 4#$u& C#/+ In'$oR/. >$@@@ ;$@@@ 8$@@@ R/. <$5<5 8$?:; 7$@@8 3:$575 3@$@@@ :$575 R/. 5$@@@ <$@@@ 3@$@@@

(ess: Cost *et Present .alue

Machine I should be preferred as net present value is /s.:$575 1hich is higher than /s.:$33@ in case of Machine II. Merits of *et Present .alue Method &he merits of this method of evaluating investment proposal are as follo1s:s &his method considers the entire economic life of the pro#ect. It ta"es into account the ob#ective of ma+imum profitabilit . It recognises the time value of mone . &his method can be applied 1here cash inflo1s are uneven. It facilitates comparison bet1een pro#ects.

D&(&%it/ o' t+i/ (&t+o) #%& #/ 'o$$o-/: It is not eas to determine an appropriate discount rate. It involves a great deal of calculations. operate. It is ver difficult to forecast the economic life of an investment e+actl . It ma not give good results 1hile comparing pro#ects 1ith une0ual It is more difficult to understand and

investment of funds. 2. Int&%n#$ R#t& o' R&tu%n M&t+o) &his method K popularl "no1n as time ad#usted rate of return method or discounted rate of return method. &he internal rate of return is defined as the interest rate that e0uates the present value of the e+pected future receipts to the cost of the

investment outla . &his internal rate of return is found b trial and error. First$ 1e compute the present value of the cash!flo1s from an investment$ using an arbitraril selected interest rate. &hen$ 1e compare the present value so obtained 1ith the investment cost. If the present value is higher than the cost figure$ 1e tr a higher rate of interest and go through the procedure again. Conversel $ if the present value is lo1er than the cost$ lo1er the interest rate and repeat the process. &he interest rate that brings about this e0ualit is defined as the internal rate of return. &his rate of return is compared to the cost of capital and the pro#ect having higher difference$ if the are mutuall e+clusive$ is adopted and other one is re#ected. As this determination of internal rate of return involves a number of attempts to ma"e the present value of earnings e0ual to investment$ this approach is also called the &rial and %rror Method. Illustration 5: Initial Investment /s.;@$@@@ (ife of the Asset %stimated net annual cash!flo1s: 3st ear 5nd ear 7rd ear 8th ear Calculate Internal /ate of /eturn. /s. 3:$@@@ /s.5@$@@@ /s.7@$@@@ /s.5@$@@@ 8 ears

Solution: Calculation of Internal /ate of /eturn

Annu#$ 9&#% 3 5 7 8 C#/+'$o3:$@@@ 5@$@@@ 7@$@@@ 5@$@@@ 1@O @.?@? @.>:; @.<:3 @.;>7 64F 64 37$;7: 3;$:5@ 55$:7@ 37$;;@ ;;$78: 12O @.>?5 @.<?< @.<33 @.;7: 64F 64 37$7>@ 3:$?8@ 53$77@ 35$<@@ ;7$7:@ 14O @.><< @.<;? @.;<8 @.:?5 64F 64 37$3:: 3:$7>@ 5@$55@ 33$>8@ ;@$:?: 15O @.>;? !@.<:; @.;:< @.:<3 64F 64 37$@7: 3:$35@ 3?$<3@ 33$85@ :?$5>:

&otal of P. of Cash inflo1

Initial investment is /s.;@$@@@. ,ence internal rate of return must be bet1een 38R and 3:R B/s.;@$:?: and /s.:?$5>:C. &he difference comes to /s. 3.73@ B/s.;@$:?: ! /s.:?$5>:C. For a difference of 3$73@$ difference in rate T 3R B%+cess P.: ;@:?:!;@$@@@T:?:C :?: &herefore$ e+act Internal /ate of /eturn T 38R U3$73@ + 3R T 38R U @.8:R D14.45O 3. 6%o'it#7i$it0 In)&A Nu(7&% It is also a time ad#usted method of evaluating the investment proposals. Profitabilit inde+ also called )enefit Cost /atio or Desirabilit factor. It is the ratio of the present value of cash inflo1s$ at the re0uired rate of return to the initial cash outflo1 of the investment. &he probabilit inde+ is less than one. ) computing profitabilit indices for various pro#ects$ the financial manager can ran" them in order of their respective ratio of profitabilit .
P. of Cash Flo1s

Profitabilit Inde+ T Initial Cost =utla

Illustration 6: &he initial cash outla inflo1s: 3st ear 5nd ear 7rd ear 8th ear Compute Profitabilit Inde+. Solution: Calculation of Profitabilit Inde+

of a pro#ect is /s.:@$@@@. %stimated cash

/s.5@$@@@ /s. 3:$@@@ /s.5:$@@@ /s. 3@$@@@

9&#% 3 5 7 8

C#/+ In'$o-/ R/. 5@$@@@ 3:$@@@ 5:$@@@ 3@$@@@

64 F#cto% #t 1@O ?.?@? @.>5; @.<:3 @.;>7 &otal

64 R/. 3>$3>@ 35$7?@ 3>$<<: ;$>7@ :;$3<:

&otal Present .alue (ess: Initial =utla *et Present .alue Profitabilit Inde+ BgrossC

T T T T

/s.:;$3<: /s.:@$@@@ ;$3<: P. Cash Inflo1 Initial Cash =utflo1 :;$3<: :@$@@@ T 3.357:

Profitabilit inde+ is higher than 3$ the proposal can be accepted.

CA6ITAL RATIONING Capital rationing is a situation 1here a firm has more investment proposals than it can finance. Man concerns have limited funds. &herefore$ all profitable investment proposal ma not be accepted at a time. In such event the firm has to select from amongst the various competing proposals$ those 1hich give the highest benefits. &here comes the problem of rationing them. &hus capital rationing ma be defined as a situation 1here the management has more profitable investment proposals re0uiring more amount of finance than the funds available to the firm. also to ran" the pro#ects from the highest to lo1est priorit Illustration -: L (td. is considering the purchase of a machine. &1o machines are available$ A and ). &he cost of each machine is /s.;@$@@@. %ach machine has an e+pected life of : ears. *et profits before ta+ but after depreciation during the e+pected life of the machine are given belo1: 9&#% 3 5 7 8 : M#c+in& A /s. 3:$@@@ 5@$@@@ 5:@@ 3:$@@@ 3@$@@@ M#c+in& ! /s. :$@@@ 3:$@@@ 5@$@@@ 7@$@@@ 5@$@@@ In such a situation$ the firm has not onl to select profitable investment proposals but

Follo1ing the method of return on investment ascertain 1hich of the alternates 1ill be more profitable. &he average rate of ta+ ma be ta"en at :@R. Solution : Computation of profit after ta+ 0&#% M#c+in& A 6%o'it T#A #t 6%o'it 7&'o%& t#A 5@O #'t&% t#A /s. 3 5 7 8 : &otal 3:$@@@ 5@$@@@ 5:$@@@ 3:$@@@ 3@$@@@ >:$@@@ <$:@@ 3@$@@@ 35$:@@ <$:@@ :$@@@ 85$:@@ /s. <$:@@ 3@$@@@ 35$:@@ <$:@@ :$@@@ 85$:@@ M#c+in& ! 6%o'it T#A #t 6%o'it 7&'o%& t#A 5@O #'t&% t#A /s. :$@@@ 3:$@@@ 5@$@@@ 7@$@@@ 5@$@@@ ?@$@@@ 5$:@@ <$:@@ 3@$@@@ 3:$@@@ 3@$@@@ 8:$@@@ V /s. 5$:@@ <$:@@ 3@$@@@ 3:$@@@ 3@$@@@ 8:$@@@

M#c+in& A Average profit after ta+ Investment Average Investment Average /eturn on Investment Average /eturn on Average Investment /s. ;@$@@@ 5 T /s. 7@$@@@ /s. 85$@@@ : T /s. >$:@@ /s. ;@$@@@ /s. ;@$@@@ 5 T /s. 8:$@@@ :

M#c+in& ! T /s. ?@@@ /s. ;@$@@@

/s. 7@$@@@

/s. >$:@@ ;@$@@@ /s. >$:@@ 7@$@@@ + 3@@ T /s. 5>.78R + 3@@ T /s. 38.3<R

/s. ?$@@@ ;@$@@@ + 3@@ T /s. 3:R /s. ?$@@@ 7@$@@@ + 3@@ T /s. 7@R

Machine ) is more profitable. Illustration , : A (td. Compan is considering the purchase of a ne1 machine 1hich 1ill carr out operations preformed b labour. W and ] are alternative models. From the follo1ing information$ ou are re0uired to prepare a profitabilit statement and 1or" out the pa !bac" period for each model.

%stimated (ife Cost of Machine Cost of indirect materials %stimated savings in scrap Additional cost of maintenance %stimated savings in direct 1ages: %mplo ees not re0uired Jages per emplo ee

Model W /s. : ears 3$:@$@@@ ;$@@@ 3@$@@@ 3?$@@@ 3:@ ;@@

Model ] /s. ; ears 5$:@$@@@ >$@@@ 3:$@@@ 5<$@@@ 5@@ ;@@

&a+ation to be regarded :@R of profit before charging depreciation. Jhich model ou recommend H Solution: Profitabilit Statement
Mo)&$ G %stimated saving per ear scrap Jages B3:@+;@@C B5@@+;@@C &otal Savings (ess: Additional Cost Cost of indirect materials ;$@@@ Cost of Maintenance 3?$@@@ Additional %arnings (ess: &a+ X :@R Cash flo1 BannualC (ess: Depreciation: 3$:@$@@@ : *et Increase in earnings Pa !bac" period: 5:$@@@ <:$@@@ 7<$:@@ 7<$:@@ 7@$@@@ <$:@@ 3$:@$@@@ 7<$:@@ T 8 ears 5$:@$@@@ :@$@@@ T : ears 5<$@@@ 7:$@@@ 3$@@$@@@ :@$@@@ :@$@@@ 83$;;< >$777 3$@@$@@@ >$@@@ 3$7:$@@@ ?@$@@@ 3$7:$@@@ :R/; 3@$@@@ Mo)&$ 9 :R/; 3:$@@@

5$:@$@@@ ;

Cost of Machine Annual Cash Flo1 <$:@@ 3$:@$@@@ +3@@ T :R >$7@@ 5$:@$@@@ +3@@ T 7.7R

A pa !bac" period of Model W is less than that of Model ]$ Fnd also the return on Investment is higher in respect of W$ Model W is recommended. Illustration 1<: A compan proposing to e+pand its production can go either for an automatic machine costing /s.5$58$@@@ 1ith an estimated life of 8G> ears or an ordinar machine costing /s.;@$@@@ having an estimated life of > ears. Automatic &he annual sales and costs are estimated as follo1s: Sales Costs: Materials (abour .ariable =verhead Dachine /s. 3$:@$@@@ :@$@@@ 35$@@@ 58$@@@ #rdinar& Dachine /s. 3$:@$@@@ :@$@@@ ;@$@@@ 5@$@@@

Compute the comparative profitabilit under pa !bac" method.

Solution:
Auto(#tic M#c+in& R/. Annual Sales (ess: .ariable Cost Materials (abour =verheads Marginal Profit :@$@@@ 35$@@@ 58$@@@ >;$@@@ ;8$@@@ :@$@@@ ;@$@@@ 5@$@@@ 3$7@$@@@ 3$:@$@@@ O%)in#%0 M#c+in& R/. 3$:@$@@@

5@$@@@ 5$58$@@@ Pa !bac" period: ;8$@@@ 7 \ ears ;@$@@@ 5@$@@@ T 7 ears

Post pa !bac" profitabilit

3 V

5@$@@@ B>!: rs.C D R/. 1<@@<@@@

;8$@@@ : 5 75 D R/. 1<2><@@@

Illustration 11: &he &amil *adu Fertili-ers (td. is considering a proposal for the investment of /s.:$@@$@@@ on product development 1hich is e+pected to generate net cash inflo1s for ; ears as under: Bear 3 5 7 8 : ; 8et Cash "lows 7<<<$ *il 3@@ 3;@ 58@ 7@@ ;@@

&he follo1ing are the present value factors X 3:R p.a. ]ear Factor Solution: Calculation of *et Present .alue 9&#% 3 5 7 8 C#/+ In'$o-/ :J@@@; R/. *il 3@@ 3;@ 58@ 64 F#cto% @.>< @.<; @.;; @.:< 6%&/&nt 4#$u&/ :J@@@; R/. *il <;.@ 3@:.;@ 37;.>@ 3 @.>< 5 @.<; 7 @.;; 8 @.:< : @.:@ ; @.87

: ;

7@@ ;@@

@.:@ @.87 &otal (ess: Cash =utla *et Present .alue

3:@.@@ 5:>.@@ <5;.8@ :@@.@@ 55;.8@

As the net present value is positive$ the proposal is acceptable. Illustration 1%: &he financial manager of a compan has to advise the )oard of Directors on choosing bet1een t1o compelling pro#ect proposals 1hich re0uire an e0ual investment of /s. 3$@@$@@@ and are e+pected to generate cash flo1s as under: Pro;ect I /s. 8>$@@@ 75$@@@ 5@$@@@ *il 58$@@@ 35$@@@ Pro;ect II /s. 5@$@@@ 58$@@@ 7;$@@@ 8>$@@@ 3;$@@@ >$@@@

%nd of ear

3 5 7 8 : ;

Jhich pro#ect proposal should be recommended and 1h H Assume the cost of capital to be 3@R p.a. &he follo1ing are the present value factors at 3@R p.a. ]ear Factor Solution: Calculation of *et Present .alue 9&#% 6%oK&ct I N&t C#/+ In'$o-/ /s. 3 5 8>$@@@ 75$@@@ 6%oK&ct II N&t C#/+ In'$o-/ /s. 5@$@@@ 58$@@@ ?.?@? @.>5; 64 F#cto% S 1@O /s. 87$;75 5;$875 /s. 3>$37@ 3?$>.58 64 o' 6%oK&ct I 64 o' 6%oK&ct 11 3 @.?@? 5 @.>5; 7 @.<:3 8 @.;>7 : @.;53 ; @.:;8

7 8 : ;

5@$@@@ *il 58$@@@ 35$@@@

7;$@@@ 8>$@@@ 3;$@@@ >$@@@

@.<:3 @.;>7 @.;5.3 @.:;8 &otal

3:$@5@ *il 38$?@8 ;$<;> 3$@;$<:; 3$@@$@@@ ;$<:;

5<$@7; 75$<>8 ?$?7; 8$:35 3$35$5<5 3$@@$@@@ 35$5<5

(ess: Cash =utla *et Present .alue

Pro#ect II should be accepted as the *P. is more than that of Pro#ect I. Illustration 1(: From the follo1ing information$ calculate the net present value of the t1o pro#ects and suggest 1hich of the t1o profits should be accepted assuming a discount rate of 3@R.

Profit A /s. Initial Investment %stimated (ife Scrap .alue 5@$@@@ : ears 3$@@@

Profit B /s. 7@$@@@ : ears 5$@@@

Profits before depreciation and after ta+es are as follo1s: ]ear Profit A /s. 3 5 7 8 : :$@@@ 3@$@@@ 3@$@@@ 7$@@@ 5$@@@ Profit B /s. 5@$@@@ 3@$@@@ :$@@@ 7$@@@ 5$@@@

Solution :
9&#% C#/+ F$o-/ 6%oK&ct G 6%oK&ct 9 64 o' R&.1 S1@O @.?@? @.>7; @.<:3 @.;>7 @.;53 @.;53 6%&/&nt 4#$u& o' N&t C#/+ F$o6%oK&ct G 6%oK&ct 9

/s. 3 5 7 8 : ;
:$@@@ 3@$@@@ 3@$@@@ 7$@@@ 5$@@@ 3$@@@

/s.
5@$@@@ 3@$@@@ :$@@@ 7$@@@ 5$@@@ 5$@@@

/s.
8$:8: >$5;@ >$:3@ 5$@8? 3$585 ;53 58$55< 5@$@@@ 8$55<

/s.
3>$3>@ >$5;@ 7$<:: 5$@8? 3$585 3$585 78$<5> 7@$@@@ 8$<5>

Pro#ect ] should be selected as *P. of Pro#ect ] is higher. Illustration 13: A firm is considering the purchase of a machine. &1o machines A and ) are available$ each costing /s.:@$@@@. In comparing the profitabilit of those machines a discount rate of 3@R is to be used! %arnings after ta+ation are e+pected to be as follo1s: ]ou are also given the follo1ing data: Bear Dachine A Cash Inflow /s. 3 5 7 8 8 3:$@@@ 5@$@@@ 5:$@@@ 3:$@@@ 3@$@@@ Dachine * Cash Inflow /s. :$@@@ 3 :$@@@ 5@$@@@ 7@$@@@ 5@$@@@

]ou are also given the follo1ing data : &ear 3 PV "actor F 1<E discount @.?@?

5 7 8 :

@.>5; @.<:3 @.;>7 @.;53

%valuate the pro#ects using: BaC BbC BcC BdC Solution: Bear Cash Inflow /s. 3 5 7 8 : 3:$@@@ 5@$@@@ 5:$@@@ 3:$@@@ 3@$@@@ Cumulati'e Cash Inflow /s. 3:$@@@ 7:$@@@ ;@$@@@ <:$@@@ >:$@@@ the pa !bac" period the accounting rate of return the net present value the profitabilit inde+

&he above calculation sho1s that in t1o ears /s.7:$@@@ has been recovered. /s. 3:$@@@ is left out of initial investment. In the 7 rd ear cash inflo1 is /s.5:$@@@. It means the pa !bac" period is bet1een 5nd and 7 3:$@@@ 5:$@@@ T 5.; !ears ear$ thus:

Pa !bac" Period T 5U BbC Machine ) Bear

Cash Inflow /s.

Cumulati'e Cash Inflow /s. :$@@@

:$@@@

5 7 8 :

3:$@@@ 5@$@@@ 7@$@@@ 5@$@@@

5@$@@@ 8@$@@@ <@$@@@ ?@$@@@

In three ears /s.8@$@@@ has been recovered. &he balance left out of initial investment is /s. 3@$@@@. It means the pa !bac" period is bet1een 7 rd and 8th ear$ thus: Pa !bac" Period T 7U 3@$@@@ 7@$@@@ T 7.77 !ears

Machine A should be purchased. )ecause pa !bac" period is less. Accounting /ate of /eturn Mac"ine A &otal /eturns Average /eturn T T /s.>:$@@@ /s.>:$@@@ : T /s.3<$@@@ 3<$@@@ :@$@@@ + 3@@ T 78R

Average /ate of /eturn T

Mac"ine 4 &otal /eturns Average /eturn T T /s.?@$@@@ /s.?@$@@@ : T /s.3>$@@@ 3>$@@@ :@$@@@ + 3@@ T 7;R

Average /ate of /eturn T

N&t 6%&/&nt 4#$u& Calculation of *et Present .alue

64 F#cto% / S 1@O /s. 3 5 7 8 : @.?@? @$>5; @.<:3 @.;>7 @.;53

C#/+ In'$o-/ M#c+in& A /s. 3:$@@@ 5@$@@@ 5:$@@@ 3:$@@@ 3@$@@@

C#/+ In'$o-/ M#c+in& ! :$@@@ 3:$@@@ 5@$@@@ 7@$@@@ 5@$@@@ &otal (ess: Cash =utla *et Present .alue

64 M#c+in& ! /s. 37$;7: 3;$:5@ 3>$<<: 3@$58: ;$53@ ;:$7>: :@$@@@ 3:$7>:

64 M#c+in& A /s. 8.:8: 35$7?@ 3:$@5@ 5@$8?@ 35$85@ ;8$>;: :@$@@@ 38$>;:

&he *et Present .alue of Machine A is more than that of Machine ). So$ Machine A should be purchased. Probabilit Inde+ Present .alues Machine A T Cost of Investment ;8$>;: Machine ) T :@$@@@ T 3.5?< Probabilit Inde+ of Machine A is more than that of Machine ) and therefore$ Machine A should be preferred. T ;:$7>: :@$@@@ T 3.7@>

LESSON - 15 : CASE STUD9 CASE-1 !USINESS DECISION

Adams Compan and )a"er Compan are in the same line of business and both 1ere recentl organi-ed$ so it ma be assumed that the recorded costs for assets are close to e+tent mar"et values. &he balance sheets for the t1o companies are as follo1s at 9ul 73$ 3? ADAMS COM6AN9 !#$#nc& S+&&t 3u$0 31<1? A//&t/ Cash Accounts receivable (and )uilding =ffice e0uipment T 8$>@@ ?$;@@ 7;$@@@ ;@$@@@ 35$@@@ 122<4@@ Li#7i$iti&/ H O-n&%J/ ECuit0 (iabilities: *otes pa able Bdue in ;@ da sC Accounts pa able &otal liabilities =1nerIs %0uit %d Adams$ capital 3;$>@@ 122<4@@ ;5$8@@ 87$5@@ 3@:$;@@ T

!AFER COM6AN9 !#$#nc& S+&&t 3u$0 31<1? UUU

A//&t/ Cash Accounts receivable (and )uilding =ffice e0uipment

T 58$@@@ 8>$@@@ <$5@@ 35$@@@ 3$5@@

Li#7i$iti&/ H O-n&%J/ ECuit0 (iabilities: *otes pa able Bdue in ;@ da sC Accounts pa able &otal liabilities =1nerIs %0uit %d Adams$ capital

T 38$8@@ ?$;@@ 58$@@@ ;>$8@@ ?2<4@@

?2<4@@ Pu&/tion/ : B3C

Assume that ou are a ban"er and that each compan has applied to ou for a ?@!da loan of d 35$@@@. Jhich 1ould ou consider to be the more favourable prospectH

B5C

Assume that ou are an investor considering the purchase of one or both of the companies. )oth %d Adams and &om )a"er have indicated to ou that the 1ould consider selling their respective business. In either transaction ou 1ould assume the e+isting liabilities. For 1hich business 1ould ou be 1illing to pa the higher priceH %+plain our ans1er full . BIt is recognised that for either decision$ additional information 1ould be useful$ but ou are to reach our decisions on the basis of the information availableC.

CASE- 2 !USINESS DECISION

/ichard Fell$ a college student 1ith several summersI e+perience as a guide on canoe camping trips$ decided to go into business for himself. &o start his o1n guide service$ Fell estimated that at least d 8$>@@ cash 1ould be needed. =n 9une 3$ he borro1ed d 7$5@@ from his father and signed a three! ear note pa able 1hich stated

that no interest 1ould be charged. ,e deposited this borro1ed mone along 1ith d 3$;@@ of his o1n savings in a business ban" account to begin a business "no1n as )irchbar" Canoe &rails. &he d I7$5@@ note pa able is a liabilit of the business entit . Also on 9une I$ )irchbar" Canoe &rails carried out the follo1ing transactions: BiC BiiC BiiiC )ought a number of canoes at a total cost of d ;$8@@$ paid d 3$;@@ cash and agreed to pa the balance 1ithin ;@ da s. )ought camping e0uipment at a cost of d 7$5@@ pa able in ;@ da s$ )ought supplies for cash$ d >@@. After the close of the season on September 3@$ Fell as"ed another student$ 9oseph 6allal$ 1ho had ta"en a course in accounting$ to help him determine the financial position of the business. A &he onl record Fell had maintained 1as a chec"boo" 1ith memorandum notes 1ritten on the chec" stubs. From this source 6allal discovered that Fell had invested an additional d 3$;@@ of his o1n savings in the business on 9ul 3$ and also that the accounts pa able arising from the purchase of the canoes and camping e0uipment had been paid in full. A ban" statement received from the ban" on September 3@ sho1ed a balance on deposit of d 7$58@. Fell informed 6allal that he had deposited in the ban" all cash received b the business. ,e had also paid b chec" all bills immediatel upon receiptA conse0uentl $ as of September 3@$ all bills for the season had been paid. &he canoes and camping e0uipment 1ere all in e+cellent condition at the end of the season and Fell planned lo resume operations the follo1ing summer$ In fact he had alread accepted reservations from man customers 1ho 1ished to return. 6allai felt that some consideration should be given to the 1ear and tear on the canoes and e0uipment but he agreed 1ith Fell that for the present purpose the canoes and e0uipment should be listed in the balance sheet at the original cost. &he supplies remaining on hand had cost d 8@ and Fell felt that he could obtain a refund for this amount b returning them to the supplier. 6allai suggested that t1o balance sheets be prepared$ one to sho1 the condition of the business on 9une 3 and the other sho1ing the condition on September

3@. ,e also recommended to Fell that a complete set of accounting records be established. Pu&/tion/ : 3. 2se the information in the first paragraph Bincluding the three numbered transactionsC as a basis for preparing a balance sheet dated 9une 3. 5. Prepare a balance sheet at September 3@. B)ecause of the incomplete information available$ it is not possible to determine the amount of cash at September 3@$ b adding cash receipts and deducting cash pa ments throughout the season. &he amount on deposit as reported b the ban" at September 3@$ is to be regarded as the total cash belonging to the business at that dateC. 7. ) comparing the t1o balance sheets$ compute the change in o1nerIs and state

e0uit . %+plain the sources of this change in o1nerIs e0uit

1hether ou consider the business to be successful. Also comment on the cash position at the beginning and end of the season. ,as the cash position improved significantl H %+plain.

CASE-3 !USINESS DECISION

Condensed comparative financial statements for Pacific Corporation appear belo1:

6ACIFIC COR6ORATION
Co(5#%#ti.& !#$#nc& S+&&t/ A/ o' M#0 31 Bin thousands of dollarsC A//&t/ 9&#% 3 d Current assets Plant and e0uipment Bnet of depreciationC &otal assets (iabilities ' Stoc"holderIs %0uit Current liabilities (ong!term liabilities Capital stoc" Bd3@ parC /etained earnings &otal liabilities ' stoc"holderIs e0uit 5$538 8$<3; 35$;@@ :$;<@ 5:$5@@ 5$@:5 7$<@> 35$;@@ 8$38@ 55$:@@ 3$>@@ 7$;@@ >$3@@ 8$:@@ 3>$@@@ 7$?;@ 53$58@ 5:$5@@ 9&#% 2 d 5$;3@ 3?$>?@ 55$:@@ 9&#% $ d 7$;@@ 38$8@@ 3>$@@@

6ACIFIC COR6ORATION

Co(5#%#ti.& Inco(& St#t&(&nt/ Fo% 9&#%/ M#0 31 :in t+ou/#n)/ o' )o$$#%/; A//&t/ 9&#% 3 d *et sales Cost of goods sold 6ross Profit on sales =perating e+penses Income before income ta+es Income ta+es *et income Cash dividends paid Bplus 5@R in stoc" in ]ear 5C Cash dividends per share ?@$@@@ :>$:@@ 73$:@@ 5>$3<@ 7$77@ 3$:7@ 3$>@@ 5<@ @;7 9&#% 2 d <:$@@@ 8;$:@@ 5>$:@@ 5:$5<: 7$55: 3$:@@ 3$<5: 8;: 3.33 9&#% $ d ;@$@@@ 7;$@@@ 58$@@@ 53$58@ 5$<;@ 3$5;@ 3$:@@ 8@: 3.:@

Pu&/tion/ I 3. Prepare a three! ear comparative balance sheet in percentages rather than dollars$ using ]ear 3 as the base ear. 5. Prepare common si-e comparative income statements for the three! ear period$ e+pressing all items as percentage components of net sales for each ear. 7. Comment on the significant trends and relationships revealed b the

anal tical computations in 3 and 5. &hese comments should cover current assets and current liabilities$ plant and e0uipment$ capital stoc"$ retained earnings$ and dividends. 8. If the capital stoc" of this compan 1ere selling at d 33.:@ per share$ 1ould ou consider it to be overpriced$ underpriced$ or fairl pricedH Consider

such factors as boo" value per share$ earnings per share$ dividend ield$ trend of sales and trend of the gross profit percentage. Also consider the t pes of investors to 1hom the stoc" 1ould be attractive or unattractive.

CASE-4 !USINESS DECISION Combelt Cereal Compan is engaged in manufacturing a brea"fast cereal. ]ou are as"ed to advise management on sales polic for the coming ear. &1o proposals are being considered b management 1hich 1illE BiC increase the volume of sales$ BiiC reduce the ratio of selling e+pense to sales$ and BiiiC decrease manufacturing cost per unit. &hese proposals are as follo1s: Proposal *o.3: stamps It is proposed that each pac"age of cereal 1ill contain premium stamps 1hich 1ill be redeemed for cash pri-es. &he estimated cost of this premium plan for a sales volume of over :@@$@@@ bo+es is estimated at d ;@ per 3$@@@ bo+es sold. &he ne1 advertising plan 1ill ta"e the place of all e+isting advertising e+penditures and the current selling price of <@ cents per unit 1ill be maintained. 6%o5o/#$ No. 2 : R&)uc& /&$$in 5%ic& o' 5%o)uct It is proposed that the selling price of the cereal be reduced b :R and that advertising e+penditures be increased over those of the current ear. &his plan is an alternative to Proposal *o.3$ and onl one 1ill be adopted b management. Management has provided current earIs operations: ou 1ith the follo1ing information as to the Increase advertising e+penditures b offering premium

Guantit sold Selling price per unit Manufacturing cost per unit

:@@$@@@ 7oA&/ d@.<@ d@.8@

Selling e+penses$ 5@R of sales Bone!fourth of 1hich 1as for ne1spaper advertisingC

Administrative e+penses$ ;R of sales %stimates for the coming ear for each proposal are sho1n belo1: 6%o5o/#$ No. 1 Increase in unit sales volume :@R Decrease in manufacturing cost 3@R per unit *e1spaper advertising =ther selling e+penses Premium plan e+pense Administrative e+penses Pu&/tion/: 3. 5. Jhich of the t1o proposals should management selectH In support of our recommendation$ prepare a statement comparing the income from operations for the current ear 1ith the anticipated income from operations for the coming ear under Proposal *o.l and under Proposal *o.5. In preparing the statement use the follo1ing column headings: Current ]ear Proposal *o. 3A and Proposal *o. 5 *one >R of sales d @.@; per bo+ :R of sales 6%o5o/#$ No. 2 7@R :R 3@R of sales >R of sales *one 3@R of sales

MODEL PUESTION 6A6ER 6#5&% 1.6: FINANCIAL AND MANAGEMENT ACCOUNTING &ime : 7 hours 6ART-A An/-&% #n0 Fi.& Cu&/tion/ 3. 5. 7. 8. :. ;. <. Jhat are the advantages of management accounting$ ho1 it differ from financial accountingH Jhat are the different t pes of errors$ ho1 this can be managed 1ellH Describe the various accounting standards. Jhat are the advantages and limitations of ratio anal sisH State the difference bet1een cash flo1 and fund flo1 statement. State the re0uisites for an effective budgetar control s stem. From the trial balance and the additional information of a public school$ prepare Income and %+penditure Account for the ear ending December 73$ 3??> and the )alance Sheet as at that date. :rial 4alance as at 0ecem er 11, 1223 Amount )uilding Furniture (ibrar )oo"s 3;R Investments B3!3!?>C Salaries Stationer 6eneral %+penses Annual Sports %+pense Cash Dr.$ 5$:@$@@@ Admission Fees 8@$@@@ &uition Fees ;@$@@@ /ent of ,all 5$@@$@@@ Creditors 5$@@$@@@ for )oo"s Amount Cr.$ :$@@@ 5$@@$@@@ 8$@@@ ;$@@@ 35$@@@ 3$8@$@@@ 5:$@@@ 8$@@$@@@ Ma+imum Mar"s: 3@@ :5A>D 4@ (#%8/;

Supplied Miscellaneous /eceipts 6overnment rant /eceived for

3:$@@@ Annual >$@@@

Donations librar boo"s ;$@@@ Capital Fund 3$@@@

)an"

5@$@@@ Interest on Investments ><@@<@@@

>$@@@ ><@@<@@@

A))ition#$ In'o%(#tion: 3C 5C 7C 8C >. &uition fees receivable for the ear 3??> amounted to /s. 3@$@@@. Salaries pa able for the ear 3??> amounted to /s. 35$@@@ Furniture costing /s. 3@$@@@ 1as purchased on 3!<!3??>. depreciation on furniture X 3@R p.a. Depreciate building b :R and librar boo"s b 5@R. A boo" "eeper 1hile preparing his trial balance finds that the debit e+ceeds b /s. <$5:@. )eing re0uired to prepare the final account he places the difference to a suspense account. In the ne+t discovered: aC A sale of /s. 8$@@@ has been passed through the purchase da boo". &he entr in the customerIs account has been correctl recorded$ bC 6oods 1orth /s. 5$:@@ ta"en a1a b the proprietor for his use has been debited to repairs accountA cC A bill receivable for /s. 3$7@@ received from 4rishna has been dishonoured on maturit but no entr passedA dC Salar of /s. ::@ paid to a cler" has been debited to his personal accountA eC A purchase of /s. <:@ from /aghubir has been debited to his account. Purchase account has been correctl debitedA fC A sum of /s. 5$5:@ 1ritten off as depreciation on furniture has not been debited to depreciation account. ear the follo1ing mista"es 1ere Charge

Draft the #ournal entries for rectif ing the above mista"es and prepare the suspense account and profit and loss ad#ustment account *ournal aC Suspense ADc &o Profit ' (oss Ad#ustment ADc B)eing 1rong recording of sales as purchase last rectifiedC bC Dra1ings ADc &o Profit ' (oss Ad#ustment ADc B)eing Dra1ings made last repairs no1 rectifiedC cC 4rishna ADc &o )ills /eceivable ADc B)eing bill dishonoured last ear no1 recorded in the boo"sC dC &o Profit ' (oss Ad#ustment ADc Dr. &o Cler"Is Personal ADc B)eing salar paid to cler" last ear inadvertentl sho1n in his personal account no1 rectifiedC eC Suspense ADc &o /aghubir ADc B)eing purchase from /aghubir Csho1n on debit side of his account inadvertentl no1 rectified fC Profit ' (oss Ad#ustment ADc &o Suspense ADc B)eing depreciation not sho1n last ear no1 rectifiedC Dr 5$5:@ 5$5:@ Dr. 3$:@@ 3$:@@ ;:@ ear inadvertentl Dr. sho1n as 3$7@@ 3$7@@ ;:@ Dr. ear 5$:@@ 5$:@@ Dr. >$@@@ >$@@@

6ART - ! An/-&% #n0 Fou% Cu&/tion/. Guestion 8o. 14 is compulsor&

B8 + 3: T ;@ mar"sC

?.

Data /am maintains his records on single entr s stem. Jhile records of business ta"ings and pa ments have been "ept$ these have not been reconciled 1ith cash in hand. From time to time cash has been paid into a ban" account and che0ues thereon have been dra1n both for business use and private purposes. From the follo1ing information$ prepare the final accounts for the ear 3??>: Assets and liabilities at the beginning and at the end of the period have given belo1: 3!3!3??> 5@$@@@ >$@@@ 7@@ 38$@@@ 5<$7@@ :@$@@@ 73!35!3??> 3:$@@@ 35$@@@ 8@@ 5@$@@@ 7@$@@@ :@$@@@

Stoc" )an" )alance Cash in hand Debtors Creditors Investments

=ther transactions are as follo1s: Cash paid in ban" Private dividends paid into ban" Private pa ments out of ban" )usiness pa ments for goods out of ban" Cash ta"ings Pa ment for goods b cash and che0ue Jages Deliver %+penses /ent and rates (ighting 6eneral %+penses

3$:@$@@@ :?$<@@ 5;$@@@ 3$55$@@@ 5$:@$@@@ 3$;@$@@@ ?<$<@@ <$@@@ 5$@@@ 3$@@@ 8$;@@

During the ear$ cash amounting to /s. 5@$@@@ 1as stolen from the till. 6oods 1orth /s. 58$@@@ 1ere 1ithdra1n from private use. *o record has been "ept of amounts ta"en from cash for personal use and a difference in calls amounting to /s. <$7@@ is treated as private e+penses.

3@.

Follo1ing are summarised )alance Sheets of IWI (td. as on 73 st December$ 5@@@ and 5@@3. ]ou are re0uired to prepare a Funds Flo1 Statement for the ear ended 73st December$ 5@@3. 1ia!ilities %<<< 3$@@$@@@ 5:$@@@ 3:$5:@ 7:$@@@ <:$@@@ 3:$@@@ %<<1 3$5:$@@@ 7@$@@@ 3:$7@@ ;<$;@@ ! 3<$:@@ Assets 6ood1ill )uildings Plant Stoc"! Debtors )an" Cash 2<65<25@ 2<55<4@@ %<<< 3$@@$@@@ <:$@@@ :@$@@@ 8@$@@@ ! 5:@ 2<65<25@ %<<1 5$:@@ ?:$@@@ >8$:@@ 7<$@@@ 75$3@@ 8$@@@ 7@@ 2<55<4@@

Share Capital 6eneral /eserve P'( ADc )an" (oan B(ong!termC Creditors Provision for &a+

Additional Information: BiC BiiC BiiiC 33. Dividend of /s.33$:@@ 1as paid. Depreciation 1ritten off on plar.t /s. <$@@@ and on buildings /s. :$@@@. Provision for ta+ 1as made during the ear /s. 3;$:@@. From the follo1ing )alance Sheets of %+e. (td. Ma"e out the statement of sources and uses of cash: 1ia!ilities %0uit Share Capital >R /edeemable Preference Share Capital 6eneral /eserve 8@$@@@ %<<< 7$@@$@@@ 3.:@.@@@ %<<1 Assets %<<< 3$3:$@@@ 5$@@$@@@ %<<1 ?@$@@@ 3$<@$@@@

8$@@$@@@ 6ood1ill 3$@@$@@@ (and and )uildings <@$@@@ Plant

>@$@@@

5$@@$@@@

Profit ' (oss Account Proposed Creditors )ill Pa able Provision for &a+ation Dividend

7@$@@@ 85$@@@ ::$@@@ 5@$@@@ 8@$@@@ 6<==<@@@

8>$@@ Debtors :@$@@@ Stoc" >7$@@@. )ills /eceivable 3;$@@@ Cash in ,and :@$@@@ Cash at )an" ><1=<@@@

3$;@$@@@ <<$@@@ 5@$@@@ 3:$@@@ 3@$@@@ 6<==<@@@

5$@@$@@@ 3$@?$@@@ 7@$@@@ 3@$@@@ >$@@@ ><1=<@@@

A))ition#$ in'o BaC BbC BcC 5. Depreciation of /s. 3@$@@@ and /s. 5@$@@@ have been charged on Plant and (and and )uilding respectivel in 5@@3. An interim dividend of /s. 5@$@@@ has been paid in 5@@@$ /s. 7:$@@@ Income!ta+ 1as paid during the ear 5@@3. 6ama %ngineering Compan (imited manufacturers t1o Products W and ]. An estimate of the number of units e+pected to be sold in the firsA seven months of 5@@3 is given belo1: Mont+/ 9anuar Februar March April Ma 9une 9ul It is anticipated that: BaC BbC &here 1ill be no 1or"!in!progress at the end of an monthA Finished units e0ual to half the anticipated sales for the ne+t month 1ill be in stoc" at the end of each month Bincluding 9une 5@@3C. 6%o)uct G :@@ ;@@ >@@ 3$@@@ 3$5@@ 3$5@@ 3$@@@ 6%o)uct 9 3$8@@ 3$8@@ 3$5@@ 3$@@@ >@@ >@@ ?>@

&he budgeted production and production costs for the ear ending 7l rt 9une$ 5@@3 are as follo1s:

6#%ticu$#%/ Production Direct materials per unit Direct 1ages per unit =ther manufacturing charges apportionable to each t pe of product ]ou are re0uired to prepare: aC

B2nitsC B/s.C B/s.C B/s.C

6%o)uct G 33$@@@ 35 : 77$@@@

6%o)uct 9 35$@@@ 3? < 8>$@@@

Production budget sho1ing the number of units to be manufactured each month.

bC

Summarised production cost budget for the ; month!period 9anuar to 9une 5@@3.

37.

A firm is considering the purchase of a machine. &1o machines A and ) are available$ each costing /s.:@$@@@. In comparing the profitabilit e+pected to be as follo1s: Jear Mac"ine A cas" +nflo$ /s. 3:$@@@ 5@$@@@ 5:$@@@ 3:$@@@ 3@$@@@ Mac"ine 4 cas" +nflo$ /s. :$@@@ 3:$@@@ 5@$@@@ 7@$@@@ 5@$@@@ of those machines a discount rate of 3@R is to be used. %arnings after ta+ation are

3 5 7 8 : ]ou are also given the follo1ing data:

Jear 3 5 7

PG Factor . 1FI discount @.?@? @.>5; @.<:3

8 : %valuate the pro#ects using : BaC BbC BcC BdC the pa !bac" period the accounting rate of return the net present value the profitabilit inde+

@.;>7 @.;53

38. 1ia!ilities

Follo1ing are )alance sheet of .ina (td. for the ear ended 73 st December 5@@@ and 5@@3. %<<< /s. 3$@@$@@@ :@$@@@ 3@$@@@ <$:@@ 5@$@@@ 3@$@@@ <$:@@ 2<3@<@@@ %<<1 /s. 3$;:$@@@ Fi+ed Assets B*etC <:$@@@ Stoc" 3:$@@@ Debtors 3@$@@@ )ills receivable 5:$@@@ Cash at )an" 35$:@@ Cash in hand 35$:@@ 3<4@:@@@ 2<3@<@@@ 3<4@<@@@ Assets %<<< /s. 3$5@$@@@ 5@$@@@ :@$@@@ 3@$@@@ 5@$@@@ :$@@@ %<<1 /s. 3$<:$@@@ 5:$@@@ ;5$:@@ 7@$@@@ 5;$:@@ 3:$@@@

%0uit capital Pref. Capital /eserves P'( ADc Creditors Provision for ta+ation Proposed dividends

Prepare a common si-e balance sheet and interpret the same.

3:.

Attempt the follo1ing Case: CASE: !USINESS DECISION Condensed comparative financial statements for appear belo1:

6ACIFIC COR6ORATION Co(5#%#ti.& !#$#nc& S+&&t/ A/ o' M#0 31 Bin thousands of dollarsC A//&t/ Current assets Plant and e0uipment Bnet of depreciationC &otal assets (iabilities ' Stoc"holderIs %0uit Current liabilities (ong!term liabilities Capital stoc" Bd3@ parC /etained earnings &otal liabilities ' stoc"holderIs e0uit 9&#% 3 d 7$?;@ 53$58@ 5:$5@@ 5$538 8$<3; 35$;@@ :$;<@ 5:$5@@ 9&#% 2 d 5$;3@ 3?$>?@ 55$:@@ 5$@:5 7$<@> 35$;@@ 8$38@ 55$:@@ 9&#% 1 d 7$;@@ 38$8@@ 3>$@@@ 3$>@@ 7$;@@ >$3@@ 8$:@@ 3>$@@@

6ACIFIC COR6ORATION Co(5#%#ti.& Inco(& St#t&(&nt/ Fo% 9&#%/ M#0 31 Bin thousands of dollarsC A//&t/ *et sales Cost of goods sold 6ross Profit on sales =perating e+penses Income before Income ta+es Income ta+es *et income Cash dividends paid Bplus 5@R in stoc" in ]ear 5C Cash dividends per share Pu&/tion/: 3. Prepare a three! ear comparative balance sheet in percentages rather than dollars$ using ]ear 3 as the base ear. 5. Prepare common si-e comparative income statements for the three! ear period$ e+pressing all items as percentage components of net sales for each ear$ 7. Comment on the !significant trends and relationships revealed b the 9&#% 3 d ?@$@@@ :>$:@@ 73$:@@ 5>$3<@ 7$77@ 3$:7@ 3$>@@ 5<@ @.;7 9&#% 2 d <:$@@@ 8;$:@@ 5>$:@@ 5:$5<: 7$55: 3$:@@ 3$<5: 8;: 3.33 9&#% 1 d d ;@$@@@ 7;$@@@ 58$@@@ 53$58@ 5$<;@ 3$5;@ 3$:@@ 8@: 3.:@

anal tical computations in 3 and 5. &hese comments should cover current assets and current liabilities$ plant and e0uipment$ capital stoc"$ retained earnings$ and dividends. 8. If the capital stoc" of this compan 1ere selling at d 33.:@ per share$ 1ould ou consider it to be overpriced$ underpriced$ or fairl pricedH Consider such factors as boo" value per share$ earnings per share$ dividend ield$ trend of sales and trend of the gross profit percentage. Also consider the t pes of investors to 1hom the stoc" 1ould be attractive or unattractive.