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FINANCIAL AND MANAGEMENT ACCOUNTING

Unit - 1
Accounting

Defination

According

for

historical

function

and

managerial function Scope of accounting Financial accounting and


Management accounting Managerial uses Differences.

Financial Accounting: Accounting concepts Convections Principles


Accounting standards International Accounting standards.

Unit-2
Double entry system of accounting - Accounting books Preapartion of
journal and ledger, subsidiary books - Errors and rectification Preparation of
trial balance and final accounts.

Accounting from incomplete records - Statements of affairs methods


-Conversion method - Preparation of Trading, Profit & Loss Account and Balance
Sheet from incomplete records.

Unit - 3
Financial Statement Analysis - Financial statements - Nature of financial
statements - Limitations of financial statements - Analysis of interpretation
-Types of analysis -- External vs Internal analysis - Horizontal vs Vertical
analysis - Tools of analysis - Trend analysis - Common size statements
-Comparative statements.

Ratio Analysis - Types - Profitability ratios - Turnover ratios - Liquidity


ratios - Proprietary ratios - Market earnings ratios - Factors affecting efficiency
of ratios - How to make effective use of ratio analysis - Uses and limitation of
ratios - Construction of Profit and Loss Account and Balance Sheet with ratios
and relevant figures - Inter-firm, Intra-firm comparisons.

Unit -4
Fund Flow Statements - Need and meaning - Preparation of schedule of
changes in working capital and the fund flow statement - Managerial uses and
limitation of fund flow statement.

Cash Flow Statement - Need - Meaning - Preparation of cash flow


statement - Managerial uses of cash flow statement - Limitations Differences
between fund How and cash tlow analysis.

Unit-5
Budgeting and Budgetary Control: Preparation of various types of budgets
- Classification of budgets - Budgetary control system - Mechanism -Master
budget.

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

FINANCIAL AND MANAGEMENT ACCOUNTING

LESSON

TITLE

1.

Accounting an Introduction

2.

Management Accounting

3.

Theory Base of Accounting - Accounting Standards

4.

Practical Base of Accounting - Origin and Analysis of Business


Transactions

5.

Financial Statements of Profit-making Entities Manufacturing-cumTrading Organisations

6.

Financial Statements of Non-Profit-making Entities

7.

Errors Management

8.

Accounts from Incomplete Records - Single Entry System

9.

Financial Statement Analysis

10.

Ratio Analysis

11.

Fund Flow Analysis

12.

Cash Flow Analysis

13.

Budgeting and Budgetary Control

14.

Capital Budgeting

15.

Case Study

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

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

NATURE OF ACCOUNTING:
1.2 Accounting
i. is man-made;
ii. has evolved over a period of time;
iii. is practiced in a social system;

iv. is a systematic exercise;


v. is judgmentat at times;
vi. follows flexible, not a rigid approach;
vii.is essentially a language;
viii.

as a language, has a very well defined syntax of its own; and

ix. Communicates financial information for decision making.

Accounting being a man-made system has evolved over a period of time to


provide financial information of business enterprises to users of accounting
information. A large number of groups with varied interests in affairs of a
business enterprise have emerged over a period of time, especially after
emergence of corporate forms of organization involving separation of ownership
management. These user groups include those who;

manage the activities of the enterprise( management)

own the enterprise( owners/ shareholders)

extend credit for supply of goods to the enterprises


(creditors)

buy goods from the enterprises( customers)

lend

money to the enterprises(

banks

and financial

information)

are employed in the enterprises (employees)

intend to make investment in the enterprises(ivestors)

are doing research(researchers)

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

authorities)

formulate

fiscal

and

monetary

policies

(other

Government

department)

are members of the public at large(general public)

Internal users of accounting information are inside the enterprise and


need information to control and plan the activities of the business to manage it

effectively. These include Owners in case of non corporate enterprises and


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

to

external

user

group

for

decision

making.

The

need

for

communicating relevant and useful information to that potential internal and


external users is always there and accounting is intended to perform that role.
Thus, accounting may be defined as:

"the process of identifying, measuring and communicating information to


permit

judgement

and decision by the users" ( American Accounting

Association)

BRANCHES OF ACCOUNTING

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

its function of stewardship, planning, control and decision-making. As


information needs of management vary from enterprise to enterprise, the
grouping and reporting of information takes different forms. Trie different ways
of grouping information and preparing reports as desired by managers for
discharging their functions are referred to a management

accounting.

Management accounting provides information to the management not only


about cost but also revenue, profit, investment etc., for managing business more
efficiently and effectively. A very important component of management
accounting is cost accounting which deals with cost ascertainment and cost
control.
Few other branches of accounting which are of recent origin are
social responsibility accounting and human resources accounting. The first one
involves accounting for social costs incurred by the enterprise and social
benefits created by it while the second deals with accounting for human
resources.

In the present book, we are concerned with financial accounting


only. The word accounting and financial accounting are used interchangeably.

Financial accounting provides information to external user groups


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

The syntax of accounting language comprises of analysis and


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

(GAAP), Conceptual framework and Accounting Standards (AS) issued by the


professional accounting bodies all over the world,

The credibility of the financial statements is established through


analysis independent examinations by a chattered accountant who certifies that
the information provided therein gives true and fair view of the activities of tM
business in conformity with accepted principles and practices. This process of
attestation of account is known as auditing of accounts.

MEANING OF FINANCIAL ACCOUNTING


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

A. Creation of financial information:


Creation of financial information involves three steps:

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

What to record? Since-accounting is regarded as language of the business, it


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

When to record? Usually business transaction is recorded only when it has


occurred. Thus accounting is basically historical in nature.

How to record? Usually business transaction has two aspects and both these
are recorded by passing analysts entry in an journal book. This system of
recording is called double entry book keeping system.

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


decision about the value of the transaction is needed.
A number of different valuation bases are used in accounting in
varying degrees and include historical cost, current cost, realizable value and
present value. These valuation based generally assume significance in case of
valuation of assets. Historical cost refers to amount paid / payable to acquire an

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

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

Recording
Journal
Book

Analysis of
business
transaction
evidenced
by source
document

Classificati
on in ledger
book

Summariza
tion first in
trial
balance
and then in
financial

Thus recording, classifying and summarizing are three basic steps


involved in creation of financial statement which ascertain and communicate
result of business entity. For this is assumed that business and its owner have
separate existence. For accounting purpose, even a division of the business or a
branch of it may be treated as an accounting entity.

B. Use of Financial Information / Statements:


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

Cash flow statement

Fund flow statement Ratio analysis

Comparative statement

Common size statement

However to analyze and interpret these financial statements, the


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

review. They reflect a combination of recorded facts, accounting, conventions


and personal judgements and judgements and conventions applied after them
materially. The soundness of the judgement necessarily depends on the
competence and integrity of those who make them and on their adherence to
Generally Accepted Accounting Principles and Conventions. (Bombay Stock
Exchange Official Directory).
OBJECTIVES OF ACCOUNTING
The main objective of accounting are as follows:
The main records of business: In accounting, systematic record of
monetary aspects of business events are maintained. The first step in
preparation of financial statements. This is referred to as book-keeping.
Calculation of profit or loss: To calculate profit earned or losses suffered
during a period of time, a business enterprise prepares an Income
Statement. It is also referred to a trading and profit and loss account.
Depiction of financial position: In addition to profit (or loss), sound
decision-making requires information about the financial position of a
busiriess enterprises. To depict financial position of a business, financial
position statement is prepared. On the one hand, it gives details of
resources owned by the business enterprise. Resource owned are termed
as assets. On the other hand it contains the information about obligations
of business. Obligation of the business towards outsiders and owner are
referred to as liabilities and capital respectively.

Financial position

statement is also termed as balance sheet which provide information


about sources of finance (e.g. outside liability and owners equity) and the
resources (eg. assets) of the business.
To portray the liquidity position: Financial reporting should provide
information about how an enterprise obtains and spends cash, about its
borrowing and repayment of borrowing about its capital transactions,
cash dividends and other distribution of resources by the enterprise to
owners and about other factors that may affect an enterprise's liquidity
and solvency.

Control over the property and asset of the firm: Accounting provides upto-date information about the various assets that the firm possess and
the liabilities the firm owes so that nobody can claim a payment which is
not due to him.
To file tax returns: This is the objective which really hardly needs
emphasis. The credible accounting records provide the best bases for
filing returns of both, direct as well as indirect taxes.
To make financial information available to various groups and users:
Accounting is called the language of business. It aims to communicate
information about financial results and financial position of a business
enterprise to decision makers,

USERS OF ACCOUNTING INFORMATION


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

Managers: For managing business profitably information aboutHnancial result


and financial position is needed by management By providing this information,
accounting helps managers in efficient and smooth running of a business
enterprise.

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

Creditors and Financial Institutions: Whosoever is extending credit or loan to


a business'enterprise, would like to have information about its repaying
capacity, creditworthiness etc., The required information can be obtained by
analyzing and interpreting the financial statements of the business enterprise.

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

Government: Government policies relating to taxation, providing subsidies etc.,


are guided by the relevance of the industry in the economic development of the
country and the past performance of the industry. Information about the past
performance is provided by the accounting system, collection of taxes is also
based on accounting records.

Researchers: Researchers need financial information for testing hypothesis and


development of theories and models. The financial statement provides the
recorded information.

Customers: (Customers who have developed loyalties to a business are ceitainly


interested in the continuance of the business. They certainly want to know
about the future directions of the enterprise with which they are associating
themselves. The way to information about the enterprise is through their
financial statements.

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

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

ACCOUNTING AND THEIR DISCIPLINES:


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

Linkage with Economics:


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

Accountant tries to impart practicability to the concept of capital and


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

Linkage with Mathematics:


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

Linkages with Statistics:


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

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

Linkages with Law:


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

LESSON - 2
MANAGEMENT ACCOU NTING

DEFINITION OF MANAGEMENT ACCOUNTING


The accounting activity can be classified into two parts. Financial
Accounting and Management Accounting. Though both of them are interlinked,
Management accounting is future oriented, dynamic and is made to be decisive
and control relevant.
International Federation of Accountants (IFAC) defined Management
Accounting

process

as

"the

process

of

identification,

measurement,

accumulation, analysis, preparation, interpretation and communication of


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

Accounting

as

"the

provision

of

information

required

by

management for such purposes as:


1. Formulation of policies
2. Planning and controlling the activities of the enterprise
3. Decision taking on alternative course of action
4. Disclosure to those external to the entity (shareholders and others)
5. Disclosure to employees
6. Safeguarding assets

The assets involves participation in management to ensure that there is


effective:

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

Formulation

of

short-term

operation

plans

(budgeting/

profit

making)".

American Accounting Association defines Management Accounting as "the


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

the

system

of

reporting

that

is

linked

to

organisational

responsibilities and contributes to the effective performance measurement. The


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

SCOPE OF MANAGEMENT ACCOUNTING


Management Accounting includes Financial Accounting and extends to
the operation of a system of cost accounting and financial management. While
meeting the legal and conventional requirements regarding the presentation of
financial statements (profit and loss account, balance sheet and funds flow

statements) it stresses upon the establishment and operation of internal


controls. The scope of Management Accounting, inter alia, includes:
Formation, installation and operation of accounting, cost accounting, tax
accounting and information systems. Management Accountant has to
construct and re-construct these systems to meet the changing needs of
management functions
The compilation and preservation of vital data for management planning.
The account and document files are respository of vast quantities of
details about the past progress of the enterprise, without which forecasts
of the future is very difficult for the enterprise. The Management
Accountant presents the past data in such a way as to reflect the trends
of events to the management.
Providing means of communicating management plans to the various
levels of organisation. This, on the one hand, ensures the coordination of
various segments of the enterprise plans and on the other defines the role
of individual segments in the whole plan and assists the management in
directing their activities.

Providing and installing an effective system of feedback reports. This


would enable the management in its controlling function. By pinpointing
the significant deviations between actual and expected activities, and by
adhering to the principles of selectivity and relevance, such reports help
in jthe installation and operation of the system of 'Management by
Exception'. The Management Accounting is expected to analyse the
deviation by reasons and responsibility and to suggest appropriate
corrective measures in deserving cases.

Analysing and interpreting accounting and other data to make it


understandable and usable to the management. It is only through such
analysis and clarification that the management is enabled to place the
various data and figures in proper perspective in the performance of its

functions. Such analysis assists management- in the location of


responsibilities and to effect necessary changes in the organisational
setup to achieve the objectives of the enterprise in a more efficient
manner.

Assisting management in decision making by (i) providing relevant


accounting and other data and (ii) analysing the effect of alternative
proposals on the profits and position of the enterprise. Management
Accountant helps the management in proper understanding and analysis
of the problem in hand and presentation of factual information obviously
in financial terms.

Providing methods and techniques for evaluating the performance of the


management in the light of the objectives of the enterprise, thus assisting
in the jrnpiementation of the principle 'Management by Objectives'.

Improving, modifying and sharpening the effectiveness of the existing


techniques of analysis. The Management Accountant would always think
of increasing the practicability of existing techniques. He should be on the
look-out of the development of new techniques as well.

Thus, Management Accounting serves not only as a tool in the hands of


management, but also provides for a technique evaluating the performance of its
functions of planning/decision making and control, and at the same time,
enabling the owners and other interested parties to evaluate and appraise the
management of the enterprise.

FUNCTIONS OF MANAGEMENT ACCOUNTING


Management Accountant is one of the best assets for management. His
contribution has been growing with passage of time. He will continue to deliver
the goods in a magnificent manner in future with varied experiences. Scope is

expanding and managements of various sectors are benefiting. Excerpts from


the "Preface to Statements on International Management Accounting" issued oy
the international Federation of Accountants in February 1987 are reproduced
below:
"Management Accounting is used by management to;
Plan - to gain an understanding, to expected business transactions and
other economic events and their impact on the organisation, and to use
this understanding as a basis for a course of action to be followed by the
organisation in the future;

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


Control - to ensure the integrity of financial information concerning an
organisation's activities or its resources;

Assure accountability - to implement the system of reporting that is closely


aligned to organisational responsibilities and that contributes to the
effective measurement of management performance"

The functions of Management Accounting can be broadly classified into;


(a) Periodic interval accounting reports, and
(b) Ad hoc analysis of data decision making.
It is increasingly felt that Management Accountants should involve
themselves more and more in decision making and problem solving of
organisations. The areas of decision making and problem solving are dealt in
the following paras:
Strategic Management Accounting: This function helps the organisation
prepare long-term plans, formulate corporate strategy and forecast and
evaluate the competitors.

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


investment (ii) funding of accepted programmes projects, and (iii) postaudit of accepted programmes.
Financial Management: It deals with raising of funds for investment,
managing surplus funds, controlling working capital etc,
Short-term ad hoc decisions: This includes analysing data for taking
decisions c i pricing, product introduction, acceptance of special orders
etc.
Managing the organisation of information system: This includes not only
organising the enterprise's financial data but fulfilling the information
needs of all the segments of the organisation.

FUNCTIONS OF MANAGEMENT ACCOUNTANT


The term 'Management Accountant' has many Director, Financial Director,
Financial Controller, Finance Comptroller etc., are some of the terms used to
designate with the work Management Accounting.

Depending situation,

size, nature arid organisational setup and his position in the company, the
Management Accountant may be required to perform various and varied
functions. The importance and effectiveness of his function would also depend
upon the confidence reposed in him by the top management and the functional
managers. His functions generally embrace each and every activity of the
management. The essence of Management Accountant's functions are as
follows:
The Management Accountant will establish, coordinate and: administer
plans to facilitate the forecasting of sales, expense budgets and cost
standards that will permit profit planning, capital budgeting and
financing.
The Management Accountant will formulate accounting policy and
procedures. Operating data and special reports must be prepared so that
the performance can be compared with plans and standards, and any
variance between actual operations and pre-determined standards can be

analysed for corrective actions by management Such comparisons


between actual and expected activities should help the management in
proper fixation of responsibility and also in evaluation of various
functional and divisional heads.
The Management Accountant will be responsible for the protection of
business assets to the extent possible by external controls and internal
auditing and insurance coverage.
The Management Accountant will be responsible for tax policies and
procedures and will supervise and coordinate the reports required by
various authorities. ;
The Management Accountant must continually e aware of economic and
social forces as well as the effect of the Government policies and actions
on business activities.

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


reflects the status of a Management Accountant. He is the principal office incharge of the accounts of the company. He shall be responsible to the Board of
Directors for the maintenance of adequate accounting procedures and records
on the operation of business. He shall be responsible to the President or the
Chairman of the Board or the Board of Directors. Thus, in his broad functional
activities, the Management Accountant is responsible to the policy making
group of top management, whereas, in his administrative activities he ss
responsible to the top executive offer.

MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING


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

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

Financial Accounting and Management Accounting both appear to be similar


inasmdch as both study the impact of business transactions and events of the
enterprise, reports and interpret the results thereof. Both provide information
for internals as well as external use. But Management Accounting although
having its roots in Financial Accounting differs from the latter in following
respects:
Financial Accounting studies the business transactions and events for the
enterprise as a whole. It does not trace the path of events with in the
enterprise. Management Accounting, in additions to the study of the
events in relation to the enterprise as a whole, takes organisation in its
various units and segments and attempts to trace the impact and effect of
the business transactions and events through these various divisions and
sub-divisions. Thus, while the financial statements -profit and loss
account, balance sheet and flow statements reveal the overall performance
and position of the enterprise. Management Accounting reports emphasis
on the details of operational costs, inventories, products, processes and
jobs. It traces the effect and impact of the business transactions and
events on costs, inventories, processes, jobs and products.
Financial Accounting is more attached with reporting the results and
positions of business to persons and authorities other than managementGovernment, Creditors, Investors, Owners, etc. At times, Financial
Accounting follows window-dressing tactics in order to project a better
than actual image of the enterprise. Management Accounting is
concerned more with generating information for the use of internal
management and hence the information reflects the real or really expected
position.

Financial Accounting is necessarily historical. It records and analyses


business events long after they have taken place. Management Accounting
analyses the events as they take place and also anticipates such events
for the future. Thus, it uses data which generally has relevance to the
future.

Since Financial Accounting data is historical in nature, it is more precise


than the Management Accounting data, which generally reflects Ihe
expected future, and hence could only be an estimation. This provides the
necessary rapidly to Management Accounting information.

The periodicity in reporting financial accounts is much wider than in case


of Management Accounting. In Financial Accounting, generally, results are
reported on year to year basis. In Management Accounting is free to
formulate its own rules, procedures and forms because the information
generates is solely for internal consumption.

Financial Accounting has to governed by the 'generally accepted


principles'. This is so because, it has to cater for the informational needs
of the outsiders and legal provisions. Management Accounting is free to
formulate its own rules, procedures and forms because the information it
generates is solely for internal consumption.

Financial Statements prepared under Financial Accounting consists 'of


monetary information only. Management Accounting statements, in
addition

to

monetary

information,

also

consists

non-monetary

information viz., quantities of materials consumed, number of workers,


quantities produced and sold and so on.

TABLE 1.1: MANAGEMENT ACCOUNTING


Nature

vs. FINANCIAL ACCOUNTING

Fianacial Accounting

Management

1. Governed by

Company law etc.

Accoutning
Needs of managers

2. Basic functions

Transaction

Decision

support

recording,

Provision

of

Publication
3. Users

of Management

external

financial information

statements

Internal

4. Availibility

External
Publicly available

Confidential

5. Time focus

Past and present

Present and future

6. Period

Usually one year

As appropriate

7. Main emphasis

Explanation

Planning and control

8. Speed
prepartion

of Slow but detailed and Fast but approximate


accurate

9. Form
of whole of entity
presentations

Segmented to control

10.
Style and Standardized
details

Tailored

Objective,
11.

Criteria

12.
Unit
account

of

13.
Nature of
data

units
to

requirement

and

verifiable summarized

and consistent

Relevant, useful and

Money

understandable

Somewhat technical

Money physical units


For

use

accountants

by

non-

LESSON - 3
THEORY BASE OF ACCOUNTING - ACCOUNTING STANDARDS

Accounting is "the process of identifying, measuring and communicating


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

are based on similar accounting procedures and policies so that


meaningful comparisons over a period of time can be made 1 about he
progress of the enterprise. This is commonly referred to as 'Time series
analysis.

The financial statements of many enterprises at a point of time are

based

on

similar

accounting

procedures

and

policies

so

that

conclusions can be drawn about their relative performance at a point of


time. It is known as 'Cross-sectional analysis'. ,

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


structural framework so that credible financial statements of the highest quality
can be produced. According to T.P. Ghosh accounting standards are defined as
under.

Accounting standards are the policy documents issued by the recognised


expert accountancy body relating to various aspects of measurement,
treatment and disclosure of accounting transactions and events

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

framework for the preparation of the financial statements.

They also draw the

boundaries within which acceptable conduct lies. In the absence of accounting


standards, many alternatives will exist and will give the accountant the|
leverage to colour'his accounting records the way he likes.

Such 'Creative

Accounting Practices will certainly create financial statements which are


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

The whole idea of Accounting

Standards is centred around harmonisation in the accounting policies and


practices followed by businesses. The basic purpose of 'Accounting Standards' is
to standardize the diverse accounting practices

followed

for

many

aspects

of accounting. The harmonisation of accounting policies and practices is needed


at national level as well as international level. To tackle the problem at national
level, the Institute of Chartered Accountants of" India issues accounting
standards (called AS's) formulated by the Accounting Standards Board (ASB). At
international level, International Accounting Standards Committee (IASC)
issues International Accounting Standards (called lAS's).

The objective of the

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

presentation

of

financial

statements'.

The

Institute

of

Chartered

Accountants of India is a member of IASC and has a tacit understanding with


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

contemplated in existing standards on valuation of inventories and accounting


for construction contracts.

ACCOUNTING STANDARDS (N INDIA


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

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

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

FORMULATION OF ACCOUNTING STANDARDS


The following points need to be kept in mind while drafting accounting
standards, namely

The accounting standards issued are in conformity with the provisions of


the applicable laws, customs, usage and business environment of our
country;

The accounting standards are in the nature of laws but not laws. Though
every possible care is taken while drafting standards that they are in
conformity with eh applicable laws, still the conflict between the law and
an accounting standard might arise due to amendments in the law
subsequent to the issuance of the accounting standard. As clarified in the
'Statements of Accounting Standards', accounting standards cannot and
do not override the statute and in all such cases of conflicts, the
provisions of the law will prevail and the financial statements should be
prepared in conformity with the relevant laws Obviously, to that extent,
the accounting standards shall not be applicable. However, "the institute
will determine the extenl of disclosure to be made in financial statements
and the related auditor's reports. Such disclosure may be

by way of

appropriate notes explaining the treatment of particular items. Such


explanatory notes will be only in the nature of clarification and therefore,
need not be treated as adverse comments on the related financial
statements"

The accounting standards are intended to apply only to items which are
material and become applicable from the date as specified by the
institute. They are applicable to all classes of enterprise unless otherwise
stated. No standard is applicable retroactively, unless otherwise stated;

The accounting standards are to address the basic mattes, to the extent
possible. The idea is to confine them to essentials only and not to make
them complex.

The ASB has drawn an elaborate procedure for formulating accounting


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

a) Firstly, the ASB determines the broad areas in which accounting


standards need to be formulated;

b) Secondly, the ASB takes the assistance of the various study groups to
formulate standards The preliminary drafts of the standards are
prepared by the Study groups
assigned to them.

which take 'up the specific subjects

The draft prepared by a Study Group is considered

by ASB and sent to various outside bodies like FICCI, ASSOCHAM,


SCOPE, CLB, C&AG, ICWAI, ICSI, CBDT etc. and the representative of
these bodies are also invited at a meeting of ASB for discussion.

c) Thirdly, after taking into consideration their views, the draft of the
standard is issued as exposure draft for soliciting comments from
members of the institute and public at large. The draft is issued to a
large number of institutions and is published in the journal of the
institute. The exposure draft includes the following basic points:

A statement of concepts and fundamental accounting principles


relating to the standard;

Definitions of the terms used in the standard;

The manner in which the accounting principles have been applied


for formulating the standard;

The presentation and disclosure requirements in complying with


the standard;

Class of enterprises to which the standard will apply,

Date from which the standard will be effective.

d) Fourthly, the comments on the exposure draft are then considered by the
ASB and a final draft is prepared and submitted to the council of the
institute;

e) Lastly, the council of the institute considers the final draft of the proposed
standard, and if found necessary, modifies the same in consultation
with ASB. The accounting standard on the relevant subject is then
issued under the authority of the council.

NATURE OF ACCOUNTING STANDARDS

The accounting standards issued by the ICAI-are recommendatory in


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

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

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

Self-regulation on the part of the business organisation so that I hey


adhere to these standards while finalising their accounts;

Legal backing to the accounting standards. The standards as they are


issued not have no legal backing and institute depends on its memters for
their implementation through their attest function;

Publicising the use of accounting standards and making the user: of


accounting information more informed about their right of getting a more
true and fair picture of the results of business based on these accounting
standards;

To avoid duplication of authority. If more than one authority issues


standards, it is bound to create a confusion in the mind of the user as to
which standard needs to be followed.

A recent development, worthy of

attention, is the establishment of two accounting standards by the


government under the Income Tax Act, 1961 which are to be followed in
the preparation of financial statements in case the assessee prefers
mercantile

basis

accounting,

(Accounting

Standard

'relating

to

disclosure of accounting policies and Accounting Standard II relating to


disclosure of prior period and extraordinary items and changes in
accounting policies).

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

accounting standards

to provide objective

and reliable

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

ACCOUNTING STANDARDS ISSUED BY THE INSTITUTE


AS-1 Disclosure of Accounting Policies :

The standard defines 'Accounting Policies' as referring to the specific


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

AS-2 Valuation of Inventories :

The inventories should be normally valued at 'Lower of Cost or Market'


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

The historical cost of manufactured inventories may be arrived on the


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

The accounting policy in respect of inventories should be properly


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

The 'Specific Identification Method', 'Adjusted Selling Price Method',


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

AS-3 Changes in Financial Position :

A statement of changes in financial position should be published along


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

AS-3 (Revised) Cash Flow Statement:

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

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

mentioned above are not met, a disclosure should be made of the existence of
the contingency specifying:

the nature of the contingency;

the uncertainties which may affect the future outcome;

an estimate of the financial effect, or a statement that such ail estimate

cannot be made.

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

the nature of the event; I

an estimate of the financial effect, or a statement that such an estimate


cannot be made.

AS-5 (Revised) Net Profit or Loss for the Period, Prior hems and Changes in
Accounting Policies :

The objective of this standard is to prescribe the classification and disclosure of


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

Ordinary activities are any activities which are undertaken by an


enterprise as part of its business and such related activities in which the
enterprise engages in furtherance of, incidental to, or arising from, these
activities. Extraordinary items are incomes or expenses that arise from events
or transactions that are clearly distinct from the ordinary activities of the
enterprise and, therefore, are not expected to recur frequently or regularly. Prior
period items are'income or expenses which arise in the current period as a
result of errors or omissions in the preparation of the financial statements of
the one or more prior periods. The net profit or loss for the period comprises the
following components, each of which should be disclosed on the face of the
statement of profit and loss;

profit or loss from ordinary activities; and

extraordinary items.

Prior period items are normally included in the determination of net profit
or loss for the current period. An alternative approach is to how such items in
the statement of profit and loss after determination of current net profit or loss.
The second approach seems better because that will help ascertain the result of
current period unaffected by the mistakes of the past, in either case, the
objective is to indicate the effect of such items on the current profit or loss.

Change in Accounting Estimates Vs. Change in Accounting Policies:


A distinction should always be made between change in accounting estimates
and changes in accounting policies. When it is difficult to distinguish between

the change in accounting estimate and change in accounting policies, it should


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

AS-6 (Revised) Depreciation Accounting :

The depreciable amount of an asset comprising of its historical cost, or


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

respect of each class of asset and related accumulated depreciation. The


following information should be disclosed in the financial statements along with
disclosure of other accounting policies:

depreciation methods used; and

depreciation rates or the useful lives of the asset, if they are different from
the principal rates specified in the statute governing the enterprise.

AS-7 Accounting for Construction Contracts :

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

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

AS-8 Accounting for Research and Development:

The prescribed research and development costs outlined in para 7 of Hie


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

AS-9 Revenue Recognition :

The standard mainly deals with the timing of revenue. Revenue is defined
as "gross inflow of cash, receivable or other consideration arising in the course
of ordinary activities of an enterprise from the sale of goods, from the rendering
of services, and from the use by others of enterprise resources yielding interest,
royalties and dividends. The revenue is recognised in case of sale when:

the seller of goods has transferred the property in goods tci the buyer
along with significant risks and rewards of the ownership and seller has
no effective control over goods transferred;

no

significant

uncertainty

exists

regarding

the

amount

of

the

consideration that will be derived from the sale.

The revenue from rendering of services is recognised either under


completed service method or proportionate completion method. Completed
service method is a method of accounting which recognises revenue in the
statement of profit and loss only when the rendering of services under a
contract is completed or substantially completed. Proportionate completion
method is a method of accounting which recognises revenues in the statement
of profit and loss proportionately with the degree of completion of services under
a pontract.
Revenue arising from interest is recognised on a time proportion basis, royalties
on an accrual basis and dividends from investments in shares when the owner's
right to receive payment is established.

AS-10 Recounting for Fixed Assets :

Fixed asset is an asset held with the intention of being used for the
purpose of producing or providing goods or services and is not he!d for :he sais
in the notarial course of business.

The gross book vaiue of a fixed asset shoulo

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

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

Normally the entire class of asset should be revalued and revaluation


should never result in the net book value of the class of asset being greater than
the recoverable amount of assets of that class. Gain on revaluation should
normally be taken to the owners interest in the form of Revaluation Reserve
Alternatively it could be taken to profit and loss account. Loss on revaluation
should normally be taken to profit and loss account except that such a decrease
is related to; an increase which was previously recorded as a credit to the
revaluation reserve and which has not been subsequently reversed or
44haracte, it may be charged directly to that account. On disposal of a
previously revalued item of fixed asset, the difference between net disposal
proceeds and the net book value should be charged or credited to the profit and
loss statement except that to the extent that such a loss is related to an
increase which was previously recorded as a credit to revaluation reserve and
which has not been subsequently reversed or 44haracte, it may be charged
directly to that account. Goodwill should he recorded in the books only when
some consideration in money or moneys worth has been paid for it. A proper
disclosure of the gross and net book value of the asset as well as relevant
amount, if the assets are stated at revalued amounts should be made.

AS-H (Revised) Accounting for tbc Effects of Changes in Foreign Exchange


Rates :

The standard deais with (a) accounting for transactions in foreign


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

AS-12 Accounting for Government Grants :

Government grants are assistance by government in cash or kind to an


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

AS-13 Accounting for Investments :

The standard deals with accounting for investment in financial statements


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

investment other than a current investment. The cost of acquisition should


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

Current investments should be carried in the financial statements at the


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

AS-14 Accounting for Amalgamation :

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

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


transferor company.

The identity of all the reserves in amalgamation in the nature of merger is


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

AS-15 Accounting for Retirement Benefits in the Financial Statements of


Employers:

The standard deals with the accounting of retirement benefits consisting


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

LESSON-4
PRACTICAL BASE OF ACCOUNTING ORIGIN AND ANALYSIS OF BUSINESS
TRANSACTIONS

Accounting process begins with the origin of business transactions and is


followed by analyses of these transactions. After origin and analysis of
transactions comes recording, classification and summarization of business
transactions culminating in preparation of financial statements,

Origin of Business Transactions

Accounting deals with business transactions which have already taken


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

nce cf the transaction is called the Source Document.

Analysis of Business Transactions

In accounting record is made of monetary transactions which are


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

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

9. Accounting Equation Approach:

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

ASSETS = LIABILITIES + CAPITAL

expected Where assets refer to resources which are owned by business


enterprise and are to benefit future operations, liabilities are debts payable to
parties external to business and capital means the amount payable to owners of
the business enterprise (also called owners equity )

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


10.

Introduction of resources by the owner:

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

ASSETS = LIABILITIES + CAPITAL


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

is provided by the

accounting equation appears as under:


Cash

Furniture

= Capital

proprietor, the

(Rs.5,00,000)

11.

(Rs.20,000)

+(5,00,000

Rs. 5,20,000

20,000 )
Rs.5,20,000

Purchase of assets for cash and / or credit :

Purchased

building

for

Rs,2,00,000

and

paid

Rs.

10,000

cash

immediately. It increases business assets or resources by Rs, 1,90,000 as cash


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

Furniture

(Rs.20,000)

Creditors for building + Capital


(Rs.1,90,000)

(Rs.5,20,000)

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

12.

= Rs.7,10,000

Paid into bank Rs.3,00,000

It decreases cash balance and increase bank balance and thus, have no
net effect on total assets as shown below:

Cash +

Bank

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

Creditors for building +


(Rs.1,90,000)

(Rs. 3,00,000)
+ Building

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

-7,10,000

= Rs.7,10,000

Capital

(Rs.5,20,000)

14.

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

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


Rs. 1,90,000 as shown below:

Cash +
(Rs.1,90,000

Bank

(Rs. 3,00,000)

(Rs.1,90,000)

- Rs. 1,90,000)
+ Furniture

Creditors for building +

Capital

(Rs.5,20,000)

- Rs. 1,90,000)

+ Building

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

Rs. 5,20,000

15.

= Rs. 5,20,000

Purchase of goods for Cash/Credit:

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

It increases stock of goods by Rs. 70,000, decreases cash by Rs.50,000


and creates analysis obligation to pay. Rs.20,000 to the supplier of goods. After
this accounting equation appears as follows:

Cash

+ Bank

+ Stock of goods

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


16.

(Rs.70,000)

= Creditors + Capital
(Rs.20,000)

(Rs.5,20,000)

50,000)

+ Furniture

+ Building

(Rs. 20,000)

(Rs.2,00,000)
Rs. 5,40,000

= Rs.5,40,000

17.

Rs. 40,000 cash and Rs.20,000 goods withdrawn for personal

use:
It decreases cash by Rs.40,000 and goods by Rs.20,000. At the same time, it
decreases capital by Rs.60,000 as shown below:

Cash
(Rs. 1,40,000

+ Bank
(Rs. 1,10,000)

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

+ Stock of goods = Creditors


(Rs.70,000
-Rs,20,000)

(Rs.20,000)

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

+ Building
(Rs.2,00,000)

Rs. 4,80,000

= Rs.4,80,000

if accounting equation after above transactions is to be presented in the form of


balance sheet, it will appear as follows :

Balance Sheet
Liabilities
Capital
Creditors

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

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

Classification of Accounts and rules for Recording Transactions :


For recording business transaction all accounts are divided into three
categories,

1)

Assets Account

2)

Liability Account

3)

Capital Account

For recording changes in assets, liabilities and capital two basic


rules are followed :

Rule No. 1 for recording changes in assets :


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

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


Increase in liabilities and capital are credited and decrease in liabilities
and capital are debited.

Transactio
n

Assets

No.
Creditor
Furniture
Cash +

Bank +

Stock+

s for
Building

Building

1.

5,00,00

20,000

+
-

2.

0
5,00,00

20,000

+2,00,00

- 10,000
4,90,00

20,000

0
2,00,000

3.

+3,00,00

Trade
Creditor

Capital

s+
-

5,20,000

5,20,000

1,90,000
1,90,000

5,20,000

1,90,000

5,20,000

3,00,00

4.

5.

0
1,90,00

3,00,000

20,000

20,000

-1,90,000

1,90,000
-

5,20,000

+ 20,000

20,000

5,20,000

- 60,000

20,000

4,60,000

+ 50,000

20,000

4,65,000

1,90,00
0

6.

- 50,000
1,40,00
0

7.

- 40,000
1,00,00
0

8.

+ 25,000
1,25,00

1,10,000
-

1,10,000
-

1,10,000
-

1,10,000

20,000

20,000

+70,000

70,000

20,000

20,000

-20,000

50,000

20,000

20,000

-20,000

30,000

20,000

20,000

Analysis of Changes in Capital Account

Increases and decreases in capital account can take place due to


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

a) Revenue Account(mcluding other incomes and gains)


b) Expense Account(mcludmg losses)
c) Drawing Account.

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

Revenue increases capital and decrease in capital is credited, therefore


revenue earned is credited to revenue account.

ii.

Expense decreases capital and decrease in capital is debited, therefore,


expenses are debited to expense account.

iii.

Drawings decrease capital and decrease in 'capital is debited,


therefore, the value of assets withdrawn for personal use is debited to
drawings account.

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

Closing capital = Opening capital + Additional capital


- Drawings
+Revenue and Gains
- Expenses

To sum up, under accounting equation approach all accounts are


divided into three, categories namely, assets, liabilities and capital. Capital
account is further sub-divided into permanent and temporary account For
recording changes in assets Rule NO. 1 is applied and to record increases and
decreases in liabilities and capital Rule N0.2 is followed.

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

Rs.
20,000
4,000
4,000

cheque
4. Machine purchased for
5. Traveling Expenses

10,000
5,000

Statement Showing Analysis of Transactions


Transactions

Analysis

Received cash Increase

Title and
Nature of
Account
Cash

Rule

Entry

Debit

from debtors cash

Asset

increase in

Rs. 20,000

Decrease

Debtor

assets

Credit

the amount

Asset

Credit

Debtors

Debit cash

Deposited

due from

decrease in

debtors
Increase

Bank

asset
Debit

asset

increase in

cash in bank bank


Rs. 4000

balance
Decreases

asset
Cash - asset

decrease

hand

increase
asset
Debit

Debit

Creditors

decrease in

creditors

Liability

liability

decreases

Bank

Credit

bank

Asset

decrease in

to Decreases

creditors

by amount

cheque

payable to

Rs.4,000

creditors

balance

Credit Bank

asset

Increases

Machinery

Debit

Debit

machinery

asset

increase in

machinery

purchased
Rs.10,000

Credit cash

Credit

cash in

Payment

Machinery

Debit bank

asset
Decreases

Cash - asset

Credit cash

cash in

Credit

hand

decrease in
asset

Traveling

Expenses

Traveling

incurred on

expense-

Debit
Debit

traveling

expenses

travel

Temporary

increase in

Rs.5000

increases

capital

expenses

cash in

(Expense)

hand

Cash - Asset Credit

decreases

Expenses

Credit cash

decrease in
asset

Analysis of Valuation of Assets and Liabilities


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

Rules relating to analyze to assets and liabilities can be extended to


accommodate analysis of valuation accounts as follows:

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

As decrease in assets are credited, therefore valuation accounts resulting


in decrease in assets are credited.

For example, assets machine of Rs. 2,00,000 is depreciated by Rs. 20,000


at the end of accounting year 1998, the depreciation reduces (or decreases) the
value of asset and it is calculated to the assets account with the help of the
following entry.

Debit Depreciation account (Being and expenses account and hence


debited) Credit Machinery account.

Alternatively, with the help of a valuation account called provision for


depreciation account, decrease in asset account can be recorded using the
following entry:

Debit Depreciation Account


Credit provision for depreciation account (or accumulated depreciation)

The provision for depreciation is shown as assets deduction from


the machinery account (because it has assets credit balance and machinery
account has a debit balance) and the same impact is achieved.

Conversely, if revaluation result in increase in value of assets, the f


valuation accounts are debited.

Thus rule is as follows:

Credit valuation account if asset account is to be decreased.


Debit valuation account if asset account is to be increased

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

Debit valuation account if liability account is to be decreased.


Credit valuation account if liability account is to be increased.

Second aspect of valuation accounts generally appears in temporary


capital accounts and ultimately affects capital account.

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


Increase in asset or
Decrease in liabilities or
Decrease in capital or
Increase in Drawings or
Increase in expense

and analysis entry on credit side of an account indicates either


Increase in liabilities or
Increase in capital or
Decrease in asset or

Increase in revenue

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

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

1. Natural person(s)

Accounts are accounts of individual living beings and include


accounts ;of individuals such as Ramesh capital account. Ram account, Neha
account and so on.

2. Artificial or legal person(s)


Accounts include accounts of legal entities such as Reliance
Industries Limited Account, Delhi Corporation Account, Goodwill Co-operative
society Account, Punjab National Bank Account and so on.

3. Group / representative personal account:


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

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

1. Tangible real accounts:

Accounts of properties having physical existence like cash, building,


stock of goods, furniture etc., are called tangible real accounts.

2. Intangible real accounts:


Include account of things which cannot be physically felt or touched
but are capable or monetary measurement such as accounts of goodwill,
patents rights, trade-marks rights, copy rights etc.,

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

Rule No.I - for personal accounts.


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

Dual aspect of some business transactions is analyzed by applying traditional


rules as follows.

Transactions

Analysis

Title and

Rule

Entry

Nature of
Introduction

Business

Account
Cash-Real

Debit what Debit cash

of

cash

by gets cash Capital

owners

owner

cash

the giver
Bank

deposited
bank

comes in.

is personal

Bank-Personal

in receives

Credit

the Credit

giver
Debit

Capital
the Debit bank

receiver

cash
Business

Cash Real

Credit what Credit cash

gives

goes out

Building

cash
Building

purchased

comes in

Building Real

Debit what Debit


comes in

Building

from Mr. X on X is the X Personal

Credit

credit
Purchase

giver
Credit X
Debit what Debit Goods

goods
cash

giver
of Goods
for are

comes

received
Cash

Payment

Goods Real

Cash Real

in

in

Credit what Credit cash


goes out

paid
of Service of Salary

salary to an the
employee

the

Nominal

Debit

all Debit salary

expenses

employee
utilized

Credit cash

Business

Credit what

pays cash Cash Real

goes out

for
service

utilized
of Building

Rent
building

due is

but not paid

Rent Nominal Debit

used Rent

by

outstanding

business

personal

rent

all Debit

expenses
Credit

Credit

Rent
rent

the outstanding

giver

for (representative)

the
period is
payable
Note: Rent payable or outstanding is a personal account and shows he amount
payable to the owner of the building.

Advantages of Double Entry System

1. Scientific System:
Double entry system records, classifies and summarizes business
transactions in a systematic manner and thus, produce useful information for
decision-makers. It is more scientific as compared to single entry system of
book-keeping.

2. Complete record of business transactions:


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

3. Arithmetical accuracy of records:


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

4. Ascertainment of profit of loss:


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

5. Information about financial position of the business enterprise:


It can be obtained by preparing balance sheet .at a point of time.

6. Lesser possibility of fraud:


Possibility of frauds and misappropriation is minimized as complete
information is recorded under this system.

7. Helps users of accounting information:


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

Analysis of Purchases and Sales of Goods


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

2. Discount received and discount allowed,


3. Sales tax
4. Cheques issued and cheques received.
5. Bad debts (applicable in case of credit transactions only).

1. Analysis of Purchases and Sales:


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

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

Goods purchased increases stock (Asset /Real account) by Rs.5,000


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

Rs.
5,000
5,000

At the time of sale of goods costing Rs.4,000 for Rs.6,500 cash


(Asset / Real account) increases by Rs.6,500 stock (Asset / Real account)
decreases by Rs.4,000 and profit on sale ( Gain / Temporary capital account )
increases by Rs.2,500

Therefore, the entry is as follows.


Debit cash

Rs.
6,500

Credit stock
Credit profit on sale

4,000
2,500

Theoretically, it is possible to find out the stock in hand after each


purchase transaction and to calculate stock of goods and profit ( or loss ) on sale
of goods at the time of sale and record this in accounting records.

But it is impracticable or not feasible to record Sale and purchase


transactions in this manner.
Purchase of goods are recorded in purchase account. Sales are
recorded in sales account and no attempt is made to calculate profit (or loss) on
sale at the time of sale.
At the time of cash purchase of goods
Debit purchases (Asset / Real account)
Credit cash (Asset / Real account)

Rs.
5,000
5,000

At the time of cash sale of goods:


Debit cash (Asset J Real account)
Credit sales (Revenue / Temporary

6,500

Capital account (Revenue))

6,500

At the end of the accounting period:


Cost of goods remaining unsold is determined on the basis of
physical stock-taking. Goods in hand are listed and generally prices at its
historical cost. In this case physical stock taking will reveal stock in hand worth
Rs. 1,000 i.e. cost of goods purchased (Rs.5,000) minus the cost of goods sold
(Rs.4,000). Value of stock in hand at the end of the account in g^ period is
recorded as follows.
Real

Rs.
1,000

account)
Credit purchases (Asset / Real account)

1,000

Debit

closing

stock

(Asset

In case of purchases and opening stock are transferred ni trading


account and to record the amount of closing stock following procedure is
followed,

Debit closing stock


Credit Trading Account

The gross profit along with other incomes is compared with indirect expenses to
find out net profit ( or loss) during an accounting period. Then net profit ( or
loss) is transferred to capital account Assuming there are no expenses, net
profit is equal to Rs.2,500. ( i.e. sales (6500) - cost of sales (4000)). The entry for
transfer of net profit to capital account is as follows:
Rs.
Debit

profit

and

loss

(nominal 2,500

Account)
Credit capital (capital Account)

2,500

2. Analysis of Commission, Rebate and Discount:,

Commission is the amount payable to analysis agent, broker,


employee etc., for services rendered by him in transacting the business. It is
generally calculated as a percentage of the value of the business transacted.

Rebate is a reduction granted on the amount chargeable for goods


sold and services rendered. It is given under specified conditions such as rebate
in airfare to senior citizens, rebate in rail fares to the handicapped persons,
rebate to the senior citizens under the Income Tax Activities etc..

Discount is a reduction from a states amount such as discount


allowed to debtors to encourage prompt payment, issue of securities ata price
below their nominal value to attract subscribers, amount charged by assets
bank

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

Suppose a dealer in Vimal Fabrics purchases cloth from Reliance


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

Book of M/S Vimal Fabrics

Debit purchases
Credit cash

Rs.
195 (Revenue A/C)
180

Credit Discount

15

A/C)

Allowed
Credit sales

195 (Revenue
A/C)

Received

3. Analysis of Sales Tax:

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

Books of Seller

Books of Purchaser

Debit Cash 1,100 (Real A/C)


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

1,100 (Real A/C)


1,100 (Real A/C)

(Represtative personal A/C)

4. Analysis of cheques issued and cheques received:


In case of payments made by issue of cheque, it is recorded in
bank account straightway. But in case of cheques received, it is recorded in
bank account only when the cheque is deposited in bank on the same day. If the
cheque received is not deposited on the same day, it is treated as cash on the
day of receipt of cheque and when it is deposited in bank, it is treated as cash
deposited in bank.

For example, if Rs.5,000 cheque received from Mr. P on 31.1.1999 is deposited


in bank on 31.1.1999 itself, the entry on 31.1.1999 is as follows

Debit bank
Credit P

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

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

(Real Account)
(Account)

On 5.2.1999
Debit bank
Credit cash

(Personal Account)
(Real Account)

Above mentioned traditional approach for cheques received is followed


when:
1. Cheques received are currently due. Post - dated cheques should not be
recorded in cash book.

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

A better way of recording cheques received is to record these as '


cheques in Hand', and to transfer it to bank account at the time cheque is
deposited in bank.

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

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

The basic operation of a trading organisation involves purchase of,


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

contrast, a

Manufacture-cum-Trader's

basic

operation

involves

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

those

of

'Raw

(popularly called

Materials 'Finished

Work-in-process).

Goods', and

He like a trader^'

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

Gross Profit = Net Sales - Cost of Goods Sold

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

Note the contrast in the determination of the Gross Profit of a


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

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

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

The 'Indirect Costs' comprising of indirect material costs, indirect labour


costs and indirect other costs are collectively called 'Overheads'. Overheads are
further

subdivided

in

three

categories

namely,

Factory;

Office

and

Administration and Selling and Distribution. Hence, a manufacturer views his


total cost in six ways, namely,
(a) Direct Material Cost;
(b) Direct Labour Cost;
(c) Other Direct Cost;
(d) Factory Overheads;
(e) Office & Administration Overheads;
(f) Selling & Distribution Overheads;

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

Computation of cost of finished goods manufactured during the period.


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

Opening stock of Raw Material + Purchase of Raw Material during the.


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

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

xxx
xxx
xxx
xxx
xxx
xxx

xxx
xxx

Goods transferred to
trading account
xxx

xxx

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

MANUFACTURING DEPARTMENT AS PROFIT CENTRE


The business organisation, instead of being viewed as a whole, can be
looked up as comprising of various parts where each part is responsible for the
overall results of the business in their own small measures. These small parts
arc called 'Responsibility Centres' of the business and are categorised as (a)
Expense Centres (b) Revenue Centres (c) Profit Centres and (d) Investment
Centres. These centers, being headed by responsible managers who are subject
to internal evaluation by their seniors at regular intervals, have a strong case for
projecting their division / part of business as a profit-making division.
Hence often the goods are transferred by the manufacturing department
to the trading department at a transfer price which is made up of its
manufacturing cost + mark up or profit In other words, the manufacturing
department is essentially viewed as a 'Profit centre'. The transfer of goods
internally at a profit leads to the profit being recognised in the manufacturing
account which is transferred to the profit and loss account with the help of the
following entry.

Manufacturing A/c

Dr.

To Profit and Loss A/c

However, this profit is not realised unless goods are sold to the ultimate
customer by the trading division. Hence if finished goods remain unsold at the
end of the accounting period it leads to valuation of the finished goods at a price
which is more than the cost of these goods to the business as a whole. The
excess represents the 'Unrealised profit' contained in the value of the stock. This
valuation of inventory violates the principle of 'Lower of cost or market value' as
inventory value advocated by AS-2 on valuation of inventories. It also violates
'Conservatism' principle by recognising a profit which is not realised (anticipated
gains) by transferring goods from one of business department to another
department.

The anomaly is removed by creating a stock reserve for the unrealized profit
contained in the closing stock from the profit and loss account with the help of
the following entry.

Profit and Loss A/c

Dr.

To Stock Reserve A/c


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

VALUATION OF INVENTORIES IN A MANUFACTURING DEPARTMENT


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

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

The historical cost of inventory is normally

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

However, while valuing it, the concepts of Equivalent


to

institute

of Cost

and

Management

accountants, London, 'Equivalent units are a notional- quantity of completed


units substituted for an actual quantity of incomplete physical units in progress
when the aggregate work content of the incomplete units is deemed to be
equivalent to that of substituted quantity .......'.

Hence by using the concept of

equivalent units, a 50% complete work in process of 10,000 units is treated as


5,000 completed units and then the overall cost can be allocated amongst the
completed units as well as incomplete units, the complete units being taken as
100% complete.

Illustration 1:

From the following particulars, prepare the manufacturing

account of A with units column:

Opening Stock - Raw Material


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

Unit
1,000
10,000
500

1,500

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

Closing Stock Work in Process (30% complete)

3,000

Dr.
Particulars

To Purchases Raw Matertial


To Freight Inward

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

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

1,500

Unit

Cr.
Amount

500
3,000

6,000
27,000

9,000

2,67,000

12,500

3,00,000

70,000
15,000

12,500 3,00,000
Working Notes:

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

Cost of Purchase + Freight (Inward)

Average pncs of Purchase made during the year =

No. of units purchase

= (1,10,000 + 10,000)
10,000
= Rs. 12

Value of closing stock of raw material

500 units x Rs. 12


=

= Rs. 6,000

2. Factory Overheads
Indirect Factory wages
Other Factory overheads

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

3.

Calculation of closing stock of work in process and finished goods

transferred to trading department.

Units manufactured during


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

Units

% of completion

Equivalent units

during the year


1,500

60 %

900

7,500

100 %

7,500

3,000

30 %

900
9,300

Cost incurred during the year


Raw Material Consumed
Direct Labour
Factory overheads

=
=
=

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

Hence, average cost of equivalent

2,79,000/9,300

Value of closing stock of work in

Rs. 27,000

process
Value of finished goods

[Opening stock of WIP + Cost of

units

completing opening WIP + Cost


of goods started and finished

during the year]


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

+ 7,500 units x Rs. 30


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

2,25,000
Rs. 2,67,000

* Opening stock at the beginning of the year was 40% complete and hence %
completed during the year was remaining 60%.
** Total finished goods transferred during the year is 9,000. Since 1,500 units
are from the opening stock of WIP, the remaining (7,500 units) must be those
which were started and finished during the year on the basis of cost flow
assumption of FIFO.
*** 10,000 (Opening stock +RM) + 1,10,000 (Purchases) - 6,000 (Closing Stock)
+1 0,000 (Freight) = Rs. 1,24,000.

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

On the other hand, primary objective of a non-profit organisation is to


meet some socially desirable goal or to render services to its members.

Non-profit organisations include hospitals, educational institutions,


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

A person familiar with preparation of financial statements of profitmaking

organisations

should

have

no

difficulty

in

preparing

financial

statements of non-profit organisations for clear and effective communication,


with their users. This is so because the set of rules or principles followed for
preparing financial statements of both profit-making and non-profit making
entities are almost same.

Non-profit organisations do not prepare profit and loss account because


their primary objective is not to earn profit but to serve its members or society
in general. However, these organisations compare incomes and expenses to
check whether the organisation have sufficient resources to carry out its
objectives. To achieve this 'Income and Expenditure Account* is prepared by:
non-profit organisations and is accompanied by a balance sheet tc show the
financial position of the organisation.

INCOME AND EXPENDITURE ACCOUNT


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

a)

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


and all incomes and gains on credit side of the account. As it records
incomes and expenses, the word 'expenditure' is used here in the sense of
an expense.

b)

Expenses debited to income and expenditure account include expenditure'


of revenue nature. Similarly, the incomes credited to income and
expenditure account are also of revenue nature. Items of capital nature
are, not included in income and expenditure account but the portion of
capital \ expenditure which expires during the year is charged to income
and expenditure account as depreciation.

c)

It includes incomes and expenses of current year on accrual basis


irrespective of flow of cash. Therefore, adjustment relating to outstanding
expenses, prepaid expenses, accrued income, unearned income etc. are
taken into account.

d)

Excess of credit side over debit side is termed as surplus and is known as
excess of income over expenditure. However, if debit side exceeds credit
side, there is a deficit and is termed as excess of expenditure over income. :
Like transfer of profit or loss to capital account in case of profit-making
entities, surplus or deficit of non-profit organisations is transferred to
capital fund.

Some Peculiar Items: Though the rules for preparing profit and loss account of'
commercial organisations and income and expenditure account of non-profit.
organisations are same, but there are some items which are peculiar to nonprofit organisations. Items peculiar to non-trading organisations are as follows:

a)

Capital Fund : Excess of assets over liabilities is called capital fund or


general fund. It is similar to capital account of commercial organisations.

b)

Annual Subscription : Subscription received from members is a revenue


item and credited to income and expenditure account. It is primary
source of income of a non-profit organisation.

c)

Government Grant: Government schools, colleges, public hospitals etc.


depend upon Government grant for their activities. The recurring grants
in the form of maintenance grant is, by and large, spent in the year of
receipt and is treated as revenue receipt (income) and credited to income
and expenditure account. Other grants such as building grant, library
grant etc., are treated as capital receipt and transferred to a fund
account. Besides Government's contribution to library fund, building
fund etc., additions may take the form of retention of surplus, amount
charged from students, contribution from trustees etc.

d)

Life-Membership Fees: Fees received for life membership is a capita]


receipt, as it is of non-recurring nature. It is directly added to capital fund
or general fund.

e)

Entrance Fees : Fees paid by new members at the time of joining the
organisation is called entrance fees. Since, the fees is paid only once by
members, it is clearly of non-recurring nature. Hence, it should be treated
as capital receipt and be shown in balance sheet as a part of the general
fund.

f)

Donation : Donations received for specific purposes are capitalized and


recorded on liabilities side of the balance sheet. These included donation
for building, donation for extension of library hall, donation for library
books, donation for seminar room, donation for sports activities etc. When
the donation is utilised for the purpose, the amount of donation is
transferred to capital fund. When the purpose for which the donation is to
be utilised is not mentioned, It is called general donation and treated as
income.

g)

Honorarium : Payment to non-employees for services received is called


honorarium. It is a revenue item and debited to income and expenditure
account.

h)

Legacy : Amount received by non-profit organisations as per Will of a


deceased person is called legacy. As this item is of non-recurring nature,
it is treated as capital receipt and recorded on liabilities side of the
balance sheet.
However, if the amount is small it can be credited to income and
expenditure account.

i)

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


contains assets uonated by the donor with stipulation that income earned
by these assets but not the gift itself can be used for principal activities of
the organisation. Sometimes, income may also be restricted. These kind of
restrictions must properly be reflected in the financial statements. The
fund is treated as capital receipt and recorded on the liability side.

j)

Subscription for Periodicals : Subscription for newspapers, magazines


etc. is treated as income and credited to income and expenditure account.

k)

Sale of Old Periodicals : Sale of old newspapers, magazines etc. is


treated as income and credited to income and expenditure account.

l)

Sale of Assets : Sale price of old asset is a capital receipt and not
recorded in income and expenditure account. However, profit or loss on
sale of asset is transferred to income and expenditure account. To
recapitulate profit (or loss) on sale of fixed asset is calculated by
comparing sale price with book value of asset sold on the date of sale.

m)

Income from specific fund and expenses related to specific fund :


Generally, incomes and expenses are recorded in income and expenditure
account. But if expenses arc incurred on certain items for which a fund
exists, then expenses are not debited to income and expenditure account
but deducted from specific fund account. Similarly,

income from

investment of specific fund is added directly to fund is added directly to


fund and not credited to income and expenditure account For example,
match fund balance of Rs. 10,000 income from matches Rs. 5,000 and
match expenses Rs. 12,000 ure shown on liabilities side of balance sheet
-as foolows;

Match Fund
Add

income

10,000
from

5,000

matches

15,000

Less Mtch Expenses

12,000 3,000

However, if after adjustment of income and expenses related to a specific


fund, fund balance is negative, it is transferred to debit side of income and
expenditure account

n)

Outstanding expenses & prepaid expenses : To recapitulate, the


expenses of current year are to be taken on accrual basis while making
income and expenditure account. Hence, the payment on account of

expenses need to be adjusted for outstanding expenses and prepaid


expenses. The entries for the two aspects may be recalled from the
chapter on final accounts, namely:-

for outstanding expenses.


Expenses A/c

Dr.

To Outstanding Expenses A/c


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

Outstanding expenses account is shown in the balance sheet on liability side


and prepaid expenses account on the asset side. Both accounts are transferred
to their respective expense accounts of the next year to find out its amount
correctly.

o) Accrued income (or income outstanding) and unearned income (or


income received in advance):
The same treatment is accorded to the income to be shown in income and
expenditure account The entries passed are:

For income outstanding


Income Outstanding A/c

Dr.

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

Dr.

To Income Received in Advance A/c

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

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

p)

Life

membership

fund

Sometimes,

member

of a

non

organisation pay their membership fees at die time of admission only. The
fees received is clearly of non-recurring nature and is given in lieu of
subscriptions to be paid every year which are of recurring nature. If
nothing is specified in the question, assume that life membership fund to
be capital nature and add it to be capital fund. However, if some kind of
amortisation schedule is given, than a suitable part out of capital fund
should be transferred to income and expenditure denoting the income of
that year.

Illustration I: From the trial balance and the additional information of a


public school, prepare Income and Expenditure Account for the year
ending December 31,1998 and the Balance Sheet as at that date.

Trial Balance as at Decembr 31, 1998

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

Stationery

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

Admission Fees
Tution Fees
Rent of Hall
Creditors for Books

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

General Expenses

Grant
8,000 Donations Received

Annual Sports Expense

for library books


6,000 Capital Fund

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

12,000

1,40,000

25,000

4,00,000

Cash
Bank

1,000
20,000 Interest on

8,000

Investments
8,00,000

8,00,000

Additional Information;
1) Tuition fees receivable for the year 1998 amounted to Rs. 10,000.
2) Salaries payable for the year 1998 amounted to Rs. 12,000
3) Furniture

costing

Rs.

10,000 was purchased on 1 -7-1998.

depreciation on furniture @ 10% p. a.


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

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

Outstanding
15,000 By
Annual

1,40,000

Goverenment
Grant
To

Annual

6,000

Sports Expenses
To
General

8,000 By

Expenses
To Depreciation
on Furniture
On 10,000 (for

5,000

Fees
By Rent of Hall

500

4,000

By

year)

12,000

Miscellanoues

On 30,000 (for 1

3,000

Receipts
3,500 By Interest on

year)
To Deprecitation

12,500

on Building
To Depreciation

12,000 Add

on

Admission

Investment

Library

Books
To Excess
Income

of

8,000

Accured

24,000

32,000

Interest

1,34,000

over

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

4,03,000

Liabilities
Outstanding
Salary
Creditors

Amount
12,000 Cash

for

6,000 Bank

for

25,000 Tution

Assets

Amount
1,000

20,000

Books
Supplied
Donation

Library Books
Capital Fund

Fees

Receivable
Accounted
Interest

On 1-1-98
Add Surplus

10,000

4,00,000
1,34,000

24,000
on

Investment
Investments
5,34,000 Furniture on 1-

20,000
30,000

1-98
Add purchased

10,000

on 1-7-1998
Less

40,000
3,500

36,500

Depreciation
Library Books
Less

60,000
12,000

48,000

2,50,000
12,500

2,37,500

Deprcaition
Building
Less
Depreciation
5,77,000

5,77,000

RECEIPT AND PAYMENT ACCOUNT

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

Account'. It is nothing but a summary of cash receipts and cash payments


during the relevant period. From chronological record of cash transactions in
the cashbook, summary of cash transactions is prepared at the end of the
period under consideration. It does not give the date of the transact ion (s).
Thus, both cashbook and 'Receipt and Payment Account' provide the same
information but in a different manner.
a)

It is real account. All receipts are recorded on its debit side and all
payments are credited.

b)

It starts with balance of cash and bank in the beginning of the period
under consideration.

c)

It records all items of revenue and capital nature resulting in' inflow and
outflow of cash. Again the period to which the transaction relates is not
significant. Transactions of previous year, current year and subsequent
years are recorded, provided they affect flow of cash in the current year.

d)

Balance of receipt and payment account shows the balance of cash and
bank at the end of the period under consideration.

Difference between Income and Expenditure Account and Receipt and


Payment Account:

Income and Expenditure A ccount


Receipt and Payment Account
I) It is a nominal account.
It is a real account.
2) It is a summary of the working of It is a summary of cash and bank
the organisation.

transactions of the organisation.

3) It is based on accrual system.


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

side

5)

It is a temporary account and has

no opening and closing balance.

6)

It is real account and starts


with opening balance of cash and

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

and balance figure of the account is year


transferred to capital fund.

7)

and

the

balance

carried

forward shows the cash and bank

balance at the end of the period.


It records items of revenue nature It records items both of capital

only irrespective of their effect on flow and revenue nature provided they
of cash.
affect flow of cash.
8) It records transactions of current It records transactions of previous
year only.

years,

current

year

and

subsequent years provided flow of


cash is affected.
BALANCE SHEET

Like commercial organisations, non-profit organisations prepare balance


sheet to show the financial position of the Organisation. If trial balance is not
given in the question, first of all balance sheet on the first day of the period
under consideration (called Opening Balance Sheet) is prepared. It records
assets and liabilities in the beginning of the period. Donations to capital fund
are added to balance of capital fund in the beginning of the period and after
adjustment of deficit or surplus as revealed by income and expenditure account,
the balance capita] fund is recorded in the balance sheer prepared on the last
day of the period under consideration (called Closing Balance Sheet)

Opening and Closing balance sheet on the basis of information given in


Illustration 2 appear as follows:

Balance Sheet as at December 31. 1997


Liabilities
Salaries

Amount
4,000 Cash

Outstanding
Capital Fund
(Balancing figure)

Assets

Amount
1,000

1,59,000 Bank
Outstanding

40,000
2,000

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

Amount
1,000 Cash

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

Assets

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

Amount
900

Bank
Outstanding

20,000
3,000

Add

4,500

it

is

amply
clear

Subscriptio
n
1,63,000 Investments

Hence

that
the

30,000

Surplus
Add Accrued

600

Interest
Furniture

20,000

on 1-1-98
Less sold
Building
Less

5,000
1,00,000
5,000

30,600

15,000
95,000

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

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

ii)

Receipts

&

transactions

Payments
because

Account
most

of

which
the

is

summary

transactions

of

of

cash

non-profit

organisation are in cash (and/or bank);


In fact, these two statements plus some additional information
(essentially j about the outstanding / prepaid expenses and accrued /
unearned incomes) provide the basic material which is necessary to
compute the deficit / surplus generated by the non-profit organisation
and to find out their financial position at the end of the period. This is
done in the next two statements, namely,

iii)

Income and Expenditure Account showing incomes generated and


expenses incurred during the year to find out the deficit / surplus;

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

iv)

All these statements are intimately connected. In examination, normally one or


two of these statements are given along with additional information well, it will
be easier to make the statements required in examination problems. For
example,

a)

Fixed assets appearing in the opening balance sheet will go to the closing
balance sheet after not sold. If they are sold, the sale price wi 11 increase
the receipts of cash during the year in receipts and payments account and
the difference of sale price and their value on the date of sale will be
charged to income and expenditure account as loss or gain on sale of fixed
asset

b)

The receipts in receipts and payment account will be divided in two parts,
namely capital and revenue. Revenue receipts, e.g., subscription received
will denote (he subscription received during the year whether pertaining
to past / present / future years. However, it will be adjusted in the light of
information about accrued / unearned subscription given in the opening

balance sheet and additional information and adjusted subscription,/


representing subscription of the current year whether received in past /
current / future years, will be shown on the credit side of the income and
expenditure account of the current year. Capital receipts such as Iife
membership fees, legacy etc. will be taken to liability side of the closing
balance sheet under suitable headings.

c)

The payments in receipts and payment account will be divided in two


parts, namely, capital and revenue. Revenue payments or expenses, e.g.
salary paid will denote the salary paid during the year whether pertaining
to past / present / future years. However, it will be adjust in the light of
information about outstanding /prepaid salary and adjusted salary,
representing salary of the expenditure account Capital expenditure,
denoting assets will be taken to asset side of the closing balance sheet
after depreciation which will be shown in the income and expenditure
account on the debit side (expenditure side).

From examination point of view, preparation of financial statements of no-profit


organisations can be studies under the following categories:

1)

When Receipts and Payments account along with additional information


is given and rest of the basic statements are to be prepared;

2)

When results of an incidental trading (commercial) activity ofa non-profit


organisation (e.g. Bar activities in a club) are to be ascertained by
preparing (Bar) Trading Account along with income and expenditure
account and balance sheet at the end of the period;

3)

When in receipts and Payments account the balance of bank is given as


per pass book;

4)

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

5)

When Income and Expenditure account along with additional information


is given and rest of Ihe basic statements are to be prepared;

6)

When both Receipts and Payments account and Income and Expenditure
account along with additional information are given, and balance sheet in
the beginning and at the end are required;

7)

When balance sheet at the beginning and at the end along with additional
information is given, and Receipts and Payments account and Income and
Expenditure account for the year are required;

8)

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

9)

When wrong statements / incomplete statements are given and corrected


accounts of non-profit organisation are to be prepared;

10)

Accounts of hospitals;

11)

accounts of educational institution including libraries.

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

Generally examination problems require preparation of income and expenditure


account and balance sheet at the end of the period from the information given.
But to complete balance sheet the figure of capital fund in the beginning is
required. To calculate information about capital fund in the beginning, balance

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

1) Balance sheet at the beginning of the period.


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

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

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

Non profit organisations basically survive on donations, grants subscriptions


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

a)

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


trading activity. All costs and revenues and incomes directly related with
such activity are recorded in trading account. Balance of trading account
showing profit or loss is transferred to income and expenditure account.

b)

Income and Expenditure account records, besides trading profit (or loss)
all other incomes and expenses not directly related with trading activity.
Surplus (or deficit) as revealed by income and expenditure account is
transferred to capital fund as usual.

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

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

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

Case V: When Income and expenditure Account along with Additional


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

Sometimes examination problem requires receipt and payment account and


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

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

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

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

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

a)

Insurance premium amount in receipt and payment account is Rs. 200


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

b)

Income and Expenditure account shows stationery amount Rs.500 and


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

c)

Interest on investment in income and expenditure account is Rs.1000 and


Rs.1500 is shown in receipt and payment account on account if interest
on investment. In this case difference of Rs.500 can be treatedi as interest
received in advance at the end of the year and recorded on liabilities side
of closing balance sheet. Alternatively difference of Rs.500 can be
assumed on account of interest earned but not received in the beginning
of the year and recorded on asset side of opening balance sheet ;

d)

Salary account recorded in receipt and payment account is Rs. 10,000


and Rs.9,000 is shown in income and expenditure account In this case,
Rs. 1,000 can be shown in closing balance sheet on asset side as advance
salary or it can be treated as salaries outstanding in the beginning of the
year and recorded on liabilities side of opening balance sheet.

It is clear from above that if amount appearing in receipt and payment! account
is more than that appearing in income and expenditure account, it ispossible to

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

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

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

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

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

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

Case

XI:

Accounts

of

educational

institutions:

like

other

non-profit

organisations, educational institutions need to report on their activities and to


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

LESSON - 7
ERRORS MANAGEMENT

Trial balance is prepared to check the arithmetical accuracy or


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

Type of Errors
1.

Errors of Omission : It refers to omission of a transaction at the time of


recording in subsidiary books or posting to ledger. When a transaction is
not recorded in the books of original entry, agreement of trial balance is
not affected because both (debit as well as credit) aspects of a transaction
are not recorded. However, if omission takes place at the time of posting
into ledger accounts, agreement of trial balance is disturbed as either
debit or credit aspect of the transaction is ignored. For example, omission
of credit purchase transaction at the time of recording in purchases book
does not affect the agreement of trial balance, as posting to purchases
book does not affect the agreement of trial balance, as posting to
purchases amount and supplier's account is not done. However, omission

at the time of posting to supplier's account affects the agreement of trial


balance as posting to purchases account takes place.

2.

Errors of Commission : Besides omission at the time of recording or


posting, business transactions are sometimes recorded and posted in a
wrong manner. Such errors are referred to as errors of commission. These
errors may or may not affect the agreement of trial balance. For example,
1 recording of wrong amount in subsidiary books, posting an amount to
wrong account, etc. are two sided errors and do mot affect trial balance;
However wrong totaling (or casting) of subsidiary books, posting on wrong
side of an account, posting of wrong amount, wrong balancing of an
account etc, are one sided errors and affect the agreement of trial
balance.

3.

Compensating Errors: When two or more one sided errors take place in
such a way that their effect is nullified, these are referred to as I
compensating errors. For example, if Rs. 500 credit sales to Ramesh to '
posted to debit side of Ramesh's account is omitted at the time of posting
and Rs. 500 credit purchases from Naresh to be posted to credit side of
Naresh's account is not posted to credit side of Naresh's account, these ?'
are termed as compensating errors. First error reduces debit side total by
Rs. 500 and second error reduces credit side total by Rs. 500. As a result,
trial

balance

agrees.

Thus, compensating errors do not affect the

agreement of trial balance. Errors of omission, commission and


compensating errors are also termed as clerical errors

4.

Errors of Principle : Besides clerical errors, sometimes accounting


principles are violated in accounting process. Errors involving violation of
accounting principles are termed as e.rors of principle. Generally, these
errors relate to distinction between capital and revenue items. Treatment
of capital expenditure as revenue receipts or vice versa are errors of
principle. For example, debiting purchase of furniture to office expenses

account, crediting rent received from tenant to tenant's account, crediting


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

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

Prevention of errors,

ii.

Detection of errors, and

(A) Prevention of Errors


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

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

Ignorance on the part of employees of latest accounting developments,

generally accepted accounting principles, appropriate account classification of


the necessary subsidiary ledgers with controlling accounts and of good
accounting practices in general;
ii)

Carelessness on the part of those doing the accounting work.

(B) Detection of Errors

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

i)

Errors which do not affect the agreement of the triafbalance. They


are also called two sided errors or undisclosed errors. These errors
take the form of complete omission, commission, principles or
compensating errors. The errors are called undisclosed because one
is net sure of their presence or absence.

ii)

Errors which effect the agreement of trial balance. They are also
caiied ''one-sided errors or disclosed errors. These errors take the
form of partial omission or commission errors. They are also called
disclosed errors because one is sure of their existence due to
disagreement of trial balance.

Following procedure can be adopted to locate the errors which are there is the
trial balance:
a)

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

b)

Recheck the ledger balances as to their amount and nature (whether Dr.
or Cr.) and ensure that they are posted on the right side of the trial
balance;

c)

If still error is not located, divide the difference in trial balance by 2. If the
amount of any account is same as computed number, recheck the nature
of the account (whether Dr. and Cr.) and ensure it is posted on the right
side of the trial balance;

d)

Divide the difference by 9. If it is completely divisible, the error probably


may be an outcome of the transposition of the figure (e.g.. 95 written as
59). Although it may give some idea, the exercise has to be very thorough;

e)

If the difference is very big, the balance in various accounts should be


compared with balances of me last year. If the difference is material, we
have sufficient cause to examine the account in detail;

f)

If still the error is not locatable, recheck the totals of subsidiary books
and ensure they are properly transferred;

g)

Recheck the schedules of debtors and creditors;

h)

Recomputed the account balances;

i)

If stil! the error is not detected, recheck all the entries in the genera!
journal for any possible omission, ' commission, principle and self
compensating errors.

(C) Rectification of Errors


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

Rectification of Two Sided Errors


Two sided errors are rectified by passing a journal entry called rectifying
entry. Thus, rectification entries are entries passed to correct the errors
committed and set right the accounting records.

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

Entry Passed:

Landlord Account
To cash Account

Entry Required:

Rent Account
To cash Account

Dr. 5,000
5,000

Dr. 5,000
5,000

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

Dr. 5,000
5,000

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

Furniture Account

Dr. 5,000

To cash Account

Entry Required:

5,000

Purchases Account

Dr. 5,000

To cash Account

5,000

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

Purchase Account

Dr. 5,000
To Furniture Account

5,000

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


Entry Passed:

Cash Account

Dr. 5,000

To Naresh Account

Entry Required:

Cash Account

5,000

Dr. 5,000

To Ramesh Account

5,000

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

Naresh Account
To Ramesh Account

Dr. 5,000
5,000

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

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


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

25,000 therefore, purchases account is debited by Rs. 10,000. Thux. rectifying


entry is:
Purchase Account
To Anil Account

Dr. 10,000
10,000

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

Dr. 9,000
9,000

Rectification of One-Sided Errors


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

Dr.

Sales Account

Cr.

By sundries as per sales books

By undercasting of sales book

9,500

500

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

In case of disagreement of trial balance, efforts are made to locate errors,


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

Journal entries for one-sided errors through suspense account:


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

Journal entries required to rectify the one-sided errors given in


illustration 6 are as follows:

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

Dr. 500
500

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

Dr. 1,000
1,000

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

Dr. 1,000
1,000

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

Dr. 630
630

5) Rs. 4,000 cash paid to a creditor has been posted to the credit side of
creditor's account: Rs. 4,000 cash paid to a creditor should have been debited
To creditor account but ft is actually credited to creditors account. To have
correct balance in creditors account Rs. 8,000 should be debited to creditors
accounf. Debiting of double amount i.e., Rs. 8,000 nullfiles the effect of wrong
credit of Rs. 4,000 and ensures correct debit of Rs. 4,000. The journal entry' |
passed for this is as follows:

Creditors Account

Dr. 3,000

To Suspense Account

8,000

Above entries are posted to suspense account as follows;

Dr

Suspense Account
To

Difference

trial

in

7,870

balance

(balancing figure)
To X

1,000

To Y

630

By Purchase A/c

Cr.
500

By Sales A/c

1,000

By Creditors

8,000

After rectification of all the errors, suspense account must balance. In


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

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

Wrong credit to sales account increase reported profit by Rs.


70,000. Correct profit can be calculated by rectification of this error.
Rectification reduces sales account balance and thus, profit by Rs.
70,000.

b)

Wrong debit to wages account reduces reported profit by Rs. 1,000.


To calculate correct profit rectification entry is passed. It ^uces
wages account balance by Rs. 1,000 and thus, increases profit by
Ri. 1,000.

c)

Non-posting of discount received balance reduces reported; profit by


Rs 2,500 and thus, increase profit figures by Rs. 2,500 to reportcorrect profit figure, -

d)

Non-oostine of totalsales return increases net sales by Rs. 12,000.


It by Rs. 12,000. Rectification ;of this error reduces net sales by Rs.
32,000 and thus profit after rectification is reduced by Rs 12,000 to
report correct profit,

e)

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

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

Rectification

of Errors after Finalisation

of Accounts or in the next

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

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

However, if the error involves a nominal account having its impact on the
profit, the rectification is done in a different manner. For example, if last year
(he sales be jk was undercast by Rs. 10,000, it would have led to a suspense
account with a credit balance of Rs. 10,000 in the trial balance. If the error was
to be detected last year before the fmalisation of accounts, the rectification entry
would have been ;
Suspense Account
To Sales Account

Dr. 10,000
10,000

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

period as a result of errors omissions in the preparation of the financial


statements of the one or more prior periods. It is recommended that the impact
of the prior period items be shown separately in the profit and loss account of
the current accounting period.

Hence, the entry for this aspect will be:


Suspense Account

Dr 10,000

To Profit & toss Adjustment Account

10,000

The profit and loss adjustment account is closed by transfer to the


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

Dr. 5,000
5,000

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


Profit & Loss Adjustment Account
To Suspense Account

Dr. 5,000
5,000

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

Dr. 2,000
2,000

Profit & Loss Adjustment Account


To Debtors Account

Dr. 2,000
2,000

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


Rectification entry if it is done in the accounting period of the error itself
Drawings Account
To Purchase Account

Dr. 1,000
1,000

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


Drawings Account

Dr. 1,000

Profit & Loss Adjustment Account

1,000

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

Dr. 8,000
4,000

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


Suspense Account

Dr. 8,000

To X Account

4,000

To V Account

4,600

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

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

b)

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

c)

bill receivable for Rs.

1,300 received from Krishna has

been dishonoured on maturity but no entry passed; :

d)

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

e)

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


account. Purchase account has been correctly debited;

f)

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


been debited to depreciation account.

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

Suspense A/c

Dr. 8,000

To Profit & Loss Adjustment A/c


(Being
b)

wrong

recording

of

sales

8,000
as

purchase last year rectified)


Drawings A/c

Dr. 2,500

To Profit & Loss Adjustment A/c


(Being

Drawings

inadvertently
c)

2,500

made

last

year

as

repairs

now

shown

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

Dr. 1,300
1,300

d)

To Profit & Loss Adjustment A/c

Dr. 650

To Clerk's Personal A/c

650

(Being salary paid to clerk last year


inadvertently shown in his personal
e)

account now rectified)


Suspense A/c

Dr. 1,500

To Raghubir A/c

1,500

(Being purchase from Raghubir) shown


on
f)

debit

side

of

his

account

inadvertently now rectified)


Profit & Loss Adjustment A/c

Dr. 1,500

To Suspense A/c
(Being

1,500

depreciation

not

shown

last

year now rectified)

Dr.
To

Suspense Account
Cr.
Profit

&

Loss

Adjustment A/c
To Raghubir A/c

8,000

By balance b/d

1,500

By

Profit

&

7,250
Loss

2,250

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

9,500
Profit & Loss Adjustment Account

9,500

Persona]

650

By Suspense A/c

8,000

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

2,250
7,600

By Drawings A/c

2,500

Adjustment

A/c

(Transfer)
10,500

10,500

LESSON - 8
ACCOUNTS FROM INCOMPLETE RECORDS-SINGLE ENTRY SYSTEM

SALIENT FEATURES
a)

Incomplete Double Entry System : Dual aspect of a transaction is not


recorded under this system. Recording is done according to convenience
and information needs of the business. As information needs of business
entities are governed by size of business, nature of Business, prevailing
circumstances etc., the procedure of recording followed by different
business entities may vary. Therefc

e, there is no uniformity in

maintenance of records under single entry system.

b)

Flexibility : Single entry system is flexible as recording procedure can be


adjusted according to the information needs of a particular business
enterprise. As rules of double entry system are not followed, knowledge of
principles of double entry system of book-keeping is not necessary.

c)

Variation of Recording Process : Single entry system is incomplete


double entry system, varying according to information needs of business
entities.

There is no hard and fast rule for maintenance of records under

this system. But, generally, cash book and personal accounts are
maintained under this system.

d)

Importance of Source Document: As complete recording is not done


urder single entry system, source document like sales bills, purchase
bills, vouchers etc., play very important role in collection of necessary
information, for finding out profit (or loss) and preparing financial position
statement.

c)

Less Expensive: As complete records are not kept, time and labou;
involved in maintaining accounting records is less in comparison to
double entry system.

d)

Suitability : Use of single entry system is not permitted in case of


corporate entities. It is generally followed by non-corporate entities of
small size.

Limitations of Single Entry

System.

Single entry

system

has following

limitations;
a)

Unscientific : There are no set rules for maintaining records under such
system. Absence of systematic recording of both aspects of a transaction
under single entry system makes it unscientific.

b)

No trial balance : Dual aspect of a transaction is not recorded under this


system. As a result, trial balance can not be prepared from accounting
records maintained. Hence, arithmetical accuracy of accounting records
can not be checked.

c)

Determination of true profit (or loss) not possible : Nominal accounts


are not maintained and, therefore, it is not possible to prepare trading
account and profit and loss account to calculate gross profit and net profit
respectively. Although the amount of net profit is determinable but the
absence of details of revenue, other incomes, expenses and losses affect
sound decision making.

d)

True financial position cannot be determined: Absence of real


accounts makes the job of preparation of balance sheet a very difficult
one. As information about assets is not available from records, these
items are estimated. Statement listing assets and liabilities in this case is

called 'Statement of Affairs' instead of Balance sheet. Statement of affairs


fails to reveal the true financial position of the business.

e)

More chances of errors and frauds : Trial balance cannot be prepared to


check prima facie arithmetical accuracy of accounts. It encourages
carelessness, misappropriations and frauds because, in the absence of
comolete records, detection of errors and frauds is very difficult.

f)

Unsuitable for planning and control : In the absence of reliable


information about nominal and real account, effective planning and
control over expenses, assets etc., is not possible. :

g)

Legally not recognised : According to the Indian Companies Act, 1956,


single entry system cannot be employed by companies. Moreover,
accounts maintained on single entry are

not accepted by sales tax and

income tax authorities.

h)

Inter- firm Comparisons not possible : Because of variation in.


accounting procedure and rules, comparisons of two or more businesses
is not possible.
'Inspite of the above limitations, an accountant is required to

ascertain profit, (or loss) and prepare financial position statement at accounting
date. Methods followed for this are a follows:

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


b) Conversion Method or Quasi Single-Entry System.

Statement of Affairs Method


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

Liabilities
Creditors
Bills payable
Outstanding

Amount

Assets

Amount

Cash
Bank
Debtors

expenses
Unearned income
Loans
Capital (Balancing

Bills receivable
Stock
Prepaid expenses

figure)
Accrued income
Fixed assets
Distinction Between Statement of Affairs and Balance Sheet : Following are
the points of difference between a statement of affairs and a balance shed.
a)

Balance shees records balances of assets, liabilities and capital drawn


from the ledger books. Statement of Affairs contains information either
drawn from accounting records (if records are maintained) or bases on
estimates

(if

records

are

not

maintained).

Therefore,

information

contained in balance sheet is more reliable as compared to information


contained in the statement of Affairs.

b)

Balance sheet contains information about capital as per accounting


records In statement of affairs capital is taken as balancing figure, being
the difference between lotal assets and total liabilities.

c)

Balance sheet lists balances of assets, liabilities and capital .drawn from
accounting records based on double entry system. If an asset or liability is
omitted, balance sheet does not tally. Then, error is detected and
corrected. However, in case of statement of affairs, omission of an asset or
liability goes unnoticed because capital is taken as balancing figure.

d)

Balance sheet is prepared to show financial position of the business as


per accounting records. Statement of affairs, on the other hand, is
prepared to calculate capital at a particular point of time.

Calculation of Profit (or loss): To calculated profit or 'oss following steps are
required:
a)

To find out capital in the beginning of the year (called opening capital)
prepare statement of affairs at the beginning of the year.

b)

To calculate capital at the end of the year (called closing capital)


statement of affairs at the end of the year is prepared.

c)

After calculating opening capital and closing capital, capita] introduced


and drawings made during the year are adjusted to find out profit (or loss)
for the year by using the following relationship.

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

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

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

Profit as shown by statement cf profit is'adjusted to calculate net profit as


follows:
Profit and Lots Account /or the year ending.....
To Depreciation on Fixed Asset

By Profit before
adjustment as shown in

To Provision for Doubtful Debts


To Interest on Capital
To Net Profit transferred to
Capital Account

the statement of profit


By Interest on Drawing

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

In actual practice, conversion involves completion of ledger books,


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

Prepare statement of affairs in the beginning of the year.

b)

Prepare cash book or cash account.

c)

Prepare total debtors account and bills receivable account.

d)

Prepare final accounts.

Whatever information is given in the question, record that in accounts)


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

Proforma of Total Debtors Account, Total Creditors Account, Bills


Receivable Account and Bills Payable Account is given below to have an idea
about the items isuaily appearing in these accounts.

Dr.

Total Debtors A/c

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

By Cash or Bank A/c


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

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

year)
Dr.

Bills Receivable A/c

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

By Cash A/c & Discount A/c


(for B/R Discount)
By Creditors A/c
(B/R endorsed to creditors)
By Cash A/c
(B/R encashed on due date)
By Debtors A/c
(B/R dishonoured)
By balance c/d
(B/R at the end)

Dr.

Total Creditors A/c

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

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

To Bills Payable A/c


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

Dr.

By Bills payable A/c


(Bills payable dishonoued)

Bills Payable A/c

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

By balance b/d
(B/P in the beginning)
By Creditors A/c
(Bills accepted during the
year)

To balance c/d
(B/P at the end)
Gross Profit Ratio: Sometimes, gross profit ratio (i.e. Gross profit / Net sales x
100) is given in the question. In that, case, the amount of gross profit figure in
trading account, calculation of missing information about any one of the items
recorded in trading account can take place. Items recorded in trading account
are opening stock, purchases, direct expenses and closing stock.

Illustration 1:

Find out the amount of direct expenses from the following

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

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

Trading Account for the year ended March 31, 1999

To Opening Stock
To Purchases
To Direct Expenses

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

1,28,000
12,000

Cr.

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

1,40,000

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

While records of.

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

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

Stock
Bank Balance
Cash in hand
Debtors
Creditors
Investments

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

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

Other transactions are as follows:


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

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

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

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

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

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

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

Bank A/c

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

To

Capital

8,000 By drawings A/c


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

A/c

Cr.
26,000
1,22,000

57,700

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

12,000
2,17,000

Sundry Debtors A/c


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

(balancing

Cr.
1,42,000
20,000

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

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

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

figure)
30,000

30,000

Balance Sheet as at 1-1-98


Liabilities
Creditors
Capital (Balancing figure)

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

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

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

20,000 By Sales :

A/c
To Wages
To Purchaes :
Cash

97,700 Cash
Credit
By closing Stock

1,60,000

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

A/c
Credit
Less Drawings
To Gross Profit

2,700
1,62,000
24,000

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

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

4,13,000

1,22,000 By Gross Profit

1,56,600

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

1,56,600

Balance Sheet as at 31-12-98

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

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

Assets
Investment
Stock
Debtors

Amount
50,000
15,000
20,000

67,400 Bank

12,000

30,000 Cash
97,400

400
97,400

Difference between Double Entry system and Single Entry System

Of difference between double u"Hry system aj)d single entry system of


book keeping.
a)

Dual-Aspect : Under double ciury syrricrti bolh aspects of al! business


transactions are rcco:tie. Under single entry system both aspects of all
business transactions are not recorded.

b)

Trial Balance: Under double entry system trial balance can be prepared
to check the arithmetical accuracy of accounts. Under single entry sysuai
trial balance cannot be prepared because duaI-aspect of ail transactions
are not recorded.

c)

Type of Accounts: Under double entry system nominal, persona! and


real accounts are maintained. Under single entry system, generally,
personal accounts and cash books is maintained.

d)

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


system are followed by all concerns. Under single entry system, as the
system is adjusted according to convenience and needs of the business,
rules followed for recording vary from concern to concern.

c)

Cost : As complete records ore kept under double entry system, cost of
maintaining records is more in comparison to single entry system.

d)

Legal Recognition : Corporate entities cannot follow single entry system


as it goes against the provisions of the Indian Companies Act, 1956. Even
sales tax and income tax authorities do not recognise single entry system.

g)

Details of Net Profit (or Loss) : Under double entry system details of
expenses, revenue and incomes are available because of maintenance of
normal accounts. Under single entry system, though net profit (or loss) is
calculated, but details of expenses revenue and incomes are not available.

h)

Financial position : Under double entry system, financial'position


statement reveals trne financial position based on accounting, records.
Under single entry system, statement of affairs based on incomplete
records and estimates is prepared to reveal financial position of 'he
business.

i)

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


recording

under

single

entry

system

encourages

carelessness,

misappropriations and frauds. Fear of detection of errors and frauds


under double entry system reduces chances of errors and frauds.

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


is possible under double entry system because same set of rules are
followed by all concerns. Inter-firm comparisons under single entry are
not valid because of variation in rules of recording.

k) Reliability : Absence of systematic recording on the basis of double entry


rules makes information available under single entry system less reliable
as compared to information available under double entry system.

l) Suitable : Double entry system is suitable for all types of business. IS>
enTry system suits only small non-corporate enuues.

LESSON - 9 FINANCIAL STATEMENT ANALYSIS

MEANING OF FINANCIAL STATEMENTS

According to Himpton John, "A financial statement is an organized


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

On the basis of the information provided in the financial statements,


management makes a review of the progress of the company and decides the
future course of action.

DIFFERENT TYPES OF FINANCIAL STATEMENTS


1. Income Statement
2. Balance Sheet
3. Statement of Retained earnings
4. Funds flow statement
5. Cash flow statement.
6. Schedules.

FUNDAMENTAL CONCEPTS OF ACCOUNTING


1. Going concern concept
2. Matching concept ( Accruals concept)
3. Consistency concept
4. Prudence concept ( conservation concept)

5. Business entity concept


6. Stable monetary unit concept
7 Money measurement concept
7. Objectivity concept
8. Materiality concept
9. Realization concept.

LIMITATIONS OF FINANCIAL STATEMENTS


1.

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

historical
costs.

2.

Profit arrived at by the profit and loss account is of interim nature. Actual
profit can be ascertained only after the firm achieves the maximum
capacity.

3.

The net income disclosed by the profit and toss account is not absolute
but only relative.

4.

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


accountants cannot be removed in the matters of depreciation, stock
valuation, etc.,

5.

The profit and loss account does not disclose factors like quality of
product, efficiency of the management etc.,

6.

There are certain assets and liabilities which are not disclosed by the
balance sheet. For example the most tangible asset of a company is its
management force and a dissatisfied labour force is its liability which are
not disclosed by the balance sheet.

7.

The book value of assets is shown as original cost less depreciation. But
in practice, the value of the assets may differ depending upon the
technological and economic changes.

8.

The assets are valued in a Balance sheet on a going concern basis. Some
of the assets may not relate their value on winding up.

9.

The accounting year may be fixed to show a favorable picture of the


business. In case of Sugar Industry the Balance sheet prepared in off
season depicts a better liquidity position than in the crushing season.

10.

Analysis Investor likes to analyse the present and future prospectus of the
business while the balance sheet shows past position. As such the use of
a balance sheet is only limited.

11.

Due to flexibility of accounting principles, certain liabilities like provision


for gratuity etc. are not shown in the balance sheet giving the outsiders a
misleading picture.

12.

The financial statements are generally prepared from the point of view of
shareholders and their use is limited in decfsion making by the
management, investors and creditors.

13.

Even the audited financial statements does not provide complete


accuracy.

14.

Financial statements do not disclose the changes in managernent, Loss of


markets, etc. which have a vital impact on the profitability of the concern.

15.

The financial statements are based on accounting policies which vary


form company to company and as such cannot be formed as a reliable
basis of judgment.

FORMATS OF FINANCIAL STATEMENTS


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

Income Statement

There is no legal format for the profit and loss A/C. Therefore, it can be
presented in the traditional T form, or vertically, in statement form. An example
of the two formats is given as under.

(i) Horizontal, or T form:


Manufacturing, Trading and profit and loss A/C

of ........... for the

year ending .........................

Dr

Cr

Particulars
To opening stock

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

To opening stock of finished

Rs.

Particualrs
By cost of finished Goods

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

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

Rs.
Xxxx

xxx
xxx

xxx
xxx
xxx

goods
To cost of Finished goods

goods
xxx By Gross Loss c/d

xxx

To Gross Loss b/d


To office and Admn.

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

xxx
xxx
xxx

Expense
To Interest and financial

xxx By Net Loss c/d

xxx

b/d
To Gross Profit c/d

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

net loss b/d


general reserve
Dividend
Balance c/f

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

xxx
xxx
xxx

xxx

xxx

(ii) Vertical Form


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

Rs.

Rs.
xxxx
xxx
xxx

xxxx
xxxx
xxxx
xxxx
xxxx
xxxx

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

xxxx
xxx

xxx
xxx

xxx
Xxxx
Xxx

Less: Non-oprating Expenses (including Interest)


Profit before Tax
Less : Tax
Profit After Tax
Appropriations
Transfer to reserves
Dividend declared /paid
Surplus carried to Balance sheet

xxxx
xxx
xxxx
xxx
xxxx

xxxx
xxx
xxx
xxxx

Balance Sheet
The Companies Activities, 1956 stipulates that the Balance sheet of a
joint stock company should be prepared as per part I of schedule VI of the
Activities. However, the statement form has been emphasized upon by
accountants for the purpose of analysis and Interpretation. The permission of
the Centra! Government is necessary for adoption of the 'statement* form.
(i) Horizontal Form
Balance sheet of .................... as on ....................
Liabilities
Share Capital
(with
all
paticulars
Authorized,

of

Rs.
Assets
xxx Fixed Assets:
1. Goodwill

Issued,

Subscribed capital) Called

2. Land & Building


xxx 3. Leasehold property

Rs.
xxx
xxx
xxx

up capital

4. Plant and Machinery

xxx

Less: Calls in Arrears


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

5. Furniture and Fittings


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

xxx
xxx
xxx

xxx
xxx
xxx
xxx
xxx
xxx
xxx

xxx
xxx

and loss A/C (if any)


5. Profit and Loss
Appropriation A/C
6. Sinking Fund

xxx
xxx

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

xxx
xxx

xxx
xxx

Secured Loans
Debentures
Add: Outstanding Interest

xxx
xxx

Loans from Banks


Unsecured Loans

xxx 9. Prepaid Expenses


Miscellaneous Expenditure

xxx
xxx
xxx

(to the extent not written off

Fixed Deposits
Short-term
loans

and

advances
Current

and

Liabilities

or
xxx adjusted)
xxx

1. Preliminary expenses

Provisions

2.

Discount

xxx
xxx Profit

3.

(Loss),
xxx if any

received

in

advance
4. unclaimed Dividends
5. Other Liabilities

xxx
xxx

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

xxx
xxx
xxx

pension
fund contingent
not
Provided for

on

Issue

xxx
of

shares
and debentures
3. Underwriting Commssion

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

Income

xxx

liabilities

and

Loss

account

xxx

xxx

xxx

xxx

(ii) Vertical Form:


Balance sheet of . as on

Particulars

Schedule No.

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

Current

Previous

year

Year

xxxx
xxxx

xxxx
xxxx

xxxx
xxxx

xxxx
xxxx

xxxx
xxxx
xxxx
xxxx

xxxx
xxxx
xxxx
xxxx

2. Investments

xxxx

xxxx

3. Current Assets, Loans and Advances


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

xxxx
xxxx
xxxx
xxxx
xxxx

xxxx
xxxx
xxxx
xxxx
xxxx

xxxx
xxxx
xxxx

xxxx
xxxx
xxxx

xxxx

xxxx

xxxx
xxxx

xxxx
xxxx

Less : current Liabilities and Provisions


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

(ii) Vertical Form for analysis


Balance sheet of as on ..

Particulars

Rs.

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

xxxx
xxxx
xxxx
xxxx
xxxx

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

xxxx
xxxx
xxxx
xxxx
xxxxx

xxxx

xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxxx

Statement of Retained Earnings:


Profit and Loss Appropriation Account

To

Particulars
transfer

Reserves
To Dividend

to

Rs.
xxx By

Particulars
Last
years

balance
xxx By Current Years net

Rs.
xxx

xxx

profit

(Transferred

from profit and loss


A/C)
To Dividend proposed
To surplus carried to
Balance sheet

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

xxx

xxx
xxxx

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

Sales
Opening stock
Closing stock
Purchases
Operating Expenses

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

Rate of Tax 50%


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

Rs.

Rs.
2,00,000

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

Less: Income tax (50%)


Net profit after tax

74,500
74,500

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

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

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

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

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

Particulars

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

2000

2001

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

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

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

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

Net profit before tax


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

The following techniques are adopted in analysis of financial


statements of a business organization:

Comparative Statements

Common size Statements

Trend Analysis

Funds flow Analysis

Cash flow Analysis

Ration Analysis

Value Added Analysis.

The first three topics are covered in this chapter and the rest are
discussed in the subsequent chapters in detail.

Comparative Financial Statements


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

Absolute data (money values or rupee amounts)

ii.

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

iii.

Increase or reduction in absolute data (in terms of percentages)

iv.

Comparison (in terms of ratios)

v.

Percentage of totals.

a. Comparative Income Statement or Profit and Loss Account:


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

b. Comparative Balance Sheet


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

Comparative statements can also be used to compare the performance of


the industry or inter-firm comparison. This helps in identification of the
weaknesses of the firm and remedial measures can be taken; accordingly.

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

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

Particulars
To Cost of
goods sold
To Office

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

23,266

27,068 Less

expenses

45,912

expenses
To Loss on

627

57,816

5,794

6,952

3,54,934

4,10,173

1,896

1,750 By Other

sale of

Tax
To Net

2001
Rs.
4,17,125

Returns

To Interest

fixed
To Income

2000
Rs.
3,60,728

incomes :

21,519

40,195 By Discount

2,125

35,371

on purchase
44,425 By Profit on

1,500

Profit

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

3,60,457

4,13
,379

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

Particulars

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

2000 Rs. 2001 Rs. Increase (+)

Increase (+)

Decrease (-)

Decrease (-)

Amount

Percentages

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

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

+15.63
+19.98
+15.56
+4.46

1,23,309 1,68,223

+44.914

+36.42

23,266

27,068

+3,802

+ 16.34

expenses
Selling

45,912

57,816

+11,904

+25.93

expenses
Total operating

69,178

84,884

+15,706

+22.70

Less: Other

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

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

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

+53.96
-41.95
+45.08
-30.35

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

56,890
21,519
35,371

84,620
40,195
44,425

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

+48.74
+86.79
+25.60

expenses
Operating profit
Add: Other incomes

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

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

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

Particulars

2000

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

2001
Rs.

Rs.

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

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

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

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

Fixed Assets

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

Solution:
Comparative Balance Sheet
31st Dec.

31st Dec.

Inerease(+)

Increase(+)

2000

2001

Decrease(-)

Decrease(-)

Rs.

Rs.

Amount(Rs.)

Percentages

50,000

83,000

+33,000

+66

20,000
1,00,000
40,000

60,000
1,25,000
50,000

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

+200
+25
+25

10,000

12,000

+2,000

+20

Total Current Assets


Fixed Assets

2,20,00
2,40,000

3,30,000
3,50,000

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

+50
+45.83

Total Assets

4,60,000

6,80,000

2,20,000

47.83

Bank overdraft
Creditors
Proposed dividend

50,000
40,000
15,000

50,000
50,000
25,000

+10,000
+10,000

+25
+66.67

Provision for taxation

20,000

25,000

+5,000

+25

1,25,000

1,50,000

+25,000

+20

Liabilities
Capital and Reserve:
Equity share capital

2,00,000

3,30,000

+1,30,000

+65

Preference

1,00,000

1,50,000

+50,000

+50

capital
Reserves

20,000

30,000

+10,000

+50

Profit and Loss a/c

15,000

20,000

+5,000

+33.33

3,35,000

5,30,000

+1,95,000

+58.21

4,60,000

6,80,000

+2,20,000

+47.83

Particulars

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

LIABILITIES
Current Liabilities:

Total

Current

share

Total Liabilities

Interpretation:

1.

The above comparative Balance sheet reveaJs the current assets has been
increased to 50%, while current liabilities increase to 20% only. Cash
increased to Rs.33,000 (i.e. 66%), There is an improvement in liquidity
position.

2.

The fixed assets purchased was for Rs, 1,10,000. As there are no longterm funds, it should have been purchased partly from Share Capital.

3.

Reserves and Profit and Loss a/c increased by 50% and 33.33%
respectively. The company may issue bonus shares in near future.

4.

Current financial position of the company is satisfactory. It should issue


more long-term funds.

COMMON SIZE STATEMENTS


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

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

Particulars

Amount (Rs.)

% to Sales

Sales

(A)

14,00,000

100

Raw materials

5,40,000

16.4

Direct wages

2,30,000

16.4

Faciory expenses

1,60,000

11.4

9,30,000

66.4

(A) -

4,70,000

33.6

Administrative

1,10,000

7.9

distribution

80,000

5.7

2,80,000

20.0

40,000

2.9

3,20,000

22.9

60,000

43

2,60,000

18.6

80,000

5.7

1,80,000

12.9

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

Non-operating

expenses
Profit before tax
Less: Income tax
Profit after tax

Common Size Balance Sheet of XYZ


Particulars

Amount (Rs.)

% to Total

ASSETS
Fixed Assets
Land

50,000

5.3

Buildings

1,10,000

11.7

Plant and Machinery

2,50,000

26.6

Raw materials

80,000

8.5

Work-in-progress

50,000

5.3

1,60,000

17.0

Current Assets :
Inventory

Finished goods

Sundry debtors

2,10,000

22.4

30,000

3.2

9,40,000

100.0

Euqity Share capital

2,50,000

26.6

Preference Share Capital

1,00,000

10.6

General reserve

1,60,000

17.0

80,000

8.5

2,20,000

23.4

Creditors for expenses

40,000

4.3

Bills payable

90,000

9.6

9,40,000

100.0

Cash at Bank
Total
Capital and Liabiltiies

Debentures
Current Liabilities
Sundry Creditors

Analysis of performance and position can be made from the above


Common Size Statements.

llustration: 6
From the following P&L A/c prepare a Common Size Income StatementParticulars
To Cost of goods
sold
To Administrative
expenses
To
Selling
expenses
To Net Profit

2000
Rs.
12,000

2001
Particulars
Rs.
1 5,000 By Net Sales

400

400

600

800

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

2000
Rs.
16,000

16,000

2001
Rs.
20,000

20,000

Common Size Income Statement


Particulars

2000

2001

Net sales

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

Less: Cost of goods sold

12,000

Gross
Profit
Less:

7500

4,000

25.00

5,000

25.00

400

2.50

400

2.00

Operating

expenses
Administration
expenses
Selling expenses
Total

75.00 15,000

600

Operating 1,000

3.75

800

4.00

6.25

1,200

6.00

18.75

3,800

19.00

expenses
Net Profit

3,000

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

Liabilities
Equity capital

2000

2001

Rs.

Rs.

1,00,000

Assets

1 ,65,000 Fixed Assets (Net)

2000
Rs.

2001
Rs.

1 ,20,000 1,75,000

Pref. Capital

50,000

75,000 Stock

20,000

25,000

Reserves

10,000

15,000 Debtors

50,000

62,500

P&L A/c

7,500

10,000 Bills receivable

10,000

30,000

Creditors

20,000

25,000 Cash at Bank

20,000

26,500

Provision

10,000

12,500 Cash in hand

5,000

15,000

for taxation
Proposed

7,500

12,500

2,30,000

3,40,000

dividends
2,30,000 3,40,000

Prepare a common size balance sheet and interpret the same.

Solution;

Common Size Balance Sheet of Vinay Ltd.


for the year ended 31.12.2001 & 2002

Particulars
Rs.
Capital & Reserves:
Equity Capital

2000
%

Rs.

2001
%

1,00,000

43,48 1 ,65,000

48.53

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

21,74
4.34
3.26
72.82

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

22.05
4.41
2.95
77.94

Bank overdraft
Creditors
Provisions for taxation

25,000
20,000
10,000

10.87
8.70
4.35

25,000
25,000
12,500

7.35
7.35
3.68

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

7,500
62,500
2,30,000

3.26
27.18
100.00

12,500
75,000
3,40,000

3.68
22.06
100.00

1,20,000

52.17

1,75,000

51.47

20,000
50,000
10,000

8.70
21.74
4.34

25,000
62,500
30,000

7.35
18.38
8.82

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

Fixed Assets (Net)


Current Assets:
Stock
Debtors
Bills receivable

(a)

Cash al bank
Cash in hand

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

Interpretation :
(1)

In 2001 Current Assets were increased from 47.83% to 48.53%. Cash


balance increased by Rs. 16,500.

(2)

Current Liabilities were decreased from 27.18% to 22.06%. So, the


company can pay off the Current Liabilities from Current Assets. The
liquidity position is reasonably good.

(3)

Fixed Assets were increased from Rs. 3,20,000 in 2000 to Rs. 1,75,000 in
2001. These were purchased from the additional share capital issued.

(4)

So, the ove.all financial position is satisfactory.

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

Trend analysis can

be .done

by trend

percentage, trend ratios and graphic and diagrammatic representation.

The

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

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

Particulars

1999
Rs.

2000
Rs.

2001
Rs.

Sales

50,000

75,000 1,00,000

Purchases

40,000

60,000

72,000

Expenses

5,000

8,000

15,000

Profit

5,000

7,000

13,000

Solution:
Particulars

1999 Rs.

2000

Rs.

Rs.
Rs.

Purchases

2001 Rs. Trend Percentage Base 1999

Rs.

1999

2000

2001

40,000

60,000

72,000

100

150

180

Expenses

5,000

8,000

15,000

100

160

300

Profit

5,000

7,000

13,000

100

140

260

Sales

50,000

75,000

1,00,000

100

150

200

Illustration: 9
From the following data, calculate trend percentages (1999 as base)

Particulars

1999

2000

2001

Rs.

Rs.

Rs.

Cash
Debtors

200
400

240
500

160
650

Stock

600

800

700

Other Current Assets

450

600

750

Land

800

1,000

1,000

Buildings

1,600

2,000

2,400

Plant

2,000

2,000

2,400

Solution:

Particulars

2000 2001 (Base Year 1999)


Rs.

Rs.

Rs.

1999 2000 2001

Cash

200

240

160

100

120

80

Debtors

400

500

650

100

125

163

450

600

Other

Current

750

100

133

167

Assets
Total

Current 1,650 2,140 2,260

100

130

137

800 1,000 1,000

100

125

125

Buildings

1,600 2,000 2,400

100

125

150

Plant

2,000 2,000 2,400

100

100

120

Total Fixed Assets

4,400 5,000 5,800

100

114

132

Assets
Fixed Assets:
Land

LESSON-10
RATIO ANALYSIS

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

Ratio

analysis

is

very

powerful

analytical

tool

for

measuring

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

Ratio analysis is a process of comparison of one figure against another,


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

Information of non-financial nature will also be taken into consideration before


a meaningful analysis is made.
Ratio analysis is extremely helpful in providing valuable insight into a
company's financial picture. Ratios normally pinpoint a business strengths and
weakness in two ways:

Ratios provide an easy way to compare today's performance with past.

Ratios depict the areas in which a particular business is competitively


advantaged or disadvantaged through comparing ratios to those of other
businesses of the same size within the same industry.

CATEGORIES OF RATIOS
The ratio analysis is made under six broad categories as follows:

Long-term solvency ratios

Short-term solvency ratios

Profitability ratios

Activity ratios

Operating ratios

Market test ratios

Long-Tenn Solvency Ratios


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

Debt-Equity Ratio

Shareholders Equity Ratio .

Debt to Networth Ratio

Capital Gearing Ratio

Fixed Assets to Long-term Funds Ratio

Proprietary Ratio

Dividend Cover

Interest Cover

Debt Service Coverage Ratio

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

Long - term debt


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

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

The shareholders of a highly geared company reap disproportionate


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

A debt-equity ratio which shows a declining trend over the years is


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

2. Shareholders Equity Ratio :


This ratio is calculated as follows:

Shareholders Equity
Total assets (tan gible)

It is assumed that larger the proportion of the shareholders' equity, the


stronger is the financial position of the firm, This ratio will supplement the
debt-equity ratio. In this ratio the relationship is established between the
shareholders funds and the total assets. Shareholders funds represent both
equity and preference capital plus reserves and surplus less losses. A reduction
in shareholder's equity signaling the over dependence on outside sources for
long-term financial needs and this carries the risk of higher levels of gearing.
This ratio indicates the degree to which unsecured creditors are protected
against iosr in the event of liquidation.

3. Debt to Net worth Ratio :


This ratio is calculated as follows:

Long - term debt


Networth

The ratio compares long-term debt to the net worth of the firm i.e., the
capital and free reserves less intangible assets. This ratio is finer than the debtequity ratio and includes capital which is invested in fictitious assets like
deferred expenditure and carried forward tosses. This ratio would be of more
interest to the contributories of long-term finance to the firm, as the ratio gives
a S factual idea of the assets available to meet the long-term liabilities.

4. Capital Gearing Ratio :


It is the proportion of fixed interest bearing funds to Equity shareholders,
funds:
Fixed int eresi bearing funds :

Equity Shareholder's funds


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

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

5. Fixed Assets to Long-term Funds Ratio :


The fixed assets is shown as a proportion to long-term funds as follows:

Fixed Assets
Long - term Funds

The ratio includes the proportion of long-term funds deployed in fixed


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

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

Net worth
Total Assets

Net worth

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

Total Assets = Fixed Assets + Current Assets (excluding fictitious assets)


Reserves earmarked specifically for a particular purpose should not be
included in calculation of Net worth. A high proprietory ratio indicative of strong
financial position of the business. The higher the ratio, the better it is.

7. Interest Cover:
Profil before interest depreciationand tax
Interest

The interest coverage ratio sLjws how many times interest charges are
covered by funds that are available for payment of interest. An interest cover of
2:1 is considered reasonable by financial institutions. A very high ratio indicates
that the firm is conservative in using debt and a very low ratio indicates
excessive use of debt.

8. Dividend Cover :
Net Profit after tax
Dividend

This ratio indicates the number of times the dividends are covered by net
profit his highlights the amount retained by a company for financing of future
operations.

9. Debt Service Coverage Ratio :


It indicates whether the business is earning sufficient profits to pay not
only the interest charges, but also the instalments due to the 'principal'
amount. It is calculated as:
PBIT
Interest + Periodic Loan Instalment
(1 - Rate of Income Tax)
The greater the debt service coverage ratio, the better rs the servicing
ability of the organisation.

Short-term Solvency Ratios


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

obligations.

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

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

The corporate liquidity has two dimensions viz., quantitative and


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

The important ratios in measuring short-term solvency

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

1. Current Ratio :

Current Assets, Loans & Advances

Current Liabilities & Provisions

This ratio measures the solvency of the company in the short-term.


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

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

Current Assets, Loans & Advances - Inventories

Current Liabilities & Provisions- Bank Overdraft

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

3. Absolute Liquid Ratio (Super Quick Ratio):


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

Absolute Liquid Assets

Current Liabilities

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


investments

The ideal Absolute liquid ratio is taken as 1:2 or 0.5.

Activity Ratios or Turnover Ratios


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

1. Inventory :

A considerable amount of a company's capital may be tied up in the


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

Inventory Turnover Ratio =

Cost of goods sold


Average Inventory

Sales
Average Inventory

Average inventory =

Opening stock+Closing stock


2

The higher the stock turn over rate the lower the stock turnover period
the better, although the ratios will vary between companies. For example, the
stock turnover rate in a food retailing company must be higher than the rate in
a manufacturing concern. The level of inventory in a company may be assessed
by the use of the inventory ratio, which measures how much has been tied up in
inventory.
Inventory Ratio =

Inventory

X 100

Current Assets

The inventory turnover ratio measures how many times a company's


inventory has been sold during the year. If the inventory turnover ratio has
decreased from past, it means that either inventory is growing or sales are
dropping. In addition to that, if a firm has a turnover that is slower than for its
industry, then there may be obsolete goods on hand, or inventory stocks may be
high. Low inventory turnover has impact on the liquidity of the business.

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

(1) Debtor Turnover Ratio


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

(ii) Average Collection Period


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

Average debtors

X 365

Credit Safes

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

(ii) Bad Debts


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

3. Creditors:
(i) Creditors Turnover Period
The measurement of the creditor turnover period shows the average time
taken to pay for goods and services purchased by the company. The formula is:
Average creditors

X 365

Purchases
In general the longer the credit period achieved the better, uecause delays
in payment mean that the operation of the company are being financed interest
free by, suppliers of funds. But there will be a point beyond which-delays in
payment will damage relationships with suppliers which, if they are operating in
a seller's market, may harm the company. If too long a period is taken to pay
creditors, the credit rating of the company may suffer, thereby making it more
difficult to obtain suppliers in the future.

(ii) Creditors Turnover Ratio


Credit purchases
Average creditors

The term creditors include trade creditors and bills payable.


4. Assets Turnover Ratios:
This measures the company's ability to generate sales revenue in relation
to the size of the asset investment A low asset turnover may be remedied by
increasing sales or by disposing of certain assets or both. To assist in
establishing which part of the asset structure is not being used efficiently, the
asset turnover ratio should be sub-analysed.

(i) Fixed Assets Turnover Ratio


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

The ratio of the accumulated depreciation provision to the total of fixed


assets at cost might be used as an indicator of the average age of the assets;
particularly when depreciation rates are noted in the accounts.

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

(ii) Total Assets Turnover Ratio


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

5. Working Capital Turnover Ratio :


This ratio is calculated as follows:
Sales
Working capital
This ratio indicates the extent of working capital turned over in achieving
sales of the firm.

6. Sales to Capital Employed Ratio :


This ratio is ascertained by dividing sales with capital employed.
Sales

Capital employed
This ratio indicates, efficiency in utilisation of capital employed in
generating revenue.

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

profitability is increasing or declining. The profitability of the firm is the net


result of a large number of policies and decisions. The profitability ratios are
measured with reference to sales, capital employed, total assets employed;
shareholders funds etc. The major profitability rates are as follows:
(a) Return on capital employed (or Return on investment) [ROI or ROCE]
(b) Earnings per share (EPS)
(c) Cash earnings per share (Cash EPS)
(d) Gross profit margin
(e) Net profit margin
(f) Cash profit ratio
(g) Return on assets
(h) Return on Net worth (or Return on Shareholders equity)

I. Return on Capital Employed (ROCE) or Return on Investment (ROI)


The strategic aim of a business enterprise is to earn a return on capital. If
in any particular case, the return in the long-run is not satisfactory, then the
deficiency should be corrected or the activity be abandoned for a more
favourable one. Measuring the historical performance of an investment center
calls for a comparison of the profit that has been earned with capital employed.
The rate of return on investment is determined by dividing net profit or income
by the capital employed or investment made to achieve that profit.
ROI = Profit

X 100

Invested capital
ROI consists of two components viz, I. Profit margin, and fl. Investment
turnover, as shown below:
ROI

= Net profit

= Net profit

Sales

Investment

Sales

Investment in assets

It will be seen from the above formula that ROI can be improved by
increasing one or both of its components viz., the profit margin and the
investment turnover in any of the following ways:

Increasing the profit margin

Increasing the investment turnover, or

Increasing both profit margin and investment turnover

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

Boosts sales

Reduces invested capital

Reduces costs (while holding the other two factors constant)

Table-1: Computation of Capital Employed


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

xxx
xxx

(c) Preliminary expenses


(d) Debit balance of Profit and Loss

xxx

A/c
Capital employed

xxx
xxx
xxx
xxx

xxx

xxx

Return on in vestment analysis provides a strong incentive for optimal


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

2. Earnings Per Share (EPS):


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

EPS = Net Profit after tax and preference dividend


No. of Equity Shares
I EPS when Debt and Equity used
=

(EBIT 1) (1 T)
N

II. EPS when Debt, Preference and Equity used


=

(EBIT I ) (1 T) - DP
N

Where

EBIT = Earnings before interest and tax


I = Interest
T = Rate of Corporate tax
DP = Preference Dividend
N = Number of Equity shares

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

3. Cash Earnings Per Share :


The cash earnings per share (Cash EPS is calculated by dividing the net
profit before depreciation with number of equity shares.
Net profit + Depreciation
No. of Equity Shares
This is a more reliable yard stick for measurement of performance of
companies, especially for highly capital intensive industries where provision for
depreciation is substantial. This measures the cash earnings per share and is
also a relevant factor for determining the price for the company's shares.

However, this method is not as popular as EPS and is used as a supplementary


measure of performance only.

4. Gross Profit Margin :


The gross profit margin is calculated as follows:
= Sales - Cost of goods sold X 100

Gross profit X 100

Sales

Sales

The ratio measures the gross profit margin on the total net sales made by
the company. The grosi, profit represents the excess of sales proceeds during
the

1 period

under

observation

over

their

cost,

before

taking

account administration, selling and distribution and financing charges.

into
The

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

When everything normal, the gross profit margin should remain


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

(i)

Price cuts:

A company need to reduce its selling price to achieve the

desired increase in sales.

(ii)

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

unless

an appropriate adjustment is made to the selling price.

(iii)

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

different
(iv)

gross profit percentages.

Under or Over-valuation of stocks.


If closing stocks are under-valued, cost of goods sold is inflated and profit

understated. An incorrect valuation may be the result of an error during stock


taking or it may be due to fraud The gross profit margin may be compared with
that of competitors in the industry to assess the operational performance
relative to the other players in the industry.

5. Net Profit Margin:


The ratio is calculated as follows:
Net profit before interest and tax X 100
Sales
The ratio is designed to focus attention on the net profit margin arising
from business operations before interest and tax is deducted. The convention is
to express profit after tax and interest as a percentage of sales. A drawback is
that the percentage which results, varies depending on the sources employed to
finance business activity; interest is charged 'above the line while dividends are
deducted 'below the line'. It is for this reason that net profit i.e. earnings before
interest and tax (EBIT) is used.

This ratio reflects nt: profit margin on the total sales after deducting all
expenses but before deducting interest and taxation. This ratio measures the
efficiency of operation of the company. The net profit is arrived at from gross
profit after deducting administration, selling and distribution expenses. The
non-operating incomes and expenses are ignored in computation of net profit
before tax, depreciation and interest

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

6. Cash Profit Ratio


Cash profit X 100
Sales

Where Cash profit = Net profits Depreciation


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

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

Net profit after tax

X 100

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

8. Return on Shareholders Funds or Return on Net Worth


Net profit after interest and taxX 100
Net worth

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

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

The factor which motivates shareholders to invest in a company is the


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

The further modification of this ratio is made by considering the


profitability from equity shareholders point of view can also be worked out by
taking the profits after preference dividend and comparing against capital
employed after deducting both long-term loans and preference capital.

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

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

1.

Materials Cost Ratio

= MaterialsConsumed
X 100
Sales

2.

Labour Cost Ratio

X 100
= Labour Cost Sales
Sales

3.

Factory Overhead Ratio

X 100
= Factory Expenses
Sales

4.

Administrative Expense Ratio

X 100
= Administrative Expenses
Sales

5.

Selling and distribution


expenses ratio

= Selling and Distribution Expenses X 100


Sales

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

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

Market Test Ratios


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

1.

Dividend payout ratio

2.

Dividend yield

3.

Book value

4.

Price/Earnings ratio

1. Dividend Payout Ratio:


Dividend per share
Earnings per share

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

2. Dividend Yield
Dividend per share
Market price

X 100

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

3. Book Value:
Equity Capitalf +Reserves - Prqfit&Lass debit balance.
Total number of equity shares;

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

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

Current market price


Earnings per share

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

It signifies the number of

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

track record, conservative distribution policy and average prospects quote a


low P/E ratios.

The market price discounts the expected earnings of a

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

LIMITATIONS IN THE USE OF RATIO ANALYSIS


Ratios by themselves mean nothing.

They must always be compared

with:

a norm or a target

previous ratios in order to assess trends

the ratios achieved in other com; arable companies (inter-company


comparisons), and

caution has to be exercised in using ratios.

The following limitations must be taken into account:

Ratios are calculated from financial statements w'.ach are affected


by the financial bases and policies adopted on such matters as
depreciation and the valuation of stocks.

Financial statements do not represent a complete picture of the


business, but merely a collection of facts which can be expressed in
monetary terms. They may not refer to other factors which affect
performance.

Over use of ratios as controls on managers could be dangerous, in


that management might concentrate more on simply improving the ratio
than on dealing with the significant issues. For example, the return on
capital employed can be improved by reducing assets rather than
increasing profits.

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

denominator In comparing ratios it may be difficult to determine whether


differences are due to changes in the numerator, or in the denominator or
in both.

Ratios are inter-connected. They should not be treated in isolation.

The effective use of ratios, therefore, depends on being aware of all these
limitations and ensuring that, following comparative analysis, they are
used as a trigger point for investigation and corrective action rather than
being treated as meaningful in themselves.

The

analysis

of

ratios

clarifies

trends

and

weaknesses

in

performance as a guide to action as long as proper comparisons are made


and the reasons for adverse trends or deviations from the norm are
investigated thoroughly.

Illustration 1: From the given Balance Sheets calculate:


(a)

Debt-equity ratio

(b)

Liquid ratio

(c)

Fixed assets to current assets ratio

(d)

Fixed assets to Net worth ratio


Balance Sheet
Liability

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

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

Assets
Goodwill
Fixed assets (Cost)
Stock
Debtors
Advances
Cash

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

Outsiders Funds

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

Shareholders Funds

Outsider's Funds

Rs.

Shareholders'

Rs.

Secured Loans

Funds
80,000 Share Capital

Creditors

50,000 Reserves

20,000

Provisions for taxation

20,000 Profit and Loss a/c

30,000

1,00,000

1,50,000

1,50,000

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


1,50,000

(b) Liquid ratio = Liquid Assets


Current Liabilities

Note: Advances are treated as current asset.


Secured Joans are treated as current liability.
Liquid ratio =

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

(c) Fixed Assets to Currents Assets Ratio =

Fixed Assets

Current Liabilities
Fixed Assets = 1,40,000

Current Assets (Rs)

Cash

30,000

Stock

30,000

Debtors

30,000

Advances

10,000
1,00,000

Fixed assets to current assets ratio =

1,40,000
= 1.4:1
1,00,000

(d) Fixed Assets to Net worth Ratio =

Fixed Assets
Net worth

Share Capital
Reserves
P & L a/c

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

Less: Provision for taxation

1,40,000

Fixed Assets to Net worth ratio =

1,30,000

= 1.08:1

Illustration 2: From the following data calculate;


(a)

Current ratio

(b)

Quick ratio

(c)

Stock Turnover ratio

(d)

Operating ratio

(e)

Rate of return on equity capital


Balance Sheet as on Dec., 31,2001

Liabilities
Equity
Capital
shares)
Profit

Rs.
Share

(Rs.

and

10

loss

account
Creditors
Bills payable

Assets

1,00,000 Plant

Rs.
and

6,40,000

Machinery

3,68,000 Land and buildings

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

80,000

1, 60,000

3,60,000
Less: Provision for
bad

Other

Current

40,000
20,000 Stock

3,20,000

debts

4,80,000

liabilities
Prepaid Insurance
16,92,000

12,000
16,92,000

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


(Rs.)
Sales
Less: Cost of goods sold

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

Less: Operating expenses


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

Rs. 3,00,000

Stock

Rs. 4,00,000

Solution:
(a) Current ratio =

Current Assets
Current Liabilities

Current Assets

Rs.

Current Liabilities

Cash

Creditors

Rs.
1,04,000

Debtors

3,20,000 Bills Payable

Stock

4,80,000 Other

2,00,000
Current

20,000

Liabilities
Prepaid insurance

12,000
9,72,000

Current ratio

(b) Quick ratio =

Liquid Assets

3,24,000

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

Current Liabilities

Liquid assets

(Rs.)

Cash Debtors

Current liabilities Rs.3,24,000

1,60,000
3,20,000
4,80,000

Liquid ratio =

4,80,000

= 1.48:1

3,24,000

(c) Stock Turnover Ratio =

Cost of goods sold


Average slock

Cost of goods sold = 30,80,000


Average Stock

Opening Stock + Closing Stock


2
= 4,00,000 + 4,80,000
= 4,40,000
2

Stock Turnover Ratio = 3,80,000

= 7 times

4,40,000

(d) Operating Ratio =

Cost of goods sold + Operating expresses X 100


Net Sales
= 94%

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

(e) Rate of return on equity capital:


= Net profit afer lax
Equity share capital

1,20,000

= 12%

X 100

10,00,000

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

Particulars
To Opening Stock
To Purchases
To Wages

Particulars

9,950 By Sales
54,5.25 By Closing Stock

Rs.
85,000
14,900

1,425

To Gross Profit
To

Rs.

Administrative

34,000
99,900

99,900

15,000 By Gross Profit

34,000

Expenses
To Selling Expenses

3,000 By Interest

300

To Financial Expenses

1,500 By Profit on sale

600

of shares
To Loss on sale of assets
To Net Profit

400
15,000

34,900

34,900

Balance Sheet
Liabilities

Rs.

Share Capital

Assets

20,000 Land and Buildings

Reserves

9,000 Plant & Machinery

Current Liabilities

13,000 Stock

P&LA/c

Rs.
15,000
8,000
14,900

6,000 Debtors

7,1000

Cash at Bank
48,000

3,000
48,000

You are required to Calculate;


(a) Current Ratio
(b) Operating Ratio
(c) Stock Turnover Ratio
(d) Net Profit Ratio
(e) Fixed Assets Turnover Ratio

Solution:
(a) Current ratio

Current Assets
Current Liabilities

Current Assets
Cash at Bank
Current liabilities
Debtors
Stock

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

Current ratio

= 25,000
13,000

(b) Operating Ratio =

Cost of goods sold + Operating expresses X 100


Net Sales

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

Operating expenses
Operating Ratio

= 51,000

= 19,500

= 51,000 + 19,500

= 82.94%

X 100

85,000

(c) Stock Turnover Ratio = Cost of goods sold


Average stock
Average Stock =

9,950 + 14,900

= 12,425

Stock Turnover Ratio =

51,000

= 4.1 times

12,425

(d) Net Profit Ratio =

Net Profit

= 100

Net Sales

= 15,000

= 17.65%

= 100

85,000

(e) Fixed Assets Turnover Ratio

= Net Sales
Fixed Assets
= 85,000

= 3.7 times

23,000

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

Trading and P & L A/c


Particulars

Rs.

Particulars

To Opening Stock

10,000 By Sales

To Purchases

55,000 By Closing Stock

To Gross Profit c/d

50,000
1,15,000

To Administrative Expenses

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

15,000 By Gross Profit b/d

To Interest

Rs.

50,000

3,000

To Selling Expenses

12,000

To Net Profit

20,000
50,000

50,000

Balance Sheet
Liabilities
Capital

Rs.

Assets

Rs.

1,00,000 Land and Buildings

50,000

Profit and Loss a/c

20,000 Plant & Machinery

30,000

Creditors

25,000 Stock

15,000

Bills Payable

15,000 Debtors

15,000

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

Bills receivable

12,500

Cash at Bank

17,500

Furniture

20,000
1,60,000

(c) Gross profit ratio


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

(a) Inventory Turnover ratio

Average stock
Cost of goods sold
Opening Stock
Purchases

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

Less: Closing Stock

Average Stock = Opening Stock + Closing Stock


2
= 10,000 + 15,000

= 12,500

Stock Turnover ratio = 50,000

= 4 times

12,500

(b) Current ratio = Current Assets


Current Liabilities

Current Assets
Current Assets

(Rs.)
Rs.

Current liabilities

Rs.

Stock

15,000 Creditors

25,000

Debtors

15,000 Bills Payable

15,000

B/R

12,500

Cash at Bank

17,500
60,000

40,000

Current ratio = 60,000

= 1.5:1

40,000
(b) Gross Profit Ratio = Gross Profit

X 100

= 50%

Net Sales

(c) Net Profit Ratio = Net Profit

X 100

Net Sales
= 20%

= 20,000
1,00,000

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

= 100

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

(Rs.)

Administration expenses Selling expenses

15,000
12,000
27,000

Operating ratio

= 50,000 + 27,000 X 100

77 %

1,00,000

(e) Liquidity ratio = Liquid Assets


Current Liabilities
Current Assets
Liquid Assets
Cash at Bank
Bills Receivable
Debtors

(Rs.)
Rs.

Current liabilities

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

Rs.
25,000
15,000
40,000

Liquidity ratio = 45,000


40,000

(f) Proprietary ratio = Shareholders Funds

X 100

Total Assets
Shareholder's Furuis

(Rs.)

Capital Profit and Loss a/c


Total Assets

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

Proprietary ratio = 1,20,000

= 75%

X 100

1,60.000

Illustration 5: A company has a profit margin of 20% and asset turnover of 3


times. What is the company's return on investment? How will this return on
investment vary if
(i)

Profit margin is increased by 5% ?

(ii)

Asset turnover is decreased to 2 times?

(iii)

Profit margin is decreased by 5% and asset turnover is increased to 4


times.

Calculation of impact of change in profit margin and change in asset turnover


on return on investment

Return on investment

= Profit Margin x Asset Turnover


= 20% x 3 times

(i)

If profit margin is increased by 5% :


ROI = 25% x 3

= 75%

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

= 60%

ROI = 20% x 2

= 40%

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


ROI

= 15% x 4

= 60%

Illustration 6: There are three companies in the country manufacturing a


particular chemical. Following data are available for the year 2000-2001.
(Rs. lakhs)
Company

Net Sales

Operating Cost Operating Assets

A Ltd.

300

255

125

B Ltd.

1,500

1,200

750

C Ltd.

1,400

1,050

1,250

Which is the best performer as per your assessment and why?


Comparative Statement of Performance
Particulars
Sales
Less: Operating Cost
OperatingProfit (A)
Operating Assets (B)
Return on capital employed

A Ltd.
300
255
45
125
36%

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

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

(A) / (B) x 1 00
Analysis:
Basing on the return on capital employed, B
performer as compared to A Ltd. and C Ltd.
Illustration 7: Calculate the P/E ratio from the following:
(Rs.)
Equity Share Capital (Rs. 20 each)
Reserves and Surplus
Secured Loans at 15%
Unsecured Loans at 12.5%
Fixed Assets
Investments

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

Operating Profit

25,00,000,

Income-taxRate50%

(Rs.)

Ltd., is the best

Operating Profit
Less: Interest on
Secured Loans @ 15%

25,00,000
3,75,000

Unsecured Loans @ 12.5%


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

1,25,000

No. of Equity shares


EPS

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

Profit after tax


No. of Equity shares

Rs. 10,00,000

= Rs. 4

Rs. 2,50,000

Market price per share

= Rs. 50

P/E Ratio

= Market price per share / EPS


= Rs.50/Rs.4

= 12.50

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

10% Preference shares of Rs.10 each


Equity shares of Rs. 100 each

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

Additional information:
Profit after tax at 50%

Rs. 15,00,000

Deprication

Rs. 6,00,000

Equity dividend paid

10%

Market price per equity share Rs. 200

Calculate the following:


(i)

The cover for the preference and equity dividends

(ii)

The earnings per share

(iii)

The price earnings ratio

(iv)

The net funds flow

Solution:
(i) The cover for the Preference and Equity dividends:
Profit after tax
= Preference dividend + Equity dividend

= Rs. 15,00,000

= 1.25 times

Rs. 5,00,000 + to 7,00,000

(ii) The Earning Per Share:


= Net profit after preference dividend
No. of Equity Shares
= Rs. 15,00,000 Rs. 5,00,000= Rs. 14.29
Rs.7,00,000

(iii) The Price Earnings Ratio:

= Market price per share


Earning per share

= Rs.200

= 14 times

Rs. 14.29

(iv) The Net Funds Flow:


(Rs.)
Profit after tax

15,00,000

Add: Depreciation

6,00,000
21,00,000

LESSON-II
FUNDS FLOW ANALYSIS

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

FUNDS FLOW ANALYSIS


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

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

It is a very useful tool in analysis of finrncial statements which analyses


the changes taking place between two balance sheet dates. The statement
analyses the change between the opening and closing balance sheets for the
period.

A balance sheet sets out the financial position at a point of time, setting
liabilities from which funds have been raised against assets acquired, by the use
of those funds. A funds flow statement analyses the changes which have taken
place in the assets and liabilities during certain period as disclosed by a
comparison of the opening and closing balance sheets.

Concept of'Fund

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

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

CLASSIFICATION OF BALANCE SHEET ITEMS

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

Table 1: CLASSIFICATION OF BALANCE SHEET ITEMS

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

Rs.

XXX
XXX
XXX
XXX

Non-Current Liabilities

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

Rs.
XXX
XXX
XXX

Vehicles
Patents

XXX
XXX

XXX

II. Non-Current Assets


Trade Marks

XXX

Goodwill

XXX

Preliminary expenses

XXX

Profit and Loss A/c (Debit

XXX

balance)
Total (A)

XXX

III. Current Liabilities

Total (A)

XXX

Total (A)

XXX

IV. Current Assets

Trade Creditors

XXX

Inventories

XXX

Bank Overdraft

XXX

Trade Debtors

XXX

Bills Payable Provisions

XXX

Bills Receivable

XXX

against current liabilities

XXX

Cash and Bank Balances

XXX

Loans and Advances

XXX

Investments Temporary)

XXX

Total (B)
Grand Total (A+B)

XXX
XXX

Total (B)
Grand Total (A+B)

XXX
XXX

The excess of current assets over current liabilities is called working


capital. The excess of funds generated over funds outgo from non-current assets

and non-current liabilities will lead to increase or decrease in working capital.


This can further be analysed into increase or decrease in respective current
assets and current liabilities.

IDENTIFICATION OF 'FLOW OF FUNDS

A 'flow' of funds takes place only if a Current Account is involved. To


identify a flow, journalise the transaction, identify the two accounts involved as
'Current' and 'Non-Current' and apply the General Rule.

General Rule

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

Transactions which involve only Non-Current Accounts do not result in a


flow.

Transactions which involve one Current Account and one Non-Current


Account results in a flow of funds.

Proformas of Funds Flow Statement

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

Table 2: PROFORMA OF STATEMENT OF SOURCES AND APPLICATION


OF FUNDS
Stage 1: Statement of Sources and Application of Funds of XYZ Ltd., for the year
ended 31st March, 2001.

Fund from Operations


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

Rs.
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx

changes in w.c)
Total

Application or Uses of Funds:


Funds Lost in Operations
Redemption of Preference Share Capital
Redemption of Debentures
Repayment of long-term loans

xxx

xxx
xxx
xxx
xxx

Purchase of non-current investments


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

xxx
xxx
xxx
xxx
xxx

changes in w.c)
Total

xxx

The funds flow statement can also be presented in a vertical form,


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

Table 3: FORM OF FUNDS FLOW STATEMENT


Funds Flow Statement of XYZ Ltd., for the year ended 31" March, 2001

Sources

Rs.

Applications

Rs.

Funds from Operations

xxx Funds lost in Operations

Issue of Share Capital

xxx Redemption of Preference , Share xxx

Issue of Debentures

capital
xxx Redemption of Debentures:

Raising

of

long-term xxx Repayment of long-term loans

xxx

xxx
xxx

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

of

long-term xxx

(fixed) assets :
Non-trading

of

long-term xxx

Investments
receipts xxx Purchase

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

xxx

Investments
Net Decrease in Working xxx Payment of tax*

xxx

Capital
Net Increase in Working Capital

xxx

xxx

xxx

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

STATEMENT OF CHANGES IN WORKING CAPITAL


This statement follows the Statement of Sources and Application, of
Funds.

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

Working Capital, as arrived in Funds Flow Statement.

In this statement, all

Current Assets and Current Liabilities are individually listed.

Against each of

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

The net change in its position is also shown.

The changes taking place with respect to each account should add up to equal
the ; net change in working capital, as shown by the Funds Flow Statement. A
proforma of the Statement of changes in -Working Capital is being presented '
below:

Increase in current assets and decrease in current liabilities : The


acquisition of current assets and repayment of current liabilities will
result in funds outflow.

The funds may be applied to finance an increase

in stock, debtors etc or to reduce the amount owed to trade creditors,


bank overdraft, bills payable etc.

Decrease in current assets and increase in current liabilities: The


reduction in current assets e.g. stock or debtors balances will result in
release of funds to be applied elsewhere. Short-term funds raised during
the period by any increase in the current liabilities like trade creditors,
bank overdraft and tax dues, means that these sources have lent more at
the end of the year than at the beginning.

STATEMENT OF CHANGES IN WORKING CAPITAL

Table 4: PROFORMA OF STATEMENT OF ANALYSIS OF CHANGES IN


WORKING CAPITAL

The relation between Stage I and Stage II is given below in the figure:

Stage I :

List the sources from which capital has been derived during the
accounting period, and the ways in which working capital has been
used up, i.e. list the transactions which cause working capital to
increase or decrease

Stage IIl :

Analyse the net increase or decrease in working capital into


changes in the constituent items i.e. stock, debtors, creditors and
cash

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

An increase in an asset over the year is an application of funds.

A decrease in an asset over the year is a source of funds.

A decrease in a liability over the year is an application of funds.

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

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

Funds Generated from Operations

During the course of trading activity; a company generates revenue"


mainly in the form of sale proceeds and paid out for costs.

The difference

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

The funds generated from business operations are aruved at after

making the following adjustments:

Table 5: PROFORMA FOR COMPUTATION OF FUNDS GENERATED FROM


OPERATIONS
Funds from operations can also be calculated by preparing Adjusted Profit and
Loss Account as follows:

ADJUSTED PROFIT AND LOSS ACCOUNT

Table 6: PROFORMA OF ADJUSTED PROFIT AND LOSS ACCOUNT


Notes :

Depreciation on fixed assets or amortisation of intangible assets like


preliminary expenses, patens, goodwill etc., written off is charged, against
profit to reflect the use of fixed assets or written off of intangible asset. In,
these transactions there is no corresponding cash outlay occurs and

hence, add back the amount charged against profit, to arrive at the total
funds generated from business operations.

The Profit or Loss on sale of non-current assets (fixed asses and longterm, investments) is adjusted to arrive at the true funds from operations.

The provision for tax made in the profit and loss account is to be added
back to the reported profit The actual amount paid as tax is to be shown
as the' application of funds in the funds flow statement. The provision for
tax, if it' is shown in the balance sheet, need not be considered for
calculation of funds! generated fro operations.

Any amount appropriated in the Profit and Loss account towards transfer
to reserves or proposed dividend is to be added back to arrive at the funds
generated from operation. The actual amount paid as dividend is to be
shown, as application of funds in the funds flow statement. The dividend
proposed but awaiting payment is a current liability in tie balance sheet.
If this amount increases, from one year end to the next, the extra liability
appears as a source of funds.

Funds raised from Shares, Debentures and Long-term Loans

The long-term funds injected into the business during the year by issue of
new shares or debentures and by raising long-term loans. If any premium is
collected, that is also form part of funds raised from the above said sources of
finance.

Sale of Fixed Assets and Long-term Investments

Any amount generated from sale of fixed assets or long-term investments


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

APPLICATION OF FUNDS

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

1.

Repayment of Preference Capital or Debentures or Long-term Debt:


This represents the application of organisation's funds released from
business through redemption of preference shares or debentures,
repayment of long-term loans previously made by the organisation. Any
reduction in Equity capital is also taken as application of funds.

2.

Purchase of Fixed Assets or Long-term Investments: The funds used to


purchase long-term assets are usually the most significant application of
fund during the year. This group includes capital expenditures on land,
building plant and machinery, furniture and fittings, vehicles and longterm investments outside the business.

3.

Distribution of Dividends
distributed to

the

and Payment of Taxes: The

dividends

shareholders and tax paid during the year is the

application of funds for the firm.

4.

Loss from Operations: Losses made in the trading activities use up th e


funds. If costs exceed revenue, a cash outflow will be experienced. The
adjustments are made as shown above in point (i) in the sources of funds,

Illustration 1: Calculate funds from operations with the help of the following
Profit and Loss A/c.

Calculation of funds from operations

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

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

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

Particulars

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

P&L A/c
Provision for Taxation
Proposed Dividends

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

Additional Information
1)

Tax Paid during the year 2000 2001

Rs. 2,500

2)

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

On the basis of the above information, calculate Funds from Operations taking
provision for tax and proposed dividend as (a) Non-current liabilities (b) Current
liabilities.

a) Provision for tax and proposed Dividend are taken as non-current liabilities
Provision for Taxation A/c

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

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

(closing balance)

Rs.
10,000

7,500

made in the current


year)
[bal.fig.]
17,500

17,500

Particulars
To Dividend A/c

Rs.
Particulars
1,000 By Balance b/d

(being dividend paid


during the year)
To balance c/d

Rs.
5,000

(Opening balance)

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

(closing balance

6,000

dividend for the


current
11,000

11,000

Adjusted P & L A/c


Particulars
To Provision for

Rs.
Particulars
7,500 By Balance b/d

Taxation

Rs.
50,000

(opening balance)

A/c
To proposed Dividend

6,000 By Funds from

43,500

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

80,000

(closing balance
93,500

93,500

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

31st Dec. 2000


80,000
30,000
25,000

31st Dec. 2001


2,00,000
35,000
40,000

The following additional information is also available:


(i)

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

(ii)

On January 1, 2001, a machine costing Rs. 15,000 (with an accumulated


depreciation of Rs.5,000) was sold for Rs.7,000.

Find out sources/ application of funds.


Particulars
To Machinery A/c
To Balance c/d

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

Rs.
30,000
10,000

(balancing figure)
40,000

40,000

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

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

Rs.
7,000
5,000

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

To Cash-Purchases
(balancing figure)

(Loss on sale)
By Balance c/d

3,000

2,00,000
2,15,000

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

Rs.

Particulars

Rs.

10,000 By Balance b/d

3,000 By

Funds

25,000

from

Operations (bal. fig.)


40,000
53,000

(i)

28,000

53,000

Purchase of machinery for Rs.20,000 by issue of equity shares is neither a


source nor an application of funds.

(ii)

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

(iii)

Purchase of machinery for Rs.1,15,000 for cash is an application of funds,


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

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


the amount of flow of funds on account of Plant.

Opening Balance of Plant


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

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

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

61,000

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

Accumulated Deprecation A/c

Particulars
To Machinery A/c

Rs.

Particulars

Rs.

40,000 By Balance b/d

4,24,000

(Depn.
of sold Machine)
To Closing balance c/d

4,11,000 By Adjusted P&L A/c

27,000

(Balancing Figure( [Depn.


provided during the year]
4,51,000

4,51,000

Illustration 8 :
Extracts from Balance Sheets
Particulars

As on 31st

As on 31st March

March,

2001

2000

Equity from Balance Sheets


8% Preference Share Capital

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

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

Additional Information :
(i)

Equity shares were issued during the year against purchase of


machinery for Rs.50,000.

(ii)

8% Preference shares worth Rs. 1,00,000 were redeemed during the


year.

Prepare necessary accounts to find out sources/applications of funds.

Equity Share Capital A/c

Particulars

Rs.

To Machinery A/c

Particulars

40,000 By Balance b/d

Rs.
4,24,000

(Depn.
of sold Machine)
To Closing balance c/d

4,11,000 By Adjusted P&L A/c

27,000

(Balancing Figure( [Depn.


provided during the year]
4,51,000

4,51,000

Equity Share Capital A/c


Particulars
To Balance c/d

Rs.

Particulars

5,00,000 By Balance b/d

Rs.
4,00,000

By Machinery A/c

50,000

By Cash-Issue (balancing

50,000

figure)
5,00,000

5,00,000

8% Preference Share Capital A/c


Particulars

Rs.

Particulars

To cash (Application)

1,00,000 By Balance b/d

To Balance c/d

1,50,000 By Cash-Issue (balancing

Rs.
2,00,000
50,000

figure)
2,50,000
1.

2,50,000

Issue of equity shares purchase of machinery is neither a source nor


application of funds.

2.

Issue of shares worth Rs.50,000 for cash is a source of funds.

3.

Redemption of preference shares worth Rs.1,00,000 is an application of


funds.

4.

Issue of preference shares of Rs. 50,000 is a source of funds.

Illustration 9 :
Prepare a statement showing changes in working capital
Particulars

2000

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

2001

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

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

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

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

Statement showing changes in working capital

Particulars

Current Assets
Cash
Debtors
Stock

2000

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

Current Liabilities
Creditors
Working Capital (CACL)
Net increase in

2001

Increase

Decrease

(+)

(-)

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

1,40,000
3,20,000

90,000
4,14,000

34,000
10,000
20,000

50,000

94,000

94,000

Working Capital
4,14,000

4,14,000

1,04,000

1,04,000

Illustration 10 : Following are summerised Balance Sheets X Ltd. as on 31 st


December, 2000 and 2001. You are required to prepare a Funds Statement for
the year ended 31st December, 2001.

Liabilities

2000

2001

Assets

2000

2001

1,00,000

1,25,000

Goodwill

2,500

General Reserve

25,000

30,000

Buildings

1,00,000

95,000

P&L A/c

15,250

15,300

Plant

75,000

84,500

Bank Loan

35,000

67,600

Stock

50,000

37,000

(Long-term)
Creditors

75,000

Debtors

40,000

32,100

Provision for Tax

15,000

17,500

Bank

4,000

Cash

250

300

2,65,250

2,55,400

Share Capital

2,65,250

2,55,400

Additional Information:
(i)

Dividend of Rs. 11,500 was paid.

(ii)

Depreciation written off on plant Rs.7,000 and on buildings Rs.5,000.

(iii)

Provision for tax was made during the year Rs. 16,500.

Statement showing Changes in Working Capital


Particulars

2000

2001

Increas

Decrease

(-)

(+)
Current Assets
Cash
Bank
Debtors
Stock

250
-

300
4,000

40,000 32,100
50,000 37,000

90,250 73,400

50
4,000
7,900
13,000

Current Liabilities
Creditors Working

75,000

75,000

Capital (CA - CL)


Net increase in Working

15,250 73,400
8,150

58,150

Capital
73,400 73,400

79,050

79,050

Funds Flow Statement


Rs.

Sources

Application

Rs.

Funds from

45,050

Purchase of Plant

16,500

operations
Issue of Shares

25,000

Income tax paid

14,000

Hank Loan

32,600

Dividend paid

11,500

Goodwill paid

2,500

Net increase in

58,150

Working Capital
1,02,650

1,02,650

Working Notes:
Share Capital A/c
Particulars
To Balance c/d

Rs.
1,25,000

Particulars
By Balance b/d
By Bank a/c

1,25,000

Rs
1,00,000
25,000
1,25,000

General Reserve A/c


Particulars
To Balance c/d

Rs.
30,000

Particulars
By Balance b/d
By P&L a/c

Rs.
25,000
5,000

30,000

30,000

Provision for Taxation A/c


Particulars

Rs.

Particulars

To Bank a/c

14,000

By Balance b/d

15,000

To Balance c/d

17,500

By P&L a/c

16,500

31,500

Rs.

31,500

Bank Loan A/c


Particulars

Particulars

Rs.

To Balance c/d

67,600

By Balance b/d
By Bank a/c

67,600

Rs.
35,000
2,600
67,600

Land and Building A/c


Particulars
To Balance c/d

Rs.

Particulars

1,00,000

By

Depreciation

Rs.
5,000

a/c (P&L a/c)


By Balance c/d
1,00,000

95,000
1,00,000

Plant A/c
Particulars
To Balance c/d

Rs.

Particulars

Rs.

75,000

By Depreciation a/c

7,000

(P&L a/c)
To Bank

16,500
91,500

By Balance c/d

84,500
91,500

Goodwill A/c
Particulars
To Bank

Rs.
2,500

Rs.

Particulars
By Balance c/d

2,500

2,500

2,500

Calculation of Funds from Operations:


(Rs.)
Balance of P&L a/c (2001)
Add: Non-fund and non-operating
items which have already debited to
P&L a/c:
General reserve
Provision for tax
Dividends paid
Depreciation:
On Buildings
On Plant

5,000
16,500
11,500
5,000
7,000

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


Funds from Operations

45,000
60,300
15,250
45,050

Illustration 11: From the following Balance Sheets of ABC Ltd. on 31 st Dec.
2000 and 2001, you are required to prepare (i) A Schedule of changes in working
capital, (ii) A Funds Flow Statement.
(Rs.)
Liabilities
Share Capital

2000

2001

Assets

2,00,000 2,00,000 Goodwill

2000

2001

24,000

24,000

General Reserve

28,000

36,000 Buildings

80,000

P&L A/c

32,000

26,000 Plant

74,000

72,000

Creditors

16,000

10,800 Investments

20,000

22,000

60,000

46,800,

4,000

6,400

36,000

3 8,000

Bills payable
Provision for Tax

Provision for
doubtful debts

2,400
32,000

800

1,600 Stock
36,000 Bills
receivable
1,200 Debtors

72,000

Cash & Bank

13,200

30,400

balances
3,11,200 3,11,600

3,11,200 3,11,600

Additional Information:
(i)

Depreciation provided on plant was Rs.8,000 and on Buildings


Rs.8,000

(ii)

Provision for taxation made during the year Rs.38,000

(iii)

Interim dividend paid during the year Rs. 16,000.

Statement showing Changes in Working Capital


Particulars
Current Assets
Cash & Bank
Balances
Debtors
Bills Receivable
Stock
Current Liabilities
Provision for
doubtful debts
Bills Payable
Creditors Working

2000

Increase

Decrease

in W.C.

in W.C.

2001

13,200

30,400

17200

36,000
4,000
60,000
1,13,200

38,000
6,400
46,800
1,21,600

2,000
2,400

800

1,200

2,400

1,600

800

16,000

10,800

5,200

19,200
94,000

13,600
1,08,000

13,200

400

Capital (CA - CL)

Increase in Working

14,000

14,000

Capital
1,08,000

1,08,000

27,600

27,600

Funds Flow Statement


Sources
Funds from

Application

Rs.
72,000

Rs.

Purchase of Plant

6,000

operations
Tax paid

34,000

Purchase of investments
Interim dividend paid

2,000
16,000

Increase in Working Capital

14,000

72,000

72,000

Working Notes:
Provision for Taxation A/c
Particulars

Rs.

Particulars

Rs:

To Balance c/d

36,000 By P&L a/c

32,000

To Balance c/d

36,000 By P&L a/c

28,000

70,000

70,000
Plant A/c

Particulars
To Balance c/d
To Balance (Purchase)

Rs.

Particulars

Rs:

74,000 By Depreciation

8,000

6,000 By Balance c/d

72,000

80,000

80,000
Buildings A/c

Particulars
To Balance c/d

Rs.

Particulars

Rs:

80,000 By Depreciation

8,000

By Balance c/d

72,000

80,000

80,000

Investments A/c
Particulars
To Balance b/d

Rs.

Particulars

20,000 By Balance c/d

Rs.
22,000

To Bank (Purchase)

2,000
22,000

22,000

Adjusted Profit & Loss A/c


Particulars
To

Non-fund

operating

Rs.

and

items

Nonalready

debited to P&L a/c:


Transfer to General Reserve
Provision for Tax

Particulars

Rs.

By Balance on (31-12-200)

32,000

By Funds from operations

72,000

8,000
38,000

Depreciation on Plant

8,000

Depreciation on Buildings

8,000

Interim dividend

16,000

To Balance on 3 1-1 2-2001

26,000
1,04,000

1,04,000

General Reserve A/c


Particulars
To Balance c/d

Rs.

Particulars

Rs.

36,000

By Balance

28,000

By P&L a/c

8,000

36,000

36,000

Illustration 12: From the following Balance Sheet of X Ltd., as on 31 st


December, 2000 and 31st December 2001, you are required to prepare a funds |
flow statement.
(Rs.)
Liabilities

2000

Share Capital

4,00,000

General

80,000

Reserve
P&L A/c

64,000

2001

Assets

2000

2001

5,00,000 Land and

4,00,000

4,80,000

Buildings
1,40,000 Machinery

3,60,000

2,60,000

2,00,000

2,52,000

78,000 Stock

Bank Loan

3,20,000

(Long term)
Creditors

3,00,000

Provision for

60,000

80,000 Debtors

1,60,000

2,60,000 Cash at Bank

1,04,000

1,28,000

18,000

80,000

Taxation
12,24,000 11,38,000

12,24,000

11,38,000

Additional Information :
(i)

During the year ended 31st December 200 dividend of Rs.84,000 was
paid.

(ii)

Assets of another company were purchased for a consideration of Rs.


1,00,000 payable by the issue of shares. The assets included Land- '
and Buildings of Rs.50,000 and stock of Rs.50,000.

(iii)

Depreciation written off on machinery is Rs.24,000 and on Land and '.


Buildings is Rs.45,000.

(iv)

Income-tax paid during the year was Rs.70,000.

(v)

Additions to Buildings were for Rs.75,000.

Statement showing Changes in Working Capital


Particulars

2000

2001

Increase in

Decrease

W.C.

in W.C.

Current Assets
Cash at Bank

1,04,000

18,000

86,000

Debtors

1,60,000 1,28,000

32,000

Stock

2,00,000 2,52,000

52,000

4,64,000 3,98,000
Current Liabilities
Creditors
Working 3,00,000 2,60,000
Capital

40,000

1,64,000 1,38,000
1,64,000 1,38,000
Decrease in working

26,000

26,000

capital
1,64,000 1,64,000

1,18,000

1,18,000

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

Rs.

Sources

Application

Issue of Shares

50,000 Purchase Of Land &

Sale of Machinery

Buildings
76,000 Bank Loan paid

Funds from
operations
Decrease

3,17,000 Dividend paid

in

26,000 Income-tax paid

Rs.
75,000

2,40,000
84,000

70,000

Working Capital
4,69,000

4,69,000

Working Notes:
Provision for Taxation A/c
Particulars

Rs.

Particulars

To Cash

70,000 By Balance b/d

60,000

To Balance b/d

80,000 By Adj. P&L a/c

90,000

1,50,000

Rs.

1,50,000

Machinery A/c
Land and Buildings A/c
Particulars
To Balance b/d

Rs.

Particulars

Rs.

3,60,000 By Adj. P&L a/c

24,000

By

Sale

of

Machinery
By Balance c/d

76,000

2,60,000

3,60,000

3,60,000

Land and Buildings A/c


Particulars

Rs.

To Balance b/d

Particulars

Rs.

4,00,000 By Adj. P&L a/c

45,000

To Share Capital

50,000 By Balance c/d

To Cash

75,000
5,25,000

4,80,000
5,25,000

General Reserve A/c


Particulars

Rs.

To Balance c/d

Particulars

Rs.

1,40,000 By Balance b/d

80,000

By Adj. P&L a/c

60,000

1,40,000

1,40,000

Adjusted Profit & Loss A/c


Particulars

Rs.

To Machinery

24,000 By Opening Balance 64,000

To

Land

Buildings
To Provision

&

45,000 By

Funds

Operations
for

90,000

tax
To General

60,000

Reserve
To Dividends paid

84,000

To Closing

78,000

balance

Particulars

Rs.
from 3,17,000

3,81,000

3,81,000

FUNDS FLOW STATEMENT Vs. PROFIT AND LOSS ACCOUNT


Following are the main differences between a Funds Flow Statement and a
Profit and Loss Account:
1.

Objective: The main objective of preparing a Funds Flow Statement is


to ascertain the funds generated from operations. The statement
reveals the sources of funds and their uses. The main objective of
preparing a Profit and Loss Account is to ascertain the net profit
earned/ loss incurred by the company out of the business operations
at the end of a particular period.

2.

Basis: The Funds Flow Statement is prepared based on the financial


statements of two consequent years. A Profit and Loss Account is
prepared on the basis of nominal accounts.

3.

Usefulness: The Funds Flow Statement is useful for creditors and


management. The Profit and Loss Account is useful not only to
creditors and management but also to the shareholders and outside
parties.

4.

Type of Data Used: The Funds Flow Statement takes into account only
the funds available from trading operations but also the funds
available from other sources like issue of share capital/ debentures,
sale of fixed assets etc. Whereas, the Profit and Loss Account uses
only

income

and

expenditure

operations of a particular period.

transactions

relating

to

trading

For instance, when shares are issued for cash, the same is shown in funds flow
statement as a source of funds whereas in profit and loss account it is now shown as
income.

5.

Legal Necessity: Preparation of Funds Flow Statement is not a


statutory obligation and is left to the discretion of management.
Preparation of Profit' and Loss Account is a statutory obligation.

FUNDS FLOW STATEMENT Vs. BALANCE SHEET

Following are the main difference between a Funds Flow Statement and a
Balance Sheet.

1.

Objective: The Funds Flow Statement is prepared to know the total


sources and their uses in a year. Balance Sheet is prepared to know the
financial position of a company as on a particular date.

2.

Basis: The Funds Flow Statement is prepared with the help of the
balance sheets of two consecutive years. The Balance Sheet is prepared oh
the basis of different accounts in the ledger.

3.

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


internal financial management. A Balance Sheet is useful not only for the
management but also to the shareholders, creditors, outsiders and
Government agencies etc.

4.

Treatment of Current Assets and Current Liabilities:

In Funds Flow

Statement current assets and current liabilities are used to find out
increase or decrease in working capital. In Balance Sheet, current assets
and current liabilities are shown itemwise.

5.

Legal Necessity: Preparation of Funds Flow Statement is at the


discretion of management. Preparation of Balance Sheet is a statutory
obligation.

USES OF FUNDS FLOW STATEMENT

(1)

To determine financial consequences of operations: Funds Flow


Analysis determines the financial consequences of business operations.
In the following cases, Funds Flow Analysis helps the management to
understand the movement of funds and in effective funds management:

Many a time, a company inspite of earning large profits may have


unsatisfactory liquidity position. The reasons for such a position
and the financial consequences of business operations can be
ascertained with the help of funds flow statement.

The company may be incurring losses but its liquidity position is


sound or the firm will be investing in fixed Assets despite losses.

The firm may declare dividend inspite of losses or low profits.

The profit earned by the firm from different sources is not easily
understood by the management.

There may be sufficient cash in the business. But how such high
liquidity is existing is not known.

To fill financial blind spots : The Funds Flow Statement is designed to fill
financial blind spots of the operating statement. It translates the economic
consequences of operations into financial information as a basis for action.
(2)

Working capital utilisation: The Funds Flow Statement helps the


management in assessing the activity of working capital and whether

the working capital has been effectively used to the maximum extent in
business operations or not. The statement also depicts the surplus or
deficit in working capital than required. This helps the management to
use the surplus working capital profitability or to locate the sources of
additional working capital in case of scarcity.
(3)

To aid in securing new finances: A statement of changes in financial


position is useful for the creditor in considering the company's request
for new term loan.

(4)

Helps in allocation of financial resources: Funds Flow Statement helps


the management in taking decisions regarding allocation of the limited
financial resources among different projects on priority basis.

(5)

Helps in deciding the urgency of a problem: Funds Flow Analysis


helps to relate the time factor to financial planning. This enables the
management to identify critical points throughout the passage of time.
The management as also the outsiders concern themselves with the
information system geared up; towards changes in financial position as
the behaviour of funds flow figures relates to the criteria upon which
management strategy is based.

(6)

Helps in evaluation of operational issues: The statement of changes


functions as an analytical guide for evaluating operational issues. The
statement enables the management to ascertain in which the study of
trends of success or failure of operations and available resources.

DRAWBACKS OF FUNDS FLOW ANALYSIS

Historical nature: The funds flow statement is historical in nature like


any other financial statement. It does not estimate the sources and
application of funds for the near future.

Structural changes are not disclosed: The funds flow statement does
not disclose the structural changes in financial relationship in a firm not
it discloses the major policy changes with regard to investment in current
assets and short term financing. Significant additions to inventories
financed by short term creditors are not furnished in the statements as
they are offset by each other while computing net changes in working
capital.

New items are not disclosed: The funds flow statement does not disclose
any new or original items which affect the financial position of the
business. The funds flow statement simply rearranges the data given in
conventional financial statements and schedules.

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


changes in funds for the purpose of managerial decision-making.

Not foolproof: The funds flow statement is prepared from the data
provided in the balance sheet and profit and loss account. Hence, the
defects in financial statements will be carried over to funds flow statement
also.

LESSON-12
CASH FLOW ANALYSES
INTRODUCTION
Cash flow statement provides information about the cash receipts and
payments of a firm for a given period. It provides important information that
compliments the profit and loss account and balance sheet. The information
about the cash-flows of a firm is useful in providing users or financial
statements with a basis to assess the ability of the enterprise to generate cash
and cash equivalents and the needs of the enterprise to utilise these cash flows.
The economic decisions that are taken by users require an evaluation of the
ability of an enterprise to generate cash and cash equivalents and the timing
and certainly of their generation. The statement deals with the provision of
information about the historical changes in cash equivalents of an enterprise by
means of a cash flow statement which classifies cash flows during the period
from operating) investing and financing activities.

Meaning of certain Terms

Cash comprises cash on hand and demand deposit with banks.

Cash equivalents are short-term, highly liquid investments that are


readily convertible into known amounts of cash and which are subject to
an insignificant risk of changes in value. Examples of cash equivalents
are, treasury bills, commercial paper etc.

Cash flows are inflows and outflows of cash and cash equivalents. It
means the movement of cash into the organisation and movement of cash
out of the organisation. The difference between the cash inflow and
outflow is known as net cash flow which can be either net cash inflow or
net cash outflow.

Classification of cash flows

The cash flow statement during a period is classified into three main categories
of cash inflows and cash outflows:

Cash flows from Operating activities:

Operating activities are the principal revenue-producing activities of the


enterprise and other activities that are not investing and financing activities.
Operating activities include cash effects of those transactions and events that
enter into the determination of net profit or loss. Following are examples of cash
flows from operating activities:

Cash receipts from the sale of goods and the rendering of services

Cash receipts from royalties, fees, commissions, and other revenue

Cash payment to suppliers for goods and services

Cash payments to and on behalf of employees

Cash receipts and payments of an insurance enterprise for premiums and


claims, annuities and other policy benefits

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


identified with financing and investing activities.

Cash receipts and payments relating to future contracts, forward


contracts, option contracts, and swap contracts when the contracts are
held for dealing or trading purpose etc.,

Cash From Operations

Funds from Operations


(as learnt in the previous chapter)
Add: Increase in Current Liabilities

xxx
xxx

(excluding Bank Overdraft)


Decrease in Current Assets

xxx

xxx

(excluding cash & bank balance)


xxx
Less: Increase in Current Assets

xxx

(excluding cash & bank balance)


Decrease in Current Liabilities

xxx

xxx

(excluding bank overdraft)


Cash from Operations

xxx

Cash Flows from Investing Activities:

Investing activities are the acquisition and disposal of long-term assets and
other investments not included in cash equivalents. In other words, investing
activities include-transactions and events that involve the purchase and sale of
long-term productive assets, (e.g., land, building, plant and machinery, etc) not
held for re sale and other investments. The following are examples of cash flows
arising* from investing activities:

Cash payments to acquire fixed assets (including intangibles). ;

These payments include those relating to capitalised research and


development costs and self-constructed fixed assets.

Cash receipts from disposal of fixed assets (including intangibles)

Cash payments to acquire shares, warrants, or debt instruments of other


enterprises and interests in joint ventures (other than payments for those
instruments considered to be cash equivalents and those held for dealing
or trading purposes)

Cash receipts from disposal of shares, warrants, or debt instruments of


other enterprises and interests in joint ventures (other than receipts from
those instruments considered to be cash equivalents and those held for
dealing or trading purposes)

Cash advances and loans made to third parties (other than advances and
loans made by a financial enterprise)

Cash receipts from the repayment of advances and loans made to third
parties (other than advances and loans of a financial enterprise)

Cash receipts and payments relating to future contracts, forward


contracts,, option contracts, and swap contracts except when the
contracts are, held for dealing or trading purposes, or the receipts are
classified as financing activities.

Cash Flows from Financing Activities:

Financing activities are activities that result in changes in the size and
composition of the owners capital (including preference share capital in the
case of a company) and borrowings of the enterprise. Following are the examples
of cash flows arising from financing activities:

Cash proceeds from issuing shares or other similar instruments

Cash proceeds from issuing debentures, loans notes, bonds and other
short-term borrowing

Cash repayments of amounts borrowed

Payment of dividend

Information required for Cash Flow Statement

The following basic information is needed for the preparation of a cash


flow statement:

Comparative Balance Sheets: Balance Sheets at the beginning and at the


end of the accounting period indicate the amount of changes that have
taken place in assets, liabilities and capital.

Profit and Loss Account : The profit and loss account of the current
period enables to determine the amount of cash provided by or used in
operations during the accounting period after making adjustments for
non-cash, current assets and current liabilities.

Additional Data: In addition to the above statements, additional data are


collected to determine how cash has been provided or used e.g., Sale or
purchase of assets for cash.

Cash Flow Statement of XYZ Ltd. for the year ending 31" March 2001

Source
Opening Balances

Rs.

Application
Opening Balances

Cash

XXX Bank overdraft

Bank

XXX Cash outflows

Cash Inflows

Rs.

Redemption of Redeemable

XXX

Cash from Operations

Preference Shares
XXX Redemption of Debentures

XXX

Issue of Shares

XXX Repayment of Loans

XXX

Raising of Long Term


Loans/Debentures

Non Operating Expenses


XXX Closing Balances

XXX
XXX

Sale of Fixed Assets XXX Cash

XXX

and Investments
Non Trading Receipts

XXX

XXX Bank

XXX

XXX

Note : The Cash Flow Statement can also be presented in the vertical form.
However, the horizontal form given above is convenient and is more commonly
used.

Funds Flow Statement vs. Cash Flow Statement


Both funds flow and cash flow statements are used in analysis of past
transactions of a business firm. The difference between these two statements
are given below:

Funds flow statements is based on the accrual accounting system. In case


of preparation cash flow statements all transactions effecting the cash or
cash equivalents is only taken into consideration.

Funds flow statement analysis the sources and application of funds of


long-term nature and the net increase or decrease in long-term funds will
be reflected on the working capital of the firm. The cash flow statement
will only consider the increase or decrease in current assets and current'
liabilities in calculating the cash flow of funds from operations.

Funds Flow analysis is more useful for long range financial planning.
Cash flow analysis is more useful for identifying and correcting die
current liquidity problems of the firm.

Funds flow statement analysis is a broader concept, it takes into account


both long-term and short-term funds into account in analysis. But cash
flow statement only deal with the one of the current assets on balance
sheet assets side.

Funds flow statement tallies the funds generated from various sources
with various uses to which they are put. Cash flow statements Start with

the opening balance of cash and reach to the closing balance of cash by
proceeding through sources and uses.

Illustration: 1
From the following information, you are required to ascertain cash flow
operation
Particulars
Net Profit
Debtors
Bills Receivable
Creditors
Bills payable
Stock

31.12.2000
42,000
8,000
47,000
15,000
58,000

31.12.2001
70,000
40,000
13,000
50,000
10,000
65,000

Calculation of Cash from operations


Profit made during the year

70,000

Add: Decrease in debtors

2,000

Increase in Creditors

3,000

5,000
75,000

Less: Increase in Bill Receivable


Increase in stock

5,000
7,000

[ Decrease in Bills payable

5,000

17,000
58,000

Cash from operations


Illustration: 2

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

Particulars

December December

Debtors
Bill Receivable
Creditors
Bills Payable
Outstanding Expenses
Prepaid Expenses
Accrued Income
Income Received in Advance
Profit made during the year

31 2000
50,000
10,000
20,000
8,000
1,000
800
600
300
-

31 2001
47,000
12,500
25,000
6,000
1200
700
750
250
1,30,000

Calculation of Cash from operations


Profit made during the year
Add: Decrease in debtors
Increase in Creditors
Increase in Outstanding Expenses
Decrease in Prepaid Expenses
Less: Increase in Bill Receivable
Increase in Accrued Income
Decrease in Bills Payable
Decrease in Income Receive in Advance
Cash from Operations

1,30,000
3,000
5,000
200
100
1,38,000
2,500
150
2,000
50

4,700
1,33,600

Illustration: 3
From the following information, calculate cash from operations
Particulars
P&LA/c (credit)
Debtors
Bills Receivable
Prepaid Rent
Prepaid Insurance
Goodwill
Depreciation
Creditors

2000

2001

40,000
20,000
20,000
2,000
1,000
20,000
32,000
20,000

50,000
26,000
12,000
3,000
800
14,000
40,000
30,000

Statement showing Cash from operations


Closing balance P&L A/c

50,000

Add: Decrease in Bill Receivable

8,000

Decrease in Prepaid Insurance

200

Increase in Creditors

10,000

Depreciation

8,000

Goodwill

6,000

32,200
82,200

Less: Increase in debtors

6,000

Increase in prepaid rent

1,000

Opening balance of P&L A/c

40,000

Cash from Operations

47,000
35,200

Illustration: 4
From the following balance sheets of Sulekha Ltd. you are required to prepare a
cash flow statement

Liabilities

2000

Share capital

Rs.
3,00,000

Trade editors

1,05,000

2001

Assets

Rs.
3,75,000 Cash
67,500 Debtors

2000

2007

Rs.
45,000

Rs.
70,500

1,80,000

1,72,500

P&L A/c

15,000

34,500 Stock in Trade

1,20,000

1,35,000

75,000

99,000

4,20,000

4,77,000

Land
4,20,000

4,77,000

Cash flow Statement of Sulekha Ltd. for the year 2001


Sources

Rs.

Application

Rs.

Opening Balance of cash

45,000 Purchase of Land

24,000

Issue of Share Capital

75,000 Decrease

37,500

Cash

Creditors
19,500 Closing balance

Operating

Profit

(Diff. In P&L A/c)


Decrease in Debtors

in

Trade

70,500

7,500
1,47,000

1,47,000

Illustration: 5
From the following balance sheets of Zindal Ltd/prepare cashflow statement.
2000 2007

Liabilities
Share Capital
8% redeemable
Shares
General reserve

Pref.

2000 2007

600

800 Goodwill

230

180

300

200 Land & Buildings

400

340

140 Plant

160

400

320

400

154

218

166 Bills Receivable

40

60

80

P&L Account

60

Proposed dividend

84

Creditors

Assets

110

96 Debtors
100 Stock

Bills Payable

40

32 Cash in hand

30

20

Provision for tax

80

100 Cash at Bank

20

16

Total

1354 1634

1354 1634

Additional information:
1)

Depreciation of Rs.20,000 and Rs.40,000 have been charged on plant


account and land and buildings account, respectively in 2001.

2)

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

3)

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

1. Plant Account

Particulars

Particulars

Rs.

To Opening Balance 1,60,000 By Depreciation

20,000

on 1-1-2001
To Purchases-cash

Rs.

2,60,000 By closing balance

4,00,000

on 31-12-2001
4,20,000
2.

4,20,000

Land and Building Account

Particulars

Rs.

Particulars

To Opening Balance 4,00,000 By Depreciation

Rs.
40,000

on 1-1-2001
By cash (salesbalancing figure)
By closing balance on 3,40,000
31-12-2001
4,00,000

3.

4,00,000

Provision for taxation Account


Particulars

Cash

Rs.

Particulars

70,000 By Opening Balance on

1-1-2001
To closing balance 1,00,000 By P&L Account
on 31-12-2001

Rs.
80,000

90,000

(balancing figure)
1,70,000

1,70,000

Calculation of cash from operations


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

96,000

2001:
Less: Balance of P&L A/c on 1-1-2001:
Add: Profit used for reserves &

60,000

provisions:
Proposed dividend
Interim dividend
Provisions for taxation
Transfer to general reserve

1,00,000
40,000
90,000
60,000

36,000

2,90,000
3,26,000

Add : Profit used for writing off noncash A/c:


Goodwill
Depreciation:
Plant
Land & Building

50,000
20,000
40,000
1,10,000
4,36,000
56,000
4,92,000

Add: increase in creditors


Funds from operations
Less: Increase in current assets:
Debtors
Stock
Bills Receivable

80,000
64,000
20,000

Less: Decrease in current liabilities:


Bills Payable
Cash from Operations

1,64,000
3,28,000
8,000
3,20,000

Cash flow statement for the year ended December 31,2001


Cash in-flows
Op. Bal. As on 1-1-2001
Cash
Bank

Add: Cash inflows:

Rs.

Cash out-flows

Rs.

30,000 Purchase of plant


20,000 Payment of final

2,60,000
84,000

dividend for 2000


Payment of interim

40,000

dividend
Income-tax paid

70,000

Operations

3,20,000 Redemption of Pref.

1,00

Shares
Sale of land & bldg.
Issue of shares

20,000
2,00,000

1,00,000
5,54,000
Closing balance on
31-12-2001
Cash in hand
Cash in bank

20,000
16,000
5,90,000

5,90,000
Illustration: 6

From the following information you are required to prepare a Cash Flow
Statement of Shanti Stores Ltd for the year ended 31" December, 2001

Balance Sheets
Liabilities
Share Capital

2000
70,000

2001

2000

2001

50,000

91,000

15,000

40,000

5,000

20,000

20,000

7,000

2,000

4,000

92,000

1,62,000

70,000 Plant
Machinery
Inventory

Secured Loans
Repayable (2001)
Creditors

Assets

40,000 Debtors
14,000

Tax payable

1,000

39,000 Cash
3,000 Prepaid
General Exp.

P&L A/c

7,000

10,000

92,000 1,62,000

Profit & Loss A/c for the year ended 31" December, 2001
Particulars

Rs.

Particulars

To Opening Inventory

15,000 By sales

To Purchases
To Gross Profit c/d

98,000 By Closing inventory


27,000

Rs.
1,00,000
40,000

1,40,000
To General Expenses

11,000 By Gross Profit b/d

To Depreciation
To Taxes

8,000
4,000

To Net Profit c/d

4,000
27,000

1,40,000
27,000

27,000

To Dividend

1,000 By Balance b/d

7,000

To Balance c/d

10,000 By Net Profit b/d

4,000

11,000

11,000

Working Notes:
Machinery A/c
Particulars

Rs. Particulars

To Balance b/d
(Opening balance)

By Depreciation a/c

Rs.
8,000

50,000 By Balance c/d


(closing balance)

91,000

To Bank a/c Purchases (bal. Fig.)

49,000
99,000

99,000

Provision for Taxation


Particulars

Rs. Particulars

To Bank a/c - tax


Paid (bal. Fig.)

By Balance b/d

1 ,000

2,000 By P & L a/c -

To Balance c/d -

closing balance

Rs.

(current year)

4,000

3,000
5,000

5,000

(Rs.)
Net Profit

4,000

Add: Depreciation

8,000

Taxes

4,000

Funds from Operations

16,000

Cash from Operations

Rs.
Funds from Operations

16,000

Add: Increase in Creditors

25,000
41,000

Less: Increase in Debtors

15,000

Increase in Inventory

25,000

Increase in Prepaid General Expenses

2,000

Cash lost in Operations

42,000
1,000

Cash Flow Statement of M/s Shanti Stores Ltd.


for the year ending 31" December, 2001
Sources
To Balance c/d Opening Cash Balance
Cash Inflows
Secured Loans raised

Rs.

Application
Cash Outflow
20,000 Machine Purchased
40,000 Taxes Paid
Dividends paid
Cash lost in Operations
Closing cash Balance
60,000

Rs.
49,000
2,000
1,000
1,000
7,000
60,000

Illustration: 7
The following are the balance Sheets of X Ltd. For the year ending 31 st
December 2000 and 2001

Particulars
Liabilities
Share Capital

2000
Rs.
2,00,000

2001
Rs.
3,00,000

Profit and Loss Account

1,20,000

1,60,000

Sundry creditors

60,000

50,000

Provision for taxation

40,000

50,000

Proposed Dividend

20,000

30,000

4,40,000

5,90,000

2000

2001

Rs.

Rs.

1,60,000

2,00,000

40,000

60,000

2,00,000

2,60,000

18,000

24,000

1,82,000

2,36,000

8,000

16,000

1,60,000

2,18,000

Debtors

60,000

80,000

Cash

30,000

40,000

4,40,000

5,90,000

Particulars
Assets:
Fixed Assets
Add: Additions
Less: Depreciation
Investments
Stock

Additional information:
1)

Taxes Rs. 44,000 and dividend Rs. 24,000 were paid during the year 2001

2)

The net profit for the year 2001 before depreciation Rs. 1,34,000
Cash Flow Statement for the year ending 31 st December, 2001
Sources

Opening Balance of
Cash
(1-1-2001)
Cash inflows:

Rs.

Application

Rs.

Cash Outflows

30,000 Purchase of fixed assets


Taxes paid

Issue of share capital

1,00,000 Dividend paid

Cash from operations

1,34,000 Purchase of investments

60,000
44,000
24,000
8,000

Increase in Stock

58,000

Increase in debtors

20,000

Decrease in creditors

10,000

Closing balance of cash

40,000

2,64,000

2,64,000

Working Notes:
Fixed Assets a/c
Particulars

Rs.

To Balance

Particulars

Rs.

2,00,000 By Balance c/d

2,60,090

To Bank a/c

60,000
2,60,000

2,60,000

Investments a/c

Particulars

Rs.

To Balance b/d

Particulars

Rs.

8,000 By Balance c/d

16,000

To Bank

50,000

(Balancing figure)

94,000

16,000

Provision for taxation a/c


Particulars

Rs.

Particulars

Rs.

To Bank

44,000

By Balance c/d

44,000

To Balance c/d

50,000

By P & L a/c

50,000

94,000

94,000

Proposed dividends a/c


Particulars

Rs.

Particulars

Rs.

To Bank

24,000 By Balance c/d

24,000

To Balance c/d

30,000 By P & L a/c

30,000

54,000

54,000

Calculation of cash from operations


Rs.
Profit and Loss a/c balance on (3 1-12-2001)
Add: Non-cash and non-operating items

1,60,000

already debited to Profit and Loss a/c :


Depreciation on fixed assets
Proposed dividend
Provision for taxation
Less:

Non-cash

and

non-operating

6,000
34,000
54,000

94,000
2,54,000

items

which have already been credited to P&L a/c


Profit and Loss a/c on 1-1-2001
Cash operating profit

1,20,000

1,20,000
1,34,000

Illustration: 8
From the following Balance Sheets of Exe. Ltd. Make out the statement of
sources and uses of cash:
Liabilities

2000

2001

Assets

2000

2001

Equity Share

Rs.
Rs.
3,00,000 4,00,000 Goodwill

Rs.
1,15,000

Rs.
90,000

Capital
8% Redeemable

1,50,000 1,00,000 Land and

2,00,000

1,70,000

80,000

2,00,000

1,60,000

2,00,000

Preference Share

Buildings

Capital
General Reserve

40,000

70,000 Plant

Profit & Loss

30,000

48,000 Debtors

Account
Proposed

42.000

50,000 Stock

77,000

1,09,000

Dividend
Creditors

55,000

83,000 Bills

20,000

30,000

Bill Payable

20,000

Receivable
16,000 Cash in Hand

15,000

10,000

Provision for

40,000

50,000 Cash at Bank

10,000

8,000

Taxation
6,77,000 8,17,000

6,77,000 8,17,000

Additional information:
a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant
and Land and Building respectively in 2001.

b) An interim dividend of Rs. 20,000 has been paid in 2000.

c) Rs. 35,000 Income-tax was paid during the year 2001.

Working Notes:
(i) Adjusted Profit & Loss account
Particulars

Rs.

To Depreciation on
plant
To Depreciation

Particulars

10,000 By Balance b/d

to

20,000 By

buildings

Funds

Rs.
30,000

from

2,18,000

operations
(balancing figure)

To Goodwill written off

25,000

To Provision of taxation

45,000

To Interim dividend

20,000

To Dividend proposed

50,000

To Transfer to

30,000

General Reserve
To Balance c/d

48,000
2,48,000

(ii)

Provision for taxation account

2,48,000

Particulars

Rs.

Particulars

Rs.

To Bank

35,000 By Balance b/d

40,000

To Balance c/d

50,000 By P.& L A/c

45,000

85,000

85,000

(iii) Land and building account


Particulars
To Balance b/d

Rs.

Particulars

2,00,000 By Depreciation

2,00,000

Rs.
20,000

By Bank (sale)

10,000

By Balance c/d

1,70,00
2,00,000

(iv) Plant account


Particulars

Rs.

To Balance b/d

Particulars

80,000 By Depreciation

To Bank (purchase)

Rs.
10,000

1,30,000 By balance c/d

2,00,000

2,10,000

2,10,000

(v) Cash from operations


Rs.
Funds from operations
Add: Increase in creditors
Less:
Decrease in Bills Payable
Increase in Debtors
Increase in Stock
Increase in Bills receivable
Cash from operations
(vi)

2,18,000
28,000
2,46,000
4,000
40,000
32,000
10,000

86,000
1,60,000

In the absence of information, it has been presumed that there is no profit


(loss) and no accumulated depreciation on that part of land and buildings
which has been sold.

Cash flow statement for the year ending 31st December 2001
Cash Balance as on 11-2001
Cash in hand

Rs. Outflows of cash:

1 5,000 Redemption

Add: Inflows of cash:

Land

Payments

of

and

Building
Funds from operations
Increase in creditors

50,000

20,000
interim

dividend
1,00,000 Payment of tax

Issue of Shares
of

of

Redeemable
10,000 Preference share

Cash at bank

Sale

Rs.

42,000

35,000

10,000 Purchase of Plant

1,30,000

2,18,000 Decrease in bills payable


28,000 Increase in debtors

4,000
40,000

Increase in stock

32,000

Increase in B/R

10,000

Cash Balance as on 3112-2001


Cash in hand

10,000

Cash at bank

8,000

3,81,000

3,81,000

Illustration: 9
Balance Sheets of XYZ Ltd. as on 1-1-2000 and 31-12-2001 was as follows:
Liabilities
Capital
Creditors
Bank loan
Bills Payable
Assets:
Cash
Debtors
Stock
Machinery

1-1-2001
1,25,000
1,40,000
65,000
20,000
3,50,000

31-12-2001
1,53,000
1,44,000
50,000
30,000
3,77,000

20,000
30,000
45,000
80,000

17,000
80,000
35,000
65,000

Land
Buildings
Goodwill

90,000
65,000
20,000
3,50,000

80,000
70,000
30,000
3,77,000

During the year, a machine costing Rs. 12,000 (accumulated depreciation


Rs.4,000) was sold for Rs.7,000. Balance of provisions for depreciation against
machinery as on 1-1-2001 was Rs.35,000 and on 31-12-2001 Rs. 50000
Prepares cash Flow statement.

Cash Flow Statement for the year ending 31st December 2001
Sources

Rs.

Opening balance of Cash

Applications

Rs.

20,000 Cash outflows:

Cash inflows:

Building Purchased

Sale of Machinery

5,000

7,000 Machinery Purchased

Sale of Land

12,000

10,000 Bank Loan repaid

Increase in creditors

15,000

4,000 Goodwill

10,000

Increase in Bills Payable

10,000 Drawings

27,000

Decrease in stock

10,000 Increase in debtors

50,000

Cash from operations

75,000 Cash balance (31-12-2001)

17,000

1,36,000

1,36,000

Machinery a/c
Sources
To Balance b/d
To Bank (Purchase)

Rs.

Applications

1,15,000 By Bank (Sale)


12,000 By Provisions for depreciation
a/c
By P & L a/c (Loss on sale)
By Balance c/d
1,27,000

Rs.
7,000
4,000

1,000
1,15,000
1,27,000

Land a/c
Particulars
To Balance b/d

Rs.
Particulars
90,000 By Bank (Purchase)
By Balance c/d

Rs.
10,000
80,000

90,000

90,000

Buildings a/c
Particulars
To Balance b/d
To Bank (Purchases)

Rs.
Particulars
65,000 By Balance c/d
5,000
70,000
Goodwill a/c

Particulars
To Balance b/d
To Bank

Rs.
Particulars
20,000 By Balance c/d
10,000
30,000

Rs.
70,000
70,000
Rs.
30,000
30,000

Bank Loan a/c


Particulars
To Bank
To Balance c/d

Rs.
Particulars
15,000 By Balance c/d
50,000
65,000

Rs.
65,000
65,000

Provisions for Depreciation a/c


Particulars
To Machinery a/c
To Balance c/d

Rs.
Particulars
4,000 By Balance c/d
50,000 By P & L a/c
54,000

Rs.
35,000
19,000
54,000

Calculation of Cash from operations


Balance of P & L a/c
(Net Profit on (31/12/2001)
Add : Non-cash and non-operating items
debited to P & L a/c
Depreciation on Machinery
Loss on sale of Machinery
Cash from operations

55,000

19,000
1,000

20,000
75,000

Capital a/c
Particulars
To Drawings (Balancing
figure)
To Balance c/d

Rs.
Particulars
27,000 By Balance b/d

1,53,000 By Net Profit


1,80,000

Rs.
1,25,000

55,000
1,80,000

USES CASH FLOW STATEMENT

Helps in efficient cash management - One of the most important


functions of the management is to manage company's cash resources in
such a way that adequate cash is available to meet the liabilities. A
projected cash flow statement enables the management to plan and coordinate the financial operation of the business efficiently.

Helps in internal financial management - The cash flow analysis helps


the management in exploring the possibility of repayment of long term
debts which depends upon the availability of cash.

Discloses the movement of cash - The cash flow statement discloses the
increase or decrease in cash and the reasons therefore. It helps the
finance Manager in explaining how the company is short of cash despite
higher profit and vice versa.

Discloses success or failure of cash planning - Comparison of actual


and budgeted cash flow statement will disclose the failure or success of
the management in managing cash resources and necessary remedial
measures can be taken in case of deviations. :

Helps to determine the likely flow of cash - Projected cash flow


statements help the management to determine the likely inflow or outflow
of cash from operations and the amount of cash required to be raised
from other sources to meet the future needs of the business.

Supplemental

to

funds

flow

statement

Cash

flow

analysis

supplements the analysis provided by funds flow statement as cash is a


part of the working capital.

Better tool of analysis - For payment of liabilities which are likely ,to be
matured in the near future, cash is more important than the working
capital. As such, cash flow statement is certainly a better tool of analysis
than funds flow statement for short term analysis.

LIMITATIONS OF CASH FLOW ANALYSIS

Misleading inter-industry comparison - Cash flow statement does not


measure the economic efficiency of one company in relation to another.
Usually a company with heavy capital investment will have more cash
inflow. Therefore, inter-industry comparison of cash flow statement may
be misleading.

Misleading comparison over a period of time - Just because the


company's cash flow has increased in the current year, a company may
not be better off than the previous year. Thus, the comparison over a
period of time can be misleading.

Misleading inter-firm comparison - The terms of purchases and sales


will differ from firm to firm. Moreover, cash inflow does not always mean
profit. Therefore, inter-firm comparison of cash flow may also be
misleading.

Influenced by changes in management policies - The cash balance as


disclosed by the cash flow statement may not represent the real liquid
position of the business. The cash can be easily influenced by purchases
and sales policies, by making certain advance payments or by postponing
certain payments.

Cannot be equated with income statement - Cash flow statement


cannot be equaled with the income statement. An income statement,

takes into account both cash as well as non-cash items. Hence net cash
flow does not necessarily mean net income of the business.

Not a replacement of other statements - Cash flow statement is only a


supplement of funds flow statement and cannot replace the income
statement or the funds flow statement as each one has its own function
or, purpose of preparation.

Despite the above limitations, cash flow statement is a very useful tool of
financial analysis. It discloses the volume and speed at which cash flows in
various segments of the business and the amount of capital tied-up in a
particular segment.

LESSON- 13
BUDGETING AND BUDGETARY CONTROL
BUDGET

Budget is a financial and/or quantitative statement, prepared and


approved prior to a defined period of time, of the policy to be pursued during
that period for the purpose of attaining a given objective.
-

CIMA Official Terminology


-

It is a plan quantified in monetary terms, prepared and approved prior to


a defined period of time, usually showing planned income to be generated
and/or expenditure to be incurred during that period and the capital to be
employed to attain a given objective. It is a plan of future activities for an
organisation. It is expressed mainly in financial terms, but also usually
incorporates many non-official quantitative measures as well.

BUDGETING

Budgeting is the whole process of designing, implementing and operating


budgets. The main emphasis in this is short-term budgeting process involving
the prevision of resources to support plans which are being implemented.

BUDGETARY CONTROL

Budgetary

control

is

the

establishment

of

budgets

relating

the

responsibilities of executives to the requirements of a policy, and the continuous


comparison of actual with budgeted results, either to secure by individual action
the objective of that policy or to provide a basis for its revision.

- CMA Official Terminology

FORECAST Vs. BUDGET


A forecast is a prediction of the future state of world, in connection with
those aspects of the world, which are relevant to and likely to affect on future
activities. Forecast is calculation of probable events. Both forecasting and
planning involve recognition of the relevant factors in a given situation and
understanding of what each factor has contributed to it and how each is likely
to affect the future. Any organised business cannot avoid anticipating or
calculating future conditions and trends for the framing of its future policy and
decision. Forecast is concerned with 'probable events' and the budgeting relates
to 'planned events' Budgeting should be preceded by forecasting, but forecasts
may be made for purpose other than budgeting.

Requirements of a Sound Budgeting System

The following are the essential requirements of a sound budgeting system:

Clear lines of authority and responsibility have to be established


throughout the organisation and the authority and responsibility of
different levels of management and departmental executives are clearly
defined.

The organisational goal should be quantified and clearly stated. These


goals should be within the framework of organisations strategic and long
range plans. The setting of budgets is not a process detached from
planning of the company's overall policy. A well defined business policy
and objective is a prerequisite for budgeting.

The budget system should be established on the highest possible level of


motivation. All levels of management should participate in setting
budgets. Since this can produce more realistic targets, lead to better

understanding of corporate objectives and the constraints within which


organisation works. Participation in budgeting process will motivate the
personnel to achieve budget levels of efficiency and activity.

The budget control system should provide for a degree of flexibility


designed to change in relation to the level of activity attained and the
impact of changes in sales and production levels on revenue, expenses are
known. It enables more accurate assessment of managerial and
organisational performance.

Proper communication systems should be established for management


reporting and information service so that information relating to actual
performance is presented to the manager responsible for it promptly to
enable the manager to know the nature of variations so that remedial
action is taken wherever necessary.

Educating the budget process and creation of cost awareness atmosphere


will lead to effective implementation of budgets.

The top management's involvement in budget process is essential for


successful implementation of the budgets. It should take interest not only
in setting the budgets and targets but also to check upon the actual
attainment, motivating the personnel, rewarding for achievements,
investigation into reasons for any deviation of actuals from budgeted
results, taking punitive action wherever necessary.

A sound system for generating accurate and reliable and prompt


accounting information is basic for successful implementation of budget
system in an organisation.

Advantages of Budgeting

Budgetary control establishes a basis for internal audit by regularly


evaluating departmental results.

Only reporting information which has not gone according to plan, it


economises on managerial time and maximizes efficiency. This is called
'Management by Exception reporting.

Scarce resources should be allocated in an optimal way, thus controlling


expenditure

It forces management to plan ahead so that long-term goals are achieved.

Communication is increased throughout the firm and coordination should


be improved.

An effective budgetary control system will allow people to participate in


the setting of budgets, and thereby have a motivational impact on the
work force. Individual and corporate goals are aligned.

Areas of efficiency and inefficiency are identified. Variance analysis will


prompt remedial action where necessary

The budget provides a yardstick against which the performance of the firm
can be evaluated. It is better to compare actual with budget rather than
with the past, since the latter may no longer be suitable for current and
expected conditions.

People are made responsible for items of cost and revenue, i.e. areas of
responsibility are clearly delineatea.

Problems in Budgeting

Budgets are perceived by the work force as pressure devices imposed by


top management. This can have an adverse effect on labour relations.

It can be difficult to motivate an apathetic work force.

The pressure in the budgeting system may result in inaccurate record


keeping. :

Managers may over-estimate costs in order that they will not be held
responsible in the future for over spending. The difference between the
minimum necessary costs and the costs built into the budget is called
slack.

Departmental

conflict

arises

because

of

competition

for

resource

allocation. Departments blame each other if targets are not achieved.

Uncertainties can occur in the system,' e.g. uncertainty over demand,


inflation, technological change, competition, weather etc. ;

It may be difficult to align individual and corporate goals. Individual goals


often change and may be much lower than the firm's goals.

It is important to match responsibility with control, otherwise, a manager


will be demotivated. Costs can only be controlled by a manager if they
occur within a certain time span and can be influenced by that manager.
A problem arises when a cost can be influenced by more than one person.

Managers are often accused of wasting expenditure when they either

(i)

demand a greater budget allowance than is really needed, or

(ii)

unnecessary spending in order to fully utilise their allowance


through fear of future cut-backs. Zero base budgeting can
overcome this problem.

Sub-optimal decisions may arise when a manager tries to enhance his


short-run performance in a way which is detrimental to the organisation
as a whole, e.g. delaying expenditure urgently needed repairs.

They are based on assumed conditions (e.g. rates of interest) and


relationship (e.g. product-wise held constant) that are not varied to reflect
the actual circumstances that come about.

They make allowance for tasks to be performed only in relation to volume


rather than time.

They compare current costs with estimates "based only on historical


analysis.

Their short-term horizon limits the perspective, so short-term results may


be sought at the expense of longer term stability or success.

They have a built-in bias that tends to perpetuate inefficiencies. For


example, next year's budget is determined by increasing last year's by 15
per cent, irrespective of the efficiency factor in last year.

As with all types of budgets the game of 'beating the system' may take
more energy factor in last year.

The fragile internal logic of static budget will be destroyed if top


management reacts to draft budgets by requiring changes to be made to
particular items, which are then not reflected through the whole budget.

BUDGETING PROCESS

The method by which the annual budget is prepared will differ from
organisation to organisation. In some organisations budgeting may be a well
organised, well documented procedures while in others the budget may be
prepared in a rather ad hoc and disorganised manner. The budget process is
shown in the following figure. The steps in budgeting process representative to
all organisations is given below:

1.

Specification and Communication of Organisational Objectives :

Budget is a medium through which organisation's objectives and polices


are reflected. Budgeting is used as a tool for implementing the organisational
objectives. It is essential to understand, specification and documentation of
organisational

objectives

before

the

managers

start

for

budgeting

the

organisational activities. Following from a statement of objectives, a corporate


long-range or strategic plan can be built up. Distinction may be drawn between
current operating activities and future strategic activities. Budgeting is a
management tool used for shorter term planning and control. This classification
of activities into short-term and strategic long-term and communication to the
managers will lay down a sort of guide for budgeting the activities within the
specified objectives and activities.

2.

Determination of Key Success Factors :

The performance of every organisation will be particularly influenced by


certain critical success factors, key factor will influence the activities of an
undertaking and it will limit the volume of output and will have direct impact on
the profitability of the organisation. Critical success factors may consist of a
specified raw material, a specific type of labour skill, a tool, a service facility,
floor space, cash resources etc. The limitation or shortage of such critical
factors may result in restricting capacity utilisation. The limiting factors may
shift from time to time due to external and internal circumstances,. In
organisations which are already operating at maximum capacity, the most
critical success factor is likely to be productive capacity. In majority of
organisation the most critical factor is likely to be consumer demand or the
expected level of revenues or funds. Because of this, the sales or funds budget is
usually the first budget to be prepared. It will determine the content of other
related budgets.

3.

Establishment of Clear Ones of Authority and Responsibility:

An organisational chart defining the lines of authority and responsibility


of the managers responsible for accomplishment of organisational objectives is
to be prepared. The organisational chart should define the following:

The responsibility of individual functional managers

4.

Delegation of authority to the concerned functional managers

Inter-functional relationship of the organisation.


Establishment of Budget Centres :

Budget centre is a section of an organisation for which separate budgets


can be prepared and control exercised (CMA official terminology). The entire
organisation is divided into different segments, which are clearly defined for the
purpose of budgetary control according to responsibilities of departmental
heads. These segments of an organisation defined for the purpose of budgetary
controL are technically referred to as budget centers.

5.

Determination of Budget Period :

Budget period is a period for which the budget is prepared. A budget can;
be a long-term budget or short-term budget. A short term budget is generally
prepared for one year or lesser period.

Quarterly, monthly or even weekly

budget can be prepared for certain operations of the company. The short-term
budget will generally not exceed the full accounting year. The long-term budget
which extend to five or even more years. This long-term budget will agree with
long-term

forecast

of

sales,

organisational

schemes

for

expansion

modernisation, diversification etc. The long-term budgets are used for planning
whereas short-term budget is used for implementation of long range plans,
activities, objectives and also for control purposes. Capital expenditure budget
and Research and development expenditure budget are the examples of long-term budgets.

Annual sales budget, Income and expenditure budget are the

examples of short-term budgets.

6.

Establishment of Budget Committee :

In small organisations, the person incharge of finance and accounting


functions will involve in preparation of budgets. The setting up of a budget

Committee is necessary in case of large and complex organisations. As the


budget involves the various functional activities, the closest association of
functional

managers

is

essential

for

satisfactory

formulation

and

implementation of the budget The budget committee will be composed of major


functional heads. It can be effective medium for coordination and review of the
budget programme. The main functions of budget committee are as follows:

To review the functional budget estimates.

To recommend the functional budgets for revision.

To review and advise on the general policies affecting more than one
function.

To review, approval and adoption of revised budgets.

To receive and analyse the-periodic performance reports from budget


centers.

To examine the budget reports showing actuals compared with budget.

To locate the responsibility for discrepancies between actuals and


budgets, and recommends the corrective action.

To participate in decision making in strategic issue like, expansion,


modernisation, diversification and revision of organisational activities,
which have direct relationship to the company's budgets.

7.

Appointment of Budget Controller :

Proper budget administration is facilitated by the budget controller who is


made responsible for the preparation of the budget and coordinating activities of
the individual departments. His functions and responsibilities will include the
following:

(a)

Generation and dissemination of information needed for decision-making


and planning to each person

in the organisation having such

responsibilities. The information may include, but is not limited to,


forecasts of economic and social conditions, governmental influences,

organisation goals and standards for decision making, economic and


financial guidelines, performance data, performance standards and the
prerequisite plans of others in the enterprise.

(b)

Establishing and maintaining a planning system which:

Channels of information to each of persons responsible for planning,

Schedules the formulation of plans,

Structures the plans of sub-sections of the enterprise into composites


at which points, tests are made for significant deviations from
economic and financial guidelines and from goal achievement and
repeats the process for larger segments to and including the
enterprises as a whole, and

Disseminates advice of approval, disapproval or revision of plans to


affected individuals in accordance with established lines of authority
and organisational responsibilities.

(c)

Construction and using models of the enterprise both in total and by


sub-sections, to test the effect of internal and external variables upon
the achievement of organisation goals.

(d)

Ensuring the accumulation of performance data related to responsibility


centers within the organisation, measured against the plans, whether
period or project, for each centre, transmitted to each centre, and the
analysis of deviations of actual from planned performance.

The budget controller is responsible for the final preparation, presentation and
interpretation of the financial plan of the company. He is responsible for
development of budget procedures. He will act as a staff manager coordinating
all budget functions.

8.

Preparation of Budget Manual:

Budget manual is the documentation of policies and procedures involved


in implementation of budgetary control system. A budget manual will normally
set out the following:

Responsibility and authority of different levels of management.

Establishment of organisational hierarchy.

Definition and clarification of various terms used in budgets.

Fixation of responsibility for preparation and implementation of budgets


and budgetary system.

Specification and timing of statements and reports.

Procedures in management information system in the organisation.

Procedures in feed-back and feed-forward control systems.

Exhaustive programme of budget preparation.

The budget manual contains the standardised form which become information
generation for preparation of budgets. It contains a complete programme of
activities involved in budget preparation. The budget' manual should provide
detailed procedure for preparation and development and control of each budget
like Sales budget, Production budget, Direct material budget, Direct labour
budget, Overhead budget, Capital expenditure budget, R&D expenses budget
etc.

PREPARATION OF SALES OR REVENUE BUDGET

The sales revenue budget is the starting point of most master budgets. In
manufacturing organisations sales budgeting begins with the forecasting of the
sales of individual products. These forecasts may be by geographical area, by
class of customer or by some other segment. In case of manufacturing
companies, the budgeting will begin with the Revenue budget of the
organisation.

Forecasting sales is a difficult task as many assumptions need to

be made about consumer demand, environmental conditions likely customer

demand at different prices, the probable prices for similar products sold by
competitors, the number of economic activity in the regions where the product
is sold, the number of sales personnel required to service the estimated
demand, the appropriate level of advertising and promotional expenditures, the
impact of anticipated changes in exchange rates and changes in the taxes such
as value added tax or customs and excise duties.

PREPARATION OF BUDGETS

Once the sales budget has been determined from a range of sales
forecasts it is possible to construct the following other budgets:

1.

Production Budget

The production budget is an estimate of the quantity of goods that must


be produced during the budget period. The aim of the production function will
presumably be to supply finished goods of a specified quality to meet marketing
demands. The sum of sales requirements plus changes in stock levels of finished
goods gives the production requirements for the period being budgeted. In order
to construct the production budget we need the level of sales expected and the
desired levels of stock of finished goods. The following formula is used for
calculation of units to be produced.

Production = Sales + Closing stock - Opening stock

Production budget should be developed keeping in view the optimal,


balance between sales, inventories and production so as to result in minimum
cost. Once the production level is determined, it becomes the starring point for
the direct materials, direct labour and manufacturing overhead budgets.

2.

Plant Utilisation Budget

Plant utilisation budget is prepared for the estimation of plant capacity to


meet the budgeted production during the period considered under the budget"
For this purpose the plant capacity is expressed in terms of convenient units of
measurement like production in hours, production in weight (M.T./Kg.)
production in units etc. Budgeted machine load in each department should be
worked out. In case the budgeted plant utilisation is more than the plant
capacity the management may think of extra shift working, purchase of new
machinery, overtime working, sub-contracting etc. When the budgeted plant
utilisation in lesser than the plant capacity, management should consider the
ways to increase sales volume.

3.

Direct Materials Budget

The direct materials budget specifies the budgeted quantities of each raw
material required for the budgeted production. The requirement to purchase of
direct material can be calculated with the help of the following formula.
Purchases = Closing stock + Usage - Opening stock

The materials budget provides basis for fixing optimum levels of inventory
stocks, establishment of control over material usage and purchase cost budget.

4.

Direct Labour Budget

The direct labour budget will ensure that the plan will make the required
number of employees of relevant grades and suitable skills available at the right
times. It specifies the direct labour requirement, of various products as
envisaged in the production budget. The direct labour budget will be developed
for both direct labour hours and direct labour cost. After the labour
requirements relating to different grades are finalized, estimated rate per hour
and labour cost per unit is arrived at:

Illustration 1:

The

direct

labour

hour

requirements

of

three

of

the

products

manufactured in a factory, each involving more than one labour operation, are
estimated as follows:

Direct Labour Hour / per unit (in minutes)

Product

Operation
1
2
3

18
9

42
12
9

30
24
-

The factory works 8 hours per day, 6 days in a week. The budget quarter is
taken as 13 weeks and during a quarter, lost hours due to leave and holidays
and other causes are estimated to be 124.

The budgeted hourly rates for the workers manning the operations, 1, 2
and 3 are Rs.2.00, Rs.2.50 and Rs.300 respectively. The budgeted sales of the
product during the quarter are:

Product

1
2
3

9,000 units
15,000 units
12,000 units

There is a carry over of 5,000 units of Product 2 and 4,000 units of Product 3
and it is proposed to built up a stock at the end of the budget quarter as follows:

Product

1
3

1,000 units
2,000 units

Prepare a manpower budget for the quarter showing for each operation:
(i) Direct labour hours, (ii) Direct labour cost, and (iii) Number of workers.

Before preparing the quarterly manpower budget for 3 products operation-wise,


it is necessary to work out the following:

(a) Production budget, (b) Direct labour hours for each product operationwise, (c) Number of workers required for each operation.
(a) Production Budget for the quarter ending .....
Particulars

Product 1

Product 2

Product 3

Budgeted Sales (units)

9,000

15,000

12,000

Add: Stock to be (closing)

1,000

2,000

10,000

15,000

14,000

5,000

4,000

10,000

10,000

10,000

built up
Total
Less:

Carry- (opening)

over stock
Budgeted
Production
(b)

Direct Labour Hour for each Product (operation-wise)

Operation I
Particulars

Product 1

Product 2

. Product 3

Direct labour hrs. per unit

18

42

30

10,000

10,000

10,000

10,000 x 18
60

10,000 x 42
60

10,000 x 30
60

3,000 hrs.

7,000 hrs.

5,000 hrs.

(minutes)
Budget Production (units)

Direct labour hrs. required:

Total labour hours required for Operation I = 15,000 hours.


Operation II
Particulars

Product 1

Product 2

. Product 3

Direct labour hrs. per unit


(minutes)
Budget Production (units)

Direct labour hrs. required:

12

24

10,000

10,000

10,000

10,000 x 12
60

10,000 x 24
60

2,000 hrs.

4,000 hrs.

Total labour hours required for Operation II = 6,000 hours.

Operation III
Particulars

Product 1

Product 2

. Product 3

Direct labour hrs. per unit

10,000

10,000

10,000

(minutes)
Budget Production (units)

Direct labour hrs. required:

10,000 x 9
60

10,000 x 6
60

1,500 hrs.

1,000 hrs.

Total labour hours required for Operation III = 2,500 hours.

(c)

Number of Workers required for each Operation

Working hrs. of factory in a quarter = 13

624 hours

weeks x 6 days week x 8 hours a day

Less: Loss of hours due to leave, holidays

124 hours

and others causes

Total available hours per man

500 hours

Now, the requirements for manpower for each operation can be worked out.

Manpower Requirement:
Total direct labour hrs./ Total available hours required per man
a. Operation I
b. Operation II
c. Operation III

= 15,000/500
= 6,000/500
= 2,500/500

= 30 men
= 12 men
= 5 men

Now, manpower budget for the quarter can be prepared for the three products
and for each operation. The same is given below:

Operation

Hr.
rate
Rs.

2.00
2.50

II
III
Total

5.

3.00

Product I

D.I.
Hrs.

Cost
Rs.

3,000 6,000
-

1,500 4,500

Product II

D.L.
Hrs.
7,000

Cost
Rs.
14,000

Product 3

D.L.
Hrs.
5,000

Cost
Rs.

Total

D.L.
Hrs.

No. of
workers

Cost
Rs.

10,000 15,000 30,000

30

2,000

5,000 4,000 10,000

6,000

15,000

12

1,000

3,000

2,500

7,500

4,500 10,500 10,000

22,000 9,000 20,000 23,500 52,500

47

Manufacturing Expenses Budget

Manufacturing overhead refers to the aggregate' of factory indirect


material, indirect labour and indirect expenses which can be divided into fixed
and variable elements of manufacturing overhead. The fixed manufacturing
overhead will not vary with the change in the level of activity and it can be
estimated with a fair degree of accuracy. On the other hand, variable
manufacturing overhead per unit will be estimated and the total variable
manufacturing overhead will be determined with the help of the activity level.

Preparation of variable overhead budget is based on scheduled production and


operating conditions.

Illustration 2:

Gama Engineering Company Limited manufacturers two Products X and


Y. An estimate of the number of units expected to be sold in the first seven
months of 2001 is given below:

Months

Product X

Product Y

January

500

1,400

February

600

1,400

March

800

1,200

April

1,000

1,000

May

1,200

800

June

1,200

800

July

1,000

980

It is anticipated that:
(a)

There will be no work-in-progress at the end of any month;

(b)

Finished units equal to half the anticipated sales for the next month will
be in stock at the end of each month (including June 2001).

The budgeted production and production costs for the year ending 31 st June,
2001 are as follows:

Particulars

Product X

Product Y

(units)

11,000

12,000

Direct materials per unit

(Rs.)

12

19

Direct wages per unit

(Rs.)

Other manufacturing charges

(Rs.)

33,000

48,000

Production

apportionable to each type of

product

You are required to prepare:


(a)

Production budget showing the number of units to be manufactured


each month.

(b)

Summarised production cost budget for the 6 month-period


January to June 2001.

(a) Production Budget (for the 6 months ending 30th June, 2001)

(units)
Particulars

Jan. Feb.

March April

May

June

600

500

Product X
Closing Stock

300

400

500

Sales

500

600

800

600

800 1,000 1,300


Less: Opening Stock

250

300

400

Production (in units)

550

700

900

1,000 1,200

1,200

1,600 1,800

1,700

500

600

600

1,100 1,200

1,100

Product Y
Closing stock

700

Sales

600

500

400

400

450

1,400

1,400 1,200 1,000

800

800

2,100

2,000 1,700 1,400

1,200

1,250

500

400

400

900

800

850

Less: Opening Stock

700

Production (in units)

1,400

700

600

1,300 1,100

(b) Summarised Production Cost Budget (for the 6 months ending 30 th June,
2001) .
(Rs.)
Production

X-5,550 units
Unit
Cost

Total Cost

Y-6,350 units
Unit Cost

Total Cost

Direct materials

12

66,600

19

1,20,650

Direct wages

27,750

44,450

Manufacturing

16,650

25,400

20

1,11,000

30

charges
Total

1,90,500

Note: Manufacturing charges have been presumed to be variable costs in the


absence of any other information. They could, however be presumed to be fixed
charges also for the whole year. In such a case they will be taken as 50% of the
annual charges for the first six months in each case.

6.

Administrative Expenses Budget


Administrative expenses in an organisation will be incurred for the

following activities:
(a)

Formulation of policies,

(b)

Directing the organisation, and

(c)

Controlling the operations of an organisation etc.

The administrative expenses will not include those expenses which are
incurred for manufacturing, selling and distribution, R&D functions. The
administrative overheads are of a fixed nature and the change in the level of
activity will not bring any change in the administrative expenses incurred. Cm
study o behaviour of costs, if any administrative expenses are of variable or
semi-variable nature, those expenses can be budgeted with the Level of activity.

7.

Selling and Distribution Expense Budget


Selling expenses refers to expenses incurred relating tc the activities:
(a)

Creation and stimulation of demand of company's product, and

(b)

Secure orders.

Selling expenses include salesmen's salaries, commissions, expenses and


related administrative cost etc. Distribution expenses refers fo expenses incurred
relating to the following activities:
(a)

Maintaining and creating demand of product, and

(b)

Making the goods available in the hands of the customer.

Distribution expenses include transportation, freight charges, stock control,


warehousing etc.

Preparation of selling and distribution expense budget is based on the sales


budget. The selling and distribution expenditure can be estimated with the help
of flexible budgeting technique.

8.

Research and Development Budget

This will cover materials, equipment and suppliers, salaries, expenses and
other costs relating to design, development and technical research projects.

9.

Capital Expenditure Budget

The capital expenditure budget represents the expected expenditure on


fixed assets during the budget period. It is an outlay on assets that are required
and held for the purpose of generating income, e.g. plant and machinery, motor
vehicles, premises etc. It is a plan for capital expenditure, in monetary terms.
Capital

expenditure

may

be

incurred

for

expansion,

diversification,

modernisation plans. It relates to projects involving huge capital outlay and


long-term commitments. A capital expenditure budget must reveal following
information projectwise:

Original appropriation

Cumulative expenditure up-to-date

Unutilised appropriation

Fresh appropriation, and

Limit carried to next period

Programme

budgeting

technique

is

more

appropriate

for

capital

expenditure budgeting.

Capital expenditure authorisation is the formal authority to incur capital


expenditure which meets the criteria defined to achieve the results laid down
under a system of capital appraisal. Levels of authority must be clearly defined
and the reporting structure of actual expenditure through prior authorisation
on a formal proposal basis and monitoring as expenditure is incurred.

10.

Manpower Budget

Manpower budget will taken an overall view of the organisations needs for
manpower for all areas of activity - sales, manufacturing, administrative,
executive and so on for a period of years.

11.

Marketing Expenditure Budget

Marketing budget include estimated expenditure to be inquired for


advertising

promotional

activities,

public

relations,

marketing

research,

customer services etc. during the budget period.

12.

Capital Budget

Capital budget is concerned with the question of capacity and strategic


direction. This must deal with the evaluation of alternate dispositions of capital
funds as well as with the choice of the best capital structure.

PREPARATION OF MASTER BUDGET AND ITS IMPLEMENTATION

Master budget is a budget which is prepared from, and summarises the


functional budgets. It is a summary budget that incorporates the key figures
and totals of ail other budgets. The process in preparation of Master budget is
shown in the figure Budgetary Process (given at the beginning of this chapter).

The

Master budget

may

closely

reflect

two

dimension

of the

organisations:
(1)

Organisational Structure: All revenues and expenditures must be


attributed to the budget centre and managers responsible for
them. At the control stage, later, a system of responsibility
accounting reports must be built up to inform responsible
managers for the progress of that result against budgets.

(2)

Products

or

information

Programmes:
is

organised

In

this

to

show

dimension,
the

the

revenues,

budget
costs,

contributions, profits and levels of production/ sales activity for


each product or programme produced by, the organisation.

Negotiation of Budgets :

Budgets may be prepared in a top-down or bottom-up manner. In either


process, the budget will need to be negotiated by superiors, subordinates and by
different departments competing for the scarce resources. This process of
negotiation allows the exercise of both formal and informal power. Participation
in budgeting appears to lead to more positive attitude towards the budget and
greater acceptance of it.

Coordination and Review of Budget:

Incompatibility and inconsistency may arise because the budgeting


process, usually involves a number of different departments - e.g. sales,-

production, marketing and numerous senior and lower level managers. It should
be ensured that consistency is arrived at in finalisatcin of master budget.

Acceptance of Communication of Budgets :

After the master budget is accepted and agreed upon by all the levels of
organisational hierarchy, it will be passed on for implementation. It is essential
that each manager responsible for implementing the budget policy be informed
as to his responsibility.

Budget Monitoring:

It is important that the actual performance of each manager should be


regularly and frequently compared against budget targets in order to prevent it
from getting 'out of control' and in case of change in internal and external
business environment a revision of the budget may be necessitated.

CASH FLOW BUDGET

Cash flow budget is a detailed budget of income and cash expenditure


incorporating both revenue and capital items. The cash flow budget should be
prepared in the same format in which the actual position is to be presented. The
year's budget is usually phased into shorter periods for control, e.g. monthly or
quarterly. Cash budget is concerned with liquidity must reflect changes between
opening and closing debtor balances and between opening and closing creditor
balances as well as focusing attention on other inflows and outflows of cash.
The cash budget shows the cash flows arising from the operational budgets and
the profit and assets structure. A cash budget can be prepared in the following
ways:

1.

Receipts and Payments Method :

In this method all the expected receipts and payments for budget period
are considered. All the ash inflow and outflow of all functional budgets including
capital expenditure budgets are considered. Accruals and adjustments in
accounts will not affect the cash flow budget. All anticipated cash inflow is
added to the opening balance of cash and all ash payments are deducted from
this to arrive at the closing balance of cash. This method is commonly used in
business organisations.

2.

Adjusted Income Method :

In this method the annual cash flows are calculated by adjusting the sales
revenues and costing figures for delays in receipts and payments (changes in
debtors and creditors) and eliminating non-cash items such as Depreciation.

3.

Adjusted Balance Sheet Method :

In this method, the budgeted balance sheet is predicted by expressing


each type of assets and short-term liabilities as percentage of the expected
sales. The profit is also calculated as a percentage of sales, so that the increase
in owners equity can be forecast. Known adjustments, may be made to longterm liabilities and the balance sheet will then show if additional finance is
needed.

It is important to note that the capital budget will also be considered


while preparation of cash flow budget because the annual budget may disclose a
need for new capital investments and also, the costs and revenues of any new
projects coming on stream will need to be incorporated in the short-term
budgets. A number of additional financial statements, such as sources and
application of funds

statement

or schedules or loan

capital raising schedules may be produced.

service

payments or

Illustration 3:

Prepare a cash budget for the three months ending 30 th June, 2001 from
the information given below:
a.

(Rs.)
Month

Sales

Materials

Wages

Overheads

February

14,000

9,600

3,000

1,700

March

15,000

9,000

3,000

1,900

April

16,000

9,200

3,200

2,000

May

17,000

10;000

3,600

2,200

June

18,000

10,400

4,000

2,300

b.

Credit Terms:

Sales/ Debtor - 10% sales are on cash, 50% of the credit sales are collected next
month and the balance in the following month.

Creditors

Materials

2 months

Wages

month

Overheads

month

c.

Cash and bank balance on l" April, 2001 is expected to be Rs.6,000.

d.

Other relevant information is:


(i)

Plant and Machinery will be installed in February 2001 at a cost of


Rs.96,000. The monthly instalments of Rs.2,000 is payable from April
onwards.

(ii)

Dividend @ 5% on Preference Share Capital of Rs.2,00,000 will be paid


on 1st June.

(iii)

Advance to be received for sale of vehicles Rs.9,000 in June.

(iv)

Dividends from investments amounting to Rs. 1,000 are expected to be


received in June.

(v)

Income-tax (advance) to be paid in June, is Rs.2,000.

Working Notes:
Collection from Sales/ Debtors

Month

Calculation

April

May

June

February

(14,000-10% of 14,000) x 50%

6,300

March

(15,000-10% of 15,000) x 50%

6,750

6,750

April

10% of 16,000

1,600

(16,000-10% of 16,000) x 50%

7,200

7,200

10% of 17,000

1,700

(17,000-10% of 17,000) x 50%

7,650

10% of 18,000

1,800

May
June

14,650 15,650 16,650

Cash budget for the quarter April - June 2001


Particulars
1. Balance b/f
2. Receipts
Sales (Note 1)

April

May

June

Total

6,000

3,950

3,000

6,000

16,650

46,950

14,650 15,650

Dividend

1,000

1,000

Advanced against
vehicle

9,000

9,000

29,650

62,950

Total 20,650 19,600


3. Payment
Creditors*

9,600

9,000

9,200

27,800

Wages*

3,150

3,500

3,900

10,550

Overhead*

1,950

2,100

2,250

6,300

Capital Expenditure

2,000

2,000

2,000

6,000

Income tax advance

2,000

2,000

29,350

62,650

300

300

Total 16,700 16,600


4. Balance c/f

3,950

3,000

* Payments for creditors, wages and overhead have been computed on the same
pattern.

FLEXIBLE BUDGETING

Flexible budget is a budget which, by recognising the difference in


behaviour between fixed and variable costs in relation to fluctuations in output,
turnover, or other variable factors etc. It is designed to change in relation to the
level of activity actually attained.

A flexible budget is one that takes account of a range of possible volumes


It is sometimes referred to as a multi-volume budget. The range of possible
outputs may be known as the relevant range. 'Flexing' a budget takes place
when the original budget is deliberately amended to take account of change
activity levels.

The flexible budget is based on the fundamental difference in behaviour of


fixed costs, variable costs and semi-variable costs. Since fixed costs do not vary
with short-run fluctuations in activity it can be seen that the flexible budget will
really consist of two parts: The first is a fixed budget begin made up of fixed
costs and the fixed component of semi-variable costs. The second part is a truly
flexible budget that consists solely of variable costs.

Steps in Preparation
The steps involved in preparation of flexible budget are as follows:

Specify the time period that is used.

Classify all costs into fixed, variable and semi-variable categories.

Determine the types of standards that are to be used.

Analyse cost behaviour patterns in response to past levels of activity.

Build up the appropriate flexible budget for specified levels of activity.

Importance

Flexible budgets are important aids to decision making which help the
management in the following ways:

Flexible budget enable an organisation to predict its performance and


income levels at a given range of sales levels and activity levels. It can be
seen the impact of changes in sales and production levels on revenue,
expenses and ultimately income.

Flexible budgets enables more accurate assessment of managerial and


organisational performance.

Disadvantages

The procedure for drawing up a flexible budget is quite straight forward.


The flexed budget is only accurate, if costs behave in a predicted manner. All too
often assumptions are made about cost behaviour which are too simplistic and
hence do not reflect what actually happens.

Flexible budgets assume linearity of costs and therefore take no account


of, for example discounts for bulk purchases of materials Labour costs are
unlikely to behave in a linear fashion unless a piecework scheme is in
operation.

Such budgets also rely on the assumption of continuity when costs may
actually behave in a stepped or discontinue matter.

The method of determining the fixed and variable elements of costs is


often arbitrary and hence the flexed cost bear little relation to the correct
budgeted cost for the flexed level of activity.

Although flexed budgets tend to maintain fixed costs at the same level
whatever the level of output/ sales, very often fixed costs are actually
fixed only over a relevant output range.

Illustration 4:

ABC Ltd. Manufactures a single product for which market demand exists
for additional quantity. Present sale of Rs.60,000 per month utilised only 70%
capacity of the plant. Sales Manager assures that with a reduction of 10% in the
price he would be in a position to increase the sale by about 25% to 30%

The following data are available:

a) Selling price
b) Variable cost
c) Semi-variable cost
d) Fixed cost

Rs. 10 per unit


Rs.3 per unit
Rs.6,000 fixed plus Re.0.50 per unit
Rs.20,000 at present level estimated to be
Rs.24,000 as 80% output.

You are required to submit the following statements to the Board showing:
1.

The operating profits at 60%, 70% and 80% levels at current selling
price and at proposed selling price.

2.

The percentage increase in the present output which will be required to


maintain the present profit margin at the proposed selling price.

Statement of Operating Profit at different capacity levels at Current


Selling Price
(Rs.)
Capacity Levels Product and Sales

60%

70%

80%

(units)

6,000
60,000

7,000
70,000

8,000
80,000

Sales (@Rs. 10)

(A)

Costs:
Variable cost (@ Rs.3)

18,000

21,000

24,000

6,000

6,000

6,000

3,000

3,500

4,000

20,000
47,000

20,000
50,500

24,000
58,000

(A) - (B) 13,000

19,500

22,000

Semi-variable cost
Fixed component
Variable component (@ Re.0.50 per unit)
Fixed cost
Total cost

(B)

Profit

Statement of Operating Profit at different capacity levels at proposed


Selling Price

(Rs.)
Capacity Levels
Sales

(@ Rs.9)

60%

70%

80%

54,000 63,000 72,000

Less: Total cost

47,000 50,500 58,000


Profit

7,000 12,500 14,000

Calculation of Percentage Increase in present output for desired profit


(Rs. per unit)
Proposed selling price
Less: Variable cost
Contribution per unit

9.00
(Rs.3.00 + Re.0.50)

3.50
5.50
(Rs.)

Present Profit
Add: Fixed cost
Desired Contribution

Required Output

13,000
(Rs.20,000 + Rs.6,000)

26,000
39,000

Desired Contribution
Contribution per unit

Rs.39,000
Rs.5.50

= 7,091 units

Increase in Production required


= 7,091 units - 6,000 units

Percentage increase over present Output


=

1,091
6,000

x 100

= 18.18%

1,091 units

LESSON-14
CAPITAL BUDGETING
MEANING OF CAPITAL BUDGETING

Capital budgeting is the process of making investment decisions in the


capital expenditures. A progressive business firm always moves ahead, its fixed
assets and other resources continue to expand or there comes a need for
expanding them. Capital budgeting actually the process of making investment
decisions in capital expenditure, or fixed assets. A capital expenditure may be
as an expenditure the benefits of which are expected to be received over a period
of time exceeding one year. Capital expenditure is one which is intended to
benefit future periods and normally includes investments in fixed assets and
other development projects.

It is essentially a long-term function.

Capital

budgeting is also known as Investment Decision Making, Capital Expenditure


Decisions, Planning Capital Expenditure etc.

Capital budgeting is the most important and complicated problem of


managerial decisions. Because it is concerned with designing and carrying out
through a systematic investment programme. It involves the planning of such
expenditures which provide yields over a number of years.

Charles T Homgreen has defined capital budgeting as, "Capital budgeting


is long term planning for making and financing proposed capital outlays.

According to Philippatos, "Capital budgeting is concerned with the


allocation of the firm's scarce financial resources among the available market
opportunities. The consideration of investment opportunities involves the
comparison of the expected future streams of earnings from a project, with the
immediate and subsequent streams of expenditure for it".

Richard and Green have defined "Capital budgeting as acquiring inputs


with long-run return".

According to Lynch, "Capital budgeting consists in planning development


of available capital for the purpose of maximising the long-term profitability of
the concern"

Features of Investment Decisions:

Capita] budgeting decisions

Huge funds are invested in long-term asets.

The future benefits will occur to the firm over a series of years.

They involve the exchange of current funds for the benefits to be achieved
in future.

They have a significant effect on the profitability of the concerns.

They are 'strategic' investment decisions.

They are irreversible decisions.

Capital budgeting has a vital role to play in the broader process of strategic
planning and budgetary control. Capital budgeting systems should strive to
create an atmosphere which encourages the generation of new investment
proposals and evaluates them as accuracy as possible. However, loss-making
proposals must be identified at the earliest possible moment.

IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting means planning for capital assets. Capital budgeting


decisions are among the most crucial and critical business decisions. It is the
most important single area of decision-making for the management. Unsound
investment decision may prove to be fatal to the very existence of the concern.
The significance of capital budgeting arises mainly due to the following:

(1)

Large Investment:

Capital budgeting decisions, generally, involve large investment of funds.


The funds available with the firm are always limited and the demand for the
funds far exceeds the resources. These funds are raised by the firm from
various internal and external resources at substantial cost of capital. A wrong
decision prove disastrous for the continued survival of the firm. Hence it is very
important for a firm to plan and control its capital expenditure.

(2)

Long-Term Commitment of Funds:

The funds involved in capital expenditure are not only large but more or
less permanently blocked also in long-term investment. The longer the time, the
greater the risk involved. Greater the risk involved, greater is the need for
careful planning of capital expenditure, i.e. capital budgeting. The long-term
commitment of funds increases the financial risk involved in the investment
decision. Firm's decision to invest in long-term assets has a decisive influence
on the rate and direction of its growth. An unsound investment decision may
prove to, be fatal to the very existence of the firm. Hence a careful planning is
essential:

(3)

Irreversible in Nature :

Most investment decisions are irreversible. Once the decision for acquiring
a permanent asset is taken, it is very difficult to reverse that decision. It is

difficult to find a market of such capital goods once they have been acquired.
The only alternative will be to scrap the capital assets so purchased or sell them
at a substantial loss in the event of the decision being proved wrong.

(4)

Complicacies of Investment Decisions :

The long term investment decisions are more complicated in nature. The
capital budgeting decisions require an assessment of future events which are
uncertain. It is really a difficult task to estimate the probable future events. In
most projects the investment of funds has to be made immediately but the
returns are expected over a number of future years. Both returns as well as the
length of the period over which they will accrue are uncertain.

(5)

Long-term Effect on Profitability:


Capital budgeting decisions have a long-term and significant on the

profitability of a concern. Capital budgeting is of utmost importance to avoid


over-investment or under-investment

HI

fixed assets. An unwise decision may

prove disastrous and fatal to the very existence of the concern. The future
growth and profitability of the firm depends upon the investment decision taken
today. Capital expenditure projects exercise a great impact on the profitability of
the firm for a very long time.

(6)

National Importance:
Investment decision taken by individual concern is of national importance

because it determines employment, economic activities and economic growth.

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions to the


investment of current funds for the benefit to be achieved in future and the
future is always uncertain. A capital budgeting process may involve a number of

steps depending upon the size of the concern, nature of projects, their numbers,
complexities and diversities etc. That is, capital budgeting decisions of a firm
have a pervasive influence on the entire spectrum of entrepreneurial activities.
Hence they require a complex combination and knowledge of various disciplines
for their effective administration, such as economics, finance, mathematics,
economic forecasting, projection techniques and techniques of financial control.
In order to tie all these elements, a financial manager must keep in mind the
three dimensions of capital budgeting programme - policy, plan and programme.
These three Ps constitute a sound capital budgeting programme.

Quinin G David has suggested that (a) project generation, (b) project
evaluation, (c) Project selection and (d) project execution are the important steps
involved in a capital budgeting process. However, the following procedure may be
adopted in the process of capital budgeting.

(1)

Identification of Investment Proposals

Investment opportunities have to be identified or searched for: they do not


occur automatically. The capital budgeting process begins with the identification
of investment proposals. The first step in capital budgeting process is the
conception of a profit-making idea.

Investment proposals of various types may

originate at different levels within a firm, depending on their nature. They may
originate from the level of workers to top management level. Most of the
proposals, in the nature of cost reduction or replacement or process for product
improvement take place at plant level. The proposal for adding new product may
emanate from the marketing department or from plant manager who thinks of a
better way of utilizing idle capacity. Suggestions for replacing an old machine or
improving the production techniques may arise at the factory level. The
departmental head analyses the various proposals in the light of the corporate
strategies and submits suitable proposals to the capital expenditure planning
committee in case of large organisation or to the officers concerned with the
process of long-term investment decisions.

A continuous flow of profitable capital expenditure proposals is itself an


indications of a healthy and vital business concern. Although business may
pursue many goals, survivals and profitability are two of the most important
objectives.

(2) Screening the Proposals

Screening and selection procedures would differ from firm to firm. Each
proposal is then subjected to a preliminary screening process in order to assess
whether it is technically feasible; resources required are available and the
expected returns are adequate to compensate for the risk involved. In large
organisations, a capital expenditure planning committee is established for
screening for various proposals received from different departments. The
committee views these proposals from various angles to ensure that these are in
accordance with the corporate strategies or selection criterion of the firm and
also do not lead to departmental imbalances. All care must be taken in selecting
a criterion to judge the desirability of the projects. The criterion selected should
be a true measure of the investment project's profitability, and as far as
possible, it must be consistent with the firm's objective of maximising its market
value. This stage involves the comparison of the proposals with other projects
according to criteria of the firm. This is done either by financial manager or by a
capital expenditure planning committee. Such criteria should encompass the
supply and cost of capital and the expected returns from alternative investment
opportunities.

(3)

Evaluation of Various Proposals

The next step in the capital budgeting process is to evaluate the


profitability of various proposals. If a proposal satisfies the screening process, it
is then analysed in more detail by gathering technical, economic and other data.
Projects are also classified, for example, new products or expansion or
improvement and ranked within each classification with respect to profitability,
risk and degree of urgency. There are many methods which may be used for this
purpose such as pay back period method, rate of return method, net present
value method etc. All these methods of evaluating profitability of capital

investments proposals have been discussed in detail below. The various


proposals of investments may be classified as:
(a)

Mutually exclusive proposals

(b)

In-dependent proposals

(c)

Contingent proposals

Mutually Exclusive Proposals serve the same purpose and compete with
each other in a way that the acceptance of one precludes the acceptance of
other or others. Thus, two or more mutually exclusive proposals cannot both or
all be accepted. Some technique has to be used for selecting the better or the
best one. Once this is done, other alternative automatically gets eliminated. A
company may, for instance, propose to use semi-automatic machine or highly
automatic machine for production. Here choosing the highly automatic machine
precludes the acceptance of the semi-automatic machine.

Independent Proposals are those which do not compete with one


another and the same may be either accepted or rejected on the basis of
minimum return on investment required. For instance, when there are two
proposals, a firm can undertake both the proposals.

Contingent or Dependent Proposals are those whose acceptance


depends upon the acceptance of one or more other proposals. For instance, a
firm decides to build a factory in a remote area, it may have to invest in houses,
hospitals, roads etc. for the staff Thus, building a factory also requires
investment in facilities for employees. The total investment will be treated as asingle investment.

(4)

Establishing Priorities

After evaluation of various proposals, the unprofitable or uneconomic


proposals are rejected, the accepted proposals i.e. profitable proposals are put

in priority. It may not be possible for the firm to invest immediately in all the
acceptable proposals. Thus, it is essential to tank the various proposals and to
establish priorities after considering urgency, risk and profitability involved
therein.

(5)

Final Approval

Proposals finally recommended by the committee are sent to the top


management along with a detailed report, both of capital expenditures and of
sources of capital. Financial manager will present several alternative capital
budgets. When capital expenditure proposals are finally selected, funds are
allocated for them. Projects are then sent to the budget committee for
incorporating them in the capital budget.

(6)

Implementing Proposals

Preparation of a capital expenditure budgeting and incorporation of a


particular proposal in the budget does not itself authorise to go ahead with the
implementation of the project. A request for authority to spend the amount
should further be made to the capital expenditure committee which may like to
review the profitability of the project in the changed circumstances. Further,
while implementing the project, it is better to assign responsibilities for
completing the project within the given time frame and cost limit so as to avoid
unnecessary delays and cost over runs. Network techniques used in the project
management such as PERT and CPM can also be applied to control and monitor
the implementation of the projects.

(7)

Performance Review

Last but not the least important step in the capital budgeting process is
an evaluation of the performance of the project, after it has been fully
implemented. It is the duty of the top management or executive committee to

ensure that funds are spent in accordance with the allocation made in the
capital budget. A control over such capital expenditure is very much essential
and for that purpose a monthly report showing the amount allocated, amount
spent, amount approved but not spent should be prepared and submitted to the
controller. The evaluation is made through post completion audit by way of
comparison of actual expenditure on the project with the budgeted one, and
also by comparing the actual return from the investment with the anticipated
return. The unfavourable variances, if any, should be looked into and the causes
of the same be identified so that corrective action may be taken in future.

EVALUATION OF INVESTMENT PROPOSALS

The funds available with the firm are always limited and it is not possible
to invest funds in all the proposals at a time.

Therefore, it is very essential to

select from amongst the various competing proposals, those which give the
highest benefit. A firm may face a situation where more investment proposals
may be poor- The management has to select the most profitable project or to
take up the most profitable project first. There are many considerations,
economic as well as non-economic, which influence the capital budgeting
decisions. Because of the utmost importance of the capital budgeting decision, a
sound appraisal method should be adopted to measure the economic worth of
each investment project. Capital expenditures represent long-term commitment
in the sense that current investment yields benefits in future. The capital
expenditure decisions assume great importance for the future development of
the concern.

The important factor that influences the capital budgeting

decision is the profitability of the prospective investment. The risk involved in


the proposal cannot be ignored because profitability and risk are directly
related, that is, higher the profitability, the greater because profitability and risk
are directly related, that is, higher the profitability, the greater the risk and viceversa. The goal of financial management of a firm is the worth maximisation of
the firm, and in order to achieve this goal, the management must select those
projects which deserve first priority in terms of their profitability. While

evaluating, two basic principles are kept in mind, namely, the bigger benefits are
always preferable to small ones and that early benefits are always better than
the deferred ones.

The essential property of sound evaluation technique is that

it should maximise the shareholders' wealth. The following other characteristic


should also be possessed by a sound investment evaluation criterion:

(1)

It should provide a means of distinguishing between acceptable and


unacceptable projects

(2)

It should provide clear cut ranking of the projects in order of the


profitability or desirability.

(3)

It should also solve the problem of choosing among alternative projects.

(4)

It should be a criterion which is applicable to any conceivable


investment project.

(5)

It should emphasise upon early and bigger cash benefits in comparison


to distant and smaller benefits.

(6)

The method should be suitable according to the nature and size of


capital project to be evaluated.

METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSALS

A number of appraisal methods may be recommended for evaluating the


capital expenditure proposals. The most important and commonly used
methods are:
Traditional Methods:

1. Pay-back period Method or Pay-out or Pay-off Method


2. Improvements in Traditional Approach to Pay-back period Method.
3. Rate of Return Method or Accounting Method.

Time Adjusted Methods or Accounting Methods:


4. Net Present Value Method
5. Internal Rate of Return Method
6. Profitability Index Method.

TRADITIONAL METHODS
(1)

Pay-back Period Method

The term pay-back (or pay-out or pay-off or break-even period or


recoupment period) refers to the period in which the project will generate the
necessary cash to recoup the initial investment. Business units, while selecting
investment projects, would consider the recovery of cost as the first and
foremost concern even though earning maximum profits is their ultimate .goal.
This method describes in terms of period of time the relationship between
annual savings (cash inflow) and total amount of capital expenditure
(investment), payback period is defined as the number of years required for the
savings in costs or net cash inflow (after tax but before depreciation) to recoup
the original cost of the project In simple sentence, it represents the number of
years in which the investment is expected to "pay for itself. Under this method,
various investments are ranked according to the length of their pay-back period
in such a manner that the investment with a shorter pay-back period is
preferred to the one which has longer pay-back period.
Calculation of Pay-back Period
(a)

In the case of even cash inflows :

If the annual cash inflows are constant, the pay-back period can be
computed by dividing cash outlay (original investment) by annual cash inflows.
For instance, if a project requires Rs. 10,000 as initial investment and it will
generate an annual cash inflow of Rs.2,500 for ten years, the pay-back period
will be 4 years, calculated as follows:

Pay - back Period

(b)

Initial Investment
Annual Cash Inflow

Rs. 10,000
Rs. 2,500

= 4 years

In the case of uneven inflows :

If cash inflows are not uniform, the calculation of pay-back period takes a
cumulative form. In such a case the pay-back period can be found out by
adding up the figure of net cash inflows until the total is equal to initial
investment. For instance, if-a project requires an initial investment of Rs.
10,000 and the annual inflow for 5 years are Rs.3,000; Rs.4,000; Rs.2,500;
Rs.2,000 and Rs.2,000 respectively, the pay-back period will be calculated as
follows:

Year

Annual Cash

Cumulative Cash

1
2
3
4
5

Inflows
Rs.
3,000
4,000
2,500
2,000
2,000

Inflow
Rs.
3,000
7,000
9,500
11,500
13,500

The above workings show that in 3 years Rs.9,500 has been recovered.
Rs.500 is left out of in-tial investment. In the fourth year the cash inflow is
Rs.2,000. It means the pay-back period is between 3 to 4 years, calculated as
follows:
Rs.500
Pay - back Period = 3 years + Rs.2,000
= 3.25 years

Illustration 1: Payoff Ltd., is producing articles mostly by manual labour and is


considering to replace it by a new machine. There are two alternative models M
and N of the new machine. Prepare a statement of profitability showing the payback period from the following information:

Estimated life of machine


Cost of machine
Estimated savings in scrap
Estimated savings in direct wages
Additional cost of maintenance
Additional cost of supervision

Machine M
4 years
Rs.9,000
Rs.500
Rs. 6,000
Rs.800
Rs. 1,200

Machine N
5 years
Rs. 18,000
Rs.800
Rs. 8,000
Rs. 1,000
Rs. 1,800

Solution:
Statement showing annual cash inflows

Machine M Machine N Rs.


Rs.
500

800

Estimated savings in direct wages

6,000

8,000

Total savings (A)

6,500

8,800

800

1,000

Additional cost of supervision

1,200

1,800

Total additional cost (B)

2,000

2,800

New cash inflow (A) - (B)

4,500

6,000

Estimated savings in scrap

Additional cost of maintenance

Pay-back Period

Original Investment
Annual Average Cash Inflow
Rs.9,000
Rs.4,500 = 2 years

Rs.18,000
Rs.6,000

= 3 years

Machine M should be preferred because it has a shorter pay-back period.

Acceptance or Reject Criterion :

Many firms use the pay-back period as an accept or reject criterion as


well as a method of ranking projects. If the pay-back period calculated for a
project is less than the maximum pay-back period set by management, it would
be accepted; if not, it would be rejected. As a ranking method, it gives highest
ranking to the project which as shortest pay-back period and lowest ranking to
the project with highest pay-back period. Thus, if die firm has to choose among
two mutually exclusive projects, project with shorter pay-back period will be
selected.

Advantages of Pay-back Method :

1)

It is easy to calculate and simple to understand.

2)

It saves in cost, as it requires lesser times and labour as compared to


other methods.

3)

Under this method, a shorter pay-back period is preferred to the one


having a longer pay-back period, and it reduces the loss through
obsolescence and is more suited to the developing countries, like India,
which are in the process of development and have quick obsolescence.

4)

This method is useful to a concern which is short of cash and is eager to


get back the cash invested in a capital expenditure project.

5)

As the method considers the cash flows during the pay-back period of the
project, the estimates would be reliable and the result may be
comparatively more accurate.

Disadvantages of Pay-back Method :

(1)

It does not take into account the cash inflows earned after the pay-back
period and hence the true profitability of the project cannot be correctly
assessed.

(2)

This method does not consider the amount of profit earned on investment
after the recovery of cost of investment.

(3)

It does not take into consideration the cost of capital which is a very
important factor in making a sound investment decisions.

(4)

It may be difficult to determine the minimum acceptable pay-back period,


it is usually, a subjective decision.

(5)

It ignores interest factor which is considered to be a very significant factor


in taking sound investment decision.

(6)

Too much emphasis on the "liquidity of the investment", ignoring the


"profitability of investment" may not be justified in a number of situations.

(7)

It ignores time value of money. Cash flows received in different years are
treated equally.

(8)

It doe not take into account the life of the project, depreciation, scrapvalue, interest factor etc. Because, a rupee tomorrow is worthless than a
rupee today.

(2)

Improvement in Traditional Approach to Pay-back Period

One of the most commonly used techniques for evaluating capital


investment proposal is the cash pay-back method. Some authorities on
accountancy, in order to make up the deficiencies of the pay-back period
method, evolved new concepts. The improvements are discussed below:

(a)

Post Pay-back Profitability :

One of the limitations of the pay-back period method is that it neglects


the profitability of investment beyond the pay-back period. This method is also
known as Surplus Life over pay-back period. According to this method, the
project .Which gives the greatest post pay-back period profits may be accepted.
It has been explained in the following illustration:

Post pay-back profitability = Annual Cash Inflow (Estimated Life Pay-back Period)

Further, post pay-back profitability index can also be calculated by


multiplying the above formula with 100.

Illustration 2: A concern is considering two projects X and Y.

Following are

the particulars in respect of them:

Cost (Rs.)
Economic Life (in years)
Estimated Scrap (in Rs.)
Annual Savings

Project X
1,40,000
10
10,000
25,000

Project Y
1,40,000
10
14,000
20,000

Ignoring income-tax, recommend the best of these projects using (a) payback period, (b) post pay-back profit, and (c) index of post pay-back profit.
Solution:
Project X
1.

Cost

2.

Savings

3.

Pay-back period

4.

Economic Life

5.

Project Y

1,40,000

1,40,000

25,000

20,000

5.6 years

7 years

10 years

10 years

Surplus Life

4.4 years

3 years

6.

Post pay-back profit (2 x 5)

1,10,000

60000

7.

Index of post pay-back profit

1,10,000

60,000

1,40,000 x 100 1,40,000 x 100


= 78.6%
= 42.9%
Project X is the best one by all the methods of ranking.

(B)

Discounted Pay-back Period :


Another serious limitation of pay-back period method is that it ignores the

time value of money. This method can be improved or modified to consider the
time value of money. Under this method the present values of all cash outflows
and inflows are computed at an appropriate discount rate. The number of
periods taken in recovering the investment outlay on the present value basis is

called the discounted pay-back period. The present values of all inflows are
cumulated in order of time. The time period at which the cumulated present
value of cash inflow equals the present value of cash outflows is known as
discounted payback period.
Illustration 3: The following are the particulars relating to a project
Rs.
50,000

Cost of the project


Operating Savings:
1st year
2

nd

5,000

year

20,000

3rd year

30,000

4th year

30,000

5th year

10,000

Calculate (i) pay-back period ignoring interest factor and (ii) discount payback period taking into account interest factor at 10%.
Solution:
(i)

Pay-back period
Year

Annual

Cumulative

Savings Rs.
5,000

Savings Rs.
5,000

20,000

25,000

30,000

55,000

Upto second year, Rs.25,000 recovered


Therefore, pay-back period = 2 years +

Rs.50,000- Rs.25,000
Rs.30,000

Rs.25,000
= 2 + Rs.30,000
= 2 years 10 months
(ii)

Discounted Pay-back period at 10% interest factor

Years

Savings

PV Factor

Rs.

Discounted

Cumulative

Savings
Rs.

Discounted Savings
Rs.

5,000

0.9091

4,546

4,546

20,000

0.8265

16,530

21,076

30,000

0.7513

22,539

43,615

30,000

0.6830

20,490

64,105,

Discounted pay-back period

Rs. 50,000 - Rs.43,615


= 3 years +
Rs.20,490
= 3 years 4 months

(C)

Pay-back Reciprocal

Sometimes, pay-back reciprocal method is employed to estimate the


internal rate of return generated by a project.

Annual Cash Inflow


Pay-back Reciprocal = Total Investment
However, this method of ranking investment proposals should be used
only when:

(3)

Annual savings are even for the entire period.

The economic life of the project is at least twice of the pay-back

period.

Rate of Return Method (Accounting Method)

This method is also known as Accounting Rate of Return method or


Return on Investment of Average Rate of Return method. According to this
method, various projects are ranked in order of the rate of earnings or rate or
return. Projects which yield the highest earnings are selected and others are

ruled out. The return on investment can be expressed in several ways, as


follows:

(a)

Average Rate of Return Method

Here, average profit, after tax and depreciation, is calculated and then it is
divided by the total capital outlay or total investment in the project. This method
establishes the ratio between the average annual profits to total outlay.

Average Rate of Return =

Average Annual Profit


Outlay of the Project

x 100

Project giving a higher rate of return will be preferred over those giving lower
rate of return.

(b)

Return Per unit of Investment Method

In this method, the total profit after tax and depreciation is divided by the
total investment. This gives us the average rate of return per unit of amount
invested in the project.

Return per unit of Investment =

(c)

Total Profit
Net Investment

x 100

Return on Average Investment Method

Under this method the percentage return on average amount of


investment is calculated. To calculate the average investment, the outlay of the
project is divided by two.

Return on Average Investment =

Total Profit after deprec. & Taxes


Total Net Investment /2
x 100

(d)

Average Return on Average Investment Method

Under this method, average profit after depreciation and taxes is divided
by the average of amount of investment. This is an appropriate method of rate of
return on investment.
Average Annual
Net Investment / 2

Average Return on Average Investment =

x 100

Illustration 4: Calculate the average rate of return for projects A and B from the
following:
Project A
Rs.20,000
4 years

Investment
Expected Life (no salvage value)

Project B
Rs.30,000
5 years

Projected Net Income, after interest, depreciation and taxes:


Years
1
2
3
4
5
Total

Project A
Rs.
2,000
1,500
1,500
1,000
6,000

Project B
Rs.
3,000
3,000
2,000
1,000
1,000
10,000

If the required rate of return is 1 2% which project should be undertaken?

Solution:

Total profit, after interest,


depreciation and taxes
Expected Life
Average Profit
Investment

Project A

Project B

Rs.

Rs.

6,000

10,000

4 years

5 years

1,500

2,000

20,000

30,000

Average Rate of Return


Average Rate of Return

1-500

2,000

1,500

2,000

Average Return on

20,000 x 100 = 7.5%


1,500

30,000 x 100 = 6.6%


2,000

Average Investment

20,000/2 x 100 = 15% 30,000/2 x 100 = 13.33%

The average return on average investment is higher in the case of Project


A, besides it is also higher than the required rate of return of 12%. Project A is
suggested to be undertaken.
Merits of Rate of Return Method
The following are the merits:

It is simple to understand and easy to calculate.

It takes into consideration the total earnings from the project during its
life time. Thus this method gives a better view of profitability as compared
to pay-back period method.

It is based upon accounting concept of profit. It can be calculated from


the financial data.

Demerits of Rate of Return Method :


This method suffers from the following demerits:

It ignores the time value of money. Profits earned in different periods are
valued equally.

This method may not reveal true and fair view in the case of long-term
investments.

It does not take into consideration the cash flows which is more important
than the accounting profits.

It ignores the fact that profits can be reinvested.

There are different methods for calculating the Accounting Rate of Return.
Each method gives different results. This reduces the reliability of the
method.

TIME ADJUSTED METHOD (DISCOUNTED CASH FLOW METHOD)

Discounting is just opposite of compounding. In compound rate of


interest, the future value of the present money is ascertained whereas in
discounting, the present alue of future money is calculated. The rate at which
the future cash flows are reduced to their present value is termed as discount
rate. Discount rate, otherwise called time value of money, is some interest rate
which expresses the time preference for a particular future cash flow.

The discounted cash flow method is an improvement on the pay-back


method as well as accounting rate of return. This method is based on the fact
that future value of money will not be equal to the present value of money. That
is, discounted cash flow technique recognises that Re. one of today (cash
outflow) is worth more than Re. one received at a future date (cash inflow). Die
time adjusted or discounted cash flow method take into account the profitability
and also the time value of money. The discounted cash flow method for
evaluating capital investment proposals are of three types:

1.

Net Present Value Method

This method is also known as Excess Present Value or Net Gain Method or
Time Adjusted methods. Under this method, cash inflows and cash outflows
associated with each project are first worked out. The present values of these
cash inflows and outflows are then calculated at the rate acceptable to the
management. This rate of return is considered as the cut-off rate and is
generally determined on the basis of cost of capital suitably adjusted to allow for
the risk element involved in the project.

The present values of total of cash inflows should be compared with


present values of cash outflows. If the present value of cash inflows are greater
than (or equal to) the present value of cash outflows (or initial investment), the
project would be accepted. If it is less, then proposal will be rejected.

Illustration 5: A company is considering the purchase of the two machines


with the following details:

Machine I

Machine II

3 years
Rs.
10,000

3 years
Rs.
10,000

8,000
6,000
4,000

2,000
7,000
10,000

Life Estimated
Capital Cost
Net earning after tax:
1st year
2nd year
3rd year

You are required to suggest which machine should be preferred.

Solution:
Calculation of Net Present Value (10%)

Machine I
Year

PV Factor

0.909

Cash

Machine II

Present

Cash

Present

Inflow Rs. Value Rs. Inflow Rs. Value Rs.


8,000
7,272
2,000
1,818

0.826

6,000

4,956

7,000

5,782

0.751

4,000

3,004

10,000

7,510

Less: Cost Net Present Value

15,232

15,110

10,000

10,000

5,232

5,110

Machine I should be preferred as net present value is Rs.5,232 which is


higher than Rs.5,110 in case of Machine II.
Merits of Net Present Value Method
The merits of this method of evaluating investment proposal are as
follows:s

This method considers the entire economic life of the project.

It takes into account the objective of maximum profitability.

It recognises the time value of money.

This method can be applied where cash inflows are uneven.

It facilitates comparison between projects.

Demerits of this method are as follows:

It is not easy to determine an appropriate discount rate.

It involves a great deal of calculations.

It is more difficult to understand

and operate.

It is very difficult to forecast the economic life of any investment exactly.

It may not give good results while comparing projects with unequal
investment of funds.

2.

Internal Rate of Return Method

This method ^ popularly known as time adjusted rate of return method or


discounted rate of return method. The internal rate of return is defined as the
interest rate that equates the present value of the expected future receipts to the
cost of the investment outlay. This internal rate of return is found by trial and
error. First, we compute the present value of the cash-flows from an investment,
using an arbitrarily selected interest rate. Then, we compare the present value
so obtained with the investment cost.

If the present value is higher than the

cost figure, we try a higher rate of interest and go through the procedure again.
Conversely, if the present value is lower than the cost, lower the interest rate
and repeat the process.

The interest rate that brings about this equality is

defined as the internal rate of return. This rate of return is compared to the
cost of capital and the project having higher difference, if they are mutually
exclusive, is adopted and other one is rejected. As this determination of internal
rate of return involves a number of attempts to make the present value of

earnings equal to investment, this approach is also called the Trial and Error
Method.

Illustration 6: Initial Investment Rs.60,000


Life of the Asset
Estimated net annual cash-flows:
1st year

Rs. 15,000

2nd year

Rs.20,000

3rd year

Rs.30,000

4th year

Rs.20,000

Calculate Internal Rate of Return.

4 years

Solution:
Calculation of Internal Rate of Return
Annual

PVF

PVF

PVF

Cashflow
15,000

10%
0.909

13,635

12%
0.892

PV
14%
13,380 0.877 13,155

15%
0.869

13,035

20,000

0.856

16,520

0.797

15,940 0.769 15,380

-0.756

15,120

30,000

0.751

22,530

0.711

21,330 0.674 20,220

0.657

19,710

20,000

0.683

13,660

0.635

12,700 0.592 11,840

0.571

11,420

Year

PVF
PV

Total of PV of Cash inflow

PV

66,345

63,350

PV

60,595

59,285

Initial investment is Rs.60,000. Hence internal rate of return must be


between 14% and 15% (Rs.60,595 and Rs.59,285). The difference comes to Rs.
1.310 (Rs.60,595 - Rs.59,285).
For a difference of 1,310, difference in rate = 1%
(Excess PV: 60595-60,000=595)
595
Therefore, exact Internal Rate of Return = 14% +1,310 x 1%
= 14% + 0.45%

=14.45%
3.

Profitability Index Number

It is also a time adjusted method of evaluating the investment proposals.


Profitability index also called Benefit Cost Ratio or Desirability factor. It is the
ratio of the present value of cash inflows, at the required rate of return to the
initial cash outflow of the investment. The probability index is less than one. By

computing profitability indices for various projects, the financial manager can
rank them in order of their respective ratio of profitability.
PV of Cash Flows
Initial Cost Outlay

Profitability Index =

Illustration 7: The initial cash outlay of a project is Rs.50,000. Estimated cash


inflows:
1st year
2nd year
3rd year

Rs.20,000
Rs. 15,000
Rs.25,000

4th year

Rs. 10,000

Compute Profitability Index.

Solution:
Calculation of Profitability Index

Year

Cash Inflows

PV Factor at
10%

PV Rs.

Rs.
20,000

9.909

18,180

15,000

0.826

12,390

25,000

0.751

18,775

10,000

0.683

6,830

Total

56,175

Total Present Value


Less: Initial Outlay
Net Present Value

=
=
=

Profitability Index (gross)

Rs.56,175
Rs.50,000
6,175
PV Cash Inflow
Initial Cash Outflow
56,175
50,000

= 1.1235

Profitability index is higher than 1, the proposal can be accepted.

CAPITAL RATIONING

Capital

rationing is

a situation

where a firm

has more

investment

proposals than it can finance. Many concerns have limited funds. Therefore, all
profitable investment proposal may not be accepted at a time. In such event the
firm has to select from amongst the various competing proposals, those which
give the highest benefits.

There comes the problem of rationing them.

Thus

capital rationing may be defined as a situation where the management has more
profitable investment proposals requiring more amount of finance than the
funds available to the firm.

In such a situation, the firm has not only to select

profitable investment proposals but also to rank the projects from the highest to
lowest priority

Illustration 8: X Ltd. is considering the purchase of a machine. Two machines


are available, A and B. The cost of each machine is Rs.60,000. Each machine
has an expected life of 5 years. Net profits before tax but after depreciation
during the expected life of the machine are given below:
Year
1
2
3

Machine A
Rs.
15,000
20,000
2500

Machine B
Rs.
5,000
15,000
20,000

4
5

15,000
10,000

30,000
20,000

Following the method of return on investment ascertain which of the


alternates will be more profitable. The average rate of tax may be taken at 50%.

Solution :
Computation of profit after tax
year

Machine A
Machine B
Profit
Tax at
Profit
Profit
Tax at
Profit
before tax 50% after tax before tax 50% after tax

Rs.

Rs.

Rs.

_ Rs.

15,000

7,500

7,500

5,000

2,500

2,500

20,000

10,000

10,000

15,000

7,500

7,500

25,000

12,500

12,500

20,000

10,000

10,000

15,000

7,500

7,500

30,000

15,000

15,000

10,000

5,000

5,000

20,000

10,000

10,000

Total

85,000

42,500

42,500

90,000

45,000

45,000

Average profit
after tax

Machine A
Rs. 42,000
5 = Rs. 8,500

Investment

Average
Investment

Average Return on
Investment

Machine B
Rs. 45,000
5 = Rs. 9000

Rs. 60,000

Rs. 60,000
2 =

Rs. 60,000
Rs. 30,000

Rs. 8,500
60,000

Rs. 60,000

2 =

Rs. 30,000

Rs. 9,000
x 100 = Rs. 14.17%

60,000 x 100 = Rs. 15%

Average Return on
Average

Rs. 8,500
30,000

Rs. 9,000
x 100 = Rs. 28.34%

30,000

x 100 = Rs. 30%

Investment

Machine B is more profitable.

Illustration 9 : A Ltd. Company is considering the purchase of a new machine


which will carry out operations preformed by labour. X and Y are alternative
models. From the following information, you are required to prepare a
profitability statement and work out the pay-back period for each model.

Estimated Life
Cost of Machine
Cost of indirect materials
Estimated savings in scrap
Additional cost of maintenance
Estimated savings in direct
wages:
Employees not required
Wages per employee

Model X
Rs.
5 years
1,50,000
6,000
10,000
19,000

Model Y
Rs.
6 years
2,50,000
8,000
15,000
27,000

150
600

200
600

Taxation to be regarded 50% of profit before charging depreciation. Which model


you recommend ?

Solution:
Profitability Statement

Estimated saving per

Model X

Model Y (Rs)

(Rs)
10,000

15,000

90,000

1,35,000

1,00,000

1,35,000

year scrap

Wages (150x600)
(200x600)

Total Savings
Less: Additional Cost
Cost of indirect

8,000

materials 6,000
Cost of Maintenance
19,000
Additional Earnings
Less: Tax @ 50%
Cash flow (annual)
Less: Depreciation:

25,000
75,000
37,500
37,500
30,000

27,000

2,50,000 6

35,000
1,00,000
50,000
50,000
41,667

1,50,000 5
Net Increase in
earnings
Pay-back period:

7,500

8,333

1,50,000
37,500

2,50,000
= 4 years

50,000

= 5 years

Cost of Machine
Annual Cash Flow
7,500

8,300

1,50,000 x100 =

2,50,000 x100 = 3.3%

5%

A pay-back period of Model X is less than that of Model Y, ^nd also the
return on Investment is higher in respect of X, Model X is recommended.

Illustration 10: A company proposing to expand its production can go either


for an automatic machine costing Rs.2,24,000 with an estimated life of 5V2
years or an ordinary machine costing Rs.60,000 having an estimated life of 8
years.

The annual sales and

Automatic

Ordinary

Machine
Rs.

Machine
Rs.

costs
are estimated as follows:
Sales
1,50,000

1,50,000

Costs:
Materials

50,000

50,000

12,000
24,000

60,000
20,000

Labour
Variable Overhead

Compute the comparative profitability under pay-back method.

Solution:

Annual Sales

Automatic Machine

Ordinary Machine

Rs.

Rs.

1,50,000

1,50,000

Less: Variable Cost


Materials

50,000

50,000
Labour

60,000

12,000
Overheads 24,000

86,000

Marginal Profit

20,000

1,30,000

64,000
20,000

2,24,000

3 years

60,000

Pay-back period: 64,000

Post pay-back profitability

20,000

1 _

64,000 5 2
32
= Rs. 1,28,000

= 3 years

20,000 (8-5
yrs.)
= Rs. 1,00,000

Illustration 11: The Tamil Nadu Fertilizers Ltd. is considering a proposal for
the investment of Rs.5,00,000 on product development which is expected to
generate net cash inflows for 6 years as under:

Year
1
2
3
4
5
6

Net Cash Flows ('000)


Nil
100
160
240
300
600

The following are the present value factors @ 15% p.a.

Year
Factor

0.87

0.76

0.66

0.57

0.50

0.43

Solution:
Calculation of Net Present Value

Year

Cash Inflows

PV Factor

Present Values

1
2
3
4
5

('000) Rs.
Nil
100
160
240
300

0.87
0.76
0.66
0.57
0.50

('000) Rs.
Nil
76.0
105.60
136.80
150.00

600

0.43

258.00

Total
Less: Cash Outlay
Net Present Value

726.40
500.00
226.40

As the net present value is positive, the proposal is acceptable.

Illustration 12: The financial manager of a company has to advise the Board of
Directors on choosing between two compelling project proposals which require
an equal investment of Rs. 1,00,000 and are expected to generate cash flows as
under:

End of year

1
2
3
4
5
6

Project I
Rs.
48,000
32,000
20,000
Nil
24,000
12,000

Project II
Rs.
20,000
24,000
36,000
48,000
16,000
8,000

Which project proposal should be recommended and why? Assume the cost of
capital to be 10% p.a. The following are the present value factors at 10% p.a.

Year
Factor

0.909

0.826

0.751

0.683

0.621

0.564

Solution:
Calculation of Net Present Value
Year

Project I

Project II

PV

PV of

PV of

Net Cash

Net Cash

Factor

Project I

Project

Inflows
Rs.

Inflows
Rs.

@ 10%
Rs.

11
Rs.

48,000

20,000

9.909

43,632

18,130

32,000

24,000

0.826

26,432

19,8.24

20,000

36,000

0.751

15,020

27,036

Nil

48,000

0.683

Nil

32,784

24,000

16,000

0.62.1

14,904

9,936

12,000

8,000

0.564

6,768

4,512

Total 1,06,756
Less: Cash Outlay
Net Present Value

1,12,272

1,00,000

1,00,000

6,756

12,272

Project II should be accepted as the NPV is more than that of Project I.

Illustration 13: From the following information, calculate the net present value
of the two projects and suggest which of the two profits should be accepted
assuming a discount rate of 10%.

Profit X

Profit Y

Rs.

Rs.

Initial Investment

20,000

30,000

Estimated Life

5 years

5 years

1,000

2,000

Scrap Value

Profits before depreciation and after


taxes are as follows:

Year

Profit X

Profit Y

Rs.

Rs.

5,000

20,000

10,000

10,000

10,000

5,000

3,000

3,000

2,000

2,000

Solution :
PV of Re.1

Cash Flows

Year

1
2
3
4
5
6

Project X

Project Y

Rs.

Rs.

5,000

20,000

10,000
10,000

@10%

Present Value of Net


Cash Flow
Project X

Project Y

Rs.

Rs.

0.909

4,545

18,180

10,000
5,000

0.836
0.751

8,260
8,510

8,260
3,755

3,000
2,000

3,000
2,000

0.683
0.621

2,049
1,242

2,049
1,242

1,000

2,000

0.621

621
24,227
20,000
4,227

1,242
34,728
30,000
4,728

Project Y should be selected as NPV of Project Y is higher.

Illustration 14: A firm is considering the purchase of a machine. Two


machines A and B are available, each costing Rs.50,000. In comparing the
profitability of those machines a discount rate of 10% is to be used- Earnings
after taxation are expected to be as follows:
You are also given the following data:

Year

Machine A Cash

Machine B Cash

Inflow
Rs.

Inflow
Rs.

15,000

5,000

20,000

1 5,000

25,000

20,000

15,000

30,000

10,000

20,000

You are also given the following data :

year

PV Factor @ 10%

discount
1

0.909

0.826

0.751

0.683

0.621

Evaluate the projects using:


(a)

the pay-back period

(b)

the accounting rate of return

(c)

the net present value

(d)

the profitability index

Solution:
Year

Cash Inflow

Cumulative Cash

Rs.

Inflow
Rs.

15,000

15,000

20,000

35,000

25,000

60,000

15,000

75,000

10,000

85,000

The above calculation shows that in two years Rs.35,000 has been
recovered. Rs. 15,000 is left out of initial investment. In the 3 rd year cash inflow
is Rs.25,000. It means the pay-back period is between 2nd and 3 year, thus:

Pay-back Period = 2+

15,000
25,000 = 2.6 years

(b) Machine B
Year

Cash Inflow

Cumulative Cash

Inflow
Rs.

Rs.

5,000

5,000

15,000

20,000

20,000

40,000

30,000

70,000

20,000

90,000

In three years Rs.40,000 has been recovered. The balance left out of initial
investment is Rs. 10,000. It means the pay-back period is between 3 rd and 4th
year, thus:
Pay-back Period = 3+

10,000
30,000 = 3.33 years

Machine A should be purchased. Because pay-back period is less.


Accounting Rate of Return
Machine A
Total Returns

Rs.85,000

Average Return

Rs.85,000 5 = Rs.17,000

17,000
50,000

Average Rate of Return =

x 100 = 34%

Machine B
Total Returns

Rs.90,000

Average Return

Rs.90,000 5 = Rs.18,000

Average Rate of Return =

Net Present Value

18,000
50,000

x 100 = 36%

Calculation of Net Present Value

PV Factor Cash Inflows Cash Inflows

PV

PV

@ 10%
Rs.

Machine A
Rs.

Machine B

Machine B
Rs.

Machine A
Rs.

0.909

15,000

5,000

13,635

4.545

0,826

20,000

15,000

16,520

12,390

0.751

25,000

20,000

18,775

15,020

0.683

15,000

30,000

10,245

20,490

0.621

10,000

20,000

6,210

12,420

65,385

64,865

50,000

50,000

15,385

14,865

Total
Less: Cash Outlay
Net Present Value

The Net Present Value of Machine A is more than that of Machine B. So,
Machine A should be purchased.

Probability Index

Present Values
Machine A = Cost of Investment

65,385
=

50,000

= 1.308

64,865
Machine B = 50,000

= 1.297

Probability Index of Machine A is more than that of Machine B and


therefore, Machine A should be preferred.

LESSON - 15 : CASE STUDY


CASE-1
BUSINESS DECISION

Adams Company and Baker Company are in the same line of business
and both were recently organized, so it may be assumed that the recorded costs
for assets are close to extent market values. The balance sheets for the two
companies are as follows at July 31, 19

ADAMS COMPANY
Balance Sheet
July 31,19
Assets

Liabilities & Owner's

Cash

4,800

Equity
Liabilities:

Accounts

9,600

Notes payable (due in

62,400

43,200

receivable
Land

36,000

60 days)
Accounts payable

Building

60,000

Total liabilities

Office equipment

12,000

Owner's Equity
Ed Adams, capital

122,400

105,600
16,800
122,400

BAKER COMPANY
Balance Sheet
July 31,19 ___

Assets

Liabilities & Owner's

Cash

24,000

Equity
Liabilities:

Accounts

48,000

Notes payable (due in 60

receivable
Land
Building
Office equipment

7,200

days)
Accounts payable

12,000

Total liabilities

1,200

Owner's Equity
Ed Adams, capital

92,400

14,400

9,600
24,000
68,400

92,400

Questions :

(1)

Assume that you are a banker and that each company has applied to you
for a 90-day loan of $ 12,000. Which would you consider to be the more
favourable prospect?

(2)

Assume that you are an investor considering the purchase of one or both
of the companies. Both Ed Adams and Tom Baker have indicated to you
that they would consider selling their respective business. In either
transaction you would assume the existing liabilities. For which business
would you be willing to pay the higher price? Explain your answer fully. (It
is recognised that for either decision, additional information would be
useful, but you are to reach your decisions on the basis of the information
available).

CASE- 2

BUSINESS DECISION

Richard Fell, a college student with several summers' experience as a


guide on canoe camping trips, decided to go into business for himself. To start
his own guide service, Fell estimated that at least $ 4,800 cash would be
needed. On June 1, he borrowed $ 3,200 from his father and signed a threeyear note payable which stated that no interest would be charged. He deposited
this borrowed money along with $ 1,600 of his own savings in a business bank
account to begin a business known as Birchbark Canoe Trails. The $ '3,200
note payable is a liability of the business entity. Also on June I, Birchbark
Canoe Trails carried out the following transactions:
(i)

Bought a number of canoes at a total cost of $ 6,400, paid $ 1,600


cash and agreed to pay the balance within 60 days.

(ii)

Bought camping equipment at a cost of $ 3,200 payable in 60 days,

(iii)

Bought supplies for cash, $ 800.

After the close of the season on September 10, Fell asked another student,
Joseph Gallal, who had taken a course in accounting, to help him determine the
financial position of the business. ;

The only record Fell had maintained was a checkbook with memorandum
notes written on the check stubs. From this source Gallal discovered that Fell
had invested an additional $ 1,600 of his own savings in the business on July 1,
and also that the accounts payable arising from the purchase of the canoes and
camping equipment had been paid in full. A bank statement received from the
bank on September 10 showed a balance on deposit of $ 3,240.
Fell informed Gallal that he had deposited in the bank all cash received by the
business. He had also paid by check all bills immediately upon receipt;
consequently, as of September 10, all bills for the season had been paid.

The canoes and camping equipment were all in excellent condition at the
end of the season and Fell planned lo resume operations the following summer,
In fact he had already accepted reservations from many customers who wished
to return.

Gallai felt that some consideration should be given to the wear and

tear on the canoes and equipment but he agreed with Fell that for the present
purpose the canoes and equipment should be listed in the balance sheet at the
original cost. The supplies remaining on hand had cost $ 40 and Fell felt that he
could obtain a refund for this amount by returning them to the supplier.

Gallai suggested that two balance sheets be prepared, one to show the
condition of the business on June 1 and the other showing the condition on
September 10. He also recommended to Fell that a complete set of accounting
records be established.

Questions :

1.

Use the information in the first paragraph (including the three numbered
transactions) as a basis for preparing a balance sheet dated June 1.

2.

Prepare a balance sheet at September 10. (Because of the incomplete


information available, it is not possible to determine the amount of cash
at September 10, by adding cash receipts and deducting cash payments
throughout the season. The amount on deposit as reported by the bank
at September 10, is to be regarded as the total cash belonging to the
business at that date).

3.

By comparing the two balance sheets, compute the change in owner's


equity. Explain the sources of this change in owner's equity and state
whether you consider the business to be successful. Also comment on
the cash position at the beginning and end of the season. Has the cash
position improved significantly? Explain.

CASE-3
BUSINESS DECISION

Condensed comparative financial statements for Pacific Corporation


appear below:

PACIFIC CORPORATION
Comparative Balance Sheets
As of May 31
(in thousands of dollars)

Assets

Year 3 Year 2

Current assets
Plant

and

equipment

(net

depreciation)
Total assets

Year l

3,960

2,610

3,600

of 21,240 19,890

14,400

25,200 22,500

18,000

Liabilities & Stockholder's Equity


Current liabilities

2,214

2,052

1,800

Long-term liabilities

4,716

3,708

3,600

Capital stock ($10 par)


Retained earnings
Total
equity

liabilities

12,600 12,600
5,670

&

4,140

stockholder's 25,200 22,500

8,100
4,500
18,000

PACIFIC CORPORATION
Comparative Income Statements
For Years May 31
(in thousands of dollars)

Assets

Year 3

Year 2

Year l

Net sales

90,000

75,000

60,000

Cost of goods sold

58,500

46,500

36,000

Gross Profit on sales

31,500

28,500

24,000

Operating expenses

28,170

25,275

21,240

Income before income taxes

3,330

3,225

2,760

Income taxes

1,530

1,500

1,260

Net income

1,800

1,725

1,500

Cash dividends paid (plus 20% in

270

465

405

stock in Year 2)
Cash dividends per share

063

1.11

1.50

Questions ;
1.

Prepare a three-year comparative balance sheet in percentages rather


than dollars, using Year 1 as the base year.

2.

Prepare common size comparative income statements for the three-year


period, expressing all items as percentage components of net sales for
each year.

3.

Comment on the significant trends and relationships revealed by the


analytical computations in 1 and 2. These comments should cover
current assets and current liabilities, plant and equipment, capital
stock, retained earnings, and dividends.

4.

If the capital stock of this company were selling at $ 11.50 per share,
would you consider it to be overpriced, underpriced, or fairly priced?
Consider such factors as book value per share, earnings per share,
dividend yield, trend of sales and trend of the gross profit percentage.
Also consider the types of investors to whom the stock would be
attractive or unattractive.

CASE-4
BUSINESS DECISION

Combelt Cereal Company is engaged in manufacturing a breakfast cereal.


You are asked to advise management on sales policy for the coming year.

Two proposals are being considered by management which will" (i)


increase the volume of sales, (ii) reduce the ratio of selling expense to sales, and
(iii) decrease manufacturing cost per unit. These proposals are as follows:

Proposal No.1:

Increase advertising expenditures by offering premium

stamps

It is proposed that each package of cereal will contain premium stamps


which will be redeemed for cash prizes. The estimated cost of this premium plan
for a sales volume of over 500,000 boxes is estimated at $ 60 per 1,000 boxes
sold. The new advertising plan will take the place of all existing advertising
expenditures and the current selling price of 70 cents per unit will be
maintained.

Proposal No. 2 : Reduce selling price of product

It is proposed that the selling price of the cereal be reduced by 5% and


that advertising expenditures be increased over those of the current year. This
plan is an alternative to Proposal No.1, and only one will be adopted by
management.

Management has provided you with the following information as to the


current year's operations:

Quantity sold
Selling price per unit
Manufacturing cost per unit

500,000 boxes
$0.70
$0.40

Selling expenses, 20% of sales (one-fourth of which was for newspaper


advertising)

Administrative expenses, 6% of sales


Estimates for the coming year for each proposal are shown below:
Increase

in

unit

Proposal No. 1
sales 50%

Proposal No. 2
30%

volume
Decrease in manufacturing 10%

5%

cost per unit


Newspaper advertising
Other selling expenses
Premium plan expense
Administrative expenses

10% of sales
8% of sales
None
10% of sales

None
8% of sales
$ 0.06 per box
5% of sales

Questions:
1.

Which of the two proposals should management select?

2.

In support of your recommendation, prepare a statement comparing the


income from operations for the current year with the anticipated income
from operations for the coming year under Proposal No.l and under
Proposal No.2. In preparing the statement use the following column
headings:

Current Year

Proposal No. 1; and

Proposal No. 2

MODEL QUESTION PAPER


Paper 1.6: FINANCIAL AND MANAGEMENT ACCOUNTING
Time : 3 hours

Maximum Marks: 100

PART-A

(5x8= 40 marks)

Answer any Five questions


1.

What are the advantages of management accounting, how it differ from


financial accounting?

2.

What are the different types of errors, how this can be managed well?

3.

Describe the various accounting standards.

4.

What are the advantages and limitations of ratio analysis?

5.

State the difference between cash flow and fund flow statement.

6.

State the requisites for an effective budgetary control system.

7.

From the trial balance and the additional information of a public school,
prepare Income and Expenditure Account for the year ending December
31, 1998 and the Balance Sheet as at that date.

Trial Balance as at December 31, 1998


Amount

Building
Furniture
Library Books
16% Investments
(1-1-98)
Salaries
Stationery

General Expenses

Amount

(Dr.)
2,50,000 Admission Fees

Cr.)
5,000

40,000 Tuition Fees


60,000 Rent of Hall
2,00,000 Creditors

2,00,000
4,000
for

Books

Supplied
2,00,000 Miscellaneous Receipts
15,000 Annual

8,000

rant
Donations
library books

6,000

12,000

Government

1,40,000

Received for

25,000

Annual Sports Expense

6,000 Capital Fund

Cash

1,000

Bank

4,00,000

20,000 Interest on Investments

8,000

8,00,000

8,00,000

Additional Information:
1)

Tuition fees receivable for the year 1998 amounted to Rs. 10,000.

2)

Salaries payable for the year 1998 amounted to Rs. 12,000

3)

Furniture costing Rs. 10,000 was purchased on 1-7-1998.

Charge

depreciation on furniture @ 10% p.a.


4)

8.

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

A book keeper while preparing his trial balance finds that the debit
exceeds by Rs. 7,250. Being required to prepare the final account he
places the difference to a suspense account. In the next year the following
mistakes were discovered:

a)

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

b)

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

c)

A bill

receivable for Rs. 1,300

received

from

Krishna

has

been dishonoured on maturity but no entry passed;

d)

Salary of Rs. 550 paid to a clerk has been debited to his personal
account;

e)

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


account. Purchase account has been correctly debited;

f)

A sum of Rs. 2,250 written off as depreciation on furniture has


not been debited to depreciation account.

Draft the journal entries for rectifying the above mistakes and prepare the
suspense account and profit and loss adjustment account
Journal
a) Suspense A/c

Dr.

8,000

To Profit & Loss Adjustment A/c

8,000

(Being wrong recording of sales as purchase last


year rectified)
b) Drawings A/c

Dr.

2,500

To Profit & Loss Adjustment A/c

2,500

(Being Drawings made last year inadvertently


shown as repairs now rectified)
c) Krishna A/c

Dr.

1,300

To Bills Receivable A/c

1,300

(Being bill dishonoured last year now recorded in


the books)
d) To Profit & Loss Adjustment A/c

Dr.

650

650

To Clerk's Personal A/c


(Being salary paid to clerk last year inadvertently
shown in his personal account now rectified)
e) Suspense A/c
Dr.

1,500

To Raghubir A/c

1,500

(Being purchase from Raghubir )shown on debit


side of his account inadvertently now rectified
f) Profit & Loss Adjustment A/c
Dr
To Suspense A/c

2,250
2,250

(Being depreciation not shown last year


now rectified)

PART - B

(4 x 15 = 60 marks)

Answer any Four questions.


Question No. 15 is compulsory

9.

Data Ram maintains his records on single entry system. While records of
business takings and payments have been kept, these have not been
reconciled with cash in hand. From time to time cash has been paid into a
bank account and cheques thereon have been drawn both for business
use and private purposes. From the following information, prepare the
final accounts for the year 1998:

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

Stock
Bank Balance

1-1-1998
20,000
8,000

31-12-1998
15,000
12,000

Cash in hand

300

400

Debtors

14,000

20,000

Creditors

27,300

30,000

Investments

50,000

50,000

Other transactions are as follows:


Cash paid in bank
Private dividends paid into bank
Private payments out of bank
Business payments for goods out of bank
Cash takings
Payment for goods by cash and cheque
Wages

1,50,000
59,700
26,000
1,22,000
2,50,000
1,60,000
97,700

Delivery Expenses
Rent and rates
Lighting
General Expenses

7,000
2,000
1,000
4,600

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

10.

Following are summarised Balance Sheets of 'X' Ltd. as on 31 st December,


2000 and 2001. You are required to prepare a Funds Flow Statement for
the year ended 31st December, 2001.

Liabilities

Assets

2000

2001

Share Capital 1,00,000 1,25,000

Goodwill

2,500

General

25,000

30,000

Buildings 1,00,000

Reserve
P&L A/c

15,250

15,300

Plant

75,000

84,500

Bank Loan

35,000

67,600

Stock-

50,000

37,000

(Long-term)
Creditors

75,000

Debtors

40,000

32,100

17,500

Bank

4,000

Cash

250

300

Provision

2000

for 15,000

2001

95,000

Tax
2,65,250 2,55,400

2,65,250 2,55,400

Additional Information:

(i)

Dividend of Rs.11,500 was paid.

(ii)

Depreciation written off on plar.t Rs. 7,000 and on buildings Rs. 5,000.

(iii)

Provision for tax was made during the year Rs. 16,500.

11.

From the following Balance Sheets of Exe. Ltd. Make out the statement of
sources and uses of cash:

Liabilities

2000

2001

Assets

2000

2001
90,000

Equity Share

3,00,000 4,00,000 Goodwill

1,15,000

Capital
8% Redeemable

1.50.000 1,00,000 Land and

2,00,000 1,70,000

Preference Share

Buildings

Capital
General Reserve

40,000

Profit & Loss

30,000

Account
Proposed

42,000

Dividend
Creditors

55,000

Bill Payable

Provision for

70,000 Plant
48,00 Debtors

80,000 2,00,000
1,60,000 2,00,000

50,000 Stock

83,000. Bills

77,000 1,09,000

20,000

30,000

20,000

Receivable
16,000 Cash in

15,000

10,000

40,000

Hand
50,000 Cash at

10,000

8,000

Taxation

Bank
6,77,000 8,17,000

6,77,000 8,17,000

Additional info
(a)

Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant
and Land and Building respectively in 2001.

2.

(b)

An interim dividend of Rs. 20,000 has been paid in 2000,

(c)

Rs. 35,000 Income-tax was paid during the year 2001.

Gama Engineering Company Limited manufacturers two Products X and


Y. An estimate of the number of units expected to be sold in the firs; seven
months of 2001 is given below:

Months

Product X

Product Y

January
February

500
600

1,400
1,400

March

800

1,200

April
May

1,000
1,200

1,000
800

June
July

1,200
1,000

800
980

It is anticipated that:

(a)

There will be no work-in-progress at the end of any month;

(b)

Finished units equal to half the anticipated sales for the next month will
be in stock at the end of each month (including June 2001).

The budgeted production and production costs for the year ending 3l rt June,
2001 are as follows:

Particulars
Production
Direct materials per unit
Direct wages per unit
Other manufacturing charges

(Units)
(Rs.)
(Rs.)
(Rs.)

Product X
11,000
12
5
33,000

Product Y
12,000
19
7
48,000

apportionable to each type of


product
You are required to prepare:
a)

Production budget showing the number of units to be manufactured each


month.

b)

Summarised production cost budget for the 6 month-period January to


June 2001.

13.

A firm is considering the purchase of a machine. Two machines A and B


are available, each costing Rs.50,000. In comparing the profitability of
those machines a discount rate of 10% is to be used. Earnings after
taxation are expected to be as follows:

Year

Machine A cash

Machine B cash

1
2
3
4
5

Inflow
Rs.
15,000
20,000
25,000
15,000
10,000

Inflow
Rs.
5,000
15,000
20,000
30,000
20,000

You are also given the following data:

Year

PV Factor @ 10%

1
2
3
4
5
Evaluate the projects using :
(a)

the pay-back period

(b)

the accounting rate of return

(c)

the net present value

(d)

the profitability index

discount
0.909
0.826
0.751
0.683
0.621

14.

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

Liabilities

2000
Rs.

Equity capital

2001

Assets

Rs.

2000
Rs.

1,00,000 1,65,000 Fixed Assets

2001
Rs.

1,20,000 1,75,000

Pref. Capital

50,000

(Net)
75,000 Stock

Reserves

10,000

15,000 Debtors

50,000

62,500

P&L A/c

7,500

10,000 Bills

10,000

30,000

20,000

receivable
25,000 Cash at

20,000

26,500

10,000

Bank
12,500 Cash in

5,000

15,000

Creditors

Provision for
taxation
Proposed dividends

20,000

25,000

hand
7,500

12,500

2,30,000 3,40(000
2,30,000 3,40,000
Prepare a common size balance sheet and interpret the same.

15.

Attempt the following Case:

CASE: BUSINESS DECISION


Condensed comparative financial statements for appear below:

PACIFIC CORPORATION
Comparative Balance Sheets
As of May 31
(in thousands of dollars)

Assets
Current assets
Plant and equipment

(net

of

depreciation)
Total assets
Liabilities & Stockholder's Equity
Current liabilities
Long-term liabilities
Capital stock ($10 par)
Retained earnings
Total liabilities & stockholder's
equity

Year 3
$
3,960
21,240

Year 2
$
2,610
19,890

Year 1
$
3,600
14,400

25,200

22,500

18,000

2,214
4,716
12,600
5,670
25,200

2,052
3,708
12,600
4,140
22,500

1,800
3,600
8,100
4,500
18,000

PACIFIC CORPORATION
Comparative Income Statements
For Years May 31
(in thousands of dollars)

Assets
Net sales
Cost of goods sold
Gross Profit on sales
Operating expenses
Income before Income taxes
Income taxes
Net income
Cash dividends paid (plus 20% in
stock in Year 2)
Cash dividends per share

Year 3
$
90,000
58,500
31,500
28,170
3,330
1,530
1,800
270

Year 2
$
75,000
46,500
28,500
25,275
3,225
1,500
1,725
465

Year 1
$
$ 60,000
36,000
24,000
21,240
2,760
1,260
1,500
405

0.63

1.11

1.50

Questions:

1.

Prepare a three-year comparative balance sheet in percentages rather


than dollars, using Year 1 as the base year.

2.

Prepare common size comparative income statements for the three-year


period, expressing all items as percentage components of net sales for
each year,

3.

Comment on the -significant trends and relationships revealed by the


analytical computations in 1 and 2. These comments should cover
current assets and current liabilities, plant and equipment, capital
stock, retained earnings, and dividends.

4.

If the capital stock of this company were selling at $ 11.50 per share,
would you consider it to be overpriced, underpriced, or fairly priced?
Consider such factors as book value per share, earnings per share,

dividend yield, trend of sales and trend of the gross profit percentage.
Also consider the types of investors to whom the stock would be
attractive or unattractive.