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Unit - 1
Accounting
Defination
According
for
historical
function
and
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.
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.
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.
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.
LESSON
TITLE
1.
Accounting an Introduction
2.
Management Accounting
3.
4.
5.
6.
7.
Errors Management
8.
9.
10.
Ratio Analysis
11.
12.
13.
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;
lend
banks
and financial
information)
authorities)
formulate
fiscal
and
monetary
policies
(other
Government
department)
to
external
user
group
for
decision
making.
The
need
for
judgement
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
accounting.
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?
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.
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
Comparative statement
Financial position
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,
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.
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.
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.
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.
LESSON - 2
MANAGEMENT ACCOU NTING
process
as
"the
process
of
identification,
measurement,
Accounting
as
"the
provision
of
information
required
by
Formulation
of
short-term
operation
plans
(budgeting/
profit
making)".
the
system
of
reporting
that
is
linked
to
organisational
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
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.
to
monetary
information,
also
consists
non-monetary
Fianacial Accounting
Management
1. Governed by
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
6. Period
As appropriate
7. Main emphasis
Explanation
8. Speed
prepartion
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
Money
understandable
Somewhat technical
use
accountants
by
non-
LESSON - 3
THEORY BASE OF ACCOUNTING - ACCOUNTING STANDARDS
based
on
similar
accounting
procedures
and
policies
so
that
Such 'Creative
followed
for
many
aspects
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
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.
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
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.
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.
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:
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.
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:
basis
accounting,
(Accounting
Standard
'relating
to
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.
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:
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:
AS-5 (Revised) Net Profit or Loss for the Period, Prior hems and Changes in
Accounting Policies :
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.
depreciation rates or the useful lives of the asset, if they are different from
the principal rates specified in the statute governing the enterprise.
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.
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
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.
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.
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
LESSON-4
PRACTICAL BASE OF ACCOUNTING ORIGIN AND ANALYSIS OF BUSINESS
TRANSACTIONS
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.
Equality of assets on one hand and liabilities and capital on the other
hand is called basic accounting equation and is written as
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:
is provided by the
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
Purchased
building
for
Rs,2,00,000
and
paid
Rs.
10,000
cash
Furniture
(Rs.20,000)
(Rs.5,20,000)
Rs. 10,000)
+ Building
(Rs. 2,00,000)
-7,10,000
12.
= Rs.7,10,000
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
(Rs. 3,00,000)
+ Building
-7,10,000
= Rs.7,10,000
Capital
(Rs.5,20,000)
14.
Cash +
(Rs.1,90,000
Bank
(Rs. 3,00,000)
(Rs.1,90,000)
- Rs. 1,90,000)
+ Furniture
Capital
(Rs.5,20,000)
- Rs. 1,90,000)
+ Building
Rs. 5,20,000
15.
= Rs. 5,20,000
Business enterprise purchase goods worth Rs. 50,000 for cash and
Rs.20,000 on credit.
Cash
+ Bank
+ Stock of goods
(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.
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)
(Rs.20,000)
+ Capital
(Rs.5,20,000
- Rs.60,000) +
+ Building
(Rs.2,00,000)
Rs. 4,80,000
= Rs.4,80,000
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
1)
Assets Account
2)
Liability Account
3)
Capital Account
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
As these accounts record changes which affect capital account only, no separate
rule is required for recording changes in temporary accounts. For example:
i.
ii.
iii.
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
Analysis
Title and
Nature of
Account
Cash
Rule
Entry
Debit
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
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
decreases
Expenses
Credit cash
decrease in
asset
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.
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:
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)
Real Accounts:
Real Accounts relate to properties of a business enterprise which
can be tangible or intangible.
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.
Transactions
Analysis
Title and
Rule
Entry
Nature of
Introduction
Business
Account
Cash-Real
of
cash
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
gives
goes out
Building
cash
Building
purchased
comes in
Building Real
Building
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
paid
of Service of Salary
salary to an the
employee
the
Nominal
Debit
expenses
employee
utilized
Credit cash
Business
Credit what
goes out
for
service
utilized
of Building
Rent
building
due is
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.
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.
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:
Rs.
5,000
5,000
Rs.
6,500
Credit stock
Credit profit on sale
4,000
2,500
Rs.
5,000
5,000
6,500
6,500
Rs.
1,000
account)
Credit purchases (Asset / Real account)
1,000
Debit
closing
stock
(Asset
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
at the time of discounting of a bill of exchange for discounting future cash flow
to its present value etc.,
Debit purchases
Credit cash
Rs.
195 (Revenue A/C)
180
Credit Discount
15
A/C)
Allowed
Credit sales
195 (Revenue
A/C)
Received
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 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)
2. Cheques received are not crossed 'Account Payee '. Crossed cheques are
recorded in bank column directly.
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
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:
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.
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'. '
subdivided
in
three
categories
namely,
Factory;
Office
and
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:
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 A/c
Dr.
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.
Dr.
per AS-2, the inventory is valued at lower of cost or market price characterised
by the net realizable value.
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
institute
of Cost
and
Management
Illustration 1:
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
3,000
Dr.
Particulars
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:
= (1,10,000 + 10,000)
10,000
= Rs. 12
= Rs. 6,000
2. Factory Overheads
Indirect Factory wages
Other Factory overheads
= 40,000
= 30,000.
70,000
3.
Units
% of completion
Equivalent units
60 %
900
7,500
100 %
7,500
3,000
30 %
900
9,300
=
=
=
1,24,000***
85,000
70,000
2,79,000/9,300
Rs. 27,000
process
Value of finished goods
units
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
organisations
should
have
no
difficulty
in
preparing
financial
a)
b)
c)
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)
b)
c)
d)
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)
g)
h)
i)
j)
k)
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
Match Fund
Add
income
10,000
from
5,000
matches
15,000
12,000 3,000
n)
Dr.
Dr.
To Income A/c
For income received in advance
Income A/c
Dr.
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.
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
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.
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
Besides income and expenditure account and the balance sheet, financial
statements of non-profit organisations invariably include 'Receipts and Payment
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.
side
5)
6)
bank.
Itlis closed at the end of the year It is balanced at the end of the
7)
and
the
balance
carried
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
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
iii)
A balance sheet at the end of the period {i.e., closing balance sheet)
iv)
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
c)
1)
2)
3)
4)
When trial balance along with additional information is given and few
basic statements are to be prepared;
5)
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)
10)
Accounts of hospitals;
11)
Case I: When Receipt and Payment Account along with additional information is
given, and rest of the basic statements are to be prepared. '
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;
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.
a)
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.
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)
b)
c)
d)
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
LESSON - 7
ERRORS MANAGEMENT
Type of Errors
1.
2.
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.
4.
ERROR MANAGEMENT
The whole idea of error management can be executed in three steps, namely:i.
Prevention of errors,
ii.
The errors other than fraud are caused by the following reasons:
i)
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)
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)
e)
f)
If still the error is not locatable, recheck the totals of subsidiary books
and ensure they are properly transferred;
g)
h)
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.
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
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.
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
Dr.
Sales Account
Cr.
9,500
500
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
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
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)
b)
c)
d)
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
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
Dr 10,000
10,000
Dr. 5,000
5,000
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
Dr. 2,000
2,000
Dr. 1,000
1,000
Dr. 1,000
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
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)
d)
Salary of Rs. 650 paid to a clerk has been debited to his personal
account;
e)
f)
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
wrong
recording
of
sales
8,000
as
Dr. 2,500
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)
Dr. 650
650
Dr. 1,500
To Raghubir A/c
1,500
debit
side
of
his
account
Dr. 1,500
To Suspense A/c
(Being
1,500
depreciation
not
shown
last
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)
e, there is no uniformity in
b)
c)
this system. But, generally, cash book and personal accounts are
maintained under this system.
d)
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)
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)
c)
d)
e)
f)
g)
h)
ascertain profit, (or loss) and prepare financial position statement at accounting
date. Methods followed for this are a follows:
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)
(if
records
are
not
maintained).
Therefore,
information
b)
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)
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)
c)
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.
By Profit before
adjustment as shown in
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.
b)
c)
d)
Dr.
Cr.
To balance b/d
(Debtor in the beginning)
To Sales A/c
(Credit sales)
To Bills receivable A/c
(Bill dishonoured)
year)
Dr.
Cr.
To balance b/d
(Balance in the beginning)
To Debtors A/c
(Bills drawn during the year)
Dr.
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)
Dr.
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:
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%
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.
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
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
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
(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
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
1,56,600
2,000
1,000
4,600
7,000
20,000
1,56,600
1,56,600
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
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)
d)
c)
Cost : As complete records ore kept under double entry system, cost of
maintaining records is more in comparison to single entry system.
d)
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)
i)
under
single
entry
system
encourages
carelessness,
l) Suitable : Double entry system is suitable for all types of business. IS>
enTry system suits only small non-corporate enuues.
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.
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.
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.
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.
14.
15.
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.
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
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
xxx
xxx
xxx By Gross profit b/d
xxx By Miscellaneous Receipts
xxx
xxx
xxx
Expense
To Interest and financial
xxx
b/d
To Gross Profit c/d
expenses
To provision for Income-tax
To Net Profit c/d
To
To
To
To
xxx
xxx
xxx
xxx By Balance b/d
xxx (from previous year)
xxx By Net profit b/d
xxx
xxx
xxx
xxx
xxx
xxx
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
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,
Rs.
xxx
xxx
xxx
up capital
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
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
xxx
xxx
xxx
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
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
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
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
To
Particulars
transfer
Reserves
To Dividend
to
Rs.
xxx By
Particulars
Last
years
balance
xxx By Current Years net
Rs.
xxx
xxx
profit
(Transferred
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
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
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
Comparative Statements
Trend Analysis
Ration Analysis
The first three topics are covered in this chapter and the rest are
discussed in the subsequent chapters in detail.
ii.
iii.
iv.
v.
Percentage of totals.
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
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
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
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
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.
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
Amount (Rs.)
% to Total
ASSETS
Fixed Assets
Land
50,000
5.3
Buildings
1,10,000
11.7
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
2,50,000
26.6
1,00,000
10.6
General reserve
1,60,000
17.0
80,000
8.5
2,20,000
23.4
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
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
2000
2001
Net sales
Rs.
%
Rs.
%
16,000 100.00 20,000 100.00
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
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
30,000
Creditors
20,000
20,000
26,500
Provision
10,000
5,000
15,000
for taxation
Proposed
7,500
12,500
2,30,000
3,40,000
dividends
2,30,000 3,40,000
Solution;
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:
(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)
(2)
(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)
TREND ANALYSIS
In trend analysis ratios of different items are calculated for various
periods for comparison purpose.
be .done
by trend
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
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
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
Rs.
Rs.
Cash
200
240
160
100
120
80
Debtors
400
500
650
100
125
163
450
600
Other
Current
750
100
133
167
Assets
Total
100
130
137
100
125
125
Buildings
100
125
150
Plant
100
100
120
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.
CATEGORIES OF RATIOS
The ratio analysis is made under six broad categories as follows:
Profitability ratios
Activity ratios
Operating ratios
Debt-Equity Ratio
Proprietary Ratio
Dividend Cover
Interest Cover
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.
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.
Shareholders Equity
Total assets (tan gible)
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.
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.
Fixed Assets
Long - term Funds
6. Proprietor Ratio :
It express the relationship between net worth and total asset
Net worth
Total Assets
Net worth
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.
obligations.
most liquid of assets. It refers to the ability to pay in cash, the obligations that
-are due.
are:
(1) Current Ratio
(2) Quick Rarip
(3) Absolute Liquid Ratio
1. Current Ratio :
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:
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.
Current Liabilities
1. Inventory :
Sales
Average Inventory
Average inventory =
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
2. Debtors :
The three main debtor ratios are as follows:
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.
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.
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.
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
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:
The obvious generalisations that can be made about the ROI formula are that
any action is beneficial provided that it:
Boosts sales
xxx
xxx
xxx
A/c
Capital employed
xxx
xxx
xxx
xxx
xxx
xxx
(EBIT 1) (1 T)
N
(EBIT I ) (1 T) - DP
N
Where
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.
Sales
Sales
The ratio measures the gross profit margin on the total net sales made by
the company. The grosi, profit represents the excess of sales proceeds during
the
1 period
under
observation
over
their
cost,
before
taking
into
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.
(i)
Price cuts:
(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
(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)
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.
7. Return on Assets :
This ratio is calculated as follows:
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.
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.
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.
= MaterialsConsumed
X 100
Sales
2.
X 100
= Labour Cost Sales
Sales
3.
X 100
= Factory Expenses
Sales
4.
X 100
= Administrative Expenses
Sales
5.
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.
1.
2.
Dividend yield
3.
Book value
4.
Price/Earnings ratio
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.
This ratios measures the number of times the earnings of the latest year
at which the share price of a company is quoted.
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
with:
a norm or a target
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
Debt-equity ratio
(b)
Liquid ratio
(c)
(d)
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
30,000
1,00,000
1,50,000
1,50,000
70,000
= 0.47:1
1,50,000
Fixed Assets
Current Liabilities
Fixed Assets = 1,40,000
Cash
30,000
Stock
30,000
Debtors
30,000
Advances
10,000
1,00,000
1,40,000
= 1.4:1
1,00,000
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
1,40,000
1,30,000
= 1.08:1
Current ratio
(b)
Quick ratio
(c)
(d)
Operating ratio
(e)
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
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
4,00,000
30,80,000
9,20,000
6,80,000
2,40,000
1,20.000
1,20,000
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
Stock
4,80,000 Other
2,00,000
Current
20,000
Liabilities
Prepaid insurance
12,000
9,72,000
Current ratio
Liquid Assets
3,24,000
9,72,000
3:1
3,24,000
Current Liabilities
Liquid assets
(Rs.)
Cash Debtors
1,60,000
3,20,000
4,80,000
Liquid ratio =
4,80,000
= 1.48:1
3,24,000
= 7 times
4,40,000
X 100
= 30,80,000 + 6,80,000 + 40,00,000
40,00,000
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
34,000
Expenses
To Selling Expenses
3,000 By Interest
300
To Financial Expenses
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
Reserves
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
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
Operating expenses
Operating Ratio
= 51,000
= 19,500
= 51,000 + 19,500
= 82.94%
X 100
85,000
9,950 + 14,900
= 12,425
51,000
= 4.1 times
12,425
Net Profit
= 100
Net Sales
= 15,000
= 17.65%
= 100
85,000
= 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.
Rs.
Particulars
To Opening Stock
10,000 By Sales
To Purchases
50,000
1,15,000
To Administrative Expenses
1,00,000
15,000
1,15,000
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.
50,000
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
Average stock
Cost of goods sold
Opening Stock
Purchases
10,000
55,000
65,000
1 5,000
50,000
= 12,500
= 4 times
12,500
Current Assets
Current Assets
(Rs.)
Rs.
Current liabilities
Rs.
Stock
15,000 Creditors
25,000
Debtors
15,000
B/R
12,500
Cash at Bank
17,500
60,000
40,000
= 1.5:1
40,000
(b) Gross Profit Ratio = Gross Profit
X 100
= 50%
Net Sales
X 100
Net Sales
= 20%
= 20,000
1,00,000
= 100
Net Sales
Cost of goods sold = 50,000
Operating expenses
(Rs.)
15,000
12,000
27,000
Operating ratio
77 %
1,00,000
(Rs.)
Rs.
Current liabilities
17,500 Creditors
12,500 Bills Payable
15,000
45,000
Rs.
25,000
15,000
40,000
X 100
Total Assets
Shareholder's Furuis
(Rs.)
1,00,000
Rs. 1,60,000
20,000
1,20,000
= 75%
X 100
1,60.000
(ii)
(iii)
Return on investment
(i)
= 75%
= 60%
ROI = 20% x 2
= 40%
= 15% x 4
= 60%
Net Sales
A Ltd.
300
255
125
B Ltd.
1,500
1,200
750
C Ltd.
1,400
1,050
1,250
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.)
Operating Profit
Less: Interest on
Secured Loans @ 15%
25,00,000
3,75,000
1,25,000
5,00,000
20,00,000
10,00,000
10,00,000
2,50,000
Rs. 10,00,000
= Rs. 4
Rs. 2,50,000
= Rs. 50
P/E Ratio
= 12.50
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
10%
(ii)
(iii)
(iv)
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.200
= 14 times
Rs. 14.29
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.
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.
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
For preparation of funds flow statement, the whole iterrs of the sheet is
classified into the following four categories as shown in Table
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
XXX
Goodwill
XXX
Preliminary expenses
XXX
XXX
balance)
Total (A)
XXX
Total (A)
XXX
Total (A)
XXX
Trade Creditors
XXX
Inventories
XXX
Bank Overdraft
XXX
Trade Debtors
XXX
XXX
Bills Receivable
XXX
XXX
XXX
XXX
Investments Temporary)
XXX
Total (B)
Grand Total (A+B)
XXX
XXX
Total (B)
Grand Total (A+B)
XXX
XXX
General Rule
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.
Rs.
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
changes in w.c)
Total
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
changes in w.c)
Total
xxx
Sources
Rs.
Applications
Rs.
Issue of Debentures
capital
xxx Redemption of Debentures:
Raising
of
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.
Against each of
account, the figure pertaining to that account at the beginning and at the end of
the accounting period is 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:
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 :
SOURCES OF FUNDS
The funds inflow into the organisation will come from the following sources:
The difference
between these two items will be the amount of funds generated by the trading
operations.
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.
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.
APPLICATION OF FUNDS
1.
2.
3.
Distribution of Dividends
distributed to
the
dividends
4.
Illustration 1: Calculate funds from operations with the help of the following
Profit and Loss A/c.
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)
Rs. 2,500
2)
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
17,500
Particulars
To Dividend A/c
Rs.
Particulars
1,000 By Balance b/d
Rs.
5,000
(Opening balance)
(closing balance
6,000
11,000
Rs.
Particulars
7,500 By Balance b/d
Taxation
Rs.
50,000
(opening balance)
A/c
To proposed Dividend
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
A machine costing Rs. 20,000 was purchased during the year by issue of
equity shares.
(ii)
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.
3,000 By
Funds
25,000
from
(i)
28,000
53,000
(ii)
(iii)
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.
Particulars
To Machinery A/c
Rs.
Particulars
Rs.
4,24,000
(Depn.
of sold Machine)
To Closing balance c/d
27,000
4,51,000
Illustration 8 :
Extracts from Balance Sheets
Particulars
As on 31st
As on 31st March
March,
2001
2000
Rs.
4,00,000
2,00,000
Rs.
5,00,000
1,50,000
Additional Information :
(i)
(ii)
Particulars
Rs.
To Machinery A/c
Particulars
Rs.
4,24,000
(Depn.
of sold Machine)
To Closing balance c/d
27,000
4,51,000
Rs.
Particulars
Rs.
4,00,000
By Machinery A/c
50,000
By Cash-Issue (balancing
50,000
figure)
5,00,000
5,00,000
Rs.
Particulars
To cash (Application)
To Balance c/d
Rs.
2,00,000
50,000
figure)
2,50,000
1.
2,50,000
2.
3.
4.
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
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
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
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)
(ii)
(iii)
Provision for tax was made during the year Rs. 16,500.
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
15,250 73,400
8,150
58,150
Capital
73,400 73,400
79,050
79,050
Sources
Application
Rs.
Funds from
45,050
Purchase of Plant
16,500
operations
Issue of Shares
25,000
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
Rs.
30,000
Particulars
By Balance b/d
By P&L a/c
Rs.
25,000
5,000
30,000
30,000
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
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
Rs.
Particulars
1,00,000
By
Depreciation
Rs.
5,000
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
5,000
16,500
11,500
5,000
7,000
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
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
13,200
30,400
balances
3,11,200 3,11,600
3,11,200 3,11,600
Additional Information:
(i)
(ii)
(iii)
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
Increase in Working
14,000
14,000
Capital
1,08,000
1,08,000
27,600
27,600
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
14,000
72,000
72,000
Working Notes:
Provision for Taxation A/c
Particulars
Rs.
Particulars
Rs:
To Balance c/d
32,000
To Balance c/d
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
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
Rs.
22,000
To Bank (Purchase)
2,000
22,000
22,000
Non-fund
operating
Rs.
and
items
Nonalready
Particulars
Rs.
By Balance on (31-12-200)
32,000
72,000
8,000
38,000
Depreciation on Plant
8,000
Depreciation on Buildings
8,000
Interim dividend
16,000
26,000
1,04,000
1,04,000
Rs.
Particulars
Rs.
36,000
By Balance
28,000
By P&L a/c
8,000
36,000
36,000
2000
Share Capital
4,00,000
General
80,000
Reserve
P&L A/c
64,000
2001
Assets
2000
2001
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
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)
(iii)
(iv)
(v)
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
Sale of Machinery
Buildings
76,000 Bank Loan paid
Funds from
operations
Decrease
in
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
60,000
To Balance b/d
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.
24,000
By
Sale
of
Machinery
By Balance c/d
76,000
2,60,000
3,60,000
3,60,000
Rs.
To Balance b/d
Particulars
Rs.
45,000
To Share Capital
To Cash
75,000
5,25,000
4,80,000
5,25,000
Rs.
To Balance c/d
Particulars
Rs.
80,000
60,000
1,40,000
1,40,000
Rs.
To Machinery
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
2.
3.
4.
Type of Data Used: The Funds Flow Statement takes into account only
the funds available from trading operations but also the funds
available from other sources like issue of share capital/ debentures,
sale of fixed assets etc. Whereas, the Profit and Loss Account uses
only
income
and
expenditure
transactions
relating
to
trading
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.
Following are the main difference between a Funds Flow Statement and a
Balance Sheet.
1.
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.
4.
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.
(1)
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)
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)
(4)
(5)
(6)
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 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.
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.
The cash flow statement during a period is classified into three main categories
of cash inflows and cash outflows:
Cash receipts from the sale of goods and the rendering of services
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
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 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)
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 debentures, loans notes, bonds and other
short-term borrowing
Payment of dividend
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.
Cash Flow Statement of XYZ Ltd. for the year ending 31" March 2001
Source
Opening Balances
Rs.
Application
Opening Balances
Cash
Bank
Cash Inflows
Rs.
Redemption of Redeemable
XXX
Preference Shares
XXX Redemption of Debentures
XXX
Issue of Shares
XXX
XXX
XXX
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 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 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
70,000
2,000
Increase in Creditors
3,000
5,000
75,000
5,000
7,000
5,000
17,000
58,000
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
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
50,000
8,000
200
Increase in Creditors
10,000
Depreciation
8,000
Goodwill
6,000
32,200
82,200
6,000
1,000
40,000
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
1,20,000
1,35,000
75,000
99,000
4,20,000
4,77,000
Land
4,20,000
4,77,000
Rs.
Application
Rs.
24,000
75,000 Decrease
37,500
Cash
Creditors
19,500 Closing balance
Operating
Profit
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
400
340
140 Plant
160
400
320
400
154
218
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
80
20
16
Total
1354 1634
1354 1634
Additional information:
1)
2)
3)
1. Plant Account
Particulars
Particulars
Rs.
20,000
on 1-1-2001
To Purchases-cash
Rs.
4,00,000
on 31-12-2001
4,20,000
2.
4,20,000
Particulars
Rs.
Particulars
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
Cash
Rs.
Particulars
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
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
50,000
20,000
40,000
1,10,000
4,36,000
56,000
4,92,000
80,000
64,000
20,000
1,64,000
3,28,000
8,000
3,20,000
Rs.
Cash out-flows
Rs.
2,60,000
84,000
40,000
dividend
Income-tax paid
70,000
Operations
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
Rs.
1,00,000
40,000
1,40,000
To General Expenses
To Depreciation
To Taxes
8,000
4,000
4,000
27,000
1,40,000
27,000
27,000
To Dividend
7,000
To Balance c/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
91,000
49,000
99,000
99,000
Rs. Particulars
By Balance b/d
1 ,000
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
16,000
Rs.
Funds from Operations
16,000
25,000
41,000
15,000
Increase in Inventory
25,000
2,000
42,000
1,000
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
1,20,000
1,60,000
Sundry creditors
60,000
50,000
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
60,000
44,000
24,000
8,000
Increase in Stock
58,000
Increase in debtors
20,000
Decrease in creditors
10,000
40,000
2,64,000
2,64,000
Working Notes:
Fixed Assets a/c
Particulars
Rs.
To Balance
Particulars
Rs.
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.
16,000
To Bank
50,000
(Balancing figure)
94,000
16,000
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
Rs.
Particulars
Rs.
To Bank
24,000
To Balance c/d
30,000
54,000
54,000
1,60,000
Non-cash
and
non-operating
6,000
34,000
54,000
94,000
2,54,000
items
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
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
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
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.
Working Notes:
(i) Adjusted Profit & Loss account
Particulars
Rs.
To Depreciation on
plant
To Depreciation
Particulars
to
20,000 By
buildings
Funds
Rs.
30,000
from
2,18,000
operations
(balancing figure)
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)
2,48,000
Particulars
Rs.
Particulars
Rs.
To Bank
40,000
To Balance c/d
45,000
85,000
85,000
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
Rs.
To Balance b/d
Particulars
80,000 By Depreciation
To Bank (purchase)
Rs.
10,000
2,00,000
2,10,000
2,10,000
2,18,000
28,000
2,46,000
4,000
40,000
32,000
10,000
86,000
1,60,000
Cash flow statement for the year ending 31st December 2001
Cash Balance as on 11-2001
Cash in hand
1 5,000 Redemption
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
1,30,000
4,000
40,000
Increase in stock
32,000
Increase in B/R
10,000
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
Cash Flow Statement for the year ending 31st December 2001
Sources
Rs.
Applications
Rs.
Cash inflows:
Building Purchased
Sale of Machinery
5,000
Sale of Land
12,000
Increase in creditors
15,000
4,000 Goodwill
10,000
10,000 Drawings
27,000
Decrease in stock
50,000
17,000
1,36,000
1,36,000
Machinery a/c
Sources
To Balance b/d
To Bank (Purchase)
Rs.
Applications
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
Rs.
Particulars
15,000 By Balance c/d
50,000
65,000
Rs.
65,000
65,000
Rs.
Particulars
4,000 By Balance c/d
50,000 By P & L a/c
54,000
Rs.
35,000
19,000
54,000
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
Rs.
1,25,000
55,000
1,80,000
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.
Supplemental
to
funds
flow
statement
Cash
flow
analysis
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.
takes into account both cash as well as non-cash items. Hence net cash
flow does not necessarily mean net income of the business.
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
BUDGETING
BUDGETARY CONTROL
Budgetary
control
is
the
establishment
of
budgets
relating
the
Advantages of Budgeting
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
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
(i)
(ii)
As with all types of budgets the game of 'beating the system' may take
more energy factor in last year.
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.
objectives
before
the
managers
start
for
budgeting
the
2.
3.
4.
5.
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.
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.
6.
managers
is
essential
for
satisfactory
formulation
and
To review and advise on the general policies affecting more than one
function.
7.
(a)
(b)
(c)
(d)
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.
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.
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.
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
2.
3.
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.
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:
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.
(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
9,000
15,000
12,000
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)
Operation I
Particulars
Product 1
Product 2
. Product 3
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)
Product 1
Product 2
. Product 3
12
24
10,000
10,000
10,000
10,000 x 12
60
10,000 x 24
60
2,000 hrs.
4,000 hrs.
Operation III
Particulars
Product 1
Product 2
. Product 3
10,000
10,000
10,000
(minutes)
Budget Production (units)
10,000 x 9
60
10,000 x 6
60
1,500 hrs.
1,000 hrs.
(c)
624 hours
124 hours
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.
30
2,000
6,000
15,000
12
1,000
3,000
2,500
7,500
47
Illustration 2:
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)
(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
(Rs.)
12
19
(Rs.)
(Rs.)
33,000
48,000
Production
product
(b)
(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
250
300
400
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
800
800
2,100
1,200
1,250
500
400
400
900
800
850
700
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
6.
following activities:
(a)
Formulation of policies,
(b)
(c)
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.
(b)
Secure orders.
(b)
8.
This will cover materials, equipment and suppliers, salaries, expenses and
other costs relating to design, development and technical research projects.
9.
expenditure
may
be
incurred
for
expansion,
diversification,
Original appropriation
Unutilised appropriation
Programme
budgeting
technique
is
more
appropriate
for
capital
expenditure budgeting.
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.
promotional
activities,
public
relations,
marketing
research,
12.
Capital Budget
The
Master budget
may
closely
reflect
two
dimension
of the
organisations:
(1)
(2)
Products
or
information
Programmes:
is
organised
In
this
to
show
dimension,
the
the
revenues,
budget
costs,
Negotiation of Budgets :
production, marketing and numerous senior and lower level managers. It should
be ensured that consistency is arrived at in finalisatcin of master budget.
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:
1.
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.
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.
statement
or schedules or loan
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.
d.
(ii)
(iii)
(iv)
(v)
Working Notes:
Collection from Sales/ Debtors
Month
Calculation
April
May
June
February
6,300
March
6,750
6,750
April
10% of 16,000
1,600
7,200
7,200
10% of 17,000
1,700
7,650
10% of 18,000
1,800
May
June
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
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
2,000
2,000
29,350
62,650
300
300
3,950
3,000
* Payments for creditors, wages and overhead have been computed on the same
pattern.
FLEXIBLE BUDGETING
Steps in Preparation
The steps involved in preparation of flexible budget are as follows:
Importance
Flexible budgets are important aids to decision making which help the
management in the following ways:
Disadvantages
Such budgets also rely on the assumption of continuity when costs may
actually behave in a stepped or discontinue matter.
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%
a) Selling price
b) Variable cost
c) Semi-variable cost
d) Fixed cost
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.
60%
70%
80%
(units)
6,000
60,000
7,000
70,000
8,000
80,000
(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
19,500
22,000
Semi-variable cost
Fixed component
Variable component (@ Re.0.50 per unit)
Fixed cost
Total cost
(B)
Profit
(Rs.)
Capacity Levels
Sales
(@ Rs.9)
60%
70%
80%
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
1,091
6,000
x 100
= 18.18%
1,091 units
LESSON-14
CAPITAL BUDGETING
MEANING OF CAPITAL BUDGETING
Capital
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.
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.
(1)
Large Investment:
(2)
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)
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)
HI
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
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)
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.
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)
(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.
(4)
Establishing Priorities
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
(6)
Implementing Proposals
(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.
The funds available with the firm are always limited and it is not possible
to invest funds in all the proposals at a time.
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.
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.
(1)
(2)
(3)
(4)
(5)
(6)
TRADITIONAL METHODS
(1)
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:
(b)
Initial Investment
Annual Cash Inflow
Rs. 10,000
Rs. 2,500
= 4 years
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
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
800
6,000
8,000
6,500
8,800
800
1,000
1,200
1,800
2,000
2,800
4,500
6,000
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
1)
2)
3)
4)
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.
(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)
(5)
(6)
(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)
(a)
Post pay-back profitability = Annual Cash Inflow (Estimated Life Pay-back Period)
Following are
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.
1,10,000
60000
7.
1,10,000
60,000
(B)
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
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
Rs.50,000- Rs.25,000
Rs.30,000
Rs.25,000
= 2 + Rs.30,000
= 2 years 10 months
(ii)
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,
(C)
Pay-back Reciprocal
(3)
period.
(a)
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.
x 100
Project giving a higher rate of return will be preferred over those giving lower
rate of return.
(b)
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.
(c)
Total Profit
Net Investment
x 100
(d)
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
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
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
Solution:
Project A
Project B
Rs.
Rs.
6,000
10,000
4 years
5 years
1,500
2,000
20,000
30,000
1-500
2,000
1,500
2,000
Average Return on
Average Investment
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 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.
There are different methods for calculating the Accounting Rate of Return.
Each method gives different results. This reduces the reliability of the
method.
1.
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.
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
Solution:
Calculation of Net Present Value (10%)
Machine I
Year
PV Factor
0.909
Cash
Machine II
Present
Cash
Present
0.826
6,000
4,956
7,000
5,782
0.751
4,000
3,004
10,000
7,510
15,232
15,110
10,000
10,000
5,232
5,110
and operate.
It may not give good results while comparing projects with unequal
investment of funds.
2.
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.
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.
Rs. 15,000
2nd year
Rs.20,000
3rd year
Rs.30,000
4th year
Rs.20,000
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
-0.756
15,120
30,000
0.751
22,530
0.711
0.657
19,710
20,000
0.683
13,660
0.635
0.571
11,420
Year
PVF
PV
PV
66,345
63,350
PV
60,595
59,285
=14.45%
3.
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 =
Rs.20,000
Rs. 15,000
Rs.25,000
4th year
Rs. 10,000
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
=
=
=
Rs.56,175
Rs.50,000
6,175
PV Cash Inflow
Initial Cash Outflow
56,175
50,000
= 1.1235
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.
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.
profitable investment proposals but also to rank the projects from the highest to
lowest priority
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
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%
Average Return on
Average
Rs. 8,500
30,000
Rs. 9,000
x 100 = Rs. 28.34%
30,000
Investment
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
Solution:
Profitability Statement
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 =
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.
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
Solution:
Annual Sales
Automatic Machine
Ordinary Machine
Rs.
Rs.
1,50,000
1,50,000
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
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
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
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
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
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%
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
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
year
PV Factor @ 10%
discount
1
0.909
0.826
0.751
0.683
0.621
(b)
(c)
(d)
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
Rs.85,000
Average Return
Rs.85,000 5 = Rs.17,000
17,000
50,000
x 100 = 34%
Machine B
Total Returns
Rs.90,000
Average Return
Rs.90,000 5 = Rs.18,000
18,000
50,000
x 100 = 36%
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
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
Cash
4,800
Equity
Liabilities:
Accounts
9,600
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
Cash
24,000
Equity
Liabilities:
Accounts
48,000
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
(ii)
(iii)
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.
3.
CASE-3
BUSINESS DECISION
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
2,214
2,052
1,800
Long-term liabilities
4,716
3,708
3,600
liabilities
12,600 12,600
5,670
&
4,140
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
58,500
46,500
36,000
31,500
28,500
24,000
Operating expenses
28,170
25,275
21,240
3,330
3,225
2,760
Income taxes
1,530
1,500
1,260
Net income
1,800
1,725
1,500
270
465
405
stock in Year 2)
Cash dividends per share
063
1.11
1.50
Questions ;
1.
2.
3.
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
Proposal No.1:
stamps
Quantity sold
Selling price per unit
Manufacturing cost per unit
500,000 boxes
$0.70
$0.40
in
unit
Proposal No. 1
sales 50%
Proposal No. 2
30%
volume
Decrease in manufacturing 10%
5%
10% of sales
8% of sales
None
10% of sales
None
8% of sales
$ 0.06 per box
5% of sales
Questions:
1.
2.
Current Year
Proposal No. 2
PART-A
(5x8= 40 marks)
2.
What are the different types of errors, how this can be managed well?
3.
4.
5.
State the difference between cash flow and fund flow statement.
6.
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.
Building
Furniture
Library Books
16% Investments
(1-1-98)
Salaries
Stationery
General Expenses
Amount
(Dr.)
2,50,000 Admission Fees
Cr.)
5,000
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
Cash
1,000
Bank
4,00,000
8,000
8,00,000
8,00,000
Additional Information:
1)
Tuition fees receivable for the year 1998 amounted to Rs. 10,000.
2)
3)
Charge
8.
A book keeper while preparing his trial balance finds that the debit
exceeds by Rs. 7,250. Being required to prepare the final account he
places the difference to a suspense account. In the next year the following
mistakes were discovered:
a)
A sale of Rs. 4,000 has been passed through the purchase day
book. The entry in the customer's account has been correctly
recorded,
b)
Goods worth Rs. 2,500 taken away by the proprietor for his use
has been debited to repairs account;
c)
A bill
received
from
Krishna
has
d)
Salary of Rs. 550 paid to a clerk has been debited to his personal
account;
e)
f)
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
8,000
Dr.
2,500
2,500
Dr.
1,300
1,300
Dr.
650
650
1,500
To Raghubir A/c
1,500
2,250
2,250
PART - B
(4 x 15 = 60 marks)
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
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.
Liabilities
Assets
2000
2001
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)
(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
1,15,000
Capital
8% Redeemable
2,00,000 1,70,000
Preference Share
Buildings
Capital
General Reserve
40,000
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)
(c)
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)
(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
b)
13.
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
Year
PV Factor @ 10%
1
2
3
4
5
Evaluate the projects using :
(a)
(b)
(c)
(d)
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.
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.
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.
2.
3.
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.