MANAGEMENT ACCOUNTING THIRD EDITION MY KHAN Professor of Finance and Formerly Dean, Faculty ot Business and Head, Department of Financial Studies University of Delhi Dethi PK JAIN Dalmia Chair Professor and Professor of Finance Department of Management Studies Indian Institute of Technology Delhi Tata McGraw-Hill Publishing Company Limited NEW DELHI ‘McGrawHil Offices 5 Now Delhi Now York St Louis San Francisco Auckland ‘Bogoté Caracas i Usbon Landon Madrid. Maxico Gity Milan. Montoal San Juan Singapore Sydney ‘Tokyo Toronto‘Tata McGraw-Hill © 2000, 1993, 1984, Tata McGraw-Hill Publishing Company Limited Fousicenth reprint 2005 RYNDCREBROBZL. 'No part of this publication can be reproduced in any form or by any means ‘without the prior written permission of the publishers ‘This edition can be exported from India only by the publishers, Tata McGraw-Hitt Publishing Company Limited ISBN 0-07-463656-1 Published by Tata McGraw-Hill Publishing Company Limited, 7 West Patel Nagar, New Delhi 110 008, fpeset at The Composers, and printed at S P Printers, E-120, Sector 7, Noida Cover: MeenakstiPREFACE TO THE THIRD EDITION ‘The objective of the third revised edition of Management Accounting is two-fold: (i) t0 enlarge the cover- age of the subject matter and (ji) t0 incorporate the emerging management accounting practices in the ‘country, The focus comimues to be on’ providing to the readers an in-depth analysis of how to use accounting information for profit planning, cost control, and managerial decision-making New Features ‘The most notable feature ofthis revised euiton is the inclusion of the following new chapters, with a view to widen the voverage of the book: 44 Costing and Control of Materials (Chapter 6) ‘4. Costing and Control of Labour (Chapter 7) 4. Costing and Control of Factory Overheads (Chapter 8) ‘4. Uniform Costing and Interfirm Comparison (Chapter 13) ‘4. Capital Budgeting (Chapter 17) Chapter 10 (nventory Costing) has been consequently deleted from the third edition. The chapter-sise changes ate detailed below: () Chapter 2 Annexure 2A.1 (Financial Statements and Accounting Practices) and Appendix 2-B (Financial Accounting System) have been added. (ii) Chapter 3 Accounting Standard: AS 3 (Revised) Cash Flow Statenients issued by the Institute of, Chartered Accountants of India, in 1997 has been included. il) Chapter 4 Inclusion of Debt Service Coverage Ratio, (iv) Inclusion of Problems—Solutions and Exercises: A large number of problems-solutions and exer- cises have been included in all the chapters of the revised edition. Pedagogical Features ‘The new edition retains the time-tested pedagogical features ofthe earlier editions. They areas follows: Organisation The treatment of the subject matter is structured around the external as well as internal «ses of financial and cost accounsing information for profi planning, cost contro, performance evaluation and managerial decision-making. Our approach is to describe a concept followed by an illustration with the help of aumerous step-by-step examples and their solutions, to make it easier to understand. We have followed a concise and simple writing style so thatthe text is easy to read. In short, we have adopted a lucid, rnon-mathematical, problem-and-solution approach to explain the concepts and theories of management accounting Solved Problems Our experience has shown that the intricacies of conceptstheoris are best learnt by numerical illustrations. Several real-life illustrative problems reflecting emerging management account- ing practices in the country with solutions have, sherefore, been inchaded in each chapter, This i, in fact one of the unique features of our text.Wi Preface to the Third Eaton Exercises A comprebensive set of questions and real-life class-tested problems at the end of all the chapters serve a5 a means by which students may test their grasp of the material presented within the chapters. Numerous problems are included t0 provide multiple selfesting opportunities to the reader. ‘Answers to the end-of-chapter problems are provided to help readers cross-check their perforinance, Support Items The detailed bibliography and index are intended to guide those who aay be intr- este in a more detailed study of the subject. In conclusion, we hope our readers will fin the book useful and interesting, We shall welcome sugges tions for improvement of tbe book and We hope thatthe revised third edition will receive as much support from them as was extended to the earlier two editions. Avmiors tPreFACE TO THE FIRST EDITION ‘Management Accounting is a’complementary volume to our earlier work, Financial Management. It ad- dresses itself to the use of accounting information for planning, control and decision-making. Management accounting, as a system of accounting, focuses on how 0 use as distinct from how to prepare accounts of business firms. The use of the inforniation contained in the accounts of business enterprises can be made by outsiders such as creditors, shareholders, piospective investors, government, and so on for decision-making, ‘regarding a firm. Such information can also be used for decision-making by a firm itself. Thus, the uses to Which accounting information can be put may be either external or internal. The present volume describes in depth both types of uses of accounting information. A distinct feature of this book is that it provides a penetrating and: comprehensive analysis of thie concepts, theories and techniques in a simple, lucid style inthe framework of the Indian business environ- ‘ment, It‘also contains a variety of real-life solved problems/illustrations to explain the intricacies of the theories/eoncepts/techniques. Yet another feature of this book is that it contains a comprehensive list of jroblems/ecercises atthe end ofeach chapter to help the readers to test their understanding of the subject. A fairly exhaustive bibfiogsaphy is also given atthe end of the book. ‘Management Accounting, we hope, will be found weeful by @ wide section of readers, particularly teachers and advanced students of Commerce, Business Management, Chartered and Cost Accountancy. Those appearing in the civil services examination and the examination coridicted by the Indian Institute of Bankers would also find ita satisfying text. Practising accountants/managers Would find it no less useful ‘The subject matter of this volume is woven round the application of accounting information for decision- ‘making both about a firm as well as by a firm. It is divided into six parts consisting of 19 chapters. Part 1 consists of ane chapter which presents an overview of management accounting in terms of its relationship with financial accounting—the second element of the accounting system of a business firm— ante main coments of management asouting formato. This chou sees aa eskproundto he detailed discussions in chapters that follow. Pare Il, comprising 3 chapters, relates to decision-making about a firm by outside panties. Chapter 5 provides an insight into the nature and type of information contained iti the two conventional financial statements, namely the balance sheet and the profit and loss account (income statement). The main elements of the third financial statement, ic, statement of changes in financial position are covered in Chapter 6. Chapters 5 and 6 are very useful and impertant in analysing the financial statements for decision-making purposes. It is against this background that Chapter 6 dwells on the analysis and interpretation of the financial statements. ‘The preparation of the conventional financial statements involves certain problems in terms of policy alternatives to management. Part II is concerned with three such policy issues. The first aspect relates to the alternative methods and pricing of inventory which is examined in Chapter 2. Chapter 3 addresses itself to the choice of an appropriate method of depreciation of fixed asfets. Price level adjusted financial statement$ is the theme of Chapter 4vii Proface to the First Edition Parts £V through VI deal with decision-making by a firm. Budgeting, as tool of profit planning and control, is explained in Part IV. Toe fist chapter of this part (Chapter 8) provides an overview of budgeting, and illustrates the operating and financial budgets. Long-term budgeting is elaborated upon in Chapters 9 and 10. While Chapter 9 deals with the generation of data, Chapter 10 outlines the methods/techniques for capital budgeting art V consists of seven chapters. The theme of this section is the vse of cost data for planning and control. Chapter 11 highlights the different types of cost data as felated to varying managerial needs. The subsequent chaptess of this section dwell on the various techniques relevant to costprofit planning and control (Chapter 12); standard costs (Chapter 13); variance analysis (Chapters 14 and 15); variable costing and absorption costing (Chapter 16); and cost-volume-profit analysis (Chapter 11), Finally, the two chapters of Part VI cover the special short-term non-recurring decisions. While Chapter 18 relates to pricing and product decisions, Chapter 19 illustrates resource decisions. In the preparation of this book we have received help and encouragement from different sources. In panticular, Mr HC Jain, Librarian, Delhi University South Campus Library deserves our gratitude forthe prompt and generous help in supplying the books and journals but for which our efforts would not have succeeded Prof Abad Ahmed, Director, Delhi University South-Campus, has been a source of constant encoura- gement and help. Our colleagues Prof R $ Nigam, Head of the Department of Commerce, Delhi School of Economics, Delhi University, Prof LS Porwal, Prof P K Ghosh, Dr HM Mathur, Principal, Shri Ram College of Commerce, University of Delhi, Dr R N Goyale, Dr R A Sharma have assisted us in several ways We also thank the Yarmouk University, Jordan particularly, Dr Hisham Gharaibeh, Dean, Faculty of Economies and Administrative Sciences, where a part of the book was writen. ‘We would be failing in our duty if we did not put on record our deep sense of obligation to ous families ‘Who provided an environment conductive to hardwork. Finally, Mr P L Kadalbaju, Deputy Registrar, Delhi University South Campus, deserves our thanks for the diverse assistance he provided. Complete solutions to all exercises given at the end of various chapters of this book ig available in the authors book entitled Management Accounting and Financial Management~Problems and solutions. MY Kuan, PK JanConTENTS Preface to the Third Edition Preface to the First Edition Part 1 BACKGROUND Management Accounting—An Overview Introduction 1.3 Financial, Cost and Management Accounting 1.3 Contents of Management Accounting 1.6 Part 2 USING FINANCIAL STATEMENTS Statements of Financial Information Introduction 2.3 Contents of Balance Sheet 2.3 Contents of Frofit and Loss Account 28 Appendix 2-A Generally Accepted Accounting Principles (GAAPs) 2.11 Annexure 2A.1 Financial Statements and Accounting Practice 2.13, Appendix 2-B Financial Aécounting System 2.19 Statement of Changes in Introduction 3.1 Meaning of Changes in Financial Position 3.2 ‘Statement of Changes in Financial Position (SCFP)—Working Capital Basis, ‘Statement of Changes in Fintancial Position (SCFP}—Cash Basis 3.11 yancial Position 32 ‘Statement of Changes in Financial Position (SCFP)—Total Resource Basis 3.14 Accounting Standard: AS 3 (Revised), Cash Flow Statements 3.15 Importance and Usefulness 3.23 Financial Statement Analysis, Inioduction 4.1 Ratio Analysis 4.2 Common Size Statements 4.31 Importance and Limitations of Ratio Analysis 4.33 1g 21-2.26 313.43 414.71x Contents 5. 10, nL. 2 [COST ACCUMULATIONDPTERMINATION Cost Concepts Introduction 5.3 . Cost Concepts Relating to Income Measurement 5.3, Cost Concepts Relating to Profit Planning 5.6 Cost Concepts for Control 5.16 Cost Concepts for Decision-making 5.17 Costing and Control of Materials Introduction 6.1 Control of Materials 6.1 “Cost of Inventory and Costing Methods 6.18 Costing and Control of Labour Inwoduction 7.2 Accounting for Labour 7.2 Special Problems Relating to Accounting for Labour 7.3 Labour Turnover -7.10 Costing and Control of Factory Overheads Introduction 8.2 Factory Overhead Costs 8.1 Cost Allocation 8.5 Absorption of Factory Overheads 8.11 Under-Absorption and Overabsorption of Factory Overheads 8,16 Job-order, Batch and Contract Costing Introduction 9.1 JoblOrder Costing 9.7 Batch Costing 9.12 | Contract Costing 9.14 Process, Joint and By-product Costi Introduction 10. Nature and Suitability 10.1 ‘Cast Accumulation in Process Costing 10.2 Joint Prodsets 10.27 By-products 10.25 Sell. Now (At Split-off Point) or Process Further 10.27 Unit/Single/Output and Operating Costing Introduction 11.1 UnivSingle/Output Costing 1.1 Operating Costing 11.12 Variable Costing and Absorption Costing Introduction 12.1 Variable and Absorption Costing: A Comparison 12.2 $.1-5.20 6.1-6.44 T7248 9A-DAT 0.66 A-11.36 121-1261CHAPTER 1 R Background T BACKGROUND This part provides an overview of management accounting, It describes the relationship between financial accounting, cost accounting and management accounting. The contents of management accounting are also discussed here. ‘These discussions form a background for a detailed account of management accounting, in the subsequent parts of this book.2B. 14, 15. 16. 7. 18. 1 Variable and Absorption Costing: Reonciliation 12.9 Variable Costing and Short-term Decision-making 12.1 Advantages and Limitations of Variable Costing 12.18 Uniform Costing and Inter-Firm Comparison Introduction 13.1 Uniform Costing 13. Inter-firm Comparisons 13.5 Reconciliation and Integration Introduction 14.1 Reconciliation of Financial and Cost Accounts 14.1 Integrated Accounts 14.7 Parr 4 PROFIT PLANNING Cost-Volume-Profit Analysis Introduction 15.3 Break-even Analysis 15.4 Budgeting. 16.1 Budget—Definition and Meaning 16.2 Budgets—Purpose 16.3 Preparation/Types of Budgets 16.5 Capital Budgeting Introduction 17.1 Nature of Capital Budgeting 17.1 ‘Data Requirement: Identifying Relevant Cash Flows 17.4 Evaluation Techniques 17.15 Parr 5 COST CONTROL, Standard Costs Introduction 18.3 Meaning of Standards 18.3 Establishing Cost Sandards 18.4 ‘Components of Standard Cost 18.5 Variance Analysis: Cost Variances Introduction 19.1 Material Variances 19.2 Labour Variances 19.11 Overhead Variances 19.16 Standard Cost Accounting » 19.26 Contents xi 14.1-14.36 15.-15.73 16.1-16.51 W7-17.44 18.1-18.10 19.1-19.6820, a. 2. Contents Variance Analysis: Revenue Variances Introduction 20.1 Sales Variances 20.1 Profit Variances 20.5 Actual Profit and Budgeted Profit: Recon Variance Reporting 20.11 Disposition of Variances 20.15 208 Responsibility Accounting Introduction 21.1 Meaning and Objectives 2/.1 ‘Types of Responsibility Centres 2/.4 Pant 6 DECISION-MAKING Short-run Decision Analysis Introduction 22.3 Analytical Framework 22.3 Decision-situations 22.5 Appendices Select Bibliography Index 20.1-20.35 21.1-21.43, 2.122.500 ALAS SB.1-SB3 1141.10Management Accounting— An Overview INTRODUCTION ‘This chapter aims to present a general description. of management accounting. It includes two inter-related aspects, namely, thé () relationship between financial accounting, cost accounting: and management accounting, and (i) contents of management accounting. Section J of the chapter outlines the relationship among financial accounting and management accounting as a part of the accounting information system of a bisiness enterprise. The contents of management accounting are elaborated. in Section 2. Finally, the main points of the discussion are summarised in the last section. FINANCIAL, COST AND MANAGEMENT ACCOUNTING Accounting may be defined as a system of collecting, summarising, analysing and reporting information about a business enterprise, in financial (monetary) terms. The business accounting system consists of three parts: (i) Financial accounting, (ii) Cost accounting, and (ii) Management accounting. Financial and Management Accounting Similarities’ Financial accounting and management accounting represent the two parts of the account- {ng iiformation system of busiiess enterprises. These are similar on two counts. Firstly, operating informa- tion is used in the preparation of financial as well as management accounts. If the enterprise has two completely different systems for collecting information for the two purposes, it would involve, among other1.4 Management Accounting things, the incurrehce of extra costs. The use Of financial accounting information for management account- ing i, therefore, economical. This implies that financial accounting has a significant influence on manage- ment accounting. Secondly, the considerations which make Generally Accepted Accounting Principles {GAAPS)', useful in financial accounting, are equally relevant in management accounting also. For example, rmanageinent cannot base its reporting system on non-vesifable, subjective estimates of profits because cost and revénue concepts in financial accounting are based on the idea of objectivity. Differences Nevertheless, the two systems of accounting differ from each other in several respects. One basic difference between financial accounting and management accounting relates to the structure or format of presenting information. Financial accounting has a single, unified structure, in the sense that, the information relating to the operations of various enterprises is presented on a more of less uniform basis. It may be recalled that the end-products of financial accounting are the three financial statements: (i) Balance sheet, (i) Profit and loss account/Income statement, and (ii) Statement of changes in financial position. The dalance sheet reports the financial position of a business at a-particular point of tiie. The results of ‘operations over a specified period of time, usually a year, ae contained in the profit and loss account. The statement of changes in financial position reports the inflow and, outflow of financial resources during a given period of time. The preparation of various financial statements on the basis of a specified model implies that, while preparing financial accounts, all firms arrange the information in a uniform manner. In other words, financial accowiting has a unified structure. Why is the structure of financial accounting uniform? The primary objective of financial accounting is to provide information to outside partes, namely shareholders, creditors, government, the general public, and 50 on. These outside-users of the financial statements are interested in information from many different businesses. In order to enable an inter-firm comparison, there is a distinct need to present financial accounts fon a uniform basis, and within a unified structure. The unified structure of financial accounts, therefore, facilitates communication between a business, and the outside parties interested in it. Jn contrast, management accounting concems itself with accounting information that is useful to the management only. As this type of accounting is undertaken for internal use, its structure: varies’ with the’ requirements and circumstances of each case. In other words, management accounting is tailored to meet the needs of the management of a specific, business, and therefore, it lacks a single unified structure. A related aspect isthe impact of the GAAPs on the preparation of the two types of accounting. Financial accounting is, prepared in accordance with the GAAPs, Accounting is the ‘language of business”as it is-the principal means by which information about a business is coramunicated to those interested in it. If, therefore, the information is to be communicated effectively and understood properly it should be prepared in accordance with a mutually understood set of rules. These ground rules are referred to as GAAP. They represent laws ‘or rules to be used as a guideline in the preparation of financial accounts. In other words, GAAPs provide a specified frdygework for the preparation of financial accounts which have evolved over the years and are ‘based on experience, reason, usage, convention and necessity. Thus, GAAPS ensure that financial accounts are prepared in accordance with certain norms and standards for better comprehension and reliability. On the other hand, management accounting is for the exclusive use of the management ofa firm. Outsiders do not need such accounts and have no access to them. Therefore, there is scope for flexibility in its prepara- tion. It can be tailored to the specific needs of the management. The criteria for inclusion of any information in management accounting is utility. In short, financial accounting, which essentially caters to the needs of ltsiders, is prepared according to the norms set by the GAAPs, whereas management accounting, as an aid to managerial decision-making, is dependent on, and largely influenced by, the internal requirements of the management.\ Management Accounting —An Overview 1.5 ‘The third difference between fimdcial accounting and management accounting relates to the need for preparing such accounts. The preparation of financial accovnts is a statutory obligation. In fact, the corpo- rate laws and regulations that govern the functioning of corporate enterpriseS not only make it mandatory to prepare such accounts but also lay dow the model/fortmat in which such accounts are to be prepared. Corporate laws also prescribe independent audit by professional auditors to ensure that the accounts reflect ‘a true and fair view of the firms’ affairs. Apart from thi, tax regulations also require the maintenance of records by business establishments. In sharp contrast, management accounting is entirely optional. It is prepared only if it is deemed useful to the managemest. There are no external compulsions for its preparation, The format, as also the items to be included, are exclusively dependent on the management's discretion ‘The end-products of financial accounting are the three financial statements, namely, balance sheet, profit and loss account, and statement of changes in financial position. The balance sheet and the profit and loss ocount report the financial position on a particular date, and the results of the operations of the firm during fn accounting period respectively. The statement of changes: in financial position reports the inflow and outflow of financial resources during a given period of time. These are essentially records of what has- happened in the past. Therefore, these are aptly called historical aecaunts. On the other hand, management Accounting does not record the financial history of an enterprise. Though past data is included in manage- ment accounting, a major part of its contents is related to the future plans. Its, therefore, future-oriented. 1. aims at providing data for budgeting, planning, and so on. Thus, management accounting lays more empha- sis on the future Moreover, financial accounting celates to the business as a whole. While there is no doubt that some firms prepare financial accounts on a segmented basis, forthe main lines of business, the fact remains that, the emphasis is on te entire business. Management accounting focuses on parts of the business. In manage- tment accounting, the business is divided into different responsibility centres-cost, profit and investment. ‘The term responsibility centre refers to the division of an enterprise into sections, departments, products, individual activities, and so orIn brief, financial aczdunting deals with the business as a whole whereas ‘management accounting focuses on its different parts Finally, financial accounting and management accounting also differ in relation to their ultimate objec- tives. Financial accounting, is prepared to serve the purpose of extemal reporting. Therefore, from the viewpoint of the management, the purpose of financial accounting is accomplished when itis reflected in the three financial statements, that is, the balance sheet, profit and loss account and statement of changes in financial position. In a way, it is an end in itself whereas management accounting is only a means to an end. In other words, management accounting is designed t0 serve as an aid to managerial decision making. With the help of management accounting, the management can discharge its planning, directing and controlling functions. In planning, the manager decides what actions should be taken to help the arganisation achieve its goals. In directing, the manager oversees the conduct of day-to-day operations. And in controlling, steps are taken to ensure that the responsibility centrés are operating in the best possible manner. Cost and Management Accounting Cost accounting is that branch of the accounting information system, which records, measures and reports information about costs. A cost is a sacrifice of resources. Costs are reflected in the accounting system by outlays of cash, promises. to pay cash at a future date, and the expiration of the value of an asset. The primary purpose of cost accounting is cost ascertainment and its use in decision-making and performance. evaluation, A cost accounting system provides data for both financial accodgting and management account- ing. When costs ave used by outsiders, such as shareholdets or creditors, to evaluate the performance of the1.8 Management Accounting management and make investment decisions, they are said to be used for financial accounting purposes. On the ather-hand, when cobt data are used inside the organisation to evaluate the performance of operations, activities, personnel, and so on, a5 the basis of decision-making, they are said to be used for management accounting purposes. For instance, in a manufacturing business; the’ costs of products sold, and on hand, include the total expendicure on materials, labour and all the other production. costs, Each of these cos's ‘must first be measured, then accumulated, and finally, distributed to the. work-in-process, finished goods and cost of goods sold. Consequently, the amount of profit reported by a manufacturing company depends on the accuracy ofits cost calculations. Thus, cost accounting is useful for performance appraisal. Cost accounting also helps in planning, Panning is a process of setting goals and allocating resources 10 achieve these goals, The expected financial outcome of planning is expressed in terms of budgets. A firm can increase its profits in two ways: (i) By increasing unit sale price/sales volume and (ii) By reducing cost. ‘While the first cannot always be under the control of the marlagement, second falls well within the ‘managétial domain. A detailed cost accounting system is an important requirement for a systematic cost contol. For this reason, the management must understand the nature and behaviour of different elements of cost, know whet and where they are incurred and: who is responsible for them, The actual, cost should be compared with the planned estimates. The differences between these should be analysed to identify the reasons for deviations, and corrective action should be taken to eliminate them. Thus, cost accounting is very useful to management for profit planning. ‘Cost accounting i also useful for the purpose of control. Control comprises managerial action to correct conditions that cause deviation between the actual and planned. performance. Comparison. between the actual and budgeted cost will highlight.a poor or good performance, as well as the operations that have gone out of control and warrant corrective action. Thus, cost accounting provides the basis for managerial control. CONTENTS OF MANAGEMENT ACCOUNTING White outlining the difference between financial accounting and management accounting, it was pointed out that management accounting does not have a unified structure. The format in which itis prepared varies widely according to the circumstances in each case and the purpose for which the- information is being summarised. Broadly speaking, management accounting consists'of three types of information each of which is governed by. a different set of principles. These are: (i) Full cost accounting, (i) Differential accounting, and (iii) Responsibility accounting. Full Cost Accounting ‘One approach 10 management accounting is full cost accounting. The. term cost refers to the resources, ‘expressed in monetary terms, which are used to achieve some purpose. For instance, in the manufacture of ‘Boods, raw. material and ‘abour are required. When the quantity of-raw material consumed during, the ‘production of the goods is expressed in terms of money (in rupees.or dollars), itis an item of cost, Similarly, payment of wages to labour is also a cost. Cost canbe of two types: direct or indirect. Direct costs are those Which are conveniently, wholly and exclusively attributable to a particular unit of production. Examples of such costs are raw materials, wages, and so on..On the ather hand, indirect costs relate to the organisation as, a whole and cannot be identified. with specific units of production. This category of cnst includes factory rent, works manager's salary and $0.0n. The sum of direct and indirect costs is the total or full cost. Thus,‘ Managemen Accounting —An Overview 1.7 full cost accounting may be defined as a system of management accounting that is prepared in circum- stances. where the full cost of an item consisting of the direct costs and fair share of the indirect costs is relevant, Full cost is relevant in two'situations: Firstly; while preparing financial accounts, items are shown 6 the’ basis of full cost, that is, cost af goods sold is shown in the profit and loss accouilt and amount of, inventory on the assets side of the balance sheet. Secontly, full cost is lso useful in fixing the sale price of ‘goods and Services. In hnorinal circumstances, the Sale price is determined on the basis of full cost plus a margin of profit. To illustrate full cost acéounting, agsuine that the direct cost of manuficturing an item of machinery is. Rs 5,00,000. And the indirect cost aséocisted with itis Rs 1,00,000. Assuming a 10 per cent profit, the sale price and ful cost of the machine would be Rs 6,60,000 and Rs 6,00,000 respectively Differential Accounting The second type of management accounting is differential accounting. One decision-situation before man- agement is an alternative-choice-decision-sitwation, defined as a situation in which there are alternative uses to which the resources (cost) can be put, These alternatives are mutually exclusive, that is, ifthe resources (Cost) are put to one use, they cannot be utilised for any other use. Therefore, the selection of the one altemative precludes the seieetion of the other. Alterative choice decisions include make or buy decisions, lease or buy decisions, capital budgeting decisions and: soon. The accounting information that is used in ‘making alternative:choice decisions is termed as differential accounting. The term, “differential cost” refers 10 a cost which varies according to the alternatives under consideration. If one alternative is chosen, the cost associated with it will be different from the cost if a competing alternative is selected. As such, in manage- ‘ment accounting, only differential: costs are relevant for decision-making. “To iitstrate differential accounting, assume that the management of a firm is considering the acquisition of a component:10 be tsed in its final product. The firm has a choice between buying it from an outside supplier, or produeing it. Assume the price at which the componet can be purchased, Rs'5 per unit and let its annual requirement be' 10,000 unis. The cost of manufacturing 10:000 units by the firm is calculated as follows: material cost, Rs 2 per unit; direct labour cost, Re 1 per unit and additional fixed cost, Rs 10,000; thus, total cost amounts to Rs 40,000: Since the total cost involved in buying the component is RS 50,008 (10,000 units x Rs:5), the differential cost is Rs 10,000. Obviously, itis preferable to make the component rather than buy it 7 Responsibility Accounting Finally, management accounting also takes the form of responsibility accounting, Here, the information is summarised for each responsibility centre. The term responsibility centre refers tp the division of an enterprise into segments, each having a defined responsibilty, and headed by & manager. Thus, accounts are prepared ot only forthe organisation as a whole but also for its segments. The technique usually adopted to Prepare such an accounting is budgeting. A budget is a plan, expressed in financial terms, forthe activ and operations of a firm. There. are three‘elements of planning as a tool of responsibility accounting (@ Budgeted or planned performance, (i) Actual performance, and (ii) Differences between the budgets and actual performance: This information is tabulated for each responsibility certre. Ths isthe essence. of responsibility accounting. A simplified view of responsibility accounting is presented in Table 1.11.8 Management Accounting Table 1.1. Responsibility Accounting Fesponsibilty (Expense) Centres Product x ¥ —Buageteisal —Diferanco ~ Batigt hetualDiforence mM __@ (3) @) ) (6) a x “Rs 1,000 As 1,100 As (100) As 800 Rs 450, Rs 60 8 500 600 (100) 00 280 20 ¢ 1500 4,700 (200) 200 190 10 Tota cost by responsibilty centres 30003400400) —1,000 220 co SommanY Management accounting is that branch of the accounting information system of a business enterprise which uses accounting information fa planning, controlling, and decision-making. It uses partly financial account- ing but mainly cost accounting. However, there are wide differences between them. The differences between management accounting and financial accounting relate to: (i) The format in which the two types of accounting are presented, (i) The impact or otherwise of generally accepted accounting principles (if) The Purpose behind their preparation, (iv) The historical versus future orientation, (v) The extent of coverage Analysis, and (vi) Their ultimate objectives. Cost accounting serves both financial accounting and management, dedounting. It serves financial, ac- ‘counting by accumulating unit cost, needed for investory valuation and ascertaining the cost of goods sold for income determination. It assists management accounting by providing cost data as a basis for perfor- ‘mance appraisal, planning, control, and decision-making. ‘Management accounting consists of three types of information, namely, fll cost accounting, differential accounting and responsibility accounting. Each of these types of information is compiled on the basis of a different set of principles to aid the managerial decision-making process. REFERENCES |. For a detailed discussion on GAAP, please refer to Appendix 2 - A. ExerciseS LJ. “Management accounting is a mid-way between financial accounting and cost accounting”. Elucidat. 1.2 “There are no externally imposed ‘Generally Accepted Accounting Principle’ for management accounting.” In the light of the above statement, discuss giving illustrations, che nature and scope of management accounting. 13. Explain the following: (a) "Management accounting is at extension of financial accounting.” (b) "Management accounting assists in corporate planning process.”Management Accounting — An Overview 1.9 144 “The emphasis of financial accountng is different fom that of cost secountng.” Comment. LS "Management accounting isthe presentation of aecOuning information in such a way a8 to astist the manage ‘ment in the creation of policy, and in te day-to-day operation of an undertaking.” Elida 1.6 In what essential espe is management accounting different from financial accounting? 17 (a) “There is no single, unified management Sesounting system, rather, there are thee different types of information, each, used for different purposes.” labora. (b) Mention ths differences which exist between Financial accounting ané management accounting. Also point out the similarities, i any, between the voCHAPTER 2 \ Statements of Financial Information CHAPTER 3 R Statement of Changes in Financial Position CHAPTER 4 T Financial Statement Analysis -o USING FINANCIAL SFATEMENTS One us¢ of accounting information is decision-making about a firm by outsiders such as shareholders, creditors and prospective investors. Part two, accordingly, is devoted to a discussion of the use of financial statements in decision-making. This part is divided into three chapters. Chapter 2 covers the nature and type of information contained in the balance shect and profit and loss account. Chapter 3 concerns itself with the preparation and use of the statement of changes in financial position. Finally, Chapter 4 discusses the techniques of analysing and interpreting the balance sheet and profit and loss account.Statements of Financial , Information INTRODUCTION Accounting is a system of collecting, summerising, analysing and reposting, in monetary terms, the informa- tion about an organisation’. The end-products of financial accounting are the financial statements compris- ing the balance sheet, profit and loss account and staternent of changes in financial position: These state~ ‘ments are, therefore, the sources of information, on the basis of which conclusions can be drawn regarding the firm's operaiion. The analysis and interpretation of financial statements depends on the nature and type of information available therein. This-chapter attempis to outline the types of information available in the financial statements. It should be noted that the focus is on the financial statements as a source of informa- tion relating to a firm. The ground rules which gover the preparation of these statements are briefly outlined in Appendix 2-A, while the procedural aspects are summarised in Appendix 2-B. The contents of a balance sheet are discussed in Section 1, while the information available in the profit and loss account is analysed in Section 2. The main points are summarised in Section 3. CONTENTS OF BALANCE SHEET ‘The balance sheet is a significant financial statement of a firm. In fact, it-is called the fundamental accounting report. Other terms to describe this financial statement are the statement of financial position ot the position statement. As the name suggests, the balance sheet provides information about the financial standing/position of a firm at a-Particular point of time, say, as on March 3J. It can be visualised as & snapshot of the financial status of,a-company. The financial position of the company is valid for only one dday—the reference day. The position of the firm on the preceding or following day is bound to be different.2.4 Management Accounting ‘The financial position ofa firm as disclosed by the balance sheet refers to its resources and obligations, and the interests ofits owners in the business. In operational terms, the balance sheet contains information regatding’asses, abilities and shareholders’ equity. ‘The balance sheet can be present in either of the two forms: (i) the account form, or (i) the teport form. It is Usually presented in the account form as shown in Format 2.1. In the report form, a step-wise balance sheet, (Format 2.2) is prepared, listing aBsets at the top followed by the liabilities and owner's equity Format 2.1 Balance Sheet—Account Form The Hypothatical Lids: Balance Sheet as on March 31 abilities and owner's equity Amount Assets ‘Amount Share capital m Fined assets Equity Land, buildings, plants, otc. Preference : Less: depreciation Reserves and surplus cE Investments (at cost) Long-term loans Current assets Debentures Inventory Mortgages Debtors Current fabilties and provisions: Cash’and bank Bills payable ‘Advance deposits ete. Creditors Other assets For goods For expenses Customer's advance Unclaimed dividend Provision for dividend, Provision for taxation Format 22 Balance Sheet — Report Farm The Hypothetical Ltd Balance Sheet as on March 31 ‘Assets, labiliies and owner's equity Amount Fixed assets Land, building, plant, machinery, etc, Leis: depreciation Investments (at cost) Current assets Inventory Debtors Cash.and bank balance’ Advance deposits, otc, Less current liabilities and provisions Bills payable Creditors: For goods: For expenses (Contd). Statoments of Financial Information 2.8 (Cont) Customer's advances: Unclaimed dividend Provision for dividend Provision for taxation Net current assets, Other assets Total net assets Financed by ‘Share capital Reserves and surpluses Shareholder's equity Non-current liabilities. Debentures Mortgages Total obligations ‘The contents of the balance sheet, in either form, include assets of the firm and the means by which assets have been financed, that is, the liabilities and owner's equity. The main elements of these are described in what follows. Assets ‘Asset may be described as valuable tesources owned by a business which have been acquired at a measurable money cost. Asan economic resource, they satisfy three requirements. In the first place, the resotrce must be valuable. A resource is valuable if () it is cash or convertible into cash or (i) it can, provide future benefits to the operations of the firm. Secondly, the resources must be owned. Mere posses sion or control of a resource would not constitute an asset; it must be owned in the legal sense of the term. Finally, the resource must be acquired at » measurable money cost. In case where an asset is not acquired ‘with cash or.a promise to pay cash, the criterion is, what the asset would have cost, had cash been paid for it ‘The assets in the balance sheet are listed either in the order of liquidity-promptness with which they are expected fo be converted into cash—or in reverse order, that is, fixity or listing of the least liquid asset (fixed) first, followed by others. All assets are grouped into categories, that is, assets with similar character- istics are put in one category. The assets included in one category are different from those in other categories. The standard classification of assets divides them into: (i) Fixed assets/Long-term assets, i) Curent assets, il) Investments, and (iv) Other assets Fixed Assets As the name suggests, such assets are fixed in the sense that they are acquired to be ‘fetained in the business on a long-term basis to produce goods and sérvices, and are not for resale. They are, ina sense, long-term resources in that they are held for longer than one accounting period. Such assets ace obviously of crucial significance a the future earingsrevenue /pofits of firms are basicaly determined by them, They fall into two categories; tangible and intangible. Tangible Fixed Assets are those which have a physical existence and generate goods and services. Included in this category of fixed assets are land, buildings, plant, machiaery, furniture, and so on. They are shown in the balance sheet, in accordance with the cost concept, at their cost to the firm atthe time they ‘were purchased. The cost of these assets is allocated to/charged againsUspread over their useful life. The yearly charge is referred to as depreciation. As a result, the amount of tangible fixed assets shown in'the2.6. Management Accounting balance sheet every year, declines to the extent of the depreciation charged in that year and by the end of the ‘useful life of the asset, it equals the salvage value, if any. Salvage value signifies the amount realised by the sale of the discarded asset at the end of its useful life. Intangible Assete do not generate goods and services directly. In a way, they reflect the rights of the firm. This category of assets comprises patents, copyrights, trade marks and goodwill. These assets confer certain exclusive rights on their owners. Patents confer exclusive rights to use an invention; copyrights relate to production and sale of literary, musical and artistic works; trade marks represent exclusive rights to use certain names, symbols, labels, designs, and so on. Intangible fixed assets are also ‘Written-off over & petiog of time, Current Assets The second estegory of assets included in the balance sheet are current assets. In Contrast to fixed assets, current assets ase short-term in nature. AS short-term assets, they refer to assets/ resources which are either held in the form of cash or are expected to be realised in cash within the accounting parid or the normal operating cycle of the business. The term “operating cycle” means the time span during which cash is converted into inventory, inventory into seceivables/cash sales and receivables into cath. Conventionally, current assets designate assets which are held for a short period of time, usually ‘ot more than a year fromn the balance sheat date. These ste also known as liquid assets. Current assets include cash, marketable securities, accounts receivable (debtors), notes/bills receivable and inventory. Cash It is the most liquid current asset und includes cash in hand and cash at bank. It provides instant liquidity and can be used to meet obligations/acquire assets without any delay. ‘Marketable Securities These are short-term investments which are both readily marketable and which are expécted to be converted into cash within a year. They provide an outlet to invest temporarily surplus? idle fundsicash. According to the Genecally Accepted Accounting Principles, marketable securities are shown in the balance sheet at lower of the cost or the market price. When, however, shown at cost, the ‘current market value is also shown in parenthesis Accounts Receivable They represent the amount the customers owe to the firm, arising from the sale of ‘goods on credit. They are shown in the balance sheet as the amount owed less an allowance (bad debts) for the portion which may not be collected. Notes/Bills Receivable These refer to amounts owed by outsiders for which written acknowledgements, of the obligation are available. Inventory It means the aggregate of those items which aye held for sale inthe ordinary course of business Gnished goods), or are in the process of production for such sales (work-in-process), or are to be wurrently, consarned in the production of goods and services (raw materials) to be available for sale. Itis the least liquid current asset. Included in inventory are raw materials, work-in-process (eemi-tititshed) and finished goods\ Bach of these serves a useful purpose in the process of-production and sale. Inventory is Feported in the balance sheet atthe cost or market value whichever is lower. Investments The third category of assets is investments. They represent investment of funds in the securities of another company. They are long-term assets outside the business of the firm. The purpose of such investments is either to earn a return or/and to control another company. It is customarily shown in the balance sheet with the market value shown in parenthesis.7 Statements of Financial Information 2.7 Other Assets Included in this category of assets are what are called deferred charges, that is, adver- tisement expenditure, preliminary expenses, and so on. They are prepayments for services/benefits for periods exceeding the accounting period. Liabilities ‘The second major content of the balance sheet is liabilities of the firm. Liabilities may be defined as the Claims of outsiders against the firm. Alternatively, they represent the amount that the firm owes to outsiders ‘that js, other than owners. The assets have to be financed by different sources. One source of funds is borrowing—long-term as well as short-term. The firms can borrow on a long-term basis from financial institutions/banks or through bonds/mortgages/debentures. The short-term borrowing may be in the form of ‘purchase of goods and services on eredit. These outside sources from which a firm can borrow are termed 8s liabilities. Since they finance the assets, they are, in a sense, claims against the assets. The amount shown, ‘against the iability items is on the basis of the amount owed, not the amount payable.? Depending upon the periodicity of the funds, liabilities can be classified into: (i) Longc-term liabilities, and (i) Corrent liabilities. Long-term Liabilities They are so called because the sources of funds included in them are available for periods exceeding one year. In other words, such liabilities represent obligations of a firm payable after the accounting period. The sources of long-term borrowings are: (i) Debentures, (ii) Bonds, (Gi), Mortgages, and (iv) Secured loans from financiah institutions and commercial banks. They have to be repaid/redeemed either in lump sum at the maturity of the-loan/debenture or in instalments over the: life of the loan, Long-term liabilities are shown inthe balance sheet net of redemption/repayment. Current Liabilities The second type of liability is current liabilities. In contrast, to the long-term liabilities, such liabilities are obligations to outsiders repayable in a short period, usually within the account- ing period or the operating cycle of the firm. It can be said to be the counterpart of fhe current assets. Conventionally, they are paid out ofthe current assets; in some cases, however, existing curren abilities can be liquidated through the creation of additional current liabilities. Included in this eatégory of liabilities are: (i) Accounts payable, (ii) Bills/Notes payable, (iii) Tax payable, (iv) Accrued expenses, (v) Deferred income, and (vi) Short-term bank credit. The first two categories are also called trade credit. Trade Credit represents the claims of such outsiders as have sold goods to the firm on credit for a short period depending upon tradé practices. Usually, such credit is unsecured. One form of this type of short- term credit (current liability) is that the buyer-firm will pay the amount after a lapse of time but there is no formal written oan agreement. This type is known a account payable. When the claims of the supplier of |! the goods/services is evidenced by a note/bill—written acknowledgement of debt—it is called bills/notes payable. A bill/ note is a promise in writing to pay a certain sum of money at some specific date. Short-term Bank Credit is another source of short-term funds (current liability) i draft, cash credit and loans and advances. the form of over- ‘Tax Payable refers to the amount to be paid to the governmént as taxes. Accrued Expenses represent certain obligations which are claims against assets but there is no documen- tary evidence, Examples of this type of current liability are outstanding wages, salaries, rent and commis- sion.2.8 Management Accounting Deferred Income represents the lability that arises out of receipt of income in advance, for example, rent received in advance. Owners? Equity ‘The third major content of a balance sheet is the owner's equity. Conceptually it refers to the claims of the ‘owners of the business against the assets of the firm. Alternatively, owners’ equity may be viewed as that part of the resources of a firm which are supplied by its owners. The owners of a business are known as shareholders. There are two types of sharcholders—ordinary and preference. The preference shareholders are entitled to a stated amount of dividend and return of principal at maturity. They are akin to creditors (abilities) ofthe firm. ‘The otdinary shareholders, also called equity holders, are different from the preference sharcholders as well as the creditors. They are entitled to the income/assets of the firm remaining after the claims of the creditors/preference shareholders are met in full. Their claim against the assets ofthe firm is, thus, residual. This is also known as the equity of the owners. ‘The owners’ equity may be said to consist of two elements: (i) Paid-up capita, that is, the initial amount of funds contributed by the shareholders; (i) Retained earningsireserves and surplus, that is, that part of the profits belonging to the shareholders which is not paid out to them as dividends but instcad is retained/ ploughed back in the business. CONTENTS OF PROFIT AND LOSS ACCOUNT ‘The second major statement of financial information is the profit and loss account. It is also known by several other titles such as incomie statement, statement of earnings, statement of operations and profit and loss statement While the balance sheet, as a stock/position statement, feveals thé financial condition of a business ata particular point of time (date), the profit and loss account portrays, as a flow statement, the operations over! during a particular period of time. The period of time is an accounting period/year. Since the purpose of cevery business firm is to ear profit, the operations of a firm in a given period of time will truly be reflected in the profit edrned by it. Thus, the income statementiprofit and loss account of a firm repotts the results of ‘operations in terms of income/net profit in a year. In operational terms, the accounting report that summarises the revenue items, the expense items and the difference between them (nei income) for an accounting period? is called the income statement. From this, description may be deduced the following three contents of the profit and loss account: (i) Revenues, i) Expenses, and (iii) Net income/profitloss, The main components of each of these are briefly examined in what follows. ‘The profit and loss account can be presented broadly in two forms: (3) The usual account form, and Gi) Step-form. A sumsnered view of the first type is presented in Format 2.3 The step-form of the profit and Joss account is summarised in Format 2.4Statements of Financial information 2.9 Format.2.3 Profi! and Loss Account—Account Form The Hypothetical Ltd Profit and Loss Account for the Year Ending March 31 Expenses ‘Amount Revenues Amount ost of goods sold ‘Sales General and administrative expenses Other income Selling expenses Interest Depreciation ‘Non-operating expenses Provision for tax Net profit Provision for dividend Net profit Reserves and surplus = Format 2.4 Profit and Loss Account-—Step Form The Hypothetical Lid Profit andl Loss Account for the Year Ending March 31 (A) Revenues Sales Other sources Total (6) Expenses Cost of goods sold General and administrative expenses Selling expenses Interest Depreciation Non-operating expenses Provision for tax Total (C), Not profit after tax Provision for dividends Reserves and surplus Revenues One group of items listed on the profit and loss account is revenues. The term revenue may be defined as the income that accrues to the firm by the sale of goods/services/assets or by the supply of the firin’s, resources to others. Alternatively, revenues mean the value’ that a firm receives from its customers. The valuefincome can arise from three sources: (i) Sale of products/goods/services, (ii) Supply of firm's resources to others, and (ii) Sale of assets like plant, investments, (fixed assets). Sales Income Revenue The sales revenue equals net sales, that i, gros sales less (i) returns and allowances, and (ii) sales discounts. Gross sales is the total invoice price of the goods sold/services rendered plus the cash sales during the year. Sales return represent the sale value of goods that were returned by the customers. Sales discount is the amount of cash discounts taken by customers for prompt payment2.40 Management Accounting External Use of Economic Resources The second source of revenue is obtained by investing a firm's resources outside and earning interest, rent, dividend, royalty, commission, fee, and so on. Sale of Fixed Assets Such assets are sold usually wher they ae not of much use in the operations of the firm Expenses ‘The cost of earning revenues is called expense. An important item of expense appearing in the profit and loss account is the cost of the goods sold. Included in this expense are material cost, labour cost and other ‘manufacturing expenses such as fuel and power, repairs and maintenance, consumable stores, insurance of ‘goods, and so on. The general sind administrative expenses include salary, managerial remuneration, rent, rates and taxes, staff welfare expenses, and so on. Other items are self-explanatory. Net Income/Profit ‘The difference between revenues and expenses is net profit. The profit and loss account may also show the appropriation of the net profits between dividends paid (o the shareholders and retained earnings/amount transferred to reserves and surplus. This last item is transferred to the balance shect in the owners’ equity. “Thus, it is a link, in a way, between the profit and loss account and the balance sheet SumniarY ‘The two financial statements, namely, the balance sheet and profit and loss accourt of business firm ‘contain useful information. The balance sheet shows the sources from which funds currently used to operate the business have been obtained, tat is, liabilities and owners’ equity, and the type of properly rights in which these funds are currently locked up, that is, assets. The profit and loss account represents the scoreboard of the performance of the firm in terms of the profitability of its operations. REFERENCES 1. Anthony, RN. Management Accounting —Text and Cases, (Richard D., Irwin, Horiewood,Ilinos, 1970), P. 1. 2. Ibid, p40 3. Ibid, p. 68 ExerciseS 2.1 Discuss the contents of a balance sheet. 2.2. What are the main items included in the profit and loss account ?Statements of Financial Information 2.1, Appendix 2-A GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAPs) GAAPs, whieh have evolved over the years, comprise the following: (i) Money measurement, (ji) Business entity, (ii) Going concera, tw) Cost, (Duality aspect, (vi) Conservatism, (vii) Accrual, (vii) Realisation, and (ix) Consistency, ‘A bref account of these is given below. 7 ‘The Money Measurement Concept ea (te principle which guides the preparation of nancial acount is ha infomation js exprested in monetary tems ‘There af to aspetis ofthe money meaturement concept. Inthe fst place, the operons of a firm involve several dimensions which are expressed indifferent unit, For nance, caw materials may be expressed in ers of numbers or ‘weighs; abour charges and consumption of elect are expressed in diferent un, and eo on. In ender to enable a ompariso, iti needed that all the jens aré shown in common terms. Expresion of facts in monetary terms in financial secounts provides sch a common denominator. A related aspect i that fets about a business which casiot be expressed in monetary terms would be exclded. For example: the ability of management, the quality of asset, the nate of competion and soon ae not amenable to expression i Monetary terms, and, therefore lie outside he scope of financial counts, Thus, financial accoarting is incapable of giving al information about the operations of business. The second aspect ofthe money messurement concep i tha transacio® are receded in monetary terms at ahs value atthe time they ake place, Tn other words, any change in rmonelary value a8 a result of changes in the parcasing poker of money have mo fest onthe financial gecouns, The Business Entity Concept ‘The business entity concept implies that financial accounts aré prepared on the premise that « business has a separate ‘entity from its owners, Therefore, while recording the various items in financial accounts, the approach isto éonsider the transactions from the. viewpoint of the firm and not from the viewpoint of those who own the business. One probable reason for treating the business as separate from its owners is that since the funds from owners and creditors are placed atthe disparal ofthe management who are responsible for the wise and efficient use of funds, the accounts prepared, on the assumption of separate entity of business enable us to judge whether or not the management has scepeded in the task assigned fo it The Going Concen Concept ‘Another element of GAAPS is the assusnption of going concera, that is, while preparing the Sinancigh accounts it i assumed thatthe business is a going concer. The term “going concern” means that the business ‘vil continue.10 opetate in future and wilt not cease doing business, sll its assets and make final payment to its creditors and owners. ‘The operational implication ofthis principle is that while placing value against itemsassets ofa firm, what is taken imo account is not the value which can be realised by the sale ofthe assets inthe market, but the value in terms of the Vale ‘of the goods/services produced by the use ofthe assets. Another way of saying the same thing is that for purposes of preparing the financial accounts a business is viewed" as @ mechanism for adding value to the resources it uses and its2:12. Mangement Accounting success is measured by the difference between the value of its output and ae cost of the resources used in creating that ‘output. In valuing assets, theiefore, curent resale value is relevant as they will not be sold as such, but rather, they will be used in creation of future gatput values. The going concer value is, thus, an antithesis ofthe liquidation value. The Cost Concept . ‘Another fundamental accounting concept, closely related to the going concem cotiept, isthe cost concept. According to it, an asst defined as resources owned by a business, is ofdinarly shown in financial accounts at cost, that is, the price paid to acquire it. The basis to value assets is cost and not current market value or current worth. The cost basis has two mefits,Firstvit provides a elajively objective basis for accaunting-as compared to the alternative of attempting to estimate current value. Secondly, the market value/eurent value concept is dificult to apply. The difficulty arses from the fact that those responsible oc preparing accounts would be compelled to keep & tack of the changes in the market prices, The gost-based system is much more feasible. Usually, the term “book value” is usedfor arnounts (cost) 1s shown in the financial accodnts and the term market value is used forthe actual value ofthe asset as reflected in the ‘market price. ‘The Duality Concept cae Financial accounting, based as itis on double entry system, follows the duality concept, According to it, there are two aspects of each transaction. In other words, each transaction affects two items. For example, X starts business and eposits a certain amount of money in a ban. The dual aspects of this transaction is that the business has cash (fesources) and the owner has a claim against this. The resources owsied by a business are called assets, while the laims against ic are of two types: () The claims of creditors and (i) The owners" claims. These are called “equities”. ‘The telationship between assets and equities is: Assets = Equities. This isthe duality concept. Conservatism ‘Yet atother GAAP is the principle of conservatism, It has @ referice 16 the basis on which incodke/profits and ‘expenseslosses have to be accounted for in finaneial accounts, Th conservative concept implies a prudent policy by ‘which profits are considered only when actually realised but account must be taken of all expenses—actual as well a8 anticipated. The dew is: aciipare no prof, and provide fr-elt-passtble eises. In relation tothe valuation of sets, te conservative principles implies thatthe basis would be the cost or the current replacément value whichever is lover. ‘The Accrual Concept Financial accouns ae prepared after certain time intervals which ee willy referred to asthe accountng period. The sual secounting period is one year. In preparing the accounts relating ta particular accounting period, a Basie principle is the acenat concep. It is often described as the “matching” concep. According tt, the expenses recognised in an accounting period shouldbe mache withthe revendes recognised in that period. For example, when certain units ofa product ae sol in the "current Year, and their sales valu recognised a revere in the “current ‘yea, the cost of manufacturing those nis should alo‘be recognised as expense inthe curent yea. Two steps are involved in.matching the revenue and expenses: First, to determine the revenues to be recognised in a given accounting petiod and, second, o determine the expenses that are-asociated with these revenues. ‘The Realisation Concept ‘The concept relates tothe basis of recognising revenues. According tothe realisation concept, fevenue is considered as being earned on the date at which it is realised, that fs, on the date when goods «ind services are Furnished to the ‘customers in exchange for cash or sore other valuable consideration. It may, however, be noted that eamming revenue has nothing to-do with the actual receipt of cash,‘Statomehts of Financial Information 213. ‘The Consistency Concept In the preparation of financial accounts, an item ean be treated in several ways. For example, a firm has Sarious alternatives to value its stock, or charge depreciation on its assets, and so on. Which of these alternatives a fi vould adopt is a matter of business policy. The consistency concept requires that once a company has decided to adopt one of the alternatives, it will continue to adopt the same basis in furure also, The reason underlying this concept is that if @ company daes not follow a consistent policy, comparison of accounting figutes over a period of time would be vitisted. ‘The GAAPs at illustrated in Annexure 2-A.1 ANNEXURE 24.1 FINANCIAL STATEMENTS AND ACCOUNTING PRACTICES ‘The accounting practices relating to the financial statements are illustrated in this Annexure with reference to: @ Balance sheet and (i) Profit and loss account. Balance Sheet Balance sheet has two sides—assets owned and liabilities owed. The two sides of the position statement always tally, For exaraple, let us ussume that 2 group of five friends form Premium Fan Company Private Ltdto market fans. [reach friend contnbutes Rs. lakh towards capital, assuming the initial contibation is made in cash, the balance sheet would Nook as follows: Balance Sheet of Premium Fan Company Private Limited as at abilities “Amount (Rs lakh) Assets ‘Amount (is lakh) ‘Capital 10 Cash 10 10 70. “The contributors of capital (owmers/pomoters) do_not figure in this balance sheet. For accounting purposes & company is considered a separa emity distinct from its promotersowners as the outcome of operations—profts or Joss—eannot be ascribed toa single person in the organisation This is the principle of separate or business entity ‘hich requires that every transaction should be seen from the perspective ofthe campany. Accordingly, capital ie a libility for he company for it represeas funds provided to it by the promoterlowners TIERS 7 lakh is deposited ina bank, cash balance would fall to Rs 3 lakh and Rs'7 lakh shown as bank balance. Balance Sheet of Premium Fan Company Private Limited as at Liabilities ‘Amount (As lakh) Assets ‘Amount (fis lakh) Capital 10 Cash 3 Bank balance 7 7 i Assume further that the company acquires fans words Rs 2 lakh against cash payment. Thus, cash balance declines and the inventory or stock of finished goods appears om the assets sides. The two sides of the balance sheet tally as shown below: .244 Management Accounting Balance Sheet of Premium Fan Company Private Limited as at Uabiltes ‘Amount (Fs lakh) Assets ‘Amount (Rs lakh) Capital 10 Cash 7 Bank balance 7 Stock of finished goods 2 70 10 “The firm is\assumed'to sell fans worth Rs 1 lakh for Rs 1.} lakh, as a result of which cash balance goes up by the amount of cash sales (Rs 1.1 lakh). The value of stock fats by Rs 1 lakh (the cost of goods sold). The difference of Rs 0.1 Inkh between cost and sale amount is profit eamed, Since the company isa custodian ofthe promoters/owners funds, profits earned belong to them and appear as a liability for Use company. The equal and simultaneous effect on the sides of the balance sheet is called the principle of duality Balance Sheet of Premium Fan Company Private Limited as at Liabilities “Amount (Fs lakh) Assots “Amount (Rs lakh) Capital 10.0 Gash 7 24 Profit ot Bank balance 70 Stock of finished goods 1.0 Toa To. ‘Gradually, the company establishes itself and decides to venture into manufacturing of fans. ts exedibility helps in raising a Tong term lozn of Rs 8 lakh from State Industrial Development Corporation (SIDC). This results in higher bank balance on assets side and Jong-term loan on lability side. Balance Sheet of Premium Fan Company Private Limited as at abilities ‘Amount (Fis lakh) Assets ‘Amount (Fs lakh) Capital 10.0 Cash 24 Profit on Bank balance 15.0 Long-term foan 80 Stock of finished goods 1.0 73.1 731 For expansion, the company buys a small industrial shed for Rs 5 lakh and machinery for Rs 7 lah. This time the vendors accept the cheque and the payment is made through the bank. The bank balance would decline and building (shed) and machinery would appear on the balance sheet as shown below: Balance Sheet of Premium Fan Company Private Limited as at .. tiabilies “Amount (Rs lakh) Assots “Amount (Rs lakh) Capital 70.0 Cash 2a Profit oa Bank balance 30 {Long-term loan 80 «Stock of finished goods 1.0 Building/shed 50 Machinery 70 Tet Tat ‘After some time, the company discovers that due wo indusial and infrastructural development in the vicinity oftheir premises, the market value of their building has increased . Now, the obvious question is should the company recognise this development, and value the building et price paid for itor at its current market price. The company has not been ‘reated to complete a specitic job. I is expected to continue its operation for an indefinite period. In other words, i will, not be liquidated in the near foreseeable future. This explains the going concern concept.. ‘Statements of Financial Information 2.15 shes reason is the-nature of asset. The building has boon acquired o carry out business fom the sits its nt smeant forsale, Besides, determination of objective and undisputed market pice of an asst not intended forsale is fatty expensive and time-consuming. Since he market value constantly Undergoes change, recordings of transacting 2 the market Price introduces instability in accounts and reunee tei acceptance and effectiveness. The pracie of recording amsactons and assets at st (caution price is called the coat concept. Unik building and other assets held for use over a fon period, cuent asses, which are meam forsale inthe normal course of busines like stock, or Conversion int cath within a short pio lke debtors fr credit sales) may be recoded atthe marke price. But conservative approach i flowed in ths regard and lower ofthe cot or market, Price is taken i> consideration. This isthe principle of conservatism which says anieipte no profits unless realised nd provide forall probable loses while recording transactions 'By now the company is fairly Well known andthe supplies do ot mind transacting business on credit bas. I acquires raw material worth Ra lakh fom Supreme Metal Lid on eri. Axe csut raw materials recorded on assets fide andthe claim of te suplie is shown on the liabilities side as creditors. Again, the principle of duality has resulted in double entry, affecting the two sides of balance sheet—eredtors onthe lailies side and aw meri sockcon the assets sie Balance Sheet of Premium Fan Company Private Limited as at Uabiities “Amount (Rs tak) Assets ‘Amount (Fs lakh) Capital ° 70.0 Cash 24 Proftt on Bank balance 3.0 Long-term loan 80 Stock of finished goods 1.0 Creditors Toke Building 50 Machinery 70 Stock of raw material 10 ‘A-careful examination of the above balance sheets shows that a balance sheet ray be visualised asa source-resource “statement. Assets are fesources at the command of the company. These are provided by vasious individuals and institutions either directly (like raw material) or indirectly, that is, aeqUiced out of funds provided by them. In othex ‘words they constitute sources of funds. Technically, they are referred 10 as liabilities or equities. ‘Depending upon the identity ofthe claimants or sources, a distinction is made between sourees. Generally, capital und profits are considered as internal sources or owners equity, for they represent the residual claims of the owners in the event of Vguidation ofthe firm, Borrowings, loan, bank overdraft and creditors, 1nd so on are external sources. In the above explanation, profit is included in owners equity which appears on the lablities side. If profits are liabilities losses are assets. Technically, losses are assets for they represent claims of the company on owners. Eventi ally, losses are to be borne by owners who are the ultimate beneficiaries of the profits eared by the firm, Another reason is the going concern concept. The business operation is continued inthe hope of eathing profits. Hence, instead ‘of subtracting ioses from owmers equity, these ae separately shown as firm's claim on owners. Although losses are assets, unlike other assets, they do nat help the company in generation of income. This Ieads to the question of efective capizal or effective resources.’To illustrate ths point, assume that goous worth Rs | lakh had to be sold for just Rs 08 lakh due to some defects in fans. It resulted in a loss ck Rs 0.2 lakh. Besides, additional expenses fof Ry 0.1 lakh were incurred as selling expenses. This raised the losses to Rs 0.3 lakh and increased cash balance by Rs 07 lakh (sales proceed ininus expenses). In the following balance sheet, the loss is frst off set against the accumulated profits of Rs 0.1 lakh and the balance of Rs 0.2 Jakh appears on the assets side. Hence, the value of clfecive capital is Rs 98 lakh (Rs 10 lakh, capital minus Rs 0.2 lak, loss)2:48 Management Accounting Balance Shet of Premium Fan Company Private Limited as at Liabilities ‘Amount (Rs lakh) - Assets ‘Amount (Rs lakh) Capital 70.0 Cash 28 Long-term loan 80 _Bank balance 3.0 Creditors 1.0 Building 5.9 Machinery 70 Stock of raw matotial 1.0 Loss 02 130 79.0 Its obvious that with every transaction, there isa change in balance sheet. Ths, in a way, balance sheet is soap shot of the financial condition of the firm at a point of time. That is why itis a position statement and we write the caption a8 balance sheet of Premier Fan Company Private Ltd atthe end of a specific day (say March 31). Profit and Loss Account Profit and loss account or Income statement is prepare to find out the efficiency of operations and management. This statement is made generally for one year andthe reves for that time period are matched with the expenses ofthat time perio. This is called matching principle. For example, considera situation where ret @ Rs 1, 000 per month for te factory has been paid in advance forthe next year also, that is, Rs 24, 000 has been paid. Out of Rs 24,000, only Rs 12, 000 are the expénss ofthe curent year and the balance is rent pad in advance or pre-paid expenses. Ths, the rent paid shoul be apportioned between the cument andthe next year. This is called the accrual concept according to swhich’cash ig not the bass forthe recognition of income or expenses; rather itis the time frame. Since reat paid in advance pértains tothe next year, it has not accrued or become due as yt. Similary, out of Rs 1,500 received as inerest inthe carent year, let us assume, only Rs 1,000 pertains to the curent year and the balance of Rs $00 is ‘onsideed forthe year in Which it becomes due. On te same line, expenses (income) which have become due for payment (ecg) but not paid (received as yet are treated as expenses income) of the current year, for eash isnot the basis for income deteminaton. 5 ‘A logical corollary of accrual concept sind matching principle is further classification of receipts and expendires as capital reeeipts/apital expenditure and revenue receips/rvenue expenditure. Usually, non-recurring items having 2 bearing on more than one accounting year are taken as capital receipsfexpenditue, for example, purchase of ‘machinery and sale of surplus land. In contrast, revenue receipafexpenditure items are comparatively smaller in Value and recur either annually or on a regular basis within a year. Since revenue items pertain to a year, the matching Principle is eay to fellow. For example, sles, payment of wages, interest, and tax. But items lke R&D expenditure in ‘View oftheir peculiar nature are called deferred reverue expenditure. Spending on RAD takes place on regular basi ‘Whereas it may frucify after along time and the benefits are enjoyed over a period of time. ‘Normally, the income statement is divided into wo parts: Trading/Manufactring Account and Profit and Loss ‘Account. It facilitates separate evaluation ofthe efficiency of production /manufacuring units and administrative uit. “The difference between revenue and expenses inthe trading/manufaturing account is income from operations which is called gross profit or operating income. Yn oer wors, itis net sles minus cost of goods sold. ‘Trading account is prepared when merchandise or goods purchased are sold without any further processing. In this ‘case, cost of goods sold for inclison in trading account is calculated as: Cost of goods sold = Opening stock + Purchases ~ Closing stock. Manufacturing accoant is prepared in the cae ofa manufacturing company. Here, computation of the cost of good sold is prepared by computation of manufacturing costs. Afler two years of operations, manufacturing account of ‘Premium Fan Company Lid fr the first quarter would appear as follows:‘Statements of Financial Information 2.17» Manufacturing Account of Premium Fan Company Private Lid forthe Period Ending June 30, Current Year (RS lath) Direct material 103. Sale of sorap 02 Direct labour 42 Cost of goods ‘manufactured 16.8 ‘Manufacturing overheads: Factory rent Power and electricity of piarit Depreciation ot plant and mac Repairs/maintenance of machinery ‘Other overheads 0 ‘Opening stock of finished goods Sales 22.0 Gost of goods manufactured Closing stock (finished goods) 1.0 Gross profit (balancing item) . 230 Profit and Loss Account of Premium Fan Company Private Lid forthe Period Ending June 30, Current Year (Rs lakh) Seling expenses Interest Salaries of general statt Depreciation on office equipment Rent . Provision for. tax Nat profit (balancing figure) Gross profit 50 Other income 10 5 ‘The income so calculated is.an approximation, an estimate showing performance of the company. Abnormal sitions (ansactons) may give @ wrong picture about its erformance, for instance, abnormal losses due 10 fire, flood, riots and other natural calamities. Similarly, there cafi-be abnormal profits, say, on sale of piece of land. These ‘tend to distort the true picture of efficiency of management if considered in the year of occurrence only. With abnormal los, the lower pois may be taken as ineficiency of management. In conrast, abnormal profits may project a weak imaragement as an effective ove. Thus, they re nommally appropriated over a period of time. Besides, management may also try to sort profit and as gure to paints rosy pitre fr present and prospeative investrs to ward off competition, prestore fom unions, rues tax Tiability and soon, I is done through change in “aecountng policy for weatment of cera items, like method of competing deprecation and inventory Valaton. In order to maintain niformity and reveal tru and fair view of the performance ofthe company the accounting policies Should be followed on & consistent basis. This i principle of consistency. Incase it is necesiay t0 change the policy, theghange and its impact shouldbe clearly mentioned ‘he use or appropriation of profs so determined is dealt with in a separate account called the Profit and Loss Applopration Account othe Statement of Retained Earnings Profit and Lose Appropriation Account of Premium Fan Company Private Ld forthe Period Ending June 30, Current Year(s lath) Geheral reserve Fixéd assots replacement reserve Dividend equalisation fund/reserve Dividend (proposed) Retained eamings (accumulated profits) [Net profit (earnings after tax) 282.48 Mariagament Accounting ‘The' eserves created in this manner are-nét kept idle. They may be temporarily invested in fInancial assets and eveniually used to fund expansion, diversification ad rhademisation plans. I is the principle of financial prudence ‘which suggests that port of profits should be retained and used for financing new asses Despite general aczepiability of thé above concepts and principles, meatment of certain items, like depreciation and preparation of financial statements may differ. It depends on the users and nurpose, such as, determination of income ‘ax, preparation of annual report as per company law and, managerial decision-making.‘Statements of Financial Information 2.19 APPENDIX 2-B FINANCIAL ACCOUNTING. SYSTEM Mustration 2.1 "Record the fllowing financial transactions in the appropriate books of accounts of Mls Growthfrm. Also open various ledger accounts and draw teal balance as at the end of March of current year 1. Mls Growth firm commenced business sty wih iil capital OF Rs 21 lakh in cash on January 1 contibuted by the group of persons interested inthe said business activity 2. Deposited Rs 20 lakh in Bank Ale. 3, Purchased following assets /aw material against cheque payments. (@) On January 5, land aoe builing CRS 5 lakh (©) On Janusy 10, plant and machinery for Rs 10 lakh (©) On January 15, fumiture and fixes for Rs | lakh (@) On January 20, raw material for Rs 2 lakh 4 The firm prcested saw cateril ino inished goods and sod goods for Re 5 lakh as pe following details = (@) On February 5 to Ramesh and Company for Rs 1,00,000 on 30 days crest. Ramesh and Company returned goods worh Rs 25,000 on February 20 as they were not as per samples and sen balance of Rs 75,000 by cheque (On February 10 to Suresh and Company for Rs 1,50,000 on 30 days credit. Payments from Suresh and Company were received on due dat. (©) On February 15 to Eximp and Company for Rs 2,00,000 on cash basis. @ On Febmoary 15 to Solvent and Company for $0,000 on 30 days credit, Solvent and Company paid Rs 25,000'on due date and promised to pay balance Rs 25,000 later on. 5, (@) The firm purchased goods for Rs 2.50900 from Creat and Company on Masch 1 (4 days credit) but returned Rs $0,000 worth of goods due to afferent specitications/qulty (&) The fem purchased goods for Rs 1,00,000 from Chote Lal Company on March 3 and paid by cheque. 6. Other expenses for the pesiod January to March are as undet: Ra ; January February ‘March Wages and salaries Ris 9,500, Rs 2,500 Rs 3,000 Re 4,000 Rent 3,000 1,000 4,000 1,000 Electricity and fuel 2,500 2,600 Travelling 4,000 1,000 Repairs 3,000 3,000 Solling and administration 4,200 4,200 Postage 700 700 Telephoneltax te 500 500 Stationary 4,500 1,500220 Management Accounting SOLUTION "Cash Book Folio number 14(assumed) F Recolpts Uae Payments Dato Particulars LF* Amount Dato ‘Particulars LF Amount . Tanuary 1 To Capital Ale 11” As 21,00,000 January 1 By Bank Ale 17 Ris 20,00,000 31 By Wages/salary 114 2,500 34. By Rent 115 31. By Balance old 21,00,000 February 1 To Balance bit 96,500 February 28. By Wages/salary 114 18 To Sales. 33 2,00,000 28 By Rent 115 By Balance old 286,500 March "1 To Balance byt 2,82;500 March 31 By Wagoslsalary 114 31 By Rent 115 31. By Electricity & fuel 116 31 By Traveling 117 31. By Repairs 118 By Selling and administration 119 31. By Postage 120 ' 31 By Telfax 121 31 By Stationery 122 31 By Balance cid FEB Apt 1_To Balance bit “BTA 106. ‘Bank Ale ~ Folio number 17(assumed) Deposits Withdrawals Date Particulars LF Amount Dato Particulars iF Amount January 1 To Gash Ae 14 Ais 20,00,000 January 6 By Land and February20_ To Ramesh building 23 Rs 5,00,000 and.Go." 94 75,000 10. By Plant and March 10 To Suresh machinery 24 —-~10,00,000 andCo. 35 ——_+1,50,000 18 By Fumiture 28 1,00,000 18 To Sohent. « = 120, By Purchases 49.—=—=—2,00,000 andCo, 36 25,000 March 3 By Purchases. © 49——_—1,00,000, 31 By Balance cid “_,3:60,000 E5000 722,50,000 April 1. To,Balanco: bit 3.50,000Statements of Financial information 2.21 Sales Book Folio munber O%assuned) a Date Particulars LF Invoice deta (assumed) “Amount Februaiy 8 Ramesh and Company 84 Number 38 February 8 Re 1,00,000 10 Suresh and Company 35. Number 142 February 10 150,000 48 Solvent and Company 38 Number 176 February 15 50,000 am. Siler Return Book Folio nunber 03 (assumed) Date Partiulars LF Invoice detals (assumed) “Amount Fabuaiy20 Ramesh and Company 34 Nomber 68 February 20 is 35,606 25,000 Purchase Book Folio number 05 Date Particulars LF Invoice details (assumed) “Amount March 7 Gredinet and Company 83 Number 45 March 7 is 2,50,000 250,000 Parchate Returns Book Folio mmber 06 Date Paniulars LF Invoice details (assumed) “Amount March 1 Gredinet and Company 6 Number 183 March Bs 607000 = 50,000 DEBTOR'S LEDGER Ramesh and Company's A/c Ledger folio number 34 (assumed) Debit Crecit Daly Patours Anon Bato Patoaas——F Amoant Febriany 5 To Sales 2 Re 7,00,000 February 20 By Sales retum 4 Ae 25,000 in 20 ByBank Ac = 17 75,000 7000 700,000 ‘Suresh and Company's Ae Ledger folio munber 35 (assumed) Dato | _ Particulars JF Amount Dale __—Parltulars F__Amourh February S| To Sales 2s 7,50,000 March 10 By Bank Ae 7A 1,50,000 Solvent and Company's le Ledger folio number 36 (assumed) Dato Parculars JF. Amount _Dato___Partulars a February 15 To Seles 2 Re 80000 March 18 By Bank Ae 7 oe 31 By Balance ct 30,000 ‘Apt 1___To Balance bf 25,000 “UF: Joural flo222 Ma CREDITOR'S LEDGER M/s Crediimet and Company Ledger folio number 52 (assumed) ; Debit Credit. Date Particulars JF Amount —_Dato Particulars JF | Amount March 1 To purchase March 1 By Purchases (08 Fis 2,50,000 retums 4 Rs 60,000 March 31 To Balance cid 200,000 2,50,000 BO Apr’ __1_By Balance bit 2,00,000 EXPENSES LEDGER Wages and Salaries Ale Folio number i14 Debit Credit Date Particulars JF Amount ‘Dato _—_—_—Parculars JF Amount January 31 To Gash 14 Rs 2,500 March 81 By Balance oidt Rs 61500 February28 To Gash 14 3,000 March 31 To Cash 14 4,000 Apel 1_To Balance bit 2.500 300 Rent Ae Folio number 115 Debit ret Date Particulars JF Amount ‘Date Particulars sF___ Amount January 31° To Cash 14 Fie 1,000. March 81 By Balance oa Fis 3,000 February28 To Cash 14 March 31 To Cash 14 "5000 Apil__1_TorBelance byt Blectrcty and Fuel Ale Folio number 1i6 Debit Credit Date Pariouass JF Amount ‘Date Particulars F___ Amount March 81 To Cash 74 Rs 2500. March 31 By Balance old Fis 2,500, April 1_To Balance bi 2 Traveling Ae Folio number 117 Debit : Cree Dato Particilars JF Amount ‘Date ‘Particulars JF ___ Amount March 31 To Gash 14 fis 1,000, March $1 By Balance afd 75000 April 1 To Balance bit 7,000.‘Statements of Financial information 2.23 Repairs Ale Folio number 118 Debit Credit Date Particulars JF Amount Date. Particulars JF Amount Warch “St” To Cash 14 Rs 3000, March 1 By Balance cid Fs 3,000 April 1 To Balance bit 3,000 Selling and Administration A/c Folio number 119 Debit Credit Date Particulars JF Amount. . Dato. Particulars JF Amount Maresh 31 To Cash 14 Rs 4,200 March 31 By Balance old 7200 April 1 To Balance bit 4,200 Postage Me Folio number 120 Debit Credit Dato Particulars JF “Amount Date Particulars JF Amount March 81 To Cash 14 Ris 700. March 31 By Balance oid Rs 700 Apil 1 To Balance bt 700 Telephone/Fax Ale Folio number 121 Debit Credit Date Particulars JF - Amount Date Particulars JF Amount Warch 81 To Cash 4 is 500, March 81 By Balance old is 600 ‘Api. 1 To Balance bit 500" Stationery Ale Debit Credit Date Particulars JF Amount Date _—_-Paariculars JF. Amount March 31} To Cash 14 Rs 1,500 March 31 By Balance fd is 1,500 April 1! To Balance bit 7,500 ae “in ft, a a mater of aosounting principle all expenses and revenue sooovnis aro closed by tansfering vo Profit and Lass AUG a ‘rd help the reader to understand preparation of wil balance, balances of these accounts have beea drava/shown GENERAL LEDGER a Capital Ave Folio number I1(assumed) i Debit Credit Dato Particulars JF Amount. Dato _—Pariculars. UE Amount March 31 To Balance efd . As 21,00,000 January 1 -By Cash Ale 14 Rs 27,00,000 Api “1 By Balance bit 21,00,0002.24 Management Accounting Land aed Building A/e Folio number 23{assumed) Debit Cre Dato Particulars "JF Amount. Dato Pariculars| F__ Amount January § To Bank Ae 17 Fs 500000. March 81 By Balance afd Fs 5,00,000 April 1 To Balance bit 5,00,900 =" : Plant and Machinery Ale Folio number 24(assumed) Debit Credit Dato Particulars JF Amount Date Particulars Amount January 10 To Banke 17 As1090,000_ March 31 By Balance od is-10,00,000 Aon 1 To Balance bit 10,00,000 aoa Furniture Ae Folia. number 25(assumed) Debit Credit Dato _Parlowlars “JF Amount. Dato ‘Particulars vE_ Amount January 15 To Bank Ae 47 Ais 1,00,000_ March 31 By Balance old. As 1,00,000 ‘pil 1 _To Balanoo bit 700,000 ancl Sales Afo : Folio number 3(assuned) Debit rat ‘Date Particulars JF Amount Dato ‘Particulars F March 81 To Balance cfd Rs 600,000 February 18 By Cash AG at March 31. By Salon book 02 5,00 000 April 1 By Balance bit Sales Return Me Folio number 93(ssumed) Debit Credit Date Particulars JF Amount Date __‘Pariculars wF Amount February20_T6 Sales Tetum book 03 Rs 25,000 February 28 By Balance cid 21s 26,000 March 28 Yo Balance bit 25,000 mane . Purchase Ale Folio number 49 Debit Credit Date Particulars JF Amount Date. Particulars JF Amount ‘ahuiary 20 To Bank Ale 17 Rie 2,00,000 March 81 By Balance ofd Fis 5,50,000 March 3 To Bank Me 17 March 31 To Purchage~ a ‘book e 2. _250,000 apn! 4 To.Balance bit 550,01‘Statemonts of Financial Information 2.25 Purchase Retum Ale » Folio number 94 Debit Credit Date Particulars JF Amount ‘Dato __—_‘Partculars JF Amount March 81 To Balance od fis 50,000 March 31 By Purchase . retum book 04s 60,000 Aprl__4 __ By Balance bit 0,000 Trial Balance as at Murch 31, Current Year Particuta Debt, Credit Capital Rs 21,00,000 Land and building ‘Rs 5,00,000 Plant and machinery 410,00,000 Furniture 1,00,000, Sales 5,00,000 Sales return 25,000 Cash 2,74,100 Bank balance 30,000 ‘Wages and salary 9,500 Rent 3,000 Electricity and fuel 2,500 Travelling 1,000 Repairs 3,000 Selling and administrative - 4,200 : Postage i 700 Tolephonetax 00 Stationery 1,500 Sundry debtors 25,000 ‘Sundry creditors . 2,00,000, Purchases 550,000 Purchase return 50,000 Totat £28,50,000 28,80,000 Illustration 2.2 In g6ntinustion to illustration 2.1, from the trial balance drawn above, prepare Income Statement for the period Ist January to March, of the current year and balance sheet as at March 31 with the following adjustments: 4) Depreciation—2 per cent on furniture and Rs 5,000 on plant and machinery ') Provision for bad debts—S per cent ofthe debtor. ‘ ©) Unpaid wages re Rs 500 6) Inventories(fésingstock)—Rs 200,000,2.26 Management Accounting SOLUTION Income Statement for the Current Year (January 1 March) Revenue, Sales Re 6,00,000 Loss: sales retun 25,000 Fis 476,000 Expenditures: Loss: Gost of goods sold: Purchase (net) Fis 500,000 Less closing stock 2,00,000 3,00,000 Wages and salaries 10,000 Font . 3,000 Electricity and fuel 2,500 Traveling 1,000 Repairs 3,000 Seling and administration 4,200 Postage 700 “Tolephonerfax 500 Stationery 1,500 Depreciation: Plant and machinery 5,000 Fumiture 2,000 7,000 Provision for bad debts 1,250 Profit boforo taxes 140,350 Total 475,000 4,75,000. Balance Sheet as at March 31, Current Year abilities: Capital Unpaid wages Sundry creditors Profits-rom income statement Total Assets: / ese ulin 5,00,000 Plant and machinery Rs 10,00,000 Less: depreciation 5,000 9,95,000 Fumiture 700,000 Less: depreciation 2,000 198,000 Inventories (closing stéck) 2,00;000 Cash 2,74,100 Bank balance Z 3,50,000 Sundry debtors 25,000 Less.provision for bad debt 1,250 23,750 24 40,850Statement of Changes in : Financial Position INTRODUCTION The balance sheet and income statement (profit and loss-account) are.the traditional basic financial state- ‘ments of a business enterprises. While. they do furnish useful financial data regarding its. operations, a Serious limitation of these sittements is that they do not provide information regarding changes in the firm's financial position during a particular period of time. In operational ters, they fail to answer questions such ‘What have beén the factors responsible forthe difference in owner's equity, assets and liabilities of the firm at two dates of consecutive balance sheets? ‘What have been the premier financing and investment activities ofthe firm during this period? Have long-term sources been adequate to finance fixed assets purchases? Does the firm possess adequate working capital? ‘Why did the firm not pay dividends in spite of adequate profits? ‘How much funds have been generated from operations? Has the liquidity position of the fim improved? ‘The statement of changes in financial position (SCFP) overcomes. these limitations of basic financial statements. In other words, the SCFP throws light on the above aspects which are of considerable interest 10 the financial managers and Outside investors. The prevent chapter illustrates the presentation and use Of SCFP. The firt section of the chapter outlines the meaning and objectives of the SCFP: The preparation of the SCEP in terms of working capital, cash, and total sesources is respectively covered in Sections 2 through 4. The Accounting Standard AS3 (Revised), Cash Flow Statements issued by the Institute of Chartered Accoutants of India in 1997, is summarised in Section 5, Section 6 examines the, usefulness of such statements, Finaly, the main points are summarised in the last section of the chapter. :3.2 Management Accounting . MEANING OF CHANGES IN FINANCIAL POSITION The statement of changes in financial position (SCP) is a statement of flows, that is, it measures the changés'that have taken place in the financial position of a firm between two balance: sheet dates. It sutimatises the sources from which funds have been obtained and the uses to which they have been applied, ~ AS & statement of sources and uses of funds, drawing on the information contained in the basic financial statemémt, it shows the source of funds and application of funds during the period. The changes in financial position could be related to several different concepts of funds. The two most common usages of the term. funds are cash and working capital. Viewed in this sense, the SCEP would explain the changes in cash or working capital. Accordingly, thers are two statements, that is, statement of changes in cash (popularly caifed cagh flow statetnent) and statement of changes in working capital (popularly known as sources and ‘uses statements of funds flow statements). The preparation and use of the SCFP, as a tool of financial analysis and-management, is illustrated here with reference to changes in: (i) The net working capital (ii) ‘The cash position, and (iii) The rota! resources. STATEMENT OF CHANGES IN FINANCIAL POSITION (SCFP)— WORKING CAPITAL BASIS Tre net working capital, NWC, ofa fim isthe amount by which its curent assets, CA, exceed its current liabilities, CL. The magnitude of working capital is a measure of the safety margin that exists for the protection of short-term creditors. Working capita! may also be viewed as funds available for acquisition of _non-current assets as well as 2 repay non-current Kabilities. Any transaction that results in an inerease in ‘working capital is a source of WC; any transaction that causes & net decrease in WC is an application of ‘WE: Some transactions merely change the form of working capital, without altering the amount of working capital as such. Cleary, such items neither constitute 9 source nor the use of working capital General Rules Let us formulate some general rules to ascertain which transactions give rise (0 4 source or a use of working capital and which do not. This exercise is useful for the preparation of the funds flow statement. Symboli- cally, wC=CA-CL ey From Eq, 3.1 the following may be deduced: (@) Transactions affecting WC: @ An increase in CA causes an increase in WC. Gi) A decrease in CA. causes a decrease in WC. (il) An increase in CL causes a decrease in WC. Gy) Acdecrease in CL causes an increase in WC. (b) Transactions not affecting WC: (9) A simultaneous increase in CA and increase in CL does not affect WC. (vi) A simultaneous decrease in CA and decrease in CL does not affect WC,‘Statement of Changes in Financial Pasition 3.3 Concrete Examples Corresponding to Each General Rule {Issue of equity shares causes an increase in cash (CA) and increase in non-current liability (NCL). (i) Purchase of non-curremt asset (NCA) causes decrease in cash (CA) and increase in (NCA). (ii) Bank overdraft to repay long-term loans causes an increase in CL and. decrease in NCL. (Gv) Bank overdiaft paid by issue of debentures causes a decrease in bank overdraft (CL) and an increase in NCL. () Purchase of inventories on credit causes an increase ia inventory (CA) and an increase in creditors cD. (vi) Payment of creditors causes a decrease in cash (CA) and a decrease in creditors (CL). ‘A close examination of the above rules and illustrations shows that a transaction which givés rise to a source of use of working capital should affect both: (2) Current account (CA or CL) and (ii) Non-current accourit (NCA or NCL) simultaneously. However, if a transaction occurs where either only current accounts (as-shown in rulés v and vi) are affected, working capital is not changed. Likewise, if both non- current accounts are affecved asa result ofthe transaction, it does not bring about any change inthe working capital, For instance, a conversion of debentures into equity, increases one component of NCL (equity) and decreases afiother component of NCL (debentures) Sources and Uses of Working Capital The major sources and use of working capital are suramarised below: (@) Sources of Working Capitat (Funds from business operations (ii) Other incomes (iii) Sale of non-current assets (iv) Long-term borrowings (©) lssue of additional equity capital or preference share capital (b) Uses of Working Capital (i) Losses from business operatiéns (ii) Purchase of non-current assets (ii) Redemption of debentures and/or preference shares (iv) Dividends to shareholders: Funds From Business Operations The profivloss figure, as shown in the profit and loss account of the firm, per se does not indicate the quantum of working capital provided by business operaiians because the revenues and expenses shown d6 not run parallel.to the flow of working capital. The profit and loss account contains.a varity of write-offs and other adjustments witich do not involve any corresponding movement of funds. Therefore, appropriate adjustments are to-be made to the profit disclosed by the profit and loss account to arrive at the funds fram. business operations. For this purpose: (i) All such expenses which have been deducted from revenue but do not reduce working capitat-are to be added back, (i) Such items'as have been added to revenue but have not contributed to the working capital are to be subtracted, and (ii) AlN such revenues which are not directly caused by business operations should also be ‘deducted arid showin sepa- rately inthe statement. The items requiring adjustment ate listed in Exhibit 3.1+ ‘8.4 Management Accounting Exhibit 3.1. Adjustment to Profit (A) Net income (or loss) as shown by the profit and loss account; 'B) Add: Depreciation expenses; Amottisation of goodwill, patents and other intangible assets; ‘Amortisation of discount on debentures or share issue expenses; ‘Amortisation of extraordinary losses occurred in previous years; Loss on sale of non-current assets; (C) Less: Amortisation of premium received on debentures: Profit on sale of equipment; Profit on revaluation of non-current asset Dividends and interest recelved on investments (reported separately). und from business operations. (A+B-o) ‘An Alternative Method of Estimating Funds from Business Operations The alternative method of measuring funds provided by business operations, in aétual practice, is by recasting. the profit and loss account itself. To be specific, the profit and loss account should be prepared afresh so as to incorporate: () Only business revenues providing working capital on the income side (leaving the items which are to be deducted as.per Exhibit 3.1) and (ii) Only those operating expenses which involve the use of working capital (leaving the items which are to be added as per Exhibit 3.1). The balancing figure of such a statement would represent the amount of net working capital provided (or used) in business operations. Exhibit 3.2 summarises the format.of such a procedure, Exhibit'3.2 - Adjusted Profit and Loss Account (A) Sales revenue (B) Less: Expenses using working capit Cost of raw materials used ‘Wages and salary expenses Manutacturing expenses (excluding depreciation) Advertising expenses Insurance expenses Office expenses Other operating expenses Interest Income taxes. (A~B) = Funds from bu 1988 operations Funds from businéss operations éan also be obtained from the statement of retained earnings. In order to ascertain funds from business operations with the help of the statement of retained earnings, the following protedutes should be adopted: (i) Balance of profit at the end of the year requires adjustment as explained in Exhibit 3.1, Gi) The amount of transfer to the general reserve or any other reserve indicating appropriation out of profits should be added back as these transactions merely involve the reclassification of items and do. not involve any. corresponding use of working capital. (Gii) Payment of dividends (as is separaiely shown under “uses” of the statement) should be added back. (Gy) Finally, the balance of profit atthe beginning of the year should be deducted. ‘The computation of funds from business operations is shown in Example 3.1.Statement of Changes in Financial Position 3.5 EXAMPLE 3.1 From the following income statement (Table 3.1) of Hypothetical Ltd, determine the funds obtained from operations, using various methods. Table 3.1 income Statement of Hypothetical Ltd. for the Current Year ‘Amount (As thousand) Amount (As thousand) Sales revenues 420 Less: Cost of goods sold 200 Operating cash expenses 40 Depreciation’ 30 Amortsation of - (i) Patont 5 (i) Prolisinary expenses 2 Loss on. sate of ald equipment 3 280 Operating income 140 Less: Income taxes 70 70 ‘Add: Other income: Gain on sale of land 5 “Gain on redemption of debentures 1 Dividends from investments in-other companies. 4 Revaluation of land 8 Not income Beginning balance of P&L Alc Net income for the current yoar Less: Transfer to general reserve 18 Amorigation of goodwill 3 Dividend on preference shares 20 Dividend on equity shares af) 1280 Ending balance of P&L Ale 70 SOLUTION ‘Alternative 1: (based on Exhibit 3.2) ‘Amount (AS in thousand) “420 Sales revenues Less: Expenses using working capital: Cost of goods sold 200 Operating cash expenses 40 Income taxes 70 310 Funde-from business’ operations 1103.6 Management Accounting Alternative 2: (based on Exhibit 3.1) 3 Net Income ‘Add: Expenses not involving the use of working capita Depreciation 30 Amortisation () Patent (i) Preliminary expenses Loss on sale of equipment . Less: Income not augmenting working capital: Revaluation of land 15 Income separately reported: Dividends from investment in other companies 4 Incomes clubbed with other items of sources: “Gain from sale of land 8 Gain from redemption of debentures 1 38 Fainds from business operations 710 Alternative 3: (retained earnings statement as base): Ending balance of Profit and Loss Ale 70 Add: Expenses not involving the use of working capital: Depreciation 30 Amortisation of Patent 8 Preliminary expenses 2 Gootwi 5 3 5 Loss on sale of equipment Transfer to general reserve 1 Expenses separately reported: Dividends on preference shares 20 Dividends on equity shares 40, 120, 190) Less: Incomes not augmenting working capital: Revaluation of land 15 Income separately roported: Dividends from investment in other companies Incomes clubbed with other items of sources: Gain from sate of fand Gain from redemption of debentures 25 165 ‘Less: Baginning balance of P&L Alc 55, Funds from business operations Tio 4 5 Changes in Non-Current Assets Apart from funds from operations, the transactions relating to not current assets also require. some special consideration. The changes in non-current assets like patents, oodwill and other intangible assets are due to their amortisation or acquisitions. If there is decrease in their balances, it is reasonable to assume, in the, absence of information to the contrary, that the asset has been amortised. An increase, On-the other hand, implies purchase of an asset, and accordingly should be indicated 5 Use of funds.‘Statement of Changes in Financial Position 3.7 ‘The changes in other non-current assets, particularly plant and equipment account, require a more careful analysis to ascertain Turd obtained-from.thir sale or funds use in their acquisition. Fortis purpose. we should investigate thre things: (i) Increase/decrease in plant and equipment account and accumulated depreciation (if plant and equipment is maintained on gross basis), (ji) Gains or losses 18 the profit and less account indicating that plants and equipment have been sold, and (ji) Other information relating tothe acquisition aié retirement of plant and equipment that accompanies the financial statements. This is shown in Example 3.2. EXAMPLE 3.2 From the following information furnished to you relating to plant and equipment account of Hypothetical Ltd, determine the funds obtained from sale of old plant and equipment Previous year Current Yaar~ “Amount (Fis in thousand) Amount (Rs in thousand) Plant and equipment (gross) 400 728 20 20 (i) Loss on sale of plant and equipment + (i) Depreciation charged during the year on plant and equipment 14 (i) Purchase of new plant dung the yoar . 35 SOLUTION The gross increase in plant and equipment is Rs 25,000. But the reported purchases are Rs 38,000. From these two items of information, it follows that in the absence of any sale on plant account, its balance 48 at the end of the current year would have been Rs 1,35,000 (Rs 1,00,000 (opening balance) + Rs 35,000 (xditions during the year)]. But the balance of the account is Rs 1,25,000, indicating that plant ard ‘equipment having ® gross book value of Rs 10,000 has been sold, Further, there is an increase inthe balance of accumulated depreciation by Rs 10,000 but the deprecia- tion amount charged during the year is Rs 14,000. Therefore, in the absence of any writing-off the deprecia- tion during the year, its balance would have been Rs 34,000 [Rs 20,000 (opening-balance) ~ Rs F4,000 (charged during the year)] as against Rs 30,000 a8 at the end of current year. These facts, taken!together, indicate that the amount of depreciation on the plant sold is Rs 4,000, ‘The following information relating to the plant and equipment that has been sols, thus available: Gross book value (original purchase cost) Rs 10,000 ‘Accumillated depreciation 4,000 Net book value (Rs 10,000 ~ Rs 4,000) 6.000 ‘Therefore, sale proceeds of plant (Rs 6,000 ~ Rs 1,000 toss) 5,000 ‘The preceeding information can be tabulated in.the form of ledger accounts which provide the desired information more clearly.8.8 Management Accounting Plant and Equipment Account ‘Amount ‘Araunt (Rs in thousand) (Bs in thousand) ‘pening balance 100 Original cost of sold plant ash (few equipment (balancing figure) 16 purchase given) 36 Closing balance 125 735; 135 Accumulated Depreciation Account Total depreciation on sold plant ‘Beginning balance 20 (balance figure) 4 Depreciation expenses charged Closing balance 30 during the year 44 2 34 34 Changes in Non-Current Liabilities Another item which deserves consideration in this éonneétion is changes in non-current liabilities (NCL). The changes in NCL account will be either due to fresh issues of shares and debentures or their redemption. The increase in the NCL account is indicative of an additional issue of securities and is regarded as a source of funds/working capital. However, if tis due tothe issue of bonus shares, it is not a source of funds. It simply amounts to reclassification of accounts, that is, reducing retained earningv/reserves and increasing equity share capital. It should be checked whether the new issue of securities is at par, premium, or discount. Inthe case of the latter two situations, the net increase would not be the trie representative of the source of funds. Inthe case of premium, the actual amount received wold bbe more, while it would be less if the new issue is made at discount. Likewise, in the case of the retirement of debt or preference shares, care should be token to ascertain whether the redemption is at par, premium oF discount. Example 3.3 illustrates coinprehensively the SCFP — working éapital basis. EXAMPLE 3.3, Given below are the balance sheets as on March 31, previous year and current year, and a statement of income and reconciliation of earnings for the current year of Electronics Ltd (EL). The only item in the buildings and equipment account ‘sold during the year was’a specialised machine that originally cost Rs 15,000. The accumulated depreciation on.this machine at the time of sale was.Rs 8,000. ‘The machine ‘was sold for Rs.6,000 and full payment was received in cash. The EL purchased patents for Rs 16,000 “during the year. Besides cash purchases of plant and equipment, the assets of another company were also Purchased for Rs 1,00,000 payable in fully paid-up shares, issued at par, the assets purchased being ‘goodwill, Rs'30,000 and equipments, Rs 70,000. Electronics Limited Comparative Balance Sheets ‘March 31 March 34 Previous year Current year (Rs in thousand) (As in thousand) Cash : i 74 a7 ‘Accounts receivable 54 — Inventories: 312 ar Toniet)Statement of Changes in Financial Position 3.9 (Conta!) Pre-paid expenses 6 4 Land ‘80. 60 Patonts 55 65 Buildings and equipment 420 550 Less Accumulated. depreciation (305) (120) Goodwill 30 Total assets 76 950 ‘Accounts payable 38 =acae Notes payable 28 8 imated income-tax 86 12 eial security taxes accrued 3 5 Spentures 220 60 Suity capitat 250 560 Zetained eamings 231 ait é Total liabilities ‘876. ‘950 Electronics Limited Statement of Income and Reconciliation of Earnings for Current Year “Amount (Rs in thousand) Net sales 1,970 Less cost of goods sold 480 Gross profit 490 Less operating expenses(includes depreciation on buildings and equipment) 486 Less interest on debentures 14 Net-loss from operations 49) ‘Less other revenues i Net loss @ ‘Add retained earings (previous year) 231 Less dividend paid 16 228 Less loss on sale of assets 1 17 Retained eamings (March 31, current year) — ait From the foregoing information, prepaze a funds flow statement for Electronics Lid. SOLUTION Table 3.2 Funds Statement of Electronics Limited for the Current Year 7 “Amount (Rs in thousand) (A) Sources of funds; Funds from business operations: Net sales |” 1,970 Less: Cost of goods sold 11480 Less: Cash operating expenses 457 Less: Interest 4 19 78) Funds from other revenues Zz (29) (Conta)8.10 Management Accounting (Contd ‘Sale of nor-current assets (machine) é lsue of long-term ilties for cash (equily capital) 210. . 242 (®) Uses of funds: Purchase of non-curont assets: Buildings and equipment (cash) 5 (1.0) Patents 16 6) Payment of long-term liabilities (debentures) 160 (86.1) Recurring payments to investors: Dividend pald to shareholders. GF Tot Net decrease in working capital (B — A) (uses ~ sources) 25 (10, Note Figures in brackets ae percentages to the sources. Building arid Equipment Account ‘Amount ‘Amount (Rs in thousand) (Rs in thousane) To balance b/d 420 By cash é To equity share capital 70 By P&L AC 1 To cash (purchases) 75 By accumulated depreciation 8 By balance old 550 5 565. Patent Account “Amount “Amount (Bs in thousand) (As in thousand) To balance b/d S By P & L Ale (amortisation) é To cash (purchases) 48_. By balance oid — 7 7A Table-3.3 Statement of Changes in Working Capital (Rs in. thousand) March 31, ‘March 31, Working Captal Previous year Current year Thevease ‘Decroase, @) a (A) Qurrent assets: Cash © / ma a7 37 ‘Accounts/ receivable Bt a7 7 Inventories 312 arr 35 Pre-paid expenses 6 4 2 wa6 365 (8) Current tiabilties: ‘Accounts payable 58 94 36 (Contd)Statement of Changes in Financial Position 9.11 (Conta) Notes payable 28 @ 20 Estimated income tax 86 74 Social security tax 2 795. _ Net working capital: 7 — (CA~ cl) ani 24 119 Decrease in net working capital 25, _ 2 aA 719 19 Interpretation Example 3.3 highlights the financing and investing activities of Electronics Lid. Its major source of funds is the issue of additional equity capital (86.8 per cent). Funds from other sources constitute a minor part (13.2 per cent) of its total financial resources. On the ‘uses’ sie, the major items are payment of long-term liabilities (66.1 per cent) and purchases of buildings and equipment (31 per cent). In absolute terms, the funds obtained by the issue of equity shares in the market (Rs 2,10,000) have been utilised primarily for repayment of debentures (Rs 1,60,000) and partly forthe purchase of building and equipment (Rs 75,000), It reflects shortage of working capital with:the'EL. There has been a decrease in every component of current assets (Table 3.2). The EL is required to raise additional long-term funds to salvage its current financial position ; ‘The above illustration clearly shows the immense usefulness of the statement of changes in financial position to know major activites of the EL: financial, operational and investment, STATEMENT OF CHANGES IN FINANCIAL POSITION (SCFP)— CASH BASIS The statement of change in financial position based on working capital is of immense use in long-range financial planning. The long-term financing and investment activities are specifically portrayed. The net ‘working capital requirements (in one lump sum amount) are shown as a residual figure. However, the _working capital concept may conceal or exclude too much, It treats increases in inventories and accounts receivable as equivalent to increase in cash, Likewise, an increase in accounts payable and accrued expenses ae treated as equivalent to an inerease in.bank overdraft. Ths is.not a correct treatment. In fact, acerued expenses like wages and salaries may become payable in the next 10 days or so; sundry ereditor’s bills may fall due for payment during the next one month, whereas bank overdraft may be for a longer period of, say, three months ar even more. Similarly, inventories and accounts receivable undergo a transformation before they become money assets. It is possible that there is sufficient net working capital as revealed by the statement of changes in financial position, and yet the firm may be unable to meet its current liabilities as and when they fall due. It may be due t0 a sizeable piling up of inventories and an inctease in debtors caused by a slow-down in coHections. The firm’s failure to meet its short-term commitments, in spite ofits sound long-range financial position and adequate profitability, may. plunge it into technical insolvency. ‘Therefore, in making plans for the more immediate future (short-range financial planning), the management is vitally concerned with a statement of cashflows which provides mete detailed information. Such a statement is useful for the management to assess its ability to meet obligations ta trade creditors, to pay bank Joans, to pay interest to debenture-holders, and. dividends to its shareholders. Furthermore, the812 Management Accounting projected cash flow statements prepared month-wise or so! (Which are constructed like the funds statement) ‘can be useful in presenting information of excess cash in some months and shortage of cash in others. By making available such information in advance, the statement of cash flows enables the management t0 revise its plans. In the months when cash receipts are expected to be greater than cash payments, bank overdraft can be repaid, short-term government securities can de purchased, cash discount can be availed of, ands0 on. Likewise, in the months whén cash payments are expected to exceed receipts, the firm would be required to arrange for bank overdraft or sell its marketable securities. In essence, cash flow statements are statements of changes in financial position prepared on the basis of funds defined as cash or cash-equivalents. In short, cash flow statements summarise sources of cash inflows and uses of cash outflows of the firm during a perticular period of time. Preparation of Cash Flow Statement ‘The principal difference between a funds-flow statement and the cash flow statement lies in the amount shown as resources. provided by business operations. Therefore, from the point of preparing a cash flow statement, funds from business operations are to be adjusted so as to obtain cash from operations. Most of, the other items reported in-the funds statement generally involve cash receipts or payments, for example, issue of equity shares or preference shares, sale or purchase of non-curtent assets like equipments building, and so on. These items alse appear in a cash flow statement. Cash from Business Operations Funds from business operations under working capital concept are based on accrual accounting procedure in that sales, whether credit or cash, are recognised as a source of working capital Likewise, purchases, whether credit or cash are considered as a use of working capital But, under the cash concept of funds, the concem is with the cash basis of accounting. Only cash sales and cash receipts from debtors against credit sales are’ recognised as a source of cash. Similarly, eash purchases and cash payments to suppliers for credit purchases are regarded as the use of cash. The same holds true for ‘ther expenses and incomes. No consideration is given for outétanding and pre-paid expenses and incomes. ‘Thus, every item in the profit and loss account is altered according to the cash approach. Some of the items of adjustment of the profit and loss account in the cash flow approach would be the same as in the funds statements, for instarice, depreciation on plant and equipment, amortisation of various deferred rev- ‘enue expenses, and so on. Since these items do not involve any corresponding outflow of funds (cash) they ae added back to determine funds from operations in funds statements. The logic that is applied in the funds statement also applies in the cash flow statement, but the analysis is required to be extended further. Cash is only one of the current assets ands part of the net- working capital. Therefore, the changes in all of the other curtent assets and in the current liabilities must be analysed in relation to their effect on cash. The rules for relating the changes in current assets and current liabilities to the profit and loss acébunt in the computation of a flow of cash from operations are suminarised below. (Al increases in the current assets excluding cash and decreases in the currentiabilities which increase working capital, decrease cash. The decrease in curtent liabilities takes place whea theyre paid in cash. For instance, decrease in creditors, bank overdrafts, bills payable, dividends payable will occur due to their payment. A word of explanation is necessary to show the negative impact of increase in current asses on cash, For instance] an inerease in sundry debtors takes place because credit'sales are greater than cash collections from them; inventories ihcreage when the cost of goods purchased is more than the cost of goods sold. Tnerease in pre-paid expenses involves payment of more cash thai is required for their current services. Q : ‘t) From the first follows the second rule: all decreases in cureft assets other than cash, ad increases in current liabilities’ which causes a decrease in working capital, increase cash, Debtors would decrease‘Statement of Changes in Financial Position 3.13 because cash collection is more than current credit sales. Inventories would decrease because cost of goods sold is more than cost of goods purchased; decrease in pre-paid expenses reflects that the firm has paid less for services than are currently used. Lixhibit 3.3 shows the procedure for determining cash from operations. Exhibit 3.3 Format of Cash Flows from Business Operations “Amount (A) Working capital from business operations (as per funds-flow statement) (8) Adjustment to convert to cash basis: () Add: Decrease in WC (-CA or + CL) Decrease in current assote other than cash (item-wise) Increase in current liabilities (tem-wise) (i) Less: Increase in WC (+ CA or ~CL) Increase in current assets other than cash (item-wise) Decrease in current Il (©) Cash flow irom business operations ‘The complete cash flow statement for Electronics Ltd of Example 3.3 is shown in Table 3.4. Table 3.4 Cash Flow Statement of Electronics Ltd for the Current Year “Amount Percentages (Rs in thousand) (@). Sources of cash: Cash inflow from business operations 7 (3.0) Cash infiow from other revenues 7 Bo) Sale of non-currént assets (machine) 6 26) Issue of long-term labites: save of equity shares 210 (91.4) Total sources of cash 230 TH100.0) (B) Uses of cash: Purchases of non-current assets: Building and equipments 75 (326) Patents 16 63) Payment of long-term labilties: Retirement of debentures 160 (69.8) Recurring. payment to investors: Dividends paid to shareholders 16 (69) Total uses of cash 267 < Decrease in cash: (Uses ~ Sources) 37 (16.0) Working Notes (Rs in thousand) : Cash from business operations: Funds trom business operations 19 ‘Adjustments to convert to cash basis: ‘Add: Decrease in WC (-CA or +CL) . . () Current assets: i Accounts receivatiie” z (conta3.14 Management Accounting (Conta) inventories 35 Pre-paid expenses 2 44 (i) Curent Waites: ‘Acoount-payable 36 Social security taxes acorued 2 38 Lass: increase in WC (4CA or ~CL) ae (0) Current assets . Nit (3) Current tablties: Notes payable 3 20 Estimated income tax 74 94 Gash intiow tram operations 7 Note Figures in brackets are percentages (0 total sources. STATEMENT OF CHANGES IN FINANCIAL POSITION (SCFP)— ‘TOTAL RESOURCE BASIS ‘The SCFP based on working capital as well as cash are incomplete and inadequate to the extent that they omit some majet financial and investment activities like issue of equity shares or debentures for purchase of building or plant and machinery, conversion of debentures into shares, issue of bonus shares, and so on. Such items, ofcourse, do not affect working capital but are significant, and therefore, need to be shown in the SCEP 10 achieve the objective of showing all financing and investment activities of the firm. ‘The SCFF statement prepared on the basis ofthe tolal resources concept includes all these significant financial transac- tions. Thus, the “total resources” concept is the best and the most comprehensive approach 10 disclose the changes jn the financial position of the firm. For the firm in Example 3.3, the SCFP on total resources basis is illustrated in Table 3.5 Table 3.5 SCFP Based on Total Resources of Electronics Ltd, for the Current Year ‘Amount ‘Percentages (fs thousand) TA) Total resource provided: Funds trom businoss operations 33 @3) Funds from other revenues 7 20) Sale of non-current assets (machine) 6 7) Issue of long-term lebilitios Equity capital (for cash) 210 (69.0) Equity capital (fo purchase ot equipments ‘and goodwil) 4100 (28.0) 358 7100-0) (8) Total resources used: camman ares Purchaso of non-current assets |, Building and equipment (cash) 75 1.1) | Equipment (in exchange for equity shares) 70 (19.7) Goodwin exchange for equily shares) 30 (64) (Patents 16 (45) Payment of debentures . 160 (44.9) 1 (ania)‘Statement of Changes in Financial Position 3.15 (cont) Dividends paid to shareholders 16 (4.8) Interest paid to debentureholdors 14 ) at (07-0) 7 () Not decrease in working capital (B-A) en Oe Note Figures in brackets are percentage to total resources. Working Notes (Rs in thousand) Funds from business operations: Net sales e 1,970 Less: cost of goods sold 4,480 Cash operating expenses 457 1987 33 ACCOUNTING STANDARD: AS 3 (REVISED), CASH FLOW STATEMENTS In the initial years, this accounting standard (AS) is recommendatory in character. During this period, this standard is recommended for.ise by companies listed on a recognised stock exchange and other commercial, industrial, and business enterprises in the public and private sectors. Objectives Information about the cash flows of an énterprise is useful in providing users of 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 those 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 certainty of their generation. ‘The AS deals withthe provision of information about the historical changes in cash and cash-equivalents of an enterprise by means of a cash flow statement which classifies vash flows during the period from operating, investing, and financing activities. Scope ‘An enterprise should prepare a cash flow statement and should present it for each peri for which financial statements are presented, Definitions The following terms are used in this statement with the meanings specified: ‘Cash comprises cash on hand and demand deposits with banks. Cash-equivalents are short term, highly liquid investments that are readily convertible into known amounts of cash, and which are subject to an insignificant risk of chahges in value. 7 Cash flows are inflows and outflows of cash and cash-equivalents.8.16 Management Accounting Operating activities are the principal revenve-producing activities of the enterprise and other activities that are not investing or financing activities. Investing activities are the acquisition and disposal of long-term assets and ther investments not in- ‘huded in cash equivalents Financing activities are activities that result in changes inthe size and composition ofthe owners’ capital (including preference share capital inthe ease of a company) and borrowings ofthe enterprise. Presentation of a Cash Flow Statement ‘The cash flow statement should report cash flows ising the period classified by ‘operating, investing, and financing activities. Reporting Cash Flows from Operating Activities An enterprise should report cash flows from operating activities using either: (@) The direct method, whereby major classes of gross cash receipts and gross cish payments are disclosed or (b) The indirect method, whereby net profit or loss is adjusted forthe effects of transactions of a non-cash nature, any deferrals or acerusls of pastor future operating cast receipts or payménts, and items of income or expense associated with invesing or financing cashflows. Reporting Cash Flows from Investing and Financing Activities . An enterprise should report separately major classes of gross cash receipts and gross cash payments arising from investing. and financing activities, except to the extent that cash flows described below are reported on a net basis. Reporting Cash Flows on a Net Basis Cash flows sing fom the following operating, investing or financing activities may be reported on a ret basi (a) Cash receipts and payments on behalf of customers when the cash flows reflect the activities of the ‘eustomer rather than those of the enterprise and (©) Cash receipts and payments for items in which the turnover i quick, the amounts are large, and the ‘maturities are short. ‘Cash flows arising from each of the following activites ofa financial enterprise may be reported on a net basis: (@) Cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date; (b) The placemnent of deposits with and withdrawal of deposits from other financial enterprises; and (©) Cash advances anid loans made to customers and the repayment of those advances and loans. Foreign Currency Cash Flows Cash flows arising from transactions in a foreign currency should be recorded in an enterprise’s reporting curreney by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign curency at the date of the cashflow. A rate that approximates the actual rate may be used ifthe result is substantially the same as would arise if the rates at the dates of the cash flows were used. The effect of changes in exchange rates on cash and cash-equivalents held in a foreign currency should be reported as 1 separate part of the reconciliation of the changes in cash and cash-equivalents during the period.‘Statoment of Changes in Financial Position 3.17 Extraordinary Items ‘The cash flows associated with extraordinary items should be classified as arising from operating, investing, or financing activities as appropriate and separately disclosed. Interest and Dividends Cash flows from interest and dividends received and paid should each be disclosed separately. Cash flows arising from interest paid and interest and dividends received in the case of a financial enterprise should be classified as cash flows arising from operating activities. Inthe case of other enterprises, cash flows arising from interest paid should be classified as.cash flows from financing activities, while interest and dividends received should be classified.as éash flows from investing activities, Dividends paid should be classified as cash flows from financing activities ‘Taxes on Income Cash floWws arising from taxes'on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activites Investments in Subsidiaries, Associates, and Joint Ventures ‘When accounting for an investment in an associate or a subsidiary ora joint venture, an investor restricts its reporting in the cash flow statement to the cash flows between itself and the investee/joint venture, for example, cash flows relating to dividends and advances. Acquisitions and Disposals of Subsidiaries and Other Business Units ‘The aggregate-cash flows arising from acquisitions and from disposals of subsidiaries or other business lunits should be presented separately and classified as investing activities. ‘Anetiterprise should disclose, in aggregate, in respect of both acquisition and disposal of subsidiaries or other business units during the period, each of the following: (a) The total purchase or disposal consideration and (b) ‘The portion of the purchase or disposal consideration discharged by means of cash, and cash-equiva- ents Non-Cash Transactions * Investing and financing transactions that do not require the use of cash oF cash-équivalents should be excluded from a cash flow. statement, Such transactions should be disclosed elsewhgre in the financial statements in a way that provides all the relevant information about these investing and financing activities. Components of Cash and ash-Equivalents ‘An enterprise should disclose the compohents of cash and cash-equivalents and should present a reconcilia- tion of the amounts jn its cash flow statement with the equivalent items reported in the balance sheet.3.18 Management Accounting : Other Disclosures ‘An enterprise should disclose, together with a commentary by management, the amount of sig ‘and cash-equivalent balances held by the enterprise that are not available for use by it. ‘The preparation of cashflow statements is shown in Exhibits 3.4 and 3.5. Exhibit 3.4 Cash Flow Statement for Enterprise Other than a Financial Enterprise The exhibit is ilustrative only and does not form a par of the accounting standard. The purpose of this exhibits to illustrate the application of the accounting standard, 4. The example shows only current period accounts. "2!" Information from the statement of profit and loss and balance sheet is provided to show how the ‘statements ‘of ¢ash flows under the direct method ahd the indirect method have been derived. Neither the statement of profit and loss nor the balanée sheet Is presented in conformity with the disclosure and presentation requirements of applicable laws and accounting standards. The ‘working notes giver towards the end of this appendix are intended to assist in understanding the manner in which the various figures appearing in the cash flow statement have been derived. ‘These working notes do not form part of the cash flow statement and, accordingly, need not be published. 3. The following additional information js also relevant for the preparation of the statement of cash flows (figures are in '000).. ~~ (@) An amount of 250. was raised from the issue of share capital and a further 250 was raised {rom long-term borrowings. (b) Interest expenses was 400 of which 170 was paid during the period: 100 relating te interest ‘expense of the prior period was also paid during the period, (¢) Dividends paid were 1,200. (@) Tax deducted at source on dividends received (included in the tax expense of 300 for the year) amounted to 40. (@) During the period, the enterprise acquired fixed assets for 950, The payment was made in cash, (f) Plant-with original cost of 80 and accumulated depreciation of 60 was sold for 20. (g) Foreign exchange loss of 40 represents the reduction in the carrying amount of a short-term investment in foreign currency designated bonds arising out of a change in exchange rate between the date of acquisition of the investment and the balance sheet date. (h) Sundry debtors and sundry creditors include amounts relating to credit sales: and credit purchases only. Balance Sheet as at March 31 (Rs in Thousand) Year 2 Year 1 esate Cash.on hand and balances with banks 200 25 ‘Short-torm investments 670 135 ‘Sundry debtors 1,700 41,200 Interest receivable 100 ~ Inventories 900 1,950 Long-term investments 2.500 2,500 Fixed asset at cost 2,180 1,910 ‘Accumulated depreciation (1,450) (1,060) Fixed assets (ne!) —— ._70 ———__ 280 Total assets TB560, (ContaStatement of Changes in Financial Position 3.19 (Conta!) abies ‘Sundry creditors: 150 1,890 Interest payable 230 100, Income taxes payable +400 1,000 Longsterm debt 4,110 4,040 Total liabilities 1,890, "4,030 Sharehiders’ Funds ‘Share capital 1,500 1,250 Reserves 3410. 11380 Total shareholders’ funds ‘4.910 2,630 Total lablties and shareholders’ funds 6,800. _ eat) Statement of Profit and Loss for the Period Ended March 31, Year 2 Sales: 30,650 Cost of sales (26,000) Gross profit 4.650. Depreciation (450) ‘Administrative and selling expenses (910) Interest expenses (400) Interest income, ‘300 Dividend income 200 Foreign exchange loss (40) Net profit before taxation and extraordinary item 3350 Extraordinary item: insurance proceeds from earthquake disaster settlement Nat profit after extraordinary item 3,590 Income tax (300) Net profit 3,230 Notes to the Cash Flow Statement (Direct & Indirect Method): 1. Cash and Cash-Equivalents Cash and cash-equivalents consist of cash on hand and balances with banks, and inyestments in money- ‘market instruments, Cash and cash-quivalents included in the cash flow statement comprises the following balance sheet amounts. Year 2 Year 1 ‘Cash on hand and balances with banks 200 Short-term investments ‘ 870, Cash and cash-equivalonts 870 Effect of exchange rate changes 40. Cash and cash-equivalonts as restated 910 160 Cash and cash-equivalents at the end of she period include deposits with banks, 100, held by a branch which are not freely remissible to the company because of currency exchange restrictions. ‘The company has undrawn borrowing facilites of 2,000, of which 700 may be used only for future expansion, 2. Toral tax paid during the year (including tax deducted at source oh dividends received) amounted to 900,3.80 ‘Mardgamiont Accounting’ ‘ Direct Method Cash Flow Statement Year 2 Gash flows from operating activiios Cash receipts from customers 30,150 “Cash paid to suppliers and employees (27,800) Cash generated from operations 2,550 Income tax paid (860) Cash flow belore extraordinary item 77,690 — Proceeds trom earthquake disaster settlement 180 Net cash from operating activities 1870 Cash flows from investing actvties Purchase of fixed assets (350) Proceeds from sale of equipment 20 Interest recelved 200 Dividend received 160 [Net cash from investing actvtios 20 Cash flows from financing actviies Proceeds from issuance of share capital 250 Proceeds from long-term borrowings 250 Repaymens of long-term borrowings (180) Interest paid (270) Dividend paid (1,200) ‘Net cash used in financing activities Ta *_ 0,480) Net increase in cash and cash-equivalents 7 Cash and cash-equivalents at beginning of period (See Note 1) 160 Gash and cash equivalents at end of period (See Note 1) 310 Indirect Method Cash Flow Statement Year 2 ach flows from operating actvlies Not profit before taxation, and extraordinary item 3,350 Aqjustment for Depreciation 450 Foreign exchange loss 40 Interest income (200) Dividend income (200) Interest expense 400 Operating profit before working capital changes 3740 Increase in sundry debiors (600) Decrease in inventories 4,050 Decrease in sundry creditors (1,740). Cash generated from operations “2850 Income. tax.paid: (860) Cash flow before extraordinary item 6 Procéeds from earthquake disaster settlement 180 [Net cash from operating activiias 1.870‘Statement of Changes in Financial Position. 3:21 (Contd) Gash fow from Investing activities Purchase of fixed assets (350) Proceeds, from sale of equipment 20 interest received 200 Dividends recelved 460 Net cash from investing activities 30 Cash flow from financing activities Proceeds from issuance of share’ capital 250 Proceeds trom fong-term borrowings 230 Repayment of long-term borrowings (180) Interest paid (270) Dividends pats (1,200) [Net cash used in financing activities Tot (6160) ‘Net inctease in cash and cash-equivalents: 750 ‘Cash end cash-equivalents at beginning of period (See Note 1) ‘160 Cash and cash-equivalents at the end of period (See Note 1) 910 ‘Alternative Presentation (Indirect Méthod) {As an alternative, in an indirect method, cash flow statement, and operating profit before working capital changes is sometimes presented as follows: Revenues excluding invesiment income "30,650 Operating expenses excluding depreciation (26810) Operating profit before working capital changes 3.740 Working Notes The working notes given below do not form part of the cash flow statement and, accordingly, need not be published. The purpose of these working notes is merely to assist in understanding the manner in which various figures in the cash flow statement have been derived. (Figures are in Rs "000) 1. Cash receipts from customers Sales 30,650 ‘Add: Sundry debtors atthe beginning of the year 1,200 31,850 Less: Sundry debtors at the end of the year 1,700 2. Cash paid to suppliers and employees Cost of sales ‘Administrative & selling expenses ‘Add: Sundry ereditors at the beginning of the year 1,890 Tnventories at the end of the year 900. Less: Sundry creditors at the end of the year 150 Invent ies atthe beginning of the year 1,9503.22 Management Accounting 3. Income taxes paid (including tax deducted at source from dividends received) Income tax expense for the year (including tax deducted at source from dividends received) 300 ‘Add: Income tax liability-at the beginning of the year 1,000 1,300 Less: Income tax liability at the end of the year 400 ‘ 900 ut of 900, tax deducted at source on dividends received (amounting to 40) is included in cash flows form investing activities and the balance of 860 is included in cash flows from operating activities (see paragraph 34). 4, Repayment of long-term borrowings Long term debt at the beginning of the year 1,040 ‘Add: Long-term borrowings made during the year 250 1,290 Less: Long-term borrowings at the end of the year 1.110 180 5. Interest paid Interest expenses for the year 400 ‘Add: Interest payable at the beginning of the year 100 300 Less: Interest payable atthe end of the year 230 270 Exhibit 3.5 Cash Flow Statement for a Financial Enterprise The exhibit is illustrative only and does not form part of the accounting standard. The purpose of this exhibit is to illustrate the application of the accounting standard. 4. The example ‘shows only current petiod amounts. 2. The example is presented using the direct method. Year 2 Cash flows from operating activities Interest and commission receipts 28,447 Interest payments (23,463) Recoveries on loans previously written-off 237 Cash payments to employees and suppliers (997) Operating profit before changes In operating assets, a (increase) decrease in operating assets: ‘Short-term funds (650) Deposit held for regulatory or monetary control purposes 234 Funds advanced to customers (288) Not increase in credit card receivables (360) Other short-term securities (20) Increase (Decrease) in operating liabilities: Deposits from customers 600 Certificates of deposit (200) Net cash trom operating activities before income tax 3.440 Income taxes paid (300) Net cash from operating activities 3,340 (ania)‘Statement of Changes in Firiancial Position 3.23 (Conte) Gash owe from investing activities Dividends received: 250 Interest received 300 Proceeds, from salo of permanent. investments 1,200 Purchase of permanent investments ° (600) Purchase of fixed assots (600) [Not cash from invasting activities 650 Cash flows from financing activities Issue of shares 1,800 eepayment of long-term borrowings (200) Net decrease in other borrowings (1,000) Dividends paid (400) Net cash from financing activities Net increase In cash and cash-equivalonts Cash and cash-equivalents at beginning of period Cash and cash-equivalonts at ond of period IMPORTANCE AND USEFULNESS ‘The SCFP is used for two principal purposes: (i) As a means of analysing what has happened in the past and (ii) As a means of planning and decision-making for future. ‘As a tool of historical analysis, the statement highlights not only the magnitude and direction of change in the net working capital during the period of two suecessive balance sheets, but also the factors respon- sible for it. The information shown in the SCFP is relevant to those making economic decisicns. It helps to provide answers to some of the important financial questions related to company such as: (@ Where did the profits go? i) Why are dividends not larger? (iii) How was it possible to distribute dividends in excess of current eatni loss for the period? Gv) Why have the net current assets gone down although the net income has gone up? (v) How is it that the net current assets have risen even though there has been a net loss for the period? (vi). Why must money be borrowed to finance purchases of new plant and equipment when the “cash flow” (the sum of the net income and depreciation) is in excess of the required amount? (vii): How has the expansion in plant and. equipment been financed? (ii) What happened to the proceeds of the sale of plant and equipment resulting from a contraction of operations? (ix) How was the retirement of debt accomplished? (®) What became of the assets derived from an increase in outstanding share capital? (xi) What became of the proceeds of the debt issue? (xii) How was the increase in working capital financed? ‘These questions apart, the SCFP also enables the management to ascertain whether the magriitude and type of commitment pertaining to various, sources of raising funds are in conformity with the type of Commitment required for their corresponding uses. To be specific, it enables the management to see whethét the long-term funds are adequate to finance major fixedassets expansion. A situation in which short-term sources (bank overdraft, temporary loans, and 50 on) constitute the bulk of sources for long-term purposes oF in the presence of @ net9.24 Management Accounting ‘may not be desirable, Such & pattern of financing is likely to cause problems for the firm to meet its current liabilities in future, Besides, the SCEP also indicates the extent of reliance on external resources vis-a-vis the internal sources in the use of funds. Thus, the SCEP clearly highlights the firm’s financing and invest- tment activities. ° “Moreover, the SCFP is of utmost significance for working capital management decisions also. By listing, all transactions of sources and uses of working capital, it proyides the management with a net figure of changes in, working capital during the two consecutive balance sheet dates. In case the change in WC is, significant, it will provoke the management to make an indepth investigatiof/ analysis into its causes. The undesired increase or decrease in WC entails cost. The former clearly involves higher interest cost. Besides interest costs, there are chances of inventory accumulations, locking up of receivables, maintaining exces- sive cash balances, and 50 on. The latter situation is still more dangerous in terms of its serious conse- «quences to.the smooth functioning and running of the business. Clearly, the SCFP provides @ measure of capital management FP, when prepared on a projected basis, has immense potentials/utilty as a tool of financial planning. I'Shows the effect of various financing and investment decisions on WC in future, If the imple- ‘mentation of the decision results. in excessive or inadequate WC, steps may be taken to improve the situation or review the decisions. For instance, ifthe WC position is expected to deteriorate, funds may be raised by borrowing or issuing new equity shares. If the required amount is not feasible to be raised, plans for acquisition of assets may be postponed or alternative operative plans can be developed to ensure thatthe desired furure Jevel of business operations, expansion, and so of, are achieved, Thus, the SCFP enables the management t0,revise/teview its investments, operations and financing activities so as to conform to the desired financial inflow and outflow of resources. Above all, the long-term lenders of funds can use the statement a5 a means of estimating the firm's ability to service its debs. SonmarnY ‘The SCFP, as a statement of financial analysis, demonstrates changes in funds (net working capita, cash and total resources) over a period of time, generally between two consecutive years. ‘The SCFP, based on net working capital concept, is more popularly known as funds-flow-staement. According to this basis, only those transactions which bring about changes in net working capital are included in the statement while others are excluded. The statement enumerates major sources and uses of ‘working capital. The major ‘sources’ of working capital are: funds from business operations, non-operating incomes, sale proceeds of fixed assets, raising additional share capital, and long-term borrowings. The pal ‘uses’ of working capital are: purchase of fixed assets, repayment of long-term borrowings, redemption of preference shares/debentures, payment of dividends, and s0 on. ‘The SCFP, based on cash concept of funds, is commonly referred to as the cash-flow statement, Inthe Preparation of such a statement al the items that increase/decrease cash are included but all those items ‘Which have no effect on cash are excluded. Hence, it is essentially «tool of short-erm financial planning. ‘The SCFP, based on all resources concept of funds, isthe most comprehensive and appropriate basis of| ‘measuring the changes in the financial position. Unlike funds-flow-statement, the statement based on total, resources does not exclude major financing and investment activities such as purchase of assets by new issue of shares and debentures, conversion of debentures, and so on, which do not affect working capital. ‘Thus, all financial resources concept isthe best approach to disclose the changes in the financial position of a firm among the three alternative concepts of funds, :F Statement of Changes ia Financial Position 3.25 REFERENCES 1 For details refer to chapter 18 of this book. 2 Peary Mason, “Cash Flow analysis and the Funds Statement," Accounting Research Study No.2, AICPA, 1961, pp.49-50, PracticaL ProstemS 3, The following are the balance sheets of Andhra Industrial Corporation Lid as on 34st March, previous year and ccurent year. Balance Sheet Provious year (Current year easels: Fixed assets: Property Rs 1,489,500 Rs 1,44,250 Machinery 112,950 1,26,200 Goodwill = 10,000 Current assets Stock 1,10,000 192,000 Trade debiors '86,160 69,430 Cash and bank 1/500 11,000 Pre-payments 3370. 1000 : 0 753,880 Liabities: ‘Shareholder's funds: Paid-up capital 220,000 2,70,000 Reserves "30,000 40,000 Proft & Loss Ae 39,600 41,220 Current tabiltes: ‘Creditors 39,000 43,880 Bills payable 33,790 14,000 Bank overdraft 0,000 — Provision for taxation 40,000 50,000 Daring the current year ended on 31st March, a dividend of Rs 26,000 was paid and the assets of another company were purchased for Rs $0,000 payable in flly paid-up shares: Stock, Rs 21,640; Machinery, Rs 18,360; Goodwill, Rs 10,000, In addon, plant ata cost of Rs 5,650 was purchased during'the year. The depreciation written-off during the year ‘were: property, Rs 4,250 and machinery, Rs 10,760, Income tax during the year amounting to Rs 28,770 was charged ‘© provision for taxation, Net profit fr the year before tax was Rs 76,300, ‘Prepare a statement of changes in financial position on total resource basis, Also prepare a schedule of changes in the working capital,8.26 Management Accouniting SOLUTION Statement of Changes in Financial Position of Andhia Industries Corporation Lid for the Current Year Ending 31st March: ‘Amount Sources of working capital Funds from business operations Rs. 52,540 Issue of long-torm liabilities: Issue of equity shares (for the purchase of assets of another company) 50,000 Total financial resources provided 702,540 Uses of working capital ae Purchase of non-current assets: Plant (for cash) 5,650 Machinery (in exchange for equity shares) 18,360 Goodwill (in exchange for equity shares) 10,000 Recurring payments to investors: Dividends paic 26,000 Total financial resources used Increase in working capital: (source-uses) Working Notes (L) Determination of Funds from Business Operations Profit and Loss A/c balance (March 31, previous year) ‘Add: ‘Depreciation: (). Property Rs 4.250 (i) Machinery 10,760 Dividends “Transfer to reserves Loss: Profit and loss Alc balance as on March 31, current year 42,530 Statement of Changes in Working Capital Previous year Current year Working capital Taerease ‘Decrease (#) 0 Current assets: Stock Rs 1,10,000 Rs_-92,000 Rs 18,000 Trade debtors 186,160 16,730 Cash and bank 41,500 Rs 9,500 Pre-payments 3,370 2,370 207,080 Current liabilities: Pameeer ‘Sundry creditors 39,000 2,860 Bills payable 33,790 22,790 (Conia)‘Statement of Changes in Financial Position 3.27 (Contd) ‘Bank overdraft {60,000 = 0,000 Provision for taxation 40,000 50,000 40,000 . i72,780 7,02,660 ‘Net working capital: (Current assets-Curcent liabilities) 28,240 70,770 = Increase in net working capital 42,530 42,530 70,770 70,770 92,200 92,280 P32 From the figures given below relating to the Hypothetical Ltd, prepare a statement showing application and sources of funds during the current year ending March: ‘March 31, previous year March 31, current year {Rs in thousand) (BS in thousand) Assets: Fixed assets (ne!) 510 620 Investments 30 80 Currer assets 240 375 Discount on debentures 10. 5. 730 7,080 abilities and capital: Share capital (equity) 300 350 Share capital (preference) 200 100 Debentures 100 200 Reserves 110 270 * Provision for doubttul debts, 10 15 Current labitties 70 145 790 41,080) ‘You are informed that during the year: (@) A machine costing Rs 70,000 (book value Rs 40,000), was disposed off for Rs 25,000. (i) Preference share redemption wes cartied out sa premium of S per cent and (Gi) Dividend @ 15 per cent was paid on equity shares forthe previous year. Further: (2) The provision for depreciation stood atthe beginning of the current year at Rs 150,000 and Rs 1,90,000 atthe fend ofthe year. () Stock which wes valued at Rs 90,000 atthe beginning of the year was wrtten-up to its cost (Rs 1,00,000) for Preparing the profit and loss account for the curvent year. ‘SOLUTION Statement of Sources and Application of Funds for the Current Year Ended 31st March ‘Amount (Rs in thousand) ‘Sources of funds: Funds from business operations 280 Sale of non-current assets: Machine 25 (Contd)8.28 Management Accounting (Conte) Issue of fong-term liabilities Equity shares. 50 Debentures 100 Total financial resource provided 465 Application of funds: Purchase of non-current assots: Fixed assets 220 Investments 50 Payment of long-term liabilities: Redemption of preference shares, > 105 Recurring payment to investors: __ Equity holders (dividends) 45, ‘Total financial resources used 20 Increase In net working capital: (source-uses) 45 Working Notes (@) Determination of Fends from Business Operations ‘Amount (R8 In thousand) Balance of reserves as on March 31, current year 270 Add: Depreciation’ on fixed assets 70 Discount on debentures 5 Premium on redemption of preference shares 5 Loss on sale of machine 15 Dividends 45 a0 Less: Balance of reserves as on March 31, previous year (Rs 1,10,000 + Rs 10,000 upward ravaluation of opening stock) 120 280 @ Fixed Assets (gr085) Ae (Rs in thousand) To balance b/d 660 By cash 25 To cash (balancing figure for ByP&LAC 18 purchases) 220 By accumulated depreciation 30 By balance cfd 810 880) ‘880 Accumulated Depreciation Ae (Rs in thousand) To fixed assets 30 By balance b/d 180 To balance old 190 By P & L Ac (balancing figure of depreciation) 70 220 220Statement of Changes in Working Capital (Rs in thousand) ‘Statement of Changes in Financial Position 3.29 ‘March 31 ‘March 31 Work tal previous current Tnerease Decrease year year w a Current assets 250 375 125 (Ais 240.+ Rs 10 added to ‘opening stock of current year) Current liabilities 70 145 75 Provision for doubt debts 10. 16 5 Total current liablities 30 760. Net working capital (Current assets ~ Current liabilities) 170 215 Increase in working capital 45 45, 215 216 125 125 P.33 The chief executive of a plastic manufacturing company has reviewed the annual financial statements for tbe current yest and is unable to determine from a reading of the balance sheet the reasons for the changes in working capital during the year. He asks you for assistance and presents the following balance sheets of the Hypothetical Lu: ‘March 31 ‘March 31 Increase previous current (decrease) year ‘year Assets: Goodwill s_1,00,000 (Ni) _(1,00,000) Buildings 22,80,000, Rs 4,05,000 4,25,000 Land "75,000 70,000 (6,000) Machinery 4,00,000 1,85,000 65,000 Tools '35,000 "20,000 (15,000) Trade investments 7,500 9,000 4,500 Inventories 1,09,000 > —_1,05,000 (4,000) Sundry debtors '48,000 ‘90,000 44,000 Bills receivable 49,500 0,500 (3,000) Cash in hand 4,500 _ 1,000 (8.500) Unexpired insurance 700 ‘600 (100) Unamortised discount on debentures 1,250 1,050 (200) 7,72,450 7,04,700, Lsbilies: —— Equity share capital 200,000 3,50,000 1,60,000 Debenturos '50,000 "75,000. "25,000 Sundry creditors 26,000 29,000 '3,000 Bank overdraft _ 4,000 4,000 Bills payable 5,000 4,500 (600) Bank loans (short-term) 3,400 750 (2,850) Accrued taxes 4,500 2,500 74,000, Accrued interest 3,000 5,000 2,000 ‘Allowance for doubtful accounts 1,160 2,250 41,100 Accumulated depreciation 190,500 1,95,600 45,100 Retained eamings 391,800, 268,550 (1,23,360)3.30 Management Accounting Additional information: (There were no purchases or sales of tools. Gi) Equity shares were issued ata discount of 10 per cent ii), Old machinery that cost Rs 2,250 was scrapped and written off the books. Accuriulated depreciation on such ceguipment was Rs 1,650. (Gv) The inoome stement forthe current year is Sales (net) is 6,25,000 Less expenses: Operating charges: Materials and supplies Direct labour Manufacturing overhead Depreciation ~ Selling expenses General expensos Interest expenses Unusual items: Waiting off of goodwill Writing off of land Loss on machinery Discount on issue of equity shares Net loss 744,960 7,19,350 ‘You are required to prepare: (A statement of changes in financial position using 2 working capital approach and Gi) A statement of changes in financial position using a cash basis approach (cash flow statement. SOLUTION (@ Statement of Changes in Financial Postion for the Year Ending March 31 Current Year. {Working capital approach) Sources of working capital: Funds from business operations: Sales Rs 6,25,000 Less: Expenses involving use of working capital: Materials and supplies Rs 1,285,000 Direct labour 4,0,000 Manufacturing overhead 90,750 Salling expenses 1,22,600 General expenses (less amortisation (of Ris 200 as discount on debentures) 1,14,800. Interest expenses 3,750 Issuance of long-term liabilties: Proceeds from equity share capital Debentures Total sources of working capitalStatement of Changes in Financial Position 3.31 (Conta!) Uses of working capita Purchase of non-current assets: Building 128,000 Machinery °. '67,250 Trade investments 1,500 Reourring payment to investors: Dividend to equityholders Total uses of working capital Increase in net working capital (Total sources-Total uses) Working Notes 1. Determination of dividend amount: Ralance of retained earings 31st March, previous year Rs 3,91,900 Less net loss of current year 119,350 2,72,550 However, the balance of retained earings as on 31st December curent year is Rs 2,68,550, tat is, Rs 4,000 less In the absence of any other information, this amount is assumed to have been paid as dividends to equityholders. 2. Putchase of machinery: ‘Machinery (beginning ofthe year) Rs 1,00,000 Less: Scrap value of machine 2,250 97,750 Closing balance of machinery 165,000 Difference represents purchases 61,250 (i) Cash Flow Statements for the Year Ending March 31 Current Year ‘Sources of cash: Gash from business operations. {ssue of long-torm tabiltes: Cash proceeds from equity share capital Debentures Total sources of cash Application of cash: Purchases of non-current assets: Buildings Machinery Trade Investments Recurring payments to investors: Dividend to equityholders Net decrease in cash (application ~ sources)8.82 Management Accounting. Working Notes Determination of Gash trom Business Operation ‘Working capital trom business operation Rs 63,200 ‘Add: transactions, other than cash, decreasing working capita: Decrease in current assots: Inventories Rs 4,000 Bills receivable 3,000 Unexpired insuranee.. 100 7,100 Inerease in curent labittes: Sundry creditors Bank ovérdraft ‘Accrued interest Accrved taxes Allowances for doubtful accounts Less: Transactions other than cash increasing working capital Increase in curront assets: Sundry debtors (4,000) Dectease in current Habit Bills payable Bank loans (shor-term) 11,100 P.34 The summarized balance sheet,of Omega Ltd as on ist March, year 1, year 2, year 3 are given below: Bad The ‘As on March 31 ear 7 YoarZ Year S bilities Paid-up equity capital 194 194 194 Long-term borrowings; From banks 68 7 124 From others 281 343 379 Current liabilties 52 54 99, 395 688 796 Assets a ame ae Gross block 355 956 361 Less: Depreciation 69 95 122 Net block 286 261 238 Current assets 143 199 234 Profit & loss account 166 228 323 EG 638. 796: Prepare a statement of net sources and uses of funds forthe year ended on 31st March, years 2 and 3 and give ‘comment on the same. -‘Statement of Changes in Financial Position 3.33 ‘SOLUTION Statement of Sources and Uses of Funds of Omega Lid for Years 2 and 3:Rs in lakh) Year 2 Year 3 “Sources of funds: Issue of long-term liabilties: Borrowings from banks 29 27 Borrowings from others 62 36 Total sources ot 63. Uses of funds: Funds lost in operations 368 68 Purchase of non-current assets: Fixed assets 4 5 Total uses. 37 73. Increase (decrease) in working capital 5 Toy Working Notes Comment The firm is suffering from heavy cash losses (apart ftom sizeable loss as per Profit & Loss A/c) in both the ‘years. In fat, its net wort is negative ‘The firm has resorted to borrowings to finance its operations. Borrowings have not been used to finance expansion. Given these facts, the frm is likely to go into liquidation in near future as the fim does not seem to have the capacity to service/tepay its long-term borrowings. Funds ffom business operations: Increase in losses @ 3) ‘Add depreciation charged 26 20 ands Jost in business operations 36 e 'P3.$ The balance sheets of Hari Ltd as on 33st March, year Land year 2 are given below: z ‘ist March Year? Year? Share capital FAs 6,00,000 Fs 8,00,000 Capital reserve = "20,000 General resorve 340,000, 4.00,000 PAL account 41,20,000 4,50,000 Debentures 4,00,000 2,80,000 Creditors 2,40,000 260,000 Provision for income-tax 41,80,000 41,70,000 Proposed dividend ‘60,000 Unpaid dividend = 19,40,000 Fixed assets (at cost) Less depreciation Trade investments 2,00,000 160,000 Current assets 560,000 80,000 Preliminary expenses 40,000 20,000 79,40,000. 2i,60,000"8.94 Manabement Accounting During the year 2.the company: , (i) Sold one machine for Rs $0,000 the cost of which was Rs 1,00,000 and depreciation provided on it was Rs 40,000. (ii) Provided &s 1,80,000 as depreciation. (ii) Redeemed 30 per cent of debentures @ Rs 105. (Gv) Sold some wade investments ata profit of Rs 20,000, which was credited to capital reserve (¥) Decided to value stock at cost, whereas previously the practice was to value stock at cost less 10 per cent. The stock according to books on 31st March (year 1) was Rs 1,08,000. The stock on 3st Masch (year 2) was correctly valued at Rs 1,50,000, and (0) Decided to write-off fixed assets costing Rs 28,000 on which depreciation amounting to Rs 20,000 has been Provided You are required to prepare the statement of sources and application of funds during year 2, showing the changes ia ‘working capital SOLUTION Statement of Sources and Application of Funds forthe Year 2 Ending on 31st March ‘Sourves of funds: Funds from business operations Rs 3,74,000 Sale of non-current assets: Machine 50,000 Trade investments 60,000 Iseue of long torm liabilities ‘Share capital __2,00,000 Total sources provided 684,000 Uses of funds: Purchase of non-current assets: Fixed assots 4,28,000 Payment of long-term tables: Redemption of debentures (Rs 1,20,000 + 5% premium) 126,000 Recurting payment to investors: Dividends 60,000 Total resources used 8,14,000 Ineroase in net working capital 70,000 Statement of Changes in Working Capital March 31 Working capital, an Teréase ‘Decrease @ oO Current assets (Fis 5,60,000 + increased value of stock, Fis 12,000) . Rs 5,72,000 Fs 660,000 Rs ‘88,000 a Current liabiltios Creditors 240,000 —_-2,60,000 — Provision for Income tax 4180.00 —_1,70,000 10,000 Unpaid dividend = 8,000, - Net working capital T2000 © “22,000 7 Inerease in working capital 70,000 = -‘Statement of Changes in Financial Position 9.95 Working Notes 1. Increase in value of stock Stock at 90 per cent of cost ag on 31st Mach, year 1 Rs 1,08,000 ‘Stock valued at cust: Re 1,08,00010.90 120,000 Increase in value 100 2. Funds from business operations Increase in balance of Pal. A/c [Rs 1,50,000 ~ Rs 1,32,000 (Rs 1,20,000 + Rs 12,000 ‘stock adjustment)) 18,000 ‘Add increase in general reserve, ‘60,000 ‘Add premium on rederaption of debentures 6,000 ‘Add proposed dividend (yeas 2) 72,000 ‘Add depreciation charged in yeat 2 180,000 ‘Add loss on sale of machinery 10.000 (Book value, Rs 60,000 ~ Rs 50,000, sale value) ‘Ad loss due to discarding of fied asset (Rs 28,000 ~ Rs 20,00) 8,000 ‘Add prelrainary expenses wittten-off 20,000 3, Purchase of fixed assets: Fised Asset (net) Me To balance b/d Rs 11,40,000 By Bank (sale) Rs 50,000, To purchase (balancing figure) 4.28,000 By P&L Alc (loss on sale) 10,000 ‘By Depreciation 1,80,000 By P&L Ac (loss on discarding machine) 8,000 ___By Balance c/d 13,20,000 15,68,000, 16,68,000, P.3.6 You have been given the following statement of a company s6 at 31st March of two consecutive years: Previous year Current year aso: Fixed assets jess depreciation Rs 7,20,000 Rs 12,00,000 Investments: 22,500 '20,000 Stock in trade 285,000 3,92,000 Sundry debtors 1,81,400 2,90,000 Cash at bank 2;60,000 {90,000 Prepaid expenses 42,000 20;24,000 Uabittios: ae ‘Share of 4,80,000 Reserve and surplus 828,000 ‘Secured loan from bank Provision for taxation ‘Sundry creditors 74,96,9008.98 Management Accounting : Purther information is available from the recotds: The position in respect of reserves and surplus is as under: Balance as at Ist April, eurent year Rs 2,96,000 [Net profit forthe current year Less: Dividend Closing balance () On 31st March, current year, the accumulated depreciation on fixed assets was Rs 4,00,000 and on Sist March previous year was Rs 3,60,000, Machinery costing Rs 40,000, which was one-half depreciated, was discarded and written-off in current year, Depreciation for the curent year amounted to Rs 60,000. (Gi) avestments costing Rs 10,000 were sold during the current year for Rs 9,600 and government secusities of the face value of Rs 8,000 were purchased during the current year for Rs 7,500. You are required to prepare statement of sources and application of funds. ‘SOLUTION ‘Statement of Sources and Application of Funds forthe Current Year Ended March 31 Sources of funds: Funds from business operations Rs 4,77,400 Sale of nor-current assets: Tavestments 9,600 Issue of long-term liabilities Equity share capital 66,000 Total financial resources provided Application ot funds: Purchase of non-current assets: Fixed assets 5,60,000 Government securties 7,500 Payment of long-term liabiltes: Fopayment of loan from bank (assumed long-term) 4,74,000 Recurring payment to investors: Equity dividends —_ £9,000 Total financial resources used 310,500, Decrease in net working capital (Uses ~ Sources) 257,500 Working Notes Funds ffom business operations [Net profit for the current year s3,97.000, ‘Add deprecation charged 60,000 ‘Add loss on discarding the machine 20,000 ‘Add loss onsale of ivesuments 490 aro Fixed Asset (net) Ve To balance bid Rs 7,20,000 By depreciation Fs 60,000 To bank (purchase of net By P&L Alc (loss on discarding fixed assets) 5,60,000 machine) 20,000 By balance old _1200,000 12,80,000 12,80,0007 Statement of Changes in Financial Position 3.37 . Irvesmest Ne Je balance via Re 22500 By bank Pe 9300 To bank (purchases) 71500 By PAL Ac (loss on sale ‘400 vn By balance oft __ 20,000, 000 30,000 ExerciseS ‘BAL What are the different meanings of the term ‘funds’ in the preparation of a statement of changes in financial position? Which meaning of funds is appropriate for long-range fiaancial planning? ‘3.2. What isthe purpose ofthe statement of changes in financial position? How does it differ from a balance sheet oF income statement? ‘3.3. What additional information is required to convert a statement of sources and uses of net working capital into a statement of changes in financial position? 34 “The analysis ofthe Mow of funds through an organisation can be Very useful tothe management.” Elucidate this statement [38 Briefly describe the all fnancial-resources concept of funds flow, What basic data are necessary to prepare such a starement? 36 In analysing working capital ows, business transactions may be classified into dhree categories: transactions ‘which affect only current assets or current liabilities, wansactions which affect both current and non-current accounts, and transaction which affect only non-current accounts. Indicate the effect of each category on ‘working capital. Givs examples to support your answer. 3.7 Give three examples of financial transactions that woubd be omitted if a working capital concept not including all financial resources were used asthe basis for preparing a statement of changes in financial postion. 38 The following transaction was recorded during the current year: Plant and equipment Dr. Rs 9,00,000 Goodwill Dr. 100,000 ‘To equity share capital Rs 6,00,000 ‘To debentures 2,00,000 To bank 2,00,000 Describe two ways in which this transaction can be reporied in statement of changes in financial position on @ ‘working capital Dasis. Which da you prefer, and why? 3.9 Enumerate the approaches that are followed in arriving at working capital provided by business operations inthe sfatement of changes in financial position, 3.10 Briefly describe the procedure of converting net income from the accrual tothe cash basis. ‘ALL Discuss the usefulness of cash flow statement for the management. Would such a statement be helpful to outsiders also? 312 The following are the summarised balance sheets of V. Lid, x6 2k 31st March previous year and current year: Uebitties Provious Curent Assets Previous Current year year year year Share capital Ris 2,00,000 Re 280.000 Goodwill — Rs 20,000 PalAc ‘30,690 41,220 Machinery «Re. 1,12,950 1,16,200 Reserves 50,000 50,000 Buildings 148,500 1,48,250 Tax provision 40,000__50,000_Stock 411,040 97.370 Teontar)3.38 “Management Accounting (Conta) Bank overdraft 59,510 = Sundry debtors 67,490 73,360 Bills payable 33,780 11,625 Cash 2,500 2,700 Sundry creditors 39,500 41,135 62,480 “453,880 F62HB0 453,880 ‘The following addtional information is obtained from the general ledger: (@) During the current year an interim dividend of Rs 26,000 was paid. (©) The assets of another company were purchased for Rs 60,000 payable in fully paid shares of V. Lid These assets included stock, Rs 22,000 and machinery Rs 18,000. In addition, sundry purchases of machinery amounted to RS 5,600 (©) Income-tax paid during the year amounted to Rs 25,000. (@) The net profit for the year before tax was Rs 62,530. Prepare a statement showing the sources and application of funds forthe current year and a schedule seting cout changes in working capital 3.13 The non-current assets and equities of Northern Tools Lid are given at the beginning and at end of the current yew End Beginning (Rs in thousand) (Rs in thousand) Plant assets, net of depreciation 285 127 Investment in the shares of North-Eastem Tool Ltd 580 26a Bonds payable 140 500 Capital stock 7 800 800 Retained eamings eat 478 ‘You are unable to obtain complete balance sheet data or an income statement for the year, but the following information is available: (i) Dividend, Rs 75,000 were pad. i) A gain on the sale of equipment of Rs 26,000 has been inchided in net income. The gross plant assets increased by Rs 1,86,000 even though equipment costing Rs 58,000 with a net book value of Rs 38,000 was sold, Prepare a satement of sources and uses of net working capital from the information mentioned above. 3114 Prepare a funds flow statement of Atlantic Business Corporation from the following information: Balance Sheet as at Aprit and March 31, Current Year ‘April 1 March 31 Gash and bank As 40,000 Rs 44,400 ‘Accounts receivable 10,000 20,700 Inventories 15,000 18,000 Land 4,900 4,000 Business premises 20,000 16,000 Plant and equipment 45,000 17,000 ‘Accumulated depreciation (6,000) (2,800) Patents and trade-marks 1,000 900 Total assets 700,000. 715,200 (Conta‘Statement of Changes in Financial Position 33% (Conte) = - Current fables 30,000 32,000 Bonds payable 22,000 22000 Bonds payable discount (2,003) (1,200) Capital stook 35,000 43,500 Retained oarnings 18,000 19,500, Total liaittios 0 Additonal information. Income forthe petiod. Rs 10,000. (ii) A building that costs Rs 4,000 and which had a ook value af Rs 1,000 was sold for Rs 1.400 (ili) The depreciation charge forthe period was Rs 800. (iv) There was @ Rs 5,000 issue of capital stock (0) Cash dividenids of Rs 2,000 and bonus shares of Rs 3,500 were declared. 3.15 _From the following financiat information of ABC Lud, prepare statements required by the chief executive of the ‘company to explain the causes of increase in working capital and cash, in spie ofthe frm incurring lostes: Income Statement Sales Fis 6,00,000 Dividends from investment in another company __ 2,000 Expenses: Gost of gaods soid Rs 4,00,000 Depreciation 50,000 Other operating expenditure 1.75.00 Loss on sale of equipment (Gale valve Fs 7,200) 3,000 6,28,000 Not loss ~ 5.000 J Reiained Earnings Beginning balance Rs 50,000 et toss (26,000) Dividends 416,000) Ending balance 4.000 Postion Staement Data ‘March 31 March 31 Previous ‘Cumrent year year Gash Fis 18,400 Rs 43200 Marketable securities ‘800 — ‘Sundry debtors 28,600 16800 Inventory 33,000 22,000 Pre-payments 2,200 1,800 Investments 48,000 18,000 Land 48,000 15,000 Plant assots 4,19,800 1,10,400 ‘Accumulated depreciation (75,200) (78,400) ‘Total assets 780,600 1,48,800 (Contd)3.40 Management Aecounting (Conta) ‘Aecounts payable 18,200 10,200 ‘Acorued liabilities 1,200 2,400 Dividends payable 1,200 2200 Debentures 12,000 16,000 ‘Equity capital 50,000 160,000 Preference share capital 28,000 50,000 Retained eamings 8,000 Total liabilities 7,560,600 748,800 3.16 The following isthe condensed information of the XYZ Lud: ‘March 34 ‘March 31 Previous year Current year Current assets ae RS 1,35,000 Rs 1,27,200 Investments: 18,000 21,400 Land 9,000 9,000 Plant and machinery (accumulated. depreciation) 81,000 1,085,000 (24,000) (26,000) Patents 16,200 42,600 Total assets 232,200 249,200 Current liabilities 24,600 34,800 12% Debentures 43,400 = 14% Debentures = 39,000 Equity share capital 90,000 » 1,00,000. Reserve for future loss on investments 6,000 3,600 Retained earings 68,200_ 71,800, Total liabilities 232,200, 349,200 ‘Additional information (_A reconciliation of the balances in retained earings is a fllows Beginning balance Rs 68,200 Net income. for current year 3,000 ‘Awdird received trom settlement of patent infringement case 15,600 Dividends, 15,000) Ending balance 71,800 (ii) Net income of the curreat year includes a cost of Rs 4,800 on the sale of a part plant. The plant was for Is 19,000 atthe beginning of the year, accumulated depreciation being Rs 6,000. (Gi) Investments of Rs 15,000 were sold during the year at 8 loss. The loss was charged tothe reserve for future losses on investments and did not appear in the income statement. (iv) During the current year the 12% Debentures were called for redemption. Most of them were refunded through the issuance of new 14% Debentures, and the rest were retired for cash (%) "The equity shares were issued in exchange for machinery. The rest of the plark snd machinery were purchased for cash, ‘You are required to prepare a ststement of changes in financial position forthe current year on total resources basis| Statement of Changes in Financial Position 3.41 3.17 ‘The following information is obtained fiom the records of XYZ Lid: Net Changes in Accounts Balances During the Current Year Debit Creait Cash Rs 17,475 Accounts receivable 45,000 Allowances for doubtful accounts, Rs 1,250 Stock-in-trade 47525 Equipment and machinery 75,000 ‘Accumulated depreciation Goodwill Income taxes payable ‘Accounts payable Debentures Premiumon debentures Preference share capital 420,000 Equity share capital Retained earnings Statement of Retained Earnings Beginning balance Rs 6,00,000 ‘Add: Net income for the year (after amortisation of goodwill) Tax refund 4,10,000 70,10,000 Less: Cash dividends Bonus shares to equity shareholders Premium on redemption of preference shares 3,66,000 Ending balance 644,000 ‘Accounts receivable of Rs 10,000 were written off during the year. Equipment, costing Rs 1,00,000 which ‘was 80 per cent depreciated, was gold at carrying value and new equipment with lager capacity was acquired. ‘You are required to prepare: (i) A statement of changes in financial position (working capital bass), 68) A statement. af changes in financial position (cash basis) and (i) A staiement of change in financial position (total resources basis). 3.18 Given below is the balance sheet of Excellent Lid. Year 1 Fixed asset at cost ‘Additions during the year Depreciation Current assets: Investments ‘Stock at cost Trade debtors is 45,000 Rs 51,000 (Contd)8.42 Management Accounting (Conta, Less current liabilities: Bank overdraft Trade creditors & provisions Proposed dividend 55,000 1,19,200 '24,000 7,98,200 77,36,200_ Represented by Ordinary share capital 75,000 4,00,000 General reserve 26,000 '38,000 Profit & Loss Account 35,200 48,500 19% Debentures 1,368,200, ‘You are required to prepare funds Now statement for March-end year 2, Also highlight areas of major achievement of the management and mention the ateas management should re-examine from the viewpoint of the financing pattern 3.19 Two divisions of XYZ Lil start the current year with identical balance sheets but the position changed by the end of the year as shown below: Division A Division B. Bogining of End of “Beginning of ‘End of the year the year the year __the year Ganent assets Fis 625,000 Fis 625,000 As 625,000 As 6,25 000 Current liabilities 8,75,000 ‘Working capital 250,000 Fixed assets (net) 2,50,000 Capital employed 500,00 Financed by: Long-term debt 5 Equity share capital and reserves 5,00,000 5,00,000 ‘You have the following additional information: (2) Both the divisions have identical earning power (©) Each division earns a nt profit of Rs 65,000, a (©) Depreciation amounts to Rs 40,000. You are required to prepare funds flow statement for each division and comment on the financial policy and practices adopted by each as revealed by the funds flow analysis, taxation @ 35 per cent ANswerS 3.12 Increase in net working capital, Rs 42,530. 3.13 Decrease in net working capital, Rs 4,79,000, 3.14 Increase in net working capital, Rs 13,100. ‘3:15 Increase in net working capital, Rs 6,600; total sources of eash, Rs 88,400, and total uses of cash, Rs 63,600, 3.16 Decrease in net working capital, Rs 18,000. . 3.17 Increase in net working capital, Rs 68,750; increase in cash, Rs 17,475,A ‘Statement of Changes in Financial Position 3.43, 3.18 Increase in net working capital, Rs 62,300; operationally efficient; intemal funds were adequate (o meet expan- sion requirements; raising equity funds does not seem tobe financially prudent. 3.19 Division A, no change in net working capital; Division B, decrease in net working capitl, Rs 1,25,000; while Division B does not vse debt at all in meetisig its expansion needs, Division A relies more on debt.Finaneial Statement Analysis INTRODUCTION ‘As observed in the preceding chapter, a basic limitation of the traditional financial statements comprising the balance sheet and the profit and loss account is that they do not give all the information regarding the financial operations of a firm. Nevertheless, they provide some extremely usefil information to the extent the balance sheet mirrors the financial position on a particular date in terms of the structure of assets, liabilities and owners equity, and so on and the profit and loss account shows the results of operations during a certain period of time in terms of the revenues obtained and the cost incurred during the year. Thus, the financial statements orovide a summarised view of the financial position and operations of a firm. ‘Therefore, much can be learnt about a firm from a careful examination of its financial statements as invaluable documents/performance reports. The analysis of financial statement is, thus, an important aid to financial analysis. ‘The focus of financial analysis is oi Key figures in the financial statements and the significant relation- ship that exists between them. The analysis of financial statements is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of the firm's position and performance." The first task of the financial analyst is fo select the information relevant to the decision under consideration from the total information contained in the financial statement. The second step involved in financial analysis is to artange the information in a way to highlight significant relationships. ‘The final step is interpretation and drawing of inferences and conclusions. Jn brief, financial analysis isthe process of selection, relation, and evaluation ‘The present chapter is devoted 10 an in-depth analysis of financial stitements and its use for decision- ‘making by various patie interested in them. The focus of the chapter is on ratio analysis asthe most-widely used technique of financial statement analysis. Section 2 of the chapter discusses common-size statements as a method of analysis of financial statements. The importance of ratio analysis and its limitations are briefly outlined in Section 3. The major points are suinmarised in the last section of the chapter.4.2 Management Accounting RATIO ANALYSIS Meaning and Rationale Ratio. analysis is a widely-used too! of financial analysis. It is defined as the Systematic use of ratios to interptet the financial statements so thatthe strengéis and weaknesses of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between to items/variables. This relationship can be expressed as: (i) Percen ‘ages, Say. net profits are 25 per cent of sales (assuming net profits of Rs 25,000 and sales of RS 1,00,000), (4) Fraction (net profit is one-fourth of sales), and (iii) Proportion of numbers (the relationship between net, profits and sales is 1:4), These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratios does not‘add any information not Blready inherent in the above figures of profits and sales. What the ratios do is that they reveal the relationship in a more meaningful Way 80 aS to enable us to draww cOnclusions from them. ‘The rationale of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no meaning-but wien expressed in terms of a related figure, it yields significant inferences. For instance, te fact that the net profits ofa firm amount to, say, Rs 10 lakh throws no light on its adequacy or otherwise. The figure of net profit has to be considered in relation to other variables, How does it stand in elation to sales? What does it represent by way of return on total assets used or total capital employed? If, therefore, net profits are shown in terms of their relationship with items such as sales, assets, capital employed, equity capital and so on, meaningful conclusions can be drawn regarding their adequacy. To carry the above example further, assuming the capital employed to be Rs 50 lakh aad Rs 100 lakh, the net profits are 20:per cent and 10 pef cent respectival;. The ratio analysis, thus, as a quantitative tool, ‘enables analysts to draw quantitative answers to questions such as: Are the net profits adequate? Are the assets being used efficiently? Is the firm solvent? Can the firm meet its current obligations? And so on, Basis of Comparison Ratios, as shown abiove, aré relative figures reflecting the felationship between variables. They enable analysts to draw conclusions regarding financial operations. The use of ratios, asa tool of financial analysis involves their comparison, for a single ratio, like absolute figures, fails to reveal the true positin.'For example, if inthe case of a firm, the return on capital employed is 15 per cent ina particular year, what does it indicate? Only if the figure is related to the fact that in the preceding year the relevant return was 12 per cent or 18 per ent, it can be inferred: Whether the profitability of the firm has declined or improved. Alternatively, if we know that the return for the industry as a whole is 10 per cent or 20’ per cent, the profitability of the firm in question can be evaluated. Coniparison with related facts is, therefore, the basis: of ratio analysis. Four sypes of Comparisons are involved: (i) Trend ratios, (i) Inter-firm comparison, Gii) Comperison of items Within a single yeat’s financial statement of a firma, and (iv) Comparison with standards or plans “Trends rails involve a comparison of fatios of a firm, over & tine, that is, ptesent ratio ae’ compared wit past ratios forthe same firm. The comparison of the profitability ofa firm, say, year'l through 5 is an illustration of a trend ratio. Trend fatios indicate the direction of change in the performance—improvement, deterioration, or congtancy’—over the years. ‘The fter-firm comparison involving, comparison of the ratios ofa firm with those-of others in the same line of business or for thé industry 28 @ Whole, reflects its performance in relation to its competitors.Financial Statement Analysis 4.3 Other types of comparison may relate to comparison of items within a single year’s financial statement of a firm and comparison with standards or plans. ‘Types of Ratios Ratios can be classified, for purposes of exposition, into four broad groups: (i) Liquidity ratios, (ii) Capital structure/leverage rats, (it) Profitability ratios, and (iv) Activity ratios Liquidity Ratios The importance of adequate liquidity inthe sense of the ability of a firm to mest ccurenvshor-term obligations. when they become due for payment can hardly be overstressed. In fact liquidity is a prerequisite forthe very survival of a fir. The short-term creditors ofthe frm are interested in the short-term solvency or liquidity ofa firm. But liquidity implics, from the viewpoint of utilisation of the funds of the Fim, that funds ate idte or they cam very litle. A proper balance between the two contradictory requirements, that is, liquidity and profitability 18 required for efficient financial management. The liquilty ratios measure the ability ofa firm to meet its short-term obligations and reffeet the short-term, financial strength/solvency of a firm. The ratios which indicate the liquidity of a firm are: (i) Net working capital, i) Current ratios, (ii) Acid tesvquick ratios, (iv) Super quick ratios, (v) Tumover ratios and (vi) Defensive-interval ratios. Net Working Capital Net working capital (NWC) represents the excess of current assets over current liabilities, The term current assets refers to assets which in the normal course of business get converted into cash without dimunition in value over a short period, usually not exceeding one year or length of operating! ‘cash cycle, whichever is more. Current liabilities are those liabilities which at the inception are required 10 bbe paid in short period, normally a year. Although NWC is really not a ratio, it is fr€quently employed as a ‘measure of a company’s liquidity position. An enterprise should have sufficient NWC in order to be able to meet the claims of the creditors and meeting the day-to-day needs of business. The greater is the amount of NWC, the greater is the liquidity of the firm. Accordingly, NWC is a measure of Tiquidity. Inadequate ‘working capital is the first sign of financial problems for a firm, There is, however, no predetermined criterion as to what constitutes adequate NWC. Moreover, the size, of the NWC is not an appropriate measure of the liquidity position of a firm as shown in Table 4.1: Table 4.1. Net Working Capitat Company A ‘Telal corent as00%5 ie 1 60,000 “otal curent liabities nwc 60,000. If the size of NWC is a measure of liquidity, company. A must be theee times as liquid as company B. However, a deeper probe would show that this is not so. A comparison of current liabilities and ctrent assets of both the firms shows that for each rupee of current liability, B has [is 3 of current assets, while A has only Rs 1.50. Thus, while A has three times of the NWC of B, the current assets of the former are only 1.5 times its current liabilities as compared to.3 times in case of the latter. Obviously, from the viewpoint of the ability to med its current obligations, firm B is in a better postion than firm A.’Another limitation of, NWC, as a measure of liguidity, is that a change in NWC does not necessarily reflect a change in the liquidity position of a firm, Witness Table 4.2.4.4 Management Accounting Table 4.2 Chango in Net Working Capital End-year 2 Current assets As 2,00,000 Current Habilties Nwe Although the NWC has gone up for the fem in Table 4.2 from Rs 75,000 to Rs 1,00,000, that is, by Rs 25,000, or 33.3 per cent between two points of time, there is, in reality, a deterioration in the liquidity position. Inthe first year, the firm had Rs 4 of current assets foreach rupee of current liabilities; but by the end of the second year, the amount of current assets for each rupee of current liabilities declined to Rs 2 only, that is, by 50 per cent. For these reasons, NWC is not a satisfactory measure of the liquidity of a firm. for inter-firm comparison or for trend analysis.? A better indicator isthe current rato, Current Ratio The current ratio is the ratio of total current assets to total current liabilities. It is calculated by dividing current assets by current liabilities: Current assets Current ratio (4. Current abilities con ‘The current assets ofa firm, as already stated, represent those assets which can, in the ordinary course of business, be converted into cash within a short period of time, normally not exceeding one year, and include ceash and bank balances, marketable securities, inventory of raw materials, semi-finished (work-in-progress) ‘and finished goods, debtors net of provision for bad and doubtful debts, bills receivable, and pre-paid ‘expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be met, as originally contemplated, within a year, consist of trade creditors, ills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. The current ratio for firms A and B of Table 4.1 are shown in Table 4.3. Table 4.3 Current Ratio Firm A Fim 8 Curent assets Fs 1,80,000 Fs 80,000 Current liabilities As 1,20,000 Rs 10,000 (15:4) gut Rationale The current ratio of a firm measures its short-term solvency, that is, its ability to meet short- term obligations. As a measure of short-termicurtent financial liquidity, it indicates the,rapees of current assets available for each rupee of current liabilty/obligation. The higher is the current ratio, the larger is the amount of rupees available per rupee of current liability, the more is the firm's ability to meet current obligations, and the greater isthe safety of funds of short-term creditors. Thus, current ratio, in a way, is a measure of margin of safety'to the creditors. ‘The need for safety of margin arises from the inevitable unevenness in the flow of funds through the current assets.and liabilities account. Ifthe flows were absolutely smooth and uniform each day so that inflows exactly equalled absolutely maturing obligations, the requirement of a safety Margin would be small. The fact thata firm can rarely count on such an even flow, requires thatthe size of the current assets should be sufficiently larger than current liabilities so thatthe firm would be assured of being able to pay its current“natiring debt as and when it becomes due, Moreover, the current liabilities can be settled by onlyFinancial Statement Analysis, “4,8 ‘making payment whereas the current assets available to liquidate them are subject to shrinkage for various reasons, such as bad debis, inventories becoming obsolete or unsaledble and Gccurrence of unexpected losses in marketable securities, and soon. The current ratio measures the size of the short-term liquidity “buffer.” A satisfactory current ratio would enable a firm to meet its obligations even when the value of the current assets declines. Interpretation m be case of company A in the above example, the current ratio is 1.5: 1. 1 impligs that, for every one rupee of current liabilities, current assets of one and half rupees are available to meet thes. (3 other words, the current assets are one-and-a-half times the current liabilities. The current ratio of 3 #!1 for company B signifies that curtent assets are three-foldits short-term obligations. The liquidity position, as ‘measured by the current ratio, is better in the case of B as compared to A. Tis is because the safety margin in the former (200 per cent) is substantially higher than in the latter (50 per cent). A slight decline in the value of current assets will adversely affect the ability of firm A to meet its obligations and, therefore, from the viewpoint of creditor, itis a mare risky venture. In contrast, there isa sufficient cushion in firm B and even with two-thirds shrinkage in the value of its assets, it wll beable to meet its Obligations in fll. For the creditors the firm is less risky. The interpretation is: In inter-firm comparison, the firm with the higher ‘current ratio has better liquidity/shortterm solvency. It is, however, important to note that a very high ratio of current assets to current lisbilities may be indicative-of slack management practices, as it might signal excessive inventories for the current require rents and poor eredit management in terms of overextended accounts receivable. At the same time, the firm may not be making full use of its curcent borrowing capacity.* Therefore, a firm should have a reasonable current ratio. ‘Although there is no hard and fast rule, conventionally, a current ratio of 2 : 1 (current assets twice current liabilities) is considered satisfactory. The logic underlying the conventional rule is that even with a ‘dropout of 50 per cent (half) in the value of current assers, a firm can thet its obligations, that is, a 50 per cent margin of safety is assumed to be sufficient to ward-off the worst of situations. Firm A of our example, having a current ratio of 1.5: 1, can be interpreted, on the basi of the conventional rule, to be inadequately liquid from the point.of view of its ability to always satisfy the claims of short-term creditors. Firm B, of course, is sufficiently liquid as its current ratio is 3 : 1. The rule of thumb (a current ratio of 2 : 1) cannot, however, be applied mechanically. What is a satisfactory ratio will differ depending on the development of the capital market and the availability of long-term funds to finance current assets, the nature of industry, and 50 on. In capital-ich countries, where long-term funds from the capital market are available in abundance, firms depend on current liabilities for financing a relatively small part of their current asset requirements, and itis not unusual for afirm to finance two-thitds to three-quarters ofits current assets by long-teri sources.® This policy of relying to a limited extent on short-term credit (current liabilities) is probably to avoid the difficulty in which the firms may be put by the eseditors in times of temporary adversity. Ia under-developed countries, there is no alternative to relying heavily on short-term figancing. Yet, in view of the risk which Such a practice entails, the firms would be well advised to keep the current liabilities within reasonable limits and finance a certain minimum part of the current assets by long-term sources. It may, nat be out of place to mention here that the Tandon Committee (1974) had prescribed in India the’minimuin scdle of ‘current asset financing by Song-term. Cunds$ f ‘Another factor which has a bearing on the current ratio isthe nature of the industry. For instance; public utility companies generally have a very low current ratio, as normally such companies have very litle need: for current assets. The wholesale dealers, on the other hand, purchasing goods on cash basis or on credit basis fora very short period but selling to retailers on credit basis, requine a higher current ratio. If, in air above example, firm A is a public utility, its liquidity position can be interpreted to be satisfactory even4.8 Management Accounting. though its current ratio is less than the conventional norm, Thus, the standard norm of current ratio (2 : 1) may vary from industry to industry. However, a ratio of less than 1 : 1 would certainly be undesirable in any Industry as at least some safety margin is required to protect the interest of the creditors and to provide cushion to the firm in adverse circumstances The current ratio, though superior to NWC in measuring short-term financial solvency, is rather a crude ‘measure ofthe liquidity of a firm. The limitation of current ratio arises from the fact that it is a quantitative father than a qualitative index of liquidity. The term quantitative refers to the fact that it takes into account the total curent assets without making any distinction between various types of current assets such as cash, inventories and so on.’ qualitative measures takes into account the proportion of various types of current sets to the total current assets. A satisfactory measure of liquidity should consider the liquidity of the various current assets per se. As already mentioned, while current liabilities are fixed in the sense that they have to be paid in full in all circumstances, the current assets are subject to shrinkage in value, for example, possibility of bad debts, unsaleability of inventory, and so on. Moreover, some of the current assets are. ‘more liquid than others: cash is the most liquid of all; receivables are more liquid than inventories, the last being the least liquid as they have to be sold before they are converted into receivables and, then, into cash, A firm with a higher percentage of its current assets in the form of cash would be more fiquid, in the sense of being able to meet obligations as and when they become due; than one with a higher percentage of slow- moving and unsaleable inventory and/or slow-paying receivables, even though both have the samie current ratio. In fact, the later type of firm may encounter serious difficulties in paying is bills even though it may ‘have a current ratio of 2: , whereas the former may do well with a ratio lower than the conventional norm: ‘Thus, the current ratio is not a conclusive index of the real liquidity of a firm. It fails to-answer questions, such a5, how liquid are the receivables and the inventory? What effect does the omission of inventory have on the liquidity of a firm? To answer these and related questions, an additional analysis of the quality of _current assets is required. This is done in Acid-Test or Quick Ratio. Acid-Test/Quick Ratio As observed above, one defect of the current ratio is that it fails to convey any {information on the composition ofthe current assets of a firm. A rupee of cash is considered equivalent to a rupee of inventory or receivables. But itis not so. A rupee of cash is more readily available (that is, more liquid) to meet current obligations than a rupee of, say, inventory. This impairs the usefuiness of the current ratio, The acid-test ratio is a measure of liquidity designed to overcome this defect of the current ratio. It is “often referred to as quick ratio because itis a measurement of a firm’s ability to convert its-curtent assets guickly into cash in order to n:ect its current liabilities. Thus, it is a measure of quick or acid liquidity. ‘The acid-test ratio is the ratio between quick current assets and, current liabilities and is calculated by dividing the quick assets by ihe current liabilities: ck assets Acid-test ratio = 42) (Current liabilities ‘The term quick assets refers to current assets which can be converted into cash immediately or at a short notice without diminution of valve. Included in this category of current assets are: (i) Cash and bank balances, (i) Short-term marketable securities, and (il) Debtors/receivables: Thus, the current assets which aré excluded are— pre-paid expenses and inventory. The exclusion of inventory is based on the reasoning” that it isnot easily"and readily convertible into cash. Pre-paid expenses by their very nature ai® not available to pay-off current debts. They merely réduce the amount of cash required in one period because of payment 1 prior period.” The acid-test ratio of a hypothetical firm is calculated in Table 4.4.Financial Statement Analysis 4,7 Table 4.4. Acid-Test Ratio ‘Amaunt Cash Rs 2,000 Debtors, 2,000 Inventory 42,000 ‘Total current assets: 16,000 Total current liabilities 3,000, (i) Current ratio oe (i) Acid-est ratio 7 05:4 Interpretation It's a rigorous measure of firm's ability to service short-term lsbiities, The usefulness of the ratio lies in the fact that itis widely accepted as the best available test ofthe liquidity position of a firm, That the acid-test ratio is superior to the current rato is evident from Table 4.4. The current ratio of the hypothetical firm is 2: 1 and can certainly be considered satisfactory. This interptetation of the liquidity position of the firm needs modification in the light of the quick ratio. Generally speaking, an acid-test ratio. Of 1 : Lis considered satisfactory as a firm can easily meet all current claims. Inthe case of the hypothetical firm the quick ratio (0.5 : 1) is less than the standard/norm, the satisfactory custent ratio. notwithstanding. ‘The interpretation that can be placed on the current ratio (2: 1) and acid-test (0.5 : 1) is that a large part of the curtent assets of the firm is tied up in slow-moving and unsaleable inventories andor stow-paying debts. ‘The firm would find it difficult to pay its current liabilities. The acid-test ratio provides, in 8 sense, a check con:the liquidity position. of a firm as shown by its curtent ratio, The quick ratio is a more rigorous and penetrating test ofthe liquidity position of a firm. Yet, itis not a.conclusive test: Both the current and quick Tatios should. be considered in relation to. the industry. average to. infer whether the firm's. shortecm financial position is satisfactory or not. ‘Acvariation of this ratio.® may be Super-Quick/Acid-Test Ratio. This ratio i calculated by dividing the superquick assets by the current liabilities ofa firm. The super-quick current assets are cash and marketable ‘securities, This rato is the mos rigorous and conservative tet of firm's liquidity position. Further, it is suggested that it would be useful, for the’management, if the liquidity measure also takes into account ‘reserve borrowing power’ as the firm's real debt paying ability depends not only on cash resources available with it but also-on its capacity to borrow from the market at short notice: ‘Turnover Ratio The liquidity ratios discussed so far relate tothe liquidity ofa firm as,a whole. Another way of examining the liquidity isto determine how quickly certain current asets are converted into cash. ‘The ratios to measure these are referred to as turnover ratios. These are, as activity ratios, covered in detail later in this chapter. Here, we focus on them to supplement the three liquidity ratios discussed above. The three turnover ratios that are relevant are: (i) Inventory turnover ratio, ji) Debtors tumover ratio, and (ii) Creditors turnover ratio. 5 Inventory Turnover Ratio Iv is computed by dividing the cost of goods sold by the average inventory. ‘Thus, Tnvéotory hives rato + CS Of Epos sd ws “Average inventory ‘The cost of goods sold means sales mimos gross-profit. The average inventory refers tothe simple a of the opening and closing inventory. The ratio indicates how fast inventory is sold. A high ratio is good4.8 Management Accounting from the-viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time. This is illustrated in Example 4.1. EXAMPLE 4.1 A-firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the javentory turnover ratio? SOLUTION (Rs 3,00,000 ~ Rs 60,000) i = 6 (times per year) (Rs°35,000 + Rs 45,000) + 12 months Inventory turnover ratio = Inventory holding period = = 2 months Debtors Turnover Ratio It is determined by dividing the net credit sales by average debtors outstanding during the year. Thus, Net credit sales “Average debtors Net credit sales consist of gross ctedit sales minus returns, if any, from customers. Average debtors is the simple average of debtors at the beginning and at the end of year. The analysis of the debtors turnover ratio, supplements the information regarding the liquidity of one item of current assets of the firm. The ratio ‘measures how rapidly debts are collected. A high ratio is indicative of shorter time-lag between credit sales, and cash collection, A low ratio shows that debs are not being collected rapidly. Ths is shown in Example 42. Debtors turnover rat (44) EXAMPLE 4.2 A firm has made credit sales of Rs 2,40,000 during the -year. The outstanding amount of debt at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtor turnover ratio. SOLUTION Debtors ts io = 0 8 i ’ tumover ratio= 735 77,500 Re 32,500) 23» (mes PH 12 months Debs collection period = —>~ "OS _ = 1.5 months ena ‘Debtors turnover Creditors Turnover Ratio It is a ratio between net credit purchases and the average amount of creditors outstanding during the year Its calculated as follows: «+ Creditors turnover ratio = Net oma Parchares_ . as) ‘Average creditorsFinancial Statement Analysis 4.9 [Net credit purchases = Gross credit purchases less returns to suppliers ‘Average creditors = Average of creditors outstanding at the beginning and at the end of the year ‘A Tow turnover ratio reflects liberal credit terms granted by suppliers, while a high satio shows that accounts ate to be settled rapidly. The creditors turnover ratio is an important t00l of analysis as a firm can reduce its requirement of current assets by relying on supplier's credit. The extent to which trade creditors ate willing t0 wait for payment can be approximated by the creditors tumover ratio. EXAMPLE 4.3 ‘The firm of Examples 4.1 and 4.2 has made credit purchases of Rs 1,80,000. The amount payable 10 the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors tumover ratio. SOLUTION Rs 180,000 (Rs 42,500 + Rs 47,500) + 2 12 months Creditors turnover ratio @) ‘The summing up of the three turnover ratios has a bearing on the liquidity of a firm. The combined effect Of the three turnover ratios is summarised below: Creditors turnover ratio (times per year) Creditor's payment period = 3 months Inventory holding period 2 months ‘Add debtor's cellection period 4+ 15 months Less creditor's payment period . =3 months ~ 0.5 month As ale the shorter is this period, the beter ae the liquidity ratios as measuted above and vice versa Defensive-Intervai Ratio The liquidity ratios of a firm outlined in the preceding discussions throw light on the ability of a firm to pay its current liabilities. Apart from paying current libilities, the liquidity Position of a firm should also be ekamined in relation to its ability to meet projected daily expenditure from operations. The defensve-interval ratio provides such a measure of liquidity. Iisa ratio between the quick! liguid assets and the projected daily cash requirements and is calculated according to Eq.46. Liquid assets Defensive-interval ratio =———— 5 __ 46) Projected daly cash requirement Where, Projected cash operating expenditure ‘Number of dayd ina year (65) ‘The projected cash operating expenditure is based on past expenditures and future plans. It is equivalent to the cost of goods sold excluding depreciation, plus selling and administrative expenditure and other ‘ordinary cash expenses. Alternatively, a very rough estimate of cash operating expenses can be obtained by subtracting the non-cash expenses like depreciation and amortisation from total expenses. Liquid assets, a8 already stated, include current assets excluding inventory and pre-paid expenses. Projected dailycash requirement =4.10 “Management Accounting ‘The defensive-intetval ratio measures the time span a firm can operate on present liquid assets (compris- ing cash and marketable securities and cash collected from debtors) without resorting to next year’s income, Consider Example 4.4 EXAMPLE 4.4 ‘The projected cash operating expenditure of a firm for the next year is Rs 1,82,500. It has liquid current assets amount to Rs 40,000. Determine the defensive-inierval ratio. SoLuTion Rs 1,82,500 Projected daily cash requirement = “* “S70 = Rs 500 Rs 40,000 Defensive-interval ratio = 80 days Rs 500 ‘The figure of 80 days indicates that the. firm has liquid assets which can meet the operating cash requirements of business for 80 days without resorting to future revenues. A higher ratio would be favourable. as it WOuld reflect the ability of a firm to meet cash requirements for a longer period of time. It provides a safety margin to the firm in determining its ability to meet basic operational costs. A higher ratio would provide the firm with a relatively higher degree of protection and tends to off-set the weakness indicated by low current and acid-testratios.? Sorter and Benston'? have also suggested a ratio of liquid assets to-daily ‘eash operating expenditure as a measure of short-term solvency. To conclude the discussion of liquidity ratios, the short-term solvency of a firm can be judged not merely in terms of the traditional liquidity ratios such as current and acid-tests, but the analysis should also be extended towards examining the quality of turnover of the ftems of current assets on which such ratios are based. These qualitative considerations (turnover ratios) coupled with the defensive-intérval ratios would reveal the true liquidity position of the firm. . ‘The liquidity ratios are, no doubt, primarily relevant from thé viewpoint of the creditors of the firm. In theory, therefore, the higher isthe liquid ratios, the better is te firm. But high ratios have serious implica- tions from the firm’s point of view. High current and acid-test ratios would imply that funds have unneces- sarily accumulated and’ are not béing profitably utilised. Similarly, an unusually high rate of inventory turnover may indicate that a firm is losing business by failing to maintain an adequate level of inventory to serve the customer's heeds. A rapid turnover of debtors may reflect sirict credit policies that hold revenue ‘below levels that could be obtained by granting more liberal credit terms. Finally, while interpreting the short-tetm position of the firm by the creditors, it should be recognised that the management may be tempted to indulge in “window-dressing” just before the financial statements are prepared so as to make the current financial pasition appear beter than what actually it is. For instance, by postponing purchase, allowing inventories to fall below the normal levels, using all available cash to pay off current liabilities, and pressing collection on debtors, the current and acid-test ratios,and debtors turnover ratios may be artificially improved. Even when no deliberate attempt has been made to present a {ood picture, the current financial position shown by the year-end financial statemeats, is probably more favourable than at any other time of the year. This is particularly true when a firm adopts a natural business year that ends during an ebb in the seasons swing of business activity. At the time of peak activity, debtors, inventories and current liabilities tend to be at higher levels. In such cases, an analysis of current financial Position based solely on-year-end data will tend to overstate a firm's average liquidity position."!