FINANCIAL ACCOUNTING

Important Highlights of UGC NET

Management P-2 Unit- 4
By – Rohit Kumar
CAPITAL STRUCTURE :
Capital structure means a combination of all long-
term sources of finance. It includes equity share
capital, reserves and surplus, preference share
capital, loan debentures and other such long term
sources of finance.

Capital structure theories are :

• Net income approach
• Net operating income approach
• Traditional approach
• M&M approach
Capital structure
It is used as financial leverage or financing mix.
Also referred as the degree of debts in the
financing or capital of a business firm.
There are mainly two types of capital 1. Debt 2.
Equity .
Debt is a cheaper source of finance, because the
rate of interest will be less than the cost of equity
and interest payments are a tax deductible
expense.
Net income Approach : (By- Durand)
A/c to Durand “A change in financial leverage would
lead to a change in the cost of capital.”

If the ratio of debt in the capital structure

increases, the WACC decreases and hence the
value of the firm increases.
Assumptions :
• There are no taxes – corporate or personal.
• Kd is less than Ke
Net operating income approach : (By- Durand)
It is opposite of the net income approach if there
are no taxes.

This approach suggest that value of the firm is

dependent on the operating income and
associated business risk. Change in the leverage
(debt) fails to affect the value of the firm.

Assumptions :
• Overall capitalization rate remains constant
irrespective of debt.
• Value of equity is the difference between total
firm value less value of debt.
• WACC remains constant
MM Approach (Modigliani & Miller) :
• MM approach named after Franco Modigliani &
Merton Miller .
• MM theory proposed two propositions.

• Proposition – 1: It says that the capital structure

is irrelevant to the value of a firm. The value of
two identical firms would remain the same and
value would not affect by the choice of finance
adopted to finance the assets.
Value of a firm is dependent on the expected
future earnings. It is when there are no taxes.
• Proposition-2 : It says that the financial leverage
boosts the value of a firm and reduces WACC. It
is when tax information is available
• Total value of firm is independent of its capital
structure .
Assumptions :
a) Information is available at free of cost
b) The same information is available for all
investors.
c) Securities are infinitely divisible.
d) Investors are free to buy or sell securities
e) There is no transaction cost
f) There are no bankruptcy cost
g) Investors can borrow without restrictions as the
same terms on which a firm can borrow.
h) Dividend payout ratio is 100%
i) EBIT is not affected by the use of debt.
• Traditional Approach :
Traditional approach says that the cost of capital is
a function of the capital structure.
It believes an optimal capital structure.
As per this approach, debt should exist in the
capital structure only up to a specific point,
beyond which any increase in leverage would
result in the reduction in value of the firm.
Assumptions :
• The rate of interest on debt remains constant
for a certain period.
• The expected rate by equity, shareholders
remains constant or increase gradually.
• The WACC first decreases and then increases.
• Cost of capital : it is required return necessary to
make a capital budgeting project such as building
a new factory, worth while…
• It refers to the cost of equity if the business is
financed solely through equity or to the cost of
debt if it is financed solely through debt.

Pecking order theory : (Proposed by Donaldson

1961) , further developed by Myers in 1984 .”this
theory asserts that a company’s capital structure is
more dependent on internal cash flows, cash
dividend payment and acceptable investment
opportunities ” (i.e NPV > 0)
• A/c to Pecking order theory , a firm will link its
dividend policy with its capital gearing and
investment decisions.

• When company looks for long term investment,

it has well defined order of preference to the
sources of finance it uses.
• Financial Breakeven: Breakeven point is when a
company is making no profit.

• Financial breakeven point is a point defining the

level before EBIT at which the earnings per share
of the company is equal to zero.
 EBIT = Fixed Financial costs
For calculation, it is mandatory to include
Fixed finance costs such as interest payment,
preference dividend etc.

Financial BEP = Preferred dividends/ (1 – tax rate)

+ interest expense
Indifference point/level : “the level of EBIT beyond
which the benefits of financial leverage begin to
operate with respect to earning per shares.(EPS)”
Leverage : the term leverage in general refers to a
relationship between two interrelated variables.
In financial analysis it represents the influence of
one financial variable over some other related
financial variables.

Operating leverage : the DOL (degree of operating

leverage) measures how a percentage change in
sales from the current level will affect company’s
operating profits.
• DOL = % change in EBIT / % change in sales
• Or DOL = Contribution / EBIT
• Financial leverage : FL may be defined as “the use
of funds with a fixed cost in order to increase
earning per share.”
Trading on equity is the financial process of using
debt to produce gain for residual owners (equity
share holders).

Larger the magnitude of debt in capital structure,

the higher is the variation in EPS given any
variation in EBIT

If R.O.I > fixed interest charges, it is beneficial

• Combined (super) leverage : (DCL)
OL & FL together cause wide fluctuation in EPS for
a given change in sales.
• Cost of capital : It is defined as “the rate of return
the firm requires from investment in order to
increase the value of the firm in the market
place.”
CLASSIFICATION :
Historical costs are book costs relating to the
past, while future costs are estimated costs act
as guide for estimation of future costs .
Composite cost (Also known as the weighted
average cost of capital)
Implicit cost is also known as opportunity cost.
• Explicit cost of any source of finance is the
discount rate which equates the present values of
cash inflows with the present value of cash
outflows.

• Perpetual Debt : (Contractual agreement to

receive)
Kd (before tax) = I/Po
Kd (after tax)= I/P(I - T)
Kd = cost of debt , I = interest , Po = Net proceeds
T = tax rate
• Redeemable Debt :
• Cost of preference share capital :

Kp =

Np= net proceeds D = Annual preference dividend

Mv = Maturity value Kp = cost of preference capital
N = maturity period
• Budgeting & Budgetary control :
“A Budget is a financial and or quantitative
statement, prepared prior to a defined period of
time, of the policy to be pursued during that
period for the purpose of attaining a given
objective.”
Steps in Budgetary control :
1. Budgets
2. Measurement of actual performance
3. Calculation of the variance
4. Revision of budgets
5. Suitable or prompt action
Performance Budgeting :
Performance budget focuses on the results.
It asks the question that “why the money is being
spent”
Advantages :
Set accountability
Clear purpose , Transparency
Improvement in performance
Disadvantages :
Subjective in nature, Manipulation of data
Strong system of evaluation
Difficult for long term projects .
Zero based Budgeting :
It is an approach to making a budget from scratch .
• Goal of ZBB budgeting is to reduce spending by
looking at where cost can be cut.
• ZBB as practical today was developed at texas
instruments Inc. during 1969 by peter pyhrr.
• It helps in reduction in redundant activities and
overcomes the weakness of incremental
budgeting of budget inflation.
• However, it is a time- intensive and costly
exercise.
Fund flow Analysis :
• Flow of funds means inward and outward
movement of funds of an enterprise.

• Fund flow analysis is the analysis of flow of fund

from current asset to fixed asset or current asset
to long term liabilities or vice-versa.

• Funds refers to working capital :

Working capital = current assets – current liabilities
Fund flow is a statement of sources and application
of funds.
Various sources (inflows) and use of Funds :
• Trading profits or funds provided by operations.
• Issues of equity and preference shares (including
premium or excluding discount.)
• Issues of debentures (including premium or
excluding discount.)
• Long term loan
• Sale of fixed assets
• Sale of investment
• Non-trading incomes
Application (outflows) :
• Trading loss or funds depleted by operations.
• Redemption of redeemable preference shares
(including premium excluding discount.)
• Redemption of debentures
• Repayment of long term loans.
• Purchase of fixed asset
• Purchase of investment
• Payment of non-trading items, if any
Importance of fund flow statement :
• Gives information about amount of working
capital and changes in the amount of working
capital.
• It analyses balance sheet to reveal the financing
& investing activities.
• It analyses the P&L account to reveal the effect
of business activities of the concern on the flow
of funds.
• It is a tool for planning future activities of
business.
Cash flow statement :
This statement depicts
Change in cash position between the beginning
and end of the financial period.
Various sources of cash inflow & uses of cash
during a period.
AS-3 issued by ICAI in June 1981, which dealt with
a statement showing ‘changes in financial
position’ (fund flow statement), has been revised
and now deals with the preparation &
presentation of cash flow statement.
Meaning of cash as per AS-3 :
• Cash in hand
• Demand deposits with bank
• Cash equivalents.
Financial management :
A/c to Ezra solomon, the changing concept of finance
can be analysed by dividing the entire process into
three broad groupings.

• First approach : this approach just emphasizes only

on the liquidity and financing of the enterprise.
• Traditional approach : Used for raising funds used in
an organization. It encompasses instruments,
institutions & practice through which funds
augmented and the legal and accounting relationship
between a company and its source of funds.
• Modern approach : this approach is concerned
not only with raising of funds, but their
administration also.

• Evolution of financial management :

Classical financial management (till mid 1950s)
Modern financial management (mid 1950 to
1980s)
Post modern financial management (since 1990)
• Functions of financial management :
• Objectives of financial management
• Steps in financial planning :
Dupont Analysis :
It is a framework for analyzing fundamental
performance popularized by Dupont corporation.

Dupont analysis is a useful technique used to

decompose the different drivers of return on
equity (ROE).
An investor can use analysis like this to compare
the operational efficiency of two similar firms.
Manager can use Dupont analysis to identify
strengths or weakness should be addressed.
• Dupont Analysis = Net profit margin * AT * EM
• Dupont 3 steps calculation :

• Dupont 5 step calculation :

EBIT – EPS Analysis :
It gives a scientific basis for comparison among
various financial plans and shows ways to maximize
EPS.

It is a tool of financial planning that evaluates

various alternative of financing project under
varying levels of EBIT and suggests the best
alternative having highest EPS & determine the
most profitable level of EBIT .
Advantage of EBIT – EPS Analysis :
• Financial planning
• Comparative analysis
• Performance evaluation
• Determining optimum mix
Limitation :
• No consideration for risk
• Contradictory result , over capitalization

EPS = Earning available to equity share holder /

number of equity share
Cost sheet :

Component of cost sheet :

Direct material , direct labor , general &
administrative expense , selling & distribution
expenses .
• Flow of cost :
• Cost volume profit Analysis :
• CVP Formula :
Standard costing & Variance Analysis :
Standard cost is a predetermined cost that refers to
that amount which ought to be incurred. It is
computed in advance of production. The main use
of standard costs is in performance measurement,
control, stock valuation and in the establishment of
selling price.
Types of standard :
Process of standard costing :
Types of variance :
• Controllable & Uncontrollable
• Favorable & Adverse
Principles of Analysis of variance :
• Variance should be stated in monetary terms.
• Variance should be analyzed product-wise
• Variance should be favorable and unfavorable
• Total cost variance happens to be the difference
between the standard cost of actual output and
the actual cost incurred.
• Material cost variance (MVC) = Standard cost –
Actual cost
• Labor cost variance (LCV) = Standard wages –
Actual wages
• Variable overhead cost variance = Standard
variable overheads for production – Actual
variable overhead
Marginal costing :
A/c to CIMA London “Marginal costing is the cost
of one unit of product or service which would be
avoided if that unit were not produced or
provided.”
Under Marginal costing system, fixed costs are
excluded from unit cost.
Alternatives of GAAP : ‘IFRS’ (International financial
reporting standards) regulated by IASB
(international accounting standard board)

Standard setting bodies :

• Securities & exchange commission (SEC)
• Financial accounting standards board (FASB)
• International accounting standards Board (IASB)
Notes :
• ICAI has withdrawn AS-8 on accounting for
research and development.
• ICAI amends AS-2, AS-4, AS-10, AS-13, AS-14, AS-
21, AS-29 And withdraw AS-6 .
• ICAI withdraws its announcement on treatment
of exchange difference under AS-11 .
• Companies (Accounting standards) amendment
rules, 2018 notified by MCA. (AS-11 amended)
• List of ICAI’s non-mandatory AS – 30~32
Indian accounting standards (Ind-AS) :
Ind-AS is the accounting standard adopted by
companies in India and issued under the
supervision of ASB (Accounting standard board).
Which was constituted in 1977.
ASB is a committee under institute of chartered
accountants of India (ICAI) which consists of
representative from government department,
academicians other professional bodies viz ICAI,
representative from ASSOCHAM, CII, FICCI etc.
MCA has notified 41 Ind-AS.
Important IND-AS :
• Ind AS 102 : share based payment
• Ind AS 103 : business combination
• Ind AS 108 : operating segments
• Ind AS 110 : consolidated financial statement
• Ind AS 113 : fair value measurement
• Ind AS 1 : presentation of financial statement
• Ind AS 12 : income taxes
• Ind AS 16 : Property, plant and equipemnt
• Ind AS 27 : separate financial statements
• Ind AS 29 : financial reporting in hyper inflationary
economies.
• Ind AS 33 : earning per shares
• Ind AS 34 : interim financial reporting
• Ind AS 37 : provisions, contingent, liabilities and
contingent assests.
• Ind AS 38 : intangible assets
• Ind AS 40 : investment property
• Ind AS 41 : agriculture
Phase of adoption :
Mandatory applicability of IND-AS to all companies
from 1st April 2016, provided :
• It is a listed or unlisted company
• It’s net worth is greater than or equal to Rs. 500 cr.
• Net worth shall be checked for the previous three
financial years (2013-14, 2014-15 & 2015-16)
PHASE -2
Mandatory applicability of IND-AS to all companies
from 1st April 2011, provided.
• It is a listed company or is in the process of being
listed (as on 31.03.2016)
• Its net worth is greater than or equal to Rs. 250
cr. But less than Rs. 500 cr. (for any of the below
mentioned period.)
• Net worth shall be checked for the previous 4
financial years (2013-14, 2014-15, 2015-16 &
2016-17)
PHASE 3
Mandatory applicability of IND-AS to all banks,
NBFCs and insurance companies from 1st April
2018, whose :
• Net worth is Tran or equal to INR 500 crore with
effect from 1st April 2018.
• IRDA (insurance regulatory & development
authority) of India shall notify the separate.
PHASE 4
All NBFCs whose net worth is more than or equal to
INR 250 cr. But less than INR 500 cr. Shall have IND-
AS mandatorily applicable to them with effect from
1st April 2019.
• NFRA (National Financial reporting Authority)
Recently MCA has published NFRA rules in 2008 to
keep check on compliance of accounting standards
and policies by the companies & also to penalize
the defaulters.
NFRA has been constituted under section 132 of
the companies act, 2013.
Function of NFRA :
• Make recommendation to central government on
formulation of accounting/auditing
policies/standards.
• Monitoring & enforcing the accounting & auditing
standards compliance.