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Stewardship Accounting
In earlier times in history, wealthy people employed 'stewards' to manage their property. These stewards rendered an account of their
stewardship to their owners periodically. This notion lies at the root of financial reporting even today which essentially involves the orderly
recording of business transaction, commonly known as 'book-keeping'.
Financial Accounting
Financial accounting dates from the development of large-scale business and the advent of Joint Stock Company (a form of business which
enables the public to participate in providing capital in return for 'shares' 'in the assets and the profits of the company). This form of business
organization permits a limit to the liability of their members to the nominal value of their shares. This means that the liability of a shareholder
for the financial debts of the company is limited to the amount he had agreed to pay on the share he bought. He is not liable to make any
further contribution in the event of the company's failure or liquidation. As a matter of fact, the governing the operations (or functioning) of a
company in any country (for instance the Companies Act in India) gives a legal form to the doctrine of stewardship which requires that
information be disclosed to the shareholders in the form of annual income statement and balance sheet.
Cost Accounting
The industrial revolution in England presented a challenge to the development of accounting as a tool of industrial management. Costing
techniques were developed as guides to management actions. The increasing awareness on the part of entrepreneurs and industrial
managers for using scientific principles of management in the wake of scientific management movement led to the development of cost
accounting. Cost accounting is concerned with the application of costing principles, methods and techniques for ascertaining the costs with a
view to controlling them and assessing the profitability and efficiency of the enterprise.
Management Accounting
The genesis of modern management with its emphasis on detailed information for decision- making provided a tremendous impetus to the
development of management accounting. Management accounting is concerned with the preparation and presentation of accounting and
control information in a form which assists management in the formulation of policies and in decision-making on various matters connected
with routine or non-routine operations of business enterprise. It is through the techniques of management accounting that the managers are
supplied with information which they need for achieving objectives for which they are accountable.
Social Responsibility Accounting
Social responsibility accounting is a new phase in the development of accounting and owes its birth to increasing social awareness which has
been particularly noticeable over the last two decades. This is a growing feeling that the concepts of growth and profit as measured in
traditional balance sheets and income statements are too narrow to reflect the social responsibility aspects of a business.
Inflation Accounting
Inflation Accounting is concerned with the adjustment in the values of assets (current and fixed) and of profit in the light of changes in the
price level. It thus aims at correcting the distortions in the reported results caused by price level changes. Human Resource Accounting
(HRA) is a branch of accounting which seeks to report and emphasise the importance of human resources in a company's earning process
and total assets. It is concerned with "the process of identifying and measuring data about human resources and communicating this
information to interested parties".
ACCOUNTING AS AN INFORMATION SYSTEM
Accounting as a social science can be viewed as an information system since it has all the features of a system. It has its inputs (raw data),
processes (men and equipment), and outputs (reports and information).
Shareholders and Investors: Since shareholders and other investors have invested their wealth in a business enterprise, they are
interested in knowing periodically about the profitability of the enterprise, the soundness of their investment and the growth prospects of the
enterprise.
Historically, business accounting developed to supply information to those who had invested their funds in business enterprises.
Creditors: Creditors may be short-term or long-term lenders. Short-term creditors include suppliers of materials, goods or services. They are
normally known as trade creditors. Long-term creditors are those who have lent money for a long period, usually in the form of secured loans.
The main concern of the creditors is focused on the credit worthiness of the firm and its ability to meet its financial obligations.
Employees: The view that business organizations exist to maximise the return to shareholders has been undergoing change as a result of
social changes. A broader view is taken today of economic and social role of management. The importance of harmonious industrial relations
between management and employees cannot be over-emphasised. That the employees have a stake in the outcomes of several managerial
decisions is recognised.
Government: In a mixed economy it is considered to be the responsibility of the Government to direct the operation of the economic system
in such a manner that it sub serves the common good. Controls and regulations on the operation of private sector enterprises are the
hallmark of mixed economy. Several government agencies collect information about various aspects of the activities of business
organizations.
Management: organizations may or may not exist for the sole purpose of profit. However, information needs of the managers of both kinds of
organizations are almost the same, because the managerial process i.e. planning, organising and controlling is the same. The emphasis on
efficient and effective management of organizations has considerably extended the demand for accounting information.
Consumers and others: Consumers' organizations, media, welfare organizations and public at larger arc also intcr'1sted in condensed
accounting information in order to appraise the efficiency and social role of the enterprises in different sectors of the economy, that is, what
levels of profits and outputs arc being achieved, in what way the social responsibility is being discharged and in what manner the growth is
being planned by the enterprises in accordance with the national priorities etc.
ROLE AND ACTIVITIES OF AN ACCOUNTANT
a.
b.
c.
d.
e.
f.
g.
ACCOUNTING PERSONNEL
There is hardly any organization which does not have an accountant. His role is all pervasive and he is involved in a wide range of activities,
particularly in a large and complex organization.
Internal Auditor is an employee of the organization in contrast to an external auditor who is paid a fee for his services. The internal auditor is
responsible for performing monitoring activities and other services, including designing and operating the system of internal control, auditing
the data reported to the directors of the company and assisting external auditors. The head of the internal audit function reports directly either
to the chief executive or the audit committee of the Board of Directors. Internal audit includes continuous verification of entries appearing in
the books of account with the original vouchers and proper accounting of assets. Further, it attempts to ensure that the policies and
procedures regarding financial matters are being compiled with. Internal auditing is also concerned with administering the system of internal
check so that mistakes, innocent or intentional, are prevented from taking place.
Controller --- the other name for Chief Accountant ---is usually the head of the whole area of accounting, including internal audit. He is
overall in-charge of all the activities comprising financial accounting, cost accounting, management accounting, tax accounting etc. His main
functions are --Preparing financial statements and reports, establishing and maintaining systems, supervising internal audit, supervising
computer applications, overseeing cost control, preparing budget, making forecasts and analytical reports, handling tax matters etc.
Treasurer
He is the custodian and manager of all the cash and near-cash resources of the firm. The treasurer handles credit reviews and sets policy for
collecting receivables (debtors of the firm whom the firm has sold good or services). He also handles relationships with banks and other
lending or financial institutions.
Finance Officer
Finance is the life blood of business. Procuring financial resources and their judicious utilisation are the two important activities of financial
management which is a specialialised function. Financial management, includes three major decisions: investment decision, financing
decision and dividend decision.
Consistency Concept
The consistency concept requires that once a company has decided on one method and has used if for some time, it should continue to
follow the same method or procedure for all subsequent events of the same character unless it has a sound reasons to do otherwise. If for
valid reasons the company makes any departure from the method it has been following so far, then the effect of the change must be clearly
1.
2.
3.
4.
5.
6.
English Approach. (i) Rule of Personal Accounts. According to this approach if Mahendra gives Rs.2,000 to the business then it is said that
Mahindra has some honour or reputation in the eyes of business. His account, therefore, will be credit by Rs.2,000. Credit word has been
derived from the Latin word credere which means 'to believe'. On the other hand, if Satish receives Rs.700 from the business then it is clear
that Satish owes Rs.700 to the business. In other words, Satish's account will be debited. Debit word has been derived from Latin word
'debere' which means 'to owe'. Thus from the above discussion a simple rule can be derived that "Debit that person's account who receives
something from the business and credit that person's account who gives something to the business."
(ii) Rule for real account. Again if the storekeeper of the business has received goods or furniture or some other real thing then, in
accordance with the above rule, storekeeper is receiver and his account should be debited. But actually storekeeper is acting on behalf of the
business and does not owe any amount to business. Thus, instead of debiting his personal account, the account representing the thing is
debited. Similarly, when storekeeper supplies something then, he is acting on behalf of the business and instead of crediting his personal
account, the account representing the thing is credited. Thus, a simple rule can be derived that in the case of real thing "debit what comes
into the business and credit what goes out of the business.
(iii) Rule for expenses and incomes. Supposing cashier pays cash for rent. Then as per the second rule the cashier is not the giver of cash
and instead of his account cash account will be credited. Further, the account of landlord who has received rent (as per rule) should be
debited. But this would mean that landlord is a debtor when actually he is not. Thus instead of debiting landlord's account the expense on
which account cash has been paid will be debited. In this case rent account will be debited. When interest is received by the cashier, cash
account (instead of cashier's account) will be debited and instead of person's account who has given interest (because he does not become
the creditor of the business) the particular income account is credited. Now a simple rule can be derived: "Debit all expenses and losses and
credit all gains and incomes." All accounts for expenses and incomes are called nominal accounts.
To summarise, it can be said that there are three types of accounts, that is, personal accounts, real accounts and nominal accounts and
there are three rules for them. Rules are:
Natural persons' accounts. For example, proprietor's account, suppliers' accounts, receivers' accounts (like Mohan's A/c, Shashi's
A/c, Naresh's A/c).
ii.
Arrificial persons' and body of persons' accounts. For example' any limited company's account, bank account, insurance company's
account, and firm's account, any government's account any institution's account, any club's account.
iii.
Representatives personal accounts. When an account represents a certain person or persons then it is called a representative
personal account. In books the names of the actual parties appear. But since they are of the same nature and many in number, the
amounts standing against these accounts are added and put under one common title. For example, if a business is not able to pay
salary for the last two months to all the workers or some of them then the workers will be treated as the creditors of the business
(since they have given the services but in exchange they have not been paid for). The amount due to these employees will be
added and put under one common title "Salaries Outstanding Account". Thus the salary outstanding account is a personal account
representing the employees. Similarly, if a business is not able to pay rent of (say) 20 shops then all landlords of those shops stand
as creditors and the amount due to them is added and put under common head "Rent Outstanding Account ". Rent outstanding
account is again a personal account representing so many landlords. Other examples of the personal accounts of this nature are:
a.
b.
c.
d.
e.
Real Accounts. Real accounts can take the following two forms:
i.
Tangible and real account. Tangible real accounts are the accounts of such things which can be touched, felt, measured,
purchased, sold, etc. Examples are: land account, building account, furniture account, stock account, cash account (not that bank
account is a personal account and not a real account because bank account is the account of the some banking company which is
an artificial person).
ii.
Intangible real account. They are the accounts of such things which are difficult to touch in the physical sense but of course they can
be measured in pecuniary value. Examples are: good will, trade marks, patents rights.
Nominal Accounts. Nominal accounts are those accounts which are in name only. They are simply used to define the nature of
transactions. This will be clear from one example. If in a factory the manager gets salary, the commission agents gets commission, the
worker gets wages, the carrier of goods gets carriage, the lender of money gets interest on money, then in fact they all get cash. Cash is the
real thing which exists and salary, commission, wage, carriage, interest, etc., are only ways of describing the nature of head for which cash
has been paid. In the absence of these nominal heads it will be very difficult for the management to know the amount paid separately on
account of salary, wages, commission, etc. It will also be almost impossible for the management to know on what head of expenditure the
money spent is unreasonable and what steps should it take to avoid it.
POSTING TO LEDGER
What is ledger? Ledger is a set of accounts. In other words, ledger is a book n which various accounts (of nominal, personal and real
nature) are opened. In earlier days, ledgers were bound books and some of them still are. Modern trend is to keep loose leaf ledgers in the
form of 'cards in trays' or 'punched sheets kept in the binder' or any other device something like that
The following are important points about the above prepared T' ledger account:
i.
ii.
iii.
There are two sides of ledger account. The left-hand side is known as debit side while the right-hand side is known as credit side.
The words 'Dr.' and 'Cr.' are used to denote Debit and Credit.
The name of the account is written in the middle of the account.
'JF' denotes folio or page number on which its journal entry may be found.
What is Posting? Posting is the process of entering in the ledger the information given in the journals (both special and general). Posting
from the journal or book done periodically, may be weekly or fortnightly or monthly as per the convenience of the business. In order to
understand the full process of posting from the books of original records to the ledger, we will take each book separately and see how the
posting is done from that book.
Relation between Journal and Ledger. The journal and the ledger are the most important books of the double entry system of accounting and
are indispensible for a proper system. Following are the points of comparison between these two types of books:
i.
ii.
iii.
iv.
v.
The journal is the book of first entry (original entry) ; the ledger is the book of second entry
The journal is the book for chronological record; the ledger is the book for the analytical record.
The journal, as a book of source entry, ordinarily, has greater weight as legal evidence than the ledger.
The unit of classification of data within the ledger is the account; the unit of classification of data within the journal is the transaction.
The process of recording in the journal is called journalising; the process of recording in the ledger is called posting.
Guiding Rules for Posting Transactions. The following are the guiding rules for posting transactions:
a.
b.
c.
The debit side of the journal entry is posted to the debit side of the account and on that side the reference is given of that fact which
is put on the credit side of the journal entry.
The credit side of journal entry is posted on the credit side of the account and on that side the reference is given of that fact which is
put on the debit side of the journal entry.
Thus it may be concluded that a journal entry (not compound entry) needs two accounts to post it fully: one account is debited and
the other is credited.
Score-keeping.
Attention-directing, and
Problem-solving
Score keeping
It basically deals with the financial health of the enterprise. How are we doing? What is doing is bad? Is profit earned good? If so, how much?
Is it profit alone is not sufficient? One is that of keeping record of actual data on performance.
Attention-directing
It is nothing but the process of giving a signal to the user of accounting information about the need to take a decision.
Problem-solving
The problem-solving function of accounting information involves provision of such information which enables the manager to find solutions to
the problems.
ACCOUNTING AND CONTROL IN organization
The annual accounts or financial statements of a business comprise balance sheet and profit and loss account. Sometimes they also include
the fund flow statement. Balance sheet, and Profit & Loss Account provide valuable information linking the profit to investment or assets used
in business. By making the best use of accounting information of the past in relation to the expectations of future, we try to make integrated
financial plan for an organization.
USES OF EARNINGS INFORMATION
The earnings information is useful for
1.
2.
3.
4.
measuring accomplishment,
deciding how much could be withdrawn from the business without impairing its current level of operations,
identifying the problems, and
determining a market value for the enterprise.
Accomplishments: Profit is an important indicator of the accomplishment of business. Other things remaining the same, higher the profits
greater is the accomplishment.
APPROPRIATION DECISION
How much money can be withdrawn without impairing its current level of operations?
Problem identification Using Earnings Data
Uses of Balance Sheet
KEY WORDS
Problem-solving role of accounting consists of supplying such information as would be useful to managers for taking a variety of routine and
non-routine decisions.
Profit and loss Account is a summary of the revenues and expenses, including gains and losses from extraordinary items of a business unit
disclosing at a given moment of time its assets, liabilities ad ownership equities.
Balance Sheet is a statement of financial position of a business unit disclosing at a given moment of time its assets, liabilities and ownership
equities.
Appropriation of net profits means the (allocation) disposal of net profit for various purposes. In the case of non-corporate entities, the net
profit is distributed to the owners. In the case of corporate entities usually a part of the net profit is provided for estimated tax liability, a part is
retained in business to strengthen its financial position and for future growth, a part is distributed to shareholders in the form of dividends and
any amount left is carried forward to the next period.
Before the preparation of trial balance. Errors are normally corrected before the preparation of final trial balance. If it is done then
the correction is carried out without the help of Suspense Account.
b.
Before the preparation of trial balance and final accounts. If correction is carried out at this stage then correction is carried out with
the help of suspense account. It may be noted that corrections even at this stage may not need the help of suspense account.
c.
After the preparation of final accounts. At this stage the correction relating to errors affecting those accounts which are shown in
trading and profit and loss account is carried out with the help of profit and loss adjustment account or capital account. The use of
suspense account is made wherever necessary.
Normally the question should mentioned the stage at which the correction is being carried out. But it is often seen that students are
not given any direction to this effect. Under such circumstances it is proposed that students should assume that corrections are to
be carried out at the first stage, that is, before the preparation of final trial balance. However, students are free to make any other
reasonable assumption and carry out corrections after appending a necessary note.
Error of omission;
Error of recording;
Error of posting to wrong account;
Error of principle.
As these errors affect two or more accounts, rectification of such errors can often be done with the help of journal entry. Sometimes even
here the entry is completed with the help of suspense account. In case there is no suspense account, then rectification is carried out by
giving explanatory notes.
Error of omission
Error of omission stands for omission of recording the transaction in the books of subsidiary records. Omission in posting has already been
done under the heading 'error of posting' affecting one account. Omission of a transaction from a subsidiary record affects two accounts.
Because of omission the transaction does not appear in the book and monthly casting of that book becomes wrong, which in its turn, affects
that account where the total of the book is taken. The omission also affect the individual account because in the absence of any record in the
book posting to that account is done.
Errors of recording
Recording is the first stage of book-keeping and any mistake committed at this stage means an error in the subsidiary book. This error also
affects two accounts. First, wrong recording affects the casting of the book which, in turn, affects the impersonal account where the total is
posted, and, secondly, the individual account is incorrectly posted.
Error of principle
Error of principle involves an incorrect allocation of expenditure of receipt between capital and revenue. This distinction between capital and
revenue is of paramount importance because any incorrect adjustment or allocation in this respect would falsify the final results as disclosed
by both the profit and loss account and the balance sheet. It is, therefore, urgently needed that a close and careful study of the principles of
allocation be made.
SUSPENSE ACCOUNT
It has already been said that all the errors, which affect one account, affect the agreement of trial balance at the end of the year, and
ultimately delays the preparation of final accounts. Therefore, in order to avoid the delay in the preparation of final accounts, the difference in
the trial balance is put to suspense account. For example, if the debit side of trial balance exceeds the credit side, then difference is put on
the credit side and suspense account shows a credit balance. When errors are located entries are passed with the help of suspense account
and thus when all errors affecting the trial balance are located suspense account stands closed. It suspense account still shows a balance,
then it is taken to the balance sheet.
DIFFERENCE IN TRIAL BALANCE
Trial balance is affected only by those errors which are rectified with the help of suspense account. Therefore, in order to calculate the
difference of suspense account a table is prepared and if suspense account is debited in the rectification entry, the amount is put on the debit
side, and if suspense account is credited, the amount is put on the credit side of the table. In the end, the balance is calculated and is
reversed for suspense account, that is, if credit side exceeds, difference is put on the debit side of suspense account (not on the credit side)
and vice versa.
Trading Account
Profit and Loss Account
Balance Sheet
2.
3.
4.
5.
6.
7.
8.
Ascertaining gross profit or gross loss. The main purpose of preparing Trading account is to ascertain gross profit or gross loss.
Excess of credit side over the debit side of Trading account is gross profit and the excess off debit side over the credit side is gross
loss. The gross profit ratio between 20 to 30% is treated as standard. Gross profit should be sufficient to cover selling and
distribution expenses. The adequacy of gross profit is measured with reference to sales.
Ascertaining ratio of direct expenses to gross profit. Trading account shows the details of direct expenses incurred in acquiring
and manufacturing goods. Cost of production increases with the increases in direct expenses. The margin and the amount of profit if
vitally affected by direct expenses. The ratio of direct expenses to gross profit is calculated and compared with the desired and
previous performance and efficiency is measured.
Ascertaining ratio between purchases and direct expenses. Relationship between purchases and direct expenses is
ascertained through Trading account. The amount of purchases and direct expenses are available from Trading account. Direct
expenses add to the cost of purchases.
Calculation of cost of goods sold. Gross profit or loss is based upon cost of goods sold. It is based upon the information available
from Trading account. Cost of goods sold ascertained by adding opening stock, purchases and direct expenses and deducting
closing stock from it. It can also be calculated by deducting gross profit from sales. Cost of goods sold helps us in calculating profit
of the firm.
Calculation of gross profit ratio. The firm calculates gross profit ratio and measures the efficiency of its performance. Gross profit
ratio is calculated by comparing gross profit to net sales. Gross profit ratio should be sufficient to cover expenses. The ratio is
compared with the desired ratio or with the ratio of previous year and performance evaluated.
Comparison of stock with the stock or previous year. Stock disclosed by trading account is compared with the closing stock of
previous year. Stock is the part of goods remaining unsold with the firm. It should be the least possible "The more stock the lesser
selling efficiency of the firm". It is always in the interest of the firm to dispose off goods purchased or manufactured.
Comparing the actual performance with desired performance. The actual performance shown by the Trading account as
regards purchases, sales, stock and cost of production can be compared with the desired performance. In case of weaknesses,
effective corrective measures can be applied.
Comparing the actual performance with previous performance. The actual performance as disclosed by the Trading account is
compared with the performance of the previous year. The comparison shows the plus and minus performance of the business.
These plus and minus points should be identified. Minus point should be removed and plus point should be enforced.
Proforma of Trading Account
Trading Account
(For the period ending ....19.....)
Opening stock. It is the stock available with the firm on the opening day of the accounting period. It may also be termed as stock at
the beginning of the year. This stock is available from the debit side of trial balance. It shows a debit balance, so it is shown at the
debit side of trading account. In case of newly started business, opening stock will not be there. If the firm has existed for more than
one year it will definitely have opening stock.
Classification of opening stock. In case of manufacturing firms or factories stock may be classified as :
2.
a.
Stock of raw material. Factories use raw material for production of the product in which they have been dealing. Value of
the raw material at the beginning of the accounting period is shown at the debit side of Trading account.
b.
Stock of work in progress or semi-manufactured or partly finished goods. It is the value of that part of raw material
which is in the production process. It is neither raw material nor finished goods. In case of cotton mills the value of threads
and the unfinished cloth will be stock of work in progress. The stock will also be shown at the debit side of Trading account.
c.
Finished goods. It is the value of goods which are finished and ready for sale. The firm has certain finished goods in the
beginning of the year. In case of flour mills, the value of packed flours or in case of cotton mills, the value of finished cloth
is the value of finished goods, which must be shown at the debit side of Trading account, if it relates to beginning of the
year.
Purchases. Purchase account includes all cash and credit purchases of goods made during the year. It does not include purchase
of assets. We have to show net purchases in the Trading account. This is why, we show the amount of purchases in the inner
column and deducted purchases return or returns outward from it. After deduction, the net purchases are written at the amount
column. Goods taken by the proprietor for personal use or goods given as charity are also changed at cost price, so 'their' value is
deducted from purchases. If it has not been adjusted in the purchases as yet it must be deducted from purchases at the debit side of
Trading account.
In case of goods purchased arc still in transit it will be better to pass the following journal entry for it:
Goods in Transit A/c
To Supplier's A/c
Dr .
It appears from the journal entry that Trading account is not involved in the transaction. Goods in transit will be shown at the assets
side.
Goods received on consignment should not be treated as purchases.
Goods received on sale or return basis should also not be treated as purchases.
3.
Purchases return on return outward. Purchases return shows a credit balance. Instead of showing it at the credit side of Trading
Account, it should be deducted from purchases at the debit side of Trading account to ascertain net purchases.
4.
Expenses for acquiring goods. All expenses concerning purchases or acquiring of goods are direct expenses. They add to the
cost of goods purchased. The expenses are carriage, cartage, freight and cooliage. It should be noted that the expense must be
incurred in connection with the acquiring of goods. It should not be paid on selling goods. If it is carriage and freight outward or on
sales, it will not be shown in the Trading account. It will be shown at the debit side of Trading account if it is carriage or carriage
inward or carriage on purchases. Cartage and freight will also be treated in the same manner.
Payment of octroi or local taxes on the purchases of goods will also be shown at the debit side of trading account. This expense will
increase the cost of goods purchased. It is, therefore, justified that the expenses should be debited to trading account.
In case of foreign trade, we have to pay import duty, customs, landing charges and clearing charges. These expenses will add to the
cost of goods imported, so they are also shown at the debit side of trading account.
5.
Expenses for manufacturing goods. The factories or the manufacturing concern have to consume certain manufacturing
expenses, i.e., coal, gas, power and wages. These expenses are the part of the value of goods manufactured by the firm. It is,
therefore, necessary that expenses must be added to the cost of goods produced and debited to Trading account. Wages and
salaries account should also be shown at the debit side of trading account as a matter of convention. The debit side of trading
account shows the value of goods available for sale. The value of goods is determined by adding expenses incurred on acquiring or
manufacturing goods to the cost of goods purchased or manufactured.
6.
Consumable stores. It includes engine oil, cotton waste, tallow and soft soap. They are necessary to maintain the working
efficiency of the plant, machine and equipment. They are essential for production so they are debited to Trading account.
7.
Packing charges. Packing charges to make goods saleable or to bring it in saleable position are direct expenses. These expenses
are the part of the cost of finished goods, so they will be debited to Trading account, just as other direct expenses.
8.
Royalty. It is the amount payable to the landlord of mines and tea gardens for the right to work his mines or garden. The amount is
paid by the company and treated as direct expenses. Royalty is also paid by the publisher to the author for the right to publish his
Dr.
To Opening Stock
(Being transfer of opening stock of trading account)
2. For purchases. Purchases account is transferred to the debit side of trading account with the total of cash and credit purchases, i.e.,
gross purchases.
Journal Entry
Trading A/c
Dr.
To Purchases A/c
(Being transfer of opening stock of trading account)
3. For purchases return. The balance of purchases return account is transferred to purchases account.
Journal Entry
Purchases Return A/c
Dr.
To Purchases A/c Dr .
(Being transfer of Purchases to Purchases account)
4. For direct expenses. Direct expenses add to the cost of goods purchased or manufactured. They are posted at the debit side of trading
account.
Journal Entry
Trading A/c
Dr.
Dr.
To Trading A/c
(Being transfer of opening stock of trading account)
6. For sales returns or returns inward. The balance of sales return is transferred to sales account.
Journal Entry
Sales A/c
Dr.
Dr.
Dr.
To Opening Stock
To Purchases A/c
To Wages A/c
To Carriage or Cartage or Freight A/c
To Coal, Gas and Power A/c
To Manufacturing Expenses A/c
2. Sales A/c
Closing Stock A/c
Dr.
Dr .
Dr.
If the debit side of trading account exceeds the credit side, the excess is supposed to be gross loss and transferred to profit and loss account.
(b) Profit and Loss A/c
Dr.
To Trading A/c
(Being transfer of gross Profit to Profit and loss A/c)
Knowledge of net profit or net loss. The purpose of preparing profit and loss account is to ascertain the amount of net profit or
loss. This is the actual profit available to the proprietor and credited to his capital account. In case of net loss proprietor's capital
account will be debited. The net profit is calculated after charging all indirect expenses.
2.
Ascertaining ratio between net profit and sales. We get net profit from profit and loss account. This net profit is matched with the
net sales to calculate net profit ratio. This ratio is compared with the desired net profit ratio and if there is any short coming, that will
be removed. This ratio can also be compared with the ratio of previous years and effective future line of action can be taken.
3.
Calculation of expenses ratio to sales. Expenses ratio to sales is calculated. We can calculate individual expenses to sales ratio
and compare it with desired expenses ratio and with the ratio of previous years. It will always be in the interest of the firm that the
expenses ratio should be the minimum.
4.
Comparison of actual performance with desired performance. The actual performance of the business is available with the
profit and loss account as regards net profit, individual expenses and individual income. We compare our actual performance with
our planned and desired performance, identify weakness and try to remove them.
5.
Maintaining provision and reserves. We have to maintain certain reserves and provision to meet our future uncertainties. The
amount of provisions, reserves and funds to be maintained depends upon net profit earned by the firm. It is necessary to prepare
profit and loss account to determine the net profit, so that effective provision for uncertain future could be maintained.
6.
Determining future line of action. We can adopt effective future line of action on the basis of the informations available from profit
and loss account regarding net profit and other expenses.
Explanation
1.
Salaries . Salaries are paid to employees of the firm working in the office. Salaries paid to workers of the factory, works manager,
production engineer and foreman is direct expense so debited to Trading account. Salaries and wages are also indirect expenses as
a matter of convention. As the word salaries being an indirect expenses will take the wages also with it and the entire expense
under the head 'salaries and wages' will be carried forward to the debit side of profit and loss account. Salaries paid to partners is
also on indirect expense. It should be separately shown.
2.
Rent. Rent of the office, shop, show-room etc. is an indirect expense and posted to the debit side of profit and loss account. Rent of
the factory is a direct expense and debited to Trading account. If a part of the building is sublet, rent received should be credited to
rent received account and shown at the credit side of profit and loss account.
3.
Interest . The firm has to pay interest on loan borrowed by it. It has also to pay interest on overdraft or bills over due. It is an
expense of indirect nature and debited to profit and loss account Interest on fixed deposit, investments and loan advanced by the
firm is an income, so it will be posted at the credit side of profit and loss account. Interest paid and received should be separately
shown.
4.
Commission. The firm has to avail of the services of the agents and broker to sell its goods. Brokerage or commission paid to these
agents are indirect expenses. It is selling and distribution expense so it will be debited to profit and loss account.
Commission and brokerage paid to agents and brokers on the purchase of goods is direct expense and posted to the debit side of
trading account.
5.
Trade expenses . These expenses are also known as sundry expenses, miscellaneous expenses and office expenses. These
expenses are of nominal value so it is not necessary to open a separate account for these petty expenses. Selling expenses or
general expenses or petty expenses and indirect expenses are also this type of expenses and debited to profit and loss account.
Travelling expenses are paid to the travelling agents for their services of selling goods and promoting sales. It is an indirect expense
and debited to profit and loss account. Stable expenses are incurred by those firms which have got live- stock, generally horses.
Horses and carts are used for small soap and soft drink factories for distribution of their product. Horses are lodged in stables.
Stable expenses are indirect expense and debited to profit and loss account.
6.
Carriage and freight outward . Carriage and freight outward are an indirect expenses. It is incurred to send goods outward after
sale. It is one of the selling and distribution expense, so it should be debited to profit and loss account. It may also be named as
carriage or f eight on sale. It should be noted that carriage inward is direct expense.
7.
Printing and stationery . It includes all the expenses of printing bills, invoices, registers, letter heads' hand bills, visiting cards and
other documents. Stationery includes pen, ink, paper and other writing materials. It is an indirect expense and posted at the debit
side of profit and loss account.
8.
Advertisement. The firm has to adopt certain publicity measures to promote its sales. Advertisement creates demand and sustains
demand of the commodity among existing consumers of the commodity. It is an indirect expense and debited to profit and loss
account. If huge amount is spent on advertising, the benefits of which are to be obtained for five to ten years in future, it is treated as
deferred revenue expenditure and written off in certain specified year. In this case advertising suspense will be shown at the assets
side so far it is n t completely written off.
9.
Samples . Certain samples are to be distributed among prospective consumers so that they may purchase more of the commodity.
The cost of these samples is treated as an expense and debited to profit and loss account.
10. Discount
a. Trade discount. Trade discount is allowed at the time of selling goods. It is known as off season discount, New Year's
discount, bumper sale and festival discount etc. The amount of this discount is deducted from sale, we do not pass any
journal entry for trade discount.
b. Cash discount. It is allowed at the time of making or receiving payment. If the payment is made immediately or at an early
date we may allow our debtors certain discount.
Discount allowed to debtors is an expense, so it will be debited to profit and loss account. In the same way, discount allowed to us
by our creditors is termed as discount received. It is an income so credited to profit and loss account. Discount allowed and discount
received is shown separately at the debit and credit side of profit and loss account.
11. Insurance premium. The firm has to pay insurance premium against fire, marine and other policies. This insurance premium is an
expenses and debited to profit and loss account. It should be noted that life insurance premium paid on the personal policy of the
proprietor or partner is drawing and deducted from capital. It should not be debited to profit and loss account. Premium paid on joint
life policy of partners is an expense of the firm and posted to the debit side of profit and loss account.
12. Loss on gain on sale of assets . There may be loss on the sale of assets. For example, furniture costing Rs.20,000 may be sold
for Rs.16,000. In this case, there is a loss of Rs.4,000 on the sale of furniture. This is a business loss, so it should be debited to
profit and loss account. It should be noted that loss on sale of assets is no operating loss. If we have to calculate operating net profit
we shall exclude loss on sale of assets from the debit side of profit and loss account.
13. Any other loss . Losses are the unwanted burden which the firm may be forced to bear. These losses may be loss by fire or loss by
accident or bad debts etc. These losses will be shown at the debit side of profit and loss account.
Expenses not to be shown in profit and loss account . Following expenses are not shown in the profit and loss account.
1.
Direct expenses . All direct expenses add to the cost of goods purchased or manufactured so they are debited to Trading
account. It will be incorrect to debit these expenses to profit and loss account.
2.
Capital expenditure . Expenses incurred on acquiring assets are capital expenditure. These assets are shown at the
assets side of Balance Sheet. For example, expenses incurred for purchase of land and building, plant etc. or wages paid
for construction of building or carriage paid for acquiring assets is capital expenditure. This expenditure should not be
shown at the debit side of profit and loss account.
3.
Income tax . Income tax is levied on the personal income of the proprietor, so it is deducted from capital at the liabilities
side of balance sheet. Income tax charged from salaries of the employees as Tax deducted at source's is neither an
income nor expense. It is not debited or credited to profit and loss account. Actual salaries paid to the employees will be
debited to profit and loss account.
4.
Private or domestic expenses. These expenses are not business expenses, so they can not be charged from profit and
loss account. It is the personal expense of the proprietor, so it will be known as drawing and deducted from capital at the
liabilities side of balance sheet.
5.
Life insurance premium . The insurance premium has been paid on the personal life policy of the proprietor, so it is not a
business expense. It will not be shown at the debit side of profit and loss account. It should be treated as drawing and
deducted from capital at the liabilities side of the balance sheet.
Closing journal entries regarding profit and loss account . Profit and loss account records selling and distribution
expenses on the debit side and income at the credit side. Items regarding following closing journal entries are passed:
Dr.
(Being transfer of indirect expenses to the debit side of profit and loss account )
2. For transfer of sundry income:
Rent received A/c
Discount received A/c
Interest received A/c
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
To Capital A/c
(Being transfer of net profit to capital account)
4. For transfer of net loss . Excess of the debit side of profit and loss account over the credit side is the net loss and transferred to capital
account.
Capital A/c
Dr.
features:
1.
Balance sheet is a statement . Though Balance Sheet is an integral part of double entry system, but it is not an account. It has got
the balance of certain ledger accounts. The balance of II ledger accounts are not shown in it.
2.
Prepared on a specified date . Balance Sheet is prepared on a specific date, i.e., at the end of accounting period. It is common
practice and also legal requirement to prepare Balance sheet together with Trading and profit and loss account at the end of the
accounting year. It may be prepared after every six months if the proprietors so desire. Accounting year may consist of calendar
st
st
year or assessment year or its own accounting year. Companies are required to adopt assessment year (April 1 to 31 March) as
per legal requirement. Sole proprietorship and partnership can adopt accounting year which suits them, i.e., Diwali to Diwali or
Dussehra to Dussehra or assessment or calendar year.
3.
It is a statement of assets and liabilities . Though the Balance Sheet has debit and credit balance but its sides are named as
assets and liabilities. The left hand side is a liability representing credit balance. Right hand side is assets representing debit
balances.
4.
Knowledge of nature of assets and liabilities . Balance sheet categories assets as liquid assets, current assets, fixed assets and
fictitious assets. Knowledge of liabilities as current liabilities, fixed liabilities and reserve and funds can be gained from Balance
Sheet.
5.
Knowledge of financial position. Balance sheet depicts true financial position of the business. The position can be a ascertained
by study of the Balance Sheet. We can calculate short term and long term financial ratios, proprietory and other ratios to have the
knowledge of the financial soundness of the business.
6.
Assets and liabilities tally each other . The total of assets must be equal to liabilities. According to accounting equation, assets
are always equal to creditors, and proprietor's equity. If the total of assets and liabilities are not equal, there is likely to be certain
mistake.
Knowledge of proprietary ratio . Balance sheet provides requisite information to ascertain proprietor's funds and the capital
employed by him. Capital, reserves retained earning and accumulated profit from proprietor's funds. Proprietors claim against
business is said to be proprietor's fund. Proprietary ratio shows the relationship between proprietor's funds and total assets.
2.
Protection against possible losses . The position statement or the Balance Sheet throws light on the current liability and current
assets. The ideal ratio between current assets and current liabilities is 2: I. If it is lesser than that the short term financial position of
the firm cannot be said to be healthy. In such case, firm will adopt suitable measures to protect itself from possible misfortune.
3.
Calculation of financial ratios . Balance sheet provides sufficient information for calculation of short term and long term financial
ratios. These ratios indicate the present and prospective financial position of the firm.
4.
Calculation of working capital. Working capital is the excess of current assets over current liabilities. Information regarding current
assets and current liabilities is available from the Balance Sheet. Working capital should be sufficient to meet routine requirement of
the business.
5.
Ascertaining funds from operation . Balance sheet helps us in ascertaining the funds from operation. It shows the operational
efficiency of the firm. Funds from operation excludes non-operating expenses and income.
6.
Knowledge regarding sources and application of funds . Balance sheet helps in ascertaining sources from where additional
funds have been obtained and where they have been applied. For this purpose funds flow statement is prepared. The total of inflow
and outflow of funds is always equal.
Proforma
BalanceSheet
as on ......
KEY WORDS
Asset: Anything, tangible or intangible, of monetary value to a business entity.
Liability: Any amount owed by one person (the debtor) to another (the creditor). In a balance sheet all those claims against the assets of the
entity, other than those of the owners.
Current Assets: All those assets held by a firm with the objective of conversion to cash within the operating cycle or within one year
whichever is longer. Current Assets include items such as cash, receivables, inventory and prepayments.
Current Liabilities: All those claim against the assets of the firm to be met out of cash or other current assets within one year or within the
operating cycle, whichever is longer. Usually include items such as accounts payable, tax or other claims payable, and accrued expenses.
Intangible Assets: Any long-term assets useful to the business and having no physical characteristics. Include items such as goodwill,
patents, franchises, formation expenses and
Contingent Liability: A liability which has not been recognised as such by the entity. It becomes a liability only on t e happening of a certain
future event. An example could be the liability which may arise out f a pending law suit.
Fixed Asset: Tangible long-lived asset. Usually having a life of more than one year. Includes items such as land, building, plant, machinery,
motor vehicles, furniture and fixtures.
Owner's Equity: It is the owner's claim against the assets of a business entity. It could be expressed as total assets of an entity less claims
of outsiders or liabilities. Includes both contributed capital a d retained earnings.
Revenue: Assets received from the sale of goods or services to customers. Also includes income generated from assets and investments
usually classified as non-operating revenue. Revenue increase owners' equity
Expense: Any reduction in owners' equity (total assets minus total liabilities) not resulting from distribution to owners. Represents expiration
of costs, use of loss of an asset without being replaced by another asset.
Realisation: Recognition of the revenue in accounting based on the assumption that increase in owners' equity arises at the point of delivery
or provision of goods or services.
Accrual: Income measured on the realisation of revenue independent of the timing of cash receipt and payment.
Profit: Revenue minus expenses for a given accounting period. Negative profit (income) is known as loss.
Profit and Loss Account: The final summary of all revenues, gains, expenses and losses during an accounting period. Shows the net profit
or loss for the period.
Depreciation: The amortisation representing allocation of cost expiration of tangible fixed assets over their useful life.
Cheques' deposited. When cheques are deposited, in the books of the concern bank account is immediately debited but in the
books of bank, the concern's account is not credited until they are actually collected by the bank. It is quite usual that some of the
cheques deposited by the concern may remain uncollected at the time the pass book is sent for comparison.
b.
Cheques issued. Similarly, the entry for the issue of cheque is made in the books of the concern immediately and the bank account
is credited. But in the books of bank entry for payment can be made only when cheque is presented for payment. At the time of
comparison it is quite possible to find out some cases where cheques were issued and recorded in the cash book but not presented
for payment and remained unrecorded in the bank books and thus causing a difference.
c.
Bank charges. Bank renders many services to its clients and for that it levies charges. Entry for such charges is made by the bank
but corresponding entry for it does not appear in the cash book of the concern because it is not known to the client until he receives
a statement. This causes a difference.
d.
Dividend, etc. Sometimes, on standing instructions, bank collects dividend on shares, interest on Government securities, for which
there is no entry in the cash book of the client and c uses a difference in the two balances.
e.
Direct payment. Some customers deposit money direct into the account in the bank, the corresponding entry of which may not
appear in the cash book, due to delay in necessary instructions by the customer.
f.
Errors. Besides these, there could be difference due to errors in recording the transactions by any of the two parties.
How to adjust the difference? In order to adjust the difference a statement called Bank Reconciliation Statement is prepared. This can be
done on the following lines:
1.
2.
Take balance either as per cash book or as per pass book as a starting point.
3.
Adjust the balance which has been taken as a starting point and adjust it according to the other one. For example, if balance as per
cash book has been taken as a starting point then cash book balance is to be adjusted according to the entries passed in the pass
book and vice versa.
Forms of Problems. This chapter discusses the following forms of problems relating to bank reconciliation statement:
a.
Where cause of differences together with the balance as per cash book are given and student is required to adjust this balance in
the light of wrong and unrecorded entries and then he is required to make a reconciliation statement.
b.
Where cause of difference together with the balance as per cash book are given and student is required to adjust this balance in the
light of wrong and unrecorded entries and then he is required to make a reconciliation statement after taking the adjusted cash book
balance as a starting point. Where cause of differences are not given .Instead of these a student is given extracts from cash book
and with the help of these extracts he is required to prepare a bank reconciliation statement.
Where causes of difference are not given. Instead of these a student is given extracts from cash book and pass book and with the
help of these extracts he is required to prepare a bank reconciliation statement.
2.
3.
4.
5.
6.
7.
Accountants have developed certain specific words to denote the loss in the value of particular assets, other than depreciation. These words
are as under:1.
Obsolescence. Sometimes new inventions throw away the existing machines and equipments as obsolete (useless) although the
old machines and equipments are not completely useless. The firm will have to replace the old machine and equipment with the
latest, up-to-date and newly invented machine and equipment. Loss due to the obsolescence of the old machine and equipment is
known as obsolescence.
2.
Depletion. The firm may posses certain mineral wealth such as coal, oil, iron ore etc. The more we extract mineral wealth from
these mines the more mines are depleted. Decrease in mineral wealth of the mines is termed as depletion.
3.
Amortisation. The word 'amortisation' is used to show loss in the value of intangible assets. These assets are goodwill, patents and
preliminary expenses etc. These assets are written off over certain period.
4.
Fluctuation. Increase and decrease in the market value of assets is known as fluctuation. As we record the value of these assets
on historical basis, we do not pass any entry for the fluctuations ns in the market value of assets. In case of permanent fall in the
value of investments fluctuation may be recorded.
CAUSES OF DEPRECIATION
1.
By constant use. The loss in the value, efficiency and utility of fixed assets due to its constant use is termed as depreciation.
2.
By expiry of time. The effective life of assets goes on decreasing with the passage of time. If certain lease has been obtained for
20 years for Rs. 1,00,000, it will lose its 1/20 th i.e (1/ 20 X 1,00,000) = 5,000 value at the end of the first year and so on. At the end
of 20th year it will become valueless.
3.
By obsolescence. The old assets will become obsolete due to new inventions and improved techniques.
4.
By depletion. Loss of mineral wealth due to constant working of mines is also depreciation, but specifically known or as 'depletion'.
Suppose a particular mine has got 1,00,000 ton of coal during 1 st year, coal with 5,000 tons have been extracted. The loss of 5,000
tons of coal from mines is loss due to depletion. This is why, we charge depreciation on these mineral wealth according to depletion
method.
5.
Permanent fall in price. Though fluctuations in the market value of fixed assets is not recorded in the books. Sometimes we have
to account for this loss such as permanent fall in the value of investments.
6.
By accidents. Depreciation may also be due to the loss in the value of assets by accidents and damage.
Depreciation in the value of assets in all the above cases is accounted for in the books of accounts.
Importance or need for providing depreciation . Recording depreciation in the books of accounts is essential due to the following reasons:
1.
For determination of net profit or loss. Loss in the value of assets is undoubtedly a business expense. It must be recorded and
shown at the debit side of the profit and loss account for the correct calculation of net profit or net loss. The ultimate objective of
accounting is to determine the correct net income. This objective will not be achieved unless we account for depreciation in the
books of accounts.
2.
For showing assets at fair and true value in the balance sheet . If depreciation is not charged, the assets will be shown at value
more than its actual value. The purpose of recording assets is to show them at their true value. Provision for depreciation reduces
the value of assets with the amount of depreciation and assets are shown at their true and fair value.
3.
Provision of funds for replacement of assets . The assets acquired and used in the business will become useless after expiry of
their estimated life or even before that, we will have to replace the obsolete assets with another fresh asset. The replacement will
require funds. Proper method of depreciation will make the funds available for the purchase of fresh assets.
4.
Ascertaining accurate cost of production. Deprecation on factory plant and machinery is factory overhead. It will increase the
cost of production and the price of the commodity will be fixed at higher rates. In the absence of provision for depreciation, the sales
price of the commodity will be fixed at lower rates, because cost of production will also be lower due to ignorance of depreciation.
Profit will thus be reduced.
5.
Distribution of dividend out of profit only . Depreciation is charged out of Profit and loss account, so the profit after charging
depreciation will be lesser. Shareholders will get dividend out this profit. If depreciation is no charged, the profit will be more and the
excess dividend will be paid out of capital which should have been paid out of profit.
6.
Avoiding over payment of income tax . If depreciation is not charged, profit and loss account will show more profit. We will have
to pay income tax on this profit. In this way, the payment of tax will be definitely more than what it should here actually been. The
profit will reduce with the amount of depreciation, so lesser or the actual income tax due will be paid. Provision for depreciation in
this way avoids over payment of income-tax.
Factors affecting the amount of depreciation. It is quite impossible to calculate the actual and accurate amount of depreciation. It can
always be estimated, though we try our best to be more accurate and correct. Following factors have to be considered before estimation of
the amount of depreciation.
1.
Total cost of assets. Value of assets is determined after adding all expenses of acquiring, installing and constructing the assets.
We should take into consideration the total cost of assets for determining the rate and the amount of depreciation.
2.
Estimated useful life of assets. The estimated working life of the assets may be measured in terms of years, months, hours,
output (units) or kilometers (for trucks). In case of depreciation the value of assets is allocated over the estimated useful life of the
asset. If expected life is more, the rate of depreciation will be lesser and vice-versa.
3.
Estimated scrap value. It is the residual value, which is expected to be realised even if the asset becomes, obsolete, we shall have
to make provision of the amount which is the value of assets less its scrap value. Suppose we purchase a machine for Rs.10,000,
whose expected life is ten years. If the scrap value is Rs.1,000. we will have to arrange Rs.9,000 i.e. 10,000-1,000 in ten years.
Every year will bear a depreciation of RS.900 i.e 9,000/10. If the scrap value in the above case is Rs.2,OOO depreciation to be
charged will be Rs.800 only.
4.
Chances of obsolescence. If the asset acquired is expected to be obsolete within 5 years, we will have to split its value over 5
years. If it will be obsolete within four years the value will be split over four years. It shows that the amount of depreciation charged
every year will decrease with comparatively remote chances of obsolescence.
5.
Addition to assets. Depreciation should be charged on the additions to the assets also. If book value f furniture on Jan. I, 1998 is
Rs.10,000 and additions worth Rs.5,000 are made on July 1, 1988 . Depreciation is to be charged @ 10%. We shall be calculating
depreciation on Rs.10,000 for the whole year and on 5,000 for six months.
6.
Legal provisions. The rate and method of depreciation being used must be subject to legal provisions. Companies have to honour
the legal provision with regard to depreciation.
Characteristics of Depreciable Assets. There are certain pertinent economic characteristics of plant machinery and equipment that is by
far the most important of fixed and depreciable assets:
i.
ii.
iii.
Although plant assets are not consumed in the same sense as are inventories, they are subject to physical deterioration that may
have the effect of reducing productive capacity per unit of time.
Depending upon the nature of the asset item, the effects of wear and tear can be offse to a greater or lesser degree with the effect
that periodic service capacity may be held reasonably constant over a substantial portion of asset's life but it is likely that, even to
get such a result will increase with the asset's age.
The useful lives of fixed assets are limited by obsolescence as well as physical deterioration, the impact of the former being either
evolutionary like water or revolutionary like physical damage manifested by a decline in the market value of the service rendered by
the asset.
Rationale of Operation . The determination of the cost of depreciation of fixed assets is important in view of the fact that the cost of using
these long lives assets has to be reckoned in measuring periodic income according to the principle of 'matching cost to revenue' as well as in
appraising the results of managerial action. In spite of the fact that some persons ridicule the efforts of accountants to allocate the cost of
fixed asset to expense over the duration of its useful life, it is, generally agreed that depreciation accounting should attempt to allocate cost of
an asset to expense with the object of burdening the revenues of a period with a reasonable portion of the expenses of using the asset during
that period.
A prediction of cash inflow expected to be generated by the investment is needed for the establishment of the producer to be used for
computing depreciation. Still, it does not have to be an absolutely current forecast of the future but has to be only a reasonable estimate,
preferably the estimate that may be the basis of the decision to invest.
Concept of Depreciation . Simply, depreciation is a permanent continuing and gradual shrinkage in the book value of a fixed asset. This
clear fact about depreciation has in a way been underlined by J H Burton accordingly, "Depreciation is the shrinkage in the value of an asset
at a given date as compared with its value at a previous date."
The Chartered Accountants of England and Wales Institute has described it as:
"Depreciation represents that part of the cost of a fixed assets to its owner which is not recoverable when the asset is finally put out of use by
him. Provision against this loss of capital as an integral cost of conducting the business during the effective commercial life of the asset and
is not depending upon the amount to profit earned".
There are many senses in which the world is more or less widely used in accounting and business literature and some of these are as
follows:
i.
Depreciation as fall in price . The word depreciation means either a fall in price or a fall in value under certain situations, the work
is used in the sense of a fall in price. In this way, when a person buys an asset, it depreciates by a stated amount as soon as it is
subjected to use. It must, still be emphasized that a fall in price is not necessarily accompanied by any decrease in usefulness in as
much as an asset, like a motor car carefully driven for several hundred miles may be a more useful asset than a new one but this is
not normally thought a virtue for the purpose of deter mining its price and the word 'depreciation' appears to be used in context to
indicate a fall in price.
ii.
Depreciation as physical deterioration . It is, generally regarded as a physical or economic phenomenon. There is almost
universal agreement that a physical asset does, in the process of use, wear out at least to the extent of making its continued use
uneconomical.
iii.
Depreciation as fall in value . This very often expressed interpretation of depreciation is as a diminution in the value of an asset.
From the historical point of view, it seems that probably the word was used in this sense before it was applied to that of physical
deterioration which seems to have been variably expressed as wear and tear, up to some time in the nineteenth century and is often
so expressed even now. Offing 1850, the thoughts of wear and tear or physical deterioration and diminution in value came under the
word depreciation. As some dictionaries point out "it is a decline in value of an asset due to such causes as wear and tear, action of
Depreciation as cost allocation . The concept of depreciation as cost allocation is too familiar as it has been upheld and stressed
with ---few qualifications, by the accredited bodies of accountants in mostly and world countries. This view presents deprecation as
simply a plant cost in the absorbed or expired stage while the periodic deprecation change is a portion, in terms of monetary Units,
of the package of plant facilities used in business operation.
v.
Causes of Depreciation . The chief causes of depreciation in the value of fixed asset may be thought under the following four
broad heading:
1.
Physical wear and tear resulting from use. It reduces an asset's future technical capacity to serve, as well as its future
earnings power, with the result that it brings about a reduction in its value.
2.
Physical deterioration resulting from exposure to the elements. As compared to deterioration that occurs as a result of use,
a majority of assets deteriorate with the passage of time being continually exposed to the elemental forces of nature, like
winds and weather, so that the extent of deterioration is a function of time.
3.
Expiration of few legal rights. This is related to leases patents and licences and its again a function of time to be treated as
such.
4.
Diminution in value because of change in demand. In few cases, there is slackening or even stoppages of demand for
services given by an asset. It may be because of various causes like technical changes within the industry, technical
progress in other industries, changes in tastes and habits of the consumer, changes in the supply and location of natural
resources.
Characteristics Of Depreciation.
i.
Depreciation relates to the fall in value . It is mainly a fall in the value of an asset. Depreciation conjures up to the facts of an
asset having lost in value. Still, every fall in value cannot by called depreciation unless it has some cogent characteristics.
ii.
Depreciation represents a fall in book value . Always, depreciation refers to the value of the asset in the books of account that
may neither be equal to the market value of the asset nor to its cost price except in the first year of the asset's life.
iii.
Depreciation conveys special fall in value . In view of the fact that every fall in value cannot be said, 'depreciation', it is quite
necessary that the shrinkage in the value of the asset must be permanent, continuing and gradual. In the this way, it is a slow,
graduated and unobtrusive process rather than sudden event.
iv.
Depreciation has reference to fixed assets . It is clear that a permanent, continuing and gradual shrinkage in the book value of
the asset, as is seen in the case of depreciation, can take place only in the case of fixed asset and it would be contradiction in terms
to speak of such a reduction as description in the case of floating asset as book value in such a case does not have an existence
independent of either cost of market value.
METHODS OF DEPRECIATION
(a) Traditional Method:
Fixed installment of straight line method . Most preliminary and accepted method of providing depreciation. In the method, a
fixed amount is provided as depreciation every year during the life time of the asset so that the value of asset is reduced to zero, or
its break up value, as the case may be, at the end of its useful life.
The predominance of the fixed instalment method is probably attributable to the simplicity of its concept, clarity of presentation in the
balance sheet and case of its application rather than to any reasoned preference for either the time basis or for the uniform charge.
Defects . It tends to in equalize the charge to Profit and Loss account in respect of depreciation and repairs put together.
Again, the method does not take into account the interest on the capital investment in the asset.
The method is used, generally in the case of assets of small value as well as those which do not require large scale repairs and
renewals as furniture, patents short lease.
Diminishing Balance Method or Reducing Balance Method . This is also known as accelerated depreciation method. It includes
the charging of depreciation in any particular year at a certain percentage of the debit balance of the asset account in the beginning
of the year with the result that as the debit balance on the asset accounting goes on diminishing every year, the amount of
depreciation provided on the asset goes on also decreasing every year and hence the method is so named.
The strongest point in its favour is that it tends to equalize the burden on profit and loss account in respect of depreciation and
repairs put together, as the asset gets older in age, the amount of depreciation goes on decreasing while the expenses of repairs go
on increasing so that the total charge to the debit of profit and loss account over the years more or less remains the same.
Defects . It fails to reduce the value of asset to zero and some balance, howsoever, insignificant, would always be left on the asset
account at the end of its useful life. Like the Fixed Installment Method, it also ignores interest on capital on capital investment in the
asset.
The method suits to plant and machinery in which additions and extensions take place so often and th4 problem of repairs is also
very important.
Production Method . This method involves a uniform change per unit of output. It is mostly used in extractive industries as the
usefulness of mine head installations is closely related to the size of the ore deposit. The specific term for the amortization of natural
resources costs, is normally computed in this manner.
In cases where physical deterioration or exhaustion is the probable limiting factor or economic usefulness, the life forecast
necessarily depends upon an estimate of the asset's total service capacity. Still, if obsolescence is the limiting factor, a life estimate
can be made without projecting service capacity and estimating the latter requires an extra forecast oft e demand for asset's
services over the expected life span. Hence, this further complication has inhibited adoption of the production method in those
industries where obsolescence is an important consideration.
SUBSEQUENT DEVELOPMENTS
a.
Annuity Method . At the beginning of every year, it envisages the provision of depreciation at a flat rate on the capital invested in
the asset, together with at a stipulated rate on the capital so invested so as to reduce the asset to its residual value at the end of its
useful life.
In this way, asset account is debited with interest which is ultimately credited to profit and loss account and is credited with the
amount of depreciation that remains fixed year after year.
The method is based on a comprehensive interpretation of the term 'cost of the asset' which is its purchase price and the interest on
the capital investment in the asset that would have been earned on the amount invested therein.
Unlike the traditional method of providing depreciation, annuity method takes into account interest on capital invested in the asset.
Again, being regarded as most exact and precise from the point of view of calculations, the method is most scientific.
Defects:
i.
The method is very complicated as it needs a number of calculations.
ii.
In case the asset needs frequent additions and extensions, the calculations have to be revised quiet often further
complicating its application and operation.
iii.
Like the fixed instalment method, it has the tendency to in equalize the charge to profit and loss account in respect of
depreciation and repairs put together as the amount of depreciation remains fixed over the period of the life of the asset.
The method is very well applicable to asset which require considerable investment, do not call for frequent additions and do
not need replacement, e.g. long leases.
b.
Depreciation Fund Method . The method needs the depreciation on the asset to be provided through a depreciation of sinking fund
brought into being by accumulating thereon the amount of depreciation at a flat rate charged to the profit and loss account every
year investing the amount of depreciation annually allocated to the fund in outside securities bearing interest at a stipulated rate
which is also credited to the fund and invested in securities.
The method has two very important characteristics:
1. The asset is shown in the Balance Sheet at its original value although its life while the depreciation thereon accumulated
separately on the depreciation fund is placed on the liabilities side of the balance sheet.
2.
The method can be super imposed over other methods of depreciation so that actual depreciation on the asset may be
provided by the fixed instalment or reducing balance or annuity method and the same may be accumulated separately on
the Fund Account showing the provision for replacement of the asset.
The most important strong point of this method of depreciation is that, apart from providing depreciation on the asset, it makes
provision for the replacement of the asset at the end of its working life while such a feature is conspicuous by its absence in other
methods.
Disadvantages . The main disadvantage of the depreciation Fund method is that, a depreciation amount remains fixed through out
the life of the asset, it has a tendency to place unequal burden on profit and loss account over different years of assets in respect of
depreciation and repairs put together with the result that profit and loss account is let off lightly in earlier years and is heavily
burdened in later years.
c.
Insurance Policy Method . A serious drawback of Depreciation fund method of providing depreciation is the possibility of loss on
the realization of securities in which the fund is invested with the result that the whole programme of the replacement of the asset at
the end of its useful life would be adversely affected and, to that extent, the method fail in making full provision for replacement.
In order to remove such a possibility, a slight deviation is made from the conventional depreciation fund method by investing the
amount yearly provided as depreciation on the asset and credited to the fund, in paying premium on an insurance policy to mature
at the time of the replacement of the asset thereby making available funds for the purchase of the new asset. The other aspects of
the mechanics of depreciation fund method by and large remain the same.
MODERN METHOD
Rate of Return Method . Modern literature on depreciation accounting suggests that the proper depreciation charge is determined
at the time the decision to invest in the asset is made when the cash proceeds of the future period are discounted back to the
The desirability of a systematic pre-established amortization plan for the good and sufficient reason of protecting the investor
against reliance of subjective and possibly biased data, has been strongly underlined by practical experience. Hence, as soon as it
becomes apparent that the depreciation schedule set up at the time of acquisition of an asset is obviously realistic, the plan should
be immediately recast.
ii.
It seems reasonable that the recovery of the initial costs of plant asset must have precedence over the payment of dividend of taxes.
If provision for depreciation is inadequate from this point of view, such payment may become really speaking, distributions of capital
rather than earnings despite the fact that inadequate depreciation would certainly result in losses at the time of retirement of the
asset, losses which are be deductible for tax purposes in the period of retirement.
iii.
In view of the fact that substantial variations can be expected in both the output and operating characteristics of different types of
plant assets manifested to a certain extent in the application of different depreciation methods, a variety of systems must be used if
periodic depreciation charges are to serve as meaningful indices of the expiration of productive capacity.
DEPRECIATION POLICY AND PRICE LEVEL CHANGES --- HISTORICAL Vs. REPLACEMENT COST.
Accounts Approach---Historical Cost . As concerned to the Accountant, an investment in a fixed asset is a prepaid cost to be charged to
operations and recovered in cost over the serviceable life of the asset. It is the object of depreciation policy to allocate this cost to successive
periods of time, or units of production, by some systematic procedures calculated to complete the process by the time the asset is needed. In
ordinary course, accountant's concept of depreciation is designed to recover simply the number of monetary units originally committed the
asset regardless of differences in purchasing power. The approach has been upheld by authoritative opinion on accounting problems
represented by the Institute of Certified Public Accountants U.S. and the Institute of Chartered Accountants in England .
Impact of inflation . The accountant's approach stability but can be seriously and sometime even inflation such as the one being witnessed
since the outbreak of Worl War II characterized by abnormal increase in the price level resulting monetary units all over the world.
The general nature of difficulty with the historical cost systems of depreciation is that the purchase of assets at a particular date is normally
recorded on the basis of the actual money cost on that date in monetary units of known purchasing power so that, in the case of in
inflationary rise in prices. Subsequently transactions relating to those assets will be recorded in terms of depreciation monetary units.
Economist's concept---Replacement Cost . According to the economist's approach, the ideal object of depreciation policy is to recover
each year a sufficient number of current monetary units to equal that year's capital consumption in terms of original monetary units. Failure to
recognize this problem had led repeatedly. Under conditions of extreme inflation, to wholesale dissipation of real capital.
It may be stressed that the replacement cost is not the estimated cost of replacing an asset at the end of its estimated service life. Perhaps
many years in future because an attempt to guess the amount that would have to be spend to replace the capacity to render service
represented by an existing asset would simply be a fruitless exercise. The most significant fact to management and to all others financially
interested ---is the current level of plant cost that if reflected in new construction and equipment purchases and the most influentially in
authorities in certain European countries, have accorded special treatment to replacement cost depreciation. In this way, other countries
have authorized the writing up of depreciable assets to approximately their current value and the subsequent tax free recovery of
depreciation on written up value. In almost all countries, the rigors of changing price levels on provision for depreciation on fixed assets.
Managerial performance. As the performance of management is generally measured by either income, or return on investment both of
which depend on the method of depreciation accounting the manner of the provision of depreciation would affect the measure of
performance. Though the straight line depreciation will given reasonably good measure of income in case the revenues and maintenance
requirements are constant throughout the life of the assets it would distort the return or investment, which would increase with the decrease
in the book value of the asset due to depreciation.
Funds generation . The relationship of depreciation and funds is generally misunderstood, it is being throughout that depreciation is a
source of funds. Still it is none of the functions of depreciation accounting to provide funds for replacement which must come from the
revenues of the business, and the charge for depreciation neither increases nor decreases the amount available to purchase new equipment.
Even the making of charges to income and setting up of funds for replacement unless they are in some way earmarked for purpose
conversely, funds set aside for replacement would be available that purpose whether charges have been made to depreciation or not.
Of course, in calculating funds from operations, it is the usual practice to add to the income that amount of depreciation that had been
subtracted to arriving at the' net income. This is only reasonable as depreciation expense in one which does not utilize funds in the period in
which it is recognized with the result that an expense not utilizing funds has been subtracted from the revenues of the period and therefore,
must be added back to compute funds generated by the operations.
Make or buy decisions . The type of decisions required to be usually taken be management of business relate to either the manufacturer of
a piece of equipment or for buying the same. As a general rule, in a make of buy decision a relevant cost would be a cost that could be
avoided.
The depreciation of the factory building cannot be avoided by the elimination of one phase of production and in this way, would not be
relevant in making the decision. Never the less, the position would get complicated where factory building devoted to the production of the
part would be used to make an alternative product so that, though the depreciated of factory building would not be relevant, the opportunity
cost of foregoing production of the product would be very much relevant.
On the other hand, the depreciation of machinery engaged in the manufacture of the part would not be relevant, if there are no other uses for
the machinery, but the opportunity cost of not producing the other product would have to be computed in case there are other uses for the
machinery. One possible use of machinery would be its sale and, if machinery could be sold, it is an opportunity being foregone by producing
the part with the result that the sale price of the machinery as well as the expected decrease in its value would be relevant for decision
making purposes.
Pricing Decisions . As to the general principle of economic theory, a firm is expected to produce at a point where its marginal cost equals
marginal revenue and to charge a price equal to the average revenue that sell the proper quantum of output.
In this way, theoretically the problem of output and price to settled without reference to any fixed costs. Though it can be asserted that fixed
costs affect total costs and, hence affect the price, this is not the case in as much fixed costs are common to all levels of output and thus do
not affect the pricing decision. The largest income is also at the level of output where marginal cost equals marginal revenue because at that
output the difference between total costs would be the greatest.
DEPRECIATION ACCOUNTING
It is a process of allocation and not valuation. So it must be clearly understood that the process of charging depreciation is the accountant's
technique of recovering the cost of fixed assets over a period.
Depreciable assets are assets which :
i.
ii.
iii.
are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purpose
and not for the purpose of sale in the ordinary course of business.
Fixed Assets
Depletion
Amortization
Dilapidation
Replacement cost as the basis for depreciation
Objectives of providing depreciation
To calculate proper profits
To show the asset at its reasonable value
Conservation of cash resources
Is depreciation a source of working capital?
Causes of Depreciation
Internal
External
Factors influencing the total amount of depreciation
Methods of allocating depreciation
Requirements of Companies Act, 1956
Revision of estimate of useful life
Depreciation on revaluation or revision of historic cost
Additions or extensions to an existing asset
Scrapping of an asset
Methods of recording depreciation
First Method ---(When provision for depreciation account is not maintained
1.
2.
4.
2.
3.
4.
5.
6.
Appraisal method
7.
Annuity Method
2.
3.
4.
2.
3.
Percentage Method . The relationship between two figures is presented in percentage. For example, if sales is Rs.1l,00,000 and
gross profit is Rs.25,000, the relationship can be presented as gross profit to be 25% of sales i.e.
In this way, it is a common practice to present gross profit, net profit, expenses and operating ratio by percentage method.
Rate Method . According to this method one figure is presented in times of the other relative figure. In the previous example, where
sales is Rs.1,00,000 and gross profit is Rs.25,000 the relationship between the two can be said as gross profit to be 0.25 times of
1/4th of sales i.e., or sales to be 4 time of gross profit.
It is customary to calculate stock turn over, current and liquid ratio according to rate. Method.
Ratio Method. The relationship between two figures is presented in ratio such as in the above example, the ratio of gross profit of
sale can be said to be 25,000 : 1,00,000 or 1: 4. In other words, the ratio between sales and gross profit may also be known as
1,00,000 : 25,000 of 4 : 1.
These are three different methods of presenting financial statement analysis but they lead to the same conclusion, Either of the three
methods can be followed in solving questions.
ACCOUNTING RATIOS
Accounting ratio are the numerical relationship between two numbers. Ratios are the expression of one figure in terms of another. Ratios are
the systematic numerical calculation of the relationship of one fact with other to measure the profitability, operational efficiency and financial
soundness of the business.
Accounting ratios are used for -i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ACCOUNTING RATIO
Accounting Ratio are true test of the profitability efficiency and financial soundless of the company. These ratios are put to the following uses:
i.
Measurement of the Profitability . We can measure the profitability of the business by calculating gross profit, net profit, expenses
ratios and others. Profitability is the profit earning capacity of the business so profitability ratios indicate the actual performance of
the business. If these ratios fall effective corrective measures will be applied to improve the working.
ii.
Judging the operational efficiency of management . The operational efficiency of the business an be ascertained by calculating
operating ratio. As the operating ratio shows the opera ional cost of the business so it will be in the interest of business if it is lower.
We use operating net profit for calculating net profit ratio, wherein non-operating expenses and incomes are not taken into
consideration.
iii.
Assessing the solvency of the business . We can ascertain whether the firm is solvent or not by calculating solvency ratios.
Solvency ratios show relationship between total liabilities and total assets. If total assets are lesser than the total liabilities it shows
unsound position of the business. In such case the business will try its best to improve its solvency.
iv.
Measuring short and long-term financial position of the company . We can know the short term and long term financial position
of the business by calculating various ratios. Current and liquid ratio indicate short term financial position, whereas Debt equity
ratios, fixed assets ratios and proprietory ratios shows long term financial position. In case of unhealthy short term or long term
financial position efforts are made to improve them.
v.
Facilitating comparative analysis of the performance . Every promising firm has to compare its present performance with the
previous and discover the plus and minus points. These points can be located by the calculation of different ratios. Causes
responsible for poor performance have to be removed. Comparison with the performance of other competitive firms can also be
made. Comparison tells where the firm stands and what are its prospects.
vi.
Indicator of true efficiency . Financial statement i.e. trading P/L Accounts and Balance Sheet may indicate the amount of profit or
the balances of different amount but the profitability can be known by analysis of financial statements i.e. calculation of accounting
ratios. Calculation of gross profit, net profit, operating 0 earning ratios shows the profit earning capacity of business.
vii.
Helpful in Budgeting and Forecasting. Accounting ratios provides a reliable data which can be compared, studied and analysed.
These ratios provide sound footing for future forecasting. The indicate the future prospects. The ratios can also serve as a basis for
preparing budgets and also determining future line of action.
viii.
Helpful in simplifying accounting figures . Accounting ratios make the figures under stand able. They simplify, summarise and
systematise the long monotonous figures. The ratios can be easily understood by those who do not know accounting. The
importance of the ratios lies in the fact that they provide relationship between different figures.
ix.
The ratio analysis is also useful in shareholders who know the profitability of the company, to creditors, who know solvency of the
business to potential investor in assessing earning potential to workers for computation of the bonus and even to the Government in
judging the progress of industry as a whole.
False results . Ratios are based upon the financial statements. In case financial statements are incorrect or the data upon which
ratios are based is incorrect, ratios calculated will also be false and defective. The accounting system itself suffers from so many
inherent weaknesses so the ratios based upon it can not be said to be always reliable.
2.
Limited Comparability . The ratio of the one firm can not always be compared with the performance of other firm if uniform
accounting policies are not adopted by them. The difference in the methods of calculation of stock or the methods used to record the
depreciation on assets will not provide identical data, so they cannot be compared.
3.
Absence of standard universally accepted terminology . Different meaning are given to particular term such as some firms take
profit before interest and after tax, others may take profit before interest and tax. Bank overdraft is taken as current liability but some
firms may take it as on-current. The ratios can be comparable only when uniform terminology is adopted by both the firms.
4.
Price level changes affect ratios . The comparability of ratios suffers if the prices of the commodities in two different years are not
the same. Change in the price affects the cost of production sales and also the value of assets. It means that the ratio will be
meaningful for comparison if the prices do not change.
5.
No single standard ratio . There is not a single standard ratio which can indicate the true performance of the business at all time
and in all circumstances. Every firm has to work in different situations and circumstances so a particular ratio can not be supposed
to be standard for every one. Strikes, Lockouts, Floods, Wars etc. materially affect the performance so it, can not be matched with
the circumstances in normal days.
6.
Ignoring qualitative factors . Ratio analysis is the quantitative measurement of the performance of the business. It ignores the
qualitative aspect of the firm how so ever important it may be. It shows that ratio is only one-sided approach to measure the
efficiency of the business.
7.
Misleading results in the absence of absolute data . In the absence of actual data the size of t e business can not be known. If
gross profit ratio of two firms is 25%. It may be just possible that the gross profit of one is Rs. 2,500 and sales Rs. 10,000 whereas
the gross pr fit and sales of the others is Rs.5,00,000 and sales Rs.20,00,000. Profitability of the two firms is the same but the
Profitability ratios:
i.
Gross profit ratio
ii.
Net profit ratio
iii.
Operating ratio
iv.
Expenses ratio
v.
Debts service ratio
vi.
Return on capital employed
vii.
Earning per share X
viii.
Price Earning ratio.
2.
Turnover ratio:
i.
Stock or Inventory Turnover ratio
ii.
Total capital Turnover ratio
iii.
Fixed Assets Turnover ratios
iv.
Working Capital Turnover ratios
v.
Debtors Turnover ratio
vi.
Creditors Turnover ratio
3.
Financial Ratios:
i.
Current ratio
ii.
Liquid ratio
iii.
Debt equity ratio
iv.
Fixed assets ratio
v.
Proprietory ratio
vi.
Solvency ratio
vii.
Capital gearing ratios.
The ratio can also be classified on the basis of available data. On this basis it can be:
1.
Income statement ratios . These ratios are calculated on the basis of information available from income statement i.e. Trading and
P/L Account. Such as gross profit. net profit expenses and operating ratio.
2.
Position statement ratio . These ratios are calculated on the basis of information available from balance sheet such as current
ratio, liquid ratio, proprietory ratio and capital gearing ratios etc.
3.
Inter-statement ratios . In these ratios, both the income and position statements are involved. These ratios may be stock turnover
ratio, working capital turnover ratio. Debtors ,and creditors turnover ratio.
The gross profit ratio also works as a guide to the management in determining its selling and distribution expenses. The gross profit should
be enough to cover the selling expenses of the firm.
The effective stock control system can be adopted on the basis of gross profit ratio. Higher gross profit ratio is always preferable.
RATIO ANALYSIS
Classification
Primary Criterion
Secondary measures
Ratios tagged to needs of interest groups
Management and operational control
Owner's viewpoint
Lender's evaluation
Fundamental classification
Liquidity ratios
Activity ratios
Profitability ratios
The Norms For Evaluation
Against a trend over time
Against an average of some past period
Against an industry average
Against an average of a cross-section sample
Computation and Purpose
Managerial Uses of the Primary Ratio
KEY WORDS
Primary Ratio is of primary concern for management because it provides an overall measure of business efficiency and is measured by the
much controversial but nevertheless much widely employed Return on Capital Employed.
PBDIT or Profits before depreciation, interest and taxes. This amounts to gross cash flow.
Liquidity Ratios measure the short-term solvency of the firm.
Leverage Ratios measure the long-term solvency of the firm and also provide an idea of the equity cushion for long-term indebtedness.
Activity or Turn over Ratios measure the intensity with which resources of the firm are being utilised.
Average Capital Employed is one-half of the sum total of opening and closing balances of capital, reserves, accumulated depreciation and
long-term debt.
Net Total Assets are obtained by deducting current liabilities from total assets.
Equity Multiplier is used to derive the Return on Equity from the Return on Investment, and is computed by dividing Equity into total assets.
Ratio Norm is obtained for different kinds of ratios either as an average over time of the same firm, or an industry average or an average of a
cross-section of firms, and is used to evaluate performance and for control purposes.
Average Collection period is obtained by dividing average accounts receivables with net credit sales and multiplying the resultant with 365
days of the year. It suggests the average credit period actually granted during a year.
ii.
Funds statement
iii.
iv.
v.
According to Mr. Robert N. Authony, "Funds flow statement describes the sources from which additional funds Were derived and the uses to
which these funds were applied."
In the worlds of Roy A. Foukle. "Funds flow statement is a technical device designed to highlight the changes in the financial condition of a
business
FUND FLOW ANALYSIS
Accounting theory and practice has its salient feature from the evolution that the preparation and presentation of (final accounts and
statements undertaken with the object of giving as much information as possible for public scene. With this view-point, the traditional package
of final accounts and statements consisting of Balance Sheet and income statement (or P/L A/c) fulfils this objective by well.
The balance sheet shows the financial position of the concern, the assets side showing the employment of resources in various kinds of
properties and the liabilities side showing the manner in which these resources were got. The income statement measures the change in the
owner's equity as a result of period's productive and commercial activities. In this way it is just as important to know what funds become
available during the accounting period as it is to know what assets and liabilities exist and what profit has been made as the conduct of
business involves a flow of funds in to operating assets and then back to funds once again. This underlines the utility of statement prepared
to report changes and movements not clearly shown in the balance sheet and income statement.
Concept of Funds . The explanation of the precise concept of 'funds' is essential for giving a proper construction of reference and focus of
understanding for the entire exercise involved in funds flow analysis. The term 'funds' has a variety of meanings. At one extreme, to many the
word 'funds' is synonymous with cash so those funds statement is nothing but an enumeration of the net effects of various kinds of business
events on the cash. This explains the trend towards the preparation and presentation of cash flow statements in published annual reports of
accounts. A record of cash receipts and disbursements while valuable in its own way and undoubtedly a form of funds statement, is probably
very narrow in its import.
On the other extreme in this view that funds refer to economic values expressed in money measurements t at are subject to firm's jurisdiction
--the reservior of these values is described in the list of assets to which funds stand committed and the source of these values is detailed in
the list of liabilities from where the funds are derived. This is known as 'all financial resources' concept of fund.
Whereas both these concepts of 'funds' constitute the extremes, the most acceptable view is the one relating to net working capital. The term
'working capital' is particularly appropriate expression for showing the wealth of an enterprise which is continuously revolving through the
stages more desired by the customers (inventories) and by the firm cost. The intervening stage (receivables) identifies the current
relationship between the firm and its customers. The magnitude of the investment is working capital is an important dimension of managerial
strategy. The commitment of firms' funds over and above those provided by short term creditors is the net working capital. In this way, one of
the main uses of funds is to furnish working capital.
It is of course, true that during the cycle of business operations, the current assets are constantly circulating through the cash accounts but
many transactions have a delayed effect upon cash. The purchase of merchandise shown as part of cost of goods sold may represent an
increase in accounts payable rather than an immediate cash outlay. In the same way, expense may be reflected in a current liability, such as
accrued expenses, rather than immediately in cash.
However, increase in current debt have the same effect on net current assets on working capital as decrease in cash. Consequently, have for
such exceptions as depreciation, the current income and expenses are best thought of as changing working capital rather than cash. This
reasoning leads to visualizing of balance sheet changes including the net income, as working capital changes rather than a movement of
funds.
Besides, the fact that the use of the word 'working capital' assist in deciding the content of funds statement, it acts as the basis for
determining the inclusion or exclusion of a financial event may cause any external transaction, which increases' net working capital' is by
definition, a source of funds and any such transaction resulting in the decrease of 'net working capital' is for the same reason, an application
of funds.
Sources of Funds:
In general, funds are got from :-i.
ii.
Operation of business.
iii.
iv.
Contribution of shareholders.
v.
vi.
Operating losses.
ii.
iii.
iv.
v.
vi.
vii.
Concept of flow. The flow of funds refers to transfer of economic values from one asset to another, from one equity to another, from an
asset to an equity or vice-versa or a combination of any of these. According to working capital concept of funds, the 'flow' of funds refers to
movements of funds described in terms of the flow in and out of the working capital area. This occurs when changes occurring in non-current
accounts as fixed assets, fictious, assets, long-term liabilities, internal reserves are offset by corresponding changes in current accounts
(current assets or current liabilities and (vice-versa), like when a cash purchase of machinery is effected, debentures are redeemed by
payment in cash. creditor are paid by raising long term loan, cash dividend is distributed among shareholders or changes and combinations
of any of these.
Funds flow statement. The statement of sources and applications of funds also called Funds Flow Statement' or statement of Deviation and
disposition of the means of operation or where got where gone statement by similar other titles in an attempt to report the flow of funds
between the various assets and equity items during an account period. In this way, it gives a missing link in the complement of final account
statements.
Rationale of funds flow statement . It is many a time argued that on the basis of seemingly magic balancing that exists between assets and
liabilities, the balance sheet may be taken to be a good statement of funds as the items on its assets side are the result of utilization of
sources detailed on the liabilities side. If we recall our concept of funds statement for a movement, it would soon be realized that the balance
sheet cannot appropriately describe the consents of a funds statement.
Views regarding funds statement being better or worse than the income statement are absolutely for. The two statements have fully different
functions. The income statement relates to the primary goal of the enterprise and provides summaries or business and manufacturing
activities.
The income statement is not capable of rendering an accurate of even the resources from operating alone unless the income date is
concerted into fund data. Again, income data by itself would not suffice for the fund statement, because funds from several other sources,
e.g. borrowing, issue of capital and also applications e.g. repayments of loans, redemption of share capital will have to be taken into account.
As the traditional package of final accounts and statements, shows the position of accounting, rather than the financial condition of the
business in term of flows of funds, no conclusions regarding the financial position there of can be got on the basis of such statements.
In this way, the funds flow statement is intended to supplement, and not to supplant, the balance sheet and P/L account either in whole or in
part.
To sum up, neither the balance sheet nor the income statement, is capable of unearning the entire complement of flow of resources for an
accounting period in respect of which reports are prepared for the perusal of and appraisal by the top management or the owners. This
shows the potentialities of the funds statement as an analysical tool from the point of view of the management, for a comprehensive reporting
on its performance.
Managerial uses of Funds Flow Analysis. The statement of sources and applications of funds is a useful tool in the financial manager's
analytical kit. Because from it emerges better as will as more detailed analysis and understanding of change in the distribution of resources
between Balance Sheet dates.
Firstly. The funds statement determines the financial consequences of business operations. A concern may operate in profit year by year
and yet its liquid position may become more and more imbalanced and sound to such an extent that it may have damaging implications from
the point of view of the conduct of business.
Secondly. Nowadays, financing through borrowing from organised lenders e.g. bankers and financial institut1ons have become almost
imperative for every modem business enterprise. Before the credit is granted, a number of embarrassing, intricate and searching questions
are put to the financial manager regarding the over all creditworthiness of his concern, the feasibility of the scheme for which the loan is
needed, ratio of current assets to current liabilities the sources for repayment, the current funds generating capacity of the normal operations
of the business, the company's financing of the normal operations of the business, the company's financing policy as indicated by methods of
financing used in the recent past, the manner in which the management has utilized liquid funds in the past and the likely current and long
term uses of the funds.
Thirdly. It works as an instrument for the allocation of resources. In modem large scale business, as the need for resources is always more
than their availability productive enterprises have to evolve an order of priorities for putting through their expansion programmes, that are
phased accordingly, and funds have to be arranged as different phases of the programmes get into their stride. The amount of funds to be
available from current business operations in meeting the needs of such programmes is estimated by the financial manager through the
projection of the funds flow analysis.
Fourthly. Funds also evaluate the urgency of operational issues; Problems faced by a business do not arise all of a sudden. They take time
to adopt serious proportions invariably using a financial commitment to which the management has to measure itself. While the problem is in
this way developing, it is affected by a number of factors.
The real contribution of funds flow analysis is in bringing all these factors in a delicate balance for determining the time limit within the
problem would reach a critical stage.
This is done by projecting the funds flow statement which then provides a perspective for the proper consideration of the financial limitations
of evolving issues and enables suitable action to be initiated to reverse an unfavorable trend.
Lastly, in the end, funds statement points to the effectiveness with which management has handled working capital during the period under
review, the sufficiency of otherwise of the present funds and tells the shareholders or investors something of management' plans for the
future.
As put by Pyle, W.W. and White, J.J.: "It is an objective evidence of management decision to dilute ownership rights by issuing more shares,
trade on the equity by increasing long term debt, expand or modernize the plant: or accumulate funds for better investment opportunities
expected in the future".
Though the statement of sources and uses of funds subserves a number of objective of modem financial management, a word of caution is
necessary as it is easy to become too enthusiastic about the funds statement, an enthusiasm not warranted by the capabilities of the
instrument.
Firstly, it is undoubtedly, true that the funds statement does supply information not otherwise available in the conventional statements but, as
it ignores non funds transactions, it is cruder divide that the income statement and balance sheet at least in one respect.
Secondly, funds flow statement does not introduce the original evidence of financial status or change but only rearranges data appearing
elsewhere in accounts focusing on those aspects that relate most intimately to the purpose of investigation and stand out in the actual
situation as being materially significant.
Thirdly, it is said that even more important than the changes in working capital is the change in cash.
In the end, though attempts are being made to project the funds statement in future; it is essentially, historical in nature. The reporting of what
has happened is desirable but in planning for the future estimates of sources and applications of working capital are necessary for coming
accounting periods.
Indeed of this, the information coming from the funds statement may materially, help management in planning for expansion in devising
dividend policies planning for financial organizations of the firm or in any number of other major programmes.
"Properly handled, a statement of funds is better suited for the dissemination of this kind of information that the conventional statement with
its highly abstract, sophisticated cost allocations and estimates and its completely different orientation."
Constructing the Funds Flow Statement:
Basic information. The main documents necessary for constructing a funds flow statement are the comparative balance sheets at the
beginning and end of the period for which it is being made. The effects of the conduct of business are shown in its balance sheet by
increases or decreases in the various assets and liabilities and in proprietors' equity or capital. Besides, a summed up operating statement or
at least material information having a bearing upon determination of funds from operations from that statement is also needed to highlight
correctly, the impact of informations upon the funds.
Hidden Information's. Even though, the condensed funds statement prepared from the basic minimum information is correct as far it goes, it
is not really informative to financial management.
This is so because of the fact that the changes in equities and assess shown in the condensed statement are net changes, the residual from
the offsetting effects of many kinds of different transactions and hence may hide significant information as to the sources and applications of
funds. The net changes in owner's equity may sometimes by fully the result of net profit for the year, but usually it is the residual of many
influences like net profit less dividends declared or paid, plus proceeds of new sale of shares, less redemption of share capital.
It may, also be affected by the accounting adjustments during the period. The net change in long- term liabilities may be the net result
affecting substantial activity in debt repayments and raising of new loans during the year. In the same way the net change in non current
assets is the residual effect of purchases, retirements, depreciation written off, accounting adjustments and, sometimes even revaluation of
assets.
Format. Preparation of statement of sources and applications of funds is time consuming work, Depending upon the object of analysis it may
range from causal observation of the changes in the various items summed in the beginning and ending balance sheets to the extensive
work sheet reconstructions of trend transactions. However, sufficient information can be taken from an approximate analysis without going
through the long, hard and difficult exercise involved in adjustments required for refining the analysis. The financial manager may find it
sufficient and most convenient to make a rough and ready analysis from time to time, for himself to appraise the trend of development
concerning some aspects of the financial conditions of his own unit.
ii.
ssue of debentures
iii.
Institutional loans
iv.
v.
vi.
Applications
i.
ii.
iii.
Redemption of debentures
iv.
v.
Or
An Alternative Specimen
Increase or decrease in work capital as per statement of changes in working capital.
Changes in working Capital. In the funds statement the usual practice is to show the difference between the aggregate of sources and total
applications as either increase or decrease in working capital or funds over the period covered by the statement. Working capital represents
the excess of current liabilities are the components of working capital, it is necessary, in order to ascertain the working capital or fund at the
beginning and at end of the period and to measure the increase or decrease therein, to prepare what may be called, "A statement of
schedule of changes in working capital," A proforma is given hereon.
While preparing a schedule of changes in working capital it should be noted that:
i.
ii.
The changes in all current assets and current liabilities are merged into one figure only --- either in increase or decrease in working
capital over the period for which funds statement has been prepared. If the working capital at the end of the period is more than the
working capital of the beginning thereof, the difference is expressed as "increase in working capital."
An alternative method is to show the changes in current assets and current liabilities during the period under review as specific sources and
uses throughout the body of the statement.
Current Assets . The expression 'current assets' is used to denote those assets which are continually on the move.
Statement of changes in working capital
Since they are constantly in motion, they are also known as the circulating capital of the business. These assets can or will be converted into
cash during a complete operating cycle of the business.
Current assets include:
a.
b.
Debtors
c.
d.
Stores
e.
Bills receivable
f.
Cash at Bank
g.
Cash in hand
h.
Work in progress
Current liabilities. Current liabilities mean those liabilities that are to be paid in the near future, i.e. during a complete operating cycle of the
business. Such liabilities include:
a.
Trade creditors
b.
c.
Bills payable
d.
e.
Dividend declared
f.
Bank overdraft.
Some practical hints. While preparing a statement of sources and applications of funds matters need special attention.
i.
Trading Profit or Funds from Operation . The current operations of the business are the most important single source of funds
and over the long run they are the largest source of funds. The repayment of loans, purchase of plant, payment of dividends must
ultimately depend upon this source.
Sales result in inflow of funds in the form of increase in cash debtors and bills receivable but at the same time cost of goods sold plus other
operating expenses incurred cause outflow of funds by increasing creditors of outstanding expenses and reducing the cash or bank balance.
Adjustments for certain debits or deductions and credits (or additions) appearing in the profit and loss accounts or (income statement),
Debit or Deductions . It is better to remember that the net income as shown by income statement (or P/L A/C) does not always correctly
measure the change (increase or decrease) in resources of the business or a count of operations for the period. Some of the debits (or
deductions) appearing in the P/L A/C or income statement, although through going cost of operation, do not constitute a current drain on
liquid resources of funds, e.g. depreciation, depletion, amortization of patents, good will. There are some other debits which are neither a part
of current fund outflow nor strictly speaking components of 'operating cost' although according to standard accounting practice, valid
deductions in determining net income, e.g. writing off share or debenture discount and preliminary debits may be called 'non fund' or 'non
operating' debits or deduction. If the funds from operations are being calculated on the basis of balances (opening or closing) of the
Appropriation Account or Statement of Retained earnings, such debits or deductions in this account like transfers to reserves, provision for
dividends, taxation will also be considered.
The criteria for distinguishing between non funds and non operating and other debits comment out of the above may be summed up in the
following:
Did the debit taken by itself.
i.
ii.
If these question are answered in positive, the item is not a non funds or non operating debt. If any of the questions is answered in the
negative, the item should be classified as a non fund and non-operating debit. This will act as a touchstone for determining the inclusion or
exclusion of a financial event in the income statement or P/L A/c as recasted for finding funds from operations.
Examples:
i.
Salary.
Debit appearing in the profit and loss account against salary may be composed of (a) salary paid (b) salary outstanding (c) salary
adjusted against earlier advance payment.
Each of these three components of salary constitutes on element of 'operating cost' and affects current account (decrease in a
current asset as cash; increase in current liabilities as outstanding salary and decrease in a current asset as advance payment. In
this way, in each case, both the key questions are answered in the affirmative and therefore, salary is not a non-operating item.
ii.
Depreciation:
It is the usual practice to write off the fixed assets over their life time by means of a depreciation charge which is debited in the profit
and loss account and the corresponding credit is made in the asset account concerned or in the depreciation provision account. It
will be seen that is simply a book keeping entry, having the effect of reducing the book value of the fixed assets as well as the profit
of the same amount. It is thus obvious that depreciation does not affect any current asset or current liability. i.e. working capital or
funds.
Two points should, however, be noted regarding depreciation:
iii.
a.
b.
It may not produce funds but it definitely saves funds in the current period. To furnish with an illustration, if fixed assets
used in the manufacturing process are not owned by the enterprise and hire is paid for their use which will certainly include
charge for depreciation, the funds from operation for the current period could be correspondingly reduced.
Preliminary expenses :
These give another example of an item which may be written off. The Book-Keeping entry involved is to debit the Profit and loss A/c
or P/L appropriation account and credit preliminary expenses account. The writing off of preliminary expenses neither affects any
current asset or current liability nor is constitutes an operating charge. In this way, it is non funds and non operating item because
both the key questions are answered in the negative.
iv.
Goodwill
It is a fixed asset, when a goodwill is written off Profit and Loss A/c and P/L appropriation account is debited and the goodwill
account is credited. The writing off of goodwill does not involve a change in any current asset or liability. It is hence a non funds item
.
v.
Transfer to general reserve, Dividend Equalization Reserve, Sinking fund or any other Reserve:
All these transfers constitute an appropriation of profit and not an operating charge against profits. Again, they do not involve a
change in any current asset or liability. Hence, they stand for non funds and non operating items.
vi.
Credits or additions.
Items credited in the profit and loss account (P/L A/c here includes manufacturing and trading accounts and profit and loss
appropriation account) should be carefully examined in order to spot out non funds or non operating credits. Such credits are those
which either do non affect any current account (Current asset or current liability) or do not show an operating Income.
Examples:
i.
ii.
If the provision for taxation has been treated as a current liability, it affects a current liability but does not constitute an
'operating income'. It will be seen as a source in the funds statement as a current liability, i.e. provision for taxation has
been reduced by a corresponding credit to a non current account a profit and loss account or P/L appropriation account.
2.
If the provision for taxation has been considered as an internal reserve (a non current account), such transfer only involves
a book keeping entry. It neither changes any current asset or current liability nor does it constitute 'an operating income'.
Hence, it shows, a 'non funds' and 'non operating' credit.
3.
Refund or tax. It increase a current asset---cash---but does not represent an operating income. It will appear as a source in
the funds statement.
4.
Rental Income. Revised or receivable it is not 'operating income, although it increases a current asset either cash or
debtor. It will be shown as a source in the funds statement.
5.
Profit or loss on sale of a fixed asset. This should be treated exactly in the same manner as has been recorded in the
books. It has three possibilities:
i.
It might have been transferred to some reserve, e.g. general reserve or capital reserve. Here it will not be
considered while determining funds from operations. It will, however, be posted on the appropriate side of the
reserve A/c in the worksheet as it is a non-funds items.
ii.
It might have been transferred to either any reserve or profit and loss account. Then it must be appearing either
on the liabilities side (profit) or on the asset side (loss) in the current balance sheet as the case may be. In this
case also, it will not be taken into account to calculate funds from operations. It will constitute a non current
account and as such will not appear in schedule of working capital.
i.
Analysis of Transactions:
The accounts of an undertaking show the effects of many different kinds of transaction but for the purpose of funds statement
Transactions affecting funds accounts only . All transactions, occurring during the period covered by funds flow
statement, which affect only currents accounts (i.e. either current assets only or current liabilities only or both current
assets and current liabilities) do not affect the funds position.
Example:
1.
Cash collected from debtors,
ii.
2.
3.
iii.
1.
2.
3.
iv.
0.
1.
ii.
iii.
Investments :
Investment may be held by a business concern either as a current asset or as a fixed asset. If the investments
shows surplus funds temporarily invested in marketable securities, they are to be treated as current assets. If, on
the other hand, investments are of a permanent nature, i.e. trade investments, they should be treated as a fixed
asset. If in the former case, any change in the figures of investments in between the dates of Two Balance Sheets
would be automatically adjusted through the schedule of changes in the working capital and no separate
treatment there of would be needed in the funds flow statement. Still, in the later case, an investment account
should be prepared exactly as it appears in the ledger. The preacquisition dividend should be adjusted exactly as
it has been de It with in the books of account. If the investment were purchased cum dividend and dividend
received out of preacquisition profits was utilised for reducing the cost of investment, the same should be shown
on the credit side of investment account.
Method II
In this method, provision for taxation made during the current year will be dealt with as follows:
(i) In case, nothing in respect thereof will appear in the Adjusted P/L A/c.
(ii) In case, no adjustment will be made to net profit figure as it will neither be added back to nor deducted from net profit.
(iii) In case it will be deducted from the figure of net profit. It is submitted that procedure under method I is preferable to that
of under it for two reasons.
(iv) The fact that a current liability has been created by a corresponding debit to a non current account will be apparent
from funds statement.
(b) It may be taken to represent an appropriation of profit (interval reserve), I in this case, it will not appear in the schedule
of working capital. Instead, an account should be constructed for this item in the worksheet showing there in the opening
balance and closing balance on the credit and debit side respectively and tax paid on the debit side. Tax paid will also be
shown as an application in the funds statement. The balancing figure on the credit side showing provision made during the
current year after provision for taxation, it will be added back to net profit.
(v) Proposed Dividend:
Prior to the passing of accounts the general meeting proposed dividend is actually a part of the surplus although shown as
a provision in the accounts. But as soon as the proposed dividend is declared by the shareholders in the General Meeting,
it becomes a current liability legally due and payable by the company to members.
As a current liability . Here, proposed dividend will appear in the 'schedule of working capital'. Any payment of dividend
made during the current year, against proposed dividend for previous year or an earlier year will not be shown as an
application in the funds statement as such payment will not change net working capital or fund it will affect two current
accounts --cash and proposed dividend.
The proposed dividend for the current year appearing in the accounts should not affect funds from operation because,
though it represents a current liability. It is not a trading or operating charge. In the adjusted P and L A/c proposed dividend
will appear on its debit side. If funds from operation are worked out on the basis of 'net profit' for the current year before
debit for proposed dividend, no adjustment there would be made on account of proposed dividend.
It may be noted that proposed dividend for the current year, representing creation of a current; liability out of a non current
account as retained earnings or P/L Appropriation Account will be shown as an application in the statement of sources and
application of funds.
As an Internal Reserve or Surplus. Proposed dividend will not figure in 'schedule of change, in working capital. Payment
made during the current year against proposed dividend for previous year or an earlier year will be shown as an application
in the funds statement.
An account for proposed dividend would be written up in the worksheet showing there in opening balance on the credit
side, and closing balance and amount paid in respect of previous years proposed dividend on the debit side. The balancing
figure will represent provision for dividend made during the current year by debit to P and L app. A/c. It will be shown on the
debit side of 'Adjusted P and L A/c" to find out funds from operations are calculated from Net profit for the current year
before provision for dividend', no adjustment there to in respect of provision for dividend is called for.
It is submitted that treatment of proposed dividend as a current liability is preferable because the time gap between
recommendation of dividend by directors and declaration of the same by the share holders in the general meeting is only a
technicality.
v.
vi.
added back.
vii.
a.
The current asset may be shown gross under current assets and the provision shown under current liabilities in the
'schedule of working capital.' Thus, increase or decrease in the former as well as in the latter will affect the working capital.
But the combined effect of the two changes will be the same.
b.
Provision may be treated as an internal reserve or surplus. In this case, it will not appear in the 'schedule of working capital'
and the corresponding current asset will appear at gross figure therein.
A separate account for the provision will be prepared in the worksheet and balancing figure representing provision made during the
current year will either be transferred to the debit of 'adjusted P and L A/c' or added back to net profit for the current year after
debiting the provision to determine funds from operation.
It may be noted that in each of the above alternatives, nothing in regard to the provision made during the year will appear in the
funds statement.
viii.
Dividend income:
(a) Received. Net collections, i.e. gross amount of dividend less income tax deducted at source on account of dividend should be
taken as a source of funds irrespective of their nature whether they are out of pre-acquisition profits or otherwise the allocation
between capital and revenue is a matter to be considered for preparing the profit and loss account and balance sheet, but the whole
amount received is a source of fund.
If the dividend account has been credited in the books of account with the gross amount and the difference between the gross
amount and payment received debited to 'tax deducted at source account, the above treatment will hold good- provided the 'tax
deducted at source account' is not included in the 'schedule of changes in working capital' as a current asset.
(b) Receivable. If the gross amount of dividends receivable has been debited to dividends receivable account and credited to
dividends accounts in the books of accounts, the same amount may be taken as a source and the dividends receivable account is
shown as current asset in the schedule of changes in working capital. Alternatively, if the Dividends Receivable Account' has been
debited with only the net amount to be received and the rest to Tax to be deducted at source Account' has been debited with only
the net amount to be received and the rest to Tax to be deducted at source Account' the above treatment will hold good provided
both-- Dividends receivable account and the ax to be deducted at source A/c are shown in the statement of changes as current
assets.