Unit 2
Unit 3
Unit 9
Unit 14
Prof. Nandagopal V. B.
Board of Studies
Professor, Manipal Universal Learning
Prof. K. V. Varambally
Ms. Vimala Parthasarathy
Health, Medical and Technological studies.
Mr. Shankar Jagannathan
Former Group Treasurer
Mr. Abraham Mathews
Chief Financial Officer
Infosys BPO, Bangalore
Mr. Pankaj Khanna
Content Preparation Team Peer Review By
1. Dr. Y. Rajaram Dr. Nagesh Malavalli
Adjunct Faculty, Manipal Universal Learning Principal &
Professor of Finance & Accounting
M.P. Birla Institute of Management, Bangalore
2. Mr. S. N. Dorai Raj
Retd Principal & Professor of commerce,
Seshadripuram College, Bangalore.
Edition: Fall 2008
This book is a distance education module comprising of collection
of learning material for our students.
All rights reserved. No part of this work may be reproduced
in any form by any means without permission in
writing from Sikkim Manipal University of Health, Medical and
Technological Sciences, Gangtok, Sikkim.
Printed and Published on behalf of Sikkim Manipal University of
Health, Medical and Technological Sciences,
Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal
Learning Pvt. Ltd., Manipal – 576 104.
Printed at Manipal Press Limited, Manipal.
Accounting is a systematic effect of collecting. Classifying
and analyzing financial information for
effective use in decision making activities. There are two facts of
accounting namely Financial
Accounting and Management Accounting. While financial
accounting is concerned with recording and
preparation of financial statements, management accounting focuses
on using the information for
planning, decision making and controlling the financial activities
of business enterprise. In view of the
fast changing scenario world over, MBA students should acquaint
themselves with rudiments of the
subject. This book contains 15 Units.
Unit 1: Financial Accounting – An Introduction
Presents an overview of meaning, purpose and evolution of
accounting and introduces
basic terminology.
Briefly describes the accounting concepts and assumption in
financial accounting.
Unit 3: Double Entry Accounting
Deals with basic accounting principles of Double – entry system.
Unit 4: Primary Books
Contains details of primary books- General journal and subsidiary
books.
Unit 5: Secondary Books
Covers the process of posting from primary books to ledger, which
is called secondary
book.
Unit 6: Trial Balance
Deals with the process of preparing trial balance, errors and
rectification.
Unit 7: Final Accounts
Presents the meaning and scope of Management Accounting.
Unit 9: Financial Statement Analysis
Deals with ratio analysis as a part of analysis of financial
statements.
Unit 10: Funds Flow Analysis
Focuses on fund flow analysis.
Unit 11: Cash Flow Analysis
Gives a brief sketch of cash analysis.
Unit 12: Understanding Cost
Unit 13: Marginal Costing and Break Even Analysis
Introduces the tool of marginal costing and its usage.
Unit 14: Budgetary Control
Provides an insight of budgets – as a means of control.
Unit 15: Standard Costing
Reference Books:
1. Accounting for managers by Jawahara Lal. 2. Financial Accounting
by S.N.Maheswari.
3. Financial Accounting for Managers by R.Narayana Swamy. 4.
Introduction to Management by Anthony Reece.
Sikkim Manipal University 1
Structure:
Self Assessment Questions 3
Self Assessment Questions 5
Self Assessment Questions 6
Self Assessment Questions 7
1.1 Introduction
Accounting is a branch of knowledge, concerned with recording
classifying, analyzing and
reporting financial information to owners, bankers, creditors,
government and host of
stakeholders regarding the financial performance of organizations -
business or bon-business
entities. Over a period of time, accounting has assumed a status of
a science and an art. In order
to achieve uniformity globally, international standards have also
emerged in accounting. In this
Unit, the historical perspective of Accounting, its meaning,
functions and basic terms used in the
subject are discussed.
Sikkim Manipal University 2
Learning Objectives:
After studying this unit, you should be able to understand the
following
1. To expose the students with meaning, need and purpose of
accounting.
2. To know the functions Accounting.
3. To understand the difference between Financial Accounting and
Management Accounting.
4. To acquaint with the basic terminology used in the
subject.
1.2 Evolution of Financial Accounting
Any branch of knowledge does not emerge all of a sudden. Knowledge
is a product of continuous
intellectual exercise and the changes in the environmental and
social demands. Accounting is an
ancient art. Michael Russel in his article ‘Evolution of
Accounting’ points out that as early as 8500
B.C, accounting was existing. Archeologists have found clay tokens
as old as 8500 BC in
Mesopotamia which were usually cones, disks, spheres and pellets.
These tokens correspond to
such commodities like sheep, clothing or bread. They were used in
the Middle West in keeping
records. Similarly in ancient civilizations like China, Babylonia,
Greece and Egypt, record keeping
was in practice in the same manner as stated above. During 3600 BC
in Babylonia payment of
salaries was recorded in clay tablets. The rulers of these
civilizations kept track of labour and
material costs by using accounting methods.
In an article published by John R. Alexander on ‘History of
Accounting’, he stated that an
improved system of book keeping known as double entry book keeping
was introduced in 14 th
century and the following seven key ingredients were responsible
for the creation of double entry
book keeping.
• Private property: The power to change ownership,
because book keeping is concerned with
recording the facts about property and property rights
• Capital: Wealth productively employed, because
otherwise commerce would be trivial and
credit would not exist
• Commerce: The interchange of goods on a widespread
level, because purely local trading in
small volume would not create the sort of press of business needed
to spur the creation of an
organized system to replace the existing hodgepodge of record
keeping
• Credit: The present use of future goods, because there
would have been little impetus to
record transactions completed on the spot.
Sikkim Manipal University 3
• Writing: A mechanism for making a permanent record in
a common language given the limits
of human memory.
• Money: The common denominator for exchange, since
there is no need for book keeping
except as it reduces transactions to a set of monetary
values.
• Arithmetic: A means of computing the monetary details
of the deal.
Double entry records first came out during 1340 A.D. in Genoa. In
1494, the first systematic
record keeping was formulated by Fra Luca Pacioli a Franciscan monk
and one of the most
celebrated mathematicians to this day. Pacioli is considered as the
father of accounting.
Michael Russel, in his article states that industrial revolution,
which brought paradigm changes in
the working and business transactions paved way to the specialized
field of accounting called
‘cost accounting’ in order to meet the need for the analysis of
various costs. Mean while,
corporate form of organisation came into being which made it
necessary to report financial
information to the owners (shareholders) by the management.
Virtually management and
ownership got separated and to instill confidence of the
shareholders, managers had to submit
reports, as prepared on the basis of accounting information.
Welsch and Anthony, in their book’ Fundamentals of Financial
Accounting’, comment that the
growth of business organizations in size, particularly publicly
held corporations, has brought
pressure from stock holders, potential investors, creditors,
government agencies, and the public
at large, for increased financial disclosure. The public’s right to
know more about organizations
that directly or indirectly affect them (whether or not they are
shareholders) is being increasingly,
recognized as essential. An open society is one that has a high
degree of freedom at the
individual level and typically evidences an effective commitment to
measuring the quality of life
attained. These characteristics make it essential that the members
of the society be provided
adequate, understandable, and dependable financial information from
the major institutions that
comprise it. So accountants have a greater responsibility of not
only being accurate but also
transparent to the possible extent.
At present, there have been tremendous advancements in accounting
to meet the needs brought
about by information technology. Work is done faster, more
accurate, and more dependable by
using computers. Business can be transacted without even facing one
another and accounting
has become so customer friendly that records and reports are
generated instantaneously to all
parties concerned.
Sikkim Manipal University 4
2. A new accounting system called _______ emerged during industrial
revolution.
3. Double Entry book keeping was introduced during ___________
century.
1.3 Need
Economic activities are carried on by trading and non-trading
organizations, the former with profit
motive and the latter with a focus on service. Business is
prominently carried on under different
forms of organizations, namely sole trading, partnership, Hindu
undivided family firms (HUF),
cooperative societies and companies. Having invested capital in the
business, one has to find out
at the end of a particular period whether the business has yielded
any profit or loss; any assets
are created; the liabilities payable; total expenses incurred;
total revenues generated and so on
and so forth. Innumerable business transactions might have taken
place during the period and
remembering all transactions is humanly impossible, let alone
finding the results of the
transactions. Even to put them in a computer, it requires a
systematic approach to record,
classify, analyse and report the financial data to the stake
holders of a business enterprise.
Precisely for this purpose, financial accounting is needed.
Proprietor/s in case of sole trading and partnership firms, members
in case of cooperative
institutions, shareholders in case of companies, suppliers,
customers, tax authorities, banking
institutions, lenders, borrowers, employees, government agencies
and general public are the
various parties interested in the financial information of a
business enterprise and each one them
is interested in different aspects of the business. Accounting
information has to be supplied in a
prescribed manner to these parties and this information is
contained in the form of different
statements such as trading account, profit and loss account,
balance sheet, cash flow statement,
fund flow statement, statement of investments and so on. While a
proprietor/
partner/member/shareholder is interested in profit and loss account
and balance sheet, bankers
are interested in cash and fund flow statements in addition to
P&L account and balance sheet,
government is interested in the amount of tax collections,
employees are interested in P&L
account, customers, in total sales, suppliers in cash statements,
security analysts in the ratio
analysis of various financial parameters of the business
organization. Financial accounting fulfills
the aspirations of the above parties regarding the enterprise. Thus
Accounting has emerged for
two purposes, namely to record all business transactions since one
can not remember them and
Sikkim Manipal University 5
Self Assessment Questions 2:
1. What are the two purposes of accounting?
2. Shareholders of a company are interested in ______ and _______
of a business.
3. Bankers are interested in _________ and _______ besides P&L
A/C and balance sheet.
1.4 Meaning of Accountancy, Book-keeping and Accounting
Book-keeping, accounting and accountancy are the terms used in the
science of financial
accounting. Book-keeping means recording of business transactions
in the books of accounts in
accordance with the principles of accounting. Book keeping is an
adjunct for accounting. Day to
day transactions are entered in a systematic manner to facilitate
the preparation of profit and loss
account, balance sheet and other statements containing information
about debtors, creditors, tax
payment etc., For the purpose of recording the financial data,
debit and credit principles are
adopted so that cross checking is made possible, summary of each
account is known at the end
of an accounting period.
Accounting on the other hand is the discipline of measuring,
communicating and interpreting
financial activities and it is widely referred to as language of
business.
Way back in 1941, the definition for the word Accounting was given
by the Committee on
Terminology of the American Institute of Chartered Public
Accountants, (AICPA)thus, ‘accounting
is an art of recording, classifying and summarizing in a
significant manner and terms of money
transactions and events which are, in part at least, of a financial
character, and interpreting the
results thereof.’
The American Accounting Association (AAA) in 1966 provided the
following definition:
“Accounting is the process of identifying, measuring and
communicating economic information to
permit informed judgements and decisions by users of the
information”
In 1970, the AICPA emphasized accounting with reference to the
concept of information..
Accounting is treated as a service activity. The function of
accounting is to provide quantitative
information, primarily financial in nature, and about economic
activities, that is intended to be
useful in making economic decisions.
Accountancy is the profession and the practitioners of accountancy
are called accountants.
Therefore book keeping is the basic activity of recording,
accounting is the analysis and reporting
function and accountancy is the profession of carrying the above
activities.
Self Assessment Questions 3:
Sikkim Manipal University 6
2. Define Accounting.
3. Accountancy is a __________ and the practitioners of accountancy
are __________ .
1.5 Characteristics of Accounting
From the above definitions of Accounting, one can list out the
characteristics of accounting:
1. Accounting is an art and science: Recording and maintenance of
accounts of various
transactions needs special skill and knowledge. Reading and
interpreting the results, obtained
by the accounting system requires experience. From this angle,
accounting is an art.
Accountants are endowed with this special skill and aptitude and it
is difficult to acquire
proficiency in this art. It is like a doctor who diagnoses and
prescribes medicines just by
looking to the medical reports, an accountant on a gaze of the
financial reports can find out
the financial health of an enterprise and suggests measures to
improve the financial position.
Accounting is also a science, not like physics or chemistry, but it
is an exacting science.
Accounting is governed by definite principles, rules, concepts,
conventions and policies. A
systematic and scientific approach is adopted to classify, record,
analyse and interpret the
accounting information.
2. Accounting involves a process of identifying, classifying and
recording financial information,
expressed in terms of money. All financial transactions are
expressed in terms of money.
Incomes, expenses, acquisition of assets, payment of liabilities,
capital of shareholders etc.,
are stated in money terms and all transactions are broadly
classified as related to definite
heads of account, namely – personal, real and nominal. After
classification, they are recorded
in the books of original entry as per the accounting principles.
The book of original entry is
called Journal. From Journal, the transactions are summarized under
each head of relevant
account and posting takes place to a book called ledger. At the end
of a particular accounting
period, the gist or the net balance of all ledger accounts is
aggregated to prepare a trail
balance. From trial balance, it is possible to prepare trading,
profit and loss accounts and
balance sheet.
3. Events of non financial nature can not be recorded, even though
such events may have an
impact on the operational results of the enterprise. For instance
financial manager and
production manager of a concern do not have good relationship and
owing to this the
production process is affected and subsequently the profitability.
This event of non financial
nature can not be reflected in accounts.
Sikkim Manipal University 7
4. Accounting is an information system. The results of analysis and
interpretation are
communicated to the management and other interested parties.
Internal control is effectively
exercised and accountability is ensured through accounting
information.
5. It helps in taking managerial decisions.
Self Assessment Questions 4:
1. The book of original entry is called __________ .
2. Profitability of an enterprise is affected if the finance
manager and production manager do not
agree each other. Does this picture in accounts?
1.6 Functions and Objectives of Accounting
From the above paragraphs, it can be concluded that accounting
involves the following functions
and objectives.
a) Systematic recording of all business events or transactions and
subsequent posting to ledger
to finally prepare financial statements – profit and loss account
and balance sheet.
b) Reporting the results to management, shareholders, creditors,
bankers, investors, stock
brokers, stock exchanges, employees, governments etc.,
c) Satisfying the statutory requirements, especially of Registrar
of Companies, SEBI (Securities
Exchange Board of India) in case the company is listed, tax
authorities (sales tax, excise,
customs, income tax) and government in order to protect the
interest of general public.
d) Protecting the properties of business by recording them on the
date of acquisition and
showing their accounts in the balance sheet.
e) It helps for internal control by holding the concerned persons
responsible for any errors,
lapses or under performance. Equally it helps to identify the
strong areas of excellent
performance and subsequently pin point the individuals or
departments to be rewarded or
appreciated.
f) Accounting is a tool for effective planning. Current year’s
financial performance becomes the
basis for future predictions and estimations. Since it is tool for
planning, it also acts as tool for
controlling. Preparation of budgets, cost analysis, tax planning,
auditing are some of the
functions of accounting.
1. State any two functions of accounting.
Sikkim Manipal University 8
1.7 Differences between Book Keeping and Accounting
As already said, book keeping is a system of recording the day to
day transactions in the books of
enterprise. Accounting enjoys wider scope and includes not only
book keeping but also analysis,
interpretation and reporting of financial information. The later
part of accounting is the core
function of accounting. Now - a-days, owing to information
technology, ready made packages like
Tally are available, which facilitate entry of transactions and
preparation of ledger accounts are
made easy. In case of large industrial enterprises and multi
national corporations, regular journal
entries are not recorded owing to very large number of transactions
taking place day in and day
out. On the other hand subsidiary books such as cash book, sales
book, purchases book, bills
receivable book are prepared and ledger accounts are drawn from
them. The differences
between book keeping and accounting are as under:
Book keeping Accounting
transactions in books of accounts
• It includes recording, analyzing and
communicating
recording
knowledge and experience
accounting
end of accounting period
reasons for financial results and
communicate the results to all stakeholders
in a manner they understand.
Self Assessment Questions 6:
2. State two differences between book keeping and accounting.
1.8 Financial Accounting and Management Accounting
Financial accounting is the preparation and communication of
financial information to outsiders
such as creditors, bankers, government, customers and so on.
Another objective of financial
accounting is to give complete picture of the enterprise to
shareholders. Management accounting
on the other hand aims at preparing and reporting the financial
data to the management on
regular basis. Management is entrusted with the responsibility of
taking appropriate decisions,
planning, performance evaluation, control, management of costs,
cost determination etc., For
Sikkim Manipal University 9
both financial accounting and management accounting the financial
data is the same and the
reports prepared in financial accounting are also used in
management accounting But the
following are major differences between Financial accounting and
Management accounting.
Financial accounting Management accounting
accounting information are
shareholders, creditors, government
authorities, employees etc.,
the information for planning and decision
making
measurement unit like labour hours, machine
hours or product units for the purpose of
analysis
definite period, say one year or a
quarter
• Financial accounting focuses on
future
policies and conventions
disciplines like economics, management,
Self Assessment Questions 7:
2. State any two differences between Financial accounting and
Management accounting.
1.9 Basic Terms
To understand the subject, proper understanding of the following
terms is essential.
1. Transaction: It is transfer of money or goods or service
from one person or account to
another person or account. For example, purchase of goods, sale of
goods, payment of cash
towards rent, receipt of cash towards interest on loans given, cash
brought in as capital
dividend paid to share holders etc are all transactions. There are
cash transactions, credit
transactions and paper transactions. In all cash transactions, cash
is paid or received
immediately. Ex: Rama paid cash Rs.10000 for purchase of goods.
Krishna sells goods for
cash Rs1000.Credit transaction is one where there is a promise to
pay/receive cash at a
Sikkim Manipal University 10
adjustment is made in the records only. Bad debts of previous year
are written off;
depreciation provided on fixed assets etc.,
2. Capital: Funds brought in to start business, by the
owner/s. In the case of a company,
capital is collected by issue of shares. Capital used to purchase
fixed assets is called fixed
capital and that capital used for day to day affairs of business is
known as working capital.
From business point of view, Capital is a liability.
3. Assets: Every enterprise has assets. Land and buildings,
plant and machinery, furniture and
fixtures, cash in hand and at bank, debtors and stock etc., are
regarded as assets, by the
use of which business is carried on. Assets may be fixed, current,
liquid or fictitious. Fixed
assets are those which are held for use in the production or supply
of goods and services.
Ex: plant and machinery, which is used fairly for long period.
Current assets are those which
are held or receivable within a year or within the operating cycle
of the business. They are
intended to be converted into cash within a short period of time.
Ex: Stock in trade, debtors,
bills receivable, cash at bank etc., Liquid assets are those which
can be easily converted
into cash and for instance, cash in hand, cash at bank, marketable
investments etc.,
Fictitious assets are in the form of such expenses which could not
be written off during the
period of their incidence. For example, promotional expenses of a
company which could not
be treated as expenditure in the year of incidence are shown as
fictitious asset.
4. Liability: Obligation to be fulfilled in future with
respect to payment towards acquisition of an
asset or performance of a service. Current liability is that
obligation which has to be satisfied
within a year. For example, payment to be made sundry creditors for
the goods supplied by
them on credit; bills payable accepted by the businessman;
overdraft raised by the
businessman in a bank etc.
5. Goods: Commodities or articles purchased for resale are
called goods. Furniture items
dealt by a furniture dealer constitute goods for that business. If
rice dealer purchases
furniture, not for resale but for use, it is called purchase of
asset and the same furniture
becomes asset. Rice for rice dealer is goods, because he purchases
only for resale.
6. Trade: Purchase and sale of goods is called trade.
7. Purchases: It refers to goods bought in exchange for cash
or credit. In case of credit
purchase, goods are received against a promise to pay the price for
the same at a future
date.
Sikkim Manipal University 11
8. Sales: Goods sold to customers either for cash or for
credit are regarded as sales. In case
of cash sales, cash is received immediately and in case of credit
sales, cash will be received
at a future date.
9. Sole trader: A single individual carrying on business with
or without the help of his kith and
kin is called sole trader.
10. Partnership: It is a relationship between partners to
contribute capital to start business,
agree to distribute profits and losses in an agreed proportion and
the business being carried
on by all or any one acting for all. Partnership firm refers to
business where as the
partnership refers to relationship caused by agreement.
11. Joint Stock Company: It is an organization, for which the
capital is contributed by
shareholders to carry on business and it is registered under
Companies Act and it has a
legal entity, having perpetual existence and a common seal.
12. Debtor: Debtor is a person who owes some thing to
business. A person to whom goods are
sold on credit becomes a trade debtor to the business.
13. Creditor: A creditor is a person to whom the business owes
some thing. For example, a
person from whom goods are purchased on credit and amount is yet to
be paid is called a
trade creditor.
14. Stock: Total goods kept on hand by a trader or industrial
enterprise on a given date. It
represents unsold part of goods.
Self Assessment Questions 8:
1. A company is registered under ___________ .
2. A partnership is ___________ among partners.
3. Rama & Co., owned by Govind. Is it a firm or sole
trader?
4. If A purchases goods from B, A is ___________ to B and B is
_________ to A.
5. X co Ltd., sold goods to Y Co Ltd and Y Co gave a cheque payable
after one month. Is it a
cash sale or credit sale?
6. Mr. P brings furniture worth Rs.10000 and goods worth Rs.200000
into his business. Is it
capital?
1. Briefly describe the meaning of accountancy, book-keeping and
accounting.
2. Write the differences between accounting and book-keeping.
Sikkim Manipal University 12
4. State the meaning of the folling terms
a. Transaction
b. Assets
Self Assessment Questions 1:
1. Fra Luca Pacioli
Self Assessment Questions 2:
1. Record all business transactions and communicate the results to
interested parties.
2. Profit and loss and balance sheet
3. Cash flow and fund flow statements
Self Assessment Questions 3:
2. Accounting is the discipline of measuring, communicating and
interpreting financial
activities.
Self Assessment Questions 5:
internal control, tool for effective planning (Any two).
2. Shareholders, creditors, bankers, brokers, debtors, customers,
suppliers, Government etc.
Self Assessment Questions 6:
Sikkim Manipal University 13
2. Book keeping is a process of recording but accounting is not
only recording but also analyzing
and communicating; book keeping requires the knowledge of
accounting principles but
accounting requires not only knowledge but also skill and
experience.
Self Assessment Questions 7:
1. Taking decisions, planning, evaluating and
controlling
2. FA considers historical data and MA focuses on future; FA is a
discipline by itself but
MA makes use of other disciplines like economics, information
system etc.
Self Assessment Questions 8:
Answer for Terminal Questions:
Sikkim Manipal University 184
Structure:
Self Assessment Questions 14
Sikkim Manipal University 185
Self Assessment Questions 15
Self Assessment Questions 16
Self Assessment Questions 18
10.1 Introduction
The usefulness of developing certain financial statements as an aid
to evaluate past and / or
present performance of a business concern is unquestionable and
beyond any dispute. The
Income Statement reports the revenues earned and expenses incurred
or outstanding. The
Balance Sheet conveys about the deployment of funds in various
assets and equities The Fund
Flow analysis is a modern technique of analyzing the movement of
“funds” of a concern. The
Fund Flow statement shows the movement of funds between two balance
sheet dates. As per
Robert N. Anthony “the Funds Flow statement describes the sources
from which additional funds
were derived and the use to which these funds were put”. Such a
statement is becoming more
and more popular and is being increasingly published as part of the
annual accounts. Para 20 of
International Accounting Standards 7 reads as follows :
“A statement of changes in financial position should be included as
an integral part of financial
statements. The statement of changes in financial position should
be presented for each period
for which the income statement is prepared”.
The inclusion of such a statement, therefore, is very helpful to
improve the understanding of the
operations and activities of an enterprise for the reporting
period.
Learning Objectives:
After studying this unit, you should be able to understand
the following
1. Understand the meaning and the concepts of funds flow
statement.
2. Familiar with techniques of fund flow statement.
3. Preparation of fund flow statement.
Sikkim Manipal University 186
10.2 Meaning of Fund Flow Statement
Statement of Sources and Uses of Funds is a statement which depicts
the sources from which
funds are obtained and the uses to which they are being put. It is
essentially derived from the
analysis of changes which have occurred in assets and equities
between two Balance Sheets
periods. It is not the end-product of accounting records. The
statement speaks about the
changes in financial items of Balance Sheets prepared at two
different dates. Therefore, the
funds flow indicates the inflows and outflows of funds during a
particular accounting period
generally a year. The flow exhibits the movements of funds in both
the directions – inside and
outside the business. As such, the term ‘flow’ in the context of
funds indicates the transfer of
cash or cash equivalent from asset to equity or one equity to
another equity or from one asset to
another asset.
2. FFS speaks about changes in _______________________ Balance
Sheets.
3. Flow exhibits the flows _______________ And ________________
business.
4. Flow refers to transfer of ___________________ And
__________________.
10.3 Concept of Fund
The term “funds” has been defined in a number of ways in financial
circles. The three common
usages of the term are cash , working capita and total financial
resources..
Cash: Under this concept, the term “funds” is used only
in the sense of cash. Here, only the
changes in cash are considered. Hence, the statement is called
“Cash Flow statement. This
statement aims at listing the various items which bring about
changes in the cash balance
between two balance sheet dates. Cash planning becomes
useful for control purposes.
Using this method has certain disadvantages. Since cash is
considered as short term assets,
they are subjected to short term fluctuations. A delay in making
payment to suppliers and a
provision of one month’s credit for making a payment of land
purchases may show sufficient cash
flow . They may reflect a satisfactory position. But it is not a
reality. Therefore, cash equivalent
concept of fund is useful only for short term financial planning
and not for long term or
general financial position assessment.
Sikkim Manipal University 187
or decrease working capital are included in this statement. It
excludes all such items which do
not affect the working capital. The working capital concept of
funds is in conformity with normal
accounting procedures. Hence, a funds flow statement based on this
concept fits well with the
other statements. Moreover, working capital is also a measure of
short term liquidity of the firm.
Therefore, an analysis of factors bringing about a change in the
amount of net working capital is
useful for decision making by shareholders, creditors and
management. Due to these reasons,
the working capital approach to funds is more useful than the cash
approach.
Total Financial Resources : The term “funds” is very often
used in the sense of useful financial
resources also. Cash approach and working capital approach both are
incomplete and
inadequate to the extent that they omit a few major financial and
investment transactions. Such
items do not affect net working capital. But, if they are included,
they would certainly provide
qualitative information for the decision making.,
For example issuing equity shares and debentures for purchase of
buildings or assets shall not
have any effect on the working capital. But it is a significant
financial transaction that should be
disclosed. Therefore, this concept seems to be the best approach to
disclose the changes in the
financial position as compared to other concepts. It is in
conformity with the statutory regulations
and legal requirements.
4. Working capital is __________________________________.
6. Working capital means ______________________________.
Objectives:
The main objectives of the funds flow statement is normally based
on the purpose its going to be
served. These are :
a) to help in understanding the changes that are likely to take
place in the assets and liabilities
Sikkim Manipal University 188
b) To inform the stakeholders as to how a firm can use the funds
which are available at its
disposal.
c) To bring out the financial strengths and weaknesses of the
business.
Self Assessment Questions 3
1. The objectives of FFS is to identify ______________ in ______.
and ____.
2. FFS is to bring out _______________________.
10.4 Techniques Of Preparing A Funds Flow Statement
Like other accounting statements, the structure of Fund Flow
Statement is based on the equality
of financial assets and liabilities including capital. The basic
understanding is that the funds are
obtained through profit, external borrowings or by issue of shares.
If funds are not available
readily from these sources, the other alternative available is to
sell the fixed assets and
investments. . The preparation of Funds Flow Statement is normally
based on the following to
bring to scientific method of preparation.
a) Schedule of working capital changes
b) Statement of Sources and Uses of Fund.
Schedule of Working Capital Changes : It is also known as
“Comparative change in Working
Capital Statement” or “Working Capital Variation Statement”. The
net change in working capital
is projected here in the place of individual changes in all the
current assets and current liabilities
in the Funds Flow Statement. The statement indicates the amount of
working capital at the end of
two years. It shows the increase or decrease in the individual
items of current assets and current
liabilities. The effect of the changes in the individual items of
the current assets and current
liabilities on working capital is also presented clearly and
precisely. The difference in the amount
of working capital at the end of two years will depict either the
increase or decease in working
capital. While ascertaining the increase or decrease in individual
items of current assets and
current liabilities and its impact on working capital, the
following Rules should be taken into
account.
Sikkim Manipal University 189
It is, therefore, noted that the changes in the items of current
assets are positively correlated to
the changes in the working capital. On the other hand, changes in
current liabilities are inversely
related to the changes in the working capital.
Self Assessment Questions 4
2. FFS is prepared based on ___________________.
3. Working capital schedule indicates the
______________________.
4. Increase in current assets ___________________ the Working
capital.
5. Decrease in CA _____________________________________ the
WC.
6. Increase in CL ______________________________________ the
WC.
7. Decrease in CL ______________________________________ the
WC.
8. Changes in CA ________________________________ changes in
WC.
9. Changes in CL ________________________________ changes in WC.
10.5 Sources of Funds
The transactions that increase the working capital are sources of
funds. Following may the
sources of funds in a concern.
Funds from operations : Profit earned by the concern during
the current year is deemed to be
the source of funds. It is very important source of funds inflow.
Net profit is arrived at by
deducting cost of goods sold and other expenses from total sales
revenue. However, the profit so
calculated is seldom equal to the funds from operations because
there are many items which are
debited or credited in the Profit and Loss Account which do not
affect working capital. Therefore,
in calculating the funds from operations, the following adjustments
must be kept in mind:
Items to be added back to net profit :
a. Non-fund revenue deductions: These are items which
are debited to Profit and Loss
account. These do not cause outflow of funds such as depreciation
and depletion on non-
current assets, amortization of fictitious and intangible assets,
preliminary expenses,
redemption of preference shares or debentures, deferred charges,
advertising suspense
account written off. If non fund expenditures does not affect the
current assets such as
unexpired insurance, do not add back. So also, all allowances for
income tax payable in
future years are excluded.
Sikkim Manipal University 190
b. Non-trading charges or losses : These items which
were debited to Profit and Loss account
reduce the profits but they do not cause any outflow of funds.
Hence, profit should be
corrected by adding back all such charges and losses. These include
appropriation of
retained earnings such as general reserve, dividend equalization
fund, reserve for
contingencies, sinking fund. In addition the dividend on shares
must be added back since it
is an appropriation and not trading charge. The losses arising out
of sale of land, buildings,
machinery, long term investments which were written off to the
profit and loss account must
be added back. Do not add the loss arising out of sale of a current
asset such short term
investments. It is a trading loss and hence it will not require any
adjustment. The amount set
aside as provision for current taxation will also be added back.
This will be considered only
when the provision for taxation is treated as a charge on profits.
Items to be deducted from Net Profit.
The non fund and non trading revenue receipts or incomes must be
deducted
Net profit in order to compute funds from operations. The items
are:
(a) Dividend received or receivable: Although this
transaction increases the current assets
such as cash and debtors, it is not a trading income. Hence, it
should be deducted from the
net profits to determine the funds from operations.
(b) Retransfer of excess provisions: Where the
provisions made for taxation, depreciation,
doubtful debts exceed the genuine requirements, the excess amount
is transferred back to
the Profit and loss account. It does not create any inflow of funds
since it is an accounting
entry. Hence, deduct it.
(c) Profit on sale of non current assets: It is a non
trading income. Hence it must be
eliminated from the amount of profit.
(d) Appreciation in fixed assets: The amount of
appreciation on revaluation of fixed assets is
normally credited to the profit and loss account. If it is so,
deduct it from the profit to compute
the funds from operations.
Self Assessment Questions 5
2. Decrease in WC _____________________________.
3. Net profit is ________________________________.
4. Items to be added back to net profit are __________.
5. Some of non-fund revenue items _______________.
Sikkim Manipal University 191
10.6 Increse in Funds
In a nutshell, the sources of funds can be observed as follows
:
a) increase of fresh shares derived from increase in share
capital.
b) Issue of debentures derived from increase in debentures.
c) Raising of new loan derived from increase in long term
loans
d) Sale of fixed assets for cash or for other current assets
derived from decrease in fixed assets
and additional information.
e) Non trading income
f) Profit from operations before deducting non cash items of
expenses and losses and before
additional non cash, non trading incomes.
g) Decrease in working capital derived from the Schedule of Working
capital changes.
Self Assessment Questions 6
2. Increase in debentures _______________________________ of
cash.
3. Increase in raising loans ______________________________.
4. sale of fixed assets __________________________________.
5. Non trading income is _______________________________.
6. Profit f rom operations is _____________________________.
7. Decrease in working capital is ________________________.
10.7 Decrease in Assets
Decrease in assets is always a source of funds for the business.
Decrease may be in many
ways: such as cash received from debtors, sale of goods for cash,
Bills realized, sale of assets,
fixed assets through provision for depreciation or amortization of
fictitious assets. Decrease in an
item of assets results in either a parallel decrease in some other
liabilities or a parallel increase in
some other item of assets example repayment of bank loan.. It
should be remembered at the
very outset that the decrease is ascertained by comparing the cost
of fixed assets and not by
comparing the written down value i.e cost less depreciation. If
fixed assets have been shown not
at cost but at written down value, then cost may be ascertained by
adding total depreciation
written off to-date (generally known as accumulated depreciation)
to the written down value The
Sikkim Manipal University 192
the problem about this. The decrease in fixed assets not on account
of depreciation or writing off
is known as sale of fixed assets. It must be noticed that the total
sale proceeds and not the cost
of fixed assets sold are shown as source of fund. If the
information in respect of sale of fixed
assets is not clearly given, the following steps should be taken to
find out the value of sale
proceeds.
Less: Cost of Fixed Assets of Current year ( ………………)
Cost of Fixed Assets x x x x x x x x
ADD : Profit or DEDUCT loss on sale ………………………
Sale Proceeds to be treated as source XXXXXXXXXXXXXX
The amount of profit or loss on sale of fixed assets for the above
purpose derived from profit and
loss account or from capital reserve or from any specific reserve.
This is based on the fact that
such profit or loss are credited or debited or transferred to these
accounts in accordance with the
accounting principles. It must be remembered that profit or loss on
sale of fixed assets are not
included in profit from operation for the purpose of this Fund Flow
Statement.
If such profit or loss has been included in Profit and Loss Account
, adjustment has to be made.
If there is profit on sale of assets, the net profit disclosed by
Profit and Loss Account is reduced
by the amount of profit earned on the sale of fixed assets. On the
other hand, the net profit
shown by Profit and Loss Account is increased by the amount of loss
incurred on the sale of fixed
assets.
Example:
The land and buildings account had a balance of Rs.5,00,000on Jan
2007. A piece of land has
been sold . There is no purchase. Rs.30,000 depreciation has been
charged in 2007. The profit
on sale has been credited to Capital Reserve Account . The balance
stood on January 1, 2007
was Rs.20,000 and Rs.50,000 on December 31. The balance of land and
building account as on
December 31 is Rs.4,50,000. Find the sale proceeds.
Solution
Balance of land and building on Jan 1, 2007 5,00,000
LESS : Depreciation charged (30,000)
Sikkim Manipal University 193
LESS: Balance of Land and Building on Dec 31 ( 4,50,000)
Cost of Land sold 20,000
ADD : Profit on sale (derived from capital reserve)
30,000
(closing minus opening balance
2. Profit or loss on sale of fixed assets
____________________.
10.8 Increase In Liabilities
The increase in liabilities is always a source of funds for the
business. It may occur as a result of
many transactions such as equity share capital or / and debentures
to the public., purchase of
goods on credit. Outstanding expenses are also considered as source
of funds since payments
are postponed and cash saved is parked in the business. A
comparison of the amount of the
items of long term liabilities i.e debentures and mortgage and
other loans for the current year and
previous year will disclose the increase or decrease in the long
term liabilities. Additional
information should also be taken into account for determining the
correct amount of increase or
decrease for the purpose of this statement.
Any increase on account of the issue of debentures for
consideration other than cash or current
assets for the purchase of fixed assets or redeeming other
debentures or preference shares
would not at all be shown in the statement because in such a case
there is no flow of fund.
Self Assessment Questions 8
2. Outstanding expenses is __________________ .
10.9 Increase In Net-Worth
There can be only two main channels of increase in net-worth or
equity :
a) procurement of more funds by issue of additional shares
b) through accumulation of retained earnings or profits in
business
As the increased in owned funds is concerned, it happens only
when the business has plans for
expansion, diversification, modernization. The increase in paid-up
equity
Sikkim Manipal University 194
Share capital is not a regular feature. Its occurrence is only
sporadic. But profit generated from
operations is a normal feature and is virtually a continuous
process from year to year. Profit
earned during an operating period increases the new worth of the
business and hence it is
always considered as a source of funds. Sometimes, the premium
received on sale of equity
shares and credited to share premium account is also a source of
funds as it adds to the size of
net worth .
Share capital consists of equity share capital and preference share
capital. The change in equity
share capital is always in the form of increase it can never be in
the form of decrease. The
increase in equity share capital as per Balance Sheet values must
be adjusted in terms of
additional information. If the increase has taken place on account
of the issue of fresh shares,
only that portion of increase should be treated as sources which is
due to the issue of fresh
shares for cash and other current assets. Increase on account of
share issues for consideration
involving the purchase of fixed assets or redemption of preference
shares or debentures shall
not partake the character of inflow of funds and hence should not
be shown in the statement. If
fresh shares have been issued at premium, the amount of premium
must be added to the
increase in share capital for the purpose of showing it as source
of fund. If the fresh shares
have been issued at discount, the amount of discount must be
deducted from the increase in
share capital because it does not involve inflow of fund.
Example:
The opening and closing balance of Share capital are Rs.6,00,000
and Rs.9,50,000 respectively.
The Preference Share capital included in opening balance is
Rs.1,00,000. During the year,
Rs.75,000 worth of Preference shares were redeemed at 8 % premium.
Bonus shares at Re.1
for every five equity shares held . In addition, a business was
purchased by issue of Rs.90,000
shares at a premium of 10 %. The opening and closing balance in the
Premium Account is
Rs.8,00,000 and Rs.14,000 respectively. Calculate the further fresh
issue.
Solution:
Less: Redemption of Preference
Sikkim Manipal University 195
(1/5 of 6,00,000)
8,000 minus 9,000) 3,000
Self Assessment Questions 9
2. Increase in net worth is needed for
________________________.
3. Profit earned _________________________________ net worth.
4. Premium on shares is __________________________.
5. Change in equity shares is always ________________.
6. Decrease in preference share capital is
____________.
10.10 Sources Of Funds
The use of funds results in cash outflows. The outflows are known
as :application” of funds. The
uses of funds are mainly concerned with.
a) Redemption of Preference shares in cash derived from decrease in
share capital.
b) Redemption of debentures in cash derived from decrease in
debentures
c) Repayment of loan derived from decrease in long term loans
d) Purchase of fixed assets for consideration other than shares,
debentures or long term debt
derived from increase in fixed assets and additional
information.
e) Loss from operations
Self Assessment Questions 10
3. Redemption of debentures is __________________.
4. Redemption of long term loan is _______________.
5. Purchase of fixed asset is _____________________.
6. Loss from operations is ______________________.
Sikkim Manipal University 196
7. Payment of dividend is ______________________.
10. 11 Increase In Assets
The increase in fixed assets is known in the accounting language as
“Purchase of fixed assets”.
In order to find out the increase in fixed assets, cost of fixed
assets of previous year as reduced
by the cost of fixed assets sold during the current year is
deducted from the cost of fixed assets of
the current year. In other words, the increase in fixed assets is
calculated as under :
Cost of Current year fixed assets ………………
DEDUCT Cost of previous fixed assets ………..
LESS: Cost of fixed assets sold or
Written off during the
Current year (……….) (………………..)
INCREASE in fixed assets x x x x x x x
Example: The opening and closing written down balances of an
asset are Rs.5,00,000 and
Rs.5,50,000. The accumulated depreciation has been Rs.1,50,000 at
the beginning and
Rs.1,90,000 at the close. A machine costing Rs.30,000 (accumulated
depreciation Rs.18,000)
was sold during the year for Rs.9,500. Calculate the purchase price
of the fixed assets.
Solution
Depreciation : 5,50,000 + 1,90,000 7,40,000
Value + opening accumulated Depreciation
(6,20,000)
1,20,000
Sometimes, it may happen that the cost figures cannot be
ascertained on the basis of information
available. Increase in fixed assets, in this case, has to be found
out with reference to the written
down value along with annual depreciation. If no purchase of fixed
assets were made during
Sikkim Manipal University 197
should be equal to the values of the previous year minus annual
depreciation for current year.
The excess of current year’s value over previous year’s value minus
annual depreciation will be
treated as increase. This will represent the purchase of fixed
assets.
Current year written down value of Asset ……………..
DEDUCT Previous year WDV
_______________
Increase in Fixed Asset being Purchases x x x x x x
Example: The written down value of a Machinery at the
beginning and at close were Rs.2,00,000
and 1,75,000. An old machine whose written down value was Rs.12,000
was sold for Rs.6,500.
Rs.32,000 depreciation was charged during the current year.
Calculate the purchase price.
Solution:
DEDUCT : Previous year written down
Value of Machinery 2,00,000
1,68,000
(1,56,000)
2. Purchase is _______________________________________.
________________.
10.12 Decrease In Liabilities
It implies application which is the flow of funds out of business.
Decrease in liability may be done
due increase in one or more liability items or due to decrease in
one or more asset items. It may
also be partly due to increase in liability and partly due to
decrease in assets. . Any amount of
Sikkim Manipal University 198
account of redemption of debentures through the issue of another
debentures or preference
shares should also not be shown in the statement.
Example:
On January 1, 2007, the balance of 8 % Debentures Account stood at
Rs.5,00,000. Rs.60,000
debentures were repaid at 5 percent premium. Rs.75,000 debentures
were purchased at Rs.95
from the market and cancelled. The closing balance of debentures
was Rs. 2,00,000. Calculate
the outflow of funds.
LESS: Closing balance of Debenture Account ( 2,00,000)
Decrease 3,00,000
Value of Rs.100 each or 750 debentures x
Rs.5 each (Rs.100 minus Rs.95) ( 1,250)
2,98,750
Outflow of funds 3,01,750
Self Assessment Questions 12
2. Premium on redemption of debentures is _____________ .
10.13 Net Worth
It may be used due to (a) loss from operations (b) payment of cash
dividend out of accumulated
reserves and (c) return of a part of paid up share capital to
shareholders implying reduction of
share capital – a rare occurrence. If there is decrease in
preference share capital and this
decrease is on account of redemption of these shares in cash or
other current assets, such
decrease should be shown as use of fund. But the decrease on
account of redemption by the
issue of another preference shares or equity shares or debentures,
shall never be shown in the
statement because it will not involve outflow of fund. If the
preference shares have been
redeemed at a premium, necessary adjustments should be
made
Self Assessment Questions 13
Sikkim Manipal University 199
3. Net worth can be ________________________.
10.14 Flow of Funds
It refers to change in fund. Increase of funds of any transaction
is a source and decrease of
funds in any transaction is application or uses of funds. But the
transactions which do not result
in any change in the funds is called “Non-fund”. Flow of fund takes
place when a business
transaction brings a change in the working capital. Such change may
be increase or decrease.
The increase is a positive change and the decrease being the
negative. These directions in
change are known as fund elements or fund factors. They are
commonly known as “inflows” and
“outflows”. The basic rule is :
Flow of fund if a transaction involves :
a) Current assets and fixed assets that is machine sold for
cash
b) Current assets and fixed liabilities that is issue of debentures
to the public
c) Current assets and owner equity that is issue of shares for
cash
d) Current liabilities and fixed assets that is transfer of assets
to discharge a claim
e) Current liabilities and fixed liabilities that is conversion of
creditors due by issue of
debentures.
f) Current liabilities and capital that is conversion of creditors
into owner’s equity by issue of
equity shares.
5. Flow takes place due to __________________ working
capital.
6. The increase in fund is a __________________ change.
7. The decrease in fund is a __________________ change.
10.15 Transactions that do not affect the flow of Funds
a) Current assets and current liabilities creditors paid
b) Fixed assets and fixed liabilities purchase of assets for
debentures
Sikkim Manipal University 200
Self Assessment Questions 15
10.16 Steps In Preparation Of Funds Flow Statement
There are three steps involved in the preparation of a Fund Flow
Statement (FFS). They are as
follows:
a) Preparation of Statement of changes in working capital or
Schedule of changes in working
capital.
b) Preparation of Adjusted Profit and Loss Account (APL)
c) Statement of changes in Financial position as per AS –
7
Self Assessment Questions 16
2. Second step in the preparation of FFS is _____________.
3. Third step in the preparation of FFS is _______________.
10. 17 Computation of Changes in Working Capital and
Funds f rom Operations
It is a customary practice that only the net changes in working
capital should be shown in the
Fund Flow Statement instead of individual changes. Here, the
current assets and current
liabilities are considered. For this purpose, a separate statement
or schedule is being prepared.
Individual items are entered here. The opening and closing balances
are entered one after the
other. The corresponding increase or decrease are entered based on
the following rules :
a) Increase in a current asset item increases working
capital.
b) Decrease in a current asset item decreases working
capital.
c) Increase in a current liability item decreases working
capital.
d) Decrease in a current liability item increases working capital
.
Insert the total of current asset and current liabilities of both
opening and closing periods. Say,
the total of current assets as A and that of total of current
liabilities as B. Deduct A minus B. The
answer is known as net Working capital. If the working capital at
the end of the current year is
more than the working capital at the end of previous year, the
excess is called as “increase in
working capital”. Otherwise, if previous year’s working capital is
more than the current year’s
working capital, the difference is called as “Decrease in working
capital”. Increase in working
capital is shown as application of funds and decrease in working
capital as source of funds in the
Funds Flow Statement.
Sikkim Manipal University 201
The funds from operation can be found with the help of preparing an
Adjusted Profit and Loss
Account.
2. Working capital equation is _______________________.
3. A is total _____________________________________.
4. B is total ____________________________________.
5. Working capital is _____________________________.
10.18 Layout
The layout for schedule of changes in Working Capital is as follows
Balances as on Effect on
Details Last Current Increase Decrease
Year Year
CURRENT ASSETS
CURRENT LIABILITIES
Sundry Creditors
Bills Payable
Bank Overdraft
Outstanding expenses
NET WORKING CAPITAL
A minus B
Sikkim Manipal University 202
Jan 1 Dec 31
Bills Receivable 16,000 30,000
Prepare a schedule of changes in working capital
Sikkim Manipal University 203
Details Jan 1 Dec 31 Increase Decrease
Current Assets
Sundry Debtors 65,000 1,05,000 40,000
Bills Receivable 16,000 30,000 14,000
Inventory 90,000 84,000 – 6,000
Current Liabilities
Short term loans 32,000 36,000 – 4,000
Total Current Liabilities, B 1,10,000 1,49,000
Working Capital A minus B 89,000 1,10,000
Net Increase in working capital
(balancing figure) 21,000 21,000
Sikkim Manipal University 204
Example :
Prepare a statement of changes in working capital from the
following information.
Jan 1 Dec 31
Provision for Depreciation on Fixed Assets 22,000 27,000
Investments in shares of subsidiaries 15,000 15,000
8% Debentures (redeemable in 5 equal
annual instalment of Rs.20,000 each,
from the current year) 20,000 –
Prepaid expenses 21,000 14,000
Outstanding expenses 5,000 12,000
Solution
Details Balances as on Effect on WC
Jan 1 Dec 31 Increase Decrease
Current Assets
Sikkim Manipal University 205
59,000 39,000 3,000
Dr. Cr.
To By
Depreciation Provision last year from Balance
Preliminary expenses written Sheet
Goodwill written off Profit on sale of Fixed assets
Discount on issue of shares and Dividend and interest
received
Debentures written off from trade investments
Fixed assets discarded or
Loss on sale of trade investments TRADING OPERATIONS
Transfer to General Reserve, (balancing figure) transferred
to Funds Flow Statement as
Sinking Funds, Reserve Funds application of funds
Transfer to other Reserves
Premium on redemption of
Year Profit and Loss Account
TOTAL
Sikkim Manipal University 206
NOTE : If debit total of APL is more than the credit total,
the difference is Funds generated from
Operation : Record on the credit side of Adjusted Profit and Loss
Account.
If credit total of APL is more than the debit total, the difference
is funds lost in operations. Record
on the debit side of Adjusted Profit and Loss Account
The balancing figures should be transferred in opposite
direction to Funds Flow statement..
Example 3: Calculate funds from operations from the following
Profit and Loss Account
To By
Outstanding
Loss on sale of machine 4,000
Discount 200
Goodwill 20,000
To Rs. By Rs.
Discount written off 200 (balancing figure)
Loss on sale of machines 4,000
Net Profit 1,15,800
2,10,000 2,10,000
Example 4: Following are the extracts from the Balance sheets
of DR Lt.
31-3-2007 31-3-2008
Rs. Rs.
General Reserve 7,400 9,250
Preliminary expenses 2,200 1,500
Sikkim Manipal University 207
During the year, the company sold land whose book value was
Rs.50,000 for Rs.54,000 and paid
an interim dividend of Rs.2,000
Calculate funds from operations.
To Rs By Rs.
(9,250 minus 7,400) 1,850 being opening balance
Goodwill written off Profit on sale of land 4,000
(3,700 minus 1.850) 1,850
Depreciation written operations (balancing
Off 700 figure) 6,800
Interim dividend paid 2,000
Closing balance of Profit
And Loss account 14,800
NOTES:
1. There is an increase in the balance in General Reserve. It
implies that some amount has
been transferred to the account from the Profit and Loss account.
This is an appropriation of
profit which does not result in any outflow of funds.
2. The balance in Goodwill Account and preliminary expenses account
has come down which
indicates tht the difference has been written. This also does not
result in an outflow of funds.
3. The increase in provision for depreciation is on account of
current year’s depreciation which
does not result in any outflow of funds.
4. Profit on sale of land and interim dividend being non-operating
items are to be separately
Sikkim Manipal University 208
Opening balance of Plant Rs.1,32,500. Closing balance of Plant
Rs.1,97,500. Provision for
Depreciation in Plant at the beginning 45,000 and at close
Rs.61,000. During the year
Rs.65,000 worth of Plant was purchased in exchange for fully paid
debentures and old Plant
costing Rs.40,000 was sold for Rs.34,000. Depreciation provided
Rs.18,000. Calculate the flow
of funds.
Debenture Account 65,000 Provision for Depreciation
(Plant purchased) Account : Depreciation on
sold 18,000
Bank Account : Plant
Calculation of Profit on sale : 34,000 minus (40,000 – 18,000) =
12,000
Provision for Depreciation on Plant Account
To By
Plant Account
Closing Balance 61,000 Depreciation (bal.figure 34,000
79,000 79,000
Note: For all Asset Account, record the opening balance on the
debit side and closing balance on
the credit side of the concerned Asset Account. For all liabilities
, record the opening balance on
Sikkim Manipal University 209
10.19 TREATMENT OF CERTAIN ITEMS
There are certain items whose treatment is not uniform. Different
authors differ differently. But,
in this study material, an uniformity is maintained. The likely
arguments have been provided for
treating items on a particular principle. The items are
:
Provision for Bad Debts
Sometimes, it is shown as reserve for bad / doubtful debts.
Actually, this item is shown as
deduction from total book debts to the asset side of the Balance
Sheet. Therefore, this item
should be deducted from the amount of debtors shown in the schedule
of working capital
changes. Since such treatment may complicate the calculation work,
it is suggested that it should
be shown along with current liabilities, although, it does not
belong to that category.
Provision for Tax:
DO not treat this item as a current liability. The Provision has to
be made to meet the tax liability
of current year. If there is a Provision for last year, it has to
be paid this year. Hence, the last
year Provision actually becomes the current year cash outflow.
Hence record it in the Funds flow
statement.
Proposed Dividend
Normally, the proposed dividends are given as Balance Sheet item on
the liability side. The
Directors propose the final dividend which needs to be approved by
the General Meeting. Hence,
it is fair to assume that the proposed dividend is not
a current liability. Do not show in the
schedule of working capital changes. The last year proposed
dividend should be paid during the
current year, hence a cash outflow
Investments
It poses problems in its treatment. The Rule is :
a) if the investments are in the form of Government or other
marketable securities, treat it as
current assets.
b) If it is mentioned as trade investments, that is investments in
shares and debentures of
another companies, treat it as fixed assets.
c) If nothing is mentioned specifically, the
treatment is :
: if investments have been sold simultaneously, treat it as
current assets
: in other cases, treat it as Fixed Assets.
Sikkim Manipal University 210
Depreciation
Normally, the value of deprecation will be provided in the problem
as an adjustment items.
Depreciation is a non cash item. It is, therefore,
charged to Profit and Loss and recorded in the
concerned Fixed Assets Account. If the depreciation is given as
a percentage, calculate the
value on the opening balance of the concerned account..
If the value of depreciation is not
given, it has to be found out as follows :
Opening balance of Fixed Assets ……..
ADD: Purchases …….
Depreciation charges x x x
If a concern intends to show its fixed assets at its cost price,
the periodic annual depreciation is
shown under “liabilities” side as Provision for Depreciation
commonly known as Accumulated
Depreciation Fund Account. If there were to be an Accumulated
Depreciation Fund Account in
already in operation, the current year depreciation is charged
against this Provision for
accumulated Depreciation Account and not recorded directly into
Adjusted Profit and Loss
Account . In other words, the current year depreciation is
routed through the Provision Account.
Increase / Decrease in Fixed Assets
The increase or decrease by means of cash is recorded in the FFS.
Increase or decrease due to
purchase consideration through shares and debentures are not
recorded.
Increase / Decrease in long-term liabilities
Compare debentures and mortgages as per the Balance Sheet figures.
Only consider if cash is
the main striker to cause the increase or decrease. If the changes
were to be due to
consideration other than cash or current assets, do not record it
in the FFS..
Hidden Items
Prepare the necessary ledger accounts concerned in the fixed
assets, fixed liabilities and share
capital and carry out all the necessary adjustments. The balancing
figure, if any, would be the
cash transactions. For all non, cash transactions, concentrate on
the Adjusted Profit and Loss
Account.
Sikkim Manipal University 211
Self Assessment Questions 18
2. Provision for doubtful debts is _______________ from gross
debtors
3. Provision is shown in _______________________
4. Provision for tax may be _____________________
5. If Provision for Tax is maintained , treat it in
_________________
6. Proposed dividend is shown on ________________ of Balance
sheet
7. Proposed dividends are to be approved by
_____________________
8. Proposed divided. Is not considered as
________________________
9. Last year proposed dividend is cash
__________________________
10. Government investments are
_______________________________
12. Depreciation is _____________________
14. If Depreciation is given as a percentage, calculate on
_____________
15. If Provision for depreciation account is maintained, charge the
current depreciation to
_____________ and not to _______________________
Problem 6: The Balance Sheets are given below :
Year (Rs.in lakhs)
Debentures 10 -
Sikkim Manipal University 212
2006 2007
Working Capital : CA minus CL 80 110
Net Increase in working capital transferred to 30 -
FFS (application)
110 110
To By
Closing Balance 30 Funds from Operations 6
36 36
Issue of Equity shares 60 Purchase of Fixed Assets 16
Funds from operation 6 Purchase of investment 10
Redemption of debenture 10
66 66
Sikkim Manipal University 213
Problem 7 : From the following extracts, calculate funds from
operations
Year
Proposed dividends 5,000 10,000
Additional information: Tax paid Rs.2,500. Dividends paid
Rs.1,000.. Calculate funds from
operation taking provision for tax and provision for tax and
proposed dividend as (a) non current
liabilities and (b) current liabilities.
Solution:
Provision for tax and proposed dividend are taken as non-current
liabilities
To By
Closing balance 15,000 provision made (balance
Figure)
Dividend paid during the Profit and loss account
Year 1,000 proposed dividend 6,000
Closing balance 10,000
Sikkim Manipal University 214
To By
Proposed Dividend 6,000 Funds from operations
Closing balance 80,000 (balancing figure) 43,500
93,500 93,500
c) If Provision of tax and proposed dividend are taken as a current
liability, funds from
operations will be the difference in Profit and Loss account at the
beginning and the end of
the year.
NOTES
1. In case a) Income tax paid Rs.2,500 and Dividend paid Rs.1,000
are shown as application of
funds in the FFS.
2. In case (b), there is no need to prepare proposed dividend
account and provision for tax
account,. However, the opening and closing balances of the two
accounts are shown as
current liabilities in the statement of changes in working capital
Problem 8: The book value of trade investments of DR Ltd as
on March 1, 2006 and March 31,
2007 was Rs.50,000 and Rs.70,000 respectively. During the year,
Rs.5,000 was received as
dividends, of which Rs.2,000 pertained to pre-acquisition profits
which have been credited to
Investments Account. Investments costing Rs.10,000 have been sold
during the year for
Rs.10,000. Find the flow of funds on account of
investments.
Solution:
Of investments (balance 32,000 Bank : sale of investments
10,000
Closing balance 70,000
Sikkim Manipal University 215
Notes:
1) The investments purchased were valued cum-dividend. Hence, on
receipt of dividends, they
were rightly credited to Investments. Hence there is no need for
any further adjustment.
2) The investments sold has been at the book value. There is no
profit or loss on account of the
transactions. If the transaction had resulted in profit, it will
have to be deducted from net profit
to calculate funds from operations. In case of loss, it would be
added to net profit to calculate
funds from operations.
Problem 9: Prepare a fun d flow statement of DR Ltd.
Year
11 % debentures 8,00,000 6,00,000
Share Premium Account 1,00,000 95,000
Additional information (a) 10 % Preference shares have been
redeemed at a premium of 10%,
the premium amount was charged to the share premium account (b)
There has been a profit of
Rs.1,000 on the redemption of debentures.
Solution:
Bank (Fresh issue) 5,00,000
Premium on redemption 30,000
Sikkim Manipal University 216
Profit on redemption 1,000
capital
1,25,000 1,25,000
Equity share capital 5,00,000 Redemption of Preference shares
3,30,000
Share Premium 25,000 Redemption of Debentures 1,99,000
Decrease in working capital 4,000
5,29,000 5,29,000
Problem 10: The following are the summarized Balance Sheets of
DR Ltd.
Liabilities 2006 2007
Debentures 3,00,000 2,50,000
Provision for Income tax 60,000 80,000
12,20,000 12,20,000
Sikkim Manipal University 217
2006 2007 Increase Decrease
Cash 1,00,000 75,000 - 25,000 .
Current Liabilities
Provision for income tax 60,000 80,000 - 20,000
Total CL, say B 2,30,000 2,40,000
Working Capital, A – B 3,60,000 4,35,000
Increase in Working capital 75,000 - - 75,000
Total 4,35,000 4,35,000 1,40,000 1,40,000
Adjusted Profit and Loss Account
To By
Depreciation 90,000 Funds from Operation 1.45,000
Closing balance 65,000 transferred to source
1,85,000 1,85,000
Sikkim Manipal University 218
Sources Application
Increase in working capital 75,000
2,45,000 2,45,000
Notes:
1) The increase in General Reserve is due to transfer a part of
profit of the current year and
hence the difference is transferred to APL since it’s a non-cash
item
2) The difference in depreciation is charged to APL, since it’s a
non-cash item.
3) Increase in Equity Share capital is assumed to be the fresh
issue which is a cash item. It is
recoreded in FFS.
4) The difference is debentures is the redemption. It’s a cash
item. Hence taken to FFS
5) Purchase of fixed asset is difference between the opening and
closing balance of fixed
assets. It’s a cash item. Hence taken to FFS .
Problem 11
Balance Sheets
Profit & Loss 14,750 17,000 Debtors 25,000 27,000
Trade Creditors 31,000 29,000 Investment 5,000 -
Mortgage 10,000 15,000 Fixed Assets 70,000 80,000
Short term loans 16,500 15,000 Less: Depreciation (25,250)
(7,000)
Accrued expenses 7,500 8,000 Goodwill 5,000 -
1,29,750 1,49,000 1,29,750 1,49,000
Sikkim Manipal University 219
Balances as on
Current Liabilities
Accrued expenses 8,000 7,500
Working capital, A – B 20,000 24,000
Net increase in Working capital 4,000 -
Total 24,000 24,000
To By
Dividend 3,500 operations 12,500
Sikkim Manipal University 220
Issue of fresh equity 15,000 Purchase of fixed assets 30,000
Sale of investment 5,000 Payments of dividends 3,500
Loan on mortgage 5,000 Increase in working capital 4,000
Funds from operations 12,500
Rupees in 000s
Debenture - 25 Plant 18 96
Profit and Loss 15 25 Stock 40 35
Proposed Dividend 5 6 Debtors 15 32.5
Creditors 20 30 Cash 8 9
Liabilities for expenses 5 3.5 Preliminary exp 4 2.5
100 200 100 200
A business was purchased during the year by the issue of
25,000 shares and 25,000 debentures.
Depreciation Rs.6,000 has been provided in the year. A machine has
been sold for Rs.1,50,000,
the written down value being Rs.1,000. The business purchased had
the following assets and
liabilities : Machine Rs.20,000, Stock Rs.5,000, Debtors Rs.15,000,
Creditors Rs.5,000. Prepare
the Funds Flow Statement.
Solution
In this problem, another business concern was purchased whereby the
assets and liabilities come
into business. For this purchase, the payment is through the issue
of shares and debentures. If
the payment were to be in excess of assets and liabilities taken
over, the excess payment is
known as “Goodwill”.
Sikkim Manipal University 221
Stock 5,000
Debtors 15,000
Total payments made : Share capital + Debentures 50,000
Excess payment being treated as Goodwill (50,000-35,000)
15,000
Statement showing changes in working capital:
Balances as on
Current Liabilities
Overdraft 5,000 10,500
Working capital A – B 33,000 32,500
Decrease in working capital (source) - 500
33,000 33,000
Sikkim Manipal University 222
To By
Preliminary expenses 1,500 Profit on sale of Plant 500
Depreciation 6,000 Funds from operations 28,000
Proposed dividend 6,000
Closing balance 25,000
cash for current assets
Funds from operations 28,000
Capital 500
70,000 70,000
Terminal Question
Problem 1: The balance in the Provision for taxation : opening
Rs.30,000 and closing
Rs.40,000. Taxes paid during the year was Rs.25,000. Calculate
Funds from operation. (b) What
is the provision made during the year?
Sikkim Manipal University 223
2006 2007
General Reserve 20,000 25,000
Calculate funds from operation
Profit and Loss Account
Depreciation 70,000 Gain on sale of land 60,000
Loss on sale of plant 4,000
Discount on Debenture 200
Plant (gross) 1,00,000 1,25,000
b) Depreciation charged - 14,000
Sikkim Manipal University 224
Capital 25,000 20,000 Cash 4,700 3,000
Profit and Loss 2,300 1,000 Debtors 11,500 12,000
Bills Payable 4,500 7,000 Land 6,600 5,000
Stock 9,000 8,000
Answer Self Assessment Questions
Self Assessment Questions 1
2. Two
Self Assessment Questions 2
2. Control
4. Current assets minus current liabilities
5. Excluded
8. Qualitative information
Self Assessment Questions 4
1. Financial assets and liabilities including capital
Sikkim Manipal University 225
4. Increases
5. Decreases
6. Decreases
7. Increases
4. Non fund revenue, non trading changes or losses
5. intangible assets and revenue items
6. Appropriation of retained earnings.
Self Assessment Questions 6
Self Assessment Questions 8
1. Source of funds
2. Source of funds
Self Assessment Questions 9
2. Expansion, diversification and modernization
Sikkim Manipal University 226
6. Redemption
3. Increase in fixed assets
Self Assessment Questions 12
Self Assessment Questions 14
1. Change of fund
Sikkim Manipal University 227
Self Assessment Questions 16
2. Adjusted Profit and Loss account
3. Funds flow statement
Self Assessment Questions 17
3. (c) Current assets
5. In Provision account
Sikkim Manipal University 228
15. Provision account and not to Profit and Loss account
16. Fixed assets
1: 35,000, (b) Taxes paid is an application of funds.
2. Rs.24,000
3. Rs.1,50,000
Sikkim Manipal University 229
Structure:
Self Assessment Questions 5
11.1 Introduction
The funds flow analysis deal with the flow of funds within and
outside the organization. The main
focus of funds flow statement is to explain the changes which have
taken place in net working
capital during the period under consideration. Funds flow statement
normally fails to explain the
changes in cash balance. The movement of cash is of vital
importance to the management. The
organization may become directionless if the cash inflows are not
sufficient to meet the cash
outflows. Many a time, a management is posed with the paradox of
huge profits and yet
impossible to pay dividends or even taxes. This is due to the
ground realities that cash is either
not received or the cash received is drained out in other items.
Hence, it has become a
necessity to have a cash flow analysis on a day to day basis. The
statement shows the items
resulting in cash inflows and cash outflows.
Sikkim Manipal University 230
Learning Objectives:
After studying this unit, you should be able to understand
the following
1. Understand the meaning of cash flow statement.
2. Appreciate the uses of cash flow statement.
3. Acquaint with steps in preparation of CFS.
4. Distinguish between FFS and CFS.
5. Compute the CFS.
11.2 Meaning of Cash Flow Statement
Cash flow statement, also known as “Statement Accounting for
variations in cash” shows the
movement of cash and their causes during the period under
consideration. The statement is
mainly prepared to show the impact of financial policies and
procedures on the cash position. It
takes into account all the transactions that have a direct impact
upon cash.
Self Assessment Questions 1
11.3 Objectives
The main objective of cash flow analysis is to show the causes of
changes in cash balances
during the period under consideration. The necessary information
required to keep the
management of the real cash position, this statement is comes
handy. It bring in the liquidity
position of the firm. It is of particular importance in short range
planning. It enables a
management to take a strong short term financial decision relating
to liquidity and ways and
means to achieve it.
Self Assessment Questions 2
2. CFS brings in ___________________ position.
3. CFS is ________________ of importance in ________ planning.
11.4 Uses of Cash Flow Statement
The cash flow statement, being one of the important financial
documents a firm has to possess ,
Sikkim Manipal University 231
It also shows the major sources and uses of cash. By effectively
maintaining the cash and
controlling the outflow of cash, it is possible to set in motion
the smooth functioning of the
organization. It helps the financial decisions more effectively
with regard to short term liquidity
position of an organization. Projections of cash inflows and
outflows can be regulated based on
the records available in the past. Proper projections can be made
once the reasons are
analyzed. Based on this, it is possible to liquidate the short term
obligations without much fun-
fare. Short term obligations need to be serviced so that the credit
worthiness of an organization
can be carried on unabated.
Self Assessment Questions 3
2. CFS shows _________ flows.
11.5 Steps In Preparation Of Cash Fl