Accounting for Managers: Assignment

Section A

Q.1. Bank reconciliation Statement as an 31 March 1979 Dr Cr Balance per cash cash book 180 0001. Cheque issued but not presented for payment:

A 2500B 4500C 4000 11000

2.Interest allowed by banks 2500

193 500.00Less cheque sent to bank:

P 2500Q 3500R 1900

4900

Cheque entered into cash book 1000Interest changed by bank 1000

6 900

Balance as per bank pass book 186600

Section C

Q.1. What is accounting? What are its objectives and limitations?

Accounting is the recording of financial transactions plus storing, sorting, retrieving, summarizing, and presenting the information in various reports and analyses. Accounting is also a profession consisting of individuals having the formal education to carry out these tasks.

One part of accounting focuses on presenting the information in the form of general-purpose financial statements (balance sheet, income statement, etc.) to people outside of the company. These external reports must be prepared in accordance with generally accepted accounting principles often referred to as GAAP or US GAAP. This part of accounting is referred to as financial accounting.

Accounting also entails providing a company's management with the information it needs to keep the business financially healthy. These analyses and reports are not distributed outside of the company. Some of the information will originate from the recorded transactions but some of the information will be estimates and projections based on various assumptions. Three examples of internal analyses and reports are budgets, standards for controlling operations, and estimating selling prices for quoting new jobs. This area of accounting is known as management accounting.

Another part of accounting involves compliance with government regulations pertaining to income tax reporting.

Today much of the recording, storing, and sorting aspects of accounting have been automated as a result of the advances in computer technology.

Objectives of Accounting

The broad objects of Accounting may be briefly stated follows:

1. To maintain the cash accounts through the Cash Book and to find out the Cash balance on any particular day.

2. To maintain various other Journals for recording day-to –day non –cash transactions.

3. To maintain various Ledger Accounts to find out the exact amounts of incomesand expenses or gain and losses or receivables and payables.

4. To furnish information regarding Purchases and Sales, both Cash and Credit.5. To find out the net profit or net loss or surplus or deficit for any particular period.6. To find out the total capital on a particular date.7. To find out the positions of assets on a particular date.8. To find out the position of liabilities on a particular date.9. To detect any defalcations and to check the frauds and misappropriations of

money.10. To detect the various errors and to rectify those through entries in the journal

proper.11. To confirm about the arithmetical accuracy of the books of accounts.12. To help the management by supplying accounting ratios, reports and relevant

data.13 To calculate the cost of productions.14. To help the management formulate policies for controlling cost, preparation of

quotation for competitive supply etc.

1. Accounting records only those transactions which can be measured in monetary

terms.

2. Accounting transactions are recorded at cost in the books. The effect of price level

changes is not brought into the books with the result that comparison of the various

years becomes difficult. For example, the sale to total asset in 2009 would be much

higher than in 2002 due to rising prices , fixed assets being shown at the cost and not

at market price.

3. Accounting statements are prepared by following basic concepts and conventions.

Therefore the accounting information may not be realistic.

4. Accountant may select any method of depreciation, valuation of stock, amortization of

fixed assets, and treatment of deferred revenue expenditure. Therefore

accounting statements are influenced by the personal judgment of the accountant.

Q.2 . Distinguish between Book-keeping and Accounting.

Bookkeeping: Literally, it means the activity of keeping (or maintaining) books. The books referred to, in this context, are the books of accounts. This involves extensive data input. A few activities under book-keeping are:

1. Input of invoice and voucher details into the ERP system.2. Receiving and recording payments by customers.3. Making and recording payments to vendors.4. Efficiently processing payroll information, etc.

Accounting:  Accounting, on the other hand, is the process which includes recording, classifying, summarizing and interpreting the financial information of an economic unit. The economic unit is considered as a separate legal entity. Accounting information is widely used by various types of parties for several different reasons. A few activities under accounting are:

1. Preparation of a trial balance, ledger accounts, etc.2. Preparation of financial statements.3. Analysis of financial data.

Q.3. Explain briefly the meaning of 'financial transactions.

A financial transaction is an agreement, communication, or movement carried out between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals. The buyer and seller are separate entities or objects, often involving the exchange of items of value, such as information, goods, services, and money. It is still a transaction if the goods are exchanged at one time, and the money at another. This is known as a two-part transaction: part one is giving the money, part two is receiving the goods.

Q.4. Distinguish fixed assets and floating assets

Fixed assets, also known as tangible assets[1] or property, plant, and

equipment (PP&E), is a term used in accounting forassets and property that cannot

easily be converted into cash. This can be compared with current assets such as cash

or bank accounts, which are described as liquid assets. In most cases, only tangible

assets are referred to as fixed.

IAS 16 (International Accounting Standard) defines Fixed Assets as assets whose

future economic benefit is probable to flow into the entity, whose cost can be measured

reliably.

Moreover, a fixed/non-current asset can also be defined as an asset not directly sold to

a firm's consumers/end-users. As an example, a baking firm's current assets would be

its inventory (in this case, flour, yeast, etc.), the value of sales owed to the firm via credit

(i.e. debtors or accounts receivable), cash held in the bank, etc. Its non-current assets

would be the oven used to bake bread, motor vehicles used to transport deliveries, cash

registers used to handle cash payments, etc. While these non-current assets have

value, they are not directly sold to consumers and cannot be easily converted to cash.

These are items of value that the organization has bought and will use for an extended

period of time; fixed assets normally include items such as land and buildings, motor

vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and

machinery. These often receive favorable tax treatment (depreciation allowance) over

short-term assets.

It is pertinent to note that the cost of a fixed asset is its purchase price, including import

duties and other deductible trade discounts and rebates. In addition, cost attributable to

bringing and installing the asset in its needed location and the initial estimate of

dismantling and removing the item if they are eventually no longer needed on the

location.

The primary objective of a business entity is to make profit and increase the wealth of its

owners.  In the attainment of this objective it is required that the management will

exercise due care and diligence in applying the basic accounting concept of “Matching

Concept”. Matching concept is simply matching the expenses of a period against the

revenues of the same period.

The use of assets in the generation of revenue is usually more than a year, i.e. long

term. It is therefore obligatory that in order to accurately determine the net income or

profit for a period depreciation is charged on the total value of asset that contributed to

the revenue for the period in consideration and charge against the same revenue of the

same period. This is essential in the prudent reporting of the net revenue for the entity in

the period.

Net book value of an asset is basically the difference between the historical cost of that

asset and its associated depreciation. From the foregoing, it is apparent that in order to

report a true and fair position of the financial jurisprudence of an entity it is relatable to

record and report the value of fixed assets at its net book value. Apart from the fact that

it is enshrined in Standard Accounting Statement (SAS) 3 and IAS 16 that value of

asset should be carried at the net book value, it is the best way of consciously

presenting the value of assets to the owners of the business and potential investor.

Floating Asset that is continually changing in quantity and/or value, such as amount of accounts receivable, cash, inventory, outstanding shares.

Q.5.Write notes on creditors for goods.

A credit note is a document which is sent by the seller to the buyer to correct an

undercharge. A credit note or credit memorandum (memo) is a commercial document

issued by a seller to a buyer. The seller usually issues a credit memo for the same or

lower amount than the invoice, and then repays the money to the buyer or sets it off

against a balance due from other transactions.

It can also be a document from a bank to a depositor to indicate the depositor's balance

is being in event other than a deposit, such as the collection by the bank of the

depositor's note receivable.

A credit note lists the products, quantities and agreed prices for products or services the

seller provided the buyer, but the buyer returned or did not receive. It may be issued in

the case of damaged goods, errors or allowances. In respect of the previously issued

invoice, a Credit Memo will reduce or eliminate the amount the buyer has to

pay. Note: A Credit Memo is not to be substituted as a formal document. The Credit

Memo rarely contains: PO #, Date, Billing Address, Shipping Address, Terms of

Payment, List of products with quantities and prices. Usually it references the original

Invoice and sometimes states the reason for issue.

This is received if the goods are incomplete, damaged, or incorrect; customers may also

receive one if they paid too much money, or if they had been overcharged.

Buyer to purchase an item or service from that seller on a future date, i.e. a gift card or

store card credit. Credit notes may be issued by a seller as a goodwill gesture to a

buyer who wishes to return previously purchased merchandise (instead of cash

repayment) in circumstances where the original sales agreement did not include an

explicit refund policy for returned items. In such circumstances, a credit note of value

equal to the price of the returned item is usually issued allowing the buyer to exchange

his purchase for other items available with the sale.

Q. 6 What do you mean by material facts in accounting?

Material facts are documents pertaining to the historical events of the facts being

justified.  Material facts in accounting means those facts that involves material amount

and which may affect the financial statements to a great extend and hence needed to

be disclosed in the company’s financial statement.

Material facts in accounting means those facts that involves material amount and which

may affect the financial statements to a great extend and hence needed to be disclosed

in the company’s financial statement.

Material facts means the vouchers, Bills and any relevant document like Invoices, Bills of Lading, Debit and Credit Notes, Receipts, etc., on the basis of which the accounts books prepared and get audited.

Q.7. Explain the term ‘Dual Aspects’ briefly.

This state that there are two aspects of accounting, one represented by the assets of the business and the other by the claims against them. The concept states that these two aspects are always equal to each other. In other words, this is the alternate form of the accounting equation:Assets=Liabilities+CapitalDual aspect concept is known as "Double Entry Book Keeping System".

This concept is the basis of the fundamental accounting equation:

Assets = Liabilities + EquityAssets are what the company owns.Liabilities are what the company owes to creditors against those assets.

Equity is the difference between the two and represents what the company owes to its investors/owners.All accounting transactions must keep this equation balanced so when there is an increase on one side there must be an equal increase on the other side or an equal decrease on the same side.

Objectivity: The objectivity concept states that accounting will be recorded on the basis of objective evidence (invoices, receipts, bank statement, etc…). This means that accounting records will initiate from a source document and that the information recorded is based on fact and not personal opinion.

Q.8. Differentiate between gross income and net income.

No matter what the context, gross numbers are always used in the calculation of net numbers. For business accounting, gross income includes all revenue that a company earns over the course of the year. Gross income incorporates all cash, checks, credit charges, rents, interest earned and dividends, among others. Net income calculations start with gross income before subtracting business expenses. Business expenses can

be broken down in several ways, including cost of goods sold, operating expenses, interest paid, repairs and maintenance, etc.

Gross Income

Gross income is one of the most simple and fundamental numbers when analyzing a company and its revenue potential. Like many simple financial numbers, gross income is most useful when put into context based on the industry in question as gross income can vary greatly between industries. Gross income is sometimes called gross profit or gross margin. In some circumstances, gross income is represented as total revenue less cost of goods sold.

Net Income

Net income is another simple indicator and is used to analyze the overall financial health of a company. Net income usually requires two critical pieces of context: industry knowledge and individual company net income trends based on past performance. In short, you want to see net income increase over time and be relatively high compared to competitor firms.

Q.9. What is the meaning of double entry Accounting?

Double entry means that every transaction will involve at least two accounts. For example, if your company borrows money from the bank, the company's asset Cash is increased and the company's liability Notes Payable is increased. If your company pays the six-month insurance premium, your company's asset Cash is decreased and its asset Prepaid Insurance is increased. If an employee works for hourly wages, the company's account Wages Expense is increased and its liability account Wages Payable is increased. When the employee is paid, the account Wages Payable is decreased and Cash is decreased.

Double entry also requires that one account be debited and the other account be credited. Accounting software might record the effect on one account automatically and only require information on the other account. For example, if you are preparing a check, the software will automatically reduce the Cash account. Therefore, the accounting software needs only to prompt you for information on the other account involved in the payment being processed.

Q.10. What do you understand by Money Measurement Concept?

Accounting concept stands on 4 basic ones and money measurement concept is one of them. money measurement concept state-

“ Any transaction which can be measured in monetary value and are relevant to business transactions, will be recorded and anything otherwise will be left out of the records.”Now, the words in the definition of money measurement concept are going to be defined to make you understand the meaning of the definition:

Any exchange/sacrifice of resources, which has a monetary value, of the business to

get any benefit or, relevant to business opportunity, is called a transaction.

Now, as transaction is defined it is evident that monetary evaluation is a must for any sacrifice to be a transaction. Now, if an entity sacks one of their employees who they used to pay a salary of $10000, should the sack be a transaction?

The clear answer is NO. If the entity pays the employee some salary then the payment of salary will be a transaction otherwise it is nothing of any sort.Keep in mind that, even if the transaction is with invisible money even then this will be recorded as transaction.

Money measurement concept example:

Entity decides to set the asset at hand at a rate of 10% per annum for depreciation A portion of 2.5% is deemed to be uncollectible from this year’s sales/debtors

In both the cases there is an amount behind these but, the resultant amount should be calculated. See, the calculated amount is derived and deducted from the real ones, moreover, the amount calculated is based on assumption not some real figures. But, learn from here that any assumption based calculation is allowed as long as that is within the premises of the accounting rules. If the valuation is done by a professional accountant and that is permitted, then there is no problem.Note that, such a sacrifice gives you sacrificed amounts to the relevant accounts and though no monetary sacrifice is traced, transaction should be recorded.

Q.11. Explain the convention of consistency.

The convention of consistency is a principle that the same management accounting

principles should be used for preparing financial statements over a number of time

periods. It enables the management to draw important conclusions regarding the

working of the concern over a longer period. It allows a comparison in the performance

of different periods. If different accounting procedures and processes are used for

preparing financial statements of different years then the results will not be comparable

because these will be based on different postulates.

The concept of consistency does not mean that no change should be made in

accounting procedures. There should always be a scope for improvement but the

changes should be notified in the statements. The impact of changes of procedures

should be clearly stated. It will enable the readers to analyze information according to

new procedures. In the absence of any information regarding the change, it will be

presumed that old methods have been used this time also. Whenever, consistency is

not followed this fact may be fully disclosed. For example, if a change in the method of

charging depreciation is made or a change is made in the method of allocating

overhead expenses to different products, a foot note to the financial statements should

be given indicating the extent of change. If possible, net monetary effect of these

changes should also be given. Consistency may be of three types:

1. Vertical consistency

2. Horizontal consistency

3. Third dimensional consistency

The vertical consistency is maintained within inter-related financial statements of the

same period. If a change has been made in dealing with two aspects of the same

statement then it will be vertical inconsistency. For example, if one method of

depreciation is used while preparing profit and loss account and another method is

followed while preparing balance sheet, it will be a case of vertical inconsistency. When

figures of one financial year are compared with the figures of another financial year of

the same organization it will be a case of horizontal consistency. Third dimensional

consistency will arise when financial statements of two different organizations, in the

same industry, are compared.

Q.12. Explain the meaning of expenses. Also differentiate between direct and indirect

expenses.

Expenses: Money spent or cost incurred in an organization's efforts to generate revenue, representing the cost of doing business.

Expenses may be in the form of actual cash payments (such as wages and salaries), a computed expired portion (depreciation) of an asset, or an amount taken out of earnings (such as bad debts). Expenses are summarized and charged in the income statement as deductions from the income before assessing income tax. Whereas all expenses are costs, not all costs (such as those incurred in acquisition of income generating assets) are expenses

An expense is a cost that occurs as part of a company's operating activities during a specified accounting period. A retailer will likely incur the following expenses: the cost of goods sold, commissions earned by the sales staff, rent for the retail space, the cost of the electricity used, advertising that took place, wages and salaries that were incurred, etc.Under the accrual method of accounting, an expense is reported on the income

statement for the period when 1) the cost best matches the related revenues, 2) the cost is used up or expires, or 3) there is uncertainty or difficulty in measuring the future benefit.

Expenses are often divided into two major classifications: operating and non operating. Operating expenses involve a company's main activities.

For example, a retailer's operating expenses include 1) The cost of goods sold, and 2) The selling, general and administrative (SG&A) expenses.

The company may further sort these expenses by department, product line, and so on. A retailer's non operating expenses pertain to its incidental activities. A common non operating expense for a retailer is interest expense.

Direct Expenses:  Direct expenses are those expenses that are paid only for the business part of your home.  For example, if you pay for painting or repairs only in the area used for business, this would be a direct expense. 

Indirect Expenses:  Indirect Expenses are those expenses that are paid for keeping up and running your entire home.  Examples of indirect expenses generally include insurance, utilities, and general home repairs.  Since these are expenses you would pay for the entire home, these are considered indirect expenses. 

Note:  If you paid one of these separately and specifically for the part of your home you are using for business, these could be considered "direct expenses".  For example, if you paid separate utilities that were specifically for your home office, this could be considered a direct expense.  If any part of that bill included utilities for the whole house, though, that would be an indirect expense.

Q.13. What is balance sheet?

A condensed statement that shows the financial position of an entity on a specified date (usually the last day of an accounting period).

Among other items of information, a balance sheet states (1) What assets the entity owns, (2) How it paid for them, (3) What it owes (its liabilities), and (4) What is the amount left after satisfying the liabilities?

Balance sheet data is based on a fundamental accounting equation (assets = liabilities + owners' equity), and is classified under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities.

With income statement and cash flow statement, it comprises the set

of documents indispensable in running a business. An audited balance sheet is often

demanded by investors, lenders, suppliers, and taxation authorities; and is

usually required by law. To be considered valid, a balance sheet must give a true and

fair view of an organization's state of affairs, and must follow the provisions of GAAP in

its preparation. Also called statement of condition, statement of financial condition, or

statement of financial position.

Q.14. What do you understand by trial balance.

At the end of an accounting period, after all the journal entries have been made, accounting professionals create what's called a trial balance. A trial balance is a list of all the accounts of a business and their balances. Since each business account falls into one of three major categories - asset, liability or owner's equity - they each have what's called a normal balance. Asset accounts are those accounts that are related to items that the business owns, such as supplies, inventory, buildings, and equipment. These types of accounts normally have a debit balance.

Liability accounts are those accounts that are related to items that a company owes, such as utilities expense, payroll expense, and loans payable. Liability accounts normally have credit balances.

Owner's equity accounts are accounts that are related to personal investments that are made by owners of the business, such as the owner's capital account and stockholder's equity accounts. These types of accounts, like liability accounts, normally have a credit balance.

The main reason that the trial balance is created is to check the accuracy of the mathematical calculations made to each account balance as a result of journal entries. If the total amount in the debit column of the trial balance equals the total amount in the credit column of the trial balance, the assumption is made that the accounts are in balance.

Q.15. What is an Income Statement?

An income statement shows a company’s revenues less their costs and expenses over a given period (e.g. a financial year or one month). The conclusion of an income statement shows the company’s net income (or net loss).

An income statement is an integral component of a company’s financial statements.It shows how a company’s revenue is converted into net income first by displaying the revenues recognized for a specific period, and then by subtracting.

The costs and expenses from these revenues (including write-offs and taxes).The income statement is used in order to show internal and external company stakeholders whether the company made or lost money during the reporting period.

Q. 16. Define is a financial Analysis.

The process of evaluating businesses, projects, budgets and other finance-related entities to determine their suitability for investment. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to be invested in. When looking at a specific company, the financial analyst will often focus on the income statement, balance sheet, and cash flow statement. In addition, one key area of financial analysis involves extrapolating the company's past performance into an estimate of the company's future performance.

Q.17. What is the importance of financial statements for creditors?

Importance of Financial statements is declarations of information in financial terms about an enterprise that are believed to be fair and accurate. They describe certain attributes of the enterprise that are important for decision makers, particularly investors (owners) and creditors.

Pro forma statements are prepared in order to analyze a company's financial position under hypothetical circumstances. In the financial planning process, pro forma statements can be key to understanding what will happen to a company's financial position after a hypothetical event, like a change in regulatory environment, merger or acquisition, extraordinary event (like a natural disaster), or exogenous economic shocks.

They can also be used to forecast how a company's financial position may evolve from a marketing campaign or restructuring, or how the company may grow in the future.

Q. 18. What do you mean by accounting ratios?

Accounting ratios are an important tool of financial statements analysis. A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times.

When the number is calculated by referring to two accounting numbers: • Explain the meaning, objectives and limitations of accounting ratios;• Identify the various types of ratios commonly used ;• Calculate various ratios to assess solvency, liquidity, efficiency and profitability of

the firm. • Interpret the various ratios calculated for intra-firm and inter firm comparisons.

Accounting Ratios 5 Accounting Ratios 203 the financial statements, it is termed as accounting ratio. For example, if the gross profit of the business is Rs. 10,000 and the ‘Revenue from Operations’ are Rs. 1,00,000, it can be said that the gross profit is 10% × 10, 000 100 1, 00, 000 of the ‘Revenue from Operations’ . This ratio is termed as gross

profit ratio. Similarly, inventory turnover ratio may be 6 which imply that inventory turns into ‘Revenue from Operations’ six times in a year.

It needs to be observed that accounting ratios exhibit relationship, if any, between accounting numbers extracted from financial statements. Ratios are essentially derived numbers and their efficacy depends a great deal upon the basic numbers from which they are calculated. Hence, if the financial statements contain some errors, the derived numbers in terms of ratio analysis would also present an erroneous scenario. Further, a ratio must be calculated using numbers which are meaningfully correlated.

A ratio calculated by using two unrelated numbers would hardly serve any purpose.For example, the furniture of the business is Rs. 1, 00,000 and Purchases are Rs. 3, 00,000. The ratio of purchases to furniture is 3 (3, 00,000/1, 00,000) but it hardly has any relevance. The reason is that there is no relationship between these two aspects.

Q.19. What is a Current Asset?

A current asset is cash and any other company asset that will be turning to cash within one year from the date shown in the heading of the company's balance sheet. If a company has an operating cycle that is longer than one year, an asset that will turn to cash within the length of its operating cycle is considered to be a current asset.

Current assets are generally listed first on a company's balance sheet and will be presented in the order of liquidity. That means they will appear in the following order: cash which includes currency, checking accounts, petty cash, temporary investments, accounts receivable, inventory, supplies, and prepaid expenses.

Supplies and prepaid expenses will not literally be converted to cash. They are included because they will allow the company to avoid paying cash for these items during the upcoming year.

It is important that the amount of each current asset not be overstated. For example, accounts receivable, inventories, and temporary investments should have valuation accounts so that the amounts reported will not be greater than the amounts that will be received when the assets turn to cash. This is important because the amount of company's working capital and its current ratio are computed using the current assets' reported amounts.Current assets are also referred to as short term assets.

Q. 20. What is a Current liability?

Current Liabilities' A company's debts or obligations that is due within one year. Current liabilities appear on the company's balance sheet and include short term debt, accounts payable, accrued liabilities and other debts.If a company's operating cycle is longer than one year, current liabilities are those obligations due within the operating cycle.

Current liabilities are usually presented in the following order:1. The principal portion of notes payable that will become due within one year

2. Accounts payable

3. The remaining current liabilities such as payroll taxes payable, income taxes payable, interest payable and other accrued expenses.

The parties who are owed the current liabilities are referred to as creditors. If the creditors have a lien on company assets, they are known as secured creditors. The creditors without a lien are referred to as unsecured creditors.

The amount of current liabilities is used to determine a company's working capital current assets minus current liabilities and the company's current ratio current assets divided by current liabilities.

Q. 21. How would you determine whether an asset is current asset or a current asset?

The term current assets generally include: (1) Cash in bank or on hand; (2) Sums due a market agency from a custodial account for shippers' proceeds; (3) Accounts receivable, if collectible; (4) Notes receivable and portions of long-term notes receivable within one year from

date of balance sheet, if collectable; (5) Inventories of livestock acquired for purposes of resale or for purposes of market

support; (6) Feed inventories and other inventories which are intended to be sold or

consumed in the normal operating cycle of the business; (7) Accounts due from employees, if collectable; (8) Accounts due from officers of a corporation, if collectable; (9) Accounts due from affiliates and subsidiaries of corporations if the financial

position of such subsidiaries and affiliates justifies such classification;(10) Marketable securities representing cash available for current operations and not

otherwise pledged as security; (11) Accrued interest receivable; and (12) Prepaid expenses.

The term current assets generally exclude:

(1) Cash and claims to cash which are restricted as to withdrawal, such as custodial funds for shippers' proceeds and current proceeds receivable from the sale of livestock sold on a commission basis;

(2) Investments in securities (whether marketable or not) or advances which have been made for the purposes of control, affiliation, or other continuing business advantage;

(3) Receivables which are not expected to be collected within 12 months; (4) Cash surrender value of life insurance policies;(5) Land and other natural resources; and (6) depreciable assets.

Q.22. What is current ratio? What does in indicate?

The current ratio is a financial ratio that measures whether or not a firm has enough

resources to pay its debts over the next 12 months. It compares a firm's current

assets to itscurrent liabilities. It is expressed as follows:

The current ratio is an indication of a firm's market liquidity and ability to meet creditor's

demands. Acceptable current ratios vary from industry to industry and are generally

between 1.5 and 3 for healthy businesses. If a company's current ratio is in this range,

then it generally indicates good short-term financial strength. If current liabilities exceed

current assets the current ratio is below 1, then the company may have problems

meeting its short-term obligations. If the current ratio is too high, then the company may

not be efficiently using its current assets or its short-term financing facilities. This may

also indicate problems in working capital management.

Low values for the current or quick ratios values less than 1 indicate that a firm may

have difficulty meeting current obligations. Low values, however, do not indicate a

critical problem. If an organization has good long-term prospects, it may be able to

borrow against those prospects to meet current obligations. Some types of businesses

usually operate with a current ratio less than one. For example, if inventory turns over

much more rapidly than the accounts payable become due, then the current ratio will be

less than one. This can allow a firm to operate with a low current ratio.

If all other things were equal, a creditor, who is expecting to be paid in the next 12

months, would consider a high current ratio to be better than a low current ratio,

because a high current ratio means that the company is more likely to meet its liabilities

which fall due in the next 12 months. You should view the relation between the

operation cycle period and the current ratio.

Q.23. How do you compute ‘Stock – turnover rate”? What does it indicate?

Stock turnover is a financial efficiency ratio that helps answer a questions like "have we got too much money tied up in inventory"?

An increasing stock turnover figure or one which is much larger than the "average" for an industry may indicate poor inventory management.

Stock turnover = Cost of Sales Average stock held

Cost of Sale = N$ 13 , 465Average Stock = N$1.325Stock turnover = 10.2 times

As a general guide, the quicker a business turns over its stocks, the better.But, it is more important to do that profitably rather than sell stocks at a low gross profit margin or worse at a loss.Interpreting the stock turnover ratio needs to be done with some care. For example:Some products and industries necessarily have very high levels of stock turnover. Fast-food outlets turnover their stocks over several times each week, let alone 8-10 times per year! A distributor of industrial products might aim to turn stocks over 10—20 times per year. Some businesses have to hold large quantities and value of stock to meet customer needs. They may have to stock a wide range of product types, brands, sizes and so on.Stock levels can vary during the year, often caused by seasonal demand. Care needs to be taken in working out what the "average stock held" is – since that directly affects the stock turnover calculation.

A business can take a range of actions to improve its stock turnover: Sell-off or dispose of slow-moving or obsolete stocks Introduce lean production techniques to reduce stock holdings Rationalise the product range made or sold to reduce stock-holding requirements Negotiate sale or return arrangements with suppliers – so the stock is only paid

for when a customer buys it

The last point to remember is that stock turnover is an irrelevant ratio for many businesses in the service sector. Any business that provides personal or professional services, for example, is unlikely to carry significant stocks.

Q. 24. Differentiate between gross profit ratio and operating profit ratio.

Operating Profitability can be divided into measurements of return on sales and return on investment.

Return on Sales

1. Gross Profit MarginThis shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry.

Formula 7.15Gross profit margin = gross profit                                   net sales

Where:Gross profit = net sales - cost of goods sold.

2. Operating Profit MarginThis ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure.

Formula 7.16

Operating profit margin = operating income                                       net sales

Where:Operating income = earnings before tax and interest from continuing operations

3. EBITDA MarginThis ratio indicates the profitability of current operations. This ratio does not take into account the company's capital, non-cash expenses or tax structure.

Formula 7.17

EBITDA margin = earnings before interest, tax, depreciation and amortization                                                  net sales

4. Pre-Tax Margin (EBT margin)This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure.

Formula 7.18

Pre-tax margin = Earning before tax                                sales

5. Net Margin (Profit Margin)This ratio indicates the profitability of a company's operations.

Formula 7.19Net margin = net income                     sales

6. Contribution MarginThis ratio indicates how much each sale contributes to fixed expenditures.

Formula 7.20

Contribution margin = contribution                                    sales

Where:Contributions = sales - variable cost.

Q.25. How is working capital turnover ratio calculated?

The working capital turnover ratio is also referred to as net sales to working capital. It indicates a company's effectiveness in using its working capital.

The working capital turnover ratio is calculated as follows: net annual sales divided by the average amount of working capital during the same 12 month period.

For example, if a company's net sales for a recent year were $2,400,000 and its average amount of working capital during the year was $400,000, its working capital turnover ratio was 6 ($2,400,000 divided by $400,000).

Working capital is defined as the total amount of current assets minus the total amount of current liabilities. As indicated above, you should use the average amount of working capital for the year of the net sales.

As with most financial ratios, you should compare the working capital turnover ratio to other companies in the same industry and to the same company's past and planned working capital turnover ratio.

Q.26. What is an operating ratio? How do you calculate it? What does it indicate?

The operating ratio is a financial term defined as a company's operating expenses as a

percentage of revenue. This financial ratio is most commonly used for industries which

require a large percentage of revenues to maintain operations, such as railroads. In

railroading, an operating ratio of 80 or lower is considered desirable.

The operating ratio can be used to determine the efficiency of a company's

management by comparing operating expenses to net sales. It is calculated by dividing

the operating expenses by the net sales. The smaller the ratio, the greater the

organization's ability to generate profit. The ratio does not factor in expansion or debt

repayment. Alternatively, it may be expressed as a ratio of sales to cost. In such case a

higher ratio indicates a better ability to generate revenue.

Operating Ratio = Operating Expenses / Net Sales

It is often expressed as a percentage.

To see how operating margin works, consider Company XYZ's income statement:

Using this information and the formula above, we can calculate that Company XYZ's operating ratio is:

Operating Ratio = $850,000 / $1,000,000 = 0.85 or 85%In this example, Company XYZ pays out $0.85 of operating expenses for every $1 in sales. It therefore has the remaining $0.15 to cover non operating expenses such as interest payments, nonrecurring items, taxes, and other costs not directly related to the company's day-to-day operations.

Q. 27. Illustrate the method of determining debtor’s turnover ratio? What does it

indicate?

Debtor’s turnover ratio, also called accounts receivable turnover ratio, is a ratio that is used to gauge the number of times a business is able to convert its credit sales to cash during a financial year.  Collection period is the time taken by the company to convert its credit sales to cash. Both these ratios indicate the efficiency factor of the company in collecting receivables from its debtors and the speed at which they are able to do it. These two ratios are largely used to indicate the liquidity position of the company along with its efficiency with which operates. It also reflects the power the company has to dictate credit terms.

Formula for Calculating Debtor’s Turnover Ratio:

Debtor’s Turnover Ratio = Net Credit Sales / Average DebtorsHere, ‘net credit sales’ is considered because cash sales generate immediate cash. Also, net credit sales mean total credit sales less sales returns if any.Average Debtors is the average of opening debtors and closing debtors. However, in certain cases, it may be required to consider only current year as the company may have gone for new product, geographical expansion etc. which may cause debtors to deflate if average is taken. (Note: bills receivables will also form part of debtors for the said calculation)

Formula for Calculating Average Collection Period:

Average Collection Period = Number of days / Debtor’s turnover ratioUsually 360 days are taken into calculation for calculating the number of days. This ratio is expressed in terms of number of days and represents the length of time taken to convert debtors to cash.

Let us analyse the ratios with an example so as to provide key understanding of the topic.

Analysis with an Example of Debtors Turnover Ratio/ Average Collection Period:

Credit sales                         =             $ 5,000,000Sales returns                      =             $ 1,400,000Opening Debtors             =             $ 400,000Closing Debtors                =             $ 500,000Opening bills receivables =          $ 100,000Closing bills receivable   =             $ 200,000Average Debtors = ($ 400,000 +$ 500,000) / 2

                                  = $ 450,000Average Bills = ($ 100,000 +$ 200,000) / 2

                                  = $ 150,000Debtor’s Turnover Ratio               = Net Credit Sales / Average of Debtors and bills= ($ 5,000,000 – $1,400,000) / ($ 450,000 + $ 150,000)

                                                = 6 times

Average Collection period = Number of days/ Debtor’s turnover ratio

  = 360 / 6 = 60 days

A debtor’s turnover ratio of 6 times means that on an average; the debtors buy and payback 6 times in a year. So we can assume that 6 times a year means once every two months which is nothing but the average collection period of 60 days. The credit sales get converted to cash 60 days from the date of sale on an average basis.

Q. 28.Explain any three accounting rations based on sales.

LIQUIDITY RATIOS

Sales to receivables (or turnover ratio): Net Sales/Accounts Receivable—measures the

annual turnover of accounts receivable. A high number reflects a short lapse of time

between sales and the collection of cash, while a low number means collections take

longer. Because of seasonal changes this ratio is likely to vary. As a result, an annual

floating average sale to receivables ratio is most useful in identifying meaningful shifts

and trends.

Days' receivables ratio: 365/Sales to receivables ratio—measures the average number

of days that accounts receivable are outstanding. This number should be the same or

lower than the company's expressed credit terms. Other ratios can also be converted to

days, such as the cost of sales to payables ratio.

Cost of sales to payables: Cost of Sales/Trade Payables—measures the annual

turnover of accounts payable. Lower numbers tend to indicate good performance,

though the ratio should be close to the industry standard.

Cash turnover: Net Sales/Net Working Capital (current assets less current liabilities)—

reflects the company's ability to finance current operations, the efficiency of its working

capital employment, and the margin of protection for its creditors. A high cash turnover

ratio may leave the company vulnerable to creditors, while a low ratio may indicate an

inefficient use of working capital. In general, sales five to six times greater than working

capital are needed to maintain a positive cash flow and finance sales.

Q.29. What is a funds flow statement?

Funds flow statement is a statement which is prepared in order to determine the sources and application of funds. Fund flow statement is commonly used in business plans and proposals to show investors about the flowing of their funds through the organization. This is not used in annual reports. It is used by bankers who want to know how borrowed funds will flow through company operations. It is used to show the management how the cash is flowing through the company operations.

A funds flow statement is a consolidated statement of all the cross transactions over the period for which the flow is being analyses.

Cross Transactions i.e. transactions involving a current account and a non-current account bring about a change in the fund or working capital. Some bring about an increase in fund and others bring about a decrease in the available fund (working capital).

The cross transactions presented in the funds flow statement are classified/grouped into two as,

1. Sources/Inflows of fundsTransactions which bring about an increase in the available fund (working capital)

2. Applications/Outflows of fundsTransactions which bring about a decrease in the available fund (working capital)

Q.30. Is depreciation a source of funds? Give reasons in support of your answer.

Depreciation expense is reported as a positive amount on the statement of cash flows prepared under the popular indirect method. However, the reason it is listed is to adjust the net income amount that had been reduced by depreciation expense on the income statement. (Recall that the depreciation entry debits Depreciation Expense and credits Accumulated Depreciation—the cash account is not involved.) In other words, the positive depreciation amount reported on the statement of cash flows is merely one of the adjustments needed to convert the accrual net income to the cash provided from operating activities. Depreciation is not a source of cash.

Let's illustrate this with some amounts. A sidewalk florist operates a cash only business. During the most recent year, this florist had cash revenues of $100,000. Its expenses included $70,000 of cash expenses and $8,000 of depreciation expense on its truck that was purchased in an earlier year. During the year there were no other revenues or expenses, and the florist's cash balance increased by $30,000. The florist's income statement will report net income of $22,000 (revenues of $100,000 minus expenses of $78,000).

The florist's statement of cash flows prepared under the indirect method will begin with net income of $22,000. It will then add the $8,000 of depreciation expense. The result is cash provided by operating activities of $30,000—which agrees to the business's change in its cash balance.

Q 31. Enumerate four heads of sources and application of funds.

The Source and Application of Funds Statement shows the total sources of new funds raised between Balance Sheet dates and the total uses of those funds in the same period.The Source and Application of Funds Statement tells exactly where the company got their money from and how it was spent. It tells whether management has made sound investment decisions.This statement is made up by listing the changes that have occurred in all of the Balance Sheet Items between any two Balance Sheet dates.

The statement consists of two sections:

The Source (where the money has come from) This arises either from : An increase in Liabilities OR A decrease in Assets Source of Funds originate from: Net Income after Tax Disposal or revaluation of fixed assets The proceeds of loans raised The proceeds of shares that were issued

Repayments received on loans previously granted by the company Any decrease in net working capital The Application (where the money has gone) This arises either from: A decrease in Liabilities OR An increase in Assets

Application of Funds originates from:

Losses to be met by the companyThe purchase of fixed assetsThe full or partial payment of loansThe granting of loansLiability for taxesDividends paid and proposedAny increase in net Working Capital

The information supplied in the Source and Applications of Funds Statement is useful to:Users within the business (internal)Directors of CompaniesMembers of Closed CorporationsPartners of PartnershipsOwners / Sole ProprietorsUsers outside the business (external)ShareholdersBanksReceiver of Revenue.

They use the Source and Applications of Funds statement to pick up healthy, or unhealthy trends regarding the company's trading activities.Net Income (After taxation)Net Income is the main source of funds for a company.Add: Items not affecting the flow of funds - Depreciation (Non cash items)The Net Income figure needs to be adjusted, to arrive at the true figure for funds, generated by the company.

Depreciation is shown as an expense in the Income Statement. It is only a book entry and does not really require the physical outlay of cash, unlike some of the other expenses.As the Funds Statement is only concerned with the actual movement of funds, we need to add back the depreciation expense.

Funds originated from operations:This reflects the actual income originated from the company's operations.Acquisition of: Fixed and other assetsSpecifies the amounts paid for assets purchasedIncrease in Net Working Capital (Net Current Assets)

Specifies the actual increase of Working Capital during the financial year.

Q.32. Distinguish between funds flow statement and position statement.

There are three (3) key financial statements that are typically produced for a business. They are:

Balance Sheet (also known as the Statement of Financial Position) which describes the financial strength of a business at a particular point in time. That is, it identifies the net worth of the business in the value of the equity section as well as provides insights into the financial leverage (information about the funding arrangements of the business, be it internal or external), the liquidity (information about the ability of the business to pay its bills as they are due) and asset management (information about the efficiency of management's use of the business assets).

Income statement (also known as the Statement of Financial Performance) which describes the financial sustainability of the business. That is, it identifies the profit or the excess (or otherwise) of revenue over the costs of earning that revenue for a particular period. It also provides information relating to the adequacy of the selling prices (via the gross profit %) and the sufficiency of the profit in relation to the owner's investment (via a Return on Investment calculation). The net profit for the period appears in the equity section of the Balance Sheet as current earnings.

Cash Flow Statement which describes the source and application of funds received and dispensed during the reporting period by comparing the opening balances with the closing balances on cash or cash equivalent accounts. The cash flow statement ties together all the details from the income statement and the balance sheet to give you a summary of the overall picture of your cash inflows and outflows. In particular, it reports on the inflow and outflow of cash in relation to your operating activities, investing activities and financing activities. The cash flow statement informs decision makers about the movement of cash funds between where the cash funds came from and how those funds have been used.

The purpose of all financial statements is to provide appropriate information to internal and external decision makers who need to make decisions about the allocation of resources within their control. As you can see by the descriptions above, each of the financial report provides unique, accessible and necessary information to help decision makers choose the best possible resource allocation option.

Q.33 Which transaction do not affect in the flow of funds?

In preparing a statement of changes in financial position, on working capital basis or funds flow statement, it is convenient to classify business transactions into three categories:

(a) Both debit and credit aspects of the transaction affecting current accounts only.(b) Both debit and credit aspects of the transaction affecting non-current accounts only.(c) One aspect of the transaction affecting current account and another aspect affecting a non- current account (non-current asset or non-current liability).

The effect of above mentioned categories of transactions on the funds flow statement can be analyzed with the help of following examples: 

1. Transactions Affecting Current Accounts Only—Do not Result in Flow of Fund:These transactions produce changes in working capital accounts but do not change the amount of working capital.

Few examples of such transactions are given below:

Hence, such transactions would not be reflected as a source or use in a working capital basis statement of changes in financial position.

2. Transactions Affecting Non-Current Accounts Only—Do not Result in Flow of Fund:

These transactions have no direct effect on the amount of working capital. The entry to record depreciation is an example of such a transaction. Such transactions may not be considered in preparing a statement of changes in financial position on working capital basis.

Few examples of such transactions are:

3. Transactions Affecting Non-Current Account and Current Account Result in Flow of Fund Resulting Either in a Source of Fund or Application of Fund:

These transactions bring about either an increase or a decrease in the amount of working capital. If changes in non-working capital accounts are analyzed, these events are brought to light, and their effect on working capital will be reported in the statement of changes in financial position.

Few examples of such transactions and their effects on working capital are shown below:

Q.35. What do you understand by overheads?

The Overhead is those costs required to run a business, but which cannot be directly attributed to any specific business activity, product, or service.

Thus, overhead costs do not directly lead to the generation of profits. Overhead is still necessary, since it provides critical support for the generation of profit-making activities. For example, a high-end clothier must pay a substantial amount for rent (a type of

overhead) in order to be located in an adequate facility for the sale of clothes. The clothier must pay overhead to create the proper retail environment for its customers.

Examples of overhead are: Accounting and legal expenses Administrative salaries Depreciation Insurance Licenses and government fees Property taxes Rent Utilities

Overhead costs tend to be fixed, which means that they do not change from period to period. Examples of fixed overhead costs are depreciation and rent. Less frequently, overhead varies directly with the sales level, or varies somewhat as the activity level changes.

The other type of expense is direct costs, which are those costs required to create products and services, such as direct materials and direct labor. Overhead and direct costs, when combined, equal all of the expenses incurred by a company.

Similar TermsOverhead is also known as burden or indirect costs. A subset of overhead is manufacturing overhead, which are all overhead costs incurred in the manufacturing process. Another subset of overhead is administrative overhead, which are all overhead costs incurred in the general and administrative side of a business.

Q. 36. Distinguish between overhead apportionment and over-head absorption?

Apportionment of Overheads:

Distribution of an overhead cost to several departments or cost centers is known as apportionment of overheads. It is the process of charging or apportioning costs to a number of cost centers or cost units. If a given cost is common to two or more departments or cost centers, such cost should be apportioned or divided among these departments on an equitable basis. For example, the amount of factory rent should be apportioned to all the departments. Similarly, the amount of remuneration of the general manager should be distributed to the production, administration and marketing departments as the general manager is associated with all these departments.

The absorption of overheads: It’s also known as the recovery of the overheads. Absorption of overheads is the process of sharing the overhead costs by all the products of a particular department. Absorption of overheads is the application of overheads to each unit of output. In other words, the process of ascertaining the total overhead costs of each unit of output or job by using overhead rate is known as the absorption of overhead. Thus the distribution of the overhead expenses allotted to a

particular department over the units of produced in that department is absorption of overheads.

In order to absorb the overheads by the units if output of a particular department, the overhead absorption rate or overhead rate should be determined. The two popular methods of absorption of overheads are labor hour rate and machine hour rate. 

The formula to calculate overhead rate under these methods are given below.

Labor hour rate = Total Overheads/Total Labor HoursMachine hour rate = Total Overheads/ Total Machine Hours

Q.37. Why are the following items added to profit calculate the fund from operations?

i) Depreciation

Funds from operations is the cash flows generated by theOperations of a business. The term is most commonly used in relation to the cash flows from real estate investment trusts (REITs). This measure is commonly used to judge the operational performance of REITs, especially in regard to investing in them.Funds from operations do not include any financing-related cash flows, such as interest income or expense. It also does not include any gains or losses from the disposition of assets, or any depreciation or amortization of fixed assets.

Thus, the calculation of funds from operations is:Net income - Interest income + Interest expense + Depreciation- Gains on asset sales + Losses on asset sales= Funds from operations 

Fo example, the ABC REIT reports net income of $5,000,000, depreciation of $1,500,000, and a gain of $300,000 on the sale of a property. This results in funds from operations of $6,200,000.

A variation on the funds from operations concept is to compare it to the stock price of a company (usually an REIT). This is can be used in place of the price-earnings ratio, which includes the additional accounting factors just noted.The funds from operations concept is needed, especially for the analysis of an REIT, because depreciation should not be factored into the results of operations when the underlying assets are appreciating in value, rather than depreciating; this is a common situation when dealing with real estate assets.The funds from operations concept is considered to be a better indicator of the operational results of a business than net income, but keep in mind that accounting chicanery can impact a variety of aspects of the financial statements. Thus, it is always better to rely upon a mix of measurements, rather than a single measure that can potentially be twisted.

Adjusted Funds from OperationsIt is possible to adjust the formula even further for some types of capital expenditures that are recurring in nature; depreciation related to recurring expenditures to maintain a property (such as carpet replacements, interior painting, or parking lot resurfacing) should be included in the FFO calculation. This altered format results in lower profitability figures. This revised version of the concept is called adjusted funds from operations.

ii) Loss on sale of the fixed assests:

The current operating profit is the main source of internal funds. The operating profit is the excess of sales revenue over operating cost which includes cost of goods sold and operating expenses.

While calculating fund from operations or trading profit only those transactions which affect the movement of funds should be considered.

In other words, non-fund or non-operating transactions such as depreciation on fixed assets, write-off and write-up of fixed assets or fictitious assets, appropriation of profit (i.e., transfer to General Reserve, transfer to specific fund, provision for proposed dividend and taxation etc.), loss on sale of fixed assets etc. should be added back to the current net profit if they have already been charged to such profits.

Similarly, if profit and loss account has been credited with certain non-fund or non-operating income, viz., dividend received, refund of income tax, interest on investment, profit on sale of fixed assets or investments etc. then such items should be readjusted to the current profits.For making such readjustments, an Adjusted Profit and Loss Account should be prepared which is shown below:

Note:In the case of accumulated losses, the opening balance should be shown in the debit side of the Adjusted Profit & Loss Account and the closing balance should be shown on the credit side.

iii) Goodwill written off

The Goodwill written off is a Prevalent and large – from 2003 to 2009, more than 4,600 firms have written-off goodwill due to impairment, including 1,393 firms in 2008 – amount of goodwill write-off totaled $970 billion, representing 20% of recorded goodwillThe news of goodwill write-off also precedes CEO resignation and can trigger shareholder lawsuit. According to managers – goodwill write-offs are the natural result of it is just a acquisition with overpriced shares benign, inconsequential accounting ritual with no

real substance (e.g., no effect on cash flows) – write-offs reflect the effects of economic no necessaryrecession, industry downturn, etc relation with prior acquisition decisions I examine the root cause of goodwill write off by tracing goodwill write-offs back to prior acquisitions giving rise to goodwill Focus on share overvaluation prior to acquisition as an antecedent of goodwill write-off the relation is empirical in nature lack, ill-advised acquisition overpriced shares goodwill impairment.

The extent of share overpricing is positively associated with the incidence of acquisitions, particularly stock-financed deals, and, more importantly, the magnitude of goodwill. This relation is strengthened by managerial share holding and weakened by good corporate governance.

The effect is stronger for foreign acquisitions. Share overpricing has a positive relation with subsequent goodwill write-offs and shareholder lawsuits alleging ill-advised acquisitions

Acquisitions with overpriced shares and the extent of goodwill have negative effects on future stock performance and accounting profitability beyond the reversal of share overpricing. The extent of share overpricing predicts the occurrence and magnitude of subsequent goodwill write-off and the incidence of shareholder lawsuits involving ill-advised acquisitions. Firms with goodwill write-offs significantly under-perform in future. 14 Implications of goodwill write-off .

Key issue – acquisition price vs. post-merger synergies Our results suggest that share overpricing lead to ill-advised acquisitions with negative consequences. Accounting test for goodwill impairment may conceal ill-advised acquisitions because – test is performed at operating unit level – allows capitalization of intangibles in the test.

Calculating Funds from Operations

Dr Profit and Loss Adjustment a/c Cr

Particulars Amount Particulars Amount

To Provision for Taxes 

To Depreciation on Machinery 

To Depreciation on Furniture 

To Loss on Sale of Motor Car 

To General Reserve 

To Special Reserve 

To Goodwill Written off 

To Discounts on issue of Shares 

To Net Profit

1,32,000 

87,000 

39,000 

91,000 

1,25,000 

75,000 

50,000 

40,000 

5,25,000 

By Funds from

Operations 

By Profit on Sale of Asset

11,00,000 

64,000 

11,64,000  11,64,000 

iv) Transfer to General Reserve