FUNDAMENTALS OF BOOK-KEEPING & ACCOUNTANCY

Subject Paper Submitted By

Indradeep Guha(Roll no: BIMS/AC/2/2008/6005)

(Course: PGDIM)

*Answers to: Q1 (a/b), Q2 (a/b), Q4 (a/b), Q5(a/b) & Q6 (a/b/c/d/g)

Q1. (a) What is Book-keeping and Transaction? Explain Double Entry and Single Entry Book-Keeping.

A. A transaction is an agreement, communication, or movement carried out between separate entities or objects, often involving the exchange of items of value, such as information, goods, services, and money.

Financial transaction Real estate transaction Transaction cost Database transaction Atomic database transaction Transaction processing POS Transaction

Bookkeeping is the recording of financial transactions. Transactions include sales, purchases, income, and payments by an individual or organization. Bookkeeping is usually performed by a bookkeeper. Bookkeeping should not be confused with accounting. The accounting process is usually performed by an accountant. The accountant creates reports from the recorded financial transactions recorded by the bookkeeper. There are some common methods of bookkeeping such as the Single-entry bookkeeping system and the Double-entry bookkeeping system. But while these systems may be seen as "real" bookkeeping, any process that involves the recording of financial transactions is a bookkeeping process.

Two common bookkeeping systems used by businesses and other organizations are the single-entry bookkeeping system and the double-entry bookkeeping system. Single-entry bookkeeping uses only income and expense accounts, recorded primarily in a revenue and expense journal. Single-entry bookkeeping is adequate for many small businesses. Double-entry bookkeeping requires posting (recording) each transaction twice, using debits and credits.

Single-entry bookkeeping system also known as Single-entry accounting system is a method of bookkeeping relying on a one sided accounting entry to maintain financial information.

Most businesses maintain a record of all transactions based on the double-entry bookkeeping system. However, many small, simple businesses maintain only a single-entry system that records the "bare-essentials." In some cases only records of cash, accounts receivable, accounts payable and taxes paid may be maintained. Records of assets, inventory, expenses, revenues and other elements usually considered essential in an accounting system may not be kept, except in memorandum form. Single-entry systems are usually inadequate except where operations are especially simple and the volume of activity is low.

This type of accounting system with additional information can typically be compiled into an income statement and balance sheet by a professional accountant.

Single-entry systems are used in the interest of simplicity. They are usually less expensive to maintain than double-entry systems because they do not require the services of a trained person.

Demerits of Single-entry systems are as follows:

1. Data may not be available to management for effectively planning and controlling the business. 2. Lack of systematic and precise bookkeeping may lead to inefficient administration and reduced control

over the affairs of the business. 3. Single-entry records do not provide a check against clerical error, as does a double-entry system. This is

one of the most serious defects of single-entry systems. 4. Single-entry records seldom make provision for recording all transactions. In addition, many internal

transactions, such as adjusting entries are often not recorded. 5. Because no accounts are provided for many of the items appearing in both the Income Statement and

Balance Sheet, omission of important data is possible. 6. In the absence of detailed records of all assets, lax administration of those assets may occur. 7. Theft and other losses are less likely to be detected.

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Sample revenue and expense journal for single-entry bookkeeping below

No. Dt Items Revenue Expense SalesSales Tax

Services Inventory Advert FreightOffc

SupplMisc

7/13Balance forward

1,826.00 835.00 1,218.00 98.00 510.00 295.00 245.00 150.00 83.50 61.50

1041 7/13Printer- Advert flyers

450.00 450.00

1042 7/13Wholesaler - inventory

380.00 380.00

1043 7/16office supplies

92.50 92.50

-- 7/17bank deposit

1,232.00

- Taxable sales

400.00 32.00

- Out-of-state sales

165.00

- Resales 370.00

- Service sales

265.00

bank 7/19bank charge

23.40 23.40

1044 7/19 petty cash 100.00 100.00

TOTALS 3058.00 1,880.90 2,153.00 130.00 775.00 675.00 695.00 150.00 176.00 184.90

The double-entry bookkeeping system refers to a set of rules to record financial information in a financial accounting system wherein every transaction or event impacts at least two different accounts. In modern

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accounting this is done using debits and credits, and serves as a kind of error-detection system: if, at any point, the sum of debits does not equal the corresponding sum of credits, then an error has occurred.

This system is called double-entry because each transaction is recorded in at least two accounts. Each transaction results in at least one account being debited and at least one account being credited, with the total debits of the transaction equal to the total credits. This requirement has a benefit to the bookkeeper, but also introduces confusion to the layman. The benefit is that the accuracy of the accounts can be checked quickly - for, when all the accounts that have debit balance are summed, they should equal the sum of all the accounts which have a credit balance. Without this requirement, there would be no quick means to check accuracy. The confusion arises because a healthy business with money in the bank will have a debit balance in the account called "Bank". This is contrary to the layman's experience that, when the layman's bank balance is healthy, his bank statement shows a credit balance. An easy way to visualize this is to consider that the bank writes the statement from its own point of view; hence if you are in credit, you are a liability on their balance sheet - you can turn up and draw your money out.

Consider also these two examples, if Business A sells an item for cash to Business B, the bookkeeper of the Business A would credit the account called "Sales" and debit the account called "Bank". Conversely, the bookkeeper of Business B, would debit the account called "Purchases" and credit the account called "Bank".

For instance, you might have an account called ‘Goods ordered’. Then, if the vehicle above was ordered, the cash account would decrease by £15,000, and the ‘Goods ordered’ account would increase by £15,000. This is just a transfer in the accounts: no real money would have moved.

But it would show you that you have put aside £15,000 for something. When the vehicle arrives, and you have to pay the bill for it, then the double entry that you make would be to decrease the ‘Goods ordered’ account by £15,000, and increase the ‘vehicles’ account by £15,000.

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(b) Explain the basic features of accounting principles and also describe its concept.

A. The principles of accountancy are applied to business entities in three divisions of practical art, named accounting, bookkeeping, and auditing.

Accounting is defined by the AICPA as "The art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof." The body of rules that governs financial accounting is called Generally Accepted Accounting Principles, or GAAP. Generally Accepted Accounting Principles (GAAP) is the Americanized term used to refer to the standard framework of guidelines for financial accounting used in any given jurisdiction which are generally known as Accounting Standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements.

Financial accounting is information that must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP).

Principles derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP.

Principle of regularity: Regularity can be defined as conformity to enforced rules and laws.

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Principle of consistency: This principle states that when a business has once fixed a method for the accounting treatment of an item, it will enter all similar items that follow in exactly the same way.

Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company's financial status.

Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company.

Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, a revenue with an expense, etc. (see convention of conservatism)

Principle of prudence: This principle aims at showing the reality "as is”: one should not try to make things look prettier than they are. Typically, revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.

Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value (see depreciation and going concern).

Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire time-span and not counted for entirely on the date of the transaction.

Principle of Full Disclosure/Materiality: All information and values pertaining to the financial position of a business must be disclosed in the records.

Basic Features of Accounting Principles:

Following are the three basic features of allowing principles

Usefulness:

An accounting principle should be useful; an accounting rule which does not increase the utility of the records is not accepted as an accounting principle.

Objectivity:

Accounting principle should be objective in nature. It should not be influenced by personal bias.

Feasibility:

Accounting principle should be practicable and feasible.

Kinds of Accounting Principles:

There are two kinds of accounting principles, “Concepts” and conventions”.

The term concept is used to mean the accounting postulates necessary ideas and assumptions which are fundamental to accounting practice. The term convention is used to mean customs and or traditions as a guide to the preparation of accounting statements.

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The following diagram gives the classification of generally accepted accounting principle into “concepts” and conventions.

Q2. (a) What do you understand by Final Account? Illustrate with the help of a chart the process of final accounts.

A. Accounts made up only at the end of a firm's financial year. For a manufacturing firm, the final accounts consist of (1) manufacturing account, (2) trading account, (3) profit and loss account, and (4) profit and loss appropriation account. A trading firm's final accounts will include all of the above except the manufacturing account. Together, these accounts generate the gross profit, net income, and distribution of net income figures of the firm.

Generally the Trading, Profit and Loss Accounts are prepared every financial year (12 months period) to find out status of business, profit or loss and also to know the Asset & Liabilities (net worth) of the business, such accounts can be made of regular intervals depending on need for decision making.

It is important to know the following terms during finalization.

Trial Balance (T/B): The trial balance is prepared by listing out the balances (Debit or Credit) of each ledger account (summary of account). If the balances are rightly recorded the credit and debit balance if totalled will tally. This ensures arithmetical accuracy of the account.

Balance Sheet (B/S): This is a statement which shows the capital assets and liabilities of a business.

Incomes: This amount will show the various receipt of amount by sale of goods or services rendered.

Expenses: This is the amount spent for running the business; it covers all expenses.

Closing Entries: Again through journal proper we have to make certain entries to transfer all nominal accounts to trading, profit and loss account. After passing the entries the relevant ledger accounts are posted two more accounts, trading accounts and profit and loss account are prepared. After preparation of Trading, Profit & Loss Account, only Real and Personal Account (Assets & Liabilities) will have balances which will be later on opening balances for the next accounting period.

Depreciation: The process of writing off of a part of the cost of the various assets like land, building, vehicles, plant, machinery etc. used in business is known as depreciation. Many of the assets will have a life

ConceptsEntity

Going ConcernDuality

Accounting PeriodHistoric cost

Money MeasurementRevenue Recognition

MachingAccural

Objectivity

Conservatism

Consistency

Disclosure

Materiality

Conventions

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span and hence the cost written off every year be used to replace such assets. The expenditure incurred for acquiring the assets are known as capital expenditure.

Process of Finalization of Accounts: Briefly following is the finalization process of accounts. The balance in all ledger accounts, balance in cash books, petty cash books, bank book are summarized and tabulated in the form of trial balance as per the following format.

Trial Balance for the period 01-04-06 to 31-03-07

Sr. Name of Account

Ledger Folio Debit (Rs.) Credit (Rs.)

The total of Debit Column and Credit Column will be equal which ensures arithmetical accuracy.Adjustments entries are passed, closing entries are passed. Depreciation is calculated on assets as per rules

Following illustration will explain the process clearly

TRIAL BALANCE AS ON 31-03-2007

PARTICULARS DEBIT (DR) Rs. CREDIT (CR) Rs.

Purchase Account 41,000Sales Returns 3,000Sales Account 46,300Purchase Returns 20,000Staff Welfare Account 200Conveyance Account 50Salaries Account 300Postage & Telegram Account 25Interest Account 2,000Depreciation Account 1,670Books & Periodicals Account 40Discount Allowed Account 50Rent Account 100Professional Charges Account 250Electricity Account 150Bad Debts Account 50Discount Received Account 160Capital Account 44,000Avinash Loan Account 10,000Balu Account 5,000Shyam Account 1,000Chavan Account 1,500Goods withdrawn for Personal use A/c. 500Goods withdrawn for Free Sample A/c. 200Goods Donated A/c 300Goods lost by theft Account 50Drawings Account 1,100Plant & Machinery Account 4,080Furniture & Fixture Account 2,000

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Office Equipment Account 1,350Investments Account 3,000Telephone Deposit Account 1,500Dinesh Account 2,000Rajesh Account 5,000Raj Account 3,850Cash on hand 13,795Bank Balance 22,530Advertisement Account 200Donation and charity Account 300Loss by Theft Account 50Advance Salary Account 100Advance to Saurabh Account 2500Dividend Account 300Profit on Sale of Furniture Account 1,000Hemali Account 100Bank Charges Account 20Bank Interest Account 50Jay Account 5,000Bombay Furniture Mart Account 5,000TOTAL 1,17,360 1,17,360

Following additional information is given

i. Stock as on 31st march 2007 was Rs. 2,800/- at cost. The market value of which was Rs. 3,500/-

ii. Interest of Rs. 800/- was paid in advance

iii. Salaries of Rs. 60/- were outstanding at end of the year.

For illustration, the following adjusting and closing entries are passed (also taking into additional information provided above.

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(b) Which all techniques are adopted while doing Financial Forecasting? Also explain the problems of it.

A. Financial forecasting is a continuous process of directing and allocating financial resources to meet strategic goals and objectives. The output from financial planning takes the form of budgets. The most widely used form of budgets is Pro Forma or Budgeted Financial Statements. The foundation for Budgeted Financial Statements is Detail Budgets. Detail Budgets include sales forecasts, production forecasts, and other estimates in support of the Financial Plan. Collectively, all of these budgets are referred to as the Master Budget.

We can also break financial forecasting down into planning for operations and planning for financing. Revenue people focus on sales and production while financial planners are interested in how to finance the operations. Therefore, we can have an Revenue Plan and a Financial Plan. However, to keep things simple and to make sure

Decide whether transaction is Completed or not

No Yes

No entry Decide which subsidiary Book to enter

Credit Purchase

Credit Sale

Purchase Return

Sale Return

Cash Transaction

Bank Transaction

Others

Enter in Purchase Registers

Enter in Sales Registers

Enter in Purchase Return

Enter in Sales Return Registers

Enter in Cash Book Registers

Enter in Bank Book

Enter in journal Proper

Post in Ledger

Balance Ledger Accounts

Prepare Trial Balance

Prepare Final Accounts

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we integrate the process fully, we will consider financial forecasting as one single process that encompasses both operations and financing.

Financial forecasting aims at predetermining the demand for funds and the avenues where in the funds are to be utilized. Thus, a systematic projection of the financial data is made in the form of financial statements. Fund Flow Statement, Financial ratios etc. These projections are based on past record of an enterprise with a view to predict the future financial performance. Financial forecasting generates certain information which is utilized by the management of an enterprise for taking decisions particularly for judging the financial efficiency of the funds and projecting a scale of standards to be followed in the future course. Another important basic objective of financial forecasting is its use as a control device. Standard of financial performance of an enterprise could e laid down through financial forecasting for evaluating the results and assuring its growth. It aids the corporate unit in planning its growth on anticipation of the financial needs. Optimum utilization of fund, by a company can be planned through financial forecasting. A pre-testing of financial feasibility of implementation of its production prospects or programmes can also be arranged through financial forecasting.

Financial forecasting is done by using the following techniques:

(1) Fund Flow Analysis

Fund flow analysis is accomplished by preparing a fund flow statement for evaluating the uses of funds and determining the sources of funds to finance those uses. Fund flow analysis is done by studying past fund flows and projecting future fund flows. Fund flow statement provides the management of a corporate enterprise complete first hand knowledge of the financial growth of the enterprise and its resulting financial needs. As a matter of fact funds flow statement is known as the best way of determine as to how to finance those needs. It is a useful foot in planning needs.

(2) Proforma Financial Statement

Preparation of Proforma financial statement is another technique for financial forecasting. In Proforma financial statement, the Proforma Balance Sheet and Profit and Loss Account (or Income Statement) is prepared to enable the management to evaluate the performance of the enterprise in future financial conditions.

(3) Cash Budget

Cash Budget is another technique of financial forecasting. It is used to determine short term cash needs. The liquidity position of an enterprise and degree of business risk involved for planning a realistic margin of safety. It given clues of the enterprise for adjusting the liquidity cushion, rearranging maturity structure of the debts and making arrangement for availing cash credit facilities from the banks.

Problems in Financial Forecasting

(1) Business environment is frequently changing. Every change reflects upon the uncertainty of future and enhances the degree of incompatibility of present decision in future. Therefore, the likely margin of error inherent in forecasting the future should be considered in advance to avoid disappointment caused by false results and the loss to be incurred due to inaccuracy attached to the forecast.

(2) Pretesting under controlled conditions of forecast should be done by designing alternative forecasts for making a better choice and flexibility in decision making by allowing to pick up one out of several alternative forecasts.

(3) Continuous modifications should be made in forecasting to adjust the same against changes in business environment. Many experts hold that forecasting is a changeable phenomenon and forecasts should be continuously reviewed and modified and adjusted to changes in sales volumes, inventory levels, balances of debtors affected by seasonal parameters.

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(4) To make the forecast reliable and also as a precautionary measure to unpredictability of forecasting results, the corporate enterprise is advised by experts to maintain sufficient cash balances to minimize the risk involved in higher degree of unpredictability associated with forecasting liquidity.

(5) Use of mathematical techniques can make the forecast more reliable and dependable. These techniques may include (a) simple linear regression method; (b) simple curvilinear regression method or (c) multiple regression models.

Q5. (a) Explain the process of determining Cost of an item. Describe through a table the components of Total Cost.

A. In business, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In economics, a cost is an alternative that is given up as a result of a decision. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production.

In accounting, costs are the monetary value of expenditures for supplies, services, labor, products, equipment and other items purchased for use by a business or other accounting entity. It is the amount denoted on invoices as the price and recorded in bookkeeping records as an expense or asset cost basis.

The Process of determination of cost involves the following steps:

(1) Collection and classification of costs: After costs are collected from some basic or subsidiary documents, they have to be classified and analyzed according to the needs of the organization. Costs may be classified according to their nature and a number of other characteristics. Such as, function variability, controllability, normality etc. This has been discussed in detail subsequently.

(2) Analysis of Costs: If management is to be provided with the data required for cost control it is necessary to analyze costs. The total cost of production or service can be ascertained without such analysis and in most cases an average unit cost can also be obtained, but none of the by what is known as “Element of Cost”.

(3) Allocation and apportionment of costs to the Cost Centers or Cost Units: Allocation implies identification of the overhead costs with particular cost centre or production or service department to which they relate. It is the process of charging the full amount of overhead costs to a particular cost centre. This is possible when the nature of expense is such that it can be easily identified with a particular cost centre. As for example, the salary paid to a foreman of a particular production department can be directly identified with that department and therefore it should be directly charged to that production department.

Appointment refers to the distribution of overheads among department of cost centers on an equitable basis. In short, appointment involves charging a share of the aggregate overhead expenses, to a number of departments or cost centers. This is done in case of those overhead items which cannot be wholly allocated to a particular department. As for example, the salary paid to the works manager of the factory, factory rent, general manager’s salary etc. cannot be charged wholly to a particular department or cost centre, but will have to be charged to all departments or cost centers on an equitable basis.

A greater degree of precision is required in allocation while there is an effort to obtain a reasonable standard of precision in apportionment.

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(4) Absorption of overheads: Absorption of overheads is charging of overheads from cost centers to products or services by means of absorption rates for each cost centre which is calculated as follows :

Overhead absorption Rate = Total overheads of the cost centre Total quantum of base

The base (denominator) is selected on the basis of type of the cost centre and its contribution to the products or services, for example, machine hours, labor hours, quantity produced etc.

Overhead absorbed = Overhead absorption rate x units of base in product or service

(5) Determination of Cost: After the costs are analyzed into different elements the next step is to proceed towards determining the total cost. In arriving at the total cost of the product from the different elements of cost, the build up is done in four stages successfully known as (I) Prime Cost, (II) Works Cost of Factory Cost (III) Cost of Production and (IV) Total Cost or Cost of Sales. This can be expressed in the form of chart as follows:

Components of Total Cost

(I) Prime Cost: Direct materials plus direct labor plus direct expenses together make up the prime cost. This is also known as direct cost first cost, flat cost etc.

(II) Works Cost: Prime cost plus works overhead together make up the Works Cost. This is also known as Factory cost, production cost, manufacturing cost etc.

(III)Cost of Production: Works cost plus office and administration overhead together makeup the cost of production. This is also known as office cost, administrative cost etc.

(IV) Total Cost: Cost of production plus selling and distribution plus selling and distribution overhead together make up the total cost. This is also known as cost of sales, selling cost etc.

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(b) Define with a chart Working Capital Management. Explain Credit Policy

1st Stage 2nd Stage 3rd Stage 4th Stage1. Direct Materials

4. Prime Cost Add (+)

6. Works Cost or Factory Cost Add (+)

8.Cost of Production Add (+)

10. Total cost of Cost of Sales

2. Direct Labour

5. Factory Overhead or Works Overhead

7. Office and Administration Overhead

9. Selling and Distribution Overhead

3. Direct Expenses

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A. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

By definition, working capital management entails short term decisions - generally, relating to the next one year period - which is "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability.

One measure of cash flow is provided by the cash conversion cycle - the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity

Debtor’s management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.

Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

The requirement of working capital is generally decided by the Revenue cycle of the business which we discussed above.

Daily requirement of cash Minimum requirement of raw material for smooth production activities The number of day’s requirement to convert raw material into finished product. Minimum quantity of finished goods to be kept on stock to meet market demand. The number of day’s credit given to customers.

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Credit policy

Credit gives the consumer the opportunity to buy, purchase or acquire goods and services, and pay for them at a later date. This has its advantages and disadvantages as follows:

Advantages of credit trade

Usually results in more customers than cash trade. Can charge more for goods to cover the risk of bad debt. Gain goodwill and loyalty of customers. People can buy goods and pay for them at a later date. Farmers can buy seeds and implements, and pay for them only after the harvest. Stimulates agricultural and industrial production and commerce. Can be used as a promotional tool. Increase the sales. Modest rates to be filled.

Disadvantages of credit trade

Risk of bad debt. High administration expenses. People can buy more than they can afford. More working capital needed. Risk of Bankruptcy. May lose peace of mind.

Forms of credit

Suppliers credit: Credit on ordinary open account Installment sales Bills of exchange Credit cards Contractor's credit Factoring of debtors Cash credit Cpf credits Exchange of product

Factors which influence credit conditions

Nature of the business's activities

Finished Goods

Current Assets Cycle

Accounts Receivable

Work in Process

Wages, Salaries Factory Overheads

Raw Materials

Cash Supplies

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Financial position Product durability Length of production process Competition and competitors' credit conditions Country's economic position Conditions at financial institutions Discount for early payment Debtor's type of business and financial positions

We will see how the decision of credit policy affects the working of the company and the profitability.

Following three credit policies were under consideration of ‘X’ Ltd we have to find out which of the policies would be beneficial to the company considering the net profit for the year concerned.

Particulars Credit Policy (A) 30 days

Credit Policy (B) 45 days

Credit Policy (C) 60 days

Sales in Units 25,000 30,000 40,000Sales price per unit (RS.) 100 100 100Profit/Volume Ratio 50% 51% 51%Fixed Cost (Rs) 1,00,000 1,00,000 1,00,000Cost of Credit Interest 15% 15% 15%Collection expenses 1% 2% 3%Bad Debts 1% 2% 3%

Answer

Particulars Credit Policy (A)

Credit Policy (B)

Credit Policy (C)

Sales 25,00,000 30,00,000 40,00,000Less: Variable cost 12,50,000 14,70,000 19,60,000Contribution 12,50,000 15,30,000 20,40,000Less: Fixed Cost 1,00,000 1,00,000 1,00,000Gross Profit (a) 11,50,000 14,30,000 19,40,000Less: Cost of credit Interest 30,822, 55,479 98,630Collection Expenses 25,000 60,000 1,20,000Bad Debts 25,000 60,000 1,20,000Total cost of credit (b) 80,822 1,75,479 3,38,630Net Profit (a) - (b) 10,69,178 12,54,521 16,01,370

From the above working, we can come to a conclusion that credit policy ‘C’ would give more profit hence to be ranked as I, credit policy ‘B’ as II and credit policy ‘A’ as III.

Note: collection expenses and bad debts are calculated as percentage of sales. Interest is calculated on average receivables. Credit policy ‘A’ Rs.25,00,000 x 30 = Rs. 2,05,479/-

365Interest on Rs. 2,05,479 x 15% = Rs. 30,822/-

Policy ‘B’ Rs. 30,00,000 x 45 = Rs. 3,69,863/- 365Interest on Rs. 3,69,863 x 15% = Rs. 55,479/-

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Policy ‘C’ Rs. 40,00,000 x 60 = Rs. 6,57,534/-

Interest on 6,57,534 x 15% = Rs. 98,630/-

Q5. (a) How do you define Budgetary Control Expenditure? Also explain Pay-Back and Accounting Rate Of Return methods.

A. The capital budgeting refers to the process of planning the investment of funds is long term assets of an enterprise. The purpose is to help the management control capital expenditure. With the help of capital budgeting, the management is able to reject poor investment decisions and select profitable ones. The same principles apply to additions, replacements modification etc. where funds are required.

A wide range of techniques are used for evolving investment proposals. The most commonly used technique are as follows:

The pay back method (PBP)

This technique estimate the time required by the project to recover through cash inflows, the first initial outlay while estimating net cash inflows the following points are to be considered.

The cash inflows should be estimated on incremental basis, so that only the difference between the cash inflows of the firm with an without the proposed investment is considered.

Cash inflow should be estimated on after tax basis. Since non cash expense like depreciation do not involve any cash out flows estimated

cash inflows form a project should be adjusted for such item.

Pay back period= Initial investment = Rs.25,000 = 5 YearsAnnual cash inflows 5,000

The annual cash inflow is calculated taking into account the net income of the asset before depreciation and after taxation advantages of pay back period method.

1. It is easy to calculate and investment proposals can be ranked quickly.2. It considers early recovery of investment3. The pay back method permits the firm to determine the length of time required to recover the investment.4. It is suitable for industries which are subject to early obsolescence.5. Due to lesser PBP the operational tension is less for the managers.

Disadvantages

1. It ignores the time value of money2. It does not consider long term profits given by a firm3. It does not take into account salvage value (Residual value) of the asset.4. It ignores the cost of capital

Suitability of the Method

Where the firm suffers from liquidity problem and is interested in quick recovery of fund the profitability.

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High external financing cost of the project. Those projects involving uncertain return Political and economic pressures.

Average Accounting of rate of return method (ARR)This method considers the relative profitability of different capital investment proposals for ranking the projects. Rate of return is calculated by dividing earnings by capital invested. We may find number of variations to the average rate of return method. The following are the common variations.

a) Average rate of return on original investment= Net earnings after depreciation of taxes ÷ Average investment

No. of years project will last

b) Average rate of return on average investment= Net earnings after depreciation of taxes ÷ Average investment

No. of years project will last

Average investment is arrived at by dividing the total original investment and investment in the project at the end of its economic life by 2.

The following example will help us to learn how the ARR is calculated and how it can be compared with pay back period method.

There are two investments proposals ‘A’ and ‘B’ each with capital investment of Rs. 20,000/- and depreciable like of 4 years. Assume that following are the estimated profits and cash inflows when annual straight line depreciation charges is Rs. 5,000/-

Period Project ‘A’ Project ‘B’Book Profits Net Cash

inflowsBook Profits Net cash

inflowsRs. Rs. Rs. Rs.1 4,000 9,000 1,000 5,0002 3,000 8,000 2,000 6,0003 2,000 7,000 3,000 7,0004 1,000 6,000 4,000 8,000

Total 10,000 30,000 10,000 30,000

Average rate of return = Average Annual Profit x 100 Investments x 2500 x 100

ARR = *2,500 x 100 2,000 2,000

= 12.5% = 12.5%* Average profit of 4 years

Hence both the projects are equally profitable as per ARR method. But if we apply PBP method project ‘A’ is more favorable as it gives better cash flows in the initial years

Advantages of this method

1. Earnings for the entire life of profits are considered.

2. Easy to understand and single to follows

3. Accounting comparison possible

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Disadvantages

1. It does not consider early recovery of investments

2. Not suitable for fast changing industries

3. Does not consider time value of money.

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(b) Narrate the principle advantages of a Budgetary Control System. Also give out the phases in Budgetary Control.

A. The budget is a statement of estimated performance for a specific period. The means of performance evaluation is the comparison between the ideals and actual. Hence the ideals are the budgeted or standard specifications which are not before preparation of the budget. Hence the actual performance is confirmed with the standard / budgeted performance. This comparison gives the fact of success or failure of the actual performance.

Budgetary control refers to the principles, procedure and practices of achieving given objective through budgets. A budgetary control system secures control over Performa and costs in the different parts of a business. If a budgeting is the Art of planning, budgetary control is the act of adhering to the plan.

Advantages of budgetary control

The principle advantages of a budgetary control system are as follows:

1. Budgetary control aims at maximization of profits through effective planning and control of income and expenditure.

2. There is a planned approach to expenditure and financing of the business so that economy is affected in the utilization of funds to the optimum benefit of the concern.

3. It provides a clear definition of the objective and policies of the concern and subjecting these policies to provide reviews.

4. The task of managerial coordination is facilitated through budgeting control.

5. Since each level of management is aware of its task to be performed maximum utilization of men, material and resources can be attained.

6. Reports are furnished under the principles of management or control by exception; only deviations from budgets which point out the week spots and inefficiencies are properly looked into

7. It enables the management to think ahead, making possible to identify the problems in advances before taking decisions.

8. Budgetary control system assists delegation of authority and is a powerful tool of responsibility accounting.

9. Budgets help setting up the conditions for standard tooling.

10. Provides a basis for performance appraisal (variance analysis). A budget is basically a yardstick against which actual performance is measured and assessed. Control is provided by comparisons of actual results against budget plan. Departures from budget can then be investigated and the reasons for the differences can be divided into controllable and non-controllable factors.

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11. It helps in establishing reward and punishment system for better / work performance.

12. It ensures better working capital.

13. Prerequisites for an effective budgeting control system.

14. The objectives, plans and policies of the business should be defined in clear terms.

15. A budget committed should be set up for formation and execution of plans.

16. The budges should primarily be prepared by those who are responsible to perform.

17. For the success of a budgetary control system there should be a sound organization for budget preparations, headed by budget controller or budget director.

Phases in budgetary control

Following are the stages to be considered and followed while budget as a technique of control and performance evaluation.

1. Preparing a budget statement

2. Recording the actual performance

3. Periodical comparison between the budgeted and actual performance and finding out the variances (favorable and unfavorable).

4. Foundry out the causes for such variances

5. Grouping the variances as ‘controllable’ and uncontrollable based on the causes found.

6. Deciding the quantum of reward of penalty for the individual or group of individuals for their favorable or unfavorable variances.

7. If required revising the standards or budgeted specification in order to suit the cyclical environment changes.

It is clear from above that the process of budgetary control has to be continuous, flexible and unbiased. The technique of budgetary control requires the knowledge and practical application of following concepts:

1. Cost benefit analysis including social,

2. Contingency approach

3. Responsibility accounting based on the application of the technique of variance analysis.

4. Value analysis for revenues, system, cost incurrence etc.

5. Application of certain mathematical models such as PERT, CPM, Transportation and assignment models, L.P. and simplex models, sensitivity analysis, etc.

Q6. Write short notes on:

(a) Functional & Master Budget

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A. Functional Budget:

There are 3 major business functions in an organization viz., manufacturing, administration and selling. The result of these functions is aimed at net profit. Hence, the Company Budgets to incurrence, volume, methods and results of these functions to be carried during the next year.

The following are the major functional budgets in Manufacturing:

1. Production budget

2. Material purchase budget

3. Manpower and wages budget

4. Manufacturing overhead budget

5. Production cost budget

6. Capital expenditure (investment) for manufacturing assets budget

The following are the major functional budgets in Administrative Functions:

1. Administrative wages budget

2. Internal audit activity budget

3. Planning and co-ordinates activity budget

4. Total administrative budget

The following are the major functional budgets in Sales & Distribution:

1. Sales volume budget

2. Sales value budget

3. Sales and distribution expense budget

4. Capital expenditure (investment) for sales budget

The following are the major functional budgets in Finance:

1. Cash budget

2. Capital (fund) raising and repayment budget

3. Funds flow statement (working capital budget)

Apart from above functional budget, the company should plan for expansion, new ventures and development budget.

Master Budget:

It combines all the budgets together for a period into one harmonious unit and thus it shows the overall business plan. As profit planning is the main objective of a budget programme, it is necessary that all subsidiary budgets

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should be coordinated and projected into a master or summary which should ultimately show the final project results of the plan. The master budget incorporates all the subsidiary functional budgets and the budgeted profit & loss account and balance sheet.

Master budget is of great importance for the top management as it enables the planning and control of the profit of business, the accuracy of all the budgets are automatically checked.

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(b) Indian financial market

A. Financial market means an organized or unorganized system though which funds are raised by the industries to meet their financial needs. The savings of both individual and corporate sector are harnessed to meet the above need. Let us now find out the structure of Indian Financial Market.

INDIAN FINANCIAL MARKET

From the above chart we can observe that the Indian Capital Market is mainly divided into two organized and unorganized. Under unorganized we have money lenders and Indigenous Bankers. In the organized sector we have a host of Agencies and Systems, Security Market under which there are news issues and further Government bonds and Corporate Securities. Then there is stock market under which again Government Bonds and Corporate Securities and under Corporate Securities here are again Bonds and Shares. In addition to these under organized sector there are Banks and Non Banking Financial Institutions exclusively engaged in capital financing. The

Indian Financial System

Unorganized

Money Lenders

Indigenous Bankers

Organized

Securities Market

Loans from Banking Non Banking Financial Institutions

New Issue Market Stock Market

Government Bond

Corporate Securities

Government Bond

Corporate Securities

Bonds/ Debentures

Shares

IFCIICICILICIDBIUTISIDBIState Finance Corporations

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organized sector is under the direct control of Reserve Bank of India and those under the unorganized sector they work under certain guidelines of government or Reserve Bank of India. Let us now have a look into the role of major financial institutions that provides long and medium term capital market.

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(c) Securities and Exchange Board of India (SEBI)

A. SEBI is the regulator for the Securities Market in India. It was formed officially by the Government of India in 1992 with SEBI Act 1992 being passed by the Indian Parliament. Chaired by C B Bhave, SEBI is headquartered in the popular business district of Bandra-Kurla complex in Mumbai, and has Northern, Eastern, Southern and Western regional offices in New Delhi, Kolkata, Chennai and Ahmedabad.

SEBI has to be responsive to the needs of three groups, which constitute the market:

the issuers of securities the investors the market intermediaries.

SEBI has three functions rolled into one body quasi-legislative, quasi-judicial and quasi-executive. It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it passes rulings and orders in its judicial capacity. Though this makes it very powerful, there is an appeals process to create accountability. There is a Securities Appellate Tribunal which is a three member tribunal and is presently headed by a former Chief Justice of a High court - Mr. Justice NK Sodhi. A second appeal lies directly to the Supreme Court.

SEBI has enjoyed success as a regulator by pushing systemic reforms aggressively and successively (e.g. the quick movement towards making the markets electronic and paperless rolling settlement on T+2 basis). SEBI has been active in setting up the regulations as required under law.

In 1998 Government of India established the Board with the following objectives.

To guide & control companies while issuing shares / debentures etc. To regulate stock market operation

To audit and inspect the brokers, lenders etc.

To control amalgamation and mergers

To design rules for investor protection

To control intermediates like, mutual funds, Merchant Bankers, portfolio managers etc.

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(d) Capital and Revenue

A. There are no single fixed criteria for deciding the distinction between capital and Revenue Expenditure and Receipt.

Capital Expenditure:

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An expenditure incurred to get an asset or advantage or benefit of an enduring nature for the business such expenditure is considered as capital and not revenue. Expenditure on Land & Building, Plant and Machinery, development of patent trade mark etc.

Capital expenditures (CAPEX or capex) are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond the taxable year. Capex are used by a company to acquire or upgrade physical assets such as equipment, property, or industrial buildings. In accounting, a capital expenditure is added to an asset account ("capitalized"), thus increasing the asset's basis (the cost or value of an asset as adjusted for tax purposes). Capex is commonly found on the Cash Flow Statement as "Investment in Plant Property and Equipment" or something similar in the Investing subsection.

Revenue Expenditure:

In business, a Revenue expense is a day-to-day expense such as sales and administration, or research & development, as opposed to Production, costs, and pricing. In short, this is the money the business spends in order to turn inventory into throughput. Revenue expenses also include depreciation of plants and machinery which are used in the production process.

On an income statement, "Revenue expenses" is the sum of a business's Revenue expenses for a period of time, such as a month or year.

In throughput accounting, the cost accounting aspect of Theory of Constraints (TOC), Revenue expense is the money spent turning inventory into throughput. In TOC, Revenue expense is limited to costs that vary strictly with the quantity produced, like raw materials and purchased components. Everything else is a fixed cost, including labor unless there is a regular and significant chance that workers will not work a full-time week when they report on its first day.

In a real estate context, Revenue expenses are costs associated with the operation and maintenance of an income producing property. Revenue expenses include

accounting expenses license fees maintenance and repairs, such as snow removal, trash removal, janitorial service, pest control, and lawn

care advertising office expenses supplies attorney fees and legal fees utilities, such as telephone insurance property management, including a resident manager property taxes travel and vehicle expenses leasing commissions salary and wages

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(g) Classification of Costs

A. In accounting, costs are the monetary value of expenditures for supplies, services, labor, products, equipment and other items purchased for use by a business or other accounting entity. It is the amount denoted on invoices as the price and recorded in bookkeeping records as an expense or asset cost basis.

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Classification of costs is the process of grouping costs according to their common characteristics. In order to identify costs with cost centers or cost units a suitable classification of costs is of much significance, costs may be classified from difference view points which are as follows

a. Costs may be classified from the view point of their nature : According to the nature of items, costs may be of two types, namely

I). Direct Costs :Direct costs refer to those costs which can be easily identified with a product, process or department, materials used and labor employed in manufacturing in article or in a particular process of production are common examples of direct costs.

II). Indirect Costs :Indirect costs, on the other hand, refer to those costs which are not traceable to any particular product, process or department, but are common to a number of products, processes or departments; Factory rent, factory manager’s salary etc. are typical examples of indirect costs.

b. Costs may be classified from the view point of their variability. According to variability, cost may be classified into three types, namely

I). Fixed Costs :Fixed costs refer to those costs which tend to remain unaffected by variations in the volume of output of sales. In other words, fixed costs remain the same when the volume of output or sale changes.

II). Variable Costs :Variable costs refer to those costs which vary directly in proportion to changes in the volume of output or sales. These costs increase or decrease with the rise of fall in production or sales.

III). Semi Variable Costs :Some costs have tendency to vary with changes in the volume of output or sales, but not in direct proportion to the change. These costs are partly fixed and partly variable and as such these costs are known as semi variable costs.

c. Costs may be classified from the view point of their controllability. According to controllability costs may be classified into two types namely

I). Controllable Costs :Controllable costs refer to those costs which can be influenced by the action of a specified member of an undertaking. Any undertaking is usually divided into departments or costs centres which are placed under the direct control and supervision of specified persons.

II). Uncontrollable Costs :Uncontrollable costs, on the other hand, refer to those costs which cannot be influenced by the action of a specified member of an undertaking.

d. Costs may be classified from the view point of their normality

I). Normal or unavoidable costs :Normal or unavoidable costs refer to those costs which are normally incurred at a given level of output in the conditions in which that level of output is normally attained. Such costs cannot be avoided at all.

II). Abnormal or Avoidable costs :

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Abnormal or avoidable costs refer to those costs which are not normally incurred at a given level of output in the conditions in which the level of output is attained. Such costs can be avoided if proper action is taken.

e. Costs may be classified from the view point of relevance to decision making and control. According to relevance to decision making and control, costs may be classified into

I). Sunk Costs :Sunk costs refer to those costs which have already been incurred and cannot be altered by any decision in the future.

II). Out of pocket costs :Out of pocket costs refer to those costs which signify the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of decision made.

III). Opportunity costs :Opportunity costs refer to those costs which are related to benefits sacrificed or foregone.

IV). Imputed Costs :Imputed costs refer to those costs which are not included in costs but are considered for making management decisions.

V). Differential costs :Differential costs refer to the difference in total costs between two alternatives. In case, the choice of alternative results in an increase in total costs such increased costs are knows as incremental costs.

END

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