Accounting and Finance for Managers
Content
MS-04
Management Programme
ASSIGNMENT FIRST SEMESTER 2013
MS - 04: Accounting and Finance for Managers
School of Management Studies INDIRA GANDHI NATIONAL OPEN UNIVERSITY MAIDAN GARHI, NEW DELHI – 110 068
ASSIGNMENT Course Code : MS-4 Course Title : Accounting and Finance for Managers Assignment Code : MS-04/TMA/SEM-I/2013 Coverage : All Blocks Note : Attempt all the questions and submit this assignment on or before 30th April, 2013 to the coordinator of your study center. 1. Explain in detail the various accounting concepts and discuss the application of these concepts in the preparation of financial statements. Ans: The main purpose of financial accounting is to provide necessary economic information required for decision-making in a business. Financial accounting follows certain rules and guidelines to prepare reports on the financial standing of an entity. These rules and guidelines are usually referred to as Generally Accepted Accounting Principles (GAAP). GAAP sets its accounting standards and guidelines for preparing financial reports for public, private, nonprofitable organizations, and government-owned companies. Fundamental Concepts of Accounting Business Entity This principle treats the company as a separate entity from its owners. Personal accounts of owners/partners should be kept separate from profits and expenses of the company. So, the accounting reports are prepared from the viewpoint of business purposes and not from the owner's outlook. Cost This principle states that the company has to consider the original cost of fixed assets like building and machinery, rather than market value. But today, most of the companies report only the market value. Sincerity
According to this principle, the auditors should prepare the financial reports in order to project the real financial position of the company rather than fabricating facts. Monetary Unit This principle assumes that transactions should be recorded in a single currency and exchange rate. This will help the company compare its accounts to the previous years, in spite of a change in the rate of inflation. This principle actually supports the preparation of business reports in a uniform manner. Consistency According to this principle, the accountants should use the same methods and functions for different periods of time. For example, the same rate of percentage should be applied for all depreciation. This principle is also known as the principle of regularity. Prudence The main objective of this principle is to show the real financial position of the company. The accountants should show the correct revenue accounts and provide a provision for expenses, which may occur in the future. Matching According to this principle, all the revenues and concerned expenses incurred should be shown in the same financial period. The main objective is to avoid any overstatements of income at any particular time. Accrual This principle requires the company to record the revenue or income when it is actually earned. Continuity or Going Concern This principle presumes that the functioning of the company will be smooth and the business entity will continue to operate for a fairly long period. This principle mainly helps in
preparing financial statements of the company as well as ensures that investors will get revenue on their investments. Realization This concept indicates the actual amount of revenue or cash inflows earned and realized from a business transaction. It means that realization occurs at the time of receiving the cash in the exchange of goods and services, and not at the time when the contract is granted. Time Period This principle specifies a particular interval of time for which the financial reports are prepared. It can be either year, fiscal year or short period like a quarter or a month. Full Disclosure/Materiality This principle states that the full disclosure of information and events should be ensured. The financial reports should not mislead the investors and should provide clear details of the financial position of the business. Dual Aspect According to this principle, all financial transitions have two effects. This concept, which is the cornerstone of accounting principles, assumes that making a record of transactions in the books of accounts has a dual outcome. For instance, getting goods for some amount of money has two effects: (1) paying cash and (2) receiving goods. A record of both should be made into the books of accounts. The dual aspect concept is expressed by the following equation: Assets = Liabilities + Equity Assets are owned by a business, and liabilities are the debts of a business, that the company owes to its creditors. Equity is what the company owes to its owners. So all transactions must comply to the above equation. Due to these guidelines of GAAP, consistency in the methods of preparations of financial accounts of the companies has been maintained. These principles are directly proportional to
the complexity of the accounts of a business and may hence, seem complex. The continuing complexity of business transactions has made it necessary for the accounts sector to have some standardization. GAAPs have not only set the benchmark for standardization, but have also ensured that the general public has a clearer view of the financial stability of a company.
2. Fairdeals Ltd. presents the balance sheets as at 31.12.2009 and 31.12.2010 as follows: Assets Fixed Assets at cost Less: Depreciation Investments Marketable Securities Inventories Book Debts Cash and Bank Preliminary Expenses 31.12.09 Rs. 31,30,000 6,80.000 24,50,000 12,50,000 60,000 4,10,000 5,30,000 1,20,000 1,00,000 49,20,000 31.12.10 Rs. 36,05,000 8,20,000 27,85,000 13,50,000 30,000 5,20,000 5,05,000 1,40,000 50,000 53,80,000 25,00,000 4,70,000 4,00,000 8,00,000 2,50,000 9,60,000 53,80,000
Liabilities Share Capital 20,00,000 Reserve and Surplus 4,20,000 Profit and Loss Account 3,80,000 13.5% Debentures 10,00,000 (Convertible) Mortgage Loan 3,00,000 Current Liabilities 8,20,000 49,20,000
You are informed that during 2010 (i) Rs. 2,00,000 of debentures were converted into shares at par; (ii) Rs. 1,00,000 shares were issued to a vendor of fixed assets; (iii) A machine costing Rs. 50,000 book value Rs. 30,000 as at 31 st December, 2009 was disposed off for Rs. 20,000; (iv) Rs. 30,000 of marketable securities (cost) was disposed off for Rs. 36,000. You are required to prepare a schedule of working capital changes and funds flow statement of the company for 2010.
Ans:
Schedule of changes in Working Capital for the year 2010 Particulars 2009 2010 Net effect on working capital Increase Decrease Current Assets Marketable Securities 60,000 30,000 30,000 Inventories 4,10,000 5,20,000 1,10,000 Book Debts 5,30,000 5,05,000 25,000 1,20,000 Cash & Bank 1,40,000 20,000 Current Liabilities 9,60,000 Current Liabilities 8,20,000 1,40,000 1,30,000 1,95,000 Decrease in Working Capital 65,000 1,95,000 1,95,000
Preparation of Non-Current Account (a) Calculation of Purchased of Fixed Asset for cash: Fixed Asset Account Particulars Rs. Particulars 31,30,00 By Accumulated To Balance b/d 0 Depreciation A/C To share Capital Purchase 1,20,000 By Bank (Sale) By Adjusted profit & To Bank (Purchase) (Balancing Fig.) 4,05,000 loss A/C (loss on sale) By Balance c/d Rs. 36,55,00 0 Rs. 20,000 20,000 10,000 36,05,000 36,55,000
(b) Calculation of depreciation on Fixed Asset: Accumulated Depreciation A/C Particulars Rs. Particulars To Fixed Assets a/c (Depreciation on machine sold) 20,000 By balance b/d By adjusted profit & Loss a/c (Current year’s 8,20,00 depreciation) (Balancing To Balance c/d 0 Figure) 8,40,00 0 Rs. 6,80,000
1,60,000 8,40,000
Calculations of Funds from Operation Adjusted profit and Loss A/C Particulars To Proposed Dividend To Depreciation To Preliminary expenses To loss on sale of machine To bonus share To Balance c/d Rs. Particulars 4,00,000 By balance b/d 1,60,000 By premium on issues of shares By funds from operations (Balancing 50,000 Fig.) 10,000 2,00,000 4,70,000 12,90,000 12,90,000 Rs. 4,20,000 20,000 8,50,000
Sources Funds from operations Sale of Machine Decrease in Working Capital
Rs.
Applications 8,50,000 Payment of Dividend Purchase of fixed asset (for 20,000 cash) Purchase of trade 65,000 investments
Rs. 3,80,000 4,05,000 1,00,000
Repayment of Mortgage Loan 9,35,000
50,000 9,35,000
3. An Analysis of S Ltd. cost records give the following information. Variable Cost Fixed Cost (% of Sales) Rs. Direct Material 32.8% Direct Labour 28.4 Factory Overhead 12.6 1,89,000 Distribution Overhead 4.1 58,400 Administration Overhead 1.1 66,700 Budgeted sales for the next year is Rs. 18, 50,000. You are required to determine: (a) Break even sales value (b) Profit at the budgeted sales volume (c) Profit if actual sales: (i) drop by 10% (ii) increase by 5% from the sale.
Ans: Percentage of variable cost to sales is 79% calculated as follows: Direct Materials Direct Labour Factory Overheads Distribution Expenses General & Administrative Expenses Total Variable Cost 32.8% of sales 28.4% of sales 12.6% of sales 4.1% of sales 1.1% of sales 79% of sales
Percentage of Contribution to Sales = 100 – 79 = 21 (Contribution = Sales – Variable Cost) P/V Ratio (Profit/Volume Ratio) = Contribution / Sales = 21/100 or 21% (i) Break Even Sales Volume = Fixed Costs / P/V Ratio = Rs. 1,89,000 + Rs. 58,400 + Rs. 66,700 / Rs. 21/100 = Rs. 15,00,000 (ii) Profit at the budgeted sales of Rs. 18,50,000 Percentage of Contribution to sales = 21 Contribution at the budgeted sales of Rs. 18,50,000 = 18,50,000 x 21/100 = Rs. 3,88,500 Profit = Contribution – Fixed Expenses = Rs. 3,88,500 – Rs. 3,15,000 = Rs. 73,500
(iii) (a) Profit if actual sales drop by 10% Rs. 18,50,000 1,85,000 16,65,000 3,49,650 3,15,000 34,650
Budgeted Sales Less: 10% Decline Contribution @ 21% of sales = 16,65,000 x 21/100 Less: Fixed Expenses
(b) Profit if actual sales increase by 5% from budgeted sales Budgeted Sales Add: 5% increase Contribution @ 21% on sales = 19,42,500 x 21 / 100 Less: Fixed Expenses 18,50,000 92,500 19,42,500 4,07,925 3,15,000 92,925
4. Briefly explain the following a) Rolling budget b) Performance budgeting c) Zero base budgeting d) Measures of financial beverage Ans: a) Rolling budget
A rolling budget is a budget that is continually updated to add a new budget period as the most recent budget period is completed. A rolling budget calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a rolling basis, then the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved in the process. Advantages and Disadvantages of the Rolling Budget This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.
Example of a Rolling Budget ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to December. After a month passes, the January period is complete, so it now added
a budget for the following January, so that it still has a 12-month planning horizon that now extends from February of the current year to January of the next year.
b) Performance budgeting Performance-based budgeting is the practice of developing budgets based on the relationship between program funding levels and expected results from that program. The performancebased budgeting process is a tool that program administrators can use to manage more costefficient and effective budgeting outlays. A budget that reflects the input of resources and the output of services for each unit of an organization. This type of budget is commonly used by the government to show the link between the funds provided to the public and the outcome of these services. Decisions made on these types of budgets focus more on outputs or outcomes of services than on decisions made based on inputs. In other words, allocation of funds and resources are based on their potential results. Performance budgets place priority on employees' commitment to produce positive results, particularly in the public sector.
c) Zero base budgeting Zero-based budgeting is an approach to planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting (Historic Budgeting), departmental managers justify only variances versus past years, based on the assumption that the "baseline" is automatically approved. By contrast, in zero-based budgeting, every line item of the budget must be approved, rather than only changes. During the review process, no reference is made to the previous level of expenditure. Zero-based budgeting requires the budget request be re-evaluated thoroughly, starting from the zerobase. This process is independent of whether the total budget or specific line items are increasing or decreasing.
The term "zero-based budgeting" is sometimes used in personal finance to describe "zerosum budgeting", the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. Zero based budgeting also refers to the identification of a task or tasks and then funding resources to complete the task independent of current resourcing. Advantages 1. Efficient allocation of resources, as it is based on needs and benefits rather than history. 2. Drives managers to find cost effective ways to improve operations. 3. Detects inflated budgets. 4. Increases staff motivation by providing greater initiative and responsibility in decision-making. 5. Increases communication and coordination within the organization. 6. Identifies and eliminates wasteful and obsolete operations. 7. Identifies opportunities for outsourcing. 8. Forces cost centers to identify their mission and their relationship to overall goals. 9. Helps in identifying areas of wasteful expenditure, and if desired, can also be used for suggesting alternative courses of action Disadvantages 1. More time-consuming than incremental budgeting. 2. Justifying every line item can be problematic for departments with intangible outputs. 3. Requires specific training, due to increased complexity vs. incremental budgeting.
4. In a large organization, the amount of information backing up the budgeting process may be overwhelming.
d) Measures of financial Leverage Financial leverage simply means the presence of debt in the capital structure of a firm. In other words, we can also call it existence of fixed-charge bearing capital which may include preference shares along with debentures, term loans etc. The objective of introducing leverage to the capital is to achieve maximization of wealth of the shareholders. Financial leverage deals with the profit magnification in general. It is also well known as gearing or ‘trading on equity’. The concept of financial leverage is not just relevant to businesses but it is equally true for individuals. Debt is an integral part of financial planning of anybody whether it is an individual, firm or a company. We will try to understand it from the business point of view. In a business, a debt is acquired not only on the grounds of ‘need for capital’ but it is also taken to enlarge the profits accruing to the shareholders. Let me clarify it further. Introduction of debt in the capital structure will not have impact on the sales, operating profits etc but it will increase the share of the equity shareholders, the ROE % (Return on Equity). Measures of Financial Leverage: There are various measures of Financial Leverage
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Debt Ratio: It is the ratio of debt to total assets of the firm which means what percentage of total assets is financed by debt. Debt Equity Ratio: It is the ratio of debt to equity which signifies how many dollars of debt is taken per dollar of equity. For More Interest Coverage Ratio: It is the ratio of profits to interest. This ratio is also represented in times. It represents how many times of the interest is the available profit to pay it off. Higher such ratio, higher is the interest paying capacity. The reciprocal of it is income gearing. For More Degree of Financial Leverage: Degree of financial leverage is nothing but a measure of magnification that happens due to debt capital in the structure. Degree of financial leverage is the proportion of a percentage change in EPS due to a certain percentage change in EBIT. % change in EPS Degree of Financial Leverage (DFL) = % change in EBIT
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5. What is capital structure? Explain the features and determinants of an appropriate capital structure. Ans: Capital structure: It represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, etc. Any earned revenue and capital surpluses are included. Capital Structure Planning: Decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency. The small companies often do not plan their capital structure. The capital structure is allowed to develop without any formal planning. These companies may do well in the short-run, however, sooner or later they face considerable difficulties. The unplanned capital structure does not permit an economical use of funds for the company. A company should therefore plan its capital structure in such a way that it derives maximum advantage out of it and is able to adjust more easily to the changing conditions. Instead of following any scientific procedure to find an appropriate proportion of different types of capital which will minimise the cost of capital and maximise the market value, a company may just either follow what other comparable companies do regarding capital structure or may consult some institutional lender and follow its advice. Theoretically, a company should plan an optimum capital structure in such a way that the market value of its shares is maximum. The value will be maximised when the marginal real cost of each source of funds is the same. In general, the discussion on the issue of optimum
capital structure is highly theoretical. The determination of an optimum capital structure in practice is a formidable task, and we have to go beyond the theory. That is why, perhaps, significant variations among industries and among' different companies within the same industry regarding capital structure are found. A number of factors influence the capital structure decision of a company. The judgement of the person or group of persons making the capital structure decision plays a crucial role. Two similar companies can have different capital structures if the decision makers differ in their judgement about the significance of various factors. These factors are highly psychological, complex and qualitative and do not always follow the accepted theory. Capital markets are not perfect and the decision has to be taken with imperfect knowledge and consequent risk. You might have become interested in identifying some of the important factors which influence the planning of the capital structure in practice. However, before we discuss these factors let us examine the features of an appropriate capital structure in the next section. Determinants of capital structure: capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. Once a company has been formed and it has been in existence for some years, the financial manager then has to deal with the existing capital structure. The company may need funds to finance its activities continuously. Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects most advantageous sources keeping in view the target capital structure: Thus the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finance.
The factors to be considered whenever a capital structure decision is taken are: (i) Financial Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let it’s briefly explain these factors. (i)Financial Leverage or Trading on Equity: The use of sources of finance with a fixed cost, such as debt and preference share capital, to finance the assets of the company is known
as financial leverage or trading on equity. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners' investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders' equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (BPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm's capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans. (ii) Cost of Capital: Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimise the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest, whether it makes profits or not. For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt
is. Thus, in order to minimise the overall cost of capital, a company should employ a large amount of debt.
(iii) Cash Flow: One of the features of a sound capital structure is conservation. Conservation does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed charges, created by the use of debt or preference capital in the capital structure in the context of the firm's ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of debt. If a company is not able to generate enough cash to meet its fixed obligations, it may have to face financial insolvency. The companies which expect large and stable cash inflows can employ a large amount of debt in their capital structure. It is somewhat risky to employ sources of capital with fixed charges for companies whose cash inflows are unstable or unpredictable.
(iv) Control: In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. The existing management team may not only what to be elected to the Board of Directors but may also desire to manage the company without any outside interference. The ordinary shareholders have the legal right to elect the directors of the company. If the company issues new shares, there is a risk of loss of control. This is not a very important consideration in case of a widely held company. The shares of such a company are widely scattered. Most of the shareholders are not interested in taking active part in the company's management. They do not have the time and urge to attend the meetings. They are simply interested in dividends and appreciation in the price of shares. The risk of loss of control can almost be avoided by distributing shares widely and in small lots. Maintaining control however could be a significant question in the case of a closely held company. A shareholder or a group of shareholders could purchase all or most of the new shares and thus control the company. Fear of having to share control and thus being
interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control the companies may issue preference shares or raise debt capital. (v) Flexibility: Flexibility means the firm's ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economise on the use of funds. (vi) Size of the Company: The size of a company greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds. A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure. (vii) Marketability: Marketability here means the ability of the company to sell or market particular type of security in a particular period of time which in turn depends upon -the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favours debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share
market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary4shares to raise finances. (viii) Floatation Costs: Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner's capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies.
Management Programme
ASSIGNMENT FIRST SEMESTER 2013
MS - 04: Accounting and Finance for Managers
School of Management Studies INDIRA GANDHI NATIONAL OPEN UNIVERSITY MAIDAN GARHI, NEW DELHI – 110 068
ASSIGNMENT Course Code : MS-4 Course Title : Accounting and Finance for Managers Assignment Code : MS-04/TMA/SEM-I/2013 Coverage : All Blocks Note : Attempt all the questions and submit this assignment on or before 30th April, 2013 to the coordinator of your study center. 1. Explain in detail the various accounting concepts and discuss the application of these concepts in the preparation of financial statements. Ans: The main purpose of financial accounting is to provide necessary economic information required for decision-making in a business. Financial accounting follows certain rules and guidelines to prepare reports on the financial standing of an entity. These rules and guidelines are usually referred to as Generally Accepted Accounting Principles (GAAP). GAAP sets its accounting standards and guidelines for preparing financial reports for public, private, nonprofitable organizations, and government-owned companies. Fundamental Concepts of Accounting Business Entity This principle treats the company as a separate entity from its owners. Personal accounts of owners/partners should be kept separate from profits and expenses of the company. So, the accounting reports are prepared from the viewpoint of business purposes and not from the owner's outlook. Cost This principle states that the company has to consider the original cost of fixed assets like building and machinery, rather than market value. But today, most of the companies report only the market value. Sincerity
According to this principle, the auditors should prepare the financial reports in order to project the real financial position of the company rather than fabricating facts. Monetary Unit This principle assumes that transactions should be recorded in a single currency and exchange rate. This will help the company compare its accounts to the previous years, in spite of a change in the rate of inflation. This principle actually supports the preparation of business reports in a uniform manner. Consistency According to this principle, the accountants should use the same methods and functions for different periods of time. For example, the same rate of percentage should be applied for all depreciation. This principle is also known as the principle of regularity. Prudence The main objective of this principle is to show the real financial position of the company. The accountants should show the correct revenue accounts and provide a provision for expenses, which may occur in the future. Matching According to this principle, all the revenues and concerned expenses incurred should be shown in the same financial period. The main objective is to avoid any overstatements of income at any particular time. Accrual This principle requires the company to record the revenue or income when it is actually earned. Continuity or Going Concern This principle presumes that the functioning of the company will be smooth and the business entity will continue to operate for a fairly long period. This principle mainly helps in
preparing financial statements of the company as well as ensures that investors will get revenue on their investments. Realization This concept indicates the actual amount of revenue or cash inflows earned and realized from a business transaction. It means that realization occurs at the time of receiving the cash in the exchange of goods and services, and not at the time when the contract is granted. Time Period This principle specifies a particular interval of time for which the financial reports are prepared. It can be either year, fiscal year or short period like a quarter or a month. Full Disclosure/Materiality This principle states that the full disclosure of information and events should be ensured. The financial reports should not mislead the investors and should provide clear details of the financial position of the business. Dual Aspect According to this principle, all financial transitions have two effects. This concept, which is the cornerstone of accounting principles, assumes that making a record of transactions in the books of accounts has a dual outcome. For instance, getting goods for some amount of money has two effects: (1) paying cash and (2) receiving goods. A record of both should be made into the books of accounts. The dual aspect concept is expressed by the following equation: Assets = Liabilities + Equity Assets are owned by a business, and liabilities are the debts of a business, that the company owes to its creditors. Equity is what the company owes to its owners. So all transactions must comply to the above equation. Due to these guidelines of GAAP, consistency in the methods of preparations of financial accounts of the companies has been maintained. These principles are directly proportional to
the complexity of the accounts of a business and may hence, seem complex. The continuing complexity of business transactions has made it necessary for the accounts sector to have some standardization. GAAPs have not only set the benchmark for standardization, but have also ensured that the general public has a clearer view of the financial stability of a company.
2. Fairdeals Ltd. presents the balance sheets as at 31.12.2009 and 31.12.2010 as follows: Assets Fixed Assets at cost Less: Depreciation Investments Marketable Securities Inventories Book Debts Cash and Bank Preliminary Expenses 31.12.09 Rs. 31,30,000 6,80.000 24,50,000 12,50,000 60,000 4,10,000 5,30,000 1,20,000 1,00,000 49,20,000 31.12.10 Rs. 36,05,000 8,20,000 27,85,000 13,50,000 30,000 5,20,000 5,05,000 1,40,000 50,000 53,80,000 25,00,000 4,70,000 4,00,000 8,00,000 2,50,000 9,60,000 53,80,000
Liabilities Share Capital 20,00,000 Reserve and Surplus 4,20,000 Profit and Loss Account 3,80,000 13.5% Debentures 10,00,000 (Convertible) Mortgage Loan 3,00,000 Current Liabilities 8,20,000 49,20,000
You are informed that during 2010 (i) Rs. 2,00,000 of debentures were converted into shares at par; (ii) Rs. 1,00,000 shares were issued to a vendor of fixed assets; (iii) A machine costing Rs. 50,000 book value Rs. 30,000 as at 31 st December, 2009 was disposed off for Rs. 20,000; (iv) Rs. 30,000 of marketable securities (cost) was disposed off for Rs. 36,000. You are required to prepare a schedule of working capital changes and funds flow statement of the company for 2010.
Ans:
Schedule of changes in Working Capital for the year 2010 Particulars 2009 2010 Net effect on working capital Increase Decrease Current Assets Marketable Securities 60,000 30,000 30,000 Inventories 4,10,000 5,20,000 1,10,000 Book Debts 5,30,000 5,05,000 25,000 1,20,000 Cash & Bank 1,40,000 20,000 Current Liabilities 9,60,000 Current Liabilities 8,20,000 1,40,000 1,30,000 1,95,000 Decrease in Working Capital 65,000 1,95,000 1,95,000
Preparation of Non-Current Account (a) Calculation of Purchased of Fixed Asset for cash: Fixed Asset Account Particulars Rs. Particulars 31,30,00 By Accumulated To Balance b/d 0 Depreciation A/C To share Capital Purchase 1,20,000 By Bank (Sale) By Adjusted profit & To Bank (Purchase) (Balancing Fig.) 4,05,000 loss A/C (loss on sale) By Balance c/d Rs. 36,55,00 0 Rs. 20,000 20,000 10,000 36,05,000 36,55,000
(b) Calculation of depreciation on Fixed Asset: Accumulated Depreciation A/C Particulars Rs. Particulars To Fixed Assets a/c (Depreciation on machine sold) 20,000 By balance b/d By adjusted profit & Loss a/c (Current year’s 8,20,00 depreciation) (Balancing To Balance c/d 0 Figure) 8,40,00 0 Rs. 6,80,000
1,60,000 8,40,000
Calculations of Funds from Operation Adjusted profit and Loss A/C Particulars To Proposed Dividend To Depreciation To Preliminary expenses To loss on sale of machine To bonus share To Balance c/d Rs. Particulars 4,00,000 By balance b/d 1,60,000 By premium on issues of shares By funds from operations (Balancing 50,000 Fig.) 10,000 2,00,000 4,70,000 12,90,000 12,90,000 Rs. 4,20,000 20,000 8,50,000
Sources Funds from operations Sale of Machine Decrease in Working Capital
Rs.
Applications 8,50,000 Payment of Dividend Purchase of fixed asset (for 20,000 cash) Purchase of trade 65,000 investments
Rs. 3,80,000 4,05,000 1,00,000
Repayment of Mortgage Loan 9,35,000
50,000 9,35,000
3. An Analysis of S Ltd. cost records give the following information. Variable Cost Fixed Cost (% of Sales) Rs. Direct Material 32.8% Direct Labour 28.4 Factory Overhead 12.6 1,89,000 Distribution Overhead 4.1 58,400 Administration Overhead 1.1 66,700 Budgeted sales for the next year is Rs. 18, 50,000. You are required to determine: (a) Break even sales value (b) Profit at the budgeted sales volume (c) Profit if actual sales: (i) drop by 10% (ii) increase by 5% from the sale.
Ans: Percentage of variable cost to sales is 79% calculated as follows: Direct Materials Direct Labour Factory Overheads Distribution Expenses General & Administrative Expenses Total Variable Cost 32.8% of sales 28.4% of sales 12.6% of sales 4.1% of sales 1.1% of sales 79% of sales
Percentage of Contribution to Sales = 100 – 79 = 21 (Contribution = Sales – Variable Cost) P/V Ratio (Profit/Volume Ratio) = Contribution / Sales = 21/100 or 21% (i) Break Even Sales Volume = Fixed Costs / P/V Ratio = Rs. 1,89,000 + Rs. 58,400 + Rs. 66,700 / Rs. 21/100 = Rs. 15,00,000 (ii) Profit at the budgeted sales of Rs. 18,50,000 Percentage of Contribution to sales = 21 Contribution at the budgeted sales of Rs. 18,50,000 = 18,50,000 x 21/100 = Rs. 3,88,500 Profit = Contribution – Fixed Expenses = Rs. 3,88,500 – Rs. 3,15,000 = Rs. 73,500
(iii) (a) Profit if actual sales drop by 10% Rs. 18,50,000 1,85,000 16,65,000 3,49,650 3,15,000 34,650
Budgeted Sales Less: 10% Decline Contribution @ 21% of sales = 16,65,000 x 21/100 Less: Fixed Expenses
(b) Profit if actual sales increase by 5% from budgeted sales Budgeted Sales Add: 5% increase Contribution @ 21% on sales = 19,42,500 x 21 / 100 Less: Fixed Expenses 18,50,000 92,500 19,42,500 4,07,925 3,15,000 92,925
4. Briefly explain the following a) Rolling budget b) Performance budgeting c) Zero base budgeting d) Measures of financial beverage Ans: a) Rolling budget
A rolling budget is a budget that is continually updated to add a new budget period as the most recent budget period is completed. A rolling budget calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a rolling basis, then the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved in the process. Advantages and Disadvantages of the Rolling Budget This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.
Example of a Rolling Budget ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to December. After a month passes, the January period is complete, so it now added
a budget for the following January, so that it still has a 12-month planning horizon that now extends from February of the current year to January of the next year.
b) Performance budgeting Performance-based budgeting is the practice of developing budgets based on the relationship between program funding levels and expected results from that program. The performancebased budgeting process is a tool that program administrators can use to manage more costefficient and effective budgeting outlays. A budget that reflects the input of resources and the output of services for each unit of an organization. This type of budget is commonly used by the government to show the link between the funds provided to the public and the outcome of these services. Decisions made on these types of budgets focus more on outputs or outcomes of services than on decisions made based on inputs. In other words, allocation of funds and resources are based on their potential results. Performance budgets place priority on employees' commitment to produce positive results, particularly in the public sector.
c) Zero base budgeting Zero-based budgeting is an approach to planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting (Historic Budgeting), departmental managers justify only variances versus past years, based on the assumption that the "baseline" is automatically approved. By contrast, in zero-based budgeting, every line item of the budget must be approved, rather than only changes. During the review process, no reference is made to the previous level of expenditure. Zero-based budgeting requires the budget request be re-evaluated thoroughly, starting from the zerobase. This process is independent of whether the total budget or specific line items are increasing or decreasing.
The term "zero-based budgeting" is sometimes used in personal finance to describe "zerosum budgeting", the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. Zero based budgeting also refers to the identification of a task or tasks and then funding resources to complete the task independent of current resourcing. Advantages 1. Efficient allocation of resources, as it is based on needs and benefits rather than history. 2. Drives managers to find cost effective ways to improve operations. 3. Detects inflated budgets. 4. Increases staff motivation by providing greater initiative and responsibility in decision-making. 5. Increases communication and coordination within the organization. 6. Identifies and eliminates wasteful and obsolete operations. 7. Identifies opportunities for outsourcing. 8. Forces cost centers to identify their mission and their relationship to overall goals. 9. Helps in identifying areas of wasteful expenditure, and if desired, can also be used for suggesting alternative courses of action Disadvantages 1. More time-consuming than incremental budgeting. 2. Justifying every line item can be problematic for departments with intangible outputs. 3. Requires specific training, due to increased complexity vs. incremental budgeting.
4. In a large organization, the amount of information backing up the budgeting process may be overwhelming.
d) Measures of financial Leverage Financial leverage simply means the presence of debt in the capital structure of a firm. In other words, we can also call it existence of fixed-charge bearing capital which may include preference shares along with debentures, term loans etc. The objective of introducing leverage to the capital is to achieve maximization of wealth of the shareholders. Financial leverage deals with the profit magnification in general. It is also well known as gearing or ‘trading on equity’. The concept of financial leverage is not just relevant to businesses but it is equally true for individuals. Debt is an integral part of financial planning of anybody whether it is an individual, firm or a company. We will try to understand it from the business point of view. In a business, a debt is acquired not only on the grounds of ‘need for capital’ but it is also taken to enlarge the profits accruing to the shareholders. Let me clarify it further. Introduction of debt in the capital structure will not have impact on the sales, operating profits etc but it will increase the share of the equity shareholders, the ROE % (Return on Equity). Measures of Financial Leverage: There are various measures of Financial Leverage
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Debt Ratio: It is the ratio of debt to total assets of the firm which means what percentage of total assets is financed by debt. Debt Equity Ratio: It is the ratio of debt to equity which signifies how many dollars of debt is taken per dollar of equity. For More Interest Coverage Ratio: It is the ratio of profits to interest. This ratio is also represented in times. It represents how many times of the interest is the available profit to pay it off. Higher such ratio, higher is the interest paying capacity. The reciprocal of it is income gearing. For More Degree of Financial Leverage: Degree of financial leverage is nothing but a measure of magnification that happens due to debt capital in the structure. Degree of financial leverage is the proportion of a percentage change in EPS due to a certain percentage change in EBIT. % change in EPS Degree of Financial Leverage (DFL) = % change in EBIT
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5. What is capital structure? Explain the features and determinants of an appropriate capital structure. Ans: Capital structure: It represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, etc. Any earned revenue and capital surpluses are included. Capital Structure Planning: Decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency. The small companies often do not plan their capital structure. The capital structure is allowed to develop without any formal planning. These companies may do well in the short-run, however, sooner or later they face considerable difficulties. The unplanned capital structure does not permit an economical use of funds for the company. A company should therefore plan its capital structure in such a way that it derives maximum advantage out of it and is able to adjust more easily to the changing conditions. Instead of following any scientific procedure to find an appropriate proportion of different types of capital which will minimise the cost of capital and maximise the market value, a company may just either follow what other comparable companies do regarding capital structure or may consult some institutional lender and follow its advice. Theoretically, a company should plan an optimum capital structure in such a way that the market value of its shares is maximum. The value will be maximised when the marginal real cost of each source of funds is the same. In general, the discussion on the issue of optimum
capital structure is highly theoretical. The determination of an optimum capital structure in practice is a formidable task, and we have to go beyond the theory. That is why, perhaps, significant variations among industries and among' different companies within the same industry regarding capital structure are found. A number of factors influence the capital structure decision of a company. The judgement of the person or group of persons making the capital structure decision plays a crucial role. Two similar companies can have different capital structures if the decision makers differ in their judgement about the significance of various factors. These factors are highly psychological, complex and qualitative and do not always follow the accepted theory. Capital markets are not perfect and the decision has to be taken with imperfect knowledge and consequent risk. You might have become interested in identifying some of the important factors which influence the planning of the capital structure in practice. However, before we discuss these factors let us examine the features of an appropriate capital structure in the next section. Determinants of capital structure: capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. Once a company has been formed and it has been in existence for some years, the financial manager then has to deal with the existing capital structure. The company may need funds to finance its activities continuously. Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects most advantageous sources keeping in view the target capital structure: Thus the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finance.
The factors to be considered whenever a capital structure decision is taken are: (i) Financial Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let it’s briefly explain these factors. (i)Financial Leverage or Trading on Equity: The use of sources of finance with a fixed cost, such as debt and preference share capital, to finance the assets of the company is known
as financial leverage or trading on equity. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners' investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders' equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (BPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm's capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans. (ii) Cost of Capital: Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimise the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest, whether it makes profits or not. For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt
is. Thus, in order to minimise the overall cost of capital, a company should employ a large amount of debt.
(iii) Cash Flow: One of the features of a sound capital structure is conservation. Conservation does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed charges, created by the use of debt or preference capital in the capital structure in the context of the firm's ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of debt. If a company is not able to generate enough cash to meet its fixed obligations, it may have to face financial insolvency. The companies which expect large and stable cash inflows can employ a large amount of debt in their capital structure. It is somewhat risky to employ sources of capital with fixed charges for companies whose cash inflows are unstable or unpredictable.
(iv) Control: In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. The existing management team may not only what to be elected to the Board of Directors but may also desire to manage the company without any outside interference. The ordinary shareholders have the legal right to elect the directors of the company. If the company issues new shares, there is a risk of loss of control. This is not a very important consideration in case of a widely held company. The shares of such a company are widely scattered. Most of the shareholders are not interested in taking active part in the company's management. They do not have the time and urge to attend the meetings. They are simply interested in dividends and appreciation in the price of shares. The risk of loss of control can almost be avoided by distributing shares widely and in small lots. Maintaining control however could be a significant question in the case of a closely held company. A shareholder or a group of shareholders could purchase all or most of the new shares and thus control the company. Fear of having to share control and thus being
interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control the companies may issue preference shares or raise debt capital. (v) Flexibility: Flexibility means the firm's ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economise on the use of funds. (vi) Size of the Company: The size of a company greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds. A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure. (vii) Marketability: Marketability here means the ability of the company to sell or market particular type of security in a particular period of time which in turn depends upon -the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favours debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share
market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary4shares to raise finances. (viii) Floatation Costs: Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner's capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies.
