Gauhati University Question Papers
COST AND MANAGEMENT ACCOUNTING (May-June’ 2014)
Full Marks: 80
Time Allowed: 3 hours
GROUP – A
COST ACCOUNTING
Marks: 40
Answer either in English or Assamese
The figures in the margin indicate full marks for the questions
ANSWER ALL THE QUESTIONS AS DIRECTED
1. Answer the following as directed: 1x4=4
a) Cost audit report is addressed to the shareholders. (State whether the statement is true or false)
Ans: True
b) Prime cost + Factory overheads = _____. (Complete the blank space)
Ans: Works cost if there is not WIP or works cost incurred if there is WIP.
c) What is overhead rate?
Ans: Overhead rate is a cost which is allocated to the production of a product or service.
d) What is standard hour?
Ans: It is the time which is to be taken to complete the actual work.
2. Answer (any three) Questions of the following: 2x3=6
a) Give two examples of semi variable costs.
Ans: Telephone charges, Depreciation
b) Give two causes of idle time.
Ans: Machine break down, power failure, Time lost between the finish of one job and starting of next job.
c) Give two reasons for over and under absorption of overheads.
Ans: Reason of over or under-absorption of overheads: The under or over-absorption of overhead arises due to following reasons:
a) Errors in estimating overheads.
b) Overhead may change due to change in method of production.
c) The seasonal fluctuation in overhead cost in some industries.
d) Under utilization of available capacity, unexpected change in the volume of out put.
d) Give two cause of Material Usage Variance.
Ans: Actual input is differed from standard input, Actual output is differed from standard output.
3. Write short notes on (any two) of the following: 5x2=10
a) Distinction between Cost-Audit & Financial Audit.
Ans: Difference between Financial Audit and cost Audit
Financial Audit | Cost Audit |
1. Financial audit is the audit of financial accounts of an organization, at the end of the financial year to reflect true and fair view of accounts. | 1. Cost audit is the audit of cost accounting records of an organization to reflect true cost of a product or service and pricing. |
2. Financial audit is compulsory for every company as per company's act, 2013. | 2. Cost audit is not compulsory except in certain' cases i.e. companies' carrying. on business of manufacturing or mining and where the Central government has directed to maintain cost accounts in certain industries. |
3. The purpose of financial audit are to find out whether financial accounts are properly maintained and whether reflects true and fair view of the state of affairs of the company. | 3. The objects of cost audit are to examine the cost accounting records, verify it and to give report regarding efficiency or inefficiency in cost of production and detailed analysis of cost data's. |
4. In this audit all types of financial transactions are examined. | 4. In case of cost audit, only expenses related to costs i.e. material, labour, overheads, and stores are thoroughly checked. |
5. Financial audit is primarily conducted to protect the interest of the shareholders. | 5. Cost audit is primarily conducted to protect the interest of the management, customers, government and of the society. |
b) Selling and Distribution Overhead.
Ans: Selling and Distribution Overheads: Overheads incurred for getting orders from consumers are called as selling overheads. On the other hand, overheads incurred for execution of order are called as distribution overheads. Examples of selling overheads are sales promotion expenses, marketing expenses, salesmen’s salaries and commission, advertising expenses etc. Examples of distribution overheads are warehouse charges, transportation of outgoing goods, packing, commission of middlemen etc.
c) Incremental and decremental costs.
Ans: Incremental cost: Incremental costs mean increase in cost due to increase in level of activity. It is also known as marginal cost because marginal cost is nothing but the change in cost due to the increase in one unit of product. In simple words, it is the additional cost of additional output.
Decremental costs: Decremental costs mean decrease in cost due to decrease in level of activity.
4. Describe the objectives of cost accounting. Highlight the areas in which cost accounting can be treated as an aid to management. 10
Ans: Objectives/functions of Cost Accounting: According to Blocker and Weltemer, “Cost Accounting is to serve management in the execution of polices and in comparison of actual and estimated results in order that the value of each policy may be appraised and changed to meet the future conditions”. The main objectives/functions of cost accounting are:
1) Ascertain Cost: To ascertain the cost of product or a services reveled and enable measurement of profit by proper valuation of inventory.
2) Analyse Costs: To analysis costs or to classify the expenses under different heads of accounts viz. material, labour, expenses etc.
3) Allocate and Apportion the Costs: To allocate or charge the direct expenses or specific costs such as Raw Material, Labour to particular product, contract or process and to distribute common expenses to each product, contract or process on a suitable basis.
4) Cost Reporting: Cost Reporting or presentation includes:
a) What to report i.e. what is the nature of information to be presented?
b) Whom to Report i.e. to whom the report is to be addressed.
c) When to Report i.e. when the report is to be presented i.e. Daily weekly monthly yearly etc.
d) How to Report i.e. in what format the report is to be presented.
5) Assist the Management: Cost Accounting assist the management in the following ways
a) Indicate to the management any inefficiencies and extent of various forms of waste of Raw Material, Time, Expenses etc.
b) Help the management in fixing of selling price.
c) Provide information to enable management to take decision of various types.
Costing is an Aid to Management)
a) Helps in Decision Making: Cost accounting helps in decision making. It provides vital information necessary for decision making. For instance, cost accounting helps in deciding:
1. Whether to make a product buy a product?
2. Whether to accept or reject an export order?
3. How to utilize the scarce materials profitably?
b) Helps in fixing prices: Cost accounting helps in fixing prices. It provides detailed cost data of each product (both on the aggregate and unit basis) which enables fixation of selling price. Cost accounting provides basis information for the preparation of tenders, estimates and quotations.
c) Formulation of future plans: Cost accounting is not a post-mortem examination. It is a system of foresight. On the basis of past experience, it helps in the formulation of definite future plans in quantitative terms. Budgets are prepared and they give direction to the enterprise.
d) Avoidance of wastage: Cost accounting reveals the sources of losses or inefficiencies such as spoilage, leakage, pilferage, inadequate utilization of plant etc. By appropriate control measures, these wastages can be avoided or minimized.
e) Highlights causes: The exact cause of an increase or decrease in profit or loss can be found with the aid of cost accounting. For instance, it is possible for the management to know whether the profits have decreased due to an increase in labour cost or material cost or both.
f) Reward to efficiency: Cost accounting introduces bonus plans and incentive wage systems to suit the needs of the organization. These plans and systems reward efficient workers and improve productivity as well improve the morale of the work -force.
g) Prevention of frauds: Cost accounting envisages sound systems of inventory control, budgetary control and standard costing. Scope for manipulation and fraud is minimized.
h) Improvement in profitability: Cost accounting reveals unprofitable products and activities. Management can drop those products and eliminate unprofitable activities. The resources released from unprofitable products can be used to improve the profitability of the business.
Or
“One of the major objectives of a system of material control is to ensure that there is no over-stocking and under-stocking of materials.” Discuss.
Ans: Inventory control means to monitor the stock of goods used for production, distribution and captive (self) consumption. For a specific time period, stocks of goods are placed at some particular location. Stock of goods includes raw-materials, work in progress, finished goods, packaging, spares, components, consumable items, etc. Inventory Control means maintaining the inventory at a desired level. The desired-level keeps on fluctuating as per the demand and supply of goods.
According to Gordon Carson, "Inventory control is the process where by the investment in materials and parts carried in stocks is regulated, within pre-determined limits set in accordance with the inventory policy established by the management."
Simply "Inventory control is a method to identify those stocks of goods, which can be used for the production of finished goods. It shall be supported by a schedule which gives details regarding; opening stock, receipt of raw-materials, issue of materials, closing stock, and scrap generated."
Objectives of store control: The following are the important objectives of store control
a) to make available the right type of raw material at the right time in order to have smooth and continuous flow of production;
b) to ensure effective utilization of material;
c) to prevent over stocking of materials and consequent locking up of working capital;
d) to procure appropriate quality of raw materials at reasonable price;
e) to prevent losses during storage of materials;
f) to supply information to the management regarding the cost of materials and the availability of stock;
Significance/Advantages of Inventory control
1. Protects from fluctuations in demand: There are always chances of fluctuations in the demand of a material. These fluctuations can be adjusted if there are sufficient items in the stock of inventory. Therefore, proper inventory control protects the company from fluctuations in demand.
2. Better services to customers: If the company maintains a proper inventory of raw-materials, then it can complete its production in time. So, it can deliver the finished goods to the customers in time. Similarly, if the company has a proper inventory of finished goods, then it can satisfy the additional demand of the customers.
3. Continuity of production operations: Proper inventory control helps to maintain continuity of production operations. This is because it maintains a smooth flow of raw materials. So, there are no shortages of raw-materials required for production process.
4. Reduces the risk of loss: Proper inventory control helps to reduce the risk of loss due to obsolescence (outdated) or deterioration of items. This is because it checks all the items regularly.
5. Minimizes the administrative workload: Proper inventory control helps to minimize the administrative work load of purchasing, inspection, warehousing, etc. This will reduce the manpower requirement and will minimize the labour cost too.
6. Facilitates cost accounting activities: Inventory control facilitates cost accounting activities. This is because, inventory control provides a means of allocating materials cost of products, departments or other operating accounts.
7. Avoids duplication in ordering: Inventory control avoids duplication in ordering of stock. This is done by maintaining a separate purchase department.
5. Explain the principles and basis of allocation and apportionment of overheads. 10
Ans: Allocation of Overhead Expenses: Allocation is the process of identification of overheads with cost centres. An expense which is directly identifiable with a specific cost centre is allocated to that centre. So it is the allotment of whole item of cost to a cost centre or cost unit or refers to the charging of expenses which can be identified wholly with a particular department. For example, the whole of overtime wages paid to the workers relating to a particular department should be charged to that department. So, the term allocation means the allotment of the whole item without division to a particular department or cost centre.
Apportionment of Overhead Expenses: Cost apportionment is the allotment of proportions of items to cost centres or cost units on an equitable basis. The term refers to the allotment of expenses which cannot identify wholly with a particular department. Such expenses require division and apportionment over two or more cost centres or units. So cost apportionment will arise in case of expenses common to more than one cost centre or unit. It is defined as the allotment to two or more cost centres of proportions of the common items of cost on the estimated basis of benefit received. Common items of overheads are rent and rates, depreciation, repairs and maintenance, lighting, works manager’s salary etc.
Guidelines or Principles of Apportionment:
The guidelines or principles which facilitate in determining a suitable basis for apportionment of overheads are explained below:
1. Derived Benefit: According to this principle, the apportionment of common item of overheads should be based on the actual benefit received by the respective cost centers. This method is applicable when the actual benefits are measurable. For example, rent can be apportioned on the basis of floor area occupied by each department.
2. Potential Benefit: According to this principle, the apportionment of common item of overheads should be based on potential benefits (i.e. benefits likely to be received). When the measurement of actual benefit is difficult or impossible or uneconomical this method is adopted. For example, the cost of canteen can be apportioned as the basis of number of employees in each department which is a potential benefit.
3. Ability to pay: According to this method, overheads should be apportioned on the basis of the sales ability or income generating ability of respective departments. In other words, the departments which contribute more towards profit should get a higher proportion of overheads.
4. Efficiency method: According to this principle, the apportionment of overheads is made on the basis of the production targets. If the target is higher, the unit cost reduces indicating higher efficiency. If the target is not achieved the unit cost goes up indicating inefficiency of the department.
5. Specific criteria method: According to this principle, apportionment of overheads is made on the basis of specific criteria determined in a survey. Hence this method is also known as 'Survey method'. When it is difficult to select a suitable basis in other methods, this method is adopted. For example, while apportioning salary of foreman, a careful survey is made to know how much time and attention is given by him to different departments. On the basis of the above survey the apportionment is made.
Or
From the following information prepare a Cost Sheet for the period ended on 31st March, 2014:
Particulars | Amount in (Rs.) |
Opening stock of raw material Purchase of raw material Closing stock of raw material Direct wages Direct expenses Factory overheads Office & administrative overhead Selling & distribution overhead Cost of opening stock of finished goods Cost of closing stock of finished goods | 41,000 1,59,000 35,000 44,000 20,000 50% of direct wages 25% of work cost 40,000 40,000 20,000 |
Also calculated the volume of sales to earn a profit of Rs. 5,00,000.
GROUP – B
MANAGEMENT ACCOUNTING
Marks: 40
The figures in the margin indicate full marks for the questions.
6. Answer the following as directed: 1x4=4
a) The term management accounting was first used in the year. (Fill in the blank)
Ans: 1950
b) Vertical Analysis is also known as ‘Static Analysis’. (State whether the statement is true or false)
Ans: True, also known as Common-size analysis
c) Contribution is the difference between the sales and the total cost of sales. (State whether the statement is true or false)
Ans: False
d) How Earnings per share (E.P.S.) is calculated?
Ans: EPS = Amount of profit available for equity shareholders/No. of equity shares
7. Write short notes on (any three) of the following: 2x3=6
a) Budget Manual.
Ans: A budget manual is a document which tells out the duties and also responsibilities of various executives concerns with the budgets. It specifies the relation among various functionaries.
b) Liquidity Ratio.
Ans: The ratios which show the relationship between current assets and current liabilities of the business enterprise and indicates is short term payment capacity are called liquidity ratio. Example: Current Ratio, Liquid Ratio.
c) Margin of Safety.
Ans: The positive difference between the sales volume and the break even volume is known as the margin of safety. The larger the difference, the safer the organization is from a loss making situation. It can be calculated either in cash or in units. Margin of Safety can be derived as follows:
Margin of Safety = Actual Sales – Break even Sales or,
Margin of Safety (in cash) = Profit / P/V Ratio
d) Return on capital Employed.
Ans: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit. Return on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
8. Answer (any two) of the following: 5x2=10
a) Nature of management accounting.
Ans: Characteristics or Nature of management accounting: The task of management accounting involves furnishing of accounting data to the management for basing its decisions on it. It also helps, in improving efficiency and achieving organisational goals. The following are the main characteristics of management accounting:
1. Providing Accounting Information. Management accounting is based on accounting information. The collection and classification of data is the primary function of accounting department. The information so collected is used by the management for taking policy decisions. Management accounting involves the presentation of information in a way it suits managerial needs.
2. Cause and Effect Analysis. Financial accounting is limited to the preparation of profit and loss account and finding out the ultimate result, i.e., profit or loss Management accounting goes a step further. The ‘cause and effect’ relationship is discussed in management accounting. If there is a loss, the reasons for the loss are probed. If there is a profit, the factors directly influencing the profitability are also studies. So the study of cause and effect relationship is possible in management accounting.
3. Use of Special Techniques and Concepts. Management accounting uses special techniques and concepts to make accounting date more useful. The techniques usually used include financial planning and analysis, standard costing, budgetary control, marginal costing, project appraisal, control accounting, etc. The type of technique to be used will be determined according to the situation and necessity.
4. Taking Important Decisions. Management accounting helps in taking various important decisions. It supplies necessary information to the management which may base its decisions on it. The historical date is studies to see its possible impact on future decisions. The implications of various alternative decisions are also taken into account while taking important decisions.
b) Purposes of performance budgeting.
Ans: Performance Budgeting had its origin in U.S.A. after the Second World War. It tries to rectify some of the traditional budget. In the traditional budget amount are earmarked for the objects of expenditure such as salaries, travel, office expenses, grant in aid etc. In such system of budgeting the money concept was given more prominence i.e. estimating or projecting rupee value for the various accounting heads or classification of revenue and cost. Such system of budgeting was more popularly used in government departments and many business enterprises. But is such system of budgeting control of performance in terms of physical units or the related costs cannot be achieved.
Purpose of performance budgeting are as follows:
a. To helps the management to regulate its each and every activity according to predetermined standards of performance, targets and objectives.
b. It is not only an estimate of future needs but goes beyond that and- includes functions, programmes, activity schemes and time schedules to help effective and economic allocation for the programmes.
c. It lays great stress on the management of organisational structural and overall policy, personnel, financial, etc. from traditional to dynamic one.
d. It is not merely a projection of trends and targets but planning the business from grass root level to top level on rational thinking and forecasting.
e. To improve budget formulation process.
c) Limitations of financial statement.
Ans: Limitations of financial statements: Financial Statements suffers from various limitations which are given below:
(i) Historical Records: Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future. The financial statements are not of much help as the information given in these statements is historic in nature and does not reflect the future.
(ii) Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. Different assets are shown at the historical cost in financial statements. It, therefore, ignore the price level change or present value of the assets.
(iii) Qualitative aspect Ignored: Financial statements considered only those items which can be expressed in terms of money. Financial Statements ignores the qualitative aspect such as quality of management, quality of labour force, Public relations.
(iv) Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.
(v) Not free from Bias: Financial statements are largely affected by the personal judgement of the accountant in selecting accounting policies. Therefore, financial are not free from bias.
9. Explain in detail five leading tools and techniques used for analysis of Financial Statement. 10
Ans: Tools of Analysis of Financial Statements: The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. If this is not the case, the deviation in the use of accounting principles should be mentioned as a footnote. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’.
2. Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’.
3. Trend Analysis: It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bear to the same item in the base year. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.
4. Ratio Analysis: It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the technique of ratio analysis.
5. Funds flow statement: The financial statement of the business indicates assets, liabilities and capital on a particular date and also the profit or loss during a period. But it is possible that there is enough profit in the business and the financial position is also good and still there may be deficiency of cash or of working capital in business. Financial statements are not helpful in analysing such situation. Therefore, a statement of the sources and applications of funds is prepared which indicates the utilisation of working capital during an accounting period. This statement is called Funds Flow statement.
Or
Discuss the significance and computation of the following ratios. 2 ½ x 4=10
a) Return on investment.
Ans: Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.
Return on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.
b) Debt-Equity Ratio.
Ans: Debt-Equity Ratio: Debt equity ratio shows the relationship between long-term debts and shareholders funds’. It is also known as ‘External-Internal’ equity ratio.
Debt Equity Ratio = Debt/Equity
Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.
Equity (Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets
Objective and Significance: This ratio is a measure of owner’s stock in the business. Proprietors are always keen to have more funds from borrowings because:
(i) Their stake in the business is reduced and subsequently their risk too
(ii) Interest on loans or borrowings is a deductible expenditure while computing taxable profits. Dividend on shares is not so allowed by Income Tax Authorities.
The normally acceptable debt-equity ratio is 2:1.
c) Operating Profit Ratio.
Ans: Operating Profit Ratio: Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner:
Operating Profit Ratio = (Operating Profit/Net Sales) x 100
Where Operating Profit = Gross Profit – Operating Expenses
Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales Return
Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.
d) Stock Turnover Ratio.
Ans: Stock Turnover Ratio: Stock turnover ratio is a ratio between cost of goods sold and average stock. This ratio is also known as stock velocity or inventory turnover ratio.
Stock Turnover Ratio = Cost of Goods Sold/Average Stock
Where Average Stock = [Opening Stock + Closing Stock]/2
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Objective and Significance: Stock is a most important component of working capital. This ratio provides guidelines to the management while framing stock policy. It measures how fast the stock is moving through the firm and generating sales. It helps to maintain a proper amount of stock to fulfill the requirements of the concern. A proper inventory turnover makes the business to earn a reasonable margin of profit.
10. From the following information find out: 4+4+2=10
a) Sales at Break-Even point.
b) P/V Ratio.
c) Margin of Safety
Ø Sales Rs. 2,60,000/- (at Rs. 20-per unit)
Ø Fixed Cost Rs. 80,000/-
Ø Variable Cost Rs. 10/-
Or
How is a Cash Flow Statement prepared as per Indian Accounting Standard? State the utility of preparing such a statement. 5+5=10
Ans: Preparation of Cash flow statement/Various activities under cash flow statement (AS-3)
Cash flow statement is a statement which shows the movement of cash and cash equivalents over a particular period of time. It comprised of three sections: Operating activities, investing activities and financing activities. There are two methods of preparing cash flow statement: the direct method preferred by FASB and indirect method preferred by most businesses because of its simplicity. The difference between the two methods lies in the operating section only. Investing and financing activities calculation are same under both the methods.
A) Section one: Cash flow from operating activities: Operating activities are the principal revenue generating activities of the business. These are cash flows from regular course of operations such as manufacturing, trading etc. All activities that are not investing or financing activities are included under operating activities.
Under indirect method cash flow from operating activities is calculated with the help of net profit before tax and extraordinary items. Non-cash and non-operating expenses and losses are added and non-cash and non-operating incomes are deducted from net profit before tax and extraordinary items to find net cash flow from operating activities before working capital change. After this changes in working capital is adjusted and payment of taxes during the year is deducted to find cash flow from operating activities.
B) Section two: Cash from investing activities: The investing activities of a business include all cash flow arises due to acquisition and disposal of long term assets (whether tangible and intangible) and investments. Acquisition or disposal of companies also comes under investing activities. These are separately discloses in cash flow statement.
All the sources of cash from investing activities are added and all the applications of cash in investing activities are deducted to find net cash flow from investing activities.
C) Section three: Cash flows from financing activities: Financing activities are the activities which results in changes in the size and composition of the owner’s capital and borrowings of the enterprises from other sources. The financing activities of a firm include issuing or redemption of share capital, issue and redemption of debentures, raising and repayment of long term loans etc. Dividends and Interest paid are also come under financing activities.
All the sources of cash from financing activities are added and all the applications of cash in financing activities are deducted to find net cash flow from financing activities.
Last section – Bottom line: All the cash flows from three sections are added to find net cash flow during the year. Thereafter opening balance of cash and cash equivalent s are added with this amount and the resulting amount will be the closing balance of cash and cash equivalents. Here cash and cash equivalents means:
Cash: Cash comprises cash on hand and demand deposits with banks.
Cash Equivalents: Cash Equivalents are short-term, highly liquid investments that are readily convertible cash. Examples of cash equivalents are: (a) treasury bills, (b) commercial paper, (c) money market funds and (d) Investments in preference shares and redeemable within three months.
Importance of Cash Flow statement:
Cash flow statement is very useful to the management for short-term planning due to the following reasons:
(i) Show the relationship of net income to changes in the business cash: Generally there is direct relation between net income and cash. High net income leads to increase in cash and vice versa. But there may be a situation where a company’s net income is high but decrease in cash balance and increase in cash balance when net income is low. Every user is interested to know the reasons or difference between the net income and net cash provided by operations.
(ii) Helpful in preparing Cash Budget: A Cash Budget is an estimate of cash receipts and disbursement for a future period of time. Cash Flow Statement provides help to the management to prepare Cash Budget. A comparison of cash budget and cash flow statement reveals the extent to which the sources of the business were generated and used as per the plans of the business.
(iii) Measurement of Liquidity: Liquidity means ability of a business enterprise to pay off its liabilities when due. Cash Flow Statement helps to know about the sources where from the cash will be available to pay off the liabilities.
(iv) Dividend Decisions: The Capacity of the firm to pay dividends to shareholders depends on the generation of cash flows. Cash flow statement helps the management to know about the sources of cash to pay off dividend.
(v) Prediction of sickness: With the help of preparing cash from operation a business enterprise may come to know about cash losses in operation. It helps to predict this type of sickness.
(vi) Future Guide: Most of the users are interested to assess the ability of the firm in generating future cash flows, its timing and certainty. These questions can be answered by analysing the cash flow statement.
(vii) The use of cash in investing and financing Transaction: Information in cash flow statement would be useful to find out as to how cash has been obtained from investing and financing activities and how cash has been used to invest and repay borrowings etc. The statement would be useful to users to ascertain the following:
a) The change in the net assets of the business.
b) The change in the financial structure.
c) The financing of expansion.
d) The utilisation of finance obtained by the enterprise.
e) The impact of investing and financing activities on the cash balance of the enterprise.
(viii) Enhances the Comparability of report: It enhances the comparability of the reporting of operating performance by different enterprises, because it eliminates the effect of using different accounting treatments for the same transactions and events.
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