What is Capital Budgeting?

Capital Budgeting: Capital budgeting is the process of identifying and selecting investments
in the long lived assets or the assets which are expected to produce benefits over more than
a year. Business is all about exploring avenues for growth and innovation, which requires
continuous evaluation of possible investment opportunities. Capital budgeting to a large
extent depends upon the corporate strategy.
There are four stages in the capital budgeting process:
Stage 1: Investment Screening and Selection − Projects consistent with the corporate
strategy are identified by the various functional units (production, marketing, research and
development) of the firm. Once the projects are identified, projects are evaluated and
screened by an investment committee comprising of senior managers. The main focus of
this process is to estimate how the investment proposal will affect the future cash flows of
the firm and hence the value of the firm.
Stage 2: Capital Budgeting Proposal − Once the investment proposal survives the scrutiny of
the investment committee, a capital budget is proposed for the project. The capital budget
lists the amount of investment required for each investment proposal. This proposal may
start with estimates of expected revenue and costs. At a later stage inputs from marketing,
purchasing engineering, production and accounting and finance functions are put together.
Stage 3: Budgeting Approval and Authorisation Projects included in the capital budgets are
authorised, which allows further fact gathering research and analysis as a result of which the
capital budget proposal is refined and put up for approval. The approval allows the
expenditure on the project. In some firms the projects are authorised and approved
concurrently, where as in others a project is first authorised so that the estimates can be
refined. It is then approved. Large expenditures require formal authorisation and approvals
whereas capital expenditures within a certain limit can be approved by the managers
themselves.
Stage 4: Project Tracking − Once the project is approved the next step is to execute it. The
concerned managers periodically report the progress of the project as well as any variances
from the plan. The managers also report about time and cost overruns. This process of
reporting is known as project tracking.

Explain Time Value of Money.

The notion that money has time value is one of the most basic concepts of investment
analysis. For any productive asset it’s value will depend upon the future cash flows
associated with that particular asset. In order to assess the adequacy of cash flows one of
the important parameters is to assess the time value of the cash flows viz., Rs.100 received
after one year would not be the same as Rs.100 received after two years. There are several
reasons to account for this difference based on the timing of the cash flows, some of which
are as follows: • there is a general preference for current consumption to future
consumption, • capital (savings) can be employed to generate positive returns, • due to
inflation purchasing power of money decreases over time, • future cash flows are uncertain.
Translating the current value of money into its equivalent future value is referred to as
compounding. Translating a future cash flow or value into its equivalent value in a prior
period is referred to as discounting. This Unit deals with basic mathematical techniques
used in compounding and discounting.

After going through this unit, you should be able to:

• understand the time value of money.
• understand what gives money its time value.
• understand the methods of calculating present and future value.
• understand the use of present value technique in financial decisions.

Describe Economic Order Quantity.

The economic order quantity can also be determined with the help of a graph. Under this
method ordering cost, carrying cost and total inventory costs according to different lot sizes
are plotted on the graph. The point at which the line of inventory carrying cost and the
ordering cost intersect each other is the economic order quantity. At this point the total
inventory cost is also minimum.
Assumption of the EOQ Model The basic EOQ model is based on the following assumption:
1) The forecast usage/demand for a given period, usually one year, is known
2) The usage/demand is even throughout that period
3) Inventory orders can be replenished immediately (There is no delay in placing and
receiving orders). There are two distinguishable costs associated with inventories: costs of
ordering and costs of carrying.
Figure 3.1 shows a graph illustrating the behaviour of the carrying cost, the ordering cost,
and the sum of these two costs. The carrying cost varies directly with the order size (since
the average level of inventory is one-half of the order size), whereas the ordering cost varies
inversely with the order size.
EOQ Formula For determining the EOQ formula we shall use the following symbols:
U = annual usage/demand
Q = quantity ordered
F = cost per order
C = per cent carrying cost
P = price per unit
TC = total costs of ordering and carrying
Given the above assumptions and symbols, the total costs of ordering and carrying
inventories are equal to
What is Contingent Liabilities? Explain.

Contingent liabilities should be distinguished from estimated liabilities. Estimated liabilities

are known liabilities where the amount is uncertain. Contingent liabilities on the other hand
are not liabilities at the current moment. They may become liabilities only on the happening
of a certain event. In other words, both the amount and the liability (or obligation) are
uncertain till the specified event occurs in future. These may include items like a claim
against the company contested in a court. Only if the court gives an unfavourable verdict, it
becomes a liability. They are not listed as liabilities in the body of the balance sheet.
However, if the firm wishes, it may make same provision for the same.

Long-Term Liabilities
Long-term liabilities are usually for more than one year. They cover almost all the outsider’s
liabilities not included in the current liabilities and provisions. These liabilities may be
unsecured or secured. Security for long-term loans, are usually the fixed assets owned by
the firm assigned to the lender by a pledge or mortgage. All details such as interest rate,
repayment commitment and nature of security are disclosed in the balance sheet. Usually,
such long-term liabilities include debentures and bonds, borrowings from financial
institutions and banks.

Explain Cash Flow Statement.

Cash is another form of fund although in a narrow sense, it refers to a supply that can be
drawn upon, according, to the need. Here the term cash includes both cash and cash
equivalents. Cash equivalents are highly liquid short-term investments which could be easily
converted into cash without much delay. It may however be appreciated that the
obligations and liabilities of a business arising on a day-to-day basis are met through “Cash”
or “Cheque”. But, inreality it never happens. Further, we must also be able to distinguish
between “Profit” and “Cash”. One cannot pay the creditors, electricity bills, tax or even
dividend with the “Net Profit”. For such and many other purposes, a business needs either
cash balance or credit limits with banks. Not to be able to meet the business comitments
through cash as and when these arise can spell disaster for a business even if it has a strong
working capital base and has earned a handsome profit.

Cash flow statement is an important tool in the hands of the management for short term
planning and coordinating of various operations and projecting the cash flows for the future.
It presents a complete view on the movement of cash and identifies the sources from which
cash can be acquired when needed. The comparison of the actual cash flow statement with
the projected cash flow statement helps in understanding the trends of the movement of
cash and also the reasons for the success or failure of cash planning. Cash flow and fund
flow statements are similar to each other in many respects. The main difference however,
lies in the fact that the terms “fund” and “cash” import different meaning. The term “fund”
in fund flow statement has a wide meaning and it means current assets – current liability. A
fund flow statement examines the impact of changes in fund’s position during the period
 under review on the working capital of the concern (working capital refers to current assets
- current liabilities). Cash in the cash flow statement refers only to cash and or balance with
bank, i.e., a small part of the total fund, although very important. The cash flow statement
starts with the opening cash balance, shows the sources from where additional cash was
received and also the uses to which cash was put and ends up showing the closing balance
as at the end of the year or period under review. Whereas, there are no opening and closing
balances in Funds Flow statement. Increase in current assets or decrease in current liabilities
increases the working capital, whereas the decrease in current assets or increase in current
liabilities increases the cash flow.

Differentiate between NPV and IRR.

Parameter Net Present Value Internal Rate of Return
Meaning The present value of all cash IRR is the rate at which the cash inflows are equal to
flows of a project or cash outflows. In other words, it is the rate at which
investment is called NPV. the Net Present Value of an investment is zero.
Representation Represented in absolute terms Represented in percentage terms
Indicates Surplus from an investment or It is the break-even point of an investment or a
a project project – no profit or no loss scenario.
Rate for Cost of capital rate Internal Rate of Return
reinvestment
Variable Cash It will not have an impact on Results in negative or multiple IRR
outflows the NPV.

What is Commercial Paper?

The CP introduced into the Indian financial market, on the recommendations of the Vaghul
Committee has become a popular debt instrument of the corporate world. CP is a debt
instrument for short-term borrowing, that enables highly rated corporate borrowers to
diversify their sources of short-term borrowings, and provides an additional financial
instrument to investors with a freely negotiable interest rate. The maturity period ranges
from three months to less than a year. Since it is a short-term debt, the issuing company is
required to meet dealers’ fees, rating agency fees and any other relevant charges.
Commercial paper is short-term unsecured promissory note issued by corporations with
high credit ratings.
Salient Features:
Eligibility Criteria: A company can issue CP only if:
1) Its tangible net worth is not less than Rs. 4 crore as per the latest audited balance sheet.
2) Its fund based working capital limit is not less than Rs. 4 crore.
3) It has obtained the specified minimum credit rating for issuance of CP from an approved
credit rating agency. Such credit rating should not be more than 2 months old at the time of
issue of the CP.
 4) Its borrowal account is classified as ‘standard’ by the financing bank.
5) It has a minimum current ratio of 1.33:1 as per the latest audited balance sheet and the
classification of current assets and liabilities are in conformity with the Reserve Bank
guidelines issued from time to time.

Write a detail note on VED Analysis.

VED (Vital, Essential, and Desirable) analysis is a technique used for spare part inventory
Analysis and is widely used in the automobile industry specially for the maintenance
of the spare parts inventory. According to this technique, inventory items are
Classified as follows:
• Vital (V) items constitute such items of inventory, which are vital for continuous
Operations. Shortage or absence of these items will bring the production activity to
a halt. These items of inventory are critical for continuous production and
therefore require close monitoring.
• Essential (E) items are those items of inventory, which are essential for
continuous production. The difference between vital and essential items is that the
shortage of essential items can be tolerated for a few hours viz., it will not bring
the production process to a halt. The level of these type of inventory is moderately
low.
• Desirable (D) items do not have any immediate impact on the production process,
hence inventory of these items may or may not be maintained.
In VED analysis the focus is not on the value of the inventory, but the focus is on their
likely impact on production.
SED Analysis
SDE (Scarce, Difficult and Easy) analysis evaluates the importance of inventory items
on the basis of their availability. As per SDE analysis the inventory items are grouped
into the following categories:
• Scarce (S) items are those items which are in short supply. Most of the time these
items are important and essential for continuous production.
• Difficult (D) items are those items which cannot be produced easily
• Easy (E) items are those items which are readily available in the market.

In SDE analysis the main focus is on the availability of the inventory. This type of
analysis is resorted to when the markets are regulated and input and output is
controlled by the government.
FSN Analysis:
Under this method inventory items are classified according to the usage/consumption
pattern. They are classified as follows:
• Fast Moving (F) items are stored in large quantities as their usage rate is high.
Special attention is given to the inventory level of these types of items.
• Slow Moving (S) items are not frequently required by the production department,
hence moderate quantities with moderate supervision are maintained.
 • Non Moving (N) items are rarely required by the production department, hence
small number of items are kept in stores and less supervision is required for these
kind of inventory items

Describe Human Resource Accounting.

Way back in 1964, the first attempt to include figures on human capital in the balance sheet
was made by Hermansson which later came to be known as Human Resource Accounting
(HRA). However there has been a great socio-economic shift in the 1990s with the
emergence of the knowledge economy, a distinctive shift towards recognition of human and
intellectual capital in contrast to physical capital. Human Resource Accounting is a branch of
accounting which seeks to report and emphasis the importance of human resources
(knowledgeable, trained, loyal and committed employees) in a company’s earning process
and total assets. It is concerned with “the process of identifying and measuring data about
human resources and communicating this information to interested parties”. In simple
words, it involves accounting for investment in people and their replacement costs, as well
as accounting for the economic values of people to an organisation. Generally, the methods
used for the valuing and accounting of human resources are either based on costs, or on
economic value of human resources. However, providing adequate and valid information on
human assets (capital), which are outside the concept of ownership, in figures is very
difficult. Nevertheless HRA is a managerial tool providing valuable information to the top
management to take decisions regarding adequacy of human resources, and thus,
encouraging managers to consider investment in manpower in a more positive way.

State the difference between Fixed and Variable Working Capitals.

Fixed Capital Working Capital

Definition

Investing capital in the long term assets of Working capital is the capital invested in the current
an enterprise. assets of an enterprise.

Types of assets acquired

Used to acquire non-current assets for the Used to acquire current assets for the company
company

Liquidity

Fixed capital is not at all liquid Working capital is highly liquid

Conversion to cash

Not possible to convert into cash Can be converted into cash

 Objective served

Serves strategy oriented objectives  Serves operational objectives

Define a.) Fixed working capital b.) Variable working capital

a.) Fixed working capital is that portion of the total capital that is required to be maintained
in the business on the permanent basis or uninterrupted basis. This working capital is
required to invest in fixed assets. The requirement of this type of working capital is
unaffected due to the changes in the level of activity.

b.) Variable working capital is that portion of the total capital that is required over and
above the fixed working capital. This working capital is required to meet the seasonal needs
and some contingencies. The requirement of this type of working capital changes with the
changes in the level of activity.

Explain Accounting Rate of Return (ARR).

The Accounting Rate of Return uses the accounting information as revealed by

financial statements, to measure the profitability of an investment. The accounting
rate of return is the ratio of average after tax profit divided by average investment.

Here average income is adjusted for interest. Of the various accounting rate of return, the
highest rate of return is taken to be the best investment proposal. In case the accounting
rate of return is less than the cost of capital or the prevailing interest rate than that
particular investment proposal is rejected.

Describe Financial Accounting in detail.

Financial accounting dates from the development of large-scale business and the advent of
the Joint Stock Company. This form of business which enables the public to participate in
providing capital in return for shares in the assets and the profits of the company. This form
of business organisation permits a limit to the liability of their members to the nominal
values of their shares. This means that the liability of a shareholder for the financial debts of
the company is limited to the amount he had agreed to pay on the shares he bought. He is
not liable to make any further contribution in the event of company’s failure or liquidation.
As a matter of fact, the law governing the operations (or functioning) of a company in any
country (for instance, the Companies Act in India) gives a legal form to the doctrine of
stewardship which requires that information be disclosed to the shareholders in the form of
annual income statement and balance sheet such statements are generally known as annual
financial statements.
Briefly speaking, the income statement is a statement of profit and loss made during the
year of the report; and the balance sheet indicates balances of the assets held by the firm
and the monetary claims against the firm as on a particular date. The general unwillingness
of the company directors to disclose more than the minimum information required by the
law, and the growing public awareness have forced the governments in various countries of
the world to extend the disclosure (of information) requirements.

The importance attached to financial accounting statements can be traced to the need of
the society to mobilise savings, and channel them with profitable investments. Investors,
whether they are large or small, must be provided with reliable and sufficient information in
order to be able to make sound investment decisions. This is the most significant social
purpose of financial accounting.

Write a note on Management Accounting.

The advent of management accounting was the next logical step in the developmental
process. The practice of using accounting information as a direct aid to management is a
phenomenon of the 20th century, particularly the last 30-40 years. The genesis of modern
management, with its emphasis on detailed information on decision-making, provided a
tremendous impetus to the development of management accounting. Management
accounting is concerned with the preparation and presentation of accounting and
controlling information in a form which assists management in the formulation of policies,
and in decision-making on various matters connected with routine and/or non-routine
operations of business enterprise. It is through the techniques of management accounting
that managers are supplied with information that they need for achieving objectives for
which they are accountable. Management accounting has, thus, shifted the focus of
accounting from recording and analysing financial transactions, to using information for
decisions affecting the future. In this sense, management accounting has a vital role to play
in extending the horizons of modern business. While the reports emanating from financial
accounting, specially for outsiders, are subject to the conceptual and legal framework of
accounting, internal reports−routine or non-routine−are free from such constraints.

Write the formula for the following ratios.

Explain the Trial Balance.

A statement which is prepared to show the debit balances and credit balances separately
for each account is known as the Trial Balance. It is prepared after posting the accounts in
the ledger, and the balance of each account has been found. It is prepared by listing each
and every account, and entering their balances into separate columns of the debit and
credit. The totals of the debit and credit columns of a trial balance must be equal. An
equality indicates that the trial balance does not contain an arithmetical error. This follows
from the fact that under the Double Entry System, the amount written on the debit side of
various accounts is always equal to the amounts entered on the credit side of other
accounts, and vice-versa. Hence, the total of the debit side must be equal to the total of
credit side. Also, the total of the debit side balances will be equal to the total of the credit
side balances. Once this agreement is established, there is reasonable confidence that the
accounting work is free from arithmetical errors, though it is not proof of cent per cent
accuracy, because some other error (such as principle and compensating errors) may still
remain.

OBJECTIVES OF PREPARING TRIAL BALANCE:

1. The trial balance enables one to establish whether the posting and other accounting
processes have been carried out without committing arithmetical errors.
2. Financial statements are normally prepared on the basis of agreed trial balance,
otherwise the work may be cumbersome.
3. The trial balance serves as a summary of what is contained in the ledger.
4. Trial balance helps in locating errors in book-keeping work.

What is letter of credit? Explain.

Under the documentary bills the seller faces a lot of risk − the risk of non-payment or
non-acceptance of goods. This poses a major risk for the seller. This additional
security under this method comes from the fact that, the letter of credit is issued by the
bank and not by the party to the contract buyer. This instrument guarantees payment
to the seller on fulfilment of certain conditions specified therein. The Letter of Credit
can be defined as an instrument issued by a bank in favour of the seller (known as
beneficiary) whereby the issuing bank undertakes to pay the beneficiary a certain sum
against delivery of specific documents within a stated period of time. There are many
forms of a letter of credit; the most widely used are as follows:
1) Revocable vs. Irrevocable Letter of Credit
2) Confirmed vs. Unconfirmed Letter of Credit
3) Revolving Letter of Credit
4) Transferable Letter of Credit
5) Back to Back Letters of Credit
6) With Recourse vs. Without Recourse Letter of Credit

Explain the Money Measurement Concept.

In accounting, only those facts which can be expressed in terms of money are
recorded. As money is accepted not only as a medium of exchange but also as a
measuring rod of value, it has a very important advantage since a number of widely
different assets and equities can be expressed in terms of a common denominator.
Without this adding heterogeneous factors like five buildings, ten machines, six trucks
will not have much meaning.
While money is probably the only practical common denominator and a yardstick, we
must realise that this concept imposes two sever limitations. In the first place, there
are several facts which, though vital to the business, cannot be recorded in the books
of account because they cannot be expressed in money terms. For example, the state
of health of the Managing Director of a company, who has been the key contributor to
the success of business, is not recorded in the books. Similarly, the fact that the
Production Manager and the Chief Internal Auditor are not on speaking terms, or that
a strike is about to begin because labour is dissatisfied with the poor working
conditions in the factory, or that a competitor has recently taken over the best
customer, or that it has developed a better product, and so on will not be recorded
even though all these events are of great concern to the business.
From this standpoint, one could say that accounting does not give a complete account
of the happenings in the business. You will appreciate that all these have a bearing on
the future profitability of the company.
Second, the use of money implies that a rupee today is of equal value to a rupee ten
years back or ten years later. In other words, we assume that there is a stable or
constant value of the rupee. In the accounts, money is expressed in terms of its value
at the time an event is recorded. Subsequent changes in the purchasing power of
money do not affect this amount. You are, perhaps, aware that most economies today
are in inflationary conditions with rising prices. The value of a rupee in the 80s has
depreciated to an unbelievably low level in the 90s. Most accountants know fully well
that the purchasing power of a rupee does change, but very few recognise this fact in
accounting books and make an allowance for changing price level. This is so, despite
the fact that the accounting profession has devoted considerable attention to this
problem, and numerous suggestions have been made to account for the effects of
changes in the purchasing power of money. In fact, one of the major problem of
accounting today is to find means of solving the measurement problem, that is, how to
extend the quality and the coverage of meaningful information. It will be desirable to
present, in a supplementary analysis, the effect of price level changes on the reported
income of the business and the financial position.

What do you mean by Accounting Standards?

theory of accounting. These concepts (postulates or conventions), however, permit a

variety of alternative practices to co-exist. As a result, the financial results of different
companies cannot be compared and evaluated unless full information is available
about the accounting methods which have been used. The variety of accounting
practices have made it difficult to compare the financial results of different
companies. Further, the alternative accounting methods have also enabled, the
reporting of different results, even by the same company.
Need for Standards: The information contained in published financial statements is
of particular importance to external users, such as shareholders and investors. Without
such information they would not be able to take the right decisions about their
investments. As in several other countries, Parliament in India specified in the
Companies Act, the type and minimum level of information which companies should
disclose in financial statements. It is the responsibility of the accounting profession to
ensure that the required information is properly presented. It is evident that there
should not be too much discretion to companies and their accountants to present
financial information the way they like. In other words, the information contained in
financial statements should conform to carefully considered standards. Public
confidence in accounting information contained in financial statements will grow if
they are satisfied as to the logic, consistency and fairness of the figures shown therein.
For instance, a company could incur a loss and still pay dividends by manipulating the
loss into a profit. In the long run, this course may have a disastrous effect on the
company and its investors.
You would be better able to appreciate the function of accounting standards by
relating them to the basic purpose of financial statements, which is the communication
of information affecting the allocation of resources. Ideally, such information should
make it possible for investors to evaluate the investment opportunities offered by
different firms and to allocate scarce resource to the most efficient ones. In theory,
this process should result in the capital distribution of resources within the economy,
and should maximise the potential benefit to society.
Describe the Business Entity Concept.
In accounting we make a distinction between business and the owner. All the records
are kept from the viewpoint of the business, rather than from that of the owner. An
enterprise is an economic unit, separate and apart from the owner, or owners. As such,
transactions of the business and those of the owners should be accounted for, and
reported separately. In recording a transaction, the important question is how does it
affect the business? For example, if the owner of a shop were to take cash from the
cash box for meeting certain personal expenditure, the accounts would show that cash
had been reduced even though it does not make any difference to the owner himself.
Similarly, if the owner puts cash into the business, he has a claim against the business
for capital brought in.
This distinction can be easily maintained in the case of a limited company because a
company has a legal entity (or personality) of its own. Like a human being, it can
engage itself in economic activities of producing, owning, managing, storing,
transferring, lending, borrowing and consuming commodities and services.
Distinction, however, is difficult in the case of partnership, and even more so in the
case of a one-man business. Nevertheless, accounting still maintains separation of
business and owner. This implies that, owner’s personal and household expenses or
obligations (e.g., expenditure on food, clothing, housing, entertainment, debts,
mortgages, etc.) will not appear in the books of account. It may be clarified that it is
only for accounting purposes that partnerships and sole proprietorships are treated as
separate and apart from the owners though the law does not make such a distinction.
A creditor would be justified in looking to both the business assets and the private
estate of the owner for satisfaction of his claim. One reason for this distinction is to
make it possible for the owners to have an account of the performance from those who
manage the enterprise. The managers are entrusted with funds supplied by owners,
banks, and others; they are responsible for the proper use of the funds. The financial
accounting reports are designed to show how well this responsibility has been
discharged.