JAIIB Notes

Compiled by Sekhar Pariti

Book No 67 from The Banking Tutor

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 Preface
With a view to help the young Bankers in preparation for Promotion Tests or
Professional Examinations conducted by various Institutes, I am sharing Notes
related to Accounting and Financial Management for Bankers (AFM) which is
prepared based on the revised syllabus, 2023 of IIBF.

IIBF Syllabus consists the following 4 Modules –

Module A: Accounting Principles and Processes

Module B: Financial Statements and Core Banking Systems

Module C: Financial Management

Module D: Taxation and Fundamentals of Costing

In this Book I am providing Notes related to all the 4 modules cited.

I will share objective type points related to all the 4 modules shortly.

I hope this Book may be useful to those Bankers who are appearing for Promotion
Tests, Certificate/Diploma Examinations conducted by various Institutes.

24-04-2023 Sekhar Pariti

+91 94406 41014

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 Syllabus 2023

Accounting and Financial Management for Bankers (AFM)

Module A: Accounting Principles and Processes

Definition, Scope & Accounting Standards including Ind AS, Basic Accountancy
Procedures, Maintenance of Cash/Subsidiary Books and Ledger, Bank
Reconciliation Statement, Trial Balance, Rectification of Errors and Adjusting &
Closing Entries, Depreciation and its Accounting, Capital and Revenue
Expenditure, Bills of Exchange, Operational Aspects of Accounting Entries, Back
Office Functions/Handling Unreconciled Entries in Banks, Bank Audit & Inspection.

Module B: Financial Statements and Core Banking Systems

Balance Sheet Equation, Preparation of Final Accounts, Company Accounts-I,

Company Accounts-II, Cash Flow and Funds Flow, Final Accounts of Banking
Companies, Core Banking Systems and Accounting in Computerised Environment.

Module C: Financial Management

Financial Management -An Overview, Ratio Analysis, Financial Mathematics

Calculation of Interest and Annuities, Financial Mathematics Calculation of YTM,
Financial Mathematics- Forex Arithmetic, Capital Structure and Cost of Capital,
Capital Investment Decisions/Term Loans, Equipment Leasing/Lease Financing,
Working Capital Management, Derivatives.

Module D: Taxation and Fundamentals of Costing

Taxation: Income Tax/TDS/Deferred Tax, Goods & Services Tax, An Overview of

Cost & Management Accounting, Costing Methods, Standard Costing, Marginal
Costing, Budgets and Budgetary Control,

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 Index
Accounting and Financial Management for Bankers (AFM)

Module A: Accounting Principles and Processes

Chapter No Topics covered

01 Definition, Scope & Accounting Standards including Ind AS,
Basic Accountancy Procedures
02 Maintenance of Cash/Subsidiary Books and Ledger, Bank
Reconciliation Statement, Trial Balance, Rectification of Errors
and Adjusting & Closing Entries
03 Depreciation and its Accounting
04 Capital and Revenue Expenditure
05 Bills of Exchange; Operational Aspects of Accounting Entries
06 Back Office Functions/Handling Unreconciled Entries in Banks
07 Bank Audit & Inspection

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 01. Basic Accountancy Concepts & Procedures

Topics covered in this Chapter are Definition, Scope & Accounting Standards
including Ind AS, Basic Accountancy Procedures.

###

Accounting often is called the language of business. The basic function of any
language is to serve as a means of communication. In this, context, the purpose of
accounting is to communicate or report the results of business operations and the
financial health of the organization.

Accounting is an art of recording, classifying and summarising business

transactions: it not only records the business transaction but also records them in
an orderly manner. It also classifies business transactions according to their
nature, before recording them in the books of account.

Accounting also summarises the data, recorded in books of account, and presents
them in a systematic way, in the form of:

a) Trial Balance ;
b) Profit and loss account and
c) . Balance sheet

Accounting records the transactions it terms of money: Accounting records

business transactions by expressing them in term of money. This makes the
recorded data more meaningful. Events that cannot be expressed in money terms,
are not recorded in the books of account.

Accounting records only the transactions of a financial Character. Accounting also

interprets the financial data.

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Purpose and Objectives of Accounting

• To Keep a systematic record

• To Ascertain the result of the operations
• To ascertain the financial position of the business
• To facilitate rational decision- making
• To satisfy the requirements of law (Companies Act, Societies Act, Public
Trust Act etc and also compulsory under the Sales Tax Act and Income Tax
Act).

Types of Accounting:

• Financial Accounting
• Cost Accounting
• Management Accounting
• Social Responsibility Accounting
• Human Resource Accounting
• Inflation Accounting

The International Financial Reporting Standards (IFRS) are accounting standards

that are issued by the International Accounting Standards Board (IASB) with the
objective of providing a common accounting language to increase transparency in
the presentation of financial information.

Accounting Concept and Convention

The financial statement is based on various concepts and conventions. Accounting

concepts are the fundamental accounting assumptions that act as a foundation
for recording business transactions and preparation of final accounts.

Accounting conventions are the methods and procedures which have universal
acceptance. These are followed by the firm while recording transactions and
preparation of financial statement.

Business Entity Concept: The concept assumes that the business enterprise is
independent of its owners.

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Money Measurement Concept: As per this concept, only those transaction which
can be expressed in monetary terms are recorded in the books of accounts.

Cost concept: This concept holds that all the assets of the enterprise are recorded
in the accounts at their purchase price.

Going Concern Concept: The concept assumes that the business will have a
perpetual succession, i.e. it will continue its operations for an indefinite period.

Dual Aspect Concept: It is the primary rule of accounting, which states that every
transaction effects two accounts.

Realisation Concept: As per this concept, revenue should be recorded by the

firm only when it is realized.

Accrual Concept: The concept states that revenue is to be recognized when they
become receivable, while expenses should be recognized when they become due
for payment.

Periodicity Concept: The concept says that financial statement should be

prepared for every period, i.e. at the end of the financial year.

Matching Concept: The concept holds that, the revenue for the period, should
match the expenses.

Accounting Conventions are the practice adopted by an enterprise over a

period of time, that rely on the general agreement between the accounting
bodies and helps in assisting the accountant at the time of preparation of financial
statement of the company.

The Basic accounting conventions:

Consistency: Financial statements can be compared only when the accounting

policies are followed consistently by the firm over the period. However, changes
can be made only in special circumstances.

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Disclosure: This principle state that the financial statement should be prepared in
such a way that it fairly discloses all the material information to the users, so as to
help them in taking a rational decision.

Conservatism: This convention states that the firm should not anticipate incomes
and gains, but provide for all expenses and losses.

Materiality: This concept is an exception to the full disclosure convention which

states that only those items to be disclosed in the financial statement which has a
significant economic effect.
Accounting Concept Vs. Convention

1) Accounting concept is defined as the accounting assumptions which the

accountant of a firm follows while recording business transactions and preparing
final accounts. Conversely, accounting conventions imply procedures and
principles that are generally accepted by the accounting bodies and adopted by
the firm to guide at the time of preparing the financial statement.

2) Accounting concept is nothing but a theoretical notion that is applied while

preparing financial statements. On the contrary, accounting conventions are the
methods and procedure which are followed to give a true and fair view of the
financial statement.

3) While accounting concept is set by the accounting bodies, accounting

conventions emerge out of common accounting practices, which are accepted by
general agreement.

4) The accounting concept is basically related to the recording of transactions and

maintenance of accounts. As against, the accounting conventions focus on the
preparation and presentation of financial statements.

5) There is no possibility of biases or personal judgement in the adoption of

accounting concept, whereas the possibility of biases is high in case of accounting
conventions.

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To sum up, the accounting concept and conventions outline those points on
which the financial accounting is based. Accounting concept does not rely on
accounting convention, however, accounting conventions are prepared in the
light of accounting concept.

Systems of Book Keeping

Single entry system: A single entry system records each accounting transaction
with a single entry to the accounting records, rather than the vastly more
widespread double entry system. The single entry system is centered on the
results of a business that are reported in the income statement.

Double entry system: The double-entry system of accounting or bookkeeping

means that for every business transaction, amounts must be recorded in a
minimum of two accounts.

The double-entry system also requires that for all transactions, the amounts
entered as debits must be equal to the amounts entered as credits.

Principles of Double Entry system

The following are main principles of double entry system:

a) For every transaction, two parties must be interested

b) Every business transaction has two aspects, one of receiving the benefit and
the other of giving it. In simple words, “Double entry” system means “every
debit has a corresponding credit”.

c) Both the aspects, are recorded in the books of account.

d) The two-fold effect of a business transaction is recorded by debiting one

account and crediting the other account at the same time.

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Principle of Conservatism

The conservatism principle is the general concept of recognizing expenses and

liabilities as soon as possible when there is uncertainty about the outcome, but to
only recognize revenues and assets when they are assured of being received.
Thus, when given a choice between several outcomes where the probabilities of
occurrence are equally likely, you should recognize that transaction resulting in
the lower amount of profit, or at least the deferral of a profit. Similarly, if a choice
of outcomes with similar probabilities of occurrence will impact the value of an
asset, recognize the transaction resulting in a lower recorded asset valuation.

Under the conservatism principle, if there is uncertainty about incurring a loss, you
should tend toward recording the loss. Conversely, if there is uncertainty about
recording a gain, you should not record the gain.
The conservatism principle can also be applied to recognizing estimates. For
example, if the collections staff believes that a cluster of receivables will have a 2%
bad debt percentage because of historical trend lines, but the sales staff is leaning
towards a higher 5% figure because of a sudden drop in industry sales, use the
5% figure when creating an allowance for doubtful accounts, unless there is
strong evidence to the contrary.

Accrual Concept -In actual business operations, the obligation to pay and the
actual movement of cash may not coincide. In connection with the sale of goods,
revenue may be received.

• Before the right to receive arise, or

• After the right to receive has been created.

Accounting Cycle

Accounting Cycle include the following stages

Recording: In the first instance, all transactions should be recorded in the journal
or the subsidiary books as and when they take place.

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Classifying: All entries in the journal or subsidiary books are posted to the
appropriate ledger account to find out at a glance the total effect of all such
transactions in a particular account.

Summarising: The last stage is to prepare the trial balance and final accounts
with view to ascertain the profit or loss made during a particular period and the
financial position of the business on a particular date.

Ledger - The Ledger is the principal book of accounts where similar transactions
relating to a particular person or property or revenue or expense are recorded. In
other words, it is a set of accounts. It contains all accounts of the business
enterprise whether real, nominal or personal.

The main function of a ledger is to classify or sort out all the items appearing in
the journal or the other subsidiary books under their appropriate accounts, so that
at the end of the accounting period each account will contain the entire
information of all the transactions relating to it in a summarized or condensed
form.

Classification of Accounts:

Accounts are broadly classified into two classes - • Personal Accounts and and
Impersonal Accounts

Personal Accounts - These accounts show the transactions with customers,

suppliers, moneylenders, banks and the owner.

Personal accounts can take the following forms:

a) Natural Personal accounts: The term natural person means persons who are
the creation of God. For example, proprietor’s account, supplier’s account,
receiver’s account (Abhinav a/c, Alpa A/c).

b) Artificial personal accounts: These accounts include the accounts of

corporate bodies or institutions that are recongnised as persons in business
dealings. Example: firm’s a/c , club a/c.

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c) Representative personal account: These are accounts that represent a certain
person or group of person. Example: Salary outstanding, Rent prepaid etc.

There following list indicates, some more of the usual accounts coming under
each category: (Personal accounts)

Bank (an artificial Person)

Tata Iron & Steel Co. (a Company)
Ramu (an Individual)
Capital (Krishna –owner)
Bank loan (an artificial person)
Rent outstanding (representative personal account)

Impersonal Accounts are further sub-divided into - Real Accounts & Nominal
Accounts

Real Accounts - Real accounts may be of the following types:

Tangible real accounts: These are accounts of such things that are tangible, i.e,
which can be seen, touched, physically. Example: Land, building, cash etc.

Intangible real accounts: These account represent such things that cannot be
touched. Example: Trademarks, Patent right etc.

There following list indicates, some more of the usual accounts coming under
each category: (Real accounts)

Plant and machinery

Investment
Land and building
Stock in hand
Bill receivable
Trademarks
Cash

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Nominal Accounts - Nominal accounts are opened in the books to explain the
nature of the transactions. Example: Salary is paid to the employees, rent is paid
to the property owner etc.

There following list indicates, some more of the usual accounts coming under
each category: (Nominal accounts)

Interest
Salaries
Rent
Carriage
Commission received
Insurance
Discount received
Wages
Ind AS
Accounting standards have been developed in India over time. It is also called Ind
As. Such standards need to be adopted by various corporate form and NBFCs in
India under the supervision of the Accounting Standards Board (ASB).

The Accounting Standards Board was established in 1977 as a regulator and body.

ASB is a professional and autonomous body managed by the Institute of

Chartered Accountants of India (ICAI).

Apart from this, there are other bodies such as Confederation of Indian Industry
(CII), Federation of Indian Chambers of Commerce and Industry (FICCI) and
Associated Chambers of Commerce and Industry of India (ASSOCHAM) which
regulate ASB.

Individuals, professors and academics from the above-mentioned bodies acquire

different standards with regard to accounting.

Indian accounting standards were developed to harmonize standards related to

international accounting and reporting. International Accounting Standards
comply with International Financial Reporting Standards (IFRS).

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The Indian government body that recommends this standard to the Department
of Corporate Affairs is the National Advisory Committee on Accounting Standards
(NACAS).

Objectives of Indian accounting standards (Ind As): Following are the

objectives of applying Indian accounting standards:

Ensure companies in India adopt these standards to implement internationally

recognized best practices.

Ensure that compliance is maintained worldwide.

Have a single framework for a single accounting system.

The standard was developed in accordance with IFRS principles. Therefore, it

serves as a guide for the implementation of the standard.

Accounting systems used in India can be analyzed and understood by global

companies.

This will make the annual financial statements and company accounts transparent.

These standards are harmonized to ensure that companies comply with global
requirements.

A wider scope is acceptable through this Indian accounting standard as Indian

companies have expanded their global scope as compared to the past.

Applicability of Ind As:

The Government of India and the Department of Corporate Affairs have

announced the recognition and adoption of Indian accounting standards by all
companies in India. This notice was filed under the Company Accounting
Standards Act (US IND) of 2015. In accordance with the notification above, all
companies that receive this notification will be required to receive Ind As in stages
during the 2016-17 fiscal year. Since its adoption, there have been three
notification changes in 2016, 2017 and 2018.

Benefits of Adopting Indian Accounting Standards:

Adopting Indian accounting standards comes with several advantages:

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Harmonization: By adopting these standards, companies can harmonize
accounting rules. Global accounting principles can be built through
harmonization.

International Base: These are Internationally recognized accounting standards.

So when a company wants to expand internationally, such principles are adopted.

Global Acceptance: The existence of these standards guarantees international

recognition of all government institutions and agencies.

Compliance: By adopting these standards, companies can ensure effective

compliance.

Introduction Phase of Indian Accounting Standards: In the notification, the

Ministry of Corporate Affairs has highlighted the requirement of Indian companies
to gradually adopt Indian accounting standards in the 2016-17 reporting year.

This standard is adopted in stages, depending on the net worth and listing status
of the exchange.

MCA has divided the applicability and adoption of these accounting standards
according to different principles.

India’s system of voluntary adoption of accounting standards was applied to

companies in the 2014-15 and 2015-16 fiscal years. These standards can be
adopted voluntarily or mandatorily. However, MCA states that the standard must
be adopted by the company for a certain period of time.

Following are the stages of implementation:

Phase I: This phase is classified as mandatory according to the Indian accounting

standards required by the companies. This phase is implemented starting April 1,
2016.

Phase I applies to the following companies: Listed Companies (companies whose

securities are listed on a recognized stock exchange). Companies with a net worth
of more than Rs. 500 crores. Note – For the application of net assets, the
company’s financial statements for the last three years are audited. Since this
accounting standard was introduced in 2016-17, the previous fiscal years are
taken into account, namely 2013-14, 2014-15, and 2015-16.

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Phase II: At this point, all companies have to adopt Ind AS (Indian Accounting
Standards) from 1 April 2017. Therefore, the next fiscal year is considered for the
adoption of Indian Accounting Standards.

Phase II applies to the following companies: Listed companies (companies whose

securities are listed on a recognized stock exchange – as of March 31, 2016.
Companies that have the net worth of more than Rs. 250 crore but less than Rs
500 crore.

Note – Since this accounting standard was introduced in 2016-17, previous fiscal
years are taken into account; 2013-14, 2014-15 and 2015-16.

Phase III: This stage is considered mandatory for the implementation of Ind As by
all types of banks, NBFIs, SEBI regulated companies and insurance companies.

This phase is effective from April 1, 2018.

Phase III applies to the following companies:

Companies having net worth more than Rs. 500 crores. The net worth requirement
will only apply to the company until April 1, 2018.

The Insurance Regulatory and Development Authority of India (IRDAI) ensures by

separate notification that the insurer meets the net asset requirements.

The net worth requirement of NBFC and other financial institutions is calculated
taking into account the last three fiscal years namely 2015-16, 2016-17 and 2017-
18.

Phase IV: This phase will only apply to all NBFCs whose net worth is more than Rs.
250 crores but less than Rs 500 crores. This implementation will be taken into
account starting April 1, 2019.

Indian accounting standards apply to subsidiaries or associate companies. If

accounting standards are adopted by Indian companies, it will apply to all forms
of subsidiary i.e. sister, parent and associate companies. Either form of individual
qualification is not possible for this type of company. This means that the IND can
be applied automatically.

If a company is controlled by a foreign company, the accounting principles should

be viewed as a separate basis. IND As application is not required for these
companies.

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Indian Accounting Standards – Key Factors for Transformation:

There are various significant and key factors that we need to consider when Indian
companies adopt the above standards:

Activities managed by the organization.

Identify and analyze various tax consequences resulting from the application
of these standards.

Redefinition and revision of annual financial statements to ensure compliance

with standards.

Identify and review issues related to accounting standards.

Revision of contracts and conclusion of negotiations carried out by various

parties.

Preparation of financial statements annually in accordance with the

requirements of Indian accounting standards.

The following table provides a list of the Ind As: (applicable to Bankers)

Sr No Points related to

Ind AS 1 Presentation of Financial Statements

Ind AS 2 Inventories Accounting

Ind AS 7 Statement of Cash Flows

Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Ind AS 10 Events after Reporting Period

Ind AS 12 Income Taxes

Ind AS 16 Property, Plant and Equipment

Ind AS 17 Leases

Ind AS 18 Revenue

Ind AS 19 Employee Benefits

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Ind AS 20 Accounting for Government Grants

Ind AS 21 The Effects of Changes in Foreign Exchange Rates

Ind AS 23 Borrowing Costs

Ind AS 24 Related Party Disclosures

Ind AS 27 Separate Financial Statements

Ind AS 28 Investments in Associates and Joint Ventures

Ind AS 32 Financial Instruments: Presentation

Ind AS 33 Earnings per Share

Ind AS 34 Interim Financial Reporting

Ind AS 36 Impairment of Assets

Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets

Ind AS 101 First-time adoption of Ind AS

Ind AS 105 Non-Current Assets Held for Sale and Discontinued Operations

Ind AS 109 Financial Instruments

Ind AS 110 Consolidated Financial Statements

Ind AS 111 Joint Arrangements

Ind AS 112 Disclosure of Interests in Other Entities

The adoption of Indian Accounting Standards (Ind SA) has improved the
comparability of financial information of Indian companies worldwide.

However, Ind AS involves the application of several new and complex concepts.
This requires a high level of assessment and evaluation, accompanied by detailed
qualitative and quantitative information according to Ind AS.

It is crucial to understand that these Indian Accounting Standards (Ind SA) upscale
the methodology of Indian Accounting.

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 02 Maintenance of Books and Accounts
Topics covered in this Chapter are Maintenance of Cash/Subsidiary Books and
Ledger, Bank Reconciliation Statement, Trial Balance, Rectification of Errors and
Adjusting & Closing Entries.

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Journal - The form of a journal contains a column Ledger folio. Journal records
each transaction. However, if anyone wants to find out transactions affecting a
personal account or an expense account, he will have to turn over pages of
journal, add all debits and credits and then find out the balance of a particular
account.

Cash Book - The Book that keeps records of all cash transactions, i.e. cash
receipts and cash payments is called a cash book. Its ruling is like a ledge account
and is divided into two sides, viz, debit and credit. All receipts are recorded on the
debit side whereas all payment are recorded on the credit side. Since it serves the
function of cash account, there is no need for opening cash account in the ledger.

Ledger - The Ledger is the principal book of accounts where similar transactions
relating to a particular person or property or revenue or expense are recorded. In
other words, it is a set of accounts. It contains all accounts of the business
enterprise whether real, nominal or personal.

The main function of a ledger is to classify or sort out all the items appearing in
the journal or the other subsidiary books under their appropriate accounts, so that
at the end of the accounting period each account will contain the entire
information of all the transactions relating to it in a summarized or condensed
form.

Accounting and Columnar Accounting Mechanics

Cash book may be defined as the record of transactions concerning cash receipts
and cash payments. In other words, in cash book, all transactions (i.e receipts and
payment of cash) are recorded as soon as they take place. Cash book is in the
form of an account and actually it serves the purpose of a ‘Cash Account’. Cash
book thus serves the purpose of a book of original entry as well as that of a
ledger account.

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A Cash Book has the following features:

a) Only cash transactions are recorded in the cash book.

b) It performs the functions of both, the journal and the ledger, at the same
time.

c) All cash receipts are recorded in the debit side and all cash payments are
recorded in the credit side.

d) It records only one aspect of transaction i.e, cash.

e) All cash transactions are recorded chronologically in the cash book.

Types of Cash Books

Simple (Single column) Cash Book: This cash book will only record cash
transactions. The cash coming in (receipts) will be on the left and the cash
payments will be on the right. And since we will record all cash transactions here
there is no need for a cash ledger account.

Two Column Cash Books – In this, we have an additional column for discounts.
So along with the cash transactions, we will also record the discounts in the same
cash book. So both discounts received and the discount that is given is recorded
here. If any organization is in a general practice of giving or receiving discounts
this is the preferable option.

Discount is a Nominal Account – so the discount is given (loss) is on the debit

side and discount received (profit) is on the credit side. At the end of the period,
we balance both columns and transfer the closing balances.

Three Column Cash Books

This cash book has the cash, the discount and additionally the bank columns in it.
Since the development of banking most firms, these days prefer to deal in
cheques or other such bills of exchange. And so having a bank column in your
cash book makes things concise and simpler to understand. So when you receive
a cheque and you deposit it in the bank the same day you make the entry in the
bank column (the debit side in this case). But say you send the cheque later (not
the same day) then this will be a contra entry.

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A Contra Entry is transactions that happen between a cash account and a bank
account. Ultimately your Cash & Bank balance remains the same, the money just
moves around.

Petty Cash Book - In a firm, there are usually cash transactions happening in all
the departments. These we will record in one of the above formats of cash books.
But there are many cash transactions happening for very small amounts.
Sometimes there are dozens of such transactions that occur in just one day. These
are known as petty transactions. Examples are expenses for postage, stationery,
traveling, food bills, etc.

So since the number of such transactions tends to be very high we maintain a

separate cash book for them – the petty cash book. Such a cash book is
maintained by the petty cashier (who in most cases also handles the petty cash).
There are Two types of petty cash book - Simple petty cash Book & Columnar
Petty cash Book

Journalising refers to recording business transactions systematically and in a

summarised form in the journal. It means a process of entering the twofold effects
of transactions in the form of debt and credit in the journal.

Rules for Journalising Transactions: (Golden rules of Accountancy)

Personal Account: It relates to persons(natural or legal) with whom a business

keeps dealings. Rule: Debit the receiver and Credit the giver.

E.g. Goods worth Rs. 5000/- sold to Alpa. Here, because Alpa is the receiver of
goods so it is to be debited.

Real Account: It relates to property or goods which may come or go from the
business. Rule: Debit what comes in and Credit what goes out.

E.g. Goods worth Rs. 7000/- sold on cash. Here, cash a/c is to be debited because
cash flows out.

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Nominal Account: It relates to business expenses, losses, incomes, and gains. Rule:
Debit all the expenses or losses and Credit all a the incomes, gains or profits.

E.g. Paid Rs. 2000/- as commission to the agent. Here, commission a/c is debited
because it is a business expense.

Bank Reconciliation Statement (BRS) is a report or statement prepared by the

business to match the bank transactions recorded in the books of accounts with
the bank statement. The bank reconciliation statement helps to check the
correctness of the entries recorded in the books of accounts and thereby, ensures
the accuracy of bank balances.

Need for BRS

a) Cheques Issued but not cleared in the bank

b) Difference in cheque deposited and cheque credited date

c) Date of cheque issued towards payment and date on which it is debited is

different

d) Cheque issued or received is not presented to the bank for clearing

e) Bank interests, charges etc. are not accounted for. Reason being it is not
known till you reconcile.

f) Banks can also do mistake in debiting or crediting the transactions.

Depending on the volume and value of bank transactions, the reconciliation

activities are carried out daily, weekly, fortnightly etc. If the volume or value of
transactions is higher, the reconciliation activities are carried on daily to mitigate
the risk of payment/cheque bounce.

Bank reconciliation statement (BRS) involves the process of identifying the

transactions individually and match it with the bank statement such that the
closing balance of bank in books matches with the bank statement. For one which
is not matched, suitable adjustments or correction will be done in the book to
match it.

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How to prepare a BRS

The first step is to compare opening balances of both the bank column of the
cash book as well as bank statement; these could be different due to un-credited
or un-presented cheques from a previous period.

Second Step - Now, compare the credit side of the bank statement with the debit
side of the bank column of the cash book and the debit side of the bank
statement with the credit side of the bank column of the cash book. Place a tick
against all the items appearing in both the records.

Third Step - Analyze the entries both in the bank column of the cash book as well
as the passbook and look for entries that have been missed to be posted in the
bank column of the cash book. Make a list of such entries and make the necessary
adjustments in the cash book.

Correct if any mistakes or errors appear in the cash book.

Calculate the corrected and revised balance of the cash book’s bank column.

Now, start the bank reconciliation statement with an updated cash book balance.

Add the un-presented cheques (cheques which are issued by the business firm to
its creditors or suppliers but not presented for payment – Expense) and deduct
un-credited cheques (Cheques paid into the bank but not yet collected – Income).

Make all the necessary adjustments for the bank errors. In case the bank
reconciliation statement begins with the debit balance as per the bank column of
the cash book, add all the amounts erroneously credited by the bank and deduct
all the amounts erroneously credited by the bank. Do vice-versa in case its start
with the credit balance.

The resultant figure must be equal to the balance as per the bank statement.

Trial Balance

Multiple entries in various accounts will make a Ledger. Taking all the ledger
balances and presenting them in a single worksheet as on a particular date is Trial
Balance.

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To understand a trial balance, we must first understand the following:

a) Double entry system – Recording two entries for a single transaction that is
equal and opposite in nature

b) Journal – All transactions recorded in double entry system of bookkeeping

c) Ledger – Summary of all journals of a similar nature.

Features and Purpose of a Trial Balance

a) It is a list of debit and credit balance drawn from ledger.

b) It includes cash and Bank balance.

c) Its main purpose is to establish arithmetical accuracy of transactions

recorded in the books of account.

d) It is usually prepared at the end of the year but it can also be prepared any
time, as and when required, ( monthly, quarterly or half yearly).

e) It enables the trader to know amounts receivable from customers and

amounts payable to suppliers.

f) It facilities preparation of final accounts.

There are two types of Trial balance - Gross Trial Balance & Net Trial Balance.

Gross Trial Balance is prepared in the following stages:

a) Take totals of debit and credit columns of each ledger account.

b) Take totals of receipts and payments of cashbook showing separately cash,

bank and discount columns.

c) Write names of all accounts as per the ledger and cash, bank and discount
accounts as per cash book onto a statement.

d) Enter the debit and credit totals against each item.

e) Finally take total of debit and credit columns.

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Net Trial Balance - Under this trial Balance, net balance of each amount are
drawn and shown in trial balance. If debit total of an account is more, it will show
debit balance and of credit total of an account is more, it will show a credit
balance.

Disagreement of a trial balance may be caused by the wrong totalling or

balancing of ledger accounts. While totalling the figure of subsidiary books there
may arise some errors that will cause disagreement of trial balance. Omission to
post a ledger balance also causes the disagreement of a trial balance.

Errors can be broadly divided into two types - Clerical Errors & Principle Errors.

Clerical Errors - Errors of Omission, Errors of Commission, and Compensating

errors.

Errors of Omission will occur when a transaction is not recorded in the books of
accounts or omitted by mistake. The Errors of Omission two types - Partial &
Complete

The partial errors may happen in relation to any subsidiary books. This is the result
of when a transaction is entered in the subsidiary book but not posted to the
ledger. For example, cash paid to the suppliers has been entered in the payment
side of the cash book but it will not be entered in the debit side of the suppliers
account.

The complete omission may happen the transaction is completely omitted from
the books of accounts. For example, an accountant fails to enter a specific invoice
from the sales day book.

Errors of Commission

When a transaction is entered in the books of accounts in wrongly, this may be

entered as partially or incorrectly. This kind of errors are known as Errors of
Commission. The Errors of Commission may happens because of ignorance or
negligence of the accountant. This may be of different types, the main reasons are
Errors relating to subsidiary books and Errors relating to ledger. Following are
some of the examples:

• Posting of correct amount but on the wrong side

• Posting of a wrong amount but on the correct side
• Posting of a wrong amount on wrong side of an account

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Compensating Errors are those errors which compensates themselves in the net
results of the business. This means, if there are over debit in one account which
will be compensated by the over credit in some account in the same extent of the
business. Like that, if there is a wrong debit in one account which will be
neutralized by some wrong credit in the same extent of the business.

Errors of Principles - This kind of errors are occurs when the entries are made
against the principle of accounting. These Errors are made because of the
following reasons:-

• Errors happens due to the inability to make a distinction between the

revenue and capital items.

• Errors happens due to the inability to make a difference between the

business expenses and personal expenses.

• Errors happens because of the inability to make a distinction between the

productive expense and non productive expenses.

Rectification of Errors

One- sided Errors - These errors affect only one account. Thus, these are one-
sided errors. We can rectify these errors by giving an explanatory note in the
account or by passing a journal entry with the help of Suspense A/c. When we
detect an error before posting to the ledger, we can correct it by simply crossing
the wrong amount, writing the correct amount above it and initializing it. Similarly,
we can also correct an error in the ledger account. Errors of casting, errors of
carrying forward the balances, errors of balancing the accounts, errors of posting
the wrong amount in the correct account, error of posting in the correct account
on the wrong side, omitting to show an account in the trial balance, posting in
wrong side with wrong amount are the examples of errors affecting the Trial
Balance.

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Two-sided Errors - These errors affect two or more accounts simultaneously.
Thus, these are two-sided errors. We can rectify these by passing a journal entry
giving the correct debit and credit to the accounts. In order to rectify an error, we
need to cancel the effect of wrong debit or credit by reversing it and restore the
effect of correct debit or credit. When there is short debit or excess credit in an
account we need to debit the concerned account. Whereas, when there is short
credit or excess debit in an account we need to credit the concerned account.

Complete omission to record an entry in the journal or the subsidiary books,

incorrect recording of transactions in the books, complete omission of posting
and errors of principle are the examples of these errors.

Suspense Account - When the trial balance does not tally due to the one-sided
errors in the books, an accountant puts the difference between the debit and
credit side of the trial balance on the shorter side as the Suspense A/c. As and
when we locate and rectify the errors, the balance in the Suspense A/c reduces
and consequently becomes zero. Thus, we cannot categorize the Suspense A/c. It
is a temporary account and can have debit or credit balance depending upon the
situation.

While using the Suspense A/c to rectify the one-sided errors, the accountant
needs to follow the following steps:

• Identification of the account with the error.

• Ascertainment of the excess debit or credit or short debit or credit in the

above account.

• In case of short debit or excess credit in an account, we need to debit the

concerned account. Whereas, in case of short credit or excess debit in an
account we need to credit the concerned account.

Adjusting Entries - Final Account are the accounts which are prepared at the end
of the trading year. These accounts show the final results of the business carried
out. Final accounts are prepared to find out profit earned or loss sustained by a
concern.

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At the end of the accounting year, all ledger accounts are balanced and then trial
balance is prepared.

Form the trial balance, final accounts, i.e. trading, profit and loss account and
balance sheet are drawn. While preparing trading and profit and loss account, all
expenses and incomes for the full period are to be taken into consideration.

If expenses have been incurred but not paid or income is due but not received,
necessary entries are required to be passed to show the correct picture of the
business. These entries are called “Adjusting Entries’.

Closing Entries - At the end of cash year, all accounts of expenses and incomes
must be closed. The balance of these accounts are transferred to trading account
and profit and loss account. The entries passed to transfer these balances are
called “Closing entries”.

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 03. Depreciation and its Accounting
Amortization and Depreciation

When a company acquires assets, those assets usually come at a cost.

However, because most assets don't last forever, their cost needs to be
proportionately expensed based on the time period during which they are
used.

Amortization and Depreciation are methods of prorating the cost of business

assets over the course of their useful life.

Amortization is a method of spreading the cost of an intangible asset over a

specific period of time, which is usually the course of its useful life. Intangible
assets are non-physical assets that are nonetheless essential to a company,
such as patents, trademarks, and copyrights. The goal in amortizing an asset is
to match the expense of acquiring it with the revenue it generates.

Depreciation is used for tangible assets, which are physical assets such as
equipment, business vehicles, and computers. The purpose of depreciation is
to match the expense of obtaining an asset to the income it helps a company
earn.

Differences between Amortization and Depreciation

The key difference between amortization and depreciation is that amortization

is used for intangible assets, while depreciation is used for tangible assets.

Another major difference is that amortization is almost always implemented

using the straight-line method, whereas depreciation can be implemented
using either the straight-line or accelerated method.

Finally, because they are intangible, amortized assets do not have a salvage
value, which is the estimated resale value of an asset at the end of its useful
life. Depreciated assets, by contrast, often have a salvage value. An asset's
salvage value must be subtracted from its cost to determine the amount in
which it can be depreciated.

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Depletion - The term depletion is used for the depreciation of wasting assets
such as mines, oil wells, timber trees etc.

Fast changing in market prices is called fluctuation. It is not called depreciation

because, it is not related to use of fixed asset.

Difference between depreciation and obsolescence - when fixed asset are

used for producing goods and services of business, their values are bound to
decrease such reduction in value of fixed assets due to their productive use is
called depreciation. obsolescence refers to decrease in usefulness caused on
account of the asset becoming out of date , olf fashioned etc.

The total amount of depreciation to be written off over the life of an asset is
equal to the cost of the asset less its scrape value.

Obsolescence and inadequacy are called the economic factors causing

depreciation.

Over or under provision of depreciation is taken to profit and loss account as

profit or loss at the time of termination or sale of assets.

The useful life of depreciable asset for an enterprise may be shorter than its
physical life. This is usually because of such factors as obsolescence and
inadequacy .

In the case of wasting assets the amount of charge determined on the basis of
exhaustion of the asset is known as depletion .

Depreciation Methods- Fixed assets differ from each other in their nature so
widely that the same depreciation methods cannot be applied to each. The
following methods have therefore been evolved for depreciating various
assets:

Fixed installment or Straight line or Original cost method.

Fixed installment method is also know as straight line method or original cost
method. Under this method the expected life of the asset or the period during
which a particular asset will render service is the calculated. The cost of the
asset less scrap value, if any, at the end of its expected life is divided by the
number of years of its expected life and each year a fixed amount is charged in
accounts as depreciation.

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The amount chargeable in respect of depreciation under this method remains
constant from year to year. This method is also know as straight line method
because if a graph of the amounts of annual depreciation is drawn, it would be
a straight line.

The following formula or equation is used to calculate depreciation under this

method:

Annual Depreciation = [(Cost of Assets – Scrap Value)/Estimated Life of

Machinery]

Diminishing Balance Method or Written down value method or Reducing

Installment method. Diminishing balance method is also known as written
down value method or reducing installment method. Under this method the
asset is depreciated at fixed percentage calculated on the debit balance of the
asset which is diminished year after year on account of depreciation.

Annuity Method of Depreciation

According to this method, the purchase of the asset concerned is considered

an investment of capital, earning interest at certain rate. The cost of the asset
and also interest thereon are written down annually by equal instalments until
the book value of the asset is reduced to nil or its bread up value at the end of
its effective life. The annual charge to be made by way of depreciation is found
out from annuity tables. The annual charge for depreciation will be credited to
asset account and debited to depreciation account, while the interest will be
debited to asset account and credited to interest account.

Depreciation fund method or Sinking fund amortization fund method -

Under this method, a fund know as depreciation fund or sinking fund is
created. Each year the profit and loss account is debited and the fund account
credited with a sum, which is so calculated that the annual sum credited to the
fund account and accumulating throughout the life of the asset may be equal
to the amount which would be required to replace the old asset. In order that
ready funds may be available at the time of replacement of the asset an
amount equal to that credited to the fund account is invested outside the
business, generally in gilt-edged securities. The asset appears in the balance
sheet year after year at its original cost while depreciation fund account
appears on the liability side.

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Insurance policy method - Insurance policy method is a slight modification of
the depreciation fund method or sinking fund method. Under this method the
amount represented by the depreciation fund, instead of being used to buy
securities, is paid to an insurance company as premium. The insurance
company issues a policy promising to pay a lump sum at the end of the
working life of the asset for its replacement.

Revaluation method - As the name implies under revaluation method, the

assets are valued at the end of each period so that the difference between the
old value and the new value, which represents the actual depreciation can be
charged against the profit and loss account. This method is mostly used in case
of assets like bottles, horses, packages, loose tools, casks etc.

Sum of the year’s digits method (SYD) – is an accelerated method of

depreciation which is also based on the assumption that the loss in the value of
the fixed asset will be greater during the earlier years and will go on decreasing
gradually with the decrease in the life of such asset. The SYD method is found
by estimating an asset’s useful life in years, then assessing consecutive
numbers to each year, and totaling these numbers. For n years: SYD = 1 + 2 +
3 + 4 + …… + n

Double declining balance method

Double declining balance method is another type of accelerated depreciation

method. The depreciation expense is computed by multiplying the asset cost
less accumulated depreciation by twice the straight line rate expressed in
percentage. No provision is made for salvage value of the asset.

Depletion Method of Depreciation

Depletion method of depreciation is especially suited to mines, quarries, sand

pits, etc. According to it the cost of the asset is divided by the total workable
deposits. In this way, rate of depreciation per unit of output is ascertained.
Depreciation in any particular year is charged on the basis of the output during
that year.

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Example - A mine was acquired at a cost of Rs 20,00,000 the quantity of
minerals expected to be mined is 5,00,000 tons, the rate of depreciation per
unit will be Rs 4 i.e., (20,00,000 / 5,00,000). If during the year 25,000 tons
minerals is extracted, the amount of depreciation will be 25,000 × 4 = Rs
1,00,000.

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 04. Capital and Revenue Expenditure
Expenditure means spending on something. This can be a payment is cash or can
also be the exchange of some valuable item in exchange for goods or services. It
is the process of causing a liability by a commodity. Receipts and invoices keep
the records of expenditures. An expense is a word very similar to expenditure but
expense shows the deduction in the value of the asset while expenditure simply
denotes the obtaining of assets.

Two types of expenditures are present on the basis of time durations, That is

(a) Capital expenditures a

(b) Revenue expenditures.

Capital Expenditures are expenditures for high-value items that holds longer
duration requirements. Capital expenditures are long-term expenditures. In other
words, when the expenses are made for a particular asset but they do not get
completely consumed in the specific time. Due to this the earning capacity
increases, and in the meanwhile, the price of the assets decreases. Example: Cash
money spent on business purposes, Purchasing of Plants and machinery items etc.

Revenue Expenditures are the routine expenditures that takes place in the
normal business. In other words, this kind of expenditure maintains fixed assets.
The assets get consumed in an accounting year and no future benefits are
available.

Capital Receipts are from issue of Equity/ Preference share/ Capital Instruments
or from sale of Disposal of fixed Assets/Long Term investment or from Grants
received from Government for Building of Capital Assets. Capital receipts are not
routed through Profit & Loss account. However profit/loss, if any, arising from
such transactions is recorded in the P & L account.

Revenue Receipts

Revenue Receipts are from day to day operation of the company or receipts
where is no further obligation on the entry to perform certain actions. Revenue
Receipts are routed through Profit and loss account.

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 05. Bills of Exchange - Operational Aspects of
Accounting Entries
Types of Instruments of Credit - In a business, credit transactions play very
important role. For manufacturing goods, manufacturer purchases raw materials,
the majority of which will be on credit.

Credit may also be granted by a moneylender, a banker or financial institution.

Credit is, generally, provided by obtaining, a written document called ‘Instrument
of Credit’. The serves as a proof of existence of credit.

Bills of Exchange

Bills of Exchange is an instrument in writing containing an unconditional order,

signed by the maker, directing a certain person to pay on demand or at fixed or
determinable future time a certain sum of money only to, or to the order of, a
certain person or to the bearer of the instrument.

• Drawer: A person who draws the bill.

• Drawee: A person on whom the bill is drawn

• Payee: A person who is going to receive money.

Trade bill: Where the bill of exchange is drawn and accepted to settle a trade
transaction, it is called Trade bill.

Accommodation bill: Where a bill of exchange is drawn and accepted for mutual
help, it is called Accommodation bill.

A promissory notes, on the other hand, is written by the debtor (buyer) promising
the creditor (seller) to pay a specified sum after a specified period.

In a case of Promissory notes, there are two parties:

• Maker: A person who makes the note and promises to make the payment.

• Payee: A person who is to receive money.

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Difference between Bills of Exchange and Promissory Note

Bills of Exchange Promissory Note

It is an unconditional order to pay It is an unconditional promise to pay

It is made by a creditor. It is made by a debtor.

Acceptance by debtor is necessary No acceptance is required

On dishonour of a bill, it is usually Nothing is not necessary.

noted by the notary Public

Difference between Bills of Exchange and Cheque

Bills of Exchange (B.E) Cheque

A B.E can be drawn upon any person A cheque can be drawn only upon a
including a bank. bank.

A B.E requires acceptance. A cheque does not requires any

acceptance

The acceptor of a B.E. allowed three A cheque is always payable on demand

days of grace after the date maturity of
the bill.

Notice of dishonour is necessary Notice not required.

A B.E. must be stamped. (However, A cheque does not require any stamp.
exceptions are there)

Accommodation Bill is one which is drawn and accepted with no consideration

passed or received. The Bill, which is drawn just to oblige a friend, who is in need
of money, of course without any trading activities, with sole intention of raising
funds required for ready cash is known as Accommodation Bill. This is called Kite
Flying. Accommodation bills are sometimes also referred to as wind-bills or
windmills.

Bill Books are two types - Bills receivable book & Bills Payable Book

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Bills receivable book is a book where all the bills, which are received, are
recorded and posted directly to the credit of respective customer’s account from
there. The total amount of bills so received during the period, either at the end of
the week or month, is to be posted to, in one lump sum, to the debit of the bills
receivable account.

Bills Payable Book is a book where all particular relating to the bills accepted are
recorded and , posted from there, directly to the debit of the respective creditor’s
account. The total amount of the bills so accepted during the period, either at end
of the week or month, is to be posted in one lump sum to the credit of bills
payable account.

Honouring of Bill: When the drawee pays the amount of the bill on due date, the
bill is said to be ‘Honoured Bills’.

Dishonour of Bill: When the drawee fails to pay the amount of the bill on due
date, the bill is said to be ‘Dis-honoured Bill’.

Discounting of Bills: The drawer may discount the bill with the bank before the
due date. The bank charges discounting charges from the drawer at a certain rate.
Thus, at the time of discounting the bank deposits the net amount after charging
such amount of discount in the account of the holder of the bill.

Endorsement of bills: Transfer of bill to same other person by the holder.

Retirement of bills: When a drawee pays the bill before its due date. It is called
retirement of bill.

Renewal of bill: Renewal of bill of exchange is an act of cancellation of old bill

before its maturity in return of a new bill, including interest, for an extended
period. It is done by drawer on request of drawee.

Notary Public: A notary public of the common law is a public officer constituted
by law to serve the public in non-contentious matters usually concerned with
estates, deeds, powers of-attorney, and foreign and international business.

Rebate: When a bill is paid by drawee before due date, same allowance is given
to him. This allowance is called ‘Rebate’.

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Noting is authenticating the fact that a bill or note has been dishonoured. When
a note or a bill has been dishonoured by non-acceptance or non-payment, the
holder causes such dishonour to be noted by a Notary Public. Noting is a minute
recorded by a notary public on the dishonoured instrument. When an instrument,
say a bill of exchange, is to be noted for dishonour, is taken to Notary Public who
presents it once again for acceptance or payment, as the case may be; and if the
drawee or acceptor still refuses to accept or pay the bill, it is noted, i.e., a minute is
prepared containing the date of dishonour, reason for such dishonour, etc. which
is attached to the instrument; and the facts are noted on the instrument.

Protest - When an instrument is dishonoured, the holder may cause the fact not
only to be noted, but also to be certified by a Notary Public that the bill has been
dishonoured. Such a certificate is referred to as a protest.

Journal Entry for Bills of Exchange

The drawer is the person who draws or makes the bill and sends it to the drawee
or the payer for the acceptance. Once accepted, the bill becomes Bills Receivable
for the drawer and Bills Payable for the drawee or payee.

The drawer may endorse the bill to another person who becomes the holder of
the bill. On the due date, the holder presents the bill to the drawee for payment.

The payee is the person who eventually pays for the bill. Drawee will be the payee
as well most of the time but sometimes a third party will pay the bill on behalf of
the drawee then the third party will become the payee

The drawer can treat the bill in the following ways:

Retain it till maturity

Discount it with the bank

Endorse it in favour of another person

On the due date, there can be two situations:

The bill is honoured.

The bill is dishonoured.

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Journal Entry for Bills of Exchange

Accounting for bills of exchange starts when the drawer draws a bill and the
drawee accepts it. The drawee returns the bill to the drawer after accepting. Now,
the drawer is the holder of the bill.

Once the drawer is the holder of the bill, they can use the bill in several ways:

By holding the bill till due date

By discounting the bill

By endorsing the bill

By sending bill to bank for collection

The drawee is liable to meet the drawer's acceptance, but sometimes they fail to
do so and dishonour the bill.

Accounting for bills of exchange involves making journal entries and preparing
ledger accounts in the books of the drawer and drawee.

Journal Entries for Bills of Exchange

1. When Goods are Sold and Purchased

Journal of Drawer Journal of Drawee

Drawee’s Personal A/c………………..Dr Purchase A/c…………………..Dr

Sales A/c……………….Cr Drawee’s Personal A/c……………Cr

(Goods sold on Credit) Goods Purchased on Credit

2. When the Bill is Drawn and Accepted

Bill Receivable A/c ……………………..Dr Drawee’s Personal A/c…………………Dr

Drawee’s Personal A/c…………Cr Bill Payable A/c………………Cr

(Acceptance received) (Acceptance given)

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A. When Drawer Holds Bill Until Due Date (Option 1)

3. If the Bill is Honoured on Due Date - Journal Entries for Honoured Bill

Cash A/c ……………..Dr Bill Payable A/c…………..Dr

Bill Receivable A/c ……………..Cr Cash A/c………………………..Cr

(Amount of Bill received) (Bill met)

4. If Bill is Dishonoured on Due Date - Journal Entries for Dishonoured Bill

Drawee’s Personal A/c…………Dr Bill Payable A/c……………….Dr

Bill Receivables A/c…………………Cr Drawee’s Personal A/c…………Cr

(Bill Dis-honoured) (Bill Dis-honoured)

B. When Drawer Discounts Bill (Option 2)

5. When the bill is discounted - Journal Entries for Discounted Bill

Bank A/c…………………Dr
Discount A/c…………….Dr
Bill Receivable A/c……………..Cr No entry because they are liable to pay
the bill on due date
(Bill Discounted)

6. If discounted bill is met on due date - Journal Entries for Honoured

Discounted Bill

No Entry (Because they have already Bill Payable A/c………………..Dr

received the amount of the bill from
Cash A/c…………………………Cr
Bank)
(Bill Met)

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7. If discounted bill is dishonoured - Journal Entries for Dishonoured
Discounted Bill

Drawee’s Personal A/c………….Dr Bill Payable A/c…………Dr

Bank A/c……………………………………Cr Drawee’s Personal A/c……..Cr

(Discounted Bill Dis-honoured) (Bill dis-honoured)

C. When Bill Is Endorsed to Third-party Endorsee (Option 3)

8. When the bill is endorsed - Journal Entries for Endorsed Bill

Endorsee’s Personal A/c………Dr

Bill Received A/c…………………Cr No entry as they are liable to pay on the

due date.
(Bill endorsed to……)

9. If the endorsed bill is met on due date - Journal Entries for Honoured
Endorsed Bill

No entry as they have endorsed the bill Bill Payable A/c……………..Dr

to settle their debt
Cash A/c…………………………Cr

(Bill met)

10. If the endorsed bill is dishonoured - Journal Entries for Dishonoured

Endorsed Bill

Drawee’s Personal A/c…………Dr Bill Payable A/c……………..Dr

Endorsee’s Personal A/c……………Cr Drawee’s Personal A/c………..Cr

(Endorsed bill dis-honoured) (Bill dishonoured)

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D. When Bill Is Sent to Bank for Collection (Option 4)

11. When the bill is sent for collection - Journal Entries for Bill Sent For
Collection

Bank Collection A/c…………….Dr

Bill Receivable A/c……………………Cr No entry as they are liable to pay the

bill on due date.

(Bill sent to Bank for collection)

12. When the bill sent for collection is met - Journal Entries for Honoured
Bill sent for Collection

Bank A/c……………………..Dr Bill Payable A/c…………Dr

Bill for Collection A/c……………..Cr Cash A/c……………………..Cr

(Bill collected by Bank) (Bill met)

13. If the bill sent for collection is dishonoured - Journal Entries for
Dishonoured Bill sent for Collection

Drawee’s Personal A/c………………Dr Bill Payable A/c…………Dr

Bill for Collection A/c…………………….Cr Drawee’s Personal A/c……………Cr

(Bill sent to Bank for collection) (Bill dis-honoured)

Sometimes, the drawee pays the bill before the due date and receives a rebate.
This is known as retirement of the bill.

In other cases, the drawee may ask the drawer to cancel the bill and draw another
bill for an extended period.

This is known as renewal of the bill. The drawee pays an additional amount as
interest for the extended period.

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Journal entries under these cases are as follows:

14. Retired Bill of Exchange Journal Entry

Cash A/c…………………..Dr Bill Payable A/c………Dr

Rebate A/c…………….. Dr Cash A/c……………………..Cr

Bill Receivable A/c…………..Cr Rebate A/c………………….Cr

(Bill retired @...% …months before due (Bill retired @...% …months before due
date) date)

15. If the bill is cancelled (for renewal purposes) - Cancelled Bill of Exchange
Journal Entry

Drawee’s Personal A/c………………Dr Bill Payable A/c…………Dr

Bill for Collection A/c…………………….Cr Drawee’s Personal A/c……………Cr

(Bill cancelled) (Bill cancelled)

16. If a partial amount is received from the drawee - Partial Amount Journal
Entry

Cash A/c…………………..Dr Drawee’s Personal A/c………Dr

Drawee’s Personal A/c…………Cr Cash A/c……………………………. Cr

(Cash received as partial payment) (Cash paid as partial payment)

17. If interest is charged to the drawee - Interest Charged Journal Entry

Drawee’s Personal A/c…………..Dr Interest A/c………………..Dr

Interest A/c…………………..Cr Drawee’s Personal A/c………….Cr

(Interest receivable from Drawee) (Interest payable to drawer)

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18. If interest is received in cash - Interest Paid in Cash Journal Entry

Cash A/c……………………Dr Interest A/c………………….Dr

Interest A/c……………………..Cr Cash A/c…………….Cr

(Cash received as interest) (Interest paid in cash)

Bill of Exchange - Miscellaneous Points -

Discounted and Endorsed Bill - A Contingent Liability:

After a bill is discounted or endorsed, the drawer has no more responsibility.

However, their accounting records are affected if the drawee dishonours the bill
on the due date.

Therefore, until the bill's due date, it remains the drawer's contingent liability.

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 06. Back Office Functions &
Handling Unreconciled Entries in Banks
Back office functions can be grouped as under :

a) Book keeping and accounting – Transaction processing, maintenance of

General Ledger and other book of accounts

b) Deposits – Calculation and posting of interest, service charges

c) Loans – processing end-to-end loan originations, calculation of EMI, calculation

and posting of interest, penal interest, processing fee, commission, charges, risk
management

d) Regulatory compliance – Identifying KYC gaps, customer grievance redressal

system

e) e-Banking – handling transactions through internet, mobile banking or ATMs

f) Other functions – Clearing, Collection, Remittances

Reconciliation functions in Banks

Reconciliation of accounts for payments involving intermediaries

Reconciliation of accounts for with correspondent banks

Reconciliation of bank accounts with RBI and other banks and institutions

Reconciliation of Inter branch entries

Reconciliation of Inter Office transactions

Reconciliation Set Up & Process at Banks

The reconciliation work of Inter Office accounts is normally centralized at a

designated office of the bank (the reconciliation department).

In the new CBS environment, most of the banks have centralized this
reconciliation work at the IT department at the Head Office.

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While practices may differ from bank to bank, the inter branch accounts are
normally sub divided into segments or specific areas, e.g. ‘Drafts paid/payable’,
‘Inter –branch remittances’, H.O. A/c etc.

Each branch has to send periodic statements of Inter Office account to the Central
Reconciliation Department (CRD).

If there is no transaction in this account , a NIL statement has to be sent by the

branch. Based on these daily statements, the computer system matches the
originating entries with responding (reversal) entries for a particular day/period.

If there remain any un reconciled entries, it could be because of the

following reasons :

a) Nature of Entry : There is a time lag involved in some of the entries like draft
issued.

b) Mistake in one or more daily statements sent by the branch : Even a minor
mistake may result in system showing the entry as unreconciled.

c) Frauds : e.g. If a forged draft is paid at a branch, there will be a responding

entry for which there is no originating entry.

The CBS system will generate the report of unreconciled entries for any particular
day or period in any format, age wise, amount wise, branch wise, branch wise,
category wise etc. as per the requirement of the CRD. But that is where the role of
artificial intelligence stops and that of human intelligence begins. All the
unreconciled entries in the statement generated by the system have to be
examined/enquired into with branches and appropriate action/decision has to be
taken.

Each bank has it’s own policies and procedures regarding periodicity, escalation to
higher level etc., regarding the unreconciled entries. Some of the practices
involved are as under :-

Tackling mistakes in daily statement of branches : As these daily statement

form the basis of reconciliation by CRD, branches are required to introduce the
system of properly preparing and checking the statements.

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a) The common errors in the daily statements are as under :

1. Wrong identification of the type of transaction

2. Record of particulars in incorrect fields

3. Wrong accounting of bank charges , commission etc.

4. Errors in writing amount

5. Recording same transaction twice

6. Difference between closing and opening balances in successive daily

statement

7. Incorrect branch code no 8. Incorrect schedule no

b) Application of the concept of A-B-C analysis. That is to segregate bulk

transactions, high value items, vulnerable truncations involving cash etc.

c) Prescribe a procedure for action to be taken by Head Office regarding any

entries (Particularly Debit entries) not being responded by the branch concerned
within a reasonable time.

d) Special procedure are evolved by the bank to expediate clearance of the

arrears, particularly in respect of large value entries.

e) Special emphasis on any reversal entries indicating the possibility of irregular

payment or fraud.

f) Put in place a system to watch for any unusual entries put through
interbranch/head office. This system should also check whether transactions other
than those relating to inter branch transactions have been included in inter-
branch accounts.

g) Put in place procedure of ensuring timely dispatch of the daily statements by

the branches. Process may include identification of branches habitually sending
delayed statements.

h) To have a system of checking opening balances. Computer programme itself

may contain an instruction to check this aspect.

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i) Procedure to check whether the balances include any items in the nature of cash
– in – transit (e.g. cash meant for deposit into currency chest) included in this
head which remain pending for more than a reasonable period. This is because
such items are not expected to remain outstanding beyond a very small period
during which they are in transit.

j) To have a well defined system to follow up with branches regarding outstanding

entries will they are cleared/reconciled.

k) Device a system to review by BOD as desired by RBI.

l) Introduce the system to restrict originating debits to Head Office account to

Cash/fund transfer, purchase of securities/capital assets, withdrawal from PF,
advances to staff members etc. as advised by RBI.

Reconciliations in bank branches & Inter Office Transactions

Reconciliation in Banks:

The problem about reconciliation at the branch level, which has not been resolved
by computerization, is that of suspense and sundry deposit accounts. Suspense
account balance is included under ’Other Assets’ in the balance sheet. If the
accounts are maintained properly and on a timely basis any entry in suspense
account may not arise.

But, particularly suspense account is often used to temporarily record certain

items like :-

a) Accounts temporarily recorded under this head till the precise nature thereof
has been determined or pending transfer thereof to the appropriate head of
accounts;

b) Debit balance arising from payment of interest warrants/dividend warrants

pending reconciliation of amounts deposited by a company and the payment
made by various branches on this account;

c) Losses caused due to frauds and awaiting adjustment A neglect of the control
over suspense account can make it an easy target for committing frauds by
passing debit entries in the account and siphoning off the amount. Therefore, the
reconciliation of outstanding entries becomes important.

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Details of old outstanding entries in suspense account, along with narrations, are
prepared periodically and decision on each entry is taken by the branch or Head
Office, Each bank has its own policy towards provision/write off for old
outstanding items. Outstanding Entries in ‘Sundry Deposits’ or ‘Sundries Account’
are also expected to be cleared expeditiously even though the entries (Unlike
Suspense Account) may not be fraud prone.

Inter Office (or Branch) Adjustments (Net) : This item in balance sheet
represents the difference on account of incomplete recording of transactions
between one branch and another branch or between one branch and head office.
It may be noted that only net position is to be shown of inter office accounts,
inland as well as foreign. Origination/Response (Reversal) of Inter Office
Transactions: In many transactions, undertaken by the branch, one leg of the
transaction involved is inter office account. The major type of transactions, which
result in Inter Office debit or credit entry are :-

1. Issue of remittance instruments like drafts on other branches

2. Payment of remittance instruments like drafts by other branches

3. Payment to/ Receipt from other branches of the proceeds of instruments

received/sent for collection /realization/clearing.

4. Transactions through NEFT,ECS and RTGS

5. ATM transactions of the customers either at ATM linked with other branch or
merchant establishment.

6. Transactions through payment gateway of ATM, etc.

7. Payment of instruments like gift cheques/bankers’ cheque/interest

warrant/dividend warrant/repurchase warrant/refund warrant/travellers cheque,
etc which are paid by branch on behalf of other branches which have received the
amount for payment of these instruments from customers concerned.

8. Operations by authorized branches on the bank’s NOSTRO accounts

9. Foreign Exchange transactions entered into the branch for which it has to deal
with nodal forex department of the bank for exchange of rupees with foreign
currency

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10. Deposit and withdrawal of money by branches from the currency chest
maintained by another branch

11. Cash sent/ received from other branches

12. Head Office interest receivable and payable by branches

13. Profit/loss transferred by the branch to head office account

14. Government receipts and payments handled by the branch either as nodal
branch or agent of nodal branch

15. Interest based transactions other than inter account transfers with same
branch

16. Credit card related transactions of the customers

17. NOSTRO Accounts of Indian Branches maintained with overseas branches of

the bank

18. Capital Fund with Overseas Branches

19. Head Office balance with the overseas branches including subordinate debt
lent to the overseas branches

20. Transactions from overseas branches

21. Payment made under LCs of other branches For the bank as a whole, the
transactions which remained unmatched/unreconciled appears as inter office
adjustments balance in “Branch Adjustment Account” in the balance sheet of the
bank – under the head ‘Other Assets’ if it is debit and under ‘Other Liabilities and
Provisions’ if in credit.

RBI Guidelines regarding Inter Office Entries:

Considering the fraud prone nature and the fact that there are large number of
transactions in inter-office account and the non-reconciliation is widely extended
across the banks, RBI has taken a number of measures to achieve an expeditious
reconciliation of these transactions by the banks concerned.

Non reconciliation result in a ‘fraud risk factor’.

RBI had instructed the banks to reconcile the entries outstanding in their inter
branch accounts within a period of six months:

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a) Banks have been advised by RBI to segregate the credit entries outstanding for
more than 5 year in inter branch accounts and transfer them to a separate
‘Blocked Accounts’ which should be shown in the balance sheet under the head
’Other Liabilities and Provisions – Others’ (Schedule 5). While arriving at the net
amount of inter-branch transactions for inclusion in the balance sheet, the
aggregate amount of Blocked Account should be excluded and only the amount
representing the remaining credit entries should be netted against debit entries.
Banks have been advised that any adjustment from Blocked Accounts should be
permitted only with the authorization of two officials one of them should be from
branch concerned.

b) RBI has also advised the banks to maintain head wise accounts for various
types of transactions put through inter branch accounts so that netting can be
done category wise.

c) There may be debits in ‘Inter- Branch Adjustment‘ which may not termed assets
(Debits may be because of frauds etc.) Banks are required to arrive at the category
wise position of un reconciled entries outstanding in the Inter branch adjustment
account for more than six months as on 31st March and make provision
equivalent to 100% of the aggregate net debit under all categories. Banks to
ensure :-

i) The credit balance in the Blocked Account created is also taken into account

ii)The net debit in one category is not set off against net credit in another
category.

d) Considering large volume of transactions relating to demand drafts RBI has

advised the banks to segregate inter branch transactions relating to DD from
other Inter branch transactions.

e) RBI has advised banks to restrict originating debits to head office account to
cash/funds transfer, purchase of securities/capital assets, withdrawal from
Provident Fund, Advances to Inspection and other staff members, etc.

@@@

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 07. Bank Audit & Inspection
Banks occupy the pride of place in any financial system by virtue of the
significant role they play in spurring economic growth by undertaking maturity
transformation and supporting the critical payment systems.

The balance sheet and the profit and loss account of a banking company have
to be audited as stipulated under Section 30 of the Banking Regulation Act,
1949.

Credibility of an institution, particularly that of financial institution depends on

its internal control and supervision mechanism which can promptly detect
irregularities, if any, and take corrective measures and ensure non recurrence of
irregularities. Business of banking is susceptible to frauds. It is therefore
necessary to have an internal control and supervision mechanism for ensuring
that no one person is in a position to violate procedures, rules, regulations,
guidelines, do an unauthorized act detrimental to the organization which
remains undetected for an indefinite period or long time. Therefore, inspection
and audit plays crucial role in success of banking operations.

Audit of a Banking Company

The balance sheet and the profit and loss account of a banking company have
to be audited as stipulated under Section 30 of the Banking Regulation Act,
1949. Every banking company’s account needs to be verified and certified by
the Statutory Auditors as per the provisions of legal frame work. The powers,
functions and duties of the auditors and other terms and conditions as
applicable to auditors under the provisions of the Companies Act are
applicable to auditors of the banking companies as well.

Inspection of a Banking Company

As per Sec 35 of the Banking Regulation Act, the Reserve Bank of India is
empowered to conduct an inspection of any banking company. After
conducting the inspection of the books, accounts and records of the banking
company a copy of the inspection report to be furnished to the banking
company. The banking company, its directors and officials are required to
produce the books, accounts and records as required by the RBI inspectors,
also the required statements and/or information within the stipulated time as
specified by the inspectors.
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Supervisory Function in India

To have better supervision and control, a separate board was constituted

namely “The Board for Financial Supervision” as per the provisions of the RBI.
The Board has the jurisdiction over the banking companies, nationalized banks,
State Bank of India and its subsidiaries. The members of the Board are:
Governor of the Reserve Bank of India as the chairperson, Deputy Governors of
the Reserve Bank of India, and one of the deputy governors should be
nominated by the Governor as the full time vice chairman, four directors from
the Central Board of the Reserve Bank nominated by the Governor as
members.

Core Principles of Banking Supervision

The Core Principles for Effective Banking Supervision are the de facto minimum
standard for sound prudential regulation and supervision of banks and banking
systems.

Originally issued by the Basel Committee on Banking Supervision in 1997, they

are used by countries as a benchmark for assessing the quality of their
supervisory systems and for identifying future work to achieve a baseline level
of sound supervisory practices.

The RBI has continued with the post-liberalization strategy of setting prudential
norms based on international best practices within which banks are left free to
operate. The compliance of the Bank with the Basel Committee’s Core
Principles on Banking Supervision was gone into in great detail and the gaps in
supervision were addressed by setting up seven in-house groups to make
necessary recommendations.

Preconditions for Effective Banking Supervision

a) sound and sustainable macroeconomic policies;

b) a well established framework for financial stability policy formulation;
c) a well developed public infrastructure;
d) a clear framework for crisis management, recovery and resolution;
e) an appropriate level of systemic protection (or public safety net); and
f) effective market discipline

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Importance of Audit – Audit & Inspection

The purpose of audit is to bring about qualitative improvement and

operational efficiency in the working of the branches / units by alerting the top
management at the right time about the early warning signals observed during
the audit. It should be understood that audit is not a mere fault finding
exercise. The Auditor has to play a positive role. Therefore, focusing on critical
areas of the functioning of the branch is important in any inspection.

The role of Internal Auditor is essentially to verify

a) that the books and records are being maintained in accordance with the
practices and procedures prescribed by the management.

b) the Advances are realizable and enforceable by law, that the assets really
exist,

c) that all income accruing has been brought into account, that all expenditures
are appropriately charged.

d) that all directives and instructions / guidelines of the RBI are complied with
and these have properly percolated and are clearly understood by the
operating officials.

With the implementation of Basel Committee Recommendations, the role of

inspection and audit has enlarged to risk identification and suggestion of risk
mitigating steps. The focus of internal audit has been shifted to the application
and effectiveness of risk assessment /management procedures and evaluation
of effectiveness of internal control systems.

Audit is an independent management function, which involves a continuous

and critical appraisal of the functioning of People, Process & Structures in the
Organization with a view to suggest improvements thereto and add value to
and strengthen the overall governance mechanism of the Bank, including the
strategic risk management and internal control system.

Audit and Inspection

The expressions 'audit' and `inspection' are many times synonymously and
interchangeably used. Often their coverage also is found to telescope into each
other. There is, however, a distinction between the two.

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Audit is a quantitative analysis of the operations of an organization. It is
primarily concerned with correct and honest record keeping in accordance with
sound accounting principles and statutory requirements. Its basic purpose is to
assess the integrity of the books of account and other records to ensure that
they reflect the assets, liabilities, income and expenses correctly. Inspection is
some what broader in scope than audit.

Inspection does include elements of audit but it is fundamentally a qualitative

review of the affairs of an organization. Its objective is not only to verify
observance of the prescribed procedures and guidelines but also to promote
and maintain safe and sound operating practices and conditions. It is desirable
that audit and inspection functions be kept distinct and separate to ensure
their speedier completion and to achieve qualitative excellence."

Below are the key differences between an Inspection and an Audit.

1) Inspections focus on what, audits focus on why

2) Inspections focus on an action, audits are the process

3) Inspections are quantitative, audits are qualitative

4) Inspections are simple, audits are complex

5) Inspections create actions, audits create recommendations

An audit thoroughly examines all aspects of a business, product, or service. It is

designed to assess the accuracy and efficiency of a company's operations. An
audit may be conducted by an internal auditor or by an independent auditor
hired by the company being audited. There are three main types of audits:
product, process, and system.

An inspection evaluates something (usually a piece of equipment, a work area,

or a person) to determine if it meets some specified requirements.

Audits focus on the future by identifying weaknesses in the system and looking
at opportunities to improve processes. On the other hand, inspections are
focused on the past performance of the process.

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Types of Audits

Banks may assign various types of Audits depending on the need. Some Audits
are assigned only to Internal Auditors and some are exclusively to External
Auditors (Chartered Accountants). Some Audits are assigned either to External
Auditor or to Internal Auditor. There are many types of Audits. Banks may
name them differently. In this Chapter, I am going to discuss common type of
Audits only.

Statutory Audit

Reserve Bank of India Act requires RBI to have statutory audit and the rights
and obligations of the Statutory Auditor are specified in the Act.

Banking Regulation Act requires every bank in the country to get it’s accounts
audited.

Long Form Audit Report

The Reserve Bank of India requires the Statutory Auditor of a commercial bank
to prepare and submit to the management of the bank and RBI a specific
report called Long Form Audit Report (LFAR) on completion of statutory audit.
The contents of the Long Form Audit Report in a way enable the statutory
Auditor to report specifically on various issues.

In case, the matters on which the auditors give report in LFAR are so important
that these would necessitate a qualification in main audit report, it is not
sufficient for the auditors to report in LFAR alone. In such cases, the Auditor
should consider whether the matter needs to be mentioned as a qualification
in the main Audit Report.

Internal Audit – Risk Based Internal Audit (RBIA)

All branches and service units like Accounts Section, Clearing Section, Currency
Chest are subjected to inspection at periodical intervals. This inspection was
earlier known as Regular Inspection. Ever since the concept of RBIA (Risk Based
Internal Audit) came into being in the year 2007, the term Regular Inspection is
replaced by the term RBIA. RBIA is a very comprehensive verification of all
areas of branch functioning/administrative units' functioning.

Normally, RBIA is carried over by Internal Auditors of the Bank.

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Concurrent Audit

Concurrent Audit is a part of Bank's Early Warning System to ensure timely

detection of irregularities and lapses which helps in preventing fraudulent
transactions at the branches / units.

The Concurrent / Continuous Audit attempts to shorten the interval between

the transaction and its examination coupled with emphasis in favour of
substantive checking in key areas rather than test checking. This type of
inspection should be able to alert the top management well in time about the
early warning signals in the borrowal accounts and in the functioning of the
auditee branch. The auditor shall necessarily have to see whether the
transactions or decisions taken are within the policy parameters/guidelines laid
down by the Head Office and they do not violate the instructions or policy of
the RBI, and that they are within the laid down parameters and procedures.

The Audit is required to be carried out either by identified internal Inspecting

Officers, or Chartered Accountants empanelled as external auditors.

Concurrent Audit and Continuous Audit :

The words ‘continuous audit’ and concurrent audit are used in the following
context :

a) Where the concurrent auditor is stationed at the branch / office permanently

and does the audit on a daily basis, he is referred to as continuous auditor.

b) On the other hand, if the concurrent auditor visits the branch / office at
periodical intervals, i.e., monthly and does the audit of the present monthly
transactions, he is referred to as the concurrent auditor.

As per RBI guidelines, Concurrent Audit at branches shall cover at least 50% of
the advances and 50% of deposits of a bank. However, as per Basant Seth
Committee recommendations, Banks shall cover 70% of the advances and 70%
of deposits of the Bank.

As part of Audit rationalization, the concurrent audit at branches should cover

70% of Advances and 50% of Deposits of the Bank as at the end of the
financial year, which shall be in sync with Basant Seth Committee
recommendations and Revised RBI guidelines.

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The identification of the branches for concurrent audit to be done on the basis
of the business position as at 31st March every year on a yearly basis.

All sensitive branches/Units shall be subjected to concurrent audit. Considering

the large number of frauds happening in the banking industry, it is decided to
strengthen the surveillance system through concurrent audit, by increasing the
number of branches for concurrent audit. Concurrent Auditors are required to
conduct physical verification of both prime and collateral securities for limits /
loans sanctioned by the branches where early warning signals are noticed.

Stock Audit

The banks appoint CA firms to verify and report on the stocks maintained by
the borrowers of the Banks. The auditors are required to report on the system
of record keeping and verify the actual stocks held on a timely basis.

Revenue Audit (Income Audit)

The Income Audit is conducted along with RBIA / Concurrent / Continuous

Audit branches covering both income and expenditure areas of the branch.

In addition to these branches, as per Jilani Committee recommendations, some

branches / units are identified for conducting income audit on quarterly basis,
based on a threshold limit fixed for the income leakages detected during the
previous financial year in the various audits (RBIA / CA /Income audit)

The audit shall cover areas such as interest on loans and advances, overdue
interest on bills, DD commission, penal interest, exchange commission and
discount earned, interest paid on deposits, etc.

The banks may appoint CA firms to check the income of the branches and
require the auditors to check that all the revenues of the bank are properly and
regularly accounted for.

Snap Audit

The CA firms are appointed to check and verify certain specific aspects like KYC
compliance within the bank or branches and report to the top management on
these specific matters. Banks also appoint CA firms to check certain specific
issues or matters in respect of certain borrowers and require them to carry out
Snap Audit.

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Credit Audit (or Pre Release Audit)

Some banks ask CA firms to review and report on certain credit proposals. The
CA firms look into the loan transaction covering the process of sanction,
documentation and operation of the loan account. Such credit audit can bring
out the lacunas, if any, in the processing and sanctioning of loans as well as the
problems in documentation and monitoring of loan accounts. In some Banks
Pre Release Audit is in vogue. Pre Release Audit is carried over either by
External Auditors or Identified Internal Officials.

Monitoring Accountants (Special Mention Accounts)

Certain banks appoint CA Firms as Monitoring Accountants in respect of very

large borrowers. The banks expect the firms to report on specific issues
covered by the appointment letter as well as any other issues which the
auditors may notice in the review of books of accounts of the borrowers. Such
Monitoring Accountant visit the borrowers factories and offices regularly and
submit their reports as per the predetermined frequency.

KYC Audit

The importance of the documents taken at the time of opening of a bank

account is tremendous. RBI is insisting on the banks that their guidelines about
Know Your Customer (KYC) are extremely important. Therefore, some banks
appoint auditors to verify and report on KYC documents

NPA Audit

The identification of Non-performing Assets is extremely important for the

bank since this aspect has impact on the income recognition and provisioning
requirements. Certain banks appoint auditors to check whether the loan assets
are correctly identified as Non Performing Assets and consequently whether
the income recognition and provisioning requirements are correctly followed.

Investment / Treasury Audit

RBI has issued specific guidelines on the investments to be made by the banks
including the CRR & SLR requirements. Many banks appoint auditors to check
that the Investment policy is correctly followed and all the investments are
done in accordance with the RBI directives.

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System Audit

Practically all banks in the country use computers. Many banks use core
banking solutions which cover majority of their branches across the country.
Certain banks use Software systems which cover some of their branches. In all
these cases, it has become essential to appoint agencies to carry out Systems
Audit. CA firms are well suited to carry out these System Audits.

Legal Audit :

RBI has observed that large number of frauds were perpetrated on account of
submission of forged documents by the borrowers which had been certified by
professionals, i.e. Valuers / Advocates/ Chartered Accountants other than one
who has given LSR. RBI has advised all banks to conduct Legal Audit.

Legal Audit envisages re-verification of title deeds and other documents in

respect of credit exposures of both fund based and non fund based, in
aggregation of Rs.5 Crore and above as a part of regular audit exercise. It is to
be conducted during succeeding RBIA immediately after 3 years from the date
of first sanction or on crossing of the threshold limit of Rs.5 Crores. Subsequent
legal audits shall be conducted after a gap of 3 years from the date of first
legal audit. This shall coincide with succeeding RBIA due.

Sustenance Audit

The System of Sustenance Audit is in place to verify the compliance of LFAR

Audit Observations for the year end furnished by the statutory auditors. Such
verification of the compliance of LFAR comments shall be made immediately
after completion of the balance sheet audit by the statutory auditors i.e., in the
month of April.

Normally, Sustenance Audit is carried over by Internal Auditors of the Bank.

Thematic Audit

Thematic audit may have both compliance and performance audit objectives.
The objectives of such audits are to focus on a particular audit objective across
sectors or audited entities. These audits could be basically compliance or
performance audits. Thematic Audit is conducted on identified theme / areas
to assess whether the stated goals for which they have been conceptualized,
have been achieved.

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Thematic Audits assess the risks and evaluate the controls across the
business/activities/sub-activities. The audit ensures organization and its
stakeholders are aware of status and initiate appropriate steps for course
correction and remediation.

Normally, Sustenance Audit is carried over by Internal Auditors of the Bank.

Quality Audit

Quality Audit is to verify the correctness of compliance given by

branches/offices to the inspection remarks. Quality Audit indicates the factual
position with regard to compliance submitted by the branch / unit for the
observations of previous inspection.

Wrong reporting / Compliance, if any will be viewed seriously and will attract
staff accountability. It also attracts high risk under inspection rating of the
branch / unit.

It is very much common that branches are tempted to give confirmation of

compliance first and attempt for rectification later which may or may not
happen.

Quality Audit to carried over by the concerned Auditor (External Auditor or

Internal Auditor).

Short Inspection

Wherever the Branch-in – charge opted for voluntary retirement /resignation

and in respect of retiring Managers on Superannuation in branches / Sensitive
Units undertake Short Inspection of the branches immediately. Such short
inspection among other things shall cover sanctions made, expenditures
approved, OTS/Concession in rate of interest permitted/recommended, long
outstanding entries under Minor Subsidiaries (GL Heads) etc. and other matters
which are of sensitive nature which affect the interest of the Bank by such
official from the previous inspection till date.

If RBIA has covered part of the tenure of the retiring employee in any of his
previous branches, the remaining period shall also be covered by short
inspection. In other words, the period of coverage shall start from the end of
review period of previous RBIA till the date of relief of the retiring employee
from that branch.

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The purpose of such short inspection is to ensure that any irregularities if any
are detected and rectified before the employee is relieved from the services of
the Bank.

Normally Short Inspection is assigned to Internal Inspectors.

Risk Based Internal Audit (RBIA)

The evolvement of financial instruments and markets has enabled banks to

undertake varied risk exposures.

In view of introduction of the New Basel Capital Accord under which capital
maintained by a bank will be more closely aligned to the risks undertaken and
Reserve Bank's moved towards risk-based supervision (RBS) of banks. Under
the RBS approach, the supervisory process would seek to leverage the work
done by internal auditors of banks. In this regard, RBI has identified five
significant areas for action on the part of banks, including putting in place Risk
Based Internal Audit system to facilitate a smooth switchover to RBS.

A sound internal audit function plays an important role in contributing to the

effectiveness of the internal control system.

Historically, the internal audit system in banks has been concentrating on

transaction testing, testing of accuracy and reliability of accounting records and
financial reports, integrity, reliability and timeliness of control reports, and
adherence to legal and regulatory requirements. However, in the changing
scenario such testing by itself would not be sufficient. There is a need for
widening as well as redirecting the scope of internal audit to evaluate the
adequacy and effectiveness of risk management procedures and internal
control systems in the banks.

To achieve these objectives, banks have moved gradually towards risk-based

internal audit which includes, in addition to selective transaction testing, an
evaluation of the risk management systems and control procedures prevailing
in various areas of a bank’s operations.

The implementation of risk-based internal audit would mean that greater

emphasis is placed on the internal auditor's role in mitigating risks.

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While focusing on effective risk management and controls, in addition to
appropriate transaction testing, the risk-based internal audit would not only
offer suggestions for mitigating current risks but also anticipate areas of
potential risks and play an important role in protecting the bank from various
risks.

Risk Assessment

Inherent business risks indicate the intrinsic risk in a particular area/activity of

the bank and could be grouped into low, medium and high categories
depending on the severity of risk.

Control risks arise out of inadequate control systems, deficiencies/gaps and/or

likely failures in the existing control processes. The control risks could also be
classified into low, medium and high categories.

In the overall risk assessment both the inherent business risks and control risks
should be factored in.

The banks should also analyse the inherent business risks and control risks with
a view to assess whether these are showing a stable, increasing or decreasing
trend.

The Risk Matrix should be prepared for each business activity/location.

Risk Assessment in Banking – Types of Risks

The areas identified for assessment of risk at various levels for the purpose of
risk profiling the Branch/Offices are classified under two categories as under:

Business Risk will indicate the intrinsic risks in a particular area/activity

undertaken by the branch/office.

Control Risk will arise out of inadequate Systems, non-adherence to existing

Systems and Procedures and failure in the existing control systems.

The assessment process involves identification of inherent business risks of the

activity concerned and evaluation of effectiveness of the control systems for
monitoring the risks.

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Components of Business Risk

a) Credit Risk
b) Operational Risk
c) Liability Risk
d) Earning Risk

Components of Control Risk

a) Credit Risk Controls

b) Operation Risk Controls
c) Management Risk
d) Compliance Risk

Shri Basant Seth Committee (Guidelines on Internal Audit, Information

Systems Audit and Concurrent Audit Systems)

It has been observed that there is a multiplicity of overlapping audits in the

Public Sector Banks (PSBs). While the audit is essential for the health of the
PSBs, it has been observed that multiple overlapping audits throughout the
year engage a lot of attention, resources and time of the PSBs. It has also been
observed that there is a need to revamp the audit system in PSBs in the wake
of increasing computerization and shifting of operations on I.T. based system.
The present audit system is lagging behind the technological advancement
achieved by PSBs.

In the above background the Government of India has constituted a

Committee under the Chairmanship of Shri Basant Seth, ex-CMD of Syndicate
Bank which has submitted its report.

In pursuance to compliance of BASEL II norms, a system of Risk Based Internal

Audit (RBIA) was introduced replacing the system of Regular Inspection/IS
Audit.

The Basant Seth Committee had suggested for giving more weightage for
Control aspects in the audit.

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 Module B: Financial Statements and
Core Banking Systems
Index
Chapter No Topics Covered

01 Balance Sheet Equation

02 Preparation of Final Accounts

03 Company Accounts

04 Cash Flow and Funds Flow

05 Final Accounts of Banking Companies

06 Core Banking Systems and Accounting in Computerised

Environment.

Note: In this Book I am giving importance to only Concepts. As the Test is

in objective Mode, I am not covering Numerical Examples/Exercises.
Readers may depend other available Books for Numerical
Examples/Exercises.

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 01. Balance Sheet Equation
The fundamental part of accounting and the most basic equation in
accounting is the Balance Sheet Equation. It forms the base for a double-
entry accounting system.

The Balance Sheet shows the company’s total assets and how these assets are
financed, i.e. through debt or equity. The balance sheet shows stake owners
of the business, and that is how we come up with the balance sheet equation
as:

Assets = Liabilities + Equity

The Balance Sheet Equation is the base of a double-entry accounting system.

As per this rule, every transaction will result in two entries in the books.
Hence, the Accounting equation will always be balanced on both sides.

Components of the Balance Sheet Equation

Balance sheet components show how the balance sheet is structured, and
three major components are Assets, Liabilities, and Shareholders’ Equity. They
are further divided by:

Assets

Current Assets: Assets, which are expected to be converted into cash

generally within a year.

Cash and Equivalents: A most liquid asset in the balance sheet, while assets
with short term, i.e. under three months maturity, are also considered under
cash equivalents. Cash equivalents can be liquidated easily if needed.

Account Receivable: Revenue which is still on credit. As the company recovers

account receivable, this amount decreases while the company will get the
same amount of cash.

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Inventory: Amount of raw materials, Work in Progress, and finished goods
that have not been sold.

Non-Current Assets:

Property, Plant, and Equipment: These are generally long-term assets. Most
of these items are generally recorded after the deduction of depreciation.

Intangible assets: In this section, the company includes assets that may not
be identifiable. It includes Patents, Licences, Goodwill, etc.

Liabilities

Current Liabilities: Liabilities, which has to be paid and settled within a year
by the company.

Accounts payable: Amount of money the company owes to suppliers or

services bought on credit. As the company pays off its account payable this
amount, gets reduced with the same reduction in cash.

Accrued expenses: Bills, which are, still need to be paid by the company.
These items include general expenses like distribution expenses etc.

Non-Current Liabilities:

Long-term debt: Long-term debt is generally the company’s projects, which

are financed for a long period, or assets bought by the company for a long-
term purposes, which are financed by loans, Bond issues, Capital leases, etc.

Importance of Balance Sheet Equation is:

Foundation of Accounting: Balance sheet equation set base for a double-

entry accounting system, which considers every transaction in the company
will have two entries in books of accounts.

Assets = Liabilities + Equity

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Logic: The logic of the Balance sheet equation is every asset in the company
is financed by liability, i.e. Debt (Short or long-term), or by equity, i.e. by
owners capital invested in the company. Mismatch on both sides helps
accountants and finance professionals point out quick mistakes made in
building books of accounts.

Represents Stake owners interests in business:

Balance sheet equation shows:

Assets: Which are owned and controlled by the company.

Liabilities: Obligation, which companies have to pay off.

Equity: Owners’ investments in the business.

Shows the company’s liquidity, leverage, Financial capacity, growth:

Liquidity: The balance sheet reflects how the company can pay its short-term
obligations.

Leverage: How much the company’s activities are financed by debt and
whether the company can pay off this debt or not.

Financial Capacity: The balance sheet shows the financial capacity of the
firm and how assets are financed, the ability to pay off its debts, the efficiency
of turning assets into revenue and cash management.

Growth: Overall view of the balance sheet shows how the company is
performing over a period. Ability to generate returns through various assets,
which are financed by equity and debt.

Universal application: The balance sheet equation is applicable everywhere,

which makes regulators, companies, and the public to understand the
financial statements of any company.

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Advantages

Some of the advantages are given below:

Risk and returns: The balance sheet shows the assets and liabilities of the
company. It shows the ability of the company to pay out its short-term
liability as well as the ability to settle long term debt. At the same time, it also
shows whether the company can generate returns compare to the risks (debt)
and overall growth structure of the company over a period.

Helpful to secure loans and additional investments: Due to the balance

sheet equation, reading and understanding of balance sheet become easy
and useful for lenders and new investors. It helps them to understand the
company’s financial ability to pay-out its debt and grow in the future, which
further help them to decide to invest in a company or not.

Ratio calculations: The balance sheet equation is the base part of the double-
entry accounting system. It helps us to understand various ratios. E.g. the
current ratio provides liquidity status, the debt to equity ratio provides
leverage status, etc. For investors as well as businesses, these ratios are
important as they reflect how well the current structure and operations of the
company are well managed.

Disadvantages

Some of the disadvantages are given below:

Misstated long-term assets: The balance sheet records the value of long-
term assets at historical prices instead of current value. Book value can create
a distortive picture of the company’s financials, as it underestimates long-
term assets.

Need comparison: To understand the balance sheet as per the balance sheet
equation and making investments or business decision needs comparison of
the balance sheet of peers over many years.

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The balance sheet equation is a very basic and simple equation, which helps
us understand the logic behind financial statements. Mismatch on the asset
or liabilities side helps point out mistakes in calculations or missing entry of
transactions for finance professionals and accountants. The universal
application makes it easy for business owners and investors to make
important decisions.

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 02. Preparation of Final Accounts
The most important function of an accounting system is to provide
information about the profitability of the business. A sole trader furnishes a
Trading and Profit and loss Account which depicts the result of the business
transactions of the sole trader. Along with the Trading and Profit and Loss
Account he also prepares a Balance Sheet which shows the financial position
of the business.

Steps in the Process of Finalization of Accounts

For Trading Concerns:

1. Trading Account.
2. Profit and Loss Account.
3. Balance Sheet.

For Manufacturing and Trading Concerns:

1. Manufacturing Account.
2. Trading Account.
3. Profit and Loss Account.
4. Balance Sheet

Preparation of Financial Statements

Profitability Statement – This statement is related to a complete accounting

period. It shows the outcome of business activities during that period in a
summarized form. The activities of any business will include purchase,
manufacture, and sell.

Balance Sheet – Business needs some resources which have longer life (say
more than a year). Such resources are, therefore, not related to any particular
accounting period, but are to be used over the useful life thereof. The
resources do not come free. One requires finance to acquire them. This
funding is provided by owners through their investment, bank & other
through loans, suppliers by way of credit terms.

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The Balance Sheet shows the list of resources and the funding of the
resources i.e. assets and liabilities (towards owners and outsiders). It is also
referred as sources of funds (i.e. liabilities & capital) and application of funds
(i.e. assets).

Trading Account: It is an account which is prepared by a merchandising

concern which purchases goods and sells the same during a particular period.
The purpose of it to find out the gross profit or gross loss which is an
important indicator of business efficiency.

Manufacturing account

The main aim of accounting is to arrange accounting data in order to

ascertain the amount of profit or loss of an entity. For this purpose, we
prepare the financial statements. The primary purpose of preparing
Manufacturing Account format is to ascertain the manufacturing costs of
finished goods.

Non-manufacturing entities or the trading entities are involved in the

purchase and sale of goods at a profit. Usually, Manufacturing entities
prepare a Manufacturing Account also in addition to Trading Account, Profit
and Loss Account and Balance Sheet.

The manufacturing account helps to better the cost-effectiveness of

manufacturing activities. After the ascertainment of the costs of finished
goods, we need to transfer this cost to Trading Account.

The trading account shows Gross Profit. Whereas, the Manufacturing

Account depicts the cost of goods sold and also includes direct expenses.
Manufacturing account addresses the raw material and work in progress and
does not deal with the finished goods.

Thus, the cost of finished goods includes the cost of raw materials and all
direct expenses. All indirect expenses form a part of the Profit and Loss A/c.

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 Manufacturing Account Format

However, there is no standardized format of a Manufacturing Account. The

following format covers various elements:

Manufacturing Account for the year ended………

Particulars Units Amount Particulars Units Amount

To Opening Work-in- By Closing Work-in-
progress process
By Sale of Scrap
To Raw material By Trading Account
consumed: (Transfer of Cost of
Opening inventory Production)

Add: Purchases

Less: Closing inventory

To Direct Wages

To Direct expenses

To Factory expenses:

Factory rent

Repairs &
Maintenance of plant
and machinery

Depreciation on plant
and machinery

Depreciation on
factory building

Indirect wages

Points to remember:
In the absence of ledger balances like Inventories, quantity manufactured etc,
we need to calculate the figures for Inventories, sales etc. from the available
data.

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The Manufacturing Account format must show the quantities and values.

Units sold = Opening inventory + units manufactured- closing inventory

In the absence of specific information, we always assume “first in-first out”

basis, for closing inventory valuation.

The following items will appear in the debit side of the Trading Account:

Opening Stock: In case of trading concern, the opening stock means the
finished goods only. The amount of opening stock should be taken from Trial
Balance.

Purchases: The amount of purchases made during the year. Purchases

include cash as well as credit purchase. The deductions can be made from
purchases, such as, purchase return, goods withdrawn by the proprietor,
goods distributed as free sample etc.

Direct expenses: it means all those expenses which are incurred from the
time of purchases to making the goods in suitable condition. This expenses
includes freight inward, octroi, wages etc.

Gross profit: If the credit side of trading A/c is greater than debit side of
trading A/c gross profit will arise.

The following items will appear in the credit side of Trading Account:

Sales Revenue: The sales revenue denotes income earned from the main
business activity or activities. The income is earned when goods or services
are sold to customers. If there is any return, it should be deducted from the
sales value. As per the accrual concept, income should be recognized as soon
as it is accrued and not necessarily only when the cash is paid for.

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The Accounting standard 7 (in case of contracting business) and Accounting
standard 9 (in other cases) define the guidelines for revenue recognition. The
essence of the provisions of both standards is that revenue should be
recognized only when significant risks and rewards (vaguely referred to as
ownership in goods) are transferred to the customer. For example, if an
invoice is made for sale of goods and the term of sale is door delivery; then
sale can be recognized only on getting the proof of delivery of goods at the
door of customer. If such proof is pending at the end of accounting period,
then this transaction cannot be taken as sales, but will be treated as unearned
income.

Closing Stocks: In case of trading business, there will be closing stocks of

finished goods only. According to convention of conservatism, stock is valued
at cost or net realizable value whichever is lower.

Gross Loss: When debit side of trading account is greater than credit side of
trading account, gross loss will appear.

Trading Account for the Year ended……

Dr Cr
Particulars Amount Particulars Amount

Opening Stock Sales

Add Purchases Less Sales Returns
Less Purchase Returns Closing Stock
Gross Profit Gross Loss
(Transferred to P&L A/c) (Transferred to P&L A/c)

Total Total

Profit and Loss Account:

The following items will appear in the debit side of the Profit & Loss A/c:

Cost of Sales: This term refers to the cost of goods sold. The goods could be
manufactured and sold or can be directly identified with goods.

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Other Expenses: All expenses which are not directly related to main business
activity will be reflected in the P & L component. These are mainly the
Administrative, Selling and distribution expenses. Examples are salary to
office staff, salesmen commission, insurance, legal charges, audit fees,
advertising, free samples, bad debts etc. It will also include items like loss on
sale of fixed assets, interest and provisions.

Abnormal Losses: All abnormal losses are charged against Profit & Loss
Account. It includes stock destroyed by fire, goods lost in transit etc.

The following items will appear in the credit side of Profit & Loss A/c:

Revenue Incomes: These incomes arise in the ordinary course of business,

which includes commission received, discount received etc.

Other Incomes: The business will generate incomes other than from its main
activity. These are purely incidental. It will include items like interest received,
dividend received, etc.

The end result of one component of the P & L A/c is transferred over to the
next component and the net result will be transferred to the balance sheet as
addition in owners’ equity. The profits actually belong to owners of business.
In case of company organizations, where ownership is widely distributed, the
profit figure is separately shown in balance sheet.

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 Profit & Loss Account for the year ended…….
Dr Cr
Particulars Amount Particulars Amount

Gross Loss Gross Profit

(Transferred from Trading (Transferred from Trading
Account) Account)
Administrative Expenses Other Income
Office salaries Interest received
Travel & Conveyance Commission received
Office Rent Profit on Sale of Assets
Depreciation of Office Rent Received
assets Net Loss
Audit fee
Insurance
Repairs & Maintenance
Selling Expenses
Advertising
Commission Paid
Interest on loans
Loss on Sale of Assets
Net Profit

Total Total

The Basics of Profit & Loss Account

The profit and loss (P&L) statement summarizes the revenues and expenses
incurred during a specified period, usually a fiscal quarter or year.

The P&L statement is also known as Income Statement, Statement of Profit

and Loss, Statements of Operations, Statement of Financial Results or Income
Earnings Statement or Expense Statement.

This Statement provide information about a company's ability to generate

profit by increasing revenue, reducing costs, or both.

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Basic elements of the profit and loss report are:

1. Revenue (Net Sales) : This entry represents the value of goods or services a
company has sold to its customers. Commonly sales are presented net of
different discounts, returns, etc.

2. Cost of Goods Sold. This element measures the total amount of expenses,
related to the product creation process, including the cost of materials,
labour, etc. Costs of goods sold include direct costs and overhead costs.
Direct costs (materials; parts of product purchased for its construction; items,
purchased for resale; labour costs; shipping costs, etc.) are the expenses that
can be actually associated with the object and its production. Overhead costs
(labour costs, equipment costs, rent costs, etc.) are the expenses that are
related to the business running process, but cannot be directly associated
with the particular object of production.

3. Gross Profit. Gross profit is net revenue excluding costs of goods sold.

4.Operating Expenses. Operating expenses include selling and administrative

expenses.

Selling expenses are the expenses, which relate to the process of generating
sales by a company, including miscellaneous advertisement expenses, sales
commission, etc. All the expenses connected with company’s operation
administration, such as salaries of the office employees, insurance, etc., refer
to the administrative expenses.

5. Operating Income Operating income is gross profit excluding operating

expenses.

6. Other income or expense. This entry contains all the other income or
expense values that weren’t included to any of the previous entries. It may be
dividends, interest income, interest expense, net losses on derivatives, etc.

7. Income Before Income Taxes. Income before income taxes is operating

income including (or excluding) other income or expense.

8. Income Taxes. This entry includes all state and local taxes, which are based
on the reported profit of an enterprise.

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9. Net Income. Net income is the amount of money remaining after taking
the net sales of a business and excluding all the expenses, taxes depreciation
and other costs. In other words, this entry reflects the basic goal of an
enterprise functioning – its profit. It is also often referred as net profit or net
earnings.

Operating Income = GP – Overheads (also known as Operating Expenses)

Operating Expenses include wages & salaries, utilities such as power, water,
logistics, Rent, depreciation.

Net Profit = Operating Income – Interest – Taxes

P&L management refers to how a company handles its P&L statement

through revenue and cost management.

Model Balance Sheet

Balance Sheet of………………………as at ………………….

Liabilities Rs Assets Rs

Capital : Fixed Assets

Opening Balance Good Will

Add Net Profit Land
(Less Net Loss) Building
Less Drawings Plant & Machinery
Long Term Liabilities Furniture & Fixtures
Term Loan Investments
Current Liabilities Current Assets

Income received in advance Closing Stock

Sundry Creditors Accrued Income
Bills Payable Prepaid Expenses
Outstanding expenses Sundry Debtors
Bank Overdraft Bills Receivables
Cash at Bank
Cash at Hand
Total
Total

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A. Liabilities

(a) Capital: This indicates the initial amount the owner or owners of the
business contributed.

This contribution could be at the time of starting business or even at a later

stage to satisfy requirements of funds for expansion, diversification etc. As
per business entity concept, owners and business are distinct entities, and
thus, any contribution by owners by way of capital is liability.

(b) Reserves and Surplus: The business is a going concern and will keep
making profit or loss year by year. The accumulation of these profit or loss
figures (called as surpluses) will keep on increasing or decreasing owners’
equity. In case of non-corporate forms of business, the profits or losses are
added to the capital A/c and not shown separately in the balance sheet of the
business.

(c) Long Term or Non-Current Liabilities: These are obligations which are
to be settled over a longer period of time say 5-10 years. These funds are
raised by way of loans from banks and financial institutions. Such borrowed
funds are to be repaid in instalments during the tenure of the loan as agreed.
Such funds are usually raised to meet financial requirements to procure fixed
assets. These funds should not

(d) Short Term or Current Liabilities: A liability shall be classified as Current

when it satisfies any of the following :

• It is expected to be settled in the organisation’s normal Operating Cycle,

• It is held primarily for the purpose of being traded,

• It is due to be settled within 12 months after the Reporting Date, or

• The organization does not have an unconditional right to defer settlement

of the liability for at least 12 months after the reporting date (Terms of a
Liability that could, at the option of the counterparty, result in its settlement
by the issue of Equity Instruments do not affect its classification)

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Current liabilities comprise of :

(i) Sundry Creditors - Amounts payable to suppliers against purchase of

goods. This is usually settled within 30-180 days.

(ii) Advances from customers – At times customer may pay advance i.e.
before they get delivery of goods. Till the business supplies goods to them, it
has an obligation to pay back the advance in case of failure to supply. Hence,
such advances are treated as liability till the time they get converted to sales.

(iii) Outstanding Expenses: These represent services procured but not paid
for. These are usually settled within 30–60 days e.g. phone bill of Sept is
normally paid in Oct.

(iv) Bills Payable: There are times when suppliers do not give clean credit.
They supply goods against a promissory note to be signed as a promise to
pay after or on a particular date. These are called as bills payable or notes
payable.

(v) Bank Overdrafts: Banks may give fund facilities like overdraft whereby,
business is permitted to issue cheques up to a certain limit. The bank will
honour these cheques and will recover this money from business. This is a
short term obligation.

B. Assets

In accounting language, all debit balances in personal and real accounts are
called as assets.

Assets are broadly classified into fixed assets and current assets.

(a) Fixed Assets: These represent the facilities or resources owned by the
business for a longer period of time. The basic purpose of these resources is
not to buy and sell them, but to use for future earnings. The benefit from use
of these assets is spread over a very long period.

The fixed assets could be in tangible form such as buildings, machinery,

vehicles, computers etc, whereas some could be in intangible form viz.
patents, trademarks, goodwill etc. The fixed assets are subject to wear and
tear which is called as depreciation. In the balance sheet, fixed assets are
always shown as “original cost less depreciation”.

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(b) Investments: These are funds invested outside the business on a
temporary basis. At times, when the business has surplus funds, and they are
not immediately required for business purpose, it is prudent to invest it
outside business e.g. in mutual funds or fixed deposit. The purpose if to earn
a reasonable return on this money instead of keeping them idle. These are
assets shown separately in balance sheet.

Investments can be classified into Current Investments and Non-current

Investments. on-current Investments are investments which are restricted
beyond the current period as to sale or disposal.

Whereas, current investments are investments that are by their nature readily
realizable and is intended to be held for not more than one year from the
date on which such investment is made.

(c) Current Assets: An asset shall be classified as Current when it satisfies

any of the following :

• It is expected to be realised in, or is intended for sale or consumption in the

organisation’s normal Operating Cycle,

• It is held primarily for the purpose of being traded,

• It is due to be realised within 12 months after the Reporting Date, or

• It is Cash or Cash Equivalent unless it is restricted from being exchanged or

used to settle a Liability for at least 12 months after the Reporting Date.

Current assets comprise of:

(i) Stocks: This includes stock of raw material, semi-finished goods or WIP,
and finished goods.

Stocks are shown at lesser of the cost or market price. Provision for
obsolescence, if any, is also reduced. Generally, stocks are physically counted
and compared with book stocks to ensure that there are no discrepancies. In
case of discrepancies, the same are adjusted to P & L A/c and stock figures
are shown as net of this adjustment.

(ii) Debtors: They represent customer balances which are not paid. The bad
debts or a provision for bad debt is reduced from debtors and net figure is
shown in balance sheet.

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(iii) Bills receivables: Credit to customers may be given based on a bill to be
signed by them payable to the business at an agreed date in future. At the
end of accounting period, the bills accepted but not yet paid are shown as
bills receivables.

(iv) Cash in Hand: This represents cash actually held by the business on the
balance sheet date. This cash may be held at various offices, locations or sites
from where the business activity is carried out. Cash at all locations is
physically counted and verified with the book balance. Discrepancies if any
are adjusted.

(v) Cash at Bank: Dealing through banks is quite common. Funds held as
balances with bank are also treated as current asset, as it is to be applied for
paying to suppliers. The balance at bank as per books of accounts is always
reconciled with the balance as per bank statement, the reasons for
differences are identified and required entries are passed.

(vi) Prepaid Expenses: They represent payments made against which

services are expected to be received in a very short period.

(vii) Advances to suppliers: When amounts are paid to suppliers in advance

and goods or services are not received till the balance sheet date, they are to
be shown as current assets.

This is because advances paid are like right to claim the business gets.

Please note that both current assets and current liabilities are used in day-to-
day business activities. The current assets minus current liabilities are called
as working capital or net current assets.

Meaning of Analysis of Financial Statements

The process of critical evaluation of the financial information contained in the

financial statements in order to understand and make decisions regarding the
operations of the firm is called ‘Financial Statement Analysis’. It is basically a
study of relationship among various financial facts and figures as given in a
set of financial statements, and the interpretation thereof to gain an insight
into the profitability and operational efficiency of the firm to assess its
financial health and future prospects. The term ‘financial analysis’ includes
both ‘analysis and interpretation’. The term analysis means simplification of
financial data by methodical classification given in the financial statements.
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Interpretation means explaining the meaning and significance of the data.
These two are complimentary to each other. Analysis is useless without
interpretation, and interpretation without analysis is difficult or even
impossible

Significance of Analysis of Financial Statements

Financial analysis is the process of identifying the financial strengths and

weaknesses of the firm by properly establishing relationships between the
various items of the balance sheet and the statement of profit and loss.
Financial analysis can be undertaken by management of the firm, or by
parties outside the firm, viz., owners, trade creditors, lenders, investors, labour
unions, analysts and others. The nature of analysis will differ depending on
the purpose of the analyst. A technique frequently used by an analyst need
not necessarily serve the purpose of other analysts because of the difference
in the interests of the analysts.

Financial analysis is useful and significant to different users in the

following ways:

(a) Finance manager:

Financial analysis focusses on the facts and relationships related to

managerial performance, corporate efficiency, financial strengths and
weaknesses and creditworthiness of the company. A finance manager must
be well-equipped with the different tools of analysis to make rational
decisions for the firm. The tools for analysis help in studying accounting data
so as to determine the continuity of the operating policies, investment value
of the business, credit ratings and testing the efficiency of operations. The
techniques are equally important in the area of financial control, enabling the
finance manager to make constant reviews of the actual financial operations
of the firm to analyse the causes of major deviations, which may help in
corrective action wherever indicated.

(b) Top management:

Management of the firm would be interested in every aspect of the financial

analysis. Financial analysis helps the management in measuring the success
of the company’s operations, appraising the individual’s performance and
evaluating the system of internal control.

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(c) Trade payables:

Trade payables, through an analysis of financial statements, appraises not

only the ability of the company to meet its short-term obligations, but also
judges the probability of its continued ability to meet all its financial
obligations in future. Trade payables are particularly interested in the firm’s
ability to meet their claims over a very short period of time. Their analysis will,
therefore, evaluate the firm’s liquidity position.

(d) Lenders:

Suppliers of long-term debt are concerned with the firm’s long term
solvency and survival. They analyse the firm’s profitability over a period of
time, its ability to generate cash, to be able to pay interest and repay the
principal and the relationship between various sources of funds (capital
structure relationships). Long-term lenders analyse the historical financial
statements to assess its future solvency and profitability.

(e) Investors:

Investors, who have invested their money in the firm’s shares, are interested
about the firm’s earnings. As such, they concentrate on the analysis of the
firm’s present and future profitability. They are also interested in the firm’s
capital structure to ascertain its influences on firm’s earning and risk. They
also evaluate the efficiency of the management and determine whether a
change is needed or not. However, in some large companies, the
shareholders’ interest is limited to decide whether to buy, sell or hold the
shares.

(f) Labour

unions: Labour unions analyse the financial statements to assess whether it

can presently afford a wage increase and whether it can absorb a wage
increase through increased productivity or by raising the prices.

(g) Others:

The economists, researchers, etc., analyse the financial statements to study

the present business and economic conditions. The government agencies
need it for price regulations, taxation and other similar purposes.

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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.

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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. Cash Flow Analysis:

It refers to the analysis of actual movement of cash into and out of an

organisation. The flow of cash into the business is called as cash inflow or
positive cash flow and the flow of cash out of the firm is called as cash
outflow or a negative cash flow. The difference between the inflow and
outflow of cash is the net cash flow. Cash flow statement is prepared to
project the manner in which the cash has been received and has been utilised
during an accounting year as it shows the sources of cash receipts and also
the purposes for which payments are made. Thus, it summarises the causes
for the changes in cash position of a business enterprise between dates of
two balance sheets.

Comparative Statements

As stated earlier, these statements refer to the statement of profit and loss
and the balance sheet prepared by providing columns for the figures for both
the current year as well as for the previous year and for the changes during
the year, both in absolute and relative terms. As a result, it is possible to find
out not only the balances of accounts as on different dates and summaries of
different operational activities of different periods, but also the extent of their
increase or decrease between these dates.

Limitations of Financial Statements

Financial statement or report is the formal or written record which provides

information about the financial activities of business, status, condition, and
position of the business and much other business entities.

These financial statements have some advantages as well as some

disadvantages. Let us see the limitation of financial statement.

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The limitations of financial statements are those factors that one should be
aware of before relying on them to an excessive extent. Having knowledge of
these factors can result in a reduction in investing funds in a business, or
actions taken to investigate further. Let us discuss them in detail.

1. Based on historical costs:

Financial statements do not disclose the current worth of the company.

Initially we record transactions at their cost. The value of assets and liabilities
changes over time.

Sometimes items, such as marketable securities, we alter the amount to

match changes in their market values, but other items, such as fixed assets,
do not change. Thus, the balance sheet could be misleading if we present a
large part of the amount which is based on historical costs.

2. Based on Personal judgment:

The value of assets that appears in the statements depends on the standards
of the person who deals with it. For example, the method of depreciation,
mode of amortization of assets etc, depends on the personal judgment of the
accountant.

3. Inflationary effects:

If the situation of inflation the rate is relatively high, the amounts of assets
and liabilities in the balance sheet will appear inordinately low, as we cannot
adjust it for inflation. This mostly applies to long-term assets.

4. Judgment in respect of various accounting policies:

As we prepare a balance sheet on the basis of going concern concept, where

asset valuation does not represent realizable value or replacement value of
the asset. We know that the amount that we express through financial
statements is not accurate. Further, it depends on the judgment of the
management in respect of accounting policies followed.

5. Intangible assets not recorded:

We do not record many intangible assets as assets. Instead, we charge any

expenditure made to create an intangible asset as an expense.

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This policy underestimates the value of a business, especially one that who
spend a large amount to build up a brand image or to develop new products.
It is a particular problem for startup companies that who creates intellectual
property, but so far who generates minimal sales.

6. Interim reports are produced:

As we know financial statements are interim reports, thus these are not final
reports. Therefore, a user can gain an incorrect view of financial results by
only looking at one reporting period. We can only compute final gain or loss
of the business at the time of termination of business.

7. Not always comparable across companies:

If a company wants to compare the results of its company with different

companies, their financial statements are not always comparable, because
different companies use different accounting practices.

8. False figures:

The management team of a company may skew the results. This situation
arises when there is undue pressure to report excellent results, such as when
a bonus plan calls for pay-outs only if the sales level increases. One might
suspect the presence of this issue when the results spike to a level exceeding
the industry norm.

9. Lack of non-financial factors:

The financial statements take into consideration only financial factors and
they do not address non-financial issues, such as the environmental
attentiveness of a company’s operations, or how well it works with the local
community.

A business reporting excellent financial results might be a failure in these

other areas such as the image of the business, the loyalty of its workers, etc.

10. Figures are distorted:

Financial statements provide information about either historical results or the

financial status of a business as of a specific date. The statements do not
provide any value in predicting what will happen in the future.

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For example, a business could report excellent results in one month, and no
sales at all in the next month. Because a contract on which it was relying has
ended.

If the financial statements have not been audited, this means that no one has
examined the accounting policies, practices, and controls of the issuer to
ensure that it has created accurate financial statements. An audit of the
financial statements is evidence of such a review.

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 03 Company Accounts
A company is a voluntary business organization that is legally recognized and
exists as a separate entity. It is considered an artificial individual with its unique
signature or seal. For investors planning to venture their money and services into
a certain corporation, a proper analysis of company accounts is crucial before
putting their assets at stake. It includes proper studying of the company’s balance
sheets, profit-loss statements, cash flow statements and various other documents
that give a basic idea about the status of the company in question. This blog will
help you comprehend the basics of company accounts introduction and thereby
establish a strong foundation of the concept.

Important Features of a Company

Before getting to the management of the company accounts, we must first

understand what a company is. The following are the important features defining
a company:

1. Legal Incorporation - For the establishment of a company as a separate legal

entity, it should be incorporated under the Companies Act 1956 or, the
Companies Act 2013. These acts lay down the responsibilities of companies and
their members, along with the guidelines for certain procedures concerning the
company’s activity.

2. Perpetual Succession - A company can have investors all over the world, and
all those people investing capital to it are its members or shareholders. Even if
one of the members dies, the company continues to function incessantly.

3. Board of Directors - It is elected by the company’s shareholders for the

management purpose. However, the ownership of the company resides with all its
members and not just the Board.

4. Seal - Like every person has his unique signature, a company has its exclusive
seal which is imprinted on all the agreements and documents pertaining to the
company’s windings.

Share in terms of Company Accounts

A share is defined as a unit of ownership representing a part of the company’s

combined capital. It is an element of company accounts which brings in
investment in the form of money or other assets. It is mainly of two types -
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1. Preferential Shares - Members holding preferential shares are given a fixed
dividend irrespective of the profit earned by the company. Also, in case the
corporation shuts down due to any reason, preference is given to these
shareholders at the time of repayment.

2. Equity Shares - The amount of dividend received by these shares depends

upon the net profit made by the company. Investors in such shares have the right
to vote in the company’s decision-making process.

The Balance Sheet

The company accounts introduction is incomplete without the dissertation of the

balance sheet. It is regarded as a statement of the company’s financial position at
a given point of time, in terms of its assets, liabilities and shareholder’s equity
such that the amount of assets is always equal to the sum of liabilities and equity.

Asset - It is a resource possessed by a financial entity that has a positive

economic value.

1. Current Asset - It refers to all the assets that are on the balance sheet for less
than a year. It includes the available cash at the time of preparation of the balance
sheet, the money to be received from various sources, the stocked inventory and
the prepaid expenses.

2. Non-Current Asset - It is also called a long-term asset as it remains on the

balance sheet of company accounts for more than a year.

It consists of the manufacturing units, equipment, land, property, furniture, etc.

Liability - It is a financial debt owed by a company to other entities as a result of

past transactions or favours received as capital investment.

1. Current liability - It includes the amount payable to the suppliers, the payroll,
and the tax.

2. Non-Current Liability - It comprises loans and other debts not required to be

paid within a year.

Equity - It is the amount of money that would be left with the company after
paying off all its liabilities. In other words, it represents the net worth of a
corporation.

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Company accounts are known as a summarization of an organization's financial
activity which has been performed over a period of 12 month. They are prepared
every year and consist of the Balance Sheet, the Profit and Loss Statement, and
the Cash Flow Statement. (“Company Profit Sharing Accounts”) and any
contributions made by an Employer under prior plans, as well as to any income
and/or earnings attributable to such Company Contributions and prior plan
contributions.

Purpose of Company Accounts:

Company accounts are used to track the cash balance, money owed to the
business, money owed to creditors, Excess, and access and the payroll paid to
employees.

Company accounts are an analysis of an organization’s financial activity over a

period (12 months). For showing the financial performance of a company,
accounts are maintained and they are prepared in corporate accounting.

It is a recording of the issue of shares, debentures, etc. of the company. Other

routine accounts of the company are also recorded. With all these details, every
year the company prepares accounts consisting of the Cash Flow Statement, the
Profit and Loss Statement, and Balance Sheet.

Company Accounts- Issue of Shares

The issue of shares is a process in which a company allocates new shares to the
public. The company issues prospectus, receives applications and then allocates
them to the public. Shares are issued either at par or a premium or a discount. If
the shares of a company are issued at a price more than the face value of the
shares, the excess amount is called the premium. If the shares are issued at a price
less than the face value of the share, it is called shares issued at a discount. The
image below gives a clear idea of the issue of shares.

Company Accounts- Accounting for Share Capital

A company cannot generate its capital, which has to be necessarily collected from
several persons. The persons who contributed the amount are the shareholders
and the amount thus collected is the share capital of the company. The capital
amount collected is kept in a “Share Capital Account”.

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From the point of accounting, the share capital of the company is classified as

(1) Authorized Capital,

(2) Issued Capital,

(3) Subscribed Capital,

(4) Called up Capital,

(5) Paid-up Capital,

(6) uncalled capital, and

(7) Reserve Capital.

The issue of ordinary shares is accounted for by allocating the proceeds under
Share Capital Account and Share Premium Account.

All the money received along with the application is deposited with a scheduled
bank in a separate account as above opened for the Purpose.

Company accounts are a consolidation of a company’s financial activities for one

year. It consists of the Cash Flow Statement, Balance Sheet, and Profit & Loss
Account.

The Cash Flow Statement reveals the movement of cash in and out of the business
over the financial year. There are three categories in the cash flow statement. One
is Operating activities, which reveals the amount of cash that came from the sales
of goods and services less the amount needed to sell goods/ services. The second
one is Investing activities, which shows the amount of cash spent on capital
expenditure. And, the third one is Financing activities, which shows the amount of
cash spent on outside financing.

The Balance Sheet of a company gives an insight into the assets, liabilities, and
shareholders' equity at a specific point in time. It indicates the financial health of
the company.

In a Profit & Loss Account, we can see the details of the revenues and expenses of
business throughout the financial year. It differs from the balance sheet as it
records performance over some time rather than a snapshot.

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Some of the advantages and limitations that Company Accounts hold are as
under:

Advantages:

The shareholders of a corporation have limited liability.

A company entity can raise its amount by selling shares and issuing bonds.

A company holder can transfer his ownership.

Since the ownership of a company can be transferred, it has a perpetual life.

Owners can also receive tax-free benefits.

Limitations:

Generally, in such companies, paying taxes gets doubled as the corporation itself
pays tax depending on its type and then shareholders pay taxes on the dividends
received by them.

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 04. Cash Flow and Funds Flow
Funds flow analysis is aimed at identifying the various sources and uses of funds.
It helps in analyzing the interaction between short term and long term funds.

The following example may be useful to explain the concept :

Asset or Liability Year 2022 Year 2023 Change

Capital 100 120 + 20

Reserves 50 60 + 10

Term Loan 50 40 -10

Creditors 10 10 -----

Cash Credit 100 130 +30

Total 310 360 +50

Fixed Assets 100 90 -10

Investments 50 60 +10

Goodwill 5 5 -----------

Stocks 80 110 +30

Bookdebts 65 85 +20

Cash 10 10 -----------

Total 310 360 +50

The above table is prepared based on Balance Sheets of two years (i.e 2022 and
2023).

Increase in Reserves is due to profit earned and decrease in Fixed Assets is due to
depreciation. Decrease in Term Loan is due to repayment of instalments.

It compares the two balance sheets by analyzing the sources of funds (debt and
equity capital) and the application of funds (assets).

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It helps to understand where the money has been spent and from where the
money is received.

From the above data, the following funds flow statement is prepared.

Sources – Change in Long Term Sources

Increase in Capital 20

Net Profit 10

Depreciation 10

Change in Short Term Sources

Increase in Working Capital 30

Total Change in ST Sources 30

Total Change in Sources 70

Uses – Change in LT Uses

Increase in Investments 10

Decrease in Term Loan 10

Change in ST Uses

Increase in Stocks 30

Increase in Bookdebts 20

Total Change in ST Uses 50

Total Change in Uses 70

Increase in ST Sources 30

Increase in ST Uses 50

Change in Working Capital (-) 20

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Analysis of movement of funds :

In order to find out changes in the funds flow pattern comparison of a minimum
of two financial statements is to be done.

Any increase in a liability item would be a source of funds and any increase in
asset would represent use of funds.

Any decrease in liability would be a use and decrease in assets would be a source.

For example, if sundry debtors have decreased between the dates of two balance
sheets it means that sundry debtors have been collected and therefore it is a
source. Similarly if sundry creditors have decreased between the dates of two
balance sheets, it means that the sundry creditors have been paid off which would
mean that the resources have been utilized i.e. a use.

The long term sources and uses are identified/bifurcated. If the long term sources
are found to be more than long term uses, it shows that the excess or difference
has gone to short term uses.

Where the short term sources are found to be more than the short term uses and
the difference being utilized for long term uses, this state would lead to a decline
in the current ratio and a decline in the net working capital. If a portion of the
current liabilities (short term source) is diverted to long term uses (investment in
fixed or non current assets), it would result in current liabilities going up, while the
current assets do not increase proportionately. This would mean a reduction in
working capital. Hence, whenever there is a diversion, there is a reduction in the
net working capital.

In the above example, ST Uses are more than the ST Sources and the shortfall is
20, which is compensated by LT Sources. As a Banker we accept such situation. If
the reverse position is observed (where ST Sources are more than ST Uses) it
implies that the Firm is making use of ST Sources to met LT Uses, which is not
acceptable to Banker as this situation may lead to Liquidity Crunch in near future
and once the Firm faces Liquidity Shortage, it is very difficult to come out of this
Liquidity Trap.

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If the long-term source is not increased during the period and term liability is
reduced or non-current assets are increased it indicates that short-term source is
utilized for long term source. In bankers parlance using short-term source for long
term use is the diversion of funds which has the dire consequence towards the
operation of the entity.

Bankers, normally, analyse Funds Flow Statement to see whether the Firm has
resorted to divert Short Term Funds to meet Long Term Uses. If such situation is
observed Banker has to initiate corrective steps.

Funds flow analysis is also useful in determining whether the unit has adopted a
wise policy in the matter of raising funds from various sources and whether the
funds so obtained are properly deployed.

Difference between Funds Flow and Cash Flow :

The Cash Flow Statement is prepared on a cash basis, whereas , The Fund Flow
Statement is prepared on an accrual basis. Funds flow would take into account all
the changes in the pattern of economic resources, whereas, a cash flow
statement would represent only the effect of cash transactions.

For example, One Individual has supplied machinery with a condition that the
Sale consideration of the said machinery will be paid to him by way of Share
Capital in the Firm. In the Balance Sheet of the Firm (who had purchased
machinery) the machinery representing an increase in assets would appear as a
long term use and capital would appear as a long term source in a funds flow
statement. In a cash flow statement this should not figure on either side because
no transaction has taken place in cash.

Basically, any change in the assets and liabilities may result in the inflows and
outflows of funds, but not always, as in case of depreciation or revaluation of
assets, there is no inflow or outflow of funds. Hence, only those assets or liabilities
will become a part of the statement, which actually leads to the flows of the fund
to/from the business.

Funds flow statement is also called by various other names such as “Sources and
Application of Funds”; “Where came in and Where gone out Statement”; “Where
got, Where gone Statement” ; “Movement of Funds Statement”; “Funds
Generated and Expended Statement”; etc.

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For the purpose of appraisal of a term loan proposal, an analysis of funds flow is
made, as the funds flow takes into account all transactions whether they represent
cash transactions or not.

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 05 Final Accounts of Banking Companies

The accounting system of a banking company is different from that of a trading or

manufacturing enterprise.

As per Section 29, a banking company incorporated in India, is required to

prepare, at the end of each accounting year, a Balance sheet and profit and
Loss Account as on the last working day of the year.

Profit and Loss Account

A banking company is required to prepare its Profit and Loss Account according
to Form B in the Third Schedule to the Banking Regulation Act, 1949. The Profit
and Loss Account of a banking company must be prepared as per Form B of the
Act in vertical form like Balance Sheet.

Thus, Profit and Loss Account will present the net result of the operation. This
accounts deals with the expenses and incomes of the current year, i.e. if incomes
exceed expense, this is profit, and vice versa in the opposite case. The same is
brought forward.

Appropriation:

Only appropriation items will appear in this account viz, amount transferred to
General Reserve or Statutory Reserve or Proposed Dividend etc. and the balance
will appear in the Liability side of the Balance Sheet.

It is divided into:

(1) Income;

(2) Expenditure;

(3) Profit and Loss;

(4) Appropriation

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Schedule XIII — Income:

These includes:

(1) Interest Earned: (i) Interest, Discounts on advance and bills; (ii) Income on
investment; (iii) Interest on balance with RBI.

(2) Others. It is the first item under this head.

Schedule XIV — Other Incomes:

These include:

(1) Commission, Exchange and Brokerage

(2) Profit on Sale of Investment;

(3) Profit on Revaluation of Investments;

(4) Profit on Sale of Land etc.

(5) Profit on exchange transactions.

(6) Income from dividend.

15. Schedule XV — Interest Expended:

These include:

(1) Interest on Deposits;

(2) Interest on RBI deposit;

(3) Others. It is the second item.

16. Schedule XVI — Operating Expenses:

These include: All revenue expenditures and provisions, viz. Rent, Taxes and
Lighting, Salaries, Wages, Depreciation, Law charges etc. Provision for Bad Debt,
Provision for Contingences, etc.

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Balance Sheet

The Balance Sheet of Banking Company is prepared according to Form A in Third

Schedule.

Balance Sheet should be prepared as per the format advised by RBI following the
vertical method for its preparation including the last year’s figure.

The Balance Sheet contains 12 Schedules which are:

Capital and Liabilities:

1. Schedule I — Capital:

Capital is shown under the head “Capital and Liabilities” as first item.

2. Schedule II — Reserves and Surplus: These includes:

(1) Statutory Reserve;

(2) Capital Reserves;

(3) Securities Premium;

(4) Reserve and other Reserves (including Profit and Loss Accounts). It is the
second item under the head “Capital and Liabilities”.

3. Schedule III — Deposits: These include:

(1) Demand Deposits;

(2) Savings Bank Deposits;

(3) Term Deposits. It is the third items under the head “Capital and Liabilities”.

4. Schedule IV — Borrowings: These includes:

(1) Borrowings in India (RBI, other banks, other institutions and agencies);

(2) Borrowings outside India. It is the fourth item under the head “Capital and
Liabilities”.
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5. Schedule V — Other Liabilities & Provisions: These include:

(1) Bills Payable;

(2) Inter office Adjustment (Net);

(3) Accrued Interest;

(4) Others (including provisions).

Assets:

6. Schedule VI — Cash and Balance with RBI: These include:

(1) Cash in hand;

(2) Balances with RBI (in Current Account, in other accounts). It is the first
item under the head “Assets”.

7. Schedule VII — Balance with Banks and Money at Call & Short Notice:
These include Balance with Banks

(a) Current Account

(b) Other Deposit Accounts;

(c) Money at call and Short notice

8. Schedule VIII — Investments: These include:

(1) Investment in India in Govt. Securities and others;

(2) Investments outside India in Govt. Securities and others.

9. Schedule IX — Advances: These include:

(1) Bills purchased and discounted, Cash Credits, Overdrafts, and Term Loans;

(2) Secured by tangible assets;

(3) Advances in India.

(4) Advances outside India.

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10. Schedule X — Fixed Assets: These include:

(1) Premises;

(2) Other fixed assets.

11. Schedule XI — Other Assets: These include:

(1) Inter-office Adjustment (Net);

(2) Accrued Interest;

(3) Tax paid in Advance;

(4) Stationery and stamps;

(5) Non-banking assets.

(6) Others.

12. Schedule XII — Contingent Liabilities: These include:

(1) Claims against the bank not acknowledged as draft;

(2) Liability for partially paid investment;

(3) Liability against forward outstanding contract;

(4) Guarantee given on behalf of constituents;

(5) Acceptances, endorsements and other obligations;

(6) Other items.

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 06 Core Banking Systems and Accounting in
Computerised Environment.
Computerised Accounting

An accounting system is one that performs the following functions:

It captures business transactions in the form of accounting entries.

The accounting entries are then used to prepare financial statements.

The financial statements are prepared based on accounting standards.

Various financial reports are prepared from the data available in the financial
statements.

Features of Computerized Accounting

Speed

Accuracy

Various informative reports can be generated

Economy

A Computerised system may be a single stand Along unit or a Multiple User,

ie, LAN, WAN etc.

Advantages of Computerized Accounting

Accurate, High speed and low cost or operation

Availability of various reports from the same accounting data

Error- free accounting

Automatic completion of all records by feeding only one entry into the
computer

Multiple set of Printouts available

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Disadvantages of Computerized Accounting

Requirement of special Programme and Professional

Qualified staff required for Operations

Costly computer peripherals and stationery

Regular back-up is required as Data may be lost for various reasons

Computer viruses

Core Banking Components

Core Banking is delivered as a set of integrated core banking components that are
then tailored to fit the institution’s individual business requirements. These
components can be easily re-configured as business requirement change,
protecting the organisation’s strategic investment and maintaining a unified
business approach.

Core Bank components include

Core Bank financial institution infrastructure

Core Bank customer management and customer overview

Core Bank Account Administration

Core Bank Payments

Core Bank Management Information

Advantages of Core Banking

Makes the internal staff more competent.

Minimises human intervention thereby limiting errors.

Helps prevent frauds and thefts with real-time banking facilities.

Reduces operational costs.

Aids in studying changing customer demands.

Facilitates decision making through reporting and analytics.

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Information Security

Information Security is basically the practice of preventing unauthorized access,

use, disclosure, disruption, modification, inspection, recording or destruction of
information. Information can be physical or electrical one.

Information system Security

Information systems security provides essential information for managing the

security of an organization where information technology is an important factor.

It is mainly for all the staff, who are the first-line support, responsible for the daily,
efficient operation of security policies, procedures, standards and practices.

It cover

Access control systems and methodologies

Computer operations security

E-mail and internet access

Application and systems developments

Cryptography

Law, investigations and ethics

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 Module C : Financial Management
Chapter No Topics covered

01 Financial Management -An Overview

02 Ratio Analysis

03 Interest, Annuities, YTM

04 Forex Arithmetic

05 Capital Structure and Cost of Capital,

06 Capital Investment Decisions/Term Loans,

07 Equipment Leasing/Lease Financing,

08 Working Capital Management,

09 Derivatives.

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 01 Financial Management -An Overview
Financial management is one of the most important aspects of a business.
Financial management is strategic planning, organising, directing, and controlling
of financial undertakings in an organisation or an institute. It also includes
applying management principles to the financial assets of an organisation, while
also playing an important part in fiscal management.

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise.
It means applying general management principles to financial resources of the
enterprise.

Scope/Elements of Financial Management

Investment decisions includes investment in fixed assets (called as capital

budgeting). Investment in current assets are also a part of investment decisions
called as working capital decisions.

Financial decisions- They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.

Dividend decision- The finance manager has to take decision with regards to the
net profit distribution. Net profits are generally divided into two:

Dividend for shareholders- Dividend and the rate of it has to be decided.

Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

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Objectives of Financial Management

The financial management is generally concerned with procurement, allocation

and control of financial resources of a concern. The objectives can be-

Maintaining enough supply of funds for the organisation;

Ensuring shareholders get good returns on their investment;

Optimum and efficient utilisation of funds;

Creating real and safe investment opportunities.

To plan a sound capital structure.

Functions of Financial Management

Estimation of capital requirements: A finance manager has to make estimation

with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a concern.

Estimations have to be made in an adequate manner which increases earning

capacity of enterprise.

Determination of capital composition: Once the estimation have been made,

the capital structure have to be decided.

This involves short-term and long-term debt equity analysis. This will depend
upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.

Choice of sources of funds: For additional funds to be procured, a company has

many choices like-

Issue of shares and debentures

Loans to be taken from banks and financial institutions
Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and
period of financing.
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Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.

Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:

Dividend declaration - It includes identifying the rate of dividends and other

benefits like bonus.

Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.

Management of cash: Finance manager has to make decisions with regards to

cash management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.

Financial controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can be done
through many techniques like ratio analysis, financial forecasting, cost and profit
control, etc.

Importance of Financial Management

Helps organisations in financial planning and acquisition of funds;

Aids organisations to effectively utilise and allocate the funds received or

acquired;

Supports organisations in making critical financial decisions;

Helps in improving the profitability of organisations;

Increases the overall value of organisations;

Provides economic stability.

@@@
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 02 Ratio Analysis
Ratio analysis is referred to as the study or analysis of the line items present in the
financial statements of the company. It can be used to check various factors of a
business such as profitability, liquidity, solvency and efficiency of the company or
the business.

Ratio analysis is mainly performed by external analysts as financial statements are

the primary source of information for external analysts. The analysts very much
rely on the current and past financial statements in order to obtain important data
for analysing financial performance of the company. The data or information thus
obtained during the analysis is helpful in determining whether the financial
position of a company is improving or deteriorating.

Categories of Ratio Analysis

1. Liquidity Ratios: Liquidity ratios are helpful in determining the ability of the
company to meet its debt obligations by using the current assets. At times of
financial crisis, the company can utilise the assets and sell them for obtaining
cash, which can be used for paying off the debts.

Some of the most commonly used liquidity ratios are quick ratio, current ratio,
cash ratio, etc. The liquidity ratios are used mostly by creditors, suppliers and any
kind of financial institutions such as banks, money lending firms, etc for
determining the capacity of the company to pay off its obligations as and when
they become due in the current accounting period.

2. Solvency Ratios: Solvency ratios are used for determining the viability of a
company in the long term or in other words, it is used to determine the long term
viability of an organisation.

Solvency ratios calculate the debt levels of a company in relation to its assets,
annual earnings and equity. Some of the important solvency ratios that are used
in accounting are debt ratio, debt to capital ratio, interest coverage ratio, etc.
Solvency ratios are used by government agencies, institutional investors, banks,
etc to determine the solvency of a company.

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3. Activity Ratio: Activity ratios are used to measure the efficiency of the business
activities. It determines how the business is using its available resources to
generate maximum possible revenue.

These ratios are also known as efficiency ratios. These ratios hold special
significance for business in a way that whenever there is an improvement in these
ratios, the company is able to generate revenue and profits much efficiently.

Some of the examples of activity or efficiency ratios are asset turnover ratio,
inventory turnover ratio, etc.

4. Profitability ratios: The purpose of profitability ratios is to determine the

ability of a company to earn profits when compared to their expenses. A better
profitability ratio shown by a business as compared to its previous accounting
period shows that business is performing well.

The profitability ratio can also be used to compare the financial performance of a
similar firm, i.e it can be used for analysing competitor performance.

Some of the most used profitability ratios are return on capital employed, gross
profit ratio, net profit ratio, etc.

Use of Ratio Analysis - Ratio analysis is useful in the following ways:

1. Comparing Financial Performance: One of the most important things about

ratio analysis is that it helps in comparing the financial performance of two
companies.

2. Trend Line: Companies tend to use the activity ratio in order to find any kind
of trend in the performance. Companies use data from financial statements that is
collected from financial statements over many accounting periods. The trend that
is obtained can be used for predicting the future financial performance.

3. Operational Efficiency: Financial ratio analysis can also be used to determine

the efficiency of managing the asset and liabilities. It helps in understanding and
determining whether the resources of the business is over utilised or under
utilised.

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To explain important Ratios I am making use of following Simple Balance Sheet

Liabilities Assets

Capital 300000 Land & Building 192150

General Reserves 55000 Plant & Machinery 128600

P&L A/c (Credit Balance) 6750 Total Fixed Assets (after 265000
Depreciation)

Term Loan from Bank 100000 Goodwill 15000

Liability in OCC 38000 Pre-operative Expenses 15000

Creditors (for goods) 26000 Cash 250

Provision for Tax 9250 Receivables (Bookdebts) 125050

Dividend Proposed 15000 Stock (Inventory) 128200

Pre-paid expenses 1500

Total 550000 Total 550000

Other Information : Net Sales : 15,00,000/-

Purchases : 10,50,000/-
Depreciation 55,750/-

From the above Sample Balance Sheet we have arrived at following :

Current Assets (CA) = Cash + Receivables + Stock + Pre-paid Expenses

= 250 + 125050 + 128200 + 1500 = 255000

Quick Assets (QA)= Cash + Receivables = 250 + 125050 = 125300

Current Liabilities (CL) = OCC + Creditors + Provision for Tax + Dividend

Proposed

= 38000 + 26000 + 9250 + 15000 = 88250

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Current Ratio = CA / CL = 255000 / 88250 = 2.89 : 1

Quick Ratio + QA / CL = 125300 / 88250 = 1.42 : 1

Net Working Capital = CA – CL = 255000 – 88250 = 166750

Current Liabilities other than Bank Borrowings (CLOBB ) = CL – Bank Borrowings

for WC = 88250 – 38000 = 50250

Working Capital Gap (WCG) = CA – CLOBB = 255000 – 50250 = 204750

Net Worth = Capital + Reserves + Credit Balance in P&L Account = 361750

Intangible Assets = Good Will + Pre-operative Expenses = 30000

TNW = Net Worth – Intangible Assets = 361750 – 30000 - 331750

Debt Equity Ratio (DER) = Long Term Debt / TNW = 100000 / 331750 = 0.30 : 1

Stock Turnover Ratio = Net Sales / Stock = 11.70 (approximately 12 times)

Debtor Velocity Ratio = Debtors / Net Sales x 12 = 1 month

Creditor Velocity Ratio = Creditors / Purchases x 12 = 26000/1000000 x 12 = 0.3

month.

Other way of arriving at NWC = Long Term Funds – Long Term Uses

Long Term Funds are also known as Long Term Sources (LTF or LTS)

LTS = Capital + Reserves + P&L Credit Balance + Term Loan

300000 + 55000 + 6750 + 100000 = 461750

LTU = Fixed Assets after Depreciation + Intangible Assets

FA after Depreciation = Land & Building + Plant & Machinery – Depreciation

192150 + 128600 – 55750 = 265000

LTU = 265000 + 30000 = 295000

NWC arrived at using Long Term Items = LTS – LTU = 461750 – 295000 =
166750.

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Though arithmetically calculating NWC using CA-CL formula correct, as Margin
represents the borrower’s own funds, it is apt if we calculate NWC using Long
Term Items. (LT Sources - LT Uses).

Please note the difference between Pre-paid Expenses and Pre-operative

Expenses. We find both these on Assets side.

Prepaid expenses are future expenses that have been paid in advance. These are
treated as Current Asset.

Preoperative expenses are those expenses incurred by a company before

commencement of commercial operations; or before starting to earn income.
These are distinct from preliminary expenses or formation expenses.

Preliminary expenses (also known as Formation Expenses) are those that are
incurred before incorporation of a company or commencement of business.

Preliminary expenses (Formation Expenses) and Pre-operative expenses are

treated as Intangible Assets.

In Balance Sheet, Though original value of Fixed Assets is furnished (this is known
as Gross Block), while computing Value of Assets, we take into account Value of
Fixed Assets after deducting Depreciation. This Depreciated Value of Fixed Assets
is known as Net Block .

In the above example, total of Land & Building (192150) and Plant & Machinery
(128600) is known as Gross Block (320750). If we deduct Depreciation (55750)
from Gross Block we get Net Block (265000) which is taken into account while
computing Balance Sheet.

Current ratio is a liquidity ratio which measures a company's ability to pay its
current liabilities with cash generated from its current assets. It equals current
assets divided by current liabilities.

Current Assets are assets that are expected to be converted to cash within normal
operating cycle, or one year.

Please note that a Vehicle used by the Firm for transporting its goods is a fixed
asset, though it is mobile (not fixed).

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We have to decide whether the Asset is current or fixed basing on its usage to
particular activity. Goods Vehicle used by a Firm is Fixed Asset as it helps the Firm
in its activity. However, the same Goods Vehicle is a current asset to Automobile
Dealer who is in the business of trading in Goods Vehicles. So to decide whether
the one is current asset or fixed asset, we have to see the purpose for which it is
used in the related activity.

Further, in some cases, where operating cycle is very long (beyond one year), the
items used in the production process are treated as Current Assets, even if cash is
not generated within one year. For example, in case of Ship Building Activity, in
some cases it may take 2 to 3 years for completing the ship building. In such
cases, we can treat all items used in the production as current assets, even if they
are not converted into cash within one year.

Current Liabilities are obligations that require settlement within normal operating
cycle or next 12 months. Examples of current liabilities include accounts payable,
salaries and wages payable, current tax payable, sales tax payable, accrued
expenses, etc. Though, working capital limits are permitted with tenability more
than one year, we have to treat them as current liability as they are payable on
demand, though tenability of the limit is more than one year.

Current ratio compares current assets with current liabilities and tells us whether
the current assets are enough to settle current liabilities. There is no single good
current ratio becuase ratios are most meaningful when analyzed in comparison
with the company's competitors.

Interpretation of Current Ratios

If Current Assets > Current Liabilities, then Ratio is greater than 1.0 -> a desirable
situation to be in.

If Current Assets = Current Liabilities, then Ratio is equal to 1.0 -> Current Assets
are just enough to pay down the short term obligations.

If Current Assets < Current Liabilities, then Ratio is less than 1.0 -> a problem
situation at hand as the company does not have enough to pay for its short term
obligations.

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A current ratio of 1 is safe because it means that current assets are more than
current liabilities and the company should not face any liquidity problem. A
current ratio below 1 means that current liabilities are more than current assets,
which may indicate liquidity problems. In general, higher current ratio is better.

A rising current ratio is not necessarily a good thing and a falling current ratio is
not inherently bad. A very high current ratio may indicate existence of idle or
underutilized resources in the company. This is because most of the current assets
do not earn any return or earn a very low return as compared to long-term assets.
A very high current ratio may hurt a company’s profitability and efficiency.

Please note the following relation between Current Ratio (CR) and NWC (Net
Working Capital) :

1) When CR is 1 – NWC is zero

2) When CR is above 1 – NWC is positive.
3) When CR is less than 1 – NWC is negative.

Let us discuss which of the following companies is in a better position to pay its
short term debt.

Item Company A Company B Company C

Current Assets 300 160 400

Current Liabilities 200 110 180

Current Ratio 1.50 1.45 2.22

From the above table, it is pretty clear that company C has 2.22 of Current Assets
for each 1.0 of its liabilities. Company C is more liquid and is apparently in a better
position to pay off its liabilities.

However, please note that we must investigate further.

Let us see the breakup of Current Assets and we will try and answer the same
question again.

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 Item Company A Company B Company C

Cash ------ 160 -----

Receivables 300 ---- ----

Inventory ---- ----- 400

Total CA 300 160 400

Total C L 200 110 180

Current Ratio 1.50 1.45 2.22

Company C has all of its current assets as Inventory. For paying the short term
debt, company C will have to move the inventory into sales and receive cash from
customers. Inventory takes time to be converted to Cash. The typical flow will be
Raw Material inventory -> WIP Inventory -> Finished goods Inventory -> Sales
Process takes place -> Cash is received. This cycle may take a longer time. As
Inventory is less than receivables or cash, the current ratio of 2.22 does not look
too great this time.

Company A, however, has all of its current assets as Receivables. For paying off
the short term debt, company A will have to recover this amount from its
customers. There is a certain risk associated with non-payments of receivables.

However, if you look at Company B now, it has all cash in its current assets. Even
though it’s Ratio is 1.45 , strictly from the short term debt repayment perspective,
it is best placed as they can immediately pay off their short term debt.

Seasonality & Current Ratio

It should not be analyzed in isolation for a specific period. We should closely

observe this ratio over a period of time – whether the ratio is showing a steady
increase or a decrease.

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Current ratios should be analyzed in the context of relevant industry. Some
industries for example retail, have very high current ratios. Others, for example
service providers such as accounting firms, have relatively low current ratios
because their business model is such that they do not have any significant current
assets.

Further, it is quite possible for two companies to have same current ratios but
vastly different liquidity position for example when one company has a large
amount of obsolete inventories.

We can sum up its limitations as under :

1) It does not focus on the breakup of Assets or Asset Quality. The example that
we saw earlier Company A (all receivables), B (all cash) and C (all inventory)
provide different interpretations.

2) This ratio in isolation does not mean anything. It does not provide an insight on
product profitability etc.

3) This ratio can be manipulated by management. An equal increase in both

current assets and current liabilities would decrease the ratio and likewise, an
equal decrease in current assets and current liabilities would increase the ratio.

A more meaningful liquidity analysis can be conducted by calculating Quick Ratio

(also called Acid-test Ratio) and Cash Ratio. These ratios remove the illiquid
current assets such as prepayments and inventories from the numerator and are a
better indicator of very liquid assets.

Debt Equity Ratio

DER is included under gearing ratios. Gearing ratios are a metric used to
demonstrate the funding of an entity’s operations i.e. whether it was covered
through debt or the investment made by shareholders.

This is the ratio between debt and equity. i.e., debt / equity. It indicates the
relation-ship between the loan capital and capital raised by way of equity. In the
numerator we take only Long Term Outside Liabilities as Debt.

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A company's capital structure refers to how it finances its operations and growth
with different sources of funds. Capital structure is sometimes referred to as
"financial leverage" . There are two main forms or sources of capital for a capital
structure: equity capital and debt capital (loan capital).

The main difference between loan capital and equity is that the interest payable
on the loan capital has prior charge and has to be paid before any dividend can
be declared. While there can be no dividend without profits, interest may have to
be paid even if there is no profit.

In the calculation of the ratio, debt is defined as the outside liabilities. As per the
definition, the debt would include debentures, current liabilities, and loans from
banks and financial institutions.

However, the inclusion of current liability is controversial because debt to equity

ratio is all about long-term financial solvency and current liability is a short-term
liability and the amount of current liability fluctuates far and wide over the year.
Further, current liabilities are taken care of in liquidity ratios (such short-term
ratio and quick ratio) and the interest on them is not so huge. In view of the
above in calculation of DER, Debt represents long term outside liabilities.

'Equity' refers to tangible net worth.

As the debt to equity ratio expresses the relationship between external equity
(liabilities) and internal equity (stockholder’s equity), it is also known as “external-
internal equity ratio”.

If a unit has more debt and less capital, it may be in a disadvantageous position as
the servicing of loan, i.e., payment of instalments and interest, may be a problem,
in the event of its failure to earn sufficient profit.

Debt/equity ratio may misguide the potential investors as well since a low debt to
equity ratio can be a result of the company not appropriately using technology
available. This is an indication of technical inefficiency which would result in lower
returns even if the debt/equity ratio is low.

Though, the optimal debt/equity ratio is 1:1, it cannot be applied to all situations.
In respect of traders, loans from friends and relatives received on a long term
basis, subordinated to the Bank can be treated as equity.

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A capital-intensive entity may have a high debt/equity ratio indicating that net
assets have been regularly maintained and financed through the debts obtained
which would increase returns in the future due to higher production.

However, a low-capital industry doesn’t need to invest in factories and types of

equipment hence its optimal ratio should be around 1:1. This is one of the major
limitations of the debt/equity ratio since it can only compare similar companies’
financial performance.

On the other hand, if the unit obtains all its needs of long term funds by floating
equity capital, it will have no worry as there is no legal need of payment of
dividends and the capital will be repaid only in the event of the liquidation of the
unit. Conversely, the shareholders of a unit stand to gain considerably if a part of
these funds is obtained by borrowings.

Turnover Ratios

Turnover Ratios are also known as Activity Ratios.

These ratios basically measure the efficiency with which assets are being utilized
or managed. This is why they are also known as productivity ratio, efficiency ratio
or more famously as turnover ratios.

These ratios show the relationship between sales and any given asset. It will
indicate the ratio between how much a company has invested in one particular
type of group of assets and the revenue such asset is producing for the company.

The following are the different kinds of Activity Ratios that measure the
effectiveness of the funds invested and the efficiency of their performance

1) Stock Turnover Ratio and Inventory Holding Level

2) Debtors Turnover Ratio and Debtors Holding Level
3) Creditors Turnover Ratio and Creditors Holding Level

Stock Turnover Ratio :

This ratio focuses on the relationship between the cost of goods sold and average
stock. So it is also known as Inventory Turnover Ratio or Stock Velocity Ratio.

It measures how many times a company has sold and replaced its inventory
during a certain period of time.

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Inventory turnover ratio is computed by dividing the cost of goods sold by
average inventory at cost. The formula/equation is given below:

Cost of Goods Sold

Inventory Turnover Ratio = ……………..……………………………
Average Inventory at Cost

Two components of the formula of inventory turnover ratio are cost of goods sold
and average inventory at cost.

Cost of goods sold is equal to cost of goods manufactured (purchases for trading
company) plus opening inventory less closing inventory. Average inventory is
equal to opening balance of inventory plus closing balance of inventory divided
by two.

If cost of goods sold is not known, the net sales figure can be used as numerator
and if the opening balance of inventory is unknown, closing balance can be used
as denominator. For example if both cost of goods sold and opening inventory
are not available in the data provided, the formula would be as follows:

Inventory turnover ratio = Sales / Inventory

It allows Management to figure out their inventory reordering schedule, by

indicating when all the stock will run out. It also helps them analyze how
efficiently the stock and its reordering is being managed by the purchasing
department.

The inventory holding levels measure the average length of time required to sell
inventory.

Its usefulness lies in its comparison to past years or to similar companies.

Debtors Turnover Ratio

This Ratio measures the efficiency with which Receivable are being managed.
Hence it is also known as ‘Receivable Turnover ratio’. Definition:

Debtor’s turnover ratio or accounts receivable turnover ratio or velocity ratio

indicates the velocity of debt collection of a firm.

In simple words, it indicates the speed of collection of credit sales.

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It is computed by dividing the net credit sales during a period by average
receivables.

Accounts receivable turnover ratio simply measures how many times the
receivables are collected during a particular period. It is a helpful tool to evaluate
the liquidity of receivables.

Net Credit Sales

Accounts Receivable Turnover Ratio = ………….…………..……………………………
Average Trade Receivables (Net)

Two components of the formula are “net credit sales” and “average trade
accounts receivable”. It is clearly mentioned in the formula that the numerator
should include only credit sales. In case this information not available in the data
provided, the total sales should be used as numerator assuming all the sales are
made on credit.

Average receivables are equal to opening receivables (including notes receivables)

plus closing receivables (including notes receivables) divided by two. But
sometimes opening receivables may not be available in the data provided. In that
case closing balance of receivables should be used as denominator.

The higher the value of debtor’s turnover the more efficient is the management of
debtors or more liquid the debtors are. Similarly, low debtors turnover ratio
implies inefficient management of debtors.

Average Collection Period : Debtors Holding Level

This ratio is significant in managing the debtors of a company. This is also

known as Debtors’ Velocity Ratio and it indicates the time it takes for a business
to receive payments owed by its clients in terms of accounts receivable.
Companies calculate the average collection period to make sure they have
enough cash on hand to meet their financial obligations.

The average collection period is calculated by dividing the average balance of

accounts receivable by total net credit sales for the period and multiplying the
quotient by the number of days in the period.

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Average collection periods are most important for companies that rely heavily on
receivables for their cash flows.

The Formula to arrive at Average Collection Period is .......

Average Book-debts
------------------------------ x 365 (for days) or (12) for months
Net Sales

Creditors Turnover Ratio (also known as Accounts Payable Turnover Ratio)

Accounts payable turnover ratio indicates the creditworthiness of the company. A

high ratio means prompt payment to suppliers for the goods purchased on credit
and a low ratio may be a sign of delayed payment.

Accounts payable turnover ratio also depends on the credit terms allowed by
suppliers. Companies who enjoy longer credit periods allowed by creditors usually
have low ratio as compared to others.

A high ratio (prompt payment) is desirable but company should always avail the
credit facility allowed by the suppliers.

It measures the number of times, on average, the accounts payable are paid
during a period.

It is calculated by using the following formula :

Net Credit Purchases

Accounts Payable Turnover Ratio = ………….…………..……………………………
Average Accounts Payable

In above formula, numerator includes only credit purchases. But if credit

purchases are not known, the total net purchases should be used.

Average accounts payable are computed by adding opening and closing balances
of accounts payable and dividing by two. If data related to opening balance of
accounts payable is not available , the closing balance of Creditors should be
used.

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Creditors’ Velocity or Creditors’ Payment Period :
(Average Payment Period: Credtors Holding Level)

Average Creditors
----------------------- x 365 (for days) or (12) for months
Purchases

The Account Payable turnover ratio shows the speed at which a company pays
its suppliers.

Investors can use the accounts payable turnover ratio to determine if a company
has enough cash or revenue to meet its short-term obligations.

Creditors can use the ratio to measure whether to extend a line of credit to the
company.

A decreasing Account Payable turnover ratio indicates that a company is taking

longer to pay off its suppliers than in previous periods.

When the Account Payable Turnover Ratio is increasing, the company is paying
off suppliers at a faster rate than in previous periods. An increasing ratio means
the company has plenty of cash available to pay off its short-term debt in a timely
manner. As a result, an increasing accounts payable turnover ratio could be an
indication that the company managing its debts and cash flow effectively.

However, an increasing APT Ratio over a long period could also indicate the
company is not reinvesting back into its business, which could result in a lower
growth rate and lower earnings for the company in the long term.

Debt Service Coverage Ratio (DSCR)

We make use of “DSCR” (Debt Service Coverage Ratio) or simply DCR (Debt
Coverage Ratio) in the Appraisal of Term Loans.

DSCR is a ratio of cash available to cash required for debt servicing. In other
words, it is the ratio of the sufficiency of cash to repay the debt. It measures a
company’s ability to service its current debts by comparing its net operating
income with its total debt service obligations.

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This ratio indicates whether the earnings are adequate to meet the burden of
fixed financial charges. A borrowing concern is required to pay interest on the
loan as also to pay the stipulated instalments. It must, therefore, have sufficient
earnings to enable it to meet these financial commitments.

Calculation of DSCR is very simple. Debt service coverage ratio is calculated as

follows :

Net profit after tax + depreciation + interest on term loans

DSCR = ----------------------------------------------------------------------
interest on term loans + principal repayment instalment

To calculate this ratio, following items from the financial statement are required:

Profit after tax (PAT)

Noncash expenses (e.g. Depreciation, Miscellaneous expenses are written off

etc.)

Interest for the current year

Instalment for the current year

Lease Rental for the current year

Sometimes, these figures are readily available but at times, they are to be
determined using the financial statements of the company/firm.

Profit after tax (PAT)

PAT is generally available readily on the face of the Profit and loss account. It is
the balance of the profit and loss account which is transferred to the reserve and
surplus fund of the business. Sometimes, in an absence of the profit and loss
statement, we can also find it on the Balance Sheet by subtracting the current
year P/L account from the previous year’s balance, which is readily available under
the head of reserve & surplus.

Interest

The amount which is payable for the financial year under concern on the loan is
taken.

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Noncash expenses

Noncash expenses are those expenses which are charged to the profit and loss
account for which payment has already been done in the past years. Following are
the noncash expenses:

a) Writing off of preliminary expenses, pre-operative expenses etc,

b)Depreciation on the fixed assets.
c)Amortization of the intangible assets ( goodwill, trademark, patent etc)

d) Provisions for doubtful debts,

e)Deferment of expenses like an advertisement, promotion etc.

Depreciation is added back to the operating profit in the funds flow analysis in
order to arrive at true funds from operations or real funds from operations.
Depreciation is a non-cash charge and it does not reflect any actual out go of
funds. It is generally entered in the books in order to satisfy certain accounting
conventions and sometimes to provide for replacement of the assets. Since
depreciation does not reflect any actual outgo of funds it is added back to the
operating profit in order to arrive at the real funds from operation. This would
apply to any other non-cash charge debited before the operating profit stage.

Principal amount

It is the amount payable on the loan for the financial year under review. It includes
the payment towards principal for the financial year.

Lease Rental

The amount of lease rent paid or payable for the financial year.

Interpretation of Debt Service Coverage Ratio

The result of a debt service coverage ratio is an absolute figure. Higher this figure
better is the debt serving capacity.

If the ratio is less than 1, it is considered bad because it simply indicates that the
cash of the firm are not sufficient to service its debt obligations.

The acceptable norm for a debt service coverage ratio is between 1.5 to 2.

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Ratios related to P & L Account

Interpretation of Profitability Ratios :

The income statement of the firm contains information that can be used for
computation of certain financial ratios, which measure firm’s performance and
position over the reporting period. Depending on the ratio, it can be a measure of
firm’s profitability or financial sustainability.

There are two types of profit ratios viz., gross profit and net profit ratio.

Gross Profit
GP Ratio = --------------------
Net Sales

Gross Profit = Sales - Cost of goods sold

When gross profit ratio is expressed in percentage form, it is known as gross

profit margin or gross profit percentage. The formula of gross profit margin or
percentage is given below:

Gross Profit
GP Margin = -------------------- x 100
Net Sales

This indicates the efficiency and competence with which the unit is being
managed. A high GP ratio implies that the cost of production is relatively low and
margin of profit consequently high.

Net Profit Ratio

Also known as Net Profit Margin ratio, it establishes a relationship between net
profit earned and net revenue generated from operations (net sales).

Net profit ratio is a profitability ratio which is expressed as a percentage hence it

is multiplied by 100.

Net Profit
Net Profit Margin = -------------------- x 100
Net Sale

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Net Profit = Operating Income – (Direct Costs + Indirect Costs)

Net Sales = (Cash Sales + Credit Sales) – Sales Returns

The Profitability Ratios are explained hereunder by making use of the

following Simple P&L Account

Operating Revenue

Product sales 12,000

Service sales 4,000

Sales Returns 1000

Total Operating Income (Net Sales) (Total Sales – Sales Returns) 15,000

Operating Expenses

Cost of goods sold (COGS) 7,000

Gross Profit (Net Sales - COGS) 8,000

Overhead

Rent 1,500

Insurance 250

Office supplies 150

Utilities 100

Total Overhead 2,000

Operating Income (GP-Overheads) 6,000

Other Income (Add) 500

Other Expenes – Interest on Loan (Deduct) 1000

Earnings Before Income Taxes 5,500

Income Taxes (Deduct) 500

Net Profit 5,000

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From the above data we calculate GP Ratio and NP Ratio hereunder :

Gross Profit = Net Sales - COGS

Gross Profit 8000

GP Ratio = --------------------- x 100 = ---------------- x 100 = 53.33 %
Net Sales 15000

Net Profit 5000

NP Ratio = --------------------- x 100 = ---------------- x 100 = 33.33 %
Net Sales 15000

Operating Income = GP – Overheads (also known as Operating Expenses)

Operating Expenses include wages & slaries, utilities such as power,water,

logistics, Rent, depreciation.

Net Profit = Operating Income – Interest – Taxes

Net Profit ratio is the main indicator of a firm’s profitability, a trend analysis is
usually done between two different accounting periods to assess improvement or
deterioration of operations.

GP ratio may increase due to the following :

a. A higher sale price while cost of production remaining constant.

b. Lower cost of goods sold while sale price remaining constant.

GP ratio may decline due to the following :

a. Fall in prices of products

b. Increase in input costs not compensated by matching price increase

c. Decline in efficiency in production

d. Idle capacity

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High Net Profit Ratio – A high ratio may indicate low direct and indirect costs
which will result in a higher net profit of the organization. This ratio is the overall
measure of the firm's ability to turn each rupee of sales into profit. A firm with a
high net profit ratio would be in an advantageous position in the face of fall in
sale prices, rise in cost of production or decline in the demand for the product as
it would be able to absorb the market fluctuation to a certain extent.

Low Net Profit Ratio – A low ratio may indicate unnecessarily high direct and
indirect costs which will result in a lower net profit of the organization, thus
reducing the numerator to lower than the desired number.

The following contribute to a decline in net profit ratio :

a. The incidence of fixed costs may lead to a decline in profit when turnover
falls.

b. Expenses not entirely pertaining to current year

c. Presence of idle assets, accumulated inventory, debtors posing difficult of

realization.

d. Expenses not resulting in revenue.

e. Lack of control over fixed assets.

P&L management refers to how a company handles its P&L statement through
revenue and cost management.

@@@

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 03. Calculation of Interest and Annuities
People will earn money for their livelihood i.e. to spend on rent, food, clothing,
education etc. along with this they need money to meet some extra expenditure
like marriage in family, purchasing of vehicle, house or set up their own business
and so on. Some people will manage with their own money, but most people have
to borrow money for such contingencies.

Interest can be defined as the price paid by a borrower for the use of a lender’s
money. It is compensation paid to the depositor.

Interest is the price paid by a borrower for the use of a lender’s money.

Reasons for Charging Interest:

There are a variety of reasons for charging the interest, they are-

Time value of money:

Time value of money means that the value of a unity of money is different in
different time periods. The sum of money received in future is less valuable than it
is today. In other words the worth of rupees received after some time will be less
than a rupee received today.

Since a rupee received today has more value, rational investors would prefer
current receipts to future receipts. If they postpone their receipts, they will
certainly charge some money i.e. interest.

Opportunity Cost:

The lender has a choice between using his money in different investments. If he
chooses one, he forgoes the return from all others.

In other words, lending incurs an opportunity cost due to the possible alternative
uses of the lent money.

Inflation:

Most economies generally exhibit inflation. Inflation is a fall in the purchasing

power of money. Due to inflation, a given amount of money buys fewer goods in
the future than it will now. The borrower needs to compensate the lender for this.

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Liquidity Preference:

People prefer to have their resources available in a form that can immediately be
converted into cash rather than a for that takes time or involves expenditure to
realize

Risk Factor:

There is always a risk that the borrower will go bankrupt or otherwise default on
the loan. Risk is one determinable factor in fixing rate of interest.

A lender generally charges more interest rate (risk premium) for taking more risk.

Types of Interest

Interest can be of two types:

Simple Interest
Compound Interest

Simple Interest:

SI is interest earned on only the original amount, called Principal, lent over a
period of time at a certain rate.

Formula for SI-=PRT /100,

For ex: Rs.1000 deposited for one year at the rate of 8% p.a. interest will be Rs.8.

Compound Interest (CI)

CI is interest earned on any previous interests earned as well as on the Principal

lent. It is Interest on interest. Compound interest is the interest paid on both
principal and existing interest. Hence, it is usually termed "interest over the
interest". Here, the interest so far accumulated is added to the principal and the
resulting amount becomes the new principal for the next interval. i.e., Compound
Interest = Interest on principal + Interest over existing interest.

Daily Product Method

Finance is the life blood of trade, commerce and industry. Now-a-days, banking
sector acts as the backbone of modern business. Development of any country
mainly depends upon the banking system. With a bank people can open saving
account, current account, fixed deposit account and recurring deposit account.

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RBI Guidelines on Saving Account

Savings bank account interest calculation by banks in India as per the new RBI
guidelines is based on daily products, i.e. the balances outstanding as at the end
of the day.

Equated Monthly Installment

An Equated Monthly Installment (EMI) is “A fixed payment amount made by a

borrower to a lender at a specified date. Equated monthly installments are used to
pay off both interest and principal each month, so that over a specified number of
years, the loan is paid off in full.” common types of loans, such as real estate
mortgages, the borrower makes fixed periodic payments can be paid with the
help of EMI. EMIs differ from variable payment plans, in which the borrower is
able to pay higher payment amounts at his or her discretion. In EMI plans,
borrowers are usually only allowed one fixed payment amount each month.

EMI depends on three factors: loan amount, interest rate and the duration of the
loan.

The EMI is decided when the loan is sanctioned and remains constant throughout
the period of the loan, provided there is no change in any of the factors on the
basis of which it is calculated.

The EMIs are structured in such a way that the interest portion forms a major part
of the payment that is made in the initial years. In the later years, the principal
component becomes high.

The EMI can change in the case of an alteration in interest rates or if there is a
prepayment.

It is also possible to keep the EMI constant and increase or decrease the tenure of
the loan to reflect the changes in interest rates or loan prepayment.

Fixed and Floating Interest Rates

There are two different modes of Interest. They are-

Fixed Rates

Floating Rates (also called as variable rates)

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Fixed Interest Rate

People who opt for Fixed Interest Rate have to repay the loan in fixed and equal
instalments as per the loan tenure. The advantage of fixed interest rate is that it
would not change even if there are fluctuations or changes in the Indian financial
market conditions or trends. Fixed Interest rate becomes the first preference when
the financial market is down. Consumers take the opportunity by blocking or
fixing the interest rate as per their preference.

Floating Interest Rate

Interest rate which is volatile and keeps on changing as per market scenario is
termed as Floating Interest Rate. This type of interest rate depends on the base
rate offered by several lenders, so whenever the base rate changes, the interest
rate gets automatically revised. As compared to fixed interest rate, floating rates
are comparatively cheaper.

Annuities

In investment, an annuity is a series of payments made at equal intervals. The

term "annuity" refers to a plan made by financial institutions with the intention of
paying out invested funds in a fixed income stream in the future. Investors invest
in or purchase annuities with monthly premiums or lump-sum payments. The
holding institution issues a stream of payments in the future for a specified period
of time or for the remainder of the annuitant's life.

Annuity versus Recurring Deposit

In a recurring deposit, the depositor deposits a fixed amount every month and
gets a fixed amount (based on a pre-decided annual return) at the maturity. But in
case of annuity deposit exactly the reverse happens. Here the depositor pays a
lump sum amount and receives a fixed amount every month for the entire tenure.

There are two stages to any annuity contract.

Accumulation Stage

Distribution Stage

The first stage is the Accumulation Stage, or the period where you save and
potentially grow your retirement funds while building the cash value of your
annuity.

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The accumulation phase ends at the onset of the Distribution Stage. This is when
you're ready to begin withdrawing funds to create an income in retirement. With
annuities, this is called Annuitization – or the process of converting your annuity
into regular payments for retirement.

Immediate and Deferred Annuities

Annuities can begin immediately upon deposit of a lump sum, or they can be
structured as deferred benefits.

The immediate payment annuity begins paying immediately after the annuitant
deposits a lump sum.

Deferred income annuities, on the other hand, don't begin paying out after the
initial investment. Instead, the client specifies an age at which they would like to
begin receiving payments from the insurance company.

Fixed and Variable Annuities

Annuities can be structured generally as either fixed or variable.

Fixed annuities provide regular periodic payments to the annuitant. Variable

annuities allow the owner to receive larger future payments if investments of the
annuity fund do well and smaller payments if its investments do poorly, which
provides for less stable cash flow than a fixed annuity but allows the annuitant to
reap the benefits of strong returns from their fund's investments.

While variable annuities carry some market risk and the potential to lose principal,
riders and features can be added to annuity contracts—usually for an extra cost.
This allows them to function as hybrid fixed-variable annuities.

Ordinary Annuity: Payment are required at the end of each period. For an
illustration, straight bonds usually make coupon payments at the end of every six
months until the bond’s maturity date.

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Annuity Due: Payments are required at the beginning of each period. Rent is an
illustration of annuity due. You are usually required to pay rent when you first
move in at the beginning of the month, and then on the first of each month
thereafter.

Yield to Maturity refers to the expected returns an investor anticipates after

keeping the bond intact till the maturity date. Unlike the current yield , which
measures the present value of the bond, the yield to maturity measures the value
of the bond at the end of its bond term. In other words, a bond’s expected returns
after making all the payments on time throughout the life of a bond. YTM
considers the effective yield of the bond, which is based on compounding.

Yield to maturity allows an investor to compare the bond’s present value with
other investment options in the market.

TVM (Time value of money) is taken into consideration while calculating YTM,
which helps in better analysis of the investment about a future return.

It promotes making credible decisions as to whether investing in the bond will

fetch good returns compared to the value of the investment at the current state

###

I am not furnishing Formulae to calculate different rates of interest and

Calculation of Annuities etc. for two reasons –
(a) it is more technical in nature which a Banker need not know in detail and
(b) As the Test is in objective Mode, questions related to Calculation of
Annuities may come across very rarely.

@@@

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 04. Forex Arithmetic
In this Chapter after explaining various concepts related to Forex Arithmetic, I will
furnish some numerical examples to make the things clear.

Foreign Exchange is the trading of one currency for another. For example, one can
swap the U.S. dollar for the Indian Rupees. Foreign exchange transactions can take
place on the foreign exchange market, also known as the Forex Market.

There are three fundamental aspects of this general mechanism of foreign

exchange.

Almost every country has its own currency (legal tender, distinctive unit of
account) and the useful possession of the currency, can normally be had only in
that country, in which it passes.

The exchange from one currency for another is, mostly, put though by the banks
by means of bookkeeping entries carried out in the two centres concerned.

Almost all exchanges of one currency for another are affected with the help of
credit instruments.

Indian Forex Market

The exchange rate movements in the Indian forex market do not necessarily
follow the international trend, particularly in the short run. The main reason for
this is the restriction on the free flow of capital into or out of the country. Prior to
the method ‘Liberalised Exchange Rate Management System’ (LERMS) the Reserve
Bank fixed the buying and selling rates and the market would remain within the
ceiling and the floor, thus fixed by the Reserve Bank. However, at present, the
forces of demand and supply in the local Interbank market derive the Exchange
rate.

Direct and Indirect Quote

The quote is direct when the price of one unit of foreign currency is expressed in
terms of the domestic currency.

The quote is indirect when the price of one unit of domestic currency is expressed
in terms of Foreign currency.

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Since the US dollar (USD) is the most dominant currency, usually, the exchange
rates are expressed against the US dollar. However, the exchange rates can also
be quoted against other countries’ currencies, which is called as cross currency.

Now, a lower exchange rate in a direct quote implies that the domestic currency is
appreciating in value. Whereas, a lower exchange rate in an indirect quote
indicates that the domestic currency is depreciating in value as it is worth a
smaller amount of foreign currency.

Cross Rate

If a person wants to remit Euros from India, and as a banker, and for argument
sake, rupees/ Euros are not normally quoted and therefore, what we have to do is
first buy dollars against the rupees and the same dollars will be disposed off
overseas to acquire the Euros.

If a rate in Mumbai market are US 1 Dollar- Rs 60.8450/545 and rates in London

market are US 1 Dollar=Euros 0.7587 we will gets US 1 dollar for Rs 60.8545 and
for one Us dollar we will get Euro 0.7587, thus we can form a sort of chain rule as
under;

How many Rs.= 1 Euro

If 0.7587 Euro= US 1 dollar

Therefore, 1 Euro= Rs. 60.8545/0.7587 Or 1 Euro= Rs. 80.21

If an export customer has a bill for 100000 pound, the bank has purchase the
Pound from him and give an equivalent amount in rupees to the customer.
Presuming the inter-bank market quotations for spot delivery are as follows:

US 1 dollar= Rs 60.8450/545

The London market is quoting cable (STG/DLR) as

1 pound= US 1.9720/40 Dollar

The bank has to sell pound in the London market at US 1.9720, ie. The market’s
buying rate for Pound 1. The US dollars so obtained have to be disposed off in the
local inter-bank market at US 1 dollar= Rs 60.8450 (market’s buying rate) for US
dollar.

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By chain rule, we get:

Pound 1= 1.9720*60.8450

= Rs 119.9863

Chain Rule:

The fixing of the rate of exchange between the foreign currency and the Indian
rupee through the medium of some other currency is done by a method known
as Chain Rule. The rate thus obtained is the Cross rate between these currencies.

Value Date

The value date is a date on which the exchange of currencies actually takes place.
Based on this concept, we have the following types of exchange rates.

Cash/ready: it is the rate when an exchange of currencies takes place on the date
of the deal.

TOM: When the exchange of currencies takes place on the place on the next
working day, i.e, tomorrow it is called the TOM rate.

Forward Rate: If the exchange of currencies takes place after period of spot date,
it is called the forward rate. Forward rates generally are expressed by indicating a
premium/ discount for the forward period.

Premium: When a currency is costlier in forward or say, for a future value date, it
is said to be at a premium. In the case of the direct method of quotations, the
premium is added to both the selling and buying rate.

Discount: If currency is cheaper in the forward of for a future value date, it is said
to be at a discount. In the case of a direct quotation, the discount is (deducted)
subtracted from both the rates, i.e buying and selling rates.

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Forward Exchange Rates

The forward exchange rate (also referred to as forward rate or forward price) is the
exchange rate at which a bank agrees to exchange one currency for another at a
future date when it enters into a forward contract with an investor. The Exchange
rate for settlement on a date beyond the spot is naturally different and the same
is called the forward rate.

Arbitrage

Arbitrage is an operation by which one can make risk free profits by undertaking
off setting transactions Arbitrage can be in interest rates, i.e. borrow in one centre
and lend in another at a higher rate. Arbitrage can occur in exchange rates also.
However, with the present day efficient communication system, arbitrage
opportunities are very rare.

Basis of Exchange Rate quotation:

Buying:- Rate at which Foreign Currency bought from customer can be sold in
the market i.e., market buying rate.

Selling:- Rate at which Foreign Currency to be sold to the customers can be

bought in the market i.e., market selling rate.

Base rate is the rate derived from ongoing market rate, based on which buying /
selling rates are quoted for merchant transactions. The interbank rates are
normally for spot deliveries. Hence, for quoting rates for merchant transaction on
cash basis (i.e. value Today), the base rate will be adjusted to the extent of
cash/spot differences.

Exchange Margin

The Base Rates, which are derived from the ongoing interbank spot rates, are
applied for arriving at rates for merchant purchase and sale transactions. Banks
have been given freedom to fix the quantum of exchange margin to be loaded to
the base rate for quoting rates for different types of merchant transactions e.g. TT
Buying/Selling, Bill Buying/Selling etc.

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In line with the business maxim of “Buy Low Sell High” while arriving at the
merchant rate the exchange margin is reduced from the base rate in case of
purchases and added on for sale transactions in the case of direct quotation.

The TT buying rate is applicable for:

a. Clean inward remittances (TT/DD) for which cover has already been
credited to our Nostro account.

b. Proceeds of export bills/cheques etc. sent for collection.

c. Cancellation of outward TT/DD etc.

d. Cancellation of forward sale contract on or after due date.

e. Conversion of RFC, EEFC, FCNR(B) deposits and PCFC/FC Loan into Indian
Rupees.

Bill Buying Rate (OD Buying)

The bill buying rate is applicable for purchase/discounting of bills and other
instruments. Although the Bank on purchasing/discounting the export bill
immediately parts with the Rupee equivalent, the foreign exchange will be
received (delivered) on a future date after realisation of the bill. In the case of
usance bill, forward rate will be applicable. However, in the case of sight bill,
forward rates are not quoted even though transit period is involved, as bills are
likely to be realised early.

TC Buying Rate is applied for purchase of foreign currency traveller cheques.

Currency Buying Rate is applied for purchase of foreign currency notes tendered
by a customer.

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The TT Selling rate is applicable for :

i) Outward remittance in foreign currency (TT/DD)

ii) Cancellation of purchase

a) Bill purchased/returned unpaid

b) Bill purchased/transferred to collection a/c
c) Refund of inward remittances

iii) Forward purchase contract cancellation on or after due date

iv) Conversion of NRE deposit to FCNR/RFC deposits

v) Recovery of interest on PCFC/FC Loan

Bill Selling Rate

The Bill Selling rate is applied for transactions involving transfer of proceeds of
import bills.

It is to be noted that although the transfer may take place by way of a DD/TT etc.
the TT selling rate is not to be applied.

TC Selling Rate is applicable for sale of foreign Traveller Cheques to the

customers.

Currency Selling Rate is applicable for sale of foreign currencies.

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Numerical Problems
01. Suppose, USD being quoted at Rs.61.50/55. Furnish / Calculate the following

a) Base Rate
b) Bill Buying Rate (OD Buying)
c) TC Buying Rate
d) Currency Buying Rate
e) TT Selling Rate
f) Bill Selling Rate
g) TC Selling Rate
h) Currency Selling Rate

Solution

A) Base Rate

As USD being quoted at Rs.61.50/55, the market will buy USD from us at Rs.61.50
and hence the base rate will be taken at Rs.61.50.

B) Bill Buying Rate (OD Buying)

Base Rate Rs. 61.50

Add premium/deduct discount as the case may be, for the period
ofdelivery/realisation.

For Ex, Premium for 3 months Rs.0.60 Rs. 00.60

----------
Rs. 62.10

Less: Exchange Margin @ say 0.150% Rs. 00.09

------------
Rs.62.01

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C) TC Buying Rate

Base Rate Rs. 61.50

Less : Margin say 1% Rs. 00.62

----------
Rs. 60.88

Round off to nearest 5 paise Rs. 60.85

D) Currency Buying Rate

Base Rate is TC Buying rate Rs. 60.85

Less: Margin say 0.5% Rs. 00.30

-----------
Rs. 60.55

Round off to nearest 5 paise Rs. 60.55

E) TT Selling Rate

On being quoted USD 1= Rs.61.50/55 in the interbank market, the Bank will have
to purchase the required US Dollar from the market at Rs.61.55.

The base rate would be Rs.61.53

(after adjusting Cash/Spot Difference say 2 Paise)

Add : Exchange margin, say 0.150% Rs 00.09

------------
Rs. 61.62

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F) Bill Selling Rate

Base rate would be Rs. 61.53

(after adjusting Cash/Spot Difference say 2 Paise)

Add: Exchange margin, say 0.200% Rs. 00.12

----------

Rs. 61.65

G) TC Selling Rate

Base rate is TT Selling rate Rs. 61.62

Add. Margin say 0.50% Rs. 00.30

-----------
Rs. 61.92

Rounded off to nearest 5 paise Rs. 61.95

(Additional commission @1% if advised by Bank need to be added)

H) Currency Selling Rate

This rate is applicable for sale of foreign currencies :

Base Rate is TC Selling Rate Rs.61.95

Add :Margin say 0.50% Rs 00.30

---------
Rs.62.25

Rounded off to nearest 5 paise Rs.62.25

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02. A Bank quote its rate as - One US dollar=Rs.46.57- 46.75

In the above context

a) What is the Buying Rate ?

b) What is the Selling Rate ?

Answer :

a) In the case of One US dollar=Rs.46.57- 46.75, the first Rs.46.57 is the buying
rate,

b) In the case of One US dollar=Rs.46.57- 46.75, the first Rs.46.57 is the buying
rate, the second 46.75 is the selling rate.

03. A Bank quote its rate as - Rs.100=USD 2.2432- 2.2768.In the above context

a) What is the Buying Rate ?

b) What is the Selling Rate ?

Answer :

a) In the case of Rs.100=USD 2.2432-2.2768, the bank agrees to sell at the rate of
USD 2.2432 for Rs.100.

b) In the case of Rs.100=USD 2.2432-2.2768, the bank is willing to buy at USD

2.2768 for Rs.100.

(The buying rate is known as the bid rate and the selling rate is known as offer
rate)

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04. From the following Inter Bank Rates, calculate Rupee Franc Rate

US Dollar to Indian Rupee is $1=Rs.34.2400 – 34.2600

US Dollar and French Franc are $1=French Franc 4.9660 -4.9710.

Answer :

First the customer buys US Dollar from the market in India at $1 selling rate of
Rs.34.2600.

The US Dollar thus acquired is disposed off in the London market for French Franc
at the market buying rate $1=French Franc 4.9660.

Therefore the Rupee Franc Rate is:

French Franc 1= 34.2600/4.9660 = 6.8989

Rounded off to Rs. 6.8990.

05. From the following data arrive at Quote for Swiss Francs (SFR) against the
Deutsch Mark (DM).

$1=SFR 1.1326/1.1336 and $1=DM1.3750/1.3755

Answer :

Our aim is to derive the Selling and Buying Rates for Swiss Francs (in terms of
Deutschmarks (DM)

If we are selling Swiss francs we will be buying Deutschmarks.

So we begin with the rate for selling Swiss francs and buying dollars; we then
move to selling dollars and buying Deutschmarks.

We have to apply Cross Rule (Chain Rule) of these two rates to arrive at Rate for
selling Swiss francs and buying Deutschmarks.

Step 1 (to calculate rate for One USD in SF)

The rate for selling Swiss francs to the dealer and buying Dollars is SFR 1.1336;

When SFR 1.1336 = 1 USD

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One SFR = 0.8822 { 1 / 1.1336 = 0.8821 }

To get one USD we have to pay SFR 0.8821

Step 2 ((to calculate rate for One USD in DM)

The rate for selling Dollars and buying Deutschmarks is DM 1.3750.

One USD = DM 1.3750

One USD = SFR 1.1336

Step 3

As such Quote SFR/DM will be as under:

DM 1.3750 = SFR 1.1336 (as both are equal to one USD)

One DM = SFR 1.1336 / DM 1.3750 = 0.8244

Or

SFR 1.1336 = DM 1.3750 (as both are equal to one USD)

One SFR = 1.3750 / 1.1336 = 1.2130

Thus the rate for Selling Swiss francs and Buying Deutschmarks is

1 SFR =DM 1.2130 or 1 DM = SFR 0.8244

06. From the following data calculate Rupee Franc Rate

Inter bank rate for USD to INR is $1=Rs.34.2400 – 34.2600 and

Inter bank for USD and French Franc is $1=French Franc 4.9660 - 4.9710.

Solution :

First, the customer buys US dollar from the market in India at $1 selling rate of
Rs.34.2600.

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The US dollar thus acquired is disposed off in the London market for French Franc
at the market buying rate $1=French franc 4.9660.

Rupee Franc rate is =

Rate at which Dollar was purchased by paying Rupees

= ---------------------------------------------------
Rate at which Dollar is sold to get French Franc

34.2600
One French Franc = ------------------- = 6.8989
4.9660

Rounded off to Rs. 6.8990

07. US dollar is quoted as under in the interbank market on 25th January as

under:

Spot USD 1 = Rs.48.4000/4200

Spot/February 2000/2100
Spot/March 3500/3600

From the above details calculate following Outright Rates (both buying and
selling)

Spot delivery
Forward delivery February
Forward delivery March

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Solution:

The market quotation for a currency consists of the spot rate and the forward
margin.

The outright forward rate has to be calculated by loading the forward margin into
the spot rate.

The following points should be noted in interpreting the above quotation.

A) The first statement is the spot rate for dollars. The quoting bank buying rate is
Rs.48.4000 and selling rate is Rs.48.4200.

B) The second and third statements are forward margins for forward delivery
during the months of February. Spot/March respectively.

Spot/February rate is valid for delivery end February.

Spot/March rate is valid for delivery end March.

C) The margin is expressed in points, i.e., 0.0001 of the currency. Therefore, the
forward margin for February is 20 paise and 21 paise.

D) The first rate in the spot quotation is for buying and second for selling the
foreign currency. Correspondingly, in the forward margin, the first rate relates to
buying and the second to selling. Taking Spot/February as an example, the margin
of 20 paise is for purchase and 21 paise is for sale of foreign currency.

E) Where the forward margin for a month is given in ascending order as in the
quotation above, it indicates that the forward currency is at premium. The outright
forward rates arrived at by adding the forward margin to the spot rates.

From the above, outright forward rates for dollar can be arrived at as under.

Buying Rates

February March
Spot rate 48.4000 48.4000

Add Premium 00.2000 00.3500

48.6000 48.7500

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 Selling Rates

February March

Spot rate 48.4200 48.4200

Add Premium 00.2100 00.3600
48.6300 48.7800

From the above we may conclude as under.

Buying Selling

Spot delivery USD 1 48.4000 48.4200

Forward delivery February 48.6000 48.6300
Forward delivery March 48.7500 48.7800

08. If the quotation for Pound Sterling in the Interbank Market is ……..

Spot GBR 1 = Rs. 73.4000/4300

Spot/May 3800/3600
Spot/June 5700/5400

From the above data, calculate following Outright Rates (both buying and selling)

Spot delivery
Forward delivery May
Forward delivery June

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Solution:

Since the forward margin is in descending order (3800/3600), forward sterling is at

discount.

The outright forward rates are calculated by deducting the related discount from
the spot rate.

Buying Rates

May June

Spot rate 73.4000 73.4000

Less discount 00.3800 00.5700

73.0200 72.8300

Selling Rates

May June

Spot rate 73.4300 73.4300

Less discount 00.3600 00.5400

73.0700 72.8900

From the above we may conclude as under.

Buying Selling

Spot GBR 1 73.4000 73.4300

Forward delivery May 73.0200 73.0700
Forward delivery June 72.8300 72.8900

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09. Spot rate $1=Deutschmark 1.5000

Interest for USD = 3.5%

Interest for DEM = 11.5%

Based on the above information Calculate the Forward Margin.

Solution:

The forward margin can be calculated for a specific period given the spot rate and
interest differential.

Interest rate differential = 8 % (US 3.5% and DEM 11.5%).

Let us also assume that the Number of days in a year to be 360 days and the
forward margin is for a period of 180 days or 6 months.

Forward period x Interest Differential x Spot rate

Forward Margin = -----------------------------------------------------
100 x No. of days in the year

180 x 8 x 1.5000 2160

= --------------------------- = --------- = 0.0600
100 x 360 36000

The Forward margin for 180 days = 0.0600.

10. A forward sale contract for French francs 2,50,000 for an import customer on
15th March for delivery on 15th April at Rs.7.0450.

The customer requests for cancellation of the contract on the due date.

The following information are available.

French francs were quoted in London foreign exchange market as under.

Spot USD 1 = FRF 6.0200/0300

1 month 305/325
2 months 710/760

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The U.S dollars were quoted in the local inter bank exchange market on the date
of cancellation is as follows.

Spot USD 1 = Rs. 42.2900/2975

Spot/May 3000/3100
Spot/June 6000/6100

Exchange margin required is 0.10%.

What will be the cancellation charges payable by the customer?

Solution:

The sale contract will be cancelled at the ready T.T buying rate.

Dollars/rupee market buying rate = Rs. 42.2900

Less exchange margin at 0.10% = Rs. 00.0423

------------
Rs.42.2477

Dollar/Franc markets spot selling rate = FRF 6.0300

TT buying rate for Franc (42.2477 / 6.0300) = Rs. 7.0062

Rounded off the applicable rate is Rs. 7.0050

Franc sold to customer at Rs. 7.0450

Now bought from him at Rs. 7.0050

Net amount payable by customer per franc Re 0.0400

For FRF 2,50,000 @ Rs 0.04 per FRF Rs 10,000 + Flat Service Charge Rs 100 – Total
Rs 10,100/- to be collected from the Customer on Cancellation of Forward
Contract.

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11. As a dealer in the “Dealing Room‘ sells through an exchange broker in the
local market USD 5, 00,000 delivery spot in cover of a telegraphic transfer from
abroad. Calculate the rupee amount receivable from this sale assuming that US
dollar / Rupees rates are quoted in the local market as under:

Spot USD 1 = Rs. 42.8000/8500

Brokerage 0.01%

Solution:

The bank sells at the market buying rate of Rs. 42.8000.

Rupee amount received on sale of USD 5,00,0000 at Rs. 42.8000 = Rs. 2,14,00,000

Brokerage payable at 0.01% - Rs. 2,140

Net amount receivable on the deal = Rs. 2,13,97,860

12. A customer sold French Francs 10,00,000 value spot to another customer at
Rs. 6.5200 and covered himself in London market on the same day when the
exchange rates were - Spot USD 1 = FRF 6.5880/5920

Local inter bank market rates for US dollars were - Spot USD 1 = Rs. 42.7…/8500

Calculate the cover rate and ascertain the profit or loss in the transaction. Ignore
brokerage on the inter bank transaction.

Solution:

The bank covers itself by buying Francs (or selling dollars) from the London
market at market buying rates for dollar.

The requisite dollar is acquired in the local inter bank market at the market selling
rate for dollar against rupee.

Dollar/Rupee selling rate = Rs. 42.8500

Dollar/Franc buying rate = FRF 6.5880

Franc/Rupee cross rate (42.8500 / 6.5880) = Rs. 6.5042

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 Franc is sold to customer at Rs. 6.5200

The sale is covered at Rs. 6.5042

Profit per Franc sold = Rs. 0.0158

Profit on FRF 10,00,000 at Re. 0.0158 per Franc = Rs. 15,800.

13. Mr Ram, a forex dealer had entered into a cross currency deal and had sold
USD 5,00,000 against Deutsche Marks at USD 1 = DEM 1.4400 for spot delivery.
However, later during the day, the market became volatile and Mr , in compliance
with his top management‘s guidelines had to square up the position by
purchasing USD 5, 00,000 against DEM at the on-going rate. Assuming the spot
rates are as under, what will be the gain or loss in the transaction? Ignore
brokerage.

USD 1 = INR 42.4300/4500

USD 1 = DEM 1.4440/4450

Solution:

To square its position the bank can purchase US dollars against marks at the
market selling rate of DEM 1.4450 per dollar.

DEM acquired on sale of USD 5,00,000 at DEM 1.4400 = DEM 7,20,000

DEM paid on purchase of USD 5,00,000 at DEM 1.4450 = DEM 7,22,500

Loss on combined deal in Marks = DEM 2,500

In terms of rupees the loss would be the rupee outlay required to acquire DEM
2,500 from the market. The bank sells USD and acquires DEM at the market USD
buying rate of DEM 1.440.

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It can acquire USD in the market at the market selling rate of Rs. 42.4500.

The Mark/Rupee cross rate is (42.4500 / 1.4440) Rs. 29.3975.

Loss on the transaction in rupees = Rs. 23.3975 x 2,500

= Rs. 73.494.

14. If US dollar is quoted at Rs. 42.4000 in Mumbai and New York Indian rupees
are quoted at Rs. 42.4800 per dollar. In such a case, is it advantageous for a bank
in Mumbai to buy US dollars locally and arrange to sell them at New York.
Assuming the operation to involve Rs. 10 lakhs, what is the gross profit made by
the bank ?

Solution

At Mumbai US dollars purchased for Rs. 10,00,000 at Rs. 42.4000 would be

(10,00,000 ÷ 42.4000) USD 23,584.90.

Amount in rupees realized on selling USD 23,584.90 at New York at Rs. 42.4800
would be Rs. 10,01,887.

Therefore, the gross profit made by the bank on the transaction is Rs, 1,887.

15. If the following rates are prevailing:

Mumbai on New York Rs. 42.4000

New York on London USD 1.5100
Mumbai on London Rs. 64.0600

Based on quotation for dollar in Mumbai and for sterling in New York, the sterling
rate in Mumbai should be Rs. 64,0250 while the prevailing rate is Rs.64.0600. The
bank can buy dollar locally and utilize it in New York to acquire sterling there. The
sterling thus purchased may be disposed of locally. Suppose the transaction in
undertaken for Rs. 10,00,000. Whether it gives profit or loss and to what extent ?

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Solution

Step 1 -

The bank buys dollars for Rs. 10,00,000 at Mumbai.

Amount realized in dollars is (10,00,000 ÷ 42.4000) USD 23,584.90.

Step 2

The bank sells USD 23,584.90 at New York and acquires pound sterling.

Amount realized in pound sterling at USD 1.5100 per pound is (23,584.90 ÷

1.5100) GBP 15,619.14.

Step 3

The bank sells GBP 15,619.14 at Bombay at Rs. 64.0600 and realizes Rs. 10,00,562.

Therefore, the gross profit on the combined transaction is Rs. 562.

Such an arbitrage operation which involves more than two currencies is known as
“compound” or “indirect” arbitrage.

16. Mumbai bank may quote the rate of dollar as USD 1 = 49.1625/1750. What
does this mean?

Solution

The Mumbai Bank maker is willing to buy foreign exchange US dollar at the rate
of 49.1625 rupees; and he is willing to sell at the rate of 49.1750 rupees per dollar.

In actual practice, while quoting, they will not give the whole number Rs.49 as
every operator will be knowing the ‘big number‘. Hence the quotation will be -
USD 1 = 1625/1750

From this, it is evident that the Mumbai Bank wants to make a profit of Rs.0.0125
(difference between 1750 and 1625) in the deal of buying and selling one dollar.

This is a direct quotation, and the bank will apply the rule “Buy Low; Sell High”.

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 05 Capital Structure and Cost of Capital

Capital Structure

The most crucial component of starting a business is capital. It acts as the

foundation of the company. Debt and Equity are the two primary types of capital
sources for a business. Capital structure is defined as the combination of equity
and debt that is put into use by a company in order to finance the overall
operations of the company and for its growth.

Capital structure refers to the combination of borrowed funds and owners’ fund
that a firm uses for financing its fund requirements. Herein, borrowed funds
comprise of loans, public deposits, debentures, etc. and owners’ fund comprise of
preference share capital, equity share capital, retained earning etc. Generally,
capital structure is simply referred as the combination of debt and equity that a
firm uses for financing its funds. It is calculated as the ratio of debt and equity or
the proportion of debt in the total capital used by the firm.

Algebraically,

Debt Debt
Capital Structure is ---------- or -------------
Equity Debt + Equity

The proportion of the debt and equity used by the firm affects its financial risk
and profitability. While on one hand, debt is a cheaper source of finance than
equity and lowers the overall cost of capital but on the other hand, higher use of
debt, increases the financial risk for the firm. Thus, the decision regarding the
capital structure should be taken with utmost care.

Capital structure is said to be optimal when the proportion of debt and equity
used is such that the earnings per share increases.

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Types of Capital Structure

The meaning of Capital structure can be described as the arrangement of capital

by using different sources of long term funds which consists of two broad types,
equity and debt. The different types of funds that are raised by a firm include
preference shares, equity shares, retained earnings, long-term loans etc. These
funds are raised for running the business.

Equity Capital

Equity capital is the money owned by the shareholders or owners. It consists of

two different types

a) Retained earnings: Retained earnings are part of the profit that has been kept
separately by the organisation and which will help in strengthening the business.

b) Contributed Capital: Contributed capital is the amount of money which the

company owners have invested at the time of opening the company or received
from shareholders as a price for ownership of the company.

Debt Capital

Debt capital is referred to as the borrowed money that is utilised in business.

There are different forms of debt capital.

Long Term Bonds: These types of bonds are considered the safest of the debts
as they have an extended repayment period, and only interest needs to be repaid
while the principal needs to be paid at maturity.

Short Term Commercial Paper: This is a type of short term debt instrument that
is used by companies to raise capital for a short period of time

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and equity
financing that helps in maximising the value of a company in the market while at
the same time minimises its cost of capital.

Capital structure varies across industries. For a company involved in mining or

petroleum and oil extraction, a high debt ratio is not suitable, but some industries
like insurance or banking have a high amount of debt as part of their capital
structure.

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Financial Leverage

Financial leverage is defined as the proportion of debt that is part of the total
capital of the firm. It is also known as capital gearing. A firm having a high level of
debt is called a highly levered firm while a firm having a lower ratio of debt is
known as a low levered firm.

Importance of Capital Structure

Capital structure is vital for a firm as it determines the overall stability of a firm.
Here are some of the other factors that highlight the importance of capital
structure.

A firm having a sound capital structure has a higher chance of increasing the
market price of the shares and securities that it possesses. It will lead to a higher
valuation in the market.

A good capital structure ensures that the available funds are used effectively. It
prevents over or under capitalisation.

It helps the company in increasing its profits in the form of higher returns to
stakeholders.

A proper capital structure helps in maximising shareholder’s capital while

minimising the overall cost of the capital.

A good capital structure provides firms with the flexibility of increasing or

decreasing the debt capital as per the situation.

Factors Determining Capital Structure

Following are the factors that play an important role in determining the capital
structure:

Costs of capital: It is the cost that is incurred in raising capital from different fund
sources. A firm or a business should generate sufficient revenue so that the cost
of capital can be met and growth can be financed.

Degree of Control: The equity shareholders have more rights in a company than
the preference shareholders or the debenture shareholders. The capital structure
of a firm will be determined by the type of shareholders and the limit of their
voting rights.

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Trading on Equity: For a firm which uses more equity as a source of finance to
borrow new funds to increase returns. Trading on equity is said to occur when the
rate of return on total capital is more than the rate of interest paid on debentures
or rate of interest on the new debt borrowed.

Government Policies: The capital structure is also impacted by the rules and
policies set by the government. Changes in monetary and fiscal policies result in
bringing about changes in capital structure decisions.

Costs of Capital
Cost of Capital is referred to as the required amount of return necessary to make
a capital budgeting project. It is used by the companies internally to determine if
the capital project is worth the resource expenditure done and by investors in
determining whether the project is worth the risk when compared to its return.

The cost of capital is determined from the weighted average cost of all the
sources of capital.

The cost of capital is a blended weighted average of the cost of equity and the
cost of debt that is expected by an organisation. An organisation utilises the cost
of capital to conclude whether a task or a project merits the expenditure on its
assets. Financial backers use it for a comparative reason.

Cost of equity is the profit required by the organisation to ensure that the
business ventures and investments that have been made meet the prerequisites
for capital returns. It resembles a trade framework between the organisation and
the market. The organisation makes up for its possession and ownership of
resources with its cost of equity.

Whenever the cost of equity is interconnected with the cost of debt and the
weighted average is taken, it is known as the cost of capital. Capital is
fundamentally a standard that concludes whether a venture or a project is worth
its assets or regardless of whether investment merits the risk of its profits and
returns.

Organisations set up funds in two ways; by gaining or acquiring debt or entirely

through equity. Hence, the cost of capital is likewise exclusively subject to the
financing technique.

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As a rule, organisations utilise a combination of the two methodologies, wherein
case the cost of capital is ascertained by their weighted average.

An organisation’s choices for project business ventures and investments should

create a return that surpasses the cost of capital, so financial backers return. The
cost of capital is assessed by the strategy called Weighted Average Cost of Capital
(WACC). This equation thinks about the weighted proportionality of the cost of
debt and the cost of equity.

The expense of capital is one of the most fundamental variables in the dynamic
decision-making course of business ventures and investments made in capital
undertakings. It is the norm underneath which the business venture or a project
should not be invested as the financial backer won’t get any advantages on the
off chance that the profits fall.

Cost of Equity:

The cost of equity is basically the rate of return an investor gets on an equity or
value investment that they have made. It is a worth or a value that basically
implies the sum one might acquire by putting or investing resources into one
more asset with equivalent risk. The number will convince a financial backer to put
resources or to invest into the organisation’s resources.

The cost of equity is a fundamental part of stock assessment. There are two
methods for evaluating the cost of equity; the dividend capitalisation method and
the asset pricing method. Be that as it may, the profit or the dividend strategy
must be applied assuming the organisation delivers profits or dividends. The
capital asset pricing technique is one where it contemplates the risk associated
with the investment existing in the market.

Cost of equity is fundamentally the engaging quality of the venture in which the
firm would need the financial backers to contribute. As an organisation, it is the
rate of return expected to convince a financial backer and an investor. It is the rate
of return expected by one to invest or to put resources into the assets of a firm or
organisation. Contingent upon how one ascertains it, the expense of equity relies
upon the profits paid by the organisation or the risk related to the market.

Cost of Equity and Cost of Capital

Cost of equity and Cost of Capital are two crucial terms in the finance world that
help get more information about the risks involved with potential investments.
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Companies arrange for finances in two ways; by acquiring debt or through equity.

Thus, the Cost of capital is also solely dependent on the financing method. In
most cases, companies use a mixture of the two approaches, in which case the
Cost of Capital is determined by their weighted average.

The Cost of capital tells you the amount required to raise new money.

The cost of equity tells the investors the number of returns they should expect,
considering the percentage of risk involved in the market.

The Cost of Capital is one of the most essential factors in the decision-making
process of investments made in capital projects. It is the standard below which the
project must not be invested in as the investor will not get any benefits if the
returns fall.

Cost of Equity is the returns needed by the company to make sure that the
investments that have been made meet the requirements for capital returns.

The Cost of Capital is a mixed weighted average of the Cost of debt and the Cost
of Equity expected by a company. A company uses the Cost of capital to decide
whether a project is worth the expenditure on its resources.

The Cost of equity is the rate of return a shareholder receives on an equity

investment they have made. It is a value that essentially means the amount one
may earn by investing in another asset with equal risk.

Cost of equity is basically the attractiveness of the project in which the firm would
want the investors to invest.

Main Differences between Cost of Equity and Cost of Capital

The main difference between the Cost of equity and the Cost of capital is that the
cost of equity is the value paid to the investors. In contrast, the Cost of Capital is
the expense of funds paid by the company like interests, financial fees, etc.

The Cost of capital plays a more critical role while making decisions about capital
projects than the Cost of equity. The Cost of Capital must always be less than the
number of returns calculated by the Cost of equity for investors to make an
investment. The Cost of equity is a component of the Cost of Capital.

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The Cost of equity does not consider debt, whereas the Cost of Capital takes debt
also into account.

Capital Cost and Cost of Capital

We tend to treat both Capital Cost and Cost of Capital as one and the same.
However, both are different from each other.

Capital costs are fixed, one-time expenses incurred on the purchase of land,
buildings, construction, and equipment used in the production of goods or in the
rendering of services. In other words, it is the total cost needed to bring a project
to a commercially operable status. Whether a particular cost is capital or not
depend on many factors such as accounting, tax laws, and materiality.

Cost of Capital is the rate of return the firm expects to earn from its investment in
order to increase the value of the firm in the market place. In other words, it is the
rate of return that the suppliers of capital require as compensation for their
contribution of capital.

Cost of capital represents the return a company needs to achieve in order to

justify the cost of a capital project, such as purchasing new equipment or
constructing a new building.

A company's investment decisions for new projects should always generate a

return that exceeds the firm's cost of the capital used to finance the project.
Otherwise, the project will not generate a return for investors.

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 06. Capital Investment Decisions/Term Loan

Investment decision refers to selecting and acquiring the long-term and short-
term assets in which funds will be invested by the business. Investment decision
refers to financial resource allocation. Investors opt for the most suitable assets or
investment opportunities based on risk profiles, investment objectives, and return
expectations.

Investment decision involves careful selection of assets in which funds are to be

invested. Decisions relating to investment in fixed assets are known as capital
budgeting decisions, whereas, those concerning investment in current assets are
called working capital decisions.

A business needs to invest funds for setting up a new business, for expansion and
modernisation. The investment decision is taken after scrutiny of available
alternatives in terms of costs involved and expected return.

These decisions are very crucial for any business. Earning capacity of the fixed
assets of a firm, profitability, and competitiveness, all are affected by the capital
budgeting decisions. Moreover, these decisions usually involve a huge amount of
investment and are irreversible.

a) Cash flow of the project: Capital budgeting considers factors associated with
nature of the industry, taxation, policy and regulatory structures, political and
social stability, etc., to make decisions related to expected-cash flows for huge
investments.

b) Returns from investment: The selection of projects requiring investments are

identified based on possible benefits or returns a business will obtain by
preparing appraisal reports. These reports determine the amount of investments
required and the availability of possible returns against the required amount.

c) Trade-off between profitability and liquidity: If a business should have

continuous liquidity or enough working capital for continuing operations that
generate sales and cater to current obligations. Lack of working capital for current
assets would make the business illiquid and lead to losses.

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Short term investment decisions are the decisions related with the bills
receivables, inventories, levels of cash and debtors etc. These decisions are also
known as working capital decisions.

The long term investment decision is also known as Capital Dudgeting decision

Importance of Capital Budgeting decisions.

i) Long Term Implications: Investment on capital assets (long term assets) yield
return in the future. Thereby, they affect the future prospects of a company. A
company’s long term growth prospects depend on the capital budgeting
decisions taken by it.

ii) Huge Amount of Funds: Investing in fixed capital involves a large amount of
funds. This makes the capital budgeting decisions all the more important as huge
amount of funds remain blocked for a longer period of time. These decisions once
made are difficult to change. Thus, capital budgeting decisions need to be taken
carefully after a detailed study of the total requirement of funds and the sources
from which they are to be raised.

iii) High Risk: Fixed assets involve huge amount of money and thereby, involve
huge risk as well. Such decisions are risky as they have an impact on the long term
existence of the company. For example, decision about the purchase of new
machinery involves a risk in terms of whether the return from the machinery
would be greater than the cost incurred on it.

iv) Irreversible Decisions: These decisions once made are irrevocable. Reversing
a capital budgeting decision involves huge cost. This is because once huge
investment is made on a project, withdrawing it would mean huge losses.

Firms have limited financial resources; therefore, the top-level management

undertakes capital budgeting and fund allocation into long-term assets. Managers
overseeing business operations opt for short-term investments to ensure liquidity
and working capital. Investment decisions are also influenced by the frequency of
returns, associated risks, maturity periods, tax benefits, volatility, and inflation
rates.

Also, individuals and corporate investors have to decide between various

options—assets, securities, bonds, debentures, gold, real estate, etc. For
businesses, investments could be in the form of new ventures, projects, mergers ,
or acquisitions as well.
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Investment decisions are further classified into short-term and long-term. For
example, the final decision may involve a Investments are primarily classified into
short-term and long-term. Further, they are categorized into a strategic
investment, capital expenditure, inventory, modernization, expansion,
replacement, or new venture investments.

The investment process involves the following steps: formulating investment

objectives, ascertaining the risk profile, allocating assets, and monitoring
performance.

Investment decisions are made to reap maximum returns by allocating the right
financial resource to the right opportunity. These decisions are taken considering
two important financial management parameters—risks and returns.

Investors and managers dedicate a lot of time to investment planning—these

decisions involve massive funds and can be irreversible—impact on the investors
and business is long-term.

Factors affecting Investment Decision

An investment is a planned decision, and some of the factors that are responsible
for these decisions are as follows:

Investment Objective: The purpose behind an investment determines the short-

term or long-term fund allocation. It is the starting point of the decision-making
process.

Return on Investment: Managers prioritize positive returns—they try to employ

limited funds in a profitable asset or security.

Return Frequency: The number of periodic returns an investment offer is crucial.

Financial management is based on financial needs; investors choose between
investments that yield monthly, quarterly, semi-annual, or annual returns.

Risk Involved: An investment may possess high, medium, or low risk, and the risk
appetite of every investor and company is different. Therefore, every investment
requires a risk analysis.

Maturity Period or Investment Tenure: Investments pay off when funds are
blocked for a certain period. Thus, investor decisions are influenced by the
maturity period and payback period.

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Tax Benefit: Tax liability associated with a particular asset or security is another
crucial deciding factor. Investors tend to avoid investment opportunities that are
taxed heavily.

Safety: An asset or security offered by a company that adheres to regulatory

frameworks and has a transparent financial disclosure is considered safe.
Government-backed assets are considered the most secure.

Volatility: Market fluctuations significantly affect investment returns and,

therefore, cannot be overlooked.

Liquidity: Investors are often worried about their emergency funds—the

provision to withdraw money before maturity. Hence, investors look at the degree
of liquidity offered by a particular asset or security; they specifically consider
withdrawal restrictions and penalties.

Inflation Rate: In financial management, investors look for investment

opportunities where returns surpass the nation’s inflation rate.

Types of investment decisions

Investment decisions are classified into:

1. Strategic investment

2. Capital expenditure

3. Inventory investment

4. Modernization investment

5. Replacement investment

6. Expansion investment

7. New venture investment

In organizations, investment decisions are crucial for growth and profitability—

impact cash flows—have a long-term impact as many of these decisions are
irreversible. Even with limited funds, individuals can obtain impressive returns if
the investment is well-planned.

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Term Loan
Term loan is a single transaction loan where the loan amount is disbursed either
in lumpsum or in stages and the same is repaid in instalments along with interest.
Unlike in an operative account, the facility of reinstating the limit to the extent of
repayment is not available. This is due to the fact that the loan is availed for a
specific purpose / project. Term loan is also defined as under :

Short Term Loans :

Term loans are loans which are repaid through regular prescribed payments or in
bullet form and maturity in excess of one year.

Medium Term Loans :

Loans repayable in periods of above one year upto 3 year

Long Term Loans :

Loans repayable in periods of above 3 years.

Term Loan is given both for industrial and non-industrial borrowers i.e., both for
activities involved in manufacture / processing / repairing and business / trading /
service activities etc.

Term loan is normally extended for acquisition of Land, Building and machinery.
Term loans are also granted for purchase of vehicles and along with working
capital finance as composite loans.

Concepts related to Term Loans

DSCR and DER – We have discussed these two in Chapter No 2 of Module C

of this Book.

Margin and Promoter’s Contribution

Bankers/Lenders insist on promoter’s contribution or Margin to ensure Borrower’s

stake in the business. Any Business owner or promoter should bring part of total
project cost which is called Promoter’s Contribution. Margin is part of Promoter’s
Contribution. In certain cases, both Promoter’s Contribution and Margin is one
and the same, but it is not so in all cases.

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Though, in certain cases both Margin and Promoter’s Contribution is one and the
same, they are different in many cases. Following examples are furnished to make
the concepts clear.

Example: When Applicant want to purchase a Car for Rs 10 lacs (inclusive of

Purchase Price, Registration Expenses and Cost of Insurance), we insist him to
bring 20% (i.e Rs 2 lacs) and we extend finance to the extent of Rs 8 lacs. In this
case, both promoter’s contribution and Margin are one and the same (20% or Rs
2lacs)

In case the Applicant approached for Loan to meet cost of construction of

residential building in the site purchased by him two months back for Rs 5 lacs.
Now he has approached for a loan of Rs 9 lacs to meet cost of construction and
to provide other amenities like electricity, which is estimated at Rs 12 lacs. In this
case, Total Project Cost is Rs 17 lacs (Cost of Site + Cost of Construction). Already
he has invested Rs 5 lacs (towards purchase of site from his own sources) and he
is ready to bear Rs 3 lacs ( difference between Cost of Construction and Amount
of the Loan sought). As such total amount brought by the Borrower is Rs 8 lacs.
This Rs 8 lacs is known as Promoter’s Contribution. Though he had already
invested his own funds of Rs 5 lacs towards purchase of site, we will not sanction
Rs 12 lacs to meet cost of construction. We stipulate minimum percentage of
estimated cost to be brought in by Applicant, which is known as Margin. In the
above case, Rs 3 lacs, which he is ready to bring-in from own sources to meet the
part of construction, is known as Margin.

Thus, Margin is different from the promoter's contribution. While the promoter's
contribution is calculated with reference to project as a whole, margin is in respect
of each asset acquired out of each loan.

Gestation Period :

In any manufacturing unit there will be a time lag between commencement of the
project and commercial production. This period is known as gestation period.
This period is very important in the point of view of bankers as during this period
there will be no generation of funds. A repayment holiday may have to be
permitted during this period. Longer the gestation period, higher will be the
burden of accrual of interest. The promoter's contribution / funds / margin
invested would also not earn any return during this period.

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With reference to the projected financial statements, whether the unit would be
able to bear the accumulation of commitments during the period should be
verified.

ii. In the case of units having a long gestation period, it should also be verified
that permit / licences issued for a specific period do not expire during or shortly
after the gestation period and there is sufficient time for utilizing them. Otherwise
the unit would be forced to utilize the licences even before the material /
machinery is actually required and we may have to finance against them which
would be an idle investment.

Eg : In cases involving import of machinery / raw materials, if the construction

period is say 8 months before which or within a short time after which the import
licence would be expiring, the unit would be forced to import them in advance
and keep the same idle.

Gestation Period is different from Repayment Holiday. Gestation period is

related to the period between commencement of the project and
commencement of commercial operations. Repayment holiday refers to
Term Loan Repayment.

Term Loans – Various Repayment Stages

The following are the stages, through which the loan accounts have to pass
depending upon the schedule selected at the time of opening.

Holiday / Moratorium Period - During this period neither instalment nor interest
is to be expected to be paid by the borrower (Holiday period for both principal
and interest – For example, Education Loan). However, during this period, interest
is calculated at monthly rests, compounded or simple as the case may be.

The total interest accrued during the entire holiday period will be charged to the
account only on completion of the holiday period by crediting to 'interest
accrued' and fresh schedule is drawn for the outstanding balance for the term of
the loan. This is called as 'Capitalization' of interest.

Interest Only Instalment (IOI) Period - This is holiday period for only principal
instalments. During this period, Interest debited on calendar/ anniversary date
becomes due and principal instalments are not expected (For example, Housing
Loan to customers).

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Interest Principal Instalment (IPI)– Principal in equal monthly instalments +
Interest as and when due) - During this period actual interest debited to the
account and fixed instalment amount will be payable by the borrower. For
example If a loan of Rs.1,00,000 has to be recovered within 10 months, then the
IPI will be Rs.10,000 + Actual Interest charged to the account for the month.

Equated Periodic Instalments (EPI/EMI) – During this period, equated

instalment will become due periodically (actual interest + principal recovery to
match the EMI amount. However, while appropriation, actual Interest charged to
the account for the month will be recovered, then any other dues and finally the
remaining amount will be appropriated towards principal.

Post Maturity Instalment Stage - If the loan is not cleared before the due date,
on maturity, the loan account slips in to PMI stage and the account will be
governed by the rates/rules defined under this stage for the given schedule.

Term Loans – Various Repayment Options

Different Repayment Options

Bullet - With bullet repayment type we receive the monthly interest payment and
on the maturity date, we receive the whole chunk of the principal back. .

Balloon - Here we lock away the investment for the fixed period of time. The
interest for the entire period will be paid out on the maturity date together with
the loan principle.

Step Up Repayment Facility (SURF) –The loan instalment is low in the initial
stages. As our income increases over the years, the loan instalment increases
accordingly.

Flexible Loan Instalments Plan (FLIP) - The loan instalment is higher in the
initial years and decreases subsequently in proportion to the income.

Tranche Based EMI - We can use this option when we purchase a property under
construction. We have the facility to repay the interest amount on the loan
amount drawn until the final disbursement. We can start paying our regular EMIs
after that.
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Accelerated Repayment Scheme - We get the flexibility to increase our EMIs
every year in proportion to the increase in our income. It enables us to repay our
loan faster.

Telescopic Repayment Option - We get the benefit of extended repayment

tenure up to 30 years.

Break Even Analysis

A break-even analysis is an economic tool that is used to determine the cost
structure of a company or the number of units that need to be sold to cover the
cost. Break-even is a circumstance where a company neither makes a profit nor
loss but recovers all the money spent.

The break-even analysis is used to examine the relation between the fixed cost,
variable cost, and revenue. Usually, an organisation with a low fixed cost will have
a low break-even point of sale.

Importance of Break-Even Analysis

Manages the size of units to be sold: With the help of break-even analysis, the
company or the owner comes to know how many units need to be sold to cover
the cost. The variable cost and the selling price of an individual product and the
total cost are required to evaluate the break-even analysis.

Budgeting and setting targets: Since the company or the owner knows at which
point a company can break-even, it is easy for them to fix a goal and set a budget
for the firm accordingly. This analysis can also be practised in establishing a
realistic target for a company.

Manage the margin of safety: In a financial breakdown, the sales of a company

tend to decrease. The break-even analysis helps the company to decide the least
number of sales required to make profits. With the margin of safety reports, the
management can execute a high business decision.

Monitors and controls cost: Companies’ profit margin can be affected by the
fixed and variable cost. Therefore, with break-even analysis, the management can
detect if any effects are changing the cost.

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Helps to design pricing strategy: The break-even point can be affected if there
is any change in the pricing of a product. For example, if the selling price is raised,
then the quantity of the product to be sold to break-even will be reduced.
Similarly, if the selling price is reduced, then a company needs to sell extra to
break-even.

Components of Break-Even Analysis

Fixed costs: These costs are also known as overhead costs. These costs
materialise once the financial activity of a business starts. The fixed prices include
taxes, salaries, rents, depreciation cost, labour cost, interests, energy cost, etc.

Variable costs: These costs fluctuate and will decrease or increase according to
the volume of the production. These costs include packaging cost, cost of raw
material, fuel, and other materials related to production.

Uses of Break-Even Analysis

New business: For a new venture, a break-even analysis is essential. It guides the
management with pricing strategy and is practical about the cost. This analysis
also gives an idea if the new business is productive.

Manufacture new products: If an existing company is going to launch a new

product, then they still have to focus on a break-even analysis before starting and
see if the product adds necessary expenditure to the company.

Change in business model: The break-even analysis works even if there is a

change in any business model like shifting from retail business to wholesale
business. This analysis will help the company to determine if the selling price of a
product needs to change.

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Company X sells a pen. The company first determined the fixed costs, which
include a lease, property tax, and salaries. They sum up to ₹1,00,000. The variable
cost linked with manufacturing one pen is ₹2 per unit. So, the pen is sold at a
premium price of ₹10.

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Therefore, to determine the break-even point of Company X, the premium pen
will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,oo,000/10

= 10,000

Therefore, given the variable costs, fixed costs, and selling price of the pen,
company X would need to sell 10,000 units of pens to break-even.

PERT and CPM

Project management can be defined as a structural way of planning, scheduling,

executing, monitoring and controlling various phases of a project. To achieve the
end goal of a project on time, PERT and CPM are two project management
techniques that every management should implement. These techniques help in
displaying the progress and series of actions and events of a project.

Meaning of PERT

Program (Project) Evaluation and Review Technique (PERT) is an activity to

understand the planning, arranging, scheduling, coordinating and governing of a
project. This program helps to understand the technique of a study taken to
complete a project, identify the least and minimum time taken to complete the
whole project. PERT was developed in the 1950s, with the aim of the cost and time
of a project.

Meaning of CPM

Critical Path Method or CPM is a well-known project modelling technique in

project management. It is a resource utilising algorithm that was developed in the
1950s by James Kelly and Morgan Walker.

CPM is mainly used in projects to determine critical as well as non-critical tasks

that will help in preventing conflicts and reduce bottlenecks.

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In essence, CPM is about choosing the path in a project that will help in
calculating the least amount of time that is required to complete a task with the
least amount of wastage.

The Critical Path Method or CPM has been used in many industries starting from
defence, construction, software, aerospace, etc.

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 07 Equipment Leasing/Lease Financing

Leasing is the process by which a firm can obtain the use of certain fixed assets
for which it must make a series of contractual, periodic, tax-deductible payments.

A lease is a contract that enables a lessee to secure the use of the tangible
property for a specified period by making payments to the owner.

Equipment leasing is a type of financing in which you rent equipment rather than
purchase it outright. You can lease expensive equipment for your business, such
as machinery, vehicles or computers. The equipment is leased for a specific
period; once the contract is up, you may return the equipment, renew the lease or
buy it.

Equipment leasing is different from equipment financing – taking out a business

loan to purchase the equipment and paying it off over a fixed term with the
equipment as collateral. In that case, you own the equipment once you pay off the
loan.

With an equipment lease, the equipment isn’t yours to keep once the leasing term
is over. As with a business loan, you pay interest and fees when leasing equipment
and they’re usually added into the monthly payment. There may be extra fees for
insurance, maintenance and repairs.

Equipment leasing can be much more expensive in the long term than purchasing
equipment outright, but for cash-strapped small business owners, it’s a means to
access necessary equipment quickly.

Hire Purchasing

Hire Purchasing is an agreement, in which the hire vendor transfers an asset to the
hire purchaser, for consideration. The consideration is in the form of Hire Purchase
Price (HPP) which includes cash down payment and instalments. The hire purchase
price is normally higher than the cash price of the article because interest charges
are included in that price. The instalment paid by the hirer at periodical intervals
up to a specified period.

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Under Hire Purchase transaction only the possession of the assets is transferred to
the hirer. However, there is a condition of the transfer of ownership, i.e., hire-
purchaser ought to pay all the instalments due on the asset transferred. By virtue
of this, if the hire purchaser is unable to pay the outstanding instalments, then the
hire vendor can repossess the asset without paying any compensation to the hirer.

Difference Between Hire Purchasing and Leasing

Both Hire-Purchase and Lease are the commercial arrangement, but they are not
one and the same.

Hire Purchasing is a business deal in which the purchaser of the asset, pays a small
amount at the beginning and the rest of the price in instalments. On the contrary,
Leasing is an agreement between two parties in which the lessor purchases the
asset and permits the lessee, use the asset for the payment of monthly rentals.

Advantages of Lease Financing

The advantages from the viewpoint of the lessee

Saving of Capital: Leasing covers the full cost of the equipment used in the
business by providing 100% finance. The lessee is not to provide or pay any
margin money as there is no down payment. In this way, the saving in capital or
financial resources can be used for other productive purposes, e.g., the purchase
of inventories.

Flexibility and Convenience: The lease agreement can be tailor-made in respect

of lease period and lease rentals according to the convenience and requirements
of all lessees.

Planning Cash Flows: Leasing enables the lessee to plan its cash flows properly.
The rentals can be paid out of the cash coming into the business from the use of
the same assets.

Improvement in Liquidity: Leasing enables the lessee to improve its liquidity

position by adopting the sale and leaseback technique.

Shifting of Risk of Obsolescence: The lessee can shift the risk upon the lessor by
acquiring the use of assets rather than buying the asset.

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Maintenance And Specialized Services: In the case of a special kind of lease
arrangement, the lessee can avail specialized services of the lessor for
maintenance of asset leased. Although lesser charges higher rentals for providing
such services, leases see overall administrative and service costs are reduced
because of specialized services of the lessor.

Off-the-Balance-Sheet-Financing: Leasing provides “off-balance-sheet”

financing for the lessee in that the lease is recorded neither as an asset nor as a
liability.

The advantages from the viewpoint of the lessor

There are several extolled advantages of acquiring capital assets on lease:

Higher profits: The Lessor can get higher profits by leasing the asset.

Tax Benefits: The Lessor being the owner of an asset, can claim various tax
benefits such as depreciation.

Quick Returns: By leasing the asset, the lessor can get quick returns than
investing in other projects of the long gestation period.

Disadvantages of Lease Financing

The disadvantages from the viewpoint lessee

Higher Cost: The lease rental includes a margin for the lessor as also the cost of
risk of obsolescence; it is, thus, regarded as a form of financing at a higher cost.

Risk: Risk of being deprived of the use of assets in case the leasing company
winds up.

No Alteration in Asset: Lessee cannot make changes in assets as per his

requirement.

Penalties on Termination of Lease: The lessee has to pay penalties in case he

has to terminate the lease before the expiry lease period.

The disadvantages from the viewpoint of lessor

High Risk of Obsolescence: The Lessor has to bear the risk of obsolescence as
there are rapid technological changes.

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Price Level Changes: In the case of inflation, the prices of an asset rise, but the
lease rentals remain fixed.

Long term Investment: Leasing requires the long term investment in the
purchase of an asset and takes a long time to cover the cost of that asset

Types of the Lease

Leasing takes different types, which are given below;

Based on Nature.

Operating lease.

Financial lease.

Based on the Method of Lease.

Direct lease.

Sale & Leaseback.

Leverage lease.

Operating Lease: An operating lease is a cancellable contractual agreement

whereby the lessee agrees to make periodic payments to the lessor to obtain an
asset set’s services. An operating lease is short term lease used to finance assets &
is not fully amortized over the life of the asset. It is also known as Service Lease.

Financial Lease: A financial (or capital) lease is a longer-term lease than an

operating lease that is non-cancellable and obligates the lessee to make
payments for the use of an asset over a predetermined .period of time. In a
financial lease, the lessor transfer to the lessee substantially all the risks and
rewards identical to the ownerships of the asset whether or not the title is
eventually transferred.

Direct Lease: Under direct leasing, a firm acquires the right to use an asset from
the manufacture directly. The ownership of the asset leased out remains with the
manufacture itself.

Sale & Leaseback: Under the sale & leaseback arrangement, the firm sells an
asset that it owns and then leases to the same asset back from the buyer. This
way, the lessee gets the assets for use, and at the same time, it gets cash.

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Leveraged Lease: Leveraged lease is the same as the direct lease, except that a
third party, the lender, is involved in addition to the lessee & lessor. The lender
partly finances the purchase of the asset to be leased; the lessor turns to be a
borrower.

Lease Financing
Lease financing is a contractual agreement between the owner of the asset who
grants the other party the right to use the asset in return for a periodic payment
and the other party who is the user of such assets.

The owner of the party is known as Lessor and the user of the asset under such
agreement is known as lessee and the rental paid is known as lease rental.

Merits of Lease financing

Cheap source - It enables the lessee to acquire the asset with a lower investment
only.

No dilution of ownership - It provides the finance without diluting the

ownership or control of the business.

Easy replacement of asset - The risk of obsolescence is borne by the lesser. This
allows greater flexibility and cheap financing to the lessee to replace the asset.

Tax benefits - Lease rentals paid by the lessee are deductible for computing tax
liabilities. It further reduces the cost of taking asset on lease.

Limitations of lease financing

Contractual constraints - A lease agreement may restrict the lessee to make any
alteration or modification in the asset.

Renewal of lease agreement - The normal business operations and growth of

the business is badly affected in case the lease is not renewed.

No capital gains - The lessee never becomes the owner of the asset in spite of
paying heavy lease rentals. It deprives him of the residual value of the asset.

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Financial Lease versus Capital Lease

Financial Lease

A financial lease is a monetary loan utilized by a corporation to purchase

equipment for its business. These full-pay out loans are non-negotiable once
enacted, and the lessee, not the lending institution, is responsible for the
maintenance of purchased equipment, as well as all relevant taxes and insurance
necessary for its use. In financial leases, banks merely finance equipment for
business while lessees are responsible for its upkeep.

Capital Lease

Any property purchased through a capital loan must be recorded as a taxable

asset on the lessee's financial records.

Financial leases are non-negotiable once entered into, whereas capital leases
offer lessees more flexibility.

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 08 Working Capital Management
As a Banker we may be interested in “Management of Working Capital
Credit Limits”. However, in this chapter we confine our discussion only to
Working Capital Management. As such we will not discuss various methods
of working capital assessment etc.

Working capital management is a business strategy designed to ensure that a

company operates efficiently by monitoring and using its current assets and
liabilities to their most effective use.

The efficiency of working capital management can be quantified using ratio

analysis.

Working capital management requires monitoring a company's assets and

liabilities to maintain sufficient cash flow to meet its short-term operating costs
and short-term debt obligations.

Managing working capital primarily revolves around managing accounts

receivable, accounts payable, inventory, and cash.

Working capital management involves tracking various ratios, including the

working capital ratio, the collection ratio, and the inventory ratio.

Working capital management can improve a company's cash flow management

and earnings quality by using its resources efficiently.

Working capital management strategies may not materialize due to market

fluctuations or may sacrifice long-term successes for short-term benefits.

The primary purpose of working capital management is to enable the company to

maintain sufficient cash flow to meet its short-term operating costs and short-
term debt obligations. A company's working capital is made up of its current
assets minus its current liabilities.

Current assets include anything that can be easily converted into cash within 12
months. These are the company's highly liquid assets. Some current assets include
cash, accounts receivable, inventory, and short-term investments. Current
liabilities are any obligations due within the following 12 months. These include
accruals for operating expenses and current portions of long-term debt payments.

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Working capital management monitors cash flow, current assets, and current
liabilities using ratio analysis, such as working capital ratio, collection ratio, and
inventory turnover ratio.

Components of Working Capital Management

Certain balance sheet accounts are more important when considering working
capital management. Though working capital often entails comparing all current
assets to current liabilities, there are a few accounts more critical to track.

Cash

The core of working capital management is tracking cash and cash needs. This
involves managing the company's cash flow by forecasting needs, monitoring
cash balances, and optimizing cash inflows and outflows to ensure that the
company has enough cash to meet its obligations. Because cash is always
considered a current asset, all accounts should be considered. However,
companies should be mindful of restricted or time-bound deposits.

Receivables

To manage capital, companies must be mindful of their receives. This is especially

important in the short-term as they wait for credit sales to be completed. This
involves managing the company's credit policies, monitoring customer payments,
and improving collection practices. At the end of the day, having completed a sale
does not matter if the company is unable to collect payment on the sale.

Payables

Payables in one aspect of working capital management that companies can take
advantage of that they often have greater control over. While other aspects of
working capital management may be out of the company's hands (i.e. selling
goods or collecting receivables), companies often have a say in how they pay
suppliers, what the credit terms are, and when cash outlays are made.

Inventory

Companies primary consider inventory during working capital management as it

may be most risky aspect of managing capital. When inventory is sold, a company
must go to the market and rely on consumer preferences to convert inventory to
cash.

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If this cannot be completed in a timely manner, the company may be forced to
have short-term resource stuck in an illiquid position. Alternatively, the company
may be able to quickly sell the inventory but only with a steep price discount.

Types of Working Capital

In its simplest form, working capital is just the difference between current assets
and current liabilities. However, there are many different types of working capital
that each may be important to a company to best understand its short-term
needs.

Permanent Working Capital: Permanent working capital is the amount of

resources the company will always need to operate its business without
interruption. This is the minimum amount of short-term resources vital to
operations.

Regular Working Capital: Regular working capital is a component of permanent

working capital. It is the part of the permanent working capital that is actually
required for day-to-day operations and makes up the "most important" part of
permanent working capital.

Reserve Working Capital: Reserve working capital is the other component of

permanent working capital. Companies may require an additional amount of
working capital on hand for emergencies, seasonality, or unpredictable events.

Fluctuating Working Capital: Companies may be interested in only knowing

what their variable working capital is. For example, companies may opt into
paying for inventory as it is a variable cost. However, the company may have a
monthly liability relating to insurance it does not have the option to decline.
Fluctuating working capital only considers the variable liabilities the company has
complete control over.

Gross Working Capital: Gross working capital is simply the total amount of
current assets of a business before considering any short-term liabilities.

Net Working Capital: Net working capital is the difference between current
assets and current liabilities.

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Working Capital Gap is the difference between total current assets and total
current liabilities other than bank. It can also be defined as Long term sources less
long term uses. Working capital gap= Current assets – current liabilities (other
than bank borrowings).

Working capital management can improve a company's cash flow management

and earnings quality through the efficient use of its resources. Management of
working capital includes inventory management as well as management of
accounts receivable and accounts payable.

Working capital management also involves the timing of accounts payable (i.e.,
paying suppliers). A company can conserve cash by choosing to stretch the
payment of suppliers and to make the most of available credit or may spend cash
by purchasing using cash—these choices also affect working capital management.

The objectives of working capital management, in addition to ensuring that the

company has enough cash to cover its expenses and debt, are minimizing the cost
of money spent on working capital, and maximizing the return on asset
investments.

Working Capital Management Ratios

Three ratios that are important in working capital management are the working
capital ratio (or current ratio), the collection ratio, and the inventory turnover ratio.

Current Ratio (Working Capital Ratio)

The working capital ratio or current ratio is calculated by dividing current assets
by current liabilities. The current ratio is a key indicator of a company's financial
health as it demonstrates its ability to meet its short-term financial obligations. A
working capital ratio below 1.0 often means a company may have trouble meeting
its short-term obligations. That is because the company has more short-term debt
than short-term assets. In order to pay all of its bill as they come due, the
company may need to sell long-term assets or secure external financing, Working
capital ratios of 1.2 to 2.0 are considered desirable as this means the company has
more current assets compared to current liabilities. However, a ratio higher than
2.0 may suggest that the company is not effectively using its assets to increase
revenues. For example, a high ratio may indicate that the company has too much
cash on hand and could be more efficiently utilizing that capital to invest in
growth opportunities.

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Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO), is a measure of
how efficiently a company manages its accounts receivable. The collection ratio is
calculated by multiplying the number of days in the period by the average
amount of outstanding accounts receivable. Then, this product is divided by the
total amount of net credit sales during the accounting period. To find the average
amount of average receivables, companies most often simply take the average
between the beginning and ending balances.

The collection ratio calculation provides the average number of days it takes a
company to receive payment after a sales transaction on credit. Note that the
days sales outstanding ratio does not consider cash sales. If a company's billing
department is effective at collecting accounts receivable, the company will have
quicker access to cash which is can deploy for growth. Meanwhile, if the company
has a long outstanding period, this effectively means the company is awarding
creditors with interest-free, short-term loans.

Inventory Turnover Ratio

Another important metric of working capital management is the inventory

turnover ratio. To operate with maximum efficiency, a company must keep
sufficient inventory on hand to meet customers' needs. However, the company
also needs to strive to minimize costs and risk while avoiding unnecessary
inventory stockpiles.

The inventory turnover ratio is calculated as cost of goods sold divided by the
average balance in inventory. Again, the average balance in inventory is usually
determined by taking the average of the starting and ending balances.

The ratio reveals how rapidly a company's inventory is being used in sales and
replaced. A relatively low ratio compared to industry peers indicates a risk that
inventory levels are excessively high, meaning a company may want to consider
slowing production to ease the cost of insurance, storage, security, or theft.
Alternatively, a relatively high ratio may indicate inadequate inventory levels and
risk to customer satisfaction.

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Working Capital Cycle

In addition to the ratios discussed above, companies may rely on the working
capital cycle when managing working capital.

Working capital management helps maintain the smooth operation of the net
operating cycle, also known as the cash conversion cycle (CCC) - the minimum
amount of time required to convert net current assets and liabilities into cash.

The working capital cycle is a measure of the time it takes for a company to
convert its current assets into cash.

The working capital cycle represents the period measured in days from the time
when the company pays for raw materials or inventory to the time when it
receives payment for the products or services it sells. During this period, the
company's resources may be tied up in obligations or pending liquidation to cash.

Working Capital Cycle in Days = Inventory Cycle + Receivable Cycle -

Payable Cycle

Inventory Cycle

The inventory cycle represents the time it takes for a company to acquire raw
materials or inventory, convert them into finished goods, and store them until
they are sold. During this stage, the company's cash is tied up in inventory.
Though it starts the cycle with cash on hand, the company agrees to part ways
with working capital with the expectation that it will receive more working capital
in the future by selling the product at a profit.

Accounts Receivable Cycle

The accounts receivable cycle represents the time it takes for a company to collect
payment from its customers after it has sold goods or services. During this stage,
the company's cash is tied up in accounts receivable. Though the company was
able to part ways with its inventory, it's working capital is now tied up in accounts
receivable and still does not give the company access to capital until these credit
sales are received.

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Accounts Payable Cycle

The accounts payable cycle represents the time it takes for a company to pay its
suppliers for goods or services received. During this stage, the company's cash is
tied up in accounts payable. On the positive side, this represents a short-term
loan from a supplier meaning the company is able to hold onto cash even though
they have received a good. On the negative side, this creates a liability that needs
to be managed.

Limitations of Working Capital Management

With strong working capital management, a company should be able to ensure it

has enough capital on hands to operate and grow. However, there are downsides
to the approach. Working capital management only focuses on short-term assets
and liabilities. It does not address the long-term financial health of the company
and may sacrifice the best long-term solution in favour for short-term benefits.

Even with the best practices in place, working capital management cannot
guarantee success. The future is uncertain, and it's challenging to predict how
market conditions will affect a company's working capital. Whether its changes in
macroeconomic conditions, customer behaviour, and supply chain disruptions, a
company's forecast of working capital may simply not materialize as they
expected.

Last, while effective working capital management can help a company avoid
financial difficulties, it may not necessarily lead to increased profitability. Working
capital management does not inherently increase profitability, make products
more desirable, or increase a company's market position. Companies still need to
focus on sales growth, cost control, and other measures to improve their bottom
line. As that bottom line improves, working capital management can simply
enhance the company's position.

Working capital management is at the core of operating a business. Without

sufficient capital on hand, a company is unable to pay its bill, process payroll, or
invest in growth. Companies can better understanding their working capital
structure by analyzing liquidity ratios and ensuring its short-term cash needs are
always met.

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 09 Derivatives
The term derivative refers to a type of financial contract whose value is dependent
on an underlying asset, group of assets, or benchmark. A derivative is set between
two or more parties that can trade on an exchange or over-the-counter (OTC).

These contracts can be used to trade any number of assets and carry their own
risks.

Prices for derivatives derive from fluctuations in the underlying asset.

These financial securities are commonly used to access certain markets and may
be traded to hedge against risk.

Derivatives can be used to either mitigate risk (hedging) or assume risk with the
expectation of commensurate reward (speculation).

Derivatives can move risk (and the accompanying rewards) from the risk-averse to
the risk seekers.

Derivates mean financial contracts that earn their value from a group of assets or
underlying assets are called derivatives. Depending on the market conditions, the
value of derivatives keeps on changing.

The primary principle of entering into derivative contracts is to earn a large

amount of profits by contemplating the underlying asset's value in the future.

Imagine you've invested in an equity share and the market price of that equity
share fluctuates up and down continuously. If the market falls, you may suffer a
loss due to a stock value downfall.

In this type of situation, you may enter into a derivative contract, either make to
profit by placing an exact bet, or simply take a rest from yourself from the losses
that occurred in the stock market where the stock is being traded.

There are four different types of derivatives that can easily be traded in the Indian
Stock Market.

Each derivative is different from the other and consist of varying contract
conditions, risk factor and more.

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The four different types of derivatives are as follows:

Forward Contracts

Future Contracts

Options Contracts

Swap Contracts

Forward Contracts

Forward contracts mean two parties come together and enter into an agreement
to buy and sell an underlying asset set at a fixed date and agreed on a price in the
future.

In simpler words, it is an agreement formed between both parties to sell their

asset on an agreed future date.

The forward contracts are customized and have a high tendency of counterparty
risk. Since it is a customized contract, the size of the agreement entirely depends
on the term of the contract.

Forward contracts do not require any collateral as they are self-regulated. The
settlement of the forward contract gets done on the maturity date, and hence
they are reserved by the expiry period.

Suppose you need to buy some gold ornaments from a local jewellery
manufacturer Gold Inc. Further, assume you need these gold ornaments some 3
months later in the month of August, 2023. You agree to buy the gold ornaments
at INR 32000 per 10 gram on 15 April, 2023. The current price, however, is INR
31800 per gram. This will be the forward rate or the delivery price four months
from now on the delivery date from the Gold Inc. This illustrates a forward
contract. Please note that during the agreement there is no money transaction
between you and Gold Inc. Thus during the time of the creation of the forward
contract no monetary transaction takes place. The profit or loss to the Gold Inc.
depends rather, on the spot price on the delivery date. Now assume that the spot
price on delivery day becomes INR 32100 per 10 gram. In this situation, Gold Inc
will lose INR 100 per 10 gram and you will benefit the same on your forward
contract. Thus, the difference between the spot and forward prices on the delivery
day is the profit/loss to the buyer/seller.

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Future Contracts

Future contracts are similar to forward contracts. Future contracts mean an

agreement made by the two parties to buy or sell an underlying instrument at a
fixed price on a future date.

Future contracts do not allow the buyer and seller to meet and enter into an
agreement. In fact, the deal gets fixed through exchange mode.

In futures contracts, the counterparty risk is low because it is a standardized

contract. In addition, the clearinghouse plays the role of a counterparty to the
parties of the contract, which reduces the credit risk in the future.

The size of future contracts is fixed, and it is regulated by the stock exchange just
because it is known as a standardized contract.

Since these contracts are standard, the futures contracts listed on the stock
exchange cannot be changed or modified in any possible way.

In simpler words, future contracts have pre-decided size, pre-decided expiry

period, pre-decided size. In futures contracts, an initial margin is required because
settlement and collateral are done daily.

Suppose you plan to travel to Dubai after 3 months. The flight cost today is Rs
35,000. Now we all know that booking in advance is always better. So, you book a
ticket today with Emirates to fly for Dubai after 3 months. This transaction
between you and the airlines is like a futures contract.

Futures is a standardised agreement to buy or sell the underlying asset at a pre-

determined price on a specific date. The underlying asset can be a stock, currency,
commodities or an index.

In the above example: You have already decided that you will pay Rs 35,000 for a
Dubai ticket. This is your pre-determined price. Even if the airfare increases after 3
months to say Rs 40,000 you will still pay only Rs 35,000. Similarly, even your date
of travel is already decided in advance. This is your specific date. Both you and the
airlines are bound by an agreement. You have to pay them Rs 35,000 and they
have to reserve a seat for you on a specific date.

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So, every futures contract has the following:

A pre-determined price

A pre-determined date

2 parties – the buyer and the seller.

An important point to note here is that both the buyer and the seller will have
different views on the underlying asset. In the above example, you expect the
ticket prices to rise, hence you bought the tickets in advance. While the airline
expects the ticket prices to fall hence they sold the ticket in advance to reduce
their loss.

Let us now use this example to understand what are futures in the stock markets.

Suppose you expect the stock prices of Reliance Industries to increase in the
coming months. And you want to make money from this opportunity. You have
two options –

Buy shares of Reliance Industries from the spot market.

Buy futures or options with Reliance Industries as the underlying.

Let’s explore the first option. Suppose the market price of one share of Reliance
Industries is Rs 2,000. You want to buy 100 shares. The cost of 100 shares will be
Rs 2 Lakhs!

But you only have Rs 1 Lakh. So, you end up buying 50 shares. As expected, the
price of Reliance Industries rises to Rs 2,500 after 3 weeks. You sell your 50 shares
and book a profit of Rs 25,000. You made 25% returns in just 3 weeks! You are on
top of the world! But could you have made more profit?

The answer is Yes. You could have made much higher profits if you had explored
option two – Investing in Reliance Futures. Let us see how scenario two would
play out.

You have Rs 1 lakh for investment. Let’s assume that one Reliance futures contract
is available at Rs 2,186. One Reliance futures contract contains 250 shares. So, the
total value of the contract is Rs 5,46,500. The good news is that you do not have
to pay the entire Rs 5,46,500 to buy a Reliance futures contract. You simply need
to pay an initial margin. We will learn more about this later.

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For now, assume that the initial margin required to carry one Reliance futures
contract is Rs 64,700. You can calculate margin requirements here.

So, you buy one Reliance futures contract for Rs 64,700. As expected, the share
price of Reliance Industries rises from Rs 2,000 to Rs 2,500 in the spot market.
Remember I told you that if the price of underlying asset increases, even the price
of the derivative will increase.

So, the price of your futures contract increases from Rs 2,186 to Rs 2,558 after 3
weeks. Now you decide to sell your contract before expiry. Your buying price is Rs
2,186 and your selling price is Rs 2,558. So, you made Rs 372 per share. Since, one
lot of Reliance Industries contains 250 shares, your total profit is Rs 93,000!

This is a gain of 144% in less than 1 month!

Now you do not have to be a financial genius to know that 144% gain is better
than 25% gain! So, here’s what you got by trading Reliance futures instead of
buying from the spot market:

Superior returns – 144% vs 25%

Access to better volumes – In the spot market you could buy only 50 shares. But
in the futures contract, you bought 250 shares!

Lower Capital – In spot market you invested Rs 1 Lakh, whereas in the futures
market you invested only Rs 64,700.

Basics of Futures Contract in India

1. Lot Size: Lot size is similar to buying milk from the market. There are standard
lots. You can buy milk in 250 ml, 500 ml and 1 litre quantities. You cannot ask the
shop keeper to give you half a glass of milk! Similarly, futures contracts also have
lot sizes.

For example:

The lot size of Reliance Industries futures is 250 shares.

The lot size of State Bank of India is 3000 shares.

The lot size of Nifty Futures is 50 shares.

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2. Futures Price: This is your buying price per share. The price of a futures
contract tracks the price of the underlying asset (in our case stocks) and is
generally higher. For example:

The price of 1 futures contract of Reliance Industries is Rs 2,186

The price of 1 futures contract of State Bank of India is Rs 386.75

3. Contract Value: Contract value is the actual value of your position. It is

calculated by multiplying the lot size by the price of the futures contract.

The contract size of 1 Reliance Futures contract is Rs 5,46,500 (Rs 2,186*250)

The contract size of 1 State Bank of India futures contract is Rs 11,60,250 (Rs
386.75*3,000)

4. Expiry Date: Every futures contract comes with a fixed expiry date. All futures
contracts expire on the last Thursday of the month. In case the last Thursday is a
holiday, the contract will expire on Wednesday.

At any given point of time, there are 3 futures contracts available for trading. In
the below snapshot –

Futures contract expiring on 25th March 2021 – Current Month

Futures contract expiring on 29th April 2021 – Next Month

Futures contract expiring on 27th May 2021 – Far Month

5. Underlying Price: This is the price of the underlying asset. In case of Reliance
futures, the underlying asset is the share price of Reliance in the cash market. The
futures prices will ideally move in the same direction as the underlying prices.

6. Buyer of a futures contract: The person who buys the futures contract is
known as the buyer of the futures contract. Buyers have a bullish view on the
stock. This means that the buyer expects the price to increase in the future. Hence,
he is buying it at a lower price today itself. When you buy a futures contract, you
are said to be long on a stock.

7. Seller of a futures contract: The person who sells the futures contract is
known as the seller of a futures contract. He has a bearish view on the stock. His
aim is to lock-in the sell price today itself so that a fall in the future will not cause
him a loss. When you sell a futures contract, you are said to be short on a stock.

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8. Settlement of a futures contract: Majority of futures contracts in India are
cash settled before expiry. What does this mean? All futures contracts come with
an expiry date. So, you have to settle them. This means that if you bought a
futures contract, you will have to sell it before or on expiry. Similarly, if you sold a
futures contract, you will have to buy it back on expiry.

Prior to October 2019, futures in India were cash-settled. But since then, if you do
not settle your position before expiry, then you will have to settle your transaction
physically. But what does physical and cash settlement mean in futures? Let’s
understand how a future contract works with this example.

Workings of a Futures Contract

Suppose you buy one lot of Reliance futures expiring on 25th March 2023. Your
cost price is Rs 2,186 per lot. Your contract value is Rs 5,46,500. You are the buyer
so you expect the share price of Reliance Industries to increase. Since you are the
buyer, there definitely must be a seller who sold you the futures contract.

So, the seller’s position will be also be worth Rs 5,46,500. You have till 25th March
2023 to square-off (close) your position. On 20th March 2023, the value of your
Reliance futures contract increases from Rs 2,186 to Rs 2,500.

So, you have made a profit of Rs 93,000. Your profit is the seller’s loss. So, the
seller makes a loss of Rs 93,000. This is why futures are known to be a zero-sum
game.

By selling your futures contract, you have squared-off or closed your buy position.
The exchange will debit the sellers trading account by Rs 93,000 and credit your
trading account with Rs 93,000. This is known as cash-settlement. Here only the
difference amount is credited or debited to buyers and sellers trading account.
But cash settlements can be done only if you square-off your positions before
expiry.

Let us assume that did not sell your futures contract till 25th March 2023. In that
case, you will actually have to take delivery of 250 shares and the seller will have
to make delivery of the 250 shares. This is known as physical settlement. This
happens only if you do not square off your position before expiry.

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9. Open Interest: Open interest or OI, shows the number of open contracts or
position on a given date. A high open interest shows high liquidity.

Open Interest increases when new contracts are added

Open Interest decreases when contracts are settled / squared-off.

A very high Open Interest may indicate an over-leveraged market.

10. Change in Open Interest: This shows the daily change that has taken place in
the futures contract. A positive change in OI along with increase in price shows
that more contracts have been added and that people are going long (buying) on
the futures contract.

Options Contracts

It is a derivative contract that gives the owner the right to buy or sell securities at
an agreed-upon price within a certain period. Although there are many types of
options in the stock market, there are broadly two types of options namely, Call
and Put.

Call Option

A call option contract, in simple terms, is a “right to buy”. It gives the owner of this
contract the right to buy a stock at an agreed-upon price, also known as the strike
price, at any time before or on the expiration date. This Options type is bought
when the investor expects the market price of the stock to rise in the future (i.e. a
bullish market). When the market price goes up, the contract-holder can exercise
their option and buy the stock at the strike price, which is below the market price
at the time, thereby making a profit.

Example of Call option: Stocks of Company X are trading at ₹500. You buy a call
contract at a strike price of ₹500 for a premium of ₹10. The trading price of
Company X’s stocks starts rising and has reached ₹550. You can exercise your
right to buy at the strike price, i.e. ₹500 and sell it at the market price i.e. ₹550.
Thus, you have made ₹40 as profit (₹50 - ₹10 paid as premium).

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Put Option

Conversely, a Put option gives the owner a “right to sell”. A Put holder can sell as
stock at a strike price within the expiration period. When an investor expects the
market price to fall in the future (i.e. a bearish market), that’s when they place a
Put Option. As the market price of the underlying asset falls, the Put holder can
exercise their right to sell it at the strike price, which is higher than the market
price at the time. Thus, the investor makes a profit.

Example of Put option: Similarly, you expect the price of Company X’s stock to
fall and buy a put option for a strike price of ₹500 for a premium of ₹10. The
market price of the stock falls and becomes ₹470. You can exercise your right to
sell at the strike price i.e. ₹500, making a profit of ₹20 ( ₹30 - ₹10 paid as
premium).

In both types of options in the stock market, the loss is limited to the premium of
the Options contract.

In case one buys a call option and the price falls, they are not obligated to
exercise their right to buy. They can simply let the contract expire without
exercising it. Similarly for a put-holder, if the market price of the stock were to
increase, they can choose not to sell at all.

Options are further classified based on the underlying security and the expiration
cycle. In the Indian Options market, there are various securities for which an
Options contract, both Call and Put, can be purchased. The expiration cycles
between different Options can range from weekly to long-term (up to three
years). Here’s a closer look at these types of Options.

Types of Options based on an underlying security

The most common type of option is a stock option in which the underlying
security is stock in a publicly listed company. Therefore, there are various option
types depending based on the assets. Here are a few examples of different types
of options based on underlying security:

Stock Options: A very popular choice amongst investors, it has the shares of a
publicly listed company as its underlying security.

Index Options: Quite like the stock options, instead of a particular company’s
shares, the Index option is based on an index like NSE, BSE, etc.

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Forex/Currency Options: This option type gives the owner the right to buy or sell
a specific currency at an agreed exchange rate.

Futures Options: For this type of option the underlying security is a specified
futures contract. A futures option allows the owner to enter into that specified
futures contract.

Commodity Options: In Commodity Options, the underlying asset can either be

a physical commodity or a commodity futures contract.

Types of options based on Expiration Cycle

The expiration cycle refers to the time frame within which the contract-owner can
exercise their right to buy or sell the relevant asset. While some option types are
available with a fixed expiration cycle, you can choose an expiration cycle for
other types of options.

Examples of different types of options based on the expiration cycle are

listed below:

Regular Options: These options have a standard expiration cycle. You can choose
between at least four different expiration months, according to your preference
and strategy.

Weekly Options: This option type has a much shorter expiration date and they
are also known as weeklies. However, they work on the same principles as regular
options.

Quarterly Options: These are also known as quarterlies. The investor can choose
any expiration cycle between the nearest four quarters plus the final quarter of the
following year.

Long-Term Expiration Anticipation Securities: This type of option, as the name

suggests, is for a long term lasting from one to three years before expiry. Regular
Options: These options have a standard expiration cycle. You can choose between
at least four different expiration months, according to your preference and
strategy.

Options contracts are way different than future and format contracts because
these contracts do not require any compulsion to discharge the contract on a
specific date.

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American options:

These are options that can be exercised at any time up to the expiration date.

European options:

These options can be exercised only on the expiration date.

Swap Contracts

Swap contracts mean the agreement is done privately between both parties. The
parties who enter into swap contracts agree to exchange their cash flow in the
future as per the pre-determined formula.

Under swap contracts, the underlying security is the interest rate or currency, as
these contracts protect both parties from several major risks.

These contracts are not traded to the Stock Exchange as investment banker plays
the role of a middleman between these contracts.

Derivative contracts like future, forward options are one of the best contracts to
earn profit. The traders can analyze and predict the future price movement of
their equity share and accumulate huge profits out of these contracts.

In finance, a swap is an agreement between two counterparties to exchange

financial instruments, cashflows, or payments for a certain time. The instruments
can be almost anything but most swaps involve cash based on a notional principal
amount.

Swaps are primarily over-the-counter contracts between companies or financial

institutions.

Retail investors do not generally engage in swaps.

Swaps are derivative contracts made for a financial exchange between two parties.
The two said parties agree to exchange the earnings on two separate financial
instruments. Moreover, only the cash flows are exchanged, whereas the principal
amount invested remains with the original parties.

Every cash flow exchange is known as a ‘leg’.

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Types of swaps

Interest rate swaps

Commodity swaps

Credit-default swaps

Debt-equity swaps

Total return swaps

Currency swaps

Interest rate swaps

This is the most common type of swap contract, wherein, the fixed exchange rate
is swapped for a floating exchange rate. For instance, X and Y enter into an
interest rate swap. Here, X agrees to pay Y an interest at a predetermined fixed
rate. In exchange, Y pays X interest at a floating rate. These interest payments are
made at specified intervals throughout the contract’s duration. It allows the
parties to hedge against the risk that arises from interest rate fluctuations. This is
also known as a plain vanilla swap.

Commodity Swaps

In most cases, producers enter into a swap with buyers and fix a selling price for
the commodity. This helps them mitigate the losses that may arise from
fluctuations in price. The underlying asset in such a swap can be any commodity,
including grains, crude oil, and metals. The value of such commodities is
determined at a spot price, which can be highly volatile.

Credit-default swaps

This type of swap works like insurance for a lender against the risk of default by
the borrower. Here, a third-party guarantees to pay the principal as well as the
interest to the lender if the borrower is unable to repay. It reduces the risk
undertaken by the lender and allows the borrower to avail of loans more easily.
However, the swap contract only comes into action if the borrower defaults.

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Debt-equity swaps

This swap is used to exchange debt for equity or vice versa. It is a method
employed to restructure the capital of a company. In many cases, companies do
so when they are unable to pay their dues on the debt they have undertaken.
Shifting to equity allows them to push the repayment.

Total return swaps

Total return swaps involve one party providing interest at a fixed rate to the other
party. For example, A owns shares that are exposed to price fluctuations and other
benefits such as dividends. He enters into a swap contract with B. B agrees to
provide A a fixed interest. This reduces A’s risk as he gets a stable return. In
exchange, B benefits from the price fluctuations, dividends, and appreciation of
the share’s value.

Currency swaps

Currency swaps involve a loan amount, interest on which is exchanged by the two
parties. This amount is in separate currencies. Many businesses use this to avoid
foreign exchange taxes and get easy loans in a local currency. Governments also
enter into such contracts to stabilize exchange rate fluctuations.

Benefits of swaps

Swaps can help the party reduce the risk that comes with fluctuations in the
market. Moreover, a commodity swap reduces the risk for the producer as it
ensures a specified amount to them, even if the prices go down.

Swaps allow the market players to venture into markets they previously could not
access. It can be utilized to approach new financial markets as hedging allows you
to reduce your risk.

Swaps are financial derivatives that are generally used by big businesses and
financial institutions. A swap contract involves the exchange of cash flows from an
underlying asset. The major benefit of swaps is that it allows investors to hedge
their risk while also allowing them to explore new markets.

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Badla Trading

The “Badla” trading is a mechanism of trade settlement in India.

“Badla” is a Hindi term for carryover transactions.

Badla trading facilitates trade shares on the margin on the Bombay Stock
Exchange. Further, it also allows to carry forward the positions to the next
settlement cycle. There was no fixed expiration date, contract terms for such
carryover transactions. Also, no standard margin requirement was there.
Moreover, earlier such transactions were carry forward indefinitely. But this was
later fixed for a maximum period of 90 days. The SEBI put a complete ban on
Badla trading in 2001 with the introduction of futures trading.

@@@

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Module D : Taxation and Fundamentals of Costing
Index
Chapter No Topics Covered

01 Taxation: Income Tax/TDS/Deferred Tax, Goods & Services Tax

02 An Overview of Cost & Management Accounting

03 Costing Methods, Standard Costing, Marginal Costing

04 Budgets and Budgetary Control

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 01 Taxation
(Income Tax/TDS/Deferred Tax, GST)
Taxes are termed as an obligatory contribution made by individuals or
corporations falling under the tax slab, to the Government of India. From local to
national, taxes are applicable on all levels in India and are considered to be one of
the major sources of income for the Government.

The government levies taxes on the citizens of the country to produce income for
business projects, enhance the country’s economy, and lift the standard of living
of the nationals. The government’s authority to levy tax in our country is drawn
from the Constitution of India that deals out the supremacy to levy taxes to the
State as well as Central governments. All the taxes levied within the country
require being backed by an escorting law passed by the State Legislature or the
Parliament.

Types of Taxes: In broader terms, there are styles of taxes namely, direct taxes
and oblique taxes. The implementation of each tax differs.

Direct Taxes

Income Tax

Capital Gains Tax

Securities Transaction tax

Perquisite Tax

Corporate Tax

Indirect Taxes (Oblique Taxes)

Sales Tax

Service Tax

Customs Duty and Octroi (on Goods)

Excise Duty

Value Added Tax (VAT)

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‘Other Taxes’ are imposed on each of the taxes, direct and indirect tax just like
they released Swachch Bharat Cess Tax, Infrastructure Cess Tax, and Krishi Kalyan
Cess Tax amongst others.

Direct Tax

As said earlier, you pay those taxes immediately. The authorities levy such taxes
immediately on a character or an entity and that they cannot get transferred to
another character or entity. There is best one such federation that winks on the
direct taxes, i.e., the Central Board of Direct Taxes (CBDT) ruled via way of means
of the Department of Revenue.

Types of direct taxes in India:

Income Tax Act:

Income Tax Act is likewise referred to as the IT Act, 1961. Income Tax in India is
ruled via way of means of the guidelines by this act. The profits taxed via way of
means of this act may be generated from any supply consisting of profit obtained
from salaries and investments, owning assets or a house, a business, etc.

Wealth Tax Act:

The Wealth Tax Act got here into impact in the year 1951 and is in charge of the
taxation connected with a character’s internet wealth, a Hindu Unified Family
(HUF), or an agency.

Gift Tax Act:

This Act become delivered into lifestyles in the year 1958 and confident that if
someone obtained presents or presents, valuables, or money, he has to pay a tax
on the one’s presents. The tax at the aforementioned presents become sustained
at 30 percentage however it becomes positioned to an end in the year 1998.
Originally, if a present becomes given, it becomes particularly like shares, jewelry,
assets, etc.

Expenditure Tax Act:

The Expenditure Tax Act got here into lifestyles in the year 1987 and copes with
the expenditure made via way of means of you, as someone, can also additionally
incur even as you avail the offerings of an eating place or a hotel.

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Interest Tax Act:

This Act of 1974 copes with the tax, which becomes chargeable on hobbies
produced in a few precise situations. In the Act’s closing amendment, it miles said
that this act does now no longer follows to hobby earned after March 2000.

Capital Gains Tax:

Capital Gains Tax is payable every time you get a tremendous sum of money. It
may be from the sale of any assets or investment. This is typical of 2 types of
capital gains, this is:

1. Long-period Capital Gains

2. Short period Capital Gains

Securities Transaction Tax:

It isn't a difficult nut to crack to understand approximately the right buying and
selling at the inventory market, and change securities, you live nevertheless to
make an in-depth sum of money. This too is a mine of profits, however, has its tax
this is referred to as the Securities Transaction Tax.

Perquisite Tax:

Perquisites are all of the privileges and perks that the employers would possibly
pull out to the employees. These civil liberties can also additionally consist of a
vehicle furnished to your use or a house, given via way of means of the agency.
These perquisites aren't simply restricted to massive compensations consisting of
homes or cars; they'll even consist of matters consisting of repayment for phone
payments or fuel.

Corporate Tax:

The income tax an agency will pay from the sales earned via way of means of its
miles is referred to as a corporate tax. The corporate tax additionally has a slab of
its own, which makes a decision on the quantity of tax to be paid. The agency’s
profits are dealt with one after the other from the shareholder’s dividend under
the corporate tax and are levied on home corporations in addition to overseas
corporations.

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Indirect Tax

The taxes levied on items and offerings are called oblique taxes. They are
distinctive from direct taxes as they may be now no longer imposed on a man or
woman who shells out them at once to the Indian authorities, they may be, as an
alternative, imposed on the goods and an intermediary, the individual promoting
the product, collects them. The maximum trivial examples of oblique taxes are
Sales Tax, Taxes levied on imported items, Value Added Tax (VAT), etc. Such taxes
are imposed by summating them with the fee of the services or products this is
possible to push the fee of the product up.

Types of Indirect Taxes:

Sales Tax:

The tax imposed at the sale of any product is known as sales tax. This product can
be either produced in India itself or imported and also can cover offerings
provided. The income tax is levied at the product’s supplier who then passes it to
the man or woman who buys the stated product with this tax summated to the
product’s fee.

Service Tax:

Like income tax, the provider tax is likewise summated to the fee of the product
bought withinside the country. It isn't charged on items however at the groups
that provide offerings and as soon as each region or each month it's far gathered
at the manner offerings are offered.

Goods and Service Tax-GST:

The Goods and Service Tax is the largest reform withinside the shape of Indirect
Tax in India for the reason that marketplace commenced unlocking 25 years back.
The items and offerings tax is an intake-primarily based total tax due to the fact
it's far chargeable in which the intake is taking place.

Value Added Tax:

VAT, popularly referred to as industrial tax isn't chargeable for the commodities,
which can be zero-rated for meals and important pills or the ones falling below
exports. VAT is imposed at all the steps of the delivery chain, from producers to
sellers to vendors to the end-user.

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Customs Duty and Octroi:

When you purchase whatever that calls for being imported from abroad, you've
implemented a rate on it and this is referred to as the customs obligation. It is
implemented for all the goods, which are available through air, sea, or land. Octroi
is meant to ensure that the products traversing the country's borders interior
India are correctly taxed. The country authorities levy this and feature it in nearly
the equal manner because of the customs obligation.

Excise Duty:

The excise obligation is this type of tax this is imposed on all of the synthetic
items or the produced items in India. This tax varies from customs obligation as
it's far chargeable best at the matters which can be produced in India and is
likewise known as the Central Value Added Tax or CENVAT.

Other points relevant to Taxation

Fringe Benefit Tax

To reduce the profit on booked entry, many companies started providing various
benefits to their employees and maintain them under their input cost. Thus
reducing the profit which in turn leads to less taxation by the government.

Therefore government-imposed Fringe Benefits Tax (FBT) which is fundamentally

a tax that an employer has to pay instead of the benefits that are given to his/her
employees. It was an attempt to comprehensively levy a tax on those benefits,
which evaded the tax.

The list of benefits encompassed a wide range of privileges, services, facilities, or

amenities which were directly or indirectly given by an employer to current or
former employees, be it something simple like telephone reimbursements, free or
concessional tickets, or even contributions by the employer to a superannuation
fund. FBT was introduced as a part of the Finance Bill of 2005 and was set at 30%
of the cost of the benefits given by the company. This tax needed to be paid by
the employer in addition to the income tax, irrespective of whether the company
had an income-tax liability or not.

The fringe benefits tax was abolished in the 2009 Union budget of India.

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Minimum Alternate Tax

The concept of Minimum Alternate Tax (MAT) was introduced in the direct tax
system to make sure that companies having large profits and declaring substantial
dividends to shareholders but who were not contributing to the Government by
way of corporate tax, by taking advantage of the various incentives and
exemptions provided in the Income-tax Act, pay a fixed percentage of book profit
as minimum alternate tax.

As per the Income Tax Act, if a company’s taxable income is less than a certain
percentage of the booked profits, then by default, that much of the book profits
will be considered as taxable income and tax has to be paid on that.

It is called MAT and is a direct tax. It was introduced to deter some companies
who managed their account in such a way that they end up paying zero or no tax
to the government.

Alternate Minimum Tax

Under the existing provisions of the Income-tax Act, Minimum Alternate Tax
(MAT) and Alternate Minimum Tax (AMT) are levied on companies and limited
liability partnerships (LLPs) respectively.

That means what is MAT to the companies, AMT is to the LLPs. However, no such
tax is levied on the other form of business organizations such as partnership firms,
sole proprietorship, an association of persons, etc.

To widen the tax base vis-à-vis profit linked deductions, it is proposed to amend
provisions regarding AMT contained in the Income-tax Act to provide that a
person other than a company, who has claimed deduction under any section
(other than section 80P), shall be liable to pay AMT.

Under the proposed amendments, where the regular income-tax payable for a
previous year by a person (other than a company) is less than the alternate
minimum tax payable for such previous year, the adjusted total income shall be
deemed to be the total income of such person and he shall be liable to pay
income-tax on such total income at the rate of eighteen and one-half percent.

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Taxation Types - Tax Base and Tax Rate

Considering the relation between the tax rate and the tax base (income), there can
be four types of taxation, viz.:

a) Proportional taxes,
b) Progressive taxes,
c) Regressive taxes and
d) Digressive taxes.

Proportional Taxes:

Taxes in which the rate of tax remains constant, though the tax base changes, are
called proportional taxes.

Here, the tax base may be income, money value of property, wealth, or goods etc.
Income is, however, regarded as the main tax base, because it is the determinant
of taxable capacity of a person.

In a proportional tax system, thus, taxes vary in direct proportion to the change in
income. If income is doubled, the tax amount is also doubled.

Thus, a proportional tax extracts a constant proportion of rising income.

Progressive Taxes:

Taxes in which the rate of tax increases are called progressive taxes. Thus, in a
progressive tax, the amount of tax paid will increase at a higher rate than the
increase in tax base or income, for the taxation amount is the product of
multiplying the base by the rate and both these increase in a progressive tax.
Thus, a progressive tax extracts an increasing proportion of rising income.

Regressive Taxes:

When the rate of tax decreases as the tax base increases, the taxes are called
regressive taxes. It must be noted that in regressive taxation, though the total
amount of tax increases on a higher income in the absolute sense, in the relative
sense, the tax rate declines on a higher income. As such, relatively a heavier
burden (sacrifice involved) falls upon the poor than on the rich.

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Generally, taxes on necessaries are regressive as they take away a greater
percentage of lower incomes as compared to higher incomes.

Thus, regressive taxation is unjust and inequitable. It does not comply with the
canon of equity. It tends to accentuate inequalities of income in the community.

Digressive Taxes:

Taxes which are mildly progressive, hence not very steep, so that high income
earners do not make a due sacrifice on the basis of equity, are called digressive. In
digressive taxation, a tax may be progressive up to a certain limit; after that it may
be charged at a flat rate.

In digressive taxation, thus, the tax payable increases only at a diminishing rate.

Regressive and digressive taxation are, of course, not accepted by any economist
on the ground of equity.

But, there has been a heated controversy regarding proportional and progressive
taxation.

Relative Merits of Proportional Taxes:

1. Proportional taxation leaves the tax payer in the same relative economic status.

2. Proportional taxation is simple to calculate and to administer. Since it is

uniformly levied, it is very convenient to estimate.

3. Proportional taxation in not as repugnant to tax payers as progressive taxation.

4. The effect on willingness to work hard and save is not adverse in the case of
proportional taxes.

Relative Merits of Progressive Taxes:

1. A proportional tax is inequitable, as it falls relatively heavily on poor incomes. A

progressive tax is more equitable, as a larger part is taxed on higher incomes it is
justifiable just as the law of diminishing marginal utility operates in the case of
money. Hence, the disutility of paying a high tax by rich is not as much as that of
poor in paying even a low tax. Therefore, the rich should be taxed at a higher rate
than the poor.

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2. Progressive taxes may be justified on the ground that higher incomes contain
surpluses, which have cent per cent capacity to bear taxes. Thus, progressive
taxation fully complies with the principle of capacity to bear or ability to pay the
tax.

3. Progressive taxes are more economical, as the cost of collection does not rise
when the rate of tax increases.

4. Progressive taxation has greater revenue productivity than proportional

taxation.

5. The progressive tax system also complies with the canon of elasticity. For, a rise
in income is automatically taxed at a higher rate under the system so that revenue
increases with economic expansion.

6. Progressive taxes are an engine of social improvement. The strong should assist
the weak and the rich should aid the poor. This social morale is well sustained by
progressive taxation.

7. Progressive taxation can lead to a better distribution of income and wealth,

hence, an increase in general welfare of the community. According to Kaldor, the
desire to reduce economic inequalities can be regarded as a justification for
adopting a highly progressive tax system.

Tax Avoidance and Tax Evasion

The terms "tax avoidance" and "tax evasion" are often used interchangeably, but
they are very different concepts. Basically, tax avoidance is legal, while tax evasion
is not.

Tax Avoidance

Tax avoidance is the legitimate minimizing of taxes and maximize after-tax

income, using methods included in the Tax Laws . Businesses avoid taxes by
taking all legitimate deductions and all legal and under the Tax Acts.

Tax Loopholes and Tax Shields

A tax loophole is tax avoidance. it's a clause in the tax laws that people creates a
hole people can go through to reduce their taxes. It's a way to avoid paying
taxes, but since it's in the tax code it's not evasion.

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Since the tax code is so complex, savvy tax experts have found ways to lower taxes
for their clients without breaking the law, taking advantage of parts of the law. If
you are tempted to use a tax loophole, be aware that the tax laws are complex
and difficult to interpret. Getting a competent, honest tax expert can save you
from going over the line to tax evasion.

Tax Shields are another strategy for avoiding taxes. A tax shield is a deliberate use
of tax expenses to offset taxable income.

Some tax loopholes are deliberate on the part of lawmakers; accelerated

depreciation is one example.

Tax Evasion

Tax Evasion, on the other hand, is using illegal means to avoid paying taxes.
Usually, tax evasion involves hiding or misrepresenting income. This might be
underreporting income, inflating deductions without proof, hiding or not
reporting cash transactions, or hiding money in offshore accounts.

Deferred Tax

Deferred tax (DT) refers to the difference between tax amount arrived at from
the book profits recorded by a company and the taxable income. The effect arises
when taxes are either not paid or overpaid. Companies calculate book profits
using a particular accounting method; tax authorities charge taxes based on tax
laws, and the two often differ.

Deferred tax is the gap between income tax determined by the company’s
accounting methods and the tax payable determined by tax authorities.

Deferred tax arises when there is a difference in the treatment of income,

expenses, assets, and liabilities under the company’s accounting procedure and
the tax provision.

It is the difference between income tax paid and income tax accrued. The
difference results in a surplus or deficit.

The difference is seen as a deferred tax asset (DTA) or a deferred tax liability (DTL).
When the reported income tax exceeds income tax payable, the difference is an
asset. When the income tax payable exceeds reported income tax, it becomes a
liability for the company.

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Tax Deducted at Source (TDS)

The concept of TDS was introduced with an aim to collect tax from the very
source of income. As per this concept, a person (deductor) who is liable to make
payment of specified nature to any other person (deductee) shall deduct tax at
source and remit the same into the account of the Central Government.

Tax Collected at Source (TCS)

Tax Collected at Source (TCS) is a tax payable by a seller which he collects from
the buyer at the time of sale of goods.

Goods and Services Tax (GST)

The GST was launched on 1st July 2017.

GST was first recommended by the Kelkar committee task force.

It is a tax levied when a consumer buys a good or service. It is meant to be a

single, comprehensive tax that will subsume all the other smaller indirect taxes on
consumption like service tax, etc.

It subsumed 17 large taxes and 13 cesses.

It is a single tax on the supply of goods and services, right from the manufacturer
to the end consumer.

GST does not tax or get into specific commodities.

GST Mechanism

Stage 1 - Let’s consider a manufacturer of bags.

Let’s say he buys raw material worth Rs 100, a sum that includes a tax of Rs 10.

With the raw materials, he manufactures bags.

In the process of creating the bag, the manufacturer adds value to the materials
he started out with.

Let us take this value added by him to be Rs 30.

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The gross value of his good would, then, be Rs 100 + 30, or Rs 130.

At a tax rate of 10%, the tax on output (the gear) will then be Rs 13.

But under GST, he can set off this tax (Rs 13) against the tax he has already paid
on raw material/inputs (Rs 10). This setoff is also called as input credit. This forms
the crux of GST.

Therefore, the effective GST incidence on the manufacturer is only Rs 3 (13 – 10).

Stage 2

The next stage is that of the good passing from the manufacturer to the
wholesaler.

The wholesaler purchases it for Rs 130, and adds on value (which is basically his
‘margin’) of, say, Rs 20.

The gross value of the good he sells would then be Rs 130 + 20 — or a total of Rs
150.

A 10% tax on this amount will be Rs 15.

Under GST, he can set off the tax on his output (Rs 15) against the tax on his
purchased good from the manufacturer (Rs 13).

Thus, the effective GST incidence on the wholesaler is only Rs 2 (15 – 13).

Stage 3

In the final stage, a retailer buys the gear from the wholesaler.

To his purchase price of Rs 150, he adds value, or margin, of, say, Rs 10.

The gross value of what he sells, therefore, goes up to Rs 150 + 10, or Rs 160.

The tax on this, at 10%, will be Rs 16.

But by setting off this tax (Rs 16) against the tax on his purchase from the
wholesaler (Rs 15), the retailer brings down the effective GST incidence on himself
to Re 1 (16 –15).

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Thus, the total GST on the entire value chain from the raw material/input suppliers
(who cannot claim any tax credit since they haven’t purchased anything
themselves) through the manufacturer, wholesaler and retailer are Rs 10 + 3 +2 +
1, or Rs 16.

Credits of input taxes paid at each stage will be available in the subsequent stage
of value addition, which makes GST essentially a tax only on value addition at
each stage.

The final consumer will thus bear only the GST charged by the last dealer in the
supply chain, with set-off benefits at all the previous stages.

Salient features of the GST Bill:

No differentiation between good and services tax. One rate for both goods and
services

Subsumes most of the Indirect taxes at state and central level (barring few
exceptions listed below)

The Central GST (CGST) and the State GST (SGST) would be levied simultaneously
on every transaction of supply of goods and services except on exempted goods
and services, goods which are outside the purview of GST and the transactions
which are below the prescribed threshold limits. Further, both would be levied on
the same price or value unlike State VAT which is levied on the value of the goods
inclusive of Central Excise.

Tax Impact and Tax Incidence

Impact refers to the initial burden of the tax, while incidence refers to the ultimate
burden of the tax.

The final burden of tax is known as tax incidence and the initial burden of tax is
known as tax impact. Tax incidence is upon the person who eventually pays it and
the tax impact is upon the person from whom the tax is collected.

Tax incidence will fall on the consumers who pay the price for buying a product,
and the tax impact will fall upon the producers for producing a product.

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 02 Cost & Management Accounting
Cost Concept:

Cost is defined as the amount of expenses (actual or notional) incurred on or

attributable to specified thing or activity.

This activity of the cost will reflect in the manufacturing of the product or
rendering of the services which will cover expenditures under various heads. For
examples: salary, materials, other expenses etc. In the case of service industry,
they are interested in the cost of ascertaining the cost of the services it renders.
The cost per unit is arrived by dividing the total expenditure incurred to the total
number of production or the service rendered. This method can be used when
there is only one product. If the manufacturing company manufactures more than
one product, it becomes imperative to split the total cost among the number of
products.

Costing:

Costing is determining the costs of products/services and also planning and

controlling such costs. Costing means finding of cost by any process or technique.
Principles and rules which are determining the costing are as follows:

a. The cost of manufacturing a product.

b. The cost of providing a service.

Cost Accounting:
Cost Accounting is a specialized branch of accounting, whichinvolves
classification, accumulation, assignment, and control of costs. Cost accounting
deals with the collection, analysis of relevant cost data for interpretation and
presentation for various problems of management.

Cost Accountancy:

Cost Accountancy is the application of costing and cost accounting principles,

methods and techniques to the science, art and practice of cost control and the
ascertainment of profitability as well as presentation of information for the
purpose of managerial decision making.

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Cost Accountancy is a science as it is a knowledge which a cost accountant should
possess to carry out his duties and responsibilities. It is an art as it required skills
by the cost accountant to apply principles of cost accountancy to various
managerial problems like price, expenditures etc. Practice refers to the efforts
taken by the Cost Accountant in the field of cost accountancy. Along with the
Theoretical knowledge, cost accountant should possess sufficient practical
training and exposure to real life costing problems.

Objectives of Cost Accounting:

The Objectives of Cost Accounting are as follows:

1. Ascertaining the Cost: It refers to the cost for a specific product or activity with
a reasonable degree of accuracy.

2. Determining the Selling Price: It helps in finalizing the cost of the product after
which the profit margin is added by the manufacturer and thus the selling price of
the product is fixed.

3. Cost Control and Cost Reduction: It helps in improving profitability by

controlling and reducing costs. This objective is important for current scenario
due to increase in competition in the business world.

4. Management in Decision Making: Taking Management decision in respect of

the price of the product for which the comparison of actual and standard cost is
required to analysis the causes of variation and to take corrective decisions.

5. Ascertaining the Profit: It helps in ascertaining the profit of the business by

matching the cost with the revenue of that activity.

6. To Provide basis of operating policies

7. To provide information about inefficient and carelessness

8. To provide information about actual situation of production activity

9. To inform the principles and procedures to be followed in Costing System

10. To prepare comparative analysis through data collection

11. To estimate cost

12. To disclose and minimize the waste

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Importance of Cost Accounting:

Cost accounting has many importance. Specially, the following parties are
benefitted from it.

1. Importance to management

Management is highly benefitted with the introduction of cost accounting. It

helps to ascertain the cost and selling price of the product.

Cost data help management to formulate the business policies. The introduction
of budgetary control and standard cost would be an aid to analyse cost. It also
helps to find out reasons for profit or loss. It provides data to submit tender as
well. Thus, cost accounting is an aid to management.

2. Importance to investors

Investors can obtain benefit from the cost accounting. Investors want to know the
financial conditions and earning capacity of the business. An investor must gather
information about organization before making investment decision and investor
can gather such information from cost accounting.

3. Importance of consumers

The aim of costing is to reduce the cost of production to minimize the profit of
business. Reduction in the cost is usually passed on the consumers in the form of
lower price. Consumers get quality goods at a lower price.

4. Importance to Employees

Cost accounting helps to fix the wages of the workers. Efficient workers are
rewarded for their efficiency. It helps to induce incentive wage plan in business.

5. Importance to Government

Cost accounting is one of the prime sources to provide reliable data to internal as
well as external parties. It helps government agencies to determine excise duty
and income tax. Government formulates tax policy, industrial policy, export and
import policy based on the information provided by the cost accounting.

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Scope of Cost Accounting

1. Costing: It is ascertainment of cost of products, processes, jobs services etc. it is

the most important function of cost accounting.

2. Cost Recording: It is a maintaining record of all the cost (expenses) incurred

during the process of the production of the final products/ services. Such records
are kept on the basis of double entry system.

3. Cost Analysis: All the costs that are recorded are analyzed and categorized
separately. Example: Direct and Indirect Costs, Fixed and Variable Costs, etc.

4. Cost Control: Cost Accounting, compares the actual cost and standard cost, the
difference between the two are analyzed and used for cost control purpose.

5. Cost Report: Cost accounting generates periodical reports such as weekly,

monthly reports that is used by the management for taking decisions. These
reports are used for planning and controlling, performance appraisal and
management decision making.

6. Cost Audit: It is the verification of cost accounts and to check on the progress
of cost accounting plan. Its main focus is on the expenditure and efficiency of
performance.

Role of Cost Accountant in Decision Making

Cost Accountant plays an important role in an organization. It is really imperative
that organizations pays attention on the job of cost analysist. Cost Accountancy
deals in the preparation of various reports for the information of internal
management for the smooth running of the business. All the important decision
taken by the management for the future of the company’s progress is prepared
by the cost accountants.

Cost Accountants perform following duties:

1. To analyse material, labour and overhead expenses.

2. To reconcile daily productions with accounting transactions.

3. To co-ordinate with research and development department for the new

products.

4. To assist the controller in developing the cost improvement opportunities.

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5. To prepare new product costing as well as to do gross profit analysis for the
marketing in order to determine the feasibility before presenting the samples and
pricing to the final consumers.

Management Accounting
Management accounting is the study of managerial aspect of financial
accounting, "accounting in relation to management function". It shows how the
accounting function can be re-oriented so as to fit it within the framework of
management activity.

The primary task of management accounting is, therefore, to redesign the entire
accounting system so that it may serve the operational needs of the firm. If
furnishes definite accounting information, past, present or future, which may be
used as a basis for management action. The financial data are so devised and
systematically development that they become a unique tool for management
decision.

Objectives of Management Accounting:

Main functions of Management Accounting are as follows:

1. Planning - Information and date provided by management accounting helps

management to forecast and prepare short-term and long term plans for the
future activities of the business and formulate corporate strategy. For this purpose
management accounting techniques like budgeting, standard costing, marginal
costing.

2. Coordinating: Management accounting techniques of planning also help in

coordinating various business activities. For example, while preparing budgets for
various departments like production, sales, purchases, etc., there should be full
coordination so that there is no contradiction. By proper financial reporting,
management accounting helps in achieving coordination in various business
activities and accomplishing the set goals.

3. Controlling: Controlling is a very important function of management and

management accounting helps in controlling performance by control techniques
such as standard costing, budgetary control, control rations, internal audit, etc.

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4. Communication: Management accounting system prepares reports for
presentation to various levels of management which show the performance of
various sections of the business. Such communication in the form of reports to
various levels of management helps to exercise effective control on various
business activates and successfully running the business.

5. Financial analysis and interpretation: In order to make accounting data easily

understandable, the management accounting offers various techniques of
analyzing, interpreting and presenting this data in nonaccounting language so
that every one in organization understands it.

Ratio analysis, cash flow and funds flow statements trend analysis, etc., are some
of the management accounting techniques which may be used for financial
analysis and interpretation.

6. Qualitative Information: Apart from monetary and quantitative data,

management accounting provides qualitative information which helps in taking
better decisions. Quality of goods, customers and employees, legal judgments,
opinion polls, logic, et, are some of the expels of qualitative information supplied
and used by the management accounting system for better management.

7. Tax Policies: Management accounting system is responsible for tax policies and
procedures and supervises and coordinates the reports prepared by various
authorities.

8. Decision – Making: Correct decision making is crucial to the success of a

business. Management accounting has certain special techniques which help
management in short team and long term decisions. For example, techniques like
marginal costing, differential costing, discounted cash flow, et., help in decisions
such as pricing of products, make or buy, discontinuance of a product line, capital
expenditure, etc.

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 organizational goals.

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The following are the main characteristics of management accounting:

1. Providing Accounting Information: Management according 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 away it suits

managerial needs. The accounting data is used for reviewing various policy
decisions. Management accounting is a service function and it provides necessary
information to different levels of management.

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 different expenditures, current assets,
interest payables, share capital, etc. 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 data 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 data is studied to see its possible
impact on future decisions. The implications of various alternative decisions are
also taken into account while taking important decisions.

5. Achieving of Objectives: In management accounting, the accounting

information is used in such a way that it helps in achieving organizational
objectives. Historical data is used for formulating plans and setting up objectives.
The recording of actual performance and comparing it with targeted figures will
give an idea to the management about the performance of various departments.
In case there are deviations between the standards set and actual performance of
various departments corrective measures can be take at one. All this is possible
with the help of budgetary control and standard costing.
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6. Increase in Efficiency: The purpose of using accounting information is to
increase efficiency of the concern. The efficiency can be achieved by setting up
goals for each department. The performance appraisal will enable the
management to pin point efficient and inefficient spots.

An effort is made to take corrective measures so that efficiency is improved. The

constant review of working will make the staff cost – conscious. Every one will try
to control cost on one’s own part.

7. Supplies Information and not decision: The management accountant supplies

information to the management. The decisions are to be taken by the top
management. ‘How is the data to be utilized’ will depend upon the efficiency of
the management.

8. Concerned with forecasting: The management accounting is concerned with the

future. It helps the management in planning and forecasting. The historical
information is used to plan future course of action.

Scope of Management Accounting

Financial Accounting: Financial Accounting deals with the historical data. The
recorded facts about an organization are useful for planning the future course of
action. Though planning is always for the future but still it has to be based on past
and present data. The control aspect too is based on financial data. The
performance appraisal is based on recorded facts and figures. So management
accounting is closely related to financial accounting.

Cost Accounting: Cost Accounting provides various techniques for determining

cost of manufacturing products or cost of providing service. It uses financial data
for finding out cost of various jobs, products or processes. The systems of
standard costing, marginal costing, differential costing and opportunity costing
are all helpful to the management for planning various business activities.

Financial Management: Financial Management is concerned with the planning

and controlling of the financial resources of the firm. It deals with raising of funds
and their effective utilization so to maximize earnings. Finance has become so
important for every business that all managerial activities are connected with it.
Financial viability of various propositions influence decisions on them. Therefore
management accounting includes and extends to the operation of financial
management also.

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Budgeting and Forecasting: Budgeting means expressing the plans, policies and
goals of the enterprise for a definite period in future. The targets are set for
different departments and responsibility is fixed for achieving these targets. The
comparison of actual performance with budgeted figures will give an idea to the
management about the performance of different departments. Forecasting, on
the other hand, is a prediction of what will happen as a result of a given set of
circumstances. Both budgeting and forecasting are useful for management
accountant in planning various activities.

Inventory Control: Inventory is used to denote stock of raw materials, goods in

the process of manufacture and finished products.

Inventory has a special significance in accounting for determining correct income

for a given period. Inventory control is significant as it involves large sums. The
management should determine different levels of stocks, ie. minimum level,
maximum level, re- ordering level for inventory control. The control of inventory
will help in controlling costs of products. Management accountant will guide
management as to when and from where to purchase and how much to purchase.
So the study of inventory control will be helpful for taking managerial decisions.

Reporting to Management: One of the functions of management accountant is

to keep the management informed of various activities of the concern so as to
assist it in controlling the enterprise. The reports are presented in the form of
graphs, diagrams, index numbers or other statistical techniques so as to make
them easily understandable. The management accountant sends interim reports
to the management and these reports may be monthly, quarterly, half – yearly.
The reports may cover profit and loss statement, cash and found flow statements,
stock reports, absentee reports and reports on orders in hand, etc. These reports
are helpful in giving a constant review of working of the business.

Interpretation of Data: The management accountant interprets various financial

statements to the management. These statements give an idea about the financial
and earning position of the concern. These statements may be studied in
comparison to statements of earlier periods or in comparison with the statements
of similar other concerns.

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The significance of these report is explained to the management in a simple
language. If the statements are not properly interpreted then wrong conclusions
may be drawn. So interpretation is also important as compiling of financial
statements.

Control procedures and Method: Control procedures and methods are needed
to use various factors of production in a most economical way. The studies about
cost, relationship of cost and profits are useful for using economic resources
efficiently and economically.

Internal Audit: Internal audit system is necessary to judge the performance of

every department. The actual performance of every department and individual is
compared with the pre-determined standards. Management is able to know
deviations in performance.

Internal audit helps management in fixing responsibility of different individuals.

Tax Accounting: In the present complex tax systems, tax planning is an important
part of management accounting. Income statements are prepared and tax
liabilities are calculated. The management is informed about the tax burden from
central government, state government and local authorities. Various tax returns
are to be filed with different departments and tax payments are to be made in
time.

Tax accounting comes under the purview of management accountant’s duties.

Office services: Management accountant may be required to control an office.

He will be expected to deal with data processing, filing, copying, duplicating,
communicating etc. He will also be reporting about the utility of different office
machines.

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 03 Costing Methods
(Standard Costing, Marginal Costing)
Cost estimation and cost accounting system is referred to as the costing method.

The nature of industries, as well as the products and services they provide, differ.
As a result, different industries have different costing strategies. For instance, a
building contractor’s costing method differs from a transportation company’s.

The two most common methods of costing are Job Costing and Process Costing.
Job costing is fit for industries that manufacture or perform work per customer
specifications. Process costing is suitable for industries where continuous
production and the units produced are all the same. All other approaches are
variations, extensions, or enhancements of these fundamental techniques.

Different Methods of Costing

The costing procedures are the cost estimation and cost accounting systems.
Industries differ in terms of their nature and also the products and services they
supply. As a result, many industries employ various costing methodologies. A
building contractor’s costing method, for example, differs from that of a
transportation firm. Job costing and process costing are the two most popular
costing approaches.

Job costing is useful in industries that manufacture or perform work to customer

specifications. Process costing is appropriate for industries where production is
continuous and the units produced are uniform. All additional methods are
modifications, extensions, or improvements on these basic principles. The
following are examples of costing methods:

Job Costing

Job costing is a type of accounting that monitors costs and revenues by “work”
and allows for uniform profitability reporting by the job. An accounting system
must allow job numbers to be allocated to specific expenses and revenues to
support job costing.

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Contract Costing

Contract costing is the tracking of costs associated with a specific contract with a
customer. For example, a company submits a bid for a large construction project
with a possible customer. The two sides also agree in a contract that the company
will be reimbursed in a specified method.

Batch Costing

Batch cost is a collection of costs paid when a group of items or services is

manufactured that cannot be traced back to individual products or services within
the group. It may be essential to assign the batch cost to individual units within a
batch for cost accounting reasons.

Process Costing

Process costing is an accounting method for tracking and accumulating direct

expenses in a manufacturing process and allocating indirect costs. Costs are given
to items in huge batches, which can span a month’s worth of production.

Unit Costing

A company’s unit cost is the cost of producing, storing, and selling one unit of a
given product. All fixed and variable expenses in production are included in unit
costs. A cost unit is a unit of measurement used to determine the volume of a
service or product. Mines, oil drilling units, cement works, brickwork, or unit
production cycles, such as radios and washing machines, all use unit costs.

Operation Costing

Job costing and process costing are combined in operation costing. It may be
employed when a product is made from various raw materials and then finished
using a standardised procedure for a group of items. The main goal of this
strategy is to figure out the cost of each procedure.

Multiple Costing

When things are sold that contain various other processed parts, multiple costing,
also known as composite costing, is an accounting method used when these parts
cost differently. Each of the elements made by other processes, like the ultimate
product, has a cost connected with it.

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Operating Costing

Operating costs, often known as operational expenses, are expenses connected to

the running of a business or a product, component, piece of equipment, or facility.
They seem to be the costs of resources used by a company just to stay in
business. Airlines, trains, road transport companies (both products and
passengers), hotels, cinema halls, power plants, and other businesses employ
operating costs.

The method of estimating costs differs from industry to industry. When using a
costing method, one should choose the right one. This is because the wrong
method can significantly raise the production cost of a good or service. For
example, a costing approach developed for incremental pricing decisions may not
be appropriate for long-term decisions.

Standard Costing
Standard Costing is a method used to compare revenue and the standard cost
with the actual result, to check the variance and its causes. It informs the
management of the deflection and initiates correct measures for improvement.

It can be defined as the predicted cost per unit of the product manufactured
during a period, based on different factors. It calculates the performance,
inventory valuation, controlling the deviation, and deciding the selling price of the
product. There are three main components of standard costing.

Direct Material Cost

Direct Labour Coat

Overheads

Standard Costing is a sophisticated technique, under which the standards are

decided in advance and the actual costs are compared with such standard costs.
Causes of variations, especially the unfavourable ones, are analysed and
appropriate corrective measures are initiated so as to have the optimum efficiency
in production.

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Objectives of Standard Costing

The broad objectives of standard costing are summarized in the following points:

Promoting and Measuring Efficiency :

Standard Costing, besides enhancing the competence and performance, also acts
as a tool to measure them. If the actual cost happens to be less than the standard
cost, it indicates efficiency and competency; on the other hand, if the actual cost
happens to be more than the standard cost, it is indicative of inefficiency and
competency.

Controlling and Reducing Casts :

While computing the Standard Cost, appropriate provisions are made with regard
to normal wastage, normal breakdown, normal idle capacity, normal mistakes, etc.
This exercise ensures proper monitoring as well as reduction in the cost.

Simplifying Costing Procedure :

The exercise of Standard Costing is invariably specific to a product/ process / job.

For every product, or process, or job a separate exercise of standard costing is
required to be undertaken. This is generally done by the professionals (cost and
management accountants) after having n thorough discussion with the
management and the technical specialists, which ensures smoothening of the
entire process.

Valuing Inventories :

Undertaking the valuation exercise in respect of stock and issue of material on the
basis of standard costs results in substantial savings of time and energy in the
maintenance of stores ledger.

Fixing Selling Price :

Selling price of a product may be fixed either on the basis of actual cost or on the
basis of standard cost. It has been experienced that due to various reasons, there
are lot of fluctuations in actual cost and as such the selling price cannot be fixed
on the basis of actual cost, because price of a product needs to be generally
stable and not volatile. Thus, the preferred basis of fixing the price of a product is
standard cost, to which a suitable margin is added.

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Advantages of Standard Costing

Measuring Efficiency :

Standard costing may be used as a measuring tool for the management to

measure efficiency. The difference between the actual costs and standard costs
reflects the level of performance of different cost centres.

Formulation of Production and Price Policy :

Creation of production policies is facilitated by the standard costing. On the basis

of prevailing conditions, the standards are fixed. Standard costs are helpful in
deciding production plans and in determining prices of different products.

Determination of Variance :

Variances are determined by comparing actual cost and standard cost. Such
variations brings core areas of incompetence, which in turn enables the
management to fix staff accountability for inefficiencies and initiate remedial steps
promptly and ensure better performance in future.

Reduction of Work :

Under the historical costing, a number of records are required to be regulated for
the determination of costs, whereas under the standard costing minimal records
are required to be maintained, resulting in the reduction of clerical job to a great
extent

Management by Exception :

A system, which envisages that every individual should be given a target to be

achieved within a defined time-frame, is referred to as management by exception.
Day-to-day supervision of various activities and individual performance is not
required under this system.

Facilitates Cost Control :

The twin objective of any costing system is cost control and cost reduction are
achieved in the system of standard costing. The standards are scrutinized and
analysed on: an ongoing basis with a view to have further improvement in
efficiency. Causes of variance, whenever takes place, are thoroughly studied and
analysed, which is followed by initiation of prompt remedial steps.

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Disadvantages of Standard Costing

The system of standard costing exhibits the following disadvantages :

Fixation of Standards :

Fixation of realistic standards during the introduction of standard costing system

is an extremely significant and challenging job. A wrong assessment of standards
may lead to a faulty system. Fixation of standards on a realistic basis requires a
technical expertise, which is difficult to implement.

Frequent Technology Alterations :

Some of the industries are known for frequent technological alterations.

Introduction of standard costing system in such industries may prove to be a
costly affair, as the standards would need a frequent revision. Standard costing
system, therefore, may not be suitable for such industries.

Expensive Technique :

Expenses involved in setting up and continuing the system of standard costing are
quite heavy. It is difficult for small-sized business organisations to afford such a
costly system.

Fixation of Responsibility :

In case of any lapse, the job of fixing staff accountability, perse, is a difficult one.
In case of standard costing system, such accountability can be fixed only for the
controllable variances and not for the uncontrollable variances. But to establish
whether a variance is controllable or uncontrollable is also a tough exercise, due
to the fact that the variances controllable at one point of time may become
uncontrollable at another point of time.

Analysis of Historical Events :

Variance analysis involves analysis of historical events, which cannot be changed.

As such it is of limited use for the management.

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Marginal Costing
Marginal costing, or variable costing, is a valuable tool for managers to make
informed decisions about pricing, product mix, and profitability. By separating
variable costs from fixed costs, marginal costing provides a clear picture of how
changes in production volume affect a company’s bottom line. In this way, this
costing method helps managers to optimize their operations and maximize
profits.

Marginal costing is a cost accounting technique that helps businesses determine

the cost of producing one additional unit of a product or service. Marginal costing
is also known as variable costing because it only considers the variable costs
associated with producing an additional unit of a product or service, such as direct
labour and direct materials.

Under marginal costing, fixed costs, such as rent and salaries, are considered
period costs that are not directly related to the production of a specific unit.
Instead, fixed costs are expensed in the period they are incurred. This is different
from absorption costing, another cost accounting technique that allocates fixed
costs to each unit produced.

Marginal costing can be useful for decision-making, as it allows businesses to

determine the profitability of producing additional units of a product or service.
For example, suppose a business is considering whether to produce and sell
additional product units. In that case, they can use this method to determine the
incremental cost of producing and selling those units and compare it to the
expected revenue from selling those units.

Overall, this method provides a simplified view of a business’s costs that can be
useful for decision-making and planning.

Advantages of Marginal Costing

Marginal costing offers several advantages to businesses. Here are some of the
key advantages of this costing technique:

Helps in decision-making: Using this method businesses can make informed

decisions about pricing, product mix, and production levels. By calculating the
marginal cost of producing one additional unit, businesses can determine the
profitability of each unit and make decisions accordingly.

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Simple and easy to understand: It is a simple costing method that only
considers variable costs. This makes it easy for managers to understand and use in
decision-making.

Identifies profit drivers: It helps businesses identify the key profit drivers for
their products or services. By focusing on the variable costs associated with each
unit, businesses can identify the factors that drive profitability and focus on
improving those areas.

Improves cost control: It can be used by businesses to monitor and control their
costs closely. By separating fixed and variable costs, businesses can focus on
reducing variable costs and improving efficiency.

Facilitates breakeven analysis: This method is useful in performing breakeven

analysis. By calculating the contribution margin, businesses can determine the
number of units they need to sell to break even.

Overall, this costing technique is useful as it provides businesses with valuable

insights into their costs and profitability. It can help businesses make informed
decisions, improve cost control, and identify the key profit drivers for their
products or services.

Overall, while marginal costing has its limitations and should not be used in
isolation, it can be a valuable tool for businesses seeking to better understand
their costs and profits. It is a useful technique for businesses to analyze the cost
and profitability of their products or services. By separating variable costs from
fixed costs, businesses can more accurately determine the impact of changes in
sales volume on their profits. This can help businesses make better decisions
about pricing, production, and sales strategies.

Disadvantages of Marginal Costing

While this costing method offers several advantages, there are also some
disadvantages that businesses should be aware of. Here are some of the key
disadvantages:

Doesn’t consider all costs: This approach only considers variable costs and
doesn’t consider fixed costs, such as rent and salaries. This can lead to an
incomplete picture of a business’s costs and profitability.

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Can be misleading: It can be misleading in situations where fixed costs are high,
and production levels are low. In such cases, the marginal cost per unit may be
high, which could lead to the incorrect conclusion that the product could be more
profitable.

Difficult to allocate fixed costs: This costing method doesn’t allocate fixed costs
to each unit produced, making it difficult to determine each unit’s cost accurately.

Not suitable for long-term planning: It is primarily a short-term planning tool

and may not be suitable for long-term planning. In the long term, fixed costs may
change and become variable, which could affect the profitability of products.

Doesn’t account for inventory valuation: This method needs to consider the
value of inventory, which can lead to distorted profitability figures.

Overall, while marginal costing has its limitations and should not be used in
isolation, it can be a valuable tool for businesses seeking to better understand
their costs and profits. It is a useful technique for businesses to analyze the cost
and profitability of their products or services. By separating variable costs from
fixed costs, businesses can more accurately determine the impact of changes in
sales volume on their profits. This can help businesses make better decisions
about pricing, production, and sales strategies.

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 04 Budgets and Budgetary Control
The term ‘Budget’ appears to have been derived from the French word ‘baguette’
which means ‘little bag' , or a container of documents and accounts. A budget is
an accounting plan. It is a formal plan of action expressed in monetary terms. It
could be seen as a statement of expected income and expenses under certain
anticipated operating conditions. It is a quantified plan for future activities –
quantitative blue print for action.

Every organization achieves its purposes by coordinating different activities. For

the execution of goals efficient planning of these activities is very important and
that is why the management has a crucial role to play in drawing out the plans for
its business. Various activities within a company should be synchronized by the
preparation of plans of actions for future periods. These comprehensive plans are
usually referred to as budgets. Budgeting is a management device used for short‐
term planning and control. It is not just accounting exercise.

Budgetary Control:

Budgetary Control is a method of managing costs through preparation of

budgets. Budgeting is thus only a part of the budgetary control.

Budgetary control helps to direct capital and energy into the most profitable
channels by classifying expenditure and fixed expenses and variable expenses.
This allows businesses to learn the break-even points for output and sales.

Budgetary control does not merely involve the matching of estimated expenses to
actual expenses. In addition, it involves placing responsibility for failures. The
periodic checking up of income, costs, and expenses related to the administration
of the budget is known as budgetary control.

Objectives

Planning: Detailed plans relating to production, sales, raw‐material requirements,

labour needs, capital additions, etc. are drawn out. By planning many problems
estimated long before they arise and solution can be thought of through careful
study. In short, budgeting forces the management to think ahead, to foresee and
prepare for the anticipated conditions. Planning is a constant process since it
requires constant revision with changing conditions.

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Co‐ordination: Budgeting plays a significant role in establishing and maintaining
coordination. Budgeting assists managers in coordinating their efforts so that
problems of the business are solved in harmony with the objectives of its
divisions.

Efficient planning and business contribute a lot in achieving the targets. Lack ofco‐
ordination in an organization is observed when a department head is permitted to
enlarge the department on the specific needs of that department only, although
such development may negatively affect other departments and alter their
performances.

Thus, co‐ordination is required at all vertical as well as horizontal levels.

Measurement of Success: Budgets present a useful means of informing

managers how well they are performing in meeting targets they have previously
helped to set. In many companies, there is a practice of rewarding employees on
the basis of their accomplished low budget targets or promotion of a manager is
linked to his budget success record. Success is determined by comparing the past
performance with a previous period's performance.

Motivation: Budget is always considered a useful tool for encouraging managers

to complete things in line with the business objectives. If individuals have
intensely participated in the preparation of budgets, it acts as a strong motivating
force to achieve the goals.

Communication: A budget serves as a means of communicating information

within a firm. The standard budget copies are distributed to all management
people that provides not only sufficient understanding and knowledge of the
programmes and guidelines to be followed but also gives knowledge about the
restrictions to be adhered to.

Control: Control is essential to make sure that plans and objectives laid down in
the budget are being achieved. Control, when applied to budgeting, as a
systematized effort is to keep the management informed of whether planned
performance is being achieved or not.

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Advantages

1. This system provides basic policies for initiatives.

2. It enables the management to perform business in the most professional

manner because budgets are prepared to get the optimum use of resources and
the objectives framed.

3. It ensures team work and thus encourages the spirit of support and mutual
understanding among the staff.

4. It increases production efficiency, eliminates waste and controls the costs.

5. It shows to the management where action is needed to remedy a position.

6. Budgeting also aids in obtaining bank credit.

7. It reviews the present situation and pinpoints the changes which are necessary.

8. With its help, tasks such as like planning, coordination and control happen
effectively and efficiently.

9. It involves an advance planning which is looked upon with support by many

credit agencies as a marker of sound management.

Limitations

1. It tends to bring about rigidity in operation, which is harmful. As budget

estimates are quantitative expression of all relevant data, there is a tendency to
attach some sort of rigidity or finality to them.

2. It being expensive is beyond the capacity of small undertakings. The

mechanism of budgeting system is a detailed process involving too much time
and costs.

3. Budgeting cannot take the position of management but it is only an instrument

of management. ‘The budget should be considered not as a master, but as a
servant.’ It is totally misconception to think that the introduction of budgeting
alone is enough to ensure success and to security of future profits.

4. It sometimes leads to produce conflicts among the managers as each of them

tries to take credit to achieve the budget targets.

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5. Simple preparation of budget will not ensure its proper implementation. If it is
not implemented properly, it may lower morale.

6. The installation and function of a budgetary control system is a costly affair as it

requires employing the specialized staff and involves other expenditure which
small companies may find difficult to incur.

Types of Budget: Classification of Budget

Functional Classification:

a) Sales Budget
b) Production Budget
c) Raw Materials Budget
d) Purchase Budget
e) Labour Budget
f) Production Overhead Budget
g) Selling & Distribution Budget
h) Administration Cost Budget
i) Capital Expenditure Budget
j) Cash Budget

Sales Budget:

The sales budget is an estimate of total sales which may be articulated in financial
or quantitative terms. It is normally forms the fundamental basis on which all
other budgets are constructed. In practice, quantitative budget is prepared first
then it is translated into economic terms. While preparing the Sales Budget, the
Quantitative Budget is generally the starting point in the operation of budgetary
control because sales become, more often than not, the principal budget factor.

The factor to be consider in forecasting sales are as follows:

a) Study of past sales to determine trends in the market.

b) Estimates made by salesman various markets of company products.
c) Changes of business policy and method.
d) Government policy, controls, rules and Guidelines etc.
e) Potential market and availability of material and supply.

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Production Budget:

The production budget is prepared on the basis of estimated production for

budget period.

Usually, the production budget is based on the sales budget. At the time of
preparing the budget, the production manager will consider the physical facilities
like plant, power, factory space, materials and labour, available for the period.
Production budget envisages the production program for achieving the sales
target. The budget may be expressed in terms of quantities or money or both.
Production may be computed as follows:

Units to be produced = Desired closing stock of finished goods + Budgeted sales

– Beginning stock of finished goods.

Production Cost Budget:

This budget shows the estimated cost of production. The production budget
demonstrates the capacity of production. These capacities of production are
expressed in terms of cost in production cost budget. The cost of production is
shown in detail in respect of material cost, labour cost and factory overhead. Thus
production cost budget is based upon Production Budget, Material Cost Budget,
Labour Cost Budget and Factory overhead.

Raw‐Material Budget:

Direct Materials budget is prepared with an intention to determine standard

material cost per unit and consequently it involves quantities to be used and the
rate per unit. This budget shows the estimated quantity of all the raw materials
and components needed for production demanded by the production budget.
Raw material serves the following purposes:

a) It supports the purchasing department in scheduling the purchases.

b) Requirement of raw‐materials is decided on the basis of production budget.

c) It provides data for raw material control.

d) Helps in deciding terms and conditions of purchase like credit purchase, cash
purchase, payment period etc.

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It should be noted that raw material budget generally deals with only the direct
materials whereas indirect materials and supplies are included in the overhead
cost budget.

Purchase Budget:

Strategic planning of purchases offers one of the most important areas of

reduction cost in many concerns. This will consist of direct and indirect material
and services. The purchasing budget may be expressed in terms of quantity or
money.

The main purposes of this budget are:

a) It designates cash requirement in respect of purchase to be made during

budget period; and

b) It is facilitates the purchasing department to plan its operations in time in

respect of purchases so that long term forward contract may be organized.

Labour Budget:

Human resources are highly expensive item in the operation of an enterprise.

Hence, like other factors of production, the management should find out in
advance personnel requirements for various jobs in the enterprise. This budget
may be classified into labour requirement budget and labour recruitment budget.
The labour necessities in the various job categories such as unskilled, semi‐skilled
and supervisory are determined with the help of all the head of the departments.
The labour employment is made keeping in view the requirement of the job and
its qualifications, the degree of skill and experience required and the rate of pay.

Production Overhead Budget:

The manufacturing overhead budget includes direct material, direct labour and
indirect expenses. The production overhead budget represents the estimate of all
the production overhead i.e. fixed, variable, and semi‐variable to be incurred
during the budget period.

The reality that overheads include many different types of expenses creates
considerable problems in:

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1) Fixed overheads i.e., that which is to remain stable irrespective of vary in the
volume of output,

2) Apportion of manufacturing overheads to products manufactured, semi

variable cost i.e., those which are partly variable and partly fixed.

3) Control of production overheads.

4) Variable overheads i.e., that which is likely to vary with the output.

The production overhead budget engages the preparation of overheads budget

for each division of the factory as it is desirable to have estimates of
manufacturing overheads prepared by those overheads to have the responsibility
for incurring them. Service departments cost are projected and allocated to the
production departments in the proportion of the services received by each
department.

Selling and Distribution Cost Budget:

The Selling and Distribution Cost budget is estimating of the cost of selling,
advertising, delivery of goods to customers etc. throughout the budget period.
This budget is closely associated to sales budget in the logic that sales forecasts
significantly influence the forecasts of these expenses. Nevertheless, all other
linked information should also be taken into consideration in the preparation of
selling and distribution budget. The sales manager is responsible for selling and
distribution cost budget. Naturally, he prepares this budget with the help of
managers of sub‐divisions of the sales department. The preparation of this budget
would be based on the analysis of the market condition by the management,
advertising policies, research programs and many other factors. Some companies
prepare a separate advertising budget, particularly when spending on
advertisements are quite high.

Administration Cost Budget:

This budget includes the administrative costs for non‐manufacturing business

activities like director’s fees, managing directors’ salaries, office lightings, heating
and air condition etc.

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Most of these expenses are fixed so they should not be too difficult to forecast.
There are semi‐variable expenses which get affected by the expected rise or fall in
cost which should be taken into account. Generally, this budget is prepared in the
form of fixed budget.

Capital‐ Expenditure Budget:

This budget stands for the expenditure on all fixed assets for the duration of the
budget period. This budget is normally prepared for a longer period than the
other functional budgets. It includes such items as new buildings, land, machinery
and intangible items like patents, etc. This budget is designed under the
observation of the accountant which is supported by the plant engineer and other
functional managers.

At the time of preparation of the budget some important information should be

observed:

a) Overfilling on the production facilities of certain departments as revealed by

the plant utilization budget.

b) Long‐term business policy with regard to technical developments.

c) Potential demand for certain products.

Cash Budget:

The cash budget is a sketch of the business estimated cash inflows and outflows
over a specific period of time. Cash budget is one of the most important and one
of the last to be prepared. It is a detailed projection of cash receipts from all
sources and cash payments for all purposes and the resultants cash balance
during the budget. It is a mechanism for controlling and coordinating the fiscal
side of business to ensure solvency and provides the basis for forecasting and
financing required to cover up any deficiency in cash. Cash budget thus plays
avital role in the financing management of a business undertaken.

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Cash budget assists the management in determining the future liquidity
requirements of the firm, forecasting for business of those needs, exercising
control over cash. So, cash budget thus plays a vital role in the financial
management of a business enterprise.

Function of Cash Budget:

a) It makes sure that enough cash is available when it is required.

b) It designates cash excesses and shortages so that steps may be taken in

time to invest any excess cash or to borrow funds to meet any shortages.

c) It shows whether capital expenditure could be financed internally.

d) It provides funds for standard growth.

e) It provides a sound basis to manage cash position.

Classification on Flexibility

a) Fixed Budget
b) Flexible Budget

Fixed Budget:

A fixed budget is prepared for one level of output and one set of condition. This is
a budget in which targets are tightly fixed. It is known as a static budget. It is firm
and prepared with the assumption that there will be no change in the budgeted
level of motion. Thus, it does not provide room for any modification in
expenditure due to the change in the projected conditions and activity. Fixed
budgets are prepared well in advance.

This budget is not useful because the conditions go on the changing and cannot
be expected to be firm. The management will not be in a position to assess, the
performance of different heads on the basis of budgets prepared by them
because to the budgeted level of activity. It is hardly of any use as a mechanism of
budgetary control because it does not make any difference between fixed, semi‐
variable and variable costs and does not provide any space for alteration in the
budgeted figures as a result of change in cost due to change in the level of
activity.

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Fixed budget can be revised in the light of changing situations, yet the rigidity
and control over costs and expenses would be lost in such cases. Fixed budgets
should be prepared only where sales, production and costs can be accurately
estimated.

Flexible Budget:

This is a dynamic budget. In comparison with a fixed budget, a flexible budget is

one “which is designed to change in relation to the level of activity attained.” The
underlying principle of flexibility is that a budget is of little use unless cost and
revenue are related to the actual volume of production. The statistics range from
the lowest to the highest probable percentages of operating activity in relation to
the standard operating performance. Flexible budgets are a part of the feed
advance process and as such are a useful part of planning. An equally accurate
use of the flexible budgets is for the purposes of control.

Flexible budgeting has been developed with the objective of changing the budget
figures so that they may correspond with the actual output achieved. It is more
sensible and practical, because changes expected at different levels of activity are
given due consideration. Thus a budget might be prepared for various levels of
activity in accord with capacity utilization.

Flexible budget may prove more useful in the following conditions:

a) Where the level of activity varies from period to period.

b) Where the business is new and as such it is difficult to forecast the

demand.

c) Where the organization is suffering from the shortage of any factor of

production. For example, material, labour, etc. as the level of activity depends
upon the availability of such a factor.

d) Where the nature of business is such that sales go on changing.

e) Where the changes in fashion or trend affects the production and sales.

f) Where the organization introduces the new products or changes the

patterns and designs of its products frequently. Where a large part of
output is intended for the export.

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Classification on Time Budget

With regard to time, budgets may be classified into four categories:

(a) Long‐term Budget: These budgets are prepared on the basis of long‐term
projection and portray a long‐range planning. These budgets generally cover
plans for three to ten years. In this regard it is mostly prepared in terms of
physical quantities rather than in monetary values.

(b) Short‐term Budget: In this budget forecasts and plans are given in respect of
its operations for a period of about one to five years. They are generally prepared
in monetary units and are more specific than long‐term budgets.

(c) Current Budgets: These budgets cover a very short period, may be a month
or a quarter or maximum one year. The preparation of these budgets requires
adjustments in short‐term budgets to current conditions.

(d) Rolling Budgets: A few companies follow the practice of preparing a rolling
or progressive budget. In this case companies prepare the budget for a year in
advance. A new budget is prepared after the end of each month or quarter for a
full year in advance. The figures for the month or quarter which has rolled down
are dropped and the statistics for the next month or quarter are added.

Performance Budgeting (PB):

Performance budgeting is a budgeting system, which involves the assessment of

the performance of the business, and both its specific and overall objectives. It
gives clarity about organizational objectives and provides an exact direction to
each employee in the business.

The term performance implies results or outputs. ‘ A performance budget is one

which presents the purposes and objectives for which funds are required, the
costs of the programmes proposed for achieving those objectives, and
quantitative data measuring the accomplishments and work performed under
programme. Thus, PB is a technique of presenting budgets for costs and revenues
in terms of functions, programmes and activities and correlating the physical and
financial aspects of the individual items comprising the budget.

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As per the National Institute of Bank Management, PB technique is, "the process
of analyzing, identifying, simplifying and crystallizing specific performance
objectives of a job to be achieved over a period in the framework of the
organizational objectives, the purpose and objectives of the job. The technique is
characterized by its specific direction towards the business objectives of the
organization." As a result, performance budget accentuates the execution of
specific goals over a period of time.

Steps in Performing Budgeting (PB):

a) Establishment of performance targets

b) Establishment of responsibility centre
c) Estimating financial requirements
d) Comparison of actual with budgeted performance
e) Reporting and action

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 List of Books compiled by The Banking Tutor
So far the following Books are compiled by me which can be shared by any one
free of cost, without any permission from me or without any intimation to me.

Book No Title

01 Banking Jargon - Vol 01

02 Alerts - Vol 01

03 Forex - Vol 01

04 Banker and Legal Enactments - Vol 01

05 Banker and Financial Statements

06 Confusables – Vol 01

07 Banking Jargon - Vol 02

08 ABC (Awareness of Basics of Credit)

09 The Can Support_2020

10 The Core Support_2020

11 The Sundries_2020

12 The Soft Support

13 Management of W C Limits

14 The Notes_2021 (for Promotion Test)

15 Confusables - Vol 02

16 Banking Information

17 Banking Jargon - Vol 03

18 Bankers and Court Verdicts - Vol 01

19 Inland Bank Guarantees

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20 The Dirty Dozen

21 SPA (Not related to Banking)

22 Banks - Supporting Agencies - Vol 01

23 Banking Jargon - Volume 4

24 Banks - Supporting Agencies - Vol 2

25 Banks - Supporting Agencies - Vol 3

26 JAIIB Notes - PPB

27 JAIIB Notes - LRB

28 JAIIB Notes – AFB

29 CAIIB Notes – ABM

30 CAIIB Notes – BFM

31 Confusables - Vol 03

32 Banking Jargon - Vol 05

33 The Banking Regulations & Business Laws (BRBL)

34 Accounting & finance for Bankers

35 Bank Financial Management

36 Retail Banking & Wealth Management

37 Concepts for Credit Professional - OT

38 Advance Business Management

39 Principles & Practice of Banking

40 Indian Economy & Indian Financial System - OT

41 Concepts for Credit Professional - Notes

42 Less Known Forex Terminology

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43 KYC & AML – Notes & MCQ

44 Treasury Management - Objective Type

45 Treasury Management - Notes

46 Indian Economy & Indian Financial System - Notes

47 MSME -Notes

48 MSME – Objective Type

49 Banking Jargon – Volume 06

50 50 Essays in Practical Banking

51 Promotion 2022

52 Basics of Bank Audits

53 The Shortens

54 Recap TIN 2022

55 NumLogEx

56 Basic Statistics for Bankers

57 JAIIB IE & IFS - Module A : Indian Economic Architecture

58 JAIIB IE & IFS - Module B : Economic Concepts Related to Banking

59 JAIIB IE & IFS - Module C : Indian Financial Architecture

60 JAIIB IE & IFS - Module D : Financial Products and Services

61 Banking Jargon – Volume 07

62 JAIIB – PPB – Module A - General Banking Operations

63 JAIIB 2023 – IE & IFS – Objective Type

64 JAIIB Notes 2023 - PPB - Mod B - Functions of Banks

65 JAIIB Notes 2023 - PPB - Mod C - Technology and Mod D - Ethics

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66 JAIIB 2023 – PPB – Objective Type

67 JAIIB 2023 – AFM - Notes

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 My Activity
I am sharing the following in my WhatsApp Groups (The Banking
Tutor), Telegram Group of The Banking Tutor ; TBT Exam Corner
and Blog (The Banking Tutor - TBT).

1. One Point related to Banking & Finance Daily (Daily Point).

Started on 16-09-2019, so far shared 1317 points without any
break.

2. Once 3 days (on 3rd, 6th, 9th ,12th….) one Lesson on Banking
& Finance (Banking Tutor’s Lessons - BTL), started on 06-09-
2018, so far shared 537 lessons.

3. Monthly Last day - TIN - Terms in News (related to Banking &

Finance). Started on 28-02-2021, so far shared 26 issues.

4. Monthly First Day – Recap of Daily Points shared during the

previous month.
5. Sharing lessons for IIB Exams and Promotion tests of various
Banks daily in Telegram Group “TBT- Exam Corner” (earlier Name
of this Group is “TBT JACA”)
My mail id – [email protected] ;

WhatsApp +91 94406 41014

Banking Tutor Blog – https://thebankingtutor.blogspot.com/
24-04-2023 Sekhar Pariti

+91 9440641014

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