Category: Bangalore University B.com Notes

Risk management encompasses the identification, analysis, and response to risk factors that form part of the life of a business. Effective risk management means attempting to control, as much as possible, future outcomes by acting proactively rather than reactively. Therefore, effective risk management offers the potential to reduce both the possibility of a risk occurring and its potential impact.

Risks Management Structures

Risk management structures are tailored to do more than just point out existing risks. A good risk management structure should also calculate the uncertainties and predict their influence on a business. Consequently, the result is a choice between accepting risks or rejecting them. Acceptance or rejection of risks is dependent on the tolerance levels that a business has already defined for itself.

Risk Management in Indian banks is a relatively newer practice but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. In times of volatility and fluctuations in the market, financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Hence, an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Thus, the need for an efficient risk management framework is paramount to factor in internal and external risks.

Total Impact of Risk

Total impact of the risk (TIR) occurring would entail as the impact (I), the risk would cause multiplied by the Risk Ratio. It is essentially how much a bank would be impacted in the chance that the risk did occur. This essentially helps ascertain what is the total value of their investments that may be subject to risk and how it would impact them.

TIR = I × RR

Types of Risk

Types of Risks in Banking

The term Risk and the types associated to it would refer to mean financial risk or uncertainty of financial loss. The Reserve Bank of India guidelines issued in Oct. 1999 has identified and categorized the majority of risk into three major categories assumed to be encountered by banks. These belong to the clusters:

• Credit risk
• Market risk
• Operational risk

The type of risks can be fundamentally subdivided in primarily of two types, i.e. Financial and Non-Financial Risk. Financial risks would involve all those aspects which deal mainly with financial aspects of the bank. These can be further subdivided into Credit Risk and Market Risk. Both Credit and Market Risk may be further subdivided.

Non-Financial risks would entail all the risk faced by the bank in its regular workings, i.e. Operational risk, Strategic risk, Funding risk, Political risk, and Legal risk.

If a business sets up risk management as a disciplined and continuous process for the purpose of identifying and resolving risks, then the risk management structures can be used to support other risk mitigation systems. They include planning, organization, cost control, and budgeting. In such a case, the business will not usually experience many surprises, because the focus is on proactive risk management.

Response to Risks

Response to risks usually takes one of the following forms:

• Avoidance: A business strives to eliminate a particular risk by getting rid of its cause.
• Mitigation: Decreasing the projected financial value associated with a risk by lowering the possibility of the occurrence of the risk.
• Acceptance: In some cases, a business may be forced to accept a risk. This option is possible if a business entity develops contingencies to mitigate the impact of the risk, should it occur.

When creating contingencies, a business needs to engage in a problem-solving approach. The result is a well-detailed plan that can be executed as soon as the need arises. Such a plan will enable a business organization to handle barriers or blockage to its success, because it can deal with risks as soon as they arise.

Importance of Risk Management

Risks management is an important process because it empowers a business with the necessary tools so that it can adequately identify and deal with potential risks. Once a risk’s been identified, it is then easy to mitigate it. In addition, risk management provides a business with a basis upon which it can undertake sound decision-making.

For a business, assessment and management of risks is the best way to prepare for eventualities that may come in the way of progress and growth. When a business evaluates its plan for handling potential threats and then develops structures to address them, it improves its odds of becoming a successful entity.

In addition, progressive risk management ensures risks of a high priority are dealt with as aggressively as possible. Moreover, the management will have the necessary information that they can use to make informed decisions and ensure that the business remains profitable.

Other important benefits of risk management include:

• Creates a safe and secure work environment for all staff and customers.
• Increases the stability of business operations while also decreasing legal liability.
• Provides protection from events that are detrimental to both the company and the environment.
• Protects all involved people and assets from potential harm.
• Helps establish the organization’s insurance needs in order to save on unnecessary premiums.

The importance of combining risk management with patient safety has also been revealed. In most hospitals and organizations, the risk management and patient safety departments are separated; they incorporate different leadership, goals and scope. However, some hospitals are recognizing that the ability to provide safe, high-quality patient care is necessary to the protection of financial assets and, as a result, should be incorporated with risk management.

Risk Analysis Process

Risks analysis is a qualitative problem-solving approach that uses various tools of assessment to work out and rank risks for the purpose of assessing and resolving them. Here is the risk analysis process:

1. Identify existing risks

Risk identification mainly involves brainstorming. A business gathers its employees together so that they can review all the various sources of risk. The next step is to arrange all the identified risks in order of priority. Because it is not possible to mitigate all existing risks, prioritization ensures that those risks that can affect a business significantly are dealt with more urgently.

2. Assess the risks

In many cases, problem resolution involves identifying the problem and then finding an appropriate solution. However, prior to figuring out how best to handle risks, a business should locate the cause of the risks by asking the question, “What caused such a risk and how could it influence the business?”

3. Develop an appropriate response

Once a business entity is set on assessing likely remedies to mitigate identified risks and prevent their recurrence, it needs to ask the following questions: What measures can be taken to prevent the identified risk from recurring? In addition, what is the best thing to do if it does recur?

4. Develop preventive mechanisms for identified risks

Here, the ideas that were found to be useful in mitigating risks are developed into a number of tasks and then into contingency plans that can be deployed in the future. If risks occur, the plans can be put to action.

Conclusion

Our business ventures encounter many risks that can affect their survival and growth. As a result, it is important to understand the basic principles of risk management and how it can be used to help mitigate the effects of risks on business entities.

Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period.

Marginal costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost. In marginal costing, costs are classified into fixed and variable costs.

The concept of marginal costing is based on the behaviour of costs that vary with the volume of output. Marginal costing is known as ‘variable costing’, in which only variable costs are accumulated and cost per unit is ascertained only on the basis of variable costs. Sometimes, marginal costing and direct costing are treated as interchangeable terms.

The major difference between these two is that, marginal cost covers only those expenses which are of variable nature whereas direct cost may also include cost which besides being fixed in nature identified with cost objective.

Contribution of Marginal Costing:

In marginal costing, costs are classified into fixed and variable costs. The concept marginal costing is based on the behaviour of costs with volume of output. From this approach, it is not possible to identify an amount of net profit per product, but it is possible to identify the amount of contribution per product towards fixed overheads and profits. The contribution is the difference between sales volume and the marginal cost of sales.

In marginal costing it is not possible to determine the profit per unit of product because fixed overheads are charged in total to the profit and loss account rather than recovered in product costing. Contribution is a pool of amount from which total fixed costs will be deducted to arrive at the profit or loss.

The distinction between contribution and profit is given below:

Contribution:

1. It includes fixed cost and profit.
2. Marginal costing technique uses the concept of contribution.
3. At break-even point, contribution equals to fixed cost.
4. Contribution concept is used in managerial decision making.

Profit:

1. It does not include fixed cost.
2. Profit is the accounting concept to determine profit or loss of a business concern.
3. Only the sales in excess of break-even point results in profit.
4. Profit is computed to determine the profitability of product and the concern.

Formulas used in Marginal Costing:

Sales — Variable cost + Fixed cost + Profit

Sales – Variable cost = Contribution

Sales – Variable cost = Fixed cost + Profit

Contribution = Fixed cost + Profit

Contribution – Fixed cost = Profit

Features of Marginal Costing

(a) All costs are categorized into fixed and variable costs. Variable cost per unit is same at any level of activity. Fixed costs remain constant in total regardless of changes in volume.

(b) Fixed costs are considered period costs and are not included in product cost, only variable costs are considered as product costs.

(c) Stock of work-in-progress and finished goods are valued at marginal cost of production.

(d) In marginal process costing, products are transferred from one process to another are valued at marginal costs only.

(e) Prices are determined with reference to marginal cost and contribution margin.

(f) Profitability of departments, products etc. is determined with reference to their contribution margin.

(g) In accounting, marginal cost, the overhead control account in the cost ledger represents only the variable overhead. Fixed costs are taken as expenses in the profit and loss account and thus excluded from costs.

(h) Presentation of data is oriented to highlight the total contribution and contribution from each product.

(i) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production since all the product costs are variable costs.

Arguments in Favour of Marginal Costing:

(a) Fixed costs are period costs in nature and it should be charged to the concerned period irrespective of the quantum or level of production or sale.

(b) Inclusion of fixed costs in the product cost distorts the comparability of products at different volumes and disturbs control actions. It highlights the significance of fixed costs on profits. In a highly competitive situation, it may be wise to take an order which covers marginal costs and makes some contribution towards fixed costs, rather than loose the order.

(c) The difficulty in apportionment and absorption of fixed costs to product cost will not exist in contribution approach and it is much easier for accounting and determination of product costs.

(d) Marginal cost method is simple in application and is easy for exercise of cost control. It is more informative and simple to understand.

(e) It helps the management with more appropriate information in taking vital business decisions like make or buy, subcontracting, export order pricing, pricing under recession, continue or discontinue a product/division, selection of suitable product mix etc.

(f) Profit-volume analysis is facilitated by the use of break-even charts and profit-volume graphs, and so on.

(g) The analysis of contribution per key factor or limiting resource is a useful aid in budgeting and production planning.

(h) Pricing decisions can be based on the contribution levels of individual products.

(i) The profit and loss statement is not distorted by changes in stock levels. Stock valuations are not burdened with a share of fixed overhead, so profits reflect sales volume rather than production volume.

(j) Responsibility accounting is more effective when based on marginal costing because managers can identify their responsibilities more clearly when fixed overhead is not charged arbitrarily to their departments or divisions.

Criticism against Marginal Costing:

(a) Difficulty may be experienced in trying to separate fixed and variable elements of overhead costs. Unless this can be done with reasonable accuracy, marginal costing cannot be very accurate. Application of common sense and judgment will be necessary.

(b) The misuse of marginal costing approach may result in setting selling prices which do not allow for the full recovery of overhead. This may be most likely in times of depression or increasing competitors when prices set to undercut competitors may not allow for a reasonable contribution margin.

(c) The main assumption of marginal costing is that variable cost per unit will be same at any level of activity. This is only partly true within a limited range of activity. With a major change in activity there may be considerable change in the rates and prices of men, material due to shortage of material, shortage of skilled labour, concessions of bulk purchase, increased transportation costs, changes in productivity of men and materials etc.

(d) The assumption that fixed costs remain constant in total regardless of changes in volume will be correct up to a certain level of output. Some fixed costs are liable to change from one period to another. For example, salaries bill may go up because of annual increments or due to change in the pay rates and due to pay structure. If there is a substantial drop in activity, management may take immediate action to cut the fixed costs by retrenchment of staff, renting of office-premises, warehouses taken on lease may be given-up etc.

(e) Increased automation and mechanization has resulted the reduction in labour costs and increased fixed costs like installation, maintenance and operation costs, depreciation of machinery. The use of marginal costing creates a tendency to disregard the need to recover cost through product pricing. For long-run continuity of the business, it is not good. Assets have to be replaced in the long-run.

(f) Exclusion of fixed overheads from costs may lead to erroneous conclusions. It may create problems in inter-firm comparison, higher demand for salaries and other benefits by employees, higher demand for tax by the Government authorities etc.

(g) The exclusion of fixed overhead from inventory cost does not constitute an accepted accounting procedure and, therefore adherence to marginal costing will involve deviation from accepted accounting practices.

(h) The income-tax authorities do not recognize the marginal cost for inventory valuation.

Absorption Costing and Marginal Costing: Impact on Profit

In absorption costing, stock is valued at total cost while in marginal costing stock valuation is done at variable cost only. This means that in absorption costing, stock valuation is higher than in marginal costing. When production exceeds sales, profit under absorption costing is higher than that of marginal costing. But when sales exceed production, profit under absorption costing is lower than that of marginal costing.

Absorption costing is a principle whereby fixed, as well as, variable costs are allotted to cost units and total overheads are absorbed according to activity level. Absorption costing confirms with the accrual concept by matching costs with revenue for a particular accounting period. Stock valuation complies with the accounting standard and fixed production costs are absorbed into stocks.

Absorption costing method avoids separation of costs into fixed and variable elements, which is not easily and accurately achieved. Cost plus pricing under absorption costing ensures that all costs are covered.

Pricing at the marginal cost may, in the long-run, result in failing to cover the fixed costs. It is important to note that in absorption costing sales must be equal to or exceed the budgeted level of activity otherwise fixed costs will be under absorbed.

The absorption of production overheads under absorption costing has the following impacts:

(i) When production exceeds sales during the period, a higher profit is shown under absorption costing, since the fixed overhead is absorbed over more number of units produced, and carried to next accounting period along with closing inventory.

(ii) When sales are in excess of production, a lower profit is reported under absorption costing. Since, less portion of fixed production overhead is recovered in valuation of closing stock and current period’s cost of production is higher.

The following generalizations to be made on the impact on profit of these two different methods of costing:

(a) Where sales and production levels are constant through time, profit is the same under the two methods.

(b) Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.

(c) Where sales are constant but production fluctuates, marginal costing provides for constant profit, whereas under absorption costing, profit fluctuates.

(d) Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold.

(e) Where sales exceeds production, profit is higher under marginal costing. The fixed costs, which previously were part of stock values, are now charged against revenue under absorption costing. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than that incurred for the period.

The choice between using absorption costing and marginal costing will be determined by the following factors:

(a) The system of financial control in use e.g., responsibility accounting is inconsistent with absorption costing.

(b) The production methods in use e.g., marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely differing amounts of attention, the absorption costing may be more realistic.

(c) The significance of prevailing level of fixed overhead costs.

Advantages

(i) The technique is simple to understand and easy to operate because it avoids the complexities of apportionment of fixed costs which, is really, arbitrary.

(ii) It also avoids the carry forward of a portion of the current period’s fixed overhead to the subsequent period. As such cost and profit are not vitiated. Cost comparisons become more meaningful.

(iii) The technique provides useful data for managerial decision-making.

(iv) There is no problem of over or under-absorption of overheads.

(v) The impact of profit on sales fluctuations are clearly shown under marginal costing.

(vi) The technique can be used along with other techniques such as budgetary control and standard costing.

(vii) It establishes a clear relationship between cost, sales and volume of output and break­even analysis.

(viii) It shows the relative contributions to profit which are made by each of a number of products, and shows where the sales effort should be concentrated.

(ix) Stock of finished goods and work-in-progress are valued at marginal cost, which is uniform.

Limitations

(i) Segregation of costs into fixed and variable elements involves considerable technical difficulty.

(ii) The linear relationship between output and variable costs may not be true at different levels of activity. In reality, neither the fixed costs remain constant nor do the variable costs vary in proportion to the level of activity.

(iii) The value of stock cannot be accepted by taxation authorities since it deflates profit.

(iv) This technique cannot be applied in the case of contract costing where the value of work-in-progress will always be high.

(v) This technique also cannot be used in the case of cost plus contracts unless fixed costs and profits are considered.

(vi) Pricing decisions cannot be based on contribution alone.

(vii) The elimination of fixed costs renders cost comparison of jobs difficult.

(viii) The distinction between fixed and variable costs holds good only in the short run. In the long run, however, all costs are variable.

 (ix) With the increased use of automatic machinery, the proportion of fixed costs increases. A system which ignores fixed costs is, therefore, less effective.

(x) The technique need not be considered to be unique from the point of cost control.

Applications

The following are the 4 applications of marginal costing:

1. Cost control: in marginal costing there is fixed cost as well as variable cost . fixed cost is controlled by top management and variable cost is controlled by lower management. Sometimes there are the cases when profit decreases even when sale increases in such situations marginal cost helps the concern in finding out the reasons.
2. Evaluation of performance: it helps in evaluating the performance of each sector of concern.
3. Profit planning: profit increased and decreased due to change in selling price, variable cost etc. marginal cost helps in profit planning.
4. Decision making: marginal cost helps in short-term decision-making. Like:

a) Fixing the selling price: Selling price must be equal to the marginal cost. If selling price is more than the marginal cost then there will be loss.

b) Key factor: A factor which puts limit on the production and profit of the business is called key or limiting factor. A company is not able to sell all its production. Sometimes a company can sell all its produces and sometimes not. So choice has to be made regarding whose production has to be increased or who’s decreased.

c) Make or buy decision: It is better for the company to use its idle capacity and produce component parts in the factory itself rather than buying them from the market. If its cost is less than it is better to make it in the factory.

d) Selection of good product mix: This happens in the case when company is producing number of products in that case it is better to select a good product mix which gives more of profit.

e) Effect of change in sale price: Management must be aware of the effect of change in price and make necessary changes from time to time.

f) Closing down activities: Sometimes it becomes necessary for the management to close or suspend some activities of a particular product.

g) Alternative method of production: Marginal costing is helpful in knowing which alternative method of production is to be selected.

h) At the end while selecting alternative course of action management must maintain desired level of profit.

Concept of budget

According to CIMA, London, budget is described as financial and quantitative statement prepared and approved prior to defined period of time, of the policy to be pursued during that period for the purpose of accomplishing a given objective. It may include income, expenditure and employment of capital. In other words, budget refers to a plan covering all the sectors of operations expressed in monetary or quantitative terms for a definite future period.

A budget can be made for a person, family, and group of people, business, government, country, multinational organization or for any thing that makes and spends money. Budget facilitates people to vigilantly look at how much money they are taking in during a given period, and work out the best way to divide it among various categories. When making a personal budget, an individual will normally assign the appropriate amount of money to fixed expenses such as rent, car payments, or utility bills, and then make an educated estimation for how much money they will spend in other categories, such as groceries, clothing, or entertainment.

Batty explained that the entire process of preparing the budget is known as budgeting. Therefore the term budgeting refers to the act of preparing budget (Bhattacharyya, 2011). In technical view, a budget is a statement that includes a conjecture of revenues and expenditures for a period of time, generally a year. It is a broad plan of action intended to accomplish the policy objectives set by the government for the coming year. A budget is a plan and a budget document is a manifestation of the government actions in future. While any plan need not be a budget, a budget has to be necessarily a plan. It explains detailed and location of resources and pro production and taxation or other method for their understanding. More explicitly, a budget contains information about plans, programmes, projects, schemes and activities-current as well as new proposals for the coming year, resource position and income from different sources, including tax and non-tax revenues, actual receipts and expenditure for the previous year; and economic, statistical and accounting data regarding financial and physical performance of the various agencies and organs of the government.

Many persons, corporations and governments plan their financial actions by preparing budgets. In order to get huge success in business area, an organization must plan its financial activities well in advance. It must assess its income and expenditures using historical data of activities in the past and predict future trends. The budget as explained by numerous experts is not just a financial plan that sets forth cost and revenue goals but it is an effective tool for controlling, synchronization, communication, enthusiasm and performance measurement.

Attributes of budget:

A budget must have following features :

1. It should reflect the managerial plans and policies to accomplish business goals and objectives.
2. It must be expressed in monetary or quantitative terms or both.
3. It is comprehensive plan for definite future period.
4. Though it is basically an instrument of planning, it still provides the basis for performance evaluation.

Classification of Budgets

Budget is generally categorized on the basis of the need of respective organization. Preparation of budget may be required by organization for the purpose of its flexibility of production or its functions involved or for the purpose of its period covered.

Classification of budget on the basis of period: On the basis of period, or time covered in budget, it is grouped into short term and long term budget. When budget is prepared for business activity covering a period of more than one year, it is called long term budget. . When budget is prepared for business activity covering a period of one year or less, it is termed as short term budget such as for sales, cash.

Classification of budget on the basis of flexibility of production: In this category, budget is classified into three parts that include fixed, flexible and current budget. Fixed budget is prepared for particular level of production. Flexible budget include series of budgets prepared in respect of different levels of activity during a budget period. Current budget is associated with current business activities of a concern and is prepared under current condition for a very short period.

Classification of budget on the basis of function and coverage: In this heading, budget is grouped into three parts such as operating, financial and master budget. Operating budget is related to different activities of concern. It is a plan of expected revenues and cost. This budget has three categories that include production, cost and sales budget. Financial budgets of function and coverage is associated with all expected financial transactions that are to be incurred during budget period. This is classified into cash and capital expenditure budget. Master budget is the summary of all financial budgets. This budget includes sales budget, production budget, cost budget, cash budget, projected income statement, and projected balance sheet.

Figure: Classification of budget:

The Concept of Budgetary Control

Budgetary control is a method to control costs which includes the preparation of budgets. Budgeting is only a part of the budgetary control. Chartered Institute of Management Accountants explained Budgetary Control as “the establishment of the budgets relating to the responsibilities of the executive to meet the objective of an organization and the continuous comparison of actual with budgeted estimates so that if remedial is necessary it may be taken at an early stage”. CIMA London elucidated that budgeting control is establishment of budgets relating to the responsibilities of executives of a policy and the continuous comparison of actual with budgeted results either to secure by individual action objective of the policy or to provide a basis for its revision. It can be established that budgeting control is a technique of control under which budgets are prepared at first for all business activities of an organization and actual performance of all those business activities are compared with the respective budgeted data so that corrective measures can be taken for any adverse deviation from the budget.

Other experts described it as a continuous process which reviews and adjusts budgetary targets during the financial year and produces a control mechanism to hold budget holder to account. This signifies that budgetary control is a system that encompasses the complete process starting from the preparation of the budget or the action plan, covering monitoring and review culminating in counteractive action.

The characteristics of budgetary control are as follows:

1. Establish target of performance/budget
2. Record the actual performance
3. Compare the actual performance with the budgeted
4. Establish the differences and analyse the reason
5. Act immediately for corrective actions.

Objectives of budgetary control:

Planning: A budget provides a comprehensive plan of action for activities over a definite period of time. Planning helps to anticipate many problems long before they arrive and solutions wanted through careful study.

Next is to coordinate: Budgeting helps managers in coordinating their efforts so that objectives of the organization are synchronized with the objectives of its constituents. This will help in achieving result.

Other objective is to effectively communicate: A budget is a communication tool. The approved budget represents the details of planned activities which assist in communicating the plans. The copies are distributed to the different ministries, extra ministerial departments and agencies.

Another objective is to control: The budget guarantees that plans and objectives are being achieved. Control in budgeting may be combined effort aimed at keeping management informed of what pre-determined plans will achieve. Control comes through variance analysis and reporting.

Objective of budgetary control is to motivate: Careful budgeting control motivates the human resource of the organization.

Performance evaluation: It is most powerful device to management for performance evaluation.

Advantages of Budgetary Control

There are numerous advantages of budgeting control:

It offers an efficient plan based on facts. It provides definite objectives with regard to future operation.

It acts as standard for evaluation of actual performance.

Control: It facilitates management to control each function, sector, ministry or department in order to accomplish the best possible result.

Coordination: It supports and encourages synchronization between departments of activities for the accomplishment of the overall progress of the organization/institution

Cost awareness: It makes management to become more cost conscious and reduce waste and inefficiency in its operations.

Management by exception: It is a time saving device, as attention is directed to areas of more serious needs.

Management Responsibility: It allows each manager to presume responsibility which is clearly established. It clearly defines the area of responsibility for all concerned executives who are engaged in various business activities.

It increases the operational efficiency of various business actions.

It assists in effective utilization of resources of organization.

Limitations of Budgetary Control:

The budget plan is based on estimates: Budgets are based on forecasts and prediction estimates. Absolute exactness is not possible in forecasting and budgeting. The potency or flaw of the budgetary control system depends to a large extent on the precision with which estimates are made.

Danger of rigidity: Budget will not stand the test of time if not flexible because of the dynamic and constant change in business condition.

Management tool: Budget is typically a mechanism of management and cannot reinstate it. Its implementation depends on the will and nature of management concerned. The tool is as good as its applier.

Expensive technique: Budget operation is expensive and need expert team as well as there is incidental expenditure.

Inappropriate condition: Budgets are made round existing organizational structure which may be unsuitable for existing conditions.

In budgets, it is difficult to make clear objectives, fulfil the desired goal.

The process of budgetary control lose its usefulness if it is not revised with changing circumstances.

Importance of Budgetary Control:

In management, there is great significance of budgeting control:

1. It increases competence
2. It reveals inefficiency positions
3. The causes of variances between the budgeted and actual are recognized to chart the remedial process.
4. It checks over-expenditure on the part of spending officer.
5. It reduces huge losses since it is a constant measuring of actual and budgeted.

Essentials of good budgetary control system:

Good budgetary system must fulfill following requirement:

1. It should be headed by senior management of organization.
2. Representatives of all departments should be made part of the budget committee.
3. Organizational goals must be clearly defined.
4. There should be proper management information system.
5. Periodic reports should be made to disclose the performance of budgeting system.
6. Effective follow-up system should be present.

When comparing Budget and Budgetary Control, it can be demonstrated that budget is quantitative plan of action for future period. Whereas Budgetary Control is a system of controlling cost and performances of various business actions through preparation of budgets, assigning responsibilities, evaluation of actual performance by comparing actual results with budgeted data and taking corrective measures in case of any adverse deviation is noticed. Although budget is essential part of Budgetary Control system, both are interrelated and dependent on each other.

To summarize, Budget and Budgetary Control is the staying power of financial control system. In management literature, budget is plan relating to future. It is statement of various activities to be performed in future and these activities are supported funds. Control exercise for execution of budget is called Budgeting control. Budgeting control represents the application of comprehensive system of budgeting in the organization to help the management in the process of its planning, organizing, coordinating, controlling and performance evaluation. It is an effective device to the management to accomplish the business goals and objectives of the organization.

The stress of financial control was in the private sector. Government organize master budget which is supported by budget classification as revenue, capital expenditure and cash budget. The budget targets are traditionally evolved not by agreement but from top to bottom. The incremental approach to budgeting surpasses the zero-base and programme-cum-performance approaches.

The reporting to management is a process of providing information to various levels of management so as to enable in judging the effectiveness of their responsibility centres and become a base for taking corrective measures, if necessary.

Meaning of Reporting:

The term “reporting” mean different things as follows:

(a) Narrating some facts

(b) Reviewing certain matter with its merits and demerits and offering comments

(c) Furnishing data at regular intervals in standardized forms

(d) Submitting specific information for particular purpose upon specific request instruction.

Management reporting refers to the formal system whereby relevant required information is furnished to management by means of reports constantly. Thus ‘report’ is the essence of any manage­ment reporting system.

The term ‘Report’ normally refers to a formal communication, which moves upwards, i.e., for factual communication by a lower level to a higher level of authority in response to orders received from higher level. Reports provide the means of checking the performance. A person, who is issued with orders or instructions to do certain things, should report back what he has done in compliance thereof. Reports may be oral or written and also routine or special.

Objectives or Purpose of Reporting to management

A Management Accountant has to prepare the report for the following purposes.

1. Means of Communication: A report is used as a means of upward communication. A report is prepared and submitted to someone who needs that information for carrying out functions of management.
2. Satisfy Interested Parties: The interested parties of management report are top management executives, government agencies, shareholders, creditors, customers and general public. Different types of management reports are prepared to satisfy above mentioned interested parties.
3. Serve as a Record: Reports provide valuable and important records for reference in the future. As the facts and investigations are recorded with utmost care, they become a rich source of information for the future.
4. Legal Requirements: Some reports are prepared to satisfy the legal requirements. The annual reports of company accounts is prepared to furnished the same to the shareholders of the company under Companies Act 1946. Likewise, audit report of the company accounts is submitted before the income tax authorities under Income Tax Act 1961.
5. Develop Public Relations: Reports of general progress of business and utilization of national resources are prepared and presented before the public. It is useful for increasing the goodwill of the company and developing public relations.
6. Basis to Measure Performance: The performance of each employee is prepared in a report form. In some cases, group or department performance is prepared in a report form. The individual performance report is used for promotion and incentives. The group performance report is used for giving bonus.
7. Control: Reports are the basis of control process. On the basis of reports, actions are initiated and instructions are given to improve the performance.

Requisites of a Good Reporting System:

A good reporting system is a better guide and effective tool for efficient managerial decision ­making.

Hence, the essentials of a good reporting system are as follows:

1. Proper Form:

In order to facilitate decision-making the information supplied should be in proper form. The style and layout of a report depend upon the needs of the individual who will use the same. The report may be submitted in the form of narration [written statement of facts], statisti­cal tabulations, graphs, charts, etc.

2. Proper Time:

Promptness is very important because information delayed is information denied. Reports are meant for action and when adverse tendencies or events are noticed, actions should follow forthwith. The sooner the report is made, the quicker the corrective action be taken.

3. Proper Flow of Information:

The information should flow from the right level of authority to the level of authority where the decisions are to be made. Further complete and consistent infor­mation should flow in a systematic manner.

4. Flexibility:

The system should be capable of being adjusted according to the requirements of the user. For example, production manager should be provided with information relating to his division or area of control only.

5. Facilitation of Evaluation:

The system should distinctively report deviations from standards or estimates. Controllable factors should be distinguished from non-controllable factors and re­ported separately. A good reporting system should give information required for the evaluation of each manager’s area of responsibility in relation to the goals of the organization.

6. Economy:

There is a cost for rendering information and such cost should be compared with benefits derived from the report or loss sustained by not having the report. Economy is an informa­tion aspect to be considered while developing reporting system.

Purpose of Reporting for Management:

The reports serve the following purposes:

(a) Communication Mode:

The basic object of preparation of reports for reporting purposes is to facilitate upward communication. Through reports someone who has some information communicates to higher authority who needs that information for carrying out various functions of management.

Reports serve as a communication mode to communicate relevant information to management executives, government agencies, shareholders, creditors, suppliers, customers or general public. Reports also communicate authentic information to research scholars who are interested in collecting data information for various research matters. Hence reports can be considered most effective communication mode.

(b) Helpful in Record Keeping:

Reports also facilitate record keeping function. Since reports provide valuable and authentic records for future references. Reports usually include facts and findings of investigations which can be stored as valuable information. These stored facts can be of great importance in future.

(c) Meeting Legal Requirements:

Some of the reports are also prepared and submitted to fulfill legal requirements. For instance, annual report of company’s accounts is necessary to be furnished to the shareholders under Companies Act 1956. Similarly, audit report of accounts must accompany the Income tax return under Income tax Act, 1961, Interim reports are submitted quarterly as per clause 41 of listing agreement.

(d) Provides Basis for Taking Important Decisions:

Reports usually contain factual information related with some event. Reports kept as a valuable record also help management in providing basis for taking important decision. For instance salesman’s report and dealers report will provide basis for taking any decision related with sales matters.

(e) Develop Public Relations:

Sometimes reports are also written and submitted presenting information of general progress of business and utilization of national resources. These reports are usually available for general public and help in enhancing goodwill of the reporting entity and hence in developing public relations.

(f) Provide Basis to Measure Performance:

Routine reports about the work performance of employees help the management to measure performance in view of the objects. The reports on performance of employees shall also become basis for promotions and incentives.

(g) Facilitates Control:

Reports also facilitate control process in the organisation. Reports provide a relevant basis of any control process. In normal course of the business, it is on the basis of reports, actions are initiated and instructions are given to improve the performance.

(h) Feedback:

Reports also help the lower levels in providing feedback to the management in form of reactions on decisions taken by the management.

Author and Reece have rightly said, “Reports on what has happened in a business, are useful for two general purposes which may be called information and control respectively.”

So information reports are useful to tell management what is going on. Control reports on the other hand, are useful in assessing personal performance and economic performance.

(i) Help in Combating Changes:

Since business itself is dynamic one, business conditions keep on changing, they pose a serious challenge to the existence of a corporate entity. Reports aim at analyzing the impact of business dynamics and how best changes can be exploited to the benefit of the company.

(j) Facilitates Coordination:

Reporting also helps in coordinating the activities in an organisation. The act of coordinating can be best performed with the help of various reports.

(k) Contact with Users:

Reports act as a mean to remain in touch with consumers, suppliers, shareholders and Government agencies.

A good reporting system helps the management in proper planning and controlling. If the reports are available to every level of management at the proper time, current activities may be regulated and controlled and necessary corrective actions may also be taken in time. Hence, some principles have been followed for making the reporting system more effective. Such principles are briefly explained below.

General Principles of Reporting System

1. Proper Flow of Information: The information should be free flow from the proper place to the right end user of the report. Hence, the information should be presented in the right format and at a proper time so that it helps in planning and co-ordination. The flow of report should not be delayed at any cost. Flow of information is a continuous activity. Information may flow upward, downward or sideways within an organization. Orders, instructions, plans etc may flow from top to bottom. Reports of grievances, suggestions etc. may flow from bottom to top. Notifications, letters, settlements and complaints may flow from outside. Annual Report, Financial Statement Analysis Report, Directors Report, Auditors report etc. may flow from inside to outside. Information flows as sideways from one manager to another at the same level through meetings, discussion etc.
2. Proper Timing: The very purpose of preparation of report is controlling the unfavorable activities. Hence, the report should be submitted at the required time at any cost. If not so, there is no use of preparing such report. Moreover, the efforts used for preparing the report and time are also waste. In the case of routine report, the time schedule should be strictly adhered to. The absence of information at required time leads to taking wrong decision.
3. Accurate Information: The report contains only accurate information. If wrong information are included in the report, it may lead to take wrong decision. Hence, the supply of accurate information helps the managerial executives to understand the situation very clearly. At the same time, the presentation of accurate information in the report should not involve excessive cost of preparation and should not result in the delay in the presentation of report.
4. Relevant Information: Proper attention should be devoted to include only relevant information in the report. The inclusion of irrelevant information is waste one and increase the time in the report preparation. Moreover, the irrelevant information confuse the end user of the report.
5. Basis of Comparison: The information bestowed by reports will be helpful when it carries provision to compare with past figures, standards set or objectives. The trend of the variation can be find out only through the comparison. Corrective action can be taken with the help of comparative information.
6. Reports should be Clear and Simple: The very purpose of preparing a report is helping the management in planning, coordinating and controlling. Hence, the report should be presented in very simple terms and can be clearly understood by anybody. If not so, there is no meaning of preparing a report. The method of presenting a report is in such a way that attracts the eye of the readers and enables them to arrive at a conclusion. The arrangement of information in a report is in brief, complete, clear and simple.
7. Cost: The management incur some expenses with regard to report preparation. Such expenses should be commensurate with the benefits derived from the report preparation. If possible, more benefits may be available than the expenses incurred. In this way, reporting system can be installed. In other words, there should be an endeavor to make the system as economical as possible.
8. Evaluation of Responsibility: The reporting system has been installed in such a way to evaluate the managerial responsibility. The standards or targets are fixed for each functional department. The record of actual performance is monitored along with the standards so as to enable management to assess the performance of different individuals.
9. Factual: A good reporting system should be based on reports containing factual information’s. Management has to take decision in future on the basis of the information contained in various reports. Any false information contained in the reports will not be helpful in taking correct decisions.
10. Principle of Brevity: Principle of brevity should be followed while reporting since long reports are very difficult to analyze and long reports generally rely greatly on highlighting irrelevant minor details and major issues involved are not taken up properly.
11. Principle of Scheduling: Principle of scheduling should also be followed in a way that reports can be prepared without excess burden on the staff. Employees must be given sufficient time to do the work well on the preparation of report. Time lag between collection of data and finished report should not be much longer.

1. Classification on the Basis of Object and Purpose:

(a) External Reports:

The reports prepared for external users or for the persons outside the business are known as external reports. External users may include shareholders, investors, creditors, suppliers and bankers. Though company may not be answerable to outsiders but still some reports are meant for outsiders.

The company publishes income statement and balance sheet at the end of every financial year and these statements are filed with the Registrar of companies and stock exchanges. Final statements of accounts are expected to conform to certain basic details in India Companies Act 1956 has made it obligatory to disclose some minimum information in final accounts. Following is an instance of Balance

(b) Internal Reports:

Internal reports refers to those reports which are meant for different level of management. Internal reports are not public documents and they are not expected to conform to any standards. These reports are prepared by keeping in view the needs of disposal for scanning them.

These reports may be meant for top level, middle level and lower level. The report meant for different levels of management may be regarded as internal reports. The frequency of these reports vary in accordance with purpose they serve.

Some of the internal reports that are commonly used are! Period report about profit and loss account and financial position, statement of cash flow, changes in working capital, report about cost of production, production trends and utilization of capacity.Labour turnover reports, material utilization reports, periodic reports on sales, credit collection periods and selling and distribution expenses, report on stock position etc.

2. Classification on the Basis of Nature:

According to nature, reports can be classified into three categories:

(a) Enterprise Reports:

These reports are prepared for the concern as a whole. These reports serve as a channel of communication with outsiders. Enterprise reports may concern all activities of the enterprise or may be related to different activities. Enterprise reports may include balance sheet, income statement, income tax returns, employment report, chairman’s report.

These reports contain standardized information and are beneficial to outsiders. The interpretation of financial statement can also be undertaken from these reports. The reports are important from financial analysis point of view. For instance following is chairman’s report presented by ShashiRuia Chairman of Essar Steel Ltd. reproduced for information:

Chairman’s Statement:

Dear Shareholder,

It is now well accepted by economic pundits and studies conducted across the globe that India and China will dominate the world economy in the 21st century. India is today the fourth largest economy in terms of purchasing power parity and is expected to overtake Japan and become third largest economic power after the United States of America and China, before the end of the decade. As India prepares to become an economic super power, it must further quicken the pace of reform and liaberalization by enabling the development of world class infrastructure, competitive manufacturing in scale and technology and sustainable development.

GDP growth of over 6.5% significant investments in infrastructure, a good agricultural output and a spurt in consumer demand across all sectors augurs for industry. If we are able to achieve a GDP growth of 8% annually, India will be the fastest growing free market democracy in the world.

Steel the backbone of Industry:

The steel industry is crucial to a nation’s economic competitiveness and security. Steel is integral to building of bridges, railroads, homes, automobiles, appliances and much more. Today’s steels are radically different than what was available ten years ago. They are lighter, higher in strength and more versatile.

The industry has undergone a major transformation in the last few years with companies investing in new process and product technologies, capacity enhancements and customer service initiatives. Indian steel companies are at the ‘leading edge’ of technology and spend considerable amounts on research and development.

The industry and particularly your company are able to compete internationally on technology, quality and price and have demonstrated that the India of tomorrow belongs to Indian entrepreneurs and Indian consumers. The Government needs to encourage and support the industry with a more realistic iron ore policy that creates level playing field.

Essar Steel- an eventful year:

Essar Steel’s excellent results demonstrate the company’s success in structurally improving its operating performance as a result of strategic actions and timely execution of projects. We have seen some signs of over-supply in international markets, but we do not see this as a long term issue. Your company is also much better prepared to manage cyclically in markets due to its geographic coverage and product portfolio.

Essar Steel is now a fully integrated producer with end-to-end control of all operations related to steel making. The acquisition of Hy-Grade Pellets Ltd. and Steel Corporation of Gujarat Ltd. make your company a totally integrated steel producer. The company has taken a number of initiatives in its manufacturing facilities to fulfill its mission of being one of the most cost efficient producers of steel globally.

From Bailadilla- where the iron ore beneficiation plant is located, close to the iron mines- to the final stage where the end products are dispatched to domestic and international destinations, your company has ensured that every stage of manufacture is seamlessly integrated. This will enable us to offer high quality, customized products for use by wide range of industries such as automobile and auto components, white goods, construction and consumer durables.

We focus on value addition at every stage of manufacture and also direct our efforts to high revenue generating markets. We do this by targeted marketing in specialized customer segments and technical and aftermarket support. We expect these value added products to contribute over 35% of the company’s revenues in the coming year.

Looking Ahead:

Currently we are producing at a capacity of 3 million tonnes and we have planned to augment this to 4.6 million tonnes by June 2006, making us the largest producer of flat steel in the private sector in India. This will involve an incremental investment ofRs 2000 crore, which is much below industry average and will considerably reduce our cost of production. We also plan to increase the pellet making capacity at Visakhapatnam from 4 to 8 million tonnes in this fiscal year.

The acquisitions, capacity expansions, technology upgradation and other productivity improvement measures will give you company a significant competitive edge in domestic and international markets. Our thrust on maintaining cost leadership through integrated manufacturing processes, research and new innovation and high productivity will provide a hedge against cyclically.

Managing Financial Turnaround:

Your company has been able to build a platform for consolidation and sustain the rejuvenation of its performance. In October 2002, at the time of the announcement of the CDR package, the Company had a term debt of? 5371 crore, which has been reduced to Rs 4262 crore as at March 31, 2005, a reduction of over Rs 1100 crore. The significant financial turnaround by the Company in such a short period of time is indeed noteworthy. With all other parameters of financial performance showing considerable improvement, your company is in a much stronger position to plan for more aggressive growth.

Our Driving Force:

Essar Steel is today at a significant point in its history. The past has given us learning’s that we have used to build a platform of security from the future. I must acknowledge the tremendous efforts put in by employees at all levels, who have to admirably risen to the challenges that change inevitably brings. Organizations must continuously change in order to survive and prosper. The Essar family has shown the capability and resilience to manage this change. We look to the future with confidence that arises out of our actions and the achievements of our people, as we prepare to face the “Brave New World”.

I also take this opportunity to thank our customers, vendors, business associates and bankers who have helped us come this far and look forward to their continued support in our journey to globalization.

Thank You.

ShashiRuia Chairman

(b) Control Reports:

Control reports deal with two aspects. One aspect relates to the personal performance and the other aspect deals with the economic performance. The first type of reports are prepared and reported to judge performance of managers and heads of various responsibility centres with what performance should have been under the prevailing circumstances.

The reasons for deviations in performance are also identified. The second type of reports shows how well the responsibility centre has fared as an economic activity. Such analysis is made periodically. This type of analysis requires the use of full cost accounting rather than responsibility accounting.

Control reports should consider the following:

(i) Control reports should be related to personal responsibility.

(ii) They should compare actual performance with the standards.

(iii) They should highlight significant information.

(iv) These reports should be sent at a proper time as to enable taking corrective measures.

(v) If possible various accounting ratios like, capacity, efficiency, activity and calendar ratios may be calculated.

(c) Investigating Reports:

These reports are linked with control reports. In case some serious problem arises then the causes of this situation are studied and analyzed, investigative reports are based on outcome of special solution studies. These reports are intermittent and are prepared only when a situation arises. They are prepared according to the nature of every situation. They are helpful to the management in analyzing the causes of some problem.

Example of Investigating Report:

The following information is available from monthly cost report of M/s Hard Engineering Co.:—

3. Classification on the Basis of Period:

According to the period repots can be classified as under:

(a) Routine Reports:

These reports are prepared about day to day working of the concern. They are periodically sent to various levels of management. These persons may differ according to the nature of information about details to be reported so far as the timing is concerned they may be sent daily, weekly, monthly or quarterly.

Routine reports may relate to sales information, production figures, capital expenditures, purchases of raw materials, market trends etc. There is a tendency to ignore routine reports by all recipients because of their routine nature. Important information in the report should be high-lighted or presented in a different way or may be written in a different ink.

Example of two routine reports are:

1. Statement of Production
2. Statement of Expenses

(b) Special Reports:

The management may confront some difficulties and routine report may not give sufficient information to tackle such situations. Under such circumstances, special reports are called for. Special reports are required for special purposes only.

These reports are prepared according to the need of situation. Available accounting information may not be sufficient, so data may have to be specially collected. There may be need to put extra staff for compiling these reports. It may also involve co-ordination of different departments and different levels of management. According to J. Batty33 special reports should be divided into sections each covering the following main purposes: 1. Reason for the report 2. Investigation made 3. Finding a conclusion and recommendations.

Special reports may deal with following topics:

(i) Information about market analysis and methods of distribution of competitors.

(ii) Technological changes in industry.

(iii) Problems about the purchase of materials.

(iv) Reports about change in methods of production and their implications.

(v) Trade association matters.

(vi) Report by secretary on company matters.

(vii) Political development at home and abroad having impact on business.

(ix) Report effect of idle capacity on cost of production.

(x) Make or buy decisions.

(xi) Report most suitable method of raising funds.

(xii) The effect of labour disputes on production and cost of production.

(xiii) Report on general economic forecast.

(xiv) Feasibility study for a project.

(xv) Report on effect of change in Government Policy.

4. Classification of Reports on the Basis of Functions:

According to function the reports may be divided into two categories:

(a) Operating Reports

(b) Financial Reports

(a) Operating Reports:

These reports provide information about operations of the concern.

The operating reports may consist of the following:

(i) Control Reports:

These reports are used for management control purposes. They are intended to spot deviations from budgeted performance without loss of time so that corrective action can be taken. Control reports are also used to assess the performance of individuals.

(ii) Information Reports:

These reports are prepared to provide useful information which will enable planning and policy formation for future. Information reports can take the form of trend reports and analytical reports. Trend reports provide information in comparative form over a period of time. Graphic presentation can be effectively used in trend reports. As opposed to trend reports, analytical reports provide information in a classified manner about composition of certain results so that one can identify specific factors in the overall total.

(b) Financial Reports:

These reports provide information about the financial position of the concern on specific dates or movement of finances during a specific period. The Balance Sheet provides information about a concern on a specific date. On the other hand Cash Flow Statement provides data about the movement of cash during a particular period. These reports can be either static or dynamic. Balance Sheet and other subsidiary reports are examples of static reports; Cash Flow, Fund Flow Statements and other reports showing financial position as compared to the budgeted are examples of dynamic reports.

• A Cash Flow Statement only reveals the inflow and outflow of cash. The cash balance disclosed by this statement may not depict the true liquid position. There are controversies over a number of items like Cheques, stamps, postal orders etc. to be included in cash.
• A Cash Flow Statement cannot be equated with the income statement. An income statement takes into account both cash and non-cash items. Hence Cash Fund does not mean net income of the business.
• Working Capital being a wider concept of funds, a funds flow statement presents a more complete picture than cash flow statement.
• Fails to Present Net Profit: The cash flow statement fails to present the net income of a firm for the period as it ignores non-cash items which are considered by Profit and Loss Statement. The cash flow statement does not help to assess profitability as it neither considers cost nor revenues. However, it can be used as a supplement to the income statement.
• Not a substitute to Funds Flow Statement or Income Statement: The functions which are performed by funds flow statement or income statement cannot be done by cash flow statement.
• Industry Comparison not possible: As the cash flow statement does not measure the efficiency of the firm, intercomparison with other inter-industry is not possible. A firm having less capital investment shall have less cash flow than the firm which more capital investment resulting in higher cash flows.
• Does not Properly Assess Liquidity position: In a practical scenario, the cash flow statement does not assess liquidity or solvency position of the firm as it presents cash position only on a particular date. It only helps to know what amount of obligation can be met. In nutshell, it does not represent the real liquidity position.
• It does not give complete picture of the financial position of the business concern.
• The preparation of cash flow statement is only postmortem analysis. There is no projection of cash in future in this method.
• It is not a substitute of Income Statement.
• The accuracy of cash flow statement is based on the balance sheet. If balance sheet is wrong, the cash flow statement is also wrong.
• It is not prepared on the basic accounting concept of accrual basis. Hence, the accuracy of cash flow statement is questionable.
• It is not suitable for judging the profitability of a firm as non-cash items are not included in the calculation of cash flow from operating activities.

The purpose of the cash flow statement is to show where an entities cash is being generated (cash inflows), and where its cash is being spent (cash outflows), over a specific period of time (usually quarterly and annually). It is important for analyzing the liquidity and long term solvency of a company.

The cash flow statement uses cash basis accounting instead of accrual basis accounting which is used for the balance sheet and income statement by most companies. This is important because a company may accrue accounting revenues but may not actually receive the cash. This could produce profits and taxes payable but not provide the resources to stay solvent.

Cash Flow Statement Components

The cash flow statement components provide a detailed view of cash flow from operations, investing, and financing:

Cash Flow from Operating Activities

The net amount of cash coming in or leaving from the day to day business operations of an entity is called Cash Flow from Operations. Basically it is the operating income plus non-cash items such as depreciation added. Since accounting profits are reduced by non-cash items (i.e. depreciation and amortization) they must be added back to accounting profits to calculate cash flow.

Cash flow from operations is an important measurement because it tells the analyst about the viability of an entities current business plan and operations. In the long run, cash flow from operations must be cash inflows in order for an entity to be solvent and provide for the normal outflows from investing and finance activities.

Cash Flow from Investing Activities

Cash flow from investing activities would include the outflow of cash for long term assets such as land, buildings, equipment, etc., and the inflows from the sale of assets, businesses, securities, etc. Most cash flow investing activities are cash out flows because most entities make long term investments for operations and future growth.

Cash Flow from Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e. interest to bondholders) and shareholders (i.e. dividends and stock buybacks) and cash inflows from sales of bonds or issuance of stock equity. Most cash flow finance activities are cash outflows since most entities only issue bonds and stocks occasionally.

Main uses of cash flow statement.

• Since a cash flow statement is based on the cash basis of accounting, it is very useful in the evaluation of cash position of a firm.
• A projected cash flow statement can be prepared in order to know the future cash position of a concern so as to enable a firm to plan and coordinate its financial operations properly. By preparing this statement, a firm can come to know as to how much cash will be generated into the firm and how much cash will be needed to make various payments and hence the firm can well plan to arrange for the future requirements of cash.
• A comparison of the historical and projected cash flow statements can be made so as to find the variations and deficiency or otherwise in the performance so as to enable the firm to take immediate and effective action.
• A series of intra-firm and inter-firm cash flow statements reveals whether the firm’s liquidity (short-term paying capacity) is improving or deteriorating over a period of time and in comparison to other firms over a given period of time.
• Cash flow statement helps in planning the repayment of loans, replacement of fixed assets and other similar long-term planning of cash. It is also significant for capital budgeting decisions.
• It better explains the causes for poor cash position in spite of substantial profits in a firm by throwing light on various applications of cash made by the firm. It further helps in answering some intricate questions like -what happened to the net profits? Where did the profits go? Why more dividends could not be paid in spite of sufficient available profit?
• Cash flow analysis is more useful and appropriate than funds flow analysis for short-term financial analysis as in a very short period it is cash which is more elevant then the working capital for forecasting the ability of the firm to meet its immediate obligations.
• Cash flow statement prepared according to AS-3 (Revised) is more suitable for making comparisons than the funds flow statement as there is no standard format used for the same.
• Cash flow statement provides information of all activities classified under operating, investing and financing activities. The funds statement even when prepared on cash basis, did not disclose cash flows from such activities separately. Thus, cash flow statement is more useful than the funds statement.

Cash and cash equivalents (CCE) are the most liquid current assets found on a business’s balance sheet. Cash equivalents are short-term commitments “with temporarily idle cash and easily convertible into a known cash amount”. An investment normally counts to be a cash equivalent when it has a short maturity period of 90 days or less, and can be included in the cash and cash equivalents balance from the date of acquisition when it carries an insignificant risk of changes in the asset value; with more than 90 days maturity, the asset is not considered as cash and cash equivalents. Equity investments mostly are excluded from cash equivalents, unless they are essentially cash equivalents, for instance, if the preferred shares acquired within a short maturity period and with specified recovery date.

Cash is the money in the form of currency. Currency includes currency notes and coins. Any currency notes and coins held by an enterprise are part of the term “cash”.

Demand deposit is a type of an account from which funds can be withdrawn at any time without having to inform the bank or depository institution. Most of the checking and saving accounts are demand deposits.

One of the company’s crucial health indicators is its ability to generate cash and cash equivalents. So, a company with relatively high net assets and significantly less cash and cash equivalents can mostly be considered an indication of non-liquidity. For investors and company’s cash and cash equivalents are generally counted to be “low risk and low return” investments and sometimes analysts can estimate company’s ability to pay its bills in a short period of time by comparing CCE and current liabilities. Nevertheless, this can happen only if there are receivables that can be converted into cash immediately.

First, owners and investors can contribute money to the business in exchange for a percentage ownership in the company. Second, the company can generate money from selling goods or services to customers as part of its ongoing operations. Third, the business can borrow money from banks, financial institutions, and other lenders.

Controlling cash flow and financing is a crucial part of running any business. A business can be profitable and still not be able to pay its bills on time because money was not managed properly. Profitability does not always equate to large amount of free cash flow. Investors and creditors need to know where the company’s cash comes from and where it goes. That’s why management details each cash activity for the period on the statement of cash flows.

However, companies with a big value of cash and cash equivalents are targets for takeovers (by other companies), since their excess cash helps buyers to finance their acquisition. High cash reserves can also indicate that the company is not effective at deploying its CCE resources, whereas for big companies it might be a sign of preparation for substantial purchases. The opportunity cost of saving up CCE is the return on equity that company could earn by investing in a new product or service or expansion of business.

Examples of cash are:

• Coins
• Currency
• Cash in checking accounts
• Cash in savings accounts
• Bank drafts
• Money orders
• Petty cash

Cash Equivalent

Cash equivalents are investments that can be readily converted to cash. Common examples of cash equivalents include commercial paper, treasury bills, short term government bonds, marketable securities, and money market holdings. An item should satisfy the following criteria to qualify for cash equivalent.

• The investment should be short term. They should mature in less than three months. If they mature in more than three months they will be classified as other investments.
• They should be highly liquid. This means that they should be easily sold in the market. The buyers of these investments should be easily available.
• They should be convertible to known amounts of cash. This means that their market price should be available and this market price should not be subject to significant fluctuations.
• They should not be too risky. There should be very little risk of changes in their value. This means that equity shares cannot be classified as cash equivalents. But preferred shares purchased shortly before the redemption date can be classified as cash equivalents.

In short, cash and cash equivalents mean the cash and those assets which are immediately convertible to cash. Cash and cash equivalents are the most liquid assets of any business. Cash and cash equivalents are very important for the liquidity of a business. A company should have sufficient cash and cash equivalents to meet its urgent liabilities when they fall due. 

Examples of cash equivalents are:

• Commercial paper
• Marketable securities
• Money market funds
• Short-term government bonds
• Treasury bills

Businesses can report these two categories of assets on the balance sheet separately or together, but most companies choose to report them together.

GAAP allows this financial statement presentation because some investments are so liquid and risk adverse that they are considered cash. Take T-bills for example. These investments are backed by the U.S. government and will always be paid. It’s not like a private short-term bond or loan where the company can default or go bankrupt. T-bills are a safe, guaranteed investment that can be cashed in at any time. Thus, GAAP recognizes these investments as if they were actual currency.

If the T-bills can’t be cashed in because of debt covenants or some other agreement, like in our debt restriction example above, the restricted T-bills must be reported in a separate investment account from the non-restricted T-bills on the balance sheet.

Accounts receivable is not considered cash because it isn’t currency. It is, however, considered an equivalent because it is highly liquid and easily converted into cash in a short period of time. Thus, it would be included in equivalents calculation.

CDs are short-term securities that are easily converted into a known amount of cash in a short period of time. Certificates of Deposit are always included in cash equivalents.

Sources of Cash Flow Statements:

Cash flow statement is not a substitute of income statement, i.e., a profit and loss account, and a balance sheet. It provides additional information and explains the reasons for changes in cash and cash equivalents, derived from financial statements at two points of time.

A cash flow statement, also known as the statement of cash flows, is a financial statement that summarizes the amount of all cash inflows and outflows of the company.

The cash flow statement is a mandatory part of a company’s financial reports since 1987.

The Statement of Cash Flows is one of the 3 key financial statements that reports the money generated and spent throughout a particular amount of period within the organization.

The procedure for preparing a cash flow statement is different from the procedure followed in respect of profit and loss account and balance sheet. It is prepared with the help of financial statements.

The basic information required for the preparation of a cash flow statement is obtained from the following three sources:

(i) Comparative balance sheets at two points of time, i.e. in the beginning and at the end of the accounting period.

(ii) Income statement of the current accounting period or the profit and loss account.

(iii) Some selected additional data to extract the hidden transactions.

Steps for Preparation of Cash Flow Statement:

The preparation of a cash flow statement involves the following steps:

Step 1: Compute the net increase or decrease in cash and cash equivalents by making a comparison of these accounts given in the comparative balance sheets.

Step 2: Calculate the net cash flow provided (used in) operating activities by analyzing the profit and loss account, balance sheet and additional information. There are two methods of converting net income into net cash flows from operating activities: the direct method and the indirect method. These methods have been discussed separately in this chapter.

Step 3: Calculate the net cash flow from investing activities.

Step 4: Calculate the net cash flow from financing activities.

Step 5: Prepare a formal cash flow statement highlighting the net cash flow from (used in) operating, investing and financing activities separately.

Step 6: Make an aggregate of net cash flows from the three activities and ensure that the total net cash flow is equal to the net increase or decrease in cash and cash equivalents as calculated in Step 1.

Step 7: Report significant non-cash transactions that did not involve cash or cash equivalents in a separate schedule to the cash flow statement e.g., purchase of machinery against issue of share capital or redemption of debentures in exchange for share capital.

For a business organization, the cash flow statement is the foremost vital financial statement to prepare. It traces the flow of funds (or working capital) into and out of the business throughout an accounting period.

For a small business, a cash flow statement ought to be in all probability to be ready as often as possible.

Three Sections of a Statement of Cash Flows:

1. Cash from operating activities,
2. Cash from investing activities,
3. Cash from financing activities.

Cash from operating activities

Cash Flow from Operations usually includes the money flows related to sales, purchases, and other expenses. In other words, it reflects how a lot of money is generated from a company’s products or services.

These operating activities include Receipts from sales of product and services, Interest payments, Income tax payments, Payments made to suppliers of product and services, Salary and wage, Rent payments etc.

Cash from investing activities

Cash Flow from investment Activities includes the cash flows related to buying or selling property, plant, and equipment, other non-current assets, and other financial assets.

Usually, cash flow from investment activities is a “cash out” item, because money is used to spend for new instrumentation, buildings, or short-term assets such as marketable securities.

Cash from financing activities

Cash flows from financing activities generally include cash flows associated with borrowing and repaying bank loans, and issuing and buying back shares.

The payment of a dividend is also treated as a finance income. If a company issues a bond to the general public, the company receives cash financing; but, when interest is paid to bondholders, the company is reducing its cash.

Here is an example of statement of cash flow:

Cash Flow Statement	Rs.
Operating Cash Flow Net Earning Plus: Depreciation and Amortization Less: Changes in Working Capital	15,474 19,500 9,003
Cash from Operations   Investing cash flow Investment in Property & Machines	25,971     (15,000)
Cash from Investing Financing cash Flow Issuance of Debt Issuance of Equity	(15,000)   (8,000) 1,70,000
Cash from Financing   Net increase/Decrease  in Cash Opening cash Balance	1,62,000   1,72,971 11,000
Closing Cash Balance	1,83,971

Importance of Cash Flow Statement:

It is equally as important as like as the profit-and-loss statement and balance sheet for cash flow analysis.

Without a cash flow statement, it may be tough to have a correct image of a company’s performance.

The income statement can tell you the way a lot of interest you paid on a loan and therefore the record can tell you the way a lot of you owe, but solely the cash flow statement can tell you the way a lot of money was consumed servicing that loan.

The income statement can record sales and profits however it’s the income statement that may provide you with a warning if those sales aren’t generating enough money to cover expenses.