Relationship between Planning and Control

Planning and control are the two sides of the same coin. They are in fact parts of one integral function and it can be quite difficult to separate the two. This means that we cannot tell when the planning function ends and the control functions begin. Planning sets the philosophy and the guidelines on which the company operates. And controlling ensures that the activities of the firm conform to these plans, goals, objectives etc.

Planning and controlling are inter-related to each other. Planning sets the goals for the organization and controlling ensures their accomplishment. Planning decides the control process and controlling provides sound basis for planning. In reality planning and controlling are both dependent on each other. In the words of M.C. Niles, “Control is an aspect and projection of planning, where as planning sets the course, control observes deviations from the course, and initiates action to return to the chosen course or to an appropriately changed one.”

The relationship between planning and control can be explained as follows:

  1. Planning Originates Control:

In planning the objectives or targets are set in order to achieve these targets control process is needed. So, planning precedes control.

  1. Controlling Sustains Planning:

Controlling directs the course of planning. Controlling spots, the areas where planning is required.

  1. Controlling Provides Information for Planning:

In controlling the actual performance is compared to the standards set and records the deviations, if any. The information collected for exercising control is used for planning also.

  1. Planning and Controlling are Interrelated:

Planning is the first function of management. The other functions like organizing, staffing, directing etc. are organized for implementing plans. Control records the actual performance and compares it with standards set. In case the performance is less than that of standards set then deviations are ascertained. Proper corrective measures are taken to improve the performance in future. Planning is the first function and control is the last one. Both are dependent upon each other.

  1. Planning and Control are Forward Looking:

Planning and control are concerned with the future activities of the business. Planning is always for future and control is also forward looking. No one can control the past, it is the future which can be controlled. Planning and controlling are concerned with the achievement of business goals. Their combined efforts are to reach maximum output with minimum of cost. Both systematic planning and organized controls are essential to achieve the organizational goals.

Kinds of Partners, Partnership Deed

Active or managing partner:

A person who takes active interest in the conduct and management of the business of the firm is known as active or managing partner.

He carries on business on behalf of the other partners. If he wants to retire, he has to give a public notice of his retirement; otherwise, he will continue to be liable for the acts of the firm.

Sleeping or dormant partner:

A sleeping partner is a partner who ‘sleeps’, that is, he does not take active part in the management of the business. Such a partner only contributes to the share capital of the firm, is bound by the activities of other partners, and shares the profits and losses of the business. A sleeping partner, unlike an active partner, is not required to give a public notice of his retirement. As such, he will not be liable to third parties for the acts done after his retirement.

Nominal or ostensible partner:

A nominal partner is one who does not have any real interest in the business but lends his name to the firm, without any capital contributions, and doesn’t share the profits of the business. He also does not usually have a voice in the management of the business of the firm, but he is liable to outsiders as an actual partner.

Sleeping vs. Nominal Partners:

It may be clarified that a nominal partner is not the same as a sleeping partner. A sleeping partner contributes capital shares profits and losses, but is not known to the outsiders.

A nominal partner, on the contrary, is admitted with the purpose of taking advantage of his name or reputation. As such, he is known to the outsiders, although he does not share the profits of the firm nor does he take part in its management. Nonetheless, both are liable to third parties for the acts of the firm.

Partner by estoppel or holding out:

If a person, by his words or conduct, holds out to another that he is a partner, he will be stopped from denying that he is not a partner. The person who thus becomes liable to third parties to pay the debts of the firm is known as a holding out partner.

There are two essential conditions for the principle of holding out : (a) the person to be held out must have made the representation, by words written or spoken or by conduct, that he was a partner ; and (6) the other party must prove that he had knowledge of the representation and acted on it, for instance, gave the credit.

Partner in profits only:

When a partner agrees with the others that he would only share the profits of the firm and would not be liable for its losses, he is in own as partner in profits only.

Minor as a partner:

A partnership is created by an agreement. And if a partner is incapable of entering into a contract, he cannot become a partner. Thus, at the time of creation of a firm a minor (i.e., a person who has not attained the age of 18 years) cannot be one of the parties to the contract. But under section 30 of the Indian Partnership Act, 1932, a minor ‘can be admitted to the benefits of partnership’, with the consent of all partners. A minor partner is entitled to his share of profits and to have access to the accounts of the firm for purposes of inspection and copy.

He, however, cannot file a suit against the partners of the firm for his share of profit and property as long as he remains with the firm. His liability in the firm will be limited to the extent of his share in the firm, and his private property cannot be attached by creditors.

On his attaining majority, he has to decide within six months whether he will become regular partner of withdraw from partnership. The choice in either case is to be intimated through a public notice, failing which he will be treated to have decided to continue as partner, and he becomes personally liable like other partners for all the debts and obligations of the firm from the date of his admission to its benefits (and not from the date of his attaining the age of majority). He also becomes entitled to file a suit against other partners for his share of profit and property.

Other partners:

In partnership firms, several other types of partners are also found, namely, secret partner who does not want to disclose his relationship with the firm to the general public. Outgoing partner, who retires voluntarily without causing dissolution of the firm, limited partner who is liable only up to the value of his capital contributions in the firm, and the like.

However, the moment public comes to know of it he becomes liable to them for meeting debts of the firm. Usually, an outgoing partner is liable for all debts and obligations as are incurred before his retirement. A limited partner is found in limited partnership only and not in general partnership.

Partnership Deed

Partnership Agreements are be used by Partners wishing to form a partnership for doing business together. It is strongly recommended or encouraged for partnerships to have some kind of agreement among themselves, in case future disputes prove difficult to arbitrate. It is meant to promote mutual understanding and avoid mistrust. It indicates the terms on which the business corporation is founded.

A partnership is a unique form of business in which partners work together to achieve common goals. Due to this feature of partnerships, partners are allowed to decide the terms of their relationship with each other. The documents which they do so are called partnership deeds.

Partnership Deed

As explained above, partners are free to define the terms of their relationships, even if they go contrary to the Act in certain cases. They can either decide on such terms with an oral agreement or a written one.

Partnership deeds, in very simple words, are an agreement between partners of a firm. This agreement defines details like the nature of the firm, duties, and rights of partners, their liabilities and the ratio in which they will divide profits or losses of the firm.

Although the drafting of partnership deeds is not compulsory, it is always advised to do so. This helps in ensuring that all terms agreed by partners exist in written form on paper. Doing so can reduce disputes between partners and govern their functioning better.

Unlike similar documents like articles of association of companies, partnership deeds need not be registered mandatorily. However, registration can ensure the prevention of legal challenges to its validity when disputes arise. An ideal partnership deed is comprehensive and clear about all details pertaining to the functioning of a firm. It should not contain any ambiguities.

Absence of a Partnership Deed

In case partners do not adopt a partnership deed, the following rules will apply:

  • The partners will share profits and losses equally.
  • Partners will not get a salary.
  • Interest on capital will not be payable.
  • Drawings will not be chargeable with interest.
  • Partners will get 6% p.a. interest on loans to the firm if they mutually agree.

Contents of Partnership Deeds

Although there is no specific format prescribed for drafting a partnership deed, a typical deed contains the below mentioned clauses.

  • The name of the firm
  • Name and details of all partners
  • Date of commencement of business
  • Duration of the firm’s existence
  • Capital contributed by each partner
  • Profit/loss sharing ratio
  • Interest on capital payable to partners
  • The extent of borrowings each partner can draw
  • Salary payable to partners, if any
  • The procedure of admission or retirement of a partner
  • The method used for calculating goodwill
  • Preparation of accounts of the firm
  • Mode of settlement of dues with a deceased partner’s executors
  • The procedure followed in case disputes arise between partners

Approaches to Management Planning

All organizations plan; the only difference is their approach. Prior to starting a new strategic planning process, it will be necessary to access the past planning approach that has been used within the organization and determine how the organization’s cultural may have been affected. Addressing these cultural issues is critical to the success of the current planning process.

The four possible approaches to planning are:

Reactive past oriented

Reactive planning is an active attempt to turn back the clock to the past. The past, no matter how bad, is preferable to the present. And definitely better than the future will be. The past is romanticized and there is a desire to return to the “good old days.” These people seek to undo the change that has created the present, and they fear the future, which they attempt to prevent.

Inactive present oriented

Inactive planning is an attempt to preserve the present, which is preferable to both the past and the future. While the present may have problems it is better than the past. The expectation is that things are as good as they are likely to get and the future will only be worse. Any additional change is likely to be for the worse and should therefore be avoided.

Preactive predict the future

Preactive planning is an attempt to predict the future and then to plan for that predicted future. Technological change is seen as the driving force bringing about the future, which will be better than the present or the past. The planning process will seek to position the organization to take advantage of the change that is happening around them.

Proactive – create the future

Proactive planning involves designing a desired future and then inventing ways to create that future state. Not only is the future a preferred state, but the organization can actively control the outcome. Planners actively shape the future, rather than just trying to get ahead of events outside of their control. The predicted changes of the preactive planner are seen not as absolute constraints, but as obstacles that can be addressed and overcome.

Strategic Management Planning

  1. Top-Down Approach:

In a centralised company, such planning is done at the top of the corporation and the departments and outlying activities are advised straightway what to do.

In a decentralised company, the CEO or the President may give the divisions guidelines and ask for plans. The plans after review at the head office are sent back to the divisions for modifications or with a note of acceptance.

  1. Bottom-Up Approach:

The top management gives the divisions no guidelines but asks them to submit plans.

Such plans may contain information on:

(i) Major opportunities and threats;

(ii) Major objectives;

(iii) Strategies to achieve the objectives;

(iv) Specific data on sales/profits/market share sought;

(v) Capital requirements, etc.

These plans are then reviewed at top management levels and the same process, as in the top-down approach, is then followed.

  1. Mixture of the Top-Down and Bottom-Up Approaches:

This is practised in most large decentralised companies. In this approach, the guidelines given by the top management to the divisions are broad enough to permit the divisions a good amount of flexibility in developing their own plans. Sometimes, the top management may decide basic objectives by dialogue with divisional managers in respect of sales and return on investments especially when divisional performance is measured upon those criteria.

  1. Team Approach:

The chief executive, in a small centralised company, often use his line managers to develop formal plans. The same approach is used even by the president of a large company. In many other companies, the president meets and interacts with his group of executives on a regular basis to deal with all the problems facing the company so that the group can develop written strategic plans.

Within each of these approaches, there are many alternatives as follows:

(i) Complete SWOT analysis or not:

In some companies, the divisions supply the top management with perceived opportunities and threats and with the strategies to exploit opportunities and avoid threats.

(ii) Depth of analysis:

Some companies, at the initial stage, do not make in-depth analysis of all aspects of planning. They increase the intensity of analytical exercise gradually as experience is gained.

(iii) Degree of formality:

Divergent practices are in vogue as regards formality. For some large companies having centralised organisation structures, and comparatively stable environment and homogeneous product lines, planning is less formal than large diversified companies with decentralised and semi-autonomous product division structures.

High technology companies usually have more formal systems; yet, they recognise informality in decision making and managerial activities associated with planning.

(iv) Reliance on staff:

It is up-to the managers to decide the extent of delegation.

(v) Corporate planner or not:

Large corporations employ corporate planners to help in the planning process. Smaller companies cannot afford to this luxury.

(vi) Linkage with plans.

(vii) Getting the process started:

Strategic planning may begin with an effort to solve a particular problem. It may begin with a SWOT analysis or simply with a review of current strategy.

(viii) Degree of documentation:

A balance has to be struck between too little and too much paper work.

(ix) Role of CEO:

The chief executive officer’s role is critical depending on the degree of complexity of organisations.

Line and Staff Conflicts

Line and staff managers are supposed to work harmoniously to achieve the organizational goals. But their relationship is one of the major sources of conflict in most organizations. Since such conflicts lead to loss of time and organizational effectiveness, it is always desirable to identify the sources of such conflicts and initiate necessary action to overcome them.

Theoretically, it is impossible to differentiate between line and staff functions and because of this, conflicts cannot be avoided. However, line and staff conflicts can be grouped into three categories conflicts due to line viewpoint, conflicts due to staff viewpoint, and conflicts due to the very nature of line and staff relation­ships.

The important causes of line and staff conflict as reported by line men:

(a) Staff does not know its place and wants to assume line authority. This feeling is generated more where the staff advisor forgets his position of having to be helpful rather than being in position to dictate.

(b) Staff officers encroach upon the line authority. They interfere in the work of line managers and try to tell them how to do their work.

(c) Staff takes full credit for successful programmes and hold line people wholly responsible for unsuccessful schemes.

(d) Staff men generally fail to see the whole picture objectively as they are specialists in their particular areas.

(e) The advice of the staff is academic, and is devoid of reality. Since they are not involved in the real work situations, their ideas are impractical. They emphasise about their area of specialisation rather than the interest of the organisation. In essence, they are armed-chair theoreticians, living in their own ivory towers, and totally cut-off from the realities obtaining in the organisation.

Conflicts due to Line Viewpoint:

  1. Lack of accountability:

Line managers generally perceive that staff managers are not accountable for their actions. Such lack of account­ability on the part of staff leads to ignoring of the overall organizational objectives. Staff takes the credit for achieving the results, which is actu­ally achieved by the line people. But if anything goes wrong, they blame the line. Such perception among the line managers is one of the most important sources of line and staff conflict.

  1. Encroachment on line authority:

Line managers often allege that staff managers encroach upon their authority by giving recommendations on matters that come within their purview. Such encroachments influ­ence the working of their departments and often lead to hostility, resent­ment, and reluctance to accept staff recommendations.

  1. Dilution of authority:

Staff managers often dilute the authority and be- little the responsibilities of line managers. Line managers fear that their responsibilities may be reduced and they even suffer from a feeling of insecurity.

  1. Theoretical basis:

Staff being specialists, they generally think within the ambit of their specialization. They fail to relate their suggestions to the actual reality and are unable to understand the actual dimensions of the problems. This is because staff is cut-off” from the day-to-day opera­tions. This results in impractical suggestions, making it difficult to achieve organizational goals.

Conflicts due to Staff Viewpoint:

  1. Lack of proper use of staff:

Staff managers allege that line managers often take decisions without any input from them. Line just informs staff after taking decisions. This makes staff managers feel that line do not need staff. But even in such cases (where line takes its own decisions without consulting staff), if anything goes wrong, staff is made respon­sible.

  1. Resistance to new ideas:

Line managers resist new ideas as they feel implementing new ideas means something is wrong with the present way of working. Such rigidity of line managers dissuades staff from implementing new ideas in the organization and adds to their frustra­tion.

  1. Lack of proper authority:

Staff often alleges that despite having the best solutions to the problems being faced in their areas of specialization, they fail to contribute to organizational goals. This is because the staff lack the authority to implement the solutions and are unable to persuade the line managers (who have the authority) to implement them.

Conflicts Due to the Very Nature of Line and Staff Relationships:

  1. Different backgrounds:

Line and staff managers are usually from dif­ferent backgrounds. Normally line managers are seniors to staff in terms of organizational hierarchy and levels. On the contrary, staff managers are relatively younger and better educated. Staff often looks down upon the line. Such complexes create an atmosphere of mistrust and hatred between the line and staff.

  1. Lack of demarcation between line and staff authority:

In practice it is difficult to make a distinction between line and staff authority. Overlap­ping and duplication of work creates a gap between the authority and responsibility of line and staff. Each tries to shift the blame to the other.

  1. Lack of proper understanding of authority:

Failure to understand au­thority causes misunderstandings between the line and staff. This leads to encroachment and creates conflict.

To overcome the line and staff conflict, it is necessary for an organization to follow certain approaches:

  1. Clarity in relationships:

Duties and responsibilities of both line and staff should be clearly laid down. Relationships of staff with the line and their scope of authority need to be clearly defined. Similarly, line man­agers should also be made responsible for decision making and they should have corresponding authority for the same. Line should enjoy the freedom to modify, accept, or reject the recommendations or advice of the staff.

  1. Proper use of staff:

Line managers must know how to maximize orga­nizational efficacy by optimizing the expertise of staff managers. They need to be trained on the same. Similarly, staff managers should also help the line to understand how they can improve their activities.

  1. Completed staff work:

Completed staff work denotes careful study of the problem, identifying possible alternatives for the problem, and pro­viding recommendations based on the compiled facts. This will result in more staff work and pragmatic suggestions.

  1. Holding staff accountable for results:

Once staff becomes accountable, they would be cautious about their recommendations. Line also would have confidence on staff recommendations, as staff is accountable for the results.

Grievances of Line against Staff:

(a) The staff authorities try to encroach upon the line authority and interfere with the work of line managers.

(b) Staff does not know its place in the structure and wants to assume line authority. This feeling is generated more when the staff authority forgets his position and begins to dictate.

(c) Attitude:

Staff wants to take full credit for success of programmes and hold line men fully responsible for unsuccessful programmes.

(d) Approach:

The advice of the staff authority may lack practicality as their advice purely academic and they do not understand the reality of the situation.

(e) Capriciousness:

The staff authorities may fail to study the problem fully and objectively as they are specialists in their respective areas. So, the staff authorities are considered to be short-sighted.

(f) Accountability:

As the staff authority is not vested with accountability for performance, they tend to be over-jealous and recommend a course of action which is not practicable.

Grievances against Line by Staff:

The staff authorities also complain against line executives.

The causes of conflict as reported by the staff are:

(a) Ego:

The advice of staff is resorted to as the last step as the line executives feel that asking for advice is defeat.

(b) Frustration:

The advice suggested by the staff may not be implemented. This causes resentment and frustration among staff.

(c) Indifferent:

The line authority often resists the new ideas given by the staff specialists and at times they are not prepared to listen to the staff proposals.

(d) Sabotage:

Line authorities are not making use of staff authorities full and try to sabotage the programmes.

Besides these there are other reasons are also exist which are responsible for the conflict:

(a) Inefficient Staff:

The inefficient and incompetent authorities may create conflict.

(b) Unity of Command:

Violation of this concept also may create conflict.

(c) Poor Delegation:

This is another source of conflict due to ambiguity in authority delegation and lack of clarity in defining line and staff relationship.

Resolving of the Conflict:

The conflict disturbs the peace and harmony in the organisation and this should be resolved peacefully.

(a) Well defined Authority:

It should be made clear that the line authority is ultimately responsible for implementation of the decisions and the staff is responsible only for providing advice and service to the line executives.

(b) Due Consideration:

Due consideration is to be to staff proposals to act upon and the line executives are to give reasons where they disagree with staff and convince them.

(c) Co-Operation:

Both the authorities should try to understand the orientation of each other. They should try to achieve and secure co-operation among themselves.

Planning Advantages and Disadvantages

Advantages of Planning

Planning is an important per-requisite for attaining the cherished goals of a business enterprise. Of all the managerial activities, it comes first because of the following benefits:

  1. Planning leads to more effective and faster achievements in any organization.
  2. Since planning foresees the future and also makes a provision for it, it gives an added strength to the business for its steady growth and continuous prosperity.
  3. It secure unity of purpose, direction and effort by focusing attention on the objectives. Hence, unnecessary duplication, overlapping and cross-purpose workings are eliminated.
  4. It has the effect of minimizing the cost of operations
  5. It ensures an even flow of work, minimizes false steps and protects against unwanted deviations.
  6. It enhances the efficiency of other managerial functions.
  7. It provides an effective basis for control in all organizations whether small or big.
  8. It facilitates the process of decision-making.
  9. It enables the management to implement future programmes in a systematic way so that the management may get the maximum benefit out of the programmes framed. It enables all the activities to be conducted in an orderly and coordinated manner in order to achieve the common goals of the enterprise.
  10. With the rapid growth of technological development, it is essential for a manager to keep abreast of the up-to-date technology. Otherwise, the products are likely to become obsolete. Planning helps in this process.

Limitations/Disadvantages of Planning

  1. Lack of Reliable Data:

Planning is based on various facts and figures supplied to the planners. If the data on which decisions are based are not reliable then decisions based on such information will also be unreliable. Planning will lose its value if reliable facts and figures are not supplied.

  1. Time Consuming Process:

Practical utility of planning is sometimes reduced by the time factor. Planning is a time- consuming process and actions on various operations may be delayed because proper planning has not yet been done. The delay may result in loss of opportunities. When time is of essence then advance planning loses its utility. Under certain circumstances an urgent action is needed then one cannot wait for the planning process to complete.

  1. Expensive:

The planning process is very expensive. The gathering of information and testing of various courses of action involve greater amounts of money. Sometimes, expenses are so prohibitive that small concerns cannot afford to use planning. The long-term planning is a luxury for most of the concerns because of heavy expenses. The utility derived from planning in no case should be less than expenditure incurred on it.

According to Hainman, “The cost of planning should not be in excess of its contribution, and wise managerial judgment is necessary to balance the expense of preparing the plans against the benefits derived from them.”

  1. External Factors may Reduce Utility:

Besides internal factors there are external factors too which adversely affect planning. These factors may be economic, social, political, technological or legal. The general national and international climate also acts as limitation on the planning process.

  1. Sudden Emergencies:

In case certain emergencies arise then the need of the hour is quick action and not advance planning. These situations may not be anticipated. In case emergencies are anticipated or they have regularity in occurrence then advance planning should be undertaken for emergencies too.

  1. Resistance to Change:

Most of the persons, generally, do not like any change. Their passive outlook to new ideas becomes a limitation to planning. McFarland writes. “The principal psychological barrier is that executives, like most people have more regard for the present than for the future. The present is not only more certain than the future, it is also more desirable. Resistance to change is commonly experienced phenomenon in the business world. Planning often implies changes which the executive would like to ignore, hoping they would not materialize.” The notion that things planned for future are unlikely to happen is not based on logical thinking. It is the planning which helps in minimizing future uncertainties.

Difference between Depreciation, Amortization and Depletion

Depreciation

Depreciation is the accounting term used for assets such as buildings, furniture and fittings, equipment etc. Companies use this to record the diminishing value of their assets as they are used in the business from the time of purchase of such assets. Hence cost is allocated periodically as value lost due to usage (as expense affecting the business’s net income) and the declining value of assets is recorded (affecting the value of business). Different methods exist in calculating the depreciation amount and these are different depending on the asset type. The depreciation is calculated from the time an asset is used / placed for service and the depreciation is recorded periodically. Depreciation is calculated taking the cost of the asset, the expected useful life of the asset, residual value of the asset and percentage where necessary. Depreciation is not taken into account once the full cost of the asset is recovered / the asset is no longer in the company’s possession (i.e. sold, stolen and fully depreciated). Two main ways exist in calculating depreciation and they are the straight line (which allows deducting the same amount each year over the life of the asset) and reducing balance method / declining balance method (which provides for a higher charge in the first year and reducing amount throughout the asset life).

Depletion

Depletion is an accounting concept which is used mostly in mining, timber, petroleum or other similar industries. Being similar to depreciation, depletion allows accounting for the reduction of the resource’s reserve. There are two main types of depletion calculation: cost depletion (where cost of the resource allocated over the period) and percentage depletion (the percentage of the property’s gross income where percentage is specified for each mineral).

When dealing with a natural resource also referred as a mineral asset the concept of depreciation or amortization cannot be applied. “Depletion” is a form of a systematic reduction in the value of a natural resource based on the rate at which it is being used.

For example: A coal mine has 10 Million tonnes of coal and the coal extraction is happening at the rate of 1 Million tonnes per year. In this case, depletion rate would be 10% p.a. since at this rate of extraction the coal mine is being depleted at 10% per year.

Though both have similar concepts, difference between depreciation and depletion exist as mentioned below.

  1. Depreciation is on tangible assets whereas depletion is on non-renewable resources.
  2. Depreciation is the deduction of the asset value due to aging, whereas depletion is the actual physical reduction of the company’s natural resources (accounting for consumption).

Amortization

Prorating cost of an “Intangible Asset” over the period during which benefits of this asset are estimated to last is called Amortization. The concept of amortization is also used with leases & debt repayment.

Amortization is for Intangible assets whereas depreciation is for tangible fixed assets. Examples of intangible assets are copyrights, patents, software, goodwill, etc.

Method of Reduction Type of Asset Examples
Depreciation Fixed Assets Building, Machinery etc.
Amortization Intangible Assets Copyright, Patent etc.
Depletion Mineral Assets Mines, Oil fields etc.

Factors affecting depreciation

  1. Normal Physical Wear and Tear:

Due to normal use of the assets, the assets deteriorate physically, which results in reduction in their value.

  1. Efflux of Time:

Certain intangible assets have fixed life span such as Trade Marks, Patents or Copyrights etc. The value of such assets decreases anyway with the passage of time irrespective of the fact business enterprise is using them or not.

  1. Obsolescence:

Research & Development leads to innovations, in the form of better and technically advanced machines that scrap old machines even though they may be capable of being run physically.

In that case there may be a permanent decrease in the market prices of certain assets like Computers, Motor Cars etc. This results in decline in the value of old machines. Obsolescence is a loss arising from outdating and replacing the existing asset with the new and improved model of that asset.

  1. Accidents:

Destruction or damage caused by an accident may result in reducing the value of assets.

Factors Affecting Depreciation:

As already stated, depreciation is not an attempt to record the changes in the market value of the asset but a systematic allocation of the total cost of depreciable asset (capital expenditure) to expenses (revenue expenditure) over the useful life of the asset because market value of some assets may increase in short run but even then the depreciation process continues. Based on the matching principle a reasonable portion of capital expenditure (i.e. the cost of the asset) should be charged to revenue during the useful life of an asset.

The calculation of amount of depreciation expense for an accounting period is affected by the:

(i) Actual cost of the asset

(ii) Estimated useful life of the asset

(iii) Estimated residual value of the asset.

It is worth mentioning here that out of three factors, two factors are based on just estimation and only one factor is based on actual. Thus, calculation of depreciation expense is just an estimated loss in value of assets and not the real and exact decrease in value of an asset.

Now we shall move on to discuss each of the above factors in detail:

  1. Actual Cost of the Asset:

Actual cost or historical cost means the acquisition cost of the asset and includes all incidental expenses which are necessary to bring the asset to its present condition and location. Examples of such expenses are installation charges, freight inwards or expenses incurred for improvements of such assets and which are of capital nature.

  1. Estimated Useful Life of the Asset:

Estimated useful life of the asset is either:

(i) The period over which a depreciable asset is expected to be used by the enterprise or

(ii) The number of production or similar units expected to be obtained from the use of the asset by the enterprise.

  1. Estimated Residual or Scrap Value of the Asset:

Residual or scrap value is the expected value which may be realized when the asset is sold or exchanged at the end of its estimated useful life. When residual value is significant, it should be taken into consideration for computing depreciation. However, an insignificant residual value can be ignored for computation of depreciation.

Depreciation is a continuous process, but we don’t record depreciation daily. Actually, the total amount of depreciation to be charged on any asset is an advance expenditure which has been paid by the enterprise at the time of acquisition of such asset.

In other words, this expenditure should be treated like deferred expenditure and only adjusting entries, for charging reasonable and appropriate amount of depreciation to revenue in the income statement, are required to be passed every year.

Objectives of providing for depreciation

  • For the presentation of assets in the balance sheet at their proper value: Depreciation must be charged to each fixed asset for the true and fair presentation of assets in the balance sheet. The depreciation is deducted from the cost or book value of assets each year.
  • For the replacement of assets: The fund equal to the amount of the depreciation is created which will remain in the firm. After the expiry of the life of asset, the same fund can be utilized to replace the new asset.
  • For the determination of correct cost of production: Correct cost of production cannot be ascertained if the depreciation is not charged to the fixed assets. Thus, it is necessary to include amount of depreciation in the calculation of cost of each product.
  • For the determination of true profit or loss: Depreciation is also an expense like repair and maintenance which must be included in profit and loss account to ascertain the correct profit or loss of a business for the year.

Objectives or Need for Providing Depreciation:

(a) To ascertain true profits:

Depreciation is a charge for capital assets used in earning profits and therefore, it should be viewed as business expenditure. Unless proper charge for this expense is made in accounts, the correct profit cannot be ascertained.

(b) To show the assets at their proper values:

Depreciation must be accounted for in order to show the assets at their proper values and thereby present a true and fair view of the financial position of the business. Unless depreciation is provided, the value of the assets will be overstated in the Balance Sheet and it will not reflect the true and fair view of the business.

(c) To create funds for replacement of assets:

Depreciation is non-cash expenditure. Hence, the amount of depreciation charged to Profit and Loss account remains in the business and the amount thus accumulated during the working life of the asset provides funds for its replacement at the end of the working life of the asset.

(d) To keep the capital in tact:

If depreciation is not charged, the amount of profit will be inflated. If such profits are distributed among the owners, then it will amount to the distribution of fixed capital from the business. In the long run it will affect the financial health of the business.

(e) Statutory Need: Provision of depreciation is a statutory need:

Section 205 of the Indian companies Act has made compulsory for a joint stock company to provide for depreciation before distributing the profits as dividends.

Suspense Account

A suspense account is an account used temporarily or permanently to carry doubtful entries and discrepancies pending their analysis and permanent classification.

A suspense account is a general ledger account in which amounts are temporarily recorded. The suspense account is used because the appropriate general ledger account could not be determined at the time that the transaction was recorded.

It is useful to have a suspense account, rather than not recording transactions at all until there is sufficient information available to create an entry to the correct accounts. Otherwise, larger unreported transactions may not be recorded by the end of a reporting period, resulting in inaccurate financial results.

It can be a repository for monetary transactions (cash receipts, cash disbursements and journal entries) entered with invalid account numbers. The account specified may not exist, or it may be deleted/frozen. If one of these conditions applies, the transaction should be directed to a suspense account.

In branchless banking (BB): Banking through mobile for unbanked – these accounts are used for ‘money-in-transit’. For example, sender sends payment from US ACH account to a BB mobile number in Japan. The customer receives an alert on their mobile to withdraw this money from a BB agent. Until they withdraw, the remittance stays in a suspense account, earning the financial institute or the BB enabler float/interest on that money. When customer withdrawal is completed, the money moves from the suspense account to the account of the agent who facilitated the cash withdrawal.

A suspense account is an account in the general ledger in which amounts are temporarily recorded. A suspense account is used when the proper account cannot be determined at the time the transaction is recorded. When the proper account is determined, the amount will be moved from the suspense account to the proper account. It can also be used when there is a difference between the debit and credit side of a closing or trial balance, as a holding area until the reason for error is located and corrected.

Suspense accounts should be cleared at some point, because they are for temporary use. Suspense accounts are a control risk.

An accountant was instructed to record a significant number of journal entries written by the controller of a large company. Unfortunately, there was one amount that did not have an account designated. In order to complete the assignment by the deadline, the accountant recorded the “mystery” amount in the general ledger Suspense account. When the controller is available, the accountant will get clarification and will move the amount from the Suspense account to the appropriate account.

Ascertainment of correct Cash book balance

The following steps will be followed to ascertain the correct cash book balance

i) The first step is to put the balance of pass book as the starting point Showing balance as per pass book.

ii) The cheques deposited but not yet collected are added.

iii) All the cheques issued but not yet presented for payment, amounts directly deposited in the bank account are deducted.

iv) All the items of charges such as interest on overdraft, payment by bank on standing instructions and debited by the bank in the pass book, but not entered in cash book, bills and cheques, dishonoured etc are added.

v) All the credits given by the bank such as interest on dividends collected etc and direct deposits in the bank are deducted

vi) Adjustments for errors are made according to the principles of rectification of errors.

vii) Now, the net balance shown by the statement should be same as shown by the cash book.

Illustration

From the following particulars, ascertain the Bank balance as per Pass Book as on 31st December.

  1. The Bank balance as per Cash Book on the date was Rs 11,500.
  2. Cheques issued but not cashed before that date amounted to Rs 1,750.
  3. Cheques paid into Bank, but not cleared before December amounted to Rs 2,150.
  4. Interest on Investments collected by the Bank but not entered in the Cash Book amounted to Rs 275.
  5. Local cheque paid in but not entered in the Cash Book Rs 300.
  6. Bank Charges debited in the Pass Book Rs 25.

With adjustment in Cash Book:

If the balance at Bank, as per the Cash Book adjusted, it will be Rs 12,050, thus:

Dr.

Cash Book (Bank Col)

Cr.
 

Dec 31

 

To Balance b/d

To Interest on investment

To Cheques omitted

Rs

11,500

275

300

 

Dec 31    By Bank Charges

        “     By Balance c/d

 

Rs

25

12050

    12,075   12,075
 

Bank Reconciliation Statement

As on 31st December

 
 

Rs.

Rs.
Bank balance as per Cash Book     12,050
Add: Cheques issued nut not presented

1750

(+)1,750
      13,800
Less: Cheques paid in but not collected

2,150

(-) 2,150
  Bank Balance as per Pass Book   11,650
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