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Question: 1.1Explain the Purpose & requirement for keeping financial records.
Answer: Most of us do maintain some kind of a written record of our income and expenditure. The idea behind maintaining such records is to know the correct position regarding income and expenditure. The need for keeping a record of income and expenditure in a clear and systematic manner has given rise to the subject of book keeping.
It is all the more necessary for an organization or a concern to keep proper records. At the end of the year the true result of the economic activities of a concern must be made available otherwise it will not be possible to run the concern. In case of a business concern the profit or loss at the end of the year must be ascertained, because, the amount of profit must be adequate in relation to that of investment made in the business. If it is not so or if there is a loss, it is an indication of some defects existing somewhere in the management of the business. All such defects need to be detected and analyzed and appropriate measures taken for their rectification. But it is only possible if proper books of records are maintained in the business. There are several very good reasons for keeping different types of business and financial records. Records are required for tax preparation, filing and if needed for any audits. Lenders require certain financial information about the business before making any new loans or extending new credit. Managing the business including making plans and solving problems is much easier if records of past performance are available. Monitoring and evaluating business performance cannot be done without the important information, problems may be going undetected and opportunities missed. Records are needed to provide a paper trail or documentation. Records provide a sound basis for developing business agreements both with family members and with others. For taxes and for financial management purposes, records of sales, cash received and cash paid out records are needed. Records of accounts payable and receivable are needed to ensure timely payment and for cash flow management. Question: 1.2Analyse Techniques for recording financial information in a business organization.
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Answer: Accountants have developed systematic and relatively simple techniques for recording financial information. The initial starting point for collecting financial information is to systematically collect records of financial transactions e.g. invoices, receipts etc and to enter these into some form of book keeping system.
Single Entry Book Keeping: A simple system in which transactions of accounting information are recorded only once is called Single entry book keeping. It is used primarily in simple applications such as check book balancing or in very small cash based business. It does not require keeping of journals and ledgers. It is incomplete, faulty, inaccurate, unsystematic and unscientific style of account keeping, generally less costly and the both aspects of debit and credit are not recorded. It is not possible to prepare trial balance, profit and loss account and balance sheet.
Double Entry Book Keeping:
Every business transaction causes at least two changes in the financial position of a business concern at the same time hence both the changes must be recorded in the books of account. Otherwise the books of accounts will remain incomplete and the result ascertained therefore will be inaccurate. For example we buy machinery for £100,000. Obviously it is a business transaction. It has brought two changes machinery increases by £100,000 and cash decreases by an equal amount. While recording this transaction in the books of account both changes must be recorded. In accounting language these two changes are termed as a debit change and a credit change.
We see that for every transaction there will be two entries one debit entry and another credit entry. For each debit there will be a corresponding credit entry of an equal amount. Conversely for every credit entry there will be a corresponding debit entry of an equal amount. So, the system under which both the changes in a transaction are recorded together – one change is debited, while the other change is credited with an equal amount, is known as Double Entry System.
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In this connection, the successive processes of the Double Entry System may be noted:
First of all, transactions are recorded in a book known as Journal.
In the second process transactions are classified in a suitable manner and recorded in another book known as Ledger.
In the third process, the arithmetical accuracy of the books of account is tested by means of Trial Balance.
In the fourth and final process the result of the full year working is determined through the Final Accounts.
The initial record of each transaction is evidenced by a business document such as invoice, cash voucher etc. As soon as a transaction takes place its debit and credited aspect are analyzed and first of all recorded in a book together with its short description. This book is known as Journal. Thus we see that the most important function of Journal is to show the relationship between the two accounts connected with a transaction. Since transactions are first of all recorded in Journal, so it is called Book of Original Entry.
All the changes for a single account are located in one place, in a ledger account. This makes it easy to determine the current of any account. The book in which accounts are maintained is called Ledger. Generally one account opened on each page of this book, but if transaction relating to a particular account numerous, it may extend to more than one page. All transactions relating to that account are recorded there. From journal each transaction is posted to at least two concerned accounts.
Remember that, if there are two accounts involved in a journal entry, it will be posted to two accounts in the ledger and if the journal entry consists of three accounts it will be posted to three different accounts in the ledger. But it must be remembered that transactions cannot be recorded directly in the ledger, they must be routed through journal.
Transactions ïƒ Journal ïƒ Ledger
So, the book in which all the transactions of a business concern are finally recorded in the concerned account in a summarized and classified form, is called Ledger.
The fundamental principle of Double entry system is that at any stage, the total of debits must be equal to the total of credits. If entries are recorded and posted correctly, the ledger will reflect equal debits and credits and the total credit balances will then be equal to the total debited balances. As we know that under Double entry system for each at every transaction one account is debited and another account is credited with an equal account. If all the transactions are correctly recorded strictly according to this rule, the total amount of debit side of all the ledger accounts must be equal to that of credit side of all the ledger accounts. This verification is done through Trial Balance.
If the trial balance agrees, we may reasonably assume that the books are correct. On the other hand if does not agree, it indicates that the books are not correct there are mistakes somewhere. The mistakes are to be detected and corrected otherwise correct result cannot be ascertained. The trial balance serves to check the equality of debit and credits or mathematical test of accuracy and to provide information for use in preparing Final accounts.
Thus in the light of above discussion a Trial Balance may be defined as ‘’an informal accounting schedule or statement that lists the ledger account balances at a point in time and compares the total of debited balances with the total of credit balances’’.
Computerised System: A system in which computers and software’s are used to maintain the records of a business or any other organisation is called Computerised System. In computerised system operations can be done with high pace and accuracy, there will be lot of time saved in maintaining accounts. It provides quick information when ever needed. Maintaining and installation of computerised system cost is high and its operation requires technical knowledge and training.
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Manual System: A system under which the records are maintained manually by using pen and paper or account work is done by humans what has been sold and for how much is called Manual System. These days there is no using this of type. Pen and paper are very old school technique of writing and saving different types of information.
Question 1.3 and 1.4
2.1 Analyses components of working capital.
Components of Working Capital:
Working capital constitutes various current assets and current liabilities.
Assets which are short-lived and which can be converted into cash quickly to meet short term liabilities are called Current Assets, e.g. Stock, Debtors, Receivables, Prepaid expenses, Accrued income, Cash etc. Such assets change their form repeatedly and so, they are also known as Circulating or floating assets. For example on purchase of goods cash is converted into stock and on sale of goods, stock is converted into debtors, on collection from debtors, debtors take the form of cash etc.
Current or Short-Term Liabilities:
The debts which are repayable within a short period of time are called Current or Short-Term Liabilities, e.g. Creditors, Bills Payable, Bank overdraft, outstanding expenses, Dividend payable, Provision for taxation etc. Current liabilities may again be divided into two:
- Deferred Liabilities: Debts which are repayable in the course of less than one year but more than one month are called Deferred Liabilities, e.g. Short-Term Loan etc.
- Liquid or Quick Liabilities: Debts which are repayable in the course of a month are called Liquid or Quick Liabilities, e.g. Bank overdraft, outstanding expenses, creditors etc.
The main components of working capital are:
- Cash: Cash is one of the most liquid and main component of working capital. Holding cash involves cost because the value of cash held and a year later it will be less than the value of cash as on today. Excess of cash balance should not be held in reserve in business because cash is a non-earning asset. Hence a suitable and well judged cash management is of extreme importance in business.
- Marketable Securities:
These securities also don't give much capitulate to the business because of two reasons:
- Marketable securities act as a replacement for cash.
- These are used are impermanent investments.
These are held not for provisional balances but only as a security against potential lack of bank credit.
- Accounts Receivable:
Lots of debtors always lock up the firm's assets particularly during inflationary tendencies. It is a two step account. When goods are sold, inventories are reduced and accounts receivables are formed. When payment is made, debtors reduce and cash level increases. Thus quantum of debtors depends on two things, volume of Credit sales and usual length of time between sales and collections. The capitalist should find out the most advantageous credit standards. An optimal credit policy should be established and the firm's operations should be always monitored to attain higher sales and minimum bad debt losses.
Inventories stand for an important amount of firm's assets. Inventories must be properly managed so as to this investment doesn't become too large and it would result in blocked capital which could be put to productive use elsewhere. On the other hand having too little or small inventory could result in loss of sales or loss of customer goodwill. An optimum level of inventory therefore should be maintained.
2.2 Explain how business organizations can effectively manage working capital.
3.1 Explain the difference between management accounting and financial accounting.
Production of summary of financial statements for external users.
Production of detailed accounts, used by management to control the business and plan for the future.
Prepare annually (six months or quarterly in some countries).
Normally prepared monthly, often on a rolling basis.
Generally required by law.
Not required by law.
Reflects past performances and current position.
Includes budgets and forecast of future activities as well as reflecting past performance.
Question 3.2 and 3.3
Evaluate the use of different costing methods for pricing purposes
- What are the effects of absorption and marginal costing on profit?
- Advantages and Disadvantages of Marginal Costing Technique.
Differenr costing methods are mentioned below:
Job Costing: A job is a cost unit which consists of a single order or contract. Job costing consists of a single order undertaken to customer special requirements and is usually for a short duration. Contract Costing:Contract costing is a form of job costing which applies where the job is on a large scale and for a long duration. The majority of costs relating to a contract are direct costs. Batch Costing:A batch is a cost unit where a quantity of identical items is manufactured. It consists of a separate, readily identifiable group of product unit which maintains their separate identity throughout the production process.
Operating Costing or Service Costing:Service costing can be used by companies operating in a service industry or by companies wishing to establish the cost of services carried out by some of their departments. Service costing is cost accounting for services or functions, e.g. canteen, maintenance, personnel. These may be referred to as service centers, departments or functions. Process Costing: Process costing is a costing method which is applicable or industries producing homogenous products in large quantities. The purpose of process costing is a typical one i-e, stock valuation.
- effects of absorption and marginal costing on profit:
The difference in profits reported under the two systems is due to the different stock valuation methods used.
- If stock level increases between the beginning and end of the period, absorption costing will report higher profit. This is due to some fixed production overhead is carried forward to next period in the closing stock value.
- If stock level decreases, then absorption costing shows lower profit than marginal costing due to fixed production overhead brought forward in the opening stock charged into the current period profit statement.
- If sales are constant and production fluctuates then the marginal costing profit is constant but the profit of absorption costing fluctuates.
- If the output volume is constant and the volume of sales fluctuates then both profits are different in the direction of sales.
If stock level increases, absorption costing profit > marginal costing profit.
If stock level decrease, absorption costing profit < marginal costing profit.
If stock level remains the same, absorption costing profit = marginal costing profit.
(okay hay ye b)
- Advantages and Disadvantages of Marginal Costing Technique:
4.1: Demonstrate the main methods of project appraisal by explaining various investment appraisal techniques. State, in general terms, which method of investment appraisal you consider to be most appropriate for evaluating investment projects and why?
Key Methods of Project Appraisal:
Net present value:
The net present value method calculates the present value of all cash flows, and sums them to give the net present value. If this is positive, then the project is acceptable.
The net present value (NPV) method of evaluation is as follows.
- Determine the present value of costs.
In other words decide how much capital must be set aside to pay for the project. Let this be £C.
- Calculate the present value of future cash benefits from the project.
To do this we take the cash benefit in each year and discount it to a present value. This shows how much we would have to invest now to earn the future benefits, if our rate of return were equal to the cost of capital. By adding up the present value of benefits for each future year, we obtain the total present value of benefits from the project. Let this be £B.
- Compare the present value of costs £C with the present value of benefits £B.
The net present value is the difference between them: £ (B-C)
- NPV is positive.
The present value of benefits exceeds the present value of costs. This in return means that the project will earn a return in excess of the cost of capital. Therefore, the project should be accepted.
Compared to other investment appraisal techniques such as the IRR and the discounted payback period, the NPV is viewed as the most reliable technique to support investment appraisal decisions. There are some disadvantages with the NPV approach. If there are several independent and mutually exclusive projects, the NPV method will rank projects in order of descending NPV values. However, a smaller project with a lower NPV may be more attractive due to a higher ratio of discounted benefits to costs (see BCR below), particularly if there affordability constraints. The NPV method should be always be used where money values over time need to be appraised.
Accounting Rate of Return –ARR:
A capital investment project may be assessed by calculating the return on investment (ROI) or accounting rate of return (ARR) and comparing it with a pre-determined target level. A formula for ARR which is common in practice is: ARR = Estimated average profits divided by Estimated average investment and multiply by 100% It allows owner of a business compare easily profit potential for investments and projects.
Internal Rate of Return (IRR):
The internal rate of return technique uses a trial and error method to discover the discount rate which produces the NPV of zero. The discount rate will be the return forecast for the project.
The internal rate of rate of return method involves two steps:
- Calculating the rate of return which is expected from a project.
- Comparing the rate of return with the cost of capital.
If a project earns a higher rate of return than the cost of capital, it will be worth undertaking (and its NPV would be positive). If it earns a lower rate of return, it is not worthwhile (and its NPV would be negative). If a project earns a return which is exactly equal to the cost of capital, its NPV will be 0 and it will only just be worthwhile.
This is the time taken to recover the initial outlay from the cash flows of the project. Payback period is the amount of time. It is expected to take for the cash inflows from a capital investment project to equal the cash outflows. Payback period is always calculated as:
Initial investment ÷ Annual cash inflows
If the cash inflows are for the same amount and incurs after the same time period.
Decision Rule: If payback period < Target, accept it and if payback period > Target then reject it.
An alternative of the payback method is the discounted payback period. The discounted payback period is the amount of time that it takes to cover the cost of a project by adding the net positive discounted cash flows arising from the project. It is never the lone appraisal method used to measure a project but is a handy performance indicator to judge the projects expected performance.
4.3 Explain how finance might be obtained for a business project.