Finding/Calculating Funds from Operations : Direct, Adjusted Profit/Loss a/c, Add Back Methods

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Funds From Operations

 
 
The Funds from Operations in most cases is not equal to the Net Profit revealed by the Profit and Loss a/c. The profits arrived at by taking the Gross Profit and setting off only those charges (adding only those incomes) that are acceptable in Funds Flow Analysis, is what forms the Funds from Operations.

DrProfit and Loss a/c
[For Finding Funds from Operations]
Cr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Rent
To Salaries
To Interest
To Taxes
To Depreciation
To Loss on Sale of Assets
To Reserve for Bad Debts
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares










By Gross Profit
By Profit on Sale of Assets


       

  • All the items that have been struck off represent appropriation of profits for the purpose of Funds Flow Analysis.
    To Reserve for Bad Debts, though termed a reserve, represents a charge.
  • By Profit on Sale of Assets is an item that is not considered as real income for the purpose of Funds Flow Analysis.

Only those items of the Profit and Loss account which result in a flow of fund are to be considered for the purpose of calculating Funds from Operations.

• Methods for finding Funds from Operations

There are three methods available for finding the funds from operations
  • Direct Method
  • Adjusted Profit and Loss Account Method
  • Add Back Method

» Which method to use?

We can use any method of our choice for ascertaining the Funds from Operations.

To use the Direct Method, we should be knowing the figure of Gross Profit.

The other two methods are the same. The difference is in the way the information is presented. It would be useful to know both the methods.

It would be convenient to learn about these methods through an illustration.

Funds from Operations » Problem

 
 
From the information provided in the following profit and loss account, find out the Funds from Operations

DrProfit and Loss a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Salaries and Wages
To Rent and Rates
To Interest
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To Reserve for Bad Debts
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
3,42,000
1,24,000
76,000
1,32,000
87,000
39,000
91,000
42,000
1,25,000
75,000
50,000
40,000
5,25,000
By Gross Profit
By Commission
By Miscellaneous Income
By Profit on Sale of Asset
12,50,000
2,80,000
1,54,000
64,000
       

Funds from Operations » Direct Method

 
 
Under the direct method, we make up the Profit and Loss account starting with Gross Profit.

The P/L a/c is debited and credited with only those items of the actual Profit and Loss a/c that are relevant in Fund Flow analysis i.e. only those items which result in a flow of fund.

DrProfit and Loss a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Salaries and Wages
To Rent and Rates
To Interest
To Reserve for Bad Debts
To Funds From Operations
3,42,000
1,24,000
76,000
42,000
11,00,000
By Gross Profit
By Commission
By Miscellaneous Income
12,50,000
2,80,000
1,54,000
  16,84,000   16,84,000

• Is it a Source(inflow)/Application(outflow)?

If the Funds From Operations appear on the
  • Debit side, it represents a Source/Inflow of Fund
    [It represents Net Profit being carried down from the P/L a/c to the Appropriation a/c]
  • Credit side, it represents an Application/Outflow of Fund
    [It represents Net loss being carried down from the P/L a/c to the Appropriation a/c]

The Funds from Operations obtained is included on the relevant side of the Funds Flow Statement depending on what it represents.

• Net Profit from Funds from Operations

The Net profit can be obtained from Funds from Operations by preparing the Profit and Loss appropriation a/c. The Net Profit as the residue (balance) after appropriating Funds from Operations.

DrProfit and Loss Appropriation a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000
By Funds from Operations
By Profit on Sale of Asset
11,00,000
64,000
  11,64,000   11,64,000

This second part of the account is not needed to be prepared if we are to calculate only the Funds from operations.

» Note

The term appropriation has a different meaning in Financial accounting and Funds flow analysis, the profit and loss appropriation account in both the cases is not the same.

• Why call this the Direct Method?

Since we prepare the account starting with the gross profit, (just like in case of the Profit/Loss account), this method is called the Direct Method.

Funds from Operations » Adjusted Profit and Loss account Method

 
 
Under this method, we make up the Profit and Loss a/c starting with Net Profit. The P/L a/c is debited/credited with only those items of the actual Profit and Loss a/c that are not relevant in Fund Flow analysis i.e. only those items which do not result in a flow of fund. The Funds from Operations is thus obtained as a balancing figure from the account.

This is exactly the same as the second part of the account prepared above, with the Funds From Operations being a figure that is obtained through calculations.

DrAdjusted Profit and Loss a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000
By Funds from Operations (?)
By Profit on Sale of Asset
11,00,000
64,000
  11,64,000   11,64,000

• Is it a Source(inflow)/Application(outflow)?

If the Funds From Operations appear on the
  • Credit side, it represents a Source/Inflow of Fund
    [It represents Net Profit brought down from the P/L a/c to the Appropriation a/c]
  • Debit side, it represents an Application/Outflow of Fund
    [It represents Net Loss brought down from the P/L a/c to the Appropriation a/c]

The Funds from Operations obtained is included on the relevant side of the Funds Flow Statement depending on what it represents.

• Why call it Adjusted Profit and Loss a/c method?

Since we prepare the account starting with the Net Profit, and find the Funds from Operations by adjusting the appropriations, this method is called the Adjusted Profit and Loss account Method.

Funds from Operations » Add Back Method

 
 
Under this method, we make up a statement starting with Net Profit. This method is exactly the same as the Adjusted Profit and Loss account method, with the only difference being the format in which the information is presented.
  • We start with the NET PROFIT

    Where the current period Net Profit is not given, we ascertain it from the ledger account to which the Net Profit is credited. This can be obtained as a difference between the closing and opening balances in that account (where there is no other adjustment made to that account). If the figure obtained is negative, it indicates a net loss during the current period.

  • To it we ADD

    The items on the debit side of the Profit and Loss account that are not relevant in Fund Flow analysis i.e. those items which do not result in a flow of fund are added to the figure of net profit.

  • From that sum we DEDUCT

    From this sum, the items on the credit side of the Profit and Loss account that do not result in a flow of fund are deducted to arrive at the figure of Funds from Operations.

Statement for Calculation of Funds from Operations
Particulars Amount Amount
Profit and Appropriation a/c:
    Closing Balance
Less: Opening Balance
Current Period Profit
Add: Items of Expenses debited to Profit/Loss a/c
        not resulting in a flow of funds
1) Provision for Taxes
2) Depreciation on Machinery
3) Depreciation on Furniture
4) Loss on Sale of Motor Car
5) General Reserve
6) Special Reserve
7) Goodwill Written off
8) Discounts on issue of Shares/Debentures



1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000









6,39,000
Less: Items of Incomes credited to Profit/Loss a/c
        not resulting in a flow of funds
1) Profit on Sale of Asset


64,000
11,64,000

64,000
Funds From Operations 11,00,000

• Why is it called the Add Back method?

Since we prepare the account starting from taking net profit, and find the Funds from Operations by adding the appropriations already deducted in arriving at the figure or Net Profit, this method is called the Add Back Method.

Are Funds From Operations Sources (inflows)/Applications (outflows)

 
 
Any change in the Capital a/c or the Profit and Loss Appropriation a/c (Fund accounts) that brings about a change in working capital indicates a Flow of Fund.

• Profits » Inflow/Source of Fund

The Capital a/c or Profit/Loss Appropriation a/c balance increases when there are profits. Both of them represent Fund Liabilities. Increase of a Fund liability amounts to Inflow/Source of Fund.

Thus there will be an inflow of Fund when there are profits.

• Loss » Outflow/Application of funds

The Capital a/c or Profit/Loss Appropriation a/c balance decreases when there are losses. Both of them represent Fund Liabilities. Decrease of a Fund liability amounts to Outflow/Application of Fund.

Thus there will be an outflow of Fund when there are losses.

• Is Profit and Loss a/c a Current natured Account

The balance in the P/L a/c represents the net balance after accumulating and setting off the balances in the nominal accounts.

All the nominal accounts are closed at the end of the accounting period by transfer to either the Trading a/c or the Profit and Loss a/c as the case may be.

Since all nominal accounts have a life span equal to that of the accounting period (which is a year in most cases), we can assume the nominal accounts to be Current natured. Therefore, the net balance of these accounts should also be current natured. Therefore, Profit and Loss account represents a current natured account.

Thus, these transaction is a cross transactions
- between a Fund account and a Current account.
Transfer of profits Transfer of losses
Dr. Profit and Loss a/c
Cr. Capital a/c
Dr. Capital a/c
Cr. Profit and Loss a/c

» Profit and Loss a/c ≠ Profit and Loss Appropriation a/c

These are two distinct accounts and the difference between them should be noted clearly. P/L a/c is a nominal account which is closed at the end of the accounting period and P/L Appropriation account is a special nominal account whose balance is carried forward to the subsequent accounting periods.
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