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Charge against/on Profits
Synonyms = Bind, Commit, Obligate, Entrust, Burden, Load
• Charge on Profits
A ledger account prepared to ascertain profits is a nominal account. Trading a/c, Profit and Loss a/c, Consignment a/c, Branch a/c, Joint Venture a/c etc., are all such accounts. These accounts carry a credit balance when there are profits.
A Charge against/on profit is a transaction that results in a debit to the ledger account that is prepared to ascertain profits/losses. Thus, a charge on profit would result in the available credit balance in those accounts getting reduced or the debit balance increasing.
» Real Charge on Profits
All debits to the nominal account prepared for ascertaining profits reduce the available profits and are thus capable of being called charge on profits. However, there are certain transactions which result in a debit to the profit and loss which do not reduce the profits in real terms, but would shift the profits from that account to another account. Such transactions are called appropriations.
Thus only those debits to the accounts prepared for ascertaining profits, which result on account of a transaction that represents either an expenditure or a loss would be a real charge on/against profit.
Appropriation of Profits
Synonyms = allocation, setting aside
• Appropriation of Profits
Appropriating profits amounts to keeping aside the profits for some specific purpose. A most common example for appropriation of profits is creating a Reserve.
There would be a credit balance when there are profits.
This can also be interpreted as maintaining the profits in two different accounts instead of a single account.
Influence of Profits/Losses on Capital
Rules of debit/credit for Nominal Accounts - Debit all expenses and losses. Credit all incomes and gains.
Profit and Loss a/c which is a nominal account and shows a credit balance when there are profits and debit balance when there are losses.
Just like other nominal accounts the P/L a/c is also closed at the end of the accounting period. It is closed by transfer to the Capital a/c.
Profit increases Capital and loss decreases Capital.
• Transfer to Profit and Loss Appropriation account
Where the organisation intends to maintain distinct information relating to the Capital raised and the Capital accumulated through profits, it maintains two separate account
In such a case, the Profit and Loss account, is closed by transfer to the Profit and Loss Appropriation a/c.
Profit increases the P/L Appropriation a/c balance and loss decreases the P/L Appropriation a/c balance.
Capital a/c and Profit and Loss Appropriation a/c in general carry a credit balance. Crediting those accounts amounts to increasing the balance in them and debiting those accounts amounts to decreasing the balance in them.
Funds From Operations
By Operations we mean the activities involved in the business whose Funds Flow is being analysed.
Funds from Operations can be understood as capital accumulated through profits made by the business. This may be the Net Profit revealed by the Profit and Loss account. In most cases it is not so.
• Why is Funds from Operations ≠ Net Profit
The Net profits cannot be assumed to be Funds from Operations because, the term appropriation of profits is given a different meaning in Funds Flow Analysis.
The profits arrived at by taking this difference into consideration would be capable of being called the Funds from Operations.
The profits arrived at by taking the Gross Profit and deducting those charges (and adding only those incomes) that are acceptable in Funds Flow Analysis, is what forms the Funds from Operations.
Funds Flow analysis » Funds From Operations : Appropriations/Charges
The segregation of debits as to charges and appropriations is done in a slightly different manner for the purpose of Funds Flow analysis.
• Items of Expenses not resulting in a Flow of Fund » Treated as Appropriations
For the purpose of Funds Flow analysis, only those transactions which influence the items/accounts within the Fund Area which bring about a change in Working Capital are considered to be transactions resulting in a flow (inflow/outflow). This happens only when there is a cross transaction, i.e. a transaction involving an account/item within the Fund Area and the Current Area.
Based on this logic, certain charges against profits in the normal course, are treated as appropriations.
Funds Flow Analysis » Funds From Operations : Incomes
• Items of Incomes not resulting in a Flow of Fund » Not real incomes
Just like in the case of charges to the profit and loss account, there are certain credits to the profit and loss account which are not be considered in analysing profits for the purpose of Funds Flow Analysis.
Reserve for Bad and Doubtful Debts - A Charge
The prefix "Reserve" in Reserve for Bad Debts creates an understanding that a debit in the profit and loss account by this name should be an appropriation of profit.
» Appropriation!! - No
It can be claimed to be an appropriation since the debit in the profit and loss account results in a transfer of profit from the profit and loss account to the Reserve for Bad Debts a/c. This argument would hold only if we accept the Reserve for Bad Debts account to be an account indicating accumulated profits (reserve like the general reserve). On such an assumption.
Profit and Loss a/c is a Fund Liability and Reserve for Bad and Doubtful Debts a/c is a Fund Liability
However, we do not make such an assumption as explained below.
» Charge - Yes
The reserve for Bad and Doubtful Debts (RBD) is given a special status, since it has a specific purpose i.e. to meet the losses on account of bad debts.
We deduct the RBD from the value of debtors on the assets side of the balance sheet. Deducting an item from the assets side is the same as placing the item on the liabilities side. Since Sundry Debtors are Current Assets, the reserve related to it would be a Current Liability. Based on this treatment we can say that the RBD a/c is a Current Liability and not a Fund Liability.
Profit and Loss a/c is a Fund Liability and Reserve for Bad and Doubtful Debts a/c is a Fund Liability
Balance Sheet Area affected » Appropriation - Fund Area, Charge - Current Area
For the purpose of this explanation let us limit our thought to those transactions which have an effect on the Balance Sheet items only.
Consider the following debits to the Profit and Loss account, one a charge and the other an appropriation
• Result/Effect of a Charge
Where the debit to the profit and loss account represents a charge, then the balance sheet area affected on account of that is the Current Area
The charge created by recording outstanding expenses is one good example for this
Consider the net entry to understand the effect.
• Result/Effect of an Appropriation
Where the debit to the profit and loss account represents an appropriation, then the balance sheet area affected on account of that is the Fund Area
The Fund Area is also identified as Non-Current Area.
• Balance Sheet area Affected
The effect of both the above transactions on the Profit and Loss account is the same (a debit). However the area of the balance sheet they affect is different.
Another way of interpreting the charge and appropriation is based on the balance sheet area affected.
Reserve for Taxation/Dividends - Charge/Appropriation
Reserve for Taxation and Reserve for Dividends are two items which are capable of being treated both as a charge as well as appropriations. This treatment in effect is dependent on the area of the balance sheet they are assumed to be included/present in.
• in Current Area
If they are assumed to be included in the current area, then any debit to the profit and loss account on account of these would be a charge.
If these are included in the Current area, then these items/accounts should be treated like other current liabilities.
• in Fund (Non-Current) Area
If they are assumed to be included in the Fund (non-current) area, then any debit to the profit and loss account on account of these would be an appropriation of profit.
If they are included in the Fund (Non-Current) Liabilities, then these items/accounts should be treated like other Fund Liabilities.
• How to decide whether they are Current Liabilities or Non-Current Liabilities?
There is no specific rule to decide whether the provision for taxation and provision for dividend are to be treated as current liabilities or non-current liabilities.
In problem solving, their nature is determined based on their presence in the balance sheet. If these accounts are placed along with the current liabilities, then we assume that they are current and if they are placed along with reserves we assume them to be non-current.
If it is not possible to decide based on their presence in the Balance Sheet (in cases where the balance sheet items are not arranged in an order or where the Balance Sheet is not known/given), then we can make our own assumption. Because these are capable of being treated in two ways, in problem solving, it would always be appropriate to indicate what you are considering it to be.
» Both need not be of the same kind
It is not a requirement that both the accounts would have to be of the same kind. One of them can be a Current account and the other a non-current account.
Reserve for Taxation/Dividends - Assumptions
In problem solving, accounts like Reserve for Taxation, Reserve for Dividends are treated as current in some and non-current in some.
In Funds Flow analysis, we identify the changes occurring in the Fund accounts (Non - Current) over the period for which the Funds Flow is being analysed. Thus, we need to think of the changes occurring in these accounts (Provision for Taxation/Dividends) only if they form part of the Fund Area i.e. if they are Non Current Liabilities.
• Opening Balance is cleared by paying out
The opening credit balance in the Reserve for Taxation/Dividend represents a liability as and when the tax/dividend due is determined. One most common assumptions that we make (in the absence of information to the contrary) is that the opening balance in these accounts which represents a liability is paid out in full.
• Closing balance represents/relates to reserve created during the current period
Because the opening balance is assumed to be paid out in full, the total closing balance would be on account of the provision created during the current period (derived as a balancing figure).
• Why such an Assumption
» Reserve for Taxation
The opening balance of Provision for Taxation account represents profits set aside (charged) to pay up taxes. It would be rational to assume that a tax liability that has been provided for towards the end of the previous period is paid out by the end of the current period.
It would be irrational to assume the statutory liability to be unpaid for over a year.
However where there is a specific information/indication with regard to the amount paid as tax during the current period, that should be considered. The actual tax liability assessed can be more/less than the amount provided for in which cases, the amount paid may be more/less than the opening balance.
Where the amount provided for during (at the end of) the current period is known, we find out the amount paid out as the balancing figure.
» Provision for Dividends
The opening balance in the Provision for Dividends account represents the profits set aside for the purpose of payment of dividends to shareholders.
Even in this case it would be rational to assume that the dividend has been declared and paid out within the one year period.
The statutory obligation to pay out dividends within a period of 30 days once they are declared also supports this assumption.
Companies Act, 1956 Hide/Show
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