Funds from Operations - Appropriations/ Charges - Profit/Loss a/c

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Charge against/on Profits

 
 

• Charge

Meaning
  1. Assign a duty, responsibility or obligation to
  2. Attribute responsibility to

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.

DrProfit and Loss a/cCr
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










   
       

» 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.

DrProfit and Loss a/cCr
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










   
       

  • To General Reserve, To Special Reserve - represent appropriation of profits.
  • To Reserve for Bad Debts, though termed a reserve, represents a charge.

Appropriation of Profits

 
 

• Appropriate

Meaning
  1. Give or assign a resource to a particular person or cause
  2. Setting aside money for a specific purpose

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.
Creation of General Reserve
Dr. Profit and Loss a/c
Cr. General Reserve a/c

There would be a credit balance when there are profits.

Transfer of credit balance from one account to a second results in the second being credited, thereby increasing the credit balance in the second account.

DrProfit and Loss a/cCr
Date Particulars J/F Amount
(in Rs)
Date Particulars J/F Amount
(in Rs)
31-03-07
31-03-07
To General Resrv a/c
To Balance c/d

1,25,000
12,75,000
31-03-07 By Balance b/d 14,00,000
  Total   14,00,000   Total   14,00,000
        01-04-07 By Balance b/d 12,75,000

DrGeneral Reserve a/cCr
Date Particulars J/F Amount
(in Rs)
Date Particulars J/F Amount
(in Rs)
31-03-07 To Balance c/d
3,65,000 31-03-07
31-03-07
By Balance b/d
By Profit/Loss a/c

2,40,000
1,25,000
  Total   3,65,000   Total   3,65,000
        01-04-07 By Balance b/d 3,65,000

This can also be interpreted as maintaining the profits in two different accounts instead of a single account.

Though, reserves are created by charging profits, creation of a reserve is an appropriation of profits and not a charge against profits.

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.

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

Transferring a Debit/Credit balance from one account to a second results in the second account being debited/credited and the first account being credited/debited.

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
  • Capital a/c (to record capital brought in and taken out) and
  • Profit and Loss Appropriation a/c (to record accumulated profits).

In such a case, the Profit and Loss account, is closed by transfer to the Profit and Loss Appropriation a/c.

Transfer of Profits Transfer of Losses
Dr. Profit and Loss a/c
Cr. Profit and Loss Appropriation a/c
Dr. Profit and Loss Appropriation a/c
Cr. Profit and Loss a/c

Profit increases the P/L Appropriation a/c balance and loss decreases the P/L Appropriation a/c balance.

• Note

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.

  • Charging Depreciation

    Recording Depreciation Charging Depreciation Net Effect
    Dr. Depreciation a/c
    Cr. Asset a/c
    Dr. Profit and Loss a/c
    Cr. Depreciation a/c
    Dr. Profit and Loss a/c
    Cr. Asset a/c

    Profit and Loss a/c is a Fund Liability and Asset a/c is a Fund Asset.
    ⇒ This transaction for charging depreciation not being a cross transaction is considered an appropriation of profit.

  • Writing off Accumulated Losses like Discounts on Issue of Shares/Debentures, Goodwill etc

    Writing off Goodwill Charging Depreciation Net Effect
    Dr. Profit and Loss a/c
    Cr. Goodwill a/c
    Dr. Profit and Loss a/c
    Cr. Discount on Issue of Shares a/c
    Dr. Profit and Loss a/c
    Cr. Miscellaneous Expenses a/c

    Profit and Loss a/c is a Fund Liability and
    Goodwill a/c, Discount on Issue of Shares a/c, Miscellaneous Expenses a/c are all Fund Assets.
    ⇒ These transactions not being cross transactions are treated as appropriations of profits.

  • Loss on Sale of Assets

    Sale of Asset Loss Combined Entry
    Dr. Bank a/c
    Cr. Asset a/c
    Dr. Profit and Loss a/c
    Cr. Asset a/c
    Dr. Bank a/c
    Dr. Profit and Loss a/c
    Cr. Asset a/c

    » Ledger Hide/Show

    DrAsset a/cCr
    Date Particulars J/F Amount
    (in Rs)
    Date Particulars J/F Amount
    (in Rs)



     





    By Bank a/c
    By P/L a/c



    3,75,000
    1,25,000
     
                   
                   

    Assuming an asset whose book value is 5,00,000 is sold for 3,75,000

    Considering only the entry pertaining to loss,
    Profit and Loss a/c is a Fund Liability and Asset a/c is a Fund Asset
    ⇒ This transaction not being a cross transaction is treated as appropriation of profit.

DrProfit and Loss a/cCr
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 not an item to considered as real income for the purpose of Funds Flow Analysis.

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.
  • Profit on Sale of Assets

    Sale of Asset Profit Combined Entry
    Dr. Bank a/c
    Cr. Asset a/c
    Dr. Asset a/c
    Cr. Profit and Loss a/c
    Dr. Bank a/c
    Cr. Asset a/c
    Cr. Profit and Loss a/c

    » Ledger Hide/Show

    DrAsset a/cCr
    Date Particulars J/F Amount
    (in Rs)
    Date Particulars J/F Amount
    (in Rs)


    To P/L a/c
     




    1,00,000

    By Bank a/c


    5,00,000
     
                   
                   

    Assuming an asset whose book value is 4,00,000 is sold for 5,00,000

    Considering only the entry pertaining to profit,
    Profit and Loss a/c is a Fund Liability and Asset a/c is a Fund Asset
    ⇒ This transaction not being a cross transaction is treated as appropriation of profit.

Reserve for Bad and Doubtful Debts - A Charge

 
 
Reserve for Bad Debts is created by charging profits

Creating Reserve for Bad and Doubtful Debts
Dr. Profit and Loss a/c
Cr. Reserve for Bad and Doubtful Debts a/c

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
⇒ This transaction not being a cross transaction is treated as appropriation of profit.

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
⇒ This transaction being a cross transaction is treated as a charge against/on profits.

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

DrProfit and Loss a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)

To Outstanding Salaries

To General Reserve

42,000

75,000
   
       

• 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

Recording Outstanding Recording Charge Net Effect/Combined Entry
Dr. Expenses a/c
Cr. Outstanding Expenses a/c
Dr. Profit and Loss a/c
Cr. Expenses a/c
Dr. Profit and Loss a/c
Cr. Outstanding Expenses a/c

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

Creating a General Reserve
Dr. Profit and Loss a/c
Cr. General Reserve a/c

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.
Area of Balance Sheet affected

Another way of interpreting the charge and appropriation is based on the balance sheet area affected.

The debits to the Profit and Loss account, which influence the Fund Area (Non-Current Area), are appropriations of profits and those debits which influence the Current Area are charges on/against profits.

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.

» Example

Balance Sheet of M/s ______ as on
Liabilities 31stMarch Assets 31stMarch
2006 2007 2006 2007

Reserve for Taxation

1,24,000
 

1,32,000
     
           

DrReserve for Taxation a/cCr
Date Particulars J/F Amount
(in Rs)
Date Particulars J/F Amount
(in Rs)

31/03/07
To Bank a/c
To Balance c/d

1,24,000
1,32,000
01/04/06
31-03-07
By Balance b/d
By P/L Appr a/c (?)

1,24,000
1,32,000
  Total   2,56,000   Total   2,56,000
        01/04/07 By Balance b/d 1,32,000
The opening balance of Rs. 1,24,000 is assumed to have been paid out during the current period. The closing balance of Rs.1,32,000 represents the provision made during the current period.

• 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

This assumption is based on a rational approach.

» 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

Sec 205A. Unpaid dividend to be transferred to special dividend account

(1)Where, after the commencement of the Companies (Amendment) Act, 1974, a dividend has been declared by a company but has not been paid, or claimed, within thirty days from the date of the declaration, to any shareholder entitled to the payment of the dividend, the company shall, within seven days from the date of expiry of the said period of thirty days, transfer the total amount of dividend which remains unpaid or unclaimed within the said period of thirty days, to a special account to be opened by the company in that behalf in any scheduled bank, to be called "Unpaid Dividend Account of ... ... ... Company Limited/ Company (Private) Limited".

[Explanation.- In this sub-section, the expression "dividend which remains unpaid" means any dividend the warrant in respect thereof has not been encashed or which has otherwise not been paid or claimed.]

(2)Where the whole or any part of any dividend, declared by a company before the commencement of the Companies (Amendment) Act, 1974, remains unpaid at such commencement, the company shall within a period of six months from such commencement, transfer such unpaid amount to the account referred to in sub-section (1).
(3)Where, owing to inadequacy or absence of profits in any year, any company proposes to declare dividend out of the accumulated profits earned by the company in previous years and transferred by it to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be made by the Central Government in this behalf, and, where any such declaration is not in accordance with such rules, such declaration shall not be made except with the previous approval of the Central Government.
(4)If the default is made in transferring the total amount referred to in sub-section (1) or any part thereof to the unpaid dividend account of the concerned company, the company shall pay, from the date of such default, interest on so much of the amount as has not been transferred to the said account, at the rate of twelve per cent per annum and the interest accruing on such amount shall ensure to the benefit of the members of the company, in proportion to the amount remaining unpaid to them.
(5)Any money transferred to the unpaid dividend account of a company in pursuance of this section which remains unpaid or unclaimed for a period of seven years from the date of such transfer shall be transferred by the company to the Fund established under Sec 205C(1).
(6)The company shall, when making any transfer under sub-section (5) to the Fund established under section 205C any unpaid or unclaimed dividend, furnish to such authority or committee as the Central Government may appoint in this behalf a statement in the prescribed form setting forth in respect of all sums included in such transfer, the nature of the sums, the names and last known addresses of the persons entitled to receive the sum, the amount to which each person is entitled and the nature of his claim thereto, and such other particulars as may be prescribed.
(7)The company shall be entitled to a receipt from the authority or committee under sub-section (4) of section 205C for any money transferred by it to the Fund and such a receipt shall be an effectual discharge of the company in respect thereof.
(8)If a company fails to comply with any of the requirements of this section, the company and every officer of the company who is in default, shall be punishable with fine which may extend to 10[five thousand rupees] for every day during which the failure continues.
Author Credit : The Edifier ... Continued Page 8

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