# Funds Flow Statement, Funds from Operations - Adjustments

In financial accounting, adjustments are transactions relating to the business, which have not yet been journalised.

These are incorporated into accounting by making mathematical adjustments to the figures in the trading account, profit and loss account and balance sheet at the time of making up final accounts.

To know what adjustments are to be made in relation to a transaction, we need to know the journal entry that we use to record that transaction.

### Adjustments in Funds Flow Analysis

Even in Funds Flow analysis, adjustments are transactions relating to the business.

However, they are transactions which have already been journalised.

They represent transactions relating to the business which might have brought about a change in (influenced) working capital (Fund).

To know the influence of a transaction, we need to know the journal entry that we use to record that transaction.

### Why do we need adjustments?

In Funds flow analysis, we identify the changes in working capital from the changes in non-current accounts. The balance sheets provide us only the figures of opening and closing balances in the Non-Current accounts.

The opening figure after going through none or more changes during the period for which funds flow is being measured, would end up as the closing figure.

Analysing funds flow is analysing the reasons for the change in balances of non-current accounts. Therefore, to analyse funds flow we need the information relating to the accounting transactions that have brought about a change in the balances.

### What do we do with the adjustments?

We consider the journal entry relating to each transaction given under adjustments, find out the affect of the transaction on the non-current account and thereby identify the changes in working capital on account of that transaction.

For this we prepare a working notes by building the non-current ledger accounts (on a memorandum basis) and posting each transaction to enable us to explain the difference between the opening and closing balance.

If the difference still remains unexplained, we make proper assumptions to explain the remaining difference.

While making up the journal entries, considering Profit and Loss a/c for nominal accounts in case of cross transactions and Profit and Loss Appropriation a/c for nominal accounts in case of non-cross transactions which are not cross transactions would be helpful.

## Depreciation Charged on Assets

Depreciation is a loss and the transaction for recording depreciation would be a non-cross transaction.

The journal entries for recording depreciation are

 Recording Appropriating Dr. Depreciation on Asset a/c Cr. Asset a/c Dr. Profit/Loss Appropriation a/c Cr. Depreciation on Asset a/c Dr. Profit/Loss Appropriation a/c Cr. Asset a/c Non-Current Non-Current

For the purpose of analysing the affect of these transactions we consider the net effect

### Where depreciation is recorded using Depreciation Reserve a/c

Under this method, depreciation is accumulated in a separate account named "Depreciation Reserve a/c" instead of writing off every year from the asset account.
 Appropriating Net Effect Dr. Profit/Loss Appropriation a/c Cr. Depreciation Reserve a/c Dr. Profit/Loss Appropriation a/c Cr. Depreciation Reserve a/c Non-Current Non-Current

At any point of time, the written down value of the asset is ascertained by setting off the asset account and the relevant depreciation reserve account.

## Purchase of Assets

The transaction relating to purchase of an asset would be a cross transaction where the other account involved in the transaction is a current account, i.e. Cash a/c or Bank a/c (where the payment is made in cash or by cheque) a current asset or current liability (by taking over the vendors/sellers liability).
 Purchase of Asset Dr. Asset a/c Cr. Cash/Bank/Creditor a/c Non-Current Current

Where the other account involved is a non-current account, the transaction would not be a cross transaction and as such would not result in a change in working capital.

 Purchase of Asset Dr. Asset a/c Cr. Capital/Debentures/Old Asset a/c Non-Current Non-Current

Assets purchased by issuing capital or by accepting long term liability, or in exchange of another asset would be examples of such transactions.

## Sale of Asset at a Profit or Loss

### Asset maintained at its net value - depreciation written off to the Asset account

Where the asset is maintained at its net value, the value of the asset is shown at its net value in the books of accounts.

At the end of every accounting period, value equal to the depreciation to be charged is transferred from the asset account to the depreciation account treating it as a loss.

There are two transactions involved in the sale of such asset. The transaction of sale of asset and the transaction of recording profit/loss on the sale of asset. They are two distinct transactions. Where there is neither profit/loss on sale, the second transaction would be irrelevant.

In financial accounting we generally combine both the transactions which should be avoided here to get a clear understanding.

 Recording Asset Sale Recording Gain Dr. Cash/Bank a/c Cr. Asset a/c Current Non-Current Dr. Asset a/c Cr. Profit/Loss Appropriation a/c Non-Current Non-Current Dr. Profit/Loss Appropriation a/c Cr. Asset a/c Non-Current Non-Current

#### When sale is recorded using Asset Disposal a/c

 Writing off Asset Sold Recording Asset Sale Dr. Asset Disposal a/c Cr. Asset a/c Non-Current Non-Current Dr. Cash/Bank a/c Cr. Asset Disposal a/c Current Non-Current Dr. Asset Disposal a/c Cr. Profit/Loss Appropriation a/c Non-Current Non-Current Dr. Profit/Loss Appropriation a/c Cr. Asset Disposal a/c Non-Current Non-Current

Using Asset sale account would give a better understanding of the transaction by providing clear information.

The basic purpose of accounting is derivation of information. The more the information we need the more the accounting heads we need to maintain.

### Asset maintained at its cost - Depreciation Reserve a/c is maintained

Where a depreciation reserve account is being maintained, the value of the asset is shown at its cost in the books of accounts.

At the end of every accounting period, value equal to the depreciation to be charged on the asset is credited to the depreciation reserve account by charging the profit and loss account.

The reserve account is carried forward over the accounting periods and is shown on the liabilities side of the balance sheet or is adjusted from the value of the relevant asset on the assets side of the balance sheet. At the time of sale or disposal of the asset, the depreciation reserve account is closed by transfer to the relevant asset account thereby bringing down the asset to its real value.

Even in the sale of this asset, there are two transactions involved. The transaction of sale of asset and the transaction of recording profit/loss on the sale of asset. They are two distinct transactions. Where there is neither profit/loss on sale, the second transaction would be irrelevant.

 Writing off Depreciation Reserve Recording Asset Sale Dr. Depreciation Reserve a/c Cr. Asset a/c Non-Current Non-Current Dr. Cash/Bank a/c Cr. Asset a/c Current Non-Current Dr. Asset a/c Cr. Profit/Loss Appropriation a/c Non-Current Non-Current Dr. Profit/Loss Appropriation a/c Cr. Asset a/c Non-Current Non-Current

#### When sale is recorded using Asset Disposal a/c

 Writing off Asset Sold Writing off Depreciation Reserve Dr. Asset Disposal a/c Cr. Asset a/c Non-Current Non-Current Dr. Depreciation Reserve a/c Cr. Asset Disposal a/c Non-Current Non-Current Dr. Cash/Bank a/c Cr. Asset Disposal a/c Current Non-Current Dr. Asset Disposal a/c Cr. Profit/Loss Appropriation a/c Non-Current Non-Current Dr. Profit/Loss Appropriation a/c Cr. Asset Disposal a/c Non-Current Non-Current

Notice that the journal entry indicating the Net Effect in all the above cases is the same.

### Sale of Asset - Non Cross Transaction

The transaction relating to sale of an asset would be a cross transaction where the other account involved in the transaction is a current account, i.e. Cash a/c or Bank a/c (where the sale proceed is received in cash or by cheque) a current asset or current liability (by the buyer taking over a liability).
 Recording Asset Sale Dr. Cash/Bank a/c Cr. Asset a/c Current Non-Current

Where the other account involved is a non-current account, the transaction would not be a cross transaction and as such would not result in a change in working capital (fund).

 Recording Asset Sale Dr. Machinery/Debentures a/c Cr. Asset a/c Non-Current Non-Current

Giving away an Asset for clearing a long term liability, giving an asset in exchange of another asset would be examples of such transactions.

## Reserve for Bad and Doubtful Debts

In general, creation of any Reserve amounts to appropriation of profits.
 Creating General Reserve Dr. Profit and Loss a/c Cr. General Reserve a/c Non-Current Non-Current

Bad Debt Reserve is also created by appropriating profits. However, for the purpose of funds flow analysis, this transaction is treated as a cross transaction involoving nominal accounts and thus the debit to the profit and loss account is considered a charge against profits.

 Creating Bad Debt Reserve Dr. Profit and Loss a/c Cr. Reserve for Bad and Doubtful Debts a/c Non-Current Current

### Why is it a charge?

The prefix 'Reserve' in Reserve for Bad and Doubtful Debts creates an understanding that the transaction amounts to an appropriation of profit and not a charge.

A transaction resulting in a debit to the profit and loss can be claimed to be an appropriation if the account to which the profits are being transferred is a part non-current liabilities in the balance sheet.

Therefore, creation of reserve for bad and doubtful debts can be treated as an appropriation if the Reserve for Bad and Doubtful Debts account is a non-current liability in the balance sheet.

#### Where is Bad Debt Reserve positioned in the balance sheet?

In making up a balance sheet, we conventionally deduct the balance in the reserve for bad and doubtful debts account, 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.

Assuming that the balance sheet is marshalled, since Sundry Debtors are Current Assets, the reserve related to it would be a Current Liability. Thus Reserve for Bad and Doubtful Debts is treated as a current account.

Any transaction resulting in a debit to the profit and loss account wherein the other account involved is a current account results in a charge on profits.

## Provision for Taxes and Dividends

### Where Provision for Taxes/Dividends accounts are Non-Current Liabilities

Where provision for taxation and provision for dividends accounts are non-current accounts, the transaction for creating the reserve would not be a cross transaction and as such would not result in a change in working capital.
 Creation of Reserve for Taxation Creation of Reserve for Dividends Dr. Profit and Loss Appropriation a/c Cr. Provision for Taxation a/c Non-Current Non-Current Dr. Profit and Loss Appropriation a/c Cr. Provision for Dividends a/c Non-Current Non-Current

### Where Provision for Taxes/Dividends accounts are Current Liabilities

Where provision for taxation and provision for dividends accounts are current accounts, the transaction for creating the reserve would be a cross transaction and as such would bring about a change in working capital.
 Creation of Reserve for Taxation Creation of Reserve for Dividends Dr. Profit and Loss a/c Cr. Provision for Taxation a/c Non-Current Current Dr. Profit and Loss a/c Cr. Provision for Dividends a/c Non-Current Current

Since the debit is made to the profit and loss account, it represents a transaction that results in a charge to the profit and loss account. The affect of all such transactions on the working capital is considered in a consolidated manner under the head funds from operations.

Moreover, because these accounts are current accounts, they would not be considered for the purpose of analysing funds flow They will be taken into consideration only for the purpose of preparing the statement of changes in working capital.

### Note

Using Profit/Loss account in place of Profit/Loss Appropriation account for non-cross transactions would be helpful in finding the funds from operations easily.

### Are they Current or Non-Current

Where there is no specific indication as to whether the accounts like provision for taxation/dividends accounts are current natured or non-current natured, we are required to make an assumption and decide for ourselves.

When there is no indication we may choose either of the options. However, it is a convention that if we find the accounts grouped together with current accounts we treat them as current natured and if they are grouped together with non-current natured accounts we treat them as non-current accounts.

Where 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 assumptions, in the absence of any other indication regarding the same. In such cases, because these are capable of being treated either ways, it would always be appropriate to indicate our assumption.

#### All need not be of the same kind

Where there are two or more such accounts and we are required to decide upon their nature, it is not a requirement that all of them should be considered to be of the same kind. One or more of them can be assumed to be current natured and the rest to be non-current natured accounts.

## Payments for Taxes and Dividends

### Where Provision for Taxes/Dividends accounts are Non-Current Liabilities

Assuming payment of tax/dividend in cash, the transaction of payment of tax/dividend would be a cross transaction, where the provision for taxation/dividend account are non-current accounts as the other account involved is a current account (cash/bank account)
 Payment of Taxes Payment of Dividends Dr. Provision for Taxation a/c Cr. Cash/Bank a/c Non-Current Current Dr. Provision for Dividends a/c Cr. Cash/Bank a/c Non-Current Current

### Where Provision for Taxes/Dividends accounts are Current Liabilities

Assuming payment of tax/dividend in cash, the transaction of payment of tax/dividend would be a non-cross transaction, since both the accounts affected by the transaction would be current accounts.

Such a transaction, since it is not related to any non-current account would be irrelevant for the purpose of analysing funds flow.

## Reserve/Provision for Taxation/Dividends - Assumptions

In problem solving, there are certain assumptions we make with regard to the reserve/provision for taxation/dividend accounts.

### Opening Balance becomes a determined liability

The opening credit balance in the Reserve for Taxation/Dividend is an amount that has been created by charging/appropriating the previous period profits.

It represents

• An existing liability, when the account is assumed to be a current liability
• A provision for a future liability (one which has not been determined), when the account is assumed to be a non-current liability.

In this case, the liability would become an existing liability as and when the tax/dividend due is determined.

In the absence of information to the contrary, we make the following assumptions,

• By the end of the current period the liability has been determined and is equal to opening balance in these accounts.

### Determined liability is cleared by paying out

In the absence of information to the contrary, we make the following assumptions,
• The liability which has been pre determined or has been determined in the current period is paid out in the current period.

### Closing balance represents/relates to reserve created during the current period

In the absence of information to the contrary, we make the following assumptions,
• The total closing balance in the reserve for Taxation/Dividend accounts is on account of the provision created during the current period.

### Example

Balance Sheet of M/s ___ as on ___
Liabilities 31st March Assets 31st March
2009 2010 2009 2010

Reserve for Taxation

1,24,000

1,32,000

...

...

...

Where only the information relating to the opening and closing balances is known, we assume that the opening balance becomes a determined liability by the end of the accounting period and is therefore paid out by the end of the accounting period.

Dr Reserve for Taxation a/c Cr
Date Particulars Amount Date Particulars Amount
../../09
31/03/10
To ...
To Balance c/d
1,24,000
1,32,000
01/04/09
31/03/10
By Balance b/d
By P/L Appropriation a/c (?)
1,24,000
1,32,000
2,56,000  2,56,000
01/04/10 By Balance b/d 1,32,000

Assumptions

1. The opening balance of 1,24,000 is paid out during the current period.
2. The balancing represents the provision made by charging profits during the current period or by appropriating profits at the end of the accounting period.

### The basis for such assumptions

This assumption is based on a rational approach.

#### Reserve for Taxation

The opening balance of Provision for Taxation account represents the amount set aside by charging/appropriating the previous period profits. When charged to profits, it represents a determined liability and when appropriated from profits it represents profits set aside to cover taxes that would be determined in the subsequent accounting period.

Where it represents a provision for future liability, it would be rational to assume that the tax liability that has been provided for towards the end of the previous period would be determined by the end of the current period i.e. within a years time. Once the tax liability becomes a determined liability, it being a statutory obligation, becomes payable within a short time. For this reason, we assume the liability to have been paid out by the end of the year.

However, where there is a specific information/indication regarding the amount paid as tax during the current period, only that should be considered. Where the actual tax liability assessed is more/less than the amount provided for during the previous period, the amount paid may be more/less than the opening balance in the reserve/provision account.

Where the opening balance, the closing balance and the amount provided for during (at the end of) the current period are 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 amount set aside by charging/appropriating the previous period profits. When charged to profits, it represents a determined liability and when appropriated from profits it represents profits set aside to cover liability on account of dividends payable which would be determined in the subsequent accounting period.

Where it represents a provision for future liability, it would be rational to assume that the tax liability that has been provided for towards the end of the previous period would be determined by the end of the current period i.e. within a years time. Once the dividend has been declared, the provision becomes an existing liability on account of the statutory obligation to payout dividends within a period of 30 days of their declaration. For this reason, we assume the liability to have been paid out by the end of the year.

However, where there is a specific information/indication regarding the amount paid as dividend during the current period, only that should be considered. Where the actual dividend liability determined is more/less than the amount provided for during the previous period, the amount paid may be more/less than the opening balance in the reserve/provision account.

Where the opening balance, the closing balance and the amount provided for during (at the end of) the current period are known, we find out the amount paid out as the balancing figure.

## Interim Dividend - Appropriation - Payment

Normally the dividends of a company for a particular financial year can be paid only out of the profits for that year arrived at after providing for depreciation. Thus declaration of dividends would be possible only after finalising accounts.

### Companies Act, 1956 Show

Interim dividend can be declared by the Board of Directors at any time.

### Companies Act, 1956 Show

Interim dividends are first paid and then appropriated from profits.

If provision for dividends account exits, then we consider the interim dividend account to be similar in nature to the provision for dividends account. Interim dividend account is treated as a current account or a non-current account accordingly as the provision for dividends account is current or non-current.

### Interim Dividend - Current Account

The interim dividend account being a current account has to be considered only for the purpose of preparing the statement of changes in working capital.

Since we need to consider only the accounts present in the balance sheet for the purpose of preparation of the statement of changes in working capital, and the interim dividend account would not be present in the balance sheet, we need not consider the transactions relating to interim dividends for the purpose of analysing funds flow when it is a current account.

 Payment of Interim Dividend Charge to/against Profits Dr. Interim Dividend a/c Cr. Bank a/c Current Current Dr. Profit and Loss a/c Cr. Interim Dividend a/c Non-Current Current

### Interim Dividend - Non-Current Account

The transaction relating to payment of interim dividend would be a cross transaction.
 Payment of Interim Dividend Appropriation from Profits Dr. Interim Dividend a/c Cr. Bank a/c Non-Current Current Dr. Profit and Loss Appropriation a/c Cr. Interim Dividend a/c Non-Current Non-Current

Since the balance sheet is prepared after finalisation of accounts, we will find no trace of the interim dividend, unless there is an indication in the form of adjustments or additional information.

## Appropriation of Profits to Reserves

This being a transaction involving a nominal account representing an appropriation of profit is not a cross transactions and thus does not bring about a change in working capital (fund).

 Appropriating Dr. Profit/Loss Appropriation a/c Cr. Reserve a/c Non-Current Non-Current

## Capital brought in - Additional Capital raised

Capital can be contributed either by bringing in an asset or taking over a liability.

Capital being a non-current liability, the asset brought in or the liability taken over towards contribution of capital should be of a current nature so as to form a cross transaction bringing about a change in working capital.

 Recording Dr. Cash/Bank/Current (Asset/Liability) a/c Cr. Capital a/c Current Non-Current

If the asset brought in is a non current Asset, or if the liability taken over is a non-current Liability, the transaction would not amount to a cross transaction and as such there would be no change in working capital on account of this transaction.

 Recording Dr. Machinery/Debentures (Asset/Liability) a/c Cr. Capital a/c Non-Current Non-Current

## Drawings of Capital

The drawings in the form of the ownership taking over any Current Assets or the organisation taking over any current liability of the owners would give rise to a cross transaction and thus result in a change in working capital (fund).
 Drawings made Adjusting drawings Dr. Drawings a/c Cr. Cash/Bank/Current (Asset/Liability) a/c Non-Current Current Dr. Capital a/c Cr. Drawings a/c Non-Current Current

Drawings in the form of the ownership taking over any Non-Current Assets or the organisation taking over any non-current liability of the owners would not give rise to a cross transaction and thus does not result in a change in working capital (fund).

 Drawings made Adjusting Drawings Dr. Drawings a/c Cr. Furniture/Bank Loan (Asset/Liability) a/c Non-Current Non-Current Dr. Capital a/c Cr. Drawings a/c Non-Current Non-Current
 ... 121314 ...