ACCOUNTING ERRORS

ACCOUNTING ERRORS

The statement of Trial Balance is not a final and conclusive proof of the complete correctness of books. This is because, there are certain errors in the books of accounts which may be committed while recording, classifying or summarizing the financial transactions which are not disclosed by the trial balance. The following are some of the errors which will not affect the agreement of Trial Balance:

·         Classification of Errors

Errors can be classified on the basis of its nature:

I. Errors of Omission.  

II. Errors of Commission.

III. Errors of Principles.

IV. Compensating Errors.

I.       Errors of Omission: When business transaction is either completely or partly omitted to be recorded in the books of prime entry it is called an ‘error of omission’. When a business transaction is omitted completely, it is called a ‘complete error of omission”, and when a business transaction is partly omitted, it is called a “partial error of omission”. A complete error of omission does not affect the agreement of trial balance whereas a partial error of omission may or may not affect the agreement of trial balance.

An example of a complete error of omission is goods purchased or sold may not be recorded in the purchase book or sales book at all. This error will not affect the trial balance. An example of a partial error of omission is goods purchased for Rs. 5,500 recorded in Purchase Book for Rs. 550. This is a partial error of omission.

II.    Errors of Commission: Errors of Commission may be occurred by wrong recording in the books of original entry. The committed errors arise due to the negligence of the Accountant while recording, totaling, carrying forward and balancing the accounting process. The errors of commission may arise due to the following ways :

(1) Entering the wrong amount to the correct side of correct subsidiary books

(2) Entering the correct amount to the wrong side of correct subsidiary books

(3) Entering the correct amount to the correct side of wrong subsidiary books

(4) Posting wrong amount to the correct side of the accounts

(5) Posting correct amount to the wrong side of the accounts

(6) Posting to the correct side of the account but making double posting.

III. Errors of Principles: When a business transaction is recorded in the books of original entries by ignoring the basic/fundamental principles of accountancy it is called an error of principle. Some examples of these errors are:

(a)    When revenue expenditure is treated as capital expenditure or vice-versa, e.g. building purchased is debited to the purchase account instead of the building account.

(b)   Revenue expenses debited to the personal account instead of the expenses account, e.g. salary paid to Mr. Ashok, a clerk, for the month of June, debited to Ashok’s account instead of salary account.

IV. Compensating Errors: Compensating errors refer to those errors which are compensated by each other. In other words, the effect of one error is compensated by the other. Such errors which do not affect the agreement of the trial balance. For example, if wage paid Rs. 1,000 is debited in the Wage Account at Rs. 1,500 and dividend received Rs. 1,500 is credited in the Dividend Account at Rs. 2,000, the excess debit in Wage Account is compensated by an excess credit of Rs. 500 in Dividend Account.

RATIO ANALYSIS

RATIO ANALYSIS

Meaning of Ratio:- A ratio is simple arithmetical expression of the relationship of one number to another. It may be defined as the indicated quotient of two mathematical expressions.

According to Accountant’s Handbook by Wixon, Kell and Bedford, “a ratio is an expression of the quantitative relationship between two numbers”.

 Ratio Analysis:- Ratio analysis is the process of determining and presenting the relationship of items and group of items in the statements. According to Batty J. Management Accounting “Ratio can assist management in its basic functions of forecasting, planning coordination, control and communication”.

 It is helpful to know about the liquidity, solvency, capital structure and profitability of an organization. It is helpful tool to aid in applying judgement, otherwise complex situations.

Ratio analysis can represent following three methods.

Ratio may be expressed in the following three ways :

1.     Pure Ratio or Simple Ratio :- It is expressed by the simple division of one number by another. For example , if the current assets of a business are Rs. 200000 and its current liabilities are Rs. 100000, the ratio of ‘Current assets to current liabilities’ will be 2:1.

2.     ‘Rate’ or ‘So Many Times :- In this type , it is calculated how many times a figure is, in comparison to another figure. For example , if a firm’s credit sales during the year are Rs. 200000 and its debtors at the end of the year are Rs. 40000 , its Debtors Turnover Ratio is 200000/40000 = 5 times. It shows that the credit sales are 5 times in comparison to debtors.

     3.     Percentage :- In this type, the relation between two figures is expressed in hundredth. For                   example, if a firm’s capital is Rs.1000000 and its profit is Rs.200000 the ratio of profit                         capital, in term of percentage, is 200000/1000000*100 = 20%

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as:

1)   Fraction

2)   Percentages

3)   Proportion of numbers

These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.

ADVANTAGES OF RATIO ANALYSIS

1) Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.

2)  Ratios avoid distortions that may result the study of absolute data or figures.

3) Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.

4) Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.

5) Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.

6) Ratios are increasingly used in trend analysis.

7) Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.

8) Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.

9) Ratios are yard stick increasingly used by bankers  and financial institutions in evaluating the credit standing of their borrowers and customers.

LIMITATIONS OF RATIO ANALYSIS:

An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks. Some of them are listed below:

1. Rations can sometimes be misleading if an analyst does not know the reliability and soundness of the figures from which they are computed and the financial position of the business at other times of the year. A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1

2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.

3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year. Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.

4. Changes in the price level make the interpretations of the ratios Invalid. The interpretation and comparison of ratios are also rendered invalid by the changing value of money. The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result. Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.

For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable. The return of the first firm is overstated because its plant and machinery have a low book value.

5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult. In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit, current assets etc. Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.

6. Ratios are not reliable in some cases as they many be influenced by window / dressing in the balance sheet.

7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent. The balance sheet prepared at different points of time is static in nature. ­They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.

8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.

      CLASSIFICATION OF RATIO 

     Ratio may be classified into the four categories as follows:

A.    Liquidity Ratio

a.      Current Ratio

b.     Quick Ratio or Acid Test Ratio

B.    Leverage or Capital Structure Ratio

a.      Debt Equity Ratio

b.     Debt to Total Fund Ratio

c.     Proprietary Ratio

d.     Fixed Assets to Proprietor’s Fund Ratio

e.      Capital Gearing Ratio

f.       Interest Coverage Ratio

C.    Activity Ratio or Turnover Ratio

a.      Stock Turnover Ratio

b.     Debtors or Receivables Turnover Ratio

c.     Average Collection Period

d.     Creditors or Payables Turnover Ratio

e.      Average Payment Period

f.       Fixed Assets Turnover Ratio

g.     Working Capital Turnover Ratio

D.    Profitability Ratio or Income Ratio

             (A) Profitability Ratio based on Sales :

                    a. Gross Profit Ratio

                    b. Net Profit Ratio

                    c. Operating Ratio

                    d. Expenses Ratio

           (B) Profitability Ratio Based on Investment :

             I.       Return on Capital Employed

            II.      Return on Shareholder’s Funds :

a.      Return on Total Shareholder’s Funds

b.     Return on Equity Shareholder’s Funds

c.     Earning Per Share

d.     Dividend Per Share

e.      Dividend Payout Ratio

f.       Earning and Dividend Yield

g.     Price Earning Ratio

Format Of Fund Flow Statement

Format Of FUND FLOW STATEMENT

Three Statements are prepared:

1)      Statement of Working Capital Changes

2)      Fund from Operations

3)      Fund Flow Statement

I)                   FORMAT OF SCHEDULE OF WORKING CAPITAL CHANGES

II)                PROFIT FROM OPERATIONS or LOSS FROM OPERATIONS:

         Balance of P/L a/c (current year) as per B/S                                       …………

Less: Balance of P/L a/c (previous year) as per B/S                                    …………

Add: Appropriations :

(i)                 Transfer to Reserve         ……….

(ii)               Proposed Dividend          ……….

(iii)             Interim Dividend              .……...

(iv)             Other Reserves etc.          ……….                                           …………

Net Profit for the current year                                                              …………

Add: Non-cash items:

         Depreciation

         Preliminary Expenses

         Goodwill written off

         Discount on Debenture

         Fixed Assets written off

Add: Non-operating Losses:

         Loss on Sale of Fixed Assets

         Loss on Sale of Long-term Investments

Less: Non-operating Incomes:

         Profit on Sale of Fixed Assets

         Interest & Dividend Received

III)          Format of Fund Flow Statement

Fund Flow Statement
(As on…………..)

Sources of Funds	Amount	Application of Funds	Amount
Issue of share capital	…….	Redemption of pref. share	……..
Issue of debenture	…….	Redemption of debenture	…….
Raising of long term loan	…….	Payment of long term loan	……….
Sales of fixed assets	…….	Purchase of fixed assets	……….
Interest received	…….	Interest paid	……..
Dividend received	…….	Dividend paid	.…….
Refund of Taxes	…….	Payment of Taxes	……..
Decrease in working capital	…….	Increase in working capital	……..
Fund from operation	…….	Fund lost in operation	.…….
TOTAL	……..	TOTAL	……..

DIFFERENCE BETWEEN CASH FLOW & FUND FLOW STATEMENT

Cash Flow Statement	Fund Flow Statement
It shows net change in the position of cash and cash equivalents	It shows change in the position of „working capital‟.
It is based on narrower concept of funds i.e. cash and cash equivalents.	It is based on broader concept of funds i.e. working capital.
Now, it is mandatory for all the listed companies and is more widely used in India or abroad.	It is not mandatory and it is not being used by the companies.
Changes in working capital are adjusted for ascertaining cash generated from operations.	Statement of changes in working capital is prepared under fund flow statement.
In Cash flow statement, decrease in current liability or increase in current assets results in decrease in cash and vice – versa.	In working capital, decrease in current liability or increase in current asset brings increase in working capital and vice – versa.

Difference between Fund Flow & Cash Flow statement

Distinction between Cash Flow Statement & Fund Flow Statement

Followings are the main differences between cash flow statement and funds flow statement.

1. Concept
Cash flow statement is based on narrow concept of funds, which considers changes in cash. Funds flow statement is based on the changes in working capital which considers both the changes in cash as well as other components of current assets and current liabilities.

2. Basis Of Preparation
Cash flow statement is prepared on cash basis. Funds flow statement is prepared on accrual basis.

3. Working capital
Cash flow statement does not require use of changes in working capital because all the changes in assets and liabilities are summarizes in cash flow statement. Funds flow statement requires to use of separate statement of changes in net working capital.

4. Link
The preparation of cash flow statement considers only those transactions that are linked with flow of cash. The preparation of funds flow statement considers those transactions that are linked with flow of funds along with actual cash.

5. Usefulness
Cash flow statement is more useful in short term analysis and cash planning. Funds flow statement is more useful in long-term analysis of financial planning.

Fund Flow Statement

FUND FLOW STATEMENT

The term of ‘Funds Flow’ has made up with the two words – Funds and Flow of funds. Let us first we understand these meaning and then we see how funds flow statement is prepared.

Meaning of Funds:

The term ‘fund’ has different meanings:

CASH -

In narrow sense, the term ‘fund’ is used to mean only the cash and bank balance. Therefore, in this sense, funds flow statement is a statement reflecting the changes in cash and bank balances only. This concept is better for the preparing of ‘Cash Flow Statement’ Therefore, this term is not used in this sense.

TOTAL RESOURCES -

In broader sense it includes all resources used in the business whether in the form of men, material, machinery, money and methods etc.

Working Capital –

In popular sense, the term ‘Fund’ is used to mean working capital i.e. the excess of current assets over current liabilities. Therefore, in this sense, fund flow statement includes all the transactions affecting current assets and current liabilities.

q  Hence, Fund means Working Capital.

Working Capital = Current Assets - Current Liabilities.

MEANING OF FLOW 

The term ‘Flow’ means changes – incoming and outgoing. When this term is used with funds, it means the changes taking place in funds during a certain period. Whenever there is change in the funds, it is presume that flow in funds has taken place. Transactions that bring working capital into the firm are sources of funds and on the contrary, if the working capital decreases, it is an application of funds.

THEREFORE THE TERM FLOW OF FUNDS MEANS “CHANGES IN FUNDS” OR “CHANGES IN WORKING CAPITAL”. IN OTHER WORDS, ANY INCREASE OR DECREASE IN WORKING CAPITAL MEANS “FLOW OF FUNDS”.

MEANING OF FUNDS FLOW STATEMENT

The Funds flow statement (FFS) is a financial statement which reveals the methods by which the business has been financed and how it has used its funds between the opening and closing Balance-Sheet dates. It studies – from where the funds have been received and where the funds have been used.

Fund flow statement is the statement prepared for the purpose of studying the changes in the funds of an organization between the two balance sheet dates.

“A statement of sources and application of fund is a technical device designed to analyse the changes in the financial condition of a business enterprise between two dates.”      -Foulke

“Fund flow statement is a statement prepared to indicate the increase in the cash resources and the utilization of such resources of business during the accounting period.”    - Robert N. Anthony

A fund flow statement is:

ü   a statement shows the changes in funds

ü   b/w two balance sheet of two different dates.

Other Cognate Names of Fund Flow statement:

Fund flow statement bears the following names as well:

(1)   Application of Funds statement;

(2)   Statement of Sources & Application of Funds;

(3)   Statement of sources and uses of funds;

(4)   Statement of Funds Supplied and applied.

 Flow of Funds Chart

Transaction Involves between

 No Flow of Funds Chart

Uses / advantages of Fund Flow Statement :

1. Fund flow statement helps the management in the assessment of long range forecasts of a cash requirements and availability of liquid resources. The manager can judge the quality of management decisions.

 2. With the help of Fund Flow Statement, the investors are able to measure as to how the company has utilized the funds supplied by them and its financial strength. Also, the investors can judge the company’s capacity to generate funds from operations.

 3. It serves as effective tools to the Management for economic analysis as it supplies additional information which cannot be provided by financial statement based on historical data.

 4. Fund flow statement explains the relationship between changes in working capital and net profits. 

5. Fund flow statement helps the management in making planning process of a company. It is also useful in assessing the resources available and the manner of utilization of the resources. 6. It explains the financial consequences of business activities. It also provides explicit and clean answer to questions regarding liquid and solvency position of the company.

6. Fund Flow Statement provides clues to the creditors and financial institutions as to the ability of a company to use funds effectively in the best interest of the investors, creditors and owners of the company.

Limitations of Fund Flow Statements

 1. It should not be overlooked that Fund Statements ignore non-cash transactions, therefore it is considered as cruder device than the financial statement.

 2. Fund Flow Statements merely rearrange a part of the information contained in financial statements. They do not serve as original evidence of financial status.

 3. Though changes in cash resources are more significant, they are not highlighted by Fund Statements except being shown by them as a part of working capital.

 4. As Fund Flow Statements are prepared from information provided by financial statements, they are essentially historical in nature.

Preparation of Fund Flow Statement

Example:- The Balance Sheet of ABC Ltd. at the end of 2006 and 2007 are as follows:

	31 March 2006	31 March 2007
Liabilities:
Accounts Payable	15,000	20,000
Notes Payable	25,000	10,000
Other Current Liabilities	10,000	15,000
6 % Bonds	------	20,000
Retained Earning	80,000	1,10,000
Mortgage	------	10,000
Shares	50,000	50,000
TOTAL	1,80,000	2,35,000
Assets:
Cash	10,000	5,000
Marketable Security	10,000	-------
Inventory	70,000	1,05,000
Receivables	30,000	40,000
Fixed Assets	1,00,000	1,40,000
Accumulated Depreciation	(-)40,000	(-)55,000
TOTAL	1,80,000	2,35,000

You are required to prepare a Statement of Changes in Working Capital and Fund Flow Statement.

Solution: 

Statement of Changes in Working Capital

Particular	2006	2007	Effect on Working Capital
			Increase	Decrease
Current Assets:	Rs.	Rs.	Rs.	Rs.
Cash	10,000	5,000	-----	5,000
Marketable Security	10,000	-----	-----	10,000
Inventory	70,000	1,05,000	35,000	-----
Receivable	30,000	40,000	10,000	-----
	1,20,000	1,50,000
Current Liabilities:
Accounts Payable	15,000	20,000	-----	5,000
Notes Payable	25,000	10,000	15,000	-----
Other Current Liabilities	10,000	15,000	-----	5,000
	50,000	45,000
Net Increase in Working Capital(Balance)			-----	35,000
TOTAL			60,000	60,000

Adjusted Profit & Loss Account

Particular	Amount	Particular	Amount
To Depreciation  (55,000 – 40,000)	15,000	By Opening Balance of P & L A/c	80,000
To Closing Balance of P & L A/c	1,10,000	By Fund from Operation (Balance)	45,000
	1,25,000		1,25,000

Fund Flow Statement
( As on 31 march 2007)

Sources	Amount	Application	Amount
Mortgage	10,000	Purchase of Fixed Assets	40,000
6 % Bonds	20,000	Net Increase in Working Capital	35,000
Funds from Operation	45,000
	75,000		75,000

IMPORTANT QUESTIONS

Short answer questions

1. State the meaning of Funds flow statement
2. How  is the  schedule of changes in working capital prepared?
3. Discuss the importance  of funds flow statement .
4. Explain the  terms ‘funds items‘ and ‘non funds items. Give examples.
5. Write short notes on application of funds.
6. How are the funds from operations calculated?
7. Distinguish between the funds flow statement and Balance-Sheet.

Long Answer questions 

1. Explain the terms ‘Funds’ and ‘Flow in funds ’ in respect of funds flow statement
2. What is a ‘Funds Flows statement’? How is it prepared? What are the various sources and uses of funds ?
3. How is a funds flow statement prepared ?Give a Performa of schedule of changes in working capital and funds flow statement. 

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