Grade 12 Account Note

Statement of Changes in Financial Position

Introduction

Financial statements are most necessary to report financial performance of an organization. Balance sheet, part of traditional financial statements package, contains the position of business in terms of development in assets and liabilities over accounting period. The income statement shows the operating performance of enterprise, which shows the periods and productive and commercial activities and its ultimate effect in change in owners' equity. Although these financial statements are of high importance and shows the change in assets and liabilities compared between beginning and ending of the period at single snap-shot, it fails to portray those activities which made changes or causes change in these financial items.

These additional statements of change in financial position are prepared in two different ways:

i)Working capital basis as funds flow statement.

ii)Cash basis as cash flow statements.

 

MEANING AND DEFINITION

The funds flow statement are prepared to show the changes in financial position between two balance sheet dates so that decision maker and analyst use it more purposefully. The word funds flow statement consists two different words ‘funds’ and ‘flow’. The funds have different meaning in their places like cash or working capital or all the other financial resources. Flow means changes occurred in fund from one specific date to another date under review. Flow may be inflows and outflows. Thus it can be said that statement prepared to show the flow of funds on working capital basis is known as funds flow statement. It shows the different sources of funds and application of fund in the business.

According to Roy Fouke, “A statement of sources and application of funds is a technical device designed to analyze the changes in the financial position of a business enterprise between two dates.”

 

IMPORTANCE

Funds flow statement is an important financial tool, which is required to analyse the changes in financial position of a firm showing the sources and applications of its funds. It provides valuable information about the firms operating, financing and investing activities during a particular period. The importance of funds flow statement is;

To show the relationship of net profit to the changes in fund from business operation.
To show the firms ability to generate long term financial to satisfy the investment.
To predict future funds flow it reports about past fund flow as an aid.
To identify the change in level of current assets investment and current liabilities financing.
To analyse the changes in working capital level of a firm.
Toshow the relationship of net income to the changes in funds from business operation.
To determining the firms liability to pay interest and dividends, and pay debt when they become due.
To show the relationship of net profit to the changes in fund from business operation.
To show the firms ability to generate long term financial to satisfy the investment.

 

 

CONCEPT OF FUNDS, FLOW AND STATEMENTS

FUNDS

The word funds refer to the cash, i.e., all financial resources in the business. The term “funds” has more than one meaning. In funds flow statement, however, cash is not used as basis, because it concentrates only on changes in a single asset, cash. Instead, the term funds are used in the broader sense of working capital, as it focuses on changes in broader category of working capital.

However, there are two concepts of working capital, i.e gross concept and net concept. The gross concept of working capital means the form’s total investment in its current assets. In its net concept, working capital is the difference between firm’s current assets and current liabilities, such that:

Net working capital = Current Assets – Current Liabilities

The net working capital is thought as a pool of funds to be used in the smooth operation of the business.

Flow

Here the word “Flow” refers to movement or change of funds in terms of net working capital. It means inflow or increase and outflow or decrease of funds, i.e net working capital, as a result of certain financial transactions that have taken place in the firm during the specific period. All financial transactions finally affect the balance sheet, but they all do not affect the net working capital of the firm. The financial transaction which increase current assets or decrease current liabilities with corresponding decrease in fixed assets or increase in liabilities and capital create inflow or increase in funds or net working capital. On the other hand, the transactions which decrease current assets or increase current liabilities with corresponding increase in fixed assets or decrease in long-term liabilities and capital cause outflow or decrease in funds or net working capital.

There are following types of transactions that change(increase and decrease) of funds:

1.Transactions involving current liabilities and non-current liabilities: In flow or outflow of funds there involves result of transactions of current liabilities and non-current liabilities and equity. For instance, issue of debentures and shares for the payment of sundry creditors will cause inflow of funds, while drawing bills of exchange for the redemption of debenture and preference shares will cause outflow of funds.

2.Transactions involving current liabilities and non-current assets: Changes in funds is also effected by those transactions involving in current liabilities such as bills payable, sundry creditors, dividends payable , and bank overdraft and non-current assets also effect.

3.Transactions involving current assets and non-current assets: Those transactions, which involve current assets such as cash, receivable and inventory and non-current assets such as fixed assets, intangible assets and investments result in the flow of funds.

4.Transactions involving current assets and non-current liabilities and owner’s equity: The transactions, which involver current assets and non-current liabilities such as along-term loans and owners equity will cause flow of funds.

5.Transactions involving non-operating receipts and non-operating loss: The transactions, which involve non-operating receipts and loss result or decrease of funds. All non-operating receipts increase funds, while on-operating payments decrease funds.

 

STATEMENT

In simple way “ statement” is a written record which present some kind of information and facts about some events in a systematic manner. The funds flow statement is, therefore, a written record of the sources of funds in terms of net working capital and its application on different  heads during a particular period of time. It is also called statement of sources and application of funds or how funds come and where funds gone statement.

Horizontal form

The funds flow statement can be prepared by using the horizontal form. In this form, sources of funds are shown on the left-hand side and uses or applications of funds on the right-hand side of the statement as shown below:

Sources of funds

Amount

Application of funds

Amount

Funds from operations……

Net decrease in working ……

Issue of common shares…

Issue of preference shares….

Issue of bonds and debentures….

Borrowing of long-term loans…..

Sales of fixed assets ……

Sales of investments………

Non-operating receipts

Rent…………………………….………

Dividends………………………………

Interest on investments………

Refund of tax………………………….

 

 

 

 

Loss from operations ……………

Net increase in working capital……….

Redemption of preference shares….

Redemption of bonds and debentures…

Repayment of long-term loans………….

Purchase of fixed assets…………..

Purchase of investments…………

Fixed deposits……………………

Non-operating  payments

Payments made due to legal action….

Payment of interim & final dividends…

Payment of tax…………………………….

 

 

 

 

 

 

Vertical form

Alternatively, the funds flow statement can be prepared by using the vertical form. In this form sources of funds are shown on the up-side and uses or applications of funds on the down-side of the statements.

PREPARATION OF FUNDS FLOW STATEMENT

Funds flow statement is prepared mainly with the help of the balance sheet of any two successive dates. It is prepared by comparing the balance sheets of the two dates and using the income statement of the year for which the statement is being prepared. The following are the steps of funds flows statement:

Step 1:

In the preparation of funds flow statement, the first step is to find out the net amount of increase or decrease of working capital, as increase in net working capital is a use of funds and decrease in net working capital is a source. Since net working capital is excess of current assets over current liabilities, the increase or decrease in the net working can be found out by comparing the current assets and current liabilities contained in the balance sheets of two following dates. For this purpose, a statement is prepared which is called statement or schedule of changes in net working capital.

The following points are taken into account:

Increase in current assets, increase in net working capital
(↑NWC= ↑CA-CL)

Decrease in a current assets, decrease in net working capital
(↓NWC =↓CA-CL)

Increase in current liabilities, decrease in net working capital
(↓NWC=↑CA-CL)

Decrease in current liabilities, decrease in net working capital
(↑NWC=CA-↓CL)

Using only current account

The statement or schedule of changes in working capital can be prepared by using only current account, viz. account of current assets and current liabilities. While preparing the statement, the current assets and current liabilities of the previous year are compared with those of the current year, and the changes (increase or decrease) therein are determined. If the total of increase is more than that of decrease, there is an increase in net working capital, or vice versa.

Using both current and non-current accounts

The statement or schedule of changes in net working capital can also be prepared by using both current as well as non-current accounts. Current account is the account of current assets and current liabilities, and non-current account is the account of non-current assets and non-current liabilities and owners equity. Increase in an item of current assets or decrease in an item of current liabilities or decrease in an item of current assets is credited to current account. On the other hand, increase in an item of non-current assets or decrease in an item of non-current liabilities from the previous year to the year is debited, while increase in an item of non-current liabilities and owners equity and decrease in an item of non-current assets is credited to non-current account. The rules for debiting and crediting current an non-current accounts are ;

Current account

Debit the account, if an item of current asset increases or an item of current liabilities decreases from that year to this year.

Credit the account, if an item of current liabilities increases or an item of current assets decreases from that year to this year.

 Non-current accounts

Debit the account, if an item of non-current assets increases or an item of non-current liabilities decrease from that year to this year.

Credit the account, if an item of non-current liabilities increases or an item of non-current assets decreases from that year to this year.

Step 2:

Statement of funds from operation

The second step is statement of funds from operation to determine the amount of funds from business operations. It refers to the funds or loss, which is generated or suffered in the business as a result of its regular operations during the period. The funds from operations are an important source of funds, while loss from operations is one of the important applications of funds. The funds or loss from operations is determined by adjusting the firm’s net income in a statement called the statement of funds from operations.

Non-cash expenses such as depreciation and amortization of intangible assets do not result in actual cash outflow. Non-operating expense are those which are not treated as regular expenses of the business.

Non-operating and Non-cash Expenses

Depreciation for the year
Amortization of goodwill, copyright, patents, trademarks, preliminary expenses.
Discount on issue of shares and debentures written off.
Loss on sales of fixed assets or investment.
Loss on revaluation of fixed assets.
Premium on redemption of debentures and preference shares.
Provision for tax during the year
Provision for dividend during the year
Transfer to reserves and funds
Interim dividend paid.


Incomes and gains which are not earned from the normal business operations are called non-operating incomes. These incomes are included while ascertaining the business income, but are excluded while determining the funds from operations. The following are the expenses of the non-operating incomes.

Non-operating incomes

Gain on sales of fixed assets and investment
Gain on revaluation of fixed assets.
Discount on redemption of debentures and preference shares.
Compensation received
Interest received
Refund of tax
Transfer fees received
Appreciation on fixed assets

 

Preparation of statement of funds from operations

Funds from operations can be determined by using one of the two following methods:

1.Add back method

Under this method, net profit is taken as the base. All non-operating and non-cash expenses are added to net profit and non-operating incomes are deducted.

2.Profit and Loss adjustment account method

Alternatively, funds from operations can also be determined by preparing an account called profit and loss adjustment account. The profit and loss adjustment account begins with opening balance of profit on its credit side and closing balance on the debit side. Instead of opening and closing balance of profit and loss account, only the amount of net profit for the year can also be brought down to the debit side of this account. Then the items of non-operating expenses and non-cash expenses are adjusted to the debit side and then items of non-operating incomes are adjusted to the credit side to determine the amount of funds form operations.  It is also called profit and loss adjustment account because it needs the adjustment for non-operating and non-cash items for the purpose of calculating funds from operations.

Step 3:

Funds flow statement

After ascertaining the increase or decrease in net working capital and funds or loss from operations, the next step is to prepare the funds flow statement. The purpose of preparing the funds flow statement is to know about the funds obtained and used by the fir. The funds flow statement has two sides. On the left hand side, the sources of funds are shown and on the right hand side, the uses or applications of funds are shown.

Sources

Amount

Application

Amount

Funds from operation……………………….

Decrease in working capital…………………….

Issue of shares……………………………

Issue of debentures……………………..

Increases in long-term liabilities……….

Sale of fixed assets………………………….

Sale of long term investment………….

Non trading receipts like dividend, tax refund, rent etc……………………

 

Increase in working capital…………………

Loss from operation………………………….

Redemption of preference shares………

Redemption of debentures …………………

Repayment of long-term liabilities……….

Purchase of fixed assets………………………

Investment made………………………………

Non trading payment like dividend……….

 

 


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