Unit 1: Fundamentals of Accounting

1.1 Meaning, Concepts, Principles, Accounting Rules

1.2 Single and Double Entry System
1.3 Journal Entry, Bookkeeping, Ledger
1.4 Accounts Receivable and Accounts Payable
1.5 Payroll and Executive Remuneration
1.6 Trial Balance
1.7 Rectification of Errors
1.8 Asset Accounting and Depreciation
1.9 Reserves and Provisions

1
MEANING, CONCEPTS, PRINCIPLES,
ACCOUNTING RULES

STRUCTURE

1.1 Introduction
Objectives
Book Keeping
1.2 Single Entry and Double Entry System
Main Accounting Terms
Accounting Equation
Advantages of Double Entry System.
1.3 Journal Entries
Accounts
Rules Regarding Dr. And Cr.
Entry
Journal
Ledger
Trial Balance
Methods of Preparing Trial Balance
Objectives of preparing Trial Balance
Limitations of Trial Balance
1.4 Accounts Receivable and Accounts Payable
Accounts receivables meaning
Accounts payable meaning
Process
1.5 Payroll and Executive Remuneration
1.6 Trial Balance
1.7 Rectification of Errors
1.8 Asset Accounting and Depreciation
1.9 Reserves and Provisions

2
1.1 INTRODUCTION

So far you have studied who is an entrepreneur, how he starts his business and
how he arranges finance for his business. Now the next step should be control
over the finance and overall performance of the business. This can be done only
by proper maintenance of accounts. Lack of accounting knowledge may seriously
affect the working of the business. Through accounting processes the entrepreneur
can obtain many useful information regarding sources and application of funds,
amount of expenses, sales, purchases, cost of goods sold etc. If he has detailed
information regarding each and every item than only he can control the
activities of the business properly. This is facilitated through the preparation
of accounts only. For maintaining accounts, he may hire a professional
accountant but still he must have some basic accounting knowledge in order to
understand what the accountant is telling him.

MEANING AND DEFINITION OF ACCOUNTING:

The main purpose of accounting is to ascertain profit or loss during a

specified period, to show financial condition of the business on a particular
date and to have control over the firm's property. Such accounting records
are required to be maintained to measure the income of the business and
communicate the information so that it may be used by managers, owners
and other interested parties. Accounting is a discipline which records,
classifies, summarizes and interprets financial information about the
activities of a concern so that intelligent decisions can be made about the
concern. The American Institute of Certified Public Accountants has
defined the Financial Accounting as "the art of recording, classifying and
summarizing in as significant manner and in terms of money transactions
and events which in part, at least of a financial character, and interpreting
the results thereof". American Accounting Association defines accounting
as "the process of identifying, measuring, and communicating economic
information to permit informed judgments and decisions by users of the
information.
3
From the above the following attributes of accounting emerge:
(i) Recording: It is concerned with the recording of financial transactions
in an orderly manner, soon after their occurrence In the proper books of
accounts. (ii) Classifying: It Is concerned with the systematic analysis of
the recorded data so as to accumulate the transactions of similar type at one
place. This function is performed by maintaining the ledger in which
different accounts are opened to which related transactions are posted.
(iii) Summarizing: It is concerned with the preparation and presentation of
the classified data in a manner useful to the users. This function involves
the preparation of financial statements such as Income Statement, Balance
Sheet, Statement of Changes in Financial Position, Statement of Cash
Flow, and Statement of Value Added.
(iv) Interpreting : Nowadays, the aforesaid three functions are performed
by electronic data processing devices and the accountant has to concentrate
mainly on the interpretation aspects of accounting. The accountants should
interpret the statements in a manner useful to action. The accountant
should explain not only what has happened but also (a) why it happened,
and (b) what is likely to happen under specified conditions.
Rules of accounting that should be followed in preparation of all accounts
and financial statements. The four fundamental concepts are

(1) Accruals concept: revenue and expenses are recorded when they occur
and not when the cash is received or paid out;

(2) Consistency concept: once an accounting method has been chosen,

that method should be used unless there is a sound reason to do otherwise;

(3) Going concern: the business entity for which accounts are being
prepared is in good condition and will continue to be in business in the
foreseeable future;

(4) Prudence concept (also conservation concept): revenue and profits are
included in the balance sheet only when they are realized (or there is

4
reasonable 'certainty' of realizing them) but liabilities are included when
there is reasonable 'possibility' of incurring them.

Other concepts include

(5) Accounting equation: total assets equal total liabilities plus owners'
equity;

(6) Accounting period: financial records pertaining only to a specific

period are to be considered in preparing accounts for that period;

(7) Cost basis: asset value recorded in the account books should be the
actual cost paid, and not the asset's current market value;

(8) Entity: accounting records reflect the financial activities of a specific

business or organization, not of its owners or employees;

(9) Full disclosure: financial statements and their notes should contain all
relevant data;

(10) Lower of cost or market value: inventory is valued either at cost or

the market value (whichever is lower);

(11) Maintenance of capital: profit can be realized only after capital of

the firm has been restored to its original level, or is maintained at a
predetermined level;

(12) Matching: transactions affecting both revenues and expenses should

be recognized in the same accounting period;

(13) Materiality: minor events may be ignored, but the major ones should
be fully disclosed;

(14) Money measurement: the accounting process records only activities

that can be expressed in monetary terms (with some exceptions);

(15) Objectivity: financial statements should be based only on verifiable

evidence, including an audit trail;

5
(16) Realization: any change in the market value of an asset or liability is
not recognized as a profit or loss until the asset is sold or the liability is
paid off;

(17) Unit of measurement: financial data should be recorded with a

common unit of measure (dollar, pound sterling, yen, etc.).

Also called accounting conventions, accounting postulates, or accounting

principles
Accounting Concept and Principles

Accounting Concepts and Principles are a set of broad conventions that

have been devised to provide a basic framework for financial reporting. As
financial reporting involves significant professional judgments by
accountants, these concepts and principles ensure that the users of financial
information are not mislead by the adoption of accounting policies and
practices that go against the spirit of the accountancy profession.
Accountants must therefore actively consider whether the accounting
treatments adopted are consistent with the accounting concepts and
principles.

In order to ensure application of the accounting concepts and principles,

major accounting standard-setting bodies have incorporated them into their
reporting frameworks such as the IASB Framework.

Following is a list of the major accounting concepts and principles:

• Relevance
• Reliability
• Matching Concept
• Timeliness
• Neutrality
• Faithful Representation
• Prudence
• Completeness
• Single Economic Entity Concept
• Money Measurement Concept

6
 • Comparability/Consistency
• Understandability
• Materiality
• Going Concern
• Accruals
• Business Entity
• Substance over Form
• Realization Concept
• Duality Concept

In case where application of one accounting concept or principle leads to a

conflict with another accounting concept or principle, accountants must
consider what is best for the users of the financial information. An example
of such a case would be the tradeoff between relevance and reliability.
Information is more relevant if it is disclosed timely. However, it may take
more time to gather reliable information. Whether reliability of information
may be compromised to ensure relevance of information is a matter of
judgment that ought to be considered in the interest of the users of the
financial information.

Matching Principle - topic contents

1. Definition

Matching Principle requires that expenses incurred by an hospital

organization must be charged to the income statement in the accounting
period in which the revenue, to which those expenses relate, is earned.

2. Explanation

Prior to the application of the matching principle, expenses were charged

to the income statement in the accounting period in which they were paid
irrespective of whether they relate to the revenue earned during that period.
This resulted in non recognition of expenses incurred but not paid for
during an accounting period (i.e. accrued expenses) and the charge to
income statement of expenses paid in respect of future periods (i.e. prepaid
expenses). Application of matching principle results in the deferral of
7
prepaid expenses in order to match them with the revenue earned in future
periods. Similarly, accrued expenses are charged in the income statement
in which they are incurred to match them with the current period's revenue.

A major development from the application of matching principle is the use

of depreciation in the accounting for non-current assets. Depreciation
results in a systematic charge of the cost of a fixed asset to the income
statement over several accounting periods spanning the asset's useful life
during which it is expected to generate economic benefits for the entity.
Depreciation ensures that the cost of fixed assets is not charged to the
profit & loss at once but is 'matched' against economic benefits (revenue or
cost savings) earned from the asset's use over several accounting periods.

Matching principle therefore results in the presentation of a more balanced

and consistent view of the financial performance of an organization than
would result from the use of cash basis of accounting.

3. Examples

Examples of the use of matching principle in IFRS and GAAP include the
following:

Deferred Taxation

IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require
the accounting for taxable and deductible temporary differences arising in
the calculation of income tax in a manner that results in the matching of tax
expense with the accounting profit earned during a period.

Cost of Goods Sold

The cost incurred in the manufacture or procurement of inventory is

charged to the income statement of the accounting period in which the
inventory is sold. Therefore, any inventory remaining unsold at the end of
an accounting period is excluded from the computation of cost of goods
sold.

8
Government Grants

IAS 20 Accounting for Government Grants and Disclosure of Government

Assistance requires the recognition of grants as income over the accounting
periods in which the related costs (that were intended to be compensated
by the grant) are incurred by the entity.

4. Matching Vs Accruals Vs Cash Basis

In the accounting community, the expressions 'matching principle' and

'accruals basis of accounting' are often used interchangeably. Accruals
basis of accounting requires recognition of income and expenses in the
accounting periods to which they relate rather than on cash basis. Accruals
basis of accounting is therefore similar to the matching principle in that
both tend to dissolve the use of cash basis of accounting.

However, the matching principle is a further refinement of the accruals

concept. For example, accruals basis of accounting requires the recognition
of the estimated tax expense in the current accounting period even though
the actual settlement of the provision may occur in the subsequent period.
However, matching principle would also necessitate the recognition of
deferred tax in the accounting periods in which the temporary differences
arise so as to 'match' the accounting profits with the tax charge recognized
in the accounting period to the extent of the temporary differences.

OBJECTIVES

OBJECTIVES OF ACCOUNTING
The following are the main objectives of accounting:
1. To keep systematic records: Accounting is done to keep a systematic
record of financial transactions. In the absence of accounting there would
have been terrific burden on human memory which in most cases would
have been impossible to bear.
2. To protect business properties: Accounting provides protection to
business properties from unjustified and unwarranted use. This is possible
on account of accounting supplying the following information to the
manager or the proprietor:
9
(i) The amount of the proprietor's funds invested in the business.
(ii) How much the business have to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b) Cash
in hand, (c) cash at bank, (d) stock of raw materials, work-in-progress
and finished goods?
Information about the above matters helps the proprietor in assuring that
the funds of the business are not necessarily kept idle or underutilized.
3. To ascertain the operational profit or loss: Accounting helps in
ascertaining the net profit earned or loss suffered on account of carrying
the business. This is done by keeping a proper record of revenues and
expense of a particular period. The Profit and Loss Account is prepared at
the end of a period and if the amount of revenue for the period is more than
the expenditure incurred in earning that revenue, there is said to be a profit.
In case the expenditure exceeds the revenue, there is said to be a loss.
Profit and Loss Account will help the management, investors, creditors, tc.
in knowing whether the business has proved to be remunerative or not. In
case it has not proved to be remunerative or profitable, the cause of such a
state of affairs will be investigated and necessary remedial steps will be
taken.
4. To ascertain the financial position of the business : The Profit and
Loss Account gives the amount of profit or loss made by the business
during a particular period. However, it is not enough. The businessman
must know about his financial position i.e. where he stands ?, what he
owes and what he owns? This objective is served by the Balance Sheet or
Position Statement. The Balance Sheet is a statement of assets and
liabilities of the business on a particular date. It serves as barometer for
ascertaining the financial health of the business.
5. To facilitate rational decision making : Accounting these days has
taken upon itself the task of collection, analysis and reporting of
information at the required points of time to the required levels of authority
in order to facilitate rational decision-making. The American Accounting
Association has also stressed this point while defining the term accounting
when it says that accounting is the process of identifying, measuring and

10
communicating economic information to permit informed judgments and
decisions by users of the information. Of course, this is by no means an
easy task. However, the accounting bodies all over the world and
particularly the International Accounting Standards Committee, have been
trying to grapple with this problem and have achieved success in laying
down some basic postulates on the basis of which the accounting
statements have to be prepared.
6. Information System : Accounting functions as an information system
for collecting and communicating economic information about the business
enterprise. This information helps the management in taking appropriate
decisions.
The main aim of every business is to earn profit. Profit is nothing but the
excess of Income over expenditure. So to calculate profit the businessman
must record the incomes and expenditure related to his business, this
recording of business transactions is called book-keeping. Thus book keeping
means recording, classifying and summarizing business transaction
systematically so that the businessman may be able to know his profit or loss
during a specified period.

1.2 SINGLE AND DOUBLE ENTRY SYSTEM

The system of accounting is based on Dual Aspect concept. According to

this concept, every financial transaction involves a two – fold aspect – (a)
receiving of a benefit (b) giving of that benefit, for example if a business
has acquired an asset, it must have given up some other asset such as cash.
Thus a giver necessarily implies a receiver and a receiver necessarily
implies a giver. There must be a double entry to have a complete record of
each business transaction, an entry being made in the giving account and
an entry of the same amount in the receiving account. The receiving
account is termed as debtor and the given account is called creditor. Thus
every debit must have a corresponding credit and vice – versa and upon
this dual aspect has been raised the whole superstructure of double entry
system of accounting. Thus we may define the Double Entry System as
that system which recognizes and records both the aspects of transaction”.
11
This system has been proved to be systemic and has been found of great
use for recording the financial affairs of all institutions requiring use of
money.
RULES OF DEBIT AND CREDIT
Basically, debit means to enter an amount to the left side of an account and
credit means to enter an amount to the right side of an account. In the
abbreviated form Dr. stands for debit and Cr. stands for credit. Both debit
and credit may represent either increase or decrease depending upon the
nature of an account.

The Rules for Debit and Credit are given below :

Types of Accounts Rules for Debit Rules for Credit

(a) For Personal Accounts Debit the receiver Credit the giver
(b) For Real Accounts Debit what comes in Credit what goes out
(c) For Nominal Accounts Debit all expenses Credit all incomes and
and losses gains

ACCOUNTING EQUATION

Total Assets = Total liabilities

= Capital + liabilities
This is known as accounting equation, which means that the total
assets of the firm are always equal to the total liabilities of the firm. At
any point of time the total assets will be equal to the total claims. If
there is any change in the amount of assets or of the liabilities the
owner’s claim or liability is bound to change accordingly.
We can say
Assets = Total claims
= Liabilities + Capital
= (Outsider’s claim) + (Owner’s claim)
Liabilities = Assets – Capital
Capital = Assets – Liabilities

12
Effect of transactions on accounting equation
Suppose Ramesh starts a business and following transactions take place.

I. Commence business with a capital of Rs. 2, 00,000

Assets = Liabilities + Capital

Cash
Rs. 2, 00,000 = 0 + Rs. 2, 00,000

II. Purchase Furniture for Rs. 5,000 in cash

Assets = Liabilities + Capital

Cash + Furniture
Old balance 2, 00,000 + 0 = 0 + 2, 00,000
New Transaction - 5,000 + 5,000 = 0+0

New Balance 1, 95,000 + 5,000 = 0 + 2, 00,000

III. Purchase goods for Rs. 10,000 on cash and Rs. 10,000 on credit
Assets = Liabilities + Capital
Cash + Furniture + Goods = Creditors + Cap
Old Balance 1, 95,000+5,000+0 = 0 + 2, 00,000
New Transaction (-) 10,000+ 0 +20,000 = 10,000+ 2,00,000

New Balance 1, 85,000+5,000+20,000 = 10,000+2, 00,000

IV. Business sells goods on credit for Rs. 30,000 the cost of the goods is
Rs. 15,000
Assets = Liab + Cap.
Cash + Furniture +Goods +Debtors = Creditors + Cap.
Old Balance 1, 85,000+5,000+20,000+0 = 10,000+2,00,000
New Transaction 0 +0 - 15,000+30,000 = 0+ (15,000)
(Profit added to
the capital)

13
 New Balance 1, 85,000+5,000+5,000+30,000 = 10,000+2, 15,000

The business pays Rs. 1,000 for rent and Rs. 2,000 for salaries.
Assets = Liab. + Cap
Cash+ Furniture + Goods + Drs = Creditors + Cap
Old Balance 1, 85,000+5,000 +5,000+30,000 = 10,000+ 2, 15,000
New Transaction (-) 3,000+ 0+ 0 +0 = 0 (-) 3,000

New Balance 1, 82,000+5,000+5,000+30,000 = 10,000+2,12,000

Q. 1. Supply missing amounts on the basis of accounting equation.

Assets = Liab + Capital

(a) 20,000 = 15,000+?

(b) ? = 5,000+ 10,000

(c) 10,000 = ? + 8,000

Q.2. Develop accounting equation from the following transactions.

Rs.

(i) X starts business with cash 50,000

(ii) Purchased goods on cash 30,000

(iii) Purchased goods on credit 20,000

(iv) Sold goods (cost Rs.10, 000) for 12,000

……………………………………………………………………..

……………………………………………………………………..

………………………………………………………………………

14
ADVANTAGES OF DOUBLE ENTRY SYSTEM

1. Scientific system – This system is the only scientific system of

recording business transactions as compared to other systems of book
keeping. It helps to attain the objectives of accounting.

2. This system maintains a complete record of all business transactions.

3. By the use of this system the accuracy of the accounting work can be
established through device of Trial Balance.

4. This system helps in assessment of profit earned or loss suffered by the

business though preparation of Profit and Loss A/C.

5. The financial position of the firm can be ascertained at the end of each
period, through preparation of Balance Sheet.

6. This system permits accounts to be kept in as much detail as necessary

and therefore affords significant information for purposes of control
etc.

7. Comparative study is possible – results of one year may be compared

with those of previous year and reasons for the change may be
ascertained.

8. Helps management for decision-making. The management may be able

to obtain good information for its work, especially for decision-
making.

9. No scope for fraud – The firm is saved from frauds and

misappropriations since full information about all assets and liabilities
will be available.

It is because of these advantages that the system has been used extensively in
all countries.

15
1.4 JOURNAL ENTRIES

For making journal entries the understanding of three things is required.

ACCOUNT

You have seen how the accounting equation is true in all cases. A person starts
his business with Rs. 10,000. Both Capital and Cash are then Rs. 10,000.
Transactions entered into by the firm will affect the cash balance in two ways:
some will increase the cash balance and other will decrease it. Payments will
reduce the cash balance and receipts will increase it.

You can change the cash balance with every transaction but this will be a
cumbersome job. Instead it would be better if all the transactions that lead to
an increase were recorded in one column and those that reduce the balance in
another column. If to the opening balance of cash you add all increases and
then deduct the total of all decreases, you shall know the closing balance. In
this manner significant information will be available relating to cash. The
two columns of which we talked of above are put usually in the following
form, which is the form of an Account.
ACCOUNT
Dr. Cr.
Date Particulars Amount Date Particulars Amount
(Rs.) (Rs.)

16
Types of Accounts

The classification may be illustrated as follows:

ACCOUNTS

Personal A/Cs Impersonal A/Cs

Relates to persons e.g. Which are not personal?

debtors creditors, capital
a/c of the proprietor

Real A/Cs Nominal A/Cs

Relates to the assets of Relates to

the firm e.g. land, expenses, losses,
building, investment, gains, revenue e.g.
cash etc. sales a/c, interest
a/c etc.

17
RULES REGARDING DEBIT AND CREDIT

The left hand side of the T form of account is called the debit side (Dr). and
the right hand side is called credit side (Cr.). When an amount is recorded in
Dr. side of the account one says that one has debited the account and vice –
versa.
Rules of Dr. and Cr.

I Increase in Asset – Dr. As per classification of accounts:

Decrease in Asset – Cr. I. Personal Account
II. Increase in Liabilities – Cr. - Dr. the receiver and Cr. The
giver.
Decrease in Liabilities – Dr.
II. Real Account
III. Increase in capital – Cr.
- Dr. what comes in and Cr.
Decrease in Capital – Dr. what goes out.
IV. Increase in Expenses – Dr. III. Nominal Account
Decrease in Expenses – Cr. - Dr. all the expenses and losses
V. Increase in Income – Cr. and Cr. all the incomes and
gains.
Decrease in Income – Dr.

ENTRY
An entry is the record made in the books of accounts in respect of a
transaction or event. An entry can be made by following rules of Debit. And
Credit transaction or event. An entry can be made by following rules of
Debit. And Credit

18
Example 1. Ramesh starts business with Rs. 1, 00,000

Cash A/C Dr. 1, 00,000 (Increase in Cash – Dr.)

To Capital A/C 1, 00,000 (Increase in Liab – Cr.)

II. Purchase furniture for Rs. 50,000

Furniture A/C Dr. 50,000 (Dr. what comes in and
To cash 50,000 Cr. What goes out)

III. Purchase goods for Rs. 10,000 for Cash and Rs. 10,000 on
credit
Purchases A/C Dr. 20,000 (Stock is increased)
To cash Rs. 10,000 (cash is Decreased)
To creditors Rs. 10,000 (liability is increased)

IV. Sale of goods for cash Rs. 10,000

Cash A/C Dr. 10,000 (Cash is increased)
To sales A/C. Rs. 10,000 (stock of goods is
decreased)

V. Sale of goods to Ram on credit for Rs. 1,000

Ram A/C Dr. 1,000 (Debtors increased)
To sales A/C 1,000 (stock decreased)

VI. Rs. 1,000 received from Ram

Cash A/C Dr. 1,000 (Cash increased)
To Ram 1,000 (Debtors decreased)

VII. Paid Rs. 5,000 as salary in Cash

Salary A/C Dr. 5,000 (Dr. the Exp.)
To Cash 5,000 (Decrease in Cash)

13
 JOURNAL

The book in which entries are recorded is called journal. It is also called books of
original entry. The Specimen Performa of a Journal is as follows:
Journal
Date Particulars L. Dr. Amount Cr. Amount
F.
Rs. Rs.

21.3.2006 Salary A/C Dr. 1,000

To Cash A/C 1,000
(For salary is paid in Cash)

Check Your Progress

Q.3. Journalise these transactions: Rs.
2006
January 1 X started business with Cash 10,000
January 2 Salary paid in cash 7,000
January 3 Bought goods for cash 5,000
January 4 Sold to Krishna goods on credit 1,500
January 5 Machinery purchased for cash 10,000

…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………

14
LEDGER

The book, which contains accounts, is known as the ledger also called the Principal
Book. Ledger provides necessary information regarding various accounts. Personal
accounts in ledger show how much money firm owes to the creditors and the amount it
can recover from its debtors. The real accounts show the value of properties and also
the value of stock. Nominal accounts reflect the sources of income and also the amount
spent on various items. The financial position of the business concern can be
ascertained easily at any time with the help of ledger.

Posting the entries:

Recording the amount involved in Entry in the related accounts is called posting the
entries. This posting of entries can be illustrated through following example:

Entry - Furniture A/C Dr. 12,000

To Modern Furnishers A/C Rs. 12,000

The amount of Rs. 12,000 will be debited to the Furniture A/C and credited to
Modern furnishers A/C in the following way –
Furniture A/C Modern Fur A/C
Dr. Cr. Dr. Cr
To Modern 12,000 By Furniture A/C 12,000
Furnishers

Posting the opening entry

The first entry in the journal is to record the closing balances of various assets and
liabilities at the end of the previous year or the opening balance in the beginning of
the New Year. It is called the opening entry.

Posting – The assets will all show a Dr. Balance such accounts will be opened and
the relevant amounts written on the Dr. Side as “To Balance brought down” (To Bal
b/d).

15
Example Dr. Cash A/C Cr.

To Bal b/d -

The accounts of liabilities show credit balance Account for each liability will be
opened and the relevant amount will be written on the credit side as “By Balance
brought down “(By Bal b/d).
Example Dr. Creditors A/C Cr.

By Bal b/d
Balancing an account

At the end of each month or year or any particular day, it may be necessary to
ascertain the balance in an account. This is not a difficult thing to do – suppose a
person has bought goods worth Rs. 1,000 and has paid only Rs. 850 he owes Rs. 150
and that is the balance in his account. To ascertain the balance in any account, one
has to total the two sides and ascertain the difference. If the credit side is bigger than
the debit side it will be a credit balance and vice versa. The credit balance is written
on the Debit side as “To Balance carried down” (To BAL C/D) and the debit balance
is written in the credit side as “By Balance carried down“(by Bal c/d). After these
two sides totals will be equal. The totals are written on the two sides opposite one
another with one line above and two lines below like this.

It should be noted that nominal accounts are not balanced, the balance in them are
transferred to Profit and Loss A/C. Only personal and real accounts ultimately show
balances

Example
Journalize following transactions. Prepare sri Ram a/c

1.1.06 Purchased goods from Ram Rs. 15000

3.1.06 Purchased goods from Ram on Credit Rs. 12,500

4.1.06 Amount paid to Ram Rs. 10,000

16
Solution Journal

Date Particulars L.F. Dr. Cr.

Amount Amount

1.1.06 Purchases A/C Dr. 15,000

To Ram 15,000
(Goods purchased from Ram
on credit)

3.1.06 Purchases A/C Dr. 125000

To Ram 12,500
(Goods purchased from Ram
on credit)

4.1.06 Ram A/C Dr. 10,000

To Cash 10,000
(Cash paid to Ram)

Sri RamsA/C
Dr. Cr.

Date Particulars Amt. Date Particular Amt. Rs.

Rs.

4.1.06 To Cash /Ac 10000 1.1.06 By Purchases A/C 15000

31.1.06 To Bal C/d 17500 3.1.06 By Purchases A/c 12500

2750 27500
===== =====

Check Your Progress

1. Find out five key words used in the above discussion

17
 …………………………………………………………………………………

SUMMARY

A business is working well or not, earning profits or incurring losses – these

questions can be answered by the accounts of that business. It is well said that
accounting is the language of the business; therefore to read the accounts every
businessman must have knowledge of basic accounting.

This chapter threw light on some basic concepts of accounting. The knowledge of
which will help you to understand the superstructure of accounts.
Accounting starts with book keeping which means recording of business transactions.
Every business transaction has two aspects. The whole superstructure of the
accounting is based on this dual aspect. When both the aspects of a transaction are
recorded the system followed is called as Double Entry system.
First of all journal entries are made, then they are posted to ledger accounts and from
the balances appearing in the ledger, Trial Balance is prepared.

MAIN ACCOUNTING TERMS

Before going ahead you must have knowledge of accounting terminology, which is,
used daily in business world.
1. Capital - It is the amount invested by the proprietor in the firm. For the
business it is liability towards the owner.
Capital = Assets – Liabilities.
2. Asset – Assets are things of value owned. In other words anything, which will
enable the firm to get cash or a benefit in future, is called asset. Money owing
by debtors, stock, cash, furniture, machinery, buildings etc. are a few
examples of assets.
3. Liability – It is the amount, which the firm owes to outsiders
Liability = Assets – Capital
4. Revenue – It is the amount, which is added to the capital as a result of
operation. Receipts from sale of goods, rental income etc. are a few examples
of revenue.

18
5. Expense – It is the amount spent in order to produce and sell the goods and
services which produce the revenue. Some examples of expenses are salaries,
wages, rent, etc.

Income = Revenue – Expense.

5. Purchase – Cash and Credit purchases of goods.
6. Sale – Cash and Credit sales of goods.
7. Stock – Stock includes goods lying unsold on a particular date.
8. Debtors – A person who owes money to the firm.
9. Creditor – A person to whom the money owes by the firm.
10. Proprietor – The person who makes the investment and bears all the risks
connected with the business is called the proprietor.
11. Drawings – It is the amount of the money or the value of goods which the
proprietor takes for his domestic or personal use.
12. Transaction – exchange of goods or services for cash e.g. purchase of a
machinery etc.

GLOSSARY

Final accounts-are those accounts, which are prepared at the end of the accounting
period to find out the profit or loss and the financial position of the business.
Profit and Loss account – An account prepared to calculate Net Profit or Net Loss of
the business for an accounting period
Balance Sheet – Statement showing assets and liabilities of the business at a certain
date

SELF ASSESSMENT QUESTIONS

Explain the meaning of book keeping.
1. Explain the meaning of Double Entry System and describe its advantages.
2. Explain in Brief
a. Capital b. Asset
c. Liability d. Revenue
e. Expense
4. What do you mean by Trail Balance? How it can be prepared?
19
5. What are the main limitations of Trail Balance?
6. What do you mean by an account? What are the main types of account?
7. What are rules regarding debit and credit.

8. Journalise the following transactions and prepare relevant accounts in the ledger.
(i) Balances in the beginning

Cash – Rs. 5,000

Machinery – Rs. 50,000
Loan – Rs. 1, 00,000
Creditors – Rs. 10,000

(ii) Purchase goods on credit from X Co. Rs. 15,000

(iii)Sale of goods for cash – Rs. 1,00,000
(iv) Salaries paid in Cash – Rs. 10,000
(v) Amount paid to X Co. – Rs. 10,000

1.4 ACCOUNTS RECEIVABLES

Accounts receivable are a legally enforceable claim for payment to a business by

its customer/ clients for goods supplied and/or services rendered in execution of
the customer’s order. These are generally in the form of invoices raised by the
business and delivered to the customer for payment within an agreed time frame.
Accounts receivable are shown in the balance sheet as asset. It is one of a series of
accounting transactions dealing with the billing of a customer for goods and
services that the customer has ordered. These may be distinguished from notes
receivable, which are debts created through formal legal instruments called
promissory notes.
Accounts receivable represents money owed by entities to the firm on the sale of
products or services on credit. In most business entities, accounts receivable is
typically executed by generating an invoice and either mailing or electronically
delivering it to the customer, who, in turn, must pay it within an established
timeframe, called credit terms or payment terms.
20
21
The accounts receivable department uses the sales ledger, because a sales ledger
normally records:
• The sales a business has made.
• The amount of money received for goods or services.
• The amount of money owed at the end of each month varies (debtors).
The accounts receivable team is in charge of receiving funds on behalf of a
company and applying it towards their current pending balances.
Collections and cashiering teams are part of the accounts receivable department.
While the collections department seeks the debtor, the cashiering team applies the
monies received.
Payment terms
An example of a common payment term is Net 30 days, which means that
payment is due at the end of 30 days from the date of invoice. The debtor is free to
pay before the due date; businesses can offer a discount for early payment. Other
common payment terms include Net 45, Net 60 and 30 days end of month. The
creditor may be able to charge late fees or interest if the amount is not paid by the
due date.
Booking a receivable is accomplished by a simple accounting transaction;
however, the process of maintaining and collecting payments on the accounts
receivable subsidiary account balances can be a full-time proposition. Depending
on the industry in practice, accounts receivable payments can be received up to 10
– 15 days after the due date has been reached. These types of payment practices
are sometimes developed by industry standards, corporate policy, or because of
the financial condition of the client.
Since not all customer debts will be collected, businesses typically estimate the
amount of and then record an allowance for doubtful accounts[4] which appears
on the balance sheet as a contra account that offsets total accounts receivable.
When accounts receivable are not paid, some companies turn them over to third
party collection agencies or collection attorneys who will attempt to recover the
debt via negotiating payment plans, settlement offers or pursuing other legal
action.
Outstanding advances are part of accounts receivable if a company gets an order
from its customers with payment terms agreed upon in advance. Since billing is
22
done to claim the advances several times, this area of collectible is not reflected in
accounts receivables. Ideally, since advance payment occurs within a mutually
agreed-upon term, it is the responsibility of the accounts department to
periodically take out the statement showing advance collectible and should be
provided to sales & marketing for collection of advances.

ACCOUNTS PAYABLE

Accounts payable is money owed by a business to its suppliers shown as a liability

on a company's balance sheet. It is distinct from notes payable liabilities, which
are debts created by formal legal instrument documents.[1]
An accounts payable is recorded in the Account Payable sub-ledger at the time an
invoice is vouchered for payment. Vouchered, or vouched, means that an invoice
is approved for payment and has been recorded in the General Ledger or AP
subledger as an outstanding, or open, liability because it has not been paid.
Payables are often categorized as Trade Payables, payables for the purchase of
physical goods that are recorded in Inventory, and Expense Payables, payables for
the purchase of goods or services that are expensed. Common examples of
Expense Payables are advertising, travel, entertainment, office supplies and
utilities. A/P is a form of credit that suppliers offer to their customers by allowing
them to pay for a product or service after it has already been received. Suppliers
offer various payment terms for an invoice. Payment terms may include the offer
of a cash discount for paying an invoice within a defined number of days. For
example, 2%,30 Net 31 terms mean that the payor will deduct 2% from the
invoice if payment is made within 30 days. If the payment is made on Day 31 then
the full amount is paid.
In households, accounts payable are ordinarily bills from the electric company,
telephone company, cable television or satellite dish service, newspaper
subscription, and other such regular services. Householders usually track and pay
on a monthly basis by hand using cheques, credit cards or internet banking. In a
business, there is usually a much broader range of services in the A/P file, and

23
accountants or bookkeepers usually use accounting software to track the flow of
money into this liability account when they receive invoices and out of it when
they make payments. Increasingly, large firms are using specialized Accounts
Payable automation solutions (commonly called ePayables) to automate the paper
and manual elements of processing an organization's invoices.
Commonly, a supplier will ship a product, issue an invoice, and collect payment
later, which describes a cash conversion cycle, a period of time during which the
supplier has already paid for raw materials but hasn't been paid in return by the
final customer.
When the invoice is received by the purchaser it is matched to the packing slip
and purchase order, and if all is in order, the invoice is paid. This is referred to as
the three-way match. The three-way match can slow down the payment process,
so the method may be modified. For example, three-way matching may be limited
solely to large-value invoices, or the matching is automatically approved if the
received quantity is within a certain percentage of the amount authorized in the
purchase order.
Problem 1: Solution
Assets Major Classification
Construction in progress Property and equipment
Cash advance to affiliated co. Noncurrent receivable
Petty cash Current assets
Trade receivables Current assets
Building Property and equipment
Cash surrender value of life insurance Other assets
Notes receivable--long term Noncurrent receivable
Office supplies Current assets
Land Property and equipment
Unamortized franchise costs Other assets
Organizational costs Other assets
Food inventory Current assets
Prepaid insurance Current assets
Surgical improvements Property and equipment

24
Problem 2: Solution
SVS HOSPITAL Balance SheetDecember 31, 20X6
ASSETS
Current Assets: Rs.
Cash 15,000
Accounts Receivable 6,000
Inventories 30,000
Prepaid Insurance 10,000
Total Current Assets 61,000
Property and Equipment:
Land 600,000
Buildings 600,000
Equipment 300,000
Less: Accumulated Depreciation (100,000)
Net Property and Equipment 1,400,000
Total Assets 1,461,000
LIABILITIES AND OWNERS' EQUITY
Current Liabilities: Rs.
Accounts Payable 12,000
Wages Payable 15,000
Mortgage Payable--current 50,000
Taxes Payable 7,000
Total Current Liabilities 84,000
Long-Term Liabilities:
Mortgage Payable--long-term 800,000
Total Long-Term Liabilities 800,000
Total Liabilities 884,000
Owners' Equity:
SVS hospital , Capital 577,000
Total Owners' Equity 577,000
25
 Total Liabilities and Owners' Equity 1,461,000

Problem 3: Solution
1. Retained Earnings decreases by Rs.50,000. Dividends Payable
increases Rs.50,000.
2. Cash increases Rs.10,000. Accounts Receivable decreases Rs.10,000.
3. Equipment increases Rs.30,000. Cash decreases Rs.5,000. Notes
Payable increases Rs.25,000.
4. Cash increases Rs.20,000. Inventory decreases. Retained Earnings
increases.
5. Food Inventory increases Rs.2,000. Accounts Payable increases
Rs.2,000.
6. Cash decreases Rs.10,000. Wages Payable decreases Rs.10,000.
7. Supplies (inventory) increases Rs.2,000. Accounts Payable increases
Rs.2,000.
8. Cash decreases Rs.20,000. Treasury Stock increases Rs.20,000.
Common Stock decreases Rs.10,000.
9. Long-term Debt decreases Rs.40,000. Current maturities of long term
debt increases Rs.40,000.
10. Cash decreases Rs.1,000. Accounts Payable decreases Rs.1,000.

26
1.5 PAY ROLL AND EXECUTIVE REMUNERATION

In a company, payroll is the sum of all financial records of salaries for an

employee, wages, bonuses and deductions. In accounting, payroll refers to the
amount paid to employees for services they provided during a certain period of
time. Payroll plays a major role in a company for several reasons.
From an accounting perspective, payroll is crucial because payroll and payroll
taxes considerably affect the net income of most companies and they are subject
to laws and regulations (e.g. in the US payroll is subject to federal and state
regulations). From an ethics in business viewpoint payroll is a critical department
as employees are responsive to payroll errors and irregularities: good employee
morale requires payroll to be paid timely and accurately. The primary mission of
the payroll department is to ensure that all employees are paid accurately and
timely with the correct withholdings and deductions, and to ensure the
withholdings and deductions are remitted in a timely manner. This includes salary
payments, tax withholdings, and deductions from a paycheck.
Payroll Management
Payroll is a method of administering employees' salaries in an organization. The
process consists of calculation of employee salaries and tax deductions,
administrating employee benefits and payment of salaries. Payroll system can also
be called as an accounts activity which commences the salary administration of
employees in the organization. Our Payroll Management System is fully
integrated with accounts and give’s the benefits of simplified Payroll processing
and accounting.

27
Benefits
1 Our Payroll System has user friendly interface, can be customized as per a
business requirement and can be scalable.
2 Our Payroll system saves time and lowers the error ratio.
3 You can enter payment information quicker when compared to a manual
system
4 Run payroll registers to double-check your information before depositing
salary in employee’s bank accounts. This allows you to identify errors and
adjust them in advance.
5 Computerized payrolls simplify tax processing by computing the data.
6 Our payroll system can integrate with other software's as well.
7 Computerized payroll eliminates the stress of processing all the records.
8 You can get your old payroll reports when you needed in just a click.
9 Our payroll system will reduce TCO and increase ROI.
10 This payroll system will track and maintain all the information of salary
transfer.
11 Payroll system helps saves much time

28
 1.6 TRIAL BALANCE

After posting the accounts in the ledger, a statement is prepared to show separately
the debit and credit balances such a statement is known as Trial Balance.

METHODS OF PREPARATION OF TRIAL BALANCE

There are mainly two methods of preparing Trial Balance

1 The Totals Method – in this method the totals of each side of the account is
entered in Dr. and Cr. Column of the Trial Balance
2 The Balance Method – in this method only the Dr. or Cr. Balances are entered
in two columns.
Performa of Trial Balance
Trial Balance
As at……………
Name of the Ledger Debit Credit
Accounts Amount (Total or Amount (Total or
Balance) Balance)
Rs. Rs.

================== ===============

At the end the two columns are totaled, whatever way it is prepared the totals of the
two columns should agree. An agreement indicates reasonable accuracy of the
accounting work, if the two sides do not agree there is definitely some error or
errors.

29
OBJECTIVES OF PREPARATION OF TRIAL -
BALANCE

1 To ascertain the arithmetic accuracy of accounts – the Trial Balance

enables one to establish whether the posting and other accounting
processes have been carried out without committing arithmetical
errors.
2 To facilitate preparation of Final Accounts – Final accounts are
prepared on the basis of information given in the Trial Balance.
3 Summary of each account. The Trial Balance serves as a summary of
what is contained in the ledger.
4 To help in locating errors – Trial Balance helps in locating errors in
book keeping work. It should however be noted that it does not
disclose all types of errors in book keeping work.

As I explained in my earlier posts, for every debit there will be equally credit
also, that means sum of the debit should match with the sum of credit, and
posting to the ledger should be done accurately in order to avoid any
mismatch in debit and credit balance of accounts. Trial balance is a tool to
verify this accuracy of double entry aspect; trial balance ensures the
arithmetical accuracy of ledger balances. However, tallying of the trial
balance is not a conclusive proof of the accuracy of the accounts. It only
ensures that all debits and the corresponding credits have been properly
recorded in the ledger.

Additionally trial balance has a vital role in accounting process, which shows
the final position of all accounts and helps in preparing the final statements.
The task of preparing final accounts is simplified as because accountant can
directly take the account balances from Trial Balance instead of searching
each account in the ledger.

Normally Trial Balance prepared at the end of the financial year, however an
organization may prepare a trial balance periodically such as quarterly,
30
monthly, yearly as per their requirements.

In order to prepare a trial balance an accountant has to follow certain steps as

follows:

List each account with their balance in debit and credit column.

Compute the total of debit and credit column.

Verify the sum of debit balance column with sum of the credit balance
column. If the balance doesn’t match, there are some errors happened while
preparing trial balances or posting from journal to ledger.

For better understanding a replica of trial balance is give below:

31
When a Trial Balance is not tallying, we know that there must be some error
somewhere occurred at any of those stages of accounting process such as totaling
the subsidiary books, posting the journal entries in the ledger, calculating the
account balances, hauling account balances to the trial balance, totaling the trial
balance columns etc.

Even if the total of debit and credit balances is equal, this accuracy doesn’t
provide any surety of error free accounting books. For instance, the book-keeper
may debit a correct amount in the wrong account while making the journal entry
or in posting a journal entry to the ledger. This error would cause two accounts to
have incorrect balances but the trial balance would tally. Another error is to record
an equal debit and credit of an incorrect amount. This error would give the two
accounts incorrect balances but would not create unequal debits and credits. As a
result, the fact that the trial balance has tallied does not imply that all entries in the
books of original record (journal, cash book, etc.) have been recorded and posted
correctly. However, equal totals do suggest that several types of errors probably
have not occurred.

LIMITATIONS OF TRIAL BALANCE

As said earlier Trial Balance do not disclose all types of errors. In other words in spite
of the agreement of the Trial Balance some errors may remain. These may be of the
following types:-
1. A transaction has not been entered at all in the journal.
2. Wrong amount has been written in both columns of the journal.
3. A wrong amount has been mentioned in the journal.
4. An entry has not all been posted in the ledger.
5. An entry is posted twice in the ledger.
But the preparation of Trial Balance is still very useful, without it the preparation of
financial statement the Profit and Loss A/C and Balance sheet would be difficult.

32
1.7 RECTIFICATION OF ERRROR

ACCOUNTING ERRORS
If the two sides of a trial balance agree it is a prima facie evidence of the
arithmetical accuracy of the entries made in the Ledger. But even 7 if the trial
balance agrees, it does not necessarily mean that the accounting records are free
from all errors, because there are certain types of errors, which are not revealed by
a Trial Balance. Therefore a Trial Balance should not be regarded as a conclusive
proof of accuracy of accounts. In accounting an error is a mistake committed by
the book-keeper (Accountant/Accounts Clerk) while recording or maintaining the
books of accounts. An error is an innocent and non-deliberate act or lapse on the
part of the persons involved in recording business transactions. It may occur while
the transactions are originally recorded in the books of original entries i.e. Journal,
Purchase Book, Sales Book, Purchase Return Book, Sales Return Book, Bills
Receivable Book, Bills Payable Book and Cash Book, or while the ledger
accounts are posted or balanced or even when the trial balance is prepared. These
errors may affect the arithmetical accuracy of the trial balance or may defeat the
very purpose of accounting. These errors can be classified as follows:
1. Clerical errors
2. Errors of Principle
A brief description of the above errors is given below:
(a) Clerical errors
Clerical errors are those errors, which are committed by the clerical staff during
the course of recording business transactions in the books of accounts. These
errors are:
1. Errors of omission
2. Errors of commission
3. Compensating errors

33
4. Errors of duplication
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. Omission of recording a business
transaction either completely or partly, omission of ledger posting, omission of
casting and balancing of an account and omission of carrying forward are some
examples of the errors of omission.
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.
This error will also not affect the agreement of trial balance. Another example of a
partial error of omission is that if goods purchased for Rs. 5,500 is recorded in the
Purchase Book for Rs. 5,500 but the personal account of the supplier is not posted
with any amount on the credit side in the ledger, it is a partial error of omission
and it will affect the agreement of trial balance.
Error of commission: Such errors are generally committed by the clerical staff
due to their negligence during the course of recording business transactions in the
books of accounts. Though, the rules of debit and credit are followed properly yet
some mistakes are committed .These mistakes may be due to wrong posting of a
business transaction either to a wrong account or on the wrong side of an account,
or due to wrong casting (addition) i.e. over-casting or under-casting or due to
wrong balancing of the accounts in the ledger.
Compensating errors: Compensating errors are those errors, which cancel or
compensate themselves. These errors arise when an error is either compensated or
counter-balanced by another error or errors so that of the other on the debit or
credit side neutralizes the adverse effect of one on credit side or debit side.
For example, over posting on one side may be compensated by under posting of
an equal amount on the same side of the same account or over posting of one side
34
of an account may be compensated by an equal overprinting on the opposite side
of some other account. But these errors do not affect the trial balance.
Errors of duplication: When a business transaction is recorded twice in the prime
books and posted in the Ledger in the respective accounts twice, the error is
known as the ‘Error of Duplication’. These errors do not affect the trial balance.
(b) Errors of principle
When a business transaction is recorded in the books of original entries by
violating the basic/fundamental principles of accountancy it is called an error of
principle.
Some examples of these errors are:
(i) 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.
(ii) 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. These errors do not affect the Trial Balance. The
disagreement of the Trial Balance will disclose the following errors:
(i) An item omitted to be posted from a subsidiary book into the Ledger i.e. a
purchase of Rs. 6,000 from Satpal omitted to be credited to his account. As a
result of this error, the figure of sundry creditors to be shown in the Trial Balance
will reduce by Rs. 6,000 and the total of the credit side of the Trial Balance will
be Rs. 6,000 less as compared to the debit side of the Trial Balance.
(ii) Posting of wrong amount to a ledger account i.e. credit sale of Rs. 12,000 to
Nisha wrongly posted to her account as Rs. 1,200. The effect of this error will be
that the figure of sundry debtors will reduce by Rs. 10,800 and the total of the
debit side of the Trial Balance will be Rs. 10,800 less than the total of the credit
side of the Trial Balance. (iii) Posting an amount to the wrong side of the ledger
account i.e. Rs. 150 discount allowed to a customer wrongly posted to the credit
instead of the debit of the Discount Account. As a result of this error, the credit
side of the Trial Balance will exceed by Rs. 300 (double the amount of the error).
(iv) Wrong additions or balancing of ledger account, i.e. while balancing Capital
Account at the end of the financial year, credit balance of Rs. 1,89,000 wrongly
35
taken as Rs. 1,79,000. As a result of this error, the credit total of the Trial Balance
will be short by Rs. 10,000.
(v) Wrong totalling of subsidiary books, i.e. Sales Book is overcast by Rs. 1,000.
As a result of this error, Credit side of the Trial Balance will be excess by Rs.
1,000 because Sales Account will appear at a higher figure on the credit side of
the Trial Balance.
(vi) An item in the subsidiary book posted twice to a ledger account, i.e. a
payment of Rs. 9,000 to a creditors posted twice to his account.
(vii) Omission of a balance of an account in the Trial Balance, i.e. cash and bank
balances may have been omitted to be included in the Trial Balance.
(viii) Balance of some account wrongly entered in the Trial Balance i.e. a balance
of Rs. 614 in Stationery Account wrongly entered as Rs. 416 in the Trial Balance.
(ix) Balance of some account written to the wrong side of the Trial Balance, i.e.,
balance of Commission Earned Account wrongly shown to the debit side instead
of the credit side of the Trial Balance.
(x) An error in the totaling of the Trial Balance will bring the disagreement of the
Trial Balance.

1.8 ASSET ACCOUNTING AND DEPRECIATION

Concept, Meaning and Features of Depreciation

Concept of Depreciation
Every business acquires some non-trading fixed assets. These fixed assets are used
in the business for facilitating its trading activities and enhancing its revenue
earning capacity. These assets are basically purchased for the business with the
intention of permanent use and not for resale.
All fixed assets except the value of land decreases with the passage of time. The
value of these assets decrease each year. Such gradual reduction or decrease in the
value of fixed assets for the purpose of earning revenue is called depreciation.
Depreciation is closely related with the determination of profit or loss for the
period. Unless depreciation is charged to the revenues, the true income of the
business cannot be ascertained properly. As such, depreciation is a revenue

36
expense.
Fixed assets are also called depreciable assets. The characteristics of depreciable
assets are as follows.
* The expected life of the asset is more than one accounting period.
* Those assets have a limited useful life.
* Those assets are held by the business for use in production of goods and
services.
* Those assets are not for the purpose of sale in the ordinary course of business.
The cost of fixed asset indicates 'the price for the future service of the assets'. It is
necessary to spread its cost over a number of years during which benefit of the
asset is received. This process of allocating the cost of fixed assets is termed as
'depreciation'.
Meaning Of Depreciation
In general words, depreciation is the reduction in the value of an asset due to
usage, passage of time, wear and tear, technological out dating or obsolescence,
depletion, inadequacy, decay or other such factors.
In accounting, depreciation is a term used to describe any method of attributing
the historical or purchase cost of an asset across its useful life, roughly
corresponding to normal wear and tear. It is mostly used when dealing with assets
of a short, fixed service life, and which is an example of applying the matching
principle as per generally accepted accounting principles.
Depreciation is calculated on all depreciable assets which can be defined as those
which have a useful life for more than one accounting period but is limited and are
held by an enterprise for use in the production or supply of goods and services.
Examples of depreciable assets are machines, plants, furniture, buildings,
computers, trucks, vans, equipment, etc. Moreover, depreciation is the allocation
of 'depreciable amount' which is the 'historical cost' or other amount substituted
for historical cost less estimated salvage value.
Depreciation has significant effect in determining and presenting the financial
position and results of operations of an enterprise. Depreciation is charged in each
accounting period by reference to the extent of the depreciable amount.
In this way, depreciation is an allocation of the cost of assets over their useful life.
A systematic procedure of for allocating the cost over the periods of its useful life
37
in a rational manner is called depreciation accounting.

Features Of Depreciation
Following are the main features of depreciation:
1. Depreciation is decline in the book value of fixed assets.
2. Depreciation includes loss of value of assets due to passage of time, usage
or obsolescence.
3. Depreciation is a continuing process till the end of the useful life of assets.
4. Depreciation is an expired cost and hence must be deducted before
calculating taxable profits.
5. Depreciation is a non-cash expense. It does not involve ant cash flow.
6. Depreciation is the process of writing-off the capital expenditure already
incurred.
Major Causes Of Depreciation
1. Wear And Tear
wear and tear refer to a decline in the efficiency of asset due to its constant use.
When an asset losses its efficiency, its value goes down and depreciation arises.
This is true in case of tangible assets like plant and machinery, building, furniture,
tools and equipment used in the factory.
2. Effusion Of Time
The value of asset may decrease due to the passage of time even if it is not in use.
There are some intangible fixed assets like copyright, patent right, and lease hold
premises which decrease its value as time elapse.
3. Exhaustion
An asset may loss its value because of exhaustion too. This is the case with
wasting assets such as mines, quarries, oil-wells and forest-stand. On account of
continuous extraction, a stage will come where mines and oil-wells get completely
exhausted.
4. Obsolescence
Changes in fashion are external factors which are responsible for throwing out of
assets even if those are in good condition. For example black and white televisions
have become obsolete with the introduction of color TVs, the users have discarded
black and white TVs although they are in good condition. Such as loss on account
38
of new invention or changed fashions is termed as obsolescence.
5. Other Causes
Market value and accident of an asset are other causes of depreciation which
decrease in the value of assets.
Methods Of Providing Depreciation
There are various methods of calculating the amount of depreciation. These
methods are listed below.
1. Fixed Installment Method
2. Diminishing Balance Method
3. Annuity Method
4. Depreciation Fund Method
5. Insurance Policy Method
6. Revaluation Method
7. Machine Hour Rate Method
8. Sum Of The Year's Digits Method
Fixed installment method and diminishing balance method are most commonly
used methods of providing depreciation.

Factors Affecting The Amount Of Depreciation

Following are the important factors which should be considered for determining
the amount of depreciation.
1. Cost Of Assets
The cost of asset include the purchase price, less any trade discount plus all the
costs essential to bring the asset to a usable condition.In other word, the total cost
of asset includes from purchase price to the installation.
2. Estimated Scrap Value
Scrap value refers to the value estimated to be realized after the expiry of the
useful working life of the asset. This is also known as residual value or salvage
value. Depreciation should be determined after deducting the estimated scrap
value from the cost of asset.
3. Estimated Useful Life
An asset cannot work forever. Every asset has a certain working and useful life.
The longer the working life, the amount of depreciation will be lower and vice
39
verse. Therefore, the useful life of an asset is generally to be taken in terms of
asset's expected use. This estimated useful life of asset determines the rate or the
amount of depreciation.

4. Legal Provisions
The amount of depreciation also depends upon the statutory and legal provisions
prescribing the admissible rate of depreciation on fixed assets.

Straight Line Method of Depreciation:

Definition and Explanation:

Straight line method is also known as fixed installment method and original
cost method. This method is very simple and conceptually appropriate to employ.
This is one of the most widely used method for the calculation of depreciation
charge. By this method, the number of years of use is estimated and the the cost is
then divided by the number of years to give the depreciation charge each year.

Under this method , the amount of depreciation will be equal each year, since
depreciation is charged at fixed rate on cost of asset. This is the special feature of
this method. If the annual depreciation is plotted on a graph paper, it will show a
straight line, since the amount of depreciation is equal every year. This is why this
method is called straight line method.

Formula: Depreciation charge under this method is calculated by using the

following formula:

Cost less salvage value

Depreciation
=
charge
Estimated service life

Example: Assume a machine was bought for Rs.500,000 and we thought we

would keep it for four years and then sell it for Rs.50,000 (salvage value) the
depreciation to be charged each year would be calculated as follows:

Cost less salvage value

=Depreciation

40
 charge
Estimated service life

500,000 - Rs.50,000*
=Rs.90,000
5
*Salvage value

Merits:

1. Straight line method or fixed installment method is very easy to employ

because of its simplicity.
2. The asset can be written off to zero value under this method.
3. This method is useful for providing depreciation on leasehold property,
patent right, trade mark, copyright etc.

Demerits:

There are two major objections to the straight line method. These are:

1. This method assumes the same economic usefulness of the asset each year.
2. The repair and maintenance expenses are essentially same each period.

Another problem in the use of straight line method or fixed installment method of
depreciation is that its use results in distortion in the rate of return analysis
(income/assets). The following example shows how the rate of return increases,
given constant revenue flows, because the asset's book value decreases.

Income after
Rate of return
Year Depreciation Book value depreciation
(income/assets)
expenses
0 Rs.500,000
1 Rs.90,000 Rs.410,000 Rs.100,000 24.4%
2 Rs.90,000 Rs.320,000 Rs.100,000 31.2%
3 Rs.90,000 Rs.230,000 Rs.100,000 43.5%
4 Rs.90,000 Rs.140,000 Rs.100,000 71.4%

41
 5 Rs.90,000 Rs.50,000 Rs.100,000 200.0%

Journal Entries:

Under this method depreciation is recorded as follows:

When depreciation is provided:

Depreciation Account Dr.
Asset Account Cr.
(Being depreciation charged on -@- for the year)

When depreciation is transferred to profit and loss

account:
Profit and Loss Account Dr.
Depreciation Account Cr.
(Being depreciation account transferred to profit and loss
account)

When asset is sold on expiry of its useful life:

Bank Account Dr.
Asset Account Cr.
(Being scrap of asset sold)

If profit is earned on sale of asset:

Asset Account Dr.
Profit and Loss Account Cr.
(Being profit on sale of scrap transferred to profit and
loss account)

42
If loss is incurred on sale of asset:
Profit and Loss Account
Asset Account
(Being loss on sale of scrap transferred to profit and loss
account)

43
Reducing Balance Method of Depreciation:

DEFINITION AND EXPLANATION:

Under reducing balance method, the depreciation is charged at a fixed rate like
straight line method (also known as fixed installment method). But the rate
percent is not calculated on cost of asset as is done under fixed installment method
- it is calculated on the book value of asset. The book value of an asset is obtained
by deducting depreciation from its cost. The book value of asset gradually reduces
on account of charging depreciation. Since the depreciation rate per cent is applied
on reducing balance of asset, this method is called reducing balance
method or diminishing balance method. The calculation of depreciation under
this method will be clear from the following example.

EXAMPLE:

Suppose the cost of asset is Rs.1,000 and rate of depreciation 10% p.a.

Cost of asset 1,000

Depreciation:

1st year: 10% of 1,000 100

Book value 900

2nd year: 10% of 900 90

Book value 810

3rd year: 10% of 810 81

Book value 729

44
 and so on.......

Under fixed installment method the amount of annual depreciation remains the
same but under reducing balance method the amount of annual depreciation
gradually reduces.

This method is especially suitable to assets with long life, e.g., plant and
machinery, furniture, motor car etc.

Under this method the real cost of using an asset is the depreciation and repair
expenses so this method gives better results because in early years when repair
expenses are less the depreciation is more. As the asset gets older repair charges
on it increases and the amount of depreciation decreases. So the combined effects
of both these costs remain almost constant on the profit and loss of each year.

The great weakness of this method is that it takes very long time to write off an
asset to approximately nil, unless a very high rate is used, in which case the
burden on earlier years shall be excessive. This method is used by income tax
authorities for granting depreciation allowance to assess.

FORMULA FOR THE CALCULATION OF DEPRECIATION RATE:

The calculation of correct rate of depreciation is very important under this

method. Following formula should be applied under given conditions:

When the cost of asset, residual value and useful life of an asset is given:

r = 1 - (S/C)1/n

Where:

r = Rate of depreciation

n = Estimated useful life of asset

45
 S = Residual value after the expiry of useful life

C = Original cost of asset

EXAMPLE 2:

If n = 3 years, S = 64,000 and C = 1,000,000 calculate rate of depreciation.

r = 1 - (64,000/1,000,000)1/3

= 1 - 40/100

= 60/100

= 60%

DIFFERENCE BETWEEN STRAIGHT LINE METHOD AND REDUCING

BALANCE METHOD:

Following are the main points of difference between straight line method and
reducing balance method of depreciation:

Straight Line Method Reducing Balance Method

1. The rate and amount of depreciation 1. The rate remains the same,
remain the same each year. but the amount of
depreciation diminishes
gradually.

2. Depreciation rate per cent is calculated 2. Depreciation rate per cent

on cost of assets each year is calculated on book value
of asset.

3. At the end of its life the value of asset 3. The value of asset is never
reduced to zero at the end

46
 is reduced to zero or scrap value. of its life.

4. The older the asset the larger the cost 4. The amount of
of its repair. But the amount of depreciation decreases
depreciation remains the same each gradually, while the cost of
year. Hence, the total of depreciation repairs increases. So the
and repairs increases every year. This total of depreciation and
reduces annual profit gradually. repairs remain more or less
the same each year. Hence,
it causes little or no change
in annual profit/loss.

5. Computation of depreciation under 5. Depreciation can be

straight line method is comparatively computed without any
easy and simple. difficulty, but it is not easy
and simple.

1.9 RESERVES AND PROVISIONS

Meaning and Objectives Of Reserve
Meaning Of Reserve
A reserve is a part of the profit set aside to meet future contingencies and losses.
Usually, the whole amount of profit earned by the business is not distributed to the
owners or shareholders. A part of the profit is retained in the business either for
meeting its unexpected future liabilities and losses or for strengthening financial
position. It can be created for redeeming liabilities or replacing depreciable assets
or declaring uniform rate of dividend over years. It is created out of the profit
only. If there is no profit in a particular year, no reserve can be created in that
year. It is created by debiting the profit and loss appropriation account. It does not
reduce the figure of net profit because it is created after determining profit. The
reserve, therefore, reduces only the figure of divisible profit. It belongs to the
47
owners and shareholders. It can be distributed to the shareholders if its existence is
no longer required.

48
Objectives Of Reserve
The main objectives of maintaining reserve are as follows:
• To meet unexpected future losses, liabilities and contingencies.
• To strengthen the financial position of the business.
• To redeem debentures, preference shares and other loans and liabilities.
• To replace wasting or depreciating assets.
• To declare and distribute the uniform rate of dividend over years.
• To meet the need of fund from internal sources.
• To provide additional working capital and to improve the working capacity
of the business.
RESERVE (ACCOUNTING)
In financial accounting, the term reserve is most commonly used to describe any
part of shareholders' equity, except for basic share capital. In nonprofit
accounting, an "operating reserve" is commonly used to refer to unrestricted cash
on hand available to sustain an organization, and nonprofit boards usually specify
a target of maintaining several months of operating cash or a percentage of their
annual income, called an Operating Reserve Ratio. [1]
Sometimes, reserve is used in the sense of the term provision; such a use,
however, is inconsistent with the terminology suggested by International
Accounting Standards Board. For more information about provisions, see
provision (accounting).
There are different types of reserves used in financial accounting like capital
reserves, revenue reserves, statutory reserves, realized reserves, unrealized
reserves.
Concept And Meaning Of Capital Reserve, Its Objectives, Advantages And
Disadvantages
Concept And Meaning Of Capital Reserve
A reserve which is created out of the capital profit is known as capital reserve. It
is not created out of the profit earned in normal course of the business. Capital
reserve is created out of the profit earned from some specific transactions of
capital nature. Capital reserve is not available for the distribution to the
shareholders. The examples of capital profit from which capital reserve is created

49
are as follows:
* Profit on sale of fixed assets
* Profit on sale of investment
* Profit on revaluation of assets and liabilities
* Premium on issue of shares and debentures
* Profit on re-issue of forfeited shares
* Discount on redemption of debentures
* Profit on purchase of an existing business

Objectives and Advantages of Capital Reserve

The following are the objectives and advantages of capital reserves
• Capital reserve helps in making the organization financially strong.
• Capital reserve helps in writing off the capital losses arising from the sale
of fixed assets, shares and debentures.
• Capital reserve helps in the issue of fully paid bonus shares to the existing
shareholders.
Disadvantages Of Capital Reserve
The following are the disadvantages of capital reserve
• Capital reserve is not available for the distribution to shareholders.
• Capital reserve does not give any indication of operating efficiency of the
business.
• Capital reserve does not help in making the management responsible to
sale old assets at satisfactory price.
PROVISION (ACCOUNTING)
Meaning and Objectives Of Provision
Meaning of Provision
A provision is the sum of amount set aside by charging against the profit and loss
account. It is created for meeting a known loss or liability. Provision is maintained
for meeting an anticipated loss or liability of uncertain amount. Such amount of
anticipated loss or liability can only be estimated. If the present regular
transactions undoubtedly bring certain losses or liabilities of unknown amount in
further then provisions should be made for them in current year's book. Such

50
provisions should be made every year by debiting the profit and loss account
without considering whether the business is in profit or loss. A provision is always
created for the specific purpose. It is not for the distribution to the shareholders.
The provision, in fact, reduces the figure of profit and not the figure of divisible
profit.
Generally, a business maintains different types of provisions with some specific
purposes. They are as follows:
• Provision for doubtful debts
• Provision for discount on debtors
• Provision for taxation
• Provision for repairs and renewals
Objectives Of Provision
Some of the important objectives of maintaining provisions are as follows:
* To Meet Anticipated Losses And Liabilities
Provisions are created for meeting anticipated losses and liabilities such as
provision for doubtful debts, provision for discount on debtors and provision for
taxation.
* To Meet Known Losses And Liabilities
Provisions are created for meeting known losses and liabilities such as provision
for repair and renewals.
* To Present Correct Financial Statements
In order to present correct financial statements and to report true profit and
financial position, the business must maintain provision for known liabilities and
losses.
In financial accounting, a provision is an account which records a present liability
of an entity to another entity. The recording of the liability affects both the current
liability side of an entity's balance sheet as well as an appropriate expense account
in the entity's income statement.
Under the International Financial Reporting Standards (IFRS) a provision is a
liability, while under United States Generally Accepted Accounting Principles
(GAAP) it is an expense. Thus, in the United States, a liability for income tax is
described as Income Tax Expense, while under IFRS it is described as Income
Tax Payable. Similarly, warranty costs are treated as an expense under GAAP and
51
a liability under IFRS.
Sometimes in IFRS, but not in GAAP, the term reserve is used instead of
provision. Such a use is, however, inconsistent with the terminology suggested by
International Accounting Standards Board.[citation needed] The term "reserve"
can be a confusing accounting term. In accounting, a reserve is always an account
with a credit balance in the entity's Equity on the Balance Sheet, while to non-
professionals it has the connotation of a pool of cash set aside to meet a future
liability (a debit balance).Provisions are also defined in AS-29 of the Indian
Accounting Standards.

DIFFERENCES BETWEEN RESERVE AND PROVISION

The following are the main differences between reserve and provision:
1. Mode Of Creation
Reserve is created against the charge of the profit and loss appropriation account.
Provision is created against the charge of the profit and loss account.
2. Objective
Main objective of reserve is to strengthen the financial position and to meet future
unknown losses and liabilities. Objective of provision is to meet known losses and
liabilities the amount of which is not certain.
3. Accounting Treatment
Reserve is shown on debit side of profit and loss appropriation account and
liabilities side of balance sheet. Provision is shown on debit side of profit and loss
account and assets side of balance sheet as deduction from the concerned asset.
4. Relation With Profit
Reserve is created when there is enough profit in the business. Provision is created
even if there is loss in the business.
5. Distribution
Reserve can be distributed to shareholders as dividend. Provision can not be
distributed as dividend to shareholders.
6. Future Requirement
Reserve is created without considering the future requirement of the business.
Provision is created by estimating the future requirement of the business.
7. Impact
52
Impact of reserve will be on financial position. Impact of provision will be on
profit or loss of the business.
Types of Reserve
The following are the main types of reserves
1. Capital Reserve
2. Revenue Reserve
a)General Reserve
b) Specific Reserve
*Dividend Equalization Fund
* Research And Development Fund
*Sinking Fund
- Sinking fund for replacement of assets
- Sinking fund for redemption of liabilities
1. Journalize the following transactions:
2005 Feb
03 X commenced business with a capital of Rs.15,000
05 Purchased good Rs.6,000
07 Purchased goods on credit from S & Co. Rs.3,000
10 Purchased furniture Rs.2,400
11 Sold goods Rs.3,900
15 Sold goods on credit to D Rs.2,250
20 Paid salaries Rs.960
25 Received commission Rs.75
26 Returned goods to S & Co. Rs.600.
27 Returned goods by D Rs.450
28 Received from D Rs.1,500
Paid to S & Co. Rs.1,800
X withdrew from business Rs.900
Charged depreciation on Rs.240
Borrowed from K Rs.1,500

53
SOLUTION:

Journal

Date Particular L.F Amount Amount

2005

Feb. Cash A/C ......................................................Dr. 15,000

3 Capital 15,000
(Being capital brought in)

5 Purchases A/C...............................................Dr. 6,000

Cash A/C 6,000
(Being goods purchased for cash)

7 Purchases A/C...............................................Dr. 3,000

S & Co. A/C 3,000
(Being goods purchased form S & Co on
credit)

10 Furniture 2,400
A/C.................................................Dr. 2,400
Cash A/C
(Being furniture purchased for cash)

11 Cash A/C......................................................Dr. 3,900

Sales A/C 3,900
(Being goods sold for cash)

15 D Bros. A/C..................................................Dr. 2,250

Sales A/C 2,250
(Being goods sold on credit to D)

20 Salaries A/C.................................................Dr. 960

Cash A/C 960
(Being salaries paid)

25 Cash A/C......................................................Dr. 75
Commission A/C 75
(Being commission received)

26 S & Co. A/C..................................................Dr. 600

Purchases A/C Return 600
(Being goods returned to S & co.)

54
 27 Sales Returns A/C........................................Dr. 450
D Bros. A/C 450
(Being goods returned by D Bros.)

28 Cash A/C......................................................Dr. 1,500

D Bros. A/C 1,500
(Being amount received from D Bros.)

" S & Co. A/C..................................................Dr. 1,800

Cash A/C 1,800
(Being amount paid to S & Co.)

" Drawings 900

A/C................................................Dr. 900
Cash A/C
(Being amount paid to S & Co.)

" Depreciation 240

A/C...........................................Dr. 240
Furniture A/C
(Being depreciation charged on furniture)

" Cash A/C......................................................Dr. 1,500

K A/C 1,500
(Being amount borrowed from K)

Enter the following transactions in journal and post them into ledger:
2005
Jan. 1 Mr. Javed started business with cash Rs.100,000
2 He purchased furniture for Rs.20,000
3 He purchased goods for Rs.60,000
5 He sold goods for cash Rs.80,000
6 He paid salaries Rs.10,000

55
Solution:

Journal

Date Particular L.F Amount Amount

2005

Jan. Cash A/C .....................................................Dr. 9 100,000

1 Capital 11 100,000
(Being capital brought in)

2 Furniture 13 20,000
A/C.................................................Dr. 9 20,000
Cash A/C
(Being furniture purchased for cash)

3 Purchases A/C...............................................Dr. 15 60,000

Cash A/C 9 60,000
(Goods purchased for cash)

5 Cash A/C......................................................Dr. 9 80,000

Sales A/C 17 80,000
(Sold goods for cash)

6 Salaries A/C..................................................Dr. 19 10,000

Cash A/C Return 9 10,000
(Salaries paid)

Ledger

Cash Account (No.9)

Date Particular J.R Amount Date Particulars J.R Amount

2005 2005

Jan.1 Capital A/C 1 100,000 Jan.2 Furniture A/C 1 20,000

Jan.5 Sales A/C 1 80,000 Jan.3 Purchases A/C 1 60,000

Jan.6 Salaries A/C 1 10,000

Balance c/d 90,000

Total 180,000 Total 180,000

56
 Capital Account (No.11)

Date Particular J.R Amount Date Particulars J.R Amount

2005 2005

Jan.6 Balance c/d 100,000 Jan.1 Cash A/C 1 100,000

Total 100,000 Total 100,000

Furniture Account (No.13)

Date Particular J.R Amount Date Particulars J.R Amount

2005 2005

Jan.2 Cash A/C 1 20,000 Jan.6 Balance c/d 20,000

Total 20,000 Total 20,000

Purchases Account (No.15)

Date Particular J.R Amount Date Particulars J.R Amount

2005 2005

Jan.3 Cash A/C 1 60,000 Jan.6 Balance c/d 60,000

Total 60,000 Total 60,000

Sales Account (17)

Date Particular J.R Amount Date Particulars J.R Amount

2005 2005

Jan.6 Balance c/d 80,000 Jan.5 Cash A/C 1 80,000

Total 80,000 Total 80,000

57
 Salaries Account (19)

Date Particular J.R Amount Date Particulars J.R Amount

2005 2005

Jan.6 Cash A/C 1 10,000 Jan.6 Balance c/d 10,000

Total 10,000 Total 10,000

SELF BALANCING FORM OF LEDGER ACCOUNTS:

In practice the standard form of the ledger account is not used. But it is usually
used for examination purposes.

In practice, the self balancing form of ledger accounts is used. The advantage of
this type of ledger account is that the balance of the account after each transaction
is available at a glance from the last column. So, much time and labor is saved. In
the following example self balancing ledger accounts have been used.

Example:

Enter the following transactions in journal and post them into the ledger and also
prepare a trial balance.

2005

Jan. 1 Mr. X started business with cash Rs.80,000 and furniture Rs.20,000.

Jan. 2 Purchased goods on credit worth Rs.30,000 from Y.

Jan. 3 Sold goods for cash Rs.16,000.

Jan. 4 Sold goods on credit to S for Rs.10,000

Jan. 8 Cash received from S Rs.9,800 in full settlement of his account.

58
Solution:

Journal

Date Particulars L.F DR. Cr.

2005 Amount Amount
(Rs.) (Rs.)
Jan. 1 Cash A/C 5 80,000
Furniture A/C 7 20,000
Capital A/C 9 1,00,000
(Owner invested cash and furniture)

Jan. 2 Purchases Account 11 30,000

Y 13 30,000
(Bought goods on credit)

Jan. 3 Cash A/C 5 16,000

Sales A/C 15 16,000
(Sold goods for cash)

Jan. 4 S A/C 17 10,000

Sales A/C 15 10,000
(Sold goods on credit)

Jan. 8 Cash A/C 5 9,800

Discount A/C 19 200
S A/C 17 10,000
(Cash received and discount allowed)

Ledger

Cash Account (No.5)

Date References J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 1 Capital A/C 5 80,000 80,000

Jan. 3 Sales A/C 5 16,000 96,000

59
Jan. 8 S A/C 5 9,800 105,800

Furniture Account (No.7)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 1 Capital A/C 5 20,000 20,000

Capital Account (No.9)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 1 Cash A/C 5 80,000 80,000

Jan. 1 Furniture A/C 5 20,000 1,00,000

Purchases Account (No.11)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 2 Y A/C 5 30,000 30,000

Y Account (No.13)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 2 Purchases A/C 5 30,000 30,000

Sales Account (No.15)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

60
Jan. 3 Cash A/C 5 16,000 16,000

Jan. 4 S A/C 5 10,000 26,000

S Account (No.17)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 4 Sales A/C 5 10,000 10,000

Jan. 8 Cash A/C 5 9,800

Jan. 8 Discount A/C 5 200 Nil

Discount Account (No.19)

Date references J.R Debit Credit Balance

2005 Dr. Cr.

Jan. 8 S A/C 5 200 200

Methods of Preparing Trial Balance:

There are three methods for the preparation of trial balance. These methods are:
• Total or gross trial balance
• Balance or net trial balance
• Total - cum - balance trial balance
• The method 1 and 2 are described below:
Total or Gross Trial Balance:
Under this method the two sides of all the ledger accounts are totaled up.
Thereafter, a list of all the accounts is prepared in a separate sheet of paper with
two "amount" columns on the right hand side. The first one for debit amounts and
the second one for credit amounts. The total of debit side and credit side of each
61
account is then placed on "debit amount" column and "credit amount" column
respectively of the list. Finally the two columns are added separately to see
whether they agree of not. This method is generally not followed in practice.

Balance or Net Trial Balance:

Under this method, first of all the balances of all ledger accounts are drawn.
Thereafter, the debit balances and credit balances are recorded in "debit amount"
and "credit amount" column respectively and the two columns are added
separately to see whether they agree or not. This is the most popular method and
generally followed.
The various Steps involved in the preparation of Trial Balance under this method
are given below:
• Find out the balance of each account in the ledger.
• Write up the name of account in the first column.
• Record the account number in second column.
• Record the debit balance of each account in debit column and credit
balance in credit column.
Add up the debit and credit column and record the totals.

Enter the following transactions in journal and post them into the ledger and also
prepare a trial balance.

2005
Jan. 1 Mr. X started business with cash Rs.80,000 and furniture Rs.20,000.
Jan. 2 Purchased goods on credit worth Rs.30,000 from Y.
Jan. 3 Sold goods for cash Rs.16,000.
Jan. 4 Sold goods on credit to S for Rs.10,000
Jan. 8 Cash received from S Rs.9,800 in full settlement of his account.

Solution:

Journal

Date Particulars L.F DR. Cr.

2005 Amount Amount

62
 (Rs.) (Rs.)

Jan. 1 Cash A/C 5 80,000

Furniture A/C 7 20,000
Capital A/C 9 1,00,000
(Owner invested cash and furniture)

63
Jan. 2 Purchases Account 11 30,000
Y 13 30,000
(Bought goods on credit)

Jan. 3 Cash A/C 5 16,000

Sales A/C 15 16,000
(Sold goods for cash)

Jan. 4 S A/C 17 10,000

Sales A/C 15 10,000
(Sold goods on credit)

Jan. 8 Cash A/C 5 9,800

Discount A/C 19 200
S A/C 17 10,000
(Cash received and discount allowed)

Ledger

Cash Account (No.5)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 1 Capital A/C 5 80,000 80,000
Jan. 3 Sales A/C 5 16,000 96,000
Jan. 8 S A/C 5 9,800 105,800

Furniture Account (No.7)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 1 Capital A/C 5 20,000 20,000

Capital Account (No.9)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 1 Cash A/C 5 80,000 80,000
Jan. 1 Furniture A/C 5 20,000 1,00,000

64
65
 Purchases Account (No.11)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 2 Y A/C 5 30,000 30,000

Y Account (No.13)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 2 Purchases A/C 5 30,000 30,000

Sales Account (No.15)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 3 Cash A/C 5 16,000 16,000
Jan. 4 S A/C 5 10,000 26,000

S Account (No.17)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 4 Sales A/C 5 10,000 10,000
Jan. 8 Cash A/C 5 9,800
Jan. 8 Discount A/C 5 200 Nil

Discount Account (No.19)

Date references J.R Debit Credit Balance

2005 Dr. Cr.
Jan. 8 S A/C 5 200 200

Trial Balance

A/C
S. No. Account Name Debit Credit
No.
1 Cash Account 5 105,800
2 Furniture Account 7 20,000
3 Capital Account 9 -- 100,000

66
 4 Purchases Account 11 30,000
5 Y Account 13 -- 30,000
6 Sales Account 15 -- 26,000
7 S Account 17 -- --
8 Discount Account 19 200 --
Total 156,000 1,56,000

FINAL ACCOUNTS
The Completion of Accounting Cycle:
Definition and Explanation of Final Accounts:
Every businessman goes into a business with the idea of making profit, which is
the reward of this effort. He tries his best to get more and more profit at the
smallest economic cost. Click here to read more.
Trial Balance - A Starting Point for Final Accounts:
The trial balance is simply a list of ledger accounts balances at the end of an
accounting period. Click here to read more.
Meanings and Sources of Revenue:
In common language revenue means tax or income. But in a business concern
revenue means sales proceeds of goods or services or it is the price of goods sold
or services rendered to the customers. Click here to read more.
Direct and Indirect Expenses:
Expenses means the expired costs incurred for earning revenue of a certain
accounting period. They are the cost of the goods and services used up in the
process of obtaining revenue. Click here to read more.
Matching Revenue and Expenses:
To determine net profit for any particular accounting period, we use the matching
principle. Click here to read more.
Trading Account:
The account which is prepared to determine the gross profit or gross loss of a
business concern is called trading account. Click here to read more.
Profit and Loss Account:
The account, through which annual net profit or loss of a business is ascertained,
is called profit and loss account. Gross profit or loss of a business is ascertained

67
through trading account and net profit is determined by deducting all indirect
expenses (business operating expenses) from the gross profit through profit and
loss account. Thus profit and loss account starts with the result provided by
trading account. Click here to read more.
Difference between Gross Profit and Net Profit:
Gross profit is ascertained by deducting cost of goods sold (all direct expenses
like purchases, carriage, custom duty, sock charges, octroi duty etc.) from sales.
Balance Sheet:
Balance sheet is a list of the accounts having debit balance or credit balance in the
ledger. On one side it shows the accounts that have a debit balance and on the
other side the accounts that have a credit balance. Click here to read more.
Difference between Trial Balance and Balance Sheet:
This page explains the difference between trail balance and balance sheet. Click
here to read
DIFFERENCE BETWEEN TRIAL BALANCE AND BALANCE
SHEET:

Following are the main points of difference between trial balance and balance
sheet:

TRIAL BALANCE BALANCE SHEET

It is prepared to verify the 1 It is prepared to disclose the

arithmetical accuracy of books of true financial position of the
1
accounts business

It is prepared with balances of all 2 It is prepared with the

2 the ledger accounts balances of assets and
liabilities accounts.

It is not a part of final accounts 3 It is an important part of final

3
accounts.

It is prepared before the 4 It is prepared after the

4 preparation of final accounts preparation of trading and
profit and loss account.

68
 It may be prepared a number of 5 It is generally prepared once
5
time in an accounting year. at the end of accounting year.

Generally, it includes opening 6 It always includes closing

6
stock but not closing stock. stock but not opening stock.

There is no rule for arranging the 7 Assets and liabilities must be

7 ledger balances in it. shown in it according to the
rule of marshaling.

It is not required to be filed to 8 It must be filed with the

8 anybody. registrar of companies if the
business is a company.

uditor need not to sign it. 9 Auditor must sign it.

TRADING ACCOUNT AND PROFIT AND LOSS ACCOUNT AND

BALANCE SHEET - EXAMPLE:

The following trial balances have been taken out from the books of XYZ as on
31st December, 2005.

Dr. Cr.
Rs. Rs.

Plant and Machinery 100,000

Opening stock 60,000

Purchases 160,000

Building 170,000

Carriage inward 3,400

Carriage outward 5,000

Wages 32,000

Sundry debtors 100,000

Salaries 24,000

Furniture 36,000

Trade expense 12,000

69
 Discount on sales 1,900

Advertisement 5,000

Bad debts 1,800

Drawings 10,000

Bills receivable 50,000

Insurance 4,400

Bank balances 20,000

Sales 480,000

Interest received 2,000

Sundry creditors 40,000

Bank loan 100,000

Discount on purchases 2,000

Capital 171,500

795,500 795,500

Closing stock is valued at Rs.90,000

Required: Prepare the trading and profit and loss account of the business for the
year ended 31.12.2005 and a balance sheet as at that date.

XYZ hospital
Trading and Profit and Loss Account
For the year ended 31st, December 2005

Opening
60,000 Sales 480,000
stock
Less
Purchases 160,000 1,900 478,100
discount

70
Less discount 2,000 158,000
Closing
90,000
stock
Carriage
3,400
inward
Wages 32,000

Gross profit
(transferred 314,700
to P&L)

568,100 568,000

Gross
Carriage profit
5,000 314,700
outward (transferre
d to P&L)
Interest
Salaries 24,000 2,000
received

Trade
12,000
expenses
Advertiseme
5,000
nt
Bad debts 1,800
Insurance 4,400
Net profit
(transferred 264,500
to capital)

316,700 316,700

Note: Discount on purchases and discount on sales are deducted from purchases
and sales respectively. They may be shown on the credit and debit side of profit

71
and loss account respectively and it will not affect the net profit of the business.
The gross profit will be affected if discount is treated so.

72
 XYZ
Balance Sheet
For the year ended 31st, December 2005

Assets Rs. Liabilities Rs.

Current Current
Assets: Liabilities:
Sundry
Bank balance 20,000 40,000
creditors

Bills
50,000 Bank loan 100,000
receivable

Sundry Fixed and

100,000
debtors Long Term:

Closing stock90,000 Capital 171,500

+Net
Fixed Assets: 264,500
profit
Furniture 36,000
Plant and
100,000 -Drawings 10,000 426,000
Machinery
Building 170,000

566,000 566,000

73
Unit 2: Cash Accounting and Cash Management

2.1 Billing / Cash Receipts and Daily Cash Summary

2.2 Bank Accounts and Bank Reconciliation

2.3 Cash Book

2.4 Petty Cash Management

2.5 Authorization and Approval

2.6 Cash Flow Analysis

2.7 Cash Budgeting

2.8 Cash Control

74
2.1 BILLING / CASH RECEIPTS AND DAILY CASH
SUMMARY

Now days it is common practice to keep separate journals for inflow of cash
(receipts) and outflow of cash (payment). Thus, the business maintains two cash
journals, one is Cash Receipt Journal and another is Cash Payment Journal.

Cash Receipts Journal. This is Journal meant for recording all cash receipts and
posting is done on daily basis from the Receipts Book to the Journal. The
appropriate accounts credited to the amount mentioned in the Cash Receipts
Journal. Usually at the end of the week, the total amount of Cash Receipts Journal
during the period will be debited to cash account.

Cash Payment Journal. This is Journal meant for recording all cash payments
and posting is done on daily basis from the Cash Payments Book to the Journal
and the concerned accounts are debited. At the end of the period (normally at the
end of the week), cash account is credited with the total cash paid during the
period.

Cash Journal

Hospital Cash Journal (Cash Book) is for recording all day to day transactions.
Generally cash transactions are numerous. What is credit transaction today will be
cash transaction tomorrow. In other words, all credit transactions are finally
settled by cash. If like all other transactions cash transactions are also recorded
primarily in Journal. So the Cash book is the substitute for the Cash Account. In
fact, no separate Cash account is opened in the ledger; cash book serves the
purpose of the cash account.

The entries in cash book are regarded as one aspect of the double entry system;
the other aspect is posted to the ledger in the concerned account. “Every entry in
the cash book makes one half of a double entry; the other half of the double entry
appears on the opposite side of some account in the Ledger.” From this angle,
‘Cash Book is a Ledge’.
75
On the other hand, all cash transactions are primarily recorded in the Cash Book
in order of date and thereafter posted to the concerned ledger accounts. Judging
from this angle, ‘Cash Book is a Journal’. Thus we see that a Cash Book is the
‘mixture of Journal and Ledger’. According to Spicer & Pegler, “The cash book is
in fact a ledger version, but due to the huge amount of entries completed in that, it
is reserved in a separate book, this is known as a cash book, which is used also as
a book of principal entry.”

It is one of the main Special Journal for the following reasons:

In an enterprise, the number of cash transactions is pretty bulky and has to pay for
salaries, rent, purchase of goods and it has to receive the cash for sales of goods
and capital assets. Chance for fraud is bit high compare to other assets, therefore
strict internal control is required and a properly maintained cash book should be
maintained in order to overcome this objective.

Cash is the main object in any enterprise. Timely payments to supplier will boost
the reputation of the enterprise. Likewise timely cash collection from the
customers also will help to improve the financial position and liquidity of the
business.

Normally there are six types of cash journals, names are given below:

1 Simple Cash Book

2 Two Columnar Cash Book
3 Three Columnar Cash Book
4 Multi Columnar Cash Book
5 Cash Receipts Book
6 Cash Payments Book

Simple Cash Book (Single Column)

A Simple Cash book may be meant for recording cash transactions or bank
transactions only, all the pure cash transactions recorded over here. Bank
transactions if any, are shown through Bank Account in the ledger.

76
For better understanding about the transactions and their posting to the ledger can
be understood by the following illustration.

77
Mar. 1 Opening Cash Balance 5000.00

Mar. 4 Insurance paid 2000.00

Mar. 6 Interest received 3000.00

Mar.15 Cash Purchases 4000.00

Mar. 25 Cash Sales 8000.00

Mar. 31 Salaries paid 2000.00

78
Two Columnar Cash Book (Double Column)

This book has two columns i.e. Cash column and Discount Column. Cash column
is meant for recording all cash receipts and cash payments and discount column is
to enter all the discount received and discount allowed transactions. Debit side of
the discount represents the discount allowed while Credit side of the discount
represents discount received.

As I explained in my previous posts, cash account serves both the functions of a

book as well as an account, whereas discount column does not serve the function
of a discount account. Therefore a separate account has to maintained the in the
ledger, sometimes two separate accounts are kept in the ledger one for discount
received and one for discount allowed.

The recording of two columnar transactions will be clearer with following

illustration.

Jan 1 Cash Balance 5,000.00

Jan 6 Sale goods to ABC 4,000.00

Jan 8 Purchased goods from XYZ 3,000.00

Jan 15 Cash received from ABC 3,900.00 in full satisfaction

Jan 20 Paid to XYZ 2,830 in full satisfaction

Jan 25 Sold goods to EFG 3,000.00

Received cash from EFG 2,900.00 in full satisfaction

79
Three Columnar Cash Book

It is a type of cash book with columns for Cash, Bank and Discount. The discount
column is memorandum in nature, the debit side of which records discount
allowed while the credit side records discount received. The entries are made
according to the same principles as in normal Cash book.The recording of three
columnar transactions will be clearer with following illustration.

1998

Jan-01 Cash in hand Rs. 5,000

Jan-01 Cash at Bank Rs. 10,000

Jan-03 Cash Sales Rs.1,000

Jan-05 Received Cheque from Rahul on Account Rs. 600. Ready money
sales Rs. 400

80
Jan-07 Dinesh settled his account of Rs. 1,000 less 5% discount by Cheque

Jan-09 Paid Ramesh by Cheque Rs. 500

Jan-10 Countermanded the payment of Cheque issued to Ramesh by order

to the Bank

Jan-12 Discounted with the Bank a Bill of Rs. 2,000 for Rs. 1,900

Jan-13 Deposited Cash into Bank 1,000

Jan-15 Sold goods on credit to Rajesh Rs. 1,100 and paid Rs. 100 out of
cash for carriage

Jan-18 Rajesh settled his account by Cheque less 5% Cash Discount

Jan-20 Withdrew Cash from Bank for Office use Rs. 1,000

Jan-24 Received a bearer cheque from Ramesh against sale of old furniture
Rs. 2,000

Jan-25 Cashed the above cheque over Bank counter

Jan-27 Goods purchased for cash Rs. 500

Jan-29 Debtors pay directly to the Bank Account of the proprietor Rs. 2,000

Jan-30 The cheque was returned dishonoured

Jan-30 Purchased goods on credit Rs. 4,000 from Sachin

Jan-31 The payment was settled at a Discount of 5%

Jan-31 Paid into Bank the entire balance after retaining Rs. 400 at office.

Importance of Cash Management

81
Cash management consists of taking the necessary actions to maintain adequate
levels of cash to meet operational and capital requirements and to obtain the
maximum yield on short-term investments of pooled, idle cash. A good cash
management program is a very significant component of the overall financial
management of a hospital‘s. Such a program benefits the city or town by
increasing non-tax revenues, improving the control and superintendence of cash,
increasing contacts with members of the financial community and lowering
borrowing costs, while at the same time maintaining the safety of the hospital ‘s
funds.

The Goals of Cash Management

The primary goals of a good cash management system are:

To maintain adequate monies at hand to meet the daily cash requirements of the
hospital ‘s while maximizing the amount available for investment.

To obtain the maximum earnings on invested funds while ensuring their safety.

In order to reach these primary goals, a treasurer should strive to:

Develop strong, internal control of cash receipts and disbursements.

Establish improved procedures for collecting outstanding taxes.

Establish clear lines of communication between the treasurer and department

heads.

Develop solid professional relationships with local bankers and other members of
the investment community.

Elements of an Effective Cash Management Program

Bank Relations

The treasurer should strive to be constantly aware of the range of services

available from area banks. Since banks’ service charges and investment rates
vary, the treasurer should regularly evaluate the charges and rates of the banks
used by the hospital ‘s to make certain that continuing to utilize these banks best
82
serves the interests of the hospital ‘s. When selling bonds or notes, the treasurer
should endeavor to receive a sufficient number of bids to ensure competitive rates
for the borrowed funds. Whether borrowing or investing monies, the treasurer
should solicit bids from at least 3 area banks. The treasurer should critically
review bank statements for treasury checking accounts and should funnel all
activity into one account when possible.

Cash Flow Statements

As a component of implementing an effective cash management program, the

treasurer must prepare a cash flow statement, also called a cash budget. Cash
budgeting involves the estimation of cash receipts and cash disbursements to
determine cash availability. A treasurer can best identify the hospital ‘s major
cash items by examining an annual budget, payment and collection records and
past cash flow patterns.

Estimating Collection Receipts

Doctors’ fees and hospital fees constitute the primary sources of hospital funds.
By reviewing a hospital funds treasury and accounting records, a treasurer can
determine the pattern of receipts of that hospital. To assist in determining this
pattern, the treasurer should develop a table that displays:

(1) the type of each receipt,

(2) the total amount of the receipt and

(3) the month when each portion of the receipt was received. If the treasurer
traces the cash flow back 2 or 3 years, a recognizable pattern should become
apparent.

The treasurer should assess the historical patterns of these cash flows in light of
current estimates and events. Although making adjustments for changing time
environments is uncertain business, attempting to make such adjustments should
improve a collections forecast.

Forecasting Disbursements

83
Municipal payrolls account for approximately 70% of the expenditures of most
cities and towns. These expenditures tend to be relatively constant; accordingly,
they can be reliably predicted. A treasurer should use prior payroll records,
together with the next fiscal year’s budget, to calculate the amount of the annual
payroll.

The gross payroll, however, is not the amount disbursed. Rather, the amount
disbursed is the gross payroll amount less deductions for federal and state income
taxes and for fringe benefits, such as workers compensation and retirement. The
payroll disbursement forecast should also include adjustments for seasonal or
temporary workers and for seasonal payments, such as vacation advances in the
summer months. If a hospital‘s offers a lump sum payment option for teachers,
the payments are disbursed at the end of the school year.

Disbursement of monies previously withheld for income taxes and for employee
benefits constitutes a significant payment by a hospital‘s. To forecast the amount
of this disbursement for some discrete period, such as from July 1 through January
1, the treasurer must add all of the deductions from a weekly or biweekly payroll
and multiply the sum by the number of pay periods falling within the designated
time period.

As part of forecasting disbursements for personnel costs, the treasurer should

attempt to estimate the actual cash disbursement if that disbursement deviates
from the budgeted or authorized amount. Budgeted amounts can change only
with supplemental appropriations, while authorized amounts can change with the
increase or decrease of actual employees.

After completing the payroll disbursement forecast, the treasurer should develop
forecasts for other kinds of payments. The treasurer might begin by analyzing
each departmental budget for non-payroll items and then focusing on the more
expensive items first. For each item, the treasurer should converse with the
departmental officials familiar with expenditures to discover the pattern of past
cash disbursements with respect to that item and the anticipated pattern and
amount of expenditure for the item for the upcoming year. The treasurer, based

84
upon a greater familiarity with the timing and volume of cash outflows, should
ensure that these patterns and expenditure projections are reasonable.

85
Analyzing Cash Flow and Preparing a Budget

At a minimum, a treasurer should prepare cash flow data on a monthly basis for
the current year. In larger communities, the treasurer should compile cash flow
information more frequently, on a daily, weekly, or biweekly basis, depending on
the size of the community.

The treasurer should prepare cash flow summaries using two basic categories of
inflows and outflows of cash, recurring and extraordinary. Recurring payments
and receipts, such as payroll expenses and property taxes payments, can be
anticipated regularly, month after month; extraordinary payments and receipts, on
the other hand, result from nonrecurring programs or items, such as federal grants
or capital expenditures.

The treasurer should use the history of major collections and disbursements for the
previous 3 to 5 years to identify recurring expense and disbursement patterns. The
treasurer should then extrapolate these past trends into the future, being careful, at
the same time, to make adjustments for anticipated changes in timing and payment
patterns and to recognize when particular historical data is not representative.

Analyzing the hospital funds current operating budget, looking particularly for the
percentage increase in payroll and in other expenditures, for changes in seasonal
spending patterns and for adjustments caused by the addition or deletion of
programs, will provide crucial information for preparing a cash flow analysis.
Also, examining the capital budget and communicating with department heads
will assist in making projections concerning special cash flow items. (See pg. 11-
26 for a sample projection of the flow of receipts and disbursements related to
special revenues and expenditures.) Of course, analyzing historical information is
of little assistance in projecting special revenues and expenditures in a cash flow
analysis.

Because cash availability is the fundamental concern of cash management, some

treasurers are very conservative in estimating receipts of funds and liberal in
estimating disbursements when they prepare a cash budget. For instance, they
might budget a receipt expected to be taken in at the end of a month as being

86
received the following month. Certainly, it is better to err on the conservative
side. Notwithstanding, accuracy is critical in estimating and managing a hospital
funds cash.

Suggestions for Improving Cash Flow

The treasurer can maximize the amount of hospital funds available cash by
accelerating cash receipts. A treasurer can increase the available cash amount by:

Making daily deposits.

Using a lock box.

Receiving wire transfers of state aid.

Applying promptly for reimbursement of state/federal grants.

Utilizing, direct deposits, Automated Clearing House payments, and other

electronic means of transferring funds, whenever possible, make sure that the
appropriate safeguards are in effect.

The treasurer should induce municipal departments with large cash receipts to
make deposits directly into an account specified by the treasurer, providing the
treasurer with a written notice of each deposit, together with the deposit receipt
provided by the bank. This practice will result not only in an earlier deposit of the
funds, but also in a more accurate deposit record since the bank will check the
accuracy of the deposit slip.

The treasurer should ensure that checks for large amounts are deposited
immediately. If, for example, a tax collector receives tax escrow payments from a
mortgage bank at a time when the collector is too busy to process them, the
treasurer should instruct the collector to prepare a deposit slip and deposit the
bank check immediately, retaining a duplicate copy of the deposit slip with the
payment breakdown. In this way, the money will be available for investment right
away, and the collector can process the payment information whenever
convenient.

87
The treasurer should urge the collector to make use of tax takings and other tax
payment enforcement remedies allowed by law to expedite the collection of
unpaid taxes. The treasurer should actively proceed with tax foreclosures and
with land of low value sales in accordance with the best interests of the hospital‘s.

The treasurer can also improve cash flow by working with department heads to
schedule certain cash disbursements. For example, if a hospital‘s has appropriated
money to the public works department for the purchase of new trucks, the
treasurer should encourage the department head to arrange for delivery of the
trucks no earlier than late April, close to the due date of the 2 nd semiannual tax
payments or the 4th quarterly tax payments, when funds will be on hand to pay for
those trucks. Such planning minimizes the need for revenue anticipation
borrowing.

When possible, the treasurer should first pay bills that offer discounts, postponing
the payments of other bills until the due date. Also, when market conditions
permit, the treasurer should schedule the issuance of debt to make the payment
due dates coincide with times when the community’s cash revenues are at their
maximums. The treasurer should require all capital project managers to provide
regular reports of project payment schedules, permitting the treasurer to obtain
maximum earnings on project funds.

Effectively Investing Available Cash

The treasurer should use the answers to these questions as a basis for planning
investments. By maintaining a chart of deposit accounts, such as the bank ledger
discussed in Chapter 3, adding the daily deposits to these accounts, and sub-
tracting amounts transferred or paid on warrants, the treasurer can determine
exactly how much cash is available to invest. Furthermore, the cash flow budget
will permit the treasurer to determine the length of time for which particular funds
can remain in investments.

The Yield Curve

The cost of money varies according to the length of time for which it is borrowed
or loaned. Generally, longer time periods are deemed to have a greater risk
88
associated with them and thus command higher interest rates. This phenomenon,
of course, favors a hospital‘s when making long-term investments and disfavors
the community when making long-term borrowings. Accordingly, treasurers
should use cash flow budgets to design investments for the longest reasonable
periods in order to obtain the highest yields on these investments.

Treasurers should attempt to be constantly aware of the various interest rates

offered by area banks. They should regularly communicate with these banks and
ask to be on their mailing lists for publications about bank services and about
interest rates on different types of investments over varying time periods.
Treasurers should also visit the websites of area banks to review information
about interest rates and bank products.

BILLING AUTOMATION

Billing automation system helps in billing customer through online orders and
invoices. This helps to manage the billing process with greater efficiency saving
time and money.

Key Features

1 Create templates for all the services provided with their price
2 Set currencies to be used in this application
89
3 User can edit and copy a template for future use
4 Add new associate services and save their information
5 Create new client and save information
6 Create and send quotation to client
7 Add more than one services in quotations
8 Modify the pricing in Quotations, set discounts
9 All the quotations can be sent as a PDF file
10 Track pending, closed and deleted quotations
11 Follow up on Pending Quotations
12 Calculate service Tax and TDS
13 Create and send Invoice to client
14 Add more than one service in Invoice
15 Calculate discounts
16 Add Service Tax details, Pan number and account number details
17 Track pending, closed and deleted Invoices
18 Follow up on Pending Invoices
19 Generate reports
20 Email notifications

Benefits

1 Increase revenue, decrease TCO

2 Enhance customer experience
3 Send invoices on a timely manner
4 Set discounts in quotations and Invoices to be send to clients
5 Track and follow up on quotations and invoices
6 Improve cash management

90
2.2 BANK ACCOUNTS AND BANK RECONCILIATION

BANK ACCOUNT

A bank account is a financial account between a bank customer and a financial

institution. A bank account can be a deposit account, a credit card, or any other
type of account offered by a financial institution. The financial transactions which
have occurred within a given period of time on a bank account are reported to the
customer on a bank statement and the balance of the account at any point in time
is the financial position of the customer with the institution. a fund that a customer
has entrusted to a bank and from which the customer can make withdrawals.

Bank accounts may have a positive, or credit balance, where the bank owes
money to the customer; or a negative, or debit balance, where the customer owes
the bank money Broadly, accounts opened with the purpose of holding credit
balances are referred to as deposit accounts; whilst accounts opened with the
purpose of holding debit balances are referred to as loan accounts. Some accounts
can switch between credit and debit balances. Some accounts are categorized by
the function rather than nature of the balance they hold, such as savings account.
All banks have their own names for the various accounts which they open for
customers.

• Types of accounts
• Deposit account
• Checking account
• Current account
• Personal account
• Transaction deposit
• Savings account
• Individual Savings Account

91
 • Time deposit/certificate of deposit
• Tax-Exempt Special Savings Account
• Tax-Free Savings Account
• Money market account
• Other accounts
• Loan account
• Joint account
• Low-cost account
• Numbered bank account
• Negotiable Order of Withdrawal account

Bank statement

A bank statement or account statement is a summary of financial transactions

which have occurred over a given period of time on a bank account held by a
person or business with a financial institution.

Bank statements are typically printed on one or several pieces of paper and either
mailed directly to the account holder's address, or kept at the financial institution's
local branch for pick-up. Certain ATMs offer the possibility to print, at any time, a
condensed version of a bank statement. In recent years there has been a shift
towards paperless, electronic statements.

Paper statements

Historically, bank statements were paper statements produced quarterly or even

annually. Since the introduction of computers in banks in the 1960s, bank
statements are generally produced monthly. Bank statements for accounts with
small transaction volumes, such as investments or savings accounts, are usually
produced less frequently. Depending on the financial institution, bank statements
may also include certain features such as the cancelled cheques (or their images)
that cleared through the account during the statement period.

Some financial institution use the occasion of posting bank statements to include
notices such as changes in fees or interest rates or to include promotional material.

92
Electronic statements

With the introduction of online banking, bank statements (also known as

electronic statements or e-statements) can be viewed online. Due to identity theft
concerns, an electronic statement may not be seen as a dangerous alternative
against physical theft as it does not contain tangible personal information, and
does not require extra safety measures of disposal such as shredding. However, an
electronic statement can be easier to obtain than a physical through computer
fraud, data interception and/or theft of storage media.

ACCOUNTING FOR NON-TRADING CONCERNS:

EX: HOSPITALS

Definition and Explanation of Non trading Concerns:

Individuals or institutions with activities other than trade are known as non-
trading concerns. Examples of non trading concerns are clubs, hospitals,
libraries, colleges, athletic clubs etc.

These institutions are started not for carrying on a business and making a profit
but for some charitable, religious or similar purpose. Their income, which is
derived from donations, subscriptions, entrances fees etc., is spent on the objects
for which they are started.

Final Accounts of Non-Trading Concerns:

Non-trading concerns usually maintain their accounts by the double entry system
and periodically prepare their final accounts for the submission to their members
and subscribers. The method of preparing final accounts by non trading concerns
is different than trading concerns.

The method of preparing final accounts by non trading concerns is different than
trading concerns. As these concerns does not deal in any goods like trading
concerns, so they cannot prepare a trading and profit and loss account. At the end
of the year they make out an account called an Income and expenditure
account and balance sheet. The Income and expenditure account serve the same
93
purpose as the profit and loss account in the case of trading concerns and is made
out exactly in the same manner.

Usually the non-profit making institutions do not maintain a full set of books
but merely a cash book in which all receipts and payments are entered. At the end
of the year the cash book is summarized under suitable heads and the summary
thus prepared is called a Receipt and Payment Account. In order to know the
result of the year's working it should be converted into Income and expenditure
account.

Receipt and Payment Account:

Receipt and payment account is a mere summary of cash book for a year. It begins
with the cash in hand at the commencement and ends with that at the close of the
year. Similarly to cash account, in receipts and payments account receipts are
shown on the debit side while payments are shown on the credit side.

Receipt and payment account is a mere summary of cash book for a year. It
begins with the cash in hand at the commencement and ends with that at
the close of the year. Similarly to cash account, in receipts and payments account
receipts are shown on the debit side while payments are shown on the credit side,
without any distinction between capital and revenue. Moreover, it does not
include an unpaid expenditure not any unrealized income relating to the period
under review and so fails to reveal the financial position on the concern.

FORMAT OF RECEIPT AND PAYMENT ACCOUNT:

Receipts Rs. Payments Rs.

EXAMPLE:

RECEIPT AND PAYMENT ACCOUNT

Receipts Rs. Payments Rs.

94
To Balance b/d 4,240 By general expenses 5,550
To subscription 4,630 By salaries and wages 3,550
To Life membership fees 1,250 By furniture 1,800
To Entrance fees 1,240 By rent, rates & taxes 500
1,180 125
To interest received 1,050 By printing & stationary 150
To misc. receipts By Repairs 915
13,590 By Balance c/d 13,590

Income and Expenditure Account:

Income and expenditure account is merely another name for profit and loss
account. Such type of profit and loss account is generally adopted by non trading
concerns like clubs, societies, hospitals, and like etc. This account is credited with
all earnings (both realized and unrealized) and debited with all expenses (both
paid and unpaid) The difference represents a surplus of deficiency for a given
period which is carried to the capital account. It should be noted that items of
receipts or payments of capital nature such as legacies, purchases or sales of any
fixed assets must not be included in this account.

Income and expenditure account is merely another name for profit and loss
account. Such type of profit and loss account is generally adopted by non trading
concerns like clubs, societies, hospitals, and like etc. This account is credited with
all earnings (both realized and unrealized) and debited with all expenses (both
paid and unpaid) The difference represents a surplus of deficiency for a given
period which is carried to the capital account. It should be noted that items
of receipts or payments of capital nature such as legacies, purchases or sales of
any fixed assets must not be included in this account.

HOW TO CONVERT A RECEIPT AND PAYMENT ACCOUNT INTO

INCOME AND EXPENDITURE ACCOUNT:

The following steps will be necessary to convert a receipt and payment

account into an income and expenditure account:

95
Opening and closing balances of receipt and payment account should be excluded.
All items of capital receipts and payments should be excluded.
All incomes of previous years or for years to come should be excluded.
All expenditures of previous years and years to come should be excluded.
All accrued income and outstanding expenditures relating to the period should be
included.
Item such as bad debts, depreciation, etc. will have to be provided.

TREATMENT OF PECULIAR ITEMS:

Generally in exercises the instructions are given as to the treatment of special

items. Such instructions are based on the rules of the concern. These should be
followed while solving questions. In cases where no specific instructions are given
the following guidelines may be considered.

LEGACY:

It is the amount received by the concern as per the will of the donor. It appears in
the receipt side of receipt and payment account. It should not be considered as as
an income but should be treated as capital receipt i.e., credited to capital
fund account.

DONATION:

Amount received from any source by way of gift is described as donation. It

appears on the receipts side of receipt and payment account. Donations are usually
credited to income. Rules of the association may provide that a part of donations
are to be treated as capital. However, if donations are received for a specific
purpose viz., building, free dispensary etc., then it should require special
treatment. Donations for specific purposes should not be credited to income and
expenditure account. Similarly donations representing heavy amount may also be
treated as capital receipts.

96
SUBSCRIPTION:

The members of the associations, as per rules, are generally required to make
annual subscription to enable it to serve the purpose for which it was created. It
appears on the receipts side of the receipt and payment account and is usually
credited to income. Care must be exercised to take credit for only those
subscriptions which are relevant.

LIFE MEMBERSHIP FEES:

Generally the members are required to make the payment in a lump sum only once
which enables them the members for whole of life. Life members are not required
to pay the annual membership fees. As life membership fees is substitute for
annual membership fees therefore, it is desirable that life membership fees should
be credited to separate fund and fair portion be credited to income in subsequent
years. In the examination question if there is no instruction as to what portion be
treated as income then whole of it should be treated as capital.

ENTRANCE FEES:

Entrance fees is also an item to be found on the receipt side of receipts and
payments account. There are arguments that it should be treated as capital receipt
because entrance fees is to be paid by every member only once (i.e., when
enrolled as member) hence it is non-recurring in nature. But another argument is
that since members to be enrolled every year and receipt of entrance fees is a
regular item, therefore, it should be credited to income. In the absence of the
instructions any one of the above treatment may be followed but students should
append a note justifying their treatment.

SALE OF NEWS PAPERS, PERIODICALS ETC.

97
As the old newspapers, magazines, and periodicals etc. are to be disposed of every
year, the receipts on account of such sales should be treated as income, and
therefore to be credited to income and expenditure account.

SALES OF SPORTS MATERIAL:

Sale of support materials (used) is also a regular feature of the clubs. Sales
proceeds should be treated as income, and therefore to be credited to income and
expenditure account.

98
HONORARIUM:

Persons may be invited to deliver lectures or artists may be invited to give their
performance by a club (for its members). Any money so paid is termed as
honorarium and not salary. Such honorarium represents expenditure and will be
debited to income and expenditure account.

SPECIAL FUND:

Legacies and donations may be received for specified purchases. As discussed

above these should be credited to special fund and all expenses related to such
fund are shown by way of deduction from the respective fund and not as
expenditure in income and expenditure account.

CAPITAL FUND:

Any concern - whether profit seeking or nonprofit seeking - requires money for
conducting day to day functions. In the case of profit seeking concerns such
money is called "capital", while in the case of non - profit seeking concerns it is
called "capital fund". The excess of total assets over total external liabilities of a
concern is called capital fund. Capital fund is created with surplus revenue and
capital receipts and incomes. It is shown on liabilities side of balance sheet.

INCOME AND EXPENDITURE ACCOUNT

Expenditures Rs. Income Rs.

99
EXAMPLE:
PREPARE INCOME AND EXPENDITURE ACCOUNT AND
BALANCE SHEET FORM THE FOLLOWING RECEIPT
AND PAYMENT ACCOUNT OF A NURSING SOCIETY.

RECEIPT AND PAYMENT ACCOUNT

Receipts Rs. Payments Rs.

To Balance at bank - 1-7-90 2,010 By Salaries of nurses 656

To Subscriptions 1,115 By Board, laundry
To Fees from non members 270 and domestic help 380
1,000 200
To Municipal grant By Rent, rates and taxes
1,560 2,000
To Donation for building fund 38 By Cost of car 840
To Interest By Car expenses 670
By Drugs and incidental exp. 1,247
By Balance c/d

5,993 5,993

The society owns freehold land costing Rs.8,000 on which it is proposed to build
the nurse's hostel. A donation of Rs.100 received to building fund was wrongly
included in subscription account. A bill for medicine purchased during the year
amounting to Rs.128 was outstanding.

Solution: Nursing Society Income and Expenditure Account

Expenditures Rs. Income Rs.

To Salaries of nurses 656 By Subscriptions 1,115

To Board, laundry and Less Wrong inclusion 100 1,015
domestic help 380 By Fees from non members 270
To Rent, rates and taxes 200 By Municipal grant 1,000
2,000 38
To Cost of car 840 By Interest 551
To Car expenses 670 By Deficit
To Drugs and incidental exp. 798
To Outstanding expenses
2,874 2,874

100
101
NURSING SOCIETY
BALANCE SHEET ON 31ST DECEMBER, 1991
Liabilities Rs. Assets Rs.

Building fund 1,560 Cash 1,247

Add omission 100 1,660
Motor car 2,000
128
Outstanding expenses
8,000
Land
Capital fund 10,010 9,459
Less deficiency 551 11,247 11,247

DIFFERENCE BETWEEN RECEIPTS AND PAYMENTS AND

INCOME AND EXPENDITURES ACCOUNT

RECEIPTS & PAYMENT INCOME & EXPENDITURE

ACCOUNT ACCOUNT
1 It is a summary of the cash book 1 It takes the place of profit and loss
account in non-trading concerns.

2 It begins with an opening balance 2 Does not commence with any

and ends with a closing balance. balance

3 It records all sums received and paid 3 It includes revenue items only
whether they relate to revenue or
capital items

4 It include all sums actually received 4 It includes the items relating to year
during the year whether they relate for which it is prepared. Provision is
to the past, current or next year. made for all outstanding expenses
and accrued income.

5 The receipts are shown on the debit 5 Income is shown on the credit side
side and the payments on the credit and expenses on the debit side.
side.

6 It simply ends with a closing balance 6 It definitely shows whether there has
of cash and does not show the result been an excess of income over
for the period. expenditures or vice versa.

7 It is not accompanied by a balance 7 It is always accompanied by a

sheet. balance sheet.

102
103
BANK RECONCILIATION STATEMENT

Definition and Explanation:

From time to time the balance shown by the bank and cash column of the cash
book required to be checked. The balance shown by the cash column of the cash
book must agree with amount of cash in hand on that date. Thus reconciliation of
the cash column is simple matter. If it does not agree it means that either some
cash transactions have been omitted from the cash book or an amount of cash has
been stolen or lost. The reason for the difference is ascertained and cash book can
be corrected. So for as bank balance is concerned, its reconciliation is not so
simple.

The balance shown by the bank column of the cash book should always agree with
the balance shown by the bank statement, because the bank statement is a copy of
the customer's account in the banks ledger. But the bank balance as shown by the
cash book and bank balance as shown by the bank statement seldom agree.
Periodically, therefore, a statement is prepared called bank reconciliation
statement to find out the reasons for disagreement between the bank statement
balance and the cash book balance of the bank, and to test whether the apparently
conflicting balance do really agree.

FEATURES OF BANK RECONCILIATION STATEMENT:

1. It is just a statement not an account

2. It is not a part of double entry book keeping system.
3. It is prepared for a perticular day , not for a period.
4. It is prepared at regular intervals, say every month , three month, 6 month
etc according to the trequirement of the company.
5. It is prepared by a person who has an account with a bank, A bank does
not prepare it.
6. It explain the causes of disagreement between bank statement and cash
book.

104
Causes of Disagreement Between Bank statement and Cash book:

Usually the reasons for the disagreement are:

1. Outstanding cheques paid in to the bank but yet not cleared.

2. Cheques are issued but yet not presented for payment.
3. Cheques received and entered in the cash book but omitted tobe paid into
the bank.
4. Bank charges and interest on overdraft charged by the bank but yet not
entered in the cash book.
5. Direct deposit by the customer entered in bank statement but left tobe
written in cash book.
6. Dishonoured cheques and bills debited in the bank statement but yet not
entered in the cash book.
7. Mistakes made either by bank or the firm

How to Prepare a Bank Reconciliation Statement:

• To prepare the bank reconciliation statement, the following rules may be

useful for the students:
• Check the cash book receipts and payments against the bank statement.
• Items not ticked on either side of the cash book will represent those which
have not yet passed through the bank statement.
• Make a list of these items.
• Items not ticked on either side of the bank statement will represent those
which have not yet been passed through the cash book.
• Make a list of these items.
• Adjust the cash book by recording therein those items which do not appear
in it but which are found in the bank statement, thus computing the correct
balance of the cash book.

Prepare the bank reconciliation statement reconciling the bank statement balance
with the correct cash book balance in either of the following two ways:

(i) First method (Starting with the cash book balance)

105
(ii) Second method (Starting with the bank statement balance)

First Method (Starting With the Cash Book Balance):

If the cash balance is a debit balance, deduct from it all cheques, drafts etc., paid
into the bank but not collected and credited by the bank and added to it all cheques
drawn on the bank but not yet presented for payment. The new balance will agree
with bank statement.

If the bank balance of the cash book is a credit balance (overdraft), add to it all
cheques, drafts, etc., paid into the bank but not collected by the bank and deduct
from it all cheques drawn on the bank but not yet presented for payment. The new
balance will then agree with the balance of the bank statement.

Second Method (Starting With the Bank Statement Balance):

(a) If the bank statement balance is a debit balance (an overdraft), deduct from it
all cheques, drafts, etc., paid into bank but not collected and credited by the bank
and add to it all cheques drawn on the bank but not yet presented for payment.
The new balance will then be agree with the balance of the cash book.

(b) If the bank statement balance is a credit balance (in favor of the depositor), add
to it all cheques, drafts, etc., paid into the bank but not collected and credited by
the bank and deduct from it all cheques drawn on the bank but not yet presented
for payment. The new balance will agree with the balance of the cash book.

Alternatively:

Information Cash book shows debit balance i.e., bank statement shows credit
balance Cash book shows credit balance i.e., bank statement shows debit balance

Cash book shows

Cash book shows credit
debit balance i.e.,
balance i.e., bank statement
bank statement
Information shows debit balance
shows credit balance
CB to
BS to CB CB to BS BS to CB
BS
Cheques issued but not presented
Add Less Less Add
in the bank

106
Cheques paid into bank but not
Less Add Add Less
collected and credited by the bank
Credit, if any in the bank
Add Less Less Add
statement
Debit, if any in the bank statement less Add Add Less

On December 31 1991 the balance of the cash at bank as shown by the cash book
of a trader was Rs.1,401 and the balance as shown by the bank statement was
2,253.

On checking the bank statement with the cash book it was found that a cheque for
Rs.116 paid in on the 31st December was not credited until the 1st January, 1992
and the following cheques drawn prior to 31 December were not presented at the
bank for payment until the 5th January 1992. Rashid & Sons Rs.29, Bashir & Co.
Rs.801, MA Jalil Rs.6, Khalid Bros., Rs.132.

Prepare a statement recording the two balances:

SOLUTION:
Bank Reconciliation Statement on 31st December 1991

First Method:
Balance as per cash book - Dr. 1,401
Less cheques paid in but not collected 116

1,285
Add cheques drawn but not presented:
Rashid & Sons 29
Bashir & Co. 801
MA Jalil 6
Khalid Bros. 132 968

Balance as per bank statement - Cr. 2,253

Second Method:
Balance as per bank statement - Cr. 2,253
Less cheques drawn but not presented 968

107
 1,285
Add cheques paid in but not collected 116

Balance as per cash book - Dr. 1,401

EXAMPLE 2:

On 31st March, 1991 the bank statement showed the credit balance of Rs.10,500.
Cheque amounting to Rs.2,750 were deposited into the bank but only cheque of
Rs.750 had not been cleared up to 31st March. Cheques amounting to Rs.3,500
were issued, but cheque for Rs.1,200 had not been presented for payment in the
bank up to 31st March. Bank had given the debit of Rs.35 for sundry charges and
also bank had received directly from customers Rs.800 and dividend of Rs.130 up
to 31st March. Find out the balance as per cash book.

SOLUTION:

Bank Reconciliation Statement as on 31st March, 1991

Balance as per bank statement - Cr. 10,500

Add cheques deposited but not credited 750

11,250
Less cheques issued but not presented 1,200

10,050
Add bank charges made by the bank 35

10,085
Less omission in cash book (Rs.800 + Rs.130) 930

Balance as per cash book 9,155

Note:

108
Charges made by the bank Rs.35 have not been recorded in the cash book,
therefore, the balance in cash book is more. Add to bank statement balance also.
Dividend and amount from customers received by the bank have not been
recorded in the cash book. Therefore, in the cash book there is no entry of Rs.930
(800 + 130). Deduct from the bank statement balance to adjust it according to cash
book balance.
2.3 CASH BOOK

Cash Book

Cash book is a book of original entry in which transactions relating only to cash
receipts and payments are recorded in detail. When cash is received it is entered
on the debit or left hand side. Similarly, when cash is paid out the same is
recorded on the credit or right hand side of the cash book.

The cash book, though it serves the purpose of a cash book of original entry viz.,
cash journal really it represents the cash account of the ledger separately bound
for the sake of convenience. It is more a ledger than a journal. It is journal as cash
transactions are chronologically recorded in it. It is a ledger as it contains a
classified record of all cash transactions. The balances of the cash book are
recorded in the trial balance and the balance sheet.

Vouchers:

For Every entry made in the cash book there must be a proper voucher. Vouchers
are documents containing evidence of payment and receipts. When money is
received generally a printed receipt is issued to the payer but counterfoil or the
carbon copy of it is preserved by the cashier. The copy receipts are called debit
vouchers, and they support the entries appearing on the debit side of the cash
book. Similarly when payment is made a receipt is obtained from the payee. These
receipts are known as credit vouchers. All the debit and credit vouchers are
consecutively numbered. For ready reference the number of the vouchers are
noted against the respective entries. A column is provided on either side of the
cash book for this purpose.

109
Balancing Cash Book:

The cash book is balanced at the end of a given period by inserting the excess of
the debit on the credit side as "by balance carried down" to make both sides agree.
The balance is then shown on the debit side by "To balance brought down" to start
the next period. As one cannot pay more than what he actually receives, the cash
book recording cash only can never show a credit balance.

Format:

The following is the simple format of a cash book:

Date Particulars L.F. Amount Date Particulars L.F. Amount

Single column cash book:

Definition and Explanation:

Single column cash book records only cash receipts and payments. It has only
one money column on each of the debit and credit sides of the cash book. All the
cash receipts are entered on the debit side and the cash payments on the credit
side. While writing a single column cash book the following points should be kept
in mind:

The pages of the cash book are vertically divided into two equal parts. The left
hand side is for recording receipts and the right hand side is for recording
payments.

Being the cash book with the balance brought forward from the preceding period
or with what we start. It appears at the top of the left side as "To Balance" or "To
Capital" in case of a new business.

Record the transactions in order of date.

110
If any amount of cash is received on an account, the name of that account is
entered in the particulars column by the word "To" on the left hand side of the
cash book.

If any amount is paid on account, the name of the account is written in the
particulars column by the word "By" on the right hand side of the cash book.

It should be balanced at the end of a given period.

Posting:

The balance at the beginning of the period is not posted but other entries
appearing on the debit side of the cash book are posted to the credit of the
respective accounts in the ledger, and the entries appearing on the credit side of
the cash book are posted to the debit of the proper accounts in the ledger.

Format of the Single Column Cash Book:

Following is the format of the single column cash book,

Posting:

The balance at the beginning of the period is not posted but other entries
appearing on the debit side of the cash book are posted to the credit of the
respective accounts in the ledger, and the entries appearing on the credit side of
the cash book are posted to the debit of the proper accounts in the ledger.

Format of the Single Column Cash Book:

Following is the format of the single column cash book:

Date Particulars L.F. Amount Date Particulars L.F. Amount

111
Example:

Write the following transactions in the simple cash book and post into the ledger:

1991

Jan. 1 Cash in hand 15,000

" 6 Purchased goods for cash 2,000

" 16 Received from Akbar 3,000

" 18 Paid to Babar 1,000

" 20 Cash sales 4,000

" 25 Paid for stationary 60

" 30 Paid for salaries 1,000

" 31 Purchased office furniture 2,000

Solution: Cash Book

Date Particulars L.F. Amount DateParticulars L.F. Amount

1991

Jan. To Balance b/d 15,000 Jan. By Purchases a/c 2,000

1 6
To Akbar 3,000 By Babar 1,000
16 18
To sales a/c 4,000 By stationary 60
20 25
By Salaries a/c 1,000
30
By Furniture a/c 2,000
31
By Balance c/d 15,940

112
 22,000 22,000

15,940
To Balance b/d

Akbar

1991
Jan. 16 By Cash

A double column cash book or two column cash book is one which consists of
two separate columns on the debit side as well as credit side for recording cash
and discount. In many concerns it is customary for the trader to allow or to receive
small allowance off or against the dues. These allowances are made for prompt
settlement of accounts. In certain business almost all receipts or payments are
accompanied by such discounts and in order to avoid unnecessary postings
separate columns in the cash book are introduced to record the discounts received
or allowed. These discount columns are memorandum columns only. They do not
form the discount account. The discount column on the debit side of the cash book
will record discounts allowed and that on the credit side discounts received.

POSTING:

The cash columns will be posted in the same way as single column cash book. But
as regards discount column, each item of discount allowed (Dr. side of the cash
book) will be posted to the credit of the respective personal accounts. Similarly
each item of discount received will be posted to the debit of the respective
personal account. Total of the discount column on the debit side of the cash book
will be posted to the debit side of the discount account in the ledger and the total
of discount column on the credit side of the cash book on the credit side of the
discount account. The discount columns are not balanced like cash column of the
tow column cash book.

113
 FORMAT OF THE DOUBLE COLUMN CASH BOOK:

Debit Side Credit Side

DateParticularsV.N.L.F. DiscountCashDateParticularsV.N. L.F.DiscountCash

EXAMPLE OF TWO COLUMN CASH BOOK:

1991

Jan. 1 Cash in hand Rs.2,000

" 7 Received from Riaz & Co. Rs.200; discount allowed Rs.10

" 12 Cash sales Rs.1,000

" 15 Paid Zahoor Sons Rs.500; discount received Rs.15

" 20 Purchased goods for cash Rs.300

" 25 Received from Salman Rs.500; discount allowed Rs.15

" 27 Paid Hussan & Sons Rs.300.

" 28 Bought furniture for cash Rs.100

" 31 Paid rent Rs.100

114
From the
following
transactions write up a two column cash book and post into ledger:

SOLUTION: CASH BOOK

Debit Side Credit Side

Date Particulars V.N. L.F. Discount Cash Date Particulars V.N. L.F. Discount Cash

1991 1991
Jan.1 To 2,000 Jan.5 By Zahoor & 15 500
" 7 Balance 10 200 " 20 Sons 300
" 12 " 27
b/d 1,000 By purchase 300
" 25 " 28
To Riaz & 15 500 " 31 a/c 100
Co. By 100
To Sales Hussan&Sons 2,400
a/c By Furniture
1991 To Salman 25 3,700 a/c 15 3,700
Feb1 By Rent a/c
2,400 By Balance
c/d

To
Balance
b/d

RIAZ & CO.

1991 Rs.
Jan. 7 By Cash 200
By Discount 10

SALES ACCOUNT
1991 Rs.
Jan. 12 By Cash 1,000

115
SALMAN ACCOUNT
1991 Rs.
Jan. 25 By Cash 500
By Discount 15

BABAR ACCOUNT
1991 Rs.
Jan. 18 To Cash 1,000

ZAHOOR ACCOUNT
1991 Rs.
Jan. 15 ToCash 500
Discount 15

PURCHASES ACCOUNT
1991 Rs.
Jan. 20 To Cash 300

HUSSAN & SONS

1991 Rs.
Jan. 27 To Cash 300

FURNITURE ACCOUNT
1991 Rs.
Jan. 28 To Cash 100

RENT ACCOUNT
1991 Rs.
Jan. 31 To Cash 100

DISCOUNT ACCOUNT
1991
Jan. 31 To Sundries as per Cash book

116
A three column cash book or treble column cash book is one in which there are
three columns on each side - debit and credit side. One is used to record cash
transactions, the second is used to record bank transactions and third is used to
record discount received and paid.

When a trader keeps a bank account it becomes necessary to record the amounts
deposited into bank and withdrawals from it. Fir this purpose one additional
column is added on each side of the cash book. One of the main advantages of a
three column cash book is that it is very helpful to businessmen, since it reveals
the cash and bank deposits at a glance

WRITING A THREE COLUMN CASH BOOK:

OPENING BALANCE:

Put the opening balance (if any) on cash in hand and cash at bank on the debit side
in the cash book and bank columns. If the opening balance is credit balance
(overdraft) then it will be put in the credit side of the cash book in the bank
column.

CHEQUE/CHECK OR CASH RECEIVED:

If a cheque is received from any person and is paid into the bank on the same date
it will appear on the debit side of the cash book as "To a Person". The amount will
be shown in the bank column. If the cheque received is not deposited into the bank
on the same date then the amount will appear in the cash column. Cash received
will be recorded in the usual manner in the cash column.

PAYMENT BY CHEQUE/CHECK OR CASH:

When we make payment by cheque, this will appear on the credit side "By a
person" and the amount in the bank column. If the payment is made in cash it will
be recorded in usual manner in the cash column.

CONTRA ENTRIES:

If an amount is entered on the debit side of the cash book, and the exact amount is
again entered on the credit side of the same account, it is called "contra entry".
Similarly an amount entered on the credit side of an account also may have a
contra entry on the debit side of the same account.

Contra entries are passed when:

117
Cash is deposited into bank by office: It is payment from cash and receipt in
bank. Therefore, enter on credit side, cash column "By Bank" and on debit side
bank column "To Cash". The reason for making two entries is to comply with the
principle of double entry which in such transactions is completed and therefore,
no posting of these items is necessary. Such entries are marked in the cash book
with the letter "C" in the folio column

Cheque/Check is drawn for office use: It is payment by bank and receipt in

cash. Therefore, enter on the debit side, cash column "To Bank" and on credit
side, bank column "By Cash".

BANK CHARGES AND BANK INTEREST ALLOWED:

Bank charges appear on the credit side, bank column "Bank Charges." Bank
interest allowed appear on the debit side, bank column "To Interest".

POSTING:

The method of posting three column cash book into the ledger is as follows:

The opening balance of cash in hand and cash at bank are not posted.

Contra Entries marked with "C" are not posted.

All other items on the debit side will be posted to the credit of respective accounts
in the ledger and all other items on the credit side will be posted to the debit of the
respective accounts.

As regards discounts the total of the discount allowed will be posted to the debit
of the discount account in the ledger and total of the discount received to the
credit side of the discount account.

FORMAT OF THE THREE COLUMN CASH BOOK:

Debit Side Credit Side

DateParticulars V.N.L.F. Dis- Cash BankDateParticulars V.N.L.F.Dis- Cash Bank

count count

EXAMPLE OF THREE COLUMN CASH BOOK:

118
2.4 PETTY CASH MANAGEMENT

PETTY CASH BOOK

DEFINITION AND EXPLANATION:

IN ALMOST ALL BUSINESSES, IT IS FOUND NECESSARY TO

KEEP SMALL SUMS OF READY MONEY WITH THE CASHIER OR
PETTY CASHIER FOR THE PURPOSE OF MEETING SMALL
EXPENSES SUCH AS POSTAGE, TELEGRAMS, STATIONARY
AND OFFICE SUNDRIES ETC. THE SUM OF MONEY SO KEPT IN
HAND GENERALLY TERMED AS PETTY CASH AND BOOK IN
WHICH THE PETTY CASH EXPENDITURES ARE RECORDED IS
TERMED AS PETTY CASH BOOK.

IN LARGE BUSINESS HOUSES , THE CASHIER HAS TO HANDLE

EVERY DAY A LARGE NUMBER OF RECEIPTS AND PAYMENTS
AND IF IN ADDITION TO THIS HE IS FURTHER SADDLED WITH
PETTY CASH PAYMENTS, HIS POSITION BECOMES
EMBARRASSING. BESIDES, IT IS MOST COMMON TO FIND
WITH LARGE COMMERCIAL ESTABLISHMENTS THAT ALL
RECEIPTS AND PAYMENTS ARE MADE THROUGH BANK. SINCE
EXPENSES LIKE POSTAGE, TELEGRAMS, TRAVELING ETC,
CANNOT BE MADE BY MEANS OF CHEQUES, THE
MAINTENANCE OF A SMALL CASH BALANCE TO MEET THESE
PETTY PAYMENTS BECOMES ALL THE MORE NECESSARY.

A PETTY CASH BOOK IS GENERALLY MAINTAINED ON A

COLUMNAR BAS IS - A SEPARATE COLUMN BEING ALLOTTED
FOR EACH TYPE OF EXPENDITURE. THE IS ONLY ONE MONEY
COLUMN ON THE DEBIT SIDE AND ALL SUM RECEIVED FROM
TIME TO TIME BY THE PETTY CASHIER FROM THE CHIEF
CASHIER ARE ENTERED IN IT. THE CREDIT SIDE CONSISTS OF
SEVERAL ANALYSIS COLUMNS. EVERY PAYMENT MADE BY
119
THE PETTY CASHIER IS ENTERED ON THIS SIDE TWICE -
FIRSTLY IT IS RECORDED IN THE TOTAL COLUMN AND THEN
TO THE APPROPRIATE COLUMN TO WHICH THE EXPENSE IS
CONCERNED. THE TOTAL OF THE "TOTAL COLUMN" WILL
NATURALLY AGREE WITH THE TOTAL OF ALL SUBSIDIARY
COLUMNS. THE DIFFERENCE BETWEEN THE TOTAL OF THE
DEBIT ITEMS AND THAT OF THE "TOTAL COLUMN" ON THE
CREDIT SIDE AT ANY TIME WILL REPRESENT THE BALANCE
OF THE PETTY CASH IN HAND AND THIS SHOULD TALLY WITH
THE PETTY CASHIER'S ACTUAL HOLDING OF CASH.

THE POSTING FROM THE PETTY CASH BOOK TO THE

RESPECTIVE ACCOUNTS IN THE LEDGER ARE MADE DIRECTLY
IN TOTAL AT THE END OF EVERY MONTH OR ANY OTHER
FIXED PERIOD.

THE IMPREST SYSTEM:

THE MORE SCIENTIFIC METHOD OF MAINTAINING PETTY

CASH SO FOR INTRODUCED INTO PRACTICE IS THE IMPREST
SYSTEM. UNDER THIS SYSTEM A FIXED SUM OF MONEY IS
GIVEN TO THE PETTY CASHIER TO COVER THE PETTY
EXPENSES FOR THE MONTH. AT THE END OF A MONTH THE
PETTY CASHIER SUBMITS HIS STATEMENT OF PETTY
EXPENSES TO THE CHIEF CASHIER. THE CHIEF CASHIER ON
THE RECEIPT OF SUCH STATEMENT REFUNDS TO THE PETTY
CASHIER THE EXACT AMOUNT SPENT BY HIM DURING THE
MONTH, THUS MAKING THE IMPREST FOR THE NEXT MONTH
THE SAME AS IT WAS AT THE BEGINNING OF THE CURRENT
MONTH.

IT IS TO BE NOTED THAT THE AMOUNT OF CASH IN THE

HANDS OF THE PETTY CASHIER IS A PART OF THE CAS H
BALANCE, THEREFORE IT SHOULD BE INCLUDED IN THE CASH
BALANCE WHEN THE LATTER IS SHOWN IN THE TRIAL
BALANCE AND THE BALANCE SHEET. IT SHOULD ALSO BE
KEPT IN MIND THAT PETTY CASH BOOK IS NOT LIKE THE
CASH BOOK. IT IS A BRANCH OF CASH BOOK.

120
ADVANTAGES OF IMPREST SYSTEM:

THE MAIN ADVANTAGES OF IMPREST SYSTEM OF PETTY

CASH ARE AS FOLLOWS:

A S THE PETTY CASHIER HAS TO PRODUCE TO THE CHIEF

CASHIER THE PETTY CASH BOOK FOR INSPECTION, IT ACTS
AS A HEALTHY CHECK ON THE PETTY CASHIER.

AS THE PETTY CASHIER HAS TO ACCOUNT FOR HIS EXPENSES,

BEFORE HE CAN DRAW FURTHER SUMS, THE PETTY CASH
BOOK REMAINS UP TO DATE.

AS THE PETTY CASHIER CANNOT DRAW AS AND WHEN HE

LIKES, IT PREVENTS UNNECESSARY ACCUMULATION OF CAS H
IN HIS HAND THUS THE CHANCES OF DEFALCATION OF CASH
ARE MINIMIZED.

FORMAT OF THE PETTY CASH BOOK:

The following is the simple format of a petty cash book:

Amount Date Particulars V.N. Total Postage Printing and Cartage Traveling Misc.
Received Stationary Expenses

Enter the following transactions in the columnar petty cash book of a cashier who was given
Rs.100 on 1st March, 1991 on the imprest system:-

1991

March 2 Paid for postage stamps 8

" 2 Paid for stationary 10

" 3 Paid for cartage 4

121
" 3 Paid for postage stamps 6

" 8 Paid for paper 1

" 12 Paid for cartage 6

" 18 Paid for trips to office peons 2

" 23 Paid for ink and nibs 4

" 25 Paid for Tiffin to office peons 6

" 26 Paid for train fair 5

" 28 Paid for bus fair 4

" 29 Envelops and letter heads 6

" 30 Printing address on above 4

" 31 Taxi fare to manager 10

SOLUTION:
Amount Date Particulars V.N. Total Postage Printing and Cartage Traveling Misc.
Received Stationary Expenses

Rs. 1991
Rs.100 March1 To Cash
" 2 By Postage 8 8
" 2 By Stationary 10 10 4
" 3 By Cartage 4
" 3 By Postage 6 6
" 3 By Paper 1 1
" 12 By Cartage 6 6 2
" 18 By Tip to peon 2
" 23 By Ink & nibs 4 4 6
5
" 25 By Tiffin to Peon 6 4
" 26 By train fair 5
" 28 By bus fair 4
" 29 By Envelops et. 6 6 10
" 30 By printing 4 4
" 31 By Taxi fair 10
" 31 By balance c/d 24

100 100 14 25 10 19 8

April 1 To Balance b/d

24
" 1 To Cash
76

122
2.5 AUTHORISATION AND APPROVAL
Authorizations and Approvals Required for Financial Transactions

Purpose

To establish Hospital policy with respect to authorization and approval of

financial transactions.

Definitions

Financial transactions - All receipts, disbursements and transfers that are

ultimately recorded in a Hospital activity/project, regardless of funding source.
Transaction data and supporting documents may be maintained in electronic
and/or hard copy form. Examples of such documentation might include
authorizations and requests relating to Hospital bank accounts, payrolls,
requisitions and purchase orders, travel payment requests and expense
reimbursements, petty cash reimbursement requests, journal entries, fund
transfers, campus orders, and other similar documents and transactions.

Account Executive or Principal Investigator - A faculty or administrative person

who is designated to bear primary responsibility for maintaining financial
accountability and control for funds under his/her jurisdiction. For all projects
(sponsored agreements), this individual is recognized as the principal investigator.
For all other financial activities, this individual is called the account executive.

The account executive or principal investigator has authority to expend Hospital

funds to accomplish assigned responsibilities, and is accountable for all
transactions in his/her activities/projects. This includes ensuring that transactions
are:

123
Reasonable and necessary

Consistent with established Hospital Regulations

Consistent with any applicable laws and government regulations

Consistent with sponsor or donor restrictions.

Expenditures that are solely for personal benefit or purposes other than those that
benefit the Hospital are prohibited.

Authorized Alternate - An individual to whom financial stewardship is delegated

from official offices of the account executive, principal investigator, ORG head,
department chair, director, dean, vice president, or president to act in his/her
behalf in matters requiring approval of Hospital financial transactions as outlined
in this policy. An Authorized Alternate may act on behalf of the responsible
person in his/her planned or occasional absence, as a "proxy," or may receive a
more permanent delegations of authority for one or many particular financial
functions.

Satellite Processing Units - Departments that are granted authority to

independently input transactions into the Hospital financial system.

Policy

General

All Hospital financial transactions require authorization by the account executive

or principal investigator responsible person, an ORG head, a supervisory officer
above the account executive or principal investigator responsible person
(department chair head, dean, director, etc.), or an authorized alternate.
Transactions submitted to central administrative departments without appropriate
authorization may be returned to the initiating department and not processed. Such
transactions may be resubmitted when the authorization is obtained. Validation of
transactions requiring account executives, principal investigators and authorized
alternates signatures requires submittal of a signature authorization form.
Signature Authorization Forms are available through the “employee” tab of the
Campus Information System, under the heading Financial & Business
Services/Forms.

Financial transactions wherein an individual requests payment to himself or

herself for services rendered or for reimbursement of expenses (including petty
cash) will require the approval of the next higher ORG head or authorized
alternate. Payment or reimbursements to the president shall be reviewed by the
Hospital's internal auditor, who will summarize and provide a periodic report to

124
the Audit Committee of the Hospital's Board of Trustees in a format approved by
the Audit Committee.

Facsimile signatures on documents supporting financial transactions are not

acceptable on financial documents except where such signatures are affixed under
controlled conditions, and are authorized by the Vice President for Administrative
Services or his/her designee.

Designations of authorized alternates shall be submitted in writing either on the

Signature Authorization Form or when appropriate in a memo on business
letterhead addressed to Financial and Business Services (see item III.A, above).
Memos of authority delegation should contain effective dates where appropriate.
Revised/updated forms must be submitted within one month when changes occur
due to hiring, termination, or reassignment. Electronic systems and tools will
become available where authorized alternate designations will become specific to
function and will be managed by effective dating. Administrative offices will rely
on tools of electronic designation for validation purposes, but will have to
continue to rely upon paper designations until electronic systems are
implemented.

While an authorized alternate may be designated, the following conditions apply:

The account executive or principal investigator remains accountable for the

activity/project.

The authorized alternate shall sign his/her own name or use his/her own identity
and not the name or identity of the account executive or principal investigator or
any other person.

Authorization and approval authority may not be delegated for certain transactions
and documents A key element in the Hospital's system for maintaining control is
review and approval of the monthly accounting statements. The statements should
be reviewed and approved by a person with supervisory responsibility for the
individual(s) who initiate transactions. The account executive or principal
investigator should not seek to delegate this function, and may do so only when
there is no practical alternative. If review and approval authority must be
delegated, it is imperative that the account executive or principal investigator
remain sufficiently involved to be knowledgeable about financial matters and
exert meaningful oversight.

Approval must be evidenced by the signature of the person who completes the
review, along with the date. Approval should ordinarily be completed within one
month of receipt of the management reports. Approval indicates agreement that:

Transactions are accurate, or that necessary corrections are in process.

125
Expenditures are reasonable, necessary, and are for legitimate Hospital business.

Expenditures and other charges are allowable and consistent with donor or
sponsor restrictions.

Supporting documentation exists and is retained by the department for possible

review by internal or external auditors.

Requests for exceptions to this policy shall be made in writing by the president or
the cognizant vice president when, in his/her judgment, special circumstances or
emergency conditions make strict compliance impracticable. Any policy
exception request under this paragraph shall be submitted to the Office of the Vice
President for Administrative Services or his/her designee for final approval, where
compliance issues exceed matters of routine policy.

When a satellite processing unit independently inputs financial transactions into

the Hospital system, the satellite department retains the supporting documentation.
The satellite department must adhere to this policy, making certain appropriate
business processes, which are consistent with Hospital policy, are in effect for
documenting, approving, and recording financial transactions.

Referral and Authorization Process in the Managed Care Environment

126
Referral and Authorization Process in the Managed Care
Environment
Managed Care Background

Managed Health Care is “A regrettably nebulous term. At the very

least, a system of health care delivery that tries to manage the cost of

health care, the quality of health care, and the access to that care.

Common denominators include a panel of contracted providers that is

less than the entire universe of available providers, some type of

limitations on benefits to subscribers who use noncontracted providers

(unless authorized to do so), and some type of authorization system.

Managed health care is actually a spectrum of systems, ranging from

so-called managed indemnity through PPOs, POS plans, open panel

HMOs, and closed panel HMOs.”1 In 1973, fewer than one in every 25

privately insured Americans were enrolled in a managed care plan, now

two out of every three privately insured Americans are in such a plan.2

Authorization Process

1
Kongstvedt, Peter R. (1997) Essentials of Managed Health Care. Gatihersburg, Maryland:
Aspen Publishers, Inc. 548.
2
Wehrwein, Peter (October 1997) Will State Legislators Keep Playing Doctor?
Managedcaremag.com/archiveMC/9710/9710.legislators.html.

127
 An authorization system is one of the definitive elements of managed

health care. It may be as basic as precertifiction of elective

hospitalizations in an indemnity plan or preferred provider organization

(PPO) or as complex as mandatory authorization for all non-primary

care services in a health maintenance organization (HMO). The

authorization system provides the key element of managing the delivery

of health care services. The following are the four main reasons for an

authorization system:

Case review for medical necessity by the by the medical management

function of the plan.

Direct care to the most appropriate setting (Inpatient vs. Outpatient or in the

provider’s office).

Provide timely information to the concurrent review utilization system and

the case management system,

Assist in the finance estimate of the accruals for medical expenditures each

month.

An authorization system must define what services will require

authorization and what will not. This information must be made

available to the consumer in the marketing literature. There is usually

no authorization requirements for accessing primary care services;

however, the key issues revolve around what non-primary care services

require authorizations. In a tight managed care plan (HMO) all services

not rendered by the PCP may require authorizations (any service from a
128
 referral specialist, hospitalizations, procedures, etc.). Having a tighter

authorization process increases the plan’s ability to manage utilization.

Next the authorization system has to determine who has the authority to

authorize services. This is dependent on the plan and the degree it will

medically managed the services provided. For optimal control, the PCP

authorizes services for their patients, except for those expensive

services that require the plan’s medical director. So if a referring

specialist wants to schedule additional tests or procedures, they must go

through the PCP “gatekeeper” first. This requires the use of unique

authorization numbers that tie to specific bills, and the claims

department must be able to back up with documentation. As a result, if

an authorization number is not associated with a claim, then payment

can be denied by the plan due to not having prior authorization. The

plan must develop and communicate their policies and procedures for

defining what services require authorization and which ones do not.

There are six types of authorizations:

Prospective or precertification is issued before any service is rendered. This

allows for the greatest control to direct care to the most appropriate setting

and provider.

Concurrent authorization is rendered at the time the service is rendered.

Does not allow for the plan to determine if services need rendered, but it

does allow for timely data collection and the ability to impact the outcome.
129
Retrospective authorization takes place after the services are rendered.

These authorizations are usually issued for “emergency situation”, such as

an automobile accident requiring immediate care and hospitalization.

Pended (for review) authorization is for those cases that it needs to be

determined if an authorization was issued or will be issued. The case must

have a medical review to determine:

Medical necessity

Eligibility (Is the service covered?)

Administrative review

Denial means there will not be an authorization for services.

Subauthorizations allow for one authorization to attach to another. This is

common with hospital based professional services such as, anesthesia,

pathology, radiology, etc.

The data elements commonly captured for authorizations are listed

below:

Member’s name

Member’s birth date

Member’s plan identification number

Eligibility status

Commercial group number or public sector (i.e., Medicare & Medicaid)

group identifier

Line of business (e.g., HMO, POS, medicare, medicaid, conversion, private,

self-pay)
130
Benefits code for particular service (e.g., noncovered, partial coverage,

limited benefit, full coverage)

PCP

Referral provider’s name and specialty

Outpatient data elements

Referral or service date

Diagnosis (ICD-9-CM, free text)

Number of visits authorized

Specific procedures authorized (CPT-4, free text)

Inpatient data elements

Name of institution

Admitting physician

Admission or service dare

Diagnosis (ICD-9-CM, diagnosis related group, free text)

Discharge date

Subauthorizations (if allowed or required)

Hospital-based providers

Other specialists

Other procedures or studies

Free text to be transmitted to the claims processing department

Since every authorization number must be unique, the authorization

system must be able to generate and link the number to the specific data
131
 for which the number was issued. A claim must include the

authorization number in order to be processed for payment.

There are three main methods for communicating with a plan’s

authorization system:

Paper-Based Authorization Systems require the provider to fill out pre-

printed forms per referral request and submit by mail to the health plan.

Process is labor intensive, untimely, plagued with data entry errors, and

each plan has own set of required forms that the PCP staff must keep

straight.

Telephone-Based Authorization Systems require the PCP or office staff to

call a central number and give the required information over the phone for

an authorization. This system is known for its problems of busy signals for

long lengths of time, being placed on hold for long periods of time and

tying up office and hospital staff time. This system often is used in

conjunction with a fax machine to receive authorization forms and to supply

the MCO with further clinical data (office notes, previous test results,

expanded diagnosis list). It is not productive and can waste precious time.

Electronic Authorization Systems require the participating providers and

hospitals to connect electronically to the health plan. Today, this is usually

132
through a dumb terminal or a computer in the office. This electric hook-up

is most common with claims submission, but authorizations are also

possible. Usually, electronic systems have built in edits available on-line to

eliminate missing required data elements and automated eligibility

information about the members.

A managed health plan must have an effective authorization system in

order to fulfill their requirements of providing health care to their

members. The system must be able to handle large volumes of

information in a timely manner to meet the needs of the members and

providers.3 Additionally, the information collected is downloaded into

Data Warehouses to be retrieved by Decision Support Systems for data

analysis.

Players

The players in the Referral and Authorization Process are the insurance

plans, participating providers (PCPs, Specialists), hospitals, clinics,

long term care facilities, regulatory agencies (NCQA, JCAHO, State of

PA., ect) and the patients/members.

3
Kongstvedt, Peter R. (1997) Essentials of Managed Health Care. Gatihersburg, Maryland:
Aspen Publishers, Inc. 342-351.

133
Problem

The referral and authorization process per insurance plan is complex

and labor intensive for the providers and the payers. Each plan has its

unique requirements for the providers to submit information and access

the plan. Since there are multiple insurance plans with a variety of

benefits, it is increasingly more difficult to manage the process in a

streamlined and cost effective manner. Managed care transactions

require an enormous amount of paperwork, especially when the referral

requests and authorizations never catch up to the claims submitted for

the already provided services. This results in a delay in payment to the

provider and resubmitted claims as well as phone calls to the plan to

resolve the problem. Because the system is so fragmented and

contracts and coverage for members is changing it is extremely difficult

to stay current with the requirements on a daily basis. Reimbursement

is declining and costs are increasing for getting authorizations and

receiving payment for services from the health plans. Health care is

known for being labor intensive, but a majority of those costs are not

associated with direct patient care but for administrative costs

associated with the system of coordinating the services of authorized

care. This requires meeting all the insurance plans requirements for

each of their members and then they will provide payment. Cash flow

is a significant issue for providers today and delays in reimbursement

for submitted claims needs to be addressed because of the overall

134
negative impact on the hospitals, physicians, payers and the patients

requiring services.

General Role of Information Technology

The role of Information Technology with respect to patient eligibility

has been addressed through the use of various electronic modalities; i.e.

the swiping of a card, telephone messaging systems, or entering

member ID numbers into a computer. Oftentimes these systems are

applicable to only one insurance provider, meaning that multiple tools

are needed in any primary care office to submit inquiries. Obviously,

these types of systems have only narrowly addressed the entire issue of

providing coordinated care to the patient throughout the managed care

network.

With the advent of Application Service Providers (ASP) healthcare

organizations are able to strategically reshape information systems to

improve their control over operating costs and clinical performance.

ASPs provide eligibility verification systems which are integrated with

referral and authorization requests, and claims submission on one

platform. These services are provided through Internet connections.

Physician offices, hospitals, and managed care organizations are

realizing cost savings, reduction in errors, and improved patient

satisfaction through the deployment of products such as those offered

by Officemed.com, Phycom.com, and Asterion.com These particular

135
 companies provide the aforementioned functionality through Internet

connections, promoting real-time access and rapid turnaround times for

referrals, authorizations, and claims. One of the major advantages seen

by the physician office staff is the “one stop shopping feature”. There

is reduced training time and operational time is minimized by not

having to use different systems for various insurers. These types of

systems free employees in physician offices and managed care

organizations to perform duties more befitting their roles. Physician

office staff can be communicating with and caring for patients instead

of spending hours on the telephone requesting authorizations.

Similarly, the nurses in the managed care plan are able to spend time

more appropriately on Case and Disease Management instead of

spending hours on data entry. One Boston HMO saw processing time

of authorizations drop to ten minutes or less under an automated

system, compared to thirty minutes under the manual method of

shuffling paperwork and playing telephone tag.4 Proof of the

efficiencies to be gained through such a system. Medical Mutual of

Ohio, automated their referral/authorization system and was able to

decrease staff by 10 to 12 FTEs or about Rs.600,000 per year.5

On the cost side, the ASP option is attractive over the traditional way of

4
Morrison, John, ed., “Boston HMO Streamlines Referrals Affordably, Online,” Eye on INFO,
Supplement to Modern Healthcare. 2000:4.
5
“Managed Care Transactions, Streamling the Refferal Process,” in Solutions in Healthcare,
supplement to Health Data Management, 2000: S-18.

136
 automating office systems. Under the old client/server model,

physicians had to purchase, install, and maintain hardware and

software, along with facilitating training and upgrades. These Internet

connections are able to replace the inefficient phone calls and faxes

while promising to decrease costs, broaden access, and provide a

system of documentation and follow up.6 Physician offices are able to

spread the cost of software licenses and startup costs over the term of a

contract along with the monthly subscription price. A process more

amenable, in this time of decreased reimbursement, than an outlay of

cash to purchase/maintain an office system. One medical group

composed of 625 preferred physicians at more than 150 locations who

see a total of 120,000 patients have seen significant results through the

use of the Asterion.com product. Ninety percent of the referrals for this

group are made online at the point of care.7 This system has been able

to link the patient, and health plan information to the referral. The

result is that the appropriate care is rendered to the patient and

connected to the claim while reducing errors and overhead costs.

6
“What’s Up with ASPs?,” (1999),www.bhtinfo.com, (Accessed March 17, 1999).
7
Morrissey, John, “Providers put faith in Internet,” Modern Healthcare:30:66.
137
 Regulatory Pressures

Advantages are not only seen on the cost and efficiency areas but in the

regulatory area as well. In 1996, Congress passed the Health Insurance

Portability and Accountability Act (HIPAA). One of the lesser known

sections of this law is Administrative Simplification. Under this law

nearly all aspects of health care data interchange will be affected.

Medical practices will see and advantage of the standardization of

information required on claims and referrals. Insurers will see the

challenge of trying to implement the standards. HIPAA also limits the

modifications of format standards to once every twelve months.8 The

outcome should provide eligibility date available to the physician from

all payers due to the standardization of the information. Another

regulatory aspect is Act 68. Under this legislation, if a provider

submits a “clean claim”, defined as having all the proper data

accurately entered onto claims (electronically or preprinted forms), then

the insurer is required to pay that claim within sixty days. As any

business savvy person knows cash flow is a key issue.

Vendor Solution – Web ROAR

Locally, Highmark has implemented the third generation of its

electronic referral/authorization and patient eligibility system, known as

Web ROAR. Web ROAR is only one piece of the entire Careconnect
8
“Major Electronic changes Coming!,” LINK Newsletter, 2000:37, www.careconnect.com,
(Accessed March 18, 2000).
138
 module which Highmark has rolled out. The impetus behind the

development is clear. Keystone Health Plan ranked number eight in the

nation’s 25 largest individual HMO plans with an enrollment of

1,151,224 members.9 Web ROAR provides an opportunity for busy

medical practices to operate with more efficiency by allowing offices

to:

Submit patient referral and authorization requests

Verify patient membership information

Search for participating specialists, providers, hospitals, or other facilities

List historical referrals and authorizations for a patient or practice

Track utilization patterns for a practice

Web ROAR is replacing the paper referral system as well as the

dedicated computer based ROAR system. The computer based ROAR

system entailed Highmark placing PCs, printers, and lines into

physician offices. Even with the declining costs of these components,

the financial impact was surely significant. Not only the installation

but maintaining and upgrading for the Highmark market must require

numerous FTEs.

Web ROAR’s Main Menu provides a snapshot of the functionality of

the system. The commands include:

9
“HMO Market Leaders,” Managed Care Digest Series 1999, Hoechst Marion Roussel, 1999”12.
139
Request for Request medical services for a

Services patient

View Messages View messages for authorization

Member Review referral or authorization

History history for a patient.

Office History Review referral or authorization

history for your office.

Member Check Verify a patient’s membership in

the Highmark network.

Specialist Access the Physician Search

Check feature without entering a ROAR

request.

Facility Check Access the Facility Search feature

without entering a ROAR request.

Procedure Lookup a procedure code without

Lookup entering a referral.

Diagnosis Lookup a diagnosis code without

Lookup entering a referral.

Report Select criteria to generate usage

Selection reports

Bulletin Board Display bulletins regarding ROAR.

140
 Case/Disease View options for Case or Disease

Management Management.

Help Display detailed information about

performing tasks in ROAR

Exit Log off the ROAR System

The extensiveness of the menu depicts the advantages to the users of

the system; the physician office is able to quickly produce referrals and

the managed care company to able to respond quickly while collecting

detailed information on enrollee care, which can be used to evaluate

services.10 Refer to Appendix A to view a diagram of Web ROAR

from a user's perspective.

IT Gap Analysis

Although the Internet appears ubiquitous in today’s society, it is

amazing to find that 85% of the physician offices do not use the

Internet for business purposes. This provides an obstacle for the

implementation of systems such as Web ROAR. From the physician

office perspective, although Web ROAR greatly simplifies the referral

authorization process, there are several limitations:

Web ROAR only provides access to Highmark enrollees; therefore multiple

systems are still required in the office.

10
Web ROAR User’s Guide, Version 1.3.0, (1999), 3,13,24.
141
Highmark has carved-out referrals for CT scans, MRIs, and Nuclear

Cardiology through contracting with NIA (National Imaging Association).

These referrals must be phoned in, although the authorization number may

be accessed several days later in Web ROAR.

Access to the information in Web ROAR is limited to Highmark and

primary care offices. Although faxes can be requested to be sent to the

specialist, ancillary service provider, or hospital, these entities are still

buried in a sea of paperwork. Consequently, primary care offices are the

recipients of numerous phone calls regarding authorization numbers. In

essence, network connectivity is incomplete. Highmark has recognized this

limitation and is planning to roll out Web ROAR to the hospitals,

specialists, and ancillary service providers during the Summer of 2000.

Summary

These improvements in the referral/authorization process are certainly

seen as a way to eliminate wasted time and provide more satisfied

customers, including patients, physicians, and office staff. Most

importantly, if the healthcare community can provide the right care, the

right setting, without delay of waiting for paperwork…these systems

have the potential to save lives!

142
2.6 CASH FLOW ANALYSIS
CASH FLOW STATEMENT

Introduction to cash flow statement:

Three major financial statements are ordinarily required for external reports―an
income statement, a balance sheet, and a statement of cash flows. The purpose of
the statement of cash flow is to highlight the major activities that directly and
indirectly impact cash flows and hence affect the overall cash balance. Managers
focus on cash for a very good reason―without sufficient cash balance at the right
time, a company may miss golden opportunities or may even fall into bankruptcy.
The cash flow statement answers questions that cannot be answered by the income
statement and a balance sheet. For example a statement of cash flows can be used
to answer questions like where did the company get the cash to pay dividend of
nearly 140 million in a year in which, according to income statement, it lost more
than Rs. 1 billion? To answer such questions, familiarity with the statement of
cash flows is required.

The statement of cash flows is a valuable analytical tool for managers as well as
for investors and creditors, although managers tend to be more concerned with
forecasted statements of cash flows that are prepared as a part of the budgeting
process. The statement of cash flows can be used to answer crucial questions such
as the following:

Is the company generating sufficient positive cash flows from its ongoing
operations to remain viable?

Will the company be able to repay its debts?

Will the company be able to pay its usual dividends?

Why is there a difference between net income and net cash flow for the year?

143
To what extent will the company have to borrow money in order to make needed
investments?

For the statement of cash flows to be useful to managers and others, it is important
that companies employ a common definition of cash. It is also important that a
statement be constructed using consistent guidelines for identifying activities that
are sources of cash and uses of cash. The proper definition of cash and the
guidelines to use in identifying sources are discussed in coming paragraphs.

Definition of Cash:

In preparing a statement of cash flows, the term cash is broadly defined to include
both cash and cash equivalents. Cash equivalents consist of short term, highly
liquid investments such as treasury bills, commercial paper, and money market
funds that are made solely for the purpose of generating a return on temporary idle
funds. Instead of simply holding cash, most companies invest their excess cash
reserves in these types of interest bearing assets that can be easily converted into
cash. These short term liquid investments are usually included in marketable
securities on the balance sheet. Since such assets are equivalent to cash, they are
included with cash in preparing a statement of cash flows

Sections of cash flow statement:

The cash flow statement is usually divided into three sections: Operating,
investing and financing activities.

Operating Activities:

Operating activities involve the cash effects of transactions that enter into the
determination of net income, such as cash receipts from sales of goods and
services and cash payments to suppliers and employees for acquisition of
inventory and expenses

Investing Activities:

144
Investing activities generally involve long term assets and include (a) making and
collecting loans (b) acquiring and disposing of investments and productive long
lived assets.

Financing Activities:

Financing activities involve liability and stock holder's equity items and include
obtaining cash from creditors and repaying the amounts borrowed and obtaining
capital from owners and providing them with a return on, and a return of, their
investment. Below is the typical classification of cash receipts and payments
according to operating, investing and financing activities.

145
Operating Activities:
Cash inflows:
From sales of goods or services. Income Statement Items
From return on loans (interest) and on equity
securities. dividends
Cash outflows:
To suppliers for inventories.
To employees for services.
To government for taxes.
To lenders for interest.
To others for expenses.

Investing Activities: Generally Long Term Asset

Cash inflow: Items
From sale of property, plant and equipment.
From sale of debt or equity securities of other Generally Long term Liability
entities. and Equity Items
From collection of principles on loans to other
entities.
Cash Outflows:
To purchase property, plant and equipment.
To purchase debt or equity securities of other entities.
To make loans to other entities.

Financing Activities:
Cash inflows:
From sale of equity securities.
From issuance of debt ( bonds and notes ).
Cash outflows:
To stock holders as dividends
To redeem long term debt or reacquire capital stock.

Some cash flow relating to investing or financing activities are classified as

operating activities. For example, receipts of investment income ( interest and
dividend ) and payment of interest to lenders are classified as operating activities.
Conversely, some cash flows relating to operating activities are classified as
investing or financing activities. For example, the cash received from the sale of
property plant and equipment at a gain, although reported in the income statement,

146
is classified as an investing activity, and effects of the related gain would not be
included in net cash flow from operating activities. Likewise a gain or loss on the
payment of debt would generally be part of the cash out flow related to the
repayment of the amount borrowed, and therefore it is financing activity.

FORMAT OF THE CASH FLOW STATEMENT:

The three activities discussed in preceding paragraphs constitute the general

format of the statement of cash flows. The cash flows from operating activities
section always appears first, followed by the investing section and then financing
activities section. The individual inflows and outflows from investing and
financing activities are reported separately. That is, they are reported gross, not
netted against one another. Thus, cash outflows from the purchasing of property is
reported separately from the cash inflow the sale of property. Similarly, the cash
inflow from the issuance of debt is reported separately from the cash outflow from
its retirement. The net increase or decrease in cash reported during the period
should reconcile the beginning and ending cash balances as reported in the
comparative balance sheets.

The Skelton hospital cash flow statement is presented as follows: This is also
called cash flow statement pro forma.

147
Company Name
Cash Flow Statement Format
Period Covered
Cash Flows From Operating Activities:
Net income XXX
Adjustment to reconcile net income to net cash provided by
XX
operating activities:
-------
(List of individual items)
XX XXX
Net cash flows from operating activities. ------- -------
Cash Flows From Investing Activities: XXX
(List of individual inflows and outflows)
XX
Net cash provided (used) by operating activities -------
Cash Flows from Financing Activities: XXX
(List of individual inflows and outflows)
XXX
Net cash provided (used) by financing activities -------
XXX
Net increase (decrease) in cash XXX
Cash at beginning of period -------
XXX
Cash at the end of period =====

2.7 CASH BUDGETING

If hospitals are to provide high quality medical care at the lowest possible cost,
a basic plan is essential a plan through which all expenditures and revenues from
all sources may be forecasted and controlled. This basic plan, expressed in
quantitative terms, is called a "budget".

The objective of this chapter is to present a method by which hospitals of all

sizes will set up an effective budgeting program. A formal budget will also assist
those responsible for hospital management to forecast the quantity and cost of
148
services to be rendered and determine the amount and sources of the revenue
necessary to provide services consistent with a desired level of patient care.

The budget, by itself, will not decide the quality and quantity of care. The
preparation of a budget, however, forces thinking in terms of these functions and
sharpens the decision making process.

The hospital's budget must facilitate hospital management to control operations

and also provide summary data for reporting to the Department. An analytical
framework must be developed that incorporates both planning and control of
operations. This Manual describes the techniques of budget preparation to serve
these functions.

PREREQUISITES TO AN EFFECTIVE BUDGET PROGRAM

Since the budget is utilized to assist in the planning, coordinating, and

controlling functions of management as well as reporting to the Department, it is
essential that certain conditions exist in the facility to ensure the successful use of
the budget. The prerequisites necessary to establish an effective budgeting system
include:

Commitment to long-range planning and management of the hospital's

operations: Top management must recognize the importance of planning for the
hospital's future, translating the plan into a budget and using the budget as a
standard to measure and influence performance.

Well defined goals and objectives: The annual objectives of the hospital
must be responsive to the achievements of goals as defined by the governing
board. As hospital management and succeeding levels of supervision adopt
objectives and define policies that lead ultimately to attainment of the hospital's
goals, a coordinated plan takes shape. Relating a budget to this plan and then
comparing the hospital's performance with the budget keeps the hospital on track
towards its goals, which are often long range.

149
 Effective organizational structure: An organizational structure within the
hospital with clear and direct lines of authority is essential. All levels of hospital
management should be aware of their responsibilities and the extent of their
authority. It is only when authority is clearly defined that an individual can be
held responsible for the activities of the department. With job descriptions and
organizational lines clearly drawn, one of the major objectives of the budget can
be more easily accomplished; i.e., to bring responsibility for costs down to the
department level where they are incurred.

Responsibility accounting system with functional and natural classification

visibility: The system of accounts has been prepared to insure a uniform
departmental structure within the hospital. The revenue and expense accounts are
related and follow the lines of responsibility to be defined in the organizational
plan of the hospital. Meaningful and timely performance reports can then be
provided to the department head or supervisor. Functional classification of
revenues and expenses provided in the system of accounts links financial data
with clinical programs and allows for the comparison internally from one year to
another and externally with other hospitals. The system of accounts also provides
for the reclassification of data accumulated in the hospital's responsibility oriented
accounting system into functionally oriented reports for comparing hospital
performance. Natural classification of operating expenses is important to the
Department and the hospital to make possible more effective analysis,
measurement, budgeting and cost management.

Accumulation of adequate statistical data: Adequate and uniform statistics

are essential to measure the performance of a department, not just in dollars and
cents, but in terms of actual measure of work performed and results produced. The
standard unit of measure, as prescribed by the Department in the system of
accounts, represents the measurable unit of production (output). The forecast of
these units is the basis for budgeting the expenses and revenues.

150
 Uniform budget reporting system: Effective operating con¬trols can be
developed and corrective action taken with the use of these uniform reports by the
Department and hospital management. These reports should be distributed to all
levels of supervision. They will provide operational data for areas of
responsibility. A formal reporting system also facilitates and encourages
discussions between levels of supervision and allows corrective action to be taken
on a timely basis. Other internal reports should be produced to allow program
monitoring and aid in long range planning.

TYPES OF BUDGETS

Two types of budgets are used in the reporting system; forecast budgets and
flexible budgets.

FORECAST BUDGET

The forecast budgeting method is one that may be used for operations, capital,
and cash budgeting requirements. This method is an acceptable budgeting
procedure. It contains estimates for only a single level of activ¬ity. The forecast
budget has limited flexibility, since devia¬tions from planned expenditures do not
require formal budget changes. With planning confined to a single level of
activity, however, the operational part of the forecast budget loses some of its
value for control purposes if the attained level of activity deviates from the
planned level of activity to any significant degree.

FLEXIBLE BUDGET

The flexible budgeting method is the preferred budgeting technique, and

hospitals are encouraged to use this method for their operations budget. It is built
on the premise that there are cer¬tain costs that will vary with the level of activity
and that other costs will remain relatively fixed within a wide range of activity.
For a flexible budget (also known as a variable cost budget) to operate effectively,
the organization must attempt to isolate cost factors according to behavior as the
levels of activity change. For example, the number of dietary meals served will
vary in proportion to the number of patient days; the dollar amount of food costs
(vari¬able costs) for the dietary department will vary based on the meals served
within the defined time period. On the other hand, since depreciation on the
kitchen equipment is computed on the straight line basis, the depreciation cost for
the time period will be the same (fixed) regardless of the number of meals served
by the dietary department.

151
 In between these two extremes are many types of costs that are not so neatly
defined. These costs are a mixture of variable and fixed elements and may change
with different levels of activity, but not necessarily in proportion to the change in
that activity.

In preparing a flexible budget, some estimate must be made of the variability

of the different cost factors that enter into the budget making process. The flexible
cost portion of the budget will be represented as a constant dollar amount per unit
of output, with the total amount dependent on the actual level of activity. The
fixed cost portion of the budget will be fixed in total amount for the time period
when related to the relevant range of activities.

The flexible budget is management's most effective tool in controlling costs,

once the fiscal year is underway. This flexibility presupposes a list of realistic
standards that can be used to measure activity. The flexible budget requires fairly
elaborate data collection and processing procedures.

The Department recommends that all hospitals should strive to use the flexible
budgeting method for operations to the maximum extent feasible.

COMPONENTS OF A BUDGET

The total budget program consists of the operating budget, the capital budget,
and the cash flow budget.

OPERATING BUDGET

In general, the term operating budget will be used to designate five separate
parts of the overall plan: (a) the statistical (units of service) budget, (b) the
expense budget, (c) reclassifications and cost allocation (d) prospective rate
setting, and (e) the revenue budget.

The operating budget consists of estimates of revenues and expenses and their
anticipated results for a given period. Estimated future requirements and expenses
for personnel, supplies and other items are collected for all departments or areas of
responsibility. It also includes estimates of units of service. After determining
budgeted expenses and units of measure, the expenses are reclassified and
allocated by the cost finding process to determine total operating expenses of each
revenue producing department. Revenue requirements for daily hospital and
ancillary services are then determined for the preparation of the revenue budget.

152
The combination of estimated revenues and expenses and their results for a given
period determines the operating budget.

CAPITAL BUDGET

A capital budget consists of estimates of the costs for replacements,

improvements, and additions to fixed assets that are expected to be acquired
during the budget period along with a determination of the sources of funds. The
cost of the estimated fixed asset requirements, together with the anticipated dates
of acquisition, should be accumulated in an organized manner for each department
or area of responsibility. By combining individual capital budget requests,
information regarding anticipated acquisitions, priorities, and timing, as well as
the feasibility of acquisition, is provided within the capital budget.

CASH FLOW BUDGET

A cash flow budget is an estimate of cash requirements. It consists of the

beginning balance, estimates of receipts and disbursements and the estimated
ending balance for a given period. The cash flow budget should be prepared by
estimating cash receipts from patients and other sources, and applying them
against the cash disbursements required to meet obligations as they come due. The
cash required for operations, fixed assets, and long term debt should be
determined separately and combined in a summary to reflect the overall
requirements. This budget is not required by the Department, but is essential for
hospital management to insure that the required cash flow is available during the
budget period.

THE PROCESS

The total budget process consists of three major budgets: (l) the operating
budget which consists of five separate parts (a) estimates of the volume and mix
of activities expressed in terms of statistical measures and other work units, (b)
estimates of expenses, (c) reclassifications and cost allocation, (d) determination
of prospective rates, (e) estimates of revenues; (2) the capital budget, and (3) the
cash flow budget.

DEPARTMENTAL FUNCTIONS

All departments of the hospital must share the responsibility for their
performance under the budget, and must be involved in the preparation of the
budget. The departmental involvement in the budgeting process should include the
following functions:
Establishment of operational goals and policies for the department;

Translation of these goals into management objectives for the

department;
153
Development of historical, statistical, and financial data for the department;

Preparation of the required budget forms;

Testing the financial feasibility of the departmental budget and

demonstrating the results of other patient load possibilities and financial
alternatives;

Approval of the final departmental budget; and

Periodic performance reporting by the department of "earned" budget

and actual expenses incurred.

The budget director or controller should coordinate the departmental budget

preparation and develop the master budget for review and evaluation by the
governing board.

KEY PERSONNEL IN BUDGETING

The key individuals and groups that play important roles in the organization,
review and approval of the budget program are outlined below.

GOVERNING BOARD

The key function of the governing board is to establish goals and policies and
to give final approval to the budget. From this point of view, the budget is a
planning document, and to the extent that it encompasses the overall affairs of the
hospital, it is properly subject to governing board approval. It is essential that the
governing board give tangible support to the budget process.

ADMINISTRATOR

The ultimate line responsibility for the budget formulation and execution is
vested in the administrator (chief executive officer). The administrator develops
the overall budget goals and objectives within the policy guidelines established by
the governing board. In addition, the budget is utilized in evaluating the
performance of the departments. Of necessity, a large part of the development and
administration of the budget program is delegated to subordinate management
personnel in the larger hospitals.

DEPARTMENT HEADS

154
 The department head, the person to be controlled, should have a voice in
developing the budget to be used as an evaluation tool. Unless the department
head agrees to the reasonableness of the departmental budget, the control of
operations by the budget will be ineffective. Obviously, then, a principal function
of the department head is to develop a budget for his own area of operations, as
previously discussed, within the framework of broad policies and plans set forth
by higher authority. In addition, the department head has the administrative
responsibility for budget performance that is, securing results in accordance with
the budget plans which promotes cost consciousness throughout the hospital.

BUDGET DIRECTOR OR CONTROLLER

Generally, the controller (chief financial officer) is the logical choice for
budget director. The function of the budget director should be to develop
procedural details, departmental forms and schedules; provide past statistical and
cost data for operating personnel; coordinate the review and revision of budget
estimates; and develop the final documents for submission to the governing board.

The budget director must also develop periodic budget performance reports
and variance analyses for hospital management. The significant point requiring
emphasis is that the budget is made and enforced by the line organization, not the
controller. The controller performs the staff function of providing assistance in
the technical aspects of budget preparation and reporting.

BUDGET COMMITTEE

Depending on the size of the hospital, there may be a more or less formalized
committee assisting in the budget preparation and review process. As a general
rule, this committee may be defined as a budget committee chaired by the
controller. For example, the budget committee might be composed of the
administrator, the controller, and one or more department heads. Representatives
of the medical staff and the governing board should serve in an advisory capacity.

BUDGET COORDINATION

Before preparing a budget, all personnel involved in budget preparation should

meet to discuss the factors that affect the volume of activity anticipated in the
budget period. At such meetings, policies and recent changes in policy should be
discussed, and planned expansion or changes in facilities or services should be
brought to the attention of all concerned. Representatives from the medical staff
should be asked to discuss any changes in practice and the budgetary implications
of these changes. Any facts that will assist in making more accurate forecasts
155
should be discussed. These meetings of the staff will help to develop a better
understanding of the hospital's goals and will emphasize the importance of
integrated efforts. The budget calendar (timetable) must also be developed to
specify the timing of preparation and review of the required reports by all
personnel.

After the general policies and facts relative to the services the hospital expects
to furnish have been established, statistics and financial data must be analyzed to
observe trends. Trends must be related to current expectations in estimating
workload units and in developing requirements for personnel and supplies. Since
the current fiscal year will not have been completed, the accounting department
must compile and summarize the most recent projections of activity to the end of
the current fiscal year. The prior year data must also be available to assist in the
budget preparation.

The cash flow budget would be compiled by the budget director or controller
following the completion of the expense, revenue, and capital budgets. If the cash
flow budget, based on estimates contained in the operating and capital budgets,
reflects a deficiency in cash balances, adjustments in the other budgets or means
of generating cash must be determined by administration.

BUDGET CALENDAR (TIMETABLE)

The schedule for the preparation of budget work papers, including the
development of a budget calendar, must be completed early in each year by the
controller or budget director and approved by hospital management. Some
considerations in preparing a budget calendar are:

Work should be spread over an adequate amount of time to avoid unnecessary

interference with the normal operations of the hospital.

Adequate time should also be allowed for review and revision of the
budget.

Because a number of accounting personnel would probably be

involved in various aspects of the budget preparation, the budget should
be started early and completed well ahead of the reporting date to the
governing board.

CASH FLOW BUDGET

156
 Very little planning can be done with the cash flow budget until the operating
and capital budgets are completed. The work in determining time lags in cash
receipts, however, can be done at an earlier time.

HOSPITAL GOALS AND OBJECTIVES

Generally, the overall goals of a hospital will be:

To provide high quality patient services to fulfill the needs of the

community, and

To deliver these health care services at reasonable rates in an efficient manner

through good management of facilities and other resources.

These goals, by their nature, are conflicting. This conflict provides the
underlying rationale for a budget and prospective rate setting procedure. Only
through effective planning can a balanced relationship between services and costs
of services begin to be achieved.

The governing board defines the overall objectives of the hospital's long range
plan, relates them to the area's needs, and identifies a long range timetable for
implementation. It attests to the plan's financial and overall feasibility. It sees that
the plan is updated and that the institution remains viable and on course. In order
to do this, the board periodically (or at least annually) evaluates the progress of
the institution toward the attainment of its objectives.

To assist the board, it is necessary that hospital management and department

heads develop objectives for at least the coming year. The objectives must be
segments of the hospital's overall goals and objectives. Hospital management must
also develop plans and measure performance of those persons reporting to them.

The hospital's objectives are achieved by people, not by the hospital. In order
to accomplish the objectives of the hospital in an effective manner, the
departments must be organized and staffed to perform selected functions. In order
to achieve the hospital's objectives, each department must meet its objectives by
effective coordination of personnel, equipment, and other resources.

SETTING OBJECTIVES

Setting of annual objectives is a critical element in assuring the long term

success of budgeting as a management tool. Criteria for an effective statement of
objectives are generally recognized to be as follows:

Measurability The objective should be stated in a way that the degree to which it
is being attained can be measured.
157
Understandability The objective should be stated in a way that is fully understood
by those responsible for its attainment.

Achievability Attainment of the objective should be feasible within the

constraints given.

Constraints Constraints are critical to setting and achieving the objectives.

Constraints arise from limited resources and conflicts. Both should be reflected in
the plan of action.

ORGANIZATION AND EXPRESSION OF OBJECTIVES

All objectives must be in written form to provide an easy reference for all
personnel. Objectives may be organized into the following areas of concern:

Patient care program services

Management effectiveness

Training and development

Communication and community relations

Quality control and improvement

Medical education and research programs

Staffing

Once the governing board has identified the hospital's long range goals in
these areas, they must specify the time frame for accomplishment of the objectives
each year. The long range plan should span a minimum of three years. It should be
quite specific and comprehensive, particularly in regard to changes in patient care
programs, services and major capital asset needs.

All hospital management personnel should be aware of the hospital's entire

long range plan and each year's objectives. This will assist in developing
departmental objectives which will be related to the overall institution and avoid
conflicting activities. Some hospitals may prefer to identify departmental
objectives for several years, rather than just for the budget year.

The determination of objectives must be a joint effort of the department head

and the appropriate administrative executive. This is particularly true when
setting the departmental staffing objectives. Input from clinical chiefs should also
be considered before setting the staffing objectives in patient care departments.

Financial planning (budgeting) contributes significantly to the

accomplishment of most objectives. It provides management with the means to
158
make critical decisions. Only with a well conceived budget is it possible to foresee
the results of proposed operating alternatives with some degree of confidence;
thus, testing the feasibility of objectives greatly increases the changes of the
objectives being attained.

The departmental objectives must be completed, analyzed, and revised, if

necessary, prior to beginning preparation of the operating budget.

2.8 CASH CONTROL

Cash control is a process that is used to verify the complete nature and accurate
recording of all cash that is received, as well as any cash disbursements that take
place. As a broad principle of responsible financial accounting, this process takes
place in any environment where goods and services are bought and sold. As such,
businesses, non-profit organizations and households all employ its basic tenets.

To fully understand cash control, it is helpful to understand what is meant by cash,

when it comes to financial accounting. Along with referring to currency and coin,
this term is also understood to include forms of financial exchange like money
orders, credit card receipts, and checks. Essentially, any type of financial
exchange that can be immediately negotiated for a fixed value qualifies.

Cash control means competently managing all these types of financial instruments
by maintaining an accurate tracking system that accounts for both receiving and
disbursing the cash. Designing this process is thpically not difficult, and there are
a few basic elements that will be incorporated into the process, regardless of
whether the procedure is used in the home or in an office or business environment.

First, all transactions related to cash must be documented and recorded

immediately. The accrual method of accounting, in which earnings and expences
are recorded when they are incurred, rather than when they are received or paid, is
not used. Each cash receipt is recorded upon reception, while each disbursement is
entered at the time that the payment is released. This mode of documentation
requires only some basic templates that will record the necessary data. For the
home, a checking account can be used to track all cash deposited into a common
account for the good of the home, and the check book register can serve as the
basic document that keeps track of the inbound and outbound transactions.

159
Next, solid procedures require that there be multiple, but limited, individuals who
have access to the cash, which serves two purposes. First, people can be held
accountable for the way that the cash is managed. Second, having at least two
people oversee the process helps to ensure that important transactions can take
place at any time, even if one individual is unavailable for some reason.

Cash control also demands that the documents related to the task are kept
separated from the physical location of the cash. In other words, the accounting
book that is used to record the cash transactions should not be kept in the safe with
the currency, money orders, and checks. This simple precaution helps to ensure
that the task of altering the physical evidence related to cash in hand is more
difficult, and therefore minimizes the chances for theft to occur.

Cash Control Procedures

In addition to these tips, avoiding company credit cards is also wise, as this helps
to reduce financial stress, which enables increased success at cash control.
Conducting monthly bank reconciliations is an important cash control tip to
follow because it allows a business to verify that its cash is not being abused,
misused, or lost.

Even small amounts of cash can be kept in a locked box and secured in a locked
drawer or filing cabinet for safer cash handling. Cash handling procedures
typically indicate who has access to the key to this room or cabinet, and this
person is often different from the one with knowledge of the combination to the
safe.

CASH CONTROL SYSTEM

In addition to these tips, avoiding company credit cards is also wise, as this helps
to reduce financial stress, which enables increased success at cash control.
Conducting monthly bank reconciliations is an important cash control tip to
follow because it allows a business to verify that its cash is not being abused,
misused, or lost.

It can control the temperature, filter it to ensure high air quality, control the
humidity, and maintain a safe cabin pressure. The environmental control system
constantly circulates air inside a cabin of an airplane.

INTERNAL CASH CONTROL

160
In addition to these tips, avoiding company credit cards is also wise, as this helps
to reduce financial stress, which enables increased success at cash control.
Conducting monthly bank reconciliations is an important cash control tip to
follow because it allows a business to verify that its cash is not being abused,
misused, or lost.

To fully understand cash control, it is helpful to understand what is meant by cash,

when it comes to financial accounting.

CONTROL AUDIT:

Material collected during a quality control audit can be pulled together into a
report.An essential part of quality control is ensuring the safety of the workers and
the materials that are being used. A quality control audit is a mandatory practice
that helps ensure every standard is being met

161
Unit 3: Hospital Accounting and Financial Statement

3.1 Departmentalized Accounting

3.2 Internal Control and Internal Auditing

3.3 Trust Funds

3.4 Investment Accounting

3.5 Application of Software

3.6 Revenue and Capital Expenditure

3.7 Receipt and Payment Account

3.8 Income and Expenditure Statement

3.9 Balance Sheet

3.10 Statutory Audit

.1 DEPARTMENTALISED ACCOUNTING
DEPARTMENTALISED ACCOUNTING SYSTEM

1. Departmentalised Accounting Scheme has been introduced in 1976. Broad

features of the scheme are given below in brief:-

i) The Controller General of Accounts in the Ministry of Finance is now in charge

of compilling and keeping the accounts of various Ministries and the Comptroller
and Auditor General of India has been relieved of this responsibility.

ii) The Secretary of the Ministry is the Chief Accounting Authority who functions
with the assistance of Integrated Financial Adviser.

iii) The accounting set up is headed by a Principal Accounts Officer (Controller of

Accounts) who is directly under the Integrated Financial Adviser.

162
iv) Under the Principal Accounts Officer in the Ministry, Pay and Accounts
Officers look after the payment and accounting in respect of departmental offices
situated at various places.

v) The Integrated Financial Adviser assists the Chief Accounting Authority in

organising a sound system of internal check to ensure accuracy in accounting and
efficiency of operation as part of management.

2. The Departmentalised Accounting system has come into force in the Ministry
of Information and Broadcasting from Ist October, 1976. Principal Accounts
Officer under the Chief Controller of Accounts in the Ministry and various pay &
Accounts Offices at Delhi, Calcutta, Bombay, Madras and Lucknow including
PAO, IRLA Group at New Delhi have been set up.

3. The PAO, IRLA Group at New Delhi, deals with payments and accounting in
respect of all Gazetted Officers in the Ministry and its units. The arrangements for
payment is the same as under the earlier IRLA system except that TA and
Medical claims of Gazetted Officers are now drawn from the respective PAO's or
Cheque Drawing DDO's and not from PAO, IRLA.

FINANCIAL STATEMENT
A Financial Statement (Financial Report) is a formal record of the financial
activities of a business, person, or other entity.

For a business enterprise, all the relevant financial information, presented in a

structured manner and in a form easy to understand, are called the financial
statements. They typically include four basic financial statements, namely:

Balance Sheet: also referred to as statement of financial position or condition,

reports on a company’s assets, liabilities, and ownership at a particular time
frame, its also called a statement of asset, liabilities and equities.

Income Statement: also referred to as Profit and Loss statement (or a “P&L”),
reports on a company’s income, expenses, and profits over a period of time. Profit
& Loss account provide information on the operation of the enterprise. These
include sale and the various expenses incurred during the processing state.

Statement of Retained Earnings: explains the changes in a company’s retained

earnings over the reporting period. Retained earning as accumulated earning that
have not been distributed to the shareholders but rather reinvested in the business.

Statement of Cash Flows: reports on a company’s cash flow activities, particularly

its operating, investing and financing activities.

163
For large corporations, these statements are often complex and may include an
extensive set of notes to the financial statements and management discussion and
analysis. The notes typically describe each item on the balance sheet, income
statement and cash flow statement in further detail. Notes to financial statements
are considered an integral part of the financial statements.

Purpose of Financial Statements

The main purpose of the financial statements are to provide the information’s
about the financial positions, performances, and changes I financial position of a
business which is beneficial for managements to take essential economic
decisions. Financial should be easily understandable, reliable and comparable.

Financial statements should be understandable to its readers, at least who have a

basic knowledge about business activities, and who are willing to study the
information’s.

Owners and managers require financial statements to make important business

decisions that affect its continued operations. Financial analysis is then performed
on these statements to provide management with a more detailed understanding of
the figures. These statements are also used as part of management’s annual report
to the stockholders.

Employees also need these reports in making collective bargaining agreements

with the management, in the case of labor unions or for individuals in discussing
their compensation, promotion and rankings.

Prospective investors make use of financial statements to assess the viability of

investing in a business. Financial analyses are often used by investors and are
prepared by professionals (financial analysts), thus providing them with the basis
for making investment decisions.

Financial institutions (banks and other lending companies) use them to decide
whether to grant a company with fresh working capital or extend debt securities
(such as a long-term bank loan or debentures) to finance expansion and other
significant expenditures.

Government entities (tax authorities) need financial statements to ascertain the

propriety and accuracy of taxes and other duties declared and paid by a company.

Vendors who extend credit to a business require financial statements to assess the
creditworthiness of the business.

Media and the general public are also interested in financial statements for a
variety of reasons.

164
3.2 INTERNAL CONTROL AND INTERNAL AUDITING
Internal control

Internal control, as defined in accounting and auditing, is a process for assuring

achievement of an organization's objectives in operational effectiveness and
efficiency, reliable financial reporting, and compliance with laws, regulations and
policies. A broad concept, internal control involves everything that controls risks
to an organization.[1]

It is a means by which an organization's resources are directed, monitored, and

measured. It plays an important role in detecting and preventing fraud and
protecting the organization's resources, both physical (e.g., machinery and
property) and intangible (e.g., reputation or intellectual property such as
trademarks).

At the organizational level, internal control objectives relate to the reliability of

financial reporting, timely feedback on the achievement of operational or strategic
goals, and compliance with laws and regulations. At the specific transaction level,
internal control refers to the actions taken to achieve a specific objective (e.g.,
how to ensure the organization's payments to third parties are for valid services
rendered.) Internal control procedures[2] reduce process variation, leading to more
predictable outcomes. Internal control is a key element of the Foreign Corrupt
Practices Act (FCPA) of 1977 and the Sarbanes–Oxley Act of 2002, which
required improvements in internal control in United States public corporations.
Internal controls within business entities are also referred to as operational
controls.

Internal controls have existed from ancient times. In Hellenistic Egypt there was a
dual administration, with one set of bureaucrats charged with collecting taxes and
another with supervising them. In the Republic of China, the Control Yuan
(監察院; pinyin: Jiānchá Yùan), one of the five branches of government, is an
investigatory agency that monitors the other branches of government.

Definitions

There are many definitions of internal control, as it affects the various

constituencies (stakeholders) of an organization in various ways and at different
levels of aggregation.

Under the COSO Internal Control-Integrated Framework, a widely used

framework in not only the United States but around the world, internal control is
165
broadly defined as a process, effected by an entity's board of directors,
management, and other personnel, designed to provide reasonable assurance
regarding the achievement of objectives relating to operations, reporting, and
compliance..

COSO defines internal control as having five components:

Control Environment-sets the tone for the organization, influencing the control
consciousness of its people. It is the foundation for all other components of
internal control.

Risk Assessment-the identification and analysis of relevant risks to the

achievement of objectives, forming a basis for how the risks should be managed

Information and Communication-systems or processes that support the

identification, capture, and exchange of information in a form and time frame that
enable people to carry out their responsibilities

Control Activities-the policies and procedures that help ensure management

directives are carried out.

Monitoring-processes used to assess the quality of internal control performance

over time.

The COSO definition relates to the aggregate control system of the organization,
which is composed of many individual control procedures.

Discrete control procedures, or controls are defined by the SEC as: "...a specific
set of policies, procedures, and activities designed to meet an objective. A control
may exist within a designated function or activity in a process. A control’s
impact...may be entity-wide or specific to an account balance, class of transactions
or application. Controls have unique characteristics – for example, they can be:
automated or manual; reconciliations; segregation of duties; review and approval
authorizations; safeguarding and accountability of assets; preventing or detecting
error or fraud. Controls within a process may consist of financial reporting
controls and operational controls (that is, those designed to achieve operational
objectives)."[3]

More generally, setting objectives, budgets, plans and other expectations establish
criteria for control. Control itself exists to keep performance or a state of affairs
within what is expected, allowed or accepted. Control built within a process is
internal in nature. It takes place with a combination of interrelated components –
such as social environment effecting behavior of employees, information
necessary in control, and policies and procedures. Internal control structure is a
plan determining how internal control consists of these elements.[4]

166
The concepts of corporate governance also heavily rely on the necessity of
internal controls. Internal controls help ensure that processes operate as designed
and that risk responses (risk treatments) in risk management are carried out
(COSO II). In addition, there needs to be in place circumstances ensuring that the
aforementioned procedures will be performed as intended: right attitudes, integrity
and competence, and monitoring by managers.

Roles and responsibilities in internal control

According to the COSO Framework, everyone in an organization has

responsibility for internal control to some extent. Virtually all employees produce
information used in the internal control system or take other actions needed to
affect control. Also, all personnel should be responsible for communicating
upward problems in operations, noncompliance with the code of conduct, or other
policy violations or illegal actions. Each major entity in corporate governance has
a particular role to play:

Management

The Chief Executive Officer (the top manager) of the organization has overall
responsibility for designing and implementing effective internal control. More
than any other individual, the chief executive sets the "tone at the top" that affects
integrity and ethics and other factors of a positive control environment. In a large
company, the chief executive fulfills this duty by providing leadership and
direction to senior managers and reviewing the way they're controlling the
business. Senior managers, in turn, assign responsibility for establishment of more
specific internal control policies and procedures to personnel responsible for the
unit's functions. In a smaller entity, the influence of the chief executive, often an
owner-manager, is usually more direct. In any event, in a cascading responsibility,
a manager is effectively a chief executive of his or her sphere of responsibility. Of
particular significance are financial officers and their staffs, whose control
activities cut across, as well as up and down, the operating and other units of an
enterprise.

Board of directors

Management is accountable to the board of directors, which provides governance,

guidance and oversight. Effective board members are objective, capable and
inquisitive. They also have a knowledge of the entity's activities and environment,
and commit the time necessary to fulfill their board responsibilities. Management
167
may be in a position to override controls and ignore or stifle communications from
subordinates, enabling a dishonest management which intentionally misrepresents
results to cover its tracks. A strong, active board, particularly when coupled with
effective upward communications channels and capable financial, legal and
internal audit functions, is often best able to identify and correct such a problem.

Auditors

The internal auditors and external auditors of the organization also measure the
effectiveness of internal control through their efforts. They assess whether the
controls are properly designed, implemented and working effectively, and make
recommendations on how to improve internal control. They may also review
Information technology controls, which relate to the IT systems of the
organization. There are laws and regulations on internal control related to
financial reporting in a number of jurisdictions. In the U.S. these regulations are
specifically established by Sections 404 and 302 of the Sarbanes-Oxley Act.
Guidance on auditing these controls is specified in PCAOB Auditing Standard No.
5 and SEC guidance, further discussed in SOX 404 top-down risk assessment. To
provide reasonable assurance that internal controls involved in the financial
reporting process are effective, they are tested by the external auditor (the
organization's public accountants), who are required to opine on the internal
controls of the company and the reliability of its financial reporting.

Audit committee

The role and the responsibilities of the audit committee, in general terms, are to:
(a) Discuss with management, internal and external auditors and major
stakeholders the quality and adequacy of the organization’s internal controls
system and risk management process, and their effectiveness and outcomes, and
meet regularly and privately with the Director of Internal Audit; (b) Review and
discuss with management and the external auditors and approve the audited
financial statements of the organization and make a recommendation regarding
inclusion of those financial statements in any public filing. Also review with
management and the independent auditor the effect of regulatory and accounting
initiatives as well as off-balance sheet issues in the organization’s financial
statements; (c) Review and discuss with management the types of information to
be disclosed and the types of presentations to be made with respect to the
Company's earning press release and financial information and earnings guidance
provided to analysts and rating agencies; (d) Confirm the scope of audits to be
performed by the external and internal auditors, monitor progress and review
results and review fees and expenses. Review significant findings or
168
unsatisfactory internal audit reports, or audit problems or difficulties encountered
by the external independent auditor. Monitor management's response to all audit
findings; (e) Manage complaints concerning accounting, internal accounting
controls or auditing matters; (f) Receive regular reports from the Chief Executive
Officer, Chief Financial Officer and the Company's other Control Committees
regarding deficiencies in the design or operation of internal controls and any fraud
that involves management or other employees with a significant role in internal
controls; and (g) Support management in resolving conflicts of interest. Monitor
the adequacy of the organization’s internal controls and ensure that all fraud cases
are acted upon.

Personnel benefits committee

The role and the responsibilities of the personnel benefits, in general terms, are to:
(a) Approve and oversee administration of the Company's Executive
Compensation Program; (b) Review and approve specific compensation matters
for the Chief Executive Officer, Chief Operating Officer (if applicable), Chief
Financial Officer, General Counsel, Senior Human Resources Officer, Treasurer,
Director, Corporate Relations and Management, and Company Directors; (c)
Review, as appropriate, any changes to compensation matters for the officers
listed above with the Board; and (d)Review and monitor all human-resource
related performance and compliance activities and reports, including the
performance management system. They also ensure that benefit-related
performance measures are properly used by the management of the organization.

Operating staff

All staff members should be responsible for reporting problems of operations,

monitoring and improving their performance, and monitoring non-compliance
with the corporate policies and various professional codes, or violations of
policies, standards, practices and procedures. Their particular responsibilities
should be documented in their individual personnel files. In performance
management activities they take part in all compliance and performance data
collection and processing activities as they are part of various organizational units
and may also be responsible for various compliance and operational-related
activities of the organization.

169
Staff and junior managers may be involved in evaluating the controls within their
own organisational unit using a control self-assessment.

Limitations

Internal control can provide reasonable, not absolute, assurance that the objectives
of an organization will be met. The concept of reasonable assurance implies a high
degree of assurance, constrained by the costs and benefits of establishing
incremental control procedures.

Effective internal control implies the organization generates reliable financial

reporting and substantially complies with the laws and regulations that apply to it.
However, whether an organization achieves operational and strategic objectives
may depend on factors outside the enterprise, such as competition or technological
innovation. These factors are outside the scope of internal control; therefore,
effective internal control provides only timely information or feedback on
progress towards the achievement of operational and strategic objectives, but
cannot guarantee their achievement.

Describing internal controls

Internal controls may be described in terms of: a) the pertinent objective or

financial statement assertion; and b) the nature of the control activity itself.

Objective or assertions categorization

Controls may be defined against the particular financial statement assertion to

which they relate. There are five such assertions:

Existence/Occurrence/Validity: Only valid or authorized transactions are

processed.

Completeness: All transactions are processed that should be.

170
Rights and obligations: Assets are the rights of the organization and the liabilities
are its obligations as of a given date.

Valuation: Transactions are valued accurately using the proper methodology, such
as a specified means of computation or formula.

Presentation and disclosure: Accounts and disclosures are properly described in

the financial statements of the organization.

For example, a validity control objective might be: "Payments are made only for
authorized products and services received." A typical control procedure would be:
"The payable system compares the purchase order, receiving record, and vendor
invoice prior to authorizing payment." Management is responsible for
implementing appropriate controls that apply to all transactions in their areas of
responsibility.

Activity categorization

Control activities may also be explained by the type or nature of activity. These
include (but are not limited to):

Segregation of duties – separating authorization, custody, and record keeping roles

to prevent fraud or error by one person.

Authorization of transactions – review of particular transactions by an appropriate

person.

Retention of records – maintaining documentation to substantiate transactions.

Supervision or monitoring of operations – observation or review of ongoing

operational activity.

Physical safeguards – usage of cameras, locks, physical barriers, etc. to protect

property, such as merchandise inventory.

Top-level reviews-analysis of actual results versus organizational goals or plans,

periodic and regular operational reviews, metrics, and other key performance
indicators (KPIs).

IT general controls – Controls related to: a) Security, to ensure access to systems

and data is restricted to authorized personnel, such as usage of passwords and
review of access logs; and b) Change management, to ensure program code is
properly controlled, such as separation of production and test environments,
system and user testing of changes prior to acceptance, and controls over
migration of code into production.

171
IT application controls – Controls over information processing enforced by IT
applications, such as edit checks to validate data entry, accounting for transactions
in numerical sequences, and comparing file totals with control accounts.

Control precision

Control precision describes the alignment or correlation between a particular

control procedure and a given control objective or risk. A control with direct
impact on the achievement of an objective (or mitigation of a risk) is said to be
more precise than one with indirect impact on the objective or risk. Precision is
distinct from sufficiency; that is, multiple controls with varying degrees of
precision may be involved in achieving a control objective or mitigating a risk.

Precision is an important factor in performing a SOX 404 top-down risk

assessment. After identifying specific financial reporting material misstatement
risks, management and the external auditors are required to identify and test
controls that mitigate the risks. This involves making judgments regarding both
precision and sufficiency of controls required to mitigate the risks.

Risks and controls may be entity-level or assertion-level under the PCAOB

guidance. Entity-level controls are identified to address entity-level risks.
However, a combination of entity-level and assertion-level controls are typically
identified to address assertion-level risks. The PCAOB set forth a three-level
hierarchy for considering the precision of entity-level controls.Later guidance by
the PCAOB regarding small public firms provided several factors to consider in
assessing precision.

Fraud and internal control

Internal control plays an important role in the prevention and detection of

fraud.Under the Sarbanes-Oxley Act, companies are required to perform a fraud
risk assessment and assess related controls. This typically involves identifying
scenarios in which theft or loss could occur and determining if existing control
procedures effectively manage the risk to an acceptable level. The risk that senior
management might override important financial controls to manipulate financial
reporting is also a key area of focus in fraud risk assessment.

Internal Audit

• The business environment of the 21st century requires a new focus from
public, private and not-for-profit organizations on compliance and operations. We
understand that companies need help in assessing the effectiveness and efficiency
of organizational practices and core business operation.

172
We take the time to understand our client's business environment, systems, and
processes in order to help them develop an effective internal audit program.
Unlike traditional internal audit approaches that tend to be narrowly focused, we
strive to provide value-added services that leverage the extensive "hands-on"
operational and financial experience of our seasoned team of professionals.

Services to Hospitals

The healthcare regulatory and business climate has never been more complex.
EisnerAmper's team of experienced internal audit professionals is ready to help
you alleviate many of the challenges facing your organization. Whether the need
is related to internal controls, technology, regulatory compliance, reimbursement,
or cash flow improvement, our team is ready to provide you with a quality
solution. Our professionals have deep experience in this field.

Assurance and Compliance

Hospitals need internal auditors that understand healthcare. Our internal audit
team members are experts in hospital operations, risks and challenges and are
ready to provide services in the following areas:

Enterprise Risk Management (ERM)

Internal controls
Revenue recognition
Procurement
Federal and State regulatory compliance

Revenue Management

Dealing with and understanding the operational, billing and coding requirements
under Medicare and other 3rd party reimbursement programs represents a major
challenge for many hospitals. EisnerAmper has experienced revenue and coding
specialists that can assist you with:

Potential cash flow improvements

Accounts receivable
Coding and documentation reviews

Information Technology

Technology is always evolving which helps hospitals become more

efficient and enhance controls. In addition, new regulations and mandates
have created the need for hospitals to develop new processes and enhance

173
 their existing systems and software. Eisner Amper has the information
technology experience to help with the following:
Software and vendor selection
Electronic Health Record (EHR) review
Meaningful use review
Internal controls
IT governance

3.3 TRUST FUNDS

Trust Fund

The Trust Fund is part of the Public Account according to Section 10 of the Act.
All public moneys are payable into either the Trust Fund or the Consolidated
Revenue Fund depending on the nature of the receipt.

The Trust Fund consists of a number of trust accounts established under Section
15 of the Act. The aggregate of the balances in the individual trust accounts
constitutes the Trust Fund balance. Public moneys are payable into the Trust
Fund only if such payments are within the specific scope of any individual trust
account; otherwise such moneys must be paid into the Consolidated Revenue
Fund.

Categories of Trust Accounts

Trust Accounts have been established to account for the following types of
transactions or funds:

(i) Moneys held in trust for third parties.

(ii) Revolving or working capital funds provided for certain Government,

commercial or trading operations.

(iii) Suspense or other transitory transactions which are to be held

in special accounts until they are transferred to the final accounts.

The Trust Accounts have been divided into the following categories in the Trust
Funds Account Code for accounting purposes. (for example,

Category (a): Finance Operating Trust Accounts

Category (b): General Trust Accounts

(i) with bank account

(ii) without bank account

174
Category (c): Investment Trust Accounts

Category (d): Project Trust Accounts

General Trust Accounts:

General Trust Fund Accounts may be categorised into 2 types: (i) those with
separate bank accounts (Trust Accounts of Public Curator, Registrar of National
Court, Public Solicitors, General Hospital Welfare, World Bank, ADB,
Correctional Services, Stabex Entitlement, Police Messing, POM General
Hospital Fees are examples of these trust accounts ), and (ii) those without
separate bank accounts and which operate through Waigani Public Account (
Plant & Transport Trust, Vocabulary Stores Trust, Trust Account for each
Provincial Government, Trust Account for Hospital Fees are examples of this type
of trust ). The liability for balances in the first category (General Trust Fund
Accounts with bank accounts) is represented by moneys held in separate bank
accounts for these trust accounts.

Christie Hospital NHS Foundation Trust

The Christie NHS Foundation Trust is located in Withington, Manchester, and is

one of the largest cancer treatment centres in Europe. The Christie became a NHS
Foundation Trust in April 2007 and is also an international leader in cancer
research and development, and home to the Paterson Institute for Cancer
Research.

Foundation of the Christie Hospital

The hospital had its beginnings in Sir Joseph Whitworth, a wealthy Mancunian
inventor who left money in his will in 1887 to be spent at the discretion of three
legatees. Whitworth wished for this money to spend on good causes in
Manchester and entrusted this request to three legatees, one of which was Richard
Copley Christie.[1] Consequently some of that money was used to buy land off
Oxford Road, adjacent to Owens College and intended to allow the movement of
the central Manchester hospitals out of the crowded city centre.[2] A committee
chaired by one of the Whitworth legatees, Richard Christie, was established in
1890 and, partly funded by a legacy ofRs.10,000 from Daniel Proctor, a Cancer
Pavilion and Home for Incurables was founded on the site in 1892 some distance
south-east of the eye hospital.[3] In 1901 it was renamed the Christie Hospital in
honour of Richard Christie and his wife Mary.[4] It was the only hospital in the
provinces for the treatment of cancer alone and active in pathological research.[5]

Foundation of the Holt Institute

175
In 1901, the Christie Management Committee agreed to the request of Dr Robert
Biggs Wild to spendRs.50 on the equipment necessary to test the efficacy of X ray
treatment, after promising results reported from London and from three patients
treated in the Physics Laboratory of Professor Schuster locally in Owens College.
The Roentgen apparatus was purchased, but no records survive of treatment, and
by 1907 the equipment was no longer being used (it was given to the Skin
Hospital in 1910).[6] By 1905, Dr Wild had become interested in the therapeutic
use of the newly discovered radium and experimented, once more with aid from
Professor Schuster, on three patients. Radium was expensive, however, and the
management refused to purchase any more until the results of tests from London
hospitals were available. By 1914, a leading local doctor, Sir William Milligan,
had begun a campaign in the 'Manchester Guardian' to raise funds for radium
treatment. Appealing to a mixture of local pride and the contemporary enthusiasm
for the curative powers of radium, an appeal was launched, on the advice of Ernest
Rutherford, forRs.25,000. An initial contribution ofRs.2000 from local brewer
Edward Holt was not initially much emulated, but following the intervention of
the Mayor, a series of 'Radium days' were organized which eventually raised
enough money to start a small Radium Institute, initially housed in the Manchester
Royal Infirmary. In 1921 it moved to new premises in Nelson Street donated by
Sir Edward and Lady Holt, and became the Manchester and District Radium
Institute.[6] By contrast with the dispersed and competitive provision of London
radiotherapy, Manchester became the first provider of a centralised radiotherapy
service, which would have long-lasting effects on the patterns of British cancer
care.[7][8]

The Christie at Withington

In 1932 the Institute, renamed as the Holt Radium Institute, and the Christie
Hospital moved to a new joint site in Withington and began to be jointly managed
although a formal merger did not occur until 1946.[6]

Ralston Paterson was appointed as Director of the Radium Institute in 1931, and
went on to build a world recognised centre for the treatment of cancer by
radiation.[8] Among the team was his wife Edith Paterson, who started research
work at the Christie in 1938, initially unpaid, and who became a world-renowned
pioneer in biological dosimetry, childhood cancers and anti-cancer drug treatment
methods.[citation needed] After Ralston Paterson's retirement, Professor Eric
Craig Easson was appointed Director of the Christie Hospital. He became world
famous for his contribution to the curability of Hodgkin's disease and to cancer
education. He was awarded a personal Professorial Chair at the University of
Manchester, and was President of the Royal College of Radiologists (1975–1977).
He was the government adviser on cancer for many years, and was a prime mover
in the Union Internationale Contre Cancer in Geneva, as well as the WHO cancer
group. During Professor Easson's tenure as Director, many doctors from
176
throughout the world visited the Christie Hospital to absorb its ethos, but
particularly to learn its techniques.

Early impetuses to research came from new local diseases of industrialisation such
as mule spinners' cancer and chimney sweep's cancer, and the search for links to
machine oils and airborne soot. Subsequent therapeutic milestones have
included:[4]

1932 - development of the Manchester Method, the first international standard for
radium treatment

1944 - world's first clinical trial of diethylstilbestrol (Stilboestrol) for breast

cancer

1970 - world's first clinical use of tamoxifen (Nolvadex) for breast cancer

1986 - world's first use of cultured bone marrow for leukaemia treatment

1991 - world's first single harvest blood stem-cell transplant

Paterson Institute for Cancer Research[edit]

When the Patersons retired in 1962, Professor Laszlo Lajtha was appointed as the
first full-time director of the research laboratories, which he named after the
Patersons. Lajtha added research into his own fields of interest, experimental
haematology and epithelial biology. New research laboratories, provided by the
Women's Trust Fund, were opened in 1966. The Women's Trust Fund was a local
charity, chaired by Lady Margaret Holt, daughter-in-law of Sir Edward Holt, who
left her entire estate of overRs.8 million to the Christie when she died in 1997.[3]
Core funding for the laboratories was secured from the Medical Research Council
and the Cancer Research Campaign (CRC). The CRC also located the CRC
Department of Medical Oncology, led by Professor Derek Crowther, at the
Paterson.[9]

Professor Lajtha was succeeded as Director in 1983 by Professor David Harnden,

who introduced molecular biology and built-up cancer genetics. He set up a new
Department of Drug Development which combined various groups working on
drugs already in the clinic and new generation drugs. He was briefly succeeded by
Professor T. Michael Dexter before Professor Nic Jones became the Director in
March 1999.[9]

The laboratory has been further enlarged with support from the Kay Kendall
Leukaemia Fund, the Cancer Research Campaign, the Christie Hospital Research
Endowments and, once again, the Women's Trust Fund. In 1981 the Cancer
Research Campaign took over sole responsibility for the major funding of the
177
Institute but the Christie Hospital Research Endowments also provide much
support.[9]

Services

The Christie registers around 12,500 new patients and treats about 40,000 patients
every year. It is the lead cancer centre for the Greater Manchester and Cheshire
Cancer Network, covering a population of 3.2 million, and runs clinics at 16 other
general hospitals.[10] Around 15% of patients are referred from outside Greater
Manchester and Cheshire, and there is also a private patients unit. Patients are
referred from district general hospitals, having already had their cancer diagnosed.

The Christie is the largest cancer treatment centre of its kind in Europe and an
international leader in research and development. As of 2010 The Christie is home
to the largest clinical trials unit of its kind in Europe.

The Christie provides services including specialist surgery, chemotherapy,

radiotherapy,brachytherapy, palliative and supportive care and endocrinology. It
has one of the largest radiotherapy departments in the world, with over 80,000
radiotherapy treatments a year. It annually delivers over 30,000 chemotherapy
treatments and undertakes around 3,700 operations every year. It has one of the
eight dedicated teenage cancer units in the United Kingdom. It has 257 inpatient
beds with an average length of stay of seven days.[10]

The hospital has one of the largest clinical trials units in the United Kingdom for
phase I/II cancer trials, with around 1,200 patients going on new trials, with plans
to double over the next few years to be one of largest clinical trials units in the
world.[10]

It is a partner in the Manchester Cancer Research Centre and home to the North
West Cancer Information Service, the cancer registry for the whole of the North
West region, and the Wolfson Molecular Imaging Centre.

Foundation Trust

The Christie became a NHS Foundation Trust on 1 April 2007. It has a total
annual turnover of aroundRs.143 million. Eight percent of its income is from
private patients. Around 2000 staff and over 300 volunteers work at the
Christie.[10]

The first Chair of the Trust was Jim Martin. He was replaced in May 2011 by
Lord Keith Bradley [11]

A ccounting for Hospitals Research & Guidance

Bloomberg BNA Tax & Accounting is your trusted source for detailed analysis
and insights on accounting for hospitals. Our renowned Portfolios — written by
178
leading practitioners — provide you with key analysis and compliance guidance
on every aspect of accounting for hospitals, such as Fund Accounting and FAS
117; general accounting considerations for investments; leases; equipment
liabilities; sources of GAAP, including FASB, GASB, and Centers for Medicare
and Medicaid Services (CMS); Anti-Kickback and Stark Rules; and more. Our
experts give you real-world business scenarios providing best practices and
alternative approaches to tax & accounting topics and transactions. Access to
practice tools, working papers, and sample forms fully equip you to deal with any
transaction.

3.4 INVESTMENT ACCOUNTING

Hospital Accounting

Hospital Accounting, written by Charles A. Borek, CPA, J.D., addresses a variety

of unique operating circumstances that face hospitals and give rise to a multitude
of accounting issues. Complicating this is the fact that hospitals may be organized
as either for-profit or not-for-profit entities.

This Portfolio describes the fundamental concepts involved in accounting and

financial reporting for hospitals. Since the majority of hospitals are not-for-profit,
this Portfolio discusses in depth the accounting rules affecting these types of
organizations highlighting major differences between not-for-profit and for-profit
treatment.

The hospital industry is also heavily regulated, and this regulation impacts
accounting and financial reporting in several ways. Most notably, hospitals rely
extensively on third party payors, such as insurance companies and the
government, for much of their revenues. The myriad of cost reimbursement and
receivables issues are addressed, as are the charity care activities engaged in by
not-for-profit hospitals to retain their tax-exempt status.

Hospitals receive, in addition to patient care revenue, income from ancillary

services such as laboratories, gift shops, and physician office leases. This Portfolio
analyzes accounting for the most common categories of hospital revenues and
offers suggestions for improved reporting and, to a lesser extent, financial
management.

Although tax exemption is a major issue for not-for-profit hospitals, tax matters
are only addressed insofar as they impact accounting and financial disclosure.

179
Hospital Accounting allows you to benefit from: Hundreds of hours of original
research on specific tax planning topics from leading practitioners in this area
.Invaluable practice documents including tables, charts and lists.

Guidance from world-class experts. Real-world and in-depth analysis that lets you
explore various options. Time-saving access to relevant sections of tax laws,
regulations, court cases, IRS documents and more .Alternative approaches to both
common and unique tax scenarios.

This Portfolio is included in the Accounting Policy & Practice Series, a

comprehensive series of titles which explain, explicate, and offer commentary on
a wide range of accounting and financial management topics, including revenue
recognition, income taxes, leasing, business combinations, debt instruments, risk
management, internal controls and more.

3.5 APPLICATION SOFTWARE

Advanced Hospital Management System:
From ARPIT SOFTWARES:

Advanced Hospital Management System is a complete package one needs for a

hospital to deal with all the day to day operations taking place. The program can
look after Inpatient admissions, OPD patients records, treatments prescribed,
billing, appointments etc. it also maintains the in hospital info such as Wards and
their details , Doctor in Charge, Departments and associated physicians with
administration (Multilevel Login into the system) .The latest additions in the
league have been ICD10 database, a complete lab module(RENEWED and
FIXED), LAN Connectivity, Webcam Support to instanly capture patient/
Relevant Medical Images. A lot of bugfixes have been made in this version to
make it more stable.

What's new in this version: Version 4.0 is a bug fixing release.

180
Read more: Advanced Hospital Management System - Free download and
software reviews - CNET Download.com http://download.cnet.com/Advanced-
Hospital-Management-System/3000-2065_4-10855165.html#ixzz2tSBKuPZo

3.6 REVENUE AND CAPITAL EXPENDITURE

Capital and Revenue Items:
Capital Expenditures:

An expenditure which results in the acquisition of permanent asset which is

intended lo be permanently used in the business for the purpose of earning
revenue, is known as capital expenditure. These expenditures are 'non-recurring'
by nature. Click here to continue reading.

Revenue Expenditures:

All the expenditures which are incurred in the day to day conduct and
administration of a business and the effect-of which is completely exhausted

181
within the current accounting year are known as "revenue expenditures". Click
here to continue reading.

Difference between Capital Expenditure and Revenue Expenditure

When Revenue Expenditures are not regarded as Revenue Expenditures?

There are some items of expenditure which are revenue by nature, yet they are not
regarded as revenue expenditure. Such expenditures may be divided into two
groups. These are Deferred revenue expenditures and capitalized revenue
expenditures. Click here to continue reading.

Principles for making distinction between Capital Expenditure and Revenue

Expenditure:

We have no hard and fast rule for distinguishing capital expenditure from revenue
expenditure because, the same item of expenditure may be treated as capital,
revenue or deferred revenue depending upon the circumstances.

Capital Expenditures:

Definition and Explanation:

An expenditure which results in the acquisition of permanent asset which is

intended lo be permanently used in the business for the purpose of earning
revenue, is known as capital expenditure. These expenditures are 'non-recurring'
by nature. Assets acquired by incurring these expenditures are utilized by the
business for a long time and thereby they earn revenue. For example, money spent
on the purchase of building, machinery, furniture etc. Take the case of machinery-
machinery is permanently used for, producing goods and profit is earned by
selling those goods. This is not an expenditure for one accounting period,
machinery has long life and its benefit will be enjoyed over a long period of time.
By long period of time we mean a period exceeding one accounting period.

Moreover, any expenditure which is incurred for the purpose of increasing profit
earning capacity or reducing cost of production is a capital expenditure.
Sometimes the expenditure even not resulting in the increase of profit earning
capacity but acquires an asset comparatively permanent in nature will also be a
capital expenditure.

It should be remembered that when an asset is purchased, all amounts spent up to

the point till the asset is ready for use should be treated as capital expenditure.
Examples are: (a): A machinery was purchased for Rs.50,000 from Karachi. We
paid carriage Rs.1,000, octroi duty Rs.500 to bring the machinery from Karachi to
Lahore. Then we paid wages Rs.1,000 for its installation in the factory. For all
these expenditures, we should debit machinery account instead of debiting

182
carriage A/c, octroi A/c and wages A/c. (b): Fees paid to a lawyer for drawing up
the purchase deed of land, (c): Overhaul expenses of second-hand machinery etc.
(d): Interest paid on loans raised to acquire a fixed asset etc.

Examples:

Purchase of furniture, motor vehicles, electric motors, office equipment,

loose tools and other tangible assets.
Cost of acquiring intangible assets like goodwill, patents, copy rights,
trade marks, patterns and designs etc.
Addition or extension of assets.
Money spent on installation and erection of plant and machinery and other
fixed assets.
Wages paid for the construction of building.
Structural improvements or alterations in fixed assets resulting in an
increase in their useful life or profit earning capacity.
Cost of issue of shares and debentures (certain expenditures are incurred
by the companies when share and debentures are issued).
Legal expenses on raising loans for the purchase of fixed assets.
Interest on loan and capital during the construction period.
Expenditures incurred for the development of mines and plantations etc.
Money spent to bring a second-hand asset into working condition.
Cost of replacing factory building from an old place to a new arid better
site.
Premium given for a lease.

Revenue Expenditure:
Definition and Explanation:

All the expenditures which are incurred in the day to day conduct and
administration of a business and the effect-of which is completely exhausted
within the current accounting year are known as "revenue expenditures". These
expenditures are recurring by nature i.e. which are incurred for meeting day today
requirements of a business and the effect of these expenditures is always short-
lived i.e. the benefit thereof is enjoyed by the business within the current
accounting year. These expenditures are also known as "expenses or expired
costs." e.g. Purchase of goods, salaries paid, postages, rent, traveling expenses,
stationery purchased, wages paid on goods purchased etc.

This expenditure is incurred on items or services which are useful to the business
but are used up in less than one year and, therefore, only temporarily increase the
profit-making capacity of the business.
183
Revenue expenditure also includes the expenditure incurred for the purchase of
raw material and stores required for manufacturing saleable goods and the
expenditure incurred to maintain the- fixed assets in proper working conditions
i.e. repair of machinery, building, furniture etc.

Examples:

Following are the examples of revenue expenditure.

Wages paid to factory workers.

Oil to lubricate machines.
Power required to run machine or motor.
Expenditure incurred in the ordinary conduct and administration of
business, i.e. rent, , carriage on saleable goods, salaries, wages
manufacturing expenses, commission, legal expenses, insurance,
advertisement, free samples, postage, printing charges etc.
Repair and maintenance expenses incurred on fixed assets.
Cost of saleable goods.
Depreciation of fixed assets used in the business.
Interest on borrowed money.
Freight, cartage, octroi duty, transportation, insurance paid on saleable
goods.
Petrol consumed in motor vehicles.
Service charges to motor vehicles.
Bad debts.

Capital and Revenue Receipts:

When the business receives money it is again of two sorts. It my be a long-term

receipt, a contribution by the owner, either to start the business off or to increase
the funds available to it. It might be a mortgage or an which brings money into the
business for a long-term, but in this case it is not the owner of the business but
some other investor who is supplying the money. Click here to continue reading.

Capital and Revenue Profits and Losses:

Capital profit is a profit which is earned, on the sale of a fixed asset or profit
earned on raising capital for a company (by issuing shares at premium). This is
not a regular profit of the business and is not earned in the ordinary trade of the
business. Click here to continue reading.

Capital and Revenue Payments:

When the business receives money it is again of two sorts. It my be a long-term

receipt, a contribution by the owner, either to start the business off or to increase
the funds available to it. It might be a mortgage or an which brings money into the
184
business for a long-term, but in this case it is not the owner of the business but
some other investor who is supplying the money.

It may be noted that there is a difference between an expenditure and payment.

Expenditure is the full amount spent by a business whether paid or yet to be paid
while payment means the amount actually paid. For example, a machinery is
purchased for Rs.50,000 from Saleem & Co., Rs.30,000 were paid to them in
cash, agreeing to pay Rs.20,000 after one month. In this case, total amount spent
is Rs.50,000 but the payment is Rs.30,000 only.

Capital Payments:

This is an amount which is actually paid on account of a capital expenditure.

Revenue Payments:

This is an amount which is actually paid on account of some revenue expenditure.

For example, we purchase goods of Rs.30,000, this is a revenue expenditure of
Rs.30,000. We paid cash to the supplier only Rs.20,000, this is a revenue
payment. If the whole amount is paid in cash, then both the revenue expenditure
as well as revenue payment will be Rs.30,000.

Example:

Do you consider the following to be capital or revenue items? Give reasons.

Amount contributed by the proprietor as his capital.

Amount realized from sale of old furniture.

Money borrowed from a bank to acquire fixed assets.

Amount received from a debtor whose account was previously written off as bad.

Rs.20,000 received from sale of old machinery which had cost Rs.12,000.

A motor car, whose book value is Rs.8,000 was sold for Rs.60,000.

Received Rs.2,00,000 from the sale of shares of a company.

Expenses on issue of shares amounted to Rs.2,500.

Plant and Machinery which stood in books at Rs.7,50,000, included a machine at

book value of Rs.1,50,000. This being obsolete was sold off for Rs.50,000 and
was replaced by a new machine which costs Rs.2,40,000.

The fixtures and fittings appeared in the books at Rs.75,000. Of these some
portion of the book value of Rs.15,000 was discarded and sold off for Rs.16,000
and new i furniture was acquired for Rs.12,000.
185
Solution:

No. Nature of Items Reasons

1. Capital Receipt. Amount contributed by the proprietor in his

business is a capital receipt because the benefit
of this receipt will be enjoyed for a long-period
of time by the business

2. Capital Receipt. When furniture was purchased it was a capital

expenditure. therefore, the sale of furniture will
be a capital receipt now.

3. Capital Receipt. Money is borrowed to acquire fixed assets, that

will benefit the business for many years, so it is
a capital receipt.

4. Revenue Receipt. When debtor's account was previously written

off, it was treated as a revenue loss
(expenditure), now, amount received from him
will be treated as a revenue receipt.

5. (a) Rs.20,000, Capital Furniture of Rs.12,000 was sold for Rs.20,000

Receipt and there was a profit of Rs.8,000. Therefore,
Rs.20,000 is a Capital Receipt and the profit of
(b) Rs.8000, Capital Rs.8,000 is regarded as Capital Profit.
Profit.
6. (a) Capital Receipt A motor car of the book value of Rs.80,000 is
Rs.60,000 sold for Rs.60,000 and so there is a loss of
Rs.20,000. The full amount received Rs.60,000
(b) Capital loss is a capital receipt and loss of Rs.20,000 is a
Rs.20,000 capital loss, because this is not a loss which
occurred in the ordinary course of the business.

7. Capital Receipt Amount received from sale of share is a capital

receipt because it will benefit for a long-period
of time.

8. Capital Expenditure. Amount spent on issue of shares is a capital

expenditure because it is incurred to raise the
capital of the business.

9. (a) Capital Receipt Amount received on sale of a portion of plant

186
 Rs.50,000 and machinery is treated as capital receipt
(Rs.50,000) and Rs.1,00,000, the difference
(b) Capital Expenditure between the book value of the machine sold an
Rs. 2,40,000. the amount realized on sale will have to be
charged off t revenue as depreciation.
Rs.2,40,000, the cost of new machinery is
treated as a capital expenditure.

10. (a) Capital Receipt Rs.1,000, the difference between the book value
Rs.16000 of fixture and fitting discarded and the amount
(b) Capital Profit received on sale of them will be treated as
Rs.1,000 capital profit and Rs.12,000, the cost of new
(c) Capital Expenditure fixture etc. is a capital expenditure. The total
Rs. 12,000 value realized Rs.16,000 from sale is treated as
a capital receipt.

DISTINCTION BETWEEN CAPITAL RECEIPT AND REVENUE

RECEIPT:

REVENUE RECEIPT CAPITAL RECEIPT

1. It has short-term effect. The benefit 1. It has long-term effect. The benefit
is enjoyed within one accounting is enjoyed for many years in future.
period.

2. It occurs repeatedly. It is recurring 2. It does not occur again and again.

and regular. It is nonrecurring and irregular.

187
3. It is shown in profit and loss 3. It is shown in the Balance Sheet on
account on the credit side. the liability side.

4. It does not produce capital receipt. 4. Capital receipt, when invested,

produces revenue receipt e.g. when
capital is invested by the owner,
business gets revenue receipt (i.e.
sale proceeds of goods etc.).

5. This does not increase or decrease 5. The capital receipt decreases the
the value of asset or liability. value of asset or increases the
value of liability e.g. sale of a fixed
asset, loan from bank etc.

6. Sometimes, expenses of capital 6. Sometimes expenses of revenue

nature are to be incurred for
revenue receipt, e.g. purchase of
shares of a company is capital
expenditure but dividend received
on shares is a revenue receipt.
nature are to be incurred for such
receipt e.g. on obtaining loan (a
capital receipt) interest is paid until
its repayment.

CAPITAL AND REVENUE PROFITS AND LOSSES:

CAPITAL PROFITS:

Capital profit is a profit which is earned, on the sale of a fixed asset or profit
earned on raising capital for a company (by issuing shares at premium). This is
not a regular profit of the business and is not earned in the ordinary trade of the
business. For example, if a machinery having book value of Rs.50,000 is sold for
Rs.60,000, the profit of Rs.10,000 will be a capital profit. In the same way, a joint
stock company issues shares of Rs. 2,00,000 at a premium of Rs.10,000 to raise
capital, such premium of Rs.10,000 will be a capital profit.

In this connection the distinction between capital receipt and capital profit may be
noted. A machinery of Rs.50,000 is sold for Rs.60,000. Here capital receipt is
Rs.60,000 and capital profit is Rs.10,000. This type of profit is not recurring and
regular. It will be shown on the liability side of the Balance Sheet under the head
"Capital Reserve".
188
REVENUE PROFITS:

This is a profit which is earned during the ordinary course of business e.g. profit
on sale of goods, rent received, interest received etc.

CAPITAL LOSS:

This is a Joss suffered by a business on the sale of a fixed asset or it is incurred on

raising capital of a joint stock company. This is not a recurring loss and is not
made in the ordinary course of the business. e.g. A machinery having book value
of Rs.50,000 is sold for Rs.45,000, the loss of Rs. 5,000 is a capital loss. In the
same way, a company issued shares of Rs.1,00,000 at 10% discount, the loss of
Rs.10,000 (10% of Rs.1,00,000) is a capital loss. Capital loss is sown in the
Balance Sheet on the asset side as a fictitious asset which is gradually written off
out of the profits every year.

REVENUE LOSS:

This loss is made in the ordinary course or day to day operation of a business such
as loss on sale of goods etc. Revenue loss appears in the profit and loss account or
income statement in the year in which it occurs.

3.7 RECEIPT AND PAYMENT ACCOUNT

Receipt and Payment Account:

Definition and Explanation:

"A receipt and payment account is a summarized cash book (cash and bank) for a
given period".

or

"This is simply a summary of the cash transactions as in the cash book, analyzed
and classified under suitable headings, including the opening and closing
balances".

Non-profit organizations (also called non-trading concerns) prepare a receipt and

payment account at the end of year. With the help of this account and some
additional information, an income and expenditure account is prepared to disclose
the true results of non-profit organizations. Receipt and payment account cannot
disclose the true result of non-trading concern.

189
All the information necessary for the preparation of this account is available from
cash book. Various cash receipts and cash payments during the whole year find
place in this account in a classified manner. Its closing balance indicates cash in
hand and cash at bank at the year end.

Following are the characteristicsof receipt and payment account:

It is abridged addition of cash book - it is, in effect, a summary of cash book.

All cash receipts during the whole year are recorded on its left hand (i.e., debit)
side. While all the cash payments during the whole year written on its right hand
(i.e., credit) side, arranged in a classified form.

Cash receipts and cash payments of both capital and revenue nature are recorded
here.

Only cash transactions are recorded in this account.

It generally shows a debit balance. In case of bank overdraft balance, however, its
net balance may be credit. Again, it may also show nil balance but such occasion
is rare.

Its closing balance indicates closing cash in hand and closing cash at bank.

It is not an account within the double entry system - it is a statement only.

It is prepared on the last day of the accounting year.

Advantages:

The following are the advantages of receipt and payment account:

Total receipts and total payments under various heads are available at a glance.

The amount of cash in hand at the year end can be ascertained.

The correctness of cash book can be verified through it. The total of debit side of
cash book will agree with the total of receipt side of this account. On the other
hand, the total of credit side of cash book will agree with that of payment of this
account.

Method of Preparation:

190
Receipts and payment account is prepared with all the cash receipts and cash
payments of the whole year. The net result of cash receipts and cash payments of a
fixed time is determined through this account. So it is its heading will be:

Receipt and Payment Account For the Year Ended 31.12.2005

Its left hand side is called "Receipts" and right hand side "payments". On the left
hand side all cash receipts are recorded, while on the right hand side all cash
payments are recorded arranged in a classified form. It starts with last year's
closing cash in hand and cash at bank and closes with current year's closing cash
in hand and cash at bank. In other words, its opening balance indicates last year's
closing cash in hand and cash at bank, while its closing balance means current
year's closing cash in hand and cash at bank.

Concept Of Receipts And Payments Account, Its Features And

Limitations
Concept Of Receipts And Payments Account

Receipt and payment account is a summary of cash receipts and payments during
the accounting period. It records all cash receipts and cash payments including
capital receipts and revenue revenue receipts irrespective of accounting period.
All cash receipts are recorded on debit side or receipts side and all cash payments
are recorded on credit or payments side of receipts and payments account.

Features Of Receipts And Payments Account

The essential features of receipts and payments account are as follows:

1. Summary Of Cash Transactions

All cash receipts and payments made by the concern during the accounting period
are recorded in this book. Therefore, receipts and payments account can be taken
as a summary of cash transactions.

2. Cash And Bank Items In One Column

All receipts either cash or bank are recorded in receipts column of receipts side
where all cash and bank payments are recorded in one column of payment column
of receipts and payments account. The cash and bank transactions are merged to
avoid contra entries of cash and bank transactions.

3. No Distinction Between Capital And Revenue

All cash receipts and cash payments irrespective of capital and revenue nature are
recorded in receipts and payments account. No distinct is made for capital receipts
, revenue receipts, capital expenditures and revenue expenditures.
191
4. Opening And Closing Balance Of Cash

Receipts and payments account starts from opening balance of cash and bank ends
with the closing balance of cash and bank.

5. Recording Of Cash Receipts And Payments

All cash and cheque receipts are recorded on debit side where as all cash and
cheque payments are recorded on credit side of receipts and payments account.

Ignores Non-cash Transactions

Receipts and payments account does not record non-cash transactions.

Limitations Of Receipts And Payments Account

The receipts and payments accounts suffers from the following limitations:

1. Receipts and payments account does not differentiate capital and revenue
expenses and incomes.

2. Receipts and payments account fails to show expenses and incomes on accrual
basis.

3. Receipts and payments account fails to show surplus and deficiency.

4. Receipts and payments account fails to show non-cash transactions such as

depreciation of fixed assets, pilferage etc.

Differences Between Receipts And Payments Account And Income And

Expenditure Account

The following are the main differences between receipts and payments account
and income and expenditure account:

1. Nature

Receipts and payments account is a summary of cash transactions for a period and
it is a real account. Income and expenditure account is a summary of expenditure
and income like trading and profit and loss account and it is a nominal account.

2. Objective

Receipts and payments account is prepared to show cash and bank receipts and
payments during the period to derive closing balance of cash and bank. Income
and expenditure account is prepared to show the net result of the operation during
the period to derive surplus or deficit.

192
3. Recording

All cash and cheque receipts are recorded on debit side of receipts and payments
account where as all cash and bank payments are recorded on credit side. In
income and expenditure account all expenditure of revenue nature are recorded on
debit side and all incomes of revenue nature are recorded on credit side.

4. Capital And Revenue Items

There is no distinction between capital and revenue receipts and payments in

receipts and payments account. All expenses and incomes of revenue nature are
recorded on accrual basis in income and expenditure account.

5. Contents

Receipts and payments account contains only cash and bank transactions. Income
and expenditure account contains both cash and non-cash expenses and incomes
of revenue nature.

6. Balance Sheet Requirement

Receipts and payments account is not required to prepare balance sheet. Income
and expenditure account is required to prepare balance sheet.

7. Adjustments

No adjustments are required in receipts and payments account. In income and

expenditure account adjustments are made because it is prepared on accrual basis.

From the following cash book prepare receipts and payments account for the year
ended 31 December 2005.

Cash Book

Dat Referenc L/ Dat Reference Amou

Amount L/R
e es R e s nt

200 200
5 5

Jan. Balance Jan.

250 Rent 200
1 b/d 5

Feb Subscript 600 Jan. Traveling 15

193
. 2 ion 16 expenses

Ma
Admissio Fed
r. 25 Salaries 250
n fee . 12
10

Ma Entertainm
Apr Subscript
950 r. ent 50
. 5 ion
17 expenses

Sale of
Ma
old Apr Electric
y 10 20
newspape . 20 charges
20
rs

Jun Subscript Ma
880 Furniture 300
e 3 ion y5

Jul Ma
Admissio
y 30 y Postage 18
n fee
15 10

Sale of
Au
old Jun
g. 15 Stationary 120
newspape e3
20
r

Jul
Sep Electric
Donation 100 y 30
.5 charges
12

Sale of
Oct Au
old 150 Newspaper 25
.1 g. 3
furniture

No
Sep
v. Donation 50 Salaries 320
. 15
15

De Subscript 250 Sep Newspaper 65

194
c. ion . 20
28

Oct Traveling
25
. 3 expenses

Oct
Postage 12
. 12

No
Rent 300
v. 5

No Entertainm
v. ent 80
16 expenses

De
Books 450
c. 5

De
c. Salaries 350
12

De
c. Rent 130
25

De
Balance
c. 550
c/d
31

3,310 3,310

200
6

195
Jan.
550
1

SOLUTION:

ABC hospital
Receipt and Payment Account
For the year ended 31st December, 2005

Receipts Rs. Payments Rs.

Rent
Balance b/d 250 630
[200+300+130]

Traveling
Subscription [600+950+880+250] 2,680 expenses 40
[15+25]

Salaries
Admission fee [25+30] 55 920
[250+320+350]

Entertainment
Sale of old newspaper [10+15] 25 expenses 130
[50+80]

Electric charges
Donation [100+50] 150 50
[20+30]

Furniture
Sale of old furniture 150 300
[200+300+130]

196
 Postage
30
[18+12]

Stationary 120

Newspaper
90
[25+65]

Books 450

Balance c/d 550

3,310 3,310

Balance b/d 550

197
The following is the receipt and payment account of a Hospital for the year ended
31.12.2005

Receipt and Payment Account For the Year Ended 31.12.2005

Receipts Rs. Payments Rs.

Balance b/d 5,000 Surgigal epuipmentt 7,000

Subscription: Salaries & wages 3,000

2004 2,000 Office expenses 400

2005 10,000 Electric charges 600

Donation 1,000 Telephone charges 600

Entrance fees (To be

2,000 Balanced c/d 8,400
capitalized)

20,000 20,000

In 2004 subscription for 2005 was received Rs.1,000.

Outstanding subscription Rs.1,500

Outstanding salaries & wages Rs. 1,000.

Depreciation to be charged @ 20% on surgical equipments.

Required: Prepare from the above particulars the income and expenditure account
of the club.

Income and Expenditure Account

For the Year Ended 31.12.2005

Receipts Rs. Income Rs.

Salaries & 3,000 Subscriptio 10,000

198
wages n

Add
Add
1,000 4,000 received in 1,000
outstanding
2004

Add
1,500 12,500
accrued

Office
expenses

Electric
Donation 1,000
charges

Telephone
charges

Depreciatio
n on sports
equip.

20% of
1,400
7,000

Surplus i.e.
excess of
income
6,500
over
expenditure
s

13,500 13,500

NOTE:

Rate of depreciation on surgical equipment is 20% (not 20% p.a). so the amount
of depreciation will be Rs.1,400 (20 % of 7,000). The date of purchase is
immaterial here.

3.8 INCOME AND EXPENDITURE ACCOUNT

199
Concept And Features Of Income And Expendiutre Account

Concept Of Income And Expenditure Account

Income and expenditure account is prepared by non-trading concern to reveal the

surplus or deficit arising out of the operating activities during the accounting
period. It is one of the final accounts of non-trading concern like the profit and
loss account of trading concern. All the revenue incomes during the accounting
period are shown on income side and all of the revenue expenses during the period
are shown to debit (expenditure) side of income and expenditure account. The
excess of credit side over the debit side or excess of income over expenditure is
termed as surplus, where the excess of expenses over the revenue income is
termed as deficit. The surplus or deficit of income over expenditure is transferred
to capital fund. The surplus is added to capital fund and vice-verse. Income and
expenditure account is prepared on the accrual basis.

Features Of Income And Expenditure Account

* Income and expenditure account is prepared on accrual basis.

* Income and expenditure account records all cash and non-cash expenses and
income, which are revenue nature.

* Income and expenditure account is debited with the expenses and losses and
credited with the incomes and gains.

* The closing balance of income and expenditure account either surplus or deficit
is transferred to capital fund in the balance sheet.

INCOME STATEMENT

An income statement (US English) or profit and loss account (UK English)[1]
(also referred to as a profit and loss statement (P&L), revenue statement,
statement of financial performance, earnings statement, operating statement, or
statement of operations)[2] is one of the financial statements of a company and
shows the company's revenues and expenses during a particular period.[1] It
indicates how the revenues (money received from the sale of products and
services before expenses are taken out, also known as the "top line") are
transformed into the net income (the result after all revenues and expenses have
been accounted for, also known as "net profit" or the "bottom line"). It displays
the revenues recognized for a specific period, and the cost and expenses charged
200
against these revenues, including write-offs (e.g., depreciation and amortization of
various assets) and taxes.[2] The purpose of the income statement is to show
managers and investors whether the company made or lost money during the
period being reported.

One important thing to remember about an income statement is that it represents a

period of time like the cash flow statement. This contrasts with the balance sheet,
which represents a single moment in time.

Charitable organizations that are required to publish financial statements do not

produce an income statement. Instead, they produce a similar statement that
reflects funding sources compared against program expenses, administrative costs,
and other operating commitments. This statement is commonly referred to as the
statement of activities. Revenues and expenses are further categorized in the
statement of activities by the donor restrictions on the funds received and
expended.

The income statement can be prepared in one of two methods.[3] The Single Step
income statement takes a simpler approach, totaling revenues and subtracting
expenses to find the bottom line. The more complex Multi-Step income statement
(as the name implies) takes several steps to find the bottom line, starting with the
gross profit. It then calculates operating expenses and, when deducted from the
gross profit, yields income from operations. Adding to income from operations is
the difference of other revenues and other expenses. When combined with income
from operations, this yields income before taxes. The final step is to deduct taxes,
which finally produces the net income for the period measured.

Income statements should help investors and creditors determine the past financial
performance of the enterprise, predict future performance, and assess the
capability of generating future cash flows through report of the income and
expenses.

However, information of an income statement has several limitations:

Items that might be relevant but cannot be reliably measured are not reported (e.g.
brand recognition and loyalty).

Some numbers depend on accounting methods used (e.g. using FIFO or LIFO
accounting to measure inventory level).

Some numbers depend on judgments and estimates (e.g. depreciation expense

depends on estimated useful life and salvage value).

Income and Expenditure Account:

201
All transactions relating to non-profit-seeking concerns like Club, Library etc. are
recorded in the books of account strictly according to Double Entry System. At
the year-end result is determined through Final Accounts. Final Accounts consist
of two stages:

Income and Expenditure Account

Balance Sheet

Here we are going to discuss income and expenditure account.

Definition and Explanation:

The account through which surplus or deficit of a non-profit-seeking concern is

ascertained, is called Income and Expenditure Account.

All the information necessary for preparation of this account will be available
from ledger accounts. Its left-hand (i.e. Debit) side records all revenue
expenditure, while the right-hand (i.e. Credit) side records all revenues relating to
the current year. The balance of the account, if credit, indicates surplus, i.e. excess
of income over expenditure. Conversely, the balance of the account, if debit,
indicates deficit, i.e. excess of expenditure over income.

Characteristics:

The following are the characteristics of Income and Expenditure Account:

It is in fact like a Profit and Loss Account of a profit-seeking concern.

All expenses are recorded on Debit side and all revenues on Credit side.

Only revenue transactions are included in it. No capital items is taken into
account.

All the items of income/revenue concerning current year — whether received in

cash or not—and all items of expense —whether paid in cash or not—are taken
into account. But no item of income or expense concerning last year or next year
is included in it.

Surplus or deficit of a concern is ascertained through this account. Credit balance

"indicates surplus, while debit balance indicates deficit.

Its balance is transferred to Capital Fund Account.

It is prepared on the last day of an accounting year.

It does not start with any opening balance.

202
Method of Preparation:

The following points are to be noted, while preparing the above account:

Surplus or deficit of a fixed, period of time is ascertained through this account. So

it's heading will be:

Income and Expenditure Account for the year ended 31.12.2005.

Income and Expenditure Account is a Nominal Account. Hence, only revenue (no
capital) items will find place in it.

All items of revenue income and expenditure relating to the current year will
appear in it. In other words, all items of income relating to the current year -
whether received in cash or not - and all items of expenditure relating to the
current year - whether paid in cash or not - will find place in this account. No
items of income or expenditure relating to last year or next year will be included
in this account.

- INCOME STATEMENT MMM HOSPITAL -

For the year ended DECEMBER 31 2010

Debit Credit

Revenues

GROSS REVENUES (including INTEREST income) 296,397

--------

Expenses:

ADVERTISING 6,300

BANK & CREDIT CARD FEES 144

BOOKKEEPING 2,350

SUBCONTRACTORS 88,000

ENTERTAINMENT 5,550

INSURANCE 750
203
 LEGAL & PROFESSIONAL SERVICES 1,575

LICENSES 632

PRINTING, POSTAGE & STATIONERY 320

RENT 13,000

MATERIALS 74,400

TELEPHONE 1,000

UTILITIES 1,491

--------

TOTAL EXPENSES (195,512)

--------

NET INCOME 100,885

3.9 BALANCE SHEET

BALANCE SHEET
In financial accounting, a balance sheet or statement of financial position is a
summary of the financial balances of a sole proprietorship, a business partnership,
a corporation or other business organization, such as an LLC or an LLP. Assets,
liabilities and ownership equity are listed as of a specific date, such as the end of
its financial year. A balance sheet is often described as a "snapshot of a company's
financial condition".[1] Of the three basic financial statements, the balance sheet
is the only statement which applies to a single point in time of a business' calendar
year.

A standard company balance sheet has three parts: assets, liabilities and ownership
equity. The main categories of assets are usually listed first, and typically in order
of liquidity.[2] Assets are followed by the liabilities. The difference between the
assets and the liabilities is known as equity or the net assets or the net worth or
capital of the company and according to the accounting equation, net worth must
equal assets minus liabilities.[3]

Another way to look at the balance sheet equation is that total assets equals
liabilities plus owner's equity. Looking at the equation in this way shows how
assets were financed: either by borrowing money (liability) or by using the
204
owner's money (owner's or shareholders' equity). Balance sheets are usually
presented with assets in one section and liabilities and net worth in the other
section with the two sections "balancing".

A business operating entirely in cash can measure its profits by withdrawing the
entire bank balance at the end of the period, plus any cash in hand. However,
many businesses are not paid immediately; they build up inventories of goods and
they acquire buildings and equipment. In other words: businesses have assets and
so they cannot, even if they want to, immediately turn these into cash at the end of
each period. Often, these businesses owe money to suppliers and to tax
authorities, and the proprietors do not withdraw all their original capital and
profits at the end of each period. In other words businesses also have liabilities.

Balance Sheet - Last Stage in Final Accounts:

Definition and Explanation:

Balance sheet is a list of the accounts having debit balance or credit balance in the
ledger. On one side it shows the accounts that have a debit balance and on the
other side the accounts that have a credit balance. The purpose of a balance sheet
is to show a true and fair financial position of a business at a particular date. Every
business prepares a balance sheet at the end of the account year. A balance sheet
may be defined as:

"It is a statement of assets, liabilities and owner's equity (capital) on a particular

date".

"It is a statement of what a business concern owns and what it owes on a

particular date". What is owns are called assets and what it owes are called
liabilities.

"It is a statement which discloses total assets, total liabilities and total capital
(owner's equity) of a concern on a particular date".

"It is a statement where all the ledger account balances which remain open after
the preparation of trading and profit and loss account, find place".

Balance sheet is so called because it is prepared with the closing balance of ledger
accounts at the end of the year. It has two sides - assets side or left hand side and
liabilities side or right hand side. The accounts have a debit balance are shown on
the asset side and those have a credit balance are shown on the liabilities side and
the total of the two sides will agree.

Assets means all the things and properties under the ownership of the business i.e.
building, plant, furniture, machinery, stock, cash etc. Assets also include anything

205
against which money or service will be received i.e. creditors accrued income,
prepaid expenses etc.

Liabilities means our dues to others or anything against which we are to pay
money or render service, i.e. creditors, outstanding expenses, amount payable to
the owner of the business (capital) etc.

Asset side of the balance sheet indicates the different types of assets owned by a
concern, while liabilities side discloses the various sources through which funds
have been obtained in order to acquire those assets. Balance sheet reveals the
financial position of the firm on a particular date at a point of time, so it is also
called "position statement". It is prepared on the last day of the accounting year
and discloses concern for the whole year cannot be determined through the
balance sheet because financial position is ever changing. The is why the heading
of the balance sheet is given as under:

Balance Sheet as at 31st December, 2005

(If accounting year ends on 31 Dec. 2005)

Features of Balance Sheet:

Balance sheet has the following features:

It is the last stage of final accounts

It is prepared on the last day of an accounting year.

It is not an account under the double entry system - it is a statement only.

It has two sides - left hand side known as asset side and right hand side known as
liabilities side.

The total of both sides are always equal.

The balances of all asset accounts and liability accounts are shown in it. No
expense accounts and revenue accounts are shown here.

It discloses the financial position and solvency of the business.

It is prepared after the preparation of trading and profit and loss account because
the net profit or net loss of a concern is included in it through capital account.

Method of Preparation of Balance Sheet:

All the information necessary for the preparation of balance sheet is available
from trial balance and from some other ledger accounts. After transferring
accounts relating to expenses and revenues to trading and profit and loss account,
the trail balance contains only the accounts of assets, liabilities, and capital. All
206
assets have debit balances and all liabilities and capital have credit balances. The
asses are shown on the asset side of the balance sheet and liabilities and capital are
shown on the liabilities side of the balance sheet after arranging them properly.

As the balance sheet is prepared on the last day of an accounting year, so its
heading and format will be:

Balance Sheet
as at 31st December, 2005

Asset Rs. Liabilities and Capital Rs..

CLASSIFICATION OF ASSETS:

Assets may be classified as follows:

REAL ASSETS:
207
Assets which have some market value are called real assets, e.g. building,
machinery, stock, debtors, cash, goodwill, etc. Real assets are further divided into
two types according to their permanence:

Fixed Assets: Assets which have long life and which are bought for use for a long
period of time are called "fixed assets". These are not bought for selling purposes,
e.g. land, building, plant, machinery, furniture etc. Fixed assets are again sub-
divided into two:

Tangible Assets: Assets which have physical existence and which can be seen,
touched and felt are called "tangible assets", e.g. building, plant, machinery,
furniture etc.

Intangible Assets: Assets which have no physical existence and which cannot be
seen, touched or felt are called "intangible assets", e.g. goodwill, patent right,
trade mark etc.

Current Assets: Assets which are short-lived and which can be converted into
cash quickly to meet short term liabilities are called "current assets", e.g. stock
debtors, cash etc. Such assets change their form repeatedly and so, they are also
known as circulating or floating assets. For example, on purchase of goods cash is
converted into stock and on sale of goods, stock is converted into debtors, on
collection from debtors, debtors take the form of cash etc.

Out of current assets those which can be converted into cash very quickly or
which are already in the form of cash are called liquid or quick assets e.g. debtors,
cash in hand, cash at bank etc.

Fictitious Assets: Assets which have no market value are called fictitious assets.
examples of fictitious assets include preliminary expenses, loss on issue of shares
etc. They are also known as nominal assets.

Besides these, there is another type of assets whose value gradually reduce on
account of use and finally exhaust completely. This type of assets is called
wasting assets e.g. mine, forest etc.

208
CLASSIFICATION OF LIABILITIES:

INTERNAL LIABILITIES:

The total amount of debts payable by a business to its owner is called internal
liability e.g. Owner's equity (capital), reserve etc. From practical view point
internal liabilities should not be regarded as liabilities, since there is no question
of meeting such liabilities al long as the business continues.

EXTERNAL LIABILITIES:

All debts payable by a business to the outsiders (other than the owner) are called
external liabilities e.g. creditors, debentures, bills payable, bank overdraft, etc.
External liabilities are further divided into two.

Fixed or Long Tern Liabilities: The liabilities which are payable after a long
period of time are called fixed or long term liabilities e.g. debentures, loan on
mortgage etc.

Current or Short Term Liabilities: The debts which are repayable within a short
period of time are called current or short-term liabilities e.g. creditors, bills
payable, bank overdraft etc. Current liabilities may again be divided into two:

Deferred Liabilities: Debts which are repayable in the course of less than one year
but more than one month are called deferred liabilities e.g. Short term loan etc.

Liquid or Quick Liabilities: Debts are repayable in the course of a month are
called liquid or quick liabilities e.g. bank overdraft, outstanding expenses,
creditors etc.

209
Besides the above, there is another type of liability which is known as contingent
liability. It is one which is not a liability at present, but which may or may not
become a liability in in future. It depends upon certain future event. For example,
suppose, the buyer of goods filed a suit in the court against the seller claiming
damage of Rs.10,000 for breach of contract. This will be regarded as a contingent
liability to the seller until the receipt of the court's order. To the buyer, this is a
contingent asset. Both contingent liability and contingent asset are not recorded in
the balance sheet. They are generally mentioned in the balance sheet as a note.

GROUPING AND MARSHALING OF ASSETS AND LIABILITIES IN

BALANCE SHEET:

As we have discussed that the main purpose of balance sheet is to disclose a true
and fair financial position of a business on a particular date. So, the assets and
liabilities must be shown in such a manner that the financial position of the
business can be assessed through it easily and quickly. Thus an arrangement is
made in which assets and liabilities are shown in the balance sheet. Such an
arrangement is called marshaling of assets and liabilities. There are three methods
of marshaling:

Permanency Preference Method

Liquidity Preference Method

Mixed Method

These methods of preparing a balance sheet are briefly explained below:

PERMANENCY PREFERENCE METHOD:

Under this method, the assets and liabilities are shown in balance sheet in the
order of their permanence. In other words, the more permanent the assets and
liabilities, the earlier are they shown. This method is adopted by joint stock
companies and under this method the balance sheet will take the following form:

210
Balance Sheet as at.....

Assets Rs. Liabilities Rs.

Fixed Assets: Fixed Liabilities:

Good will Capital

Patent Reserves
Land Long term loans
Building
Plant & Machinery Current Liabilities:
Furniture & Fixtures
Sundry creditors
Current Assets: Bills payable
Bank overdraft
Investment Outstanding expenses
Stock
Sundry debtors
Bills receivable
Prepaid expenses

Liquid Assets:

Cash at bank
Cash in hand

LIQUIDITY PREFERENCE METHOD:

Under this method, assets and liabilities are shown in order of their liquidity. The
more liquid the assets, the earlier are they shown. The sooner the liabilities are to
be paid off, the earlier are they shown. This method is adopted by sole
proprietorship and partner ship business. Under this method the form of balance
sheet is:

211
Balance Sheet as at.....

Assets Rs. Liabilities Rs.

Liquid Assets: Current Liabilities:

Cash at bank Sundry creditors

Cash in hand Bills payable
Bank overdraft
Current Assets: Outstanding expenses

Investment Fixed Liabilities:

Stock
Sundry debtors Capital
Bills receivable Reserves
Prepaid expenses Long term loans

Fixed Assets:

Good will
Patent
Land
Building
Plant & Machinery
Furniture & Fixtures

(Liquidity preference method is exactly reverse of the first method)

3.10 STATUTORY AUDIT

Statutory Audits

AUDIT OF HOSPITALS

The hospitals are usually established with the fund provided by the government,
local authorities, municipalities and similar other types of funds. On the basis of
ownership, hospitals can be government hospitals or private hospitals or a joint
venture of public-private partnership. As the nature of activities of a hospital are
totally different from that of other organisations or institutions, the audit
programme to be followed for conducting audit of these types of organisations
will also differ. The auditors pay attention to the following points, while auditing
the accounts of a hospital:

212
Auditing Services

Tax Audit in compliance with Income-tax act, 1961.

Statutory Audit of Corporate Enterprises in compliance with the Indian
Corporate laws
Audit of Charitable Organizations / Hospitals
Internal Audit, Internal reviews of Financial Systems and Controls of the
organization
Audit of Insurance Companies
Audit of Nationalized, Private, Cooperative Banks
Stock Audit
Compliance audit in relation to Labour acts
Finalization of accounts for VAT audit in compliance with Karnataka sales
tax act.
Performing departmental audits such as HR Audit, Purchase Audit, System
Audit etc.

General Matters

Legal Status

The auditor should see relevant documents to ascertain the legal status of the
hospital. He should examine the constitution of the management and provisions
affecting annual accounts for consideration of auditing techniques to be used.

Inspection of the Minute Book

If there is a managing committee or a governing body, the auditor should go

through the minutes of their meetings in order to note decisions concerning
financial matters, especially engagement of staff, acquisition and sale of fixed
assets and investments, delegation of authority regarding expenditure etc. and to
see that the resolution affecting accounts have been duly complied with.

Internal Check System

The auditor should examine the internal check as regards the issue and receipts of
stores, linen, apparatus, clothing, instruments etc. so as to ensure that purchases
have been properly recorded in the stock register and that issues have been made
only against proper authorisation.

213
Receipts

Cash Collections

The auditor should check the cash collections as entered in the cash book, with the
receipt counterfoils and other evidence. He should also check the bill registers of
patients to see that the bills have been correctly prepared.

Free Bed Facility

He should see that bills have been issued to all patients from whom any amount
was recoverable according to the rules of the hospital. He should also ensure that
free bed facilities were extended to the patients only according to the hospital
regulations.

Income from Property and Investments

The auditor should refer to the Properties and Investment Registers to see that all
the incomes that should have been recovered by way of rent from properties,
dividend and interest on securities etc. have been collected.

Payments and Expenses

Distinction Between Capital and Revenue Expenditure

The auditor should see that proper distinction has been made in the accounts
between capital expenditure and revenue expenditure.

Purchase and Sale of Assets

Purchase and sale of movable as well as immovable properties should be verified

with the help of relevant documents. The auditor should assure himself about their
existence through physical verification at a particular point of time.

Vouching of Expenses

The auditor should vouch all the expenses including the capital expenditure. He
should verify that the capital expenditure has been incurred only with the prior
sanction of the Managing Committee.

Depreciation on Fixed Assets

He should see that depreciation at appropriate rates has been written off against all
the fixed assets.

214
Assets and Liabilities

Verification of Assets and Liabilities

The auditor should see that all fixed assets have been acquired under proper
authority and that proper registers are maintained to record their particulars. He
should also confirm about their physical existence either through physical
verification or through confirmation from the concerned parties.

Stock-in-Trade

The auditor should obtain inventories of stocks and stores at the end of the year
and check a percentage of them physically. He should also verify Stock Register
in respect of stock and stores such as medicines, test tubes, cleaning materials etc.
and see that management has carried out a periodical inspection of all such store
items.

Income Tax

Taxability of Income

The auditor should see whether the income of the hospital is exempt from income
tax according to the provisions of the Income Tax Act, 1961 and if so, whether
refund of income tax deducted at source, if any, has been claimed from the tax
authority.

Financial Statement

True and Fair View

The auditor should examine the financial statements and see whether they give a
true and fair view of the financial results as well as of the financial position of the
hospital.

Audit report of applo hospitals

We have audited the attached Consolidated Balance Sheet of Apollo Hospitals

Enterprise Limited. (`The Company') it’s Subsidiaries and jointly controlled
entities (The Company, its Subsidiaries and jointly controlled entities constitute
`The Group') as at 31st March 2012, the Consolidated Statement of Profit and
Loss and the Consolidated Cash Flow Statement of the group for the year ended
on that date, both annexed thereto. The Consolidated financial statements include
investment in associates accounted on the equity method in accordance with
Accounting Standard 23 (Accounting for Investments in Associates in
Consolidated Financial Statements) and the jointly controlled entities accounted in
accordance with Accounting Standard 27 (Financial Reporting of Interests in Joint
Ventures) as notified under the Companies (Accounting Standards)Rules, 2006.
215
ii. These financial statements are the responsibility of the management of Apollo
Hospitals Enterprise Limited. Our responsibility is to express an opinion on these
financial statements based on our audit.

iii. We conducted our audit in accordance with Generally Accepted Auditing

Standards in India. These standards require that we plan and perform the audit to
obtain reasonable assurance whether the financial statements are prepared in all
material aspects, in accordance with an identified financial reporting framework
and are free of material misstatements. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant
estimates made by Management, as well as evaluating the overall financial
statements. We believe that our audit provides a reasonable basis for our opinion.

iv. The financial statements of Subsidiaries (AB Medical Centres Limited, Apollo
Health and Lifestyle Limited, Samudra Healthcare Enterprises Limited, Imperial
Hospitals and Research Centre Limited, Pinakini Hospitals Limited, Apollo
Hospital (UK) Limited, Apollo Cosmetic Surgical Centre Private Limited,
Alliance Medicorp (India) imited, Unique Home Health Care Ltd, Western
Hospitals Corporation Private Limited), Joint Ventures (Apollo Gleneagles
Hospitals Limited, Apollo Gleneagles PET CT Private Limited, Apollo Munich
Health Insurance Company Limited, Quintiles Phase One Clinical Trials India
Private Limited, Apollo Lavasa Health Corporation Limited, Apollo Hospitals
International Limited and Future Parking Private Limited) which in the aggregate
represents total assets (net) as at 31st March 2012 of ` 5,405.69 million
(31.03.2011: ` 4,684.25 Million) and total revenues (net) for the year ended on
that date of ` 8,270.94 Million (31.03.2011: ` 5,641.59 Million) and of Associates
(Indraprastha Medical Corporation Limited, Apollo Health Street Limited, Family
Health Plan Limited and Stemcyte India Therapautics Private Limited) which
reflect the Group's share of profit of ` 70.99 million (31.03.2011: profit of ` 83.77
Million) for the year, and upto 31st March 2012 profit of ` 1,367.01 million
(31.03.2011: Profit of ` 1,347.34 Million), is subject to adjustment based on the
observation of the independent auditor of Apollo Health Street Limited as stated
in clause

(v) of this Auditors Report and the profit for the year will be consequently less by
` 189.34 million resulting in the Group's share of loss of ` 188.91 million for the
year and profit upto 31st March 2012 will be less by ` 189.34 million, have been
audited by other auditors (Unique Home Health Care Limited and Apollo Munich
Health Insurance Company Limited audited by us) whose reports have been
furnished to us, and in our opinion:

216
a) The effect of the impairment loss, if any which has been reported by the
auditors of Apollo Health Street Limited, an associate, has not been considered for
the purpose of consolidation and no adjustment has been made to the group share
of Total assets as the auditors have not quantified the quantum of impairment loss
Accounting Policies & Notes forming part of Consolidated Accounts of Apollo
Hospitals Enterprise Limited, its Subsidiaries, Associates and Joint Ventures.

1. BASIS OF ACCOUNTING

The financial statements are prepared under the historical cost convention under
accrual method of accounting and as a going concern, in accordance with the
Generally Accepted Accounting Principles (GAAP) prevalent in India and the
Mandatory Accounting Standards as notified under the Companies (Accounting
Standards) Rules, 2006 and according to the provisions of the Companies Act,
1956.

Apollo Hospital (UK) Limited The financial statements have been prepared in
accordance with United Kingdom Generally Accepted Accounting
Practice(United Kingdom Accounting Standards and applicable law). Suitable
accounting policies are selected and applied consistently and judgments and
estimates made are reasonable and prudent. The financial statements have been
prepared on a going concern basis unless it is inappropriate to presume that the
Company will continue in business.

Quintiles Phase One Clinical Trials India Private LimitedThe Company is a Small
and Medium Sized Company (SMC) as defined in the General Instructions in
respect of AccountingStandards notified under Section 211 (3C) [Companies
(Accounting Standards) Rules 2006 as amended] of the CompaniesAct, 1956.
Accordingly, the Company has complied with the Accounting Standards as
applicable to a Small and Medium Sized Company.

Apollo Munich Health Insurance Company Limited The financial statements have
been prepared in accordance with generally accepted accounting principles and
practicesfollowed in India and conform to the statutory requirements of the
Insurance Act, 1938, The Insurance Regulatory and Development Authority
(Preparation of Financial Statements and Auditor's Report of Insurance
Companies) Regulations 2002, orders and directions issued by IRDA in this
217
regard, The Companies Act, 1956 to the extent applicable and the accounting
standards issued by the Institute of Chartered Accountants of India (ICAI) to the
extent applicable. The financial statements have been prepared on 'historical cost
convention and on ccrual basis' as a going concern.

2. BASIS OF CONSOLIDATION

The Consolidated Financial Statements have been prepared in accordance with

Accounting Standard 21-Consolidated Financial Statements, Accounting Standard
23-Accounting for Investment in Associates in Consolidated Financial Statements
and Accounting Standard 27-Financial Reporting of Interests in Joint Ventures, as
notified under the Companies (Accounting Standards) Rules, 2006.

218
Unit 4: Hospital Finance: Fundamentals, Budgeting, and Costing
4.1 Need and Importance of Financial Discipline
4.2 Basic Concepts : Liquidity, Profitability and Leverage
4.3 Role of Finance Controller and Responsibility Accounting
4.4 Budgeting
4.5 Need, Elements, Stages and Terms of Budgeting
4.6 Operating Budget : Activity / Zero Based Budgeting
4.7 Capital Budgeting : Return on Investment
4.8 Problem of Budgeting in Hospital
4.9 Costing
4.10 Basics of Cost Accounting : Types and Elements
4.11 Cost Behavior
4.12 Cost Centers
4.13 Cost Volume Profit Analysis / Breakeven Analysis
4.14 Hospital Rate Setting / Pricing Decision
4.15 Cost Containment

4.1 NEED AND IMPORTANCE OF FINANCIAL DISCIPLINE

Introduction

The study of healthcare financial management is fascinating and rewarding. It is

fascinating because so many of the concepts involved have implications for both
professional and personal behavior. It is rewarding because the health-care
environment today, and in the foreseeable future, is forcing managers to place
increasing emphasis on financial implications when making operating decisions.

First and foremost, financial management is a decision science. Whereas

accounting provides decision makers with a rational means by which to bud-get
for and measure a business’s financial performance, financial management
provides the theory, concepts, and tools necessary to make better decisions. Thus,

219
the primary purpose of this textbook is to help healthcare managers and students
become better decision makers. The text is designed primar-ily for nonfinancial
managers, although financial specialists—especially those with accounting rather
than finance backgrounds or those moving into the health services industry from
other industries—will also find the text useful.

The major difference between this text and corporate finance texts is that this text
focuses on factors unique to the health services industry. For example, the
provision of health services is dominated by not-for-profit or-ganizations (private
and governmental), which are inherently different from investor-owned
businesses.1 Also, the majority of payments made to health-care providers for
services are not made by patients—the consumers of the services—but rather by
some third-party payer (e.g., a commercial insurance company or a government
program). Even the purchase of health insurance is dominated by employers rather
than by the individuals who receive the services. This text emphasizes ways in
which the unique features of the health services industry affect financial
management decisions.
Although this text contains some theory and a great number of fi-nancial
management concepts, its primary emphasis is on how managers can apply the
theory and concepts; thus, it does not contain the traditional end-of-chapter
questions and problems. (Note, however, that end-of-chapter problems in
spreadsheet format are available as ancillary materials.) Rather, the text is
designed to be used with the book Cases in Healthcare Finance, fourth edition,
which contains cases based on real-life decisions faced by prac-ticing healthcare
managers. The cases are designed to enable students to apply the skills learned in
this text’s chapters in a realistic context, where judgment is just as critical to good
decision making as numerical analysis. Furthermore, the cases are not directed,
which means that although students receive some guidance, they must formulate
their own approach to the analyses, just as real-world decision makers must do.
Personal computers have changed the way managers think about struc-turing and
performing financial analyses. Computers are capable of provid-ing answers to
questions that were not even asked 20 years ago. Thus, this text and the casebook
are oriented toward the use of spreadsheets that can help managers make better
220
decisions. This text has accompanying spreadsheet models that illustrate the key
concepts presented in many of the chapters. The casebook has spreadsheet models
that make the quantitative portion of the case analyses easier to do and more
complete.

It is impossible to create a text that includes everything that a manager needs to

know about healthcare financial management. It would be foolish even to try
because the industry is so vast and is changing so rapidly that many of the details
needed to become completely knowledgeable in the field can be learned only
through contemporary experience. Nevertheless, this text pro-vides the core
competencies readers need to (1) judge the validity of analyses performed by
others, usually financial staff specialists or consultants, and (2) incorporate sound
financial management theory and concepts in their own managerial and personal
decision making.

INTRODUCTION
Business concern needs finance to meet their requirements in the economic world.
Any kind of business activity depends on the finance. Hence, it is called as
lifeblood of business organization. Whether the business concerns are big or
small, they need finance to fulfill their business activities.

In the modern world, all the activities are concerned with the economic activities
and very particular to earning profit through any venture or activities. The entire
business activities are directly related with making profit. (According to the
economics concept of factors of production, rent given to landlord, wage given to
labour, interest given to capital and profit given to shareholders or proprietors), a
business concern needs finance to meet all the requirements. Hence finance may
be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind
of economic activity.

221
MEANING OF FINANCE

Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the
provision of money at the time when it is needed. Finance function is the
procurement of funds and their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. But each
word is having unique meaning. Studying and understanding the concept of
finance become an important part of the business concern.

DEFINITION OF FINANCE

According to Khan and Jain, “Finance is the art and science of managing money”.

According to Oxford dictionary, the word ‘finance’ connotes ‘management of

money’.

Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on

study of the management of funds’ and the management of fund as the system that
includes the circulation of money, the granting of credit, the making of
investments, and the provision of banking facilities.

DEFINITION OF BUSINESS FINANCE

According to the Wheeler, “Business finance is that business activity which

concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise”.

According to the Guthumann and Dougall, “Business finance can broadly be

defined as the activity concerned with planning, raising, controlling, administering
of the funds used in the business”.
222
In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in
non-financial fields of industry”.

Hospital finance is concerned with budgeting, financial forecasting, cash

management, credit administration, investment analysis and fund procurement of
the business concern and the business concern needs to adopt modern technology
and application suitable to the global environment.

DEFINITION OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is concerned

with the duties of the financial managers in the business firm.

The term financial management has been defined by Solomon, “It is concerned
with the efficient use of an important economic resource namely, capital funds”.

The most popular and acceptable definition of financial management as given by

S.C. Kuchal is that “Financial Management deals with procurement of funds and
their effective utilization in the business”.

Howard and Upton : Financial management “as an application of general

managerial principles to the area of financial decision-making.

Weston and Brigham : Financial management “is an area of financial decision-

making, harmonizing individual motives and enterprise goals”.

Joshep and Massie : Financial management “is the operational activity of a

business that is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations.

SCOPE OF FINANCIAL MANAGEMENT

223
Financial management is one of the important parts of overall management, which
is directly related with various functional departments like personnel, marketing
and production. Financial management covers wide area with multidimensional
approaches. The following are the important scope of financial management.

1. Financial Management and Economics

Economic concepts like micro and macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro
environmental factors are closely associated with the functions of financial
manager. Financial management also uses the economic equations like money
value discount factor, economic order quantity etc. Financial economics is one of
the emerging area, which provides immense opportunities to finance, and
economical areas.

2. Financial Management and Accounting

Accounting records includes the financial information of the business concern.

Hence, we can easily understand the relationship between the financial
management and accounting. In the olden periods, both financial management and
accounting are treated as a same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance
manager to take decisions. But nowaday’s financial management and accounting
discipline are separate and interrelated.

3. Financial Management or Mathematics

Modern approaches of the financial management applied large number of

mathematical and statistical tools and techniques. They are also called as
econometrics. Economic order quantity, discount factor, time value of money,
present value of money, cost of capital, capital structure theories, dividend
224
theories, ratio analysis and working capital analysis are used as mathematical and
statistical tools and techniques in the field of financial management.

4. Financial Management and Production Management

Production management is the operational part of the business concern, which

helps to multiple the money into profit. Profit of the concern depends upon the
production performance. Production performance needs finance, because
production department requires raw material, machinery, wages, operating
expenses etc. These expenditures are decided and estimated by the financial
department and the finance manager allocates the appropriate finance to
production department. The financial manager must be aware of the operational
process and finance required for each process of production activities.

5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches.
For this, the marketing department needs finance to meet their requirements.

The financial manager or finance department is responsible to allocate the

adequate finance to the marketing department. Hence, marketing and financial
management are interrelated and depends on each other.

6. Financial Management and Human Resource

Financial management is also related with human resource department, which

provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each
department and allocate the finance to the human resource department as wages,
salary, remuneration, commission, bonus, pension and other monetary benefits to
the human resource department. Hence, financial management is directly related
with human resource management.
225
OBJECTIVES OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization of the
finance by the business concern. It is the essential part of the financial manager.
Hence, the financial manager must determine the basic objectives of the financial
management. Objectives of Financial Management may be broadly divided into
two parts such as:

1. Profit maximization

2. Wealth maximization.

Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is
also functioning mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern. Profit maximization consists of the following
important features.

1. Profit maximization is also called as cashing per share maximization. It leads

to maximize the business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all
the possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern.

So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
226
Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It

creates some unnecessary opinion regarding earning habits of the business
concern.

(ii) It ignores the time value of money: Profit maximization does not consider the
time value of money or the net present value of the cash inflow. It leads certain
differences between the actual cash inflow and net present cash flow during a
particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the business
concern. Risks may be internal or external which will affect the overall operation
of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves latest

innovations and improvements in the field of the business concern. The term
wealth means shareholder wealth or the wealth of the persons those who are
involved in the business concern.

Wealth maximization is also known as value maximization or net present worth

maximization. This objective is an universally accepted concept in the field of
business.

227
FUNCTIONS OF FINANCE MANAGER

Finance function is one of the major parts of business organization, which

involves the permanent, and continuous process of the business concern. Finance
is one of the interrelated functions which deal with personal function, marketing
function, production function and research and development activities of the
business concern. At present, every business concern concentrates more on the
field of finance because, it is a very emerging part which reflects the entire
operational and profit ability position of the concern. Deciding the proper
financial function is the essential and ultimate goal of the business organization.

Finance manager is one of the important role players in the field of finance
function. He must have entire knowledge in the area of accounting, finance,
economics and management. His position is highly critical and analytical to solve
various problems related to finance. A person who deals finance related activities
may be called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate

the financial requirement of the business concern. He should estimate, how much
finances required to acquire fixed assets and forecast the amount needed to meet
the working capital requirements in future.

2. Acquiring Necessary Capital

After deciding the financial requirement, the finance manager should concentrate
how the finance is mobilized and where it will be available. It is also highly
critical in nature.

3. Investment Decision
228
The finance manager must carefully select best investment alternatives and
consider the reasonable and stable return from the investment. He must be well
versed in the field of capital budgeting techniques to determine the effective
utilization of investment. The finance manager must concentrate to principles of
safety, liquidity and profitability while investing capital.

4. Cash Management
Present days cash management plays a major role in the area of finance because
proper cash management is not only essential for effective utilization of cash but it
also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing,

production, personel, system, research, development, etc. Finance managr should
have sound knowledge not only in finance related area but also well versed in
other areas. He must maintain a good relationship with all the functional
departments of the business organization.

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of business organization. It needs to meet the requirement

of the business concern. Each and every business concern must maintain adequate
amount of finance for their smooth running of the business concern and also
maintain the business carefully to achieve the goal of the business concern. The
business goal can be achieved only with the help of effective management of
finance. We can’t neglect the importance of finance at any time at and at any
situation. Some of the importance of the financial management is as follows:

Financial Planning

Financial management helps to determine the financial requirement of the

229
business concern and leads to take financial planning of the concern. Financial
planning is an important part of the business concern, which helps to promotion of
an enterprise.

Acquisition of Funds

Financial management involves the acquisition of required finance to the business

concern. Acquiring needed funds play a major part of the financial management,
which involve possible source of finance at minimum cost.

Proper Use of Funds

Proper use and allocation of funds leads to improve the operational efficiency of
the business concern. When the finance manager uses the funds properly, they can
reduce the cost of capital and increase the value of the firm.

Financial Decision

Financial management helps to take sound financial decision in the business

concern. Financial decision will affect the entire business operation of the
concern. Because there is a direct relationship with various department functions
such as marketing, production personnel, etc.
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper
utilization of funds by the business concern. Financial management helps to
improve the profitability position of the concern with the help of strong financial
control devices such as budgetary control, ratio analysis and cost volume profit
analysis.
Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of

the investors and the business concern. Ultimate aim of any business concern will
230
achieve the maximum profit and higher profitability leads to maximize the wealth
of the investors as well as the nation.

Promoting Savings

Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings.

Nowadays financial management is also popularly known as business finance or

corporate finances. The business concern or corporate sectors cannot function
without the importance of the financial management.

4.2 BASIC CONCEPTS: LIQUIDITY, PRABITABLITY, AND

LEVERAGE

Profitability
Every business is most concerned with its profitability. Profitability is the ability
to make profitfrom all the business activities of an organization, company, firm, or
an enterprise. It shows howefficiently the management can make profit by using
all the resources available in the market.One of the most frequently used tools of
financial ratio analysis is profitability ratios, which areused to determine the
company's bottom line. Profitability ratios show a company's overallefficiency
and performance. Profitability and management efficiency are usually taken to
bepositively associated: poor current profitability may threaten current
management efficiency andvice versa; poor management efficiency may threaten
profitability. It is related to the goal ofshareholders‟ wealth maximization, and
investment in current assets is made only if anacceptable return is obtained. While
liquidity is needed for a company to continue business, acompany may choose to
hold more cash than needed for operational or transactional needs i.e.for
231
precautionary or speculative reasons. It can also be termed as the rate of return
oninvestment. If there will be an unjustifiable over investment in current assets
then this wouldnegatively affect the rate of return on investment (vishnani & shah,
2007). The basic purpose ofmanaging working capital is controlling of current
financial resources of a firm in such a way thata balance is created between
profitability of the firm and risk associated with that profitability(ricci & vito,
2000). Profitability is a widely used financial measure of performance. The
conceptof profitability may be used in two senses: commercial/private
profitability and public profitability.Although the use of public profitability which
is based on economist‟s notion of cost andbenefits, i.e., the true opportunity cost
and the benefits for the society as a whole, appears to bea more appropriate
measure of performance of public enterprises, the measure of
commercialprofitability has been used in this study. This is because of the fact that
commercial profitabilityis widely used to measure the performance of public
enterprises in Bangladesh and even inother countries of the world like India, the
UK, France etc. And also for its general acceptanceand ready understandability.
Two major types of profitability ratios are computed: (i) profitabilityin relation to
sales and (ii) profitability in relation to investment. Gross profit margins (gpm),
netoperating margin (nom), return on total assets (Rota), return on equity (roe),
and return oninvestment (roi) are the main measures of profitability. Therefore,
profit is an absolute measureand profitability is a relative measure of efficiency of
the operations of an enterprise

INTRODUCTION

Financial decision is one of the integral and important parts of financial

management in any kind of business concern. A sound financial decision must
consider the board coverage of the financial mix (Capital Structure), total amount
of capital (capitalization) and cost of capital (Ko). Capital structure is one of the
significant things for the management, since it influences the debt equity mix of
the business concern, which affects the shareholder’s return and risk. Hence,
deciding the debt-equity mix plays a major role in the part of the value of the
company and market value of the shares. The debt equity mix of the company can
232
be examined with the help of leverage.

The concept of leverage is discussed in this part. Types and effects of leverage
is discussed in the part of EBIT and EPS.

Meaning of Leverage

The term leverage refers to an increased means of accomplishing some purpose.

Leverage is used to lifting heavy objects, which may not be otherwise possible. In
the financial point of view, leverage refers to furnish the ability to use fixed cost
assets or funds to increase the return to its shareholders.

Definition of Leverage

James Horne has defined leverage as, “the employment of an asset or fund for
which the firm pays a fixed cost or fixed return.

Leverage
Finacial Leverage
OperatingLeverage
CompositeLeverage

The company may use finance or leverage or operating leverage, to increase

the EBIT and EPS.

OPERATING LEVERAGE

The leverage associated with investment activities is called as operating

leverage. It is caused due to fixed operating expenses in the company.
Operating leverage may be defined as the company’s ability to use fixed
operating costs to magnify the effects of changes in sales on its earnings
233
before interest and taxes. Operating leverage consists of two important costs
viz., fixed cost and variable cost. When the company is said to have a high
degree of operating leverage if it employs a great amount of fixed cost and
smaller amount of variable cost. Thus, the degree of operating leverage
depends upon the amount of various cost structure. Operating leverage can be
determined with the help of a break even analysis.

Operating leverage can be calculated with the help of the following formula:

OL = C/OP

OL = Operating Leverage
C = Contribution
OP = Operating Profits

Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the

profits resulting from a percentage change in the sales. It can be calculated
with the help of the following formula:

Percentagechangein profits
DOL =
Percentagechangeinsales

234
4.3 ROLE OF FINANCE CONTROLLER AND RESPONSIBILITY
ACCOUNTING

The Role of Financial Management in the Health Services Industry

Until the 1960s, financial management in all industries was generally viewed as
descriptive in nature, its primary role being to secure the financing needed to meet
a business’s operating objectives. A business’s marketing, or planning, department
would project demand for the firm’s goods or services; facilities managers would
estimate the assets needed to meet the projected demand; and the finance
department would raise the money needed to purchase the required land,
buildings, equipment, and supplies. The study of financial management
concentrated on business securities and the markets in which they are sold and on
how businesses could access the financial markets to raise capital. Consequently,
financial management textbooks of that era were almost totally descriptive in
nature.

Today, financial management plays a much larger role in the overall management
of a business. Now, the primary role of financial management is to plan for,
acquire, and utilize funds (capital) to maximize the efficiency and value of the
enterprise. Because of this role, financial management is known also as capital
finance. The specific goals of financial management depend on the nature of the
business, so we will postpone that discussion until later in the chapter. In larger
organizations, financial management and accounting are separate functions,
although the accounting function typically is carried out under the direction of the
organization’s chief financial officer (CFO) and hence falls under the overall
category of “finance.”
In general, the financial management function includes the following activities:
235
• Evaluation and planning. First and foremost, financial management
involves evaluating the financial effectiveness of current operations and planning
for the future.
• Long-term investment decisions. Although these decisions are more
important to senior management, managers at all levels must be con-cerned with
the capital investment decision process. Such decisions focus on the acquisition of
new facilities and equipment (fixed assets) and are the primary means by which
businesses implement strategic plans; hence, they play a key role in a business’s
financial future.

• Financing decisions. All organizations must raise funds to buy the as-sets
necessary to support operations. Such decisions involve the choice between the
use of internal versus external funds, the use of debt versus equity capital, and the
use of long-term versus short-term debt. Al-though senior managers typically
make financing decisions, these choices have ramifications for managers at all
levels.

• Working capital management. An organization’s current, or short-term,

assets, such as cash, marketable securities, receivables, and inven-tories, must be
properly managed to ensure operational effectiveness and reduce costs. Generally,
managers at all levels are involved, to some extent, in short-term asset
management, which is often called working capital management.

• Contract management. Health services organizations must negotiate, sign,

and monitor contracts with managed care organizations and third-party payers.
The financial staff typically has primary responsibility forthese tasks, but
managers at all levels are involved in these activities and must be aware of their
effect on operating decisions.

• Financial risk management. Many financial transactions that take place to

support the operations of a business can increase a business’s risk. Thus, an
236
important financial management activity is to control financial risk

Forms of Business Organization

This text focuses on business finance—that is, the practice of financial man-
agement in business organizations. There are four primary forms of business
organization: (1) proprietorship, (2) partnership, (3) corporation, and (4) hybrid
forms. Because most healthcare managers work for corporations and because not-
for-profit businesses are organized as corporations, this text em-phasizes this form
of organization. However, many individual physician prac-tices are organized as
proprietorships, and partnerships are common in group practices and joint
ventures. In addition, hybrid forms are becoming more prevalent among physician
practices. Healthcare managers must be familiar with all forms of business
organization.

Proprietorship

A proprietorship, sometimes called a sole proprietorship, is a business owned by

one individual. Going into business as a proprietor is easy—the owner merely
begins business operations. However, most cities require even the smallest
businesses to be licensed, and state licensure is required of most healthcare
professionals.

The proprietorship form of organization is easily and inexpensively formed, is

subject to few governmental regulations, and pays no corporate income taxes. All
earnings of the business, whether reinvested in the business or withdrawn by the
owner, are taxed as personal income to the proprietor. In general, sole
proprietorships pay lower total taxes than comparable, tax-able corporations do
because corporate profits are taxed twice—once at the corporate level and once by
stockholders at the personal level when profits are distributed as dividends or
when capital gains are realized.

237
Partnership

A partnership is formed when two or more individuals associate to conduct a non-

incorporated business. Partnerships operate under different degrees of formality,
ranging from informal, verbal understandings to formal agreements filed with the
state in which the partnership does business. Like proprietor-ships, partnerships
are inexpensive and easy to form. In addition, the tax treat-ment of partnerships is
similar to that of proprietorships; a partnership’s earn-ings are allocated to the
partners and taxed as personal income regardless of whether the earnings are paid
out to the partners or retained in the business.

Proprietorships and partnerships have three important limitations:

1. It is usually difficult for owners to sell or transfer their interest in the

business.
2. The owners have unlimited personal liability for the debts of the busi-
ness, which can result in losses greater than the amount invested in the business.
In a proprietorship, unlimited liability means that the owner is personally
responsible for the debts of the business. In a partnership, it means that if any
partner is unable to meet his or her pro rata obligation in the event of bankruptcy,
the remaining partners are responsible for the unsatisfied claims and must draw on
their personal assets if necessary.

3. The life of the business is limited to the life of the owners.

From a finance perspective, these three disadvantages—difficulty in transferring

ownership, unlimited liability, and impermanence of the busi-ness—lead to a
fourth major disadvantage: It is difficult for proprietors and partners to attract
substantial amounts of capital (raise money for the busi-ness). This difficulty is
not a particular problem for a slow-growing business or when the owners are
238
wealthy, but for most businesses, it becomes a handi-cap if the business needs to
expand rapidly to take advantage of market op-portunities. For this reason,
proprietorships and most partnerships are small businesses.5 However, almost all
businesses start as sole proprietorships, part-nerships, or hybrids and then convert
to the corporate form of organization if large amounts of capital are needed.

Corporation

A corporation is a legal entity that is separate and distinct from its owners and
managers. Although corporations can be investor owned or not for profit, this
section focuses on investor-owned corporations. The unique features of not-for-
profit corporations will be discussed in later sections. The creation of a separate
business entity gives the corporation three main advantages:

1. A corporation has an unlimited lifespan and can continue in existence after its
original owners and managers have died or left the firm.
2. It is easy to transfer ownership in a corporation because ownership is divided
into shares of stock that can be easily sold.
3. Owners of a corporation have limited liability.

To gain an understanding of limited liability, suppose that one per-son made an

investment of Rs.10,000 in a partnership that subsequently went bankrupt and
owed Rs.100,000. Because the partners are liable for the debts of the partnership,
that partner can be assessed a share of the partnership’s debt in addition to the
initial Rs.10,000 contribution. If the other partners are unable to pay their shares
of the debt, one partner would be held liable for the entire Rs.100,000. If the
Rs.10,000 had been invested in a corporation that went bankrupt, the loss for the
investor would be limited to the initial Rs.10,000 investment. (In the case of
small, financially weak corporations, the limited liability feature of ownership is
239
often fictitious because bankers and other lenders require personal guarantees
from the stockholders.) With these three factors—unlimited life, ease of
ownership transfer, and limited liabil-ity—corporations can more easily raise
money in the financial markets than sole proprietorships or partnerships can.

The corporate form of organization has two primary disadvan-tages. First,

corporate earnings of taxable entities are subject to double taxation—once at the
corporate level and once at the personal level, when dividends are paid to
stockholders or capital gains are realized. Second, setting up a corporation, and
then filing the required periodic state and federal reports, is more costly and time
consuming than establishing a proprietorship or partnership.

Although a proprietorship or partnership can begin operations with-out much legal

paperwork, setting up a corporation requires that the found-ers, or their attorney,
prepare a charter and a set of bylaws. Today, attorneys have standard forms for
charters and bylaws, so they can set up a “no-frills” corporation with much less
work than that required to do so in the past. In addition, required forms are
available online so that founders can do the work themselves. Still, setting up a
corporation remains relatively difficult when compared to setting up a
proprietorship or partnership, and it is even more difficult if the corporation has
nonstandard features.

The charter includes the name of the corporation, its proposed activi-ties, the
amount of stock to be issued (if investor owned), and the number and names of the
initial set of directors. The charter is filed with the appropri-ate official of the state
in which the business will be incorporated. When the charter is approved, the
corporation officially exists.7 After the corporation has been officially formed, it
must file quarterly and annual financial and tax reports with state and federal
agencies.

Bylaws are a set of rules drawn up by the founders to provide guidance for the
governing and internal management of the corporation. Bylaws include in-
240
formation about how directors are to be elected, whether the existing sharehold-
ers have the first right to buy new shares that the firm issues, and the procedures
for changing the charter or bylaws.

For the following three reasons, the value of any investor-owned busi-ness, other
than a very small one, generally will be maximized if it is organized as a
corporation:

1. Limited liability reduces the risks borne by equity investors (the owners);
in general, the lower the risk, the higher the value of the investment.

2. A business’s value is dependent on growth opportunities, which in turn

are dependent on the business’s ability to attract capital. Be-cause
corporations can obtain capital more easily than other forms of business
can, they are better able to take advantage of growth

opportunities.

3. The value of any investment depends on its liquidity, which means the
ease with which the investment can be sold for a fair price. Because an
equity investment in a corporation is much more liquid than a similar
investment in a proprietorship or partnership, the corporate form of
organization creates more value for its owners.

Not-for-Profit Corporations

If an organization meets a set of stringent requirements, it can qualify for

incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt
corporations are sometimes called nonprofit corporations. Because non-profit
businesses (as opposed to pure charities) need profits to sustain operations, and
because it is hard to explain why nonprofit corporations should earn profits, the
term “not-for-profit” is more descriptive of non-profit health services
corporations.
241
Tax-exempt status is granted to businesses that meet the tax definition of a
charitable corporation, as defined by Internal Revenue Service (IRS) Tax Code
Section 501(c)(3) or (4). Hence, such corporations are also known as 501(c)(3) or
(4) corporations. The tax code defines a charitable organization as “any
corporation, community chest, fund, or foundation that is organized and operated
exclusively for religious, charitable, scientific, public safety, liter-ary, or
educational purposes.” Because the promotion of health is commonly considered a
charitable activity, a corporation that provides healthcare ser-vices can qualify for
tax-exempt status, provided it meets other requirements.

In addition to having a charitable purpose, a not-for-profit corporation must

operate exclusively for the public, rather than private, interest. Thus, no profits
can be used for private gain and no political activity can be conducted. Also, if the
corporation is liquidated or sold to an investor-owned firm, the pro-ceeds from the
liquidation or sale must be used for a charitable purpose. Because individuals
cannot benefit from the profits of not-for-profit corporations, such organizations
cannot pay dividends. However, prohibition of private gain from profits does not
prevent parties of not-for-profit corporations, such as managers and physicians,
from benefiting through salaries, perquisites, contracts, and so on.

Not-for-profit corporations differ significantly from investor-owned corporations.

Because not-for-profit firms have no shareholders, no single body of individuals
has ownership rights to the firm’s residual earnings or exercises control of the
firm. Rather, control is exercised by a board of trust-ees, which is not constrained
by outside oversight. Also, not-for-profit cor-porations are generally exempt from
taxation, including both property and income taxes, and have the right to issue
tax-exempt debt (municipal bonds).

Finally, individual contributions to not-for-profit organizations can be de-ducted

from taxable income by the donor, so not-for-profit firms have access to tax-
subsidized contribution capital. (The tax benefits enjoyed by not-for-profit
242
corporations are reviewed in a later section on tax laws.)

The financial problems facing most federal, state, and local govern-ments have
caused politicians to take a closer look at the tax subsidies provid-ed to not-for-
profit hospitals. For example, several bills have been introduced in Congress that
require hospitals to provide minimum levels of care to the indigent to retain tax-
exempt status. Such efforts by Congress prompted the American Hospital
Association in 2007 to publish guidelines for charity care that include (1) giving
discounts to uninsured patients of “limited means”;

(2) establishing a common definition of “community benefits,” which en-compass

the full range of services provided to the population served; and (3) improving
“transparency,” or the ability of outsiders to understand a busi-ness’s governance
structure and policies, including executive compensation. Starting with tax year
2009, Schedule H of the revised Form 990 requires that hospitals collect and
analyze additional data regarding their community benefit activities and the
charity care they provide, and determine the value of both according to standards
adopted by the IRS.

Likewise, officials in several states have proposed legislation that mandates the
amount of charity care provided by not-for-profit hospitals and the billing and
collections procedures applied to the uninsured. For example, Texas has
established minimum requirements for charity care, which hold not-for-profit
hospitals accountable to the public for the tax exemptions they receive. The Texas
law specifies four tests, and each hos-pital must meet at least one of them. The test
that most hospitals use to comply with the law requires that at least 4 percent of
net patient service revenue be spent on charity care. Ohio legislators have held
hearings to discuss whether a law should be passed requiring Ohio’s not-for-profit
hospitals to make “Payments in Lieu of Taxes (PILOTS).”

Finally, money-starved municipalities in several states have attacked the property

243
tax exemption of not-for-profit hospitals that have “neglected” their charitable
missions. For example, tax assessors are fighting to remove property tax
exemptions from not-for-profit hospitals in several Pennsylvania cities after an
appellate court ruling supported the Erie school district’s authority to tax a local
hospital that had strayed too far from its charitable purpose. According to one
estimate, if all not-for-profit hospitals had to pay taxes comparable to those their
investor-owned counterparts pay, local, state, and federal governments would
garner an additional Rs.3.5 billion in tax revenues. This estimate explains why tax
authorities in many jurisdictions are pursuing not-for-profit hospitals as a source
of revenue.

The inherent differences between investor-owned and not-for-profit organizations

have profound implications for many elements of healthcare fi-nancial
management, including organizational goals, financing decisions (i.e., the choice
between debt and equity financing and the types of securities is-sued), and capital
investment decisions. Ownership’s effect on the application of healthcare financial
management theory and concepts will be addressed throughout the text.

Organizational Structures

Whether investor owned or not for profit, health services organizations can be
structured in an almost unlimited number of ways. At the most basic level, a
healthcare provider can be a single entity with one operating unit. In this situation,
all of the financial management decisions for the organization are made by a
single set of managers. Alternatively, corporations can be set up with separate
operating divisions or as holding companies with wholly or par-tially owned
subsidiary corporations in which different management layers have different
financial management responsibilities.

Holding Companies

Today, many organizations, both investor owned and not for profit, have adopted
holding company structures to take advantage of economies of scale, or scope, in
244
operations and financing or to gain favorable legal or tax treatment. Holding
companies date from 1889, when New Jersey became the first state to pass a law
permitting corporations to be formed for the sole purpose of owning the stocks of
other firms. Many of the advantages and disadvantages of holding companies are
identical to those inherent in a large firm with several divisions. Whether a firm is
organized on a divi-sional basis or as a holding company with several subsidiary
corporations does not affect the basic reasons for conducting large-scale,
multiproduct or multiservice, multi-facility operations. However, the holding
company structure has some distinct advantages and disadvantages when
compared to the divisional structure.

There are several advantages to holding companies:

• Control with fractional ownership. A holding company may buy 5, 10, or 50

percent of the stock of another corporation. Such fractional ownership may be
sufficient in giving the acquiring firm effective work-ing control, or at least
substantial influence, over the operations of the firm in which it has acquired stock
ownership. Working control is often considered to entail more than 25 percent of
the common stock, but it can be as low as 10 percent if the stock is widely held.

• Isolation of risks. Because the various operating firms in a holding company

system are separate legal entities, the obligations of one unit are separate from
those of the other units. Therefore, catastrophic losses incurred by one unit of the
system are not transferable into claims against the other units. This separation can
be especially beneficial when the operating units carry the potential for large
losses from malpractice or other liability lawsuits. Note, though, that the parent
firm often vol- untarily steps in to aid a subsidiary with large losses, either to
protect the good name of the firm or to protect its investment in the subsidiary.

• Separation of for-profit and not-for-profit subsidiaries. Holding company

245
organization facilitates expansion into both tax-exempt and taxable activities well
beyond patient care. However, a tax-exempt holding company must ensure that all
transactions with the taxable subsidiaries are conducted at arm’s length, otherwise
the tax-exempt status of the parent holding company can be challenged. Investor-
owned multihospital systems are organized similarly, except all of the entities are
taxable, for-profit organizations. Note that although not-for-profit holding
companies are allowed to have taxable subsidiaries, for-profit holding companies
are not permitted to own tax-exempt subsidiaries.

Holding companies have the following disadvantages:

• Partial multiple taxation. Investor-owned holding companies that own at least

80 percent of a subsidiary’s common stock can file a consolidated return for
federal income tax purposes. In effect, the holding company and the subsidiary are
treated as a single entity; all of their revenues and costs are aggregated. However,
when less than 80 percent of the stock is owned, the only way that the subsidiary
can transfer funds to the hold-ing company is by paying dividends, and such
dividends face partial multiple taxation. For example, holding companies that own
more than 20 percent but less than 80 percent of the stock of another corporation
must pay tax on 20 percent of the dividends received (80 percent are nontaxable),
and companies that own less than 20 percent must pay tax on 30 percent of the
dividends (70 percent are nontaxable). Because the subsidiary must pay taxes on
the earnings prior to making the dividend payment, the funds transferred to the
parent are taxed twice.

• Ease of forced divestiture. In the event of antitrust action, a holding company

can easily relinquish ownership in a subsidiary by selling the stock to another
party. This ease of transfer is considered a disadvantage because it increases the
likelihood that government agencies will demand divestiture if antitrust concerns
arise.
Multihospital Systems

246
Multihospital systems, including tax-exempt and for-profit organizations, have
grown much faster than freestanding hospitals over the past 30 years. Several
advantages of multihospital systems have been hypothesized, including the
following:

• Better access to capital markets, which results in lower capital costs

• Elimination of duplicate services, which increases the volume of ser-vices at

the remaining sites and results in lower unit costs and increased quality

• Economies of scale

• Access to specialized managerial skills within the system

• Ability to recruit and retain better personnel because of superior training

programs, advancement opportunities, and transfer opportunities
• Increased political power in dealing with governmental issues such as
property taxes, certificates of need, and government reimbursement systems
• Increased bargaining power with payers
In recent years, the largest systems have tended to shed some hospi-tals, although
there continues to be some consolidation within local markets. Hospital systems
appear to have more economies of scale within local markets than they do
regionally or nationally. However, large healthcare systems have also faced
increased scrutiny as critics question whether their group bargain-ing power stifles
competition. For example, Partners HealthCare System, which includes two large
academic medical centers and 11 community hospi-tals and outpatient facilities,
was the subject of a spotlight series in the Boston Globe that accused the
organization and its pricing strategies for the increase in the cost of care in
Massachusetts.

247
Corporate Alliances

Corporate alliances can provide some of the benefits of multi-institutional systems

without requiring common ownership. Industry trade groups, which tend to
operate at both state and national levels, are the least binding type of corporate
alliance. For example, the American Hospital Association and its state
organizations—such as the Florida Hospital Association—consti-tute one major
hospital trade association. Also, the American Association of Equipment Lessors
is the trade group for firms that lease equipment to the health services industry.

Other types of alliances can be more binding but provide more ben-efits to their
members. For example, several hospital alliances exist primarily to give their
members purchasing clout. One of the largest of such alliances is VHA (formerly
Voluntary Hospitals of America), a for-profit firm whose shareholders are its
member hospitals, all not-for-profit institutions, and their physicians. VHA’s firms
and subsidiaries provide members and affiliates with management services in such
areas as procurement, data management, mar-keting, and even capital acquisition.
VHA’s members and affiliates retain local control and autonomy yet gain many of
the advantages of a large system.

In addition to alliances among similar organizations, alliances are also being

formed among dissimilar providers to offer a more complete range of services.
Such vertical alliances are discussed in the next section.

Integrated Delivery Systems

The most dynamic recent changes to organizational structures in health ser-vices

have centered on the integrated delivery system.10 In the 1970s, horizon-tal
integration, such as the combining of hospitals, was the dominant trend in
organizational evolution. In the 1980s and well into the 1990s, the dominant
organizational movement was toward vertically integrated systems. In an in-
248
tegrated delivery system, a single organization, or a closely aligned group of
organizations, offers a broad range of patient care and support services oper-ated
in a unified manner. The range of services offered by an integrated de-livery
system may focus on a particular area, such as long-term care or mental health, or
more commonly it may offer comprehensive subacute, acute, and post-acute
services.

An integrated delivery system may have a single owner, or it may have multiple
owners joined together by contracts and agreements. The driving force behind
these systems is the motivation to offer a full line of coordinated services and
hence to increase the overall effectiveness and lower the overall cost of the
services provided. Costs are reduced by providing only necessary services and
ensuring that the services are provided at the most cost-effective clinical level.
Integrated delivery systems may be formed by managed care plans or even
directly by employers, but more often they are formed by pro-viders to facilitate
contracting with plans or employers.

The key feature of integrated delivery systems is that, to be successful, the

primary focus must be the clinical effectiveness and profitability of the sys-tem as
a whole, as opposed to each individual element. This emphasis requires a much
higher level of administrative and clinical integration than is seen in most
organizations and, more importantly, it requires that managers of the system’s
individual elements place their own interests second to those of the overall
system. In addition, it requires a management information system that seamlessly
passes managerial and patient data among all of the components of the integrated
system. Although single-owner systems appear to have ad-vantages over systems
that are contractually created, such advantages, if they do exist, have proven to be
difficult to realize in practice. The emphasis now appears to be on creating
smaller, more focused businesses that are easier to manage. However, the
integration of hospitals and physicians appears to be gaining momentum in
anticipation of healthcare reform implementation measures that reward hospital–
physician cooperation.

249
Organizational Goals

Financial decisions are not made in a vacuum but with an objective in mind. An
organization’s financial management goals must be consistent with and support
the overall goals of the business. Thus, by discussing organizational goals, health
services organizations develop a framework for financial decision making.

In a proprietorship, partnership, or small, privately owned corporation, the owners

of the business generally are also its managers. In theory, the busi-ness can be
operated for the exclusive benefit of the owners. If the owners want to work hard
to maximize wealth, they can. On the other hand, if every Wednesday is devoted
to golf, no one is hurt. (Of course, the business still has to cater to its customers or
else it will not survive.) It is in large publicly owned corporations, in which
owners and managers are separate parties, that organizational goals become most
important.

Large, Investor-Owned Corporations

From a financial management perspective, the primary goal of investor-owned

corporations is generally assumed to be shareholder wealth maximiza-tion, which
translates to stock price maximization. Investor-owned corpora-tions do, of
course, have other goals. Managers, who make the decisions, are interested in
their own personal welfare, in their employees’ welfare, and in the good of the
community and society at large. Still, the goal of stock price maximization is a
reasonable operating objective on which to build financial decision rules.

The primary obstacle to shareholder wealth maximization as the goal of investor-

owned corporations is the agency problem. An agency problem ex-ists when one
or more individuals (the principals) hire another individual or group of individuals
(the agents) to perform a service on their behalf and then delegate a decision-
making authority to those agents. In a healthcare finan-cial management
framework, the agency problem exists between stockholders and managers, and
250
between debtholders and stockholders.

The agency problem between stockholders and managers occurs because the
managers of large, investor-owned corporations hold only a small proportion of
the firm’s stock, so they benefit little from stock price increases. On the other
hand, managers often benefit substantially from actions detrimental to stockhold-
ers’ wealth, such as increasing the size of the firm to justify higher salaries and
more fringe benefits; awarding themselves generous retirement plans; and spend-
ing too much on such items as office space, personal staff, and travel. Clearly,
many situations can arise in which managers are motivated to take actions that are
in their best interests, rather than in the best interests of stockholders.

However, stockholders recognize the agency problem and counter it by creating

the following mechanisms to keep managers focused on share-holder wealth
maximization:

• The creation of managerial incentives. More and more firms are creat-ing
incentive compensation plans that tie managers’ compensation to the firm’s
performance. One tool often used is stock options, which allow managers to
purchase stock at some time in the future at a given price. Because the options are
valuable only if the stock price climbs above the exercise price (the price that the
managers must pay to buy the stock), managers are motivated to take actions to
increase the stock price. How-ever, because a firm’s stock price is a function of
both managers’ actions and the general state of the economy, a firm’s managers
could be doing a superlative job for shareholders but the options could still be
worthless. To overcome the inherent shortcoming of stock options, many firms
use performance shares as the managerial incentive. Performance shares are given
to managers on the basis of the firm’s performance as indicated by objective
measures, such as earnings per share, return on equity, and so on. Not only do
managers’ receive more shares when targets are met; the value of the shares is
also enhanced if the firm’s stock price rises. Finally, many businesses use the
concept of economic value added (EVA) to structure managerial compensation.
251
(EVA is discussed in Chapter 13.) All incentive compensation plans—stock
options, performance shares, profit-based bonuses, and so forth—are designed
with two purposes in mind. First, they offer managers incentives to act on factors
under their control in a way that will contribute to stock price maximization. Sec-
ond, such plans help firms attract and retain top-quality managers

• The threat of firing. Until the 1980s, the probability of a large firm’s
stockholders ousting its management was so remote that it posed little threat.
Ownership of most firms was so widely held, and management’s control over the
proxy (voting) mechanism was so strong, that it was almost impossible for
dissident stockholders to fire a firm’s managers. Today, however, about 70
percent of the stock of an average large corpo-ration, such as pension funds and
mutual funds, is held by institutional investors rather than individual investors.
These institutional money managers have the clout, if they choose to use it, to
exercise considerable influence over a firm’s managers and, if necessary, to
remove the current management team by voting it off the board.

• The threat of takeover. A hostile takeover—the purchase of a firm against its

management’s wishes—is most likely to occur when a firm’s stock is undervalued
relative to its potential because of poor manage-ment. In a hostile takeover, a
potential acquirer makes a direct appeal to the shareholders of the target firm to
tender, or sell, their shares at some stated price. If 51 percent of the shareholders
agree to tender their shares, the acquirer gains control. When a hostile takeover
occurs, the managers of the acquired firm often lose their jobs, and any manag-ers
permitted to stay on generally lose the autonomy they had prior to the acquisition.
Thus, managers have a strong incentive to take actions to maximize stock price. In
the words of the president of a major drug manufacturer, “If you want to keep
control, don’t let your company’s stock sell at a bargain price.”

In summary, managers of investor-owned firms can have motivations that are

inconsistent with shareholder wealth maximization. Still, sufficient mechanisms
are at work to force managers to view shareholder wealth max-imization as an
252
important, if not primary, goal. Thus, shareholder wealth maximization is a
reasonable goal for investor-owned firms.

4.4 BUDGETING

Introduction:
A budget is a plan for the future. Hence, budgets are planning tools, and they
are usually prepared prior to the start of the period being budgeted. However,
the comparison of the budget to actual results provides valuable information
about performance. Therefore, budgets are both planning tools and
performance evaluation tools.

Usually, the single most important input in the budget is some measure of
anticipated output. For a factory, this measure of output is the number of units
of each product produced. For a retailer, it might be the number of units of
each product sold. For a hospital, it is the number of patient days (the number
of patient admissions multiplied by the average length of stay).

The static budget is the budget that is based on this projected level of output,
prior to the start of the period. In other words, the static budget is the
“original” budget. The static budget variance is the difference between any
line-item in this original budget and the corresponding line-item from the
statement of actual results. Often, the line-item of most interest is the “bottom
line”: total cost of production for the factory and other cost centers; income for
profit centers.

The flexible budget is a performance evaluation tool. It cannot be prepared

before the end of the period. A flexible budget adjusts the static budget for the
actual level of output. The flexible budget asks the question: “If I had known
253
at the beginning of the period what my output volume (units produced or units
sold) would be, what would my budget have looked like?” The motivation for
the flexible budget is to compare apples to apples. If the factory actually
produced 10,000 units, then management should compare actual factory costs
for 10,000 units to what the factory should have spent to make 10,000 units,
not to what the factory should have spent to make 9,000 units or 11,000 units
or any other production level.

The flexible budget variance is the difference between any line-item in the
flexible budget and the corresponding line-item from the statement of actual
results.

The following steps are used to prepare a flexible budget:

1. Determine the budgeted variable cost per unit of output. Also determine
the budgeted sales price per unit of output, if the entity to which the budget
applies generates revenue (e.g., the retailer or the hospital).

2. Determine the budgeted level of fixed costs.

3. Determine the actual volume of output achieved (e.g., units produced for
a factory, units sold for a retailer, patient days for a hospital).

4. Build the flexible budget based on the budgeted cost information from
steps 1 and 2, and the actual volume of output from step 3.

Flexible budgets are prepared at the end of the period, when actual output is
known. However, the same steps described above for creating the flexible
budget can be used prior to the start of the period to anticipate costs and
revenues for any projected level of output, where the projected level of output
is incorporated at step 3. If these steps are applied to various anticipated levels
of output, the analysis is called pro forma analysis. Pro forma analysis is
useful for planning purposes. For example, if next year’s sales are double this
254
year’s sales, what will be the company’s cash, materials, and labor
requirements in order to meet production needs?
Following are pro forma monthly income statements for Malar hosptial, a
small, start-up fashion jeans manufacturer. The pro forma analysis was
prepared at the beginning of the month and considered three alternative sales
levels. The company has no variable marketing costs.

MALAR HOSPTIAL
PRO FORMA ANALYSIS
255
FOR THE UPCOMING MONTH

Income Budgeted Pro Forma Analysis for

Statement amount Alternative Output Levels
line-item per unit
10,000 units 20,000 units 30,000 units
Revenue Rs.40 Rs.400,000 Rs.800,000 Rs.1,200,000

Variable costs:
Materials 15 150,000 300,000 450,000
Labor 10 100,000 200,000 300,000
Overhead 5 50,000 100,000 150,000
Total 30 300,000 600,000 900,000

Contribution Rs.10 100,000 200,000 300,000

margin

Fixed costs:
Manufacturing 100,000 100,000 100,000
Overhead 50,000 50,000 50,000
Marketing costs 150,000 150,000 150,000
Total fixed costs
(Rs.50,000) Rs.50,000 Rs.150,000
Operating income

Since by definition, fixed costs are not expected to change as volume of output
changes within the relevant range, fixed costs remain the same at all three
projected levels of output. Revenue and variable costs vary with output in a
linear fashion. Hence, when output increases 100% from 10,000 units to
20,000 units, revenue, each line-item for variable costs, and contribution
margin all increase 100%.

Static Budget Variance at Malar hosptial:

256
Guess Who management decides that 10,000 units is the most likely output
volume, and sets the static budget based on this sales and production level.
After the end of the month, company personnel prepare the following table,
showing the static budget, actual results, and the static budget variance.

MALAR HOSPTIAL
STATIC BUDGET VARIANCE
FOR THE MONTH JUST ENDED
Income Budgeted Static Actual Static
Statement amount Budget Results Budget
line-item per unit (A) (B) Variance

257
 10,000 units 16,000 units (A) – (B)

Revenue Rs.40 Rs.400,000 Rs.670,000 Rs.270,000

Variable costs:
Materials 15 150,000 230,000 (80,000)
Labor 10 100,000 167,000 (67,000)
Overhead 5 50,000 84,000 (34,000)
Total 30 300,000 481,000 (181,000)

Contribution Rs.10 100,000 189,000 89,000

margin

Fixed costs:
Manufacturing 100,000 105,000 (5,000)
Overhead 50,000 49,000 1,000.
Marketing costs 150,000 154,000 (4,000)
Total fixed costs
(Rs.50,000) Rs.35,000 Rs.85,000
Operating income

In the variance column, positive numbers are favorable variances (good news),
and negative numbers are unfavorable (bad news).

The static budget variance shows a large favorable variance for revenue, and
large unfavorable variances for variable costs. These large variances are due
primarily to the fact that the static budget was built on an output level of
10,000 units, while the company actually made and sold 16,000 units. The
258
revenue variance might also be due to an average unit sales price that differed
from budget. The variable cost variances might also be due to input prices that
differed from budget (e.g., the price of fabric), or input quantities that differed
from the per-unit budgeted amounts (e.g., yards of fabric per pair of pants).

There are also small variances for fixed costs. These costs should not vary
with the level of output (at least within the relevant range). However, many
factors can cause actual fixed costs to differ from budgeted fixed costs that are
unrelated to output volume. For example, property tax rates and the fixed
salaries of front office personnel can change, and depreciation expense can
change if unexpected capital acquisitions or dispositions occur.

The Flexible Budget Variance at Malar hosptial:

In order to better understand the causes of the large revenue and variable cost
variances in the static budget variance column, Guess Who personnel prepare
the following flexible budget.

MALAR HOSPTIAL
FLEXIBLE BUDGET VARIANCE
FOR THE MONTH JUST ENDED
Income Budgeted Flexible Actual Flexible
Statement amount Budget Results Budget
line-item per unit (A) (B) Variance
16,000 units 16,000 units (A) – (B)
Revenue Rs.40 Rs.640,000 Rs.670,000 Rs.30,000

Variable costs:

259
Materials 15 240,000 230,000 10,000.
Labor 10 160,000 167,000 (7,000)
Overhead 5 80,000 84,000 (4,000)
Total 30 480,000 481,000 (1,000)

Contribution Rs.10 160,000 189,000 29,000

margin

Fixed costs:
Manufacturing 100,000 105,000 (5,000)
Overhead 50,000 49,000 1,000.
Marketing costs 150,000 154,000 (4,000)
Total fixed costs
Rs.10,000 Rs.35,000 Rs.25,000
Operating income

4.5 NEED, ELEMENTS STAGES AND TERMS OF BUDGETING

PREPARING A BUDGET

The budget should reflect the Principal Investigator's best estimate of the

actual cost of conducting the scope of the work outlined in other sections of

the proposal.

Budgets for federal contracts and grants should be prepared in accordance with

guidelines incorporated with Office of Management and Budget Circular A-21

260
(Cost Principles for Educational Institutions). Other sponsors may have their

own specific requirements.

Budgets generally include both direct and indirect costs. Indirect costs are now

referred to as Facilities & Administrative costs (F&A). Both are real costs.

Direct plus F&A costs equal total costs.

Direct costs can be easily identified with a particular project, (e.g., salaries for

the faculty and staff who conduct the research or the cost of equipment and

supplies used in the research). OMB Circular A-21 requires that costs be:

Reasonable: costs a prudent person would have incurred

Allocable: costs directly benefit the project to which they are charged and are

in proportion to the benefit received by the project

Allowable: costs are allocable, reasonable and not specifically excluded by A-

21

When OMB Circular A-21 was revised in 1993, departmental administrative

and clerical salaries, office supplies and postage, local telephone charges and

membership were no longer allowed as direct charges on most projects. At

UCLA this change went into effect as of July 1, 1995. There are some

261
exceptions based on special circumstances. When exceptions are requested,

they need to be well justified.

ELEMENTS OF A BUDGET

DIRECT COSTS

Direct costs can be easily identified with a particular project, (e.g., salaries for

the faculty and staff who conduct the research or the cost of equipment and

supplies used in the research), and must be considered reasonable, allocable

and allowable to be incorporated into a proposal budget.

Salaries and Wages:

The names of all persons who will work on the project. Where positions are

not filled, use "To Be Named" or "TBN."

The University payroll title for each academic and staff appointee. For new

hires, use the University payroll title and estimate the salary by using the

midpoint of the appropriate salary range.

The current annual or monthly salary for each position based on current salary

and wage scales. The nature of the appointment should be specified (e.g., 9

month or fiscal year appointment). For faculty with nine month appointments,

summer salary should be shown as a separate line item.

The number of months per year and/or percentage of effort for each position.

262
Project cost of living increases, specify the period to which they apply, and

explain the basis upon which these increases were calculated. Show the new

annual or monthly rate for each position and the period to which it applies.

Project merit increases and specify the period to which they apply, and explain

the basis upon which these rates were calculated. Show the new, annual or

monthly rate for each position.

10 Important Steps Involved in the Hospital Budget Process

As a shortcut to budget making, many times the financial performance of

previous some months (for which accounting data would be readily available)
is obtained, and a pro-rata figures for the remaining months of the year, and
some percentage allowances for inflation are added to it to make up the year’s
forecast. This is the system generally followed in many hospitals.

The budget process needs to be very well-understood by the hospital

administrator, even though a lot of it will fall in the domain of the finance
officer. However, all depart-ments must get actively involved in the
preparation of the budget.

1. The first step in the budget process is for the hospital administrator to
prepare assumptions, in statistical terms, about the kinds of services (outputs)
the hospital expects to provide (produce), i.e. prepare a quantitative expression

263
of the plans of the hospital, e.g. patient days of service, by specialties, number
of procedures by departments like pathology, radiology, physiotherapy, etc.
number of outpatient visits, and so on.

The purpose of budget assumptions is to share as much information as possible

with all departments.

The entire hospital will then be planning on the same track. Assumptions can
include projected patient statistics, additional services, proposed salary
revisions, economic factors, expense policies, etc.

2. The second step is for the hospital administrator to prepare the economic
forecasts in respect of new developments, or other factors, that can affect the
hospital’s income or expenditure during the budget period, such as new
services by neighbouring hospitals, specialists and super specialists likely to
join or leave the hospitals, inflation factors on materials and supplies, and any
new government regulations.

3. The third step is for the hospital administration to outline the budget goals
and policies as per the directives of the governing board or board of trustees
and in consultation with the finance officer, which will constitute a tentative
outline of the financial plan.

These may include a financial strategy, targeted gain (or loss), and similar
factors that may have a bearing on hospital finances.

4. The fourth step is for the Finance Officer to prepare a budget package
incorporating written instructions regarding the framework for the budgeting
process, procedures to be followed, accompanied by illustrative forms and

264
calculations, also containing the goals and policies, assumptions, schedules
and past data applicable to the department.

He passes on the budget package to all department heads to enable them to

prepare preliminary draft of their budget. The budget package should be
collectively explained to the department heads in a specially convened
meeting.

The hospital administrator and finance officer can take advantage of these
meetings in instructing the department heads in accounting techniques.

5. The fifth step is for each department head to analyse financial and statistical
data generated by his department as well as provided to him by the
administration or finance department, to critically assess the department’s
operations and performance, and develop indices for planning and control.

He reviews the budget plan, develops departmental goals and objectives, and
prepares the departmental expense budget.

6. A budget hearing is organised by the Finance Officer at the departmental

level where the department head presents his or her draft budget. After a joint
analysis and review by the hospital administrator and the finance officer, a
summary of the departmental budget is prepared.

In the sixth step, the summary of each department’s budget hearing records the
commitments and statements made between the administration and the
department head, and also includes observation of the Finance Officer.

7. The seventh step is for the Finance Officer to develop the department’s
revenue budget, summarise depart-mental expense budget, and forward the
department’s budget hearing summary to the concerned department head.
265
8. The eighth step is for the Finance Officer to prepare a preliminary operating
revenue budget for the whole hospital, by summarising and collating the
individual department’s budgets. Finance officer also prepares a cash budget at
this stage.

If the expected revenue does not cover the budget expense, price increases
may become necessary. If price increases are not acceptable, the finance
officer may propose areas, functions or categories of budgeted expenses that
can be cut.

In addition to the departmental budgets, the finance officer will budget for
other items that affect the entire hospital such as depreciation, contributions to
employee’s provident fund and benefits, interest expense and other
administrative expenses.

9. The ninth step is for the Finance Officer to summarise the total budget
(including capital budget and cash budget) into a proper budget format
including statistical summaries.

10. In the final step, the budget is presented by the Finance Officer to the
governing board or board of trustees or to the finance committee for their
approval.

The budget is then adopted by the board or the committee with revisions if
necessary. It is later communicated to all department heads and other
concerned persons.

The time taken to prepare a hospital budget can vary from some weeks to
some months.

Therefore, it is prudent to set up a budget timetable listing the time schedule of

each part of the budget process, persons responsible for each part, and
266
providing guidelines and explanation for the purpose of each part. The budget
timetable then becomes a plan for the completion of the budget in time and to
set deadlines.

4.6 OPERATING BUDGET: ACTIVITY/ZERO BASED BUDGETING

Operating Budgets

A budget is a quantitative plan for the future that assists the organization in
coordinating activities. All large organizations budget. Many organizations
prepare detailed budgets that look one year ahead, and budgets that look
further into the future that contain relatively less detail and more general
strategic direction.

The budget assists in the following activities:

- Planning. A budget helps identify the resources that are needed,

and when they will be needed.

- Control. A budget helps control costs by setting spending

guidelines.

- Motivating Employees. A budget can motivate employees and

managers. Budgets are more effective motivational tools if employees and
managers “buy into” the budget, which is more likely to occur if they
participate in the preparation of the budget in a meaningful way.

267
- Communication. A budget can provide either one-way (top-
down) or two-way communication within the organization.

A company’s overall budget, which is sometimes called a master budget,

consists of many supporting budgets. These supporting budgets include:

- Sales budget
- Pro forma income statement
- The production budget and supporting schedules
- Budgets for capital assets and for financing activities
- Budgets for individual balance sheet accounts and
departmental expenses
- Cash budget, including cash disbursements and cash receipts
budgets
- Pro forma balance sheet

There is a logical sequence for the preparation of these budgets. The first step
in a corporate setting is almost always to forecast sales and to assemble a sales
budget.

The Sales Budget:

The individuals who are best able to forecast sales are usually the sales force
and product managers. Their ability to accurately forecast sales depends on the
nature of the industry and on characteristics of the product. Demand is
seasonal for many products, in which case each month’s forecast usually
incorporates information about sales for the same month last year. Accurately
forecasting sales of new products and fashion products can be difficult.
Demand for some products is sensitive to macroeconomic forces such as
interest rates and foreign exchange rates. On the other hand, given the
seemingly arbitrary way in which most of us decide where to eat lunch,
restaurants can usually predict each day’s lunch revenue with astounding
accuracy.
268
Most companies face a downward-sloping demand curve for their products,
which implies that forecasting sales revenue requires predicting sales volume
at the planned sales price.

Pro Forma Income Statement:

With planned sales prices, forecasted sales volumes, and an understanding of
the cost structure of the business, the company can assemble a pro forma
income statement (an anticipated income statement for the upcoming period).
This process is illustrated below, in a simple one-product setting, for the Malar
hospital Company. The planned sales price is Rs.40 per unit. Assume that the
sales manager’s best guess of sales volume at this price is 20,000 units for
October. Then anticipated revenue for October is Rs.800,000. The company’s
cost structure is characterized by Rs.30 of variable manufacturing costs per
unit, and Rs.150,000 in fixed manufacturing and S.G.&A. (selling, general and
administrative) costs. This information is sufficient to complete the pro forma
income statement that is shown below.
MALAR HOSPITAL
PRO FORMA CONTRIBUTION MARGIN
INCOME STATEMENT FOR OCTOBER
Income Statement Budgeted Sale of
Account amount 20,000
Per unit units
Revenue Rs.40 Rs.800,000
Variable manufacturing costs:
Materials 15 300,000
Labor 10 200,000
Overhead 5 100,000
Total 30 600,000
Contribution margin Rs.10 200,000
Fixed costs:
Manufacturing overhead 100,000

269
 Selling, general & admin. 50,000
Total fixed costs 150,000
Operating income Rs.50,000

The Production Budget:

The next step in the budgeting process is more complicated for manufacturing
firms than for merchandising firms, because manufacturing companies have three
types of inventory accounts: raw materials, work-in-process and finished goods.
However, regardless of the number of asset accounts involved, the goal is to
determine the required additions to each account (purchases or transfers-in from
an upstream account). The calculation to determine required additions is derived
by expanding the Sources = Uses equality as follows:

Beginning balance + additions = transfers out + ending balance

This calculation sometimes uses physical quantities, and sometimes uses dollar
values, depending on which makes the most sense under the circumstances.

The beginning balance equals the ending balance for the prior period, which is
available either from actual results (the ending balance sheet), or from another
budget if the start of the period being budgeted is in the future.

The ending balance is a target established by the company, and is usually based on
anticipated activity for the following period (that is, the period following the one
for which the current budget is being prepared).

Transfers-out equals the demand for the asset derived from a previous step in the
budgeting process:

- If the asset account is finished goods inventory, the demand is based on

cost of goods sold, as derived from the pro forma income statement.

270
- If the asset account is work-in-process inventory, the demand is based on
the additions to the finished goods account, as calculated by applying the sources
= uses equation shown above to the finished goods account.

- If the asset account is raw materials inventory, the demand is based on the
additions to the work-in-process account for materials, as calculated by applying
the sources = uses equation shown above to the work-in-process account.

The unknown in the sources = uses equation is additions, which can be solved for,
thus completing the production budget. The following table provides balance
sheet information for Malar hospital for September 30, which is the period just
ended. (This is also the beginning balance for October 1, the period for which the
budget is being prepared, because balance sheet amounts at the end of the day on
September 30 are the same as the opening balances on the morning of October 1).
We will use the information in this table to budget for October’s production.
Because Malar hospital makes only one product, it is more convenient to use
physical quantities in the sources = uses equations than dollars. We assume that
the budget for October is being prepared on October 1st.

271
MALAR HOSPITAL
BALANCE SHEET
SEPTEMBER 30 (THE MONTH JUST ENDED)

Assets Amount Liabilities Amount

Cash Rs. 67,000 Accounts Rs. 295,000
Accounts 676,000 Payable 345,000
Receivable Line of Credit

Inventory: 13,500
Raw Materials 35,000 Stockholders’ 100,000
(1,800 yards) 150,000 Equity: 72,500
Work in Process 198,500 Common stock 1,009,000
(1,500 units) Additional paid- 1,181,500
Finished Goods in capital
(5,000 units) 880,000 Retained
Total inventory earnings
Rs.1,821,500 Total S/H Rs.1,821,500
Property, Plant & equity
Equipment,
net of
accumulated
depreciation Total

Total

Required additions to finished goods inventory: Malar hospital expects to sell

20,000 units each month for the next two months (October and November). The
company would like to have on hand, at the beginning of each month, 20% of next
272
month’s sales. The company did not achieve this operational goal for October,
because 5,000 units are on hand on October 1, and expected sales are 20,000 units,
but the company came close to its goal (25% versus 20%). At the end of October,
the company would like to have 4,000 units on hand (20% of 20,000 units
expected to be sold in November).
Beginning balance + additions = transfers out + ending balance

5,000 units + additions = 20,000 units in expected sales + 4,000 units for desired
ending inventory additions = 19,000

Hence, Malar hospital should plan to transfer out 19,000 units from work-in-
process to finished goods inventory during the month of October.
Required additions to work-in-process: Malar hospital would like to have on
hand, at any point in time, 1,200 units in work-in-process. The company has
determined that this level of work-in-process provides optimal efficiency on the
production line. (As shown above, the level of work-in-process is slightly higher
than desired at the end of September.)

Beginning balance + additions = transfers out + ending balance

1,500 units + additions = 19,000 units transferred to finished goods + 1,200 units
for desired ending WIP

additions = 18,700

Hence, Malar hospital should plan to start production of 18,700 units during the
upcoming month of October.

Required additions to raw materials: On average, 2 yards of fabric are required for
each unit of product. Malar hospital would like to maintain 2,000 yards of fabric
on hand at any point in time. (The company had less fabric on hand than desired at
the end of September.)
273
Beginning balance + additions = transfers out + ending inventory

1,800 yards + additions = (2 yards per unit x 18,700 units) + 2,000 yards desired
in ending inventory on October 31

1,800 yards + additions = 37,400 yards + 2,000 yards

Additions = 37,600 yards of fabric

Hence, Malar hospital should plan to purchase 37,600 yards of fabric during the
month of October. Using the budgeted cost of Rs.7.50 per yard, the expected
expenditure for these fabric purchases is Rs.282,000.

ACTIVITY-BASED COSTING

Activity-based costing (ABC) is a better, more accurate way of allocating

overhead.
Recall the steps to product costing:
Identify the cost object;
Identify the direct costs associated with the cost object;
Identify overhead costs;
Select the cost allocation base for assigning overhead costs to the cost object;
Develop the overhead rate per unit for allocating overhead to the cost object.
Activity-based costing refines steps #3 and #4 by dividing large heterogeneous
cost pools into multiple smaller, homogeneous cost pools. ABC then attempts to
select, as the cost allocation base for each overhead cost pool, a cost driver that
best captures the cause and effect relationship between the cost object and the
incurrence of overhead costs. Often, the best cost driver is a nonfinancial variable.

ABC can become quite elaborate. For example, it is often beneficial to employ a
two-stage allocation process whereby overhead costs are allocated to intermediate
cost pools in the first stage, and then allocated from these intermediate cost pools
274
to products in the second stage. Why is this intermediate step useful? Because it
allows the introduction of multiple cost drivers for a single overhead cost item.
This two-stage allocation process is illustrated in the example of the apparel
factory below.

ABC focuses on activities. A key assumption in activity-based costing is that

overhead costs are caused by a variety of activities, and that different products
utilize these activities in a non-homogeneous fashion. Usually, costing the activity
is an intermediate step in the allocation of overhead costs to products, in order to
obtain more accurate product cost information. Sometimes, however, the activity
itself is the cost object of interest. For example, managers at Levi Strauss & Co.
might want to know how much the company spends to acquire denim fabric, as
input in a sourcing decision. The “activity” of acquiring fabric incurs costs
associated with negotiating prices with suppliers, issuing purchase orders,
receiving fabric, inspecting fabric, and processing payments and returns.

Apparel Factory Example of Two-Stage ABC Allocations:

Assume that an apparel factory uses forklifts in only two departments:

The first department is Receiving, where large rolls of fabric are unloaded from
semi-trailers and moved into storage, and later moved from storage to the cutting
room.

The second department is Shipping, where cartons of finished pants are staged and
then loaded onto semi-trailers for shipment to the warehouse.

Zero-based budgeting

275
Zero-based budgeting is an approach to planning and decision-making which
reverses the working process of traditional budgeting. In traditional incremental
budgeting (Historic Budgeting), departmental managers justify only variances
versus past years, based on the assumption that the "baseline" is automatically
approved. By contrast, in zero-based budgeting, every line item of the budget
must be approved, rather than only changes.[1] During the review process, no
reference is made to the previous level of expenditure. Zero-based budgeting
requires the budget request be re-evaluated thoroughly, starting from the zero-
base. This process is independent of whether the total budget or specific line items
are increasing or decreasing.
The term "zero-based budgeting" is sometimes used in personal finance to
describe "zero-sum budgeting", the practice of budgeting every unit of income
received, and then adjusting some part of the budget downward for every other
part that needs to be adjusted upward. 7 Zero based budgeting also refers to the
identification of a task or tasks and then funding resources to complete the task
independent of current resourcing.

Efficient allocation of resources, as it is based on needs and benefits rather than

history.
Drives managers to find cost effective ways to improve operations.
Detects inflated budgets.
Increases staff motivation by providing greater initiative and responsibility in
decision-making.
Increases communication and coordination within the organization.
Identifies and eliminates wasteful and obsolete operations.
Identifies opportunities for outsourcing.
Forces cost centers to identify their mission and their relationship to overall goals.
Helps in identifying areas of wasteful expenditure, and if desired, can also be used
for suggesting alternative courses of action.
Disadvantages
276
More time-consuming than incremental budgeting.
Justifying every line item can be problematic for departments with intangible
outputs.
Requires specific training, due to increased complexity vs. incremental budgeting.
In a large organization, the amount of information backing up the budgeting
process may be overwhelming.
Use in the public sector[edit]

Background
Zero Base Budgeting (ZBB) in the public sector and the private sector are very
different processes, and this must be understood when implementing a ZBB
process in the public sector. “The use of ZBB in the private sector has been
limited primarily to administrative overhead activities (i.e. administrative
expenses needed to maintain the organization…)”.[2] For example, Peter Phyrr
used ZBB successfully at Texas Instruments in the 1960s and authored an
influential 1970 article in Harvard Business Review. In 1973, President Jimmy
Carter, while governor of Georgia, contracted with Phyrr to implement a ZBB
system for the State of Georgia executive budget process.[3]
President Carter later required the adoption of ZBB by the federal government
during the late 1970s. “Zero-Base Budgeting (ZBB) was an executive branch
budget formulation process introduced into the federal government in 1977. Its
main focus was on optimizing accomplishments available at alternative budgetary
levels. Under ZBB agencies were expected to set priorities based on the program
results that could be achieved at alternative spending levels, one of which was to
be below current funding.” [4]
According to Peter Sarant, the former director of management analysis training for
the US Civil Service Commission during the Carter ZBB implementation effort,
“ZBB means “different things to different people.” Some definitions are implying
that zero-base budgeting is the act of starting budgets from scratch or requiring
each program or activity to be justified from the ground up. This is not true; the
acronym ZBB, is a misnomer. ZBB is a misnomer because in many large agencies
a complete zero-base review of all program elements during one budget period is
not feasible; it would result in excessive paperwork and be an almost impossible
277
task if implemented.” [5] In many respects the “common misunderstanding” of
ZBB noted above resemble a “sunset review” process more than a traditional
public sector ZBB process.
Definition
According to Sarant, ZBB is a technique which complements and links to existing
planning, budgeting and review processes. It identifies alternative and efficient
methods of utilizing limited resources . It is a flexible management approach
which provides a credible rationale for reallocating resources by focusing on a
systematic review and justification of the funding and performance levels of
current programs.”
A method of budgeting in which all expenses must be justified for each new
period. Zero-based budgeting starts from a "zero base" and every function within
an organization is analyzed for its needs and costs. Budgets are then built around
what is needed for the upcoming period, regardless of whether the budget is
higher or lower than the previous one.
ZBB allows top-level strategic goals to be implemented into the budgeting process
by tying them to specific functional areas of the organization, where costs can be
first grouped, then measured against previous results and current expectations.

Components of a public sector ZBB analysis

In general there are three components that make up public sector ZBB:
Identify three alternate funding levels for each decision unit (Traditionally, this
has been a zero-base level, a current funding level and an enhanced service level.);
Determine the impact of these funding levels on program (decision unit)
operations using program performance metrics; and
Rank the program “decision packages” for the three funding levels.
The process was also specifically intended to involve both program staff and
budget staff in the process. In many cases, program staffers were asked to look for
alternative service delivery models that could deliver services more efficiently at
lower funding level.
The US General Accounting Office (GAO) reviewed past performance budgeting
initiatives in 1997 and found that ZBBs “main focus was on optimizing

278
accomplishments available at alternative budgetary levels. Under ZBB agencies
were expected to:
Set priorities based on the program results that could be achieved at alternative
spending levels, one of which was to be below current funding.
In developing budget proposals, these alternatives were to be ranked against each
other sequentially from the lowest level organizations up through the department
and without reference to a past budgetary base.

In concept, ZBB sought a clear and precise link between budgetary resources and
program results.” [6]
Further, “ZBB illustrated the usefulness of:
Defining and presenting alternative funding levels; and
Expanded participation of program managers in the budget process.”
The federal ZBB budgeting system had the following components: “Budget
requests for each decision unit were to be prepared by their managers, who would
(1) identify alternative approaches to achieving the unit’s objectives, (2) identify
several alternative funding levels, including a “minimum” level normally below
current funding, (3) prepare “decision packages” according to a prescribed format
for each unit, including budget and performance information, and (4) rank the
decision packages against each other.” [7]
ZBB was officially eliminated in federal budgeting on August 7, 1981. “Some
participants in the budget process as well as other observers attributed certain
program efficiencies, arising from the consideration of alternatives, to ZBB.
Interestingly, ZBB established within federal budgeting a requirement to:
Present alternative levels of funding; and
Link (them) to alternative results.” [8]
This element of the ZBB budgeting process remained in effect through the
Reagan, Bush and early Clinton administrations before being eliminated in 1994.
Defining the government program zero-base
As noted earlier, there is often considerable confusion over the meaning of zero-
base budgeting. There is no evidence that public sector ZBB has ever included
“building budgets from the bottom up” and “reviewing every invoice” as part of
the analysis. In discussions of ZBB, there is often confusion between a ZBB
279
process and a sunset review process. In a sunset review the entire function is
eliminated unless evidence is provided of program effectiveness. This confusion
ultimately leads to the question: what is a zero-base?
Sarant’s definition of the zero-base based on the federal training experience is: “A
minimum level is actually the grass roots funding level necessary to keep a
program alive. Therefore, the minimal level is the “program or funding level
below which it is not feasible to continue a program… because no constructive
contribution can be made toward fulfilling its objective.” [9] Identifying this level
of program funding has been subjective and problematic.
Consequently, “some states have selected arbitrary percentages to insure that an
amount smaller than last year’s request in considered. They do this by stipulating
that one alternative must be 50 or 80 or 90 percent of last year’s request.” [10]
This equates to analyzing the impact on program operations of a 10, 20 or 50
percent reduction in funding as the “zero base” funding level.

Importance of performance measures

Performance measures are a key component of the ZBB process. At the core, ZBB
requires quality measures that can be used to analyze the impact of alternative
funding scenarios on program operations and outcomes. Without quality measures
ZBB simply will not work because decision packages cannot be ranked. To
perform a ZBB analysis “alternative decision packages are prepared and ranked,
thus allowing marginal utility and comparative analysis.” [11]
Traditionally, a ZBB analysis focused on three types of measures. “They (federal
agency program staff) were to identify the key indicators to be used in measuring
performance and results. These should be “measures of:effectiveness,efficiency,
and workload for each decision unit.
Indirect or proxy indicators could be used if these systems did not exist or were
under development.” [12]
Impact of ZBB on Government Operation
According to the GAO:
“Agencies believed that inadequate time had been allowed to implement the new
initiative. The requirement to compress planning and budgeting functions within
280
the timeframes of the budget cycle had proven especially difficult, affecting
program managers’ ability to identify alternative approaches to accomplishing
agency objectives. Some agency officials also believed that the performance
information needed for ZBB analysis was lacking.” [13]
According to the National Conference of State Legislatures:[14]
“In its original sense, ZBB meant that no past decisions are taken for granted.
Every previous budget decision is up for review. Existing and proposed programs
are on an equal footing, and the traditional state practice of altering almost all
existing budget lines by small amounts every year or two would be swept away.
No state government has ever found this feasible. Even Georgia, where Governor
Jimmy Carter introduced ZBB to state budgeting in 1971, employed a much
modified form.

State programs are not, in practice, amenable to such a radical annual re-
examination. Statutes, obligations to local governments, requirements of the
federal government, and other past decisions have many times created state
funding commitments that are almost impossible to change very much in the short
run. Education funding levels are determined in many states partly by state and
federal judicial decisions and state constitutional provisions, as well as by statutes.
Federal mandates require that state Medicaid funding meet a specific minimum
level if Medicaid is to exist at all in a state. Federal law affects environmental
program spending, and both state and federal courts help determine state spending
on prisons. Much state spending, therefore, cannot usefully be subjected to the
kind of fundamental re-examination that ZBB in its original form envisions.
To the extent that ZBB has encouraged governors and legislators to take a hard
look at the impact of incremental changes in state spending, it produced a
significant improvement in state budgeting. But in its classic form--begin all
budget evaluations from zero--ZBB is as unworkable as it ever was.”

4.7 CAPITAL BUDGETING : RETURN ON INVESTMENT

281
Capital Budgeting

Capital projects involve the acquisition of assets that generate returns over
multiple periods. Examples are the construction of a factory or the purchase of
a new machine. In this context, a dollar saved is as good as a dollar earned.
Hence, capital investments that reduce operating expenses are equivalent to
capital investments that generate additional revenues.

This chapter describes four performance measures for capital projects. These
performance measures can use budgeted data as a planning tool, to decide
whether to invest in a proposed capital project or for choosing among
proposed projects. Also, these performance measures can be used
retrospectively, to evaluate a capital project against planned performance or
against other projects.

A characteristic feature of capital projects is that the bulk of the cash outflows
precede the cash inflows. Although a capital project may involve cash
outflows that occur over time, and cash inflows that vary from year to year,
our discussion will often assume a typical scenario in which there is a single
cash outflow for the acquisition of the asset that occurs at the beginning of
year one (called “time zero”), followed by a series of equal cash inflows that
occur at the end of each year for the life of the project. This series of cash
inflows is called an annuity.

Time Value of Money:

A dollar today is worth more than a dollar one year from now. The reason for
this appreciation is that cash is an asset, and like any asset, it can be invested
to earn a return over time. The discount rate is a measure of the time value of
money; it measures how much more a dollar is worth today than a dollar one
year from now. For example, if you are indifferent between receiving Rs.1.00
today and Rs.1.20 one year from now, your discount rate is 20%. The time
value of money has nothing to do with inflation, which works in the opposite
282
direction. Inflation refers to the declining purchasing power of the dollar that
occurs when prices of goods and services rise over time.

Software spreadsheet applications and financial calculators include present

value functions that calculate the present value of any amount received (or
paid) at any time in the future. These tools also provide the future value, for
any point in time in the future, of any amount received (or paid) today. Before
these electronic resources were commonplace, tables were widely available
that allowed one to easily calculate present values and future values for
frequently-used discount rates and time periods. Although such tables are
unnecessary in practice today, we will use them in this chapter, because they
visually illustrate the relevant concepts.

Table 1 at the end of this chapter is a present value table. It provides present
value factors for selected discount rates that range from 6% to 20%, and time
periods that range from one period to twenty periods. If the interest rates are
expressed per annum, then the time periods represent years. For example, to
determine the present value of any amount X received five years from now, at
an interest rate of 8% per annum, one would find the factor at the intersection
of Row 5 and the Column for 8% (the factor is 0.6806), and multiply this
factor by the amount X.

Many situations involve a stream of equal payments or receipts over a

consecutive number of periods. For example, financing the purchase of an
automobile might require monthly payments of Rs.1,000 for the next three
years, or a proposed capital acquisition might increase revenues by Rs.10,000
every year for the next seven years. Such streams of cash inflows and
outflows are called annuities.

Software spreadsheet applications and financial calculators include functions

that calculate the present value and future value of annuities. Again, before
these electronic resources were widely available, tables were used to calculate
the present value or future value of an annuity by multiplying the annual
283
annuity amount by the factor in the table. Table 2 at the end of this chapter is
a present value table for annuities. In order to use the table for an annuity of
monthly payments or receipts (such as the example of monthly payments for
the financing of an automobile), one can treat the rows as months if the
interest rates in the column headings are treated as monthly percentages. For
example, if the annual interest rate on the car loan is 24%, the monthly
interest rate is 2%, and one would need to use the column for 2% (which is
not shown in Table 2, but would have been included in tables used by
practitioners).

There is an important relationship between Table 1 and Table 2. The present

value of any annuity can be calculated by using Table 1 separately for each
period over which the annuity occurs, and then summing these individual
amounts. Table 2 (or the annuity present value function on a calculator)
simplifies the task, by calculating the present value of the entire stream of
payments or receipts at once. This relationship implies that one can always
“build” Table 2, row by row, by summing the entries for the corresponding
column in Table 1, down to that row. For example:

Table 1: Present value of Rs.1

received (or paid) n years from now
N 6% 7% 8% 9%
1 0.9434 0.9346 0.9259 0.9174
2 0.8900 0.8734 0.8573 0.8417
3 0.8396 0.8163 0.7938 0.7722
4 0.7921 0.7629 0.7350 0.7084

284
 Table 2: Present value of an annuity
of Rs.1 for the next n years
N 6% 7% 8% 9%
1 0.9434 0.9346 0.9259 0.9174
2 1.8334 1.8080 1.7833 1.7591
3 2.6730 2.6243 2.5771 2.5313
4 3.4651 3.3872 3.3121 3.2397

0.9346 + 0.8734 + 0.8163 = 2.6243

Hence, an annuity of Rs.1 for three years at 7% equals Rs.2.6243, which can be
derived either by adding the three annual amounts provided in Table 1, or more
simply by using the factor in row 3 of Table 2.

Next we examine four methods for evaluating capital projects.

Payback Period:
The payback period measures the time required to recoup the initial investment in
the capital asset. Consider the following two examples.

Proje Initial Cash Inflows in Year

ct Cost 1 2 3 4 5 6 7
A Rs.10,0 Rs.2,0 Rs.2,0 Rs.1,0 Rs.3,0 Rs.2,0 Rs.1,5 Rs.0
00 00 00 00 00 00 00
B Rs.10,0 Rs.2,0 Rs.2,0 Rs.2,0 Rs.3,0 Rs.2,0 Rs.2,0 Rs.2,0
00 00 00 00 00 00 00 00

285
The payback period for Project A is five years, because the sum of cash inflows
for years one through five is Rs.10,000 and Rs.10,000 is also the initial cost of the
project. The payback period for Project B is greater than four years but less than
five years, because the sum of cash inflows through year four is Rs.9,000, and the
sum of cash inflows through year five is Rs.11,000, while the initial cost is
Rs.10,000. In this situation, the payback period could be expressed as 4½ years.
If cash inflows are constant from year to year during the life of the project, the
payback period can be calculated as follows:

Payback = Initial
Period Investment
Annual Cash
Inflow

The payback period has two drawbacks. First, it ignores the time value of money.
However, this drawback is somewhat mitigated by the fact that, in any case, the
payback period tends to favor projects that recover the initial investment quickly.
The second drawback is that the payback period ignores cash inflows that occur
after the end of the payback period. The following example illustrates these
issues:

Proje Initial Cash Inflows in Year

ct Cost 1 2 3 4 5 6 7
C Rs.8,0 Rs.2,0 Rs.2,0 Rs.1,0 Rs.3,0 Rs.0 Rs.0 Rs.0
00 00 00 00 00
D Rs.8,0 Rs.2,0 Rs.2,0 Rs.2,0 Rs.2,0 Rs.2,0 Rs.2,0 Rs.2,0
00 00 00 00 00 00 00 00

Both projects have a payback period of four years. However, Project D is clearly
preferred to Project C, both because Project D generates more cash inflows earlier

286
during the payback period (Rs.2,000 in year three versus Rs.1,000 for Project C,
which is offset in year four), and because Project D continues to generate returns
after the payback period is over.

The payback period is a heuristic. A heuristic is a decision-aid that is easily

understood and easily communicated, but that might not always result in the best
decision.

Net Present Value:

The net present value (NPV) of a capital project answers the following question:

What is the project worth in today’s Rupee?

The NPV is the sum of the present value of all current and future cash inflows and
outflows. Since the present value of a cashflow that occurs today is its face value,
the NPV of a project is the sum of any cashflows that occur at time zero plus the
present value of all future cashflows.
In the typical scenario in which there is an initial cash outlay for the acquisition of
an asset, followed by cash inflows throughout the useful life of the asset, the NPV
can be calculated as follows:

NPV  cash
= inflow  initial
n
(1+k) outlay
Where k is the discount rate, n is the number of periods from time zero in which
the cash inflow occurs, and the summation is over the n periods of the life of the
project. If the cash inflows are an annuity over the life of the project, the
numerator in the above equation can be moved outside of the summation to obtain
the following:

NPV annual cash 1

287
 = inflow x  (1+k)n  initial
outlay
The summation now depends only on k and n:

 __1___
(1+k)n
It is exactly this term that is provided in a present value table for annuities (see
Table 2 at the end of this chapter), where k represents the discount rate in the
column heading, and n represents the number of years (the row).

Example: The Sunrise Bakery is considering purchasing a new oven. The oven
will cost Rs.1,500, and the owner anticipates that the oven will increase the
bakery’s future net cash inflows by Rs.800 per year for the next five years. What
is the anticipated NPV of this capital acquisition, if the bakery’s discount rate is
10%?

NPV = (Rs.800 x 3.7908) – Rs.1,500 = Rs.3,033 – Rs.1,500 = Rs.1,533.

The factor 3.7908 comes from Table 2: the intersection of the column for 10% and
row 5.
Because NPV provides an absolute measure of the return from the project, not a
ratio, it tends to favor large projects. Also, the NPV calculation implicitly assumes
that free cash flows can be reinvested at the discount rate. Despite these potential
drawbacks, net present value is usually the most reliable criterion by which to
judge capital projects on an individual basis.

Internal Rate of Return:

The internal rate of return (IRR) is the discount rate computed such that the net
present value of the project equals zero. Software spreadsheet applications and
financial calculators usually include a function that calculates the IRR. The
following example illustrates how the IRR was approximated prior to the
widespread availability of these electronic tools.

288
Example: The Sunrise Bakery is considering an expansion to its outdoor dining
space that would require an initial cash outlay of Rs.26,000 and increase net cash
inflows by Rs.8,000 per year for four years. The owner of the bakery does not
anticipate any benefit from this expansion after year four, because at that time she
hopes to finance a major renovation of the building that would expand the indoor
dining area into the location of the patio. What is the IRR of the proposed
expansion to the current outdoor dining space?

Setting the NPV equal to zero in the NPV equation, and solving for the present
value factor:

0 = (Rs.8,000 x the present value factor) – Rs.26,000

 present value factor = 3.25

Looking in Row 4 of Table 2 (since the life of the annuity is four years), the
closest factor to 3.25 is 3.2397 in the column for 9%. Therefore, the IRR is
approximately 9%.

Relative to NPV, the advantage of IRR is that it provides a performance measure

that is independent of the size of the project. Hence, IRR can be used to compare
projects that require significantly different initial investments.

An important drawback of IRR is that it can induce managers to reject proposed

projects that shareholders would like the company to accept. For example, if the
manager is evaluated based on the average IRR of all capital projects undertaken,
and if a proposed capital project offers an IRR that is above the company’s cost of
capital, but below the average of all capital projects undertaken thus far, the
proposed project would adversely affect the manager’s performance measure,
although it would increase economic returns to shareholders.

289
IRR implicitly assumes that free cash flows can be reinvested at the computed
internal rate of return. This assumption is analogous to the assumption imbedded
in the NPV calculation that free cash flows can be reinvested at the discount rate.
However, in the context of IRR, the assumption is more problematic than in the
context of NPV if the IRR is unusually high or low.

Net Present Value and Internal Rate of Return, Compared:

There is an important and close relationship between NPV and IRR. The NPV is
greater than zero if and only if the IRR is greater than the discount rate. This
relationship implies that if a single proposed capital investment is considered in
isolation, both NPV and IRR will provide the same answer to the question of
whether or not the investment should be undertaken.

However, NPV and IRR need not provide the same answer if projects that require
different investments are compared. Consider the following example, comparing
two projects each with a one-year life. Assume a 10% discount rate in the NPV
calculation. In this simple setting with a one-year life, the IRR is easily calculated
as the profit divided by the initial investment.

Project Initial Payout at Net Present Value Internal

Investment end of year Rate of
Return
A Rs.1,000 Rs.1,200 Rs.91 [(1,200 ÷ 1.1) – 20%
1,000]
B Rs.100 Rs.200 Rs.82 [(200 ÷ 1.1) – 100%
100]

Hence, NPV favors Project A, while IRR favors Project B. What is the “correct”
answer? The answer depends on the opportunity cost associated with the
additional Rs.900 required to finance Project A compared with financing Project
B. For example, if the company has Rs.1,000 to invest and can replicate Project B
ten times, doing so would clearly be preferable to Project A. On the other hand, if
290
the company can earn only 1% on the Rs.900 additional funds available if Project
B is chosen over Project A, then the company prefers Project A, calculated as
follows:

Project NPV IRR

A Rs.91, as determined above 20%, as determined above
B plus Rs.900 Rs.8 [(Rs.1,109 ÷ 1.1) – (Rs.1,109  Rs.1,000) ÷ Rs.1,000
invested at 1% Rs.1,000] = 1.1%

The Rs.1,109 in the bottom row is the total payout at the end of the year from this
option, calculated as Rs.200 from Project B plus Rs.909 from the Rs.900
investment that earns 1%. The NPV of Rs.8 is actually less than the NPV from
Project B alone, because the NPV of the Rs.900 invested at 1% is negative.

In conclusion, NPV and IRR need not rank projects equivalently, if the projects
differ in size.

The Discount Rate

The discount rate is critical in determining whether the NPV of a project is
positive or negative (and equivalently, whether the project IRR is greater or less
than the discount rate). However, the choice of discount rate is seldom obvious.

In most situations, the appropriate discount rate is the company’s cost of capital.
The cost of capital is a weighted average of the company’s cost of debt and its
cost of equity. Interest rates on borrowings provide information about the cost of
debt. Determining the cost of equity is more difficult, and constitutes an important
topic in the area of finance. The Weighted Average Cost of Capital (WACC) is a
291
concept from corporate finance that frequently serves as an appropriate discount
rate for capital budgeting decisions. In some cases, however, the company would
benefit from distinguishing between the existing average cost of capital, and
the marginal cost of capital, because the cost of debt generally increases as
companies become more highly leveraged.

Many companies establish a company-wide hurdle rate, to communicate to

managers the appropriate discount rate for investment decisions. Often, the hurdle
rate seems to exceed the company’s cost of capital, which encourages managers to
act conservatively in their capital budgeting decisions: an outcome that is difficult
to justify with finance theory.

Another option for the discount rate is the opportunity cost associated with the
funds required for the capital project. In most cases, the cost of capital and the
opportunity cost should be approximately equal. However, most of us pay a higher
rate to borrow funds than we earn on our financial investments. Hence, if a
decision-maker has cash to either invest in a capital project or invest in the
financial markets, an appropriate discount rate for the capital project is the
opportunity cost of the earnings the decision-maker would have earned in the
financial markets. This rate is probably lower than the cost of raising additional
financing for the project.

292
4.8 PROBLEM OF BUDGETING IN HOSPITAL

PAYBACK PERIOD

The Payback Period represents the amount of time that it takes for a Capital
Budgeting project to recover its initial cost. The use of the Payback Period as a
Capital Budgeting decision rule specifies that all independent projects with a
Payback Period less than a specified number of years should be accepted. When
choosing among mutually exclusive projects, the project with the quickest
payback is preferred.

The calculation of the Payback Period is best illustrated with an example.

Consider Capital Budgeting project A which yields the following cash flows
over its five year life.

Year Cash Flow

0 -1000

1 500

2 400

3 200

4 200

5 100

293
To begin the calculation of the Payback Period for project A let's add an
additional column to the above table which represents the Net Cash Flow
(NCF) for the project in each year.

Cash Net Cash

Year
Flow Flow

0 -1000 -1000

1 500 -500

2 400 -100

3 200 100

4 200 300

5 100 400

Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 =
-100) while after three years the Net Cash Flow is positive (-1000 + 500 + 400
+ 200 = 100). Thus the Payback Period, or breakeven point, occurs sometime
during the third year. If we assume that the cash flows occur regularly over the
course of the year, the Payback Period can be computed using the following
equation:

294
 Thus, the Payback Period for project A can be computed as follows:

Payback Period

Payback Period = 2 + (100)/(200) = 2.5 years

Thus, the project will recoup its initial investment in 2.5 years.

NET PRESENT VALUE

The Net Present Value (NPV) of a Capital Budgeting project indicates the
expected impact of the project on the value of the firm. Projects with a positive
NPV are expected to increase the value of the firm. Thus, the NPV decision rule
specifies that all independent projects with a positive NPV should be accepted.
When choosing among mutually exclusive projects, the project with the largest
(positive) NPV should be selected.

The NPV is calculated as the present value of the project's cash inflows minus the
present value of the project's cash outflows. This relationship is expressed by the
following formula:

295
where

• CFt = the cash flow at time t and

• r = the cost of capital.

The example below illustrates the calculation of Net Present Value. Consider
Capital Budgeting projects A and B which yield the following cash flows over
their five year lives. The cost of capital for the project is 10%.

Project A Project B

Cash Cash
Year
Flow Flow

0 Rs.-1000 Rs.-1000

1 500 100

2 400 200

3 200 200

4 200 400

5 100 700

Net Present Value

Project A:

296
Project B:

Thus, if Projects A and B are independent projects then both projects should be
accepted. On the other hand, if they are mutually exclusive projects then Project A
should be chosen since it has the larger NPV.

INTERNAL RATE OF RETURN

The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount
rate at which the Net Present Value (NPV) of a project equals zero. The IRR
decision rule specifies that all independent projects with an IRR greater than the
cost of capital should be accepted. When choosing among mutually
exclusive projects, the project with the highest IRR should be selected (as long as
the IRR is greater than the cost of capital).

Where CFt = the cash flow at time t and

The determination of the IRR for a project, generally, involves trial and error or a
numerical technique. Fortunately, financial calculators greatly simplify this
process.

The example below illustrates the determination of IRR. Consider Capital

Budgeting projects A and B which yield the following cash flows over their five
year lives. The cost of capital for both projects is 10%.

297
 Project A Project B

Cash Cash
Year
Flow Flow

0 Rs.-1000 Rs.-1000

1 500 100

2 400 200

3 200 200

4 200 400

5 100 700

Internal Rate of Return

Project A:

Project B:

298
Thus, if Projects A snd B are independent projects then both projects should be
accepted since their IRRs are greater than the cost of capital. On the other hand, if
they are mutually exclusive projects then Project A should be chosen since it has
the higher IRR.

Accounting Rate of Return:

The accounting rate of return (ARR) is sometimes called the book rate of
return. Of the four capital project performance measures discussed in this
chapter, the accounting rate of return is the only performance measure that
depends on the company’s accounting choices. It is calculated as follows:

Accounting Rate of Return

=
Average Incremental Annual
Income from the Project
Average Net Book Investment in the Project

In the simple setting in which the capital project consists of the purchase of a
single depreciable asset, the numerator is the average incremental annual cash
inflow (additional revenues or the reduction in operating expenses) attributable
to the asset, minus the annual depreciation expense. The denominator is the net
book investment in the asset, averaged over the life of the asset.

299
Example: A machine costs Rs.12,000 and increases cash inflows by Rs.4,000
annually for four years. The machine has zero salvage value.

Depreciation expense = Rs.12,000 ÷ 4 = Rs.3,000 per year.

Incremental income from the machine = Rs.4,000 – Rs.3,000 = Rs.1,000 per

year.

Because income from the machine is identical in each year of its four-year life,
the average income over the life of the asset is also Rs.1,000 annually.

For the calculation of the Net Book Investment in the denominator, even
though the asset life is four years, five points in time must be considered: time
zero (the beginning of year one), and the end of years one through four. At the
time the machine is purchased (time zero), the net book investment equals the
purchase price of Rs.12,000. As the machine is depreciated, the accumulated
depreciation account balance increases, and the net book investment decreases.

Year Historical Cost Accumulated Net Book

Depreciation Investment
0 Rs.12,000 Rs. 0 Rs.12,000
1 12,000 3,000 9,000
2 12,000 6,000 6,000
3 12,000 9,000 3,000
4 12,000 12,000 0
The denominator in the accounting rate of return is calculated as

Rs.12,000 + = Rs.6,000
Rs.9,000 +
Rs.6,000 +
Rs.3,000 +

300
 Rs.0
5

The accounting rate of return is

Rs.1,000 = 16.7%
Rs.6,000
This calculation depends on the company’s
depreciation method. For example, if the company used double-declining
depreciation, the accounting rate of return would exceed 16.7% (the numerator
does not change, but the average net book investment decreases).
When straight-line depreciation is used, the calculation of the denominator
simplifies, because the average of any straight line is the midpoint of that line. The
midpoint is calculated as

Initial book value + ending book value

2

For the numerical example above, the calculation is

Rs.12,000 + = Rs.6,000
Rs.0
2

Graphically, this is illustrated as follows:

301
If the machine has a salvage value, and if the company accounts for that salvage
value by decreasing the depreciable basis of the asset, the salvage value has a
counterintuitive effect on the denominator of the ARR calculation: it actually
increases the company’s net book investment.
For example, assume that the machine in the example above has a salvage value
of Rs.4,000. In this case, the annual depreciation expense is (Rs.12,000 –
Rs.4,000) ÷ 4 = Rs.2,000. The schedule of net book investment is as follows:
Year Historical Cost Accumulated Net Book
Depreciation Investment
0 Rs.12,000 Rs. 0 Rs.12,000
1 12,000 2,000 10,000
2 12,000 4,000 8,000
3 12,000 6,000 6,000
4 12,000 8,000 4,000

The denominator in the accounting rate of return is then calculated as

Rs.12,000 + = Rs.8,000
Rs.10,000 +
Rs.8,000 +

302
 Rs.6,000 +
Rs.4,000
5

The accounting rate of return is then

Rs.4,000  Rs.2,000 = 25%

Rs.8,000
Again, because straight-line
depreciation is used, the denominator can be calculated more simply as

Initial book value + ending book value

2

which is now

Rs.12,000 + = Rs.8,000
Rs.4,000
2

and graphically

303
To illustrate how the accounting rate of return depends on the company’s choice
of accounting policies, assume that instead of treating the salvage value as a
reduction in the depreciable basis of the asset, the company treats the salvage
value as income in the year of disposal. In this case, the average annual income
from the asset is calculated as follows:

Rs.1,000 + = Rs.2,000
Rs.1,000 +
Rs.1,000 +
Rs.5,000
4 years

The average net book investment is Rs.6,000, as in the original example. The
accounting rate of return is now

Rs.2,000 = 33.3%
Rs.6,000

Hence, depending on how the company chooses to treat the salvage value of the
machine, the accounting rate of return is either 25%or33.3%.

The accounting rate of return can also be calculated year by year, instead of
averaging over the life of the project. In this case, the ARR provides information
about the impact of the project on the company’s (or division’s) return on
investment, which is an important performance measure discussed in Chapter 22.

Depreciation Expense, Income Taxes, and Capital Budgeting:

Because net present value and internal rate of return focus on cashflows, and
depreciation expense is not a cashflow, depreciation does not enter NPV and IRR
calculations directly. However, if income taxes are incorporated into the capital
budgeting decision (as should normally be the case), then depreciation expense
becomes relevant, because depreciation expense reduces taxable income, and
304
 hence, reduces tax expense. Obviously, the capital budgeting analysis should
incorporate depreciation expense as determined for tax reporting purposes, not for
financial reporting purposes, if there is a book-tax difference.

The reduction in taxes generated by depreciation expense is sometimes called

the depreciation tax shield.

The effect of income taxes can also be incorporated into the payback period and
the accounting rate of return in a straightforward manner. In other words, any of
these capital budgeting techniques can be applied on a pre-tax or a post-tax basis.

RESENT VALUE TABLES:

Table 1: Present value of Rs.1 received (or paid) n years from now
n 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 20%

305
1 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8333
2 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.6944
3 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.5787
4 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.4823
5 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4019
6 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.3349
7 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.2791
8 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.2326
9 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.1938
10 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.1615
11 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1346
12 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1122
13 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.0935
14 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.0779
15 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.0649
16 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0541
17 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0451
18 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0376
19 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0313
20 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0261

306
Table 2: Present value of an annuity of Rs.1 received (or paid) each year for the next n years

n 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 20%

1 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8333
2 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.5278
3 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.1065
4 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.5887
5 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 2.9906
6 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.3255
7 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 3.6046
8 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 3.8372
9 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.0310
10 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.1925
11 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 4.3271
12 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 4.4392
13 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 4.5327
14 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 4.6106
15 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 4.6755
16 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 4.7296
17 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 4.7746
18 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 4.8122
19 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 4.8435
20 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 4.8696

307
4.9 COSTING

INTRODUCION :

Costs: Resources sacrificed to achieve a specific objective, such as

manufacturing a particular product, or providing a client a particular service.

Sunk costs: These are costs that were incurred in the past. Sunk costs are
irrelevant for decisions, because they cannot be changed.

Opportunity cost: The profit foregone by selecting one alternative over

another. It is the net return that could be realized if a resource were put to its
next best use. It is “what we give up” from “the road not taken.”

Relevant costs: These are costs that are relevant with respect to a particular
decision. A relevant cost for a particular decision is one that changes if an
308
alternative course of action is taken. Relevant costs are also called differential
costs.

The following discussion elaborates on these definitions:

Costs:
Costs are different from expenses. Costs are resources sacrificed to achieve an
objective. Expenses are the costs charged against revenue in a particular
accounting period. Hence, “cost” is an economic concept, while “expense” is a
term that falls within the domain of accounting. Profit is calculated as
revenues minus expenses, and hence, profit is generally a function of various
accounting conventions and choices. Profits can be calculated for the
organization as a whole, or for a part of the organization such as a division,
product line, or individual product.

Costs can be classified along the following functional dimensions:

1. The value chain. The value chain is the chronological sequence of

activities that adds value in a company. For example, for a manufacturing
firm, the value chain might consist of research & development, design,
manufacturing, marketing and distribution.

2. Division or business segment: e.g., Chevrolet, Oldsmobile, G.M.C.

3. Geographic location.

Classification of costs according to the value chain is particularly important

for financial reporting purposes, because for external reporting, only
manufacturing costs are included in the valuation of inventory on the balance
sheet. Non-manufacturing costs are treated as period expenses. To some
extent, traditional management accounting systems have been influenced by
external reporting requirements, and consequently, costing systems usually
reflect this distinction between manufacturing and non-manufacturing costs.
309
Sunk Costs:
Sunk costs are costs that were incurred in the past. Committed costs are costs
that will occur in the future, but that cannot be changed. As a practical matter,
sunk costs and committed costs are equivalent with respect to their decision-
relevance; neither is relevant with respect to any decision, because neither can
be changed. Sometimes, accountants use the term “sunk costs” to encompass
committed costs as well.

Experiments have been conducted that identify situations in which individuals,

including professional managers, incorporate sunk costs in their decisions.
One common example from business is that a manager will often continue to
support a project that the manager initiated, long after any objective
examination of the project seems to indicate that the best course of action is to
abandon it. A possible explanation for why managers exhibit this behavior is
that there may be negative repercussions to poor decisions, and the manager
might prefer to attempt to make the project look successful, than to admit to a
mistake.

Some of us seem inclined to consider sunk costs in many personal situations,

even though economic theory is clear that it is irrational to do so. For example,
if you have purchased a nonrefundable ticket to a concert, and you are feeling
ill, you might attend the concert anyway because you do not want the ticket to
go to waste. However, the money spent to buy the ticket is sunk, and the cost
of the ticket is entirely irrelevant, whether it cost Rs.5 or Rs.100. The only
relevant consideration is whether you would derive more pleasure from
attending the concert or staying home on the evening of the concert.

Here is another example. Consider a student who is between her junior and
senior year in college, deciding whether to complete her degree. From a
financial point of view (ignoring nonfinancial factors) her situation is as
follows. She has paid for three years of tuition. She can pay for one more year
310
of tuition and earn her degree, or she can drop out of school. If her market
value is greater with the degree than without the degree, then her decision
should depend on the cost of tuition for next year and the opportunity cost of
lost earnings related to one more year of school, on the one hand; and the
increased earnings throughout her career that are made possible by having a
college degree, on the other hand. In making this comparison, the tuition paid
for her first three years is a sunk cost, and it is entirely irrelevant to her
decision. In fact, consider three individuals who all face this same decision,
but one paid Rs.24,000 for three years of in-state tuition, one paid Rs.48,000
for out-of-state tuition, and one paid nothing because she had a scholarship for
three years. Now assume that the student who paid out-of-state tuition
qualifies for in-state tuition for her last year, and the student who had the
three-year scholarship now must pay in-state tuition for her last year. Although
these three students have paid significantly different amounts for three years of
college (Rs.0, Rs.24,000 and Rs.48,000), all of those expenditures are sunk
and irrelevant, and they all face exactly the same decision with respect to
whether to attend one more year to complete their degrees. It would be wrong
to reason that the student who paid Rs.48,000 should be more likely to stay
and finish, than the student who had the scholarship.

Opportunity Cost:
As noted above, opportunity cost is the profit foregone by selecting one
alternative over another. Opportunity costs are relevant for many decisions,
but are sometimes difficult to identify and quantify, and are seldom recorded
in an organization’s accounting system.

A common and very important type of opportunity cost that arises in all
sectors of the economy is the opportunity cost associated with the limited
capacity of an asset. The asset might be a tangible asset such as a machine or a
factory, or it might be an intangible asset that may or may not be recorded in
the accounting records, such as human capital. For example, in a given period
of time such as a day or month, a machine can run only so many hours, a
311
factory can produce only so many units, and an employee can work only so
many hours. The appropriate way to analyze a decision of whether to accept a
new client or sales order, or to produce a new type of product, depends
fundamentally on whether the organization has the capacity to service the new
client, fill the sales order, or make the new product, without displacing
existing customers, orders or products. If the new client, sales order, or
product can be accommodated without displacing existing clients, orders or
products, the organization is described as having sufficient excess capacity,
whereas if the new client, sales order or product will displace existing clients,
orders or products, the organization is described as having a capacity
constraint. If the organization has a capacity constraint, then the decision of
whether to accept the new client or order, or produce the new product, should
consider the opportunity cost of clients, orders or products that will be
displaced. If the organization has excess capacity, the decision is typically
simpler: there is no opportunity cost arising from a capacity constraint, so the
appropriate decision depends only on the marginal costs and revenues from the
new client, order or product.

The term opportunity cost is sometimes ambiguous in the following sense.

Sometimes it is used to refer to the profit foregone from the next best
alternative, and sometimes it is used to refer to the difference between the
profit from the action taken and the profit foregone from the next best
alternative.

Example: Tina has Rs.5,000 to invest. She can invest the Rs.5,000 in a
certificate of deposit that earns 5% annually, for a first-year return of Rs.250.
Alternatively, she can pay off an auto loan on her car, which carries an interest
rate of 7%. If she pays off the auto loan, she will save Rs.350 (7% of
Rs.5,000) in interest expense. (In this context, a dollar saved is as good as a
dollar earned.)

312
Question: What is Tina’s opportunity cost from investing in the certificate of
deposit?

Answer: The opportunity cost is the “profit foregone” from the best action not
taken. The payoff from the action not taken is clear: it is the Rs.350 in interest
expense avoided by paying off the loan. However, there is some ambiguity as
to whether the opportunity cost is this Rs.350, or the difference between the
Rs.350, and the Rs.250 that would be earned on the certificate of deposit,
which is Rs.100.

This ambiguity is only a question of semantics with respect to the definition of

opportunity cost; it does not create any ambiguity with respect to the
information provided by the concept of opportunity cost. Clearly, the
opportunity cost of paying off the auto loan implies that Tina is better off
paying off the loan than investing in the certificate of deposit.

When opportunity cost is defined in terms of the difference between the two
profits (the Rs.100 in the above example), then the opportunity cost can be
either positive or negative, and a negative opportunity cost implies that the
action taken is better than all alternatives.

Relevant Costs:
Relevant costs are costs that change with respect to a particular decision. Sunk
costs are never relevant. Future costs may or may not be relevant. If the future
costs are going to be incurred regardless of the decision that is made, those
costs are not relevant. Committed costs are future costs that are not relevant.
Even if the future costs are not committed, if we anticipate incurring those
costs regardless of the decision that we make, those costs are not relevant. The
only costs that are relevant are those that differ as between the alternatives
being considered.

313
Including sunk costs in a decision can lead to a poor choice. However,
including future irrelevant costs generally will not lead to a poor choice; it will
only complicate the analysis. For example, if I am deciding whether to buy a
Toyota Camry or a Subaru Legacy, and if my auto insurance will be the same
no matter which car I buy, my consideration of insurance costs will not affect
my decision, although it will add a few numbers to my analysis.

Microeconomic Analysis and the Matching Principle:

The matching principle (matching expenses with the associated revenues)
provides useful information, if properly interpreted. However, there are ways
in which the matching principle can obscure relevant costs. For example, to
honor the matching principle, companies capitalize assets and depreciate them
over their useful lives. In manufacturing companies, depreciation expense in
any one year for assets used in production is allocated yet again, to individual
products made during the period. The result is that the cost of each unit of
product includes depreciation expense that represents the allocation of a cost
that was probably incurred years ago. However, except for any tax
implications that arise because depreciation expense reduces taxable income,
depreciation expense should be ignored with respect to all decisions.

4.10 BAICS OF COST ACCOUTING : TYPES AND ELEMENTS

Cost Accountancy
“It is the application of costing and cost accounting principle, method
and techniques to the science, art and practice of cost control and the
ascertainment of profitability. It includes the presentation of information
derived there from for the purpose of managerial decision – making”.

314
 The term ‘Cost Accountancy’ includes Costing and Cost accounting.
Its purposes are Cost-control and Profitability – ascertainment. It serves as an
essential tool of the management for decision – making.
Cost Accounting
“The process of accounting for cost from the point at which
expenditure is incurred or committed to the establishment of its ultimate
relationship with cost centres and cost units. In its widest usage it embraces the
preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of activities carried out or planned”
Cost accounting means such as analysis of accounting and other
information as to enable management to know the cost involved in each
activity together with its significant constituent elements in order to arrive at
proper decisions.Cost accounting provides management with cost data relating
to products, processes, jobs and different operations in order to control the
costs and maximize the earnings. It play a vital role in all the business
activities.
Definition of Cost Accounting
The application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the ascertainment
of profitability. It includes the presentation of information derived these from
for the purpose of managerial decision making.
Objects of Cost Accounting
1. To serve as a guide to price fixing of products.
2. To disclose sources to wastage in various operations of manufacture.
3. To reveal sources of economy in production process.
4. To provide for an effective system of stores and material.
5. To measure the degree of efficiency of the various departments or units
of production.
6. To provide suitable means and information to the top management to
control and guide the operations of the business organisation.
7. To exercise effective control on the costs, time and efforts of labour,
machines and other factors of production.

315
8. To compare actual costs with the standard costs and analyse the causes
of variation.
9. To provide necessary information to develop cost standards and to
introduce the system of budgetary control.
10. It enables the management to know where to economize on costs, how
to fix prices, how to maximize profit and so on.

TECHNIQUES AND METHOD OF COSTING

The types and techniques of costing are as follows:
1. Historial Costing:
‘The ascertainment of costs after they have been incurred’ Historical
costs are, therefore, ‘postmortem’ costs as under this method all the expenses
incurred on the production are first incurred and them the costs are ascertained.
2. Standard Costing:
‘The preparation and use of standard costs, their comparison with actual costs
and the analysis of variance to their causes and points of incidence’.
Here the standards are first set and then they are compared with actual
performances. The difference between the standard and the actual is known as
the variance. The variances are analyzed to find out their causes and also the
points or locations at which they occur.
3. Marginal Costing:
‘The ascertainment of marginal costs and of the effects on profit of changes in
volumes or type of output by differentiating between fixed costs and variable
costs’.
The fixed costs are those which do not change but remain the same,
with the increase or decrease in the quantum of production. The variables costs
are those which do change proportionately with the change in quantum of
production.
The marginal costing takes into account only the variable costs to find
out ‘marginal costs’. The difference between Sales and Marginal costs is
known as ‘Contribution’ and contribution is an aggregate of Fixed costs and
Profit/Loss. So the fixed costs are deducted from the contribution to find out
the profits. Marginal costing is a technique to ascertain the effect on profits.
316
Marginal costing is a technique to ascertain the effect on profit by the change
in the volume of output or by the change in the type of output.
4. Direct Costing:
The practice of charging all direct cost to operations, process or products,
leaving all the indirect costs to be written off against profits in the period in
which they arise
5. Absorption Costing
‘The practice of charging all costs, both variables and fixed, to operations,
processes or products.
This is the traditional technique as opposed to Marginal or Direct costing
techniques. Here both the fixed and variables cost are charged in the same
manner.
Methods of Costing
The methods of costing can be divided into three main groups:
1. Job Costing;
2. Process Costing; and
3. Farm Costing.
1. Job Costing: The job costing methods are applicable where the unit of
manufacture is one and complete in itself. They include printers, job foundries,
tool manufactures, contractors, etc. the following methods are included in Job
Costing:
(i) Contract Costing: This method if applied in undertakings erecting
buildings or carrying out constructional works, e.g., House buildings, ship
building, Civil Engineering contracts. Here the cost unit is one and completed
in itself. The cost unit is a contract which may continue for over more than a
year. It is also known as the Terminal Costing, since the works are to be
completed within a specified period as per terms of contract or agreement
executed by the contractor and contractee.
Contracts can be differentiated from fobs in as much as the contracts jobs are
carried out outside the factory and generally are of a long-term while jobs are
carried out inside the factory and are of a short duration. If an order complete
in itself and meant only for the person who has placed the order, this job-order

317
is executed inside the press and the completion of the order takes a short time
as against the contract which may take years.
(ii) Batch Costing: In this method, a batch of similar or identical products
is treated as a job. Here the unit of cost is a batch of group of products, costs
are collected and analyzed according to batch numbers and the costs are
ascertained batch wise. This method is applied in pharmaceutical industries
where medicines or injections are manufactures batch wise or in general
engineering factories producing components in convenient batches.
1. Process Costing: Process costing method is applicable to those
industries manufacturing an number of units of output requiring processing.
Here an article has to undergo two or more processes for reaching the stage of
finished goods and succeeding process till completion.
Classification of Cost
The cost-classification is the process of grouping costs according to
their characteristics. The cost can be classified into the following:
1. According to elements;
2. According to Functions or Operations;
3. According to Nature or Behaviour,
4. Accounting to Controllability,
5. According to Normality,
6. According to Relevance to decision-making and Control.
• According to Elements: The cost is classified into i) Direct Cost, and
ii) Indirect Cost according to elements, viz., Materials, Labour and Expenses,
the description of which occurs in the earlier pages of this chapter.
• According to Functions: the cost is classified into the following:
i) Production Cost or Manufacturing Cost,
ii) Administration Cost,
iii) Selling Cost, and
iv) Distribution Cost,

A brief description of each these items are given below:

318
i) Production Cost is ‘The cost of sequence of operation which begins
with supplying materials, labour and services and ends with primary packing
of the product’.
It is also known as Manufacturing of Factory Cost.
ii) Administration Cost is “The Cost of formulating the policy, directing
the organisation and controlling the operations of an undertaking, which is not
related directly to a production, selling, distribution, research or development
activity or function.” Administration Cost comprise office and Administration
expenses.
iii) Selling Cost is “The cost of seeking to create and stimulate demand
(sometimes termed ‘marketing’) and of securing order.”
It is also known as Selling expenses or Selling overheads which include all the
expenses of Selling Department.
iv) Distribution Cost is “The cost of sequence of operations which begins
with making the packed product available for dispatch and ends with making
the re-conditioned returned empty package, if any, available for re-use”.
It is known as Distribution expenses or overheads which include expenses like
packing, warehouse expenses, cost of freight, shipping charges and also the
expenses of re-conditioning the returning empty packages for using them
again.
• According to Nature or Behaviour: Cost can be classified into
i) Fixed Cost ii) Variable Cost, and iii) Semi-Fixed for Semi-variable
Cost.
i) Fixed Cost is “A cost which tends to be unaffected by variations in
volume of output. Fixed costs depend mainly on the effluxion of time and do
not vary directly with volume of rate of output. Fixed Costs are sometimes
referred to as period costs in systems of direct costing.” Fixed costs or Fixed
expenses are those expenses which do not change with the increase or decrease
in the quantum of production but remain stable. They are period costs, e.g.,
Rent of Building, Salaries etc.
ii) Variable Cost is “A cost which tends to vary directly with volume of
output, Variable costs are sometimes referred to as direct costs in systems of
direct costing.” Variable costs or expenses are those which increase in direct
319
proportion with the increase in production or which decrease in direct
proportion with the decrease in production, e.g., Direct Materials, Direct
Labour, Power, Fuel etc.
iii) Semi-fixed or Semi-variable cost is “A cost which is partly variable.”
This is a cost with changes but not in direct proportion to the increase or
decrease in the production-output, e.g., Repairs and Maintenance, Salary of
supervisors etc.
• According to controllability: The cost can be divided into:
i) Controllable Cost, ii) Uncontrollable Cost.

i) Controllable Cost: This is a cost which can be influenced by the action

of a specified member of an undertaking. The organisation is divided into
departments or responsibility centres each managed by a Head. The costs of a
particular department or centre re guided by the person-in-charge of the
department. The costs which can be controlled by a ‘specified member’ who is
generally an important link in the management are the controllable costs. they
Head of a cost-centre or a department ahs control over variable costs only
which include Prime cost and other variable overheads. So the controllable
costs are the variable costs.
v) Uncontrollable Costs: it is a cost which cannot be influenced by the
action of a specified member of an undertaking. Uncontrollable costs are
generally the Fixed costs, the control of which does nto lie within the province
of a member of the undertaking. The change in Fixed costs is a mater to be
decided at the top level of the management depending upon the policy of the
undertaking. Another example of he uncomtrollable cost is where the cost of
one department is shared by the other department for reason that the other
department is taking the benefit of services of the department. Suppose, the
cost of Power departments is shared by the Machine Department, the cost of
this share is uncontrollable as it has no control over the cost of the other
department, viz., the Power Department.
• According to Normality:
The cost is classified into i) Normal cost, and ii) Abnormal cost

320
i) Normal Cost: It is the cost at a given level of output in the condition at
which that level of output is normally attained.
ii) Abnormal cost: it is a cost which is beyond normal cost.
• According to relevance to decision-making and Control:
The costs classified on this basis are the following
i) Shut-down Cost: A cost which will still be required to be incurred even
though a plant is closed or shut-down for a temporary period, e.g., the cost of
rent, rates, depreciation, maintenance etc., is known as shut-down cost.
ii) Shun Cost: A cost which has been incurred in the past or sunk in the
past and is not relevant to the particular decision-making is a sunk cost. If it is
decided to replace the existing plant; the written down book value of the plant
less the sale value of the existing plant, is a Sunk a Irrevocable cost.
iii) Opportunity Cost: “The net selling price, rental value or transfer value
which could be obtained at a point in time if a particular asset or group of
assets were to be sold, hired, or put to some alternative use available to the
owner at that time” is the opportunity cost. The cost which are related to the
sacrifice made or the benefits foregone are opportunity costs. to take an
example, if a part of the factory building has been let out on rent and now we
want to use that portion for installing a plant, we would naturally lose the rent
that we used to get. So the loss of rent is the opportunity which would arise
due to putting the part of that factory building to an alternative use available to
the owner, and this cost should be kept in view while installing the plant.
iv) Imputed cost: it is hypothetical cost required to be considered to make
costs comparable. If the owner of the factory charges rent of the factory to the
cost of production to make cost comparable with that of those undertakings
which run production in rented factories, it is an Imputed cost as the rent has
actually not been paid. Some is the case with charging Interest on one’s own
capital.

4.11 COST BEHAVIOUR

321
Introduction:
The most important building block of both microeconomic analysis and cost
accounting is the characterization of how costs change as output volume
changes. Output volume can refer to production, sales, or any other principle
activity that is appropriate for the organization under consideration (e.g.: for a
school, number of students enrolled; for a health clinic, number of patient
visits; for an airline, number of passenger miles). The following discussion
examines the volume of production in a factory, but the same principles apply
regardless of the type of organization and the appropriate measure of activity.

Costs can be variable, fixed, or mixed.

Variable Costs:
Variable costs vary in a linear fashion with the production level. However,
when stated on a per unit basis, variable costs remain constant across all
production levels within the relevant range. The following two charts depict
this relationship between variable costs and output volume.

322
A good example of a variable cost is materials. If one pair of pants requires Rs.10
of fabric, then every pair of pants requires Rs.10 of fabric, no matter how many
pairs are made. The fabric cost is Rs.10 per unit at every level of production. If
one pair is made, the total fabric cost is Rs.10; if two pairs are made, the total
fabric cost is Rs.20; and if 1,000 pairs are made, the total fabric cost is Rs.10,000.
Hence, the total cost is increasing and linear in the production level.

Fixed Costs:
Fixed costs do not vary with the production level. Total fixed costs remain the
same, within the relevant range. However, the fixed cost per unit decreases as
production increases, because the same fixed costs are spread over more units.
The following two charts depict this relationship between fixed costs and output
volume.

323
In this example, fixed costs are Rs.50,000. The first chart shows that fixed costs
remain Rs.50,000 at all production levels from 100 units to 1,000 units. The
second chart shows that the fixed cost per unit decreases as production increases.
Hence, when 100 units are manufactured, the fixed cost per unit is Rs.500
(Rs.50,000 ÷ 100). When 500 units are manufactured, the fixed cost per unit is
Rs.100 (Rs.50,000 ÷ 500).
324
Relevant Range:
The relevant range is the range of activity (e.g., production or sales) over which
these relationships are valid. For example, if the factory is operating at capacity,
increasing production requires additional investment in fixed costs to expand the
facility or to lease or build another factory. Alternatively, production might be
reduced below a threshold at which point one of the company’s factories is no
longer needed, and the fixed costs associated with that factory can be avoided.
With respect to variable costs, the company might qualify for a volume discount
on fabric purchases above some production level. The relevant range for
characterizing fabric as a variable cost ends at that production level, because the
fabric cost per unit of output is different when the factory produces above that
threshold than when the factory produces below that threshold.

Mixed Costs:
If, within a relevant range, a cost is neither fixed nor variable, it is called semi-
variable or mixed. Following are two common examples of mixed costs.

325
In this example, although the total cost line increases in production, it does not
pass through the origin because there is a fixed cost component. An example of a
cost that fits this description is electricity. A fixed amount of electricity is required
to run the factory air conditioning, computers and lights. There is also a variable
cost component related to running the machines on the factory floor. The fixed
component in this example is Rs.3,000 per month. The variable cost component is
Rs.10 per unit of output. Hence, at a production level of 500 units, the total
electric cost is Rs.8,000 [Rs.3,000 + (Rs.10 x 500)].

326
The mixed cost illustrated in the above chart is called a step function. An example
of such cost behavior would be the total salary expense for shift supervisors. If the
factory runs one shift, only one shift supervisor is required. In order for the factory
to produce above the maximum capacity of a single shift, the factory must add a
second shift and hire a second shift supervisor, so that total shift supervisor salary
expense doubles. If the factory runs three shifts, three shift supervisors are
required.

Cost Behavior Assumptions in Management Accounting Versus

Microeconomics:
Microeconomic analysis usually assumes decreasing marginal costs of production,
sometimes followed by increasing marginal costs of production beyond a certain
production level. Hence, economists’ graphs of the total cost of production and the
average per-unit cost of production show smooth, curved functions. Management
accountants usually assume the linear relationships depicted in the previous
graphs. Linearity is a more accurate description of many situations encountered by
management accountants than the economists’ curves, and even when linearity
constitutes a simplifying assumption it is almost always sufficiently descriptive
for the task at hand.

4.12 COST CENTRES

COST-CENTRE AND COST-UNIT

Cost are ascertained according to Cost Centres or Cost Units.

Cost-centre

A Cost-Centre is a very wide term and includes the Productions.

Department Processes, Work orders, Service Department, Operations,
Machine Centers, Area or regions of sales, Warehouses, Persons, etc., of
which the cost is to be ascertained. A Cost-Centre can be classified into
the following four types:

327
 1. Impersonal, 2. Personal, 3. Operation, 4. Process.

For manufacturing operations, the cost centres may be Production cost

centers, i.e., the Production Departments engaged in producing, or the
Service cost-centres, i.e., the Service Departments which help the
production work e.g., Store, Power Dept. Internal Transport Dept., Repairs
and Maintenance Dept., etc.,

For sales operations, the cost-centres, all the machine or the persons
operating those machines are brought together under one cost-centre for
determination and control of costs. where the work is carried on through
processes, each process is a cost centre. A machine or a group of machines
can also be cost-centre. The Cost Centres are very useful for analysis,
ascertainment and control of costs.

Cost Unit

A Cost Unit is a unit of quality of product, service, or time (or a

combination of these) in relation to which costs may be ascertained or
expressed.

Job is a cost unit which consists of a single order (or contract).

Batch is a cost unit which consists of a group of identical items which

maintains its identity throughout one or more stages of production.

Product Group is a cost unit which consists of a group of similar products.

Thus, cost unit is a sub-division into proper nomenclatures attributable to a

unit of measurements of cost. Cost Units are of two types: 1) Single. 2)
Composite. The examples of Single Cost unit are-per tone, per meter, per
kilogram etc., and the examples of composite units are-per passenger-
kilometer, per tone-kilometer etc.

INSTALLATION OF COSTING SYSTEM

The need and importance of the installation and the organisation of a good
system of cost accounting are being increasingly realized presently all over
328
the business versatility. The common experience of enthusiastic youths
climbing the business – tree and falling mid-way without even collecting
the leaves owes to the ignorance of he use installation and organisatoin of
accosting system, and to the infatuation that the profits could be earned
without it. A good system is the key-point governing, the mechanism of
an enterprise in the field of cost control, ascertainment of profitability, and
managerial decision-making.

Installation of a cost system is not an expense but an investment as the

rewards are much greater than the expenses incurred. The cost system is
for the business and not the business for a system of cost. Therefore, the
system has to be so designed as to meet the specific needs of the
enterprise.

A) General Consideration for installing Costing System

The general considerations to be observed in installing a costing system

are as follows:

• The Objective: Whether the objective of installing the costing

system is limited to a specific area, e.g. material management, or
fixing selling price. Or to arrive at a certain managerial decision; or
the object is to install the system for covering all the aspects of cost
affecting the business. The approach to install the system will be
dependent on its objectives.

• The Area of Operation: Having decided the objective, the areas of

operation of the system are to be studied, by which the
management can be best benefited. If production is slack, attention
will have to be paid to increase it; if production is good but the
sales are receding, study will be made to increase the sales and
action taken according to the results of study and analysis. Such

329
 areas which require immediate attention are to be carved out on
priority basis to be handled by the cost system,

• The Organisation of the Business: No system of cost installation

would succeed until the organisation structure of the business is
taken into account. The organizational part would help to
determine the scope of working and improvement. If the interests
of management call for certain minor changes in the organizational
structure, to its advantage, the same may have to be done.

• The Conception & Reception of the Idea: The idea of the

installation of the cost system is to be placed before the staff and
the workers in a manner that it is well received and not objected to
on flimsy grounds. The success of the system would depend on the
cooperation of he persons engaged in the enterprise, and the
cooperation will be forth coming only if the idea and plans are well
conceived and received. The benefits of introducing the system to
all the sections should be well explained.

• Collection of Data & Prompt Information: The cost data works as a

base for decision-making. There should be evolved a proper system
for the collection of the required cost data and information
promptly. Secondly, there should be a system to verify the
correctness of the data supplied, otherwise the conclusions drawn
would be wrong and time spent in its working would go waste.

• Cost Records & Cost Books: The maintenance of cost records and
cost books depends on the size and nature of the business, but the
basic requirements. The manner in which the financial accounts
could be interlocked into an integral accounting system has to be
studied and worked out. Decision has to be taken if two separate
set of books-one for financial accounts and other for cost accounts-
have to be maintained and thereafter the results are to be reconcile.
Proper books and records are to be kept and maintained to meet the
requirements of either of the two situations mentioned above.
330
 • Control system for the Elements of Cost: System would have to be
devised for recording and controlling costs of materials, labour and
overheads, in accordance with costing principles and procedures.

• Type and Method of Costing: The choice of method of costing

would depend on the nature of production, e.g., Job Cost method or
the Process Cost method. For cost control, standard costing along
with Budgetary control may have to be selected and applied.
Similarly, for decision making, Marginal and Differential costing
techniques may be found useful. Preparations for the application of
the particular method and technique/type should be made initially.

• Responsibility Accounting: Responsibility accounting is a

technique of cost control by delegating, etc., known as
responsibility centres. Its has to be judged whether a particular
official who had been assigned a particular function, has
implemented the same or not within the time’ allotted to him, or
not, and thus the responsibility has got to be fixed for failure-action
on individual persons, for the sake of control of cost. For this
purpose, a system of responsibility accounting should be evolved.

B) Specific considerations for installing costing system

The specific considerations as distinct from general considerations to be

kept in view while installing a cost system are as follows:

• Size and Nature of Business: In a business of big size, a detailed

cost system is necessary while in a small business, the system
should be within the requirements so that the expenses on the
installation and its working may not out-weigh the utility.

• The cost system is good for business engaged in manufacturing or

in service-rendering concerns but for others. Even in production
enterprise like colliery where the production costs are all direct
costs, the financial where the production costs are all direct costs,

331
 the financial accounts may be so designed as to obviate the need of
any cost system, unless otherwise called for.

• Products: the nature of product determines the method of costing to

be applied. If the material content of the product is more valuable,
the material cost records need be kept in comparatively more
elaborate manner so as to make material cost control effective.
Same is the position with regard to labour and overhead.

• Organisatoin: The organizational set up for a costing system should

be modeled that the control part is exercised by the Cost
Accountant, as such, the present organizational set up of the
costing department need close study to suggest necessary changes.

• Functional study: The functional divisions of an undertaking based

on cost are a) Manufacturing, b) Administration, and c) Selling &
Distribution. A study of the present working of the different
departments in necessary to suggest improvements.

C) Principles for Smooth Working

The following principles should be kept in mind while introducing the cost
system:

• The system should be simple and easy to operate.

• The system should be flexible, so that it may be expanded or

contracted per needs of the business.

• The existing pattern should be disturbed only as little as may be

considered desirable.

• The desired changes be introduced gradually and not in haste.

• Confidence be created by the Cost accountant in the minds of

management and

332
 • Executives regarding the utility of the system, so as to avoid
unnecessary criticism

• And to obviate obstacles.

D) Line of Action

The following line of action is recommended for the installation of cost

system.

• Determination of the type of costing and the method of costing, as

may be suitable for the undertaking.

• To prepare forms, card, report-performs, books etc., for keeping

records of all the elements of cost, viz., material, labour and
overheads.

• To decide issues regarding material cost control, i.e., purchase,

storing, issue and valuation.

• To decide matters regarding labor cost control, i.e., job evaluation,

merit rating, appointment, time recording, division of work,
remuneration of labour and other allied problems like idle time,
overtime, labour turnover, casual workings, etc.

• Where the work is carried on more by machines, proper records be

kept for the machines.

• To suggest a suitable system for the collection, classification and

analysis of all.

• Types of everheads, i.e., manufacturing, administrative, and selling

& distributive.

• To decide the methods of allocation and apportionment of

overheads among the production departments and Service
departments which should be earlier clearly demarcated, and to
decide the method of absorption of overheads.

333
 • To decide normal capacity of production and prepare budgets and
standards.

• To maintain books of cost control based on double-entry principle.

• To devise information system by which the costing department

may communicate to other departments and receive reports and
other necessary informations promptly .

Cost Centers and Departments:

A cost center represents the smallest segment of an organization for which

costs are collected and reported. A department is an organization with one or
more operational objectives or responsibilities that exist independently of its
manager and has one or more workers assigned to it.

The following two components need to be considered in designing your

enterprise structure:

Cost centers

Departments

COST CENTERS
A cost center also represents the destination or function of an expense as
opposed to the nature of the expense which is represented by the natural
account. For example, a sales cost center indicates that the expense goes to the
sales department.

A cost center is generally attached to a single legal entity. To identify the cost
centers within a chart of accounts structure use one of these two methods:

334
Assign a cost center value in the value set for each cost center. For example,
assign cost center values of PL04 and G3J1 to your manufacturing teams in
the US and India. These unique cost center values allow easy aggregation of
cost centers in hierarchies (trees) even if the cost centers are in different
ledgers. However, this approach will require defining more cost center values.

Assign a balancing segment value with a standardized cost center value to

create a combination of segment values to represent the cost center. For
example, assign the balancing segment values of 001 and 013 with cost center
PL04 to represent your manufacturing teams in the US and India. This creates
001-PL04 and 013-PL04 as the cost center reporting values.

The cost center value of PL04 has a consistent meaning. This method requires
fewer cost center values to be defined. However, it prevents construction of
cost center hierarchies using trees where only cost center values are used to
report results for a single legal entity. You must specify a balancing segment
value in combination with the cost center values to report on a single legal
entity.
Departments

A department is an organization with one or more operational objectives or

responsibilities that exist independently of its manager. For example, although
the manager may change, the objectives do not change. Departments have one
or more workers assigned to them.

335
4.13 COST VOLUME PROFIT ANALYSIS / BREAKEVEN ANALYSIS

The Basic Profit Equation:

Cost-Volume-Profit analysis (CVP) relates the firm’s cost structure to sales

volume and profitability. A formula that facilitates CVP analysis can be easily
derived as follows:

Profit = Sales – Expenses

Profit = Sales – (Variable Costs + Fixed Costs)

Profit + Fixed Costs = Sales – Variable Costs

336
 Profit + Fixed Costs = Units Sold x (Unit Sales Price – Unit
Variable Cost)

This formula is henceforth called the Basic Profit Equation and is abbreviated:

P + FC = Q x (SP – VC)

Contribution margin is defined as

Sales – Variable Costs

The unit contribution margin is defined as

Unit Sales Price – Unit Variable Cost

Typically, the Basic Profit Equation is used to solve one equation in one
unknown, where the unknown can be any of the elements of the equation. For
example, given an understanding of the firm’s cost structure and an estimate of
sales volume for the coming period, the equation predicts profits for the period.
As another example, given the firm’s cost structure, the equation indicates the
required sales volume Q to achieve a targeted level of profits P. If targeted profits
are zero, the equation simplifies to

Q = FC ÷ Unit Contribution Margin

In this case, Q indicates the required sales volume to break even, and the exercise
is called breakeven analysis.

CPV analysis can be depicted graphically. The graph below shows total revenue
(SP x Q) as a function of sales volume (Q), when the unit sales price (SP) is
Rs.12.

337
The following graph shows the total cost function when fixed costs (FC) are
Rs.4,000 and the variable cost per unit (VC) is Rs.5.

338
The following graph combines the revenue and cost functions depicted in the
previous two graphs into a single graph.

The intersection of the revenue line and the total cost line indicates the breakeven
volume, which in this example, occurs between 571 and 572 units. To the left of
this point, the company incurs a loss. To the right of this point, the company
generates profits. The amount of profit or loss can be measured as the vertical
distance between the revenue line and the total cost line.

Assumptions in CVP Analysis:

The Basic Profit Equation relies on a number of simplifying assumptions.

1. Only one product is sold. However, multiple products can be accommodated

by using an average sales mix and restating Q, SP and VC in terms of a
representative bundle of products. For example, a hot dog vendor might calculate
that the “average” customer buys two hot dogs, one bag of chips, and two-thirds

339
of a beverage. Q is the number of customers, and SP and VC refer to the sales
price and variable cost for this “average” customer order.

2. If the equation is applied to a manufacturer, beginning inventory is assumed

equal to zero, and production is assumed equal to sales. Relaxing these
assumptions requires additional structure on the equation, including specifying an
inventory flow assumption (e.g., FIFO or LIFO) and the extent to which the
matching principle is honored for manufacturing costs.

3. The analysis is confined to the relevant range. In other words, fixed costs
remain unchanged in total, and variable costs remain unchanged per unit, over the
range of Q under consideration.

Target Costing:
A relatively recent innovation in product planning and design is called target
costing. In the context of the Basic Profit Equation, target costing sets a goal for
profits, and solves for the unit variable cost required to achieve those profits. The
design and manufacturing engineers are then assigned the task of building the
product for a unit cost not to exceed the target. This approach differs from a more
traditional product design approach, in which design engineers (possibly with
input from merchandisers) design innovative products, manufacturing engineers
then determine how to make the products, cost accountants then determine the
manufacturing costs, and finally, merchandisers and sales personnel set sales
prices. Hence, setting the sales price comes last in the traditional approach, but it
comes first in target costing.

Target costing is appropriate when SP and Q are predictable, but are not choice
variables, such as might occur in well-established competitive markets. In such a
setting, merchandisers might know the price that they want to charge for the
product, and can probably estimate the sales volume that will be achieved at that
price. Target costing has been used successfully by a number of companies
including Toyota, which redesigned the Camry around the turn of the century as
part of a target costing strategy.
340
Constrained Resources:
Contribution margin analysis plays an important role when a multi-product
organization has a binding resource constraint. The resource constraint can take
many forms, such as production throughput on a critical machine, freezer space,
or skilled labor hours in a particular function. In the presence of a resource
constraint, the optimal production decision is to maximize the contribution margin
per unit of the constraint.

For example, assume that a company makes small widgets and large widgets.
Small widgets incur Rs.5 in variable manufacturing and non-manufacturing costs,
and sell for Rs.10. Large widgets incur Rs.11 in variable manufacturing and non-
manufacturing costs, and sell for Rs.15. If production throughput is constrained by
the capacity of a particular machine, and both small and large widgets require one
hour of processing time on that machine, then the company should make only
small widgets, because small widgets provide a contribution margin of Rs.5 per
unit, whereas large widgets provide a contribution margin of Rs.4 per unit. On the
other hand, if each small widget requires two hours of processing time on the
machine, and large widgets require only one hour, then the company should make
only large widgets, calculated as follows:

Small widgets: contribution margin per machine hour = (Rs.10 - Rs.5) ÷ 2 =

Rs.2.50 per hour

Large widgets: contribution margin per machine hour = (Rs.15 - Rs.11) ÷ 1 =

Rs.4.00 per hour

The company maximizes profits by making large widgets, even though large
widgets have a lower contribution margin per unit than small widgets, because
large widgets require less machine time and hence, are more efficient with respect
341
to the limited resource. In other words, the large widgets generate a higher
contribution margin per hour on the machine that constitutes the capacity
constraint of the factory.

Leverage:
There is often a trade-off between fixed cost inputs and variable cost inputs. For
example, in the manufacturing sector, a company can build its own factory
(thereby operating with relatively high fixed costs but relatively low variable
costs) or outsource production (operating with relatively low fixed costs but
relatively high variable costs). A merchandising company can pay its sales force a
flat salary (relatively higher fixed costs) or rely to some extent on sales
commissions (relatively higher variable costs). A restaurant can purchase the
equipment to launder table cloths and towels, or it can hire a laundry service.

A company that has relatively high fixed costs is more highly leveraged than a
company with relatively high variable costs. Higher fixed costs result in greater
downside risk: as Q falls below the breakeven point, the company loses money
more quickly than a company with less leverage. On the other hand, the
company’s lower variable costs result in a higher unit contribution margin, which
means that as Q rises above the breakeven point, the more highly-leveraged
company is more profitable.

There is an ongoing trend for companies to outsource support functions and other
“non-core” activities to third party suppliers and providers. Usually, outsourcing
reduces the leverage of the company by eliminating the fixed costs associated with
conducting those activities inside the firm. When the activities are outsourced, the
contractual payments to the outsource providers usually contain a large variable
cost component and a relatively small or no fixed cost component.

Examples:
Breakeven: Steve Poplack owns a service station in Walnut Creek. Steve is
considering leasing a machine that will allow him to offer customers the
342
mandatory California emissions test. Every car in the state must be tested every
two years. The machine costs Rs.6,000 per month to lease. The variable cost per
test (i.e., per car inspected) is Rs.10. The amount that Steve can charge each
customer is set by state law, and is currently Rs.40.

How many inspections would Steve have to perform monthly to break even from
this part of his business?

Q = FC ÷ Unit Contribution Margin

Q = Rs.6,000 ÷ (Rs.40 - Rs.10) = 200 inspections

Targeted profits, solving for volume: Refer to the information in the previous
question. How many inspections would Steve have to perform monthly to
generate a profit of Rs.3,000 from this part of his business?

P + FC = Q x (SP – VC)
Rs.3,000 + Rs.6,000 = Q x (Rs.40 - Rs.10)
Q = 300 inspections

Targeted profits, solving for sales price: Alice Waters (age 9) runs a lemonade
stand in the summer in Palo Alto, California. Her daily fixed costs are Rs.20. Her
variable costs are Rs.2 per glass of ice-cold, refreshing, lemonade. Alice sells an
average of 100 glasses per day. What price would Alice have to charge per glass,
in order to generate profits of Rs.200 per day?

P + FC = Q x (SP – VC)
Rs.200 + Rs.20 = 100 x (SP - Rs.2)
SP = Rs.4.20 per glass

Contribution margin: Refer to the previous question. What price would Alice have
to charge per glass, in order to generate a total contribution margin of Rs.200 per
day?

343
Total CM = Q x (SP – VC)
Rs.200 = 100 x (SP - Rs.2.00)
SP = Rs.4.00 per glass

Target costing: Refer to the information about Alice, but now assume that Alice
wants to charge Rs.3 per glass of lemonade, and at this price, Alice can sell 110
glasses of lemonade daily. Applying target costing, what would the variable cost
per glass have to be, in order to generate profits of Rs.200 per day?

P + FC = Q x (SP – VC)
Rs.200 + Rs.20 = 110 x (Rs.3 – VC)
VC = Rs.1

344
4.14 HOSPITAL RATE SETTING / PRICING DECISION
HOSPITAL CHARGE SETTING PRACTICES

Goals in Charge Setting

Each respondent was first asked to describe the goals of their charge master
update process. A majority of respondents mentioned compliance with federal
regulators as a primary goal. A number of other hospitals did not explicitly list
compliance as a goal, but indicated that ‘it was simply a given’ when probed.
In order to receive appropriate payment, hospitals must comply with CMS
laws and regulations by following the appropriate coding and charging
procedure(s).

Inaccuracies in the charge master can lead to fines, penalties, and

imprisonment. Representative comments include: “Another goal is to ‘stay out
of prison’– the charge master is used as a basis for our
ability to comply with billing and regulations.” “Our number one goal is to
stay in compliance. We have a multi-disciplinary group that monitors coding
or charge changes.”

“The main goal is that we are compliant from a coding perspective.” For
almost all respondents, charge practices are at least partly driven by financial
pressures. Examples of respondent comments are presented below: “Our price
updates focus on the areas that give us the ‘biggest bang for the buck’.” “Our
key goal with the charge master is to help the hospital meet its profitability and
cash flow needs. We try to take advantage of those payers on a percent of
charge arrangement, so we capture all the revenue codes.”

345
“Our first priority is making sure we can meet the bottom line.”
“We want a competitive charge structure – we are a small hospital and have a
very small margin.”

Hospitals in large urban areas and major teaching hospitals tended to place
greater importance on the relationship between costs and charges and were
concerned about their hospital’s ability to cover operating costs. This variation
is likely due to the greater resources of these larger facilities, which often have
cost accounting systems and specified procedures to track costs. About a third
of all hospitals volunteered that covering hospital costs was a goal of their
charge master system and process.

Influencing Factors in Charge Setting

Respondents were then asked to score the importance of the following
influencing factors on a scale of one to five, with five being “highly
important,” and one being “not important”:
1. Overall cost inflation;
2. Changes in costs of specific services/procedures/devices;
3. Hospital mission;
4. Competitive forces;
5. Influence of specific payers;
6. Community perception;
7. Managed care contract terms;
8. Indirect cost allocation; and
9. Other factors

The Role of Cost in Setting Prices

Introduction:
This chapter discusses the role that product costs play in setting sales prices.
For most companies operating in competitive markets, as well as for
unregulated monopolies (such as a pharmaceutical company that has a drug
under patent with no close substitutes), the most important factor in setting the
346
profit-maximizing sales price is the elasticity of demand (the sales demand as
a function of price). The elasticity of demand is affected by such factors as
competitors’ prices, consumers’ preferences, and the availability of substitute
goods. Ignoring the elasticity of demand, and setting the sales price based on
cost of production (such as full cost plus 30%) is generally a really bad idea.

Nevertheless, production costs do play a supporting role in setting prices

generally, and for a relatively small number of products and markets,
production costs play the lead role.

Short-Run Pricing Decisions:

Occasionally, a company faces a sales opportunity for which the only relevant
costs and revenues are the incremental costs and revenues for that one
transaction. In this situation, accurate information about marginal costs are
important, because the company should be willing to set the sales price at any
amount in excess of marginal cost (marginal production cost plus any marginal
non-manufacturing costs such as distribution and marketing costs). Typically,
marginal production costs consist of all variable production costs.

These opportunities probably occur relatively infrequently (certainly less

often, for example, than one might infer from Eliyahu Goldratt’s popular
business novel The Goal). Among the conditions that are typically required for
the optimal sales price to depend only on the variable costs of the one
transaction the company now faces are: (1) excess production capacity (so that
the sales order does not displace existing orders); (2) a one-time customer
(since the price the customer is willing to pay in the future might depend on
the price the customer pays today); and (3) a customer not in the company’s
normal sales channels (because if other customers learn that the company has
given another customer a price break, they are likely to demand similar
concessions).

Intermediate-Run Pricing Decisions:

347
Over the course of several months to a year or two, costs associated with many
fixed assets are unavoidable, but the company can make meaningful decisions
about product prices, production levels and product mix. For these decisions,
microeconomics provides analytical tools for jointly determining the optimal
sales price and production level to maximize profits. The solution to this
problem depends on the elasticity of demand and also on variable production
costs (marginal production cost, in the terminology of economics).

Long-Run Pricing Decisions:

In the long-run, all fixed costs become relevant costs. Factories and
warehouses can be built, rebuilt, purchased or sold. Salaried employees can be
hired, fired, reassigned, or given incentives to resign or retire. Long-term
leases and other contracts come up for renewal. In the long-run, the company’s
revenues must exceed its costs, if it is to survive. Therefore, the management
accounting system should provide managers information about whether sales
prices for products are sufficiently in excess of their full cost of production to
cover non-manufacturing costs and still provide the company a reasonable rate
of return. Management should consider dropping products that are unable to
cover their full costs (manufacturing costs plus non-manufacturing costs),
unless there are extenuating circumstances such as a product that serves as a
“loss leader” (e.g., sell the inkjet printer at or near cost, and make high profit
margins on sales of ink cartridges). The timing for eliminating unprofitable
products might depend on when the costs of fixed assets associated with those
products can be avoided.
Pricing Decisions when the Demand Function is Unknown:
For new products, the demand function is often unpredictable. Also, important
macro-economic, political and technological changes can create significant
uncertainty about the demand function. In these situations, the sales price
might be based on cost of production. As better information about the demand
function becomes known over time, this information should then be
incorporated into pricing decisions.

Regulated Monopolies:
348
Natural monopolies that provide essential services are usually regulated.
Traditionally, utility companies that provide electricity, natural gas and
telephone service have been natural monopolies in their local service areas.
When these services are provided by a for-profit company, as opposed to a
municipality or cooperative, a regulatory agency determines the rates that the
company is allowed to charge customers, in order to cover its costs and earn a
reasonable return on its investment. Hence, rate-setting requires the
determination of the utility company’s cost of providing the service. In effect,
sales prices for the utility company are based on its costs.

In the telecommunications industry, changes in technology have created

competition that did not exist before. For example, one can easily purchase
cellular phone service from one of a number of providers, and entirely avoid
the company that provides local land-line telephone service. Changes in laws
and technology permit customers to purchase long distance telephone service
from any of a number of providers. Attempts have been made to deregulate the
electric and natural gas markets, although the results have been mixed with
respect to consumer welfare. When an industry that was previously a natural
monopoly becomes a competitive market, regulatory rate-setting is no longer
necessary.

Cost-Plus Contracts:
In a few specialized markets, sales prices are often based on cost. The U.S.
Defense Department frequently contracts with companies for the design and
manufacture of military equipment using cost-plus contracts: the contractor
receives reimbursement for production costs plus a negotiated profit. Cost-plus
contracts are useful when it is difficult for the manufacturer to predict
production costs, when product specifications may have to change after the
contract is signed, or when there is only one logical supplier. Military
equipment with long design and production lead-times, such as complex
weapons systems and aircraft, often meet one or more of these criteria.

349
An important purpose of cost-plus contracts is to transfer risk from the seller
to the buyer. For example, given the uncertainty surrounding the cost of
building the next-generation Navy submarine, it is possible that no company
capable of undertaking the project would be willing to do so, if the company
were required to commit to a price beforehand. A significant cost overrun
could bankrupt the company. Conversely, if the contracted price significantly
exceeded actual cost, the large profits that would be earned by the defense
contractor could cause the military considerable political embarrassment.
Cost-plus contracts avoid both issues by ensuring that the defense contractor
earns a reasonable profit.

Medicare, which was discussed earlier, is another government program that

originally used a cost-plus reimbursement scheme. Another example is Federal
support of scientific research. National Science Foundation grants usually
allow grant money to be used to cover the direct costs of the research as well
as a share of institutional overhead. The indirect cost reimbursement rate is
based on estimates of the indirect costs of the grant recipient. In other words,
the indirect cost reimbursement rate is institution-specific. When the
researcher is employed by a university, which is often the case, these indirect
costs can include general and administrative expenses that sometimes appear
far removed from the researcher and department that receives the grant.

In the entertainment industry, actors and writers sometimes sign contracts that
provide them a percentage of the profits from a movie or television show.
These contracts are not cost-plus contracts, but they do incorporate cost in the
determination of the amount to be received by the actor or writer. Risk sharing
in this situation does not apply so much to uncertainty about the cost of
production, as to uncertainty about revenue. These contracts allow the actor or
writer to share in the upside potential of the project.

Disputes under Cost-Plus Contracts:

There are fairly complex guidelines for how government contractors can
allocate overhead. These rules have been promulgated by the Cost Accounting
350
Standards Board. Within these guidelines, contractors that are working on a
mix of cost-plus contracts and traditional fixed fee contracts have incentives to
allocate as much overhead as possible to the cost-plus contracts and away from
fixed fee contracts. The fixed fee contracts could represent sales to
government agencies or to commercial enterprises. To the extent that overhead
is allocated to the cost-plus contracts, the contractor will be reimbursed for
those overhead costs. Headlines sometimes report apparently excessive
charges under cost-plus contracts, such as Rs.500 toilet seats for military
airplanes. Usually, these amounts reflect the allocation of large amounts of
overhead, including research and design, to a relatively small production run
and they are not improper.

On the other hand, contractors also have incentives to shift direct costs from
fixed fee contracts to cost-plus contracts, and this type of cost-shifting
constitutes fraud. Several cases have arisen over the past few decades in which
defense contractors have been accused of this practice, as well as other
practices involving the improper treatment of overhead.

In the 1990s, Stanford University came under public scrutiny for allegedly
including in its indirect cost pool, for the purpose of determining
reimbursement rates on Federal grants, the cost of depreciation on a yacht that
had been donated to the University, and the cost of expensive linen at the
University President’s house. The inclusion of these costs was apparently not a
concerted effort to increase the reimbursement rate. In point of fact, however,
Stanford had one of the highest reimbursement rates of any university in the
nation, and Stanford put on seminars, attended by personnel from other
universities, on how to maximize reimbursement under Federal grants. At one
point, University President Donald Kennedy remarked “I expect our
controllers to do their best on behalf of the university.” There were
Congressional hearings, and the scandal prompted Kennedy to resign.

351
There have been so many public allegations over the years by actors and
writers that film and television studios overstate costs, and thus significantly
reduce or completely eliminate the incentive component of the actor’s or
writer’s contract, that it is difficult to understand why artists continue to sign
these contracts. Stan Lee, creator of Spiderman, sued Marvel in 2002, claiming
that his contract entitled him to 10% of Marvel’s profits whenever his
characters were used in film or television. The lawsuit asserted that the first
Spiderman movie had grossed more than Rs.400 million, that Marvel had
reported millions of dollars in earnings from the movie, but that Lee had not
received a penny. Marvel issued a statement that Stan Lee was well-
compensated for his contributions to the industry, and that Marvel was in
compliance with its contract with Lee, which probably meant that there were
no “profits” from the movie as “profits” are defined in the company’s contract
with Lee.

Actors and writers would be on surer ground signing contracts based on a

percentage of revenues, which are less susceptible to manipulation than
profits.

Intra-Company Sales:
The cost of production is often used as the basis for setting the sales price for
internal sales of product that sometimes occur from one part of a company to
another part of the same company. These internal sales are called transfers,
and the topic is referred to as transfer pricing. Chapter 23 discusses transfer
pricing. Most companies that use a cost-based transfer price include an
allocation of fixed costs in the determination of cost.

The role of cost in the legal resolution of disputes over pricing:

For the most part, aside from the exceptions noted above, most companies
conducting business in the U.S. are free to charge whatever they want for their
products. There are, however, laws that prevent certain types of price
discrimination and predatory pricing practices. Price discrimination consists of
charging different customers different amounts for the same product.
352
Predatory pricing consists of charging low prices in an attempt to drive a
competitor out of business (or out of the local market).

The Sherman Act of 1890 prohibits companies from monopolizing trade,

conspiring in restraint of trade, or engaging in predatory pricing. The Clayton
Act of 1914 elaborated on the Sherman Act, and made price discrimination
illegal. The concern at that time was that manufacturers were granting lower
prices to large customers, and the purpose of the Clayton Act was to encourage
competition among retailers by allowing small retailers to buy merchandise at
the same price as large retailers. In effect, the concern that Congress was
addressing at the beginning of the last century mirrors the concern of many
people today about the proliferation of large, national retail chains like Wal-
Mart at the expense of small, locally-owned “Main Street” stores.

The Clayton Act was amended by the Robinson-Patman Act in 1936. This Act
delineates three defenses against a charge of price discrimination. The first
defense is that the manufacturer is allowed to offer volume discounts. This
defense gives large retailers a great advantage. The second defense is that price
can reflect differences in manufacturing costs, which might arise, for example,
from different product specifications by different customers. The third defense
is that manufacturers are allowed to meet competitors’ prices, even if doing so
results in charging lower prices in one geographic market (where the
competitor has a presence) than in other locations.

The resolution of disputes that arise under these laws usually involves a
determination of the manufacturer’s costs. However, the Congressional Acts
identified above do not specify how cost is to be determined. Hence, this issue
was left to the courts. Case law has resulted in a determination that marginal
cost is to be used.

Considering the three defenses specified in the Robinson-Patman Act, the

courts’ determination of how costs are to be calculated, and the fact that price
discrimination applies only to manufacturing companies (not to service sector
353
companies), it would seem very difficult for any plaintiff to prevail in a
lawsuit alleging either price discrimination or predatory pricing. Recently, the
Supreme Court defined predatory pricing as a situation in which a company
sets prices below average variable cost, with plans to raise prices later to
recover the temporary losses (Brooke Group Ltd. vs. Brown & Williamson
Tobacco Corp., 1993). The Supreme Court then interpreted economic theory
as indicating that predatory pricing does not work. In effect, the Court appears
to have asserted that predatory pricing cannot succeed, and that therefore, it is
unreasonable to assert that any company would engage in it. In the subsequent
37 predatory pricing cases, the defendants prevailed. In 2001, a Federal judge
threw out a high-profile legal action brought by the Justice Department against
American Airlines that alleged predatory pricing in the Dallas/Fort Worth
market.

Predatory pricing also applies to international trade. Anti-dumping laws

preclude foreign companies from dumping product onto domestic markets,
which refers to selling large quantities of product at unusually low prices.
Such actions by foreign competitors can drive domestic industries out of
business, and in fact, there are frequent accusations that this is the intent of
dumping. U.S. anti-dumping laws stipulate that the import price into the U.S.
cannot be lower than the cost of production. The World Trade Organization
found that the number of cases brought under anti-dumping laws increased
35% from 1995 to 2000.

The Downward Demand Spiral:

If sales price is established based on cost of production, and if cost of
production includes an allocation of fixed costs, then the cost-based price will
be a decreasing function of sales volume. Thus, if sales volume increases, the
per-unit sales price decreases; and if sales volume decreases, the per-unit sales
price increases. If in addition, the demand function is decreasing in price,
which normally would be the case, then this situation can result in something
called the downward demand spiral (occasionally called the death spiral; we
accountants are so dramatic).
354
Start with either a decrease in demand for the product, or an increase in fixed
costs. The downward demand spiral refers to the reduction in demand that can
occur if prices are raised to recover the higher fixed cost per unit of product,
which in turn induces another price increase, because fixed costs must be
recovered from a smaller customer base, which leads to another drop in
demand, etc., etc.

The downward demand spiral does not occur often, and when it does, it
probably occurs most frequently for “internal sales” by service departments. In
this setting, service departments might view demand as relatively inelastic,
when in fact, user departments might be surprisingly creative in finding either
less costly external service providers, or alternative in-house solutions. For
example, there is a story about a downward demand spiral that supposedly
occurred in the typing pool of a high-tech company in the 1970s or 1980s. The
typing pool charged out its services on a per-page basis at a time when
managers were becoming increasingly proficient with desktop computers and
word-processing software. As managers became more proficient with the
technology, their demand for the typing pool decreased, which resulted in
higher per-page costs, which prompted more managers to avoid the typing
pool, to the point where the cost-per-page was ridiculously high.

355
4. 15 COST CONTAINMENT

Definition
The process of controlling the expenses required to operate an organization or
perform a project within pre-planned budgetary constraints. The cost containment
process is an important management function that helps keep costs down to only
necessary and intended expenses in order to satisfy financial targets.

COST CONTAINMENT : MEANING

Given today’s challenging economy, organizations of all kinds face intense

financial pressure from such factors as slowing sales, squeezed profits and
hard-to-raise capital. In response, many are setting strategies to limit their
operational costs. Cost containment, done right, is a powerful way to outpace
the competition, reward investors and help an organization achieve its most
important financial goals.

Effective cost containment can have a huge impact on corporate expenditure or

the profitability of an underwriter.
Increasing expectations regarding the quality of medical care and the
explosion of costs in public and private health sectors have contributed to the
need for strict cost control. Medical Facilities in some countries are notorious
for overcharging treatment. Most of the European Private Hospitals fall in line
with the European Regulations, but in some instances, this does not stop them
over charging.
one Assist checks and audits the incoming invoices and actively seeks to
negotiate reductions on the bills where there are detected errors or items
excessively priced.

356
Many medical establishments will agree to a significant reduction on their bill
in return for prompt settlement. This practice is known as "Cost Containment".
Most of the cost containment process is carried out in house before passing the
invoice for payment to the appointed Claims Handler, using the following
guidelines:
Does the real admission period match the days invoiced on the final bill?
Is the treatment given acceptable for the illness/injury sustained?
Have the hospital over treated the patient? I.e. kept the patient hospitalised
longer than necessary.
Has any non-emergency treatment, or any exploratory or remedial procedures
been performed that OAL has not expressly authorised.
In some countries, we will utilise the services of specific agents to do the cost
containment on our behalf. We find that local agents are sometimes best
placed as they know the local cost and the personnel in the hospitals to talk to
achieve the best result.

COST CONTAINMENT MEASURES IN CONNOLLY HOSPITAL

As you may have read in the media, Connolly Hospital is currently

experiencing serious financial difficulties which have stretched the Hospital’s
budget to the limit. The non-pay element of the Hospital’s budget has been cut
back to unprecedented levels and as a consequence, the Hospital has decided
to reduce non-core pay expenditure through reductions in overtime and other
spending. The Hospital has also decided on a programme of ward closures and
service curtailments. For NCHDs this has meant the introduction of new
rostering arrangements designed to reduce the Hospital’s unrostered overtime
liability.
Several NCHDs have already told the IMO that these rosters are unrealistic
and that they do not have the support of some Consultants. This will present
NCHDs with problems into the future, as Consultants clinics run into times
when the NCHDs are, theoretically at any rate, not meant to be on site. The
IMO sits on a group of unions and management in Connolly and meets with
the management of Connolly Hospital once a month. The IMO will continue
357
to take the opportunity to raise this and other issues at that forum and ensure
that, in Connolly’s cost curtailment programme, NCHDs are not
disproportionately affected.

Every Insurer and Client wants to reduce the claims ratio and improve the
performance of their health Insurance policy and we at WAPMED acknowledge
the importance of putting systems & protocols in place to ensure that unnecessary
expenses are eliminated. First step in achieving this is negotiating discounts with
all providers get special rates for large Group Policies. Regular monitoring of /
visits to hospitals to detect any unhealthy practices and excess / unwarranted
billing / admissions is also an important part of this exercise. Few others steps that
helps achieve WAPMED its goal are as follows-

Investigation of suspicious member claims and random visits to hospitals by

our Doctor’s / Investigators to confirm the admissions and also to validate the
information provided by the hospital in the Pre Auth request with the actual
facts.

358
Every claim irrespective of claimed amount or no. of invoices is scrutinized by
a staff with clinical background.The objective of the present medical scrutiny
done at WAPMED is to identify Inappropriate billing pattern, Detection of
customary overcharges, Duplicate billing detection, Visiting Doctors charges,
Fee schedule, filter out unnecessary admissions, monitor length of stays.
The software used by WAPMED is highly sophisticated and has in built
checks and restrictions, which makes claims processing faster and reduces the
error rate, since there are few points where manual intervention or decision
making is required. Every member enrolled in WAPMED’s software has
Unique Health Identification no. (UHID). All the policies and their respective
claims for the particular member are mapped under the same UHID no. Hence
all the medical history (Pre-existing / Chronic) are available in the same
window which is accessible by all the assessors for medical scrutiny.
Discounts: Based on the business volume WAPMED has been able to
negotiate considerable discounts on the published rates from providers on its
network. WAPMED has also been successful in negotiating package rates for
a large number of procedures with majority of the hospitals, which reduces the
claims ratio and improves the performance of the Health policy. For large
groups where a majority of the employees go to specified few providers,
WAPMED has been able to negotiate a higher discount or a lower tariff for
those groups, by restricting the network. Many optical centers, pharmacies,
diagnostic centers have agreed to give special discounts to WAPMED clients
even on services which are not covered under the Insurance plan.

CHECK YOUR PROGRESS

359
Unit 5: Financial Decisions and Fundraising

5.1 Working Capital Management

5.2 Sources and Application of Fund
5.3 Analysis of Financial Statements
5.4 Financial Performance of Hospital
5.5 Financial Planning: Long Term and Short Term
5.6 Financing of Health
5.7 Analysis of Need for Fund for Modernization and Expansion

5.8 Financial Information System and Reporting

5.9 Investment Management

5.10 Fundraising

5.10.1 Art of Fundraising

5.10.2 Analyzing Donor Markets
5.10.3 Organizing for Fundarising
5.10.4 Fundraising Goals and Strategies
5.10.5 Fundraising Tactics
5.10.6 Evaluating Fundraising Effectiveness

5.1 WORKING CAPITAL MANAGEMENT

INTRODUCTION

Working capital management is also one of the important parts of the financial
management. It is concerned with short-term finance of the business concern
which is a closely related trade between profitability and liquidity. Efficient

360
working capital management leads to improve the operating performance of
the business concern and it helps to meet the short-term liquidity. Hence, study
of working capital management is not only an important part of financial
management but also are overall management of the business concern.

Working capital is described as the capital which is not fixed but the more
common uses of the working capital is to consider it as the difference between
the book value of current assets and current liabilities.

This chapter deals with the following important aspects of the working capital
management.

• Meaning of Working Capital

• Concept of Working Capital

• Types of Working Capital

• Needs of Working Capital

• Factors determining Working Capital

• Computation of Working Capital

• Sources of Working Capital

• Working Capital Management Policy

• Working Capital and Banking Committee

MEANING OF WORKING CAPITAL

361
 Capital

Working
Fixed Capital Capital

Fixed capital means that capital, which is used for long-term investment of the
business concern. For example, purchase of permanent assets. Normally it
consists of non-recurring in nature.

Working Capital is another part of the capital which is needed for meeting day
to day requirement of the business concern. For example, payment to creditors,
salary paid to workers, purchase of raw materials etc., normally it consists of
recurring in nature. It can be easily converted into cash. Hence, it is also
known as short-term capital.

Definitions

According to the definition of Mead, Baker and Malott, “Working Capital

means Current Assets”.

According to the definition of J.S.Mill, “The sum of the current asset is the
working capital of a business”.

According to the definition of Weston and Brigham, “Working Capital refers

to a firm’s investment in short-term assets, cash, short-term securities,
accounts receivables and inventories”.

According to the definition of Bonneville, “Any acquisition of funds which

increases the current assets, increase working capital also for they are one and
the same”.

362
According to the definition of Shubin, “Working Capital is the amount of
funds necessary to cover the cost of operating the enterprises”.

According to the definition of Genestenberg, “Circulating capital means

current assets of a company that are changed in the ordinary course of business
from one form to another, for example, from cash to inventories, inventories to
receivables, receivables to cash”.

CONCEPT OF WORKING CAPITAL

Working capital can be classified or understood with the help of the following
two important concepts.

Gross Net
Working Working
Capital Capital

Gross Working Capital

Gross Working Capital is the general concept which determines the working
capital concept. Thus, the gross working capital is the capital invested in total
current assets of the business concern.
Gross Working Capital is simply called as the total current assets of the
concern.
GWC = CA
Net Working Capital
363
Net Working Capital is the specific concept, which, considers both current assets
and current liability of the concern.
Net Working Capital is the excess of current assets over the current liability
of the concern during a particular period.
If the current assets exceed the current liabilities it is said to be positive
working capital; it is reverse, it is said to be Negative working capital.
NWC = C A – CL
Component of Working Capital
Working capital constitutes various current assets and current liabilities. This can
be illustrated by the following chart.

Working Capital

Current Current
Assets Liability

Cash in Hand Bills Payable

Cash at Bank Sundry Creditors

Outstanding
Bills Receivable Expenses
Short-term Loans
Sundry Debtors and Advances

Shotr-term Loans Advances Dividend Payable

Inventories Bank Overdraft

Provision for
Prepaid Expenses Taxation

Accrued Income

TYPES OF WORKING CAPITAL

Working Capital may be classified into three important types on the basis of time.

364
 Working Capital

Semi
Permanent Temporary Variable
Working Working
Capital Working Capital Capital

Seasonal Special
Working Working
Capital Capital

Permanent Working Capital

Amount of
Working
Capital Ti
me

Amou
nt
of Tempo
Worki rary
ng
Worki
Capital ng
Capita
l

Time
Semi Variable Working Capital
Certain amount of Working Capital is in the field level up to a certain stage and
after that it will increase depending upon the change of sales or time.

365
NEEDS OF WORKING CAPITAL

Working Capital is an essential part of the business concern. Every business

concern must maintain certain amount of Working Capital for their day-to-day
requirements and meet the short-term obligations.

Working Capital is needed for the following purposes.

1. Purchase of raw materials and spares: The basic part of manufacturing

process is, raw materials. It should purchase frequently according to the needs
of the business concern. Hence, every business concern maintains certain
amount as Working Capital to purchase raw materials, components, spares,
etc.

2. Payment of wages and salary: The next part of Working Capital is

payment of wages and salaries to labour and employees. Periodical payment
facilities make employees perfect in their work. So a business concern
maintains adequate the amount of working capital to make the payment of
wages and salaries.

3. Day-to-day expenses: A business concern has to meet various

expenditures regarding the operations at daily basis like fuel, power, office
expenses, etc.

4. Provide credit obligations: A business concern responsible to provide

credit facilities to the customer and meet the short-term obligation. So the
concern must provide adequate Working Capital.

Working Capital Position/ Balanced Working Capital Position.

366
A business concern must maintain a sound Working Capital position to
improve the efficiency of business operation and efficient management of
finance. Both excessive and inadequate Working Capital lead to some
problems in the business concern.

A. Causes and effects of excessive working capital.

(i) Excessive Working Capital leads to unnecessary accumulation of raw

materials, components and spares.

(ii) Excessive Working Capital results in locking up of excess Working

Capital.

(iii) It creates bad debts, reduces collection periods, etc.

(iv) It leads to reduce the profits.

B. Causes and effects of inadequate working capital

(i) Inadequate working capital cannot buy its requirements in bulk order.

(ii) It becomes difficult to implement operating plans and activate the

firm’s profit target.

(iii) It becomes impossible to utilize efficiently the fixed assets.

(iv) The rate of return on investments also falls with the shortage of
Working Capital.

(v) It reduces the overall operation of the business.

367
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

Working Capital requirements depends upon various factors. There are no set
of rules or formula to determine the Working Capital needs of the business
concern. The following are the major factors which are determining the
Working Capital requirements

1. Nature of business: Working Capital of the business concerns largely

depend upon the nature of the business. If the business concerns follow rigid
credit policy and sell goods only for cash, they can maintain lesser amount of
Working Capital. A transport company maintains lesser amount of Working
Capital while a construction company maintains larger amount of Working
Capital.

2. Production cycle: Amount of Working Capital depends upon the length

of the production cycle. If the production cycle length is small, they need to
maintain lesser amount of Working Capital. If it is not, they have to maintain
large amount of Working Capital.

3. Business cycle: Business fluctuations lead to cyclical and seasonal

changes in the business condition and it will affect the requirements of the
Working Capital. In the booming conditions, the Working Capital requirement
is larger and in the depression condition, requirement of Working Capital will
reduce. Better business results lead to increase the Working Capital
requirements.

4. Production policy: It is also one of the factors which affects the

Working Capital requirement of the business concern. If the company
maintains the continues production policy, there is a need of regular Working
Capital. If the production policy of the company depends upon the situation or
conditions, Working Capital requirement will depend upon the conditions laid
down by the company.
368
5. Credit policy: Credit policy of sales and purchase also affect the
Working Capital requirements of the business concern. If the company
maintains liberal credit policy to collect the payments from its customers, they
have to maintain more Working Capital. If the company pays the dues on the
last date it will create the cash maintenance in hand and bank.

6. Growth and expansion: During the growth and expansion of the

business concern, Working Capital requirements are higher, because it needs
some additional Working Capital and incurs some extra expenses at the initial
stages.

7. Availability of raw materials: Major part of the Working Capital

requirements are largely depend on the availability of raw materials. Raw
materials are the basic components of the production process. If the raw
material is not readily available, it leads to production stoppage. So, the
concern must maintain adequate raw material; for that purpose, they have to
spend some amount of Working Capital.

8. Earning capacity: If the business concern consists of high level of

earning capacity, they can generate more Working Capital, with the help of
cash from operation. Earning capacity is also one of the factors which
determines the Working Capital requirements of the business concern.

COMPUTATION (OR ESTIMATION) OF WORKING CAPITAL

Working Capital requirement depends upon number of factors, which are

already discussed in the previous parts. Now the discussion is on how to
calculate the Working Capital needs of the business concern. It may also
depend upon various factors but some of the common methods are used to
estimate the Working Capital.
369
A. Estimation of components of working capital method

Working capital consists of various current assets and current liabilities.

Hence, we have to estimate how much current assets as inventories required
and how much cash required to meet the short term obligations.

Finance Manager first estimates the assets and required Working Capital for a
particular period.

B. Percent of sales method

Based on the past experience between Sales and Working Capital

requirements, a ratio can be determined for estimating the Working Capital
requirement in future. It is the simple and tradition method to estimate the
Working Capital requirements. Under this method, first we have to find out the
sales to Working Capital ratio and based on that we have to estimate Working
Capital requirements. This method also expresses the relationship between the
Sales and Working Capital.

C. Operating cycle

Working Capital requirements depend upon the operating cycle of the

business. The operating cycle begins with the acquisition of raw material and
ends with the collection of receivables.

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
370
 5. Creditors Payment Period Stage. (C)

O = R + W + F + D–C

D W

Each component of the operating cycle can be calculated by the following

formula

Average Stock of Raw Material

R=
Average Raw Material Consumption Per Day
W= Average Work in Process nventory
Average Cost of Production Per Day

Average Finished Stock Inventory

F=
Average Cost of Goods Sold Per Day

Average Book Debts

D=
Average Credit Sales Per Day
Average Trade Creditors

C= .
Average Credit Purchase Per Day

371
WORKING CAPITAL MANAGEMENT

Management of Working Capital is also an important part of financial

manager. The main objective of the Working Capital Management is
managing the Current Asset and Current Liabilities effectively and
maintaining adequate amount of both Current Asset and Current Liabilities.
Simply it is called Administration of Current Asset and Current Liabilities of
the business concern.

Management of key components of working capital like cash, inventories and

receivables assumes paramount importance due to the fact the major portion of
working capital gets blocked in these assets.

Meaning

Working capital management is an act of planning, organizing and controlling

the components of working capital like cash, bank balance inventory,
receivables, payables, overdraft and short-term loans.

Definition

According to Smith K.V, “Working capital management is concerned with the

problems that arise in attempting to manage the current asset, current liabilities
and the inter-relationship that exist between them”.

According to Weston and Brigham, “Working capital generally stands for

excess of current assets over current liabilities. Working capital management
therefore refers to all aspects of the administration of both current assets and
current liabilities”.

INVENTORY MANAGEMENT

372
Introduction

Inventories constitute the most significant part of current assets of the business
concern. It is also essential for smooth running of the business activities.
A proper planning of purchasing of raw material, handling, storing and
recording is to be considered as a part of inventory management. Inventory
management means, management of raw materials and related items.
Inventory management considers what to purchase, how to purchase, how
much to purchase, from where to purchase, where to store and when to use for
production etc.

Meaning

The dictionary meaning of the inventory is stock of goods or a list of goods. In

accounting language, inventory means stock of finished goods. In a
manufacturing point of view, inventory includes, raw material, work in
process, stores, etc.

Kinds of Inventories

Inventories can be classified into five major categories.

A. Raw Material

It is basic and important part of inventories. These are goods which have not
yet been committed to production in a manufacturing business concern.

B. Work in Progress

These include those materials which have been committed to production

process but have not yet been completed.
373
C. Consumables

These are the materials which are needed to smooth running of the
manufacturing process.

D. Finished Goods

These are the final output of the production process of the business concern. It
is ready for consumers.

E. Spares

It is also a part of inventories, which includes small spares and parts.

Objectives of Inventory Management

Inventory occupy 30–80% of the total current assets of the business concern. It
is also very essential part not only in the field of Financial Management but
also it is closely associated with production management. Hence, in any
working capital decision regarding the inventories, it will affect both financial
and production function of the concern. Hence, efficient management of
inventories is an essential part of any kind of manufacturing process concern.

The major objectives of the inventory management are as follows:

• To efficient and smooth production process.

• To maintain optimum inventory to maximize the profitability.

• To meet the seasonal demand of the products.

• To avoid price increase in future.

374
• To ensure the level and site of inventories required.

• To plan when to purchase and where to purchase

• To avoid both over stock and under stock of inventory.

Techniques of Inventory Management

Inventory management consists of effective control and administration of

inventories. Inventory control refers to a system which ensures supply of
required quantity and quality of inventories at the required time and at the
same time prevent unnecessary investment in inventories. It needs the
following important techniques.

Inventory management techniques may be classified into various types:

Inventory Management Technique

Techniques Techniques Techniques

Based on Based on Based on
Order the the
Quantity Classification Records

VE Invent Invent
ABC D HML Aging ory ory
Analy Analy Analy Sched Repo Budge
sis sis sis ule rt t

Determin Determin Economic

ation ation Order
375
 of Stock of
Level Stock Quality

A. Techniques based on the order quantity of Inventories

Order quantity of inventories can be determined with the help of the following
techniques:

Stock Level

Stock level is the level of stock which is maintained by the business concern at
all times. Therefore, the business concern must maintain optimum level of
stock to smooth running of the business process. Different level of stock can
be determined based on the volume of the stock.

Minimum Level

The business concern must maintain minimum level of stock at all times. If the
stocks are less than the minimum level, then the work will stop due to shortage
of material.

Re-order Level

Re-ordering level is fixed between minimum level and maximum level. Re-
order level is the level when the business concern makes fresh order at this
level.

Re-order level=maximum consumption × maximum Re-order period.

Maximum Level

376
It is the maximum limit of the quantity of inventories, the business concern
must maintain. If the quantity exceeds maximum level limit then it will be
overstocking.

Maximum level = Re-order level + Re-order quantity

– (Minimum consumption × Minimum delivery period)

Danger Level

It is the level below the minimum level. It leads to stoppage of the production
process.

Danger level=Average consumption × Maximum re-order period for

emergency purchase

Average Stock Level

It is calculated such as,

Average stock level= Minimum stock level + ½ of re-order quantity maximum
level

CASH MANAGEMENT

Business concern needs cash to make payments for acquisition of resources

and services for the normal conduct of business. Cash is one of the important
and key parts of the current assets.

Cash is the money which a business concern can disburse immediately without
any restriction. The term cash includes coins, currency, cheques held by the
business concern and balance in its bank accounts. Management of cash

377
consists of cash inflow and outflows, cash flow within the concern and cash
balance held by the concern etc.

Motives for Holding Cash

1. Transaction motive

It is a motive for holding cash or near cash to meet routine cash requirements
to finance transaction in the normal course of business. Cash is needed to
make purchases of raw materials, pay expenses, taxes, dividends etc.

2. Precautionary motive

It is the motive for holding cash or near cash as a cushion to meet unexpected
contingencies. Cash is needed to meet the unexpected situation like, floods
strikes etc.
3. Speculative motive

It is the motive for holding cash to quickly take advantage of opportunities

typically outside the normal course of business. Certain amount of cash is
needed to meet an opportunity to purchase raw materials at a reduced price or
make purchase at favorable prices.

4. Compensating motive

It is a motive for holding cash to compensate banks for providing certain

services or loans. Banks provide variety of services to the business concern,
such as clearance of cheque, transfer of funds etc.

Cash Management Techniques

Managing cash flow constitutes two important parts:

378
A. Speedy Cash Collections.

B. Slowing Disbursements.

Speedy Cash Collections

Business concern must concentrate in the field of Speedy Cash Collections

from customers. For that, the concern prepares systematic plan and refined
techniques. These techniques aim at, the customer who should be encouraged
to pay as quickly as possible and the payment from customer without delay.
Speedy Cash Collection business concern applies some of the important
techniques as follows:

Prompt Payment by Customers

Business concern should encourage the customer to pay promptly with the
help of offering discounts, special offer etc. It helps to reduce the delaying
payment of customers and the firm can avoid delays from the customers. The
firms may use some of the techniques for prompt payments like billing
devices, self address cover with stamp etc.

Early Conversion of Payments into Cash

Business concern should take careful action regarding the quick conversion of
the payment into cash. For this purpose, the firms may use some of the
techniques like postal float, processing float, bank float and deposit float.

Concentration Banking

It is a collection procedure in which payments are made to regionally

dispersed collection centers, and deposited in local banks for quick clearing. It
is a system of decentralized billing and multiple collection points.

379
Lock Box System

It is a collection procedure in which payers send their payment or cheques to a

nearby post box that is cleared by the firm’s bank. Several times that the bank
deposit the cheque in the firms account. Under the lock box system, business
concerns hire a post office lock box at important collection centers where the
customers remit payments. The local banks are authorized to open the box and
pick up the remittances received from the customers. As a result, there is some
extra savings in mailing time compared to concentration bank.

Slowing Disbursement

An effective cash management is not only in the part of speedy collection of

its cash and receivables but also it should concentrate to slowing their
disbursement of cash to the customers or suppliers. Slowing disbursement of
cash is not the meaning of delaying the payment or avoiding the payment.
Slowing disbursement of cash is possible with the help of the following
methods:

1. Avoiding the early payment of cash

The firm should pay its payable only on the last day of the payment. If the firm
avoids early payment of cash, the firm can retain the cash with it and that can
be used for other purpose.

2. Centralised disbursement system

Decentralized collection system will provide the speedy cash collections.

Hence centralized disbursement of cash system takes time for collection from
our accounts as well as we can pay on the date.

RECEIVABLE MANAGEMENT

380
The term receivable is defined as debt owed to the concern by customers
arising from sale of goods or services in the ordinary course of business.
Receivables are also one of the major parts of the current assets of the business
concerns. It arises only due to credit sales to customers, hence, it is also known
as Account Receivables or Bills Receivables.

Management of account receivable is defined as the process of making

decision resulting to the investment of funds in these assets which will result
in maximizing the overall return on the investment of the firm.

The objective of receivable management is to promote sales and profit until

that point is reached where the return on investment in further funding
receivables is less than the cost of funds raised to finance that additional credit.

The costs associated with the extension of credit and accounts receivables are
identified as follows:

A. Collection Cost

B. Capital Cost

C. Administrative Cost

D. Default Cost.

Collection Cost

This cost incurred in collecting the receivables from the customers to whom
credit sales have been made.

Capital Cost

381
This is the cost on the use of additional capital to support credit sales which
alternatively could have been employed elsewhere.

Administrative Cost

This is an additional administrative cost for maintaining account receivable in

the form of salaries to the staff kept for maintaining accounting records
relating to customers, cost of investigation etc.

Default Cost

Default costs are the over dues that cannot be recovered. Business concern
may not be able to recover the over dues because of the inability of the
customers.

Factors Considering the Receivable Size

Receivables size of the business concern depends upon various factors. Some
of the important factors are as follows:

1. Sales Level

Sales level is one of the important factors which determines the size of
receivable of the firm. If the firm wants to increase the sales level, they have to
liberalise their credit policy and terms and conditions. When the firms
maintain more sales, there will be a possibility of large size of receivable.

2. Credit Policy

Credit policy is the determination of credit standards and analysis. It may vary
from firm to firm or even some times product to product in the same industry.
Liberal credit policy leads to increase the sales volume and also increases the
size of receivable. Stringent credit policy reduces the size of the receivable.
382
3. Credit Terms

Credit terms specify the repayment terms required of credit receivables,

depend upon the credit terms, size of the receivables may increase or decrease.
Hence, credit term is one of the factors which affects the size of receivable.

4. Credit Period

It is the time for which trade credit is extended to customer in the case of
credit sales. Normally it is expressed in terms of ‘Net days’.

5. Cash Discount

Cash discount is the incentive to the customers to make early payment of the
due date. A special discount will be provided to the customer for his payment
before the due date.

6. Management of Receivable

It is also one of the factors which affects the size of receivable in the firm.
When the management involves systematic approaches to the receivable, the
firm can reduce the size of receivable.

5.2 SOURCES AND APPLICATION OF FUND

INTRODUCTION

Finance is the lifeblood of business concern, because it is interlinked with all

activities performed by the business concern. In a human body, if blood
circulation is not proper, body function will stop. Similarly, if the finance not
being properly arranged, the business system will stop. Arrangement of the
383
required finance to each department of business concern is highly a complex
one and it needs careful decision. Quantum of finance may be depending upon
the nature and situation of the business concern. But, the requirement of the
finance may be broadly classified into two parts:

Long-term Financial Requirements or Fixed Capital Requirement

Financial requirement of the business differs from firm to firm and the nature
of the requirements on the basis of terms or period of financial requirement, it
may be long term and short-term financial requirements.

Long-term financial requirement means the finance needed to acquire land and
building for business concern, purchase of plant and machinery and other fixed
expenditure. Long-term financial requirement is also called as fixed capital
requirements. Fixed capital is the capital, which is used to purchase the fixed
assets of the firms such as land and building, furniture and fittings, plant and
machinery, etc. Hence, it is also called a capital expenditure.

Short-term Financial Requirements or Working Capital Requirement

Apart from the capital expenditure of the firms, the firms should need certain
expenditure like procurement of raw materials, payment of wages, day-to-day
expenditures, etc. This kind of expenditure is to meet with the help of short-
term financial requirements which will meet the operational expenditure of the
firms. Short-term financial requirements are popularly known as working
capital.

SOURCES OF FINANCE

Sources of finance mean the ways for mobilizing various terms of finance to
the industrial concern. Sources of finance state that, how the companies are
mobilizing finance for their requirements. The companies belong to the
existing or the new which need sum amount of finance to meet the long-term
384
and short-term requirements such as purchasing of fixed assets, construction of
office building, purchase of raw materials and day-to-day expenses.

Sources of finance may be classified under various categories according to the

following important heads:

1. Based on the Period

Sources of Finance may be classified under various categories based on the

period.

Long-term sources: Finance may be mobilized by long-term or short-term.

When the finance mobilized with large amount and the repayable over the
period will be more than five years, it may be considered as long-term sources.
Share capital, issue of debenture, long-term loans from financial institutions
and commercial banks come under this kind of source of finance. Long-term
source of finance needs to meet the capital expenditure of the firms such as
purchase of fixed assets, land and buildings, etc.

Long-term sources of finance include:

● Equity Shares

● Preference Shares

● Debenture

● Long-term Loans

● Fixed Deposits

Short-term sources: Apart from the long-term source of finance, firms can
generate finance with the help of short-term sources like loans and advances
385
from commercial banks, moneylenders, etc. Short-term source of finance
needs to meet the operational expenditure of the business concern.

Short-term source of finance include:

● Bank Credit

● Customer Advances

● Trade Credit

● Factoring

● Public Deposits

● Money Market Instruments

2. Based on Ownership

Sources of Finance may be classified under various categories based on the

period:

An ownership source of finance include

● Shares capital, earnings

● Retained earnings

● Surplus and Profits

Borrowed capital include

386
● Debenture

● Bonds

● Public deposits

● Loans from Bank and Financial Institutions.

3. Based on Sources of Generation

Sources of Finance may be classified into various categories based on the

period.

Internal source of finance includes

● Retained earnings

● Depreciation funds

● Surplus

External sources of finance may be include

● Share capital

● Debenture

● Public deposits

● Loans from Banks and Financial institutions

4. Based in Mode of Finance Security finance may be include

387
● Shares capital

● Debenture

Retained earnings may include

● Retained earnings

● Depreciation funds

Loan finance may include

● Long-term loans from Financial Institutions

● Short-term loans from Commercial banks.

The above classifications are based on the nature and how the finance is
mobilized from various sources. But the above sources of finance can be
divided into three major classifications:

● Security Finance

● Internal Finance

● Loans Finance

SECURITY FINANCE

If the finance is mobilized through issue of securities such as shares and

debenture, it is called as security finance. It is also called as corporate
securities. This type of finance plays a major role in the field of deciding the
capital structure of the company.

388
Characters of Security Finance

Security finance consists of the following important characters:

1. Long-term sources of finance.

2. It is also called as corporate securities.

3. Security finance includes both shares and debentures.

4. It plays a major role in deciding the capital structure of the company.

5. Repayment of finance is very limited.

6. It is a major part of the company’s total capitalization.

Types of Security Finance

Security finance may be divided into two major types:

1. Ownership securities or capital stock.

2. Creditorship securities or debt capital.

Ownership Securities

The ownership securities also called as capital stock, is commonly called as

shares. Shares are the most Universal method of raising finance for the
business concern. Ownership capital consists of the following types of
securities.

● Equity Shares

389
● Preference Shares

● No par stock

● Deferred Shares

EQUITY SHARES

Equity Shares also known as ordinary shares, which means, other than
preference shares. Equity shareholders are the real owners of the company.
They have a control over the management of the company. Equity
shareholders are eligible to get dividend if the company earns profit. Equity
share capital cannot be redeemed during the lifetime of the company. The
liability of the equity shareholders is the value of unpaid value of shares.

Features of Equity Shares

Equity shares consist of the following important features:

1. Maturity of the shares: Equity shares have permanent nature of capital,

which has no maturity period. It cannot be redeemed during the lifetime of the
company.

2. Residual claim on income: Equity shareholders have the right to get

income left after paying fixed rate of dividend to preference shareholder. The
earnings or the income available to the shareholders is equal to the profit after
tax minus preference dividend.

3. Residual claims on assets: If the company wound up, the ordinary or

equity shareholders have the right to get the claims on assets. These rights are
only available to the equity shareholders.
390
4. Right to control: Equity shareholders are the real owners of the
company. Hence, they have power to control the management of the company
and they have power to take any decision regarding the business operation.

5. Voting rights: Equity shareholders have voting rights in the meeting of

the company with the help of voting right power; they can change or remove
any decision of the business concern. Equity shareholders only have voting
rights in the company meeting and also they can nominate proxy to participate
and vote in the meeting instead of the shareholder.

6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-

emptive right is the legal right of the existing shareholders. It is attested by the
company in the first opportunity to purchase additional equity shares in
proportion to their current holding capacity.

7. Limited liability: Equity shareholders are having only limited liability

to the value of shares they have purchased. If the shareholders are having fully
paid up shares, they have no liability. For example: If the shareholder
purchased 100 shares with the face value of Rs. 10 each. He paid only Rs. 900.
His liability is only Rs. 100.

Total number of shares 100 Face value of shares Rs. 10

Total value of shares 100 × 10 = 1,000
Paid up value of shares 900
Unpaid value/liability
100

Liability of the shareholders is only unpaid value of the share (that is Rs. 100).

Advantages of Equity Shares

391
Equity shares are the most common and universally used shares to mobilize
finance for the company. It consists of the following advantages.

1. Permanent sources of finance: Equity share capital is belonging to

long-term permanent nature of sources of finance, hence, it can be used for
long-term or fixed capital requirement of the business concern.

2. Voting rights: Equity shareholders are the real owners of the company
who have voting rights. This type of advantage is available only to the equity
shareholders.

3. No fixed dividend: Equity shares do not create any obligation to pay a

fixed rate of dividend. If the company earns profit, equity shareholders are
eligible for

profit, they are eligible to get dividend otherwise, and they cannot claim any
dividend from the company.

4. Less cost of capital: Cost of capital is the major factor, which affects
the value of the company. If the company wants to increase the value of the
company, they have to use more share capital because, it consists of less cost
of capital (Ke) while compared to other sources of finance.

5. Retained earnings: When the company have more share capital, it will
be suitable for retained earnings which is the less cost sources of finance while
compared to other sources of finance.

Disadvantages of Equity Shares

1. Irredeemable: Equity shares cannot be redeemed during the lifetime of

the business concern. It is the most dangerous thing of over capitalization.
392
2. Obstacles in management: Equity shareholder can put obstacles in
management by manipulation and organizing themselves. Because, they have
power to contrast any decision which are against the wealth of the
shareholders.

3. Leads to speculation: Equity shares dealings in share market lead to

secularism during prosperous periods.

4. Limited income to investor: The Investors who desire to invest in safe

securities with a fixed income have no attraction for equity shares.

5. No trading on equity:When the company raises capital only with the

help of equity, the company cannot take the advantage of trading on equity.

PREFERENCE SHARES

The parts of corporate securities are called as preference shares. It is the

shares, which have preferential right to get dividend and get back the initial
investment at the time of winding up of the company. Preference shareholders
are eligible to get fixed rate of dividend and they do not have voting rights.

Preference shares may be classified into the following major types:

1. Cumulative preference shares: Cumulative preference shares have right

to claim dividends for those years which have no profits. If the company is
unable to earn profit in any one or more years, C.P. Shares are unable to get
any dividend but they have right to get the comparative dividend for the
previous years if the company earned profit.
393
2. Non-cumulative preference shares: Non-cumulative preference shares
have no right to enjoy the above benefits. They are eligible to get only
dividend if the company earns profit during the years. Otherwise, they cannot
claim any dividend.

3. Redeemable preference shares: When, the preference shares have a

fixed maturity period it becomes redeemable preference shares. It can be
redeemable

during the lifetime of the company. The Company Act has provided certain
restrictions on the return of the redeemable preference shares.

Irredeemable Preference Shares

Irredeemable preference shares can be redeemed only when the company goes
for liquidator. There is no fixed maturity period for such kind of preference
shares.

Participating Preference Shares

Participating preference sharesholders have right to participate extra profits

after distributing the equity shareholders.

Non-Participating Preference Shares

394
Non-participating preference sharesholders are not having any right to
participate extra profits after distributing to the equity shareholders. Fixed rate
of dividend is payable to the type of shareholders.

Convertible Preference Shares

Convertible preference sharesholders have right to convert their holding into

equity shares after a specific period. The articles of association must authorize
the right of conversion.

Non-convertible Preference Shares

There shares, cannot be converted into equity shares from preference shares.

Features of Preference Shares

The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity

period except in the case of redeemable preference shares. Preference shares
can be redeemable only at the time of the company liquidation.

2. Residual claims on income: Preferential sharesholders have a residual

claim on income. Fixed rate of dividend is payable to the preference
shareholders.

3. Residual claims on assets: The first preference is given to the

preference shareholders at the time of liquidation. If any extra Assets are
available that should be distributed to equity shareholder.

4. Control of Management: Preference shareholder does not have any

voting rights. Hence, they cannot have control over the management of the
company.
395
Advantages of Preference Shares

Preference shares have the following important advantages.

1. Fixed dividend: The dividend rate is fixed in the case of preference

shares. It is called as fixed income security because it provides a constant rate
of income to the investors.

2. Cumulative dividends: Preference shares have another advantage

which is called cumulative dividends. If the company does not earn any profit
in any previous years, it can be cumulative with future period dividend.

3. Redemption: Preference Shares can be redeemable after a specific

period except in the case of irredeemable preference shares. There is a fixed
maturity period for repayment of the initial investment.

4. Participation: Participative preference sharesholders can participate in

the surplus profit after distribution to the equity shareholders.

5. Convertibility: Convertibility preference shares can be converted into

equity shares when the articles of association provide such conversion.

Disadvantages of Preference Shares

1. Expensive sources of finance: Preference shares have high expensive

source of finance while compared to equity shares.

396
2. No voting right: Generally preference sharesholders do not have any
voting rights. Hence they cannot have the control over the management of the
company.

3. Fixed dividend only: Preference shares can get only fixed rate of
dividend. They may not enjoy more profits of the company.

4. Permanent burden: Cumulative preference shares become a permanent

burden so far as the payment of dividend is concerned. Because the company
must pay the dividend for the unprofitable periods also.

5. Taxation: In the taxation point of view, preference shares dividend is

not a deductible expense while calculating tax. But, interest is a deductible
expense. Hence, it has disadvantage on the tax deduction point of view.

INTERNAL FINANCE

A company can mobilize finance through external and internal sources. A new
company may not raise internal sources of finance and they can raise finance
only external sources such as shares, debentures and loans but an existing
company can raise both internal and external sources of finance for their
financial requirements. Internal finance is also one of the important sources of
finance and it consists of cost of capital while compared to other sources of
finance.

Internal source of finance may be broadly classified into two categories:

A. Depreciation Funds

B. Retained earnings
397
Depreciation Funds

Depreciation funds are the major part of internal sources of finance, which is
used to meet the working capital requirements of the business concern.
Depreciation means decrease in the value of asset due to wear and tear, lapse
of time, obsolescence, exhaustion and accident. Generally depreciation is
changed against fixed assets of the company at fixed rate for every year. The
purpose of depreciation is replacement of the assets after the expired period. It
is one kind of provision of fund, which is needed to reduce the tax burden and
overall profitability of the company.

Retained Earnings

Retained earnings are another method of internal sources of finance. Actually

is not a method of raising finance, but it is called as accumulation of profits by
a company for its expansion and diversification activities.

Retained earnings are called under different names such as; self finance, inter
finance, and plugging back of profits. According to the Companies Act 1956
certain percentage, as prescribed by the central government (not exceeding
10%) of the net profits after tax of a financial year have to be compulsorily
transferred to reserve by a company before declaring dividends for the year.

Under the retained earnings sources of finance, a part of the total profits is
transferred to various reserves such as general reserve, replacement fund,
reserve for repairs and renewals, reserve funds and secrete reserves, etc.

Advantages of Retained Earnings

398
Retained earnings consist of the following important advantages:

1. Useful for expansion and diversification: Retained earnings are most

useful to expansion and diversification of the business activities.

2. Economical sources of finance: Retained earnings are one of the least

costly sources of finance since it does not involve any floatation cost as in the
case of raising of funds by issuing different types of securities.

3. No fixed obligation: If the companies use equity finance they have to

pay dividend and if the companies use debt finance, they have to pay interest.
But if the company uses retained earnings as sources of finance, they need not
pay any fixed obligation regarding the payment of dividend or interest.

4. Flexible sources: Retained earnings allow the financial structure to

remain completely flexible. The company need not raise loans for further
requirements, if it has retained earnings.

5. Increase the share value: When the company uses the retained earnings
as the sources of finance for their financial requirements, the cost of capital is
very cheaper than the other sources of finance; Hence the value of the share
will increase.

6. Avoid excessive tax: Retained earnings provide opportunities for

evasion of excessive tax in a company when it has small number of
shareholders.

7. Increase earning capacity: Retained earnings consist of least cost of

capital and also it is most suitable to those companies which go for
diversification and expansion.

Disadvantages of Retained Earnings

399
Retained earnings also have certain disadvantages:

1. Misuses: The management by manipulating the value of the shares in

the stock market can misuse the retained earnings.

2. Leads to monopolies: Excessive use of retained earnings leads to

monopolistic attitude of the company.

3. Over capitalization: Retained earnings lead to over capitalization,

because if the company uses more and more retained earnings, it leads to
insufficient source of finance.

4. Tax evasion: Retained earnings lead to tax evasion. Since, the company
reduces tax burden through the retained earnings.

5. Dissatisfaction: If the company uses retained earnings as sources of

finance, the shareholder can’t get more dividends. So, the shareholder does not
like to use the retained earnings as source of finance in all situations.

SOURCES AND APPLICATION OF FUNDS

"Cash flow" is one of the most vital elements in the survival of a business. It
can be positive, or negative, which is obviously a most undesirable situation.
The chapter develops the concept of cash flow and then shows how the funds
can be used in the business. Funds are not only generated internally; they may
be externally generated, and so the chapter finishes with a discussion of
externally generated funds.

Aim of a cash flow statement

The aim of a cash flow statement should be to assist users:

400
· to assess the company's ability to generate positive cash flows in the future
· to assess its ability to meet its obligations to service loans, pay dividends etc
· to assess the reasons for differences between reported and related cash flows
· to assess the effect on its finances of major transactions in the year.
The statement therefore shows changes in cash and cash equivalents rather
than working capital.

Indirect method cash flow statement

Pro forma cash flow statement

Cash Flow Statement For The Year Ended 31 December 19X4

Rs. Rs.
Net cash inflow from operating activities X
Returns on investments and servicing of finance
Interest received X
Interest paid (X)
Dividends paid (X)
Net cash inflow/ (outflow) from returns on investments and servicing of X
finance
Taxation
Corporation tax paid (X)
Tax paid (X)
Investing activities
Payments to acquire intangible fixed assets (X)
Payments to acquire tangible fixed assets (X)
Receipts from sales of tangible fixed assets X
Net cash inflow/ (outflow) from investing activities X (X)
or
Net cash inflow before financing X
Financing
Issue of ordinary capital X
Repurchase of debenture loan (X)
Expenses paid in connection with share issues (X)
Net cash inflow/ (outflow) from financing X (X)
or
401
Increase/ (Decrease) in cash and cash equivalents X

Cash flow statement

Set out below are the accounts for TPK hospital as at 31 December 19X4 and
19X5.

PROFIT AND LOSS ACCOUNTS FOR THE YEARS TO 31 DECEMBER

19X4 19X5
Z$'000 Z$'000
Operating profit 9,400 20,640
Interest paid - (280)
Interest received 100 40
Profit before taxation 9,500 20,400
Taxation (3,200) (5,200)
Profit after taxation 6,300 15,200
Dividends
Preference (paid) (100) (100)
Ordinary: interim (paid) 1,000) (2,000)
final (proposed) (3,000) (6,000)
Retained profit for the year 2,200 7,100
BALANCE SHEETS AS AT 31
DECEMBER
Fixed Assets
Plant, machinery and equipment at cost 17,600 23,900
Less: accumulated depreciation 9,500 10,750
8,100 13,150
Current Assets
Stocks 5,000 15,000
Trade debtors 8,600 26,700
Prepayments 300 400
Cash at bank and in hand 600 -
14,500 42,100
Current liabilities
Bank overdraft - 16,200
Trade creditors 6,000 10,000
Accruals 800 1,000
Taxation 3,200 5,200
Dividends 3,200 6,000
3,000 38,400
402
 9,600 16,850
Share capital
Ordinary shares of $1 each 5,000 5,000
10% preference shares of $1 each 1,000 1,000
Profit and loss account 3,000 10,100
9,000 16,100
Loans
15% debenture stock 600 750
9,600 16,850

Prepare a cash flow statement for the year to 31 December 19X5.

STATEMENTS OF SOURCE AND APPLICATION OF FUNDS

Although cash flow statements have now superseded statements of source and
application of funds, funds flow statements may not disappear entirely. Some
businesses or industries will continue to find fund flow statements useful and
informative. For this reason, it is necessary to examine funds flow statements.

Funds statement on a cash basis

Funds statements on a cash basis can be prepared by classifying and/or

consolidating:

a) net balance sheet changes that occur between two points in time into
changes that increase cash and changes that decrease cash
b) from the Income statement and the surplus (profit and loss) statement, the
factors that increase cash and the factors that decrease cash and

c) this information in a sources and uses of funds statement form.

403
Step (a) involves comparing two relevant Balance sheets side by side and then
computing the changes in the various accounts.

Sources of funds that increase cash

Sources of funds which increase cash are as follows:
· a net decrease in any asset other than cash or fixed assets
· a gross decrease in fixed assets
· a net increase in any liability
· proceeds from the sale of preferred or common stock
· funds provided by operations (which usually are not expressed directly in the
income statement).

5.3 ANALYSIS OF FINANCIAL STATEMENTS

INTRODUCTION

A financial statement is an official document of the firm, which explores the

entire financial information of the firm. The main aim of the financial
statement is to provide information and understand the financial aspects of the
firm. Hence, preparation of the financial statement is important as much as the
financial decisions.

MEANING AND DEFINITION

According to Hamptors John, the financial statement is an organized collection

of data according to logical and consistent accounting procedures. Its purpose
is to convey an understanding of financial aspects of a business firm. It may
show a position at a moment of time as in the case of a balance-sheet or may
reveal a service of activities over a given period of time, as in the case of an
income statement.
404
Financial statements are the summary of the accounting process, which,
provides useful information to both internal and external parties. John N. Nyer
also defines it “Financial statements provide a summary of the accounting of a
business enterprise, the balance-sheet reflecting the assets, liabilities and
capital as on a certain data and the income statement showing the results of
operations during a certain period”.

Financial statements generally consist of two important statements:

(i) The income statement or profit and loss account.

(ii) Balance sheet or the position statement.

A part from that, the business concern also prepares some of the other parts of
statements, which are very useful to the internal purpose such as:

(i) Statement of changes in owner’s equity.

(ii) Statement of changes in financial position.

Income Statement

Income statement is also called as profit and loss account, which reflects the
operational position of the firm during a particular period. Normally it consists
of one accounting year. It determines the entire operational performance of the
concern like total revenue generated and expenses incurred for earning that
revenue.

Income statement helps to ascertain the gross profit and net profit of the
concern. Gross profit is determined by preparation of trading or manufacturing
a/c and net profit is determined by preparation of profit and loss account.
405
Position Statement

Position statement is also called as balance sheet, which reflects the financial
position of the firm at the end of the financial year.

Position statement helps to ascertain and understand the total assets, liabilities
and capital of the firm. One can understand the strength and weakness of the
concern with the help of the position statement.

Statement of Changes in Owner’s Equity

It is also called as statement of retained earnings. This statement provides

information about the changes or position of owner’s equity in the company.
How the retained earnings are employed in the business concern. Nowadays,
preparation of this statement is not popular and nobody is going to prepare the
separate statement of changes in owner’s equity.

Statement of Changes in Financial Position

Income statement and position statement shows only about the position of the
finance, hence it can’t measure the actual position of the financial statement.
Statement of changes in financial position helps to understand the changes in
financial position from one period to another period.

Statement of changes in financial position involves two important areas such

as fund flow statement which involves the changes in working capital position
and cash flow statement which involves the changes in cash position.

TYPES OF FINANCIAL STATEMENT ANALYSIS

406
Analysis of Financial Statement is also necessary to understand the financial
positions during a particular period. According to Myres, “Financial statement
analysis is largely a study of the relationship among the various financial
factors in a business as disclosed by a single set of statements and a study of
the trend of these factors as shown in a series of statements”.

Analysis of financial statement may be broadly classified into two important

types on the basis of material used and methods of operations.

Types of Financial
Analysis

On the basis of On the basis of

Methods of
Materials Used Operations

Vertic
External Internal Horizontal al
Analy
Analysis Analysis Analysis sis

1. Based on Material Used

Based on the material used, financial statement analysis may be classified into
two major types such as External analysis and internal analysis.

A. External Analysis

Outsiders of the business concern do normally external analyses but they are
indirectly involved in the business concern such as investors, creditors,
government organizations and other credit agencies. External analysis is very
much useful to understand the financial and operational position of the
407
business concern. External analysis mainly depends on the published financial
statement of the concern. This analysis provides only limited information
about the business concern.

B. Internal Analysis

The company itself does disclose some of the valuable informations to the
business concern in this type of analysis. This analysis is used to understand

14 Financial Management

the operational performances of each and every department and unit of the
business concern. Internal analysis helps to take decisions regarding achieving
the goals of the business concern.

2. Based on Method of Operation

Based on the methods of operation, financial statement analysis may be

classified into two major types such as horizontal analysis and vertical
analysis.

A. Horizontal Analysis

Under the horizontal analysis, financial statements are compared with several
years and based on that, a firm may take decisions. Normally, the current
year’s figures are compared with the base year (base year is consider as 100)
and how the financial information are changed from one year to another. This
analysis is also called as dynamic analysis.

B. Vertical Analysis
408
Under the vertical analysis, financial statements measure the quantities
relationship of the various items in the financial statement on a particular
period. It is also called as static analysis, because, this analysis helps to
determine the relationship with various items appeared in the financial
statement. For example, a sale is assumed as 100 and other items are converted
into sales figures.
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is interpreted mainly to determine the financial

and operational performance of the business concern. A number of methods or
techniques are used to analyse the financial statement of the business concern.
The following are the common methods or techniques, which are widely used
by the business concern

Techniques

Comparati Common Funds Cash

Ratio ve Trend Flow Flow
Size Statemen
Analysis Statement Analysis Statement t
Analysis

1. Comparative Statement Analysis

A. Comparative Income Statement Analysis

B. Comparative Position Statement Analysis

2. Trend Analysis

409
3. Common Size Analysis

4. Fund Flow Statement

5. Cash Flow Statement

6. Ratio Analysis

Comparative Statement Analysis

Comparative statement analysis is an analysis of financial statement at

different period of time. This statement helps to understand the comparative
position of financial and operational performance at different period of time.

Comparative financial statements again classified into two major parts such as
comparative balance sheet analysis and comparative profit and loss account
analysis.

Comparative Balance Sheet Analysis

Comparative balance sheet analysis concentrates only the balance sheet of the
concern at different period of time. Under this analysis the balance sheets are
compared with previous year’s figures or one-year balance sheet figures are
compared with other years. Comparative balance sheet analysis may be
horizontal or vertical basis. This type of analysis helps to understand the real
financial position of the concern as well as how the assets, liabilities and
capitals are placed during a particular period.

Example1

410
The following are the balance sheets of MMM hospital , for the years 2003
and 2004 as on 31st March. Prepare a comparative balance sheet and discuss
the operational performance of the business concern.

Balance Sheet of MMM HOSPITAL

As on 31st March (Rs. in thousands)

Liabiliti
es 2003 2004 Assets 2003 2004
Rs. Rs. Rs. Rs.
Cash and
Capital 2,845 2,845 Balance
Reserve
and with RBI 27,06,808 22,37,601
39,66,00 47,65,40 Balance
Surplus 9 6 with Banks
4,08,45,7 4,40,42, and Money
Deposits 83 730 at call &
Borrowin and short
gs notice 11,36,781 16,07,975
Other 2,14,21,0 2,35,37,0
Liabilities 7,27,671 2,84,690 Investments 60 98
Provisio 16,74,16 17,99,19 1,95,99,7 2,11,29,8
ns 5 7 Advances 64 69
Fixed Assets 4,93,996 5,36,442
Other Assets 18,58,064 18,35,883

4,72,16,4 5,08,94, 4,72,16,4 5,08,94,8

73 868 73 68

411
Solution
Comparative Balance Sheet
Analysis

Increased/ Increased/
Particulars Year ending 31st March Decreased Decreased
(Percentage
(Amount) )
2003 2004
Rs. Rs. Rs. Rs.
Assets
Current Assets

Cash and Balance with

RBI 27,06,808 22,37,601 (+) 4,69,207 (+) 17.33
Balance with Banks and
money at call and short
notice 11,36,781 16,07,975 (–) 4,71,194 (–) 41.45

Total Current Assets 38,43,589 38,45,576 1987 0.052

Fixed Assets
(-)
Investments 2,14,21,060 2,35,37,098 21,16,038 (-) 9.88
(-)
Advances 1,95,99,764 2,11,39,869 15,40,105 (-) 7.86
Fixed Assets 4,93,996 5,36,442 (-) 42,446 (-) 8.59
Other Assets 18,58,064 18,35,883 (+) 22,181 (+) 1.19

(+)
Total Fixed Assets 4,33,72,884 4,70,49,292 36,76,408 8.48
Total Assets 4,72,16,473 5,08,94,868 36,78,395 7.79
Current Liabilities
Borrowings 7,27,671 2,84,690 (+) 4,42,981 60.88
Other Liability and
Provisions 16,74,165 17,99,197 (–) 1,25,032 7.47

Total Current Liability 24,01,836 20,83,887 3,17,949 13.24

Fixed Liability Capital 2,845 2,845 — —
Reserves surplus 39,66,009 47,65,406 (+) 7,99,397 20.16
(+)
Deposit 4,08,45,783 4,40,42,730 31,96,947 7.83

(+)
Total Fixed Liability 4,48,14,637 4,88,10,981 39,96,344 8.92

Total Liability 4,72,16,473 5,08,94,868 36,78,395 7.79

412
FUNDS FLOW STATEMENT

Funds flow statement is one of the important tools, which is used in many
ways. It helps to understand the changes in the financial position of a business
enterprise between the beginning and ending financial statement dates. It is
also called as statement of sources and uses of funds.

Institute of Cost and Works Accounts of India, funds flow statement is defined
as “a statement prospective or retrospective, setting out the sources and
application of the funds of an enterprise. The purpose of the statement is to
indicate clearly the requirement of funds and how they are proposed to be
raised and the efficient utilization and application of the same”.

CASH FLOW STATEMENT

Cash flow statement is a statement which shows the sources of cash inflow
and uses of cash out-flow of the business concern during a particular period of
time. It is the statement, which involves only short-term financial position of
the business concern. Cash flow statement provides a summary of operating,
investment and financing cash flows and reconciles them with changes in its
cash and cash equivalents such as marketable securities. Institute of Chartered
Accountants of India issued the Accounting Standard (AS-3) related to the
preparation of cash flow statement in 1998.

Difference Between Funds Flow and Cash Flow Statement

413
 Funds Flow
Statement
Funds flow statement is the
report on the
1.
movement of funds or working
capital
Funds flow statement explains
how working
2.
capital is raised and used
during the particular
The main objective of fund
flow statement is
3.
to show the how the resources
have been
balanced mobilized and used.
Funds flow statement indicates
the results of
4.
current financial management.
In a funds flow statement
increase or decrease
5.
in working capital is recorded.
In funds flow statement there
is no opening
6.
and closing balances.
Cash Flow Statement
Cash flow statement is the
1. report showing
sources and uses of cash.
Cash flow statement explains
2. the inflow and
out flow of cash during the
particular period.
The main objective of the cash
3. flow statement
is to show the causes of
changes in cash
between two balance sheet
dates.
Cash flow statement indicates
4. the factors
contributing to the reduction
of cash balance
in spite of increase in profit
and vice-versa.
In a cash flow statement only
5. cash receipt and
payments are recorded.
Cash flow statement starts
6. with opening cash
balance and ends with closing
cash balance.
414
5.4 FINANCIAL PERFORMANCE OF HOSPITAL

5.5 FINANCIAL PLANNING: LONG TERM AND SHORT TERM

Funds use and credit planning

Funds (or capital) is a collective term applied to the assortment of productive

inputs that have been produced. Funds may be broadly categorised into
operating (or working) capital (difference between current assets and current
liabilities), and ownership (or investment) capital.

Operating capital in a company or firm usually refers to production inputs that

are normally used up within a production year. On the other hand, investment
capital (or funds) refers to durable resources like machines and buildings in
which money invested is tied up for several years. Funds are generally
quantified in monetary value terms.

Funds use, especially borrowed capital, is usually influenced by many factors,

namely: the alternative demands for it; the availability of credit as and when
needed; the time and interest rate payable on it; the types of loans that might
be needed to generate it; and the cost of funds and business ownership cost.
Thus, careful credit planning is essential in the successful operations of any
company.

In general, this requires the application of what, in strategic company

management, has come to be known as the strategic four-factor model called
"SORS". The letters that make up SORS stand for:-

· Strategic planning (S)

415
· Organisational planning (O)
· Resource requirements (R)
· Strategic control (S).
Figure 3.2 summarises the simplified matrix of interacting factors and
component parts that make up 'SORS'. In general terms, SORS is influenced or
determined by four major factors: the external environment, the internal
environment, organisational culture and resource (especially funds)
availability. These four factors interact to create four inter-related components
which normally determine the success or failure of any given company. These
are:

a) competitive environment
b) strategic thrust
c) product/market dynamics
d) competitive cost position and restructuring.
A proper and pragmatic manipulation of these four component parts requires:

· assessing the external environment

· understanding the internal environment
· adopting a leadership strategy
· strategically planning the finances of the company.
The purpose of this text is not to cover all the components summarised in
figure 3.1. Instead, the major concern is to have a proper understanding of
financial analysis for strategic planning. This, in strategic management,
requires a sound financial analysis backed by strategic funds programming,
baseline projections (or budgeting), what-if (decision tree) analysis, and risk
analysis. This book attempts to cover all these areas.

Alternative uses of funds

Dealing with alternatives is what management is all about. Some of the tools
for evaluating alternatives (e.g. partial budgets, cash flow budgets and
financial statements), are covered in this text.
416
It is assumed that most people are already familiar with the analysis that
usually leads to major capital use decisions in various companies. However,
highlighted are some of these points throughout the book, since company
backgrounds differ and what is considered "major capital use decisions" varies
with the size of businesses. For instance, a $50,000 expenditure may be major
to one company and of little significance to another.

Figure 3.2 The strategic four-factor model

Almost everyone is familiar with the substantial capital or funds demand in all
forms of business. Obviously, this does not all have to be owned capital.
Evaluation of successful businesses has found that many of them operate with
50 percent or more rented or borrowed capital. The pressure on businesses to
grow is likely to continue, and these businesses are likely to grow faster than
will be permitted by each reinvesting its own annual savings from net income
alone. Thus, because demand for credit will continue to expand, careful credit
planning and credit use decisions are of paramount importance to marketing
companies in any country.

Credit and types of loans

Credit is the capacity to borrow. It is the right to incur debt for goods and/or
services and repay the debt over some specified future time period. Credit
provision to a company means that the business is allowed the use of a
productive good while it is being paid for.

Other than the fact that funds generated within a business are usually
inadequate to meet expanding production and other activities, credit is often
used in order to:

· increase the returns on equity capital

· allow more efficient labour utilisation
417
· increase income.
The process of using borrowed, leased or "joint venture" resources from
someone else is called leverage. Using the leverage provided by someone
else's capital helps the user business go farther than it otherwise would. For
instance, a company that puts up $1,000 and borrows an additional $4,000 is
using 80% leverage. The objective is to increase total net income and the
return on a company's own equity capital.

Borrowed funds are generally referred to as loans. There are various ways of
classifying loans, namely:

· in payment terms, e.g. instalment versus single payment

· in period-of-payment terms, e.g. short-term versus intermediate-term or long-
term
· in the manner of its security terms, e.g. secured versus unsecured
· in interest payment terms, e.g. simple interest versus add-on, versus discount,
versus balloon.
On the basis of the above classification, there are twelve common types of
loans, namely: short-term loans, intermediate-term loans, long-term loans,
unsecured loans, secured loans, instalment loans, single payment loans,
simple-interest loans, add-on interest loans, discount or front-end loans,
balloon loans and amortised loans.

Short-term loans are credit that is usually paid back in one year or less. Short
term loans are usually used in financing the purchase of operating inputs,
wages for hired labour, machinery and equipment, and/or family living
expenses. Usually lenders expect short-term loans to be repaid after their
purposes have been served, e.g. after the expected production output has been
sold.

Loans for operating production inputs e.g. cotton for the Cotton Company of
Zimbabwe (COTCO) and beef for the Cold Storage Company of Zimbabwe
(CSC), are assumed to be self-liquidating. In other words, although the inputs
418
are used up in the production, the added returns from their use will repay the
money borrowed to purchase the inputs, plus interest. Astute managers are
also expected to have figured in a risk premium and a return to labour
management. On the other hand, loans for investment capital items like
machinery are not likely to be self-liquidating in the short term. Loans for
family living expenses are not at all self-liquidating and must come out of net
cash income after all cash obligations are paid.

Intermediate-term (IT) loans are credit extended for several years, usually one
to five years. This type of credit is normally used for purchases of buildings,
equipment and other production inputs that require longer than one year to
generate sufficient returns to repay the loan.

Long-term loans are those loans for which repayment exceeds five to seven
years and may extend to 40 years. This type of credit is usually extended on
assets (such as land) which have a long productive life in the business. Some
land improvement programmes like land levelling, reforestation, land clearing
and drainage-way construction are usually financed with long-term credit.

Unsecured loans are credit given out by lenders on no other basis than a
promise by the borrower to repay. The borrower does not have to put up
collateral and the lender relies on credit reputation. Unsecured loans usually
carry a higher interest rate than secured loans and may be difficult or
impossible to arrange for businesses with a poor credit record.

Secured loans are those loans that involve a pledge of some or all of a
business's assets. The lender requires security as protection for its depositors
against the risks involved in the use planned for the borrowed funds. The
borrower may be able to bargain for better terms by putting up collateral,
which is a way of backing one's promise to repay.

Instalment loans are those loans in which the borrower or credit customer
repays a set amount each period (week, month, year) until the borrowed
419
amount is cleared. Instalment credit is similar to charge account credit, but
usually involves a formal legal contract for a predetermined period with
specific payments. With this plan, the borrower usually knows precisely how
much will be paid and when.

Single payment loans are those loans in which the borrower pays no principal
until the amount is due. Because the company must eventually pay the debt in
full, it is important to have the self-discipline and professional integrity to set
aside money to be able to do so. This type of loan is sometimes called the
"lump sum" loan, and is generally repaid in less than a year.

Simple interest loans are those loans in which interest is paid on the unpaid
loan balance. Thus, the borrower is required to pay interest only on the actual
amount of money outstanding and only for the actual time the money is used
(e.g. 30 days, 90 days, 4 months and 2 days, 12 years and one month).

Add-on interest loans are credit in which the borrower pays interest on the full
amount of the loan for the entire loan period. Interest is charged on the face
amount of the loan at the time it is made and then "added on". The resulting
sum of the principal and interest is then divided equally by the number of
payments to be made. The company is thus paying interest on the face value of
the note although it has use of only a part of the initial balance once principal
payments begin. This type of loan is sometimes called the "flat rate" loan and
usually results in an interest rate higher than the one specified.

Discount or front-end loans are loans in which the interest is calculated and
then subtracted from the principal first. For example, a $5,000 discount loan at
10% for one year would result in the borrower only receiving $4,500 to start
with, and the $5,000 debt would be paid back, as specified, by the end of a
year.

420
On a discount loan, the lender discounts or deducts the interest in advance.
Thus, the effective interest rates on discount loans are usually much higher
than (in fact, more than double) the specified interest rates.

Balloon loans are loans that normally require only interest payments each
period, until the final payment, when all principal is due at once. They are
sometimes referred to as the "last payment due", and have a concept that is the
same as the single payment loan, but the due date for repaying principal may
be five years or more in the future rather than the customary 90 days or 6
months for the single payment loan.

In some cases a principal payment is made each time interest is paid, but
because the principal payments do not amortise (pay off) the loan, a large sum
is due at the loan maturity date.

Amortised loans are a partial payment plan where part of the loan principal
and interest on the unpaid principal are repaid each year. The standard plan of
amortisation, used in many intermediate and long-term loans, calls for equal
payments each period, with a larger proportion of each succeeding payment
representing principal and a small amount representing interest.

The repayment schedule for a 10 year standard amortised loan of $10,000 at

7% is presented in table 3.1.

The constant annual payment feature of the amortised loan is similar to the
"add on" loan described above, but involves less interest because it is paid
only on the outstanding loan balance, as with simple interest. Amortisation
tables are used to determine the regular payment for an amortised loan. The
$1,424.00 annual payment for the 10 year loan was determined by using the
amortisation factor (AF) of 0.1424 and multiplying that by $10,000, the face
value of the loan. The proper procedure for deriving a schedule as in table 3.1
is to:

421
a) first read off the amortisation factor from an amortisation table for a given
interest rate against the given year the loan is expected to last
b) calculate the total payment at the end of each year

c) then, on a year-by-year basis, calculate the annual interest payable on the

balance of the principal

d) obtain the annual principal payment by subtracting the calculated annual

interest from the total end-of-year payment.

5.6 FINANCING OF HEALTH

A hospital is a health care institution providing patient treatment by

specialized staff and equipment.
Hospitals are usually funded by the public sector, by health organizations (for
profit or nonprofit), health insurance companies, or charities, including direct
charitable donations. Historically, hospitals were often founded and funded by
religious orders or charitable individuals and leaders.[1] Today, hospitals are
largely staffed by professional physicians, surgeons, and nurses, whereas in
the past, this work was usually performed by the founding religious orders or
by volunteers. However, there are various Catholic religious orders, such as
the Alexians and the Bon Secours Sisters, which still focus on hospital
ministry today, as well as several Christian denominations, including the
Methodists and Lutherans, which run hospitals.[2]
In accord with the original meaning of the word, hospitals were originally
"places of hospitality", and this meaning is still preserved in the names of

422
some institutions such as the Royal Hospital Chelsea, established in 1681 as a
retirement and nursing home for veteran soldiers.

5.7 ANALYSIS OF NEED FOR FUND FOR MODERNIZATION AND

EXPANSION

5.8 FINANCIAL INFORMATION SYSTEM AND REPORTING

5.9 INVESTMENT MANAGEMENT

423
5.10 FUNDRAISING

EIGHT STRATEGIES FOR FUND RAISING:

Though scaling back has become a fact of the recession, CFOs who take a
different tack with their philanthropic divisions may find a strong strategic
partner waiting to improve their bottom line.

1. Decide if it's fundraising or development. Fundraising is designed to focus

on the next cause, says John B. Donovan, executive director at Dubuque
Mercy Health Foundation in Dubuque, IA, part of the Trinity Health Network.
The foundation, which was created in February 2008, gathers charitable
contributions for the 288-bed, Catholic nonprofit Mercy Medical Center.
Getting the foundation off to a swift start was difficult in the down economy,
though Donovan says that realigning the focus to look at the larger picture for
the facility is the key to long-term success.

"You may not develop long-term donors if your primary goal is to raise money
for the latest project," Donovon says. Instead, he advocates for development,
in which a regular team is used to cultivate donors and looks at the broader
scope of capital projects for the entire facility and works toward larger goals.
It's a tactic Sharp Healthcare Foundation has employed successfully for nearly
eight years.

2. Use performance measures. You measure every other aspect of your

finances, if you aren't tracking performance measures for your philanthropy
division in the organization's monthly "dashboard" reports, then start. McGinly
says when evaluated on net return philanthropy is sometimes the hospital's
most valuable revenue producer.

424
Sharp HealthCare uses these measures, and Littlejohn says they take a
strategic approach by reviewing the hospitals five-year capital plan and the
five-year cash projection, then they determine how the foundations efforts will
fit into the larger plan for the facility.

"Our approach is a bit of a departure from other organizations who may look at
philanthropy [donations] as a 'nice thing' to have," says Donovan. "We want to
know what role our team will play in funding the long-term projects, so we
can articulate this to our donors."

3. Get the right tools in place. CFOs can be instrumental in helping the
fundraising team evaluate information systems to track their financials. The
information that is gathered can go a long way toward helping you set up
performance measures and establish five-year projections.

4. Educate your team. Your finance team may need a better understanding of
what the fundraising team does for the hospital. Have the philanthropy team
explain the multitude of reasons people give to hospitals and the value their
efforts bring to the bottom line. By ensuring your team has a clear
understanding of the value of the donor-hospital relationship, they will be
better able to support philanthropy.

5. Give at the office. If you want to show your team to value your
philanthropic efforts, make a personal donation. Whether it's via a check or
through event attendance, the more efforts you make to support philanthropy
at your hospital, the more likely your team will follow suit.

6. Keep the team intact. In this economy, cost reductions are important and
that means sometimes CFOs need to reduce staff. This is not the department to
target first. Rather than cut personnel, first look for other ways to reduce their
costs, such as reducing events.

425
"You have to keep the fundraising office as strong as you can and not lose
seasoned people," advises McGinly. "You don't want to rebuild that
infrastructure when the [economic] shift comes around."

McGinly continues that if you have a capital campaign that is currently being
delayed and you cut your fundraising department to the core, "you are going to
have some real rebuilding problems and that will impact the community as
things start to turn around." Philanthropic relationship-building is no easy task
and donors are more inclined to give to people and facilities that they have
developed a relationship.

"There's always money for projects that are worth doing, you just have to
make a case to the donors as to why the community will be better off when it's
completed. But to do that you need to have the right people ask them for the
donation, just as you need to have the right project for them to support," says
Donovan.

7. Stretch the idea of donation projects. Certainly calls, letters, and events go a
long way toward keeping you in contact with donors, but there are less
conventional fundraising efforts that facilities can turn to, as well. For
instance, Sharp offers potential donors a deferred gifts program called the Life
Estate Gift Annuity. The program allows some people to donate their homes to
the health system and live in them for the rest of their lives. Sharp takes
ownership of the home when the donor dies and sells the property.

The majority of candidates are over 70 years old and either own their home or
are close to it, and Sharp pays the donors an annuity based on the value of the
house.

8. Say "Thank You." Now more than ever those two words mean a lot. For
nearly seven years, Sharp's philanthropic team has focused on gathering larger
numbers of smaller donors. The effort proved fruitful when the economy
dipped. Littlejohn explains that all former patients are potential donors, and
426
many make donations to express their thanks to the hospital. But the gratitude
shouldn't stop with your donors. Personal "thank you" calls or notes from the
CFO or CEO of a facility go a long way toward helping to build a strong
relationship with your donor community. "Call them up and say 'Thank you.'
Let them know their donations are touching lives," says Donovan. "Give them
examples of positive ways their gifts will be used."

It's the season of giving, but if you haven't given your philanthropic division a
once over in quite a while, your facility may be truly missing out on a great
opportunity to not only live up to their mission, but also to bring in some
greatly needed funds for your future capital projects.

5.10.1 ART OF FUNDRAISING

Funding:

In the modern era, hospitals are, broadly, either funded by the government of
the country in which they are situated, or survive financially by competing in
the private sector (a number of hospitals also are still supported by the
historical type of charitable or religious associations).

Charlotte Regional Medical Center, a for profit hospital in Punta Gorda,

Florida
In the United Kingdom for example, a relatively comprehensive, "free at the
point of delivery" health care system exists, funded by the state. Hospital care
is thus relatively easily available to all legal residents, although free
emergency care is available to anyone, regardless of nationality or status. As
hospitals prioritize their limited resources, there is a tendency for 'waiting lists'
for non-crucial treatment in countries with such systems, as opposed to letting
higher-payers get treated first, so sometimes those who can afford it take out
private health care to get treatment more quickly.[40] On the other hand, some
countries, including the USA, have in the twentieth century introduced a

427
private-based, for-profit-approach to providing hospital care, with few state-
money supported 'charity' hospitals remaining today.[41] Where for-profit
hospitals in such countries admit uninsured patients in emergency situations
(such as during and after Hurricane Katrina in the USA), they incur direct
financial losses,[41] ensuring that there is a clear disincentive to admit such
patients. In the United States, laws exist to ensure patients receive care in life
threatening emergency situations regardless of the patient's ability to pay.[42]
As the quality of health care has increasingly become an issue around the
world, hospitals have increasingly had to pay serious attention to this matter.
Independent external assessment of quality is one of the most powerful ways
to assess this aspect of health care, and hospital accreditation is one means by
which this is achieved. In many parts of the world such accreditation is
sourced from other countries, a phenomenon known as international healthcare
accreditation, by groups such as Accreditation Canada from Canada, the Joint
Commission from the USA, the Trent Accreditation Scheme from Great
Britain, and Haute Authorité de santé (HAS) from France.

(Hospital Arts Fundraising)

5.10.2 ANALYZING DONOR MARKETS

5.10.3 ORGANIZING FOR FUNDARISING

INTRODUCTION

The "Internet Resources" section of A GUIDE TO FUNDING

RESOURCES includes links to searchable databases offering funding
opportunities from government and/or private sources that are available to local
428
governments, community organizations, and individuals. It provides web links to
more than sixty full-text online guides, manuals, and tips to assist grantwriters
prepare successful proposals. The section of "Additional Resources" is a
bibliographic listing of published grant writing resources and funding directories.

The reader may locate links to additional funding programs and information on
the Rural Information Center (RIC):

• FUNDING RESOURCES page at:http://ric.nal.usda.gov/funding-

resources.
• RURAL COMMUNITY DEVELOPMENT RESOURCES page
at: http://ric.nal.usda.gov/community-development-resources
• RURAL HEALTH page at http://ric.nal.usda.gov/rural-health-0.

For additional information, contact the RIC at 1-800-633-7701 or

ric@ars.usda.gov

The use of trade, firm, or corporation names in this publication (or page) is for the
information and convenience of the reader. Such use does not constitute an
official endorsement or approval by the United States Department of Agriculture
or the Agricultural Research Service of any product or service to the exclusion of
others that maybe suitable.
For more information about National Agricultural Library Policy and Disclaimers

This resource guide was revised and updated by Patricia LaCaille John, November
2004.
Modified: July, 2013.
Rural Information Center Publication Series; no. 68 2004

THE FUNDING PROCESS

429
The process of grantsmanship covers a broad scope of activities including
preliminary planning and research, proposal development, and proposal follow-
up. Through this process, two questions are commonly asked by grantseekers,
"Where is the money available?" and "How do I get it?" The following discussion
addresses these questions and provides useful information for grantseekers in
search of funding dollars.

Where Does the Money Come From?

The two primary sources of grant money are public and private funds. Public
funds are obtained from governmental units, such as federal, state, and local
agencies. Private funds, on the other hand, come from organizations involved in
charitable giving, such as foundations, direct giving programs, voluntary agencies,
and community groups.

Federal Funding

The Federal government is the largest of all the grantmakers. However, much of
the federal grant budget moves to the states through formula and block grants.
From there it is up to the states to decide how to use the money.

The federal government administers several types of grants designed to

accomplish different purposes, such as conducting scientific research,
demonstrating a particular theory, or delivering services to a specific population.
Examples of these grants include:

• research grants to support investigations aimed at the discovery of facts,

revision of accepted theories, or application of new or revised theories;
• demonstration grants to demonstrate or establish the feasibility of a
particular theory or approach;

430
 • project grants to support individual projects in accordance with
legislation that gives the funding agency discretion in selecting the project,
grantees, and amount of award;
• block grants to provide states with funding for a particular purpose; and
• formula grants to provide funding to specified grantees on the basis of a
specific formula, using indicators such as per capita income, mortality, or
morbidity rates, outlined in legislation or regulations.

Data Universal Numbering System (DUNS) Number

All organizations applying for a federal grant or cooperative

agreement MUST have a DUNS number. Individuals who would personally
receive a grant or cooperative agreement award from the federal government apart
from any business or non-profit organization they may operate, and foreign
entities are exempt from this requirement.

The DUNS number is a unique nine character identification number provided by

the commercial company Dun & Bradstreet (D&B). The DUNS number is D&B's
copyrighted, proprietary means of identifying business entities on a location-
specific basis worldwide.

A DUNS Number remains with the company location to which it has been
assigned even if it closes or goes out-of-business. The DUNS Number is widely
used by both commercial and federal entities and was adopted as the standard
business identifier for federal electronic commerce in October 1994. The DUNS
was also incorporated into the Federal Acquisition Regulation (FAR) in April
1998 as the Federal Government's contractor identification code for all
procurement-related activities.

431
 • DUNS Q&A: http://www.usda.gov/rus/telecom/dlt/pdf_files/duns_qa.pdf
• DUNS Number
Guide: http://www.ccr.gov/pdfs/DUNSGuideGovVendors.pdf
• Request a DUNS Number by web http://fedgov.dnb.com/webform, or toll
free, 866-705-5711

In addition to federal funding, state and local agencies also administer grants.
Monies used to support these programs are obtained primarily through state and
local tax revenues and funds received from the federal government (e.g., block
and formula grants).

Federal Application Forms. FedForms.gov provides "one-stop-shopping" for the

federal forms most used by the public. Fedforms contains many, but not all, of the
forms issued by the federal agencies. If you can not find the forms you need in
FedForms, try the Agency Forms Links
at: http://www.forms.gov/bgfPortal/agencyDocs.do.

Private Funding

Private funding can be obtained from a variety of sources, such as foundations,

corporations, voluntary agencies and community groups. For the most part,
philanthropic organizations fund programs which either address their individual
interests (e.g., farm safety) or benefit a particular group (e.g., company employees
and their dependents). Examples of major types of philanthropic organizations
include:

432
 • private foundations which receive income from an individual, family or
group of individuals. The funding priorities of private foundations are
usually based on the personal philosophies of the founding members.
• corporate foundations which receive contributions from a profit-making
entity, such as a corporation.
• community foundations involved in grant giving within a specific
community or region.
• direct giving programs philanthropic arms of corporations which donate
goods and services for charitable causes.
• voluntary agencies private organizations which support charitable
programs that are consistent with their overall mission. The American Red
Cross, for example, provides printed materials and staff consultation for
health projects in various communities.
• community groups local organizations which focus on supporting
projects within their communities. Examples of these organizations
include churches, Junior Leagues, and civic organizations.

How Can I Obtain Funding?

Regardless of the type of funding desired, the grantsmanship process involves

three distinct phases: preliminary planning and research, effective proposal
writing, and proposal follow-up. To complete these phases successfully, the
grantseeker should consider the following steps:

STEPS IN THE FUNDING PROCESS

Steps Questions to Consider

Step 1: - What is the problem?

Identify a Need - How does my plan address the problem?

433
 - Who should I approach for funding?
Step 2:
- How do I obtain information about potential
Identify Funding Sources
funders?

- What are the goals and objectives of the program?

- How will the program be carried out?
Step 3:
- How will I budget the program?
Develop Proposal
- What type of proposal format should be used?
(e.g., forms or letters)

- Am I consistent with the funder's application

Step 4: deadlines?
Submit Proposal - Am I sending the proposal to the appropriate
contact?

- Was the proposal accepted?

Step 5:
- If not, why?
Follow-up
- Should I submit a revised proposal?

Although not exhaustive, these steps provide a general "game plan" for
individuals embarking on a grant search. By following these guidelines,
grantseekers can prepare a more effective funding strategy and increase their
overall chances for success.

How Do I Get Started?

Perhaps the hardest part of the grantsmanship process is getting started! With this
in mind, the following checklist has been developed to help grantseekers get off
on the right track.

• Become Familiar with the Grantsmanship Process!

434
If you are a first time grantseeker, you may wish to attend a grant writing
workshop or team up with an experienced fund raiser. In addition, you may also
wish to hire a professional consultant for proposal guidance and development.

Check your local library! Several libraries have sections related to grantsmanship
and funding resources. If your local library does not have a copy of a book or
periodical mentioned in this publication, they should be able to obtain a copy
through interlibrary loan.

• Check the Funding Sources in Your Own Back Yard!

Oftentimes grantseekers approach the larger, national foundations for projects

which may be more attractive to local, community funders. Remember, national
funders support projects which have a broad impact, while smaller funders support
those which effect their own community. Be sure to consider this when beginning
your search.

Contact associations and members of organizations that are related to your field of
interest. They might be able to offer suggestions for the best place to begin your
funding search.

• Pursue Several Potential Funders!

Be sure to identify several potential funders when conducting your search. The
odds of a successful search are greater when you approach a variety of funders.

Maintain a journal of what organizations you have contacted and when. Each
grant program will probably have a different set of deadlines, so it is helpful to
have a master list.

• Check In With Us!

The staff of the Rural Information Center may be able to direct you to potential
funding sources. Contact RIC at 1-800-633-7701 or ric@ars.usda.gov

435
INTERNET RESOURCES
FEDERAL FUNDING DATABASES

1. CATALOG OF FEDERAL DOMESTIC ASSISTANCE

(CFDA). CFDA is an Internet database containing information about all
federal domestic programs including federal grants, loans, insurance, and
training programs; information is available on eligibility, application
procedures, selection criteria, and deadlines. https://www.cfda.gov/
2. FEDERAL FUNDING SOURCES FOR RURAL AREAS DATABASE
FOR RURAL AREAS DATABASE. This online Internet database contains
information about rural federal domestic programs including federal
grants, loans, insurance, and training programs;information is available on
eligibility, application procedures, selection criteria, and
deadlines.http://ric.nal.usda.gov/Rural-Federal-Funding-Database
3. GRANTS.GOV
1-800-518-4726
http://www.grants.gov
Grants.gov is an online database containing information on more than 900
federal grant programs.

PRIVATE FUNDING DATABASES

GUIDESTAR at: http://www2.guidestar.org/AdvancedSearch.aspx allows you to

search more than 1 million U.S. nonprofits by subject, category, keyword, state,
nonprofit type, etc. to identify local or state organizations.
Guide to GuideStar: http://www.charitablegift.org/your-charitable-
plan/overview.shtml.

1. THE FOUNDATION CENTER. http://foundationcenter.org/

o FOUNDATION
FUNDER at: http://foundationcenter.org/findfunders/

436
 o LINKS TO PRIVATE FOUNDATION WEBSITES, A-Z, Subject,
Geographic, or Keyboard search
at:http://foundationcenter.org/getstarted/topical/sl_dir.html
o LINKS TO GRANTMAKING CORPORATE FOUNDATION
WEBSITES, A-Z, Subject, Geographic, or Keyboard search
at:http://foundationcenter.org/getstarted/faqs/html/corporate_giving
.html
o FOUNDATION
FINDER at: http://foundationcenter.org/findfunders/
2. COMMUNITY FOUNDATIONS BY STATE. TGCI, The Grantsmanship
Center. http://www.tgci.com/funding.shtml
3. COMMUNITY FOUNDATIONS BY STATE. Council On
Foundations.http://www.cof.org/whoweserve/community/resources/index.
cfm?navItemNumber=15626#locator
4. IDEALIST.ORG at: http://www.idealist.org allows you to search more
than 40,000 nonprofit and community organizations in 165 counties by
city, state, keyword, etc.
5. SEARCH FOR CHARITIES. IRS. Search by city, city and state, or
state. http://www.irs.gov/charities/index.html

GUIDES TO STATE FOUNDATIONS

1. FINDING LOCAL FUNDING: A GUIDE TO STATE FOUNDATION

DIRECTORIES. Marc Green. TGCI, The Grantsmanship
Center.http://www.tgci.com/magazine/Finding%20Local%20Funding.pdf
2. STATE AND LOCAL FUNDING DIRECTORIES: A
BIBLIOGRAPHY. Sarah Collins, Jimmy Tom. The Foundation
Center.http://foundationcenter.org/getstarted/faqs/html/state.html

437
FOUNDATION DATABASES/DIRECTORIES BY STATE

1. CA: FOUNDATION & GRANTMAKERS DIRECTORY. Northern

California Community Foundation,
Inc.http://www.foundations.org/grantmakers.html
2. CO: FINANCIAL ASSISTANCE. Colorado Department of Local
Affairs. http://www.dola.state.co.us/financial_assistance.html
3. DE: DIRECTORY OF DELAWARE GRANTMAKERS 2003. Delaware
Community
Foundation.http://www.delcf.org/Download/2003%20DIRECTORY%20O
F%20DELAWARE%20GRANTMAKERS.pdf
4. MA: GRANTMAKERS IN MASSACHUSETTS. Fundsnet Online
Services. http://www.fundsnetservices.com/massachu.htm
5. MA/NH: ASSOCIATED GRANT MAKERS. Associated Grant
Makers. http://www.agmconnect.org
The GRANT MAKERS DIRECTORY is available to members only.
6. NH: DIRECTORY OF CHARITABLE FUNDS IN NEW
HAMPSHIRE. New Hampshire Department of
Justice.http://doj.nh.gov/publications/directory-main.html
7. NJ: DIRECTORY OF REGISTERED CHARITIES (DATABASE). Office
of the Attorney General. Division of Consumer
Affairs.http://www.state.nj.us/lps/ca/charity/chardir.htm
8. NM: NEW MEXICO FUNDING DIRECTORY (DATABASE). University
of New Mexico's Office of the Vice Provost for
Research.http://research.unm.edu/nmfd/index.cfm
9. NM: NEW MEXICO FUNDING DIRECTORY. 6TH ED. University of
New Mexico's Office of the Vice Provost for
Research.http://research.unm.edu/publications/nmfd_book/

438
 10. SC: SOUTH CAROLINA FOUNDATION DIRECTORY 2006. South
Carolina State Library. http://www.statelibrary.sc.gov/grant-and-funding-
sources
11. SD: SOUTH DAKOTA GRANT DIRECTORY (DATABASE). South
Dakota State Library.http://apps.sd.gov/applications/de100sdgrantdir/

NEWSLETTERS

1. FEDERAL REGISTER. Washington, DC: Office of the Federal Register,

National Archives and Records Administration. Monday through
Friday. http://www.gpoaccess.gov/fr/index.html

Includes information on federal assistance such as grants and contracts.

2. GIVING FORUM NEWSPAPER ONLINE. Minneapolis, MN: Minnesota

Council on Foundations. Quarterly.http://www.mcf.org/mcf/forum/

Features articles on funding programs, profiles people in philanthropy,

lists grants made by both foundations and corporate giving programs, and
includes a calendar of philanthropic events and educational opportunities.

3. THE GRANTSMANSHIP CENTER MAGAZINE. Los Angeles: The

Grantsmanship Center. Quarterly.http://www.tgci.com/magazine.shtml.

Contains articles about grantsmanship, fundraising techniques,

grantsmanship seminars and reference literature on funding sources.
Available free to staff of nonprofits and government agencies.

4. HUMANITIES: THE MAGAZINE OF THE NATIONAL ENDOWMENT

FOR THE HUMANITIES. Washington, DC: National Endowment for the
Humanities (NEH). Bimonthly. http://www.neh.gov/news/humanities.html
439
 Describes NEH projects and programs in the humanities. It lists recent
grants, application deadlines, and other useful information for grant
seekers.

5. PHILANTHROPY NEWS DIGEST. New York: Foundation Center.

Weekly. http://foundationcenter.org/pnd/

Compendium of philanthropy-related articles and features culled from

print and electronic media outlets nationwide.

6. PND CONNECTIONS. New York: Foundation Center.

Biweekly. http://foundationcenter.org/pnd/connections/index.jhtml

Covers philanthropy-related content on the web.

7. PND RFP BULLETIN. New York: Foundation Center.

Weekly. http://foundationcenter.org/pnd/rfp/

Covers recently announced requests for proposal (RFPs) from private,

corporated, and government funding sources.

Grant Writing Resources

General

1. BASIC ELEMENTS OF GRANT WRITING. Corporation for Public

Broadcasting. http://www.cpb.org/grants/grantwriting.html
2. A CONDENSED VERSION OF PROPOSAL PLANNING AND
WRITING. JEREMY T. MINER, LYNN E.
MINER.http://www.minerandassociates.com/PPW3 Brief.htm

440
3. DEVELOPING AND WRITING GRANT PROPOSALS. CATALOG OF
FEDERAL DOMESTIC ASSISTANCE. http://aspe.hhs.gov/cfda/ia6.htm
4. THE FOUNDATION CENTER'S USER-FRIENDLY GUIDE TO
FUNDING RESEARCH &
RESOURCES.http://foundationcenter.org/getstarted/tutorials/gfr/
5. GRANT WRITING AND FUNDRAISING ARTICLES.
TECHSOUP. http://www.techsoup.org/learningcenter/funding/index.cfm
6. NON-PROFIT GUIDES: GRANT-WRITING TOOLS FOR NON-
PROFIT ORGANIZATIONS. http://www.npguides.org/index.html
7. PREPARING A GRANT PROPOSAL: FIVE STEPS IN THE
PROPOSAL WRITING PROCESS. APPALACHIAN REGIONAL
COMMISSION.http://www.arc.gov/index.do?nodeId=102
8. PROPOSAL BUDGETING BASICS. FOUNDATION
CENTER. http://foundationcenter.org/getstarted/tutorials/prop_budgt/
9. PROPOSAL WRITING: THE BASIC STEPS IN PLANNING AND
WRITING A SUCCESSFUL GRANT APPLICATION. ERIC
RINEHART, BARBARA BOUIE-
SCOTT. http://www.ildceo.net/NR/rdonlyres/EC10F834-50A0-4CB0-
8121-B6185951F91D/0/ProposalWriting2003.pdf
10. PROPOSAL WRITING SHORT COURSE. AVAILABLE IN ENGLISH
AND SPANISH. FOUNDATION
CENTER.http://foundationcenter.org/getstarted/tutorials/shortcourse/budg
et.html
11. WHAT GRANTMAKERS WANT APPLICANTS TO KNOW.
GUIDESTAR. http://www2.guidestar.org/rxa/news/articles/2003/what-
grantmakers-want-applicants-to-know.aspx
12. WHAT TO DO BEFORE YOU WRITE A GRANT PROPOSAL. OHIO
LITERACY RESOURCE
CENTER.http://literacy.kent.edu/Oasis/grants/first.html
13. WRITING A SUCCESSFUL GRANT PROPOSAL. MINNESOTA
COUNCIL ON
FOUNDATIONS. http://www.mcf.org/mcf/grant/writing.htm

441
 Guides for Research Grants

14. THE ART OF GRANTSMANSHIP. JACOB

KRAICER. http://www.hfsp.org/how/ArtOfGrants.htm
15. AWARD AND ADMINISTRATION GUIDE. NATIONAL SCIENCE
FOUNDATION. http://www.nsf.gov/publications/pub_summ.jsp?ods_key
=aag081&org=NSF
16. GRANTS AND GRANT-PROPOSAL WRITING. 3rd ed. John
O'del.http://www.slu.edu/Documents/business/eweb/grant01v32e.pdf
17. A GUIDE FOR PROPOSAL WRITING. National Science
Foundation. http://www.nsf.gov/publications/pub_summ.jsp?ods_key=nsf
04016
18. PROPOSAL WRITER'S GUIDE. Don
Thackrey. http://www.drda.umich.edu/proposals/pwg/PWGCONTENTS.H
TML
19. WRITING FROM THE WINNER'S CIRCLE: A GUIDE TO
PREPARING COMPETITIVE GRANT PROPOSALS. David
Stanley.http://epscor.unl.edu/rfps/winnerscircle.shtml

Sample Grant Proposals

20. EXAMPLES OF SUCCESSFUL PROPOSALS. Appalachian Regional

Commission. http://www.arc.gov/index.do?nodeId=1730
21. A SAMPLE GRANT PROPOSAL. Plugged
In. http://www.pluggedin.org/tool_kit/sample_grant.html
22. SAMPLE GRANT PROPOSALS. The Idea
Bank. `http://theideabank.com/onlinecourse/samplegrant.html
23. SAMPLE PROPOSALS. Non-Profit
Guides. http://www.npguides.org/guide/sample_proposals.htm
24. SAMPLE PROPOSALS.
SchoolGrants. http://www.k12grants.org/samples/

442
 Glossaries

25. COMPLETE GLOSSARY. Dorothy A. Johnson Center for Philanthropy &

Nonprofit
Leadership.http://www.nonprofitbasics.org/CompleteGlossary.aspx?ID=-1
26. FINANCIAL GLOSSARY. The Robertwood Johnson
Foundation.http://www.rwjf.org/grantees/howtotools/financialglossary.jsp
27. GLOSSARY. Foundation
Center. http://foundationcenter.org/getstarted/tutorials/gfr/glossary.html
28. GLOSSARY OF GRANT TERMS. Oakton Community
College. http://www.oakton.edu/resource/grants/glossary.pdf
29. GLOSSARY OF TERMS. Fidelity Charitable Gift
Fund. http://www.charitablegift.org/basics_glossary.shtml
30. GRANTWRITING GLOSSARY OF TERMS. Marywood
University. http://www.marywood.edu/orcc/glossary.html

ADDITIONAL RESOURCES

FUNDING INFORMATION SOURCES

• DIALOG CORPORATION
Corporation Headquarters
11000 Regency Parkway, Suite 10
Cary, NC 27511
(800) 3-DIALOG (North America)
http://www.dialog.com

THE DIALOG INFORMATION RETRIEVAL SERVICE provides online

access, for a fee, to more than 450 databases with subject coverage of a
wide range of disciplines. The databases include statistical data,
443
 bibliographic citations, abstracts, and full-text products. The Dialog
include information on funding programs include the FOUNDATION
GRANT INDEX, theGRANTS DATABASE, and the FOUNDATION
DIRECTORY.

• THE FOUNDATION CENTER

79 Fifth Avenue/ 16th Street
New York, NY 10003
(800) 424-9836
http://www.foundationcenter.org

THE FOUNDATION CENTER provides up-to-date information on

foundation and corporate giving. Its national collections are located in
Washington, DC and New York, NY. At both locations, grantseekers have
free access to core Center publications plus a wide range of books,
periodicals, and research documents relating to foundations and
philanthropy. The Center's website contains many useful funding
information resources. The Foundation Center provides both CD-ROM
and online subscription access to the FOUNDATION DIRECTORY
ONLINE, Providing access to more than 77,000 grant makers.

• GRANTS DATABASE
Greenwood Publishing Group, Inc.
88 Post Road West, P.O. Box 5007
Westport, CT 06881-5007
(800)-225-5800
http://www.greenwood.com

GRANTS provides information on more than 10,000 available grants

offered by federal, state, and local government, commercial organizations,
associations, and private foundations. Each entry includes full description,
qualification, money available, and renewability. Full name, address, and
telephone number for each sponsoring organization, if available, are also
included. The Grants database corresponds to the print

444
 publications DIRECTORY OF RESEARCH GRANTS, DIRECTORY OF
BIOMEDICAL AND HEALTH CARE GRANTS, GRANTS IN THE
HUMANITIES, FUNDING SOURCES FOR COMMUNITY AND
ECONOMIC DEVELOPMENT, FUNDING SOURCES FOR K-12
SCHOOLS AND EDUCATIONAL ORGANIZATIONS AND
OPERATING GRANTS FOR NONPROFIT
ORGANIZATIONS. The GRANTS DATABASE in available from
DIALOG online on a fee-based subscription service.

GRANT WRITING PUBLICATIONS

1. ASKING FOR MONEY. The Grantsmanship Center. Los Angeles: TGCI.

Brief guide on how to approach face-to-face situations in fund raising.

2. BEST OF BOTH WORLDS: WINNING GOVERNMENT FUNDING

FOR COMMERCIAL PRODUCT DEVELOPMENT UNDER THE
SMALL BUSINESS INNOVATION RESEARCH PROGRAM. Wellesley
Hills, MA: SPHINX Technologies, 1994. 245 p.

Presents an overview of the SBIR and STTR programs. Includes topics

formulating a winning technical proposal, preparing a cost proposal, and
managing your SBIR project.

3. EARNING MORE FUNDS: EFFECTIVE, PROVEN FUNDRAISING

STRATEGIES FOR EVERY NONPROFIT GROUP. Chip & Ralfie
Blasius. Fort Wayne, IN: B.C. Creations, 1995. 180 p.

Provides an overview of several tested fundraising strategies.

4. FINDING FUNDING: GRANT WRITING FROM START TO FINISH,

INCLUDING PROJECT MANAGEMENT AND INTERNET USE, 4th

445
 ed. Ernest W. Brewer, Charles M. Achilles, and Jay R. Fuhriman.
Thousand Oaks, CA: Corwin Press, 2001. 392 p.

Introduces where to look for government grants and how to write

proposals. Describes the steps involved with implementing, conducting,
and following a project through to completion.

5. FINDING FUNDING: THE COMPREHENSIVE GUIDE TO GRANT

WRITING, 2nd ed. Daniel M. Barber. Long Beach, CA: Bond Street
Publishers, 2002. 287 p.

Appropriate for the beginning grant writer or the experienced fund seeker.
Covers every aspect of the grant process.

6. THE FOUNDATION CENTER'S GUIDE TO PROPOSAL WRITING.

Foundation Center. New York: The Center. Updated regularly.

Provides guidance on every aspect of proposal preparation and follow-up.

It gives a step-by-step approach; provides actual sample proposals, cover
letters, project descriptions and budgets; and covers information on current
trends in grantmaking and the proposal review process.

7. FOUNDATION FUNDAMENTALS: A GUIDE FOR GRANTSEEKERS.

New York: Foundation Center. Updated regularly.

Includes basic procedures of grant application and a complete overview of

the grant-making process and points the user to appropriate funding
sources.

8. FUND RAISING BASICS: A COMPLETE GUIDE, 2nd ed. Barbara

Kushner Ciconte and Jeanne G. Jacob. Gaithersburg, MD: Aspen
Publishers, 2001.

Offers a comprehensive view of fund raising. It covers the basics, such as

the vocabulary of fund raising; trends; case studies; diverse approaches;

446
 and real life examples. It is written for both development staff and novice
fund raisers.

9. FUNDRAISING IDEAS: OVER 225 MONEY MAKING EVENTS FOR

COMMUNITY GROUPS, WITH A RESOURCE DIRECTORY. Janell
Shride Amos. Jefferson, NC: McFarland & Company, 1995. 148 p.

Provides a brief description of the event, helpful planning tips and creative
suggestions, notes about the type of workers and tools needed to ensure
success, cross- references to related ideas, and resource recommendations.

10. GRANT APPLICATION WRITER'S HANDBOOK, 4th ed. Liane Reif-

Lehrer. Sudbury, MA: Jones & Bartlett Publishers, 2004. 416 p.

Introduces several tips and tricks for every aspect of the fund raising
process. There are sections about proposal writing, as well as following up
your requests for funding.

11. GRANTWRITING, FUNDRAISING, AND PARTNERSHIPS:

STRATEGIES THAT WORK! Karen B. Ruskin, Charles M. Achilles.
Thousand Oaks, CA: Corwin Press, 1995. 200 p.

Helps schools identify funders, describe the school setting with effective
catchwords, market the grant proposal, and develop relationships with
community businesses.

12. HANDBOOK FOR WRITING PROPOSALS. Robert J. Hamper and L.

Sue Baugh. Lincolnwood, IL: NTC/Contemporary Publishing Group,
1995. 209 p.

Reviews steps involved in choosing the right project to bid on, conducting
research, and producing documents to follow up the project. It also has
samples from every stage of the process, including helpful graphics.

13. THE "HOW TO" GRANTS MANUAL: SUCCESSFUL

GRANTSEEKING TECHNIQUES FOR OBTAINING PUBLIC AND
447
 PRIVATE GRANTS. David. G. Bauer. 5th ed. Westport, CT: Praeger
Publishers. 2003.

Describes how to organize the grantseeking process, discusses proposal

development, and describes how to research funding sources.

14. KEYS TO SUCCESSFUL FUNDING: A SMALL COMMUNITY GUIDE

TO FEDERAL & FOUNDATION RESOURCES. Hamilton Brown,
Nancy Stark, Dennis Reader. Washington, DC: National Center for Small
Communities, 1999. 96 p.

Focuses on federal grants for small towns and rural areas, especially in the
areas of infrastructure rebuilding and economic development. It also offers
a section on grant proposal writing.

15. PRACTICAL GUIDE TO PLANNED GIVING. Taft Group. Farmington

Hills, MI: Taft Group.

Includes basic information on marketing and running a planned giving

program, describes planned giving options and explains the advantages
and disadvantages of each, lists additional information sources, and
discusses tax laws related to planned giving.

16. PROGRAM PLANNING & PROPOSAL WRITING. Expanded Version.

TGCI. Los Angeles: TGCI. 48 p.

Offers a basic introduction to the fundamentals of proposal writing.

17. PROPOSAL PLANNING & WRITING. 3d ed. Lynn E. Miner, Jeremy T.

Miner. Westport, CT: Greenwood Press, 2003. 216 p

Features a concise, straightforward, and topical approach to grant seeking.

It identifies print and non-print foundation, corporate, and federal funding
resources. Charts, outlines, and proposal examples are included.

448
 18. PROPOSAL WRITER'S GUIDE. 2nd ed. Michael E. Burns. New Haven:
Development and Technical Assistance Center, 1993. 64 p.

Provides quick information on proposal writing.

19. RAISING MONEY FROM GRANTS AND OTHER SOURCES

SUCCESS KIT. Tyler G. Hicks. Merrick, NY: International Wealth
Success, Inc., 1998-9.

Collection of seven books on fundraising.

20. SUCCESSFUL FUNDRAISING FOR ARTS AND CULTURAL

ORGANIZATIONS. 2nd ed. Karen Brooks Hopkins and Carolyn Stolper
Friedman. Phoenix, AZ: Oryx Press, 1997. 280 p.

Focuses on corporate sponsorship, but also covers endowment campaigns.

Includes statistics, examples, and many types of sample documents and
forms.

21. WINNING GRANTS STEP BY STEP: THE COMPLETE WORKBOOK

FOR PLANNING, DEVELOPING, WRITING SUCCESSFUL
PROPOSALS, 2nd ed. Mim Carlson. San Francisco: Jossey-Bass
Publishers, 2002.

Structured Exercises both government and private foundation proposals

guide the reader of through the entire proposal writing process. The
exercises are for .

FOUNDATION DIRECTORIES

For HEALTH-RELATED funding sources, see the following Rural Information

Center publications:

• RURAL HEALTH SERVICES FUNDING: A RESOURCE

GUIDE at http://www.nal.usda.gov/ric/ricpubs/healthguide.htm

449
 • CAPITAL ASSISTANCE FUNDING: A RURAL HEALTH RESOURCE
GUIDE athttp://www.nal.usda.gov/ric/ricpubs/capital_assistance.htm
• RURAL HEALTH FUNDING SOURCES: NATIONAL
FOUNDATIONS at http://www.nal.usda.gov/ric/ricpubs/foundat.htm

The following directories are divided into subject categories for easier access.
Directories that cover the entire range of grant givers are listed under the
heading: GENERAL.

Arts and Humanities

1. ARTS FUNDING: AN UPDATE ON FOUNDATION TRENDS. New

York: Foundation Center. Updated regularly.

Analyzes grantmaking and grantmakers in arts and culture, allowing the

user to determine how and where to find the best funding opportunities.

2. DIRECTORY OF GRANTS IN THE HUMANITIES. Westport, CT: Oryx

Press. Updated annually.

Contains nearly 4,000 entries with information on private, government,

and corporate grants available for projects in the arts and humanities.
Include a guide to proposal planning and writing.

3. NATIONAL GUIDE TO FUNDING IN ARTS AND CULTURE. New

York: Foundation Center. Updated regularly.

Includes descriptions of foundations and corporations that support arts and

culture and advice on researching them. A partial listing of areas includes
theaters, museums, archeology projects, orchestras, and dance groups.

BUILDING, CONSTRUCTION, AND TECHNOLOGY

4. DIRECTORY OF BUILDING AND EQUIPMENT GRANTS. Richard M.

Eckstein. Loxahatchee, FL: Research Grant Guides, Inc.

450
 Includes over 5,000 funding entries covering grants for building,
equipment, and renovation.

5. DIRECTORY OF COMPUTER AND HIGH TECHNOLOGY GRANTS.

Loxahatchee, FL: Research Grant Guides, Inc.

Includes over 500 foundations that provide funding for computers and
technological equipment are profiled.

6. NATIONAL GUIDE TO FUNDING FOR INFORMATION

TECHNOLOGY. New York: Foundation Center. Updated regularly.

Covers grantsmakers of awards for projects in computer science,

engineering and technology, telecommunications, and related fields of
information technology.

Disabilities

7. DIRECTORY OF GRANTS FOR ORGANIZATIONS SERVING

PEOPLE WITH DISABILITIES. Loxahatchee, FL: Research Grants
Guides, Inc.

Contains information on more than 800 foundations and 2,700 grant

entries. Indexed by subject categories.

8. FINANCIAL AID FOR PERSONS WITH VISUAL IMPAIRMENTS. El

Dorado Hills, CA: Reference Service Press. Updated regularly.

Describes nearly 200 programs that offer financial aid to persons with
visual impairments. Available in regular and large print versions.

9. FINANCIAL AID FOR THE DISABLED & THEIR FAMILIES. El

Dorado Hills, CA: Reference Service Press. Updated regularly.

Describes scholarships, fellowships, loans, grants, awards, and internships.

EDUCATION
451
10. THE DISTANCE LEARNING FUNDING RS.OURCEBOOK: A GUIDE
TO FOUNDATION, CORPORATE, AND GOVERNMENT SUPPORT
FOR TELECOMMUNICATIONS AND THE NEW MEDIA. Arlene
Krebs, ed. Dubuque, IA: Kendall/Hunt Publishing, 1998. 448 p.

Provides information about foundations, federal government programs,

regional and local telephone companies, corporations, and contacts in the
cable television industry.

11. FUNDING SOURCES FOR K-12 SCHOOLS AND ADULT BASIC

EDUCATION. Westport, CT: Oryx Press. Updated regularly.

Covers grants/funding available for technology, arts in education, teacher

development, career education, literacy, language and citizenship, and job-
skills training for minorities, women, veterans, immigrants, and the
disadvantaged.

12. GUIDE TO FEDERAL FUNDING FOR EDUCATION. Washington, DC

: Educational Funding Research Council. Updated quarterly

Includes information on funds available to state education agencies, school

districts, colleges, and community groups. Each entry includes the
program's purpose and goals, application procedures and deadlines,
program restrictions, information about previous grant recipients, and
contact information.

13. NATIONAL GUIDE TO FUNDING FOR ELEMENTARY AND

SECONDARY EDUCATION. New York: Foundation Center. Updated
regularly.

Profiles foundation support for elementary and secondary education

projects.

14. NATIONAL GUIDE TO FUNDING IN HIGHER EDUCATION. New

York: Foundation Center. Updated regularly.

452
 Covers nearly 4,000 foundations and corporate programs that have
previously awarded grants for higher-education projects and institutions.

Elderly

15. NATIONAL GUIDE TO FUNDING IN AGING. New York: Foundation

Center. Updated regularly.

Covers funding programs of state and federal agencies, foundations, and

nonprofit organizations that support programs for the elderly.

General

16. AMERICA'S NEW FOUNDATIONS. Farmington Hills, MI: Taft Group.

Updated annually.

Provides details on private, corporate, and community foundations created

since 1988. Includes listing of grants.

17. ANNUAL REGISTER OF GRANT SUPPORT: A DIRECTORY OF

FUNDING SOURCES. New Providence, NJ: R.R. Bowker.

Lists thousands of United States and foreign grant sources. It includes

foundations, corporate giving programs, federal agencies, education
associations, professional associations, church organizations, and social-
service agencies. Includes contact information; type and amount of each
grant; application instructions and deadlines; and eligibility requirements.

18. CORPORATE GIVING DIRECTORY. Farmington Hills, MI: Taft Group.

Updated annually

Offers profiles of the 1,000 largest corporate foundations and corporate

charitable giving programs.

19. THE DIRECTORY OF CORPORATE AND FOUNDATION GIVERS.

Farmington Hills, MI: Taft Group. Updated annually.

453
 Profiles over 8,000 private foundations that have assets of at least Rs.1.8
million or that distribute at least Rs.250,000 annually in grants, describes
3,900 corporate giving programs, and gives details on nearly 50,000 actual
grants. Customized versions are available on diskette and magnetic tape.

20. DIRECTORY OF OPERATING GRANTS. Loxahatchee, FL: Research

Grant Guides, Inc. Updated annually.

Profiles more than 640 foundations and includes 4,000 funding entries in
the following categories: AIDS, animal welfare, community funds, culture,
disabled, education, elderly, environment, health, hospitals, minorities,
recreation, religion, social welfare, universities, women, and youth.

21. FOUNDATION 1000. New York: Foundation Center. Updated regularly.

Profiles the largest 1,000 grant makers listed in The Foundation Directory.
It also includes extensive lists of grants the donors have made in the past.

22. THE FOUNDATION CENTER'S GUIDE TO GRANTSEEKING ON

THE WEB. New York: Foundation Center. 2003. Approx. 800 p.

Includes an introduction to the World Wide Web and a structured guide

through Web-based grants resources. Provides abstracts of 200+ Web
sites; profiles of searchable databases; and lists of government resources,
online journals and newsletters, and interactive services.

23. THE FOUNDATION DIRECTORY. New York: Foundation Center.

Updated annually.

Provides information, arranged by state, on over 10,000 U.S. grantmaking

foundations that hold assets of at least Rs.2 million or that award grants
totaling Rs.200,000 or more annually. Information is included for more
than 200 specific subject areas.

454
24. FOUNDATION DIRECTORY PART 2: A GUIDE TO GRANT
PROGRAMS RS.50,000-RS.200,000. New York: Foundation Center.
Updated annually.

Provides information, arranged by state, on the second 10,000 U.S.

grantmaking foundations that award grants totaling Rs.50,000 to
Rs.200,000 annually. Information is included for more than 200 specific
subject areas.

25. FOUNDATION YEARBOOK: FACTS AND FIGURES ON PRIVATE

AND COMMUNITY FOUNDATIONS. New York: Foundation Center.
Updated annually.

Presents an overview of recent trends in grantmaking and summarizes the

history of the growth in foundation giving.

26. FOUNDATION GRANTS INDEX. New York: Foundation Center.

Updated annually.

An index of recently awarded grants, divided into subject areas, then

broken down geographically. More recent updates are available in The
Foundation Grants Index Quarterly.

27. FOUNDATION REPORTER: COMPREHENSIVE PROFILES AND

GIVING ANALYSES OF AMERICA'S MAJOR PRIVATE
FOUNDATIONS. Taft Group. Farmington Hills, MI: Taft Group. Updated
regularly.

Lists comprehensive profiles and analyses of America's major private

foundations. It covers more than 1,000 leading foundations in the United
States that have assets of at least Rs.10 million or that annually give a
minimum of Rs.500,000. It is indexed by state, and by type and location of
grant recipient.

455
28. GOVERNMENT ASSISTANCE ALMANAC. Detroit, MI: Omnigraphics,
Inc. Update annually.

Includes more than 1,500 federal domestic assistance programs and

includes coverage of grants, loans, fellowships, and scholarships.

29. THE GRANTS REGISTER. New York: Palgrave Macmillan. Updated

annually.

Describes assistance available, from government agencies and

organizations, for professional or advanced vocational training and for
students above the graduate level. Includes scholarships, fellowships,
research grants, grants-in-aid, artistic or scientific project grants,
professional awards, and vocational awards.

30. GUIDE TO FEDERAL FUNDING FOR GOVERNMENTS AND

NONPROFITS. Washington DC: Thompson Publishing Group. Updated
regularly.

Includes a primer on the federal grants process, descriptions for hundreds

of federal programs, contact information, and information on online
resources.

31. NATIONAL DIRECTORY OF CORPORATE GIVING. New York:

Foundation Center. Updated regularly.

Provides information on over 2,800 company-sponsored foundations and

more than 900 direct corporate giving programs.

32. NATIONAL DIRECTORY OF NONPROFIT ORGANIZATIONS.

Farmington Hills, MI: Taft Group. Updated regularly.

Comprehensive resource aid to locating funding from charitable

organizations of all varieties. Volume 1 covers organizations with annual
revenues of over Rs.1 million. Volume 2 covers organizations with annual

456
 revenues between Rs.25,000 and Rs.99,999. Additional indexes allow
users to locate organizations by activity and geographical location.

33. NATIONAL GUIDE TO FUNDING FOR THE ENVIRONMENT &

ANIMAL WELFARE. New York: Foundation Center. Updated regularly.

Provides information on over 2,900 foundations that support for those

working on projects involving the environment or animal welfare.

34. THE PRI DIRECTORY: CHARITABLE LOANS AND OTHER

PROGRAM-RELATED INVESTMENTS BY FOUNDATIONS, 2ND
ED. New York: Foundation Center, 155 p. 2003.

Lists leading PRI(program-related investing) providers and includes tips

on how to seek out and manage PRIs. PRIs have been used to support
community revitalization, low-income housing, microenterprise
development, historic preservation, human services, and more.

35. WHO GETS GRANTS: FOUNDATION GRANTS TO NONPROFIT

ORGANIZATIONS. New York: Foundation Center. Updated regularly.

Allows grantseekers to pinpoint typical funding sources for organizations

similar to their own. Indexed by subject areas and by locale within each
subject area.

Government, Community, and Economic Development

36. FUNDING SOURCES FOR COMMUNITY AND ECONOMIC

DEVELOPMENT. Westport, CT: Oryx Press. Updated regularly.

Includes funding for capital construction, equipment, travel, outreach, and

ongoing support for community programs and projects.

37. NATIONAL GUIDE TO FUNDING FOR COMMUNITY

DEVELOPMENT. New York: Foundation Center. Updated regularly.

457
 Profiles more than 2,600 programs and focuses on grantmakers that have
contributed to economic development projects. Examples include housing
construction and rehabilitation, community groups, and employment and
vocational training programs.

38. FOUNDATION GRANTS TO INDIVIDUALS. New York: Foundation

Center. Updated regularly.

Includes opportunities for support in education, the arts and culture, and
research, and grants for company employees, professionals, and others.
Also includes prizes and awards, and grants by nomination. Indexed by
subject area, types of support, geographic area, sponsoring company,
educational institution, and grantmaker name.

Libraries and Museums

39. THE BIG BOOK OF LIBRARY GRANT MONEY, 2004/2005. Prepared

by the Taft Group for the American Library Association. Chicago, IL: The
Association, 2004.

Includes library-specific funding programs from the broader, more

expensive funding directories.

40. THE BIG BOOK OF MUSEUM GRANT MONEY. American Association

of Museums. Washington, DC: The Association, 1996. 896 p.

Profiles 3,000 private sector funders that have contributed to museum

programs.

41. LIBRARIES AND INFORMATION SERVICES GRANT GUIDE. New

York: Foundation Center. Updated regularly.

Describes foundation grants of at least Rs.10,000 awarded for library and

information services.

458
42. NATIONAL GUIDE TO FUNDING FOR LIBRARIES AND
INFORMATION SERVICES. New York: Foundation Center. Updated
regularly.

Lists approximately 800 funding sources for libraries and information

services.

Minorities

43. FINANCIAL AID FOR AFRICAN AMERICANS. El Dorado Hills, CA:

Reference Service Press. Updated regularly.

Describes scholarships, fellowships, loans, grants, awards, and internships.

44. FINANCIAL AID FOR ASIAN AMERICANS. El Dorado Hills, CA:

Reference Service Press. Updated regularly.

Describes funding opportunities for Asian Americans.

45. FINANCIAL AID FOR HISPANIC AMERICANS. El Dorado Hills, CA:

Reference Service Press. Updated regularly.

Describes funding opportunities for Hispanic Americans.

46. FINANCIAL AID FOR NATIVE AMERICANS. El Dorado Hills, CA:

Reference Service Press. Updated regularly.

Describes funding opportunities for Native Americans, Alaskans, and

Pacific Islanders.

Religious Organizations

47. FUND RAISER'S GUIDE TO RELIGIOUS PHILANTHROPY.

Farmington Hills, MI: Taft Group. Updated regularly.

Includes over 500 corporate and private philanthropies who have recently
awarded grants for religious causes.
459
48. NATIONAL GUIDE TO FUNDING IN RELIGION. New York:
Foundation Center. Updated regularly.

Provides information on more than 8,400 corporate giving programs and

foundations that provide funding for programs sponsored by organizations
affiliated with religion. Includes contact information, application
requirements and deadlines, and descriptions of recently-awarded funds.

Research

49. DIRECTORY OF RESEARCH GRANTS. Westport CT: Oryx Press.

Updated regularly.

A comprehensive guide to research funding from foundations, private

sources, state and local organizations, and federal sources.

Social Services

50. DIRECTORY OF SOCIAL SERVICE GRANTS. 2nd ed. Loxahatchee,

FL: Research Grant Guides, Inc, 1998.

Profiles more than 900 foundations that offer grants to disadvantaged

groups and special populations. Examples of subject categories include
child welfare, the disabled, the elderly, family services, food banks,
substance abuse, and women.

51. FUND RAISER'S GUIDE TO HUMAN SERVICE FUNDING. Taft

Group. Farmington Hills, MI: Taft Group. Updated.

Profiles more than 1,850 leading private and corporate foundations that
provide support for human service organizations. Cites potential funding
sources for programs for the elderly, homeless, disabled, children, family,
and for other human service programs.

52. NATIONAL GUIDE TO FUNDING FOR CHILDREN, YOUTH, AND

FAMILIES. New York: Foundation Center. Updated regularly.
460
 Includes data on foundations and corporate direct giving programs that
award grants for programs designed to benefit children, youth, or families.

Veterans

53. FINANCIAL AID FOR VETERANS, MILITARY PERSONNEL, AND

THEIR DEPENDENTS. El Dorado Hills, CA: Reference Service Press.
Updated regularly.

Describes scholarships, fellowships, loans, grants, awards, and internships

set aside specifically for veterans, military personnel, and their families.

Women

54. DIRECTORY OF FINANCIAL AIDS FOR WOMEN. El Dorado Hills,

CA: Reference Service Press. Updated regularly.

Aids in locating fellowships, awards, grants, internships, loans, and

scholarships for women.

55. NATIONAL GUIDE TO FUNDING FOR WOMEN AND GIRLS. New

York: Foundation Center. Updated regularly.

Profiles foundations and corporate giving programs that award grants to

programs designed to benefit women and girls. Funding is available for
education programs, health clinics, shelters for abused or homeless
women, girls' clubs,

461
5.10.4 FUNDRAISING GOALS AND STRATEGIES

Hospital Fundraising

Hospitals have their own opportunities and challenges when it comes to

fundraising. Most find that they receive donations from grateful patients and
relatives almost passively. However, with a little planning and effort, this can
be increased significantly.

As well as increasing revenue funding, hospitals can also carry out major
capital appeals for new buildings or equipment.

Specific hospital fundraising opportunities include:

Legacy fundraising
Community fundraising
Major donor fundraising
Individual giving
Corporate fundraising
Trust fundraising
New media fundraising
Major capital campaigns across multiple sectors
In order to maximise income, hospital fundraising commonly make use of the
following consultancy services:

Fundraising audits or reviews (to identify the best opportunities and to know
where to invest)
Fundraising strategy development (to set out how best to exploit the
opportunities)
Campaign planning support (e.g. to design a legacy campaign)
Prospect research (e.g. screening of a database to identify potential major
donors, or in-depth profiling of individual prospects)
Development of specific areas of fundraising (e.g. help to establish a trust
fundraising or corporate programme)

462
Website and new media fundraising development
Direct marketing consultancy (e.g. to develop an individual donor fundraising
programme)
Hospital fundraising within the NHS has its own challenges with which we are
familiar. However, we know that it is possible with some planning and
investment to raise significant sums for this important work.

5.10.5 FUNDRAISING TACTICS

Before you can begin to raise funds successfully, it is crucial to know what
you need funds for, whether the money is actually available for what you want
to do and to be clear about how you will raise it.

As a result, we have developed a range of strategic services, which help an

organisation to prepare for fundraising, as well as monitor the success of its
work and the risks it faces.

Business Planning for Fundraising read more

To be effective, voluntary organisations need to set objectives and develop
strategies to achieve them. One way to achieve this is to develop a business
plan.

Fundraising Reviews read more

A fundraising review (also known as a health check or audit) takes an
impartial look at your fundraising activities and helps to identify new areas of
potential, as well as any areas of weakness to address.

Funding Feasibility Studies read more

463
Are you planning a major project or capital appeal? Do you need evidence of
potential funding? Is your organisation actually in a position to raise the
funds? To answer these questions, you probably need a funding feasibility
study.

Fundraising Strategies read more

“Fail to plan = plan to fail”. This applies especially to fundraising, where the
sustainability of an organisation depends not on short term actions, but on a
planned and sustained effort to maximise funding opportunities over time.

Risk Management for Charities read more

Like all organisations, charities and other not-for-profit organisations face
risks every day, which they need to identify and manage.

Project Evaluation Service read more

Funders such as charitable trusts, lottery boards and statutory organisations are
accountable to their stakeholders and need to know that their money is being
used well.

5.10.6 EVALUATING FUNDRAISING EFFECTIVENESS

464
Introduction

New realities are placing pressures on the healthcare industry, and how patient
care is delivered. Rising hospital management costs, an aging population, a
shortage of healthcare workers, challenges in accessing services, timely
availability of information, issues of safety and quality, and rising
consumerism are some of the facts of today’s healthcare system. The industry
has reached a point of chasm, where they need to decide how services could be
delivered more effectively to reduce costs, improve quality, and extend reach.
The critical questions facing the industry today include: how can we
effectively manage hospitals and provide enhanced services without placing
additional burden on a system already pushed to its limits; how can we provide
care in a cost-efficient manner at a time when healthcare spending is rising;
and how do we most efficiently use our resources and support front-line staff
in order to reduce medical errors and enhance quality of care.

These are just a few questions facing the industry. It looks bleak, but there’s
hope. There are new information technologies available to help. Information
technologies that enable immediate, information-rich communications and
provide easy-to-use collaborative tools are increasingly becoming a vital part
of today’s healthcare.

Quintegra, as a healthcare IT solutions partner, is committed to preparing

hospitals to meet future challenges - and to secure their attractiveness to
patients, referral sources, and staff by means of long-term concepts.
Leveraging upon a dedicated healthcare practice group, Quintegra has
developed a next-generation Hospital Management & Information System
(HMIS) that is powerful, flexible and easy to use and has been designed &
developed to deliver real conceivable benefits to hospitals. The HMIS has
been conceived by a blend of seasoned professionals with rich and relevant

465
experience in healthcare industry. The system incorporates the best healthcare
practices and is designed to deliver key tangible benefits to clients across the
globe.

Offering

Quintegra’s HMIS is a revolutionary solution with end-to-end features for

simplifying hospital management – all at a cost which provides the fastest
ROI. Access to the right information and the automation of complex tasks &
workflow is the key focus of the HMIS, enabling freeing the staff to spend
more time on caring for patients and extending the reach of services.

A MIS for a hospital would require being very precise and must result in
operational cost reduction, process improvement and efficient management.
We have developed a HMIS solution which is very accurate in its approach
and suits all environments including large, medium or small hospitals.

The HMIS is designed to cover a wide range of hospital administration and

management processes. It is an integrated client server application. It runs on
all standard hardware platforms and can be easily customized to suit the
requirements and reflect the priorities of a hospital management team.

The HMIS provides the benefits of streamlined operations, enhanced

administration and control, improved response to patient care, cost control,
and improved profitability. Quintegra believes that every hospital is unique in
terms of its requirements and priorities. Hence, flexibility has been built into
the HMIS to allow easy customization. The HMIS features unparalleled
flexibility & scalability, comprehensive report types, easy customization,
intuitive visuals and interactive graphics that simplify complex data,
dashboards-supported quality initiatives and comprehensive drill-down
capabilities.

466
With technology expertise garnered for over a decade and specialists drawn
from diverse fields of medicine, we help hospitals provide better managed care
through the state-of-the-art HMIS solution.

The HMIS solution has been designed as a three-tier application built on the
model-view-controller architecture. The interfaces to all external actors on the
system are a part of the view tier. This includes the graphical user interfaces to
the application, interfaces to equipment, interfaces to external software
applications and also APIs. The HMIS addresses both HIPAA & HL7
requirements.

The HMIS modules have been designed according to three categories – core
modules, supporting modules and enterprise-enabling modules. These modules
can further be customized according to hospital needs

467
The HMIS provides an effective solution to hospitals that plan to reduce the
costs of administrative and clinical transactions, and at the same time, provide
better service to their consumers. The benefits of the HMIS include:

It aids hospital administrators by significantly improving operational control

and streamlining operations.

It enables improved response to demands of patient care because it automates

the process of collecting, collating and retrieving patient information.
Clinical pathways mapped to the system improve diagnoses and
treatments offered.

It provides doctors and hospital staff with the decision support system that
they require for delivering patient care, which is comparable to global
standards.
By enabling an automated and intelligent flow of patient information, the
HMIS enables hospitals and doctors to better serve their patients. Additionally,
the HMIS provides a host of direct benefits such as easier patient record
management, reduced paperwork, faster information flow between various
departments, enhanced availability of timely and accurate information,
reduced length of stay, reduced test requests, greater organizational flexibility,
reliable and timely information, easier resource management, minimal
inventory levels, reduced wastage, reduced waiting time at the counters for
patients and reduced registration time for patients. The indirect benefit would
be an improved image of the hospital and increased competitive advantage.
The HMIS optimizes the resources to be deployed and helps in prioritizing the
developmental activities of the hospital.

Quintegra’s HMIS not only provides an opportunity to the hospital to enhance

their patient care but can also increase the profitability of the organization. The
Return on Investment (ROI) coupled with an enhanced image of the hospital

468
act as drivers for healthcare providers to invest in the HMIS that will keep
their patients satisfied.

Quintegra Laboratory Information Management System (Q-LIMS)

In today’s competitive environment, current processes in laboratory networks

have several drawbacks that impede efficiency. Fragmentation, distributed
data repository, large degree of manual processes and time delays are common
ailments. The driving factor of Q-LIMS is to integrate laboratory networks
into a single entity and provide high level of automation by implementation of
the system. Value-adding benefits of Q-LIMS include networking all the labs
leading to branch automation, 24x7 online availability of lab results,
integrating multiple locations into a single point, increased accountability,
centralized control, enhanced quality of outputs and better revenue
management.

Q-LIMS is a web-enabled, fully customizable solution which provides features

such as patient administration, remote lab-orders, bar-coding, scheduling for
instruments, automated results capture, integrated billing, reporting and safety
data sheets. Q-LIMS can seamlessly integrate with existing instruments,
finance / accounting system and human resource management system. It can
also seamlessly integrate with Quintegra’s leading solution for hospitals –
Hospital Management and Information System (HMIS).

Q-LIMS is an effective and efficient tool for management to automate and

simplify key processes. Achieve enterprise-wide integration of all centers into
a single point, and high-level of automation after deploying Q-LIMS. It
provides online availability of results immediately to the respective centers
and labs. It integrates with existing lab instruments and provides automated
data capture. Single database server leads to consolidation of information.
Perfect inventory control and fully configurable real-time workflow is made
possible. Q-LIMS enables easy equipment calibration to increase response
times, providing accurate results and minimizing errors. Flexible reporting
469
options, including graphs & trends, provide real-time results on various
parameters. Preventive maintenance schedule reminders automated for all
instruments addresses quality control specifications.

Q-LIMS provides integration of multiple locations at a single point through

networking, giving more control to the management from the point of view of
strategizing the business prospects of the organization.

Benefits of Q-LIMS include:

Savings – Substantial savings in manpower, time and costs through improved

productivity

Effectiveness – Increased administrative & operational effectiveness and

improved communications between the peripheral labs with the central lab

Simplification – Improved and simplified work / process flow through

automation

Quality – Reduced errors and duplication of work

Simplification – Improved and simplified work / process flow through

automation

Centralization – Consolidation of information into a single point

470
Optimization – Empowers better use of existing resources (people, time and
money) at the organization

MIS – Comprehensive reporting on various customizable parameters

Competitive Advantage – Improved customer satisfaction and market position

471