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Disadvantages Of Insufficient Working Capital

The amount of working capital should be sufficient. Inadequate amount of working capital may create a lot of financial problems in business. Sometimes, inadequate working capital may be the major causes for closing down the business organization. Due to shortage of working capital, raw materials can not be purchased on time and payment of labor and other expenses can not be made on time. The disadvantages suffered by a firm with insufficient working capital are as follows:

1. The firm is unable to take advantages of new opportunities or adapt to change.

2. Trade discounts are lost. A firm with sufficient working capital is able to finance larger stocks and can therefore place large orders.

3. Cash discounts are lost. Some firms will try to persuade their debtors to pay early by offering cash discounts.

4. The advantages of being able to offer a credit line to customers are forgone.

5. Financial reputation is lost due to non-payment of trade creditors on time.

6. Creditors may apply to the court for winding up if the firm fails to pay their obligations on time.

Related Topics
Meaning And Concept Of Working Capital
Determination Of Working Capital

Need And Importance Of Working Capital

Working capital is the life blood and nerve center of business. Working capital is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages or importance of working capital are as follows:

1. Strengthen The Solvency
Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

2. Enhance Goodwill
Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.

3. Easy Obtaining Loan
A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.

4. Regular Supply Of Raw Material
Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production.

5. Smooth Business Operation
Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.

6. Ability To Face Crisis
Adequate working capital enables a firm to face business crisis in emergencies such as depression.

Related Topics
Meaning And Concept Of Working Capital
Classification Of Working Capital
Factors Affecting Working Capital

Classification Of Working Capital

Working capital can be classified into the following types:

1. Permanent Or Fixed Working Capital
Permanent working capital represents the current assets required on continuing basis over the entire year. A fixed amount of current assets are required to operate the business. Every business organization must maintain minimum current assets to ensure effective utilization of fixed facilities and for maintaining the circulating of current assets. Thus, minimum level of current assets is called is called permanent or fixed working capital. Permanent working capital or fixed working capital consists of minimum stock, minimum cash and bank balance and minimum other current assets. Generally, permanent working capital is financed by long-term sources of funds.

2. Temporary Or Variable Working Capital
Temporary working capital represents additional current assets required during the operation of the year. It is the extra working capital needed to support the changing production and sales activities of the firm. Any excess amount of working capital over the permanent working capital is called temporary working capital. It is required to meet the seasonal demands and contingencies. Temporary working capital is fluctuating, sometimes decreasing and sometimes increasing. Generally, temporary working capital is financed from short term sources of funds.

Related Topics
Meaning And Concept Of Working Capital
Need And Importance Of Working Capital
Factors Affecting Working Capital

Meaning And Concept Of Working Capital

Meaning Of Working Capital
Business organization require adequate capital to establish business and operate their activities. The total capital of a business can be classified as fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital.Similarly, the capital, which is needed for investing in current assets, is called working capital.
The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital. Working capital is used for regular business activities like for the purchase of raw materials, for the payment of wages, payment of rent and of other expenses. Working capital is kept in the form of cash, debtors, raw materials inventory, stock of finished goods, bills receivable etc.

Concept Of Working Capital
Generally, there are two concepts of working capital i.e. gross concept and net concept.
1.Gross Concept Of Working Capital
According to gross concept, working capital refers to all the current assets and represents the amount of funds invested in current assets. Thus, gross working capital is the capital invested in current assets. Current assets are those assets which can be converted into cash within the short-time period.

Gross Working Capital = Total current assets

In this way, gross working capital refers to the firm's investment in current assets. Gross working capital represents total of current assets which includes cash in hand, cash at bank, inventory, prepaid expenses, bills receivable etc.

2.Net Concept Of Working Capital
According to the net concept, working capital is the excess of current assets over current liabilities. In other words, the difference between current assets and current liabilities is called net working capital.

Net Working Capital = Current Assets - Current liabilities

In this way, net working capital is the difference of current assets and current liabilities.

Related Topics
Classification Of Working Capital
Need And Importance Of Working Capital
Factors Affecting Working Capital

Meaning, Features And Objectives Of Current Costing Accounting(CCA) Approach

Meaning Of Current Costing Accounting (CCA) Approach
Current costing method is an alternative to current purchasing power (CPP) method. CCA approach was introduced in 1975 to overcome the difficulties of CPP method.Actually the CPP method applies the retail price index for finding out the conversion factors to restate the income statement and balance sheet. So the CPP approach was criticized by the business world.
Current costing accounting (CCA) approach recognizes the changes in the price of individual due to the change in general price level. This is the method which includes the process of preparing and interpreting financial statement in such a way that relevant change in the price is considered significantly. In CCA method, the assets are valued in current cost basis. It does not consider the retail price index. This method considers the replacement value of the assets for its real accounting records. The value of assets at which it is to be replaced in future is called the replacement value. Sometimes it is known as replacement cost accounting approach also. Under this method, each financial statement is to be restated in terms of the current value of such items.

Features Of Current Cost Accounting(CCA)

1. The fixed assets are recorded at replacement cost value in the balance sheet.
2. Inventories are shown at market value rather than market or cost price whichever less as in the historical system is.
3. Revaluation surplus are transferred to current cost accounting reserve but not distributed as dividend to shareholders.
4. Depreciation of fixed assets is to be calculated at replacement value.
5. Two types of profit i.e. profit from operation and profit from revaluation are calculated.
6. Liabilities are recorded in their original value because there is no any change in monetary unit.

Objectives Of Current Cost Accounting(CCA) Approach

1. To provide correct and reliable financial information based on the current replacement cost.
2. To calculate the profit without changing the historical profit.
3. To protect the business in the event of normal inflationary situation.
4. To keep level of capital in very balance position by making valuation of assets in proper value based on replacement value.
5. To provide realistic information to the management, investors, creditors, government and to other interested parties.
6. To prepare the financial statement at the end of the year on the basis of current value of such items.

Related Topic
Meaning And Characteristics Of Current Purchasing Power(CPP) Method

Steps Of Current Purchasing Power (CPP) Method

Under current purchasing power ( CPP) method, financial statements prepared under historical cost accounting are re-stated by using an approved price index. The following steps should be followed to prepare financial statements under CPP method of accounting for price level changes.

1. Calculation Of Conversion Factor
CPP method involves the re-statement of historical figures at current purchasing power. For this purpose, historical figures must be multiplied by conversion factors. The formula for the calculation of conversion factor is:
Conversion factor = Price Index at the date of Conversion/Price Index at the date of item arose

Conversion factor at the beginning = Price Index at the end/Price Index at the beginning

Conversion factor at an average = Price Index at the end/Average Price Index

Conversion factor at the end = Price Index at the end/Price Index at the end

Average Price Index= Price Index at beginning + Price Index at the end/2

CPP Value = Historical value X Conversion factor

Notes:
* For the items taken from the beginning period (e.g assets, liabilities, taken from the operating balance sheet), beginning conversion factor is used.
* For the items which occur throughout the year like sales, purchases, operating expenses etc., average conversion factor is used.
* For the items which occur at the end of the year like tax, dividend etc. ending conversion is used.

2. Distinction Between Monetary And Non-monetary Accounts
CPP method classifies all assets and liabilities into two groups i.e. monetary items and non-monetary items.
Monetary Items: Monetary items are assets and liabilities, the amounts of which are receivable or payable only at current monetary value. Monetary assets include cash, bank, bills receivables, debtors, prepaid expenses, account receivables, investment in bond or debentures, accrued income etc. Monetary liabilities include creditors, account payable, bills payable, outstanding expenses, notes payable, dividend payable, tax payable, bonds or debentures, loan, advance income, preference share capital etc.
Non-monetary Items: Those items which cannot be stated in ficed monetary value are called non-monetary items. Such items denote assets and liabilities that do not represent specific monetary claims. Non-monetary accounts include land, building, machinery, vehicles, furniture, inventory, equity share capital, irredeemable preference share capital, accumulated depreciation etc. Non-monetary items do not carry a fixed value like monetary items. Therefore, under CPP method, all such items are to be restated to represent current general purchasing power.

3. Gain Or Loss On Monetary items
Monetary items are receivable or payable in fixed amount irrespective of changes in purchasing power of money. The change in purchasing power of money has an effect on monetary assets and monetary liabilities, Therefore, the holding of such items results gain or loss in terms of real purchasing power. Such gain or loss is termed as general price level gain or loss. During the period of inflation, holding of monetary assets results in loss and holding of monetary liabilities result in gain. Such gain or loss must be taken into accounts when income statement is prepared under CPP method to arrive at the overall profit or loss.

4. Valuation Of Cost Of Sales And Inventories
Cost of sales and inventory value vary according to cost flow assumptions i.e. first-in-first-out (FIFO) or last-in-first-out (LIFO). Under FIFO, cost of sales comprises the entire opening stock and current purchases less closing stock. And closing is entirely from current purchase. Under LIFO method, cost of sales comprises current purchase only. However, if the current purchase are less than cost of sales, a part of opening inventory may also become a part of cost of sales. And closing stock comprises purchases made in previous year.

5. Ascertainment Of Profit
Under current purchasing power method, profit can be determined in two ways. They are:

i. Re-statement Of Income Method
Under this method, historical income statement is re-stated in CPP terms. Following conversion factors are used to restate the figures of historical cost statement.
* Sales and operating expenses are converted at the average rate application for the year.
* Cost of sales is converted as per cost flow assumption i.e. FIFO and LIFO.
* Depreciation is converted on the basis of indices prevailing on the dates when assets were purchased.
* Taxes and dividend paid are converted on the indices that were prevalent on the dates when they are paid.
* Gain or loss on monetary items should be shown as separate item to arrive at the overall profit or loss.

ii. Net Change Method
This method is based on the normal accounting principle that profit is change in equity during an accounting period. In order to determine profit, following steps are taken.
* Opening balance sheet prepared on historical cost accounting method is converted in CPP forms at the end of the year.Monetary and non-monetary items are re-stated by using proper conversion factors. Equity share capital is also converted. The difference in the balance sheet is taken as reserve. Alternatively, the equity share capital may not be converted and the difference in balance sheet be taken as equity.
* Closing balance sheet prepared under historical costing is also converted. Only non-monetary items are re-stated. The difference in balance sheet is taken as reserve after converting equity capital. Alternatively, the equity capital may not be restated in CPP terms and balance be taken as equity.
* Profit is equivalent to net change in reserve where equity capital has also been converted or net change in equity where equity capital has not been re-stated.

6. Restated Balance Sheet
The historical balance sheet is prepared as per the historical income statement, so it can not represent the revised or changed value of assets and liabilities. Under the price level change, the historical balance sheet should be revised to reflect the true picture of financial position of any organization. Inside the historical balance sheet, both monetary and non-monetary items are listed. So, the monetary and non monetary items should be separated first of all. It is not necessary to change the monetary item into CPP value because such items are already utilized while calculating the holding gain or loss. Only the non monetary items are to be adjusted to the CPP value by multiplying appropriate conversion factors.

Related Topics
Meaning And Characteristics Of CPP Method
Advantages And Disadvantages Of CPP Method


Advantages And Disadvantages Of Current Purchasing Power (CPP) Method

CPP method is useful for finding out real financial position of organization. Following are the advantages of CPP method.

1. CPP method adopts the same unit of measurement by taking into account the price changes.

2. Under CPP method, historical accounts continue to be maintained. CPP statements are prepared on supplementary basis.

3. CPP method facilitates the calculation of gain or loss in purchasing power due to the holding of monetary items.

4. CPP method uses common purchasing power as measuring unit. So, the comparative study is easy.

5. CPP method provides reliable financial information for taking management decision to formulate plans and policies.

6. CPP method ensures keeping intact the purchasing power of capital contributed by shareholders. So, this method is of great importance from the point of view of the shareholders.

Disadvantages Of Current Purchasing Power (CPP) Method
Following are the some major points for the critism of CPP method:

1. CPP method considers only the changes in general purchasing power. It does not consider the changes in the value of individual items.

2. CPP method is based on statistical index number which can not be used in an individual firm.

3. It is very difficult to choose a suitable price index.

4. CPP method fails to remove all the defects of historical cost accounting system.

5. The use of general price index for CPP method is questioned. While general price index deals with consumer goods, business is interested in the price movement of producer goods.

Related Topics
Meaning And Characteristics Of Current purchasing Power Method
Steps Of Current Purchasing Power Method

Meaning And Characteristics Of Current Purchasing Power(CPP) Method

Current Purchasing Power (CPP) Method
The introduction of current purchasing power (CPP) method is one of the greatest revolutions in the field of accounting. Under current purchasing power (CPP) method, any established and approved general price index is used to convert the values of various items in the balance sheet and profit and loss account. It involves the restatement of some or all of the items in the historical financial statement for changes in the general price level. For this purpose, approved price index is used to convert the various items of historical financial statement. This method helps to present financial statement in terms of units of equal purchasing power.
Under this method, financial statements are prepared on the basis of historical cost and a supplementary statement is prepared showing historical items in terms of current value on the basis of general price index. Retail price index or wholesale price index is taken as an appropriate index for the conversion of historical cost items to show the changes in value of money. This method takes into consideration the changes in the value of items as a result of general price level, but it does not account for changes in the value of individual items.

Characteristics Of CPP Method

1. A supplementary statement is prepared and annexed to historical financial statement. The supplementary statement includes re-statement of income statement and re-stated balance sheet.

2. Any statement prepared under CPP method is based on the historical statement.

3. Consumer price index or wholesale price index is used as conversion factor for re-stated of historical items.

4. All the items in financial statement are classified into monetary and non-monetary items. Non-monetary items are adjusted, there is no need of any adjustment for the monetary items.

5. Net gain or loss account of monetary items is to be accounted in the profit and loss account.

Related Topics
Advantages And Disadvantages Of CPP Method
Steps Of Current Purchasing Power (CPP) Method
Meaning, Features And Objectives Of Current Costing Accounting Method

Objectives And Methods Of Accounting For Price Level Changes

Objectives Of Accounting For Price Level Changes

Historical cost accounting financial statements are prepared on the assumption that monetary unit is stable. But in reality, monetary unit is never stable and most of the countries have been facing high rates of inflation. Therefore, financial statements prepared under historical cost accounting do not reflect current economic realities. They fail to give realistic and correct picture of the state if affairs of a concern. To overcome the limitation of historical cost accounting, there is a need to consider the effects of changes in value of money as a result of changes of price of goods and services. Following are the objectives of accounting for price level changes.

* To show the true result of the operations i.e. real profit or loss.
* To show the true financial position in current values.
* To show the realistic value of fixed assets in financial statement.
* To provide sufficient depreciation to generate funds for the replacement of fixed assets.
* To indicate the real capital employed.
* To make distinction between holding gain or loss and operating gain or loss.
* To make accounting records reliable for the various users.

Methods Of Accounting For Price Level Changes
There are many methods of adjustments for the effects of changes in prices. The generally accepted methods of accounting for price level changes are as under:

1. Current purchasing power method or general purchasing power method(CPP or GPP)
2. Current cost accounting method(CCA method)
3. A hybrid method i.e mixture of CPP and CCA method.

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Meaning Of Accounting For Price Level Changes
Limitation Of Historical Cost Accounting

Limitation Of Historical Cost Accounting (HCA)

Financial statements prepared under historical accounting system suffer from a number of limitations, which are as follows:

1. No Consideration Of Price Level Changes
Financial statements prepared under historical cost accounting are merely statement of historical facts. Changes in the value of money as a result of changes in general level of price are not taken into account. Hence, they fail to give true and fair picture of the state of affairs of the organization.

2. Unrealistic Fixed Assets Values
In historical cost accounting, fixed assets are recorded and presented at the price at which they are acquired. Changes in the market value of such assets are ignored.

3. Insufficient Provision For Depreciation
Depreciation is a mechanism of generating funds to replace the fixed assets when the replacement becomes due. In historical cost accounting, depreciation is charged on the basis of historical cost of fixed assets, not at the price at which the same assets are acquired. The provision made by way of depreciation charge on the original cost will not be sufficient for the replacement of assets.

4. Unrealistic Profit
Income statement prepared under historical cost accounting does not reveal true profit. Revenues are recorded on current value basis whereas expenses are recorded at historical cost. Profits are over-stated during the period of inflation.

5. Mixing Up Of Holding And Operating Gain
In historical cost accounting, gain or loss on account of holding inventories may be mixed up with operating gain or losses. Holding gain or losses should be segregated from operating gain or losses to determine the true operating performance.

6. Fails To Present A Fair Value Of Financial Position
Balance sheet consists of monetary and non-monetary items. Monetary items like cash, loan, debtors, creditors etc. are shown at their current money value. Non-monetary items like inventory, building, land etc. are shown at historical costing, not at current value. During period of inflation, non-monetary items are understated. Thus, balance sheet fails to present a fair value financial position.

Related Topics
Meaning Of Accounting For Price Level Changes
Objectives And Methods Of Accounting For Price Level Changes
Impact Of Inflation

Impact Of Inflation

Inflation means the increase in general level of prices. Due to increase in general level of price, the value or purchasing power of money declines. In other words, inflation is upward movement in the prices of goods and services. When the price of goods of services decreases, the movement is referred to as deflation. Due to deflation, the value or purchasing power of money increases.
Inflation is economically unsound, political dangerous and morally disastrous. The impact of inflation can be explained as under:

1. Inflation causes decline in purchasing power of money. It increases expenditure and discourages saving.

2. During inflation, cost of living increases which hurts the people whose income is fixed.

3. Due to inflation, purchasing power of money declines. As a result, debtors gain and creditors lose.

4. Capital formation is reduced due to inflation.

5. Due to inflation, there is continuous fall in the value of domestic currency.

6. Inflation increases black-marketing, theft, robbery, prostitution and so on. It corrupts the society.

7. Inflation brings political instability.

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Introduction And Meaning Of Accounting For Price Level Changes

Introduction Of Accounting For Price Level Changes
Conventional or historical cost accounting assumes that money has stable value. But in reality, value of money varies from time to time as a result of changes in the general level of prices. Prices of goods and services change over the time. The change in price as a result of various economic and social forces brings about a change in the purchasing power of money.
Accounting is known as the language of business. The basic objective if accounting is to prepare financial statements in such a way that they give a true and fair view of business. Income statement should disclose the true profit or loss made by the business during a particular period where as balance sheet must show a true and fair view of the financial position of the business on a particular date. The recording of business transactions under the assumption that monetary unit is stable is called historical cost accounting (HCA). Under HCA, assets are recorded by the business at the price at which they are acquired and there will be no change in their values even if the market values of such assets change. Likewise, liabilities are recorded at the amounts contracted for and such amounts are not revised to compensate for changes in the price level. Costs are recorded on historical basis where are revenues are recorded on current value basis. Under HCA, it is assumed that money has stable value. But in reality, the value of money varies from time to time. The historical accounting system does not consider the impact of price level change on financial statements. Therefore, accounting for price level changes has been emerged as new accounting system.
Meaning Of Accounting For Price Level Changes
The general tendency in changes of prices of goods and services over a time is called price level. The rise in general price level is called inflation. During the period of inflation, purchasing power of money declines. The fall in the general price level is called deflation. During the period of deflation, purchasing power of money increases. Price level change means increase or decrease in the purchasing power of money over a period of time. The accounting which considers price level changes is called accounting for price level changes.
Accounting for price level changes is a system of maintaining accounts in which all items in financial statements are recorded at current values. This system of accounting ascertains profit or loss and presents financial position of the business on the basis of current prices. Accounting for price level changes is also called inflation accounting.

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Objectives And Methods Of Accounting For Price Level Change
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Impact Of Inflation