There are two ways of treating this item in the Funds Flow Statement:
(a) Provision for Taxation made during the year may be treated as current liability. If this is the treatment, then provision for taxation made during the year is not used for adjusting the net profit made during the year for calculating the funds from operations. As such, tax paid during the year is not treated as ‘Application of Fund’.
(b) Provision for taxation may be treated as internal appropriation and thus a non-current liability. Then it will be used for adjusting the net profit made during the year, and tax paid during the year is treated as an Application of funds.
This item is also treated in two ways in the Funds Flow Statement:
(a) Proposed dividend may be treated as current liability. Then it will not be used for adjusting the net profit made during the year for calculating funds from operations.
(b) The proposed dividend may be treated as non-current liability i.e., an appropriation of profits. In that case, dividends paid during the year are shown as application of funds.
It may be noted that it is the payment of dividend (and not the declaration of dividend) which reduces the working capital. The declaration of dividend does not affect the working capital because; it is a mere appropriation of funds.
In order to find out funds from operations, such proposed dividends should be added back to the current year’s net profit.
Sometimes, the information required for the funds flow statement may have to be found out. Difference in the values of fixed assets and investments in the comparative balance sheet would generally represent either sources, or application byway of sale or purchase thereof, subject to an amount written-off as depreciation.
A separate fixed assets account may be prepared in order to find out the inflow and/or outflow of funds from fixed assets.
In the same way, the inflow and/or outflow of funds from long-term liabilities could be found out by taking into consideration the differences in the values of such liabilities. A separated ledger account may be prepared to locate such differences.
For example, if the balance sheets on two different dates show machinery account as Rs. 50,000 and Rs. 60,000 respectively, and it is given that Depreciation on Machinery has been provided to the extent of Rs. 10,000 the hidden information can be ascertained by preparing a Machinery Account as under:
Suppose the opening balance of the machinery in the above example is Rs. 80,000 then the Machinery Account would appear as follows:
It may be noted that while preparing the fixed assets account as shown above, the opening and closing balances of such assets should be shown at cost.
If the balances of fixed assets and prevision for depreciations are given separately in the balance sheets, then the fixed assets accounts are prepared at original cost and a separate provision for Deprecation Account is prepared in order to find out deprecation provided during the year.
But, if the assets are shown at their written down values in the balance sheets, and the provision for depreciation in the adjustments, then such provisions should be added back to the concerned balances of fixed assets and be shown as balance in their respective account.
These points are illustrated as follows:
Opening and closing balances of the Machinery Account (at W.D.V.) appearing in the. Comparative balance sheets are Rs. 1,50,000 and Rs. 2,50,000 respectively. The opening and closing balances of accumulated Depreciation Account were Rs. 25,000 and 40,000 respectively.
Further it is given that during the year (a) a machine costing Rs. 50,000 was purchased in exchange for fully paid up shares, and (b) an old machine costing Rs. 10,000 (accumulated depreciation Rs. 4,000) was sold for Rs. 4,500. Show the ledger accounts.
1. Purchase of machinery by exchanging fully paid-up shares is non-fund item which will not affect working capital and therefore will not be shown in the funds flow statement.
2. Original cost minus Accumulated Depreciation minus amount sold (i.e., Rs. 10,000 – Rs. 4,000 – Rs. 4,500)
Depreciation refers to the decrease in the value of assets, particularly fixed assets. Fixed assets may lose their values due to wear and tear, obsolescence, passage of time, exhaustion and accident.
As this loss in value i.e., depreciation arises out of operations of fixed asset, in the business, it is treated as an operating expense to profit and loss account.
The usual treatment of depreciation in final account is to debit the same to profit and loss account and credit the concerned fixed asset account (i.e., deducted from fixed assets in balance sheet).
Since, profit and loss account and fixed asset account are non-current accounts; depreciation is treated as a non-fund item while preparing the fund flow statement.
In other words, depreciation is added back to operating profit to find out funds from operations since it does not affect the flow of funds. Hence, it is neither a source nor an application of funds.
If depreciation were really a source of funds by itself, then any business could improve its funds position by providing periodical depreciation charge.
However, depreciation may be considered as a source in a limited sense for the reasons given below:
(a) Depreciation reduces taxable income and therefore tax liability for example, a company is in 40% tax bracket and the amount of depreciation charged to its profit and loss account is, say Rs.40,000.
The company reduces the taxable income by Rs.40,000 and the tax liability by Rs. 16,000 (i.e. 40% on Rs.40,000). The opportunity saving of cash outflow may be taken as a source of funds.
(b) Depreciation may not generate funds but it definitely saves funds. For example, if a company has taken an asset on lease, it must pay lease rentals which are cash outflows. But it may avoid this situation by owning the same asset.
(c) Depreciation forms part of current asset when it is charged as overheads. For example, the value of closing stock may include depreciation as an element of cost and in that case, it becomes a fund item.