|Management of agricultural research: A training manual. Module 7: Financial Management (1997)|
|Session 1. Financial management 1: Components and information needs|
|Reading note: Financial management 1: Components and information|
Almost all organizations that are accountable to their stakeholders record day-to-day transactions in their account books. In these account books, all transactions are first classified and then summarized. Using the summarized information, the organization develops and prepares financial statements, which help management in measuring the performance of various activities and assessing the financial position of the organization. The statements also draw the attention of management towards those factors which are necessary to maintain the promises of the organization in meeting its objectives.
The two basic financial statements prepared by an organization are the income and expenditure account, and the balance sheet.
Income and expenditure account
The income and expenditure account statement provides information on how the organization has performed during a given period, which is generally one year. The statement summarizes all revenue earned and expenditure incurred during the given period. In deriving these statements, two principles are generally followed:
· accrual assumption, namely matching costs with revenue, and
· provision for depreciation.
Accrual assumption is fundamental to the preparation of an income and expenditure account. The objective is to facilitate the matching of costs with revenue relative to a particular period. This principle assumes increasingly greater importance in modern management, where availability of funds is a major constraint, requiring each organization to get the best possible use out of them. In contrast, the cash basis of accounting is recording only cash inflows and outflows. The transaction is recorded only when cash is involved. If we follow a cash basis of accounting, a meaningful comparison of the operating and financial performance is not possible, particularly in a situation when there are a large number of unpaid bills or a large amount of revenue has not been collected. For example, if the maintenance bills for a period totalled $ 30 000 and the organization has paid only $ 25 000 during the period, in the cash basis of accounting only $ 25 000 would be recorded, while $ 30 000 would be recorded under the accrual system.
As agricultural research institutes become more conscious of the need to prepare and use budgets as control mechanisms, the accrual system assumes more importance. It is very difficult for an organization to effectively use budgets without using the accrual system. A accrual basis also helps management to measure the cost of activities accurately, which is a more correct way of recording expenses.
Depreciation is a means to reflect the actual value of an asset. All organizations use assets to produce goods or services. The value of these assets, except land, is likely to decrease as time passes. Depreciation represents the diminution in the value of fixed assets. The Committee on Terminology of the American Institute of Certified Public Accountants defines depreciation as: "Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of a tangible capital asset (less salvage value, if any) over the estimated useful life of the asset, in a systematic and rational manner. It is the process of allocation. Depreciation for the year is the portion of the total charge under such system that is allocated for the year."
The systematic and rational manner of distributing the cost of the asset may be done in various ways. One approach is to write off the value of the asset using the following formula:
The cost is the expense incurred in purchasing the asset. It is also the book value of the asset in the year of its purchase. The net book value will continuously decline as the organization charges depreciation each year. The salvage value is what the organization expects to recover by selling the asset at the end of its useful life. The above formula ensures that equal amounts are apportioned over the life of the asset, and is called the 'straight line' method of depreciation. There are other methods of charging depreciation.
Until recently there was some controversy concerning charging depreciation in the books of non-profit organizations, but now depreciation accounting has become a generally accepted accounting principle. By not charging depreciation, management's may be misled into thinking that actual costs were less than what they really are. Depreciation represents the cost of using the asset for producing goods or services. Charging of depreciation is more important where the organization is selling its services to outside agencies, more particularly to the government. In such situations the organization may be required to work out a 'reimbursement formula,' which should certainly take into account depreciation charges. If depreciation is regularly charged in the account books, the organization should have no difficulty in negotiating the formula. Another reason for charging depreciation is to avoid an overstatement of the value of assets in the balance sheet.
The income and expenditure sheets should be prepared on the basis of explicit inclusion of depreciation costs. The basic objective is to charge the cost of a fixed asset over its estimated life. If depreciation is ignored, the costs of providing services are distorted.
To illustrate this, the NIFR income and expenditure accounts for 1992 and 1993 are given as Table 1.
The balance sheet is considered to be a window on the business, through which one can look inside and obtain significant details about the financial position of the organization. This statement provides information - as of a given date - about assets and liabilities. Assets represent the economic resources which are going to generate future benefits and are possessed by the organization. They could be stored purchasing power (cash), money claims (investment in securities, stocks, etc.) and tangible movable and fixed items (buildings, equipment, machinery, etc.). Liabilities represent capital grants received from government and other agencies and debts payable by the organization on account of purchases and operating expenses. Two basic principles are followed when preparing the balance sheet of the organization:
· a clear distinction is made between capital and revenue expenditure; and
· capital grants are treated as contributions and not income in the year in which they are received.
Capital and revenue items should be distinguished under all circumstances, according to the nature of the transaction. In the absence of this distinction, the surplus or deficit figure in the income and expenditure account is distorted, and the balance sheet will not provide a correct picture of the financial position of the organization.
Capital grants are most often received in order to create specific facilities. They are not repayable and hence the organization does not create any liability for repayment of these amounts. As noted above, these grants are not treated as income in the year in which they are received, because they cannot be classified as revenue receipts. The balance sheet is prepared on the basis of treating these items as deferred liability during the tenure of the project. When the project is complete, the project cost is transferred to the contribution account. This account is similar to owners' funds in a commercial organization.
Table 2 in this case study gives the balance sheet of the organization for two years.