CHAPTER NO. 3MANAGEMEN

T OF EARNING

MANAGEMENT OF EARNINGS

The term management of earnings means how the earnings of a firm utilized i.e. How much is paid to the shareholders in the form of dividends & how much is retained & ploughed back in the business. The way the companies apportion their earnings between dividends & retention is known as management of earnings

‘Management of income includes the management of each phase of the company’s business because, the minutest activity of the business usually involves income or expenditure”

GERSTENBERG

SCOPE OF MANAGEMENT OF EARNINGS

MANAGEMENT OF EARNINGS INCLUDES

1. (A) DETERMINATION OF PROFITS (B) DETERMINATION OF SURPLUS (C) CREATION OF RESERVE2. PROVISION FOR DEPRECIATION &

DEPRECIATION POLICY3. DECLARATION OF DIVIDEND & DIVIDEND

POLICY4. RETAINED EARNINGS & PLOUGHING BACK

OF PROFITS (SELF- FINANCING)

DETERMINATION OF PROFITS For correct reporting to the shareholders For declaration of dividends, For ascertaining the operating efficiency of the

company For deciding about the future expansion &growth For ascertaining the intensive use of capital For determining the credit worthiness of the firm For payment of correct taxes For determining the basis of mergers and

amalgamations For ascertaining the importance of the industry

in the national economy

SOURCES OF PROFITS

• INCOME FROM OPERATIONS OF THE BUSINESS IS THE MAIN SOUREES OF PROFITS

INCOME FROM

BUSINESS

• THIS INCLUDES INCOME FROM SUCH SUBSIDIARY SOURCES WITH UNCERTAINTIES

INCOME FROM OTHER

SOURCES

• THIS INCLUDES FUNDS FROM THE INVESTMENTS IN THE GOVERNMENT SECURITIES, BONDS, SHARES AND DEBENTURES ETC.

INCOME FROM

INVESTMENTS

SURPLUSSurplus according to one school of thought

The balance remaining after deducting the liabilities and share capital from the total assets

is known as surplus.In the opinion of other school

Surplus represents the undistributed earnings of the company i.e., the balance of profits remaining after paying dividends to the

shareholders. Still there are others in whose opinion

Surplus is a left over which represents an addition to assets that is carried over on the equity side.

IMPORTANCE OF SURPLUS SURPLUS†

WELCOME SIGN BY MANAGEMENT

TYPE OF BLANKETS COVERING MANY CORPORATE PURPOSES

REFLECTS SOUND ESRNING OF THE CONCERN

ENABLES COMPANY

TO FOLLOW STABLE

DIVIDEND

POLICY

CUSION TO ABSORB THE

SHOCKK OF THE

BUSINESS AS WELL

AS OF ECONO

MY

KINDS & SOURCES 0F SURPLUS

1. EARNED SURPLUS - The use of the term surplus as accumulation of past earnings accounts for its common identification with earned surplus.

2. CAPITAL SURPLUS – It is that part of the surplus which is not related directly to the operating results of the business .

3. SURPLUS FROM UNREALISED APPRECIATION OF ASSETS - During prosperity or boom the value of fixed assets may increase or intangible values may be added by accounting entries.

4. SURPLUS FROM REALISED APPRECIATION OF ASSETS - The sales of assets at price in excess of book values may result in realised surplus.

5. SURPLUS FROM MERGERS , CONSOLIDATION & REORGANIZATIONS - These are generally accompanied by an upward valuation of assets , the resulting surplus may be larger than the total of that resulting in an increase in surplus.

7. Surplus from secret reserves – this is one which is not disclosed in the balance sheet.

8. Paid in surplus. – it raises from the issue of shares at premium.

USES OF SURPLUS

1. USES OF EARNED SURPLUS 2. USES OF CAPITAL SURPLUS

Reducing the value of fixed & working capital

Writing off intangible assets

Equalizing the rate of dividend

Financing schemes of expansion & growth

Absorbing the shocks of business cycles

Supplementing other reserves

For expansion & growth

For protecting investments against a decline in values

For providing funds to working capital

For writing down of operating losses

For absorbing depreciation

METODS TO HIDE SURPLUS

UNDER VALUATION OF ASSTS OVER STATEMENT OF LIABILITIES

o Charging excessive depreciation

o Charging capital expenses as revenue

o Writing off assets by charging against surplus

Showing a contingent liability as an actual liability

Use of fictitious liabilities

Providing excessive provision for taxation

RESERVES

It refers to that amount set aside out of profits to cover any liability, contingency, commitment or depreciation in the value of assets. If amount equal to reserve are invested in out side investments the reserve is called reserve fund.

IN MODERN DAYS The term reserve used only in connection with restriction on, or appropriation of retained earnings.

CLASSIFICATION OF RESERVES

1. GENERAL RESERVE

• It is that part of profits which is set aside to meet any future unknown contingency or emergency.

2. SPECIFIC RESERVE

• This is created for some definite or specific purpose i.e., Dividend equalization reserve

3. REVENUE RESERVE

• These reserves consist of uncontributed revenue gains consisting of profits made in the ordinary course of business

4. CAPITAL RESERVE

• These are created to strengthen the financial position of the company.

5. ASSETS RESERVE

• Theses reserves are set up to off set the loss of value of some assets such as plant &machinery , Account receivables

6. PROPRIETARY RESERVE

• These are the part of shareholders equity to provides cushion against future risks

7. LIABILITY RESERVE

• These reserves may be provided for current as well as emergency liabilities

8. FUNDED RESERVES.

• It is merely a surplus appropriation that is included in shareholders’ equity.

9. SINKING FUND RESERVES

•This fund is built up by regular contribution/ appropriation out of profits & the amount of interest on such contributions & the interest itself.

10. SECRET RESERVE

•A secret reserve is a surplus which although exists in a business but is not disclosed in the balance sheet.

PLOUGHING BACK OF PROFITS

The ploughing back of profits is a technique under which all profits of a company are not distributed amongst the shareholders as dividend, but a part of profits is retained or reinvested in the company. This process of retaining and utilization year after year in the business is known as ploughing back of profits.

This is also known as self financing process Internal financing process Inter financing process

NECESSITY OF PLOUGHING BACK

1. EXPANSION &GROWTH OF

BUSINESS

2. CONTRIBUTION TOWARDS

CRRENT &FIXED NEEDS

3. IMPROVING THE EFFICIENCY

4. MAKING COMPANY SELF

DEPENDENT

5. REDEMPTIONS OF LOANS &

DEBENTURES

6. REPLACEMENTS OF OLD ASSETS

FACTORS INFLUENCING THE RE-INVESTMENT OF PROFITS

REINVESTMENT DEPEND

UPON

EARNING CAPACITY

DIVIDEND POLICY

TAXATION POLICY

FUTURE FINANCIAL

REQUIREMENTS

DESIRE & TYPE OF

SHAREHODERS

MERITS OF PLOUGHING BACK OF PROFITS

ADVANTAGES TO THE COMPANY

•A cushion to absorb the shocks of economy•Economical method of financing•Aids in smooth & undistributed running of the business•Helps in following stable dividend policy•Flexible financial structure.•Makes the company self dependent•To redeem long term liabilities

ADVANTAGES TO THE

SHAREHOLDERS• Increase in the

value of shares• Safety of

investment• Enhanced the

earning capacity• No dilution of

control• Evasion of super

taxes

ADVANTAGES TO THE SOCIETY OR

NATION

•Increases the rate of capital formation•Stimulates industrialization•Increases productivity•Decreases the rate of industrial failure•Higher standard of living

LIMITATIONS OF PLOUGHING BACK OF PROFITS

1. Over capitalization

2. Creation of monopolies

3. Depriving the freedom of the investors

4. Misuse of retained earning

5. Manipulation in the value of shares

6. Evasion of taxes

7. Dissatisfaction among shareholders

COST OF RETAINED EARNINGS

FORMULA OF COST OF RETAINED EARNINGS

FORMULA OF COST OF RETAINED EARNINGS TO MAKE ADJUSTMENTS OF TAX & COST OF PURCHASING NEW SECURITIES

Kr = COST OF RETAINED EARNINGS

D = EXPECTED DIVIDENDNP = NET PROCEEDS OF

SHARE ISSUEG = RATE OF GROWTH

Kr = COST OF RETAINED EARNINGSD = EXPECTED DIVIDENDNP = NET PROCEEDS OF SHARE ISSUEG = RATE OF GROWTHT = TAX RATEb = COST OF PURCHASING NEW

SECURITIES, OR BROKERAGE COSTS

Thank you