Direct Method for calculating Funds from Operations

Funds Flow Cash Flow • Funds Flow Analysis • Study Notes •     n~12 t~2 «Note~12_Topic~3 » n~12 t~4
Direct method involves redrawing/making up the profit and loss account with postings that represent incomes and expenses excluding the posting that represent losses, gains, appropriations and adjustments.

To use this method, we at least need to have the information relating to gross profit, incomes and expenses.

Problem

From the information provided in the following profit and loss account, find out the Funds from Operations
Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To Reserve for Bad Debts
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit 		3,42,000
1,24,000
76,000
1,32,000
87,000
39,000
91,000
42,000
1,25,000
75,000
50,000
40,000
5,25,000  		By Gross Profit
By Commission
By Miscellaneous Income
By Profit on Sale of Asset 		12,50,000
2,80,000
1,54,000
64,000 
16,84,000  16,84,000 

Finding/Calculating Funds from Operations

Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Reserve for Bad Debts
To Funds From Operations 		3,42,000
1,24,000
76,000
42,000
11,00,000  		By Gross Profit
By Commission
By Miscellaneous Income 		12,50,000
2,80,000
1,54,000 
16,84,000  16,84,000 

The funds from operations would be carried down to the Profit and Loss appropriation account. The affect of the other transactions relating to losses, gains, appropriations and adjustments is dealt with through this account.

Deriving Net Profit from Funds from Operations

The Funds from Operations are brought down from the Profit and Loss account to the Profit and Loss appropriation a/c and the postings relating to losses, gains, appropriations and adjustments are made in that account for ascertaining the net profit.
Dr Profit and Loss Appropriation a/c Cr
Particulars Amount Particulars Amount
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit (unappropriated) 		1,32,000
87,000
39,000
91,000
50,000
40,000
7,25,000  		By Funds from Operations
By Profit on Sale of Asset 		11,00,000
64,000 
11,64,000  11,64,000 
To General Reserve
To Special Reserve
To Net Profit 		1,25,000
75,000
5,25,000  		By Net Profit (unappropriated)
7,25,000
7,25,000  7,25,000 

We first consider the postings representing losses, gains and thus obtain the net profit before appropriations and adjustments. Next we consider the postings representing appropriations and adjustments thereby obtaining the net profit transferred to the capital account.

We generally come across a consolidated view of the above account wherein information relating to losses and appropriations are mixed up and information relating to adjustments and gains are mixed up instead of being dealt with separately.

Dr Profit and Loss Appropriation a/c Cr
Particulars Amount Particulars Amount
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit 		1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000  		By Funds from Operations
By Profit on Sale of Asset 		11,00,000
64,000 
11,64,000  11,64,000 

Profit and Loss Appropriation account in Financial Accounting and Financial Management

The Profit and Loss account in financial accounting is posted with transactions representing expenses, losses, incomes and gains. whereas in financial management (in finding funds from operations) it is posted with transactions representing incomes and expenses only.

The Profit and Loss appropriation account in financial accounting is posted with transactions representing appropriations and adjustments only. Whereas in financial management (in finding funds from operations) it is posted with transactions representing losses, gains, appropriations and adjustments.

Why call this the Direct Method?

Since we prepare the account starting with the gross profit, (just like in the case of the Profit/Loss account), this method is called the Direct Method.

Clubbing both the accounts may give a better idea

Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Reserve for Bad Debts
To Funds From Operations 		3,42,000
1,24,000
76,000
42,000
11,00,000  		By Gross Profit
By Commission
By Miscellaneous Income 		12,50,000
2,80,000
1,54,000 
16,84,000  16,84,000 
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit (unappropriated) 		1,32,000
87,000
39,000
91,000
50,000
40,000
7,25,000  		By Funds from Operations
By Profit on Sale of Asset 		11,00,000
64,000 
11,64,000  11,64,000 
To General Reserve
To Special Reserve
To Net Profit 		1,25,000
75,000
5,25,000  		By Net Profit (unappropriated)
7,25,000
7,25,000  7,25,000 
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