Sunday, 10 July 2011

accounting glossaory-5

Greetings to fellow blog readers......

Depreciation: It is a perminant continuing and gradual shrinkage in the book value of a fixed asset.
           Methods: 
1. Fixed Instalment method or Stright line method
Dep. = Cost price – Scrap value/Estimated life of asset.
2. Diminishing Balance method: Under this metod, depreciation is calculated at a certain percentage each year on the balance of the asset, which is bought forward from the previous year.
3. Annuity method: Under this method amount spent on the purchase of an asset is regarded as an investment which is assumed to earn interest at a certain rate. Every year the asset a/c is debited with the amount of interest and credited with the amount of depreciation.
EOQ: The quantity of material to be ordered at one time is known EOQ. It is fixed where minimum cost of ordering and carryiny stock.
 Key Factor: The factor which sets a limit to the activity is known as key factor which influence budgets.
              Key Factor = Contribution/Profitability
              Profitability =Contribution/Key Factor
Sinking Fund: It is created to have ready money after a particular period either for the replacement of an asset or for the repayment of a liability. Every year some amount is charged from the P&L a/c and is invested in outside securities with the idea, that at the end of the stipulated period, money will be equal to the amount of an asset.
Revaluation Account: It records the effect of revaluation of assets and liabilities. It is prepared to determine the net profit or loss on revaluation. It is prepared at the time of reconsititution of partnership or retirement or death of partner.  
Realisation Account: It records the realisation of various assets and payments of various liabilities. It is prepared to determine the net P&L on realisation.


Leverage: - It arises from the presence of fixed cost in a firm capitalstructure.
                        Generally leverage refers to a relationship between two interrelated variables.
These leverages are classified into three types.
1.            Operating leverage
2.            Financial Leverage.
3.            Combined leverage or total leverage.


1.            Operating Leverage: It arises from fixed operating costs (fixed costs other than the financing costs) such as depreciation, shares, advertising expenditures and property taxes.

When a firm has fixed operatingcosts, a change in 1% in sales results in a change of more than 1% in EBIT
                         %change in EBIT 
                         % change in sales
                  
The operaying leverage at any level of sales is called degree.
Degree of operatingLeverage= Contribution/EBIT

Significance: It tells the impact of changes in sales on operating income.
                     If operating leverage is high it automatically means that the break- even point would also be reached at a highlevel of sales.

2.            Financial Leverage:  It arises from the use of fixed financing costs such as interest. When a firm has fixed cost financing. A change in 1% in E.B.I.T results in a change of more than 1% in earnings per share.
F.L =% change in EPS / % change in EBIT
Degree of Financial leverage= EBIT/ Profit before Tax (EBT)
                      Significance: It is double edged sword. A high F.L means high fixed financial costs and high financial risks.

3.            Combined Leverage: It is useful for to know about the overall risk or total risk of the firm. i.e, operating risk as well as financial risk.
                         C.L= O.L*F.L
                               = %Change in EPS / % Change in Sales
                            Degree of C.L =Contribution / EBT

A high O.L and a high F.L combination is very risky. A high O.L and a low F.L indiacate that the management is careful since the higher amount of risk involved in high operating leverage has been sought to be balanced by low F.L
A more preferable situation would be to have a low O.L and a F.L.

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