Statement of changes in working capital

What is the statement of changes in working capital?

Statement of changes in working capital is prepared by recording the changes in current assets and
current liabilities during the accounting period. The working capital during the accounting period is bound to change due to increase or decrease in the current assets and current liabilities.

Purpose of preparing the Statement

The purpose of preparing this statement is to measure the increase or decrease in the individual items of current assets and current liabilities and calculate the net increase or decrease in the working capital during the accounting period. A convenient format is used to depict the changes in working capital as shown below.

Format of a statement of changes in working capital

Format-of-statement-of-changes-in-working-capital

Before preparing a statement of changes in working capital, note the following:

  1. Increase in current asset and decrease in current liability increases working capital.
  2. Decrease in current asset and increase in current liability decreases working capital.

Steps to be followed in preparing the statement of changes in working capital

  1. Draw the pro forma
  2. Identify and enter all current assets under the heading current assets.
  3. Enter the amount of current assets for the base year and current year in the respective columns.
  4. Ascertain the difference in the current assets between the two periods. Enter the difference of amount in increase or decrease column depending upon the Situation.
  5. Identify current liabilities and enter them under the heading current liabilities.
  6. Enter the amount of current liabilities for the base year and current year in the respective columns.
  7. Ascertain the difference in the current liabilities between the two periods. Enter the difference of amount in increase or decrease column depending upon the situation.
  8. Total the current assets and current liabilities for the previous year and current year. Denote total of current assts by A and current liabilities by B.
  9. Calculate working capital for both current period and base period by subtracting current liabilities (B) from current assets (A).
  10. Compare the difference between the amount of working capital for the current and the base year.
  11. If the working capital of the current year is greater than the working capital of the previous year, enter the amount of difference in working capital in the previous year. In the particular column, enter increase in working capital against the amount written.
  12. If the working capital of the current year is less than the working capital of the previous year, enter the amount of difference in working capital in the current year. In the particular column, enter decrease in working capital against the amount written.
  13. Total both previous and current year columns.

The following items require special attention while preparing the statement of changes in working capital

1. Investment:

Investments of short-term nature (say, held for a period of one year or less) are called as marketable securities. They are the current assets of the enterprise which are automatically adjusted through the statement of changes in working capital. Therefore, marketable securities do not require any separate treatment.

But the trade investments of long-term nature being fixed assets (say, held for a period beyond one year with the intention of earning regular income in the form of interest or dividends) require a separate treatment. If the closing balance of long-term investments is lower than the opening balance, the difference is the application of funds (certain investments are bought as income yielding securities for long term). As this is not adjusted automatically in the statement of changes in working capital (not being a current asset), it needs a separate treatment.

2. Advance payment of income tax:

An enterprise is bound to pay tax on its income. Income tax is payable on the income of the previous year during the assessment year. But the income tax department insists that the tax should be paid during the previous year itself on the estimated income to be earned on the principle of pay as you earn. The tax payable during the assessment year, if paid in the previous year, is called as Advance payment of Income Tax. The entry passed in the books for advance payment of tax is:

journal-entry-for-advance-payment-of-income-tax

3. Provision for taxation:

Income tax is a charge on the profit and loss account of a business enterprise. The enterprise makes a provision for tax payable on a self-assessment basis, The estimated liability for tax payable on self-assessment is recorded in the books with an entry:

Journal-entry-for-provision-for-taxation

Any one of the following two ways may be adopted to treat this item:

(a). Treat provision for taxation as current liability and show it on the ‘statement of changes in the working capital’. It should be noted that the payment of tax during the year will not appear as application of funds in the fund flow Statement for the obvious reason that such payments affect two current accounts, viz. cash and provision for taxation.

Note: No adjustment is required at the time of preparing the profit and loss adjustment account or statement of funds from operations.

(b). Treat provision for taxation as non-current liability and do not show it in the ‘statement of changes in working capital’. But payment of tax made during the current year should be shown as ‘application of funds’ in the funds flow statement. To find out the funds from operations, the difference between the opening balance on the credit side, the closing balance and the tax paid debit side should be debited to profit and loss adjustment account. This difference is found out by recording the items in the worksheet. (See below example).

Application of funds

From the following information find out:

(i) The amount to be shown as ‘application’ in the funds flow statement.
(ii) The amount to be debited to the profit and loss adjustment account as ‘provision for income tax’ to ascertain ‘funds from operations’.

Information:

Statement-of-changes-in-working-capital-example

Income tax paid during the year 2018-19 in respect of the year 2017-18 is $45,000.

[Treated as Non-current Liability]

Work Notes

Provision for Income tax Account

Provision-for-income-tax

Notes:

(i) $45,000 should be shown as application of funds in the funds flow statement.
(ii) $65,000 will be debited to profit and loss adjustment account as the difference between the closing balance of income tax provision plus tax paid minus the opening balance of provision for income tax.

4. Provision for bad debts:

Generally, provision for bad debts is deducted from sundry debtor and net amount is shown in the statement of changes in working capital. If this is not the case, then it can be treated as a current liability and can be shown in the changes in working capital under current liability. The provision for bad debts will be treated as surplus when all debtors are good. For calculating funds from operation, the difference between closing balance and opening balance of provision for bad debts shall be taken into account.

5. Interim dividend:

Interim dividend is paid between the two general body meetings of the company during the accounting period. Interim dividend paid during the year/period should be shown as ‘application of fund’ and it should be taken into account for calculating funds from operations.

6. Proposed dividend:

Dividend is proposed or recommended by the Board of Directors to be approved by the shareholders in the General Body Meeting. The treatment of proposed dividend is similar to provision for taxation, i.e., either to treat it as a non-current liability or a current liability.

However, proposed dividend is preferably treated as a non-current liability and it is not shown in the ‘statement of changes in working capital’. It is rather shown as ‘application of fund’ in the ‘funds flow statement’. In the worksheet, proposed dividend account is prepared by crediting the opening balance and debiting the closing balance and proposed dividend during the year. The difference between the two sides will be debited to profit and loss adjustment account to find out ‘funds from operations’.

Treating Proposed Dividend as Non-current liability

From the following information calculate:

1. the amount to be shown as application of fund in the funds flow statement; and
2. the amount to be debited to profit and loss adjustment account as proposed dividend to find out ‘funds flow from operations’ for the year 2019-20.

Treating-proposed-dividend-in-statement-of-changes-in-working-capital

Proposed dividend for the year 2018-19 was paid during the year 2019-20.

Solution:

Work Notes

Provision for Income Tax Account

Practical-problem-statement-of-changes-in-working-capital

Note:

(i) %60,000 will be shown as ‘application of fund’ in the ‘funds flow statement’; and
(ii) %90,000 will be debited to profit and loss adjustment account to find out ‘funds from operations’.

When it is treated as current liability:

The proposed dividend is shown in the statement of ‘changes in working capital’. The payment of proposed dividend during the current year should not be shown in the ‘funds flow statement’.

Note: While calculating the funds from operations, no adjustment is required to be done in the profit and loss adjustment account.

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