INTEREST-A REWARD FOR ONE BUT AN OBLIGATION FOR ANOTHER

As per the heading ,the concept of 'interest' can be explained under two different aspects:

The first aspect can be considered favourable as it will represent 'interest' as a Reward.

The second aspect can be considered unfavourable as it will represent 'interest' as a compulsory obligation*

*Compulsory obligation represents a liability.

The concept of interest plays its role when the money is used as Medium of loan or a grant.

Here two parties are involved -Lender,who gives his money as a loan and receiver who acquires the  money.

Interest represents the percentage of principal amount of money taken as loan.
In today's business environment there is nothing free of cost i.e there is always a consideration for a benefit.

Here it must be noted that a lender or receiver may be an institution also.

Let's understand this concept with an illustration:

You as a business owner (receiver) took a loan of INR 2500000 from a financial institution (lender) at 1% rate of interest per month.

Therefore, according to it monthly interest will be INR 25000(2500000*1/100)
 Here it must be noted that interest amount does not include any part of principle amount i.e the amount of borrowing (or loan)will be the same.

But with the mutual concent of both the parties there may be a provision under which interest may include some part of principle amount so that the burden of loan get reduced to some extent.For example interest amount may be INR 30000(25000+5000) so next interest will be calculated on INR 2495000(2500000-5000).
Here INR 5000 is part of principle amount.

There is one more point that we should consider is that in case of arrears (i.e non payment of interest)
the interest will be calculated on loan amount + interest due.
If in above mentioned illustration there is non payment of interest for one month then on next month interest will be calculated as:

1% of 2525000(2500000+25000)=INR 25250

In this illustration 'interest' is considered as an obligation from your side.

Now let's understand it as a reward:

For example you as an investor invested your money on various marketable securities like bonds.
Here you are giving your idle money which can be utilised for other purposes.
Suppose you invested INR 50000 on fixed income securities like 10% government bonds
Therefore interest=INR 5000
Hence interest becomes a reward for you.

ASCERTAINING THE FUTURE VALUE

In the modern scenario where there is always uncertainty in the environment, it's very important for the people to save some part of their income i.e to facilitate savings.But savings will only be useful when it maintains the value of money.


Now the question arises what's the value of money??

Money value for a person refers to his purchasing power i.e. how much purchase he can make with his given income.

For example:If there is inflation in the economy i.e prices of commodities increases but the income remains same so the purchasing power of people decreases as the value of money decreases and in case of deflation the prices of commodities decreases and as a result purchasing power increases.


In order to combat such situations a new concept called 'investments' was developed in which a person uses his idle money in various securities or funds so that a reasonable interest can be gained.


As an investor every person wants to know the future value of his investment in a particular time period which influences his decision of investing.

Let's take an example:Assume a common consumer wants to use his savings of INR 10000 in a fixed interest securities so that he doesn't have to bear the market risks.It is known as conservative investment i.e fixed return with zero risk. For ascertaining the future value(FV) we must have 3 important information:

(1) amount of investment i.e present value(PV)

(2) rate of interest on investment(i)

(3) Time period for which the amount is invested(n)


It can be represented by following formula:

Lets understand it with an illustration:

Suppose the person invested INR 10000 in a 12% government securities for a period of 2 years

Now the future value will be:


FV=PV *(1+i)^n


=10000*(1+0.12)^2

=INR 12544


Therefore, future value will be INR 12544


Here it must be noted that a person invests it's amount only when he gets the benefit of 'compounding'.


Compounding means earning interest on interest earned.

In the above illustration if interest is calculated separately then for the first year interest will be INR 1200(10000*12%)

and for the second year interest will be INR 1344[(10000+1200)*12%].

Total interest:INR 2544(1200+1344)

VALUE AFTER 2 YEARS=INR 12544(10000+2544)

COST ANALYSIS -GOODS MANUFACTURED

Every product that is sold in the market  has its cost i.e cost of producting or manufacturing it.
For every manufacturing business it is crucial to ascertain such costs as it is the only means that will guide the producer to decide the selling price at which it has to be sold to the market intermediaries (i.e agents, wholesalers and retailers).

In order to cost of goods sold we must know how to calculate the manufacturing cost.

Manufacturing costs involves 3 main elements:

• Raw materials used
• Direct labour
• Manufacturing overheads
  
  
  
  
  
  
  

Inorder to have a clear understanding let's know about the elements in a descriptive way:

(A) RAW MATERIAL USED:
      Raw materials are the inputs(or ingredients)that are used to form a product.
       Without raw material a production process cannot be initiated (or started).

It can be expressed through a formula:

(B) DIRECT LABOUR:
         This involves wages, salaries or any other form of remuneration that is paid to skilled or unskilled labour who are directly related with the production process.
     

(C) MANUFACTURING OVERHEADS:
      It involves any other form of expenses that are incurred for the purpose of smooth production process.These are indirect in nature as they do not add directly to production but it's essential for the process.
  For example:

• Rent of factory building
• Electricity charges
• Quality control
• Indirect factory supplies
• Indirect labour

   In a production process there may be work in process I.e.semi finished goods at the beginning and at the end and cost of such work in process is also taken into consideration for calculating cost of goods manufactured:

CURRENT ASSETS-A LIQUIDITY INDICATOR

In our earlier post ' ASSETS-THE BACKBONE OF A COMPANY' we have discussed about ' current assets ' in a brief form.

Now let's understand it in a descriptive form:

• Current assets represents the short term assets of a company i.e assets which are liquified(or converted into cash)or consumed within a period of one year or its operating cycle*  whichever is longer.

*Operating cycle indicates the time period between the cash outflow for the purpose of purchase, manufacturing of goods and cash inflows from its sale.

Now for a more detailed understanding let's know about some accounting items which are included in this head:


(1) CASH AND CASH EQUIVALENTS

Cash is the most liquid form of an assets as it is already cash.
Cash includes coins,balance in saving account,money orders ,bank drafts etc.

Cash equivalents includes short term securities with a very short maturity period say about 3 months or less.
These are highly liquid investments.

(2) MARKETABLE SECURITIES

These include share ,bonds and other securities with a maturity period of less than 1 year.

(3) SUPPLIES
Supplies include stationery items as they consumed within one year.

(4) INVENTORY

Inventory is the most crucial (important) item in a business entity as it is the most important means of generating revenue.*

*Revenue means proceeds from sale of goods and services.

Inventory involves stock of items which are produced or purchased for the purpose of future sales.

Inventory is considered as current assets as it is assumed that it will be sold within 1 year .

(4) ACCOUNTS  RECEIVABLES

It involves amount to be received on a future date on account of credit sales.

The person or business enterprise from whom the amount is to be received is known as 'Debtors'which becomes a part of current assets.

A debtor may issue a document as a written promise to pay the amount.
Such a document is known as 'BILL RECEIVABLE'.It is also included in current assets.

(5)PRE-PAID EXPENSES

As the name depicts it means amount of expense which are paid in advance.

Now the question arises why an expense is treated as an 'asset'
The reason is that the consumption of such an expense will be done on a future date i.e company gets a firm hold on the benefits of that expense until the date when the expense was to be actually paid.

For example:A insurance premium of ₹ 6000 was to be paid for 6 months in a one month installment system(i.e ₹1000) but the company decided to the whole amount in the first installment.
In this case the asset side will increase by ₹5000 as ₹1000 will be consumed on first installment only and rest ₹5000 will be for prepaid expenses.
Now when second instalment comes prepaid expenses will be reduced by ₹1000 thereby reducing assets side to ₹4000 (₹5000-₹1000).

CHEQUE-A SUBSTITUTE OF CASH

In today's business world a 'cheque' has become an important tool for the financial transactions.
:
Now the question arises ,what is a cheque??

In simple language,a cheque is an instrument in writing containing an order given by the drawer* to his banker(known as drawee) to pay a certain sum of money to the payee*.

*Drawer: person who has to pay the amount.
*Payee: person who has to receive the amount.On his name cheque is drawn.

Here it must be noted that cheque operates only when the transaction is  done through banks.

Now let's know about its 3 main types:

1.BEARER CHEQUE: 
These type of cheques are normally used for cash transactions.
In a bearer cheque  the word 'or bearer' is written on the face of the cheque.

This type of cheque is considered risky as the bank gives payment to the person holding the cheque at its counter .
If the cheque is lost and get in the wrong hands it can be misutilized.

*Nowadays banking system has become more aware and it demands id proof of the holder.

2.ORDER CHEQUE:

When the word 'bearer' appearing on the face of cheque is cancelled and in its place the word 'or order' is used ,the cheque is called order cheque.

Such a cheque is payable to the person specified therein or to any person to whom it is endorsed(or transferred).

*A cheque can be transferred to a third person by writing his name and details at the back of the cheque.

3.CROSSED CHEQUE:


It is the most commonly used type of cheque in business as it is the most secured.
Crossing of a cheque means drawing two parallel line on top left corner of the cheque with or without the additional words like 'a/c payee' or 'not negotiate'.

This type of cheque involves actions of 2 banks  -first of the drawer and second of the payee.

Here there is no cash payment ,the payment is made through bank accounts.
The amount can only be credited to the payee's account not to the bearer of the cheque.


Now let's understand it with the help of an illustration:
Suppose there is a company SUNSHINE LTD. which has to make a payment amounting to ₹100000 to its creditor named MESCO PVT LTD. and sunshine Ltd has its account in TURBO BANK.

For such payment instead of cash payment Sunshine Ltd opted for issuing a cheque so the company issued a crossed cheque amounting to ₹100000

Let's see its diagrammatic representation:

Now let's see how a transaction done by a cheque instead of cash is treated in accounts:
 Such type of  transaction is represented by  'Bank a/c'

IN THE BOOKS OF SUNSHINE LTD.
  MESCO Pvt Ltd    Dr.    100000
   To  Bank a/c                             100000



IN THE BOOKS OF MESCO PVT LTD.
      Bank a/c      Dr      100000     
    To sunshine Ltd                100000

NET WORTH-AN INDICATOR OF FINANCIAL POSITION

Net worth represents the financial position of an individual and business entity.

Now the question  arises how to calculate net worth:

As you have learned about Assets and  Liabilities in our earlier posts it would be very simple for you.

There is a very simple formula for calculating net worth:

 To make it more clear,let's have a look below at the following representation of assets and liabilities of an individual:
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Now net worth of the individual=₹35,80,000-₹27,00,000=8,80,000

LIABILITIES-A FINANCIAL PROMISE

In business ,'Liability' represents an obligation* to pay in the future and it also represents a promise to perform a service in future.

*Obligation=promise

In accounting, there is a term called  'payables' which is most frequently used to denote liabilities specially short term liabilities.

Let's understand the nature of liabilities with the help of an example:
_ suppose you purchased a raw material worth ₹100000 from a supplier and you promised him to pay the amount after 1 month.
In this situation you owe him ₹ 100000 and this amount is a liability for you.
Here the supplier will issue you a document called 'Bills payable'.
(Bills payable=It's a credit instrument  which is received on a credit purchase.)

Like Assets ,as we have discussed earlier , liabilities are also of  2 types:

    Now let's understand the accounting nature of liabilities-