MB 0041

Financial and Management Accounting

Contents
Unit 1
Financial Accounting – An Introduction 1
Unit 2
Accounting Concepts, Principles, Bases and Policies 20
Unit 3
Double Entry Accounting 44
Unit 4
Secondary Books 67
Unit 5
Trial Balance 93
Unit 6
Final Accounts 127
Unit 7
Introduction to Management Accounting 157
Unit 8
Financial Statement Analysis 171
Unit 9
Funds Flow Analysis 199
Edition: Spring 2010

th
BKID – B1130 30 Dec. 2009
Unit 10
Cash Flow Analysis 228
Unit 11
Understanding Cost 260
Unit 12
Marginal Costing and Break Even Analysis 288
Unit 13
Decisions involving Alternative choices 310
Unit 14
Budgetary Control 327
Unit 15
Standard Costing 346
Reference Books 368
Dean
Directorate of Distance Education
Sikkim Manipal University

Board of Studies
Chairman Mr. Pankaj Khanna
HOD Management & Commerce Director
SMU – DDE HR, Fidelity Mutual Fund
Additional Registrar Mr. Shankar Jagannathan
SMU – DDE Former Group Treasurer
Wipro Technologies Limited
Controller of Examination Mr. Abraham Mathew
SMU – DDE Chief Financial Officer
Infosys BPO, Bangalore
Dr. T. V. Narasimha Rao Ms. Sadhna Dash
Adjunct Faculty & Advisor Ex-Senior Manager, HR
SMU – DDE Microsoft India Corporation (Pvt.) Ltd.
Prof. K. V. Varambally
Director
Manipal Institute of Management
Manipal

Content Preparation Team

M.S. Shoba Mani Dr. Shivaram Krishnan Dr. Y. Rajaram
Lecturer & Consultant HOD Adjunct Faculty
Sikkim Manipal University Sikkim Manipal University Manipal Universal Ltd.

Edition : Spring 2010

This book is a distance education module comprising of collection of learning

material for our students.
All right reserved. No part of this work may be reproduced in any form by any
means Without permission in writing form Sikkim Manipal University of Health.
Medical and Technological Sciences, Gangtok, Sikkim.
Printed and Published on behalf of Sikkim Manipal University of Health, Medical
and Technological Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen , GM,
Manipal Universal Learning Pvt. Ltd., Manipal – 576104. Printed at Manipal Press
Limited, Manipal.
SUBJECT INTRODUCTION
Accounting is a systematic effect of collecting. Classifying and analyzing
financial information for effective use in decision making activities. There are
two facts of accounting namely Financial Accounting and Management
Accounting. While financial accounting is concerned with recording and
preparation of financial statements, management accounts focuses on using
the information for planning, decision making and controlling the financial
activities of business enterprise. In view of the fast changing scenario world
over, MBA students should acquaint themselves with rudiments of the
subject. This book contains 15 Units.
Unit 1: Financial Accounting – Introduction
This unit presents an overview of meaning of accountancy, book keeping,
accounting, explains accounting process involved, and describes the
objectives of accounting. This unit concludes with advantages and
disadvantages of accounting, difference between financial accounting and
management accounting and introduces basic terminologies in accounting.
Unit 2: Accounting Concepts, Principles, Bases and Policies
This unit briefly describes the meaning of accounting concepts, principles,
policies and standards. This unit explains different types of accounting
concepts and accounting policies, changes in accounting policies and the
disclosure norms. A brief introduction of IFRS is made at the end of the unit.
Unit 3: Double Entry Accounting
This unit describes the meaning of double entry accounting, classification of
accounts under traditional approach and modern approach, compares
traditional approach with modern approach and explains process involved in
accounting trail. It provides a rich source of information on accounting
equation. The unit ends with meaning and rules of debit and credit.
Unit 4: Secondary Books
This unit deals with various secondary books, cash book- single columnar,
double and triple columnar cash book and petty cash book. It describes the
procedure of posting transactions in various ledger accounts.
Unit 5: Secondary Books
This unit deals with preparation of trial balance, describes various adjusting
entries, deals with rectification of errors both that are disclosed by trial
balance and not disclosed by trial balance. It also explains the steps to
locate the errors.
Unit 6: Final Accounts
This unit deals with adjustments that are made before preparing final
accounts in the area of depreciation, provision for doubtful debts, reserve
for discount on debtors and creditors, closing stock. Sufficient examples are
given on preparation of trading, profit and loss account and balance sheet.
Unit 7: Introduction to Management Accounting
This unit deals with meaning, role, functions of management accounting. It
explains management accounting framework, tools of management
accounting, balanced scorecard, cash management system and value
added concept. This unit concludes with merits and demerits of
management accounting and distinction between management accounting
and financial accounting.
Unit 8: Financial Statement Analysis
This unit deals with meaning of ratio analysis, steps involved in ratio
analysis, classification of ratios under various categories, Du Pont chart with
sufficient examples. The unit concludes with merits and demerits of ratio
analysis.
Unit 9: Funds Flow Analysis
This unit deals with meaning of funds flow statement, techniques involved in
preparation of funds flow statement. It provides sufficient examples and
exercises on the schedule of changes in working capital, adjusted profit and
loss account and funds flow statement.
Unit 10: Cash Flow Analysis
This unit deals with meaning of cash flow statement, purpose of cash flow
statement, steps involved in preparation of cash flow statement, problems
on cash flow statement under both direct and indirect method. The unit
concludes with difference between cash flow statement and funds flow
statement and uses of cash flow statement.
Unit 11: Understanding Cost
This unit deals with meaning, objective and methods of costing, techniques
of costing, classification of cost, elements of cost. It provides a detailed
specimen of cost sheet with sufficient examples and solved problems.
Unit 12: Marginal Costing & Break even Analysis
This unit deals with concept and characteristics of marginal costing,
difference between absorption costing and marginal costing, CVP analysis,
Break even Chart, Break even point, Price Volume ratio and margin of
safety. It concludes with merits, demerits and application of marginal
costing.
Unit 13: Decision involving alternative choices
This unit deals with meaning of decision making, types of costs, types of
choices decisions- make or buy, addition or discontinuance of the product,
sell or process further, operate or shut down decisions and exploring new
markets etc.
Unit 14: Budgetary Control
This unit deals with meaning of budget, budgetary control, merits and
essential features of budgetary control. It covers steps involved in budgetary
control, types of budgetary control – cash budget, flexible budget with
sufficient examples. This unit concludes with limitation of budgetary control.
Unit 15: Standard Costing
This unit deals with definition of standard costing, describes the meaning of
standard costs, and explains how standards are established, the difference
between standard costs and budgetary control. It describes various types of
variance – material cost variance, material price variance, material usage
variance, material mix variance, material yield variance, direct labour
variance, labour efficiency variance, labour rate variance, labour mix
variance and labour yield variance with examples.
Financial and Management Accounting Unit 1

Unit 1 Financial Accounting – An Introduction

Structure:
1.1 Introduction
Objectives
1.2 Meaning of Accountancy, book-keeping and Accounting
1.3 Accounting Process
1.4 Objectives for accounting
1.5 Differences between book-keeping and accounting
1.6 Users of accounting information
1.7 Limitations of Accounting
1.8 Basic terminologies
1.9 Summary
1.10 Terminal Questions
1.11 Answers

1.1 Introduction
All of you at one point of time would have visited a grocery shop or a
medical shop. You might have wondered how the business person
maintains the record of all the transactions done during a particular period of
time say a year. You might have also thought why he or she has to maintain
a record, how is it beneficial and whether it is mandatory or not? As against
this, imagine the role of a business organization. They provide goods that
might range from simple safety pin to fighter aircrafts. Those who are in
service industry provide various services such as transportation services,
hospitality services, developing complex software programmes etc.
To make sound decision a business enterprise need accounting information.
This information is also needed by government agencies, regulatory bodies,
analyst and individuals at various point of time and at different levels.
Accounting is perhaps one of the oldest, structured management
information system. It has evolved in response to the social and economic
needs of society. Accounting as an information system is concerned with
identification, measurement and communication of economic information of
an organization to its users who may need the information for rational

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decision making. The accounting system is a means to provide relevant and

reliable financial information to all the interested parties.
In this unit we are dealt the meaning of accounting, book-keeping and
accountancy, the steps involved in accounting process. It explains the
various objectives of accounting, discusses the difference between book-
keeping and accounting and how accounting information is used by various
users of accounting information. This unit concludes with basic
terminologies in accountancy.
Objectives:
After going through this unit, you should be able to:
1. Define book keeping, accounting and accountancy
2. Describe the accounting process
3. Explain the objectives of accounting
4. Distinguish between book keeping and accounting
5. Categorize various users of accounting information
6. Acquaint with the basic terminology used in the subject.

1.2 Meaning of Book-keeping, Accounting and Accountancy

Accounting as a discipline was introduced to have permanent and
systematic record of business transactions. This would help a business
person to record all relevant business transactions, to ascertain the profit
earned during a particular period and finally evaluate the financial position of
his/her business. Book keeping, accounting and accountancy are the terms
used in the science of financial accounting.
Book-keeping is defined as the science and art of recording business
transactions in a systematic manner in a certain set of books known as
books of accounts. It identifies the transactions and events, measures the
identified transactions and events in a common measuring unit, records
them in proper books of accounts and finally classifies them in another book
called the ledger.
Accounting is termed as language of business which records all events and
transactions that are of monetary value and facilitates communication
among individuals in a society.

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Accountancy refers to a systematic knowledge of accounting. It explains

„why to do‟ and „how to do‟ of various aspects of accounting. It tells us why
and how to prepare the books of accounts and how to summarize the
accounting information and communicate it to the interested parties.

1.3 Accounting Process

Accounting is the process of identifying the transactions and events,
measuring the transactions and events in terms of money, recording them in
a systematic manner in the books of accounts, classifying or grouping them
and finally summarizing the transactions in a manner useful to the users of
accounting information.

ACCOUNTING ENCOMPASSES

1. IDENTIFICATION 2. MEASURING

3. RECORDING 4. CLASSIFYING

5. SUMMARISING 6. ANALYSING

7. INTERPRETING 8. COMMUNICATING

1. Identifying the transactions and events: This is the first step of

accounting process. It identifies the transaction of financial character
that is required to be recorded in the books of accounts. Transaction is
transfer of money or goods or services from one person or account to
another person or account. Events happen as a result of internal policies
or external needs. Events of non financial character cannot be recorded
even though such events may have an impact on the operational results
of the firm.
2. Measuring: This denotes expressing the value of business transactions
and events in terms of money (in terms of rupees in India).

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3. Recording: It deals with recording of identifiable and measurable

transactions and events in a systematic manner in the books of original
entry that are in accordance with the principles of accountancy.
4. Classifying: It deals with periodic grouping of transactions of similar
nature that appear in the books of original entry into appropriate heads
by posting or transfer entries. For Eg: All purchases of goods made for
cash or on credit on different dates are brought to purchase account.
5. Summarizing: It deals with summarizing or condensing transactions in
a manner useful to the users. This function involves the preparation of
financial statements such as income statement, balance sheet,
statement of changes in financial position and cash flow statement.
6. Analyzing: It deals with the establishment of relationship between the
various items or group of items taken from income statement or balance
sheet or both. Its purpose is to identify the financial strengths and
weaknesses of the enterprise. The above six process in the present day
scenario are generally performed using software packages.
7. Interpreting: It deals with explaining the significance of those data in a
manner that the end users of the financial statement can make a
meaningful judgment about the profitability and financial position of the
business. The accountants should interpret the statement in a manner
useful to the users, so as to enable the user to make reasoned decision
out of the alternative course of action. They should explain various
factors on what has happened, why it happened, and what is likely to
happen under specific conditions.
8. Communicating: It deals with communicating the analyzed and
interpreted data in the form of financial reports/ statements to the users
of financial information eg Profit and loss account, Balance Sheet, Cash
flow and Funds Flow statement, Auditors report etc.

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The Accounting Information System

INPUTS PROCESSING

 Business Transaction  Accounting concepts

Conventions and Principles
 External events measured  Management plans & policies
in financial terms  Law & regulations
 Classification & Interpretation

OUTPUT USERS

 Profit & Loss a/c  Shareholders

 Balance Sheet  Regulators
 Cash Flow statement  Lenders
 Explanatory Notes  Employees
 Auditors report  Management
 Regulatory filings  Rating agencies

Source: Adapted from Financial Accounting, Management perspective

by R. Narayaswamy.
Self Assessment Questions
1. Book keeping _________ the transactions and events, _________the
identified transactions and events in a common measuring unit, records
them in proper books of accounts and finally classifies them in the
ledger.
2. Accounting in addition to book keeping involves ________ the classified
transactions and ________ the summarized results.
3. ____________ interprets the analyzed results and communicates the
interpreted information to the interested parties.

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Activity 1:
Take a balance sheet of a company and a bank balance sheet from a
published source say a newspaper or annual report or web site. Reading
the balance sheets give at least 10 differences.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

1.4 Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves
the following functions and objectives.
a) Accounting helps in systematic recording of all business events or
transactions. Written records are more preferable to memorizing (oral
recording) because the latter may fade away with time. Also systematic
records can be used by different persons for different decision making
purposes.
b) Accounting measure the financial performance of the enterprise. The
results of operations are ascertained by preparing profit and loss
account, balance sheet and cash flow statements. This will enable the
business person to ascertain what the business owes to others, what
others owe them and whether his/her capital remained same or
increased or decreased.
c) Accounting facilitates in reporting the results to both internal and
external users. The management requires information for internal
purpose at various levels of operations. They need to prepare various
reports such as production report, idle time report, cash budget report,
receivable report, accounts payable report, project appraisal report,
capital budgeting report etc. The management reports the financial
performance of the firm to external users such as shareholders,
creditors, bankers, investors, stock brokers, stock exchanges,
employees, governments etc.,

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d) Accounting is required to fulfill the statutory requirements of various

regulatory bodies such as Registrar of Companies, SEBI (Securities
Exchange Board of India) income tax authorities and the Government.
e) Accounting helps in internal control by holding the concerned persons
responsible for any errors, lapses or under performance. Equally it helps
to identify the strong /weak areas of each unit or department.
Accounting is a tool for effective planning. Current year‟s financial
performance becomes the basis for future predictions and estimations.
Since it is tool for planning, it also acts as tool for controlling. Preparation of
budgets, cost analysis, tax planning, auditing are some of the functions of
accounting.
Self Assessment Questions:
4. Accounting is a tool for _______________ and ________
5. Expand SEBI.
6. Mention any five stakeholders.

1.5 Distinction between Book-keeping and Accounting

Accountancy is the profession and the practitioners of accountancy are
called accountants. Book keeping is the basic activity of recording. On
recording the transactions and events in the books of accounts, accounting
does the role of analysis and reporting. Accountancy is the profession of
carrying the activities of book keeping and accounting. Accounting enjoys
wider scope and includes not only book keeping but also analysis,
interpretation and reporting of financial information. The later part of
accounting is the core function of accounting. In the present day
environment, sophisticated software packages are available, which facilitate
entry of transactions and preparation of ledger accounts.

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Book keeping Accounting

 It is a process of identifying,  It involves summarizing the classified

measuring, recording and transaction, interpreting the analyzed
analyzing the transactions in results and communicating the
books of accounts information to the users of financial
statement.
 Adopt principles of accounting  Analyzing and interpreting requires
for recording skill, knowledge and experience

 Book keeping is the first stage of  Accounting follows book keeping. It

accounting process is the secondary stage
 The objective is to prepare final  The objective is to ascertain net
accounts and balance sheet in a results of financial operations and
systematic manner at the end of communicate the results to all
accounting period stakeholders in a manner they
understand.
 Accounts executives who  Accountants who perform this
perform this function may not function need higher analytical skills
require higher level of to interpret the data and to take
knowledge. appropriate decisions.

 The nature of job is routine and  The nature of job is non routine but
clerical analytical.

1.9 Users of Accounting Information

Accounting reports are designed to meet the common information needs of
most decision makers. These decisions include when to buy, hold or sell the
enterprise shares. It assesses the ability of the enterprise to pay its
employees, determine distributable profits and regulate the activities of the
enterprise. Investors and lenders are the most obvious users of accounting
information.
a) Investors: Investors may be broadly classified as retail investors, high
net worth individuals, Institutional investors both domestic and foreign.
As chief provider of risk capital, investors are keen to know both the
return from their investments and the associated risk. Potential investors
need information to judge prospects for their investments.
b) Lenders: Banks, Financial Institutions and debenture holders are the
main lenders and they need information about the financial stability of

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the borrower enterprise. They are interested in information that would

enable them to determine whether their borrower has the capability to
repay the loans along with the interest due on it. They also use the
information for monitoring the financial condition of the borrowers. They
may stipulate certain restrictions (known as covenants) such as upper
limit on the total debt borrowed from all sources or ask for additional
security etc. Short term lenders (trade creditors) who provide short term
financial support need information to determine whether the amount
owing to them will be paid when due and whether they should extend,
maintain or restrict the flow of credit.
c) Regulators, Rating Agencies and Security Analyst: Investors and
creditors seek the assistance of information specialist in assessing
prospective returns. Equity analyst, bond analyst and credit rating
agencies offer a wide range of information in the form of answering
queries on television shows, providing trends in business newspapers
on a particular stock, offer valuable information in seminars, discussion
groups, meetings and interviews. Security analyst obtain valuable
information including insider information by means of face-to-face
meetings with the company officials, visit their premises and make
constant enquiry using e-mails, teleconference and video conference.
Firms build a good rapport with such type of information seekers to gain
visibility in the market.
d) Management: Management needs information to review the firm‟s short
term solvency and long term solvency. It has to ensure effective
utilization of its resources, profitability in terms of turnover and
investment. It has to decide upon the course of action to be taken in
future. Management may also be interested in acquiring other business
which is undervalued. When managers receive a commission or bonus
related to profit or other accounting measures, they have a natural
interest in understanding how those numbers are computed. Further
when faced with a hostile takeover attempt, they communicate additional
financial information with a view to boosting the firm‟s stock price.
e) Employees, Trade Union and Tax authorities: Employees are keen to
know about the general health of the organization in terms of stability
and profitability. Current employees have a natural interest in the

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financial condition of the firm as their compensation will depend on the

financial performance of the firm. Potential employees may use financial
information to find out the future prospects of the firm. Trade unions use
financial reports for negotiating wage package, declaration of bonus and
other benefits. Tax authorities need information to assess the tax liability
of the firm.
f) Customers: Customers have an interest in the accounting information
about the continuation of company especially when they have
established a long term involvement with or are dependent on the
company. For Eg. Car owners, buyers of white goods, electronic
gadgets, depend on the manufacturer for warranty service support,
continued supply of spare parts. The sales of Matiz car was badly
affected due to the abrupt closure of Daewoo Motors.
g) Government and regulatory agencies: Government and the regulatory
agencies require information to obtain timely and correct information, to
regulate the activities of the enterprise if any. They seek information
when tax laws need to be amended, to provide institutional support to
the lagging industries. The regulatory agencies use financial reports to
take action against the firm when appropriate returns are not filed in time
or when the returns fails to provide true and fair position of the business
or to take appropriate action against the firm when complaints /
misappropriation are being lodged. Stock exchange has a legitimate
interest in financial reports of publicly held enterprise to ensure efficient
operation of capital market.
h) The Public: Every firm has a social responsibility. Firms depend on local
economy to meet their varied needs. They may get patronage from local
government in the form of capital subsidy, cheap land or tax sops in the
form of tax holidays for certain period of time. Prosperity of the
enterprise may lead to prosperity of the economy both directly and
indirectly. Growth in software industry in Bangalore, Karnataka State, led
to boom in housing sector, education sector, entertainment sector, travel
sector and tourism sector in and around Bangalore. Published financial
statement assist public by providing information about the trends and
recent developments of the firm.

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Activity 2:
The following is the abstract of annual report of Sundaram Clayton
Limited for 2008 –
During the year under review, the vehicle industry registered a negative
growth of 2.1%. While the medium / heavy commercial vehicles
segment recorded a negative growth of 1%. The light commercial
vehicle segment registered a growth 13%. Car segment achieved a
positive growth of 14% and two wheeler segments suffered a negative
growth of 5%.
Despite this, the Company achieved sales of Rs. 427 crores during
2007-08 as against Rs. 309 crores in 2006-07, registering a growth of
38.2%.
As an investment advisor tracking automobile sector how would you use
this information?

Self Assessment Questions

7. ________ as chief provider of risk capital is keen to understand both
the return from their investments and the associated risk.
8. _________ use financial reports for negotiating wage package,
declaration of bonus and other benefits.
9. ___________ has a legitimate interest in financial reports of publicly
held enterprise to ensure efficient operation of capital market.
10. The regulatory agencies use _____________ to take action against the
firm when appropriate returns are not filed in time or when the returns
fails to provide true and fair position of the business or to take
appropriate action against the firm when complaints / misappropriation
are being lodged.

1.7 Limitations of Accounting

1) Though accounting system is the only source for extracting financial
information of the firm, it grossly lacks qualitative elements. Qualitative
resources could include leadership of top brass, highly talented human
resource, highly motivated team, best products, the power of resource
and development, brand image etc.
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2) Accounting is not free from bias. The accountants have some leeway or
freedom on the methods of depreciation charged, inventory valuation
etc. Though the convention says consistency has to be maintained on
the policies adopted, there is considerable room for bias, favourism and
personal judgment.
3) Accounting reveals the estimated position and not the real position of
the firm. Generally financial statements are prepared on separate entity
concept, conservatism concept etc. which are based on the estimates
that may lead to over valuation or under valuation of assets and
liabilities. The exact picture of the financial situation can be ascertained
only on the liquidation of an enterprise.
4) Accounting ignores the price level changes when financial statements
are prepared on historical cost. Fixed assets are shown in the balance
sheet at historical cost less accumulated depreciation and not at their
replacement value. Land value is shown at historical cost but the
replacement value could be far higher than the value stated in the
balance sheet due to appreciation of land value over the period of time.
5) The danger of window dressing arises when the management decides to
incorporate wrong figures to artificially inflate revenue or deflate losses
or when there is a threat of hostile takeover. In such a situation the
management fails to provide true and fair view of the financial position to
the various users of the financial statement. Satyam Computer Services,
the fourth largest software firm went into bust when the information on
inflated income to the extent of Rs.7000 crore was revealed.
Self Assessment Questions
11. Accounting grossly lacks ____________elements
12. The exact picture of the financial situation can be ascertained only on
the ________of an enterprise.
13. The danger of ___________ arises when the management decides to
incorporate wrong figures to artificially inflate revenue or deflate losses
or when there is a threat of hostile takeover.
14. Accounting ignores the price level changes when financial statements
are prepared on __________.

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1.8 Basic Terminologies

To understand the subject, proper understanding of the following terms is
essential.
1. Transaction: It is transfer of money or goods or service from one
person or account to another person or account. There are cash
transactions, credit transactions and paper transactions. In all cash
transactions, cash is paid or received immediately. Credit transaction
is one where there is a promise to pay/receive cash at a future date.
Paper transaction is one where there is no cash inflow or outflow but
adjustment is made in the records only. (Bad debts of previous year
are written off; depreciation provided on fixed assets etc.),
2. Capital: Funds brought in to start business, by the owner/s. In the
case of a company, capital is collected by issue of shares. Capital
used to purchase fixed assets is called fixed capital and that capital
used for day to day affairs of business is known as working capital.
From business point of view, Capital is a liability.
3. Share: A share in a company is one of the units into which the total
capital of the company is divided.
4. Assets: An asset is a resources legally owned by the enterprise as a
result of past events and from which future economic benefits are
expected to flow to the enterprise. Eg: Land and buildings, plant and
machinery, furniture and fixtures, cash in hand and at bank, debtors
and stock etc., are regarded as assets, Assets may be fixed, current,
liquid or fictitious.
5. Fixed assets are those which are held for use in the production or
supply of goods and services. Ex: plant and machinery, which is used
fairly for long period.
6. Current assets are those which are held or receivable within a year or
within the operating cycle of the business. They are intended to be
converted into cash within a short period of time. Ex: Stock in trade,
debtors, bills receivable, cash at bank etc.,
7. Liquid assets are those which can be easily converted into cash and
for instance, cash in hand, cash at bank, marketable investments etc.,

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8. Fictitious assets are in the form of such expenses which could not be
written off during the period of their incidence. For example,
promotional expenses of a company which could not be treated as
expenditure in the year of incidence are shown as fictitious asset.
9. Liability: It is a financial obligation of an enterprise arising from past
event the settlement of which is expected to result in an outflow of
resources embodying economic benefit. Eg. Loans payable, salaries
payable, term loans.
10. Current liability is that obligation which has to be satisfied within a
year. For example, payment to be made sundry creditors for the goods
supplied by them on credit; bills payable accepted by the
businessman; overdraft raised by the businessman in a bank etc.
11. Equity: Equity is the residual interest in the asset of the enterprise
after deducting all its liabilities. The equity of a company is called
shareholders‟ equity. Its components include share capital, share
premium and retained earnings.
12. Entity: It is an economic unit that performs economic activities.
13. Sole trader: A single individual carrying on business with or without
the help of his kith and kin is called sole trader.
14. Partnership: It is a relationship between partners to contribute capital
to start business, agree to distribute profits and losses in an agreed
proportion and the business being carried on by all or any one acting
for all. Partnership firm refers to business where as the partnership
refers to relationship caused by agreement.
15. Joint Stock Company: It is an organization, for which the capital is
contributed by shareholders to carry on business and it is registered
under Companies Act and it has a legal entity, having perpetual
existence and a common seal.
16. Goods: Goods refer to merchandise, commodities, products, articles
or things in which a trader deals. It is the commodities or things meant
for resale. Goods account is divided into six heads viz: purchase
account, sales account, purchase return account, sales return account,

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opening stock account and closing stock account. Let us get the
meaning of each one.
 Purchase: Goods purchased by a business are called purchase.
 Sales: Goods sold by a business are called sales.
 Purchase Return or Return Outward: Goods returned by the
business to its suppliers out of the purchases already made from
them are called purchase return.
 Sales Return or Return Outward: Goods returned to a business
by its customers out of the sales already made to them are called
Sales Return.
 Opening Stock: Unsold goods lying in a business at the
beginning of a year, are called opening stock.
 Closing Stock: Unsold goods lying in a business at the end of a
year, are called closing stock.
17. Inventory: Inventory refers to goods held by a business for sale in the
ordinary course of business or for consumption in the production of
goods or service for sale. It includes stock of raw materials, stock of
work in – progress and stock of finished goods.
18. Drawings: It refers to cash, goods or any other asset withdrawn by the
proprietor from his business for his personal or domestic use. In short,
amounts the owner withdraws from his business for living and personal
expenses.
19. Debtor: A debtor is a person who owes money to the business. A
debtor may be of 4 types.
 Trade debtor is a person who owes money to the business for the
goods supplied to him on credit.
 A loan debtor is a person who owes money to the business for
the loan advanced to him.
 Debtor for asset sold is a debtor who owes money to the
business for any asset sold to him on credit.
 A debtor for service rendered is a debtor who owes money to the
business for the service rendered to him on credit.
20. Debt: The amount due from a debtor to the business is called a “Debt”,
generally debt may be of three types:
 Good debt refers to fully recoverable debt.
 Bad debt refers to debt, which is not recoverable (irrecoverable).
 Doubtful debt refers to debt whose recovery is doubtful.

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21. Creditors: A creditor is a person to whom the business owes money.

A creditor also may be of 4 types.
 Trade creditor is a person to whom the business owes money for
goods purchased from him on credit.
 Loan creditor is a person to whom the business owes money for
the loan borrowed from him.
 Creditor for asset purchased is a creditor to whom the business
owes money for any asset purchased from him on credit.
 Expenses creditor refers to a creditor to whom the business owes
money for any service received from him on credit. For e.g.:
salaries unpaid, commission unpaid etc.
22. Loss: It refers to money or money‟s worth given up without any benefit
in return. For e.g. loss of cash by theft, loss of goods by fire etc. It is a
situation where in the expenses of the business exceeds revenues. An
expense brings some benefits, but loss does not bring any benefit.
23. Profit: It is a situation where the revenue of a business exceeds its
expenses. In other words, the amounts we earned were greater than
our expenses.
24. Journal: A journal is a daily record of business transactions. It is a
book of original, prime or first entry in which all the business
transactions are first entered in the specified manner in the order of
dates. A preliminary record where business transaction is first entered
into the accounting system.
25. Ledger: A ledger is an account book in which all the accounts are
maintained. It is the books of final entry as well as principal book of
accounts.
26. Entry: It is the record of a transaction made in any book of account,
either in the book of original entry or in the books of final entry.
27. Narration: It is a brief explanation to a journal entry, given below the
journal entry, with in brackets. It gives the explanation for the particular
journal entry.
28. Posting: Posting is the process of entering in the ledger the
information already recorded in the journal or in any of the subsidiary
books. In other words process of transferring balances from
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bookkeeping records called journals to a "final" bookkeeping record

called the general ledger.
29. Voucher: It refers to any written document in support of a financial
transaction.
30. Trial Balance: A worksheet listing of all the accounts appearing in the
general ledger with the dollar amount of the debit or credit balance of
each, used to make sure the books are "in balance" total debits and
credits are equal.
31. Balance Sheet: It is the financial statement, which shows the amount
and nature of business assets, liabilities, and owner's equity as of a
specific point in time. It is also known as a Statement of Financial
Position or a Statement of Financial Condition.
32. Carried Forward: The term carried forward or its abbreviation [c/f] is
used at the foot of a page to indicate that the total amount at the foot of
that page has been carried forward to the head of the next page.
33. Brought Forward: The term brought forward or its abbreviation [b/f] is
used at the head of page to indicate that the total amount at the head
of that page has been brought forward from the foot of the previous
page.
34. Carried Down: The term carried down or its abbreviation [c/d] is
written in a ledger account at the time of its closing to indicate that the
balance in that account has been carried down to the next period.
35. Brought Down: The term brought down or its abbreviation b/d is
written in a ledger account at the time of its opening to indicate that the
opening balance in that account has been brought down from the
previous period.
36. Bill of exchange: It is documentary evidence in writing containing an
unconditional order signed by the maker, directing a certain person to
pay a certain sum of money only to, or to the order of, a certain person
or the bearer of the instrument.
37. Bills Payable: It is a bill of exchange stating an obligation to pay a
certain sum of money at a specified date. In case of purchase of raw
materials on credit the supplier or the creditor draws bills of exchange

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on the business entity. When the entity accepts the bill it becomes bills
payable for the entity. The same bill for the supplier is termed as bills
receivable.
38. Bills Receivable: It is a bill of exchange containing an acceptance
from the drawee (or Payee) a certain sum of money at a specified date.
On sale of goods on credit the entity draws a bill of exchange on the
customer. When the customer or debtor accepts the bill it becomes bills
receivable for the firm. Bills receivables can be discounted with banks
or discount houses.

1.9 Summary
Accounting is the process of identifying the transactions and events,
measuring the transactions and events in terms of money, recording them in
a systematic manner in the books of accounts, classifying or grouping them
and finally summarizing the transactions in a manner useful to the users of
accounting information.
The main objective of accounting is to determine income, financial reporting
and disclosure of relevant and pertinent information to the users of financial
information.
The users of accounting information are investors, lenders, regulators, rating
agencies, security analysts, management, employees, trade unions, tax
authorities, customers, government and the general public.
Accounting ignores qualitative aspects while providing information. It is not
free from bias. It ignores price level changes and pose the danger of window
dressing. Management accounting refers to the use of financial data for the
purpose of planning and decision making, performance evaluation etc.

1.10 Terminal Questions

1. Explain the process involved in accounting.
2. What are the objectives of accounting?
3. Distinction between book-keeping and accountancy.
4. How accounting information is used by investors and lenders?

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5. How Government and Regulatory agencies use accounting information

to regulate the activities of the firm?
6. Distinguish between financial accounting and management accounting

1.11 Answers to SAQ’s and TQ’s

1. Identifies, measures 11. Qualitative

2. Summarizing, analyzing 12. Liquidation
3. Accounting 13. Window dressing
4. Effective planning, controlling 14. Historical Cost
5. Securities Exchange Board of
India
6. Shareholders, Creditors,
Bankers, Government,
Employees
7. Investors
8. Trade Union
9. Stock Exchange
10. Financial Reports

Answers to Terminal Questions

1. Refer 1.3
2. Refer 1.4
3. Refer 1.5
4. Refer 1.6
5. Refer 1.6
6. Refer 1.8

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Unit 2 Accounting Concepts, Principles,

Bases and Policies
Structure:
2.1 Introduction
Objectives
2.2 Accounting Concepts, Principles, Policies and Standards
2.3 Types of accounting concepts
Business Separate entity concept
Going concern concept
Money measurement concept
Periodicity concept
Accrual concept
2.4 Accounting Principles
Principle of Income recognition
Principle of expense
Principle of matching cost and revenue
Principle of Historical costs
Principle of full disclosure
Double aspect principle
Modifying Principle
Principle of materiality
Principle of consistency
Principle of conservatism or prudence
2.5 Accounting Policies
Changes in Accounting Policies
Disclosure in case of changes in Accounting Policies
2.6 Accounting Standards
Scope and functions of Accounting Standards Board
International Financial Reporting System
2.7 Summary
2.8 Terminal Questions
2.9 Answers
Annexures – I and II

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2.1 Introduction
In the previous unit we had discussed on the meaning, objectives of
accounting, the accounting process involved and the distinction between
book keeping and accounting. Accounting is a reflection of all business
transactions expressed in terms of money pertaining to a definite period of
time. The objective of accounting is to find out profit or loss arising out of
transactions and finally to judge the financial position of the business
organization.
Accounting is based on certain postulates, concepts and policies. In this
Unit, we have dealt with various types of concepts, principles and policies of
accounting with suitable examples. A brief introduction is made on
accounting standards issued by Accounting Standards Board of ICAI and
International Financial Reporting System (IFRS).
Objectives:
After going through this unit, you should be able to:
1. Define the meaning of concepts, principles and policies
2. Explain the different types of accounting concepts
3. Explain the different types of accounting principles.
4. Explain the major consideration governing accounting policies, changes
in accounting policies and the disclosure if there is change in accounting
policies.
5. Define the scope and functions of Accounting Standards
6. State the meaning and objectives of International Financial Reporting
System.

2.2 Meaning of Accounting Principles, Concepts & Policies

Accounting information is used by various stakeholders. Since all the
stakeholders should understand the accounting language in the same
sense, certain principles, concepts and policies of accounting have been
laid down.
Accounting Principles: Accounting Principles are basically the rules of
action adopted by the accountants universally while recording accounting
transactions. The principles are doctrines associated with theory and

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procedures and current practices of accounting. These principles may be

classified as concepts and conventions.
Concepts: Concepts take the form of assumptions or conditions, which
guide the accountants while preparing accounting statements.

Example: Business is started with an assumption that it shall be

continued for a long period of time and none wishes it to close down
within a short period of time.

Based on this assumption, business person purchases fixed assets, uses

long term source to fund the fixed assets etc. This strong assumption that
the business will continue for a long period of time is called a concept.

ACCOUNTING PRINCIPLES

ACCOUNTING ACCOUNTING
CONCEPTS CONVENTIONS

Assumptions or Customs and

Conditions Traditions

Accounting policy is one which is adopted by management

relevant to the situations.

Conventions: Conventions are those customs and traditions which guide

the accountants while preparing the financial statements.

Example: Inventory (stock) in a business is valued at the end of an

accounting period, at cost or market price whichever is lower. This is
an accepted convention or a practice in accounting.

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Accounting Policy: Accounting policy refers to the specific accounting

principles and methods of applying those principles adopted by the
enterprise in the preparation and presentation of financial statements.

Example: While depreciating an asset the practice of adopting

straight line method or diminishing balance method or any other
method is a convention

The choice of selecting straight line method of depreciation or any other is

the policy of the management. No management can exercise discretion
regarding fundamental presumptions of accounting. But every management
has a choice of making an accounting policy.
Generally Accepted Accounting Principles:
The double entry system of accounting is based on a set of principles which
are called generally accepted accounting principles. It incorporates the
consensus at a particular time as to:
 Which economic resources and obligations should be recorded as
assets and liabilities by financial accounting,
 Which changes in assets and liabilities should be recorded,
 When these changes are to be recorded,
 How the assets and liabilities and changes in them should be measured,
 What information should be disclosed and
 Which financial statement should be prepared
For example, an entity having research and development department may
follow the policy of deducting all the R&D expenses incurred in a year as
revenue expense while for the same situation another entity may classify
R&D expenses into projects and may write off only when the project is not
expected to offer any future benefits.
Annexure 1 given at the end of this unit provides you details on the
difference between US GAAP norms and Indian GAAP norms.
Accounting Standards
To bring uniformity in terminology, accounting concepts, conventions, and
assumptions, the Institute of Chartered Accountants of India (ICAI)
established Accounting Standards Board (ASB) in 1977. An Accounting
Standard is a selected set of accounting policies or broad guidelines

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regarding the principles and methods to be chosen out of several

alternatives. There are altogether 32 accounting standards issued by ASB
out of which, one standard (AS8) has been withdrawn pursuant to AS26
becoming mandatory. Annexure 2 given at the end of this unit provides you
the details of 32 Accounting Standards (AS).
Self Assessment Questions:
1. Accounting principles are _______, associated with theory and practice
of accountings.
2. Accounting Principles are classified as ________ and ________.
3. Assets may be depreciated on fixed installment method or reducing
balance method. Is it a concept or a convention?
4. A business is started with an assumption of making profit. Is this
assumption, a concept or a convention?
5. The purpose of establishing ICAI and ASB is to ________.
6. How many accounting standards are issued by ASB so far?

2.3 Types of Accounting Concepts

As said earlier, concepts are the basic assumptions or conditions upon
which the science of accounting is based. There are five basic concepts of
accounting, namely – business entity concept, which is also termed as
separate entity concept, going concern concept, money measurement
concept, periodicity concept and accrual concept. Each concept is
discussed below.

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2.3.1 Business Separate Entity Concept

The essence of this concept is that business is a separate entity and it is
different from the owner or the proprietor. It is an economic unit which owns
its assets and has its own obligations. This enables the business to
segregate the transactions of the company from the private transactions of
the proprietor(s).

Example: Personal bank account of the proprietor, Cash withdrawal

from business for private purpose should be accounted separately.

This legal separation between business and ownership is kept in mind while
recording the transactions in the books of business.
Self Assessment Questions:
7. State true or false:
a. If the household expenses of Rs 25,000 of a proprietor are shown as
business expenses, the profit of the business will be understated to
the extent of Rs.25,000.
b. If a proprietor invests Rs.1,00,000 in the business, it is deemed that
the proprietor has given Rs.1,00,000 to the „business‟ and it is shown
as an asset in the books of the business.
8. Business and its owner are _______________ entities.
9. Profits earned in business form an addition to the _____________ of the
owner.
2.3.2 Going concern concept
The fundamental assumption is that the business entity will continue fairly
for a long time to come. There is no reason why an enterprise should be
promoted for a short period only to liquidate the business in the foreseeable
future. This assumption is called “going concern concept”.
This concept forms the basis for the distinction between expenditure that will
yield benefit over a long period of time (Fixed Assets) and expenditure
whose benefit will be exhausted in the short term (Current Asset). Similarly
liabilities are classified as short term liabilities and long term liabilities.
According to AS 1 issued by ICAI, if this concept is followed, this fact need
not be disclosed in the financial statement since its acceptance and uses
are assumed. In case this concept is not followed, the fact should be
disclosed in the financial statement along with the reasons.
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Going concern concept is not valid in the following cases:

 When an enterprise was set up for a particular purpose
 When the government declares a company sick.
 When the company has been in the grip of severe financial crisis
and is expected to wind up shortly
 When a receiver or liquidator has been appointed to wind up the
company.

Self Assessment Questions:

10. Accounting of a small calculator as an expense and not as an asset
is the application of principles of prudency. State true or false.
11. Classification of assets as current and fixed assets is the application
of going concern concept. State true or false.
12. Purchase a building for your business is made under the assumption
that it would last for a long period. This is in accordance with the
materiality principle. State true or false.
13. What is the underlying intention in making a provision every year
when an asset is purchased?
2.3.3 Money Measurement Concept
All transactions of a business are recorded in terms of money. An event or a
transaction that cannot be expressed in money terms, cannot be accounted
in the books of accounts.

Example:
 The honesty of the employees, dynamism of the selling agents,
promptness and integrity of the cashier might influence the
business results, but cannot be accounted in the books of
accounts.
 It makes no sense if the assets are expressed as 10 tons of raw
materials, five vehicles, one premise and a few items of furniture,
unless all these assets are expressed separately in terms of
monetary value.
 Money is the common denominator in which the business
transactions should be expressed.

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Activity 1:
Warren Buffet, 79, CEO of Berkshire Hathaway and the world’s most
admired investor said at Columbia University’s business School
that the financial panic that gripped the globe in 2008 is a thing of
past. He said there are great opportunities to invest in U.S.
If your firm is an exporter to U.S. would you put Warren Buffet’s
statement under money measurement concept and take a decision?

Self Assessment Questions:

14. An event or a transaction expressed in monetary value is measured
but inflation or changes in the purchasing power are ignored in
money measurement concept. Say yes or no.
15. Transactions or events should be expressed in ___________.
16. Revenues are matched with expense in accordance with money
measurement principle. State true or false
2.3.4 Periodicity Concept
The time interval for which accounts are prepared is an important factor
even though we assume long life for a business.

Example: The time interval is usually one year and this period is called
accounting year.

The accounting period could be half year or even a quarter. The financial
statements should be prepared at the end of each accounting period so that
income statement shows profit or loss for that accounting period. So also a
balance sheet is prepared to depict the financial position of the business.
Self Assessment Questions:
17. The economic life of the entity is artificially split into periodic intervals
in accordance with periodicity concept. State true or false
18. The accounting data must disclose all relevant information in
accordance with periodicity concept. State true or false
19. The accountants are free to submit financial statement at arbitrary
points in time during the life of the entity. This is in accordance with
periodicity concept. State true or false.

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2.3.5 Accrual Concept

Profit earned or loss suffered for an accounting period is the result of both
cash and credit transactions. It is possible that certain incomes are earned
but not received and similarly certain expenses incurred but not yet paid
during an accounting period. But it is relevant to consider them while
computing the financial results just because they are related to the specific
accounting period.

Example: On 31st December 2006, Interest receivable on Fixed

deposit was Rs. 12000. The interest amount was credited to the bank
account in February 2007 (two months later). According to accrual
concept the income from interest is Rs.12000 though it is received after
31-12-2006.

Similarly the expenses that are incurred for the accounting period could be
paid after the accounting period. Such accrued expenses are deducted
while calculating the profit for the accounting period. This is the accrual
concept.
Self Assessment Questions:
20. Interest earned but not received within an accounting period is called
_______.
21. Following straight line method of depreciation of a particular asset
year after year adhere to consistency concept. State true or false.
22. Accrued income should be _________ to compute profit and prepaid
expenses should be _____ according to accrual concept of
accounting.
23. Accrual concept considers not only cash transactions but also
______ transactions.

2.4 Accounting Principles

Accounting Principles are the rules basing on which accounting takes place
and these rules are universally accepted.

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There are ten such basic principles, namely principle of income recognition,
principle of expense, principle of matching cost and revenue, historical cost
principle, principle of full disclosure, double aspect principle, modifying
principle, principle of materiality, principle of consistency and principle of
conservatism. A brief description is in the following paragraphs.
2.4.1 Principle of Income Recognition
According to this concept, revenue is considered as being earned on the
date on which it is realized, i.e., the date on which goods and services are
transferred to customers for cash or for promise. It should further be noted
that it is the amount which the customers are expected to pay which shall be
recorded. In effect, only revenue which is actually realized should be taken
to profit and loss account. Unrealized revenue should not be taken into
consideration for determining the profit. Example:

Example
 A sale is considered to be made when the property in goods
(ownership) is transferred from the seller to buyer.
 Similarly, when a businessman receives an order for the sale
of such products, yet to be manufactured, then revenue is said
to have been generated when the products are ready and
physically present in deliverable state and payment is received
or promised to be received but not when the order is received.

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Self Assessment Questions:

24. Income is considered as earned only when it is ____________.
25. Income is realized whether it is actually received in cash or promised
to be received. Is it True or False?
26. Income realized is different from cash received. Is it true or false?
27. A sale is made on credit. Does it constitute income realization?
28. An order is received for sale of goods. Is it realization of income?
29. An order is received with an advance of Rs.100000 cash. Can this
be called income?
2.4.2 Principle of Expense
Expenses are different from payments. A payment becomes expenditure or
an expense only when such payment is revenue in nature and made for
consideration.

Salaries Paid – Expenses

Furniture purchased – Capital Payment

Therefore all revenue expenses are transferred to profit and loss account to
ascertain profit or loss of the business undertaking. In other words, there
are revenue expenses and capital expenses. While revenue expenses are
charged against profit, capital expenses are shown in the balance sheet as
assets.
Self Assessment Questions:
30. A cash payment may be a revenue payment or capital payment. Is it
true or false?
31. A payment which is revenue in nature is expenditure. Is it true or
false?
32. Plant is purchased and payment is made. Is it an expenditure or
acquisition of asset?
33. All revenue expenses are charged against ___________.
34. Capital payments resulting in acquisition of assets appear in the
balance sheet. True or False?
2.4.3 Principle of Matching Cost and Revenue
Revenue earned during a period is compared with the expenditure incurred
to earn that income, whether the expenditure is paid during that period or
not. This is matching cost and revenue principle, which is important to find

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out the profit earned for that period. Here costs are reported as expenses in
the accounting period in which the revenue associated with those costs is
reported.

 Sales revenue in 2005 – Rs.50 lakhs

 Expenses incurred during the period - Rs.30 lakhs.
 It is assumed that some of these costs might be payable in 2006.
 Yet, they are considered for the period 2005, when the sales
revenue was earned.

While preparing the final accounts adjustments are made for outstanding
expenses, prepaid expenses, outstanding income and income received in
advance.
Self Assessment Questions:
35. Matching concept of accounting considers only revenue incomes
and expenses relating to a particular accounting period. True or
False?
36. Incomes and expenses for an accounting period are considered to
compute _____.
37. Expenditure paid or payable and revenue earned whether realised or
not in cash are taken into account to find out profit or loss. True or
False?
38. For the actual revenue received, outstanding incomes are ________
and income received in advance are_________________ to find out
the revenue income for the given period.
39. For the actual revenue expenses (costs) paid during the accounting
period, outstanding expenses are _____ and prepaid expenses are
_____ to find out expenses for the accounting period.
2.4.4 Principle of Historical Costs
This is called „cost‟ principle. All assets are recorded at the cost of
acquisition and this cost is the basis for all subsequent accounting for the
assets. The expenses and the goods purchased are shown at the value at
which they are incurred. The value of the assets is constantly reduced by
charging depreciation against their cost to present their book value in the
balance sheet.

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Example: Land bought for Rs.5,00,000 will be shown at purchase

price irrespective of the market value.

However, on account of inflationary situations, this cost concept does not

portray correct picture of the business and so inflation accounting has
emerged.
Self Assessment Questions:
40. All assets are shown at historical cost in balance sheet. True or
False?
41. Depreciation is charged against the historical cost of assets. True or
False?
42. Historical cost is the cost at which an asset is actually purchased.
True or False?
43. Machinery is bought for Rs.200000 and its market value is
Rs.80000. Which of these values do you consider to mention in the
balance sheet according to cost principle?
44. Inflation accounting has emerged as a result of limitation of historical
cost concept. True or False?
2.4.5 Principle of Full Disclosure
The business enterprise should disclose relevant information to all the
parties concerned with the organization. It means that any information of
substance or of interest to the average investors will have to be disclosed in
the financial statements.

Example: The practice of providing Appending Note to the

financial statements.

The Companies Act, 1956 requires that income statement and balance
sheet of a company must give a fair and true view of the state of affairs of
the company.
Self Assessment Questions:
45. The principle of full disclosure implies that information which is of
___________ should be stated in financial statements.
46. The material information that is disclosed should be of great interest
to the average investors. True or False?
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47. Non-disclosure of material information amounts to ___________.

48. Disclosing about assets without disclosing about liabilities is against
the principle of full disclosure. True or False?
2.4.6 Double Aspect Principle
This concept is the most fundamental one for accounting. A business entity
is an independent unit and it receives benefits from some and gives benefits
to some other. Benefit received and benefit given should always match and
balance.
BALANCE SHEET as on ……..

Liabilities Assets
Capital 20000 Stock 10000
Cash at Bank 8000
Cash in hand 2000
_______ _______
20000 20000

The total liabilities are equal to the total of assets. This is dual aspect of
accounting. The established principle of accounting is that for every debit
there is an equivalent credit and this is called double entry principle of
accounting.
Self Assessment Questions:
49. Under dual aspect principle, total benefits received by business
should match with total benefits given. True or False?
50. Total liabilities should be equal to ___________ as per dual aspect
principle.
51. For every debit, there should be an equivalent credit. This is called
_________ of accounting.
2.4.7 Modifying Principle
The modifying principle states that the cost of applying a principle should not
be more than the benefit derived from. If the cost is more than the benefit,
then that principle should be modified. This is called cost-benefit principle.
There should be flexibility in adopting a principle and the advantage out of
the principle should over weigh the cost of implementing the principle.

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Self Assessment Questions:

52. Modifying principle is also known as _____________.
53. The modifying principles states that benefit derived should over
weigh the cost of implementing it. State true or False?
54. A firm plans to establish costing department. By doing so it was
estimated that the cost of the product would increase by 50%. Is it
advisable to have cost-department?
2.4.8 Principle of Materiality
While important details of financial status must be informed to all relevant
parties, insignificant facts which do not influence any decisions of the
investors or any interested group, need not be communicated. Such less
significant facts are not regarded as material facts. What is material and
what is not material depends upon the nature of information and the party to
whom the information is provided. While income has to be shown for income
tax purposes, the amount can be rounded off to the nearest ten and fraction
does not matter. The statement of account sent to a debtor contains all the
details regarding invoices raised, amount outstanding during a particular
period. The information on debtors furnished to Registrar of Companies
need not be in detail.
Self Assessment Questions:
55. Principle of materiality states that relevant information should be
given to relevant parties. True or False?
56. Details of debtors should be given to creditors. True or False?
57. The material information to one party need not be so for another
party. True or False?
58. The method of depreciation adopted should be disclosed to Income
Tax Authorities. True or False?
2.4.9 Principle of Consistency
Consistency is required to help comparison of financial data from one period
to another. Once a method of accounting is adopted, it should not be
changed. For instance if stock is valued under FIFO method in first year it
should be valued under the same method in the subsequent years also.
Likewise if the firm chooses to depreciate assets under diminishing balance
method, it should continue to do so year after year, unless the management
takes a policy decision to change the depreciation method. Any change in

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the accounting methods should be informed to the concerned authorities

with justification.
Self Assessment Questions:
59. The purpose of principle of consistency is to help for ______ from
one period to another period.
60. Consistency principle helps for proper assessment of profit or loss.
True or False?
2.4.10 Principle of Conservatism or Prudence
Accountants follow the rule “anticipate no profits but provide for all
anticipated losses “. Whenever risk is anticipated sufficient provision should
be made. The value of investments is normally taken at cost, even if the
market value is higher than the cost. If the market value expected is lower
than the cost, then provision should be made by charging profit and creating
investment fluctuation fund. This is the principle of conservatism and it does
not mean that the income or the value of assets should be intentionally
under stated.
Self Assessment Questions:
61. Provision should be made whenever _____________ is anticipated.
62. The underlying spirit of principle of conservatism is __________ .
63. State the name of the relevant accounting principles for the following
statements.
a. Following FIFO method of stock valuation year after year
b. Appending notes to the financial statements.
c. Anticipate no profit but provide for all probable losses

2.5 Accounting Policies

It refers to specific accounting principles and methods of accounting
adopted by the enterprise while preparing and presenting the financial
statements. The management of each enterprise has to select appropriate
accounting policies based on the nature and circumstances of the business
they are in. Some of the areas in which different accounting policies may be
adopted are:
 Methods of depreciation, amortization,
 Treatment of expenditure during construction,
 Conversion or translation of foreign currency items,
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Financial and Management Accounting Unit 2

 Valuation of inventories,
 Treatment of goodwill,
 Valuation of investments,
 Treatment of retirement benefits,
 Recognition of profit on long-term contract,
 Valuation of fixed assets and
 Treatment of contingent liabilities.
The major considerations governing the selection and application of
accounting policies are:
a. Prudence: Uncertainties are a fact and it is inevitable. This should be
recognized by exercising prudence in preparing financial statements.
b. Substance Over form: Transactions and events should be accounted
for and presented in accordance with their substance and financial
reality and not merely with their legal form.
c. Materiality: Financial statement should disclose all material items which
might influence the decision of the users of the financial statement.
2.5.1 Change in Accounting Policies:
The change in accounting policy is recommended only in the following
circumstances:
a. If it is required by statute for compliance with an accounting standard
b. If is considered that the change would result in a more appropriate
presentation of the financial statements of an enterprise.
2.5.2 Disclosure in case of change in Accounting Policy:
 If change has a material effect in current period and the effect of change
is ascertainable the amount of change should be disclosed.
 If the change has a material effect in current period and the effect of
change is not ascertainable wholly or in part, the fact should be
disclosed.
 If change has no material effect in current period but which is reasonably
accepted to have a material effect in later periods, the fact of such
change should be appropriately disclosed.

2.6 Accounting Standards

It is a selected set of accounting policies or broad guidelines regarding the
principles and methods to be chosen out of several alternatives. Standards
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adhere to certain laws, customs, usage and business environment in which

it operates.
The basic purpose of accounting standards is to harmonize the diverse
accounting policies and practices that are currently used in India. The
adoption of accounting standards ensures uniformity, comparability and
qualitative improvement in the preparation and presentation of financial
statement. Accounting standards facilitates more disclosure of financial
information that is beyond the statutory limits.
2.6.1 Scope and functions of Accounting Standard Board
The Accounting standards board (ASB) was constituted by The Institute of
chartered Accountants of India on 21st April, 1977. The aim of the board was
to bring in uniformity among various accounting policies and practices that
were practiced in India.
To determine the broad areas in which accounting standards need to be
formulated and hold a dialogue with various representatives of the
government, industry and other organization to ascertain their views. On the
basis of the discussions they hold, the board prepares and issues a draft
proposal for comments by the members of the Institute and the public.
After modification (if any) in the draft proposal a final draft is submitted to the
council of the institute. The accounting standard will then be issued under
the authority of the Council. At present there are 30 accounting standards
issued by the Council.
2.6.2 International Financial Reporting System:
IFRS are standards, interpretations and framework for the preparation and
presentation of financial statements. IFRS was framed by International
Accounting Standards Board (IASB).
The objective of financial statement is to provide information about the
financial position, performance and changes in the financial position of an
entity. It should also provide the current financial status of the entity to all
the users of financial information. IFRS follows accrual basis of accounting
and the financial statements are prepared on the basis that an entity will
continue for the foreseeable future. IFRS helps entities access global capital
market with ease.

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Under IFRS, we need to submit a statement of financial position (Balance

Sheet), Comprehensive income statement (Profit & Loss/ Income and
Expenditure account), either a statement of changes in equity or statement
of recognized income or expenses, cash flow statement and notes including
summary of significant accounting policies.

2.7 Summary
Accounting Principles are basically the rules of action adopted by the
accountants universally while recording accounting transactions.

Accounting conventions are those customs and traditions which guide the
accountants while preparing the financial statements.

Accounting concepts are the basic assumptions or conditions upon which

the science of accounting is based. There are five basic concepts of
accounting, namely – business entity concept (separate entity concept),
going concern concept, money measurement concept, periodicity concept
and accrual concept.

Accounting policy refers to the specific accounting principles and methods of

applying those principles adopted by the enterprise in the preparation and
presentation of financial statements.

Different types of Accounting Principles are Principles of Income

recognition, Principles of expense, Principles of matching cost and revenue,
Principles of Historical cost, Principle of full disclosure, Principles of double
aspects, Modifying Principles, Principles of Materiality, Principles of
consistency, and Principles of conservatism or prudence.

An Accounting Standard is a selected set of accounting policies or broad

guidelines regarding the principles and methods to be chosen out of several
alternatives. There are altogether 28 accounting standards issued by ASB
which have to be adopted by management of different enterprises to
improve the quality of presentation of financial statements in our country.

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2.8 Terminal Questions

1. What are the basic principles of Accountancy?
2. The salaries paid in 2004 Rs.500000; Salaries outstanding Rs.20000;
Salaries paid in advance for 2004 Rs.30000; What is the actual salary
expenditure for 2004? What is the accounting principle involved in this?
3. What is wrong if assets like buildings are shown at market value in the
balance sheet?
4. A business receives capital of Rs.100000 and a loan is raised for
Rs.50000. This is represented by cash Rs.15000; Machinery Rs.85000;
Furniture Rs.20000 and goods Rs30000. Find the total of debits and
credits from business point of view. What principle of accounting is
underlying in this case?
5. What is substance over form?

2.9 Answer for Self Assessment Questions

SAQ 1: 20. Accrued 45. Substance

1. Doctrines interest 46. True
2. Concepts, 21. True 47. Fraud
conventions 22. Added, 48. True
3. Convention deducted 49. True
4. Concept 23. Credit 50. Total Assets
5. Bring uniformity in 24. Realized 51. Double entry
accounting 25. True principle
terminology and 26. True 52. Cost-benefit
principles 27. Yes principle
6. 32 28. No 53. True
7. a. True, b. False 29. No 54. No
8. separate 30. True 55. True
9. capital 31. True 56. False
10. False 32. Asset 57. True
11. True Acquisition 58. True
12. False 33. Profit 59. Comparison
13. To replace it after 34. True 60. True
a certain period. 35. True 61. Risk

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14. Yes 36. Profit or loss 62. Anticipate no profit

15. Monetary value 37. True but provide for all
16. False 38. Added, anticipated losses
17. True Deducted 63. a. Principles of
18. False 39. Added, consistency
19. False Deducted b. Principles of
40. True full disclosure
41. True c. Principles of
42. True conservatism
43. Rs.200000
44. True
Answers for Terminal Question:
1. Income recognition, principle of expense, matching of cost and revenue,
historical cost principle, full disclosure principle, double aspect principle,
modifying principle, materiality principle, consistency principle and
conservatism principle.
2. Rs.490000 (500000 + 20000 – 30000); Matching cost and revenue
principle.
3. If assets like building are shown at market value instead of historical
cost in the balance sheet, the profit or loss arising out of such valuation
is against to the principle of income recognition. The profit or loss is said
to arise only when the asset is sold or revalued for a specific purpose.
The day when the assets are valued, the market value may be high and
later the prices may fall. Therefore it is wrong to consider the unrealized
or anticipated profit. Hence the assets should be shown at historical cost
in the balance sheet.
4.
Liabilities Assets
Capital 100000 Cash 15000
Loan 50000 Machinery 85000
Furniture 20000
Goods 30000
Total 150000 Total 150000
It is as per double aspect principle.

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5. Refer unit 2.5

ANNEXURE-1

US GAAP INDIAN GAAP

It is established under FASB and It is established under ICAI
AICPA
Balance Sheet, Income Statement Balance Sheet and income statement
& Funds Flow Statement are are alone mandatory
mandatory
Any change in foreign exchange Any difference in foreign exchange
fluctuations cannot be capitalized can be capitalized.
but the difference can be shown or
debited to Income statement
Financial accounting, Management Only financial accounting and Income
accounting and income tax tax accounting are prepared.
accounting are prepared separately
The basic tenets is globalization of The basic tenet is localization
business
Any long term loan repayable is the Long term loans maturing in the
current financial year is shown current financial year need not be
separately disclosed separately
In lease contract, lessee is more In lease contract, lessor is eligible for
beneficiary because he can claim depreciation allowance and not the
depreciation allowance lessee.
It is more transparent and accepted It is comparatively less transparent.
worldwide. More disclosure is For listing the securities in other
required country‟s stock exchange USGAAP is
mandatory

ANNEXURE 2
ACCOUNTING STANDARDS
AS No Title Recommendary Mandatory from
or Mandatory accounting period
beginning on or
after
AS-1 Disclosure of Accounting Mandatory 1.4.1991
Policies
AS-2 Valuation of Inventories Mandatory 1.4.1999
AS-3 Cash Flow Statement Mandatory 1.4.2000

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AS-4 Contingencies and events Mandatory 1.4.1995

occurring after the Balance
Sheet date (revised)
AS-5 Prior Period and Mandatory 1.1.1987
extraordinary items and
changes in Accounting
Policies
AS-6 Depreciation Accounting Mandatory 1.4.1995
(revised)
AS-7 Accounting for construction Mandatory 1.4.1991
contracts
AS-8 Accounting for Research Mandatory 1.4.1991
and Development
AS-9 Revenue Recognition Mandatory 1.4.1991
AS-10 Accounting for Fixed Assets Mandatory 1.4.1991
AS-11 Accounting for the effects of Mandatory 1.4.1995
changes in foreign
exchange rates (Revised)
AS-12 Accounting for Government Mandatory 1.4.1994
Grants
AS-13 Accounting for Investment -------- -------
AS-14 Accounting for Mandatory 1.4.1995
Amalgamation
AS-15 Accounting for retirement Mandatory 1.4.1995
benefits in the financial
statement of employers
AS-16 Borrowing Costs Mandatory 1.4.2000
AS-17 Segment Reporting Mandatory 1.4.2001
AS-18 Related party disclosure Mandatory 1.4.2001
AS-19 Leases Mandatory 1.4.2001
AS-20 Earnings Per Share Mandatory 1.4.2001
AS-21 Consolidated financial Mandatory 1.4.2001
statement
AS-22 Accounting for taxes on Mandatory 1.4.2001
income
AS-23 Accounting for investments Mandatory 1.4.2002
in associates in
consolidated financial
statements

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AS-24 Discontinuing operations Mandatory 1.4.2002

AS-25 Interim financial reporting Mandatory 1.4.2002
AS-26 Intangible assets Mandatory 1.4.2003
AS-27 Financial reporting of Mandatory 1.4.2002
interests in joint venture
AS-28 Impairment of assets Mandatory 1.4.2004
AS-29 Provisions, Contingent Mandatory 1.4.2004
Liabilities & Contingent
Assets
AS-30 Financial Instruments: Mandatory from 1.4.2009
Recognition, Measurement 1.4.2011
and Limited Resources
AS-31 Financial Instruments: Mandatory from 1.4.2009
Presentation 1.4.2011
AS-32 Financial Instruments: Mandatory from 1.4.2009
Disclosure and limited 1.4.2011
revision to AS 19 (leases)

 AS 8 was withdrawn in pursuant to AS 26 becoming mandatory.

 29 accounting standards are issued as of date and only 28 is applicable.
 AS 30, 31, 32 are published but they will come into effect from 1.4.2009.
It is mandatory on or after 1.4.2011

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Financial and Management Accounting Unit 3

Unit 3 Double Entry Accounting

Structure:
3.1 Introduction
Objectives
3.2 Meaning of double entry accounting
3.3 Classification of accounts under Traditional approach
3.4 Classification of accounts under Accounting Equation approach
3.5 Comparison of traditional approach with Modern approach equal
approach
3.6 Accounting Trail
3.7 Transactions and events
3.8 Meaning and roles of debit and credit
3.9 Accounting equation
3.10 Summary
3.11 Terminal Questions
3.12 Answers

3.1 Introduction
In the previous unit we had dealt with different types of accounting
principles, concepts, policies and accounting standards. Accounting
Principles are basically the rules of action adopted by the accountants
universally while recording accounting transactions. Accounting concepts
are assumptions which guide the accountant in preparation of financial
statements while accounting conventions are customs and traditions
followed in preparation of the financial statements. Accounting policies are
those concepts and conventions adopted by the management based to the
situations but more importantly, consistency is needed while adopting them.
Accounting standards is a select set of accounting policies, methods chosen
by the firm.
In this unit, we have dealt the meaning of double entry accounting, the
classification of accounts under traditional approach and accounting
equation approach. This classification is needed because business entity
may not be confined to the geographical boundaries of the nation.
Accounting trial is a sequential order in which the accounting process flows.

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The eight process involved in accounting trail is discussed briefly in this unit.
Finally a brief explanation of the rules of debit and credit on various types of
accounts is dealt.
Finally a brief explanation of the rules of debit and credit on various types of
accounts is dealt.
Objectives:
After going through this unit, you should be able to:
1. Define Double entry book keeping.
2. Classify different types of accounts under traditional approach
3. Classify different types of accounts under Accounting equation approach
4. Compare traditional approach with modern approach
5. State the process involved in accounting trail.
6. State the meaning of transactions and events
7. Explain the rules of debit and credit
The students should be able to appreciate the double entry system and
know the accounting process.

3.2 Meaning of Double Entry Accounting

We have learnt that the dual aspect recording is the most important
accounting concept. According to the concept, every business transaction
involves receiving aspect and giving aspect. A transaction is a business
activity involving transfer of money or money’s worth.
Double Entry Book-Keeping System:
Every account has two sides:
1) One account is the receiver of the benefit
2) Other account is the giver of the benefit.
It must be noted that the amount of benefit received by one account is equal
to the amount of benefit given by the other account. This enables us to
record the two effects of any busines transaction. If capital is brought in by
the owner of the business unit, the owner is the giver of the benefit and the
business unit is the receiver of the benefit. It is a liability to the business unit
and it is equally balanced by an asset in the business unit, in the form of
cash received towards capital. Therefore every liability is represented by
an asset. This is also expressed as every debit has an equivalent credit.

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Illustration1: We shall consider five transactions and show how they are
accounted for in the books of the business.
1. Mr. Abhi brings Rs.100000 cash as capital into his business.
2. He purchases furniture to his shop Rs.10000
3. He buys goods for cash Rs.50000
4. He sells goods worth Rs.30000 for Rs.40000 on credit to Arjun
5. He pays wages to servants Rs.1000
Transaction 1: The business receives capital in cash. Capital is a liability
and cash is an asset to the business.

Liability Asset
Capital 100000 Cash 100000
Transaction 2: Furniture is purchased for cash. This transaction can be
reflected as under

Capital 100000 Cash Rs. (100000- 10000) 90000

Furniture 10000
Total 100000 Total 100000
Transaction 3: Purchased of goods for cash. This can be reflected in the
statement as under.

Capital 100000 Cash Rs (90000 – 50000) 40000

Furniture 10000
Stock of goods 50000
Total 100000 Total 100000
Transaction 4: Sold goods to Arjun on credit for Rs.40000, the cost of
which is only Rs. 30000. In this transaction the affected accounts are Goods
account, Arjun account and Profit & Loss account. Since the profit belongs
to the owner it is fair to add it to the owner’s capital. The effect of this
transaction can appear on the statement as shown below:

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Capital 100000 Cash 40000

Profit 10000 Furniture 10000
Stock of goods
(50000-30000) 20000
Arjun (Debtors) 40000
110000 110000
Transaction 5: Payment of wages Rs.1000.The cash balance gets reduced
in the asset side and profit gets reduced as a result of the expenditure
(wages account) on the liability side. This changes the statement as shown
below:

Capital 100000 Cash (40000 – 1000) 39000

Profit (10000-1000) 9000 Furniture 10000
Stock of goods 20000
Arjun (debtors) 40000
109000 109000
From the above illustrations, it is clear that every transaction has dual effect.
Recording these aspects is the fundamental idea behind double entry
system of book keeping.
Self Assessment Questions 1:

1. The system of recording transactions based on dual aspect concept is

called
a) Double account system
b) Double entry system
c) Single entry system
2. Show the dual aspect effect of the following transactions on the assets
and liabilities of business.
a. Purchased goods for cash Rs.80000
b. Purchased delivery van on credit for Rs.400000
c. Paid Rs.5000 to a supplier of goods on credit
d. The proprietor withdrew Rs.20000 from the bank account of
business for Personal expenses.

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3.3 Classification of accounts under Traditional Approach

The identification of the accounts affected in the transactions is a major
task. There are three types of accounts, namely personal accounts, real
accounts and nominal accounts.

Personal Account Deals with accounts of individuals like creditors,

debtors, bank account, outstanding/prepaid
accounts
Real Account It represents various asset accounts both tangible
and intangible.
Nominal Account It consists of various types of expenses or incomes
or loss or profit.
Personal Account:

ARTIFICIAL PERSONAL REPRESENTATIVE PERSONAL

ACCOUNT PERSONAL ACCOUNT ACCOUNT
Canara Bank account Outstanding rent Abhi account
ICICI Bank account account Outstanding Mohan’s account
Bank of India account salaries a/c Prepaid rent Sonali account
account

Real Accounts:
Real accounts are those which may be tangible real accounts and intangible
real accounts. Tangible real accounts relate to things that can be touched,
felt, physically measurable. Building account, furniture account, stock
account, cash account etc are tangible real accounts. Intangible real
accounts are such that they cannot be seen or touched. They can be
measured in terms of money such as goodwill, patent rights etc.
Nominal Accounts:
Nominal accounts are also known as impersonal accounts. They are in the
form of expenses or losses, incomes or gains. They do not really exist in
physical form, but behind every nominal account cash is involved. For
example, salary account is a nominal account and when salary is paid cash
goes out and there is nothing in physical form. Therefore salary account is
regarded as nominal account. Similarly all expenses and losses and all
incomes and gains accounts are regarded as nominal accounts.

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3.4 Classification of accounts according to Accounting Equation

Approach:
The preparation of financial statements is the objective of accounting.
Accounting as an information processing system, should facilitate in the
preparation of income statement and balance sheet. This in turn, would
require that the terms in the accounting equation should be the summary of
all the accounting records from an accounting system.
Accounting equation approach classifies different types of accounts into
assets account, liabilities account, capital account, revenue account and
expenses account.

Types of Meaning Examples

Accounts
Asset account Deals with tangible Land a/c, Building a/c,
and intangible real Plant & Machinery a/c,
assets. Cash a/c, Good will a/c,
Trademark a/c, Patents
a/c, Investments a/c
Liabilities account Deals with the Long term loans,
financial obligations Debentures, Bank loans,
of the firm on Trade creditors,
outsiders. Outstanding expenses.
Capital account Deals with accounts Capital a/c, Drawings a/c
of the owners of the
company
Revenue account Deals with amount Sales a/c, Royalty received
charged for goods a/c, interest received a/c,
sold or service dividend received a/c
rendered, and other
incomes.
Expenses account Deals with expenses Purchases a/c, Discount
incurred in the allowed a/c, Interest paid
process of earning a/c, Loss by fire a/c.
revenue

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3.5 Comparison of traditional approach with Modern approach or

Accounting Equation approach:

Traditional approach Modern approach

Personal account:
 (other than those relating to  Asset a/c
owner) having debit balance
 (other than those relating to  Liabilities a/c
owners) having credit balance
 Those relating to owners  Capital a/c
Real account  Asset a/c
Nominal account:
 Relating to expenses  Expenses a/c
 Relating to revenue  Revenue a/c
Illustration 2:
Classify the following accounts according to Traditional and Modern
approach
1. Capital a/c 2. Drawings a/c 3. Building purchased
4. Purchases 5. Sales account 6. Carriage inward
account
7. Carriage outward 8. Cash received 9. Cash paid
10. Interest paid 11. Interest received 12. Commission paid
13. Comm received 14. Discount allowed 15. Conveyance
charges
16. Sales promotion 17. Entertainment 18. Subscription paid.
exp expenses
19. Subscription 20. Light,Power & 21. Telephone,
received Electricity postage and
telegram
22. Repairs incurred 23. Insurance 24. Bad debts written
premium paid off
25. Bad debts 26. Discount 27. Postage &
recovered received stationery
purchased

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28. F&F purchased 29. Bank a/c 30. Wages & Salaries
paid
31. Travelling 32. current a/c of the 33. Loan a/c of a partner
expenses partner
34. Sales return 35. Bank overdraft 36. Loan a/c of the
a/c partner
37. O/s salaries a/c 38. Prepaid rent a/c 39. Interest accrued a/c
40. Interest received
in advance
Solution:
According to Traditional Approach:
Personal a/c 1, 2, 29, 32, 33, 35, 37, 38, 39, 40
Real a/c 3, 8, 9, 28
Nominal a/c 4, 5, 6, 7, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20,
21, 22, 23, 24, 25, 26, 27, 30, 31, 34, 36
According to Accounting Equation or Modern Approach:
Asset a/c 3, 8, 9, 28, 29, 38, 39
Liabilities a/c 33, 35, 37, 40
Capital a/c 1, 2, 32
Revenue a/c 5, 11, 13, 19, 25, 26, 34
Expenses a/c 4, 6, 7, 10, 12, 14, 15, 16, 17, 18, 20, 21, 22, 23,
24, 27, 30, 31, 36
Self Assessment Questions:
3. State yes or no
a) State Bank of India is a Nominal Account.
b) Machinery is a Real Account.
c) Life Insurance Corporation is a Personal Account.
d) Proprietor’s Capital Account is a Personal Account.
e) Loan Account is a Real Account.
f) Postage and Telegram Account is a Nominal Account.
g) Interest on investment Account is a Nominal Account.
h) Carriage on Goods Account is a Real Account
i) The giver of a benefit must be debited.
j) Nominal Accounts fall in the category of impersonal accounts.
k) Every debit has an equal and corresponding credit.
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l) Loss by fire is a Nominal Account.

m) Outstanding Wages Account is a Nominal Account.
n) Brokerage Account is a Real Account.
o) Investment Account is a Personal Account.

3.6 Accounting Trail

Accounting Trial is a sequential order in which the accounting process flows.
All transactions are recorded first in a book called journal. The transactions
are posted to the respective accounts, maintained in a separate book called
ledger. Later, all adjustments such as opening entries, closing entries,
adjusting entries are made in a book called journal proper and thereafter,
the ledger balances are summarized to form a trial balance. From trial
balance, trading account, profit and loss account and balance sheet are
prepared.
Accounting trail is the process of:

Identifying the transactions or events

Preparation of vouchers

Recording them as journal entries

Preparation of ledger accounts

Balancing the ledger accounts

Incorporating all adjustments

Preparation of a Trail Balance

Preparing the financial statements

and balance sheet

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Self Assessment Questions:

4. Accounting trial is a process starting from identifying the transactions or
events to preparation of final statement of accounts. True or False
5. There are three types of accounts namely ____________ and
________________.
6. A trial balance is the summarized form of ledger balances. True or False

3.7 Transactions and Events

A transaction is a business activity involving transfer of money or money’s
worth. It may be cash transaction or credit transaction. In cash transaction
cash flows immediately where as in credit transaction cash will be paid or
received at future date. Assets acquired or sold, liabilities incurred or paid,
expenses paid or payable, incomes received or receivable – are all business
transactions. But there are events which are neither cash nor credit
transactions but it has an impact on the financial position of a business.
These events may include provision for bad debts, provision for repairs,
depreciation, taxation, transfer of profit towards reserve fund or sinking fund
or investment fluctuation fund, etc., Events happen as a result of internal
policies or external needs. In accounting, transactions and events have
equal relevance and they must be recorded to arrive at the financial results
of the business concern.
Self Assessment Questions:
7. A transaction is a business activity which involves transfer of money or
money’s worth. True or False
8. An event happens as a result of internal policy of an organization. True
or False
9. Business transactions and events have equal importance in finding the
financial results of the business concern. True or False?
10. Identify the following as transactions or events as the case may be.
i) Depreciation of assets :___________
ii) Tax rates announcement :___________
iii) Acquisition of assets :___________
iv) Selling an asset :____________
v) Transfer of profits to Reserve Fund:______________

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3.8 Meaning and rules of debit and credit

Debit and credit are the two words basic for accounting. Debit represents
receiving aspect and credit represents giving aspect.
The rules of debit and credit when accounts are classified on
traditional approach:
Type of accounts DEBIT CREDIT
Personal account The receiver the giver
Real account What comes in what goes out
Nominal account Expenses & losses Income and
gains
The rules of debit and credit when accounts are classified on
Accounting Equation Basis:
Types of accounts Rules for Debit Rules for credit
Asset account Debit the increase Credit the decrease
Liabilities account Debit the decrease Credit the increase
Capital account Debit the decrease Credit the increase
Revenue account Debit the decrease Credit the increase
Expenses account Debit the increase Credit the decrease
Illustration 3: Analyze the following transactions according to Traditional
approach and modern approach:
a. Subramanya started his business with cash
b. Borrowed from Mahesh
c. Purchased furniture
d. Purchased furniture from Mohan on credit
e. Purchased goods for cash
f. Purchased goods from Ram on credit
g. Sold goods for cash
h. Sold goods to Shyam on credit
i. Received cash from Shyam
j. Paid cash to Ram
k. Deposited into bank
l. Withdrew cash for personal use
m. Withdrew from bank for office use
n. Withdrew from bank for personal use
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Financial and Management Accounting Unit 3

o. Received a cheque from a customer, shyam at 5 pm

p. Deposited Shyam’s cheque next day
q. Bank intimated that shyam’s cheque was dishonored
r. Paid Ram by cheque
s. Paid salary
t. Paid rent by cheque
u. Goods withdrawn for personal use
v. Paid an advance to suppliers of goods
w. Received an advance from customers
x. Paid interest on loan
y. Paid installment of loan
z. Interest allowed by bank
Solution:
Analysis of Transaction under Traditional Approach
Sl. Accounts Nature of How affected Debit/
no involved account Credit
a Cash a/c Real Cash is coming in Debit
Capital a/c Personal Subramanya is the Credit
giver
b Cash a/c Real Cash is coming in Debit
Loan from Personal Mahesh is the giver Credit
Mahesh
c Furniture a/c Real Furniture is coming in Debit
Cash a/c Real Cash is going out Credit
d Furniture a/c Real Furniture is coming in Debit
Mohan a/c Personal Mohan is the giver Credit
e Purchase a/c Nominal Purchase is an Debit
Cash a/c Real expense Credit
Cash is going out
f Purchase a/c Nominal Purchase is an Debit
Ram’s a/c Personal expense Credit
Ram is the giver
g Cash a/c Real Cash is coming in Debit
Sales a/c Nominal Sales is revenue Credit
h Shyam’s a/c Personal Shyam is the receiver Debit
Sales a/c Nominal Sales is revenue Credit
i Cash a/c Real Cash is coming in Debit
Shyam’s a/c Personal Shyam is the giver Credit

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Financial and Management Accounting Unit 3

j Ram’s a/c Personal Ram is the receiver Debit

Cash a/c Real Cash is going out Credit
k Bank a/c Personal Bank is the receiver Debit
Cash a/c Real Cash is going out Credit
l Drawing’s a/c Personal Subramanya is the Debit
Cash a/c Real receiver Credit
Cash is going out
m Cash a/c Real Cash is coming in Debit
Bank a/c Personal Bank is the giver Credit
n Drawing’s a/c Personal Subramanya is the Debit
Bank a/c Personal receiver Credit
Bank is the giver
o Cash a/c Real Cash (cheque) is Debit
Shyam a/c Personal coming in Credit
Shyam is the giver
p Bank a/c Personal Bank is the receiver Debit
Cash a/c Real Cash (cheque) is going Credit
out
q Shyam a/c Personal Shyam is the receiver Debit
Bank a/c Personal Bank is the giver Credit
r Ram’s a/c Personal Ram is the receiver Debit
Bank a/c Personal Bank is the giver Credit
s Salary a/c Nominal Salary is an expense Debit
Cash a/c Real Cash is going out Credit
t Rent a/c Nominal Rent is an expense Debit
Bank a/c Personal Bank is the giver Credit
u Drawings a/c Personal Subramanya is the Debit
receiver
Purchase a/c Nominal Decrease is stock Credit
v Advanced to Personal Suppliers are the Debit
Suppliers a/c receivers
Cash a/c Real Cash is going out Credit
w Cash a/c Real Cash is coming in Debit
Advance from Personal Customers are givers Credit
customers a/c
x Interest on Nominal Interest is expense Debit
loans a/c Real Cash is going out Credit
Cash a/c

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Financial and Management Accounting Unit 3

y Loan a/c Personal Lender is the receiver Debit

Cash a/c Real Cash is going out Credit
z Bank a/c Personal Bank is the receiver Debit
Bank interest Nominal Bank interest is an Credit
a/c income

Activity 1:
Using the above example analyze the accounting treatment under
modern approach.

3.9 Accounting equation

The preparation of balance sheet is the final step in accounting process.
The accounting equation indicates that the sources of funds should be equal
to uses of funds. In other words, proprietor’s equity and liabilities to
outsiders should be equal to assets.

Sources of Fund = Application of funds OR

Owner’s equity = Assets OR
Owner’s equity + outside liabilities = Assets

L+ P = A
L=A–P
P =A–L
A – L – P = Zero

Where L is liabilities, P is Proprietor’ equity and A is assets.

Steps involved in developing accounting equation:
 Ascertain the variables (Assets, Liabilities or capital) of an equation
affected by the transaction.
 Find out the effect (in terms of increase or decrease) of a transaction on
the variables of the equation
 Show the effect on the appropriate side of an equation.

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Financial and Management Accounting Unit 3

Illustration 3:
Transaction 1: Started business with Rs.1, 00,000.
Variables affected Asset and capital
Effect of the Increase in asset and capital
transaction
Accounting Equation Asset = Liabilities + Capital
1,00,000 = 0 + 1,00,000
Transaction 2: Purchased Goods for cash Rs.20,000
Variables affected Asset
Effect of the transaction Increase in asset (Stock) and decrease
in another asset (cash)
Accounting Equation Asset = Liabilities + Capital
-20,000 +20,000 = 0 + 0
Transaction 3: Sold goods costing Rs.10,000 for cash Rs.12,000.
Variables affected Asset and capital
Effect of the transaction Increase in asset (Cash) and decrease in
another asset (Stock) and increase in
capital
Accounting Equation Asset = Liabilities + Capital
- Stock + Cash
-10,000 +12,000 = 0 + 2,000

Self Assessment Questions:

11. Liabilities plus Equity is equal to ____________________________.
12. Assets minus liabilities to outsiders’ are equal to
__________________.
13. If assets are Rs.5 lakhs, liabilities are Rs.3 lakhs, find out the equity.
14. If Owner’s equity is Rs.3 lakhs, Outsider liabilities are Rs.2 lakhs,
Owner’s share of profit is Rs.1 lakhs, find out the total value of assets.
15. Every transaction influences balance sheet and it is shown by
accounting equation True or False?

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Financial and Management Accounting Unit 3

Illustration 4: Show what accounts are affected in the following

transactions. Also show the accounting equation for the transactions
1. Madan commenced business with cash Rs. 70000
2. Purchased goods on credit 14000
3. Withdrew for private use 3000
4. Goods purchased for cash 12000
5. Paid wages 5000
6. Paid to creditors 10000
7. Sold goods on credit (cost price Rs18000) 22000
8. Sold goods for cash (Cost price Rs.3000) 6000
9. Purchased furniture for cash 5000
10. Received from debtors 11000
Solution:
Transaction Accounts affected Account to be debited and account
No in the books of to be credited
the business
01 Capital account Cash account being real account is
and cash account debited and Capital account being
personal account is credited
02 Goods account and Goods account being real account is
creditors account debited and creditor’s account being
personal account is credited
03 Personal drawings Drawings account being personal
account and cash account is debited and cash account
account being real account is credited
04 Goods account and Goods account being real account is
cash account debited and cash account being real
account is credited
05 Wages account Wages account being nominal account
and cash account is debited and cash account being real
account is credited
06 Cash account and Creditor’s account being personal
creditors account account is debited and cash account
being real account is credited
07 Goods account, Debtor’s account being personal
Debtor’s account account is debited, profit transferred to
and profit account capital account being personal account

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Financial and Management Accounting Unit 3

is credited and goods account being

real account is also credited
09 Furniture account Furniture account being real account is
and Cash account debited and cash account being real
account is credited
10 Cash account and Cash account being real account is
debtor’s account debited and debtor’s account being
personal account is credited.

Accounting equations for the transactions

Transa- Assets = Liabilities + Owners
ction Equity
Cash Goods Debtors Furnitur Creditor Madan’s
(+) (+) (+) e s Capital
(+) = (+)
01 70000 70000
02 14000 14000
03 - 3000 -3000
04 - 12000 +12000
05 - 5000 -5000
06 -10000 -10000
07 -18000 22000 +4000
08 +6000 - 3000 +3000
09 -5000 5000
10 +11000 - 11000
End 52000 5000 11000 5000 4000 69000
equation + + + + +
= 73000 = 73000

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Activity 2:
Show the Accounting Equation for the following transaction:
a) Shri Ram commenced business with Rs.50,000
b) Paid rent in advance Rs.2000
c) Purchased a typewriter for Rs.7000
d) Bought furniture from M/s Mohan Lal on credit for Rs.3000
e) Purchased goods from Sohan for cash Rs.35,000
f) Sold goods to Shyam for cash Rs.40,000 (costing Rs.30,000)
g) Bought goods from Ramesh for Rs.30,000
h) Sold goods to Shyam costing Rs.30,000 for Rs.50,000
i) Purchased household goods for Rs.15,000 giving Rs.5,000 in cash and
the balance through a loan.
j) Goods destroyed by fire (cost Rs.500, Sale Price Rs.600)
k) Paid half the amount owed to Mohan Lal.
l) Paid cash Rs.500 for loan and Rs.300 for interest.
m) Withdrew goods for personal use (cost Rs.500, sale price Rs.600)
n) Received Rs.49,500 from Shyam in full settlement
o) Paid Rs.29,700 to Ramesh in full settlement
p) Paid salary Rs.500 and salary outstanding Rs.100
q) Charged depreciation of Rs.300 on furniture and Rs.100 on typewriter.

3.10 Summary
Double entry system has two effects: 1) One account is the receiver of the
benefit, 2) Other account is the giver of the benefit. Every transaction has
dual effect and recording these two aspects which are known as debit and
credit aspects is the fundamental idea behind double entry system of book
keeping.
Under traditional approach accounts are classified into personal account,
real account and nominal account. Under accounting equation or modern
approach, the accounts are classified into asset a/c, liability a/c, capital a/c,
revenue a/c and expenses a/c.
A transaction is a business activity involving transfer of money or money’s
worth. It may be cash transaction or credit transaction. Events are neither
cash nor credit transactions but it has an impact on the financial position of
a business. Events happen as a result of internal policies or external needs.
Accounting Trial is a sequential order in which the accounting process flows.

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Financial and Management Accounting Unit 3

The accounting equation indicates that the sources of funds should be equal
to uses of funds. In other words, proprietor’s equity and liabilities to
outsiders should be equal to assets.

3.11 Terminal Questions

1. The accounting equation is Assets = _______________ +
_______________.
2. State the meaning of double entry book keeping.
3. What is accounting trail?
4. Find the value of the following:
a. If the total assets are Rs87000 and the liabilities are Rs47000, find
out the amount of capital.
b. If the capital of proprietor is Rs400000 and the total assets are
Rs600000, what is the amount of liabilities to outsiders?
c. If creditors are Rs56000, bank overdraft is Rs100000 and
outstanding expenses are Rs.8000, what is the total amount of
assets?
d. Fixed assets are Rs.70000 and current assets are Rs.100000 and
the creditors are Rs.30000. What is capital?

3.12 Answer for Self Assessment Questions

SAQ 3. Yes : (b, c, d, f, g, j, k, l,)

1. (b) No : (a, e, h, i, m, n, o)
2. a. Stock of goods increases 4. True
and cash balance is 5. Personal, real and nominal
reduced
6. True
b. Delivery Van is an asset
and the supplier of the 7. True
delivery van becomes a 8. True
creditor and it appears as 9. True
liability
10. i) Event ii) Event
c. Creditor’s balance is iii) Transaction iv) Transaction
reduced on liabilities side v) Event
and cash paid brings down
the cash balance on the 11. Assets
asset side 12. Equity
d. The bank balance comes 13. Rs.2 lakh

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Financial and Management Accounting Unit 3

down on asset side and 14. Assets are Rs.6 lakh

capital account is reduced
15. True
by the amount of drawings
on the liabilities side.

Answers for Terminal Questions:

1. Liabilities + Owner’s capital
2. Every transaction has two aspects, debit and credit and for every
debit there is equivalent credit.
3. Refer Unit 3.6
4. a) Rs.40000 b) Rs.200000 c) Rs.164000 d) Rs.140000
Answer to Activity 1:
Analysis of the transaction using Modern approach
Accounts Nature of How affected Debit/ credit
involved account
A Cash a/c Asset Increased Debit
Capital a/c Capital Increased Credit
B Cash a/c Asset Increased Debit
Loan from Liability Increased Credit
Mahesh a/c
C Furniture a/c Asset Increased Debit
Cash a/c Asset Decreased Credit
D Furniture a/c Asset Increased Debit
Mohan a/c Liability Increased Credit
E Purchase a/c Expenses Increased Debit
Cash a/c Asset Decreased Credit
F Purchase a/c Expenses Increased Debit
Ram’s a/c Liability Increased Credit
G Cash a/c Asset Increased Debit
Sale a/c Revenue Increased Credit
H Shyam’s a/c Asset Increased Debit
Sales a/c Revenue Increased Credit
I Cash a/c Asset Increased Debit
Shyam’s a/c Asset Decreased Credit

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Financial and Management Accounting Unit 3

J Ram’s a/c Liability Decreased Debit

Cash a/c Asset Decreased Credit
K Bank a/c Asset Increased Debit
Cash a/c Asset Decreased Credit
L Drawing’s a/c Capital Decreased Debit
Cash a/c Asset Decreased Credit
M Cash a/c Asset Increased Debit
Bank a/c Asset Decreased Credit
N Drawing’s a/c Capital Increased Debit
Bank a/c Asset Decreased Credit
O Cash a/c Asset Increased Debit
Shyam a/c Asset Increased Credit
P Bank a/c Asset Increased Debit
Cash a/c Asset Decreased Credit
Q Shyam a/c Asset Increased Debit
Bank a/c Asset Decreased Credit
R Ram’s a/c Lability Decreased Debit
Bank a/c Asset Decreased Credit
S Salary a/c Expenses Increased Debit
Cash a/c Asset Decreased Credit
T Rent a/c Expenses Increased Debit
Bank a/c Asset Decreased Credit
U Drawings a/c Capital Increased Debit
Purchase a/c Expenses Decreased Credit
V Advanced a/c Asset Increased Debit
Suppliers a/c Asset Decreased Credit
W Cash a/c Asset Increased Debit
Advance from Liability Increased Credit
customers a/c
X Interest on Expenses Increased Debit
loans a/c Asset Decreased Credit
Cash a/c
Y Loan a/c Liability Decreased Debit
Cash a/c Asset Decreased Credit
Z Bank a/c Asset Increased Debit
Bank interest Revenue Increased Credit
a/c

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Financial and Management Accounting Unit 3

Answer to Activity 2
Accounting Equation: Asset = Liabilities + Capital
a 50,000 = 0 + 50,000
b 50,000 = 0 + 50,000
(-) 2,000
(+) 2,000
NEW EQUATION 50,000 = 0 + 50,000
c (-) 7,000
(+) 7,000
NEW EQUATION 50,000 = 0 + 50,000
D (+) 3,000 = 3,000 + 0
NEW EQUATION 53,000 = 3,000 + 50,000
E (-) 35,000
(+) 35,000
NEW EQUATION 53,000 = 3,000 + 50,000
F (-) 30,000
(+) 40,000 = 0 + 10,000
NEW EQUATION 63,000 = 3,000 + 60,000
G (+) 30,000 = 30,000 + 0
NEW EQUATION 93,000 = 33,000 + 60,000
H (-) 30,000
(+) 50,000 = 0 + 20,000
NEW EQUATION 1,13,000 = 33,000 + 80,000
I (-) 5000 = 10,000 + (-) 15,000
NEW EQUATION 1,08,000 = 43,000 + 65,000
J (-) 500 = 0 + (-) 500
NEW EQUATION 1,07,500 = 43,000 + 64,500
K (-) 1,500 = (-) 1,500
NEW EQUATION 1,06,000 = 41,500 + 64,500
L (-) 800 = (-) 500 + (-) 300
NEW EQUATION 1,05,200 = 41,000 + 64,200
M (-) 500 = 0 + (-) 500
NEW EQUATION 1,04,700 = 41,000 + 63,700

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N (+ 49,500
(-) 50,000 = 0 + (-) 500
NEW EQUATION 1,04,200 = 41,000 + 63,200
O (-) 29,700 = (-) 30,000 + 300
NEW EQUATION 74,500 = 11,000 + 63,500
P (- ) 500 = (+) 100 + (-) 600
NEW EQUATION 74,000 = 11,100 + 62,900
Q (-) 300
(-) 100 = 0 + (-) 400
NEW EQUATION 73,600 = 11,100 + 62,500

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Financial and Management Accounting Unit 4

Unit 4 Secondary Books

Structure:
4.1 Introduction
Objectives
4.2 Secondary books
4.3 Purchases Book/Purchases Day book
Cash discount, Trade discount
Difference between cash discount and trade discount
4.4 Sales Book or Sales Day book
Purchase Returns Book
Sales Returns Book
4.5 Bills receivable book
Bills payable book
Cash book
4.6 Posting to Ledger accounts
Posting to Ledger
Summary
4.7 Terminal Questions
4.8 Answers

4.1 Introduction
In the previous unit we discussed the meaning of double entry accounting,
the various classifications of accounts both under traditional approach and
accounting equation approach. Accounting trial is a sequential order in
which the accounting process flows.
Journal is a book of original entry. Journal is basically a day book in which
transactions are first entered in a systematic manner adopting the principles
of debit and credit. Journal is subdivided into several books of original entry,
namely purchases, sales, cash, bills receivable, bills payable, returns
inwards, returns outwards books. They are also regarded as subsidiary
books. When once the transactions are recorded in the journal or other
subsidiary books, posting is made to ledger.

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Financial and Management Accounting Unit 4

In this unit we are discussing the meaning of secondary books, various

types of secondary books and posting of entries to ledger accounts.

Objectives:
After going through this unit, you should be able to:
1. List various primary books containing original entries.
2. Explain the meaning of trade and cash discount and the distinction
between them.
3. Describe purchase book, purchase return book, sales book, sales
return book and the posting of transactions to ledger accounts.
4. Recall the format of Bills receivable and Bills Payable books
5. Know the method of preparing single column, double column and triple
column Cash Book.
6. Know the method of preparing Petty Cash Book.

4.2 Secondary Books

Journal is a book of original entry and only one journal is maintained if the
business is very small in size and the transactions are limited. However, if
the transactions are multifarious, then subsidiary books which are known as
books of original entry are prepared. The types of subsidiary books include:
1. Purchases book
2. Sales book
3. Purchase returns book
4. Sales returns book
5. Bills receivable book
6. Bills payable book
7. Cash book and
8. Journal Proper.
The entries are made in these books straight without recording in usual
journal. From the respective books, posting is made to ledger. In fact, from
the entries made in the subsidiary books, journalizing can be done. A
detailed note is given in the following paragraphs on each of the subsidiary
books.

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Financial and Management Accounting Unit 4

4.3 Purchases Book

Purchases book is also called purchases journal. Only credit purchases of
goods are recorded in this journal. „Goods‟ mean items or commodities
procured for resale. Cash purchases are recorded in cash book and credit
purchases are recorded in purchases book. The form of a purchases book is
given below.

Format of Purchase Book

Date Purchase Name of the L.F. Details Amount
Invoice No. supplier

Trade Discount
It is a reduction granted by a supplier from the list price of goods or services
on business consideration (such as quantity bought, trade practices etc).
For prompt payment cash discount is allowed.
Example: If 5 gold coins are sold at the list price of Rs.15000 each subject
to trade discount of 12%. The trade discount will be calculated as under:

5 Gold coins @ Rs.15,000 75,000

Less Trade discount @ 12 % 9,000
Amount payable as per invoice 66,000

Cash Discount
It is the reduction granted by the supplier from the invoice price in
consideration of immediate payment or payment within a stipulated period.

Example: If 5 gold coins are sold at the list price of Rs.15000 each subject
to trade discount of 12%. The invoice price after trade discount is
Rs.66,000. Cash discount terms are 2%, 30 days. This denotes the buyer
will get 2% cash discount if he makes payment within 30 days. The cash
discount is calculated as follows:

Amount payable as per invoice 66,000

Less Cash discount @ 2% 1,320
Cash payable within 30 days 64,680

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Difference between Trade Discount and Cash Discount:

1. Trade discount is a reduction granted by a supplier from the list price on
goods or services on business considerations such as quantity bought,
trade practices etc while cash discount is a reduction granted from the
invoice price in consideration of immediate payment or payment within a
stipulated period.
2. Trade discount is allowed to promote the sales while cash discount is
allowed to encourage early or prompt payment
3. Trade discount is shown by the way of deduction in the invoice itself.
Hence no further entry is required in the books of accounts. Cash
discount is shown as an expense in profit and loss account.
4. Trade discount may vary with the quantity purchased while cash
discount varies with the period.
Illustration 1: From the following transactions, prepare the purchase book
of Adithya Bros and post the transactions recorded in the Purchase book to
the Ledger:

Date Invoice No. Particulars

5.3.20X1 442 Purchased on credit from Goyal Bros – 55
Polyester sarees @ Rs.100 Less: Trade
Discount @10%
8.3.20X1 445 Purchased for cash from Greg Mac – 100
Orissa cotton sarees @ Rs 200
15.3.20X1 450 Purchased on credit from Adikari Mills – 10
silk sarees @ Rs2500 Less Trade Discount
@10%

Solution: Purchase Book

Date Purchase Name of the L.F. Details Amount
Invoice No. supplier
5.3.20X1 442 Goyal Bros 5500
Less Trade 550 4950
Discount 10% _____
8.3.20X1 450 Adikari Mills 25000
Less: Trade 2500 22,500
Discount 10% ______

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Financial and Management Accounting Unit 4

Cash purchases from Greg Mac will be recorded in cash book.

Ledger of Adithya Bros
Goyal Bros a/c
Date Particulars Folio Amount Date Particulars Folio Amount
5.3.20X1 By 4950
Purchases
a/c

Adikari Mills a/c

Date Particulars Folio Amount Date Particulars Folio Amount
8.3.20X1 By 22500
Purchases
a/c

Purchases a/c
Date Particulars Folio Amount Date Particulars Folio Amount
31.3.To sundries as 27450
20X1 per purchase
book

Observe that in every case of credit purchase, the supplier‟s account is

credited and goods account is debited.
At the end of the day or week or month, the total of purchases is transferred
to one ledger account known as Purchases account in the ledger.
Self Assessment Questions:
1. All purchases cash or credit is entered into purchases day book. (State
True/False)
2. Purchases of goods and other assets can also be recorded in purchase
book. (State True/False)
3. Inwards Invoice is a document to verify the quantity, price and other
details of goods purchased. (State True/False)
4. Purchases made from Mr. Ganesh on credit for Rs 6000, entered in the
purchases book. What is the journal entry?

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Financial and Management Accounting Unit 4

4.4 Sales book

Sales book or sales day book contains the details of credit sales of goods
made during a particular period. The total of the sales book is transferred to
ledger to an account called sales account. The parties to whom credit sales
are made are known as trade debtors. All debtors are classified as personal
accounts and for each party; ledger account is prepared in the ledger. Sales
account shows credit balance and debtor‟s account shows debit balance. A
pro forma of sales book is as given under.
Illustration 2: From the following transactions, prepare the Sales Book of
Adithya Bros and post the transactions recorded in the Sales book to the
Ledger:

Date Invoice No. Particulars

5.3.20X1 442 Sold on credit from Goyal Bros – 55 Polyester
sarees @ Rs.100 Less: Trade Discount @10%
8.3.20X1 450 Sold on credit from Adikari Mills – 10 silk sarees @
Rs2500 Less Trade Discount @10%

Solution: Sales Book

Date Sales Invoice Name of the supplier L.F. Details Amount
No.
5.3.20X1 442 Goyal Bros 5500
Less Trade Disc 10% 550 4950
_____
8.3.20X1 450 Adikari Mills 25000
Less: Trade Disc10% 2500 22,500
______

Cash Sales from Greg Mac will be recorded in cash book.

Ledger of Adithya Bros
Goyal Bros a/c
Date Particulars Folio Amount Date Particulars Folio Amount
5.3.20X1 To Sales a/c 4950

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Adikari Mills’s a/c

Date Particulars Folio Amount Date Particulars Folio Amount
8.3.20X1 To Sales 22500
a/c

Sales a/c
Date Particulars Folio Amount Date Particulars Folio Amount
5.3.20X1 By Sundries 27450
as per sales
book

Outward/Sales Invoice number is the number of the invoice issued by the

businessman to its customer. Similarly the respective ledger accounts of
the customers will be prepared in the ledger.

Self Assessment Questions:

5. Sales day book contains only credit sales of goods made. (State
True/False)
6. Sale of any other asset other than goods is also recorded in sales day
book. (State True/False)
7. Persons to whom sales are made on credit are called ________.
8. Outward invoice is a document issued to customer, when the goods are
sold on credit. (State True/False)

4.5 Purchase Returns Book

When the business person purchases the goods and finds they are
damaged or not as per the specifications he /she decide to return the goods
to the supplier from whom the goods were purchased. All such purchase
returns are recorded in a journal called purchase returns book. Normally the
supplier‟s account is credited when the purchases are made. If the goods
are returned, then a debit note will be sent and the number of debit note is
recorded in the purchase returns book.
A debit note is a document prepared by the purchaser to inform the supplier
that his account has been debited with the amount mentioned and for the
reason stated therein.

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Financial and Management Accounting Unit 4

Format of Purchases Returns Books

Date Debit Note No. Name of the L.F Details Amount
Supplier

The total of the items is transferred to ledger to an account called purchase

returns account, which shows credit balance. The respective personal
accounts of the suppliers/creditors are debited in their respective ledger
accounts.

Self Assessment Questions:

9. Purchase returns are also called returns outwards. (State True/False)
10. Purchase returns take place when the goods bought are not as for the
specification. (State True/False)
11. When goods bought are returned the suppliers account is _________
and purchase return account is _____________.
12. Debit note is a document to show the supplies account is being
debited. (State True/False)

4.6 Sales Returns Book

Sales returns book (also known as Return Inward book) is opened for the
purpose of recording the return of goods sold on credit. Then a credit note is
prepared to show that the customer‟s/debtor‟s account is credited to the
extent of the value of the goods returned by them to us. Goods are received
from the customers and a credit note is sent to them.
A credit note is a document prepared by the seller to inform the buyer that
his account has been credited with the amount mentioned for the reasons
stated therein. Credit notes are issued to the customers while debit notes
are issued by the customers.

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Financial and Management Accounting Unit 4

Format of Sales Returns Books

Date Credit Note No. Name of the Supplier L.F Details Amount

The total of the book is transferred to an account called sales returns

account in the ledger and this account shows debit balance. The respective
personal accounts of the customers are credited with the value of the goods
returned by them.
Self Assessment Questions:
13. Sales return are also called returns inwards. (State True/False)
14. Credit note is a document to indicate that the goods are received as
returned by customers. (State True/False)
15. Credit noted is sent by _____________ to __________.

4.7 Bills Receivable Book

When a business person sells goods on credit, the proceeds is received at a
later date. Suppose the business person requires cash immediately, he may
opt to draw a bill of exchange against the customer. The duly filled bill of
exchange is sent to the customer for acceptance. The customer accepts by
the way of putting his signature on the bill of exchange and returns it back to
the business person. On the receipt of the signed bill, the business person
discounts it with his banker for a commission. The business person receives
90 percent of the bill amount on discounting.
Bill of exchange is a document in writing, promising to pay a certain sum of
money or money‟s worth to the drawer at a certain date for value received.
The businessman who draws the bill of exchange is called the „drawer‟ and
the customer on whom it is drawn is called a „drawee‟ or „acceptor‟. The
businessman maintains a journal/ subsidiary book containing the details of
the bills receivable.

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Bills Receivable Book of Sham Sundar & Co.,

From
No. of Date of Date of Where Term of Amount
Whom Acceptor Due Date LF Remarks
the bill Receipt the bill payable the bill Rs.
received

1 04-7-04 04-7-04 Mr.X Mr. X Delhi 3 mths 7-10-04 7,000

2 1-8-04 01-8-04 Mr. Y Mr. Y Noida 4 mths 4-12-04 9,000

3 9-9-04 09-9-04 Mr. A Mr. A Agra 3 mths 12-12-04 12,000

4 10-9-04 10-9-04 Mr. B Mr. B Delhi 4 mnth 13-1-05 10,000

38,000

For every bill the due date is calculated after adding three days of grace.
The total of the bill receivable is transferred to bills receivable account in the
ledger. The bills receivable account shows debit balance and the amount
receivable against them is an asset.

Self Assessment Questions:

16. A bill is an instrument in writing similar to that of a promissory note.
(State true or false)
17. Who is a drawer of a bill of exchange in a business?
18. Who is the acceptor of a bill of exchange in a business?
19. Bills Receivable account shows _____________balance.
20. Can bills receivable be discounted?

4.8 Bills Payable Book

What is bills receivable for a drawer, is bills payable to the drawee. When a
business person purchases goods on credit he need not pay for it
immediately. Instead he may accept the bills of exchange drawn by the
supplier. All such bills accepted by the business person are recorded in a
separate book called bills payable book. The sum of the value of bills
payable for a period ending will be transferred to the ledger. Usually bills
payable account shows credit balance and hence is a liability. The form of
bills payable book is given here under.

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Bills Payable Book of Sun Shine Co.,

No. of Date of the To whom Where Term of the Amount Date
Drawer Payee Due date LF Re-marks
the bill bill given payable bill Rs paid
1 7.6.2000 Ram & Co Ram & Co Ram & Agra 3 months 2000 56,000
Co. Sept 10

2 June 12 Sunder Sunder Sunder Delhi 4 months Oct 15 72,000

3 June 20 KV & Co KV & Co KV & Co Chenn 5 months Nov 23 50,000
ai
Total 1,78,000

Self Assessment Questions:

21. Bills of exchange drawn by the supplier of goods and accepted by the
proprietor of the business are called _________.
22. Every bill has ______days of grace .
23. Bill payable account shows _________ balance.
24. Bill payable represents a ________.
25. When bills payable account is credited ________ account is debited.

4.9 Cash Book

Cash book is an important subsidiary book and a book of original entry. It is
a record of cash receipts and cash payments made during a particular
period. On the right hand side, receipts are recorded and on the left hand
side, payments are recorded. A simple cash book has two sides, receipts
side and payment side. The receipts are on debit side and the payments are
on credit side. Just as a ledger account, the words „To‟ and „By‟ are used.
Cash book may also contain cash column and bank column. Cash column
represents cash in the business and bank column represents cash kept in
the bank. Bank column of cash book is a reflection of bank pass book.
In this connection, it is important to note that in a few transactions, affecting
both cash and bank accounts, contra entries are drawn.
Cash book containing cash and bank columns is known as two column cash
book. In the case of three column cash book, on the receipt side, cash, bank
and discount allowed columns are stated. On the credit side, cash, bank and
discount received columns are mentioned.

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Single column Cash Book of Rekha & Bros

Date Receipts Cash Date Payments Cash

2003 2003
July 1 To Balance b/d 4,500 July 1 By Rent of shop 900
4 To Sales 8,050 3 By Postage 50
10 To Interest on FD 2,000 14 By Purchases 7,000
20 To Commission 4,000 20 By Stationery 800
28 To Sale of goods 10,000 28 By wages 2,000
30 To Balagopalan 5,000 31 By Narasimhan 9,000
By balance c/d 13,800
Total 33,550 Total 33,550

Two-Column Cash Book of Simpson Co.,

Cash Cash Bank
Date Receipts Bank (Rs.) Date Payments
(Rs.) (Rs) (Rs)
2003 2003
Apr 5 To Balance b/d 1,500 13,000 Apr 2 By Wages 400
To Sales 800 5 By Electricity 50
7 To Ashok Co 2,000 8 By repairs 400
11 To Beta Co 2,350 15 By Venki Ltd 10,800
20 To Sales 500 30 By Balance c/d 2,350
6,150
Total 2,800 17,350 Total 2,800 17,350

Three-Column Cash Book of Janardhan Works

Date Receipts Discount Cash Bank Date Payments Dis-count Cash Bank
2002 2002
Jan 2 To balance b/d 3700 4,500 Jan 6 By wages 1,550
Jan 5 To Patel 100 2,400 Jan 3 By Agarwal 50 950
Jan10 To Neelima 6,000 Jan15 By Cash C 3,000
15 To Bank C 3,000 22 By 2,000
drawings
30 To Cash C 1,000 30 By Bank C 1,000
31 To Dividend 2,000 31 By rent 1,500
from X Co
31 By bal c/d 5,600 7,000
Total 100 9,100 13,500 Total 50 9,100 13,500

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Note the following points from the above illustration:

a) Discount column on the debit side represents discount allowed and on
the credit side, it represents discount received. Balancing is not done for
these columns for a simple reason to find out separately the discount
allowed and received.
b) There are two contra entries each on 15th and 30th. On 15th the
transaction is cash withdrawn from bank Rs. 3,000. It is a payment from
bank and it is receipt to business cash. Similarly on 30th Cash is
deposited to bank Rs.1000. It is a receipt to the bank account and
payment from cash account.
c) To indicate contra entry, „C‟ is mentioned against the entry.
d) Drawings represent the amount withdrawn from bank for business
purposes.
e) Dividend from X Co is received by cheque and the company should have
remitted the dividend directly to the bank account of the businessman.
f) The balance c/d is the closing balance for the month of January 2002
and this becomes opening balance for February, 2002.

Self Assessment Questions:

State True or False
26. Cash book and cash account are one and the same. (State true/false)
27. Trade discounts allowed to customers or received from suppliers are
not recorded in cash book.
28. Cash discount allowed to customers appears on the ____ side of cash
book. Cash discount received appears on the ____ side of cash book.
29. Discount columns are independently totaled and not balanced. (State
true/false)
30. Contra entry is an entry where both cash account and bank account
are affected. (T/F)

4.10 Petty Cash Book

In large organizations, petty expenses like stationery, postage, stamps,
refreshments, carriage, cartage, daily wages etc are incurred day in and day
out. All these expenses are more in number and very insignificant in value.
To look after payment of such expenses, a separate petty cashier is
appointed who obtains a definite sum of money at the beginning of a month

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and gives a statement of account at the end of the period to the chief
cashier. To record such payments, a separate book, known as petty cash
book is maintained.
There is a distinct method, namely Imprest system which is adopted in
maintaining such petty cash book. Under this system, at the beginning of a
month, a definite sum of money is given by chief cashier to petty cashier for
petty expenses. At the commencement of the next period, the petty cashier
is reimbursed equal to what he had spent during the earlier period.
Example:
1st Jan 2004: Amount received by the Petty cashier - Rs. 10000
Expenses incurred during the month of Jan 2004 - Rs. 9000
31st Jan 2004: Cash balance - Rs. 1000
Amount reimbursed by the Chief cashier - Rs. 9000
1st Feb 2004: Opening petty cash balance - Rs. 10000

Self Assessment Questions:

31. Petty cash book is maintained in case of petty organization.
32. Imprest system of cash book is a system where the expenses incurred
are reimbursed.
33. The closing balance in imprest system of petty cash book always
remains the same.
34. Imprest system of cash book is also called analytical cash book.

Illustration 3:
Enter the following transactions in an analytical petty cash book. Also open
relevant ledger accounts.
2005 Nov 1st. Received a cheque for petty cash Rs.1000
2nd. Paid bus fare to messengers Rs50
4th. Paid auto fare Rs.70
10th. Postal stamps purchased Rs.80
12th. Paid for stationery Rs90
15th. Paid for carriage Rs.60
16th. Purchased envelopes Rs.50
20th. Wages paid Rs 100 .
25th. Tips given to driver Rs.50
30th. Telephone calls paid Rs. 20

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PETTY CASH BOOK

Date Parti- Amount Date particulars V no Total LF Led-
culars Pay- Analysis of Payments ger
ments A/cs
Nov Tra Post Carr P & Wages Sundry
Rs Rs Rs S Rs Exps
Rs Rs

Nov 1 To bank 1000 1st By bus fare 50 50

2 By Auto fare 70 70
4 By Postal 80 80
10 By stationery 90 90
12 By carriage 60 60
15 By Envelopes 50 50
16 By Wages 100 100
20 By tips 50 50
25 By Telegram 20 20
30 Total Exp 570 120 100 60 140 100 50
No30 By Balance c/d 430
Total 1000
To bal 430
Dec 1st b/d 570
To Cash

Note:
1. CBF stands for cash book folio
2. V.No. stands for Voucher No.
3. Tra stands for Travelling expenses
4. Carr indicates Carriage expenses
5. P & S stands for printing and stationery

CASH BOOK
Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov By petty cash 1000

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LEDGER
TRAVELLING EXPENSES ACCOUNT
Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 120

POSTAGE EXPENSES ACCOUNT

Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 100

CARRIAGE EXPENSES ACCOUNT

Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 60

PRINTING AND STATIONERY ACCOUNT

Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 140

WAGES ACCOUNT
Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 100

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Financial and Management Accounting Unit 4

SUNDRY EXPENSES ACCOUNT

Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 50

4.11 Posting to Ledger

The next important stage of accounting is preparation of ledger accounts in
a book called ledger. The book contains the summary of transactions
concerning to various heads of accounts for a given period. Posting is made
to ledger accounts from journal entries and various subsidiary books and at
the end of the accounting period, each ledger account is balanced.
Procedure for balancing a Ledger account:
 Total both the debit column and credit column
 If the debit total exceeds credit total, put such difference (called debit
balance) on the credit side as “By balance c/d”.
 If the credit total exceeds debit total put such difference ( called credit
balance) on the debit side as “ To balance c/d”
 Total both the debit side and the credit side of the account
 Enter the date of the next accounting period and bring down the balance
of the previous accounting period. If it is debit balance write “To balance
b/d “on the debit side of the account and if it is credit balance write “By
balance b/d” on the credit side of the account.

CASH ACCOUNT
Debit Side Credit Side
Date Particulars Ledger Amount Date Particulars Ledger Amount
Folio (Rs) Folio (Rs)
2005 2005
Jan. 1 To Balance b/d 20000 Jan 05 By salaries 10900
Jan15 To Joseph 35 10900 Jan 25 By Furniture 123 6000
Jan 28 To Sales 18 108900 Jan 30 By purchases 19 58800
Jan 31 By Rent 298 7500
By balance c/d 56600
Total 139800 Total 139800
Feb 1 To balance b / d 56600

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Observe the following from the above account:

1. The balance brought down is the closing balance of the last month,
December, 2004
2. The amount received from Joseph is Rs.10900 and his account is
prepared in the in the page number 35 of the ledger.
3. The credit side contains payment of cash towards salary, furniture,
purchase of goods and rent respectively on different dates.
4. The balance carried down is the closing balance on the last day of
January, 2005 and it is brought down as opening balance on Feb,1
5. On the debit side, „To‟ and credit side „By‟ are the prefix used for every
entry as a matter of convention.
There is a standard form of drawing a ledger account. It is similar to that of a
pass book issued by a bank. The above illustration is shown in the standard
form.

CASH ACCOUNT
Date Particulars Post. Ref. Debit Credit Balance
2005 LF Rs Rs Rs
Jan 1 Opening balance 20000 20000
b/d
Jan 5 Salaries 10900 9100
Jan 15 Joseph 35 10900 20000
Jan 25 Furniture 123 6000 14000
Jan 28 Sales 18 108900 122900
Jan 30 Purchases 19 58800 64100
Jan 31 Rent 298 7500 56600

Self Assessment Questions:

35. Rules of debit and credit are different for different types of accounts.
True or False?
36. The words “To Balance b/d‟ or “By Balance b/d” denote an opening
entry. State true or false.
37. _________ And __________ are balanced while ______ are closed by
transfer to trading and profit and loss account.

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38. In the ledger account during the beginning of the accounting period “To
Balance b/d” denotes debit balance and “By balance b/d” denotes
credit balance. State true or false.

Activity 1
Given in the table are various types of accounts. Mention whether
it carries debit or credit balance.

Name of the account Debit / credit

balance
Capital
Personal Drawings
Creditors
Bills Payable
Bank overdraft
Loans from others
Outstanding expenses
Pre received incomes
Reserves for future expenses or losses
All items of incomes
Cash in hand or at bank
Assets such as furniture, buildings, plant, machinery,
tools, stock of goods, etc
Debtors, Bills receivable
Loans given to others
Investments made
All expenses such as wages, carriage, insurance,
salaries, printing and stationery, advertising, commission
paid, interest paid, etc
Prepaid insurance, rent or any prepaid expenses
Outstanding incomes
Losses like depreciation, loss in the revaluation of assets
or sale of assets,
Any other asset

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4.12 Summary
Secondary books are also known as books of original entry. They include
purchase book, sales book, purchase return book, sales return book, bills
receivable book, bills payable book, cash book and journal proper.
Trade discount is a reduction granted by a supplier from the list price of
goods or services on business consideration. Cash discount is the reduction
granted by the supplier from the invoice price in consideration of immediate
payment or payment within a stipulated period.
Bill of exchange is a document in writing promising to pay a certain sum of
money or money‟s worth to the drawer at a certain date for value received.
Cash book is an important subsidiary book and a book of original entry. It
records cash receipts and cash payments made during a particular period.

4.13 Terminal Question

1. Purchases book records___________________ purchases.
2. Cash purchases are recorded on_____________ side of cash book.
3. Credit sales are entered in __________book.
4. Record a journal entry for drawings made for personal purposes of the
business person.
5. If drawings are made from bank for office purpose, what is the entry?
6. During the year, if the total owner‟s equity of Beta Co. increased from
Rs. 50,000 to Rs. 60000. This is due to earnings made during the year.
Is this statement necessarily true?
7. Enter the following transactions in the single column cash book of
Gopichand.
March, 2003
1st .Commenced business with cash 20000
nd
2 Bought goods for cash 5000
rd
3 . Sold goods for cash 4000
th
4 . Goods purchased from Ravi Kumar 10000
th
10 .Paid to Ravi Kumar 7000
14th. Cash sales 8000
th
18 . Purchased furniture for office 4000
nd
22 . Paid wages 500

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25th. Paid rent 600

30th. Received Commission 4000
30th. Withdrew for personal purpose 1000
31st. Paid salary 900

8. Record the following transactions in two column cash book (Cash and
Bank)in the books of Soft Silk Co., for the month of July, 2004.Find out
the closing balances for the month of July 2004.
July, 2004 Rs.
st
01 . Opening balance b/d(Cash) 14,500
Opening balance b/d (Bank) 7,000
04th. Cash purchases 6,700
th
05 . Rent for June month paid by cheque 2,500
th
09 . Cash sales 15,200
th
12 . Dividend paid by cheque 4,350
15th. Cash deposited into bank 5,000
18th. Cash paid to Rahim Bros to settle his account 10,000
th
20 . Repairs paid 1,000
nd
22 . Commission paid by cheque 2,000
rd
23 . Customer, Deepak remitted to our bank account 20,000
25th. Cash withdrawn from bank for office use 5,000
th
27 . Drawings made from business cash for personal purposes 2,000
28th. Purchased stationery by cash 3,000
th
30 . Cash withdrawn for personal use from bank 1,400

9. Enter the following transactions in the cash book with discount, cash and
bank columns. Prepare three columnar cash book for the month of May.
May 1st Balance of cash in hand Rs. 14000; bank overdraft at
bank Rs.5000
4th Invested further capital Rs. 10000 out of which Rs.6000
was deposited in the bank.
6th Sold goods for cash Rs. 30000
6th Collected from debtors of last year Rs. 80000; Discount
allowed to them Rs. 2000.
10th Purchased goods for cash Rs. 55,000

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11th Paid Ram Vilas, our creditor Rs. 25,000; discount

allowed by him Rs.650
13th Commission paid to our agent Rs. 5,300
14th Office furniture purchased for cash Rs. 2,000
14th Rent paid Rs. 400; electricity charges paid Rs. 1,000
14th Drew cheque for personal use Rs. 7,000
17th Cash sales Rs. 25,000
18th Collection from Atal Bihari Rs.40,000, deposited in the
bank on 19th April
19th Drew from the bank for office use Rs.5,000
22nd Drew cheque for petty expenses Rs.1,500
24th Dividend received by cheque Rs.500, deposited in the
bank on the same day
25th Commission received by cheque Rs.2,300, deposited in
the bank on 28th April
29th Drew from the bank for salary of the office staff
Rs.15,000
30th Deposited cash in the bank Rs.10,000.

10. Prepare petty cash book on imprest system from the following
particulars.
i. Jan 1st – Received for petty cash payment Rs. 500/-
ii. Jan 2nd – Paid for postage Rs. 40/-
iii. Jan 5th – Paid for stationery Rs. 25/-
iv. Jan 8th – Paid for advertisement Rs. 150/-
v. Jan 12th – Paid for wages Rs. 50/-
vi. Jan 16th – Paid for carriage Rs. 25/-
vii. Jan 20th – Paid for conveyance Rs. 22/-
viii. Jan 25th – Paid for traveling expenses Rs. 80/-
ix. Jan 27th – Paid for postage Rs. 50/-
x. Jan 28th – Paid wages to cleaner Rs. 10/-
xi. Jan 30th – paid for telegram Rs. 20/-
xii. Jan 30th – Sent registered notice Rs. 10/-

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4.14 Answer for Self Assessment Questions

1. False 13. True 26. True

2. False 14. True 27. True
3. True 15. Businessman, the 28. Debit,
4. Purchases A/c Customer 29. Credit
Dr. To Ganesh 16. True 30. True
account (Being 17. Owner of the 31. False
purchases made) business who is
5. True the seller 32. True
6. False 18. Customer / debtor 33. False
7. Debtors 19. Debit 34. True
8. True 20. Yes 35. True
9. True 21. Bills payable 36. True
10. True 22. Three 37. Personal, real
and nominal
11. Debited, Credited 23. Credit
38. True
12. True 24. Liability
25. Supplier‟s
account /
Creditors account

Answer for Terminal Questions:

1. Credit
2. Credit
3. Sales Day
4. Drawings A/c Dr.
To Cash a/c
5. Cash account Dr.
To Bank account.
6. The statement is true if additional capital is not brought in during the
year. Owner‟s equity increases if profits are added or additional capital
is brought in.

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7. Cash Book of Gopichand

st
1 March To Capital 20,000 2nd By Goods 5000
3rd To Sales 4,000 10th By Ravi Kumar 7000
14th To Sales 8,000 18th By office furniture 4000
30th To Commission 4,000 22nd By wages 500
25th By rent 600
30th By drawings 1000
31st By salary 900
31st By bal c/d 17,000
36,000 36,000

Hint: Goods Purchased from Ravi Kumar is a credit purchase.

8. CASH BOOK
July04 Cash Bank July04 Cash Bank
1st To Op bal b/d 14,500 7000 4th By 6700
Purchases
9th To Sales 15,200 5th By Rent 2500
15th To Cash (c) 5000 12th By dividend 4350
paid
23rd To Deepak 20,000 15th By bank (c) 5000
25th To Bank ( c ) 5000 18th By Rahim & 10,000
Bros
20th By repairs 1000
22nd By comm. 2000
paid
25th By cash ( c ) 5000
27th By drawings 2000
28th By stationery 3000
30th By drawings 1400
30th By balance 7000 16750
c/d
34700 32,000 34700 32,000

To Bal b/d 7,000 16,750

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9. Cash Book
Disc Cash Bank Disc Cash Bank
Rs Rs Rs Rs Rs Rs
To bal b/d 14,000 By balance b/d 5000
To Capital 4000 6000 By purchases 55,000
To Sales 30,000 By Ram vilas 650 25,000
To Debtors 2000 80,000 By commission 5,300
To Sales 25,000 By office furniture 2000
To Atal 40,000 By rent 400
Bihari
To Cash (c) 40,000 By electricity 1000
To Bank (c) 5,000 By drawings 7000
To Dividend 500 By banks (c) 40,000
To Comm 2300 By cash (c) 5,000
To Cash (c) 2300 By petty expenses 1,500
To Cash (c) 10,000 By bank (c) 2,300
By salary 15,000
By bank ( c) 10,000
By balance c/d 59,300 25,300
Total 2000 2,00,300 58800 Total 650 2,00,300 58,800

10. Petty cash book

Cash Date Postage
Total Carri- Printing Travel
recd 1996 Particulars LF & Advt Wages Sundry
payment age & stry exp.
Rs Jan telegram
500 1st To cash
nd
2 By postage 40 40
5th By stationery 25 25
8th By advt 150 150
th
12 By wages 50 50
16th By carriage 25 25
20th By 22 22
conveyance
25th By traveling Cr 80 80
th
27 By postage 50 50
28th By wages 10 10
th
30 By telegram 20 20
30th By register 10 10
482 120 25 25 150 102 60

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Financial and Management Accounting Unit 4

30th By balance 18
b/d
500 500
18 July To balance
1st b/d
482 July To cash
1st

Activity 1 Solution

Name of the account Debit / credit

balance
Capital Credit
Personal Drawings Debit
Creditors Credit
Bills Payable Credit
Bank overdraft Credit
Loans from others Credit
Outstanding expenses Credit
Pre received incomes Credit
Reserves for future expenses or losses Credit
All items of incomes Credit
Cash in hand or at bank Debit
Assets such as furniture, buildings, plant, machinery, Debit
tools, stock of goods, etc
Debtors, Bills receivable Debit
Loans given to others Debit
Investments made Debit
All expenses such as wages, carriage, insurance, Debit
salaries, printing and stationery, advertising,
commission paid, interest paid, etc
Prepaid insurance, rent or any prepaid expenses Debit
Outstanding incomes Debit
Losses like depreciation, loss in the revaluation of Debit
assets or sale of assets,
Any other asset Debit

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Financial and Management Accounting Unit 5

Unit 5 Trial Balance

Structure:
5.1 Introduction
Objectives
5.2 Meaning
5.3 Objectives of preparing a trial balance
5.4 Methods of preparing a trial balance
5.5 Preparation of Trial balance
5.6 Adjusting Entries
5.7 Errors and their rectification
5.8 Errors disclosed by Trial Balance
5.9 Errors not disclosed by Trial Balance
5.10 Steps to locate the errors
5.11 Summary
5.12 Terminal Questions
5.13 Answers

5.1 Introduction
In the previous unit we learnt how about various secondary books that
include purchase book, sales book, purchase return book, sales return
book, bills receivable book, bills payable book, cash book and journal
proper. Cash book is an important subsidiary book that records all cash
receipts and payments during a particular period. Posting of entries in ledger
and the procedure for balancing in ledger account was briefly dealt.
In this unit we have dealt with the meaning, the need of trial balance, and
the methods of preparing trial balance. There are different types of errors.
Students should be acquainted with types of errors and how they are
rectified. There are certain errors that are disclosed in the trial balance while
certain errors are not disclosed in the trial balance. Trial Balance is a
statement of debit balances and credit balances that are extracted from
ledger accounts on a particular date. It stands as a bridge between primary
and secondary books on one hand and final statements of accounts on the
other hand.

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Objectives:
After going through this unit, you should be able to:
1. Explain the meaning and recall the format of trial balance.
2. Explain the objectives of preparing a trial balance
3. List the guidelines to prepare a trial balance.
4. Identify and rectify the errors that are disclosed by trial balance
5. Identify and rectify the errors that are not be disclosed by trial balance
6. Know the steps to locate the errors.
7. Prepare trial balance after incorporating adjustments.

5.2 Meaning
Trial Balance is a statement containing the various ledger balances on a
particular date. It is prepared to check the arithmetical accuracy of the
posting of transactions to the ledger. It is a list of debit and credit totals or a
list of debit and credit balances of all the ledger accounts prepared on any
particular date to verify whether the entries in books of accounts are
authentically correct. As the primary and secondary books are maintained
on the double entry concept, the balances in the trial balance must tally.
A trial balance is not a part of books of account. It is drawn as a separate
statement, and this becomes the source document for preparing external
financial statement such as profit and loss account, cash flow statement and
Balance Sheet.

5.3 Objectives of Preparing a Trial Balance:

There are three objectives of preparing a trial balance.
a) To check the arithmetic accuracy of entries made. In double entry, every
debit has an equivalent credit. Even in General Journal, we have seen
that the total of debits equals the total of credits. Similarly, if the debits
and credits tally in a trial balance, it indicates that the books of account
are arithmetically accurate.
b) Basis for financial statements. As stated earlier, trial balance is a bridge
between ledger and final statements. Trial balance facilitates in the
preparation trading account, profit and loss account and balance sheet.
c) It is a summarized ledger. The position of a ledger account is judged
simply by looking at the trial balance. It is because, all ledger accounts,

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after being balanced, are grouped as those showing debit and those
showing credit balances. The total of all debit balance is equal to total of
all credit balance. If in any case the trial balance does not tally, the
difference is temporarily transferred to suspense account till such
difference is rectified.

5.4 Methods of preparing a Trial Balance

Totals method and Balance method are the two techniques of preparing trial
balance. In the first method, the totals of debits and credits of every account
are shown in the trial balance. For instance, a cash account has a debit total
of Rs.45000 and credit total of Rs.35000. Creditors has a debit total of
Rs.70000 and credit total of Rs.80000. Both these totals are carried to trial
balance.
Performa of Trial Balance under Totals Method
TRIAL BALANCE As On _________

Debit Totals Rs. Credit Total Rs.

Cash 45,000 Cash a/c 35,000
Creditors 70,000 Creditors 80,000
Total 1,15,000 Total 1,15,000

The same logic is applied for all other accounts.

Balance Method:
In the Balance method, instead of transferring the totals of both debit and
credit, the net balance of every account for example in case of cash account
of Rs.10000 (45000 – 35000) is shown on the debit side of trial balance.
CASH ACCOUNT
To _____ xxxx By _____ xxxx
To _____ xxxx By _____ xxxx
By balance c/d 10000
Total 45000 Total 45000

To balance b/d 10000

If the debit side is greater than the credit side the difference is termed as
debit balance. Creditors have Rs.70000 as debit total and Rs.80000 as
credit total. The closing balance is shown on the credit side.

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CREDITORS ACCOUNT
To ______ xxxx By ______ xxxx
To balance c/d 10000
Total 80000 Total 80000

By balance b/d 10000

If the credit side is greater than the debit side the difference is termed as
credit balance.
Proforma of Trial Balance under Balance Method
TRIAL BALANCE as on _________
Particulars Debit balance Credit Balance
Rs. Rs.
Cash 10,000
Creditors 10,000
Total 10,000 10,000

In the second method only the difference (debit balance/credit balance) is

alone considered. The same principle is adopted for all the other accounts.
In the first method, more details are revealed but it is cumbersome. The
second method gives the gist of the account and hence the second method
is popular.

5.5 Preparation of Trial Balance

The following steps should be followed to prepare a Trial Balance.
a) Prepare the ledger accounts
b) Balance them at the end of accounting period
c) Group all accounts showing debit balance and show them of left hand
side of trial balance
d) Group all those accounts showing credit balance and show them on the
right hand side of trial balance.
e) Total the debits and credits and they must be equal, what ever be the
method of preparing the trial balance.

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Illustration 1:
The following are the ledger accounts of Mr. X as on 31st December, 1998.
Prepare a trial balance.
Dr. Cash Account Cr.
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
1-4-04 To balance b/d 50,000 6-4-04 By Cash 5,000
2-4-04 To Sales 45,000 10-4-04 By Kumar 29,000
16-4-04 To Mohan 35,000 14-4-04 By Purchases 50,000
26-4-04 To Sales 10,000 18-4-04 By creditors 20,000
20-4-04 By Furniture 5,000
22-4-04 By Wages 500
By Printing 1,000
By Comm 2,000
30-4-04 By Electricity 500
By Telephone 1,000
By salaries 4,000
By balance 22,000
c/d
1,40,000 1,40,000
1-5-04 To balance b/d 22,000

Building Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
1-4-04 To balance b/d 2,00,000 30-4-04 By balance c/d 2,00,000
1-5-04 To balance b/d 2,00,000

Furniture Account
Date Particulars Amount Date Particulars Amount
Rs. Rs.
1-4-04 To balance b/d 10,000 30-4-04 By balance
20-4-04 To Cash 5,000 c/d 15,000
15,000 15,000
1-5-04 To balance b/d 15,000

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Bank Fixed Deposit Account

Amount Amount
Date Particulars Date Particulars
Rs. Rs.
1-4-04 To balance b/d 30-4-04 By balance 1,07,000
12-4-04 To Interest 1,00,000 c/d
7,000
1,07,000 1,07,000
1-5-04 To balance b/d 1,07,000
Stock Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
1-4-04 To balance 25,000 30-4-04 By balance c/d 25,000
b/d
1-5-04 To balance b/d 25,000

Creditor’s Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
18-4-04 To Cash 20,000 1-4-04 By balance b/d 35,000
30-4-04 To balance c/d 15,000
35,000 35,000
1-5-04 By balance b/d 15,000

Capital Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To balance c/d 3,50,000 1-4-04 By balance b/d 3,50,000
35,000 3,50,000
1-5-04 By balance b/d 3,50,000

Purchases Account
Amount Amount
Date Particulars Date Particulars
Rs, Rs.
4-4-04 To Kumar 30,000 30-4-04 By balance c/d 95,000
14-4-04 To Cash 50,000
To Sarin 15,000

95,000 95,000
1-5-04 To balance b/d 95,000
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Sales Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To balance 2-4-04 By Cash 45,000
c/d 95,000 8-4-04 By Mohan 40,000
26-4-04 By Cash 10,000
95,000 95,000
1-5-04 By balance b/d 95,000

Kumar Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
10-4-04 To Cash 29,000 4-4-04 By Purchases 30,000
To discount 1,000
30,000 30,000

Note: There is no balance and hence his account will not appear in trial balance

Repairs Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
6-4-04 To Cash 5,000 30-4-04 By balance c/d 5,000
5,000 5,000
1-5-04 To balance b/d 5,000

Mohan Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
8-4-04 To sales 40,000 16-4-04 By Cash 35,000
30-4-04 By balance c/d 5,000
40,000 40,000
1-5-04 To balance b/d 5,000

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Discount Received Account

Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To balance c/d 1,000 10-4-04 By Kumar 1,000
1,000 1,000
1-5-04 By balance b/d 1,000

Interest on Fixed Deposit Account

Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To balance c/d 7,000 12-4-04 By Bank FD 7,000
7,000 7,000
1-5-04 By balance b/d 7,000

Wages Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
22-4-04 To Cash 500 30-4-04 By balance c/d 500
500 500
1-5-04 To balance b/d 500

Printing Account
Date Particulars Amount Date Particulars Amount
Rs. Rs.
22-4-04 To Cash 1,000 30-4-04 By balance c/d 1,000
1,000 1,000
1-5-04 To balance b/d 1,000

Commission Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
22-4-04 To Cash 2,000 30-4-04 By balance c/d 2,000
2,000 2,000
1-5-04 To balance b/d 2,000

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Electricity Account
Date Particulars Amount Date Particulars Amount
Rs. Rs.
30-4-04 To Cash 500 30-4-04 By balance c/d 500
500 500
1-5-04 To balance b/d 500

Telephone Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To Cash 1,000 30-4-04 By balance c/d 1,000
1,000 1,000
1-5-04 To balance b/d 1,000

Salaries Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To Cash 4,000 30-4-04 By balance c/d 4,000
4,000 4,000
1-5-04 To balance b/d 4,000

Sarin’s Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
30-4-04 To balance c/d 15,000 28-4-04 By Purchases 15,000
15,000 15,000
1-5-04 By balance b/d 15,000

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Solution
TRIAL BALANCE AS ON 30TH APRIL, 2004
Debit balances Amount Rs. Credit balances Amount Rs.
Cash 22,000 Creditors 15,000
Building 2,00,000 Capital 3,50,000
Furniture 15,000 Sales 95,000
Bank FD 1,07,000 Discount received 1,000
Stock 25,000 Interest on FD 7,000
Purchases 95,000 Sarin 15,000
Repairs 5,000
Mohan 5,000
Wages 500
Printing 1,000
Commission 2,000
Salaries 4,000
Telephone 1,000
Electricity 500
Total 4,83,000 Total 4,83,000

5.6 Adjusting Entries

Financial Accounting uses accrual basis of accounting which is supported
by GAAP. Under accrual basis of accounting revenues are recognized when
earned without regard to the timings of cash receipts. Expenses are
recognized either in the period in which related revenues are recognized or
when incurred without regard to the timings of cash disbursement.
When such system is used adjusting entries are required to be made at the
end of the period to record any previously unrecognized changes in assets,
liabilities, revenues or expenses. Adjusting entries are purely internal
transactions. There are various types of adjusting entries.
Opening Journal entries:
In the case of running business, all the assets and liabilities of the previous
year should be brought down to the current year and therefore an entry is
drawn debiting all assets account individually and crediting liabilities account
individually and the difference being credited to capital account.

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Illustration 2: On 31st Dec, 2004, the following were the assets and
liabilities of a firm:
(1) Cash at bank – Rs. 50000;
(2) Furniture – Rs. 48000;
(3) Plant and machinery – Rs.200000;
(4) Debtors – Rs.100000;
(5) Stock in trade – Rs. 20000;
(6) Creditors – Rs. 50000;
(7) Bank loan – Rs. 45000.
On 1st of January, 2005 the assets and liabilities have to be brought in. The
following entry is recorded in Journal Proper.
Date Particulars Ledger Folio Debit Rs Credit Rs
1-1-05 Cash at Bank A/c Dr 50000
Furniture A/c Dr 48000
P and M A/c Dr 200000
Debtor’s A/c Dr 100000
Stock In trade A/c Dr 20000
To Creditors A/c 50000
To Bank Loan A/c 45000
To Capital A/c (Difference) 323000
(Being assets and liabilities of
the previous year brought in)

Similarly, a newly set up business may commence its activities with some
assets and liabilities. Then the assets are debited and liabilities are credited
and the difference is transferred to capital account.
Self Assessment Questions:
1. Opening journal entries are drawn at the commencement of accounting
period. (State whether it is True / False).
2. When all assets are debited and all liabilities are credited, the difference
is transferred to ___________ account.
3. If opening liabilities including capital are more than assets, to what
account the difference is transferred?
4. Pass the opening entry in the journal of Bharat as on 1st April 20X1.
Cash in hand Rs.1,000; Cash at bank Rs.5,000; Stock Rs.20,000; Land
and Building Rs.1,00,000; Plant and Machinery Rs.50,000; Furniture
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and Fixtures Rs.25,000; Owing from X Ltd Rs.12,500; Prepaid Insurance

Rs.500; Interest received in advance Rs.250; Loan from Y Ltd
Rs.10,000; Owing to Z Ltd Rs.3,750.
Closing entries
Closing entries are drawn at the end of accounting period and the purpose
is to close down several account balances for the current period. The
accounts of assets and liabilities will not be closed because they continue to
exist further. All expenses and income accounts are closed by transferring
them to the respective revenue accounts such as Trading account and Profit
and Loss account. Example:

For example, salaries paid during the year are closed by transferring to
P & L account :
P & L account Dr
To Salaries’ account.

Self Assessment Questions:

5. All revenue accounts are closed at the end accounting period. (State
whether it is True / False).
6. All trade expenses are closed by debiting _________account
7. All expenses other than _________ are closed by transferring them to
P & L account.
8. Are assets and liabilities accounts closed at the end of the accounting
year? (State whether it is Yes / No).
After the closure of accounting year, there might be a few more transactions
left over and which are not incorporated into journal or ledger, owing to
omission and practical difficulties. Example:

Example: closing stock should be valued on the last day of the

accounting period. If the stock is so large containing several items, it
is possible that the calculation is not made along with physical
verification. In such a case, an adjusting entry is made to bring that
item into account

Similarly, with regard to rent paid in advance, expenses outstanding,

incomes received in advance etc adjusting entries are made in Journal

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proper. If they are not considered, the profit or loss reflected by the final
accounts will not give the correct picture for the accounting period.
Self Assessment Questions:
9. Transaction which are out of trial balance have to be adjusted for proper
calculation of profit / loss (state whether it is True / False).
10. What is the adjusting entry in the following cases?
a. Depreciation of Building
b. Closing stock
c. Pre-paid Insurance
d. Outstanding salaries
e. Stock used for personal purposes
Transferring entries
When the balance of one account is transferred to another account,
transferring entry is made. For instance, drawings made by proprietor
should be reduced from his capital account. To facilitate this, drawings
account, which shows debit balance, is credited and capital account is
debited (because capital is reduced as a result of drawings). This is a
transferring entry and it is recorded in Journal proper.
Compound Entry:
A compound journal entry is passed when more than two accounts are
involved in a transaction and the transaction is recorded by means of a
single entry instead of passing several journal entries.
Example 1: Paid Rs 980 to Bharat in full settlement of his account of
Rs.1000
Journal Entry:
Bharat a/c Dr.1000
To Discount Received a/c 20
To Cash a/c 980
(Being cash paid to Bharat in full settlement of his account)
Example 2: Received Rs.490 from Rajan in full settlement of his account of
Rs.500.

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Journal Entry:
Cash a/c Dr. 490
Discount allowed a/c Dr. 10
To Rajan a/c 500
(Being cash received from Rajan in full settlement of his account)

5.7 Errors and their Rectification

An error is an unintentionally committed mistake. When the Trial Balance
does not tally it is a clear indication that there are some errors in the
preparation of accounts. The errors may be committed at various stages –
 Journalizing,
 Posting,
 Casting (totaling),
 Balancing,
 Transferring to trial balance and so on.
Mere tallying of the trial balance does not ensure an error free statement.
There are certain errors such as errors of omission, error of principle and
compensating errors are not disclosed by trial balance while errors of
casting, posting to wrong side of an account or posting a wrong amount can
be detected by trial balance.
Errors whether disclosed or not disclosed by trial balance, have to be
corrected or rectified in order to obtain the correct picture of profit or loss. It
should be remembered that errors will have their impact not only on profit
but also on the asset and liability position of the business organization.
Self Assessment Questions:
11. Errors can be committed at all stages, beginning from journal entries,
posting of entries in ledger accounts, while balancing the closing
balances etc. (True / False).
12. Errors of omission, error of principle and compensating errors are not
disclosed by trial balance (True / False).
13. Errors of casting, posting to wrong side of an account or posting a
wrong amount etc can be detected by trial balance (True / False).

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5.8 Errors disclosed by Trial Balance

Those errors that can be disclosed by trial balance can easily be located. As
soon as the trial balance does not tally, the accountant can proceed to find
out the spots where the errors might have been committed. The total
amount of difference in the trial balance is temporarily transferred to a
‘Suspense Account’ so that it can be mitigated as and when the errors get
rectified. Therefore the suspense account gets debited or credited as the
case may be on rectification of these types of errors. The following are the
errors which are disclosed by trial balance:
a) Posting a wrong amount: This mistake may occur while posting an
entry from subsidiary book to ledger.

Example: Cash received from Rama Rs1150 is posted to

Rama’s ledger account as Rs.1500, while it is correctly recorded
in cash account.
RAMA’S ACCOUNT
By cash a/c 1500

Wrong amount

Rectification entry
Rama’s account Dr Rs. 350
To suspense account Rs.350
Being excess credit given to Rama’s account rectified

b) Posting to the wrong side of an account: This error is committed

while posting entries from subsidiary books to ledger.

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Example: Sales made to Krishna Rs.5000 is transferred to credit

side of the Krishna’s account in the ledger.

KRISHNA’S ACCOUNT
By sales a/c 5000

Rectification entry:
Krishna’s account Dr Rs.10000
To Suspense account Rs.10000
Being excess in Krishna’s account rectified

c) Wrong Totaling: Both under casting and over casting are detected by
trial balance. If any account is wrongly totaled, it gets reflected in the trial
balance.

Example: Purchases book total is Rs.5800. If it totaled as Rs.5700

or Rs. 5900, the difference will be shown in the trial balance.

PURCHASE BOOK TRIAL BALANCE

Debit Credit
ABC ltd xxxx Cash xxx
MNC ltd xxxx Sales xxxx
PQR ltd xxxx Purchase 5700

Total 5800
WRONG
AMOUNT

d) Omitting to post an entry from subsidiary book to ledger: If an entry

made in the subsidiary book does not get posted to ledger, the trial
balance does not tally.

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Example: Rent paid Rs.2000 recorded in cash account but is not

posted to rent account at all.
RENT ACCOUNT
To cash a/c 2000

Omitted

Rectification Entry:
Rent a/c Dr. 2000
To Suspense a/c 2000
Being the error of omitting to post rent paid in rent account
rectified.

e) Omission of an account altogether from being shown in trial

balance:

Example: Advertisement account which shows a debit balance is

completely omitted from trial balance.

ADVERTISEMENT ACCOUNT
To cash a/c xxxx By balance c/d xxxx

Total xxxx Total xxxx

To balance b/d xxxx
TRIAL BALANCE
Particulars Debit Credit
Advertisement
Omitted

Rectification entry:
Advertisement expense a/c Dr
To Suspense a/c
Being debit balance in advertisement account accounted.

f) Posting an amount to a correct account more than once: This result

in imbalance in the trial balance.
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Example: Receipt from Sundry Debtors of Rs.50000 was accounted

twice in Sundry Debtors account.

SUNDRY DEBTORS A/C

By cash a/c 50000
By cash a/c 50000

ENTERED
TWICE

Rectification Entry:
Suspense a/c Dr 5000
To Sundry Debtors a/c 5000
Being excess debit in Sundry debtors account rectified.

g) Posting an item to the same side of two different ledger accounts: If

two accounts are debited /credited for the same transaction, this type of
error occurs.
Example: Furniture purchased should be debited to furniture
account only. If it is posted to furniture account and purchases
account, then the difference arises in the trial balance.

FURNITURE ACCOUNT
By cash a/c xxxxx

PURCHASE ACCOUNT
By cash a/c xxxxx

Omitted

Rectification entry:
Suspense a/c Dr. xxxxx
To Purchase a/c xxxxx
Being wrong debit given to purchase account rectified

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Self Assessment Questions:

14. Suspense account is the difference between debit total and credit total
of a trial balance. (True / false).
15. Suspense account is created temporarily and later, it is removed as
and when errors are detected and suitable rectified (True / False).
16. If amount paid to Rama Rs 500 is credited to Ramanan accounts, what
type of error has occurred and give the rectification entry.
17. Instead of putting Rs. 1500 to debit of wages account, Rs 15000 is
recorded. Identify the type of error and tell what impact it has on profit?
18. Refer Q.No.17. How do you rectify the above error?

Activity 1
1. Telephone expenses of Rs 2500 is entered in cash account
but not posted to ledger. How do your rectify?
2. Interest paid on loan of Rs. 2116 wrongly posted twice in the
interest account once as Rs 2611 and second time as
Rs. 2161. How do you rectify this transaction?

5.9 Errors not disclosed by Trial Balance

There are four errors regarded as those which do not affect trial balance and
it is difficult to locate them. A brief description of the four errors is offered in
the following paragraphs:
a) Error of omission: Error of omission occurs when a transaction is
completely omitted from the books of accounts.

Example: If purchase of goods from Jairam on credit is not

recorded at all either in the general journal or in the purchases
book, it is termed as error of omission.
PURCHASE BOOK PURCHASE ACCOUNT
Date Suppl LF Inv Rs. To
iers’ No. Jairam xxx
name
Jairam

Omitted Omitted

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Since both aspects – debit and credit – of the transaction are missing,
the trial balance is not affected at all. To rectify such errors, the
transaction should be recorded when it is traced.
b) Error of commission: If the error of wrong posting, wrong casting,
wrong calculation etc., committed in the books of original entry or ledger,
it is said to be error commission.

Example: Purchase invoice of Rs.1730 may have been entered as

Rs.1370 in the purchases book itself, then, in the subsequent
ledger accounts the same mistake continues and thereby cannot be
disclosed by trial balance.
The difference of Rs.360 (1730-1370) should be added to
purchases account and to the respective supplier’s account.

PURCHASE BOOK PURCHASE ACCOUNT

Date Suppl L Inv Rs. To
iers’ F No. xxx 1370
name
XXX 1370

Correct
Correct
amount is
amount is
Rs.1730
Rs.1730

The error can be detected only when the original invoice is

referred to after getting the complaint from the supplier.

Rectification entry:
Purchase a/c Dr. 360
To Supplier a/c 360
Being deficit amount added to rectify the account.

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c) Error of principle: While drawing journal entries, often error of principle

is committed and this goes unnoticed because it does not affect the total
of trial balance.

Example:
Wages paid to workers
engaged in the construction
of building????

 Wages paid to workers engaged in the construction of building

should be debited to building account but not wages account.
 If the building account is debited, the value of the asset
appears in the balance sheet and the expenditure is actually
capitalized.
 In case the wages are treated as usual revenue expenditure,
they are deducted from profit.
 The error here is wages account is debited and not building
account.
Rectification Entry:
Building a/c Dr
To Wages a/c
Being wrong debit given to wages account rectified.

Similarly, treating incomes as liabilities, providing insufficient provision

for bad and doubtful debts, inadequate depreciation against assets etc.,
come under errors of principle. They must be rectified by applying the
correct principles of accounting.
d) Compensating errors: It is also called off-setting error. Compensating
error is one which is counter balanced by another error.

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Example:
 Mr. X account was debited for Rs.100 as against Rs.1000 while the
account of Mrs X account was debited Rs.1000 against the correct
amount of Rs.100.
 The first error is compensated by the second error and therefore the trial
balance is not affected. This comes to light only at a later stage or on
receipt of the complaint.

Mr. X account Mrs. X account

Dr Cr Dr Cr
To cash 100 To cash 1000

Instead of Rs.1000 Instead of Rs.100

Rectification entry:
Mr. X account Dr 900
To Mrs. X account 900
Being deficit amount debited in Mr. X account and excess amount
debited in Mrs. X account rectified.

Self Assessment Questions:

19. If error of wrong posting, wrong casting, wrong calculation are
committed in the books of original entry or secondary books, such
errors are called ________.
20. Error of commission affects trial balance (True / False).
21. Furniture purchased for cash Rs 5000/- is not recorded in journal.
Mention the type of error?
22. Error of omission can be detected only after a careful review of ledger
balances of previous years (True / False).
23. Error of principle affects the value of revenue and capital items (True /
False).
24. It is very difficult to find out the compensating errors. (True / False).

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5.10 Steps to locate the Errors

The following steps help to locate the errors. In spite of the efforts, if the
difference in the trial balance persists, a suspense account may be created
and subsequently the suspense account can be eliminated as and when the
errors are located and rectification is made.

 Check the totals of both debit side and credit side of the trial balance.
 Check the totals of debtors and creditors accounts
 Find out whether all ledger balances are carried to trial balance
 Verify the totals of all the ledger accounts.
 Divide the amount of difference in the trial balance by 2 and see if
any item of the debit or credit side, equal to that amount has been
posted to the opposite side.
 Check whether the opening balances are brought down correctly
from the previous accounting period
 Make a comparison with trial balance of the previous year to find out
if there are any items missing.
 Where the difference in the trial balance is divisible by 9 then the
difference is likely to be due to misplacement of figures like 12 for 21;
24 for 42; 36 for 63 and so on.

When errors are located, they should be rectified. It is not a good practice
nor do we have the legal right to erase the mistakes and re write the correct
ones. Rectification entries are recorded in General journal or journal proper.
Self Assessment Questions:
25. Summary of all ledger balances is called _____________________ .
26. Trial balance is necessary to prepare
_________________________ .
27. The broad two categories of errors are a) ________________
b) ____________.
28. Is casting error, an error of principle or error of commission?
29. Purchase of machinery is included in the purchases book. What type
of error is it?
30. What is error of omission? Illustrate.
31. What are the errors that cannot be disclosed by trial balance?
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32. The sum of errors in accounting is transferred temporarily to

_________ account.
33. In which journal do you make rectification entries?
34. State any four steps to locate errors.
35. If sales account is under cast by Rs. 45, what is the rectification
entry?
36. Returns inwards book is over cast by Rs. 9, write the rectification
entry.
37. Salary paid to Gopal is debited to his personal account. What is the
rectification entry to correct the error?
38. Discount received Rs. 50 is transferred to the debit side of discount
account. Write the rectification entry.
39. An invoice of purchase for Rs. 760 is entered as Rs. 670. What type
of error is this? How to rectify this error?
Illustration 1
An accountant finds that the trial balance of his client did not tally and it
showed an excess credit of Rs. 69.74. He transferred it to a suspense
account and later discovered the following errors.
a) Rs. 44.37 paid to Anand has been credited to his account as Rs. 34.37.
b) A purchase of Rs. 145.50 has been posted as Rs. 154.50 to the
purchases account
c) An expenditure of Rs. 158 on repairs has been debited to the Buildings
account
d) Rs. 80 was allowed by B as discount which has not been entered in the
books.
e) A sum of Rs.125.05 realized on the sale of old furniture has been posted
to the sales account.
Give journal entries to rectify the errors and show the suspense account as
it would appear after adjustments.

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Solution
Date Particulars LF Debit Credit (Rs.)
(Rs.)
1 Anand’s account Dr 78.74
To suspense account 78.74
(Being wrong amount,
wrongly credited to
Anand’s a/c rectified)
2 Suspense account Dr 9.00
To Purchases account
(Being over debit of 9.00
purchase a/c rectified)

3 Repairs account Dr 158.00

To Buildings account 158.00
(Being wrong debit given
to building account
rectified)
4 80.00
B’s account Dr
To Discount received a/c 80.00
(Being discount received
from B, omitted earlier,
brought to account)
5. Sales account Dr 125.05
To old furniture account
(Being sale of old 125.05
furniture wrongly
transferred to sales
account rectified)

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Suspense Account
Amount Amount
Date Particulars Date Particulars
Rs. Rs.
To Difference in By Anand’s 78.74
trial balance 69.74 a/c
To Purchases
a/c 9.00
78.74 78.74
Note:
1. The entry should have been:

Anand a/c Dr. 44.37

To Cash a/c 44.37
Being cash paid to Anand accounted

When amount is paid to Anand, his account should have been debited.
On the other hand, his account was credited for a wrong amount of
Rs.34.37. Hence there has been excess credit to the extent of Rs.78.74
(44.37 + 34.37). To rectify this double error we need to debit Anand’s
account to the extent of Rs.78.74 and credit suspense account.
2. Purchases account was over debited by Rs.9 (Rs.154.50 – Rs.145.50).
To rectify this error we need to credit purchase account to the extent of
Rs.9 and debit suspense account.
3. Repairs spent on building are, by mistake debited to building account.
This is error of principle. Repairs account is debited and buildings
account is credited to rectify the error.
4. Discount received from B has not been taken to records. This is an error
of omission. Therefore, it is now brought to accounts. This has not
affected the trial balance.
5. When old furniture is sold, the furniture account should have been
credited. On the other hand, sales account was credited against to the
principle of accounting. To rectify the error, sales account is debited and
old furniture account is credited.

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Illustration 2
The trial balance of Evergreen Co Ltd., taken out as on 31st December,
2002 did not tally and the difference was carried to suspense account. The
following errors were detected subsequently.
a) Sales book total for November was under cast by Rs1200.
b) Purchase of new equipment costing Rs.9475 has been posted to
Purchases A/c.
c) Discount received Rs.1250 and discount allowed Rs.850 in September
2002 have been posted to wrong sides of discount account
d) A cheque received from Mr Longford for Rs.1500 for goods sold to him
on credit earlier, though entered correctly in the cash book has been
posted in his account as Rs.1050
e) Stocks worth Rs.255 taken for use of Mr Dayananda, the Managing
Director, has been entered in sales day book.
f) While carrying forward, the total in Returns Inwards Book has been
taken as Rs.674 instead of Rs.647.
g) An amount paid to cashier, Mr. Ramachandra, Rs.775 as salary for
November month has been debited to his personal account as Rs757.
h) Pass journal entries and draw up the suspense account.
Solution
Journal Proper of Evergreen Co Ltd.,
Date Particulars LF Debit Credit
Rs. Rs.
31-12-2002 Suspense account Dr 1,200
To Sales account 1,200
(Being under casting of sales
book rectified)
31-12-2002 New Equipment account Dr 9,475
To Purchases account 9,475
(Being wrong debit given to
purchases account rectified)
31-12-2002 Discount allowed account Dr 1,700
Suspense account Dr 800
To Discount received a/c
(Being discount received and 2,500
discount allowed posted to

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Financial and Management Accounting Unit 5

wrong sides of discount

account rectified)
31-12-2002 Suspense account Dr 450
To Longford account
(Being short credit given to 450
Longford rectified)
31-12-2002 Sales account Dr 255
To suspense account
(Being stock used for 255
personal purpose wrongly
credited to sales account
rectified)
31-12-2002 Suspense account Dr 27
To Returns Inwards account 27
(Being excess debit given to
returns inwards account to the
extent of Rs27, now rectified)
31-12-2002 Salary account Dr 775
To Ramachandra ‘s a/c 757
To Suspense a/c 18
(Being the wrong debit of
salary to the personal account
of Ramachandra now
rectified)
Note:
In Q. No.(c): Discount received Rs.1250 is posted on the wrong side of
discount account. Discount received (income) should be credited and
discount allowed (expenses) should be debited. Instead of crediting the
discount received account, it has been wrong debited. To rectify this error,
we need to credit discount received account to the extent of Rs.2500
(Rs.1250+ Rs.1250).
In the same context, discount allowed which is an expense should be
debited instead, it is credited. To rectify the error, we need to debit discount
allowed to the extent of Rs. 1700 (850 +850). The difference between

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discount received and discount allowed account is transferred to suspense

account.
Dr SUSPENSE ACCOUNT Cr
Amount Amount
Particulars Particulars
Rs. Rs.
To sales account 1,200 By Sales 255
To Discount received a/c 800 By Salary 18
To Longford 450 By balance 2,204
To Returns Inwards a/c 27 c/d
Total 2,477 Total 2,477

5.11 Summary
Trial Balance is a list of debit and credit totals or a list of debit and credit
balances of all the ledger accounts prepared on any particular date to verify
whether the entries in books of accounts are authentically correct. As the
primary and secondary books are maintained on the double entry concept,
the balances in the trial balance must tally.
Totals method and Balance method are the two techniques of preparing trial
balance. In the first method, the totals of debits and credits of every account
are shown in the trial balance.
Financial Accounting uses accrual basis of accounting which is supported
by GAAP. Under accrual basis of accounting revenues are recognized when
earned without regard to the timings of cash receipts. Expenses are
recognized either in the period in which related revenues are recognized or
when incurred without regard to the timings of cash disbursement

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5.12 Terminal Questions

1. Prepare a trial balance from the following:
Amount Amount
Particulars Particulars
Rs. Rs.
Drawings 10,000 Interest on 200
investments
Stock on 1-1-92 46,000 Sundry Debtors 36000
Purchases 1,50,200 Sundry Creditors 29,000
Purchases return 600 Wages 25,000
Cash in hand 3400 Salaries 14,000
Bank Balance 22660 Capital 1,14,000
Freehold expenses 38600 Income tax 1600
Trade expenses 840 Discount allowed 6300
Printing Stationery 1640 Discount received 4600
& advertisement
Professional 280 Sales 2,08,950
charges
Commission 3300 Sales return 550
received
Investments as on 4000 Bills receivable 3200
1st Jan @ 10%
Office furniture 3050 Bills payable 10000
Rent rates and 4000 Provision for bad 670
insurance debts
Total 371320 Total 371320
2. The following Trial balance was extracted from the books Chetan, a
small businessman. Do you think that it is correct? If not, rewrite it in the
correct form.
Debits Rs. Credits Rs.
Stock 8250 Capital 10000
Purchases 12750 Sales 15900
Returns outwards 700 Returns inwards 1590
Discount received 800 Discount allowed 800
Wages and salaries 2500 Scooty 1750

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Rent and rates 1850 Carriage charges 700

Sundry debtors 7600 Sundry Creditors 7250
Bank Overdraft 2450 Bills payable 690
1. Rectify the following errors:
a. Purchases from Padma Rs.191 posted to her account as Rs.119
b. Purchases from Lata credited to her account as Rs.117
c. Salaries Rs.400 posted to salaries account as Rs.300
d. A cash sales of Rs.430 to Rita posted as Rs.43

5.13 Answers to SAQ’s and TQ’s

SAQ:
1. True
2. Capital
3. Goodwill
4. Opening entry:

20X1 Cash in Hand Dr 1,000

April 1 Cash at Bank Dr 5,000
Stock Dr 20,000
Land and Building Dr 1,00,000
Plant and Machinery Dr 50,000
Furniture & Fixtures Dr 25,000
X Ltd Dr 12,500
Prepaid Insurance Dr 500
To Interest received in advance 250
To Loan from Y Ltd 10,000
To Z Ltd 3,750
To Bharat’s Capital a/c 2,00,000
(Being the balance brought forward
from last year)

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5. True
6. Trading 25. Trial balance.
7. Trade expenses 26. final accounts
8. No 27. Error that are disclosed by
9. True trial balance and those
which cannot be disclosed
10. by trial balance.
a. Depreciation a/c Dr 28. Error of commission.
To Building account 29. Error of principle.
b. Closing stock A/c Dr 30. Omitting completely a
To Trading A/c transaction from books of
c. Pre-paid Insurance a/c Dr original entry. Sales made
to Raghu of Rs 12000
To insurance A/c completely ignored.
d. Salaries A/c 31. Error of omission,
To outstanding salaries commission, principle,
account. compensating error.
e. Drawings A/c Dr 32. Suspense account.
To stock account 33. Journal proper
11. True 34. Four steps to locate the
12. True errors
13. True  Check the total of both
sides of trial balance,
14. True
 Total debtors & creditors
15. True accounts,
16. It is a wrong posting and hence  Verify whether balancing
it is errors of commission is done correctly,
Rama’s a/c Dr 500  Check the totals of ledger
Ramanan’s a/c Dr 500 balances etc.
To Suspense a/c 1000 35. Suspense a/c Dr. 45
(Being amount paid to Rama To Sales a/c 45
wrongly credited to Ramanan’s Being sales account which
account rectified) was under cast rectified
17. Posting of wrong amount - Trial 36. Suspense a/c Dr.9
balance is affected. Profit
To Return Inward a/c 9
(gross) is reduced by Rs 13500.
Being returned inward book
which was over cast
rectified.
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18. Suspense a/c Dr. 13,500 37. Salary a/c Dr.

To Wages a/c 13,500 To Gopal a/c
(Being excess debit to wages Being wrong debit given to
account rectified) Gopal rectified
19. Error of commission 38. Suspense a/c Dr. Rs.100
20. False To Discount received a/c
21. Error of omission Rs.100
22. True Being wrong posting in
discount received a/c
23.True rectified.
24. True 39. This is an error of
Commission. By checking the
original invoice document, it
can be rectified.
Purchase a/c Dr Rs.90
To Creditors a/c Rs.90
Being wrong posting in purchase
book rectified.

Terminal Question Answers:

1. Trial balance total – 371320
2. Trial balance total – 37790
Suspense a/c Dr.72 Salary a/c Dr 100
To Padma’s a/c 72 To Suspense a/c 100
Being wrong posting in Padma’s a/c Being salary amount debited by
rectified. additional amount
Suspense a/c Dr. 54 Suspense a/c Dr 387
To Lata’s a/c 54 To Sales a/c 387
Being wrong posting in Lata’s a/c Being entry in sales account
rectified rectified.

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Activity 1 Solution
Telephone Expense a/c Dr To rectify the first posting the entry is:
2500 Suspense a/c Dr.495
To Suspense a/c To Interest paid a/c 495
2500
Being excess debit (2611-2116) in interest
(Being telephone expenses a/c rectified.
omitted in ledger accounted)
To rectify the second posting the entry
is:
Suspense a/c Dr.2161
To Interest paid a/c 2161
Being excess debit in interest paid a/c
rectified.
The two entries can be clubbed as:
Suspense a/c Dr.2656
To Interest paid a/c 2656
Being excess debit in interest paid a/c
(495 + 2161) rectified.

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Unit 6 Final Accounts

Structure:
6.1 Introduction
6.2 Adjustments before preparing final accounts
6.3 Depreciation
6.4 Bad Debts and accounting treatment of bad debts
6.5 Provision for doubtful debts
6.6 Reserves for Discount on Debtors
6.7 Reserve for Discount on Creditors
6.8 Closing Stock
6.9 Trading Account
6.10 Profit and Loss Account
6.11 Balance Sheet
6.12 Summary
6.13 Terminal Questions
6.14 Answers

6.1 Introduction
The previous chapter has provided a bird’s eye view of the methods of
preparing trial balance, different types of errors and the rectification process.
Trial Balance is a statement of debit balances and credit balances that are
extracted from ledger accounts. This unit deals with matters relating to
adjustments before the preparation of final accounts, depreciation methods,
preparation and presentation of Final accounts covering both trading and
corporate enterprise.
Financial statement encompasses two vital statements – the position
statement reflecting the assets, liabilities and capital of a business entity on
a particular date called the Balance Sheet, and the other called the Profit
and Loss account showing the results of business operations during the
given period. Corporate financial statements should conform to the
Companies Act 1956 requirements. The Balance sheet of a company should
be presented in accordance with Part 1 of Schedule VI of the Companies
Act.

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Objectives:
After studying this unit, you should be able to:
1. Incorporate such transactions left out and various adjustments with
regard to transactions taking place after the trial balance but relating to
the current period.
2. Incorporate adjustments such as Reserve for bad debts, Reserve for
discounts on Debtors, Reserve for discount on Creditors, bad debts out
side the trial balance.
3. Incorporate adjustments relating to prepaid expenses, outstanding
expenses, pre-received incomes, outstanding incomes etc.
5. Prepare Trading, Profit and Loss account and Balance Sheet of both
trading companies and corporate entities.

6.2 Adjustments before preparing final accounts

The Generally Accepted Accounting Principles (GAAP) supports the accrual
basis of accounting according to which revenue is recognized when it is
earned and expenses are recognized when they are incurred irrespective of
their actual receipt or actual payment. In the accrual basis of accounting
adjustment entries are prepared at the end of the period to record any
changes in assets, liabilities, revenue incomes and revenue expenses.
Adjusting entries are regarded as internal transactions.
A. Outstanding Expenses
Expenses yet to be paid or outstanding expenses for the current period
should be charged against the current period’s income. The extent to which
the amount belongs to the current year but payable in the next year is called
outstanding expenses.
 Salaries outstanding (March 20XX month salary paid in April 20XX)
 Rent outstanding

Salaries a/c Dr
To outstanding salaries a/c
Being salaries for the month of March 20XX due but not
yet paid accounted.

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Prepaid Expenses
Expenses paid in advance or prepaid expenses should be not be charged
against the revenues relating to the current period but taken to the coming
period. Prepaid expenses form an asset and therefore prepaid expenses
account is debited.
 Salaries paid in advance
 Insurance paid in advance
 Rent paid in advance
Example: insurance premium is paid from April, 2004 to March, 2005 and
the amount is Rs.3600. The accounting year of the firm ends on 31st
December, 2004. Therefore the premium relating to Jan, Feb and Mar of
2005 amounting to Rs.900 is said to have been paid in advance. To record
this internal adjustment, the entry is

Prepaid Expenses account Dr 900

To Insurance account 900
Being insurance premium for Jan, Feb and March 2005
paid in advance accounted

B. Income received in advance

Income received in advance that does not belong to the current period
should not be considered.
 Rent received in advance
Example: Rent received for one year from 1-4-2005 to 31-3-2006
Rs.48000. Accounts are finalized on 31-12-2005. Therefore rent
received for January, February and March of 2006 is said to have been
received in advance Rs.12000. The entry is

Rent received account Dr 12000

To Rent received in advance a/c 12000
Being rent received in advance accounted

C. Accrued Income
Accrued income is also called outstanding income. Income yet to be
received for the current period should be considered as income for the

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current period whether actually received in cash or not. Outstanding income

account is a personal account and it represents an asset.
 Interest accrued but not received
Example: Interest accrued on Fixed Deposit of Rs 200000 at 12% simple
interest on 31-12-2006, not yet received. The entry is

Outstanding interest a/c Dr. 24000

To Interest a/c 24000
Being interest accrued but not received accounted.

Self Assessment Questions:

1. Expenses due but not yet paid are known as ______
2. Prepaid expenses appear on the asset side of balance sheet. (State
True / False).
3. Income earned but not received is called ____________.
4. Any income received in advance is a liability (state True / False)
5. Advertisement expenses outstanding for the year ending March 2005 is
Rs.5000. Give the journal entry

6.3 Depreciation
Depreciation is reduction in the value of an asset due to constant use of the
same, which is called wear and tear. Fixed assets like, buildings, plant,
machinery, furniture etc., are subject to depreciation. Whenever, an asset is
depreciated, its value goes down and therefore it is a loss to the
organization.
Depreciation account is debited and the concerned asset account is
credited. The item of depreciation may appear in the trial balance, which
means that already the concerned asset is reduced by the amount of
depreciation. If depreciation is given as an additional adjustment, then the
depreciation amount should be charged against profit and loss account on
one hand and the concerned asset account is reduced on the other hand in
the balance sheet.
There are two popular methods of depreciation:
 Fixed installment method (Straight line method)
 Reducing balance method (Written down value method).

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In fixed installment method, depreciation is calculated on cost of the asset.

The depreciation charged remains same throughout the life of the asset. In
case of reducing balance method (Diminishing balance method), the
depreciation is charged on the reducing balance of the book value of the
asset. The depreciation amount gets reduced year after year during the life
of the asset. Reducing balance method is more popular and well
recognized.
Example: The book value of the building is Rs.400000. It is depreciated at
10% on fixed installment method. Show the journal entry and how does it
appear in the balance sheet for the first and second year under both the
methods.

Depreciation account Dr 40,000

To Building account 40,000
Being depreciation amount accounted for.

1. Depreciation charged for the first year under straight line and
reducing balance method.
BALANCE SHEET as on ______
Liabilities Assets
Building 400000
Less 10% 3,60,000
Depreciation 40000

During the first year the depreciation charged is similar under both the
methods.
2. Depreciation for the second year under:

Straight line method Reducing balance method

BALANCE SHEET BALANCE SHEET

ASSET SIDE ASSET SIDE

Building 3,60,000 Building 3,60,000
Less 10% Less 10%
SLM 40,000 Depreciation 36,000
(10% of 4,00,000) 3,20,000 (10% of 3,60,000) 3,24,000

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Self Assessment Questions:

6. Depreciation is for __________ of an asset.
7. What entry is drawn if furniture costing Rs.50000 is depreciated at 5%
under straight line method?
8. Calculate the depreciation amount charged for the second year under
written down or reducing balance method for Plant and Machinery
costing Rs.7,50,000. The depreciation rate is 10%.

6.4 Bad Debts

Bad debts are those debts which are not recovered. Bad debts form loss to
the business and reduce the amount of debtors.

Bad debts a/c Dr

To Sundry Debtors a/c
Being bad debts accounted for.

Since bad debts are losses, they are debited and the debtor’s account is
credited. If bad debts are recovered, cash account is debited and bad debts
recovered account is credited.
Accounting treatment of Bad debts:
A. If bad debts are identified and shown in trial balance:

TRIAL BALANCE PROFIT AND LOSS A/C

Dr Cr
Particulars Dr Cr
To Bad Debts xxx By …
Bad Debts xxx xxx
[If Bad debts appear in Trial
Balance only one entry is required
in P&L account. No further
adjustment in required in the
Balance Sheet]

B. If bad debts are shown outside the trial balance:

This denotes bad debts that they were identified after the preparation of
Trial Balance. Two adjustments should be incorporated.

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Example: The sundry debtors for the year 2005 are Rs.50000. The bad
debts amounted to Rs.4000 as on 31-12-2005 already shown in the trail
balance. Write off further bad debts Rs.5000. Show how the above internal
adjustments appear in the Profit and loss account and Balance Sheet.
Solution
 Bad debts shown in the trial balance is Rs.4000 and not shown in the
trial balance is Rs.5000. To incorporate those bad debts not yet shown
in the trial balance, the adjusting entry is

Bad debts account Dr 5000

To Debtor’s account 5000
Being additional bad debts accounted

Profit and Loss a/c ……. BALANCE SHEET as on…

Dr ASSETS
Bad debts S. debtors 50000
(old ) 4000 (-) Bad debts 5000 45000
+ New 5000 9000 (new)
Old denotes bad debts that
appeared in the T.B and new
denotes that bad debts that
were identified after the
preparation of Trial Balance.

Self Assessment Questions:

9. Unrecovered debts are called ______.
10. Bad debts are not expenses but they incur loss to the firm. (state True /
false)
11. If bad debts are recovered, what entry can be drawn?

6.5 Provision for Doubtful Debts

Debts that cannot be recovered are called bad debts. Debts that are
doubtful in recovery are called doubtful debts. From the past experience of
the business proprietor, what percentage of good debts may become bad in
future can be estimated and in the current year an equal amount of profit is
set aside. This provision is also known as Reserve for Bad Debts or

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Provision for Doubtful Debts or Reserve for Doubtful Debts. Since the
provision for bad debts is a charge against current year profit the adjusting
entry is

Profit and Loss Account Dr

To Provision for bad debts account
Being provision for bad debts accounted

Provision for bad debts is a liability to be incurred in future and so it should

appear on the liability side of balance sheet. However, the convention is -
RBD (Reserve for Bad and Doubtful Debts) is deducted from the amount of
good debtors. The important note here is that RBD is computed as a
percentage of good debts, which means total debtors minus bad debts
unadjusted.
Provision for bad and doubtful debts is a running account and every year the
amount keeps on changing because from the provision made in the current
year, bad debts occurring in the following year have to be adjusted and
additional amount of provision to be made is calculated.

The amount to be charged against profits in P&L A/C is :

B+N–O
 B stands for bad debts;
 N stands for new provision and
 O stands for old reserve

Illustration 1:
On 1st January 2006, the RBD account stood at Rs.9000 in the books of a
merchant. The bad debts written off during the year ended 31st December,
2006 amounted to Rs.4800 and Sundry Debtors stood at Rs.480000. It was
desired to maintain the reserve for bad debts at 5% on Debtors. During the
year 2007 bad debts written off amounted to Rs.12000 and sundry debtors
on 31st December 2007 amounted to Rs.380000. As usual 5% reserve was
required. Show the journal entries for recording the above transactions and
write up the bad debts reserve account.

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Solution
Journal Entries
Debit Credit
Date Particulars LF
Rs. Rs.
2006 Bad debts account Dr 4800
st
Dec, 31 To Sundry Debtors Account 4800
(Being the bad debts written off)

st
Dec, 31 Bad Debts Reserve account Dr 4800
To Bad Debts account 4800
(Being bad debts set off against RBD)
Profit and Loss Account Dr
st
Dec 31 To Bad Debts Reserve account 19800
(Being additional RBD made to bring 19800
the reserve to 5% of 480000)
Bad debts account Dr
To Sundry Debtors account 12000
2007 (Being bad debts written off ) 12000
st
Dec, 31
Bad debts Reserve account Dr
st
To bad debts account
Dec 31 12000 12000
(Being bad debts written off against
RBD)
Profit and loss Account Dr
To Bad debts reserve account
Dec 31st 7000
(Being additional RBD made to bring
7000
the reserve to 5% of 380000)

PROFIT AND LOSS ACCOUNT for the year 2006

Bad debts 4800
+New reserve 24000
(5%of 480000)
-Old reserve (9000) 19800

Additional reserve required to be provided in P&L a./c in 2006 is Rs19800

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PROFIT AND LOSS ACCOUNT for the year 2007

Bad debts 12000
+New reserve 19000
(5%of 380000)
-Old reserve (24000) 7000

Additional reserve required to be provided in P&L a./c in 2006 is

Rs. 7000
Reserve for Bad Debts Account
Dr Cr
Amount Amount
Date Particulars JF Date Particulars JF
Rs. Rs.
2006 2006
st st
Dec, 31 To bad debts 4800 Jan, 1 By Balance 9000
To balance c/d 24000 Dec 31st b/d 19800
By P&L A/C
Total 28800 Total 28800
2007 2007 By balance b/d 24000
st
Dec,31st To bad debts 12000 Jan 1
To balance c/d 19000 Dec 31st By P&L A/C 7000
Total 31000 Total 31000

Self Assessment Questions:

12. What is the difference between Bad debts and doubtful debts?
13. Provision for Doubtful debts is a charge against the profits of the firm
(state True / False )
14. Bad debts incurred in the subsequent period are written off against
reserve for bad debts (state True / False).
15. Give the journal entry for writing off of bad debts against RBD?

6.6 Reserves for Discount on Debtors

There are two types of discounts allowed to customers in a business. One is
trade discount and the other is cash discount. After anticipating the amount
of cash discount allowable, a provision is made in the current year itself. In
the subsequent years, the actual discount allowed is set off against the

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provision for discount on debtors. Every year, the amount of provision for
discount on debtors is deducted from the profits.
The entry for making the provision is
Profit and Loss Account Dr
To Provision for discount on debtors account
Being provision for discount on debtors accounted

The following guide lines may be kept in mind while dealing with the
reserve for discount on debtors
1. If a reserve for discount on debtors do not exist and cash discount is
allowed then transfer the discount to P&L account.
2. Any fresh reserve for discount on debtors is to be made, debit the P&L
Account with the amount of reserve.
3. If provision for discount on debtors exists at the time of providing
discount, then write off the discount from the provision already made
for the purpose.
4. New provision should then be calculated and only as much as required
to bring the existing provision to the new figure should be debited to
P&L Account.
5. If the new provision required is lower than the provision already existing
(old), then the difference shows profit and transfer the same to P&L
Account.
Illustration 2: The following items are found in the trial balance of
M/s Sharada Enterprise on 31st December 2000.
Sundry Debtors Rs. 160000
Bad Debts written off 9000
Discount allowed to Debtors 1800
Reserve for Bad and doubtful Debts 31-12-1999 16500
Reserve for discount on Debtors 31-12-1999 3200

You are required to provide for the bad and doubtful debts at 5% and for
discount on debtors at 2%. Give necessary journal entries and show bad
debts account, bad debts reserve account, discount account and provision
for discount on debtors account.

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Solution
Date Particulars L.F Debit Credit
31.12.2000 RBD a/c 9000
Dr 9000
To Bad debt a/c
Being bad debts written off against
existing reserve
-do- P&L a/c 500
Dr 500
To RBD a/c
Being addition to RBD to make the
new RBD equal to 5% of 160000
-do- Reserve for discount on debtors a/c 1800
Dr 1800
To Discount on Debtors a/c
Being discount on debtors written
off against reserve for discount on
debtors
-do- P&L a/c 1640
Dr 1640
To Reserve for discount on debtors
a/c
Being additional reserve made to
make the new reserve at 2% on
152000

NOTE:
1. The amount debited to P&L Account towards RBD is computed as
follows
Old RBD = Rs. 16500
(-) Bad debts = 9000
Balance = 7500
New RBD @5% on160000 = 8000
RBD to be provided = 500 (8000-7500)

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2. The amount debited to P&L Account towards Reserve for Discount on

Debtors is computed as follows:
Good Debtors = 160000 – 8000 (New RBD)=152000
Old Res for Dis On Drs = Rs. 3200
Less Discount on Drs = 1800
Balance Reserve = 1400
New Res for Disc at 2%
On good drs 152000 = 3040
Res for Discount to be
Provided now = 1640 (3040 -1400)
Bad Debts Account
Amount Amount
Date Particulars JF Date Particulars JF
Rs. Rs.
2000 2000
st
Dec, 31 To Sundry debtors Dec 31st By RBD 9000
account 9000 account

Total 9000 Total 9000

Reserve for Bad Debts Account

Particulars JF Amount Date Particulars JF Amount
Date Rs. Rs.
2000 2000
st st
Dec, 31 To bad debts 9000 Jan, 1 By Balance 16500
To balance c/d 8000 Dec 31st b/d 500
By P&L A/C
Total 17000 Total 17000

Discount on Debtors Account

Amount Amount
Date Particulars JF Date Particulars JF
Rs. Rs.
2000 2000
st
Dec, 31 To Sundry debtors Dec 31st By Reserve
account 1800 for Discount 1800
on Debtors
A/C
Total 1800 Total 1800

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Reserve for Discount on Debtors Account

Amount Amount
Particulars JF Date Particulars JF
Date Rs. Rs.
2000 2000
st st
Dec, 31 To Discount on 1800 Jan, 1 By Balance 3200
Debtors 3040 Dec 31st b/d 1640
To balance c/d By P&L A/C
Total 4840 Total 4840

In the balance sheet, the Sundry debtors are reduced by bad debts shown
out side the trial balance, the new RBD, discount on debtors shown out side
the trial balance and the new Reserve for discount on debtors.

6.7 Reserves for Discount on Creditors

Just as reserve is for discount on debtors is created, reserve for discount on
creditors is also created. Businessman expects that he would receive
discounts from suppliers (creditors), when the businessman remits cash to
them. Anticipating some percentage of creditors being received as discount
in the coming year, the business proprietor makes a provision for the
expected income in the current year itself. Discount on creditors is an
income and therefore reserve for discount on creditors is debited and profit
and loss account is credited to show it as anticipated profit. In the
subsequent year, when discount on creditors is actually received, it is first
set of against provision for discount on creditors and the difference between
the new provision for discount on creditors and the balance of old provision
left over is carried to P&L Account.

Discount on creditors is income and to that extent the creditors due is

reduced. So the journal entry to record them is

Creditor’s account Dr
To discount on creditors account
Being discount on creditors accounted

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If the discount received is adjusted against reserve for discount on creditors,

the entry will be
Discount on creditor’s account Dr
To Reserve for discount on creditors
Being discount on creditor adjusted against reserve for
discount on creditors

When provision for discount on creditors is made in P&L Account, the entry
is

Reserve for discount on creditors account Dr

To Profit and loss account
Being reserve for discount on creditors charged to
P&L account

The amount of provision for discount on creditors is calculated at a

percentage on creditors. In the balance sheet, creditors are shown after
deducting reserve for discount on creditors.

6.8 Closing Stock

Stock of goods – raw materials, semi finished goods, finished goods – at the
end of the accounting year should be considered for preparing trading
account and balance sheet. It is an internal adjustment. Closing stock is
normally valued at cost or market price which ever is lower, even though
there are several other methods to value stock. Closing stock does not
appear in the trial balance because the value of it is ascertained only after
the preparation of trial balance. To bring to the records, a journal entry is
passed in journal proper by debiting closing stock account and crediting
trading account. In the balance sheet, closing stock appears as an asset.
Self Assessment Questions:
16. Provision for Discount on Debtors is a charge against P & L a/c. (State
True or False)
17. Provision for discount on debtors appears as a liability in the Balance
Sheet (State true/false)
18. Discount on creditors is an item of income (State True / false ).
19. Provision for discount on creditors is shown as an anticipated income
(State True/False).
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20. What is the entry for adjusting the closing stock?

21. Closing stock always appears as an asset in balance sheet (State
true/false)

6.9 Trading Account

Trading account shows gross profit or gross loss arising out of trading
activities. Trade means buying and selling. The account mainly focuses on
finding the result of goods bought and goods sold. For every expense
outstanding and prepaid aspects must be considered. The excess of credit
over debit is gross profit and excess of debit over credit is termed as gross
loss. The gross profit or gross loss is transferred to Profit and Loss Account.
The format of a Trading Account is given below:
To prepare Trading Account, the following steps may be followed:
a) Identify the items of expenses relating to trading and show them on the
debit side of Trading Account.
b) Effect the adjustments such as outstanding or prepaid to the relevant
items of expenses
c) Show the sales less returns and closing stock on the credit side of
trading account
d) The difference is gross profit if credit total is more than debit and gross
loss if debit total is more than credit.
e) Transfer the gross profit or gross los to Profit and Loss Account as the
case may be.
Dr Trading Account for the year ending- - - - Cr
Particulars Rs. Particulars Rs.
To opening stock By sales
To Purchases Less returns inwards/sales
returns
Less Purchase By Closing stock
returns/returns outwards
To Carriage inwards
To freight and octroi
To wages
Add outstanding wages
Less prepaid wages

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To fuel and power

To Gas, coal, electricity for
production
To Import duty and clearing
charges
To stores consumed
To factory rent, insurance,
factory expenses
To other direct expenses
To Royalty paid
To Profit and Loss A/c
(Gross Profit)

Illustration 3: From the following balances extracted from Trial balance,

prepare Trading Account. The closing stock at the end of the period is
Rs. 56000
Particulars Amount in Rs.
Stock on 1-1-2004 70700
Returns inwards 3000
Returns outwards 3000
Purchases 102000
Debtors 56000
Creditors 45000
Carriage inwards 5000
Carriage outwards 4000
Import duty on materials received from abroad 6000
Clearing charges 7000
Rent of business shop 12000
Royalty paid to extract materials 10000
Fire insurance on stock 2000
Wages paid to workers 8000
Office salaries 10000
Cash discount 1000
Gas, electricity and water 4000
Sales 250000

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Dr TRADING ACCOUNT FOR THE YEAR ENDING - - - - Cr

Particulars Rs Particulars Rs
To stock on 1-1-2004 70700
To Purchases 102000 By sales 250000
(-) Returns (-) Returns
Outwards 3000 99000 Inwards 3000 247000
To Carriage inwards 5000 By Closing stock 56000
To import duty 6000
To Clearing charges 7000
To Royalty 10000
To Fire Insurance 2000
To Wages 8000
To Gas, electricity, water 4000
To Gross Profit 91300
Total 303000 Total 303000

6.10 Profit and Loss Account

Profit and loss account is an important final account that reveals the net
result of the business in the form of net profit or net loss. All revenue
receipts are those which are received regularly arising out of day to day
activities of the business and all revenue payments, which are known as
expenses are incurred regularly are recorded in profit and loss account. Any
capital receipts or capital payments are not considered while preparing profit
and loss account.
The following steps may help to prepare Profit and Loss Account
1. Identify the expenses and bring them to debit side of P&L Account
2. Identify the revenue incomes and put them on the credit side of P&L
Account
3. Check whether all adjustments like outstanding, prepaid, pre received
expenses and incomes as the case may be are brought to the account
4. Check the transfer of reserves to the relevant sides of the account
5. Transfer the net profit / net loss to the capital account

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Dr Profit and Loss Account for the year ending --- Cr

Particulars Rs Particulars Rs
To Trading Account (GL) By Trading account (GP)
To Salaries + Out standing – By Interest earned + Accrued
Prepaid salaries as per interest as per adjustments
adjustments
To Rent of the premises By Commission earned
To Travelling expenses By discount earned
To Rates and Taxes By Rent received
To Printing and stationery By Bad debts recovered
To Postage and Telegram By Interest on drawings
To Telephone charges By Reserve for discount on
Creditors
To Insurance – Prepaid By Dividends received
amount as per adjustment
To Interest paid By Royalty Received
To Discount allowed By Capital Account (Net
Loss)
To Sundry expenses
To Advertisement
To Commission
To Carriage outwards
To Bad Debts
To Reserve for Bad debts
To Reserve for discount on
Debtors
To Depreciation
To Legal charges
To Audit fee
To Interest on Capital
To Capital Account
(Net Profit)

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Illustration 4: The following Trial Balance is extracted from the books of a

merchant on 31-12-2004.

Furniture and fittings 640 Bank Over Draft 2850

Motor Vehicles 6250 Sales Returns 200
Buildings 7500 Purchase Returns 125
Capital Account 12500 Advertising 450
Bad Debts 125 Interest on Bank Over Draft 118
Provision for Bad debts 200 Commission 375
Sundry Debtors 3800 Cash 650
Sundry Creditors 2500 Taxes and Insurance 1250
Stock on 1-1-2004 3460 General Expenses 782
Purchases 5475 Salaries 3300
Sales 15450

The following adjustments are to be made:

1. Stock in hand on 31-12-2004 was Rs.3250
2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and
Motor Vehicles @ 20%.
3. Rs.85 is due for interest on bank overdraft.
4. Salaries of Rs300 and taxes Rs.120 are outstanding.
5. Insurance amounting to Rs.100 is prepaid
6. One-third of the commission received is in respect of work to be done
next year
7. Write off a further sum of Rs.100 as bad debts and provision for bad and
doubtful debts to be made equal to 10% on sundry debtors.
8. Prepare Trading Account and Profit and Loss Account.

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Trading and Profit and Loss Account for the year ending 31-12-2004
Particulars Rs Particulars Rs
To Stock on1-1-2004 3460
To Purchases 5475 By Sales 15450
Less returns 125 5350 Les Returns 200 15250

To Gross Profit 9690 By Closing Stock 3250

Total 18500 Total 18500
To Salaries 3300 By Gross Profit 9690
(+) Outstanding 300 3600 By Commission 375
To Advertising 450 (-) Received in adv 125 250
To Interest on OD 118
(+) O/s Interest 85 203
To Taxes & Insurance 1250
(+) O/s tax 120
( - ) Prepaid Insurance (100) 1270
To General expenses 782
To Bad debts 125
(+) New RBD 370
(-) Old RBD balance (100) 395
To Depreciation:
On building @ 5% 375
On Fur & Fix @ 10 % 64
On M Vehicles @20% 1250 1689
To Net Profit 1551
Total 9940 Total 9940

6.11 Balance Sheet

Corporate financial statement is financial statements / annual accounts of
corporate enterprises that are prepared in conformity with the Companies
Act 1956. Section 209 of the companies Act requires that every company
should keep at its registered office proper books of accounts.
Section 210 of the Companies Act stipulates that at every annual general
meeting of a company, the Board of Directors should lay (a) a balance sheet

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as at the end of the period and (b) a profit and loss account for the period
(financial year).
Section 211 requires that every balance sheet of a company should provide
a true and fair view of the state of affairs of a company as at the end of the
financial year and it should be set out in the form prescribed in Part 1 of
Schedule VI of the Companies Act 1956.
Section 215 of the Act requires that every balance sheet and P&L account
duly approved by the Board of Directors should be signed on behalf of the
Board of Directors of a company by its managers or secretary, if any, and at
least two directors one of whom should be a managing director, if any.
Section 216 of the Act requires that the profit and loss account of a
company is annexed to the balance sheet and the auditor’s report including
separate, special or supplementary report if any.

VERTICAL FORM OF BALANCE SHEET

Schedule Figures as at Figures as at
No. the end of the end of
current financial previous
year financial year
I. Sources of Funds:
(1) Shareholders funds
a) Capital
b) Reserves and Surplus
(2) Loan funds
a) Secured loans
b) Unsecured loans
TOTAL :
II. Applications of Funds:
(1) Fixed assets
a) Gross block
b) Less depreciation
c) Net block
d) Capital work-in-progress
(2) Investments
(3) Current assets, loans, and
advances:
a) Inventories
b) Sundry debtors

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c) Cash and bank balances

d) Other current assets
e) Loans and advances
Less : current liabilities and
provisions:
a) Liabilities
b) Provisions
c) Current assets
(4) a) Miscellaneous
expenditure to the extent
not written off or adjusted
b) Profit and Loss account
TOTAL :

Share Capital
Share capital refers to the capital raised by a company by the issue of share
in a company is one of the units into which the total capital of the company
is divided.
Preference Share Capital
Preference share capital is that part of share capital of a company which
carries preferential right in respect of both dividend payment and repayment
of capital.
Equity Share Capital
All share capitals which are not preference share capital are equity share
capital. In other words, holders of equity share capital can get dividend only
after it is paid to preference shareholders.
Authorized Share Capital
It is the maximum amount of the equity share capital and preference share
capital the company can rise in its life time.
Issued Capital
It is that part of the equity and preference share capital which has been
actually issued by the company for cash and for considerations other than
cash
Subscribed Capital
It refers to that part of the equity and preference share capital which has
been actually allotted by the company.

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Called-up Capital
It refers to that part of the allotted capital which has been called-up by the
company and the part which has not been called-up is the uncalled capital.
Paid – up Capital
It refers to the amount released on the called-up capital and it is equal to the
called-up capital minus unpaid calls.
Activity 1:
Pick out a balance sheet of a manufacturing company and list out
various types of capital, assets and liabilities.

Illustration 5: From the following trial balance of Anjana Machineries

Limited and additional information, prepare final accounts of the company as
per schedule VI of the Companies Act.
TRIAL BALANCE as on 31st March 2008
Particular Amount Particular Amount
Opening stock- Raw 1,50,000 Sales 47,50,000
materials
- Work-in-process 28,000 General reserve 25,000
- Finished goods 1,90,000 Provision for dep on P& M 1,40,000
Purchases 15,50,000 Sundry creditors 1,35,000
Salaries and wages 2,30,000 Provision for dep on 30,000
furniture
Plant & machinery (at cost) 12,20,000 Purchases returns 25,000
Investment at cost (short 3,29,000 Eq share capital (Rs. 100 30,00,000
term) each)
Sundry debtors 1,58,000 10% Pref Sh.Cap 5,00,000
(Rs 100/each)
Cash at bank 2,50,900 9% Debentures 6,00,000
Directors remuneration 80,000 Deb Redemption Reserve 3,00,000
Interim dividend 1,20,000 Bills payable 90,000
Office furniture (at cost) 1,80,000 Securities premium 2,80,000
Rates and taxes 17,000 Income from investments 30,000
Insurance 15,000 Excise duty payable 15,000
Audit fee 30,000 Profit and loss 20,000

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Sales return 70,000

Excise duty on finished 3,20,000
goods
Rent 90,000
Rent prepaid 20,000
Bad debts 18,000
Interest on debentures 27,000
Freehold premises 47,30,000
Other expenses 37,100
Bills receivable 30,000
Preliminary expenses 50,000
Total 99,40,000 Total 99,40,000

Additional information:
1. Stock as at March 31,2008
Raw materials and stores Rs. 1,45,000; Work-in-process, Rs. 22,000;
Finished goods, Rs. 1,98,000.
2. Provide depreciation on written down value basis on plant and
machinery @ 20 per cent per annum and on furniture @ 15 per cent
annum and on freehold premises @ 5 per cent per annum
3. In the middle of the year machine costing Rs. 3,00,000 was purchased
and duly recorded
4. Sundry debtors include Rs. 18,000 due for more than six months.
Provide for bad and doubtful debts @ 5 per cent on debtors.
5. Market value of investments is Rs. 3,19,000
6. Make a provision for income-tax @ 35 per cent
7. Corporate dividend tax is 14.025 per cent including surcharge of 10 per
cent and education cess of 2 per cent.
8. The Board of Directors has recommended a final dividend @ 15 per
cent on equity shares.
9. Transfer Rs. 1,00,000 to debenture redemption reserve.
10. Transfer minimum amount to statutory reserve as required by company
law.
11. Provision for depreciation on freehold premises as in 31/03/2007 was
Rs. 12,70,000.
12. Write of 1/5th of preliminary expenses
13. Interest on debentures becomes due on October 31 and March 31.

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Solution
Profit and Loss Account for the year ended March 31, 2008
Particular Rs Amount Particular Amount
To opening stock By sales 47,50,000
Work-in-process 28,000 (-) excise duty 3,20,000
Finished goods 1,90,000 2,18,000 (-)sales return 70,000 43,60,000
To Raw material
consumed By income from 30,000
Opening stock of RM 1,50,000 invt
Add purchases 15,50,000 By cl.stock 1,98,000
(-) purchase returns 25,000 Fin goods 22,000 2,20,000
(-) closing stock of RM 1,45,000 15,30,000 W-I-P

To Salaries & wages 2,30,000

To Director’s remun 80,000
To Rates and taxes 17,000
To Insurance 15,000
To Audit fees 30,000
To Rent 90,000
To Bad debts 18,000
To Prov for bad debt 7,900
To Interest on debenture
(+) interest due 27,000
To depreciation on 27,000 54,000
Plant & Machinery 20%
Office furniture 15%
2,14,000
Freehold premises 5%
22,500
2,36,500 4,73,000
To other expenses
To Loss on investment 37,100
To Pre expenses written 10,000
off
10,000
To Provision for income-
tax 6,26,500
To Net profit

11,63,500
46,10,000 46,10,000

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PROFIT AND LOSS APPROPRIATION ACCOUNT

Particular Amount Particular Amount

To interim divided 1,20,000 By Balance b/d

To Prop dividend – 4,50,000 By Net profit 20,000
equity 50,000 5,00,000 (transfer from profit 11,63,500
- Preference and loss)

To corporate 16,830
dividend tax payable
(50, 000 x
14.025%) 70,125

To Provision for 1,00,000

Corp Div Tax
(14.025% of Rs.
5,00,000) 58,175

To Debenture 3,18,370
redemption reserve
To General reserve
11,83,500
(5% of Rs.
11,63,500)
To Balance c/d 11,83,500

BALANCE SHEET OF ANJANA MACHINERIES AS AT MARCH 31, 2008

Particular Amount Particular Amount
Share capital -- Fixed Assets:
Authorized capital Freehold premises
Issued & subscribed (-) Prov for Dep 60,00,000
capital
15,06,500 44,93,500
P & M at cost
30,000 Equity shares 30,00,000 (+) purchased
of Rs. 100 each fully
paid up (-) Prov for Depr 9,20,000
5000 10% Pref shares ( 1,40,000 + 3,00,000
of 5,00,000 2,14,000)
Rs. 100 each fully paid Furniture- cost
( 3,54,000) 8,66,000
Reserves and Surplus (-) Prov for Dep
Securities premium 30,000 +22,500
1,80,000
Debentures Red res 2,80,000
(+) transfer from 3,00,000 Investments at market 1,27,500
P&La/c value 52,500
1,00,000 4,00,000
C.A, Loans &

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General reserve Advances:

(+) statutory transfer 25,000 C. Assets 3,19,000
58,175 83,175 Stock
Profit and loss Raw material
3,18,370 Work-in-process
Secured Loans: Finished goods
9% Debentures 1,45,000
Interest on 6,00,000 Debtors 22,000
debentures 27,000 (-) Prov for bad debts 1,98,000 3,65,000
Debts duemore than 6
Unsecured Loans: mths
1,58,000
Cur Lia & Other debts
(7,900) 1,50,100
Provisions Cash at bank
Current liabilities Loans & Adv
Bills payable 18,000
Bills receivable
90,000
Sundry creditors Prepaid rent
1,35,000 1,40,000
Excise duty payable
15,000 2,50,900
Corp div tax payable Misc Exps
16,830
Pre expenses
Provisions: 30,000
(-) written off
20,000 50,000
Provision for
corporate dividend 70,125
tax 6,26,500
4,50,000
Provision for tax
50,000 50,000
Prop div on Eq capital 5,00,000 40,000
10,000
Prop div on pref
capital
66,62,000 66,62,000

6.12 Summary
The Generally Accepted Accounting Principles (GAAP) supports the accrual
basis of accounting according to which revenue is recognized when it is
earned and expenses are recognized when they are incurred irrespective of
their actual receipt or actual payment. Outstanding expenses yet to be paid
or outstanding expenses for the current period should be charged against
the current period’s income.
Prepaid expenses paid in advance or prepaid expenses should be not be
charged against the revenues relating to the current period but taken to the
coming period. Depreciation is reduction in the value of an asset due to
constant use of the same, which is called wear and tear. Fixed assets like,
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buildings, plant, machinery, furniture etc., are subject to depreciation.

Whenever, an asset is depreciated, its value goes down and therefore it is a
loss to the organization.
Corporate financial statement is financial statements / annual accounts of
corporate enterprises that are prepared in conformity with the Companies
Act 1956. Section 209 of the companies Act requires that every company
should keep at its registered office proper books of accounts.

6.13 Terminal Questions

1. Explain the meaning of Depreciation. Mention the different types of
depreciation.
2. What is Bad debts? Mention the accounting treatment of bad debts
3. What is Provision for Doubtful Debts?
4. What are the guidelines that deal with reserve for discount on debtors?
5. Explain reserve for discount on creditors with suitable examples.

6.14 Answer to SAQ’s and TQ’s

1. Outstanding expenses 12. Bad debts are totally not
2. True recoverable, doubtful debts
3. Accrued or Outstanding income may be recovered.
4. True 13. True
5. Advertisement expenses a/c Dr 14. True
To Outstanding Advertisement 15. Reserve for Bad debts a/c Dr
expenses a/c To Bad debts a/c
6. Wear and Tear 16. True
7. Depreciation a/c Dr.2500 17. True
To Furniture a/c 2500 18. True
Being furniture depreciated 19. True
8. (7,50,000-75,000) = 6,75,000 x 20. Closing stock a/c Dr
10% = 67,500 To Trading a/c
9. Bad debts 21. True
10. True
11. Cash a/c
To Bad debts recovered a/c

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Answer for Terminal Question:

1. Refer Unit 6.3
2. Refer Unit 6.4
3. Refer Unit 6.5
4. Refer Unit 6.6
5. Refer Unit 6.7

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Unit 7 Introduction to Management Accounting

Structure:
7.1 Introduction
7.2 Meaning of Management accounting
7.3 The Role of Management Accounting
7.4 Management Accounting Framework
7.5 Functions of Management Accounting
7.6 Tools of Management Accounting
7.7 The Balanced Scorecard
7.8 Cost Management System
7.9 Value Added Concept
7.10 Merits of Management Accounting
7.11 Demerits of Management Accounting
7.12 Distinction between Management Accounting and Financial
Accounting
7.13 Summary
7.14 Terminal Questions
7.15 Answers to SAQ’s and TQ’s

7.1 Introduction
The origins of modern management accounting can be traced to 19th
century enterprises like textile mills, family owned business etc. These
enterprises were formed as a single large organization wherein different
processes were performed taking advantage of the economies of scale.
Slowly a need was felt to measure the efficiency of the internal production
processes. Typically for textile mill, the internal measure could be cost per
yard, and for a fertilizer unit it may be cost per tonne of fertilizer
Management accounting system plays a vital note in helping the managers
to plan & control their operation. A good management accounting system
may not guarantee competitive success if the firm does not have good
products, efficient operating process, effective marketing & sales activities.

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Objectives:
After studying this unit, you should be able to:
1. Explain the meaning of Management Accounting
2. Explain the strategic role of management accounting in the present day
setup.
3. Describe the functions of management accounting
4. State the tools of management accounting
5. Know the balance score card, Cost management system and value
added concept
6. Identify the differences between management accounting and financial
accounting.

7.2 Meaning
Managerial accounting is the process of identifying, measuring, analyzing,
interpreting and communicating information in pursuit of an organization’s
goal. Managerial accounting is an integral part of the management process.
Management accountants have taken leadership roles; act as trusted
advisor and transformed into strategic business partner for the valuable
contribution they provide.
The American Accounting association has defined Management Accounting
as ‘the application of appropriate techniques and concepts in processing
historical and projected economic data of an entity to assist management in
establishing plans for reasonable economic objectives in the making of
rational decisions with a view towards achieving these objectives.
Management Accounting is the presentation of accounting information in
such a way as to assist management in the creation of policy and in the day-
to-day operations of an undertaking.

7.3 The Role of Management Accounting

Management accounting information serves several major roles. One of the
most important types of management accounting information is cost
information. Firms use cost information to make important product features
and product mix decision. Also organizations use appropriate cost
information to improve efforts on activities that are major contributors to
cost.
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The accounting people are expected to do things that are much more
strategic and forward looking. Nowadays managerial accountants serve as
internal business consultants involving in all areas of business. They take on
leadership roles on their teams and are sought out for the valuable
information they provide. The role of the accountants in leading edge
companies has been transformed from number cruncher and financial
historian to being business partner and trusted advisor. Another important
transformation is the role it plays in strategic management highlighted in
Balanced Score Card and Value Chain.
Management accountants add value to an organization by pursuing five
major objectives:
1. Providing information for decision making and planning and proactively
participating as part of the management team in decision making and
planning processes. This includes budget preparation on projected
revenues and costs.
2. Assisting managers in directing and controlling operational activities.
Managerial accounting information often assists management through
its attention-directing function. However managerial accounting
information often directs managers’ attention to an issue that requires
their skills.
3. Motivating managers and other employees towards the organization’s
goals. Organizations have goals and organization comprise people who
have goals of their own. The goals of individuals are diverse and they do
not always match those of the organization. The main purpose of
managerial accounting is to motivate managers and other employees to
direct their efforts with the help of budgeting.
4. Measuring the performance of activities, subunits, managers and other
employees within the organization. Such measurements can be used as
the basis for rewarding performance through positive feedback,
promotions and pay raises.
5. Assessing the organization’s competitive position due to ever changing
business environment. These changes are reflected in global
competition, fast changing technology, improved communication system
etc.

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Organization’s competitive position is determined by how well it is doing

from customer’s perspective. Secondly how the organization is performing
its internal operations and business processes. Thirdly how well is it in
research and development? Does it provide a platform for learning,
continuous improvements and adaptation to new technology. Finally it
assesses the financial health in terms of liquidity, ability to raise finance,
viability and future growth.

Self Assessment Questions:

1. Management accountants have transformed from mere cost
information providers to _______________________
2. Management accountants facilitate in budget preparation on projected
______
3. Management accountants assess organization’s _______________that
arise due to changing business environment.
4. Competitive position of a firm is determined by how well it provides a
platform for __________, ___________________ and adaptation to
new technology.

7.4 Management Accounting Framework

For offering accounting and financial advice as well as for capitalizing the
available opportunities for future development, it is necessary that an
effective frame must be designed. The management accountant must
organize the whole accounting division in such a way that there is prompt
and immediate recording of the entire information flow into the department
from functional and service department. The frame must concentrate on.
 Getting rid of routine work
 Reporting actual and planned performance
 Fixing organizational responsibilities
 Application of new modern and modified practices of analyzing and
interpreting results.
 Designing of sound and efficient organization taking into account the
native and size of the business unit.

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7.5 Functions of Management Accounting

Management accounting functions may be said to include collecting,
processing, interpreting and presenting information to management.
Management Accounting serves as a vital source of data for management
planning. The data thus collected are properly complied and classified. The
accounting data is then analyzed meaningfully for effective planning and
decision making through comparative statements. It provides a means for
communicating management plans upward, downward and at lateral levels.
It helps in translating given objectives and strategies into specified goals for
attainment by a specified time and secures effective accomplishment of
these goals in an effective manner. More specifically, it provides invaluable
service to the management at every stage of functioning. Major functions
are:
Forecasting and Planning: Short and long term forecasts are very
essential. Planning the future operations of a business is crucial. This
includes profit planning, programmes of capital investment and financing,
sales forecast, expense budget and cost standards.
Controlling Performance: The management accounting is very helpful in
controlling the financial performance of the organization through comparing
actual performance with operating plans and standards and to report and
interpret the results of operations to all levels of management.
Coordinating: Management accountant consults various departments and
is responsible for policy decisions. Coordination increases the efficiency of
an organization.
Other functions: Management accounting serves in a number of other
ways. It supplies useful information to different functional authorities. It
provides accounting information and advice for price determination and
pricing decisions. It also helps in making certain strategic decisions,
decisions regarding seasonal or temporary suspension of production, make
or buy decisions, replacement decisions etc.
Self Assessment Questions:
5. Management Accounting serves as a vital source of data for
management _________.

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6. It provides a means for communicating management plans ______,

__________and at _________levels.
7. The management accounting is very helpful in controlling the financial
performance of the organization through comparing actual performance
with __________________.

7.6 Tools of Management Accounting

Management Accounting uses the following tools or techniques to fulfill its
responsibilities and duties towards management.
 Financial Statement Analysis
 Funds Flow Analysis
 Cash Flow Analysis
 Costing Techniques that includes marginal costing, differential costing,
standard costing, and responsibility costing
 Budgetary control
 Management Reporting.
Financial Statements are indicators of two significant factors that include
profitability and financial soundness. Analysis and interpretation of financial
statements enables full diagnosis of the profitability and financial soundness
of the firm. Analysis means methodical classification of the data given in the
financial statements. Methodical classification enables comparison of the
various inter-connected figures with each other. Interpretation explains the
meaning and significance of the data.
Funds Flow Analysis is an important tool for management accountant. It
reveals the changes in working capital position, the sources from which the
working capital was obtained and the purpose for which it was used. It also
reveals the changes that have taken place behind the Balance Sheet.
Cash Flow Statement identifies the sources and application of cash. It is
prepared on the basis of actual or estimated data. It depicts the changes in
the cash position from one period to another. A projected cash flow or a
cash budget will help the management in ascertaining how much cash will
be available to meet obligations to trade creditors, to pay bank loans and to
pay dividends to the shareholders.

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Standard Costing is the preparation and use of standard costs, their

comparison with actual costs and the analysis of variance. It discloses the
cost of deviations from standards. It aims at assessing the cost of a product,
process or operation under standard operating conditions.
Budgetary Control has become an essential tool of management for
controlling costs and to maximize profit. It helps to compare the current
performance with pre-planned performance thereby correcting the
deviations if any.
Management Reporting System is an organized method of providing each
manager with all the data and only those data which he needs for his
decisions, when he needs them and in a form which aids his understanding
and stimulates his action.
Self Assessment Questions:
8. ______________ is the preparation and use of standard costs, their
comparison with actual costs and the analysis of variance.
9. ___________ will help the management in ascertaining how much
cash will be available to meet obligations to trade creditors, to pay bank
loans and to pay dividends to the shareholders.
10. ______________________reveals the changes in working capital
position, the sources from which the working capital was obtained and
the purpose for which it was used.
11. ____________ means methodical classification of the data given in the
financial statements.
12. __________________helps to compare the current performance with
pre-planned performance thereby correcting the deviations if any

7.7 The Balanced scorecard

The Balanced Score Card is a framework for integrating measures derived
from strategy. While retaining financial measures of past performance, the
Balanced Score Card introduces the drivers of future financial performance.
(Figure 1) The drivers (customer, internal business process, learning &
growth perspectives) are derived from the organization's strategy translated
into objectives and measures.

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The Balanced Score Card is more than a measurement system it can be

used as an organizing framework for their management processes. The real
power of the Balanced Score Card is when it is transformed from a
measurement system to a management system. It fills the void that exists in
most management systems - the lack of a systematic process to implement
and obtain feedback about strategy

Financial Perspective
To satisfy our customers To succeed financially
how Should we appear
Goals Measures what business
processes To our owners?
must we excel ?

Customer Perspective Internal Operations Perspective

Goals Measures Goals Measures

To achieve our
Vision how should we
Appear to our customers?

Innovation and Learning Perspective

Goals Measures
To achieve our vision how will we sustain our ability to Innovate, learn and improve?

In India few noted organizations have adopted Balanced Score Card

successfully. The commercial vehicles business unit (CVBU) of Tata Motors
was among the first Asian organizations to be inducted into the prestigious
Balanced Scorecard Hall of Fame, in recognition of its exemplary success
with the model. The company is one of the world's top 10 truck
manufacturers and the CVBU began deployment of Balanced Scorecard in

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2000, in an attempt to remedy years of poor financial performance. The

focus was on achieving a turnaround, and then progressing to sustainable
growth. Within 2 years of implementation, the company began to show
tangible improvement in performance including a 40% growth in revenue.
The implementation of the Balanced Scorecard has enabled them to focus
on different elements of operational performance. Defining, cascading and
communicating strategies across the organization have brought about
transparency and alignment. The scorecard incorporates SQDCM (Safety,
Quality, Delivery, Cost and Morale) and VMCDR (Volume, Market Share,
Customer Satisfaction, Dealer Satisfaction and Receivables).

7.8 Cost Management System

The explosion in technology we are experiencing, coupled with increasing
worldwide competition is forcing managers to produce high quality goods
and services, provide outstanding customer service and do so at the lowest
possible cost. Many companies have moved away from a historical cost
accounting perspective and toward a proactive cost management
perspective. A cost management system is a management planning and
control system with the following objectives.
1. To measure the cost of the resources consumed in performing the
organization’s significant activities
2. To identify and eliminate non-value added costs. These are the costs of
activities that can be eliminated with no deterioration of product quality,
performance or perceived value.
3. To determine the efficiency and effectiveness of all major activities
performed in the enterprises.
4. To identify and evaluate new activities that can improve the future
performance of the organization.

7.9 Value Added Concept

Value added concept is a performance measure and it reports the wealth
generated by a business undertaking over a period of time. According to
ICAI, the term value added refers to ‘the increase in value of a product or
service resulting from an alteration in the form, location or availability
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excluding the cost of bought out materials and services’ It is calculated by

deducting the value of goods and services purchased from sales revenue. It
is a versatile measure for evaluating the performance and efficiency of a
firm because value added measure caters all concerned parties viz.,
owners, workers, government, lenders etc.
Value added Statement is based on ‘enterprise theory’ rather than ‘entity
theory’. Enterprise theory encompasses everyone unlike entity theory which
focuses on owners or shareholders of the firm.
Self Assessment Questions:
13. _____________is a performance measure and it reports the wealth
generated by a business undertaking over a period of time
14. ____________________identify and eliminate non-value added costs
15. The drivers of Balanced Score Card are ___________,
_________________,___________________ and
_____________________

7.10 Merits of Management Accounting

Merits
1. Efficient planning and organization which are the end product of the
system of management accounting bring systematic regularity in the
business activities.
2. Maximum return on capital employed is ensured by the use of
management accounting because it helps in the functions of planning,
coordination and control
3. Better and improved services by management to customers are assured
by this system.
4. Management accounting removes unacceptable standards or sub-
standards.
5. Industrial relations may be improved by adoption of management
accounting principles.
6. Eliminations of various types of wastages, production defectives and
other related work deficiencies are removed with the help of
management accounting.
7. Economic uplift of community and development of nation’s economy can
be achieved by the use of management accounting.
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7.11 Demerits of Management Accounting

1. Most of the information used in Management accounting is derived from
financial accounting records or cost accounting records other records.
As such fairness and accuracy of decisions deduced depends to a
greater extent upon fairness and accuracy of these original records.
2. Decisions or conclusions derived are insignificant unless properly
executed at all levels of business operations.
3. Management accounting is a mere tool for management. It cannot
substitute for financial accounting.
4. The evolution has been on account of inter-alia development of new
theories in other sciences. Hence there is a need to have a
comprehensive knowledge and understanding of all these related
disciplines to derive the full advantage.
5. Management accounting is still in its evolutionary stage. Hence, there is
an uncertainty in its use.
6. The installation of management accounting is a costly affair and as such
it has very limited scope for its use.

7.12 Distinction between Management Accounting and Financial

Accounting
Financial accounting is the preparation and communication of financial
information to outsiders such as creditors, bankers, government, customers
and so on. Another objective of financial accounting is to give complete
picture of the enterprise to shareholders. Management accounting on the
other hand aims at preparing and reporting the financial data to the
management on regular basis. Management is entrusted with the
responsibility of taking appropriate decisions, planning, performance
evaluation, control, management of costs, cost determination etc., For both
financial accounting and management accounting the financial data is the
same and the reports prepared in financial accounting are also used in
management accounting But the following are major differences between
Financial accounting and Management accounting.

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Financial accounting Management accounting

 The primary users of financial  Top, middle and lower level
accounting information are managers use the information for
shareholders, creditors, planning and decision making
government authorities,
employees etc.,
 Accounting information is always  Management accounting may
expressed in terms of money adopt any measurement unit like
labour hours, machine hours or
product units for the purpose of
analysis
 Financial data is presented for a  Reports are prepared on
definite period, say one year or a continuous basis, monthly or
quarter weekly or even daily
 Financial accounting focuses on  Management accounting is
historical data oriented towards future
 Financial accounting is a  Management accounting makes
discipline by itself and has its use of other disciplines like
own principles, policies and economics, management,
conventions information system, operation
research etc.,

Self Assessment Questions:

16. Management accounting aims at preparing and reporting financial data
to _____________.
17. Management accounting is oriented towards ______
18. In ____________financial data is presented for a definite period, say
one year or a quarter
19. __________accounting may adopt any measurement unit like labour
hours, machine hours or product units for the purpose of analysis

7.13 Summary
Management Accounting is the presentation of accounting information in
such a way as to assist management in the creation of policy and in the day-
to-day operations of an undertaking.
The accounting people are expected to do things that are much more
strategic and forward looking. Nowadays managerial accountants serve as
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internal business consultants involving in all areas of business. They take on

leadership roles on their teams and are sought out for the valuable
information they provide. The role of the accountants in leading edge
companies has been transformed from number cruncher and financial
historian to being business partner and trusted advisor.
The tools of Management Accounting are financial statement analysis, funds
flow analysis, cash flow analysis, budgetary control, Management Reporting
system.
The Balanced Score Card is a framework for integrating measures derived
from strategy.
A cost management system is a management planning and control system
Value added concept is a performance measure and it reports the wealth
generated by a business undertaking over a period of time.

7.14 Terminal Questions

1. Briefly explain the role of Management Accounting.
2. Describe the functions of Management Accounting.
3. Explain the tools of Management Accounting.
4. What is Balanced Score Card?
5. What is Cash Management System?
6. Distinguish between Management Accounting and Financial Accounting
7. What is Valued added concept?

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7.15 Answer for SAQ’s and TQ’s

SAQ 1:
1. Strategic Business Partner 13. Value added concept
2. Revenues and Costs 14. Cost Management System
3. Competitive Position 15. Customer, internal business
4. Learning, continuous process, learning, growth
improvement perspective
5. Planning 16. Management
6. Upward, downward, lateral 17. Future
7. Operating plans & standards 18. Financial Accounting
8. Standard costing 19. Management
9. Cash budget
10. Funds Flow statement
11. Analysis
12. Budgetary Control

Answer for Terminal Questions:

1. Refer to unit 7.3
2. Refer to unit 7.5
3. Refer to unit 7.6
4. Refer to unit 7.7
5. Refer to unit 7.8
6. Refer to unit 7.12
7. Refer to unit 7.9.

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Unit 8 Financial Statement Analysis

Structure:
8.1 Introduction
Objectives
8.2 Meaning of Ratio
8.3 Steps in Ratio Analysis
8.4 Classification of Ratios
8.5 Du Pont Chart
8.6 Solved Problems
8.7 Advantages of Ratio Analysis
8.8 Limitation of Ratio analysis
8.9 Summary
8.10 Terminal Question
8.11 Answers to SAQs and TQs

8.1 Introduction
“Every fact that is learned becomes a key to other facts” – E.Y. Youmans.
Based on this, this unit deals with analysis of financial statements, the
functions of which is to identify and highlight the firm‟s strengths and
weaknesses. The objective of ratio analysis is to provide with the financial
information necessary to make financial decisions.
Objectives:
After completing this unit, you should be able to:
1. Explain the meaning, various forms of ratio analysis and its role in
comparative analysis
2. Describe the steps involved in ratio analysis
3. Explain the classification of ratios
4. Calculate various ratios from Balance Sheet and Income Statement
5. Derive balance sheet items using various ratios

8.2 Meaning of Ratio

Absolute numbers tell very little. Assume that two companies A and B,
operating within the same industry submit the information:

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Company A Company B
NET PROFIT 10000 100000
One can easily say that Company B makes the most profit. But which
company is most profitable? The answer for this will naturally call for further
additional information relating to profit such as size of the company, the total
sales it generates or to how much capital is invested in it. Hence, an
assessment or a judgment is made based on making some sort of
comparison. Extending the example
Company A Company B
NET PROFIT 10000 100000
SALES 200000 500000
NET WORTH (CAPITAL RESERVE) 100000 200000
If net profit is compared with Sales, an assessment can be made on which
company generates the most net profit per Re.1 received from customers.
Return on Capital Employed:
Company A Company B
Net Profit / Sales * 100 5% 20 %
Net Profit / Net Worth * 100 10 % 25%
Ratio can be expressed in the following three forms:
1. As proportion
2. As percentage
3. As turnover rate
Simple or pure ratio is merely a quotient arrived by simple division of one
number by another. When the current assets of a business firm are Rs.
60,000 and current liabilities is Rs. 15,000
 The ratio is derived by dividing Rs. 60,000 by Rs. 15,000. It will be
expressed as 4:1
 Ratios are expressed as percentage relations when the simple or pure
ratios are multiplied by 100. (4 x 100 = 400 %)
 Ratios are expressed as rates which refer to ratios over a period of time.
Example: Stock has turned over 6 times a year
Ratio Analysis is “separation or breaking up of anything into its elements or
component parts”. Ratio analysis is therefore a technique of analysis and

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interpreting various ratios for helping in making certain decisions. It involves

the methods of calculating and interpreting financial ratios to assess the
firm‟s performance and status. The ratio analysis is one of the most powerful
tools of financial analysis. The analysis is not restricted to any one aspect
but takes into account all aspects such as earning capacity of the firm,
financial obligation, liquidity and solvency aspects, liquidity and profitability
concepts.

8.3 Steps in Ratio Analysis

Ratio analysis can provide you with this information in three steps:
1. Calculate the firm‟s ratios for the current or recent period. Ratios are
calculated from the firm‟s income statement or balance sheet. It is
helpful and sometimes necessary to have the financial statement
independently audited.
2. Compare these ratios to those calculated in past records. The purpose
of this comparison is to identify tendencies in the firm‟s ratios. This is
known as trend analysis.
3. Compare the ratios to industry averages to show how the company
compares to firms of the same size in its industry. This process is known
as Cross-sectional analysis.
Self Assessment Questions:
1. Analysis of performance between two companies can be made using
ratios. State true or false.
2. Ratios can be expressed in three forms _____________,____________
and _____________.
3. „Stock has turned over 3 times a year‟ – the ratio is expressed as
________________

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8.4 Classification of Ratios

A. Liquidity Ratios: It is the ability of a firm to satisfy its short term

obligations as they become due for payment. The liquidity is a
prerequisite for the very survival of a firm. It reflects the short term
financial strength or solvency of the firm. The ratios which indicate the
liquidity of the firm are:
1. Net Working Capital
2. Current Ratios
3. Acid test/Quick ratio
4. Super quick ratio
5. Cash flow from operations ratio
1. Net Working Capital: It represents the excess of current assets over
current liabilities.
Net working capital = Current Assets – Current Liabilities
Although NWC is really not a ratio, it is frequently employed as a
measure of a company‟s liquidity position. The greater is the amount of
NWC, the greater is the liquidity of the firm. Inadequate working capital
is the first sign of financial problems for a firm.
2. Current Ratio: It is the ratio of total current assets to total current
liabilities.
Current assets
Current Ratio =
Current Liabilities

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 The Current assets of a firm include cash and bank balances,

marketable securities, inventory of raw materials, semi-finished and
finished goods, debtors net of provision for bad and doubtful debts, bills
receivable and prepaid expenses.
 The Current liabilities include trade creditors, bills payable, bank credit,
provision for taxation dividends payable and outstanding expenses.
 As a measure of short term financial liquidity, it indicates the rupees of
current assets available for each rupee of current liability payable.
 Higher ratio, i.e., more than 2:1 indicates sound solvency position but at
the same time it may be indicative of slack management policies and
practices as it might signal excessive inventories or poor credit
management.
 Lower ratio i.e., less than 2:1 indicates inadequate working capital. In
capital rich countries, where long-term funds from capital market are
available in abundance firms dependence on current liabilities may be
less. For public utility companies such as BSNL, MTNL current ratio is
usually very low as they required fewer current assets.
3. Quick Ratio: Quick ratio is also known as liquid ratio or acid test ratio.
One defect of the current ratio is that it fails to convey any information on
the composition of the current assets of the firm. A rupee of cash is
considered equivalent to a rupee of inventory or receivable which may
not be so. The acid test ratio is a measure of liquidity designed to
overcome this defect by measuring those current assets that can be
quickly converted into cash to meet the short term obligations of current
liabilities. In a way it excludes inventory that are not easily and readily
converted into cash.

Current assets (Inv entory & PrepaidExpenses)

Liquid Ratio =
Current Liabilities

 Acid test ratio of 1:1 is considered satisfactory. This ratio is a more

rigorous and penetrating test of the liquidity position of a firm.
 Higher ratio i.e., more than 1:1 indicates sound financial position.
 Lower ratio, i.e., less than 1:1 indicates financial difficulty.

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4. Super quick / Cash ratio: This ratio is calculated by dividing the super
quick assets by the current liabilities of a firm. The super quick current
assets are cash and marketable securities. This ratio is the most
rigorous and conservative test of a firm‟s liquidity position.

Cash & MarketableSecurities

Super Quick Ratio =
Current Liabilities

5. Cash flow from Operations Ratio: This ratio measures liquidity of a

firm by comparing actual cash flows from operations (in lieu of current
and potential cash inflows from current assets) with current liability.

Cash flow fromOperations

Cash flow from Operations ratio =
Current Liabilities

Illustration 1: Given: Current Ratio is 2.5 and working capital is Rs.1,

80,000. Calculate the Current Assets and current liabilities.
Solution:
Current Ratio = CA / CL
2.5 = CA /1
CA = 2.5 (In the absence of any value, the current
liability is always taken as 1 unit)
Working Capital = CA – CL
= 2.5 - 1
Working Capital = 1.5
For 1.5 WCR = Rs.1,80,000 ( Working Capital value)
For 2.5 CAR, = Rs.1,80,000 x 2.5 / 1.5
1. Current Assets = Rs.3,00,000
For 1.0 CLR = Rs. 1,80,000 x 2.5 / 1
2. Current Liabilities = Rs.1,20,000
Illustration 2: Given Current ratio 1.5 :1; Quick ratio 1 : 1 and Current
liabilities Rs.50,000. Calculate current assets, quick assets and inventory.

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Solution:
1. Current Ratio = 1. 5 : 1 [ CA / CL]
Current liabilities = Rs.50,000
Current Ratio (1.5) = CA / 50,000
Current Assets = Rs.75,000
2. Quick Assets ( QR) = QA / 1 [ QA/CL]
1 = QA / 50,000
Quick Assets = Rs.50,000
3. Inventory = CA – QA
= Rs.75,000 – Rs.50,000
Inventory = Rs.25,000
B. Solvency / Capital structure Ratios
The long-term lenders/creditors would judge the soundness of a firm on the
basis of the long-term financial strength measured in terms of its ability to
pay the interest regularly as well as repay the installment of the principal on
due dates or in one lump sum at the time of maturity. There are two aspects
of the long term solvency of a firm: (i) the ability to repay the principal when
due and (ii) regular payment of the interest. Accordingly there are two
different but mutually dependent and interrelated types of leverage ratios.
Balance sheet ratios Capital Structure ratios
Debt – Equity ratio Interest coverage ratios
Debt- asset ratio Dividend coverage ratios
Equity- asset/Proprietor‟s fund Total fixed charges coverage ratios
ratio Cash flow coverage ratios
Debt services coverage ratios

1. Debt Equity Ratio: The relationship between borrowed funds and

owner‟s capital is known as debt-equity ratio. This ratio reflects the
relative claims of creditors and shareholders against the assets of the
firm. Debt-equity ratio is calculated a

Long term Debt

Debt-Equity Ratio =
Shareholders Equity

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The D/E ratio is an important tool to appraise the financial structure of a firm.
The ratio reflects the relative contribution of creditors and owners of
business in its financing. If D/E ratio is 1:2 it implies that for every rupee of
outside liability (debt) the firm has two rupees of owner‟s capital or the stake
of the creditors is one-half of the owners. Therefore a safety margin of 66.67
per cent is available to the creditors of the firm. A higher debt-equity ratio
say 2:1 implies low safety margin to the creditors. It would lead to inflexibility
in the firm‟s operation.
Treatment of Preference Share Capital in D/E ratio: The inclusion or
exclusion of preference share capital depends upon the purpose for which
the D/E ratio is computed. If the objective is to examine the financial solvency
of a firm in terms of its ability to avoid financial risk, preference capital should
be clubbed with equity capital. On the other hand, if D/E ratio is calculated to
show the effect of the use of fixed-interest/dividend sources of funds on the
earnings available to the ordinary shareholders, preference capital should be
clubbed with debt.
Trading on Equity: A high debt-equity ratio denotes the use of larger
proportion of debt capital in the financial structure of the firm. The debt
capital is cheaper to equity capital because interest on debt is a tax
deductible expense. The equity shareholders stands to gain for two reasons
(i) Higher returns (ii) Limited stake would be enable them to retain control.
Trading on equity or leverage is the use of borrowed funds in expectation of
higher returns to equity shareholders.
Debt Asset Ratio: It measures the share of total assets financed by outside
funds.

Total Debt
Debt Asset Ratio =
Total assets

 A low ratio of debt to total assets is desirable from the point of

creditors/lenders as there is sufficient margin of safety available to them.
 A high ratio would expose the creditors to high risk. The implications of
the ratio of equity capital to total capital are exactly opposite to that of
the debt to total assets. A firm should have neither a very high ratio nor
a very low ratio.

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2. Proprietary Ratio: This ratio indicates the proportion of total assets

financed by the owners.

Proprietor' s Fund
Proprietary Ratio =
Total Assets

 Higher ratio, say more than 75% shows lesser dependence on external
sources.
 Lower ratio, say less than 60% shows more dependence on external
sources.
3. Capital Gearing Ratio: It shows the mix of finance employed in the firm.

Fixed Incomebearingsecurities
Capital gearing Ratio =
Total Equity

Important Concepts
Equity Capital = Loan Capital = Even Gear
Equity Capital > Loan Capital = Low Gear = Over Capitalization
Equity Capital < Loan Capital = Higher Gear = Under Capitalization
4. Coverage Ratios: These ratios measure the firm‟s ability to pay certain
fixed charges. In the ordinary course of business, the obligations of the
creditors are met out of the earnings or operating profits. These claims
consist of (i) interest on loans, (ii) preference dividend and
(iii) amortization of principal or repayment of the installment of loans or
redemption of preference capital on maturity. The important coverage
ratios are (i) interest coverage (ii) dividend coverage (iii) total coverage
(iv) total cash flow coverage (v) debt service coverage ratio.
5. Interest Coverage: This ratio measures the firm‟s ability to make
contractual interest payments.

EBIT
Interest Coverage Ratio =
Interest

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An interest coverage of five times indicates that a fall in EBIT level to one-
fifth of the present level, the operating profits available for servicing the
interest on loan would still be equivalent to the claims of the lenders. From
the lender‟s point of view higher the coverage, better is the position of long-
term creditors. It also highlights the ability of the firm to raise additional funds in
future.
6. Dividend Coverage: It measures the ability of a firm to pay dividend on
preference shares which carry a stated rate of return. Higher the
coverage better is the position.

Net Profit after Tax

Dividend Coverage =
(Preference) Preference Dividend

EBIT – Preference Dividend

Dividend Coverage =
(Equity) Equity Dividend

7. Debt Service Coverage Ratio: It is considered a more comprehensive

and apt measure to compute debt service capacity of the firm. It is the
ability of a firm to make the contractual payments required on a
scheduled basis over the life of the debt.
n

∑ EAT t + Interest t +Depreciation t + OA t

t -1
DSCR =
n

∑ Installment t
t=1

The higher the ratio, the better it is. A ratio of less than one may be taken as
a sign of long term solvency problem as it indicates that the firm does not
generate enough cash internally to service debt. Financial Institutions
consider 2:1 as satisfactory ratio.

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Illustration 3: The Balance Sheet of Dravid Ltd is as follows :

Assets: Fixed Assets 10,00,000

Current Assets 5,00,000
Represented by:
Liabilities: Trade creditors 1,00,000
Reserves and surplus 1,00,000
10 % Debentures 2,00,000
6 % Preference Share capital 3,00,000
Equity Share capital 8,00,000

Calculate the Debt Ratio and Debt-equity ratio.

Solution:
1. Debt Ratio = Total Liabilities to outsiders / Total assets
= (Debentures + Trade creditors )/(Fixed + current
assets)
= (2,00,000 + 1,00,000) / (10,00,000 + 5,00,000)
= 3,00,000 / 15,00,000
= 1:5

2. Debt – Equity Ratio = Outsiders‟ funds / shareholders‟ equity or

(Debentures  Trade Creditors )
=
(Eq Sh capital  Pr ef Sh cap  Re serves)
(2,00,000  1,00,000 )
=
(8,00,000  3,00,000  1,00,000 )
= 3,00,000 / 12,00,000
= 1:4
C. Profitability Ratio: The management of the firm is interested in the
financial soundness of a firm. They are designed to provide answers to
questions such as (i) is the profit earned by the firm adequate? (ii) What
rate of return does it represent? (iii) What is the rate of profit for various
divisions and segments of the firm? (iv)What was the amount paid in
dividends? (v) What was the amount paid in dividends? (vi) What is the
rate of return to equity-holders?
1. Gross Profit Margin: It measures the percentage of each sales
rupee remaining after the firm has paid for its goods. The gross profit
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margin or gross margin measures the relationship between profit and

sales. There are two types of margins- gross profit margin and net
profit margin

Gross Profit
Gross Profit Margin = x 100
Net Sales

A high ratio of gross profit to sales is a sign of good management as

it implies that the cost of production is relatively low. A relatively low
gross margin is definitely a danger signal, a need for careful and
detailed analysis of the factors responsible for it.
2. Net Profit Margin: This measures the relationship between net
profits and sales of a firm. It measures the percentage of each sales
rupee remaining after all costs and expenses including interest and
taxes have been deducted.

EBIT
Operating Profit Ratio =
Net Sales

EAT
Net Profit Ratio =
Net Sales
The net profit margin is indicative of management‟s ability to operate
the business with sufficient success not only to recover all the cost
but also to leave a margin of reasonable compensation to the
owners. Higher the ratio of net operating profit to sales better is the
operational efficiency of the concern.
3. Expenses Ratio: These ratios indicate the relationship of various
expenses to net sales. It is computed by dividing expenses by sales.
Operating expenses include cost of goods sold, administrative
expenses, selling, distribution expense and financial expenses but
excludes taxes, dividends and extraordinary losses.

Cost of Goods sold + Operating expenses

Operating Ratio = ____________________________________ x 100
Net Sales

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Cost of Goods Sold = Opening Stock + Purchase – Closing Stock

Operating Expenses = Administrative Expenses + Financial Expenses +
Selling Expenses
The expenses ratio should be compared over a period of time with
the industry average. A low ratio is preferable to high one is
unfavorable. For manufacturing concern an operating ratio between
75% and 80% is expected.
4. Return on Capital Employed: It refers to long term funds supplied
by the lenders and owners of the firm. The capital employed
provides a test of profitability related to the source of long-term
funds. A comparison of this ratio with similar firms, with the industry
average and over time would provide sufficient insight into how
efficiently the long term funds of owners and lenders are being used.

EBIT
ROCE = x 100
Capital employed

The higher the ratio, the more efficient use of the capital employed
and better is the financial position.
5. Return on Shareholders’ Equity: It measures the return on the
total equity funds of ordinary shareholders. This ratio judges whether
the firm has earned a satisfactory return for its equity holders or not.

Net profit after tax – Preference dividends

ROEF = x 100
Shareholders’ Equity or Net worth

Illustration 4: Ranjandas Ltd provides the following information.

Cash Sales Rs.8,00,000; Credit Sales Rs.10,00,000;
COGS Rs.15,80,000 and Return Inwards Rs.20,000.
Calculate Gross Profit Ratio and ratio of COGS.

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Solution
Gross Sales = Cash Sales + Credit Sales
= 8,00,000 + 10,00,000
= 18,00,000
Net Sales = Gross Sales – Return Inwards
= 18,00,000 – 20,000
= 17,80,000
Gross Profit = Net Sales – COGS
= 17,80,000 – 15,80,000
= 2,00,000
1. Gross Profit Ratio = (Gross Profit / Net Sales) x 100
= [2,00,000 / 17,80,000] x 100
= 11.2 %
2. Ratio of COGS = 100 – GP ratio
= 100 -11.2
= 88.8%
D. Activity Ratios or Efficiency Ratios: They are concerned with
measuring the efficiency in asset management. The efficiency with
which the assets are used would be reflected in the speed and rapidity
with which assets are converted into sales.
1. Turnover Ratio: This ratio examines how quickly inventory is
converted into cash. This ratio helps the financial manager to
evaluate in inventory policy. The ratio reveals the number of times
finished stock is turned over during a given accounting period. The
three relevant turnover ratios are (i) Inventory turnover ratio
(ii) Debtors turnover ratio (iii) Creditors turnover ratio.

Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory

To judge whether the ratio of a firm is satisfactory or not, it should be

compared over a time on the basis of trend analysis.

12 months
Inventory Holding Period =
Inventory Turnover Ratio

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2. Debtor’s Turnover Ratio: It is determined by dividing the net credit

sales by average debtors outstanding during the year.

Net Credit Sales

Debtors Turnover Ratio =
Average Debtors

 Net Credit sales consist of gross credit sales minus returns from
customers. It also includes bills receivables.
 A high ratio is indicative of shorter time lag between credit sales
and cash collection.
 A low ratio indicates that debts are not being collected rapidly.
 Debt collection period is calculated by any of the following ratios:

Months/Days in a year
Debt Collection Period =
Debtors Turnover Ratio

The higher the turnover Ratio and the shorter the average collection
period, indicates better trade credit management and the better the
liquidity of debtors.
3. Creditors Turnover Ratio: It is the ratio between net credit
purchase and the average amount of creditors outstanding during
the year.

Net Credit Purchase

Creditors Turnover Ratio =
Average Creditors

12 months
Creditors Collection Period =
Creditors Turnover Ratio

A higher ratio shows that the creditors are not paid in time.
A lower ratio shows that the business is not taking the full advantage
of credit period allowed by the creditors.

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4. Assets Turnover Ratio: It indicates the efficiency with which firm

uses all its assets to generate sales. It is based on the relationship
between cost of goods sold and assets of a firm.

Cost of goods sold

Total assets turnover =
Average total assets

Cost of goods sold

Fixed asset turnover =
Average fixed assets

The total assets and fixed assets are net of depreciation and the
assets are exclusive of fictitious assets. Higher the ratio, greater is
the intensive utilization of fixed assets. Lower ratio means under
utilization of total and fixed assets.
5. Capital Turnover Ratio:

Cost of goods sold

Capital Turnover ratio =
Average capital employed

Lower ratio shows lower profit and higher ratio shows higher profit.
Illustration 5: Birla Cements Ltd provides the following
Stock: Opening Rs.75,000; Closing Rs.1,00,000.
Credit Sales Rs.2,00,000. Cash Sales Rs. 50,000. Gross Profit 25 %.
Calculate the Inventory Turnover Ratio
Solution:
Net Sales = Cash Sales + Credit Sales
= 2,00,000 + 50,000
= 2,50,000
Gross Profit = 25% of 2,50,000 ( Net Sales)
= 62,500
COGS = Net Sales – Gross Profit
= 2,50,000 – 62,500
= 1,87,500

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Average Inventory = (Opening + Closing stock) / 2

= (75,000 + 1,00,000)/2
= 87,500
Inventory Turnover Ratio = COGS / Average Inventory
= 1,87,500 / 87,500
= 2.14 times

Activity 1: Total sales of a firm Rs.5,00,000 of which the credit

sales are Rs.3,65,000. Sundry Debtors and Bills receivable are
Rs.50,000 and Rs.2,000 respectively. Calculate the Debtors
Velocity.

Activity 2: Total purchases Rs.1,00,000. Cash purchases Rs.20,000.

Discount Provision on creditors Rs.1,000. Purchase returns
Rs.2,000. Creditors at close Rs.30,000. Bills payable at close
Rs.25,000. Calculate Creditors Velocity.

Illustration 6: Total sales of a firm Rs.5,00,000 of which the credit sales

are Rs.3,65,000. Sundry Debtors and Bills receivable are Rs.50,000 and
Rs.2,000 respectively. Calculate the Debtors Velocity.
Solution:
Debtors Turnover Ratio = Net Credit Sales / (Debtors + Bills Receivables)
= 3,65,000/ (50000 + 2000)
= 7.02
Debtors‟ Velocity = No. of days in a year / Debtors turnover ratio
(Debtors collection period) = 365/7.02
= 52 days
Note: No. of days in a year is taken as 365 days.
Illustration 7: Total purchases Rs.1,00,000. Cash purchases Rs.20,000.
Discount Provision on creditors Rs.1,000. Purchase returns Rs.2,000.
Creditors at close Rs.30,000. Bills payable at close Rs.25,000. Calculate
Creditors Velocity.
Solution:
Credit purchases = Total purchase – cash purchase – purchase return
= 1,00,000 – 20,000 – 2,000
= Rs.78,000

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Net credit purchases

Creditors Turnover Ratio =
(Creditors  Bills Payable )
= 78000 / (30000 + 25000)
= 1.42
No. of days in a year
Creditor‟s Velocity =
(Crs collection period )
(Crs collection period) = 365 /1.42
= 257 days
Note: The Reserve for discount on creditors should not be considered for
calculating the net credit sales.
E. Integrated Ratios: We have dealt with various ratios and their effect on
firm‟s liquidity, solvency, efficiency and profitability independently.
However there exist interrelationships among these ratios. The overall
profitability of a firm can be accessed on the basis of a combination of
earning power and return on assets ratio. The earning power of a firm is
the overall profitability of a firm and it is computed by multiplying the net
profit margin and the asset turnover. The earning power of a firm is
portrayed in Du Pont Chart.
Self Assessment Questions:
4. For capital rich countries, the current ratio is usually ________
5. In quick ratio _________ and ___________ are excluded because
they cannot be readily converted into cash.
6. ___________ ratio is the most rigorous and conservative test of all
liquidity ratios
7. ___________ ratio reflects the relative contribution of creditors and
owners of the business in its financing
8. In debt equity ratio if the objective is to examine the financing solvency
of the firm preference share capital is _________.
9. ___________ is the use of borrowed funds is to enhance higher
returns to equity shareholders.
10. ___________ is the ability of a firm to make the contractual payments
required on a scheduled basis over the life of the debt.
11. A high debtors turnover ratio indicates ____ time lag between credit
sales and cash collection.

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12. ______________is indicative of management‟s ability to operate the

business with sufficient success not only to recover all the cost but
also to leave a margin of reasonable compensation to the owners.
13. _______________ is based on the relationship between cost of goods
sold and assets of a firm.

8.5 Du Pont Chart

Return on Investments represents the earning power of the company. It

depends on Net profit ratio and capital turnover ratio. A change in any of
these ratios will change the firm‟s earning capacity. This chart shows how
the return on capital employed is affected by various factors such as cost of

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goods sold, change in working capital, change in selling and administrative

expenses etc. This chart helps the management in detecting the core issues
that confront the management and it helps in effective use of capital.

8.6 Solved Problems

Problem 1: The income statement of Vignesh Ltd is as follows:
To Opening Stock 2,00,000 By Sales 12,00,000
Purchases 8,00,000 Closing Stock 1,00,000
Direct Expenses 1,00,000
Gross Profit 2,00,000
13,00,000 13,00,000
To Admn Expenses 1,00,000 By Gross Profit 2,00,000
Selling Expenses 80,000 Profit on sale of 60,000
Investments
Non-Operating exp 40,000 Dividends received 40,000
Net Profit 80,000
3,00,000 3,00,000

Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio,
Operating Profit Ratio and Expense Ratio.
Solution
1. Gross Profit Ratio = Gross Profit / Net Sales x 100
= 2,00,000 / 12,00,000 x 100
= 16.67 %
2. Net Profit ratio = Net Profit after tax / Net Sales x 100
= 80,000 / 12,00,000 x 100
= 6.67%
COGS = Sales – Gross Profit
= 12,00,000 – 2,00,000
= 10,00,000
3. Operating Ratio = COGS + operating expenses / Net Sales
x 100
= 10,00,000+(1,00,000+80,000) / 12,00,000 x
100
= 98.33 %

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4. Operating Profit Ratio = 100 – 98.33%

= 1.67 %
5. Expenses Ratio = Operating Expenses/Net sales x 100

= 1,80,000/ 12,00,000 x 100

= 15.00 %
Illustration 2: The capital structure of M/s NDW and M/s GDF Ltd are as
follows:
NDW GDF

Equity Share Capital (Rs.) 10,00,000 6,00,000

6 % Preference Share Capital 3,00,000 4,00,000
7 % Debentures – 2,00,000
Reserves and Surplus 2,00,000 2,00,000

Solution:
Capital Gearing Ratio = Fixed Income bearing Securities / Total Equity
NDW = 3,00,000/ 12,00,000
= 0.25
GDF = 6,00,000/ 8,00,000
= 0.75
The capital of NDW is low geared when compared to GDF.
Illustration 3: The capital structure of Arvind Ltd is as follows:
Equity Share Capital 10,00,000
Redeemable Preference Capital 5,00,000
6 % Debentures 3,00,000
Long term liabilities 2,00,000
Reserves and surplus 2,00,000
Calculate the Capital Gearing Ratio and Ratio of Total Investment to Long-
term liabilities
Solution:
Capital Gearing Ratio = Fixed Cost bearing securities / Total Capital
= 10,00,000 / 12,00,000
= 0.83 : 1
Total Investment to LTL = Total Liabilities / Long term liabilities
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= 22,00,000 / 10,00,000
= 2.2 :1
Illustration 4: From the following information provided Sarawath Ltd draw
up the Balance Sheet.
a. Current Ratio : 2.50
b. Liquidity Ratio : 1.50
c. Net Working Capital : Rs.300000
d. Stock Turnover Ratio : 6 times
e. Ratio of Gross Profit to Sales : 20%
f. Fixed Asset Turnover Ratio : 2 times
g. Average Debt collection period : 2 Months
h. Fixed Assets to Net Worth : 0.80
i. Reserve and Surplus to Capital : 0.50
Balance Sheet ……
Liabilities Rs. Assets Rs.
Capital 500000 Fixed Assets 600000
Reserves & Surplus 250000 Inventories 200000
Long-term Debt 150000 Debtors 250000
Current Liabilities 200000 Bank 50000
Total 1100000 Total 1100000
Working Notes
If Current Liabilities =1
Current Assets = 2.5
Working Capital (2.5 -1) = 1.5 = 300000
Therefore Current Assets (2.5/1.5) x 300000 = 500000
Current Liabilities (1/1.5) x 300000 = 200000

Liquidity Ratio = 1.5

Current Liabilities = 200000
Therefore Liquid Asset (200000 x 1.5) = 300000
Inventories (Current asset – Liquid asset) = 200000

Stock Turnover Ratio = 6 times

Cost of sales (6 x 200000) = 1200000

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Gross Profit Ratio = 20%

Gross Profit
If Sales is 100; Gross Profit is 20
Hence cost of sales is (100-20) = 80
Therefore Gross Profit is (20/80) x 1200000 = 300000
Sales ( Cost of Sales + Gross Profit) =1500000

Fixed Asset Turnover ratio = 2 times

(cost of sales/Fixed assets)
Therefore Fixed Assets (1200000/2) = 600000

Debtors Collection Period = 2 months

(Months in a year /Debtors turnover)
Debtors Turnover Ratio (12/2) = 6 times
(Sales/ Debtors)
Debtors (1500000/6) = 250000

Fixed Assets to Shareholders‟ Net worth = 0.80

Share holders‟ Net worth(600000 /0.80) =750000

Reserves & Surplus to Capital = 0.50

If capital is 1: reserves & Surplus is 0.5
Reserves & Surplus + Capital = Shareholder‟s Net
worth (0.5 +1 =1.5)
Reserves & Surplus (7500000 x(0.5/1.5) =250000
Therefore share Capital =500000

8.7 Advantages of Ratio Analysis

The various advantages of ratio analysis are as follows:
a) Financial Forecasting and Planning: Ratio analysis helps in the
financial forecasting and planning activities. Ratios based on the past
sales are useful in planning the financial position. Based on these future
trends are set.

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b) Decision Making: Ratio analysis throws light on the degree of

efficiency. It is also concerned with the management and utilization of
the assets. Thus, it enables for making strategic decisions.
c) Comparison: With the help of ratio analysis, ideal ratios can be
composed. These can be used for comparison in respect of the firm‟s
progress and performance, inter-firm comparison with industry average.
d) Financial Solvency: It indicates the trends in the financial solvency of
the firm. Long term solvency refers to the financial liability of a firm. It
can also evaluate the short term liquidity position of the firm. .
e) Communication
The financial strength and weaknesses of a firm are communicated in a
more easy and understandable manner by the use of ratios. The
information contained in the financial statements is conveyed in a
meaningful manner. It thus helps in the communication and enhances
the value of the financial statements.
f) Efficiency Evaluation
It evaluates the overall efficiency of the business entity. Ratio analysis
is an effective instrument which, when properly used, is useful to assess
important characteristics of business liquidity, solvency, profitability. A
critical study of these aspects may enable conclusions relating to
capabilities of business.
g) Control
It helps in making effective control of the business. Actual results can
be compared with the established standard and to take corrective action
at the right time.
h) Other uses
Financial ratios are very helpful in the early and proper diagnosis and
financial health of the firm.

8.8 Limitations of Ratio Analysis

Undoubtedly, ratios are precious tools in the hands of the analyst. But its
significance comes from proper use of these ratios. Misuse or mishandling
of these ratios and using them without proper context may lead the analyst
or management to a wrong direction. The limiting factors are:
1. The user should possess the practical knowledge about the concerns
and the industry in general.
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2. Ratios are not an end. They are only means to an end.

3. A single ratio in itself is not important. The trend is more significant in
the analysis. Comparison of ratios should be made.
4. For comparative purposes, there should be a standard ratio. There
are no such standards prescribed for the ratios.
5. The accuracy and correctness of ratios are totally dependent upon the
reliability of the data contained in the financial statement on the basis
of which ratios are calculated.
6. To use ratios, first of all there should be uniformity in the accounting
plan used by both the firms. In addition. There must be consistency in
the preparation of financial statement and recording the transactions
from year to year within that concern.
7. Ratios become meaningless if detached from the details from which
they are derived. The should be used as supplementary and not
substitution of the original absolute figures.
8. Time lag in calculation and communicating the same should not be
unnecessarily too much.
9. The method of presentation should be precise and without any
ambiguity.
10. Price level changes make the ratio analysis meaningless.
11. Inter-firm comparison should never be undertaken in the case of
concerns which are not associated or comparable.
12. All techniques concerning the ratio analysis should be taken into
account.

8.9 Summary
Ratio Analysis is “separation or breaking up of anything into its elements or
component parts”. Ratio analysis is therefore a technique of analysis and
interpreting various ratios for helping in making certain decisions. It involves
the methods of calculating and interpreting financial ratios to assess the
firm‟s performance and status Ratios are calculated from the firm‟s income
statement or balance sheet. It is helpful and sometimes necessary to have
the financial statement independently audited. Ratios are compared with
past records. The purpose of this comparison is to identify tendencies in the
firm‟s ratios. This is known as trend analysis. Ratios are classified into
liquidity, solvency, profitability, activity and integrated ratios.

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8.10 Terminal questions

Problem 1:
Calculate Current ratio, acid test ratio from the following information:
Cash in hand Rs.3,000. Cash at Bank Rs.65,000. Bills receivable
Rs.10,000. Stock Rs.1,20,000, Debtors Rs.80,000. Prepaid expenses
Rs.2,000. Creditors Rs.1,20,000. Bills payable Rs.20,000.
Problem 2:
Calculate Debt equity Ratio and Proprietary ratio from the following
information:
Balance Sheet as on………..
Equity share capital 5,00,000 Fixed assets 10,00,000
Preference share 3,00,000 Current assets 4,00,000
capital
Reserves & Surplus 2,00,000
8% Debentures 3,00,000
Current Liabilities 1,00,000
Total 14,00,000 Total 14,00,000

Problem 3: The current assets and current liabilities were Rs.16,00,000 and
Rs.8,00,000 respectively. What is the effect of each of the following
transactions individually and totally on the current ratio:
1. Purchase of new machinery for Rs.5,00,000
2. Purchase of new machinery for Rs.10,00,000 on a medium term loan
from a bank with 20 % margin.
3. Payment of a dividend of Rs.2,00,000 of which Rs.0.47 lakh was tax
deducted at source.
4. Materials purchased costing Rs.5,00,000 in respect of which bank
financed Rs.3,00,000.
Problem 4:
The current ratio is 2:1. Which of the following suggestions would improve
the ratio, which would reduce it and which would not change it?
a) to pay a current liability
b) to sell a motor car for cash at a slight loss
c) to borrow money for short time on an interest bearing promissory note
d) to purchase stock for cash

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e) to give an interest bearing promissory note to a creditor to whom money

was to be paid.

8.11 Answer for SAQ’s and TQ’s

1. True 4. Low
2. Proportion, Percentage, 5. Inventory and prepaid expenses
Turnover rate 6. Super quick/ cash
3. Turnover rate 7. Debt equity
8. Included with equity capital
9. Trading on equity
10. Debt service coverage ratio
11. Shorter
12. Net Profit margin
13. Asset Turnover ratio
Answer for Terminal Questions:
1. Current ratio 2:1 and Acid test ratio 1.14:1
2. Debt Equity ratio 0.4:1 ; Proprietary Ratio 0.5:1
3. (1) Decrease (2) decrease (3) decrease (4) increase
4. (a) increase (b) increase (c) decrease (d) no change (e) no change
Activity 1: Solution
Debtors Turnover Ratio = Net Credit Sales / (Debtors + Bills Receivables)
= 3,65,000/ (50000 + 2000)
= 7.02
Debtors‟ Velocity = No. of days in a year / Debtors turnover ratio
(Debtors collection period) = 365/7.02
= 52 days
Note: No. of days in a year is taken as 365 days.
Activity 2: Solution:
Credit purchases = Total purchase – cash purchase – purchase return
= 1,00,000 – 20,000 – 2,000
= Rs.78,000

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Creditors Turnover Ratio = Net credit purchases / (Creditors + Bills

Payable)
= 78000 / (30000 + 25000)
= 1.42
Creditor‟s Velocity = No. of days in a year / Creditors turnover
ratio
(Creditors collection period) = 365 /1.42
= 257 days
Note: The Reserve for discount on creditors should not be considered for
calculating the net credit sales.

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Financial and Management Accounting Unit 9

Unit 9 Funds Flow Analysis

Structure:
9.1 Introduction
Objective
9.2 Meaning of Funds Flow Statement
9.3 Ascertainment of flow of funds
9.4 Technique of preparing funds flow statement
9.5 Schedule of Changes in Working Capital
9.6 Adjusted Profit and Loss account
9.7 Funds Flow Statement
9.8 Summary
9.9 Terminal questions
9.10 Answers to SAQs and TQs

9.1 Introduction
Financial statements as an aid to evaluate past and / or present
performance of a business concern is unquestionable and beyond any
dispute. The Income Statement reports the revenues earned and expenses
incurred or outstanding. The Balance Sheet conveys about the deployment
of funds in various assets and equities. International Accounting Standards
7 reads as:
“A statement of changes in financial position should be included as an
integral part of financial statements. The statement of changes in financial
position should be presented for each period for which the income
statement is prepared”. The inclusion of such a statement, therefore, is very
helpful to improve the understanding of the operations and activities of an
enterprise for the reporting period.
Objectives:
After studying this unit you should be able to:
1. Explain the meaning and the concepts of funds flow statement.
2. Ascertain transactions that involve flow of funds and those that does not
involve flow of funds.
3. Know the techniques of preparing fund flow statement.

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9.2 Meaning of Fund Flow Statement

Funds Flow Statement is essentially derived from the analysis of changes
which have occurred in assets and equities between two accounting
periods. Funds Flow Statement being a toll of Management accountant can
be prepared at point in time. This statement does not form a part of financial
statement but acts as a valuable tool for the management in decision
making.
Funds flow statement is very useful in working capital management,
deciding the capital structure of the firm, financial planning and forecasting.
According to the International Accounting Standard 7, the term „Fund‟ refers
to cash, to cash and cash equivalent, or to working capital. The term „flow‟
refers to change and therefore the term „Funds flow” refers to „change in
funds‟ or „change in working capital‟. In other words, any increase or
decrease in working capital means „flow of funds‟.
Fund Flow Statement enables us to identify and recognize the changes in
assets and asset sources which are not readily evident in the income
statement or financial statement. It reveals how funds were obtained to pay
off its long term debts, how the firm managed to pay regular dividends
during volatile period, how the funds from equity issue were utilized etc.
However Funds flow statement is not a substitute to comprehensive income
statement (Profit and Loss account) and statement of Financial Position
(Balance Sheet). It facilitates additional information regarding movement of
funds during a particular period.
There are two concepts of working capital – gross concept and net concept.
Gross working capital refers to the firm‟s investment in current assets. Net
working capital means excess of current assets over current liabilities.

Working capital = Current Assets – Current Liabilities

Current assets are those which are held or receivable within a year or
within the operating cycle of the business. They are intended to be
converted into cash within a short period of time.

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Current liability is that obligation which has to be satisfied within a year.

Examples of current assets and current liabilities are:

CURRENT ASSETS CURRENT LIABILITIES

 Cash and bank balances  Accounts payable
 Inventory  Sundry creditors
 Sundry Debtors  Bank overdraft
 Temporary investments  Unclaimed dividends
 Pre-paid expenses  Provision for taxation
 Outstanding incomes  Proposed dividends
 Accounts receivables  Short term loans
 Bills receivables

Non-Current Assets refers to those assets other than current assets that
are realizable in cash or sold or consumable after one year or after a
considerable period of time. Fictitious assets are those expenses which
could not be written off during the period of their incidence. For example,
promotional expenses of a company which could not be treated as
expenditure in the year of incidence are shown as fictitious asset.
Non-current Liabilities refers to all those obligations other than current
liabilities that are likely to mature after one year period. Examples of non-
current asset and non-current liabilities are:

NON CURRENT LIABILITIES NON CURRENT ASSETS

 Share capital  Fixed assets
 Long term loans  Fictitious assets like goodwill,
 Debentures patents, copyrights, trademarks.

 Share premium a/c  Long term investments

 Forfeited shares a/c  Profit & loss a/c (debit bal)

 Profit & loss a/c (credit bal)  Discount on issue of shares &
debentures
 Appropriation of profits
 Deferred expenditures like
 Provision for taxation preliminary expenses,
 Provision for depreciation advertising expenses.
 Capital reserve

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Statement of Sources and Uses of Funds or Funds Flow Statement is a

statement which depicts the sources from which funds are obtained and
how they have been utilized. When a transaction results in increase of funds
it is termed as “Source of Fund” and when it results in decrease of fund it
is termed as “Application of Fund”.
However there are certain transactions that do not result in either increase
or decrease of fund. Such transactions are termed as Non fund Transaction.
Eg: If the funds are Rs.10000 and a fixed asset of Rs.5000 is purchased by
issuing shares of Rs.5000 the funds position will not change and therefore
this transaction will be taken as a non-fund transaction.
There are certain transactions which are not apparent and are hidden. Such
transactions have to be located in order to know their effect on the funds. In
such circumstances the relevant ledger accounts should be prepared for all
non-current assets and liabilities to find out the hidden information.
Self Assessment Questions:
5. Flow of Funds refers to change in funds or ________________
6. ____ Working Capital refers to the firm‟s investment in current assets
7. __________ are those expenses which could not be written off during
the period of their incidence
8. When a transaction results in decrease of funds it is termed as
___________________.

9.3 Ascertainment of Flow of Funds

The flow of fund can be ascertained from Balance Sheet, Profit and Loss
account and from the hidden information. A few independent transactions
are given below and the effect of each of the transaction on flow of funds is
determined.
BALANCE SHEET as on …….
Non-current liabilities: Non-current Asset
Share Capital: Goodwill 50000
16% Redeemable Buildings 1,00,000
Preference Shares of Rs.10 Plant 1,00,000
each 1,00,000 Furniture 50,000

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Equity shares of Rs.10 Long term 50,000

each 1,00,000 Investment

Long term Loans:

12%Debenture 1,00,000
Loan on Mortgage 50,000
Reserves & Surplus:
General reserve 1,00,000
Profit & Loss a/c 50,000

Total non-current 5,00,000 Total Non-current 3,50,000

liabilities Assets
Current liabilities: Current Assets:
Sundry creditors 50,000 Sundry Debtors 80,000
Bills Payable 50,000 Bills receivable 50,000
Bank Overdraft 25,000 Inventories 1,00,000
Outstanding expenses 25,000 Pre-paid Expenses 50,000
Cash balance 20,000

Total current liabilities 1,50,000 Total current assets 3,00,000

Total liabilities 6,50,000 Total assets 6,50,000

Computation of Working capital:

CURRENT ASSETS Rs.300000

CURRENT LIABILITIES Rs.150000
NET WORKING CAPITAL 150000
There will be flow of funds on account of change in working capital
position.

1. The company realizes Rs.20000 from its debtors.

Debtors will reduce from Rs.80000 to Rs.60000
Cash balance will increase from Rs. 20000 to Rs.40000

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CURRENT ASSETS Rs.300000

CURRENT LIABILITIES Rs.150000
WORKING CAPITAL 150000

This transaction will not bring any change in the working capital
because it is simply conversion of one current asset into another current
asset.

2. The company pays to its creditors a sum of Rs.10000 out of the

cash balance.
 Cash balance gets reduced from Rs.20,000 to Rs.10,000
 Sundry creditors will stand reduced from Rs.50,000 to Rs.40,000

CURRENT ASSETS Rs.290000

CURRENT LIABILITIES Rs.140000

WORKING CAPITAL 150000

There will be no change in working capital position

3. The company purchases furniture of Rs.10000 by raising long-term

loans of Rs.10000.

This transaction will not have any effect on working capital position,
since the transaction involves non-current asset and a non-current
liability which are not the constituents of working capital.

4. The company redeems preference shares of Rs.100000 by issuing

12% debentures of Rs.100000.

This transaction will not involve any change in the working capital
since both the accounts involved are not the constituents of the
working capital.

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5. The company raises Rs.50,000 in cash by issue of new shares.

 This transaction will increase the cash balance of the company from
Rs.20,000 to Rs.70,000. The working capital position will be:

Current Assets Rs.3,50,000

Current Liabilities Rs.1,50,000

Working capital 2,00,000

This transaction will involve flow of funds

6. The company sells its building having a book value of Rs.50,000 for
a sum of Rs.60,000.
 This transaction will increase the cash balance with the company
from Rs.20,000 to Rs.80,000.

Current Assets Rs.3,60,000

Current Liabilities Rs.1,50,000

Working capital 2,10,000

This transaction will increase the W.C

Note: Each transaction is independent and not linked to the previous

example.
From the above, the following general rules can be formed:
1. There will be flow of funds if a transaction involves:
 Current assets and fixed assets, e.g. purchase of building for cash
 Current assets and capital, e.g., issue of shares for cash
 Current assets and fixed liabilities, e.g. redemption of debentures in
cash
 Current liabilities and fixed liabilities, e.g. Creditors paid off in
debentures
 Current liabilities and capital, e.g., creditors paid off in shares.
 Current liabilities and fixed assets, e.g. building transferred to
creditors in satisfaction of their claims

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2. There will be no flow of funds if a transaction involves.

 Current assets and current liabilities, e.g., payment made to creditors
through cash
 Fixed assets and fixed liabilities, e.g., building purchased and
payments made in debentures.
 Fixed assets and capital, e.g. building purchased and payment made
in shares
Funds Flow Diagram

CURRENT ASSETS FIXED ASSETS

CASH IN HAND & AT BANK GOOD WILL, BUILDING
MARKETABLE INVESTMENTS PLANT AND MACHINERY
RECEIVABLES FUTURE AND FIXTURES
STOCKS LONG TERM INVESTMENTS

FIXED LIABILITIES
CURRENT LIABILITIES
SHARE CAPITAL
BANK OVERDRAFT
RESERVES AND SURPLUS
OUTSTANDING EXPENSES DEBENTURES

ACCOUNTS PAYBLE LONG TERM LOANS

FLOW OF FUNDS NO FLOW OF FUNDS

Self Assessment Questions:

5. When cash is collected from debtors there is flow of funds. State true
or false.
6. When there is sale of fixed assets and cash is obtained there is flow
of funds since it involves non-current asset and current asset. State
true or false.
7. X Ltd transfers Rs.10 lakhs of its profits to Redemption Reserve
account. Does it involve flow of funds? State yes or no
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8. Y Ltd writes off goodwill during the current accounting period. This
transaction involves flow of funds. State true or false.
9. A firm accepts bills payable drawn by its creditors. Will transaction
have effect on flow of funds? Why?
10. Give one transaction which involves one current liability and
noncurrent liability.
11. Give one transaction which involves one current liability and
noncurrent asset.

Activity 1: Give suitable examples (other than given in the

SLM) if there is flow of funds for the following transactions:
1. Current assets and fixed assets, e.g. …………………..
2. Current assets and capital, e.g. …………………………
3. Current assets and fixed liabilities, e.g. ………………….
4. Current liabilities and fixed liabilities, e.g. ………………
5. Current liabilities and capital, e.g.……………………….
6. Current liabilities and fixed assets, e.g. …………………..

9.4 Techniques of Preparing a Funds Flow Statement

Like other accounting statements, the structure of Fund Flow Statement is
based on the equality of financial assets and liabilities including capital. The
basic understanding is that the funds are obtained through profit, external
borrowings or by issue of shares. If funds are not available readily from
these sources, the other alternative available is to sell the fixed assets and
investments.
Steps in Preparation of Funds Flow Statement
There are three steps involved in the preparation of a Fund Flow Statement
(FFS). They are as follows:
a) Preparation of Statement of changes in working capital or Schedule of
changes in working capital.
b) Preparation of Adjusted Profit and Loss Account (APL)
c) Statement of changes in Financial position as per AS – 7

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9.5 Schedule of Changes in Working Capital

It is also known as “Comparative change in Working Capital Statement” or
“Working Capital Variation Statement”. The net change in working capital is
projected here in the place of individual changes in all the current assets
and current liabilities in the Funds Flow Statement. The statement indicates
the amount of working capital at the end of two years. It shows the increase
or decrease in the individual items of current assets and current liabilities.
The effect of the changes in the individual items of the current assets and
current liabilities on working capital is also presented clearly and precisely.
The difference in the amount of working capital at the end of two years will
depict either the increase or decrease in working capital. While
ascertaining the increase or decrease in individual items of current assets
and current liabilities and its impact on working capital, the following Rules
should be taken into account.
Rules for preparing the Schedule of Changes in Working Capital:

 Increase in a current asset, results in increase (+) in “working capital”

 Decrease in a current asset, results in decrease (-) in “working capital”
 Increase in a current liability, results in decrease (-) in “working capital”
 Decrease in a current liability, results increase (+) in “working capital”.

Format of Schedule of Changes in Working Capital

Particulars Previous Current Increase Decrease
Year Year
CURRENT ASSETS
Cash in hand
Cash at Bank
Sundry Debtors
Bills Receivable
Stock or Inventory
Prepaid expenses
Temporary Investments
Accrued Incomes
Total current assets (A)

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CURRENT LIABILITIES
Sundry Creditors
Bills Payable
Bank Overdraft
Outstanding expenses
Income received in advance
Provision for Taxation*
Proposed Dividends*
Total Current Liabilities (B)
NET WORKING CAPITAL
(A)-(B)
Increase/Decrease in
Working Capital (Balancing
Figure)
Total

*Provision for Taxation: It can be treated in two ways:

1. Treated as current liability: when there is no income tax paid or
additional provision made it is treated as current liability. It can be taken
to schedule of changes in working capital. No further treatment is
required.
2. Treated as non-current liability: A ledger account (Provision for
taxation a/c) is prepared. Sometimes we may have to arrive at income
tax paid during the year from the given information. These are hidden
transactions which are not apparent and are hidden.
*Proposed Dividend: It can be treated in two ways:
1. Treated as current liability: Proposed dividend may be taken as
Current liability since declaration of dividends by share holders is simply
a formality. It is taken to schedule of changes in working capital with no
further treatment.
2. Treated as non-current liability: Proposed dividend can be taken as
an appropriation of profit. In such a case, proposed dividend for the
current year will be added back to current year‟s profit in order to find out
funds from operations if such amount of dividend has already been
charged to profit. Payment of dividend will be shown as an application
of fund.

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9.6 Adjusted Profit and Loss account

Revenue transactions such as depreciation, amortization, Profit/Loss on
sale of assets etc appearing in Profit and Loss account does not belong to
either current or non-current category. All such non-operating incomes and
non-operating expenses appear in Adjusted Profit and Loss account to
ascertain the „Funds from Operations”.
Funds from Operations: Profit earned by the concern during the current
year is deemed to be the source of funds. It is very important source of
funds inflow. Net profit is arrived at by deducting cost of goods sold and
other expenses from total sales revenue. However, the profit so calculated
is seldom equal to the funds from operations because there are many items
which are debited or credited in the Profit and Loss Account which do not
affect working capital. Therefore, in calculating the funds from operations,
the following adjustments must be kept in mind:
Items to be added back to Net Profit:
a. Non-fund revenue deductions: These are items which are debited to
Profit and Loss account. These do not cause outflow of funds such as
depreciation and depletion on non-current assets, amortization of
fictitious and intangible assets, preliminary expenses, redemption of
preference shares or debentures, deferred charges, advertising
suspense account written off. If non fund expenditures do not affect the
current assets such as unexpired insurance, do not add back. So also,
all allowances for income tax payable in future years are excluded.
b. Non-trading charges or losses: These items which were debited to
Profit and Loss account reduce the profits but they do not cause any
outflow of funds. Hence, profit should be corrected by adding back all
such charges and losses. These include appropriation of retained
earnings such as general reserve, dividend equalization fund, and
reserve for contingencies, sinking fund. In addition the dividend on
shares must be added back since it is an appropriation and not trading
charge. The losses arising out of sale of land, buildings, machinery,
long term investments which were written off to the profit and loss
account must be added back. Do not add the loss arising out of sale of
a current asset such short term investments. It is a trading loss and
hence it will not require any adjustment. The amount set aside as

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provision for current taxation will also be added back. This will be
considered only when the provision for taxation is treated as a charge on
profits.
Items that are to be deducted from Net Profit:
The non fund and non trading revenue receipts or incomes must be
deducted from net profit in order to compute funds from operations. The
items are:
(a) Dividend received or receivable: Although this transaction increases
the current assets such as cash and debtors, it is not a trading income.
Hence, it should be deducted from the net profits to determine the funds
from operations.
(b) Retransfer of excess provisions: Where the provisions made for
taxation, depreciation, doubtful debts exceed the genuine requirements,
the excess amount is transferred back to the Profit and loss account. It
does not create any inflow of funds since it is an accounting entry.
Hence, deduct it.
(c) Profit on sale of non current assets: It is a non trading income. Hence
it must be eliminated from the amount of profit.
(d) Appreciation in fixed assets: The amount of appreciation on
revaluation of fixed assets is normally credited to the profit and loss
account. If it is so, deduct it from the profit to compute the funds from
operations.

Adjusted Profit and Loss a/c

To By
Depreciation written off Balance b/d (Opening bal )
Preliminary exp written off Profit on sale of investments
Goodwill written off Profit on sale of Fixed assets
Discount on issue of shares Dividend and interest received
Loss on sale of fixed assets Funds from Operations (bal
fig)
Loss on sale of trade
investments
Transfer to General Reserve
Provision for Tax
Provision for Proposed

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Dividend
Balance c/d (Net Profit)
Closing balance
Total Total

NOTE:
 If debit total of Adjusted Profit and Loss a/c is more than the credit total,
the difference is Funds generated from Operation
 If credit total of Adjusted Profit and Loss a/c is more than the debit total,
the difference is funds lost in operations.

9.7 Funds Flow Statement

This forms the final step in funds flow analysis. It consist of two components
– the source of funds and the application of funds. This statement reveals
the overall creditworthiness of the enterprise. A Funds Flow Statement
differs from an Income Statement in the following aspects:
1. Funds flow statement reveals how the funds were obtained and how
they were utilized whereas the income statement discloses the results of
the business activity.
2. A funds flow statement matches the „funds raised‟ with „funds utilized‟
3. Income statement which discloses the results of operations cannot
accurately furnish funds from operations because non-fund items such
as depreciation, writing off fictitious assets etc are included in it.
FORMAT OF FUNDS FLOW STATEMENT
SOURCES OF FUNDS Rs. Rs.
Funds from Operations
Non-trading incomes
Issue of Shares
Issue of Debentures
Borrowing of loans
Acceptance of deposits
Sale of fixed assets
Sale of Investments
Decrease in Working Capital
APPLICATION OF FUNDS
Funds lost in Operations
Non-operating expenses

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Redemption of Preference shares

Redemption of debentures
Repayment of loans
Repayment of deposits
Purchase of fixed assets
Purchase of long term instruments
Increase in Working Capital

Illustration1: XYZ Ltd provides the following information

January 1 December 31
Sundry Debtors 65,000 1,05,000
Cash in hand 13,000 20,000
Cash at Bank 15,000 20,000
Bills Receivable 16,000 30,000
Inventory 90,000 84,000
Bills Payables 12,000 8,000
Outstanding expenses 6,000 5,000
Sundry Creditors 30,000 58,000
Bank Overdraft 30,000 42,000
Short term Loans 32,000 36,000

Prepare a schedule of changes in working capital

Solution
Schedule of changes in Working Capital
Balance as on Effect of WC
Details Jan 1 Dec 31 Increase Decrease
Current Assets
Cash in hand 13,000 20,000 7,000
Cash at Bank 15,000 20,000 5,000
Sundry Debtors 65,000 1,05,000 40,000
Bills Receivable 16,000 30,000 14,000
Inventory 90,000 84,000 – 6,000
Total Current Assets (A) 1,99,000 2,59,000
Current Liabilities
Sundry Creditors 30,000 58,000 – 28,000
Bills Payables 12,000 8,000 4,000 –
Outstanding expenses 6,000 5,000 1,000 –

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Bank Overdraft 30,000 42,000 – 12,000

Short term loans 32,000 36,000 – 4,000
Total Current Liabilities 1,10,000 1,49,000
(B)
Working Capital 89,000 1,10,000
(A) – (B)
Net Increase in working 21,000 21,000
capital (balancing figure)
1,10,000 1,10,000 71,000 71,000

llustration 2: The following are the summarized Balance Sheets of

Anderson Ltd.
BALANCE SHEET AS ON…….
Liabilities 2006 2007 Asset 2006 2007
Share 5,00,000 6,00,000 Fixed 10,00,000 11,20,000
Capital Assets
Reserves 1,50,000 1,80,000 Less : (3,70,000) (4,60,000)
Dep
P&L 40,000 65,000 Stock 2,40,000 3,70,000
Account
Debentures 3,00,000 2,50,000 Book 2,50,000 2,30,000
Debts
Creditors 1,70,000 1,60,000 Cash 1,00,000 75,000
Prov. for IT 60,000 80,000
12,20,000 13,35,000 12,20,000 13,35,000

Prepare a Funds Flow statement

Solution:
Statement of changes in working capital
Particulars 2006 2007 Increase Decrease
Current Asset
Cash 1,00,000 75,000
Stock 2,40,000 3,70,000 1,30,000 –
Book Debts 2,50,000 2,30,000 – 20,000
Total CA (A) 5,90,000 6,75,000
Current Liabilities
Creditors for goods 1,70,000 1,60,000 10,000 –

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Provision for income tax 60,000 80,000 – 20,000

Total CL (B) 2,30,000 2,40,000
Working Capital (A – B) 3,60,000 4,35,000
Increase in Working 75,000 – – 75,000
capital
Total 4,35,000 4,35,000 1,40,000 1,40,000

Adjusted Profit and Loss Account

To By
Reserve 30,000 Opening balance 40,000
Depreciation 90,000 Funds from Operation 1.45,000
Closing balance 65,000
Total 1,85,000 Total 1,85,000

Funds Flow Statement

Sources Application
Issue of Share 1,00,000 Redemption of debentures 50,000
Capital
Funds from Operation 1,45,000 Purchase of Fixed Assets 1,20,000
Increase in working capital 75,000
2,45,000 2,45,000

Notes:
1) The increase in General Reserve is due to transfer a part of profit of the
current year and hence the difference is transferred to Adjusted Profit
and Loss account since it‟s a non-cash item
2) The difference in depreciation is charged to Adjusted P&L, since it‟s a
non-cash item.
3) Increase in Equity Share capital is assumed to be the fresh issue which
is a cash item. It is recorded in Funds Flow Statement as source.
4) The difference is debenture is the redemption. It is taken to Funds Flow
Statement as application of funds.
5) Purchase of fixed asset is difference between the opening and closing
balance of fixed assets. It is application of funds and taken to Funds
Flow Statement.

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Illustration 3: Following is the Balance Sheet of M/s Srinivas Ltd. You are
required to prepare a Fund Flow Statement
Particulars 2006 2007 Particulars 2006 2007
Equity Share capital 50,000 65,000 Cash balances 10,000 13,000
Profit & Loss 14,750 17,000 Debtors 25,000 27,000
Trade Creditors 29,000 31,000 Investment 5,000 nil
Mortgage 10,000 15,000 Fixed Assets 50,000 80,000
Short term loans 15,000 16,500 Less: Depreciation (5,250) (7000)
Accrued expenses 8,000 7,500 Goodwill 5,000 nil
Stock 37,000 39,000
Total 1, 26,750 1, 52,000 Total 1, 26,750 1, 52,000

Additional Information:
1. Depreciation provided is Rs.1750.
2. Write off goodwill.
3. Dividend paid Rs.3500.
Solution:
Schedule of Changes in Working Capital
Balance as on
2006 2007 Increase Decrease
Current Assets
Cash 10,000 13,000 3000
Debtors 25,000 27,000 2000
Stock 37,000 39,000 2000
Total current assets, 72,000 79,000
say A
Current Liabilities
Trade Creditors 29,000 31,000 2000
Short term loans 15,000 16,500 1500
Accrued expenses 8,000 7,500 500
Total current liabilities, 52,000 55,000
say B
Working capital 20,000 24,000
(A – B)
Net increase in Working 4,000 – 4000
capital
Total 24,000 24,000 7500 7500

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Adjusted Profit and Loss Account

To By
Depreciation 1,750 Balance b/d 14,750
Goodwill 5,000 Funds generated 12,500
from operations
(Balancing figure)
Dividend 3,500
Balance c/d 17,000
TOTAL 27,250 TOTAL 27,250

Funds Flow Statement

Issue of fresh equity 15,000 Purchase of fixed 30,000
assets
Sale of investment 5,000 Payments of 3,500
dividends
Loan on mortgage 5,000 Increase in working 4,000
capital
Funds from operations 12,500
37,500 37,500

Illustration 4: Following is the balance sheet of M/s Mahaveer Enterprise

for the year 1996 and 1997.
BALANCE SHEET as on March 31st 1996 and 1997
Liabilities 1997 1998
Share Capital 2,00,000 2,50,000
General Reserve 50,000 60,000
Profit and Loss 30,500 30,600
Bank Loan (Long-term) 70,000 -
Sundry Creditors 1,50,000 1,35,200
Provision for Taxation 30,000 35,000
Total 5,30,500 5,10,800
Assets
Land and Building 2,00,000 1,90,000
Machinery 1,50,000 1,69,000
Stock 1,00,000 74,000
Sundry Debtors 80,000 64,200
Cash 500 600
Bank - 8,000
Goodwill - 5,000
Total 5,30,500 5,10,800

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Additional Information: During the year ended 31st December,1998

1. Dividend of Rs.23,000 was paid
2. Assets of another company were purchased for a consideration of
Rs.50,000 payable in shares. The assets include Stock Rs.20000,
Machinery Rs.25,000
3. Machinery was further purchased for Rs.8000
4. Depreciation written off on machinery Rs.12,000
5. Income tax provided during the year Rs.33,000
6. Machinery worth Rs.2000 was sold for Rs.1800. Loss on sale of
machinery Rs.200 was transferred to general reserve.
You are required to prepare Schedule of changes in Working Capital and
Funds Flow Statement
Schedule of Changes in Working Capital
Particulars 1997 1998 Increase Decrease
Current Assets
Stock 1,00,000 74,000 26,000
Sundry Debtors 80,000 64,200 15,800
Cash 500 600 100
Bank - 8,000 8,000
A. Total Current 1,80,500 1,46,800
Assets
Current Liabilities
Sundry Creditors 1,50,000 1,35,200 14,800
B. Total Current 1,50,000 1,35,200
Liabilities
Working Capital 30,500 11,600
[A – B]
Decrease in 18,900 18,900
Working capital
Total 30,500 30,500 41,800 41,800
Land and Building A/c
Particulars Rs. Particulars Rs.
To Op. bal b/d 2,00,000 By Adjusted P & L A/c 10,000
[Depreciation – Bal.
Fig.]
By Cl. Balance C/d
1,90,000
2,00,000 2,00,000

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Financial and Management Accounting Unit 9

Machinery A/c
Particulars Rs Particulars Rs.
To Op. Balance B/d 1,50,000 By Adjusted P & L A/c 12,000
[Depreciation]
To Share Capital A/c 25,000 By Gen. Reserve A/c 200
[Purchase of [Loss on Sale]
Shares]
To Cash A/c 8,000 By Cash A/c [Sale] 1,800
[Purchase]
By Cl. Balance C/d 1,69,000
1,83,000 1,83,000

Goodwill A/c
Particulars Rs. Particulars Rs.
To Op. Balance B/d - By Cl. Balance C/d 5,000
To Share Capital A/c 5,000
(purchase consideration)
5,000 5,000

Share Capital A/c

Particulars Rs. Particulars Rs.
To Cl. Balance C/d 2,50,000 By Op. Balance B/d 2,00,000
By Stock 20,000
By Machinery A/c 25,000
By Goodwill A/c 5,000
(purchase consideration)
2,50,000 2,50,000

General Reserve A/c

Particulars Rs. Particulars Rs.
To Machinery A/c 200 By Op. Balance B/d 50,000
To Cl. Balance C/d 60,000 By Adjusted P & L A/c 10,200
60,200 60,200

Bank Loan A/c

Particulars Rs Particulars Rs.
To Cash A/c [Repayment] 70,000 By Op. Bal b/d 70,000
To Cl. Balance c/d -
70,000 70,000

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Financial and Management Accounting Unit 9

Provision for Tax A/c

Particulars Rs. Particulars Rs.
To Cash A/c [Tax Paid] 28,000 By Op balance B/d 30,000
(balancing figure)
To Cl. Balance C/d 35,000 By Adjusted P & L A/c 33,000
63,000 63,000

Adjusted Profit and Loss A/c

Particulars Rs. Particul Rs.
ars
To Dep - Land & 10,000 By Balance 30,500
Building. C/d
To Depreciation on 12,000 By Funds 88,300
Machinery from
Operation
[Bal Fig.]
To Gen. Reserve A/c 10,200
To Provision for 33,000
Taxation
To Dividend 23,000
To Balance C/d 30,600
1,18,800 1,18,800

Funds Flow Statement

Sources Rs. Applications Rs.
Sale of Machinery 1,800 Purchase of 8,000
Machinery
Issue of Shares [Purchase 20,000 Payment of 23,000
of Stock] Dividend
Funds from Operation 88,300 Income Tax paid 28,000
Decrease in Working 18,900 Repayment of Loan 70,000
Capital [Balancing Fig.]
1,29,000 1,29,000

* Issue of shares which involves current assets alone has to be taken here.

Illustration 5: From the following Balance Sheet of M/s. Rao Bros Ltd
prepare Statement of Changes in Working Capital and Funds Flow
Statement

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Financial and Management Accounting Unit 9

BALANCE SHEET
Liability 1990 1991 Asset 1990 1991
Rs. Rs. Rs. Rs.
Equity Share 3,00,000 3,50,000 Fixed Assets 5,10,000 6,20,000
Capital [Net]
8% Preference 2,00,000 1,00,000 Investments 30,000 80,000
Share Capital
Debentures 1,00,000 2,00,000 Current 2,40,000 3,75,000
Assets
P & L A/c 1,10,000 2,70,000 Discount on 10,000 5,000
Debentures
Prov. for 10,000 15,000
Doubtful debts
Current 70,000 1,45,000
Liabilities
7,90,000 10,80,000 7,90,000 10,80,000

Additional Information:
1. Preference Shares were redeemed at a premium of 5% during the year
1991.
2. Dividend at 15% on Equity Share for the year 1190 and Preference
dividend for 1990 were paid.
3. The Provision for Depreciation stood at Rs.150000 and Rs.190000 for
the year 1990 and 1991 respectively.
4. A machine costing Rs.70000, depreciation written off Rs.30000 was
disposed off for Rs.25000.
Solution:
Schedule of Changes in Working Capital
Particulars 1990 1991 Increase Decrease
Current Assets 2,40,000 3,75,000 1,35,000
A. Total Current 2,40,000 3,75,000
Assets

Current Liabilities 70,000 1,45,000 75,000

Prov. for Doubtful 10,000 15,000 5,000
debts
B. Total Current 80,000 1,60,000
Liabilities

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Financial and Management Accounting Unit 9

Working Capital 1,60,000 2,15,000

[A – B]
Net Increase in 55,000 55,000
Working capital
Total 2,15,000 2,15,000 1,35,000 1,35,000

Ledger Accounts for all Non-Current Assets and Liabilities

Fixed Assets A/c
Particulars Rs. Particulars Rs.
To Op. Balance B/d 6,60,000 By Prov for Dep A/c 30,000
[5,10,000 +
1,50,000]*
To Cash A/c 2,20,000 By Cash a/c [Sale] 25,000
[Purchases]

By Adjusted P & L A/c 15,000

[Loss on Sale]
By Cl. Balance C/d 8,10,000
[6,20,000 + 1,90,000]
8,80,000 8,80,000

* Fixed asset should be shown as gross amount. Hence Provision for

depreciation is added to Fixed Asset (Net).
Provision for Depreciation A/c
Particulars Rs. Particulars Rs.
To Machinery 30,000 By Op. Balance B/d 1,50,000
(sold )
To Cl. Balance 1,90,000 By Adjusted P & L A/c 70,000
C/d [Dep for Current yr.]
2,20,000 2,20,000

Discount on Debenture A/c

Particulars Rs. Particulars Rs.
To Op. Balance 10,000 By Adjusted P & L A/c 5,000
B/d [Balancing Fig.]
By Cl. Balance C/d 5,000
Total 10,000 Total 10,000

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Financial and Management Accounting Unit 9

Equity Share Capital A/c

Particulars Rs. Particulars Rs.
By Op. Balance B/d 3,00,000
To Cl..Balance C/d 3,50,000 By Cash A/c [Issue of 50,000
Shares
3,50,000 3,50,000

Investments A/c
Particulars Rs. Particulars Rs.
To Op.Balance B/d 30,000 By Cl. Balance C/d 80,000
To Cash A/c 50,000
[additional
Investment made]
80,000 80,000

8% Preference Share Capital A/c

Particulars Rs. Particulars Rs.
To Cash A/c 1,05,000 By Op. Balance 2,00,000
[Redemption at 5% B/d
premium]
[1,00,000 + 5,000]
To Cl. Balance C/d 1,00,000 By Adjusted P & 5,000
L A/c [Premium]
2,05,000 2,05,000

Debentures A/c
Particulars Rs. Particulars Rs.
To Cl. Balance C/d 2,00,000 By Op. Balance B/d 1,00,000
By Cash A/c [Issue 1,00,000
of deb]
2,00,000 2,00,000

Adjusted Profit and Loss A/c

Particulars Rs. Particulars Rs.
To Loss on Machinery 15,000 By Balance C/d 1,10,000
To Depreciation A/c 70,000 By Funds from 3,16,000
Operation [Bal
Fig.]
To Premium on 5,000
redemption of Pref.

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Financial and Management Accounting Unit 9

Shares
To dividends on 45,000
Equity Shares
To Dividends on 16,000
Preference Shares
To Discount on 5,000
Debentures
To Balance C/d 2,70,000
4,26,000 4,26,000

Funds Flow Statement

Sources Rs. Applications Rs.
Issue of Shares 50,000 Redemption of Preference 1,05,000
Shares
Issue of 1,00,000 Purchase of Fixed Assets 2,20,000
Debentures
Sale of Machinery 25,000 Equity Shares Dividends 45,000
Funds from 3,16,000 Preference Shares 16,000
Operation Dividends
Investments 50,000
Increase in Working Capital 55,000
[Balancing Fig.]
4,91,000 4,91,000

Self Assessment Questions:

12. The difference in General Reserve between two accounting period
shown in the Balance Sheet is transferred to Adjusted Profit and Loss
account since it is a _________
13. Any increase in Equity Share capital shown in the balance sheet is
recorded as _________ in Funds Flow Statement
14. Purchase of Fixed Asset is considered as application of fund. How do
you ascertain the amount if provision for depreciation is shown
separately?
15. While preparing the schedule of changes in working capital:
a. Increase in current asset and decrease in current liability results
in ______ in working capital
b. Decrease in current asset and increase in current liability results
in _________ in working capital.

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Financial and Management Accounting Unit 9

9.8 Summary
Funds flow indicates the inflows and outflows of funds during a particular
accounting period generally a year. As such, the term „flow‟ in the context of
funds indicates the transfer of cash or cash equivalent from asset to equity
or one equity to equity or from one asset to another asset.
Statement of Sources and Uses of Funds or Funds Flow Statement is a
statement which depicts the sources from which funds are obtained and
how they have been utilized. When a transaction results in increase of funds
it is termed as “source of fund” and when it results in decrease of fund it is
termed as “application of fund”. Funds flow statement reveals how the
funds were obtained and how they were utilized whereas the income
statement discloses the results of the business activity.

9.9 Terminal Question

1. What type of transactions affect flow of funds in funds flow statement?
2. What types of transactions are unaffected in the funds flow?
3. Distinguish between funds flow and income statement
4. Briefly explain the steps involved in preparation of funds flow statement
5. Prepare a statement of changes in working capital from the following
information.
Particulars Jan 1 Dec 31
Share Capital 50,000 50,000
Retained earnings 14,000 48,000
Fixed Assets at cost 80,000 90,000
Provision for Depreciation on Fixed Assets 22,000 27,000
Investments in shares of subsidiaries 15,000 15,000
Government securities 6,0000 12,000
8% Debentures (redeemable in 5 equal annual 20,000 -
installment of Rs.20,000 each, from the current
year
Prepaid expense 21,000 4,000
Outstanding expenses 5,000 12,000
Creditors and Bills Payables 30,000 25,000
Debtors and Bills Receivables 18,000 20,000
Cash and Bank balances 5,000 13,000
Provision for Doubtful Debts 4,000 2,000
Prepare Statement of Changes in Working Capital
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Financial and Management Accounting Unit 9

9.10 Answer Self Assessment Questions

1. Change in Working Capital 12. Non cash items

2. Gross 13. Source
3. Fictitious Assets 14. If provision for depreciation
4. Application of Funds is shown separately the
5. False difference between closing
6. True fixed asset (gross) and
7. No opening fixed asset (gross)
8. False is taken as additional
9. This transaction will not purchase made during the
have any effect on flow of year.
funds because it involves 15. (a) increase
only current liability. (b) decrease
10. Creditors paid off by issue
of debentures
11. Building transferred to
creditors in satisfaction of
their claims.

Answer for Terminal Questions

1. Refer Unit 9.3
2. Refer Unit 9.3
3. Refer Unit 9.7
4. Refer Unit 9.4
5. Statement of changes in working capital during the year
6.
Details Balance as on Effect on WC
Jan 1 Dec 31 Increase Decrease
Current Assets
Cash and bank 5,000 13,000 8,000 -
balances
Debtors and B.R 18,000 20,000 2,000 -
Govt. securities 6,000 12,000 6,000
Prepaid 21,000 14,000 - 7,000
expenses

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Financial and Management Accounting Unit 9

Total, say A 50,000 59,000

Current Liabilities
Outstanding 5,000 12,000 - 7,000
expenses
Creditors and 30,000 25,000 5,000
B.P.
Provision for 4,000 2,000 2,000
Doubtful Debts
Total, say B 39,000 39,000
Working Capital :
A minus B 11,000 20,000
Net increase in 9,000 - 9,000
working capital
20,000 20,000 23,000 23,000

Note: If the investments are in the form of Government Securities, it is

treated as current assets.

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Financial and Management Accounting Unit 10

Unit 10 Cash Flow Analysis

Structure:
10.1 Introduction
Objective
10.2 Meaning of Cash Flow Statement
10.3 Purpose of Cash Flow Statement
10.4 Preparation of Cash Flow Statement
10.5 Format of Cash Flow Statement (AS3: Revised Method)
10.6 Cash Flow from Operating Activities
10.7 Cash Flow Statement under Direct Method
10.8 Different between Cash Flow Analysis and Fund Flow Analysis
10.9 Uses of Cash Flow Statement
10.10 Summary
10.11 Terminal Questions
10.12 Answers to SAQ‟s and TQ‟s

10.1 Introduction
The funds flow analysis deal with the flow of funds within and outside the
organization. However the main focus of funds flow statement is to explain
the changes which have taken place in net working capital during the period
under consideration. It fails to explain the changes in cash balance. The
movement of cash is of vital importance to the management. The
organization may become directionless if the cash inflows are not sufficient
to meet the cash outflows. Many a time, a management is posed with the
paradox of huge profits and yet impossible to pay dividends or even taxes.
This is due to the ground realities that cash is either not received or the cash
received is drained out in other items. Hence, it has become a necessity to
have a cash flow analysis on periodic intervals say every quarter. The
statement shows the items resulting in cash inflows and cash outflows.
Objectives:
After studying this unit, you should be able to:
1. Explain the meaning of cash flow statement.
2. Describe the broad classification of cash flow statement
3. Recall the revised AS 3 format of cash flow statement

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Financial and Management Accounting Unit 10

4. Acquaint with steps in preparation of CFS.

5. Compute the Cash Flow Statement
6. Distinguish between Cash Flow Statement and Funds Flow Statement

10.2 Meaning of Cash Flow Statement

Cash flow statement, also known as “Statement Accounting for variations in
cash”, „Where Got Where Gone Statement‟. It shows the movement of cash
and their causes during the period under consideration. The statement is
significant to the stakeholders of the company and is prepared to show the
impact of financial policies and procedures on the cash position. It takes into
account all the transactions that have a direct impact upon cash and cash
equivalent.

10.3 Purpose of Cash Flow Statement

According to Accounting Standard 3, it is mandatory to prepare and present
Cash flow statement along with Statement of financial Position and
Statement of Income position at the end of accounting period. Unlike Fund
Flow statement, cash flow statement explains in depth the inflow and
outflow of cash and cash equivalent in three categories viz Net cash flow
from operating activities, Net cash flow investment activities and Net cash
flow from financing activities. It answers some of the important questions on
the company such as:
 How much cash has been spent on investment activities such as
purchase of new plant and machinery, purchase of land?
 Have long-term source of cash both internally generated plus raised
externally adequate to finance purchase of new long term fixed assets?
 What is the liquidity position of the company? Has it improved?
 How the company is handling large dividend payment? Is it managing
with its reserves or is it borrowing?

10.4 Preparation of Cash Flow Statement

According to Accounting Standard 3 (Revised) method cash flow statement
is sub divided into three parts – (i) cash flow from operating activities
(ii) cash flow from investing activities (iii) cash flow from financing activities.

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Financial and Management Accounting Unit 10

1. Cash flow from Operating Activities:

Operating activities are the principal revenue producing activities of the
enterprise. Therefore, they generally result from the transactions and other
events that enter into the determination of net profit or loss.
The amount of cash flows arising from operating activities is a key indicator
of the extent to which the operations of the enterprise have generated
sufficient cash flows to maintain the operating capability of the enterprise,
pay dividends, repay loans and make new investments without recourse to
external source of financing. Information about the specific components of
future operating cash flows is useful in conjunction with other information in
forecasting future operating cash flows.
Computation of Operating Profit before Working capital changes:
The Net Profit shown in the Profit and Loss Account will have to be adjusted
for non-cash items for find out operating profit before working capital
changes. Some if these items are as follows:
i. Depreciation: Depreciation does not result in outflow of cash and,
therefore, net profit will have to be increased by the amount of
depreciation or development rebate charged, in order to find out the
real cash generated from operations.
ii. Amortization of intangible assets: Goodwill, preliminary expenses,
etc., when written off should therefore, be added back to profits to find
out the cash from operations.
iii. Loss on Sale of fixed assets: It does not result in outflow of cash
and, therefore, should be added back of profits.
iv. Gains from sale of fixed assets: Since a sale of fixed assets is taken
as a separate source of cash, it should be deducted from net profits.
v. Creation of reserves: If profit for the year has been arrived at after
charging transfers to reserves, such transfers should be added back to
profits. If cash operations show a net loss, such net loss after making
adjustments for non-cash items will be shown as an application of
cash.
Thus cash from operations is computed on the pattern of computation
of „Funds‟ from operations.

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Financial and Management Accounting Unit 10

Cash generated from Operations

To find the cash from operations, adjustments will have to be made for
„changes‟ in current assets and current liabilities arising on account of
operations.
 Any decrease in current assets or any increase in current liabilities
between two periods should be added back to Operating profit before
working capital changes.
 Likewise any increase in current assets or any decrease in current
liabilities should be deducted from Operating profit before working
capital changes to arrive at cash generated from Operations.

= Cash Generated From Operations

Computation of Net Cash Flow from Operating Activities:

From cash generated from operations Income tax paid, cash flow from
extraordinary items (if any) should be adjusted (subtracted) to arrive at Net
cash flow from operating activities.

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Financial and Management Accounting Unit 10

2. Cash Flow from Investing Activities

Transactions like purchase or sale of fixed assets, proceeds from sale of
equipments, Interest on Investment received, Dividends received are
recorded.
3. Cash Flow from Financing Activities
Transactions such as proceeds from issue of shares, debentures, proceeds
from long term loans, repayment of long term loans, Interest paid on
debentures, dividend payment to equity, preference share holders are
shown to arrive at net cash used in financing activities.
Purchase of plant and machinery on lease or hire purchase should be
shown separately as deferred credit. However the cost of machinery
purchased will be shown as application of cash.
Computation of Net Increase in Cash and Cash Equivalent
The net cash flow from operating, investing and financing activities are
added to arrive at net increase in cash and cash equivalent. To this cash
and cash equivalent at the beginning of the period is added to get cash and
cash equivalent at the end of the period.

Self Assessment Questions 1:

7. Preparation and submission of Cash Flow Statement is mandatory
according to ______________
8. Cash Flow Statement has three sub division- _____________
,________________________ and ______________________.
9. Since depreciation, a component of internal source does not result in
outflow of cash; the depreciation amount is ______ to the Net Profit.
10. Give any three internal sources of cash that does not result in outflow
of cash.
11. Decrease in liability denotes ____________ of cash
12. Purchase of Plant and Machinery on deferred payment basis is shown
separately as source of cash or ________________

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Financial and Management Accounting Unit 10

10.5 Format of CASH FLOW STATEMENT [AS 3: (Revised)

Method]
CASH FLOW STATEMENT (Indirect Method) for the year ending on……
1. Cash flow from Operating Activities
Net Profit before taxation and extraordinary
items:
Adjustments for
 Depreciation
 Foreign Exchange loss
 Interest Income
 Dividend Income
 Interest expenses
Operating Profit before Working Capital
changes
(+)Decrease/(-)Increase in Sundry Debtors
(+)Decrease/(-)Increase in Inventories
(-)Decrease /(+) Increase in Sundry Creditors
Cash generated from operations
Income Tax Paid
Cash flow from extraordinary items
Proceeds from earthquake disaster settlement
Net Cash flow from Operating activities
(i)

Cash Flow from Investing Activities

Purchase of Fixed Assets
Proceeds from sale of equipment
Interest received
Dividends received
Net cash flow from investing activities
(ii)

Cash flow from Financing Activities

Proceeds from issuance of share capital
Proceeds from long term borrowings
Repayment of long term loans

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Financial and Management Accounting Unit 10

Interest Paid
Dividends Paid
Net cash used in financing activities
(iii)
Net increase in cash & cash equivalent
(i)+(ii)+(iii)
(+) Cash and cash equivalents at the
beginning of the period
= Cash and cash equivalents at the end of
the period
The closing balance of Cash and cash equivalent should tally with cash and
bank balance of Balance Sheet.
Self Assessment Questions:
7. Income Tax paid is ___________activity
(operating/investing/financing).
8. Purchase of fixed assets is cash flow from ________ activity (
financing / investing).
9. Repayment of long term loans, dividend paid are _____________
activity (financing / investing).
10. Net Increase in cash and cash equivalent +
_______________________ = Cash and cash equivalent at the end of
the period
11. Decrease in Sundry Debtors should be _________ to Operating profit
before working capital changes
12. Increase in Sundry Creditors should be _________ to Operating profit
before working capital changes.
Illustration 1: Compute the cash flow from operating activities
Profit and Loss Account
To By
Cost of goods sold 4,00,000 Sales including cash 5,00,000
sales 1,00,000
Office expenses 12,000 Profit on sale of land 30,000
Selling expenses 8,000 Interest on 20,000
investment
Depreciation 6,000
Loss on sale of plant 4,000

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Financial and Management Accounting Unit 10

Goodwill written off 3,000

Income tax 7,000
Net Profit 1,10,000
5,50,000 5,50,000

Balance Sheet as on ……….

MARCH 31
2006 2007
Stock 30,000 28,000
Debtors 15,000 12,000
Bills Receivable 6,000 8,000
Creditors 10,000 12,000
Bills Payable 8,000 5,000
Outstanding expenses 4,000 5,000

Solution
Statement showing cash flows from operating activities
Net Profit before tax and extraordinary 1,10,000
items
ADD : income tax 7,000
Adjustments for Depreciation 6,000
Goodwill written off 3,000
Loss on sale of plant 4,000
1,30,000
Less: Profit on sale of land 30,000
Interest received 20,000 (50,000)
Operating profit before working capital 80,000
changes
ADD : Decrease in current assets
Stock 2,000
Debtors 3,000
Increase in current liabilities : 2,000
Creditors
Outstanding expenses 1,000 8,000
Less :Increase in current assets : Bills 2.000
Receivable
Decrease in current liabilities : Bills payable 3,000 (5,000)
Cash generated from operating activities 83,000
Less : Payment of income tax (7000)
Net Cash from operating Activities 76,000

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Financial and Management Accounting Unit 10

Illustration 2: Calculate cash flow from operating activities if the operating

profit before working capital changes Rs.3,80,000

MARCH 31
2006 2007
Debtors 1,00,000 80,000
Bills Receivable 25,000 30,000
Bills payable 30,000 22,000
Creditors 30,000 40,000
Outstanding expenses 10,000 8,000
Income received in advance 1,000 800
Prepaid expenses 600 500
Accrued income 300 450

Solution
Statement showing cash flow from operating activities
Operating profit before working capital changes 3,80,000
ADD : Decrease in current assets
Decrease in Debtors 20,000
Decrease in Prepaid expenses 100
Increase in current liabilities
Increase in Creditors 10,000
30,100
4,10,100
Less : Increase in current assets
Increase in Bills receivable 5,000
Increase in Accrued income 150
Decrease in current liabilities
Decrease in Bill Payable 8,000
Decrease in Outstanding expenses 2,000
Decrease in Income receivable in advance 200 (15,350)
Net cash from operating activities 3,94,750

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Financial and Management Accounting Unit 10

Illustration 3: The following is the Balance sheet for the period ending 31st
March 2006 and 2007. If the Current year net loss is Rs.38,000. Calculate
the cash flows

MARCH 31
2006 2007
Short term loan to employees 15,000 18,000
Creditors 30,000 8,000
Provision for Doubtful debts 1,200 -
Bills Payable 18,000 20,000
Stock in trade 15,000 13,000
Bills Receivable 10,000 22,000
Prepaid expenses 800 600
Outstanding expenses 300 500

Solution
Statement showing Cash flows from Operating Activities
Net Loss (38,000)
ADD: Decrease in Current Assets
Decrease in Stock 2,000
Decrease in Prepaid expenses 200
Increase in current liabilities
Increase in Outstanding expenses 200
Increase in Bills payable 2,000 + 4,400
(33,600)
Less: Increase in current assets
Increase in Short term loan to the employees 3,000
Increase in Bills receivable 10,000
Decrease in Creditors 22,000
Decrease in Provision for doubtful debts 1,200 (36,200)
Net cash lost in operating activities (69,800)

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Financial and Management Accounting Unit 10

Illustration 4:
Following is the extracts of Balance Sheet in respect of a company.

MARCH
2006 2007
Debtors 30,000 10,000
Stock 25,000 28,000
B.R. 40,000 8,000
Short term loan to employees 10,000 11,000
Prepaid expenses 8,000 8,100
Creditors 10,000 20,000
B.P. 6,000 2,000
Outstanding expenses 600 300

The current year net loss is Rs. 50,000. Calculate the cash flows.
Solution:
Statement showing cash flows from operating activities
Net Loss (50,000)
Add: Decrease in current assets
Decrease in Debtors 20,000
Decrease in B.R. 32,000
Increase in current liabilities
Increase in Creditors 10,000 + 62,000
+ 12,000
Less : Increase in current assets
Increase in Stock 3,000
Increase in Short term loan to employees 1,000
Increase in Prepaid expenses 100
Increase in Current Liabilities
Decrease in B.P 4,000
Decrease in Outstanding expenses 300 (8,400)
Net cash from operating activities + 3,600

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Financial and Management Accounting Unit 10

Illustration 5: Following is the balance sheet of Amit and bros for the year
2006 and 2007. You are required to prepare Cash Flow Statement
BALANCE SHEET as on March 31st 2006 and 2007
Liabilities 2006 2007
Share Capital 2,00,000 2,50,000
General Reserve 50,000 60,000
Profit and Loss 30,500 30,600
Bank Loan (Long-term) 70,000 -
Sundry Creditors 1,50,000 1,35,200
Provision for Taxation 30,000 35,000
Total 5,30,500 5,10,800
Assets
Land and Building 2,00,000 1,90,000
Machinery 1,50,000 1,69,000
Stock 1,00,000 74,000
Sundry Debtors 80,000 64,200
Cash 500 600
Bank - 8,000
Goodwill - 5,000
Total 5,30,500 5,10,800

Additional Information:
During the year ended 31st December,2007
1. Dividend of Rs.23,000 was paid
2. Assets of another company were purchased for a consideration of
Rs.50,000 payable in shares. The assets include Stock Rs.20000,
Machinery Rs.25,000
3. Machinery was further purchased for Rs.8000
4. Depreciation written off on machinery Rs.12,000
5. Income tax provided during the year Rs.33,000
6. Machinery worth Rs.2000 was sold for Rs.1800. Loss on sale of
machinery Rs.200 was transferred to general reserve.

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Financial and Management Accounting Unit 10

CASH FLOW STATEMENT

for the year ending 31st December 2007
1. Cash flow from Operating Activities
Net Profit during the year 100
Add: Provision for Taxation 33,000
Transfer to General Reserve 10,200
Dividend Paid 23,000 66,300
Add: Depreciation on Machinery 12,000
Add: Depreciation on Building 10,000
Operating Profit before working capital 88,300
changes
Add: Decrease in Stock 46,000
Add: Decrease in Debtors 15,800
Less: Decrease in creditors (14,800)
Less: Income tax paid during the year (28,000)
Net Cash Flow from Operating activities 1,07,300

II. Cash Flow from Investing Activities:

Sale of Machinery 1,800
Purchase of Machinery (8000)
Net Cash Flow from Investing Activities (6,200)

III. Cash Flow from Financing Activities

Mortgage loan repaid (70,000)
Dividend Paid (23,000)
Net cash flow from financing activities (93,000)
Net Increase in cash and cash equivalents 8,100
Cash and Cash equivalents at the beginning 500
Cash and cash equivalents at the end of the 8,600
period
Ledger accounts of certain transactions are prepared to find the hidden
information. By the virtue of practice certain information can be traced even

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Financial and Management Accounting Unit 10

without preparation of ledger accounts [eg. Bank loan a/c, land and building
a/c]
Land and Building A/c
Particulars Rs. Particulars Rs.
To Op. bal b/d 2,00,000 By Adjusted P & L A/c 10,000
[Depreciation – Bal. Fig.]
By Cl. Balance C/d
1,9
0,0
00
2,00,000 2,00,000

Machinery A/c
Particulars Rs Particulars Rs.
To Op. Balance B/d 1,50,000 By Adjusted P & L 12,000
A/c
[Depreciation]
To Share Capital 25,000 By Gen. Reserve A/c 200
A/c [Purchase of [Loss on Sale]
Shares]
To Cash A/c 8,000 By Cash A/c [Sale] 1,800
[Purchase]
By Cl. Balance C/d 1,69,000
1,83,000 1,83,000

Goodwill A/c
Particulars Rs. Particulars Rs.
To Op. Balance B/d - By Cl. Balance C/d 5,000
To Share Capital A/c 5,000
5,000 5,000

Share Capital A/c

Particulars Rs. Particulars Rs.
To Cl. Balance C/d 2,50,000 By Op. Balance B/d 2,00,000
By Stock 20,000
By Machinery A/c 25,000
By Goodwill A/c 5,000
2,50,000 2,50,000

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Financial and Management Accounting Unit 10

General Reserve A/c

Particulars Rs. Particulars Rs.
To Machinery A/c 200 By Op. Balance B/d 50,000
To Cl. Balance 60,000 By Adjusted P & L A/c 10,200
C/d
60,200 60,200

Bank Loan A/c

Particulars Rs Particulars Rs.
To Cash A/c 70,000 By Op. Bal b/d 70,000
[Repayment] [Trf. to
Fund Flow Stnt.]
To Cl. Balance c/d -
70,000 70,000

Provision for Tax A/c

Particulars Rs. Particulars Rs.
To Cash A/c [I - Tax 28,000 By Op. Balance B/d 30,000
Paid]
To Cl. Balance C/d 35,000 B y Adjusted P & 33,000
LA/c
Balancing Fig.]
63,000 63,000

Adjusted Profit and Loss A/c

Particulars Rs. Particulars Rs.
To Depreciation on Land 10,000 By Balance 30,500
& Building. C/d
To Depreciation on 12,000 By Funds 88,300
Machinery from
Operation
[Balancing
Fig.]
To Gen. Reserve A/c 10,200
To Provision for Taxation 33,000
To Dividend 23,000
To Balance C/d 30,600
1,18,800 1,18,800

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Financial and Management Accounting Unit 10

Illustration 6
Following are the summarized balance sheets of Thomson as on 31st
December 2005 and 2006.
Liabilities 2005 2006
Share Capital 1,00,000 1,30,000
General Reserve 25,000 30,000
Profit and Loss 15,200 15,400
Bank Loan (Long-term) 35,000 -
Sundry Creditors 75,000 67,500
Provision for Taxation 15,000 17,500
Total 2,65,200 2,60,400
Assets
Land and Building 1,00,000 95,000
Machinery 75,000 84,500
Stock 50,000 37,000
Sundry Debtors 40,000 32,100
Cash 200 300
Bank - 4,000
Goodwill - 7,500
Total 2,65,200 2,60,400

Adjustments
1. Dividend of Rs. 11,500 was paid
2. Assets of another Company were purchased for a consideration of
Rs. 30,000 payable in shares. The following assets were purchased
(a) stock Rs. 10,000 (b) Machinery Rs.12,500
3. Machinery was further purchased for Rs. 4,000
4. Income tax paid Rs. 16,500 for the tear
5. Depreciation written-off in Machinery Rs. 6,000
6. Loss on sale machine Rs. 100 was written-off to General Reserve.
Prepare Cash flow statement.

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Financial and Management Accounting Unit 10

Solution:
CASH FLOW STATEMENT
for the year ending 31st December 2006
I. Cash flow from Operating Activities
Net Profit during the year 200
Add: Provision for Taxation 19,000
Transfer to General Reserve 5,100
Dividend Paid 11,500
Depreciation on Machinery 6,000
Depreciation on L & B 5,000 46,600
Operating Profit before working capital 46,800
changes
Add: Decrease in Stock 13,000
Add: Decrease in Debtors 7,900
Less: Decrease in creditors (7,500)
Less: Income tax paid during the year (16,500)
Net Cash Flow from Operating (3,100)
activities

II. Cash Flow from Investing Activities:

Sale of Machinery 900
Purchase of Machinery (4,000)
Net Cash Flow from Investing (3100)
Activities

III. Cash Flow from Financing Activities

Bank loan repaid (35,000)
Dividend Paid (11,500)
Issue of share capital (stock) 10,000
Net cash flow from financing activities (36,500)
Net Increase in cash and cash 4,100
equivalents
Cash and Cash equivalents at the 200
beginning
Cash and cash equivalents at the end 4,300
of the period

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Financial and Management Accounting Unit 10

Working Notes:
Machinery A/c
Particulars Rs Particulars Rs.
To Op. Balance 75,000 By Adjusted P & L A/c 6,000
B/d [Depreciation]
To Share Capital 12,500 By Gen. Reserve A/c 100
A/c [Purchase [Loss on Sale]
of Shares]
To Cash A/c 4,000 By Cash A/c [Sale] 900
[Purchase]
By Cl. Balance C/d 84,500
91,500 91,500

Goodwill A/c
Particulars Rs. Particulars Rs.
To Op. Balance B/d -
To Share Capital A/c 7,500 By Cl. Balance 7,500
C/d
7,500 7,500

Share Capital A/c

Particulars Rs. Particulars Rs.
To Cl. Balance C/d 1,30,000 By Op. Balance B/d 1,00,000
By Stock 10,000
By Machinery A/c 12,500
By Goodwill A/c 7,500
1,30,000 1,30,000
General Reserve A/c
Particulars Rs. Particulars Rs.
To Machinery A/c 100 By Op. Balance B/d 25,000
To Cl. Balance C/d 30,000 By Adjusted P & L A/c 5,100
30,100 30,100

Bank Loan A/c

Particulars Rs Particulars Rs.
To Bank a/c (repaid) 35,000 By Op. Bal b/d 35,000
35,000 35,000

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Financial and Management Accounting Unit 10

Provision for Tax A/c

Particulars Rs. Particulars Rs.
To Cash A/c [I - Tax 16,500 By Op. Balance B/d 15,000
Paid]
To Cl. Balance 17,500 By Adjusted P & LA/c 19,000
C/d Balancing Fig.]
34,000 34,000

Land and Building A/c

Particulars Rs. Particulars Rs.
To Balance c/d 1,00,000 By Adjusted P & LA/c 5,000
depreciation
By Balance b/d 95,000
1,00,000 1,00,000

Self Assessment Questions:

13. Dividend received is ____________ activity because income is
received from investment in shares of another company.
14. Dividend paid is _____________ activity.

10.7 Cash Flow Statement under Direct Method

Under this method gross cash receipts and gross cash payments for the
major items are disclosed, such as cash receipts from customers and cash
paid to suppliers.
Format of Cash Flow Statement under Direct Method
Particulars
Cash flows from Operating Activities
Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Income taxes paid
Net cash from operating activities

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Financial and Management Accounting Unit 10

Cash flows from Investing Activities

Purchases of plant and machinery
Purchase of patents
Proceeds from sale of plant
Net cash used in Investing Activities

Cash flows from Financing Activities

Proceeds from issuance of equity share capital
Repayment of Debentures
Interest paid to Debenture-holders
Dividends paid
Net decrease in cash balance
Less:
Cash and cash equivalents at beginning of
the year
Cash and cash equivalents at end of the year

Illustration 6: Given below are the Balance Sheet as on March 31, previous
year and current year, and a Statement of Income and Reconciliation of
earnings for the current year of Electronics Ltd. The only item in the plant
and machinery account sold during the year was a specialized machine that
originally cost Rs.15 lacs. The accumulated depreciation on this machine at
the time of sale was Rs.8 lacs. The machine was sold for Rs.6 lacs and full
payment was received in cash. Electronics Ltd. purchased patents for Rs.16
lacs during the year. Besides cash purchases of plant and equipment, the
assets of another company were also purchased for Rs.1 crore payable in
fully paid-up shares, issued at par; the assets purchased being goodwill,
Rs.30 lacs and plant, Rs.70 lacs.

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Financial and Management Accounting Unit 10

Comparative Balance Sheets

[Rs.in lacs]
Particulars March 31 March 31
[Pr. Yr.] [Cu.Yr.]
Cash 74 37
Sundry debtors 54 47
Inventories 312 277
Prepaid expenses 6 4
Land 60 60
Patents 55 65
Plant and machinery 420 550
Less: Accumulated depreciation [105] [120]
Goodwill - 30
Total Assets 876 950
Sundry Creditors 86 102
Provision for Income tax 89 17
Debentures 220 60
Equity capital 250 560
Retained earnings 231 211
Total Liabilities 876 950

Statement of Income and Reconciliation of earnings for Current Year

[Rs.in lacs]
Particulars
Net Sales 1,977
Less: Cost of goods sold [1,480]
Gross Profit 497
Less: Operating expenses [includes dep on [486]
plant & machinery,amortization of patents]
Less: Interest on Debentures [14]
Net loss from operations [3]
Add: Retained earnings [Previous year] 231
228
Less: Dividend paid 16
Less: Loss on sale of assets 1 [17]
Retained earnings [March 31, Current year] 211

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Financial and Management Accounting Unit 10

From the foregoing information, prepare a Cash-flow statement both under

Direct and Indirect Method for Electronics Ltd.
Solution [A]: [Direct method]
Cash Flow Statement of Electronics Ltd. for the Current Year
[Rs.in lacs]
Particulars
Cash flows from Operating Activities
Cash receipts from customers 1,984
[See working note: 1]
Cash paid to suppliers and employees [1,884]
[See working note: 2]
Cash generated from operations 100
Income taxes paid [72]
Net cash from operating activities 28*

Cash flows from Investing Activities

Purchases of plant and machinery [75]
Purchase of patents [16]
Proceeds from sale of plant 6
Net cash used in Investing Activities [85]

Cash flows from Financing Activities

Proceeds from issuance of equity share capital 210
Repayment of Debentures [Rs.220 – 60] [160]
Interest paid to Debenture-holders [14]
Dividends paid [16] 20
Net decrease in cash blance [Rs.85 – (28 + 20)] [37]
Less:
Cash and cash equivalents at beginning of the 74
year
Cash and cash equivalents at end of the year 37

N.B: * It may be recalled that cash from operating activities [shown in

Section II] was Rs.14; the difference of Rs.14 [Rs.28 as per AS – 3 and
Rs.14 as per CFS] is due to exclusion of interest payment on debentures
[Rs.14]; this interest payment is shown under financing activities.

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Financial and Management Accounting Unit 10

Working Notes: 1
[Rs.in lacs]
Particulars
Cash receipts from debtors and customers:
Debtors at the beginning of the year 54
Add: Net sales during the year 1,977
Total sum receivable 2,031
Less: Debtors at the end of the year [47]
Total 1,984

Working Notes :2
Cash paid to suppliers and employees:
Cost of goods sold 1,480
Add: Operating expenses excluding depreciation 457
and amortization [Rs.486 – 23 – 6]
Add: Current year prepaid expenses 4
Less: Previous year prepaid expenses [6] 455
1,935
Add: Creditors at the beginning of the year 86
Add: Inventories at the end of the year 277
2,298
Less: Creditors at the end of the year [102]
Less: Inventories at the beginning of the year [312]
Total 1,884

Solution [B]: [Indirect method]

Cash Flow Statement of Electronics Ltd. for the Current Year
[Rs.in lacs]
Particulars
Cash flows from Operating Activities
Net Loss before taxation and extra-ordinary [4]
items
Adjustments for:
Depreciation 23
Amortization of patent 6
Interest expenses 14
Loss on sale of assets 1
Operating profit before working capital 40
changes

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Financial and Management Accounting Unit 10

Add: Decrease in debtors 7

Add: Decrease in inventories 35
Add: Prepaid expenses 2
Add: Increase in creditors 16
Cash generated from operations 100
Less: Income tax paid [72]
Net cash from operating activities 28
Cash flows from Investing Activities
Purchase of plant and machinery [75]
Purchase of patents [16]
Proceeds from sale of plant 6
Net cash used in Investing Activities [85]
Cash flows from Financing Activities
Proceeds from issuance of equity share 210
capital
Repayment of Debentures [220 – 60] [160]
Interest paid to Debenture-holders [14]
Dividends paid [16] 20
Net decrease in cash balance [85 – 48] [37]
Cash and cash equivalents at beginning 74
of the year
Cash and cash equivalents at end of the 37
year

The Statement highlights that the firm does not have enough funds from its
operating activities [Rs.28 lacs] and financing activities [Rs.20 lacs] to cater
to investment requirement of Rs.85 lacs, causing decline in cash [Rs.37
lacs]

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Financial and Management Accounting Unit 10

Problem on Cash Flow And Funds Flow Statement:

Illustration 7: The financial position of M/s C and D on Jan 1 and
December 31st, 2004 was as follows:
st st st st
Liabilities 1 Jan 31 Dec Asset 1 Jan 31 Dec
Current
liability for 36,000 40,600 Cash 4000 3,600
goods (crs)
Mrs.A‟s Loan - 20,000 Debtors 35,000 38,000
Loan from 30,000 25,000 Stock 25,000 22,000
Bank
Hire Purchase - 20,000 Land 20,000 30,000
vendor
Capital 1,48,000 1,54,000 Building 50,000 55,000
Machinery 80,000 86,000
Delivery - 25,000
Van
Total 2,14,000 2,59,600 Total 2,14,000 2,59,600

The delivery van was purchased in December 2004 on hire purchase basis;
a payment of Rs.5000 was made immediately and the balance of the
amount is to be paid in 20 monthly installments of Rs.1000 each together
with interest at 12% p.a. During the year the partners withdrew Rs.26,000
for domestic expenditure. The provision for depreciation against machinery
on 31st December 2003 was Rs.27,000 and on 31st December 2004
Rs.36,000 You are required to prepare the Funds flow and Cash Flow
statement. Observe the difference between funds from operations and cash
from operations and give the inference.

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Financial and Management Accounting Unit 10

1. Preparation of funds flow statement

Schedule of Changes in working Capital
st st
1 Jan 31 Dec Effect on W.C
Increase Decrease
Current Assets
Cash 4000 3600 400
Debtors 35,000 38,000 3,000
Stock 25,000 22,000 3,000
Total (A) 64,000 63,600
Current liabilities
Creditors 36,000 40,600 4,600
Hire purchase instl - 12,000 12,000
1000x12
Total (B) 36,000 52,600
Decrease in W.C 17000
(A)- (B) 28,000 11,000 20,000 20,000

FUNDS FLOW STATEMENT

Sources:
Funds from Operation (see working notes) 41,000
Loan from Mrs.C 20,000
Decrease in working capital 17,000
Total 78,000
Application:
Repayment of bank loan 5000
Initial payment for Delivery van 5000
Installments payable in the year for delivery van 12,000
Machinery acquired (see machinery account) 15,000
Land acquired 10,000
Building acquired 5,000
Partners‟ drawings 26,000
Total 78,000

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Financial and Management Accounting Unit 10

Activity 1: Prepare Cash flow Statement using the format given below
CASH FLOW STATEMENT
for the year ending 31st December 2004
I. Cash flow from Operating Activities
Net Profit during the year

Add: Depreciation on Machinery

Operating Profit before working capital
changes
Add: Decrease in Stock
Less: Increase in Debtors
Add: Increase in creditors
Net Cash Flow from Operating activities

II. Cash Flow from Investing Activities:

Purchase of Building
Purchase of Machinery
Purchase of Land
Payment for Delivery van
Net Cash Flow from Investing Activities

III. Cash Flow from Financing Activities

Loan from Mrs. A
Payment of Bank Loan
Withdrawal by Partner
Net cash flow from financing activities
Net Increase in cash and cash equivalents
Cash and Cash equivalents at the
beginning
Cash and cash equivalents at the end of
the period

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Financial and Management Accounting Unit 10

Working Notes:
FUNDS FROM OPERATIONS
st
Capital as on 31 December 2004 1,54,000
Add: Drawings made during the year 26,000
1,80,000
st
Less: Capital as on 1 Jan 2004 (-) 1,48,000
Profit for the year 32,000
Add: Depreciation for the Machinery (+) 9,000
(36,000-27,000)
Funds from Operations 41,000

Machinery A/c
Particulars Rs Particulars Rs.
To Op. Balance B/d 80,000 By Adjusted P & L A/c 9,000
[Depreciation]
To Bank A/c 15,000
[Purchase]
By Cl. Balance C/d 86,000
95,000 95,000

10.8 Difference between Cash Flow Analysis and Funds Flow

Analysis
Following are the points of difference between Cash Flow Analysis and a
Funds Flow:
Cash Flow Analysis Fund Flow Analysis
1. It is concerned only with the 1. Is concerned with change in working
change in cash position capital position between; two balance
sheet dates.
2. It merely a record of cash 2. In Fund Flow statement net effect of
receipts and disbursements receipts and disbursements are
recorded.
3. It is more useful to the 3. It is concerned with the total provision
management as a tool of of funds.
financial analysis in short
period.

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4. Cash is part of working capital 4. An improvement in funds positions

and therefore, an improvement need not resulting improvement in
in cash position results in cash position
improvement in the funds
position
5. An increase in a current 5. An increase in a current liability or
liability of decrease in a decrease in a current asset results
current asset will result in decrease in working capital
increase in cash position
6. It is based on cash basis 6. It is based on accrual basis
7. It is not based on ledger 7. It is based on ledger principles
mode

10.9 Uses of Cash Flow Statement

The cash flow statement, being one of the important financial documents a
firm has to possess, reveals the effective uses. First of all, it explains in
depth the reasons for the low cash balance available at a particular time.
Based on this, it is possible to find the reasons for such a situation. It also
shows the major sources and uses of cash. By effectively maintaining the
cash and controlling the outflow of cash, it is possible to set in motion the
smooth functioning of the organization. It helps the financial decisions more
effectively with regard to short term liquidity position of an organization.
Projections of cash inflows and outflows can be regulated based on the
records available in the past. Proper projections can be made once the
reasons are analyzed. Based on this, it is possible to liquidate the short term
obligations without much fun-fare. Short term obligations need to be
serviced so that the credit worthiness of an organization can be carried on
unabated.

10.10 Summary
Cash flow statement, also known as “Statement Accounting for variations in
cash”, „Where Got Where Gone Statement‟. It shows the movement of cash
and their causes during the period under consideration. According to
Accounting Standard 3, it is mandatory to prepare and present Cash flow
statement along with Statement of financial Position and Statement of
Income position at the end of accounting period.

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Financial and Management Accounting Unit 10

Operating activities are the principal revenue producing activities of the

enterprise. Therefore, they generally result from the transactions and other
events that enter into the determination of net profit or loss.

10.11 Terminal Questions

1. What is cash flow statement and how is the cash flow statement
subdivided?
2. Bring out the draft format of cash flow statement as per AS3 (revised)
method?
3. What is cash flow from operating activities?
4. Bring out the difference between cash flow analysis and funds flow
analysis
5. From the following balance sheets of Joy Ltd. Prepare cash flow
statement under indirect method.
Liabilities 2005 2006
Equity Share Capital 3,00,000 4,00,000
8% Redeemable pref. Share capital 1,50,000 1,00,000
General Reserve 40,000 70,000
Profit and Loss 30,000 48,000
Proposed Dividend 42,000 50,000
Sundry Creditors 55,000 83,000
Bills payable 20,000 16,000
Provision for Taxation 40,000 50,000
Total 6,77,000 8,17,000
Assets
Goodwill 1,15,000 90,000
Land & Building 2,00,000 1,70,000
Plant 80,000 2,00,000
Sundry Debtors 1,60,000 2,00,000
Stock 77,000 1,09,000
Bills receivable 20,000 30,000
cash 15,000 10,000
Bank 10,000 8,000
Total 6,77,000 8,17,000

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Financial and Management Accounting Unit 10

Additional Information
a) Depreciation of Rs. 10,000 and Rs. 20,000 have been changed on plant
and building during the current year.
b) An interim dividend of Rs. 20,000 has been paid during the current year.
c) Rs. 35,000 was paid during the current year for income tax.

10.12 Answer Self Assessment Questions

SAQ 1: Answer for Terminal

1. AS3 Questions
2. a. Net cash flow from 1. Refer to unit 10.4
operating activities 2. Refer to unit 10.5
b. Net cash flow from 3. Refer to unit 10.6
investment activities 4. Refer to unit 10.8
c. Net cash flow from 5. Cash flow from operating
financing activities activities Rs.1,25,000; Cash
3. Added back flow from investing activities
4. Depreciation, Amortization of (Rs.1,20,000); Cash flow
intangible assets, Gains from from financing activities
sale of fixed assets (Rs.12,000).
5. Outflow
6. Deferred credit
7. Operating
8. Investing
9. Financing
10. Cash and cash equivalent at
the beginning of the year
11. Added
12. Added
13. Investment
14. Financing

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Financial and Management Accounting Unit 10

Activity 1: Solution
CASH FLOW STATEMENT
for the year ending 31st December 2004
I. Cash flow from Operating Activities
Net Profit during the year 32000

Add: Depreciation on Machinery 9000

Operating Profit before working capital 41000
changes
Add: Decrease in Stock 3000
Less: Increase in Debtors (3000)
Add: Increase in creditors 4600
Net Cash Flow from Operating 45600
activities

II. Cash Flow from Investing Activities:

Purchase of Building (5000)
Purchase of Machinery (15000)
Purchase of Land (10000)
Payment for Delivery van (5000)
Net Cash Flow from Investing (35000)
Activities

III. Cash Flow from Financing Activities

Loan from Mrs. A 20000
Payment of Bank Loan (5000)
Withdrawal by Partner (26000)
Net cash flow from financing activities (11000)
Net Increase in cash and cash (400)
equivalents
Cash and Cash equivalents at the 4000
beginning
Cash and cash equivalents at the end 3600
of the period

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Financial and Management Accounting Unit 11

Unit 11 Understanding Cost

Structure:
11.1 Introduction
Objectives
11.2 Meaning of Cost
11.3 Objective of Costing
11.4 Methods of Costing
11.5 Technique of Costing
11.6 Classification of Cost
11.7 Elements of Cost
11.8 Statement of Cost Sheet
11.9 Solved Problems
11.10 Summary
11.11 Terminal Questions
11.12 Answers to SAQ’s and TQ’s

11.1 Introduction
Management accounting is the application of accounting techniques for
providing information necessary for decision making. It is designed to help
all levels of management in planning and controlling the activities of a
business enterprise. The objective of management accounting is to
determine product cost, to facilitate planning and control of regular business
activities and to supply information for short and long run decisions.
Costing is the process of determining the cost of doing something, eg. cost
of manufacturing an article, rendering a service or performing a function.
Costing includes the techniques and processes of ascertaining cost. In this
unit we are dealing with different methods of costing, different techniques of
costing and finally classification of costs under various heads.
Objectives:
After studying this unit, you should be able to:
1. Explain the meaning of cost.
2. Differentiate between cost, expenses and loss
3. Explain the objective and methods of costing
4. Know the techniques of costing
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Financial and Management Accounting Unit 11

5. Know the various classification of cost

6. Understand the element of cost.
7. Draft the specimen of cost sheet
8. Prepare the statement of cost.

11.2 Meaning of Cost

Cost is the amount of resources given up in exchange of some goods and
services. The resources are expressed in money or money’s equivalent.
CIMA defines the term cost as “the amount of expenditure (actual or
notional) incurred on or attributable to a given thing”. The given thing may
be taken as a product, service or any other activity. While the actual
expenditure refers to the amount spent, the notional expenditure does not
involve in any cash outlay. It does not reflect itself in the accounting
records. But, it is important for the purpose of comparison of cost and in
decision making.
Cost Vs Expenses and Loss
An expense is defined as an expired cost resulting from a productive usage
of an asset. Unconsumed or unexpired part of the cost is recorded as an
asset in the balance sheet.
COST

EXPIRED COST UNEXPIRED / DEFFERED COST

(EXPENSES) (ASSET)

Loss is defined as reduction in firm’s equity other than from withdrawals of

capital for which no compensating value has been received.

11.3 Objective of Costing

It aims to serve the information needs of management for planning, control
and decision making.
 It helps to determine product cost. They are important in inventory
valuation, decision regarding pricing of the product.
 It facilitates planning and control of regular business activities. Different
alternative plans are evaluated in terms of respective cost and
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Financial and Management Accounting Unit 11

associated benefits. In control process the data generated can be

compared with budgets and estimates.
 It supplies information for short term and long term decisions. These
decisions involve whether to develop new products, when to enter which
market etc.

11.4 Methods of Costing

Costing refers to the techniques and processes of determining costs of a
product manufactured or a service rendered. The method of costing
depends on the nature of product, production method and specific business
conditions. For example, in cement or steel industry, raw materials passes
through different stages (processes) and production is done on continuous
bases while in case of construction of a house or contract to build a metro
rail / flyover / underpass the job is for a specific purpose and each job is
different from the other. In service industry like hospitality industry, software
development, back office processing work etc process costing technique is
used.

A. Job Costing B. Process Costing

(i) Batch Costing (i) Unit Costing
(ii) Contract Costing (ii) Operating Costing
(iii) Composite Costing (iii) Operation Costing

A. Job Costing: It is used in those business concerns where production is

carried out as per specific order and customer’s specification.
Batch This method is used to Eg. Production of tablets,
Costing determine the cost of a group capsules, nuts & bolts,
of identical products. The components/ spare parts
batch consist of similar
products is a unit and not a
single item within the batch.
Contract This method is based on the Eg. Construction of an
Costing principle of job costing used apartment, housing colony,
by house builders and civil Airports, flyovers etc.
contractors. The contract
becomes the cost unit for
which relevant costs are
determined.

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Composite In this method costs are Eg. Manufacture of aero

Costing accumulated for different planes, motor vehicles,
components of the product Computers etc.
and then combined because
the nature of the product is
complex.

B. Process Costing: This method is used in those industries where

manufacture is done continuously thereby it is difficult to trace costs to
specific units. The total cost is averaged for the number of units
manufactured.
Unit Costing This method is used when Eg. Sugar industry, Cement,
a single item is produced Fertilizer, Chemicals,
and the final product is Petroleum refining, LPG,
composed of homogeneous Paper etc.
units. The cost per unit is
obtained by dividing the
total cost by the total
number of units
manufactured.
Operating This method is used by Eg. Passenger mile, bed in a
Costing service industries. The unit hospital, per student in a
cost differs among these college.
services depending upon
the nature of service being
rendered.
Operation This product costing is used Eg. The professional basket
Costing when conversion activities balls are covered with
are very similar across genuine leather whereas the
products lines but the direct scholastic basketballs are
materials differ significantly. covered with imitation leather.

Cost Centre: Cost centre refers to a section of the business to which costs
can be charged. It may be location (a department, sales area), an item of
equipment (a machine, a delivery van), a person (a salesman, a machine
operator or a group of these).
Cost Unit: It is a unit of quantity of product, service or time (or a
combination of these), in relation to which cost may be ascertained or
expressed.

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Self Assessment Questions:

1. Unexpired costs is termed as ___________
2. Different types of job costing are ____________,___________ and
__________
3. Different types of process costing are _________.________ and
____________

11.5 Techniques of Costing

Techniques refer to principles and rules that are applied for ascertaining
cost of the product manufactured or an activity rendered. The following are
the costing techniques generally used:
1. Historical Costing: In this system costs are determined after they have
been incurred.
2. Standard Costing: In this system, standard costs are ascertained and
then compared with the actual cost and the variance if any is
determined. Standard costs are predetermined costs in conformity with
the most efficient operations or industry benchmark.
3. Absorption or Full Costing: In this method, all costs both fixed and
variable are charged to the products, jobs or processes.
4. Variable or Marginal Costing: In this method, only variable costs are
charged to the product or jobs. The fixed costs are written off against
profits in the period in which they arise.
5. Uniform costing: It is an attempt by several undertakings to use similar
costing principles or practices.

11.6 Classification of cost

The elements of costs are classified as materials, labor and expenses.
These three elements of cost would be grouped in to direct and indirect
categories. Following are the three broad elements of cost
 Materials – Direct (chargeable) and Indirect
 Labor – Direct and Indirect
 Expenses
1. Direct Material: It refers to the cost of materials which are conveniently
and economically traceable to specific units of output. Eg. raw cotton in

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textiles, crude oil to make diesel, steel to make automobiles, components

or parts, primary packing materials, import duties, dock charges,
transport of raw materials.
2. Direct Labour: It is defined as the labour of those workers who are
engaged in the production process. It is the labour expended directly
upon the materials comprising the finished goods.
3. Direct Expenses: These include any expenditure other than direct
material and direct labour directly incurred on a specific product or job.
Eg. cost of hiring special machinery or plant, cost of special moulds,
designs and patterns, experimental cost on models and pilot schemes,
fee paid to architects, surveyors, inward carriage and freight on special
materials, cost of patent and
4. Factory Overhead: It is defined as the cost of indirect materials, indirect
labour and indirect expenses.
 Indirect materials: It refers to materials that are needed for the
completion of the product but whose consumption with regard to the
product is either so small or so complex that it would not be
appropriate to treat it as a direct material item. These materials
cannot be conveniently assigned to specific physical units. Eg.
Lubricants, cotton waste, hand tools, works stationery.
 Indirect Labour: Indirect labour includes foremen, shop clerks,
general helpers, cleaners, material handlers, plant guards,
maintenance men.
 Indirect expenses: It covers all indirect expenditure incurred from
the time production has started to its completion and its transfer to
the finished goods store. eg. heat, light, maintenance, factory
manager’s salary.
5. Selling, Distribution and Administration Overhead: Such expenses
are generally incurred when the product is in saleable condition. It
includes advertising, salesmen salaries, commission, packing, storage,
transportation and sales administrative costs.
6. Fixed Cost: It is a cost which does not change in total for a given time
period despite wide fluctuation in output or volume of activity. These
costs are also known as standby costs, capacity costs or period costs.

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Eg. Rent, property taxes, supervising salaries, depreciation of office

facilities, advertising and insurance.
Example: The production volume and Fixed costs
Total Fixed Cost Production (in units) Average Fixed
Cost per unit
10,00,000 1000 Rs.1000
10,00,000 2,000 Rs.500
10,00,000 5,000 Rs.200
10,00,000 10,000 Rs.100

Y
10,00,000

0 2000 4000 6000 8000 10000 X

Volume of Activity (in units)
y
average 10
fixed 8
cost 6
4
2
x
0 2,000 4,000 6,000 8,000 10 000 Volume of activity
(in units)
Fixed costs will not change over a wide range of volume. They will fluctuate
before and beyond that range.
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Relevant
Range of
Total Volume Fixed cost
Fixed cost

0 Behaviour of Fixed Cost X

Classification of Fixed Cost:
 Committed cost: Such costs are primarily incurred to maintain the
company’s facilities and physical existence and over which management
has little or no discretion. Depreciation on P&M, taxes, insurance rent
etc are the examples.
 Managed cost: They relate to the current operations which must
continue to be paid to ensure the continued operating existence of the
company. eg Staff and management salaries.
 Discretionary cost: They are also known as programmed cost which is
incurred due to special policy decision, mgt program, new research or
new system development.
 Step Cost: This cost is constant for a given amount of output and then
increases in a fixed amount at a higher output level. One supervisor is
required at a salary of Rs.10000 pm for every 50 workers. The cost of
supervisor salary increases to Rs.20000 on employing 51st worker.
7. Variable Cost:
Variable costs are costs that vary directly and proportionately with the
output. There is a constant ratio between the change in the cost and the
change in the level of output. Eg. Direct material and Direct labour and
Variable overheads (factory supplies, indirect materials, sales commission,
office supplies)If the factory is shut down, variable costs are eliminated.

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Y Y

Production in Units Production in Units

8. Mixed Cost: are costs made up of fixed and variable element. They are a
combination of semi-variable cost and semi-fixed costs. Because of the
variable component they fluctuate with volume; because of the fixed
component they do not change in direct proportion to output.
Semi-fixed cost is those costs which remain constant up to a certain level of
output after which they become variable.
Semi-variable cost is the cost which is basically variable but whose slope
may change abruptly when a certain output level is reached.
9. Product Cost: Are those costs which are identified with the product and
included in inventory values. In other words the costs that is included in the
cost of manufacturing a product. It is composed of four elements- direct
materials, direct labour, direct expenses and manufacturing overhead.
10. Period Cost: are the costs which are not identified with the product or
job and are deducted as expenses during the period in which they are
incurred. They are not carried forward as a part of value of inventory to the
next accounting period.
11. Opportunity cost: it is cost of opportunity lost. It is the cost of selecting
one course of action in terms of the opportunities which are given up to
carry out that course of action. It is the benefit lost by rejecting the best
competing alternative to the one chosen.

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12. Sunk Cost: It is the cost that has already been incurred. It is generally
unavoidable because these costs cannot be changed once incurred. If the
plant has a book value of 10 lakhs and a scrap value of 50000, then the
sunk cost is 9.5lakhs.
13. Relevant Cost: are those future costs which differ between alternatives.
It may also be defined as the cost which are affected and changed by a
decision. They are not historic (sunk) cost and are only incremental
(additional) or avoidable cost.
14. Differential cost: It is the difference in total costs between any two
alternatives. It is equal to the additional variable expenses incurred in
respect of the additional output, plus the increase in the fixed costs if any.
15. Imputed cost: are costs not actually incurred in some transaction but
which are relevant to the decision as they pertain to a particular situation.
Eg. Interest on internally generated funds, rental value of company owned
property and salaries of owners.
16. Out-of-Pocket cost: While imputed costs do not involve cash outlays,
out-of-pocket costs signify the cash cost incurred on an activity. This cost
concept is significant for management in deciding whether or not a particular
project will at least return the cash expenditure associated with the project.
17. Shut Down cost: are those costs which have to be incurred under all
situations in the case of stopping manufacture of a product or closing down
a department or a division. They are fixed cost. It also refers to minimum
fixed cost which is incurred in the event of closure.
Self Assessment Questions:
4. Standard costs are predetermined costs which are compared with actual
costs and the variance is determined. (state true or false)
5. _______ include costs both fixed and variable are charged to the
products, jobs or process
6. Cost of hiring special machines, cost of special moulds are examples of
_______
7. _______ are costs are unavoidable because these costs cannot be
changed once incurred.

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11.7 Elements of Cost

Every product that is manufactured whether it is a pin or a computer needs
resources. The management must know the cost of using their resources for
its planning and control function. Therefore, the elements of costs are
classified as materials, labor and expenses. These three elements of cost
would be grouped in to direct and indirect categories
Prime Cost: It is the total of direct materials cost, direct labor cost and
chargeable expenses.
Factory Cost: It consists of prime cost and factory overheads.
Office cost or Cost of Production: It comprises of factory cost and office
and administration overheads.
Total Cost: By adding selling and distribution expenses to cost of
production, one can get the total cost or cost of sales.

11.8 Statement of Cost Sheet

Cost sheet is a statement prepared to show the different components of the
total cost. It generally shows the total cost and sales as well as cost and
selling price per unit. It is generally presented in a tabular form.
Specimen of Cost Sheet
Cost Sheet for the period __________
Production _____ units
Total Cost Cost per
unit
Opening Stock of Raw Materials
Purchases
Carriage Inward
(-) Closing Stock of Raw Materials
(-) Scrap
Direct materials Consumed (I)
Direct Wages (II)
Direct Expenses (III)
I PRIME COST = (I)+ (II)+(III)

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(+) Factory Overheads

Indirect Materials
Loose Tools
Indirect Wages
Rent and Rates (factory)
Lighting & Heating (factory)
Power & Fuel
Lubricant
Repairs and Maintenance
Drawing Office Expenses
Cost of research
Depreciation of factory plant
Works Stationery
Welfare service expenses
Insurance – Fixed assets
Insurance – Stock and finished goods
Work’s Managers salary
II FACTORY OR WORKS COST
(+) Opening stock of Work-in-progress
(-) Closing stock of Work-in-progress
III COST OF GOODS MANUFACTURED
(+) Office and Administrative overhead
Rent and Rates (office)
Salaries (office)
Lighting and Heating
Insurance of office building
Telephone and Postage
Printing and Stationery
Depreciation on furniture and fixtures
Legal Expenses
Audit fee
Bank Charges
IV COST OF PRODUCTION
(+) Opening Stock of Finished Goods

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(-) Closing Stock of Finished Goods

V COST OF GOOD SOLD
(+) Selling and Distribution Overhead
Show room rent and rates
Salesman’s salary
Commission
Travelling expenses of salesman
Advertisement
Bad debts
Carriage outward
Samples and other free gifts
VI COST OF SALES
VII NET PROFIT (LOSS)
VIII SALES

Items not included in Cost Sheet:

a) Income tax i) Commission to managing directors
b) Dividends to shareholders j) Underwriting commission
c) Premium on redemption of shares k) Writing of goodwill, preliminary
and debentures expenses
d) Capital losses i.e. loss out of sales l) Reserve for bad debts
e) Interest on loan or debentures or m) Transfer to all reserves or
bank interest appropriation of profits
f) Donations n) Share premium
g) Capital expenditure o) Interest on capital
h) Discounts on shares and p) Drawing of proprietors
debentures
q) All personal expenses of owner

11.9 Solved Problems

Illustration 1:
Prepare a cost sheet:
Direct materials Rs.2,00,000; Factory expenses Rs.1,20,000; Office
expenses Rs.90,000; Total sales Rs.6,50,000; Prime cost Rs.4,10,000;
10 % of the output is in stock.
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Solution Cost Sheet

Direct materials 2,00,000

Direct wages (Prime cost minus Direct materials 2,10,000

Prime Cost 4,10,000
Factory expenses 1,20,000
Factory Cost 5,30,000
Office expenses 90,000
Cost of Production 6,20,000
Less: closing stock of finished goods 10 % of 6.20,000 -62,000
Cost of Sales 5,58,000
Profit (balancing figure) 92,000
SALES 6,50,000

Illustration 2:
The following information is obtained from Alice Ltd. Prepare Cost sheet.
Stock on Jan 1, 2007 : Work in progress : 64,000.
1.1.2007
Raw materials 40,000 31:.12.:2007 72,000
Finished goods 30, 000 Goodwill written off 40,000.
Purchases of Raw 2,40,000 Stock on 31.12.2007
materials
Direct wages 1,36,000. Raw materials 42,000 42,000
Works expenses 70,400 Finished goods 32,000
Dividends paid 40,000 Sale of finished goods 5,50,000
Office expenses 24,000. Payment of sales tax 16,000
Depreciation 10,000
Selling and Distribution 32,000
expenses

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Solution
Cost Sheet for the January 2007
Opening stock of Raw materials 40,000
Add: Purchases of raw materials 2,40,000
Less: Closing stock of raw materials 42,000
Raw materials consumed 2,38,000
Direct wages 1,36,000
Prime Cost 3,74,000
Factory Overheads
Works expenses 70,400
Depreciation 10,000
4,54,400
Add : opening stock of WIP 64,000
Less: Closing stock of WIP (72,000)
Works Cost 4,46,400
Office and Administration overheads 24,000
expenses
Cost of Production 4,70,400
Add : opening stock of finished goods 30,000
Less : Closing stock of finished goods (32,000)
Cost of Goods sold 4,68,400
Add: Selling and Distribution expenses 32,000
Cost of Sales 5,00,400
Add: Sales Tax 16,000
Total Cost 5,16,400
Profit 33,600
Sales 5,50,000

Activity 1
Prepare a cost sheet in the format given below. The following are the
details:
Raw materials consumed Rs.1,60,000. Direct wages Rs.80,000. Factory
overheads Rs.16,000. Office overheads 10% of factory cost. Selling

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overheads Rs.12,000. Units produced 4,000.Selling price per unit

Rs.100.The closing stock is 10% of units produced.
Solution:
Cost Sheet for the period ………
Units Produced 4000 Nos.
Total Cost/unit
Raw Materials consumed
Direct Wages
I Prime Cost
(+) Factory overhead
II Factory or Works Cost
(+) Office overhead (10% of factory cost)
III Cost of Production
(+) Opening stock of finished goods
(-) Closing stock of finished goods (10%) of F.G
For 4000 units --- 281600
For 400 units --- ?
IV Cost of Goods Sold (253440 /3600)
Selling Overhead (12000/3600)
V Cost of sales/ Total Cost
VI Net Profit ( Balancing figure)
VII Sales 3600 units @ Rs.100 per unit

Illustration 3:
Calculate prime cost, factory cost, cost of production and cost of sales from
the following particulars:
Rs Rs Rs Rs
Direct materials 40,000 Consumable stores 1,000
Direct wages 10,000 Manager’s salary 2,000
Direct expense 2,000 Director’s fees 500
Oil and waste 100 Office printing & 200
stationery
Wages of foremen 1,000 Telephone charges 50
Storekeeper’s wages 500 Postage, telegrams 100

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Electric power 200 Salesmen’s 500

commission & salary
Lighting – Factory 500 Travelling expenses 200
Office 200 700 Advertising 500
Rent - Factory 2,000 Warehouse charges 200
Office 1,000 3,000 Carriage outward 150
Repairs and Renewals:
Factory -plant 500
- machinery 1,000
- Office premises 200 1,700
Depreciation 500
– Office Premises
– Plant and machinery 200 700

Solution: Cost Sheet for the period ………

Total Cost / unit
Direct Materials 40,000
Direct Wages 10.000
Direct expenses 2.000
I Prime Cost 52,000
(+) Factory overhead
Oil and waste 100
Wage for foremen 1,000
Storekeeper’s wages 500
Electric power 200
Lighting - Factory 500
Rent - Factory 2,000
Repairs and Renewals:
Factory plant 500
Machinery 1,000
Depreciation plant and machinery 200
Consumable stores 1,000 7,000
II Factory or Works Cost 59,000
(+) Office overhead

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Lighting - Office 200

Rent - Office 1,000
Repairs office premises 200
Depreciation office premises 500
Director fees 500
Office printing and stationery 200
Telephone charges 50
Postage and telegram 100
Manager’s salary 2,000 4,750
III Cost of Production 63,750
(+) Opening stock of finished goods Nil
(-) Closing stock of finished goods Nil
IV Cost of Goods Sold
Selling Overhead
Salesmen’s commission and salary 500
Travelling expenses 200
Advertising 500
Warehousing charges 200
Carriage outward 150 1550
V Cost of sales/ Total Cost 65,300

Illustration 4
A factory produces a standard product. The following information is given to
you from which you are required to prepare a cost sheet of January 2000.
Rs
Raw materials 91,000
Direct wages 29,000
Other direct expanse 11,000
Factory overheads 80% of direct wages
Office overheads 10% of works cost
Selling and distribution expenses Rs. 2 per unit sold
Units produced and sold during the month 10,000
Also find the selling price per unit on the basis that profit mark
up is uniformly made to yield a profit of 20% of the selling price.
There was no stock or work-in progress either at the beginning
or at the end of the period.

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Solution:
Cost Sheet for the period ………
Total
Direct Materials 91,000
Direct Wages 29,000
Direct expenses 11,000
I Prime Cost 1,31,000
(+) Factory overhead
80% of direct wages 23,200
II Factory or Works Cost 1,54,200
(+) Office overhead
10% of work cost office overhead 15,420
III Cost of Production/Cost of goods sold 1,69,620
Selling and distribution 2 units (10,000) 20,000
IV Cost of Sales 1,89,620
Profit 25% on selling price # 47405
V Sales 2,37,025

# Working Notes:
Profit is 20% of selling price.
If selling price is 100 profit is 20. Therefore cost price is 80.
If cost price is 80, profit is 20 or 25% (100 x (20/80)
If cost price is Rs.189620, profit is Rs.47405 (189620 x (25/100)
Illustration 5
The following data are related to the manufacture of a standard product
during the month of July 2009.
Raw Materials consumed Rs.15,000
Direct Wages Rs. 9,000
Machine hours worked 900 hours
Machine hours rate Rs.5
Administrative overheads 20% of works cost
Selling overheads Re.0.50 per unit
Units produced 17,100
Units Sold 16,000 @ Rs.4 per unit

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You are required to prepare a cost sheet from the above showing:
a. The cost per unit
b. The profit per unit sold and profit for the period.
Solution: Units produced 17,100
Particulars Amount Cost/unit
Raw materials consumed 15,000 0.88
Direct Wages 9,000 0.53
Direct Expense (900 x 5 ) 4,500 0.26
Prime cost 28,500 1.67
Add: Factory overheads NIL
FACTORY /WORKS COST 28,500 1.67
Add: Admn. overheads (20% of works 5,700 0.33
cost)
COST OF PRODUCTION 34,200 2.00
Add: Selling overheads(0.50 per unit) 8,000 0.50
16000 x 0.50 = 8,000
Add: op.stock of F. goods NIL
Less: Cl. Stock of F. Goods (1100 units) (2,200)
1100 x 2.00 = 2200
Cost of Sales (sold 16,000 units) 40,000 2.50
Profit 1.50 x 16,000 = 24,000 24,000 1.50
Sales 16,000 x 4.00 = 64,000 64,000 4.00

Illustration 6:
Vijay industries manufactures a product X. On 1st Jan 2007, there were
5000 units of finished product in stock.
Work-in-progress Rs. 57,400
Raw materials Rs. 1,16,200

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The information available from cost records for the year ended 31st Dec
2007 was as follows:
Direct material 9,06,900
Direct Labour 3 ,26,400
Freight on R M purchased 55,700
Indirect labour 1,21,600
Other factory overhead 3,17,300
st
Stock on Raw Materials on 31 Dec 2007 96,400
st
Work-in-progress on 31 Dec 2007 78,200
Sales (1,50,000 units) 30,00,000
Indirect materials 2,13,900

There are 15000 units of finished stock in hand on 31st Dec 2007. You are
required to prepare:
A statement of cost and profit assuming that opening stock of finished goods
is to be valued at the same cost per unit as the finished stock at the end of
the period.
Solution
Statement of Cost and Profit of Product X
Particular Rs. Rs.
Opening Stock of Raw Materials 1,16,200
Add: Direct Materials 9,06,900
Add: Freight on Raw Materials purchased 55,700
Total 10,78,800
Less: Closing stock of Raw Materials [96,400]
Value of Raw Materials consumed 9,82,400
Add: Direct Wages 3,26,400
Prime cost 13,08,800
Add: Factory Overheads:
Indirect Materials 2,13,900
Indirect Labour 1,21,600
Other factory overhead 3,17,300
Total 6,52,800
Add: Opening Work-in-progress 57,400

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7,10,200
Less: Closing Work-in-progress 78,200
6,32,000 6,32,000
Factory cost/ Works cost 19,40,800
Add: Op. Stock of F.Goods 5000 units @ Rs. 60,650
12.13 per unit (see working notes)
Total 20,01,450
Less: Cl. Stock of F. Goods 15000 units @ 1,81,950
Rs.12.13 ( see working notes)
Cost of Goods Sold 18,19,500
Profit 11,80,500
Sales 30,00,000

Working Notes:
Units produced during the year are not given and therefore have been
computed as follows:
Sales = Opening stock + Units Produced - Closing Stock
1,50,000 = 5000 + X – 15,000
-X = 5000 – 15,000 – 1,50,000
X = 1,60,000 units

Total cost Rs.19,40,800

Value of Cl. Stock = ------------- = ------------ = Rs.12.13 / unit
Units produced Rs.60,00
= 15000 units x Rs.12.13 = Rs.1,81,950
Value of Op Stock = 5000 units x Rs.12.13 = Rs. 60,650

Illustration 7
Prepare the cost sheet to show the total cost of production and cost per unit
of goods manufactured by a company for the month of Jan 2005. Also find
out the cost of sales.

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Rs. Rs.
Stock of raw materials as on 3,000 Office rent 500
1-1-2005
Raw materials purchased 28,000 General expenses 400
(admn)
Stock of raw materials as on 4,500 Discount on shares & 300
31-1-2005 debentures
Manufacturing wages 7,000 Advertisement expenses 600
to be charged fully
Depreciation on plant 1,500 Income tax paid 2,000
Loss on sale of a part of 300
plant
Factory rent and rates 3,000

The number of units produced during Jan 2005 was 3,000. The opening and
closing stock of finished goods was 200 and 400 units respectively. The
value of opening stock of finished goods is Rs.2800.
Solution:
Cost sheet for the period 1-1-2005 to 31-1-2005
Units produced: 3000 units
Amount Cost/unit
Op. stock of R. M. 1-1-2005 3000
Add: R. M Purchased 28,000
31,000
Less Cl. Stock of R.M. [4,500]
Raw Materials consumed 26,500 8.83
Add: Manufacturing wages 7,000 2.33
Prime Cost 33,500 11.16
Add: Factory overheads
Depreciation on plant 1,500
Factory rent and rates 3,000 4,500 1.50
Factory cost /Works cost 38,000 12.66
Add: Op stock of W-I-P NIL
Less: Cl. Stock of W-I-P NIL
Cost of goods manufactured 38,000 12.66

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Add: Office & Admn overheads

Office rent 500
General expenses 400 900 0.30
Cost of Production [3000 units] 38,900 12.96
Add: Op. Stock of F. Goods (200 units)
Total 2,800
Less: Closing stock of F. Goods 41,700
(200 + 3000 – 400) = 2800 units 5,184 ______
Cost of goods sold (2800 units) 36,516 13.04
Add: Selling & Distribution expenses
Advertisement 600 0.21
Cost of sales 37,116 13.25

Note: Loss on sale of a part of plant is a capital loss hence excluded in cost
sheet. So also Discount on Shares & Debentures, and Income tax paid
should not be excluded in cost sheet.

11.10 Summary
Costing is the process of determining the cost of doing something, eg. cost
of manufacturing an article, rendering a service or performing a function.
Costing includes the techniques and processes of ascertaining cost.
CIMA defines the term cost as “the amount of expenditure (actual or
notional) incurred on or attributable to a given thing”. The given thing may
be taken as a product, service or any other activity.
Batch costing is the method used to determine the cost of a group of
identical products. The batch consist of similar products is a unit and not a
single item within the batch.
Contract costing is a method is based on the principle of job costing used by
house builders and civil contractors. The contract becomes the cost unit for
which relevant costs are determined
The elements of costs are classified as materials, labor and expenses.
These three elements of cost would be grouped in to direct and indirect
categories.

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11.11 Terminal Questions

Problem 1:
The following extract refers to a commodity for the half year ending 31st
March 2008. Prepare a cost statement.
Purchase of raw 1, 20,000 Direct wages 1, 00,000
materials
Rent, rate, insurance 40,000 Opening stock
and Works expenses Raw materials 20,000
Finished goods (1000 units) 16,000
Work in progress: Closing stock:
opening 4, 800 raw material 22, 240
closing 16, 000 F. Goods (2,000 tons)
Carriage inwards 1, 440 Sale of finished goods 3, 00,000
Cost of factory 8,000.

Advertising, discounts allowed and selling costs Re.1 per ton sold.
Production during the year is 16,000 tons. Prepare a cost sheet.
Problem 2:
Calculate the cost of raw materials purchased: Opening stock of raw
materials Rs.10,000. Closing stock of raw materials Rs.15,000. Expenses
on purchases Rs.5,000. Direct wages Rs.50, 000 Prime cost s Rs.1, 00,000.
Problem 3:
The cost data is as follows:
Raw materials consumed Rs.1,82,000. Direct wages Rs.40,000. Chargeable
expenses Rs.20,000. Opening stock of finished goods (1,000 units)
Rs.32,000. Closing stock 2,000 units. Factory overheads 100 % of direct
labor. Office overheads 10% of works cost. Selling of Distribution expenses
Rs.4 per unit sold. Units produced 10,000. Profit mark-up 20% on selling
price. Prepare a cost sheet.

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11.12 Answer to SAQ’s and TQ’s

1. Assets
2. Batch costing, Contract Costing and Composite costing
3. Unit costing, Operating costing and Operation costing
4. True
5. Absorption costing
6. Direct costing
7. Sunk Cost

Answers to Terminal Questions

Solution: 1
Statement of Cost
Direct materials
Opening stock or raw materials 20,000
Add: Purchases of raw materials 1,20,000
Add : carriage inwards 1,440
Less: Closing stock of raw materials (22,240)
Raw materials consumed 1,19,200
Direct Wages 1,00,000
Prime Cost 2,19,200
Works Expenses
Cost of factory 8,000
Rent, rate and insurance 40,000
Add: opening WIP 4,800
Less: Closing WIP (16,000)
Factory / Works cost 2,56,000
Office and administration expenses Nil
Cost of production 2,56,000
Inventory valuation
Opening stock of finished goods 16,000
Less : Closing stock of finished goods to be
valued at cost of Production (32,000)
Cost of Goods Sold 2,40,000

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Selling and Distribution Expenses *

Advertisement and discount allowed 15,000
Total Cost or cost of sales 2,55,000
Profit 45,000
Sales** 3,00,000

*To be valued only at number of units sold. Opening stock of finished goods
+ production minus closing stock = Number of units sold.
** Always to be valued at number of units sold. Number of units sold x
Selling price per
Solution: 2
Computation of cost of raw materials purchased
Opening Stock of raw materials 10,000
Add Purchases X
Expenses on purchases 5,000
15,000 + X
Less closing stock of raw materials -15,000
Raw materials consumed X
Direct wages 50,000
Prime Cost 50,000 + X

Prime cost given in the problem is Rs.1,00,000

Hence substituting, 1,00,000 = 50,000 + X; Therefore X = Rs.50,000
Cost of Raw Materials purchased is Rs.50,000
Solution: 3
STATEMENT OF COST units produced 10000 units
Raw materials consumed 1,82,000
Direct wages 40,000
Chargeable expenses 20,000
Prime Cost 2,42,000
Factory expenses at 100 % on direct wages 40,000
Works cost 2,82,000
Office and administrative expenses 10 % of works cost 28,200
Cost of Production 3,10,200

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Inventory valuation
Opening stock of finished goods 32,000
Less : Closing stock of finished goods at COP-2000
units 3,10,200 x (2000/10000) (62,040)
Cost of Goods sold 2,80,160
Selling and Distribution overheads at Rs.4 per unit sold 36,000
Cost of Sales or Total sales 3,16,160
Profit 20 % on Selling Price : TC x 20 / 100 – 20 or
3,16,160 x 20/100 – 80 79,040
Tender Price being sales 3,95,200

Activity 1 : Solution
Cost Sheet for the period ………
Units Produced 4000 Nos.
Total Cost / unit
Raw Materials consumed 160000 40.00
Direct Wages 80000 20.00
I Prime Cost 240000 60.00
(+) Factory overhead 16000 4.00
II Factory or Works Cost 256000 64.00
(+) Office overhead (10% of factory cost) 25600 6.40
III Cost of Production 281600 70.40
(+) Opening stock of finished goods NIL -
(-) Closing stock of finished goods (10%) of
F.G
For 4000 units --- 281600 (28160)
For 400 units --- ?
IV Cost of Goods Sold (253440 /3600) 253440 70.40
Selling Overhead (12000/3600) 12000 3.33
V Cost of sales/ Total Cost 265440 73.73
VI Net Profit ( Balancing figure) 94560 26.27
VII Sales 3600 units @ Rs.100 per unit 360000 100.00

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Unit 12 Marginal Costing and

Break Even Analysis
Structure:
12.1 Introduction
Objectives
12.2 Concept of Marginal Costing
12.3 Characteristics of Marginal Costing
12.4 Difference between Absorption Costing and Marginal Costing
12.5 Marginal Cost
12.6 Contribution
12.7 Cost Volume Profit (CVP) Analysis
12.8 Break Even Chart
12.9 Break Even Point
12.10 Profit Volume ratio or MCSR
12.11 Target profit
12.12 Margin of Safety
12.13 Application of Marginal cost
12.14 Limitations of Marginal cost
12.15 Solved Problems
12.16 Summary
12.17 Terminal Questions
12.18 Answers to SAQs and TQs

12.1 Introduction
In the previous unit we learnt about understanding cost. Costing is the
process of determining the cost of doing something. Costing includes the
techniques and processes of ascertaining cost. We dealt with different
methods of costing, different techniques of costing and finally classification
of costs under various heads.
Marginal Cost determines the rate of change in costs if the volume of output
is increased or decreased by one unit Marginal costing a technique of
costing concerned with the changes in costs and profits resulting from
changes in the volume of output. Marginal costing is very helpful in decision
making and it most widely used profit planning techniques. The cost volume

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profit analysis shows the relationship among unit sale price, variable cost,
sales volume, sales mix and fixed cost.
Objectives:
After studying this unit, you should be able to:
1. Explain the concept of Marginal costing.
2. Distinguish between Marginal Costing and Absorption Costing
3. Describe contribution and its advantages
4. Familiarize with cost volume profit analysis, break even chart, and break
even point.
5. Understand the contribution marginal approach, target profit and margin
of safety.

12.2. Concept of Marginal Costing

According to Institute of Cost and Management Accounting, London
Marginal costing is defined as “the ascertainment of marginal cost and of the
effect on profit of changes in volume or type of output by differentiating
between fixed costs and variable cost”. Marginal costing a technique of
costing concerned with the changes in costs and profits resulting from
changes in the volume of output. Marginal costing is also known as
‘Variable Costing’.

12.3 Characteristics of Marginal Costing

The technique of marginal costing is based on the distinction between
product costs and period costs. Only the variable costs are regarded as the
cost of the product while the fixed cost is treated as period costs. The main
characteristics of marginal costing are:
1. It is a technique of analysis and determination of costs to help
management in decision making
2. All elements of costs are classified into variable and fixed components.
Even semi variable costs are classified into variable and fixed components.
3. The variable costs are regarded as the cost of the products
4. Fixed costs are treated as period cost and are charged to profit and loss
account for the period for which they are incurred

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5. The stock of finished goods and work-in-progress are valued at marginal

costs only
Variable and Absorption costing are techniques of costing wherein variable
costing considers only variable costs for the purpose of product costing,
inventory valuation and for other important management decisions. In
absorption costing, total costs are taken into consideration for these
purposes. Direct material, direct labour and variable overheads constitute
the only relevant costs in variable costing whereas the full/absorption
costing technique recognizes fixed overheads also as a product costs in
addition to material, labour and variable overheads.
The two techniques are not mutually exclusive. Full costing is needed while
preparing income statements for external reporting and for tax purpose
while variable costing is extensively used for internal purpose in decision
making.

Self Assessment Questions

1. Elements of costs are classified into ______ and ______
2. Fixed Cost is treated as __________ and charged to P& L account
3. _____________ costs are treated as product cost.
4. The _____________shows the relationship among unit sale price,
variable cost, sales volume, sales mix and fixed cost
Illustration 1
Hydro Electric Ltd furnishes the following information from its cost records
for the first quarter of the current year

Normal production (units) 1,000

Actual production (units) 1,100
Actual overheads per quarter at normal production 4,000
Other expenses per quarter 300
Standard fixed overhead rate per unit 4
Variable costs per unit 6
Sales volume (selling price is Rs. 14) NIL

Prepare the income statement under absorption and variable costing

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Solution:
Income statement (Absorption Costing)

Particulars Amount Amount

Sales revenue Nil
Less : Total cost of manufacturing:
Variable costs (1,100 x Rs. 6) Rs. 6,600
Fixed overheads (1,100 x Rs. 4) 4,400
11,000
Less : Cost of inventory at the end of the year (1,100 x Rs.10) 11,000 Nil
Cost of goods manufactured and sold
Gross margin (unadjusted) Nil
Capacity variance (favorable) (over-absorbed 100 x Rs. 4) Rs. 400
Gross margin (adjusted) 400
Less : Other expenses 300
Net income before taxes 100

Income Statement (Variable Costing)

Particulars Amount Amount

Sales revenue Nil
Less : Variable costs (production costs) (1,100 x Rs. 6 ) Rs. 6,600
Less : Cost of inventory at the end to the year (1,100 x Rs 6) 6,600
Cost of goods manufactured and sold Nil
Contribution Nil
Less: Fixed costs:
Fixed overheads 4,000
Other expenses 300 Rs. (4,300)
Net income before taxes (loss) (4,300)

Inference: Under absorption costing, the net income before taxes is Rs.100
while in marginal costing net income before taxes is (Rs.4300) (loss).This
significant difference can be attributed to the fact that under absorption
costing the fixed manufacturing overheads are included in inventory,
whereas in variable costing, inventory carries only variable costs

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Inventory valuation under absorption costing – 11000

Inventory valuation under variable costing – 6600
Difference – 4400
(This difference is equal to difference between Net income before taxes
under absorption costing and variable costing)

12.4 Difference between Absorption Costing and Marginal Costing

Absorption Costing Marginal Costing

It is known as full costing. Both fixed Only variable costs are included. Fixed
and variable are included to ascertain costs are recovered from contribution.
the cost
Different unit costs are obtained at Marginal cost per unit remain same at
different levels of output because of different levels of output because
fixed expenses remaining the same variable expenses vary in the same
proportion in which output varies
Difference between sales and total Difference between sales and
cost (marginal cost and fixed cost) is marginal cost is contribution and
profit difference between contribution and
fixed cost is profit or loss
A portion of fixed cost is carried Stock of work-in-progress and finished
forward to the next period because goods are valued at marginal cost.
closing stock of work-in-progress and Fixed cost of a particular period is
finished goods is valued at cost of charged to that very period and is not
production which is inclusive of fixed carried over to the next period.
cost
The apportionment of fixed expenses Only variable cost are charged to
on an arbitrary basis gives rise to over products hence marginal costing does
or under absorption of overheads not lead to over or under absorption of
fixed overheads.
It affects managerial decisions in the It is very helpful in taking managerial
areas such as whether to accept the decisions because it takes into
export order or not, whether to buy or consideration the additional cost
manufacture etc involved only assuming fixed
expenses remaining constant.
Costs are classified according to Costs are classified according to the
functional basis such as production behavior of costs – fixed costs and
cost, office and administrative cost and variable costs.
selling and distribution costs
It fails to establish relationship of cost, CVP relationship is an integral part of
volume and profit marginal costing.

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12.5 Marginal Cost

According to C.I.M.A. London, “Marginal Cost means the amount at any
given volume of output by which aggregate costs are changed if the volume
of output is increased or decreased by one unit”. Marginal cost per unit
remains unchanged irrespective of the level of activity or output. It is also
known as Variable Cost. Marginal cost is the sum total of direct material
cost, direct labor cost, variable direct expenses and all variable overheads.
The marginal cost of producing a unit declines as output increases.
Cost Drivers
The activities that cause costs to be incurred are called “Cost Drivers”. A
fixed cost remains unchanged in total as the level of activity (cost drivers)
varies. If activity increases or decreases say by 20 %, the total fixed costs
remain the same e.g. depreciation, property tax, rent to landlord. But fixed
costs per unit will change.
A variable cost changes in total in direct proportion to a change in the level
of activity or cost driver. If activity increases, say by 20%, total variable cost
also increases by 20 %. The total variable cost increases proportionately
with activity. Variable cost is fixed per unit but varies in total.

12.6 Contribution
It is the difference between sales and variable cost. It may defined as „the
excess of selling price over variable cost per unit‟. It is also termed as
Contribution Margin or Gross Margin

Contribution = Sales – Variable cost

Contribution (per unit) = Selling price – Variable cost per unit
Contribution = Fixed cost + Profit (- Loss)

Advantages of contribution: The concept of contribution is a valuable aid

to management in making managerial decisions. It includes
1. It helps the management in the fixation of selling prices
2. It assists in determining the break even point
3. It helps management in the selection of a suitable product mix for profit
maximization

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4. It helps in choosing from among alternative methods of production.

5. It helps the management in deciding whether to purchase or
manufacture, add a new product or not etc.

Self Assessment Questions:

5. Fixed cost remains constant _________.
6. Those activities that results in cost are known as ___________.
7. Variable cost is fixed ______ but varies in________.
8. Contribution is also known as contribution margin or _____________.
9. Fixed cost – Loss = ______________

Activity1: Give five examples for each of the following:

(1) Variable costs (2) semi-variable costs (3) fixed costs

12.7 Cost Volume Profit (CVP) Analysis

This technique summarizes the effects of changes in an organization‟s
volume of activity on its costs, revenue and profit. CVP analysis can be
extended to cover the effects on profit of changes in selling prices, changes
in sales volume, changes in product mix etc. It provides management with a
comprehensive overview of the effects on revenue and costs of all types of
short run financial changes. Since CVP analysis explores the fundamental
relationship between cost-volume-profit variables it becomes easier to
recognize certain level of output or a certain volume of sales that equates
cost with revenue. Such level is termed as breakeven point. Break even
analysis is an integral part of CVP analysis.

12.8 Break Even Chart

It is a graphic or visual presentation of the relationship between costs,
volume and profit. It indicates the point of production at which there is
neither profit nor loss. It also indicates the estimated profit or loss at
different levels of production. While constructing the chart, the following
assumption is normally considered.
a) Costs are classified into fixed and variable costs
b) Fixed costs shall remain fixed during the relevant volume range of
graph.

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c) Variable cost per unit will remain constant during the relevant volume
range of graph
d) Selling price per unit will remain constant
e) Sales mix remains constant.
f) Production and sales volume are equal
g) There exists a linear relationship between costs and revenue.
h) Linear relationship is indicated by way of straight line.

12.9 Break Even Point

BEP is the volume of activity where the organization‟s revenues and
expenses are equal. At a particular amount of sales, the organizations have
no profit or loss: it normally breaks even.
The general formula for computing the break even sales volume in units is:

BEP (in units) = Fixed expenses_____

Contribution margin per unit

BEP (in Rupees) = Fixed Expenses____

Contribution sales ratio

Illustration 2: Find the contribution and profit earned if the selling price per
unit is Rs.25, variable cost per unit Rs.20 and fixed cost Rs.3,05,000 for the
output of 80,000 units.
Solution:
Contribution per unit = Sales – variable cost
= Rs.25 – Rs.20
= Rs.5
Contribution = Contribution per unit x Output
= 5 x 80,000
= 4,00,000
Profit = Contribution – Fixed Cost
= 4,00,000 – 3,05,000
= 95,000

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Illustration 3: Calculate the profit earned for the data given: Fixed cost
Rs.5,00,000; Variable cost Rs.10 per unit; Selling price Rs.15 per unit;
Output 150,000 units
Solution:

Sales – Variable cost = Fixed Cost + Profit

(1,50,000 x 15) – (1,50,000 x 10) = 5,00,000 + Profit
22,50,000 - 15,00,000 -5,00,000 = Profit
2,50,000 = Profit

Illustration 4: Find the fixed costs if sales is Rs.2,00,000; Variable Cost Rs.
40,000; and Profit Rs. 30,000.
Solution:

Sales – Variable cost = Fixed Cost + Profit

2,00,000 - 40,000 = Fixed Cost + 30,000
2,00,000 – 40,000 – 30,000 = Fixed Cost
1,30,000 = Fixed Cost

12.10 Profit / Volume Ratio or MCSR

It expresses the relationship between contribution and sales. It is also
termed as Marginal Contribution Sales Ratio (MCSR).

Profit Volume Ratio = Contribution x 100

(MCSR) Sales

Illustration 5: Calculate MCSR or P / V Ratio if the Marginal cost is

Rs.24,000 and Sales is Rs. 60,000

Solution:

Contribution = Sales – Marginal Cost

= 60,000 – 24,000 or 36,000
MCSR = Contribution / Sales x 100
= 36,000 / 60,000 x 100
= 60 %

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Illustration 6: The sales turnover and profit during two periods are as
under:
Period 1 Period 2
Sales 20,000 30,000
Profit 2,000 4,000
Calculate the MCSR.
Solution:

MCSR = Change in Profit / Change in Sales x 100

= (4,000 - 2,000) / 30,000 - 20,000 x 100
= 2,000 / 10,000 x 100
= 20%

Illustration 7 : Calculate MCSR from the following details

Total Sales Total Costs

st
Year ending 31 December 2006 22,23,000 19,83,600
st
Year ending 31 December 2007 24,51,000 21,43,200

Solution:

Profit = Total Sales – Total Costs

Dec 2006 = 22,23,000 – 19,83,600 = 2,39,400
Dec 2007 = 24,51,000 – 21,43,200 = 3,07,800
MCSR = Change in profit / change in sales x 100
= 68,400 / 2,28,000 x 100
= 30 %

Illustration 8: Calculate the sales if marginal cost is Rs.2,400 & MCSR is

20 %.
Solution:

Since MCSR is 20%, the variable cost should be 100 – 20% = 80 %

Variable cost (given) = Rs.2,400 :
Therefore, Sales = 2400 / 80 %
= Rs.3,000.

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Illustration 9 : Find, Contribution and MCSR. Variable cost per unit Rs.40.
Selling price per unit Rs.80. Fixed expenses Rs.2,00,000. Output 10,000
units.
Solution:

Contribution = Sales – variable costs

= (10,000 x Rs.80) – (10,000 x Rs. 40)
= 8,00,000 – 4,00,000 or Rs.4,00,000.
MCSR = Contribution / MCSR
= 4,00,000 / 8,00,000 x 100 or 50 %

Illustration 10: Find the Break Even Point.

Selling Price per unit Rs.10
Fixed Cost 60,000
Variable cost per unit 5
Relevant range (units) : Lower limit 6000
: Upper limit 20,000
Break up of variable cost per unit:
Direct material Rs.2.00
Direct Labour Rs.1.50
Direct Expenses Re.1.00
Selling expense Re.0.50
Actual sales 18000 units 1,80,000
Plant capacity 20,000 units 2,00,000
Tax rate 50 per cent

Breakeven point lies at the point of intersection of sales line and total cost
line. The vertical distance between the sales revenue and the total cost line
measures the estimated net income (after BEP) and the estimated net loss
(before BEP) at the related sales volume. The fixed cost line is parallel to
the horizontal axis. The variable cost line is superimposed on the fixed cost
line and moves upward uniformly with sales volume at the variable cost to
volume ratio.

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At Sales level Rs.60000

Fixed cost = Rs.60000
Variable cost = Rs.30000 (6000x5 per unit)
Total cost = Rs.90000
Sales revenue = Rs.60000 ( 6000 units at Rs10 per unit)
Loss = Rs.30000
At sales level of Rs.1800000 (18000 units at Rs.10 per unit)
Fixed cost = Rs.60000
Variable cost = Rs.90000 (18000 x 5 per unit)
Total cost = Rs.150000
Sales revenue = Rs.180000 ( 18000 units at Rs10 per unit)
Profit = Rs.30000
Contribution per unit = Selling price per unit – Variable cost per unit
= 10-5 = 5 per unit
BEP (in units = Fixed cost / contribution margin
= Rs.60000 / 5
= Rs.12000 units
BEP (in Rs) = BEP ( in units) x selling price per unit
= 12000 x 10
= 120000

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12.11 Target Profit

Based on the experiences gained, an organization may intend to increase
the production and sales. When an organization was to be on its optimum
level, a direction will be provided to achieve the maximum level. In this
connection, if one intends to increase the current year production to higher
levels, no variable expenses would be incurred. A target net profit or
income may be decided in advance. To achieve this profit, efforts will be
made to effect sales. The problem of computing the volume of sales
required to earn a particular target net profit is very similar to the problem of
finding the break even point. After all, the break even point is the number of
unit sales required to earn a target net profit of zero. The target net profit is
known as “desired profit”. The formula is:

Number of units to be sold = Fixed expenses + Desired or Target profit

Contribution per unit

Illustration 11: Calculate sales in units and in rupees:

Units produced 60,000.
Fixed Expenses – Rs.1,50,000
Selling price per unit - Rs.15.
Variable cost per unit – Rs.10
Profits to be earned - Rs.87,500.
Solution:

Sales required = [Fixed expenses + target profit]

contribution per unit
= [1,50,000 + 87,500] / (15-10)
= 2,37,500 / 5
= 47,500 units
Sales (in Rs) = 47,500 x 15
= 7,12,500

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12.12 Margin of Safety

The safety margin of an enterprise is the /difference between the budgeted
sales revenue and the break even sales revenue. The safety margin gives
management a feel for how close projected operations are to the
organization‟s break even point. The formula is:

Margin of Safety = Profit / MCSR

Illustration 12: Calculate BEP and MOS:

Sales – 50,000 units per annum.
Selling price – Rs.6.00 per unit,
Prime cost – Rs.3.00 per unit.
Variable overheads – Re.1.00 per unit.
Fixed cost – Rs.75,000 per annum.
Solution:

BEP = Fixed cost / (SP - VC) per unit

= 75,000 / 6 - 4
= 75,000 / 2 or 37,500 units.
BEP in rupees = BEP in units x selling price per unit
= 37,500 x Rs.6
= Rs.2, 25,000
MOS = Actual Sales – BEP Sales
= (50,000 x 6) – 2,25,000
= Rs.75, 000

12.13 Applications of Marginal Costs

The marginal costing helps the management in taking many policy
decisions. The vital areas where these concepts are applied directly are as
follows:
Level of activity planning: Normally, the managements will consider
different levels of production or selling activities to decide optimum level of

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activity. Such periodic exercise shall put the organization in the right tract to
achieve its goal. Since the optimum level of activity results in the maximum
contribution per unit, the planning can become a perfect execution tool.
Alternative methods of production: With the help of marginal costing
techniques, it‟s possible to undertake decision about the alternate methods
of production. All the decisions should be focused at the greater
contribution so that profit can be maintained at a balanced level.
Make or buy decision: Depending upon the situational ambience, the
management can have a blue print on a vital decision. Management can
think of outsourcing the production activities or to undertake it within its
purview. Based on the comparative statement of cost of manufacture with
the purchase price, decisions can be taken.
Fixation of Selling Price: While pricing a product, the marginal costing
techniques can come handy. While fixing a price for a product, it is prudent
to take into account the recovery of marginal cost in addition to get a
reasonable contribution to cover fixed overheads. Pricing will be at ease
once the marginal cost and overall profitability of the concern are known.
Selection of optimum sales mix: The product mix plays an important role
when a firm produces more than one product. The main focus will on profit
maximization. With the help of marginal costing techniques, it is possible to
decide the best product mix which will result in maximum profits to the firm.
New Product introduction: When a firm intends to diversify its activities or
to expand its existing markets, with the help of marginal costing techniques.
By fixing the time horizon to recover the fixed costs and profit, decisions can
be taken for the introduction of new products.
Balancing of profits: As the economic trends gets changed on account of
government fiscal policies and regulations, competition at the regional,
national, and international levels, marginal costing techniques can aid to
bring out facts with regard to maintaining a desired level of profits.
Final balancing decisions: If the sales of the product were not
encouraging to cover the fixed costs, it is quite natural that the firm may
decide about its continuance. This may lead to dovetailing or completely
closing down the operations. Marginal costing helps the management to
take a sound decision.
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12.14 Limitations of Marginal Costing

There are certain limitations which can be described as follows:
Suitability: The techniques of marginal costing cannot be applied to all the
concerns. When a concern needs to carry large stocks by way of work-in-
progress, the technique becomes redundant In addition; the marginal
costing techniques are not suitable to industries working on contract basis.
Inventory valuation difficulties: Since the work in progress and the
closing inventories are valued at marginal cost basis, it will not be a sound
decision from the Balance Sheet point of view. The main focus on the „true
and fair value‟ concept gets diluted and the very purpose of exhibiting the
financial position will get defeated.
Segregation of costs: Though the marginal costing principles call for the
differentiation of costs into fixed and variable, in actual practice it becomes
difficult to classify them precisely. Many overheads which are appear to be
fixed and variable may not exactly align at various levels of production.
There is no logical method to segregate semi-variable expenses into fixed
and variable.
Time factor: The marginal costing ignores the time factor which is very
important in all managerial decisions. Ignoring the time value factor would
naturally relate to unreliable and incomplete basis for comparing two
alternative jobs.
Sales emphasis: Marginal costing principles are basically a sales-oriented
concept. While the selling function gets the prominence, other functions
are not given equal weight age. This would be a major setback.

12.15 Solved Problems

Problem 1: Calculate Break even point. Fixed costs Rs.80,000; Variable

cost per unit Rs.4. Sales Rs.2,00,000. The number of units involved
coincides with expected volume of output. Each unit sells at Rs.20.
Solution:
BEP in units = Fixed expenses / contribution per unit
Contribution = S – V or Rs.20 – Rs.4 or Rs.16
= Rs.80,000 / Rs.16 or 5,000 units.
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Problem 2: Calculate the Break Even point: Sales Rs.2,00,000; Fixed

expenses Rs.50,000. Variable expenses. Rs.1,00,000.

Solution: Since no information about the number of units produced and

costs per unit is given, only Break even point in value can be ascertained.
BEP in Rs. = Fixed costs x Total sales / Total Sales – Variable costs
= 50,000 x 2,00,000 / 2,00,000 – 1,00,000
= Rs.1,00,000
Problem 3: Calculate MCSR and Break Even Point: Sales Rs.5,00,000.
Fixed Costs Rs.1,00,000. Profit Rs.1,50,000.
Solution:
MCSR = Contribution / Sales
Contribution = Fixed Costs + Profit
= Rs.1,00,000 + Rs.1,50,000 = Rs.2,50,000
MCSR = 2,50,000 / 5,00,000 = 50%
BEP in Rs. = Fixed Costs / MCSR
= 1,00,000 / 50 % or Rs.2,00,000.
Problem 4: Find BEP. Variable cost per unit Rs.12. Selling price per unit
Rs.20. Fixed expenses Rs.60,000. What will be the selling price per unit if
the BEP is brought down to 6000 units?

Solution:
BEP in units = FC / CPU
CPU = S - V 20 – 12 or Rs.8
= 60,000 / 8 or 7,500 units
BEP in Rs = 7,500 units x Rs.20
= Rs.1,50,000.
The Selling price = FC / CPU or FC / (SP – VP) per unit
(at BEP - 6000 units) = 60,000 / (x – 12)
6,000 = 60,000 / x – 12
6000 (x – 12) = 60,000
X = Rs.22 on simplification.

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Problem 5: Calculate the following

(1) MCSR.
(2) Profit when sales are Rs.20,000
(3) New BEP if selling price is reduced by 20 %.
Given Fixed expenses Rs.4,000 and Break Even Point Rs.10,000.
Solution:
(1) BEP sales = FC / MCSR
MCSR = FC / BEP Sales
= 4,000 / 10,000 x 100
= 40 %.
(2) To calculate profit we need to find out contribution.
MCSR = Contribution /Sales
40% = Contribution / 20,000
40 % x 20,000 = Contribution
Rs.8,000 = Contribution
Contribution = Fixed cost + Profit
8,000 = 4,000 + Profit
4,000 = Profit

(3) New BEP is Selling Price is reduced by 20 %

Let the original Selling Price be Rs.x.
Therefore, at 20 % reduction, the reduction would be [0.2x]
Hence the revised SP would be x – 0.2x or 0.8x
Variable cost = 1- Contribution Margin
= 1-0.4 = 0.6
New contribution = S–V
= 0.8x – 0.6x = 0.2x.
Sales Ratio = 0.2x / 0.8x or 0.25
BEP in volume = 4,000 / 0.25 or Rs.16,000

Problem 6: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP
sales Rs.40,000. Find the actual sales.

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Solution:
MCSR is based on BEP sales
BEP sales = FC / MCSR
MCSR = FC / BEP sales or 8,000 / 40,000 = 0.2
Actual sales = FC + desired profit / MCSR
= 8,000 + 2,000 /0.2
= Rs. 50,000

12.16 Summary
Marginal Cost determines the rate of change in costs if the volume of output
is increased or decreased by one unit Marginal costing a technique of
costing concerned with the changes in costs and profits resulting from
changes in the volume of output.
The technique of marginal costing is based on the distinction between
product costs and period costs. Only the variable costs are regarded as the
cost of the product while the fixed cost is treated as period costs.
Break even chart is a graphic or visual presentation of the relationship
between costs, volume and profit. It indicates the point of production at
which there is neither profit nor loss. It also indicates the estimated profit or
loss at different levels of production.
CVP analysis provides management with a comprehensive overview of the
effects on revenue and costs of all types of short run financial changes.

12.17 Terminal Questions

1. A factory is manufacturing sewing machines. The variable cost of each

machine is Rs.200 and each machine is sold for Rs.250. Fixed costs
are Rs.12,000. Calculate the BEP for output.
2. Calculate break even point and margin of safety. Fixed cost Rs.1,60,000.
Variable cost per unit Rs.2 and Selling price per unit Rs.18. Also compute
the margin of safety if the company is earning a profit of Rs.36,000.
3. Calculate the break-even point and turnover required to earn a profit of
Rs.3,600. Fixed overheads Rs.1,80,000. Variable cost per unit Rs.2
Selling price Rs.20. If the company is earning a profit of Rs.36,000,
express the margin of safety available to it.
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4. Given variable cost Rs.6,00,000. Fixed cost Rs.3,00,000. Net profit

Rs.1,00,000. Sales Rs.10,00,000. Find (a) MCSR (b) BEP (c) Profit
when sales amounted Rs.12,00,000 (d) sales required to earn a profit of
Rs.2,00,000.
5. Given: Fixed costs Rs.4,000. Break even sales Rs.20,000. Profit
Rs.1,000. Selling price per unit Rs.20. Calculate (a) sales and marginal
cost of sales (b) new break even point if selling price is reduced by 10 %.
6. Find the margin of safety if profit is Rs.20,000 and MCSR is 40 %.
7. Calculate Break even sales and margin of safety. Given Sales
Rs.10,00,000.Fixed costs Rs.3,00,000 and Profit Rs.2,00,000.
8. Given Sales Rs.20,000. Total Costs Rs.16,000 and Variable Costs
Rs.12,000. Compute Break even sales, Margin of safety and sales to
earn a profit of Rs.4,000.

12.18 Answer Self Assessment Questions

1. Variable cost , fixed cost 5. In total
2. Period cost 6. Cost drivers
3. Variable 7. Per unit, total
4. CVP analysis 8. Gross margin
9. Contribution

Answer for Terminal Questions

1. Contribution = S –V
= 250 – 200 or Rs.50
Therefore BEP = FC / Contribution
= 12,000 / 500 or 240 units.
2. Contribution = S–V
= 18 – 2 = 16.
BEP in units = Fixed costs / contribution per unit
= 1,60,000 / 16
= 10,000 units.
Margin of safety = Actual Sales (-) Break-even sales
Actual sales = Fixed Cost + Desired profit / contribution per unit
= 1,60,000 + 36,000 / 16 or 12,250 units.
Margin of safety = 12,250 -10,000 units or 2,250 units.

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3. Contribution per unit = S – V or 20 – 2 = 18.

BEP in Units = FC / CPU
= 1,80,000 / 18 = 10,000 units.
Break even sales = BEP in units x Selling price
= 10,000 x Rs.20
= Rs.2,00,000
Sales required to earn a profit of Rs.36,000
Sales ( required) = Total Fixed overheads + Profit desired] / CPU
= 1,80,000 + 36,000 / 18
= 216000/18 =12,000 units
Sales ( in Rs) = 12,000 x Rs.20 = Rs.2,40,000.
Margin of safety = Actual sales – Break even sales
= Rs. 2,40,000 – Rs.2,00,000
= Rs.40,000
in terms of units = 12,000 – 10,000 units
= 2,000 units.
4. MCSR = Contribution / Sales x 100
= Contribution = S – V or Rs.4,00,000.
= 4,00,000 / 10,00,000 x 100 or 40%
Break even point = FC / MCSR = 3,00,000 / 0.4 = Rs.7,50,000
Profit when sales amounted to Rs.12,00,000. Contribution 40%
Therefore total contribution
12,00,000 x 40 % = Rs.4,80,000
Less fixed costs Rs.3,00,000
Profit = Rs.1,80,000
Sales to earn a profit
of Rs.2,00,000 = FC + Desired profit / MCSR
= 3,00,000 + 2,00,000 / 40 %
= Rs.12,50,000.

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5. BEP = Fixed costs / MCSR

20,000 = 4,000 / MCSR
MCSR = 4,000 / 20,000 x 100 = 20%
Contribution = Fixed cost +Profit
= 4,000 + 1,000
= Rs.5,000.
MCSR = Contribution / Sales x 100
20 = 5,000 / Sales x 100
= Rs. 25,000
Marginal cost of sales = Sales – Contribution or 25,000 – 5,000
= Rs.20,000
If selling price is reduced by 10 %
New selling price = 20 – 2 = Rs.18
Variable cost = Rs.16 (20 – 20% of 20)
Contribution = Rs.2
New MCSR = 2 /18 x 100.
New break even sales= FC /SR or 4,000 / 100
= Rs.36,000.
6. Margin of safety = Profit / 40 % = Rs.50,000
7. MCSR = Contribution / sales
= 5,00,000 / 10,00,000 = 50 %.
Break even sales = Fixed costs / MCSR
= 3,00,000 / 50 %
= Rs.6,00,000
Margin of safety = Profit / MCSR
= 2,00,000 / 50 %
= Rs.4,00,000
8. Sales 20,000, Variable cost Rs.13,000, Total Cost Rs.16,000.
Therefore, Fixed cost = Total cost – variable cost = 16,000 – 12,000 =
Rs.4,000.
Profit = Contribution – Fixed Cost = 8,000 –
4,000 = 4,000.
MCSR = Contribution / sales = 8,000 / 20,000 = 40 %.
BEP in units = FC / MCSR = 4,000 / 40% = 10,000.
Margin of safety = Profit / MCSR = 400 / 40 % = 10,000
Sales to earn a profit of Rs.4,000 = FC + Desired profit / MCSR
= 4,000 + 4,000 / 40 % = Rs.20,000.

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Unit 13 Decisions Involving Alternative Choices

Structure:
13.1 Introduction
Objectives
13.2 Decision Making
13.3 Types of Costs
13.4 Types of Choices Decisions
13.5 Make or Buy Decisions
13.6 Addition / Discontinuance of a Product line
13.7 Sell or Process Further
13.8 Operate or Shut down
13.9 Exploring New Markets
13.10 Maintaining a desired level of profit
13.11 Summary
13.12 Terminal Questions
13.13 Answers to SAQs and TQs

13.1 Introduction
In the previous unit we learnt about Marginal Costing. Marginal costing is
the ascertainment of marginal cost and of the effect on profit of changes in
volume by differentiating between fixed costs and variable costs. Marginal
cost is the amount at any given volume of output by which aggregate costs
are changed if the volume of output is increased or decreased by one unit.
Marginal costing is a very useful tool for management because of its
applications. It is used in providing assistance to the management in vital
decision-making both short term and long term. Differential analysis is the
process of estimating the consequences of alternative actions that a
decision maker may take. It is used both for short term and long term
decisions. Short term decisions relates to fixing price for the product,
selecting a suitable product mix, diversification of the product etc while long
term deals with capital budgeting decisions.

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Objectives
After studying this unit, you should be able to:
 Explain the steps involved in decision making process
 Know various types of decision choices
 Analyze and interpret various decision choices

13.2 Decision Making

Decision making is the process of evaluating two or more alternatives
leading to a final choice known as alternative choice decisions. Decision
making is closely associated with planning for the future and is directed
towards a specific objective or goal. Decision model contains the following
decision-making steps or elements:
1. Identify and define the problem
2. Identify alternative as possible solutions to the problem.
3. Eliminate alternatives that are clearly not feasible
4. Collect relevant data (costs and benefits) associated with each
feasible alternative
5. Identify cost and benefits as relevant or irrelevant and eliminate
irrelevant costs and benefits from consideration.
6. Identify to the extent possible, non-financial advantage and
disadvantage about each feasible alternative.
7. Total the relevant cost and benefits for each alternative
8. Select the alternative with the greatest overall benefits to make a
decision
9. Implement or execute the decision
10. Evaluate the results of the decision made.

13.3 Types of Costs

A decision involves selecting among various choices. Non routine types of
decisions are crucial and critical to the firm as it involves huge investments
and involve much uncertainty. Short term decision making is based on
relevant data obtained from accounting information.
 Relevant Cost are costs which would change as a result of the decision.

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 Opportunity costs are monetary benefits foregone for not pursuing the
alternative course. When a decision to follow one course of action is
made, the opportunity to pursue some other course is foregone.
 Sunk costs are historical cost that cannot be recovered in a given
situation. These costs are irrelevant in decision making.
 Avoidable costs are costs that can be avoided in future as a result of
managerial choice. It is also known as discretionary costs. These costs
are relevant in decision making.
 Incremental / Differential costs are costs that include variable costs and
additional fixed costs resulting from a particular decision. They are
helpful in finding out the profitability of increased output and give a better
measure than the average cost.
Self Assessment Questions:
1. Relevant Costs are costs which would _________as a result of the
decision.
2. ___________ are historical cost that cannot be recovered in a given
situation.
3. Opportunity costs are _________________for not pursuing the
alternative course
4. ____________ is also known as discretionary cost.

13.4 Types of Choices Decisions

The application of incremental / differential costs and revenues for decision
making is known as decision situations or types of choice decisions.
 Make or Buy decisions
 Selection of a suitable product mix
 Effect of change in price
 Maintaining a desired level of profit
 Diversification of products
 Closing down or suspending activities
 Alternative course of action
 Own or Lease
 Retain or Replace
 Change or Status quo
 Export or Local sales

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 Expand or Contract
 Take or Refuse order
 Place special orders
 Select sales territories
 Sell at split-up point or process further.

13.5 Make or Buy Decisions

Make or buy decisions arise when a company with unused production
capacity consider the following alternatives
a) To buy certain raw materials or subassemblies from outside suppliers
b) To use available capacity to produce the items within the company.
c) The quality and type of item which affects the production schedule
d) The space required for the production of item
e) Any transportation involved due to the location of production facility
f) Cost of acquiring special know how required for the item.
Illustration 1: The Anchor Company Ltd produces most of its electrical
parts in its own plant. The company is at present considering the feasibility
of buying a part from an outside supplier for Rs. 4.5 per part. If this were
done, monthly costs would increase by Rs. 1,000
The part under consideration is manufactured in Department 1 along with
numerous other parts. On account of discontinuing the production of this
part, Department 1 would have somewhat reduced operations. The average
monthly usage production of this part is 20,000 units. The costs of producing
this part on per unit basis are as follows.

Material Rs. 1.80

Labour (half-hour) 2.40
Fixed overheads 0.80
Total costs 5.00

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Solution
Decision Analysis
Particulars Make costs Buy cost
Total Per unit Total Per unit
Relevant costs:
Materials (20000 units) 36,000 1.80 – –
Labour 48,000 2.40 – –
Purchasing cost (20000 units) – – 90,000 4.50
Additional cost of purchasing – – 1,000 0.05
from outside
84,000 4.20 91,000 4.55
Differential costs 7,000 per month
Favoring making of the parts 0.35 per unit

The company should continue the practice of producing the part in

Department1.
Illustration 2: ABC ltd plans utilize its idle capacity by making components
parts instead of buying them from suppliers. The following are the data
available for decision to make or buy:

Unit cost
Direct Material 12.5
Direct Labour 8.0
Variable manufacturing overhead 5.0

The company purchases the part at a unit cost of Rs.30. The company has
been operating at 75% of normal capacity. Fixed manufacturing cost is
17 lakhs. The cost to manufacture 50000 units is:

Unit cost Total cost

Direct material 12.5 6,25,000
Direct labour 8.0 4,00,000
Variable manufacturing o/h 5.0 2,50,000
Total incremental cost 25.5 12,75,000
Cost to purchase part 30.0 15,00,000
Net advantage in parts production 4.5 2,25,000

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Inference: The total incremental cost by producing the part in-house is

Rs. 25.50 while the cost incurred on purchase of the part from suppliers is
Rs. 30.00. There is a clear advantage to the company to produce the part
in-house.

13.6 Addition or Discontinuance of a Product line or Process

The decision to add or eliminate an unprofitable product is a special case of
product profitability evaluation. When a firm is divided into multiple sales
outlets, product lines, divisions, departments it may have to evaluate their
individual performance to decide whether or not to continue operations of
each of these segments.
Illustration 3: The Hi-tech Manufacturing Company is presently evaluating
two possible processes for the manufacture of a toy, and makes available to
you the following information:

Particular Process A Process B

Rs. Rs.
Variable cost per unit 12 14
Sales price per unit 20 20
Total fixed costs per year 30,00,000 21,00,000
Capacity (in units) 4,30,000 5,00,000
Anticipated sales (next year, in units) 4,00,000 4,00,000

You are required to suggest:

i) Which process should be chosen? Substantiate your answer.
ii) Would you change your answer as given above if you were informed
that the capacities of the two processes are as follows: A 6, 00,000
units; B 5, 00,000 units? Why? Substantiate your answer.

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Solution
Comparative Profitability Statement
Process A Process B
Particular
Rs. Rs.
(i) Selling price per unit 20 20
Variable cot per unit 12 14
Contribution per unit 8 6
Total annual contribution (as per anticipated 32,00,000 24,00,000
sales)
Total fixed costs per year 30,00,000 21,00,000
Total Income 2,00,000 3,00,000
Process B may be chosen
Total contribution (if utilized to present 34,40,000 30,00,000
capacity and sold)
Less : Fixed costs 30,00,000 21,00,000
Total Income 4,40,000 9,00,000
Process B may be chosen
(ii) Total contribution (if capacity of A of 48,00,000 30,00,000
6,00,000 units and of B 5,00,000 units)
Less : Fixed costs 30,00,000 21,00,000
Total Income 18,00,000 9,00,000

Process A may be chosen.

Illustration 4: Addition of second shift
Ulfa Ltd produces a single product in its plant. This product sells for Rs. 100
per unit. The standard production cost per unit is as follows:

Raw materials (5 kgs @ Rs. 8) Rs. 40

Direct labour (2 hours @ Rs. 5) 10
Variable manufacturing overheads 10
Fixed manufacturing overheads 20
80

The plant is currently operating at full capacity of 1, 00,000 units per years
on a single shift. This output is inadequate to meet the projected sales
manager has estimated that the firm will lose sales of 40,000 units next
years if the capacity is not expanded

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Plant capacity could be doubled by adding a second shift. This would

require additional out-of-pocket fixed manufacturing overhead costs of
Rs. 10,00,000 annually. Also, a night work wage premium equal to 25 per
cent of the standard wage would have to be paid during the second shift.
However, if annual production volume were 1,30,000 units or more, the
company could take advantage of 2 per cent quantity discount on its raw
material purchases.
You are required to advise whether it would be profitable to add the second
shift in order to obtain the sales volume of 40,000 units per year?
Solution
Decision analysis
Profit without Profits with
Particulars
expansion expansion
Sales revenue Rs. 1,00,00,000 Rs. 1,40,00,000
Less: variable costs:
Raw materials (Rs 39.20 x 1,40,000) 40,00,000 54,88,000
Direct labour 10,00,000 15,00,000
Variable manufacturing overhead 10,00,000 14,00,000
Contribution 40,00,000 56,12,000
Less : fixed costs (Rs. 1,00,000 x 20) 20,00,000 30,00,000
Net Income 20,00,000 26,12,000
Yes, it would be profitable to add the second shift as it would increase
profits by Rs. 6, 12,000.
Illustration 5: Assume a company is considering dropping product B from
its line because accounting statements shows that product B is being sold at
a loss.
Income Statement
Product A B C Total
Sales revenue 50,000 7,500 12,500 70,000
Cost of sales:
D. Material 7,500 1,000 1,500 10,000
D. Labour 15,000 2,000 2,500 19,500
Indirect manufacturing cost 7,500 1,000 1,250 9,750
(50% of Direct labour)
Total 30,000 4,000 5,250 39,250
Gross margin On sales 20,000 3,500 7,250 30,750
Selling & Admn 12,500 4,500 4,000 21,000
Net income 7,500 (1,000) 3,250 9,750

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Additional information:
a) Factory Overhead cost is made up of fixed cost of Rs.5850 and variable
cost of Rs.3900.
b) Variable cost by products are: A – Rs 3000, B – Rs 400 and C – Rs 500
c) Fixed costs and expense will not be changed if product B is eliminated
d) Variable selling and administrative expenses are to the extent of
Rs.11000 can be traced to the product: A-Rs.7,500; B- Rs.1500 and
C- Rs.2000
e) Fixed selling and admn expense are Rs.10000
Solution:
Income Statement
Product A B C Total
Sales revenue 50,000 7,500 12,500 70,000
Less V.C
D. Material 7,500 1,000 1,500 10,000
D. Labour 15,000 2,000 2,500 19,500
Factory overhead 3,000 400 500 3,000
Selling & Admn cost 7,500 1,500 2,000 11,000
Total 33,000 4,900 6,500 44,400
Contribution 17,000 2,600 6,000 25,600
Less: Fixed Cost
Factory o/h 5,850
S & Ad o/h 10,000
Total Fixed cost 15,850
Net income 9,750

If the sale of product B were discontinued, the marginal contribution would

be lost and the net income would be reduced by Rs.2,600.
Assume that after dropping product B, the sales of product A increased by
10%. The total profit of the firm will not increase by this sales increase.
Product A makes only a marginal contribution of 34% (17000/50000)

Sales revenue of Product A 50000 100%

Variable cost of Product A 33000 66%
Marginal contribution of Product A 17000 34%

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On additional sales of Rs. 5000 the marginal contribution would be Rs.1700

Sales revenue 10% of 50000 5000
Variable cost 66% 3300
Marginal contribution (34%) 1700

This contribution is less than Rs. 2,600 now being realized on the sales of
product B. it would take additional sales of product A of approximately Rs.
7,647 to equal the marginal contribution of Rs. 2,600 mow being made by
product B:
Marginal contributi on of products B 2,600
 = Rs. 7,647
Marginal contributi on of products A 34%

It is possible that dropping product B may result in reduction in some of the

fixed costs. Products B now contributes Rs. 2,600 towards recovery of fixed
costs and expenses. Only if the fixed costs and expenses can be reduced
by more than this amount, it will be advisable to drop product B.

13.7 Sells or Process Further

A firm is frequently faced with the problem of continuing with the existing
policies or plans or change to new ones. Such change could be in the form
of selling a partially processed product (semi finished) or process further.
While taking a decision about such matters, the management must keep in
mind the long term consequence and the interest of the firm.
Illustration 6: A firm sells semi finished product at Rs. 9 per unit. The cost
to manufacture the semi finished product is Rs. 6. Further processing can
be done at an additional cost of Rs.3 per unit and the final product can be
sold at Rs. 15 per unit. The firm can produce 10,000 units. The analysis is
shown below:
Sell Process & Sell
Sales revenue (10,000 units) Rs. 90,000 1,50,000
Less : Manufacturing costs 60,000 90,000
Profit 30,000 60,000

There is a net advantage of Rs. 30,000 in processing the product further.

The market value of the partially processed product (Rs. 90,000) is

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considered to be opportunity cost of further processing. The figure of net

advantage of Rs. 30.000 can be arrived at in the following manner also:

Revenue from sale of final product (10,000 x 15) Rs. 1,20,000

Less : Additional processing cost (10,000 x 3 ) 30,000
Revenues from sale of intermediate product 90,000 1,20,000
Net advantage in further processing Rs. 30,000

13.8 Operate or Shutdown

Various factors both external and internal affect the functioning of the firm.
In such situations it becomes necessary for a firm to temporarily suspend or
shutdown the activities of a particular product, department or a unit as a
whole.
Illustration 7: A company operating below 50% of its capacity expects that
the volume of sales will drop below the present level of 10,000 units per
month. Management is concerned that a further drop in sales volume will
create a loss and has under consideration a recommendation that operation
be suspended, until better market conditions prevail and also a better selling
price. The present operation income statement is as follows:
Rs Rs
Sales revenue (10,000 units @ Rs. 3.00) 30,000
Less : Variable costs @ Rs. 2.00 per unit 20.000
Fixed costs 10,000
Net Income 0

The following income statements have been prepared for sales at different
capacities:
Units Produced
Shutdown 2,000 4,000 6,000 8,000 10,000
Sales revenue @ Rs. 3 0 6,000 12,000 18,000 24,000 30,000
Variable costs @ Rs. 2 0 4,000 8,000 12,000 16,000 20,000
Contribution 0 2,000 4,000 6,000 8,000 10,000
Fixed costs 4,000 10,000 10,000 10,000 10,000 10,000
Loss (4,000) (8,000) (6,000) (4,000) (2,000) 0

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It would appear that shutdown is desirable when the sale volume drops
below 6,000 units per month, the point at which operating losses exceed the
shutdown cost.

13.9 Exploring New Markets

Decisions regarding entering new markets whether within the country or
other the country should be taken after considering the following factors:
 Whether the firm has surplus capacity to meet the new demand?
 What price is being offered by the new market?
 Whether the sale of goods in the new market will affect the present
market for the goods?
Illustration 8: The following figures are obtained from the budget of a
company which is at present working at 90% capacity and producing 13,000
units per annum.

90% 100%
Rs. Rs.
Sales 15,00,000 16,00,000
Fixed Expenses 3,00,500 3,00,600
Semi- Fixed Expenses 97,500 1,00,500
Variable Overhead Expenses 1,45,000 1,49,500
Units made 13,500 15,000

Labour and material costs per unit are constant under present conditions.
Profit margin is 10 per cent.
a) You are required to determine the differential cost of producing 1,500
units by increasing capacity to 100 per cent.
b) What would you recommend for an export price for these 1,500 units
taking into account that overseas prices are much lower than indigenous
prices?

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Solution
Basic Calculation: Rs.
Sales at 90% capacity 15,00,000
Less: Profit 10% 1,50,000
Cost of Goods sold 13,50,000
Less : Expenses (Fixed, semi-variable and variable) 5,43,000
Cost of Material and Labour 8,07,000
Labour and Material at 100% capacity = Rs. 8,07,000 x 100/90
= 8,96,667

Differential cost analysis can now be done as follows:

Capacity levels 90% 100% Different cost
Production (Units) 13,500 15,000 1,500
Material and Labour 8,07,000 8,96,667 89,667
Variable overhead expenses 1,45,000 1,49,500 4,500
Semi-variable expenses 97,500 1,00,500 3,000
Fixed expenses 3,00,500 3,00,600 100
13,50,000 14,47,267 97,267

a) Different Cost = Rs. 97,267 (Rs. 14,47,267 – 13,50,000)

Rs . 97,267
b) Minimum price for export = = Rs. 64.84 per unit
1,500

At this price, there is no addition to revenue; any price above Rs. 64.84 per
unit may be acceptable.
Note: It has been presumed that
i) No capital investment is necessary
ii) No export charges are incurred and
iii) The export price will have no effect on the home market where the
product will continue to be sold at the old price. It has also been
assumed that necessary precaution have been taken to ensure that the
product is not ‘dumped back’.

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13.10 Maintaining a Desired level of profit

When deciding between alternative courses of actions the criterion should
be to select the project which yields the greatest contribution.
Illustration 9: A company is considering expansion. Fixed costs amount to
Rs. 4, 20,000 and are expected to increase by Rs. 1, 25,000 when plant
expansion is completed. The present plant capacity is 80,000 units a year.
Capacity will increase by 50 per cent with the expansion. Variable costs are
currently Rs. 6.80 per unit and are expected to go down by Rs. 0.40 per unit
with the expansion. The current selling price is Rs. 16 per unit and is
expected to remain same under either alternative. What are the break- even
points under either alternative? Which alternative is better and why?
Solution
Statement of Comparative Profitability
Particulars Present After expansion
Production & Sales 4- Unit 80,000 1,20,000
Per Unit Amount Per Unit Amount
Sales 16.00 12,80,000 16.00 19,20,000
Variable costs 6.80 5,44,000 6.40 7,68,000
Contribution 9.20 7,36,000 9.60 11,52,000
Fixed cost 4,20,000 5,45,000
Profit 3,16,000 6,07,000
Fixed costs 4,20,000 5,45,000
BEP (units ) =
Contribution per unit 9.20 9.60

= 45.652 units 56771 units

(before expansion) (after expansion)

The profitability after expansion is very good and hence it is better to

expand.
Illustration 10: Disposal of inventories
ABC Ltd has on hand 5,000 units of a product that cannot be sold through
regular sales. These were produced at a total cost of Re. 1, 50,000 and
would normally have been sold for Rs. 40 per unit. Three alternatives are
being considered.

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i. Sell the items as scrap for Rs. 2 per unit

ii. Repackage at a cost of Rs. 20,000 and sell them at Rs. 8 per unit
iii. Dispose them off at the city dump at removal cost of Rs. 500.
Which alternative should be accepted?
Solution
Exhibits the decision analysis
Decision Analysis
Alternatives
Particulars (I) Sell as scrap (II) Repackage and sell (III) Disposal
Sales revenue Rs. 10,000 Rs. 40,000 –
Less Costs:
Repackage cost – 20,000 –
Removal cost – – 500
Contribution (Loss) 10,000 20,000 (500)

Alternative II should be accepted.

13.11 Summary
 Decision making is the process of evaluating two or more alternatives
leading to a final choice known as alternative choice decisions. Decision
making is closely associated with planning for the future and is directed
towards a specific objective or goal.
 A decision involves selecting among various choices. Non routine types
of decisions are crucial and critical to the firm as it involves huge
investments and involve much uncertainty. Short term decision making
is based on relevant data obtained from accounting information.
 Relevant Cost are costs which would change as a result of the decision.
 Opportunity costs are monetary benefits foregone for not pursuing the
alternative course. When a decision to follow one course of action is
made, the opportunity to pursue some other course is foregone.
 Sunk costs are historical cost that cannot be recovered in a given
situation. These costs are irrelevant in decision making.
 Avoidable costs are costs that can be avoided in future as a result of
managerial choice. It is also known as discretionary costs. These costs
are relevant in decision making.

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 Incremental / Differential costs are costs that include variable costs and
additional fixed costs resulting from a particular decision. They are
helpful in finding out the profitability of increased output and give a better
measure than the average cost.

13.12 Terminal Questions

1. Avon garments Ltd manufactures readymade garments and uses its cut-
pieces of cloth to manufacture dolls. The following statement of cost has
been prepared.
Particulars Readymade Dolls Total
garments
Direct material Rs. 80,000 Rs. 6,000 Rs. 86,000
Direct labour 13,000 1,200 14,200
Variable 17,000 2,800 19,800
overheads
Fixed overheads 24,000 3,000 27,000
Total cost 1,34,000 13,000 1,47,000
Sales 1,70,000 12,000 1,82,000
Profit (loss) 36,000 (1,000) 35,000

The cut-pieces used in dolls have a scrap value of Rs 1,000 if sold in the
market. As there is a loss of Rs. 1,000 in the manufacturing of dolls, it is
suggested to discontinue their manufacture. Advise the management.
2. The ABC Company Ltd produces most of its own parts and components.
The standard wage rate in the parts department is Rs. 3 per hour.
Variable manufacturing overheads is applied at a standard rate of Rs. 2
per labour – hour and fixed manufacturing overheads are charged at a
standard rate of Rs 2.50 per hour.
For its current year’s output, the company will require a new part. This part
can be made in the parts department without any expansion of existing
facilities. Nevertheless, it would be necessary to increase the cost of product
testing and inspection by Rs. 5,000 per month. Estimated labour time for the
new part is half an hour per unit. Raw materials cost has been estimated at
Rs. 6 per unit.

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The alternative choice before the company is to purchase part from an

outside supplier at Rs 9 per unit. The company has estimated that it will
need 2,00,000 new parts during the current years.
Advise the company whether it would be more economical to buy or make
the new parts. Would your answer be different if the requirement of new
parts was only 1,00,000 parts?

13.13 Answers to SAQ and TQs

Answer to SAQ
1. Change
2 Sunk cost
3. Monetary benefits foregone
4. Avoidable cost
Answers to TQs:
1. Discontinue manufacture of dolls
Readymade garments Dolls Total
Total cost 134000 13000 147000
Profit (loss) 36000 (1000) 35000

2. Decision analysis : 200000 units – The company is advised to make the

new part. The differential costs favouring the decision of making the
component is Rs40000
Decision analysis : 100000 units – The company is advised to buy from
an outside supplier. Total cost to manufacture 100000 units is
Rs.9,10,000.

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Unit 14 Budgetary Control

Structure:
14.1 Introduction
Objectives
14.2 Meaning of a Budget
14.3 Budgetary control
14.4 Objectives of budgetary control
14.5 Merits of budgetary control
14.6 Essential features of Budgetary Control
14.7 Steps in budgetary Control
14.8 Types of Budgets
14.9 Cast Budget
14.10 Flexible Budget
14.11 Limitation of Budget Control
14.12 Summary
14.13 Terminal Questions
14.14 Answers to SAQ‟s and TQ‟s

14.1 Introduction
In a competitive environment, the effective operation of a concern resulting
into the excess of income over expenditure fully depends upon “as to what
extent the management follower proper planning, effective coordination and
dynamic control“. For all these aspects, it has become necessary that
management should plan for the future financial and physical requirements.
These are the basic criteria that a firm has to adopt to maintain its
profitability and productivity. The procedure for preparing plan in respect of
future financial and physical requirements is generally called “Budgeting”. It
is a forward planning exercise. It involves the preparation in advance of the
quantitative as well as the financial statements to indicate the intention of
the management in respect of the various aspects of the business. In a
broader sense, it is essentially an economic service. Budgeting requires a
deeper understanding of the economic system of the environment in which
the business concern operates.

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Objectives:
After studying this unit, you should be able to:
1. Explain the meaning of budget and budgetary control.
2. Analyze the merits, demerits, essential features of budgetary control.
3. Note the steps involved in the preparation of budgets.
4. Acquaint with various types of budgets.
5. Prepare cash and flexible budgets.

14.2 Meaning of a Budget

Cost and Management Accountants, England has defined a budget as „ a
numerical statement expressing the plans, policies and goals of an
enterprise for a definite period in the future‟. Budgets are not actual but are
estimated. It is therefore a financial and / or quantitative statement prepared
and approved prior to a definite period of time, of the policy to be pursued
during that period for the purpose of attaining a given objective.

14.3 Budgetary Control

It is applied to a system of management accounting control by which all
operations and output are forecasted far ahead as possible and actual
results when known are compared with the budget estimates.

14.4 Objectives
Budgeting is a forward planning. It basically serves as a tool for
management control. The objectives of budgeting may be taken as:
 To forecast and plan for future to avoid losses and to maximize profits.
 To help the concern in planning the activities both physical and financial.
 To bring about coordination between different functions of the
enterprise.
 To control actual actions by ensuring that actual are in tune with targets.
Budgeting and Planning: The planning normally deals with long term and
short goals and operations. The goals can be for the entire organization or
department-wise or group wise or segment wise to achieve the maximum
results and operational efficiency. After setting up objectives in terms of
plans, it becomes imperative to organize the factors of production to convert
into a reality and workable preposition. In budgeting, planning refers to the

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preparation of budgets in respect of sales, advertisement, production,

inventory, materials cost and requirements, labor cost and requirements,
expenses, research, capital expenditures, financial plans. Planning through
budgets brings together all segments of the concern in a cooperative way
and they are compelled to think seriously about the planning. The views get
enlarged than getting into contraction. Internal refinement, broad indexation
of activities, concentrated details is the essential features in planning. All
the staff must be involved in the planning function to make it more
successful and purposeful.
Budgeting and Coordination: It deals with the combined efforts of all the
people involved from the shop floor to the top management. Individual and
collective wisdom should be considered in the preparation of budgets at all
levels to make it a workable document for translation into reality. For this
adequate communication at all levels should be established. It is very
important that each member of management is having perfect and clear cut
knowledge. There must be continuity to coordination. Budget may help us
to evaluate and examine whether the members of the management are
working in a cooperative way or not.
Budgeting and control: When one relates control function to budget, we
find a system what is generally termed as budgetary control. Control
signifies such systematic efforts which help the management to know
whether actual performance is in line with predetermined goal, policy and
plans. It is basically a measurement tool. Yardsticks should be laid down.
Standards must be set up.
Therefore, the objectives can be summarized as follows:
 To conform to good business practice by planning for the future.
 To coordinate the various divisions of a business.
 To establish divisional and departmental responsibilities.
 To forecast operating activities and financial position.
 To operate most efficiently the divisions, departments and cost center.
 To avoid waste, to reduce expenses and to obtain the income desired.
 To obtain more economical use of capital available for the efficient
operation.
 To provide more definite assurance of earning the proper return on
capital employed.

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 To centralize management control.

 To show the management where action is needed to remedy a situation.
 To help in controlling cash.
 To help in obtaining better inventory control and turnover.
Self Assessment Questions:
1. Budgets are not actual but ______.
2. After setting up objectives in terms of plans, it becomes imperative to
organize the factors of production to convert into a ____________and
______________
3. _______signifies such systematic efforts which help the management
to know whether actual performance is in line with predetermined goal,
policy and plans.
4. Internal refinement, broad indexation of activities, concentrated details
is the essential features in _______.

14.5 Merits
In order to help in planning, coordinating and control, budgets need to be
prepared for every organization to get the maximum benefit. Broadly, the
merits are as follows:
1. It forces basic policies to initiatives
2. The budgetary control aims at the maximization of profits
3. Budgets fix the goals and targets without which operations lack
direction
4. Reduction in cost and elimination of inefficiencies
5. Budgetary control facilitates to make ordered effort and brings about
overall efficiency in results.
6. Budgetary control ensures that the capital employed at a particular
level is kept at a minimum level
7. Budgetary control enables the management to decentralize
responsibility without losing control
8. It is a good guide to the management for making future plans. Based
on budgetary control realistic budgets can be drawn.
9. Budgetary control facilitates an intelligent and planned forecast of the
future

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10. Budgetary control acts as a safety signal for the management. It

prevents all types of wastages.
11. Budgetary control brings to light the inefficiencies and weakness on
comparing actual performance with budget. Management can take
timely remedial measures.
12. Financial crisis can be avoided since budget provides advance
information.
13. It is a guide to the management in the field of research and
development in future.

14.6 Essential Features of Budgetary Control

An effective budgeting system should have essential features to get best
results. In this direction, the following may be considered as essential
features of an effective budgeting.
Business Policies defined: The top management of an organization
strives to have an action plan for every activity and for each department.
Every budget should reflect the business policies formulated from time to
time. The policies should be precise and the same must be clearly defined.
No ambiguity should enter the document. Clear knowledge should be
provided to all the personnel concerned who are going to execute the
policies. Periodic suggestions should be called for.
Forecasting: Business forecasts are the foundation of budgets. Time and
again discussions should be arranged to derive the most profitable
combinations of forecasts. Better results can be anticipated based on the
sound forecasts. As far as possible, quantitative techniques should be made
use of while forecasting
Formation of Budget Committee: A budget committee is a group of
representatives of various important departments in an organization. The
functions of committee should be specified clearly. The committee plays a
vital role in the preparation and execution of budget estimated. It brings
coordination among other departments. It aids in the finalization of policies
and programs. Non-financial activities are also considered to make it a
wholesome affair.

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Accounting System: To make the budget a successful document, there

should be proper flow of accurate and timely information. The accounting
adopted by the organization should be proper and must be fine-tuned from
time to time
Organizational efficiency: To make the budget preparation and its
subsequent implementation a success, an efficient, adequate and best
organization is necessary a budgeting system should always be supported
by a sound organizational structure. There must be a clear cut demarcation
of lines of authority and responsibility. There must also be a delegation of
authority from top to bottom line.
Management Philosophy: Every management should set a healthy
philosophy while opting for the budget. Management must wholeheartedly
support the activities which developing a budget. Encouragement should
flow from top management. All the members must be involved to make it a
workable preposition and a dream-driven document.
Reporting system: Proper feedback system should be established.
Provision should be made for corrective measures whenever comparative
measures are proposed.
Availability of statistical information: Since budgets are always prepared
and expressed in quantitative terms, it is essential that sufficient and
accurate relevant data should be made available to each department.
Motivation: Since budget acts as a mirror, the entire organization should
become smart in its approach. Every employees both executive and non-
executives should be made part of the overall exercise. Employees should
be persuaded than pressurized to appreciate the benefits of the budgets so
that the fruits can be shared by all the members of the organization.

Self Assessment Questions:

5. Budgetary control acts as a ________ for the management. It prevents
wastages of all types
6. Business forecasts are the foundation of ________
7. _______ must wholeheartedly support the activities which developing a
budget.

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14.7 Steps in Budgetary Control

The procedure to be followed in the preparation and control of budget may
differ from business to business. But, a general pattern of outline of budget
preparation and control may go a long way to achieve the end results. The
steps are as follows:
Formulation of policies: The business policies are the foundation stone of
budget construction. Function policies should be formulated in advance.
Long-range policies with short term projections should be made for the
functional areas such as sales, production, inventory, cash management,
capital expenditure.
Preparation of forecasts: Based on the formulated policies, forecast
should be made in respect of each function. Activity based concepts should
be introduced at the micro level for each function Forecasts should not be
considered as a mere estimates. Scientific methods should be adopted for
forecasting. Analysis of various factors based on past, and present, future
forecast should be made.
Preparation of budgets: Forecasts are converted into written codified
document. Such written documents can be used for coordination purposes.
Function budgets will act as guidelines for implementation.
Forecast combinations: While developing the budgets, through a Master
Budget various permutations and combination processes are considered
and developed. Based on this, establishment of the most preferred one
which will yield optimum benefits should be considered. All the factor
components should be identified which are likely to cause disturbances
while implementing the budgets

14.8 Types of Budgets

The budgets are normally classified according to their nature. They are:
(a) fixed budget. (b) Flexible Budget. (c) Functional Budget
Fixed Budget: It is also known as static budgets. It is prepared for a fixed
or standard volume of activity. They do not change with change in the
volume of activity. They are prepared well in advance Due to this, there are
bound to be variances at the time of comparison. Hence, the budget targets

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become unsuitable for the purpose of comparison. Wide deviations are

noticed due to changes in the volume of activity.
Flexible Budget: It is prepared with a view to take into account the periodic
changes in the level of activity attained. In this case, the revenues and costs
targets are set in respect of different levels of activity say from zero to 100
% of the production volume. Such mechanism helps to change revenues
and cost targets for the actual level of activity and thus makes the
comparison more logical and scientific.
Functional Budget: These are also known as subsidiary budgets. These
are prepared on the basis of approved forecasts for individual department.
Since departments are created based on the functions, they are known as
functional budgets. The functional budgets may vary in number from
business to business. The functional budgets include sales budget,
Production budget, selling and distribution overhead budget, plant budget,
research and development budget, overheads budget, financial budget such
as cash budget and capital expenditure budget.
Self Assessment Questions:
8. ______ is also known as static budget because it is prepared for a
fixed or standard volume of activity.
9. Types of budgets are _____________.
10. In _______ budget the revenues and costs targets are set in respect of
different levels of activity say from zero to hundred percent of the
production volume.

14.9 Cash Budget

A proper control over cash is very essential. Cash is an important
component in any activity. The control becomes inescapable. If cash is not
properly managed or if it is mismanaged, the ultimate result would be
disastrous. In many times and in many business situations, business failures
are noticed due to the lacunae found in the cash management. Hence cash
budgeting occupies a pivotal place in the study of Financial Management.
Cash budgeting is the process of forecasting the expected receipts known
as cash inflows, and expected payments known as cash outflows to meet
the future obligations. The written statement of receipts and payments is

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known as the cash budget. It is a crystal ball which enables one to observe
the future movements in cash position. It is a mere forecast of cash position
of an undertaking for a definite period of time. The period may be daily,
weekly, monthly, quarterly, semi-annually, or annually. The major two
components of cash budget would be forecast first the cash receipts and
then second forecasting the cash disbursements.
The receipts of cash are formatted as follows:
1. Opening balance of cash in hand and cash at bank
2. Cash sales
3. Collection from debtors to whom sales are effected on credit basis
4. College from Bills received
5. Interest and advances and loans granted
6. Dividends received from investments
7. Sale proceeds from capital assets
8. Proceeds from issue of shares and debentures
9. Other sources.
After determining the various sources, the quantum of receipt should be
estimated. Past analysis will help to identify the problem areas for effecting
collection of cash.
Illustration 1: A large retail stores makes 25% of its sales for cash and the
balance on 30 days net. Due to faulty collection practice, there have been
losses from bad debts to the extent of 1 % of credit sales on average in the
past. The experience of the store tells that normally 60 % of credit sales are
collected in the month following the sale, 25% in the second following month
and 14 % in the third following month. Sales in the preceding three months
have been January 2007 Rs.80,000, February Rs.1,00,000 and March
Rs.1,40,000. Sales for the next three months are estimated as April
Rs.1,50,000, May Rs.1,10,000 and June Rs.1,00,000. Prepare a schedule
of projected cash collection.

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Solution:
Statement of expected Cash Receipts
Collection form April May June
Cash sales 37,500 27,500 25,000
Collection from Debtors :
January 8,400 – –
February 18,750 10,500 –
March 63,000 26,250 14,700
April – 67,500 28,125
May – – 49,500
Total 1,27,650 1,31,750 1,17,325

Working Notes: Details of Cash and Credit Sales – Month wise

[Fig. in 000‟s Rs.]
Jan Feb Mar Apr May June
Sales 80 100 140 150 110 100
Cash 20 25 35 37.50 27.50 25
25%
Cr. 60 75 105 112.50 82.50 75
75%

Details re: Credit Sales – Month wise realization:

[Fig. in 000‟s Rs.]
Debtors Feb Mar Apr May June
60:25:14
Jan:60 36 - - - 15 - - - 8.4
Feb:75 - - - 60 - - - 18.75 - - - 10.5 - - -
Mar:105 - - - - - - 63 - - - 26.25 - - - 14.7
Apr:112.5 - - - - - - - - - 67.5 - - - 28.125 -
May:82.5 - - - - - - - - - - - - 49.5 - -

Forecasts of cash payments: The items of expenditures differ from business

to business. The normal items which come under the lists are:
1. Cash purchases
2. Payment to creditors or suppliers
3. Payments to Bills payable
4. Payment to employees in the nature of wages, salaries

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5. Manufacturing, selling and distribution and administration expenses

6. Repayments of bank load and special obligations such as bonus,
donations, advances
7. Interest and dividend payments
8. Capital expenditures for acquiring assets of enduring benefit
9. payment of tax liability
10. other expenses of periodic nature
The quantum of amount likely to be spend on the above each item is
generally determined with reference to functional budgets of the concerns.
The policy of the management will also play a crucial role. It is the policy
which determines the ratio of cash purchases and credit purchases. In many
cases, the time lag affects the amount of expenditures to be incurred in a
particular period. The formula adopted for the expenses payable in next
month is : month‟s amount x time lag
Illustration 2:
The following are the forecasts relating to wages and factory expenses.

July Aug Sept Oct Nov

Wages 32,000 32,000 32,000 40,000 32,000
Factory expenses 5,000 5,000 5,000 5,000 5,000

One eighth of wages, half of factory expenses are paid in the succeeding
month. Estimate the amount of wages and factory expenses payable in
September, October and November.
Solution
Statement showing the disbursements of cash
Particulars Sept Oct Nov
Wages: Aug 32,000 4,000 - -
Sept 32,000 28,000 4,000 -
Oct 40,000 - 35,000 5,000
Nov 32,000 - - 28,000
32,000 39,000 33,000

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Factory expenses
Aug 5,000 2,500 - -
Sept 5,000 2,500 2,500 -
Oct 5,000 - 2,500 2,500
Nov 5,000 - - 2,500
5,000 5,000 5,000

Illustration 3:
The following information is provided in respect of Rashmi Ltd. Prepare a
Cash Budget for April, May and June 2007.
Months Details Sales Purchases Wages Expenses
Jan Actual 80,000 45,000 20,000 5,000
Feb Actual 80,000 40,000 18,000 6,000
March Actual 75,000 42,000 22,000 6,000
April Budget 90,000 50,000 24,000 7,000
May Budget 85,000 45,000 20,000 6,000
June Budget 80,000 35,000 18,000 5,000

Additional information:
a. 10% of the purchases and 20% of sales are in cash
b. The average collection period of the company is 1/2 month and the
credit purchases are paid regularly after one month.
c. Wages are paid half monthly and the rent of Rs.500 included in
expenses is paid monthly. Other expenses are paid after one month lag.
d. Cash balance on April 1, 2007 may be assumed to be Rs.15,000.

Solution:
CASH BUDGET
For the month ending June 2007
Particulars April May June
RECEIPTS
Opening Balance 15,000 27,200 35,700
Cash Sales 18,000 17,000 16,000
Collection from Debtors 66,000 70,000 66,000
Total say A 99,000 1,14,200 1,17,700

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PAYMENTS
Cash purchases 5,000 4,500 3,500
Payments to creditors 37,800 45,000 40,500
Wages 23,000 22,000 19,000
Rent 500 500 500
Other expenses 5,500 6,500 5,500
Total, say B 71,800 78,500 69,000
CLOSING CASH BALANCE, A – B 27,200 35,700 48,700

Illustration 4:
Hindustan Ltd. is to start production on January 1, 2008. The prime cost of
a unit is expected to be Rs.40 (Rs.16 per material and Rs.24 for labor). In
addition, variable expenses per unit are expected to be Rs.8 and fixed
expenses per month Rs.30,000. Payment for materials is to be made in the
month following the purchases. One-third of sales will be for cash and the
rest on credit for settlement in the following month. Expenses are payable
in the month in which they are incurred. The selling price is fixed at Rs.80
per unit. The number of units to be produced and sold are expected to be :
January 900, February 1,200, March 1,800, April 2,000, May 2,100 and
June 2,400. Draw a cash budget indicating cash requirements.
Solution
CASH BUDGET
For six months ending 30th June
Particulars Jan Feb Mar Apr May June
RECEIPTS
Opening bal – (34,800) (37,600) (32,400) (5,867) 27,600
Cash Sales 24,000 32,000 48,000 53,333 56,000 64,000
Collection from – 48,000 64,000 96,000 1,06,667 1,12,000
Debtors
A. Total 24,000 45,200 74,400 1,16,933 1,56,800 2,03,600
PAYMENTS
Creditors – 14,400 19,200 28,800 32,000 33,600
Wages 21,600 28,800 43,200 48,000 50,400 57,600
Variable 7,200 9,600 14,400 16,000 16,800 19,200
Expenses

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Fixed 30,000 30,000 30,000 30,000 30,000 30,000

Expenses
B. Total 58,800 82,800 1,06,800 1,22,800 1,29,200 1,40,400
Closing Bal. (34,800) (37,600) (32,400) (5,867) 27,600 63,200
[A – B]

Working Notes:
Particulars Jan Feb Mar Apr May June
Sales [Units] 900 1,200 1,800 2,000 2,100 2,400
Sales [Rs.] 72,000 96,000 1,44,000 1,60,000 1,68,000 1,92,000
Cash Sales 24,000 32,000 48,000 53,333 56,000 64,000
[Rs.] – 1/3

Illustration 5:
Ranjini Ltd. intends to approach her Bankers for temporary overdraft facility
for three months from 1st June to 31st August, 2007. Prepare a Cash budget
for the above period.

Months Sales Purchases Wages

April 3,60,000 2,49,600 24,000
May 3,84,000 2,88,000 28,000
June 2,16,000 4,86,000 22,000
July 3,48,000 4,92,000 20,000
Aug 2,52,000 5,36,000 30,000

(a) The entire sale is on credit basis out of which 50% is realized in
succeeding month and balance in the second month following sales.
(b) Creditors are paid in the month following purchase.
(c) Estimated cash as on 1st June is Rs.50,000
Solution
Cash Budget for the period ending 31st August

Particulars June July August

RECEIPTS
Opening balance 50,000 1,12,000 (94,000)
Collection from Debtors 3,72,000 3,00,000 2,82,000
A. Total 4,22,000 4,12,000 1,88,000

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PAYMENTS
Payments to creditors 2,88,000 4,86,000 4,92,000
Wages 22,000 20,000 30,000
B. Total 3,10,000 5,06,000 5,22,000
Closing Balance [A – B] 1,12,000 (94,000) (3,34,000)
Overdraft needed NIL 94,000 3,34,000

Illustration 6:
Prepare a cash budget from January to April.
Expected Purchases Expected Sales
Jan 48,000 60,000
Feb 80,000 40,000
Mar 81,000 45,000
April 90,000 40,000

Wages paid Rs.5,000 per month. Cash balance on 1st January Rs.8,000.
Management decides that:
a) In case of deficit upto of Rs.10,000, arrangement can be made with the
bank.
b) In case of deficit exceeding Rs.10,000 but within Rs.42,000, debentures
to be issued.
c) In case of deficit exceeding Rs.42,000, equity shares to be issued.
Solution
CASH BUDGET
Particulars Jan Feb March April
RECEIPTS
Opening balance 8,000 15,000 (30,000) (71,000)
Cash sales 60,000 40,000 45,000 40,000
Total, say A 68,000 55,000 15,000 (31,000)
PAYMENTS
Purchases 48,000 80,000 81,000 90,000
Wages 5,000 5,000 5,000 5,000
Total, say B 53,000 85,000 86,000 95,000
Closing Balance A – B 15,000 (30,000) (71,000) (1,26,000)

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The total deficit of Rs.1,26,000 should be raised from the issue of Equity
Shares.

14.10 Flexible Budget

According to I.C.M.A., London, a flexible budget is “a budget which is
designed to change in accordance with the level of activity actually
attained”. The basic idea of a flexible budget is that there shall be some
standard of cost and expenditures. Thus, a budget prepared in a manner to
give budgeted costs for any level of activity is, known as flexible budget.
Such budget is prepared after considering the variable and fixed elements of
costs and the changes which may be expected for each item at various
levels of operations.
The main focus of flexible budget is to re cognize the difference in behavior
pattern of fixed and variable costs in relation to fluctuations in production
and sales.
The flexible budget is, hence, designed to change appropriately with such
fluctuations. In flexible budget, data relating to costs and expenses may
progressively be changed in any month in accordance with actual output
achieved. Costs and estimates are made in advance based on standards.
A maximum and a minimum level of operation are made. Comparison of
budgeted with actual are made. Budgeted activities are taken as basis.
The principles of flexible budgeting concepts are applied to functional
budget, master budgets. Popularly, the flexible budget is adopted for
production cost budget. A detailed classification is adopted such as variable,
fixed and semi-variables. Adopting micro-level classifications, it is intended
to pin-point the various effects on each class of overheads.
Illustration 7:
Draw a flexible budget for the level of operation at 70 %, 80 % and 90 %.
Variable overheads: at 80% capacity.
Indirect labor Rs.12,000. Stores and spares Rs.4,000.
Semi-variable overheads at 80% capacity.
Power (30% fixed) Rs.20,000. Repairs and maintenance at 60% fixed
Rs.2,000.
Fixed overheads: at 80%

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Depreciation Rs.11,000. Insurance Rs.3,000. Salaries Rs.10,000.

The estimated direct labor hours 1,24,000.
Solution:
FLEXIBLE BUDGET (OVERHEADS)
For the period …………………
Particulars Level of operation
70% 80% 90%
VARIABLE OVERHEADS
Indirect labor 10,500 12,000 13,500
Stores & Spares 3,500 4,000 4,500
Total, say A 14,000 16,000 18,000
SEMI VARIABLE OVERHEADS
Power - 30 % Rs.20,000 [fixed] 6,000 6,000 6,000
Power - 70 % [variable] 12,250 14,000
14,000 15,750
15,750
Repairs & Maintenance 60 % Rs.2,000 1,200 1,200 1,200
[fixed]
Repairs & Maintenance 40 % variable 700 800 900
Total, say B 20,150 22,000 23,850
FIXED OVERHEADS
Depreciation 11,000 11,000 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000
Total, say C 24,000 24,000 24,000
Grand Total A + B + C 58,150 62,000 65,850
Estimated labor hours 1,08,500 1,24,000 1,39,500
Standard overhead rate / hour 0.54 0.50 0.47

Divide the grand total by estimated Labour hours.

14.11 Limitations of Budgeting

The main limitations of budgeting are as under:
Budget plan: Since budget plans are based on estimates, the success or
otherwise depend on the accuracy of basic estimates or forecasts. Due to
this while making estimates, judgmental decision may accrue. The results
need to be interpreted very cautiously.

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Rigidity: Since the estimates are quantitative expression of all relevant

data, there is likely that finality attachment may become very clear. Such
consideration may result in rigidity. Rigidity may become a setback for the
changing business conditions.
Replacement: Budgeting is not a substitute for management. It is
essentially a tool of management. Under no circumstances, it should be
concluded that the budgeting is alone sufficient to ensure success and to
guarantee future profits.
Costly: The installation of budgeting system to an organization involve too
much of costs. Its scientific approach will definitely call for huge cost
allocation. Small concerns cannot afford to take over huge costs for the
establishment of business systems. Since the costs and revenues and
operational activities do not match in many occasions, the entire exercise
will become costly. The system should be adopted only when benefits
exceed the costs.

14.12 Summary
Budgets are not actual but estimated ones. It is therefore a financial and /
or quantitative statement prepared and approved prior to a definite period of
time, of the policy to be pursued during that period for the purpose of
attaining a given objective.
Budgeting is a forward planning. It basically serves as a tool for
management control.
Planning through budgets brings together all segments of the concern in a
cooperative way and they are compelled to think seriously about the
planning. The views get enlarged than getting into contraction. Internal
refinement, broad indexation of activities, concentrated details is the
essential features in planning. All the staff must be involved in the planning
function to make it more successful and purposeful.
Control signifies such systematic efforts which help the management to
know whether actual performance is in line with predetermined goal, policy
and plans. It is basically a measurement tool. Yardsticks should be laid
down. Standards must be set up.

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14.13 Terminal Questions

1. What are the merits of budgets?
2. Describe the essential features of budgetary control.
3. What are the steps in budgetary control?
4. What are the limitations of budgeting?

4.14 Answer Self Assessment Questions

1. Estimates Answer for Terminal Questions

2. Reality and workable preposition 1. Refer to unit 14.5
3. Control 2. Refer to unit 14.6
4. Planning 3. Refer to unit 14.7
5. Safety signal 4. Refer to unit 14.11
6. Budgets
7. Management
8. Fixed budget
9. Fixed , flexible, functional
10. Flexible

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Unit 15 Standard Costing

Structure
15.1 Introduction
Objectives
15.2 Definition of Standard Costing
15.3 Meaning
15.4 Difference between Standard cost and Budgetary Control
15.5 Establishment of standards
15.6 Variance analysis
15.7 Material cost variance
15.8 Material price variance
15.9 Material usage variance
15.10 Material Mix variance
15.11 Material Yield variance
15.12 Direct labor variance
15.13 Labor Efficiency Variance
15.14 Labor Rate variance
15.15 Labor mix variance
15.16 Labor Yield Variance
15.17 Summary
15.18 Terminal Questions
15.19 Answers to SAQ’s and TQ’s

15.1 Introduction
Standard costing is a very important system of cost control. It is a system
which seeks to control the cost of each unit or batch through determination
before hand of what should be the cost and then its comparison with actual
cost. Through planned accounting procedures, the difference between the
actual and pre-determined costs are analyzed and then promptly reported
upon to managers. Based on this, it is possible to take corrective and
preventive action as well as employ the data for planning, coordination and
control.

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Objectives:
After studying this unit, you should be able to :
1. Define the standard costing.
2. Understand the meaning.
3. Differentiate between standard cost and budgetary control.
4. Acquaint with establishment of standards.
5. Practice the variance analysis.

15.2 Definition of Standard Costing

Standard costing may be defined as a technique of cost accounting which
compares the standard cost of each product or service with the actual cost
to determine the efficiency of the operation so that any remedial action may
be taken immediately: Brown and Howard.
According to J. Batty “standard costing is a system of cost accounting which
is designed to show in detail how much each product should cost to produce
and sell when a business is operating at a stated level of efficiency and for a
given volume of output”.

15.3 Meaning
The meaning of standard costing is focused on the method of financial
control. It compares the predetermined and actual costs. It is normally
associated closely with budgetary control. Many organizations use both the
systems although one can be used without the other. Standard costing is
mainly applied to products and processes.
Therefore, it is a technique that is more commonly used in manufacturing
organization, though it may also be useful in service industries. As in
budgetary control, it allows the comparison of pre-determined costs and
income with the actual costs and income achieved. Any difference can then
be investigated.

15.4 Difference between Standard Cost and Budgetary Control

Both are closely interrelated. They both aim at the improvement of the
system of managerial control. They both achieve the same objective of
maximum efficiency and cost control by establishing pre-determined
standards. They compare actual performance with the predetermined
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standard. They take necessary steps to improve the situation wherever

necessary. Both techniques are forward looking.
However, the following are some of the differences identified.
1. The scope of budgetary control is wider. It is integrated plan of action,
a coordinated plan in respect of all functions of an enterprise. The
scope of standard costing on the other hand is limited to the operating
level. Here too, it is further linked to costs. Budgetary control is
extensive whereas standard costing is intensive in its application
2. Budgetary control deals with costs and revenues. But standard costing
restricts only with costs.
3. Budgetary control takes into account all activities such as production,
sales, purchases, finance, capital expenditure, personnel whereas
standard costing is restricted to deal with only costs.
4. Budgetary control targets are based on past actual adjusted to future
trends. In standard costing, standards are based on technical
assessment.
5. At the approach level, budgeted targets work as the maximum limit of
expenses above which the actual expenditure should not normally
exceed. Under standard costing, standards are attainable level of
performance.
6. Budget is projection of final accounts. Standard costs are projection of
only cost accounts.
7. Budgetary control emphasizes the forecasting aspect of the future
operations. Standard
8. Costing scope and utility is limited to only operating level of the
concern.
9. In budgetary control, the degree of variance analysis tends to be much
less and variances are not revealed through the accounts but are
revealed in total. But in standard costing, variances are analyzed in
details according to their originating causes and are revealed through
different accounts.
10. Budgetary control is possible even in parts of expenses according to
the attitude of management. A standard costing system can not be
operated in parts. All items of expenditure included in cost units are to
be accounted for.

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Self Assessment Questions:

1. Standard costing is defined as a technique of cost accounting which
compares the _____________ of each product or service with the
actual cost .
2. Standard cost focuses on _________.
3. Standard cost and budget control _________.

15.5 Establishment of Standards

Under standard costing system, there is a need to determine the standard
costs for each element of cost. The standards are fixed for three main
elements of cost namely direct material, direct labor and overhead.
Standards should be fixed for each of them separately.
Direct Material: Standard material cost for each product should be pre-
determined. This will require the determination of material quantity standard
and material price standard. The standard quantity of each type of materials
is determined by the engineering department on the basis of past records,
experience and chemical and engineering tests.
While setting such standards, an allowance should be made for the normal
wastage of materials. The standard price for each item of material is
established after carefully studying the market conditions and forecasting
the trend of prices for a future period. This is done by cost accountant with
the help of purchase officer.
Direct labor: The standard labor time and standard labor rate should be
established. Standard time for each grade of labor is fixed by the production
engineering department on the basis of time and motion study. In fixing the
standard time due allowance should be made for fatigue, tool setting,
receiving instructions and normal idle time. The standard rates of pay for
each category of labor are fixed by the cost accountant with the help of
personnel department.
Overheads: These are aggregate of indirect materials, indirect labor and
indirect expenses. Separate standards must be established for variable and
fixed overheads. As variable overheads per unit or per hour remain constant
at each level of output / sales but total amount of variable overheads tend to
vary directly with volume of output / sales.

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Therefore, it is sufficient to calculate only a standard variable overhead rate

per unit or per hour. This is done by dividing the total variable overheads for
the budget period by the budgeted output. In respect of fixed overheads
standards are set for total fixed overheads for the budget period and the
budgeted output and standard fixed overhead rate is computed by dividing
the budgeted fixed overheads with budgeted output.

15.6 Cost Variance Analysis

The distinctive feature of standard costing system is variance analysis. By
definition, the term “variance” means the variation or deviation of the actual
from the standard. In standard costing, it implies the difference between the
actual cost and standard cost. Variances indicate the extent to which
standards set have been achieved. If properly recorded and analyzed, these
variances become very important and useful tool for managerial control.
Variances by themselves are not the end. They are computed to know the
reasons and fix the responsibility for any deviations of actual performances
from pre determined targets. Based on this corrective measures are
proposed for adoption in future. Therefore, variance analysis is the process
of analyzing variances by sub-dividing the total variance in such a way that
management can assign responsibility for off standard performance It is
hence a very useful means for interpreting operating results and spotting
situations calling for correction.
Variances are interpreted as favorable and unfavorable variances. Each
variance is interpreted. Interpretation helps in deciding whether a variance is
favorable or unfavorable. When the actual cost is less than the standard
cost, the difference is termed as “favorable” or “credit” variance. On the
other hand, when actual cost exceeds the standard cost, the difference is
termed as “unfavorable”, “adverse” or “debit” variance.
Ordinarily, a favorable variance is a sign of efficiency of the organization
whereas an unfavorable variance a sign of inefficiency. But in variance
analysis, this general logic may prove to be untrue. Therefore, all variances
should be interpreted in relation to each other and only the net result be
reported to the management for corrective action.

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Controllable and Uncontrollable variances: The controllable variance can

be identified as the primary responsibility of a specified person or a
department. The variance is due to the factors beyond the control of the
concerned person or department, it is said to be uncontrollable. No person
or department can be held responsible for uncontrollable variances.
Actually revision of standards is required to remove such variances in future.
Self Assessment Questions:
4. Standards are established for _________, __________ and
_______________.
5. Variation refers to _____________.
6. When the actual cost is less than the standard cost, the difference is
termed as ____________ or “credit” variance
7. Variances are interpreted as __________ and _____________.

15.7 Material Cost Variance

It is the difference between the standard cost of materials allowed for the
actual output and the actual cost of materials used. It may be expressed
as:

Material Cost Variance = Standard Cost – Actual Cost

Standard cost = actual output x standard rate per unit of output
Actual cost = actual quantity consumed x actual price per unit
of material

Or standard quantity of material for actual output x standard price per unit of
material.
A favorable variance would result if actual cost is less than the standard cost
and vice versa. The material cost variance is the sum total of material price
variance and material usage variance.
Illustration 1: Bombay Dyeing Ltd. has decided to extend its range to
include Denim Jackets. One jacket requires a standard usage of 3 meters of
direct material which has been set at a standard price of Rs.2.20 per meter.
In the period, 80 jackets were made and 260 meters of material consumed
at a cost of Rs.1.95 per meter. Calculate the direct materials total variance.

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Solution: Calculate the standard quantity of materials for the actual level of
production

For 1 jacket = standard usage is 3 meters

For 80 jackets = 80 x 3 meters = 240 meters
MCV = (SQ x SP) – (AQ x AP)
= (240 x Rs. 2.20) - (260 x Rs.1.95)
= Rs. 21 (Favorable) variance.

The difference indicates that them company has spent less on materials
than planned for the level of production.

15.8 Material Price Variance

Under Material price variance, the price paid for materials is different from
the pre-determined price. It is calculated by multiplying the actual quantity
of materials used with the difference between standard and actual prices.
The formula is :

Material Price Variance = (Standard Price – Actual Price) x Actual quantity used.
MPV = (SP – AP) AQ

A favorable variance would result if the actual price is less than the standard
price and vice versa.
Illustration 2: Calculate the direct material price variance from the data of
Bombay Dyeing Ltd above.
Solution:

MPV = (SP – AP) AQ

= (Rs.2.20 – Rs.1.95) x 260 meters
= Rs.78 FAV

It is favorable because the company has paid less for the materials than
planned for that level of production

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15.9 Material Usage Variance

It is also known as material quantity variance or efficiency variance. It is
that portion of material cost variance which measures the difference in
material cost arising from higher or less a consumption of materials than the
standard material consumption for the actual output. It is calculated by
multiplying the standard price with the difference between the standard and
actual quantitative of materials:

Material Usage Variance = (Standard Quantity – Actual Quantity) Standard Price

MUV = (SQ – AQ) SP

A favorable variance would result if the actual quantity is less than the
standard quantity and vice versa.
Self Assessment Questions:
8. The formula for Material Cost variance is ______________.
9. The formula for Material price variance is __________.
10. The formula for Material usage variance is _______.
Illustration 3: Calculate the direct material usage variance from the data of
Bombay Dyeing Ltd above.
MUV = (SQ – AQ) SP
= (240 – 260 meters) x Rs. 2.20 per unit
= Rs. 44 (ADV)
It is adverse because the company has used more materials than planned
for that level of production.
Illustration 4: It is observed that one unit of product X requires 3 kgs of
material M at Rs.2 per kg. During January 2008, 200 units of product X were
produced consuming 620 kgs of material M, all of which was purchased at
Rs.1.80 per kg. Compute material cost variances.

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Solution:

Material Price Variance: (SP – AP) AQ or (2.00 – 1.80) x 620 = Rs. 124 F.
Material Usage variance: (SQ – AQ) SP where SQ for actual consumption is
= 200 x 3 kg / 1 kg 0r 600 kgs
= (600 – 620) Rs.2 or Rs.40 A
Material Cost Variance = Material Price Variance + Material Usage variance
= 124 (F) + 40 (A)
= 84 (FAVOURABLE)

Illustration 5: For producing a commodity, the standard quantity of material

was fixed 10 kgs and standard price was fixed at Rs.2 per kg. The actual
quantity was consumed 12 kgs and the actual price was Rs.1.90 per kg.
Calculate the material variances.
Solution:

MUV = (SQ – AQ) SP = (10 – 12) 2 = – 4.00 ADV

MPV = (SP – AP ) SQ = (2 – 1.90 ) 12 = 1.20 FAV
MCV = (SQ x SR) – (AQ x AP) = (10 x 2 ) – (12 x 1.90) = 2.80 ADV
MCV = MPV + MUV

Illustration 6: Calculate the material variance.

Standard Actual
Material for 80 kgs Output 1,65,000 kgs
Finished products 100 kgs Material used 2,00,000 kgs
Price per kg Rs.0.80 paid Actual cost Rs.1,70,000

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Solution: Calculation of standard quantity

For 80 kgs finished products needed is 100 kgs material

For 1,65,000 kgs, = 1,65,000 x 100 / 80 = 2,06,250 kgs.
MUV = (SQ – AQ ) SP or (2,06,250 – 2,00,000) x 0.80
= Rs.5,000 FAV
MPV = (SP – AP ) AQ or (0.80 – 0.85 ) 2,00,000
= Rs.10,000, ADV
Cost of 2,00,000 kgs is Rs. 1,70,000 Therefore, cost of one kg is 0.85
MCV = (SQ x SR) – (AQ x AP )
(2,06,250 x 0.80) – (2,00,000 x 0.85)
= Rs. 5,000 ADV.

Illustration 7:
It is estimated that in the manufacture of a product, for each ton of materials
consumed 100 units should be produced. The standard price per ton of
materials is Rs. 10. During the first week of January, 100 tons of materials
were issued to the Production Department. The purchase price of which
was Rs. 10.50 per ton. The actual output for the period was 10,250 units.
Calculate the cost variances.
Solution:

Standard rate of material: Standard cost per ton / standard output per ton or
10,250 units / 100 tons or 102.5 per ton
MUV = (SQ – AQ) SP
SQ = Actual output / standard quantity or 10,250 / 100 tons = 102.5 ton
= (102.5 – 100 tons) x Rs.10 = Rs. 25 FAV
MPV = (SP – AP) AQ (10 – 10.50 ) x 100 = Rs. 50 ADV
MCV = (SQ x SP) – (AQ x AP) or 102.5 x 10 – 100 x 10.50 = Rs. 25 ADV

Illustration 8: A factory works on standard costing system. The standard

estimates of material for the manufacture of 1000 units of a commodity are
400 kg at Rs. 2.50 per kg. When 2000 units of a commodity are
manufactured, it is found that 820 kgs of material is consumed at Rs. 2.60
per kg. Calculate the material variance

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Solution: First calculate the standard quantity and standard cost.

Standard quantity: For manufacture of 1000 units, the standard

estimates = 400 kgs. Therefore, for actual manufactured quantity, the
standard is 2000 x 400 / 1000 or 800 kgs.
Standard cost = Standard quantity x Standard rate
= 800 x Rs.25
= Rs.2,000
Actual Cost = 820 x Rs. 2.60 or Rs. 2,132
Material cost variance = Standard cost – Actual cost or 2000 – 21312
= 132 ADV.
Material price variance = (SR – AR) AQ or 2.5-0 – 2.60 x 820
= Rs.82 ADV
Material usage variance = 800 – 820 x 2.50 = Rs.50 ADV

15.10 Material Mix Variance

This variance arises only when more than one type of materials are used in
manufacturing the product and the quantities of materials issued to
production are not in proportion of standard mix. It is defined as that portion
of the direct materials usage variance which is due to difference between
the standard and actual, composition of a mixture. For calculating the mix
variance, first calculate the quantities of revised standard mix. This is
calculated by dividing the total quantities of actual mix in standard mix
proportion.
In the terminology of standard costing, quantities of revised standard mix
are referred to as “revised standard quantity”. Mix variance is obtained by
multiplying the standard price of materials with the difference between
revised standard quantity and actual quantity for each material. It may be
expressed as follows:
Material Mix Variance = Revised standard quantity for each material –
actual MMV Quantity for each material) x standard price.

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Where RSQ = standard quantity for each material / total of standard quantity
of all types of materials x actual mix total
RSQ = Total weight of actual mix / total weight of standard mix (x) standard
quantity.
A favorable variance would result if actual quantity is less than revised
standard quantity and vice versa.
Illustration 9: The following extracts are extracted from the books of DR
Ltd.
Standard Mix Actual Mix
Material Qty Rate Total Qty Rate Total
X 300 5 1500 280 5 1400
Y 200 10 2000 220 10 2200
Total 500 500
Calculate the material mix variance
Solution:
Revised standard quantity = Total weight of actual mix / total weight of
standard mix x standard quantity

For Material X = 500 / 500 x 300 = 300

MMV = For X = (300 – 280)_ 5 = 100 FAV
For Material Y = 500 / 500 x 200 = 200
Y = (200 – 220) 10 = 200 ADV
Total Mix variance 100 ADV

15.11 Material Yield Variance

This variance arises only when the rate of output is known. It is that portion
of the direct material usage variance which is due to the difference between
standard yield specified and actual yield obtained. It measures the loss or
saving due to wastage of materials. This variance is calculated as follows:

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MYV = (Standard yield – Actual Yield ) x standard rate per unit of output or
(Standard Loss – Actual Loss ) x standard rate per unit of output

where standard rate = standard cost of standard mix / standard output from
standard mix standard yield = standard output from standard mix / standard
mix total x actual mix total MYV is an output variance and hence a favorable
variance would result if actual yield is more than standard yield and vice
versa.
Self Assessment Questions:
11. The formula for Material mix variance is __________.
12. The formula for Material yield variance is __________.
Illustration 10: DR manufactures a product X. It is estimated that for each
ton of material consumed, 100 articles should be produced. The standard
price per ton of material is Rs. 10. During the first week of January 2008,
100 tons were issued to production, the price of which was Rs.10.50 per
ton. Production during the week was 10,200 articles. Compute the variances
Solution:

Cost variance: Standard cost – Actual Cost or Rs.1,020 – Rs.1,050 =

Rs. 30 ADV
SR = Actual output x standard rate per unit of output
= 10200 x 0.10 or Rs.1, 020
SR = Actual output / standard output per ton or 10,200 / 100 or 102
tons
Price variance = Actual quantity of input
(Standard price – Actual Price)
= (10 – 10.50) x 100 = Rs.50 ADV
Usage Variance = (Standard quantity – Actual quantity) standard price
= (102 – 100) x 10 or Rs.20 FAV
Yield variance = (Standard yield – Actual yield) standard rate per unit
of output
= (10,000 – 10,200) 0.10 or Rs.20 FAV
Standard yield = Actual quantity of material x standard rate per ton of
output
= 100 x 100 = 10,000 articles.

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Illustration 11 : The standard mix of product MS is as follows

Materials Qty in Kg Price/kg
A 50 5
B 20 4
C 30 10
The standard loss in production is 10 % of input. There is no scrap value.
Actual production for a month was 7,240 kgs of MS from 80 mixes. Actual
purchases and consumption of materials are:
Materials Qty in Kg Price/kg
A 4160 5.50
B 1680 3.75
C 2560 9.50

Solution
Statement showing standard input requirements of 80 mixes of product MS
Material Standard Actual
SQ SR SC AQ AR AC
A 4,000 5 20,000 4,160 5.50 22,800
B 1,600 4 6,400 1,680 3.75 6,300
C 2,400 10 24,000 2,560 9.50 24,320
Total 8,000 50,400 8,400 53,500
Less std.loss 800
Final output 7,200 50,400

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SC per kg of finished product = 50,400 / 7200 kg = Rs.7 per kg

Cost variance = SC - AC or 7 x 7240 -53500 or Rs.2, 820 ADV
Price Variance = (SR – AR) x A Q
A = Rs. 2,080 ADV
B = Rs. 420 FAV
C = Rs. 1,280 FAV
Mix Variance = (RSQ – AQ) SR
A = [(8400 x 50 /100)-4160] Rs. 5 = 200 FAV
B = [8400 x 20 / 100 -1680]x Rs. 4 Nil
C = [8400 x 30 / 100 -2560]x Rs. 10 = 400 ADV
Total: 200 ADV
Yield variance = (SY – AY) SR per kg
Standard yield = 8400 kg x 9 / 10 or 7560 kg
(7,560 – 7,240) Rs. 7 or Rs. 2,240 ADV

15.12 Direct Labour Variances

The same principles apply to the calculation of Direct Labor variances as for
the direct material variances. Standards are established for the rate of pay
to be paid for the production of particular products and labor time taken for
their production. The standard time taken is expressed in standard hours or
minutes and become the measure of output. By comparing the standard
hours allowed and the actual time taken, labor efficiency can be assessed.
In practice, standard times are established by work, time and method study
techniques.
Direct Labor Variance: It is the difference between actual labor cost and
the standard labor cost of production achieved. It is calculated as :

Total Labor Cost = Hours worked x Rate per hour

Labor Cost Variance = Standard Cost – Actual Cost
Shorten = SC – AC or (Standard labor hours x standard rate per hour) – (Actual
labor hours x Actual rate per hour)

Illustration 12: The management of DR Ltd decides that it takes 6 standard

hours to make one Denim jacket and the standard rate paid to labor is Rs. 8

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per hour. The actual production is 900 units and this took 5,100 hours at a
rate of Rs.8.30 per hour. Calculate the direct labor total variance.
Solution: Calculate the standard labor hour for 900 jackets.
For one Jacket production, the standard hour is 6.
Therefore, for producing 900 units, the standard hour is 900 x 6/1 = 5,400
hours.
DLV = (5,400 x 8) – (5,100 x 8.30) = Rs. 870 favorable.
A favorable variance would result when actual cost is less than standard
cost and vice versa. Labor cost variance is the sum total of labor rate
variance, labor efficiency variance, rate variance, idle time and labor
calendar variance

15.13 Labour Efficiency Variance

It is that portion of labor cost variance which is due to the difference
between the standard labs or hours specified for the activity i.e. output
achieved and the actual labor hours worked. It is calculated by multiplying
standard rate of wages with the difference between standard hours and
actual hours worked.
LEV = Standard hours – actual hours worked) x standard rate
Shorten = (SH – AH ) SR
A favorable variance would result when actual hours worked are less than
standard hours and vice versa.
Illustration 14: From the data above, calculate the labor efficiency variance;
Solution: (5400 standard hours – 5100 actual hours) x Rs. 8 standard rate
Rs. 2,400 FAV

15.14 Labour Rate Variance

It is that portion of labor cost variance which is due to the difference
between the standard rate specified and actual rate paid. It is calculated by
multiplying the actual hours paid with the difference between standard rate
specified and actual rate paid.
Labor Rate variance = (Standard Rate – Actual Rate) x actual hours paid.
Shorten = (SR – AR) AH

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Self Assessment Questions 5:

13. The formula for Direct labor variance is ___________.
14. The formula for Labor efficiency variance to _________________.
15. The formula for Labor rate variance is __________.
Illustration 15: Citing DR example, calculate the direct labor rate variance
Solution:

(Rs.8 – 8.30) x 5,100 hours or Rs.1,530 ADV

Illustration 16: The production of a certain unit is assumed to require 18

hours labor at a rate of Rs. 1.25 per hour. On completion of a unit, it was
found that the time taken was 16 hours, the wage rate being Rs. 1.50 per
hour. Calculate labor variances.
Solution:

Cost variance = Standard cost – actual cost

Rs. 22.50 – Rs. 24 or Rs. 1.50 ADV

Working:

SC = Standard hours x standard rate per hour

= 18 x Rs.1.25 = Rs. 22.50
Efficiency variance = (Standard hours – actual hours worked) x
standard rate (18 – 16) x 1.25 or Rs. 2..50 FAV
Rate variance = (Standard rate – actual rate) actual hours paid
(1.25 – 1.50) 16 or Rs. 4 ADV
LCV = LEV + LRV
= 2.5 FAV + 4 ADV = 1.5 ADV

Labor Idle Time Variance: It is that portion of labor cost variance which is
due to abnormal idle time of workers. This variance is calculated to show
separately the effect of abnormal causes affecting production such as failure
of power supplies, machine break down, waiting for materials, waiting for
instructions, strike, lock-outs. It is calculated as:
Labor idle time variance = Idle hours x standard hourly rate
This variance is always an adverse one.

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Illustration 17: In the ma manufacture of a product, 200 employees are

engaged at a rate of 50 paise per hour. A five day week of 40 hours is
worked and the standard performance is set at 250 units per hour. During
the first week in January, six employee were paid at 45 paise an hour and
four at 56 paise an hour, the remaining employees were paid at standard
rates. The factory stopped production for one hour due to power failure.
Calculate variances.
Solution:

Efficiency variance = (Std hours – actual hours worked) x std rate

(8000 – 7800) 0.50 or Rs.100 FAV
Rate variance = (SR – AR) AH
(0.50 – 190 employees x 40 hours = Nil
(0.50 – 0.40 ) x 6 x 40 12.00 FAV
(0.50 - -.56 ) 4 x 40 9.60 ADV
Total 2.40 FAV
Idle time variance = Idle hours x std rate per hour
200 hrs and 0.50 or Rs.100 ADV
Labor cost variance = LEV +_ LRV + Idle time variance
100 FAV + 2.40 FAV + 100 ADV = Rs. 2.40

15.15 Labour Mix Variance

This variance arises only when different types of workers (women and men
workers, trained, semi-trained and untrained workers, are employed in
manufacturing. If actual working force of different grades of workers is not
in the pre-determined ratio, then the mix variance will occur. The variance
shows to the management as to how much of the labor cost variance is due
to the changes in the composition of labor force. It is calculated as follows:
LMV = (Revised standard hours – actual hours worked) x standard hourly
rate Shorten (RSLH – ALH) x SR
Where revised standard hour = total time of actual worker / total time of
standard workers x standard labor rate.

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Illustration 18: The labor budget for a week is as follows:

40 skilled men at Rs.1.50 per hour for 80 hours
80 unskilled men at Re.1 per hour for 80 hours
Actual labor force was used are given below;
60 skilled men at Rs.1.50 per hour for 80 hours
60 unskilled men at Re.1 per hour for 80 hours
Calculate labor mix variance.
Solution:

Revised standard labor hours = total time of actual workers / total time
of standard workers x standard labor hours
Skilled worker = 80 / 80 x 80 = 80 hours
Unskilled = 80 / 80 x 80 = 80 hours
LMV = Skilled = (3,200 – 4,800) 1.50 = Rs. 2,400 ADV
Unskilled = (6,400 – 4,800) Re.1 = Rs.1, 600 FAV
Total labor mix variance Rs. 800 ADV.

15.16 Labour Yield Variance

This is due to the difference in the standard output specified and the actual
output obtained. The formula is as follows:
LYV = (Actual output – Standard output) x standard cost per unit
Illustration 19: Actual output 460 units. Standard output 500 units.
Standard rate of wages is Rs.9 per hour. The Standard time is 2 hour per
unit.
Solution:

Standard cost per unit = Rs.9 x 2 hours = Rs.18

LYV = (AO – SO) SC or (460 – 500 units) x Rs.18 or Rs.720 ADV

Illustration 20: Calculate (a) Labor rate variance (b) labor efficiency
variance (c) labor cost variance
Standard: Labor rate 0.24 paise per hour. Labor hours 3 per unit.

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Actual: Units produced 250. Labor rate 0.25 paise per hour. Hours worked
800.
Solution:

LRV : (SR =- AR) AH or Rs.8 ADV

LEV = (SH – AH ) SR or Rs.12 ADV
LCV = (SLC – ALC) or (SH x SR) – (AH x AR) = Rs.20 ADV

15.17 Summary
Standard costing is a system of cost accounting which is designed to show
in detail how much each product should cost to produce and sell when a
business is operating at a stated level of efficiency and for a given volume of
output
Budgetary control takes into account all activities such as production, sales,
purchases, finance, capital expenditure, personnel whereas standard
costing is restricted to deal with only costs.
The term “variance” means the variation or deviation of the actual from the
standard. In standard costing, it implies the difference between the actual
cost and standard cost.
Under standard costing system, there is a need to determine the standard
costs for each element of cost. The standards are fixed for three main
elements of cost namely direct material, direct labor and overhead.

15.18 Terminal Questions

1. How is standard costing related to budgetary control?
2. How do you fix standard for direct material, direct labor and direct
overheads?
3. Write short note on :
a) Material Price Variance
b) Material Mix Variance
c) Material Yield Variance.
4. Briefly describe labor mix variance and yield variance.
5. Compute price, usage, cost and mix variance

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Material Standard Actual

Quantity Price Total Qty Price Total

A 6 1.50 9 5 2.40 12
B 2 3.5 7 1 6 6

6. Data given below pertain to DR Ltd.

DEPARTMENT
A B
Actual gross wages 2,000 1,800
Standard hours produced 8,000 6,000
Standard rate per hour 0.30 0.35
Actual hours worked 8,000 5,800
Calculate labor variances

15.19 Answer to SAQ’s and TQ’s

1. Standard cost 8. SC – AC
2. Financial control 9. (SP – AP) x AQ
3. Closely interrelated 10. SQ – AQ x SP
4. Direct martial, direct labor, 11. RSQ – AQ x SP
overheads 12. SY – AY x SR
5. Deviation 13. SC-AC
6. Favourable 14. SH – AH x SR
7. Favorable and adverse 15. SR - AR x AH

Terminal Questions
1. Refer to unit 15.4
2. Refer to unit 15.5
3. Refer to unit 15.8, 15.10 and15.11
4. Refer to unit 15.15 and15.16
5. Price variance = (SR – AR) AQ for A = Rs. 4.50 ADV
For B = Rs.2.50 ADV total Rs.7 ADV
Usage variance: (SQ – AQ ) SP for A = 1.50 FAV
For B = 3.50 FAV Total Rs. 5 FAV
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Cost Variance = MUV + MPV = 5 – 7 or 2 ADV

Mix variance = (RSQ – AQ) SP where RSQ = A 6 /8 x 6 or 4.5 kgs
B 6 /8 x 2 or 1.5 kgs
For A (4.5 – 5) x 1.5 or 0.75 ADV
For B (1.5 – 1) x 3.5 or 1.75 FAV Therefore total 1 FAV
6. Standard labor cost; Dept A 8000 x 0.30 = 2,400
B 6,000 x 0.35 = 2,100
Actual rate A 2000. / 8000 = 0..25
B 1800 / 5800 or 900 /29 paise
LRV = (SR – AR ) AH Dept A = (0.30 – 0.25) 8000 = 400 FAV
B = (.35 – 900 /25) x 5800 = 230 ADV
LEV = (SH – AH) SR for A = (8000 – 8000) x 0.30 Nil
B = (6000 – 5800) 0.35 70 ADV
LCV : (SLC – ALC For A (2400 – 2000) 400 FAV
B (2100 – 1800) 300 ADV

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Reference Books:
1. Accounting for Managers by Jawahara Lal.
2. Financial Accounting by S. N. Maheswari.
3. Financial Accounting for Managers by R. Narayana Swamy.
4. Introduction to Management by Anthony Reece.
5. Management Accounting by Manmohan and Goel.
6. Cost and Management Accounting by Horugren etal.

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