MB0041
MB0041
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
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
ACCOUNTING ENCOMPASSES
1. IDENTIFICATION 2. MEASURING
3. RECORDING 4. CLASSIFYING
5. SUMMARISING 6. ANALYSING
7. INTERPRETING 8. COMMUNICATING
INPUTS PROCESSING
OUTPUT USERS
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.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
The nature of job is routine and The nature of job is non routine but
clerical analytical.
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?
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 __________.
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,
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.
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.
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.
ACCOUNTING PRINCIPLES
ACCOUNTING ACCOUNTING
CONCEPTS CONVENTIONS
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.
Sikkim Manipal University Page No. 25
Financial and Management Accounting Unit 2
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.
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?
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.
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.
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.
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
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.
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.
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?
Sikkim Manipal University Page No. 32
Financial and Management Accounting Unit 2
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.
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.
2.7 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.
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
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.
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.
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
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.
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.
Sikkim Manipal University Page No. 51
Financial and Management Accounting Unit 3
Preparation of vouchers
Activity 1:
Using the above example analyze the accounting treatment under
modern approach.
L+ P = A
L=A–P
P =A–L
A – L – P = Zero
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
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.
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.
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
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
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.
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.
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:
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:
Purchases a/c
Date Particulars Folio Amount Date Particulars Folio Amount
31.3.To sundries as 27450
20X1 per purchase
book
Sales a/c
Date Particulars Folio Amount Date Particulars Folio Amount
5.3.20X1 By Sundries 27450
as per sales
book
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.
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
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
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
LEDGER
TRAVELLING EXPENSES ACCOUNT
Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 120
WAGES ACCOUNT
Date Receipts Amount Date Payments Amount
Rs. Rs.
st
1 Nov To Petty cash 100
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
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
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.
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.
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
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/-
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
30th By balance 18
b/d
500 500
18 July To balance
1st b/d
482 July To cash
1st
Activity 1 Solution
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.
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.
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.
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.
CREDITORS ACCOUNT
To ______ xxxx By ______ xxxx
To balance c/d 10000
Total 80000 Total 80000
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
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
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
Sikkim Manipal University Page No. 98
Financial and Management Accounting Unit 5
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
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
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
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
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
Sikkim Manipal University Page No. 103
Financial and Management Accounting Unit 5
For example, salaries paid during the year are closed by transferring to
P & L account :
P & L account Dr
To Salaries’ account.
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.
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)
Wrong amount
Rectification entry
Rama’s account Dr Rs. 350
To suspense account Rs.350
Being excess credit given to Rama’s account rectified
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.
Total 5800
WRONG
AMOUNT
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.
ADVERTISEMENT ACCOUNT
To cash a/c xxxx By balance c/d xxxx
Rectification entry:
Advertisement expense a/c Dr
To Suspense a/c
Being debit balance in advertisement account accounted.
ENTERED
TWICE
Rectification Entry:
Suspense a/c Dr 5000
To Sundry Debtors a/c 5000
Being excess debit in Sundry debtors account rectified.
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
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?
Omitted Omitted
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.
Correct
Correct
amount is
amount is
Rs.1730
Rs.1730
Rectification entry:
Purchase a/c Dr. 360
To Supplier a/c 360
Being deficit amount added to rectify the account.
Example:
Wages paid to workers
engaged in the construction
of building????
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.
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.
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?
Sikkim Manipal University Page No. 115
Financial and Management Accounting Unit 5
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)
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:
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.
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
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
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.
Sikkim Manipal University Page No. 124
Financial and Management Accounting Unit 5
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.
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.
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.
Salaries a/c Dr
To outstanding salaries a/c
Being salaries for the month of March 20XX due but not
yet paid accounted.
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
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
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).
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:
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:
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
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
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.
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)
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.
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)
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.
Creditor’s account Dr
To discount on creditors account
Being discount on creditors accounted
When provision for discount on creditors is made in P&L Account, the entry
is
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
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.
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.
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.
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.
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
11,63,500
46,10,000 46,10,000
To corporate 16,830
dividend tax payable
(50, 000 x
14.025%) 70,125
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
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,
Sikkim Manipal University Page No. 154
Financial and Management Accounting Unit 6
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.
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.
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.
Financial Perspective
To satisfy our customers To succeed financially
how Should we appear
Goals Measures what business
processes To our owners?
must we excel ?
To achieve our
Vision how should we
Appear to our customers?
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
Sikkim Manipal University Page No. 168
Financial and Management Accounting Unit 7
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
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
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
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.
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
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
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
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.
∑ 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.
Gross Profit
Gross Profit Margin = x 100
Net Sales
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.
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.
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.
12 months
Inventory Holding Period =
Inventory Turnover Ratio
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.
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.
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:
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
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 %
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
Sikkim Manipal University Page No. 191
Financial and Management Accounting Unit 8
= 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
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.
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
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
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.
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.
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:
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
This transaction will not bring any change in the working capital
because it is simply conversion of one current asset into another current
asset.
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.
This transaction will not involve any change in the working capital
since both the accounts involved are not the constituents of the
working capital.
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.
FIXED LIABILITIES
CURRENT LIABILITIES
SHARE CAPITAL
BANK OVERDRAFT
RESERVES AND SURPLUS
OUTSTANDING EXPENSES DEBENTURES
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.
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 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.
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.
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.
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
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
* 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
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
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
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
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
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.
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
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
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
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
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)
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
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.
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
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.
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
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
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.
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
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]
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.
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
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
10.10 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.
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.
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
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
Sikkim Manipal University Page No. 260
Financial and Management Accounting Unit 11
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.
Y
10,00,000
Relevant
Range of
Total Volume Fixed cost
Fixed cost
Y Y
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.
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
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
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
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.
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
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
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
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
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.
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
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.
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.
*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
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
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
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.
Solution:
Income statement (Absorption Costing)
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
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
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.
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
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:
Illustration 4: Find the fixed costs if sales is Rs.2,00,000; Variable Cost Rs.
40,000; and Profit Rs. 30,000.
Solution:
Solution:
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:
Solution:
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:
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.
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.
Sikkim Manipal University Page No. 302
Financial and Management Accounting Unit 12
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.
Problem 6: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP
sales Rs.40,000. Find the actual sales.
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.
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.
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
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.
Expand or Contract
Take or Refuse order
Place special orders
Select sales territories
Sell at split-up point or process further.
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
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:
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
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
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
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%
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
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.
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?
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
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’.
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.
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.
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.
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
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.
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.
14.4 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
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
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.
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
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
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
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
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.
(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
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)
The total deficit of Rs.1,26,000 should be raised from the issue of Equity
Shares.
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.
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.
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.
15.3 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.
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.
Solution: Calculate the standard quantity of materials for the actual level of
production
The difference indicates that them company has spent less on materials
than planned for the level of production.
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:
It is favorable because the company has paid less for the materials than
planned for that level of production
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.
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 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
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
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:
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
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
Working:
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.
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.
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.
Actual: Units produced 250. Labor rate 0.25 paise per hour. Hours worked
800.
Solution:
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.
A 6 1.50 9 5 2.40 12
B 2 3.5 7 1 6 6
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
Sikkim Manipal University Page No. 366
Financial and Management Accounting Unit 15
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.