Accounting for Managers

Accounting for Managers

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C HAPTER 1

Introduction to Accounting Information

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INTRODUCTION Rapid growth in cross-border investments over the past two decades has resulted in an increasing demand for high quality and uniform financial reporting. Investment decisions are made based primarily on the publicly available information. Given, it is imperative to ensure credible, comparable and transparent financial reporting on part of the listed firms so as to make sure that investors belief in the efficiency of the capital markets remains intact. This Chapter introduces a conceptual framework for preparing financial statements, defining the objectives of financial reporting and the qualitative characteristics and elements of financial statements. OBJECTIVES After reading this chapter, you should be able to: Assess the need for Accounting Information Determine the need for a conceptual framework Recognize the elements of financial statements Identify the Principal Financial Statements

Section 1

The Need for Accounting Information

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We live in the information age, where every decision that we make requires collecting relevant data pertaining to the decision, analyzing and converting them into usable information, identifying the various alternatives, considering their consequences and zeroing in on a decision. Take for instance a decision to purchase a car. We collect all the relevant information such as types of cars, makes, manufacturers, mileage, etc. Next we decide which car is suitable and best for us. It consumes resources in terms of money, time and mental work. Now, think of individuals and enterprises which manage billion-

rupee businesses. If the information provided to them is not accurate, timely, etc., it could lead to poor decisions and, in turn, cost organizations billions of rupees. In an organization different people need different information, collected from different sources for making different decisions. For example, investors and creditors use information to assess the future risks to and return on their potential investments. Thus depending on the information needs, information may be quantitative or non-quantitative.

Keynote 1.1.1: Quantitative and Non-quantitative Information

Management accounting: Accounting information specifically prepared to help managers make decisions and to manage the business. Financial Accounting: Information relating to the financial performance and financial position of a firm/business is given by financial accounting. It is concerned with providing relevant financial information Video 1.1.1: to various external users. Ta x a c c o u n t i n g : T h i s information helps in filing tax returns. In some countries such as USA, companies need to maintain separate records for tax accounting purposes owing to differences in rules for tax accounting and financial accounting.
Financial Accounting vs Managerial Accounting

The above figure clearly states that information can be quantitative or/and non-quantitative. Quantitive information can be accounting information and non-accounting information. Further, accounting information can be divided into Operating Information, Financial Accounting Information, Management Accounting Information and Tax Accounting Information. They are defined as follows: Operating information: Information about the day-to-day operations of the business is referred to as operating information.

Operating information and management accounting information is generated only for people internal to the organization, but financial accounting information is useful both for internal as well as external users. For example, investors, suppliers, customers, financial institutions and government make use of Financial Accounting Information extensively for decision-making purposes.

CONCEPTUAL FRAMEWORK The conceptual framework is a very important prerequisite to understand the financial statements. It describes the basic concepts that underlie the preparation of financial statements. It is designed to prescribe the nature, functions and limits of financial accounting and can be used as guidelines for maintaining consistency in standards. The objective of the framework is to narrow down the diverse accounting principles and procedures being followed, resulting in harmonized regulations, transparency and comparability. While the Financial Accounting Standards Board (FASB) has issued conceptual framework for companies listed in the US capital markets, the International Accounting Standards Board (IASB) has issued equivalent framework to be followed globally. The Institute of Chartered Accountants of India (ICAI) has issued framework to be complied by the companies operating in India. Here we deal with the conceptual framework issued by the FASB of the US which constitutes foundation of Financial Reporting. The objectives of the conceptual framework are: To serve as the foundation upon which the Board (FASB) can construct standards that are both sound and internally consistent. Intended for use by the business community to help understand and apply standards to assist in their development.

Provide guidance in analyzing new or emerging problems of financial accounting and reporting. Solve complex financial accounting and reporting process by providing a set of common premises as a basis for discussion. Solve complex financial accounting and reporting processes by limiting areas of judgment and discretion and exclude from consideration potential solutions that are in conflict with it. Impose intellectual discipline on what traditionally has been a subjective and ad hoc reasoning process.

Conceptual framework issued by ICAI is provided here.

The components of the conceptual framework given by FASB include: Objectives of Financial Reporting by Business Enterprises. Qualitative Characteristics of Accounting Information. Elements of Financial Statements of Business Enterprises. Objectives of Financial Reporting by Non-Business Organizations. Recognition and Measurement in Financial Statements of Enterprises. Elements of Financial Statements. Using Cash Flow Information and Present Value in Accounting Measurements.

ICAI

http://220.227.161. ICAI 86/238acc_bodies _framework_ppfs. pdf

General purpose financial statements are prepared for the common needs of the users of the financial statements. Some users need additional information for their decision-making, so while preparing these statements their need should be kept in mind. Additional information is provided in the form of notes, schedules and explanatory notes, etc. Special purpose financial statements are prepared for special purposes like tax computations, for submitting it to financial institutions, etc. These special purpose financial statements are not covered by the said framework.

The Conceptual Framework issued by the IASB is provided here http://www.ifrs.org/NR/ IFRS rdonlyres/363A9F3B-D4 1C-41E7-9715-79715E815 BB1/0/EDConceptualFra meworkMar10.pdf

IFRS

We shall limit our discussion here to only a few components of the conceptual framework. The scope of the Conceptual Framework is applicable to General Purpose Financial Statements. Financial statements may be general purpose financial statements and special purpose financial statements.
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R EVIEW 1.1.1 Question 1 of 3 FASB conceptual framework is applicable to

A. Financial statements prepared for tax purposes B. Financial statements prepared for registration purposes C. General purpose financial statements D. Financial statements prepared for cost audit purposepposes

Check Answer

Section 2

Components of Conceptual Framework

Objectives of Financial Reporting

As per the Statement of Financial Accounting Concepts (SFAC) 1 of the FASB, the objectives of financial reporting are: Financial reporting provides information that is useful in making business and economic decisions. For this purpose, the users of financial statements may be internal to the organization such as management and directors of the business, or may be

external to the enterprise such as lenders, suppliers, potential investors, etc. Financial reporting provides understandable information that will aid investors and creditors in predicting future cash flows of a firm. Investors and creditors require information to evaluate the timing, amount and uncertainties of future cash flows. It provides information relative to an enterprises economic resources, claims to those

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resources/obligations, and the effect of those transactions, events and circumstances that change resources and claims to resources, etc. Users of financial reporting require information so as to ascertain: The Economic Position of the Enterprise: Financial Reporting information provides the users with the information on the economic resources, obligations and owners equity that indicates the firms strengths, weaknesses, liquidity and solvency. The Economic Performance of the Enterprise: Financial Reporting information provides the users with information about the economic performance and earnings of the enterprise that help in predicting the future performance of the firm. This information helps in assessing the changes in the economic resources and predicting the companys ability to generate cash flows in the future based on the current resources. The Liquidity and Solvency of the Firm: Financial Reporting information about cash and other funds flows such as cash flows from borrowings, repayment of borrowings, changes in economic resources, obligations, owners equity and earnings help in assessing the firms liquidity and solvency. Management Stewardship and Performance: An enterprises efficient and profitable utilization of resources, which is reflected in its economic performance and position, speaks of the management stewardship and performance,

circumstances, uncertainties, etc., enhances the usefulness of financial information.

Qualitative Characteristics of Financial Statements

Information to be useful to the users should possess certain characteristics. The qualitative characteristics are the criteria to be used in choosing and evaluating the accounting and reporting policies. These characteristics help to evaluate the

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strengths and weaknesses of accounting and its relevance to effective analysis and Video 1.2.1: Objectives and Qualdecision-making.
ity of Financial Reporting

SFAC 2 identifies the following characteristics that make information useful. RELEVANCE Information should be relevant to the
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decision-making needs of the user. Information is said to be relevant when it influences the economic decision of the users. Relevance of information is said to be affected by its nature and materiality. Information is said to be relevant when it provides feedback value and predictive value. Feedback value is derived from information concerning past events. Predictive value is derived from information concerning future events. Information to the relevant must be timely. RELIABILITY Information must be reliable. Reliability means the extent to which information is representationally faithful, verifiable and neutral. Representational faithfulness implies that information must represent faithfully the transactions and events it purports to represent. The quality of verifiability means that several independent measures obtain the same accounting measure. This quality helps to reduce and mitigate measurement bias. The quality of neutrality implies free from bias and material errors. COMPARABILITY It enhances the ability of investors and creditors to compare information across companies to make their resource allocation decisions. The financial statement users must be able to compare the statements of an entity through time in order to identify trends in financial position and compare the financial statements of different entities in order to evaluate their relative financial position and performance. Lack of consistency threatens the comparability of the financial statements.

CONSISTENCY The quality of consistency requires the use of same accounting principles from one period to another. Consistency contributes to information usefulness. This does not in any way imply that a change in accounting principle cannot and should not be made. A change in accounting principle leads to inconsistency, but it is acceptable if the disclosure is made and the change was imperative.

Elements of Financial Statements

Keynote 1.2.1: Elements of Financial Statements

Financial statements portray the effects of financial transactions by grouping these into broad classes according to their economic characteristics termed as the elements of financial statements. SFAC 6 defines ten interrelated elements as follows:
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ASSETS Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. LIABILITIES Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. EQUITY The residual interest that remains in the assets after deducting its liabilities. In a business enterprise, the equity is the ownership interest. REVENUES Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing major and central operations. EXPENSES Outflows or other using up of assets or occurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major and central operations.

GAINS Increases in equity (Net Assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distribution to owners. LOSSES Decrease in equity (Net Assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distribution to owners. COMPREHENSIVE INCOME The change in equity of a business enterprise during a period from transactions and other events and circumstances from sources other than investments by owners or distribution to owners. INVESTMENTS BY OWNERS Increases in equity of a particular business enterprise resulting from transfers to it for the purpose of increasing ownership interests. DISTRIBUTION TO OWNERS Decreases in the equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities to owners.

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Recognition Criteria of Elements of Financial Statements

The principles of recognition help determine as to when an element is to be included in the statements, while measuring principles determine the valuation of such elements. There are four revenue recognizing criteria: definitions, measurability, relevance and reliability. In case an element meets the definition of an element, is capable of being reliably measured, and makes a difference in the decision of the user and is verifiable, neutral and representationally faithful, it needs to be included in the financial statements.

CURRENT COSTS This is used for some inventories and represents the cash or its equivalent that would have to be paid for acquiring the assets currently. Certain assets like investments are to be reported at their current market values. In the case of liabilities that involve marketable securities and commodities, these are to be reported at their current market value. NET REALIZABLE (SETTLEMENT) VALUE In the case of short-term receivables and some inventories, reporting is done on the basis of their net realizable values. Liabilities that are incurred and which are known or estimated and payable at future dates are reported at their net settlement values. PRESENT (OR DISCOUNTED) VALUE OF FUTURE CASH FLOWS In the case of long-term receivables, reporting is done at their present or discounted values which is the present value of the future cash inflows which an asset is expected to be converted in due course of the business less the present value of the cash outflows that are expected to be converted in the due course of the cash outflows that are necessary to obtain those funds.

Measurement Criteria of Elements of Financial Statements

Measurement is the process of determining the amount of elements to be recognized and carried to the income statement and balance sheet. There are following four basic measurement described in the framework: HISTORICAL COST (HISTORICAL PROCEEDS) Assets such as plant, property and equipment and most of the inventories are reported at their historical values. These are the amounts of cash or its equivalents that are paid in order to acquire such assets and are commonly adjusted after the acquisition for amortization or other allocations. Liabilities are reported at cash or its equivalent that is received when the obligation was incurred and may be adjusted after acquisition for the purpose of amortization or other such allocations.

Users of Financial Statements

The basic objective of preparation of financial statements is to provide information to the users of the statements. The users may be the internal people or external people to the organization.
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SHAREHOLDER/INVESTORS/OWNERS The shareholders/owners are the investors who provide capital or resources to an enterprise in exchange for a share in ownership of the enterprise. The information provided in the financial statements help them to arrive at various investment decisions such as whether to invest further, or to withdraw the existing investments, etc. Similarly, potential investors use the financial statements to arrive at investment decisions. MANAGEMENT Since management has the ultimate responsibility for the financial performance, they periodically compile and interpret the financial statements. An analysis of the financial figures is essential for the smooth and efficient functioning of the enterprise. LENDERS Banks, financial institutions and other lenders provide funds to the business entity They would be willing to part their money only if they are assured a periodical return in the form of interest and ultimate return of their principal. The financial statements reflect the profitability and long-term solvency of the business and provide the assurance which the lenders look out for. SUPPLIERS/CREDITORS The suppliers look for the short-term liquidity and solvency of the business for judging the credibility of the firm through

the analysis of the statements. The financial statements facilitate the creditors in ascertaining the capacity of the organization to pay on time consideration for the goods and services supplied. EMPLOYEES Employees have vested interest in the continued and profitable operations of the organization in which they work. Most of the incentive plans of large number of enterprises are directly related to the profitability of their businesses. This further magnifies the interests of the employees in their companys future profitability and health. CUSTOMERS They comprise groups such as producers, wholesalers and retailers and final consumers. Legal obligations associated with guarantees, warranties and after sales service contracts tend to establish long-term relationship between the business and its customers. The financial statements may be used by the customers to draw inferences about the long-term viability of the firm. GOVERNMENT AND OTHER REGULATORY AGENCIES Governments and other regulatory agencies plans and policies in respect of taxation, subsidies and incentives are guided by the requirements of the industries and also their past performances. A lot of information in this regard can be gathered from a scrutiny of the financial statements of business enterprises.
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RESEARCH Scholars undertaking research into management science covering diverse facets of business practices look into the financial statements for the information eventually used for analysis. OTHERS Diverse persons such as academicians, researchers and analysts may approach business firms for information regarding the financial performance. The public, in general, also examine the financial statements for employment opportunities, health of the business concerns, in particular, and the economy as a whole. Additional resources to this section
Video 1.2.2: Conceptual Framework

R EVIEW 1.2.1
Question 1 of 3 Which among the following is the objective of the FASB conceptual framework

A. Intended to serve as the foundation upon which the Board (FASB) can construct standards that are both sound and internally consistent. B. Intended for use by the business community to help understand and apply standards to assist in their development. C. Provide guidance in analyzing new or emerging problems of financial accounting and reporting. D. All of the above.

Check Answer

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Section 3

Principal Financial Statements

Basically there are three principal financial statements, viz., the balance sheet, the income statement and the statement of cash flows. However, some countries require preparation of additional statements such as preparation of changes in s h a r e h o l d e r s e q u i t y, explanatory notes, etc.

It gives the information of how the company has been financed and how that money has been invested in various productive resources. A company can obtain finance from owners and outsiders. The balance sheet is prepared based upon the fundamental accounting equation of Assets = Liabilities + Equity Thus, the balance sheet has three major sections, viz., assets (i.e., the resources of the company), liabilities (i.e.,

Balance Sheet
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It is also called the Statement of Financial Position. It depicts the financial position of a company on a particular date.

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the debts of the company) and shareholders equity (i.e., the amount invested by owners). We have already defined it in the previous section. The values given in the balance sheet change from time to time, hence the values appearing in the balance sheet pertain to a specific date, generally, the end of the business financial year (for example, March 31).

Income Statement
It is also called the Profit & Loss account or Income and Expenditure Statement. It indicates the amount of net income or loss obtained by the company during a particular period. The preparation of the income statement is governed by the matching principle which states that the performance can be measured only if revenues and related costs are accounted for during the same time period. As per SFAC 6, revenues are the inflows of an entity and expenses are the outflows of an entity as a result of delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations. The main beneficiaries of this statement are the investors, creditors, management and other interested parties who are interested in knowing the financial performance of the entity. We have already dealt with the users of financial statements in the earlier section.

period. This statement Video 1.3.1: provides information about the Statement of changes in changes in owners interest in Shareholders Equity the company during the year. For example, an increase in equity resulting from profits is reflected in this statement. S i m i l a r l y, d i s t r i b u t i o n o f earnings to shareholders in the form of dividends is reflected in this statement. More specifically, this statements shows information about Preferred shares, Common shares, Additional paid in capital, Retained earnings, Treasury shares, Employee stock ownership plan adjustments, Minimum pension liability, Valuation allowance, Cumulative translation allowance, etc. In India, the statement of shareholders equity is not separately shown, but it forms a part of the Reserves and Surplus section on the Balance Sheet. This statement is useful for identifying reasons for changes in shareholders claims on assets of the company. Some changes in assets and liabilities bypass the income statement and appear in the statement of changes in stockholders equity, viz., foreign currency translation adjustments, minimum pension liability adjustments and unrealized gains or losses on available-for-sale investments. Such adjustments and other non-recurring items make it difficult to discern the operating results of an enterprise. The FASB requires financial statement recognition and measurement of many financial instruments at fair value. This
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Statement of Shareholders Equity

Statement of shareholders equity consists of change in shareholding pattern of the company during a specified

results in unrealized gains and losses on these instruments. The concept of comprehensive income offers a solution to these problems and this item appears as part of the Statement of Shareholders Equity.

Meigs and Meigs, Financial Accounting, McGraw Hills Inc. How to Read a Balance Sheet, Oxford and IBH Publishing Co. P. Ltd. Additional Resources
Video 1.3.2: Core Financial Statements Video 1.3.3: How to read Financials

Statement of Cash Flows

It is also called the Cash Flow Statement. It explains where the cash has come from, how that cash has been utilized and effects of all these transactions on the cash balance of the firm. It gives information on a companys cash flows relating to operating, financial and investing activities. Investing cash flows are those which result from acquisition or sale of property, plant and equipment; acquisition or sale of a subsidiary or segment and purchase or sale of investments in other firms. Financing cash flows are those which result from issuance or retirement of debt and equity securities and dividends paid to stockholders. Operating cash flows are those resulting from the revenue producing activities, or from operating activities of the firm. Others In addition to information provided by mandatory financial statements, both financial and non-financial information are provided in the Annual report of a firm under different heads. SUGGESTED READINGS/REFERENCE MATERIAL Gerald I. White, Ashwinpaul C. Sondhi, Dov Fried, The Analysis and Use of Financial Statements, John Wiley & Sons Inc.

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R EVIEW 1.3 .1
Question 1 of 4 The three principal financial statements are

A. Balance sheet, income statement and statement of cash flows. B. Balance sheet, statement of changes in shareholders equity and income statement. C. Balance sheet, statement of changes in shareholders equity and explanatory notes. D. Balance sheet, income statement and explanatory notes.

Check Answer

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C HAPTER 2

Income Statement

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INTRODUCTION The purpose of the income statement is the determination of profits of the business. This statement is also helpful in predicting the future profitability of the concern and the future cash generating ability of the enterprise. This statement reports the change in the owners capital or the shareholders equity as a result of operations of the enterprise. OBJECTIVES After going through the chapter, you should be able to: Differentiate between the capital and revenue expenditure. Describe briefly the concepts and principles governing Income Statement. Explain the meaning of Income statement. State the General format and contents of Income statement. Prepare Income statement.

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Section 1

Performance Statement

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The Income Statement is also called the Profit and Loss Account. It indicates the amount of net income or loss obtained by a company during a particular period. Net income is the excess of revenues over expenses, and the net loss is the excess of expenses over revenues. It gives the summarized operating information about the sales, costs, incomes, profits and losses of the company during a

particular period. It is the best measure to assess the profitability and performance of a company. The performance of a company captured in the Profit and Loss Account reveals the relationship between revenue, expenses and Profit/Loss: Income Expenses = Profit

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Video 2.1.1: What is an Income Statement?

Distinguish Between Capital and Revenue Items The concept of capital and revenue is of fundamental importance in correctly determining the accounting profits of a business and recognizing the assets of an enterprise. Capital and Revenue Expenditure Expenses can be classified into capital or revenue expenditure based on their utility to the business entity. Capital expenditure relates to those expenses which generate benefits and assist the entity in earning revenue over a period of time (e.g., more than 12 months). Revenue expenditure relates to those expenses which are incurred in earning the revenues and the benefits of which get exhausted within the accounting period. Table 1: Distinction between Revenue and Capital Expenditure

Significance of Profit and Loss Account i. It helps to know the overall net profit or loss earned or suffered by the firm during a particular period. This is the index of the profitability of the firm.

ii. It is very useful for inter-firm or intra-firm comparison. iii. Comparison of various expenses in different periods is possible so that management can take effective control over various expenses. iv. It helps in calculating cash from operations. Cash flow information is very important to security analysts and other users of financial statements. v. The various profitability ratios help the users analyze/assess the profitability of the firm better.

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Video 2.1.2: Capital vs Revenue

advertisement expenditure incurred to launch a new product. Capital Receipts and Revenue Receipts The receipts, which do not affect the profits earned or losses incurred during the course of the year, are called Capital Receipts. These take the following forms: Contributions made by the proprietor towards the capital of the business in the case of sole proprietorships. In the case of companies, the receipts from the issue of shares are considered as capital receipts. Receipts from the sale of fixed assets, previously not intended for resale. Receipts from sale of goods to customers or from rendering of services in the ordinary course of business are termed Revenue Receipts. These directly add to the profits of the business or decrease the losses of the business. The net profits remaining after deducting the revenue expenses are available for distribution to shareholders. CONCEPTS RELATING TO PROFIT DETERMINATION Determination of profit or net income is important in financial accounting. Accountants need to measure the business income or net income or profit. There are some concepts which guide the accountants while determining the income. A brief explanation of these concepts is given in this section as follows: Accounting Period Concept
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Deferred Revenue Expenditure Expenditure that is basically of revenue nature for which payment has been made or liability incurred but the benefits are presumed to result in subsequent periods can be treated as deferred revenue expenditure. The guidance note issued by the ICAI defines deferred revenue expenditure as expenditure for which the payment has been made or a liability incurred but which is carried forward on the presumption that it will be of benefit over a subsequent period or periods. The expenditure must be of revenue nature. The exact amount and the period of time for which the benefit will be available cannot be precisely determined. The expenditure does not result in acquisition of any tangible or intangible asset. The expenditure is written off over a period of time during which benefits are assumed to result. Example: Heavy

Determination of a definite period is very essential to measure net income or profit. Users of financial statements periodically would like to know the net income generated on the resources invested by them. Thus, they want regular reports about financial results and the financial position. Accountants may prepare reports for a particular period or after the completion of a particular project depending on the type of business. If the interval between the reports is one year, it will be helpful to the businessman and the users. Realization Concept The timing of revenue recognition is critical in profit determination. It ensures that proper cut-off is made to each reporting period. If this criterion is followed, it results in avoidance of overstatement or understatement of revenues. Revenue should be recognized in the period in which it is earned, not necessarily when cash is received. Matching Concept This concept helps in matching the revenues with the expenses. Determination of profit involves recognition of revenue and allocation of costs. As per this concept, the expenses are to be recognized in the period of their related revenue. Thus, matching concept requires the recognition of revenue and expenses on a comparable basis. Conservatism Concept According to this concept, accountants require to underplay favorable prospects until they are actually realized. They should Anticipate no profits, but provide for all possible losses. Thus,

revenues are to be recognized only when they are reasonably certain and expenses as soon as they are reasonably possible. This concept must be applied prudently so as not to result in secret profits and reserves which contravenes the convention of full disclosure.
REVIEW 2.1.1

Question 1 of 2 Capital expenditure is an expenditure which

A. Benefits the current accounting period. B. Will benefit the next accounting period. C. Results in the acquisition of a permanent asset. D. Results in the acquisition of a current asset.

Check Answer

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Section 2

Format of Income Statement

No specific format exists for the presentation of the Income Statement. Hence companies take considerable leeway while presenting this statement, resulting in a variety of presentations. Nonetheless, two distinct types can be identified: Multiple Step Format and Single Step Format. The multiple step format reports the results in a series of sub-totals such as Gross Profit, Operating Profit Before Interest and Depreciation, Operating P r o f i t B e f o r e Ta x a n d Exceptional items and Net P r o f i t B e f o r e Ta x a n d exceptional items. For example, the income statement of Infosys Technologies is a multiple step income statement. In contrast, the single step format groups all revenues and deducts expenses in a single step, doing away with specific sub-totals. For example, the income statement of Tata Steel Limited is a single step presentation. Traditionally, the income statement (referred to as Trading and Profit and Loss Account) was presented in the form of a Ledger Account (also known as T

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form) with expenses and losses being shown on the left side and the incomes and gains on the right side of the account. Also, traditionally Income Statement was sub-divided into manufacturing account, Trading and Profit and Loss Account. In the case of Corporate entities, Part II of the Schedule VI of the Companies Act, 1956 does not prescribe any format for the profit and loss account, but only outlines the information to be included. The Companies Act does not require the preparation of Manufacturing Account or the Trading Account. Only the requirement of Profit and Loss has been specified. Most companies prepare Profit and Loss Account in Vertical Format. Profit and Loss Account for the Year ended 31st March, xxxx (Figures in Rs.)

COMPONENTS OF INCOME STATEMENT Total Revenue: Total revenue represents the sales revenue generated from sale of goods or services to customers. The firm earns revenue from the sale of its principal products. Sales are usually shown net of any discounts, returns and allowances. Brokerage, commission paid to selling agents and cash discount other than the usual trade discounts are exhibited separately in other expenses. In the case of a service organization like Infosys, income generated from services can be the total revenue. Costs of Revenue: The first expense deduction from sales is the cost the seller incurs while selling his products sold to customers. This expense is called cost of goods sold or cost of services rendered. For a retailing firm, the cost of goods sold equals beginning inventory plus purchases minus ending inventory. In case of a manufacturing concern, the cost of goods manufactured replaces purchases since the goods are produced rather than purchased. A service firm will not have cost of goods sold
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or cost of sales, but will often have cost of development or rendering of services.

Gross Profit: The difference between net sales and cost of goods sold is called gross profit or gross margin. Gross profit is the first step in measurement of profit on the multi step income statement and is a key analytical tool in assessing a firms operating performance. The gross profit indicates how much profit the firm is generating after deducting the cost of products sold.

Video 2.2.1: More details on computation of Gross Profit

Administrative Expenses These relate to the expenses of general administration of the companys operations. They include salaries, rent, taxes, insurance, printing, stationary, postage and telephone, legal fees, audit fees, other general expenses, bad debt expenses and other costs difficult to allocate. Abnormal Losses: Losses, which arise on account of abnormal reasons, are termed abnormal losses. For example, loss due to theft, fire, accident, etc. These losses, to the extent not covered by insurance claims, are losses/ expenses in the profit and loss account. Profit or Loss on Sale of Assets: Loss on sale of assets is loss/expense in the profit and loss account. Gain or profit arising on sale of fixed assets is taken as income/gain in the profit and loss account. Cash Discount: It is the amount of cash discount given to the customers. It is a loss and is shown as an expense. The amount of cash discount received from creditors is an income and is shown on the credit side of the profit and loss account. Bad Debts and Bad Debts Recovered: The amount, which cannot be recovered from customers, is termed as bad debt. It is a loss and is shown under expenses. If the amount which was previously written off as bad debt, is received, it is treated as income. Lease Payments Lease payments include the costs associated with operating rentals of leased facilities for retail outlets. A Lease can be either an operating lease or a
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Operating Expenses: Operating expenses can be broadly classified into five categories selling, administrative, depreciation and amortization, lease payments and repairs and maintenance: Selling Expenses They of Income Statement relate to the expenses resulting from the companys effort to make sales including advertising, traveling, sales commission, sales supply and so on. Distribution expenses like advertisement, samples given to customers, storage expenses, etc., are expenses in the profit and loss account.
Video 2.2.2: Enhancement

finance lease. Operating lease is a conventional rental agreement with no ownership rights conferred on the lessee. If a lease agreement satisfies four conditions (transfer of ownership to lessee, contains a bargain purchase option, has a lease term of 75% or more of the leased propertys economic life or has minimum lease payments with a present value of 90% or more of the propertys fair value), it is called as finance lease. Each lease payment is apportioned partly to reduce the outstanding liability and partly to interest expense. Depreciation and Amortization The cost of assets that will benefit a business enterprise for more than a year is allocated over the assets service life rather than expensed in the year of purchase. The cost allocation procedure is determined by the nature of long-lived assets. Depreciation is used to allocate the cost of tangible fixed assets such as buildings, machinery, equipment, fixtures and fittings, motor vehicles, etc. Amortization is the process applied to the cost expiration of intangible assets such as patents, copyrights, trademarks, licenses, franchisees and goodwill. The cost of acquiring and developing natural resources like oil and gas, other minerals and standing timber is allocated through depletion. Repairs and Maintenance These are the costs of maintaining the firms property, plant and equipment. Expenditures in this area should correspond to the level of investment in capital equipment and to the age and condition of the companys fixed assets.

Operating Profit: It is a companys profit from its core business operations. It is arrived at after deducting operating expenses from operating revenues. Operating profit does not include interest expenses or other financing costs. Nor does it include income generated outside the normal activities of the company, such as income on investments or foreign currency gains, or extraordinary incomes and other non-operating incomes. Operating income is a measure of profitability based on a companys operations.
Video 2.2.3: Income Statement

Non-Operating Incomes and Expenses: Non-operating incomes and expenses are those which are not related to the company core business. Items such as dividend and interest earned on investments, rental income, hire charges, lease rentals, abnormal losses, profit and sale of assets, profit or loss on sale of investments, etc. are considered non-operating items.
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Profit Before Interest and Tax (PBIT): It measures the gross performance of the company. As the term indicates, it is the profit of the company (both operating and nonoperating) excluding the interest expenses and taxation expenses. This measure is generally used to measure the performance of the company with reference to its total capital employed. Interest: Interest paid on loans, overdrafts and to creditors is an expense. Any amount received in the form of interest is an income. For example, interest received on investment, interest received on deposits, etc. Interest paid on capital should be shown separately on the expense side of the profit and loss account and interest received on drawings should be shown on the income side of the profit and loss account in the case of sole proprietor and partnership firm. Profit Before Tax (PBT): This indicates the profits available after interest but before charging tax. This is to understand the impact of tax which is a compulsory charge (expense) on the net profit of the company. Profit After Tax (PAT): This is a measure of net profit of the company. It is the net profit earned by the company after deducting all expenses like interest, depreciation and tax. PAT can be fully retained by a company to be used in the business. Dividends, if declared, are paid to the shareholders from this residue. Profits Available to Equity Shareholders: This indicates the amount of current profits plus the accumulated profits

available to equity shareholders after appropriating dividends to preference shareholders. These profits can be fully distributable to equity shareholders or fully retained or partly distributed and partly retained according to the company policy. Special Items: Extraordinary items Extraordinary items may be defined as material events and transactions distinguished by their unusual nature and by the infrequency of their occurrence. Extraordinary income or expenses in a particular period should be separately stated in the statement of profit and loss in a manner that its impact on current profit or loss can be perceived. Examples include a major casualty such as fire; prohibition under a newly enacted law, etc. These items net of their tax should be shown separately. Prior period items The term refers to expenses and incomes which arise in the current period as a result of errors or omissions in the preparation of financial statements of one or more periods. Errors may occur as a result of mathematical mistakes, mistakes in applying accounting policies, misinterpretation of facts, or oversight. Prior period items may be disclosed separately to ascertain the effect of such transactions on the profit/loss for the period. In the Vertical form of Profit and Loss Account, appropriations are shown at the bottom of the Profit and Loss Account. Details such as appropriations made from the profits in
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respect of preference dividend, interim and final equity dividends and transfer to reserves, etc. are shown here. The balance in the Profit and Loss Appropriation Account, if any, is taken to the liability side of the balance sheet under the heading Reserves and Surplus. If there is any short fall (very rare) in Profit and Loss Appropriation Account (that is, a loss), then the shortfall is shown on the Asset side under the heading Miscellaneous Expenditure.
Video 2.2.4: Multi Step Income Statement

being able to meet current obligations as and when they arise which is dangerous to the company. There are many instances when businesses failed because of lack of cash inflows even though their operations were profitable. Similarly, a loss making enterprise may be holding huge cash reserves due to its inability to deploy funds for productive purpose. Under accrual system of accounting net income (revenue less expenses) does not equate net positive cash flows. The difference is the timing of sale; expenses and
Video 2.2.5: Profit vs Cash flow

See Exhibit http://www.ntpc.co .in/annualreports/ 2010-11/Profit-Loss PROFIT & LOSS -Account.pdf ACCOUNT

http://www.tatasteel .com/investors/pdf/ TATA STEEL LTD Q4-FY11.pdf

profits do not coincide with their associated cash flows. Hence there is always a discrepancy between profit and net cash flow. A statement of Cash Flows is an essential component of Financial Statements. As the profit and loss account and the balance sheet are prepared on accrual basis, the profits disclosed by the profit and loss account do not indicate the liquidity of the firm. A firm may be highly profitable but may find itself with hardly any cash or working capital to continue the operating cycle. On the contrary, a loss making firm may have sufficient cash flows.
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Profit is not Cash Flow Profit is not cash flow. Adequate cash is essential to keep business running. Inadequate cash increases the risk of not

REViEW 1.2.1

Question 1 of 3 For the purpose of calculating depreciation, cost of the asset means

A. Residual value B. Market price C. Cost + Transport + Installation expenses D. Cost Price or Market Price whichever is less

Check Answer

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Section 3

Preparation of Profit and Loss Account

Source:www.img.ehowcdn.com

Preparation of Profit and Loss Account/Income Statement is easy. In the horizontal form all the expenses pertaining to the period for which it is drawn are taken to the left hand side of the account and Incomes & Gains as appear in the Trial Balance are taken to the right hand side of the account. If the Incomes and Gains exceed the expenses & losses, the enterprise has made profit, but it makes losses for the period if the expenses and losses exceed incomes and gains. In the vertical form of Income Statement all the incomes and gains are

shown first and there from the expenses are deducted. The balance is profit. As already seen, the trial balance is the outcome of transaction analysis using Fundamental Equation, by taking all the expenses, losses on one side and incomes and gains on another side of account. However, there may be some year-end adjustments which have not been given affect to and do not appear in the trial balance. These adjustments are needed to adhere to the concepts such as accrual concept, going concern concept, conservatism concept and
33

matching concept. These appear as adjustments required to be made and integrated in the Income statement or the Balance Sheet. These adjustments call for transaction analysis through Fundamental Equation which imply they affect at least two items already appearing in the Income Statement or/and Balance Sheet.
Video 2.3.1: P & L Preparation

complete measurement of the enterprises operating performance and the Balance Sheet reflecting a more complete measurement of the financial position of the enterprise. Some of the areas where adjustment entries are required include: i. Accrued income.

ii. Income received in advance. iii. Outstanding expenses. iv. Prepaid expenses. v. Closing stock. vi. Depreciation.

Adjusting entries Even when the events effecting the enterprise have been properly recorded using Fundamental Equation and transaction analysis, there are certain account balances which need to be updated before an accountant can proceed to prepare the Financial Statements from the Trial Balance. Such entries are called the Adjusting Entries. Adjusting entries are required to implement the accrual concept, more specifically, the realization concept and the matching concept. Adjusting entries help to ensure that all revenues earned in the period are recognized in the period regardless of when the exchange of cash took place. Similarly in the case of expenses, the adjusting entries ensure that the enterprise recognizes all the expenses incurred in the period regardless of when the payment for the expenses is made. This results in the Income statement reflecting a more

vii. Bad debts. viii. Bad debts provision. ix. Provision for discount on debtors and creditors. x. Interest on capital.

xi. Interest on drawings. Accrued Income Accrued income involves the recognition of revenue earned before it is actually received. It implies that if a portion of an income has been earned but it has not yet been received as the due date of payment falls in the next accounting period, then the income must be brought into account. Few examples of accrued
34

or accruing incomes in respect of which adjustment entries may have to be made are interest on government loans, discounts on bill, interest on investments, rents and premium on leases, etc.

Keynote 2.3.1: Illustration

Income Received in Advance Income received in advance results when the enterprise receives cash from customers in one accounting period for goods or services to be provided in the next accounting period. While preparing the financial statements adjustment entries are required for this item. Rent received in advance, subscriptions received in advance in the case of clubs, etc., Keynote 2.3.2: Illustration are few examples where income may be received in advance for which adjustment are required. Outstanding Expenses Outstanding expenses refers to expenses

incurred but not yet paid. Before the preparation of the financial statements it must be ensured that all the Keynote 2.3.3: Illustration expenses which have fallen due to be paid but which have not been paid during the accounting period are brought to account. Rent outstanding, interest outstanding, wages outstanding are examples of expenses outstanding. Prepaid Expenses Prepaid expenses result when the cash outflow precedes the actual expense. In other words, these are amounts paid in the accounting period for services to be received Keynote 2.3.4: Illustration in the subsequent accounting period. It is important to identify that portion of the expenditure for which the payment has been made but the benefit is yet to be received and make an adjusting entry. Rent paid in advance, Insurance
35

prepaid, etc., are a few examples where an adjusting entry is required. Closing Stock Under the periodic verification method, the closing inventory of every item is arrived at by physically counting the inventory available and assigning a value to the same. In concerns adopting the periodic verification method, the value of the closing inventory will be shown in the Balance Sheet as an asset and goes into Income statement as a component of Cost of Goods sold. Depreciation We will deal with depreciation in detail in the chapter on Fixed Assets. An adjustment for depreciation needs to be made. This results in decrease in the value of the asset which is shown in balance sheet at Cost. And since depreciation is an expense it appears in the Income statement. Bad Debts Debts which are uncollectible or irrecoverable are a loss to the business. Hence an adjustment is needed in the books in respect of this loss. Bad debts decrease the amount due from debtors to a business, in other words, accounts receivable are reduced from the Balance Sheet and are shown as an expense/ loss in the Income Statement.

Bad Debts Provision When it is feared that Keynote 2.3.5: Illustration some of the amounts due from customers are uncollectible or irrecoverable it is prudent to provide for the expected loss in the business. An adjusting entry is needed to create a provision for these anticipated losses. This creation is a loss/expense in the Income Statement and the same is reduced from Debtors or Accounts receivable in the balance Sheet. Provision for Discount on Debtors The organization which allows the facility of making payments before the due date and enable their debtors to avail of cash discounts, must take into account the possible amount of discounts that may be allowed on closing debtors in the forthcoming year. This is necessary to show the closing sundry debtors at their realizable value. The principles for creation and maintenance of the provision for discounts for debtors are the same as those discussed in the provision for bad debts. The only point to be noted is that discounts will be estimated on debts considered good. i.e. net

36

accounts receivable balance after the bad debts are reduced from it. The above provision shall be shown in the balance sheet as a deduction from the Sundry Debtors/ Accounts Receivable

Illustration: The following is trial balance of X Ltd., as on March 31, 2011. Other Information: l. Stock on March 31, 2011 was valued at Rs.41,500.

Particulars Equity share capital (Rs.10 each) Sundry creditors Sundry debtors Bills receivable Salaries Advertisement expenses Investment (@ 12% interest acquired on October 1, 2010) Plant and machinery Provision for doubtful debts Bills payable Electricity Telephone bills Auditors fees Purchases Sales Cash at bank Opening stock (April 1st, 2010) Bad debts Furniture & Fixtures Interest on investment Building Preference shares capital (Rs.100 each) 11% debenture Repairs

Expenses/ Assets (Rs.)

Incomes/ Liabilities (Rs.) 3,50,000 1,23,000

m. Total bad debts to be written off during the year were Rs. 20,000. n. A new machine was installed on December 31, 2010 costing Rs.20,000, but it was not recorded in the books and no payment was made for it. Wages of Rs.2,000 paid for its erection have been considered as Salaries. o. An item of Rs.100 for bank charges appears in the bank statement but has not yet been entered and is not reflected in the bank account of X Ltd.. p. Provide depreciation at 10% per annum on furniture and building and 20% on plant and machinery.

2,85,000 72,000 2,50,000 50,000 2,55,000 3,80,000 12,000 55,000 42,000 16,000 16,500 3,20,000 9,80,000 38,000 38,000 17,500 3,62,300 6,300 2,70,000 6,00,000 3,00,000 14,000 24,26,300 24,26,300

q. No rent has been paid on the small business building during the year because of a dispute with the landlord. The rental agreement provides for a rent of Rs.24,000 r. A provision for doubtful debts is to be made at 5% on sundry debtors. You are required to prepare an Income Statement for the period 2010-11. Solution:
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Schedule a) Net Sales / Income from Operations b) Other Operating Income Total Operating Income [ 1(a) + 1(b) ] Total Expenditure a) (Increase) / decrease in stock-in-trade b) Purchases of finished, semi-finished steel & other products c) Staff Cost d) Advertisement e)Electricity f) Telephone Charges g) Auditor's Fees h)Repairs i) Bad debts j) Bank Charges k) Depreciation l)Rent m) Provision for Bad Debts Total Expenditure Profit Before Other Income, Finance Charges and Taxes Other Income Profit before Interest and Tax Finance Charges Profit Before Tax 4 2 3 1

Rs. 980000 0 9,80,000

Income Statement of X Ltd. for the year ended 31.3.2011: Schedule 2:Bad Debts
Bad debts 17,500 2,500 20,000

-3500 320000 248000 50,000 42,000 16,000 16,500 14,000 20,000 100 140330 24,000 2,125 889555 90,445 15,300 1,05,745 33,000 72,745 Add: Accrued 9,000 15,300 interest on investment 6,300 Add: Additional

Schedule 3 : Depreciation
Depreciation on Furniture @ 10% Building @ 10% 36,230 27,000

Machinery @ 20% 76,000 Old New 1,100 1,40,330

Schedule 4 : Other Income

Schedule 1: Staff Costs

Salary Less: Wages for machinery 2,50,000 2,000 2,48,000 38

REVIEW 2.3.1

Problems 1
a.

4. Ravi paid salaries for the period ended March 31, 2010 amounting to Rs.1,50,000. The salaries paid are in respect of services rendered during 2009-10. Salaries outstanding on March 31, 2010 is Rs.25,000. The total amount to be considered as expense in Profit and Loss account is Rs.1,75,000

Question 1 of 2 The adjustment to be made for income received in advance is

b. Rs.1,25,000 On 31.3.2011 Mr. X has the following balances in his books c. Rs.1,50,000 Debtors Rs.40,000; Bad debts Rs.600. Mr. X decided to d. Rs.1,00,000 maintain the provision for doubtful debts at 5%. How much is e. Rs.50,000. the Provision for doubtful debts that needs to be maintained? 5. The Admirable Company Limited was registered with a nominal capital of Rs.5,00,000 divided into shares of Rs.10 each, of which 20,000 shares had been issued and fully paid.

Expenses/Assets

Amount Rs.

Incomes/Liabilities

Amount Rs.

Solution

A. Added to respective income and show it as a liability. B. Deducted from respective income and show it as an asset. C. Added to respective income and show it as an asset. D. Deducted from respective income and show it as a liability.

Since Rs.600 appears in trial balance as bad debts, it implies the transaction analysis is complete. Hence the provision to be maintained will be 40,000 x 5% = Rs.2,000. Problems 2 On 31.3.2011 Mr. X has the following balances in his books Debtors Rs.40,000; Bad debts Rs.600. At the end of the year Mr. X decided to write off additional bad debts of Rs.500 (for which no transactional analysis has been made) and maintain the provision for doubtful debts at 5%. How much is the Provision for doubtful debts that needs to be maintained? Solution Since Rs.600 appears in trial balance as bad debts, it implies the transaction analysis is complete. However, transactional analysis for additional bad debts of Rs.500 has not been performed. On performing the transactional analysis, debtors will reduce by Rs.500.
39

Check Answer

Hence Net debtors = Rs.40,000 Rs.500 = Rs.39,500. On this provision of 5% will be (40,000 500) x 5/100 = Rs.1,975 into shares of Rs.10 each, of which 20,000 shares had been issued and fully paid. Problems 3 The Admirable Company Limited was registered with a nominal capital of Rs.5,00,000 divided

You are required to prepare Income Statement for the year ended December 31, 2011 after taking into consideration the following adjustments. a. Write off one-third preliminary expenses

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b. Depreciation on plant and machinery at 20% and on office furniture at 10%

Schedule Rs. 1 5,78,630 0 5,78,630 30,790 2 3 4,05,825 55,815 9,620 2,455 7,105 4,305 4,630 1,700 6,000 7,100 625 4,320 1,000 9,340 4,250 1,560 1,250 5,57,690 20,940 20 20,960 11,500 9,460
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c. Manufacturing wages Rs.945 and office salaries Rs.600 had accrued due d. Provide for interest on Bank loan for 6 months e. The stock was valued at Rs.62,420 and Loose Tools at Rs. 5,000 f. Reserve Rs.4,250 on debtors for doubtful debts

a) Net Sales / Income from Operations b) Other Operating Income Total Operating Income [ 1(a) + 1(b) ] Total Expenditure a) (Increase) / decrease in stock-in-trade b) Purchases of finished, semi-finished other products c) Manufacturing Wages d) Manufacturing Expenses e)Carriage Inwards f) Power g) Repairs h) Carriage Outwards i) Rates & Electricity j) Directors fees & Remuneration k)Office salaries and expenses l) Auditors fees m)Commission n)Preliminary expenses written off o) Depreciation on Plant & Machinery p) Provision for bad debts q)Provision for discount on debtors r) Interest on Bank Loan Total Expenditure Profit Before Other Income and Taxes Other Income Profit before Tax Provision For Taxation Net Profits

g. Reserve further Rs.1,560 for discounts on debtors h. The directors recommend dividend at 5% for the year ending December 31, 2011 after providing for taxes amounting to Rs.11,500. Solution Income statement of Admirable Company Limited for the period ended 31st March 2011

5 6

Schedule 1: sales Less: Returns 5,84,950 6,320 5,78,630 Schedule 2: Furniture Purchases Less: Returns 4,10,730 4,905 4,05,825 Schedule 7: Interest Interest on Bank loan Add: Outstanding 625 625 1,250 2,500 x 10% 250 Depreciation on 39,200 x 20% Plant & Machinery Loose Tools (6,250 5,000) 7,840 1,250 Schedule 6: Depreciation

Schedule 3 : Manufacturing Wages Manufacturing wages 54,870 Add: Due 945 55,815

Schedule 4: Office Salaries Office salaries and expenses Add: Outstanding 6,500 600 7,100

schedule 5: Preliminary Expenses Preliminary expenses written off 1,000

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C HAPTER 3

Balance Sheet

INTRODUCTION Every businessman is interested in knowing two facts about his business. One is whether he has earned a profit or suffered a loss during a particular period and the other is his financial position on a particular date. For this purpose, financial statements are prepared at the end of the accounting period. Balance Sheet is a statement that captures the financial position of the business at a certain point of time. OBJECTIVES After going through the chapter, you should be able to: State the concept of Balance Sheet. Describe the concepts and principles governing the presentation of Balance Sheet. Explain the brief contents of Balance Sheet. Explain the Preparation of Balance Sheet. State the Limitations of Balance Sheet.

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Section 1

Statement of Financial Position

Balance Sheet is also known as Statement of Financial Position. It depicts the financial position of a company on a particular date. It gives the information of how the company has been financed and how that money has been invested in various productive resources. The financial position of the enterprise, captured in the Balance Sheet, reveals the relationship between the economic resources of the enterprise and its claims against the said enterprise (obligations of the said enterprise). Economic resources in accounting terminology are

called the Assets and the claims are called Liabilities, pertaining to creditor s claims while owners equity pertains to owners claims. This can be depicted in the form of an equation as follows:

Video 3.1.1: Introduction to Balance Sheet

Source:www.lh3.ggpht.com

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Assets = Liabilities + Owners equity. Assets Assets are the probable future economic benefits obtained or controlled by a particular entity as a result of past transactions and events as stated in the Statement of Financial Accounting Concepts No.6, FASB. Assets simply mean what the enterprise owns. Liabilities Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liabilities simply mean amounts the enterprise owes to others. Equity Equity or owners equity is the residual interest in the assets of an entity that remains after deducting its liabilities. Simply put, equity or owners equity is the difference between the enterprises assets and its liabilities. Some of the definitions of balance sheet are provided as follows: The Balance sheet is a statement at a given date showing on one side the traders property and possessions and on the other side his liabilities. Palmer

A Balance sheet is an itemized list of the assets, liabilities and proprietorship of the business of an individual at a certain date. Freeman A list of balances in the asset and liability accounts. This list depicts the position of assets and liabilities of a specific business at a specific point of time. American Institute of CPA Thus, balance sheet lists down the assets, liabilities and capital of the business on a specific date. Video 3.1.2:
Why balance sheet matters?

Concepts Relating to Balance Sheet

Generally, all accounting statements are prepared based on some concepts and conventions. Balance sheet is also an accounting statement. There are no specific rules for preparing a balance sheet. It is prepared based on certain

46

concepts and conventions. Let us reiterate some important concepts and conventions, which help prepare a balance sheet: Going Concern Concept Going concern concept implies that a business entity is assumed to carry on its operations indefinitely. This concept helps in categorizing assets into fixed and current. The Going concern concept implies that the resources of the concern would continue to be used for the purpose for which they are meant to be used. If the organization is not a going concern, then the fixed assets are recorded at their realizable values. Cost Concept As per this concept, the assets should be recorded in the books of accounts at a price which forms the basis for its subsequent accounting. Assets are recorded at the cost price at the time of purchase and subsequently their value is reduced by charging depreciation. Thus, according to this concept assets shown in the balance sheet are either at their cost price or at their written down value. This concept actually flows from the going concern concept. Convention of Consistency This convention requires a business enterprise to follow consistent accounting procedures and practices from time to time. This is required to enable a comparative study of the performance of the business over a period of time and also to make objective comparison within the industry. Convention of Full Disclosure

The purpose of financial accounting is to provide information to the users for decision-making. This convention implies that all material information that could affect the decision of the user must be disclosed. Full disclosure ensures complete, fair and adequate disclosure of business transactions in financial reports.

Format of Balance Sheet

There is no specific form of balance sheet for non-corporate entities like sole proprietorship firms and partnership firms. However, the assets and liabilities may be shown in the order of: a. b. Liquidity, or Permanency.

Video 3.1.3: Classified balance sheet

a. Liquidity Order: The assets, which are easily convertible into cash (called as liquid assets), come first and those, which cannot be readily converted, come next and so on. Similarly, liabilities are also arranged in this manner. The liabilities which are payable on a priority basis come first and those payable later come next and so on. b. Permanency Order: In the order of permanency, permanent assets are shown first and those of less permanence are shown next and so on. In other words, fixed assets are shown first, followed by liquid assets. On the liabilities side, permanent liabilities are shown first and less permanent ones are shown next and so on. In other words, capital is
47

shown first followed by long-term liabilities, short-term liabilities and current liabilities in that order. In India, the Balance Sheets of companies is required to be set out in the forms prescribed under Part I of Schedule VI. Part I of Schedule VI contains two forms of Balance Sheet (1) Horizontal Form and (2) Vertical Form. Format of Horizontal Form of Balance Sheet of xxx Ltd, as on March 31, 20xx

Most companies in India follow the Vertical Form of Balance Sheet because it holds the following advantages: Easily Comprehensible: The traditional form of balance sheet was difficult to understand by a wide variety of users most of whom were not conversant with the principles of accounting. The Vertical form of Balance Sheet can be easily comprehended by all. A Birds Eye View: Only broad heads are shown in the Balance Sheet without too many details. These details are shown in schedules and are cross referenced against the Balance Sheets broad heads. This helps the readers to get a birds eye view of the position of the company and at the same time get more details through the schedules. Classification: The Balance Sheet is classified as Sources of Funds and Application of Funds. The Sources of Funds comprise Shareholders equity and Long-term debt. The Application of Funds comprise application towards Fixed Assets and Working Capital. Such nomenclatures also facilitate a better understanding of the concept. Further, in the traditional form of Balance Sheet the net working capital of the company could not be easily figured; however, this has been taken care of in the Vertical form of Balance Sheet. The introduction of schedules which form a part of the Financial Statements has given scope for more disclosure and inclusion of details giving a better picture of the items being analyzed.
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For a more detailed study of the Horizontal Form of Balance sheet visit
For a more detailed study of the Horizontal Form of Balance sheet

Vertical form of Balance Sheet is currently the most popular and is an outcome of demand for a more understandable and satisfactory format.

Format of Vertical Form of Balance Sheet

R EVIEW 3.1.1
Question 1 of 4 The balance sheet gives information regarding the

A. Results of operations for a particular period. B. Financial position during a particular period. C. Profit earning capacity for a particular period. D. Financial position as on a particular date.

Check Answer

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Section 2

Understanding Balance Sheet

SOURCES OF FUNDS The sources of funds is divided and disclosed under the heads: Shareholders Funds Loan Funds Shareholders Funds They represent the ownership interest in the company. It is the residual interest in assets that remains after meeting all liabilities. The owners bear
Source:www.4.bp.blogspot.com

the greater risk because their claims are subordinate to creditors in the event of liquidation, but owners also benefit from the rewards of a successful enterprise. The ownership interest may be further sub-divided into: Share Capital Reserves and Surplus Share Capital: The capital raised by the company through the issuance of shares is known as Share

50

Capital. The Companies Act Video 3.2.1: basically provides for two Share Capital/ Stock classes of shares Equity shares and Preference shares. Preference shares enjoy preferential treatment with regard to the payment of dividends and repayment of capital. Equity shareholders enjoy voting rights. But there is no obligation to the company to pay dividends at a fixed rate every year. Even at the time of winding up of the company, they receive their capital only after the payment to preference shareholders is made. Further details of Share Capital are as below: Authorized capital It must mention the total number of shares and the face value of each share. Issued capital It must distinguish between the various classes of shares issued to the public and in respect of each class of shares, the total number of shares issued and the face value per share should be specified. Subscribed capital It must distinguish between the various classes of shares actually taken up by the public and in respect of each class, the number of shares actually taken up and the face value should be disclosed. If shares have been allotted as fully paid-up for consideration other than cash (say, shares issued in the takeover of a business), then the number of such shares

so allotted must be disclosed. Also, the number of shares which have been allotted as fully paid-up by way of bonus shares should also be disclosed. The called-up capital and any calls unpaid or in arrears should be shown as a deduction from the called-up capital to arrive at the paid-up capital. In respect of calls-in-arrears, the calls unpaid by directors and by others must be shown distinctly. Any forfeited shares to the extent they have not been reissued and to the extent of the value originally paid-up must be shown as an addition to the capital. The particulars of different classes of preference shares should be provided. These include Terms of redemption or conversion (if any), of any redeemable preference share capital should be stated together with earliest date of redemption or conversion. The source from which the bonus shares have been issued, for example, capitalization of profits or reserves or from share premium account, should also be specified. Reserves and Surplus: Reserves and surplus are profits the firm retains. Revenue reserves represent accumulated retained earnings from profits from normal business operations. These take several forms such as general reserve, investment allowance reserve, capital redemption reserve, dividend equalization reserve, etc. Capital reserves arise out of gains which are not related to the normal
51

business operations. Examples of such gains are the premium on issue of shares or gains on revaluation of assets. Surplus is the balance in the profit and loss account which has not been appropriated (transferred) to any particular reserve account. It may be noted that reserves and surplus along with equity capital represents an owners equity. The following items appear under Reserves and Surplus: i. Capital Reserves

The share premium account should include details of its utilization in the manner specified under the Companies Act. Loan Funds These represent the creditorship interest in the concern. Loan Funds are further divided and disclosed under the heads: Secured Loans Unsecured Loans Secured Loans: Secured loans refer to loans wholly or partly secured against an asset. This head includes loans secured by hypothecation of fixed assets or current assets of the company. The nature of security is to be disclosed along with getting the hypothecation registered with the Registrar of Companies under the provisions of Section 125 of the Companies Source:www.thinkplaninvest.com Act. The following items are included under the category of secured loans: i. Debentures (Companies sometimes disclose Debentures separately in the body of the Balance Sheet itself under the head of Loan Funds after Secured Loans)

ii. Capital Redemption Reserve iii. Share Premium Account iv. Other Reserves specifying the nature of each reserve and the amount, less any debit balance in the Profit and Loss Account (if any) v. Surplus, that is, balance in the Profit and Loss Account after providing for dividend, bonus or reserves vi. Proposed additions to reserves vii. Sinking funds In respect of each of the item listed under Reserves and Surplus, the additions and deductions since the last balance sheet would be shown. The word fund in relation to any Reserve should be used only where such reserve is specifically represented by earmarked investments.

ii. Loans and Advances from Banks

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iii. Loans and Advances from Subsidiaries iv. Other Loans and Advances

Video 3.2.2: Bonds/ Debentures

APPLICATION OF FUNDS The Application of Funds are disclosed in the balance sheet under the heads Fixed Assets Investments Net Current Assets Miscellaneous Expenditure Fixed Assets A fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods and services and is not held for sale in the normal course of business.
Keynote 3.2.1: Fixed Assets

Unsecured Loans: Loans taken by the company for which no security is furnished are classified as Unsecured loans. Under the Schedule to Unsecured Loans, the following items should be shown: i. Fixed Deposits

ii. Loans and Advances from Subsidiaries iii. Short-term Loans and Advances: a. From Banks b. From Others iv. Other Loans and Advances: a. From Banks b. From Others The similar details required to be disclosed in respect of Secured Loans should be disclosed in respect of Unsecured Loans also. The short-term loans will include those which are due for not more than one year as at the date of the balance sheet.

The term fixed assets shall consist of the following:

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a. Goodwill b. Land c. Buildings d. Leasehold e. Railway Sidings f. Plant and Machinery

Source:www.calgarylistings.com

or reduction must show the increased or decreased value of the asset as the original cost. Fixed assets are to be presented as Gross Block and Net Block. Gross Block represents the original cost of the assets and additions and Source:www.1.bp.blogspot.com adjustments arising due to the purchase, sale or transfer of assets. Net Block is the net value of the assets after providing for depreciation. In other words, it represents Gross Block minus depreciation. Capital Work-in-progress It includes assets awaiting completion/installation, on-site inventories, net pre-operative expenses, including difference in income and expenditure in respect of production during trial run and interest capitalized in respect of assets not yet commissioned. Investments Investments are the assets held by an enterprise for earning income by way of dividends, interest and rentals, for capital appreciation, or for other benefits to the investing enterprise. Some represent long-term commitment of funds called long-term investments. Other investments by their very nature are readily realizable and are intended to be held for not more than one year and Source:www.lh6.ggpht.com are called short-term investments.
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g. Furniture and Fittings h. Development of Property i. j. Patents, Trade Marks and Designs Livestock, and

k. Vehicles, etc. Under each of the categories mentioned above, the original cost, additions during the accounting period and deductions therefrom during the period should be shown. Also, the total depreciation written-off or provided up to the end of accounting period should also be stated. Where the fixed assets have been written up on revaluation or have been reduced in value either due to a reduction of capital or revaluation, each balance sheet for the first five years subsequent to the revaluation or reduction should show the amount of increase effected or the reduction made as the case may be. Also every balance sheet subsequent to the writing up

The investments held by a company as on the date of the balance sheet are classified into: i. Investments in Government or Trust Securities

v. In the case of quoted investments, the aggregate amount of such investments and also their market value is shown vi. The aggregate value of the unquoted investments is also disclosed vii. A separate disclosure is made of unutilized monies indicating the form in which such unutilized funds have been invested Deferred Tax Assets: A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carry forwards. For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. Net Current Assets The Components of Net Current Assets are disclosed in the Balance Sheet under the heads: Current Assets, Loans and Advances Less: Current Liabilities

ii. Investments in shares, debentures or bonds iii. Immovable properties iv. Investments in the capital of partnership firms v. Balance of unutilized monies raised by issue While listing the investments in shares, debentures or bonds, the following additional information is also given: i. The shares which are fully paid-up and those which are partly paid-up are shown separately
Video 3.2.3: Investment in securities

ii. T h e s h a r e s a r e distinguished into different classes

iii. I n t h e c a s e o f investments in shares, debentures or bonds of subsidiary companies, information in respect of (i) and (ii) above is shown separately iv. The mode of valuation of investments (whether cost or market value) is disclosed

55

Current Assets Cash and other resources which get converted into cash during the operating cycle of the firm are defined as current assets. These are held for a short period of time as against fixed assets which are held for relatively longer Source:www.belmet.fr periods. The major components of current assets are cash, debtors, inventories, loans and advances and pre-paid expenses. Cash denotes funds readily disbursable by the firm. The bulk of it is usually in the form of bank balance while the rest comprises of currency held by the firm. Debtors (also called accounts receivable) represent the amounts owed to the firm by its customers who have bought goods or services on credit. Debtors are shown in the balance sheet as the amount owed, less an allowance for the bad debts. Inventories consist of stocks of raw materials, work-inprogress, finished goods, stores and spares. They are usually reported at the lower of cost or market value. Loans and advances are the amounts given to employees, advances given to suppliers and contractors and deposits made to governmental and other agencies. They are shown at the actual amount.

Prepaid expenses are expenditures incurred for services to be rendered in the future. These are shown at the cost of unexpired reserve. Under the category of Current Assets, the following should be listed individually under broad heads: i. ii. Stores and Spare parts Loose Tools

Current Assets Carousels

iii. Stock-in-Trade iv. Work-in-Progress v. Sundry debtors

vi. C a s h b a l a n c e o n hand vii. Bank balances, and viii. Other current Assets Under the category of Loans and Advances, the following should be shown: a. Advances and Loans to subsidiaries b. Advances and Loans to partnership firms in which the company or any of its subsidiaries is a partner c. Bills of Exchange

56

d. Advances recoverable in cash or in kind or for value to be received; for example, Rates, Taxes, Insurance, etc. e. Balances with Customs, Port Trust, etc.

Video 3.2.4: Current Liabilities

vi. Other liabilities; and vii. Interest accrued but not due on loans. Provision has been defined as any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy. The following list of provisions can be disclosed under this category: i. Provision for taxation.

The classifications and details shown with respect to sundry debtors should also be followed and disclosed in schedule for Loans and Advances. Current Liabilities and Provisions: Current liabilities may be defined as all obligations arising from operations related to an operating cycle and payable within the course of such a cycle and includes all other obligations which are to be repaid within the same accounting year in which they were incurred. The following items are classified under this category: i. ii. Acceptances; Sundry creditors;
Video 3.2.5: Provisions:

ii. Provision for proposed dividends. iii. Provision for contingencies. iv. Provision for provident fund scheme. v. Provision for insurance, pension and similar staff benefit schemes. vi. Other provisions. Miscellaneous Expenditure It includes the following: i. Preliminary expenses,

iii. Subsidiary companies; iv. Advance payments and unexpired discount; v. Unclaimed dividends;

ii. Expenses including commission or brokerage on underwriting or subscription of shares or debentures, iii. Discount allowed on the issue of shares or debentures, iv. Interest paid out of capital during construction (also stating the rate of interest),
57

v. Development expenditure not adjusted, and vi. Other items (specifying nature). The amounts shown against all the items listed above should be amounts to the extent they have not been written-off to the Profit and Loss Account or adjusted in any other manner. The other general instructions for preparation of the balance sheet include the following: i. Corresponding amounts for the immediately preceding financial year for all the items shown in the balance sheet should also be given in the balance sheet.

such investments have been made should also be disclosed. Additional Resources: Gallery
Video 3.2.6: Balance Sheet Details Video 3.2.7: Contingent Liabilities

ii. In the case of subsidiary companies, the number of shares held by the holding company as well as by the ultimate holding company and its subsidiaries must be separately stated. iii. Depreciation written-off or provided should be allocated under the different asset heads and deducted in arriving at the value of fixed assets. iv. Dividends declared by subsidiary companies after the date of the balance sheet should not be included unless they are in respect of a period which closed on or before the date of the balance sheet. v. Particulars of any redeemed debentures which the company has power to issue should be given. vi. All investments must be classified into trade and other investments and the names of the companies in which

Video 3.2.8: Special Reporting and Disclosures

58

R EVIEW 3.2 .1
Question 1 of 4 Which of the following are/is not a fixed asset?

A. Stock B. Vehicle C. Fixed deposit in bank D. Both (a) and (c) above

Check Answer

59

Section 3

Preparation of Balance Sheet

It is necessary to understand the linkage between Trial Balance, Profit and Loss Account and Balance Sheet as shown in Balance Sheet Diagram (given on the next page) to be familiar with the preparation of Balance Sheet and Profit and Loss Account.

Source:www.tutorsonnet.com

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Keynote 3.3.1: Balance Sheet Diagram

We take the rest of the items of trial balance (including adjustments) to Balance Sheet.
Video: 3.3.1 Trial Balance Video 3.3.2: Need for adjustments

Hence in a Balance Sheet, the Assets side should be equal to liabilities side. Application of Funds (Assets) should be equal to sources of funds (Liabilities). The following adjustments are explained with respect to preparation of financial statements i.e. Profit and Loss Account and Balance Sheet. The adjustments call for transaction analysis via the fundamental equation, the outcome of which is captured in the Keynote 3.3.2 following table 1.

In other words, We start with a tallied trial balance. We give double-entry effect (transaction analysis) to all adjustments outside trial balance. We take some of the trial balance items (including adjustments) to Profit and Loss Account. We take the result of profit and loss Account (net profit or net loss) to Balance Sheet (Reserves or Capital).

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Adjustment

Treatment

Reasons

1. Closing Stock a. I f i t i s g i v e n a s a n a d j u s t m e n t i. (not included in trial balance) ii. Deducted from Cost of Goods sold or Since it is an adjustment double with effect is treated as Income no profit component. to be given as per transaction analysis concept. Show as Current Asset in Balance Sheet

It is included in Trial Balance means it is b. If it is already shown as an expense in Show only as a current asset in Balance already adjusted (transaction analysis is done) Trial Balance Sheet. in cost of goods sold. If market value of stock is also given Note Take cost or market value whichever is less. Treat it as Income in profit and loss account. 2. Bad debts recovered i. 3. Income tax provision (Relating to current year) 4. Live Stock 5. Investments ii. Since it is considered as expense in the year of occurrence, it should be taken as income in the year of recovery.

Treated as expense in profit & loss It is not an appropriation of profits. account i.e. above the line. Show as a current liability in Balance Sheet. As per Schedule VI of the Companies Act.

Show as fixed asset in Balance Sheet.

Market value is to be shown in the inner Cost value is to be shown in the Balance column for information (Schedule VI Sheet as Asset. requirement).

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Adjustment
6. Secured loans a. I n t e r e s t d u e a n d i. accrued ii.

Treatment

Reasons
As per Schedule VI of the Companies Act.

Considered as expenses in profit & loss account. Interest due and accrued is to be added to loan amount in Balance Sheet (Liability side).

b. Interest due but not i. accrued ii. 7. Depreciation

Considered as expenses in profit & loss account. Interest due but not accrued is to be added to current liabilities in Balance Sheet. Is an expense in profit and loss account. Reduced from fixed assets in Balance Sheet.

As per Schedule VI of the Companies Act.

i. ii.

As per Accounting Standard guidelines.

8. Insurance prepaid

i.

Out of total insurance paid the amount prepaid is to be deducted as Since it does not belong to the ultimately only the expense pertaining to the current period is reflected in current year. profit and loss account. Amount prepaid will be shown as current asset in Balance Sheet.

ii.

9. O u t s t a n d i n g Expenditure

i.

Added to existing amount of appropriate expenditure in profit and loss Since it is an expenditure relating account as expense pertaining to current period. to that particular year. Shown as current liability in Balance Sheet.

ii.

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Adjustment
i.

Treatment

Reasons

10. M a n a g e r s a n d Managing Directors Salary.

Ta k e n a s e x p e n s e i n p r o f i t a n d l o s s a c c o u n t . Since it is a charge against It should be shown separately in profit and loss account without clubbing with the profits of the company. Administrative Salaries. It should be shown as a current liability in the balance sheet if still remains unpaid.

ii. 11. Dividends Interim and Final Dividend ii. 12. P r o v i s i o n f o r i. doubtful debts and ii. bad debts

i.

Taken as expense in profit and loss appropriation account. It should be calculated on the paid- up amount of capital i.e., issued and called up capital minus calls in arrears. To the extent unpaid taken as liability in the Balance Sheet. Bad debts is an expense in profit and loss account. For calculation of provision for doubtful debts first reduce bad debts given as adjustment from debtors and then calculate provision for doubtful debts.

iii. Consider the same as an expense in profit and loss account. iv. In the Balance Sheet the presentation should be on the asset side as Debtors XXX Less : Bad debts XXX

Less : Provision for doubtful debts Balance

64

Adjustment
13. Compulsory transfer of i. profits to reserves ii.

Treatment
Transfer 2.5% of current year profits to reserves. i.

Reasons
If dividend proposed exceeds 10% but less than 12.5% of the paid-up capital. If dividend proposed exceeds 12.5% but not 15%.

Transfer 5%. of current year profits to reserves.

ii.

iii. Transfer 7.5% of current year profits to reserves.

iii. If dividend proposed exceeds 15% but not 20%.

iv. Transfer 10% of the current year profits to reserves account. iv. If dividend proposed exceeds 20%. This transfer, is to be made through profit and loss appropriation account. 14. G o o d s s e n t t o customers on Sale or return basis 15. Calls-in-arrears Should be taken as closing stock only when the confirmation from the customer is received treating the same as sale. Deduct from called up amount share capital on the liabilities of As per Schedule VI of the Companies Act. side of the Balance Sheet. Should be clearly mentioned wherever possible as fees, paid i. As auditor ii. As advisor in respect of Taxation matter Company law matter Management services In any other manner. As per Schedule VI of the

16. Auditors fees

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Adjustment
17. Sundry debtors

Treatment

Reasons

I n t h e B a l a n c e S h e e t w h e r e v e r i n f o r m a t i o n i s a v a i l a b l e i t s h o u l d As per Schedule VI. be mentioned as sundry debtors a. b. c. Debts outstanding for a period exceeding six months. Other debts. Amounts due from directors should be separately shown.

18. M i s c e l l a n e o u s Expenses

T h e f o l l o w i n g e x p e n s e s t o t h e e x t e n t n o t w r i t t e n - o f f s h o u l d b e p r e s e n t e d a s m i s c e l l a n e o u s expenses in the Balance Sheet i. ii. iii. Preliminary expenses. Expenses including brokerage, commission on underwriting of shares, debentures. Discount on issue of shares/debentures As per Schedule VI.

iv. Interest paid out of capital during construction. The total of above expenses should not be debited to profit and loss account, whereas they can be written-off i.e., debited to P&L account on a fixed percentage basis. 19. R a i l w a y s i d i n g s , All these will appear as fixed assets in the Balance Sheet. patents, trade marks and designs and live stock 20. Importance of Period Expenditure/Revenue to be taken into profit and loss account should relate to the year of the year of accounting accounting Income/Expenditure relating to prior year or future year or of capital nature should be excluded. As per Schedule VI.

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Closing Inventory as on December 31, 2010, Rs.50,000. Illustration 1 From the following Trial Balance of Evergreen and Company prepare the Balance Sheet of Evergreen and Company. Trial Balance as on December 31, 2010 O u t s t a n d i n g w a g e s R s . 5 , 0 0 0 . Depreciation on Plant & Machinery at 10% and Furniture at 5%. The companys profit for the period ended 31.12.2010 was Rs.31,900. Solution Schedule 1 Fixed Assets: Gross block (Rs)
1,20,000 30,000 1,50,000

Category of fixed assets

Plant and machinery Furniture Total

Depreciation (Rs)
12,000 1,500 13,500

Net block (Rs)

1,08,000 28,500 1,36,500

Schedule 2 Current Liabilities Amount (Rs)

5000 44,000 48,000 97,000

Current Liabilities
Outstanding Wages Bills Payable Accounts payable

Additional information:

Total

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Schedule No.
1 I. Sources of funds 1. Shareholders funds a. b. Capital Reserves and surplus 2,00,000 31,900 2 3 4

Current Liabilities: Outstanding wages Bills Payable 5,000 44,000 48,000 97,000

2. Loan funds a. b. TOTAL II. Application of funds 1. Fixed assets: a. b. c. Gross block Less depreciation Net block 2 1,50,000 13,500 1,36,500 Secured loans Unsecured loans 1 2,31,900

Accounts Payable

Illustration 2 From the following Trial Balance of Sun Shine and Company prepare Balance Sheet (horizontal form). Trial Balance as on 31.12.2010

d. Capital work-in-progress 2. Investments 3. Current assets, loans and advances: a. Inventories b. Sundry debtors c. Cash and bank balances d. Other current assets e. Loans and advances Less: Current liabilities and provisions: a. Liabilities b. Provisions 4. a. Miscellaneous expenditure to the extent not written-off or adjusted b. Profit and loss account TOTAL

50,000 1,00,000 2,400 40,000

Additional Data: Closing Inventory Rs.8,000. Depreciation on Plant & Machinery at 15% and 10% on Buildings.

97,000

Provision for doubtful receivables Rs.500. Insurance prepaid Rs.50. Outstanding rent Rs.100.
2,31,900

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The Net Profit of the firm for the period was Rs.6,150. Solution Sun Shine and Company Balance Sheet as on 31.12.2010

LIMITATIONS OF BALANCE SHEET At this stage it may be worthwhile to come to grips with some important limitations of balance sheet. Just because a balance sheet is tallied or because the auditors have certified the balance sheet it does not however mean that a balance sheet is without any limitations.
Video 3.3.3: Limitations of Balance Sheet

Balance Sheet is considered to be a static document and it reflects the position of the concern at a moment of time. The real position of the concern may be changing day-to-day and the same is not depicted in the Balance Sheet.
69

The Balance Sheet is not a valuation statement. The values shown in it are not real values of assets. Thus, the exact position of the business cannot be gauged from the balance sheet. We have noted earlier that a balance sheet is prepared based on certain accounting policies. Such policies relate to inventory valuation (i.e., closing stock), depreciation, etc. Inventory may be valued using several methods like First-InFirst-Out (FIFO), Last-In-First-Out (LIFO), weighted average cost, etc. Similarly, depreciation may be provided using straight line method or written down value method. The management may select a rate of depreciation (which is not less than the statutory minimum rate) suitable to its own business needs. Similarly, accounting policies may differ from company to company in respect of accounting for prepaid expenses, prior period adjustments, classification between revenue and capital expenditure, writing-off preliminary expenses, etc. However, the auditors do insist that the same accounting policies are consistently used by management from year to year. Whenever there is a change in a companys accounting policy, the effect of such a change is indicated in the notes to balance sheet. In addition to such basic differences relating to accounting policies, we come across here and there deliberate windowdressing of balance sheets to forecast a better picture to shareholders, bankers and financial institutions. It presents a rosier picture than what it actually is.

Window-dressing is accomplished in general ways by not making adequate provisions (though prudence would require them) for expenses and potential losses, by taking into account income even before its actual accrual, by playing around with inter-corporate adjustments, etc.

R EVIEW 3.3.1
Question 1 of 2 Which of the following is a limitation of financial statements?

A. Assets are shown at historical cost value. B. It does not consider non-monetary assets. C. It is based on certain accounting policies and estimates. D. All of the above.

Check Answer

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Problem 1. From the following information, prepare the balance sheet as at March 31, 2011.

ii. Provide 5% reserve for doubtful debts on debtors. iii. Provide 10% depreciation on Machinery and Furniture. iv. Salaries outstanding Rs.3,600. v. Insurance prepaid Rs.900. vi. The Net Profit of the business for the period was Rs.51,000. Solution Balance Sheet as on 31-03-2011

Additional Information: i. Closing Stock of taw materials Rs.60,000; Work-in-progress Rs.18,000; Finished goods Rs.12,000.
71

Sche dule No. 1 I. Sources of funds 1. Shareholders funds a. b. Capital Reserves and surplus 2 3

Figures as at the end of current Financial Year(Rs.) 4

Schedule 1: Fixed Assets Gross block (Rs)

8,000 60,000 68,000

Category
1,08,000 51,000

Depreciatio n
800 6,000 6,800

Net block (Rs)

7,200 54,000 61,200

Furniture Machinery

2. Loan funds a. b. TOTAL II. Application of funds 1. Fixed assets: a. b. c. d. Gross block Less depreciation Net block Capital work-in-progress 2 68,000 6,800 61,200 Secured loans Unsecured loans 1 1,59,000

Schedule 2 : Inventory
Raw Material Work-in-progress Finished goods 60,000 18,000 12,000

2. Investments 3. Current assets, loans and advances: a. Inventories b. Sundry debtors c. Cash and bank balances d. Other current assets e. Loans and advances Less: Current liabilities and provisions: a. Liabilities b. Provisions 4. a. Miscellaneous expenditure to the extent not written-off or adjusted b. Profit and loss account TOTAL

Schedule 3: Sundry Debtors

90,000

Debtors Less: Provision for bad debts

90,000 4,500 85,500

3 4

85,500

900

Schedule 4: Other Current Assets

Insurance prepaid 900

78,600

97,800

Schedule 5: Current Liabilities

Creditors Salaries outstanding 75,000 3,600 78,600
72

1,59,000

Balance Sheet

73

C HAPTER 4

Revenue Recognition

Source:www.profile.ak.fbcdn.net

INTRODUCTION The objective of any economic enterprise, whether dotcom or age old commodity business, is to maximize profit. Profit is used as a measure of performance or as the basis for other measures, such as return on investment or earnings per share. The elements directly related to the measurement of profit are income and expenses. The key to income measurement is the timing of the revenue recognition. Hence the recognition, timing and measurement of income and expenses has a direct and most significant bearing on determining profit. Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration. - Accounting Standard 9 (Revenue Recognition) Revenue arises in the course of the ordinary activities of an enterprise and is referred to by a variety of different names including sales, fees, interest, dividends, royalties, rent, etc. OBJECTIVES After reading this chapter, you should be able to:

Explain revenue recognition and the concepts relating to revenue recognition; Describe the Methods of recognizing revenue; Measure the amount of revenue to be recognized; and Examine the significance and measurement of receivables, bad debts and provisions for doubtful debts.
Video 4.1: Basic Elements of Revenue Recognition

75

Section 1

Concepts Pertaining to Revenue Recognition

Recognition is the process of incorporating in the balance sheet or statement of profit and loss an item that meets the definition of an element and satisfies the criteria for recognition. An item that meets the definition of an element should be recognized if: a. It is probable that any future economic benefit associated with the item will flow to or from the enterprise; and, b. The item has a cost or value that can be measured with reliability. Sales Recognition: In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled: i. The seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and, ii. No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods. The transfer of property goods, in most cases, results or coincides with the transfer significant risks and rewards ownership to the buyer. in in of of

Source:www.i237.photobucket.co

76

However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership. Revenue in such situations is recognized at the time of transfer of significant risks and rewards of ownership to the buyer. Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the goods are at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes the parties may agree that the risk will pass at a time different from the time when ownership passes. Revenue from Service: In a transaction involving the rendering of services, performance should be measured under either: The proportionate completion method, The completed service contract method, or Whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service. Revenue from use of Enterprise Resources: Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognized when no significant uncertainty as to

measurability or collectability exists. Interest can be defined as charges for the use of cash resources or amounts due to the enterprise;

Video 4.1.1: Concept of Revenue

Royalties can be defined as charges for the use of such assets as knowhow, patents, trademarks and copyrights; Dividends can be defined as rewards from the holding of investments in shares. For ensuring comparability and consistency in accounting, certain specific procedures are to be followed. This principle applies for recognizing and accounting revenues also. There are various methods of revenue recognition which are detailed below. Whatever method the entity follows consistency is most important for easy comparability and understanding of financial statements. It also reflects the true picture of the entitys financial position. There are mainly three accounting concepts which are related with revenue recognition: 1. Conservatism Concept; 2. Realization Concept; and 3. Matching Concept.
77

1. Conservatism Concept The conservatism concept has two aspects: Recognize revenues only when they are reasonably certain. Recognize expenses as soon as they are reasonably possible. There are obvious problems in deciding what is meant by reasonably certain and reasonably possible in various situations and accounting principles give guidance for many specific problems. For example, the principle that revenue is recognized in the period in which goods are delivered applies to most sales transactions, because this is the earliest period in which it is reasonably certain that revenue has been earned. Revenue from the sale of goods is recognized in the period in which goods were delivered to customers. Revenue from the performance of services is recognized in the period in which the services were performed. If cash is received at the time of delivery or performance, it means that the revenue has been earned. It can happen, however, that the cash is received in either an earlier period or a later period than that in which the revenue is recognized. Examples of pre-collected revenues are as under:

Publishing companies sell subscriptions that the subscriber pays for in advance; that is, the company receives the cash before it renders the service of providing the magazine. If subscription money is received this year for magazines to be delivered next year, the revenue belongs in next year. Rent on property is often paid in advance. When this happens, the revenue is properly recognized in the period in which the services of the rented property are provided, not the period in which the rent payment is received. 2. The Realization Concept The conservatism concept insists on the period when revenue should be recognized whereas the realization concept indicates the amount of revenue that should be recognized from a given transaction. Realization refers to inflows of cash or claims to cash arising from the sale of goods or services. Thus, if a customer buys Rs.500 worth of items at a provision store, paying cash, the store realizes Rs.500 from the sale. If Source:www.elmundo.com. a department store sells a pressure cooker for Rs.2 800, and the purchaser agrees to pay within 30 days, the store realizes Rs.2800 (in receivables) from the sale, provided that the purchaser has a good credit record so that payment is reasonably certain. The realization
78

concept states that the amount recognized as revenue is the amount that is equal to or reasonably certain to be realized. If the sale of goods or services is made on credit the amount of revenue recognized is the total value of sale minus the estimated amount of unrealized receivables i.e. bad debts. Such an estimate can be made by previous records or experience. But in practice the entire amount of sale is taken as income and bad debts, if any, is shown separately as an expense in the income statement. 3. The Matching Concept The items for which revenues are recognized both by conservatism concept and realization concept are identified and the costs of such items a r e also accounted for in the same period in which the accounting for revenues is made. This practice is called matching concept. For example, if goods are sold at Rs.10000 and cost of the same being Rs.8000, as per matching concept Rs.8000 is booked as an expense in the same period when Rs.10000 is booked as an income. The conservatism concept and the realization concept suggest that revenue should be recognized in the earliest period in which: The entity has substantially performed what is required in order to earn income; and, The amount of income can be reliably measured.

The above criteria are expressed in terms of earning and measuring income rather than in terms of revenue, because both the revenue and expense components of a transaction need to be reliably measurable in order to recognize the revenue. Because of the matching concept, both components are recognized in the same period and the difference accrues as income.
Video 4.1.2: Basic Elements of Expense Recognition

http://220.22 7.161.86/25 Revenue Recognition 1as9new.pdf

http://www.iasb.or g/NR/rdonlyres/1 A3771B8-5627-44E Revenue 4-984E-AC90FEE1

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R EVIEW 4.1 Question 1 of 2 The accounting concept/s closely associated with the revenue recognition criteria is/are

A. Conservative concept and cost concept. B. Realization concept. C. Dual concept and entity concept. D. Conservative concept and realization concept.

Check Answer

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Section 2

Revenue Realization
Under cash basis accounting, realization (earning) of revenue occurs simply when cash is collected for sales of goods or services. Under accrual basis accounting, however, realization of revenue takes place in three phases: Goods or services must be delivered to customers (passing of risk and rewards of Source:www.onlines ownership);
tock-investing.us

Installment method. Delivery Method Revenue is earned by a business entity either by selling goods or rendering services. Under this method, revenue is recognized in the period in which goods are delivered or services actually provided. Even if a reliable estimate can be made about the realization of revenue, the accounting is made only when the actual shipment is made and goods delivered. Similarly, in case of service provided, the revenue is recognized only after the performance of service. Revenues from renting hotel rooms are recognized each day the room is rented. Revenues from maintenance contracts are recognized in each month covered by the contract. In the real life situation, the amount of income that will be earned can be reliably estimated when goods are delivered or services provided. When goods are delivered, title usually is transferred from the seller to the buyer, but transfer of title is not a necessary condition for revenue recognition. When goods are sold on the installment credit

In exchange for an asset (such as an account receivable); and, It is virtually assured of being converted soon into cash (certainty). The main four practical ways of realizing revenues are: Delivery method; Percentage completion method; Production method; and

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basis, the buyer does not have a clear title until the installment payments have been completed. If, however, there is a reasonable certainty that these payments will be made, revenue is recognized at the time of delivery. Revenue from the sale of goods shall be recognized when all the following conditions have been satisfied: The entity has transferred to the buyer the significant risks and rewards of ownership of the goods; The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the transaction will flow to the entity; and The costs incurred or to be incurred in respect of the transaction can be measured reliably. In case of consignment shipment, the supplier, or consignor, ships goods to the consignee, who attempts to sell them. The consignor retains title to the goods until they are sold; the consignee can return any unsold goods to the consignor. In these circumstances, performance has not been substantially completed until the goods are sold by the consignee. Thus, the consignor does not recognize revenue until that time.

Percentage-of-Completion Method Long-term projects which involve years for completion follow this method of revenue recognition. Examples of such projects are high-rise buildings, bridges, aircrafts, ships, space exploration hardwares and certain other Source:www.i.istockimg.com items which involve a design or development and construction sequence, etc. Such projects are performed under contracts in which the customer provides the product specifications. The contract also stipulates either (1) predetermined amounts the customer must pay at various points during the project, called a fixedprice contract, or (2) some sort of formula that will determine customer payments as a function of actual project costs plus a reasonable profit, called a cost- reimbursement contract.
Video 4.2.1: Criteria for Recognizing Revenue

The amount of revenue recognized under percentage completion method is related to the percentage of the total project work that was performed during that period. If the amount of income to be earned on the contract cannot be reliably estimated, then revenue must be recognized only when the project has been
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completed. This is the completed-contract method and costs incurred on the project are held as assets, Contract Work-in-Progress, until the period in which revenue is recognized.

Video: 4.2.2 Revenue Recognition for Services

revenue and a proportional part of the cost of sales is counted as a cost in the same period.

In a more conservative variation, the cost-recovery method, cost of sales is recorded at an amount equal to the installment payment. RevenueThe Recognition Production Method result is that no income is reported This method is followed by until the installment those where the income can be payments have reliably measured only after the completion of production. recouped the total Agriculturists who are confident to sell their produce at cost of sales. government support prices can as per GAAP (Generally Accepted Accounting The effect of the Principles) recognize installment method revenue at the time of is to postpone the recognition of revenue and income to later harvest only. GAAP also periods as compared with the delivery method. If a company permits revenue recognition wants to report as much income as it legitimately can in the when gold, silver and other current period, it will, therefore, prefer to report in its income precious metals have been statement the full amount of the transaction at the time of produced from the make sale. If it wants to postpone the recognition of taxable income even though they have not This method for income tax purposes, it will use the installment method in Source:www.lh3.ggpht.com is followed by those where the income can be reliably measured at the completion of production itself. Agriculturists who are confidentcalculating to sell their yet been sold. its taxable income. Installment Method Hence the question is - how do accountants measure 4. Installment Method revenue? Generally, accountants assume a reasonable Revenue in case of goods sold on installments is recognized when the installment Revenue in case of goods sold on installments is recognized certainty and approximate the net realizable value of the payments are received. In the pure installment method, the installment payment is when the installment payments are received. In part the counted as revenue, and a proportional of the pure cost of sales is counted as a cost asset(cash) resulting from inflow from customer. That is, the in the same period. installment method, the installment payment is counted as is the present cash equivalent value of the asset In a more conservative variation, the cost-recovery method, costrevenue of sales is recorded at an amount equal to the installment payment. The result is that no received. Obviously, if a cash sale is made, the value of the income is reported until the installment payments have recouped the total cost of
sales. The effect of the installment method is to postpone the recognition of revenue and income to later periods as compared with the delivery method. If a company wants produce at government support price can as per GAAP (Generally Accepted Accounting Principles) recognize revenue at the time of harvest only. GAAP also permits revenue recognition when gold, silver and other precious metals have been produced from the make even though they have not yet been sold.

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asset is the cash inflow. If a credit sale is made, the value of the asset is often recorded on the same basis as a cash sale. However, the realizable value of a credit sale is not really the same as a cash sale. For example, some credit customers may never pay. The need for recognizing bad debts, sales discounts, sales returns and allowances arises because of the one aspect of the realization concept that is, revenues should be reported at the amount that is reasonably certain to be collected. This concept would seem to require that these amounts be subtracted from gross revenues in order to determine the net revenue of the period. The effect of the some of the practices described above is to report the amounts as expenses rather than as adjustments to revenues. Whether companies report these amounts as expenses or as adjustments to revenues, the effect on income is exactly the same. The difference between the two methods is the way they affect revenue and gross margin. The consistency concept requires that a company follow the same method from one year to the next and thus comparisons within a company are not affected by these differences in practice.

R EVIEW 4.2.1 Question 1 of 3 Which of the following methods is not a practical way of realizing revenue?

A. Delivery Method B. Percentage of Completion Method C. Production Method D. Moving Average Method

Check Answer

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Section 3

Bad Debts
The criteria which are common among the recognition norms of various streams of revenue discussed in earlier sections are: a. b. Revenue should be measurable. It should be collectible. otherwise be lost if credit sales were not extended. That is, many potential customers would not buy if credit sales were not available. The accountant often labels the major cost as bad debt expenses and the benefit as the additional gross profit on credit sales.
Video 4.3.1: Costs and benefits of Credit sales

If there is significant uncertainty on any of the above fronts, recognition is postponed till the period in which the uncertainty is reasonably resolved. When the uncertainty relating to collectibility arises subsequent to the time of sale or the rendering of the service, it is more appropriate to make a separate provision to reflect the uncertainty rather than to adjust the amount of revenue originally recorded. Giving credit to customers entails costs and benefits. One cost is the possibility that some credit customers will never pay. Another is the cost of administration and collection. The benefit is the boost in sales and profit that would

The extent of non-payment of debts varies from industry to industry. It depends on the credit risks that managers are willing to accept. For instance, many small retail establishments will accept a higher level of risk than large stores such as Bata showrooms. Accompanying the risks are corresponding collection expenses.

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How to Measure Bad Debts Measuring bad debts of a firm can be generally done in two ways: Specific Write-off Method, and Allowance Method. Specific Write-off Method The measurement of income becomes complicated because some debtors are either unable or unwilling to pay their debts. Such bad debts are also called uncollectible accounts. Suppose a firm has credit sales of Rs.100000 near the end of 2010 and predicts on the basis of experience that Rs.2000 will never be collected. How should we account for this situation? There are two basic ways. First, consider the specific write-off method (also called specific charge-off method). Assume that during the next year, 2011, the firm identifies customers who are expected to never pay Rs.2000 that they owe from sales of 2010. See the analysis below with the help of balance sheet equation:
Video 4.3.2: Treatment of Bad debts
2011 Writeoff

Specic Write-off Method

Balance sheet equation Assets=Liabilities+(Revenue-Expenses) 2010 Sales +100000 (Increase in accounts receivables) +100000 (Increase in sales) 2000 (Increase bad 2000 (Decrease in accounts receivables) debts expenses)

When the chances of collection from specific customers become doubtful the amounts in the particular accounts are written down and bad debts expense or uncollectible accounts expense is recognized. The specific write-off method has been criticized because it fails to apply the matching principle of accrual accounting. That is, the cause of the bad debts expense was the making of the sale. Accrual accounting maintains that bad debts expense relates to the period of sale rather than the period of actual write-off. In this example, the specific write-off method produces two mistakes. In 2010, the amount of Rs.100000 for assets and revenue is overstated by Rs.2000 because only Rs.98000 is actually expected to be collected. In 2011, expenses are correspondingly overstated by Rs.2000. The Rs.2000 of bad debts expenses should be recognized in 2010 and not in 2011, because it was caused by 2010 sales. The principal arguments in favor of the specific write-off method are based on cost-benefit and materiality. This method is simple. Moreover, no great error in measurement occurs if amounts of
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bad debts are small or do not vary considerably from year to year. Allowance Method The allowance method uses estimates and a contra asset (deduction from receivables) account, often called allowance for bad debts. It is also called provision for Bad Debts. A summary of its effects on the balance sheet equation is as follows: Allowance Method
Balance sheet equation Assets=Liabilities+(Revenue-Expenses) 2010 Sales +100000 (Increase in accounts receivables) +100000 (Increase in sales) 2000 (Increase 2010 Allowance 2000 (Increase in allowance for uncollectible accounts receivables) bad debts expenses)

Accounts receivable Less: Provision for Bad Debts Net accounts receivable

Rs.100000 2000 Rs.98000

In the following table the journal entries for the specific write-off method and the allowance method are given. The principal argument in favor of the allowance method is its superiority in measuring accrual accounting income in any given year. A contra asset account is created under the allowance method because of the inability to write down a specific account at the time bad debts expense is recognized. In our example, at the end of 2010 the firm has, say, Rs.70000 in Accounts Receivable. Based on past experience, a bad debts expense is recognized at a rate of 2% of total credit sales, or 0.02 x Rs.100000 or Rs. 2000. Before Write-off
Accounts Receivable Rs.70000 2000 Rs.68000

After write-off
Rs.68000 Rs.68000

2011 writeoff

2000 (Decrease in allowance for uncollectible accounts receivables) +2000 (Increase bad debt expenses) No effect

Allowance for uncollectible accounts

Book value (net realizable value)

The allowance method, also called provision method, would result in the following presentation in the balance sheet, as on December 31, 2010:

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R EVIEW 4.3 Question 1 of 2 M/s. Book Paradise is a well established book stores in Hyderabad. The balance of sundry debtors as on April 01, 2010 and March 31, 2011 was Rs.400000 and Rs.300000, respectively. During the year 2010-2011, an amount of Rs.10000 was written off as bad debts. If the firm makes a provision for bad debts at 5% on debtors, the amount debited to Profit and loss account for the year ended March 31, 2011 is:

A. Rs.500 B. Rs.5000 C. Rs.10000 D. Rs.15000

Check Answer

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Section 4

Cash Discount and Warranty Costs

Cash Discounts Allowed

terms of 2/10, net/30, it permits customers to deCash Discounts are al- duct 2% from the invoice lowed by a business to its amount if they pay within customers when they pay 10 days; otherwise the full their accounts quickly. A (net) amount is due within business may reduce a 30 days. The cash dissmaller sum (often in percentage of the total Video 4.4.1: Cash Discount amount) from the full setvs Trade Discount tlement amount, if the payment is made within a certain period of time. The amount of reduction from the sum to be paid is known as cash discount. For example, if a business sells goods on
Source:www.5dariyanews.com

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count is recorded as an expense of the period and it is not a part of cost of goods sold (cash discounts always appear in the profit and loss section of the income statement). Warranty Costs Companies usually have an obligation to repair or replace defective goods. This obligation arises either because it is an explicit part of the sales contract or because there is an implicit legal doctrine that says that customers have a right to receive satisfactory products. In either case, the obligation is called a warranty.

sponding amount will be deducted from the Allowance for Warranties and at the same time Cash or Parts Inventory will be deducted from the assets side of the balance sheet.

Source:www.touchartists.com

If it is likely that a material amount of cost will be incurred in future periods in replacing or repairing goods sold in the current period, both the conservatism and matching concepts require that the income in the current period be adjusted accordingly. The amount of adjustment is usuVideo 4.4.2: Warranty costs ally estimated as a percentage of sales revenue (Allowance for Warranties - shown in the liability side of the balance sheet) and this amount is recorded as an expense (operating expense) in the period. When the costs are incurred in the future in repairing or replacing the goods, the corre90

R EVIEW 4.4.1 Question 1 of 3 Cash Discount is referred to as

A. Discount given by the vendor for bulk purchase made. B. Discount given by vendor for immediate transfer of risk and reward in the property. C. Discount given for prompt payment D. Discount given for placing a number of orders at a time.

Check Answer

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C HAPTER 5

Accounting For Inventories

Source:www.unirelo.com

INTRODUCTION Inventory is defined as ...those items of tangible personal property that are held for sale in the ordinary course of business, are in the process of production for such sale or are due to be currently consumed in the production of goods or services to be available for sale. - ARB 43, FASB

Describe the maintenance of inventory records under perpetual and periodic Inventory Systems; Describe the principal methods of inventory costing; and Explain the Valuation Principles with regard to Inventory.

The importance of inventories in the financial statement lies in the fact that it is reflected both in the Income Statement as well as in the Balance Sheet. Complexities arise in the accounting of inventories basically because of the high volume of their activity, the various cash flow alternatives associated with them and their classification. Broadly speaking, there are two types of entities for which such accounting of inventories is generally undertaken. The first type are the retailers and wholesalers whose inventory is generally categorized as the merchandise inventory whose main idea behind holding inventory is that it is meant for resale and the other is the manufacturer whose inventory is generally in the form of raw material, work-in-process and finished goods. OBJECTIVES After going through this chapter, you should be able to: Explain the significance of Inventory valuation; Describe the components of Inventory Cost; and

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Section 1

Inventory Pricing
For conducting business, all manufacturing and trading organizations carry stocks or inventories. Such stocks or inventories are in three different forms: 1. Raw Material Inventory; 2. W o r k - i n - P r o c e s s Inventory; and 3. F i n i s h e d G o o d s Inventory. All inventories are held for conversion into finished goods or finished goods which are awaiting sale. In both cases, the intention is to convert the inventory into cash. Sales take place not only from goods currently produced and put in stock, but also from goods which might have been produced in earlier periods and were retained in stock. Similarly, there is no certainty that all goods produced during the current accounting period would be sold during that period. Since all sales during an accounting period, whether they arise from sale of goods produced from an earlier period or from production in the current period, are treated as

Source:www.beyondlean.files.wordpress.com

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revenue, it is necessary to identify (in addition to the cost of goods produced currently) the cost or price of the goods sold from inventory. Similarly, the value of goods produced during the current period but carried over to the next period as inventory has to be identified for drawing up meaningful income statements or profit and loss accounts. The basis for pricing finished and other goods from inventories is cost, which is generally defined in terms of production cost, for those goods which are produced internally, or acquisition cost, for those goods which are purchased from outside. The inventory cost is the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. The finished goods which have been produced internally for inventory should be priced at production cost. However, there are certain difficulties in application, particularly in relation to inventories of work-in-process and finished goods. It is generally followed that only expenditure incurred in production of such goods, or such expenses Source:www.thegeminigeek.com which may be clearly related to production should be considered as cost in this context. Following this convention, general, administrative and selling expenses are not treated as part of inventory cost, as they are neither directly nor indirectly incurred in bringing the article in inventory to its existing condition and location. However, not all accountants agree

with this convention. There are individual situations where the characteristics of operational costs are sufficiently different from the normal situation to require a departure from this principle. If the general or administrative expenses include large expenses which have a production connotation, it might be justifiable in such special circumstances to include portions of such administrative expenses in the inventory. It can, therefore, be said that while the principle stated earlier is generally a sound one, its application requires exercise of judgment in individual situations with reference to the operating characteristics of the business, the accounting system in use and trade and industry practices. After the costs to be included in inventory are decided upon, the problem arises is how to value inventory in aggregate. Cost of inventory produced during different periods would not tally. However, if the number of units produced by the firm are less in the accounting period, it would not be difficult to identify the cost of each unit of inventory.
Video 5.1.1: Components of inventory cost

However, in situations where the number of units held in inventory is very large and the units are identical in their physical characteristics, it might be impossible to identify the cost of each unit. For example, it is impossible to identify at
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any point of time whether the coal that is being currently sold relates to a particular sequence of mining operations which could be identified with a particular aggregate production cost. In trading operations, this problem has a different dimension. Suppose a trader in rice buys stocks at different prices at different times. He goes on adding his purchases to his current stocks, while at the same time selling his stocks, to his customers. It would be impossible to identify the cost price of the rice sold by pinpointing the time of its purchase and hence the related purchase price. In most business situations, materials kept in inventory are interchangeable and purchased in various lots at various prices and at various times. It is thus necessary to develop a method of pricing which is based on assumptions about the identity of the goods sold in relation to the identity of the goods purchased. There are several methods for identification of costs of goods held in inventory, primarily with a view to match the cost of goods sold against the revenue derived during an accounting period.

R EVIEW 5.1.1
Question 1 of 2 Which of the following is not classified as inventory in the financial statements?

A. Finished goods B. Work-in-process C. Raw-materials and components D. Advance payments made to suppliers for raw materials

Check Answer

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Section 2

Flow of Inventory Costs

Here, we outline how raw material costs flow through as a part of work in process to finished goods. Materials: Various items of materials are issued from a storage area to the production facilities for conversion into goods. Materials used is thus the sum of all materials issued during the period. For determining the cost of materials used, the periodic method may be used. That is, the assumption is made that the amount of materials used is the difference between the materials available for use during the period (the total of the beginning inventory and the periods net purchases) and the ending inventory. Material used becomes a part of work in process along with manufacturing costs accumulated to form cost of goods manufactured. Cost of Production: Cost of production is the sum of Materials used, direct labor and other manufacturing costs. The cost of goods

Source:www.s182059091.onlinehome.us

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manufactured is the balancing figure obtained by adding to the opening work-in-process inventory, the materials used and other manufacturing expenses and then deducting the closing work in process inventory. Other manufacturing expenses include all other expenditure involved directly for production. Cost of Goods Sold: Ultimately the goods transferred to finished goods inventory account are sold and appear as sales. The cost of goods sold is obtained by adding the cost of production to the opening inventory of finished goods and then subtracting the closing finished goods inventory. From the finished goods inventory the cost of goods sold is transferred to the cost of goods sold inventory account and the cost of goods sold inventory account is closed by transferring the same to income and expenditure account or profit and loss account.
Video 5.2.1: Cost flow of Inventory

R EVIEW 5.2.1
Question 1 of 2 The cost of goods sold is equal to

A. Total purchases minus total sales B. Opening stock plus total purchases C. Opening stock plus total purchases minus closing stock + Direct Costs D. Closing stock plus total purchases

Check Answer

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Section 3

Principal Methods of Inventory Costing

There are four major methods of inventory Costing: 1. Specific Identification method: This method concentrates on the physical identification and linking of the particular items sold. This method provides a great latitude for measuring result at any given point of time. An obvious way to Video 5.3.1: account for Inventory Demonstration inventory through this method is via physical observation or the labeling of items in stock with individual numbers or codes. Such an approach is easy and economically justifiable for relatively expensive merchandise like diamond jewelry. However, most organizations have vast segments of inventories that are too numerous and insufficiently valuable per unit to warrant such individualized attention. Specific identification requires the linkage of individual inventory items with the exact purchase costs of each unit. This kind of identification is practically impossible for vast inventories. Hence the specific identification method

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continues to be largely confined to expensive individualized merchandise. Its major drawback in many cases is its expense. Moreover, many critics claim that income measurements first concern should not be with physical flows but with the economic flows.
Source:www.2.bp.blogspot.com H o w e v e r, t h i s m e t h o d permits management to manipulate income and inventory values by filling a sales order from a number of physically equivalent items bearing various inventory cost prices.

Suppose a trader purchased the following units during the month of March. March, 2 March, 5 March, 7 March, 11 March, 18 March, 21 March, 25 210 units 150 units 135 units 220 units 70 units 310 units 115 units

2. First-In First-Out (FIFO): This method assumes that the goods purchased first or manufactured first are issued/sold first. That is the goods issued or sold currently are those which represent the earliest purchases amongst the goods held in inventory. This would mean that the goods which remain in stock after the sales are those which represent the most recent purchases. The same is explained under: Example:

Let us also assume that he sold the following units of goods from the inventory during March.

March 1-500 units at the rate of Rs.120/unit March 10-300 units at the rate of Rs.105/unit March 15-250 units at the rate of Rs.100/unit March 20-350 units at the rate of Rs.125/unit If FIFO method of valuation were to be applied the cost of goods issued or sold out of inventory would be as follows:
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Adherents of FIFO maintain that it is the most practical way to describe what operating managers actually do. That is, most managers deliberately attempt to move their merchandise on a first-in, first-out basis. This approach avoids spoilage, and obsolescence. Thus the inventory flow assumption underlying FIFO corresponds most closely with the actual physical flows of inventory items in most businesses. Furthermore, the asset balance for inventories is a close approximation of the actual rupees invested, because the inventory is carried at the most recent purchase prices paid. Such prices are not likely to differ much from current prices at the balance sheet date. Consequently, its proponents maintain that FIFO properly meets the objectives of both the income statement and the balance sheet. Critics of FIFO claim that FIFO increases profits. They claim that FIFO based income is deceiving in the sense that some of the corresponding increase in net assets is merely an inventory profit. That is, an inventory profit is fictitious because for a going concern, part of it is needed for replenishing the inventory. Video 5.3.2: Consequently, it is not profit in the Methods of inventory costlaypersons sense of the term; it ing does not indicate an amount that is entirely available to pay dividends. 3. Last-In First-Out (LIFO): This method is just the opposite of FIFO Method. This method assumes that the goods issued or sold out of the inventory are the

ones most recently purchased or manufactured. Therefore, the goods held in stock represent the earliest purchases or produced. If LIFO method is applied for valuing inventory instead of FIFO in the earlier example, the effect would be as under:

Advocates of LIFO point out that there will not be any inventory profit if LIFO is followed. They also stress that in times of rising prices there may be greater pressure from shareholders to pay unjustified higher cash dividends under FIFO than LIFO. Critics of LIFO point to absurd balance sheet valuations. Under LIFO, older and older prices, and hence less-useful inventory values, are reported, especially if physical stocks grow through the years. LIFO companies can offset this criticism to some extent by disclosing FIFO inventory values in a footnote to the financial statement. Another criticism of LIFO is that, unlike FIFO, it permits management to influence immediate net income by the timing of purchases. For instance, if prices are rising and a company desires, for income tax or other reasons, to report less income in a given year, managers may be inclined to buy a large amount of inventory near the end of the year, that is, to accelerate the
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replacement of inventory that would normally not occur until early in the next year. 4. Weighted Average Method: This method assumes that all inventory available are best represented by a weighted average cost. The average cost of goods held in inventory is recalculated every time a fresh purchase is made and goods issued or sold out of inventory are priced at such average price till such time as the next lot is purchased. If this method in valuing Inventory in the earlier example is applied, the effect would be as under:

them to even out the erratic movements in the purchase prices to the best extent possible. For valuation of inventory according to standards issued by ICAI, see below http://220.227.16

1.86/243as_2new. Valuation of Inventories pdf

Keynote 5.3.1: Illustrations

Video 5.3.3: FIFO vs LIFO vs Wt.Average

The weighted average method produces given profit somewhere between that obtained under FIFO and LIFO. Advocates of this method feel that the smoothing of purchase costs achieved by the weighted average method enable
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R EVIEW 5.3.1 Question 1 of 4 Which of the following methods for stock valuation for normal inventory is recommended by AS-2?

A. FIFO Method B. LIFO Method C. Weighted Average Method D. Both (a) and (c)

Check Answer

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Section 4

Perpetual and Periodic Inventory Systems

There are two systems of maintaining Inventory Records: 1. 2. Perpetual Periodic of an accounting period, or any other reporting period decided upon when a physical count of inventory is taken. The cost of goods purchased is accumulated by recording the individual purchase transactions throughout any given reporting period, such as a year. The accountant computes the cost of goods sold by subtracting the ending inventories (determined by the physical count) from the sum of the opening inventory plus Source:www.smallbusiness.chron.com purchases. The periodic system computes cost of goods sold as a residual amount. First, the beginning inventory is added to the purchases to obtain the total cost of goods available for sale. Then the ending inventory is counted and its cost is deducted from the cost of goods available for sale to obtain the cost of goods sold. That is:

The perpetual inventory system keeps a running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis. Such a record facilitates managerial control and the preparation of interim financial statements. However, physical inventory counts should be taken at least once a year to check the accuracy of the clerical records. The periodic inventory system, unlike perpetual inventory system, does not involve a day-to-day record of inventories or of the cost of goods sold. Instead the cost of goods sold and an updated inventory balance are computed only at the end

Video 5.4.1: Perpetual Inventory System

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Amount in Rs. Beginning Inventory Purchases Cost of goods available for sale! Less : Ending Inventory! Cost of goods sold 4,00,000 5,00,000 9,00,000 2,50,000 6,50,000

surprises can be avoided if managers keep a closer watch on inventories, instead of depending on periodic systems. On the flip side, though the perpetual system is comparatively more accurate, it is quite expensive. The periodic system is less accurate, especially for monthly or quarterly statements, but it is less costly because there is no day-to-day data Video 5.4.2: FIFO Perpetual processing regarding cost of goods sold. However, if theft or the accumulation of obsolete merchandise is likely, periodic systems often prove to be more expensive in the long run.

Physical count of inventory is a must whether perpetual or periodic inventory systems is followed. Such a count is necessary for calculating the cost of goods sold in a periodic inventory system. However, it can be just as important in a perpetual system, providing a check on the accuracy of the inventory records. Suppose, on physically counting the inventory the quantum differs from the perpetual inventory amount reflected in records the gap maybe due to pilferage or incorrect recording etc, which calls for attention. Suitability of perpetual and periodic system depends on the relative costs and benefits of each. Perpetual systems are becoming more popular because they increase managements control over operations and also because their dataprocessing costs have dropped substantially. Computers and optical scanning equipment have become more versatile and less costly. Small enterprises favor the periodic inventory system. As businesses grow and become more complex, perpetual inventory systems are installed. Given, many unhappy

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R EVIEW 5.4.1
Question 1 of 3 Jojo Ltd. uses a periodic inventory system. The beginning inventory was Rs.50,000 and yearend inventory was Rs.60,000. Purchase of goods and sales during the year were Rs.2,00,000 and Rs.3,00,000 respectively. The companys cost of goods sold during the year is

A. Rs.2,00,000 B. Rs.1,90,000 C. Rs.1,50,000 D. Rs.1,40,000

Check Answer

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Section 5

Valuation of Inventory

Inventory constitutes substantial part of the assets of a business entity. Hence the value you put against it has significant impact on the working results and financial p o s i t i o n o f t h e e n t i t y. Inventories are valued at the lower of cost and net realizable value. The cost of inventories should comprise
Source:www.img.ehowcdn.com

all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. While the costs of conversion of inventories include costs directly related to the units of production, such as direct labor. They also include a

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systematic allocation of variable and fixed (based on the normal capacity of the production facilities) production overheads that are incurred in converting materials into finished goods. The cost of inventories specifically excludes: a. Abnormal amounts of wasted materials, labor, or other production costs; b. Storage costs, unless those costs are necessary in the production process prior to a further production stage; c. Administrative overheads that do not contribute to bringing the inventories to their present location and condition; and d. Selling and distribution costs. In the Retail trade, the retail method is often used to measure inventory cost. The cost of the inventory is determined by reducing the appropriate percentage gross margin from the sales value of the inventory. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Inventories are usually written down to net realizable value on an item-by-item basis. In some circumstances, however, it may be appropriate to group similar or related items. In United States, inventories are valued at lower of cost and market value. The term market means current replacement cost, whether by purchase or by reproduction, but is limited to

the following maximum and minimum amounts: i.

Video 5.5.1: lower of Cost or Market Value

Maximum: The estimated selling price less any costs of completion and disposal, referred to as net realizable value. The purpose of maximum is to prevent a loss in future periods by at least valuing the inventory at its estimated selling price less costs of completion and disposal.

ii. Minimum: Net realizable value less an allowance for normal profit. The purpose of minimum prevents any future periods from realizing any more than a normal profit. The practice of writing down inventories below cost to net realizable value is consistent with the view that assets should not be carried in excess of amounts expected to be realized from their sale or use. When the utility of the goods in the ordinary course of business is no longer as great as their cost, a departure from the cost principle of measuring the inventory is required. Whether the cause is obsolescence, physical deterioration, changes in price levels, or any other, the difference should be recognized by a charge to income in the current period.

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Additional resources to this chapter: Gallery

Video 5.5.2: Inventory Management

R EVIEW 5.5.1 Question 1 of 3 Recent developments have made much of a companys inventory obsolete. This obsolete inventory should be

http://search.proquest. Current practices com/business/docview/ in inventory valua199152773/1362A09B5 tion 4D1012DDFC/10?accou ntid=38647

http://search.proquest.c Inventory valuation om/business/docview/1 for investors LIFO 99142497/1362A09B54 and FIFO D1012DDFC/19?account id=38647

A. Written down to zero or its scrap value. B. Shown in the balance sheet at its replacement cost. C. Shown in the balance sheet at cost, but classified as a non-current asset. D. Carried in the accounting records at cost until it is sold.

http://search.proquest.c A review of the efom/business/docview/1 fects of LIFO valua99142497/1362A09B54 tion upon D1012DDFC/19?account profits id=38647

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C HAPTER 6

Accounting for Fixed Assets

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INTRODUCTION Fixed assets are assets held with an intention to use them for the production or manufacturing of goods or providing of services and are not held for resale in the normal course of business. These are also referred to as long-lived assets. Long-lived assets refer to those assets whose economic benefits last for a number of future periods as opposed to revenue expenditure whose economic benefits exhaust within a year. The provisions of GAAP regarding these assets involve the determination of the appropriate cost at which the asset is to be recorded, appropriate method to be used to allocate that cost over the periods, the measurement of impairment losses and accounting for assets to be disposed off. These assets are primarily operational assets which can be segregated into two basic types tangible and intangible assets. Tangible assets are those assets which have physical existence and substance and are categorized as: Depreciable assets, depeletable assets and other tangible assets. Intangible assets have no physical existence but their value is recorded in the Financial Statement. They are: patents, goodwill, trademarks, rights, grants, privileges to the business enterprise, etc. OBJECTIVES After going through this chapter, you should be able to: Determine the Cost of Fixed Assets.

Explain the Concept of Depreciation and Methods of Providing Depreciation. Account for the Acquisition of Fixed Assets and Depreciation. Analyze the Implications of Change in the Method of Depreciation.

Video 6.1: Assets

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Section 1

Acquisition of Fixed Assets and Determination of Cost

Video 6.1.1: Learn Accounting: Fixed Asset

All fixed assets are shown in the books of accounts of the business enterprise at their cost of acquisition or construction. In addition to acquisition costs, it is conventional to capitalize all other costs necessary to bring the asset to a state where it is ready to operate or to provide the services envisaged. This is because, the benefits of such

expenditure are expected in the future years and the costs are treated as assets hence such expenditures are capitalized. For example, The cost price of land includes the purchase price, broker s commission, legal fees and the cost of grading or of tearing down existing structures so as to make the land ready for its intended use.

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The cost includes: i. Amount paid at the date of acquisition.

Video 6.1.2: Cost Assignment to Fixed Assets

ii. N o r m a l e x p e n d i t u r e incurred to put the asset ready for use. Examples: Installation cost, Wage cost, etc. iii. Improvement expenditures, on depreciable assets to the extent it goes to increase the capacity, operating efficiency, utility or extend the useful life of the assets, if they are substantial, are capitalized. Minor expenditures usually are treated as period costs, though of capital nature. Cost of fixed assets can be those incurred at the time of acquisition and costs incurred subsequent to the initial acquisition. The initial acquisition costs of fixed assets include the purchase price and reasonable cost involved in bringing the asset to the buyer and costs incurred prior to using the asset in actual production. Such costs are to be capitalized. Examples include sales taxes, finders fees, freight costs, installation costs, breaking-in-costs and set-up costs. These costs are to be added to the cost of the fixed assets and capitalized and therefore should not be expensed in the period in which they are incurred. Self-Constructed Assets

These refer to the depreciable assets constructed by the business for its own use. All direct costs of labor, materials and variable overhead of constructing an entitys own fixed assets should be capitalized. However, a controversy exists regarding the proper treatment of fixed overhead. Two different views are: i. Charge the asset with its fair share of fixed overhead, i.e., use the same basis of allocation used for inventory.

ii. Charge the fixed asset account with only the identifiable incremental amount of fixed overhead. Basket Purchases Sometimes an entity acquires in one transaction several capital assets. This is called a basket purchase. The company must divide the baskets cost between the categories on some reasonable basis. Usually this requires an appraisal of the relative value of each asset included in the basket purchase. Such a separation is always required when land and a building are purchased in a single transaction; this is because the building will subsequently be depreciated, whereas the land will remain on the books at its cost. A separation may also be necessary if the capital assets in the basket have different useful lives, because they will be depreciated at different rates. However, the distinction between expenditures that are capitalized and expenditures that are expensed as period costs is not entirely clear-cut. Some borderline cases are described below.
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LOW-COST-ITEMS In accordance with the materiality concept, items that have a low unit cost, such as hand tools, are charged immediately as expenses even though they m a y h a v e a l o n g l i f e . Source:www.static.tumblr.com Nevertheless, the capitalized cost of a new facility may include the cost of the initial outfit of small items that do not individually meet the criteria for capitalization. Examples are the initial outfits of small tools in a factory, books in a library and tableware and kitchen utensils in a restaurant. When these items are replaced, the cost of the replacement items is charged as an expense, but not capitalized. BETTERMENTS Repairs and maintenance are work done to keep an asset in good operating condition or to bring it back to good operating condition if it has broken down. Repair and maintenance costs are ordinarily period costs; they are not added to the capitalized cost of the asset. A betterment is added to the cost of the asset. The distinction between maintenance expenses and betterments is that the maintenance keeps the asset in good condition but in no better condition than when it was purchased; a betterment makes the asset better than when it was purchased or extends its useful life beyond the original estimate. REPLACEMENTS

Replacements may be either assets or expenses, depending on how the asset unit is defined. The replacement of an

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entire asset results in the writing off of the old asset and the recording of the new asset. The replacement of a component part of an asset is maintenance expense. For example, assume that one company treats a complete airplane as a single asset unit and another company treats the airframe as one unit and the engines as another. The replacement of an engine results in a maintenance charge in the first company and in a new asset in the second. In general, the broader the definition of the asset unit, the greater will be the amount of costs charged as maintenance and, hence, expensed in the year the replacement parts are installed. To conclude, the governing principle is that the cost of an item such as property, plant, or equipment includes all expenditures that are necessary to make the asset ready for its intended use.

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Reference Material Accounting standard issued by the ICAI

Accounting for Fixed Assets

R EVIEW 6.1.1 Question 1 of 3 The cost of Self constructed Assets is taken as

Keynote 6.1.1: Illustration

A. Prime cost + Indirect cost B. Construction cost + Interest cost on funds borrowed C. Cost that relates directly to specific assets and those that are attributable and can be allocated to that specific asset D. Construction cost + interest on borrowings - loss due to strike

Check Answer

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Section 2

Depreciation

Video 6.2.1: Depreciation Concept

A provision is created in a companys account towards depreciation to account for the wear and tear of its assets caused by usage, passage of time, technological obsolescence, etc. Depreciation is the acquisition cost of an asset (less the expected salvage value) spread over its economic life. The purpose of charging depreciation

over the economic life of the asset is to match the cost of the asset over the period for which revenue is earned by using the asset. DEPRECIATION METHODS There are mainly four methods which are widely used for calculating the depreciation expenditure, i.e., the value of the fixed assets, its useful economic life and the salvage value.

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1. Straight-line method; 2. Declining balance method (also called Reducing balance method or Written down value method); 3. Sum-of-the-years digits method; and 4. Units-of-production method. Straight-line Method Under the straight-line method, the net acquisition cost or construction cost is charged off in equal proportion during Video 6.2.2: Methods of Depreciation the useful economic life and the quantum of the depreciation is arrived at by dividing the net acquisition or construction cost by the number of years of useful economic life. The net acquisition or construction cost is calculated by deducting salvage value from the acquisition or construction cost.
Asset Value Salvage Value Estimated useful life (in no. of years)

life is 8 years, the annual depreciation would be = Rs.10,000 or 10% per annum. This method has the following advantages: 1. The calculation is relatively simple; and 2. It realistically matches cost and revenue. Diminishing Balance Method Under the diminishing balance method, also known as reducing or declining balance or written down value method, the depreciation charged off during the year is deducted from the cost of the asset at the beginning of the accounting period and the Source:www.forum4finance.com balance is known as the book value or written down value (WDV). Thus depreciation is charged at a specified rate on the original cost of the asset in the first year and on book value or written down value of the previous year from 2nd year onwards. For example.

Depreciation =

For example, if the cost of an asset is Rs.1,00,000, the expected salvage value is Rs.20,000 and the estimated useful

At the end of the 1st year, the depreciation is calculated by applying the rate to the original cost. Then the written down
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value is arrived at by deducting the depreciation so arrived at from the original cost. At the end of the 2nd year, the depreciation rate is applied to the written down value at the end of the 1st year. This depreciation amount is again deducted to arrive at the written down value at the end of the 2nd year. In the above mentioned asset the depreciation calculations, say for next 6 years, will be as follows:

risk of obsolescence by concentrating the major part of the depreciation in the early years of the life of the asset. It equalizes the expenses of depreciation and repair charges taken together. It is assumed that repairs are the lowest in the initial years and higher in the later years; the depreciation under this method is higher in the initial years, but lower in the later years. Sum-of-the-Years Digits Method The sum-of-the-years digits method is an accelerated method of depreciation that provides higher depreciation expenses in the early years and lower charges in later years. To find the sum-of-the-years digits, the digit of each year is progressively numbered and then added up. For example, the sum-of-the-years digits for a five-year life would be: 5 + 4 + 3 + 2 + 1 = 15 The sum of the years digits becomes the denominator, and the digit of the highest year becomes the first numerator. For example, the first years depreciation for a five-year life would be 5/15 of the depreciable base of the asset, the second years depreciation would be 4/15 and so on.
Video 6.2.4: Sum of digits method

The following are the advantages of Diminishing Balance Method: It matches the service of the asset in the sense that higher depreciation is charged in the initial years, when the machine is most efficient compared to later years. It recognizes the
Video 6.2.3: Reducing Balance Depreciation

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Total depreciation Units-of-Production Method The depreciation rate under this method is acquisition or construction cost (i.e. Video 6.2.5: acquisition or costs minus Straight line method vs salvage value) divided by the Units of production method estimated number of units that are likely to be produced during its useful economic life. This rate is then applied to the number of units produced during an accounting period to determine the depreciation to be provided during that period. For example. A machine is purchased at a cost of $850,000 and has a salvage value of $100,000. It is estimated that the machine has a useful life of 75,000 hours.

Example: A machinery costing $11,000 has a salvage value of $1,000 and an estimated useful life of four years. The first step is to determine the depreciable base: Cost asset Less: Salvage value Depreciable base The sum of the years digits for four years is: 4 + 3 + 2 + 1 = 10 The first years depreciation is 4/10, the second years 3/10, the third years 2/10 and the fourth years 1/10 as follows: 4/10 of $10,000 3/10 of $10,000 2/10 of $10,000 1/10 of $10,000 = = = = $4,000 $11,000 1,000

3,000 2,000 1,000

In an accounting period during which the machine was used for 12,500 hours, depreciation would be $125,000 (12,500 x $10).

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The units-of-production method is used in situations in which the usage of the depreciable asset varies considerably from period to period and in those circumstances in which the service life is more a function of use than passage of time. RECORDING DEPRECIATION Assume that Tina Chemicals purchased a Machinery for Rs 1,00,000 on April 1, 2008 with an estimated life of 10 years and zero residual value. The company decided to depreciate the machinery on a straight-line basis, i.e., Rs.10,000 per year. Lets see how this amount of depreciation should be recorded. It would be possible to reduce the asset value by Rs. 10,000 a year and show on the balance sheet only the remaining amount. Thus on 31st March 2009, the Machinery will appear in the balance sheet at Rs. 90,000 (1,00,000-10,000), on 31st March 2010 at Rs. 80,000 (90,000-10,000), on 31st March 2011 at Rs. 70,000 ( 80,000-10,000) and so on. However, this is not ordinarily done. Instead, the amount of depreciation is accumulated every year and the amount of accumulated depreciation is deducted from the original cost of the assets at the end of every year. Thus as far as the net amount shown in the balance sheet for the given asset is concerned, it would remain the same. Thus on 31st March 2009, the Machinery will appear in the balance sheet at Rs. 90,000 (1,00,000-10,000), on 31st March 2010 at Rs. 80,000 (1,00,000-20,000), on 31st March 2011 at Rs. 70,000 (1,00,000-30,000) and so on.

CHANGE IN THE METHOD OF DEPRECIATION The depreciation that is charged under the straight line method remains the same every year, however, under the WDV method it reduces gradually. This gives rise to variations in the depreciation charges calculated as per the two different methods. For instance, let us assume that the following particulars relate to an asset X: Original Cost, as on 1st April 2010 = Rs.10,000 Salvage Value = Rs.1,000 Useful Life = 2 years Depreciation percentage as per diminishing balance method = 68.35% Depreciation as per straight line method = 10,000-1000/2 = Rs.4,500 per annum The company has decided to follow diminishing balance method and the Accounting period is 1st April to 31st March. Suppose on April 1, 2011 the company decides to change the method of depreciation from diminishing balance method to straight line method. What would happen? The book value of asset X as on 1st April 2011 would be 10,000 - 6835 = 3165

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If you change the method from diminishing balance to straight line method, the book value of asset X as on 1st April 2011 should be 10,000 - 4500 = 5500 Thus the book value of the asset would increase by Rs 2335 (5500-3165). If we put it in the basic accounting equation, we observe increase in the asset side of the equation, but no change in the liabilities of the firm. Therefore, the owners equity has to increase, which means the profit of Rs.2335. DISPOSAL OF FIXED ASSETS If a fixed asset is sold before the end of its useful life, then both its original cost and its accumulated depreciation should be removed from the accounts. The profit or loss on such disposal should be accounted for in the books of accounts. Example: Let us: a. Calculate the provision for depreciation of plant and machinery for the year ended 31st December, 2010. b. Prepare a statement showing Plant and Machinery and accumulated depreciation as at 31st December, 2010. c. Prepare a statement showing effect of disposal of Plant and Machinery on Gross Value of Plant and Machinery, Accumulated Depreciation and Profit /Loss . The data for this purpose is as follows:

A companys plant and machinery account on December 31, 2009 and the corresponding depreciation provision account, broken down by year of purchase are as follows: Year of Purchase
1993 1999 2000 2001 2008 2009

Plant and machinery at cost

70,000 1,05,000 3,50,000 2,45,000 1,75,000 1,05,000 10,50,000

Depreciation provision
70,000 1,05,000 3,32,500 2,08,250 26,250 5,250 7,47,250

Depreciation is at the rate of 10% per annum on cost. It is the companys policy to assume that all purchase, sales or disposal of plant occurred on 30th June in the relevant year for the purpose of calculating depreciation, irrespective of the precise date on which these events occurred. During 2010 the following transaction took place: 1. Purchase of plant and machinery for Rs.5,25,000. 2. Plant that had been bought in 1999 for Rs.59,500 was scrapped.

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3. Plant that had been bought in 2000 for Rs.31,500 was sold for Rs.1,750. 4. Plant that had been bought in 2001 for Rs.84,000 was sold for Rs.5,250. Solution a. Calculation of provision for depreciation of plant for the year ended 31st December, 2010. Year of purchase of plant
1993 1999 2000 1/2 year at 10% on 84,000 - 4,200 2001 1year at 10% on 1,61,000 - 16.100 2008 2009 2010 10% on 1,75,000 10% on 1,05,000 1/2 year at 10% on 5,25,000 17,500 10,500 26,250 92,050 20,300

Year of purchase
1993 1999 2000 2001 2008 2009

Cost
70,000 45,500 3,18,000 1,61,000 1,75,000 1,05,000 5,25,000 14,00,000

Depreciation
70,000 45,500 3,18,500 1,52,950 43,750 15,750 26,250 6,72,700

Workings

Depreciation (RS)
nil nil 17,500

2010

c. Statement showing effect of disposal of Plant & Machinery Account 2010. Plant and Machinery = 10,50,000 (opening balance) + 5,25,000 (purchase) 1,75,000 (disposal/sale) = 14,00,000 Accumulated Depreciation = Opening + additions (depreciation during the year) - deductions (disposal/sale) = 7,47,250 + 92,050 1,66,600 = 6,72,700
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b. Plant and Machinery and Accumulated Depreciation as at 31st December, 2010.

Reference Material Profit/(Loss) = Sale of Assets Net Book Value of the asset at the time of sale ( Cost - Accumulated Depreciation) = 7000 {(59500-59500) + (31500 -31500) + (84000-75600)} =7000 - 8400 = (1400) Partial-Year Depreciation When an asset is placed in service during the year, the depreciation expense is taken only for the portion of the year that the asset is used. For example, if an asset (of a company on a calendar-year basis) is placed in service on July 1, only six months depreciation is taken. Depletion is the process of allocating the cost of a natural resource over its estimated useful life in a manner similar to depreciation. An estimate is made of the amount of natural resources to be extracted, in units or tons, barrels, or any other measurement. The estimate of total recoverable units is then divided into the total cost of the asset to arrive at a depletion rate per unit. The annual depletion expense is the rate per unit times the number of units extracted during the fiscal year. If at any time there is a revision of the estimated number of units that are expected to be extracted, a new unit rate is computed. The cost of the natural resource property is reduced each year by the amount of the depletion expense for the year. This process is similar to the units-of-production depreciation explained earlier.
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Accounting standard issued by the ICAI Depreciation http://220.227.161.8 Accounting 6/248as6new.pdf

R EVIEW 6.2 .1 Question 1 of 8 Snigdha Industries depreciates its machinery at 10% p.a. on straight-line basis. On April 01, 2009 the balance in the machinery account of the firm was Rs.8,50,000 (original cost Rs.12,00,000). On July 01, 2009 a new machine was purchased for Rs.25,000. On December 31, 2009, an old machine having a written down value of Rs.40,000, as on April 01, 2009 (original cost Rs.60,000) was sold for Rs.30,000. The balance sheet will show machinery at Rs .......... as on March 31, 2010

A. Rs.7,19,125 B. Rs.7,91,500 C. Rs.7,92,125 D. Rs.7,18,500

Check Answer

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Section 3

Intangible Assets
Intangible Assets
Video: 6.3.1 Intangible Assets

goodwill copyrights customer database mortgage servicing rights fishing licenses franchises marketing rights Any perceived improvement in brand equity, corporate image from an advertising or publicity campaign Knowledge gained from research activities

Dictionary meaning of the adjective intangible is lacking substance or reality; incapable of being touched or seen; incapable of being perceived by the senses especially the sense of touch. Intangible assets thus mean assets which have no physical presence, nevertheless are of economic value, sometimes more than all tangible assets taken together, to the business entity. From the above definition of intangible assets, the items that easily come to mind are: Patents

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Please note that though the above items can be perfectly valid examples of intangible assets from a laymans point of view, not all will qualify as so when the tests of accepted accounting principles and criteria are applied to them, as we will discuss in subsequent paragraphs. AMORTIZATION Amortization is the systematic allocation of the depreciable amount of an intangible asset over its useful life. Depreciable amount is the cost of an asset less its residual value. Useful life is either: a. The period of time over which an asset is expected to be used by the enterprise; or b. The number of production or similar units expected to be obtained from the asset by the enterprise. Residual value is the amount which an enterprise expects to obtain for an asset at the end of its useful life after deducting the expected costs of disposal. Amortization Period The depreciable amount of an intangible asset should be allocated on a systematic basis over the best estimate of its useful life. There is a rebuttable presumption that the useful life of an intangible asset will not exceed ten years from the date when the asset is available for use. Amortization should commence when the asset is available for use.

Factors which need to be considered for determining the useful life of an intangible asset include: a. The expected usage of the asset by the enterprise; b. Typical product life cycles for the asset and public information on estimates of useful lives of similar types of assets that are used in a similar way; c. Technical, technological or other types of obsolescence; d. The stability of the industry in which the asset operates and changes in the market demand for the products or services output from the asset; e. Expected actions by competitors or potential competitors; f. The level of maintenance expenditure required to obtain the expected future economic benefits from the asset and the companys ability and intent to reach such a level;

g. The period of control over the asset and legal or similar limits on the use of the asset, such as the expiry dates of related leases; and h. whether the useful life of the asset is dependent on the useful life of other assets of the enterprise. Given the history of rapid changes in technology, computer software and many other intangible assets are susceptible to technological obsolescence. Therefore, it is likely that their useful life will be short.

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In some cases, there may be persuasive evidence that the useful life of an intangible asset will be a specific period longer than ten years. In these cases, the enterprise amortizes the intangible asset over the best estimate of its useful life. Reference Material - (in ICAI logo)

http://220.227.1 Intangible Assets 61.86/270accou nting_standards _as26new.pdf

Additional resources to this chapter: Gallery
Video 6.3.2: Asset Exchange Video 6.3.3: Asset Impairment

Video 6.3.4: Natural Resources as Asset

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C HAPTER 7

Cash Flow Statement

Source:www.tutor2u.net

INTRODUCTION Cash Flow Statement provides information regarding the cash inflows and outflows of an organization during a particular period. It provides a valuable analytical tool along with the financial statements. The economic decisions that have to be taken by users of financial statements include, to a large extent, an estimation of the cash and cash equivalents that the organization may generate and the timing and certainty of such a generation. This is regardless of the enterprises activities and irrespective of whether cash Source:www.iamaceo.com can be viewed as the product of the enterprise, as may be the case with a financial enterprise. In many senses it is a narrower definition of the term Funds. In a broader sense, it means the net working capital of the company, and in its narrow sense, the word conveys the meaning of cash and its equivalents, excluding all other current items. Profit and liquidity for a normal firm preparing its accounts on the accrual basis does not mean the same thing. A firm may be highly profitable but may find itself with hardly any cash or working capital to continue the operating cycle, alternatively a heavily loss making firm may find itself flush with funds. Only in case of a firm that prepares its accounts on the cash basis will find its profits and cash flow to be the same. This is the reason for preparing the cash flow statement to understand a

firms actual requirements of cash and cash equivalents. In this unit, we shall deal with the objectives of preparation of Cash Flow Statement, how it is constructed and what each section of the cash flow signifies. OBJECTIVES

Video 7.1: Evaluation of Cash flows

After going through the unit, you should be able to: Explain the Meaning of Cash Flows, Cash Flows from Operating, Financial and Investing Activities; Discuss the objectives of the preparation of Cash Flow Statements; Differentiate between Funds Flow and Cash Flow Statements; and Prepare Cash Flow Statements as per Accounting Standard - 3.

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Section 1

Operating Activities
NEED FOR CASH FLOW STATEMENT The basic objective of a cash flow statement is to provide relevant information about cash inflows and outflows of an enterprise during the accounting period. The cash flow statements help investors, creditors and analysts to: Assess a companys ability to generate cash flows from operations in the future. Assess its ability to meet its obligations, any requirement of external financing and to pay dividends to shareholder. Analyze the reasons for the difference between the net profit and cash flows. Analyze the effects on the organizations financial position its cash and non-cash investing and financing activities. Cash and Cash Equivalents Cash and Cash equipments are defined as follows in AS-3:

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Cash comprises cash on hand and demand deposits with banks. Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent, it must be readily convertible into a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. Investments in shares are excluded from cash equivalents unless they are, in substance, cash equivalents; for example, preference shares of a company acquired shortly before their specified redemption date (provided there is only an insignificant risk of failure of the company to repay the amount at maturity). TYPES OF CASH FLOWS Cash Flow Statement explains the flow of cash under three different heads. These are: i. Cash Flow from Operating Activities;

Investing Activities; and iii. Cash Flow from Financing Activities. Operating Activities may be described as the principal revenue producing activities of the enterprise and other activities that are not investing or financing [as per AS-3 and IAS-7]. These activities are what may be described as the cash that is generated or used in the core business of the entity. Generally, there are two ways in which Cash Flow from Operating Activities can be calculated: Direct Method, whereby major classes of gross cash receipts and gross cash payments are disclosed. Under the direct method, information about major classes of gross cash receipts and gross cash payments may be obtained either: a. From the accounting records of the enterprise; or b. By adjusting sales, cost of sales (interest and similar income and interest expense and similar charges for a financial enterprise) and other items in the statement of profit and loss for:

Video 7.1.1: Direct Method

ii. Cash Flow from

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i.

Changes during the period in inventories and operating receivables and payables;

the statement of profit and loss and the changes during the period in inventories and operating receivables and payables. Under the indirect method, net profit is adjusted for the following: i. Non-cash items: These include depreciation, loss/profit on sale of assets, goodwill written off, etc. Net Profit for the Year Add: Non-cash expenses Depreciation Goodwill written off Loss on sale of assets Provision for taxation Shares discount written off Less: Non-cash incomes Profit on sale of assets, etc. Net Profit after adjustment of Non-cash items ii. Current assets and current liabilities related to operating activities: This includes debtors, bills receivable, stock, creditors, bills payable, prepaid expenses, outstanding expenses, etc.

ii. Other non-cash items; and iii. Other items for which the cash effects are investing or financing cash flows. Indirect Method: In this method, net profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments and items of income or expense associated with investing or financing cash flows.
Video 7.1.2: Indirect Method

The net cash flow from operating activities is determined by adjusting net profit or loss for the effects of: Changes during the period in inventories and operating receivables and payables; Non-cash items such as depreciation, provisions, deferred taxes and unrealized foreign exchange gains and losses; and All other items for which the cash effects are investing or financing cash flows. Alternatively, the net cash flow from operating activities may be presented under the indirect method by showing the operating revenues and expenses excluding non-cash items disclosed in

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Net Profit (after adjustment of Non-cash items) Add: Decrease in Current Assets (Other than cash and cash equivalents); Increase in Current Liabilities Less: Increase in Current Assets (Other than cash and cash equivalents); Decrease in Current Liabilities. The following illustration will explain the concept clearly (also see Appendix I to the Accounting Standard 3, reproduced at the end of the chapter.) Illustration 1 Determine the cash flow from operating activities from the Profit and Loss Account and additional information given below. Profit and Loss Account for the year ended 31st March, 2011. Items
Debtors Bills receivable Creditors Outstanding Expenses 2010 10,000 10,000 16,000 2,500 2011 16,000 6,000 15,000 1,500

Solution

Other Information:
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R EVIEW 7.1 .1 Question 1 of 4 The primary purpose of a statement of cash flows is to provide relevant information about

A. An enterprises ability to meet cash operating needs. B. An enterprises ability to generate future positive net cash flows. C. The cash receipts and cash disbursements of an enterprise during a period. D. Difference between net income and associated cash receipts and disbursements.

Check Answer

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Section 2

Investing Activities

Video 7.2.1: Investing activities detailed

Investing Activities pertain to acquisition and disposal of long-term assets and other investments not included in cash equivalents [as per AS-3 and IAS-7]. An analysis of cash flows from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources

intended to generate future income and cash flows. The following are some of the elements of investing activities as described by Para 15 of AS-3 and Para 16 of IAS-7:

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Description of Investing Cash Flows as per AS-3, Para 15

Description of Investing Cash Flows as per IAS-7, Para 16

Cash payments to acquire property, plant and equipment, 1. Cash payments for acquisitions of fixed assets including intangibles and other long-term assets including payments for intangibles. development costs that are capitalized and self-constructed property, plant and equipment. 2. Cash receipts from disposal of fixed assets. Cash receipts from sale of property, plant and equipment, intangibles and other long-term assets.

3. Cash payments to acquire shares, warrants or debt Cash payments for acquisition of equity and debt instruments instruments of other enterprises or interest in joint ventures of other enterprises and interests in joint ventures. (excluding those held for trading or dealing purposes or This does not include an item covered in cash equivalents. which are cash equivalents).
4. Cash receipts from disposal of shares, warrants and debt Cash receipts from sale of equity and debt instruments of

instruments of other enterprises and interest in joint other enterprises and interests in joint ventures. ventures (excluding those held for trading or dealing This does not include an item covered in cash equivalents. purposes or which are cash equivalents).

5. Cash advances and loans made to third parties (excluding Cash advances and loans made to other parties (excluding loans, etc. made by financial institutions in ordinary course loans, etc. made by financial institutions in ordinary course of of business which is operating cash flow). business which is operating cash flow). 6. Cash receipts from repayments of advances and loans Cash receipts from advances and loans made to other parties made to third parties (excluding loans, etc. made by (excluding loans, etc. made by financial institutions in financial institutions in ordinary course of business which is ordinary course of business which is operating cash flow). operating cash flow).

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Notes: Description of Investing Cash Flows as per AS-3, Para 15

7. Cash payments for futures,

Description of Investing Cash Flows as per IAS-7, Para 16

i.

In item (1), AS-3 does not talk about capitalized expenditure like expenses during construction period and portion of operating expenses that are allocated to self-constructed assets.

swaps, forward and option contracts (excluding, contracts held for dealing Same as AS-3. or trading purposes which are classified as financing activities). 8. Cash receipts for futures, swaps, forward and option contracts (excluding, contracts held for dealing Same as AS-3. or trading purposes which are classified as financing activities).

ii. In items (3) and (4), IAS-7 is much less specific than AS-3.

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R EVIEW 7.2 .1
Question 1 of 4 A company acquired a building, paying a portion of the purchase price in cash and issuing a mortgage note payable to the seller for the balance. In a statement of cash flows what amount is included in investing activities for the above transaction?

A. Cash payment B. Acquisition price C. Zero D. Mortgage amount

Check Answer

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Section 3

Financing Activities

Financing Activities are activities that result in changes in the size and composition of the owners capital (including preference share capital) and the borrowings of the enterprise [AS-3]. IAS-7, however, states that financing activities are activities that result in the changes in the size and composition of the equity capital and borrowings of the

enterprise [emphasis added]. AS-3 specifically includes preferred capital. Some of the elements of investing activities as described by Para 17 of AS-3 and Para 17 of IAS-7 are provided in the accompanying table. They account for cash flows generated from issue of shares, issue of debentures, loans raised, redemption of

Source:www.lh4.ggpht.com
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debentures, repayment of loans, etc. Redemption of shares and repayment of borrowings result in an outflow of cash. Thus inflows and outflows related to the a m o u n t o f c a p i t a l a n d Source:www.investorsareidiots.com borrowings of the enterprise are shown under this head and the net effect of these investing activities is determined. A disclosure of the cash from financing activities helps in predicting the claims of the providers of finance on the future cash flows of the company. In the case of enterprises other than Financial enterprises, cash flows arising from interest paid should be classified as cash flows from financing activities while interest and dividends received should be classified as cash flows from investing activities. Dividends paid should be classified as cash flows from financing activities.

Illustration: You are the Senior Accounts Officer of Little Flower Ltd. The Comparative Balance sheet as on March 31, 2010 and March 31, 2011 and the Income Statement for the Financial year 2010-11 are given below: Little Flower Ltd.s Comparative Balance Sheets December 31, 2003 and 2002

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Income Statement for the Financial year 2010-11

vii. The company issued 75,000 common stock of Rs.10 each. viii. Cash dividends paid during 2010-11 amount to Rs.40,000. You are required to Prepare a Statement of Cash Flow (using indirect method) for the period ended March 31, 2011.

Additional Information: i. During the period 2010-11, Little Ltd. purchased investments amounting to Rs.3,90,000.

ii. The book value of the investments sold was Rs.4,50,000. iii. During the period, plant amounting to Rs.6,00,000 were purchased. iv. A machinery costing Rs.50,000 with accumulated depreciation of Rs.10,000 was sold for Rs.25,000. v. On March 31, 2011, Little Ltd. issued bonds of Rs.5,00,000 at face value in exchange for a plant. vi. The company repaid Rs.2,50,000 worth of bonds at face value on maturity.
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Little Flower Ltd. Statement of Cash Flows for year ended December 31, 2011

Reference material: Accounting Standard issued by ICAI

ICAI http://220.227. 161.86/244as3_ allnew.pdf

http://www.iasb.org/N IFRS R/rdonlyres/CB22235 8-B86E-44D5-A047-22 9EA40C1FA8/0/IAS7.

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R EVIEW 7.3 .1
Question 1 of 5 Net cash provided by operating activities was

A. Rs.1,160,000 B. Rs.1,040,000 C. Rs.9,20,000 D. Rs.7,05,000

Check Answer

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C HAPTER 8

The Annual Report

Source:www.thp.org

INTRODUCTION An Annual Report consists of various contents which represent a companys performance during the previous year, managements discussion of the companys strategy for the future, etc. An annual report is one of the most important documents a company produces and is often the first document someone consults when researching a company. It reports how the companies fare financially and often explains the scope of its business mission and management philosophy. It is an important communication that a companys annual report provides to the investor and analyst. A public company produces an annual report for its stakeholders - shareholders, owners, creditors, analysts, regulators, etc. Other interested parties such as customers and potential investors too read this report. OBJECTIVES After going through this chapter, you should be able to: Understand the significance of Annual Reports; List down the contents of Annual Reports and the significance of each component; Describe the qualities required to make the Financial Statements more useful; and Describe the disclosure practices that increase transparency, understandability of Financial Information of a company.
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Section 1

Understanding Annual Report

Need for Financial Accounting System All businesses maintain a financial accounting system with the objective to track all the economic transactions that the business undertakes and record them logically in a data base. The major purposes basically are: Providing information which in turn becomes the basis for exercising

decisions and actions by the potential users. Reflecting the financial progress and present health of the business. Aiding in the formulation of policies and procedures for the smooth and efficient conduct of the business. Enabling the management to discharge their obligations and

Source:www.davidgreb.com

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stewardship functions effectively. Earlier, there was no distinction between the ownership and the management and was concerned only with providing information to the owners. But with their separation and an increasing emphasis on the business being managed by qualified and competent professionals, the role and the purpose of financial accounting has undergone a paradigm shift to that of stewardship, thereby highlighting the accountability aspect of managing the enterprise. The cause of the new orientation is the increasing reliance by the interested entities such as stakeholders, investors, trade creditors, employees, customers, statutory authorities like Income tax and Excise departments, the Government and other agencies. They do not have any participation in the management of the affairs of the organization and as such collect the required information from the financial statements. Such interests displayed by a varied group of constituents necessitate the presentation of a true and fair portrayal of the financial conduct of the business. This has underscored the need for developing accounting concepts, principles and standards to ensure that accounting information serves the needs of various users. Regulatory requirements In India, Companies incorporated under the Companies Act of 1956 are required to keep proper books and records that reflect the true and fair view of the companys business affairs. Also, to impart credibility to the reported financial statements, these are required to be attested by professional accountants who perform the task of auditing (which involves examination

and verification) before expressing their opinions on the financial statements. Auditors are required to present a report o n t h e c o m p a n y s accounts to its shareholders. Companies whose sales exceed Rs.4 million are also required to undergo a tax audit. Tax audit matters are governed by the Income Tax Act.
Source:www.outlookindia.com

Annual reports are widely distributed to shareholders and are provided to domestic researchers upon request. The Annual report of the company is also generally available at the website of the company or any other websites which provide the information about the company. Company secretaries are responsible for responding to inquiries by investors. In India, The Accounting Standard Board of ICAI conducts research and develops accounting standards taking into consideration the related laws, the business environment, business practices and other reasonable factors that would depict a true and fair view of corporate financial reporting. But the Global companies have problems because national accounting differs from country to country. In this context, there is a great need of a reporting system which is capable of delivering uniform data worldwide for management purpose and for the investor, while also providing potential and different data in each country to suit the local tax requirements. There is a major effort to codify a set of accounting principles that
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would apply internationally; over 40 statements known as International Accounting Standards (IAS) have been published by the International Accounting Standards Committee (IASC) - now recognized as the International Accounting Standard Board (IASB) - located in London, England. The standards issued by the IASB are known as International Financial Reporting Standards (IFRS). Purpose of Annual Report The basic objective of creating and distributing annual reports is to: Present an overview of a company, managements discussion of its preceding year performance and its plans for the future. Report the companys financial performance for the previous year and compare it with its performances in the prior years. Fulfill part of its obligations for public financial reporting as mandated by regulatory authorities. Apart from these annual reports often include a visual representation of key financial indicators and performance highlights of a company. This allows management to effectively showcase some selected aspects
Video 8.1.1: Why Annual Reports

of the companys performance. However, an annual report is only one of the many possible sources of information for making informed investment decisions.Other sources include business press, investment analysts reports, company press releases, industry association reports, etc.

R EVIEW 8.1 .1
Question 1 of 3 The purpose of Financial Accounting Systems is

A. To provide information for decisionmaking. B. To report the financial progress and health of the company. C. To aid in formulating policies and procedures for smooth and efficient conduct of business. D. All of the above.

Check Answer

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Section 2

Contents of an Annual Report

Video 8.2.1: Key Sections of an Annual Report

The contents of an Annual report differ from company to company. While most annual reports contain optional elements, all reports contain information the primary securities regulatory body requires. Optional elements include:

Financial highlights Letter to stockholders Corporate message Board of Directors and management Stockholder information.

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Primary Securities Regulatory Body in most countries, including India, requires annual reports to contain the following information: Income Statement Balance Sheet Cash Flow Statement Statement of Accounting Policies Auditors Report Management Discussion and Analysis Notes to the Accounts Selected Financial Data Financial Highlights The section on Financial Highlights offers a quick summary of a companys financial performance. The figures appear in short tables, usually accompanied by supporting graphs. The section also highlights other important indicators such as rise/ decline in a firms consolidated revenues, earnings per share and cumulative dividend growth. Letter to Stockholders This letter may be from the Chairperson of the Board of Directors, the Chief Executive Officer, or both. It can provide an analysis and a play-by-play review of the years events, including any problems/issues and successes the company

had. It usually reflects the business philosophy and management style of a firms companys executives and often lays out direction for the firm for the next financial year. Stakeholders refer to all the people with an interest in the success and activities of a firm. This includes everyone from share owners and employees to members of the communities in which the company maintains operations. The notion of stakeholders reflects the impact firms have beyond their share owners. The section - Letter to stockholders - in annual reports of several multinational companies, operating in India, generally discusses various revenues as per the US GAAP and the Indian GAAP and their expected growth of earning based on the economic forecast and the business environment. It also forewarns of any impending risks/challenges the company might face in the forthcoming fiscal which could have adverse impacts on the firms financial performance and the remedial measures the top management has already put in place or intends to take. Corporate Message While some analysts, business executives and stockholders consider this message as an advertisement for the company others find it more useful. Nonetheless, it almost always reflects how a company sees itself or how it would like others to see it. A firm can use this section to communicate effectively about its operational/focus areas, the various business segments it operates in, markets, its mission, management philosophy, corporate culture and strategic direction, among others.
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Board of Directors and Management This list gives the names and position titles of the companys Board of Directors and the top management team. Stockholder Information

Video 8.2.2: Board of Directors Role

of company affairs, Amount proposed to be carried forward to reserves, amount recommended as dividends , any material changes and commitments affecting the financial position of the company which have occurred between the end of financial year and the date of report. It shall include Directors Responsibility statement compliance of accounting standards consistency in accounting policy reasonable estimates adherence to going concern responsibility for maintenance of proper record in compliance with Statutory requirements responsibility to safeguard assets responsibility to prevent and detect frauds and other irregularities. The Report captures the duty of directors to give the fullest information and explanation to every qualification, remarks of auditors in the Auditors Report. The Directors report reports the name of employees who draw more than Rs.25 lacs per annum. Chairmans Statement Corporate annual reports generally begin with a statement from the CEO and the chairperson. The statement is generally an overview of the company's year, and may detail the highlights of the year, how the company is handling or overcoming challenges and a statement about the future of the company.
Video 8.2.3: Chairmans statement

This information covers the basics the companys corporate office headquarters, the exchanges on which the companys stocks are listed and traded, the location and the time of the next annual s t o c k h o l d e r s m e e t i n g , o t h e r general stockholder service information, etc. Stockholder Source:www.lh6.ggpht.com information is usually given at the back of the annual report. Directors Report Directors Report can be said as the Responsibility and Accountability statement of the management towards the owners. is an annual score card of the management of the company of their performance as reflected by the accountability of the company to its owners. It is Responsibility and Accountability Report card to owners. The companies Act clearly lays down the requirements of a company shall attach to the Balance Sheet a Report by the Board of Directors. The Directors Report in speaks of the state

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This letter may be from the Chairperson of the Board of Directors, the Chief Executive Officer, or both. It can provide an analysis and a play-by-play review of the years events, including any problems, issues, and successes the company had. It usually reflects the business philosophy and management style of the companys executives, and often it lays out the companys direction for the next year. Financial Statement

Balance Sheet Income Statement (Profit and Loss Account) Statement of Cash flow Statement of Stakeholders equity Footnotes Contingencies Supplementary Schedule Schedules to the Balance Sheet, Profit and Loss Account and Cash Flow Schedules to the balance sheet present assets, liabilities and shareholders equity what the firm owns and what it owes to creditors and owners at a particular date, generally at the end of the year. Schedules to the profit and loss account show the result of a break-up of a firms operation, i.e., break-up of revenues and expenses and other sources of income and expenditure. The Schedules to the cash flow statement provide information about sources and uses of cash during the accounting period, category-wise, as follows: Net cash provided (or used) by operating activities. Net cash provided (or used) by investing activities. Net cash provided (or used) by financing activities. Fixed Assets

Video 8.2.4: Financials in Annual Report

The most important section in a corporate annual report is the basic set of financial statement. Financial statements present a summary of the financial situation of a firm based on the total sales and expenses (statement of earnings), assets, liabilities and share owners equity (statement of financial position) and the flow of cash in and out of the company (statement of cash flows). These statements help analysts determine the financial health of a company. The sectional also offers information about the following - whether the company has sufficient cash flow to keep operating successfully; whether the cash flow position of the company improves or deteriorates over time; whether the liabilities (monies owed) are less (exceed) relative to the assets (things owned); whether the company is profitable and whether the profitability increases or decreases over time. Financial statement consists of the following:

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This schedule provides the break-up of assets, i.e., assets purchased/sold, types of assets, etc. This section provides information about the actual investment in fixed assets. Investments Under this schedule, the company provides the break-up of investment. Investor can get information like how much investment of the company is in a particular company and how much of this is in traded securities, etc. Deferred Tax Assets Deferred tax assets result from (temporary) difference between the recognition of revenue and expense for taxation purposes and the reported income. Sundry Debtors Sundry debtors are the customer balance outstanding on the credit sales. This schedule provides the break-up of sundry debtors - which is good and which is doubtful - and also the provisions during the year. Cash and Bank Balances In this schedule, the break-up of cash and bank balance is provided, i.e., bank deposit in various banks and cash in hand. Loans and Advances Under this category, information regarding loans and advances (good and doubtful), advances to subsidiary

companies under the same management, advance income tax, loans and advances to employee etc., is provided. Current Liabilities and Provisions Current liabilities are divided into sundry creditors, various provisions and outstanding expenses. Expenses Expenses of a company are generally subdivided into various categories like selling and distribution, administrative expenses, general expenses, etc. Some companies also give break-ups of major expenses in the profit and loss account. For example, Infosys provides in the schedule, the break-up value of software development expenses, which are major expenses incurred by any software company. Significant Accounting Policies Under this head, a company generally provides the brief discussion of its accounting policy. In India, financial statements are prepared in accordance with the I n d i a n G e n e r a l l y A c c e p t e d Source:www.perfectinfo.com Accounting Principles (GAAP) under the historical cost convention on the accruals basis. GAAP comprises mandatory accounting standards issued by the Institute of Chartered Accountants of India (ICAI) and the provisions of the Companies Act, 1956. These accounting policies have
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been consistently applied, except for recently issued accounting standards made mandatory by the ICAI. However, some companies also provide statements in the US GAAP and their reconciliation with the Indian GAAP. Notes on Accounts The Notes on Accounts are an statement and are also major following table includes some of companies generally provide integral part of the financial disclosure materials. The the notes on accounts that in their annual reports.

Auditors Report This summary of the findings of an independent firm of certified public accountants shows whether the financial statements are complete, reasonable and consistent with the Generally Accepted Accounting Principles (GAAP) at a set time. There are four types of Source:www.media.freeola.com auditor opinions Unqualified opinion, qualified opinion, adverse opinion and disclaimer of opinion. In unqualified opinion, auditors present fairly a companys financial performance and position. When an auditor gives an opinion subject to certain reservation, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statement reflects a true and fair view subject to certain reservations. A qualification should always be preceded by the word subject to. Adverse opinion does not present fairly a companys financial performance and position. When an auditor is insufficient in scope to render an opinion, this opinion is called disclaimer of opinion. Some situation of unqualified opinion such as consistency departure due to change in accounting policies, contingency item and the items that effect the business risk of the company may be shown as additional information.

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Management Discussion and Analysis This series of short, detailed reports discusses and analyzes a companys performance. It covers results of operations and the adequacy of liquid and capital resources to fund operations of the companys future plans. This section can be a valuable tool in Source:www.imimg.com evaluating a company because it contains some quantitative information that may not be covered in the financial statement of the company. The Management Discussion and Analysis (MD&A) section provides an opportunity to the company management to analyze the companys performance through a series of discussion points like: Operations Financial Resources and Liquidity Selected Financial Data Critical Accounting Policies Deferred tax assets Detailed discussion on net profit Sundry debtors Sundry creditors Cash and cash equivalents

Loans and advances Current liabilities Unearned revenue Provisions Segregation of income and expenses Disclosure of debt Depreciation and amortization Provision for investment Stock option plans Risk Management Report The report lists out various risk management activities taken up by the management in respect of certain key risks facing the company. This report contains statements which are forwardlooking in nature. Such statements are subject to uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. The report also discusses the remedial measures taken by the company to minimize these risks. The risk management report generally covers the following risks/areas: Risk management structure Risk management framework Macro economic factors
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 Competition Concentration of revenues Service offerings Clients Industry Geography Political environment Organizational management Finance Exchange rates movement Liquidity Regulatory and legal compliance Contractual Commitments Statutory compliance Conformity with the local laws Intellectual property Immigration System and process Leadership development

Human resource management Process and project management Internal control system Security and business continuity Shareholder Information Information about corporate strategies and plans are increasingly communicated via the annual reports. In order to enhance the quality of reporting, a number of new financial and Source:www.gsk.com operational measures of performance (such as economic value added, value of human resources, etc.) have been reported by some blue chip companies including Dr. Reddys Labs and GE capital. Under Shareholder information head, Infosys Technologies discloses the following information: Frequently asked questions Share performance chart Intangible assets score sheet Human resources accounting and value-added statement Brand valuation
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 Balance sheet (including intangible assets) Current-cost-adjusted financial statements Economic Value-Added (EVA) statement Ratio analysis Statutory obligations Value Reporting Management structure Additional Resources:
Video 8.2.5: Corporate Governance

R EVIEW 8.2 .1
Question 1 of 6 The auditor of a company gives a report that the financial statements of the company reflect a true and fair view subject to certain reservations. Such a report is known as

A. Clean report B. Qualified opinion C. Unqualified opinion D. Provisional report subject to issue of final report

Check Answer

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Section 3

Quality of Financial Reporting

A good financial statement should reflect the clear picture of the company. The financial statement should be useful in both assessing the past performance as well as in predicting the future performance.

Information should be in a clearly understandable manner. Some of the important issues in Financial Reporting are discussed hereunder:

Source:www.images.betterworldbooks.com

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Accounting Policies and Estimates Choice and Changes In preparing financial statement, Video 8.3.1: the management makes choices Accounting Policies with respect to accounting policies and makes estimations in the application of those policies. Any change in application of accounting principles from one fiscal to another may affect the profit of the company. Companies must report material effects on their income when they adopt new accounting standards or change from one accounting method to another. In most cases, when a change in accounting methods is made, the income that has been reported differs from that which would have been reported in earlier periods if the new method had been used. The cumulative effect of the accounting change on income of earlier periods is reported in the income statement. An accounting change is reported as a separate item on the income statement, net of taxes. This reporting requirement calls attention to the change. Remember that consistency is an important characteristic of accounting methods. A company should not change accounting methods unless that change is justified by the companys economic circumstances or the need to adopt a new accounting standard. A change in accounting method generally alters the way income or expense is calculated. Net income computed using a particular accounting method in one year is not comparable with income computed

using a different method in the next year. Accordingly, companies must disclose the effects of the changes and restate, when possible, previous financial statement amounts that are affected by the change so that they are comparable to those reported in the current year. A change in accounting method is different from a change in accounting estimate. Many transactions require a company to make estimates. Timing of Revenue and Expense Recognition One of the important accounting principles that provides the foundation for preparing financial statement is the matching principle. To assess maintainable income, one needs the information to be presented using the matching concept. Indian GAAP states that one cannot recognize income or expenses unless the related assets or liabilities can be recognized. There are many instances where expenses incurred in the current year, which relate to revenue to be generated in a future year, cannot be capitalized because of the constraints contained in the definition of an asset, for example, advertising expenses. There are also many instances where expenses should be accounted in a year but could not because of the constraints contained in the definition of a liability, for example, costs of collecting debtors provided for in the selling price of the goods. Let us assume the selling price and cost per product are Rs.10 and Rs.6 respectively, depending upon whether the sale is recognized at production or dispatch or collection, the revenue would be Rs.90, or Rs.70 or Rs.50 respectively. Further, the cost of good sold under the three situations will be Rs.54, Rs. 42, and Rs.30 respectively. Thus it is clear that the cost
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derives its relevance only from the sale and not vice-versa. It is for this reason that revenue recognition always precedes the matching of cost. If revenue for sale is not defined, the cost cannot be defined either. In recent years the accounting practices of many companies have been in question and in some cases shareholders have filed lawsuits as a result of alleged abuses in financial reporting. Discretionary Items The financial analyst should carefully scrutinize managements policies with respect to these discretionary items through examination of trend in expenditure and compare it with Industry competitors. Expenditure made by a company consists of many discretionary items in nature. Discretionary items are mainly of the following types: Research and Development: Research and development cost is one of the major types of discretionary items and the most difficult to analyze for the purpose of earnings analysis. The main issue in the research and development cost is its successful completion. There are a number of examples of successful completion of research activity in several areas and at the same time there are numerous failures as also. The failure of research results means forgoing the benefits availed against earlier expenses. So, there is a need to carefully analyze the quality of the research and development such as caliber of staff and organization reputation of its leaders, historical result and its commercial applicability. Analysts should carefully analyze how the investment was applied for research and development activities by the company in question.

Repair and Maintenance: Repair and maintenance cost is another item for disclosure in a quality financial statement. Analysts should carefully analyze the trend in repair and maintenance cost. The main purpose of this analysis is to determine whether repairs and maintenance are at normal levels or have risen abnormally, thereby hurting the earnings of the company. A good financial reporting system should disclose the trend in repair and maintenance cost in terms of index number. Advertising and Marketing: Advertisement cost is defined as the cost incurred by a firm to promote its product(s) in the market. Advertisement cost is fluctuating in nature; also, there is a weak relation between the outlay (cost incurred) and shortterm returns. Companies like Coke and Pepsi invest consistently in advertisement without consideration of shortterm profits. Some companies may spend too much initially for promoting their products. Analysts must look at year-to-year variation in advertising costs incurred by a company to assess their impact on its future sales and earnings quality. Non-recurring and Non-operating Items: Financial analysts need to analyze non-recurring items such as restructuring and impairment charges to estimate economic-value-added earnings. These earnings should be used to estimate a more accurate measure of a firms intrinsic value. There might be revenues and expenses, but which are not directly related to a companys primary operating activities. These are reported separately. The item listed in this category most often is interest expense. Borrowing money frequently is necessary for an organizations operations; however, except for
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financial institutions, it is not part of its primary operating activities. Accordingly, other expenses and revenues are reported in the income statement after operating income. This separate listing distinguishes them from revenues and expenses that result from operating activities. The revenues and expenses described so far Video 8.3.2: Non-recurring are common to most items and non-core activicorporations. ties O c c a s i o n a l l y, h o w e v e r, companies must account for special revenues and expenses. Those special items are reported separately from other items and require special disclosure as they affect net income during the current fiscal period; though they will not affect net income in future periods. Analyst should evaluate special items differently from activities that are expected to affect income in future periods, especially when forecasting income. There are three types of special items: discontinued operations, extraordinary items and accounting changes. A company expects to derive income from its continuing operations in future years. In contrast, discontinued operations are product lines or segments from which a company will no longer derive income because it has sold or closed (or is in the process of selling or closing) that product line or segment of its operations. Discontinued operations differ in size and type of

activity from restructuring, which are reported as operating revenues or expenses. Discontinued operations involve large segments of a companys operations, such as a major product line or geographic region. Discontinued operations are rare events because a company cannot close many major segments and remain in business. A gain or loss from the sale or closing of a discontinued operation is reported in the income statement net of income taxes. Like the gain or loss from discontinued operations, the related income tax effect is a onetime event. Publicity Aspect of Reporting Several accounting scandals all over the world, notably the dramatic collapse of the US energy giant Enron, have prompted investors to demand greater transparency in corporate reporting. Given, companies are responding by expanding their annual reports. However, every company has its own unique disclosure challenges. Multinational companies face a different challenge in presenting financial statement. In addition to statutory and contractual requirements, an MNC has obligation to publish annual report because of its economic importance, overseas listings, etc. These obligations are usually very stringent. Misleading information may cause suspicion to the investor and he may not invest or can demand higher return for money invested. Disclosure by MNCs should meaningfully communicate, through the annual report, to FIIs, customers, suppliers and venture-partners on how the

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company is maximizing value for their shareholders and various other stakeholders. Other areas of increased disclosures include retirementrelated benefits, global financing, non-recurring events and trends. For example, the annual report provides information about the combined impact of all retirement-related benefit plans (pension, 401(k) and retiree medical plans) and the related assumptions, including a comparison of historical and expected rates of return. The section on global financing includes a graph of assets and debt to show how most of the companys debt is used and the notes to the consolidated financial statements include expanded disclosures about such items as workforce rebalancing charges and equity writedowns. Some annual reports also contain a road map at the beginning of the MD&A to help the reader easily find the information he or she is searching for in this section. Though accounting policies differ from country to country, most of the accounting rules remain the same all over the world; although they might vary from country to country in terms of depth or levels. Also within the country, there may be different types of disclosure norms that vary from sector to sector. For example: accounting in the private sector is generally different from that in the public sector. Basically, private sector accounting is concerned with measuring profit and source of finance for an enterprise while a public sector accounting focuses on the source of fund like the government subsidies and the government aids and its way of expenditure. Standard of reporting mainly depends on the user of the financial statement.

Additional Reading Materials

http://www.infosys.co Infosys Annual m/investors/reports-fil Report(2010ings/annual-report/an 11) nual/Documents/AR-2 011/index.html

AS 1 Disclosure of http://220.22 Accounting 7.161.86/242 Policies as_1new.pdf

AS 4 Contingencies http://220.22 and Events Occurring after the Bal7.161.86/245 ance Sheet as4new.pdf Date

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Others
AS 29 Provisions, Contingent` Liabilities and Contingent Assets

AS 5 Net Prot or Loss for http://220.227.1 the period,Prior Period 61.86/247accoun Items and ting_standards_ Changes in Accounting Policiesas5new.pdf

http://220.2 27.161.86/27 3as29new.pd

http://www.ia splus.com/en/ standards/stan http://www.ias plus.com/en/st andards/standa
Additional resources to this chapter
Video 8.3.3: Changes in Corporate Reporting
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

http://220.227.16 AS 17 Segment Reporting1.86/260accounti ng_standards_as1 7new.pdf

IAS 1 Presentation of Financial Statements

http://220.227.16 AS 21 Consolidated Financial 1.86/265accounti Statements ng_standards_as 21new.pdf

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R EVIEW 8.3 .1
Question 1 of 3 Incomes that are not normally arising from the usual operations of the firm are referred to as

A. Extraordinary Items B. Discretionary Items C. Non-recurring Items D. Non-Cash Items

Check Answer

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C HAPTER 9

Marginal Costing and CVP Analysis

Source:www.upload.wikimedia.org

INTRODUCTION Managers are continuously involved in monitoring various operations in an organization. Their need to ascertain past revenues, forecast future revenues, estimate precise costs and estimate profits of the organization to enhance their decision-making ability cannot be overemphasized. Cost Volume - Profit (CVP) analysis helps managers to make optimal decisions, identify the steps needed to avoid losses, the activity levels to be reached to achieve targeted profits, all of which result in improved organizational performance and mitigation of losses and risks. OBJECTIVES After going through this chapter, you should be able to: Differentiate between Marginal Costing and Absorption Costing; State the features of Marginal Costing and Absorption Costing; Determine the significance of CVP Analysis; Compute the Break Even Point and Margin of Safety; Apply CVP Analysis for decision-making, taking account of key limiting factors in the organization.

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Section 1

Marginal Costing and Absorption Costing

Video 9.1.1: Absorption Costing Explained

There are two main techniques for estimating product cost and profit. They are: (a) Absorption Costing (b) Marginal Costing ABSORPTION COSTING Absorption costing is a cost accounting method of charging all direct costs and all production costs of an organization to specific units

of production. Absorption costing is also known as Total Cost Method, Traditional Method, Conventional method, or Cost-plus method. Absorption costing is an approach to product costing, wherein the total cost is considered. The product cost comprises of both fixed and variable cost. In absorption costing most of the fixed cost is treated as part of product

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cost and inventory values are arrived at accordingly. Merits of Absorption Costing The following are the merits of absorption costing: a. Under absorption costing all costs should be charged to units manufactured. Thus price based on absorption costing ensures that all costs are covered. b. It helps to confirm accrual and matching concepts which require matching costs with revenue for a particular period. c. It makes calculation of gross profit and net profit separately in income statement possible. d. It discloses the efficient or inefficient utilization of production resources by indicating under-absorption or overabsorption of factory overheads. e. This method has been recognized by various bodies like FASB (USA), ASC (UK), ASB (India) for the purpose of preparing external reports and for the valuation of inventory. MARGINAL COSTING. It is also known as variable costing or direct costing. This technique takes into consideration only the variable costs as product cost. Under this method, the fixed manufacturing costs are considered as period cost and charged directly to P&L Account. According to CIMA (Chartered Institute of Management Accountants), London, Marginal Costing is the

ascertainment of marginal costs and the effect on profit of changes in volume or type of output by differentiating
Keynote 9.1.1: Meaning of Fixed cost, Variable cost, Marginal cost and Contributions

between fixed cost and variable cost. Important Concepts Features of Marginal Costing The important features of marginal costing are as follows: i. All the costs are classified into fixed and variable costs. Variable cost varies according to the level of activity, but per unit variable cost remains fixed. Fixed cost is fixed at any level of activity.
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ii. Under marginal costing, the fixed cost is treated as period cost and variable cost is treated as product cost. iii. Inventories are valued at marginal cost. iv. When marginal costing is used in process costing, the products are transferred from process to process at marginal cost. v. The product is priced on the basis of marginal cost and contribution. vi. The profitability of products and divisions are determined on the basis of contribution margin. vii. Under marginal costing, the importance will be given to total contribution and contribution from each product while presenting the data. viii. There is no effect of differences in the amount of opening stock and closing stock on unit cost of production in marginal costing. Advantages of Marginal Costing Marginal Costing has the following advantages: i. Marginal costing, by separating the costs into fixed and variable costs, exercises effective control over it and also facilitates responsibility-oriented control.

product line, aids the management in taking appropriate decisions. iii. It leads to greater accuracies in calculation of profits as the valuation of closing stock of finished goods and work-inprogress are easy and simple. iv. The data presented is more reliable and more acceptable, as it excludes the fixed cost and also avoids allocation and apportionment. Usually the fixed costs are not allocated and apportioned on scientific basis. v. The cost information presented under marginal costing is simpler, meaningful and an effective aid to the management for decision-making. Limitations of Marginal Costing Some of the important limitations of marginal costing are as follows: i.

Video 9.1.2: Limitation of Marginal Costing

ii. Marginal costing, by analyzing the cost data and showing the variable cost and contribution for each product and

Separation of all expenses into fixed and variable is practically difficult, because neither the variable cost is absolutely variable nor the fixed expenses are absolutely fixed. This problem of classification becomes more complicated with the presence of semivariable and semi-fixed expenses.
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ii. Time factor is not given due importance in marginal costing and all those expenses connected to time are excluded. Therefore, the pricing decision based on marginal costing is useful for short run but not for the long run. The long run decisions are based on total cost and not on variable cost alone. iii. Marginal cost understates the stock of finished goods and work-in-progress because of which the Balance Sheet does not exhibit the true and fair view. iv. As the closing stock is valued at variable cost under marginal costing technique, the full loss on account of goods destroyed cannot be recovered from the insurance company. v. The other cost techniques such as budgetary control and standard costing can achieve better control when Video 9.1.3: Marginal Costcompared to marginal ing vs Absorption Costing costing, as marginal costing deals with cost behavior but it does not provide any standard for evaluation of performance. vi. It fails to reveal the impact of change of manufacturing practice, for example, replacement of labor force by machine.

DIFFERENCE BETWEEN ABSORPTION COSTING AND MARGINAL COSTING The following are the main points of difference between the absorption costing and marginal costing: i. Under marginal costing, the distinction between the period cost and product cost determines when costs are matched with revenues. Direct or variable or product costs are assigned to products and matched with revenues when they are recognized while period costs are matched with revenues in the period in which the costs are incurred. But in absorption costing, fixed costs are treated as part of production cost and accordingly inventory is valued.

ii. In absorption costing, arbitrary apportionment of fixed costs over the products results in under-absorption or overabsorption of such cost, whereas, in marginal costing since fixed costs are excluded, there is no under-absorption or over-absorption of overheads. iii. In absorption costing, managerial decision-making is based on profit, which is the difference between the sales value and the total cost of the product. But in marginal costing, the managerial decisions are based on contribution and not profit. Contribution is the difference between the sales value and the marginal cost of the product.

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R EVIEW 9.1 .1
Question 1 of 5 The method of costing that leads itself to breakeven analysis is

A. Standard Costing B. Marginal Costing C. Absorption Costing D. Absolute Costing

Check Answer

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Section 2

Cost-Volume-Profit Analysis

Video 9.2.1: CVP Relationship

Cost-Volume-Profit (CVP) analysis studies the relationship of cost, volume and profit. These three factors are interrelated. The cost of the product determines its selling price and selling price determines the profit. According to CIMA, London, CVP analysis is the study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix. This is the most important technique,

which is used in managerial decision-making and profit planning. This technique summarizes the effects of changes in an organizations volume of activity on its costs, revenue and profit. CVP analysis can be extended to cover the effects on profit of changes in selling prices, service fees, costs, income tax rates and the organizations mix of products or services. It provides management with a

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comprehensive overview of the effects on revenue and costs of all kinds of short run financial changes. Although, the word profit appears in the term, CVP analysis is not confined to profit-seeking enterprises alone. Managers in non-profit organizations also routinely use CVP analysis to examine the effects of activity and other short run changes on revenue and costs. It is being used as a regular organizational tool. In CVP analysis, it is necessary that expenses should be categorized according to their cost behavior, i.e., fixed or variable. Mathematical relationship between cost-volume-profit requires the understanding of the marginal cost equation. Marginal Cost Equation Sales Revenue = Variable Cost + Fixed Expenses Loss [S = V + F P] (or) Sales Revenue Variable Cost = Fixed Expenses Loss [S V = F + P] (or) Profit/ Profit /

CONTRIBUTION/SALES RATIO OR P/V RATIO Profit/volume ratio establishes the relationship between contribution and sales. P/V ratio shows the profitability of the organization. Hence organizations can improve their P/V ratio without an increase in fixed cost. P/V ratio can be increased or improved by taking any of the following steps: By increasing the sales price or selling price per unit. By reducing the variable or marginal cost and ensuring the efficient utilization of men, material and machines. By changing the sales mix. It means selling those products more which have higher P/V values. The Profit/volume ratio is expressed in percentage. It is expressed in the following ways:

Sales Revenue Variable cost = Contribution Margin [S V = C] In order to understand the mathematical relationship between cost, volume and profit, it is desirable to understand the following concepts, their calculation and application: a. Contribution/Sales (C/S) or Profit Volume (P/V) Ratio b. Break-even Point c. Margin of Safety Desired sales, variable cost and contribution can be found out with the help of P/V Ratio. The formulae are as follows:
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Desired Sales = Desired Contribution/P/V Ratio (or) = (Fixed Cost + Desired Profit) / P/V Ratio Variable Cost = Sales (1 P/V ratio) Contribution = Sales x P/V Ratio THE BREAK-EVEN POINT A break-even point is a point at which a firm earns no profit and does not bear any loss. It is a point at which the total sales are equal to total costs. A breakeven point is calculated with the help of the following formula:
Video 9.2.2: Computation of BEP

Margin of Safety: Break-even analysis can also be used to answer the question - How low can the sales fall before the firm will begin to incur losses?

Video 9.2.3: Break Even Analysis

Scale of Operations: An important decision is to decide the scale of operations of a firm. In practical terms, this would mean deciding upon the capacity of the firm to produce and sell its products. Changes in Underlying Factors: Break-even analysis can also be used to study the effects of changes in underlying factors at the Break-even Point and Margin of Safety.
Video 9.2.4: Break Even Charts

Usefulness of Break Even Analysis Prediction: Break-even Analysis is useful in predicting what sales volume has to be achieved in order to start earning profits. For example, in the above case sales should be at least 40,000 units or Rs.4 lakh before the firm starts earning profit.

MARGIN OF SAFETY Margin of safety is the difference between the actual sales and the sales at the break-even point or, the excess of actual sales over the break-even sales. Margin of safety can also be expressed in percentage.
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The formula for calculating the margin of safety is: Margin of safety = Actual Sales Break-even Sales

Keynote 9.2.1 Illustrative Problems with Solutions

Margin of safety measures the soundness of the business. If the margin of safety is high, it indicates the concerns strength, while a low margin of safety indicates the weakness of the concern. So, in order to earn more profits, efforts should be made by the management to increase the margin of safety. The following steps increase or improve the margin of safety: i.

Video 9.2.5: Margin of Safety

Comprehensive Illustration The sales and profits during the two periods are given as follows: Years 2010 2011 Calculate i. P/V Ratio, Sales (in Rs.) Profit (in Rs.) 20,00,000 30,00,000 2,00,000 4,00,000

Increase the level of production or selling price or both.

ii. Reduce the fixed cost or variable cost or both. iii. Substitute the existing unprofitable product with the profitable ones. iv. Change the sales mix in order to increase the contribution.

ii. Fixed Cost, iii. Break-even Point,

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iv. Sales to earn a profit of Rs.5,00,000, v. Profit when sales are Rs.40,00,000, vi. Margin of safety at a profit of Rs.4,50,000, vii. Variable cost in 2005. Solution i. P/V Ratio = Rs.35,00,000. iv. Sales required to earn a profit of Rs.5,00,000

v. Profit when sales is Rs.40,00,000 Contribution = Sales x P/V Ratio = Rs.40,00,000 x 20% = Rs.8,00,000

ii. Fixed Expenses Since the P/V Ratio is 20%, the Variable Cost will be 80% (i.e. 100 20) of sales. Variable Cost = 80% of Rs.20,00,000 = Rs.16,00,000 We know that S V =F+P

Profit = Contribution Fixed Cost = Rs.8,00,000 Rs.2,00,000 = Rs.6,00,000 vi. Margin of Safety at a profit of Rs.4,50,000

Therefore, Fixed Cost = Sales Variable Cost Profit = Rs.20,00,000 Rs.16,00,000 Rs.2,00,000 = Rs.2,00,000 iii. Break-even Point = Rs.32,50,000

Margin of Safety = Actual Sales Break-even Sales = Rs. 32,50,000 Rs.10,00,000 = Rs.22,50,000
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vii. Variable Cost in 2005 Since the P/V Ratio is 20%, the Variable Cost will be 80% (i.e. 100 20) of sales. Therefore, Total Variable Cost = 80% of Rs.30,00,000 = Rs. 24,00,000. Assumptions of CVP Analysis Following are the important assumptions of cost-volumeprofit analysis: The analysis presumes that all costs can be easily divided into fixed and variable cost. It presumes the ability of predicting cost at different levels of activity or volumes. It assumes that variable cost fluctuates with volume proportionally. Efficiency and productivity is assumed to be constant. It presumes that production and sales are synchronized at a point of time, or, in other words, changes in the opening and closing inventory levels will remain insignificant in amount. Prices of the input factors are assumed to be constant.
Video 9.2.6: Assumptions of CVP

Analysis assumes that the influence of managerial policies, technology and efficiency of men, material and machines will remain constant and cost control will be neither strengthened nor weakened. Uses of CVP Analysis CVP analysis is an important tool to the management. It is useful to the management in the following areas: It helps in planning and forecasting profit at various levels of activity. It is useful in preparing flexible budget for cost control purposes. Helps the management in decision-making in the following typical areas: Identification of the minimum volume of activity that the enterprise must achieve to avoid incurring loss. Identification of the minimum volume of activity that the enterprise must achieve to attain its profit objectives. Provision of an estimate of the probable profit or loss at different levels of activity within the range reasonably expected. The provision of data on relevant costs for special decisions relating to pricing, keeping or dropping product lines, accepting or rejecting particular orders, make or buy decision, sales mix planning,
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altering plant layout, channels of distribution specifications, promotional activity, etc. Guides in fixation of selling price where the volume has a close relationship with the price level. Helps in evaluating the impact of cost factors on profit. Where a company is manufacturing more than one product of varying profitability, a change in the profitability of one product will lead to a change in the profitability of the group as a whole. The profit-volume chart may be used to illustrate the effect of changes in product mix by drawing a product profit path or separate profit lines are drawn for each of the assumed profit mix for each individual product. Limitations of CVP Analysis Following are the main limitations of CVP analysis: i. This analysis presumes the ability to predict the cost and sales at different levels of activity with certainty. In practice, these variables are uncertain and require them to incorporate the uncertainty effect into the information.

of demand. A change in mix may significantly change the result. iv. It assumes that costs are affected by the output only, but in real life situation other factors affecting cost such as economic factors, political factors, technological methods, efficiency, cost control, etc., are not considered. v. This analysis disregards that selling price is not constant at all levels of sales. A high level of sales may be obtained by offering substantial discounts, depending on the competition in the market. vi. This analysis presumes that fixed cost remains constant over a given volume. It is true that fixed costs are fixed only in respect of a given capacity, but each fixed cost has its own capacity. This factor is completely disregarded in the analysis. vii. Another assumption is that there is no stock, or if stock exists then there is no change in the stock level and profit depends on sales volume only. But, in practice, a change in stock level affects the profit. KEY OR LIMITING FACTOR Key or limiting factor is the factor, which limits the level of activity or the volume of output of a firm at a particular point of time. The objective of every business is to earn maximum profit. There are a number of factors, which limit the profit earning capacity of an undertaking. The management of the organization has to assess the influence of these factors on
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ii. A series of break-even chart is necessary when alternative pricing policies are under consideration. This differential price policy makes break-even analysis a difficult exercise. iii. It assumes that product mix will be constant, whereas the sales mix will continually change owing to the change

the profitability. In normal course of operation the product mix will be decided upon by contribution. But in case of limiting factor, the contribution must be assessed in terms of contribution per limiting factor. For a company, sales cannot exceed beyond a limit, hence the sales will be the key factor. In some cases, there will be sufficient sales and employees, but materials will not be available to produce to fully meet the orders. In such cases material becomes the key factor. The key factor can be defined as the factor in the activities of an undertaking, which at a particular point in time or over a period will limit the volume of output. If there is a key factor for the undertaking, the profitable position of the undertaking can be reached by computing the maximum contribution per unit of key factor. The profitability can be measured by using the following formula: Profitability = Contribution / Key factor Some of the examples of key factors are sales, labor, finance, material, plant capacity, etc. Keynote 9.2.1: KEY FACTOR RAW MATERIAL

Keynote 9.2.2: KEY FACTOR MACHINE HOURS

Keynote 9.2.3: KEY FACTOR ONE OF THE FACTORS OF PRODUCTION LAND

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Additional resources to this chapter: Gallery

Video 9.2.7: CVP for Multiple products Video 9.2.8: Analysis of Behavior of Costs

Video 9.2.9: BEA for Target Income

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Section 3

Case Study: Costing in Pepe Denim

This case study was written by Kavita Wadhwa, under the direction of D Satish, IBS Hyderabad. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from generalized experience. Source:www.waityk.files.wordpress.com

2011, IBSCDC. No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of the copyright owner.

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Kesar Bajaj (Bajaj), chairman of Pepe Denim, a manufacturer and retailer of jeans in India, was facing tremendous pressure to improve the financial position of the company and its market valuation.

Video 9.3.1: Absorption Costing

Bajaj and his younger brother Dinkar had floated Pepe Denim as a private limited company in Ahmedabad, Gujarat, in 1984. In 1994, the brothers decided to convert the company into a public limited company. Pepe Denim began manufacturing operations with just one factory in Ahmedabad district but the brothers put in a lot of hard work and took the company to a level where in 2011, it had 300 stores spread throughout the country and a workforce of 20,000. It also used to export its jeans to China, Brazil, and Nepal. Till 2007, the company did very good business with its sales increasing every year. It earned exceptional growth in valuation resulting from an increase in the companys stock prices. After 2007, however, the stock prices of the company started to decline even though sales continued to be consistent. Though there was no decrease in sales, the profits began to fall. The brothers thought that the decline in the stock prices and profits was due to the economic slowdown and recession. Since there was consistency in sales, they concluded that the profits were declining because of the increase in costs due to inflation. But the stock prices of the company remained flat and profits continued to decline even after 2010 when the economy had started reviving, stock indices had started rising, and the stock prices of other companies had also started soaring.

The shareholders of the company raised concerns over the declining profits of the company. As a result of a heated shareholders meeting, Bajaj came under pressure to improve the companys financial position and its market valuation. In order to understand the present status of production, costs, sales, and the future prospects of the companys product in the market, he immediately called Vipin, the companys cost accountant, and Exhibit I Production and Sales Sales Direct Wages Direct Materials Factory Overheads Administration overheads Sales overheads ? Sneha, the marketing manager. Vipin furnished the following cost information (Refer to Exhibit I) for the year ending March 31, 2010, and the changes in costs which were expected in the coming year: On account of intense competition, the following changes were estimated in the subsequent year: 15,00,000 units (in 000s) 15,00,000 2,70,000 3,30,000 3,25,000 2,05,000 90,000

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1. Production and sales activity would be increased by one third. 2. Material rate would be lowered by 25%. However, there would be a 20% increase in consumption which would take care of the increase in production level. 3. Direct wages cost would be reduced by 20% due to automation. 4. Out of the above factory overheads (given in Exhibit I), Rs. 45000 were fixed in nature. The remaining factory expenses would be variable in proportion to the number of units produced. 5. Total administration expenses would be lowered by 40%. 6. Sales overhead per unit would remain the same. On the basis of cost and profit estimation for the years ending March 31, 2010, and March 31, 2011, Vipin told Bajaj that 6 % decline in profit on sales was expected in 2011. Bajaj realized from Vipins report that the reason for the decline in profits despite the consistent increase in sales volume was the heightening competition from other brands in the market. Since Sneha was in direct contact with the market, Bajaj asked her to carefully analyze the potential of the companys product in the market and suggest the options available to overcome the problem. He gave Sneha 10 days time to do this. After 10 days, Sneha reported back to Bajaj. In order to carry out a formal analysis of the options available with regard to business opportunities, Bajaj immediately called a meeting with the board of directors and asked Vipin and Sneha to be present. Addressing the meeting, Sneha said that in order to overcome the problem, Pepe Denim needed to attract new customers and sell

more goods to repeat Video 9.3.2: Variable & customers. She said the Full Costing Overview company needed to add new product lines; however, in order to keep costs down, the product lines had to be such that they would not require much additional cost. She suggested two new products which would require the same type of material and similar labor, and would serve the female segment of the market. Sneha said the two products which could be added easily were Denim Skirts and Denim Handbags for women as these two items would require the same raw materials. Besides, with a little training, the same tailors could undertake the stitching activity. After examining the suggestion, Bajaj thought that the two products would be a good strategic fit for the existing product line. He sought the opinion of the board of directors and they too gave a favorable response. With this, it was decided that the company would add these two products as soon as possible. After one year of the introduction of the two products i.e. on March 31, 2011, Kesar called Nihit the CFO (Chief Finance Officer) of the company, to find out about the companys profitability and asked him to present Pepe Denims income statement. Nihit brought a summarized income statement which was as follows:

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Exhibit - II Income Statement of Pepe Denim for the year ending March 31, 2011 Particulars Sales Less: Cost of goods sold Gross Profit Less: Indirect expenses Office expenses Selling and distribution expenses Net Profit before depreciation Less: Depreciation Net Profit after depreciation Less: Tax (40%) Profit after tax ? 1,29,150 1,26,000 2,55,150 4,81,400 16,400 4,65,000 1,86,000 2,79,000 Details Amount (in Rs. 000s) 20,00,000 12,63,450 7,36,550 Particulars

Exhibit - III Amount (in Rs. 000s) Jeans Denim Denim Skirts Handbags 75,000 25,000

Stock of materials as on April 1, 2,00,000 2010 Stock of materials as on March 31, 2011 Material purchased during the year Sale of material (not suitable) Work-in-progress as on April 1, 2010 Work-in-progress as on March 31, 2011 Finished Stock as on April 1, 2010 1,50,000

6,00,000 3,00,000 1,00,000 25,000 1,00,000 35,000 3,50,000 10,000 5,000 -

Finished Stock as on March 31, 4,50,000 2,00,000 1,20,000 2011 Salaries (Factory) 15,350 10,000 5,000
Contd...

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Exhibit - III Amount (in Rs. 000s) Particulars Office salaries Carriage on purchases Carriage on sales Cash discount allowed Bad debts written off Repairs of plant, machinery, and tools Rent, rates, taxes, and insurance (factory) Rent, rates, taxes, and insurance (office) Traveling expenses Travelers salaries and commission Productive wages Depreciation written off on plant, machinery, tools Depreciation written off on office furniture Jeans 25,000 12,000 13,000 1800 8000 8000 12000 2000 7000 20000 300000 9000 1800 Denim Denim Skirts Handbags 15,000 6,000 5,000 550 1500 4000 6000 700 5000 13000 120000 3000 400 5,000 2,000 2,000 400 500 1600 2000 300 3000 7000 180000 2000 200
Contd...

Exhibit - III Amount (in Rs. 000s) Particulars Directors fees Dyeing and water charges (factory) Gas and water charges (office) General charges Managers salary (Office) Managers salary (factory) Advertising ? Jeans 15000 3000 850 12750 8000 10000 28000 Denim Denim Skirts Handbags 7000 1500 300 5000 5000 6900 21000 3000 500 100 3000 2000 5000 8750

From the income statement, Bajaj calculated the profit before tax percentage on sales and it worked out to be 23.25 4.25 per cent higher than the previous years profit. This improvement in profit gave him some satisfaction and he was eager to know how the new products were performing and what their cost structures were. He asked Vipin to present the cost sheet of Denim Skirts and Denim Handbags. Vipin was not ready with the cost sheets and so presented the following cost details of all the products: Required:

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1) Vipin told Kesar Bajaj that a 6 % decline in profit on sales was expected in 2011. If the given information is correct then what would be the selling price of a pair of jeans for the year ending March 31, 2011? 2) Can you help Kesar Bajaj in getting the total cost estimate of all the three products Jeans, Denim Skirts, and Denim Handbags? If yes, what is the total cost of all three products? 3) You are required to reconcile the profit with the Income Statement. 4) Do you think the decision of the company to add two new products was beneficial? If yes, how?

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C HAPTER 10

Full Cost Concepts

Source:www.cdn.geckoandfly.com

INTRODUCTION Cost means economic sacrifice, measured in terms of standard monetary unit, incurred or potentially to be incurred, as a consequence of a business decision to achieve a specific objective. Understanding the meaning of the term cost is important as it is used with a modifier or an adjective according to its purpose of use and should be construed in the context in which it is referred to. The main focus of any organization will be their products or services which finally lead to profitability. There is also a need to manage cost of products or services in order to achieve the goal of overall profitability in the business. Activity Based Costing is a modern technique that fulfills the need for accuracy in enhancing the decision-making ability of managers. It is generally used as a tool for planning and control. As competition increases and supply exceeds demand, market forces influence prices significantly. To achieve a sufficient margin over its costs, a company must manage those costs relative to the prices the market allows or the prices the firm sets to achieve certain market penetration objectives. In the context of these characteristics, the practice of target costing has evolved. OBJECTIVES After going through this chapter, you should be able to: Understand the different types of classification of costs;

Explain the preparation of Cost Sheet; Construct a Cost Sheet; Explain the significance of Activity Based Costing; Distinguish between Activity Based Costing and Traditional Costing; and Explain the significance of Target Costing.

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Section 1

Introduction to Costs and Costing

According to CIMA, London, cost is, the amount of expenditure (actual or notional) incurred or attributable to a given thing. According to the Committee on Cost Concepts and Standards of American Accounting Association, Cost means economic sacrifice, measured in terms of standard monetary unit, incurred or potentially to be
Source:www.referenceforbusiness.com

incurred, as a consequence of a business decision to achieve a specific objective. Types of Costs Cost classification is the process of grouping costs according to their common characteristics. A suitable classification of costs is very helpful in identifying a given cost with cost centers or cost units. Costs may be

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classified according to their nature, i.e., material, labor and expenses and a number of other characteristics. Depending upon the purpose to be achieved and requirements of a particular concern the same cost figures may be classified into different categories. Costs can be classified in the following ways: BY NATURE OR ELEMENT OR ANALYTICAL CLASSIFICATION Under this classification, costs are divided into three categories, i.e., Materials, Labor and Factory Overheads. Each element can undergo further sub-classification; for example, material into raw material, components and spare parts, consumable stores, packing material, etc. Materials Materials are the principal substances that go into the production process and are transformed into finished goods. They are further classified as direct materials and indirect materials. Direct materials can be easily and directly identified and easily traced with the production of finished goods. The cost of direct materials generally comprises the major cost of the finished product. All the other materials that go into the production of the finished goods are called indirect material costs. They generally form a part of the manufacturing overheads. Labor Labor is the human physical and mental effort that goes into the production of a product. It is further classified as direct

and indirect labor. Direct labor is directly involved in the production of the product. Direct labor cost generally comprises major labor cost. The residual labor, which cannot be categorized as direct labor, is indirect labor. It forms a part of factory overhead. For example, continuing with the above example in a furniture manufacturing unit, the cost of the workers who directly expend their energy on the direct material with the help of tools and machines are considered as direct labor. The supervisor who is in charge of overseeing the work of ten workers is considered as indirect labor. Overheads All other costs that are incurred by the company other than direct materials and direct labor are called overheads. Hence overheads consist of indirect materials, indirect labor and other expenses. The overheads are further sub-divided into factory overheads, office and administrative overheads and selling and distribution overheads. Continuing with the above example, factory lighting, rent of the factory, rent of administrative building, wages of administrative staff, managers, depreciation of machinery, etc., constitute overheads. BY FUNCTIONS Under this classification costs are grouped according to the broad divisions of functions of a business undertaking or basic managerial activities, i.e., production, administration, selling and distribution. According to this classification costs are divided as follows:

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Manufacturing and Production Costs Production costs include the total of costs incurred in manufacture, construction and fabrication of units of production. The manufacturing and production costs comprise direct materials, direct labor and factory overheads. Administrative Costs Administrative costs include costs incurred in planning, directing, controlling and operating a company. For example, salaries paid to managers and other administrative staff. Selling And Distribution Costs Selling costs and distribution costs are most often confused to be of the same type. However, there is a distinction between the two. Selling costs are defined as the cost of seeking to create and stimulate demand and of securing orders. Example of selling costs are advertisement, salesmen salaries, etc. Distribution costs are defined as the cost of sequence of operations which begin with making the packed product available for dispatch and ends with making the reconditioned, returned empty packages, if any, available for re-use. Examples of distribution costs are insurance on goods-in-transit, warehousing, etc. BY TRACEABILITY According to this classification, total cost is divided into direct costs and indirect costs. Direct costs are incurred for and may be conveniently identified or easily traceable with a particular cost center or cost unit. The common examples are

materials used and labor employed in manufacturing an article or in a particular process of production. Indirect costs are incurred for the benefit of a number of cost centers or cost units and cannot be conveniently identified with a particular cost center or cost unit. Examples include rent of building, management salaries, machinery depreciation, etc.

Video 10.1.1: Direct vs Indirect

The nature of the business and the cost unit chosen will determine the costs as direct and indirect. For example, the hire charges of a mobile crane used onsite by a contractor would be regarded as a direct cost since it is identifiable with the project/site on which it is employed, but if the crane is used as a part of the services of a factory, the hire charges would be regarded as indirect cost because they will probably benefit more than one cost center or department. The distinction between these two costs is essential because the direct costs of a product or activity can be accurately identified with the cost object while the indirect costs have to be apportioned on the basis of certain assumptions about their incidence. BY VARIABILITY

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The basis for this classification is the behavior of costs in relation to changes in the level of activity or volume of production. On this basis, costs are classified into three groups, viz. fixed, variable and semi-variable. Fixed Costs

Video 10.1.2: Cost Behavior

tend to remain constant per unit as production level changes. Examples are direct material costs, direct labor costs, power, repairs, etc. Semi-Variable Costs Semi-variable costs are partly fixed and partly variable. For example, telephone expenses include a fixed portion of monthly charge plus variable charge according to the number of calls made; thus total telephone expenses are semi- variable. Other examples of such costs are depreciation, repairs and maintenance of building and plant, etc. These are also called semi-fixed costs or mixed costs. BY CONTROLLABILITY On the basis of controllability costs are classified into two categories, i.e., controllable costs and uncontrollable costs. Controllable Costs If the costs are influenced by the action of a specified member of an undertaking, that is to say, costs, which are at least partly within the control of management, they are called controllable costs. An organization is divided into a number of responsibility centers and controllable costs incurred in a particular cost center can be influenced by the action of the manager responsible for the center. Generally speaking, all direct costs including direct material, direct labor and some of the overhead expenses are controllable by lower level of management. Uncontrollable Costs
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Fixed costs remain fixed in total with increase or decrease in the volume of output or activity for a given period of time or for a given range of output. Fixed costs per unit vary inversely with the volume of production, i.e., fixed cost per unit decreases as production increases and increases as production decreases. Examples are rent, insurance of factory building, factory managers salary, etc. These costs are constant in total amount but fluctuate per unit as production level changes. They are also termed as capacity costs. Variable Costs Variable costs vary in total directly in proportion to the volume of output. These costs per unit remain relatively constant with changes in volume of production or activity. Thus variable costs fluctuate in total amount but
Video 10.1.3: By Variability

If the costs cannot be influenced by the action of a specified member of an undertaking, that is to say, costs which are not within the control of the management are called uncontrollable costs. Most of the fixed costs are uncontrollable. For example, rent of the building is not controllable and so are managerial salaries. Overhead cost, which is incurred by one service section or department and is apportioned to another, which receives the service, is also not controllable by the latter. Controllability of costs depends on the level of management (top, middle or lower) and the period of time (long-term or short-term). BY NORMALITY On the basis of normality, the costs are classified into two categories, i.e., normal cost and abnormal cost. Normal Cost It is the cost which is normally incurred at a given level of output in conditions which are favorable for that level of output. This cost forms the cost of production of a product. Abnormal Cost It is the cost, which is normally incurred at a given level of output in conditions which are not favorable for that level of output. It is not considered as a part of cost of production and charged to Costing Profit and Loss Account. BY CAPITAL AND REVENUE OR FINANCIAL ACCOUNTING CLASSIFICATION

According to financial accounting terminology, costs are of two types, i.e., capital costs and revenue costs. Capital Costs

Video 10.1.4: Capital vs Revenue

If the cost is incurred in purchasing assets either to earn income or increase the earning capacity of the business, it is called capital cost. For example, the cost of a rolling machine in a steel plant. Though the cost is incurred at one point of time the benefits accruing from it are spread over a number of accounting years. Revenue Costs Revenue expenditure is any expenditure incurred to maintain the earning capacity of the concern, such as cost of maintaining an asset or running a business. Example, cost of materials used in production, labor charges paid to convert the material into production, salaries, depreciation, repairs and maintenance charges, selling and distribution charges, etc. While calculating cost, revenue items are considered, whereas capital items are completely ignored. BY TIME Costs can be classified as (i) Historical costs, and (ii) Predetermined costs. Historical Costs
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The costs, which are ascertained after being incurred, are called historical costs. Such costs are available only when a particular thing has already been produced. Such costs are only of historical value and not at all helpful for cost control purposes. Predetermined Costs Such costs are estimated costs, i.e., computed prior to production taking into consideration the previous periods costs and the factors affecting such costs. If they are determined on scientific basis they become standard costs Such costs when compared with actual costs will give the variances and reasons of variance and will help the management to fix the responsibility and to take remedial action to avoid its recurrence in future. Historical costs and predetermined costs are not mutually exclusive. Even in a system when historical costs are used, predetermined costs have a very important role to play because a figure of historical cost by itself has no meaning unless it is related to some other standard figure to give meaningful information to the management. BY IDENTIFICATION AS PART OF INVENTORY Costs on this basis are classified as product costs and period costs. This distinction is required for the purpose of profit determination. That is because product costs are carried forward to the next accounting period in the form of unsold finished stock, whereas period costs are written off in the accounting period in which they are incurred.

Product Costs Product costs are associated with the unit of output. They are absorbed by or attached to the units produced. They go into the determination of inventory valuation (finished goods and partly completed goods) hence are called inventoriable costs. They consist of direct materials, direct labor and factory overheads (partly or fully). The extent of inclusion of factory costs depends on the type of costing system in force Video 10.1.5: Product vs Period Costs absorption and direct costing. Where the absorption costing method is adopted, factory overheads - both fixed and variable content - are included as part of product cost. Where the direct costing method is adopted, only variable factory overheads are included as part of inventoriable cost. Period Costs Period costs are costs associated with time period rather than the unit of output or manufacturing activity. These costs are not treated as part of inventory and hence are treated as expenses in the period in which they are incurred. Administrative, Selling and Distribution costs are treated as period costs and are deducted as an expense for the determination of income and are not regarded as a part of inventory.
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ACCORDING TO PLANNING AND CONTROL Cost accounting furnishes information to the management which is helpful in discharging the two important functions of management, i.e., planning and control. For the purpose of planning and control, costs are classified as budgeted costs and standard costs. Budgeted Costs Budgeted costs represent an estimate of expenditure for different phases or segments of business operations, such as manufacturing, administration, sales, research and development, for a period of time in future which subsequently becomes the written expression of managerial targets to be achieved. Various budgets are prepared for different phases/ segments of business, such as sales budget, raw material cost budget, labor cost budget, cost of production budget, manufacturing overhead budget, office and administration overhead budget, etc. Continuous comparison of actual performance (i.e., actual cost) with that of the budgeted cost is made so as to report the variations from the budgeted cost to the management for corrective action. Standard Cost The Institute of Cost and Management Accountants, London, defines standard cost as the predetermined cost based on a technical estimate for materials, labor
Video 10.1.6: Why Standard Cost

and overhead for a selected period of time and for a prescribed set of working conditions. Thus standard cost is a determination, in advance of production, of what should be its cost under a set of conditions. Budgeted costs and standard costs are similar to each other to the extent that both of them represent estimates of cost. FOR MANAGERIAL DECISIONS On this basis, costs may be classified into the following categories: Marginal Costs It is the additional cost to be incurred if an additional unit is produced. In other words, marginal cost is the total of variable costs, i.e., prime cost plus variable overheads. It is based on the distinction between fixed and variable costs. Out of-Pocket Cost It is that portion of the cost which involves payment, i.e., gives rise to cash expenditure as opposed to such costs as depreciation, which do not Video 10.1.7: involve any cash expenditure. Differential costs Such costs are relevant for price fixation during recession or when make or buy decision is to be made. Differential Costs If there is a change in costs
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due to change in the level of activity or pattern or method of production they are known as differential costs. If the change increases the cost, it will be called incremental cost and if the change results in the decrease in cost it is known as decremental cost. Sunk Cost
Video 10.1.8: Cost Characteristics Sunk relevant

interest on capital before a decision is arrived as to which is the most profitable project. Opportunity Cost It is the maximum possible alternative earnings that will be foregone if the productive capacity or services are put to some alternative use. For example, if an owned building is proposed to be used for a project, the likely rent of the building is the opportunity cost which should be taken into consideration while evaluating the profitability of the project. Since opportunity costs are not the actual costs incurred but only the benefits foregone, they are not recorded in the accounting Video 10.1.9: books. However, they are Replacement Cost relevant costs for decisionmaking purposes and are considered while evaluating different alternatives. Replacement Cost It is the cost at which there could be purchase of an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price. Avoidable and Unavoidable Costs Avoidable costs can be eliminated if a particular product or department, with which they are directly related to, is discontinued. For example, salary of the clerks employed in a particular department can be eliminated, if the department is
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Sunk cost is another name for historical cost. It is a cost that has already been incurred and is irrelevant to the decisionmaking process. A good example is, depreciation on a fixed asset because the cost (of purchasing the asset) has already been incurred (when it was purchased) and it cannot be affected by any future action. Though we allocate the depreciation cost to future periods, the original cost of the asset is unavoidable. What is relevant in this context is the salvage value of the asset, not the depreciation. Thus sunk costs are not relevant for decision-making and are not affected by increase or decrease in volume. Imputed (or Notional) Cost These costs appear in cost accounts only. For example, notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid, etc. When alternative capital investment projects are being evaluated it is necessary to consider the imputed

discontinued. Unavoidable cost will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager or factory rent cannot be eliminated even if a product is eliminated. OTHER TYPES OF COSTS Future Costs These costs are expected to be incurred at a later date. Programmed Costs Certain decisions reflect the policies of the top management which result in periodic appropriations and are referred to as programmed costs. For example, the expenditure incurred by the company under the Jawahar Rojgar Yojana program initiated by the Prime Minister is a programmed cost which reflects the policy of the top management. Joint Costs It is the cost of manufacturing joint products up to or prior to the split-off point. Cost incurred after the split-off point is called separable cost. Joint cost is common to the processing of joint products and by-products till the point of separation and cannot be traced to a particular product before the point of split-off. Conversion Costs It is the cost incurred in converting the raw material into finished product. It can be calculated by deducting the cost

of direct materials from the production cost or it is the sum of direct labor and factory overheads. Discretionary Costs These costs do not have any obvious relationship with the levels of capacity or output activity and are determined as part of the periodic planning process. In each planning period the management decides on how much to spend on certain discretionary items such as advertising, research and development, employee training, etc. These costs are amenable to alteration by the management. Committed Costs It is a fixed cost, which results from the decisions of the management in the prior period and is not subject to the management control in the present on a short run basis. It arises from the possession of production facilities, equipment, organization set-up etc. Some examples of committed costs are: plant and equipment depreciation, taxes, insurance premium and rent charges. STATEMENT OF COST OR COST SHEET Cost Sheet is a statement which provides for assembly and depiction of the detailed cost in respect of cost centers and cost units. Data is collected from various sources to incorporate in the cost sheet. Cost sheet is only a statement. It is not a part of double entry cost accounting records.

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According to ICMA, London, the cost sheet is a statement which provides for the assembly of the detailed cost of a cost center or a cost unit.

Video 10.1.10: Cost Sheet Components

If the opening, closing and purchase of raw materials are given, then the material consumed can be determined in the following way.

There is no specific format for preparing a cost sheet. Generally, it is presented in a columnar form. The columns are for the total cost and per unit cost of current period and previous period. Sometimes budgeted total cost and per unit column are also incorporated in the cost sheet. If the cost sheet is presented in the ledger account format, then it is called Production Account. Specimen of Cost Sheet

Stock of Work-in-Progress Semi-finished or uncompleted units are called work-inprogress. Generally it is valued at works cost. Opening and Closing stock of work-in-progress is adjusted in the following way.

Stock of Finished Goods Opening and closing stock of finished goods are adjusted in the following way before calculating the cost of goods sold: Treatment of Stock Stock may be raw material, work-in-progress and finished goods. These are to be adjusted in the cost sheet. Stock of Raw Materials
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Treatment of Scrap Scrap may be defined as an unavoidable residue material arising in certain types of manufacturing processes. Generally it has small realizable value. It is deducted either from factory overheads, or factory cost while preparing cost sheet.

The proforma of the Comprehensive Cost Sheet, i.e., with stocks, is as under:
Opening Stock Raw Materials Add Less Purchases (including Carriage Inwards, Transit Insurance etc.) Closing Stock of Raw Materials Direct Materials Consumed Add Add Direct Labor Direct Expenses Prime Cost Add Add Less Factory Overheads (Works OH / Manufacturing OH / Production OH) Opening Stock of Work in Progress Closing Stock of Work in Progress Factory Cost / Work Cost Add Administration Overheads Cost of Production Add Less Opening Stock of Finished Goods Closing Stock of Finished Goods Cost of Goods Sold Add Selling and Distribution Overheads Cost of Sales Add Profit/Loss (Balancing Figure) Sales
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R EVIEW 10.1 .1 Question 1 of 4 An example of a production overhead would be

A. Labor costs B. Rent C. Supervisory costs D. Materials

Check Answer

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Section 2

Activity-Based Costing (ABC) and Activity-Based Management

Video 10.2.1: Activity-Based Costing

MEANING OF ACTIVITY-BASED COSTING Activity-based costing is a commonly used approach to improve a traditional costing system. Activitybased costing is a costing method that first assigns costs to activities and then to goods and services based on how much quantum of activity is used in the production of goods. Basically, ABC is a cost accounting system that focuses on the various activities performed in an organization and collects costs on

the basis of primary nature and extent of those activities. There are three fundamental components of activity-based costing, i.e., recognizing the several levels of costs exist, accumulating costs into cost pools and using multiple cost drivers to assign costs to products and services. This costing method focuses on attaching costs to products and services based on the activities conducted to produce, perform, distribute, or support those products and services. An activity is

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any discrete task that an organization undertakes to make or deliver a good or service. ABC is primarily used to establish product costs primarily for decision-making purposes. What Drives ABC? Activity-based costing is based Video 10.2.2: Traditional vs Activity-Based Costing on the following ideas. First, designing, producing and distributing products and services require many activities to be performed. Performing these activities requires resources to be purchased and used. Purchasing and using resources causes costs to be incurred. Restated in reverse order, the ABC logic is that resources generate costs, activities consume resources and products consume activities. Thus a companys activities are identified and then costs are traced to these activities (or activity cost pools) based on the resources that they require. Then, costs are assigned, or traced from each of these activity cost pools to the companys products (or services) in proportion to the demands that each product (or service) places on each activity. In ABC, a measure of the relevant activity volume is used to trace each type of costs, rather than exclusively using measurements (or allocation bases) related to the volume of the products or services produced. There are still two stages in assigning costs to products in a manufacturing environment, i.e., (i) from service departments (activities) to

producing departments, and (ii) from producing department activity cost pools to products. Cost Driver Analysis

Video 10.2.3: Activity Based Drivers

A cost driver is a characteristic of an activity or event that causes costs to be incurred by that activity or event. Companies engage in many activities that consume resources and, thus, cause costs to be incurred. Many cost drivers can be found for an individual business unit. Cost drivers are classified as volume-related and non-volumerelated. Examples of volume-related cost drivers are machine hours and non-volume-related include set-ups, work orders, or distance traveled. Cost drivers selected by management should be limited and also easy to understand, directly related to the activity being performed and appropriate for performance management. Cost driver analysis identifies the activities causing costs to be incurred. It also investigates, qualifies and explains the relationships of drivers and their related costs. Traditionally, cost drivers create only unit-level costs, meaning that they are caused by the production or acquisition of a single unit of product or the delivery of a single unit of service. Other drivers and their costs are incurred for broader-based categories or levels of activity. The categories are classified
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as batch, product or process and organizational or facility levels. Examples of the kinds of costs that occur at the various levels are as follows: Costs that are caused by a group of things being made, handled, or processed at a single time are referred to as batchlevel costs. A good example of a batch level cost is the cost of setting up a machine. A cost caused by the development, production, or acquisition of different items is called a productlevel (or process-level) cost. Costs that are incurred at the organization level for the singular purpose of supporting continuing facility operations are referred to as organizationallevel costs. Value-Added versus Non-Value-Added Activities Value-added activities enhance the value of products and services in the eyes of the organizations customers for which the customer is willing to pay while meeting its own goals. Customers can be either external or internal to the organization. Non-value-added activities do not contribute to customer-perceived value and increases the time spent on a product or service. These are unnecessary from the perspective of the customer. The companys goal is to eliminate non-value-added activities while making value-added activities more efficient. In a competitive environment, an organization should try to reduce the waste quantum of resources on nonvalue-added activities because competitors are continuously striving to get more customer value at lower cost. All organizations have some non-value-added activities that can be reduced or eliminated. The following are the most likely

sources of the non-value-added activities: Producing to build up inventory; Waiting for processing; Spending time and effort to move products from place to place; Transporting workers to work sites;

Video 10.2.4: Intro to Activity Based Costing System

Producing defective products. Process of Activity-Based Costing System Activity-based costing has maintained a high profile as a cost management innovation. Four steps can be used to determine the cost of goods and services using ABC analysis. STEP 1: IDENTIFICATION AND CLASSIFICATION OF MAIN ACTIVITIES Identify and classify the main activities related to the product performed in the organization, such as manufacturing, assembly, etc., as well as support activities, including purchasing, packing and dispatching. STEP 2: ASSIGNING COSTS TO ACTIVITY CENTERS
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After the activities have been identified and classified, the cost of resources consumed over a process must be assigned to each activity. The main aim of the organization is to identify that how much they are spending on each of its activities. STEP 3: SELECTING COST DRIVERS Selecting appropriate cost drivers for assigning the cost of activities to cost objects is the next step in Activity-Based Costing System. Cost drivers used at this stage are called activity cost drivers. Several factors are taken in consideration while selecting a suitable cost driver. Activity cost drivers consist of three types: i. ii. Transaction drivers; Duration drivers; and

significant variation exists in the amount of activity required for different outputs. For example, simple product may require only 10-15 minutes to set-up, while complex, high-precision products may require 6 hours to set-up. Using a transaction drivers, like number of set-ups, will over cost the resources required to set-up simple products and under cost the resources required for complex products. To avoid this distortion, ABC designers would use a duration drivers. Example of duration drivers includes set-up hours and inspection hours. Intensity Drivers Intensity drivers charge for the resources used each time an activity is performed. They are Video 10.2.5: the most accurate activity cost ABC Illustration drivers but are the most expensive to implement; in effect they require direct changing via a job order costing system to keep track of all the resources used each time an activity is performed. STEP 4: ASSIGNING COSTS TO PRODUCTS Assigning the cost of the activities to products is the final stage in the process of Activity-Based Costing. Activity-Based Management

iii. Intensity drivers. Transaction Drivers Transaction drivers are the least expensive and are likely to be least accurate because they assume that same quantity of resources is required every time an activity is performed. It counts the number of times an activity is performed such as number of purchase orders processed, number of customer orders processed, etc. Duration Drivers Duration drivers represent the time duration required to perform an activity. Duration drivers should be used when

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ABC is not only a cost allocation system but also extended to other costing and management techniques. It can be used as an alternative to traditional costing systems such as Absorption and Marginal Costing. ABC can also be extended to performance measurement systems such as Activity-Based Management. Activity-Based Management (ABM) evaluates the costs and values of process activities to identify opportunities to improve efficiency. ABM combines activity based costing analysis and value-added analysis to make process improvements that improve customer value and reduce waste resources. Activity-based management focuses on the activities incurred during the production or performance process as a way to improve the value received by a customer and the resulting profit achieved by providing this value. The concepts covered by activity-based management are activity analysis, cost driver analysis, activity-based costing, continuous improvement, operational control, performance evaluation and business process re-engineering. These concepts help companies to produce more efficiently, determine costs more accurately and control and evaluate performance more effectively. The primary component of activity-based management is activity analysis, which is the process of studying activities to classify them and to devise ways of minimizing or eliminating nonvalue-added activities. Activity-based-cost management systems trace indirect and support expenses accurately to individual products, services and customers. ABM includes cost-driver analysis, activity analysis and performance analysis.

What managers actually do in an activity-based management? Managers use information collected by the ABC system at the activity level to identify promising opportunities for reducing costs in indirect and support activities. Features of Activity-Based Management Activity-based management involves the following stages: Identifying the major activities that take place in an organization. Assigning costs to cost pools/cost centers for each activity. Determining the cost driver for each activity. Omits the fourth stage required for product costing ABC. ABM focuses on managing the business on the basis of the activities that make up the organization by managing the activities costs are managed in the long-term. Traditional control reports analyze costs by types of expenses for each responsibility centre whereas ABM analyzes costs by activities. Knowing the cost of activities is a catalyst for triggering action to become competitive. Activity cost information is useful for prioritizing those activities that need to be studied more closely. Activities can be classified as value-added or non-valueadded.
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Activity-based systems can also be used to manage costs at the design stage using behavioral drivers. Surveys also suggest that many organizations use cost driver rates as measures of cost efficiency. CRITICISM OF ACTIVITY-BASED COSTING/ ACTIVITYBASED MANAGEMENT ABC requires a significant amount of time, and thus, cost to implement. ABC/ABM simply assumes that functional activities are separable to an extent that they can be linked to output/products. ABC/ABM fails to seize long-term purposes of activities rather it takes a very narrow view, only concerned with the cost. Some activities, in the short run, may be costly but in the long run they are highly profitable to the company such as building relationship with suppliers. ABC also falls in the category of traditional cost allocation because ABC too accepts some common costs not traceable to products. By threatening to reduce expenditure, ABM denies space for developmental activities indigenous to the staff department. Armstrong (2002) argued that The problem with ABM is that it is programmed to deny and exterminate anything which is not on its list of routine activities, whether it is of genuine value or not.

ABM and ABC hinder improvisation, imagination and search for better ways of doing things. ABM becomes redundant when ABC method is inaccurate.

R EVIEW 10.2 .1 Question 1 of 5 Which of the following is a sign that an ABC system may be useful?

A. There are small amounts of support costs. B. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. C. Products a company is less suited to produce. D. Operations throughout the plant are fairly similar.

Check Answer

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Section 3

Target Costing

Introduction The long-term financial success of any business depends on whether its prices exceed its costs; are adequate to finance growth; provide for reinvestment; yield a satisfactory return to its stakeholders, etc. As competition increases and supply exceeds demand, market forces influence prices significantly. To achieve a sufficient margin over its costs, a company must manage those costs relative to the prices the

Video 10.3.1: Target Costing

market allows or the price the firm sets to achieve certain market penetration objectives. In the context of these characteristics, the practice of target costing has evolved. Effective management of cost makes an organization more strong, more stable and helps in improving the potential of a business. The organization calls for a system that would monitor the full economic impact of the business on resource acquisition and consumption.

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Target costing is defined as a cost management tool for reducing the overall cost of a product over its entire life cycle with the help of the production, engineering, R&D. Target costing process starts with determining market-based prices based on market and competitive conditions and then subtract the required margin to determine the product or service level target costs. Such aggregate level target costs can be useful in designing value delivery processes and determining the relative cost contribution of people, process and technology elements in such a manner as to achieve target cost before costs are incurred. Target costing is fundamentally a different approach. It is based on three premises: (i) orienting products to customer affordability or market-driven pricing, (ii) treating product cost as an independent variable during the definition of a products requirements, and (iii) proactively working to achieve target cost during product and process development. It is a profit and cost management system that helps a company to achieve market and financial success by planning the portfolio of services, designing the products, processes and related cost structures that provide value to customers. Objectives of Target Costing The fundamental objective of target costing is to enable management to use practical cost planning, cost management and cost reduction practices whereby costs are planned and managed out of a product and business early in the design and development cycle, rather than during the latter stages of product development and production. It obviously applies to new products, but can also be applied to product modifications

or succeeding generations of products. It might also be used for existing products, but costs are more difficult to reduce once a product is in production.

Video 10.3.2: Objectives

The costs most typically emphasized in the target costing process are such things as: material and purchased parts, conversion costs (such as labor and identifiable overhead expenses), tooling costs, development expenses and depreciation. However, all costs and assets that may be affected by early product planning decisions should be considered. This would include more indirect overhead expenses through the production stage and beyond, such as service costs, and, assets like inventory. Target costing is intended to get managers thinking ahead and comprehensively about the cost and other implications of the decisions they made. Target costing is as much a significant business philosophy as it is a process to plan, manage and reduce costs. It emphasizes understanding the markets and competition; it focuses on customer requirements in terms of quality, functions and delivery as well as price; it recognizes the necessity to balance the trade-offs across the organization and establishes teams to address them early in the development cycle; and it has, at its core, the fundamental objective to make money, to be able to reinvest, grow and increase value.
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Different Phases of Target Costing There are several phases to the methodology of target costing: Planning Phase Development Phase Production Phase PLANNING PHASE
Video 10.3.3: Target Cost: Value Strategy

and so on. Much time, money and effort were spent before the product reached the production stage. As a result, profit suffered. Under target costing, a products design begins at the opposite end. It first establishes a price at which the product can be competitive and then assigns a team to develop cost scenarios and search for ways to design and manufacture the product to meet those cost constraints. Several steps must be taken in order to establish a reasonable target cost. Market research should be done to determine several factors. First, the products of competitors should be analyzed with regard to price, quality, service and support, delivery and technology. After a preliminary test of competitors product, it is necessary to establish the features consumers value in this type of product and the important features that are lacking. After preliminary testing, a company should be able to pinpoint a market niche it believes is undersupplied, and, in which it believes it might have some competitive advantage. Only then can a company set a target cost close to competitors products of similar functions and value. The target cost is bound to change in the development and design stages. However, the new target costs should only be allowed to decrease unless the company can provide added features that add value to the product. DEVELOPMENT PHASE The company must find ways to attain the target cost. This involves a number of steps.
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Based upon its strategic business plans, a company must first establish what type of product it wishes to manufacture. Traditionally (before target costing), once the type of product was determined, its development was assigned to the product design department. Then the produced product was sent to the costing department, which assessed the cost of the design and frequently found it more expensive to produce than the market would tolerate. The design was then returned to the design department with instructions to reduce its costs, usually by compromising its quality. The product design was sent back and forth between the two departments until a consensus was reached. The product was then sent to the manufacturing department, which often concluded that it was impossible to manufacture it in its proposed state. It was then sent back to the design department

First, an in-depth study of the most competitive product on the market must be conducted. This study will show what materials were used and what features are provided and it will give an indication of the manufacturing process needed to complete the product. Once a better understanding of the design has been achieved, the organization can target the costs against this best design. But its competitors will probably be engaged in similar analysis and will further improve its product toward this best design. It is necessary when performing comparative cost analysis, and trying to establish the competitors cost structure, that adequate attention be paid to the competitive advantages of the competitor, such as technology, location and vertical integration. After trying to identify the cost structure of the competitor, the company should develop estimates for the internal cost structure of its own products. This is most effectively done by analyzing internal costs of similar products already being produced by the company and should take into account the different needs of the new product in assessing these costs. After preliminary analysis of the cost structures of both the competitor and itself, the company should further define these cost structures in terms of cost drivers. Focusing on cost drivers can help reduce waste, improve quality, minimize nonvalue-added activities and identify ineffective product design. The use of multiple drivers leads to better understanding of the inputs and resources required to produce products and a better cost analysis through more detailed cost information.

When enough cost information is available, the product development team is able to generate cost estimates under different scenarios. After this, the designers, manufacturers, marketers, and engineers on the team should conduct a session of brainstorming to generate ideas on how to substantially reduce costs (by smoothing the process, using different materials, and so on) or add a number of different features to the product without increasing target costs. In these brainstorming sessions, no idea is rejected, and the best ideas are integrated into the development of the product. PRODUCTION PHASE In this stage, target costing becomes a tool for reducing costs of existing products. It is highly unlikely that the design, manufacturing and engineering groups will develop the optimal, cost efficient process at the beginning of production. The search for better, less expensive products should continue in the framework of continuous improvement. The ABC technique can be useful as a tool for target costing of existing products. ABC assists in identifying non-value-added activities and can be used to develop scenarios on how to minimize them. Target costing at the activity level makes opportunities for cost reduction highly viable. Target costing is also strongly linked to consumer requirements and tries to identify the features such as performance specifications, services, warranties and delivery consumers want products to provide. These consumers may also be questioned about which features they prefer in products and how much they are worth to them. The surveys on preferable
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features and value of these features help management do cost-benefit-analysis on different features of a product and then try to reduce costs on features that are not ranked highly. Target costing also provides incentives to move towards less expensive means of production as well as production techniques that provide a more even flow of goods. JIT provides an environment where there is better monitoring of costs and product quality as well as access to ideas for continuous improvement and better production strategies. Factors to be considered while Implementing Target Costing System The following factors should be taken by the organization before implementing the target costing system: i. Target costing program begins with the management commitment and their support. The objectives of the target costing must be communicated to the remaining people in the organization. Team-Based Organization is to be established to support development program.

v.

Product cost models or cost tables are required to evaluate concept and design alternatives and support decision-making.

vi. Value analysis and design for manufacturability are needed to provide focus on functions of value to the customer, the associated and the DFM principles to reduce cost. vii. In product costs 40%-70% is spent for materials. Thus supplier involvement is required for development of pricing programs. viii. Introduction of business process re-engineering is needed for eliminating non-value-added activities and to establish activity-based costing system. ix. Monitoring of target costing is key to successful implementation. It is required to develop tracking systems, design review guidelines and ensure appropriate management focus to a target costing system. Benefits of Target Costing Target costing have the following benefits:
Video 10.3.4: Launching product below target cost

ii.

iii. A target Costing process needs to be defined and established. iv. Target costs must be established based on the analysis of markets, analysis of customers requirements and analysis of cost-volume relationships.

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i.

The process of target costing provides detailed information on the costs involved in producing a new product as well as a better way of testing different cost scenarios through the use of ABC. Target costing reduces the development cycle of a product. Costs can be targeted at the same time the product is being designed, bringing in the resources of the manufacturing and finance departments to ensure that all avenues of cost reduction are being explored and that the product is designed for manufacturability at an early stage of development.

vi. Target costing is very attractive because it is used to control costs before the company even incurs any production costs, which save a great deal of time and money. vii. Although target costing in its simplest form is merely a calculation target price minus margin todays competitive environment can make target costing an indispensable, strategic management technique. Additional resources to this chapter
Video 10.3.5: Modern cost management Video 10.3.6: Standard cost vs Actual cost

ii.

iii. The internal costing model, using ABC, can provide an excellent understanding of the dynamics of production costs and can detail ways to eliminate waste, reduce nonvalue-added activities, improve quality, simplify the process and attack the root cause of costs (cost drivers). It can also be used for measuring different cost scenarios to ensure that the best ideas available are incorporated from the outset into the production design. iv. The profitability of new products is increased by target costing through promoting reduction in costs while maintaining or improving quality. It also helps in promoting the requirements of consumers, which leads to products that better reflect consumer needs and find better acceptance than existing products. v. Target costing is also used to forecast future costs and to provide motivation to meet future cost goals.

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R EVIEW 10.3 .1 Question 1 of 2 What is the name of the costing approach used where the products selling price is identified and ways are established of meeting production costs and making an acceptable profit?

A. Benchmarking B. Activity based costing C. Total life cycle costing D. Target costing

Check Answer

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C HAPTER 11

Decisions Involving Alternate Choices

Source:www.lh6.ggpht.com

INTRODUCTION Managerial decision-making is the process of choosing one among alternative courses of action. The manager chooses that course of action, which he considers as the most effective for achieving goals and solving problems. Decision-making is an integral part of all management functions planning, organization, coordination, and control. All decisions are futuristic in nature, involving a forecast of what management thinks is likely to occur. But future is highly uncertain. Thus business decisions have to be made with the full realization that there is some probability of the prediction, which underlies the decision taken, going off the mark. Some decisions are routine in nature. These decisions take up very little of the managers time either because there is very little uncertainty or because the cost is insignificant. On the other hand, managers have to take nerve-racking decisions. The manager has to spend a considerable amount of time and thought on these decisions because they are crucial to the organization. In this chapter, we will be discussing about the meaning of Relevant Cost and Irrelevant Cost, Marginal Costing and Differential Cost Analysis and explain the various production decisions. OBJECTIVES After going through this chapter, you should be able to:
Video 11.1: Intro to Business Decisions

Distinguish between relevant and irrelevant cost; Explain the marginal costing and differential costing analysis; Explain the various production decisions such as make or buy, accept or reject a foreign order, purchase or lease, sell or further process, closing down the factory or a segment;

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Section 1

Decisions: Related Concepts

STEPS IN DECISIONMAKING PROCESS Let us now take a look at the process of decision-making while this process is complex and not amenable to standardization, the following steps seem useful for most of the problems: Defining the Problem: This is the first step in any decision-making situation. In this step a complete study to find out what the problem really is undertaken. All possible causes and effects of the problem should be studied.

It should be remembered that defining the problem correctly takes more time at first, but saves time in the decision process. Once the problem is defined the next step is to analyze the problem in detail. In this process, the decision maker collects all possible facts close to the problem. The facts should be separated based on the definition of the problem. It should be noted that the problemdefining step should be fair and unbiased. Developing Alternative Solutions: Once the

Source:www.jpcjaipur.org

217

problem is defined and analyzed, the next step is to think about the alternatives. Here, the decision maker should list out all the available alternatives. He can go for new and innovative ideas or think about the alternatives available. The alternatives collected should be in relation to the defined problem. Evaluating the Alternatives: The listed out alternatives should be evaluated with the defined problem to arrive at the suitability of the alternatives. In this step, the decision maker can ask some basic questions like whether the decision will help to reach the objectives; Is the decision time- and cost-effective?; Whether we have enough resources to implement the decision?; Is there any negative consequences of the decision which may affect the business in future?, etc. The decision maker has to consider all the evaluation factors like, risk, resources, feasibility, viability, etc. Arrive at a Decision: The steps discussed above will guide the decision maker to narrow down his problem to a few choices. In this step, he will select the best alternative from the selected choices. After selecting the best decision and implementing it, there should be a regular follow up in order to see whether the decision is serving the defined purpose. This is done at the implementation stage of the decision.

CONCEPT OF RELEVANT COST AND IRRELEVANT COST Relevant Costs: The Video 11.1.1: Relevant Cost relevant costs are given the utmost importance in managerial decisionmaking. Their magnitude will affect a decision being made. The main managerial decisionmaking involves the planning for the future of the business in terms of new products, entry in new markets, etc., and other decisions like alternative course of action. During the course of such decision-making, the management has to consider various cost aspects involved. These costs are also called relevant costs as they are relevant for the future decision-making. Therefore, a cost can be considered as relevant cost if it helps the management to take a right decision to achieve the objectives of the company. For example, a company now has two types of products and the direct material cost per unit is Rs.25 and direct labor per unit is Rs.20. It wants to make some changes in its product line. The new product line requires direct material at Rs.25 per unit and labor cost of Rs.22 per unit. In this case, the cost of material is constant and it is not relevant for decision-making. Hence the labor cost is changing from the present level in case of the proposal. Thus the labor cost is relevant.
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Irrelevant costs are those costs which will not be affected by any decision made by the management. CHARACTERISTICS OF RELEVANT COST We are already familiar with the concept of relevant costs. Relevant costs are the costs that will make difference when one alternative is selected over the competing alternatives. Essentially, relevant costs have the following two characteristics: They are Expected Future Costs: All future costs are not necessarily relevant to decision-making purposes, but no costs are relevant unless they pertain to the future. Expected future costs mean that the costs are expected to occur during the time period covered by the decision. Past or historical costs are relevant to the decision only if they are expected to continue in the future. They Differ between Alternatives: If the same costs are incurred for both the alternatives, then they are not relevant. If the costs incurred for the alternatives are different, then they become relevant costs. For example, if the manager is evaluating the purchase of either a manual or an automated drill press, both of which require skilled labor costing Rs.80 per hour, the labor rate is not relevant since it is the same under both alternatives. If however, the manual drill press requires only semi-skilled labor at Rs.60 per hour whereas the automatic drill press requires skilled labor at Rs.80 per hour, then the labor rate is relevant because it is different for the two alternatives. The difference between the amounts of the two costs is called differential cost or incremental cost.

COSTS FOR DECISION-MAKING

Typically, in cost accounting system, each product is charged with a portion of indirect costs, which are not traceable to the product. Hence cost figures drawn from the cost accounting system are often not relevant since they are historical costs. Remember that costs, which differ between the alternatives in future alone, are seen as relevant. Sunk Cost A sunk cost is an expenditure made in the past that cannot be changed. These are past costs not future costs. Thus these costs are not relevant for decision-making. For example, the cost of machinery purchased in 1995 is not relevant now in deciding whether to sell the machinery or not. Variable Cost Variable costs are the costs that vary with the level of activity. If they vary with different alternatives they are relevant for decision-making. Thus it should be remembered that all variable costs are not relevant for decision-making. Fixed Cost For the purposes of short-term decision-making, fixed costs may be either relevant or irrelevant. When a fixed cost is incurred only if a certain decision is taken, it is relevant. For example, the manufacture of a new product
Video 11.1.2: Relevant costs for Decision-Making

219

may entail the salary of a production supervisor. His salary, a fixed cost that will be incurred only if the new product is manufactured, is a relevant cost. If a fixed cost is incurred irrespective of whatever decision is taken in a certain situation, it is an irrelevant cost. For example, the salary of chief executive is incurred whether or not a new product is manufactured. Hence in the context of a decision relating to the manufacture of the new product, the salary of chief executive, a fixed cost, is not relevant. Thus it should be remembered that all fixed costs are not irrelevant for decisionmaking. Opportunity Cost This cost represents the benefit foregone in sacrificing the best alternative. To illustrate, consider the use of a machine for manufacturing the product A. If product A is not manufactured, the best alternative use of the machine is to manufacture product B that generates certain revenue. The revenue of Product B forgone to manufacture Product A is the opportunity cost. Opportunity cost is a pure decision-making cost. It is an imputed cost, which does not require cash outlay, and it is not entered in the accounting books. Out-of-Pocket Cost There are certain costs, which require cash payment to be made (like salaries and wages, rent) whereas many costs do not require cash outlay (like depreciation). Out-of-pocket costs involve cash outlays or require the utilization of current resources. These may include direct cost or indirect cost or variable cost or fixed cost. These are relevant for making

decisions like make or buy, price fixation during depression, etc. Differential Cost In management accounting, differential cost is used as a synonym to relevant cost. This can be defined as the change in the cost due to change in the level of activity or pattern or method of production. In other words, it is the difference between the cost resulting from the contemplated change. If the change in the cost is in the increasing form, it is called incremental cost, if it is decreasing with the decrease in output, it is called decremental cost. For the proper analysis of differential cost, we should know the concept of incremental revenue, incremental costs, decremental revenue and decremental costs. Incremental cost increases between two alternatives, whereas decremental cost decreases between two alternatives. Incremental revenue increases between two alternatives, while decremental revenue decreases between two alternatives. FEATURES OF DIFFERENTIAL COST The following are the important features of differential cost: Differential cost differs from one course of action to another. It is a future cost and does not include all variable costs. Variable costs are considered as differential depending upon the situation.

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The differential cost data is related to costs, revenue and investment factors.

R EVIEW 11.1 .1
Differential cost considers only incremental cost or decremental costs and not the cost per unit. While selecting an alternative, the proposal with positive difference between the revenue and cost is considered. Differential costing technique is used to analyze and present data for decision-making and it is not a regular or routine accounting work.

Question 1 of 4 Costs that are not relevant for decisionmaking and are not affected by increase or decrease in volume are

A. Out-of-pocket costs B. Differential costs C. Imputed costs D. Sunk costs

Check Answer

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Section 2

Decision-Making Using Differential Cost Analysis-1

While making decisions, management compares two or more alternatives. Differential cost analysis or differential costing is a special technique to help management in decision-making which shows how costs and revenues would differ under different alternative courses of action. When the capacity is available and it cannot be utilized for manufacture of other products, then the purchase cost is compared with the marginal cost or the total cost is compared with the purchase cost plus fixed cost of manufacture to take the decision to make or buy. When the capacity is available and it can be utilized for manufacture of other products, the purchase price should be compared with the marginal cost of the product plus opportunity cost, i.e., the loss of contribution of other product replaced. When there is no additional capacity available and it is proposed to acquire additional facilities for manufacture, the purchase
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MAKE OR BUY DECISIONS

A firm that is presently buying a product or part from outside may consider manufacturing that product or part in the firm itself. Such a decision-making alternative requires the firm to know through marginal costing what contribution to fixed costs will result from a make decision. Make or buy decisions will be taken with the help of marginal costing in the following manner:
Source:blog.vistage.com

price should be compared with the marginal cost plus fixed cost likely to be incurred for manufacturing with additional facility. Make or buy decision is important for the company. So before taking any decision one should consider certain things as: The capacity of the company in terms of people, plant, space, etc., to achieve the Video 11.2.1: Make or Buy Decision required quantity and quality. The differential cost of making or buying the item. The opportunity cost of using existing capacity to manufacture alternative items. The level of variable overheads, which are charged to the item. Illustration 1 RMS Ltd. manufactures sewing machines which have three components. The following are the data pertaining to these components: The market offers a good demand for the companys products, but the company is not able to supply the products

due to the machine capacity limitation. So the management decided to purchase one component from outside supplier and produce maximum products with the capacity of the bought product. The purchase price of the three components is: P at Rs.150, Q at Rs.180 and R at Rs.240. You are required to help the company management decide which component to buy from outside.
MACHINE HOURS VARIABLE COST (RS) FIXED COST (RS) TOTAL (RS)

COMPONENT

P Q R Packing Total Selling Price

15 24 30

72 90 90 150 402

24 30 90 60 204

96 120 180 210 606 750

PURCHASE

MACHINE HOUR

% UTILIZATION

Nil P Q R

69-15 69-24 69-30

69 54 45 59 69/54 69/45 69/39

100 128 153 177

Solution

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PARTICULARS

PRESENT

IF P PURCHASED

IF Q PURCHASED

IF R PURCHAS ED

Foreign orders or Exploring New Markets The companies may get special orders from their customers for the supply of their regular products. In such cases they have to decide whether the order should be accepted or rejected. The special orders may be either from the domestic or foreign customers. The customers will be quoting a price lesser than the normal selling price for such special orders. The companies usually take decision in such circumstances on the basis of differential cost analysis. So, they compare the incremental revenue with the differential cost. A company should consider the following factors before taking the accept/reject decision: The effect on the future revenue due to temporary reduction in selling price. The impact of reduced selling price on the existing customers when they come to know the price reduction for special order. Possibility of selling extra units for new customers other than the special order. Reliability of the cost estimates for the special order.
Video 11.2.2: Accept or Reject a Special Order

Variable Cost Rs. P Q R Packing Total Variable cost Rs. Selling Price Rs. Contribution Rs. Capacity Utilization % Contribution 72 90 90 150 402 750 348 100 116 150 90 90 150 480 750 270 128 345.6 72 180 90 150 492 750 258 135 394.7 72 90 240 150 552 750 198 177 350.5

As the contribution of Q is highest, the component Q should be purchased from the suppliers Accept or Reject an Order/
Source:www.us.123rf.com

The effect of the present and future capacity in terms of plant expansion, finance, human resources, etc.
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Illustration

PARTICULARS Material Cost Labor Cost Fixed Overheads Variable Overheads Units produced Selling price per unit

(RS) (PRESENT 30,000 UNITS LEVEL) 2,40,000 4,80,000 2,40,000 1,20,000 30,000 units Rs.40

NO.

PARTICULARS Material Labor Variable Overheads

30,000 UNITS 2,40,000 4,80,000 1,20,000 8,40,000 12,00,000

40,000 UNITS 2,80,000 6,59,794 1,60,000 10,99,794 15,00,000

VARIATIO N 40,000 1,79,794 40,000 2,59,794 3,00,000

i. ii.

Total variable cost Sales (30000 @ Rs.40 per unit) (30000 @ Rs.40 per unit+ 10000 @ Rs. 30 per unit)

A factory manufacturing mechanical toys presents the following information for the year 2011: The available capacity is a production of 40,000 units per year. The firm has an offer for the purchase of 10,000 additional units at a price of Rs.30 per unit. It is expected that by accepting this offer, there will be a saving of Re.1 per unit in material cost on all units manufactured; the fixed overheads will increase by Rs.40,000 and the overall efficiency will drop by 3% on production. Prepare a statement showing the variation of net profits resulting from the acceptance of the order.

iii. iv. v.

Contribution (ii) (i) Fixed cost Prot

3,60,000 2,40,000 1,20,000

4,00,026 2,80,000 1,20,206

40.026 40,000 206

The net prot will increase byRs.206 by the acceptance of additional order of 10,000 units

Solution
225

Statement Showing the Variation of Net Profit resulting from the acceptance of the order

PARTICULARS Incremental Revenue:

RS.

In process industries different products are seen at every stage of process. The companies can dispose off these products in the market directly or they can further process these products and sell it at a higher price. Differential cost analysis can be used for this purpose to know whether the product can be sold profitably or it requires further processing to charge a premium. If there is no further capital investment, the decision can be taken by comparing differential cost for processing and the incremental revenue.
PRODUCTION IN KGS 12,000 24,000

Product Z = 12,000 x 85 Product Y = 24,000 x 40 Incremental Revenue: Differential Cost: Additional processing cost Incremental proft

9,84,000 9,60,000 24,000

10,000 14,000

PRODUCTS X Y

SALE PRICE (RS) 30 40

Solution As the incremental profit is more than the differential cost, the company should further process the product Y into product Z.

Illustration Deccan Agro Products Ltd. produces two joint products. The following cost information is available for the year 2011: The product Y can be processed further and product Z can be produced. Product Z can be sold in the market at Rs.85 per kg. It requires an additional cost of Rs.10,000 to process 24,000 kg. of product Y and the output of this process will be 12,000 kg. of Z. You are required to help the management decide in this respect.
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R EVIEW 11.2 .1 Question 1 of 5 A company has an idle plant capacity. It gets a bulk order, which will not affect prices of company products in the market. Such a bulk order may be accepted at a price which is more that its

A. Total Cost B. Variable Cost C. Fixed Cost D. Contribution

Check Answer

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Section 3

Decision-Making Using Differential Cost Analysis-2

CLOSING DOWN OF FACTORY OR SEGMENT Sometimes it becomes necessary for a firm to temporarily closedown its factory or a segment due to trade recession. The decision regarding closing down will depend on whether products are making a contribution towards fixed costs or not. If the products are making a

contribution towards fixed cost, it is not advisable to close the factory or segment to minimize the losses. Even though the factory is closed down, some fixed costs could not be avoided, for instance maintenance of plant or overhauling, etc. So these must be taken into account while making decision. In addition to the cost consideration, some non-

Source:www.letstalkpreferences.com

228

cost considerations should be taken into account before deciding to close down a Video 11.3.1: factory or segment. The Closing Down of Segment following are relevant in this respect: Once the business is closed down, the competitors may take the advantage to establish their products and capture more market share. At a later stage it is difficult to recapture the market from our competitors. Heavy advertisement costs have to be incurred to recapture the market. Once the workers are discharged it may be difficult to get experienced and skilled laborers again to restart the business. If some segment or activities are closed down, it may affect the reputation of the firm. Temporary closure may not be advisable if the relationship with the suppliers is adversely affected. Fear of non-collection of dues from debtors in case of closure of the business may not go in its favor. Illustration

Moon Ltd. manufactures 60,000 units of A in a year at its normal production capacity. The unit cost as to variable costs and fixed costs at this level are Rs.13 and Rs.4 respectively. The selling price of the A is Rs.20. Due to trade depression, it is expected that only 6,000 units of A can be sold during the next year. The management plans to shut down the plant. The fixed cost for the next year then is expected to be reduced to Rs.99,000. Additional costs of plant shut-down are expected at Rs.36,000. Should the plant be shut down? What is shut down point?

PARTICULARS Variable cost 6,000 units @ Rs.13 Fixed cost (60,000 x Rs.4) Additional shutdown cost

PLANT IS OPERATED (RS) 52,000 2,40,000 -

PLANT IS SHUT DOWN (RS) 99,000 36,000

Total cost (a) Sales (6,000 x Rs.20) (b) Loss (b) (a)

2,92,000 1,20,000 1,72,000

1,26,000 1,26,000

Solution Comparative Statement

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Recommendation: A comparison of figures relating to two alternatives points out that loss is reduced by Rs.46,000 if the plant is shutdown. Calculation of shut down point: Shutdown point = Total fixed cost Shutdown cost/Contribution per unit = Rs.2,40,000 Rs.1,26,000/Rs. 20 Rs.13 = 16,285 units.

Video 11.3.2: Dropping a Product Line

PARTICULARS Production units Cost: Material Wages Variable overheads Fixed overheads Total cost Selling price Prot

PRODUCT X (RS) 6,000

PRODUCT Y (RS) 4,000

PRODUCT Z (RS) 10,000

36 14 4 10 64 80 16

52 18 6 16 92 120 28

60 20 6 18 104 122 18

DROPPING OR ADDING PRODUCT LINE In a multi-product company, the management may have to decide on adding or dropping a product line. If a new product line is added, its sales and certain costs will also increase, the reverse will happen when a product line is dropped. In order to arrive at such a decision, the management should compare the differential cost and incremental revenue and study its effect on the overall profit position of the organization. A decision concerning the discontinuation of a product should be taken after considering the following: Competitive nature of the products of the company. Value of resources released on discontinuation. Contribution margin earned from that product.

Any contribution from that product will reduce the burden of total fixed costs of the firm and this will help in better profits than if such product is discontinued.

Illustration Excel Ltd. is engaged in 3 distinct lines of production. Their production cost per unit and selling prices are as under:
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Total Fixed Cost X 10 Y 16 Z Rs.18 10,000 units @ 4,000 units @ Rs. 6,000 units @ Rs.

Rs. 60,000

They intend to discontinue the line, which produces Product X, as it is less profitable. a. Do you agree to the scheme in-principle? If so, do you think
Total Contribution Product X: 9,000 units @ Rs.26 per unit Rs. 2,34,000 5,40,000 7,74,000

64,000

1,80,000 3,04,000

Product Z: 15,000 units @ Rs.36 per unit

Less: Fixed Cost Prot

3,04,000 4,70,000

Contribution Selling Price - Variable Cost X Y Z Rs.80-54 Rs.120-76 Rs.122- 86 Rs.26 per unit Rs.44 per unit Rs.36 per unit Total Contribution

that the line which produces X should be discontinued? b. Offer your comments and show the necessary statements to support your decisions.
Rs. 2,34,000 2,64,000 4,98,000 Less: Fixed Cost Prot 3,04,000 1,94,000

The management wants to discontinue one line and gives the

Total Contribution Product Y: 6,000 units @ Rs.44 per unit Product Z: 15,000 units @ Rs.36 per unit Rs. 2,64,000 5,40,000 8,04,000 Less: Fixed Cost Prot 3,04,000 5,00,000

Product X: 9,000 units @ Rs.26 per unit Product Y: 6,000 units @ Rs.44 per unit

Solution If Product X is dropped Sale

231

assurance that production in two other lines shall rise by 50%.

of Y and Z will increase by 50%. Then the sales would be Y 6,000 units, and Z 15,000 units. If Product Y is dropped Sale of X and Z will increase by 50%. Then the sales would be X 9,000 units, and Z 15,000 units. If Product Z is dropped Sale of X and Y will increase by 50%. Then the sales would be X 9,000 units, and Y 6,000 units.

PURCHASING OR LEASING In case of capital investment decision, the management of the company will consider two alternatives. That is, whether the asset should be purchased, or it should be leased. For the decision-making purpose, the total cost of the two alternatives will be compared to know the additional savings. If there is a saving on purchase, then it should be considered and viceversa. LEVEL OF ACTIVITY PLANNING

From the above, it is clear that among the three alternatives, the highest amount of profit is earned when X line of production is discontinued. Thus the management decision to discontinue X is correct. Other Decisions SELL OR PROCESS DECISION In process type of industries there will be different products at every stage of process. The companies can dispose Source:www.static5.d these products in the market directly or theyepositphotos.com can further process these products and sell it at a higher price. Differential cost analysis can be used for this purpose to know whether the product can be sold profitably, or it requires further processing to charge a premium for the product. If there is no further capital investment, the decision can be taken by comparing differential cost for processing and the incremental revenue.

Marginal costing would help the management in planning the level of activity. Maximum contribution at a particular level of activity will show the position of maximum profitability. EQUIPMENT REPLACEMENT One of the important decisions is whether to buy a new capital equipment or not. This type of decision is called capital expenditure decision or capital replacement decision. The following factors will affect the decision: The benefits that the firm is likely to derive in the long run by replacing the old one; Loss on disposal of old asset; Investment of the new asset; and Increase or decrease in operating costs.
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The decision should be taken after considering the resultant savings in operating costs and the incremental investment in the new equipment.

R EVIEW 11.3 .1 Question 1 of 2 While deciding about replacement of a capital equipment, the firm should take into consideration

A. The resultant savings in operating costs. B. The incremental investment in the new equipment. C. The benefits of the firm is likely to derive in the long run. D. All of the above.

Check Answer

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This document is authorized for internal use only at IBS campuses- Batch of 2012-2014 - Semester I. No part of this publication may be reproduced, stored in a retrieved system, used in a spreadsheet, or transmitted in any form or by any means - electronic, mechanical, photocopying or otherwise - without prior permission in writing from IBS Hyderabad.