Concept, Meaning & Classification of Overhead

Concept and Meaning of Overhead

The term overhead can be defined as the production cost other than direct cost, which is necessary for production but does not become
the part of finished goods. The direct cost is easily traceable with output units. These costs include depreciation on buildings and
equipment, maintenance, supplies, supervision, materials handling, power, property taxes, landscaping of factory grounds and plant
security. These costs do not become the part of the finished goods. However, these costs are essential for the production process.

In some cases, the direct costs are also lumped into the overhead category if they form an insignificant part of the final product. This is
justified on the basis of cost and convenience. If the cost of tracing is greater than the benefit of increased accuracy, such type of direct
costs are lumped into an overhead category as indirect costs. The glue and nails used in making furniture or toys and the thread used in
making clothes are examples of materials treated as overhead.

The institute of Cost and Management Accountant defined overhead as, "Overhead is an expenditure of labor, materials or services
which cannot be economically identified with a specific saleable cost per unit."

Classification of Overhead

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Overhead can be classified on a variety of ways. The major bases of overhead classification are:

On the basis of function

On the basis of behavior / variability
On the basis of elements / nature
On the basis of control

On the basis of Function

In the functional classification of overhead, the base of classification is the major activity of the concern. Based on major activities, the
overhead can be classified into three categories, overhead incurred in production or factory department, office or administration
department and selling and distribution department.

The types of overhead classified on the basis of function are as follows:

Production or work manufacturing overhead

The indirect expenses incurred in operating manufacturing activities or operating the factory or manufacturing overhead. It includes all
the indirect expenses incurred in factory process where the raw materials are converted into finished goods.

Office / Administration overhead

It is the indirect expenses incurred in maintaining the administration of the whole organization. It includes all the expenses related to the
formulation of plans and policies, their effective implementation through proper directions, coordination and controlling of the business
activities.

Selling and Distribution overhead

The indirect expenses incurred for the selling and distribution of finished goods to customers are known as selling and distribution
overheads. It includes expenses that are incurred to create and stimulate demand and to distribute the goods.

Research and Development overhead

Customer’s interest, expectation are changeable day to day. Likewise, newly innovation, speed development of technology and
facilitated distribution are challenges for every business concern nowadays. By considering these challenges, business concern should
establish research and development department. This department concern with development department, new product, new production
planning and finding new needs of customer, etc. The cost is related to research and development department is called research and
development cost.

On the basis of Behavior or Variability

The behavioral classification of overhead considers the direction of the overhead in response to a change in the level of output. Based on
the behavior, the overheads are either fixed or variable or semi – variable as explained below:

Fixed overhead

Fixed overhead are those expenses which remain fixed in a total amount of increase or decrease in the volume of output for a given
period of time. Fixed overhead cost per unit decreases as production unit increases and vice versa. It shows a negative relationship
between production unit and fixed overhead cost per unit. Examples of such expenses are rent of building, salaries, depreciation, interest,
etc.

Variable overhead

Variable overheads are those which vary in direct proportion to the volume of output. There is a positive relationship between production
units remains constant with the change in output. There is a positive relationship between production units and variable overhead. E.g.
indirect materials, indirect wages, fuel, power, etc.

Mixed overhead

Expenses which shows both the nature of fixed and variable overhead are called mixed overhead. These expenses are constant up to a
certain level of output and the vary with the changes of production units, but they do not fluctuate proportionately to the output units.
Examples of such overheads are telephone charges, electricity, repairs and maintenance, etc.

On the basis of Element or Nature

According to the nature or sources of indirect expenditure, the overheads are classified into three types as follows:

Indirect materials

The materials which cannot be identified with a particular cost unit or cost centre are called indirect materials. They do not form the
major component of the finished product. They are not identified with a particular cost centre or cost unit.

Indirect labour

The wages which are paid to the workers who are not directly involved in the production process is called indirect labor. It cannot be
identified with a particular cost unit.
 Indirect Expenses

It includes indirect expenses other than indirect materials and indirect labor. It cannot be identified with a particular cost unit or cost
center but can be apportioned to a number of cost centers.

On the basis of Control

On the basis of control, overheads are classified into two types as shown below:

Controllable overhead

The overhead which is controlled by the decision taken by the management are called controllable overheads. These expenses are
influenced by the action of management. Consumable materials, power expenses, lighting expenses, etc. are the examples of controllable
overhead.

Uncontrollable overhead

It is the indirect expenses which are not under the control of management. These expenses are not influenced by the decision or action
taken by the management. The examples of uncontrollable overheads are fixed overhead cost like rent, salaries, legal fees, etc.
Allocation, Apportionment & Absorption of Overheads
Allocation of overhead

Overheads are the common expenses incurred for a number of departments and cost centers or cost units. Certain items of overheads can
be directly identified with a particular department or cost centre. The process of charging such items of overhead to a particular
department or cost centre is known as allocation of overhead. Allocation of overhead can be made only when the amount of overhead
incurred by a particular department or cost centre is known. Therefore, allocation of overheads means charging all the amount of cost to
a particular department or cost centre. For example repairs and maintenance for a machine should be charged or allocated to that
department where the machine is installed.

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Importance of Overhead Allocation

Allocation of overhead is important for the following reasons:

It helps to determine the product cost.

It helps to fix the price of a product.

It helps to measure the effectiveness of a particular department or cost centre.

It helps to supply the cost information to the management.

It helps to evaluate the profitability of a product line in multi-product business.

It helps to make a proper judgment for measurement of departmental efficiency.

 It helps to provide cost information for planning, controlling and managerial decision making.

It helps to make accurate pricing for the competitive market.

It can be used to control wastage and defective.

Apportionment of Overhead
There are certain overheads, which are common to a number of departments or cost centres. They cannot be directly identified or
allocated to a particular department or cost centre. The distribution of such overhead to several departments or cost centers
proportionately on some equitable basis is known as apportionment of overheads. For example, salary paid to the general manager
should be distributed to the production, administration and selling departments as the general manager looks after all the departments.
Some other common expenses are electricity, rent, lighting, etc.

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Basis of Apportionment of Overhead

The overheads which cannot be associated with the specific department distributed among the related departments on suitable basis are
technically known as apportionment. Apportionment of overheads is made on the basis of:

Benefits or services received

Capacity to bear costs
Efficiency achieved
Analysis and research

Bases of
Allocation Apartments
difference
1. The expenses are directly allocated to the The expenses are proportionately distributed
Distribution departments. to different departments.
The expenses incurred in a particular The cost is incurred by two or more
2. Activity department are an allocation to that departments are apportioned on some
department. equipment bases.
Under allocation, the entire expenditure is Under apportionment, the total expenditures
3. Burden
distributed to a particular department. are distributed among the departments.
4. Allocation is made if the expenditure is Apportionment is made if the expenditure is
Application related to a particular department. related to a number of departments.
5. Use of For allocation, no base is required to
Under it, the expenses are distributed among
suitable include the cost to a particular
the department on some suitablebases.
bases department.

Absorption of Overhead

The process of the overhead of a cost center or department to different cost units or product is called absorption of overhead. In other
words, it is the process of sharing of overheads by all products or jobs of the department. A basis for absorption of overhead for each
department is found out so that each job or product gets due share of overhead for each department when it passes through that
department.

Method of Absorption of Overhead

To determine the amount of overhead shared by the product or job of a particular department, the overhead absorption rate or overhead
rate should be found out. There are several methods of absorption of overhead. The two common methods are explained as under:

On the basis of Labour hour rate

Under this, the overheads are apportioned on the basis of labour hours consumed by a job. Labour hour rate is calculated by dividing the
total overhead by total labour hours for a certain period of time.

Overhead rate per labour hour = TotaloverheadsTotallabourhoursTotaloverheadsTotallabourhours

On the basis of Machine hour rate

Under this, the overheads are apportioned on the basis of machine hours charged to a job. It is calculated by dividing the total machine
hours.

Overhead rate per machine hour = TotaloverheadsTotalmachinehours

Concept, Importance & Components of Unit costing
Concept of Unit Costing

This unit costing is also known as single costing. It is used in those industries where a single or only a few grades of similar articles are
manufactured. For eg. paper, cement, bricks, coal, etc. Unit or output costing is an important method of costing through which cost per
unit is ascertained. The cost per unit of an article is obtained by dividing the total production cost by the number of units manufactured
during a given period of time.

Cost per unit = TotalcostofproductionTotalnumberofunitsmanufacturedTotalcostofproductionTotalnumberofunitsmanufactured

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Importance of Unit costing

It discloses the total cost and cost per unit.

It helps to determine the profitable volume of production.

It helps to determine the selling price of the product.

It enables a manufacturer to keep a close watch and control over the cost of production.

It helps to prepare the tender sheet.

It helps to make a comparison on current cost with the previous cost.

It provides the necessary cost information to the management.

Limitation of Unit costing

It is not suitable for those industries, which produce varieties of products.

It is not suitable to the services oriented organizations like school, college, hospital, etc.
 It can be used only for homogeneous products and not for heterogeneous products.

Cost sheet

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Under this costing, a cost is produced to determine the total and unit cost of an article. Cost sheet is a statement, which shows the
detailed cost under different headings like factory on cost, office on cost and selling on cost for a particular period. It also shows the
element of costs as prime cost, factory cost, the cost of production and total cost.

Cost sheet is an operating statement. It analyzes and classifies the expenses on different items for a particular period in a tabular form. It
may be prepared weekly, monthly, quarterly, half yearly or yearly at any convenient interval of time. Similarly, it may be prepared on
the basis of actual or estimated cost depending on the purpose to be achieved. It is only a memorandum statement, not an account. It does
not form a part of the double entry system.

Purpose of cost sheet

It helps in fixing selling price more accurately.

It helps comparisons of costs of similar jobs or between costs of similar periods.

It gives information for compilation of estimates i.e. Quotations or tenders.

It provides useful information to trace wastages, loss and inefficiencies and thus, affects economics.

It acts as a guide to the producer and helps him in formulating a definite production policy.

Components of Cost sheet

Cost sheet is a periodical statement prepared in a columnar form to know the total cost and per unit cost of production. It is a statement of
costs which includes the total cost on the basis of the following cost components:

Prime cost

The aggregate of all direct costs, which change in direction proportion to change in output, is called prime cost. It is the total of direction
material cost, direct labour cost and direct expenses. The purpose of determining prime cost is to know about the share of the direct cost
in the total cost of production. It is also known as basic cost, first cost or flay cost. It is computed as below:

Prime cost = Direct material + Direct labour + Direct expenses

Factory or work cost

Factory or work cost is the total of prime cost and factory or works overheads, which include indirect material cost, indirect labour cost
and indirect expenseswhich are added to prime cost then the total is called factory or work cost. It is also known as total manufacturing
cost.

Factory cost or work cost = Prime cost + Factory overheads

Cost of production

If office and administrative overheads are added to factory cost, then cost of production can be obtained. In other words, cost of
production is the total of factory cost and office and administrative overheads.

Office and administrative overheads includes those expenses which are concerned with the management of office, administration,
finance and other arrangements.

Cost of production = Factory cost + Office and Administrative overheads

Cost of sales or total cost

If selling and distribution overheads are added to the cost of production, it is called cost of sales or total cost. In other words, the total
cost of production and selling and distribution overheads is known as the cost of sales or total cost.

Total cost or cost of sales = Cost of production + Selling and distribution overheads

Treatment of stocks in Cost sheet

Opening and closing stocks of raw materials
Opening and closing stocks of work in progress
Opening and closing stock of finished goods

Opening and closing stocks of raw materials

Opening and closing stocks of raw materials are adjusted to ascertain the cost of materials consumed which is considered as a direct
material cost, a part of the prime cost.

In a cost sheet, opening stock of raw materials is shown first. Thereafter, purchase of materials, carriage inward, import duty, etc. are
added to it and closing stock of raw materials is deducted there from end result “ cost of materials consumed”.

Opening and closing stocks of work in progress

In the case of opening and closing stocks of work in progress, factory overheads are added to the prime cost and gross factory cost or
cost of goods manufactured is determined first. Then after, opening stock of work in progress is deducted there from to get factory cost
or works cost.

Opening and closing stock of finished goods

After ascertaining factory cost, office and administrative overheads are added to it and cost of production is determined. Thereafter,
opening stock of finished goods is added to it and closing stock of finished goods is deducted there from to get “cost of goods sold”.

If opening and closing stocks of finished goods are given in units, then these units should be valued on the basis of cost per unit.

Cost per unit = CostofproductionUnitsproducedCostofproductionUnitsproduced

Introduction and Classification of Cost
Concept of Cost

Cost means price; the price that is paid for something. That is the general meaning of cost. But, in Cost accounting, it is considered to be
different from price. In cost accounting, the amount of resources that is given up in exchange for some goods or services is known as
cost. Generally, the given up resources are in terms of money or monetary units.

According to Horngren, Sundem and Stratton, “Cost may be defined as the sacrifice or giving up resources for the particular purpose.
Cost is frequently measured by monetary units that must be paid for goods and services.”

The term ‘cost’ is always used with a phrase or an adjective conveying the intended meaning like direct, indirect, variable, fixed,
marginal, replacement, etc. as it does not have any significant meaning by itself.

Cost Centre:

Cost centre is an individual or group of similar activities for which costs are accumulated. According to ICMA, “a production or service,
function, activity or item of equipment whose costs may be attributed to cost units. A cost centre is the smallest organizational subunit
for which separate cost allocation is attempted.”

Cost Unit:

A cost unit refers to the cost imposed upon by a company from the production to the manufacturing, storing and finally selling a product
or service in per unit case. Simply, it is a cost per unit of any service or product including fixed and variable costs during its production
phase. For example:

Industry Cost unit

Car Per unit.

Brickworks Per 1000 bricks.

Textile mills Per lb of cloth or yard.

Steel mills Per ton of steel.

Electricity Companies Per unit of electricity generated.

Transport Companies Per passenger/ per km.

(Koirala & Acharya, 2006)

Classification of Cost

On the basis of different characteristics, cost is classified into various groups. Such as:

1. On the basis of production and process

During the production of products and services, a factory is incurred with several types of costs. These costs can be sub-divided
into 2 types. They are:
 Direct expenditure:
This expenditure contains direct expenses, material expenses and labor expenses which are easily identified wholly with a unit of
cost. For example, cloth and labor are direct expenses for a garment manufacturer.

Indirect expenditure: These expenditures refer to such expenses which are not easy to identify as they tend to occur as an extra
expense in a production process. For example, fabric softener and colour are indirect expenses for a garment manufacturer.

Differences between Direct and Indirect expenditure:

Bases of difference Direct expenditure Indirect expenditure

Direct expenditure can be identified with the main Indirect expenses cannot be identified with the main
Identification
product. product.
Part of prime cost/
It is a part of Prime cost. It is a part of overhead.
overhead
Its value is comparatively less low than direct
Value Its value is generally high.
expenditure.

2. On the basis of element

On the basis of element, cost is divided into 3 parts: material, labour and expense.

Material: Material is the most important component for the production of goods or to provide services. They are classified as
follows:

Direct material:
It refers to the materials which have huge part in the product formation and that can be easily identified through the finished
product. For example; wood, adhesive, plywood, etc. for furniture manufacture; metal, steel, rubber, etc. for bicycle
 manufacture, etc.
Indirect material:
Other expenses or material costs that occur during the production process but cannot be easily traced as the part of the
product are indirect materials. For example; dusters and chalks in teaching purposes in schools, oil and grease for the
maintenance of machinery, etc.

Labour: For the conversion of raw materials into finished goods and even after the production phase, for the proper supply and
distribution of goods, labour is needed. It can be divided into following types:

Direct labour: It is the labour cost which cost centres and cost units can identify and allocate. It is the workforce directly
involved in the production process of the products. For example: wages paid to a mason by a building contractor for the
construction of a building, wages paid to carpenters for a wooden table, etc.
Indirect labour: Salary paid to the general manager or sales managers, salary paid to foreman or supervisor, etc. are some
examples of indirect labour.

Expenses: These are the expenses that incur in the process of production and distribution of the products but not in terms of
material and labour. Its types are :

Direct expense: Also called Chargeable expenses, these are those expenses which incur for each unit of manufacture
specifically. For example; Royalties paid, carriage and freight on direct materials purchased, an amount payable to the sub
contractor, etc.
Indirect expenses: Rent, taxes, insurance of factory building, repairs to factory building, depreciation to plant and
machinery, etc. are some examples of indirect expenses.

3. On the basis of function

The cost can be classified into 4 areas on this basis. They are:

Production cost: As the name says, it refers to the costs concerned with production activity. From the supply of material to the
primary packing of the product, production covers all. It includes direct material, direct expenses, direct labour and manufacturing
expanses.

Administration cost: Also called the office cost, this is the type of cost which does not include production, distribution, research,
development or selling activities. It incurs while administrative functions of the organization are carried, such as; policy
formulation cost and its implementation to attain the objectives of the organization.

Selling and Distribution cost: Selling and Distribution cost refers to the cost of maintenance and creation of demand for product
and making them available in the customers’ hands. They are also called total cost or cost of sales.

Research and Development cost: The research cost is the cost for searching new products, manufacturing process, improvement
of existing products, equipment, services and processes and the Development cost is the cost of putting those research results on
the commercial basis.

4. On the basis of variability

On the basis of variability or behavior, cost is classified into 3 types: fixed, variable and semi-variable.

Fixed cost: Also called the capacity cost, fixed cost remains unchanged and constant no matter what, up to a certain capacity. With
the level of production, per unit cost changes to its accordance but the total amount of fixed cost remains constant. But, while its
costs remain unchanged, it’s per unit cost changes with changes in sales or output.
Some of its features are:

The amount of fixed cost is never Zero, even though the production is zero.
Fixed costs’ amount remains constant, up to a certain range.
These costs are uncontrollable costs.
Per unit fixed cost changes in vice versa to the production activity.

Variable cost: These costs are the costs that change in proportionate to the change in output. Unlike fixed costs, the total amount
of variable cost is zero, if the production is zero. But, on the other side, the variable cost per unit is always constant.
Some of its features are:

It is a controllable cost.
Its total amount changes in accordance with production level changes.
It is also called marginal cost, pocket costs, direct cost, etc.

Semi-variable cost: Semi-variable cost has both fixed and variable costs’ characteristics. It is neither absolutely fixed nor variable
in relation to changes in the volume. Telephone charges, water supply charges, electricity charges, etc. are some of its examples.
Its features are:

It can never be zero.

Its total amount increases with the increase in production level but it’s per unit cost decreases and vice versa.
Its total amount and per unit cost never remain constant.

5. On the basis of controllability

On the basis of controllability, cost is divided into 2 parts. They are:

Controllable cost: These are the costs that can be controlled; as in changed or altered by the action of an individual or a specific
manager.

Uncontrollable cost: These costs are not influenced by anyone’s actions. These are unchangeable.
ILLUSTRATION:

The following cost data are available for the production of 5000 and 10000 units of a product.

For 5000 units (in Rs.) For 10000 units (in Rs.)
Direct material.............. 25,000 50,000
Other direct expenses............ 15,000 30,000
Selling and distribution expenses............ 22,000 35,000
Repairs and maintenance expenses........... 16,000 32,000
Office and administration expenses.......... 11,000 11,000
Depreciation............ 9,000 9,000

Required: (i) Fixed cost (ii) Variable cost and (iii) Semi-variable cost.

Solution:

Fixed cost

5000 Units 10000 Units

Particulars
Total cost (in Rs.) Total cost (in Rs.)
Depreciation 9000 9000

Office and administration expenses 11000 11000

Variable cost

5000 units 10000 units

Particulars
Total cost Unit cost Total Cost Unit cost
Direct material Rs. 25000 Rs. 5.00 Rs. 50000 Rs. 5.00

Other direct expenses 15000 3.00 30000 3.00

Semi-variable cost

5000 units 10000 units

Particulars
Total cost Unit cost Total Cost Unit cost
Selling and distribution expenses Rs. 22000 Rs. 4.4 Rs. 35000 Rs. 3.4

Repairs and maintenance expenses 16000 3.2 32000 3.2

Cost Accounting and Financial Accounting

Cost Accounting
Cost accounting is the branch of accounting that deals with the classification, allocation, recording, summarization and reporting of costs.
It is the accounting process for cost ascertainment, cost allocation, cost distribution and accounting aspects. It is an internal reporting
system by the means of which costs of products and services are controlled.

Cost accounting aims to assist the management in planning and decision-making processes. Its emphasis is primarily on collection,
analysis, interpretation and presentation of cost for managerial decision makings.
According to National association of Accountants, USA, “Cost accounting is a systematic set of procedures for recording and
reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in details.”

Functions and Objectives of Cost Accounting

1. To ascertain cost:
It is the main objective of cost accounting. Costs are the expenses that incur during the production of goods and services and it is
the major objective of cost accounting to ascertain their costs. Material, labour, direct expenses, etc. are some of the examples of
cost.

2. To analyze cost and loss:

Another objective of cost accounting includes the analysis of the cost of each activity. It is important to analyze the cost in order to
classify the costs’ variability, profitability or loss chances, relevancy, etc. Similarly, breakdown or machine damage, idle time, the
effects of misuse of material, etc. are further analyzed.

3. To control cost:
Cost accounting uses cost control as the technique to minimize the cost of product and services, without any compromise on their
quality. Standard costing and budgetary control are some of the techniques that helps in controlling the cost.

4. To aid the management:

Cost accountancy provides essential costing information to the management which helps in the planning and its implementation.
This helps in the evaluation of both past activities and future planning.

5. To help in selling price fixation: Almost all the above functions are performed in order to reach the objective to determine the
selling price of the products or services in per unit term. After ascertaining the cost per unit of products, selling price per unit is
calculated with the addition of a certain profit on the total cost amount. Various techniques such as job costing, batch costing,
service costing, multiple costing, contract costing, etc. are used to fixate the selling price.

Advantages and Importance of Cost Accounting

 1. Helps in controlling cost:
Cost accounting controls the cost by comparing the actual cost with the standard or budgeted cost under techniques like Standard
Costing and Budgetary Control. If there is the deviation in existence, the corrective actions are to be taken.

2. Helps in increasing profit:

From the introduction and implementation of various cost reduction techniques to increase profit and to the disclosure of the
profitability of activities helps the management in the decision making of contract continual and expansion or contract elimination,
Cost accounting helps in every way possible to gain profit.

3. Helpful in fixing selling price:

By ascertaining the cost per unit of products and services, Cost accounting helps in the determination of selling price by adding
certain profit amount on the total cost.

4. Provides essential cost information:

Cost accounting helps the management by providing necessary cost information for planning, implementation and controlling
purposes. Further, it also provides some other necessary costing information to the outsiders like the suppliers, investors, the
government, tax authority, etc.

5. Helps to compare costs:

Comparison of costs between periods, processes, departments and volumes of output is important to take corrective actions. For
this, cost accounting provides the management with reliable data and information.

6. Advantages to customers:
Because the cost accounting makes sure in the rational usage of material, labour and technology, as well as different cost reduction
and controlling programs, customers are provided with quality goods and services at reasonable prices.

7. Advantages to government:
Fixation and control of price, formulation of foreign trade policies, determination of tax, settling minimum wages and labour
disputes, etc. are some of the issues that cost accounting helps the government with.

8. Advantages to the workers:

As cost accounting emphasizes on the rational use of labour and wage payment system, it is very beneficial to the workers too.

9. Helpful to the investors: Cost accounting is very beneficial to the investors as well as financial institutions because it shows the
financial position and profitability of the possible investments.

Limitations of Cost Accounting

1. Conceptual diversity: Cost accounting is very diverse and consists of large number estimations, conventions and flexible factors
which make it difficult to come up with exact costs. In such situation, it is difficult to count on cost accounting.
2. Costly: While fulfilling various formalities that need observation, it becomes quite a costly business for small and medium size
concerns in their establishment and running costs. Due to this, costs may be unaffordable.
3. Lack of uniformity: Because Cost accounting lacks in a uniform procedure, accounting results from the same information can
outlay different results. Thus, these results can be regarded as estimates.
4. No double entry system: Double entry system is un-adopted under Cost accounting, thus making it unhelpful in checking the
arithmetical accuracy of the transactions. Location of errors is also difficult.
5. Underdeveloped: Cost accounting’s concepts, conventions and principles are still in developing stage, making it more unreliable
at the time.

Differences between Cost accounting and Financial accounting

Cost accounting Financial accounting
Its main purpose is to provide information on Its main goal is to ascertain the profit or loss
costs for planning and decision making. incurred as well as firm’s financial position.
It emphasizes on cost control. Its emphasis is on recording transactions.
It provides information on the business
It provides information regarding business
affairs in product, service, element or activity
affairs on totality.
wise.
Inventory valuation is made of the cost or
Inventory valuation is made on cost price.
market price, whichever is less.
It’s not a statutory obligation for firms to Its maintenance is a statutory obligation for
maintain cost accounting. firms.
With the determination of total cost and cost Selling price is difficult to determine under
per unit, selling price can be fixated. financial accounting.
When required, costing reports are Reports on the financial condition and
immediately provided to the management. business operations are provided annually.
It tries to control costs such as material,
It cannot control costs.
labour and overhead.
Because it records past transactions only, it
It is both historical and futuristic.
is historic in nature.

Limitations of Financial Accounting

It is based on past transactions and historical information which lack importance.

It does not help in the determination of selling price of products.

It is not helpful in disclosing the results of each product, process, departments, jobs, etc.

Classification of the cost is unavailable.

Its control on cost is almost absent.

It lacks the assistance for the decision-making process.

Due to its lack of relevant cost information, cost ascertainment of products and services is not possible.

It lacks any standard system to measure the efficiency of the material, labour and other resources.

It cannot explain the losses which are caused due to defective materials, idle time and plant, etc.
Methods of Costing
METHODS OF COSTING

Depending upon the product’s nature, its production method and some specific business conditions, business enterprises use different
costing methods. Over the years, many costing methods have come out on display but all the methods always have the basic principles
which are related to the collection, allocation, analysis, apportionment and absorption.

The costing methods can be further classified into 2 types as specific order costing and continuous operation costing.

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1. Specific Order Costing

This is the type of costing method whose main users are those type of business enterprises that are involved in a construct
(make/assemble) jobs or products. This method is further sub divided into 3 types. They are:

i. Job order costing:

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This costing method is used in ascertaining the cost of each job or work order separately. As each job and product have its own distinct
nature, all of the relevant cost is charged considering it as a cost unit.
Under this method, firstthe production and its requirement are identified, followed by the ascertaining of the expenses relating to it. This
method is mostly suitable for the construction of road, furniture, automobile works, repair shops, etc. Some of its features are:

Under this method, production is carried out against customer’s order by the manufacturer.

Each work or job is different in nature.

The works are usually executed in the factory premises or in workshops and repair shops.

The unit of costing is the job or work order.

ii. Contract costing:

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A contract is a job of large size. Thus, in that manner, contract costing method is not so different than job costing method. Contract
costing is mostly used for large scale contracts. This method is used in such building and constructing works which take a long period of
time to be completed such as hydropower plant, road & bridge construction, ship building, etc. Its features are:

Contracts are jobs in large size.

Contracts take a long period of time to complete.

Generally, contract works are performed out in a site, outside of factory premises.

The contracts are executed in thorough specifications of the contractee.

Differences between Job order costing and Contract costing:

Job order costing Contract costing

The time period to complete a job is
comparatively less.
The work under this method is small in size.
Preliminary investment in assets is low.
It takes quite a long time to complete a contract.
Here, the contract’s size is much larger than job order.
Preliminary investment in assets is comparatively high.

Price payment for the job is usually paid after
the job completion.
The profit & loss amount earned is entirely
transferred to profit & loss account.
Product manufacturing is done within the
factory area.
Generally, price payment for contracts is done gradually in installments, before work
completion.
After transferring the profit to reserve, on the basis of work in progress, only the
remaining amount of profit is transferred to profit & loss account.
Contract work is usually carried outside of factory premises, in site.
Expenses incurred can be both direct and
The expenses incurred are usually direct expenses.
indirect in nature.

iii. Batch costing: Abatch is a group of similar products or orders in a specified number passed through a factory. Under this method,
each batch is a unit whose cost is ascertained separately. Batch costing is mostly useful in the industries of readymade garments, biscuit
manufacture, canned products, etc.

2. Continuous operation costing

This method of costing is generally used by such organizations which are involved in the mass production of products through
continuous operations. These products are then sold from stock and are not produced to customers’ specific requirements. This method is
sub-divided into five parts. They are:

i. Process costing:
This is the costing method that is used to ascertain the cost of a product in each and every stage of a process. This method is most
applicable in the manufacturing of such products which are to produce through different stages or processes, where each process is
considered a separate cost center. This method is suitable for the use of industries producing gas, oil, cement, textiles, sugar, etc. Its
features include:

The manufactured units are standardized.

The production process is continuous that are carried on for own stock.
Before completion, the products have to go through several processes, each being separately well defined.
The output of a process becomes the next process’s input and passes through various processes till they become final products.

ii. Service costing:

This is the method of costing for determining the cost of providing a service. Industries rendering services are likely the major users of
this method. This method is appropriate for hospitals, hotels, power supply companies, transport undertakings, municipal services, etc.

iii. Unit or single costing:

Also known as output costing, this method is most applicable for those manufacturers that produce a single product or a few grades of
similar products. This costing method ascertains the cost per unit of output. Industries producing coal, bricks, oil drilling, etc. are the
major users of this costing method. Its features are:

The units of output are identical and natural.

The production process is continuous.
This method ascertains the cost per unit of output like per meter, per ton, etc.

iv. Multiple costing:

This is the type of costing method is used where two or more than two costing methods are combined and applied to ascertain the cost of
the product or service. Also known as composite costing, this method is appropriate where number of component or parts of a product is
separately produced and then assembled into a final product subsequently. This costing method is used in factories manufacturing radios,
airplanes, automobile engines, cycles, etc.
(Khanal & Dulal, 2073)

v. Operation costing:
This method is a further refined method of process costing. The procedure for cost ascertainment in operating costing is so far the same
as in the process costing, except that the cost unit is not a process but an operation.
This costing method is used mainly in such industries where production is repetitive or in mass or where the components have to be
stocked in a semi-finished state, to execute special orders or issue convenience or later operations. For example: the manufacturing of
handles for bikes involves series of operations like cutting steel sheets into proper strips, then molding, machining and finally polishing.
Each of these operations is ascertained with separate costs.
Accounting for Debentures
Debenture

(Source:www.businessstudynotes.com)

The joint stock company may require money for its expansion and development. This requirement may be met by the company by public
borrowings. A debenture is one of the ways of the public borrowing. The issue of debentures helps the company in borrowing the bulk
amount of debts from the large section of the general public. A debenture is a document that recognizes such public borrowing.

A debenture is a certificate issued by a company acknowledging a debt of a specified amount of public borrowing. It is a portion of loan
capital. A debenture is also known as bond. The owners of debentures are called debenture holders. They are the creditors of the
company and are entitled to receive an agreed and fixed rate of interest on their debentures regularly. Debentures carry interest
periodically at a certain rate.

The Oxford Advanced Learner’s Dictionary has defined debenture as “ An official document that is given by a company, showing it
has borrowed money from a person and stating the interest payments that it will make to them.

A debenture is a loan certificate issued by the company to its holders under the company seal. The company instead of borrowing entire
monetary requirement from a financial institution may obtain it from the large section of the general public by issuing certificate
acknowledge debts. The borrowing is called debentures.

Features of Debentures
The following are the main features of debenture:

It is a written certificate issued by the company as an acknowledgement of a debt.

It is issued under the company’s seal.

It contains the rate of interest to be paid to the subscribers.

It contains the mode of payment of the large section of the general public.

Types of Debenture
(Source:www.efinancemanagement.com)

Debenture can be classified into different types on the basis of terms and conditions of issue. The different types of debentures issued by
a company are as follow:

1. Registered debenture: A debenture that cannot be transferred by a mere physical delivery is called registered debenture. The
name of the holder of such debenture is registered with the company.

2. Bearer Debenture: The debenture which is transferable by a mere delivery is called bearer debenture. The holders of such
debentures are its owner and are called debenture holders.

3. Irredeemable debenture: A debenture which is issued without any maturity period is known as an irredeemable debenture. This
type of debentures is also called perpetual debenture. The sum of the debenture is repaid to the debenture holders after the expiry
of the period specified at the time of issue.

4. Convertible debenture: A debenture which is issued with an option of being converted it into common share, preference share or
new debentures within a specified period at a conversion ratio is called convertible debenture.

5. Non-convertible debenture: The debentures, which have no option of being converted into equity or preference share or new
debentures are called non-convertible debenture.

6. Secured debenture: A debenture which is issued against a specific fixed assets as security is called secured debenture. Upon
 default of such debenture in due data, the debenture holder can realize their sum out of the sale realized from such fixed assets.
Secured debentures are also called mortgaged debentures.

7. Unsecured (naked) debenture: Debentures issued without any security are called unsecured debentures. The holders of such
debentures are not given any security for the issue of such debentures. The holders of such debentures are treated as the general
creditors of the company.

8. First debenture: A debenture which is issued against a specific fixed asset not currently pledge as a security for the issue is called
the first debenture. Such debentures need to be repaid fully before second debentures are issued.

9. Second debenture: A debenture which is issued against a specific fixed asset already used as a security is known as the second
debenture. Such debentures are repaid only after the first debenture have been fully settled.

10. Collateral Debenture: Debenture may also be issued to money lenders, i.e to the banks and financial institutions as an additional
security along with the principal security for the sanction of the bulk amount of loan. Such debentures are called collateral
debentures. The money lenders can exercise its rights as debenture holders if issuing company fails to pay the loan amount and
principal security falls short to recover the loan.

(Koirala, Shrestha, and Singh)

Importance of Debenture
(Source:www.efinancemanagement.com)

An issue of debenture plays a great role in long-term planning and decision-making inside the organization. In modern competitive
business age, every company requires a fund to start any business or for any business opportunity. This financing can be fulfilled only by
issuing owner's capital and debt capital. The issue of a debenture, on one side, creates the obligation for the payment of interest at a fixed
rate and in another side, it causes an increase in ' earning per share' due to comparatively less number of shares issued. (Account
management)

Debentures as a source of finance activity companies which have regular earnings to service the debt have a higher proportion of fixed
assets in their assets structure which offers adequate security and motivates investors. The company has to ensure maintenance of
discrete debt equity ratio.

1. Support from investment institutions is sufficiently available.

2. Debenture holders receive a fixed rate of return on their investment.
3. Institutional underwriters, merchant banks in public and private sector have come up to render successful underwriting services to
the investor as well as the needy companies;
4. Investor’s preference to high yielding securities with minimum risk has encouraged issue of debentures by the companies.
5. The cost of raising money through debenture is minimum as against the cost involved in other sources of finance.
6. Debenture issuing company is obliged now to create a debenture redemption fund to protect the interest of debenture holders.
7. Debentures are transferable from one person to another. (Money matter)
Advantages of Debentures
The issue of debenture does not result in dilution of interest of equity shareholders as they do not have right either to vote or take
part in the management of the company.

Interest on debenture is a tax deductible expenditure and it saves income tax.

The cost of a debenture is relatively lower than preference shares and equity shares.

Issue if debentures are advantageous during times of inflation.

Interest in debenture is payable even if there is a loss, so debenture holders bear no risk.

Disadvantages of Debenture
Payment of interest on debenture is obligatory and hence it becomes a burden if the company bear a loss.

Debentures are issued to trade on equity but too much dependence on debentures increases the financial risk of the company.

Redemption of debenture involves a larger amount of cash outflow.

During a depression, the profit of the company goes on declining and it becomes difficult for the company to pay interest.

(Trishna)

Accounting treatment for debenture (I)

Issue of Debenture
A debenture is an instrument issued under the common seal of a company, acknowledging its debt to the holder under the terms and
conditions specified. According to the Company Act, 2053(1997), " A public limited company can raise capital after the permission of
the concerned authority by issuing debentures with or without pledging immovable assets of the company. Like share, the debenture is
offered by a company to the public along with prospectus."
Issue of Debentures for cash

Debentures are issued for cash considerations either at par or at a premium or at a discount, just like the issue of share. The amount of
debentures can be collected either on lump-sum (single installment) or on an instalment basis.

Issue of debenture on a lump-sum basis

If all the money is collected in a single installment at the time of application then such issue of the debenture is said to be made on a
lump-sum basis. The whole amount of debentures is collected in a single installment with application form in this option.

Example: 1

ABC Company Ltd. Issued 2000, 8% debentures of Rs 1,000 each. All the debenture were applied for and allotted by the company.

Required: Journal Entries

Issue of Debenture on Installment Basis

The amount of debenture may be collected in several installments. The debenture money is collected in several installments as the
application, allotment and subsequent calls as on shares. The entries regarding the issue of debentures are similar to the entries for the
issue of shares.

Example: 2

Kantipur Co. Ltd issued 5000, 10% Debenture of Rs.100 each payable as Rs.40 each on an application, Rs.30 each on an allotment and
Rs.30 each on first and final call. All the debenture were fully subscribed and the debenture money called for was duly received.

Required:Journal entries
Issue of Debenture at Par

If a company issues debentures inviting the public to subscribe at face value (nominal value) then the debentures are said to be issued at
par. Their par or face value is printed on the face of debenture certificates. For example, a company issued 10,000 debentures are issued
at Rs.100 each, it is known as an issue of debentures at par.

Example: 3

Atlantic Co.Ltd issued 10,000, 10% debenture of Rs.100 each payable as under.

Rs.25 on Application

Rs.50 on allotment

Rs.25 on first and final call

All the debentures were subscribed by the public and were allotted. The entire amounts sue on debentures were received.

Required: Journal Entries

Issue of Debentures at Discount

A debenture may be issued at a price less than its face value. Such an issue of a debenture is called the issue of debentures at a discount.
For example, when a company issues debentures of Rs.1,000 face value per debenture at Rs.950 each, then Rs.50 each is considered as
the discount on issue of debenture account at the time of du. The discount on debentures is allowed at the time of allotment. Mostly, it is
debited to discount on issue of debentures at the time of due. However, it may also be debited at the time of allotment money received. It
is a capital loss, so it is shown on the balance sheet. It is to be written off as per the decision of the Board of Directors.

Example: 4

Gautam Sugar Mills Ltd. Issued 5,000, 8% debentures of Rs.500 each at 10% discount payable as follow:

On application Rs.200 each

On allotment Rs.150 each

On first and final call Rs100 each

All the debentures were fully subscribed and all the debenture money was duly received.

Required: Journal entries

Issue of debentures at Premium

When debenture are issued at a price higher than its face value, such an issue is known as an issue of debentures at the premium. If the
debenture’s face value of Rs.100 each is issued at Rs.110, the excess of Rs.10 over the face value is termed as debenture premium. It is a
capital gain and is credited to debenture premium account.

The amount of premium can be collected either with the application or with an allotment or with subsequent calls. Normally, the amount
of the premium is collected along with the application or with allotment money.

Example: 5

ND Ltd issued 10,000, 8% Debentures of Rs.100 each at 10% premium , payable as follows:

On application Rs.40

On allotment Rs.30 (with premium)

On first and final call Rs.40

All debentures were fully debenture were fully subscribed and all the money called on debentures was duly received.

Required: Journal Entries

Alternatively, when the amount of denture premium is received along with the application money then there is another possibility of
recording debenture premium as shown below:

Calls In Arrear

When debenture holders fall to pay debenture allotment or/and debenture call, such an outstanding amount is called ‘calls in arrears’.
There are two alternative methods of accounting treatment on such calls in arrears. These methods are as follows:

Showing calls-in-arrears: The outstanding amount of debenture allotment and debenture calls are shown in a separate account
called call in arrears account.

Without showing call-in-arrears: The calls in arrears amounts are not shown separately in the book of account but are deducted
out of debenture allotment and/or debenture call.
A company needs to receive interests on calls in arrears from those debenture holders who fail to pay their called money within the
stipulated time. The interest is paid on the basis of the provision made for calls in arrears in the Article of Association.

Example: 6

Bajaj Co.Ltd issued 5,000 debentures of Rs.100 each at 10% premium for public subscription. The debenture money payable on an
application was Rs.40, on allotment Rs.40 and Rs.30 on debenture first and final call. All the debentures were applied for allotted and the
money was duly received expect from a debenture-holder who held 1,000 debentures failed to pay debentures and first and final call
money.

Required: Journal Entries

Calls In Advance

The company may receive the debenture call amount in advance. Such an amount is known as calls-in-advance. It may be received with
allotment money for subsequent calls or with first call money for a second and final call. The amount so received in advance is created to
calls-in-advance account and is debited by the amount withdraw for subsequent calls. The credit balance of calls-in-advance is shown on
the capital and liabilities side of the balance sheet till it is fully withdrawn.

The company needs to pay interest at a certain rate on call-in-advance from the data receipt to the data to withdraw if its Article of
Association provides for such an interest. Interest is paid on the basis if the provision made for calls in advance in the Article of
Association.

Example: 7

Honda co.Ltd. issued 2,000, 8% debentures of Rs.100 each at 10% discount. The amount of payable on application Rs.40 each, on an
allotment, is Rs.30 each and balance on first and final call.

All the debenture were subscribed and allotted. A debenture-holders, Mr.Basu, to whom 100 debentures were allotted, paid the entire
balance of debentures with the amount of allotment.

Required: Journal Entries

Note: Call-in-advance also occurs when a company retains the excess money received in the application for subsequent allotment and
calls due to the over-subscription.(Koirala, Shrestha and Singh)

Accounting treatment for debenture (II)

Over-Subscription of debentures

Example:
X Limited Issued 10,000, 12% debentures of Rs 100 each payable Rs 40 on application and Rs 60 on an allotment. The public applied
for 14,000 debentures. Applications for 9,000 debentures were accepted in full; applications for 2,000 debentures were allotted 1,000
debentures and the remaining applications, were rejected. All money was duly received. Journalize the transactions.

Solution:

Under-Subscription

Under-subscription is a situation in which the total number of debentures issued is not fully subscribed. It occurs when the number of
debentures applied for is less than the number of debentures offered. In this case, all the debenture applications received are either
acceptable fully or rejected fully. The entries are made on the basis of the actual number of debenture applied.

Example:

MM Co. Ltd has issued 5,000, 5% debentures for Rs. 100 each at par. The amount payable per debenture is as under.

On application Rs. 40

On allotment Rs. 60

The company received applications for 4,000 debentures and allotment fully. All money was duly received.

Solution:
Issue of Debentures for Non-cash Considerations

The issue of debentures for the considerations other than cash is called the issue of debenture for non-cash considerations. The company
may issue debentures for discharging the amount due on the purchase of assets, purchase of a business and as collateral securities.

Example:

G.S.Rai Company purchase assets of the book value of Rs 99,000 from another firm. It was agreed that purchase consideration is paid by
issuing 11% debentures of Rs 100 each. Assume debentures have been issued.

1. At the par, 2. At a discount of 10%, and 3. At a premium of 10%. Record necessary journal entries.

Solution:
Issue of Debenture as Collateral Security

The issue of debentures to a bank/money lender for the sanction of a loan as a collateral security is called collateral debentures. On
repayment of the loan, the collateral security is automatically released but in a case of failure of repayment, the lender automatically
becomes a debenture.

First Method

No entry is made in the books of accounts since no liability is created by such issue. However, on the liability side of the balance sheet,
below the item of a loan, a note to the effect that it has been secured by an issue of debentures as a collateral security is appended.

Example:

X Company has issued 9%, 10,000 debentures of Rs. 100 each for a loan of Rs. 10, 00,000 taken from a bank. This fact may be shown in
the balance sheet as under:

Solution:
Second Method

The issue of debentures as a collateral security may be recorded by means of journal entry as follows:

Company Accounts and Analysis of Financial Statements Journal Entries:-

i. Issue of 10,000, 9% debentures of Rs 100 each as collateral security for bank loan of Rs 10,00,000.

Debenture Suspense A/c Dr. 10,00,000

To 9% Debentures A/c 10,00,000

ii.For cancellation of 9% debentures as collateral security for repayment of bank loan. Debenture Suspense account will appear as a
deduction from the debentures on the liability side of the balance sheet. When loan is repaid the above entry will be cancelled by a
reverse entry :

9% Debentures A/c Dr. 10,00,000

To Debenture Suspense A/c 10,00,000

Solution:
Issue of Redeemable Debentures

The debentures, which are issued with a maturity date are known as redeemable debentures. The repayment of the principal amount of
debentures to the debenture holder is made on the maturity of the debentures. The redeemable debentures may be issued under different
conditions for which the following journal entries are passed. Account treatment of issue of debenture of issue of redeemable debentures
under different condition

Redemption of Debentures

Redeemable debentures are issued with a maturity period. After the maturity of the period, the principal amount of the debenture is
repaid to the debenture holders. The repayment is made as per the terms laid in the prospectus at the time of issue of debentures. The
methods of redemption of debentures are as follow:

Modes of Redemption of Debentures

1. Redemption in instalments
2. Redemption of a fixed sum of debentures
3. Redemption by a purchase of debentures in the open market.
4. Redemption by conversion
5. Redemption in lump sum after the expiry of maturity period
6. Creating a sinking fund or debenture redemption reserve account
7. Taking an insurance policy

Redemption of debentures on Lump-Sum Basis

Under this method, all the principal amount of debenture is repaid at once on a lump-sum basis. The company may redeem the
debentures after the maturity period is over or even before the expiry of the specified period of time by serving a notice to the debenture
holders. The accounting treatment made for such redemption of debentures is shown as under.

1. X Ltd. issued 5,000, 9% debentures of Rs 100 each at par and redeemable at par at the end of 5 years out of capital.

2. X Ltd. issued 1,000, 12% debentures of Rs 100 each at par. These debentures are redeemable at 10% premium at the end of 4 years

3. X Ltd. issued 12% debentures of the total face value of Rs 1,00,000 at premium of 5% to be redeemed at par at the end of 4 years

4. X Ltd. issued Rs 1,00,000, 12% debentures at a discount of 5% but redeemable at a premium of 5% at the end of 5 years
Redemption of Debentures by annual Drawing/Instalments

When the principal amount of debentures is repaid by the annual drawing of debentures in equal instalments over the maturity period,
such a process is called redemption of debentures by annual drawing. The company may redeem the principal annually on equal
installment.

Purchase of One’s Own Debentures from Open Market

Under this method, the company purchases its own debentures from the open market. The buying of debentures is generally made prior
to the expiry of such debenture. The buying of debentures is also called the redemption of debentures. The debentures purchased from
the open market can be cancelled immediately after the purchase. The company may also retain such debentures for some time as an
investment and cancel them later.

Example:

X Ltd. purchased its own debentures of Rs. 100 each of the face value of Rs. 20,000 from the open market for cancellation at Rs. 92.
Record necessary journal entries.

Solution:

Conversion of Debentures

Convertible debentures are redeemed by converting them into new debentures or into shares. Holders of convertible debentures enjoy the
option of having their debentures converted either into shares of new debentures according to the term and condition of the issue. The
new debentures or shares can be issued either at par or at a premium or at a discount. The accounting treatment for conversion is given
below:

Example:

Arjun Plastics Limited redeemed 1,000, 15% debentures of Rs. 100 each by converting them into equity shares of Rs. 10 each at a
premium of Rs. 2.50 per share. The company also redeemed 500 debentures by utilizing Rs. 50,000 out of profit. Give the necessary
journal entries.

Solution:
WRITING OFF DISCOUNT OF ISSUE OD DEBENTURES

Discount on issue of debentures is a capital loss. A separate account entitled loss on issue of debentures account may also be opened to
show discount on issue and provision set aside for premium payable on redemption. The loss is written off as per the decision of the
Board of Directors. The discount on issue of debentures is shown on the balance sheet of redeemable debentures.

1. Annual instalment basis

2. Outstanding debentures amount basis

1. Annual instalment basis (When the Total Amount of Debentures is Redeemable at the End of the Maturity Period

The total principal amount of debenture may be redeemed at the end of the maturity period in a single installment. Each year an equal
amount of discount is written off under this method. The amount of annual discount to be written off is determined by using the
following formula:
The accounting treatment for writing off discount in issue if debentures are as follows:

Profit and loss A/c Dr xxx

To Discount on issue of debentures a/c xxx

(Being a portion of loss on issue of debentures `is written)

2. Debentures Outstanding Amount Basis (Ratio)

When the debentures are redeemable by annual drawings, the loss/discount on issue of such redeemable debentures are written off on the
basis of the debentures outstanding ratio.

Example:

Atlantic Co.Ltd. issued 2,000, 10% debentures of Rs. 100 each at Rs. 90 per debenture. Those debentures were redeemed at 10%
premium on an equal amount of annual drawing basis over the period of 4 years.

Solution:
.
Introduction and Types of Materials
Concept and Meaning of Materials

The material includes raw material, components, tools, spare parts and consumable stores. Material which forms a part of a finished
product is the first and most important element of a cost. Materials constitute such a significant part of product cost and since, this cost is
controllable, proper planning, purchasing, handling and accounting are of great importance. A manufacturing company incurs different
types of costs to produce a unit of output.

Such costs include material costs, labor costs and other costs. Among them, material costs are important because in many manufacturing
companies, such costs are greater than all other costs combined.

In other words, proper control of materials is necessary from the time orders for the purchase of materials are placed with suppliers until
they have been consumed. Material is one of the most important elements of production.

The term “material” refers to raw materials that are used for production, sub-assemblies and fabricated parts. Materials include
components, consumable stores, maintenance material, spare parts and tools. They are used in manufacturing industry in their
fundamental forms and they constitute a part of the physical form of a product. Wool, cotton, glass, sugarcane, rubber, etc. are some of
the examples of material.

The costs of all such materials constitute part of the costs of jobs, operations, productions, or services for which they are utilized.
Materials represent nearly 60%-70% of the costs of production in most manufacturing firms.
The term ‘materials’ is general, used in manufacturing concerns. Materials are the commodities or article used for processing in the
factory to manufacture goods or rendering services. It includes physical commodities used to manufacture the final product. It is the first
and most important element of cost.

Materials form a high proportion of the total cost of production. In certain cases, like sugar, materials may form as high as 60% of the
total cost. The production is rarely less than 25% to 30%in the case of most products. This means that efficiency as regards materials is a
vital factor in total cost of production and profits earned.

Any saving in materials will be directly reflected in profits. Therefore, it is necessary that maximum care should be devoted to the
purchase, storing and use of materials. Raw materials, diesel, tools, etc. are the example of materials.

Types of Materials

Normally, there are two types of materials in a manufacturing concern. They are as follows:

Direct Materials

Direct materials means the materials which form part of the finished output and can be identified with finished product easily. For
example; wood, plywood, adhesive, wood polish, nails, etc. in the case of manufacturing furniture, the cost of cotton in the case of
manufacturing cotton yarn, the cost of yarn in case of manufacturing cloth, the cost of iron in case of manufacturing machinery, etc. The
main feature of direct materials is that these enter into industry and form part of the finished product.

Indirect Materials

Indirect materials refer to the material costs, which cannot be allocated but can be apportioned to or absorbed by cost center or cost units.
These are the materials, which cannot be traced as part of the product whose cost is distributed among the various cost centers or cost
units on some equitable basis. Examples of indirect materials are coal and fuel for generating power, cotton waste, lubricating oil and
grease used in maintaining the machinery, materials consumed for repair and maintenance work, dusters and brooms used for cleaning
the factory, etc.

Differences between Direct Material and Indirect Material

The main between direct material and indirect material are given below:

Basis of
Direct Material Indirect Material
Difference
Direct material remains as the part of the Indirect material do not remain as the part of a
Part of product
product. product.
It can be easily identified with final It cannot be easily identified with final
Identification
products. products.
Nature of cost It is a part of the prime cost. It is a part of overhead.
The price of direct material is The price of indirect material is
Price
comparatively higher. comparatively lower.
Effective control is needed for direct Effective control is not needed for indirect
Control
material. material.

Meaning of Material Control

No system of costing can be said to be complete without a proper system of material control. It is a system which ensures that right
quality of material is available in the right quantity of time and right place with the right amount of investment.

Materials control basically aims at efficient purchasing of materials, their efficient storing and efficient use. In other words, it is a
systematic control over the storing, purchasing and consumption of materials so as to have the minimum cost of material. Materials
control consists of controls at two levels: Quantity controls and cost controls.

Need / Objectives for Material Control

Material control is needed for the following reasons:

1. To avoid materials continuously: There should be a proper control on a material to run the production smoothly and avoid the
materials continuously.

2. To purchase the qualitative materials at a reasonable price:Another objective of material control is to ensure that the
qualitative raw materials and instruments are to be purchased in a reasonable price. This can be achieved through trade discount,
terms of credit, carrying system, etc.

3. To provide information about the availability of materials:The success of production process largely depends on the
availability of materials. Hence, it is necessary to identify the source of material supply. For this, information about the suppliers
is vital.

4. To prevent the excessive investment in the material:Material control aims at preventing over investment in the material. This is
done by proper stocking of material i.e. removing the overstocking.

5. To prevent the wastage and misappropriation of the material:The loss or damage of materials should be stored as low as
possible in the godown. Storekeeper should be trained to handle the materials in a scientific way to avoid the wastage and
misappropriation. Leakage must be avoided to control the cost of production.

Essential of Material Control

Material control is essential and most important because of following reasons:

Proper co-ordination among the departments

There must be a proper co-ordination and balance among the departments involved in purchasing, receiving and storing so that there will
be a proper availability of materials for smooth production.

Authorized purchase

The purchase of materials should be made by authorized personnel of the department. A centralized purchase system is suitable for this.

Perpetual inventory system:

It is possible to determine the quantity and value of each type of material in stock with perpetual inventory system as required.

Internal check system:

The organization should be introduced for internal check system to ensure that all transaction involving materials are checked by
authorized persons.

Uses of standard forms:

Standards forms for orders, issue, transfer of materials from one job to the other, transfer of material from the job to the stores, etc.
should be used.

Proper classification and codification of materials:

It is necessary to classify and codify the raw materials to take proper handling and storing of the materials properly. It also helps to
maintain secrecy on the material.

Fixation of a proper stock level:

There are different types of stock levels such as maximum stock, minimum stock, average stock, etc. The main objectives of fixing the
stock level are to remove the unnecessary investment in materials and run the production smoothly.
Concept of Material Scheduling or Routing
INTRODUCTION

Store routine denotes the procedure relating to the materials control. Material scheduling or routing means the controlling the material
significantly. Normally, it involves three processes in manufacturing concerns. They are as follows:

1. Purchasing materials
2. Store keeping
3. Issuing materials

Purchase of Materials

Purchase and purchase department

Materials are the major component for any organization since it affects the production, quality of products, price and sales. Thus,
purchasing material includes the systematic process of materials. It includes the identification and the determination of material to be
purchased, selection of the appropriate suppliers, sending the purchase order, materials to ensure that examination of materials is as per
purchase order payment of bills. The purchasing department involved in the purchase of materials. The purchase procedures are
mentioned below:

The purchasing department performs the following activities.

1. To avoid the materials regularly.

2. To purchase the qualitative materials in harmonized conditions.
3. To remove the over and under stocking of materials purchase the materials in economic order quantities.
4. To maintain a cordial relationship with the suppliers.
5. To update the information on quality, price, supply, purchase procedures, terms of payment, carriage process etc.

Types of Purchase

There are two types of material purchase. They are mentioned below:

Centralized Purchasing

Centralized purchasing deals about the purchasing activities that are routed through only one department. To avoid duplication and
overlapping procurements all purchase should be made by the purchasing department. In this system, all the other departments should
send purchase requisitions to the centralized purchasing department to make timely and suitable purchases.

Advantages of Centralized Disadvantages of Centralized

Purchasing Purchasing
Centralized purchasing might lead to a
Since, all the materials required are
delay in a material purchase. Similarly, it
purchased by the purchasing
might be time-consuming while sending
department, it is better to control on
materials to the concerned departments
material purchasing activities.
and units.
Centralized purchasing enables the
favorable terms and conditions on There is no advantage of local purchase
material purchases. This is due to under centralized purchasing.
the bulk purchase of materials.
Centralized purchasing helps to
There is a high initial cost of the material
gain economy rate due to trade
under centralized purchasing due to bulk
discount facility of carriage less
purchase.
administrative expenses etc.
It helps to build specialized skills
It increases the road transportation cost of
and knowledge of materials since
material and materials that are to be
the qualified and experienced
dispatched to the departments located
personnel are involved in
away.
purchasing activities.
Due to their different material
It helps to achieve uniformity in
requirements, it might lead to
purchasing policies and practices.
misunderstanding among the departments.
Decentralized Purchasing

In this purchasing system, there is no purchasing manager and has no right to purchase material for all department and section. So,
decentralized purchasing means to purchase materials by all departments individually to fulfill their needs and the disadvantages of
centralized department can be easily removed by the decentralized purchasing method. In this system, a material can be purchased by
each department locally and separately.

Advantages of Decentralized Disadvantages of Decentralized

Purchasing Purchasing
In this system, purchasing can be A firm cannot get discount,
made easily and quickly, hence the transportation facility, credit facility etc.
departments purchase the materials under decentralized purchasing due to the
required by themselves. small quantity of purchase.
The investment in materials is low
It is not possible to have specialized
due to the purchase of material in low
service in each department.
quantity.
There is a high chance of
This system achieves the advantage of
misappropriation and misuse of material
the local purchase.
due to ineffective control.
Decentralized purchasing is costly due to
There is a low possibility of loss and
separate administrative and accounting
damage of materials.
works.

Purchase Procedures

The purchase of material has certain procedure which is mentioned below:

1. Receiving purchase Requisition

Purchase requisitions are the first step of purchase procedure in receiving the file of requisition and receiving the purchase. It is a request
made by various departments to the purchasing department for purchasing the materials. Such purchase requisition is verified by the
chief of the concerned departments in which the details about the material like quantity, codes, etc. are mentioned. Here's the sample
view of Purchase Requisition Form.

2. Selection of suppliers

The second step of the purchase procedure is the selection of the appropriate supplier. Tenders are invited to look for the possible
suppliers, quotations or a tender has other terms and conditions related to the materials involves the price and quality. The form
developed to get the required information regarding the materials to be purchased is called the tender form.

After analyzing the tender forms received from all the probable suppliers, an analysis is made to select the suppliers intending to supply
the raw materials and materials at the low price and the most favorable conditions. Besides these, the financial soundness has to own the
capacity to supply, reliability and continuity of the suppliers should consider selecting a supplier.

3. Sending Purchase Order

After selecting the suitable supplier, a purchase order is sent to get the needed materials. It is a request made to the supplier to send the
materials as per the stated price and quantity. The specimen of a purchase order is as below.
Each purchases order are made in 5 copies. The first copy is set for the supplier, the second copy to the department or person demanding
the purchase, whereas the third copy to the department receiving the materials, the fourth copy to the accounts department and the final
copy is kept by the purchasing department itself.

4. Receiving and Inspecting Materials

The fourth step of a purchase procedure is to receive and inspect the materials sent by the supplier. It has to be sure and confident about
the no loss or damage during the carriage whereas the materials are as per the purchase order.

After inspecting the material, a report is prepared and the first copy of such report is sent to the purchasing department, the second to the
accounting department and the third to the department receiving the material. The specimen of an inspection form is as under:

Before storing the materials, a statement of the materials received is prepared which is called the goods receipt note in which the code,
price, and quantity of the material are mentioned.

5. Verifying and passing bill for payment

This is the last process of purchase procedure. The final approval for the bill of materials to be paid to the suppliers the account section
makes payment of the same.

Store Keeping

Meaning of Storekeeping
Storekeeping is a specialized and important function of material control that is especially concerned with the materials and material
related goods. The storekeeper is responsible for safeguarding and keeping the materials and supplies in proper places until required in
production.
It is service function and the storekeeper is incharge of storekeeping. He is the warden of the goods stored in the store and maintains a
record of all movements of materials. The storekeeper, in fact, is a connecting link between planning and the production department.
Purchasing control must be matched by effective stores control to avoid losses from damage, deterioration and carelessness.

Objectives of Storekeeping
Store keeping includes the handling and recording of materials. Following are the main objective of storekeeping:

Effective use of available store space.

It avoids over and under stocking of material.

Efficiently and economically receiving a material, handling and issuing of stores.

Protecting goods stores against fire, loss, theft, and obsolescence.

 Ensuring an adequate and timely supply of stores under proper requisition and authorization.

Types of Stores
Although, there are various types of store, the following are the commonly used by manufacturing company. Basically, there are three
types of stores as follows:

1. Centralized stores
2. Decentralized stores
3. Centralized stores with Sub-stores

Centralized Stores:

If there is only one store to receive and issue materials to all departments of concern, such store is called centralized stores. In this type of
store, all materials are stored in one place called a central store. Materials are received by and issued from one store's department in
centralized stores.

This type of store is used by most of the manufacturing company. The main objective of a centralized store is to purchase and issue all
the materials required by all the department.

Decentralized Stores:

This store has emerged due to disadvantages of centralized stores. It is a just reverse system of centralized stores. Under this system of a
store, in each department, there should be an independent or separate store. Each department has to make a separate store for recording
the materials they required. It is not so popular because it required more installation cost and a separate store in each department.

Centralized Store with Sub-Stores:

In this store, the imprest system of stores is used where each sub-store is given some beginning stock. In a big organization, the central
store is far from production department and due to which transportation cost increases. To reduce the cost of handling and transportation,
a sub-store is maintained near production department and sub- stores are managed by central stores. Sub- store gets materials from the
central store.

Location of Store

The place is known as location. So, a location of the store means the place where the store is situated. While selecting the location of the
store, purchase department must be careful in various facts because the location of the store must be considered and the store should be
divided into racks which should be future sub- divided into small spaces. This space is known as a bin.

Factors to be considered for Selecting Location of Stores

It should be located at a central and safe place.

It must be located near to production department.

It must have enough space to keep the purchase materials.

It should be easily accessible to all the other department.

It must be equipped with enough bins and racks.

Storekeeper
A storekeeper is a person appointed for taking care of the store. He is in charge of the store and responsible for the control of the store.
Normally, all the big manufacturing concerns appoint a storekeeper. He has an important role in storekeeper. The storekeeper must have
some technical knowledge and experience in store routine. Except this, he should be trained, honest, loyal and responsible. He is also
called store manager or store superintendent.
Duties and Responsibilities of Storekeeper

A storekeeper should be responsible for the following functions:

1. Avoiding damage and deterioration of goods

2. Providing security against loss, fire and accident
3. Performing checking function on work completed
4. Protecting against the consequences of non-availability of materials
5. Recording and receiving of materials in store
6. Classification and codification of items which is received by store
7. Prohibited unauthorized persons from entering the store

Store Keeping Procedure or Store Routine

After receiving materials by receiving or store keeping department, storekeeper has to perform various jobs relating to materials. It is
known as storekeeping procedures or store routine.

Classification and codification of Materials

Recording of Materials received
Issuing of Materials

Classification and Codification of Materials

Classification and codification of materials facilities prompt identification of the materials in storage when they are being sent to
production departments. All items in the stores should properly be classified and codified. Goods and raw materials which are received
by store must be scientifically classified and coded.

Classification of Materials

As per the nature of materials facilities in various groups of goods, materials are classified to make issuing, storing and identification
materials easily and quickly. So, materials are first classified on the basis of their nature and types. It may be defined as construction,
materials consumable store, spare parts, lubricating, etc.

Codification of Materials
After classification of materials in various groups, they are codified again. Coding means to give numbers or distinctive symbols to
specific materials of stores with an arrangement for a prompt arrangement to facilitate storing. The symbol allotted to the materials
known as ‘code’.

There are three methods of codification of materials:

1. Alphabetical: Alphabets are espically used for codification of each group of material. For e.g. A, B, C…..
2. Numerical: Numbers are used for codification of each group of material. For e.g. 101, 102………
3. Alpha-Numeric: Both alphabets, as well as numeric, are used for codification of each group of material. For e.g. A-101-102…..

Recording of Materials Received

After classification and costing of materials, the next step in store routine is recording of materials received by store department.
Following are the two system of material recording received by store.

1. Bin Card
2. Store Ledger

Bin Card

The bin is the term used to symbolize the place or shelf or rack or pigeon-hole or even a big room where materials are stored and the
card attached to the bin or tag hung up there is known as Bin card. Bin card shows quantitative details of receipt, issue and balance of
materials in the bin.

This card also shows the maximum level, minimum level and re-order level of the materials. It helps the storekeeper to control material.
Bin card is used by the storekeeper to keep the only quantitative record for all the items of materials in store. Remember that, it does not
record the value of materials.

Store Ledger

Store ledger is maintained by costing department. This ledger shows the information for the pricing of materials issued and the money
value at any time of each item of stores. Store ledger contains an account for every item of stores and makes a record of the receipts,
issue and the balance, both in quantity and value. It contains the name, part number of the item and bin number.
Issuing of Materials
Materials are kept in stores so that the storekeeper may issue them whenever the production department requires these. A storekeeper
cannot issue materials unless a properly authorized material requisition is presented to him.

1. Preparation and Treatment of material Requisition form

2. Pricing of materials

Preparation and Treatment of Material Requisition Form

A material requisition is the most important document of an authority to the storekeeper to issue the materials. It is a normal request
written in a paper from production department to store department. It is signed by the authorized person so that there may be no wrong
drawl of materials.

It is prepared in triplicate. Two copies are sent to the store and one copy is sent to costing department which includes date, requisition
number, description of materials, quantity, unit price, total value, etc.
Meaning of perpetual Inventory System
The perpetual inventory system is the way of maintaining the record of inventory which can be hand ascertained at any time. It
emphasizes and maintains the up-to-date record and day to day checking of stocks. It is a method of recording inventory after every
receipt and issue to facilitate regular checking and obviate the stocktaking.

It is also known as "Automatic Inventory System". A perpetual inventory system is a technical kind of job on where controlling stock
items and maintaining store records in such a manner that stock balances at any point of time are readily available. The term "perpetual
inventory" means the system of record keeping and a continuous physical verification of the stocks, with reference and store record.

It gives the perfect and accurate stock control as we can easily check out and verify the level and position of stock lying in the store at
any moment by physical counting. Here are the definition of perpetual inventory system is given below:

“A system of records maintain by the controlling department, which reflects the physical movement of stock and their current
balance” Chartered Institute of Management Accountants (CIMA), London,

“It is a method of recording stores balance after every receipt and issue, to facilitate regular checking and to obviate closing down for
stock-taking.” Mr.Weldon,

Perpetual inventory system helps to ascertain the balance of each and every stock of the company in terms of physical quantity as well as
it's monetary value held in store at all time. For this, a company may maintain bin card, in which it separate receipt and issue of materials
and balance of stock are recorded privately in store.

Advantages of Perpetual Inventory System

The main advantages of Perpetual Inventory System

It provides an opportunity to verify the physical stock of materials daily or at regular intervals without dislocating production.

It helps in rapid stock taking which, in turn, helps in the preparation of interim accounts.

A moral check on the store staff to maintain proper stock records.

The investment in materials and supplies may be kept at the lowest point.

It is not necessary to stop production so as to carry out a complete physical stocktaking.

Deterioration, obsolescence etc, can be avoided.

Discrepancies and errors can be quickly discovered and remedial action can be taken.

Timely replenishment of stock is facilitated by means of reordering the level specified in the bin card.
Methods of Pricing Material Issued
When materials are purchased for a specific product, it's cost of materials received is wholly debited to that product. There would be no
problem in costing materials issued and in inventory valuation if all purchase were made at the same price, but purchase made at a
different time usually carries a different price and the stores ledger which is not shown in one but has several prices for the same kind of
materials. Several methods are used in concerning the pricing of materials issued from the store. Here are the important methods of
pricing material issued under perpetual inventory system.

First-In-First-Out (FIFO) Method.

Last-In-First-Out (LIFO) Method.
Simple Average (SAM) Method.

Note: As per new course of study of HSEB, SAM method is not included, so it is not explained.

First-In-First-Out Method (FIFO)

According to this method, materials received first are issued first. After the first lot of materials purchase is exhausted, the next lot is
taken up for supply. The units that are from the opening stock of materials that should be treated as if they are issued first, the units from
the first purchase issue next, and so on until the units which are left in the stock of materials that should be valued at the latest cost of
purchases.

Advantages of FIFO Method Disadvantages of FIFO Method

1. It is simple to understand and easy to use.
2. It is applicable when the price is falling.
3. It is useful in case of less transaction and price of materials
are fixed.
4. It is logical because first received goods are first issued.
1. It is unsuitable in the case of price is rising.
2. It is complex if many lots are purchased during the period at
different prices.
3. This method increases the chances of clerical error.
4. It is very hard to determine the value of the returned item.

Illustration:

The purchase and issues of material ‘X’ in the month of Baishak, 2071 are as follows:

Baishak 1 Opening balance 500 units@ Rs.10

Baishak 5 Purchase 1000 units @ Rs.11

Baishak 8 Issued 400 units

Baishak 10 Issued 800 units

Baishak 12 Purchase 1500 units @ Rs. 12

Baishak 15 Issued 1200 units

Baishak 20 Purchase 800 units @ Rs. 11

Solution:
Last in First Out Method (LIFO)

As the name LIFO, the use of inventory is valued on the basis of the opposite sequence of receipts. The LIFO method of costing deals
with the principle that materials entering production are the part of the most recent purchase. It is assumed that the most initial cost,
normally replacement cost is the most significant in matching cost with revenue in income determination.

Under this method, the cost of the last materials received is used to price material issued until the lot is finished, then the next lot pricing
is used, and so on through coming lot.

The closing stock is priced at the oldest prices.

Advantages of LIFO Method Disadvantages of LIFO Method

1. This method is simple.
2. This method is applicable in case of a rise in market
price also.
3. The valuation of stock has no role in profit or loss.
4. In the case of rising price, this method is move suitable.
1. This method is practically not better.
2. In a case of a price of material is decreasing, it is not applicable.
3. For determining the price, more than one price has often to be adopted.
4. This method can lead to clerical error because every time price has been
changed.

Illustration:

At the beginning of October, a company had 10000 units @ Rs.2 per unit. Further purchase were made during the month as follows:

4th October 2000 units @ Rs.2.50 per unit

10th October 5000 units @ Rs.3 per unit

20th October 10000 units @ Rs.3.50 per unit

Issues to work place were as follows:

12th October 16000 units

28th October 10000 units

Solution:
Common Terms used in Pricing of Material Issued:

Received Issued
1. Return to store 1. Return from store
2. Return from work order 2. Return to work order
3. Return from department 3. Return to work customer
4. Return from customer/debtors 4. Return to suppliers
5. Return from vendor 5. Return to vendor
6. Surplus 6. Shortage/loss/wastages

Stock Level or Inventory Management

Meaning and Computation of Stock Level

Inventory is the stock which firm maintains to meet its future requirement for the production and selling. The basic reason for holding
inventory is to keep up the production activities unhampered. Inventories are part of current assets, which are used within one year. In a
normal course of business operation, manufacturing organizations maintain the inventory of raw materials, work-in-progress, finished
goods, spare parts, suppliers, etc.

In the manufacturing concern, inventories make the bridge between the production and sales. Trading organizations are involved in
buying and selling of goods. Therefore, inventory of trading organizations is unsold goods i .e. finished goods. Investment on inventory
depends on certain risks and costs. Therefore, the inventory manager should try to maintain an optimal size of inventory without
disturbing the production and sales needs.

Types of Inventories

Following are the important types of inventory:

1. Raw materials: Raw material is a very important factor of production. It includes physical commodities used to manufacture the
final product.

2. Work-in-progress: Work in progress inventories are semi-manufactured products, which need more and more work before they
are converted into finished products for sale. In other words, goods partially worked on but not fully done are called work in
progress.

3. Finished goods: Inventories of finished products are the stock of goods which are ready for the sales. Finished goods are required
 for smooth marketing operations of the products.

Objectives of Inventory Management

The objectives of inventory management are mentioned below:

1. To regular supply of material: There should be a continuous availability of materials in the factory or finished goods for trade.
The main objective of inventory management is to create required inventory so that production and sales process run smoothly.

2. To minimization of over stocking: If a company keeps inventory without the proper analysis, there will be a chance of
overstocking, which will increase the cost of carrying the inventories or under-stocking of inventories that create a problem in a
smooth operation of a business. So, one of the main objectives of the inventory management is to minimize the risk caused due to
overstocking of inventory.

3. To reduce material losses: Inventory management focus to eliminate or remove the losses and misappropriation of materials. This
is done by maintaining the proper stock of materials with utmost care.

4. To minimize the costs: The proper maintenance of the information regarding inventories helps to make decisions like whether to
take discounts or not, the size of an order to be placed, when to order, etc. The total costs associated with inventory management
may be reduced by analyzing the lot size to be acquired, the offer of a discount on a various lot sized and the timing of order.

Reasons or Motives of Holding Inventory

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The main reason or motive of holding inventory is to provide the required quantity of inventory to different departments as needed so that
production / sales process does not get affected.

The motives or reasons of holding inventories are:

 1. Transaction motive: The manufacturing concerns need inventories of raw material and work in progress so as to make balance
regular production activities. Similarly, the trading organizations need the inventories of finished goods for supplying the goods
and services to the customers regularly. In this way, owning of inventories helps to have regular transactions.

2. Precautionary motive: Due to different reasons like shortage of inventory with the supplier, distance relation with the supplier,
disturbance in transportation, delay in inventory supply, etc. might take place. So, this motive helps to protect the industries from
the risk of delay in goods, etc.

3. Speculative motive: Generally, the price of inventories ris. So, the companies may keep an extra amount of inventory to get profit
by selling the surplus inventory at a higher price than a purchase price. It creates risk when the price of inventories falls.

Techniques of Inventory Management

To achieve the objective of the inventory management, different methods are used such as stock level, economic order quantity, just-in-
time purchase, perpetual inventory system, ABC analysis, etc. Stock level and economic order quantity are very popular methods of
managing inventory.

Stock Level

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Stock level is essential for the control of materials. Determination of stock level is required to avoid over and under stocking of materials.
More amount of stocks and inadequate stocks both are harmful to the organization. Over stock results extra investment of capital and
under stock affect the production. So, the organization should have adequate stock for a normal requirement.

Storekeeper must determine the stock level in such a manner that matches the requirement. Stock levels are maintained for standardized
materials which are regularly used in an organization. In order to have good and proper control materials, the following techniques are
used in cost accounting.

Re-order Stock Level

The manager has to decide when and where should be the next purchase made after the first purchase. When the quantity of material
reaches at a certain figure new order is set to get material again and again. So, reorder level is that level of material where new order
should be placed considering reorder period and the daily usage and rate. This level is fixed somewhere between the maximum and
minimum level. If the inventory falls down the re-ordering level, store keeper began purchasing the fresh goods. It is also called re-order
point.

Illustration:

Suppose,
Maximum consumption per day = 400 units
Minimum consumption per day = 200 units
Re-order period = 8 to 10 days
Then,
Re-order Level = Maximum consumption * Maximum re-order period
= 400 units * 10 days = 4000 units

Minimum Stock Level

Minimum stock level shows the minimum quantity of the material which must be maintained and protect in hand at every time. It is
needed to avoid shortage of the material in the production. The stock of goods should not be below minimum level. In order words, the
stock level is normally not allowed to fall below minimum level. While calculating minimum level, rate of consumption and nature of the
material should be considered. It is necessary to arrange the minimum stock level due to the following reasons:

A manufacturing company does not face the shortage of the materials.

A trading company does not deals with the shortage of merchandise goods for re-selling.

Illustration:

Re-order Period = 8 to 12 days

Daily consumption = 400 to 600 units
Minimum Level = ?

Solution,
Minimum Level = Re-order Level - (Normal Consumption * Normal Re-order Period)
= 7200 - (500*10)
= 2200 unit

Maximum Stock Level

In store, stock should not exceed maximum level. It shows the maximum output of an item of material which can be held in stock at any
time. The level of maximum stock is fixed to remove the problem of over stocking. Stock is normally not allowed to rise above
maximum level. Stock exceeding this level will lead to blocking capital and unnecessary increase in stock holding cost. So, the
maximum stock means the maximum quantity of an item of material which can be held in stock at any time.

Illustration:
Re-order quantity = 1000 units
Re-order Level = 1500 units
Re-ordering period = 4 to 6 days
Daily consumption = 150 to 250 units
Maximum Level = ?

Solution,
Maximum Level = Re-order Level + Re-order quantity - (Minimum consumption * Minimum Re-ordering period)
= 1500 + 1000 ( 150 * 4 )
= 1900 units

Re-order Quantity

Re-order quantity is the quantity of material that is purchased each time. This is also termed as order size. The re-order quantity is also
termed as economic order quantity if it can be acquired at the minimum cost.

Average Stock Level

Average stock level refers the normal or moderate stock level. If the store manager thinks that the demand and supply of inventory are
normal or moderate, he / she recommend keeping stock at average level.

Illustration:
Re-order quantity = 2000 units
Minimum Level = 500 units
Average stock level = ?

Solution,
Average stock level = Minimum level + 1/2 * Re-order quantity
= 500 + 1/2 * 2000
= 500 + 1000
= 1500 units

Danger Level

This is the level of material at which the issue of material is temporarily stopped. From this level, materials are issued for some abnormal
situations only. The issue of material can be made against the special order form the top level. Since, it is a danger level, some serious
actions should be taken to acquire materials.

Illustration:
Daily Consumption = 100 to 200 units
Maximum re-order period for emergency purchase = 5 days
Danger Level = ?

Solution:
Danger Level = Normal consumption * Maximum re-order for emergency purchase
= 150 * 5
= 750 units

Labor Cost
INTRODUCTION

Every organization consists of people working in it. The success of an organization depends on a large extent upon the quality of person
working in it. It is very difficult task for the management to deal with human beings, who are different in nature and hence, it is difficult
to control. Management tries to make the best use of available human resources and reduce the total labor cost by increasing their
productivity.
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On the other hand, workers always demand a high rate of wages. Due to these contradicting interests, the task of labor management has
become difficult. Management uses various methods of payment of wage rate to keep the labor cost under balance and also to account
for it properly so as to calculate labor cost of production.

Meaning of Labor Cost

Labor cost or wages is a main element of cost. Labor cost means to any remuneration paid to the employees by the organization in the
form of wages, salary, bonus, allowances, etc. for their time and effort used in production of goods or services. Any financial
compensation, given to the employees working in the organization or company to achieve the common goal is called labor cost. In other
words, it is the remuneration paid to the workers or employees for their mental and physical contribution towards the organization.
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The Institute of Cost and Management Accounts of U.K.has defined labor cost as “the cost of remuneration of the employees of an
undertaking”.

A significant expenditure has to be made to keep the employees in the organization and also to keep them satisfied so that they give their
best. The labor cost can be analyzed into the following:

Monetary benefits: Salaries and wages, other allowances or dearness, production incentive or bonus, overtime allowances,
employer`s contribution to provident fund, old age pension, payment of the insurance scheme, retirement gratuity, salary in lieu of
leave, profit-linked bonus, etc.

Non-monetary benefits ( Fringe benefits): Subsidized food and housing, subsidized or free transport, subsidized or free clothing,
subsidized or free education to employee`s children medical and recreational facilities, etc.

Types of Labor Cost

The labor cost can broadly be classified into:

Direct Labor Cost

Direct labor cost is that portion of wages and salary which can be determined and charged to a single costing unit. It is the remuneration
of the employees who are involved with the manufacturing operations or the conversion of raw materials into finished products. The
most important characteristic of direct labor costs is that it can be identified with and allocated to cost units or cost centers.
This cost is incurred for converting raw materials into finished goods. The example of direct labor cost is wages paid to workmen who
are put on definite jobs or products in the factory. Direct labor cost is also known as “Direct Wages”, “Productive Wages”,
“Manufacturing Wages”, “Operating Wages” or “Factory Wages”. Direct labor cost is a part of the prime cost.

Indirect Labor Cost

Indirect labor cost is the remuneration of the employees who are not involved with manufacturing operations. The direct employees are
not directly associated with the modification process but assist in the process by way of supervision, maintenance, transportation of
materials, material handling, etc. Their work benefits all the items being produced and cannot specifically identify the individual
products.

These costs will be an apportioned to different cost centers on an equitable basis and absorbed into product cost by forcing the overhead
absorption rate. Wages or salaries paid to the supervisor, clerical staff, storekeeper, foremen, etc, are the examples of indirect labor cost.
Indirect labor cost is also known as “Unproductive Wages”, “Indirect Wages”, and it is treated as part of “Overhead”.

Different between Direct Labor Cost and Indirect Cost:

Bases of
Direct Labor Cost Indirect Labor Cost
Differences
Involvement Direct labor cost is that cost Indirect labor cost is that cost
with which is directly involved in which is not directly involved
production the production. in the production.
The volume Direct labor cost depends on Indirect labor cost does not
of upon the volume of depend on upon the volume of
production production. production.
It can be separated in cost, It cannot be separated in unit
Separation
cost center, or unit cost. cost.
Payment It is a direct expenditure. It is an indirect expenditure.
It is used to convert raw
It is used in the production
Use materials into finished
process.
goods.
Part It is a part of the prime cost. It is a part of overhead.

Importance of Labor Cost

Accumulation, analysis and proper control over labor costs are most important to each and every manufacturing organization for the
fulfillment of given purpose:

To use direct labor cost as the basis for increasing the efficiency of workers.

To identify direct labor cost with the product, job or process for ascertaining the cost of production as accurately as possible.

To use direct labor cost as the basis for absorption of overhead, if desired.

To use direct labor as a basis for comparison with past labor cost and for substitution purpose.

To determine the amount of indirect labor cost which should be treated as overhead.

To reduce the labor turnover.

Labor Cost Control and Its Need

Labor costs may become unduly high due to the inefficiency of labor, wastage of material due to improper supervision, idle time and
unusual overtime work, an inclusion of dumpy names in the payrolls and other related factors. Inefficient use of labor not only increases
the cost of production but also adversely effects the quality of products. The primary objective of the management is to utilize the labor
as economically as possible. Therefore, it is necessary for the management to device a proper system of labor cost control.
Source: www.shutterstock.com

Control over labor costs requires proper employment and efficient utilization of labor force. These factors affect the cost and quality of
the products of any industrial undertaking and ultimately its profitability. Labor cost control involves the employment of efficiency
workers, proper training of workers, proper time keeping and time booking and proper accounting for the wages paid to them.

Department Involved in Labor cost control and their functions

Department Involved in Labor cost

The objective of labor cost control is achieved through the intensive and co-ordinated efforts of various departments. These departments
are:

1. Personnel department
2. Engineering department
3. Rate or time and motion study department
4. Time-keeping department
5. Payroll department
6. Cost Accounting department

1. Personnel Department

Generally, each and every business organization has a recruitment policy of its own. For the execution of the recruitment policy of an
undertaking, a separate ‘Personnel Department’ is made under the headship of a ‘Personnel Manager’. The main objectives of this
department are recruitment and selection, training, transfer, discharge, promotion and fixation of wages and fixing salaries of employees.
This department is considered for providing an efficient labor force and lays down good personnel policies to be followed by the entire
organization.

The functions of personnel department are as follows:

 Selection and recruitment of most needed workers for the organization.

Maintain the detailed and up to date record of workers.

Promotion, transfer and discharge of the workers after their evaluation.

Development of different forms for maintaining the records of workers.

Provide training and conduct seminar, a workshop for the worker.

2. Engineering Department

In order to gain proper utilization of labor force in an industrial undertaking, it is necessary to make the use of proper production
techniques and to provide healthy working conditions to the workers. For this, an engineering department is set up. This department
includes in maintaining control over working conditions and production methods for each job.

The function of engineering department are as follow:

Preparation of plans and specifications for each job scheduled for production.

Supervision of production activities within production departments.

Inspection of jobs after they are completed to ensure that they are satisfactorily completed.

Conducting research and experimental works before undertaking new jobs.

Maintaining safety check and efficient working conditions so that there may be a minimum possible accident and conducive
environment efficiency and health of workers.

3. Rate or Time and Motion Study Department

While performing a job or work, a worker or a machine has to make movements. It is the study of movements of the workers as well as
machine while performing an operation. Motion study is mainly done for the purpose of eliminating useless motions. The department
that is primarily concerned with the jobs of making of time and motion studies of labor and plant operations, job analysis and setting
wage rates is called time and motion study department or the rate.

Time study is done to determine the required time for the operation. It is conducted after the motion study. For determining a standard
time, various techniques are used under time study. An average worker is done as a model worker and basic or standard time is fixed for
a job or operation giving allowances of time to the workers for smoking, drinking water and so on.

The following are some important advantages of time and motion studies:

These studies help in determining the proper speed of work by eliminating unnecessary movements.

They help in fixation of suitable wage rates and the introduction of wages plans.

The efficiency of workers gets increased because they are asked to follow correct procedures.

They help in increasing output by a greater efficiency and less human fatigue.

They help in assessing the correct labor requirements of an organization.

These studies help in the cost of production per unit and increasing total earnings of workers.

They facilitate labor cost budgeting and labor cost control.

4. Time-keeping Department

For an efficient labor organization, it is necessary that all workers including those who are paid on piece work basis should be punctual.
Late arrival or early departure of a worker causes disturbance even as regards to the work of others. It is, therefore, necessary to have a
good system of keeping record of the time of arrival and departure of workers whether they are paid on the basis of time or piece works.

For the general purpose of exercising control over arrival and departure of workers, a separate Time-keeping Department is set up under
the headship of a “Time-Keeper”.
The following are the functions of time-keeping department:

It maintains up-to-date attendance of workers.

It finds out the idle time of each worker to control and minimize it.

It keeps the record of time spent by each worker including records of normal and overtime works.

It also keeps the detail records of the workers’ arrival and departure time in the workplace.

5. Pay Roll Department

The payroll department is set up for disbursement of wages rate and computation in a business concern. Payroll department is concerned
with the computation of gross wages rate of the workers and making necessary adjustment with a view to ascertaining the net amount of
wage rate payable to them.

Pay Roll concerned with how much employees have earned during a period and involve calculation of gross and net amount payable to
each employee.

The main function of payroll departments are:

To maintain the record of the job classification, department and wages rate for each worker.

To verify and summarize the time of each worker as shown by the daily time card.

To calculate the amount of wages earned by each worker.

To prepare the payroll wages sheet for each department.

To maintain permanent payroll records for each worker.

To make the disbursement of wages and salaries to the workers.

6. Cost Accounting Department

Cost accounting department is responsible for the accumulation, classification and analysis cost data in a business concern following the
cost accounting system. Labor cost is one of the important elements of total cost. In a large business concern, representative of the cost
accounting department is involved in production department in order to make proper accumulation, classification and analysis of labor
costs.

These representatives work under the direct supervision and control of the cost accountant. They assist the cost accountant in computing
the labor cost of production by departments, process, operations, production orders, jobs, etc.

The functions of cost accounting department are as follows:

To collect all types of information about cost and reporting management with analysis.

To determine the cost of each work.

To calculate labor cost by using the time card, job card and payroll.

Forms Related With Labor Cost Control

There are different forms which are used for labor cost control. Some of them are mentioned below:

Labor Placement Requisition

If in any department, the vacancy has been caused by the allowed establishment, the departmental head or manager will send a formal
written request to the personnel department in the form of a ‘Labour Placement Requisition’. The specimen of a ‘Labour Placement
Requisition’ is shown below:
Source:onlineaccountreading.blogspot.com

Employee’s History Card

For each person employed, the personnel department prepares Employee's History Card which shows the particulars of the employee,
name and address of the previous employer, the cause of leaving the previous job, previous experience, date of appointment, date of
joining and wage rate at a commencement.

Source:onlineaccountreading.blogspot.com

Time Card

The card that aims to record the incoming and outgoing time of the workers is called time card. Such card is prepared on the weekly or
monthly basis as per requirement. The personnel of time keeping department maintains such card.
Source:www.imagebon.com

Piece work card

In a factory where the workers are paid on the basis of piece work, a piece work card is issued to each worker. On the piece work card, a
worker gets recorded the quantity of output done and time spent on it. The piece work inspector puts his signature on the piecework
card.
Source:www.yourarticlelibrary.com

Payroll Sheet

When wages are paid on the basis of time, the Wages Sheet is prepared on the basis of time cards or clock cards. But, when the workers
are paid on the basis of output, the wages sheet is prepared on the basis of piece work cards. Wages sheets are prepared department-wise
is under the control of costing department.
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Eoconomic Order Quantity

INTRODUCTION TO ECONOMIC ORDER QUANTITY

One of the major problem in management is the determination of order size quantity to be purchased which should be neither small nor
big because cost of ordering and carrying materials are very high. Economic Order Quantity (EOQ) is the size of the lot to be purchased
which is economically viable or which can be purchased at minimum costs.
Fig: Economic Order Quantity graph
Source:www.eazystock.com

So, the economic order quantity is that quantity, when the total cost of an inventory is minimum and is determined to keep in view the
ordering cost and to carrying cost minimized.

An economic order quantity (EOQ) is an inventory related equation that determines the optimum order quantity that a company should
hold in its inventory given a set cost of production, demand rate and other variables this is done to minimize variable inventory costs.
Here’s the equation that uses to calculate EOQ as follows:

While the interaction of them about the cost, the economic ordering costs during a particular period are equal to carrying costs and
ordering costs. During that period, total cost to order and carry is the lowest. It is also known as re-ordering quantity. Economic order
quantity involves two types of cost:

Carrying Cost

All those costs which are incurred when we carry (or keep) the inventory in the store for a certain period of time are known as total
carrying cost. It is the cost of holding the materials in the store. In next word, carrying cost is related with the storing of materials. The
cost incurred for maintaining a given level of inventory is called carrying a cost.

Total carrying cost will increase when we purchase more and more quantities of inventory at a time. The carrying cost includes the
following costs:

Clerical cost / store administrative overhead cost.

Insurance and rent charges of inventory.

Transportation cost in relation to stock.

The cost of spoilage in the store of handling.

The cost of storage space.

 Interest on capital or loan blocked on the material.

Opportunity cost.

The cost of maintaining the material.

The cost of bin & rack for the storage of stock

Losses and thefts.

Inventory taxes.

Ordering Cost

All those costs which are related to the purchase activities of inventory are ordering costs. It is the cost of placing an order for the
purchase of material. Ordering cost varies with the number of order. The ordering cost normally includes clerical costs of preparing a
purchase order or production order and special processing and receiving costs related to cost and a number of order processed.

Ordering cost tends to increase or decrease in proportion to the number of orders placed. When we purchase more and more quantity at a
time, the number of the order will decrease.

The examples of ordering cost are:

1. The cost of staff in the purchasing department, inspection section and payment department.
2. The cost of stationery, postage and telephone charges.
3. The cost of floating tender.
4. The cost of paperwork.

Calculation of Economic Order Quantity (EOQ)

The order quantity where the total ordering cost and carrying costs are equal is known as the economic order quantity. The economic
order quantity can be calculated under the following methods;

1. Formula method
2. Graphical method
3. Trial and error method

However, according to the syllabus, we will discuss the calculation of economic order quantity using formula method only.

With the help of using following formula, the economic order quantity can be calculated.
Piece Rate System and Time Rate System
System of Wage Payment

The success of a concern largely depends upon the efficiency of labor and the efficiency of labor is considerably affected by amountof
wages paid to them. Some persons are of the view that the profit of a concern can be maximized only by reducing the wage rates payable
to the workers. But, this view is not correct. It should be noticed that low-paid workers are usually inefficient that leads to wastage of
materials, frequent breakdown of machinery, less economic use of tools and loss of time, as a result of which the cost of production goes
up.

Reasonable and fair wage rates allowed to the workers to ultimately lead to a more economic use of machines, tools, materials, and time.
Therefore, the importance of the method of wages payment should never be under-estimated.

Methods or systems of wage payment must possess the given below characteristics:

It should be simple to operate and easy to understand.

It should guarantee a minimum wage to each and every worker.

It should be acceptable to the employer and the employee.

It should be flexible enough so that changes may be made in future according to the requirements.

It should ensure the establishment of industrial peace.

The principal methods of wage payment are as follows:

1. Time Rate System

2. Piece Rate System

1. Time Rate System

Source: slideplayer.com

Under this system, the amount of remuneration or the total wages outstanding to the workers depends on the time for which he is
employed. This is a simple and common method of wage payment. In this method, the workman is paid an hourly, daily, monthly or
yearly rate of wages.

Thus, the worker is paid on the basis of time but not on his/her performance or unit of output. A number of wages payable to a workman
under this method is to be calculated as follows:

Total wages = Actual time took x time rate

or, Total wages = Total hours worked x Wages rate per hour.

Illustration:

A worker is paid Rs. 15 per hour and he spent 400 hours during a particular month in a factory. What is his total earning of that particular
month?

Solution:

Total Wages = Total hours Worked * Rate of Wage per hour = 400 hrs * Rs. 15 = Rs. 6000
Thus, the total earning of the worker is Rs. 6000

Given below points are suitable to be applied in the following circumstances:

Where the quality of work is more important than production.

Where the volume of production is not within the control of labor.
When it is difficult to fix the unit of output.
The nature of work is such that there is no incentive plan.
Where the amount of output cannot be accurately measured, counted and standardized.

Advantages of Time Rate System

The following are the advantages of time rate system,

Simplicity: It is really easy to understand and simple to calculate the earnings of workers under this method.

Guarantee of minimum wages: It guarantees minimum wages to the workers.

Quality production: Since, a number of wages rate is not linked to the quantity of output, this method ensures production of better
quality due to the careful attention of the workers.

Unity among workers: Under this system, all workers falling under a particular category are paid at an equal rate without any
calculation of their quantity of output. It encourages a feeling of equality among workers on account of which this method is also
favored by trade unions.

Economical: It involves less critical work and detailed records are not necessary. Since, the output is not the criteria for
identification of wages, tool and materials are handled carefully and wastages are also minimized.

Disadvantages of Time Rate System

This method has the following disadvantages:

No incentive to the efficient workers: It lacks incentive to efficient workers since all workers are paid equally and no distinction
is made between efficient and inefficient workers. So, effort and rewards are not correlated.

Go-slow policy: The worker in order to earn more wages may try to perform the work slowly which leads to increase in labor cost
per unit.

Dissatisfaction among the efficient workers: The efficient workers are paid wages at the rate equal to those payable to
inefficient workers, which creates dissatisfaction among the efficient workers.

Payment for idle time: Under this method, the idle time of the workers is also paid that increases the cost of production.

The high cost of supervision: Since, there is no direct link between the quantity of output and wages, wastage of time on the part
of the workers is common and the negligence of which requires considerable supervision leading to increased costs.

2. Piece Rate System

Source: slideplayer.com

In this method, wages are paid to the employees after completion of work. Under it, a worker is paid on the basis of output not the time
taken by him. This is one of the simplest and most commonly used systems of wage payment. In this system, the wage rate is expressed
in terms of per unit of output, per job or per work-order. A number of wages payable to a workman under this method is to be calculated
as follows:

Total wages = Total output x Rate per Unit of Output.

Illustration:

A worker is paid Rs. 20 per unit and he produced 50 units in 8 hours. What is his total earning?

Solution:

Total Wages = Total Output * Wage Rate per Unit of Output = 50 units * Rs. 20 = Rs. 1000
Thus, the total earning of the worker is Rs. 1000.

This system is suitable in the following cases:

Where a work is of a repetitive nature.

Where the measurement of work is simple.
Where the accuracy and quality of output are not very important.
Where strict supervision is not possible.

Advantages of Piece rate system

The advantages of piece rate system are given below:

Simplicity: Just like time rate system, the piece rate system is also simple to calculate and easy to understand. It does not involve
tedious calculations.
 The incentive to workers: This system provides an incentive to the workers to work hard as the wages are paid on the basis of the
quantity of output, not on the basis of time. So, efforts and rewards are correlated.

Ascertainment of accurate labor cost: Piece rate system wages are paid on the basis of output, the exact cost of labor per unit of
output or job can be ascertained.

No payment for idle time: Under this rating system, no payment were made to the worker for the idle time as a result of which
the cost of supervision is not considerable.

Proper care and use of machines and tools: The workers take proper care of their machines and tools since the breakdown of
machines and tools means a decrease in output resulting in less remuneration to them.

Disadvantages of Piece Rate System

This system has the following disadvantages:

Less attention to quality: As the payment of wages is made on the basis of output, the workers would try to produce more
quantity of products and not focus on the quality of products which results in production of less quality products.

Inefficient use of machines and materials: Since, the wages are paid on the basis of the quantity of output, an excessive wastage
of materials and frequent breakdown of machinery may be caused by the workers due to their efforts to obtain maximum output.

No guarantee of minimum wages: Since, there is a direct relationship between quality of output and wages, the workers suffer if
they fail to work efficiently. There is no guarantee of minimum daily wages to workers.

Dissatisfaction among inefficient workers: The inefficient workers, who work slowly, become dissatisfied by reason of lower
wages as compared to the wages paid to their efficient counterparts.

Adverse effect on worker’s health: The workers may try to work abnormally to earn more which has an adverse effect on their
health and efficiency. So, this method is not accepted by a trade union.

Differences between Time Rate and Piece Rate System of Wage Payment

Bases of
Time Rate System Piece Rate System
Differences
The basis of Wage is calculated on the basis of time spent Wage is calculated on the basis of output or
wages by the workers on the jobs. production.
There is a possibility of excessive idle time in
Idle Time There is a less chance of idle tome in this system.
this system.
There is a lack of incentive for the efficient It encourages motivated workers to produce more
Incentive
and honest workers. and earn more.
Control and Control and supervision are needed as the Control and supervision of the workers are
supervision workers may not work properly. required.
The quality of The quality of work is good as there is no The quality of works may not be good because of
work pressure to produce more goods. pressure to produce more goods.

FEATURES OF GOOD PAYMENT SYSTEM OF WAGES

The features of goods system of wages of payment are mentioned below:

1. Suitable for both employer and employee.

2. Simple to understand and easy to apply.
3. Economical system.
4. Guaranteed minimum wages.
5. Assure the equal wages for the similar job.
6. Encourage the competent workers.
7. Accepted by a trade union.
8. In accordance with the law of the country.
9. Flexible
Final Account of Company
Preparation of Final Account of a Company

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The preparation of final account of a joint stock company includes the preparation of a set of accounts and statement at the end of a
financial year. The final account includes trading account, profit and loss account and the balance sheet. Therefore, in practice, the
accounts include the following:

1. Trading account
2. Profit and loss account
3. Profit and loss appropriation account and
4. Balance sheet

1. Trading account

It shows the result of buying and selling of goods for a particular period. The trading account records the amount of purchase and
expenses relating to manufacturing of goods are known as direct expenses. When sales exceed the cost of the saleable stage, all these
expenses are known as direct expenses. When sales exceed the cost of goods sold, it results in gross profit and gross loss will result in
the reverse case.

Importance and Advantages of Trading Account

Trading account facilitates a company to know the trading result. It provides relevant information about sales and cost of goods sold that
shows the trading efficiency of the company. The main importance of trading account are as follows:

It provides information about gross profit or gross loss made during a certain accounting period.
 It helps to control direct expenses as it takes into account only those expenses which are directly related to manufacturing of
products.

It helps to judge the profitability of the company by comparing the gross profit with sales.

It helps to determine the cost of goods sold.

It helps to know the trading expenses of the company.

Preparation of Trading Account

Trading account is the first step in the preparation of final account. All expenses relating to purchase and manufacturing of the product
are shown on the debit side and a number of sales is shown in the credit side of trading account. Since, all the goods manufactured or
purchased may not be sold during the period, the amount of closing stock is also shown on the credit side, to show the true result from
buying/manufacturing and selling of products. A specimen of trading account of a joint stock company is given below.

2. Profit and Loss Account

Another important set of account in company’s final account is the profit and loss account. The Company Act 2053 of Nepal requires
that the company must prepare profit and loss account at the end of each financial year to show its operating result of the period. The
profit and loss account of the company can be defined as final account, which summarize income and gain earned and expenses incurred
during the financial year and the result thereof. Therefore, the profit and loss account is prepared to ascertain the operating results of a
company in term of net profit or loss. The profit and loss account determines net income or loss by matching income and expenses
occurred during a particular financial year.
Importance and advantage of Profit and Loss Account

The importance and advantages of a profit and loss account are as follows:

It helps to calculate the operating results of a company in terms of Profit / Loss for a specific period.

It helps to control indirect expenses.

It helps to judge the overall efficiency of the business.

It helps to determine the amount of dividend of the year.

Preparation of Profit and Loss Account

Profit and loss account is prepared after the trading which shows gross profit or loss. It records all the revenue expenses including capital
losses such as loss on sale of fixed assets, and revenue is a nominal account which is debited by the expenses and credited by incomes.
The difference between total incomes and gains and total expenses and losses is either net profit or net loss. The excess of total credit
over total debit result in net profit, while the excess of total debt over total gains result in a net loss.

A general format of profit and loss account is given below:

Note:

In a profit and loss account, either gross loss on the debit side or gross profit on credit side is shown; both are not shown in the
account at the same time.

Similarly, either net profit on the debit side or net loss on credit side is shown in the profit and loss account; both are not shown in
the account at the same time.

3. Profit and Loss Appropriation Account

Profit and loss appropriation account is the account which sets aside available profit for different purposes. It is prepared after the
preparation of profit and loss account. It shows the distribution of available profit in the way of dividend and creation of reserves. It also
adjusts the depreciation and tax. It is a common practice that the Nepalese companies prepare and present this account as a part of final
accounts.

Importance of Profit and Loss Appropriation Account

It helps to find out the total undistributed profit.

It helps to create reserve and fund for future contingencies and developments.

It helps to declare dividend and bonus.

It helps to re-adjust tax and depreciation of the year.

Preparation of Profit and Loss Appropriation Account

This account is prepared after the profit and loss account. The operating result of the company is transferred to the profit and loss
appropriation account. Profit and loss appropriation account are prepared to know the distribution of dividend, creation of reserve as well
as bonus share. The profit and loss appropriation account are debited by the appropriations of the company’s profit such as the creation
of reserves and funds and taxes paid and created by the company’s current year’s profits.

A specimen of profit and loss appropriation account is shown below:

Note:

Net loss from profit and loss account is transferred to the debit side of P/L appropriation account.

The debit balance of profit and loss appropriation account should be shown on the assets side of balance sheet.

4. Balance Sheet

A balance sheet is a statement of the financial position of a company prepared on a particular date. According to R.Stead, “Balance sheet
is a screen picture of the financial position of the company in terms of its assets, at a certain moment.” Therefore, it shows the financial
position of the company in terms of its assets, liabilities and shares capital as on the date for which it is prepared. A Nepalese company
has to prepare its balance sheet in a form prescribed by the Company Act, 2053 of Nepal.
Importance and Objectives of Balance Sheet

The balance sheet is one of the most important final account of a company. It provides important information to different users such as
shareholders, management, investors, lenders, bankers, creditors, and government for making financial decisions of their own.

It helps to know the financial position reflecting the true and fair view of assets and liabilities.

It helps to judge the debt paying capability of the company.

It helps to show the nature and value of all assets.

It helps to determine purchase consideration of the company.

It helps to know about capital, owner’s equity and borrowed capital in detail, including authorized, issued, subscribed called up ad
paid up capital.

Marshaling of Assets and Liabilities

The order in which assets and liabilities are arranged on a company’s balance sheet is known as Marshaling. It is a technique of showing
assets and liabilities and the share capital in a certain order in the company’s balance sheet. Generally, the assets, liabilities and the share
capital of the company can be arranged in its balance sheet in order of either liquidity or performance.

In order of liquidity

In order of liquidity, the most liquid form of assets is shown on the top of the balance sheet and the less liquid asset at its bottom. For
example, cash in hand is placed at the top and goodwill at the bottom on the assets side of the balance sheet according to the order of
liquidity. Similarly, in order of liquidity, the liabilities of the company which is payable early are shown on the top such as bills payable
and then sundry creditors and share capital at the bottom on the liabilities side of the balance sheet.

In order of permanence

Unlike that, in order of permanence, the item of assets and liabilities are arranged in an upside down manner. For example, most
permanent assets and liabilities are shown at the top and the down manner. For example, most permanent assets and liabilities are shown
at the top and the least at the bottom on their respective sides of the balance sheet. The following table shows an example of marshalling
of assets and liabilities in the balance sheet:

Preparation of Balance Sheet

The balance sheet of the company is prepared after the completion of its profit and loss appropriation account. All types of assets such as
current and fixed assets, investments, intangibles and fictitious assets are categorically shown on the right-hand side of the balance sheet.
Similarly, all types of liability such as current and long-term liabilities, reserves and surplus, share capital are shown on the left-hand
side. The balance sheet form is prescribed by the Companies Act, 2053 of Nepal.
Note:

All the assets and liabilities are presented in marshaling order.

It is a general practice that all assets and liabilities are marshaled on the basis of marshaling order.
In the case of issued, subscribed and called op capital, if all are the same, it can be shown at single heading.
If loose tools are depreciated year, they are treated as fixed assets.

Adjustment of Final Account

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Adjustments are unrecorded events or transactions of business organizations. Since, every transaction has two-fold effects according to
the principle of double entry system of book keeping, every adjustment, therefore, has two-sided effects in final accounts. The
adjustment is shown in either on :

Trading account and balance sheet or

Trading account and profit and loss account or
Profit and Loss account and balance sheet or
Assets side and liabilities on balance sheet or
Only in balance sheet

Closing Stock

The amount of unused materials and work-in-progress or unsold finished stock at the end of the financial year are called closing stock, it
is not included in the trial balance and therefore, is shown outside it. Therefore, it requires adjustment in final account and on the assets
side of balance sheet by passing sheet by the following adjustment entry:

Outstanding Expenses

Expenses, which are incurred but not paid during the same accounting period, are called outstanding expenses. These types of expenses
from which services goods have been received but the amount is not paid yet. It must be taken into account in the final account to find
out the true profit and loss of the business organization. The outstanding expenses firstly added to the concerned expenses on the debit
side of trading account or profit and loss account and then is existed to show on the liability side of the balance sheet.
Outstanding expense already existing in the trial balances is directly shown on the liability side of the balance sheet.

Accrued Income

Accrued income is also known as outstanding income. It represents income but the amount has not been received yet. It is the income of
the same accounting year. It should, therefore, be given effect in the final accounts of the business organization.

Depreciation

Depreciation is the decline in the value of fixed assets particularly due to their wear and tear. In case if a fixed asset is to be depreciated
based on additional information given outside the trial balance, the amount of depreciation of the concerned fixed asset should be shown
separately on the debit side of the company's profit and loss account after deducting from the concerned fixed assets on the asset side of
the balance sheet by passing the following adjustment entry.

However, in case of provision for or accumulated depreciation is given in the trial balance and the depreciation of fixed asset is to be
provided based on additional information given outside the trial balance, the amount of depreciation of the concerned fixed asset should
be shown separately on the debt side of the company's profit and loss account and added to the provision for or accumulated depreciation
on the liabilities side of the balance sheet by making the following adjustment entry:

Appreciation

Appreciation is the automatic and gradual increase in the value of fixed assets. It represents income for the business organization and
must be taken into account in the final account of the business organization. Appreciation is shown on credit side of profit and loss
account and it is shown on the balance sheet by adding it to the concerned assets.
Amortization

Amortization is reducing the value of some intangible and fictitious assets such as goodwill, patents, trademark, preliminary expenses,
underwriting commission, discount on issue of shares and premium on the redemption of debentures. These assets are reduced every
year by some amount till they are fully written-off or amortized. In case an intangible or a fictitious asset is to be written-off based on
additional information given outside the trial balance, the amount of amortization from the concerned asset deducted from the concerned
asset on the asset side of the balance sheet by passing the following adjustment entry.

Advance Income

Advance income is also known as unearned income. It is income received in advance. In other words, the amount received in advance
before delivering the services is known as advance income. Advance income doesn’t form the part of current years income, therefore, it
should be deducted from the concerned income to find out the true net income of the business organization. Advance income is deducted
from the income concerned and then it is shown in liability side of the balance sheet under the heading current liabilities. Advance
income already appearing on the trial balance sheet is directly shown as liabilities on the balance sheet.

Prepaid Expenses

Sometimes, expenses are paid-in-advance before they are due or incurred. For example, insurance premium or rent may be paid in
advance. Such expenses paid-in-advance are commonly called prepaid expenses. Prepaid expenses are deducted from the concerned
expense account on the debit side of either trading or profit and loss account and shown separately on the assets side of the balance sheet
by making the following adjustment entry.
Bad debt and provision for bad debt

When goods are sold on credit, the customer agrees to pay the due amount on the later date. However, some of the customers may not
pay their dues in time. The amount, which is uncollectible or can't be recovered from customers (debtors) is bad debt. The amount set
aside in advance to meet such losses is called provision for bad debt.

1. Adjustment entry for writing-off further bad debts based on additional information.

2. Adjustment entry for the provision of bad debt and doubtful debts based on additional information.

Note: The provision for bad debt and doubtful debts given in trial balance is to be treated as an old provision relating to the previous year
and is either shown on the credit side or deducted from the total of bad debts, further bad debt and new provision for bad and doubtful
debt on the debit side of the company profit and loss account.

Provision for discount on debtors

Discount is a rebate allowed to the customers. It is offered to the customers or debtors to pay their dues in before stipulated time. When a
provision is credited for allowing the discount to debtors, it is called provision for discount on debtors. However, the discount is only
provided to those debtors who are expected to pay their debts in time.

Provision for Discount on Creditor

Provision for discount on creditors is goodwill for the organization for the prompt payment to the creditor. If the payment is made on
time or prior to the due then the organization will be benefited with the discount provided by the creditors. If the organization generates
regular income from the discount on credits, it is created in the profit and loss account and subtract from the creditors in the balance
sheet. Adjustment entry for provision for discount creditors given in additional information.

.
Meaning and Preparation of Manufacturing Account & Tender
Manufacturing Account

There are some manufacturing concerns which do not have cost office and do not prepare cost accounts. Such manufacturing concerns
ascertain the cost of goods manufactured and manufacturing profit or loss during the year. So, it is an account prepared by the
manufacturing concern for the purpose of finding out the cost of production of the goods manufactured and the profit that has been made
by manufacturing department. When the data related to the cost of goods manufactured of a commodity are presented in a conventional
form of account i.e T-shape form, then it is known as manufacturing account. Generally, manufacturing concerns prepare this account to
exhibit cost of production or cost of goods manufactured.

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Features of manufacturing account

All the expenses relating to manufacturing goods are debited.

It shows only the figures of materials consumed instead of showing the figure of opening stock, purchase and closing stock
separately.

Opening stock of Work in Progress (WIP) is debited and closing stock of WIP is credited to manufacturing account.

The amount received from the sale of scrap is credited to manufacturing account.

The balance in the manufacturing account is the cost of production or manufacturing profit depending on the type of
manufacturing account prepared.

Importance of manufacturing account

 It ascertains the cost of goods manufactured.

It shows the profit or loss earned by a manufacturing department.

It provides a basis for fixing the price of a product.

It helps the management to evaluate the performance of the manufacturing department.

It helps to control manufacturing cost.

Preparation of manufacturing account

The manufacturing account is prepared either to ascertain the cost of goods manufactured or manufacturing profit or loss. So, it is
prepared in two ways:

For showing the cost of production.

For showing manufacturing profit or loss.

Manufacturing account showing the cost of production

For the production of the materials, opening stock of WIP, direct wages and all other expenses relating to the factory are debited. Closing
stock of WIP and amount credit from the sale of scrap are audited and the balance figure is shown on credit side would be the cost of
production.

Manufacturing account showing manufacturing profit or loss

If a manufacturing account is prepared to show the manufacturing profit or loss, all the items shown in the debit side of the previous
format of manufacturing account are also entered on the debit side of this account. On the credit side, closing stock of work in progress,
the sale of scrap and current trading price are shown and the balance figure arrived on the debit side would be the manufacturing profit.
Tender

A manufacturer has to quote the price of its product for tender at which it can supply its product to a customer. Tender or quotation price
is a price at which the company can provide its product. This price also includes a reasonable profit. For this purpose, an estimated cost
sheet has to be prepared on the basis of the cost of the preceeding period along with the consideration of likely changes in future.

Tender is a formal offer to supply goods or carry out work at a stated price. For this purpose, an estimated cost sheet has to be prepared
and forwarded to the customers who demands products.

Procedures of preparing Tender sheet

1. Firstly, prepare cost sheet of the previous year on the basis of given information.
2. Secondly, calculate the following percentages:

Percentage of factory overhead on direct wages,

= FactoryoverheaddirectwagesFactoryoverheaddirectwages × 100%

Percentage of office overhead on worksheet,

= OfficeoverheadPrimecostOfficeoverheadPrimecost ×100%

Percentage of selling and distribution overhead on worksheet

= SellinganddistributionoverheadworkcosSellinganddistributionoverheadworkcos×100%

Percentage of profit on cost,

= NetprofitTotalcostNetprofitTotalcost×100%

Or, percentage of profit on sale,

= NetprofitSaleNetprofitSale ×100%
3. Thirdly, prepare tender sheet:

Direct material, direct wages, and direct expenses are given for tender, otherwise, the same cost per unit of the previous year will
be taken for the purpose of tender.

Factory overhead, Administrative overhead and selling and distribution overhead for tender are calculated on the basis of
percentages calculated in step2. If there are any changes, they are to be considered.

Profit for tender is as follows:

Percentage of profit on cost is given

Net profit = totalcost×Rateofprofit100totalcost×Rateofprofit100

Percentage of profit on sales is given

Net profit = Totalcost×Rateofprofit100Totalcost×Rateofprofit100

Note:

Direct material, direct wages, and direct expenses should be added with changes, if any, to determine the prime cost. Other
overheads are calculated on the basis of percentage of previous year cost.

In the absence of any information, a percentage of factory overhead is computed on the basis direct wages and the percentage of
other overheads is computed on the basis of factory cost.

Illustration:

Stock of materials on 1-1-2011 35,000

Stock of materials on 31-12-2011 4,900
Purchase of materails 52,500
Direct wages 95,000
Factory expenses 17,500
Establishment expenses 10,000
Completed stock in hand on 1-1-2011 Nill
Completed stock in hand on 31-12-2011 35,000
Sales 1,89,000

The number of stoves manufactured during the year 2011 was 4,000.

The company wants to quote for a contract for the supply of 1,000. Electric Stoves during the year 2012. The stove to be quoted are
uniform quality and make and similar to those manufactured in the previous year, but the cost of the materials has increased by 15% and
the cost of the factory labor by 10%.

Prepare the statement showing the price to be quoted to give the same percentage of net profit on a turnover as was realized during the
year 2011, assuming that the cost per unit of overheads will be the same as in the previous.

Solution:
Concept & Preparation of Cost Reconciliation Statement
Concept of Cost Reconciliation Statement

Financial accounting is concerned with recording of the financial transactions and reporting the financial position of the business,
whereas cost accounting is prepared by cost accounting department and its objective is to record, classify, analyze and control the cost.
Thus, cost accounting and financial accounting are two different accounting systems.

The differences between these two topics occur not only because of the error in the system but also due to the different procedures and
principles carried by these accounts. Moreover, the amounts of profit and loss obtained from both accounts are often found to be
different. Hence, there comes necessity to reconcile the profit between these two accounts and statements. So, a statement which is
prepared for reconciling the profit shown by cost and financial account is known as reconciliation statement.

source: zaxonusa.com

Needs for reconciliation

The problem of reconciliation does not arise if there are no separate cost and financial accounts. When cost and financial accounts are
maintained independently, the accounts are reconciled. Although, both of the topics are concerned with the same basic transactions in
terms of disclosing figure of profit or loss, they do not agree with each other. Therefore, reconciliation between the consequences of
these two distinct topics is necessary because of these given sources:

It helps to find out the reasons for the differences in the profit or loss in cost and financial accounts.

It helps to ensure the mathematical accuracy and reliability of cost account and in order to have a check on the financial account.

It helps to contribute to the standardization of policies recording stock valuation, depreciation and overheads.

It helps to place management in a better position to acquaint itself with the reasons for the valuation in profit paving the way to
more effective internal control.

Reasons for disagreement in profit & loss

1. Items available only in financial account

It includes those items which are included in the financial account but may not be shown by cost account. Because of these items, profit
or loss available in a set of account may not agree with the profit or loss available in another set of account.

The following incomes and expenditures are included in financial account but excluded by cost account:

Purely financial charges:

Loss arising from sale of fixed assets

Loss on sale of investment
Interest on bank loan, debentures, mortgages loan
Penalties and fines donation and charity
Damage payable

Intangible and fictitious assets:

Goodwill
Patents
Copyrights
Trade mark
Preliminary expenses
Underwriting commission
Deferred advertisement expenses
Research and development expenses

Appropriation of expenditures/ losses:

Dividend paid
Taxes and incomes
Donation and charities
Transfers to general reserves and depreciation funds
Additional provision for bad debts
Capital expenditure specially charged to revenue expenditure

Purely financial incomes/ gains:

Gain on sale of fixed assets

Gain on sale of investments
Dividend received
Rent received/ transfer fees received
Interest on deposits/ investment

2. Items available only in cost accounts

The items included in cost accounts and not in financial accounts are:

Interest on own capital employed.

 Depreciation charged on fixed assets when the book value is reduced to a negligible figure.
Salary of proprietor when he works but does not charge salary to profit and loss account.
Rent charged when premises are owned and no rent is payable.

3. Over and Under absorption of Overheads

Overhead is absorbed on the basis of predetermined rates in cost account and overhead in financial account is absorbed in actual cost.
Due to this, the profit shown by one and the other is likely to be either higher or lower. If overheads are not fully absorbed i.e. the
amount in cost account is less than the actual amount, the short fall is called under absorption. On the other hand, if overhead expenses
in cost accounts are more than the actual, it is called over absorption.

Overheads Cost accounts Financial accounts

-Over absorbed in cost account Decreases profit Increases profit
-Under absorbed in cost account Increases profit Decreases profit

4. Different basis of stock valuation

The disagreement of profit between financial account and cost account also depends on the difference in the valuation of opening and
closing stock. Stocks are valued on the principle of “Cost or market value whichever is lower” in the financial account. But the stocks
are valued at factory cost or prime cost basis in cost account. Sometimes, stocks are valued according to the method adopted in stores
accounts. E.g. FIFO, LIFO, weighted average, etc. With such a different approach in the two sets of books, it is likely that the profit
figures are different.

Stock Valuation Result

Opening stock Over valuation Decreases profit
Opening stock Under valuation Increases profit
Closing stock Over valuation Increases profit
Closing stock Under valuation Decrease profit

5. Different methods of charging depreciation

The method of charging depreciation may differ in financial accounts and cost accounts and may cause disagreement in a profit of the
two books of accounts. The rate and method of depreciation may be different in cost and financial accounts. Overcharge of depreciation
shows less profit and undercharge of depreciation shoes more profit.

Depreciation Cost accounts Financial accounts

Over charge in cost Decrease profit Increase profit
Under charge in cost Increase profit Decrease profit

Preparation of Cost Reconciliation Statement

When there is a difference between the profits or loss disclosed by cost accounts and financial accounts, the following steps shall be
taken to prepare it.

Step 1: Ascertain the various reasons of disagreement between profit disclosed by cost account and financial account.

Step2: If profit as per cost accounts is taken as the base, then the following specimen should be taken into the mind while preparing
reconciliation statement.

Step3: If profit as per financial accounts is taken as the base, then the following format consideration should be taken into mind while
preparing reconciliation statement.

Particular Amount
Profit as per cost account or loss as per financial account XXX
Add:
XXX
Overcharge of expenses in cost account
XXX
Items of expenses recorded only in cost account
XXX
Items of income recorded only in financial account
XXX
Amount of understated income in cost account
XXX
Over-valuation of opening stock in cost account
XXX
Under valuation of closing stock in cost account
Less:
XXX
Under charge of expenses in cost account
XXX
Items of expenses recorded only in financial account

Income is shown in cost account, but not in financial XXX

account
XXX
Amount of income over state in cost account
XXX
Under valuation of opening stock in cost account XXX
Over valuation of closing stock in cost account
Profit as per financial account or loss as per cost account XXX
Company and its Formation
Meaning and Definition of a Company

A company is an entity created by law and is separated from its owner. A company is a corporate body formed to carry out certain
activities for a particular purpose . It is a body formed by the person who contributes capital, who are known as shareholders. The
shareholders have a limited liability up to their invested capital. The nature of share is that it is not returnable but transferable from one
person to another.

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A company is a voluntary association of a number of individuals, established for some common purpose of economic gain. A company
is established by different individuals so that a large scale can be raised for the purpose of mass production.

According to James Stephenson, “A company is an association of many persons who contributes money or money’s worth to common
stock and employ it in some trade or business and who share the profits and losses arising thereform."

Nepal Company Act, 2063, “A company refers to any company formed and registered under this Act. “

It is clear from the above definitions that a company is a voluntary association of a group of people willing to carry out a business for
which the major part of the capital is collected by selling the shares or debentures to the general public. It is an artificial person, which is
created by the specific law with a perpetual succession.

Characteristics of a Company
The main characteristics of a company are as follows:

An artificial person: A company is an artificial person created by the law and having a separate existence of its own. Like a real
person, it can buy or sell the property in its own name. It can sue and can be sued by others. It can conduct a lawful business and
enter into a contract with others.

Separate legal entity: A company enjoys a benefit of a separate legal entity from its owners. A company cannot be held liable for
the actions of its owners and similarly a shareholder cannot be held liable for the acts of the company.

Perpetual succession: A company is created by law and only law can liquidate it. The death, insolvent, inability or lunacy of
members does not affect the life of a company. Members may come and members may go, but the company goes on forever.

Limited liability: The liability of every owner of a company is limited to the extent of the face value of the shares purchased.
Even if, the assets of the company are not sufficient to pay the claims of the creditors, no owners are bound to pay anything more
than the face or nominal value of the shares held by them.
 Transferability of shares: The capital of the company is divided into a number of units which are called shares. These shares are
transferable. A shareholder is free to withdraw his membership from the company by transferring shares.

Common seal: Being an artificial person, the company cannot sign for itself. It acts through its officers. A common seal is the
official signature of a company. All the acts of the company are authorized by its common seal. All the documents are affixed by
the common seal for making valid documents.

Representative management: There is a separation between ownership and management of a company. Shareholders do not
participate directly in the day-to-day management of the company. So, they elect their representatives from among themselves.
These representatives manage the company on behalf of the shareholders and they are called directors. The Directors are the legal
representatives of the shareholders.

Types of Companies
The various types of companies based on their nature are as follows:

1. On the Basis of Incorporation

On the basis of incorporation, companies can be classified as follows:

Chartered Company: A chartered company is established by the Royal Charter or a Special Sanction granted by the head of the
state. The East India Company, the Bank of England. etc. are some of the examples of a chartered company. This types of
company are no more popular today.

Statutory Company: A company which is created by a special act of the parliament and whose objectives, powers and activities
are defined by the act is called the statutory company. Nepal Rastra Bank, Agriculture Development Bank. etc. are some of the
statutory company.

Registered Company: The companies which are formed and registered under the common company law are called registered
companies. The working of registered companies is governed by the provision of Company Act. Himal Cement Company, Paper
Mills, etc. are some example of registered company.

2. On the Basis of Liability

Unlimited Company: It is a company in which the liability of the members is unlimited like that of a partnership firm. If the
assets of the company are not sufficient for satisfying the claims of creditors, the shareholders are liable to pay more than the face
or nominal value of the share held by them even from their personal property.

Company Limited by Shares: A company limited by shares is registered under the provisions of the Company Act with a
specific amount of share capital divided into a definite number of shares. The liability of shareholders is limited to the extent of the
face value of the shares they have paid for.

Company Limited by Guarantee: The Company, under which each shareholder promised to pay a specific sum as a guarantee at
the time of winding up of the company, is called a Company Limited by Guarantee. Such guarantee is specified in the
Memorandum of Association of the company.

3. On the Basis of the Number of Members

Private company: A private company is a company which, by its Memorandum of Association limits the number of its members
not exceeding fifty, and prohibits the sale of its share to the general public. A private company must use the word ‘Private Limited
(Pvt, Ltd.)’ in its name.
Source:www.prismfund.com

Privileges of Private Company

Private company can be established by a single person.

It does not need to publish a prospectus at the time of the issue of its shares.
It can refuse the transfer of shares from one member to another.
It is not necessary to hold a statutory meeting.

Public company: A public company is a company which collects major capital by offering shares to the general public. Its
number of membership is governed by the authorized capital with which it is registered. The share is transferable to others. It can
sell debentures in markets to raise additional capital as loans. Nepal Bank Ltd, Commercial Bank Ltd., etc, are some examples.
Source:www.keyword-suggestions.com

Advantages of a public company

The share is transferable.

It is free to invite the public to buy its shares and debentures.
A large capital not exceeding the registered capital can be collected for mass production purpose.
An effective and efficient management is possible.

4. On the basis of Ownership

Government Company: A government company is a company in which no less than 51 percentage of the paid-up share capital is
held by the government. Himal Cement Company, Lumbini Sugar Mills are some of the examples of Government.

Non-Government Company: The company which is not a government undertaking is called the non-government company.
Generally, company owned, managed and controlled by the private sector come under this category. Buddha Airlines, Chaudhary
Group, etc. are some examples of non-government companies.

Company Promoters
Company promoters are the people who give birth to a company. Promoters generate the idea and discover business opportunities. They
make details investigation about the feasibility of the business, financial source, and competitors. They prepare necessary documents like
the Memorandum of Association, the articles of Association and the Prospectus for the incorporation of the company. The promoters
may be anyone such as an entrepreneur, a professional promoter, government and financial institution.

Main Documents of a Company

A number of documents should be prepared and presented to the Registrar of Companies in the process of formation of a company.
Following document are most essential.

For a Private Limited Company

1. Memorandum of Association
2. Articles of Association

For a Public Limited Company

1. Memorandum of Association
2. Articles of Association
3. Prospectus

Memorandum of Association

It is the main document of the company. The document which defines its objectives, power and its relationship with the outside world is
called Memorandum of Association. The company works within the framework of the memorandum.

The main contents of Memorandum are as follows:

The name of the company

The objectives of the company
The amount of capital of the company and other.

Article of Association

The document which defines the rights, power, and duties of the management, the modes, and manners of carrying the company’s
business, is called the Article of Association. It shows relation between the company’s and its member and relation among member.

According to the Company Act 2063, section 17 (2), the Article of Association contains the following:

Number of directors and their term and conditions.

The amount of minimum subscriptions by the director.
The provision relating to the rule and regulations of internal management.
Director’s remuneration and allowance and other.
Prospectus

A prospectus is an invitation to the public to purchase share or debentures of the company. Any circular, advertisement, other or any
other document by which a company gives an invitation to the public to subscribe to its shares and debentures is known as a prospectus.
According to the Company Act 2063, Prospectus contains the following:

The information relating to the management and the objectives of the company.
Number of shares to be subscribed by directors and the cash to be received from them.
The capital structure of the company dividend into authorized, issue, subscription and paid up share capital.
Estimated expenditures for the company and estimated income at least for coming three year and other particulars.
Funds Flow Statement
Statement of Changes in Financial Position

Statement of changes in financial position refers to the statement which is prepared on the basis of all financial resources like capital,
assets, and liabilities. This statement measures the changes that have taken place between two balance sheet dates in the financial
position of a concern. The changes in the financial position may occur while dealing with following transactions:

Involvement between current assets and non-current assets (fixed or permanent assets).
Involvement between current liabilities and non-current liabilities.
Involvement between current assets and non-current liabilities (long-term liabilities and capital).
Involvement between current liabilities and non current assets.

In simple words, this statement summarizes all the sources from which the funds have been obtained and the uses to which and where
they have been applied. The changes in the financial position could be related to several different concepts of funds. The 2 major usages
are Working capital funds i.e. Working capital basis (Funds Flow Statement) and Cash funding i.e. Cash basis (Cash Flow Statement).

Funds Flow Statement

Source: www.slideshare.net

Funds flow statement is the statement that shows the various sources from where the funds have been collected, within a certain time
period along with their uses during that period.In simple words, funds flow statement explains about the various sources and application
of funds. Thus, funds flow statement is an important tool for financial analysis as it presents a firm with the information on the inflow
and outflow of funds of the firm during a financial year.

According to R. N. Anthony," The funds flow statement describes the sources from which additional funds were derived and the uses
to which these funds were put."
Objectives and Importance of Funds Flow Statement
1. To analyze financial position:
Funds flow statement helps a firm in analyzing its financial position by providing the firm with analytical knowledge regarding the
business financial position. An analytical knowledge is a very helpful tool to the financial manager for planning and decision
making.

2. To help in planning and controlling:

Funds flow statement helps in estimating the required amount of fund needed for the enterprise to run a certain project, which in
turn helps in controlling the funds and plan more thoroughly for future.

3. To help in allocation of resources:

Providing information on the inflow and outflow of funds is the main objective of funds flow statement. While doing that, it also
shows current availability of those sources and where they come from. This helps in realizing the available funds for the long term
and short term projects.

4. To evaluate financial performance:

Funds flow statement showsthe weaknesses and strengths of a firm. By doing so, it becomes easy to analyze how well the
management has been running the funds and determine its financial performance.

5. To explain the changes in financial position:

Between two balance sheets, there is definitely bound to be some changes and the main motive of funds flow statement is to
disclose those changes and their causes. Thus, this statement helps in explaining the changes in financial position of the firm.

Procedures of preparing Funds Flow Statement

STEP 1: Preparation of Statement of Changes in Working Capital

Working capital is the difference between current assets and current liabilities. Current assets are those assets which are convertible into
cash without any negative effect on their value, within a year or a short time period. Some examples of current assets are bank balance,
debtors, inventories/ stock, accrued income, bills receivable, etc. On the other hand, current liabilities are the outsiders’ obligation which
must be paid within a short notice like bills payable, bank overdraft, short term loan, creditors, etc.

Rules:

Identify Current assets and Current Liabilities from the Balance sheet.
Using the followings, determine increase or decrease in Working capital.

Conditions Result Relationship

CA increase WC increase Direct relationship

CA decrease WC decrease Direct relationship

CL increase WC decrease Inverse relationship

CL decrease WC increase Inverse relationship

The format of Statement of Changes in Working capital is shown below:

Alternatively,
Note: Provision for taxation and proposed dividend are regarded as current liabilities if additional information is not given.

Illustration:

Particulars 2072 2073

 Rs. 20,000 Rs. 30,000
Debtors
40,000 50,000
Creditors
75,000 55,000
Stock
35,000 44,000
Bank balance
22,000 32,000
Short term investment
5,000 15,000
Bank overdraft
20,000 80,000
Bills receivable
20,000 10,000
Bills payable
21,000 5,000
Cash
8,000 8,000
Prepaid expenses
3,000 -
Advance income
18,000 12,000
Marketable securities
12,000 5,000
Expenses payable

Required: Statement of Changes in Working Capital.

SOLUTION:

Alternatively,
Funds Flow Statement: Determination of funds from operation
STEP 2: Determination of Funds from Operation
Determination of Funds from operation by using add back method

Under add back method, all the non-cash expenses, non-operating losses and non-operating expenses are added to the back with net
profit, for the purpose of determining funds from operation.

On the other hand, all the non-operation revenues, gain, and incomes are subtracted from the net profit. Here, all the items of profit &
loss account are paid in cash and business related operations are ignored. Below is the procedure for determining funds from operation
under add back method:

Calculation of Funds from Operation

Particulars Details Rs.

Net profit xxx

Add: Non-operating and non-cash expenses and losses

Depreciation on fixed assets

xxx
Loss on sales of assets
xxx
Intangible assetswrittenoff

(Goodwill, trademark, copyright, patent)

xxx
Fictitious assets writtenoff
xxx
Provision for taxation
xxx
Premium on redemption of debentures

Other non-operating expenses/ loss xxx

Less: Non-operating incomes and gain xxx xxx

xxx
Rent, dividend, interest, etc. received
xxx
Gain on sales of assets
xxx
Revaluationgainon non-current asset

Other non-operating incomes and gain

xxx xxx
Funds from Operation (FFO) xxx

Fictitious assets written off include Preliminary expenses, Discount onissueof shares/ debentures, underwriting commission, other assets
written off, etc.

Illustration:Consider the following Trading and Profit & Loss account.

Trading and Profit & Loss account

For the year ending 31stDecember,2015

Particulars Rs. Particulars Rs.

2,00,000
To Purchase 3,50,000
50,000
To Wages
1,00,000
To Gross profit 3,50,000 By Sales 3,50,000
20,000
1,00,000
To Salaries 10,000
6,000
To Office expenses 2,000
10,000
To Discount on issue of shares 10,000
By Gross profit
To Depreciation 8,000
By Dividend received
To Goodwill written off By profit on sales of plant
To Preliminary expenseswrittenoff 10,000

To Loss on sale of furniture 14,000

To Net profit 42,000

1,16,000 1,16,000

Required:Funds from operation.

Solution:

Calculation of Funds from Operation

Particulars Details Rs.
Net profit 42,000

Add: Non-operating and non-cash expenses and losses

Depreciation

Preliminary expenseswrittenoff 10,000

Goodwillwrittenoff 10,000

Discount on issue of shares 8,000

Loss on sale of furniture 2,000

Less: Non-operating incomes and gain 14,000 44,000

86,000
Dividend received
6,000
Gain on sales of plant
10,000 16,000
Funds from Operation (FFO) 70,000

Determination of Funds from operation by adjusted profit & loss account

An adjusted P/L account is prepared by debiting all the non-cash expenses, non-operating losses and non-operation expenses with net
profit whereas, all the non-operation revenues, gain, and incomes are credited to an adjusted P/L account. Likewise, in add back method,
all the P/L account items are paid in cash and any business related operations are ignored.

1. When net profit or loss is given:

Following adjusted P/L account is prepared when net profit or loss is given, excluding the items of P./L appropriation account:

Dr. Adjusted Profit & Loss Account Cr.

Particulars Rs. Particulars Rs.

xxx
To net profit
xxx xxx
To loss on sales of assets
xxx By gain on sales of assets xxx
To intangible assets written off
xxx By interest received xxx
To depreciation on fixed assets
xxx By dividend received
To fictitious assets written off
xxx By discount on redemption of debentures xxx
To provision for taxation (if non-
current) xxx By non-operating income/gain
To premium on redemption of xxx
By funds from operation (Balancing fig.
debenture
sources)
xxx xxx
To other non-operating expense/losses
xxx
To loss from operation (Bal. fig. uses)
xxx xxx

Intangible assets – Goodwill, Patent, Trademark, and Copyright.

Fictitious assets written off include Preliminary expenses, Discount on the issue of shares/ debentures, underwriting commission, other
assetswrittenoff, etc.

Illustration:Consider the following information and prepare Funds from the operation.

Trading and Profit & Loss account

For the year ending 31stDecember,2015

Particulars Rs. Particulars Rs.

 2,00,000
To Purchase 3,50,000
50,000
To Wages
1,00,000
To Gross profit
3,50,000 By Sales 3,50,000
20,000
1,00,000
To Salaries 10,000
6,000
To Office expenses 2,000
10,000
To Discount on issue of shares 10,000 By Gross profit
To Depreciation 8,000 By Dividend received
To Goodwill written off By profit on sales of plant……
To Preliminary expenseswrittenoff 10,000

To Loss on sale of furniture……….. 14,000

To Net profit……………………………… 42,000

1,16,000 1,16,000

Solution:

Dr. Adjusted Profit & Loss Account Cr.

Particulars Rs. Particulars Rs.

42,000

To net profit 14,000

To loss on sales of furniture 10,000

By profit on sales of plant
To preliminary expenses written 10,000 6,000
off By dividend received
10,000
To depreciation By funds from operation (Balancing fig.
8,000 sources) 70,000
To goodwill written off

To discount on issue of shares

2,000
86,000 86,000

2. When net profit or loss is not given:

When net profit or loss is not given, P/L appropriation account or Retained earnings or Reserve and surplus or Reserve fund, whichever
is given, is used. Below is the format.

Dr. Adjusted Profit & Loss Account Cr.

Particulars Rs. Particulars Rs.

 xxx
To Balance c/d (closingbal. of P/L a/c or
Retained earning) xxx

To loss on sales of assets xxx

By Balance b/d (openingbal. of P/L a/c or xxx
To intangible assets written off xxx Retained earning) xxx
To depreciation on fixed assets xxx By gain on sales of assets xxx
To fictitious assets written off xxx By interest received
xxx
To profit transfer to reserve & funds xxx By dividend received
xxx
To provision for taxation (if non-current) xxx By refund of tax

To provision for dividend (if non-current) By discount on redemption of debentures

xxx
To dividend xxx By non-operating income/gain
xxx
To premium on redemption of debenture By funds from operation (Balancing fig.
sources)
To other non-operating expense/losses xxx
xxx
To transfer to reserves xxx

To loss from operation (Bal. fig. uses) xxx

xxx
xxx xxx

Intangible assets – Goodwill, Patent, Trademark, and Copyright.

Fictitious assets are written off – Preliminary expenses, Discount on the issue of shares / debentures, underwriting commission, other
assets writtenoff, etc.

Profit transfers – General reserve, Reserve fund and Capital reserve.

Illustration:Prepare Funds from Operation from the following financial statements.

Balance Sheet

Liabilities 1992 1993 Assets 1992 1993

Share capital 1,00,000 2,50,000
Fixed assets, net of depreciation
Creditors 40,000 1,00,000 50,000 2,35,000
Debtors
Debentures 50,000 - 80,000 40,000
Stock
General reserve - 10,000 70,000 1,00,000
Cash balance
P/L app. a/c 60,000 75,000 50,000 60,000
2,50,000 4,35,000 2,50,000 4,35,000

Dr. Profit & Loss A/C for 1992Cr.

Particulars Rs. Particulars Rs.

15,000
To depreciation on fixed assets 80,000
35,000 By gross profit
To office expenses 20,000
50,000 By refund of tax
To net profit
1,00,000 1,00,000

Dr. Profit & Loss Appropriation A/C for 1992Cr.

Particulars Rs. Particulars Rs.

To dividend paid 25,000
60,000
By Balance b/d
To general reserve 10,000
50,000
By net profit b/d
To Balance c/d 75,000
1,10,000 1,10,000

Solution:

Adjusted P&L A/C for 1992 (on the net profit basis)

Dr.Cr.

Particulars Rs. Particulars Rs.

15,000 20,000
To depreciation By refund of tax
50,000 45,000
To net profit (as per P/L a/c) By Funds from operation (bal. fig.)
65,000 65,000

Dr. (a) Adjusted P&L Appropriation A/C for 1992Cr.

Particulars Rs. Particulars Rs.

25,000
To dividend paid 60,000
10,000 By Balance b/d
To general reserve 20,000
15,000 By refund of tax
To depreciation 45,000
75,000 By Funds from operation (bal. fig.)
To Balance c/d
1,25,000 1,25,000

Alternatively,

Dr. (b) Adjusted P&L Appropriation A/C for 1992Cr.

Particulars Rs. Particulars Rs.

15,000
To increase in P/L app. a/c 20,000
25,000
To dividend paid By refund of tax
10,000
To general reserve By Funds from operation (bal. fig.) 45,000
15,000
To depreciation
65,000 65,000

Cash Flow Statement: Introduction

INTRODUCTION
Source: www.shutterstock.com

Simply, cash flow statement indicates the amount of cash receipts and the amount of cash payments or disbursements during a specified
time. It outlines from where cash was generated and to where it was expensed. In other words, it reports the cash inflows and cash
outflows, during a time period.

The cash flow statement shows the net increase or decrease in cash and explains the causes for the changes in the cash balance, during a
certain time period. The major business activities that result in either net cash inflow or net cash outflow are Operating, Financing and
Investing activities.

According to Anthony, “Cash flow statement is a statement prepared to indicate the increase in the cash resources and the utilization of
such resources of a business during the accounting period.”

Statement of Cash Flow

Cash from
Cash from operations is the cash generated from everyday business operations.
operations
Cash from Cash from investing is the cash which is used for the investment purpose in assets, as well as the proceeds from
investing the sale of other businesses, equipment or other long-term assets.
Cash from Cash from financing is the cash which is paid or received for issuing or borrowing the funds. This also includes
financing dividends paid (though, sometimes it is listed under cash from operations).
Net increase or
Increases in cash from the previous year are written normally and the decreases in cash are written in () brackets.
decrease in cash

Objectives of Cash Flow Statement

To show the impact of operating, financing and investing activities on cash resources.

To explain the causes for cash balance changes.

 To report about the cash inflows and cash outflows of the firm’s operating, financing and investing activities.

To determine the financial needs of the firm.

To help in forecasting the future cash flows.

Importance of Cash Flow Statement

Cash flow statement is useful in making both internal and external financing and investment decisions such as repayment of short-
term debt and long-term debt, project expansion, etc.

It is useful in making an appraisal of various capital investment projects so that their viability and profitability can be determined.

Cash flow statement helps in explaining the anomaly of poor cash position and substantial profit.

Cash flow statement discloses the movement of the enterprise’s internal funds that are operating activities related, making this
statement more appropriate for internal financial planning, controlling and decision-making.

Cash flow statement summarizes the performance of an enterprise on a cash basis, after furnishing the important cash activities.

Cash flow statement helps the management in evaluating its ability to meet its obligations such as payment of interest, taxes,
dividend, repayment of bank loan, payment to creditors, etc.

Differences between Cash flow statement and Funds flow statement

Cash flow statement Funds flow statement

Cash flow statement is prepared to disclose the Funds flow statement is prepared to disclose causes of
causes of changes in working capital. changes in cash and cash equivalents.
It is prepared on accrual accounting basis. It is prepared on cash system of accounting basis.
It does not have an opening and closing balances. It consists of opening and closing balances of cash.
It is prepared for long-range financial planning. It is useful for only short-range financial planning.
It contains only cash, which is one of the components
It contains all the components of working capital.
of working capital.
Funds flow statement has to be prepared by every
Cash flow statement has become quite obsolete.
listed company, as per given prescription.

Cash Flow from Major Business Activities

When it comes to major cash flow business activities, it divides into 3 parts. They are operating activities, investing activities and
financing activities.

Operating activities Investing activities Financing activities

Cash receipts: Cash receipts:
· Sale of goods or services to customers. Cash receipts:
· Sale of investment.
· Collections from customers. · Borrowing (Debentures, Notes, Bonds,
· Sale of fixed assets.
Mortgages, etc).
· Insurance claims against loss of inventory.
· Sale of business segments.
· Insurance of shares at premium or
· Proceeds from settlement of the lawsuit. · Collection of principal on loans discount.
· Other operating receipts if any. made to others.
Cash payments: Cash payment:

· Operating expenses like salaries, rent, expenses, Cash payments: · Dividend paid to shareholders.
telephone, heat light & power etc.
· Loans to other entities. · Re-purchasing business own stock.
· Inventory purchase, payment of direct wages, carriage · Purchase of fixed assets.
inwards, etc. · Redemption of preference shares at
premium or discount.
· Purchase of investment i.e.
· Interest expenses on loan.
investment made. · Redemption of borrowings at premium
· Tax expenses, etc. or discount, if any.

Cash Flow from Operating Activities

Operating activities are concerned with day to day business operations. Operating activities usually involve the production and delivery
of goods and rendering services. All the cash transactions which are related to the firm’s ongoing business are cash flow from operating
activities.

Cash inflow Cash outflow

Sales revenue
From Trading a/c Cost of goods sold, wages and manufacturing expenses
Service revenue
Operating expenses (cash items only) such as selling
From Profit & Sundry operating income received such as rent, interest,
expenses, interest, tax, distribution expenses, office
Loss, a/c commission, dividend, etc. receive, bad debt recovered
expenses, etc.
From Asset side Decrease in all current assets except cash and cash Increase in all current assets except cash and cash
of balance sheet equivalents. equivalents.
From Liability
side of balance Increase in all current liabilities. Decrease in all current liabilities.
sheet

According to Nepal Accounting Standard clause 03 and section 6 (NAS-03 Sec-6), followings are the examples of cash flows related
operating activities:

Cash receipts from the fee, royalties, commission and other revenues.

Cash receipts from the sales of goods and rendering services.

Cash paid to employees.

Cash paid to suppliers for goods and services provided.

Cash payment or refund of income taxes unless they are especially identifiable with financing and investing.

Cash receipts and payments from contracts that are held for dealing or trading purposes.

Cash receipts and payments of an insurance enterprise for premium and claims, annuities and other benefits.

Cash from Operation under Direct Method

Determination of Cash from Operating Activities under Direct Method

1. Cash Sales and Cash Collection from Customers/ Debtors:

Cash collection from customers includes the cash sales amount and cash received amount from customers or credit sales. The
generated cash is determined with the help of changes in the customers’ account which is shown on the assets side of the balance
sheet.

2. Cash Paid to Suppliers for Purchase of Merchandise:

The purchase of merchandise for the purpose of selling and manufacturing finished goods is the major cash outflow area under
operating business. The purchase or cost of goods sold shown in the income statement represents both cash purchase and credit
purchase.
 3. Cash Paid to Employees and for Other Expenses:
Among different types of operating and non-operating expenses, only cash operating expenses are taken into account while
determining cash paid to employees and for other expenses. Some of the examples are:

Operating items Non-operating items

Loss on sale of fixed assets
Wages & Rent
Non-operating expenses and losses
Cost of goods sold
Provision for taxation (if non-current)
General office expenses
Provision for dividend (if non-current)
Interest expenses
Intangible assets written off
Tax expenses
Fictitious assets written off
Manufacturing expenses
Depreciation
Selling & distribution expenses
Premium on redemption of debentures
Operating expenses (cash
Other operating expenses (non-cash)
only)

Notes:

Loss on sale of the plat is a non-operating loss.

Depreciation is a non-cash item; hence, it is excluded from operating expenses.
Interest expense is to be included in operating section and dividend paid under financing section, if there is no additional
information given.

4. Interest Paid:
If not given any additional information, interest paid is included under operating section.

5. Tax Paid:
Tax paid is considered as the cash outflow from operating revenue. Its amount is determined on the basis of tax expense of the
current year and position of outstanding tax.

6. Interest and Dividend Received:

Cash flow from Interest and dividend received are disclosed separately. Each is classified in a consistent manner from period to
period. They are usually classified as cash inflows because they determine net income or loss.

On the other hand, they may also be included under investing section as they are treated as the return on investments on shares,
debentures, and other assets.

7. Net cash flow before Extra Ordinary Items (A-B-C-D-E+F):

While calculating cash flow from operation activities, net cash flow before extraordinary items, is to be found out.

8. Cash from Extra Ordinary Items:

Besides ordinary items such as cash sales and cash collection from customers, tax paid, interest and dividend received, etc., there
are some other items concerned with the operational cash flow of business such as compensation received from the insurance
company, short term borrowing, etc.

Known as extraordinary items, an increase in their balance is a source of cash inflow and a decrease in their balance indicates cash
outflow.

Particulars Increase Decrease

Notes payable + -

Bank overdraft + -

Compensation receivable from insurance company + -

Marketable securities (if excluded from cash & equivalent) - +

Short term investment (if excluded from cash & equivalent) - +

Format for Cash Flow from Operating Activities under Direct Method

Particulars Rs. Rs.

Cash flow from operating activities:

a. Cash collection from customers:

Net sales xxx

Decrease in bills receivable xxx

Decrease in accounts receivable xxx

Decrease in sundry debtors xxx

Bad debt recovered xxx

Increase in provision for doubtful debt xxx

Increase in provision of discount on debtors xxx

Discount allowed (xxx)

Increase in bills receivable (xxx)

Increase in accounts receivable (xxx)

Increase in sundry debtors (xxx)

Decrease in provision for doubtful debt (xxx)

Decrease in provision of discount on debtors (xxx)

xxx
b. Cash paid to suppliers for purchase of merchandise:

Cost of goods sold (op. stock + purchases – cl. stock) (xxx)

Decrease in bills payable (xxx)

Decrease in accounts payable (xxx)

Decrease in sundry creditors (xxx)

Increase in inventory (xxx)

Increase in sundry creditors xxx

Decrease in inventory xxx

Increase in accounts payable xxx

Increase in bills payable xxx

Discount received xxx (xxx)

c. Cash paid to employees and for other expenses:

Cash operating expenses including wages (item wise) (xxx)

Increase in outstanding (o/s) expenses xxx

Decrease in o/s expenses (xxx)

Decrease in prepaid expenses xxx

Increase in prepaid expenses (xxx) (xxx)

d. Interest paid:

Interest expense (as per income statement) (xxx)

Increase in prepaid interest (xxx)

Decrease in prepaid interest xxx

Decrease in o/s interest (xxx)

Increase in o/s interest xxx (xxx)

e. Tax paid:

Tax expense (as per income statement) (xxx)

Increase in prepaid tax (xxx)

Decrease in prepaid tax xxx

Decrease in o/s tax or provision for taxation (xxx)

Increase in o/s tax or provision for taxation xxx (xxx)

f. Interest and dividend received:

Interest received (as per income statement) xxx

Dividend received (as per income statement) xxx

Decrease in interest/ dividend receivable xxx

Increase in interest/ dividend receivable (xxx) xxx

g. Cash from operation before extra ordinary items (a+b+c+d+e+f)

xxx
h. Cash from extra ordinary items:

Increase in short term borrowings, bank overdraft, etc. xxx

Decrease in short term borrowings, bank overdraft, etc. (xxx) xxx/(xxx)

Net cash flow from operating activities xxx/(xxx)

Alternatively,

Particulars Rs. Rs.

Cash collection from customers:

Net sales xxx

Add:

Sundry debtors of last year xxx

Bills receivable of last year xxx

Accounts receivable of last year xxx

Provision for doubtful debt of current year xxx

Provision for discount on debtors of current year xxx

Bad debt recovered xxx xxx

xxx

Less:

Sundry debtors of current year xxx

Bills receivable of current year xxx

Accounts receivable of current year xxx

Provision for doubtful debt of last year xxx

Provision for discount on debtors of last year xxx

Discount allowed xxx xxx

Cash collection from customers (a) xxx
Cash paid to suppliers:

Cost of goods sold (opening stock + purchases – closing stock) xxx

Add:

Sundry creditors of last year xxx

Bills payable of last year xxx

Accounts payable of last year xxx

Inventory of current year xxx xxx

xxx

Less:

Sundry creditors of current year xxx

Bills payable of current year xxx

Accounts payable of current year xxx

Inventory of last year xxx

Discount received xxx xxx

Cash paid to suppliers (b) xxx
Cash paid to employees and for other expenses:

Operating expenses (item wise) xxx

Add:

Prepaid expenses of current year xxx

Outstanding expenses of last year xxx xxx

 xxx

Less:

Prepaid expenses of last year xxx

Outstanding expenses of current year xxx xxx

Cash paid to employees and for other expenses (c) xxx
Interest paid:

Interest expense (as per income statement) xxx

Add:

Prepaid interest of current year xxx

Outstanding interest of last year xxx xxx

xxx

Less:

Prepaid interest of last year xxx

Outstanding interest of current year xxx xxx

Interest paid (d) xxx
Tax paid:

Tax expense (as per income statement) xxx

Add:

Prepaid tax of current year xxx

Outstanding tax or provision for tax of last year xxx xxx

xxx

Less:

Prepaid tax of last year xxx

Outstanding tax or provision for tax of current year xxx xxx

Tax paid (e) xxx
Interest and dividend received:

Interest received (as per income statement) xxx

Dividend received (as per income statement) xxx

Add:

Interest/ Dividend receivable of last year xxx xxx

xxx

Less:

Interest/ Dividend receivable of current year xxx xxx

Interest and dividend received (f) xxx
Cash from operation before extra ordinary items (a-b-c-d-e+f) xxx
Cash from extra ordinary items:

Add: Increase in bank loan, bank overdraft, etc. xxx

Less: Decrease in bank loan, bank overdraft, etc. (xxx) xxx/(xxx)

Net Cash Flows from Operating Activities xxx/(xxx)

Illustration:

The income statement of BTS Company for the year is given below:
Particulars Details Rs. Amount Rs.
Sales revenue 15,00,000

Less: Merchandise purchased 4,00,000

Salaries & wages 3,00,000

Selling & distribution overhead 2,00,000

Manufacturing overhead 1,00,000

Office & administrative overhead (including depreciation Rs. 50,000) 3,00,000 13,00,000

Net profit 2,00,000

Balance sheets of last and current years:

Particulars Last year Current year

Sundry debtors 2,00,000 3,00,000

Sundry creditors 80,000 1,00,000

Account receivable 40,000 35,000

Account payable 70,000 50,000

Accrued interest 15,000 20,000

Closing stock 60,000 80,000

Required: Cash flow from operating activities.

Solution:

Calculation of Cash Flow from Operating Activities

Particulars Rs. Rs.

A. Cash collection from customers: 15,00,000

Sales revenue 5,000
Decrease in accounts receivable (1,00,000) 14,05,000
Increase in sundry debtors

B. Cash paid to suppliers: (4,00,000)

Merchandise purchased (20,000)

Increase in closing stock (20,000)

Increase in sundry creditors 20,000 (4,20,000)

Decrease in account payable

C. Cash paid to employees and for other expenses:

(3,00,000)
Salary & wages
(2,00,000)
Manufacturing overhead
(50,000)
Selling & distribution overhead

Office & administrative overhead (including depreciation Rs. 50,000)

(3,00,000) (8,50,000)
D. Interest paid:
Increase in accrued interest

Cash from operation before extra ordinary items (A+B+C+D) 5,000

1,40,000

Alternatively,

Calculation of Cash Flows from Operating Activities

Particulars Rs. Rs.

Cash collection from customers:

Net sales 15,00,000

Add:

Sundry debtors of last year 2,00,000

Accounts receivable of last year 40,000 2,40,000

17,40,000

Less:

Sundry debtors of current year 3,00,000

Accounts receivable of current year 35,000 3,35,000

Cash collection from customers (A) 14,05,000
Cash paid to suppliers:

Merchandise purchased 4,00,000

Add:

Sundry creditors of last year 80,000

Accounts payable of last year 70,000

Stock of current year 80,000 2,30,000

6,30,000

Less:

Sundry creditors of current year 1,00,000

Accounts payable of current year 50,000

Stock of last year 60,000 2,10,000

Cash paid to suppliers (B) 4,20,000

Cash paid to employees and for other expenses:

3,00,000
Salaries & wages
2,00,000
Manufacturing overhead
3,00,000
Selling & distribution overhead

Office & administrative overhead (including depreciation Rs. 50,000)

50,000
Cash paid to employees and for other expenses (C) 8,50,000
Interest paid:

Accrued interest of last year 15,000

Accrued interest of current (20,000)

Interest paid (D) (5,000)

Cash from operation before extra ordinary items (A-B-C-D)

1,40,000

Cash from Operation under Indirect Method

Determination of Cash from Operating Activities under Indirect Method

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Cash flow from operating activities is determined on the basis of the following factors:

Non-income or loss
Non-operating gain and incomes
Non-cash expenses and losses, non-operating expenses, amortizations, and losses
Changes in current liabilities
Changes in current assets (except cash & equivalents)

These items can also be presented as follows:

Cash inflows (Add) Cash outflows (Less)

Net income Non-operating incomes/ gain

Non-cash expenses (Depreciation) Dividend/ interest received

Non-operating expenses and losses Profit on sale of fixed assets

Decrease in current assets (except cash & cash Increase in current assets (except cash & cash
equivalents) equivalents)

Increase in current liabilities Decrease in current liabilities

Amortization of intangible assets Other non operating income

Format for Cash flow Operation Under Indirect Method

Working notes:

In above format, dividend and interest received are assumed as cash flows from investing activities.
Non-operating incomes like interest received, dividend received, etc. are treated either as cash flows from operating activities or
cash flows from investing activities.
Investing activities related dividend and interest received are deduced from net income to determine funds from operation. In case
if they are not from investing activities, but from operating activities, they are not deducted.

Illustration:

Particulars 2071 2072

Debtors 15,000 22,000

Creditors 6,000 7,000

Inventory 12,000 15,000

Tax paid 5,000 -

Bills receivable 7,000 9,000

Bills payable 4,000 3,000

Outstanding expenses 2,000 3,000

Additional information:

Net profit for the year 2072 is Rs.7,000

Depreciation Rs. 3,000
Loss on sale of furniture is Rs. 1,000
Goodwill is Rs. 2,000

Required: Cash from operations under Indirect method.

Solution:

Funds Flow Statement- Adjustments 1/2

Adjustments of Fund Flow Statement
While preparing ledgers, it is important to identify the inflow or outflow of funds on account of non-current account. They are as
follows:

Opening balance (given in opening balance sheet)

Closing balance (given in closing balance sheet)
Additional information (if given)

Some important adjustments required are:

Adjustment related to fixed assets

If given any additional information on fixed assets, fixed assets account must be opened to find the hidden information. They can be
opened as a gross concept or net concept, varying on the available information.

Dr. Tangible Fixed assets a/c Cr.

Particulars Rs. Particulars Rs.

By Cash (Sales) xxx
To Balance b/d xxx
By Depreciation(if) xxx
To Cash (Purchase) xxx
By Balance c/d xxx
xxx xxx

Dr. Fixed assets a/c (without depreciation) Cr.

Particulars Rs. Particulars Rs.

To Balance b/d By Cash (Sales)
xxx xxx
To Cash (Purchase) By Adjusted P/L a/c (Loss on
xxx xxx
sale)
To Adjusted P/L a/c (Gain on
xxx xxx
sale) By Balance c/d
xxx xxx

Dr. Adjusted Profit or Loss a/c Cr.

Particulars Rs. Particulars Rs.

To Net profit xxx xxx
By Gain on a sale of fixed assets (if)
To Loss on sale of fixed assets xxx
xxx xxx

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Sales on fixed assets xxx Purchases of fixed assets xxx
xxx xxx

Alternatively,

Sale of fixed assets = Opening balance – Closing balance + profit on sale or (– loss on sale)
= Decrease as per balance sheet + Profit on sale or (– loss on sale)

Purchase of fixed assets = Closing balance - Opening balance + Cost of sold part
= Increase as per balance sheet + Cost of sold part
Illustration:

Assets 2072 (in Rs.) 2073 (in Rs.)

Furniture 55,000 85,000

Plant & machinery 90,000 1,20,000

Additional information:

Furniture costing Rs. 25,000 was sold for Rs. 20,000.

Required: Ledger accounts

Solution:

Dr. Furniture a/c Cr.

Particulars Rs. Particulars Rs.

By Sales 20,000
To Opening bal. b/d 55,000
By Adjusted P/L a/c (Loss on sale) 5,000
To Cash bal. 55,000
By Closing bal. c/d 85,000
1,10,000 1,10,000

Dr. Plant & Machinery a/c Cr.

Particulars Rs. Particulars Rs.

To Opening bal. b/d 90,000
By Closing bal. c/d 1,20,000
To Cash bal. 30,000
1,20,000 1,20,000

Alternatively,

Purchase of furniture = Closing balance - Opening balance + Cost of sold part

= Increase as per balance sheet + Cost of sold part
= Rs. (85,000 – 55,000) + Rs. 25,000
= Rs. 55,000

Purchase of plant = Closing balance - Opening balance + Cost of sold part

= Increase as per balance sheet + Cost of sold part
= Rs. (1,20,000 – 90,000) + Rs. 0
= Rs. 30,000

Adjustment related to depreciation

The gradual decrease in the value of fixed assets due to their continuous use or permanent use is called depreciation. It is treated as an
expense and debited in the P/L a/c. Following are the ways how depreciation affects the Balance sheet:

1. Net cost method:

Under this method, the depreciation charged during the year is debited in P/L account. Its specimen of fixed asset account is shown
below:

Dr. Fixed assets a/c (Net) Cr.

Particulars Rs. Particulars Rs.

 By Depreciation (Adj. P/L Dr.) xxx
To Balance b/d xxx
By Cash (Sales) xxx
To Cash (Purchase) xxx
By Adjusted P/L a/c (Loss on sale) xxx
To Adjusted P/L a/c (Gain on sale) xxx
By Balance c/d xxx

xxx xxx

2. Gross cost method:

Under this method, a separate depreciation account appears either in the liabilities side or on the assets side (in the form of a deduction)
of Balance sheet.

Dr. Fixed assets a/c (Gross) Cr.

Particulars Rs. Particulars Rs.

By Acc. Dep. of sold part (Adj. P/L Dr.) xxx
To Balance b/d xxx
By Cash (Sales) xxx
To Cash (Purchase) xxx
By Adjusted P/L a/c (Loss on sale) xxx
To Adjusted P/L a/c (Gain on sale) xxx
By Balance c/d xxx
xxx xxx

Notes:

If accumulated depreciation is given in the balance sheet or in additional information, the depreciation charged for the year is not
credited in assets a/c. Only the accumulated depreciation of the sold part or lost part is credited. The depreciation for the year is
credited in accumulated depreciation account.
In the absence of accumulated depreciation, in both balance sheet and in additional information, the accumulated depreciation of
the sold part or lost part is not taken into account. Only the depreciation for the year is credited to assets account.

Dr. Accumulated Depreciation a/c Cr.

Particulars Rs. Particulars Rs.

To Fixed assets a/c xxx By Balance b/d (Opening bal.) xxx

To Balance c/d (Closing bal.) xxx By Adj. P/L a/c(Dep. for the year) xxx
xxx xxx

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Net profit xxx
xxx
To Depreciation on fixed assets xxx By Gain on sale of fixed assets (if)

To Loss on sale of fixed assets xxx

xxx xxx

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Sales on fixed assets xxx Purchases of fixed assets xxx
xxx xxx

Alternatively,

Purchase of assets = Gross difference as per balance sheet + Cost of sold part
Illustration:

Assets 2072 (in Rs.) 2073 (in Rs.)

Plant & machinery, at net value 2,00,000 3,50,000

Additional information:

During the year, accumulated depreciation at the beginning and at the end of the year is Rs. 60,000 and Rs. 1,10,000 respectively.
During the year, plant and machinery costing Rs. 1,00,000 was sold for Rs. 1,40,000.

Required: Plant & Machinery a/c

Solution:

Dr. Accumulated Depreciation a/c Cr.

Particulars Rs. Particulars Rs.

By P/L a/c (Dep. charged during the year) 50,000
To Balance c/d 1,10,000
By Balance b/d 60,000
1,10,000 1,10,000

Dr. Plant & machinery a/c Cr.

Particulars Rs. Particulars Rs.

To Opening bal. b/d 2,00,000 By P/L a/c (dep. for the year) 50,000

To P/L a/c (Gain on sale) 40,000 By Cash (Sales) 1,00,000

To Cash bal. 2,60,000 By Closing bal. c/d 3,50,000

5,00,000 5,00,000

Note: Since, the opening and closing balance of accumulated amount do not appear in the balance sheet, the value of the asset given in
the balance sheet is at net cost method (book value).

Funds Flow Statement: Flow & No flow of fund, differences & limitations
Funds Flow Statement

Funds flow statement is a statement depicting all the various sources of funds from where they have been obtained as well as the
applications to which those funds have been used on. After preparing the statement of changes in working capital and determination
funds from operation, funds flow statement is finally prepared. But, before preparing funds flow statement, the concept of the flow of
fund and no flow of fund should be understood.

Flow of Fund
Source: www.patternsmart.com

The term ‘Flow of Fund’ refers to the changes in working capital or the movement or changes of funds. In other words, while a
transaction is taking place, any increase or decrease in funds or working capital is called Flow of Fund. If the funds or working capital
increases, it is treated as the Inflow of fund or sources of fund. On the other hand, if the funds or working capital decreases, it is called
the outflow of fund.

No Flow of Fund

When a transaction affects fixed assets and fixed liabilities or current assets and current liabilities, the flow of funds does not occur. This
kind of transaction flow is called no flow of fund and it occurs only between non-current accounts. Some examples of such transactions
which do not affect the flow of funds or which are not recorded in the fund's flow statement are:

Collection from debtors or Payment to creditors

Purchase or Sales of inventory in cash or credit
Purchase or Sales of marketable securities
Exchange of fixed assets
Purchase of fixed assets by the issue of shares
Conversion of debentures into shares, etc.
Analysis of Non-Current Assets and Liabilities

To prepare funds flow statement, it is a must to take non-current assets and non-current liabilities into consideration. Because they are
shown in the statement of changes in working capital, it is very important to know about their changes and their effects.
Effects of changes in non-current assets:

Assets Changes Effect Funds Flow Statement

Fixed assets Increase Purchases of assets Uses side

(with depreciation) Decrease Depreciation on assets Add or Dr. side

Fixed assets Increase Purchases of assets Uses side

(without depreciation) Decrease Sales of assets Sources side

Increase Purchases Uses side
Intangible assets
Decrease Written off/ Amortization Add or Dr. side
Increase Payment/ Uses side
Fictitious assets
Decrease Written off/ Amortization Add or Dr. side
Increase Additional investment Uses side
Investment
Decrease Sales of investment Sources side

Effects of changes in non-current liabilities:

Liabilities & Capital Changes Effect Funds Flow Statement

Increase Issue (sources) Sources side
Preference share capital
Decrease Redemption (uses) Uses side
Increase Additional loan (sources) Sources side
Long-term debt
Decrease Repayment of loan (uses) Uses side
Increase Increase with issue (sources) Sources side
Share premium No source no use
Decrease Utilization to fictitious assets
(respective accounts)
Increase Transfer of profit from P/L a/c Add or Dr. side
Reserve & surplus
Decrease Use of reserves Less or Cr. side
Equity share capital Increase Issue of share Sources side

Format

Funds flow statement can be prepared in 2 formats; horizontal format or vertical format.

1. Horizontal format

ABC Company Ltd.

Funds Flow Statement

Sources of fund Rs. Uses of fund Rs.

Working capital decreased(step 1) xxx Working capital increased(step 1) xxx

Funds from operation (step 2) xxx Loss from operation (step 1) xxx

Issue of shares (increase) xxx Redemption of share xxx

Increase in share premium xxx Redemption of pref. share xxx

Issue of debentures (increase) xxx Redemption of debentures xxx

Sales of fixed assets xxx Purchase of fixed assets xxx

Sales of fixed premium xxx Increase in intangible assets xxx

Sales of investment xxx Additional investment xxx

Refund of tax xxx Tax paid xxx

Loan taken (increase) xxx Payment of loan (decrease) xxx

Increase in public deposit xxx Dividend paid xxx

Total xxx xxx

2. Vertical format

ABC Company Ltd.

Funds Flow Statement

Particulars Rs.
Sources:Funds from operation (step 2) xxx

· Issue of shares (increase in share capital) xxx

· Increase in share premium xxx

· Issue of debentures (increase in debenture) xxx

· Sales of fixed assets xxx

· Sales of fixed premium xxx

· Sales of investment xxx

· Refund of tax xxx

· Loan taken (increase in loan) xxx

· Increase in public deposit xxx

Total [A] xxx
Uses:Loss from operation (step 1) xxx

· Redemption of share (decrease) xxx

· Redemption of preference share xxx

· Redemption of debentures xxx

· Purchase of fixed assets xxx

· Increase in intangible assets xxx

· Additional investment xxx

· Tax paid xxx

· Payment of loan (decrease) xxx

· Dividend paid xxx

Total [B] xxx
Net increase/ decrease in working capital [A-B] xxx/ (xxx)

Illustration:

Particulars Amount (Rs.)

Decrease in net working capital 1,30,000

Funds from operation 2,10,000

Issue of equity share capital 3,00,000

Share premium increased 60,000

Purchase of furniture 30,000

Purchase of plant & machinery 1,75,000

Tax paid 90,000

Redemption of debenture 1,50,000

Repayment of mortgage loan 1,35,000

Interim dividend paid 1,20,000

Solution:

Funds Flow Statement

for the year ending 31st December 2015

Sources of fund Rs. Uses of fund Rs.

Redemption of debentures 1,50,000

Decrease in working capital 1,30,000 Purchase of furniture 30,000

Funds from operation 2,10,000 Purchase of plant & machinery 1,75,000

Issue of equity share capital 3,00,000 Tax paid 90,000

Share premium increased 60,000 Payment of mortgage loan 1,35,000

Dividend paid 1,20,000

Total 7,00,000 7,00,000

Alternatively,

Funds Flow Statement

for the year ending 31st December 2015

Particulars Rs.
Sources:Funds from operation 2,10,000

· Issue of equity share capital 3,00,000

· Share premium increased 60,000

Total [A] 5,70,000
Uses:Redemption of debentures 1,50,000

· Purchase of furniture 30,000

· Purchase of plant & machinery 1,75,000

· Tax paid 90,000

· Payment of mortgage loan 1,35,000

· Dividend paid 1,20,000

Total [B] 7,00,000
Net decrease in working capital [A-B] (1,30,000)

Differences between Funds Flow Statement and Balance Sheet:

Funds Flow Statement Balance Sheet

Balance Sheet refers to the statement prepared
Funds Flow Statement is a statement of significant
at the end of accounting period, which
changes in the assets, liabilities and capital accounts.
incorporates assets and liabilities.
Funds Flow Statement is prepared on the basis of
Balance Sheet is prepared with the help of
Profit & Loss a/c, Trading account and balance sheets
Trial balance.
of 2 subsequent dates.
Funds Flow Statement is prepared to identify how the Balance Sheet is prepared to ascertain the
profit has been utilized. financial position of the firm.
Funds Flow Statement provides additional information
Balance Sheet provides the static view of
to the firm, regarding its functions for effective
financial affairs.
management.
For the preparation of Funds Flow Statement, schedule
Balance Sheet is prepared after the completion
of changes in working capital and funds from the
of Trading a/c and Profit & Loss a/c.
operation are to be prepared first.

Differences between Funds Flow Statement and Income Statement:

Funds Flow Statement Income Statement

Income Statement is a summary of total
Funds Flow Statement is a statement of significant
income, total expenses and total losses of a
changes in the assets, liabilities and capital accounts.
year.
Funds Flow Statement is prepared to ascertain the Income Statement is prepared to ascertain the
sources and applications of funds. profit earned or losses suffered by the firm.
Funds Flow Statement is determined on the profit and Income Statement is prepared on nominal
loss a/c basis and balance sheet. accounts basis.
Funds Flow Statement helps to determine the net Income Statement helps to measure a firm’s
changes in working capital. profitability.
Funds Flow Statement deals with both revenue and Income Statement only deals with revenue
net working capital. items.
Income Statement does not require any
For the preparation of Funds Flow Statement, the
reference to the funds flow statement to be
income statement is required.
prepared.
Funds Flow Statement is a firm’s optional statement Income Statement is an essential statement of a
which covers at least 2 years. firm which covers only 1 year period.

Differences between Funds from Operation and Net Profit:

Funds from Operation Net profit

It is determined on the profit and loss a/c
Net profit is based on nominal accounts.
basis and balance sheet.
Funds from Operation exclude both non- Net profit includes both operating and non-operating items,
operating expenses/ losses and non- as it is the difference between total revenue and total
operating incomes. expenses and losses.
Funds from the operation are unrelated While calculating net profit, both cash and non-cash
with non-cash items. expenses are deducted.
It represents the flow of working capital
Net profit represents a business’s operating result.
from the operating activities.
Funds from operation help in analyzing
Net profit helps in determining the tax amount.
the operation position of a business.

Limitations of Funds Flow Statement

Funds Flow Statement might be a major financial analysis tool; however, it does have its limitations. Some of the examples are presented
below:

Funds flow statement is a re-arranged data from a balance sheet and income statement and thus, lacks originality.

Funds flow statement ignores the non-fund transactions. Such as, purchase of fixed assets by issuing shares or debentures.

It indicates only the past position in summary form and does not show various continuous changes taking place.

Funds flow statement only shows the flow of net working capital, which includes items like prepaid expenses and stock of goods
while not contributing to the short-term ability of the firm to pay its debts.

Because of its historic nature, funds flow statement is not an ideal tool for financial analysis.

Funds Flow Statement- Adjustments 2/2

Adjustment related to provision for tax & dividend
Provision for tax is treated as below:

Dr. Provision for Taxation a/c Cr.

Particulars Rs. Particulars Rs.

To Cash/Bank (paid) xxx By Balance b/d xxx

To Balance c/d xxx By Adj. P/L a/c (provision-Dr.) xxx

xxx xxx

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Provision for taxation xxx
xxx

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Payment of tax xxx
xxx

Illustration:
Liabilities 2072 (in Rs.) 2073 (in Rs.)

Provision for tax 1,00,000 1,50,000

Required:

Provision for taxation

Adjusted Profit or Loss account
Funds flow statement

Solution:

Dr. Provision for Taxation a/c Cr.

Particulars Rs. Particulars Rs.

To Cash (last yr tax paid) 1,00,000 By Balance b/d 1,00,000

To Balance c/d 1,50,000 By Adj. P/L a/c (this yr tax) 1,50,000

2,50,000 2,50,000

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Provision for taxation 1,50,000
1,50,000

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Payment of tax 1,00,000
1,00,000

Note: Last year’s balance is assumed to be paid and current year’s balance is assumed to be provisioned.

Adjustment related to share capital & debentures

Share capital and debentures are the sources of funds in funds flow statement. Premium or discount on shares or debentures is calculated
as below:

Dr. Preference shares/Debenture a/c Cr.

Particulars Rs. Particulars Rs.

To Cash (redemption) xxx By Balance b/d xxx

To Discount on redemption xxx By Premium on redemption xxx

To Balance c/d xxx By Cash (issue) xxx

xxx xxx

Dr. Share capital a/c Cr.

Particulars Rs. Particulars Rs.

By Balance b/d xxx

To Balance c/d xxx By Stock dividend/Bonus share (if) xxx

By Cash (issue) xxx

xxx xxx

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.
To Premium on redemption xxx
By Discount on redemption xxx
To Stock dividend/Bonus share (if) xxx
xxx xxx

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Issue of shares/debentures/capital xxx Redemption on shares/debentures xxx
xxx xxx

Illustration:

Liabilities 2072 (in Rs.) 2073 (in Rs.)

Equity share capital 3,00,000 5,50,000

12% preference share capital 2,00,000 1,80,000

7% debenture 2,50,000 1,50,000

Required:

Equity share capital a/c

12% preference share capital a/c
7% debenture a/c

Solution:

Dr. Equity share capital a/c Cr.

Particulars Rs. Particulars Rs.

By Balance b/d 3,00,000
To Balance c/d 5,50,000
By Cash (issue)- bal. figure 2,50,000
5,50,000 5,50,000

Dr. 12% Preference shares a/c Cr.

Particulars Rs. Particulars Rs.

To Cash (redemption) 20,000 By Balance b/d 2,00,000

To Balance c/d 1,80,000

2,00,000 2,00,000

Dr. 7% debentures a/c Cr.

Particulars Rs. Particulars Rs.

To Cash (redemption) 1,00,000 By Balance b/d 2,50,000

To Balance c/d 1,50,000

2,50,000 2,50,000

Adjustment related to interim dividend

Interim dividend is the dividend paid out by the company to its shareholders, before the determination of it’s current year profit. It is
added back with profit for the year and goes to (+) in funds from operation and goes to (-) in funds flow statement because it is an
application of funds.
Funds from operation xxx (Adj. P/L a/c – Dr. side)
Funds flow statement xxx (Uses side)

Adjustment related to Investment account (non-depreciable)

Investments can be either current assets or fixed assets. Investments are treated as fixed assets if they are on long term run, such as trade
investments. On the other hand, if they represent surplus, temporarily invested in marketable securities, they are current assets.

Dr. Investment a/c Cr.

Particulars Rs. Particulars Rs.

To Balance b/d xxx By Cash/Bank (sale) xxx

To Profit on sale xxx By Loss on sale xxx

To Cash & purchase xxx By Balance c/d xxx

xxx Xxx

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Loss on sale xxx By Profit on sale Xxx
xxx Xxx

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Cash/Bank (sale) xxx Cash & purchase Xxx
xxx Xxx

Illustration:

Liabilities 2072 (in Rs.) 2073 (in Rs.)

Investment in shares 1,00,000 2,50,000

Additional information:

Investment costing Rs. 25,000 was sold for Rs. 15,000.

The loss was charged to P/L a/c.

Required: Investment in shares a/c

Solution:

Dr. Investment in shares a/c Cr.

Particulars Rs. Particulars Rs.

By Cash a/c (sale) 15,000
To Balance b/d 1,00,000
By Loss on sale (P/L a/c) 10,000
To Cash a/c – bal. figure 1,75,000
By Balance c/d 2,50,000
2,75,000 2,75,000

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Loss on sale 10,000

10,000

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Cash a/c (sale) 15,000
15,000

Adjustments related to Retained earnings or Profit & Loss appropriation a/c

If not given any provision for dividend, the amount of dividend paid is found out by preparing profit & loss a/c like below:

Dr. Retained earnings a/c Cr.

Particulars Rs. Particulars Rs.

To Cash/Bank (dividend paid) xxx By Balance b/d xxx

To Balance c/d xxx By Net profit b/d (profit for the year) xxx
xxx Xxx

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Net profit b/d (profit for the year) xxx
xxx

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Cash/Bank (dividend paid) xxx
xxx

Illustration:

Find out the dividend paid.

Liabilities 2072 (in Rs.) 2073 (in Rs.)

Profit & Loss a/c 1,00,000 1,50,000

Additional information: Net profit for the year Rs. 1,20,000.

Solution:

Dr. Retained earnings a/c Cr.

Particulars Rs. Particulars Rs.

To Dividend paid (bal. figure) 70,000 By Balance b/d 1,00,000

To Balance c/d 1,50,000 By Net profit b/d (profit for the year) 1,20,000
2,20,000 2,20,000

Dr. Adjusted P/L a/c Cr.

Particulars Rs. Particulars Rs.

To Net profit b/d (profit for the year) 1,20,000

1,20,000

Funds Flow statement

Sources of fund Rs. Uses of fund Rs.

Cash/Bank (dividend paid) 70,000
70,000

Cash from Financial and Investing Activities

Cash Flow from Financing Activities
Financing activities refers to those activities which are responsible for the change in the size and composition of the owner’s capital and
borrowed capital of the enterprise. Financing activities section is where the sources of funds generated from them are shown. Payment of
cash dividend to shareholders and repayment of debt, both are financing activities.

Cash flow from the financing activities is calculated by analysing the liabilities side of balance sheet. Some of the major financing
activities and their effects on cash flow stream are shown below:

Financing activities Cash inflow Cash outflow

Equity shares Issue of equity shares -

Preference shares Issue of pref. shares Redemption of pref. shares

Share premium Increase in share premium -

Long term loan Increase in loan Payment of loan

Debentures Issue of debentures Redemption of debentures

Dividend paid - Cash/ Interim dividend paid

Format for Cash Flow from Financing Activities

Particulars Amount
Issue of shares at par or at premium or at discount xxx

Borrowing of bank loan & debenture at par/ premium/ discount xxx

Redemption of preference shares & debentures at par/ premium/ discount (xxx)

Payment of interim dividend (if any) (xxx)

Payment of dividend (last year’s provision of dividend) (xxx)

Net cash flows from (used by) financing activities xxx/(xxx)

Notes:

When the cash flow from financing activities is positive, it is called net cash flow from financing activities. But, if the result is
negative, it is called net cash used by financing activities.
Redemption amount = Decrease in face value + Premium on redemption (or – Discount on redemption)

Illustration:

Calculate Cash flow from financing activities.

Particulars 2014 2015

Equity share capital 2,00,000 3,50,000

Preference share capital 80,000 1,30,000

Debenture 0 70,000

Bank loan 1,50,000 2,00,000

Dividend paid 10,000 20,000

Solution:

Cash Flow from Financing Activities

Particulars Amount
Issue of share capital 1,50,000

Collection of bank loan 50,000

Issue of preference share capital 50,000

Issue of debentures 70,000

Payment of dividend (10,000)

Net cash flows from financing activities 3,10,000

Cash Flow from Investing Activities

Investing activities include purchase and sales of non-current assets such as land and building, plant and machinery, furniture and fixture,
etc. Investing activities are also related to lending money and the purchase or sale of investments and securities.

In other words, investing activities explain the overall changes in cash position between two balance sheets which occur while buying or
selling of non-current assets. The cash inflows and outflows that are related to investing activities are presented below:

Cash inflows: Sale of fixed assets, the sale of long term investment, loan repayment received, interest and dividend received.

Cash outflows: Purchase of fixed assets, additional investment, a loan given, etc.

Format for Cash Flow from Investing Activities

Particulars Amount
Purchase of fixed assets (xxx)

Additional investment (xxx)

Sales of fixed assets xxx

Sales of investment xxx

Long term loan given (xxx)

Loan repayment received xxx

Interest/ dividend received from investment (if not included in operating xxx
activities)
xxx/
Net cash flows from (used by) investing activities (xxx)

Working notes:

If the cash flow from investing activities comes out to be positive, it is called net cash flows from investing activities. But, if the
result comes out to be negative, such as in parenthesis, then it is called net cash used by investing activities.
Dividend received and interest received can be both included under either operating activities or investing activities. Generally,
though, banks and financial institutions always put them under operating activities.
When there is no depreciation given on fixed assets, such as investment, the value of purchase or sale is determined by preparing
the following account.
Fixed assets a/c (without depreciation)
Dr. Cr.

Particulars Rs. Particulars Rs.

To Balance b/d (openingbal.) xxx By Cash (sales) xxx

To Cash (purchase) xxx By P/L a/c (loss on sale) xxx
To P/L a/c (gain on sale) xxx By balance c/d (closingbal.) xxx
xxx xxx

Alternatively,

Purchase of fixed assets = Closing balance – Opening balance = Net increase

Sales of fixed assets = Opening balance – Closing balance = Net decrease

Dr. Fixed assets a/c (net) Cr.

Particulars Rs. Particulars Rs.

xxx
xxx By depreciation (dep. for the year)
To Balance b/d xxx
xxx By Cash (sales)
To Cash (purchase) xxx
xxx By P/L a/c (loss on sale)
To P/L a/c (gain on sale) xxx
By balance c/d
xxx xxx

Note: If there is depreciation on fixed assets, the depreciation is debited in Profit & Loss account, but accumulated depreciation account
is not shown on the balance sheet.

Alternatively,

Purchase of fixed assets = Closing balance – Opening balance + Depreciation = Net increase+ Depreciation
Sales of fixed assets = Opening balance – Closing balance – Depreciation = Net increase –Depreciation

Dr. Fixed assets a/c (gross) Cr.

Particulars Rs. Particulars Rs.

xxx
By accumulated depreciation a/c
xxx (Acc. Dep. of sold or decreased part)
To Balance b/d
xxx By Cash (sales) xxx
To Cash (purchase)
xxx By P/L a/c (loss on sale) xxx
To P/L a/c (gain on sale)
By balance c/d xxx
xxx xxx

Dr. Accumulated depreciation a/c Cr.

Particulars Rs. Particulars Rs.

xxx
xxx
To fixed assets a/c By balance b/d xxx
xxx
To Acc. Dep. of sold/ decreased part By adjusted P/L a/c xxx
xxx
To balance c/d Bal. figure (dep. for the year)
xxx xxx

Note: If accumulated depreciation account is given on the balance sheet, only the accumulated depreciation of the sold part is credited
in the assets account and then the depreciation for the year is to be credited to accumulated depreciation account.
Alternatively,

Purchase of fixed assets = Closing balance – Opening balance + Cost of goods sold = Net increase + Cost of goods sold
Sales of fixed assets = Opening balance + Purchases – Closing balance

Illustration:

Year 1994 1995

Land & building Rs. 1,00,000 Rs. 2,20,000

Furniture 50,000 45,000

Plant & machinery 30,000 95,000

Investment 25,000 16,000

Additional information:

Furniture costing Rs. 25,000 was sold for Rs. 20,000.

Depreciation on Plant & machinery was Rs. 8,000.
Investment was sold at a profit of Rs. 10,000.

Required: Cash flow from investing activities.

Solution:

Cash Flow from Investing activities

Particulars Amount
Purchase of land & building (1,20,000)

Purchase of Plant & machinery (73,000)

Sales of furniture 20,000

Sales of investment 26,000

Net cash flows from (used by) investing activities (1,47,000)

Cash Flow Statement under Direct and Indirect method

Cash Flow Statement under Direct Method
Cash flow statement is prepared by combining all the cash flows i.e. cash flows from operating activities, investing activities and
financing activities. Below is the format for the cash flow statement under Direct method:

Particulars Rs. Rs.

Cash flow from operating activities:

a.Cash collection from customers:

Net sales xxx

Decrease in bills receivable xxx

Decrease in accounts receivable xxx

Decrease in sundry debtors xxx

Bad debt recovered xxx

Increase in provision for doubtful debt xxx

Increase in provision for discount on debtors xxx

Discount allowed (xxx)

Increase in bills receivable (xxx)

Increase in accounts receivable (xxx)

Increase in sundry debtors (xxx)

Decrease in provision for doubtful debt (xxx)

Decrease in provision for discount on debtors (xxx) xxx

b.Cash paid to suppliers for purchase of merchandise:

Cost of goods sold (opening stock + purchases – closing stock) (xxx)

Decrease in bills payable (xxx)

Decrease in accounts payable (xxx)

Decrease in sundry creditors (xxx)

Increase in inventory (xxx)

Increase in sundry creditors xxx

Decrease in inventory xxx

Increase in accounts payable xxx

Increase in bills payable xxx

Discount received xxx (xxx)

c.Cash paid to employees and for other expenses:

Cash operating expenses including wages (item wise) (xxx)

Increase in outstanding (o/s) expenses xxx

Decrease in o/s expenses (xxx)

Decrease in prepaid expenses xxx

Increase in prepaid expenses (xxx) (xxx)

d.Interest paid:

Interest expense (as per income statement) (xxx)

Increase in prepaid interest (xxx)

Decrease in prepaid interest xxx

Decrease in o/s interest (xxx)

Increase in o/s interest xxx (xxx)

e.Tax paid:

Tax expense (as per income statement) (xxx)

Increase in prepaid tax (xxx)

Decrease in prepaid tax xxx

Decrease in o/s tax or provision for taxation (xxx)

Increase in o/s tax or provision for taxation xxx (xxx)

f.Interest and dividend received:

Interest received (as per income statement) xxx

Dividend received (as per income statement) xxx

Decrease in interest/ dividend receivable xxx

Increase in interest/ dividend receivable (xxx) xxx

g.Cash from operation before extra ordinary items (a+b+c+d+e+f)

xxx
h.Cash from extra ordinary items:

Increase in short term borrowings, bank overdraft, etc. xxx

Decrease in short-term borrowings, bank overdraft, etc. (xxx) xxx/(xxx)

Net cash flow from operating activities [A] xxx/(xxx)
Cash flow from investing activities:

Purchase of fixed assets (xxx)

Additional investment (xxx)

Sales of fixed assets xxx

Sales of investment xxx

Long term loan given (xxx)

Loan repayment received xxx

Interest / dividend received from investment xxx

Net cash flows from (used by) investing activities [B] xx/(xx)
Cash flow from financing activities:

Issue of shares at par or at premium or at discount xxx

Increase in loan & debenture at par/ premium/ discount xxx

Red. of pref. shares & deb. at par/ premium/ discount (xxx)

Payment of interim dividend (if any) (xxx)

Payment of dividend (last year’s provision of dividend) (xxx)

Net cash flows from (used by) financing activities [C] xxx/(xxx)
Net changes in cash & cash equivalents [A+B+C] xxx/(xxx)

Add:Beginning cash & cash equivalent xxx

Ending cash & cash equivalent xxx/(xxx)

Alternatively,

Cash flow statement under direct method

Particulars Rs. Rs.

Cash collection from customers:

Net sales xxx

Add:

Sundry debtors of last year xxx

Bills receivable of last year xxx

Accounts receivable of last year xxx

Provision for doubtful debt of current year xxx

Provision for discount on debtors of current year xxx

Bad debt recovered xxx xxx

xxx

Less:

Sundry debtors of current year xxx

Bills receivable of current year xxx

Accounts receivable of current year xxx

Provision for doubtful debt of last year xxx

Provision for discount on debtors of last year xxx

Discount allowed xxx xxx

Cash collection from customers (a) xxx
Cash paid to suppliers:

Cost of goods sold (opening stock + purchases – closing stock) xxx

Add:

Sundry creditors of last year xxx

Bills payable of last year xxx

Accounts payable of last year xxx

Inventory of current year xxx xxx

xxx

Less:

Sundry creditors of current year xxx

Bills payable of current year xxx

Accounts payable of current year xxx

Inventory of last year xxx

Discount received xxx xxx

Cash paid to suppliers (b) xxx
Cash paid to employees and for other expenses:

Operating expenses (item wise) xxx

Add:

Prepaid expenses of current year xxx

Outstanding expenses of last year xxx xxx

 xxx

Less:

Prepaid expenses of last year xxx

Outstanding expenses of current year xxx xxx

Cash paid to employees and for other expenses (c) xxx
Interest paid:

Interest expense (as per income statement) xxx

Add:

Prepaid interest of current year xxx

Outstanding interest of last year xxx xxx

xxx

Less:

Prepaid interest of last year xxx

Outstanding interest of current year xxx xxx

Interest paid (d) xxx
Tax paid:

Tax expense (as per income statement) xxx

Add:

Prepaid tax of current year xxx

Outstanding tax or provision for tax of last year xxx xxx

xxx

Less:

Prepaid tax of last year xxx

Outstanding tax or provision for tax of current year xxx xxx

Tax paid (e) xxx
Interest and dividend received:

Interest received (as per income statement) xxx

Dividend received (as per income statement) xxx

Add:

Interest/ Dividend receivable of last year xxx xxx

xxx

Less:

Interest/ Dividend receivable of current year xxx xxx

Interest and dividend received (f) xxx
Cash from operation before extra ordinary items (a-b-c-d-e+f) xxx
Cash from extra ordinary items:

Add: Increase in bank loan, bank overdraft, etc. xxx

Less: Decrease in bank loan, bank overdraft, etc. (xxx) xxx/(xxx)

Net Cash Flows from Operating Activities [A] xxx/(xxx)
Cash flow from investing activities:

Purchase of fixed assets (xxx)

Additional investment (xxx)

Sales of fixed assets xxx

Sales of investment xxx

Long term loan given (xxx)

Loan repayment received xxx

Interest/ dividend received from investment xxx

Net cash flows from (used by) investing activities [B] xxx/(xxx)
Cash flow from financing activities:

Issue of shares at par or at premium or at discount xxx

Increase in loan & debenture at par/ premium/ discount xxx

Red. of pref. shares & deb. at par/ premium/ discount (xxx)

Payment of interim dividend (if any) (xxx)

Payment of dividend (last year’s provision of dividend) (xxx)

Net cash flows from (used by) financing activities [C] xxx/(xxx)
Net changes in cash & cash equivalents [A+B+C] xxx/(xxx)

Add:Beginning cash & cash equivalent xxx

Ending cash & cash equivalent xxx/(xxx)

Cash Flow Statement Under Indirect Method

Particulars Rs. Rs.

Cash flow from operating activities:

Net income after tax and dividend xxx

Add: Non-operating / non-cash expenses & losses

xxx
Depreciation for the year
Provision for taxation and dividend xxx
Loss on sales of fixed assets xxx
Fictitious/ intangible assets written off xxx
Othernon operating/non cash expenses & losses xxx xxx
xxx

Less:Non operating incomes

Dividend/ interest received xxx

Gain on sales of fixed assets xxx

Other non-operating incomes xxx xxx

Funds from operation xxx

Add: Decrease in current assets (except cash & bank) xxx

Increase in current liabilities xxx xxx

 xxx

Less: Increase in current assets (except cash & bank) xxx

Decrease in current liabilities xxx xxx

xxx

Less: Tax paid xxx xxx

Net Cash flow from operating activities [A] xxx
Cash flow from investing activities:

Purchase of fixed assets & long term investment (xxx)

Sales of fixed assets & long term investment xxx

Net cash flows from (used by) investing activities [B] xxx/(xxx)
Cash flow from financing activities:

Increase in share capital & long term debt xxx

Increase in share premium xxx

Payment of loan (xxx)

Dividend paid (xxx)

Redemption of preference share & debentures (xxx)

Net cash flows from (used by) financing activities [C] xxx/(xxx)
Net changes in cash & cash equivalents [A+B+C] xxx/(xxx)

Add:Beginning cash & cash equivalent xxx

Ending cash & cash equivalent xxx/(xxx)

Notes:

If sales, operating expenses and changes in current assets and liabilities are provided, cash flow statement is prepared under
direct method.
If net profit or any other irrelevant information is given but sales and other revenues are missing, in such case, cash flow
statement is prepared under indirect method.

Determination of Net change on Cash and Cash Equivalents:

It is the final step in the preparation of cash flow statement. After the determination of cash flows from the operating activities, investing
activities and financing activities, their results are calculated and added to ascertain the net change in cash and cash equivalents.

After the estimation of net changes in cash and cash equivalents, the opening balance of cash and cash equivalents is added to it which
gives the ultimate result of the ending balance of cash and cash equivalent.
Concept and Meaning of Ratio Analysis
Concept of Ratio Analysis

Source: www.slideshare.net

Ratio analysis is the mathematical form of expressing the numerical or arithmetical relationship between two figures. It is a widely used
financial analysis tool which is expressed when one figure is divided by another. It is the systematic use of ratios that determines and
interprets the numerical relationship between two financial items. Ratio analysis assesses the strength and weakness as well as evaluates the
historical performances and current financial conditions of a firm.

According to Kohler, “A ratio is the relationship of one amount to another expressed as the ratio of or as a simple, fraction, integer, decimal
fraction or percentage.”

According to Hunt, William and Donaldson, “Ratios are simply a means of highlighting in arithmetical terms of the relationship between
figures draw from financial statements.”

Methods of Ratio Analysis

The ratio is the numerical relationship between 2 financial items and the relationship can be expressed as:

1. Percentage method:
The relationship is expressed in percentage.
For example; Assume, Sales (Rs.100,000) & Net profit (Rs.25,000):
Net profit margin = NetprofitSalesNetprofitSales x 100%
= 25,0001,00,00025,0001,00,000× 100%
= 25%

2. Fraction method or Rate method:

Here, one item is expressed in terms of other relative items.
For example; Assume as above:
Net profit margin =NetprofitSalesNetprofitSales x 100%
 =25,0001,00,00025,0001,00,000 x 100%
= ¼ or 0.25 times

3. Proportion method or Ratio method:

Under this method, the relationship is expressed in proportion or ratio.
For example; Assume as above:
Net profit margin =NetprofitSalesNetprofitSales x 100%
=25,0001,00,00025,0001,00,000 x 100%
= 1: 4

Uses of Ratio Analysis

1. Situation diagnosis:
Ratio study can help in analyzing both weak and strong points of an enterprise. This can be made by studying ratios for a number of
years of an enterprise or by the comparison of similar ratios. An analysis comparing the current assets with current liabilities can also
be prepared for different enterprises.

2. Helpful in planning:
Ratios help in planning purposes by expressing the enterprise’s targets such as the market share or the profitability rate or the saving
rate. For this, the ratios of past years and also of the competitors are analyzed.

3. Monitor performance:
Monitor performance is an important means for checking the results achieved as per expectations and if the firm has earned the
targeted and adequate profit. For this, the performance target is laid down in ratios and compared with the target ratio.

Importance of Ratio Analysis

Current ratio and Quick ratio helps in assessing the short-term solvency / liquidity of the firm.

Profitability ratios help in evaluating the financial performance of the firm.

Ratios show the degree of efficiency in the management and the utilization of resources and assets.

Capital structure ratios help in indicating the financial strength or the long-term solvency of the firm.

Ratios throw light on the firm’s current status on the use of debt funds or whether the firm is exposed to any serious financial strain.

Trend analysis of ratios over a period of years will indicate the direction of the firm’s financial policies.

Ratios help with the planning and forecasting of the firm’s business activities for periods as ratios tend to have predictor values.

Limitations of Ratio Analysis

Ratio analysis is based on the historical accounting information which sometimes makes it difficult to predict the future condition of
the business or consider the changes in the price level.

For evaluating the progress and future prospects of an organization, both quantitative and qualitative aspects are to be considered.
However, financial statements ignore it.

Financial analysis statement is not bias free as the analyst has to choose from several available financial statements on her own
personal preference.

Ratio analysis is affected by inflation and in such situation, it may not predict the true position of the firm.

Sometimes, straight-jacket comparison of ratios may be misleading because different firms follow different accounting policies.

Types of Ratios
Source: ibpexam.blogspot.com

Liquidity Ratios

1. Current ratio:
This ratio shows the quantitative relationship between current assets and current liabilities. Also known as the working capital ratio, it
indicates the ability of the firm in meeting the current obligation as expressed in terms of current liabilities. It can be calculated as:

Current ratio = CurrentassetsCurrentliabilitiesCurrentassetsCurrentliabilities

where,
Current Assets = Assets that can be converted into cash or cash equivalent within a year or an accounting period. Some common Current
Assets are:

· Cash in hand
· Cash at bank
· Bills receivable
· Account receivable
· Sundry debtors (after deducting provision)/ Book debts
· Marketable securities
· Stocks in trade/ Inventories
· Loan and advance
· Prepaid/ Unexpired expenses
· Stores and spares
· Short term investment
· Advance payment of tax
· Accrued income

Current liabilities = Liabilities that are dischargeable within a year or an accounting period. Some common Current Liabilities are:
· Sundry creditors
· Dividend payable
· Notes payable · Outstanding expenses
· Bills payable
· Provision for taxation
· Accounts payable · Short term loan
· Income tax payable
· Bank overdraft
· Income received in advance
· Instalments of loan payable with 12 months
· Proposed dividend
· Provision made regarding current assets
· Unclaimed dividend

Illustration:

The Balance Sheet of ‘ARMY Co.’ as on 31st December is given below. Calculate the Current ratio.

Liabilities Amount (Rs.) Assets Amount (Rs.)

Share capital 4,00,000 Investments 2,50,000

20% debentures 1,50,000 Sundry debtors 1,30,000

Sundry creditors 30,000 Prepaid expenses 1,00,000

Short term loans 25,000 Goodwill 55,000

Term loans 45,000 Stock 45,000

Provision for taxation 50,000 Cash and bank 1,20,000

7,00,000 7,00,000

Solution:

Here,

Current assets = Sundry debtors + Prepaid expenses + Stock + Cash and bank
= Rs. (1,30,000 + 1,00,000 + 45,000 + 1,20,000)
= Rs. 3,95,000

Current liabilities = Sundry creditors + Short term loans + Provision for taxation
= Rs. (30,000 + 25,000 + 50,000)
= Rs. 1,05,000

Finally,

Current ratio = CurrentassetsCurrentliabilitiesCurrentassetsCurrentliabilities

= 3,95,0001,05,0003,95,0001,05,000
= 3.76: 1 times

2. Quick/ Liquid Ratio:

This ratio shows the relationship between quick assets and current liabilities. Also called the Acid-test ratio, it is the improvised version of
current ratio and gives a more precise measure of liquidity than the current ratio. It is calculated as:

Quick Ratio = QuickassetsCurrentliabilitiesQuickassetsCurrentliabilities

where,

Quick Assets = Current assets – Prepaid expenses – inventories / stock

Illustration:

The SME Co.’s current ratio is 2 times and its quick ratio is 1.5 times. Holding current assets of Rs. 3,50,000, what is its level of current
liabilities and its level of inventories?

Solution:

Given,

Current assets = Rs. 3,50,000

Current ratio = 2 times
Quick ratio = 1.5 times
current liabilities = ?

We have,

Current ratio = CurrentassetsCurrentliabilitiesCurrentassetsCurrentliabilities

or, 2 = 3,50,000Currentliabilities3,50,000Currentliabilities

or, C.L = Rs. 1,75,000

Again,

Quick ratio = Currentassets−inventoryCurrentliabilitiesCurrentassets−inventoryCurrentliabilities

or, 1.5 = 3,50,000−inventory1,75,0003,50,000−inventory1,75,000

or, Inventory = Rs. 87,500

Leverage Ratios or Capital Structure Ratios

1. Debt equity ratio (Debt to shareholders’ fund ratio):

This ratio shows the relationship between total debts or long-term debts and shareholders’ funds. Also known as the solvency ratio, it tests
the long-term solvency of the firm. It can be calculated as:

Debt equity ratio = LongtermdebtShareholders′fundLongtermdebtShareholders′fund

or,
Debt equity ratio = TotaldebtsShareholders′fundTotaldebtsShareholders′fund

Below are some long-term debts:

Long-term loan
Debentures
Secured loan
Bonds
Loan from bank
Debentures premium
Mortgage loan
Public deposit
Loan from financial institutions (except bank overdraft)

Total debts = long-term debts + Current liabilities

Total debts = Total assets – shareholders’ fund

Below are some of the examples of Shareholders’ fund or equity:

Equity share capital
Profit & loss (Cr.)
Preference share capital
Profit & loss appropriation (Cr.)
Share forfeited account
Sinking fund
Share premium
Retained earnings
General reserve
Earned in surplus
Capital reserve
Assets replacement fund
Contingency reserve
Development equalization fund
Reserve & surplus
Development rebate reserve
Capital redemption reserve
Other funds
Workmen accident compensation funds
Less:

Miscellaneous expenditures (Preliminary expenses, underwritten commission, discount or loss on issue of shares or debentures)

Research & development expenditures

Deferred advertisement expenses

Profit & loss a/c (Dr.)

Profit & loss appropriation a/c (Dr.)

Illustration:

The Balance Sheet of ‘Carat Co.’ as on 31st December is given below. Calculate the Current ratio.

Liabilities Amount (Rs.) Assets Amount (Rs.)

Equity capital 16,000

10% debentures 21,000 Long-term investment 22,000

7% preference share capital 10,000 Sundry debtors 14,000

Sundry creditors 9,000 Prepaid insurance 9,000

P/L account 5,000 Preliminary expenses 3,000

Loan 6,000 Goodwill 7,000

Reserve 12,000 Stock 20,000

Bank overdraft 3,000 Furniture 14,000

Provision for taxation 7,000

89,000 89,000

Required: Debt equity ratio

Solution:

Here,

Total debts
= Debenture + Loan
= Rs. (21,000 + 6,000)
= Rs. 27,000

Shareholders’ fund
= Equity share + Preference share + reserve + P/L account – Preliminary exp.
= Rs. (16,000 + 10,000 + 12,000 + 5,000 – 3,000)
= Rs. 40,000
Finally,

Debt equity ratio

= TotaldebtsShareholders′fundTotaldebtsShareholders′fund
= 27,00040,00027,00040,000
= 67.5%

2. Debt to capital ratio:

This ratio shows the relationship between debt and total capital of a company. It helps in establishing a link between total long-term funds
available in the business and funded debt. It is calculated as:

Debt to capital ratio = Long−termdebtsCapitalemployedLong−termdebtsCapitalemployed

where,

Capital employed = Sum of debts & Permanent capital

Capital employed = Debt + Shareholders’ fund

Capital employed = Net fixed assets + Woking capital
Capital employed = Total assets – Current liabilities

Illustration:

Liabilities Amount (Rs.) Assets Amount (Rs.)

Share capital 16,000 Long-term investment 20,000

10% debentures 21,000 Sundry debtors 14,000

7% preference share capital 10,000 Prepaid insurance 6,000

5% bond 15,000 Preliminary expenses 3,000

P/L account 5,000 Goodwill 7,000

Loan 6,000 Stock 16,000

Reserve 12,000 Furniture 14,000

Share premium 7,000 Underwriter’s commission 12,000

Provision for taxation 7,000 Cash & bank 7,000

99,000 99,000

Required:

Debt equity ratio

Debt to capital ratio

Solution:

Total debts:
= Debenture + Loan + Bond
= Rs. (21,000 + 6,000 + 15,000)
= Rs. 42,000

Shareholders’ fund:
= Equity share + Preference share + reserve + P/L account + Share premium – Preliminary exp. – Underwriter’s commission
= Rs. (16,000 + 10,000 + 12,000 + 5,000 + 7,000 – 3,000 – 12,000)
= Rs. 35,000

Capital employed = Long-term debt + Shareholder’s fund = Rs. (42,000 + 35,000) = Rs. 77,000

Then,

Debt equity ratio

= TotaldebtsShareholders′fundTotaldebtsShareholders′fund
= 42,00035,00042,00035,000
= 1.2%
 Again

Debt to capital ratio

= Long−termdebtsCapitalemployedLong−termdebtsCapitalemployed
= 42,00077,00042,00077,000
= 0.545:1

Types of Activity Ratios

Activity Ratios
Activity ratios measure a firm's ability to convert different accounts like assets, capital and liabilities within its balance sheets into cashor
sales. So, activity ratios are the financial tools that are used to measure the ability of a company or firm to convert assets, liabilities and
capital accounts to cash or sales. The faster a business is able to convert its assets into cash or sales, the more efficient it runs.

Source: businessjargons.com

1. Stock/ Inventory turnover ratio

It is the relationship between the cost of goods sold during the year and the average inventory. It can be calculated as:

Inventory turnover ratio = CostofgoodssoldAverageinventoryCostofgoodssoldAverageinventory = … times

When cost of goods sold & average inventory is unavailable,

Inventory turnover ratio = SalesClosinginventorySalesClosinginventory = … times

where,

Cost of goods sold = Opening stock + Net purchase + Direct expenses + Manufacturing cost – Closing stock
or
 Cost of goods sold = Net sales – Gross profit
Average inventory = Openinginventory+closinginventory2Openinginventory+closinginventory2

Further, Inventory turnover ratio can be calculated in other ways too. Such as:

Length of inventory cycle = NumberofdaysinayearinventoryturnoverratioNumberofdaysinayearinventoryturnoverratio= ..days

Length of inventory cycle = 365∗inventorystockSales365∗inventorystockSales= ..days
Length of inventory cycle = inventorystockaveragedailysalesinventorystockaveragedailysales= ..days

Illustration:

The followings are the information of ‘Vapp Co’:

Opening stock Rs. 30,000 Closing stock Rs. 45,000

Purchase Rs. 55,000 Carriage inward Rs. 7,000
Sales Rs. 1,80,000 Carriage outward Rs. 5,000
Sales return Rs. 25,000 Number of days in a year 365 days

Required:

(a) Inventory turnover ratio

(b) Length of inventory cycle

Solution:

Here,
Cost of goods sold
= Opening stock + Purchase + Carriage inward – Closing stock
= 30,000 + 55,000 + 7,000 – 45,000
= Rs. 47,000

Average inventory
= Openinginventory+Closinginventory2Openinginventory+Closinginventory2
= 30,000+45,000230,000+45,0002
= Rs. 37,500

Then,

Inventory turnover ratio

= CostofgoodssoldAverageinventoryCostofgoodssoldAverageinventory
=47,00037,50047,00037,500
= 1.25 times

Also,

Length of inventory cycle

= NumberofdaysinayearInventoryturnoverratioNumberofdaysinayearInventoryturnoverratio
= 365Current1.25365Current1.25
= 292 days

2. Debtors turnover ratio

Debtors turnover ratio compares the sales of the uncollected amount from customers with whom goods were sold. This is to ascertain the
efficiencyfor debt collection. Also known as receivable turnover ratio, it can be calculated as:

Source: www.kcgjournal.org

Debtors turnover ratio = NetcreditsalesAveragedebtorsNetcreditsalesAveragedebtors = … times

When average debtors & credit sales are not available,

Debtors turnover ratio = TotalsalesClosingdebtorsTotalsalesClosingdebtors = … times

where,

Net sales = Sales – sales return

Net credit sales = Total credit sales – sales return
Average debtors = Openingdebtors+Closingdebtors2Openingdebtors+Closingdebtors2

Note: Total sales is taken as credit sales if there is no credit sales.

Illustration:

The following figures are given:

Particulars Opening balance Closing balance

Debtors ……………………………. Rs. 80,000 Rs. 1,10,000
Account receivable………….. Rs. 40,000 -

Total sales for the year………………………. Rs. 5,20,000

Sales return……………………………………….. Rs. 20,000

Required: Debtors turnover ratio

Solution:

Here,
Net credit sales:
= Total sales – sales return
= 5,20,000 – 20,000
= Rs. 5,00,000

Average debtors:
= Openingdebtors+Closingdebtors2Openingdebtors+Closingdebtors2+ receivable
= 80,000+1,10,000280,000+1,10,0002+ 40,000
= Rs. 1,35,000

Thus,
Debtors turnover ratio:
= NetcreditsalesAveragedebtorsNetcreditsalesAveragedebtors
=5,00,0001,35,0005,00,0001,35,000
= 3.7 times

3. Debt/ Average collection period

Also known as Days sales outstanding or Receivable conversion period, it represents the average number of days for the collection of cash
from debtors. It can be calculated as follows:

Average collection period = Days/Week/MonthinayeardebtorsturnoverratioDays/Week/Monthinayeardebtorsturnoverratio

Average collection period = Debtors(12months/52weeks/365days)creditsalesDebtors(12months/52weeks/365days)creditsales

Average collection period = debtorssalesperdaydebtorssalesperday

Illustration:

Total sales and sales return for the year are Rs. 5,00,000 and Rs. 1,50,000 respectively.
Account receivable:
1st Baisakh…………… Rs. 90,000
31st Chaitra…………… Rs. 50,000

Required:

(a) Debtors turnover ratio

(b) Average collection period

Solution:

Here,
Net credit sales
= Total sales – sales return
= 5,00,000 – 1,50,000
= Rs. 3,50,000

Average debtors
= Openingreceivables+Closingreceivables2Openingreceivables+Closingreceivables2
= 90,000+50,000290,000+50,0002
= Rs. 70,000

Then,

Debtors turnover ratio

= NetcreditsalesaveragedebtorsNetcreditsalesaveragedebtors
=3,50,00070,0003,50,00070,000
= 5 times

Also,

Average collection period

= Days/Week/MonthinayeardebtorsturnoverratioDays/Week/Monthinayeardebtorsturnoverratio
=36553655
= 73 days

4. Fixed assets turnover ratio

This ratio is the inter relationship between net sales and fixed assets. This ratio determines the efficiency of the utilization of fixed assets. It
is computed as:

Fixed assets turnover ratio = netsalesnetfixedassetsnetsalesnetfixedassets = … times

where,

Net sales = Total sales – sales return

Net fixed sales = Fixed assets – Accumulated depreciation

Note: Intangible assets such as patents, goodwill, trademark, etc. are included while calculating Net fixed assets whereas fictitious assets
are excluded. However, if Net fixed assets is separately given in Balance Sheet, then the Intangible assets are too excluded.

Illustration:

The Balance Sheet of A.R.M.Y Co. is provided below:

Balance Sheet of A.R.M.Y Co.

As on 31st December, 2015

Liabilities Amount (Rs.) Assets Amount (Rs.)

Share capital 5,00,000
Goodwill 60,000
P&L a/c 40,000
Stock 50,000
Debentures 80,000
Land & building 5,00,000
Creditors 25,000
Preliminary expenses 50,000
Accrued expenses 15,000
6,60,000 6,60,000
Cash sales during year……………………………. Rs. 7,00,000

Credit sales during year………………………….. Rs. 3,00,000

Required:
(a) Fixed assets turnover ratio

(b) Inventory turnover ratio

Solution:

Here,
Net sales
= Cash sales + Credit sales
= Rs. (7,00,000 + 3,00,000)
= Rs. 10,00,000

Net fixed assets

= Goodwill + Land & building
= Rs. (60,000 + 5,00,000)
= Rs. 5,60,000

Then,

Fixed assets turnover ratio:

=netsalesnetfixedassetsnetsalesnetfixedassets
=10,00,0005,60,00010,00,0005,60,000
= 1.79 times

Also,

Inventory turnover ratio:

=SalesClosinginventorySalesClosinginventory
=10,00,00050,00010,00,00050,000
= 20 times

5. Total assets turnover ratio

Total assets turnover ratio is the ratio that expresses the relation between net sales and total assets, on a given date. This ratio is calculated
as:

Total assets turnover ratio = netsalestotalassetsnetsalestotalassets= … times

where,

Total assets = Current assets + Fixed assets – Depreciation + Investment + Intangible assets

Illustration:

Calculate Assets turnover ratio from followings:

Particulars Amount (Rs.)

Total sales ( credit sales included) 5,00,000

Fixed assets 2,00,000

Current assets 60,000

Sales return 1,10,000

Solution:
Net sales
= Sales – sales return
= Rs. (5,00,000 – 1,10,000)
= Rs. 3,90,000

Total assets
= Fixed assets + Current assets
= Rs. (2,00,000 + 60,000)
= Rs. 2,60,000
Hence,
Assets turnover ratio:
=netsalestotalassetsnetsalestotalassets
=3,90,0002,60,0003,90,0002,60,000
= 1.5 times

6. Capital employed turnover ratio

This ratio depicts the inter-relationship between the permanent capital (capital employed) and net sales. It can be computed as:

Capital employed turnover ratio =netsalescapitalemployednetsalescapitalemployed

Illustration:

Calculate Capital employed turnover ratio:

Liabilities Amount (Rs.) Assets Amount (Rs.)

Share capital 5,00,000
Fixed assets 60,000
Reserve & Surplus 40,000
Current assets 50,000
Debentures 80,000
Preliminary expenses 50,000
General reserve 25,000
Investment 5,00,000
Current liabilities 15,000
6,60,000 6,60,000

Sales…………………… Rs. 10,00,000

Sales return………... Rs. 70,000

Solution:

Here,
Net sales
= Sales – sales return
= Rs. (10,00,000 – 70,000)
= Rs. 9,30,000

Capital employed
= Share capital + Reserve & Surplus + General reserve – Preliminary expenses
= Rs. (5,00,000 + 40,000 + 25,000 – 50,000)
= Rs. 5,15,000

Therefore,
Capital employed turnover ratio:
=netsalescapitalemployednetsalescapitalemployed
=9,30,0005,15,0009,30,0005,15,000
= 1.81 times

Types of Profitability Ratios

Profitability Ratios
Profitability ratio is a measure of profitability which helps to measure the performance of company. They are used to assess a company's
ability to earn profit or income compared to its expenses or other relevant cost that are incurred during a certain period of time.
Source: www.slideshare.net

1. Gross profit ratio

It measures the relationship between net sales and gross profit. It can be calculated as:

Gross profit ratio = GrossprofitNetsalesGrossprofitNetsales x 100%

where,

Gross profit = Net sales – Cost of goods sold

Cost of goods sold = Opening stock + Net purchase + Direct expenses – Closing stock

Illustration:

The followings are the information of ‘Caret Co’:

Opening stock Rs. 60,000 Closing stock Rs. 40,000

Purchase Rs. 3,20,000 Purchase return Rs. 5,000
Sales Rs. 6,00,000 Manufacturing expenses Rs. 55,000
Sales return Rs. 25,000

Required: Gross profit ratio

Solution:

Here,
Net sales
= Sales – sales return
= 6,00,000 – 25,000
= Rs. 5,75,000
Cost of goods sold
= Opening stock + Net Purchase + Direct expenses – Closing stock
= 60,000 + (3,20,000 – 5,000) + 55,000 – 40,000
= Rs. 3,90,000

Gross profit:
= Net sales – Cost of goods sold
= 5,75,000 – 3,90,000
= Rs. 1,85,000

Hence,

Gross profit ratio

=GrossprofitNetsalesGrossprofitNetsales x 100%
=1,85,0005,75,0001,85,0005,75,000 x 100%
= 3.22%

2. Net profit ratio

Net profit ratio is the link between sales and net profit. This ratio is calculated to ascertain the overall profitability and it can be
calculated as:

Net profit ratio =NetprofitaftertaxNetsalesNetprofitaftertaxNetsales x 100%

where,

Net sales = Sales – sales return

Net profit after tax = Gross profit – Operating expenses – Tax
Or,
Net profit after tax = (Gross profit – Operating expenses) (1 – Tax rate)

Illustration:

Calculate Gross profit ratio and Net profit ratio

Solution:

Gross profit ratio

=GrossprofitNetsalesGrossprofitNetsales x 100%
= 3,50,0004,75,0003,50,0004,75,000 x 100%
= 73.68%

Net profit ratio

 = NetprofitaftertaxNetsalesNetprofitaftertaxNetsales x 100%
= 3,51,0004,75,0003,51,0004,75,000 x 100%
= 73.89%

3. Return On Assets (ROA)

Return on assets shows the relationship between total assets and profit of a firm on a given date. It is an excellent measure to check on
a company’s overall performance. It can be computed as:

Return on Assets = NetprofitbeforeinterestandtaxTotalassetsNetprofitbeforeinterestandtaxTotalassets x 100%

where,

Net profit before interest and tax = Net profit before payment of interest on long term loans & tax.
Total assets = Total assets + Fixed assets + Current assets. However, unproductive assets are excluded but investment is included.

Further, Return on Assets can be calculated in other ways too. Such as:

Return on Assets (ROA) = NetprofitaftertaxTotalassetsNetprofitaftertaxTotalassets x 100%

Or,
Return on Assets (ROA) =Netprofitaftertax+interestTotalassetsNetprofitaftertax+interestTotalassets x 100%
Or,
Return on Assets (ROA)
= Netprofitaftertax−preferencedividendTotaltangibleassetsNetprofitaftertax−preferencedividendTotaltangibleassets x 100%

Illustration:

Balance Sheet of 'ET Co.' as on 31st Chaitra, 2070 is as follows:

Required: Return on Assets

Solution:

Here,

Net profit after tax = Profit for the year = Rs. 7,00,000

Interest
= 10% on debentures
= 10% on Rs. 12,00,000
= Rs. 1,20,000
Total assets
= Net fixed assets + long term investment + current assets
= Rs. (18,00,000 + 10,00,000 + 4,00,000)
= Rs. 32,00,000

Finally,
Return on Assets (ROA)
= NetprofitaftertaxTotalassetsNetprofitaftertaxTotalassets x 100%
=7,00,000+1,20,00032,00,0007,00,000+1,20,00032,00,000 x 100%
= 25.625%

4. Return on Shareholders’ Equity

This ratio is the inter relationship between Net profit after tax and Shareholders’ fund. This ratio is to see over the utilization of the
funds that are supplied by the shareholders. It is computed as:

Return on Shareholders’ Equity = Netprofitaftertax+interestShareholders′fundNetprofitaftertax+interestShareholders′fund x 100%

where,

Net profit after tax (NPAT) = the excess of gross profit and other incomes over the operating & non-operating expenses and losses.
Shareholders’ fund = Equity share capital + Preference share capital + Share premium + Reserve & Surplus + Profit & Loss –
Fictitious assets
or,
Shareholders’ fund = Total assets – Fictitious assets – Total liabilities

Illustration:

Calculate Shareholders’ fund from the followings:

Net profit before interest & tax Rs. 2,00,000

Preliminary expenses Rs. 7,000
Reserve & Surplus Rs. 40,000
Equity share capital Rs. 1,80,000
12% preference share capital Rs. 3,00,000
8% debentures Rs. 1,20,000
Tax on profit 45%

Solution:

Here,

Net profit before interest & tax Rs. 2,00,000

Less: Interest (8% on 1,20,000) 9600

1,90,400

85,680
Net profit before tax

Less: tax (45% of 1,90,400) 1,04,720

Then,
Shareholders’ fund
= 12% preference share + Equity share + Reserve & Surplus – Preliminary expenses
= 3,00,000 + 1,80,000 + 40,000 – 7,000
= Rs. 5,13,000

Finally,
Return on Shareholders’ Equity
= Netprofitaftertax+interestShareholders′fundNetprofitaftertax+interestShareholders′fund x 100%
= 1,04,7205,13,0001,04,7205,13,000 x 100%
= 20.41%
 5. Return on Common Shareholders’ Equity or Return on Equity (ROE)

Return on equity is the ratio that expresses the relation between net profit and common shareholders’ equity. This ratio is calculated
as:

ROE
= Netprofitaftertax−preferencedividendCommonshareholders′equityNetprofitaftertax−preferencedividendCommonshareholders′equity x
100%
or,
ROE
= TotalearningavailabletoequityshareholderEquityshareholders′fundTotalearningavailabletoequityshareholderEquityshareholders′fund x
100%

where,

Common shareholders’ equity = Equity share capital + Share premium + Reserve & Surplus + Profit & Loss – Fictitious assets

Illustration:

Calculate Return on shareholders’ equity and Return on common shareholders’ equity from the Balance Sheet given below:

Liabilities Amount (Rs.) Assets Amount (Rs.)

Equity share capital 3,00,000 Fixed assets (net) 5,00,000

Reserve & Surplus 1,40,000
Other quick assets 2,70,000
7% Debentures 80,000
Preliminary expenses 15,000
Current liabilities 1,50,000
Term investment 50,000
10% preference share capital 70,000
Closing stock 25,000
Profit & loss a/c 1,20,000

8,60,000 8,60,000

Additional information:

Fixed assets turnover was 2 times during the year.

Net profit margin before tax was 11% on sales.
Company’s tax bracket was 50%

Solution:

Here,

Fixed assets turnover

= Sales / Fixed assets
or, 2 = Sales / 5,00,000
or, Sales = Rs. 10,00,000

Common shareholders’ equity

= Equity share + Reserve & surplus + P&L – Preliminary expenses
= Rs. (3,00,000 + 1,40,000 + 1,20,000 – 15,000)
= Rs. 5,45,000

Shareholders’ equity
= Common shareholders’ equity + Preference share
= Rs. (5,45,000 + 70,000)
= Rs. 6,15,000

Net profit after interest & tax

= (Net profit before tax & interest – interest on debentures) (1-t)
= (10% on 10,00,000 – 7% on 80,000)(1 – 0.50)
= Rs. (1,00,000 – 5,600) â‚“ 0.5
= Rs. 47,200
Hence,
Return on Shareholders’ Equity
=Netprofitaftertax+interestShareholders′fundNetprofitaftertax+interestShareholders′fund x 100%
= 47,2006,15,00047,2006,15,000 x 100%
= 7.67%

Again,
ROE
=Netprofitaftertax−preferencedividendCommonshareholders′equityNetprofitaftertax−preferencedividendCommonshareholders′equity x
100%
= 47,200−7,0005,45,00047,200−7,0005,45,000 x 100%
= 7.38%

6. Return on Capital Employed

This ratio depicts the relationship between the permanent capital (capital employed) and net profit after tax. It can be computed as:

Return on Capital Employed = NetprofitaftertaxCapitalemployedNetprofitaftertaxCapitalemployed x 100%

or,
Return on Capital Employed =Netprofitaftertax+interestCapitalemployedNetprofitaftertax+interestCapitalemployed x 100%

where,

Capital employed = Equity & preference share capital + reserve + P&L a/c (Cr.) + Share premium + Undistributed profit + Long term
debts – Fictitious assets
Capital employed = Fixed assets + Current assets – Current liabilities

Illustration:

Calculate Return on Capital Employed

Liabilities Amount (Rs.) Assets Amount (Rs.)

Equity share capital 6,00,000 Fixed assets 7,70,000

Outstanding expenses 40,000 Bank balance 50,000

11% Debentures 3,60,000 Preliminary expenses 25,000

General reserve 1,10,000 Investment 1,00,000

Creditors 2,15,000 Debtors 3,20,000

P&L a/c 1,40,000 Inventories 2,00,000

14,65,000 14,65,000

Sales is Rs. 10,00,000

Tax rate is 32%
Net profit before tax is Rs. 3,00,000

Solution:

Here,

Net profit after interest & tax

= (Net profit before tax & interest – interest on debentures) (1-t)
= Rs. (3,00,000 – 39,600)(1 – 0.32)
= Rs. 1,77,072

Capital employed
= Equity share + Reserve + P&L a/c + Debentures – Preliminary expenses
= Rs. (6,00,000 + 1,10,000 + 1,40,000 + 3,60,000 – 25,000)
= Rs. 11,85,000

Therefore,
Return on capital employed:
=Netprofitaftertax+interestCapitalemployedNetprofitaftertax+interestCapitalemployed x 100%
= 1,77,07211,85,0001,77,07211,85,000 x 100%
= 14.94%
Meaning and Types of Share Capital
Concept of Share Capital

Share capital is the ownership capital of a company raised by the issue of its shares. It is the document that acknowledges the ownership
of a company to the limit of the amount contributed. It represents a single unit of share capital reflecting the extent of the interest of
shareholders. It is amount invested by the shareholders towards the nominal value of shares.

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A company needs share capital in order to finance its activities. Share capital is composed of capital generated from the funds by issuing
shares for cash and also non-cash considerations or kind. The share capital may change as the company issues new shares to generate
more money over the course of its lifetime as the business requires more capital for expansion and growth. So, there will be an increment
of share capital in a business. Share capital may be of two types: common shares and preference shares. Common shares are the primary
stockholders shares in a company who have major voting rights in the company’s decisions. Preference shareholders are the shares of
those stockholders who have the main claim of the dividend before common shareholders but they are deprived of major company
rights. There are different types of shares capital, which are as follows:

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Types of Share Capital

1. Authorized or Registered Capital:
Authorized capital can be defined as the maximum number of shares which a company can trade as it is stated in its Articles of
Associationor as contracted and decided by voting by the shareholders. Authorized capital is usually not entirely used by the
company so as to issue added number of stock in future if the company requires increasing capital rapidly in some urgent cases.
Another motive of the company to keep a part of the stock in the treasury is to hold a controlling interest in the company. So, the
capital which is mentioned in the Memorandum of Association as the maximum amount of share capital is called authorized
capital. It is the maximum amount of capital which a company can raise. For example, if a company is registered with
Rs.1,00,00,000 divided into 1,00,000 shares of Rs.100 each, the authorized capital of the company is Rs. 1,00,00,000 (100,000
shares @ Rs.100 each). The authorized capital is also called nominal or registered capital.
 2. Issued Capital:
Issued capital can be taken as the part of the authorized capital, which is actually offered to the public for subscription. The
number of issued stock is a sub-group of the total authorized or registered shares. Issued capital is the quantity of stock which the
BOD (Board of Directors) or stockholders have decided to assign. Generally, a company does not issue the entire authorized shares
at a time so that the issued capital is always less than the authorized capital. In the above example, the company may offer to the
public 50,000 shares only. In this case, the issued capital of the company is Rs.50,00,000 (50,000 shares @ Rs.100 each).

3. Subscribed Capital:
Subscribed capital can be defined as the part of the issued capital which has been subscribed by investors of the company. When
any company issues a certain part of its authorized capital, the investors may subscribe or may not subscribe to all number of its
shares. Henc,e we can say that the part of issued capital that has been subscribed by the investors of the company is called
subscribed capital for the company. It is the part of the issued capital, which is actually taken up by the investors. For example, if
a company issues 50,000 shares @ Rs.100 each and the application for 45,000 shares were received, the subscribed capital is Rs.
45,00,000 (45,000 shares @ Rs.100 each).

4. Called-up capital:
The amount of share capital due on shares is normally collected from the shareholders in installments at different intervals. The
called-up capital is that part of the nominal value of shares subscribed by shareholders which are requested by the company for
payment. For example, if the subscribed capital is 45,000 shares @ Rs.100 each and the company called only Rs.80 per share,
then, the called-up capital is Rs.36,00,000 at the rate of 80 per share on 45,000 shares. The remaining balance of Rs. 9,00,000 at
the rate of Rs.20 per share on 45,000 shares is known as uncalled capital. The uncalled capital if retained by the company to be
called-up for the payment of creditors on liquidation is treated as reserve capital.

5. Paid-up Capital:
Paid-up capital can be described as the quantity of money that a company receives from its shareholders for the purchase of shares.
Paid-up capital is the amount which is generated after the company sells its shares straight to shareholders in the primary market.
Whereas in the secondary market, no additional paid-up capital is not generated when there is a transaction of shares as the
proceeds of those dealings turn to the selling owners, not the company of issuance. It is the part of the called-up capital which has
been actually received from the company’s shareholders. If the called-up capital is 45,000 shares @ Rs.80 each and a shareholder
holding 100 shares fails to pay the second installment of Rs.20 per share, the paid-up capital is Rs.35,98,000 shares since Rs.2000
due on 100 shares at Rs.20 per share failed to pay.

Hence, share capital is the document that reflects the interest in the company reflecting the ownership thereof and entitling to receive
profit proportionately. So, the different types of share capital are authorized to share capital, issued capital, subscribed capital, called-up
capital and paid-up capital.

Meaning and Types of Shares

Meaning of Share

Each unit of ownership denotes an equal amount of a business's wealth. It enables the shareholders to an equal right to the business's
profits and an equal responsibility for the business's arrears and deficits. A share is a document that acknowledges the ownership of a
company to the limit of the amount contributed. So, the share is defined as an interest in the company reflecting the ownership then and
entitling to receive profit proportionately.

The share capital of a company is divided into fixed number of units and each such unit is called a share. Major types of shares are one
having voting and major company rights and claim holders of the profit and the other are the one who have no voting rights or major
company rights but are promised of a certain periodic income or interest. Therefore, a share can be defined as a unit of share capital
reflecting the extent of the interest of a shareholder.
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Types of Shares

The shares of the company can be divided into the following categories:

1. Equity shares

Equity shares are also called ordinary shares. These shares have no preferential rights on the payment of dividend or repayment of
capital. The amount of dividend on such shares is not fixed. The dividend on these shares is paid from profits only after paying interest
on debentures and dividends in preference share capital. Similarly, equity shareholders are paid only after the payment of all debts and
preference share capital at the time of winding-up of the company. Equity shareholders are the true risk bearers of the company and they
are the ultimate claimants of the profit. Another feature of equity shares is that the equity shareholders enjoy the voting rights for the
management and control of the company. Equity shares are important to the company as well as to the shareholders. Its importance can
be pointed out as follows:

Importance to the company:

There is no need to pay the dividend in case of the loss or deficit of the company. Another major important aspect of equity shares is that
there is no need to refund money to the equity shareholders before winding-up of the company so that the company can utilize the equity
share capital permanently. Also, the board of directors and its head are elected from the equity shareholders for the effective
management of the company. So, equity shareholders hold a powerful position in the company.
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Importance to the shareholders:

Every shareholder has a voting right to elect the company’s board of directors. Equity shareholders can claim and enjoy a higher amount
of dividend in case of a higher profit of the company. So, if any company gains huge profit in a year then equity shares are benefited the
most as they get the huge amount of dividend more than preference shareholders. Equity shareholders can also easily sell or transfer their
shares to others.

2. Preference Shares

Preference shares are those shares that are entitled to certain privileges. The dividend on preference share is paid at a fixed rate. The
dividend on such shares is paid before any dividend is paid to equity shareholders. So, from the profit of the company, the first claim of
the profit amount goes to the preference shareholders. So, preference shareholders can be taken as the secured shares as it provides fixed
benefit and security to the owners. Similarly, at the time of winding-up the company, the preference capital is repaid before such a
repayment is made to the equity shareholders. However, the preference shareholders do not have any voting rights or major company
rights which are enjoyed by the equity shareholders. They cannot influence the major decisions of the company nor can they participate
in the board of directors. The major types of preference shares are as follows:

Cumulative preference shares: Cumulative preference shares are those shares on which a number of unpaid dividends are
accumulated and is carried forward as a liability. Therefore, the unpaid dividends of the past years are paid when adequate profits
are earned by the company. If the Article of Association of the company is silent about the accumulation of dividends on
preference shares, it is assumed that such shares are cumulative. When there is the huge amount of profit in the next years, the
cumulative figure or amount is paid off to the preference shareholders.

Non-Cumulative preference shares: Non-cumulative preference shares are those shares on which the arrears of dividend do not
accumulate. As such, the arrears of past years’ dividend on account of no profit or loss are not paid in the following years. So ,the
 figure is not added for the upcoming years but is to be paid in the same year.

Redeemable preference shares: Redeemable preference shares are those that can be redeemable within a specific period of time.
The terms and conditions for redemption of preference shares need to be specified at the time of the issue of shares.

Irredeemable preference shares: Irredeemable preference shares are those which cannot be redeemed within a specific period of
time but can be redeemed only at the time of liquidation of the company. The amount of capital is not paid back to the shareholders
before winding-up of the company.

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Participating preference shares: Participating preference shares are those preference shares which have a certain right to
participate in any surplus profit of the company after paying a dividend to equity shareholders. They are specified in the Article of
Association during the time of purchase of the preference shares.

Non-participating preference shares: Non-participating preference shares are those shares which do not carry any such rights in
the profit or surplus of the company after the payment of the dividend of the equity shareholders. If the Article of Association of
the company is silent, preference shares are assumed to be non-participating preference shares.

Convertible preference shares: Convertible preference shares are those shares which can be easily converted into equity shares.
The conversion becomes possible when the company provides such opportunity to the preference shareholders. These shares are
converted into equity shares according to the terms and conditions of their issue and decisions of the company.

Non-Convertible preference shares: Non-convertible preference shares are those which cannot be converted into equity shares.
Usually, preference shares are non-convertible unless it is stated in the Articles of Association and by the company.

Hence these are the various types of preference shares. Hence a preference share might be cumulative or non-cumulative, redeemable or
Irredeemable, Convertible or Non-convertible and participating or non-participating according to their nature and the policy of the
company.
Financial Statement and Analysis
Concept of Financial Statements

Financial statement is written reports of financial affairs of a company which reports and communicate the result of its business
operations for a particular period of time and its financial position at the end of that period. The results of the business operation are
revealed by the net profit it has earned during the period. The financial position of the company is determined by presenting the picture
of its assets, liabilities and shareholders equity at the end of the period. Generally, therefore, the financial statements of the company
include its trading and profit and loss account known as the income statement and balance sheet.

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Moreover, the company is required to prepare and publish cash flow statements at the end of the period, besides profit and loss account,
profit and loss appropriation account and the balance sheet.

“Nepal Accounting, Standard, July 2002” emphasizes the preparation of financial statements by the company and offers a framework for
the preparation and presentation of these statements. Accordingly, the financial statement of the company contain the following:

Income statement or trading and profit and loss account for showing the results of its business operations in terms of net profit
earned or net loss suffered during the period of reporting.

Statement of retained earnings or profit and loss appropriation account for showing the change in the profit position of the
company during the reporting period. The change in a profit of the company occurs due to the appropriation of profits into
dividends, reserves and fund and taxes.

The balance sheet for showing the financial position of the company as the end of the period. The financial position of the
company can have revealed through the picture of its assets, liabilities and shareholders equity.

Statement of changes in financial position or cash flow statement for showing the changes in the company’s cash position
during the period. The changes in the cash position of the company resulting on account of cash inflows and outflows occurring
from its operating investing and financial activities.

Objectives of financial statements

Financial statement is the means of communicating financial information to the users of such information. It is equally important to the
management, shareholders, creditors, suppliers, employees, customers, tax authorities, financial researchers, etc. The following are the
main objectives of financial statement:
 To provide the financial information to the users.

To provide users financial information for predicting, comparing and evaluating potential cash flow of the business.

To help the users to know regarding earning power of the business.

To provide information to judge management’s ability to utilize resources effectively.

To provide a statement of financial position concerning assets and liabilities of the business.

To provide the financial statements on a periodic basis to make the comparison of the progress of the business.

To provide useful financial information for financial forecasting.

Importance of Financial Statements

Financial statements provide valuable financial information to various users for different purposes. The importance of financial
statements can be pointed out as follows:

It provides the information relating to existing profit, earning per share, the possibility of growth cost information and other
necessary financial information.

It provides the information relating to the changes of business promotion and capacity of the business.

It provides the information to the employees relating to changes increments of salary, bonus, job security, employee’s welfare
scheme, etc.

It provides the information to the creditors and bankers and other financial institutions to know the capability to repay the amount
and interest as and when repayment becomes due.

It provides the information to the government to known the amount of tax on the revenues.

It provides the information to the customers about new product research, social responsibility and other policies of the business.

It provides the information to the potential investors to know the earning potential of the business.

Limitations of Financial Statements

The following are the main limitations of financial statements:

It provides the information relating to only monetary facts.

It records the financial information relating to historical in nature.

It is an only interim repost.

It is influenced by accounting concept.

It fails to disclose the adequate information.

It ignores the effects of price level changes.

It is prepared primarily for shareholders.

Financial Statement Analysis

The figures of the company’s financial statements particularly the profit and loss account and the balance sheet do not communicate the
user much unless they are properly analyzed and interpreted. The company’s profit and loss account show only the absolute figures of
revenues, expense and profit or loss occurred during a particular period. It does not, however, reveal whether the company’s revenues
and expenses have increased over the year or its net profit has been company’s balance sheet also does not reveal more than what is the
position of its assets, liabilities and shareholders’ equity at a certain point of time. Therefore, it is essential to analyze the figures of
financial statements so that important financial information can be obtained thereof.
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The analysis of financial figures contained in the company’s profit and loss account and balance sheet by employing appropriate
techniques is known as financial statements analysis. Formally, financial statement analysis is defined as the process of analyzing and
interpreting the financial figures contained in the statement by developing some relationships among the figure in such a manner that
meaningful information can be obtained about the liquidity, efficiency, profitability and leverage position of the company.

Thus, the analysis of financial data in a purposeful manner whereby a user can easily classify and group the financing data in a
purposeful manner andncan easily understand about the survival, stability, profitability and growth prospect of the company. The
analysis of financial statements includes the following activities:

Arranging and classifying financial data in a purposeful manner.

Judging the interrelationship of financial figures in a meaningful manner.

Obtaining information in a conclusive manner for the purpose of decision-making.

Objectives of Financial Statement Analysis

The following are the important objectives if financial statements analysis:

To know about profitability: The financial statement analysis provides information about the profitability of the company in
terms if sale and investment. The profitability scenario helps shareholders to decide whether to continue holding its shares and
other potential investors to decide whether to invest in its share or not.

To judge solvency: An analysis of financial statements is helpful for judging the short-term and long-term solvency of the
company. The banks with such information will be in a position to decide whether it should extend the loan or not.

To measure strengths and weaknesses: The analysis of financial statements helps to measure the financial strengths and
weakness of the company which is essential for deciding its future course of action.

To assets managerial performance: The financial statement analysis is essential for measuring the company’s managerial
performance, which is important to decide about rewarding the management or taking action against it.

To make future planning: The financial statement analysis provides relative information guidelines for making future plans of
the company by deciding what course if action should it takes to achieve its objectives.

Note: The objectives of the analysis of financial statement are to provide financial information to the investors, creditors, management
and other interested groups about the company’s profitability, solvency, strengths and weaknesses, managerial performance for future
plans.
Methods of Financial Statement Analysis
Financial statement analysis can be performed by employing a number of methods or techniques. The following are the important
methods or techniques of financial statement analysis:

Ratio analysis:It is the analysis of the interrelationship between two financial figures.
Cash flow analysis:It is the analysis of the change in the cash position during a period.
Comparative financial statement:It is the analysis of financial statement ratios of the company over the years.
Trend analysis: It is the analysis of the trend of the financial ratios of the company over the years.

The methods to be selected for the analysis depend on upon the circumstances and the users need. The user or the analyst should use the
appropriate method to derive required information to fulfill their needs.

Importance of Financial Statement Analysis

The financial statement analysis is important for different reasons and the importance are listed below :

Holding of share
Shareholders are the owners of the company. Time and again, they may have to take decisions whether they have to continue with
the holdings of the company’s shares or sell them out. The financial statement analysis is important as it provides meaningful
information to the shareholders in taking such decision.

Decision and plans Themanagement of the company is responsible for taking decisions and formulating plans and policies for
the future. They, therefore, always need to evaluate its performance and the effectiveness of their actions to realize the company’s
goal in the past. For that purpose, financial statement analysis is important to the company’s management.

Investment decisions
The prospective investors are those who have surplus capital to invest in some profitable opportunities. Therefore, they often have
to decide whether to invest their capital in the company’s shares. The financial statement analysis is important to them because
they can obtain useful information for their investment decision-making purpose.

Extension of credit
The creditors are the providers of loan capital to the company. Therefore, they may have to take a decision as to whether they have
to extend their loans to the company and demand for higher interest rates. The financial statement analysis provides important
information to them for their purpose.

Higher benefits
The employee of the company sometimes may have to decide whether they have to demand for higher benefits such as wages and
salaries from management. The financial statement analysis is significant to them because it provides them with meaningful
information to raise their voice for their cause.

Short-term loans:
The bank provides short-term loans to the company for meeting its working capital needs. Therefore, they may have to decide
whether to extend or increase short-term loans to the company. In such a situation, they may have to resort to financial statement
analysis as it provides them relevant information to reach a decision.

Anticipating future price

The stock analysts are those who anticipate the future market price per share of the company’s stock by looking into its
profitability, solvency, performance, stability and future prospect. Therefore, analysis of the company’s financial statement is
important to them to forecast the trends of its stock market price.

Compliance with law

The financial statement analysis is significant to the government, as it has to ensure whether the company’s financial statement
comply with the prevailing rule and laws. The analysis may also be used to access corporate taxes.

Note: Financial statement analysis is important to the management for formulating future plans. So, investors use financial statement
analysis for making investment decisions, the creditor for credit extending decision, and government for assessing the corporate tax.

Limitations of Financial Statement Analysis

Although, analysis of financial statements is essential to obtain relevant information for making several decisions and formulating
corporate plans and policies, it should be carefully performed as it suffers from a number of the following limitations:

Mislead the user

The accuracy of financial information largely depends on how accurately financial statements are prepared. If their preparation is
 wrong, the information obtained from their analysis will also be wrong which may mislead the user in making their decisions.

Not useful for planning

Since, financial statements are prepared by using historical financial data, therefore, the information derived from such statements,
may not be effective in corporate planning if the previous situation does not prevail.

Qualitative aspects
The financial statement analysis provides only quantitative information about the company’s financial affairs. However, it fails to
provide qualitative information such as management labor relation, customer’s satisfaction, management’s skill and so on which
are also equally important for decisions making.

Comparison not possible

The financial statements are based on historical data. Therefore, comparative analysis of financial statements of different years
cannot be done as inflation distort the view presented by the statements of different years.

Wrong judgment
The skills used in the analysis without adequate knowledge of the subject matter may lead to navigate direction. Similarly, biased
attitude of the analyst may also lead to wrong judgment and conclusion.

Parties Interested in financial Statement Analysis

The analysis of financial figures contained in the company’s profit and loss account and balance sheet by employing appropriate
techniques is known as financial statement analysis. Financial statement analysis is used to different parties to obtain the required
information about the organization. Following are the parties interested in financial statement analysis:

1. Shareholders:
Shareholders are interested in financial statement analysis to know the profitability of the organization. Profitability shows the
growth potential of an organization and safety of investment of shareholders.
2. Investors and lenders:
Investors and lenders are interested to know the solvency position of an organization. They make analysis about the financial
statement position to know about the safety of their investment and ability to pay interest and repayment of principal amount on
due date.
3. Creditors:
Creditors are interested in analyzing the financial statement in order to know the short term liquidity position of an organization.
Creditors analyze the financial statement to know either the organization is enabled to pay the amount of short-term liabilities on a
due date.
4. Management:
Management is interested in analyzing the financial statement for measuring the effectiveness of its policies and decisions. It
analyzes the financial statement to know short term and long term solvency position, profitability, liquidity position and return on
investment from the business.
5. Government:
Government is interested in analyzing the financial position in determining the amount of tax liability. It also helps for formulating
effective plans and policies for economic growth.
Issue of Shares
INTRODUCTION

A company issues its shares to the general public through an invitation called prospectus. The prospectus states, besides others, the
number of shares offered to the public and the face value of the shares. Generally, the shares of the company are issued for cash.
However, sometimes, shares are also issued for considerations other than cash, such as for the purchase of assets and for the purchase of
business. There is mostly three-steps in the collection of the money of shares which are share application; which is taken during
accepting the first installment of the company then share allotment which is taken when the share rights are given to the investor and
finally calls money which is the remaining amount of share to be paid. So, we will look in detail about the three steps:

1. Share Application

Share application is the money which a company receives during the time of accepting the request of purchase of the share of the
company. A company issues a certain amount of shares in the market. In response, investors and shareholders apply for the issuance of
the share. When the application money is given for the rights to the share, the share application money is transferred to the share capital
money and is termed as the first installment of the share. So, a prospective subscriber intending to purchase the share pays the first
installment of the amount of share with an application form. The amount of the first installment paid is called share application money.
All the applicants deposit their application money in the bank.

2. Share Allotment

When a company receives an application for the purchase of shares, it continues to assign the shares on the predefined basis (decided on
the prospectus of the company). When the amount of application surpasses the available amount of shares, the allotment is made
uniformly. Usually, in most cases, applications for shares are received till the available stated number are received fully. The letter of
allotment is given to receive the allotment money and shares. So, the company allots the shares among different applicants after
receiving the application money. The allotment of shares implies that the company has accepted the application of the subscribers and
decided to give shares to them. The company sends letters to the application intending for subscribing the shares which are called ‘Letter
of Allotment’. The letter of allotment provides the information about the number of shares allotted to the subscribers and the amount to
be paid by them as allotment money.

3. Calls on shares

Calls may be defined as the demand by the business made to its investors and shareholders to pay the remaining part or full part of the
unpaid balance on each share value at any time in the run of a company. The remaining amount of the shares allotted is called up by
writing letters to the shareholders which are known as calls on the share. Such remaining amount is called up after receiving the
allotment money. The balance of share money can be called up either in one or two installments. If the entire balance is called up at once,
it is known as ‘first and final call’. But, if the balance of the share is called up in two or more different installments, it is known as a first
call, second call, third and final call respectively.

Issue of shares for cash

The shares of a company can be issued either at par or at a discount or at a premium. The amount of the shares can be collected either on
lump-sum or on an installment basis. If the whole amount of shares is collected at once, it is called issues of shares on a lump-sum basis.
In such case, the whole amount of share is received with the amount of share application. Such shares can be issued either at par or at a
discount or at a premium.

Issue of share at par

A share issued at a price equal to its face or nominal value is called the issue of share at par. The par or face value of the share is printed
on the face of the share certificate. For example, if a share of Rs.100 each is issued at Rs.100, it is known as the issue of share at par.

Example: 1

Let A. company Ltd. Issue 10,000 equity shares of Rs.10 each for public subscription. All the shares were applied for and the allotment
was made in full.

Required: Journal Entries

Issue of share at a discount

A share issued at a price lower than its face value or nominal value is called the issue of share at a discount. For example, if a share of
Rs.100 each is issued at Rs.90, it is known as an issue of share at a discount. Such discount is a capital loss and hence, it is debited to
‘discount on issue of share account’.

Example: 2

Let Y. Company Ltd. Issued 10,000 equity shares of Rs.10 each at a discount of 10% for public subscription. All the shares were applied
for and the allotment was made in full.

Required: Journal Entries

Issue of share at a premium

A share issued at a price greater than its face or nominal value is called issue at a premium. For example, if a share of Rs.100 each is
issued at Rs.110, it is known as an issue of share at a premium. Such premium is a capital gain and hence, it is credited to ‘share
premium account’.

Example: 3

Let Z Company Ltd. Issued 10,000 equity shares of Rs.10 each at a premium of 10% for public subscription. All the shares were applied
for and the allotment was made in full.

Required: Journal Entries

Issue of Shares on Installment Basis

A share is issued at either on a lump-sum basis or on installment basis. In lump-sum basis, cash is fully paid at once during the time of
application. However, a company might also issue its shares to be paid in various installments. This system of issuance of shares to the
shareholders is known as the issue of share on an installment basis. Also, the shares may be issued in par, which is the payment of share
at its face value, at a discount, which is the issuance of shares at a price below the face value and at a premium, which is to issue the
share above the face value of the share.

A number of shares may be collected in different installments. Generally, such amount of installments is collected in the form of
application, allotment, first call and second and final call. A prospective subscriber intending to purchase the share pays the first
installment of the amount of share with an application form. The amount of the first installment paid is called share application money.
All the applicants deposit their application money in the bank.

The company allots the shares among different applicants after receiving their share application money. The allotment of shares implies
that the company has accepted the application of the subscribers and decided to give shares to them. The company sends letters to the
applicants intending to subscribe the shares which are called ‘Letter of Allotment’. The letter of allotment provides the information about
the number of shares allotted to the subscribers and the amount to be paid by them as the allotment money.

The remaining amount of the shares allotted is called up by writing a letter to the shareholders which are known as calls on the share.
Such remaining amount is called up after receiving the allotment money. The balance of share money can be called up either in one or
two installments. If the entire balance of share is called up at once, it is called ‘first and final call’. However, if the balance of share is
called up in two different installments, it is called first call and second and final call respectively.

Now, we will see the format for the journal entries for application, allotment, and calls.
Issue of shares at par

Generally, shares are issued at par. If the shares are issued at par, the company collects the amount of shares in different installments
equal to their face or nominal value. For example: issuing shares of Rs.10 each at Rs.10 per share is called issuing share at par.

Example 1: Saugat company Ltd. Invited application for 1000, 9% preference shares of Rs.50 each at par payable as:

Rs.10-on application

Rs.15-on allotment

Rs.25 –on first and final call

All the shares were subscribed and allotted. All money was duly received.

Required: Journal Entries

Issue of shares at a discount

Generally, a company does not issue its shares at a discount. If the shares are issued in different installments after deducting the amount
discount from the face or nominal value of the shares. For example, issuing a share of Rs.10 each at Rs.9 per share is called issuing share
at a discount.

The discount on the issue of share is a capital loss. It is debited to ‘discount on issue of share account’. The discount is included in the
amount of allotment. Mostly, it is debited to discount on issue of share account at the time of making the allotment money due entry.
Since, the discount is a capital loss, it is shown on the assets side of the balance sheet. It is required to be written off in subsequent years
within the period of debenture amount outstanding as per the decision of the Board of Directors.

Example 2: Anamol Co. Ltd. Issued 20,000 equity shares of Rs.100 each at a discount of Rs.10 per share. The amount was payable Rs.40
on the application, Rs.30 on allotment and Rs.20 on first and final call. All the shares were subscribed, allotted and the money was duly
received.

Required: Journal Entries

Issue of shares at a premium

The issue of share at a price higher than its face value or nominal value is known as an issue of share at a premium. For example, if the
face value of a share is Rs.100 and is issued at Rs.110 per share, the excess amount of Rs.10 is a share premium. Such a premium is a
capital gain and credited to share premium account.

The amount of share premium can be collected with the application or with an allotment or with calls money. Normally, the amount of
premium is collected along with the allotment money. There are two methods for the treatment of the amount of share premium. They
are a due method and receipt method.

1. Due method: Under this method, the money is received in a single heading of share allotment which includes share capital and
also shares premium. Generally, the due method is preferred for recording the amount of share premium. The following entries are
prepared to record the issue of shares and premium under due method.

2. Receipt method: Under this method, the money is received under two headings which are share allotment which is the share
capital amount and share premium. The following entries are prepared to record the issue of shares at a premium under receipt
method.
If the amount of share premium is received along with the application money, it is recorded by preparing the following entries.

Example 3: Active Co. Ltd. Issued 50,000 equity shares of Rs.100 each at 20% premium. The amount payable was as follows:

On application- Rs.30 (including premium Rs.10)

On allotment- Rs.50 (including premium Rs.10)

On first and final call- Rs.40

All the shares were subscribed, allotted and the money was duly received.

Required: Journal Entries

Calls in Arrears and Calls in Advance
Calls in Arrears
Calls in Arrears refers to the amount called by the company which is not paid by the shareholders before the due date fixed for the
payment. Such amount is transferred to an account calls in arrears account from the call account.

In other words, calls in arrears are the situation when the shareholder fails to pay the called money in the allocated time by the company.
If a shareholder fails to pay the due amount of share allotment or calls, the unpaid amount of share is called ‘calls in arrears’. There are
two alternative methods of accounting treatment for calls in arrears. These methods are as follows:

1. Showing calls-in –arrears account: Under this method, the amount of unpaid share amount is shown in calls in arrears account.
2. Without showing calls-in-arrears account: Under this method, the amount of unpaid share amount is not shown in calls in
arrears account. The debit balance remaining in share allotment and calls account represents the amount of calls in arrears.

Illustrations 1:

Archana Co. Ltd. issued 5,000 shares of Rs.100 each for public subscription. The share money payable was on application Rs.30, on
allotment Rs.40 and on first and final call Rs.30 per share. All the shares were applied for allotted and the money was duly received
except from Mr. Bhattarai, a shareholder, who failed to pay first and final call money on 200 shares.

Required:Journal entries

Solution:
Illustration 2:

Snowland Co. Ltd. Registered with an authorized capital of Rs.10,00,000 divided into 10,000 equity shares of Rs.100 each. The company
issued 5,000 equity shares. The shares money payable was Rs.25 on application, Rs.50 on allotment and Rs.25 on first and final call.

Snowland Co. Ltd. Registered with an authorized capital of Rs.10,00,000 divided into 10,000 equity shares of Rs.100 each. The company
issued 5,000 equity shares. The shares money payable was Rs.25 on application, Rs.50 on allotment and Rs.25 on first and final call.

All the shares applied for were allotted. All the money was duly received except from Mr. Arjun a shareholder, to whom 300 shares were
allotted failed to pay the first and final call money. Another shareholder, Mr. Pradeep, to whom 300 shares were allotted failed to pay
first and final call money. The expenses on issue were Rs.3000.

Required: Journal entries

Solution:
Calls in Advance

A company calls for money when needed with a certain date. Some shareholders pay the money ahead of the allocated time with their
first installments. So, this payment is known as calls in advance. So, the payment of the future call money is known as calls in advance
by the shareholders of the company.

The company receives the amount of shares in different installments. Sometimes, the company may receive the uncalled amount of
installments in advance as well. The amount of installments which have not been called up but received is known as calls-in-advance.
The uncalled share amount received in advance is credited to calls in the advance account. The credit balance of calls-in-advance account
is shown on the liability side of the balance sheet till it is fully transferred to subsequent installment for which it was received.

The uninvited first call money may be received along with the amount of allotment and the uninvited second and final call money may
be received along with the amount of first call. The amount of calls-in-advance may also result due to the excess application money
retained for adjusting in allotment and subsequent calls.

Illustrations 1:

Kantipur Finance Co. Ltd. Has an authorized share capital of Rs.2,00,000 divided into 20,000 equity shares of Rs.10 each. The company
issued all the shares at 10% premium. The amount payable on application was Rs.4, on allotment Rs.3 (including premium) and balance
on first and final call.

All the shares were subscribed and allotted. Mrs. Anita, a shareholder, to whom 200 shares were allotted paid the entire balance with the
amount of allotment.

Required: Journal entries

Solution:
Illustrations 2:

Silver Nepal Ltd. offered 10,000 shares for public subscription at Rs.110 per shares. The payable amount was as follows:

On application: Rs.30

On allotment: Rs.40

On first call: Rs.20

On Second and final call: Rs.20

All the shares were subscribed and allotted. Mr.Nilam, a shareholder, who held 400 shares paid the entire money with the amount of
allotment. Another shareholder, Mr.Ashutosh, who held 200 shares paid the amount of second and final call along with the amount of
final call.

Required: Journal entries

Solution:
Note: The journal entry for the second and final call advance deposit made by Mr. Ashutosh @Rs.20 each for 200 shares prepared
separately since calls in advance amount is debited for drawing the first call amount of 400 shares deposited by Mr. Nilam along with
allotment money.

Illustration 3:

Oxford Co. Ltd. Invited application for 40,000 shares @ Rs.10 each. The amount payable per share was as follows:

On application: Rs.2

On allotment: Rs.3

On First call: Rs.3

On second and final call: Rs.2

All the shares were subscribed and allotted. Mr. Shankar, a shareholder, to whom 5,000 shares were allotted, paid the entire balance with
the amount of allotment.

Required: Journal entries

Share Forfeiture and Re-issue of Forfeited Shares

Share Forfeiture
A joint stock company allots shares to the applicants applied for the shares. Upon allotment, the applicants are liable to pay the allotment
money and call money within the time specified. If applicants fail to pay the allotment amount and the shareholders fail to pay the call
money, then the company can forfeit such shares. Forfeiture of shares is a process of withdrawing the shares allotted and seizing the
amount already paid by the defaulters.

If an applicant fails to pay allotment and the shareholder fails to pay call money, then the company should send a three months’ notice to
the defaulters requesting to pay the due amount of shares. According to section 38 of the Companies Act, 2053, a three months’ notice
shall be served to the defaulters for payment with interest after the expiry of the initial deadline of 30 days.

Even after the notice, if no payment is made, another notice should be served to the defaulters informing that his shares will be forfeited.
If the payment is not made yet, the board of directors passes a resolution to forfeit the shares held by the defaulting shareholders.

The conditions of forfeiture of shares are as follows:

Forfeiture of shares issued at par

Forfeiture of shares issued at discount
Forfeiture of shares issued at premium

Forfeiture of shares issued at par

The following journal entry is passed for the forfeiture of shares initially issued at par:
The following alternative entry can be passed for forfeiture of shares initially issued at par if calls in arrears a/c is debited, while
preparing journal entries for the share amount received with exception of calls in arrears.

Share capital a/c….Dr. xxx

To share forfeiture a/c xxx

To calls-in-arrears a/c xxx

(Being forfeiture of…shares of Rs…..each due to non-payment of allotment money of Rs….and first and final call money of Rs….each)

Illustration 1:

Citizens Co. Ltd. forfeited 1500 shares of Rs.10 each due to non-payment of first call of @ Rs.2 per share and second and final call of
Rs.3 per share.

Required: Journal entry for the forfeiture of share.

Forfeiture of share issued at discount

The discount on issue of shares initially provided is required to be withdrawn from the shareholder who has made default of share
installment amount. Discount is offered with presumption that the entire share amount will be received in the specified time, but if the
shareholders fails to meet the commitment then they has got no right to receive discount facility. Therefore, the discount on such shares
should be withdrawn.

Illustration 2:

Xerox Co. Ltd. forfeited 500 shares of Rs.100 each issued at 10% discount on which a shareholder failed to pay first and final call of
Rs.40 per share.

Required: Journal entry.

Forfeiture of share issued at premium

When a shareholder fails to pay the amount of premium: The share premium amount is normally collected along with share
allotment. The revoke of share premium is essential on non-payment of share premium.

Illustration 3:

Iceland Co. Ltd. forfeited 1000 equity shares of Rs.100 each, which were issued at a premium of Rs.10 per share due to non-payment of
allotment money of Rs.50 and first and final call money of Rs.30 per share.

Required: Journal entry

When a shareholder pays the amount of premium: The share premium amount already collected is not needed to be adjusted upon
non-payment of subsequent share call amount.

Illustration 4:

Zonal Company Ltd. forfeited 300 shares of Rs.10 each issued at a premium of Rs.2 due to non-payment of first call of Rs.2 and second
and final call of Rs.3 per share.

Required:Journal entry

The unpaid share premium amount should be revoked (adjusted) upon default of share allotment amount. But, share premium amount
received is not needed to be revoked.

Re-issue of forfeited shares

The Board of Directors of the company is empowered to reissue the forfeited shares if authorized by its articles. Such shares may be
issued either at par or at premium or at discount. When the forfeited shares are re-issued either at par or at premium, the similar entries
prepared for the issue of shares at either par or at premium is prepared at the time of reissue. The forfeited shares can also be re-issued at
discount. In such a case, a sum equal to the discount allowed is withdrawn from the share forfeited account to compensate such discount.
This needs giving debit to share forfeiture account. The following journal entry is passed for re-issue of shares at discount:

Bank a/c… Dr. (with amount received on reissue) xxx

Share forfeiture a/c…. Dr. (with amount of discount allowed) xxx

To share capital a/c (with total amount) xxx

(Being ……shares reissue at Rs….. each)

The balance remaining in shares forfeited account in the nature of capital gain and would be closed by transferring to the capital reserve
account. The following journal entry is passed for transferring the amount of net gain on capital reserve amount:

Share forfeiture a/c… Dr. (with total credit balance in share forfeiture account, after re-issue) xxx

To capital reserve a/c xxx

(Being net gain on re-issue of shares transferred into capital reserve account)

Re-issue of forfeited shares at par initially issued at par

Illustration 5:

Aggressive Co. Ltd. forfeited 100 shares of Rs.10 each due to non-payment of first and final call money of Rs.5 each. These shares were
reissued at Rs.10 per share fully paid.

Required: Journal entry

Re-issue of forfeited shares at discount initially issued at par

Illustration 6:

Progressive Co. Ltd. forfeited 300 shares of Rs.100 each fully called up on which Rs.60 per share was received. These shares were re-
issued to Mr. A at Rs.70 per share as fully paid.

Required: Journal entry

Working note:

Gain= (Amount of forfeiture/no. of forfeited shares) * No. of shares re-issued-share forfeiture (dis. amt.)

= (18000/300)*300-9000= Rs.9000

Re-issue of forfeited shares at premium initially issued at par

Illustration 7:

United Co. Ltd. forfeited 500 shares of Rs.100 each fully called up on which Rs.70 per share was received. These shares were reissued to
Mr. Gurung at Rs.110 per share as fully paid.

Required:Journal entry
Re-issue of forfeited shares initially issued at premium and partially called up

Illustration 8:

Super Co. Ltd. forfeited 500 shares of Rs.100 each issued at a premium of Rs.20 on which the company did not receive first call of
Rs.30. The second and final call money of Rs.20 was not called up. Out of these forfeited shares, 300 shares were reissued at Rs.60 per
share as Rs.80 paid up.

Required: Journal entries

The balance of share forfeiture account of 200 forfeited shares not yet issued is Rs.10, 000. The balance of the forfeited account is
required to be adjusted at the time of re-issue of 200 forfeited shared. The balance of share forfeiture account is derived by adjusting in
the following way: Rs.25000-Rs.6000-Rs.9000= Rs.10,000 means forfeiture amountwas transferred to capital reserve= Remaining
balance of forfeiture account. This amount is shown on the liability side of the balance sheet and adjusted at the time of re-issue of the
remaining forfeited shares.

Reissue of forfeited shares at Discount Initially Issued at Discount

Illustration 9:

Trishakti Co. Ltd. forfeited 300 shares of Rs.10 each, which were issued at a discount of Rs.2 due to non-payment of first call of Rs.3 and
second and final call of Rs.2 per share. Subsequently, these shares were reissued at Rs.7 per share as fully paid.

Required: Journal entries for forfeiture and reissue