SPBA104..Accouting For Managers

SPBA 104
POSTGRADUATE COURSE
MBA
FIRST YEAR
FIRST SEMESTER
CORE PAPER - IV
ACCOUNTING FOR MANAGERS
INSTITUTE OF DISTANCE EDUCATION

UNIVERSITY OF MADRAS
MBA CORE PAPER - IV
FIRST YEAR - FIRST SEMESTER ACCOUNTING FOR MANAGERS
WELCOME
Warm Greetings.
It is with a great pleasure to welcome you as a student of Institute of Distance

Education, University of Madras. It is a proud moment for the Institute of Distance education
as you are entering into a cafeteria system of learning process as envisaged by the University
Grants Commission. Yes, we have framed and introduced Choice Based Credit
System(CBCS) in Semester pattern from the academic year 2018-19. You are free to
choose courses, as per the Regulations, to attain the target of total number of credits set
for each course and also each degree programme. What is a credit? To earn one credit in
a semester you have to spend 30 hours of learning process. Each course has a weightage
in terms of credits. Credits are assigned by taking into account of its level of subject content.
For instance, if one particular course or paper has 4 credits then you have to spend 120
hours of self-learning in a semester. You are advised to plan the strategy to devote hours of
self-study in the learning process. You will be assessed periodically by means of tests,
assignments and quizzes either in class room or laboratory or field work. In the case of PG
(UG), Continuous Internal Assessment for 20(25) percentage and End Semester University
Examination for 80 (75) percentage of the maximum score for a course / paper. The theory
paper in the end semester examination will bring out your various skills: namely basic
knowledge about subject, memory recall, application, analysis, comprehension and
descriptive writing. We will always have in mind while training you in conducting experiments,
analyzing the performance during laboratory work, and observing the outcomes to bring
out the truth from the experiment, and we measure these skills in the end semester
examination. You will be guided by well experienced faculty.
I invite you to join the CBCS in Semester System to gain rich knowledge leisurely at
your will and wish. Choose the right courses at right times so as to erect your flag of
success. We always encourage and enlighten to excel and empower. We are the cross
bearers to make you a torch bearer to have a bright future.
With best wishes from mind and heart,
DIRECTOR
(i)
MBA CORE PAPER - IV
FIRST YEAR - FIRST SEMESTER ACCOUNTING FOR MANAGERS
COURSE WRITERS
Dr. S. Usha
Assistant Professor in Management Studies
University of Madras,
Chennai - 600 005.
(Lessons 1-10)
Mr. P. Rajendran
Head - Centre for Entrepreneurship Innovation & Business Incubation (CEIBI)
Associate Professor - Finanace & Strategy
Department of Management Studies
MIC College of Technology
Affiliated to JNT University
Vijayawada - 521180
(Lessons 11-16)
COORDINATION AND EDITING
Dr. B. Devamaindhan
AssociateDr. S. Thenmozhi
Professor in Management Studies
IDE, University of Madras
Associate Professor
Chennai - 600 005.
Department of Psychology
Institute of Distance Education
University of Madras
Chepauk Chennnai - 600 005.
© UNIVERSITY OF MADRAS, CHENNAI 600 005.
(ii)
MBA DEGREE COURSE
FIRST YEAR
FIRST SEMESTER
Core Paper - IV
SYLLABUS
Unit I
Financial Accounting – Meaning - Objectives - functions. Branches of Accounting: Financial,
Cost and Management Accounting - Accounting Concepts and conventions. Journal –
Ledger – Trial Balance – Preparation of Final Accounts: Trading, Profit and Loss Account
and Balance Sheet (problems)
UNIT II
Financial Statement Analysis - Objectives - Techniques of Financial Statement Analysis:
Accounting Ratios- Classification of Ratios: Profitability, Liquidity, Financial and Turnover
Ratio - problems.
Fund Flow Statement - Statement of Changes in Working Capital - Preparation of Fund
Flow Statement - Cash Flow Statement Analysis- Distinction between Fund Flow and Cash
Flow Statement - problems
UNIT – III
Marginal Costing - Definition - distinction between marginal costing and absorption costing
- Breakeven point Analysis - Contribution, p/v Ratio, margin of safety - Decision making
(iii)
under marginal costing system-key factor analysis, make or buy decisions, export decision,
sales mix decision-Problems.
UNIT – IV
Budget, Budgeting, and Budgeting Control - Types of Budgets - Preparation of Flexible and
fixed Budgets, master budget and Cash Budget - Problems -Zero Base Budgeting. Standard
costing and variance analysis.
UNIT – V
Cost Accounting: meaning – Objectives - Elements of Cost – Cost Sheet (Problems) –
classification of cost – Cost Unit and Cost Centre – Methods of Costing – Techniques of
Costing. Standard costing and variance analysis Reporting to Management – Uses of
Accounting information in Managerial decision-making.
Reference Books
1. Gupta, A., Financial Accounting for Management: An Analytical Perspective, 4th Edition,
Pearson, 2012.
2. Khan, M.Y. and Jain, P.K., Management Accounting: Text, Problems and Cases,
5thEdition, Tata McGraw Hill Education Pvt. Ltd., 2009.
3. Nalayiram Subramanian, Contemporary Financial Accounting and reporting for
Management – a holistic perspective- Edn. 1, 2014 published by S. N. Corporate
Management Consultants Private Limited
4. Horngren, C.T., Sundem, G.L., Stratton, W.O., Burgstahler, D. and Schatzberg, J.,
14th Edition, Pearson, 2008.
5. Noreen, E., Brewer, P. and Garrison, R., Managerial Accounting for Managers, 13th
Edition, Tata McGraw-Hill Education Pvt. Ltd., 2009.
6. Rustagi, R. P., Management Accounting, 2nd Edition, Taxmann Allied Services Pvt.
Ltd, 2011.
(iv)
MBA DEGREE COURSE
FIRST YEAR
FIRST SEMESTER
Core Paper - IV

SCHEME OF LESSONS
Sl.No. Title Page
1. Introduction 001
2. Principles of Accounting 016
3. Journal and Ledger 024
4. Subsidiary Books 039
5. Trial Balance 062
6. Final Accounts 069
7. Final Accounts with Adjustments 098
8. Management Accounting 123
9. Financial Statement Analysis 135
10. Tools of Financial Statement Analysis 149
11. Marginal Costing 183
12. Marginal Costing and Managerial Decision Making 210
13. Budget & Budgetary Control 223
14. Reporting to Management 256
15 Standard Costing and Variance Analysis 270
16 Cost Accounting 296
(v)
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LESSON 1
INTRODUCTION
Learning Objectives
After reading this lesson, you will be able to:
 Define the term Book Keeping
 List out objectives and Importance of Accounting
 Discuss the methods and branches of Accounting
 Explain the advantages and limitations of Accounting
 Distinguish Book keeping and Accounting
Structure
1.1 Introduction
1.2 Book-Keeping
1.2.1 Meaning
1.2.2 Definition
1.2.3 Objectives
1.3 Accounting
1.3.1 Meaning
1.3.2 Definition
1.3.3 Objectives
1.3.4 Importance
1.3.5 Functions
1.3.6 Advantages
1.3.7 Limitations
1.4 Methods of Accounting
1.4.1 Single Entry
1.4.2 Double Entry

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1.4.3 Steps involved in Double Entry System
1.4.4 Advantages of Double Entry System
1.5 Meaning of Debit and Credit
1.6 Types of Accounts and Its Rules
1.6.1 Personal Accounts
1.6.2 Real Accounts
1.6.3 Nominal Accounts
1.7 Distinction between Book Keeping and Accounting
1.8 Branches of Accounting
1.8.1 Financial Accounting
1.8.2 Cost Accounting
1.8.3 Management Accounting
1.9 Summary
1.10 Key Words
1.11 Review Questions
1.12 Suggested Readings
1.1 Introduction
Accounting is an important function in all the organizations. Accounting is often called the
language of business. The basic function of any language is to serve as a means of
communication. Accounting also serves this function. In all activities (whether business activities
or non-business activities) and in all organizations (whether business organizations like a
manufacturing entity or trading entity or non-business organizations like schools, colleges,
hospitals, libraries, clubs, temples, political parties, etc) which require money and other economic
resources, accounting is required to account for these resources. In other words, wherever
money is involved, accounting is required to account for it.
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1.2. Book-Keeping
1.2.1 Meaning
Book- keeping includes recording of journal, posting in ledgers and balancing of accounts.
All the records before the preparation of trail balance is the whole subject matter of book-
keeping. Thus, book- keeping many be defined as the science and art of recording transactions
in money or money’s worth so accurately and systematically, in a certain set of books, regularly
that the true state of businessman’s affairs can be correctly ascertained. Here it is important to
note that only those transactions related to business are recorded which can be expressed in
terms of money.
1.2.2 Definition
“Book- keeping is the art of recording business transactions in a systematic manner”.

R.N.Carter
A.H.Rosenkamph. “Book- keeping is the science and art of correctly recording in books
of account all those business transactions that result in the transfer of money or money’s worth”.
1.2.3 Objectives
 Book- keeping provides a permanent record of each transaction.
 Soundness of a firm can be assessed from the records of assets and abilities on a
particular date.
 Entries related to incomes and expenditures of a concern facilitate to know the

profit and loss for a given period.
 It enables to prepare a list of customers and suppliers to ascertain the amount to be

received or paid.
 It is a method gives opportunities to review the business policies in the light of the
past records.
 Amendment of business laws, provision of licenses, assessment of taxes etc.,are

based on records.
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1.3 Accounting
1.3.1 Meaning
Accounting, as an information system is the process of identifying, measuring and

communicating the economic information of an organization to its users who need the information
for decision making. It identifies transactions and events of a specific entity. A transaction is an
exchange in which each participant receives or sacrifices value (e.g. purchase of raw material).
An event (whether internal or external) is a happening of consequence to an entity (e.g. use of
raw material for production). An entity means an economic unit that performs economic activities.
1.3.2 Definition
American Institute of Certified Public Accountants (AICPA) which defines accounting as

“the art of recording, classifying and summarizing in a significant manner and in terms of money,
transactions and events, which are, in part at least, of a financial character and interpreting the
results thereof”.
1.3.3 Objectives
Objective of accounting may differ from business to business depending upon their specific
requirements. However, the following are the general objectives of accounting.
i) To keeping systematic record: It is very difficult to remember all the business transactions
that take place. Accounting serves this purpose of record keeping by promptly recording all the
business transactions in the books of account.
ii) To ascertain the results of the operation: Accounting helps in ascertaining result i.e.,
profit earned or loss suffered in business during a particular period. For this purpose, a business
entity prepares either a Trading and Profit and Loss account or an Income and Expenditure
account which shows the profit or loss of the business by matching the items of revenue and
expenditure of the same period.
iii) To ascertain the financial position of the business: In addition to profit, a businessman
must know his financial position i.e., availability of cash, position of assets and liabilities etc.
This helps the businessman to know his financial strength. Financial statements are barometers
of health of a business entity.
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iv) To portray the liquidity position: Financial reporting should provide information about
how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing,
about its capital transactions, cash dividends and other distributions of resources by the enterprise
to owners and about other factors that may affect an enterprise’s liquidity and solvency.
v) To protect business properties: Accounting provides upto date information about the
various assets that the firm possesses and the liabilities the firm owes, so that nobody can
claim a payment which is not due to him.
vi) To facilitate rational decision – making: Accounting records and financial statements
provide financial information which help the business in making rational decisions about the
steps to be taken in respect of various aspects of business.
vii) To satisfy the requirements of law: Entities such as companies, societies, public trusts
are compulsorily required to maintain accounts as per the law governing their operations such
as the Companies Act, Societies Act, and Public Trust Act etc.Maintenance of accounts is also
compulsory under the Sales Tax Act and Income Tax Act.
1.3.4 Importance
i) Owners: The owners who provide funds or capital to the business are interested in
knowing whether the business is being conducted profitably or not and whether the capital is
being employed properly or not. Owners, being businessmen, always keep an eye on the returns
from the investment. Comparing the accounts of various years helps in getting good pieces of
information.
ii) Management: The management of the business is greatly interested in knowing the
financial position of the firm. Accounting statements help the management to study the merits
and demerits of the business activity. Thus, the management is interested in financial accounting
to find whether the business carried on is profitable or not.
iii) Creditors: Creditors are the persons who supply goods on credit, or bankers or lenders
of money. Creditors are interested to know the financial soundness before granting credit. The
progress and prosperity of the firm, to which credits are extended, are largely watched by
creditors from the point of view of security and further credit. Profit and Loss Account and
Balance Sheet are the nerve centres to know the soundness of the firm.
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iv) Employees: Payment of salary and bonus depends upon the size of profit earned by
the firm. The more important point is that the workers expect regular income for the bread. The
demand for wage rise, bonus, better working conditions etc. depend upon the profitability of the
firm and in turn depends upon financial position. For these reasons, employees are interested
in accounting.
v) Investors: The prospective investors, who want to invest their money in a firm, of
course wish to see the progress and prosperity of the firm, before investing their amount, by
going through the financial statements of the firm. This is to safeguard the investment. Investors
are eager to go through the accounting which enables them to know the safety of their investment.
vi) Government: Government keeps a close watch on the firms which yield good amount
of profits. The state and central Governments are interested in the financial statements to know
the earnings for the purpose of taxation. To compile national accounting is essential.
vii) Consumers: These groups are interested in getting the goods at reduced price.
Therefore, they wish to know the establishment of a proper accounting control, which in turn will
reduce to cost of production, in turn less price to be paid by the consumers. Researchers are
also interested in accounting for interpretation.
viii) Research Scholars: Accounting information, being a mirror of the financial

performance of a business organization, is of immense value to the research scholar who
wants to make a study into the financial operations of a particular firm. To make a study into the
financial operations of a particular firm, the research scholar needs detailed accounting
information relating to purchases, sales, expenses, cost of materials used, current assets,
current liabilities, fixed assets, long-term liabilities and share-holders funds which is available in
the accounting record maintained by the firm.
1.3.5 Functions
i) Record Keeping Function: The primary function of accounting is recording, classifying

and summarizing the financial transactions - journalising, posting, and preparation of final
statements. These facilitate to know operating results and financial positions. The purpose of
this function is to report regularly to the interested parties by means of financial statements.
Thus accounting performs historical function i.e., attention on the past performance of a business;
and this facilitates decision making programme for future activities.
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ii) Managerial Function: Decision making programme is greatly assisted by accounting.

The managerial function and decision making programmes, without accounting, may mislead.
The day-to-day operations are compared with some predetermined standard. The variations of
actual operations with pre-determined standards and their analysis is possible only with the
help of accounting.
iii) Legal Requirement function: Auditing is compulsory in case of registered firms.

Auditing is not possible without accounting. Thus accounting becomes compulsory to comply
with legal requirements. Accounting is a base and with its help various returns, documents,
statements etc., are prepared.
iv) Language of Business: Various transactions are communicated through accounting.

There are many parties-owners, creditors, government, employees etc., who are interested in
knowing the results of the firm and this can be communicated only through accounting. The
accounting shows a real and true position of the firm or the business.
1.3.6 Advantages
The following are the advantages of accounting to a business:
 It helps in having complete record of business transactions.
 It gives information about the profit or loss made by the business at the close of a year
and its financial conditions. The basic function of accounting is to supply meaningful
information about the financial activities of the business to the owners and the managers.
 It provides useful information form making economic decisions,
 It facilitates comparative study of current year’s profit, sales, expenses etc., with those of
the previous years.
 It supplies information useful in judging the management’s ability to utilize enterprise

resources effectively in achieving primary enterprise goals.
 It provides users with factual and interpretive information about transactions and other
events which are useful for predicting, comparing and evaluation the enterprise’s earning
power.
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 It helps in complying with certain legal formalities like filing of income tax and sales-tax
returns. If the accounts are properly maintained, the assessment of taxes is greatly
facilitated.
1.3.7 Limitations
 Accounting is historical in nature: It does not reflect the current financial position or worth
of a business.
 Transactions of non-monetary mature do not find place in accounting. Accounting is limited

to monetary transactions only. It excludes qualitative elements like management, reputation,
employee morale, labour strike etc.
 Facts recorded in financial statements are greatly influenced by accounting conventions

and personal judgements of the Accountant or Management. Valuation of inventory,
provision for doubtful debts and assumption about useful life of an asset may, therefore,
differ from one business house to another.
 Accounting principles are not static or unchanging-alternative accounting procedures are

often equally acceptable. Therefore, accounting statements do not always present
comparable data.
 Cost concept is found in accounting. Price changes are not considered. Money value is
bound to change often from time to time. This is a strong limitation of accounting.
 Accounting statements do not show the impact of inflation.
 The accounting statements do not reflect those increase in net asset values that are not
considered realized.
1.4 Methods of Accounting

Business transactions are recorded in two different ways.
1. Single Entry
2. Double Entry
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1.4.1 Single Entry
It is incomplete system of recording business transactions. The business organization

maintains only cash book and personal accounts of debtors and creditors. So the complete
recording of transactions cannot be made and trail balance cannot be prepared.
1.4.2 Double Entry
It this system every business transaction is having a two-fold effect of benefits giving and
benefit receiving aspects. The recording is made on the basis of both these aspects. Double
Entry is an accounting system that records the effects of transactions and other events in at
least two accounts with equal debits and credits.
1.4.3 Steps involved in Double entry system
(a) Preparation of Journal: Journal is called the book of original entry. It records the
effect of all transactions for the first time. Here the job of recording takes place.
(b) Preparation of Ledger: Ledger is the collection of all accounts used by a business.
Here the grouping of accounts is performed. Journal is posted to ledger.
(c) Trial Balance preparation: Summarizing. It is a summary of ledger balances prepared

in the form of a list.
(d) Preparation of Final Account: At the end of the accounting period to know the
achievements of the organization and its financial state of affairs, the final accounts are prepared.
1.4.4 Advantages of Double Entry System
i) Scientific system: This system is the only scientific system of recording business
transactions in a set of accounting records. It helps to attain the objectives of accounting.
ii) Complete record of transactions: This system maintains a complete record of all
business transactions.
iii) A check on the accuracy of accounts: By use of this system the accuracy of accounting
book can be established through the device called a Trail balance.
iv) Ascertainment of profit or loss: The profit earned or loss suffered during a period
can be ascertained together with details by the preparation of Profit and Loss Account.
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v) Knowledge of the financial position of the business: The financial position of the
firm can be ascertained at the end of each period, through the preparation of balance sheet.
vi) Full details for purposes of control: This system permits accounts to be prepared or
kept in as much detail as necessary and, therefore, affords significant information for purposes
of control etc.
vii) Comparative study is possible: Results of one year may be compared with those of
the precious year and reasons for the change may be ascertained.
viii) Helps management in decision making: The management may be also to obtain
good information for its work, especially for making decisions.
ix) No scope for fraud: The firm is saved from frauds and misappropriations since full
information about all assets and liabilities will be available.
1.5 Meaning of Debit and Credit

The term ‘debit’ is supposed to have derived from ‘debit’ and the term ‘credit’ from
‘creditable’. For convenience ‘Dr’ is used for debit and ‘Cr’ is used for credit. Recording of
transactions require a thorough understanding of the rules of debit and credit relating to accounts.
Both debit and credit may represent either increase or decrease, depending upon the nature of
account.
1.6 Types of Accounts and Its Rules

The object of book-keeping is to keep a complete record of all the transactions that place
in the business. To achieve this object, business transactions have been classified into three
categories:
(i) Transactions relating to persons.
(ii) Transactions relating to properties and assets
(iii) Transactions relating to incomes and expenses.
The accounts falling under the first heading are known as ‘personal Accounts’.
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The accounts falling under the second heading are known as ‘Real Accounts’, The accounts
falling under the third heading are called ‘Nominal Accounts’.
The accounts can also be classified as personal and impersonal.
1.6.1 Personal Accounts

Accounts recording transactions with a person or group of persons are known as personal
accounts. These accounts are necessary, in particular, to record credit transactions. Personal
accounts are of the following types:
(a) Natural persons: An account recording transactions with an individual human being
is termed as a natural persons’ personal account. eg., Kamal’s account, Mala’s account, Sharma’s
accounts. Both males and females are included in it.
(b) Artificial or legal persons: An account recording financial transactions with an artificial
person created by law or otherwise is termed as an artificial person, personal account, e.g.
Firms’ accounts, limited companies’ accounts, educational institutions’ accounts, Co-operative
society account.
(c) Groups/Representative personal Accounts: An account indirectly representing a

person or persons is known as representative personal account. When accounts are of a similar
nature and their number is large, it is better tot group them under one head and open a
representative personal accounts. e.g., prepaid insurance, outstanding salaries, rent, wages
etc.
When a person starts a business, he is known as proprietor. This proprietor is represented

by capital account for all that he invests in business and by drawings accounts for all that which
he withdraws from business. So, capital accounts and drawings account are also personal
accounts.
The rule for personal accounts is:
Debit the receiver
Credit the giver
1.6.2 Real Accounts

Accounts relating to properties or assets are known as ‘Real Accounts’, A separate account
is maintained for each asset e.g., Cash Machinery, Building, etc., Real accounts can be further
classified into tangible and intangible.
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(a) Tangible Real Accounts: These accounts represent assets and properties which can
be seen, touched, felt, measured, purchased and sold. e.g. Machinery account Cash account,
Furniture account, stock account etc.
(b) Intangible Real Accounts: These accounts represent assets and properties which
cannot be seen, touched or felt but they can be measured in terms of money.
e.g., Goodwill accounts, patents account, Trademarks account, Copyrights account, etc.
The rule for Real accounts is:
Debit what comes in
Credit what goes out
1.6.3 Nominal Accounts
Accounts relating to income, revenue, gain expenses and losses are termed as nominal
accounts. These accounts are also known as fictitious accounts as they do not represent any
tangible asset. A separate account is maintained for each head or expense or loss and gain or
income. Wages account, Rent account Commission account, Interest received account are
some examples of nominal account The rule for Nominal accounts is:
Debit all expenses and losses
Credit all incomes and gains
1.7 Distinction between Book-Keeping and Accounting

The difference between book-keeping and accounting can be summarized in a tabular
from as under:
Basis of difference Book-keeping Accounting
Transactions Recording of transactions To examine these recorded

in books of original entry. transactions in order to find out their
accuracy.
Posting To make posting in ledger To examine this posting in order to

ascertain its accuracy
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Total and Balance To make total of the amount To prepare trial balance with the help
in journal and accounts of balances of ledgeraccounts.
of ledger. To ascertain
balance in all the accounts.
Income Statement Preparation of trading, Preparation of trading, profits and

and Balance Sheet Profit & loss account loss account and balance sheet is
and balance sheet is not included in it.
book keeping
Rectification oferrors These are not included These are included in accounting.
in book-keeping
Special skill and It does not require any It requires special skill and
knowledge special skill and knowledge knowledge.
as in advanced countries
this work is done by
machines.
Liability A book-keeper is not An accountant is liable for the work

liable for accountancy of bookkeeper.
work.
1.8 Branches of Accounting

The changing business scenario over the centuries gave rise to specialized branches of
accounting which could cater to the changing requirements. The branches of accounting are;
i) Financial accounting;
ii) Cost accounting; and
iii) Management accounting.
Now, let us explain these terms.
1.8.1 Financial Accounting

The accounting system concerned only with the financial state of affairs and financial
results of operations is known as Financial Accounting. It is the original form of accounting. It is
mainly concerned with the preparation of financial statements for the use of outsiders like
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creditors, debenture holders, investors and financial institutions. The financial statements i.e.,
the profit and loss account and the balance sheet, show them the manner in which operations
of the business have been conducted during a specified period.
1.8.2 Cost Accounting
In view of the limitations of financial accounting in respect of information relating to the
cost of individual products, cost accounting was developed. It is that branch of accounting
which is concerned with the accumulation and assignment of historical costs to units of product
and department, primarily for the purpose of valuation of stock and measurement of profits.
Cost accounting seeks to ascertain the cost of unit produced and sold or the services rendered
by the business unit with a view to exercising control over these costs to assess profitability and
efficiency of the enterprise. It generally relates to the future and involves an estimation of future
costs to be incurred. The process of cost accounting based on the data provided by the financial
accounting.
It is an accounting for the management i.e., accounting which provides necessary

information to the management for discharging its functions.
1.8.3 Management Accounting
According to the Anglo-American Council on productivity, “Management accounting is
the presentation of accounting information is such a way as to assist management in the creation
of policy and the day-to-day operation of an undertaking.” It covers all arrangements and
combinations or adjustments of the orthodox information to provide the Chief Executive with
the information from which he can control the business e.g. Information about funds, costs,
profits etc. Management accounting is not only confined to the area of cost accounting but also
covers other areas (such as capital expenditure decisions, capital structure decisions, and
dividend decisions) as well.
1.9 Summary
Accounting is an important function in all the organizations. Accounting is often called the
language of business. The basic function of any language is to serve as a means of
communication. Accounting also serves this function. In all activities (whether business activities
or non-business activities) and in all organizations (whether business organizations like a
manufacturing entity or trading entity or non-business organizations like schools, colleges,
hospitals, libraries, clubs, temples, political parties, etc) which require money and other economic
resources, accounting is required to account for these resources. In other words, wherever
money is involved, accounting is required to account for it. The types of account's are explained
in this lesson.
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1.10 Key Words

Accounting
Book Keeping
Credit
Debit
Nominal Accounts
Personal Accounts
Real Accounts

1. What is accounting? Explain its Objectives.
2. What is Book Keeping?
3. Explain the Branches of Accounting.
4. Bring out the advantages of Double Entry System.
5. Narrate about the Limitations of Accounting.
6. State the differences between Book keeping and Accounting.

Pearson, 2012.
2. Khan, M.Y. and Jain, P.K., Management Accounting: Text, Problems and Cases, 5thEdition,
Tata McGraw Hill Education Pvt. Ltd., 2009.
4. Horngren, C.T., Sundem, G.L., Stratton, W.O., Burgstahler, D. and Schatzberg, J., 14 th
Edition, Pearson, 2008.
5. Noreen, E., Brewer, P. and Garrison, R., Managerial Accounting for Managers, 13th Edition,
Tata McGraw-Hill Education Pvt. Ltd., 2009.
6. Rustagi, R. P., Management Accounting, 2nd Edition, Taxmann Allied Services Pvt. Ltd,
2011.
16
LESSON 2
PRINCIPLES OF ACCOUNTING
Learning Objectives
After reading this lesson, you will be able to
 Highlight various Principles of Accounting.
 Explain the Accounting Conventions
 List out Rules of Accounting
Structure
2.1 Introduction
2.2 Accounting Concepts and Conventions
2.2.1 Accounting Concepts
2.2.2 Accounting Conventions
2.3 Accounting Equation
2.3.1 Rules of Accounting Equation
2.4 Summary
2.5 Key Words
2.1 Introduction
The word ‘Principle’ has been differently viewed by different schools of thought. The
American Institute of Certified Public Accountants (AICPA) has viewed the word ‘principle’ as a
general law of rule adopted or professed as a guide to action; a settled ground or basis of
conduct of practice” Accounting principles refer, to certain rules, procedures and conventions
which represent a consensus view by those indulging in good accounting practices and
procedures. Canadian Institute of Chartered Accountants defined accounting principle as “the
body of doctrines commonly associated with the theory and procedure of accounting, serving
as an explanation of current practices as a guide for the selection of conventions or procedures
17
where alternatives exist. Rules governing the formation of accounting axioms and the principles
derived from them have arisen from common experiences, historical precedent, statements by
individuals and professional bodies and regulations of Governmental agencies”. To be more
reliable, accounting statements are prepared in conformity with these principles. If not, chaotic
conditions would result. But in reality as all the businesses are not alike, each one has its own
method of accounting. However, to be more acceptable, the accounting principles should satisfy
the following three basic qualities, viz., relevance, objectivity and feasibility.
The accounting principle is considered to be relevant and useful to the extent that it
increases the utility of the records to its readers. It is said to be objective to the extent that it is
supported by the facts and free from personal bias. It is considered to be feasible to the extent
that it is practicable with the least complication or cost. Though accounting principles are denoted
by various terms such as concepts, conventions, doctrines, tenets, assumptions, axioms,
postulates, etc., it can be classified into two groups, viz., accounting concepts and accounting
conventions.
2.2 Accounting Concepts and Conventions

2.2.1 Accounting Concepts
The term ‘concept’ is used to denote accounting postulates, i.e., basic assumptions or
conditions upon the edifice of which the accounting super-structure is based. The following are
the common accounting concepts adopted by many business concerns.
1. Business Entity Concept
2. Money Measurement Concept
3. Going Concern Concept
4. Dual Aspect Concept
5. Periodicity Concept
6. Historical Cost Concept
7. Matching Concept
8. Realisation Concept
9. Accrual Concept
10. Objective Evidence Concept

18
1. Business Entity Concept: A business unit is an organization of persons established

to accomplish an economic goal. Business entity concept implies that the business unit is
separate and distinct from the persons who provide the required capital to it. This concept can
be expressed through an accounting equation, viz., Assets = Liabilities + Capital. The equation
clearly shows that the business itself owns the assets and in turn owes to various claimants. It
is worth mentioning here that the business entity concept as applied in accounting for sole
trading units is different from the legal concept. The expenses, income, assets and liabilities not
related to the sole proprietorship business are excluded from accounting. However, a sole
proprietor is personally liable and required to utilize non-business assets or private assets also
to settle the business creditors as per law. Thus, in the case of sole proprietorship, business
and non-business assets and liabilities are treated alike in the eyes of law. In the case of a
partnership, firm, for paying the business liabilities the business assets are used first and it any
surplus remains thereafter, it can be used for paying off the private liabilities of each partner.
Similarly, the private assets are first used to pay off the private liabilities of partners and if any
surplus remains, it is treated as part of the firm’s property and is used for paying the firm’s
liabilities. In the case of a company, its existence does not depend on the life span of any
shareholder.
2. Money Measurement Concept: In accounting all events and transactions are recode
in terms of money. Money is considered as a common denominator, by means of which various
facts, events and transactions about a business can be expressed in terms of numbers. In
other words, facts, events and transactions which cannot be expressed in monetary terms are
not recorded in accounting. Hence, the accounting does not give a complete picture of all the
transactions of a business unit. This concept does not also take care of the effects of inflation
because it assumes a stable value for measuring.
3. Going Concern Concept: Under this concept, the transactions are recorded assuming
that the business will exist for a longer period of time, i.e., a business unit is considered to be a
going concern and not a liquidated one. Keeping this in view, the suppliers and other companies
enter into business transactions with the business unit. This assumption supports the concept
of valuing the assets at historical cost or replacement cost. This concept also supports the
treatment of prepaid expenses as assets, although they may be practically unsaleable.
4. Dual Aspect Concept: According to this basic concept of accounting, every transaction
has a two-fold aspect, Viz., 1.giving certain benefits and 2. receiving certain benefits. The basic
19
principle of double entry system is that every debit has a corresponding and equal amount of
credit. This is the underlying assumption of this concept. The accounting equation viz., Assets
= Capital + Liabilities or Capital = Assets – Liabilities, will further clarify this concept, i.e., at any
point of time the total assets of the business unit are equal to its total liabilities. Liabilities here
relate both to the outsiders and the owners. Liabilities to the owners are considered as capital.
5. Periodicity Concept: Under this concept, the life of the business is segmented into
different periods and accordingly the result of each period is ascertained. Though the business
is assumed to be continuing in future (as per going concern concept), the measurement of
income and studying the financial position of the business for a shorter and definite period will
help in taking corrective steps at the appropriate time. Each segmented period is called
“accounting period” and the same is normally a year. The businessman has to analyse and
evaluate the results ascertained periodically. At the end of an accounting period, an Income
Statement is prepared to ascertain the profit or loss made during that accounting period and
Balance Sheet is prepared which depicts the financial position of the business as on the last
day of that period. During the course of preparation of these statements capital revenue items
are to be necessarily distinguished.
6. Historical Cost Concept: According to this concept, the transactions are recorded in
the books of account with the respective amounts involved. For example, if an asset is purchases,
it is entered in the accounting record at the price paid to acquire the same and that cost is
considered to be the base for all future accounting. It means that the asset is recorded at cost
at the time of purchase but it may be methodically reduced in its value by way of charging
depreciation. However, in the light of inflationary conditions, the application of this concept is
considered highly irrelevant for judging the financial position of the business.
7. Matching Concept: The essence of the matching concept lies in the view that all
costs which are associated to a particular period should be compared with the revenues
associated to the same period to obtain the net income of the business. Under this concept, the
accounting period concept is relevant and it is this concept (matching concept) which necessitated
the provisions of different adjustments for recording outstanding expenses, prepaid expenses,
outstanding incomes, incomes received in advance, etc., during the course of preparing the
financial statements at the end of the accounting period.
8. Realization Concept: This concept assumes or recognizes revenue when a sale is

made. Sale is considered to be complete when the ownership and property are transferred
20
from the seller to the buyer and the consideration is paid in full. However, there are two exceptions
to this concept, viz., 1. Hire purchase system where the ownership is transferred to the buyer
when the last instalment is paid and 2. Contract accounts, in which the contractor is liable to pay
only when the whole contract is completed, the profit is calculated on the basis of work certified
each year.
9. Accrual Concept: According to this concept the revenue is recognized on its realization
and not on its actual receipt. Similarly the costs are recognized when they are incurred and not
when payment is made. This assumption makes it necessary to give certain adjustments in the
preparation of income statement regarding revenues and costs. But under cash accounting
system, the revenues and costs are recognized only when they are actually received or paid.
Hence, the combination of both cash and accrual system is preferable to get rid of the limitations
of each system.
10. Objective Evidence Concept: This concept ensures that all accounting must be
based on objective evidence, i.e., every transaction recorded in the books of account must
have a verifiable document in support of its, existence. Only then, the transactions can be
verified by the auditors and declared as true or otherwise. The verifiable evidence for the
transactions should be free from the personal bias, i.e., it should be objective in nature and not
subjective. However, in reality the subjectivity cannot be avoided in the aspects like provision
for bad and doubtful debts, provision for depreciation, valuation of inventory, etc., and the
accountants are required to disclose the regulations followed.
2.2.2 Accounting Conventions
The following conventions are to be followed to have a clear and meaningful information
and data in accounting:
i) Consistency: The convention of consistency refers to the state of accounting rules,

concepts, principles, practices and conventions being observed and applied constantly, i.e.,
from one year to another there should not be any change. If consistency is there, the results
and performance of one period can he compared easily and meaningfully with the other. It also
prevents personal bias as the persons involved have to follow the consistent rules, principles,
concepts and conventions. This convention, however, does not completely ignore changes. It
admits changes wherever indispensable and adds to the improved and modern techniques of
accounting.
21
ii) Disclosure: The convention of disclosure stresses the importance of providing accurate,
full and reliable information and data in the financial statements which is of material interest to
the users and readers of such statements. This convention is given due legal emphasis by the
Companies Act, 1956 by prescribing formats for the preparation of financial statements. However,
the term disclosure does not mean all information that ne desires to get should be included in
accounting statements. It is enough if sufficient information, which is of material interest to the
users, is included.
iii) Conservatism: In the prevailing present day uncertainties, the convention of

conservatism has its own importance. This convention follows the policy of caution or playing
safe. It takes into account all possible losses but not the possible profits or gains. A view opposed
to this convention is that there is the possibility of creation of secret reserves when conservatism
is excessively applied, which is directly opposed to the convention of full disclosure. Thus, the
convention of conservatism should be applied very cautiously.
2.3 Accounting Equation

As indicated earlier, every business transaction has two aspects. One aspect isdebited
otheraspect is credited. Both the aspects have to be recorded in accountsappropriately. American
Accountants have derived the rules of debit and creditthrough a ‘novel’ medium, i.e.,
accountingequation. The equation is as follows:
Assets = Equities
The equation is based on the principle that accounting deals with property and rights to
property and the sum of the properties owned is equal to the sum of the rights to the properties.
The properties owned by a business are called assets and the rights to properties are known as
liabilities or equities of the business. Equities can be subdivided into equity of the owners which
is known as capital and equity of creditors who represent the debts of the business know as
liabilities. These equities may also be called internal equity and external equity. Internal equity
represents the owner’s equity in the assets and external represents he outsider’s interest in the
asset. Based on the bifurcation of equity, the accounting equation can be restated as follows:
Assets = Liabilities + Capital

(Or)
Capital = Assets – Liabilities
(Or)
Liabilities = Assets – Capital.
22
2.3.1 Rules of Accounting Equation
Following rules help in making the accounting equation:
 Assets: If there is increase in assets, this increase is debited in assets account. If

there is decrease in assets, this decrease credited in assets account.
 Liabilities: When liabilities are increase, outsider’s equities are credited and when
liabilities are decreased, outsider’s equities are debited.
 Capital: When capital is increased, it is credited and when capital is withdrawn, it is

debited.
 Expenses: Owner’s equity is decreased by the amount of revenue expenses.
 Income or Profits: Owner’s equity is increased by the amount of revenue income.
2.4 Summary
The word ‘Principle’ has been differently viewed by different schools of thought. The
American Institute of Certified Public Accountants (AICPA) has viewed the word ‘principle’ as a
general law of rule adopted or professed as a guide to action; a settled ground or basis of
conduct of practice” Accounting principles refer, to certain rules, procedures and conventions
which represent a consensus view by those indulging in good accounting practices and
procedures. Canadian Institute of Chartered Accountants defined accounting principle as “the
body of doctrines commonly associated with the theory and procedure of accounting, serving
as an explanation of current practices as a guide for the selection of conventions or procedures
where alternatives exist. Rules governing the formation of accounting axioms and the principles
derived from them have arisen from common experiences, historical precedent, statements by
individuals and professional bodies and regulations of Governmental agencies”. The accounting
concepts and conventions are explained in this lesson.
2.5 Key Words

Assets
Capital
Expenses
Income
Profits
23

1. Explain in detail about Accounting Concepts and Conventions.
2. What do you understand by ‘Money Measurement Concept’?
3. What is Business Entity Concept?
4. Write down the rules for Accounting Equation

Pearson, 2012.

2011.
24
LESSON 3
JOURNAL AND LEDGER
Learning Objectives
 List out the rules for passing Journal Entry
 Differentiate Trade Discount and Cash Discount
 Outline the differences between Journal and Ledger
Structure
3.1 Introduction
3.2 Rules of Journalizing
3.3 Points to be noted before Journalizing
3.4 Differences between Trade Discount and Cash Discount
3.5 Advantages of Journal
3.6 Limitations of Journal
3.7 Ledger
3.7.1 Rules of Ledger Account
3.7.2 Ledger Posting of Journal
3.7.3 Differences between Journal and Ledger
3.8 Illustrations
3.9 Summary
3.10 Key Words

25
3.1 Introduction
Journal is derived from the French word ‘Jour’ which means a day.
 Meaning: Journal means daily recorded. It is a book of original record where every
transaction is recorded in the first instance and then is posted to the ledger.
 Journal entry: The form in which it is recorded is called Journal entry.
 Journalizing: Recording or entering a transaction in the journal is known as

journalizing.
The specimen ruling of journal is given below:
Journal
Date Particulars L.F Amount (Dr) Amount (Cr)

Rs. Rs.
Name of the a/c to be debited.

Name of the a/c to be credited.
(Narration or explanation)
3.2 Rules of Journalizing

Based on Accounting Equation:
1) Increase in assets are debits, decrease in assets are credits.

2) Increase in liabilities are credit, decrease in liabilities are debit.
3) Increase in capital are credit, decrease in capital are debit.
4) Increase in profits are credit, decrease in profits are debit.
5) Increase in expenses are debit, decrease in expenses are credit.
Based on Traditional Approach
1. Debit the receiver, credit the giver.
2. Debit what comes in, credit what goes out.
3. Debit all expenses & losses, credit all incomes and gains.
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3.3 Points to be noted before Journalizing

1. Capital account: If the proprietor has introduced cash or goods or property in business,
it is known as capital. It should be debited to cash or stock of goods or property account and
credited to the proprietor’s capital account. It must be clearly understood that the entity of the
proprietor is totally different from the business.
2. Drawings account: If the proprietor has withdrawn cash or goods from the business
for his personal Or domestic use, it is called drawings .It should be debited to drawings account
and credited to cash or purchases account.
3. Cash / Credit transactions: When goods are purchased or sold for cash, it is known
as cash transaction. If goods are purchased or sold on credit, then it will be accredit transaction.
If nothing is mentioned whether it is a credit or cash transaction, then it should be treated as a
credit transaction.
4. Casts and Carry forwards: When journal entries extend to several pages of the journal,
the total are cast done) at the end of each page. AT the end of each page the words “Total C/F
(carried forward) are written in the particulars column against the debit and credit totals .At the
end of the specified period or on the last page, the grand total is cast.
5. Goods given away as charity: If some goods from the business are given away as
charity to a particular person or Institution, it should be debited to charity account and credited
to purchases Account.
6. Compound journal entry:If there are two or more transactions of a similar nature
occurring on the same day and either debit or credit amount is common, such transactions can
be convenientlyRecorded in the form of one journal entry instead of making a separate entry for
each transaction. Such entry is known as compound journal entry.
7. Opening Entry:The balances of the previous year are brought forward in the beginning
of the year by means of an entry in a going concern. Such entry is made on the basis of
accounting equation that is by debiting all assets and crediting liabilities and capital account.
8. Cash Discount:This discount is allowed by a credit to a debit when the latter pays the
amount of goods purchased by him either immediately or within a specified period. It is an
incentive given to a debtor for making an early payment. Being a nominal account discount
allowed is debited and discount received credited.
27
Example:
1. Cash received from Mahesh Rs.1900 and allowed him discount Rs.100.
Cash a/c Dr 1900
Discount a/c Dr 100
To Mahesh’s a/c 2000
2. Paid to Suresh Rs.20, 000. Less 2% cash discount.
Suresh a/c Dr. 20000
To cash a/c 19600
To discount a/c 400
9. Trade discount: It is a deduction on the gross value are list price of goods allowed by
the manufacturer to the wholesaler or a wholesaler to a retailer in order to enable them to sell
the goods further at list price to the consumer and yet earn a profit.
10. Purchase of shares: When shares or securities are purchased, the entry is made at
market value and not at face value. Brokerage paid on the purchase of such investment is also
added in the amount of investment.
11. Sale of shares: If sale or securities are sold, the entry should be passed at market
value less brokerage, if any, paid on such shares.
12. Expenses incidental to the purchase of fixed assets:If some expenses are incurred
on the purchase of a fixed asset, these should be added to the cost of the asset to the buyer.
Such expenses should be debited to the asset account and not to any expense account. Thus
installation charges paid on the purchase of machinery are debited to machinery account.
13. Insurance of life policy:Premium paid on the proprietor’s life insurance policy is
debited to drawings account and not to insurance premium account. It is a personal expense
and not relating to the operation of the business.
14. Carriage paid on buyer’s account:When goods are sold and carriage /freight etc is
paid on buyer’s behalf, it should be debited to buyer’s personal account and not to carriage/
freight account.debited to interest account and credited to loan account.
28
15. Goods distributed as free samples: If goods are distributed as free samples to
promote the sale of the business. It should be debited to Davi account and credited to Purchases
account.
16. Bad Debts: When an amount is irrecoverable from a customer because of his
insolvency or otherwise, it is a loss for the business. It should be debited to bad debts account
and credited to customer account.
17. Interest due to loans: When a loan is taken from a person and interest is yet to be
paid, it should be debited to interest account and credited to loan account.
18. Loss of stock by fire:If some stock is lost by fire, it should be debited to loss of stock
by fire and credited to purchases account. If any part of such loss is recoverable from insurance
company, it should be debited to insurance claim account and credited to loss of stock by fire
account.
19. Commission:It is the remuneration, which is given by an enterprise to an employee,

or an agent who is performing some services relating to purchase, sale, and collections and
other types of business transactions. Commission is a nominal account, when paid will be
debited as an expense and credited and received.
3.4 Differences between Trade Discount and cash Discount

Basis of Distinction Trade Discount Cash Discount
1.When allowed It is allowed on a certain It is allowed when payment is

Quantity being purchased made before a certain date.
or As a trade provide.
2. Purpose It is given to promote sales It is allowed to encourage early

cash payment.
3. Vary with It may vary with the quantity It may vary with the period within
of goods purchased. which the payment is to be made.
4. Entry in books. It is not recorded in the A separate account in the ledger

books of accounts. is maintained for such discount.
29
5. Deduction It is deducted from It is not deducted from the

the invoice. invoice.
6. When offered It is offered at the time of It is offered at the time of getting

sale or purchase. quick payment.
7. Form It is usually given in It may be given in % or in

percentage. It is given absolute figure.
on the list price or
catalogue price or
retail price.
3.5 Advantages of Journal

1. Chronological record of all transactions.
2. Permanent record.
3. Information of debit and credit and an explanation to it.
4. Reduces the error (since both transaction are written side by side).
5. Eliminates the need for a reliance on memory of the accounts keeper.
6. Journal provides information relating to the following aspects.
a. Credit sale and purchases.
b. Allowances received and supplied.
c. Losses by fire, earthquakes, theft, etc.
d. Depreciation.
e. Transactions with bank.
f. Income earned, expenses incurred.
g. Closing entries.
h. Transfer entries (Drawings account will be transferred to capital account at the end
of the trading period).
i. Renewal of bills, dishonor, etc.

30
3.6 Limitations of Journal

1. Too long.
2. Journal is unable to ascertain daily cash balance. (That is why cash transactions
are directly recorded in a separate cashbook so that daily cash balances may be
available).
3. Difficult to post each and every transaction from the journal to the ledger.
3.7 Ledger
A ledger account may be defined a summary statement of all the transactions relating a
person, asset, expenses or income, which have taken, place during a given period of time and
shows their net effect. Ledger is a register having a number of pages, which are numbered
consecutively. One account is usually assigned one page in the ledger
3.7.1 The ruling of each account in the ledger is as following
NAME OF THE ACCOUNT
Date Particulars J. F. Amount Date Particulars J.F. Amount

Rs. Rs.
To Name of By Name
credit Account. Debit account.
3.7.2 Ledger Posting of Journal
Every transaction is first recorded in the form of a journal entry. From the journal, it is
transferred to the concerned accounts in the ledger. This process of transferring the transactions
from the journal to the ledger is known as Posting.
While posting from the journal, the Dr. Account is debited and Cr. Account is credited and
the entry in each account indicates the account in which the corresponding entry appears.
31
Balancing of Accounts
Various accounts in the ledger are balanced with a view to propriety the final accounts.
The procedure of balancing accounts is as follows.
1. Take the total of the two sides of the account concerned.
2. Ascertain the difference between the totals of 2 sides.
3. Enter the difference in the amount column of the side showing less total writing
against the difference in the particulars column “ To Balance c/d” on the credit side
of the account.
4. The balance is brought forward at the beginning of the next period.
3.7.3 Differences between Journal and Ledger

1. The journal is a book of original entry while Ledger is the book of second entry.
2. In journal transactions are recorded in the chronological order whereas Ledger is a

book for analytical record.
3. In case of disperses, the journal as a book of source entry has greater weight as
legal evidence. For accounting purpose, ledger is the main source of information.
4. The journal is a subsidiary book. Ledger is the principal book of Account.
5. The unit of classification of data in the journal is the transaction. The unit of
classification of data in the ledger is the account. The processor of recording financial
transaction in the journal is called journalizing.
3.8 Illustrations
1. Journalize the following transactions
2005
Feb. 3 X commenced business with a capital of Rs.15,000
5 Purchased good Rs.6,000
7 Purchased goods on credit from S & Co. $3,000
10 Purchased furniture Rs.2,400
11 Sold goods Rs.3,900
15 Sold goods on credit to D Rs.2,250
32
20 Paid salaries Rs.960

25 Received commission Rs.75
26 Returned goods to S & Co. Rs.600.
27 Returned goods by D Rs.450
28 Received from D Rs.1,500
Paid to S & Co. Rs.1,800
X withdrew from business Rs.900
Charged depreciation on Rs.240
Borrowed from K Rs.1,500
Solution
Date Particular L.F Amount Amount
2005
Feb. 3 Cash a/c ................................................Dr. 15,000

Capital 15,000
(Being capital brought in)
5 Purchases a/c...........................................Dr. 6,000

Cash a/c 6,000
(Being goods purchased for cash)
7 Purchases a/c..........................................Dr. 3,000

S & Co. a/c 3,000
(Being goods purchased form S & Co on credit)
10 Furniture a/c............................................Dr. 2,400

Cash a/c 2,400
(Being furniture purchased for cash)
11 Cash a/c.................................................Dr. 3,900

Sales a/c 3,900
(Being goods sold for cash)
33
15 D Bros. a/c.............................................Dr. 2,250

Sales a/c 2,250
(Being goods sold on credit to D)
20 Salaries a/c............................................Dr. 960

Cash a/c 960
(Being salaries paid)
25 Cash a/c..................................................Dr. 75
Commission a/c 75
(Being commission received)
26 S & Co. a/c................................................Dr. 600

Purchases a/c Return 600
(Being goods returned to S & co.)
27 Sales Returns a/c....................................Dr. 450

D Bros. a/c 450
(Being goods returned by D Bros.)
28 Cash a/c..................................................Dr. 1,500

D Bros. a/c 1,500
(Being amount received from D Bros.)
“ S & Co. a/c............................................Dr. 1,800

Cash a/c 1,800
(Being amount paid to S & Co.)
“ Drawings a/c...........................................Dr. 900

Cash a/c 900
(Being amount paid to S & Co.)
“ Depreciation a/c......................................Dr. 240

Furniture a/c 240
(Being depreciation charged on furniture)
34
“ Cash a/c..................................................Dr. 1,500

K a/c 1,500
(Being amount borrowed from K)
2. Enter the following transactions in journal and post them into the ledger and also
prepare a Trial Balance
2005
Jan. 1 Mr. X started business with cash $80,000 and furniture $20,000.
Jan. 2 Purchased goods on credit worth $30,000 from Y.
Jan. 3 Sold goods for cash $16,000.
Jan. 4 Sold goods on credit to S for $10,000
Jan. 8 Cash received from S $9,800 in full settlement of his account.
Solution
Journal
Date Particulars L.F DR. Cr.

2005 Amount ($) Amount ($)
Jan. 1 Cash a/c 5 80,000

Furniture a/c 7 20,000
Capital a/c 9 1,00,000
(Owner invested cash and furniture)
Jan. 2 Purchases Account 11 30,000

Y 13 30,000
(Bought goods on credit)
35
Jan. 3 Cash a/c 5 16,000

Sales a/c 15 16,000
(Sold goods for cash)
Jan. 4 S a/c 17 10,000

Sales a/c 15 10,000
(Sold goods on credit)
Jan. 8 Cash a/c 5 9,800

Discount a/c 19 200
S a/c 17 10,000
(Cash received and discount allowed)
Ledger
Cash Account (No.5)
Date Balance
References J.R Debit Credit
2005 Dr. Cr.
Jan. 1 Capital a/c 5 80,000 80,000
Jan. 3 Sales a/c 5 16,000 96,000
Jan. 8 S a/c 5 9,800 105,800
Furniture Account (No.7)
Date References J.R Debit Credit Balance
2005 Dr. Cr.
Jan. 1 Capital a/c 5 20,000 20,000
capital Account (No.9)
2005 Dr. Cr.
Jan. 1 Cash a/c 5 80,000 80,000
Jan. 1 Furniture a/c 5 20,000 1,00,000

36
2005 Dr. Cr.
Jan. 1 Cash a/c 5 80,000 80,000
Jan. 1 Furniture a/c 5 20,000 1,00,000
Purchases Account (No.11)
2005 Dr. Cr.

Jan. 2 Y a/c 5 30,000 30,000
Y Account (No.13)
2005 Dr. Cr.
Jan. 2 Purchases a/c 5 30,000 30,000
Sales Account (No.15)
2005 Dr. Cr.
Jan. 3 Cash a/c 5 16,000 16,000
Jan. 4 S a/c 5 10,000 26,000
S Account (No.17)
2005 Dr. Cr.
Jan. 4 Sales a/c 5 10,000 10,000
Jan. 8 Cash a/c 5 9,800
Jan. 8 Discount a/c 5 200 Nil

37
Discount Account (No.19)
Date references J.R Debit Credit Balance
2005 Dr. Cr.
Jan. 8 S a/c 5 200 200
3.9 Summary
Journal means daily recorded. It is a book of original record where every transaction is
recorded in the first instance and then is posted to the ledger. The form in which it is recorded
is called Journal entry. Recording or entering a transaction in the journal is known as journalizing.
The differences between journal and ledger are also explained in this lesson.
3.10 Key words

Cash Discount
Journal
Ledger
Trade Discount

1. What is Journal?
2. How will you post the journal in to ledger?
3. What are the differences between journal and ledger?
4. Explain the advantages and limitations of Journal.
5. Journalize the following transactions in the books of Shankar & Co
1998
June 1 Karthik commenced business with Rs.20,000.
June 2 Paid into bank Rs.5,000.
June 3 Purchased Plant worth Rs.10,000 from Modi& Co.
June 4 Purchased goods worth Rs. 5,000 form Anwar.

38
June 6 Goods worth Rs.4,000 sold to Anbu
June 8 Sold goods worth Rs.2,000 for cash.
June 10 Goods returned by Anbu Rs.50.
June 15 Paid rent Rs.250.
June 18 Withdrawn from bank for office use Rs. 2,500.
June 20 Paid Salaries Rs.1,800.
June 25 Withdrawn for personal use Rs.250.
June 26 Goods returned to Anwar Rs.100.
June 27 Paid for office furniture Rs.1,500 by cheque.
June 28 Received Rs.3,900 cash from Anbu and discount allowed Rs.50.
June 29 Paid Anwar on account Rs.4,800 and discount allowed by him Rs.100

Pearson, 2012.

2011.
39
LESSON 4
SUBSIDIARY BOOKS
Learning Objectives
 Explain the different types of subsidiary books
 List out the merits arising out of maintaining subsidiary books
 How to handle subsidiary books
Structure
4.1 Introduction
4.2 Reasons for maintaining Subsidiary Books
4.3 Kinds of Subsidiary Books
4.3.1 Cash Book
4.3.2 Purchase Book
4.3.3 Sales Book
4.3.4 Purchase Returns book
4.3.5 Sales Returns Book
4.3.6. Bills Receivable Book
4.3.7 Bills Payment Book
4.3.8 Journal
4.4 Source Documents
4.5 Illustrations
4.6 Summary
4.7 Key Words

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4.1 Introduction
Journal is subdivided into various parts known as subsidiary books or subdivisions of
journal. Each one of the subsidiary books is a special journal and a book of original or prime
entry. There are no journal entries when records are made in these books. Recording the
transactions in a special journal and then in the ledger accounts is the practical system of
accounting which is also referred to as English System. Though the usual type of journal entries
are not passed in these sub-divided journals, the double entry principles of accounting are
strictly followed.
4.2 Reasons for Maintaining Subsidiary Books

The various reasons for maintaining the subsidiary books are as follows:
1. Economy in Labour: If the transactions are recorded in the books of accounts directly
it will consume less time than if the transactions are recorded in the journal and then posted to
the ledger.
2. More accuracy: There will be more accuracy in the books of accounts as entries are
made in total only and that too once in a month
3. Availability of Information: Additional information can be collected while maintaining

a subsidiary book. For e.g. Sales book can collect the information relating to the sales of different
areas or of different salesmen.
4. Maintenance of accounts If specialized books are kept it may be possible to avoid

maintenance of some account books. For e.g., the date of payment, cheque number, etc, can
be noted in the purchases book which will obviate the need of maintaining the creditors account.
5. Division of work: There will be division of accounting work, as instead of one journal
there will be so many subsidiary books.
6. Specialisation and Efficiency: When the work is divided among the accounting staff
and one person is required to do that work again and again, he becomes specialist of that work
and his efficiency also increases.
7. Facility in checking: The existence of separate books helps location of errors and
detection of frauds in case the trial balance does not agree.
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4.3 Kinds of Subsidiary Books

Entering in the journal and posting in the ledger involves tremendous work as each
transaction requires separate debit to the receiving account and a credit to the giving account
to bring into the record the two-fold aspect of each transaction. Thus when all the transactions
are recorded in the journal, the book become unwieldy to handle and the desired information to
be extracted from the books of accounts will be difficult to obtain readily and the daily cash
balances cannot be checked with accuracy. There, all cash transactions are recorded in a book
called the cashbook. By doing so daily cash & bank balance can be checked easily.
Now a days, the practice is to keep a separate subsidiary book to record transactions of
similar nature.
Subsidiary books
Subsidiary books or books of primary entry or original entry are those where business
transactions are recorded in the books in the first instance and then posted to the ledger from
these books.
There are different types of subsidiary books which are commonly used in any big business
concern. They are:
 Cash Book
 Purchases Book
 Sales Book
 Purchases Returns Books
 Sales Returns Books
 Bills Receivable Books
 Bills Payable Books
 Journal
4.3.1 Cash Book
Cashbook is maintained to record the transactions, relating to the receipts and payments
of cash. Cashbook is maintained for the following reasons:
(1) There are many transactions relating to cash
(2) To have control on cash to avoid the embezzlement of cash
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(3) To know the balance of each in hand or at bank
(4) To avoid the botheration of posting every item of receipt or payment of cash
individually to cash account in the ledger.
Is Cash book a Journal or a Ledger?
Cash book plays a dual role as a book of original entry as well as a ledger. It is a
subsidiary book because all cash transactions are first recorded in the cashbook and then from
the cashbook posted to various accounts in the ledger. The recording of transactions in the
cashbook takes the shape of a ledger account. As receipts of cash are entered on the debit side
and payments of cash on the credit side, so there is no need of cash account in the ledger.
Therefore Cashbook serves the purpose of a ledger account.
Kinds of Cashbook
There are three types of cashbooks given as follows:
1. Simple Cashbook
2. Two Column cashbook
3. Three Column Cashbook
1. Simple Cash Book
This makes a record of all the receipts and payments of cash. All cash received in the
form of coin, notes, cheques, postal orders, bank drafts or treasury notes will be recorded on
the debit side and payments on the credit side. The ruling of this type of cashbook is as follows:
Dr SIMPLE CASH BOOK Cr
Date Particulars R.N. LF Amount Date Particulars V.N L.F Amount

(Rs) (Rs)
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When cash is received, it is entered on the debit side of the Cashbook in the amount
column along with the name of the party paying the cash in the particular column. Receipts
number with which cash has been received by the cashier is also written in the R.N.(Receipt
Number) column. Similarly, cash paid is entered on the credit side of the Cashbook. Each
payment must be supported by a voucher and the voucher number is entered in the V.N.(Voucher
Number) column.
Balancing the CashBook
At regular periodic intervals, preferably daily, CashBook should be balanced like other
ledger accounts and the balance shown by it should be equal to cash in hand, if no mistake or
fraud has been committed. The cashbook should always show a debit balance (i.e., cash in
hand) because total cash paid can never exceed the opening balance plus cash received.
Posting of simple cashbook
Opening balance appearing on the debit side of the CashBook is not posted to any account
in the ledger as it comes in the Cashbook from the opening entry recorded in the journal. The
other transactions recorded on the debit side of the Cashbook are posted to the credit of the
respective accounts in the ledger to complete the second aspect of the entry as the first aspect
of the transaction has been covered by giving debit to Cash account in the cashbook itself.
Similarly entries appearing in the credit side of the cashbook are posted to the debit of the
respective accounts in the ledger.
2. Two (Double) column cashbook
When discount is allowed on the receipt of cash and discount is received when payment
is made to the suppliers it becomes desirable to add discount column along with cash on both
sides of the cashbook. There will be two columns i.e, for discount and cash on each side of the
cashbook and that is why it is known as Double or Two column cashbook. Discount column is
only a memorandum column and not based on the double entry system. Cash discount is
allowed by a creditor to a debtor when the latter pays the amount of goods purchased by him
either immediately or within a specified period. It is an incentive given to a debtor for making an
early payment.
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The ruling of Two column cashbook is as follows:
TWO (DOUBLE) COLUMN CASHBOOK
Date Particulars LF Discount Cash Particulars L.F Discount Cash

(Rs) (Rs) (Rs) (Rs)
Balancing
The cash column of such a cashbook is balanced in the same way as in simple cashbook.
Discount column of such cashbook on both sides will not be balanced but simply totals are
done.
Posting of Two Column Cashbook
The posting of cash columns will be same as that of simple cashbook. Each item of
discount allowed appearing on the debit side of the cashbook will be posted to the credit side of
the respective personal account and total of discount column should be posted on the debit
side of the Discount account with the words “To sundry accounts” or “Amount as per cashbook”.
Similarly, each item of discount received appearing on the credit side of the cashbook in the
discount column will be posted to the debit side of the respective personal account and total of
discount received column should be posted to the credit of Discount Account with the words “by
sundry Accounts” or “By Amount as per cashbook”.
3. Three column Cash Book
Nowadays payments are made to other parties by cheques. Similarly, we get cheques
from other parties for the amounts which are due from them. Under such circumstances, t is
desirable to add one more column for Bank on both the sides of the cashbook. Such cashbook
which has three columns i.e., for Discount, Cash and Bank on each side is called three column
cashbook. The specimen ruling of such cash Book is as follows:
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Dr.(Receipts) CASHBOOK Cr.(Payment)
Date Particulars LF Discount Cash Bank Date Particulars L.F. Discount Cash Bank
In such a cashbook, discount columns are memorandum columns and are not based on
double entry system. Cash columns represent cash account and must have debit balance.
Bank column may have debit or credit balance. If amount withdrawn is more than deposited in
the bank, it will have a credit balance or overdraft as per bank column of the cashbook.
The following are to be noted in connection with the three column cashbook:
(1) If a business is started, the amount brought in as capital into the business will be
written in cash column if cash is introduced and in the bank column if it is directly deposited into
the bank and in the particulars “ To Capital Account” will be written. If the opening balances are
brought, it will be written as “ To balance b/d” or “By Balance b/d” in case there is opening bank
overdraft in the bank column.
(2) Cash paid into bank: When cash is paid into bank, it should be debited to Bank
Account by entering the amount in the bank column on the debit side of the cashbook as “To
cash” and credited to Cash Account by entering the amount in the cash column on the credit
side of the Cashbook as “By Bank” to record the fact of cash having gone out of the business.
This transaction needs no posting in the ledger as both accounts (i.e,. Cash account & Bank
account) involved appear in the CashBook, so letter “C” is written in the L.F. column against this
entry on each side of the Cashbook to indicate that the contra effect of this transaction is
recorded on the opposite side. Such type of entry appearing both the sides of the Cashbook is
known as Contra entry.
(3) Cash withdrawn from Bank: When cash is withdrawn from bank for office use, the
entry would be to debit Cash account by entering the amount in the cash column on the receipt
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side of the CashBook as “To Bank” and to credit the bank column as “By Cash”. No posting in
the ledger is required for this transaction as both accounts (Cash account & Bank account)
involved appear in the Cashbook.
(4) Receipt of Cheque: If a cheque is received and kept in the cash box (i.e., not sent to
the bank for collection), it should be debited in the cash column, but if it is immediately sent to
the bank for collection, the debit should be given in the bank column. Later on when cheque
kept in the cash box is sent to the bank for collection, contra entry will be recorded in the
cashbook by giving debit to the bank column recording the fact of cheque coming to the bank
and credit to cash column indicating that cheque has gone out of office.
(5) Payment by cheque: Such payments should be credited in the bank column of the
cashbook.
(6) Dishonouredcheque: If a cheque sent to the bank for collection is dishonoured, it

should be credited in the bank column of the Cash Book to cancel the previous debit given to
the bank column when the cheque was deposited in the bank.
(7) Bank charges and payments made by the bank on behalf of the customer: These
entries should be entered in the bank column on the credit side of the Cashbook as they reduce
the balance at bank.
Posting of Three Column CashBook

(1) Opening balances of cash and bank columns are not posted to any account as they
come in the Cashbook from the opening entry in the journal.
(2) Contra entry are not posted to any account as the dual aspect in respect of them
has been complied in the Cashbook itself.
(3) Remaining items appearing in the Cashbook and totals of discount columns are
posted in the same way as in the cash of Two column cashbook.
Petty Cash Book
In order to record small payments on account of expenses like carriage, cartage, coolie
hire, postage, refreshment to customer’s etc., a separate book called “ Petty Cash Book” is
maintained. The person maintaining the petty cashbook is known as petty cashier. All small
payments to be made by cash are recorded in the Petty Cash Book.
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In this, a separate column for each usual head of expenditure is provided. This book is
also known as Analytical Petty Cash Book because the various small cash payments get
automatically analysed when they are entered in their respective columns.
Ruling of Petty Cash Book
The specimen ruling of the Petty Cashbook is as follows:
Dr. PETTY CASHBOOK Cr.
Cash Date Particulars VR.No Total Stationery Cartage Postage Conveyane Sundry
Recd. & Printing &Tele gram expenses
While maintaining a petty cashbook, the following points are to be noted:
(1) The amount fixed for petty cash should be sufficient so that small payments for a
relatively fixed period say for a week or a fortnight or a month may be easily met out of that
amount.
(2) The amount to be reimbursed to the petty cashier must be supported by the vouchers
along with a statement of total payments.
(3) All vouchers should be filled in order.
(4) The petty cashier should be authorized to make payment upto a certain limit. No
payment should be made by the petty cashier without the consent of the head cashier, if the
amount is more than the specified limit.
(5) The petty cashier should not receive any cash except for reimbursement of small
payments.
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Advantages of petty cashbook
The following are the advantages of the petty cashbook:
(i) It saves time of the head cashier.
(ii) It will save the cashier time in writing up the cashbook and posting into the ledger.
(iii) It will provide control over small payments
(iv) It avoids the unnecessary details as it is convenient to post the total directly into the
ledger.
Posting of the Petty Cashbook
The petty Cashbook is just like the Cashbook. The amounts received by the petty cashier
from the main the cashier are entered on the debit side of the Petty Cashbook and payments on
the credit side of the Petty Cashbook. Every small payment is entered twice on the credit side
one in total payments column and second in one of the analytical amount columns. The periodic
total of each column is posted to the expenses accounts concerned, while the total of payments
column serves to fin out the balance of cash with the petty cashier. Thus the posting of the Petty
Cashbook can be summarized as under:
(i) When cash is handed over to the Petty Cashier Petty Cash Account is debited and
Cash or Bank A/c is credited in the ledger.
(ii) When the Petty cashbook is closed periodically each one of the totals of analysis
columns is debited to the respective nominal account and credited to the Petty Cash Account in
the ledger.
(iii) The balance of the Petty Cash Account, if any, is carried over to the Balance Sheet.
Maintenance of Petty Cashbook
Petty cashbook can be maintained as follows:
(1) Petty Cashbook as Memorandum: Memorandum accounts are kept only for the
sake of memory and the do not form part of the Double entry system. Petty Cashbook when
kept as memorandum also does not form part of the Double entry system. There are two
alternative treatments when Petty Cashbook is kept as memorandum. The amount in the
beginning, which is given by the cashier to the petty cashier, is debited to the Petty Cash
Account and credited to the main Cashbook. The double entry of this aspect is compete. But for
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all practical purposes the amount received is debited in the Petty Cashbook which is nothing
but a memorandum entry in the Petty Cashbook. When expenses incurred by the Petty cashier
are reimbursed to him by the imprest system, the main cashbook is credited and the individual
expenses accounts debited. The amount in the Petty Cash Account is not touched and the
balance is shown as asset in the Balance sheet.
(2) Petty Cashbook as a Journal: When Petty Cashbook is maintained on double entry
system or as a journal then both is credit and debit aspects are recorded.
4.3.2 Purchases Book

This book is kept to record all credit purchases of goods for resale. All the goods purchased
on credit is entered in the purchases book. Cash purchases are entered in the Cashbook, so
these are not recorded in the purchases book. This book is also known as the Invoice book.
The ruling of the purchases book is as follows:
PURCHASES BOOK
Date Particulars Invoice No. L.F Details Amount (Rs.)
In particular column, name of the party and particulars of the goods purchased are written.
While preparing this book, it should be remembered that:
(i) Cash purchases are not entered in this book because these are recorded in the
Cashbook.
(ii) Credit purchases of trading goods should be recorded in this book. Purchases of
assets as office furniture, equipment etc are not entered in this book
Multi Column purchases book
Sometimes it is required to analyse the purchases of different types of goods or materials

purchased and to maintain separate accounts for these goods in the ledger. In order to meet
this requirement additional columns can be provided in the purchases book. Then this book is
known as “Columnar Purchases Book.” A Specimen of such a book is given as under:
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COLUMNAR PURCHASES BOOK
Date Supplier’s Invoice No. L.F. Total Cloth

Name & Amount Cotton Woolen Silk
address
Posting of purchases book
Each supplier’s account is individually credited in the ledger with the amount of goods
purchased from him because he is the giver of goods. The periodical total of the Purchases
book is posted to the debit of the Purchases Account with the words “To sundries as per Purchases
Book”.
4.3.3 Sales Book
For each credit sale, the selling firm will send a document to the buyer showing full details
of goods sold and the price of the goods. This document is known as an Invoice and to the
seller it is known as Sales Invoice. The seller will keep one or more copies of sales invoice for
his own use. The seller prepares the sales book from the sales invoice.
A specimen ruling of the sales book is gives below:
SALES BOOK
Date Particulars Invoice No. L.F. Details Rs. Amount Rs.

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Multi column sales book
When it is required to maintain a separate record of various types of goods sold and
information of total sales for each type of goods is also required, additional columns are provided
in the sales book. Such sales book is called “Multi Column Sales Book”.
A specimen of such book is given below:
COLUMNAR SALES BOOK
Date Customer’s Invoice No. L.F. Total Cloth

Name & Amount Cotton Woolen Silk
address
4.3.4. Posting of Sales Book
Each customer’s account is individually debited in the ledger with amount of goods sold
to him as he is the receiver of goods. The periodical total of the Sales book is posted to the
credit of Sales Account with the words “By Sundries as per Sales book”.
Purchase Returns Book
This book keeps a record of the returns outwards, that is, return of goods bought. The
person returning the goods sends debit note to the supplier informing him that he is debiting the
latter’s account with the amount of goods returned. This book is also known as Returns Outwards
Book.
Posting of Purchases Returns Book:Each supplier’s account is individually debited

with the value of goods returned to him and the periodical total of this book is credited to Return
Outwards Account or Purchases Returns Account as the goods go out.
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RETURNS OUTWARD BOOK
Date Particulars L.F. Amount Amount

(Rs.) (Rs.)
Good Less:
returns
outward
4.3.5 Sales Returns Book
Sales returns book, also known as Returns Inwards book, is kept for recording returns
inwards, that is, returns of goods sold by us. The trader sends a credit note to the customer
informing him that he has credited the latter’s account with the value of goods returned.
Posting Sales Returns Book: Each customer’s account is credited with the value of
goods returned by him. The periodical total of the book is debited to Return Inwards Account or
Sales Returns Account as returned goods enter the business.
RETURNS INWARDS BOOK
Date Particulars L.F. Amount Amount

(Rs.) (Rs.)
Good Less:
returns
inward
4.3.6 Bills Receivable Book
This book is used to record the full particulars of bills receivable drawn by the firm and
accepted by the drawees. Sometimes we also receive the bills endorsed in our favour. A specimen
of Bills Receivable Book is given below:
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BILLS RECEIVABLE BOOK
S.No Date From Drawer Acce Where Date Time Due L.F. Amount Remarks
Received Whom ptor Payable of bill date (Rs.)
From Bills Receivable book, the personal account of the party (Acceptor or Endorsee )
from whom the bill is received is credited and total of this book is posted to the debit of Bills
Receivable Account in order to complete the double entry.
4.3.7 Bill Payable Book
In this bills drawn by the suppliers or creditors and accepted by the firm are recorded. A
specimen of Bills payable book along with the two entries is given as under:
BILLS PAYABLE BOOK
S. Date To Payable Where Date of Time Due L.F Amount Remarks

No given Whom payable bill date (Rs)
given
4.3.8 Journal
Journal is used for recording only those transactions which cannot be recorded in any
other subsidiary books. Examples of such transactions are:
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1. Opening entries.
2. Transfer entries (Transfer from one account to another)
3. Adjusting entries.
4. Closing entries.
5. Entries related to rectification of errors.
6. Entries relating to dishonourof bills or promissory notes.
7. Withdrawal of goods by the proprietor for personal use or loss of goods by theft, fire
etc.,
8. Credit purchase or sale of assets.
9. Bad debts.
4.4 Source Documents

In order to record the transactions in the books of account source documents must be
there. These documents provide evidence of a business transaction. These documents include
cash memo, invoice, and receipt, pay in slip, cheque, debit note and credit note etc.,These
documents must be preserved till the accounts and tax assessment for the current period are
completed. A source documents also serves as legal evidence in case of dispute. Accounts
are debited or credited on the basis of these documents.
Cash Memo
When goods are sold or purchased for cash, the firm receives or gives cash memos,
which provide details regarding cash transactions. These documents become the basis for
recording these transactions in the books of accounts.
Invoice or Bill
This document is prepared when goods are sold or purchased on credit. A sale invoice is
prepared to record credit sales. It contains information such as Name of the party, description
of the goods sold, total amount of sales. The original copy is sent to the buyer and the duplicate
copy is kept as evidence of sales for future reference. Credit bills support purchases made from
various suppliers. One makes an invoice but receives a bill. Invoice and bill are interchangeable
and mean the same thing.
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Receipt
When a firm receives cash from customers it issues a receipt, which is a proof for receiving
cash. It is prepared in duplicate, the original copy is handed over to the party making payment
and the duplicate is kept as record for future reference. This document contains the details
such as date, amount, and name of the party and the nature of payment.
Pay In Slip
This is a form available from a bank for depositing cash or cheque in a bank account. The
cashier returns the counterfoil to the depositer after his signatures. Separate slips for depositing
cash and cheques are used in some banks. Generally, firms get these slips bound in a book so
that counterfoil remain in place and are not lost.
Cheque
It is a document in writing drawn upon a specified banker and payable on demand. The
name of the party to whom the payment is to be made is to be written after the words ‘pat to’.
The date of the cheque, the amount both in figures and words, signature of the drawer must be
filled in or done properly. The drawer must fill in the details also on the counterfoil for future
record. The counterfoil forms the source documents for entries to be made in the account
books.
Debit and Credit Notes
These notes are prepared when goods are returned to supplier or when an additional
amount is recoverable from a customer. For the party from whom the money is recoverable this
document becomes debit note and for the party who is to recover the amount the document
becomes credit note (usually in red ink). When a customer returns goods, a proper credit note
should be sent to him.
The decision as to which account is to be debited and which is to be credited is very

important in accounting and is generally taken by the Chief Accountant. Transactions are recorded
in the books of accounts on the basis of written documents in support of business transactions.
Though the transactions can be directly recorded in the ledger but in small businesses, the
transactions are firstly recorded in the journal and then these are posted to the ledger.
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4.5 Illustrations
1. Enter the following transactions in the cash book of Mr. Jamil:
2005 $
Jan. 1 Mr. Jamil started business with cash 2,00,000
Jan. 3 Bought goods for cash 1,40,000
Jan. 5 Paid for stationary 2,000
Jan. 7 Sold goods for cash 80,000
Jan. 10 Paid for trade expenses 2,000
Jan. 14 Received cash from Mr. Asif 10,000
Jan. 15 Paid cash to Mr. Qadir 20,000
Jan. 18 Withdrew cash for personal use 6,000
Jan. 22 Bought goods for cash 40,000
Jan. 27 Paid for electricity bill 4,000
Jan. 31 Paid salary 10,000
Jan. 31 Paid rent 3,000

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Solution
Date Particulars V.N. L.F. Amount ($) Date Particulars V.N. L.F. Amount ($)
2005 2005
Jan. 1 Capital A/C 200,000 Jan.3 Purchases A/C 140,000

(Being business (Being goods
started) bought for cash)
Jan.7 Sates A/C 80,000 Jan.5 Stationery A/C 2,000

(Being goods (Being stationary
sold) purchased)
Jan. 11 Sales A/C 20,000 Jan.10 Trade expenses 2,000

(Being goods (Being expenses
sold) paid)
Jan. 14 Mr. Asif A/C 10,000 Jan.15 Mr. Qadir A/C 20,000
(Being cash (Being cash
received) paid)
Jan. 25 Sales Aft 90,000 Jan.18 Drawing A/C 6,000

(Being goods (Cash drawn
sold) for personal use)
Jan.22 Purchase A/C 40,000

(Being goods
bought)
Jan.27 Electricity A/C 4,000

(Being bill paid)
Jan.31 Salary A/C 10,000

(Being salary paid)
Jan.31 Rent A/C 3,000

(Being rent paid)
Jan.31 Balance c/d 173,000

4,00,00
Feb. 1 Balance b/d 173,000 4,00,00

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2. Enter the following transactions in proper subsidiary books and post the same in the relevant
ledger accounts
2003 Rs.
Aug. 1 Bought goods from Ganga 2,500
Aug. 2 Sold goods to Kaveri 1,500
Aug. 5 Yamuna sold goods to us 1,500
Aug. 8 Krishna purchased goods from us 1,200
Aug. 11 Received goods returned by Kaveri 150
Aug. 13 Returned goods to Ganga 100
Aug. 17 Sold goods to Ponni 800
Aug. 22 Purchased goods from Sindhu 900
Aug. 27 Returned goods to Yamuna 150
Purchases Book
Date Particulars L.F. Inward Invoice Number Rs.

2003
Aug. 1 Ganga 2,500

Aug. 5 Yamuna 1,500
Aug. 22 Sindhu 900
4,900
Sales Book
Date Particulars L.F. Outward Invoice Number Rs.
2003
Aug. 2 Kavari 1,500

Aug. 8 Krishna 1,200
Aug. 17 Ponni 800
3,500
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Purchases Returns Books
Date Name of Supplier L.F. Debit Note Rs.

2003
Aug. 13 Ganga 100
Aug. 27 Yamuna 150
250
Sales Returns Books
Date Name of Customer L.F. Credit Note Rs.
2003
Aug. 11 Kaveri 150
150
4.6 Summary
Journal is subdivided into various parts known as subsidiary books or subdivisions of
journal. Each one of the subsidiary books is a special journal and a bookof original or prime
entry. There are no journal entries when records are made inthese books. Recording the
transactions in a special journal and then in the ledgeraccounts is the practical system of
accounting which is also referred to as English System.
4.7 Key Words

Bills payable Books
Bills Receivable Books
Cash Book
Purchase Book
Purchase Return Book

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Sales Book
Sales Return Book

1. Define Subsidiary Books.
2. Explain in detail about the merits of Subsidiary Books.
3. Evaluate the kinds of Subsidiary Books.
4. What are the types of Cash Book?
5. Write a note on Petty Cash Book.
6. Give a brief note on Purchase Book.
7. Enter the following transactions in the Purchases Book and post the same in the
relevant ledger accounts.
2001 Rs.
Aug. 1 Bought goods from Sivika 1,500

Aug. 4 Bought goods from Nithi 1,000
Aug. 8 Bought goods from Abi 500
8. Enter the following transactions in sales book and post the same in the relevant
ledger accounts.
2002 Rs.
Aug. 15 Sold goods to Prabhu 2,000

Aug. 18 Sold goods to Bala 1,500
Aug. 8 Sold goods to Mano 1,000

Pearson, 2012.
61

2011.
62
LESSON 5
TRIAL BALANCE
Learning Objectives
 Define trail balance
 List out the objectives of trial balance
 Discuss the features of Trail Balance
 Explain the Methods of preparing Trial Balance
Structure
5.1 Introduction
5.2 Trial Balance
5.2.1 Meaning
5.2.2 Definition
5.3 Objectives of Trial Balance
5.4 Features of Trial Balance
5.5 Limitations of Trial Balance
5.6 Preparation of Trial Balance
5.7 Errors disclosed by Trial Balance
5.8 Illustration
5.9 Summary
5.10 Key Words
5.1 Introduction
In the previous lessons, journals, ledgers and subsidiary books were discussed. In this
lesson, let us discuss trial balance. According to the dual aspect concept, the total of debit
balance must be equal to the credit balance. It is a must that the correctness of posting to the
ledger accounts and their balances be verified. This is done by preparing a trail balance.
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5.2 Trial Balance

5.2.1 Meaning
Trial balance is a statement prepared with the balances or total of debits and credits of all
the accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the name
indicates it is prepared to check the ledger balances. If the total of the debit and credit amount
columns of the trail balance are equal, it is assumed that the posting to the ledger in terms of
debit and credit amounts is accurate. The agreement of a trail balance ensure arithmetical
accuracy only, A concern can prepare trail balance at any time, but its preparation as on the
closing date of an accounting year is compulsory.
5.2.2 Definition
According to M.S. Gosav “Trial balance is a statement containing the balances of all
ledger accounts, as at any given date, arranged in the form of debit and credit columns placed
side by side and prepared with the object of checking the arithmetical accuracy of ledger postings”.
A trial balance may be defined as a statement of debit and credit totals or balances
extracted from the various accounts in the ledger with a view to test the arithmetical accuracy of
the books.
5.3 Objectives of Trial Balance

1. To have balances of all the accounts of the ledger in order to avoid the necessity of
going through the pages of the ledger to find it out.
2. To have a proof that the double entry of each transaction has been recorded because
of its agreement.
3. To have arithmetic accuracy of the books of accounts because of the agreement of

the trial balance.
4. Important conclusions can be derived by comparing the balances of two or more

than two years with the help of trail balances of those years.
5. It is a check on the accuracy of posting. If the trail balance agrees, it proves:

(a) That both the aspects of each transaction are recorded and
(b)That the books are arithmetically accurate.
6. It facilitates the preparation of profit and loss account and the balance sheet.
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5.4 Features of Trail Balance

The following are the important features of a trail balances:
(i) A trail balance is prepared as on a specified date.
(ii) It contains a list of all ledger account including cash account.
(iii) It may be prepared with the balances or totals of Ledger accounts.
(iv) Total of the debit and credit amount columns of the trail balance must tally.
(v) It the debit and credit amounts are equal, we assume that ledger accounts are
arithmetically accurate.
Difference in the debit and credit columns points out that some mistakes have been
committed.
(vii) Tallying of trail balance is not a conclusive profit of accuracy of accounts.
5.5 Limitations of Trail Balance

Trial balance can be prepared only in those concerns where double entry system of
accounting is adopted. This system is very costly and cannot be adopted by the small concerns.
1. Though trial balance gives arithmetic accuracy of the books of accounts but there are
certain errors balances is not a conclusive proof of the accuracy of the books of accounts.
2. If trial balance is not prepared correctly then the final accounts prepared will not reflect
the true and fair view of the state of affairs of the business whatever conclusions and decisions
are made by the various groups of persons sill not be correct and s\will mislead such persons.
5.6 Preparation of Trial Balance

A trial balance can be prepared by the following two methods:
1. Total Method: In this method, the debit and credit totals of each account are shown in
the two Amount columns (one for the debit total and the other for the credit total) against it.
2. Balance Method: In this method, the difference of each account is extracted. If debit
side of an account is bigger in amount than the credit side, the difference is out in the debit
column of the trial balance and if the credit side is bigger, the difference is written in the credit
column of the trial balance.
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Trial balance can be prepared on a sheet having four columns.
A specimen is given as follows:
TRIAL BALANCE OF ………
As on………
Serial Name of Dr. Cr.

No. the account Balance (or total) Balance (or total)
Rs. Rs.
Of the 2 methods of preparation the second is usually used in practice because it facilitates
the preparation of the final accounts.
5.7 Errors disclosed by Trial Balance

A) Trial Balance disclosed by the Errors
i) Wrong totaling of subsidiary books
ii) Posting of an amount on the wrong side
iii) Omission to post an amount into ledger
iv) Double posting or omission of posting
v) Posting wrong amount
vi) Error in balancing
B) Trail Balance not disclosed by the Errors
i) Error of principle
ii) Error of omission
iii) Errors of Commission
iv) Recording wrong amount in the books of original entry
v) Compensating errors
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5.8 Illustration
From the following transactions, pass journal entries, prepare ledger accounts and also
prepare Trial Balance under (i) Balance method (ii) Total method.
1. Anil started business with Rs.8,000
2. Purchased furniture Rs.1,000
3. Purchased goods Rs.6,000
4. Sold goods Rs.7,000
5. Purchased from Raja Rs.4,000
6. Sold to Somu Rs.5,000
7. Paid to Raja Rs.2,500
8. Received from Somu Rs.3,000
9. Paid rent Rs.200
10. Received commission Rs.100
I. Balance Method
Trial Balance as on
Dr. (Rs.) Cr. (Rs.)
Cash 8,400 -
Capital - 8,000
Furniture 1,000 -
Purchases 10,000 -
Sales - 12,000
Raja - 1,500
Somu 2,000 -
Rent 200 -
Commission received - 100
21,600 21,600
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II.Total Method
Trial balance as on…..
Dr. Cr.
Rs. Rs.
Cash 18,100 9,700

Capital - 8,000
Furniture 1,000 -
Purchases 10,000 -
Sales - 12,000
Raja 2,500 4,000
Somu 5,000 3,000
Rent 200 -
Commission received - 100
36,800 36,800
5.9 Summary
Trial balance is a statement prepared with the balances or total of debits and credits of all
the accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the name
indicates it is prepared to check the ledger balances. If the total of the debit and credit amount
columns of the trail balance are equal, it is assumed that the posting to the ledger in terms of
debit and credit amounts is accurate. The agreement of a trail balance ensure arithmetical
accuracy only, A concern can prepare trail balance at any time, but its preparation as on the
closing date of an accounting year is compulsory.
5.10 Key Words

Dual Aspect Concept
Subsidiary Books
Trial Balance

1. What is Trial Balance?
2. Explain the Objectives of Trial Balance
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3. State the Features of Trial Balance.

4. What are the Limitations of Trial Balance?
5. From the following ledger accounts of Sathiya, draw Trial Balance as on 31 st
December 2004.
Particulars Rs. Particulars Rs.

House Property 45,000 Repairs 1,200
Furniture 5,000 Rent Received 4,800
Utensils 6,000 Medical Expenses 1,200
Ornaments 25,000 School Free 1,800
Cash 630 Conveyance 1,350
Bank Balance: Cosmetics 1,150
Fixed Deposits 20,000 Interest Received 3,000
Savings Bank 3,500 House Building Loan from Govt. 20,000
Shares & Govt. Securities 12,000 Interest paid 1,870
Claims against persons 1,500 Municipal Taxes 3,000
Salary (Income) 24,000 Income tax 2,500
Servants wages 1,200 Accumulated Fund 88,300
Food and Drink 3,750
Dress and Clothing’s 2,450

Pearson, 2012.
2011.
69
LESSON 6
FINAL ACCOUNTS
Learning Objectives
 Prepare Trading account, Profit & Loss Account and Balance Sheet.
 Distinguish between Profit and Loss Account and Balance Sheet.
Structure
6.1 Introduction
6.2 Preparation of Final Accounts
6.2.1 Preparation of Trading Account
6.2.2 Preparation of Profit & Loss Account
6.2.3 Balance Sheet
6.3 Distinction between Profit & Loss Account and Balance Sheet
6.4 Illustrations
6.5 Summary
6.6 Key Words
6.1 Introduction
Two main objectives of maintaining accounts are to find out the profit or loss made by the
business at the end of regular periodic interval and to ascertain the financial position of the
business on a given date. Final accounts are prepared to achieve these objectives. In order to
know the profit or loss earned by a firm, Income statement or Trading and Profit & Loss accounts
is prepared. Balance sheet or Position statement will portray the financial condition of a firm on
a particular date.
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These two statements i.e Trading and Profit & loss account and Balance sheet are prepared
to give the final results of the business, that is why both these statements are collectively called
as final accounts. Thus final accounts include the preparation of
(1) Trading and Profit &loss account
(2) Balance Sheet.
Final accounts convey the concise picture of profitability and financial position of the
business. The preparation of the final accounts is not the first step in the accounting process
but they are the end products of the accounting process, which give a concise accounting
information of the accounting period after the accounting period is over.
Before preparing the Trading and Profit & Loss account it is desirable to know the concept
of income and how it is calculated. The concept of income is used in all organizations inspite of
the fact whether they exist to earn a profit or to render service to the members of the society. In
order to calculate the income accounting will be essential for all types of organizations such as
schools, hospitals, canteens, clubs, trading & industrial firms. Every organization’s main aim is
to utilize its resources to the maximum effort and to earn maximum income. Before knowing
the meaning of Business Income, it is desirable to know some other concepts.
6.2 Preparation of Final Accounts

6.2.1 Preparation of trading account
Cost of goods sold
In order to earn income in business some money will be spent on purchasing the goods
(if it is a trading concern) and expenses like freight, cartage, etc., will be incurred to bring the
goods to the shop. The cost of purchasing the goods plus expenses directly related to the
purchase of the goods is technically known as Cost of goods sold. Cost of goods sold will be
deducted from the Sales in order to calculate the Trading profit (also known as Gross profit or
Income).
Suppose a businessman purchases goods worth Rs.10, 000 and incurs Rs.50 for freight,
cartage etc to bring the goods to the shop. The Cost of goods sold will be Rs.10, 050. Suppose
further he is able to sell the goods for Rs.15,000 then gross profit will be calculated by deducting
the Cost of goods sold from the sales, i.e.,Rs.4,950 (15,000-10,050).
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But in actual practice, it may not be possible to sell all the goods which have been purchased
by the businessman and thus some goods may remain unsold and become closing stock at the
end of the period.
Suppose in the above example, goods sold were for Rs.12, 000 and goods remain unsold
for Rs.2, 000, then Cost of goods sold will be calculated as below:
Cost of goods sold = Purchases + Direct expenses – Closing Stock.
CGS = 10,000 + 50 – 2000 = Rs.8, 050.
And Gross profit will be
Gross profit = Sales – Cost of goods sold.
If some goods remain unsold at the end of the year and treated as closing stock of
that year, it will become the opening stock for the next year. The Cost of goods sold in such a
situation will be calculated as follows:
Cost of goods sold = Opening Stock + Purchases +Direct Expenses – closing stock
Gross profit may not give the correct picture of the working results of a concern. There
are many indirect expenses like salaries, office rent, postage, stationery, printing, electric charges,
advertisement, depreciation, bad-debts etc., which must be deducted from the net profit. Such
expenses are called operating expenses. These expenses are incurred to run the business day
to day and to maintain its operational efficiency.
Meaning of Some Basic Items
1. Cost of goods sold is the cost of acquiring the goods for sale i.e. its purchase price
plus the expenses incurred in bringing the goods to the shop with due adjustment of
opening stock and closing stock.
2. Gross Profit is the excess of Sales over the cost of goods sold.
3. Gross Loss is the excess of Cost of goods sold over Sales.
4. Operating expenses are those expenses which are incurred to run the business
day to day and to maintain its operational efficiency.
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5. Net Profit is the excess of Gross Profit over operating expenses. If there is any
other income to the business, that must be added in gross profit before deducting
the operating expenses. It is also known as Business Income.
6. Net Loss is the excess of operating expenses over gross profit and other incomes.
Trading and Profit and Loss Account
This account is made up of two accounts i.e. Trading Account and Profit and Loss Account.
Trading concern i.e., those concerns which purchase goods from one market and sell these in
another market at profit, prepare this account.
Trading Account: This account is prepared to know the trading results or gross margin
on trading of the business, i.e., how much gross profit the business has earned from buying
and selling during a particular period. The difference between the Sales and Cost of goods sold
is Gross Profit. For calculating the Cost of goods sold, opening stock, purchases, direct expenses
on purchasing or manufacturing the goods and closing stock are taken into consideration. The
balance of this account represents Gross Profit or Loss is transferred to the Profit and Loss
account. The specimen proforma of a Trading account is given below:
TRADING ACCOUNT
For the year ended 31st March ……………..
Particulars Amount (Rs) Particulars Amount(Rs)
To Opening Stock By Sales
To Purchases Less: Sales Returns
Less: Purchase By Closing Stock
Returns By Gross Loss c/d
To Direct Expenses
Carriage inward
Wages
Fuel and Power
Manufacturing
Expenses
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Coal, Water,Gas
Motive Power
Octroi
Import Duty
Custom Duty
Consumablestores
Foreman/ Works
Manager’s salary
Royalty on
Manufactured goods
Gross Profit c/d
 Balancing figure will be either Gross Profit or Gross Loss.
Details about the items to be posted to the debit side of Trading Account
I. Opening Stock: This is the amount of goods in hand at the beginning of the period for
which the trading account is prepared. The figure will be available in the Trial Balance. There
will be no opening stock in case of a new business. Opening Stock consist of Raw materials,
Work-in-progress and Finished goods.
II. Purchases: It includes both cash and credit purchases of goods which are for resale
purposes. Purchases returns and discount on purchases, if any should be deducted from
purchases in the inner column and only net purchases are shown in the outer column. Points to
be notes are:
(1) Goods purchased but in transitwill not affect the Trading Account. It is better to debit
the Goods in Transit Account and credit the Supplier’s account for such goods. Goods in
Transit Account appear as an Asset and Supplier’s Account as a liability in the Balance Sheet.
(2) Goods purchased for personal use of the proprietor should be first recorded as ordinary
purchases debiting Purchases Account and crediting the Supplier’s Account. Then it should be
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recorded as Goods withdrawn by the proprietor for personal use and the entry for that will be:
Debit Drawings account and credit Purchases account.
(3) Sometimes invoices of goods purchased are received in advance before the actual
receipt of such goods. For such goods neither the purchases account will be debited nor the
goods will be included in the closing stock.
(4) Purchases made under future transactions (i.e., the goods will be delivered in future)
and goods received on consignment or on behalf of third party , should not be included in
purchases.
(5) Purchase of any asset such as furniture, machinery etc., should be kept separate.
(6) Adjusted Purchases: Some concerns, for comparison purposes, prefer to adjust the
opening and closing stock through Purchases Account. Entries for this will be as follows:
a. For adjustment of opening stock

Purchases A/c Dr.
b. For adjustment of closing stock

Closing stock A/c
To purchases A/c Dr.
Due to these adjustments there will be no opening stock in the trial balance. Adjusted
Purchases A/c is shown on the debit side of Trading Account and Closing stock (having debit
balance) appears as an asset in the Balance Sheet.
(7) Goods distributed as samples will be deducted from purchases and will be debited to
Advertisement A/c which ultimately will be shown on the debit side of the Profit & Loss A/c.
III. Direct Expenses: These include all expenses have been incurred before the goods
become ready for sale and are shown on the debit side of the Trading Account. The examples
of direct expenses are given below:
(1) Wages (or Wages & Salaries): If wages have been incurred on manufacturing goods
or making them more saleable, they become an item of direct expenses and are debited to the
Trading A/c but other wages (indirect) should be debited to Profit & Loss A/c. If nothing is
mentioned whether the wages are direct or indirect, they should be treated as direct and are
75
shown on the debit side of the Trading Account. Wages must include all wages outstanding but
wages spent on constructing a building or manufacturing any other asset should be excluded
while calculating the amount of wages.
(2) Carriage, Cartage or freight: These expenses when paid on the purchases of goods
are taken to the debit side of Trading Account. Such expenses, if incurred on purchasing an
asset should be capitalized by debiting the Asset Account and should not be taken to the
Trading Account. Outstanding carriage, Cartage or freight should be added to these expenses
and appears as liability in the Balance Sheet.
(3) Import Duty and Dock Charges:In case goods are imported from abroad, custom
duty, dock charges, etc., have to be paid. As these relate to the goods purchased, they are
shown on the debit side of the Trading Account.
(4) Octroi:When goods are brought within the municipal limits, octroi duty has to be paid.
This is debited to Trading Account.
(5) Motive Power, Coal, Gas and Fuel: These are direct expenses and are shown on
the debit side of Trading A/c.
(6) Manufacturing Expenses: All expenses incurred in manufacturing the goods in the
factory as Factory Rent, Factory Insurance, Depreciation on Factory Machinery, Factory Lighting
etc., are debited to Trading A/c.
(7) Consumable stores: These are incurred to keep the machine in right condition and
include engine oil, soft soap, cotton waste, oil, grease and waste consumed in a factory.
Expenses of Consumable stores will be calculated as follows:
Amount(Rs)
Opening Balance of Stores ———
Add : Purchases of stores during the year ———
——————
———
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Less: Closing balance of stores ———
——————
Stores consumed during the year ———
——————
The amount of such stores consumed during the year will be shown on the debit side of
Trading Account.
(8) Royalties: These are payments made to a patentee, author or landlord for the right to
use his patent, copyright or land. If royalty is paid on the basis of production, it is debited to
Trading A/c and if it is paid on the basis of Sales, it is debited to Profit & Loss A/c.
(9) Packing Charges: There may be three types of Packing as given below:
(a) Ordinary or Primary Packing which is necessary for the handling of the product as
tooth paste or bottle in case of ink. The cost of such packing is a direct expense and should be
debited to the Trading Account.
(b) If the packing is required to transport the goods from one place to another as boxes
or containers etc., then such packing charges should be treated s distribution expenses
and being indirect expenses should be debited to the Profit & Loss A/c.
(c) If the packing is fancy to attract the consumers in case of cosmetic goods then it
should be treated as selling expenses and should be debited to the Profit & Loss A/c.
Details of the items to be posted to the Credit side of Trading Account
(1) Sales: Sales should include both cash and credit sales of those goods which were
purchased for resale purposes. Some consumers might return the goods sold to them (Sales
return) which are deducted from the sales in the inner column and net amount is shown in the
outer column. While ascertaining the amount of sales, the following points need attention:
(a) If a fixed asset such as furniture, machinery etc., is sold, it should not be included in
Sales, such amount should be separated by passing the following journal entry:
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Sales A/c Dr.
To Asset A/c.
(b) Goods sold on consignment or on Hire Purchase or on Sale or Return basis should be
recorded separately. However, if their amount is included in Sales, that should be separated by
passing the following entry:
Sales A/c Dr.
To Consignee’s or Hire Purchaser’s or Customer’s A/c.
(c) If goods have been sold but not yet dispatched ,these should not be shown under
sales but are included in closing stock.
(d) Sale of goods on behalf of others and forward sales should also be excluded from
sales.
(2) Closing Stock: It is the amount of unsold goods in hand at the end of the trading
period. Generally, the closing stock is given outside the Trial Balance, but when purchases are
adjusted through opening and closing stock, in that case the closing stock will have debit balance
in the trial balance. If given outside the trial balance, it will be credited to the Trading Account
but if it is given in the trial balance, then it appears as asset in the Balance Sheet.
Closing stock may be of Raw Materials, Work-in –Progress and Fininshed goods. In
order to ascertain the value of the closing stock, a list of all goods in stock after physical checking
is prepared (known as stock taking).
Stock includes only those goods which are normally bought and sold by the trader. Goods
unsold at branches and with agent should also be included in closing stock but stock of stationery
and postage stamps will not be included in the closing stock.
Closing stock is valued at cost or realisable price whichever is less. It is hence, valued on
conservative basis,i.e., expected profit should be ignored but possible losses should be duly
provided for. Closing entries for the trading Account:
The journal entries necessary to transfer opening stock, Purchases, Sales and return to
the Trading Account are called Closing entries, as they serve to close these accounts.
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These are as follows:
1. For transfer of opening stock, net purchases and direct expenses to Trading A/c/
Trading A/c Dr.
To Opening Stock A/c
To Purchases (net)A/c
To Direct expenses A/c
2. For transfer of net sales and closing stock to Trading A/c.
Sales (net) A/c Dr.
Closing Stock A/c Dr.
3.(a) For Gross Profit
Trading A/c Dr. .
To Profit & Loss A/c
(b) For Gross Loss
Profit & Loss A/c Dr
To Trading A/c
6.2.2 Preparation of Profit & Loss Account
This Account is prepared to calculate the net profit of the business. There are certain
items of incomes and expenses of the business. These are of indirect nature, i.e., concerning
the whole business and relating to various activities, which are done by the business for the
purpose of making the goods available to the consumers.
Indirect expenses may be selling & distribution expenses, management expenses, financial
expenses, extraordinary losses, and expenses to maintain the assets into working order.
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The total expenses can be divided into operating and non-operating expenses. Operating
expenses are incurred in order to run the business efficiently and smoothly. All other expenses
are not related to the operation of business but shown on the debit side of this account, are
categorized as non-operating expenses.
This account is prepared from nominal accounts and its balance is transferred to capital
account as the whole profit or loss will be that of the owner and it will increase or decrease his
capital. The specimen proforma of this account is given as under:
Important Points in Profit & Loss A/c
(1) Salaries:These include salaries paid to office, god own, & warehouse staff and should
be shown in Profit & Loss A/c being indirect expenses. Salaries to Partners must be debited
separately.If Salaries are paid after deduction of Income Tax or Provident Fund then these
should be added back to the salaries in order to have gross figure of salaries to be shown in
Profit & Loss A/c.
If Salaries are paid in kind by providing certain facilities to the employees such as house
free of rent, meals or cloth or washing facility free of charge, e.g., in hospitals hotels, farms,
etc., then the value of such facilities should be regarded as salaries. In certain cases, Salaries
& Wages are not given separately and in such a case there is a difficulty in posting it(whether to
charge it to Trading A/c or Profit & Loss A/c) and the following two alternative treatment and a
foot note can be given stating the assumption.
(a) From the viewpoint of materiality if the Wages are greater than the Salaries, then it is
taken to the Trading A/c(Salaries being immaterial).If Salaries are greater than the Wages,
(Wages being immaterial) it is taken to the Profit & Loss A/c
(b) Another view is that ‘Wages implies –Productive & a direct expense.
Salaries implies – Unproductive & an indirect expense. When they are put together, it
becomes an indirect expense whether it is “Salaries & Wages” or “Wages& Salaries” and it
should be debited to the Profit & Loss.
(2) Rent, Rates Taxes: These include offices and warehouse rent, municipal rates &
taxes. Factory rent, rates and taxes should be debited to the Trading A/c and others to Profit &
Loss A/c. If any rent is received, it should be shown on the credit side of the Profit & Loss A/c.
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(3) Interest: Interest paid on loans, overdrafts and bills overdue is an expense and is
taken to the Profit & Loss A/c. Interest received on loans (given by the firm), on deposits and on
securities is a gain and is shown on the credit side of the Profit & Loss A/c. Interest on Capital
should be shown separately on the debit side and interest on drawings on the credit side of the
Profit & loss A/c.
(4) Commission: Commission received for doing the work of other firms may be credited
to profit and loss as a gain and commission payable to the agents employed to sell the Firm’s
goods is debited as an expense.
(5) Repairs: Repairs, small renewals or replacements relating to the plant &machinery,
fixtures, fittings, and utensils etc., are generally included in this and being an expense, it
should be debited to the Profit & Loss A/c.
(6) Depreciation: It is an expense due to wear & tear, lapse of time, and exhaustion of
assets used in the business. This is loss sustained by the fixed assets and should be charged
to the Profit & Loss A/c.
(7) Stable expenses: These are incurred for the fodder of the horse and wages paid to
persons looking after stable. Being indirect expenses these should be debited to Profit & Loss
A/c.
(8)Trade expenses: These expenses are of varied nature and separate accounts are not
opened. They are amalgamated under trade or general or sundry or petty expenses. These are
debited to Profit & Loss A/c (beng miscellaneous business expenses).
(9) Samples: Samples of the goods manufactured by the business concerns are distributed
free of charge to push up sales. Being indirect and advertisement expenses, these are debited
to Profit & Loss A/c.
(10) Advertisement: All sums spent on advertising should be charged to Profit & Loss A/
c. If a large amount is paid under a contract covering 2 or 3 years, proportionate part should be
charged to Profit & Loss A/c. and the balance appears as an asset in the Balance Sheet.
(11) Abnormal losses: Abnormal losses like loss on sale of fixed assets, cash defalcation,
stock destroyed by fire not covered by insurance etc., may arise during the accounting period.
Such losses are taken as extraordinary expenses and debited to the Profit & Loss A/c. These
expenses represent non-operating expenses
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Profit & Loss Account
For the year ended 31st March, 2009
Particulars Amount Particulars Amount

(Rs) (Rs)
By Gross Loss B/d By Gross Profit b/d
To Selling & Distribution By Interest received
expenses : By Discount
Advertisement By Rent from Tenants
Travelers’ Salaries, By Income from Investments
Expenses & commission By Apprenticeship Premium
Bad debts By Interest from Debentures
Godown Rent By Income from any other Source
Export Expenses By Miscellaneous Revenue Receipts
Carriage Outwards By Net Loss Transferred to Capital A/c*
Bank Charges
Agent’s commission
Upkeep of Motor Lorries
To Management Expenses:
Rent, Rates & Taxes
Heating & Lighting
Office Salaries
Printing & Stationery
Postage & Telegrams
Telephone Charges
Legal Charges
Audit fees
Insurance
General expenses
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To Depreciation & Maintenance:

Depreciation
Repairs & Maintenance
To Financial Expenses:
Discount Allowed
Interest on Capital
Interest on Loans
Discount on bills
To Extraordinary Expenses:
Loss by Fire (not covered by
Insurance)
Cash Defalcations
To Net Profit transferred to
Capital A/c*
(12) Apprentice Premium: This is the amount charged from a person to whom training is
given by the business. It is a gain and should be credited to the Profit & Loss A/c. If some
amount of apprentice premium has been received in advance, due adjustment must be made in
order to calculate the correct income.
(13) All incomes and gains other than Sales will be shown on the credit side of the P & L
A/c.
* Expenses not to be shown in the Profit & Loss A/c:
(a) Domestic & Household expenses :
These expenses are not shown in Profit & Loss A/c, as these are personal expenses of
the proprietor and should be treated as drawings.
(b) Income Tax:
It should be treated as a personal income of the proprietorand added to drawings. It

should not be shown as an expense in Profit & Loss A/c.
83
(c) Life Insurance Premium:
Premium paid on the life policy of the proprietor should be charged to the Drawings A/c.
* Closing entries of Profit & Loss A/c:
(1) For transfer of various expenses to Profit & Loss A/c
Profit & Loss A/c .
To Various expenses A/c Dr.
(2) For transfer of various incomes and gains to Profit & Loss A/c .
Various incomes & gains A/c Dr.
(3) (a) For Net Profit
Profit & Loss A/c Dr.
To Capital
(b) For Net Loss
Capital A/c Dr.
6.2.3 Balance Sheet
A Balance Sheet is a statement prepared with a view to measure the financial position of
a business on a certain fixed date. The financial position of a concern is indicated by its assets
on a given date and its liabilities on that date. Excess of assets over liabilities represent the
capital and is indicative of the financial soundness of a company. A Balance Sheet is also
described as a ‘statement showing the sources and application of capital’. It is a statement and
not a account and prepared from real and personal accounts.
The left hand side of the Balance Sheet may be viewed as description of the sources from
which the business obtained the capital with which it currently operates and the right hand side
as a description of the form in which the capital is invested on a specified date on the left hand
side of the Balance Sheet, the several liability items describe how much capital was obtained
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from trade creditors, from banks, from bill holders, and other outside parties. The Owner’s
equity section shows the capital supplied by the owner.
Capital obtained from various sources has been invested according to management’s
best judgement of the optimum mix or combination of assets for the business. A certain fraction
is invested in buildings, another fraction in stock, another fraction is retained as cash for current
needs of the business and so on. The Assets side of the Balance Sheet, therefore shows the
result of these management judgments as on the date of the Balance Sheet.
A properly drawn up Balance Sheet gives information relating to
(i) The nature and value of assets .
(ii) The nature and extent of liabilities.
(iii) Whether the firm is solvent.
(iv) Whether the firm is over trading.
(Regarding the stability of the business, if the total of the debts due to creditors (including
Bank Overdraft) is greater than the liquid assets ( Cash, investments, bills etc) the postion of
the firm may be financially unsound. Where the debts are being incurred without sufficient
means of payment, the firm is said to be overtrading.)
If assets exceed the liabilities, the firm is solvent i.e., able to pay its debts in full. A business
is therefore, solvent by the amount of ownership capital in it, as it is the excess of assets over
liabilities.
For the position to be quite sound, there should be some working capital, i.e., some spare
liquid assets available for current expenditure. It is not a wise policy to lock up the entire capital
in fixed assets. The concern may be solvent without being sound.
Classification of Assets and Liabilities

Assets
Assets are property of a Business. Stocks, Land, Buildings, Book Debts, Cash, Bills
Receivable are some examples of Assets.
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The classification of Assets depends on their nature. The various types of Assets are:
(1) Fixed Assets: Those Assets which are acquired and held permanently in the business
and are used for the purpose of earning profits are called Fixed Assets. Eg : Land and Buildings,
Machinery, Furniture & Fixtures etc.
(2) Current Assets: Those Assets such as Cash, Debtors, and Stock that can be realized
and readily available to discharge liabilities within an operating cycle of one year are called
Current Assets.
(3) Tangible Assets: These are definite assets, which can be seen, touched, and have
volume such as Machinery, Cash, and Stock etc.
(4) Fictitious Assets:These Assets are fictitious in nature i.e they are virtually not assets.
These are either the past accumulated losses or expenses which are incurred once in life of a
business and are capitalized for the time being. Profit & Loss A/c ( debit balance), organization
expenses, discount on issue of shares, and advertisement expenses capitalized for the time
being are examples of such Assets.
(5) Intangible Assets: Those Assets which cannot be seen, touché and have no volume
but have value are called Intangible Assets. Eg : Goodwill, Patents, Licenses, & Trade Marks
etc.
(6) Wasting Assets: Those Assets such as mines, quarries, etc. that become exhausted
or reduce by their working are called Wasting Assets.
(7) Liquid Assets:These are Cash or such items as marketable securities, which can be
converted into cash quickly.
It is an asset the existence, value, and ownership of which is dependent on the occurrence,
or non-occurrence of a specified act. For eg., if a firm has filed a suit for some specific property
now in possession of someone else. If the suit is decided in firm’s favour, the firm will get the
property. At the moment it is a contingent Asset.
Liabilities
A Liability is an amount which a business is legally bound to pay.. It is a claim by an

outsider on the assets of a business. Liabilities may be classified into four types as follows:
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(1) Fixed liabilities:The liabilities which are payable only on the termination of the business
is called Fixed Liabilties. For Eg.,Capital (Owner’s Liablility)
(2) Long term liabilities: The liabilities which are not payable within the next accounting
period but will be payable within the next 5 to 10 years are called Long term liabilities. Eg :
Debentures.
(3) Current liabilities: The liabilities which are payable out of current Assets within the
next accounting period usually a year or already due are called current liabilities. Eg : Sundry
Creditors, Bills Payable, Short term loans, Bank Overdraft etc.
(4) Contingent liabilities:A contingent liability is one which is not an actual liablility but
which will become an actual one on the happening of some event, which is uncertain. They
have two characteristics:
(a) Uncertainity about the amount involved &
(b) Uncertainty as to whether the amount will be payable or not.
Eg : Liability of a case pending in the court, Bills of Exchange, Arrears of fixed
cumulative Dividend etc.,
GROUPING & MARSHALLING OF ASSETS AND LIABILITIES
The arrangement of assets and liabilities in certain groups and in a particular order is
called Grouping and Marshalling of the Balance Sheet of a business. Assets & Liabilities can be
arranged in the Balance order of Sheet in two ways:
(1) In order of Liquidity
(2) In order of Permanence.
In order of liquidity: When assets and liabilities are arranged according to their realisability
and preferences, such an order is called liquidity order. Such arrangement is given in Balance
Sheet as below:
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BALANCE SHEET As on 31.03…...
Liabilities Amount Assets Amount

(Rs) (Rs)
Current Liabilities: Liquid Assets :
Sundry Creditors Cash in hand
Bills Payable Cash at Bank
Bank Overdraft Floating Assets:
Long term Liabilities: Sundry Debtors
Loan from Bank Investments
Debentures Bills Receivable
Fixed Liabilities: Stock in trade
Capital Prepaid Expenses
Fixed Assets:
Machinery
Building
Furniture & Fixtures
Motor car
Intangible Assets:
Goodwill
Patents
Copyright
Licenses
Fictitious Assets:
Advertisement
Misc. Expenses
Profit & Loss A/c
Total
Note: For Contingent Liabilities, if any.

88
(ii) In order of permanence

When the order is received from that what is followed in case of liquidity, it is called order
of permanence. This order is followed in case of joint stock companies compulsorily but can be
followed in other concerns also. Fixed Assets and liabilities are shown on the assumption that
these will be paid or sold only on a insolvency if the business. This order of Balance Sheet is
given below:
BALANCE SHEET
as on 31.03….
LIABILITIES Rs. ASSETS Rs.
1. Fixed Liabilities 1. Fixed Assets
2. Long term Liabilities 2. Intangible Assets
3. Current Liabilities 3. Floating Assets
4. Liquid Assets
5. Fictitious Assets
Total
6.3 Distinction between Profit & Loss Account and the Balance
Sheet
(1) Profit & Loss Account is an account prepared with balances of nominal accounts
whereas a Balance Sheet is a statement of assets and liabilities.
(2) Profit & Loss Account discloses the profits earned or losses incurred for the accounting
period usually a year whereas Balance Sheet shows the financial position of the business on
the last day of the accounting period.
(3) Balances of nominal accounts are transferred to the Profit & Loss Account. Personal
accounts and real accounts are shown in the Balance Sheet. Balance of Profit& Loss Account(
i.e., Net profit ) is also shown ion the liabilities side of the Balance Sheet.
(4) Nominal accounts are closed by transferring them to the Profit& Loss Account. But
the accounts that are shown in the Balance Sheet do not close and become the opening balances
for the next accounting period.
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6.4 Illustrations
1. From the following balance extracted from the books of ABC ltd, prepare a
Trading and profit and loss account an a Balance Sheet.
Particulars Rs Particulars Rs
Opening stock 1,250 Plant and machinery 6,230
Sales 11,800 Returns outwards 1,380
Depreciation 667 Cash at bank 895
Commission 211 Salaries 750
Insurance 380 Debtors 1,905
Carriage inwards 300 Discount(Dr) 328
Furniture 670 Bills receivable 2,730
Printing charges 481 Wages 1,589
Carriage outwards 200 Returns inwards 1,659
Capital 9,228 Bank overdraft 4,000
Creditors 1,780 Purchases 8,679
Bills payable 541 Cash in hand 47
Bad debts 180
The value of the stock on 31stDecember ,1990 was Rs.3,700
Solution:
Trading and Profit & Loss account for the year ending 31st Dec,1990
90
Particulars Amount Particulars Amount

(Rs) (Rs)
To Opening stock 1,250 By Sales 11,800
To purchases 8,679 7,299 Less : Returns inwards 1,659
Less : return outward 1,380 ————- 10,141
To wages 1,589
To carriage inward 300
To gross profit c/d 3,403
To Depreciation 667 By gross profit b/d 3,403
To Insurance 380 By commission 211
To Printing charges 481
To Carriage Outwards 200
To Salaries 750
To Discount 328
To Bad debts 180
To Net Profit 628
3,614 3,614
Balance sheet as on 31st December 1990

(Rs) (Rs)
Bills Payable 541 Plant and machinery 6,230
Creditors 1,780 Furniture 670
Bank Overdraft 4,000 Cash in hand 47
Capital 9,228 Cash at bank 895
Add: Net profit 628 Debtors 1,905
———- 9,856 Bills receivable 2,730
Closing stock 3,700
16,177 16,177
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2. The following trial balance has been taken out from the books of XYZ as on 31st
December, 2005.
Dr. Cr.
Rs. Rs.
Plant and Machinery 100,000

Opening stock 60,000
Purchases 160,000
Building 170,000
Carriage inward 3,400
Carriage outward 5,000
Wages 32,000
Sundry debtors 100,000
Salaries 24,000
Furniture 36,000
Trade expense 12,000
Discount on sales 1,900
Advertisement 5,000
Bad debts 1,800
Drawings 10,000
Bills receivable 50,000
Insurance 4,400
Bank balances 20,000
Sales 480,000
Interest received 2,000
Sundry creditors 40,000
Bank loan 100,000
Discount on purchases 2,000
Capital 171,500
795,500 795,500
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Closing stock is valued at Rs. 90,000
Required: Prepare the trading and profit and loss account of the business for the year
ended 31.12.2005 and a balance sheet as at that date.
Solution:
XYZ
Trading and Profit and Loss Account
For the year ended 31st December 2005
Rs. Rs. Rs. Rs.
Opening stock 60,000 Sales 480,000

Purchases 160,000 Less discount 1,900 478,100
Less discount 2,000 158,000
Closing stock 90,000
Carriage inward 3,400
Wages 32,000
Gross profit
(transferred to
P&L) 314,700
568,100 568,000
Carriage outward 5,000 Gross profit
(transferred to
P&L) 314,700
Salaries 24,000 Interest recd. 2,000
Trade expenses 12,000
Advertisement 5,000
Bad debts 1,800
Insurance 4,400
Net profit
(transferred
to capital) 264,500
316,700 316,700
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Note: Discount on purchases and discount on sales are deducted from purchases and sales
respectively. They may be shown on the credit and debit side of profit and loss account
respectively and it will not affect the net profit of the business. The gross profit will be affected
ifdiscount is treated so.
XYZ
Balance Sheet
For the year ended 31st, December 2005
Assets Rs. Liabilities Rs.
Current Assets: Current Liabilities:
Bank balance 20,000 Sundry creditors 40,000
Bills receivable 50,000 Bank loan 100,000
Sundry debtors 100,000 Fixed and Long Term:
Closing stock 90,000 Capital 171,500
Fixed Assets: +Net profit 264,500
Furniture 36,000
Plant and Machinery 100,000 -Drawings 10,000 426,000
Building 170,000
566,000 566,000
6.5 Summary
Two main objectives of maintaining accounts are to find out the profit or loss made by the
business at the end of regular periodic interval and to ascertain the financial position of the
business on a given date. Final accounts are prepared to achieve these objectives. In order to
know the profit or loss earned by a firm, Income statement or Trading and Profit & Loss accounts
is prepared. Balance sheet or Position statement will portray the financial condition of a firm on
a particular date.
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6.6 Key Words

Balance Sheet
Profit and Loss Account
Trading Account

1. Define Final Accounts.
2. What do you understand by Cost of Goods Sold?
3. Present the format of Trading and Profit & Loss account and also give a format of
Balance Sheet.
4. From the following balances of the ledger of Sh. Gurdeep Singh, prepare Trading
and Profit and Loss Account and Balance Sheet :—
Dr. Balances Rs. Rs.
Stock on 30-6-2007 30,000
Stock on 30-6-2008 46,200
Purchases and Sales 2,30,000 3,45,800
Returns 12,500 15,200
Commission on Purchases 1,200
Freight, octroi and carriage 26,000
Wages and Salary 10,800
Fire Insurance Premium 820
Business premises 40,000
Sundry Debtors 26,100
Sundry Creditors 26,700
Goodwill 8,000
Patents 8,400
Coal, Gas and Power 7,600

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Printing and Stationery 2,100
Postage and Telegram 710
Travelling expenses 4,250
Drawings 7,200
Depreciation 1,000
General Expenses 8,350
Capital 89,760
Investments 8,000
Interest on Investments 800
Custom Duty on imported goods 4,500
Cash in hand 2,570
Banker’s Account 5,200
Commission 4,600 4,400
Loan on Mortgage 30,000
Interest on Loan 3,000
Bills Payable 2,280
Bills Receivable 4,540
Income Tax 3,000
Horses and Carts 20,300
Discount on Purchases 1,600
TOTAL 5,21,740 5,21,740

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5. The following is the trial balance of Mr.Govil as on 31.3.2000
Particulars Dr Cr
Cash in hand 540
Cash at bank 2,630
Purchases 40,675
Sales 98,780
Returns inwards 680
Returns outwards 500
Wages 10,480
Fuel and power 4,730
Carriage on sales 3,200
Carriage on purchases 2,040
Opening stock 5,760
Buildings 30,000
Freehold land 10,000
Machinery 20,000
Patents 7,500
Salaries 15,000
General expenses 3,000
Insurance 600
Drawings 5,245
Capital 71,000
1,76,580 1,76,580
Prepare trading and profit and loss account and the Balance sheet as on 31-3-2000. The
stock as on 31.3.2000 is Rs.6,800.
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Pearson, 2012.

2011.
98
LESSON 7
FINAL ACCOUNTS WITH ADJUSTMENTS
Learning Objectives
After reading this lesson, you must be able to
 List out the adjustments related to balance sheet
 Solve the problems related to final accounts with adjustments.
Structure
7.1 Introduction
7.2 Closing Stock
7.3 Outstanding Expenses
7.4 Prepaid Expenses
7.5 Accrued Income
7.6 Income Received in Advance
7.7 Depreciation
7.8 Bad Debts
7.9 Interest on Capital
7.10 Interest on Drawings
7.11 Provision for Doubtful Debts
7.12 Reserve for Discount on Creditors
7.13 Deferred Revenue Expenditure
7.14 Loss of Stock by fire
7.15 Reserve Funds
7.16 Goods Distributed as free samples
7.17 Manager's Committees
7.18 Goods on sale on Approval Basis
7.19 Hidden Adjustments

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7.20 Illustrations
7.21 Summary
7.22 Key Words
7.1 Introduction
While preparing Trading and Profit and loss account, the expenses and income for the
full trading period are taken into consideration. An expense, which has incurred but not paid
during that period, a liability for the unpaid amount etc should be included to give the true Profit
or Loss. All expenses and Incomes should properly be adjusted through entries. These entries,
which are passed at the end of the accounting period, are, called adjusting entries. Some
important adjustments, which are to be made at the end of the accounting year, are explained
in this lesson.
7.2 Closing Stock

The unsold stock lying at the ends of the accounting period are called Closing stock.
Every concern prepares a list of items of stock, which remain unsold, and puts value against it.
Stock is to be valued at cost or realizable value whichever is less. For the total value of closing
stock, say Rs.50, 000, the following adjustment entry will be passed at the end of the year:
Stock A/c Dr. Rs.50,000
To Trading A/c Rs.50,000
Trading Account
To Trading A/c Rs.50,000 By Balance C/d Rs.50,000

100
Stock Account
By Stock Rs.50,000
The two-fold effect of the above adjustment will be:
(i) Stock being debit balance will be shown on the assets side of the Balance Sheet.
(ii) It will be shown on the credit side of the Trading Account.
Sometimes Opening & Closing Stocks are adjusted through purchases account. In this
case, there will be no opening stock in the Trial Balance. Adjusted purchases and closing stock
will be given in the Trial Balance. Adjusted purchases will be taken on the debit side of the
Trading Account and closing stock will be shown on the Assets side of the Balance Sheet. Care
should be taken to see that the Closing stock is not taken to the credit side of the Trading
Account as it has been already adjusted through purchases account. At the beginning of the
next accounting year, closing stock will become opening stock and will be brought into account
by passing reverse entry as below:
Trading Account Dr.
To opening Stock
7.3 Outstanding Expenses

Those expenses, which have been incurred and are due for payment i.e. not paid as yet
are called outstanding expenses.
For eg., If Rs.1000 p.m is paid as salary to an employee and during the year 1998, only
Rs.10,000 are paid as salary, then two month’s salary Rs.2000 which is due but not paid is
Outstanding Salary .In order to bring this fact into the books of account, the following entry will
be passed at the end of the year:
Salaries A/c Dr. Rs.2000
To Outstanding Salaries A/c Rs.2000

101
The effect of this entry on two accounts will be:
SALARIES A/c OUT STANDING SALARIES A/c
Rs. Rs. Rs. Rs.
To Cash 10,000 By Profit 12,000 To By 2000
To Outstanding & Loss A/c Balance 2000 Salaries
Salaries 2000 c/d
12000 12000 2000 2000
The two-fold aspect of the above adjustment will be:
(i) Outstanding expenses will be shown on the debit side of the Trading or profit and
loss account by way of addition to the expenses and
(ii) Outstanding expenses will be shown on the liabilities side of the Balance Sheet.
If no adjustment were made for the outstanding salary then the net profit would be
overstated by Rs.2,000 and the liabilities understated by Rs.2,000.
In the beginning of the next year, a reverse entry will be passed to cancel the effect of the
adjustment entry. Reverse entry will close Outstanding Salaries Account and adjust the next
year’s Salary Account.
7.4 Prepaid Expenses

Those expenses which have been paid in advance i.e., whose benefit will be available in
future are called prepaid (or unexpired ) expenses.
For eg; If a fire insurance policy is taken for a year paying Rs.1000 as insurance premium
on 1st July, 1995 and will expire on 30th june,1996. the position on 31st December 1995,when
accounts are closed, will be that Rs.500 i.e., premium from 1st july,1995 to 31st Dec 1995 will be
an expense but Rs.500 i.e., premium from 1st January,1996 to 30th june,1996 will be prepaid or
unexpired expense. In order to bring this into account on 31st Dec, 1995 , the following adjustment
entry will be passed:
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Prepaid Insurance Premium A/c Dr. Rs.500
To Insurance Premium A/c Rs.500
PREPAID INS.PREMIUM A/c INSURANCE PREMIUM A/c
Rs. Rs. Rs. Rs.
To By To By Prepaid 500
Insurance Balance 500 Bank 1000 Ins. Premium
Premium 500 c/d c/d A/cs
By proift & 500
Loss A/c
500 500 1000 2000
The two-fold effect of prepaid expenses will be:
(1) Prepaid expenses will be shown in the profit and loss account by way of deduction
from the expenses and
(2) Prepaid expenses being debit balance will be shown on the assets side of the Balance
Sheet.
In the beginning of the next year, a reverse entry will be passed to nullify the effect of
adjusting entry.
7.5 Accured Income

That income, which has been earned but not received during the accounting year, is
called accrued income. For eg, if business has invested Rs.10, 000 in 5% gilt edged securities
on 1st Jan, 1995 but during the year Rs.350 has been received as interest on securities. Then
Rs.150 interest on securities earned and due for payment on 31st Dec 1995 but not received,
will be accrued interest for the year 1995. In order to bring accrued interest into books of
account, the following adjusting entry will be passed:
103
Accrued Interest A/c Dr. Rs.150
To Interest A/c Rs.150
ACCRUED INTEREST A/C INTEREST A/C
Rs. Rs. Rs. Rs.
To Interest 150 By Balance 150 To Profit & 500 By Bank 500

a/c c/d Loss a/c By Accrued
Interest A/c
150 150 500 500
The two fold effect of Accrued income will be:
(1) It will be shown on the credit side of profit & loss account by way of addition to income,
and
(2) Accrued income being debit balance will be shown on the assets side of the Balance
Sheet.
In the beginning of the next year, a reverse entry will be passed to nullify the effect of
adjusting entry.
7.6 Income Received in Advance

Income received but not earned during the accounting year is called Income received in
Advance. For eg., if building has been given to tenant on Rs.2400 p.a but during the year
Rs.3000 has been received, then Rs.600 will be rent received in advance. In order to bring this
into books of account, the following adjustment entry will be made at the end of the accounting
year:
Rent A/c Dr. Rs.600
To Rent received in advance Rs.600

104
RENT RECEIVED IN ADVANCE a /c RENT a/c
Rs. Rs. Rs. Rs.
To Balance 600 By Rent 600 To Rent recd 600 By Bank 3000

c/d c/d in adv. a/c
To P&L a/c 2400
600 600 3000 3000
The two-fold effect of this adjustment will be:
(1) It is shown on the credit side of Profit and Loss account by way of deduction from the
income, and
(2) Income received in advance, being credit balance, is shown on the liabilities side of
the Balance Sheet.
7.7 Depreciation
Depreciation is the reduction in the value of fixed asset due to its use, wear & tear or
obsolescence. When an asset is used for earning purposes, it is necessary that reduction due
to its use, must be charged to the profit of that year in order to show correct profit or loss and to
show the asset at its correct value in the Balance Sheet. Generally depreciation is charged at
some percentage on the value of an asset. Suppose machinery for Rs.10, 000 is purchased on
1.1.95, 20% p.a is the rate of depreciation. Then Rs.2, 000 will be depreciation for the year
1995 and will be brought into account by passing the following adjustment entry:
Depreciation A/c Dr. Rs.2, 000
To Machinery A/c Rs.2, 000

105
DEPRECIATION A /c MACHINERY A/c
Rs. Rs. Rs. Rs.
To Machinery 2000 By P&L 2000 To 10000 By 2000
a/c a/c Bank Depreciation 8000
By Balance c/d
2000 2000 10000 10000
The two fold effect of depreciation will be
(1) Depreciation is shown on the debit side of Profit & Loss A/c, and
(2) It is shown on the assets side by way of deduction from the value of concerned
asset.
7.8 Bad Debts

Debts that cannot be recovered or become irrecoverable are called bad debts. It is a loss
for the business. For eg, if sundry debtors on 31st Mar, 1998 are Rs.55, 200, bad debts on that
date are Rs.200. In order to bring this into account, an adjusting entry will be passed:
Bad debts A/c Dr. Rs.200
To Sundry Debtors A/c Rs.200
BAD DEBTS A /c SUNDRY DEBTORS A/c
Rs. Rs. Rs. Rs.
To Sundry 200 By P&L 200 To By Bad debts a/c 200
debtors 200 A/c 200 Balance 55,200 By Balance a/c 55000
B/d 55,200 55,200

106
The two fold effect of bad debts will be that bad debts will be:
(1) Shown on the debit side of the Profit & Loss A/c, and
(2) Shown on the assets side of the Balance Sheet by way of deduction from sundry
debtors.
7.9 Interest on Capital

Sometimes in order to see whether the business is really earning profit or not, interest on
capital at a certain rate is provided. For eg, if A has invested Rs.50,000 as Capital and 10%
interest is provided, then Rs. 5,000 as interest on Capital is to be brought into the books by
passing the following adjusting entry :
Interest on Capital A/c Dr. Rs.5,000
To A’s Capital A/c Rs.5,000
INTEREST ON CAPITAL A/c A’S CAPITALA/c
Rs. Rs. Rs.
To Capital 5000 By To 55,000 By 50,000

A/c P&L A/c 5000 Balance Balance B/d
b/d By Interest 5,000
On Capital
5000 5000 55,000 55,000
The two fold effect of this adjusting entry will be:
(1) Interest on capital will be shown on the debit side of the Profit & Loss account.
(2) It will be shown on the liabilities side of the Balance Sheet by way of addition to the
capital.
7.10 Interest on Drawings

If interest on capital is allowed, it is but natural that interest on drawings should be charged
from the proprietor, as drawings to reduce capital. Suppose during an accounting period/year,
107
drawings are Rs.10, 000 and interest on drawings is Rs.500. In order to bring this into account,
the following entry will be passed:
Drawings A/c Dr Rs.500
To interest on drawings Rs.500
INTEREST ON DRAWINGS A/c DRAWINGS A/c
Rs. Rs. Rs.
To By To Cash 10,000 By
P&L 500 Drawings 500 To Int Capital A/c 10,500
A/c On 500
drawings
500 500 10,500 10,500
The Two fold effect of interest on drawings will be:
(1) Interest on Drawings will be shown on the credit side of the Profit & Loss A/c, and
(2) Interest on Drawings is shown on the liabilities side of the Balance Sheet by way of
addition to the Drawings, which are ultimately deducted from the capital.
7.11 Provision for Doubtful Debts

Sometimes, on the last day of the accounting year, certain debts may be found doubtful
i.e., the amount to be received may or may not be received. It is one of the principles of
Accountancy that anticipated losses may be provided. So provision for doubtful debts is generally
made on the basis of some percentage, which is fixed on the basis of past experience.
Suppose Sundry Debtors as on 31-03-98 are Rs.55, 200 and bad debts are Rs.200.
Provision of 5% is to be made on debtors. In order to bring the provision for doubtful debts of
Rs.2, 750 i.e., 5%on Rs.55, 000 (55,200 – 200), the following entry will be made:
Profit and Loss Account Dr Rs.2, 750
To Provision for Doubtful Debts A/c Rs.2, 750

108
Two affected Accounts will be:
(1) It will be shown on the debit side of the Profit & Loss A/c or by way of addition to Bad
debts. (Old provision for doubtful debts at the beginning of the year will be deducted).
(2) Provision for Doubtful Debts is shown on the Assets side of the Balance Sheet by way
of deduction from Sundry Debtors (after deduction of further bad debts, if any).
7.12 Reserve for Discount on Creditors

As the firm has to provide for discount on debtors, similarly, the firm may have chance to
receive discount on the last date of the accounting year, if the payment is made within the
scheduled period. Such discount on creditors is anticipated profit and therefore, reserve for
discount on creditors will be made instead of provision for discount on creditors. Such reserve
will be calculated on the amount of creditors. Suppose on 31st Dec,1997, the creditors, are
Rs.10,000 and 2.5% Reserve is to be made for discount on creditors. In order to bring this into
account, the following entry will be passed:
Reserve for Discount on Creditors A/c Dr Rs.250
To Profit & Loss A/c Rs.250
Two affected accounts will be:
PROFIT & LOSS A/c RESERVE FOR DISCOUNT ON

CREDITORS A/c
Rs. Rs. Rs. Rs.
By To By 250
Res for 250 Profit & 250 Balance c/d
dis. On Loss
Creditors A/c
A./c
250 250 250

109
The two fold effect of this reserve will be:
(1) It is shown on the credit side of the Profit & Loss A/c and
(2) Reserve for discount on Creditors is shown on the liabilities side of the Balance
Sheet by way of deduction from sundry debtors.
7.13 Deferred Revenue Expenditure

The expenditure done in the initial stage but the benefit of which will also be available in
subsequent years is called Deferred Revenue Expenditure. Part of such expenditure will be
written off in each year and the rest will be capitalized. The entry for this expenditure will be:
Profit & Loss A/c Dr. Rs.400
To Advertisement Rs.400
PROFIT & LOSSA/c ADVERTISEMENT A/c
Rs. Rs. Rs.
To Advt 400 To Bank 2000 By P&L A/c 400

By
Balance c/d 1,600
400 2000 2000
The two fold effect of such expenditure will be:
(1) It is shown on the debit side of Profit & Loss A/c, and
(2) It is shown on the assets side by way of deduction from capitalized expenditure.
7.14 Loss of Stock by Fire

In Business, the loss of stock may occur due to fire. The position of the business may be:
(a) All the stock is fully insured.
(b) The stock is partly insured.
(c) The stock is not insured at all.

110
(a) If the stock is fully insured, the whole loss will be claimed from the insurance company.
The following entry will be passed:
Insurance Company A/c Dr. Rs.15, 000
To Trading A/c Rs.15, 000
The double effect of this entry will be:
1) It will be shown on the credit side of the Trading account, and
2) It is shown on the assets side of the Balance Sheet.
(b) If the stock is fully insured, the loss of stock covered by insurance policy will be claimed
from the insurance company and the rest of the amount will be loss for the business. The
following entry will be passed:
Insurance company A/c Dr. Rs.10, 000
Profit & Loss A/c Dr.Rs. 5,000
To Trading Account Rs.15, 000
The two-fold effect of this entry will be:
(1) It will be shown on the credit side of the Trading Account with the value of stock and
shown on the debit side of the Profit & Loss A/c for that part of the stock which is not
insured, and
(2) Loss of stock by fire is shown on the Assets side of the Balance Sheet with the
amount, which is to be realized from the insurance co., i.e., that part of the loss,
which is insured.
(3) If the stock is not insured at all, whole of the loss will be borne by the firm.
The entry for this will be:
Profit & Loss A/c Dr. Rs.15, 000
To Trading A/c Rs.15, 000

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(1) Loss of stock by fire A/c
To Trading A/c
(2) Profit & Loss and/or Insurance co. A/c Dr.
To Loss of stock by fire.
7.15 Reserve Fund

Reserve is created out of Profit and loss A/c and thus is an appropriation of net profit for
strengthening the financial position of the business. Suppose Rs.2, 000 is to be transferred to
Reserve fund from the Net Profit, the entry will be:
Profit and loss A/c Dr. Rs.2, 000
To Reserve fund Rs.2, 000
(1) It is shown on the debit side of the Profit & Loss A/c along with the net profit in the
inner column , and
(2) It is shown on the Liabilities side of the Balance Sheet. If Reserve fund is already
there, it will be shown by addition to the existing reserve fund on the liabilities side
of the Balance Sheet.
7.16 Goods Distributed as Fire Samples

Sometimes in order to promote the sale of goods, some of the produced goods are
distributed as free samples. For Eg., if goods are distributed as free samples then it will be an
advertisement for the concern and on the other hand stock will be less by such goods. In order
to bring this into books of account, the following entry is passed:
Advertisement A/c Dr. Rs.2, 000
To Purchases A/c Rs.2, 000

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The two effect of this entry will be:
(1) It is deducted from the Purchases, and
(2) It is shown on the debit side of the Profit & Loss A/c as advertisement expenses.
7.17 Manager's Commission

Sometimes in order to increase the profits of the concern, manager is given some
percentage (say 10%) of commission on profits (say Rs.33, 000) of the concern. It can be given
at a certain percentage on the net profits but before charging such commission. In order to
record commission payable i.e., 10% on 33,000 or Rs.3, 300, the following entry will be passed:

To Commission Payable A/c Rs.3, 300
But sometimes commission is allowed to the manager on the net profit after charging
such commission. The commission in such a case will be calculated by the following formula:
% of commission
Commission Payable = --------------------------------------- X Residual profit
100 + Rate of commission
In the above case, the commission payable will be Rs.3, 000 i.e., ( 10/110 * 33,000 )
For Rs.3,000, the same entry will be passed in the books as given below :
To Commission Payable A/c Rs.3, 000
The two-fold effect of this entry will be:
(1) Such commission will be shown on the debit side of the Profit and loss A/c, and
(2) Commission Payable is shown on the Liabilities side of the Balance Sheet.
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7.18 Goods on Sale on Approval Basis

Sometimes the goods are sold to the customers on approval basis. If they approve, it will
become sale. If such goods are lying with the customers on the last day of the accounting year
and these can be yet returned, it should be treated as stock lying with the customer. In such a
case, two entries will be passed :
(1) Sales A/c Dr.
To Debtors A/c (with sale price)
(2) Stock A/c Dr.
To Trading A/c (at cost price of goods)
The two-fold effect of these entries will be:
(1) It will be shown on the credit side of the Trading Account by way of deduction from
the sales at sale price and added to the closing stock at cost price, and
(2) It is shown on the Assets side as a deduction from sundry debtors (sale price) and
stock at cost on the Assets side of the Balance Sheet.
7.19 Hidden Adjustments

There are certain items in the Trial Balance and require adjustment though especially no
adjustment is given relating to such items. For eg. In the Trial Balance, the following balances
are given,
Dr. (Rs) Cr.(Rs)
6 % Loan on 1.1.97 — 10,000
Interest on Loan 200 —
Actually Rs.600 interest on loan should have been paid but only Rs.200 have been paid
and the rest Rs.400 is yet payable and outstanding. In order to bring this into account, the
following entry will be passed:
(1) It will be shown on the debit side of the P & L A/c by way of addition to interest on
loan, and
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(2) Int. on Loan is shown on the liabilities side of the B.S by way of addition to the Loan
account.
Those adjustments, which are given clearly after the Trial Balance, are known as Self
Evident adjustments and adjustments hidden in the Trial Balance are called Hidden Adjustments.
7.20 Illustrations
From the following Trial Balance of Raj Kumar prepare Trading, Profit and loss account
for the year ended 31st Mar 2002 and Balance Sheet as on that date:
Trial Balance of Raj Kumar for the year ending 31st March 2002
Particulars Dr (Rs) Cr (Rs)

Capital 60,000
Drawings 10,000
Furniture 5,200
Bank Overdraft 8,400
Taxes and Insurance 4,000
Creditors 27,600
Buildings 40,000
Debtors 36,000
Rents 2000
Purchases 2,20,000
Sales 3,00,000
Sales returns 4,000
General Expenses 8,000
Salaries 18,000
Commission 4,400
Carriage on Purchases 3,600
Bad debts 1,600
Discount 3,200
Total 4,02,000 4,02,000
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The following adjustments are to be made:

(a) The closing stock was valued at Rs.40,120, but there has been a loss of stock by fire
during the period to the extent of Rs.10,000 not covered by insurance.
(b) Depreciation on Buildings Rs.2,000 and on furniture Rs.500 is to be provided for.
(c) A provision for doubtful debts at 5%on debtors is required.
(d) Unexpired insurance amounted to Rs.400.
(e) Interest on Capital at 5% per annum is to be provided.
Solution
Trading & Profit & loss account of Raj Kumar

For the year ended 31.3.2002
To Opening stock 44,000 By Sales 3,00,000

Purchases 2,20,000 Sales returns 4,000 2,96,000
Carriage on Purchases 3,600 By stock destroyed by fire 10,000
To Gross profit c/d 78,520 By closing stock 40,120
3,46,120 3,46,120
To Salaries 18,000 By Gross Profit b/d 78,520
Taxes and insurance 4,000 By Rent 2,000
Less: Unexpired insurance 400 3,600 By Discount 4,000
Commission 4,400
Discount 3,200
Bad debts 1,600
Provision for doubtful debts 1,800
Stock destroyed by fire 10,000
To Depreciation:
Buildings 2,000
Furniture 500
To interest on capital 3,000
To Net profit 28,420
84,520 84,520
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Balance Sheet of Rajkumar as on 31.3.2002

(Rs) (Rs)
Capital 60,000 Debtors 36,000
Less: drawings 10,000 Less: 5% provision

———— for doubtful debts 1,800
50,000 ——— 34,200
Add: Interest on capital 3,000 Closing stock 40,120
Net profit 28,420 Unexpired insurance 400
————— Buildings 40,000
Creditors 81,420 Less: dep 2,000
Bank Overdraft ----—— 38,000
27,600
8,400 Furniture 5,200
Less: dep 500 4,700
————
1,17,420 1,17,420 1,17,420
2. From the following balances, prepare the trading and profit and loss account and balance
sheet as on March 31, 2014
Debit Balances Amount Credit Balances Amount

Rs. Rs.
Drawings 6,300 Capital 1,50,000
Cash at bank 13,870 Discount received 2,980
Bills receivable 1,860 Loans 15,000
Loan and Building 42,580 Purchases return 1,450

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Furniture 5,130 Sales 2,81,500
Discount allowed 3,960 Reserve for bad debts 4,650
Bank charges 100 Creditors 18,670
Salaries 6,420
Purchases 1,99,080
Stock (opening) 60,220
Sales return 1,870
Carriage 5,170
Rent and Taxes 7,680
Book debts 82,740
Bad debts 1,250
Insurance 750
4,74,250 4,74,250
Adjustments 1. Closing stock Rs. 70,000 2. Create a reserve for bad and doubtful debts
@ 10% on book debts 3. Insurance prepaid Rs. 50 4. Rent outstanding Rs. 150 5. Interest on
loan is due @ 6% p.a.
Solution
Trading and Profit and Loss Account for the year ended March 31, 2014
Dr. Cr.
Expenses/Losses Amount Rs. Revenues/Gains Amount Rs.

Opening stock 60,220 Sales 2,81,500
Purchase 1,99,080 Less : Sales return (1,870) 2,79,630
Less Purchases return (1,450) 1,97,630 Closing stock 70,000
Carriage 5,170
Gross profit c/d 86,610
3,49,630 3,49,630
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Discount allowed 3,960 Gross profit b/d 86,610
Bank charges 100 Discount received 2,980
Salaries 6,420
Rent and Taxes 7,680
Add Rent outstanding

150 7,830
Insurance 750
Less Insurance prepaid (50) 700
Bad debts 1,250
Add New provision 8,274

for bad debts 9,524
Less Old provision (4,650)

for bad debts 4,874
Interest on loan outstanding 900
Net profit (transferred to

capital account) 89,590 61,176
89,590 89,590
Balance Sheet as at March 31, 2014

Rs. Rs.
Creditors 18,670 Cash at bank 13,870
Loan 15,000 Book debts 82,740
Add Interest on loan Less Reserve for

outstanding 900 15,900 bad debts (8,274) 74,466
Rent outstanding 150 Bills receivable 1,860

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Capital 1,50,000 Land and Building 42,580
Add Net profit 61,176 Plant and Machinery 31,640
2,11,176 Furniture 5,130
Less Drawings (6,300) 2,04,876 Insurance (prepaid) 50
Closing stock 70,000
2,39,596 2,39,596
7.21 Summary
While preparing Trading and Profit and loss account, the expenses and income for the
full trading period are taken into consideration. An expense, which has incurred but not paid
during that period, a liability for the unpaid amount etc should be included to give the true Profit
or Loss. All expenses and Incomes should properly be adjusted through entries. These entries,
which are passed at the end of the accounting period, are, called adjusting entries.
7.22 Key Words

Accrued Income
Bad Debts
Interest on Capital
Interest on Drawings
Outstanding Expenses

1. What do you understand by Final Accounts Adjustments?
2. How would you treat the adjustments as to Outstanding Expenses in Final Accounts?
3. Write a note on Prepaid Expenses. How are they posted?
4. How do you treat Bad debts in Final Accounts? And also show how would it appear
in the Balance Sheet?
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5. From the following data, prepare a profit and loss a/c and a balance sheet as on 31-3-
1996.
Particulars Rs. Particulars Rs
Drawings 10,000 Capital 30,000
Purchases 30,000 Purchase returns 1,000
Sales Returns 5,000 Sales 60,000
Carriage in 2,000 Wages outstanding 2,000
Carriage out 3,000 Rent received 1,000
Depreciation on Plant 4,000 Reserve for doubtful debts 1,000
Plant account 20,000 Interest (Cr) 5,000
Salaries & wages 3,000 Sundry creditors 6,000
Bad debts 2,000 Loans 38,000
Premises 20,000 Interest 5,000
Stock 1.4.95 25,000 Sundry debtors 15,000
1,44,000 1,44,000
Adjustments
(a) Stock on 31-3-96 was Rs.40,000. A fire broke-out in the godown and destroyed stock
worth Rs.5,000. Insurance company had accepted the claim in full.
(b) Provide for bad debts @ 10% and provide for discount on debtors @ 5% and on
creditors @ 10%
(c) Depreciate buildings at the rate of 15% p.a.
(d) Rent outstanding amounted to Rs.1,000
(e) Closing stock includes samples worth of Rs.2,000.
(f) Provide interest on drawings @ 10% and on capital @ 10%.

121
6. The following is the Trial balance as on 31st December 1992 extracted from the books of
ABC Ltd..
Particulars Debit Credit

Rs. Rs.
Freehold Land 35,000

Mortgage Loan 20,000
Loose tools 1.1.92 5,600
Bills payable 3,400
Book debts 18,200
Sales 1,21,500
Cash at bank 11,000
Stock 1.1.1992 10,500
Insurance 300
Bad debts 560
Purchases 50,000
Cash on hand 640
Rent, Rates, etc. 1,300
Interest 250
Wages 10,700
Trade expenses 150
Salary 1,560
Repairs to plant 875
Carriage Inwards 350
Discount 290 175
Capital 40,000
Drawings 2,500
2,00,675 2,00,675
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Prepare trading and profit and loss account and balance sheet after making the following
adjustment:
a) Provision for doubtful debts at 5% on book debts;
b) Interest on capital at 5%
c) unexpired insurance premium Rs.90;
d) Rent outstanding on 31-12-92 Rs.300;
e) Loose tools revalued at Rs.4,500,
f) Closing stock Rs.30,000.

Pearson, 2012.

2011.
123
LESSON 8
MANAGEMENT ACCOUNTING
Learning Objectives
 Define Management Accounting
 List out the objectives and functions of Management Accounting
 Distinguish Management Accounting and Cost Accounting
 Differentiate Management Accounting and Financial Accounting
Structure
8.1 Introduction
8.2 Definitions
8.3 Objectives of Management According
8.4 Scope of Management According
8.5 Functions of Management Accounting
8.6 Advantages of Management Accounting
8.7 Limitations of Management Accounting
8.8 Distinguish between Management Accounting and Cost Accounting
8.9 Distinguish between Management Accounting and Financial Accounting
8.10 Distinguish between Cost Accounting and Financial Accounting
8.11 Summary
8.12 Key Words

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8.1 Introduction
The term management accounting refers to accounting for the management. Management
accounting provides necessary information to assist the management in the creation of policy
and in the day-to-day operations. It enables the management to discharge all its functions i.e.
planning, organization, staffing, direction and control efficiently with the help of accounting
information.
8.2 Definitions
“Management accounting is concerned with accounting information that is useful to
management”. – R.N. Anthony.
“Management accounting is the presentation of accounting information is such a way as

to assist management in the creation of policy and in the day-to-day operations of an
undertaking”.- Anglo American Council of Productivity.
8.3 Objectives of Management Accounting

The objectives of management accounting are:
(1) To assist the management in promoting efficiency. Efficiency includes best possible
services to the customers, investors and employees.
(2) To prepare budget covering all functions of a business (i.e. production,sales, research
and finance).
(3) To analysis monetary and non-monetary transactions.
(4) To compare the actual performance with plan for identifying deviations and their causes.
(5) To interpret financial statements to enable the management to formulate future policies.
(6) To submit to the management at frequent intervals operating statements and short-
term financial statements.
(7) To arrange for the systematic allocation of responsibilities.
(8) To provide a suitable organization for discharging the responsibilities.
In short, the objective of management accounting is to help the management in making

decisions and implementing them efficiently.
125
8.4 Scope of Management Accounting

Management accounting has various facets. The field of management accounting is very
wide. The main purpose of management accounting is to provide information to the management
to perform its functions of planning directing and controlling. Management accounting includes
various areas of specialization to render effective service to the management.
1. Financial Accounting
Financial Accounting deals with financial aspects by preparation of Profit and Loss Account
and Balance Sheet. Management accounting rearranges and uses the financial statements.
Therefore management accounting does not exclusively maintain factual data for itself. It is
closely related and connected with financial accounting. Thus, management accounting is
dependent on financial accounting which limits its scope.
2. Cost Accounting
Cost accounting is an essential part of management accounting. Cost accounting, through

its various techniques, reveals efficiency of various divisions, departments and products. It also
provides information regarding cost of products process and jobs through different methods of
costing. Management accounting makes use of all this data by focusing it towards managerial
decisions.
3. Budgeting and Forecasting
Budgeting is setting targets by estimating expenditure and revenue for a given period.
Forecasting is prediction of what will happen as a result of a given set of circumstances. Targets
are fixed for various departments and responsibility is pinpointed for achieving the targets.
Actual results are compared with preset targets and performance is evaluated.
4. Inventory Control
This includes, planning, coordinating and control of inventory from the time of acquisition
to the stage of disposal. This is done through various techniques of inventory control like stock
levels, ABC and VED analysis physical stock verification, etc.
126
5. Statistical Analysis
In order to make the information more useful statistical tools are applied.These tools
include charts, graphs, diagrams index numbers, etc. For the purpose of forecasting, other
tools such as time series regression analysis and sampling techniques are used.
6. Analysis of Data
Financial statements are analysed and compared with past statements, compared with
those of other firms and with standards set. The analysis and interpretation results in drawing
reports and presentation to the management.
7. Internal Audit
Internal audit helps the management in fixing individual responsibility for internal control.
8. Tax Accounting
Tax liability is ascertained from income statements. Tax planning in done by following the
various tax incentives offered by the Central and State Governments. Knowledge of tax provisions
helps the management in meeting the tax liabilities and complying with other legislations like
Sales tax, Companies Act and MRTP Act.
9. Methods and Procedures
In includes keeping of efficient system for data processing and effective reporting of
required data in time.
8.5 Functions of Management Accounting

Main objective of management accounting is to help the management in performing its
functions efficiently. The major functions of management are planning, organizing, directing
and controlling. Management accounting helps the management in performing these functions
effectively.
1. Presentation of Data
Traditional Profit and Loss Account and the Balance Sheet are not analytical for decision
making. Management accounting modifies and rearranges data as per the requirements for
decision making through various techniques.
127
2. Aid to Planning and Forecasting
Management accounting is helpful to the management in the process of planning through

the techniques of budgetary control and standard costing. Forecasting is extensively used in
preparing budgets and setting standards.
3. Decision Making
Management accounting provides comparative data for analysis and interpretation for
effective decision making and policy formulation.
4. Communication of Management Policies
Management accounting conveys the polices of the management downward to the

personnel effectively for proper implementation.
5. Effective Control
Standard costing and budgetary control are integral part of management accounting.
These techniques lay down targets, compare actual with standards and budgets to evaluate the
performance and control the deviations.
6. Incorporation of non-financial information
Management accounting considers both financial and non-financial information for

developing alternative courses of action which leads to effective and accurate decisions.
7. Co ordination
The targets of different departments are communicated to them and their performance is
reported to the management from time to time. This continual reporting helps the management
in coordinating various activities to improve the overall performance.
8.6 Advantages of Management Accounting

The advantages of management accounting are summarized below:
1. Helps in Decision Making
Management accounting helps in decision making such as pricing, make or buy,

acceptance of additional orders, selection of suitable product mix etc. These important decision
are taken with the help of marginal costing technique.
128
2. Helps in Planning
Planning includes profit planning, preparation of budgets, programmes of capital investment

and financing. Management accounting assists in planning through budgetary control, capital
budgeting and cost-volume-profit analysis.
3. Helps in Organizing
Management accounting uses various tools and techniques like budgeting, responsibility
accounting and standard costing. A sound organizational structure is developed to facilitate the
use of these techniques.
4. Facilitates Communication
Management is provided with up-to-date information through periodical reports. These

reports assist the management in the evaluation of performance and control.
5. Helps in Co-ordinating
The functional budgets (purchase budget, sales budget, and overhead budget etc.) are
integrated into one known as master budget. This facilitates clear definition of department
goals and coordination of their activities.
6. Evaluation and Control of Performance
Management accounting is a convenient tool for evaluation of performance. With the

help of ratios and variance analysis, the efficiency of departments can be measured. Management
accounting assists the management in the location of weak spots and in taking corrective actions.
7. Interpretation of Financial Information
Management accounting presents information in a simple and purposeful manner. This

facilitates quick decision making.
8. Economic Appraisal
Management accounting includes appraisal of social and economic forces and government
polices. This appraisal helps the management in assessing their impact on the business.
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8.7 Limitations of Management Accounting

Management accounting suffers from the following limitations:
1. Based on Accounting Information
Management accounting derives information from past financial accounting and cost
accounting records. If the past records are not reliable, it will affect the effectiveness of
management accounting.
2. Wide scope
Management accounting has a very wide scope incorporating many disciplines. This results
in inaccuracy and other practical difficulties.
3. Costly
The installation of management accounting system requires a large organization. Hence,

it is very costly and only big concerns can afford to adopt it.
4. Evolutionary Stage
Management accounting is still in its initial stages. Tools and techniques are not fully
developed. This creates doubts about the utility of management accounting.
5. Opposition to Change
Introduction of management accounting system requires a number of changes in the

organization structure, rules and regulations. This rearrangement is not generally liked by the
people involved.
6. Intuitive Decisions
Management accounting helps in scientific decision making. Yet, because of simplicity

and personal factors the management has a tendency to arrive at decisions by intuition.
7. Not an Alternative to Management

Management accounting will not replace the management and administration. It is a tool
of the management. Decisions are of the management and not of the management accountant.
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8.8 Distinguish Between Managemnet Accounting and Cost

Accounting
Cost accounting and Management accounting are tow modern branches of accounting.
Both the systems involve presentation of accounting data for the purpose of decision making
and control of day-to-day activities. Cost accounting is concerned not only with cost
ascertainment, but also cost control and managerial decision making. Management accounting
makes use of the cost accounting concepts, techniques and data. The functions of cost
accounting and management accounting are complimentary. In cost accounting the emphasis
is on cost determination while management accounting considers both the cost and revenue.
Though it appears that here is overlapping of areas between cost and management accounting,
the following are the differences between the two systems.
1. Purpose
The main objective of cost accounting is to ascertain and control the cost of products or
services. The function of management accounting is to provide information to management for
efficiently performing the functions of planning, directing, and controlling.
2. Emphasis
Cost accounting is based on both historical and present data, whereas management
according deals with future projections on the basis of historical and present cost data.
3. Principles and Procedures
Established procedures and practices are followed in cost accounting. No such prescribed
practices are followed in Management accounting. The analysis is made and the resulting
conclusions are presented in reports as per the requirements of the management.
4. Data Used
Cost accounting uses only quantitative information whereas management accounting
uses both qualitative and quantitative information.
5. Scope
Management accounting includes, financial accounting, cost accounting, budgeting, tax
planning and reporting to management, whereas Cost accounting is concerned mainly with
cost ascertainment and control.
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8.9 Distinguish between Management Accounting and Financial

Accounting
FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING
Financial accounting is regulated Management accounting is regulated and

by law (principals, content)i.e., established by the entrepreneur, it is not
it is standardized. standardized.
Financial accounting focuses on the Management accounting also uses future

economic events of the past, the data and information, not only historical
statements contain historical data. data, for the purposes of planning.
The statements are regulated by law, The entrepreneur has no such

this is what is called the reporting obligation. onligations, he decides on the company’s
operations by himself.
It basically focuses on the financial year. The time horizon is defined by the
company itself.
The compilation of financial statements The frequency of compiling financial

for the financial year is obligatory. statements is defined by the company
itself.
The financial statements show the Management accounting focuses on

company as a whole. smaller units, so it draws attention to the
company’s organizations and products.
The information in the financial Besides value data, it basically provides

statements is mostly defined in quantitative data.
financial values.
The information content of the Information is supervised by internal

published financial statements is auditors.
typically supervised by an auditor.
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8.10 Distinguish between Cost Accounting and Financial

Accounting
1. Objectives
The main objective of cost accounting is to provide cost information to management for
decision making whereas the main objective of financial accounting is to prepare profit and loss
account and balance sheet to owners and outsiders.
2. Legal Requirement
Cost accounts are maintained to fulfil the internal requirements of the management as
per conventional guideline. Financial records are maintained as per the requirement of Companies
Act and Income Tax Act.
3. Classification of Transactions
Cost accounting records and analyses expenditure in an objective manner viz., according
to purpose for which costs are incurred. Financial accounting classifies records and analyses
transactions in a subjective manner i.e., according to nature of expenses.
4. Stock Valuation
In cost accounts stocks are valued at cost. In financial accounts, stocks are valued at cost
or realisable value, whichever is lesser.
5. Analysis of Profit and Cost
Cost accounts reveal Profit of Loss of different products, departments separately. In financial
accounts, the Profit or Loss of the entire enterprise is disclosed into.
6. Accounting period
Cost report are continuous process and are prepared as per the requirements of
managements, may be daily, weekly, monthly, quarterly, or annually. Financial reports are
prepared annually.
133
7. Emphasis
Cost accounting lays emphasis on ascertainment of cost and cost control. Financial
accounts emphasis is laid on the recording of transactions and control aspect is not given
importance.
8.11 Summary
The term management accounting refers to accounting for the management. Management
accounting provides necessary information to assist the management in the creation of policy
and in the day-to-day operations. It enables the management to discharge all its functions i.e.
planning, organization, staffing, direction and control efficiently with the help of accounting
information.
8.12 Key Words

Cost Accounting
Financial Accounting
Management Accounting

1. Define Management Accounting.
2. List out the objectives of Management Accounting.
3. Explain elaborately about the scope of Management Accounting
4. Bring out the Functions of Management Accounting.
5. Outline the advantages and disadvantages of Management Accounting.
6. State the Differences between Cost accounting and Management accounting.
7. How will you differentiate the financial accounting from management accounting?

Pearson, 2012.
134

2011.
135
LESSON 9
FINANCIAL STATEMENT ANALYSIS
Learning Objectives
 Explain about the essence of the preparation of Financial Statement Analysis.
 Prepare the financial statements of both public and private limited companies.
Structure
9.1 Introduction
9.2 Analysis and Interpretation of Financial Statements
9.3 Types of Financial Statements
9.4 Steps involved in Financial Statement Analysis
9.5 Tools of Financial Analysis
9.6 Inter Firm and Intra Firm Comparison
9.7 Limitations of Financial Statements
9.8 Summary
9.9 Key Words
9.1 Introduction
“A financial statement is an organized collection of data according to logical and consistent
accounting procedures. Its purpose is to convey an understanding of some financial aspects of
a business firm. It may show a position at a moment of time as in the case of a balance sheet
or may reveal a series of activities over a given period of time as in the case of an Income
Statement.”
- John J Hampton
136
According to the American Institute of Certified Public Accountants, financial statements

reflect “a combination of recorded facts, accounting conventions and personal judgements and
the judgements and conventions applied affect them materially. This implies that data exhibited
in the financial statements are affected by recorded facts, accounting conventions and personal
judgements.
The term financial statements generally refer to two basic statements:
i) the Income Statement and
ii) The Balance Sheet.
Two other important financial statements are
iii) A Statement of Retained Earnings, and
iv) A Statement of Changes in Financial Position.
1. Income Statement: The Income Statement also known as profit and loss account is
generally considered to be the most useful of all financial statements. It explains what has
happened to a business as a result of operations between two Balance sheet dates. For this
purpose it matches the revenue and cost incurred in the process of earning revenue and shows
the net profit earned or loss during the particular period.
2. Balance sheet: It is a statement of financial position of a business at a specified

moment of time. It represents all assets owned by the business on that date and the claims of
the owner and the outsiders against those assets. It is a snapshot of the financial condition of
the business.
3. Statement of Retained Earnings: The term “retained earning” means the accumulated
excess of earnings over losses and dividends. The balance shown by the income statement is
transferred to the balance sheet through this statement after making necessary appropriations.
It is a connecting link between balance sheet and income statement.
4. Statement of Changes in Financial Position: The balance sheet shows the financial
conditions of the business at a particular moment of time while the income statement discloses
the result of operations of the business over a period of time. This statement shows the following
aspects relating to the change in financial position of the business.
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i) Change in the firm’s working capital
ii) Change in the firm’s cash position
iii) Changes in the firm’s total financial position
The term “Fund Flow Statement” and “Cash Flow Statement” are popularly used for the
first two statements while the term “Statement of Changes in Financial Position” is used for the
third type of statement.
9.2 Analysis and Interpretation of Financial Statements

Financial statements are the indicators of two significant factors:
i) Profitability, and
ii) Financial soundness.
Analysis and Interpretation of financial statements refer to such a treatment of the

information contained in the Income Statement and the Balance Sheet so as to afford full
diagnosis of the profitability and financial soundness of the business.
The term ‘Analysis’ means methodical classification of the data given in the financial
statements. The figures given in the financial statements are arranged in a simplified form. For
example, all items relating to ‘ Current Assets’ are put in one place while all items relating to
‘Current Liabilities’ are put together. The term ‘ Interpretation’ means explaining the meaning
and significance of the data so simplified.
According to Myers, ‘ Financial Statement Analysis is largely a study of the relationship

among the various financial factors in a business as disclosed by a single set of statements and
a study of the trend of these factors as shown in a series of statements.’
9.3 Types of Financial Statement Analysis

Financial Statement Analysis or Financial Analysis can be classified into different categories
depending upon (i) the material used and (ii) the modus operandi of analysis.
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On the basis of material used: Financial analysis can be classified as :
i) External analysis: Analysis is done by outsiders for the business such as possible
investors, credit agencies and the Government who have no access to the internal
records of the company.
ii) Internal analysis: It is done by persons who have access to the books of accounts
and other information relating to the business such as the employees and the
management of the organization.
On the basis of Modus Operandi:
i) Horizontal analysis: In this type of analysis, financial statements for a number of

years are reviewed and analysed. The current year’s figures are compared with the
standard or base year. It is also called Dynamic analysis.
ii) Vertical Analysis: In this type of analysis , a study is made of the quantitative
relationship of the various items of the financial statement on a particular date. Eg.,
ratios It is useful for comparing the performance of several companies in the same
group or divisions in the same company. It is also called static analysis.
9.4 Steps involved in Financial Statement Analysis

The analysis of the financial statements requires:
(i) Methodical classification of the data given in the financial statements.
(ii) Comparison of the various inter-connected figures with each other by different ‘Tools
of Financial Analysis’.
Methodical Classification
In order to have a meaningful analysis it is necessary that figures should be arranged

properly. Usually instead of the two-column (T form) statements as ordinarily prepared, the
statements are prepared in single (Vertical) column form “which should throw up significant
figures by additing or subtracting”. This also facilitates showing the figures of a number of
firms or number of years side by side for comparison purposes
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Operating (income) statement

For the year ending ………….
Rs. Rs.
Gross sales ….
Less Sales returns …
Sales tax / excise … …..
Net sales for the year (1) ….
Cost of sales (2)
Less Raw materials consumed
Add Direct wages …
Manufacturing expenses …
Less Opening stock : Finished goods …
Work-in-Progress …
Closing stock : Finished goods …
Work – in – Progress …
Less Gross profit (1) – (2) = (3) … ....
Operating Expenses (4)
Add Administration Expenses …
Selling and Distribution Expenses
Net Operating Profit (OPBIT) (3) – (4) = (5)
Less Non – trading income …
(such as dividends, interest received, etc.) …
Non – trading Expenses (such as discount
Less on issue of shares written off)
Less Income or Earning before interest and
tax (EBIT) (6)
Interest on Debentures (7)
Net income or Earning before tax (EBT) (8)
Tax (9)
Income or Profit after tax (10)
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Balance sheet as on ……..
Rs.
Cash in hand ….
Cash at bank ….
Bills receivable ….
Book debts (less provision for bad debts) ….
Marketable trade investments
….
Liquid assets (1) …
Inventories (stock of raw materials, finished goods, etc.)
Prepaid Expenses …
Current Assets (2) ….
Bills payable ….
Trade creditors ….
Outstanding expenses ….
Bank overdraft ….
Other liabilities payable within a year
Current Liabilities (3) ….
Provision for tax ….
Proposed dividends ….
Other provisions ….
Provisions (4) ….
Current Liabilities and Provisions (3) + (4) = (5)
Net Working Capital (6) ….
[current assets – current liabilities and provisions (2)-(5)] …
….
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Good will at cost*
Land and building
Plant and machinery …
Loose tools …
Furniture and fixtures …
Investments in subsidiaries …
Patents, copyright etc.** …
Fixed Assets (7) …
Capital employed (6)+(7)=(8)
Other Assets (9) …
Investment in Government securities, unquoted investments …
Other investments (non trading)
Advances to directors
Company’s Net Assets (8)+(9)=(10) …
Debentures
Other long term loans (payable after a year) …
Long Term Loans (11)
Shareholders’ Net worth (10)-(11)=(12)
(or Total Tangible Net Worth) ….
….
…
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Preference Share Capital (13) ….
….
Equity shareholders Net worth (12)-(13)=(14)
Equity shareholders’ Net Worth is represented by
Equity share capital …. …..
Forfeited shares ….
Reserves ….
Surplus ….. ….
____
Equity shareholders’ claims
Less : Accumulated losses
Miscellaneous expenditure
(such as preliminary expenses,
discount on issue of shares or
debentures not written off) ______
Equity Shareholders Net Worth
3 Goodwill to be included only when it has been paid for and has the value.
4 Patents, copyrights etc., should be shown only when they have the value. In case
these assets are valueless, they should not be included there but should be written
off against shareholders claims with other losses.
9.5 Tools of Financial Analysis

A financial analyst can adopt the following tools for analysis of the financial statements.
These are also termed as method of financial statements.
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1. Comparative financial statements
Comparative financial statements are those statements, which have been designed in a
way so as to provide time perspective to the consideration of various elements of financial
position embodied in such statements. In these statements figures for two or more periods are
placed side by side to facilitate comparison.
2. Comparative income statements
The income statement discloses net profit or net loss on account of operations. A
comparative income statement will show the absolute figures for two or more periods, the
absolute change from one period to another and if desired the change in terms of percentages.
Since, the figure for two or more periods are shown side by side, the reader can quickly ascertain
whether sales have increased or decreased, whether cost of sales has increased or decreased
etc. thus, only a reading of data included in comparative income statements will be helpful in
deriving meaningful conclusions.
3. Comparative balance sheet
Comparative balance sheet as on two or more different dates can be used for comparing
assets and liabilities and finding out any increase or decrease in those items. Thus, while in a
single balance sheet the emphasis is on present position, it is on change in the comparative
balance sheet. Such a balance sheet is very useful in studying the trends in an enterprise.
4. Common – Size financial Statements
Common-Size financial statements are those in which figures reported are converted into
percentages to some common base. In the income statement the sales figure is assumed to be
100 and all figures are expressed as a percentage of sales. Similarly in the balance sheet the
total of assets or liabilities is taken as 100 and all the figures are expressed as a percentage of
this total.
5. Trend Percentages
Trend percentages are immensely helpful in making a comparative study of the financial
statements for several years. The method of calculating trend percentages involves the calculation
of percentage relationship that each item bears to be same item in the base year. Any year may
be taken as the base year. It is usually the earliest year. Any intervening year may also be taken
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as the base year. Each item of base year is taken as 100 and on that basis the percentages for
each of the items of each of the years are calculated. These percentages can also be taken as
index
This is the most important tool available to financial analysts for their work. An accounting
ratio shows the relationship in mathematical terms between two interrelated accounting figures.
The figures have to be interrelated (e.g., Gross Profit and Sales, Current Assets and Current
Liabilities) because no useful purpose will be served if ratios are calculated between two figures
which are not at all related to each other, e.g., sales and discount on issue of debentures. A
financial analyst may calculate different accounting ratios for different purposes.
9.6 Inter-firm and Intra-firm Comparison

Meaning of inter-firm comparison. Inter firm comparison means a comparison of two or
more firms organized by a trade association with the objective of providing companies to improve
the profitability and productivity of those companies. It thus focuses attention on both the areas
of strength and weakness of each of the member organizations. Centre for inter firm comparison,
a nonprofit making organization, established by the British institute of management has beautifully
explained this aspect in the following words.
“Inter firm comparison is concerned with the individual firm, its access and the part played
by the management in achieving it. The end product of a properly conducted inter firm comparison
is not a statistical survey but the flash or insight in the mind of the managing director of a firm
which has taken part in such exercise. The results of this give him an instant and vivid picture
of how his firms profitability, its costs, its stock turnover and other key factors affecting the
success of a business compare with those of the other firms in his industry.
Meaning of inter firm comparison. The term intra-firm comparison means comparison of
two or more department or divisions belonging to the same firm with the objective of making
meaningful analysis for the purpose of increasing the effectiveness or efficiency of the department
or divisional involved.
Thus, both inter firm and intra firm comparison have the same objective with the difference
that while former compares the performance of the firm with other firms, the latter compares the
performance of the firm within itself. The comparison may cover the financial position or operating
result or both
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Requisites for inter firm or intra firm comparison. The following are the requisites for a
meaningful and effective inter firm or intra firm comparison:
(i) Similarity of firm or departments. In order to make an effective inter firm comparison,
it is necessary that the firms or division to be compared are completely alike. This means
that the age, character of production and the market which the firms or division are catering
should be the same .for example, there can be no comparison between a textile firm
manufacturing superfine cloth for export and another textile firm manufacturing coarse
cloth only. Similarly, there can be no comparison between bokaro steel plant established
only a few years ago and TISCO established more than 65 year ago. In case comparisons
are made between dissimilar divisions or departments, the results may be meaningless
and misleading.
(ii) Use of accounting ratios. Absolute figures are unfit for comparison. Accounting ratios
should preferably be used to signify the various figures in relation to others and to indicate
the areas of strength and weakness. However, before making a selection of accounting
ratios for inter firm comparison, the concerned trade association should take into
consideration the following facts:
(a) The practical issues involved in introducing an inter firm comparison scheme in the
industry
(b) The best ratios to express the information required
(c) The relationship that can be established in the ratios chosen to assist interpretation
and corrective action where necessary.
(d) The adjustment necessary to accounting information to ensure comparability in the

ratios so produced.
(iii) Similarly in accounting policies. The firms or divisions selected for inter firm or intra
firm comparison should have uniform accounting policies regarding valuation of inventories,
depreciation, provision of gratuity, etc., in the absence of such similarities, the accounting
ratios used for comparison will not give proper results.
(iv) Adjustment for inflation. Accounting ratios usually do not take into account the effect of
inflation. The ratios calculated may greatly be distorted on account of inflationary conditions.
It is, therefore, desirable that the effects of inflation are adjusted before making any
comparison.
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The following are some of the important accounting ratios, which can be used to throw
light on overall efficiency, financial position and conditions of both over and under trading:
(a) Overall return on investment. This may be further analyzed into(i)net profit
ratio(ii)turnover ratio
(b) Debt equity ratio. This may be studied with the fixed charges cover ratio
(c) Current ratio and liquidity ratio
(d) Turnover ratios. They include stock turnover ratio, debtors turnover ratio, creditors
turnover ratio, fixed assets turnover ratio, etc.,
(e) Input and output ratio. This ratio is particularly used in case of manufacturing
industries to compare the output for a given volume of input.
Advantages of inter-firm or intra-firm comparison.
Inter firm or intra firm comparison offers the following advantage:

(i) It provides comparative data to the business/departments to assess the performance.
It provides the companies/departments with information regarding profitability and
production relevant to the specific industry and for companies/departments of similar
type and size.
(ii) It identifies specific areas in the business which may need managerial attention
(iii) It provides information to management on a uniform basis.
Limitations of inter firm or intra firm comparison.
The following are some of the limitations of the inter firm or intra firm comparison. These
limitations are more predominant in case of inter firm comparison.
(i) The success of inter firm or intra firm comparison depend on sincere co-operation
by the member firms or departments (within the company). In case co-operation is
not forthcoming, it is not possible to have meaningful comparison
(ii) In case of inter firm comparison, it is usually assured by the association collecting
the figures from the member firm that the information supplied by them will be kept
confidential. In spite of such assurance there is usually reluctance on the part of
some firms to part with information of a confidential nature. This creates problems
for the association in completing of different accounting ratios. Of course, this
difficulty is generally not faced in case of intra firm comparison.
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Besides the above limitations, one should not also forget about the various limitations
from which the financial statements or the techniques of the ratios analysis suffer. The inter
firm or intra-firm comparison should, therefore, also be viewed keeping these limitations in
mind.
9.7 Limitations of Financial Statements

Financial statements are prepared with the object of presenting a periodical review or
report on the progress by the management and deal with the (i) status of the investments in the
business and (ii) results achieved during the period under review. However, these objectives
are subject to certain limitations as given below :
1. Financial Statements are essentially interim reports :
2. Financial statements are prepared on the basis of certain accounting concepts and
conventions. On account of this reason the financial position as disclosed by these
statements may not be realistic.
3. Many items are left to the personal judgement of the accountant. For example,
the method of depreciation, mode of amortization of fixed assets, treatment of
deferred revenue expenditure
4. Financial statements do not depict those facts which cannot be expressed in terms
of money
9.8 Summary
A financial statement is an organized collection of data according to logical and consistent
accounting procedures. Its purpose is to convey an understanding of some financial aspects of
a business firm. It may show a position at a moment of time as in the case of a balance sheet
or may reveal a series of activities over a given period of time as in the case of an Income
Statement. The types of Financial Statements are explained in this lesson. The Limitations of
Financial Statements are also discussed.
9.9 Key Words

Balance Sheet
Cash Flow statements

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Fund flow statements
Income Statements

1. Explain the Types of Financial Statement Analysis
2. What are the Limitations of Financial Statements?
3. Evaluate the Steps involved in Financial Statement Analysis.
4. Compare Inter-Firm with Intra-Firm.

Pearson, 2012.

2011.
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LESSON 10
TOOLS OF FINANCIAL STATEMENT ANALYSIS
Learning Objectives
 Narrate the tools of Financial Statements and how they work for a concern.
 Highlight the effectiveness of tools of financial statement analysis.
 Differentiate Cash Flow analysis and Funds flow analysis
Structure
10.1 Introduction
10.2 Comparative Financial Statements
10.3 Common size Financial Statements
10.4 Fund Flow Statement
10.4.1 Meaning of Funds
10.4.2 Meaning of Flow of Funds
10.4.3 External Sources of funds
10.4.4 Application of Funds
10.4.5 Technique for preparing funds flow statement
10.4.6 Treatment of Provision for Tax and Proposed Dividends
10.4.7 Statement of Changes in Financial Position
10.5 Cash Flow Statement
10.6 Differences between Cash Flow Analysis and Funds Flow Analysis
10.7 Limitations of Cash Flow Analysis
10.8 Illustrations
10.9 Summary
10.10 Key Words

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10.1 Introduction
Four tools are used for financial statement analysis. They are Comparative statement,
common size statement funds, flow analysis and cash flow analysis.
10.2 Comparative Financial Statements

Comparative financial statements are also called year-to-year change statements.
Comparative financial statements can use both absolute amounts and percentages to provide
meaningful analysis. This type of analysis puts absolute changes and percentage changes in
perspective. No changes can be computed if there is no base figure available and no meaningful
change can be calculated if one figure is positive and the other is negative.
The following steps may be followed to prepare the comparative statements:
Step 1 : List out absolute figures in rupees relating to two points of time (as shown in
columns 2 and 3 of Exhibit 4.1).
Step 2 : Find out change in absolute figures by subtracting the first year (Col.2) from the
second year (Col.3) and indicate the change as increase (+) or decrease (–) and put it in
column 4.
Step 3 : Preferably, also calculate the percentage change as follows and put it in column
5.
Particulars First Year Second Absolute Increase Percentage

Year (+) or Increase (+) or
Decrease (–) Decrease (–)
1 2 3 4 5
Rs. Rs. Rs. Rs.

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10.3 Common Size Financial Statement

A common size financial statement displays all items as percentages of a common base
figure rather than as absolute numerical figures. This type of financial state ment allows for
easy analysis between companies or between time periods for the same company. The values
on the common size statement are expressed as ratios or percentages of a statement component,
such as revenue.
While most firms don’t report their statements in common size format, it is beneficial for
analysts to compute it to compare two or more companies of differing size or different sectors
of the economy. Formatting financial statements in this way reduces bias that can occur and
allows for the analysis of a company over various time periods, revealing, for example, what
percentage of sales is the cost of goods sold and how that value has changed over time. Common
size financial statements commonly include the income statement, balance sheet and cash
flow statement.
Common size analysis is of immense use for comparing enterprises which differ
substantially in size as it provides an insight into the structure of financial statements. Inter-firm
comparison or comparison of the company’s position with the related industry as a whole is
possible with the help of common size statement analysis. The following procedure may be
adopted for preparing the common size statements.
1. List out absolute figures in rupees at two points of time, say year 1, and year 2 (Column
2 & 4 of Exhibit 4.2).
2. Choose a common base (as 100). For example, revenue from operations may be
taken as base (100) in case of statement of profit and loss and total assets or total liabilities
(100) in case of balance sheet.
3. For all items of Col. 2 and 3 work out the percentage of that total. Column 4 and 5
shows these percentages in Exhibit.
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Common Size Statement
Particulars Year one Year two Percentage Percentage

of year 1 of year 2
1 2 3 4 5
10.4 Funds Flow Statement

The funds flow statement is widely used by the financial analysts and credit granting
institutions and financial managers in performance of their jobs. It has become a useful tool in
their analytical kit. This is because the financial statements, i.e., “Income Statement” and the
“Balance Sheet” have a limited role to perform. Income Statement measures flows restricted to
transactions that pertain to rendering of goods or services to customers. The balance sheet is
merely a static statement. It is a statement of assets and liabilities as on a particular date. It
does not sharply focus those major financial transactions which have been behind the balance
sheet changes.
It will be appropriate to explain the meaning of the term funds and the term ‘Flow of
Funds’ before explaining the meaning of the term ‘Funds Flow Statement.
10.4.1 Meaning of Funds
The term ‘Funds’ has variety of meanings. There are people who take it synonymous to
cash and to them there is no difference between a Funds Flow Statement and a cash flow
statement. While others include marketable securities besides cash in the definition of the term
‘Funds’. The international Accounting standard – 7 on “Statement of Changes in Financial
Position” also recognizes the absence of a single, generally accepted, definition of the term.
According to the standard, the term “Fund” generally refers to cash, to cash and cash equivalents,
or to working capital. Of these, the last definition of the term is by far the most common definition
of the term ‘fund’.
There are also two concepts of working capital – gross concept and net concept. Gross
working capital refers to the firm’s investment in current assets while the term net working
capital means excess of current assets over current liabilities. It is in the latter sense in which
the term ‘Funds’ is generally used.
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The meanings of two terms ‘current assets’ and ‘current liabilities’ have already been
explained in a preceding chapter. However, for the sake of ready reference, we are giving
below the meanings of these two terms ‘current assets’ and ‘current liabilities’ besides explaining
‘non current assets’ and ‘non – current liabilities’.
1. Current Assets
The term ‘Current Assets’ includes assets which are acquired with the intention of converting
them into cash during the normal business operations of the company. However, the best
definition of the term ‘Current Assets’ has been given by Grady in the following words.
For accounting purposes, the term ‘Current Assets’ is used to designate cash and other
assets or resources commonly identified as those which are reasonably expected to be realized
in cash or sold or consumed during the normal operating cycle of the business.
The board categories of current assets, therefore, are
(i) Cash including fixed deposits with banks
(ii) Accounts receivable, i.e., trade debtors and bills receivable
(iii) Inventory i.e., stocks of raw materials, work – in – progress, finished goods, stores
and spare parts.
(iv) Advances revocable, i.e., the advances given to supplier of goods and services or
deposit with government or other public authorities, e.g., customs, port authorities,
advance or deposit with government or the public authorities, e.g., customs, port
authorities, advance income tax, etc.,
(v) Pre – paid expenses, i.e., cost of unexplored services, e.g., insurance premium
paid in advance etc.,
2. Current Liabilities
The terms ‘Current Liabilities’ is used principally to designate such obligations whose
liquidation is reasonably expected to require the use of assets classified as current assets in
the same balance sheet or the creation of other current liabilities or those expected t be satisfied
within a relatively short period of time usually one year. However, this concept of current liabilities
has now undergone a change. The more modern version designates current liabilities. In other
words, the mere fact that an amount is due within the coming year or the operating cycle,
whichever is longer,
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(i) The use of existing current assets or
(ii) The creation of other current liabilities. In other words, the mere fact that an amount
is due within a year does not make it a current liability unless it is payable out of
existing current assets or by creation of current liabilities. For example, debentures
due for redemption within a year of the balance sheet date will not be taken as a
current liability if they are to be paid out of the proceeds of a fresh issue of shares/
debentures or out of the proceeds realized on account of sale of debentures
redemption funds investments.
Provisions against Current Assets
Provisions against current assets, such as provision for doubtful debts, provision for loss
of stock, provision for doubts, provision for loss of stock, provision for discount on debtors, etc.,
are treated as current liabilities, since they reduce the amount of current assets.
3. Non-Current Assets
All assets other than current assets come within the category of non current assets.
Such assets include goodwill, land, building, machinery, furniture, long – term investments,
patent rights, trade marks, debit balance of the profit and loss account, discount on issue of
shares and debentures, preliminary expenses, etc.
4. Non-Current Liabilities
All liabilities other than current liabilities come within the category of non current assets.
Such assets include goodwill, land and building, machinery, furniture, long - term investments,
patent rights, trade marks debit balance of the profit and loss account revenue and capital
reserves (e.g., general reserve, dividend equalization fund, debenture sinking fund, capital
redemption reserve) etc.
10.4.2 Meaning of Flow of Funds
The term ‘Flow’ means change and, therefore, the term “flow of funds” means “Change in
working capital”. In other words, any increase or decrease in working capital means “Flow of
Funds”.
The following general rules can be formed.

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1. There will be flow of funds if a transaction involves.
(i) Current assets and fixed assets, e.g., purchase of building for cash;
(ii) Current assets and capital, e.g., issue of shares for cash;
(iii) Current assets and fixed liabilities, e.g., redemption of debentures in cash.
(iv) Current liabilities and fixed liabilities, e.g., creditors paid off in debentures;
(v) Current liabilities and capital, e.g., creditors paid off in shares;
(vi) Current liabilities and fixed assets, e.g., building transferred to creditors in satisfaction
of their claims.
2. There will be no flow of funds if a transaction involves;
(i) Current assets and current liabilities, e.g., payment made to creditors;
(ii) Fixed assets and fixed liabilities e.g., building purchased and payments made in
debentures.
(iii) Fixed assets and capital, e.g., building purchased and payment made in shares.
10.4.3 External Sources of Funds

(i) Funds from long – term loans
Long – term loans such as debentures, borrowing from financial institutions will increase
the working capital and, therefore, there will be flow of funds. However, if the debentures have
been issued in consideration of some fixed assets, there will be no flow of funds.
(ii) Sale of fixed assets
Sale of land, buildings, long – term investments will result in generation of funds.
(iii) Funds from increase in share capital
Issue of shares for cash or for any other current assets results in increase in working
capital and, therefore, there will be flow of funds. However, if the debentures have been issued
in consideration of some fixed assets, there will be no flow of funds.
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10.4.4 Applications of Funds
The uses to which funds are put are called allocations of funds following are some of
purpose for which funds may be used:
(i) Purchase of fixed assets
Purchase of fixed assets such as land, building, plant machinery, long – term investments,
etc., results in decrease of current assets without any decrease in current liabilities. Hence,
there will be a flow of funds. But in case shares or debentures are issued for acquisition of fixed
assets, there will be no flow of funds.
(ii) Payment of dividend
Payment of dividends results in decrease of a fixed liability and, therefore, it affects,

funds, generally, recommendation of directors regarding declaration of dividend (i.e., proposed
dividends) is simply taken as an appropriation of profits and not as an item affecting working
capital. This has been explained in detail later.
(iii) Payment of fixed liabilities
Payment of a long – term liability, such as redemption of debentures or redemption of

redeemable preference shares, results in reduction of working capiral and hence it is taken as
an application of funds.
(iv) Payment of tax liability
Provision for raxation is generally taken as an appropriation of profits and not as an

application of funds.
But if the tax has been paid, it will be taken as an application of funds.
The “sources” and “applications” of funds are being depicted by the following diagram.
Sources
10.4.5 Technique for Preparing a Funds Flow Statement
A funds flow statement depicts change in working capital. It will, therefore, be better for
the students to prepare first a schedule of changes in working capital before preparing a fund
flow statement.
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SCHEDULE OF CHANGES IN WORKING CAPITAL
The schedule of changes in working capital can be prepared by comparing the current
assets and the current liabilities of two periods. It may be in the following form:
Schedule of changes in working capital
… …… Change
Increase Decrease
Current assets
Cash balance
Bank balance
Marketable securities
Accounts receivable
Stock-in-trade
Prepaid expenses
Current liabilities
Bank overdraft
Outstanding expense
Accounts payable
Net increase/decrease in
working capital
Rules for preparing the schedule
(i) Increase in current asset, results in increase (+) in “working capital”
(ii) Decrease in a current asset, result in decrease (-) in “working capital”
(iii) Increase in a current liability, results in decrease (-) in “working capital”
(iv) Decrease in a current liability, result in increase (+) in “working capital”.

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While preparing a fund flow statement, current assets and current liabilities are to be
ignored. Attention is to be given to changes in fixed assets and fixed liabilities. The statement
may be prepared in the following form.
FUNDS FLOW STATEMENT

Sources of funds
Issue of shares …
Issue of debentures …
Long term borrowings …
Sale of fixed assets …
Operating profit …
Total sources …
Applications of funds
Redemption of redeemable preference shares ..
Redemption of debentures …
Payment of other long term loans …
Purchase of fixed assets …
Operating loss …
Payment of dividends, tax, etc. …
Total uses …
Net increase/decrease in working capital ….
(Total sources *-Total uses)
The funds flow statement can also be prepared in ‘T’ shape form as shown below:
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FUNDS FLOW STATEMENT
Sources of funds …. Applications of funds ….
Issue of shares …. Redemption of redeemable
Issue of debenture …. Preference shares …
Sale of fixed assets … Redemption of debenture …
Operating profit /Funds from
operations* … Payment of other long-term loans
Decrease in working capital* Purchase of fixed assets …
… Payment of dividend, tax, etc. …
Operating loss/Funds lost

in Operations* …
Increase in working capital* …
* Only one figure will be there.
The change in working capital disclosed by the ‘Schedule of Changes in working capital
will tally with the change disclosed by the ‘Funds Flow Statement’.
10.4.6 Treatment of Provision for Tax and Proposed Dividends

Provision for tax
While preparing a funds flow statement, there are two options available:
(i) Provision for tax may be taken as a current liability. In such a case, when provision
for tax is made the transaction involves profit & loss appropriation account which is a fixed
liability and provision or Tax Account which is a current liability. It will thus decrease the working
caporal. On payment of tax there will be no change in working capital because it will involve a
current liability (i.e., provision for tax) and the other a current asset (i.e., bank or cash balance).
(ii) Provision for tax may be taken only as an appropriation of profit. It means there
will be no change in working capital position when provision for tax is made since it will involve
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two fixed liabilities, i.e., profit and loss appropriation account and provision for tax account.
However, when tax is paid, it will be taken as application of funds, because it will then involve
provision for tax account which has been taken as a fixed liability and bank account which is a
current asset.
Proposed Dividends
Whatever has been said about the provision for taxation is also applicable to proposed
dividends. Proposed dividends can also be dealt with in two ways;
(i) Proposed dividends may be taken as a current liability since declaration of dividends
by the shareholders is simply a formality. Once the dividends are declared in the general meeting
they will have to be paid within 42 days of their declaration. In case proposed dividends is taken
as a current liability, it will appear as one of the items decreasing working capital in the “schedule
of changes in working capital”. It will not be shown as an application of funds when dividend is
paid later on.
(ii) Proposed dividends may simply be taken as appropriation of profits. In such a case
proposed dividend for the current year will be added back to current year’s profits in order to
find out funds from operations if such amount of dividend has already been charged to profits.
Payment of dividend will be shown as an “application of funds”.
10.4.7 Statement of changes in Financial Position
“Statement changes in financial position” is an extension of “Funds Flow Statement”. It is

very informative and comprehensive in indicating the firm’s financial position, since the term
‘Fund’ is used here in a wider sense covering both current and non-current accounts. For example,
when debentures are redeemed by converting them into share capital or when fixed assets are
purchased by issue of fully paid shares to the vendors, there is no change in the working capital
of the company but there is change in the overall financial position of the company, they will be
shown in the statement of changes in financial position both as a source of funds as well as an
applications of funds. Issue of shares to vendors or for redemption of debentures will be shown
as a source of funds while redemption of debentures or purchase of fixed assets will be shown
as an application of funds. Such a presentation gives a much more detailed as well as accurate
in formation about the changes in the financial position of the company as compared to the
changes in financial position as shown by the traditional funds flow statement.
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The importance of statement changes in financial position is now undoubtedly realized by

all – shareholders, management, lenders and other. In U.S.A. the publication of the statement
of changes in financial position as part of financial statements has been made obligatory by the
accounting principle board. It states, “Information concerning the financial and investing activities
of a business enterprise and the changes in its financial position for a period is essential for
financial statement users, particularly owners and creditors, in making economic decisions.
When financial statements purporting to present both financial position (balance sheet) and
results of operations (statements of income and retained earnings) are issued a statement
summarizing changes in financial position should also be presented as a basic financial statement
for the period for which an income statement is presented.
In our country, under the existing legal requirements, the companies are under no legal
obligation to publish statement of changes in financial position alon with their financial statements.
However, there is a growing practice to publish such a statement along with financial statements
especially in the case of companies listed on the stock exchange and other large commercial,
industrial and business enterprises in the public and private sectors.
A statement of changes in financial position may be defined as statement disclosing

changes in the firm’s total financial resources. According to international accounting standards
committee (international accounting standard:7) a statement of changes in financial position
means “a statement which summaries for the period the resources made available to finance
the activities of an enterprise and the uses to which such resources have been put”.
The accounting standards board established by the institute of charged accountants of

India defines a statement of changes in financial position as “a statement which summaries for
the period covered by it, the change in the financial position including the sources from which
such funds were applied”.
According to the board, the term ‘funds’ generally refers to cash, and cash equivalent or
to working capital. Thus, according to the board, the statement of changes in financial postion
may involve – (i) change only in the firm’s cash position, (ii) changes in the firm’s working capital
position, and (iii) changes in the firm’s total financial resources position. Of course, the term
“Statement of Changes in Financial Position” is generally used in the last mentioned case.
The statement of changes in financial position provides a meaningful link between the
balance sheets as the beginning and at the end of a period and the profit and loss account for
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that period. Although the information that it contains is a selection, reclassification and
summarization of the data contained in the profit and loss account and the balance sheet, it is
in no way a replacement of either of these statements. To provide a comparative view of the
movements of funds, the statement of changes in financial position is prepared for the period
covered by the profit and loss account as well as for the corresponding previous period.
10.5 Cash Flow Statement

A cash flow statement is a statement depicting change in cash position from one period to
another. The cash flow statement explains the reasons for such inflows or outflows of cash, as
the case might be. It also helps management in making plans for the immediate future. A
projected cash flow statement or a cash budget will enable the management in ascertaining
how much cash will be available to meet obligations to trade creditors, to pay bank loans and to
pay dividend to the shareholders. A proper planning of the cash resources will enable the
management to have cash available whenever needed and put it to some profitable or productive
use in case there is surplus cash available.
Preparation of cash flow statement
A cash flow statement can be prepared on the same pattern on which a funds flow statement
is prepared. The change in the cash position from one period to another is computed by taking
into account “Sources” and “Applications” of cash.
Sources of Cash
1. Internal sources
Cash from operations is the main internal source. The net profit shown by the profit and
loss account will have to be adjusted for non – cash items for finding out cash from operations.
Some of these items are as follows:
(i) Depreciation. Depreciation does not result in outflow of cash and, therefore net profit
will have to be increased by the amount of depreciation or development rebate charged, in
order to find out the real cash generated from operations.
(ii) Amortization of intangible assets. Good will, preliminary expenses, etc., when written
off against profits, reduce the net profits without affecting the cash balance. The amounts written
off should, therefore, be added back to profits to find out the cash from operations.
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(iii) Loss on sale of fixed assets. It does not result in outflow of cash and, therefore,
should be added back to profits.
(iv) Gains from sale of fixed assets. Since sale of fixed assets is taken as a separate
source of cash, it should be deducted from net profits.
(v) Creation of reserves. If profit for the year has been arrived at after charging transfers
to reserves, such transfers should be added back to profits. In cash operations show a net loss,
such net loss after making adjustments for non – cash items will be shown as an application of
cash.
Thus, cash from operations is computed on the pattern of computation of ‘Funds’ from
operations, as explained in the earlier chapter. However, to find out real cash from operations,
adjustments will have to be made of ‘change’ in current assets and current liabilities arising on
account of operations, viz., trade debtors, trade creditors, bills receivable, bills payable, etc.,
For the sake of convenience computation of cash from operations can be studied by
taking two different situations:
1. When all transactions are cash transaction, and
2. When all transactions are not cash transactions.
2. External Sources
The external sources of cash are:
(i) Issue of new shares. In cash shares have been issued for cash, the net cash received
(i.e., after deducting expenses on issue of shares or discount on issue of shares) will be taken
as a source of cash.
(ii) Raising long-term loans. Long term loans such as issue of debentures, loans from
financial institutions, are sources of cash.
(iii) Purchase of plant and machinery on deferred payments. In case plant and machinery
has been purchased on a deferred payment system, it should be shown as a separate source
of cash to the extent of deferred credit. However, the cost of machinery purchased will be
shown as an application of cash.
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(iv) Short – term borrowings – cash credit from banks. Short term borrowing, etc., from
banks increase cash available and they have to be shown separately under this head.
(v) Sale of fixed assets, investment, etc. it results in generation of cash and therefore is a
source of cash.
Decrease in various current assets and increase in various current liabilities (discussed
before) may be taken as external sources of cash, if they are not adjusted while computing
cash from operations.
10.6 Difference between Cash Flow Analysis and Funds

Flow Analysis
Following are the points of difference between cash flow analysis and a fund flow analysis:
1. A cash flow statement is concerned only with the change in cash position while a fund
flow analysis is concerned with change in working capital position between two balance sheet
dates. Cash is only one of the constituents of working capital besides several other constituents
such as inventories, accounts receivable, and prepaid expense.
2. A cash flow statement is merely a record of cash receipts and disbursements. Of course,
it is valuable in its own way but it fails to bring to light may important changes involving the
disposition of resources. While studying the sort – term solvency of a business one is interested
not only in cash balance but also in the assets which can be easily converted into cash.
3. cash flow analysis is more useful to the management as a tool of financial analysis in
short period as compared to funds flow analysis. It has rightly been said that shorter the period
covered by the analysis, greater is the importance of cash flow analysis. For example, if it is to
be found out whether the business can meet its obligations maturing after 10 years from now,
a good estimate can be made about firm’s capacity to meet its long – term obligations if changes
in working capital position on account of operations are observed. However, if the firm’s capacity
to meet a liability maturing after one month is to be seen, the realistic approach would be to
consider the projected change in the cash position rather than an expected change in the
working capital position.
4. Cash is part of working capital and, therefore, an improvement in cash position results
in improvement in the funds position but the reverse is not true. In other words “Inflow of cash”
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results in ‘inflow of funds’ but inflow of funds may not necessarily result in ‘inflow of cash’. Thus,
a sound funds position does not necessarily mean a sound cash position but a sound cash
position generally means a sound funds position.
5. Another distinction between a cash flow analysis and a funds flow analysis can be mad
eon the basis of the techniques of their preparation. An increase in a current liability or decrease
in a current asset results in decrease in working capital and vice versa. While an increase in a
current liability or decrease in a current asset (other than cash) will result in increase in cash
and vice versa.
Utility of cash flow analysis
A cash flow statement is useful for short – term planning. A business enterprise needs
sufficient cash to meet its various obligation in the near future such as payment for purchase of
fixed assets, payment of debts maturing in the near future, expenses of the business, etc. a
historical analysis of the different sources and applications of cash will enable the management
to make reliable cash flow projections for the immediate future. It may then plan out for investment
or surplus or meeting the deficit, if any. Thus, a cash flow analysis is an important financial tool
for the management. Its chief advantages are as follows:
1. Helps in efficient cash management.
Cash flow analysis helps in calculating financial policies and cash position. Cash is the
basis for all operations and hence a projected cash flow statement will enable the management
to plan and coordinate the financial operations properly. The management can know how much
cash is needed, from which source it will be derived, how much can be generated internally and
how much could be obtained from outside.
2. Helps in internal financial management
Cash flow analysis provides information about funds which will be available from
operations, this will help the management in determining policies regarding internal financial
management, e.g., possibility of repayment of long germ debt, dividend policies, planning
replacement of plant and machinery, etc.
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3. Discloses the movements of cash
Cash flow statement discloses the complete story of cash movement. The increase in,
or decrease of, cash, and the reason therefore cash be known. It it discloses the reasons for
low cash balance in spite of heavy operating profits or for heavy cash balance in spite of low
profits. However, comparison of original forecast with the actual results highlights the trends of
movements of cash, which may otherwise go undetected.
4. Discloses success or failure of cash planning
The extent of success or failure of cash planning can be known by comparing the
projected cash flow statement with the actual cash flow statement and necessary remedial
measures can be taken.
10.7 Limitations of Cash Flow Analysis

Cash flow analysis is a useful tool of financial analysis. However, it has its won limitations.
These limitations are as under.
1. Cash flow statement cannot be equated with the income statement. An income statement
takes into account both cash as well as non – cash items and, therefore, net cash flow does not
necessarily mean net income of the business.
2. The cash balance as disclosed by the cash flow statement may not represent the real
liquid position of the business since it can be easily influenced by postponing purchases and
other payments.
3. Cash flow statement cannot replace the income statement or the funds flow statement.
Each of them has a separate function to perform.
In spite of these limitations. It can be said that cash flow statement is a useful
supplementary instrument. It discloses the volume as well as the speed at which the cash flows
in the different segments of the business. This helps the management is knowing the amount of
capital tied up in one segment of the business. The technique of cash flow analysis, when used
in conjunction with ratio analysis, serves as a barometer in measuring the profitability and
financial position of the business.
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10.8 Illustrations
1. Convert the following statement of profit and loss into the comparative statement of profit
and loss of BCR Co. Ltd.:
Particulars 2013-14 Rs. 2014-15. Rs.
(i) Revenue from operations 60,00,000 75,00,000
(ii) Other incomes 1,50,000 1,20,000
(iii) Expenses 44,00,000 50,60,000
(iv) Income tax 35% 40%
Solution
Comparative statement of profit and loss for the year ended March 31, 2014 and
2015:
Particulars 2013-14 2014-15 Absolute Percentage

Increase (+) Increase (+)
or Decrease or Decrease
(–) (–)
I. Revenue from operations 60,00,000 75,00,000 15,00,000 25.00
II. Add: Other incomes 1,50,000 1,20,000 (30,000) (20.00)
III. Total Revenue I+II 61,50,000 76,20,000 14,70,000 23.90
IV Less: Expenses 44,00,000 50,60,000 6,60,000 15.00
Profit before tax 17,50,000 25,60,000 8,10,000 46.29
V Less: Tax 6,12,500 10,24,000 4,11,500 67.18
Profit after tax 11,37,500 15,36,000 3,98,500 35.03
2. From the following Balance Sheets of Amrit Limited as at March 31, 2014 and 2015,
prepare a comparative balance sheet:
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Particulars March 31, March 31,

2015 (Rs.) 2014 (Rs.)
I. Equity and Liabilities

1. Shareholders’ Funds
a) Share capital 20,00,000 15,00,000
b) Reserve and surplus 13,00,000 14,00,000
2. Non-current Liabilities
Long-term borrowings 19,00,000 16,00,000
3. Current liabilities
Trade payables 3,00,000 2,00,000
Total 55,00,000 47,00,000
II. Assets
1. Non-current assets
a) Fixed assets
- Tangible assets 20,00,000 15,00,000
- Intangible assets 19,00,000 16,00,000
2. Current assets
- Inventories 13,00,000 14,00,000
- Cash and Cash Equivalents 3,00,000 2,00,000
Total 55,00,000 47,00,000
Solution
Comparative Balance Sheet of Amrit Limited as at March 31st, 2014 and March 31st ,
2015 (Rs. in Lakhs)
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Particulars March March Absolute Percentage

31,2014 31,2015 Increase (+) Increase (+)
Rs. Rs. or Decrease (–) or Decrease (–)
1) Shareholders’ funds
a) Share capital 15 20 5 33.33
b) Reserves and surplus 14 13 (1) (7.14)
1) Non-current liabilities
Long-term borrowings 16 19 3 18.75
3) Current liabilities
Trade payables 2 3 1 50
Total 47 55 8 17.02
II. Assets
1) Non-current assets
Fixed assets
a) Tangible assets 15 20 5 33.3
b) Intangible assets 16 19 3 18.75
2) Current assets
a) Inventories 14 13 -1 -7.14
b) Cash and Cash

Equivalents 2 3 1 50
Total 47 55 8 17.02
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3. From the following information, prepare a Common size Income Statement for the year
ended March 31, 2014 and 2015:
Particulars 2014-15 2013-14

Rs. Rs.
Net sales 18,00,000 25,00,000
Cost of good sold 10,00,000 12,00,000
Operating expenses 80,000 1,20,000
Non-operating expenses 12,000 15,000
Depreciation 20,000 40,000
Wages 10,000 20,000
Common Size Income Statement for the year ended March 31, 2013 and March 31, 2014
Particulars Absolute Amounts Percentage of Net Sales

2013-14 2014-15 2013-14 2014-15
Rs. Rs (%) (%)
Sales 25,00,000 18,00,000 100 100
(Less) Cost of goods* 12,00,000 10,00,000 48 55.56
Gross Profit 13,00,000 8,00,000 52 44.44
(Less) Operating Expenses** 1,20,000 80,000 4.80 4.44
Operating Income 11,80,000 7,20,000 47.20 40
(Less) Non-Operating expenses 15,000 12,000 0.60 0.67
Profit 11,65,000 7,08,000 46.60 39.33
* Wages is the part of cost of goods sold; ** Depreciation is the part of operating expenses
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4. Prepare common size Balance Sheet of XRI Ltd. from the following information:
Particulars March 31, 2014 March 31, 2015
1. Shareholders’ Fund
a) Share capital 15,00,000 12,00,000
b) Reserves and surplus 5,00,000 5,00,000
2. Non-current liabilities
Long-term borrowings 6,00,000 5,00,000
Trade Payable 15,50,000 10,50,000
Total 41,50,000 32,50,000
II. Assets
a) Fixed assets
- Tangible asset
Plant & machinery 14,00,000 8,00,000
- Intangible assets
Goodwill 16,00,000 12,00,000
b) Non-current investments 10,00,000 10,00,000
2. Current assets
Inventories 1,50,000 2,50,000
Total 41,50,000 32,50,000

172
Solution
Common size Balace Sheet as at March 31, 2014 and March 31, 2015:
Particulars Absolute Amounts Percentage of total assets

31.03.2014 31.03.2015 31.03.2014 31.03.2015
Rs. Rs. (%) (%)
1. Shareholders’ Fund
a) Share capital 15,00,000 12,00,000 36.14 36.93
b) Reserves and surplus 5,00,000 5,00,000 12.05 15.38
2. Non-current liabilities
Long-term borrowings 6,00,000 5,00,000 14.46 15.38
Trade Payable 15,50,000 10,50,000 37.35 32.31
Total 41,50,000 32,50,000 100 100
II. Assets
a) Fixed assets
- Tangible asset
Plant & machinery 14,00,000 8,00,000 33.73 24.62
- Intangible assets
Goodwill 16,00,000 12,00,000 38.55 36.92
b) Non-current investments 10,00,000 10,00,000 24.1 30.77
2. Current assets
Inventories 1,50,000 2,50,000 3.62 7.69
Total 41,50,000 32,50,000 100 100

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5. From the balance sheets of A ltd, make out:
(i) A statement of changes in the working capital.
(ii) A funds flow statement.
Balance Sheet
Liabilities 31st March Assets 31st March

1999 2000 1999 2000
Rs. Rs. Rs. Rs.
Equity share capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
8% redeemable pref 1,50,000 1,00,000 Land and 2,00,000 1,70,000

share capital building
General reserve 40,000 70,000 Plant 80,000 2,00,000
P and L a/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed dividends 42,000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 Bills receivable 20,000 30,000
Bills payable 20,000 16,000 Cash in hand 15,000 10,000
Provision for taxation 40,000 50,000 Cash at bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000
Following is the additional information available:
(1) Depreciation of Rs.10,000 and Rs.20,000 have been charged on plant and land
and buildings respectively in 2000.
(2) An interim dividend of Rs.20, 000 has been paid in 2000.
(3) Income tax of Rs.35, 000 has been paid in 2000.

174
Statement of changes in working capital
1999 2000 Effect of Working capital

(Rs) (Rs) Increase Decrease
(Rs) (Rs)
Current Assets:
Debtors 1,60,000 2,00,000 40,000 -
Stock 77,000 1,09,000 32,000 -
Bills Receivable 20,000 30,000 10,000 -
Cash in hand 15,000 10,000 - 5,000
Cash at Bank 10,000 8,000 - 2,000
2,82,000 3,57,000 4,000 -
Current Liabilities 55,000 83,000 28,000
Creditors 20,000 16,000
Bills payable
75,000 99,000
Working capital 2,07,000 2,58,000
Net increase in
working capital 51,000 - 51,000
2,58,000 2,58,000 86,000 86,000
Adjusted Profit and loss account
Sources of fund Rs Application of fund Rs

To general reserve 30,000 By bal b/d 30,000
Dividend 28,000 By funds from operations 1,76,000
Provision for tax 45,000
Goodwill 25,000
Depreciation 30,000
To balance c/d 48,000
2,06,000 2,06,000
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Fund flow statement
Sources of fund Rs Application of fund Rs
Funds from operation 1,76,000 Purchase of plant 1,30,000
Issue of equity shares 1,00,000 Redemption of preference shares 50,000
Sale of Land and buildings 10,000 Payment of Dividend 20,000
Payment of Income tax 35,000
Increase in Working capital 51,000
2,86,000 2,86,000
6. From the following information, Prepare Cash From Operations and Cash Flow Statement:
Particulars 31.3.2012 31.3.2013

Rs. Rs.
Assets :
Cash Balances 5,000 3,500
Trade Debtors 15,000 25,000
Stock 17,500 12,500
Machinery 40,000 27,500
Land 20,000 25,000
Building 17,500 30,000
1,15,000 1,23,500
Capital and Liabilities :
Capital 62,500 76,500
Long-Term Loans Mortgage Loans 20,000 25,000
Trade Creditors 12,500 -
20,000 22,000
1,15,000 1,23,500
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Additional Information
(1) During the year a machine costing Rs. 5,000 (accumulated depreciation Rs. 1,500)
was sold for Rs. 2,500.
(2) The provision for depreciation against machinery during the year 2012 was Rs. 12,500
and Rs. 20,000 in 2013. -
(3) Net Profit earned during the year 2013 was Rs. 22,500
Solution
Cash Flow Statement
Sources of Cash Rs Applications of Cash Rs
Opening Balances : Purchase of Land 5,000
Cash at Bank 5,000 Purchase of Building 12,500
Add: Mortgage Loan repaid 12,500
Long-Term Loans 5,000 Drawings 8,500
Sale of Machinery 2,500 Closing Balances:
Cash From Operations 29,500 Cash at Bank 3,500
42,000 42,000
Working Note:
(1) Calculation of Cash from Operations
Particulars. Rs Rs
Net Profit during the year 22,500
Add:
Depreciation on Machinery
Loss on Sale of Machinery 9,000
Decrease in Stock 1,000
Increase in Creditors 5,000
2,000 17,000
Less: decrease in creditors 10,000 39,500
10,000
Cash from operations 29,500
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(2) Machinery Account
To Balance bId 52,500 By Bank 2,500
By Loss on Sale of Machinery 1,000
By Provision for Depreciation 1,500
By Balance c/d 47,500
(40,000 + 5000 + 2500)
52,500 52,500
(3) Provision for Depreciation
To Machinery A/c 1,500 By Balance bld 12,500
To Balance cld 20,000 By P & L A/c 9,000

(Depreciation charged
- balancing figure)
21,500 21,500
4) Capital account
Particulars Rs.
Opening Balance of Capital 62,500
Add: Profit 22,500
85
Less : Closing Balance of Capital 76,500
Drawings 8,500
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10.9 Summary
Comparative financial statements are also called year-to-year change statements.
Comparative financial statements can use both absolute amounts and percentages to provide
meaningful analysis. This type of analysis puts absolute changes and percentage changes in
perspective. No changes can be computed if there is no base figure available and no meaningful
change can be calculated if one figure is positive and the other is negative. The fund flow
analysis and cash flow analysis are also explained.
10.10 Key Words

Cash Flow Statements
Common size statements
Comparative Statements
Fund Flow Statements

1. What do you understand by Comparative Financial Statement?
2. Explain the need for Financial Statement.
3. Give the meaning of Flow of Funds
4. Bring out the techniques for the preparation of Funds Flow Statement.
5. List out the treatment provision in respect of Proposed tax.
6. Explain the Importance of Funds Flow Statement.
7. Explain the differences between Funds Flow Statement and Cash Flow Statement.
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8. The following are the income statements of Swastik Ltd., Bombay for the years 1993 and
1994. Prepare a comparative income statement and comment on the profitability of the
company.
1993 1994 1993 1994

(Rs.) (Rs.) (Rs.) (Rs.)
To Opening stock 85,000 2,00,000 By Sales Less: Returns 10,00,000 12,00,000
To Purchases Less: Returns 5,00,000 5,50,000 By closing Stock 2,00,000 2,25,000
To wages 60,000 80,000 By Income from investments 12,000 15,000
To Salaries 42,000 64,000 By Dividend received 5,000 7,500
To Rent, rates and taxes 35,000 40,000
To Depreciation 40,000 60,000
To Selling expenses 12,000 12,000
To Discount allowed 5,000 7,000
To Loss on sales of plant —— 8,000
To Interest paid 12,000 14,000
Net profit 4,26,000 4,12,500
Total 12,17,000 14,47,500 Total 12,17,000 14,47,500
9. The following are the Balance Sheets of a concern for the years 1998 and 1999. Prepare
a Comparative Balance Sheet and study the financial position of the concern.
Balance Sheet As on 31st December
Liabilities 1998 1999 Assets 1998 1999

(Rs.) (Rs.) (Rs.) (Rs.)
Equity Share Capital 2,00,000 3,30,000 Fixed assets less Depreciation 2,40,000 3,50,000
Preference Share Capital 1,00,000 3,30,000 Stock 40,000 50,000
Reserves & Surplus 20,000 30,000 Bills receivables 20,000 60,000
Profit & Loss A/C 15,000 20,000 Prepaid expenses 10,000 12,000
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Bank Overdraft 50,000 50,000 Cash in bank 10,000 30,000
Provision for taxation 20,000 25,000 Cash in hand 40,000 53,000
Sundry Creditors 40,000 50,000 Prepaid Expenses 10,000 12,000
Proposed Dividend 15,000 25,000 Sundry Debtors 1,00,000 1,25,000
4,60,000 6,80,000 4,60,000 6,80,000
10. Following are the Income Statements of a company for the year ending Dec., 31, 1993
and 1994:
1993 Rs.(‘000s) 1994 Rs.(‘000s)
Sales 500 700
Miscellaneous Income 20 15
520 715
Expenses:
Cost of sales 325 510
Office expenses 20 25
Selling expenses 30 45
25 30
400 600
Net profit 120 115
520 715
Comment on the profitability position using common – size Statement.

181
11. Convert the following Balance sheets into common-size balance sheet and interpret the
results:
Liabilities 1998 1999 Assets 1998 1999

(Rs.) (Rs.) (Rs.) (Rs.)
Equity share capital 1,000 1,200 Current assets: 450 390

Debtors
Capital reserves 90 185 Cash 200 15
General reserves 500 450 Stock 320 250
Sinking fund 90 100 Investments 300 250
Debentures 450 650 Fixed assets:

Buildings
Less depreciation 800 1,400
Sundry creditors 200 150 Land 198 345
Others 15 20 Furniture and fixture 77 105
Total 2,345 2,755 Total 2,345 2,755
12. From the following financial statements for the year 1997 and 1998, prepare a fund flow
statement:
Capital and liabilities 1997 1998 Assets 1997 1998

(Rs) (Rs) (Rs) (Rs)
Sundry creditors 8,26,000 12,54,000 Cash 1,06,000 62,000
Bills payable 4,52,000 6,28,000 Investments 1,74,000 -
Loan from bank 2,00,000 4,70,000 Sundry debtors 6,92,000 10,56,000
Reserves and surplus 13,84,000 17,28,000 Stock-in-trade 8,64,000 13,66,000
Share capital 12,00,000 12,00,000 Net fixed assets 22,26,000 27,96,000
40,62,000 52,80,000 40,62,000 52,80,000
Depreciation of Rs.3, 78,000 was written off for 1998 on fixed assets.
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13. Statement of financial position of Mr. Arun is given below:
Capital and liabilities 1.1.98 31.12.98 Assets 1997 1998

(Rs) (Rs) (Rs) (Rs)
Accounts payable 29,000 25,000 Cash 40,000 30,000
capital 7,35,000 6,15,000 Debtors 20,000 17,000
Stock 8,000 13,000
Building 1,00,000 80,000
Other fixed assets 6,00,000 5,00,000
7,68,000 6,40,000 7,68,000 6,40,000
Additional information:
a) There were no drawings
b) There were no purchases or sale of either building or other fixed assets
Prepare a statement of cash flow.

Pearson, 2012.

2011.
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LESSON 11
MARGINAL COSTING
Learning Objectives
 List out the features of Marginal Costing
 Explain the advantages and limitations of marginal costing
 Discuss the objectives, advantages and limitations of break even analysis
STRUCTURE
11.1 Introduction
11.2 Marginal Costing
11.2.1 Features of Marginal Costing
11.2.2 Advantages of Marginal Costing
11.2.3 Limitations of Marginal Costing
11.2.4 Applications of Marginal Costing
11.3 Break Even Analysis
11.3.1 Objectives of Cost Volume Profit Analysis
11.3.2 Advantages of Break Even Analysis
11.3.3 Limitations of Break Even Analysis
11.3.4 Uses of Cost Volume Profit Analysis
11.4 Contribution
11.4.1 Significance of Profit Volume Ratio
11.4.2 Margin of Safety
11.5 Break Even Chart
11.6 Absorption Costing
11.7 Illustrations
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11.8 Summary
11.9 Key Words
11.1 Introduction
Marginal costing is a method of cost accounting and decision-making used for internal
reporting in which only marginal costs are charged to cost units and fixed costs are treated as
a lump sum. It is also known as direct, variable, and contribution costing. Marginal costing is not
a distinct method of ascertainment of cost but is a technique which applies existing methods in
a particular manner so that the relationship between profit & the volume of output can be clearly
brought out. It is an accounting system where only variable cost or direct cost will be charged to
the cost units.
11.2 Marginal Costing

Marginal costing, as one of the tools of management accounting helps management in
making certain decisions. It provides management with information regarding the behavior of
costs and the incidence of such costs on the profitability of an undertaking. Marginal costing is
defined as “the ascertainment of marginal costs and of the effect on profit of changes in volume
or type of output by differentiating between fixed costs and variable costs”. Marginal costing is
not a separate costing. It is only a technique used by accountants to aid management decision.
It is also called as “Direct Costing” in U.S.A. This technique of costing is also known as “Variable
Costing”, “Differential costing” or “Out-of-pocket” costing.
Marginal cost is the cost of one unit of product or service which would be avoided if that
unit were not produced or provided. According to CIMA Terminology Marginal Costing is the
ascertainment of marginal costs and of the effect on profit of changes in volume or type of
output by differentiating between fixed costs and variable costs in this technique of costing only
variable costs are charged to operations, processes or products leaving all indirect costs to be
written off against profits in the period in which they arise.
Marginal costing is the accounting system in which variable costs are charged to cost
units and fixed costs of the period are written-off in full against the aggregate contribution. Its
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special value is in decision making. It is a technique of applying the existing methods in a

particular manner in order to bring out the relationship between profit and volume of output.
11.2.1 Features of Marginal Costing

 Costs are separated into the fixed and variable elements and semi-variable costs are also
differentiated likewise.
 Only the variable costs are taken into account for computing the value of stocks of work-
in-progress and finished products.
 Fixed costs are charged off to revenue wholly during the period in which they are incurred
and are not taken into account for valuing product cost/inventories.
 Prices may be based on marginal costs and contribution but in normal circumstances
prices would cover costs in total.
 It combines the techniques of cost recording and cost reporting.
 Profitability of departments or products is determined in terms of marginal contribution.
 The unit cost of a product means the average variable cost of manufacturing the product.
11.2.2 Advantages of Marginal Costing

 Cost-volume-profit relationship data wanted for profit planning purposes is readily obtained
from the regular accounting statements. Hence management does not have to work with
two separate sets of data to relate one to the other.
 The profit for a period is not affected by changes in absorption of fixed expenses resulting
from building or reducing inventory. Other things remaining equal (e.g. selling prices,
costs, sales mix), profits move in the same direction as sales when direct costing is in
use.
 Manufacturing cost and income statements in the direct cost form follow management’s
thinking more closely than does the absorption cost form for these statements. For this
reason, management finds it easier to understand and use direct cost reports.
 The impact of fixed costs on profits is emphasized because the total amount of such cost
for the period appears in the income statement.
 Marginal income figures facilitate relative appraisal of products, territories, classes of

customers, and other segments of the business without having the results obscured by
allocation of joint fixed costs.
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 Marginal costing lies in with such effective plans for cost control as standard costs and
flexible budgets.
 Marginal costing furnishes a better and more logical basis for the fixation of sales prices
as well as tendering for contracts when business is at low ebb.
 Break-even point can be determined only on the basis of marginal costing.
11.2.3 Limitations of Marginal Costing
Marginal costing technique has the following limitations:
 In marginal costing, costs are classified into fixed and variable. Segregation of costs into
fixed and variable is rather difficult and cannot be done with precision.
 Marginal costing assumes that the behaviour of costs can be represented in straight line.
This means that fixed costs remains completely fixed over a period at different levels and
variable costs change in linear pattern i.e. the change is proportion to the change in
volume. In real life, fixed costs are liable to change at varying levels of production especially
when extra plant and equipments are introduced and hencevariable costs may not vary in
the same proportion as the volume.
 Under marginal costing technique fixed costs are not included in the value of stock of
finished goods and work-in-progress. As fixed costs are incurred, these should also form
part of the costs of the product. Due to this elimination of fixed costs from finished stock
and work-in- progress, the stocks are understated. This affects the results of profit and
loss account and the balance sheet. Thus, profit may be unnecessarily deflated.
 In the marginal costing system monthly operating statements will not be as realistic or
useful as under the absorption costing system. This is because under this system, marginal
contribution and profits vary with change in sales value. Where sales are occasional,
profits fluctuate from period to period.
 Marginal costing fails to give complete information, for example rise in production and
sales may be due to extensive use of existing machinery or by expansion of the resources
or by replacement of the labour force by machines. The marginal contribution of P/V ratio
fails to bring out reasons for this.
 Under marginal costing system the difficulties involved in the apportionment and
computation of under and over absorption of fixed overheads are done away with but
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problem still remains as far as the under absorption or over absorption of variable overheads
is concerned.
 Although for short term assessment of profitability marginal costs may be useful, long-
term profit is correctly determined on full costs basis only.
 Marginal costing does not provide any standard for the evaluation of the performance.
Marginal contribution data do not reveal many effects which are furnished by variance
analysis. For example, efficiency variance reflects the efficient and inefficient use of plant,
machinery and labour and this sort of valuation is lacking in the marginal cost analysis.
 Marginal costing analysis assumes that sales price per unit will remain the same on
different levels of production but these may change in real life and give unrealistic results.
 In the age of increased automation and technology advancement, impact of fixed costs
on product is much more than that of variable costs. As a result a system that does not
account the fixed costs is less effective because a substantial portion of the cost is not
taken into account.
 Selling price under the marginal costing technique is fixed on the basis of contribution.
This may not be possible in the case of ‘cost plus contracts’.
Thus the above limitations indicate that fixed costs are equally important in certain cases.
11.2.4 Applications of Marginal Costing

1. Profit planning
There are four ways in which profit performance of a business can be improved:
 by increasing volume;
 by increasing selling price;
 by decreasing variable costs; and
 by decreasing fixed costs.
Profit planning is the planning of future operations to attain maximum profit or to maintain
a specified level of profit. The contribution ratio (which is the ratio of marginal contribution to
sales) indicates the relative profitability of the different sectors of the business whenever there
is a change in selling price, variable costs or product mix. Due to the merging together of fixed
and variable costs, absorption costs fail to bring out correctly the effect of any such change on
the profit of the concern.
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2. Evaluation of Performance
The various section of a concern such as a department, a product line, or a particular

market or sales division, has different revenue earning potentialities. A company always
concentrates on the departments or product lines which yield more contribution than others.
The performance of each such sector can be broughtout by means of cost volume-profit analysis
or the contribution approach. The analysis will help the company to take decision that will maximise
the profits.
3. Make or Buy Decisions
When the management is confronted with the problem whether it would be economical to
purchase a component or a product from outside sources, or to manufacture it internally, marginal
cost analysis renders useful assistance in the matter. Under such circumstances, a misleading
decision would be taken on the basis of the total cost analysis. In case the proposal is to buy
from outside then, what is already being made, and the price quoted by the outsider should be
lower than the marginal cost. If the proposal is to make something what is being purchased
outside, the cost of making should include all additional costs like depreciation on new plant,
interest on capital involved and that cost should be compared with the purchase price.
4. Closure of a Department or Discontinuance of a Product
Marginal costing technique helps in deciding the profitability of a product. It provides the
information in a manner that tells us how much each product contributes towards fixed cost and
profit; the product or department that gives least contribution should be discarded except for a
short period. If the management is to choose some product out of the given ones, then the
products giving the highest contribution should be chosen and those giving the least should be
discontinued.
5. Maintaining a Desired Level of Profit
A company has to cut prices of its products from time to time because of competition,
Government regulations and other compelling reasons. The contribution per unit on account of
such cutting is reduced while the industry is interested in maintaining a minimum level of its
profits. In case the demand for the company’s product is elastic, the maximum level of profits
can be maintained by pushing up the sales. The volume of such sales can be found out by
marginal costing techniques.
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6. Offering Quotations
One of the best ways for sales promotion is to offer quotations at low rates. A company is
producing 80,000 units (80% of capacity) and making a profit of Rs.2,40,000. Suppose the
Punjab Government has given a tender notice for 20,000 units. It is expected that the units
taken by the Government will not affect the sale of 80,000 units which the company is already
selling and the company also wishes to submit the lowest possible quotation. The company
may quote any amount above marginal cost, because it will give an additional marginal
contribution and hence profit.
7. Accepting an Offer or Exporting below Normal Price
Sometimes the volume of output and sales may be increased by reducing the normal
prices of additional sale. In this case the concern should be cautious enough to see that the
sale below normal price in additional markets should not affect the normal market. To be on the
safe side the product may be sold under the label of a different brand. If there is additional sale
because of export orders, goods may be sold at a price below the normal.
8. Alternative Use of Production Facilities
When alternative use of production facilities or alternative methods of manufacturing a

product are available, contribution analysis should be used to arrive at the final choice. The
alternative which will yield highest contribution shall generally and obviously be selected.
9. Problem of Key Factor
The product giving the greatest contribution will be the most profitable. To maximize profit,
resources should be mobilized towards that product which gives the maximum contribution. But
contribution is not the only criterion for deciding profitability. In real life, there may be several
factors which may put a limit on the number of units to be produced even if the products give a
high contribution. These factors are equally important for arriving at managerial decisions because
these factors limit the volume of output at a particular point of time or over a period. These are
called key factors, scarce factors, limiting factors, principal budget factors or governing factors.
The limiting factors may be sale, raw material, labour, plant capacity and availability of capital
e.g., for a concern established in a relatively new town, labour may be a key factor or the
concern may find it difficult to acquire an unlimited quantity of raw material because of scarcity
or the quota system, etc. In the later case material will be the key factor. The extent of influence
of these factors should be carefully examined before arriving at a particular decision. Contribution
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per unit of key factor should be considered and that course of action should be adopted which
gives the highest contribution per unit of key factor.
10. Selection of a Suitable Product Mix
A concern, which manufactures more than one product, may have to decide in what
proportion should these products be produced or sold. The technique of marginal costing helps
to a great extent in the determination of most profitable product or sales mix. The best product
mix is that which yields the maximum contribution. In the absence of key factor, contribution
under various mix will be found out and the mix which gives the highest contribution will be
selected for production.
11.3 Break Even Analysis

A fundamental of accounting is that all revenues and costs must be accounted for and the
difference between the revenues and costs is the profit, or loss, of the business. Costs can be
classified as either a fixed cost or a variable cost.
A fixed cost is one that is independent of the level of sales; rather, it is related to the
passage of time.Examples of fixed costs include rent, salaries and insurance.
A variable cost is one that is directly related to the level of sales, such as cost of goods
sold and commissions. This categorization of costs into “variable” and “fixed” elements and
their relationship with sales and profits has been developed as “break-even analysis”. This
break even analysis is also known as Cost–Volume-Profit (CVP) analysis.
Cost–volume–profit (CVP) analysis is defined in CIMA’s Official Terminology as ‘the study

of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity and
mix’.
In break even analysis or CVP analysis an activity level is determined at which all relevant
cost are recovered and there is a situation of no profit or no loss. This activity level is called
breakeven point.
The break-even point in any business is that point at which the volume of sales or revenues
exactly equals total expenses or the point at which there is neither a profit nor loss under
varying levels of activity. The break-even point tells the manager what level of output or activity
is required before the firm can make a profit; reflects the relationship between costs, volume
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and profits. In another words breakeven point is the level of sales or production at which the
total costs and total revenue of a business are equal.
At Break-even point or level, the sales revenues are just equal to the costs incurred.
Below Breakeven point level the firm will make losses, while above this level it will be making
profits. This is so because that while the variable costs vary according to the variations in the
volume or level of activity while the fixed costs do not change.
Below the breakeven point, fixed costs will eat up all excess of sales over variable cost
and yet be unsatisfied, leaving a loss. Above the BEP, excess of sales over variable costs (this
excess is known as contribution) is much more than the fixed costs of the activities and, it, thus
leads to profits. Thus in Break Even analysis or Cost Volume Profit Analysis, it is possible to
analyse the effect of changes in volume, prices and variable costs on the profits of an organization,
while taking fixed costs as unchangeable.
The cost-volume-profit (CVP) analysis helps management in finding out the relationship
of costs and revenues to profit. The aim of an undertaking is to earn profit. Profit depends upon
a large number of factors, the most important of which are the cost of manufacture and the
volume of sales effected. Both these factors are interdependent-volume of sales depends upon
the volume production, which in turn is related to costs.
Cost, again, is the resultant of the operation of a number of varying factors.
Such factors affecting cost are:
a. Volume of production;
b. Product-mix;
c. Internal efficiency;
d. Methods of production; and
e. Size of plant; etc.
Analysis of cost-volume-profit involves consideration of the interplay of the following factors:
a. Volume of sales;
b. Selling price;
c. Product mix of sales;

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d. Variable costs per unit; and
e. Total fixed costs.
The relationship between two or more of these factors may be (i) present in the form of
reports and statements, (ii) shown in charts or graphs, or (iii) established in the form of
mathematical deductions.
11.3.1 Objectives of Cost Volume Profit Analysis
The objectives of cost-volume profit analysis are given below:
 In order to forecast profit accurately, it is essential to know the relationship between profits
and costs on the one hand and volume on the other.
 Cost-volume-profit analysis is useful in setting up flexible budgets which indicate costs at

various levels of activity.
 Cost-volume-profit analysis is of assistance in performance evaluation for the purposes

of control.
 For reviewing profits achieved and cost incurred the effects on costs of changes in volume
are required to be evaluated.
 Pricing plays an important part in stabilizing and fixing up volume. Analysis of cost-volume-
profit relationship may assist in formulating price policies to suit particular circumstances
by projecting the effect which different price structures have on costs and profits.
 As predetermined overhead rates are related to a selected volume of production, study of

cost volume relationship is necessary in order to know the amount of overhead costs
which could be charged to product costs at various level of operation.
11.3.2 Advantages of Break Even Analysis
 It provides detailed and clearly understandable information. The chart visualizes the
information very clearly and a glance at the chart gives a vivid picture of the whole affairs.
The information is presented in a simple form and therefore, is clearly understandable
even to alay man.
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 The profitability of different products can be known with the help of break-even charts,
besides the level of no-profit no-loss. The problem of managerial decision regarding
temporary or permanent shutdown of business or continuation at a loss can be solved by
break-even analysis.
 The effect of changes in fixed and variable costs at different levels of production or profits
can be demonstrated by the graph legibly.
 The break-even chart shows the relative importance of fixed cost in the total cost of a
product. If the costs are high, it induces management to take measures to control such
costs.
 The economies of scale, capacity utilisation, and comparative plant efficiencies can be
analysed through the break-even chart. The operational efficiency of a plant is indicated
by the angle of incidence formed at the intersection of the total cost line and sales line.
 Break-even analysis is very helpful for forecasting, long-term planning, growth and stability.
11.3.4 Limitations of Break Even Analysis
Though break-even analysis has gradually become service tool for modern financial
management, there are certain objections raised against the utility of break-even analysis:
 Fixed costs do not always remain constant.
 Variable costs do not always vary proportionately.
 Sales revenue does not always change proportionately.
 The horizontal axis cannot measure the units sold in as much as many unlike type of
products are sold by the same enterprise.
 Break-even analysis is of doubtful validity when the business is selling many products
with different profit margins.
 Break-even analysis is based on the assumption that income is influenced by changes in

sales so that changes in inventory would not directly affect income. If marginal costing is
used, this assumption would hold good but in other cases, changes in inventory will affect
income because the absorption of fixed costs will depend on production rather than sales.
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 Condition of growth or expansion in an organisation is not assumed under break-even

analysis. In actual life of any business organisation, the operation undergoes a continuous
process of growth and expansion.
 Only a limited amount of information can be presented in a single break-even chart. If we

have to study the changes of fixed costs, variable costs and selling prices, a number of
charts will have to be drawn up.
 Even simple tabulation of the results of costs and sales can serve the purpose which is
served by a break-even chart; hence there is no need of presenting the data through a
break-even chart.
 The chart becomes very complicated and difficult to understand for a layman, if the numbers
of lines or curves depicted on the graph are large.
 The chart does not provide any basis for comparative efficiency between different units
ororganisations.
10.3.4 Uses of Cost Volume Profit Analysis
 Forecasting costs and profits as a result of change in volume.
 Fixing a sales volume level to earn or cover a given revenue, return on capital employed,
or rate of dividend.
 Determination of effect of change in volume due to plant expansion or acceptance of an

order, with or without increase in costs or in other words a quantum of profit to be obtained
can be determined with change in volume of sales.
 Determining relative profitability of each product, line, and project or profit plan.
 Through cost volume-profit analysis inter-firm comparison of profitability can be done

intelligently.
 Determining cash requirements at a desired volume of output, with the help of cash
breakevenc harts.
 emphasizes the importance of capacity utilization for achieving economy.

195
 From break-even analysis during severe recession, the comparative effects of a shut
down or continued operation at a loss is indicated.
 The effect on total cost of a change in the fixed over-head is more clearly demonstrated
through break-even analysis and cost- volume- profit charts.
 The conditions of a business such as profit potentialities, requirements of capital, financial

stability and incidence of fixed and variable costs can be gauged from a study of the
position of the breakeven point and the angle of incidence in the break-even chart.
11.4 Contribution
If a system of marginal costing is operated in an organization with more than one product,
it will not be possible to ascertain the net profit per product because fixed overheads are charged
in total to the profit and loss account rather than recovered in product costing. The contribution
of each product is charged to the firm’s total fixed overheads and profit is ascertained. Contribution
is the difference between selling price and variable cost of sales. It is visualised as some sort of
a fund or pool, out of which all fixed costs, irrespective of their nature are to be met, and to each
product has to contribute its share. The excess of contribution over fixed costs is the profit. If
the total contribution does not meet the entire fixed cost,there will be loss.
Marginal Cost Equation
As we know:
Sales-Cost = Profit or
Sales- (Fixed cost + Variable cost) = Profit or
Sales- Variable cost = Fixed cost +Profit
It is known as marginal cost equation. We can convey it as under: Where S = Sales
V= Variable cost
F= Fixed cost P= Profit
The ratio or percentage of contribution margin to sales is known as P/V ratio. This ratio is
also known as marginal income ratio, contribution to sales ratio, or variable profit ratio. P/V
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ratio, usually expressed as a percentage, is the rate at which profit increases with the increase
in volume. The formulae for P/V ratio are:
P/V Ratio = Marginal Contribution / Sales
P/V Ratio = Sales Value – Variable Cost/ Sales Value
P/V Ratio = 1 – Variable Cost / Sales Value
P/V Ratio = Fixed Cost + Profit / Sales Value
P/V Ratio = Change in Profit / Change in Sales
A comparison for P/V ratios of different products can be made to find out which product is
more profitable.
Higher the P/V ratio more will be the profit and lower the P/V ratio, lesser will be the profit.
P/V ratio can be improved by:
(1) Increasing the selling price per unit.
(2) Reducing direct and variable costs by effectively utilizing, men, machines and
materials.
(3) Switching the production to more profitable products showing a higher P/V ratio.
11.4.1 Significance of Profit - Volume Ratio
Profit volume (or contribution-sales) ratio is a logical extension of marginal costing. It is

the study of the interrelationships of cost behaviour patterns, levels of activity and the profit that
results from each alternative combination. The significance of profit volume ratio may be
enumerated from the following application which is as under:
 Ascertainment of profit on a particular level of sales volume.
 Determination of break-even point.
 Calculation of sales required to earn a particular level of profit.
 Estimation of the volume of sales required to maintain the present level of profit in
case selling prices are to be reduced by a stipulated margin.
 Useful in developing flexible budgets for cost control purposes.

197
 Identification of minimum volume of activity that the enterprise must achieve to

avoid incurring losses.
 Provision of data on relevant costs for decisions relating to pricing, keeping or

dropping product lines, accepting or rejecting particular orders, make or buy decision,
sales mix planning, altering plant layout, channels of distribution specification,
promotional activities etc.
 Guiding in fixation of selling price where the volume has a close relationship with
the price level.
 Evaluation of the impact of cost factors on profit.
11.4.2 Margin of Safety
Margin of safety is the difference between the actual sales and sales at break-even point.
Sales beyond break-even volume bring in profits. Such sales represent a margin of safety.
Margin of safety is calculated as follows:
Margin of safety = Total sales – Break even sales
Margin of safety can also be calculated with the help of P/V ratio i.e.
Margin of Safety = Profit / P/V Ratio
Margin of Safety = Margin of Safety × 100 / P/V Ratio
It is important that there should be reasonable margin of safety; otherwise, a reduced

level of activity may prove disastrous. The soundness of a business is gauged by the size of the
margin of safety. A low margin of safety usually indicates high fixed overheads so that profits
are not made until there is a high level of activity to absorb fixed costs.
A high margin of safety shows that break-even point is much below the actual sales, so
that even if there is a fall in sales, there will still be a point. A low margin of safety is accompanied
by high fixed costs, so action is called for reducing the fixed costs or increasing sales volume.
The margin of safety may be improved by taking the following steps:
 Lowering fixed costs.
 Lowering variable costs so as to improve marginal contribution.

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 Increasing volume of sales, if there is unused capacity.
 Increasing the selling price, if market conditions permit, and
 Changing the product mix as to improve contribution.
11.5 Break Even Chart

On the X-axis of the graph is plotted the volume of productions or the quantities of sales
and on the Y-axis (vertical line) costs and sales revenuesare represented. The fixed costs line
is drawn parallel to X-axis. The variable costs for different levels of activity are plotted over the
fixed cost line, which shows that the cost is increasing with the increase in the volume of
output. The variable cost line is joined to fixed cost line at zero volume of production.
This line is regarded as the total cost line. Sales values at various levels of output are
plotted from the origin and joined is called the sales line. The sales line will cut the total cost line
at a point where the total costs equal to total revenues and this point of intersection of two lines
is known as breakeven point or the point of no profit no loss. The lines produced from the inter-
section to Y-axis and X-axis may give sales value and the number of units produced at break-
even point respectively. Loss and profit are as have been shown in the chart which shows that
if production is less than the break-even point, the business shall be running at a loss and if the
production is more than the breakeven level, there will be profit. The angle which the sales line
makes with total cost line while intersecting it at BEP is called angle of incidence. A large angle
of incidence denotes a good profit position of a company.
11.6 Absorption Costing

Absorption costing means that all of the manufacturing costs are absorbed by the total
units produced. In short, the cost of a finished unit in inventory will include direct materials,
direct labour, and both variable and fixed manufacturing overhead. As a result, absorption
costing is also referred to as full costing or the full absorption method. Absorption costing is
often contrasted with variable costing or direct costing.
Under variable or direct costing, the fixed manufacturing overhead costs are not allocated
to the products manufactured. Variable costing is often useful for management’s decision-
making. However, absorption costing is required for external financial reporting and for income
tax reporting. It is also referred to as the full- cost technique
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Absorption costing is a costing technique that includes all manufacturing costs, in the
form of direct materials, direct labour, and both variable and fixed manufacturing overheads,
while determining the cost per unit of a product.
In the context of costing of a product/service, an absorption costing considers a share of

all costs incurred by a business to each of its products/services. In absorption costing technique;
costs are classified according to their functions. The gross profit is calculated after deducting
production costs from sales and from gross profit, costs incurred in relation to other business
functions are deducted to arrive at the net profit. Absorption costing gives better information for
pricing products as it includes both variable and fixed costs.
Absorption costing technique absorbed fixed manufacturing overhead into the cost of
goods produced and are only charged against profit in the period in which those goods are
sold. In absorption costing income statement, adjustment pertaining to under or over-absorption
of overheads is also made to arrive at the profit. Absorption costing is a simple and fundamental
method of ascertaining the cost of a product or service. It is based on sharing of all indirect
costs and direct cost to cost units/cost centers. Following chart shows the ascertaining the
profit under absorption costing:
Finished goods inventories are over-stated in absorption costing as it includes one more
cost element in inventory value than under variable costing, i.e the fixed manufacturing cost.
Inventory value under absorption costing = Direct material+ Directlabour + variable

manufacturing costs+ Fixed manufacturing costs
11.7 Illustrations
1. Metro Service Ltd. is operating at 70% capacity and presents the following information:
Break-even point :Rs. 200 crore, P/V Ratio : 40%
Margin of safety :Rs. 50 crore
Metro management has decided to increase production to 95% capacity level with the
following modifications–
— Selling price will be reduced by8%
— The variable cost will be reduced to 55% onsales.

200
— The fixed cost will increase by Rs. 27 crore including depreciation on additions, but
excluding interest on additionalcapital.
— Additional capital of Rs. 50 crore will be needed for capital expenditure and
workingcapital.
You are required to calculate –
i. Sales required to earn Rs.7 crore over and above the present profit and also to
meet 20% interest on additionalcapital;
ii. Revised break-evenpoint;
iii. Revised P/V ratio;and
iv. Revised margin ofsafety.
Solution
Total Sales = Break even sales + Margin of Safety
= Rs. 200 Crore + Rs. 50 Crores = Rs. 250 Crores P/V Ratio = 40% (given) (100 – PV
Ratio) Variable Cost = 60% of Sales
= Rs. 250 Crores × 60% = Rs. 150 Crores Fixed cost = Break Even Sales × P/V Ratio
= Rs. 200 Crores × 40% = Rs. 80 Crores Total Cost = Variable Cost + Fixed Cost
= Rs. 150 Crores + Rs. 80 Crores = Rs. 230 Crores Profit = Total Sales – Total Cost
= Rs. 250 Crores - Rs. 230 Crores = Rs. 20 Crores
2. A company has annual fixed cost of Rs. 1,68,00,000. In the year 2013-14, sales amounted
to Rs. 6,00,00,000 as compared with Rs. 4,50,00,000 in the preceding year 2012-13. The
profit in the year 2013-14 is Rs.42,00,000 more than that in 2012-13. On the basis of the
above information, answer the following:
i. What is the break-even level of sales of thecompany?
ii. Determine profit/loss on the forecast of a sales volume of Rs.80,00,00,000.
iii. If there is a reduction in selling price by 10% in the financial year 2014-15 and
company desires to earn the same amount of profit as in 2013-14, what would be
the required salesvolume?
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Solution:
(i) P/V Ratio = Change in Sales / Change inProfits
= (42,00,000 / 600,00,000 450,00,000) x 100
= 28%
Break Even Sales = Fixed Costs / P/v Ratio
= 1,68,00,000 / 28%
= Rs. 600,00,000
(ii) Contribution for Sales Volume of Rs. 800,00,000 = P/V Ratio ×Sales
= 28% × 800,00,000
= Rs. 224,00,000
Profits = Contribution – Fixed costs
= Rs. 224,00,000 – Rs. 168,00,000
= Rs. 56,00,000
(iii) If SellingPriceis = 100
(iv) Variable Cost is (Rs.100–Rs.28) = 72
(v) New Selling Price(Rs.100-10%) = 90
(vi) New Contribution (Rs.90– Rs.72) = 18
(vii) New P/VRatio
= (18 ×100) /90
= 20%
Contribution for Sales Volume of Rs. 600,00,000 for the year 2013-14
= P/V Ratio × Sales
= 28% × Rs. 600,00,000
= Rs. 168,00,000
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Desired Profits = Contribution – Fixed Costs
= Rs. 168,00,000 – Rs. 168,00,000
= Nil
Required Sales Volume
(Fixed Costs + Desired Profits) / P/V Ratio
= Rs.1,68,00,000 / 20%
= Rs.840,00,000
3. Two manufacturing companies which have the following operating details decided to
merge:
Company – I Company – II
Capacity utilization (%) 90 60
Sales (Rs. In lakhs) 540 300
Variable costs (Rs. In lakhs) 396 225
Fixed costs (Rs. in lakhs) 80 50
Assuming that the proposal is implemented, calculate –
i. Break-even sales of the merged plant and the capacity utilization at that stage.
ii. Profitability of the merged plant at 80% capacity utilization.
iii. Sales turnover of the merged plant to earn a profit of Rs. 75 lakh.
iv. When the merged plant is working at a capacity to earn a profit of Rs.75 lakh, what
percentage increase in selling price is required to sustain an increase of 5% in fixed
overheads?
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Solution
(i) Position of the Merged Plant at 100% capacity
Company I Company II Total
Sales 600 500 1,100
Less: Variable Costs 440 375 815
Contribution 160 125 285
Less: Fixed Costs 80 50 130
Profit 80 75 155
P/V Ratio of the merged plant = (Contribution / Sales) X 100

= (285 / 1100) X 100
= 25.909%
Break ever sales of the merged plant = Fixed Cost / P/V Ratio
= (130 ×1,100) / 285
= Rs. 501.75 lakhs
Percent of capacity utilization = (501.75 /1,100) X 100 45.61%
(ii) Profitability of the merged plant at 80% capacity
Rs. (Lakhs)
Sales (at 80% capacity i.e., 80% of Rs.1,100 lakh) 880
Less: Variable Costs (80% of Rs.815 lakh) 652
Contribution 228
Less: Fixed costs 130
Profit 98
OR
Total contribution at 80% capacity = 285 lakh ×80%= 228
Less: Fixed costs 130
Profit 98
Profitability = (98/ 880)21qa X 100
= 11.14%
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(iii) Sales required to earn a profit of Rs. 75 lakh:
= (Fixed Costs + Desired Profit) / P/V Ratio
= (Rs. 130 lakhs + Rs. 75 lakh) / 25.909%
= Rs.791.23 lakh
(iv) Percentage of increase in selling price to sustain 5% increase in fixed overheads:
5% of fixed costs = 130 × ( 5 / 100)
= Rs. 6.5 lakh
Percentage increase in selling price = (6.5 / 791.23) x 100
= 0.8215%
11.8 Summary
Marginal costing is a method of cost accounting and decision-making used for internal
reporting in which only marginal costs are charged to cost units and fixed costs are treated as
a lump sum. It is also known as direct, variable, and contribution costing. Marginal costing is not
a distinct method of ascertainment of cost but is a technique which applies existing methods in
a particular manner so that the relationship between profit & the volume of output can be clearly
brought out. It is an accounting system where only variable cost or direct cost will be charged to
the cost units. The objectives, applications, advantages and limitations are also explained in
this lesson.
11.9 Key Words

Break Even Chart
Break Even Analysis
Marginal Costing
Marginal Safety

1. How variable costs and fixed costs are treated in marginal costing?
2. What is contribution? How is it related to profits?

205
3. “Fixed costs do not change with changes in volume and it is difficult for management
to control them”. Discuss.
4. What do you understand by P/V ratio? Discuss the importance of P/V ratio and
state how P/V ratio can be improved?
5. What is a break-even chart? What is a profit graph? State the purposes of

constructing such charts.
6. Kaku Ltd. produces one standards type of article. The results of the last four months
of the year 2013 are as follows:
Output units
September, 2013 200

October, 2013 300
November, 2013 400
December, 2013 600
Prime cost is Rs.10 per unit. Variable expenses are Rs.2 per unit. Fixed expenses are
Rs.36,000 per annum. Find out the cost per unit in each month.
7. From the following data, which product would you recommend to be manufactured in a
factory, time being the key factor?
Per Unit of Per unit of

Product A Product B
Direct material l 24 14
Direct labour (Rs. 1 per hr.) 2 3
Variable overhead (Rs.2 per hr.) 4 6
Selling price 100 110
Standard time to produce 2 hrs. 3 hrs.

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8. From the following information, find out the amount of profit earned during the year using
the marginal costing technique:
Fixedcost Rs.5,00,000
Variablecost Rs.10 perunit
Sellingprice Rs.15 perunit
Outputlevel 1,50,000 units
9. From the following data, recommend the most profitable productmix, presuming that direct
labour hours available are only 700:
Products
A B
Contribution perunit Rs.30.00 Rs.20.00
Direct labourper unit 10hrs 5 hrs.
The maximum production possible for each of the products A and B is 100 units. Fixed
overheads are Rs.2,000.
10. A new firm commenced production on 1st July. During the 6 months to 31st December, it
produced 1,00,000 units, selling 80,000 out of these @ Rs.20 per unit. The total costs
were the following:
Rs.
Materials 6,00,000
Labour 4,00,000
Production Overheads
Variable 3,00,000
Fixed 2,00,000
Administration and Selling expenses 1,50,000
Ascertain the profit under marginal costing and under absorption costing.
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11. A factory produces 1,00,000 units and sells the whole quantity @ Rs.25. The variable
cost is Rs.18 and the fixed cost is Rs.5 per unit. An order is received for 20,000 units @
Rs.26 per unit. State the circumstance(s) in which the order should be accepted.
12. A company produces a component for its main product at a cost ofRs.15 per unit ¾ the
operations are heavily mechanised. An outsider offers to supply the component at Rs.14,
should the offer be accepted?
In a slump likely to last for one year, the available price is Rs.20 per unit whereas the
marginal cost is Rs.22. Should production be suspended?
13. You are given the following data for the coming year of afactory: Budgeted output 80,000
units
Fixed expenses Rs.4,00,000
Variable expenses per unit Rs.10
Selling price per unit Rs.20
Draw a break even chart showing the break-even point. If the selling price is reduced to
Rs.16 per unit, what will be the new break-even point?
14. The sales turnover and profit during two periods were as follows: Period No. 1 Sales
Rs.20 lakhs Profit Rs.2 lakhs
Period No. 2 Sales Rs.30 lakhs Profit Rs.4 lakhs
(i) Calculate P/V Ratio, (ii) The sales required to earn a profit of Rs.5 lakhs.
15. What do you understand by the term ‘break-even point’? Mention the types of problems
which an accountant can expect to solve with the help of such analysis. You are required
to calculate the break-even point in the following case:
The fixed costs for the year are Rs.80,000, variable cost per unit for the single product is
Rs.4. Estimated sales for the period are valued at Rs.2,00,000. The number of units
involved coincides with the expected volume of output. Each unit sells at Rs.20.
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16. From the following results of a company, determine by how much the value of sales must
be increased for the company to break-even?
Net sales Rs.4,00,000
Fixed costs Rs.2,00,000
Variable costs Rs.2,40,000
Use a break-even chart to illustrate the case.
17. Golden Ltd. has annual fixed cost of Rs.1,20,000. In the year 2010 sales amounted to
Rs.6,00,000 as compared with Rs.4,50,000 in 2012 and the profit for 2013 was Rs.50,000
higher than in 2012. You are required to:
(i) Estimates profits for 2014 on forecast sales volume of Rs.8,40,000 on the assumption
that this would not involve any addition to the company’s capacity; and
(ii) Calculate the break-even sales volume (in rupees)
18. Following information are available from the cost records of a manufacturing company:
Fixed expenses Rs.4,000
Break-even point Rs.10,000
You are required to calculate:
(i) P/Vratio
(ii) Profit where sales are Rs.20,000
(iii) New break even point if selling price is reduced by 20%.
19. From the following information, calculate the break-even point and the turnover required
to earn a profit of Rs.36,000.
Rs.
Fixed overheads 1,80,000
Variable cost per unit 2.00
Selling price 20.00

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If the company is earning a profit of Rs.36,000 express the margin of safety available to
it.

Pearson, 2012.
2. Khan, M.Y. and Jain, P.K., Management Accounting: Text, Problems and Cases, 5th Edition,

2011.
210
LESSON 12
MARGINAL COSTING AND MANAGERIAL
DECISION MAKING
Learning Objectives
 Outline the importance of Marginal Costing in the decision making process
 List out the factors influencing marginal costing decisions
Structure
12.1 Introduction
12.2 Marginal Costing Decisions
12.3 Fixation of Selling Price
12.4 Decision to Make or Buy
12.5 Selection of a Suitable Product Mix
12.6 Key Factor
12.7 Alternative Methods of Production
12.8 Profit Planning
12.9 Suspending Activities
12.10 Illustrations
12.11 Summary
12.12 Key Words
12.1 Introduction
During normal circumstances, price is based on full cost, a certain desired margin, or
profit. But in certain special circumstances, products are to be sold at a price below total cost
based on absorption costing. In such circumstances, the price should be fixed on the basis of
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marginal cost so as to cover the marginal cost and contribute something towards fixed cost.
Sometimes it becomes necessary to reduce the selling price to the level of marginal cost.
The most useful contribution of marginal costing is that it helps management in vital
decision making. Decision making essentially involves a choice between various alternatives
and marginal costing assists in choosing the best alternative by furnishing all possible facts.
The information supplied by marginal costing technique is of special importance where information
obtained from total absorption costing method is incomplete.
12.2 Marginal Costing Decisions

The following are some of the managerial decisions which are taken with the help of
marginal costing decisions:
1) Fixation of selling price

2) Make or buy decision
3) Selection of a suitable product mix or sales mix
4) Key factor
5) Alternative methods of production
6) Profit planning
7) Suspending activities i.e., closingd own
12.3 Fixation of Selling Price

One of the main purposes of cost accounting is the ascertainment of cost for fixation of
selling price. Price fixation is one of the fundamental problems which the management has to
face. Although prices are determined by market conditions and other factors, marginal costing
technique assists the management in the fixation of selling prices under various circumstances
which is asfollows.
a) Pricing under normal conditions.

b) Pricing during stiff competition.
c) Pricing during trade depression.
d) Accepting special bulk orders.
e) Accepting additional orders to utilize idle capacity.
f) Accepting orders and exporting new materials.
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12.4 Decision to make or Buy

It is a common type of business decision for a company to determine whether to make to
buy materials or component parts. Manufacturing or making often requires a capital investment
so that a decision to make must always be made whenever the expected cost savings provide
a higher return on the required capital investment that can be obtained by employing these
funds in an alternative investment bearing the same risk. In practice, difficulties are encountered
in identifying and estimating relevant costs and in calculating non- cost considerations.
a) In case a firm decides to get a product manufactured from outside, besides savings
in cost, it must also take into account the following factors:
b) Whether the outside supplier would be in a position to maintain the quality of the
product?
c) Whether the supplier would be regular in his supplies?
d) Whether the supplier is reliable? In other words is he financially and technically

sound?
12.5 Selection of a Suitable Product Mix

When a concern manufactures a number of products a problem often raises as to which
product mix or sales mix will give the maximum profit. In other words, what should be the best
combination of varying quantities of the different products/? Which would be selected from
amongst the various alternative combinations available? Such a problem can be solved with
the help of marginal contribution cost analysis: the product mix which gives the best optimum
mix. Eg, let us consider the following analysis made in respect of three products manufactured
in acompany:
Particulars Product I (Rs) Product II (Rs) Product III (Rs)

Per unit sales price 25 30 18
Materials 6 8 2
Labour 5 4 6
Variable Overheads 4 3 5
Marginal cost 15 15 1
Marginal contribution 10 15 5
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Out of the three products, product II gives the highest contribution per unit. Therefore, if
no other factors no others factors intervene, the production capacity will be utilized to the
maximum possible extent for the manufacture of that product. Product I ranks second and so,
after meeting the requirement of Product II, the capacity will be utilized for product I. whatever
capacity is available thereafter may be utilized for Product III.
12.6 Key Factor

Firms would try to produce commodities which fetch a higher contribution or the highest
contribution. This assumption is based on the possibility of selling out the product at the maximum.
Sometimes it may happen that the firm may not be able to push out all products manufactured.
And, sometimes the firm may not be able to sell all the products it manufactured but production
may be limited due to shortage of materials, labour, plant, capacity, capital, demand, etc.
A key factor is also called as a limiting factor or principal budget factor or scarce factor. It
is factor of production which is scarce and because of want of which the production may stop.
Generally sales volume, plant capacity, material, labour etc. may be limiting factors. When
there is a key factor profit is calculated by using theformula when there is no limiting factor, the
production can be on the basis of the highest P / V ratio. When two or more limiting factors are
in operation, they will be seriously considered to determine the profitability.
Profitability = [Contribution / Key factor (Materials, Labour, or Capital)]
12.7 Alternative Methods of Production

Sometimes management has to choose from among alternative methods of production,
i.e., mechanical or manual. In such circumstances, the technique of marginal costing can be
applied and the method which gives the highest contribution can be adopted.
12.8 Profit Planning

Profit planning is the planning of the future operations to attain maximum profit or to
maintain level of profit. Whenever there is a change in sale price, variable costs and product
mix, the required volume of sales for maintaining or attaining a desired amount of profit may be
ascertained with the help of P / V ratio.
Expected Sales = [(Fixed Cost + Profit)/ P / V Ratio]

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12.9 Suspending Activities

When a firm is operating for loss sometime, the management has to decide upon its shut
down.
a) Complete shutdown: The firm may be permanently closed any intention to revive
it. Such a decision is warranted.
(i) When the selling price does not even cover the variable cost: or
(ii) The demand for the output is very low and the future prospects are bleak. Complete
shutdown saves the management from the fixed of running the factory or division or
firm.
b) Partial or temporary shutdown: Here the intention is to close down for some time
and reopen the firm when circumstances favour it. Some fixed cost will continue in
the form of irreducible minimum, like Skelton staff to maintain the factory, some
managerial remuneration, salaries, irreplaceable technical experts, etc. The saving
from the partial shutdown should be compared with the position if the firm continues.
If there is substantial savings, shut down may be preferable. Minor savings in
expenditure does not warrant shut down because reviving a firm is a cumber some
process.
12.10 Illustrations
An automobile manufacturing company finds that the cost of making Part No. 208 in its
own workshop is Rs.6. The same part is available in the market at Rs.5.60 with an assurance of
continuous supply. The cost data to make the part are:
Material Rs.2.00
Directlabour Rs.2.50
Other variable cost Rs.0.50
Fixed cost allocated Rs.1.00
—————
Rs. 6.00
—————
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a) Should be part be made or brought?
b) Will your answer be different if the market price is Rs.4.60? Show your calculations
clearly.
Solution
a) To take a decision on whether to make or buy the part, fixed cost being irrelevant
is to be ignored. The additional costs being variable costs are to be considered.
Materials Rs. 2.00
Direct labour Rs. 2.50
Other variable cost Rs. 0.50
The company should continue to Make the part if its market price is Rs.5.60
Making results in saving of Rs.0.60 (5.60 – 5.00) per unit.
b) The company should Buy the part from the market and stop its production facilities
which become Idle if the production of the part is discontinued cannot be used to
derive some income.
Note: The above conclusion is on the assumption that the production facilities which
become ‘Idle’ if the production of the part is discontinued cannot be used to derive some income.
However, if the Idle facilities can be leased out or can be used to produce some other
product or part which can result in some amount of contribution , that should also be considered
while taking the ‘Make or buy decision.
2. Two businesses S.V.P. Ltd., and T.R.R. Ltd., sell the same type of product in the same
type of market. Their budgeted Profit and Loss Accounts for the coming year are as
follows:
216
S.V.P. Ltd. T.R.R. Ltd.
Rs. Rs.
Sales 150000 150000
Less: Variable cost 120000 100000
Fixed cost 15000 35000
Budgeted Net Profit 15000 15000
You are required to:
a) Calculate break-even point of eachbusiness
b) Calculate the sales volume at which each business will earn Rs.5000/- profit.
c) State which business is likely to earn greater profit in conditionsof:
(1) Heavy demand for theproduct
(2) Low demand for theproduct
Briefly give your reasons.
Solution
Marginal Cost and Contribution Statement
Particulars SVP Ltd. Rs. TRR Ltd. Rs.

Sales 150000 150000
Less : Variable Cost 120000 100000
Contribution 30000 50000
Less : Fixed Cost 15000 35000
Profit 15000 15000
(a) Calculation of break-evenpoint
P/V Ratio = Contribution / Sales x 100 SVP Ltd.
30000 / 150000 x 100 = = 20%
TRR Ltd.
50000 / 150000 x 100 = 33 1/3 %

217
Breakeven point = Fixed cost / PV Ratio
SVP Ltd.
15000 / 20 x 100 = Rs.75,000
TRR Ltd.
35000 / 33 1/3 x 100 = Rs.1,05,000
(b) Sales required to earn profit ofRs.5,000
Required Sales = Required Profit + Fixed cost / P/V Ratio
SVP Ltd.
5000 + 15000 / 20 x 100 = Rs.1,00,000
TRR Ltd.
5000 + 35000 / 33 1/3 x 100 = Rs.1,20,000
(c) (1) In condition of heavy demand, a concern with higher P/V Ratio can earn greater
profits because of higher contribution. Thus TRR Ltd., is likely to earn greaterprofit.
(2) In conditions of low demand, a concern with lower breakeven point is likely to
earn more profits because it will start making profits at lower level of sales.
Therefore in case of low demand SVP Ltd., will make profits when its sales
reach Rs.75000, whereas TRR Ltd., will start making profits only when its sales
reach the level of Rs.105000.
3. The following particulars are extracted from the records of a company.
Particulars Product A Product B
Sales (per unit) Rs.100 Rs.120
Consumption of material 2 Kg. 3 Kg.
Material cost Rs.10 Rs.15
Direct wages cost 15 10
Direct expenses 5 6
Machine hours used 3 2

218
Overhead expenses :
Fixed 5 10
Variable 15 20
Direct wages per hour is Rs.5.
Comment on the profitability of each product (both use the same raw materials) when:
(i) Total sales potential in units is limited.
(ii) Production capacity (in terms of machine hours) is the limiting factor.
(iii) Material is in short supply.
Sales potential in value is limited.
Solution:
Statement showing key-factor contribution

Particulars Product A Cost Product B Cost
per unit (Rs). per unit (Rs).
Selling Price 100 120
Less : Variable cost 10 15
Materials 15 10
Direct Wages 5 6
Direct Expenses 15 20
Variable overhead 45 51
Contribution per unit 55 69
Contribution per machine hour 55 / 3 69 / 2 18.33 34.5
Combination per kg.of material 55 / 2 69 / 3 27.5 23
P/V Ratio 55/100 x 100 = 55% 69/120 x 100 = 57.5%
Comments on the profitability of products ‘A’ and ‘B’ on the basis of different key-factors:
 When total sales potential in units is limited, product ‘B’ will be more profitable
compared to ‘A’ as its „Contribution per unit is more by Rs.14 (69 –55).
 When production capacity in terms of machine hours is the limiting factor, product
‘B’ is more profitable as its „contribution per hour is more by Rs.16.17 (34.5 –18.33)
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 When raw material is in short supply product ‘A’ is more profitable as its ‘contribution
per kg’ is higher by Rs.4.5 (27.5 –23)
 When sales potential in value is the limiting factor product ‘B’ is better as its P/V
Ratio is higher than that of product ‘A’.
Note: Contribution per unit can be divided with any given ‘Key Factor’ or ‘Limiting factor’
to obtain ‘Key-factor contribution’ (KFC). The Product which gives higher contribution in terms
of key-factor is decided to be better and more profitable
Illustration No. 4
S & Co. Ltd., has three divisions, each of which makes a different product. The budgeted
data for the next year is as follows:
Divisions A (Rs.) B (Rs.) C (Rs.)
Sales 1,12,000 56,000 84,000
Costs :
Direct Material 14,000 7,000 14,000
Direct Labour 5,600 7,000 22,400
Variable overhead 14,000 7,000 28,000
Fixed Costs 28,000 14,000 28,000
Total Costs 61,600 35,000 92,400
The management is considering closing down Division C. There is no possibility of reducing

variables costs. Advise whether or not division C should be closeddown.
Solution:
Divisions A (Rs.) B (Rs.) C (Rs.)
Sales 112000 56000 84000
Less : Variable Costs :
Direct Material 14000 7000 14000
Direct Labour 5600 7000 22400

220
Variable overhead 14000 7000 28000
33600 21000 64000
78400 35000 20000
Less : Fixed Costs 28000 14000 28000
Loss 50400 21000 8000
Since Division C is giving a positive contribution of Rs.20000/- it should not be discharged.
12.11 Summary
During normal circumstances, price is based on full cost, a certain desired margin, or
profit. But in certain special circumstances, products are to be sold at a price below total cost
based on absorption costing. In such circumstances, the price should be fixed on the basis of
marginal cost so as to cover the marginal cost and contribute something towards fixed cost.
Sometimes it becomes necessary to reduce the selling price to the level of marginal cost.
The most useful contribution of marginal costing is that it helps management in vital
decision making. Decision making essentially involves a choice between various alternatives
and marginal costing assists in choosing the best alternative by furnishing all possible facts.
The information supplied by marginal costing technique is of special importance where information
obtained from total absorption costing method is incomplete.
12.12 Key Words

Key Factor
Take or Buy
Profit Plannig
Suspending Activities

1. Discuss the role of marginal costing in taking managerial decisions.
2. What is key factor? What is it importance?
3. Explain the different factors to be considered while taking a make or buy decision.
4. When is selling below cost is permissible or necessary?
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5. How do you decide upon the optimal sales mix?

6. Present the following information to management:
The managerial product cost and the contribution per unit and ii. The total contribution
and profits resulting from each of the sales mixes:
Cost Per Unit
Particulars A B
Variable Cost
Direct materials 10 9
Direct wages 3 2
Selling Price 20 15
Fixed expenses : Rs. 800 Sales Mix (Units)
Variable expenses are allotted 100 200

to products 100% of direct wages 150 150
200 100
Recommend which of the sales mixes should be adopted.
7. Pondicherry Trading Corporation is running its plant at 50% capacity. The management
has supplied you the followingd etails:
Particulars Cost of Production Per Unit (Rs)

Direct materials 4
Direct labour 2
Variable overheads 6
Fixed overheads (Fully absorbed) 4
16
Production per month 40000 units
Total cost of production = 40000 X Rs. 16 Rs. 640000
Sales price 40000 X Rs. 14 Rs. 560000
Rs. 80000
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8. An exporter offers to purchase 10000 units per month at Rs. 13 per unit and the company
is hesitating in accepting the offer due to the fear that it will increase its already large
operating losses.
Advise whether the company should accept or decline this offer.

Pearson, 2012.

2011.
223
LESSON 13
BUDGET & BUDGETORY CONTROL
Learning Objectives
 Explain the types of budgets
 Discuss the scope and objectives of budgetary control
 List out the steps in zero based budgeting
Structure
13.1 Introduction
13.2 Forecast Vs. Budget
13.3 Budgetary Control
13.3.1 Objectives of Budgetary Control
13.3.2 Scope and Techniques of Budgetary Control
13.3.3 Requisites for Effective Budgetary Control
13.3.4 Organisation for Budgetary Control
13.3.5 Key Factor
13.3.6 Advantages and Limitations of Budgetary Control
13.4 Types of Budget
13.4.1 Sales Budget
13.4.2 Production Budget
13.4.3 Material Purchase Budget
13.4.4 Cash Budget
13.4.5 Master Budget
13.4.6 Fixed Budget
13.4.7 Flexible Budget

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13.4.8 Distinction between Fixed Budget and Flexible Budget
13.4.9 Methods of Preparing Flexible Budget
13.5 Zero Base Budgeting
13.5.1 Steps involved in ZBB
13.5.2 Advantages of ZBB
13.6 Performance Budgeting
13.7 Illustrations
13.8 Summary
13.9 Key Words
13.1 Introduction
The Chartered Institute of Management Accountants, England, defines a ‘budget’ as under:
“A financial and/or quantitative statement, prepared and approved prior to define period of time,
of the policy to be perused during that period for the purpose of attaining a given objective.”
According to Brown and Howard of Management Accountant “a budget is a predetermined
statement of managerial policy during the given period which provides a standard for comparison
with the results actually achieved.”
An analysis of the above said definitions reveal the following essentials of a budget:
 It is prepared for a definite future period.
 It is a statement prepared prior to a defined period of time.
 The budget is monetary and/or quantitative statement of policy.
 The budget is a predetermined statement and its purpose is to attain a given objective.
A budget, therefore, be taken as a document which is closely related to both the managerial
as well as accounting functions of an organization.
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13.2 Forecast vs Budget

Forecast is mainly concerned with an assessment of probable future events. Budget is a
planned result that an enterprise aims to attain. Forecasting precedes preparation of a budget
as it is an important part of the budgeting process. It is said that the budgetary process is more
a test of forecasting skill than anything else. A budget is both a mechanism for profit planning
and technique of operating cost control. In order to establish a budget it is essential to forecast
various important variables like sales, selling prices, availability of materials, prices of materials,
wage rates etc. both budgets and forecasts refer to the anticipated actions and events. But still
there are wide differences between budgets and forecasts as given below:
Sl. Forecasts Budgets

No.
1 Forecasts is mainly concerned with Budget is related to planned events.

anticipated or probable events.
2 Forecasts may cover for longer period or Budget is planned or prepared fora
years. shorter period.
3 Forecast is only a tentative estimate. Budget is a target fixed for a period.
4 Forecast results in planning. Result of planning is budgeting.
5 The function of forecast ends with the The process of budget starts where
forecast of likely events. forecast ends and converts it
into a budget.
6 Forecast usually covers a specific Budget is prepared for the business

business function. as a whole.
7 Forecasting does not act as a tool of Purpose of budget is not merely a

controlling measurement. planning device but also a
controlling tool.
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13.3 Budgetary Control

Budgetary control is the process of establishment of budgets relating to various activities
and comparing the budgeted figures with the actual performance for arriving at deviations, if
any. Accordingly, there cannot be budgetary control without budgets. Budgetary control is a
system which uses budgets as a means of planning and controlling. According to I.C.M.A.
England Budgetary control is defined by Terminology as “the establishment of budgets relating
to the responsibilities of executives to the requirements of a individual actions the objectives of
that policy or to provide a basis for its revision”.
Brown and Howard defines budgetary control is “a system of controlling costs which
includes the preparation of budgets, co-ordinating the department and establishing
responsibilities, comparing actual performance with the budgeted and acting upon results to
achieve maximum profitability.”
The above definitions reveal the following essentials of budgetary control:
1. Establishment of objectives for each function and section of the organization.
2. Comparison of actual performance with budget.
3. Ascertainment of the causes for such deviations of actual from the budgeted
performance.
4. Taking suitable corrective action from different available alternatives to achieve the
desired objectives.
13.3.1 Objectives of Budgetary Control
Budgetary control is planning to assist the management for policy formulation, planning,
controlling and co-ordinating the general objectives of budgetary control and can be stated in
the following ways:
 Planning: A budget is a plan of action. Budgeting ensures a detailed plan of action for a
business over a period of time.
 Co-ordination: Budgetary control co-ordinates the various activities of the entity or

organization and secure co-operation of all concerned towards the common goal.
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 Control: Control is necessary to ensure that plans and objectives are being achieved.
Control follows planning and co-ordination. No control performance is possible without
predetermined standards. Thus, budgetary control makes control possible by continuous
measures against predetermined targets. If there is any variation between the budgeted
performance and the actual performance the same is subject to analysis and corrective
action.
13.3.2 Scope and Techniques of Budgetary Control

Scope
 Budgets are prepared for different functions of business such as production, sales etc.
Actual results are compared with the budgets and control is exercised.
 Budgets have a wide range of coverage of the entire organization. Each operation or
process is divided into number of elements and standards are set for each such element.
 Budgetary control is concerned with origin of expenditure at functionallevels.
 Budget is a projection of financial accounts whereas standard costing projects the cost
accounts.
Techniques
 Budgetary control is exercised by putting budgets and actual side by side. Variances are
not normally revealed in the accounts.
 Budgetary control system can be operated in parts. For example, advertisement budgets,
research and development budgets, etc.
 Budgetary control of expenses is broad in nature.
13.3.3 Requisites for Effective Budgetary Control
The following are the requisites for effective budgetary control:
 Clear cut objectives and goals should be well defined.
 The ultimate objective of realising maximum benefits should always be kept

uppermost.
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 There should be a budget manual which contains all details regarding plan and
procedures for its execution. It should also specify the time table for budget
preparation for approval, details about responsibility, cost centers etc.
 Budget committee should be set up for budget preparation and efficient of the plan.
 A budget should always be related to a specified time period.
 Support of top management is necessary in order to get the full support and
cooperation of the system of budgetary control.
 To make budgetary control successful, there should be a proper delegation of

authority and responsibility.
 Adequate accounting system is essential to make the budgeting successful.
 The employees should be properly educated about the benefits of budgeting system.
 The budgeting system should not cost more to operate than it is worth.
 Key factor or limiting factor, if any, should consider before preparation of budget.
 For budgetary control to be effective, proper periodic reporting system should be

introduced.
13.3.4 Organisation for Budgetary Control
In order to introduce budgetary control system, the following are essential to be considered
for a sound and efficient organization. The important aspects to be considered are explained as
follows:
 Organisation chart: For the purpose of effective budgetary control, it is imperative on

the part of each entity to have definite ‘plan of organization’. This plan of organization is
embodied in the organization chart. The organization chart explaining clearly the position
of each executive’s authority and responsibility of the firm. All the functional heads are
entrusted with the responsibility of ensuring proper implementation of their respective
departmental budgets. An organization chart for budgetary control is given showing clearly
the type of budgets to be prepared by the functionalheads.
 From the above chart, we can observe that the chairman of the company is the overall in
charge of the functions of the Budgeted Committee. A Budget Officer is the convener of
the budget committee, who helps in co-ordination. The Purchase Manager, Production
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Manager, Sales Manager, Personnel Manager, Finance Manager and Account Manager
are made responsible to prepare their budgets.
 Budget Center: A budget center is defined by the terminology as ‘a section of the

organization of an undertaking defined for the purpose of budgetary control’. For effective
budgetary control, budget centre or departments should be established for each of these
centers budget will be set with the help of the head of the department concerned.
 Budget officer: Budget officer is usually some senior member of the accounting staff
who controls the budgetary process. He does not prepare the budget himself, but facilitates
and coordinates the budgeting activity. He assists the individual departmental heads
and the budget committee, and ensures that their decisions are communicated to the
appropriate people.
 Budget committee: Budget committee comprising of the Managing Director, the

Production Manager, Sales Manager and Accountant. The main objective of this committee
is to agree on all departmental budgets, normal standard hours and allocations. In small
concerns, the Budget Officer may co-ordinate the work for preparation and implementation
of budgets. In large-scale concern a budget committee is setup for preparation of budgets
and execution of budgetary control.
 Budget manual: A budget manual has been defined as ‘a document which set out the
responsibilities of persons engaged in the routine of and the forms and records required
for budgetary control”. It contains all details regarding the plan and procedures for its
execution.
It also specifies the time table for budget preparation to approval, details about responsibility,
cost centres, constitution and organisation of budget committee, duties and responsibilities
of budget officer.
 Budget period: A budget is always related to specified time period. The budget period is
the length of time for which a budget is prepared and employed. The period may depend
upon the type of budget. There is no specific period as such. However, for the sake of
convenience, the budget period may be fixed depending upon the following factors:
1) Types of business
2) Types of budget
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3) Nature of the demand of the product
4) Length of trade cycle
5) Economicfactors
6) Availability of accounting period
7) Availability offinance
8) Control operation
13.3.5 Key Factor
Key Factor is also called as ‘Limiting Factor’ or Governing Factor. While preparing the
budget, it is necessary to consider key factor for successful budgetary control. The Key Factor
dominates the business operations in order to ensure that the functional budgets are reasonably
capable of fulfillment. The key factors include- raw materials may be in short supply, non-
availability of skilled labours, Government restrictions, limited sales due to insufficient sales
promotion, shortage of power, underutilization of plant capacity, shortage of efficient executives,
management policies regarding lack of capital, and insufficient research into new product
developments.
13.3.6 Advantages and Limitations of Budgetary Control
The advantages of budgetary control may be summarized as follows:
1. It facilitates reduction of cost.
2. Budgetary control guides the management in planning and formulation of policies.
3. Budgetary control facilitates effective co-ordination of activities of the various

departments and functions by setting their limits and goals.
4. It ensures maximization of profits through cost control and optimum utilization of

resources.
5. It evaluates for the continuous review of performance of different budget centres.
6. It helps to the management efficient and economic production control.
7. It facilitates corrective actions, whenever there are inefficiencies and weaknesses

comparing actual performance with budget.
8. It guides management in research and development.

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From the above it is clear that the budgetary control is an effective tool for management
control. However, it has certain important limitations which are identified below:
1. The budget plan is based on estimates and forecasting. Forecasting cannot be

considered to be an exact science. If the budget plans are made on the basis of
inaccurate forecasts then the budget programme may not be accurate and ineffective.
2. For reason of uncertainty about future, and changing circumstances which may
develop later on, budget may prove short or excess of actual requirements.
3. Effective implementation of budgetary control depends upon willingness, cooperation

and understanding among people reasonable for execution. Lack of cooperation
leads to inefficient performance.
4. The system does not substitute for management. It is like a management tool.
5. Budgeting may be cumbersome and time consuming process.
13.4 Types of Budgets

As budgets serve different purposes, different types of budgets have been developed.
The following are the different classification of budgets developed on the basis of time, functions,
and flexibility or capacity.
(A) Classification on the basis of Time:
1. Long-term budgets
2. Short-term budgets
3. Current budgets
(B) Classification according to functions:
1. Functional or subsidiary budgets
2. Master budgets
(C) Classification on the basis ofcapacity:
1. Fixed budgets.
2. Flexible budgets
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(A) Classification on the basis of time
a) Long-term budgets: Long-term budgets are prepared for a longer period varies between
five to ten years. It is usually developed by the top level management. These budgets
summaries the general plan of operations and its expected consequences. Long-term
budgets are prepared for important activities like composition of its capital expenditure,
new product development and research, long-term financeetc.
b) Short-term budgets: These budgets are usually prepared for a period of one year. The
scope of budgeting activity may vary considerably among different organization. Sometimes
they may be prepared for shorter period as for quarterly or halfyearly.
c) Current budgets: Current budgets are prepared for the current operations of the business.
The planning period of a budget generally in months or weeks. As per ICMA London,
“Current budget is a budget which is established for use over a short period of time and
related to currentconditions.”
(b) Classification on the basis of function
1. Functional budget: The functional budget is one which relates to any of the functions of
an organization. The number of functional budgets depends upon the size and nature of
business. The following are the commonlyused:
(i) Sales budget
(ii) Purchase budget
(iii) Production budget
(iv) Selling and distribution cost budget
(v) Cash budget
(vi) Capital expenditure budget
2. Master budget: The master budget is a summary budget. This budget encompasses all
the functional activities into one harmonious unit. The ICMA England defines a Master
Budget as the summary budget incorporating its functional budgets, which is finally
approved, adopted andemployed.
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(C) Classification on the basis of capacity
1. Fixed budget: A fixed budget is designed to remain unchanged irrespective of the level
of activity actuallyattained.
2. Flexible budget: A flexible budget is a budget which is designed to change in accordance

with the various level of activity actually attained. The flexible budget also called as Variable
Budget or Sliding Scale Budget, takes both fixed, variable and semi fixed manufacturing
costs intoaccount
13.4.1 Sales Budget
Sales budget is one of the important functional budgets. Sales estimate is the
commencement of budgeting may be made in quantitative terms. Sales budget is primarily
concerned with forecasting of what products will be sold in what quantities and at what prices
during the budget period. Sales budget is prepared by the sales executives taking into account
number of relevant and influencing factors such as: Analysis of past sales, key factors, market
conditions, production capacity, government restrictions, competitor’s strength and weakness,
advertisement, publicity and sales promotion, pricing policy, consumer behaviour, nature of
business, types of product, company objectives, salesmen’s report, marketing research’s reports,
and product life cycle.
13.4.2 Production Budget
Production budget is usually prepared on the basis of sales budget. But it also takes into
account the stock levels desired to be maintained. The estimated output of business firm during
a budget period will be forecast in production budget. The production budget determines the
level of activity of the produce business and facilities planning of production so as to maximum
efficiency. The production budget is prepared by the chief executives of the production
department. While preparing the production budget, the factors like estimated sales, availability
of raw materials, plant capacity, availability of labour, budgeted stock requirements etc. are
carefully considered.
Cost of Production Budget
After preparation of production budget, this budget is prepared. Production cost budgets
show the cost of the production determined in the production budget. Cost of production budget
is grouped in to material cost budget, labour cost budget and overhead cost budget. Because
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it breaks up the cost of each product into three main elements; material, labour and overheads.
Overheads may be further subdivided in to fixed, variable and semi-fixedoverheads.
Therefore separate budgets required for each item.
13.4.3 Material Purchase Budget
The different levels of material stock are based on planned out. Once the production
budget is prepared, it is necessary to consider the requirement of materials to carry out the
production activities. Material purchase budget is concerned with purchase and requirement of
direct materials to be made during the budget period. While preparing the materials purchase
budget, the following factors to be considered carefully:
 Estimated sales and production.
 Requirement of materials during budget period.
 Expected changes in the prices of raw materials.
 Different stock levels, EOQ etc.
 Availability of raw materials, i.e., seasonal or otherwise.
 Availability of financial resources.
 Price trend in the market.
 Company’s stock policy etc.
13.4.4 Cash Budget
This budget represents the anticipated receipts and payment of cash during the budget
period. The cash budget also called as Functional Budget. Cash budget is the most important
of the entire functional budget because, cash is required for the purpose to meeting its current
cash obligations. If at any time, a concern fails to meet its obligations, it will be technically
insolvent. Therefore, this budget is prepared on the basis of detailed cash receipts and cash
payments. The estimated cash receipts include: cash sales, credit sales, collection from sundry
debtors, bills receivable, interest received, income from sale of investment, commission received,
dividend received and income from non-trading operations etc.
The estimated cash payments include the following:
1. Cash purchase
2. Payment to creditors
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3. Payment of wages
4. Payments relate to production expenses
5. Payments relate to office and administrative expenses
6. Payments relate to selling and distribution expenses
7. Any other payments relate to revenue and capital expenditure
8. Income tax payable, dividend payable etc.
13.4.5 Master Budget
When the functional budgets have been completed, the budget committee will prepare a
master budget for the target of the concern. Accordingly a budget which is prepared incorporating
the summaries of all functional budgets. It comprises of budgeted profit and loss account,
budgeted balance sheet, budgeted production, sales and costs. The ICMA England defines a
Master Budget as ‘the summary budget incorporating its functional budgets, which is finally
approved, adopted and employed’. The master budget represents the activities of a business
during a profit plan. This budget is also helpful in coordinating activities of various
functionaldepartments.
13.4.6 Fixed Budget
A budget is drawn fro a particular level of activity is called fixed budget. According to
ICWA London ‘Fixed budget is a budget which is designed to remain unchanged irrespective of
the level of activity actually attained.” Fixed budget is usually prepared before the beginning of
the financial year. This type of budget is not going to highlight the cost variance due to the
difference in the levels of activity. Fixed budgets are suitable under static conditions.
13.4.7 Flexible Budget
Flexible budget is also called variable or sliding scale budget, ‘takes both the fixed and
manufacturing costs into account. Flexible budget is the opposite of static budget showing the
expected cost at a single level of activity. According to ICMA, England defined Flexible Budget
is a budget which is designed to change in accordance with the level of activity actually attained.”
According to the principles that guide the preparation of the flexible budget a series of
fixed budgets are drawn for different levels of activity. A flexible budget often shows the budgeted
expenses against each item of cost corresponding to the different levels of activity. This budget
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has come into use for solving the problems caused by the application of the fixed budget.
Advantages of Flexible Budget

1. In flexible budget, all possible volume of output or level of activity can becovered.
2. Overhead costs are analysed into fixed variable and semi-variablecosts.
3. Expenditure can be forecasted at different levels ofactivity.
4. It facilitates at all times related factor can be compared, which essential for intelligent
decision are making.
5. A flexible budget can be prepared with standard costing or without standard costing
depending upon what the company opts for.
6. A flexible budget facilitates ascertainment of costs at different levels of activity,

price determination, placing tenders and quotations.
7. It helps in assessing the performance of all departmental heads as the same can
be judged by terms of the level of activity attained by the business.
13.4.8 Distinction between Fixed Budget and Flexible Budget
Fixed budget Flexible budget
1. It does not change with the volume of 1. It can be recast on the basis of volume of
activity cost.
2. All costs are related to one level of activity 2. All costs are related to one level of
only. activity only.
3. If budget and actual activity levels 3. Flexible budgeting helps in fixation of

vary, cost ascertainment does not selling price at different levels of activity.
provide a correct picture.
4. Ascertainment of costs is not possible in 4. Costs can be easily ascertained at

fixed cost. different levels of activity.
5. It has a limited application for cost control. 5. It has more application and can be used
as a tool for effective cost control.
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6. It is rigid budget and drawn on the 6. It is designed to change according to

assumption that conditions changed conditions.
would remain constant.
7. Comparison of actual and budgeted 7. Comparisons are realistic according to the

performance cannot be done change in the level of activity.
correctly because the volume of
production differs.
8. Costs are not classified according 8. Costs are classified according to the nature
to their of their variability. variability, i.e., fixed, variable and semi-
variable.
13.4.9 Method of preparing Flexible Budget
The following methods are used in preparing a flexible budget:
1. Multi-activity method
2. Ratio method
3. Charting method.
1. Multi-Activity method: This method involves preparing a budget in response to different

level of activity. The different level of activity or capacity levels are shown in Horizontal
columns, and the budgeted figures against such levels are placed in the Vertical Columns.
The expenses involved in production as per budget are grouped as fixed, variable and
semi variable.
2. Ratio method: According to this method, the budget is prepared first showing the expected
normal level of activity and the estimated variable cost per unit at the side expected level
of activity in addition to the fixed cost as estimated. Therefore, the expenses as per
budget, allowed for a particular level of activity attained, will be calculated on the basis of
the following formula: Budgeted fixed cost + (Variable cost per unit of activity × Actual unit
of activity).
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3. Charting method: Under this method total expenses required for any level of activity, are
estimated having classified into three categories, viz., variable, and semi variable and
fixed. These figures are plotted on a graph. The expenses are plotted on the Y-axis and
the level of activity is plotted on X-axis. The graphs will thus, help in ascertaining the
quantum of budgeted expenses corresponding to the level of activity attained with the
help of thischart.
13.5 Zero Base Budgeting (ZBB)

Zero base budgeting is a new technique of budgeting. It is designed to meet the needs of
the management in order to ensure the operational efficiency and effective utilization of the
allocated resources of a concern. This technique was originally developed by Peter A. Phyhrr,
Manager of Taxas Instrument during 1969. This concept is widely used in USA for controlling
their state expenditure when Mr. Jimmy Carter was the president of the USA. At present the
technique has for its global recognition for many countries have implemented in realterms.
According to Peter A. Phyhrr ZBB is defined as an “Operative planning andbudgeting

process which requires each manager to justify his entire budget in detail from Scratch (hence
zero base) and shifts the burden of proof to each manager to justify why we should spend any
money at all”. In zero-base budgeting, a manager at all levels; have to justify the importance of
activity and to allocate the resources on priority basis.
Zero-based budgeting involves the following important aspects:
1. It emphasises on all requisites ofbudgets.
2. Evaluation on the basis of decision packages and systematic analysis, i.e., in view
of cost benefitanalysis.
3. Planning the activities, promotes operational efficiency and monitors the performance
to achieve theobjectives.
13.5.1 Steps involved in ZBB
The following are the steps involved in zero base budgeting:
 No previous year performance of inefficiencies is to be taken as adjustments in

subsequent year.
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 Identification of activities in decision packages.
 Determination of budgeting objectives to beattained.
 Extent to which zero base budgeting is to beapplied.
 Evaluation of current and proposed expenditure and placing them in order ofpriority.
 Assignment of task and allotment of sources on the basis of cost benefitcomparison.
 Review process of each activity examinedafresh.
 Weightage should be given for alternative course ofactions.
13.5.2 Advantages of ZBB

1. Utilization of resources at a maximumlevel.
2. It serves as a tool of management in formulating productionplanning.
3. It facilitates effective costcontrol.
4. It helps to identify the uneconomicalactivities.
5. It ensures the proper allocation of scarce resources on prioritybasis.
6. It helps to measure the operational inefficiencies and to take the correctiveactions.
7. It ensures the principles of management byobjectives.
8. It facilitates co-operation and co-ordination among all levels ofmanagement.
9. It ensures each activity is thoroughly examined on the basis of cost benefit analysis.
13.6 Performance Budgeting

Performance budget has been defined as a ‘budget based on functions, activities and
projects.’ Performance budgeting may be described as ‘the budgeting system in which input
costs are related to the performance, i.e., end results.’
According to National Institute of Bank Management, Performance budgeting is, “the

process of analyzing, identifying, simplifying and crystallizing specific performance objectives
of a job tobe achieved over a period, in the framework of the organizational objectives, the
purpose and objectives of the job.”
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From the above definitions, it is clear that budgetary performance involves the following:
 Establishment of well definedcentres ofresponsibilities:
 Establishment for each responsibility centre- a programme of target performance is

in physicalunits.
 Forecasting the amount of expenditure required to meet the physical plan laiddown.
 Comparison of the actual performance with the budgets, i.e., evaluation

ofperformance.
 Undertaking periodic review of the programme with a view to make modifications

as required.
13.7 Illustrations
1. Prepare a flexible budget for overheads on the basis of the following data. Ascertain
the overhead rates at 50%, 60% and 70% capacity.
At 50% capacity (Rs.)
Variable overheads:
Indirect material 3,000
Indirect labour 9,000
Semi-variable overheads:
Electricity (40% fixed 60% variable) 15,000
Repairs (80% fixed 20% variable) 1,500
Fixed overheads:
Depreciation 8,250
Insurance 2,250
Salaries 7,500
Total overheads 46,500
Estimated direct labour hours 93,000

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Solution
Flexible budget
Particulars 50% 60% 70%

capacity capacity capacity
Variable overheads:
Indirect material 2,500 3,000 3,500
Indirect labour 7,500 9,000 10,500
Semi-variable overheads:
Electricity 13,500 15,000 16,500
Repairs and maintenance 1,450 1,500 1,550
Fixed overheads:
Depreciation 8,250 8,250 8,250
Insurance 2,250 2,250 2,250
Sales 7,500 7,500 7,500
Total overheads 42,950 46,500 50,050
Estimated direct labour hours 93,000 1,08,500 77,500
Overhead rate Re. 0.55 Re. 0.50 Re. 0.46
Working notes
1. Electricity: Rs. 15,000 is the cost of electricity at 60% capacity, of which 40% are fixed
overheads, i.e., Rs. 6,000 and variable is Rs.9,000:
For 60% capacity variable overheads = Rs.9,000
For 50% capacityvariableoverheads = (9000//60) × 50 = Rs. 7,500 Therefore electricity

cost at 50% capacity = 6,000 + 7,500 = Rs. 13,500 For 70% capacity,variableoverheads =
(9000/60) × 70 = Rs. 10,500 Therefore electricity costat70% = Rs. 10,500 + Rs.6,000
= Rs. 16,500
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1. Repairs and maintenance: Rs. 1500 is the cost of repairs and maintenance at60%
capacity, of which 80% is fixed overhead, i.e., Rs. 1,200 and variable is Rs. 300: For 60%
capacity variable overhead #######
For 50% capacityvariableoverhead = (300/60) × 50 = Rs. 250 Therefore the total cost
of repairs and maintenance at 50%
= Rs. 1,200 + Rs. 250 = Rs. 1,450
For 70% capacity,variableoverhead = (300/60) × 70 = Rs. 350 Therefore the total cost
of repairs and maintenance
= Rs. 1,200 + Rs. 350 = Rs. 1,550
2. Ashish Engineering Co. Ltd. manufacturers’ two articles X and Y. Its sales department
has three divisions: West, South and East. Preliminary sales budgets for the year ending
31st December 2003, based on the assessments of the divisional executives:
Product X: West 40,000 units: South 1,00,000 units and East 20,000 units Product Y:
West 60,000 units: South 8,00,000 units and East Nil
Sales price X Rs. 2 and Y Rs. 3 in all areas.
Arrangements are made for the extensive advertising of product X and Y and it is estimated
that West division sales will increase by 20,000 units. Arrangements are also made to advertise
and distribute product Y in the Eastern area in the second half of 2003 when sales are expected
to be 1,00,000 units.
Since the estimated sales of the South division represented an unsatisfactory target, it is
agreed to increase both the estimates by 10%. Prepare a sales budget for the year to 31st
December 2003.
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Solution
Division Product X Product Y Total Rs.

Qty. Price Rs. ValueRs. Qty. Price Rs. ValueRs.
West 60,000 2 1,20,000 80,000 3 2,40,000 3,60,000
South 1,10,000 2 2,20,000 88,000 3 2,64,000 4,84,000
East 20,000 2 40,000 1,00,000 3 3,00,000 3,40,000
Total 1,90,000 3,80,000 2,68,000 8,04,000 11,84,000
3. Natarajan Ltd. has four sales territories A, B, C, D. Each salesman is expected to sell the
following number of units during the First Quarter of 2003. Assume the average selling
price to be Rs. 10:
Month A Units B Units C Units D Units
April 500 750 1,250 1,750
May 1,000 900 1,400 2,000
June 1,250 1,000 1,500 2,250
Solution:
Territory April May June Quarter
Qty. Price Value Qty. Price Value Qty. Price Value Qty. Value
Unit Rs. Rs. Unit Rs. Rs. Unit Rs. Rs. Unit Rs.
A 500 10 5,000 1,000 10 10,000 1,250 10 12,500 2,750 27,500
B 750 10 7,500 900 10 9,000 1,000 10 10,000 2,650 26,500
C 1,250 10 12,500 1,400 10 14,000 1,500 10 15,000 4,150 41,500
D 1,750 10 17,500 2,000 10 20,000 2,250 10 22,500 6,000 60,000
Tot al 4,250 42,500 5,300 53,000 6,000 60,000 15,550 1,55,500

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4. From the following particular, you are required to prepare production budget of Mittal Ltd.
a manufacturing organization that has three products X, Y and Z.
Cost of Production Budget
Product Estimated stock at Estimated stock at Estimated sales as per

the beginning of the the end of the sales budget
budget period budget period
X 5,000 units 6,400 units 21,600 units
Y 4,000 units 3,850 units 19,200 units
Z 6,000 units 7,800 units 23,100 units
Solution
Particulars X (Units) Y (Units) Z (Units)
Expected sales during the period 21,600 19,200 23,100
Add: Closing stock at the end of budget period 6,400 3,850 7,800
28,000 23,050 30,900
Product Estimated stock at the beginning of the

budget period 5,000 4,000 6,000
Estimated stock at the end of the budget period 23,000 19,050 24,900
5. Production cost of a factory for a year is as follows: Direct wages Rs. 40,000
Direct materials Rs. 60,000 Production overhead fixed Rs. 20,000
Production overhead variable Rs. 30,000 During the forthcoming year, it is expected that
a) The average rate for direct labour remuneration will be far from Rs. 3 per hour to
Rs. 2 per hour
b) Production efficiency will remain unchanged
c) Direct labour hours will increase by 331/3%

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The purchase price per unit of direct materials and of the other materials and services
which comprise overheads will remain unchanged.
Draw up a budget and a factory overhead rate, the overhead being absorbed on a direct
wage basis.
Solution:
Cost of production budget
Particulars Amount Rs. Amount Rs.
Direct Materials 60,000
Direct wages [40,000 X(2/3)X(4/3)] Prime cost 35,556
Add: Production overhead: Fixed 95,556
Variable Rs.20,000
Rs.30,000 50,000
6. Draw up a material purchase budget from the following information:
Estimated sales of a product are 30,000 units. Two kinds of raw materials A and B are
required for manufacturing the product. Each unit of the product requires 3 units of A and 4
units of B. The estimated opening balance in the beginning of the next year: finished goods
5,000 units; A 6,000 units: B, 10,000 units. The desirable closing balance at the end of the next
year: finished product, 8,000 units; A, 10,000 units, B 12,000 units.
Solution
Estimated production = Expected sales + desired closing stock of finished goods–
Estimated opening stock of finished goods
= 30,000 + 8,000 – 5,000
= 33,000 units
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Material purchase budget for the year

Particulars Material Material
A B
(Units) (Units)
Material required to meet production

Target
Material A – 33,000 ×3
Material B – 33,000 ×4 99,000 1,32,000
Add: Desired closing stock 10,000 12,000

at the end of next year
1,09,000 1,44,000
Less: Expected stock at the next

commencement of year
6,000 10,000
(opening balance)
Quantity of materials to be purchased 1,03,000 1,34,000
7. Prasad and Co. wishes to prepare cash budget from January. Prepare a cash budget for
the first six months from the following estimated revenue andexpenses:
Month Total Sales Materials Wages Production Selling and

Overheads Distribution
Overheads
Rs. Rs. Rs. Rs. Rs.
January 10,000 10,000 2,200 1,600 400
February 11,000 7,000 2,200 1,650 450
March 14,000 7,000 2,300 1,700 450
April 18,000 11,000 2,300 1,750 500
May 15,000 10,000 2,000 1,600 450
June 20,000 12,500 2,500 1,800 600
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1) Cash balance on 1st January was Rs. 5,000. New machinery is to be installed at
Rs. 10,000 on credit, to be repaid by two equal instalments in March andApril.
2) Sales commission @ 5% on total sales is to be paid within a month of following

actualsales.
3) Rs. 5,000 being the amount of 2nd call may be received in March. Share Premium
amounting to Rs. 1,000 is also obtainable with the 2ndcall.
4) Period of credit allowed by suppliers- 2months.
5) Period of credit allowed to customers- 1month.
6) Delay in payment of overheads- 1month.
7) Delay in payment of wages- ½month.
8) Assume cash sales to be 50% of totalsales.
Solution
Cash Budget from January to June
Amount in Rs
Particulars January February March April May June
Opening balance 5,000 9,000 14,900 13,500 12,350 16,550
Estimated cash receipts:
Cash sales 5,000 5,500 7,000 9,000 7,500 10,000
Credit sales - 5,000 5,500 7,000 9,000 7,500
Second call - - 5,000 - - 0
Share premium - - 1,000 - -
Total cash Receipts (A) 10,000 19,500 33,400 29,500 28,850 34,050
Estimated cash payments:

Materials - - 10,000 7,000 7,000 11,000
Wages 1,000 2,100 2,250 2,300 2,150 2,250

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Production Overheads - 1,600 1,650 1,700 1,750 1,600
Selling & Distribution

overheads - 400 450 450 500 450
Sales commission - 500 550 700 900 750
Purchase of machinery - - 5,000 5,000 -
Total cash Payment (B) 1,000 4,600 19,900 17,150 12,300 16050
Closing balance (A – B) 9,000 14,900 13,500 12,350 16,550 18,000
8. From the following data, forecast the cash position at the end of April, May and June
2005.
Amount in Rs
Month Sales Purchase Wages Miscellaneous
February 60,000 42,000 5,000 3,500
March 65,000 50,000 6,000 4,000
April 40,000 52,000 4,000 3,000
May 58,000 53,000 5,000 6,000
June 4,000 40,000 4,000 3,000
Additional information:
1) Sales: 10% realized in the month of sales; balance realised equally in two subsequent
months.
2) Purchases: These are paid in the month following the month of supply.
3) Wages: 10% paid in arrears following month.
4) Miscellaneous expenses: Paid a month in arrears.
5) Rent: Rs. 500 per month paid quarterly in advance due in April.
6) Income tax: First instalment of advance tax Rs. 15,000 due on or before 15th June.
7) Income from investment: Rs. 3,000 received quarterly in April, July etc.
8) Cash in hand: Rs. 3,000 on 1st Apri l2005.

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Solution
Cash budget for the month of April, May and June
Particulars April (Rs.) May (Rs.) June (Rs.)
Opening balance of cash 3,000 7,550 700
Add: Cash receipts:
Cash sales 4,000 5,800 4,400
Receipts from debtors (Credit Sales)
Collection in 1st month 29,250 18,000 19,800
Collection in 2nd month 27,000 29,250 18,000
Income from investment 3,000 - -
Total cash receipts (1) 66,250 60,600 42,900
Less: Cash payments:
Creditors for purchases 50,000 52,000 53,000
Wages: Current (90%) 3,600 4,500 3,600
Arrears (10%) 600 400 500
Rent 500 - -
Miscellaneous expenses 4,000 3,000 6,000
Income tax - - 15,000
Total payments (2) 58,700 59,900 78,100
Closing balance of cash (1-2) 7,550 700 (-) 35,200
Working notes:
1. Out of total sales, 10% are cash sales. Balance 90% is credit sales. In any given
month 50% of credit sale of the previous two months are collected (See W.N.).
2. In any given month, 90% of the wages of the same month and 10% of previous
month’s wages are paid.
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Working notes for collection of cash from debtors and sales
Particulars February (Rs.) March (Rs.) April (Rs.) May (Rs.) June (Rs.)
Total sales 60,000 65,000 40,000 58,000 44,000
Less: Cash 6,000 6,500 4,000 5,800 4,400
sales (10%)
Credit sales 54,000 58,500 36,000 52,200 39,600
Collection in
1st month after
credit sales - 27,000 29,250 18,000 19,800
Collection in 2nd
month after credit
sales - - 27,000 29,250 18,000
Total credit - - -56,250 47,250 37,800
9. Pushpack and Co., a glass manufacturing company requires you to calculate and
present the budget for the next year from the following information:
Toughened glass Rs. 2,00,000
Benttoughened glass Rs. 3,00,000
Direct material cost 60% of sales
Direct wages 10 workers @ Rs. 100 per month
Factory overheads
Indirect labour:
Workmanager Rs. 300 per month
Foreman Rs. 200 per month
Stores and spares 2% on sales
Depreciation on machinery Rs. 6,000
Light and power Rs. 2,000
Repairs and maintenance Rs. 4,000

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Other sundries 10% on direct wages Administration,

selling and distribution expenses
Rs. 7,000 per year.
Solution
Master budget for the year ending ………..
Particulars Amount Amount

Sales (as per sales budget):
Toughened glass 2,00,000
Bent toughened glass 3,00,000
5,00,000
Less: Cost of production:
(as per cost of production budget)
Direct materials 3,00,000
Direct wages 12,000
Prime cost 3,12,000
Add: Factory overhead:
Variable:
Stores and spares Rs. 10,000
Light and power Rs. 2,000
Repairs and maintenance Rs. 4,000 16,000
Fixed:
Work Manager’s salary Rs. 3,600
Foreman salary Rs. 2,400
Depreciation Rs. 6,000
Sundries Rs. 1,200 13,200 3,41,200
Work’s cost 3,41,200
Gross profit 1,58,800
Less: Administration, selling & 7,000
distribution overheads
Net profit 1,51,800
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13.8 Summary
Budgeting has come to be accepted as an efficient method of short-term planning and
control. It is employed, no doubt, in large business houses, but even the small businesses are
using it at least in some informal manner. Though the budgets, a business wants to know
clearly as to what it proposes to do during an accounting period or a part thereof. The technique
of budgeting is an important application of management accounting. Probably, the greatest aid
to good management that has ever been devised is the use of budgets and budgetary control.
It is a versatile tool and has helped managers cope with many problems includinginflation. The
different types of budget are explained in this lesson.
13.9 Key Words

Cash Budget
Fixed Budget
Flexible Budget
Material Purchase Budget
Production Budget

1. What do you mean by a budget? List out its essential features.
2. What are the differences between budgets and forecasts?
3. What do you understand by budgetary control?
4. What are the objectives of budgetary control?
6. What do you understand by organization for budgetary control?
7. What are the advantages and limitations of budgetary control?
8. What is sales budget? What are the factors considered in developing the sales budget?
9. Write short notes on: (a) Production budget, (b) cost of production budget, and (c) materials
budget.
10. What do you understand by cash budget? Discuss the procedure for preparing the cost
budget.
11. What do you understand by master budget?
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12. What do you understand by fixed budget and flexible budget? What are the advantages
of flexible budget?
13. Describe the different methods of preparing flexible budget.
14. Two articles A and B are manufactured in a department. Sales for the year 2003 were
planned asfollows:
Product 1st quarter 2nd quarter 3rd quarter 4th quarter

Units Units Units Units
A 5,000 6,000 6,500 7,500
B 2,500 2,250 2,000 1,900
Selling price were Rs. 10 per unit for A and Rs. 20 per unit for B respectively.
Average less return are 10% of sales and the discounts and bad debts amount to 2% of
the total sales.
15. A company is expecting to have Rs. 25,000 cash in hand on 1st April 2003 and it requires
you to prepare an estimate of cash position in respect of three monthsfrom
April to June 2003, from the information given below:
Sales Purchase Wages Expenses

(Rs.) (Rs.) (Rs.) (Rs.)
February 70,000 40,000 8,000 6,000
March 80,000 50,000 50,000 7,000
April 92,000 52,000 52,000 7,000
May 1,00,000 60,000 60,000 8,000
June 1,20,000 55,000 55,000 9,000
Additional information
a) Period of credit allowed by suppliers- two months.
b) 25% of sale is for cash and the period of credit allowed to customer for credit sale
one month.
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c) Delay in payment of wages and expenses one month.
d) Income tax Rs. 25,000 is to be paid in June 2003.
16. PQR company Ltd. has given the following particulars, you are required to prepare a cash
budget for the three months ending 1st December, 2003.
Months Sales Materials Wages Overheads
August 20,000 10,200 3,800 1,900
September 21,000 10,000 3,800 2,100
October 23,000 9,800 4,000 2,300
November 25,000 10,000 4,200 2,400
December 30,000 10,800 4,500 2,500
Credit terms are:
Sales/Debtors- 10% sales are on cash basis: 50% of the credit sales are collected next
month and the balance in the following month:
Creditors Materials 2 months
Wages 1/5 month Overheads ½ month
17. A factory is currently to 50% capacity and produces 10,000 units estimate the profits of
the company when it works at 60% and 80% capacity and offer your critical comments.
At 60% working raw materials cost increases by 2% and selling price falls by 2% at the
80% working, raw material cost increases by 5% and selling price falls by 5%.
At 50% capacity working the product costs Rs. 180 per unit and is sold at Rs. 200 per unit.
The unit cost of Rs. 180 is made up as follows:
Materials Rs. 100
Labour Rs. 30
Factory overhead Rs. 30 (40% fixed)
Administrative overhead Rs. 20 (50% fixed)

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Pearson, 2012.

2011.
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LESSON 14
REPORTING TO MANAGEMENT
Learning Objectives
 List out the objectives and principles of reporting
 Explain the types of report
Structure
14.1 Introduction
14.2 Objectives of Reporting
14.3 Principles of Reporting
14.4 Importance
14.5 Qualities of Good Report
14.6 Types of Report
14.7 Reports submitted to various Levels of Management
14.8 Summary
14.9 Key Words
14.1 Introduction
The term ‘reporting’ conveys different meanings on different circumstances. In a narrow
sense it means: supplying facts and figures. On the other hand, when a committee is appointed
to study a problem, a report is taken to mean : review of certain matter with its pros and cons
and offering suggestions. In case of dealing with routine matters, a report refers to supplying
the information at regular intervals in standardized forms. A report is a means of communication
which is in written form and is meant for use of management for the purpose of planning
decision-making and controlling.
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Simply stated it is a communication of result by a subordinate to superior. It serves as a

feedback to the management. The contents of report, the details of the data reported and the
method of presentation depend upon the size and type of the business enterprise, extent of
power delegated to subordinates and the existence of various levels of management for whom
information is meant.
14.2 Objectives of Reporting
Traditionally, reporting was aimed at showing compliance with the budget. While this
function is met in countries with a parliamentary tradition and adequate audit capacity, in other
countries, improving compliance remains the priority challenge. Nevertheless, transparency
and accountability call for wider scope of reporting. A budget reporting system should provide a
means of assessing how well the government is doing. Ideally, therefore it should answer following
questions.
1. Budgetary integrity. Have resources been used in conformity with legal

authorizations and mandatory requirements? What is the status of resources and
expenditures (uncommitted balances and undisbursed commitments)?
2. Operating performance. How much do programs cost? How were they

financed?What was achieved? What are the liabilities arising from their execution?
How has the government managed its assets?
3. Stewardship. Did the governments financial condition improve or deteriorate? What

provision has been made for the future?
4. Systems and control. Are theresystemstoensure effectivecompliance,proper

management of assets and adequate performance? Reports are an important
instrument for planning and policy formulation. For this purpose, they should provide
information on ongoing programs and the main objectives of government
departments. Reports can also be used for public relations and be a source of facts
and figures. They give an organization the opportunity to present a statement of its
achievements, and to provide information for a wide variety of purposes.
Reporting must take into account the needs of different groups of users including:
(i) the Cabinet, core ministries, line ministries, agencies, and program managers;
(ii) the legislature; and

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(iii) Outside the government, individual citizens, the media, corporations, Universities,
interest groups, investors, and creditors.
According to surveys carried out in several developed countries, all users need
comprehensive and timely information on the budget. The executive branch of government
needs periodic information about the status of budgetary resources to ensure efficient budget
implementation and to assess the comparative the costs of different programs. Citizens and the
legislature need information on costs and performance of programs that affect them or concern
their constituency. Financial markets need cash based information, etc.
14.3 Principles of Reporting

Reports prepared by the government for internal and external use are governed by the
following principles:
1. Completeness. The measures, in the aggregate, should cover all aspects of the reporting
entity’s mission.
2. Legitimacy. Reports should be appropriate for the intended users and consistent in form
and content with accepteds tandards.
3. User friendliness. Reports should be understandable to reasonably informed and

interested users, and should permit information to be captured quickly and communicated
easily. They should include explanations and interpretations for legislators and citizens
who are not familiar with budgetary jargon and methodological issues. Financial statements
can be difficult for non-accountants; where possible, charts and illustrations should be
used to improve readability. Of course, reports should not exclude essential information
merely because it is difficult to understand or because some report users choose not to
use it.
4. Reliability. The information presented in the reports should be verifiable and free of bias
and faithfully represent what it purports to represent. Reliability does not imply precision
or certainty. For certain items, a properly explained estimate provides more meaningful
information than no estimate at all (for example, tax expenditures, contingencies, or super
annuation liabilities).
5. Relevance. Information is provided in response to an explicitly recognized need. The

traditional function of year-end reports is to allow the legislature to verify budget execution.
The broader objectives of financial reporting require that reports take into account the
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different needs of various users. A frequent criticism of government financial reports is

that they are at the same time overloaded and useless.
6. Consistency. Consistency is required not only internally, but also over time, that is, once
an accounting or reporting method is adopted, it should be used for all similar transactions
unless there is good cause to change it. If methods or the coverage of reports have
changed or if the financial reporting entity has changed, the effect of the change should
be shown in the reports.
7. Timeliness. The passage of time usually diminishes the usefulness of information. A

timely estimate may then be more useful than precise information that takes longer to
produce. However, the value of timeliness should not preclude compilation and data
checking even after the preliminary reports have been published.
8. Comparability. Financial reporting should help report users make relevant comparisons
among similar reporting units, such as comparisons of the costs of specific functions or
activities.
9. Usefulness. Agency reports, to be useful both inside and outside the agency, reports
should contribute to an understanding of the current and future activities of the agency, its
sources and uses of funds, and the diligence shown in the use of funds.
14.4 Importance
In cost accounting, there are three important divisions, viz., cost ascertainment, cost
presentation, and cost control. Cost presentation serves as a link between cost ascertainment
and cost control. The management of every organization is interested in maximization of profit
through minimization of wastages, losses, and ultimately cost. So management will have to be
furnished with frequent reports on all functional areas of business to achieve these objectives.
One of the important functions of cost accounting is to provide the required information to
all levels of management at the appropriate time. The various aspects of reporting such as:
nature of reports to be prepared, the details of information to be included and mode of
presentation, are all decided at the time of installation of cost accounting system. In fact, cost
ascertainment. and cost control are designed in such a way that they suit the scheme of
information to be presented so that they serve all levels of management but not the other way
round.
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Efficient reporting is critical to an enterprise for many reasons, including:
1. Performance Measurement. Reporting enables company performance to be evaluated

on many levels, including.
2. Enterprise Performance. Consolidated executive reporting enables executives to

determine the success of their corporate vision and resulting initiatives..
3. Divisional Performance. Management reporting provides managers with a team

performance report that can be used to manage and evaluate the results against forecasts.
4. Asset Performance. Detailed reporting provides individual personnel and their managers
with either an individual or asset performance report to manage and evaluate the results
against forecasts.
5. Capital Utilization Optimization. Reporting enables management to compare and

prioritize assets to optimize capitalutilization.
6. Informed Decision Making. Reporting provides a basis for forecast development, goal
setting, result evaluation and management, and informed decision-making. These
decisions can range from corporate-wide initiatives and divisional budgeting considerations
to the hiring and firing of individual personnel.
7. Optimal profitability: Through reporting, management can steer the enterprise towards
optimal profitability. In order for profitability to be optimal, it is critical that enterprise reporting
is informative, timely, accurate and available with simplified access to the required detail.
This allows management to take an active role to ensure continuous fiscal improvement
and cost efficacy.
14.5 Qualities of a Good Report

The draft of the report should be reviewed for an appropriate number of times so that the
errors are completely avoided. While reviewing the draft, certain guidelines are to be followed,
as indicated below:
1. The text of the report should be free from ambiguity.
2. The text should convey the intendedmessage.

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3. Because the readers are with different profiles, the style and presentation of the text of
the report should suit the profile of the targeted group of readers; otherwise, the purpose
of the report will belost.
4. The content of the report should fully reveal the scope of the research in logical sequence
without omitting any item and at the same time it should be crisp andclear.
5. The report should be organized in hierarchical form with chapters, main sections,
subsections within main sections,etc.,
6. There should be continuity between chapters and also between sections as well
subsections.
7. The abstract at the beginning should reveal the essence of the entire report which gives
the overview of thereport.
8. The chapter on conclusions and suggestion is again enlarged version of the abstract with
more detailed elaboration on the inferences andsuggestions.
9. A reading of abstract and conclusion of a report should give the clear picture of the report
content to the readers. Avoid using lengthy sentences unlesswarranted.
10. Each and every table as well as figure should be numbered and it must be referred in the
main text.
11. The presentation of the text should be lucid so that every reader is able to understand and
comprehend the report content without anydifficulty.
14.6 Types of Report

Reports are classified into different types according to different bases. This is shown
below
TYPES OF REPORT
I. On the Basis of Purpose
On the basis of purpose, reports can be classified into two types, viz., (a) External report,
and (b) Internal report.
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(a) External report: External report is prepared for meeting the requirements of persons
outside the business, such as shareholders, creditors, bankers, government, stock
exchange and so on. An example of external report is the published accounts, viz., profit
and loss account and balance sheet. External report is brief in size as compared to internal
report and they are prepared as per the statutory requirements.
(b) Internal report: Internal report is meant for different levels of management. This can
again be classified into three types: (a) Report meant for top level management, (b)
Report meant for middle level management, and (c) Report meant for lower level
management. Report to top level management should be in summary form giving an
overall view of the performance of the business. Whereas external reports are prepared
annually, internal reports are prepared frequently to serve the needs of management.
Internal report need not conform to any standard form as it is not statutorily required to be
prepared.
II. On the Basis of Period of Submission
According to this basis, reports can be classified into two types, viz., (I) Routine reports,
and (2) Special reports.
(a) Routine reports: They are prepared periodically to cover normal activities of the business.
They are submitted to different levels of management according to a time schedule fixed.
While some reports are prepared and submitted at a very short intervals, some are prepared
and submitted at a long interval of time. Some examples of routine reports relate to
monthly profit and loss account, monthly balance sheets, monthly production. purchases,
sales,etc.
(b) Special reports: Special reports are prepared to cover specific or special matters
concerning the business. Most of the special reports are prepared after investigation or
survey. There is no standard form used for submitting this report. Some of the matters
which are covered by special reports are: causes for production delays, labour disputes,
effects of machine breakdown, problems involved in capital expenditure, make or buy
problems, purchase or hire of fixed assets, price fixation problems, closing down or
continuation of certain departments, cost reduction schemes,etc.
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III. On the Basis of Function
According to the purpose served by the reports, it can be classified into two types, viz., -
(a) operating report, and (b) financial report.
(a) Operating report: These reports are prepared to reveal the various functional results.
These reports can again be classified into three types, viz., (a) Control reports, which are
prepared to exercise control over various operation of the business, (b) Information report,
which are prepared for facilitating planning and policy formulation in a business, (c) Venture
measurement report which is prepared to show the result of a specific venture undertaken
as for example a new product lineintroduced.
(b) Financial report: Such reports provide information about financial position of the
undertaking. These reports may be prepared annually to show the financial position for
the year as in the case of balance sheet or periodically to show the cash position for a
given period as in the case of fund flow analysis and cash flowanalysis.
14.7 Reports submitted to various Levels of Management

1. Top Level Management
The top level management comprises of board of directors, managing director, and other
executives who are concerned with determination of objectives and formulation of policies. Top
management is to be furnished with reports at regular intervals in order to enable them to
exercise control over the activities of the business. The following are some of the matters to be
reported to board of directors.
1. Master budget which covers all functional budgets for taking remedial actions where there
are significant deviations from budgeted figures.
2. Various functional budgets prepared by various departmental managers for holding

departmental managers for any shortfall in their performance.
3. Capital expenditure budget and cash budget to know the extent of variances for taking
remedial measures.
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4. Reports relating to production and sales, which shows the trend of the performance of
business.
5. Report covering important ratios such as stock turnover ratio, fixed assets turnover ratio,
liquidity ratio, solvency ratio, profitability ratios, etc. to know the improvement in business.
6. Appraisal of various projects undertaken by the organisation.
2. Middle Level Management
It comprises of different departmental managers such as production manager, purchase

manager, sales manager, chief accountant, etc. These managers require reports to improve
the efficiency of their respective departments. The following are some of the matters reported
to production manager:
 Report relating to actual capacity utilised as compared to budgeted capacity.
 Report relating to actual output as against standard output.
 Labour and machine capacity utilised.
 Idel time lost.
 Report on scraps, wastages and losses in production.
 Report relating to stock of raw materials, work-in-progress and finished goods.
 Report relating to cost of production, operation of differentdepartments. The following are

some of the matters reported to sales manager:
 Report relating to number of orders executed, orders received and orders on hand.
 Reports relating to actual sales and budgeted sales and actual selling and distribution
expenses and budgeted selling and distribution expenses.
 Summary of selling expenses incurred in different territories and their corresponding sales.
 Gross profit earned on different products and in different areas.
 Market survey reports.
 (/) Report relating to present and potential demand.
 The following are some of the matters reported to financial manager:
 Report relating to cash position.

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 Summary of receipts and payments.
 Report relating to outstanding debts on credit sales.
 Report on debts due on credit purchases.
 Monthly profit and loss account.
 (/) Quarterly report on capital expenditure.
3. Lower Level Management
The lower level management include supervisors, foremen and inspectors who are
concerned with the operations of the factory. They are interested in increasing the efficiency of
the production departments. The reports that are to be sent to them are variances relating to
planned and actual performance. The report must also emphasise cost control aspects.
Users of accounting information
Accounting information of a business enterprise is used by a number of parties. Different

parties use accounting information for different purposes depending on their needs. Therefore,
the accounting information system of a business enterprise must be designed in a way that
should generate reports to satisfy the needs of everyone interested in accounting information.
We can broadly divide the users of accounting information into two groups – internal
users and external users. Internal users include managers and owners of the business whereas
external users include investors, creditors of funds, suppliers of goods, government agencies,
general public, customers and employees.
Internal users
Internal users use a mix of management and financial accounting information. Some
internal users of accounting information and their needs are briefly discussed below:
1. Management
Management uses accounting information for evaluating and analyzing organization’s

financial performance and position, to take important decisions and appropriate actions to improve
the business performance in terms of profitability, financial position and cash flows. One of the
major roles of management is to set rules and procedures to achieve organizational goals. For
this purpose, management uses information generated by financial as well as managerial
accounting system of the organization.
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2. Owners
Owners invest capital to start and run business with the primary objective to earn profit.
They need accurate financial information to know what they have earned or lost during a particular
period of time. On the basis of this information they decide their future course of actions such
as expansion or contraction of business.
In small businesses (like sole proprietorship and partnership) owners themselves perform
the function of management.
External users
External users normally use only financial accounting information. Some external users
of accounting information and their needs are briefly discussed below:
1. Investors
In corporate form of business, the ownership is often separated from the management.
Normally investors provide capital and management runs the business.
The accounting information is used by both actual and potential investors. Actual investors
use this information to know how their funds are used by the management and what is the
expected performance of business in future in terms of profitability and growth. On the basis of
this information, they decide whether to increase or decrease investment in corporation in future.
Potential investors use accounting information to decide whether or not a particular corporation
is suitable for their investment needs.
2. Lenders
Lenders are individuals or financial institutions that normally lend money to businesses
and earn interest income on it. They need accounting information to assess the financial
performance and position and to have a reasonable assurance that the business to whom they
are going to lend money would be able to return the principal amount as well as pay interest
there on.
3. Suppliers
Suppliers are business individuals or organizations that normally sell merchandise or raw
materials to other businesses on credit. They use accounting information to have an idea about
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the future creditworthiness of the business and to decide whether or not to continue providing
goods oncredit.
4. Government agencies
Government agencies use financial information of businesses for the purpose of imposing
taxes and regulations.
5. General public
General public also uses accounting information of business organizations. For example,
accounting information is:
Ø a source of education for students of accounting an dfinance.
Ø a source of valuable data for those researching on organizational impacts on

individuals and economy as a whole.
Ø a source of information for the people looking for job opportunities.
Ø a source of information about the future of a particular enterprise.
6. Customers
Accounting information provides important information to customers about current position

of a business organization and to make a judgment about its future. Customers can be divided
into three groups – manufactures or producers at various stages of production, wholesalers
and retailers and end users or final consumers.
Manufacturers or producers at every stage of processing need assurance that the

organization in question will continue providing inputs such as raw materials, parts, components
and support etc. The wholesalers and retailers must be assured of consistent supply of products.
The end users or final consumers are interested in continuous availability of products and
related accessories. Because of these reasons, the accounting information is of significant
importance for all three types of customers.
7. Employees
Employees who do not have a hand in core management of the business are considered
external users of accounting information. They are interested in financial information because
their present and future is tied up with the success or failure of the business. The success and
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profitability of business ensures job security, better remuneration, job promotion and retirement
benefits.
14.8 Summary
The term ‘reporting’ conveys different meanings on different circumstances. In a narrow
sense it means: supplying facts and figures. On the other hand, when a committee is appointed
to study a problem, a report is taken to mean : review of certain matter with its pros and cons
and offering suggestions. In case of dealing with routine matters, a report refers to supplying
the information at regular intervals in standardized forms. A report is a means of communication
which is in written form and is meant for use of management for the purpose of planning
decision-making and controlling.
Simply stated it is a communication of result by a subordinate to superior. It serves as a

feedback to the management. The contents of report, the details of the data reported and the
method of presentation depend upon the size and type of the business enterprise, extent of
power delegated to subordinates and the existence of various levels of management for whom
information is meant. The types of reports are explained in this lesson.
14.9 Key Words

Customers
Exployees
Investors
Lenders
Management
Owners

1. What are the objectives of reprinting?
2. List out the principles of reporting.
3. Explain the types of report.
4. Discuss the types of report submitted to various levels of management.

269

Pearson, 2012.

2011.
270
LESSON 15
COST ACCOUNTING
Learning Objectives
 List out the difference dimensions of cost accounting.
 Distinguish cost accounting from financial accounting.
 Appreciate the utility of cost accounting.
 Apply the various bases of classification of costs.
 Prepare a cost sheet or tender or quotations.
Structure
15.1 Introduction
15.2 Meaning of Cost Accounting
15.3 Distinction between Financial Accounting and Cost Accounting
15.4 Utility of Cost Accounting
15.5 Distinction between Costing and Cost Accounting
15.6 Classification of Costs
15.7 Cost Sheet
15.8 Illustrations
15.9 Summary
15.10 Key Words
15.1 Introduction
Accounting can no longer be considered a mere language of business. The need for
maintaining the financial chastity of business operations, ensuring the reliability of recorded
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experience resulting from these operations and conducting a frank appraisal of such experiences
has made accounting a prime activity along with such other activities as marketing, production
and finance. Accounting may be broadly classified into two categories – accounting which is
meant to serve all parties external to the operating responsibility of the firms and the accounting,
which is designed to serve internal parties to take care of the operational needs of the firm. The
first category, which is conventionally referred to as “financial accounting”, looks to the interest
of those who have primarily a financial stake in the organisation’s affairs – creditors, investors,
employees etc. On the other hand, the second category of accounting is primarily concerned
with providing information relating to the conduct of the various aspects of a business like cost
or profit associated with some portions of business operations to the internal parties viz.,
management. This category of accounting is divided into “management accounting” and “cost
accounting”. This lesson deals with cost accounting.
15.2 Meaning of Cost Accounting

Cost accounting developed as an advanced phase of accounting science and is trying to
make up the deficiencies of financial accounts. It is essentially a creation of the twentieth century.
Cost accounting accounts for the costs of a product, a service or an operation. It is concerned
with actual costs incurred and the estimation of future costs. Cost accounting is a conscious
and rational procedure used by accountants for accumulating costs and relating such costs to
specific products or departments for effective management action. Cost accounting through its
marginal costing technique helps the management in profit planning and through its another
technique i.e. Standard costing facilitates cost control. In short, cost accounting is a management
information system which analyses past, present and future data to provide the basis for
managerial decision making.
15.3 Distinction between Financial Accounting and Cost

Accounting
Though there is much common ground between financial accounting and cost accounting
and though in fact cost accounting is an outgrowth of financial accounting yet the emphasis
differs. Firstly financial accounting is more attached with reporting the results of business to
persons other than internal management – government, creditors, investors, researchers, etc.
Cost accounting is an internal reporting system for an organisation’s own management for
decision making. Secondly financial accounting data is historical in nature and its periodicity of
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reporting is much wider. Cost accounting is more concerned with short-term planning and its
reporting period much lesser than financial accounting. It not only deals with historic data but
also is futuristic in approach. Thirdly, in financial accounting the major emphasis in cost
classification is based on the type of transaction e.g. Salaries, repairs, insurance, stores, etc.
But in cost accounting the major emphasis is on functions, activities, products, processes and
on internal planning and control and information needs of the organisation.
15.4 Utility of Cost Accounting

A properly installed cost accounting system will help the management in the following
ways:
- the analysis of profitability of individual products, services or jobs.
- the analysis of profitability of different departments or operations.
- it locates differences between actual results and expected results.
- it will assist in setting the prices so as to cover costs and generate an acceptable
level of profit.
- cost accounting data generally serves as a base to which the tools and techniques
of management accounting can be applied to make it more purposeful and
management oriented.
- the effect on profits of increase or decrease in output or shutdown of a product line

or department can be analysed by adoption of efficient cost accounting system.
15.5 Distinction between Costing and Cost Accounting

Costing is the technique and process of ascertaining costs. It tries to find out the cost of
doing something, i.e., the cost of manufacturing an article, rendering a service, or performing a
function. Cost accounting is a broader term, in that it tries to determine the costs through a
formal system of accounting (unlike costing which can be performed even through informal
means). Stated precisely, cost accounting is a formal mechanism by means of which costs of
products and services are ascertained and controlled. The Institute Of Cost And Management
Accountants, U.K. defines Cost Accounting as: ‘the application of accounting and costing
principles, methods and techniques in the ascertainment of costs and the analysis of savings
and/or excesses as compared with previous experience or with standards’. It, thus, includes
three things:
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1. Cost Ascertainment: finding out the specific and precise total and unit costs of products
and services.
2. Cost Presentation: reporting cost data to various levels of management with a view to
facilitate decision making.
3. Cost Control: this consists of estimating costs for production and activities for the future,
and keeping them within proper limits. Budgets and standards are employed for this
purpose.
Cost accounting also aims at cost reduction, i.e., achieving a permanent and real reduction
in cost by improving the standards. Cost accountancy is a comprehensive term that implies the
‘application of costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control’. It seeks to control costs and ascertain the profitability of business
operations.
15.6 Classification of Costs

In the process of cost accounting, costs are arranged and rearranged in various
classifications. The term ‘classification’ refers to the process of Grouping costs according to
their common characteristics. The different bases of cost classification are:
1. By nature or elements (materials, labour and overheads)
2. By time (historical, pre-determined)
3. By traceability to the product (direct, indirect)
4. By association with the product (product, period)
5. By changes in activity or volume (fixed, variable, semi-variable)
6. By function (manufacturing, administrative, selling, research and development, pre-

production)
7. By relationship with the accounting period (capital, revenue)
8. By controllability (controllable, non-controllable)
9. By analytical/decision-making purpose (opportunity, sunk, differential, joint, common,

imputed, out-of-pocket, marginal, uniform, replacement)
10. By other reasons (conversion, traceable, normal, avoidable, unavoidable, total)

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Elements of Cost
The elements of costs are the essential part of the cost. There are broadly three elements
of cost, as explained below:
(A) Material
The substance from which the produce is made is called material. It can be direct as well
as indirect.
I) Direct Material: it refers to those materials which become an integral part of the final
product and can be easily traceable to specific physical units. Direct materials, thus, include:
1. All materials specifically purchased for a particular job or process.
2. Components purchased or produced.
3. Primary packing materials (e.g., carton, wrapping, card-board boxes etc.).
4. Material passing from one process to another.
Ii) Indirect Material: all materials which are used for purpose ancillary to the business and
which cannot conveniently be assigned to specific physical units are known as ‘indirect materials’.
Oil, grease, consumable stores, printing and stationery material etc. Are a few examples of
indirect materials.
(b) Labour
In order to convert materials into finished products, human effort is required. Such human
effort is known as labour. Labour can be direct as well as indirect.
i) Direct Labour:
It is defined as the wages paid to workers who are engaged in the production process and
whose time can be conveniently and economically traceable to specific physical units. When a
concern does not produce but instead renders a service, the term direct labour or wages refers
to the cost of wages paid to those who directly carry out the service, e.g., wages paid to driver,
conductor of a bus in transport service.
ii) Indirect Labour:
Labour employed for the purpose of carrying out tasks

275
Incidental to goods produced or services provided is called indirect labour or indirect

wages. In short, wages which cannot be directly identified with a job, process or operation, are
generally treated as indirect wages. Examples of indirect labour are: wages of store-keepers,
foremen, supervisors, inspectors, internal transport men etc.
(C) Expenses
Expenses may be direct or indirect.
i) Direct Expenses:
These are expenses which can be directly, conveniently and wholly identifiable with a job,
process or operation. Direct expenses are also known as chargeable expenses or productive
expenses. Examples of such expenses are: cost of special layout, design or drawings, hire of
special machinery required for a particular contract, maintenance cost of special tools needed
for a contract job, etc.
ii) Indirect Expenses:
Expenses which cannot be charged to production directly and which are neither indirect
materials nor indirect wages are known as indirect expenses. Examples are rent, rates and
taxes, insurance, depreciation, repairs and maintenance, power, lighting and heating etc.
The above elements of cost may be shown by means of a chart:

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1. Overheads
The term overheads includes, indirect material, indirect labour and indirect expenses,
explained in the preceding paragraphs. Overheads may be incurred in the factory, office or
selling and distribution departments/divisions in an undertaking. Thus overheads may be of
three types: factory overheads, office and administrative overheads and selling and distribution
overheads. This classification of overheads may be shown thus:
Classification of Overheads
2. Cost Classification by Time
On the basis of the time of computing costs, they can be classified Into historical and pre-
determined costs.
I) Historical Costs:
These costs are computed after they are incurred. Such costs are available only after the
production of a particular thing is over.
Ii) Pre-Determined Costs:
These costs are computed in advance of production on the basis of a specification of all
factors influencing cost. Such costs may be:
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1. Estimated costs: estimated costs are based on a lot of guess work. They try to ascertain
what the costs will be based on certain factors. They are less accurate as only past experience
is taken into account primarily, while computing them.
2. Standard costs: standard costs is a pre-determined cost based on a technical estimate

for material, labour and other expenses for a selected period of time and for a prescribed set of
working conditions. It is more scientific in nature and the object is to find out what the costs
should be.
3. Cost Classification By Traceability
As explained previously, costs which can be easily traceable to a product are called direct
costs. Indirect costs cannot be traced to a product or activity. They are common to several
products (e.g., salary of a factory manager, supervisor etc.) And they have to be apportioned to
different products on some suitable basis. Indirect costs are also called ‘overheads’.
4. Cost Classification By Association With Product
Costs can also be classified (on the basis of their association with products) as product
costs and period costs.
1. Product Costs: product costs are traceable to the product and include direct material,
direct labour and manufacturing overheads. In other words, product cost is equivalent to factory
cost.
2. Period Costs: period costs are charged to the period in which they are incurred and are
treated as expenses. They are incurred on the basis of time, e.g., rent, salaries, insurance etc.
They cannot be directly assigned to a product, as they are incurred for several products at a
time (generally).
5. Cost Classification By Activity/Volume
Costs are also classified into fixed, variable and semi-variable on the basis of variability of
cost in the volume of production.
1. Fixed Cost:
Fixed cost is a cost which tends to be unaffected by variations in volume of output. Fixed
cost mainly depends on the passage of time and does not vary directly with the volume of
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output. It is also called period cost, e.g., rent, insurance, depreciation of buildings etc. It must
be noted here that fixed costs remain fixed upto a certain level only. These costs may also vary
after a certain production level.
2. Semi-Variable Cost:
These costs are partly fixed and partly variable. Because of the variable element, they
fluctuate with volume and because of the fixed element, they do not change in direct proportion
to output. Semi-variable or semi-fixed costs change in the same direction as that of the output
but not in the same proportion. For example, the expenditure on maintenance is to a great
extent fixed if the output does not change significantly. Where, however, the production rises
beyond a certain limit, further expenditure on maintenance will be necessary although the increase
in the expenditure will not be in proportion to the rise in output. Other examples in this regard
are: depreciation, telephone rent, repairs etc.
3. Variable Cost:
Cost which tends to vary directly with volume of outputs is called ‘variable cost’. It is a
direct cost. It includes direct material, direct labour, direct expenses etc. It should be noted here
that the variable cost per unit is constant but the total cost changes corresponding to the levels
of output. It is always expressed in terms of units, not in terms of time.
6. Cost Classification By Function
On the basis of the functions carried out in a manufacturing concern,
Costs can be classified into four categories:
1. Manufacturing/Production Cost: it is the cost of operating the manufacturing division of

an enterprise. It is defined as the cost of the sequence of operations which begin with supplying
materials, services and ends with the primary packing of the product.
2. Administrative/Office Cost: it is the cost of formulating the policy, directing the

organisation and controlling the operations of an undertaking, which is not directly related to
production, selling, distribution, research or development. Administration cost, thus, includes
all office expenses: remuneration paid to managers, directors, legal expenses, depreciation of
office premises etc.
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3.Selling Cost: selling cost is the cost of seeking to create and stimulate demand e.g.,
advertisements, show room expenses, sales promotion expenses, discounts to distributors,
free repair and servicing expenses, etc.
4.Distribution Cost: it is the cost of the sequence of operations which begins with making
the packed product, available for despatch and ends with making the reconditioned returned
empty package, if any, available for re-use. Thus, distribution cost includes all those expenses
concerned with despatching and delivering finished products to customers, e.g., warehouse
rent, depreciation of delivery vehicles, special packing, loading expenses, carriage outward,
salaries of despatch clerks, repairing of empties for re-use, etc.
5. Research And Development Cost: it is the cost of discovering new ideas, processes,
products by experiment and implementing such results on a commercial basis.
6.Pre-Production Cost: expenses incurred before a factory is started and expenses involved
in introducing a new product are preproduction costs. They are treated as deferred revenue
expenditure and charged to the cost of future production on some suitable basis.
7. Cost Classification By Relationship With Accounting Period
On the basis of controllability, costs can be classified as controllable or uncontrollable.
1. Controllable Cost: a cost which can be influenced by the action of a specified member
of an undertaking is a controllable cost, e.g., direct materials, direct labour etc.
2. Uncontrollable Cost: a cost which cannot be influenced by the action of a specified

member of an undertaking is an uncontrollable cost, e.g., rent, rates, taxes, salary, insurance
etc.
The term controllable cost is often used in relation to variable cost and the term
uncontrollable cost in relation to fixed cost. It should be noted here that a controllable cost can
be controlled by a person at a given organisation level only. Sometimes two or more individuals
may be involved in controlling such a cost.
8. Cost Classification By Decision-Making Purpose
Costs may be classified on the basis of decision-making purposes for which they are put
to use, in the following ways:
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1.Opportunity Cost: it is the value of the benefit sacrificed in favour of choosing a particular
alternative or action. It is the cost of the best alternative foregone. If an owned building, for
example, is proposed to be used for a new project, the likely revenue which the building could
fetch, when rented out, is the opportunity cost which should be considered while evaluating the
profitability of the project.
2.Sunk Cost: a cost which was incurred or sunk in the past and is not relevant for decision-
making is a sunk cost. It is only historical in nature and is irrelevant for decision-making. It may
also be defined as the difference between the purchase price of an asset and its salvage value.
3.Differential Cost: the difference in total costs between two alternatives is called as
differential cost. In case the choice of an alternative results in increase in total cost, such increase
in costs is called ‘incremental cost’. If the choice results in decrease in total costs, the resulting
decrease is known as decremental cost.
4.Joint Cost: whenever two or more products are produced out of one and the same raw
material or process, the cost of material purchased and the processing are called joint costs.
Technically speaking, joint cost is that cost which is common to the processing of joint products
or by-products upto the point of split-off or separation.
5.Common Cost: common cost is a cost which is incurred for more than one product, job
territory or any other specific costing object. It cannot be treated to individual products and,
hence, apportioned on some suitable basis.
6.Imputed Cost: this type of cost is neither spent nor recorded in the books of account.
These costs are not actually incurred (hence known as hypothetical or notional costs) but are
considered while making a decision. For example, in accounting, interest and rent are recognized
only as expenditure when they are actually paid. But in costing, they are charged on a notional
basis while ascertaining the cost of a product.250
7.Out-Of-Pocket Cost: it is the cost which involves current or future expenditure outlay,
based on managerial decisions. For example a company has its own trucks for transporting
goods from one place to another. It seeks to replace these by employing public carriers of
goods. While making this decision, management can ignore depreciation, but not the out-of-
pocket costs in the present situation, i.e., fuel, salary to drivers and maintenance paid in cash.
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8.Marginal Cost: it is the aggregate of variable costs, i.e., prime cost plus variable
overheads.
9.Replacement Cost: it is the cost of replacing a material or asset in the current market.
15.7 Cost Sheet

Cost sheet is a statement presenting the items entering into cost of products or services.
It shows the total cost components by stages and cost per unit of output during a period. It is
usually prepared to meet three objectives: to provide the classification of costs in a summarised
form, to prepare estimates of costs for future use and to facilitate a comparative study of costs
with previous cost sheets to know the cost trends.
The layout of a typical cost sheet is provided below:
Particulars Total cost Cost per Unit
Direct materials
opening stock of materials
add purchases of materials
less closing stock of materials
(a) materials consumed
Direct wages
Direct expenses
Prime cost
Add Factory Overheads
Factory Rent, Rates, Taxes
Fuel-Power And Water
Lighting And Heating
Indirect Wages
Salaries Of Works Manager Etc.
Indirect Materials
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Drawing Office And Works Office Expenses

Depreciation On Factory Land And
Building
Less Scrap Value
Defective Work
Add Work In Progress (Opening)
Less Work In Progress (Closing)
Works cost
Add Office/Administration Overheads
Office Rent, Insurance, Lighting, Cleaning
Office Salaries, Telephone, Law And
Audit Expenses
General Manager’s Salary
Printing And Stationery
Maintenance, Repairs,
Upkeep of Office building
Bank charges and miscellaneous expenses
Cost of Production
Add opening stock of finished goods
Less closing stock of finished goods
Cost of goods sold
Add selling and distribution overheads
Showroom expenses, salesmen’s salaries

& commission, bad debts, discounts,
warehouse rent, carriage outwards,
advertising, delivery expenses, samples
and free gifts etc.
Cost of Sales
Add : Net Profit or Deduct Net Loss:
Sales
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Treatment of certain items in the cost sheet:
(a) Computation of Profit: profit may be calculated either as a
Percentage of cost or selling price.
Example: profit as a percentage of cost:
Factory cost 5,700
Administration overhead 600

———
Total cost 6,300
———
Profit 10% on cost 630

———
Selling price 6,930
———
Example: Profit as a percentage of selling price. Here the percentage is on Selling price.
Selling price includes Cost + Profit.
Sales price = 100
Less profit = 10
————-
Cost price = 90
————
This profit of rs.10 is on rs.90 which is the cost price. So it is 1/9th of cost price. In the
above example,
Total cost = 6,300
Profit on 10% on SP = 700

————
Selling price 7,000
—-———
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Cost X Percentage
So, Sale Price =
100 - Percentage
6,300 x 100
=
100 - 10
= 7,000
(b) Treatment Of Stock: the term ‘stock’ includes three items: raw materials, work in
progress and finished goods. The value of raw materials is arrived at in the following manner:
Opening stock of raw material
Add: Purchases
Add: expenses involved in the purchases of raw material
Less: closing stock of raw materials
Work-in-progress represents the quantity of semi-finished goods at the time of the

preparation of the cost sheet. It represents cost of materials, labour and manufacturing expenses
to-date. Work-in-progress may be shown in the cost sheet either immediately after the prime
cost or after the calculation of the factory overheads, as shown in the specimen cost sheet.
Finally, in respect of stock of finished goods, adjustments have to be made where opening and
closing stock of finished goods are given. This is done, as shown in the specimen cost sheet, by
adding opening stock of finished goods to the cost of production arrived at on the basis of
current figures and reducing the closing stock of finished goods from this total. Let’s explore
these aspects more clearly through the following illustrations:
Tenders and Quotations:
While preparing tenders or quotations, manufacturers or contractors have to look into the
figures pertaining to the previous year as shown in the cost sheet for that period. These figures
have to be suitably modified in the light of changes expected in the prices of materials, labour,
etc., and submit the tender or quotation accordingly.
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15.8 Illustrations
Prepare the cost sheet to show the total cost of production and cost per unit of goods
manufactured by a company for the month of july 2012. Also find out the cost of sales.
Stock of raw materials on 1-7-2012 3,000
Raw materials purchased 28,000
Stock of raw materials on 31-7-2012 4,500
Manufacturing wages 7,000
Depreciation of plant 1,500
Loss o n sale of a part of plant 300
Factory rent and rates 3,000
Office rent 500
General expenses 400
Discount on sales 300
Advertisement expenses to be fully charged 600
Income-tax paid 2,000
The number of units produced during July, 2012 3,000.
Solution
The stock of finished goods was 200 and 400 units on 1-7-2012 and 31-7-202 respectively.
The total cost of units on hand on 1-7-2012 was Rs.2,800. All these have been sold during the
month.
Output 3,000 units.

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Cost sheet for the year ended 31-7-2012
Particulars Total Cost Per Unit cost

(Rs.) (Rs.)
Raw materials consumed
Opening stock 3,000
Add purchases 28,000
31,000
Less closing stock 4,500 26,500 8.83
Direct wages 7,000 2.33
Prime cost 33,500 11.16
Factory overheads:
Depreciation 1,500
Factory rent 3,000 4,500 1.50
Factory cost 38,000 12.66
Office and administrative
Overheads:
Office rent 500
General expenses 400 900 0.30
Cost of production 38,900 12.96
Statement of cost of sales
Cost of production 38,900
Add: opening stock of
Finished goods 2,800
41,700
Less: closing stock of finished Goods (400 x Rs.12.96) 5,184
Cost of production of goods sold 36,516
Add: selling and distribution overhead:
Discount on sales 300
Advertisement expenses 600 900
Cost of sales 37,416
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2. From the following particulars, prepare a cost sheet for the year ending 31-12-2011.
Opening stock of raw materials (1-1-2011) 50,000
Purchases of raw materials 1,60,000
Closing stock of raw materials (31-12-2011) 80,000
Wages – productive 1,50,000
general 20,000
Chargeable expenses 40,000
Rent, rates and taxes – factory 10,000
Rent, rates and taxes – office 1,000
Depreciation on plant and machinery 3,000
Salary – office 5,000
Salary – travelers 4,000
Printing and stationery 1,000
Office cleaning and lighting 800
Repairs and renewals (factory) 6,400
Other factory expenses 5,000
Management expenses (including managing Director’s fees) 24,000
Travelling expenses of salesmen 2,200
Showroom expenses and samples 2,000
Carriage and freight – outwards 2,000
Carriage and freight – inwards 9,000
Octroi on purchases 1,000
Advertisement 30,000
Sales 4,60,000
Management expenses should be allocated in the ratio of 2:1:3 on factory, office and
sales departments.
288
Solution
Statement of cost and profit for 2011
Materials consumed Rupees Rupees

Add purchases 1,60,000
Add carriages freight inwards 9,000
Add OCTROI on purchases 1,000
2,20,000
Less closing stock 80,000
Cost of materials used 1,40,000
Productive wages 1,50,000
Prime cost 3,30,000
Factory expenses
General wages 20,000
Rent, rates and taxes 10,000
Depreciation on plant and
Machinery 3,000
Repairs and renewals 6,400
Other factory expenses 5,000
Management expenses: 1/6 of Rs.24,000 8,000 52,400
Factory cost 3,82,400
Administrative expenses
Rent, rates and taxes 1,000
Salary 5,000
Cleaning and lighting 800
Management expenses:1/6
of Rs.24,000 4,000 11,800
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Cost of production 3,94,200

Selling and distribution expenses
Advertising 4,000
Show-room expenses and samples 2,000
Traveller’s salary 4,000
Salesmen’s travelling expense 2,200
Carriage outwards and freight 12,000
Management expenses: 3/6 of Rs.24,000 12,000 26,200
Cost of sales 4,20,400
Sales 4,60,000
Profit 39,600
3. The following particulars relate to a company for a period of Three months:
Raw materials (1-1-2012) 55,000
Raw materials (31-3-2012) 35,000
Factory wages 80,000
Materials purchased 60,000
Sales 1,54,000
Indirect expenses 10,000
Stock of finished goods (1-1-2012) NIL
Stock of finished goods (31-3-2012) 30,000
No. Of units produced during the period was 2,000.
Prepare a statement of cost for the period and compute the price to be quoted for 500
units in order to realise the same profit as for the period under review, assuming no alternation
in wages and cost of materials.
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Solution
Statement of cost for the period ending 31-3-2012
(Output 2,000 Units)
Particulars Amount Rs.
Opening stock of raw materials 55,000
Add: purchases 60,000
1,15,000
Less: closing stock of raw materials 35,000
Raw materials consumed 80,000
Factory wages 80,000
Prime cost 1,60,000
Indirect expenses 10,000
Cost of goods sold 1,40,000
 14,000  100 
Profit   = 10% of cost 14,000
 1, 40,000 
Sales 1,54,000
Tender statement showing quotations for 500 units
Particulars Amount (Rs.)
Rupees
80,000 x 500
 80,000  500 
Materials consumed   20,000
 2,000 
291
 80,000  500 
Wages   20,000
 2,000 
Prime cost 40,000
 10,000  500 
Add: indirect expenses   2,500
 2,000 
Add: profit (10% of cost of production) 4,250
Price to be quoted 46,750
4. The following information has been taken from a factory:
Rupees
Materials 50,000
Direct wages 40,000
Factory overheads 30,000
Administration overheads 20,000
You are required to fix the selling price of a machine costing rs.4,200 in materials and
rs.3,000 in wages so that it yields a profit of 25% on selling price.
Solution
Statement of cost Rupees
Materials 50,000
Direct wages 40,000
Prime cost 90,000
Factory overheads 30,000
Works cost 1,20,000
Administration overheads 20,000

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Percentage of factory overheads to direct wages:
30,000
X 100 = 75% 75%
40,000
Percentage of office overheads to works cost:
20,000
x 100 = 16.67% 16.67%
12,0,000
Tender or quotation Rs.
Materials 4,200
Wages 3,000
Prime cost 7,200
Factory overheads - 75% of wages 2,250
Works cost 9,450
Administration overheads – 16.67% on
Works cost 1,575
Profit 25% on selling price or
331 / 3
33 1/3% on cost 11,025 x 3,675
100
Estimated selling price 14,700
5.9 Summary
Traditional accounting or financial accounting can no longer serve the purposes of all
concerned. Especially the internal organs of the business concerns, namely managements,
want a lot of analytical information which could not be provided by the financial accounting.
Hence to serve the needs of management two more kinds of accounts – management accounting
and cost accounting have evolved. Simply stated, management accounting serves the needs
of management and cost accounting tries to determine the costs through a formal system of
accounting. Costs can be classified on various bases and cost sheet is a statement presenting
the items entering into cost of products or services.
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15.10 Key Words

Cost Accounting
Cost sheet
Tender

1. What are the limitations of financial accounting?
2. Justify the need for cost accounting.
3. Explain the various bases for classification of costs.
4. What are the differences between a ‘cost sheet’ and ‘tender’.
5. Prepare a cost sheet for the production of 100 units of an article using imaginary figures.
6. Prepare a statement of cost showing:
(a) value of materials consumed
(b) total cost of production
(c) cost of goods sold and
(d) the amount of profit
From the following details relating to a toy manufacturing concern:

Rupees
Opening stock: raw materials 25,000 finished goods 20,000
Raw materials purchased 2,50,000
Wages paid to labourers 1,00,000
Closing stock: raw materials 20,000
finished goods 25,000
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Rent, rates and taxes (factory) 25,000

Motive power 10,000
Factory heating and lighting 10,000
Factory insurance 5,000
Experimental expenses 2,500
Waste materials in factory 1,000
Office salaries 20,000
Salesmen’s salary 10,000
Commission to travelling agents 5,000
Sales 5,00,000
7. Kolam products ltd., produces a stabilizer that sells for rs.300. An increase of 15% in the
cost of materials and 10% in the cost of labour is anticipated. If the only figures available
are those given below, what must be the selling price to give the same percentage of
gross profit as before?
1. Material costs have been 45% of cost of sales
2. Labour costs have been 40% of cost of sales
3. Overhead costs have been 15% of the sales
4. The anticipated increased costs in relation to the present sale
5. Price would cause a 35% decrease in the amount of present gross Profit.

Pearson, 2012.
295

2011.
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LESSON 16
STANDARD COSTING AND VARIANCE ANALYSIS
Learning Objectives
After reading this lesson, you must be able to:
 Define standard cost
 List out the functions of standard costs
 Explain the determinants of standard cost
 Compare variance analysis
Structure
16.1 Introduction
16.2 Standard Cost
16.2.1 Standard Costing
16.2.2 Functions of Standard Costing
16.3 Budgetary Control and Standard Costing
16.4 Standard Costing as a controlling Technique
16.6 Variance Analysis
16.7 Competition of Variances
16.7.1 Material Variance
16.7.2 Labour Variance
16.7.3 Overhead Variance
16.8 Summary
16.9 Key Words

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16.1 Introduction
The fundamental objective of the Management Accounting is, managing a business through
accounting information. In this process, management accounting is facilitating managerial control.
It you can also apply to your own day/monthly expenses if is facilitating managerial control. It
you can also apply to your own day/monthly expenses if necessary, applying correct measures
so that performance takes place according to plans.
Planning is the first tool form making control effective. The vital aspect of managerial
control is cost control. Hence, it is very important to plan and control costs. Standard costing is
a technique, which helps you to control costs and business operations. It aims at eliminating
wastes and increasing efficiency in performance through setting up standards or formulating
cost plans. It is a system of cost accounting, which is designed to find out how much, should be
the cost of a product under the existing conditions. The actual cost can be ascertained only
when production is undertaken. The pre-determined cost is compared to the actual cost and a
variance between the two enables the management to take necessary corrective measures.
16.2 Standard Cost

Standard cost is a predetermined estimate of cost to manufacture a single unit or a number
of units during a future period.
The Chartered Institute of Management Accountants, London, defines “Standard Cost”

as, “a pre-determined cost which is calculated from management’s standards of efficient operation
and the relevant necessary expenditure. It may be used as a basis for price fixing and for cost
control through variance analysis”.
16.2.1 Standard Costing
It is defined by I.C.M.A. Terminology as, “The preparation and use of standard costs, their
comparison with actual costs and the analysis of variances to their causes and points of
incidence”.
According to the Chartered Institute of Management Accountants, London Standard Costing

is “the preparation and use of Standard Cost, their comparison with actual costs, and the analysis
of variances to their causes and points of incidence”.
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16.2.2 Functions of Standard Costing
The study of standard cost comprises of:
1. Ascertainment and use of standard costs.
2. Comparison of actual costs with standard costs and measuring the variances.
3. Controlling costs by the variance analysis.
4. Reporting to management for taking proper action to maximize the efficiency.

Both standard costing and budgetary control aim at maximum efficiency and managerial
control. Budgetary control and standard costing have the common objective of controlling
business operations by establishing pre-determined targets, measuring the actual performance
and comparing it with the targets, for the purposes of having better efficiency and of reducing
costs. The two systems are said to be interrelated but they are not inter-dependent. The budgetary
control system can function effectively even without the system of standard costing in operation
but the vice-versa is not possible.
16.4 Standard Costing as a Controlling Technique

It is essential for management to have knowledge of costs so that decision can be effective.
Management can control costs on information being provided to it. The technique of standard
costing is used for building a proper budgeting and feedback system. The uses of standard
costing to management areas follow.
1. Formulation of Price and Production Policies
Standard Costing acts as a valuable guide to management in the fixation of price and
formulation production polices. It also assists management in the field of inventory pricing,
product, product pricing profit planning and also in reporting to higher levels.
2. Comparison and Analysis of Data
Standard Costing provides a stable basis for comparison of actual with standard costs. It
brings out the impact of external factors and internal causes on the cost and performance of the
concern. Thus, it helps to take remedial action.
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3. Cost Consciousness
An atmosphere of cost consciousness is created among the staff. Standard costing also
provides incentive to workers for efficient performance.
4. Better Capacity to anticipate
An effective budget can be formulated for the future by once knowing the deviations of
actual costs from standard costs. Data are available at an early stage and the capacity to
anticipate about changing conditions is developed.
6. Better Economy, Efficiency and Productivity
Men, machines and materials are more effectively utilized and thus benefits of economies
can be reaped in business together with increased productivity.
7. Delegation of Authority and Responsibility
The net profit is analyzed and responsibility can be placed on the person in charge for any
variations from the standards. It discloses adverse variations and particular cost centre can be
held accountable. Thus, delegation of authority can be made by management to control the
affairs in different departments.
8. Management by ‘Exception’
The principle of “management by exception can be applied in the business. This helps
the management in concentrating its attention on cases which are off standard, i.e., below or
above the standard set. A pattern is provided for the elimination of undesirable factors causing
damage to the business.
Setting the Standard
While setting standard cost for operations, process or products, the following preliminaries
must be gone through:
1. Establish Standard Committee comprising Purchase Manager, Personnel Manager,

and Production Manager. The Cost Accountant coordinates the functions.
2. Study the existing costing system, cost records and forms in use.
3. A technical survey of the existing methods of production should be undertaken.

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4. Determine the type of standard to be used.
5. Fix standard for each element of cost.
6. Determine standard costs of r each product.
7. Fix the responsibility for setting standards.
8. Account variances properly.
9. Ascertain the deviations by comparing the actual with standards.
10. Take necessary action to ensure that adverse variances are not repeated.
Determination of Standard costs
The following preliminary steps are considered before setting standards:
(a) Establishment of cost centre
(b) Classification and codification of accounts
(c) Types of standards
1. Setting the standards.
(a) Establishment of cost centre. For fixing responsibility and defining the lines of
authority, cost centre is necessary. “A cost centre is a location, person or item of equipment (or
group of these) for which costs may be ascertained and used of the purpose of cost control”.
With the help of cost centre, the standards are prepared and the variances are analyzed.
(b) Classification and codification of accounts. Accounts are classified according to

different items of expenses under suitable heading. Each heading may be given codes and
symbols. Coding is useful for speedy collection and analysis.
(c) Types of standards. The different types of standards are given below:
(i) Basic standard. It is a fixed and unaltered for an indefinite period for forward planning.
According to I.C.M.A London, it is “an underlying standard from which a current standard can
be developed”. From this basic standard, changes in current standard and actual standard can
be measured.
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(ii) Current standard. It is a short-term standard, as it is revised at regular intervals.

I.C.M.A. London refers to it as “a standard which is established for use over a short period of
time and is related to current conditions”. This standard is realistic and helpful to business. It is
useful for cost control.
(iii) Normal standard. It is an average standard, and is based on normal conditions

which prevail over a long period of a trade cycle. I.C.M.A defines it as “the average standard
which, it is anticipated, can be attained over a future period of time, preferably long enough to
cover one trade-cycle”. It is used for planning and decision making during the period of trade
cycle to which it is related. It is very difficult to apply in practice.
(iv) Ideal standard. I.C.M.A. defines it as “the standard which can be attained under the
most favorable condition possible”. It is fixed and needs a high degree of efficiency, best possible
conditions of management and performance. Existing conditions and conditions capable of
achievement should be taken into consideration. It is difficult to attain this ideal standard.
(v) Expected standard. It is a practical standard. I.C.M.A defines it as, “the standard
which, it is anticipated, can be attained during a future specified budget period”. For setting this
standard, due weightage is given for all the expected conditions. It is more realistic than the
ideal standard.
(d) Setting the standards. After choosing the standard, the setting of standard is the
work of the standard committee. The cost accountant has to supply the necessary cost figures
and co-ordinate the activity committee. He must ensure that the setting standards are accurate.
Standards cost is determined for each element of the following costs.
(i) Direct Material cost. Standard material cost is equal to the standard quantity multiplied
by the standard price. The setting of standard costs for direct materials involves
(a) Standard Material Quantity. For each product or part or the process, mechanical
calculation or mechanical analysis is made. The allowance for normal wastage or loss must be
fixed very carefully. Similarly, where different kinds of materials are used as a mix for a process,
a standard material mix is determined to produce the desire quality product.
(b) Standard Material Price. Setting of material standard price is done by the cost
accountant and the purchase manager. The current standard is the desirable and effective for
fixing the price.
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Normally one year is the period for fixation of standard price. If there are more fluctuations
in prices, then revision of standard price is necessary. Before fixing the standard, the following
points must be considered:
 Prices of materials in stock
 Price quoted by suppliers
 Trade and cash discounts received
 Future prices based upon statistical data
 Material price already contracted
(ii) Setting standard for Direct Labour. The standard labour cost is equal to the standard
time for each operation multiplied by the standard wage rate. Setting of standard cost of direct
labour involves:
(a) Fixation of standard time
(b) Fixation of standard rate
(a) Fixation of standard time: Standard time is fixed by time or motion study or past
records or test runs or estimates. Labour time is fixed by the work study engineer. While fixing
standard time, normal ideal time is allowed for fatigue, normal delays or other contingencies.
(b) Fixation of standard rate. With the help of the personnel manager, the accountant
determines the standard rate. Fixation of standard rate is influenced by (i) Union s policy (ii)
Demand for labour (iii) Policy to be followed. (iv) Method of wage payment.
(iii) Setting standard for Overhead. Overheads are divided into fixed, variable and semi-
variable. Standard overhead rate is determined on the basis of past records and future trend of
prices. It is calculated for a unit or for an hour.
Standard variable overhead rate
Standard variable overhead for the budge Period

=
Budgeted production units or budgeted hours for the budgeted period
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Revision of Standards
Standard cost may be established for an indefinite period. There are no definite rules for
the selection for a particular period. If the standards are fixed for a short period, it is expensive
and frequent revision of standards will impair the utility and purpose for which standard is set.
At the same, if the standard is set for a longer period, it may not be useful particularly in
the days of high inflation and large fluctuations of rates in case of materials and labour.
Standards have to be revised from time to time taking into consideration changing
circumstances. The circumstances may change on account of technical innovations, changed
market conditions, increase or decrease in plant capacity, developing new products or giving up
unprofitable production lines. If variations from actual occur in practice, they may be due to
controllable or uncontrollable causes. Standards should be revised only on account of those
causes which are beyond the control of the management. Changes in product design, supply of
labour and material, changes in market conditions for a long period, trade or cyclical variations
would impel the management to revise the standards. The objective, while comparing the actual
performance with the standard performance and revising standards, is to facilitate better control
over costs and improve the overall working and profitability of the organization.
Apart from the above, basic standards are revised in the course of time under the following
circumstances, when:
1. There are permanent changes in the method of production –designs and

specifications.
2. Plant capacity is changed
3. There is a large variation between the standard and the actual.

The systems of budgetary control and standard costing have the common objective of
controlling business operations by establishing pre-determined targets, measuring the actual
performance and comparing it with the targets, for the purposes of having better efficiency and
of reducing costs. The tow systems are said to be interrelated but they are not inter-dependent.
The budgetary control system can function effectively even without the system of standard
costing in operation but the vice-versa is not true. Usually, the two are used in conjunction with
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each other to have most fruitful results. The distinction between the two systems is mainly on
account of the field or scope and technique of operation.
Budgeting Standard costing
1. Budgetary control is concerned with 1. Standard Costing is related with the control
the operation of the business as a of the expenses and hence it is more intensive
whole and hence its more extensive
2. Budget is a projection of financial 2. Standard cost is the projection of cost

accounts accounts
3. It does not necessarily involve 3. It requires standardization of products.

standardization of products.
4. Budgetary control can be adopted 4. It is not possible to operate this system in

in part also. parts
5. Budgeting can be operated without 5. Standard costing cannot exist without

standard costing. budgeting.
6. Budgets determine the ceilings of 6. Standards are minimum targets which are
expenses above which actual to be attained by actual performance at specific
expenditure should not normally rise. efficiency level.
16.6 Variance Analysis

It involves the measurement of the deviation of actual performance form the intended
performances. It is based on the principle of management by exception.
The attention of management is drawn not only to the variation in monetary gain but also
to the responsibility and causes for the same.
Favourable and Unfavourable variances
Variances may be favorable (positive or credit) or unfavorable (or negative or adverse or

debit) depending upon whether the actual cost is less or more than the standard cost.
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Favorable variance: When the actual cost incurred is less than the standard cost, the
deviation is known as favorable variance. The effect of the favorable variance increases the
profit. It is also known as positive or credit variance.
Unfavorable variance: When the actual cost incurred is more than the standard cost,
the variance is known as unfavorable or adverse variance. It refers to deviation to the loss of
the business. It is also known as negative or debit variance.
Controllable and Uncontrollable variance:
Variances may be controllable or uncontrollable, depending upon the controllability of the

factors causing variances.
Controllable variance: It refers to a deviation caused by such factors which could be

influenced by the executive action. For example, excess usage of materials, excess time taken
by a worker, etc. When compared to the standard cost it is controllable as the responsibility can
be fixed on the in-charge.
Uncontrollable variance: When variance is due to the factors beyond the control of the
concerned person (or department), it is uncontrollable. For example, the wage rate increased
on account of strike, government restrictions, change in market price etc. Only revision of
standards is required to remove such in future.
Uses
The variance analysis are important tools of cost control and cost reduction and they
generate and atmosphere of cost consciousness in the organization.
1. Comparison of actual with standard cost which reveals the efficiency or inefficiency
of performance. The inefficiency or unfavorable variance is analyzed and immediate
actions are taken.
2. It is a tool of cost control and cost reduction
3. It helps to apply the principle of management by exception.
4. It helps the management to maximize the profits by analyzing the variances into
controllable and uncontrollable; the controllable variances are further analyzed so
as to bring a cost reduction, indirectly more profit.
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5. Future planning and programmes are based on the variance analysis.
6. Within the organization, a cost consciousness is created along with the team spirit.
16.7 Computation of Variances

The causes of variance are necessary to find remedial measures; and therefore a detailed
study of variance analysis is essential. Variances can be found out with respect to all the elements
of cost, i.e., direct material, direct labour and overheads. The following are the common variances,
which are calculated by the management. Sub-divisions of variances really give detailed
information to the management in order to control the cost.
1. Material variances
2. Labour variances
3. Overhead variances (a) variable (b) fixed
16.7.1 Material variance
The following are the variances in the case of materials
a) Material Cost Variance (MCV). It is the difference between the standard cost of direct
materials specified for the output achieved and the actual cost of direct materials used. The
standard cost of materials is computed by multiplying the standard price with the standard
quantity for actual output; and the actual cost is computed by multiplying the actual price with
the actual quantity. The formula is: Material Cost Variance (or) MCV:
(Standard cost of materials - Actual cost of materials used)
(or)
(Standard Quantity for actual output x Standard Price) - (Actual Quantity x Actual Rate)
(or)
(SO x SP) - (AQ x AP)
b) Material Price Variance (MPV). Material price variance is that portion of the direct
materials cost variance which is the difference between the standard price specified and the
actual price paid for the direct materials used. The formula is:
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Material Price Variance:
(Actual Quantity consumed x Standard Price) – (Actual Quantity consumed x Actual Price)
(or)
Actual Quantity consumed (Standard Price - Actual Price)
(or)
MPV= AQ (SP-AP)
c). Material Usage (Quantity) Variance (MUV). It is the deviation caused by the standards
due to the difference in quantity used. It is calculated by multiplying the difference between the
standard quantity specified and the actual quantity used by the standard price.
Thus material usage variance is “that portion of the direct materials cost variance which is
the difference between the standard quantity specified for the production achieved, whether
completed or not, and the actual quantity used, both valued at standard prices”.
Material Usage or Quantity Variance:
Standard Rate (Standard Quantity - Actual Quantity) (or)
MUV = SR (SQ-AQ)
d) Material Mix Variance (MMV). When two or more materials are used in the manufacture
of a product, the difference between the standard composition and the actual composition of
material mix is the material mix variance. The variance arises due to the change in the ratio of
material and the standard ratio. The formula is:
Material Mix Variance = Standard Rate (Standard Mix – Actual Mix)
Standard is revised due to the shortage of a particular type of material.
The formula is:
MMV = Standard Rate (Revised Standard Quantity - Actual Quantity)

Total weight of actual mix
Revised Standard Quantity (RSQ) = X Standard Quantity
Total weight of standard mix
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After finding out this revised standard mix it is multiplied by the revised standard cost of
standard mix and then the standard cost of actual mix is subtracted form the result.
Illustration: 1
The standard cost of material for manufacturing a unit a particular product is estimated as
16kg of raw materials @ Re. 1 per kg. On completion of the unit, it was found that 20kg. of raw
material costing Rs. 1.50 per kg. has been consumed. Compute Material Variances.
Solution:
MCV = (SQ x SP) - (AQ x AP) = (16 x Rs.1) - (20 x Rs.1.50)
= Rs.16 - Rs.30
= Rs. 14 (Adverse)
MPV = (SP – AP) x AQ = (1 – 1.50) x 20
= Rs. 10 (Adverse)
MUV = (SQ – AQ) x SP = (16 – 20) x 1
= Rs. 4 (Adverse)
Illustration:2
Calculate the materials mix variance from the following:
Material Standard Actual
A 90 units at rs12 each 100 units at rs. 12 each
B 60 units at rs.15 each 50 units at rs. 16 each

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Solution
Material Standard Actual
Qty Rate Amount Qty Rate Amount
A 90 12 1080 100 12 1200
B 60 15 900 50 16 800
150 1980 150 2000
MMV = SR (SQ-AQ)
Material „A : MMV = Rs.12 (90-100)
= Rs 12 x10
= Rs. 120(A)
Material „B : MMV = Rs. 15 (60-50)
= Rs. 15 x 10
= Rs 150 (F)
Total MMV = Rs. 120(A) + Rs. 150 (F)
= Rs. 30 (F)
(e) Material Yield Variance: It is that portion of the direct material usage variance which
is due to the difference between the standard yield specified and the actual yield obtained. The
variance arises due to abnormal contingencies like spoilage, chemical reaction etc. Since the
variance is a measure of the waste or loss in the production, it known as material loss or waste
variance.
ICMA, LONDON, it is defined as “ the difference between the standard yield of the actual
material input and the actual yield, both valued at the standard material cost of the produce”. in
case actual yield is more than the standard yield, the material yield variance is favourable and,
if the actual yield is less than the standard yield, the variance is unfavourable or adverse.
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(i) When actual mix and standard mix are the same, the formula is:
MYV = Standard Yield Rate (Standard Yield - Actual Yield)
or = Standard Revised Rate (Actual Loss - Standard Loss)
Here Standard Yield Rate = Standard cost of standard mix /Net standard output
Net standard output = Gross output – Standard loss
(ii) When the actual mix and the standard mix differ from each other, the formula is:
Standard Rate = Standard cost of revised standard mix /Net Standard Output
Material Yield Variance = Standard Rate (Actual Standard Yield – Revised Standard
Yield)
16.7.2 Labour Variances
Labour Variances arise because of (I) Difference in Actual Rates and Standard Rates of
Labour and (Ii) The variation in Actual Time taken y workers and the Standard Time allotted to
them for performing a job. These are computed on the same pattern as that of Material Variances.
For Labour Variances by simply putting the word “Time” in place of “Quantity” in the formula
meant for Material Variances. The various Labour Variances can be analysed as follows:
(A) Labour Cost Variance
(B) Labour Rate Variance
(C) Labour Time Or Efficiency Variance
(D) Labour Idle Time Variance
(E) Labour Mix Variance or Gang Composition Variance
a) Labour Cost Variance (LCV)
This variance represents the difference between the Standard Labour Costs and the
Actual Labour Costs for the production achieved. If the Standard Cost is higher, the variation is
favourable and vice versa. It is calculated as follows:
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Labour Cost Variance: = (Standard Cost of Labour - Actual Cost of Labour)
= (Standard Time x Standard Rate) - (Actual Time x Actual
Rate)
= (ST x SR) - (AT x AR)
b) Labour Rate Variance (LRV)
It is the difference between the Standard Rate of pay specified and the Actual Rate Paid.
According to ICMA, London, the variance is “the difference between the standard and the
actual direct Labour Rate per hour for the total hours worked. If the standard rate is higher, the
variance is Favourable and vice versa.
Labour Rate Variance = Actual Time (Standard Wage Rate x Actual Wage Rate) V
=AT (SR-AR)
C) Labour Time Or Labour Efficiency Variance (LEV)
It is the difference between the Standard Hours for the actual production achieved and
the hours actually worked, valued at the Standard Labour Rate. When the workers finish the
specific job in less than the Standard Time, the variance is Favourable. If the workers take more
time than the allotted time, the variance is Adverse.
Labour Efficiency Variance (LEV):
= Standard Rate (Standard Time - Actual Time) =SR (ST-AT)
d) Idle Time Variance: It arises because of the time during which the Labour remains idle
due to abnormal reasons, i.e. power failure, strikes, machine breakdown, shortage of materials,
etc. It is always an adverse variance
Labour Idle Time Variance = Actual Idle Time x Standard Hourly Rate
e) Labour Mix Variance or Gang Compostion Variance (LMV):
It is the difference between the standard composition of workers and the actual gang of
workers. It is a part of labour efficiency variance. It corresponds to material mix variance. It
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enables the management to study the labour cost variance occurred because of the changes in
the composition of labour force.
The rates of pay of the different categories of workers-skilled, semi-skilled and unskilled
are different. Hence, any change made in composition of the workers will naturally cause variance.
How much is variance due to the change, is indicated by Labour Mix Variance.
(i) When the total hours i.e. time of the standard composition and actual composition of
workers does not differ the formula is:
Labour Mix variance= (Standard Cost of Standard Mix) - (Standard cost of Actual Mix)
(ii) When the total hours i.e. time of the standard composition and actual composition of
workers differs, the formula is:
Total Time of Actual mix

Labour Mix variance =
Total Time of Standard mix
X (Std cost of Std. mix) - (Std. cost of Actual Mix)
If, on account of short availability of some category of workers, the standard composition
is itself revised, then Labour Mix Variance will be calculated by taking revised standard mix in
place of standard mix.
Labour Yield Variance (LYV)
It is just like Material Yield Variance. It is the difference between the standard labour
output and actual output of yield. It is calculated as below:
Labour Yield Variance
=Standard cost per unit {Standard production of Actual mix - Actual Production}
16.7.3 Overhead Variance
It is the difference between standard overheads for actual output i.e. Recovered Overheads
and Actual Overheads. It is the total of both fixed and variable overhead variances. The variable
overheads are those costs which tend to vary directly in proportion to changes in the volume of
production. Fixed overheads consist of costs which are not subject to change with the change
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in the volume of production. The variances under overheads are analysed in two heads, viz
Variable Overheads and Fixed Overheads:
Overheads Cost Variance = Standard Total Overheads-Actual Total Overheads
The term overhead includes indirect material, indirect labour and indirect expenses and
the variances relate to factory, office or selling and distribution overheads. Overhead variances
are divided into two broad categories: (i) Variable overhead variances and (ii) Fixed overhead
variances. To compute overhead variances, the following terms must be understood:
Budgeted overheads
a) Standard overhead rate per unit =
Budgeted output
Budgeted overheads
b) Standard overheads rate per hour =
Budgeted hours
Budgeted hours
c) Standard hours for actual output = X Actual output
Budgeted output
Budgeted output
d) Standard output for actual time = X Actual hours
Budgeted hours
e) Recovered or Absorbed overheads = Standard rate per unit x Actual output
f) Budgeted overheads = Standard rate per unit x budgeted output
g) Standard overheads = Standard rate per unit x Standard output for

actual time
h) Actual overheads = Actual rate per unit x Actual output
Variable Overhead Variance
Variable cost varies in proportion to the level of output, while the cost is fixed per unit. As
such the standard cost per unit of these overheads remains the same irrespective of the level of
output attained. As the volume does not affect the variable cost per unit or per hour, the only
factors leading to difference is price. It results due to the change in the expenditure incurred.
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(i) Variable Overhead Expenditure Variance
It is the difference between actual variable overhead expenditure incurred and the standard
variable overheads set in for a particular period. The formula is:-
{Actual Hours Worked x Standard Variable Overhead Rate per hour} - Actual Variable
overheads
(ii) Variable Overhead Efficiency Variance
It shows the effect of change in labour efficiency on variable overheads recovery. The
formula is:- Standard Rate (Standard Quantity-Actual Quantity)
Standard Overhead Rate = (Standard Time for Actual output- Actual Time)
(iii) Variable Overhead Variance
It is divided into two: Overhead Expenditure Variance and Overhead Efficiency Variance.
The formula is:-
Variable overhead Expenditure Variance + Variable overhead Efficiency variance
Fixed Overhead Variance (FOV)
Fixed overhead variance depends on (a) fixed expenses incurred and (b) the volume of
production obtained. The volume of production depends upon (i) efficiency (ii) the days for
which the factory runs in a week (calendar variance) (iii) capacity of plant for production.
FOV = Actual Output (Fixed Overhead Rate - Actual Fixed Overheads)
(a) Fixed Overhead Expenditure Variance. (Budgeted or cost Variance). It is that portion
of the fixed overhead which is incurred during a particular period due to the difference between
the budgeted fixed overheads and the actual fixed overheads.
Fixed Overhead expenditure variance = Budgeted fixed overhead-Actual fixed overhead
(b) Fixed Overhead Volume Variance. This variance is the difference between the
standard cost of overhead absorbed in actual output and the standard allowance for that output.
This variance measures the over of under recovery of fixed overheads due to deviation of
actual output form the budgeted output level.
315
(i) On the basis of units of output
Fixed Overhead Volume Variance = Standard Rate (Budgeted Output-Actual Output) OR
= Budgeted Cost –Standard Cost)
OR
= (Actual Output x Standard Rate)-Budgeted fixed overheads
(ii) On the basis of standard hours
Fixed Overhead Volume Variance
= Standard Rate per hour (Budgeted Hours-Standard Hours)
Standard Hour = Actual Output + Standard Output per hour
Illustration 3
A manufacturing concern furnished the following information:
Standard: Material for 70kg, finished products: 100kg; Price of materials: Re.1 per kg
Actual: Output: 2,10,000 kg; Material used: 2,80,000; cost of material: Rs.5,52,000.
Calculate
(a) Material Usage Variance (b) Material Price Variance (c) Material Cost Variance
Solution
1. Standard quantity:
For 70kg standard output
Standard quantity of material = 100 kg
2,10,000 kg of finished products
2,10,000
= X 100 = 3,00,000 kg
70
316
2,52,000
Actual Price per kg = = Re. 0.90
2,80,000
(a) Material Usage or Quantity Variance
= SP (SQ-AQ)
= Re.1 (3,00,000-2,80,000)
= Re.1 * 20,000
= Rs.20,000 (Favourable)
(b) Material Price Variance
= AQ (SP - AP)
= 2, 80,000 (Re.1 – Re.0.90)
= 2, 80,000 * 0.10 paise
= Rs. 28,000 (Favourable)
(C) Material Cost Variance (MCV)

= (SQ x SP) - (AQ x AP)
= (3, 00,000 x 1) – (2,80,000 x 0.90)
= Rs. 3, 00,000 – Rs.2,52,000
= Rs. 48,000 (Favorable)
Illustration 4
Standard mix for production of “X"
Material A: 60 tonnes @ Rs. 5 per tonne
Material B: 40 tonnes @ Rs.10 per tonne
Actual mixture being:
Material A: 80 tonnes @ Rs.4 per tonne
Material B: 70 tonnes @ Rs. 8 per tonne.

317
Calculate
(a) Material Price Variance
(b) Material sub-usage Variance, and
(c) Material Mix Variance
Solution
(a) Material Price Variance
= AQ (SP - AP)
Material A = 80 (5-4) = Rs.80 (Favourable)
Material B = 70 (10-8) = Rs. 140 (Favourable)
MPV = 80 +140 = Rs 220 (Favourable)
(b) Revised standard quantity

= X Standard Quantity
150
RSQ for material ‘A’ = X 60 = 90 tonnes
100
150
RSQ for material ‘B’ = X 40 = 60 tonnes
100
Material sub usage (Revised usage) Variance =
Standard Price (Standard. Quantity – Revised Standard Quantity)
RUV for material ‘A’ = 5(60-90) = 150 (Adverse)
RUV for material ‘B’ = 10(40-90) = 200 (Adverse)
MRV = 150+200 = Rs. 350 (Adverse)
Material Mix Variance = Standard Rate x (Revised std. Quantity - Actual qty.)
MVV for material ‘A’ = 5(90-80) = 50 (Adverse)
MVV for material ‘B’ = 10(60-70) = 100 (Adverse)
MVV = 50-100 = (-50) = Rs.540 (Adverse)

318
Illustration 5
Vinak Ltd. produces an article by blending two basic raw materials. It operates a standard
costing system and the following standards have been set for new materials.
Material Standard Mix Standard price per kg
A 40% Rs. 4.00
B 60% Rs. 3.00
The standard loss in processing is 15%
During April 1994 the company produced 1700 kgs of finished output. The position of
stocks and purchases for the month of April 1994 is as under:
Material Stock on 1st April Stock on 31st Purchased During April

1995 (Kgs) April 1995 (Kgs) 1995
A 35 5 800 3400
B 40 50 1200 3000
Calculate: Material Price Variances, Material Usage Variances, Material yield variances,
Material Mix Variances and Total Material Cost Variances.
Solution
Finished output 1,700 kgs. Standard Loss in processing 15%.
Therefore, input is
100
= 1,700 X = 2000kgs
85
For an input of 2,000 kgs., the standard cost will be as follows:

319
Material Input Standard Standard Standard Standard

Mix Units price per kg Cost
(1) (2) (3) (4) = (2) X (3) (5) (6) = (4) X (5)
A 2000kgs 40% 800 kgs Rs. 4.00 Rs. 3,200
B 2000kgs 60% 1,200 kgs Rs. 3.00 Rs. 3,600
Total 2000 kgs Rs.6,800

Less 15% 300 kgs -
Finished Output 1,700 kgs Rs.6,800
6800
Standard Yield Rate = = Rs. 4 per kg
1700
Actual Costs
A= 35+800-5 = 830kgs. = 830kgs
Consumed 35 x 4 (assumed) = Rs. 140.00 = Rs. 140.00
795 x 4.25 (purchase price) = Rs. 3,378.75 = Rs. 3,378.75
Total = Rs. 3,518.75
B = 40 + 1,200-50 = 1190kgs
Consumed 40 x 3 (assumed) = 120.00
1150 x 2.50(purchase price) = 2,875.00
Total = Rs. 3,518.75
Total 2,020 6,513.75
Less: Loss 320 -
Finished output 1,700 6,513.75

320
Material Price Variance = AQ (SP-AP)
A = 830 x 4 = 3,320 - 3,518.75 = Rs.198.75 (A)
B = 1,190 x 3 = 3,570 - 2,995 = Rs. 575.00 (F)
Total = Rs. 376.25 (F)
Material Usage Variance = SP(SQ-AQ)
A = 4 (800-830) = 120(A)
B= 3 (1,200-1,190) = 30(F)
= Rs. 90(A)
Material Yield Variance = SYR* (AY-SY)
= 4(1700-1717) = 68(A)
If SY For 2000 kgs. input SY = 1700
ThenFor 2020 kgs. input SY = x : (2020 /2000) x 1700 =1717 kgs
Material Mix Variance (MMV) = SP (RSQ-AQ)

Revised standard quantity = X Standard Quantity
2.020
For ‘A’ = 800 x = 808
2000
2.020
For ‘B’= 1,200 x = 1,212
2000
Material Mix Variance
For ‘A’ = 4 (808-803) = 88 (A)
For ‘B’ = 3 (1,212-1,190) = 66 (F)
= Rs. 22(A)
321
Material Cost Variance
= (SC - AC) = (6,800 - 6,513.75) = Rs. 286.25(F)
Labour Variance
Illustration 6
With the help of following information calculate
(a) Labour Cost Variance

(b) Labour Rate Variance
(c) Labour Efficiency Variance
Standard hours: 40@ Rs. 3 per hour
Actual hours: 50@ Rs. 4 per hour
Solution
(a) Labour Cost Variance = (Standard Time x Standard Rate) - (Actual Time x Actual Rate)
= (40 x Rs.3) – (50 x Rs.4)
= (Rs.120 - 200) = Rs.80
= Rs.80 (Adverse)
(b) Labour Rate Variance = Actual Time (Standard Rate x Actual Rate)
= 50 (Rs.3 - Rs.4) = Rs. 50
= Rs. 50 (Adverse)
(c) Labour Efficiency Variance = Standard Rate (Standard Time-Actual Time)
= Rs.3 (40-50) = Rs.30
= Rs.30 (Adverse)
322
Illustration 7
The Labour budget of a company for a week is as follows:
20 skilled men @ 50 paise per hour for 40 hours = 400
= 880
The actual labour force was used as follows:
30 skilled men @ 50 paise per hour for 40 hours‘ = 600
= 1,020
Compute labour variances.
Solution
1. Labour Rate Variance = AT (SR - AR)
(a) Skilled men = 1,200 (Rs.50 - Rs.50) = 0
(b) Unskilled men = 1,200 (Rs.30 - Rs.35) = Rs.60 (A)
2. Labour Mix variance = SR (ST - AT)
(a) Skilled men = Rs.0.50 (800 -1200) = Rs.200 (A)
(b) Unskilled men = Rs.0.30 (1600 -1200) = Rs.120 (F)
Total Labour Cost Variance = Standard labour cost - Actual cost
= 880-1020 = 140 (A)
Illustration 8
Standard labour hours and rate for production of Article A are given below:
Hrs. Rate (Rs.) Total (Rs.)
Skilled worker 5 1.50 per hour 7.50
Unskilled worker 8 0.50 per hour 4.00
Semi-skilled worker 4 0.75 per hour 3.00
323
Calculate: Labour Cost Variance, Labour Rate Variance, Labour Efficiency Variance and
Labour Mix Variance
Solution
(a) Labour Cost Variance
= (Standard Time x Standard Rate) - (Actual Time x Actual Rate)
Standard Time for Actual Production =Actual Units x ST.
Skilled Worker = 1,000 x 5 = 5000 Hrs.
Unskilled worker = 1,000 x 8 = 8,000 Hrs.
Semi-skilled worker = 1,000 x 4 = 4,000 Hrs.
Labour Cost Variance
Skilled worker = (5000 x Rs.1.50) – (4,500 x 2)
= Rs.7,500 – Rs.9,000 = Rs.1,500 (A)
Unskilled worker = Rs. (8,000 x Rs.0.50) – (10,000 x 0.45)
= 4,000 - 4,500 = Rs.500 (A)
Semi skilled worker = (4,000 x Rs.0.75) – (4,200 x Rs.0.75)
= 3,000-3,150) = Rs.150 (A)
Total Labour Cost Variance = Rs.2150 (A)
(b) Labour Rate Variance = Actual Time (Standard Rate x Actual Rate)
Skilled worker = 4500 (1.50 - 2) = Rs.2250 (A)
Unskilled worker = Rs.4,200 (0.75 – 0.75) = Nil
Semi skilled worker = 1,000 (0.50 - 0.45) = Rs.500 (F)
Total Labour Rate Variance = Rs.1,750 (A)
(c) Labour mix variance: = SR (Revised std. Mix of Actual hours worked) – Actual Mix
Std Mix
Revised Standard mix of actual hours worked = X Total Actual Hrs.
Total Std. Hours
324
5,000
Skilled worker = X 18,700 = 5,500 Hrs
17,000
8,000
Unskilled worker = X 18,700 = 8,800 Hrs.
17,000
4,000
Semi skilled worker = X 18,700 = 4,400 Hrs
17,000
Labour Mix Variance:
Skilled worker = 1.50 (5,500 - 4,500) = Rs.1,500 (F)
Unskilled worker = 0.50 (8,800-10,000) = Rs.600 (A)
Semi skilled worker = 0.75 (4,400 - 4,200) = Rs.150 (F)
Total Labour Mix Variance = Rs.1050 (F)
(d) Labour Efficiency Variance = SR (ST for Actual output – Revised Std. Hrs)
Skilled worker = 1.50 (5,000 - 5,500) = Rs.750 (A)
Unskilled worker = 0.50 (8,000 - 8,800) = Rs.400 (A)
Semi skilled worker = 0.75 (4,000 - 4,400) = Rs.300 (A)
Total Labour Efficiency Variance = Rs. ,450 (A)
Illustration 9
S.V. Ltd has furnished you the following data:
Budget Actual July 1994
No. of working days 25 27
Production in units 20,000 22,000
Fixed overheads Rs.30,000 Rs.31,000
Budgeted fixed overhead rate is Re. 1 per hour. In July 1994, the actual hours worked
were 31,500.
325
Calculate the following variance: (i) Efficiency Variance (ii) Capacity variance (iii) Volume
variance (iv) Expenditure variance and (v) Total overhead variance.
Solution
Budgeted overhead
Recovered overhead = X Actual output
Budgeted output
30,000
= x 22,000 = 33,000
20,000
(i) Efficiency Variance = Standard Rate per hour (Standard hours for actual production – Actual
hours)
= Re. 1 x (33,000 – 31,500)
= Rs.1,500 (F)
(ii) Capacity Variance = Standard Rate per hour x (Actual hours - Budgeted hours)
= Standard overheads - Budgeted overheads = Re. 1 x (31,500 – 30,000)
= Rs.1500 (F)
(iii) Volume variance = Recovered overhead – Budgeted overheads
= Rs. 33,000 – Rs. 30,000
= Rs. 3,000 (F)
(iv) Expenditure variance = Budgeted overheads – Actual overheads
= Rs.30,000 – Rs.31,000
= Rs.1,000 (A)
(v) Total overhead variance = Recovered overhead – Actual overheads
= Rs.33,000 – Rs.31,000
= Rs.2,000 (F)
326
Illustration 10
Vinak Ltd.has furnished you the following for the month of August 1994. Budget
Budgeted Actual
Output (Units) 30,000 32,500

Hours 30,000 33,000
Fixed hours Rs. 45,000 50,000
Variable overhead Rs. 60,000 68,000
Working days 25 26
Calculate the variances.
Solution
Standard Overhead Rate per Unit

Budgeted overhead
=
Budgeted output
30,000
= = 1 hours
30,000
Total standard overhead rate per hour

Budgeted overhead
=
Budgeted output
1,05,000
= = Rs.3.50 per hour
30,000
Standard fixed overhead rate per hour
Budgeted fixed overheads

=
Budgeted hours
45,000
= = Rs.1.50
30,000
327
Standard variable overhead rate per hour
Budgeted var iable overheads

=
Budgeted hours
60,000
= = Rs.2
30,000
Overhead cost variance = Recovered overheads – Actual overheads
Recovered overhead = Actual output x Standard Rate per unit
= 32,500 x Rs.3.50 = Rs.1,13,750
Overhead cost variance = 1,13,750 – 1,18,000
= Rs.4,250 (A)
Variable overhead cost variance = Recovered overheads – Actual overheads
= 32,500 hrs x Rs.2 – Rs.68,000
= Rs.3,000 (A)
Fixed overhead cost variance = Recovered overheads – Actual overheads
= 32,500 hrs x Rs.1.50 – Rs.50,000
= 48,750 – 50,000
= Rs.1,250 (A)
Expenditure variance = Budgeted overheads – Actual overheads
= Rs.45,000 – Rs.50,000
= Rs.5000 (A)
Volume variance = Recovered overheads- Budgeted overheads
= 32500 hrs x Rs.1.50 – 45,000
= 48,750 – 45,000
= Rs.3,750 (F)
328
Efficiency variance = Recovered overheads- standard overheads
OR
Standard rate (Standard hours for actual output – Actual hours)
= 1.50 (32,500 – 33,000)
= Rs.750 (A)
Capacity variance = standard overheads – Budgeted overheads
= Standard Rate (Actual hours - Budgeted hours)
= Rs.1.50 (33,000 – 30,000)
= Rs.4,500 (F)
Calendar variance = Extra / Deficit hours worked x Standard Rate.
One extra day has been worked.
The Total number of extra hours worked
30,000
= = 1,200
25
= 1,200 x 1.50 = Rs.1,800 (F)
Note:
1. (F) – Favourable; (A) – Adverse (or) Unfavaourable
2. When Standard is more than the Actual, it is favourable variance
3. When Actual is more than the Standard, it is unfavourable or adverse variance
4. In place of „Time , the term „Hours may also be used.
16.8 Summary
The functions of standard costing has been explained. Variance analysis involves
computation of material, labour and overhead variance.
329
16.9 Key Words

Standard Cost
Material Variance
Labour Variance
Overhead Variance

1. Following is the data of a manufacturing concern. Calculate:-
Material Cost Variance, Material Price Variance and Material usage variance.
The standard quantity of materials required for producing one ton of output is 40 units.
The standard price per unit of materials is Rs. 3. During a particular period 90 tons of output
was undertaken. The materials required for actual production were 4,000 units. An amount of
Rs. 14,000 units. An amount of Rs.14, 000 was spent on purchasing the materials.
2 The standard materials required for producing 100 units is 120 kgs. A standard price of
0.50 paise per kg is fixed 2,40,000 units were produced during the period. Actual materials
purchased were 3,00,000 kgs. at a cost of Rs. 1,65,000. Calculate Materials Variance.
3 From the data given below, calculate: Material Cost Variance, Material Price Variance
and Material Usage Variance
Products Standard Quantity Standard Actual Quantity Actual Price

(units) Price Rs. (units)
A 1,050 2.00 1,100 2.25
B 1,500 3.25 1,400 3.50
C 2,100 3.50 2,000 3.75
4 From the following information, calculate material mix variance:
Materials Standard Actual

Quantity Price per unit Quantity Price per unit
(units) Rs. (units) Rs.
A 40 10 50 12
B 60 5 50 8
330
5 Calculate material mix variance from the data given as such:

Quantity (units) Price per Quantity Price per unit
unit Rs. (units) Rs.
A 50 2.00 60 2.25
B 100 1.20 90 1.75
Due to the shortage of material A, the use of material ‘A’ was reduced by 10% and that of ‘B’
increased by 5%
6. From the following data calculate various material variances:

A 80 8.00 90 7.50
B 70 3.00 80 4.00
7. From the following information, Calculate material yield variance:

A 80 5 60 4.50
B 70 9 90 8.00
150 150
There is a standard loss of 10%. Actual yield is 125 units.
8. The standard Mix of a product is as under
Material Units Cost per Unit (Paise) Cost (Rs.)

A 60 15 9.00
B 80 20 16.00
C 100 25 25.00
Total 2,440 50.00

331
Ten units of finished product should be obtained from the above mentioned mix.
During the month of January, 1978, ten mixes were completed and the consumption was as
follows
Material Units Cost per Unit Cost

(Paise) (Rs.)
A 640 15 128.00
B 960 20 144.00
C 840 25 252.00
Total 240 524.00
The actual output was 90 units. Calculate various material variances.
9. In a manufacturing concern, the standard time fixed for a month is 8,000 hours. A standard
wage rate of Rs. 2.25 P. per hour has been fixed. During one month, 50 workers were
employed and average working days in a month are 25. A worker works for 7 hours in a
day. Total wage bill of the factory for the month amounts to Rs. 21,875. There was a
stoppage of work due to power failure (idle time) for 100 hours. Calculate various labour
variances.
10. The information regarding the composition and the weekly wage rates of labour force
engaged on a job scheduled to be completed in 30 weeks are as follows:
Standard Actual
Category of No. of Weekly wage No. of workers Weekly wage

workers workers rate per rate per
worker (Rs.) worker (Rs.)
Skilled 75 60 70 70
Semi skilled 45 40 30 50
Unskilled 60 20 80 20
The work was completed in 32 weeks. Calculate various labour variances.

332
11 The following data is taken out from the books of a manufacturing concern.
Budgeted labour composition for producing 100 articles

20 Men @ Rs. 1.25 hour for 25 hours
30 women @ 1.10 per hour for 30 hours
Actual labour composition for Producing 100 articles

25 Men @ Rs. 1.50 per hour for 24 hours
25 women @ Re. 1.20 per hour for 25 hours
Calculate: (i) Labour Cost Variance, (ii) Labour Rate Variance, (iii) Labour Efficency
Variance, (iv) Labour Mix Variance.
12. Calculate labour variances from the following data:
Standard Actual
Output in units 2,000 2,500
Number of workers employed 50 60
Number of working days in a month 20 22
Average wage per man per month (Rs.) 280 330
13. From the following information compute;

(i) Fixed Overhead Variance
(ii) Expenditure Variance
(iii) Volume Variance
(iv) Capacity Variance
(v) Efficiency Variance
Budget Actual
Fixed overheads for November Rs. 20,000 Rs. 20,400
Units of production in November 10,000 10,400
Standard time for 1 unit = 2 hours
Actual Hours Worked = 20,100 hours

333
14. From the following information, calculate various overhead variances:
Budget Actual
Output in units 12,000 14,000
Number of working days 20 22
Fixed Overheads (Rs.) 36,000 49,000
Variable Overheads 24,000 35,000
There was an increase of 5% in Capacity.

Pearson, 2012.

2011.
334
Model Question Paper

MBA Degree Examination, DECEMBER 2018
First Year – First Semester
Paper - IV
Time : 3 Hours Maximum : 80 Marks
SECTION - A
Answer any TEN of the following in 50 words each (10 x 2 = 20 Marks)
1. What are journals?
2. What are ledgers ?
3. List out the objectives of Financial statement analysis.
4. What are Fund Flow statements ?
5. What are Cash Flow statements?
6. What is marginal costing ?
7. What is margin of safety?
8. What are make or buy decisions?
9. What is a budget?
10. What is budgeting control?
11. What is P/V ratio?
12. What is a balance sheet ?
SECTION - B
Answer any FIVE of the following in 250 words each ( 5 x 6 = 30 Marks)
13. Distinguish Financial accounting and Management Accounting.
14. Distinguish Fund flow and Cash flow statements.
15. Distinguish book keeping and accounting.

335
16. What are the steps in Financial Statement analysis.
17. What are the limitations of Cash flow analysis ?
18. Following information are available from the cost records of a manufacturing company:
Fixed expenses Rs.4,000
Break-even point Rs.10,000
You are required to calculate:
(i) P/Vratio
(ii) Profit where sales are Rs.20,000
(iii) New break even point if selling price is reduced by 20%.
19. List out the objectives of reporting.
SECTION - C
Answer any THREE questions in about 500 words each (3 x 10 = 30 Marks)
20. The following is the trial balance of Mr.Govil as on 31.3.2000
Particulars Dr Cr
Cash in hand 540
Cash at bank 2,630
Purchases 40,675
Sales 98,780
Returns inwards 680
Returns outwards 500
Wages 10,480
Fuel and power 4,730
Carriage on sales 3,200
Carriage on purchases 2,040
Opening stock 5,760

336
Buildings 30,000
Freehold land 10,000
Machinery 20,000
Patents 7,500
Salaries 15,000
Insurance 600
Drawings 5,245
Capital 71,000
1,76,580 1,76,580
Prepare trading and profit and loss account and the Balance sheet as on 31-3-2000. The
stock as on 31.3.2000 is Rs.6,800.
21. Explain the types of budgets
22. Briefly explain the techniques of Financial statements.
23. Two articles A and B are manufactured in a department. Sales for the year 2003 were
planned asfollows:
Product 1st quarter 2nd quarter 3rd quarter 4th quarter

Units Units Units Units
A 5,000 6,000 6,500 7,500
B 2,500 2,250 2,000 1,900
Selling price were Rs. 10 per unit for A and Rs. 20 per unit for B respectively.
Average less return are 10% of sales and the discounts and bad debts amount to 2% of
the total sales. Find the break even point.
337
24. The following is the Trial balance as on 31st December 1992 extracted from the books of
ABC Ltd..
Particulars Debit Credit

Rs. Rs.
Freehold Land 35,000

Mortgage Loan 20,000
Loose tools 1.1.92 5,600
Bills payable 3,400
Book debts 18,200
Sales 1,21,500
Cash at bank 11,000
Stock 1.1.1992 10,500
Insurance 300
Bad debts 560
Purchases 50,000
Cash on hand 640
Rent, Rates, etc. 1,300
Interest 250
Wages 10,700
Trade expenses 150
Salary 1,560
Repairs to plant 875
Carriage Inwards 350
Discount 290 175
Capital 40,000
Drawings 2,500
2,00,675 2,00,675
338
Prepare trading and profit and loss account and balance sheet after making the following
adjustment:
a) Provision for doubtful debts at 5% on book debts;
b) Interest on capital at 5%
c) unexpired insurance premium Rs.90;
d) Rent outstanding on 31-12-92 Rs.300;
e) Loose tools revalued at Rs.4,500,
f) Closing stock Rs.30,000.
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SPBA 104

ACCOUNTING FOR MANAGERS

INSTITUTE OF DISTANCE EDUCATION

It is with a great pleasure to welcome you as a student of Institute of Distance

With best wishes from mind and heart,

COORDINATION AND EDITING

© UNIVERSITY OF MADRAS, CHENNAI 600 005.

ACCOUNTING FOR MANAGERS

ACCOUNTING FOR MANAGERS

Sl.No. Title Page

2. Principles of Accounting 016

3. Journal and Ledger 024

4. Subsidiary Books 039

5. Trial Balance 062

6. Final Accounts 069

7. Final Accounts with Adjustments 098

8. Management Accounting 123

9. Financial Statement Analysis 135

10. Tools of Financial Statement Analysis 149

11. Marginal Costing 183

12. Marginal Costing and Managerial Decision Making 210

13. Budget & Budgetary Control 223

14. Reporting to Management 256

15 Standard Costing and Variance Analysis 270

16 Cost Accounting 296

After reading this lesson, you will be able to:

 Define the term Book Keeping

 List out objectives and Importance of Accounting

 Discuss the methods and branches of Accounting

 Explain the advantages and limitations of Accounting

 Distinguish Book keeping and Accounting

1.4 Methods of Accounting

1.4.1 Single Entry

1.4.2 Double Entry

1.4.3 Steps involved in Double Entry System

1.4.4 Advantages of Double Entry System

1.5 Meaning of Debit and Credit

1.6 Types of Accounts and Its Rules

1.6.1 Personal Accounts

1.6.2 Real Accounts

1.6.3 Nominal Accounts

1.7 Distinction between Book Keeping and Accounting

1.8 Branches of Accounting

1.8.1 Financial Accounting

1.8.2 Cost Accounting

1.8.3 Management Accounting

1.10 Key Words

1.11 Review Questions

1.12 Suggested Readings

“Book- keeping is the art of recording business transactions in a systematic manner”.

 Entries related to incomes and expenditures of a concern facilitate to know the

 It enables to prepare a list of customers and suppliers to ascertain the amount to be

 Amendment of business laws, provision of licenses, assessment of taxes etc.,are

Accounting, as an information system is the process of identifying, measuring and

American Institute of Certified Public Accountants (AICPA) which defines accounting as

viii) Research Scholars: Accounting information, being a mirror of the financial

i) Record Keeping Function: The primary function of accounting is recording, classifying

ii) Managerial Function: Decision making programme is greatly assisted by accounting.

iii) Legal Requirement function: Auditing is compulsory in case of registered firms.

iv) Language of Business: Various transactions are communicated through accounting.

The following are the advantages of accounting to a business:

 It helps in having complete record of business transactions.

 It provides useful information form making economic decisions,